The Company's revenue is primarily comprised of premiums, commissions and investment income. The Insurance Companies derive their premium primarily from business written by the Navigators Agencies. The Lloyd's Operations derive their premium from business written by NUAL. The Navigators Agencies and NUAL receive commissions and, in some cases, profit commissions and service fees on the business produced.
It is important to understand the Company's accounting policies in order to understand its financial statements. Management considers certain of these policies to be critical to the presentation of the financial results since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures at the financial reporting date and throughout the period being reported upon. Certain of the estimates result from judgments that can be subjective and complex, and consequently actual results may differ from these estimates, which would be reflected in future periods.
The Company's most critical accounting policies involve the reporting of the reserves for losses and loss adjustment expenses (including losses that have occurred but were not reported to the Company by the financial reporting date), reinsurance recoverables, written and unearned premium, the
recoverability of deferred tax assets, the impairment of invested assets, accounting for Lloyd's results, and goodwill.
Deferred Tax Assets. The Company has recorded valuation allowances related to deferred tax assets resulting from net operating loss carryforwards due to the uncertainty associated with the realization of the deferred tax asset related to certain of the Company's foreign, state and local operations. Even though the Company's foreign operations were profitable in 2002, the valuation allowance was released only to the extent of the 2002 profits since future profitability remains uncertain. See Note 5 to the Company's consolidated financial statements, included herein.
Impairment of Invested Assets. Impairment of investment securities results in a charge to operations when a market decline below cost is other-than-temporary. Management regularly reviews its 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. A number of criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security, the length of time the security's fair value has been below amortized cost or cost, and by how much, specific credit issues related to the issuer and current economic conditions. In general, we focus our attention on those securities whose market value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. Other factors considered in evaluating potential impairment include the current fair value as compared to amortized cost or cost, as appropriate, the Company's 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 the Company considers 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 the Company's investment portfolio at December 31, 2002, including disclosures regarding other-than-temporary declines in investment value, see the BUSINESS-Investments section and Note 2 to the Company's consolidated financial statements, included herein.
Accounting for Lloyd's Results. We record our pro rata share of Lloyd's syndicate assets, liabilities, revenues and expenses, after making adjustments to convert Lloyd's accounting to U.S. GAAP. The most significant U.S. 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 syndicates. 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 reinsurance to close transactions are recorded 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 reinsurance to close transactions. See Note 1 to the Company's consolidated financial statements, included herein.
General. The Company's 2002, 2001 and 2000 results of operations reflect increasing premium rates beginning in late 2000 and continuing in 2001 and 2002.
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 reinsurance reinstatement premiums of $0.4 million, all of which originated from the Company's Lloyd's Operations. This represented the Company's best estimate of its maximum exposure determined by an analysis of policies that may have incurred a loss resulting from the terrorist attack. No additional losses related to the World Trade Center attack were incurred during 2002. However, given the uncertainty surrounding this event, the estimate may change over time as additional information becomes available.
by segment and line of business, and ceded and net written premium by segment for the periods indicated:
Surety. In late 2002, Navigators Insurance began to write surety business which consists of bonds guaranteeing the performance of a specific obligation. Our focus is on providing bid and performance bonds to small contractors requiring contract bonds for projects of $2 million or less.
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 account is closed. A Lloyd's syndicate typically closes an underwriting account by reinsuring outstanding claims on that account 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 account at the date of the assumption. Our participation in Lloyd's 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, (a) we hold an undivided interest in each asset, (b) we are proportionately liable for each liability and (c) 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." The reinsurance to close 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 as a result of this transfer, the reinsurance to close amounts vary accordingly. In our case, our participation increased from 52.5% in 1999 to 64.5% in 2000, to 67.4% in 2001, and to 68.1% in 2002. We therefore recorded our increasing proportionate share of the assets and liabilities of Syndicate 1221. At December 31, 2002, 2001 and 2000, the Company closed its 2000, 1999 and 1998 underwriting years, respectively, the net effect of which resulted in such transfers to NCUL and Millennium of $1.6 million, $4.2 million and $7.9 million, respectively. These transactions accounted for part of the increases in the premium volume in the Lloyd's Operations. The reinsurance to close
Onshore Energy. The business principally focuses on the oil and gas, chemical and petrochemical industries with coverages primarily for property damage and business interruption. The increases in the gross written premium in 2002 and 2001 were due to new business and rate increases. The 2002 increase was approximately 50% new business and 50% rate increases.
Net Written Premium. Net written premium increased 56.9% from 2001 to 2002 due to the increase in the gross written premium partially offset by the increase in the percentage of ceded premium from 38.0% in 2001 to 39.5% in 2002. Net written premium increased 59.6% from 2000 to 2001 primarily due to the increase in the gross written premium and the decrease in the percentage of premium ceded.
Net Realized Capital Gains. Pre-tax net income included $1,668,000 of net realized capital gains for 2002 compared to $790,000 for 2001 and $265,000 for 2000. On an after tax basis, the net realized capital gains were $0.14 per share, $0.09 per share and $0.02 per share for 2002, 2001 and 2000, respectively. The 2002 and 2001 net realized capital gains include $2,905,000 and $1,618,000 of impairment losses recorded on three of the Company's asset backed securities.
As previously discussed under the caption BUSINESS-Reserves there are a number of factors that could cause actual losses and LAE to differ materially from the amount that the Company has reserved for losses and LAE. The risks and uncertainties associated with setting reserves include both fact specific matters associated with particular claims as well as general trends and developments that affect all of our lines of business. These general trends and developments include changes in the judicial, legislative and social environments as well as changes in economic conditions and claims handling practices. In particular, our reserves in the marine line of business over time tend to be most affected by inflation and other economic conditions as well as the uncertainties previously discussed under BUSINESS-Environmental Pollution and Asbestos Related Claims with respect to any asbestos and environmental exposure we have within this line. General uncertainties that we expect may have a large impact on our general liability reserves include changing federal and state regulation and judicial interpretation as well as general social trends that affect the liability claims made in this line. Finally, engineering and construction claims are also particularly impacted by general trends relating to liability theories and inflation.
Commission Expense. Commission expense as a percentage of net earned premium was 20.9%, 20.7% and 20.6% for 2002, 2001, and 2000, respectively. The same ratios without the reinsurance to close premium were 21.1%, 21.3% and 22.5% in 2002, 2001 and 2000, respectively. The 2002 and 2001 commission expense ratios were similar. The decrease in the 2001 commission expense ratio compared to 2000 was primarily due to the increase in the Insurance Companies' net earned premium for the marine business. The reinsurance to close premium increased earned premium but did not change the commission expense, therefore the ratio of commission expense to earned premium decreased.
Other Operating Expenses. The increases in other operating expenses of 44.4% in 2002 and 8.8% in 2001 were primarily employee related expenses resulting from expansion of the business as discussed under the Revenues section included herein.
Interest Expense. The decreases in interest expense in 2002 and 2001 were primarily due to lower interest rates charged on the loan balance and a declining loan balance.
As of December 31, 2002 and 2001, the net deferred Federal, foreign, state and local tax asset was $6.5 million and $10.0 million, respectively. At December 31, 2002 the Company had a $6.7 million valuation allowance against its deferred tax asset compared to a $7.3 million valuation allowance at December 31, 2001. The valuation allowance has been maintained because of 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. Even though the Company's foreign operations were profitable in 2002, the valuation allowance was released only to the extent of the 2002 profits since future profitability remains uncertain. The Company will continue to evaluate the valuation allowance based on the results of its foreign, state and local operations.
The Company's bank credit facility provides a $14.5 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 $5.5 million in 2003 and $9.0 million in 2004. At December 31, 2002 and 2001, $14.5 million and $19.0 million in loans were outstanding, respectively, under the revolving line of credit facility at interest rates of 2.7% and 3.4%, 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, 2002 and 2001, letters of credit with an aggregate face amount of $53.3 million and $47.5 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. No letters of credit were drawn upon in 2002.
Total stockholders' equity was $171.3 million at December 31, 2002, a 16.4% increase for the year as the result of the Company's net income in 2002 and increase in the unrealized gains in the Company's investment portfolio.
The Company's 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 the Company's recoverables 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 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.
The carrying value of the Company's investment portfolio as of December 31, 2002 was $452.9 million of which 80.9% was invested in fixed maturity securities. The primary market risk to the investment portfolio is interest rate risk associated with investments in fixed maturity securities. The Company's exposure to equity price risk and foreign exchange risk is not significant. The Company has no commodity risk.
For fixed maturity securities, short-term liquidity needs and the potential liquidity needs of the business are key factors in managing the portfolio. The portfolio duration relative to the liabilities' duration is primarily managed through investment transactions.