UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934

 

For the Quarterly Period Ended     March 31, 2005

 

Commission file number   0-15886

 

The Navigators Group, Inc.

(Exact name of Registrant as specified in its charter)

 

Delaware		13-3138397
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)
One Penn Plaza, New York, New York		10119
(Address of principal executive offices)		(Zip Code)

 

(212) 244-2333

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last report.)

 

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes     ý  No     o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes     ý  No     o

 

The number of common shares outstanding as of April 25, 2005 was 12,760,833.

 

 

THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES

 

INDEX

 

Part I.  FINANCIAL INFORMATION:
Item 1.  Financial Statements
Consolidated Balance Sheets March 31, 2005 and December 31, 2004
Consolidated Statements of Income Three Months Ended March 31, 2005 and 2004
Consolidated Statements of Stockholders’ Equity March 31, 2005 and 2004
Consolidated Statements of Comprehensive Income Three Months Ended March 31, 2005 and 2004
Consolidated Statements of Cash Flows Three Months Ended March 31, 2005 and 2004
Notes to Interim Consolidated Financial Statements
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
Item 4.  Controls and Procedures
Part II.  OTHER INFORMATION
Item 1.  Legal Proceedings
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.  Defaults Upon Senior Securities
Item 4.  Submissions of Matters to a Vote of Security Holders
Item 5.  Other Information
Item 6.  Exhibits
Signature
Index of Exhibits

 

2

 

Part 1. Financial Information

Item 1.    Financial Statements

 

THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

($ in thousands, except share data)

 

		March 31,			December 31,
		2005			2004
		(Unaudited)
ASSETS
Investments and cash:
Fixed maturities, available-for-sale, at fair value (amortized cost: 2005, $771,506; 2004, $713,049)		$	771,307		$	722,434
Equity securities, available-for-sale, at fair value (cost: 2005, $19,254; 2004, $19,101)		20,884			21,170
Short-term investments, at cost which approximates fair value		107,574			96,653
Cash		7,652			14,676
Total investments and cash		907,417			854,933
Premiums in course of collection		179,181			176,720
Commissions receivable		3,138			3,062
Prepaid reinsurance premiums		147,012			130,761
Reinsurance receivable on paid losses		18,861			20,955
Reinsurance receivable on unpaid losses and loss adjustment expenses		520,262			502,329
Net deferred income tax benefit		21,427			17,348
Deferred policy acquisition costs		35,935			23,882
Accrued investment income		7,341			7,303
Goodwill		5,241			5,282
Other assets		19,218			14,103
Total assets		$	1,865,033		$	1,756,678
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Reserves for losses and loss adjustment expenses		$	999,766		$	966,117
Unearned premium		326,571			270,970
Reinsurance balances payable		140,451			143,427
Federal income tax payable		9,270			5,614
Payable for securities purchased		2,695			3,027
Accounts payable and other liabilities		52,524			38,945
Total liabilities		1,531,277			1,428,100
Stockholders’ equity:
Preferred stock, $.10 par value, authorized 1,000,000 shares, none issued		—			—
Common stock, $.10 par value, 20,000,000 shares authorized; issued and outstanding: 12,759,958 for 2005 and 12,657,160 for 2004
		1,276			1,266
Additional paid-in capital		156,514			154,670
Retained earnings		173,036			163,337
Accumulated other comprehensive income		2,930			9,305
Total stockholders’ equity		333,756			328,578
Total liabilities and stockholders’ equity		$	1,865,033		$	1,756,678

 

See accompanying notes to interim consolidated financial statements.

 

3

 

THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

($ and shares in thousands, except net income per share)

 

		Three Months Ended
		March 31,
		2005			2004
		(Unaudited)
Gross written premium		$	216,996		$	195,951
Revenues:
Net written premium		$	117,090		$	95,935
(Increase) in unearned premium		(39,552		)	(21,760		)
Net earned premium		77,538			74,175
Commission income		1,270			1,127
Net investment income		7,622			5,902
Net realized capital gains		167			422
Other income		897			128
Total revenues		87,494			81,754
Operating expenses:
Net losses and loss adjustment expenses incurred		46,221			43,752
Commission expense		9,604			11,028
Other operating expenses		17,444			13,432
Total operating expenses		73,269			68,212
Income before income tax expense		14,225			13,542
Income tax expense (benefit):
Current		5,172			5,007
Deferred		(646		)	(378		)
Total income tax expense		4,526			4,629
Net income		$	9,699		$	8,913
Net income per common share:
Basic		$	0.77		$	0.71
Diluted		$	0.76		$	0.70
Average common shares outstanding:
Basic		12,677			12,554
Diluted		12,760			12,654

 

See accompanying notes to interim consolidated financial statements.

 

4

 

THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

($ in thousands)

 

		Three Months Ended March 31,
		2005			2004
		(Unaudited)
Preferred Stock
Balance at beginning and end of period		$	—		$	—
Common stock
Balance at beginning of year		$	1,266		$	1,254
Shares issued under stock plans		10			5
Balance at end of period		$	1,276		$	1,259
Additional paid-in capital
Balance at beginning of year		$	154,670		$	151,765
Effect of SFAS 123 for stock options		246			200
Shares issued under stock plans		1,598			1,069
Balance at end of period		$	156,514		$	153,034
Retained earnings
Balance at beginning of year		$	163,337		$	128,472
Net income		9,699			8,913
Balance at end of period		$	173,036		$	137,385
Accumulated other comprehensive income
Net unrealized gains (losses) on securities, net of tax
Balance at beginning of year		$	7,416		$	7,871
Change in period		(6,487		)	4,770
Balance at end of period		929			12,641
Cumulative translation adjustments, net of tax
Balance at beginning of year		1,889			666
Net adjustment for period		112			219
Balance at end of period		2,001			885
Balance at end of period		$	2,930		$	13,526
Total stockholders’ equity at end of period		$	333,756		$	305,204

 

See accompanying notes to interim consolidated financial statements.

 

5

 

THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

($ in thousands)

 

		Three Months Ended March 31,
		2005			2004
		(Unaudited)
Net income		$	9,699		$	8,913
Other comprehensive income (loss):
Change in net unrealized gains or (losses) on securities, net of tax expense (benefit) of $(3,493) and $2,568 in 2005 and 2004, respectively (1)		(6,487		)	4,770
Change in foreign currency translation gains, net of tax expense of $60 and $118 in 2005 and 2004, respectively		112			219
Other comprehensive income (loss)		(6,375		)	4,989
Comprehensive income		$	3,324		$	13,902
(1)   Disclosure of reclassification amount, net of tax:
Unrealized holding gains (losses) arising during period		$	(6,378	)	$	5,044
Less: reclassification adjustment for net gains included in net income		109			274
Change in net unrealized gains (losses) on securities		$	(6,487	)	$	4,770

 

See accompanying notes to interim consolidated financial statements.

 

6

 

THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

($ in thousands)

 

		Three Months Ended March 31,
		2005			2004
\		(Unaudited)
Operating activities:
Net income		$	9,699		$	8,913
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation & amortization		349			271
Net deferred income tax (benefit)		(646		)	(378		)
Net realized capital (gains)		(167		)	(422		)
Changes in assets and liabilities:
Reinsurance receivable on paid and unpaid losses and loss adjustment expenses		(15,839		)	(32,519		)
Reserve for losses and loss adjustment expenses		33,649			61,476
Prepaid reinsurance premiums		(16,251		)	(28,204		)
Unearned premium		55,601			51,206
Premiums in course of collection		(2,461		)	(57,125		)
Commissions receivable		(76		)	89
Deferred policy acquisition costs		(12,053		)	(9,734		)
Accrued investment income		(38		)	(482		)
Reinsurance balances payable		(2,976		)	29,402
Federal income tax		3,656			4,930
Other		12,743			(690		)
Net cash provided by operating activities		65,190			26,733
Investing activities:
Fixed maturities, available-for-sale
Redemptions and maturities		7,795			52,720
Sales		77,968			45,059
Purchases		(147,561		)	(131,950		)
Equity securities, available-for-sale
Sales		—			—
Purchases		(117		)	(6,785		)
Change in payable for securities		(332		)	(4,013		)
Net change in short-term investments		(10,921		)	15,818
Purchase of property and equipment		(145		)	(266		)
Net cash (used in) investing activities		(73,313		)	(29,417		)
Financing activities:
Proceeds of stock issued from Employee Stock Purchase Plan		212			215
Proceeds of stock issued from exercise of stock options		887			175
Net cash provided by financing activities		1,099			390
(Decrease) in cash		(7,024		)	(2,294		)
Cash at beginning of year		14,676			8,399
Cash at end of period		$	7,652		$	6,105
Supplemental disclosures of cash flow information:
Federal, state and local income tax paid		1,506			77
Issuance of stock to directors		123			60

 

See accompanying notes to interim consolidated financial statements.

 

7

 

THE NAVIGATORS GROUP, INC.  AND SUBSIDIARIES

 

Notes to Interim Consolidated Financial Statements

(Unaudited)

 

Note 1.  Accounting Policies

 

The interim consolidated financial statements are unaudited but reflect all adjustments which, in the opinion of management, are necessary to provide a fair statement of the results of The Navigators Group, Inc. and its subsidiaries for the interim periods presented on the basis of accounting principles generally accepted in the United States of America (“GAAP”).  All such adjustments are of a normal recurring nature.  All significant intercompany transactions and balances have been eliminated.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting periods.  The results of operations for any interim period are not necessarily indicative of results for the full year.  The terms “we”, “us”, “our” and “the Company” as used herein mean The Navigators Group, Inc. and its subsidiaries, unless the context otherwise requires.  These financial statements should be read in conjunction with the consolidated financial statements and notes contained in the Company’s 2004 Annual Report on Form 10-K.

 

Note 2.  Reinsurance Ceded

 

The Company’s ceded earned premiums were $83,464,000 and $73,379,000 for the three months ended March 31, 2005 and 2004, respectively.  The Company’s ceded incurred losses were $53,435,000 and $64,818,000 for the three months ended March 31, 2005 and 2004, respectively.

 

Note 3.  Segment Information

 

The Company’s subsidiaries are primarily engaged in the writing and management of property and casualty insurance.  The Company’s segments include the Insurance Companies, the Lloyd’s Operations and the Navigators Agencies, each of which is managed separately.  The Insurance Companies consist of Navigators Insurance Company, which includes a branch in the U.K. (the “U.K. Branch”), and NIC Insurance Company and are primarily engaged in underwriting marine insurance and related lines of business, contractors’ general liability insurance, and professional liability insurance.  The Lloyd’s Operations underwrite marine and related lines of business at Lloyd’s of London.  The Navigators Agencies are underwriting management companies which produce, manage and underwrite insurance and reinsurance for both affiliated and unaffiliated companies.  All segments are evaluated based on their GAAP results.

 

The Insurance Companies and the Lloyd’s Operations are measured by taking into account net premiums earned, incurred losses and loss adjustment expenses (“LAE”), commission expense and other underwriting expenses.  The Navigators Agencies’ results include commission income less other operating expenses.  Parent and other operations include inter-segment income and expense in the form of affiliated commissions, income and expense from corporate operations and consolidating adjustments.  Each segment also maintains its own investments, on which it earns income and realizes capital gains or losses.

 

8

 

Financial data by segment for the three months ended March 31, 2005 and 2004 was as follows:

 

		Three Months Ended March 31, 2005
		Insurance Companies			Lloyd’s Operations			Navigators Agencies			Parent & Other Operations (1)			Consolidated Total
		($ in thousands)
Gross written premium		$	129,288		$	87,830					$	(122	)	$	216,996
Net written premium		73,581			43,509						—			117,090
Revenues:
Net earned premium		47,363			30,175						—			77,538
Commission income		—			268			$	9,750		(8,748		)	1,270
Net investment income		6,855			749			2			16			7,622
Net realized capital gains (losses		266			(99		)	—			—			167
Other income (expense)		(2		)	628			271			—			897
Total revenues		54,482			31,721			10,023			(8,732		)	87,494
Operating expenses:
Net losses and LAE		28,842			17,379			—			—			46,221
Commission expense		12,586			4,881			—			(7,863		)	9,604
Other operating expenses		2,112			4,761			10,996			(425		)	17,444
Total operating expenses		43,540			27,021			10,996			(8,288		)	73,269
Income (loss) before income tax expense (benefit)		10,942			4,700			(973		)	(444		)	14,225
Income tax expense (benefit)		3,399			1,645			(362		)	(156		)	4,526
Net income (loss)		$	7,543		$	3,055		$	(611	)	$	(288	)	$	9,699
Identifiable assets (2)		$	1,339,245		$	579,464		$	16,192		$	11,915		$	1,865,033
Loss and LAE ratio		60.9		%	57.6		%							59.6		%
Commission expense ratio		26.6		%	16.2		%							22.5		%
Other operating expense ratio		4.5		%	15.8		%							8.9		%
Combined ratio		92.0		%	89.6		%							91.0		%

 

(1) Includes inter-segment eliminations.

(2) Does not cross-foot due to inter-segment eliminations.

 

9

 

		Three Months Ended March 31, 2004
		Insurance Companies			Lloyd’s Operations			Navigators Agencies			Parent & Other Operations (1)			Consolidated Total
		($ in thousands)
Gross written premium		$	111,829		$	87,158					$	(3,036	)	$	195,951
Net written premium		54,145			41,790						—			95,935
Revenues:
Net earned premium		53,182			20,993						—			74,175
Commission income		—			62			$	7,932		(6,867		)	1,127
Net investment income		5,484			404			3			11			5,902
Net realized capital gains		205			217			—			—			422
Other income (expense)		(61		)	4			185			—			128
Total revenues		58,810			21,680			8,120			(6,856		)	81,754
Operating expenses:
Net losses and LAE		32,710			11,042			—			—			43,752
Commission expense		14,145			3,750			—			(6,867		)	11,028
Other operating expenses		1,198			3,036			8,605			593			13,432
Total operating expenses		48,053			17,828			8,605			(6,274		)	68,212
Income (loss) before income tax expense (benefit)		10,757			3,852			(485		)	(582		)	13,542
Income tax expense (benefit)		3,478			1,348			(140		)	(57		)	4,629
Net income (loss)		$	7,279		$	2,504		$	(345	)	$	(525	)	$	8,913
Identifiable assets (2)		$	1,114,640		$	447,860		$	16,876		$	32,514		$	1,535,348
Loss and LAE ratio		61.5		%	52.6		%							59.0		%
Commission expense ratio		26.6		%	17.9		%							24.1		%
Other operating expense ratio		2.3		%	14.4		%							5.7		%
Combined ratio		90.4		%	84.9		%							88.8		%

 

(1) Includes inter-segment eliminations.

(2) Does not cross-foot due to inter-segment eliminations.

 

10

 

The Insurance Companies’ net earned premium includes $7,028,000 and $7,425,000 of net earned premium from the U.K. Branch for the three months ended March 31, 2005 and 2004, respectively.

 

Note 4.  Comprehensive Income

 

Comprehensive income encompasses net income, net unrealized capital gains and losses on available for sale securities, and foreign currency translation adjustments.  Please refer to the ‘Consolidated Statements of Stockholders’ Equity’ and the ‘Consolidated Statements of Comprehensive Income’, included herein, for the components of accumulated other comprehensive income and of comprehensive income, respectively.

 

Note 5.  Stock-Based Compensation

 

Stock based compensation is expensed as the awards vest and included in other operating expenses for the periods indicated.  The amount charged to expense for stock grants was $378,000 and $362,000 for the three months ended March 31, 2005 and 2004, respectively.  The amount charged to expense for stock options was $246,000 and $200,000 for the three months ended March 31, 2005 and 2004, respectively.  Stock appreciation rights resulted in expense of $75,000 for the three months ended March 31, 2005 and income of $329,000 for the three months ended March 31, 2004.

 

In addition, $35,000 and $30,000 were expensed for the three months ended March 31, 2005 and 2004, respectively, for stock issued annually to non-employee directors as part of their directors’ compensation for serving on the Company’s Board of Directors.

 

Note 6.  Application of New Accounting Standards

 

In September 2004, the FASB approved issuing a Staff Position to delay the requirement to record impairment losses under Emerging Issues Task Force Issue No. 03-1 (“EITF 03-1”).  The approved delay applies to certain provisions relating to the recognition of other than temporary impairments for all securities within the scope of EITF 03-1 and is expected to end when new guidance is issued and becomes effective.  The Company will review the new guidance when it becomes available.

 

In December 2004, the FASB issued SFAS 123 (revised 2004), Share Based Payment, which is a revision of SFAS 123, Accounting for Stock-Based Compensation, eliminating the alternative use of APB 25.  SFAS 123 (revised 2004) has no effect on the Company’s results of operations or financial condition since the Company adopted the fair value recognition provisions of SFAS 123 in 2003.

 

Note 7.  Lloyd’s Syndicate

 

We record our pro rata share of Lloyd’s Syndicate 1221’s 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 transaction is recorded in the fourth quarter as additional written and earned premium, losses incurred, loss reserves and receivables, all in the same amount.  No gain or loss is recorded on the reinsurance to close transaction.

 

11

 

Our Lloyd’s Syndicate 1221’s stamp capacity is £135.0 million ($255.3 million) in 2005 compared to £150.0 million ($275.0 million) in 2004.  Stamp capacity is a measure of the amount of premium a Lloyd’s syndicate is authorized to write based on a business plan approved by the Council of Lloyd’s.  Syndicate 1221’s capacity is expressed net of commission (as is standard at Lloyd’s) of approximately 21%.  The Syndicate 1221 premium recorded in the Company’s financial statements is gross of commission.  The Company participates for 97.5% and 97.4% of Syndicate 1221’s capacity for the 2005 and 2004 underwriting years, respectively.  The Lloyd’s operations included in the consolidated financial statements represent the Company’s participation in Syndicate 1221.

 

The Company provides letters of credit to Lloyd’s to support its Syndicate 1221 capacity.  If the Company increases its participation or if Lloyd’s changes the capital requirements, the Company may be required to supply additional letters of credit or other collateral acceptable to Lloyd’s, or reduce the capacity of Syndicate 1221.  The letters of credit are provided through the credit facility which the Company maintains with a consortium of banks.  The credit facility agreement requires that the banks vote whether or not to renew the letter of credit portion of the facility periodically.  If the banks decide not to renew the letter of credit facility, the Company will need to find other sources to provide the letters of credit or other collateral in order to continue to participate in Syndicate 1221.  The renewal amendment executed in January 2005 renewed the letter of credit facility until June 30, 2007.  The bank facility is collateralized by all of the common stock of Navigators Insurance Company.

 

Note 8.  Income Tax - Valuation Allowance

 

The Company had state and local operating loss carryforwards amounting to potential future tax benefits of $5,409,000 and $4,493,000 at March 31, 2005 and December 31, 2004, respectively.  A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization.

 

Note 9.  Commitments and Contingencies

 

The Company is not a party to, or the subject of, any material pending legal proceedings which depart from the ordinary routine litigation incident to the kinds of business it conducts.

 

The Company was recently informed by a lead reinsurer participating on excess of loss reinsurance agreements that it may formally dispute a loss payment recovery when billed.  The recovery is for the 2004 settlement of a class action suit involving a large asbestos claim which settlement will be paid over seven years starting in June 2005.  The reinsurer has not indicated any dispute with respect to recoveries on related pro rata reinsurance agreements.

 

The Company believes such a dispute, if it should arise, is without merit and intends to vigorously pursue collection of its reinsurance recoveries.  While it is too early to predict with any certainty the outcome of this matter, the Company believes that the ultimate outcome of this matter would not be expected to have a significant adverse effect on results of operations, financial condition or liquidity, although an unexpected adverse resolution could have a material adverse effect on the Company’s results of operations in a particular fiscal quarter or year.

 

Item 2.                       Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Note on Forward-Looking Statements

 

Some of the statements in this Quarterly Report on Form 10-Q are ‘‘forward-looking statements’’ as defined in the Private Securities Litigation Reform Act of 1995.   Whenever used in this report, the words “estimate”, “expect”, “believe” or similar expressions are intended to identify such forward-looking statements.  Forward-looking statements are derived from information that we currently have and assumptions that we make.

 

12

 

We cannot assure that anticipated results will be achieved, since results may differ materially because of both known and unknown risks and uncertainties which we face. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Factors that could cause actual results to differ materially from our forward-looking statements include, but are not limited to:

 

•                  the effects of domestic and foreign economic conditions, and conditions which affect the market for property and casualty insurance;

 

•                  changes in the laws, rules and regulations which apply to our insurance companies;

 

•                  the effects of emerging claim and coverage issues on our business, including adverse judicial or regulatory decisions and rulings;

 

•                  the effects of competition from banks, other insurers and the trend toward self-insurance;

 

•                  risks that we face in entering new markets and diversifying the products and services we offer;

 

•                  unexpected turnover of our professional staff;

 

•                  changing legal and social trends and inherent uncertainties in the loss estimation process that can adversely impact the adequacy of loss reserves and the allowance for reinsurance recoverables, including our estimates relating to ultimate asbestos and environmental liabilities and related reinsurance recoverables;

 

•                  risks inherent with the collection of reinsurance recoverable amounts from our reinsurers over many years into the future based on their financial ability and intent to meet such obligations to the Company;

 

•                  risks associated with our continuing ability to obtain reinsurance covering our exposures at appropriate prices and/or in sufficient amounts and the related recoverability of our reinsured losses;

 

•                  weather-related events and other catastrophes (including acts of terrorism) impacting our insureds and/or reinsurers;

 

•                  our ability to attain adequate prices, obtain new business and to retain existing business consistent with our expectations;

 

•                  the possibility of downgrades in our claims-paying and financial strength ratings significantly adversely affecting us, including reducing the number of insurance policies we write generally, or causing clients who require an insurer with a certain rating level to use higher-rated insurers;

 

•                  the inability of our internal control framework to provide absolute assurance that all incidents of fraud or unintended material errors will be detected and prevented;

 

•                  the risk that our investment portfolio suffers reduced returns or investment losses which could reduce our profitability; and

 

•                  other risks that we identify in future filings with the Securities and Exchange Commission (the “SEC”).

 

In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this Form 10-Q may not occur. You are cautioned not to place undue reliance on any forward-looking statements, which speak only as of their respective dates.

 

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The discussion and analysis of our financial condition and results of operations contained herein should be read in conjunction with our consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-Q. It contains forward-looking statements that involve risks and uncertainties. Please see ‘‘Note on Forward-Looking Statements’’ for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-Q.

 

Overview

 

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 (the “U.K. 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 Navigators Underwriting Agency Ltd. (“NUAL”), a Lloyd’s of London (“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.

 

While management takes into consideration a wide range of factors in planning the Company’s business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how the Company is 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 managing 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.  Our insurance company subsidiaries’ operations and ability to grow their business and take advantage of market opportunities are particularly constrained by regulatory capital requirements and rating agency assessments of capital adequacy.

 

Although not a financial measure, 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 coverage 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 (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.

 

Our revenue is primarily comprised of premiums, commission and investment income. Our insurance company subsidiaries derive their premiums primarily from business written by the Navigators Agencies. The Lloyd’s Operations derive their premiums from business written by NUAL. The Navigators Agencies and NUAL

 

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receive commissions and, in some cases, profit commissions and service fees on the business produced on behalf of our insurance company subsidiaries and others.

 

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 in 2004 and into 2005.  Specialty liability losses, particularly for our California construction liability business, 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 for the California construction liability business have started to level off in 2005 after rate increases in 2004 and 2003.  In the professional liability market, the enactment of the Sarbanes-Oxley Act of 2002, together with recent financial and accounting scandals at publicly traded corporations and increased frequency of securities-related class action litigation, has lead 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.  The professional liability business experienced single digit premium rate decreases in 2004 and level rates in the 2005 first quarter.

 

Our business is cyclical and influenced by many factors.  These factors include price competition, economic conditions, interest rates, natural or man-made disasters (for example hurricanes and terrorism), state regulations, court decisions and changes in the law. Additionally, because our insurance products must be priced, and premiums charged, before costs have fully developed, our liabilities are required to be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, we cannot assure you that our actual liabilities will not exceed our recorded amounts.

 

Industry Investigations

 

The insurance industry has become the subject of increasing scrutiny with respect to insurance broker and agent compensation arrangements, and certain sales practices.  The New York State Attorney General and other state and federal regulators have commenced investigations and other proceedings relating to the payment of contingent commissions by insurance companies to insurance brokers and agents and the extent to which such compensation has been disclosed, and the solicitation and provision of fictitious or inflated quotes.  These investigations and proceedings are expected to continue, and new investigative proceedings may be commenced, in the future.  These investigations and proceedings could result in legal precedents and new industry-wide practices or legislation, rules or regulations that could significantly affect our industry and may also cause stock price volatility for companies in the insurance industry.

 

The Company has completed its own internal review with respect to such contingent commission arrangements and the anti-competitive sales practices discussed above.  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 industry investigations 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.

 

Largely as a result of these industry investigations, contingent commission and other commission practice standards are currently evolving.  For example, in December 2004 the National Association of Insurance Commissioners adopted an amendment to its Producer Licensing Model Act with respect to producer compensation disclosure obligations, and is considering further amendments to this Model Act.  The Company is supportive of industry efforts to encourage transparency in the disclosure of contingent commissions paid to brokers by insurers and does not expect to be adversely impacted by legislative developments in this area.

 

The reinsurance industry has also become the subject of increasing scrutiny with respect to the alleged improper use of reinsurance agreements to manipulate financial reporting results.  The New York State Attorney General and other state and federal regulators have commenced investigations and other proceedings

 

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related to reinsurance agreements in which the insurance risk transferred between the ceding company and reinsurer may have been insufficient to properly account for such transactions as reinsurance in financial statements filed with insurance regulatory authorities and the SEC.  Such transactions may include separate or “side” agreements that reduce, limit or mitigate the indemnification against loss or liability relating to the insurance risk transferred to the reinsurer in a reinsurance agreement.

 

As a result of these industry investigations, accounting and reporting requirements for reinsurance transactions, including risk transfer guidance used to determine when sufficient insurance risk has been transferred by the ceding company to properly account for such transactions as reinsurance, may change.

 

The Company believes that all of its reinsurance transactions meet the risk transfer requirements to be accounted for as prospective reinsurance in its financial statements, and has no separate side agreements that would limit the insurance risk transferred to the reinsurer under its reinsurance agreements.  The Company is unable to determine the reinsurance industry financial reporting changes that could occur resulting from such investigations and the effects, if any, on its financial reporting of reinsurance transactions.

 

Critical Accounting Policies

 

It is important to understand our accounting policies in order to understand our 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 reporting period. 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.

 

Our most critical accounting policies involve the reporting of the reserves for losses and loss adjustment expenses (“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.

 

Reserves for Losses and LAE.  Reserves for losses and LAE represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, judicial theories of liability and other third party factors which are often beyond our control. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may be different from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results.

 

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.

 

Written and Unearned Premium. Written premium is recorded based on the insurance policies that have been reported to us and the policies that have been written by agents but not yet reported to us. We must estimate the amount of written premium not yet reported based on judgments relative to current and historical trends of the business being written. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. An unearned premium reserve is established to reflect the unexpired portion of each policy at the financial reporting date.

 

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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.

 

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.

 

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 U.S. GAAP. The most significant GAAP adjustments relate to income recognition. Lloyd’s syndicates determine underwriting results by year of account at the end of three years. We record adjustments to recognize underwriting results as incurred, including the expected ultimate cost of losses incurred. These adjustments to losses are based on actuarial analysis of syndicate accounts, including forecasts of expected ultimate losses provided by the syndicate. At the end of the Lloyd’s three-year period for determining underwriting results for an account year, the syndicate will close the account year by reinsuring outstanding claims on that account year with the participants for the account’s next underwriting year. The amount to close an underwriting year into the next year is referred to as the reinsurance to close (“RITC”).  The RITC transaction is recorded in the fourth quarter as additional written and earned premium, losses incurred, loss reserves and receivables, all in the same amount. There are no gains or losses recorded on the RITC.

 

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.

 

Results of Operations and Overview

 

The following is a discussion and analysis of our consolidated and segment results of operations for the three months ended March 31, 2005 and 2004.  All earnings per share data is presented on a per diluted share basis.

 

Our 2005 and 2004 first quarters’ overall results of operations reflect improved market conditions beginning in late 2000 through 2003 that continued at a reduced rate through 2004 and are showing signs of softening in 2005.  Net income for the three months ended March 31, 2005 and 2004 was $9.7 million or $0.76 per share and $8.9 million or $0.70 per share, respectively.

 

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We experienced premium growth as measured by net earned premium in the first quarter of 2005 of $77.5 million compared to $74.2 million in the first quarter of 2004, a 4.5% increase.  The Company’s combined ratio, which is a measure of underwriting profitability, for the first quarter of 2005 was 91.0% compared to 88.8% for the first quarter of 2004.

 

Cash flow from operations increased in the first quarter of 2005 to $65.2 million from $26.7 million in the first quarter of 2004, a 144.2% increase, contributing to the growth in invested assets and net investment income.  Included in the 2005 first quarter cash flow is approximately $24 million attributable to the settlement of the RITC premium recorded by Lloyd’s Syndicate 1221 in the 2004 fourth quarter representing the transfer of assets and liabilities from the participants of the 2002 underwriting year to the participants of the 2003 underwriting year.  We had increased our participation in Syndicate 1221 to 97.4% for the 2003 underwriting year from 68.1% for the 2002 underwriting year.  Approximately 70% of the RITC settlement has been recorded as interest-earning funds withheld for reinsurers of the syndicate or will be distributed to third party participants of the 2002 year of account.

 

Consolidated stockholders’ equity increased 1.6% to $333.8 million or $26.16 per share at March 31, 2005 compared to $328.6 million or $25.96 per share at December 31, 2004.  The increase was primarily due to net income of $9.7 million for the first quarter of 2005, partially offset by a $6.4 million other comprehensive loss consisting of $6.5 million of decreases in unrealized gains on securities, resulting from higher interest rates, and $0.1 million increase in currency translation gains.  Other comprehensive income (loss) consists of the change in both after-tax unrealized gains and losses on investments and after-tax currency translation gains on the Company’s foreign operations.

 

Revenues.  Gross written premium increased to $217.0 million in the first quarter of 2005, from $196.0 million in the first quarter of 2004, a 10.7% increase for the three months.  The growth in gross written premium reflects a combination of business expansion in both new and existing lines of business coupled with premium rate changes on renewal policies.  The premium rate increases or decreases noted below for marine, specialty and professional liability are calculated primarily by comparing premium amounts on policies that have renewed.  The premiums are judgmentally adjusted for exposure factors when deemed significant and sometimes represent an aggregation of several lines of business.  The rate changes calculations provide an indicated pricing trend and are not meant to be a precise analysis of the numerous factors that affect premium rates or the adequacy of such rates to cover all underwriting costs and generate an underwriting profit.  The calculation can also be affected quarter by quarter depending on the particular policies and the number of policies that renew during that period.  Due to market conditions, these rate changes may or may not apply to new business which may be more competitively priced compared to renewal business.  The following table sets forth our gross and net written premium and net earned premium by segment and line of business for the periods indicated:

 

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		Three Months Ended March 31,
		2005													2004
		Gross Written Premium				%		Net Written Premium			Net Earned Premium				Gross Written Premium			%		Net Written Premium			Net Earned Premium
		($ in thousands)
Insurance Companies:
Marine		$		68,284		31.5	%	$	30,347		$		19,879		$	59,426		30.3	%	$	25,258		$		20,428
Specialty		42,949				19.8	%	36,398			20,022				34,230			17.5	%	20,511			21,539
Professional Liability		17,930				8.2	%	6,679			6,717				15,033			7.7	%	5,473			3,811
Assumed from Lloyd’s		125				0.1	%	126			711				3,054			1.6	%	2,906			7,405
Other (includes run-off)		—				0.0	%	31			34				86			0.0	%	(3		)	(1			)
Insurance Companies Total		129,288				59.6	%	73,581			47,363				111,829			57.1	%	54,145			53,182
Lloyd’s Operations:
Marine		73,931				34.1	%	40,060			29,627				79,316			40.5	%	39,059			20,518
Other		13,899				6.4	%	3,449			548				7,842			4.0	%	2,731			475
Lloyd’s Operations Total		87,830				40.5	%	43,509			30,175				87,158			44.5	%	41,790			20,993
Intercompany elimination		(122			)	-0.1	%	—			—				(3,036		)	-1.6	%	—			—
Total		$	216,996			100.0	%	$	117,090		$	77,538			$	195,951		100.0	%	$	95,935		$	74,175

 

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