In January 2000, the Company purchased an apartment in London to accommodate visitors to its London operations at a cost of approximately $820,000.
The Company is a holding company with twelve active wholly owned subsidiaries. See "BUSINESS-General" included herein for a description of the Company.
The Company's loss reserves are discussed under the BUSINESS-Reserves section and Note 6 to the Company's consolidated financial statements, both included herein. Loss reserves represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, judicial theories of liability and other third party factors which are often beyond our control. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may be different from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year's results.
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 the reinsurance contracts which could be subject to judicial theories of liability. In addition, a credit risk exists with the reinsurer particularly considering that certain of the reserves remain outstanding for an extended period of time. The Company is required to pay the losses even if the reinsurer fails to meet its obligations under the reinsurance agreement. See the BUSINESS-Reinsurance Ceded section and Note 7 to the Company's consolidated financial statements, included herein.
Impairment of investment securities results in a charge to operations when a market decline below cost is other than temporary. Management regularly reviews each investment security for impairment based on criteria that include the extent to which cost exceeds market value, the duration of that market decline and the financial health of and specific prospects for the issuer. See Note 2 to the Company's consolidated financial statements, included herein.
The 2001 results of operations were adversely impacted by approximately $4.5 million, both pretax and after tax, resulting from the September 11, 2001 terrorist attack on the World Trade Center consisting of estimated net incurred losses of $4.1 million and the net effect of reinstatement premiums of $0.4 million, all of which originated from the Company's Lloyd's Operations. This represents the Company's best estimate of its maximum exposure determined by an analysis of policies that may incur a loss resulting from the terrorist attack. However, given the uncertainty surrounding this event, the estimate may change over time as additional information becomes available. The related ceded losses recoverable of $5.5 million are reinsured by highly rated reinsurers.
The 1999 results include a charge against earnings of approximately $6.6 million pretax resulting in an after tax charge of approximately $4.3 million as the result of unrecoverable reinsurance from New Cap Reinsurance Corporation Limited ("New Cap Re") which participated in the Company's 1998 and 1997 reinsurance programs.
Since, by Lloyd's definition, the Syndicate 1221 capacity controlled by the Company exceeded 75% in 2000 (75.6%), Lloyd's Mandatory Byelaw (No. 5 of 1999) required the Company to make a mandatory offer to noncontrolled participants for their capacity at the first Lloyd's capacity auctions beginning in July 2000. As a result, the Company purchased an additional £7,379,000 ($11,018,000) of capacity for 2001 through the auction process in 2000 at a total cost of £133,000 ($199,000). The offer was made at 1.8 pence per £1 of capacity which is the minimum price that the Company was obliged to offer, being the highest price paid for capacity during the prior 12 months. If the Company exceeds the 90% control threshold, Lloyd's Major Syndicate Transactions Byelaw (No. 18 of 1997) allows for a Minority Buy-out to be effected. In such a transaction the remaining participants are required to give up their capacity in return for compensation which must be at least equal to the offer price preceding the buy-out. Syndicate 1221's capacity for 2002 will be approximately £75 million of which the Company will participate for approximately 68.1% and, by Lloyd's definition, control approximately 88.8% of the capacity.
Marine Premium. In 2001, marine premium increased 32.5% due to the increase in premium rates resulting in higher premiums on new and renewal business. The higher premium rates made the business more attractive resulting in the Insurance Companies increasing their writing of new business. Marine gross written premium remained relatively unchanged from 1999 to 2000. Navigators Insurance's net participation in the marine pool was 75% in 2001, 2000 and 1999.
Ceded Written Premium. In the ordinary course of business, the Company reinsures certain insurance risks with unaffiliated insurance companies for the purpose of limiting its maximum loss exposure, protecting against catastrophic losses, and maintaining desired ratios of net premiums written to statutory surplus. The relationship of ceded premium to gross written premium varies based upon the types of business written and whether the business is written by the Insurance Companies or the Lloyd's Operations. The amount of ceded premium in 2001 increased over 2000 due to the increase in gross written premium and the increase in reinsurance rates in 2001. The percentage of the Lloyd's Operations' ceded premium increased from 27.4% in 2000 to 28.5% in 2001 due to slightly higher reinsurance rates. The percentage of the Insurance Companies' premium which was ceded decreased from 53.3% in 2000 to 44.1% in 2001 primarily due to the increase in the specialty insurance premium of which the Insurance Companies retain more of the premium than in the other lines of business. The increase in ceded premium in the Lloyd's Operations during 2000 was due to the purchase of additional quota share protection in the marine business and increased gross written premium. The Insurance Companies' ceded premium decreased 2.8% from 1999 to 2000 primarily due to more favorable reinsurance rates in the specialty insurance.
Net Investment Income. Net investment income increased 4.9% in 2001, 15.4% in 2000 and 5.1% in 1999 from each previous year primarily due to an increase in investment income allocated to NCUL and Millennium from the investments at the Lloyd's syndicates due to their increased participation in Syndicate 1221, reduction in the Insurance Companies' municipal portfolio, reduction in the expenses to manage the portfolio and the increase in the size of the portfolio. The investments at NCUL and Millennium are represented by funds due from Lloyd's Syndicate 1221 to the Company.
Other Operating Expenses. The 8.8% increase in other operating expenses from 2000 to 2001 was primarily employee related expenses resulting from expansion of the business. The change in other operating expenses from 1999 to 2000 was minimal.
Interest Expense. The decrease in interest expense in 2001 from 2000 was primarily due to lower interest rates charged on the loan balance and a lower loan balance. The increase in interest expense in 2000 from 1999 was primarily due to higher interest rates charged on the loan balance.
and 1999, respectively. The AMT carryforwards were primarily attributable to the tax benefits from municipal bond interest. The Company began reducing its municipal bond portfolio in 1997.
As of December 31, 2001 and 2000, the net deferred Federal, foreign, state and local tax asset was $10.0 million and $9.0 million, respectively. At December 31, 2001 the Company had a $7.3 million valuation allowance against its deferred tax asset compared to a $5.8 million valuation allowance at December 31, 2000. The valuation allowance is necessitated by the uncertainty associated with the realization of the deferred tax asset for the carryforward of operating losses from certain of the Company's foreign, state and local operations.
Cash flow provided by operations was $28.8 million, $1.6 million, and $8.9 million for 2001, 2000, and 1999, respectively. The increase in the 2001 operating cash flow was primarily due to the increase in net written premium during 2001. Operating cash flow was used primarily to acquire additional investment assets and to reduce debt.
Invested assets and cash increased to $278.3 million at December 31, 2001 from $251.2 million at December 31, 2000. The increase was primarily due to the positive cash flow. Net investment income was $19.4 million in 2001, $18.4 million in 2000 and $16.0 million in 1999. The average yield of the portfolio, excluding net realized capital gains, was 6.14% in 2001, 6.55% in 2000 and 5.84% in 1999 reflecting the prevailing interest rates during those years, the decrease in the tax-exempt portfolio and reduction in expenses to manage the portfolio in 2000. As of December 31, 2001, all fixed maturity securities and equity securities held by the Company were classified as available-for-sale.
The Company's bank credit facility provides a $19 million revolving line of credit at an interest rate of either, at the Company's election, the base commercial lending rate of one of the banks or at LIBOR plus 1.25% on the used portion of the line of credit. The commitment fee on the unused portion of the line of credit is 0.25%. The line of credit facility reduces each quarter by amounts totaling to $3 million in 2002, $9 million in 2003 and $7 million in 2004. At December 31, 2001 and 2000, $19 million and $22 million in loans were outstanding, respectively, under the revolving line of credit facility at an interest rate of 3.4% and 7.6%, respectively. The credit facility also provides for a $55 million letter of credit facility which is utilized primarily by NCUL and Millennium to participate in Lloyd's Syndicate 1221. The cost of the letters of credit is 1.3% for the used portion and 0.25% for the unused portion of the letter of credit facility. At December 31, 2001 and 2000, letters of credit with an aggregate face amount of $47.5 million and $46.6 million, respectively, were issued under the letter of credit facility. In 2001, $3.8 million of letters of credit were drawn upon as discussed in the Other Income/(Expense) section.
The bank credit facility is collateralized by the common stock of Navigators Insurance. 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 total stockholders' equity, statutory surplus, minimum liquidity, loss reserves and other financial ratios. At December 31, 2001, the Company complied with all covenants.
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. The following is a discussion of the Company's primary market risk exposures and how those exposures are currently managed as of December 31, 2001. The Company's market risk sensitive instruments are entered into for purposes other than trading.
For invested assets, modified duration modeling is used to calculate changes in fair values. Durations on invested assets are adjusted for call, put and interest rate reset features. Duration on tax exempt securities is adjusted for the fact that the yield on such securities is less sensitive to changes in interest rates compared to Treasury securities. Invested asset portfolio durations are calculated on a market value weighted basis, including accrued investment income, using holdings as of December 31, 2001.