The executive and administrative office is located at 400 Atlantic Street, Stamford, CT. The lease for this space expires in October 2023. The underwriting operations are in various locations with non-cancelable operating leases including:
Earnings per diluted share of $6.51, an increase of 47.1% over prior year
Net underwriting profit of $68.9 million, an increase of 57.0% over prior year
Net investment income of $64.2 million, an increase of 14.1% over prior year
Net cash flow from operations of $222.5 million, an increase of 62.6% over prior year
We classify its business into one Corporate segment (“Corporate”) and two underwriting segments, the Insurance Companies segment (“Insurance Companies”) and the Lloyd’s Operations segment (“Lloyd’s Operations”) which are separately managed by business line divisions. The Insurance Companies are primarily engaged in underwriting Marine insurance, Primary Casualty insurance with a concentration in contractors’ general liability products, Excess Casualty insurance with a concentration in commercial umbrella products, Assumed Reinsurance, Management Liability insurance and Errors & Omissions (“E&O”) insurance. This segment is comprised of Navigators Insurance Company (“NIC”), which includes a United Kingdom (“UK”) branch (“UK Branch”), and Navigators Specialty Insurance Company (“NSIC”), which underwrites business on an excess and surplus lines basis. All of the business underwritten by NSIC is fully reinsured by NIC pursuant to a 100% quota share reinsurance agreement.
Our revenue is primarily comprised of premiums and investment income. We derive our premiums predominantly from business written by wholly-owned underwriting management companies, Navigators Management Company (“NMC”) and Navigators Management (UK) Ltd. (“NMUK”) that manage and service insurance and reinsurance business written by the Insurance Companies. Our products are distributed through multiple channels, utilizing global, national and regional retail and wholesale insurance brokers.
France, which underwrite risks pursuant to binding authorities with NUAL into Syndicate 1221. We have also established a presence in Brazil and China through contractual arrangements with local affiliates of Lloyd’s.
While management takes into consideration a wide range of factors in planning our business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how we are managed. First, underwriting profit is consistently emphasized as a primary goal, above premium growth. Underwriting profit is a non-GAAP financial measure of performance and underwriting profitability, which is derived from net earned premium less the sum of net losses and Loss Adjustment Expenses (“LAE”), commission expenses, other operating expenses and other underwriting income or loss. 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 controlling 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. The Insurance Companies’ operations and ability to grow their business and take advantage of market opportunities are constrained by regulatory capital requirements and rating agency assessments of capital adequacy. Similarly, the ability to grow our Lloyd’s Operations is subject to capital and operating requirements of Lloyd’s and the U.K. regulatory authorities.
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 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 lower 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 requirements, such as Workers Compensation and Personal Automobile insurance, because we do not believe; our technical underwriting 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 highly valued cruise ships, and Directors and Officers Liability insurance (“D&O”) which covers litigation exposure of a corporation’s directors and officers. These types of exposures require substantial technical expertise. We attempt to mitigate the financial impact of severe claims on our results through conservative and detailed underwriting, prudent use of reinsurance and a balanced portfolio of risks.
Our ability to underwrite business is dependent upon the financial strength of the Insurance Companies and Lloyd’s Operations. Financial strength ratings represent the opinions of the rating agencies on the financial strength of a company and its capacity to meet the obligations of insurance policies. Independent ratings are important to our competitive position in the insurance markets. The rating agencies consider many factors in determining the financial strength rating of an insurance company, including the relative level of statutory surplus necessary to support the business operations of our Company. These ratings are based upon factors relevant to policyholders, agents and intermediaries and are not directed toward the protection of investors. Such ratings are not recommendations to buy, sell or hold securities. We could be adversely impacted by a downgrade in the Insurance Companies’ or Lloyd’s Operations financial strength ratings, including a possible reduction in demand for our products, higher borrowing costs and our ability to access the capital markets.
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 less the amount paid to date. 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, judicial theories of liability and other third party factors, which are often beyond our control. No assurance can be given that actual claims made and related payments will not be in excess of the amounts reserved. During the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates.
This method is based on the assumption that ultimate losses vary proportionately with premiums. Pursuant to the loss ratio method, IBNR loss reserves are calculated by multiplying the earned premium by an expected ultimate loss ratio to estimate the ultimate losses for each UWY, then subtracting the reported losses, consisting of paid losses and case loss reserves, to determine the IBNR loss reserve amount. The ultimate loss ratios applied are our Company’s best estimates for each UWY and are generally determined after evaluating a number of factors which include: information derived by underwriters and actuaries in the initial pricing of the business, the ultimate loss ratios established in the prior accounting period and the related judgments applied, the ultimate loss ratios of previous UWYs, premium rate changes, underwriting and coverage changes, changes in terms and conditions, legislative changes, exposure trends, loss development trends, claim frequency and severity trends, paid claims activity, remaining open case reserves and industry data where deemed appropriate. Such factors are also evaluated when selecting ultimate loss ratios and/or loss development factors in the methods described below.
The Bornheutter-Ferguson method calculates the IBNR loss reserves as the product of the earned premium, an expected ultimate loss ratio, and a loss development factor that represents the expected percentage of the ultimate losses that have been incurred but not yet reported. The loss development factor equals one hundred percent less the expected percentage of losses that have thus far been reported, which is generally calculated as an average of the percentage of losses reported for comparable reporting periods of prior UWY. The expected ultimate loss ratio is generally determined in the same manner as in the loss ratio method.
A substantial portion of our Primary Casualty loss reserves are for liability policies issued to contractors, many of which are operating in California and other western states which have experienced significant amounts of litigation involving allegations of construction defect. Accordingly, Contractor Liability claims are categorized into two claim types: construction defect and other general liability. Other general liability claims typically derive from worksite accidents or from negligence alleged by third parties, and frequently take a long time to report and settle. construction defect claims involve the discovery of damage to buildings that was caused by latent construction defects. These claims take a very long time to report and to settle compared to other general liability claims. Since construction defect claims report much later than other Contractor Liability claims, they are analyzed separately in our quarterly actuarial loss studies.
We have extensive history in the Contractors’ Liability business upon which to perform actuarial analyses and we use the key assumption noted above relating to our own historical experience as a reliable indicator of the future for this product. However, there is inherent uncertainty in the loss reserve estimation process for this line of business given both the long-tail nature of the liability claims and the continuing underwriting and coverage changes, claims handling and reserve changes, and legislative changes that have occurred over a several year period. Such factors are judgmentally taken into account in this line of business in specific periods. The underwriting and coverage changes include the migration to a non-admitted business from admitted business in 2003, which allowed us to exclude certain exposures previously permitted (for example, exposure to construction work performed prior to the policy inception), withdrawals from certain contractor classes previously underwritten and expansion into new states beginning in 2005. Claims changes include bringing the claim handling in-house in 1999 and changes in case reserving practices in 2003, 2006 and 2011. During 2010 and 2011, we also significantly increased our claims staff and improved our claims procedures, which has allowed our Company to respond more quickly to reported construction defect claims. Our Company is closely monitoring the impact of these effects on the adequacy of our case and IBNR loss reserves. After analysis of the factors above, Management believes that our reserves remain adequate to address our exposure to construction defect losses, but given the uncertainties noted above, there is a risk that our reserves for construction defect losses may ultimately prove to be inadequate, perhaps in a material manner.
Offshore Energy provides physical damage coverage to offshore oil platforms along with offshore operations related to oil exploration and production. The significant Offshore Energy claims are generally caused by fire or storms, and thus tend to be large, infrequent, quickly reported, but occasionally not quickly settled because the damage is often extensive and not always immediately known.
Assumed Reinsurance provides proportional and excess-of-loss treaty coverage for several niche lines: A&H, Agriculture, Latin America (“LatAm”), and Professional Liability. The A&H reinsurance line primarily provides reinsurance coverage for individual medical claims that occur with small frequency. The Agriculture reinsurance line primarily provides reinsurance coverage related to crop insurance schemes, most of which are sponsored by governmental bodies in the United States (“U.S.”) and Canada. The LatAm line primarily provides reinsurance coverage for individual risk and catastrophic Property exposures, Liability exposures, and Surety Bonds in Central and South America and the Spanish-speaking Caribbean. The Professional Liability line primarily provides reinsurance coverage for exposure related to medical malpractice and other miscellaneous Professional Liability policies.
Reserves for our Company’s Lloyd’s Operations are reviewed separately for the Marine, P&C, and Professional Liability lines by product. The major Marine Products are Marine Liability, Transport, Marine Energy Liability, Cargo, Specie and Marine Reinsurance. The major P&C Products are Offshore Energy, Engineering, Onshore Energy, Operational Engineering and Direct and Facultative Property. The major products for Professional Liability are International Management Liability and International E&O.
A range of reasonable estimates has been developed based on the historical volatility of held reserves versus current estimates for the purposes of this sensitivity analysis. The history indicates that our held reserves tend to be 9.7% redundant with a standard deviation of 10.3%. We have ignored the historical conservatism and built a range around the current held amounts. Our Company’s lines of business, the market pricing adequacy and our Company’s underwriting strategies have changed dynamically over the past eleven years. There is thus a significant risk that the potential volatility of the current reserve estimates could differ in a material manner from the historical trends.
Actual emergence will vary and may exceed the historical variation. The actual losses may not emerge as expected which would cause the ranges to expand or contract from year to year. The impact from the shift on ranges will be greater for lines with longer emergence patterns. The individual lines will also have greater variance than the range for the entire book of business. The statistical variation is expected to have a somewhat higher range of deterioration than savings. The history in itself is only a rough estimate of the potential volatility. The ranges have been refined by reserve segment in three categories - Marine, Property Casualty and Professional Liability. These groupings give a sense of the volatility by sub-group but are not intended to be rigorous estimates even if such were possible. The computation of each range represents the central 50% of outcomes. The specific movement of an individual year may not fall within this range. The total reserve variability is not equal to the sum of the segment variability due to the benefit of diversification.
We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Reinsurance recoverables are established for the portion of the loss reserves that are ceded to reinsurers. Reinsurance recoverables are determined based upon the terms and conditions of reinsurance contracts, which could be subject to interpretations that differ from our own based on judicial theories of liability. We bear credit risk with respect to our reinsurers, which can be significant considering that certain of the reserves remain outstanding for an extended period of time. Additional information regarding our reinsurance recoverables can be found in the “Business - Reinsurance Recoverables” section and Note 6, Reinsurance, in the notes to the consolidated financial statements, both included herein.
Substantially all of our business is placed through agents and brokers. Written premium is recorded based on the insurance policies that have been reported to us and the policies that have been written by agents but not yet reported to us. We estimate the amount of written premium not yet reported based on judgments relative to current and historical trends of the business being written. An unearned premium reserve is established to reflect the unexpired portion of each policy at the financial reporting date. Assumed and ceded reinsurance reinstatement premiums are written and fully earned in the period in which the loss event, which caused the reinstatement premium, occurred.
A portion of our premium is estimated for unreported premium, mostly for the Marine business written by our U.K. Branch and Lloyd’s Operations as well as the A&H and LatAm reinsurance business written by NavRe. We generally do not experience any significant backlog in processing premiums. Such premium estimates are generally based on submission data received from brokers and agents and recorded when the insurance policy or reinsurance contract is written or bound. The estimates are regularly reviewed and updated taking into account the premium received to date versus the estimate and the age of the estimate. To the extent that the actual premium varies from the estimates, the difference, along with the related loss reserves and underwriting expenses, is recorded in current operations.
Additional information regarding our written and unearned premium can be found in Note 1, Organization and Summary of Significant Accounting Policies, and Note 6, Reinsurance, in the Notes to Consolidated Financial Statements, both included herein.
For equity securities, in general, our Company focuses its attention on those securities with a fair value less than 80% of their cost for six or more consecutive months. If warranted as the result of conditions relating to a particular security, our Company will focus on a significant decline in fair value regardless of the time period involved. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost of the security, the length of time the investment has been below cost and by how much the investment is below cost. If these securities are deemed to be other-than-temporarily impaired, the cost is written down to fair value with the loss recognized in earnings.
The following table presents a summary of our consolidated financial results for the years ended December 31, 2014, 2013 and 2012:
Net income for the year ended December 31, 2014 was $95.3 million or $6.51 per diluted share compared to $63.5 million or $4.42 per diluted share for the year ended December 31, 2013. The increase over prior year is generally attributable to underwriting growth,
Net operating earnings for the year ended December 31, 2013 were $61.7 million or $4.30 per diluted share compared to $37.6 million or $2.63 per diluted share for the comparable period in 2012. The increase in our net operating earnings was largely attributable to stronger underwriting results.
(1) - Includes Other operating expenses & Other underwriting income (expense)
Our 2014 net pre-tax underwriting profit of $68.9 million is $25.0 million greater than prior year of $43.9 million. The combined ratio for the year ended December 31, 2014 was 92.6% compared to 94.8% in 2013. The increase in net profit is due to strong underwriting results from our Insurance Companies and Lloyd’s Operations.
The combined ratio for the year ended December 31, 2012 was 99.3%. Our pre-tax underwriting profit for 2012 was affected by various significant events and adjustments during the year. A net loss of $20.4 million, inclusive of $8.3 million in RRPs, related to Superstorm Sandy was recorded in 2012. Gross of reinsurance our loss related to Superstorm Sandy was approximately $66.7 million. Refer to subsection “Net Losses and Loss Adjustment Expenses” within this section of the MD&A for additional disclosure related to Superstorm Sandy. Current accident year loss emergence of $14.5 million was recorded in our Agriculture product line and was driven by significant drought related crop losses across the U.S. Net losses of $13.9 million were also recorded, inclusive of $11.1 million in RRPs, related to several large losses from our Marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy. Net reserve releases of $47.2 million from our Lloyd’s Operations across all businesses and all divisions, most notably Lloyd’s Operations Marine. In addition to the above, the increase in our pre-tax underwriting profit in 2012 was affected by the mix of business and loss trends.
Gross written premiums increased $61.8 million, or 4.5%, to $1.43 billion for the year ended December 31, 2014 compared to $1.37 billion for the same period in 2013. The overall increase is primarily driven by growth from our Insurance Companies, most notably from the Property Casualty businesses, which includes a $41.8 million increase from our Primary Casualty division, driven by strong production from the continued improvement of the overall construction market, as well as a $17.5 million increase in our Excess Casualty division due to improved market conditions and the dislocation of certain competitors, and a $13.1 million increase from our Environmental division due to our continued investment in those underwriting teams, all of which are partially offset by a $11.3 million decrease from our Energy & Engineering division due to difficult market conditions and an unfavorable rating environment, and a net $6.3 million decrease from our Assumed Reinsurance division as a result of a reduction in renewal premiums from our A&H and Agriculture products. The overall increase from our Insurance Company Property Casualty business was partially offset by a $17.3 million decrease from our Insurance Companies Professional Liability business due to a reduction in our E&O division resulting from our decision to exit the small lawyers professional liability product line, as well as a decrease in our real estate agents and accountants liability product lines as a result of certain program terminations, partially offset by an increase from our Management Liability division due to an increase in subject premium on renewals. To a lesser extent, the overall increase in gross written premiums is also driven by a $15.1 million increase from our Lloyd’s Operations that is primarily driven by the continued expansion of our Lloyd’s Operations E&O division, a portion of which is due to our European expansion into new offices in Italy, the Netherlands and France.
Gross written premiums increased $84.1 million, or 6.5%, to $1.37 billion for the year ended December 31, 2013 compared to $1.29 billion for the same period in 2012. The increase in gross written premiums is primarily attributed to growth within our Insurance Companies Property Casualty business, specifically from our Excess Casualty and Primary Casualty divisions as a result of strong production attributable to an expansion of our underwriting teams and continued dislocation among certain competitors. In addition, we have experienced growth in Lloyd’s Operations Professional Liability business as a result of strong new business production. The aforementioned increases were partially offset by a decrease in our Insurance Companies Marine business in connection with the re-underwriting of our Inland Marine product line and certain non-renewals from our Blue Water Hull product line, as well as a decrease in our Lloyd’s Operations Marine business due to non-renewals from our Cargo and Transport product lines.
Average renewal premium rates for our Insurance Companies segment for the year ended December 31, 2013 increased as compared to the same period in 2012 across substantially all of our businesses within each segment. Our Insurance Companies Marine business has realized a 4.7%, 8.5% and 6.2% increase in rates for the Marine Liability, Inland Marine and Craft divisions, respectively. Within our Insurance Companies Property Casualty business, we have realized a 4.6% increase in rates for the Excess Casualty division and a 2.5% increase in the Primary Casualty division, partially offset by a 2.7% decrease from our Energy & Engineering division. Our Insurance Companies Professional Liability business has experienced an overall increase in its renewal rates of 3.4%, consisting of 5.0% and 2.7% for the Management Liability and E&O divisions, respectively. For the year, ended December 31, 2013, average renewal premium rates for our Lloyd’s Operations segment include increases for Marine and Property Casualty of approximately 3.4% and 1.6%, respectively. Our Lloyd’s Operations Professional Liability business experienced an average decrease of 1.7%.
In the ordinary course of business, we reinsure certain insurance risks with unaffiliated insurance companies for the purpose of limiting our maximum loss exposure, protecting against catastrophic losses and maintaining desired ratios of net premiums written to statutory surplus. The relationship of ceded to gross written premium varies based upon the types of business written and whether the business is written by the Insurance Companies or the Lloyd’s Operations.
Our ceded reinsurance program includes contracts for proportional reinsurance, per risk and whole account excess-of-loss reinsurance for both P&C risks and property catastrophe excess-of-loss reinsurance. In recent years, we have increased our utilization of excess-of-loss reinsurance for Marine, Property and certain Casualty risks. Our excess-of-loss reinsurance contracts generally provide for a specific amount of coverage in excess of an attachment point and sometimes provides for reinstatement of the coverage to the extent the limit has been exhausted for payment of additional premium. The number of ceded reinsurance reinstatements (“RRP”) available varies by contract, and we record an estimate of the expected RRPs for losses ceded to excess-of-loss agreements where this feature applies.
We incurred $8.4 million, $3.0 million and $26.9 million of ceded RRPs for the years ended December 31, 2014, 2013, and 2012, respectively. The RRPs for 2014, 2013 and 2012 are primarily related to large losses from our Marine business. In 2014, $3.9 million of the large loss is due to the sinking of a vessel in South Korean waters, and $1.6 million is due to additional loss activity on the grounding of the cruise ship Cost Concordia. The total RRPs recorded in 2012 included $11.1 million also from the grounding of the cruise ship Costa Concordia off the coast of Italy as well as $8.3 million in connection with our loss on Superstorm Sandy.
The following table sets forth our ceded written premiums by segment and major line of business for the calendar years ended December 31, 2014, 2013 and 2012:
Overall, the percentage of total ceded written premiums to total gross written premiums for the year ended December 31, 2014 has decreased by 5% compared to the year ended December 31, 2013. This decrease is indicative of key changes to our reinsurance programs and mix of business.
The percentage of total ceded written premiums to total gross written premiums for the year ended December 31, 2013 and 2012 has remained constant at 35%. The decrease in percentage for Insurance Companies Marine is driven by a reduction in RRPs in connection with a reduction in large loss activity, partially offset by increase in ceded written premiums related to a true up of certain estimated Minimum and Deposit premium adjustments in the year. The Insurance Companies Professional Liability business percentage increased in 2013 due to an additional proportional contract covering this business. The increase in the percentage for the Lloyd’s Operations Property Casualty business is driven by an increased use of proportional reinsurance to support our offshore energy business for 2013.
Net earned premiums increased 11.2% for the year ended December 31, 2014 compared to the same period in 2013. The increase in net earned premiums is due to increased retention resulting from changes in our reinsurance programs as well as the recent growth of our business primarily driven by our Insurance Companies’ Property Casualty business.
Net earned premiums increased 7.7% for the year ended December 31, 2013 compared to the same period in 2012, driven by earnings from the continued growth of our Insurance Companies Excess Casualty, Primary Casualty, and our Assumed Reinsurance divisions, which includes the A&H product lines that are recognized in earnings over a longer exposure period than our other lines of business. In addition, the increases are also attributable to the RRPs recorded in 2012, and are partially offset by a decrease from the re-underwriting of our Inland Marine product lines, as described above.
The increase in total investment income before investment expenses for all years presented was primarily due to growth of invested assets. The increase for 2014 is also driven by a $1.6 million one-time special dividend received in the first quarter from our equity portfolio. The annualized pre-tax investment yield, excluding net realized gains and losses and net OTTI losses recognized in earnings, was 2.3% for the year ended December 31, 2014 and 2.4% for the years ended December 31, 2013 and 2012, respectively.
The portfolio duration was 3.8 years for the year ended December 31, 2014 and was 3.7 and 3.6 years for each of the years ended December 31, 2013 and 2012, respectively.
Our Company did not have any OTTI losses for the year ended December 31, 2014.
Realized gains and losses, excluding net OTTI losses recognized in earnings, for the periods indicated, were as follows:
The ratio of net losses and LAE to net earned premiums (“loss ratios”) for the years ended December 31, 2014, 2013 and 2012 is presented in the following table:
The net loss and LAE ratio for the year ended December 31, 2013 decreased 2.0 percentage points to 61.6% from 63.6% for the year ended December 31, 2012. The decrease in the loss ratio reflects an improvement in the current accident year driven by mix of business, loss trends, and a reduction in large loss events as compared to the same period in 2012.
The segment and line of business breakdowns of prior period net reserve movements for the years ended December 31, 2014, 2013 and 2012 are as follows:
The Insurance Companies recorded $30.3 million of net prior year reserve releases, primarily driven by our Marine business, in connection with $41.4 million of net favorable loss emergence due to a lesser amount of large losses and improved underwriting over the past couple of years across all core product lines, inclusive of $13.4 million from Marine Liability, $7.2 million from Craft/Fishing vessels, $6.4 million from P&I, $4.7 million from Inland Marine, $1.1 million from Bluewater Hull and $0.7 million from Cargo.
The Lloyds Operations recorded $25.5 million of net prior year reserve releases primarily driven by $21.3 million of Marine releases in connection with favorable loss emergence across all core product lines, inclusive of $11.0 million from Marine Liability, $3.7 million from Specie, $1.3 million from Transport, $1.0 million from Cargo, $2.3 million from Energy Liability and $2.0 million from Marine Assumed.
The Lloyd’s Operations Property Casualty line recorded prior year releases of $1.5 million due to favorable loss emergence on our Onshore Energy book. Additionally, the Professional Liability business reserve releases on older UWYs was due to favorable loss emergence on both our E&O book by $1.0 million and Excess D&O by $1.7 million.
The following is a discussion of relevant factors related to the $1.3 million prior period net reserve releases recorded for the year ended December 31, 2013:
Our Insurance Companies Professional Liability business reported net prior period reserve strengthening of $10.2 million largely attributable to $6.1 million reserve strengthening from our Management Liability division related to specific large claims for UWYs 2010 and prior, and $4.4 million reserve strengthening from our E&O division related to specific large claims from our insurance agents, miscellaneous Professional Liability, and small lawyer lines from UWYs 2011 and prior.
The following is a discussion of relevant factors related to the $45.3 million prior period net reserve releases recorded for the year ended December 31, 2012:
The following table sets forth our gross and net loss and LAE reserves, incurred loss and LAE, and payments for the 2008 Hurricanes Gustav and Ike for the periods indicated:
Our exposure to Asbestos Liability principally stems from Marine Liability insurance written on an occurrence basis during the mid-1980s. In general, our participation on such risks is in the excess layers, which requires the underlying coverage to be exhausted prior to coverage being triggered in our layer. In many instances, we are one of many insurers who participate in the defense and ultimate settlement of these claims, and we are generally a minor participant in the overall insurance coverage and settlement.
The reserves for asbestos exposures as of December 31, 2014 are for: (i) one large settled claim for Excess insurance policy limits exposed to a class action suit against an insured involved in the manufacturing or distribution of asbestos products being paid over several years and (ii) attritional asbestos claims that could be expected to occur over time. Substantially all of our Asbestos Liability reserves are included in our Marine loss reserves. For the year ended December 31, 2014, the Company recognized a benefit of $2.1 million as a result of settlements with third party administrators on ceded paid losses previously written off in prior years due to bankruptcy or insolvency of the reinsurer.
Other operating expenses increased to $196.8 million for the year ended December 31, 2014 compared to $164.4 million for the same period during 2013. The increase is primarily due to continued investment in new underwriting teams and expansion of existing support departments closely aligned with business growth, an increase in incentive compensation driven by stronger underwriting results, and the expansion of our European operation. To a lesser extent, other operating expenses have been adversely affected by exchange rate movement when converting expenses denominated in British pounds to U.S. dollars.
Other operating expenses increased to $164.4 million for the year ended December 31, 2013 compared to $159.1 million for the same period during 2012. The increase is primarily due to continued investments in new underwriting teams closely aligned with business growth and an increase in incentive compensation.
In the fourth quarter of 2013 we incurred a charge of $17.9 million for the payment of a call premium in connection with the redemption of our 7.0% Senior Notes due May 1, 2016 (“7.0% Senior Notes”).
2014 interest expense relates to our 5.75% Senior Notes due October 15, 2023 (“5.75% Senior Notes”). Interest expense increased to $15.4 million for the year ended December 31, 2014 from $10.5 and $8.2 million for the years ended December 31, 2013 and 2012, respectively, primarily due to the completion of our October 4, 2013 public debt offering of $265 million principal amount of 5.75% Senior Notes and the subsequent redemption of the $115 million aggregate principal amount of our 7% Senior Notes due May 1, 2016. The effective interest rate related to the 5.75% Senior Notes and 7.0% Senior Notes, based on the proceeds net of discount and all issuance costs, approximates 5.86% and 7.17%, respectively.
As of December 31, 2014, the net deferred federal, foreign, state and local tax liability was $1.5 million, compared to a net deferred tax asset of $23.8 million as of December 31, 2013 with the change primarily due to the Lloyd’s year of account reclass to deferred from current of $9.2 million liability and the increase in tax on unrealized gains on equities and fixed maturities (including foreign exchange) of $9.4 million.
The net deferred tax asset is $23.8 million as of December 31, 2013 as compared to $3.2 million as of December 31, 2012, with the change primarily due to the increase in unrealized losses on investments and the increase in the deferred tax asset for unearned premium reserve, in line with the growth of our business. Refer to Footnote 7, Income Taxes, included herein, for further detail on the IRS and Lloyd’s tax agreement and Subpart F tax regulation.
Our Company has not provided for U.S. income taxes on approximately $22.6 million of undistributed earnings of its non-U.S. subsidiaries since it is intended that those earnings will be reinvested indefinitely in those subsidiaries. If a future determination is made that those earnings no longer are intended to be reinvested indefinitely in those subsidiaries, U.S. income taxes of approximately $2.3 million, assuming all foreign tax credits are realized, would be included in the tax provision at that time and would be payable if those earnings were distributed to our Company.
The following is a discussion of the financial results for each of our two underwriting segments.
The following table sets forth the results of operations for the Insurance Companies for the years ended December 31, 2014, 2013 and 2012:
Our Insurance Companies reported net income of $79.7 million, $65.4 million and $33.5 million for the years ended December 31, 2014, 2013 and 2012, respectively. The increase in net income for the year ended December 31, 2014 as compared to the same period in 2013 is due to stronger underwriting results, as well as increases in net investment income due to growth in our investment portfolio driven by strong operating cash flows, partially offset by a decrease in net realized gains, a foreign exchange loss and additional tax expense. The increase in net income for the year ended December 31, 2013 as compared to the same period in 2012 was due to an improvement in underwriting results.
Our Insurance Companies combined ratio for the year ended December 31, 2012 was 106.4% compared to 106.5% for the same period in 2011. For the year ended December 31, 2012, our Insurance Companies reported an underwriting loss of $36.8 million, which includes the following:
Net losses of $9.9 million, inclusive of $9.2 million in RRPs, related to several large losses from our Marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy.
The Insurance Companies Marine business experienced a 4.1% increase in renewal rates for the year ended December 31, 2013.
Property Casualty Premiums. The gross written premiums for our Property Casualty business for the years ended December 31, 2014, 2013 and 2012 consisted of the following:
The Insurance Companies Property Casualty gross written premiums for the year ended December 31, 2014 increased $55.0 million, or 7.9% compared to the same period in 2013, primarily driven by our Primary Casualty division, which increased $41.8 million, or 30.1%, due to strong production across all product lines from an improvement in the overall construction market. In addition, there were increases from our Excess Casualty division due to improved market conditions and dislocation of certain competitors, as well as from our Environmental division due to our continued investments in those underwriting teams. The aforementioned increases were partially offset by a net decrease from our Assumed Reinsurance division as a result of reduction in renewal premiums from our A&H product line and Agriculture products that was partially offset by an increase from our LatAm product lines driven by new business growth and an increase in line shares on certain renewals. In addition, we reported a decrease in premium from our Energy & Engineering division due to difficult market conditions and an unfavorable rate environment.
The Insurance Companies Property Casualty business experienced an overall renewal rate increase of 0.8% for the year ended December 31, 2014, mostly driven by a 3.3% increase from our Excess Casualty division, partially offset by a 7.3% decrease in rates from our Energy & Engineering division.
The Insurance Companies Property Casualty gross written premiums for the year ended December 31, 2013 increased 18.5% compared to the same period in 2012. The increases were primarily driven by the growth from our Excess Casualty and Primary Casualty divisions as a result of strong production attributable to an expansion of our underwriting teams and continued dislocation among certain competitors, partially offset by a decrease in our Assumed Reinsurance division attributable to the non-renewal of certain policies from our A&H product line.
The Insurance Companies Professional Liability business experienced an overall renewal rate decrease of 2.0% for the year ended December 31, 2014, inclusive of a 4.0% decrease from our Management Liability division and a 0.5% decrease from our E&O division.
Insurance Companies Other Operating Expenses. Other operating expenses for the Insurance Companies were $138.7 million for the year ended December 31, 2014 compared to $119.9 million for the same period in 2013. The increase in operating expenses is due to continued investments in new underwriting teams and support staff closely aligned with business growth and an increase in incentive compensation driven by stronger underwriting results.
Other operating expenses for the Insurance Companies increased to $119.9 million for the year ended December 31, 2013 from $113.6 million for the same period in 2012 primarily due to an increase in allocated expenses from NMC and NMUK, which is driven by continued investments in new underwriting teams, closely aligned with business growth and an increase in incentive compensation.
Our Lloyd’s Operations combined ratio for the year ended December 31, 2012 was 79.9% compared to 100.8% for the same period in 2011. Our Lloyd’s Operations underwriting results increased by $44.0 million to a $42.3 million underwriting profit for the year ended December 31, 2012 compared to a $1.7 million underwriting loss for the same period in 2011. Our Lloyd’s Operations pre-tax underwriting profit in 2012 includes:
Net loss of $7.6 million, inclusive of $2.0 million in RRPs, related to Superstorm Sandy. Gross of reinsurance our Lloyd’s Operations loss related to Superstorm Sandy was approximately $21.5 million.
Net losses of $4.0 million, inclusive of $1.9 million in RRPs, related to several large losses from our Marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy.
Our Lloyd’s Operations Marine gross written premiums for the year ended December 31, 2014 increased 3.9% compared to the same period in 2013. The lines with the greatest increase on 2013 are Transport, Assumed Marine excess-of-loss and Bluewater Hull. Marine excess-of-loss Assumed Reinsurance Product line includes $2.7 million of Assumed RRPs recognized year to date accounting for the difference. Transport has seen strong growth on new business. Bluewater Hull is inclusive of $3.4 million of new business generated from our new European offices, which commenced operation in September 2014. The total premium generated from these new offices for Marine classes was $3.8 million. War premium has decreased significantly due to less business written in high risk areas.
Our Lloyd’s Operations Property Casualty gross written premiums for the year ended December 31, 2013 increased 2.0% compared to the same period in 2012. The increase is primarily due to new business growth from our Direct and Facultative Property lines that we began writing in 2013, partially offset by Engineering and Construction and runoff business. The Lloyd’s Operations Property Casualty business achieved increases of 1.2% on renewal rates for the year ended December 31, 2013.
Professional Liability Premiums. The gross written premiums for our Professional Liability business for the years ended December 31, 2014, 2013 and 2012 consisted of the following:
Our Lloyd’s Operations Professional Liability gross written premiums for the year ended December 31, 2014 increased 26.2% compared to the same period in 2013 as a result of strong new business growth, partially offset by decreases in renewal rates of 4.2% for the year ended December 31, 2014. Gross written premium increased within Management Liability as we continue to grow our D&O portfolio, while our E&O portfolio has grown across all targeted professions. Both products also benefited from a strategy to increase distribution channels in the UK, Continental Europe, and Australia. The premium numbers are inclusive of $1.0 million of new business generated out of our new European offices, which came into operation in September 2014.
Lloyd’s Operations Other Operating Expenses. Lloyd’s Operations other operating expenses was $58.1 million for the year ended December 31, 2014 compared to $44.5 million for the same period in 2013, primarily due to an increase in employee costs associated with growth initiatives for our business as well as an increase in certain information technology charges assessed by Lloyd’s. One of the initiatives in the year was the opening of 3 new European offices in Rotterdam, The Netherlands, Paris, France and Milan, Italy and accounted for $2.4 million of the increase with additional headcount, office costs and professional fees. New staff in the London office accounted for about an additional $3.0 million of expenses over 2013. Staff expenses are also higher than last year by $1.4 million due to increased incentive compensation in 2014. Costs charged by Lloyd’s Operations were $0.5 million higher than the prior year and IT costs were $2.5 million higher than the prior year. Other operating expenses for the year ended December 31, 2014 were also affected by approximately $2.1 million due to adverse exchange rate movement between the British Pound and the U.S. Dollar which resulted in British Pound denominated expenses to increase more when expressed in U.S. Dollar terms.
(1) The amounts determined are estimates which are subject to a high degree of variation and uncertainty, and are not subject to any specific payment schedule since the timing of these obligations are not set contractually. The amounts in the above table exclude reinsurance recoveries of $851.5 million. See “Business - Loss Reserves” included herein.
Overview. 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 various 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 statutory agencies in the U.S. and the U.K. and (3) letters of credit and other forms of collateral that are necessary to support the business plan of our Lloyd’s Operations.
Shelf Registration. In July 2012, we filed a universal shelf registration statement with the SEC. This registration statement, which expires in July 2015, allows for the future possible offer and sale by our Company of up to $500 million in the aggregate of various types of securities including common stock, preferred stock, debt securities, depositary shares, warrants, units or stock purchase contracts and stock purchase units. The shelf registration statement enables us to efficiently access the public equity or debt markets in order to meet future capital needs, if necessary. This report is not an offer to sell or the solicitation of an offer to buy nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of such state.
Statutory Dividend Capacity. We primarily rely upon dividends from our subsidiaries to meet our Parent Company’s obligations. The Parent Company’s cash obligations primarily consist of semi-annual interest payments on the senior debt, which are currently $7.6 million. Going forward, the interest payments may be made from funds currently at the Parent Company or dividends from its subsidiaries.
NIC may pay dividends to the Parent Company out of its statutory earned surplus pursuant to statutory restrictions imposed under the New York insurance law. As of December 31, 2014, the maximum amount available for the payment of dividends by NIC in 2015 without prior regulatory approval is $89.4 million. NIC did not pay any dividends to the Parent Company in 2014 and 2013, but, did pay $15.0 million of dividends in 2012.
NCUL may pay dividends to the Parent Company up to the extent of available profits that have been distributed from Syndicate 1221, and as of December 31, 2014 and 2013 that amount was $9.9 million (£6.3 million) and $11.6 million (£7.0 million), respectively.
Parent Company Balance Sheet. Condensed Parent Company balance sheets as of December 31, 2014 and 2013 are shown in the table below:
On November 6, 2014, NUAL entered into a credit facility for $8.0 million Australian Dollars with Barclays Bank PLC to fund our participation in Syndicate 1221. The facility is used to fund Australian underwriting obligations for the 2014 and prior UWYs. The facility contains customary covenants for facilities of this type, including a restriction on future encumbrances that are outside the ordinary course of business, and a requirement to maintain at least £75 million of Funds at Lloyd’s. Interest is payable on the facility at a rate of 2% per annum above a floating rate tied to the average mid-rate for Australian bills of exchange administered by the Australian Financial Markets Association. The facility may be cancelled by either party after providing written notice. As of December 31, 2014, we were in compliance with all covenants.
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 within 30-45 days. 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 $0.5 million to $1.0 million) as set forth in the pro rata treaty. For the Insurance Companies, cash calls must generally be paid within 7-15 calendar days. There is generally no specific settlement period for the Lloyd’s Operations cash call provisions, but such billings have historically on average been paid within the same time period.
Net cash provided by financing activities was $1.2 million and $134.2 million for the years ended December 31, 2014 and 2013, respectively, compared to net cash provided by financing activities of $1.1 million for the year ended December 31, 2012. The decrease in cash flows from financing for 2014 compared to 2013 relates to a reduction in proceeds from exercise of stock options. The increase in cash flows from financing for 2013 compared to 2012 is due to net proceeds of $130.8 million received from our public debt offering of the 5.75% Senior Notes.
As of December 31, 2014 and 2013, debt securities for which non-credit OTTI was previously recognized and included in other comprehensive income are now in an unrealized gains position of $0.7 million and $0.5 million, respectively.
Invested assets increased in 2014 from the prior comparable periods for 2013 and 2012 primarily due to positive cash flows from operations. The annualized pre-tax yield, excluding net realized gains and losses and net OTTI losses recognized in earnings, was 2.3%, 2.4% and 2.4% for the years ended December 31, 2014, 2013 and 2012, respectively. The 2.4% annualized pre-tax yield for the years ended December 31, 2012 includes investment expenses of $4.5 million of interest expense related to the settlement of a dispute with Equitas over foregone interest on amounts that were due on certain reinsurance contracts. In the dispute Equitas alleged that we failed to make timely payments to them under certain reinsurance agreements in connection with subrogation recoveries received by us with respect to several catastrophe losses that occurred in the late 1980’s and early 1990’s. In addition, investment expenses for the year ended December 31, 2012 includes a $2.8 million investment performance fee. Excluding the impact of the aforementioned interest expense and investment performance fee, the annualized pre-tax yield for the year ended December 31, 2012 would have been 2.7%, reflective of the general decline in market yields.
The tax equivalent yields for the years ended December 31, 2014, 2013 and 2012 on a consolidated basis were 2.5%, 2.5% and 2.6%, respectively. The portfolio duration was 3.8 years and 3.7 years for the years ended December 31, 2014 and 2013, respectively. Since the beginning of 2014, the tax-exempt portion of our investment portfolio has increased by $86.3 million to approximately 21.0% of the fixed maturities investment portfolio as of December 31, 2014 compared to approximately 20.1% at December 31, 2013.
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, 2014. The securities that are not rated in the table below are primarily state bonds.
The following table sets forth the municipal bond holdings by sectors as of December 31, 2014 and 2013:
We own $77.2 million of municipal securities, which are credit enhanced by various financial guarantors. As of December 31, 2014, the average underlying credit rating for these securities is A+. There has been no material adverse impact to our investment portfolio or results of operations as a result of downgrades of the credit ratings for several of the financial guarantors.
Prime collateral consists of mortgages or other collateral from the most creditworthy borrowers. Alt-A collateral consists of mortgages or other collateral from borrowers, which have a risk potential that is greater than prime but less than subprime. The subprime collateral consists of mortgages or other collateral from borrowers with low credit ratings. Such subprime and Alt-A categories are as defined by S&P.
The following table sets forth our agency mortgage-backed securities and residential mortgage-backed securities (“RMBS”) by those issued by GNMA, FNMA, and FHLMC, and the quality category (prime, Alt-A and subprime) for all other such investments as of December 31, 2014:
Details of the collateral of our asset-backed securities portfolio as of December 31, 2014 are presented below:
Our company holds non-sovereign securities, where the issuer is located in the Euro Area, an economic and monetary union of certain member states within the European Union that have adopted the Euro as their common currency. As of December 31, 2014, the fair value of such securities was $97.6 million, with an amortized cost of $97.6 million representing 3.8% of our total fixed income and equity portfolio. Our largest exposure is in France with a total of $40.1 million followed by The Netherlands with a total of $39.6 million. We have no direct material exposure to Greece, Portugal, Italy, Spain, Ukraine or Russia as of December 31, 2014.
The following table summarizes all securities in a gross unrealized loss position as of December 31, 2014 and 2013, showing the aggregate fair value and gross unrealized loss by the length of time those securities had continuously been in a gross unrealized loss position as well as the number of securities:
In the above, table the gross unrealized loss for the greater than 12 months category consists primarily of Treasury and agency bonds, due to an increase in interest rates and unfavorable foreign exchange movement.
As of December 31, 2014, the gross unrealized losses in the table above were related to fixed maturities that are rated investment grade, which is defined as a security having an S&P rating of “BBB-” or higher, or a Moody’s rating of “Baa3” or higher, except for $0.07 million, which is rated below investment grade or not rated. Unrealized losses on investment grade securities principally relate to changes in interest rates or changes in sector-related credit spreads since the securities were acquired.
The contractual maturity for fixed maturities categorized by the number of years until maturity, with a gross unrealized loss as of December 31, 2014 is presented in the following table:
As of December 31, 2014, there were no investments with a fair value that was less than 80% of amortized cost.
We did not have OTTI losses during the year ended December 31, 2014. During the year ended December 31, 2013, we recognized OTTI losses of $2.4 million related to three equity securities and one municipal bond. During the year ended December 31, 2012, we recognized OTTI losses of $0.9 million related to one non-agency mortgage-backed security and three equity securities. The significant inputs used to measure the amount of credit loss recognized in earnings were actual delinquency rates, default probability assumptions, severity assumptions and prepayment assumptions. Projected losses are a function of both loss severity and probability of default. Default probability and severity assumptions differ based on property type, vintage and the stress of the collateral. We do not intend to sell any of these securities and it is more likely than not that, we will not be required to sell these securities before the recovery of the amortized cost basis.