Calculated as stockholders’ equity divided by actual shares outstanding as of the date indicated.
Management’s Discussion And Analysis Of Financial Condition And Results Of Operations
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.
We are an international insurance holding company focusing on specialty products for niches within the overall property/casualty insurance market. The Company’s underwriting segments consists of insurance company operations and operations at Lloyd’s of London. Our largest product line and most long-standing area of specialization is ocean marine insurance. We have also developed specialty niches in professional liability insurance and in specialty liability insurance primarily consisting of contractors liability and primary and excess liability coverages. We conduct operations through our Insurance Companies and our Lloyd’s Operations. The Insurance Companies consist of Navigators Insurance Company, which includes our U. K. Branch, and Navigators Specialty Insurance Company, which underwrites specialty and professional liability insurance on an excess and surplus lines basis fully reinsured by Navigators Insurance Company. Our Lloyd’s Operations include NUAL, a Lloyd’s underwriting agency which manages Syndicate 1221. We participate in the capacity of Syndicate 1221 through two wholly-owned Lloyd’s corporate members.
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. The Insurance Companies’ 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.
The discussions that follow include tables, which contain both our consolidated and segment operating results for each of the years in the three-year period ended December 31, 2007. In presenting our financial results we have discussed our performance with reference to underwriting profit or loss and the related combined ratio, both of which are non-GAAP measures of underwriting profitability. We consider such measures, which may be defined differently by other companies, to be important in the understanding of our overall results of operations. Underwriting profit or loss is calculated from net earned premium, less the sum of net losses and LAE, commission expense, other operating expenses and commission income and other income (expense). The combined ratio is derived by dividing the sum of net losses and LAE, commission expense, other operating expenses and commission income and other income (expense) divided by earned premium. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss.
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 (“D&O”) insurance 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 by conservative and detailed underwriting, prudent use of reinsurance and a balanced portfolio of risks.
Our revenue is primarily comprised of premiums and investment income. The Insurance Companies derive their premiums primarily from business written by the Navigators Agencies, which are wholly-owned insurance underwriting agencies of the Company. The Lloyd’s Operations derive their premiums from business written by NUAL. Beginning in 2006, the Navigators Agencies produce and manage business almost exclusively for the Insurance Companies and are reimbursed for actual costs. Prior to 2006, the Navigators Agencies received commissions and, in some cases, profit commissions on the business produced on behalf of the Insurance Companies and other unaffiliated insurers. NUAL is reimbursed for its actual costs and, where applicable, profit commissions on the business produced for Syndicate 1221.
Up until 2006, we have experienced generally beneficial market changes in our lines of business. As a result of several large industry losses in the second quarter of 2001, the marine insurance market began to experience diminished capacity and rate increases, initially in the offshore energy line of business. The marine rate increases began to level off in 2004 and into 2005. As a result of the substantial insurance industry losses resulting from
Specialty liability losses in 2001 to 2003, particularly for our construction liability business, also resulted in diminished capacity in the market in which we compete, as many former competitors who lacked the expertise to selectively underwrite this business have been forced to withdraw from the market resulting in approximate rate increases of 13% in 2004 and 49% in 2003. This was followed by a slight decline in rates of approximately 1% in 2005. The 2006 year average renewal rates for the construction liability business declined approximately 6%, primarily due to additional competition in the marketplace. This decline continued into 2007 with average renewal rates declining approximately 9.7% for the fourth quarter and 10.7% for the twelve months. We expect competitive conditions will continue into 2008 resulting in continued declines in pricing for construction liability and excess liability business.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. We continually assess our concentration of underwriting exposures in catastrophe exposed areas globally and attempt to manage this exposure through individual risk selection and through the purchase of reinsurance. We also use modeling and concentration management tools that allow us to better monitor and control our accumulations of potential losses from catastrophe exposures. Despite these efforts, there remains uncertainty about the characteristics, timing and extent of insured losses given the nature of catastrophes. The occurrence of one or more severe catastrophic events could have a material adverse effect on the Company’s results of operations, financial condition or liquidity.
The Company has significant catastrophe exposures throughout the world with the largest catastrophe exposure for offshore energy risks due to hurricanes in the Gulf of Mexico. Based on an assessment made at the end of 2007 taking into account the 2008 reinsurance structure, the Company believes that its estimated probable maximum pre-tax gross and net loss exposure in a so-called or theoretical one in two hundred and fifty year hurricane event in the Gulf of Mexico would approximate $221 million and $32 million, respectively, including the cost of reinsurance reinstatement premiums. There are a number of significant assumptions and related variables related to such an estimate including the size, force and path of the hurricane, the various types of the insured risks exposed to the event at the time the event occurs and the estimated costs or damages incurred for each insured risk. There can be no assurances that the gross and net loss amounts that the Company could incur in such an event or in any hurricanes that may occur in the Gulf of Mexico would not be materially higher than the estimates discussed above given the significant uncertainties with respect to such an estimate.
Hurricanes Katrina and Rita (the “2005 Hurricanes”) which occurred in the 2005 third quarter generated substantial losses to the property and casualty industry and the marine and energy insurance market due principally to offshore energy losses. Hurricane Wilma, which occurred in the 2005 fourth quarter, also generated substantial losses to the property and casualty industry but was not significant to either the marine and energy line of business or to the Company in general, in comparison to Hurricanes Katrina and Rita. There were no significant hurricane losses in 2007 or 2006 that impacted the marine and energy lines of business of the Company. See “Description of Business-Loss Reserves” included herein for a discussion of the impact of the 2005 Hurricanes on our financial results.
Management believes that should any adverse loss development for gross claims occur, it would be contained within our reinsurance program. Our actual losses from such hurricanes may differ materially from our estimated losses as a result of, among other things, the receipt of additional information from insureds or brokers, the attribution of losses to coverages that for the purposes of our estimates we assumed would not be exposed and inflation in repair costs due to the limited availability of labor and materials. If our actual losses from the 2005 Hurricanes are materially greater than our estimated losses, our business, results of operations and financial condition could be materially adversely affected.
To the extent a hurricane similar in force and following similar paths of Hurricane Katrina or Rita were to occur in 2008, the Company’s gross losses would be substantially less than in 2005 given the reductions in coverages provided by the Company in the Gulf of Mexico but the net loss would be somewhat higher given the reduced availability of excess of loss reinsurance protection for such exposures coupled with the increased cost of excess of loss reinstatement premiums.
Reinsurance Recoverables. 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. In addition, 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. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Additional information regarding our reinsurance recoverables can be found in the “Description of Business-Reinsurance Ceded” section and Note 6, Reinsurance, to our consolidated audited financial statements, both included herein.
A portion of the Company’s premium is estimated for unreported premium, mostly for the marine business written by our U.K. Branch and Lloyd’s Operations. We generally do not experience any significant backlog in processing premiums. Of the $1.07 billion of gross written premium recorded in 2007, $106.6 million or approximately 10% was estimated. The estimated premium was 10% and 11% of the gross written premium in 2006 and 2005, respectively. Such premium estimates are generally based on submission data received from brokers and agents and recorded when the insurance policy or reinsurance contract is bound and written. 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.
Deferred Tax Assets. We apply the asset and liability method of accounting for income taxes whereby deferred assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. Additional information regarding our deferred tax assets can be found in Note 1, Organization and Summary of Significant Accounting Policies, and Note 7, Income Taxes, to our consolidated audited financial statements, both included herein.
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 to the extent the investment manager is contemplating a transaction or transactions that may result in a realized loss above a certain threshold. Additionally, investment managers are required to notify management if they are contemplating a transaction or transactions that may result in any realized loss up until a certain period beyond the close of a quarterly accounting period.
Accounting for Lloyd’s Results. We record our pro rata share of Syndicate 1221’s assets, liabilities, revenues and expenses, after making adjustments to convert Lloyd’s accounting to U.S. GAAP. The most significant GAAP adjustments relate to income recognition. Lloyd’s syndicates determine underwriting results by year of account at the end of three years. We record adjustments to recognize underwriting results as incurred, including the expected ultimate cost of losses incurred. These adjustments to losses are based on actuarial analysis of syndicate accounts, including forecasts of expected ultimate losses provided by the syndicate. At the end of the Lloyd’s three-year period for determining underwriting results for an account year, the syndicate will close the account year by reinsuring outstanding claims on that account year with the participants for the account’s next underwriting year. The amount to close an underwriting year into the next year is referred to as the reinsurance to close (“RITC”). The RITC transaction, recorded in the fourth quarter, does not result in any gain or loss. Additional information regarding our accounting for Lloyd’s results can be found in Note 1, Organization and Summary of Significant Accounting Policies, to our consolidated audited financial statements, included herein.
Translation of Foreign Currencies. Financial statements of subsidiaries expressed in foreign currencies are translated into U.S. dollars in accordance with the Statement of Financial Accounting Standards No. (“SFAS”) 52, Foreign Currency Translation, issued by the Financial Accounting Standards Board (“FASB”). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using period end rates of exchange and the related translation adjustments are recorded as a separate component of accumulated other comprehensive income. Statement of income amounts expressed in functional currencies are translated using average exchange rates.
The following is a discussion and analysis of our consolidated and segment results of operations for the years ended December 31, 2007, 2006 and 2005. All earnings per share data is presented on a per diluted share basis.
Net income for 2007, 2006 and 2005 was $95.6 million or $5.62 per share, $72.6 million or $4.30 per share and $23.6 million or $1.73 per share, respectively. The 2005 year was adversely impacted by Hurricanes Katrina and Rita. When excluding the storm losses in 2005, underwriting profitability during such periods, as measured by the Company’s combined ratios, has improved for the 2007, 2006 and 2005 business written. This improvement in underwriting profitability reflects increasing premium rates as a result of favorable market conditions beginning in late 2000 and continuing to a lesser extent through 2004, and then leveling off in 2005 and remaining level or declining slightly in 2006 and 2007 except for marine offshore energy rates which increased beginning in the 2005 fourth quarter and into 2006 as a result of Hurricanes Katrina and Rita. We experienced premium growth as measured by net earned premium in 2007, 2006 and 2005 of 28.5%, 38.3% and 8.9%, respectively, due to the combination of increased premium rates, business expansion and retaining more business.
Consolidated stockholders’ equity increased 20.1% to $662.1 million or $39.24 per share at December 31, 2007 compared to $551.3 million or $32.94 per share at December 31, 2006. The increase was primarily due to 2007 net income of $95.6 million.
Cash flow from operations was $284.6 million, $146.0 million and $247.8 million in 2007, 2006 and 2005, respectively, contributing to the growth in invested assets and net investment income. Investment income increased 24.2% in 2007 to $70.6 million compared to 2006 and increased 53.5% in 2006 to $56.9 million compared to 2005 as the result of both the increase in invested assets and the increase in investment yields.
The 2007 results of operations reflect improved financial performance compared to 2006 due to a combination of improved underwriting results and the growth in investment income.
The underwriting results benefited from increased net premium revenues despite continuing softening market conditions, and the recording of a net redundancy of prior years’ loss reserves of $47.0 million, or $1.80 per share, which reduced the 2007 combined ratio of 87.5% by 7.8 loss ratio points.
The 2005 results of operations reflect improved financial performance consistent with the 2004 year excluding hurricane losses. The 2005 results of operations were adversely impacted by an after-tax charge of $23.9 million, or $1.75 per share, from the losses resulting from Hurricanes Katrina and Rita. The Company’s combined ratio of 101.3% was negatively impacted by 10.5 loss ratio points from Hurricanes Katrina and Rita while being reduced by 1.1 loss ratio points from a net redundancy of prior years’ loss reserves of $3.8 million, or $0.18 per share.
Revenues. Gross written premium increased to $1.07 billion in 2007 from $970.8 million in 2006 and from $779.6 million in 2005, increases of 10.2%, 25.0% and 12.0% in 2007, 2006 and 2005, respectively. 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 change calculations provide an indicated pricing trend and are 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 generally would 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:
The 2007 gross written premium increased 22.5% when compared to 2006 reflecting growth across all lines of business including primary casualty which started in the third quarter of 2006. The 2006 gross written premium increased 47.9% when compared to 2005 also reflecting growth across all lines of business along with including premiums generated from our primary casualty business which started in the third quarter of 2006. During 2005 we launched our excess casualty division in the first quarter and expanded our presence in the hospitality business by writing general liability insurance which includes liquor law liability coverage for commercial establishments such as bars, restaurants and night clubs contained in our middle markets unit. We also commenced writing first party personal lines warranty coverage on underground fuel tanks excluding pollution coverage. The average renewal premium rate changes in the contractors’ liability business decreased approximately 11%, 6% and 1% in 2007, 2006 and 2005, respectively, following increases of 13% and 49% in 2004 and 2003, respectively.
Professional Liability Premium. The gross written premium for each of the years in the three-year period ended December 31, 2007 consisted of the following:
The professional liability premium increased 7.3% to $99.6 million in 2007 from $92.8 million in 2006 when it increased 6.7% from $86.9 million in 2005 reflecting growth and the expansion in all lines of our professional liability business. Average 2007 renewal premium rates for this business decreased approximately 6.6% after being relatively level in 2006 and 2005. D&O average renewal premium rates decreased approximately 7.9% in 2007, 2% in 2006 and 2.3% in 2005.
During the 2006 first quarter, the Company entered into an agreement to acquire the renewal rights to the D&O and employment practices liability policy portfolios of Genesis Professional Liability Managers, Inc. (“Genesis”). The transaction does not include any past or existing liabilities of the policy portfolios. The Company pays an annual override or fee to Genesis based on gross written premium for a two year period to the extent the Genesis business is underwritten and renewed by the Company.
Other Premium. Other premium includes domestic inland marine business and European property business written by the U.K. Branch, which were both started by the Company in 2006.
The 2007 decrease in gross written premium of 8.1% resulted from generally deteriorating market conditions that have led us to decline risks that we believe are not adequately priced, particularly in the offshore line of business. In addition, some premium estimates recorded during 2006 have been lowered during 2007, which has reduced the 2007 calendar year gross written premium. The 2006 increase of 18.3% resulted from growth across several lines of business but primarily offshore energy which benefited from rate increases following losses from the 2005 Hurricanes. In September 2005, the Company purchased the remaining outstanding 2.5% interest of Syndicate 1221’s stamp capacity for the 2006 underwriting year.
The average renewal premium rate decreased approximately 1% in 2007 and increased approximately 13% and 3% in 2006 and 2005, respectively. The 2006 increase started in the 2005 fourth quarter in the offshore energy business resulting from losses caused by Hurricanes Katrina and Rita.
Other Premium. Other premium consists of gross written premium for European property business, engineering and construction business which provides coverage for construction projects including machinery, equipment and loss of use due to
Ceded Written Premium. 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 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.
The following table sets forth our ceded written premium by segment and major line of business for the periods indicated:
The ratio of total ceded written premium to total gross written premium in 2007 was 39.7% compared to 46.4% for 2006 and 51.2% for 2005. The Insurance Companies’ marine and Lloyd’s Operations 2005 ceded written premium includes $14.4 million of reinstatement premium related to the losses from the 2005 Hurricanes.
Modest reductions in the amounts of marine insurance ceded on a pro rata basis by the Insurance Companies.
Reductions in the amount of business ceded on a pro rata basis by the Lloyd’s Operations coupled with reductions in reinsurer participation in our Syndicate 1221 stamp capacity.
The ratio of ceded written premium to gross written premium declined in 2006 compared to 2005 due to the following factors:
Purchased the 2.5% minority interest and replaced a 5% capacity provider with our own letter of credit in Syndicate 1221 effective January 1, 2006.
Net Written Premium. The 2007 net written premium increased 24.0% compared to 2006. The 2006 net written premium increased 36.8% compared to 2005. The increase was 31.8% when excluding the $14.5 million of ceded reinstatement premiums resulting from the 2005 Hurricanes. The increases in net written premium are reflective of the changes in gross written and ceded written premium discussed above.
Net Realized Capital Gains (Losses). Pre-tax net income included $2.0 million of net realized capital gains for 2007 compared to net realized capital losses of $1.0 million for 2006 and net realized capital gains of $1.2 million for 2005. On an after-tax basis, the net realized capital gains were $1.3 million or $0.08 per share for 2007 compared to the net realized capital losses of $0.7 million or $0.04 per share for 2006 and the net realized capital gains of $0.8 million or $0.06 per share for 2005.
Net Losses and Loss Adjustment Expenses Incurred. The ratios of net loss and loss adjustment expenses incurred to net earned premium (loss ratios) were 56.6%, 57.7% and 69.6% in 2007, 2006 and 2005, respectively. The 2007 loss ratio of 56.6% was favorably impacted by 7.8 loss ratio points resulting from the $47.0 million net redundancy of prior year loss reserves. The 2007 loss ratio also included 0.9 loss ratio points for the U.K. flood losses in the Insurance Companies’ U.K. Branch’s property business and the Lloyd’s marine cargo business. The 2006 loss ratio of 57.7% was favorably impacted by 3.7 loss ratio points resulting from the $17.2 million net redundancy of prior year loss reserves.
With the recording of gross losses, the Company assesses its reinsurance coverage, potential receivables, and the
recoverability of the receivables. Losses incurred on business recently written are primarily covered by reinsurance agreements written by companies with whom the Company is currently doing reinsurance business and whose credit the Company continues to assess in the normal course of business.
As illustrated in the following table, our overall reinsurance recoverable amounts for paid and unpaid losses have declined during 2007 as the Company continues to bill and collect its recoverables for Hurricanes Katrina and Rita loss payments and retains more of its business:
As discussed below and under the caption “Description of Business-Loss Reserves,” there are a number of factors that could cause actual losses and loss adjustment expenses to differ materially from the amount that we have reserved for losses and loss adjustment expenses.
The Company’s actuaries generally calculate the IBNR loss reserves for each line of business by underwriting year for major products principally using two standard actuarial methodologies which are projection or extrapolation techniques: the loss ratio method and the Bornheutter-Ferguson method. The loss ratio method is used to calculate the IBNR for the most current underwriting year while the Bornheutter-Ferguson method is used to calculate the IBNR for all prior underwriting years, except as otherwise described below. Such methodologies are supplemented in most instances by the loss development method and the frequency/severity method which are used to analyze and better comprehend loss development patterns and trends in the data when making selections and judgments under the loss ratio method and the Bornheutter-Ferguson method. In utilizing these methodologies, each of which is generally applicable to both long-tail and short-tail lines of business and all of which are described below, to develop our IBNR loss reserves, a key objective of our actuaries is to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them so that the future can be projected more reliably. This process requires the substantial use of informed judgment and is inherently uncertain.
Bornheutter-Ferguson method: 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 underwriting years. The expected ultimate loss ratio is generally determined in the same manner as in the loss ratio method.
Marine: Generally, two key assumptions are used by our actuaries in setting IBNR loss reserves for major products in this line of business. The first assumption is that our historical experience regarding paid and reported losses for each product where we have sufficient history can be relied on to predict future loss activity. The second assumption is that our underwriters’ assessments as to potential loss exposures are reliable indicators of the level of our expected loss activity. The specific loss reserves for marine are then analyzed separately by product based on such assumptions, except where noted below, with the major products including marine liability, offshore energy, cargo, protection and indemnity (“P&I”), transport and bluewater hull.
The Company has extensive history in the contractors liability business upon which to perform actuarial analyses and does use the key assumption noted above relating to its 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 the Company 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 and 2006. A California legislative change, the effects of which are yet to be fully understood by the industry, with respect to reserves and claim frequency for construction defect repairs, became effective July 1, 2002 with a sunset provision effective January 1, 2011. The law provides for an alternative dispute resolution system that attempts to involve all parties to a claim at an early stage. The legislation may be impacting claim severity, frequency and the length of settlement which may ultimately be different than historical loss development assumptions employed in our loss reserve process.
in runoff since 1999, which are periodically monitored and evaluated by claims and actuarial personnel.
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, and thus are small, 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.
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.
The Insurance Companies recorded $10.7 million of net prior years’ savings for marine business comprised of $6.5 million of savings in the transport business, $3.7 million of savings in the marine liability business, $1.6 million of savings in the cargo business, $1.0 million of savings in each of the hull and offshore energy businesses; partially offset by $1.9 million of 2005 Hurricanes Katrina and Rita loss development and $1.6 million for uncollectible reinsurance recoverables for asbestos losses. The favorable development for the liability, cargo, hull and offshore energy coverages was primarily due to reduced claim activity for the 2005 and 2006 underwriting years. Prior to 2007, because the Company did not have sufficient experience in the transport product line, it instead used its hull and liability products loss development experience as a key assumption in setting the IBNR loss reserves for its transport product. Commencing in 2007, our actuaries determined that the Company’s loss development experience for its transport product had become sufficiently credible to begin establishing transport reserves using such experience, which resulted in the prior year savings referred to above recorded for this business.
The Insurance Companies recorded $12.1 million of net prior years’ savings for specialty business related to the contractors liability business for the years 1998 through 2006. The prior years’ savings recorded for contractors liability business was due mostly to continued favorable loss frequency and severity trends for 2003 to 2006 compared to expectations. Our actuaries believe that the favorable loss frequency trends result primarily from a number of underwriting and coverage changes since 2002, including the migration to non-admitted business from admitted business in 2003, which allowed the Company to exclude certain previously permitted exposures (for example, exposure to construction work performed prior to the policy inception), and withdrawals from certain contractor classes previously underwritten. Our actuaries believe that the favorable loss severity trends result primarily from improved claim practices coupled with a California legislative change, effective in mid-2002, which provides for an alternative dispute resolution system with respect to construction defect claims and is intended to avoid or mitigate costly litigation and claims settlements. While our actuaries were unable to precisely quantify the impact of each of the foregoing factors, such factors were judgmentally taken into account in recording such prior years’ savings for contractors liability business by evaluating actual loss development compared to expected loss development coupled with a frequency and severity claims analysis conducted in 2007.
The Insurance Companies have historically reserved for the professional liability business using ultimate loss ratios based on industry experience for this line of business given the Company’s limited claims history. Such industry experience is heavily influenced by the historical frequency and severity of large securities class action lawsuits. During 2007 the Insurance Companies reduced the net reserves for such claims-made policies compared to year-end 2006 by $10.4 million, mostly related to policies issued in 2004 and 2005. The reductions were made to recognize both the low level of open claim counts and the lack of claim
severity compared to expectations at the time the reserves were initially established using industry experience.
The Insurance Companies recorded $4.8 million of net prior years’ savings for marine business consisting of $7.9 million for business written in 2004 and 2005 mostly for favorable loss experience in cargo and marine liability business, partially offset by net prior years’ reserve deficiencies of $3.1 million for 2003 and prior years.
The Lloyd’s Operations recorded $4.5 million of net prior years’ savings, which included $1.1 million related to a loss commutation for the 1999 to 2002 years, with the balance spread across several lines of business in the 2002 to 2004 years.
The Insurance Companies recorded $0.8 million of net prior years’ savings for run-off business principally due to favorable loss experience on aviation business discontinued in 1999.
The Lloyd’s Operations recorded $1.2 million of net prior years’ savings mostly due to the favorable settlement of one large marine claim.
As discussed above, our actuaries generally apply the loss ratio method to calculate the IBNR loss reserve for the most current underwriting year while the Bornhuetter-Ferguson method is used to calculate the IBNR loss reserves for all prior underwriting years except in certain situations such as when limited or insufficient historical data is available.
The reasonably likely ranges of potential deviation in the loss ratios for each line of business for the 2000 to 2007 underwriting years expressed in loss ratio points are as follows:
For the selected alternative loss development factors for the 2000 to 2006 underwriting years, our actuaries observed the range of historical loss development factors recorded for such underwriting years for each major line of business at December 31, 2007. After evaluating the range of loss development factor variances for each underwriting year, our actuaries judgmentally selected a range of reasonably likely variations to determine alternative IBNR loss reserve amounts compared to the amounts recorded for each line of business for the underwriting years 2000 to 2006 out of the range of reasonably possible variations for such underwriting years. Such variations represent the differences in the time that it takes for losses to develop for an underwriting year.
The sensitivity analysis also reflects a likely range of impact on reported financial results by aggregating calculated redundancy amounts and deficiency amounts for each line of business. The total Company range amounts below were determined by adding the reasonably likely range amounts for each line of business,
Used 17,005,000 average diluted shares outstanding for the year ended December 31, 2007.
Other Operating Expenses. The 28.8% and 17.2% increases in other operating expenses when comparing 2007 to 2006 and comparing 2006 to 2005, respectively, were attributable primarily to employee related expenses resulting from expansion of the business.
Income Taxes. The income tax expense was $43.6 million, $34.1 million and $10.2 million for 2007, 2006 and 2005, respectively. The effective tax rates for 2007, 2006 and 2005 were 31.3%, 31.9% and 30.2%, respectively. The Company’s effective tax rate is less than 35% due to permanent differences between book and tax return income, with the most significant item being tax exempt interest. As of December 31, 2007 and 2006, the net deferred Federal, foreign, state and local tax assets were $29.2 million and $30.4 million, respectively.
We are subject to the tax regulations of the United States and foreign countries in which we operate. 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. Lloyd’s is required to pay U.S. income tax on U.S. connected income written by Lloyd’s syndicates. Lloyd’s and the IRS have entered into an agreement whereby the amount of tax due on U.S. connected income is calculated by Lloyd’s and remitted directly to the IRS. These amounts are then charged to the corporate members in proportion to their participation in the relevant syndicates. The Company’s corporate members are subject to this agreement and will receive U.K. tax credits for any U.S. income tax incurred up to the U.K. income tax charged on the U.S. income. The non-U.S. connected insurance income would generally constitute taxable income under the Subpart F income section of the Internal Revenue Code since less than 50% of the Company’s premium is derived within the U.K. and would therefore be subject to U.S. taxation when the Lloyd’s year of account closes. Taxes are accrued at a 35% rate on our foreign source insurance income and foreign tax credits, where available, are utilized to offset U.S. tax as permitted. The Company’s effective tax rate for Syndicate 1221 taxable income could substantially exceed 35% to the extent the Company is unable to offset U.S. taxes paid under Subpart F tax regulations with U.K. tax credits on future underwriting year distributions. U.S. taxes are not accrued on the earnings of the Company’s foreign agencies as these earnings are not subject to the Subpart F tax regulations. These earnings are subject to taxes under U.K. tax regulations at a 30% rate. A finance bill was enacted in the U.K. on July 19, 2007 that reduces the U.K. corporate tax rate from 30% to 28% effective April 1, 2008. The effect of such tax
The Company had net state and local deferred tax assets amounting to potential future tax benefits of $6.3 million and $6.0 million at December 31, 2007 and 2006, respectively. Included in the deferred tax assets are net operating loss carryforwards of $2.5 million and $4.8 million at December 31, 2007 and 2006, 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, 2007 expire from 2022 to 2027.
Excluding the losses from the 2005 Hurricanes, underwriting results generally reflect the favorable industry market conditions since 2001 coupled with satisfactory loss trends in the aforementioned periods. The Insurance Companies experienced premium growth in all three active lines of business as reflected in the above tables. Overall, the net earned premium increased 34.5%, 43.3% and 0.6% in 2007, 2006 and 2005, respectively, reflecting business expansion in the specialty and professional liability business units coupled with increased retention of the business written, partially offset by the effect of premium rate changes on renewal policies on certain lines of business.
The 2006 underwriting results were favorably impacted by approximately $12.7 million or 3.9 loss ratio points for net prior year savings predominately from our specialty and marine lines of business due to favorable loss development trends.
Syndicate 1221’s stamp capacity was £140 million ($280 million) in 2007, £123 million ($226 million) in 2006 and £135 million ($246 million) in 2005. The stamp capacity for 2006 and 2005 was reduced to minimize the costs associated with unused stamp capacity in 2004 coupled with anticipated declining market conditions in 2006 and 2005 following an increase in 2004. 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 provided 100% of Syndicate 1221’s total stamp capacity in 2007 and 2006 and 97.5% in, 2005. In September 2005, the Company purchased the remaining outstanding minority interest of Syndicate 1221’s capacity for the 2006 underwriting year. Syndicate 1221’s stamp capacity is expressed net of commission (as is standard at Lloyd’s). The Syndicate 1221 premium recorded in the Company’s financial statements is gross of commission.
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 underwriting year and to report most related claims, although claims may remain unsettled after the underwriting year is closed. A Lloyd’s syndicate typically closes an underwriting year by reinsuring outstanding claims on that underwriting year with the participants for the next underwriting year. The ceding participants pay the assuming participants an amount based on the unearned premiums and outstanding claims in the underwriting year at the date of the assumption. Our participation in Syndicate 1221 is represented by and recorded as our proportionate share of the underlying assets and liabilities and results of operations of the syndicate since (i) we hold an undivided interest in each asset, (ii) we are proportionately liable for each liability and (iii) Syndicate 1221 is not a separate legal entity. At Lloyd’s, the amount to close an underwriting year into the next year is referred to as the reinsurance to close (“RITC”) transaction. The RITC amounts represent the transfer of the assets and liabilities from the participants of a closing underwriting year to the participants of the next underwriting year. To the extent our participation in the syndicate changes, the RITC amounts vary accordingly. The RITC transaction, recorded in the fourth quarter, does not result in any gain or loss. 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 2006 earnings in the Lloyd’s Operations reflect the strong growth in premiums and continued favorable loss development trends. The 2006 underwriting results were favorably impacted by approximately $4.5 million or 3.2 loss ratio points for net prior years’ savings due to favorable loss development trends, primarily in our 2004 and 2005 underwriting years.
The 2005 pre-tax net loss in the Lloyd’s Operations was a result of losses caused by Hurricanes Katrina and Rita of approximately $20.2 million, including $5.3 million of reinstatement costs, which increased the Lloyd’s Operations 2005 combined ratio by 18.6 ratio points.
The 2005 underwriting results were favorably impacted by approximately $1.2 million or 1.1 loss ratio points for net prior years’ savings.
The pre-tax yields on the Lloyd’s Operations’ investments approximated 3.9%, 3.4% and 2.4% for 2007, 2006 and 2005, respectively. 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 increase in the Lloyd’s Operations net investment income is reflective of the increased investment portfolio primarily due to positive cash flow and to the increase in the yield. The increase in the Lloyd’s Operations’ 2007 yield compared to 2006 reflects Navigators’ increased participation in Syndicate 1221 as shown in the table below. As our participation increases we retain a larger share of the Syndicate’s investment income. The increase in the Lloyd’s Operations’ 2006 yield compared to 2005 reflected the 2006 increases made to the Federal Funds Rate by the Federal Reserve. The average duration of the Lloyd’s Operations investment portfolio was 1.6 years at December 31, 2007 compared to 1.0 years at December 31, 2006. Such yields are net of interest credits to certain reinsurers for funds withheld by our Lloyd’s Operations.
See “Results of Operations and Overview-Income Taxes” for a discussion of the Lloyd’s Operations income taxes.
The table below illustrates the Company’s participation for each year of account in Syndicate 1221:
Participation after reinsurance of the Lloyd’s Operations’ corporate capital vehicles, but before other third party reinsurance.
For 2008, Syndicate 1221’s stamp capacity is £123 million ($244 million) and our participation is 100%, with no reinsurer participation.
Cash flows from operations were $284.6 million, $146.0 million and $247.8 million for 2007, 2006, and 2005, respectively. Operating cash flow was used primarily to acquire additional investments of fixed income securities.
The Company has a credit facility provided through a consortium of banks. The credit facility was amended in February 2007 to increase the letters of credit available under the credit facility from $115 million to $180 million and to increase the line of credit available under the credit facility from $10 million to $20 million. Also, the expiration of the credit facility was extended from June 30, 2007 to March 31, 2009. If at that time the bank consortium does not renew the credit facility, we will need to find other sources to provide the letters of credit or other collateral in order to continue our participation in Syndicate 1221. The credit facility, which is denominated in U.S. dollars, is utilized primarily by Navigators Corporate Underwriters Ltd. and Millennium Underwriting Ltd. to fund our participation in Syndicate 1221 which is denominated in British sterling. At December 31, 2007, letters of credit with an aggregate face amount of $107 million were issued under the credit facility. The line of credit was unused at December 31, 2007.
Time lags do occur in the normal course of business between the time gross losses are paid by the Company and the time such gross losses are billed and collected from reinsurers. During 2007, 2006 and 2005, approximately 38%, 46% and 73%, respectively, of gross incurred losses of approximately $551 million, $498 million and $886 million, respectively, were ceded to
In October, 2007 the Company’s Board of Directors adopted a stock repurchase program for up to $30 million of the Company’s common stock. Repurchases may be made from time to time at prevailing prices in open market or privately negotiated transactions through December 31, 2008. The timing and amount of the repurchase transactions under the program will depend on a variety of factors, including the trading price of the stock, market conditions and corporate and regulatory considerations. We have not repurchased any of our common stock during the year ended December 31, 2007.
In July 2006, the Company filed a universal shelf registration statement with the Securities and Exchange Commission. This registration statement, which expires in July 2009, allows for the future possible offer and sale by Navigators of up to $300 million, in the aggregate, of various types of securities, including common stock, preferred stock or debt securities. 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.
We primarily rely upon dividends from our subsidiaries to meet our holding company obligations. Since the issuance of the senior debt in April 2006, the holding company cash obligations primarily consist of semi-annual interest payments of $4.4 million. Going forward, the interest payments on the Company’s senior debt will be made from one or a combination of funds at the Parent Company, dividends from its subsidiaries and the $20 million line of credit. The dividends have historically been paid by Navigators Insurance Company. Based on the December 31, 2007, surplus of Navigators Insurance Company, the approximate remaining maximum amount available for the payment of dividends by Navigators Insurance Company during 2008 without prior regulatory approval was $57.9 million. Dividends of $8.0 million, $0 and $3.0 million were paid by Navigators Insurance Company during 2007, 2006 and 2005, respectively.
At December 31, 2007 and 2006, approximately $5.1 million and $4.2 million, respectively, of investments were held in a tax escrow account on behalf of Navigators Insurance Company until the two-year tax loss carryback periods expire.
invested assets. An increase in interest rates will tend to increase our yield and have a negative effect on the fair value of our invested assets.
The consolidated financial statements required in response to this section are submitted as part of Item 15(a) of this report.