Our executive and administrative office is located at 6 International Drive in Rye Brook, NY. Our lease for this space expires in February 2014. Our underwriting operations are in various locations with non-cancelable operating leases including Charlotte, NC, Chicago, IL, Columbia, MD, Coral Gables, FL, Danbury, CT, Houston, TX, Irvine, CA, New York City, NY, Parsippany, NJ, Philadelphia, PA, Pittsburgh, PA, San Francisco, CA, Schaumburg, IL, Seattle, WA, London, England, Antwerp, Belgium, Stockholm, Sweden and Copenhagen, Denmark.
We conduct operations through our Insurance Companies and our Lloyd’s Operations segments. The Insurance Companies segment consists of Navigators Insurance Company, which includes a United Kingdom Branch (the “U.K. Branch”), and Navigators Specialty Insurance Company, which underwrites specialty and professional liability insurance on an excess and surplus lines basis. All of the insurance business written by Navigators Specialty Insurance Company is fully reinsured by Navigators Insurance Company pursuant to a 100% quota share reinsurance agreement. Our Lloyd’s Operations segment includes Navigators Underwriting Agency Ltd. (“NUAL”), a Lloyd’s of London (“Lloyd’s”) underwriting agency which manages Lloyd’s Syndicate 1221 (“Syndicate 1221”). Our Lloyd’s Operations primarily underwrite marine and related lines of business along with offshore energy, professional liability insurance and construction coverages for onshore energy business at Lloyd’s through Syndicate 1221. We controlled 100% of Syndicate 1221’s stamp capacity for the 2010, 2009 and 2008 underwriting years through our wholly-owned subsidiary, Navigators Corporate Underwriters Ltd., which is referred to as a corporate name in the Lloyd’s market. We have also established underwriting agencies in Antwerp, Belgium, Stockholm, Sweden and Copenhagen, Denmark, which underwrite risks pursuant to binding authorities with NUAL into Syndicate 1221.
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 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 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.
The discussions that follow include tables that contain both our consolidated and segment operating results for the last three calendar years. 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 other income (expense). The combined ratio is derived by dividing the sum of net losses and LAE, commission expense, other operating expenses and other income (expense) by net earned premium. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss.
Reserves for losses and loss adjustment expenses represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, 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.
Our actuaries calculate indicated 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. In general the loss ratio method is used to calculate the IBNR for more recent underwriting years while the Bornheutter-Ferguson method is used to calculate the IBNR for more mature underwriting years. When appropriate such methodologies are supplemented 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. Each of these methodologies, which are described below, are generally applicable to both long tail and short tail lines of business depending on a variety of circumstances. In utilizing these methodologies to develop our IBNR loss reserves, a key objective of management in making their final selections is to deliberate with our actuaries to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them. This process requires the substantial use of informed judgment and is inherently uncertain as it can be influenced by numerous factors including:
Annual actuarial loss studies are conducted by the Company’s actuaries at various times throughout the year for major lines of business employing the methodologies as described above. Additionally, a review of the emergence of actual losses relative to expectations for each line of business, generally derived from the annual loss studies, is conducted each quarter to determine whether the assumptions used in the reserving process continue to form a reasonable basis for the projection of liabilities for each product line. Such reviews may result in maintaining or revising assumptions regarding future loss development based on various quantitative and qualitative considerations. If actual loss activity differs from expectations, an upward or downward adjustment to loss reserves may occur. As time passes, estimated loss reserves for an underwriting year will be based more on historical loss activity and loss development patterns rather than on assumptions based on underwriters’ input, pricing assumptions or industry experience.
The following discusses the method used for calculating the IBNR for each line of business and key assumptions used in applying the actuarial methods described.
international transportation. Other marine product lines have considerably shorter periods in which losses develop and settle. Ocean cargo insurance, for example, provides physical damage coverage to goods in the course of transit by water, air or land. By their nature, cargo claims tend to be reported quickly as losses typically result from an obvious peril such as fire, theft or weather. Similarly, bluewater hull insurance provides coverage against physical damage to ocean-going vessels. Such claims for physical damage generally are discovered, reported and settled quickly. The Company currently has extensive experience for all of these products and thus the IBNR loss reserves for all of the marine products are determined using the key assumptions and actuarial methodologies described above. Prior to 2007, however, as discussed below, the Company did not have sufficient experience in the transport product line and instead used its hull and liability products loss development experience as a key assumption in setting the IBNR loss reserves for its transport product.
The substantial majority of the property and casualty loss reserves are for the contractors’ liability business, which insures mostly general and artisan contractors. Contractor liability claims are categorized into two claim types: construction defect and other general liability. Other general liability claims typically derive from workplace 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 an annual actuarial loss study.
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 and 2006.
Most recently, in setting the IBNR loss reserves for construction defect claims, our actuaries have begun to consider a new qualitative factor based on their evolving concern with the recent decline in home values caused by the subprime home mortgage crisis and its possible impact on the frequency and severity of construction defect claims. As a result, our actuaries acknowledge this uncertainty and anticipate claims arising from alleged construction defects contributing to housing value declines on policies written on newly constructed homes in our portfolio. We believe our reserves remain adequate to address such potential exposure, but we can give no assurances with respect thereto.
Our commercial middle markets or NAV PAC business consists of general liability, auto liability and property exposures for a variety of commercial middle market businesses, principally hospitality, manufacturing and garages. Commencing in 2007, our actuaries are segmenting and analyzing the components of the loss development for this business among the property, liability and auto exposures which had been previously combined. As mentioned in Part I, on January 14, 2011, we announced that we entered into a transaction for the sale of the renewal rights for our middle market commercial package and commercial automobile businesses underwritten through our NAV PAC division. This transaction did not include our Life sciences and exporters package liability products.
Primary casualty insurance provides primary general liability coverage principally to corporations in the construction and manufacturing sector. Excess casualty insurance is purchased by corporations which seek higher limits of liability than are provided in their primary casualty policies. Neither product line has a significant amount of loss activity reported to date. Because we have limited historical experience in these products, the IBNR loss reserves for both of these products are primarily established using the loss ratio method primarily based on our underwriters’ input and industry loss experience.
Loss reserves include our European property business written by the U.K. Branch which was discontinued in 2008. We have limited loss history and rely primarily on assumptions based on underwriters’ input and industry experience. In addition, loss reserves for aviation, property and assumed reinsurance business, in run-off since 1999, are periodically monitored and evaluated by claims and actuarial personnel.
The losses for D&O business are generally very large and infrequent, and often involve securities class actions. D&O claims report reasonably quickly, but may take several years to settle. Our loss estimates are based on expected losses, an assessment of the characteristics of reported losses at the claim level, evaluation of loss trends, industry data, and the legal, regulatory and current risk environment. Significant judgment is involved because anticipated loss experience in this area is less predictable due to the small number of claims and/or erratic claim severity patterns. As time passes for a given underwriting year, we place additional weight on assumptions relating to our actual experience and claims outstanding. The expected ultimate losses may be adjusted up or down as the underwriting years mature.
For the selected alternative expected loss ratios, our actuaries observed the range of ultimate loss ratios recorded for the underwriting years 2003 to 2010 for each major line of business at December 31, 2010.
Such sensitivity analysis was performed in the aggregate for all products within each line of business. The use of aggregate data was considered more stable and reliable compared to a product-by-product analysis. We cannot assure, however, that such use of aggregate data will provide a more accurate range of the actual variations in loss development. The loss ratio sensitivity analysis uses loss ratios for the 2003 to 2010 underwriting years, which are believed to be more representative compared to years prior to 2003 given our evolving mix of business, product changes and other factors. There can be no assurances, however, that the use of such recent history is more predictive of actual development as compared to employing longer periods of history. In addition, while the net loss reserves include the net loss reserves for asbestos exposures, such amounts were excluded from the sensitivity analysis given the nature of how such reserves are established by the Company. While we believe such net reserves are adequate, we cannot assure that material loss development may not arise in the future from asbestos losses given the complex nature of such exposures.
The total Company range amounts below were determined by combining the simulated results for each segment into one analysis which estimates a company-wide range reflecting the fact that the individual lines of business are not perfectly correlated. This calculation reflects the reduced volatility benefit from a diversified portfolio of loss exposures. Such amounts may not be representative of the actual aggregate favorable or unfavorable loss development amounts that may occur over time.
Used 16.4 million average diluted shares outstanding for the year ended December 31, 2010.
Written and Unearned Premium. 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 must estimate the amount of written premium not yet reported based on judgments relative to current and historical trends of the business being written. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. An unearned premium reserve is established to reflect the unexpired portion of each policy at the financial reporting date. Reinsurance reinstatement premium is earned in the period in which the event occurred which created the need to record the reinstatement premium. 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, to our consolidated financial statements, both included herein.
For equity securities, in general, we focus our attention on those securities whose fair value was less than 80% of their cost for six or more consecutive months. If warranted as the result of conditions relating to a particular security, we 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. If an equity security is deemed to be other-than-temporarily impaired, the cost is written down to fair value with the loss recognized in earnings.
Accounting for Lloyd’s Results. We record Syndicate 1221’s assets, liabilities, revenues and expenses under U.S. GAAP. 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. 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 financial statements, included herein.
The following is a discussion and analysis of our consolidated and segment results of operations for the years ended December 31, 2010, 2009 and 2008. All earnings per share data is presented on a per diluted share basis.
A shift in underwriting strategy in our D&O lines toward excess layers
With respect to net written premiums, in 2010 we recognized $19.0 million and $3.5 million in reinsurance reinstatement costs triggered by the Deepwater Horizon and West Atlas losses, respectively, which were offset by a reduction in reinsurance purchased on selected lines and shift in business mix toward lines with lower cessions.
Our net investment income declined 5.1% in 2010. Our pre-tax average investment yield declined in 2010 to 3.5% from 3.8% in 2009 resulting from lower short-term yields. Our total investment portfolio increased 4.8% in 2010 and exceeded $2 billion at the end of 2010. We experienced significantly lower investment impairments in our portfolio in 2010 as the financial markets experienced a period of greater stability compared to 2009.
Our overall loss ratio of 63.8% for 2010 was unchanged compared to 2009 and included a $4.9 million increase in the benefit from net prior year loss reserve savings. Although we continued to realize prior year loss reserve savings in our contractors liability lines, we experienced unfavorable prior year development in our D&O and run-off lines.
Consolidated stockholders’ equity increased 3.5% to $829.4 million or $52.68 per share at December 31, 2010 compared to $801.5 million or $47.58 per share at December 31, 2009. The increase was primarily due to 2010 net income of $69.6 million partially offset by the repurchase of $52.0 million of shares of our common stock.
The premium rate increases or decreases as noted below for marine, property casualty 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 a pricing trend and are not meant to be a precise analysis. 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 potentially may be more competitively priced compared to renewal business.
Property Casualty Premiums. The gross written premiums by year, including the line of business’ gross written premiums as a percentage of the total gross written premiums, consisted of the following:
The professional liability gross written premiums decreased 5.3% to $129.8 million in 2010 compared to 2009. The decline in the D&O gross written premiums was driven by the soft market conditions. The D&O market rates have declined to a level that has made it difficult to write new business and a challenge to retain renewal policies while maintaining our pricing discipline in adherence to our underwriting guidelines. The D&O pricing environment does not appear to be improving with ample capacity coupled with weak insurance buying demand due to the anemic economy. Average 2010 renewal premium rates for professional liability decreased approximately 4% in 2010 compared to 2009.
In 2009 we initiated the Brown & Brown Small Lawyers program. Despite adverse market conditions, we were successful in developing a significant portion of the portfolio in segments consistent with our underwriting approach and risk appetite. The Architects and Engineers book has transitioned from being underwritten by an MGA to being underwritten by the Company.
The professional liability gross written premiums increased 25.7% to $137.1 million in 2009 compared to 2008 reflecting continued growth and the expansion of our directors and officers business. Partially offsetting the growth was a reduction in lawyers business within the errors and omissions classification as we were in the process of re-underwriting that line and focusing more on other segments, such as miscellaneous professional liability. Average 2009 renewal premium rates for this business increased approximately 2% in 2009 compared to 2008.
The 2010 Lloyd’s property casualty gross written premiums of $94.8 million increased 21.3% compared to 2009 due to increases in our offshore energy, onshore energy and engineering and construction lines. The significant increase in our offshore energy lines was due to an increase in demand as well as an improved pricing environment as a result of the Deepwater Horizon incident. The 2009 Lloyd’s property casualty gross written premiums of $78.2 million decreased 14.4% compared to 2008 due to a decline in our offshore energy and engineering and construction lines as well as the cessation of writing our property line. We began writing Bloodstock (animal mortality) business during 2009 by participating in a facility originated by another Lloyd’s syndicate. Average premium renewal rates in our NavTech lines increased approximately 1% and 10% in 2010 and 2009 compared to the previous years, respectively.
Professional Liability Premiums. The gross written premiums by year, including the line of business’ gross written premiums as a percentage of the total gross written premiums, consisted of the following:
The 2010 and 2009 Lloyd’s professional liability gross written premiums increased 0.3% and 13.3% to $44.2 million and $44.0 million, respectively, compared to the respective prior year. We added a team at Lloyd’s at the end of 2008 to write excess D&O business. During 2008 and 2009 we began writing professional liability business from our offices in Stockholm, Sweden and Copenhagen, Denmark, respectively.
Ceded Written Premiums 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 premiums 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 premiums by segment and major line of business for the periods indicated:
Net Investment Income Net investment income decreased 5.1% in 2010 to $71.7 million and 1.4% in 2009 to $75.5 million as a result of lower investment yields partially offset by an increase in invested assets resulting from positive cash flow from operations. The pre-tax investment yield was 3.5%, 3.8% and 4.1% in 2010, 2009 and 2008, respectively. See the “Investments” section below for additional information regarding our net investment income.
The 2010 other-than-temporary impairments were primarily related to residential mortgage-backed securities. The after-tax effects of net other-than-temporary impairment losses recognized in earnings for 2010 was $0.7 million or $0.05 per diluted share.
The 2009 other-than-temporary impairments were primarily related to additional impairments on equity securities that were impaired in 2008 as well as impairments on residential mortgage-backed securities. The after tax effect of net other-than-temporary impairment losses recognized in earnings on the 2009 net income was $7.8 million or $0.45 per diluted share. In 2009, we recognized in earnings OTTI losses of $2.5 million and $0.08 million related to non-agency mortgage and asset backed securities, respectively. In 2009, we recognized in earnings OTTI losses of $8.8 million on 56 common stocks resulting from additional impairments on equity securities that were impaired in 2008. In addition, in 2009 we recognized in earnings OTTI losses of $0.6 million on 2 corporate bonds.
The 2008 other-than-temporary impairments were primarily due to equity impairments where the market value of the security was less than 80% of the book value for six consecutive months resulting from the significant overall market declines in the second half of 2008. In addition, 2008 also included impairments on residential mortgage-backed securities. During 2008, we indentified equity securities with fair value of $34.4 million which were considered to be other-than-temporarily impaired.
Other Income/(Expense) Other income/(expense) for 2010, 2009 and 2008 consisted primarily of commission income, foreign exchange gains and losses from our Lloyd’s Operations and inspection fees related to our specialty insurance business.
During the year ended December 31, 2010, we incurred gross loss and loss adjustment expenses of $88.1 million relating to the Deepwater Horizon incident. We ceded $82.1 million of this gross loss to our reinsurance program, resulting in reinsurance reinstatement premiums of $19.0 million. The remaining net loss of $6.0 million was within our loss expectations for the current year. The impact of the Deepwater Horizon loss and related reinstatement premiums on the 2010 loss ratio was an increase of 1.9 loss ratio points.
The 2009 loss ratio of 63.8% was favorably impacted by 1.3 loss ratio points resulting from an $8.9 million net favorable development of prior years’ loss reserves. The 2008 loss ratio of 61.0% was favorably impacted by 7.9 loss ratio points resulting from a $50.7 million net favorable development of prior years’ loss reserves and adversely impacted by 3.7 loss ratio points related to the 2008 Hurricanes. The result of underwriting losses caused by Hurricanes Gustav and Ike of approximately $29.3 million, including $12.2 million of reinstatement costs, increased the 2008 combined ratio by 4.3 ratio points.
As part of our regular review of prior reserves, our actuaries may determine, based on their judgment, that certain assumptions made in the reserving process in prior years may need to be revised to reflect various factors, likely including the availability of additional information. As a result of their reserve analyses, management may make corresponding reserve adjustments.
$16.5 million in our Specialty run-off books of business, including $13.3 million in our personal umbrella lines across multiple underwriting years where loss activity has exceeded our expectations and $2.0 million of adverse development in our Liquor business due to reported claim activity.
The Insurance Companies recorded $11.9 million of net prior year unfavorable development for the marine business, of which $10.6 million arose in the marine liability business due to large loss activity in excess of our prior expectations mostly across underwriting years 2005 to 2008 that we recognized by reserve strengthening.
The Insurance Companies recorded $35.7 million of net prior year savings for property casualty business in total. The favorable development included:
$5.9 million in our personal umbrella books of business across most underwriting years where large loss activity has exceeded our expectations
The Insurance Companies recorded $3.6 million of net prior year savings for professional liability. This was primarily due to the reduction in case and IBNR reserves for the directors and officers business in underwriting years 2004 through 2006 resulting from reported losses being less than anticipated during 2008.
During 2008, we recorded gross and net loss estimates of $114.0 million and $17.2 million, respectively, exclusive of $12.2 million for the cost of excess-of-loss reinstatement premiums, related to the third quarter 2008 Hurricanes Gustav and Ike. Our pre-tax net loss as a result of Hurricanes Gustav and Ike was approximately $29.3 million, which increased our 2008 combined ratio by 4.3 ratio points.
The reserves for asbestos exposures at December 31, 2010 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 (two other large settled claims were fully paid in 2007); (ii) other insureds not directly involved in the manufacturing or distribution of asbestos products, but that have more than incidental asbestos exposure for their purchase or use of products that contained asbestos; and (iii) 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.
The following table sets forth our overall reinsurance recoverable amounts for paid and unpaid losses for the periods indicated:
The following table sets forth our gross reserves for losses and LAE reduced for reinsurance recoverable on such amounts resulting in net loss and LAE reserves (a non-GAAP measure reconciled in the following table) for the periods indicated:
At December 31, 2010, the IBNR loss reserve was $678.4 million or 59.4% of our total loss reserves compared to $684.1 million or 61.5% in 2009.
Commission Expense. Commission expenses paid to unaffiliated brokers and agents are generally based on a percentage of the gross written premiums and are reduced by ceding commissions we may receive on the ceded written premiums. Commissions are generally deferred and recorded as deferred policy acquisition costs to the extent that they relate to unearned premium. The percentages of commission expenses to net earned premium was 16.5% in 2010, 14.5% in 2009 and 13.9% in 2008. The increase in the net commission ratios for 2010 when compared to 2009 was mostly attributable to greater retentions for net premiums earned in 2010 for the 2009 underwriting year, particularly on our marine quota share treaties, which have reduced the ceding commission benefit. In addition, reinsurance reinstatement costs of $19.0 million and $3.5 million resulting from the Deepwater Horizon and West Atlas losses, respectively, resulted in lower net earned premiums which in turn increased the net commission ratios by 0.6 points. The 2008 commission expense ratio excluding the effects of the 2008 Hurricanes was 13.7%.
The income tax expense was $29.3 million, $23.7 million and $17.0 million for 2010, 2009 and 2008, respectively. The effective tax rates for 2010, 2009 and 2008 were 29.6%, 27.3% and 24.8%, respectively. Our effective tax rate was 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, 2010 and 2009, the net deferred federal, foreign, state and local tax assets were $15.1 million and $31.2 million, respectively. The decline in the net deferred tax assets was primarily due to the utilization of capital losses in 2010. A finance bill was enacted in the U.K. in July 2010 that reduces the U.K. corporate tax rate from 28% to 27% effective April 2011. The effect of such tax rate change was not material.
The 2010 underwriting results were favorably impacted by $5.5 million or 1.2 loss ratio points for net prior year savings, which is discussed in the prior year reserve redundancies/deficiencies section. The 2010 net prior year savings increased $2.4 million compared to 2009.
The 2010 earnings in the Lloyd’s Operations declined $1.1 million compared to 2009. The Lloyd’s Operations experienced greater net written premiums in the Offshore Energy and Engineering and Construction lines which were offset by net reinstatement premiums of $7.8 million related to the Deepwater Horizon loss event. The 2009 earnings in the Lloyd’s Operations improved $3.1 million compared to 2008. The Lloyd’s Operations utilized less reinsurance in 2009 compared to 2008, resulting in higher net premiums. In addition, 2008 results were impacted by losses caused by Hurricanes Gustav and Ike of approximately $13.1 million, including $5.0 million of reinstatement costs, which increased the 2008 combined ratio by 7.1 combined ratio points and reduced net income by $8.5 million.
The following table sets forth the best estimate of our known contractual obligations with respect to the items indicated at December 31, 2010:
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 $843 million. See “Business - Loss Reserves” included herein.
The following tables set forth our cash and investments as of December 31, 2010 and 2009. The table as of December 31, 2010 includes other-than-temporarily impaired (“OTTI”) securities recognized within other comprehensive income (“OCI”).
The fair value of our investment portfolio may fluctuate significantly in response to various factors such as changes in interest rates, investment quality ratings, equity prices, foreign exchange rates and credit spreads. We do not have the intent to sell nor is it more likely than not that we will have to sell debt securities in unrealized loss positions that are not other-than temporarily impaired before recovery. We may realize investment losses to the extent its liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate, liquidity or credit spread environments. Significant changes in the factors we consider when evaluating investment for impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements.
Invested assets increased over the last two years primarily due to cash flows from operations as well as unrealized gains in 2010. The consolidated average investment yield of the portfolio decreased in 2010 to 3.5% from 3.8% due to the general decline in market yields over the period. The tax equivalent yields for 2010, 2009 and 2008 on a consolidated basis were 4.0%, 4.6% and 4.9%, respectively. The portfolio’s duration was 4.4 years and 4.2 years as of December 31, 2010 and 2009, respectively. Since the beginning of 2010, the tax-exempt portion of our investment portfolio has decreased by $293.8 million to approximately 18.1% of the fixed maturities investment portfolio at December 31, 2010 compared to approximately 34.9% at December 31, 2009.
The following table presents, for each of the fair value hierarchy levels, our fixed maturities, equity securities and short-term investments that are measured at fair value as of December 31, 2010:
The following tables set forth our U.S. Treasury bonds, agency bonds and foreign government bonds as of December 31, 2010 and 2009:
At December 31, 2010, we owned two asset-backed security approximating $0.09 million with subprime mortgage exposures. The securities have an effective maturity of 5.4 years. In addition, we owned residential mortgage obligations approximating $2.5 million classified as Alt-A which is a credit category between prime and subprime. The Alt-A bonds have an effective maturity of 6.0 years. We are receiving principal and/or interest payments on all of these securities and believe such amounts are fully collectible.
The commercial mortgage-backed securities are all rated investment grade by S&P or by Moody’s. The following table sets forth the fifteen largest commercial mortgage-backed securities portfolio as of December 31, 2010:
The following table sets forth the fifteen largest equity securities holdings as of December 31, 2010:
The following table summarizes all securities in an unrealized loss position at December 31, 2010 and 2009, showing the aggregate fair value and gross unrealized loss by the length of time those securities have continuously been in an unrealized loss position as well as the number of securities:
The residential mortgage obligation’s gross unrealized loss in the above table for the greater than 12 months category consists primarily of residential mortgage-backed securities. Residential mortgage-backed securities are a type of fixed income security in which residential mortgage loans are sold into a trust or special purpose vehicle, thereby securitizing the cash flows of the mortgage loans.
As of December 31, 2010, the largest single unrealized loss by an issuer in the non-government guaranteed fixed maturities category was $0.7 million.
Period for Which Fair Value is Less than 80% of Amortized Cost
The following table shows the composition by NAIC rating and the generally equivalent S&P and Moody’s ratings of the fixed maturity securities in our portfolio with gross unrealized losses at December 31, 2010. Not all of the securities are rated by S&P and/or Moody’s:
The contractual maturity by the number of years until maturity for fixed maturity securities with unrealized losses at December 31, 2010 are shown in the following table:
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Due to the periodic repayment of principal, the mortgage-backed and asset-backed securities are estimated to have an effective maturity of approximately 5.2 years.
Cash flows from operations were $118.2 million, $103.9 million and $245.3 million for 2010, 2009, and 2008, respectively. The improvement in cash flow from operations in 2010 compared to 2009 was primarily a result of improved collections on reinsurance recoverable as well as premiums receivable. Partially offsetting these items was an increase in losses and LAE paid for claims of $68.6 million. Operating cash flow was used primarily to acquire additional investments of fixed income securities.
Investments and cash increased to $2.15 billion at December 31, 2010 from $2.06 billion at December 31, 2009. The increase was primarily due to the positive cash flow from operations. Net investment income was $71.7 million for 2010, $75.5 million for 2009 and $76.6 million for 2008.
At December 31, 2010, the weighted average rating of our fixed maturity investments was “AA” by S&P and “Aa” by Moody’s. We believe that we have reduced exposure to credit risk since the fixed maturity investment portfolio, except for $19.5 million, consists of investment-grade bonds but there can be no assurance that unexpected levels of market volatility or significant negative changes in economic conditions would not result in material credit related losses in the future. At December 31, 2010, our investment portfolio had an average maturity of 5.5 years and a duration of 4.4 years. Management periodically projects cash flow of the investment portfolio and other sources in order to maintain the appropriate levels of liquidity to ensure our ability to satisfy claims. As of December 31, 2010 and 2009, all fixed maturity securities and equity securities held by us were classified as available-for-sale.
On April 1, 2010, we entered into a $140 million credit facility agreement entitled “Fifth Amended and Restated Credit Agreement” with JPMorgan Chase Bank, N.A., as Administrative Agent, and a syndicate of lenders. The credit facility is a letter of credit facility and amends and replaces the $75 million credit facility that expired by its terms on April 2, 2010. We may request that the facility be increased by an amount not to exceed $25 million. 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 through letters of credit. The letters of credit issued under the facility are denominated in British pounds and their aggregate face amount will fluctuate based on exchange rates. The credit facility expires on March 31, 2011. At December 31, 2010, letters of credit with an aggregate face amount of $129.1 million were outstanding under the credit facility.
The above mentioned credit facility contains customary covenants for facilities of this type, including restrictions on indebtedness and liens, limitations on mergers, dividends and the sale of assets, and requirements as to maintaining certain consolidated tangible net worth, statutory surplus and other financial ratios. The credit facility also provides for customary events of default, including failure to pay principal, interest or fees when due, failure to comply with covenants, any representation or warranty made by the Company being false in any material respect, default under certain other indebtedness, certain insolvency or receivership events affecting the Company and its subsidiaries, the occurrence of certain material judgments, or a change in control of the Company. The letter of credit facility is secured by a pledge of the stock of certain insurance subsidiaries of the Company. To the extent the aggregate face amount issued under the credit facility exceeds the commitment amount; we are required to post collateral with the lead bank of the consortium. We were in compliance with all covenants under the credit facility at December 31, 2010.
As a result of the April 1, 2010 amendment of the credit facility, the applicable margin and applicable fee rate payable under the letter of credit facility are now based on a schedule that is decided based on the Company’s status as determined from its then-current ratings issued by S&P and Moody’s with respect to the Company’s senior unsecured long-term debt securities without third-party credit enhancement.
Our reinsurance has been placed with various U.S. and foreign insurance companies and with selected syndicates at Lloyd’s. Pursuant to the implementation of Lloyd’s Plan of Reconstruction and Renewal, a portion of our recoverables are now reinsured by Equitas (a separate United Kingdom 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).
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. Reinsurance recoverable amounts related to those gross loss reserves are anticipated to be billed and collected over the next several years as gross losses are paid by the Company.
At December 31, 2010, ceded asbestos paid and unpaid losses recoverable were $8.4 million. We generally experience significant collection delays for a large portion of reinsurance recoverable amounts for asbestos losses given that certain reinsurers are in run-off or otherwise no longer active in the reinsurance business. Such circumstances are considered in our ongoing assessment of such reinsurance recoverables.
We believe that we have adequately managed our cash flow requirements related to reinsurance recoveries from our positive cash flows and the use of available short-term funds when applicable. However, there can be no assurances that we will be able to continue to adequately manage such recoveries in the future or that collection disputes or reinsurer insolvencies will not arise that could materially increase the collection time lags or result in recoverable write-offs causing additional incurred losses and liquidity constraints to the Company. The payment of gross claims and related collections from reinsurers with respect to Hurricanes Gustav, Ike, Katrina and Rita, as well as Deepwater Horizon, could significantly impact our liquidity needs. However, we expect to continue to pay these hurricane losses over a period of years from cash flow and, if needed, short-term investments. We expect to collect our paid reinsurance recoverables generally under the terms described above.
Our capital resources consist of funds deployed or available to be deployed to support our business operations. At December 31, 2010 and 2009, our capital resources were as follows:
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our Insurance Companies which could place the Company at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our Insurance Companies or Lloyd’s Operations are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of the credit facility.
Condensed Parent Company balance sheets as of December 31, 2010 and 2009 are shown in the table below: