The following table sets forth summary consolidated financial information of the Company for each of the years in the five-year period ended December 31, 2004 derived from the Company's audited consolidated financial statements. See the Consolidated Financial Statements of the Company including notes thereto included herein.
(1)Calculated on a GAAP basis. (2)Calculated as stockholders' equity divided by actual shares outstanding as of the date indicated. 30 - A N N U A L R E P O R T 2 0 0 4
We are an international insurance holding company focusing on specialty products for niches within the overall property/casualty insurance market. Our largest product line and most long-standing area of specialization is ocean marine insurance. We have also developed specialty niches in professional liability insurance, and in specialty liability insurance primarily consisting of contractors' liability coverages. We conduct operations through our insurance company subsidiaries, the Navigators Agencies and our Lloyd's Operations. Our insurance company subsidiaries consist of Navigators Insurance Company, which includes a United Kingdom Branch, and NIC Insurance Company which writes excess and surplus lines. The Navigators Agencies consist of five wholly-owned insurance underwriting agencies which produce business for our insurance subsidiaries. Our Lloyd's Operations include NUAL, a Lloyd's marine underwriting agency which manages Lloyd's Syndicate 1221. We participate in the capacity of Syndicate 1221 through two wholly-owned Lloyd's corporate members.
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 disciplined underwriting, prudent use of reinsurance and a balanced portfolio of risks.
Over the past three years, we have experienced generally beneficial market changes in our lines of business. As a result of several large industry losses in the second quarter of 2001, the marine insurance market began to experience diminished capacity and rate increases, initially in the offshore energy line of business. The marine rate increases began to level off and in several lines of business declined during 2004. Specialty liability losses in the contractors' business have also resulted in diminished capacity in the market in which we compete, as many former competitors who lacked the expertise to selectively underwrite this business have been forced to withdraw from the market. Rates continue to increase in our specialty liability business, albeit at a slower pace. In the professional liability market, the enactment of the Sarbanes-Oxley Act of 2002, together with financial and accounting scandals at publicly traded corporations and increased frequency of securities-related class action litigation, has led to an invigorated interest in professional liability insurance generally. These conditions resulted in rate increases in 2002 and 2003 as well as an overall improvement in policy terms and conditions for our professional liability line of business. However, the professional liability business has experienced low single digit premium rate decreases in 2004. We believe that the professional liability market will continue to see rates decrease in certain areas in 2005, including directors and officers coverages.
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In response to these various industry investigations, the Company recently completed its own internal review with respect to such contingent commission arrangements and anti-competitive practices. In this internal inquiry, the Company did not find any evidence that it has engaged in the bid-rigging and price-fixing activities that are at the core of the New York State Attorney General's investigation into these anti-competitive practices. In addition, as a result of this internal inquiry, the Company is developing guidelines with respect to its future commission payment arrangements.
Our most critical accounting policies involve the reporting of the reserves for losses and LAE (including losses that have occurred but were not reported to us 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 the translation of foreign currencies..
Deferred Tax Assets. We apply the asset and liability method of accounting for income taxes whereby deferred assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Additional information regarding our deferred tax assets can be found in Notes 1 and 5 to our consolidated audited financial statements, both included herein.
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. A number of criteria are considered during this process including, but not limited to: the current fair value as compared to cost or amortized cost, as appropriate, of the security; the length of time the security's fair value has been below cost or amortized cost, and by how much; and 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 cost or amortized cost, as appropriate, for six or more consecutive months. Other factors considered in evaluating potential impairment include the current fair value as compared to cost or amortized cost, as appropriate, 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, 2004 and 2003, including disclosures regarding other-than-temporary declines in investment value, see the "Business-Investments" section and Note 2 to our consolidated audited financial statements, both included herein.
Accounting for Lloyd's Results. We record our pro rata share of Lloyd's Syndicate 1221 assets, liabilities, revenues and expenses, after making adjustments to convert Lloyd's accounting to 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 or 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 reinsurance to close transaction. Additional information regarding our accounting for Lloyd's results can be found in Note 1 to our consolidated audited financial statements, included herein.
Translation of Foreign Currencies. Financial statements of subsidiaries expressed in foreign currencies are translated into U.S. dollars in accordance with SFAS No. 52 Foreign Currency Translation issued by the FASB. Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using period end rates of exchange and the related translation adjustments are recorded as a separate component of accumulated other comprehensive income. Functional currencies are generally the currencies of the local operating environment. Statement of income amounts expressed in functional currencies are translated using average exchange rates. Gains and losses resulting from foreign currency transactions are recorded in "other income (expense)" in the Company's Consolidated Statements of Income.
The following is a discussion and analysis of our consolidated and segment results of operations for the years ended December 31, 2004, 2003 and 2002. All earnings per share data is presented on a per diluted share basis.
Our 2004, 2003 and 2002 results of operations reflect increasing premium rates as a result of improved market conditions beginning in late 2000 and continuing through 2004, albeit to a much lesser extent in 2004. Net income for 2004, 2003 and 2002 was $34.9 million or $2.74 per share, $7.7 million or $0.80 per share and $16.4 million or $1.89 per share, respectively.
Cash flow from operations increased in 2004 and 2003 by approximately 20.8% and 24.0%, respectively, contributing to the growth in invested assets and net investment income. The growth in investment income has been mitigated in 2004 and 2003, and investment income actually declined in 2002, as a result of the overall declines in interest rates in the portfolios and the broader market.
The 2004 results of operations reflect improved financial performance compared to 2003 and 2002 due to a combination of improved underwriting results and the growth in net investment income.
While pre-tax investment yields declined to 3.5% in 2004 compared to 3.8% in 2003, net investment income increased 37% due to the cash flow from operations of $162.5 million coupled with the net proceeds of $111 million as a result of the Company's October 2003 equity offering, of which $95 million of the net proceeds was contributed to Navigators Insurance Company and invested in fixed maturity investments.
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Marine Premium. The 2004 marine gross written premium increased 7.1% principally due to the addition of protection and indemnity business written by our UK Branch commencing early in the year coupled with the 4.7% average increase in renewal premium rates during the year. Primary marine protection and indemnity (P&I) business complements our marine liability business which is generally written above the primary layer on an excess basis. The rate increases in the marine business slowed in 2004 compared to the prior two years. The 2003 and 2002 marine premium increased 9.6% and 65.5%, respectively, from the prior years due to business expansion in existing lines of business coupled with an increase in premium rates resulting in higher premiums on new and renewal business. The generally improved pricing environment resulted in Navigators Insurance Company increasing its writing of new business in 2002, which was partially offset in 2003 by a reduction of business in certain specific areas due to pricing concerns. Rate increases in 2003 and 2002 averaged approximately 13% and 21%, respectively. Navigators Insurance Company obtains its marine business through participation in the marine pool managed by the Navigators Agencies. Its participation in the marine pool was 80% in 2004 and 2003 and 75% in 2002. Commencing in 2005, Navigators Insurance Company's participation will increase to 85%.
Professional Liability Insurance. The professional liability premium increased to $71.0 million in 2004 from $53.0 million in 2003 and $23.4 million in 2002 reflecting growth and the expansion of this business. Renewal premium rates for this business decreased approximately 3.2% in 2004 compared to increases of approximately 28% in 2003. The 2004 premium rate decreases are reflective of softening market conditions which may continue into 2005. In late 2001, our insurance company subsidiaries began to write professional liability insurance, primarily consisting of directors and officers liability insurance for privately held and publicly traded corporations. In 2002, the professional liability business was expanded to include errors and omissions insurance and employment practices liability coverages. Commencing in October 2004, our U.K. Branch began writing professional liability coverages for U.K. solicitors. Beginning in 2005 we commenced writing professional liability coverages for architects and engineers.
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Substantially all of the increase in 2004 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 or gross of applicable ceded reinsurance amounts. There are no gains or losses recorded on the transaction. The comparable 2003 RITC amount was $514,000.
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 premium varies based upon the types of business written and whether the business is written by our insurance company subsidiaries or our Lloyd's Operations.
The percentage of ceded premium for professional liability business has declined each year since the Company is retaining more of its risks on a net basis as the business grows and becomes more seasoned.
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substantial portion of our stamp capacity through the utilization of quota share reinsurance agreements to third parties who provide letters of credit used as collateral at Lloyd's. A portion of this reinsurance was assumed by Navigators Insurance Company.
Net Written Premium. Net written premium increased 1.8% and 15.4% in 2004 and 2003, respectively, while gross written premium increased 14.8% and 35.4%, respectively, reflecting the cession by the Company of a greater percentage of its overall gross written premiums as discussed above. The 2004 net premium written increased $12.8 million as a result of the RITC transactions recorded in the 2004 fourth quarter, while the 2003 net written premium contains $13.9 million as a result of the commutation with a former pool member compared to 2002.
Net Earned Premium. Net earned premium increased 12.0% in 2004 compared to 2003 and 25.0% in 2003 compared to 2002. The 2004 earned premium includes $12.8 million as a result of the RITC transaction compared to 2003, while the 2003 amount contains $11.0 million as a result of the commutation with a former pool member compared to 2002.
Net Realized Capital Gains. Pre-tax net income included $0.9 million of net realized capital gains for 2004 compared to $1.9 million for 2003 and $1.7 million for 2002. On an after-tax basis, the net realized capital gains were $0.6 million or $0.05 per share, $1.2 million or $0.13 per share and $1.2 million or $0.14 per share for 2004, 2003 and 2002, respectively. The 2002 net realized capital gains include $2.9 million of impairment losses recorded on one of our asset-backed securities.
Other Income/(Expense). Other income/(expense) for 2004, 2003 and 2002 consisted principally of both foreign exchange gains and (losses) of $(1,310,000), $612,000 and $928,000, respectively, primarily related to the Lloyd's Operations, and of inspection fees of $873,000, $750,000 and $893,000, respectively, related to the specialty insurance business.
Net Losses and Loss Adjustment Expenses Incurred. The ratios of net loss and loss adjustment expenses incurred to net earned premium (loss ratios) were 60.5%, 76.0% and 64.6% in 2004, 2003 and 2002, respectively. The decrease in the 2004 loss ratio compared to 2003 was primarily due to the adverse development that negatively affected the 2003 loss ratio. 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 reinstatement premium from Hurricane Ivan. We incurred minimal losses from other 2004 hurricanes in the U.S. and from the 2004 tsunami in Asia. 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. The increase in the loss ratio in 2003 compared to 2002 was primarily due to the asbestos losses recorded in the fourth quarter of 2003 accounting for 11.4 loss ratio points of the 2003 loss ratio and, to a lesser extent, the adverse development in the California contractors' liability portion of the specialty business accounting for 10 loss ratio points and by 1.4 loss ratio points for loss activity related to run-off lines of business. The improvements in the premium rates since 2001 have benefited the loss ratios each year. We do not discount any of our loss reserves.
At December, 2004, the IBNR loss reserve was $274.0 million or 59.1% of our total loss reserves compared to 58.7% in 2003 and 48.9% in 2002.
At December 31, 2004, a 10% change in the net loss reserves would equate to $46.4 million which would represent an after-tax charge to net income of $30.2 million and 9.2% of stockholders' equity. Loss reserve estimates are reviewed each quarter to evaluate whether the assumptions made continue to be appropriate. Any adjustments that result from this review are recorded in the quarter in which they are identified.
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Commission Expense. Commission expense paid to brokers and agents is generally based on a percentage of the gross written premium and is reduced by ceding commissions the Company may receive on the ceded written premium. Commissions are generally deferred and recorded as deferred policy acquisition costs to the extent that they relate to unearned premium. Commission expense as a percentage of net earned premium was 12.6% in 2004, 14.5% in 2003 and 19.5% in 2002. The two year decrease in commission expense was primarily the result of an increase in ceding commissions from reinsurers coupled with a general decline in commission expense to brokers and agents.
Income Taxes. The income tax expense (benefit) was $17.2 million, $(4.9) million and $5.8 million for 2004, 2003 and 2002, respectively. The effective tax rates for 2004, 2003 and 2002 were 33.1%, (175.3%) and 26.2%, respectively. As of December 31, 2004 and 2003, the net deferred Federal, foreign, state and local tax assets were $17.3 million and $15.2 million, respectively.
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on such undistributed earnings and would be reflected in the tax provision for the year distributed assuming all foreign tax credits are realized.
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The Insurance Companies experienced premium growth in all three lines of business as reflected in the net earned premium increases of 9.9%, 40.3% and 100.3% in 2004, 2003 and 2002, respectively. The 2004 assumed premium from Lloyd's Operations net earned premium includes $22.2 million as a result of the RITC transaction recorded for the close of the 2002 year of account at Syndicate 1221. The 2003 marine earned premium included approximately $11.0 million as a result of a commutation agreement with a former pool member. Approximately 17.4%, 10.3% and 3.7% of the net earned premium recorded in 2004, 2003 and 2002, respectively, is a result of the Insurance Companies participating on reinsurance treaties supporting the Lloyd's Operations' marine and energy business.
The Lloyd's Operations consist of NUAL, which manages Lloyd's Syndicate 1221, Millennium Underwriting Ltd. and Navigators Corporate Underwriters Ltd. Both Millennium Underwriting Ltd. and Navigators Corporate Underwriters Ltd. are Lloyd's corporate members with limited liability and provide capacity to Lloyd's Syndicate 1221. NUAL owns Navigators Underwriting Limited (formerly Pennine Underwriting Ltd.), an underwriting managing agency with offices in Manchester, Leeds and Basingstoke, England, which underwrites cargo and engineering business for Lloyd's Syndicate 1221. The Lloyd's Operations and Navigators Management (UK) Limited, a Navigators Agency which produces business for the UK Branch of Navigators Insurance Company, are subsidiaries of Navigators Holdings (UK) Limited located in the United Kingdom.
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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 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, the reinsurance to close amounts vary accordingly. The reinsurance to close 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 were no gains or losses recorded on the RITC transaction.
Following are the results of operations of the Lloyd's Operations for each of the years in the three-year period ended December 31, 2004:
participation for the 2003 year of account to Navigators Insurance Company. A summary of the effect of the RITC transaction on our financial statements is as follows:
The table below illustrates Navigators' participation each year of account in the Lloyd's Syndicate 1221:
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In 2004, the Lloyd's Operations was taxed at a 35% rate as previously discussed under "Results of Operations and Overview-Income Taxes". The provision for income tax expense for 2003 and 2002 reflects the reversal of a previously established deferred tax asset valuation allowance. The valuation allowance was reversed up until the third quarter of 2003 only to the extent of taxable profits. The remaining valuation allowance was completely reversed in the 2003 fourth quarter since it was determined that it was more likely than not that the remaining deferred tax asset resulting from net operating loss carryforwards would be realized.
Each of the Navigators Agencies underwrites marine and related lines of business for Navigators Insurance Company and three other unaffiliated insurance companies comprising a marine insurance pool. Marine insurance policies are issued by Navigators Insurance Company with the business shared with other pool members. Navigators Insurance Company had a 75% participation in the pool for the 2002 underwriting year. As described in more detail under "Business-Marine Insurance", Navigators Insurance Company's participation in the marine pool increased to 80% for 2003 and 2004 and will increase to 85% in 2005.
Following are the results of the Navigators Agencies for each of the years in the three-year period ended December 31, 2004:
Commission income generally consists of intersegment management fees and profit commissions received from insurance premiums of the Insurance Companies for marine, specialty and professional liability business as well as business from unaffiliated insurance companies in the marine pool. Commission income increased in 2004 compared to 2003 due to the increased premium revenues generated in 2004 coupled with the recording of profit commission income. Despite increased premium revenues recorded by the Insurance Companies in 2003 compared to 2002, the commission income of the Navigators Agencies was flat due to the reduction of $5.7 million of intersegment profit commission as a result of the $32.5 million incurred losses recorded by the Insurance Companies for asbestos and environmental losses.
(1)The amounts determined are estimates which are subject to a high degree of variation and uncertainty, and are not subject to any specific payment schedule since the timing of these obligations are not set contractually. The amounts in the above table exclude reinsurance recoveries of $502.3 million. See "Business-Loss Reserves" included herein.
Cash flow provided by operations was $162.5 million, $134.5 million and $108.5 million for 2004, 2003, and 2002, respectively. The increases in the 2004, 2003 and 2002 operating cash flows were primarily due to the increases in net written premium. Operating cash flow was used primarily to acquire additional investment assets and to reduce debt in 2003 and 2002.
Investment assets and cash increased to $854.9 million at December 31, 2004 from $693.6 million at December 31, 2003 and $452.9 million at December 31, 2002. The increases were primarily due to the positive cash flow and the $110.8 million of net proceeds received from the secondary public stock offering in October 2003. Net investment income was $26.8 million for 2004, $19.6 million for 2003 and $18.1 million for 2002.
We have a credit facility provided through a consortium of banks. The credit facility which is in U.S. dollars is utilized primarily by Navigators Corporate Underwriters Ltd. and Millennium Underwriting Ltd. to fund our participation in Lloyd's Syndicate 1221 which is in British pounds. At December 31, 2004, letters of credit with an aggregate face amount of $83.8 million were issued under the credit facility.
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The credit facility was amended in January 2005 to increase the letters of credit available under the facility from $80 million to $115 million and to add a $10 million line of credit facility. The expiration of the credit facility was also extended from November 10, 2005 to June 30, 2007. If at that time the banks do not renew the credit facility, we will need to find other sources to provide the letters of credit or other collateral in order to continue our participation in Syndicate 1221. This new credit facility contains covenants similar to the covenants in the expiring credit facility discussed above.
We had annual rental commitments at December 31, 2004 under various noncancellable operating leases for our office facilities, which expire at various dates through 2013. The commitments by year are $2.9 million for 2005, $2.9 million for 2006, $2.6 million for 2007, $2.4 million for 2008, $2.3 million for 2009 and $3.6 million for 2010 and beyond.
We primarily rely upon dividends from our subsidiaries to meet our holding company obligations. The dividends have historically come primarily from Navigators Insurance Company. At December 31, 2004, the maximum amount available for the payment of dividends by Navigators Insurance Company during 2005 without prior regulatory approval was $23,556,000. During 2004, 2003 and 2002, Navigators Insurance Company paid dividends to us of $6,000,000, $6,000,000 and $6,500,000, respectively.
We are a specialty insurance company and periods of moderate economic recession or inflation tend not to have a significant direct affect 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.
We also consider the potential impact of economic trends in estimating loss reserves. Our management believes that the underwriting controls it maintains, and the fact that a significant amount of our business is in lines of insurance which have relatively short loss payout patterns, assist in estimating ultimate claim costs more reasonably and lessen the potential adverse impact of the economy on us.