(1)Calculated based on earned premium. The 2005 and prior years expense ratios have been restated to reflect the change in segment reporting in 2006.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. Please see "Note on Forward-Looking Statements" and "Risk Factors" for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K.
Hurricane Katrina struck Louisiana, Mississippi, Alabama and surrounding areas on August 29, 2005 and Hurricane Rita struck Texas and Louisiana and surrounding areas on September 24, 2005. Both storms caused significant destruction in these areas including offshore energy exposures in the Gulf of Mexico. Our initial estimates of net losses related to each hurricane were developed from a combination of preliminary claims notifications received from brokers and insureds, portfolio modeling based upon the storm tracks of these hurricanes and the Company's own internal assessment of the exposures insured under individual policies. A substantial portion of the Company's estimated loss is due to offshore energy exposures in the Gulf of Mexico. Since the 2005 third quarter, the Company has been continually monitoring the development of paid and reported claims activities in relation to the estimate of ultimate losses established for the 2005 Hurricanes. Management believes that the gross and net loss reserves established for the 2005 Hurricanes are adequate at December 31, 2006 and that any adverse loss development, for gross claims, should any occur, would be contained within our reinsurance program. Our actual losses from such hurricanes may differ materially from our estimated losses as a result of, among other things, the receipt of additional information from insureds or brokers, the attribution of losses to coverages that for the purpose of our estimates we assumed would not be exposed and inflation in repair costs due to the limited availability of labor and materials. If our actual losses from the 2005 Hurricanes are materially greater than our estimated losses, our business, results of operations and financial condition could be materially adversely affected.
Public companies have become the subject of increasing scrutiny regarding the timing and dating of employee stock option awards. The Securities and Exchange Commission and the U.S. Department of Justice have been investigating stock option award practices at a number of public companies. The Company has undertaken its own internal review with respect to its stock option award practices. In this recently completed internal inquiry, the Company did not find any evidence that it has engaged in any of the stock option award practices that are at the center of these corporate investigations.
The insurance industry has become the subject of increasing scrutiny with respect to insurance broker and agent compensation arrangements, and certain sales practices. Federal and state regulators have conducted investigations and other proceedings relating to the payment of contingent commissions by insurance companies to insurance brokers and agents and the extent to which such compensation has been disclosed, and the solicitation and provision of fictitious or inflated quotes. These investigations and proceedings could result in legal precedents and new industry-wide practices or legislation, rules or regulations that could significantly affect our industry and may also cause stock price volatility for companies in the insurance industry.
The reinsurance industry has also been the subject of scrutiny with respect to the alleged improper use of reinsurance agreements to manipulate financial reporting results. Federal and state regulators have conducted investigations and other proceedings related to reinsurance agreements in which the insurance risk transferred between the ceding company and reinsurer may have been insufficient to properly account for such transactions as reinsurance in financial statements filed with insurance regulatory authorities and the SEC. Such transactions may include separate or "side" agreements that reduce, limit or mitigate the indemnification against loss or liability relating to the insurance risk transferred to the reinsurer in a reinsurance agreement.
As a result of these industry investigations, accounting and reporting requirements for reinsurance transactions, including risk transfer guidance used to determine when sufficient insurance risk has been transferred by the ceding company to properly account for such transactions as reinsurance, may change.
Reserves for Losses and LAE. 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. 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. Additional information regarding our loss reserves can be found in "-Results of Operations-Operating Expenses-Net Losses and Loss Adjustment Expenses Incurred," "Description of Business-Reserves," and Note 5 to our consolidated audited financial statements, all of which are included herein.
Substantially all of our business is placed through agents and brokers. Since the vast majority of the Company's gross written premium is primary or direct as opposed to assumed (93% direct in 2006, 90% direct in 2005 and 89% in 2004) the delays in reporting assumed premium generally do not have a significant effect on the Company's financial statements, since 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.
$971 million of gross written premium recorded in 2006, $96 million or 10% was estimated. The estimated premium was 11% and 15% of the gross written premium in 2005 and 2004, respectively. Such premium estimates are generally based on submission data received from brokers and agents and recorded when the insurance policy or reinsurance contract is bound and written. 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.
Impairment of Investment Securities. Impairment of investment securities results in a charge to operations when a market decline below cost is other-than-temporary. 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. In general, we focus our attention on those securities whose market value was less than 80% of their cost or amortized cost, as appropriate, for six or more consecutive months. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost or amortized cost of the security, as appropriate, the length of time the investment has been below cost or amortized cost and by how much, our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. 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. For additional detail regarding our investment portfolio at December 31, 2006 and 2005, including disclosures regarding other-than-temporary declines in investment value, see the "Description of Business-Investments" section and Note 4 to our consolidated audited financial statements, both included herein.
Accounting for Lloyd's Results. We record our pro rata share of Syndicate 1221's assets, liabilities, revenues and expenses, after making adjustments to convert Lloyd's accounting to U.S. GAAP. The most significant GAAP adjustments relate to income recognition. Lloyd's syndicates determine underwriting results by year of account at the end of three years. We record adjustments to recognize underwriting results as incurred, including the expected ultimate cost of losses incurred. These adjustments to losses are based on actuarial analysis of syndicate accounts, including forecasts of expected ultimate losses provided by the syndicate. At the end of the Lloyd's three-year period for determining underwriting results for an account year, the syndicate will close the account year by reinsuring outstanding claims on that account year with the participants for the account's next underwriting year. The amount to close an underwriting year into the next year is referred to as the reinsurance to close (the "RITC"). The RITC transaction is recorded in the fourth quarter 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 RITC transaction. Additional information regarding our accounting for Lloyd's results can be found in Note 1 to our consolidated audited financial statements, included herein.
The following is a discussion and analysis of our consolidated and segment results of operations for the years ended December 31, 2006, 2005 and 2004. All earnings per share data is presented on a per diluted share basis.
Net income for 2006, 2005 and 2004 was $72.6 million or $4.30 per share, $23.6 million or $1.73 per share and $34.9 million or $2.74 per share, respectively. The 2005 year was adversely impacted by Hurricanes Katrina and Rita. When excluding the storm losses in 2005, underwriting profitability during such periods, as measured by the Company's combined ratios, has improved for the 2006, 2005 and 2004 business written. This improvement in underwriting profitability reflects increasing premium rates as a result of favorable market conditions beginning in late 2000 and continuing to a lesser extent through 2004, and then leveling off in 2005 and remaining level or declining slightly in 2006 except for marine offshore energy rates which increased beginning in the 2005 fourth quarter and into 2006 as a result of Hurricanes Katrina and Rita. We experienced premium growth as measured by net earned premium in 2006, 2005 and 2004 of 38.3%, 8.9% and 12.0%, respectively, due to the combination of increased premium rates and business expansion.
The 2006 underwriting results generally benefited from the stable or slightly declining market conditions in the professional liability and general liability markets and improved market conditions as reflected in increased premium rates in the marine business coupled with the recording of a net redundancy of prior years' loss reserves of $17.2 million which reduced the 2006 combined ratio of 87.8% by 3.7 loss ratio points.
Net investment income increased 53.5% due to the cash flow from operations coupled with the net proceeds from the Company's April 2006 debt offering and the Company's October 2005 equity offering, and the increase in the pre-tax investment yield to 4.4% in 2006 compared to 3.8% in 2005.
Marine Premium. The gross written premium for 2006 consisted of 42.6% cargo and specie, 24.2% offshore energy, 19.4% marine liability, 6.5% assumed excess of loss on marine business, 6.4% hull, and the remainder in other marine related classes of business.
Our gross written premium is based on the amount of Syndicate 1221's stamp capacity that we provide. Our percentage of participation in the stamp capacity was 100 % in 2006, 97.5% in 2005 and 97.4% in 2004. 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. The Syndicate's stamp capacity was £123 million ($226 million), £135 million ($246 million) and £150 million ($275 million) in 2006, 2005 and 2004, respectively. The marine gross written premium increased 18.3% in 2006 compared to 2005 and decreased 10.2% in 2005 compared to 2004. In September 2005, the Company purchased the remaining outstanding minority interest of Syndicate 1221's stamp capacity for the 2006 underwriting year.
The 2006 increase of 18.3% resulted from growth across several lines of business but primarily offshore energy which benefited from rate increases following losses from the 2005 Hurricanes. The 2005 decrease of 10.2% in gross written premium resulted from the RITC transaction recorded in 2004. Excluding the RITC recorded in 2004, the 2005 marine gross written premium increased 7.5%. Substantially all of the 21.5% increase in 2004 gross written premium represents premiums recorded as RITC premium representing the transfer of assets and liabilities from the participants of the 2002 underwriting year to the 2003 underwriting year in which Navigators had increased its participation to 97.4% from 68.1%. The RITC transaction is recorded as additional written and earned premium, losses incurred, loss reserves and receivables all in the same amount, net and gross of applicable ceded reinsurance amounts. There are no gains or losses recorded on the transaction. The RITC amounts were $0 in 2006, $7,000 in 2005 and $38.1 million in 2004.
The average renewal premium rate increased approximately 13% and 2.8% in 2006 and 2005, respectively. The most significant increases started in the 2005 fourth quarter in the offshore energy business resulting from losses caused by Hurricanes Katrina and Rita. Overall premium rates are expected to decline modestly in 2007.
Other Premium. Other premium consists of gross written premium for engineering and construction business which provides coverage for construction projects including machinery, equipment and loss of use due to delays, and onshore energy business which principally focuses on the oil and gas, chemical and petrochemical industries with coverages primarily for property damage and business interruption.
Excluding the effects of ceded reinstatement premiums for hurricane losses on both 2005 and 2004, the ratios of ceded written premium to gross written premium were 46.4%, 49.3% and 54.8% for 2006, 2005 and 2004, respectively. The ratio of ceded premium declined in 2006 compared to 2005 as we have retained more premiums in our marine unit by eliminating the third party participation in our marine pool in 2006, restructured our professional liability reinsurance to retain more business net effective April 1 2006, purchased the 2.5% minority interest and replaced a 5% capacity provider with our own letter of credit in Syndicate 1221 effective January 1, 2006. The ratio decline in 2005 ceded premium is principally due to three factors: the March 31, 2005 cancellation of a quota share reinsurance agreement for the specialty business, Navigators Insurance Company's increased participation in the marine pool to 85% in 2005 compared to 80% in 2004; and a gross and ceded reduced RITC transaction amount in 2005 compared to 2004.
Net Written Premium. The 2006 net written premium increased 36.8% compared to 2005 and increased 31.8% when the $14.5 million of ceded reinstatement premiums as a result of the 2005 Hurricanes are excluded. The 2005 net written premium increased 21.7% compared to 2004 reflecting increased premium writings coupled with retaining more of the business written
Net Investment Income. Net investment income increased 53.5% and 38.3% in 2006 and 2005, respectively, due primarily to the increase in invested assets resulting from positive cash flow from operations, net proceeds from the debt and common stock offerings of $123.5 million and $123.8 million received in April 2006 and October 2005, respectively, and increased yields. See the "Description of Business-Investments" section included herein for additional information regarding our net investment income.
Net Losses and Loss Adjustment Expenses Incurred. The ratios of net loss and loss adjustment expenses incurred to net earned premium (loss ratios) were 57.7%, 69.6% and 60.5% in 2006, 2005 and 2004, respectively. The 2006 loss ratio of 57.7% was favorably impacted by 3.7 loss ratio points resulting from the $17.2 million net redundancy of prior year loss reserves. The 2005 loss ratio of 69.6% was negatively impacted by 9.2 loss ratio points related to the 2005 Hurricanes. The 2005 loss ratio was favorably impacted by 1.1 loss ratio points resulting from the $3.8 million net redundancy of prior years' loss reserves. The 2004 loss ratio increased by 1.6 loss ratio points as a result of $2.9 million of net losses and $2.2 million of net reinstatement premiums from Hurricane Ivan. The 2004 loss ratio was favorably impacted by 1.2 loss ratio points resulting from the $3.8 million net redundancy of prior year loss reserves. We do not discount any of our loss reserves.
The increase in net loss reserves in all active lines of business is generally a reflection of the growth in premium volume over the last three years coupled with a changing mix of business to longer tail lines of business such as the specialty lines of business (construction defect, commercial excess, primary excess and personal umbrella), professional liability lines of business and marine liability and transport business in ocean marine. These products, which typically have a longer settlement period compared to the mix of business the Company has historically written, are becoming larger components of our overall business. The 2005 marine net loss reserve increase for both the Insurance Companies and Lloyd's Operations also increased due to loss reserves established for the 2005 Hurricanes. The increase in the 2005 marine net loss reserves for the Lloyd's Operations also contains loss reserves assumed from reinsurers and the Insurance Companies in connection with the RITC transaction for the 2003 underwriting year of account. The decrease in the 2005 other reserves for the Insurance Companies resulted from the previously mentioned RITC transaction.
The above net loss and LAE reserves represent gross reserves for losses and LAE reduced for reinsurance receivable on such amounts as follows:
The recoverable amounts above are exclusive of $108.9 million of reinsurance recoverable for all paid losses at December 31, 2006 of which $66.6 million related to the 2006 gross payments for losses from the 2005 Hurricanes. With the recording of gross losses, the Company assesses its reinsurance coverage, potential receivables, and the recoverability of the receivables. Losses incurred on business recently written are primarily covered by reinsurance agreements written by companies with whom the Company is currently doing reinsurance business and whose credit the Company continues to assess in the normal course of business.
As discussed below and under the caption "Description of Business-Loss 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.
While an annual loss reserve study is conducted for each line of business, the timing of such studies varies throughout the year. Additionally, a review of the emergence of actual losses relative to expectations for each line of business is conducted each quarter. A separate analysis of our asbestos and environmental liability exposures is also performed annually and updated quarterly. Any adjustments that result from this review are recorded in the quarter in which they are identified.
For certain long tail classes of business where anticipated loss experience is less predictable because of the small number of claims and/or erratic claim severity patterns, estimates are based on both expected losses and actual reported losses. These classes include our contractors liability business and directors and officers liability business, among others. For these classes, we set ultimate losses for each underwriting year reflecting several factors, including our evaluation of loss trends and the current risk environment. The expected ultimate losses are adjusted as the underwriting year matures.
litigation to obtain defect repairs. The legislation and its potential impact is discussed in the "Description of Business-Loss Reserves" section included herein. Accordingly, our ultimate liability may exceed or be less than current estimates due to this variable, among others.
As underwriting years age, for each subsequent quarter and following years, our actuaries, with management, continue to update and refine their estimates of selected ultimate loss ratios for each line of business by underwriting year, using the actuarial methods referred to above and incorporating relevant factors that generally include actual loss development, recent claims activity, number and dollar amount of open claims, risk characteristics of the particular line of business, the potential effects of changes in underwriting and claims procedures, historic performance relative to expectations and the relationship of the IBNR reserve levels across underwriting years and between similar lines of business. The output of this process results in refinements to the ultimate loss ratios. Such refinements to the ultimate loss ratios for the prior underwriting years generate prior year redundancies or deficiencies recorded in the year such refinements are made, as discussed below.
Following is a discussion of relevant factors impacting our 2006 loss reserves.
The Insurance Companies have historically reserved for the professional liability business using ultimate loss ratios based on industry experience for this relatively new line of business written since 2001. During 2006 the Insurance Companies further reduced the net reserves for such claims made policies compared to year-end 2005, by $1.2 million mostly related to the 2004 year. The reductions were to recognize the low level of claim counts and continued favorable development compared to expectations at the time the reserves were initially established.
The Lloyd's Operations recorded $4.5 million of net prior years' savings, which included $1.1 million related to a loss commutation for the 1999 to 2002 years, with the balance spread across several lines of business in the 2002 to 2004 years.
Following is a discussion of relevant factors impacting our 2005 loss reserves.
The Insurance Companies recorded $1.6 million of net prior years' savings from business assumed from the Lloyd's Operations principally related to the 2003 underwriting year where loss reserves reductions were related to the reductions in premium estimates.
The Insurance Companies recorded net prior years' reserve deficiencies of $1.9 million for marine business principally due to an increase of approximately $4.5 million for unallocated loss adjustment expense reserves offset by net favorable loss experience of $2.6 million mostly related to the 2002 and prior underwriting years.
The Lloyd's Operations recorded $1.2 million of net prior years' savings mostly due to the favorable settlement of one large marine claim.
During 2004 the Insurance Companies increased loss reserves for marine business for underwriting years 2002 and 2001 principally to recognize the increase in marine liability business written for those years which have a longer loss development pattern compared to the mix of marine business written in previous years. Commencing in 2004, loss reserves for marine business were evaluated by product line. Prior to 2004, such loss reserves were established in the aggregate for all marine products. This refinement was the principal factor for the $4.8 million of net prior years' loss deficiencies recorded in 2004 for marine business.
As discussed above, the Insurance Companies have historically reserved for the professional liability business using ultimate loss ratios based on industry experience. During the 2004 fourth quarter, the net loss reserves for such claims-made policies for underwriting years 2003 and 2002 were reduced by approximately $2.8 million to recognize the low level of claim counts and favorable claims development compared to expectations at the time these reserves were initially established which were based on industry data.
During 2004, ultimate loss ratios for our Lloyd's Operations were reduced for the 2003 and 2002 underwriting years for cargo, hull and the assumed marine excess of loss business mostly as a result of lower than expected claims activity coupled with the recognition of underwriting improvements for the business written for the 2003 underwriting year. Such factors were the principal reasons for the ultimate loss ratio reductions which occurred throughout the 2004 calendar year contributing to the
Marine reserves for the Insurance Companies are established by product using the Company's own historical experience adjusted for the effects of current developments and likely trends. Estimates of the ultimate liability could be redundant or deficient if the Company's own experience is not appropriate for predicting future outcomes. For example, this could occur if claims take longer to report than expected. Gross and net losses would increase by approximately $47.3 million and $22.4 million, respectively, if, on average, losses take 10% longer to report than assumed for the marine business for reserves established at December 31, 2006.
Specialty reserves are established using the Company's own experience and an industry based tail factor. Estimates of ultimate liability could be redundant or deficient if the Company's own experience is not sufficiently predictive or if the industry tail factor is not representative of our future loss development. A key assumption is the choice of tail factor for the construction liability book of business. This is dominated by construction defect exposure, which has undergone significant recent changes in the underwriting, claims handling, legislation and liability environment. If the construction tail (after 10 years) is double our current expectations, then the gross and net losses would increase by approximately $29.9 million and $26.0 million, respectively, compared to construction liability reserves established at December 31, 2006.
Interest Expense. The 2006 interest expense reflects interest on our senior notes issued in April 2006. There was no debt outstanding in 2005 or 2004 and no interest expense was recorded during these years.
We are subject to the tax regulations of the United States and foreign countries in which we operate. The Company files a consolidated federal tax return, which includes all domestic subsidiaries and the U.K. Branch. The income from the foreign operations is designated as either U.S connected income or non-U.S. connected income. Lloyd's is required to pay U.S. income tax on U.S. connected income (U.S. source income) written by Lloyd's syndicates. Lloyd's and the IRS have entered into an agreement whereby the amount of tax due on U.S. connected income is calculated by Lloyd's and remitted directly to the IRS. These amounts are then charged to the corporate members in proportion to their participation in the relevant syndicates. The Company's corporate members are subject to this agreement and will receive U.K. tax credits for any U.S. income tax incurred up to the U.K. income tax charged on the U.S. income. The non-U.S. connected insurance income would generally constitute taxable income under the Subpart F income section of the Internal Revenue Code since less than 50% of the Company's premium is derived within the U.K. and would therefore be subject to U.S. taxation when the Lloyd's year of account closes. Taxes are accrued at a 35% rate on our foreign source insurance income and foreign tax credits, where available, are utilized to offset U.S. tax as permitted. The Company's effective tax rate for Syndicate 1221 taxable income could substantially exceed 35% to the extent the Company is unable to offset U.S. taxes paid under Subpart F tax regulations with U.K. tax credits on future underwriting year distributions. U.S. taxes are not accrued on the earnings of the Company's foreign agencies as these earnings are not subject to the Subpart F tax regulations. These earnings are subject to taxes under U.K. tax regulations at a 30% rate.
We have not provided for U.S. deferred income taxes on the undistributed earnings of approximately $26.2 million of our non-U.S. subsidiaries since these earnings are intended to be permanently reinvested in the foreign subsidiary. However, in the future, if such earnings were distributed to the Company, taxes of approximately $1.0 million would be payable on such
Effective in 2006, the Company classifies its business into two underwriting segments consisting of the Insurance Companies and the Lloyd's Operations, which are separately managed, and a Corporate segment. Segment data for each of the two underwriting segments include allocations of revenues and expenses of Navigators Agencies and the Parent Company's expenses and related income tax amounts previously reported separately. Segment data for prior periods have been restated to reflect this change in segment reporting. See Note 3 to our consolidated audited financial statements, included herein.
We evaluate the performance of each segment based on its underwriting and net income results. The Insurance Companies' and the Lloyd's Operations' results are measured by taking into account net premiums earned, incurred losses and loss adjustment expenses, commission expense and other underwriting expenses. The Corporate segment consists of the Parent Company's investment income, interest expense and the related tax effect. Each segment also maintains its own investments, on which it earns income and realizes capital gains or losses. Our underwriting performance is evaluated separately from the performance of our investment portfolios.
Our Insurance Companies consist of Navigators Insurance Company, including its U.K. Branch, and Navigators Specialty Insurance Company. Navigators Insurance Company is our largest insurance subsidiary and has been active since 1983. It specializes principally in underwriting marine insurance and related lines of business, specialty liability insurance and professional liability insurance. Navigators Specialty Insurance Company, a wholly owned subsidiary of Navigators Insurance Company, began operations in 1990. It underwrites specialty and professional liability insurance on an excess and surplus lines basis fully reinsured by Navigators Insurance Company. The Navigators Agencies produce business for the Insurance Companies.
Following are the results of operations for the Insurance Companies for each of the years in the three-year period ended December 31, 2006:
Following are the underwriting results of the Insurance Companies for each of the years in the three-year period ended December 31, 2006:
Syndicate 1221's stamp capacity was £123 million ($226 million) in 2006, £135 million ($246 million) in 2005 and £150 million ($275 million) in 2004. The stamp capacity for 2006 and 2005 was reduced to minimize the costs associated with unused stamp capacity in 2004 coupled with anticipated declining market conditions in 2006 and 2005 following an increase in 2004. Stamp capacity is a measure of the amount of premium a Lloyd's syndicate is authorized to write as determined by the Council of Lloyd's. We provided 100%, 97.5% and 97.4% of Syndicate 1221's total stamp capacity in 2006, 2005 and 2004, respectively. In September 2005, the Company purchased the remaining outstanding minority interest of Syndicate 1221's capacity for the 2006 underwriting year. Syndicate 1221's stamp capacity is expressed net of commission (as is standard at Lloyd's) of approximately 21%. The Syndicate 1221 premium recorded in the Company's financial statements is gross of commission.
Lloyd's syndicates report the amounts of premiums, claims, and expenses recorded in an underwriting account for a particular year to the companies or individuals that participate in the syndicates. The syndicates generally keep accounts open 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 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 (i) we hold an undivided interest in each asset, (ii) we are proportionately liable for each liability and (iii) 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 ("RITC") transaction. The RITC 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 RITC amounts vary accordingly. The RITC transaction is recorded in the fourth quarter 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 RITC transaction.
Company's 2006 capacity at Lloyd's of £123 million, the December 31, 2006 exchange rate of £1 equals $1.96 and in the event of a maximum 3% assessment, the Company would be assessed approximately $7.2 million. In addition, beginning with the 2005 underwriting year, Lloyd's added a second tier of assets to the existing Central Fund. This second tier is being built up through a compulsory interest bearing loan to the Society of Lloyd's from the Lloyd's members based on the stamp capacity of each syndicate for the respective underwriting year. The funds are invested in assets eligible for Society of Lloyd's solvency. The loans will be repaid on a rolling year basis as each year closes. At December 31, 2006, the Company had $3.6 million of assets loaned to this fund.
The 2006 earnings in the Lloyd's Operations reflect the strong growth in premiums and continued favorable loss development trends. The 2006 underwriting results were favorably impacted by approximately $4.5 million or 3.2 loss ratio points for net prior years' savings due to favorable loss development trends, primarily in our 2004 and 2005 underwriting years.
The 2005 pre-tax net loss in the Lloyd's Operations was a result of losses caused by Hurricanes Katrina and Rita of approximately $20.2 million, including $5.3 million of reinstatement costs, which increased the Lloyd's Operations 2005 combined ratio by 18.6 ratio points as follows:
As of December 31, 2006 and 2005, all fixed maturity securities and equity securities held by us were classified as available-for-sale.
We have a credit facility provided through a consortium of banks consisting of $115 million of letters of credit and a $10 million line of credit. The credit facility, which is denominated in U.S. dollars, is utilized primarily by Navigators Corporate Underwriters Ltd. and Millennium Underwriting Ltd. to fund our participation in Syndicate 1221 which is denominated in British sterling. At December 31, 2006, letters of credit with an aggregate face amount of $91.3 million were issued under the credit facility. The line of credit was unused at December 31, 2006.
The credit facility was amended in February 2007 to increase the letters of credit available under the credit facility from $115 million to $180 million and to increase the line of credit available under the credit facility from $10 million to $20 million. Also, the term of the credit facility was extended from June 30, 2007 to March 31, 2009. If at that time the bank consortium does not renew the credit facility, we will need to find other sources to provide the letters of credit or other collateral required to continue our participation in Syndicate 1221.
Our reinsurance has been placed with various U.S. and foreign insurance companies and with selected syndicates at Lloyd's. Pursuant to the implementation of Lloyd's Plan of Reconstruction and Renewal, a portion of our recoverables are now reinsured by Equitas (a separate United Kingdom authorized reinsurance company established to reinsure outstanding liabilities of all Lloyd's members for all risks written in the 1992 or prior years of account).
The Company believes that it has adequately managed its cash flow requirements related to reinsurance recoveries from its positive cash flows and the use of available short-term funds when applicable. However, there can be no assurances that the Company 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 Hurricanes Katrina and Rita could significantly impact the Company's liquidity needs. However, we expect to pay the losses from the 2005 Hurricanes over a period of years from cash flow and, if needed, short-term investments and expect to collect our paid reinsurance recoverables generally under the terms described above.
Our capital resources consist of funds deployed or available to be deployed to support our business operations. At December 31, 2006 and 2005, our capital resources were as follows:
The Company completed its public offering of senior debt on April 17, 2006 and received net proceeds of $123.5 million of which $100 million was contributed to the capital and surplus of Navigators Insurance Company. The increase in stockholders' equity in 2006 was principally due to 2006 net income of $72.6 million.
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 several 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.
As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements
and other factors, including legal restrictions, rating agency requirements, credit facility limitations and such other factors as our board of directors deems relevant.
Condensed Parent Company balance sheets as of December 31, 2006 and 2005 are shown in the table below:
Deferred compensation payable represents accrued costs for employee stock appreciation rights which are paid by the operating subsidiaries when such stock appreciation rights are exercised.
We are a specialty insurance company and periods of moderate economic recession or inflation tend not to have a significant direct effect on our underwriting operations. They do, however, impact our investment portfolio. A decrease in interest rates will tend to decrease our yield and have a positive effect on the fair value of our invested assets. An increase in interest rates will tend to increase our yield and have a negative effect on the fair value of our invested assets.