The Company's administrative offices are occupied pursuant to a lease from an unaffiliated company which expires May 14, 2000 in a building located at 123 William Street, New York, New York. The Company has entered into a new ten year lease in a different building in New York City. Several of the Company's subsidiaries have noncancellable operating leases for their respective office location. The Company does not own any real estate at December 31, 1999.
The Company's revenue is primarily comprised of premiums, commissions and investment income. The Insurance Companies derive the majority of their premium from business written by the Somerset Companies and Anfield. The Insurance Companies are managed by Somerset Marine, Inc. The Lloyd's operations derive their premium from business written by MTC, and in 1997 from one unaffiliated Lloyd's syndicate.
Lloyd's Syndicate 1221 had capacity of (pound)67.0 million (converts to $105.9 million) in 1999, (pound)66.9 million (converts to $111.1 million) in 1998 and (pound)68.5 million (converts to $113.1 million) in 1997. The Lloyd's marine business has been subject to continued pricing competition resulting in less premiums per risk relative to certain prior years. As a result, the Company wrote less than the capacity available.
Lloyd's presents its results on an underwriting year basis, generally closing each underwriting year after three years. The Company makes estimates for each year and timely accrues the expected results.
At Lloyd's, the amount to close an underwriting year into the next year is referred to as the "reinsurance to close." At December 31, 1999, Syndicate 1221 and an unaffiliated syndicate on which NCUL participated in 1997 closed their 1997 underwriting year, the net effect of which resulted in a portfolio transfer to NCUL and Millennium of $15.5 million at December 31, 1999. At December 31, 1998, Syndicate 1221 and an unaffiliated syndicate on which NCUL participated in 1997 closed their 1996 underwriting year resulting in a portfolio transfer to NCUL of $19.7 million at December 31, 1998. This transaction accounted for the majority of the increase from 1997 to 1998 in the premium volume in the Company's Lloyd's operations. The reinsurance to close transactions are recorded as additional written and earned premium, losses incurred, loss reserves and cash received, all in the same amount. There was no gain or loss on the transactions.
The Company controls 75.6% of Syndicate 1221's capacity for the 2000 underwriting year. The actual capacity is (pound)66,297,000 (converts to $107,089,000) of which the Company directly controls (pound)42,772,000 (converts to $69,090,000) and indirectly controls another (pound)7,340,000 (converts to $11,856,000). Since the controlled capacity exceeds 75%, Lloyd's Mandatory Byelaw (No. 5 of 1999) requires the Company to make a mandatory offer to noncontrolled participants for their capacity. The offer will take the form of an Announced Auction Offer to be made at the first Lloyd's capacity auction in July 2000.
Marine Premium. Marine gross written premium increased 28.2% from 1998 to 1999 due to Navigators Insurance writing 100% of the marine risk for all of 1999 but for only six months of 1998. Navigators Insurance's participation in the marine pools increased to 75% in 1999 from 60% in 1998. The 13.9% increase from 1997 to 1998 was due to, beginning July 1, 1998, Navigators Insurance writing 100% of the marine risk and then ceding 40% to the pool members and to Navigators Insurance's participation in the marine pools increasing from 48% in 1997 to 60% in 1998.
Inland Marine Premium. As of June 1997, the Company no longer writes inland marine business, other than onshore energy.
Engineering and Construction Premium. In 1997, Navigators Insurance began writing engineering and construction business consisting of coverage for construction projects including the machinery, equipment and loss of use due to delays. In 1999, the engineering and construction business was written through the Company's facilities at Lloyd's and the UK Branch participated on the gross risk. In early 1999, the Company closed the Somerset Asia Pacific Limited office in Australia which, along with Somerset UK, had previously produced this business for Navigators Insurance.
Net Earned Premium. Net earned premium decreased 2% from 1998 to 1999 primarily due to increased unearned premium in the Company's Lloyd's operation and a smaller reinsurance to close premium which is recorded as fully earned premium. The 7.3% increase in net earned premium from 1997 to 1998 was primarily due to the increase in the net written premium in 1997.
Net Losses and Loss Adjustment Expenses Incurred. The ratio of net loss and loss adjustment expenses incurred to net earned premium was 78.2%, 68.3%, and 61.9% in 1999, 1998 and 1997, respectively. The increase in the 1999 loss ratio compared to 1998 was primarily due to unrecoverable reinsurance from New Cap Re and higher loss ratios on the Lloyd's premium, partially offset by the decrease in the reinsurance to close premium in 1999 of $15.5 million compared to $19.7 million in 1998. The reinsurance to close premium is recorded at a 100% loss ratio since the premium received represents estimated ultimate losses. The 1999 loss ratio excluding the New Cap Re unrecoverable reinsurance was 70.8%; excluding the reinsurance to close was 70.7%; and excluding both New Cap Re and the reinsurance to close was 62.1%. The increase in the 1998 loss ratio compared to 1997 was primarily due to the Company's portion of the reinsurance to close the Lloyd's 1996 underwriting year amounting to $19.7 million. The 1998 loss ratio excluding the reinsurance to close was 59.6% which decreased from 1997 primarily as the result of favorable loss experience on the Insurance Companies partially offset by slightly higher loss ratios on the Lloyd's business. The loss reserves are not discounted.
Commission Expense. Commission expense as a percentage of net earned premium was 16.5%, 13.0%, and 17.6% for 1999, 1998 and 1997, respectively. The increase in the 1999 commission expense ratio compared to 1998 was primarily due to increased commissions at Lloyd's partially offset by the $15.5 million of reinsurance to close premium resulting from closing of the Lloyd's 1997 underwriting year. The 1999 commission expense ratio without the reinsurance to close premium was 19.9%. The decrease in the 1998 commission expense ratio compared to 1997 was primarily due to the $19.7 million of reinsurance to close premium resulting from closing of the Lloyd's 1996 underwriting year. The 1998 commission expense ratio without the 1997 reinsurance to close premium was 16.6%. The reinsurance to close premium increases earned premium but does not change the commission expense, therefore the ratio of commission expense to earned premium decreases.
As of December 31, 1999 and 1998, the net deferred Federal and foreign tax asset was $13.2 million and $8.0 million, respectively. At December 31, 1999 the Company had a $3.5 million valuation allowance against its deferred Federal tax asset compared to a $1.6 million valuation allowance at December 31, 1998. The valuation allowance is necessitated by the uncertainty associated with the realization of the deferred tax asset for the carryforward of operating losses from the Company's foreign operations.
Net Income (Loss). The Company had a net (loss) of ($3.7) million in 1999 compared to net income of $11.5 million in 1998 and $12.5 million in 1997 primarily due to unrecoverable reinsurance, price competition, higher loss ratios in the Lloyd's operations and expenses related to the foreign expansion in London.
Cash flow provided by (used in) operations was $8.9 million, ($3.0) million and $12.5 million for 1999, 1998 and 1997, respectively. Operating cash flow has been used primarily to acquire additional investment assets during 1999 and 1997 of $6.0 million and $16.7 million, respectively. The negative operating cash flow in 1998 was primarily due to the payment of loss reserves on runoff business and less premiums received, partially due to Lloyd's disbursing cash only after an underwriting year has closed, normally three years later.
Total stockholders' equity was $130.4 million at December 31, 1999, a 9.0% decrease for the year primarily as the result of the Company's net loss in 1999 and the unrealized loss in the investment portfolio.
The Company's reinsurance has been placed with various U.S. companies rated "A-" or better by A.M. Best Company, as well as with foreign insurance companies and with selected syndicates of Lloyd's. Certain syndicates at Lloyd's ("Loss Syndicates") and the Lloyd's market as a whole have reported significant losses in recent years. The Company has not placed any material amounts of reinsurance with these Loss Syndicates. Pursuant to the implementation of Lloyd's Plan of Reconstruction and Renewal, a significant portion of the Company's recoverables from the Loss Syndicates are now reinsured by Equitas (a separate UK authorized reinsurance company established to reinsure outstanding liabilities of all Lloyd's members for all risks written in the 1992 or prior years of account).
The Company is at risk from policyholders' claims for insurance coverage due to their Y2K exposures. Although the Company has not received any significant insurance claims based on losses resulting from Y2K Issues, there can be no assurance that policyholders will not suffer losses of this type and seek compensation under the Company's insurance policies. If any claims are made, the Company's obligations, if any, will depend on the facts and circumstances of the claim and provisions of the policy. At this time, the Company is unable to determine whether an adverse impact, if any, in connection with the foregoing circumstances would be material.
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. The following is a discussion of the Company's primary market risk exposures and how those exposures are currently managed as of December 31, 1999. The Company's market risk sensitive instruments are entered into for purposes other than trading.
The carrying value of the Company's investment portfolio as of December 31, 1999 was $241.1 million of which 92.3% was invested in fixed maturity securities. The primary market risk to the investment portfolio is interest rate risk associated with investments in fixed maturity securities. The Company's exposure to equity price risk and foreign exchange risk is not significant. The Company has no commodity risk.
For the Company's investment portfolio, there were no significant changes in the Company's primary market risk exposures or in how those exposures are managed compared to the year ended December 31, 1998. The Company does not currently anticipate significant changes in its primary market risk exposures or in how those exposures are managed in future reporting periods based upon what is known or expected to be in effect in future reporting periods.
The Company is subject to interest rate risk on its notes payable to banks as changes in interest rates would impact future earnings, however, this interest rate risk exposure is not considered significant.
The sensitivity analysis model used by the Company produces a loss in fair value of market sensitive instruments of $10.3 million based on a 100 basis point increase in interest rates as of December 31, 1999. This loss amount only reflects the impact on an interest rate increase on the fair value of the Company's fixed maturities and short-term investments, which constitute approximately 36.3% of total assets as of December 31, 1999.
Based on the sensitivity analysis model used by the Company, the loss in fair value of market sensitive instruments, as a result of a 100 basis point increase in interest rates as of December 1999, is not material.