(2) - Calculated as stockholders’ equity divided by actual shares outstanding as of the date indicated.
The Combined ratio is a common insurance industry measure of profitability for any underwriting operation and is calculated in two components. First, the loss ratio is Net losses and LAE divided by Net earned premiums. The second component, the expense ratio, reflects the sum of Commission expenses and insurance operating expenses, divided by Net earned premiums. All items included in these components of the Combined ratio are presented in our GAAP Consolidated Financial Statements. The sum of the loss and expense ratios is the Combined ratio. The difference between the Combined ratio and 100 percent reflects the rate of Underwriting profit (loss). For example, a Combined ratio of 85 percent implies that for every $100 of premium we earn, we record $15 of Underwriting profit.
Net operating earnings is calculated as Net income before after-tax Net realized gains (losses), after-tax OTTI losses recognized in earnings, and after-tax net realized and unrealized foreign exchange gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity’s functional currency) and translation adjustments (translation of foreign currency denominated assets and liabilities into U.S.dollars (“USD”)).
Net losses and LAE reserves, as shown in the liabilities section of our Consolidated Balance Sheets, represents the total obligations to claimants for both estimates of known claims and estimates for IBNR claims. The related asset item, Reinsurance balances recoverable on unpaid losses and LAE, is the estimate of both known claims and IBNR that we expect to recover from reinsurers. The net of these two items is generally referred to as Net losses and LAE reserves and is commonly used in our disclosures regarding the process of establishing these various estimated amounts.
The following table calculates our operating earnings for the years ended December 31, 2015, 2014 and 2013:
For the year ended December 31, 2013, we recorded $1.3 million of net prior AY reserve releases due to $27.3 million of reserve releases from our Int’l Insurance reporting segment, mostly driven by a decline in large loss activity, partially offset by prior AY reserve strengthening of $15.0 million and $11.0 million from our GlobalRe and U.S. Insurance reporting segments, respectively. The loss ratio was also unfavorably impacted by $3.0 million of RRPs.
As part of our overall investment strategy, we seek to build a tax efficient investment portfolio. The tax-exempt or tax efficient portion of our investment portfolio was approximately 22.1% of the fixed maturities investment portfolio as of December 31, 2015. Additionally, substantially all of our equity portfolio is invested in tax efficient securities which qualify for the dividends received deduction. The tax equivalent yields for the years ended December 31, 2015, 2014 and 2013 on a consolidated basis were 2.7%, 2.5%, and 2.5%, respectively.
Net realized gains and losses are generated as part of the normal ongoing management of our investment portfolio. Net realized gains of $8.4 million for the year ended December 31, 2015 are primarily due to the sale of equity securities. Realized losses of $5.9 million in fixed maturities are primarily due to foreign exchange loss on the sale and maturity of fixed maturities in our Canadian portfolio. Net realized gains of $12.8 million for the year ended December 31, 2014 are primarily due to the sale of corporate bonds and equity securities. Net realized gains of $22.9 million for the year ended December 31, 2013 are primarily due to the sale of equity securities.
(2) - Includes Other operating expenses and Other underwriting income (expense).
Gross written premiums increased $61.1 million for the year ended December 31, 2014 compared to the same period in 2013 due to our Primary Casualty division, which increased $41.8 million due to strong production as a result of improving conditions within the
construction market. In addition, our Excess Casualty division increased $17.5 million due to improved market conditions and dislocation of certain competitors, our Environmental division increased $13.1 million due to continued investments in our underwriting teams, and our U.S. Marine operating segment increased $10.4 million due to new business growth across various products. Gross written premium growth was partially offset by a decrease in our U.S. Professional Liability operating segment of $20.2 million driven by our E&O division due to our decision to exit the Small Lawyers Professional Liability business line in the fourth quarter of 2013, as well as a decrease in our Real Estate E&O and Accountants products as a result of certain program terminations.
For the year ended December 31, 2015, RRPs of $5.4 million increased $3.6 million as compared to prior year of $1.8 million, primarily due to large loss activity within our U.S. Marine operating segment.
P&C operating segments, respectively, mostly due to a decline in large loss activity. The favorable prior AY reserve releases were partially offset by a $10.0 million current AY loss related to Hurricane Joaquin. The loss ratio was also unfavorably impacted by $5.5 million of RRPs, which were primarily within our U.S. Marine operating segment.
The Commission expense ratio increased 0.2 points for the year ended December 31, 2015 compared to the same period in 2014 primarily due to less ceded proportional reinsurance and related ceding commission benefit within our U.S. P&C operating segment as a result of the change in the proportional reinsurance program previously discussed partially offset by a decrease in commission expense ratio in the U.S. Professional Liability operating segment, and to a lesser extent, our U.S. Marine operating segment, due to the implementation of new proportional reinsurance programs.
Other operating expenses increased $16.8 million for the year ended December 31, 2014 compared to the same period in 2013, primarily driven by growth and continued investment in our underwriting teams and support staff in conjunction with our business growth as well as increases in incentive compensation driven by improved financial results.
Average renewal premium rates for our Int’l Insurance reporting segment for the year ended December 31, 2015 decreased 5.4%, due to decreases of 2.3%, 9.9%, and 4.6% in our Int’l Marine, Int’l P&C and Int’l Professional Liability operating segments, respectively.
For the year ended December 31, 2015, RRPs of ($4.0) million decreased $10.6 million as compared to the same period in 2014 of $6.6 million. 2015 benefited from RRP releases of $4.0 million, which included releases for Superstorm Sandy.
For the year ended December 31, 2014, RRPs of $6.6 million increased by $5.4 million compared to the same period in 2013 of $1.2 million. This was driven by an increase of $4.0 million of RRPs related to Superstorm Sandy and Hurricane Ike.
For the year ended December 31, 2015, our Int’l Insurance reporting segment recorded $26.2 million of prior AY reserve releases, driven by our Int’l Marine and Int’l P&C operating segments of $21.9 million and $8.5 million, respectively, related to favorable loss emergence. These releases were partially offset by $4.2 million of prior AY reserve strengthening within our Int’l Professional Liability operating segment due to a large loss. Current AY reserve development of $30.2 million was driven by our Int’l Marine and Int’l P&C operating segments of $23.3 million and $6.9 million, respectively, arising from large loss activity.
The commission expense ratio for the year ended December 31, 2015 decreased 1.4 points as compared to the same period in 2014, primarily driven by a favorable reduction in profit commission accrual of $0.9 million in our Int’l Marine operating segment as well as a $9.7 million decrease in RRPs as compared to the same period in 2014. These decreases were partially offset by overall growth in our Int’l Professional Liability operating segment which carries proportional reinsurance coverage that does not attract commission over-riders, as well as mix of business within our Int’l P&C operating segment principally by growth in our Property division which does not carry a proportional reinsurance program.
For the year ended December 31, 2015, Other operating expenses increased $10.6 million as compared to the same period in 2014, due to continued investment in new underwriting initiatives in continental Europe including new underwriting teams and additional
support staff. Higher temporary employment expenses and professional fees were also incurred due to increased regulatory requirements, offset by favorable foreign exchange rates.
For the year ended December 31, 2014, Other operating expenses increased $11.2 million as compared to the same period in 2013, due to an increase in employee costs associated with growth initiatives for our business as well as an increase in certain information technology charges assessed by Lloyd’s. Among the initiatives was the opening of three new European offices in Rotterdam, The Netherlands, Paris, France and Milan, Italy which accounted for $2.4 million of the increase. In addition, Other operating expenses increased $2.1 million due to adverse exchange rate movement between the GBP and USD resulting in GBP denominated expenses increasing when expressed in USD terms.
(1) - Includes Other operating expenses and Other underwriting income (expense).
Gross written premiums decreased $24.6 million for the year ended December 31, 2015 compared to the same period in 2014, primarily due to the nonrenewal of a significant multiple peril crop quota share treaty within our Agriculture product and to a lesser extent nonrenewals in our Marine product and lower assumed RRPs from our P&C and Marine products. The decline in Gross written premiums was partially offset by an increase in renewal premiums from our A&H and P&C products.
Ceded written premiums increased $0.3 million for the year ended December 31, 2014 compared to the same period in 2013, primarily due to the inception of retrocessional treaties on our new property treaty business and an increase in renewal costs for our P&C product’s retrocessional treaty from 2013.
Net earned premiums increased $16.9 million for the year ended December 31, 2014, compared to the same period in 2013, primarily due to the inception of the property treaty business in our P&C product. Increases in Net earned premiums for our A&H and Professional Liability products, and additional RRPs in our Marine and P&C products also contributed to our growth. Net earned premium growth was partially offset by a decrease in the Agriculture product due to several nonrenewals.
The Net losses and LAE reserves as of December 31, 2015, 2014 and 2013 are as follows:
The following table presents the changes in reserves and RRPs on our Net losses and LAE ratio for the years ended December 31, 2015, 2014 and 2013:
For the year ended December 31, 2014, our GlobalRe reporting segment recorded $2.1 million of net prior AY reserve releases primarily driven by $2.0 million of reserve releases from our Marine product, due to lower than anticipated loss activity. In addition, $4.0 million of RRPs received reduced our Net losses and LAE ratio, primarily driven by our Marine and P&C products. The prior AY reserve releases were partially offset by reserve prior AY strengthening in our A&H and Agriculture products.
For the year ended December 31, 2013, our GlobalRe reporting segment recorded $15.0 million of net prior AY reserve strengthening primarily driven by $13.2 million of net strengthening related to excess of loss business within our A&H product in connection with UWYs 2012 and 2011.
Other operating expenses increased $0.5 million for the year ended December 31, 2015, compared to the same period in 2014 due to continued investment in our underwriting teams and support staff, as well as an increase in our professional service fees and information technology expenses to support business growth and initiatives.
We primarily rely upon dividends from our subsidiaries to meet our Parent Company’s obligations. Our Parent Company’s cash obligations primarily consist of semi-annual (April and October) interest payments of $7.6 million on the Senior notes. Going forward, the interest payments may be made from funds held at our Parent Company or dividends from our subsidiaries.
Navigators Insurance Company may pay dividends to our Parent Company out of our statutory earned surplus pursuant to statutory restrictions imposed under the New York insurance law. As of December 31, 2015, the maximum amount available for the payment of dividends by Navigators Insurance Company in 2016 without prior regulatory approval is $94.9 million.
On November 6, 2014, NUAL entered into a credit facility for 8.0 million Australian Dollars with Barclays Bank PLC. Interest is payable under this facility at a rate of 2.0% per annum above a floating rate tied to the average mid-rate for Australian bills of exchange administered by the Australian Financial Markets Association. The facility may be cancelled by either party after providing written notice. This credit facility contains customary covenants for facilities of this type, including a restriction on future encumbrances that are outside the ordinary course of business, and a requirement to maintain at least £75.0 million of Funds at Lloyd’s. As of December 31, 2015, letters of credit with an aggregate face amount of 8.0 million Australian Dollars were outstanding under the credit facility, and our Company was in compliance with all covenants.
On November 24, 2014, we entered into a $175.0 million credit facility agreement with ING Bank N.V., London Branch, individually and as Administrative Agent and a syndicate of lenders, which is secured by all the common stock of NIC and requires us to maintain at least forty percent of the outstanding amounts under such facility as Funds at Lloyd’s. In addition, in order to support the increased
underwriting capacity of the Syndicate for the 2016 UWY, we entered into $25.0 million credit facility with ING Bank N.V., London Branch on November 20, 2015. Both of these facilities, as well as the November 6, 2014 facility, are used to fund underwriting obligations at Lloyd’s for the 2016 UWY, as well as open prior UWYs.
The November 20, 2015 credit facility is a non-committed facility which has an applicable fee rate ranging from 0.85% to 1.20% per annum based upon the Company’s S&P rating. For the November 24, 2014 credit facility the applicable fee rate payable ranges from 0.95% to 1.60% per annum based on a tiered schedule that is based on our then-current financial strength ratings issued by S&P and A.M. Best and the amount of our own collateral utilized to fund our participation in the Syndicate. The letters of credit issued under both of these facilities can be denominated in British pounds and their aggregate face amount will fluctuate based on exchange rates. If any letters of credit remain outstanding under these facilities after December 31, 2016, we would be required to post additional collateral to secure the remaining letters of credit. As of December 31, 2015, letters of credit with an aggregate face amount of $20.0 million and $175.0 million were outstanding under the November 20, 2015 and November 24, 2014 credit facilities, respectively, and we had an aggregate of $3.3 million of cash collateral posted.
We believe that the cash flow generated by the operating activities of our subsidiaries will provide sufficient funds for us to meet our liquidity needs over the next twelve months. Beyond the next twelve months, our cash flow available may be influenced by a variety of factors, including general economic conditions and conditions in the insurance and reinsurance markets, as well as fluctuations from year to year in claims experience.
Net cash provided by operating activities was $227.6 million for the year ended December 31, 2015 compared to $222.5 million for the same period in 2014. The net increase in cash flow from operations during the year ended December 31, 2015 was primarily due to increased premium collections and receipts of ceded loss recoverables, largely offset by additional claims and operating expenses paid and the impact of a prior year utilization of a non-recurring federal tax overpayment against the 2014 tax liability.
The following table sets forth the best estimate of our known contractual obligations with respect to the items indicated as of December 31, 2015:
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 $809.5 million. See “Business - Loss Reserves” included herein.
Our investment portfolio is invested primarily in publicly traded, investment grade, fixed income securities with an average credit quality of AA-/Aa3 as rated by S&P or Moody’s Investors Service (“Moody’s”). As of December 31, 2015, our portfolio had a duration of 3.8 years. Management periodically projects cash flow of the investment portfolio and other sources in order to maintain the appropriate levels of liquidity in an effort to ensure our ability to satisfy claims. As of December 31, 2015 and December 31, 2014, all fixed maturities and equity securities held by us were classified as available-for-sale.
Our portfolio is externally managed by independent, professional investment managers and is broadly diversified across geographies, sectors, and issuers. The primary objectives are to maximize total investment return in the context of preserving and enhancing shareholder value and the statutory surplus of our regulated insurance companies. As part of our overall investment strategy, we seek to build a tax efficient investment portfolio. As of December 31, 2015, the tax-exempt or tax efficient portion of our fixed maturities portfolio was approximately 22.1%. Additionally, substantially all of our equity portfolio is invested in tax efficient securities which
Invested assets increased from December 31, 2014 primarily due to strong operating cash flows. This was partially offset by spread widening and an increase in Treasury rates. The decrease in U.S. Treasury, agency and foreign government bonds is due to a strategic reallocation to municipal and corporate bonds in an effort to enhance portfolio yield. During 2015, a portion of our operating cash flows were invested in equity securities to compensate for lower yields in fixed maturities.
The following table sets forth our agency mortgage-backed securities (“AMBS”) and residential mortgage-backed securities (“RMBS”) issued by the Government National Mortgage Association (“GNMA”), Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) and the quality category (prime, Alternative A-paper (“Alt-A”) and subprime) for all other such investments as of December 31, 2015:
We analyze our mortgage-backed securities by credit quality of the underlying collateral distinguishing between the securities issued by FNMA, FHLMC and GNMA, which are federal government sponsored entities, and non-FNMA and non-FHLMC securities
We hold non-sovereign securities where the issuer is located in the Euro Area, an economic and monetary union of certain member states within the European Union that have adopted the Euro as their common currency. As of December 31, 2015, the fair value of such securities was $83.2 million, with an amortized cost of $83.3 million, representing 3.1% of our total fixed maturities and equity portfolio. Of this amount, approximately 40.9% represent securities issued by financial institutions domiciled or operating in the Euro Area. Our largest exposure is in the Netherlands with a total of $30.9 million followed by France with a total of $28.5 million. We have no direct exposure to Greece, Portugal, Italy or Spain within the Euro Area, Ukraine, Russia or China as of December 31, 2015. Our Company also holds fixed maturities issued by the Commonwealth of Puerto Rico which are fully backed by the U.S. government.
During the year ended December 31, 2015, we recognized three credit related OTTI losses of $1.7 million for certain common stocks in the energy sector and aerospace industry. Our Company did not have credit related OTTI losses for the year ended December 31, 2014. During the year ended December 31, 2013, our Company recognized credit related OTTI losses of $2.4 million related to three equity securities and one municipal bond. 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 Fixed maturities in unrealized loss positions that are not other-than-temporarily impaired before recovery. For structured securities, 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. For Equity securities, we also consider our intent to hold securities as part of the process of evaluating whether a decline in fair value represents an other-than-temporary decline in value. We may realize investment losses to the extent our 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 investments for impairment losses could result in a significant change in impairment losses reported in the Consolidated Financial Statements.
Our exposure to asbestos liability principally stems from our Marine Liability product insurance written on an occurrence basis during the mid-1980s. In general, our participation on such risks is in the excess layers, which requires the underlying coverage to be exhausted prior to coverage being triggered in our layer. In many instances, we are one of many insurers who participate in the defense and ultimate settlement of these claims, and we are generally a minor participant in the overall insurance coverage and settlement.
The reserves for asbestos exposures as of December 31, 2015 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 and (ii) attritional asbestos claims that could be expected to occur over time. Substantially all of our asbestos liability reserves are included in our U.S. and Int’l Marine operating segment loss reserves. For the year ended December 31, 2015, our Company recognized a benefit of $1.1 million as a result of settlements with third party administrators on ceded paid losses previously written off in prior years due to bankruptcy or insolvency of the reinsurer.
Our Company has significant natural catastrophe exposures throughout the world. We estimate that the largest exposure to loss from a single natural catastrophe event comes from a hurricane on the east coast of the U.S. As of December 31, 2015, our Company estimates that the probable maximum pre-tax gross and net loss exposure from such a hurricane event would be approximately $130.6 million and $44.3 million, respectively, including the cost of RRPs.
The increase in incurred losses and LAE, net of reinsurance, for the year ended December 31, 2015 was primarily driven by gross activity subject to quota share reinsurance agreements.
Reinsurance recoverable includes the balances due to us from reinsurance companies for paid and unpaid losses and loss expenses, based on contracts in force, and are presented net of a reserve for uncollectible reinsurance which is determined based upon a review of the financial condition of the reinsurers and other factors. We determine the reinsurance recoverable on unpaid losses and loss expenses using actuarial estimates as well as a determination of our ability to cede unpaid losses and loss expenses under existing reinsurance contracts. Although reinsurance makes the reinsurer liable to our Company to the extent the risk is transferred or ceded to the reinsurer, ceded reinsurance arrangements do not eliminate the obligation to pay claims to the policyholders. Accordingly, our Company bears credit risk with respect to the reinsurers. Specifically, the reinsurers may not pay claims made by our Company on a timely basis, or they may not pay some or all of these claims. Either of these events would increase the costs and could have a material adverse effect on our business.
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. Our actuaries calculate indicated IBNR loss reserves by UWY for major product groupings using standard actuarial methodologies, which are projection or extrapolation techniques, including: (a) the loss ratio method, (b) the loss development method and (c) the Bornhuetter-Ferguson method. Each of these methodologies is generally applicable to both long tail and short tail lines of business depending on a variety of circumstances. Informed subjective judgments as to our ultimate exposure to losses are an integral component of our loss reserving process due to numerous factors that contribute to the inherent uncertainty in the process of establishing loss reserves, including:
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 UWY, 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 our Company’s best estimates for each UWY and are generally determined after evaluating a number of factors which include: information derived by underwriters and actuaries in the initial pricing of our business, the ultimate loss ratios established in the prior accounting period and the related judgments applied, the ultimate loss ratios of previous UWYs, 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.
The loss development method, also known as the chain ladder or the link-ratio method, develops the IBNR loss reserves by multiplying the paid or reported losses by a loss development factor to estimate the ultimate losses, then subtracting the reported losses, consisting of paid losses and case loss reserves, to determine the IBNR loss reserves. The loss development factor is the reciprocal of the expected percentage of losses that have thus far been reported, which is generally calculated as an average of the percentage of losses reported for comparable reporting periods of prior UWYs.
The period between the date of loss occurrence and the final payment date of the ensuing claim(s) is referred to as the “claim tail.” Short tail business generally describes products for which losses are typically known and paid shortly after the loss actually occurs. For example, a personal accident where no other parties were involved tends to be a short process. The ambiguity associated with our estimate of ultimate losses for any particular accident period diminishes quickly as actual loss experience develops. Long tail business are lines of business for which specific losses may not be known or reported for a longer period and claims can take significant time to settle. For long tail lines such as general liability, the time lag for reporting claims is greater than it is in short tail lines. Facts and information are frequently not complete at the time case reserves are established, and because there is a higher risk for additional litigation, final settlement amounts are unknown. Each of our business lines is analyzed individually, with development characteristics for each short tail and long tail line of business identified and applied accordingly.
(2) - Calculated using average diluted shares of 14,825,745 for the year ended December 31, 2015.
A range of reasonable estimates has been developed based on the historical volatility of held reserves versus current estimates for the purposes of this sensitivity analysis. The history indicates that our held reserves tend to be 9.7% redundant with a standard deviation of 8.3%. We have ignored the historical conservatism and built a range around the current held amounts. Our Company’s lines of business, the market pricing adequacy and our Company’s underwriting strategies have changed dynamically over the past ten years. 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 computation of each range represents the central 50.0% of outcomes. The movement within our reporting segments in an individual year may not fall within this range. There is a significant risk that the potential volatility of the current reserve estimates could differ in a material manner from the historical trends. The total reserve variability is not equal to the sum of the segment variability due to the benefit of diversification.
Management regularly reviews our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. Our investment portfolio is the largest component of consolidated assets and a multiple of shareholder’s equity. OTTI could be material to our financial condition and results of operations. Refer to Note 3, Investments, in the Notes to Consolidated Financial Statements for additional information.