The Company is a holding company with fourteen wholly owned subsidiaries. See "BUSINESS-General" included herein for a description of the Company.
The Company's revenue is primarily comprised of premiums, commissions and investment income. The Insurance Companies derive the majority of their business from the Somerset Companies through either business written specifically for the Insurance Companies or through Navigators Insurance's participation in insurance pools managed by the Somerset Companies. The insurance business and operations of the Insurance Companies are managed by the Somerset Companies. The Lloyd's marine premium is generated as the result of capacity provided to Syndicate 1221 by NCUL and Millennium in 1998 and capacity provided to Syndicate 1221 and an unaffiliated syndicate by NCUL in 1997. The premiums, losses and expenses from the Lloyd's marine syndicates are included in the Company's financials but are not included in the Insurance Companies' results since NCUL and Millennium are not part of the Insurance Companies' operations. The Company earns investment income on its invested assets and on the invested assets held by the Lloyd's syndicates for whom NCUL and Millennium provide capacity.
The Company writes business in Southeast Asia through one of the Somerset Companies. To date, the participation in this market has been limited and therefore the Company's exposure to the economic conditions in Asia does not materially effect its operations.
Revenues. Gross written premium increased from $142.5 million in 1996 to $171.2 million in 1997 and increased to $172.2 million in 1998. The following table sets forth the Company's gross written premium by line of business and net written premium in the aggregate for the periods indicated:
Lloyd's Marine Premium. In 1998, NCUL and Millennium wrote $46.6 million of marine premium through providing capacity to Lloyd's Syndicate 1221 managed by MTC. NCUL wrote $24.7 million of marine premium through providing capacity to two Lloyd's syndicates in 1997 including Syndicate 1221.
Lloyd's presents its results on an underwriting year basis, generally closing each underwriting year after three years. The Company estimates its participation in each year and timely accrues the expected results.
Marine Premium. Marine gross written premium (non-Lloyd's) increased 14% from 1997 to 1998 due to, beginning July 1, 1998, Navigators Insurance writing 100% of the marine risk and then ceding 40% to the pool members and to Navigators Insurance's participation in the marine pools increasing from 48% in 1997 to 60% in 1998. The 1997 increase from 1996 was due primarily to Navigators Insurance's increased participation in the marine pools from 41% in 1996 to 48% in 1997. Marine premium has been subject to continued pricing competition throughout 1997 and 1998.
Engineering and Construction Premium. Somerset Asia began writing engineering and construction risks in Southeast Asia in 1997. The business was also written by Somerset UK beginning in late 1997. In 1999, the Company will write engineering and construction business through its facilities at Lloyd's instead of through the Somerset Companies. The UK Branch will participate in the business written through Lloyd's.
NET INVESTMENT INCOME. Net investment income increased 5.4% to $15.2 million in 1998 from $14.4 million in 1997 due to the investment income allocated to NCUL and Millennium from the Lloyd's Syndicates on which they participate. Net investment income increased 6% to $14.4 million in 1997 from $13.6 million in 1996 due to the increase in invested assets and the decrease of municipal bonds in the portfolio, partially offset by a decrease in fiduciary funds held by the Somerset Companies resulting in less investment income from the funds.
Net Losses and Loss Adjustment Expenses Incurred. The ratio of net loss and loss adjustment expenses incurred to net earned premium was 68.3%, 61.9%, and 62.2% in 1998, 1997 and 1996, respectively. The increase in the 1998 loss ratio compared to 1997 was primarily due to the Company's portion of the reinsurance to close the Lloyd's 1996 underwriting year amounting to $19.7 million which reflects estimated ultimate losses. The 1998 loss ratio excluding the reinsurance to close was 59.6% which decreased from 1997 primarily as the result of favorable loss experience on the Insurance Companies partially offset by slightly higher loss ratios on the Lloyd's business. The 1997 loss ratio improved modestly over 1996. The loss reserves are not discounted.
Other Operating Expenses. Other operating expenses increased 9.1% to $24.3 million in 1998 over 1997 primarily due to expenses incurred by MTC (not included in 1997), and increased expenses relating to Somerset (UK) and Somerset Asia. The 8.9% increase from 1996 to 1997 was primarily due to expenses incurred by Somerset (UK) and Somerset Asia.
Interest Expense. The increase in the interest expense from 1997 to 1998 was due to the higher loan and letter of credit balances in 1998. The decrease in the interest expense from 1996 to 1997 was due to $368,000 of interest expense in 1996 attributable to the Company's rollback liability under California Proposition 103 and to fluctuations in the loan balance.
Income Taxes. The income tax expense was $3.7 million, $4.6 million and $4.1 million for 1998, 1997 and 1996, respectively. The effective tax rates for 1998, 1997 and 1996 were 24%, 27% and 20%, respectively. The decrease in the 1998 rate compared to the 1997 rate was primarily due to revenues in Somerset (UK) and Somerset Asia beginning to utilize some of the operating losses generated by the foreign operations. The increase in the 1997 rate compared to 1996 was primarily due to not being able to utilize the losses from Somerset (UK) and Somerset Asia. The Company had a net operating loss carryforward of $3.0 million at December 31, 1995 which was fully utilized in 1996. The Company had alternative minimum tax ("AMT") carryforwards of $4.7 million, $5.1 million and $5.8 million at December 31, 1998, 1997 and 1996, 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, 1998 and 1997, the net deferred Federal and foreign tax asset was $8.0 million. At December 31, 1998 the Company had a $1.6 million valuation allowance against its deferred Federal tax asset compared to a $1.1 million valuation allowance at December 31, 1997. The valuation allowance is necessitated by the uncertainty associated with the realization of the deferred tax asset for the carryforward of operating losses from the Company's foreign operations.
Cash flow provided by (used in) operations was ($3.0) million, $12.5 million and $7.3 million for 1998, 1997 and 1996, respectively. Operating cash flow has been used primarily to acquire additional investment assets with net purchases (disposals) during 1998, 1997 and 1996 of ($1.1) million, $17.6 million and $11.5 million, respectively. The negative cash flow in 1998 was primarily due to the payment of loss reserves on runoff business and less premiums received, partially due to Lloyd's disbursing cash only after an underwriting year has closed, normally three years later.
At December 31, 1998, the Company had committed approximately $300,000 to continue to enhance its hardware and software computer systems in 1999.
Invested assets and cash (excluding fiduciary funds held by the Somerset Companies) increased from $240.7 million at December 31, 1996 to $258.6 million at December 31, 1997 and decreased to $257.2 million at December 31, 1998. Investment income during this period was $13.6 million in 1996, $14.4 million in 1997 and $15.2 million in 1998. The average yield of the portfolio, excluding net realized capital gains, was 5.4% in 1996, 5.6% in 1997, and 5.9% in 1998 reflecting the prevailing interest rates during those years and the decrease in the tax-exempt portfolio beginning in 1997. As of December 31, 1998, all fixed maturity securities and equity securities held by the Company were classified as available-for-sale.
At December 31, 1996, $17.0 million in loans were outstanding at an interest rate of 6.5% and letters of credit with an aggregate face amount of $27.1 million were issued under the Company's bank credit facility. A December 11, 1997 amendment to the bank credit facility increased the revolving credit loan facility from $20 million to $25 million. At December 31, 1997, $20 million in loans were outstanding under the revolving credit loan facility at an interest rate of 6.9% and letters of credit with an aggregate face amount of $26.0 million were issued under the letter of credit facility.
On November 21, 1998, the Company entered into a new bank credit facility which replaced the prior facility. The new credit facility provides a $25 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 0.875%. The line of credit facility reduces each quarter by amounts between $1.0 million and $2.25 million beginning January 1, 2000 until it terminates on November 19, 2003. At December 31, 1998, $23.5 million in loans were outstanding under the revolving line of credit facility at an interest rate of 5.9%. The credit facility also provides for a $60 million letter of credit facility which is utilized primarily by NCUL and Millennium to participate in Lloyd's Syndicate 1221 managed by MTC. At December 31, 1998, letters of credit with an aggregate face amount of $29.2 million were issued under the letter of credit facility. No letters of credit have been drawn upon.
Total stockholders' equity was $143.3 million at December 31, 1998, a 9.2% increase for the year primarily as the result of the Company's earnings in 1998.
The Company's reinsurance has been placed with various U.S. companies rated "A-" or better by A.M. Best Company, Inc., as well as with foreign insurance companies and with selected syndicates of Lloyd's. Certain syndicates at Lloyd's ("Loss Syndicates") and the Lloyd's market as a whole have reported significant losses in recent years. The Company has not placed any material amounts of reinsurance with these Loss Syndicates. Pursuant to the implementation of Lloyd's Plan of Reconstruction and Renewal, a significant portion of the Company's recoverables from the Loss Syndicates are now reinsured by Equitas (a separate UK 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 the cash flow generated by the operating activities of the Company's subsidiaries will provide sufficient funds for the Company to meet its liquidity needs over the next twelve months. Beyond the next twelve months, cash flow available to the Company may be influenced by a
The "Year 2000 Issue" or "Y2K Issue" is a term used to describe the predicted problems that may arise as a result of the inability of some computer programs and embedded chips to distinguish dates beginning with 19 from dates beginning with 20. This Y2K Issue could result in a variety of potential problems for all businesses from inaccurate processing of dates and date-sensitive calculations to system failures and disruptions in operations. The Company has considered the Y2K Issue a high priority since 1996 and has taken certain steps to address this important aspect of its operations.
In phase two, the results of the awareness stage were assessed to determine what actions should be taken to address Y2K compliance. During this stage, the Company analyzed what items were believed to have a significant risk to any aspect of the Company's operations. The Company believes this assessment is now 100% complete, but continues to evaluate its assessment to determine whether any additional actions should be taken to protect the Company.
replaced its underwriting, claims and accounting systems with state-of-the-art systems that are Y2K compliant. The conversion of existing data from our old systems is 100% complete and the new systems are operational. The Company has also upgraded all personal desktop computers with new high quality Y2K compliant computers.
Phase four consists of testing of our new computer systems to verify they are Y2K compliant. This process is ongoing and at present is approximately 60% complete. The Company will continue the testing process, and anticipates completing all testing by June 30, 1999. In addition, the Company has requested Y2K compliance certifications from its significant third-party vendors. Certifications have been received from our new software and hardware providers. Each reply will be evaluated to determine the Company's future relationship with each respondent and whether any remedial action is necessary.
The failure to resolve its Y2K Issues could result in the interruption of normal business operations and could materially affect the Company's financial condition. However, the Company believes that its past and continuing efforts will adequately address its internal Y2K Issues. Many factors outside the company's control could effect its Y2K readiness. Due to the uncertainty of how potential Y2K problems may effect the business community in general, the Company is unable to determine at this time whether the consequences of Y2K non-compliance may have a material impact on the Company's results of operation, liquidity or financial condition. Also, there can be no assurance that the systems of other companies on which the Company's systems rely will also be timely converted or that any such failure to convert by another company would not have an adverse effect on the Company's systems.
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, 1998. The Company's market risk sensitive instruments are entered into for purposes other than trading.
For the Company's investment portfolio, there were no significant changes in the Company's primary market risk exposures or in how those exposures are managed compared to the year ended December 31, 1997. The Company does not currently anticipate significant changes in its primary market risk exposures or in how those exposures are managed in future reporting periods based upon what is known or expected to be in effect in future reporting periods.
from the date of the consolidated financial statements. Actual results may differ from the hypothetical change in market rates assumed in this disclosure, especially since this sensitivity analysis does not reflect the results of any actions that would be taken by the Company to mitigate such hypothetical losses in fair value.
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, 1998.
The sensitivity analysis model used by the Company produces a loss in fair value of market sensitive instruments of $12.9 million based on a 100 basis point increase in interest rates as of December 31, 1998. This loss amount only reflects the impact on an interest rate increase on the fair value of the Company's fixed income and short-term securities, which constitute approximately 42% of total assets as of December 31, 1998.