Our New York underwriting office and certain executive offices are located at One Penn Plaza, New York, New York and occupied pursuant to a lease from an unaffiliated company which expires December 31, 2010. Several of our subsidiaries have noncancellable operating leases for their respective office locations.
In the first quarter of 2003, we leased additional space in Rye Brook, New York, from an unaffiliated company. Rye Brook is approximately 30 miles north of Manhattan. Our administrative, accounting and information technology staffs and certain executive offices are now located at our Rye Brook, New York office. Our lease for this space terminates in February 2013.
In January 2000, we purchased an apartment in London to accommodate visitors to our London operations at a cost of approximately $820,000.
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While management takes into consideration a wide range of factors in planning the Company's business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how the Company is managed. First, underwriting profit is consistently emphasized as a primary goal, above premium growth. Management's assessment of our trends and potential growth in underwriting profit is the dominant factor in its decisions with respect to whether or not to expand a business line, enter into a new niche, product or territory or, conversely, to contract capacity in any business line. In addition, management focuses on managing the costs of our operations. Management believes that careful monitoring of the costs of existing operations and assessment of costs of potential growth opportunities are important to our profitability. Access to capital also has a significant impact on management's outlook for our operations. Our insurance company subsidiaries' operations and ability to grow their business and take advantage of market opportunities are particularly constrained by regulatory capital requirements and rating agency assessments of capital adequacy. For example, we contributed $95 million of the approximately $110.8 million in net proceeds we received from the October 2003 equity offering to the statutory surplus of Navigators Insurance Company in order to position the Company to be able to capitalize on domestic and international insurance business opportunities that management believes will be profitable.
Although not a financial measure, management's decisions are also greatly influenced by access to specialized underwriting and claims expertise in our lines of business. We have chosen to operate in specialty niches with certain common characteristics which we believe provide us with the opportunity to use our technical underwriting expertise in order to realize underwriting profit. As a result, we have focused on underserved markets for businesses characterized by higher severity and low frequency of loss where we believe our intellectual capital and financial strength bring meaningful value. In contrast, we have avoided niches that we believe have a high frequency of loss activity and/or are subject to a high level of regulatory coverage requirements, such as workers compensation and personal automobile insurance, because we do not believe our technical expertise is of as much value in these types of businesses. Examples of niches that have the characteristics we look for include bluewater hull (which provides coverage for physical damage to, for example, highly valued cruise ships) and directors and officers liability (which
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Our business is cyclical and influenced by many factors. These factors include price competition, economic conditions, interest rates, natural or man-made disasters (for example hurricanes and terrorism), state regulations, court decisions and changes in the law. Additionally, because our insurance products must be priced, and premiums charged, before costs have fully developed, our liabilities are required to be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, we cannot assure you that our actual liabilities will not exceed the recorded amounts.
The insurance industry recently has become the subject of increasing scrutiny with respect to insurance broker and agent compensation arrangements and sales practices. The New York State Attorney General and other state and federal regulators have commenced investigations and other proceedings relating to compensation and bidding arrangements between producers and issuers of insurance products, and unsuitable sales practices by producers on behalf of either the issuer or the purchaser. The practices currently under investigation include, among other things, allegations that so-called contingent commission arrangements may conflict with a broker's duties to its customers and that certain brokers and insurers may have engaged in anti-competitive practices in connection with insurance premium quotes. The New York State Attorney General has recently entered into a settlement agreement with one large insurance broker against whom a civil complaint had been filed. These investigations and proceedings are expected to continue, and new investigative proceedings may be commenced, in the future. These investigations and proceedings could result in legal precedents and new industry-wide practices or legislation, rules or regulations that could significantly affect our industry and may also cause stock price volatility for companies in the insurance industry.
Largely as a result of these industry investigations, contingent commission and other commission practice standards are currently evolving. For example, in December 2004 the National Association of Insurance Commissioners adopted an amendment to its Producer Licensing Model Act with respect to producer compensation disclosure obligations, and is considering further amendments to this Model Act. The Company is supportive of industry efforts to encourage transparency in the disclosure of contingent commissions paid to brokers by insurers and does not expect to be adversely impacted by legislative developments in this area.
Reserves for Losses and LAE. Reserves for losses and LAE represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate liability, judicial theories of liability and other third party factors which are often beyond our control. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may be different from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year's results. Additional information regarding our loss reserves can be found in "-Results of Operations-Operating Expenses-Net Losses and Loss Adjustment Expenses Incurred," "Business-Reserves," and Note 6 to our consolidated audited financial statements, all of which are included herein.
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We experienced premium growth as measured by net earned premium in 2004, 2003 and 2002 of 12.0%, 25.0% and 47.8%, respectively, due to the combination of increased premium rates and business expansion. Underwriting profitability during such periods, as measured by the Company's combined ratios, has also improved for the 2004, 2003 and 2002 business written. The 2003 year was adversely impacted by reserve strengthening from prior years.
Navigators Insurance Company increased its gross and net asbestos reserves for losses by $77.6 million and $31.6 million, respectively, in the fourth quarter of 2003. As a result, gross and net incurred losses increased by the amount of the respective
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reserve increase. The reserve action was the result of a review of asbestos-related exposures conducted by the Company and an independent consulting firm. Following such review, the Company increased its gross and net loss reserves for asbestos exposure to $78.5 million and $32.1 million, respectively, at December 31, 2003.
The 2002 results of operations reflect a substantial improvement in underwriting profitability as evidenced by the Company's combined ratio of 98.5% compared to 104.1% for 2001. The 2002 results of operations were adversely impacted by an after tax charge of $1.9 million or $0.22 per diluted share for impairment losses on asset- backed securities.
Revenues. Gross written premium increased to $696.1 million or 14.8% in 2004 from $606.5 million in 2003, and by 35.4% from $447.8 million in 2002. The growth in gross premiums over the three year period reflects a combination of business expansion in both new and existing lines of business coupled with premium rate changes on renewal policies. The premium rate increases or decreases as noted below for marine, specialty and professional liability are calculated primarily by comparing premium amounts on policies that have renewed. The premiums are judgmentally adjusted for exposure factors when deemed significant and sometimes represent an aggregation of several lines of business. The rate changes calculation provides an indicated pricing trend and is not meant to be a precise analysis of the numerous factors that affect premium rates or the adequacy of such rates to cover all underwriting costs and generate an underwriting profit. The calculation can also be affected quarter by quarter depending on the particular policies and the number of policies that renew during that period. Due to market conditions, these rate changes may or may not apply to new business which may be more competitively priced compared to renewal business. The following table sets forth our gross and net written premium and net earned premium by segment and line of business for the periods indicated:
Specialty Premium. This business consists primarily of general liability business for small general and artisan contractors as well as other targeted commercial risks. The specialty premium increased 14.4% from 2003 to 2004, 13.4% in 2003 compared to 2002 and 109.8% in 2002 compared to 2001 due to increased rates and underwriting new policies. The average renewal rate increases in the contractors' liability business were approximately 13%, 49% and 30% in 2004, 2003 and 2002, respectively. During 2003 and 2004, the number of California construction liability in-force policies decreased significantly as a result of our efforts to scale back the number of small artisan policies we write. The new business and the rate increases resulted from a tightening market for California contractors' liability insurance. In December 2004, we hired a small team of experienced underwriters to write excess casualty and commercial and personal umbrella business for Navigators Insurance Company.
Assumed from Lloyd's Operations. Gross premiums written assumed from our Lloyd's Syndicate 1221 through quota share treaties consisted of marine and energy business of $26.0 million in 2004 compared to $33.0 million in 2003 and $8.2 million in 2002. The 2004 gross premiums written includes $22.2 million of gross and net premiums written and earned, representing Navigators Insurance Company's share of reinsurance to close premiums recorded by our Lloyd's Syndicate 1221 as a result of the transfer of assets and liabilities from the participants of the 2002 underwriting year to the 2003 underwriting year of Syndicate 1221.
The generally improved pricing environment since 2002 resulted in the Syndicate 1221 increasing its stamp capacity to take advantage of favorable market conditions as reflected in higher renewal premium rates averaging 0.6% in 2004, 15% in 2003 and 26% in 2002.
Other. Other consists of engineering and construction gross written premium which provides coverage for construction projects including machinery, equipment and loss of use due to delays, and of onshore energy premium which principally focuses on the oil and gas, chemical and petrochemical industries with coverages primarily for property damage and business interruption.
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The increases in the total dollar amount ceded each year were primarily due to the increases in the gross written premium.
The increase to 62.3% for 2004 marine business ceded premium, compared to 53.1% in 2003 and 54.7% in 2002, reflects increased purchases of quota share reinsurance for certain lines of business, net reinstatement premium costs of $2.2 million for Hurricane Ivan losses coupled with an overall increase in excess of loss reinsurance premium since 2002. The decline in the 2003 percentage of ceded marine premium compared to 2002 reflects a decline in ceded premium resulting from a commutation agreement with a former member of the marine pool offset by an overall increase in excess of loss reinsurance premiums.
The increase to 46.7% for 2004 specialty business ceded premium, compared to 34.5% in 2003, is principally due to the purchase of a quota share treaty for the construction and certain other specialty lines of business coupled with rate increases for an excess of loss treaty. The 2003 increase in the percentage of ceded specialty premiums to 34.5% compared to 18.4% in 2002 was principally due to a reinsurance treaty change for a portion of 2003 that provided a statutory accounting benefit but had no impact on net income, increased costs for the excess of loss treaty coupled with a higher percentage of ceded premium for several new lines of business.
Commission Income. Commission income from unaffiliated business increased 11.0% to $4.8 million in 2004 compared to $4.3 million in 2003. The increase principally resulted from the increased profit commission on the Lloyd's Operations business. Commission income from unaffiliated business decreased by 11.3% in 2003 compared to 2002 as a result of a decrease from 25% to 20% of unaffiliated insurers participating in the marine pool managed by Navigators Agencies. This decrease occurred effective January 1, 2003 as a result of Navigators Insurance Company increasing its participation in the marine pool from 75% in 2002 to 80% in 2003.
Net Investment Income. Net investment income increased 37.1% and 8.3% in 2004 and 2003, respectively, due to the increase in invested assets resulting from positive cash flow from operations and the $110.8 million of net proceeds from our October 2003 common stock offering. See the "Business-Investments" section included herein for additional information regarding our net investment income.
The increase in net loss reserves in all active lines of business is generally a reflection of the growth in premium volume over the last three years. The net loss reserve increase for 2003 also includes an increase in reserves to $33.2 million from $1.5 million for asbestos and environmental exposures in the marine and run-off business as well as prior year loss reserve strengthening of approximately $22.2 million in our specialty business related to the California contractors liability business. Approximately $31.8 million of the asbestos and environmental reserves are recorded in marine and $1.4 million in other, primarily related to run-off aviation business. Asbestos and environmental net loss reserves at December 31, 2004 were $32.9 million.
Other Operating Expenses. The 26.8% and 28.8% increases in other operating expenses when comparing 2004 to 2003 and comparing 2003 to 2002, respectively, are attributable primarily to employee related expenses resulting from expansion of the business coupled with the increased costs incurred to comply with Section 404 of the Sarbanes-Oxley Act of 2002. Included in 2004 and 2003 were $992,000 and $761,000, respectively, recorded for employee stock option expense. The Company adopted the fair value method of accounting for stock-based employee compensation as of January 1, 2003.
Interest Expense. The decreases in interest expense in 2003 and 2002 were primarily due to lower interest rates charged on the loan balance and a declining loan balance. The remaining loan balance was paid in October 2003 from a portion of the proceeds from the Company's common stock offering, therefore no interest expense was recorded in 2004.
We are subject to the tax regulations of both the United States and the United Kingdom. The Company files a consolidated federal tax return, which includes all domestic subsidiaries and the U.K. branch. The income from the foreign operations is designated as either U.S connected income or non-U.S. connected income. The U.S. connected income under the Subpart F regulations of the Internal Revenue Code is taxed in the year earned for tax purposes and recorded in the Company's tax return. It is also included in the tax provision at the corporate 35% rate. Foreign tax credits, where available, are utilized to offset as much of the U.S. tax as permitted on the U.S. connected income. Non-U.S. connected income from a foreign subsidiary is subject to U.S. taxation only when distributed. U.S. taxes are not accrued when the earnings are considered to be permanently reinvested in the foreign subsidiary. The Company has demonstrated its intention that the foreign earnings are permanently reinvested in the foreign subsidiary, and therefore any distribution is postponed indefinitely. The foreign earnings are subject to taxes in foreign jurisdictions which, in the case of the Company, approximate 35%.
We have not provided for U.S. deferred income taxes or foreign withholding taxes on the undistributed earnings of approximately $11.0 million of our non-U.S. subsidiaries since these earnings are intended to be reinvested indefinitely. However, in the future, if such earnings were distributed to the Company, taxes of approximately $1.0 million would be payable
The Company had net state and local operating loss carryforwards amounting to potential future tax benefits of $4,493,000 and $3,274,000 at December 31, 2004 and 2003, respectively. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. The Company's state and local tax carryforwards at December 31, 2004 expire from 2019 to 2024.
Following are the financial results of the Company's three segments: Insurance Companies, Lloyd's Operations and Navigators Agencies. We evaluate the performance of each segment based on their GAAP underwriting or operating results. Items of revenue and expenditure, including net investment income and realized capital gains and losses, are included herein based on the legal entity where they are recorded. Our underwriting performance is evaluated separately from the performance of our investment portfolios. See Note 13 to the consolidated financial statements for further information.
Following are the results of operations for the Insurance Companies for each of the years in the three-year period ended December 31, 2004:
Following are the underwriting results of the Insurance Companies for each of the years in the three-year period ended December 31, 2004:
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The 2003 underwriting results were adversely impacted by approximately $61.5 million for incurred losses related to years prior to 2002. Approximately $32.5 million of such adverse development was for incurred losses recorded for asbestos and environmental exposures (consisting of $31.1 million in marine business and $1.4 million in run-off business). As a result of recording such losses, intersegment profit commissions of $5.7 million due to Navigators Agencies were reduced. The Company also recorded adverse development in 2003 of approximately $22.2 million for specialty business mostly for California contractors liability business, and approximately $4.0 million for other marine business and $2.8 million for other run-off business. The Company strengthened its reserves for the California contractors liability business as a result of an internal actuarial analysis of the specialty business conducted during the 2003 fourth quarter.
The 2002 underwriting results were negatively impacted by approximately $6.7 million for prior year loss development recorded in specialty business mostly for the Company's California contractors liability business.
The pre-tax yield on the Insurance Companies' investment portfolio approximated 4.02%, 4.26% and 4.99% for 2004, 2003 and 2002, respectively. The portfolio yields reflect the overall declines in interest rates since 2001. Net investment income increased in 2004 compared to 2003 and in 2003 compared to 2002 despite declines in the average investment yield on the portfolio due to strong cash flows throughout 2004 and 2003 coupled with the receipt of $95 million of statutory surplus contributions in the 2003 fourth quarter.
Our Lloyd's Syndicate 1221's stamp capacity was £150 million ($275 million) in 2004 compared to £125 million ($203.5 million) in 2003 and £75.0 million ($112.7 million) in 2002. The stamp capacity for 2005 has been reduced to £135 million ($247.5 million) reflective of unused stamp capacity in 2004 coupled with anticipated declining market conditions in 2005. 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. Syndicate 1221's stamp capacity is expressed net of commission (as is standard at Lloyd's) of approximately 21%. The Syndicate 1221 premium recorded in our financial statements is gross of commission. We provided 97.4%, 97.4% and 68.1% of Syndicate 1221's total capacity for the 2004, 2003 and 2002 underwriting years, respectively. In 2003, we reinsured 15.4% of our Syndicate 1221 capacity through the utilization of quota share reinsurance agreements to third parties who provide letters of credit used as collateral at Lloyd's. The Lloyd's marine business had been subject to deteriorating pricing beginning in the mid-1990's. The pricing competition showed some signs of stabilizing in 2000 and prices increased in 2001, 2002 and 2003. The 2004 pricing stayed relatively stable. Lloyd's presents its results on an underwriting year basis, generally closing each underwriting year after three years. We make estimates for each underwriting year and timely accrue the expected results. Our Lloyd's Operations included in the consolidated financial statements represent our participation in Syndicate 1221.
Lloyd's syndicates report the amounts of premiums, claims, and expenses recorded in an underwriting account for a particular year to the companies or individuals that participate in the syndicates. The syndicates generally keep accounts open for three years. Traditionally, three years have been necessary to report substantially all premiums associated with an
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".
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The Lloyd's Operations have been experiencing business expansion coupled with improving underwriting results as a result of the generally favorable market conditions for marine and energy business from late 2001 through 2003, and continuing to a lesser extent in 2004. The 2004 net earned premium and incurred losses were increased by $12.8 million as a result of the RITC transaction for the 2002 year of account.
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(1)Participation after reinsurance of Navigators' corporate capital vehicles, but before other third party reinsurance For 2005, Syndicate 1221's stamp capacity has been reduced to £135 million ($247.5 million) and Navigators participation is 97.5%, while the cessions to the former participants referenced above will increase to 14.1%.
The pre-tax yields on funds at Lloyd's approximated 1.7%, 2.0% and 3.8% for 2004, 2003 and 2002, respectively, which are reflective of the declining interest rate environment since 2001. Generally, funds invested at Lloyd's have been invested with a
relatively short average duration in order to meet liquidity needs. The average duration of our Lloyd's Operations invested assets at December 31, 2004 was 1.4 years.
Navigators Pro, a division of a Navigators Agency, specializes in underwriting professional liability insurance and began producing directors and officers liability insurance exclusively for our insurance company subsidiaries in the fourth quarter of 2001. In late 2002, Navigators Pro introduced additional products to complement its directors and officers liability coverage. The products include employment practices liability, lawyers professional liability and miscellaneous professional liability coverages. In 2004, Navigators Pro began writing professional liability coverage for U.K. solicitors in our U.K. Branch. Beginning in 2005 Navigators Pro commenced writing professional liability coverages for architects and engineers.
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The following table sets forth our known contractual obligations with respect to the items indicated at December 31, 2004:
At December 31, 2004, the weighted average rating of our fixed maturity investments was "AA" by Standard & Poor's and "Aa" by Moody's. We believe that we have no significant exposure to credit risk since the fixed maturity investment portfolio consists of investment-grade bonds. At December 31, 2004, our portfolio had an average maturity of 4.8 years and a duration of 3.7 years. Management continually monitors the composition and cash flow of the investment portfolio in order to maintain the appropriate levels of liquidity to ensure our ability to satisfy claims. We incurred impairment losses of $2.9 million in 2002 on asset-backed securities. No impairment losses were incurred in 2004 or 2003.
The credit facility is collateralized by all of the common stock of Navigators Insurance Company. In addition, at December 31, 2004, a pledge account was funded for $3.3 million, as required by the credit agreement, whenever our funding requirement at Lloyd's, which is in British pounds, exceeds the equivalent of $80 million. The overage resulted from the conversion of the letters of credit from British pounds to U.S. dollars due to the weakening dollar. The pledge account is updated monthly for exchange rate movements between the U.S. dollar and British pounds. The credit agreement contains covenants common to transactions of this type, including restrictions on indebtedness and liens, limitations on mergers and the sale of assets, maintaining certain consolidated tangible net worth, statutory surplus and other financial ratios. Cash dividends to shareholders are limited to $2.5 million per year. No dividends have been declared or paid through December 31, 2004. At December 31, 2004, we were in compliance with all covenants.
At December 31, 2004, our consolidated stockholders' equity was $328.6 million compared to $290.0 million at December 31, 2003. The increase was primarily due to the net income for the year ended December 31, 2004.
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