The following table sets forth summary consolidated financial information of the Company for each of the years in the five-year period ended December 31, 2003 derived from the Company's audited consolidated financial statements. See the Consolidated Financial Statements of the Company including notes thereto included herein.
Over the past two years, we have experienced beneficial market changes in our lines of businesses. As a result of several large losses in the second quarter of 2001, the marine insurance market began to experience diminished capacity and rate increases, initially in the offshore energy line of business. As conditions in the overall property/casualty insurance market have hardened since the third quarter of 2001, certain property/casualty insurers who also compete in our marine and specialty liability lines of business have reduced their capacity generally and in the marine and specialty liability lines specifically. Specialty liability losses have also resulted in diminished capacity in the market in which we compete, as many former competitors who lacked the expertise to selectively underwrite this business have been forced to withdraw from the market. In the professional liability market, the enactment of the Sarbanes-Oxley Act of 2002, together with recent financial and accounting scandals at publicly traded corporations and increased frequency of securities-related class action litigation, has lead to an invigorated interest in professional liability insurance generally. These conditions have resulted in rate increases as well as an overall improvement in policy terms and conditions for our professional liability line of business. While we believe that the hardening of the markets in which we operate will continue for the foreseeable future, albeit at a less dramatic rate compared to the past twenty-four months, our business is cyclical and influenced by many factors that could cause our positive outlook to change. These factors include price competition, economic conditions, interest rates, natural or man-made disasters (for example hurricanes and terrorism), state regulations, court decisions and changes in the law. Additionally, because our insurance products must be priced, and premiums charged, before costs have fully developed, our liabilities are required to be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, we cannot assure you that our actual liabilities will not exceed our recorded amounts.
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original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year's results. Additional information regarding our loss reserves can be found in "-Results of Operations-Operating Expenses-Net Losses and Loss Adjustment Expenses Incurred," "Business-Reserves," and Note 6 to our consolidated audited financial statements, all of which are included herein.
Reinsurance Recoverables. Reinsurance recoverables are established for the portion of the loss reserves that are ceded to reinsurers. Reinsurance recoverables are determined based upon the terms and conditions of reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers which can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. See the "Business-Reinsurance Ceded" section and Note 7 to our consolidated audited financial statements, both included herein.
We experienced rapid premium growth as measured by net earned premium in 2003 and 2002 of 25.0% and 47.8%, respectively, due to the combination of increased premium rates and business expansion. Underwriting profitability during such periods, as measured by the Company's combined ratios, has also improved for the 2003 and 2002 business written which has been adversely impacted by reserve strengthening in 2003.
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in 2003 and actually declined in 2002 as a result of the overall declines in interest rates on the portfolios caused principally by overall declines in interest rates. Investment performance in 2002 and 2001 was also adversely impacted by investment losses described below.
The 2003 results of operations were adversely impacted by an after tax charge of $20.5 million or $2.14 per diluted share for incurred losses related to asbestos exposures. The Company's 2003 combined ratio of 104.0% was negatively impacted by 11.7 percentage points for incurred losses related to asbestos and environmental exposures.
Navigators Insurance Company increased its gross and net asbestos reserves for losses by $77.6 million and $31.6 million, respectively, in the fourth quarter of 2003. As a result, gross and net incurred losses increased by the amount of the respective reserve increase. The reserve action was the result of a review of asbestos-related exposures conducted by the Company. The Company's management was notified in late January 2004 that an asbestos claim would likely have to be settled for a significantly greater amount than previously anticipated. As a result of the unexpected adverse development on this individual claim, the Company retained a leading independent consulting firm in this area to assist in the identification of its potential exposure to asbestos claims from policies written directly as well as those reinsured to Navigators Insurance Company from prior members of the Company's insurance pools. The Company's increased reserves relate primarily to policies underwritten by Navigators Agencies in the late 1970's and first half of the 1980's on behalf of members of the pool, consisting of excess liability on marine related business and aviation products liability, including policies subsequently assumed by Navigators Insurance Company pursuant to reinsurance arrangements with pool members who exited the pool. Following the Company's and the independent consulting firm's recent review, the Company determined to increase its gross and net loss reserves for asbestos exposure to $78.5 million and $32.1 million, respectively, at December 31, 2003.
The 2002 results of operations reflect a substantial improvement in underwriting profitability as evidenced by the Company's combined ratio of 98.5% compared to 104.1% for 2001. The 2002 results of operations were adversely impacted by an after tax charge of $1.9 million or $0.22 per diluted share for impairment losses on asset-backed securities.
The 2001 results of operations were adversely impacted by approximately $4.5 million, pre-tax and after-tax, resulting from the World Trade Center attack, consisting of estimated net incurred losses of $4.1 million and the net effect of reinsurance reinstatement premiums of $0.4 million, all of which originated from our Lloyd's operations. This represents our best estimate of our maximum exposure determined by an analysis of policies that may have incurred a loss resulting from the terrorist attack. No additional losses related to the World Trade Center attack were incurred during 2002 or 2003. However, given the uncertainty surrounding this event, the estimate may change over time as additional information becomes available.
The 2001 results of operations also include the adverse impact of an after tax charge of $2.5 million or $0.29 per diluted share for an investment in a corporate capital vehicle which provided underwriting capacity to Lloyd's syndicates and $1.1 million or $0.12 per diluted share for impairment losses for asset-backed securities investments.
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Note: Certain amounts for prior years have been reclassified to conform to the current year's presentation.
Specialty Premium. The Specialty premium increased 13.4% from 2002 to 2003 and 109.8% from 2001 to 2002 due to increased rates and underwriting new policies. The increased premium in 2003 of $15.5 million, which is net of business that was not renewed, includes approximately $27.2 million of premium resulting from rate increases which averaged 49%. During 2003, the number of California construction liability in-force policies decreased significantly as a result of our efforts to scale back the number of small artisan policies we write. The increased premium in 2002 of $60.5 million resulted from $48.9 million of new business and $11.6 million of rate increases which averaged 30%. The new business and the rate increases resulted from a tightening market for California contractors' liability insurance.
Other. Other consists of engineering and construction premium which provides coverage for construction projects including machinery, equipment and loss of use due to delays and of onshore energy premium which principally focuses on the oil and gas, chemical and petrochemical industries with coverages primarily for property damage and business interruption.
The amount of ceded premium in 2002 increased over 2001 due to the increase in gross written premium and the increase in reinsurance rates in 2002. The percentage of the Lloyd's operations' ceded premium increased from 28.5% in 2001 to 39.3% in 2002 due to additional quota share reinsurance. The percentage of our insurance company subsidiaries' premium which was ceded decreased from 44.1% in 2001 to 43.1% in 2002 primarily due to the increase in the Specialty insurance premium, of which our insurance company subsidiaries retain more of the premium than in the other lines of business.
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Commission Income. Commission income from unaffiliated business decreased by 11.3% in 2003 compared to 2002 as a result of a decrease from 25% to 20% of unaffiliated insurers participating in the marine pool managed by Navigators Agencies. This decrease occurred effective January 1, 2003 as a result of Navigators Insurance Company increasing its participation in the marine pool from 75% in 2002 to 80% in 2003. The increase of 13.9% in 2002 compared to 2001 resulted from increased premiums written on behalf of unaffiliated insurers in the marine pool.
Net Realized Capital Gains. Pre-tax net income included $1,875,000 of net realized capital gains for 2003 compared to $1,668,000 for 2002 and $790,000 for 2001. On an after-tax basis, the net realized capital gains were $0.13 per share, $0.14 per share and $0.09 per share for 2003, 2002 and 2001, respectively. The 2002 and 2001 net realized capital gains include $2,905,000 and $1,618,000, respectively, of impairment losses recorded on three of our asset-backed securities.
Other Income/(Expense). Other income/(expense) for 2003 and 2002 consisted primarily of foreign exchange gains and inspection fees related to the Specialty insurance business. Other income/(expense) for 2001 consisted primarily of a $3,800,000 charge related to our former investment in Riverside Corporate Underwriters, Ltd., a Lloyd's corporate name. Lloyd's informed us in 2001 that it was liable for part of the adverse development in the Lloyd's syndicates in which Riverside Corporate Underwriters, Ltd. provided capacity in 1999 and 1998. We had provided a letter of credit to Riverside Corporate Underwriters, Ltd. in order for Riverside Corporate Underwriters, Ltd. to participate on various Lloyd's syndicates. We believe that we have no further exposure to Riverside Corporate Underwriters, Ltd.
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The following tables set forth our net loss reserves by segment and line of insurance business and the total case reserves and IBNR as of the date indicated:
At December, 2003, the IBNR loss reserve was $219,640,000 or 58.7% of our total loss reserves compared to 48.9% in 2002 and 46.2% in 2001.
As discussed under the caption "Business-Reserves," there are a number of factors that could cause actual losses and loss adjustment expenses to differ materially from the amount that we have reserved for losses and loss adjustment expenses.
Commission Expense. Commission expense paid to brokers and agents is generally on a percentage of the gross written premium and is reduced by ceding commissions the Company may receive on the ceded written premium. Commissions are generally deferred and recorded to deferred policy acquisition costs to the extent that they relate to unearned premium. Commission expense declined 7% in 2003 and increased 39% in 2002. The decrease in commission expense in 2003 was primarily the result of an increase in ceding commissions received as a result of a change in a reinsurance treaty for specialty business coupled with a general decline in commissions paid to brokers and agents. The 2002 increase was caused principally by an increase in premium revenue.
Income Taxes. The income tax expense (benefit) was $(4.9) million, $5.8 million and $1.7 million for 2003, 2002 and 2001, respectively. The effective tax rates for 2003, 2002 and 2001 were (175.2%), 26.2% and 31.6%, respectively. As of December 31, 2003 and 2002, the net deferred Federal, foreign, state and local tax assets were $15.2 million and $6.5 million, respectively. We had alternative minimum tax carryforwards of $0, $1.0 million and $3.9 million at December 31, 2003, 2002, and 2001, respectively. The alternative minimum tax carryforwards were primarily attributable to the tax benefits from municipal bond interest.
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Following are the results of the Insurance Companies for each of the years in the three-year period ended December 31, 2003:
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The 2003 underwriting results were adversely impacted by approximately $61.5 million for incurred losses related to years prior to 2002. Approximately $32.5 million of such adverse development was for incurred losses recorded for asbestos and environmental exposures (consisting of $31.1 million in marine business and $1.4 million in run-off business). As a result of recording such losses, intersegment profit commissions of $5.7 million due to Navigators Agencies were reduced.
The Company also recorded adverse development in 2003 of approximately $22.2 million for specialty business mostly for California contractors liability business, and approximately $7.0 million for other marine business and $2.8 million for other run-off business. The Company strengthened its reserves for the California contractors liability business as a result of an internal actuarial analysis of the specialty business conducted during the 2003 fourth quarter.
The 2002 underwriting results were negatively impacted by approximately $6.7 million for prior year loss development recorded in specialty business mostly for the Company's California contractors liability business. The 2001 underwriting results were favorably impacted by $4.5 million for a redundancy on prior year reserves mostly related to the marine business.
The pre-tax yield on the Insurance Companies' investment portfolio approximated 4.26%, 4.99% and 6.29% for 2003, 2002 and 2001, respectively. The declining portfolio yields in 2003 and 2002 reflect the overall declines in interest rates since 2001. Net investment income increased in 2003 compared to 2002 despite declines in the average investment yield on the portfolio due to strong cash flows throughout 2003 coupled with the receipt of $95 million of statutory surplus contributions in the 2003 fourth quarter.
for three years. Traditionally, three years have been necessary to report substantially all premiums associated with an underwriting year and to report most related claims, although claims may remain unsettled after the underwriting year is closed. A Lloyd's syndicate typically closes an underwriting year by reinsuring outstanding claims on that underwriting year with the participants for the next underwriting year. The ceding participants pay the assuming participants an amount based on the unearned premiums and outstanding claims in the underwriting year at the date of the assumption. Our participation in Lloyd's Syndicate 1221 is represented by and recorded as our proportionate share of the underlying assets and liabilities and results of operations of the syndicate since, (a) we hold an undivided interest in each asset, (b) we are proportionately liable for each liability and (c) Syndicate 1221 is not a separate legal entity. At Lloyd's, the amount to close an underwriting year into the next year is referred to as the reinsurance to close. The reinsurance to close amounts represent the transfer of the assets and liabilities from the participants of a closing underwriting year to the participants of the next underwriting year. To the extent our participation in the syndicate changes, the reinsurance to close amounts vary accordingly. The reinsurance to close transactions are recorded as additional written and earned premium, losses incurred, loss reserves and receivables, all in the same amount. There are no gains or losses recorded on the transactions.
Following are the results of the Lloyd's operations for each of the years in the three-year period ended December 31, 2003:
The Lloyd's operations have been experiencing business expansion coupled with improving underwriting results as a result of the generally favorable market conditions for marine and energy business since late 2001. Net earned premium revenues were reduced by $21.4 million and $5.5 million in 2003 and 2002 for business ceded to the Insurance Companies.
Each of the Navigators Agencies underwrites marine and related lines of business for Navigators Insurance Company and three other unaffiliated insurance companies comprising a marine insurance pool. Marine insurance policies are issued by Navigators Insurance Company with the business shared with other pool members. Navigators Insurance Company had a 75% participation in the pool for business written with effective dates in 2002 and 2001. As described in more detail under "Business-Marine Insurance", Navigators Insurance Company's participation in the marine pool increased to 80% for 2003.
Navigators Specialty, a division of a Navigators Agency, produces business exclusively for our insurance company subsidiaries. It specializes in underwriting general liability insurance coverage for small general and artisan contractors and other targeted commercial risks, with the majority of its business located in California. Navigators Specialty also writes surety, commercial multiple peril, commercial automobile and personal umbrella insurance.
Following are the results of the Navigators Agencies for each of the years in the three year period ended December 31, 2003:
unaffiliated insurance companies in the marine pool. Despite increased premium revenues recorded by the Insurance Companies in 2003 compared to 2002, the commission income of the Navigators Agencies was flat due to the reduction of $5.7 million of intersegment profit commission as a result of the $32.5 million incurred losses recorded by the Insurance Companies for asbestos and environmental losses.
Commission income increased substantially in 2002 compared to 2001 due to the increased premium revenues generated on behalf of the Insurance Companies.
Net investment income is earned on fiduciary funds. Other income generally represents fee revenues earned for services on behalf of third parties.
Income tax expense (benefit) includes federal and state income taxes related to the taxable income or loss of the Navigators Agencies. The 2001 income tax benefit contains a reversal of a prior year accrual that was no longer deemed necessary for a tax contingency.
Cash flow provided by operations was $134.5 million, $108.5 million and $41.3 million for 2003, 2002, and 2001, respectively. The increases in the 2003 and 2002 operating cash flows were primarily due to the increases in net written premium. Operating cash flow was used primarily to acquire additional investment assets and to reduce debt.
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At December 31, 2003, the weighted average rating of our fixed maturity investments was "AA" by Standard & Poor's and "Aa" by Moody's. We believe that we have no significant exposure to credit risk since the fixed maturity investment portfolio consists of investment-grade bonds. At December 31, 2003, our portfolio had an average maturity of 5.3 years and duration of 3.7 years. Management continually monitors the composition and cash flow of the investment portfolio in order to maintain the appropriate levels of liquidity to ensure our ability to satisfy claims. We incurred impairment losses of $2.9 million in 2002 and $1.6 million in 2001 on asset-backed securities. We incurred no impairment losses in 2003.
The bank credit facility is collateralized by the common stock of Navigators Insurance Company. It contains covenants common to transactions of this type, including restrictions on indebtedness and liens, limitations on mergers and the sale of assets, maintaining certain consolidated tangible net worth, statutory surplus and other financial ratios. At December 31, 2003, we were in compliance with all covenants.
We had annual rental commitments at December 31, 2003 under various noncancellable operating leases for our office facilities, which expire at various dates through 2013. The commitments by year are $2.4 million for 2004, $2.3 million for 2005, $2.2 million for 2006, $1.9 million for 2007 and $6.0 million for 2008 and beyond.