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 Alpharetta, GA, Charlotte, NC, Chicago, IL, Coral Gables, FL, Danbury, CT, Ellicott City, MD, Exton, PA, Houston, TX, Irvine, CA, Los Angeles, CA, New York City, NY, Parsippany, NJ, Philadelphia, PA, Pittsburgh, PA, San Francisco, CA, Schaumburg, IL, Seattle, WA, London, England, Manchester, England, Antwerp, Belgium, Copenhagen, Denmark, Stockholm, Sweden.
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 2012, 2011 and 2010 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. We have also established a presence in Brazil and China through contractual arrangements with local affiliates of Lloyd’s.
We utilize the senior debt ratings from S&P. Our senior debt is rated BBB (Adequate - negative outlook) by S&P.
Our most critical accounting policies involve the reporting of the reserves for losses and LAE (including losses that have occurred but were not reported to us by the financial reporting date), reinsurance recoverables, written and unearned premium, the recoverability of deferred tax assets, the impairment of investment securities and accounting for Lloyd’s results.
Reserves for losses and LAE represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known less the amount paid to date. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, judicial theories of liability and other third party factors which are often beyond our control. No assurance can be given that actual claims made and related payments will not be in excess of the amounts reserved. During the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates.
Our actuaries calculate indicated IBNR loss reserves for each line of business by underwriting year for major products principally using standard actuarial methodologies which are projection or extrapolation techniques: the loss ratio method, the loss development method and the Bornheutter-Ferguson method. In general the loss ratio method is used to calculate the IBNR for only the most recent underwriting years or in the absence of any statistical data upon which to estimate ultimate losses while the Bornheutter-Ferguson method is used to calculate the IBNR for recent years where a statistical basis exists for that computation with the loss development method used for more mature underwriting years. When appropriate such methodologies are supplemented by 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:
Inflationary pressures (medical and economic) that affect the size of losses;
This method is based on the assumption that ultimate losses vary proportionately with premiums. Pursuant to the loss ratio method, IBNR loss reserves are calculated by multiplying the earned premium by an expected ultimate loss ratio to estimate the ultimate losses for each underwriting year, then subtracting the reported losses, consisting of paid losses and case loss reserves, to determine the IBNR loss reserve amount. The ultimate loss ratios applied are the Company’s best estimates for each underwriting year and are generally determined after evaluating a number of factors which include: information derived by underwriters and actuaries in the initial pricing of the business, the ultimate loss ratios established in the prior accounting period and the related judgments applied, the ultimate loss ratios of previous underwriting years, premium rate changes, underwriting and coverage changes, changes in terms and conditions, legislative changes, exposure trends, loss development trends, claim frequency and severity trends, paid claims activity, remaining open case reserves and industry data where deemed appropriate. Such factors are also evaluated when selecting ultimate loss ratios and/or loss development factors in the methods described below.
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 substantial portion 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.
Primary casualty insurance provides primary general liability coverage principally to corporations in the construction, real estate and manufacturing sector. Excess casualty insurance is purchased by corporations which seek higher limits of liability than are provided in their primary casualty policies.
A range of reasonable estimates has been developed based on the historical volatility of held reserves vs. current estimates. The actuarial history indicates that Navigators held reserves tend to be 10% redundant with a standard deviation of 11%. We have ignored the historical conservatism and built a range around the current held amounts. The Company’s lines of business, the market pricing adequacy and the Company’s underwriting strategies have changed dynamically over the past eleven years. There is thus a significant risk that the potential volatility of the current reserve estimates could differ in a material manner from the historical trends.
Actual emergence will vary and may exceed the historical variation. The actual losses may not emerge as expected which would cause the ranges to expand or contract from year to year. The impact from the shift on ranges will be greater for lines with longer emergence patterns. The individual lines will also have greater variance than the range for the entire book of business. The statistical variation is expected to have a somewhat higher range of deterioration than savings. The history in itself is only a rough estimate of the potential volatility. The ranges have been refined by reserve segment in three categories - Marine, Property Casualty and Professional Liability. These groupings give a sense of the volatility by sub-group but are not intended to be rigorous estimates even if such were possible. The total reserve variability is not equal to the sum of the segment variability due to the benefit of diversification.
The range of ultimate unpaid amounts determined as described above as follows:
Substantially all of our business is placed through agents and brokers. We record estimates for both unreported direct and assumed premium. We also record the ceded portion of the estimated gross written premium and related acquisition costs. The earned gross, ceded and net premiums are calculated based on our earning methodology which is generally pro-rata over the policy period. Losses are also recorded in relation to the earned premium. The estimate for losses incurred on the estimated premium is based on an actuarial calculation consistent with the methodology used to determine incurred but not reported loss reserves for reported premiums.
A portion of our premium is estimated for unreported premium, mostly for the Marine business written by our U.K. Branch and Lloyd’s Operations as well as the Accident & Health and Latin American & Caribbean property casualty and surety reinsurance business written by NavRe. We generally do not experience any significant backlog in processing premiums. Such premium estimates are generally based on submission data received from brokers and agents and recorded when the insurance policy or reinsurance contract is written or bound. The estimates are regularly reviewed and updated taking into account the premium received to date versus the estimate and the age of the estimate. To the extent that the actual premium varies from the estimates, the difference, along with the related loss reserves and underwriting expenses, is recorded in current operations.
For fixed maturity securities, we consider our intent to sell a security and whether it is more likely than not that we will be required to sell a security before the anticipated recovery as part of the process of evaluating whether a security’s unrealized loss represents an other-than-temporary decline. We assess whether the amortized cost basis of a fixed maturity security will be recovered by comparing the present value of cash flows expected to be collected to the current book value. Any shortfalls of the present value of the cash flows expected to be collected in relation to the amortized cost basis is considered the credit loss portion of other-than-temporary impairment (“OTTI”) losses and is recognized in earnings. All non-credit losses are recognized as changes in OTTI losses within Other Comprehensive Income (“OCI”).
For equity securities, in general, the Company focuses its attention on those securities with a fair value less than 80% of their cost for six or more consecutive months. If warranted as the result of conditions relating to a particular security, the Company will focus on a significant decline in fair value regardless of the time period involved. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost of the security, the length of time the investment has been below cost and by how much the investment is below cost. If 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.
We record Syndicate 1221’s assets, liabilities, revenues and expenses under U.S. GAAP. Additional information regarding our accounting for Lloyd’s results can be found in Note 1, Organization and Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements, included herein.
The following table presents a summary of our consolidated financial results for the years ended December 31, 2012, 2011 and 2010:
Net income for the year ended December 31, 2012 was $63.8 million or $4.45 per diluted share compared to net income of $25.6 million or $1.69 per diluted share for the year ended December 31, 2011. Operating earnings for the year ended December 31, 2012 were $37.6 million or $2.63 per diluted share compared to $19.1 million or $1.26 per diluted share for the comparable period in 2011. In comparison to net income, operating earnings excludes after-tax net realized gains of $26.7 million and $7.8 million and after-tax OTTI losses of $0.6 million and $1.3 million for the years ended December 31, 2012 and 2011, respectively. The increase in our operating earnings was largely attributable to stronger underwriting results, partially offset by a decrease in net investment income driven by lower investment yields. The underwriting results for the year ended December 31, 2012 include net losses of $20.4 million related to Superstorm Sandy, $14.5 million from our Agriculture business driven by significant drought related crop losses across the U.S., and $13.9 million related to significant large losses from our Marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy.
Our book value per share as of December 31, 2012 was $62.61, increasing 8.8% from $57.57 as of December 31, 2011. The increase in book value per share primarily resulted from our increased results of operations and to a lesser extent, improvements in the value of our consolidated investment portfolio. Our consolidated stockholders’ equity increased 9.5% to $879.5 million as of December 31, 2012 compared to $803.4 million as of December 31, 2011.
Net loss of $20.4 million, inclusive of $8.3 million in reinsurance reinstatement premiums (“RRPs”), related to Superstorm Sandy. Gross of reinsurance our loss related to Superstorm Sandy was approximately $66.7 million. Refer to subsection “Net Losses and Loss Adjustment Expenses” within this section of the MD&A for additional disclosure related to Superstorm Sandy.
Net losses of $13.9 million, inclusive of $11.1 million in RRPs, related to several large losses from our Marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy.
Net reserve redundancies of $47.2 million from our Lloyd’s Operations across all businesses and all divisions, most notably Lloyd’s Marine.
Net adverse loss development of $2.1 million driven by significant loss emergence in our Professional Liability business mostly offset by redundancies from our Property Casualty business.
The following table sets forth our gross written premiums, net written premiums and net earned premiums by segment and line of business for the years ended December 31, 2012, 2011, and 2010:
Our reinsurance program includes contracts for proportional reinsurance, per risk and whole account excess-of-loss reinsurance for both property and casualty risks and property catastrophe excess-of-loss reinsurance. In recent years we have increased our utilization of excess-of-loss reinsurance for marine, property and certain casualty risks. Our excess-of-loss reinsurance contracts generally provide for a specific amount of coverage in excess of an attachment point and sometimes provides for reinstatement of the coverage to the extent the limit has been exhausted for payment of additional premium (referred to as reinsurance reinstatement premiums or RRPs). The number of reinsurance reinstatements available varies by contract.
We incurred $26.9 million, $14.8 million, and $24.0 million of RRPs for the years ended December 31, 2012, 2011, and 2010, respectively. The $26.9 million in RRPs recorded in 2012 includes $11.1 million from several large losses on our marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy as well as $8.3 million in connection with our loss on Superstorm Sandy. The $14.8 million in RRPs recorded in 2011 are due to the large energy losses from our NavTech business and the accrual for large losses from our Marine business reflective of our shift to excess-of-loss reinsurance protection. The $24.0 million in RRPs recorded in 2010 is largely attributable to the Deepwater and West Atlas losses.
The following table sets forth our ceded written premiums by segment and major line of business for the years ended December 31, 2012, 2011 and 2010:
The increase in percentage of total ceded written premiums to total gross written premiums for the year ended December 31, 2012 compared to the same period in 2011 was primarily due to a lower retention ratio on our NavTech business as a result of a new quota share program for the offshore energy book and the RRPs recognized in our Marine business as a result of significant large loss activity during the year. The aforementioned increases were partially offset by a change in the mix of business resulting in the growth of our assumed reinsurance business written by NavRe and the continued growth of the real estate products offered by our Professional liability business where our retention ratios are higher.
The decrease in the percentage of total ceded written premiums to total gross written premiums for the year ended December 31, 2011 compared to the same period of 2010 was primarily due to a change in the mix of business resulting from new business within our recently established NavRe division, a reduction in RRPs in 2011 compared to 2010 related to large loss activity for each year and, to a lesser extent, the expansion of products offered by our Professional liability business where our retention ratios are higher, partially offset by a reduction in the retention of our Lloyd’s Property Casualty business.
Net earned premiums increased 13.1% for the year ended December 31, 2012 compared to the same period in 2011 as a result of continued growth in gross written premiums as well as a change in our mix of business driven by our assumed reinsurance business, which includes the A&H lines that are recognized in earnings over a longer exposure period than our other lines of business, and to a lesser extent, the expansion of products offered by our Professional Liability division where our retention ratios are higher. The increase in net earned premiums was partially offset by the additional RRPs in connection with loss activity in our Marine business, as discussed above. Net earned premiums increased 4.8% for the year ended December 31, 2011 compared to the same period in 2010 primarily as a result of significant ceded RRPs associated with large losses in 2010. The impact of reinstatement premiums was partially offset by a change in the mix of business in 2011 written by our assumed reinsurance business, specifically the A&H lines, which are recognized in earnings over a longer exposure period than our other lines of business.
The significant inputs used to measure the amount of credit loss recognized in earnings for fixed maturity securities were actual delinquency rates, default probability assumptions, severity assumptions and prepayment assumptions. Projected losses are a function of both loss severity and probability of default. Default probability and severity assumptions differ based on property type, vintage and the stress of the collateral. We do not intend to sell any of these securities and it is more likely than not that we will not be required to sell these securities before the recovery of the amortized cost basis.
Net OTTI losses for the year ended December 31, 2010 were primarily related to residential mortgage-backed securities.
Realized gains and losses, excluding net OTTI losses recognized in earnings, for the periods indicated were as follows:
Net realized gains and losses are generated as part of the normal ongoing management of our investment portfolio. Net realized gains of $41.1 million for the year ended December 31, 2012 are primarily due to the sale of municipal bonds and equity securities in anticipation of continued market uncertainty, the proceeds of which were reinvested in U.S. Government Treasury bonds and equities. Net realized gains of $12.0 million for the year ended December 31, 2011 primarily included the sale of corporate bonds and equity mutual funds. Net realized gains of $41.3 million for the year ended December 31, 2010 included the sale of the majority of our general obligation municipal bond obligations, the proceeds of which were reinvested in corporate bonds and agency mortgage-backed securities.
Total other income for the years ended December 31, 2012, 2011 and 2010 was $1.5 million, $1.2 million and $5.1 million, respectively, and consists of foreign exchange gains and losses from our Lloyd’s Operations, commission income and inspection fees related to our specialty insurance business.
The segment and line of business breakdown of the net loss and LAE ratios for the years ended December 31, 2012, 2011 and 2010 are as follows:
The Insurance Companies recorded $1.9 million net prior period reserve deficiencies. The Marine business had $10.0 million of net reserve redundancies, which were primarily driven by:
case reserve releases of $3.4 million due to the favorable settlement of several large losses; and
The Marine reserve redundancies were partially offset by net reserve deficiencies of $7.6 million from the small lawyer and accountants lines within our Professional Liability business. This deficiency was primarily driven by IBNR increases of $3.4 million made to recognize the severity impact of several large losses that caused the actual claims emergence for these lines to exceed the expected emergence pattern. We also incurred net reserve deficiencies of $4.3 million within our Property Casualty segment, which were primarily attributable to two large hemophiliac claims from UY 2011 arising from our A&H business.
The following is a discussion of relevant factors impacting our $13.8 million net reserve redundancies for the year ended December 31, 2010:
The Insurance Companies recorded $14.9 million of net prior year redundancies for Property Casualty business in total. The favorable development included:
• $29.2 million for West Coast contractors’ liability due to an internal actuarial review conducted in 2010 which indicated that loss development on underwriting years 2006 to 2008 has been more favorable than our prior expectations with a partial offset for underwriting years 2004 and prior.
• $1.8 million of favorable development on the Somerset Re run-off book of business where we concluded the IBNR was no longer required and $1.5 million on our Agriculture reinsurance book where the reported activity was lower than our initial estimate for the 2009 treaty year.
Other operating expenses decreased to $138.0 million for the year ended December 31, 2011 from $139.7 million for the same period in 2010. The decrease was primarily due to a reduction in stock grant expense related to performance based awards that are not expected to vest, partially offset by increased expenses for continued investments in new underwriting teams.
Interest expense relates to our Senior Notes due May 1, 2016. Interest on these Senior Notes is due each May 1 and November 1 and the effective interest rate, based on the proceeds net of discount and all issuance costs, is approximately 7.17%. Interest expense was $8.2 million for each of the years ended December 31, 2012, 2011 and 2010.
We recorded income tax expense of $28.0 million, $7.1 million and $29.3 million for the years ended December 31, 2012, 2011 and 2010 respectively. The effective tax rates were 30.5%, 21.8% and 29.6% for the years ended December 31, 2012, 2011 and 2010, respectively. The increase in effective tax rate from 2011 to 2012 resulted primarily from a higher percentage of pre-tax income being subject to the maximum federal income tax rate in 2012, due in part to net realized gains on the sales of investments. The effective tax rate on net investment income was 26.8%, 27.6% and 27.0% for the years ended December 31, 2012, 2011 and 2010 respectively.
As of December 31, 2012, the net deferred federal, foreign, state and local tax assets were $3.2 million, compared to net deferred tax liabilities of $6.3 million as of December 31, 2011 with the change primarily due to the increase in the deferred tax asset for unearned premium reserve, in line with the growth of our business.
We had net state and local deferred tax assets amounting to potential future tax benefits of $0.5 million and $0.2 million as of December 31, 2012 and 2011, respectively. Included in the deferred tax assets are state and local net operating loss carry-forwards of $0.2 million for both December 31, 2012 and 2011. A valuation allowance was established for the full amount of these potential future tax benefits due to uncertainty associated with their realization. Our state and local tax carry-forwards as of December 31, 2012 expire from 2023 to 2031. Refer to Footnote 7, Income Taxes, included herein, for further detail on the temporary differences that give rise to federal, foreign, state and local deferred tax assets or liabilities.
The following table sets forth the results of operations for the Insurance Companies for the years ended December 31, 2012, 2011 and 2010:
• Current accident year loss emergence of $14.5 million from our Agriculture business that was driven by significant drought related crop losses across the U.S.
• Net loss of $12.8 million, inclusive of $6.3 million in RRPs, related to Superstorm Sandy. Gross of reinsurance the Insurance Companies’ loss related to Superstorm Sandy was approximately $45.2 million.
• Net losses of $9.9 million, inclusive of $9.2 million in RRPs, related to several large losses from our Marine business, including the grounding of the cruise ship Costa Concordia off the coast of Italy.
• 2011 accident year energy losses with a net loss of $16.1 million, inclusive of $5.5 million in reinsurance reinstatement premiums, related to drilling operations in the North Sea, Gulf of Mexico and Russia
The Insurance Companies’ combined ratio for the year ended December 31, 2010 was 101.2% and the pre-tax underwriting loss was $5.3 million mostly driven by $13.1 million in RRPs related to the Deepwater Horizon and West Atlas losses, respectively, partially offset by net prior period reserve redundancies of $5.5 million driven by significant redundancies from our Property Casualty business partially offset by loss emergence from our Professional Liability business.
The Insurance Companies’ Marine gross written premiums for the year ended December 31, 2011 increased 2.4% to $228.5 million compared to 2010 primarily due to Inland Marine which increased by 10.5% as a result of new business and a 7.3% increase on renewal rates, and the P&I product which increased by 17.3%, benefiting from reduced competition as a major competitor had stopped writing P&I business. The Transport business also grew from prior year by 11.5% due to an unexpected increase in global trade in 2011. The increases were offset by the reduction of our Customs Bonds business, reported within Other Marine in the table above, which decreased from 2010 due to the termination of an agency agreement as well as the current economy’s impact on the shipping industry. The 2011 Insurance Company Marine average renewal rate increased 1.3% from prior year.
The Insurance Companies Property Casualty gross written premiums for the year ended December 31, 2011 increased by 42.4% to $445.3 million compared to the same period in 2010. The increase was primarily driven by our recently established assumed reinsurance business, written by NavRe, which produced $106.5 million in gross written premiums for the year ended December 31, 2011. Additionally, we saw growth in our Excess Casualty and Primary Casualty lines due to an increase in underwriting activity resulting from an expansion of our underwriting team and competition dislocation in Excess Casualty. The increases were offset by activity within our Specialty Run-off division, reported within Other Property & Casualty in the table above, which decreased as a result of the sale of our NavPac business to Tower Insurance Company of New York via a renewal rights transaction.
The following table sets forth the results of operations of the Lloyd’s Operations for the years ended December 31, 2012, 2011 and 2010:
• Net reserve redundancies of $47.2 million across all businesses and all divisions, most notably Lloyd’s Marine.
We have controlled 100% of Syndicate 1221’s stamp capacity since 2006. Stamp capacity is a measure of the amount of premium a Lloyd’s syndicate is authorized to write based on a business plan approved by the Council of Lloyd’s. Syndicate 1221’s stamp capacity was £184 million ($300 million) in 2012, £175 million ($271 million) in 2011 and £168 million ($264 million) in 2010.
Property Casualty Premiums. The gross written premiums for our Property Casualty business for the years ended December 31, 2012, 2011 and 2010 consisted of the following:
Professional Liability Premiums. The gross written premiums for our Professional Liability business for the years ended December 31, 2012, 2011 and 2010 consisted of the following:
The following table sets forth the best estimate of our known contractual obligations with respect to the items indicated as of December 31, 2012:
(1) The amounts determined are estimates which are subject to a high degree of variation and uncertainty, and are not subject to any specific payment schedule since the timing of these obligations are not set contractually. The amount in the above table excludes reinsurance recoveries of $880.1 million. Refer to “Business-Loss Reserves” included herein.
We monitor our capital adequacy to support our business on a regular basis. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by various ratings agencies, at a level considered necessary by management to enable our Insurance Companies to compete, (2) sufficient capital to enable our Insurance Companies to meet the capital adequacy tests performed by statutory agencies in the United States and the United Kingdom and (3) letters of credit and other forms of collateral that are necessary to support the business plan of our Lloyd’s Operations.
We primarily rely upon dividends from our subsidiaries to meet our Parent Company’s obligations. Since the issuance of the senior debt in April 2006, the Parent Company’s cash obligations primarily consist of semi-annual interest payments on the senior debt, which are currently $4.0 million. Going forward, the interest payments may be made from funds currently at the Parent Company or dividends from its subsidiaries.
NCUL may pay dividends to the Parent Company up to the extent of available profits that have been distributed from Syndicate 1221 and as of December 31, 2012 that amount was $8.6 million (£5.3 million).
The applicable margin and applicable fee rate payable under the credit facility are based on a tiered schedule that is based on the Company’s then-current ratings issued by S&P and Moody’s with respect to the Company’s Senior Notes without third-party credit enhancement, and the amount of the Company’s own collateral utilized to fund its participation in Syndicate 1221.
We believe that we have adequately managed our cash flow requirements related to reinsurance recoveries from their 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 large losses could significantly impact our liquidity needs. However, we expect to collect our paid reinsurance recoverables generally under the terms described above.
The following tables set forth the Company’s cash and investments as of December 31, 2012 and 2011. The tables below include OTTI securities recognized within OCI.
Invested assets increased in 2012 since the prior comparable periods for 2011 and 2010 primarily due to unrealized gains and cash flow from operations. The annualized pre-tax yield, excluding net realized gains and losses and net OTTI losses recognized in earnings, was 2.4%, 3.0% and 3.5% for the years ended December 31, 2012, 2011 and 2010, respectively. The 2.4% and 3.0% annualized pre-tax yield for the years ended December 31, 2012 and 2011 include investment expenses of $4.5 million and $4.7 million, respectively, for a total of $9.2 million, of interest expense related to the settlement of a dispute with Equitas over foregone interest on amounts that were due on certain reinsurance contracts. In the dispute Equitas alleged that we failed to make timely payments to them under certain reinsurance agreements in connection with subrogation recoveries received by us with respect to several catastrophe losses that occurred in the late 1980’s and early 1990’s. In addition, investment expenses for the year ended December 31, 2012 includes a $2.8 million investment performance fee. Excluding the impact of the aforementioned interest expense and investment performance fee, the annualized pre-tax yield for the year ended December 31, 2012 and 2011 would have been 2.7% and 3.2%, reflective of the general decline in market yields.
The tax equivalent yields for the years ended December 31, 2012, 2011 and 2010 on a consolidated basis were 2.6%, 3.5% and 4.0%, respectively. The portfolio duration was 3.6 years for both the years ended December 31, 2012 and 2011. Since the beginning of 2012, the tax-exempt portion of our investment portfolio has decreased by $91.8 million to approximately 13.2% of the fixed maturities investment portfolio as of December 31, 2012 compared to approximately 19.7% at December 31, 2011.
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 aggregate amount of mortgage-backed and asset-backed securities is estimated to have an effective maturity of approximately 4.0 years.
The following table sets forth the amount and percentage of our fixed maturities as of December 31, 2012 by S&P credit rating or, if an S&P rating is not available, the equivalent Moody’s rating. The table includes fixed maturities at fair value, and the total rating is the weighted average quality rating.
The following table sets forth our agency mortgage-backed securities and residential mortgage-backed securities (“RMBS”) by those issued by GNMA, FNMA, and FHLMC, and the quality category (prime, Alt-A and subprime) for all other such investments as of December 31, 2012:
The following table sets forth the composition of the investments categorized as RMBS in our portfolio by generally equivalent S&P and Moody’s ratings (not all securities in our portfolio are rated by both S&P and Moody’s) as of December 31, 2012:
Details of the collateral of our asset-backed securities portfolio as of December 31, 2012 are presented below:
The following table sets forth the composition of the investments categorized as commercial mortgage-backed securities in our portfolio by generally equivalent S&P and Moody’s ratings (not all securities in our portfolio are rated by both S&P and Moody’s) as of December 31, 2012:
The following table sets forth the composition of the investments categorized as corporate bonds in our portfolio by generally equivalent S&P and Moody’s ratings (not all securities in our portfolio are rated by both S&P and Moody’s) as of December 31, 2012:
The following table summarizes all securities in a gross unrealized loss position as of December 31, 2012 and 2011, showing the aggregate fair value and gross unrealized loss by the length of time those securities had continuously been in a gross unrealized loss position as well as the number of securities:
We analyze the unrealized losses quarterly to determine if any are other-than-temporary. The above unrealized losses have been determined to be temporary based on our policies.
In the above table the gross unrealized loss 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.
To determine whether the unrealized loss on structured securities is other-than-temporary, we analyze the projections provided by our investment managers with respect to an expected principal loss under a range of scenarios and utilize the most likely outcomes. The analysis relies on actual collateral performance measures such as default rate, prepayment rate and loss severity. These assumptions are applied throughout the remaining term of the deal, incorporating the transaction structure and priority of payments, to generate loss adjusted cash flows. Results of the analysis will indicate whether the security is expected ultimately to incur a loss or whether there is a material impact on yield due to either a projected loss or a change in cash flow timing. A break even default rate is also calculated. A comparison of the break even default rate to the actual default rate provides an indication of the level of cushion or coverage to the first dollar principal loss. The analysis applies the stated assumptions throughout the remaining term of the transaction to forecast cash flows, which are then applied through the transaction structure to determine whether there is a loss to the security. For securities in which a tranche loss is present, and the net present value of loss adjusted cash flows is less than book value, an impairment is recognized. The output data also includes a number of additional metrics such as average life remaining, original and current credit support, over 60 day delinquency and security rating.
The following table sets forth the composition of the investments categorized as fixed maturity securities in our investment portfolio with gross unrealized losses by generally equivalent S&P and Moody’s ratings (not all of the securities are rated by S&P and Moody’s) as of December 31, 2012:
As of December 31, 2012, the gross unrealized losses in the table above were related to fixed maturity securities that are rated investment grade, which is defined as a security having an S&P rating of “BBB-” or higher, or a Moody’s rating of “Baa3” or higher, except for $0.5 million which is rated below investment grade or not rated. Unrealized losses on investment grade securities principally relate to changes in interest rates or changes in sector-related credit spreads since the securities were acquired.
The contractual maturity for fixed maturity securities categorized by the number of years until maturity, with a gross unrealized loss as of December 31, 2012 is presented in the following table:
The following table summarizes the gross unrealized investment losses by length of time that the fair value continues to be less than 80% of amortized cost as of December 31, 2012:
During the year ended December 31, 2012 we recognized OTTI losses of $0.9 million related to one non-agency mortgage-backed security and three equity securities. During 2011, we recognized OTTI losses of $2.0 million related to non-agency mortgage-backed securities, two equity securities and one corporate bond. During 2010 we recognized OTTI losses of $1.1 million related to residential mortgage-backed securities and equity securities. The significant inputs used to measure the amount of credit loss recognized in earnings were actual delinquency rates, default probability assumptions, severity assumptions and prepayment assumptions. Projected losses are a function of both loss severity and probability of default. Default probability and severity assumptions differ based on property type, vintage and the stress of the collateral. We do not intend to sell any of these securities and it is more likely than not that we will not be required to sell these securities before the recovery of the amortized cost basis.
The Consolidated Financial Statements required in response to this section are submitted as part of Item 15(a) of this report.