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, 1996. The information for the five years ended December 31, 1996 has been derived from the audited consolidated financial statements of the Company. See the Consolidated Financial Statements of the Company including notes thereto included herein.
(1) Net income from 1993 and subsequent reflects the adoption of SFAS 113 and EITF Issue No. 93-6.
(2) Investments and stockholders' equity for 1994 and subsequent reflect the adoption of SFAS 115.
The Somerset Companies specialize principally in the following lines of business: marine, aviation and property (primarily inland marine) insurance and certain lines of specialty reinsurance and non-marine insurance. In 1996, Navigators began to underwrite onshore energy business primarily covering property damage and machinery breakdown. In 1996, the Somerset Companies underwrote the marine business through a syndicate of insurance companies, Navigators having the largest participation in the syndicate. The Somerset Companies derive their revenue from commissions, investment income, service fees and cost reimbursement arrangements from Navigators and other insurers. Commissions are earned both on a fixed percentage of premiums and on underwriting profits on business placed with the participating insurance companies within the syndicate. Property and casualty insurance premiums are cyclical in nature and, accordingly, during a "hard market" demand for property and casualty insurance exceeds supply, or capacity, and as a result, premiums and commissions may increase. On the downturn of the property and casualty cycle, supply exceeds demand, and as a result, premiums and commissions may decrease.
The results of 1996 and 1995 reflect this restructuring in that written premiums have been reduced while the continuing book of business has produced profits. However, the 1995 results also reflect the further development of losses from the Northridge Earthquake. During 1995 the total reported gross losses on direct property claims arising from the Northridge Earthquake increased approximately $18,340,000 from $125,361,000 to $143,701,000. The Company also added gross bulk reserves of $11,000,000 at September 30, 1995, which are expected to cover any further deterioration of losses from the Northridge Earthquake. On a net basis, the incurred losses relating to the Northridge Earthquake represented pre-tax charges of approximately $10,721,000 in 1995. There was no further development of the losses from the Northridge
Earthquake in 1996, however, there can be no assurance given that additional losses will not be reported or adjustments made to existing reserves.
Marine Premiums. Navigators' gross marine premium decreased 5% from 1994 to 1995 and 16% from 1995 to 1996. The 1995 decrease was due to Navigators' reduced participation in the marine pool along with premium rate decreases. The 1996 decrease was due primarily to decreases in premium rates. The competition causing premium rates to decrease affects the gross written premium in that less premium is received for the policies written or the Company may decide to not write the policy. Management believes pricing in marine premium is subject to increased competition.
Property and Inland Marine Premium. Navigators' gross property and inland marine premium decreased 75% from 1994 to 1995. In 1994, this business consisted primarily of large commercial and industrial property risks, which was essentially a property catastrophe book of business, with a relatively small amount of inland marine risks. In late 1994, Navigators decided to cease writing large commercial and industrial property risks and to concentrate on inland marine risks and, therefore, 1995 gross written premium is primarily inland marine. The 25% increase in this line of business from 1995 to 1996 reflects the emphasis placed on inland marine in 1996. However, due to heavy price competition and possible adverse selection in competing with the major carriers, less emphasis will be placed on inland marine going forward.
Net Investment Income. Net investment income decreased 4% to $13.6 million in 1996 from $14.1 million in 1995 due to decreased fiduciary funds held by the Somerset Companies, the effect on invested assets from payments of earthquake losses and generally lower yields. Net investment income increased 9% to $14.1 million in 1995 from $13.0 million in 1994 due primarily to an increased amount of invested assets.
Reinsurance Ceded. In the ordinary course of business, Navigators 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. Ceded written premium decreased from $98.0 million in 1994 to $67.6 million in 1995 to $58.4 million in 1996 reflecting decreases in gross written premium and lower prices in the reinsurance market.
Expenses. The ratio of loss and loss adjustment expenses incurred to net earned premium was 62.2%, 69.5% and 108.6% in 1996, 1995 and 1994, respectively. The 1994 loss ratio was adversely impacted by the Northridge Earthquake. The loss ratio improved in 1995 compared to 1994, even though 1995 included significant adverse development from the Northridge Earthquake losses. This was due primarily to a return to more normal experience in comparison to the 1994 losses from the Northridge Earthquake, various airline losses and reinsurance costs in 1994. The Northridge Earthquake increased the loss ratio by 12.2% and 43.4% in 1995 and 1994, respectively. The improved loss ratio in 1996 compared to 1995 was due primarily to a return to more normal experience. The lower rates in the marine business was partially offset by lower costs for reinsurance.
Interest expense is due primarily to funds borrowed in 1994 to replace capital as a result of losses from the Northridge Earthquake. The decrease in the interest expanse from 1995 to 1996 is due primarily to paying down part of the loan balance and lower interest rates. The 1996 and 1995 interest expense includes $368,000 and $380,000 of interest expense on the Company's rollback liability under California Proposition 103.
In November 1988, the voters of the State of California approved Proposition 103, which required most property and casualty insurance companies, among other things, to reduce rates charged to California insureds to a level 20% below November 8, 1987 levels. On March 19, 1996, the Company agreed with the Commissioner to settle its rollback liability under Proposition 103. The settlement cost the Company approximately $2.0 million net of recoveries from reinsurers of which approximately $1.0 million was recorded in each of 1995 and 1996.
Cash flow from operations was $7.3 million, $26.6 million and $5.3 million for 1996, 1995 and 1994, respectively. Operating cash flow has been used primarily to acquire additional investment assets with net purchases during 1996, 1995 and 1994 of $11.5 million, $12.8 million and $11.2 million, respectively.
At December 31, 1996, there were no material commitments for capital expenditures, although the Company has committed approximately $1.0 million to enhance its hardware and software computer systems in 1997.
Invested assets and cash (excluding fiduciary funds held by the Somerset Companies) have grown from $203.1 million at December 31, 1994 to $235.5 million at December 31, 1995 to $240.7 million at December 31, 1996. Investment income during this period was $13.0 million in 1994, $14.1 million in 1995 and $13.6 million in 1996. The average yield of the portfolio, excluding net realized capital gains, was 5.7% in 1994 and 1995 and decreased to 5.4% in 1996, reflecting the prevailing interest rates during those years. As of December 31, 1996, all debt and equity securities held by the Company were classified as available-for-sale securities.
The Company's credit agreement, which was amended on November 19, 1996 (the "Amended Credit Agreement"), provides for a $20 million revolving credit loan facility of which $17 million was being utilized at December 31, 1996 and a $30 million letter of credit facility of which $27.1 million (In Pounds Sterling 15.8 million) was being utilized at December 31, 1996. The letters of credit consist of In Pounds Sterling 2,585,000 for the Company's portion of the business conducted by Riverside and In Pounds Sterling 7,000,000 and In Pounds Sterling 6,250,000 for 1997 capacity being provided for two separate Lloyd's of London marine syndicates. The Amended Credit Agreement is collateralized by shares of common stock of the active subsidiaries of the Company other than NIC Insurance Company and Somerset Asia Pacific Pty Limited. The Amended Credit Agreement contains covenants common to agreements of this type. The aggregate amounts available under the revolving credit loan facility decrease in quarterly increments in the amount of $500,000 commencing with the quarter beginning January 1, 1997 through the quarter ended September 30, 1999, and in varying increments thereafter through December 31, 2002. See Note 4 to the Company's Consolidated Financial Statements.
As of December 31, 1996, the Company has paid approximately $128.4 million of claims related to the Northridge Earthquake, of which approximately $94.8 million is subject to indemnification by reinsurers. To date the Company has experienced no significant difficulties collecting reinsured losses.
The Company was not in compliance with the NAIC's IRIS "Two-Year Overall Operating" ratio in 1995. The exceptional value derived from this ratio was primarily due to the underwriting losses resulting from the Northridge Earthquake. If the Two-Year Overall Operating ratio is 100% or more, the NAIC deems such results to be exceptional. During 1995, the Company's Two-Year Overall Operating ratio was 115%. The Company was within the usual values for all IRIS ratios as of December 31, 1996.
The Company is a specialty insurance company and periods of moderate economic recession or inflation tend not to have a significant direct effect on the Company's underwriting operations. They do, however, impact the Company's investment portfolio. In 1996, the Company's yield on its invested assets declined and the Company's investment income was negatively impacted by lower yields.