Our executive and administrative office is located at 6 International Drive in Rye Brook, NY. Our lease for this space expires in February 2014. Our underwriting operations are in various locations with non-cancelable operating leases including Charlotte, NC, Chicago, IL, Coral Gables, FL, Corona, CA, Houston, TX, Irvine, CA, New York City, NY, Philadelphia, PA, Pittsburgh, PA, San Francisco, CA, Schaumburg, IL, Seattle, WA, London, England, Antwerp, Belgium, Stockholm, Sweden and Copenhagen, Denmark.
We conduct operations through our Insurance Companies and our Lloyd’s Operations segments. The Insurance Companies segment consists of Navigators Insurance Company, which includes a United Kingdom Branch (the “U.K. Branch”), and Navigators Specialty Insurance Company, which underwrites specialty and professional liability insurance on an excess and surplus lines basis. All of the insurance business written by Navigators Specialty Insurance Company is fully reinsured by Navigators Insurance Company pursuant to a 100% quota share reinsurance agreement. Our Lloyd’s Operations segment includes Navigators Underwriting Agency Ltd. (“NUAL”), a Lloyd’s of London (“Lloyd’s”) underwriting agency which manages Lloyd’s Syndicate 1221 (“Syndicate 1221”). Our Lloyd’s Operations primarily underwrite marine and related lines of business along with offshore energy, professional liability insurance and construction coverages for onshore energy business at Lloyd’s through Syndicate 1221. We controlled 100% of Syndicate 1221’s stamp capacity for the 2009 and 2008 underwriting years through our wholly-owned subsidiary, Navigators Corporate Underwriters Ltd., and through both Millennium Underwriting Ltd., another wholly-owned subsidiary, and Navigators Corporate Underwriters Ltd. in 2007, which are referred to as corporate names in the Lloyd’s market. We have also established underwriting agencies in Antwerp, Belgium, Stockholm, Sweden and Copenhagen, Denmark, which underwrite risks pursuant to binding authorities with NUAL into Syndicate 1221.
Effective in 2009, we reclassified certain business lines within our segments, which had no effect on the segment classifications of the Insurance Companies and Lloyd’s Operations. Underwriting data for prior periods has been reclassified to reflect these changes.
The marine lines within both the Insurance Companies and Lloyd’s Operations are now presented as “Marine” instead of “Marine and Energy”, since the offshore energy business has now been reclassified to “Property Casualty”.
The “Middle Markets” business, formerly broken out separately in the Insurance Companies, is now included in the Insurance Companies’ “Property Casualty” business.
While management takes into consideration a wide range of factors in planning our business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how we are managed. First, underwriting profit is consistently emphasized as a primary goal, above premium growth. Management’s assessment of our trends and potential growth in underwriting profit is the dominant factor in its decisions with respect to whether or not to expand a business line, enter into a new niche, product or territory or, conversely, to contract capacity in any business line. In addition, management focuses on controlling the costs of our operations. Management believes that careful monitoring of the costs of existing operations and assessment of costs of potential growth opportunities are important to our profitability. Access to capital also has a significant impact on management’s outlook for our operations. The Insurance Companies’ operations and ability to grow their business and take advantage of market opportunities are constrained by regulatory capital requirements and rating agency assessments of capital adequacy.
Management’s decisions are also greatly influenced by access to specialized underwriting and claims expertise in our lines of business. We have chosen to operate in specialty niches with certain common characteristics which we believe provide us with the opportunity to use our technical underwriting expertise in order to realize underwriting profit. As a result, we have focused on underserved markets for businesses characterized by higher severity and low frequency of loss where we believe our intellectual capital and financial strength bring meaningful value. In contrast, we have avoided niches that we believe have a high frequency of loss activity and/or are subject to a high level of regulatory requirements, such as workers compensation and personal automobile insurance, because we do not believe our technical expertise is of as much value in these types of businesses. Examples of niches that have the characteristics we look for include bluewater hull which provides coverage for physical damage to, for example, highly valued cruise ships, and directors and officers liability (“D&O”) insurance which covers litigation exposure of a corporation’s directors and officers. These types of exposures require substantial technical expertise. We attempt to mitigate the financial impact of severe claims on our results by conservative and detailed underwriting, prudent use of reinsurance and a balanced portfolio of risks.
A 24% decline in our offshore energy lines primarily resulting from a planned reduction in our Gulf of Mexico exposure as market pricing and terms did not meet our underwriting standards.
Our net investment income declined 1% in 2009. Our pre-tax average investment yield declined to 3.8% from 4.1% in 2008 resulting from lower short-term yields. Our total investment portfolio continued to increase in 2009 and had exceeded $2 billion at the end of 2009. We experienced significantly lower investment impairments in our portfolio in 2009 as the financial markets experienced a period of stability compared to the second half of 2008.
Our overall loss ratio of 63.8% for 2009 increased compared to 2008 due primarily to a $42 million decline in net prior year savings. Although we continued to realize prior year savings in our contractors liability lines, we experienced unfavorable prior year development in our D&O and lawyers lines relating to unfavorable development in the 2006 and 2005 through 2008 underwriting years, respectively. Additional unfavorable prior year development in our Insurance Company marine liability lines resulted in a 2009 underwriting loss in both the Marine and Professional Liability divisions within the Insurance Companies segment.
The discussions that follow include tables that contain both our consolidated and segment operating results for the last three calendar years. In presenting our financial results, we have discussed our performance with reference to underwriting profit or loss and the related combined ratio, both of which are non-GAAP measures of underwriting profitability. We consider such measures, which may be defined differently by other companies, to be important in the understanding of our overall results of operations. Underwriting profit or loss is calculated from net earned premium, less the sum of net losses and LAE, commission expense, other operating expenses and commission income and other income (expense). The combined ratio is derived by dividing the sum of net losses and LAE, commission expense, other operating expenses and commission income and other income (expense) by net earned premium. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss.
There are instances in which facts and circumstances require a deviation from the general process described above. Three such instances relate to the IBNR loss reserve processes for our 2008 Hurricanes losses, our 2005 Hurricanes losses and our asbestos exposures, where extrapolation techniques are not applied, except in a limited way, given the unique nature of hurricane losses and limited population of marine excess policies with potential asbestos exposures. In such circumstances, inventories of the policy limits exposed to losses coupled with reported losses are analyzed and evaluated principally by claims personnel and underwriters to establish IBNR loss reserves.
An annual loss reserve study is conducted by the Company’s actuaries for each major line of business employing the methodologies as described above with the timing of such studies varying throughout the year. Additionally, a review of the emergence of actual losses relative to expectations for each line of business, generally derived from the annual reserve study, is conducted each quarter to determine whether the assumptions used in the reserving process continue to form a reasonable basis for the projection of liabilities for each product line. Such reviews may result in maintaining or revising assumptions regarding future loss development based on various quantitative and qualitative considerations. If actual loss activity differs from expectations, an upward or downward adjustment to loss reserves may occur. As time passes, estimated loss reserves for an underwriting year will be based more on historical loss activity and loss development patterns rather than on assumptions based on underwriters’ input, pricing assumptions or industry experience.
The claims emergence patterns for various marine product lines vary substantially. Our largest marine product line is marine liability, which has one of the longer loss development patterns. Marine liability protects an insured’s business from liability to third parties stemming from their marine-related operations, such as terminal operations, stevedoring and marina operations. Since marine liability claims generally involve a dispute as to the extent and amount of legal liability that our insured has to a third party, these claims tend to take a longer time to develop and settle. Other longer-tail marine product lines include P&I insurance, which provides coverage for third party liability as well as injury to crew for vessel operators, and transport insurance, which provides both property and third party liability on a primary basis to businesses such as port authorities, marine terminal operators and others engaged in the infrastructure of international transportation. Other marine product lines have considerably shorter periods in which losses develop and settle. Ocean cargo insurance, for example, provides physical damage coverage to goods in the course of transit by water, air or land. By their nature, cargo claims tend to be reported quickly as losses typically result from an obvious peril such as fire, theft or weather. Similarly, bluewater hull insurance provides coverage against physical damage to ocean-going vessels. Such claims for physical damage generally are discovered, reported and settled quickly. The Company currently has extensive experience for all of these products and thus the IBNR loss reserves for all of the marine products are determined using the key assumptions and actuarial methodologies described above. Prior to 2007, however, as discussed below, the Company did not have sufficient experience in the transport product line and instead used its hull and liability products loss development experience as a key assumption in setting the IBNR loss reserves for its transport product.
Primary casualty insurance provides primary general liability coverage principally to corporations in the construction and manufacturing sector. Excess casualty insurance is purchased by corporations which seek higher limits of liability than are provided in their primary casualty policies. Neither product line has a significant amount of loss activity reported to date. Because we have limited historical experience in these products, the IBNR loss reserves for both of these products currently are established using the loss ratio method primarily based on our underwriters’ input and industry loss experience.
Professional Liability: The professional liability policies mainly provide coverage on a claims-made basis mostly for a one-year period. The reserves for professional liability are analyzed separately by product with the major products being directors and officers (“D&O”) liability coverage and errors and omissions (“E&O”) liability coverage for lawyers and other professionals.
The losses for D&O business are generally very large and infrequent, and typically involve securities class actions. D&O claims report reasonably quickly, but may take several years to settle. While we have been writing D&O business since 2001, the limited claim history is generally insufficient to establish IBNR loss reserves using Company data. As a result, we principally employ assumptions based on industry experience coupled with input from its underwriters and its claims staff’s assessment of potential exposure to establish IBNR loss reserves. Another key assumption with respect to establishing IBNR loss reserves for D&O business is that such industry experience is representative of our future potential loss development with respect to trends in class action activity, such as the impact of stock option backdating, laddering and, most recently, the subprime mortgage crisis. As time passes, for a given underwriting year, additional weight is given to assumptions relating to our actual experience and claims outstanding.
The E&O IBNR loss reserve process is similar to the process for D&O, with the exception of a particular book of business of the U.K. Branch written from 2004 through 2006. For the U.K. Branch E&O business, we assume the claims, while similar in nature to the claims in the U.S. E&O business, are larger, more frequent and have a longer loss development pattern. The IBNR loss reserves for the U.K. Branch E&O business are determined judgmentally after reviewing recent loss activity relative to the remaining in-force policy count and the loss activity for similar insureds.
We do not calculate a range of loss reserve estimates. We believe that ranges may not be a true reflection of the potential volatility between carried loss reserves and the ultimate settlement amount of losses incurred prior to the balance sheet date.
Set forth below is a sensitivity analysis that estimates the effect on our net loss reserve position of using alternative expected loss ratios for the underwriting years 2002 to 2009 and alternative loss development factors for underwriting years 1997 to 2009 rather than those loss ratios and factors actually used in determining our best estimates at December 31, 2009. The analysis addresses each major line of business and underwriting year for which a material deviation to our overall reserve position is believed reasonably possible, and uses what we believe is a reasonably likely range of potential deviation for each line of business. There can be no assurance, however, that actual reserve development will be materially consistent with either the original or the adjusted expected loss ratios or loss development factor assumptions, or with other assumptions made in the reserving process.
The reasonably likely ranges of potential deviation in the loss ratios for each line of business for the 2002 to 2009 underwriting years expressed in loss ratio points are as follows:
For the loss development factor variance, our actuaries employed a standard technique which is based on the historical development factors observed for each line of business from the paid and incurred loss development triangles with the latest evaluation at December 31, 2009. The historical factors are used to generate alternative outcomes which could arise in the ultimate development due to the random variability inherent in future development. The alternative outcomes are generated by a stochastic simulation. The ranges may contract or expand if future development deviates from historical experience.
The reasonably likely ranges of potential deviations in the aggregate or overall loss development factors applicable to the total of all underwriting years for each line of business are as follows:
Reinsurance Recoverables. 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 reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers which can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Additional information regarding our reinsurance recoverables can be found in the “Business-Reinsurance Recoverables” section and Note 6, Reinsurance, to our consolidated financial statements, both included herein.
Substantially all of our business is placed through agents and brokers. Since the vast majority of our gross written premiums are primary or direct, as opposed to assumed, the delays in reporting assumed premiums generally do not have a significant effect on our 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.
Impairment of Invested Assets. 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.
Net income for 2009, 2008 and 2007 was $63.2 million or $3.65 per diluted share, $51.7 million or $3.04 per diluted share and $95.6 million or $5.62 per diluted share, respectively. The 2008 year was adversely impacted by Hurricanes Gustav and Ike, reducing net income by $19.1 million and diluted earnings per share by $1.12.
Consolidated stockholders’ equity increased 16.3% to $801.5 million or $47.58 per share at December 31, 2009 compared to $689.3 million or $40.89 per share at December 31, 2008. The increase was primarily due to 2009 net income of $63.2 million and $46.0 million of after-tax unrealized gains in 2009 within our investment portfolio.
The 2008 results of operations were adversely impacted by hurricane activity and net realized losses. Hurricanes Gustav and Ike reduced 2008 net income by $19.1 million and earnings per share by $1.12. The combined loss and expense ratio was increased by an aggregate 4.3 ratio points for such losses and are inclusive of reinsurance recoveries and related costs for reinsurance reinstatement premiums. Excluding these effects, the underwriting results benefited from increased net premium revenues despite continuing softening market conditions, and the recording of a net redundancy of prior years’ loss reserves of $50.7 million, or $1.94 per share, which reduced the 2008 combined ratio of 93.8% by 7.9 loss ratio points.
The professional liability gross written premiums increased 25.7% to $137.1 million in 2009 compared to 2008 reflecting continued growth and the expansion of our directors and officers business. Partially offsetting the growth has been a reduction in lawyers business within the errors and omissions classification as we have been in the process of re-underwriting that line and focusing more on other segments, such as miscellaneous professional liability. Average 2009 renewal premium rates for this business increased approximately 2% in 2009 compared to 2008. The professional liability gross written premiums increased 9.5% to $109.0 million in 2008 compared to 2007 due to the expansion of our professional liability business and an emerging flight to quality that occurred in the latter part of the year. Average 2008 renewal premium rates for this business decreased approximately 4% in 2008 compared to 2007.
The 2009 Lloyd’s property casualty gross written premiums of $78.2 million decreased 14.4% compared to 2008 due to a decline in our offshore energy and engineering and construction lines as well as the cessation of writing our property line. We began writing Bloodstock (animal mortality) business during 2009 by participating in a facility originated by another Lloyd’s syndicate. The 2008 gross written premiums of $91.3 million increased 5.5% compared to 2007 due to increases in all of our NavTech lines. Average premium renewal rates in our NavTech lines were a 10.1% increase in 2009 and a 10.0% decrease in 2008 compared to the previous year, respectively.
Ceded Written Premium In the ordinary course of business, we reinsure certain insurance risks with unaffiliated insurance companies for the purpose of limiting our maximum loss exposure, protecting against catastrophic losses, and maintaining desired ratios of net premiums written to statutory surplus. The relationship of ceded to written premiums varies based upon the types of business written and whether the business is written by the Insurance Companies or the Lloyd’s Operations.
Net Written Premiums The 2009 net written premiums increased 6.0% compared to 2008 primarily due to the aforementioned reduction in the amount of marine and energy quota share reinsurance purchased in 2009. The 2009 increase was 4.1% compared to 2008 when excluding the $12.2 million of ceded reinstatement premiums resulting from the 2008 Hurricanes. The 2008 net written premiums increased 2.4% compared to 2007. The 2008 increase was 4.3% compared to 2007 when excluding the $12.2 million of ceded reinstatement premiums resulting from the 2008 Hurricanes.
Commission Income Commission income from unaffiliated business decreased 91.4% to $0.1 million in 2009 compared to 2008 and decreased 42.1% to $1.0 million in 2008 compared to $1.7 million in 2007. Beginning with the 2006 underwriting year, there are no longer any unaffiliated marine pool insurance companies and we purchased the Syndicate 1221 minority interest, therefore any profit commission therefore results from the run-off of underwriting years prior to 2006.
Our net other-than-temporary impairment losses recognized in earnings for the periods indicated were as follows:
The 2009 other-than-temporary impairments were primarily related to additional impairments on equity securities that were impaired in 2008 as well as impairments on residential mortgage-backed securities. The after-tax effects of net other-than-temporary impairment losses recognized in earnings on the 2009 and 2008 net income were $7.8 million or $0.45 per diluted share and $24.1 million or $1.42 per share, respectively. In 2009, we recognized in earnings OTTI losses of $2.5 million and $0.08 million related to non-agency mortgage and asset-backed securities, respectively. In 2009, we recognized in earnings OTTI losses of $8.8 million on 56 common stocks resulting from additional impairments on equity securities that were impaired in 2008. In addition, in 2009 we recognized in earnings OTTI losses of $0.6 million on 2 corporate bonds.
The significant inputs used to measure the amount of credit loss recognized in earnings were actual delinquency rates, default probability assumptions, severity assumptions and prepayment assumptions. Projected losses are a function of both loss severity and probability of default. Default probability and severity assumptions differ based on property type, vintage and the stress of the collateral. We do not intend to sell any of these securities and it is more likely than not that we will not be required sell these securities before the recovery of the amortized cost basis.
Our realized gains and losses for the periods indicated were as follows:
Pre-tax net income included $9.2 million of net realized gains for 2009 compared to $1.3 million of net realized losses for 2008 and net realized gains of $2.7 million for 2007. On an after-tax basis, the net realized gains for 2009 were $5.9 million or $0.34 per diluted share compared to the net realized losses of $0.8 million or $0.05 per diluted share for 2008 and the net realized gains of $1.7 million or $0.10 per diluted share for 2007. Net realized gains and losses are generated from the sale of securities in the normal course of management of the investment portfolio.
Other Income/(Expense) Other income/(expense) for 2009, 2008 and 2007 consisted primarily of foreign exchange gains and losses from our Lloyd’s Operations and inspection fees related to our specialty insurance business.
The ratios of net losses and loss adjustment expenses to net earned premiums (loss ratios) were 63.8%, 61.0% and 56.6% in 2009, 2008 and 2007, respectively. The 2009 loss ratio of 63.8% was favorably impacted by 1.3 loss ratio points resulting from an $8.9 million net redundancy of prior years’ loss reserves. The 2008 loss ratio of 61.0% was favorably impacted by 7.9 loss ratio points resulting from the $50.7 million net redundancy of prior years’ loss reserves and adversely impacted by 3.7 loss ratio points related to the 2008 Hurricanes. The result of underwriting losses caused by Hurricanes Gustav and Ike of approximately $29.3 million, including $12.2 million of reinstatement costs, increased the 2008 combined ratio by 4.3 ratio points. The 2007 loss ratio of 56.6% was favorably impacted by 7.8 loss ratio points resulting from the $47.0 million net redundancy of prior year loss reserves. The 2007 loss ratio also included 0.9 loss ratio points for the U.K. flood losses in the Insurance Companies’ U.K. Branch’s property business and the Lloyd’s marine cargo business.
During 2008 and 2007, reserve reductions resulting from periodic reviews of the 2005 Hurricanes’ exposures reduced gross losses incurred by $12.3 million and $29.3 million, respectively. The reductions to the 2005 Hurricanes gross reserve estimates resulted in reductions of $1.0 million and $1.9 million to our 2008 and 2007 net loss incurred estimates, respectively, and reductions of $0.8 million and $0.7 million to our 2008 and 2007 reinstatement cost estimates, respectively. As a result of these reviews in 2007, we also reallocated our net retention for these events between our Insurance Companies and Lloyd’s operations and the result was to increase the Insurance Companies loss incurred by $1.5 million and decrease the Lloyd’s loss incurred by $3.4 million. During 2009 there was a minor increase in the gross and net losses incurred for the 2005 Hurricanes of $0.7 million and $0.1 million, respectively.
Prior year reserve redundancies of $8.9 million, $50.7 million and $47.0 million net of reinsurance were recorded in 2009, 2008 and 2007, respectively, as discussed below. The relevant factors that may have a significant impact on the establishment and adjustment of loss and LAE reserves can vary by line of business and from period to period.
Following is a discussion of relevant factors impacting our 2009 loss reserves:
$36.5 million for contractors’ liability due to an actuarial review conducted in 2009 which indicated that loss development on the 2006 and prior underwriting years has been more favorable than our prior expectations for those underwriting years
$9.3 million from our primary E&S lines and $6.2 million in excess casualty business due to favorable loss trends in underwriting years 2007 and prior, and
$8.0 million of favorable development on our offshore energy (NavTech) book due to favorable claims trends across a number of prior underwriting years.
$12.0 million in our Nav Pac business due to reported loss activity in excess of our prior expectations from most underwriting years resulting from reviews of open claims in the auto and liability lines of business
$6.4 million from our liquor business, which is now in run-off, and
$5.9 million in our personal umbrella books of business across most underwriting years where large loss activity has exceeded our expectations.
The Insurance Companies recorded $20.7 million of net prior year unfavorable development for professional liability.
The Insurance Companies recorded $11.6 million of net prior years’ savings in the marine business primarily comprised of $6.5 million of savings in the transport business, $3.7 million of savings in the marine liability business, $1.6 million of savings in the cargo business, $1.0 million of savings in each of the hull; partially offset by $1.6 million for uncollectible reinsurance recoverables for asbestos losses. The favorable development for the liability, cargo and hull coverages was primarily due to reduced claim activity for the 2005 and 2006 underwriting years. Prior to 2007, because the Company did not have sufficient experience in the transport product line, it instead used its hull and liability products loss development experience as a key assumption in setting the IBNR loss reserves for its transport product. Commencing in 2007, our actuaries determined that the Company’s loss development experience for its transport product had become sufficiently credible to begin establishing transport reserves using such experience, which resulted in the prior year savings referred to above recorded for this business.
The Insurance Companies recorded $11.8 million of net prior years’ savings almost entirely for its property casualty business related to the contractors’ liability business for the years 1998 through 2006. The prior years’ savings recorded for contractors’ liability business was due mostly to continued favorable loss frequency and severity trends for 2003 to 2006 compared to expectations. Our actuaries believe that the favorable loss frequency trends result primarily from a number of underwriting and coverage changes since 2002, including the migration to non-admitted business from admitted business in 2003, which allowed the Company to exclude certain previously permitted exposures (for example, exposure to construction work performed prior to the policy inception), and withdrawals from certain contractor classes previously underwritten. Our actuaries believe that the favorable loss severity trends result primarily from improved claim practices coupled with a California legislative change, effective in mid-2002, which provides for an alternative dispute resolution system with respect to construction defect claims and is intended to avoid or mitigate costly litigation and claims settlements. While our actuaries were unable to precisely quantify the impact of each of the foregoing factors, such factors were judgmentally taken into account in recording such prior years’ savings for contractors’ liability business by evaluating actual loss development compared to expected loss development coupled with a frequency and severity claims analysis conducted in 2007.
The Insurance Companies have historically reserved for the professional liability business using ultimate loss ratios based on industry experience for this line of business given the Company’s limited claims history. Such industry experience is heavily influenced by the historical frequency and severity of large securities class action lawsuits. During 2007, the Insurance Companies reduced the net reserves for such claims-made policies compared to year-end 2006 by $10.4 million, mostly related to policies issued in 2004 and 2005. The reductions were made to recognize both the low level of open claim counts and the lack of observed claim severity compared to expectations at the time the reserves were initially established using industry experience.
During the 2005 third quarter, we recorded gross and net loss estimates of $471.0 million and $22.3 million, respectively, exclusive of $14.5 million for the cost of excess-of-loss reinstatement premiums, related to Hurricanes Katrina and Rita.
Our exposure to asbestos liability principally stems from marine liability insurance written on an occurrence basis during the mid-1980s. In general, our participation on such risks is in the excess layers, which requires the underlying coverage to be exhausted prior to coverage being triggered in our layer. In many instances we are one of many insurers who participate in the defense and ultimate settlement of these claims, and we are generally a minor participant in the overall insurance coverage and settlement.
The reserves for asbestos exposures at December 31, 2009 are for: (i) one large settled claim for excess insurance policy limits exposed to a class action suit against an insured involved in the manufacturing or distribution of asbestos products being paid over several years (two other large settled claims were fully paid in 2007); (ii) other insureds not directly involved in the manufacturing or distribution of asbestos products, but that have more than incidental asbestos exposure for their purchase or use of products that contained asbestos; and (iii) attritional asbestos claims that could be expected to occur over time. Substantially all of our asbestos liability reserves are included in our marine loss reserves.
The ceded asbestos paid and unpaid recoverables were $8.9 million at December 31, 2009 and 2008, respectively. During 2007, we increased our provision for uncollectible reinsurance for asbestos losses by $1.6 million which was recorded in incurred losses. In addition, in 2007, we settled demands for arbitration with two asbestos reinsurers. We believe that we will be able to collect reinsurance on the gross portion of its historic gross asbestos exposure in the above table. To the extent we incur additional gross loss development for our historic asbestos exposure, we do not expect to realize additional reinsurance recoverables.
The following tables set forth our net case loss and LAE reserves and net IBNR reserves (a non-GAAP measure reconciled above) by segment and line of business for the periods indicated:
Commission Expense. Commission expenses paid to unaffiliated brokers and agents are generally based on a percentage of the gross written premiums and are reduced by ceding commissions we may receive on the ceded written premiums. Commissions are generally deferred and recorded as deferred policy acquisition costs to the extent that they relate to unearned premium. The percentages of commission expenses to net earned premium was 14.5% in 2009, 13.9% in 2008 and 12.9% in 2007. The 2008 commission expense ratio excluding the effects of the 2008 Hurricanes was 13.7%.
Interest Expense. The interest expense reflects interest on our Senior notes issued in April 2006.
The income tax expense was $23.7 million, $17.0 million and $43.6 million for 2009, 2008 and 2007, respectively. The effective tax rates for 2009, 2008 and 2007 were 27.3%, 24.8% and 31.3%, respectively. Our effective tax rate was less than 35% due to permanent differences between book and tax return income, with the most significant item being tax exempt interest. As of December 31, 2009 and 2008, the net deferred federal, foreign, state and local tax assets were $31.2 million and $54.7 million, respectively.
We are subject to the tax regulations of the United States and foreign countries in which we operate. We file 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 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. Our 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 our 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. Our effective tax rate for Syndicate 1221 taxable income could substantially exceed 35% to the extent we are 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 our 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. A finance bill was enacted in the U.K. on July 19, 2007 that reduces the U.K. corporate tax rate from 30% to 28% effective April 1, 2008. The effect of such tax rate change was not material to our financial statements.
We have not provided for U.S. deferred income taxes on the undistributed earnings of approximately $57.6 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 $4.0 million would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested in the non-U.S. subsidiary assuming all foreign tax credits are realized.
We had net state and local deferred tax assets amounting to potential future tax benefits of $2.6 million and $6.2 million at December 31, 2009 and 2008, respectively. Included in the deferred tax assets are net operating loss carryforwards of $1.3 million and $0.5 million at December 31, 2009 and 2008, respectively. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. Our state and local tax carryforwards at December 31, 2009 expire from 2023 to 2025.
We evaluate the performance of each segment based on its underwriting and GAAP results. The Insurance Companies’ and the Lloyd’s Operations’ results are measured by taking into account net earned premiums, net losses and loss adjustment expenses, commission expenses, other operating expenses, commission income and other income (expense). 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.
The Insurance Companies consist of Navigators Insurance Company, including its U.K. Branch, and its wholly-owned subsidiary, Navigators Specialty Insurance Company. They are primarily engaged in underwriting marine insurance and related lines of business, professional liability insurance and specialty lines of business including contractors general liability insurance, commercial umbrella and primary and excess casualty businesses. Navigators Specialty Insurance Company underwrites specialty and professional liability insurance on an excess and surplus lines basis. Navigators Specialty Insurance Company is 100% reinsured by Navigators Insurance Company.
The 2009 underwriting results were favorably impacted by $3.1 million or 0.6 loss ratio points for net prior year savings, which is discussed in the prior year reserve redundancies/deficiencies section. The 2009 net prior year savings declined $38.8 million compared to 2008.
The following table sets forth the impact of Hurricanes Gustav and Ike on the Insurance Companies’ 2008 financial results:
The approximate annualized pre-tax yields on the Insurance Companies’ investment portfolio, excluding net realized capital gains and losses, approximated 4.1%, 4.3% and 4.5% for 2009, 2008 and 2007, respectively. The increase in net investment income in 2009, 2008 and 2007 versus the comparable prior year was primarily due to the investment of new funds from positive cash flow from operations. The portfolio’s duration was 4.7 years at December 31, 2009 and 4.8 years at December 31, 2008.
Syndicate 1221’s stamp capacity was £124 million ($194 million) in 2009, £123 million ($228 million) in 2008 and £140 million ($280 million) in 2007. 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 controlled 100% of Syndicate 1221’s total stamp capacity in 2009, 2008 and 2007 through our wholly-owned Lloyd’s corporate member (we utilized two wholly-owned Lloyd’s corporate members prior to the 2008 underwriting year). Syndicate 1221’s stamp capacity is expressed net of commission (as is standard at Lloyd’s). The Syndicate 1221 premium recorded in our financial statements is gross of commission. We provide letters of credit to Lloyd’s to support our participation in Syndicate 1221’s stamp capacity as discussed below under the caption Liquidity and Capital Resources.
The 2009 earnings in the Lloyd’s Operations improved $3.1 million compared to 2008. The Lloyd’s Operations utilized less reinsurance in 2009 compared to 2008, resulting in higher net premiums. In addition, 2008 results were impacted by losses caused by Hurricanes Gustav and Ike of approximately $13.1 million, including $5.0 million of reinstatement costs, which increased the 2008 combined ratio by 7.1 combined ratio points and reduced net income by $8.5 million.
The 2009 underwriting results were favorably impacted by approximately $5.9 million or 2.9 loss ratio points for net prior years’ savings due to favorable loss development trends which are discussed in the prior year reserve redundancies/deficiencies section. The 2009 net prior years’ savings was a decline of $3.0 million compared to 2008.
The 2007 underwriting results were favorably impacted by approximately $13.2 million or 8.3 loss ratio points for net prior years’ savings due to favorable loss development trends, primarily in our 2004 and 2005 underwriting years.
Reviews of our Lloyd’s Operations’ Hurricanes Katrina and Rita exposures during 2007 resulted in a reduction to the storm loss estimates and increased pre-tax income by $4.1 million consisting of $3.4 million of decreases to incurred losses and a $0.7 million reduction in our reinstatement cost estimates. A portion of this impact was the result of reallocating our net retention for these events between our Insurance Companies and Lloyd’s Operations.
Management has reviewed this process by which the manager determines the prices and has obtained alternative pricing to validate a sampling of the pricing and assess their reasonableness.
The following table presents a reconciliation of the beginning and ending balances for all investments measured at fair value using Level 3 inputs during the twelve months ended December 31, 2009:
The following tables set forth our U.S. Treasury bonds, agency bonds and foreign government bonds as of December 31, 2009 and 2008:
The following table sets forth the fifteen largest holdings categorized as state, municipalities and political subdivisions by counterparty as of December 31, 2009:
The following table sets forth the composition of the investments categorized as states, municipalities and political subdivisions in our portfolio by generally equivalent S&P and Moody’s ratings (not all securities in our portfolio are rated by both S&P and Moody’s) as of December 31, 2009:
We own $282 million of municipal securities which are credit enhanced by various financial guarantors. As of December 31, 2009, the average underlying credit rating is A+. There has been no material adverse impact to our investment portfolio or results of operations as a result of recent downgrades of the credit ratings for several of the financial guarantors.
The following tables set forth our mortgage-backed securities, residential mortgage obligations and asset-backed securities by those issued by the Government National Mortgage Association (“GNMA”), FNMA, FHLMC, and the quality category (prime, Alt-A and subprime) for all other such investments as of December 31, 2009:
The commercial mortgage-backed securities are all rated investment grade by S&P or by Moody’s. The following table sets forth the fifteen largest commercial mortgage-backed securities portfolio as of December 31, 2009:
As of December 31, 2009, the largest single unrealized loss by an issuer in the fixed maturities category was $1.1 million.
The following table summarizes the gross unrealized investment losses as of December 31, 2009 by length of time where the fair value is less than 80% of amortized cost.
The fair value of our investment portfolio may fluctuate significantly in response to various factors such as changes in interest rates, investment quality ratings, equity prices, foreign exchange rates and credit spreads. We do not have the intent to sell nor is it more likely than not that we will have to sell debt securities in unrealized loss positions that are not other-than temporarily impaired before recovery. We may realize investment losses to the extent our liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate, liquidity or credit spread environments. Significant changes in the factors we consider when evaluating impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements.
The contractual maturity by the number of years until maturity for fixed maturity securities with unrealized losses at December 31, 2009 are shown in the following table:
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Due to the periodic repayment of principal, the mortgage-backed and asset-backed securities are estimated to have an effective maturity of approximately 3.5 years.
Cash flows from operations were $103.9 million, $245.3 million and $284.6 million for 2009, 2008, and 2007, respectively. The decline in cash flow from operations in 2009 compared to 2008 was primarily a result of an increase in losses and LAE paid for claims of $82.4 million. Operating cash flow was used primarily to acquire additional investments of fixed income securities.
At December 31, 2009, the weighted average rating of our fixed maturity investments was “AA” by S&P and “Aa” by Moody’s. We believe that we have limited exposure to credit risk since the fixed maturity investment portfolio, except for $31.9 million, consists of investment-grade bonds. At December 31, 2009, our investment portfolio had an average maturity of 5.1 years and a duration of 4.2 years. Management periodically projects cash flow of the investment portfolio and other sources in order to maintain the appropriate levels of liquidity to ensure our ability to satisfy claims. As of December 31, 2009 and 2008, all fixed maturity securities and equity securities held by us were classified as available-for-sale.
Generally, for pro rata or quota share reinsurers, including pool participants, we issue quarterly settlement statements for premiums less commissions and paid loss activity, which are expected to be settled by the end of the subsequent quarter. We have the ability to issue “cash calls” requiring such reinsurers to pay losses whenever paid loss activity for a claim ceded to a particular reinsurance treaty exceeds a predetermined amount (generally $1.0 million) as set forth in the pro-rata treaty. For the Insurance Companies, cash calls must generally be paid within 30 calendar days. There is generally no specific settlement period for the Lloyd’s Operations cash call provisions, but such billings are usually paid within 45 calendar days.
We believe that we have adequately managed our cash flow requirements related to reinsurance recoveries from our positive cash flows and the use of available short-term funds when applicable. However, there can be no assurances that we 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 Gustav, Ike, Katrina and Rita could significantly impact our liquidity needs. However, we expect to continue to pay these hurricane losses over a period of years from cash flow and, if needed, short-term investments. We 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, 2009 and 2008, our capital resources were as follows:
The increase in stockholders’ equity in 2009 was primarily due to 2009 net income of $63.2 million and $46.0 million of unrealized gains in 2009 within our investment portfolio. The increase in stockholders’ equity in 2008 was primarily due to net income of $51.7 million partially offset by $25.2 million of unrealized losses in 2008 within our investment portfolio.