The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. Please see “Note on Forward-Looking Statements” and “Risk Factors” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K.
The claims emergence patterns for various marine product lines vary substantially. Our largest marine product line is marine liability, which has one of the longer loss development patterns. Marine liability protects an insured’s business from liability to third parties stemming from their marine-related operations, such as terminal operations, stevedoring and marina operations. Since marine liability claims generally involve a dispute as to the extent and amount of legal liability that our insured has to a third party, these claims tend to take a longer time to develop and settle. Other longer-tail marine product lines include P&I insurance, which provides coverage for third party liability as well as injury to crew for vessel operators, and transport insurance, which provides both property and third party liability on a primary basis to businesses such as port authorities, marine terminal operators and others engaged in the infrastructure of
Property Casualty: The reserves for property and casualty are established separately by product with the major product being contractors’ liability insurance. Other products include offshore energy, commercial middle markets, primary casualty and excess casualty. Our actuaries generally utilize two key assumptions in this line of business: first, that our historical loss development patterns are reasonable predictors of future loss patterns and second, that our claims personnel’s assessment of our claims exposures and our underwriters’ assessment of our expected losses are reliable indicators of our loss exposure. However, this line of business includes a number of newer products where there is insufficient Company historical experience to project loss reserves and/or loss development is sparse or erratic, which makes extrapolation techniques for those products extremely difficult to apply, and in those circumstances we typically rely more on industry data and our underwriters’ input in setting assumptions for our IBNR loss reserves as opposed to historical loss development patterns. In addition, as discussed in more detail below with respect to construction defect reserves, our actuaries may take other market trends or events into account in setting IBNR loss reserves.
Professional Liability: The professional liability policies mainly provide coverage on a claims-made basis mostly for a one-year period. The reserves for professional liability are analyzed separately by product. The major products are D&O liability coverage and E&O liability coverage for lawyers and other professionals.
The marine liability, offshore energy and cargo products and related loss exposures are similar in nature to that described for marine business above. Specie insurance provides property coverage for chattel, such as jewelry, fine art and cash in transit. Claims tend to be from theft or damage, quick to report and quick to settle. Marine reinsurance is a diversified global book of reinsurance, the majority of which consists of excess-of-loss reinsurance policies for which claims activity tends to be large and infrequent with loss development somewhat longer than for such products written on a direct basis. Marine reinsurance reinsures liability, cargo, hull and offshore energy exposures that are similar in nature to the marine business described above.
Set forth below is a sensitivity analysis that estimates the effect on our net loss reserve position of using alternative expected loss ratios for the underwriting years 2003 to 2010 and alternative loss development factors for underwriting years beginning in the late 1990’s to 2010 rather than those loss ratios and factors actually used in determining our best estimates at December 31, 2010. The analysis addresses each major line of business and underwriting year for which a material deviation to our overall reserve position is believed reasonably possible, and uses what we believe is a reasonably likely range of potential deviation for each line of business. There can be no assurance, however, that actual reserve development will be materially consistent with either the original or the adjusted expected loss ratios or loss development factor assumptions, or with other assumptions made in the reserving process.
The reasonably likely ranges of potential deviation in the loss ratios for each line of business for the 2003 to 2010 underwriting years expressed in loss ratio points are as follows:
For the loss development factor variance, our actuaries employed a standard technique which is based on the historical development factors observed for each line of business from the paid and incurred loss development triangles with the latest evaluation at December 31, 2010. The historical factors are used to generate alternative outcomes which could arise in the ultimate development due to the random variability inherent in future development. The alternative outcomes are generated by a stochastic simulation. The ranges may contract or expand if future development deviates from historical experience.
In the first quarter of 2009, we adopted accounting guidance relating to the recognition and presentation of other-than-temporary impairments (“OTTI”) on fixed maturity securities. When assessing whether the amortized cost basis of a fixed maturity security will be recovered, we compare the present value of cash flows expected to be collected to the current book value. Any shortfalls of the present value of the cash flows expected to be collected in relation to the amortized cost basis is considered the credit loss portion of OTTI losses and is recognized in earnings. All non-credit losses are recognized as changes in OTTI losses within Other Comprehensive Income (“OCI”). Prior to 2009, when a fixed maturity security in our investment portfolio had an unrealized loss that was deemed to be other-than-temporary, we wrote the security down to fair value through a charge to operations.
Day to day management of our investment portfolio is outsourced to third party investment managers. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss based upon a change in market and other factors described above. Investment managers are required to notify management of rating agency downgrades of securities in their portfolios as well as any potential investment valuation issues at the end of each quarter. Investment managers are also required to notify management, and receive approval, prior to the execution of a transaction or series of related transactions that may result in a realized loss above a certain threshold. Additionally, investment managers are required to notify management, and receive approval, prior to the execution of a transaction or series of related transactions that may result in any realized loss up until a certain period beyond the close of a quarterly accounting period.
Our total gross written premiums declined 5.5% in 2010 primarily due to several factors:
Intense competition, excess capacity and a continued weak economy have driven down premiums across the majority of our Marine lines as well as our construction liability line
Improvements in our offshore energy line due to greater demand as well as improved pricing following the Deepwater Horizon incident
2009 net income of $63.2 million increased compared to 2008 primarily as a result of a decrease in net other-than-temporary impairment losses recognized in earnings that caused the net realized loss to decline to $2.7 million in 2009 from $38.3 million in 2008. Underwriting profit for 2009 declined by $19.8 million to $19.5 million compared to $39.3 million in 2008. The decline in the underwriting profit was primarily due to the recording of net favorable development of prior year loss reserves of $8.9 million in 2009 versus $50.7 million in 2008, a decline of $41.8 million. In addition, we recorded a $9.3 million offshore energy loss inclusive of reinstatement premiums resulting from a fire at a mobile offshore drilling unit.
The 2008 results of operations were adversely impacted by hurricane activity and net realized losses. Hurricanes Gustav and Ike reduced 2008 net income by $19.1 million and earnings per share by $1.12. The combined loss and expense ratio was increased by an aggregate 4.3 ratio points for such losses and are inclusive of reinsurance recoveries and related costs for reinsurance reinstatement premiums. Excluding these effects, the underwriting results benefited from increased net premium revenues despite continuing softening market conditions, and the recording of net favorable development of prior years’ loss reserves of $50.7 million, or $1.94 per share, which reduced the 2008 combined ratio of 93.8% by 7.9 loss ratio points.
Net realized losses were $38.3 million in 2008 compared to net realized gains of $2.0 million in 2007. The 2008 net realized losses include provisions of $37.0 million for declines in the market value of securities which were considered to be other-than-temporary. These provisions reduced 2008 net income by $24.1 million and earnings per share by $1.42 per share.
The following table sets forth our gross and net written premiums, and net earned premiums by segment and line of business for the periods indicated:
The marine gross written premiums for 2010 decreased 7.6% to $223.1 million compared to 2009 due to declining premium in our P&I, marine liability, transport and cargo businesses. The competition in this sector remains significant and excess capacity continues to exist. The weak economy has also led to reduced exposure bases which reduced premiums. The average marine renewal premium rates during 2010 increased approximately 1%. The marine gross written premiums for 2009 decreased 2.7% to $241.4 million compared to 2008 due to declining premium in our cargo, war and P&I businesses due to increased competitive market conditions. The average marine renewal premium rates during 2009 increased approximately 2%.
The 2010 property casualty gross written premiums decreased 11.3% to $312.7 million when compared to 2009 due primarily to the run-off of our personal umbrella line as well as continuing weak economic conditions that have reduced demand for construction liability insurance. Our Offshore energy line increased by 10.1% due to greater demand as well as an improved pricing environment resulting from the Deepwater Horizon incident. Finally, our commercial umbrella business line experienced growth in 2010 due to the investments we made in 2008 and 2009 in new underwriters. Our Offshore energy line saw average renewal rate increases of approximately 4%, whereas our contractors’ liability and excess casualty saw average renewal rate decreases of approximately 5% and 3%, respectively. Our primary casualty line saw a slight average renewal rate decline from 2009.
The 2010 Lloyd’s marine gross written premiums decreased 4.8% to $182.7 million compared to 2009 due to declines mostly in Cargo and specie lines as a result of the global economic slowdown. Our marine liability lines experienced a 19.6% increase due to improved energy liability activity. The overall 2009 Lloyd’s marine gross written premiums of $192.0 million were flat compared to 2008. There were increases in most lines of business which were offset by decreases in marine liability and cargo lines. The average renewal premium rates increased approximately 3% and 9% in 2010 and 2009 compared to the previous years, respectively.
The percentage of total ceded written premiums to total gross written premium in 2010 was 33.8% compared to 32.9% in 2009 and 39.0% in 2008. For the year ended December 31, 2010, the shift in business mix toward lines with lower cessions was offset by the impact of reinsurance reinstatement costs of $19.0 million and $3.5 million resulting from the Deepwater Horizon and West Atlas losses, respectively. The Insurance Companies’ and Lloyd’s Operations 2008 ceded written premiums includes $7.2 million and $5.0 million, respectively, of reinsurance reinstatement premiums related to the losses from Hurricanes Gustav and Ike. Excluding the effect of reinsurance reinstatement premiums for the 2008 Hurricanes losses, the ratio of ceded written premium to gross written premium was 38.4%. The declines in the ratio of ceded written premiums to gross written premiums in 2009 compared to 2008 was due to a reduction in the amount of marine and energy quota share reinsurance purchased for both the Insurance Companies and Lloyd’s Operations in 2009 as well as the impact of the $12.2 million of reinsurance reinstatement premiums recognized in 2008 relating to the 2008 Hurricanes.
Net Written Premiums The 2010 net written premiums decreased 6.7% compared to 2009. The impact of lower gross written premiums was offset by the decline in ceded written premiums discussed above. The 2009 net written premiums increased 6.0% compared to 2008 primarily due to the aforementioned reduction in the amount of marine and energy quota share reinsurance purchased in 2009. The 2009 increase was 4.1% compared to 2008 when excluding the $12.2 million of ceded reinstatement premiums resulting from the 2008 Hurricanes.
Net Earned Premiums Net earned premiums decreased 3.4% in 2010 compared to 2009 and increased 6.1% in 2009 compared to 2008. The changes in the 2010 and 2009 net earned premiums reflect the changes in written premiums discussed above. The 2008 net earned premium was reduced by $12.2 million of reinstatement premium as a result of the losses from the 2008 Hurricanes. Excluding the effects of ceded reinstatement premiums as a result of the 2008 Hurricanes, net earned premium increased 4.1% in 2009 compared to 2008 and 9.0% in 2008 compared to 2007.
Consequently, the cost of such securities was written down to fair value and we recognized realized losses of $28.4 million. The equity impairments include $8.6 million in write-downs to fair value for various broad based ETFs and mutual funds where the fair value was less than 80% of the book value. During 2008, we indentified fixed maturity securities with fair value of $7.4 million which were considered to be other-than-temporarily impaired. Consequently, the cost of such securities was written down to fair value and we recognized realized losses of $8.6 million.
Pre-tax net income included $41.3 million of net realized gains for 2010 compared to $9.2 million of net realized gains for 2009 and net realized losses of $1.3 million for 2008. On an after-tax basis, the net realized gains for 2010 were $26.9 million or $1.64 per diluted share compared to net realized gains of $5.9 million or $0.34 per diluted share for 2009 and net realized losses of $0.8 million or $0.05 per diluted share for 2008. Net realized gains and losses are generated from the sale of securities in the normal course of management of the investment portfolio. Our net realized gains for the year ended December 31, 2010 included the sale of the majority of our general obligation municipal obligations in the second quarter of 2010, the proceeds of which were reinvested in corporate bonds and agency mortgage-backed securities.
The ratios of net losses and loss adjustment expenses to net earned premiums (loss ratios) were 63.8% in both 2010 and 2009 and 61.0% in 2008. The 2010 loss ratio of 63.8% was favorably impacted by 2.1 loss ratio points resulting from a $13.8 million net favorable development of prior years’ loss reserves.
During 2008, reserve reductions resulting from periodic reviews of the 2005 Hurricanes’ exposures reduced gross losses incurred by $12.3 million. The reductions to the 2005 Hurricanes gross reserve estimates resulted in reductions of $1.0 million to our 2008 net loss incurred estimates and reductions of $0.8 million to our 2008 reinstatement cost estimates. During 2009 there was a minor increase in the gross and net losses incurred for the 2005 Hurricanes of $0.7 million and $0.1 million, respectively. In 2010, we reduced gross and net losses incurred by $2.3 million and $3.6 million, respectively.
Prior year reserve redundancies of $13.8 million, $8.9 million and $50.7 million net of reinsurance were recorded in 2010, 2009 and 2008, respectively, as discussed below. The relevant factors that may have a significant impact on the establishment and adjustment of loss and LAE reserves can vary by line of business and from period to period.
To the extent that reserves are deficient or redundant, the amount of such deficiency or redundancy is recorded as a charge or credit to earnings in the period in which the deficiency or redundancy is identified based on the information that is available at that time.
Following is a discussion of relevant factors impacting our 2010 loss reserves:
$29.2 million for West Coast contractors’ liability due to an internal actuarial review conducted in 2010 which indicated that loss development on underwriting years 2006 to 2008 has been more favorable than our prior expectations with a partial offset for underwriting years 2004 and prior. This internal review includes a more detailed analysis than is included in our regular quarterly reserving process.
The directors and officers’ liability book of business had $15.7 million of adverse development, which was primarily attributable to a severity study of our open claims completed during the fourth quarter. This study showed our IBNR to be significantly deficient if current trends continued and we raised our loss estimates for underwriting years 2002 to 2009. This was partially offset by $1.4 million of favorable development on a run-off lawyers book of business written from London where we saw favorable settlements of outstanding claims and $0.7 million of favorable development on other lawyers business mostly due to a favorable claim reserve settlement.
$9.3 million from our primary E&S lines and $6.2 million in excess casualty business due to favorable loss trends in underwriting years 2007 and prior
$6.4 million from our liquor business, which is now in run-off
We believe that there are no remaining known claims where we would suffer a material loss as a result of excess policy limits being exposed to class action suits for insureds involved in the manufacturing or distribution of asbestos products. There can be no assurances, however, that material loss development may not arise in the future from existing asbestos claims or new claims given the evolving and complex legal environment that may directly impact the outcome of the asbestos exposures of our insureds.
The following tables set forth our gross and net loss and LAE reserves for our asbestos exposures for the periods indicated:
The ceded asbestos paid and unpaid recoverables were $8.4 million and $8.9 million in 2010 and 2009, respectively. We believe that we will be able to collect reinsurance on the gross portion of its historic gross asbestos exposure in the above table.
Other Operating Expense. The 5.3% increase in other operating expenses when comparing 2010 to 2009 was due primarily to investments in new underwriting teams, additional letter of credit fees due to the increased size of our facility, higher Lloyd’s charges due to greater capacity and higher compliance costs, particularly relating to Solvency II. For the year ended December 31, 2010, our operating expense ratios increased due to the explanations above as well as the impact of the reinstatement costs of $19.0 million and $3.5 million resulting from the Deepwater Horizon and West Atlas losses, respectively, which resulted in lower net earned premiums and therefore increased the operating expense ratios. The 7.7% increase in other operating expenses when comparing 2009 to 2008 was attributable primarily to employee related expenses resulting from expansion of the business.
We had net state and local deferred tax assets amounting to potential future tax benefits of $2.2 million and $2.6 million at December 31, 2010 and 2009, respectively. Included in the deferred tax assets are net operating loss carryforwards of $1.4 million and $1.3 million at December 31, 2010 and 2009, respectively. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. Our state and local tax carryforwards at December 31, 2010 expire from 2023 to 2025.
We evaluate the performance of each segment based on its underwriting and GAAP results. The Insurance Companies’ and the Lloyd’s Operations’ results are measured by taking into account net earned premiums, net losses and loss adjustment expenses, commission expenses, other operating expenses, and other income (expense). Each segment also maintains its own investments, on which it earns income and realizes capital gains or losses. Our underwriting performance is evaluated separately from the performance of our investment portfolios.
The following table sets forth the results of operations for the Insurance Companies for the periods indicated:
The approximate annualized pre-tax yields on the Insurance Companies’ investment portfolio, excluding net realized capital gains and losses, approximated 3.8%, 4.1% and 4.3% for 2010, 2009 and 2008, respectively. The increase in net investment income in 2010, 2009 and 2008 versus the comparable prior year was primarily due to the investment of new funds from positive cash flow from operations. The portfolio’s duration was 4.6 years at December 31, 2010 and 4.7 years at December 31, 2009.
Syndicate 1221’s stamp capacity was £168 million ($264 million) in 2010, £124 million ($194 million) in 2009 and £123 million ($228 million) in 2008. Stamp capacity is a measure of the amount of premium a Lloyd’s syndicate is authorized to write as determined by the Council of Lloyd’s. We controlled 100% of Syndicate 1221’s total stamp capacity in 2010, 2009 and 2008 through our wholly-owned Lloyd’s corporate member (we utilized two wholly-owned Lloyd’s corporate members prior to the 2008 underwriting year). Syndicate 1221’s stamp capacity is expressed net of commission (as is standard at Lloyd’s). The Syndicate 1221 premium recorded in our financial statements is gross of commission. We provide letters of credit to Lloyd’s to support our participation in Syndicate 1221’s stamp capacity as discussed below under the caption Liquidity and Capital Resources.
The following table sets forth the results of operations of the Lloyd’s Operations for the following periods:
The 2010 underwriting results were favorably impacted by approximately $8.3 million or 3.8 loss ratio points for net prior years’ savings due to favorable loss development trends which are discussed in the prior year reserve redundancies/deficiencies section. The 2010 net prior years’ savings was an increase of $2.5 million compared to 2009. The 2009 underwriting results were favorably impacted by approximately $5.9 million or 2.9 loss ratio points for net prior years’ savings due to favorable loss development trends which are discussed in the prior year reserve redundancies/deficiencies section. The 2009 net prior years’ savings was a decline of $3.0 million compared to 2008.
The pre-tax yields on the Lloyd’s Operations investments, excluding net realized capital gains and losses, approximated 2.3%, 2.7% and 3.4% for 2010, 2009 and 2008, respectively. Such yields are net of interest credits to certain reinsurers for funds withheld by our Lloyd’s Operations. Generally, the Lloyd’s Operations’ investments have been invested with a relatively short average duration, which is reflected in the yield, in order to meet liquidity needs. The decrease in the Lloyd’s Operations’ net investment income in 2010 and 2009 was due to lower investment yields. The average duration of the Lloyd’s Operations’ investment portfolio was 4.0 years at December 31, 2010 compared to 1.6 years at December 31, 2009.
We have no material off-balance sheet transactions with the exception of our letter of credit facility. For a discussion of our letter of credit facility, see “- Liquidity and Capital Resources”, included herein.
The following table sets forth the fifteen largest holdings categorized as state, municipalities and political subdivisions by counterparty as of December 31, 2010:
The following table sets forth the composition of the investments categorized as states, municipalities and political subdivisions in our portfolio by generally equivalent S&P and Moody’s ratings (not all securities in our portfolio are rated by both S&P and Moody’s) as of December 31, 2010:
The following table sets forth the municipal bond holdings by sector for December 31, 2010 and 2009:
We own $135 million of municipal securities which are credit enhanced by various financial guarantors. As of December 31, 2010, the average underlying credit rating is A+. There has been no material adverse impact to our investment portfolio or results of operations as a result of recent downgrades of the credit ratings for several of the financial guarantors.
We analyze our mortgage-backed and asset-backed securities by credit quality of the underlying collateral distinguishing between the securities issued by the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”) which are Federal government sponsored entities, and the non-FNMA and non-FHLMC securities broken out by prime, Alt-A and subprime collateral. The securities issued by FNMA and FHLMC are the obligations of each respective entity. Recent legislation has provided for guarantees by the U.S. Government of up to $100 billion each for FNMA and FHLMC.
The following tables set forth our mortgage-backed securities and residential mortgage obligations by those issued by the Government National Mortgage Association (“GNMA”), FNMA, FHLMC, and the quality category (prime, Alt-A and subprime) for all other such investments as of December 31, 2010:
The following table sets forth the fifteen largest residential mortgage obligations as of December 31, 2010:
Details of the collateral of our asset-backed securities portfolio as of December 31, 2010 are presented below:
The following table shows the amount and percentage of our fixed maturities and short-term investments at December 31, 2010 by S&P credit rating or, if an S&P rating is not available, the equivalent Moody’s rating. The table includes fixed maturities and short-term investments at fair value, and the total rating is the weighted average quality rating.
Following is a list of the top fifteen corporate bond holdings for fixed maturities at fair value. All such fixed maturities are rated investment grade by S&P and Moody’s. These holdings represent direct obligations of the issuer or its subsidiaries and exclude any government guaranteed or government sponsored organizations, securitized, credit enhanced or collateralized asset-backed or mortgage-backed securities.
We analyze the unrealized losses quarterly to determine if any are other-than-temporary. The above unrealized losses have been determined to be temporary based on our policies. See Critical Accounting Estimates - Impairment of Invested Assets for additional information on our policies.
The following table summarizes the gross unrealized investment losses as of December 31, 2010 by length of time where the fair value is less than 80% of amortized cost.
The approximate pre-tax yields of the investment portfolio, excluding net realized gains and losses, were 3.5% for 2010 and 3.8% for 2009 and 4.1% for 2008. The decline in the pre-tax investment yields was due to a decline in yields for our short duration investment holdings.
Generally, for pro rata or quota share reinsurers we issue quarterly settlement statements for premiums less commissions and paid loss activity, which are expected to be settled by the end of the subsequent quarter. We have the ability to issue “cash calls” requiring such reinsurers to pay losses whenever paid loss activity for a claim ceded to a particular reinsurance treaty exceeds a predetermined amount (generally $1.0 million) as set forth in the pro-rata treaty. For the Insurance Companies, cash calls must generally be paid within 30 calendar days. There is generally no specific settlement period for the Lloyd’s Operations cash call provisions, but such billings are usually paid within 45 calendar days.
We monitor our capital adequacy to support our business on a regular basis. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by several ratings agencies, at a level considered necessary by management to enable our Insurance Companies to compete; (2) sufficient capital to enable our Insurance Companies to meet the capital adequacy tests performed by regulatory agencies in the United States and the United Kingdom and (3) letters of credit and other forms of collateral that are necessary to support the business plan of our Lloyd’s Operations.
In November 2009, the Parent Company’s Board of Directors adopted a share repurchase program for up to $35 million of the Parent Company’s common stock. In March 2010, the Parent Company’s Board of Directors adopted a share repurchase program for up to an additional $65 million of the Parent Company’s common stock. Purchases are permitted from time to time at prevailing prices in open market or privately negotiated transactions through December 31, 2011. The timing and amount of purchases under the program depend on a variety of factors, including the trading price of the stock, market conditions and corporate and regulatory considerations. See Item 5, Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for a schedule outlining our share repurchases in 2010 and 2009. We did not repurchase any additional shares under the share repurchase program from January 1, 2011 through February 16, 2011.
We primarily rely upon dividends from our subsidiaries to meet our Parent Company’s obligations. Since the issuance of the senior debt in April 2006, the Parent Company’s cash obligations primarily consist of semi-annual interest payments of $4.0 million. Going forward, the interest payments on our senior debt will be made from one or a combination of funds at the Parent Company or dividends from its subsidiaries. The dividends have historically been paid by Navigators Insurance Company. Based on the December 31, 2010 surplus of Navigators Insurance Company, the approximate maximum amount available for the payment of dividends by Navigators Insurance Company during 2011 without prior regulatory approval is $68.7 million. Dividends of $40.0 million and $25.0 million were paid by Navigators Insurance Company during 2010 and 2009, respectively.