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Executives

Stanley A. Galanski - Chief Executive Officer, Director, Member of Underwriting Advisory Committee and Chairman of Navigators Insurance Company

Ciro M. DeFalco - Chief Financial Officer, Senior Vice President and Member of Enterprise Risk Management Steering Committee

Analysts

Max Zormelo - Evercore Partners Inc., Research Division

Jason Oetting - FBR Capital Markets & Co., Research Division

Amit Kumar - Macquarie Research

Robert Paun - Sidoti & Company, LLC

Navigators Group (NAVG) Q1 2013 Earnings Call May 3, 2013 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Navigators Group First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

We remind everyone that today's call includes forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements concern future business conditions, expectations and the outlook for the company based on current available information that involves risks and uncertainties. The company's actual results could differ materially from those anticipated in the forward-looking statements.

We refer you to the company's most recent forms 10-K and 10-Q for a description of the important factors that may affect the company's business. The forward-looking statements made on this call and any transcript of this call are only made as of this date, and the company undertakes no obligation to publicly update the forward-looking statements to reflect subsequent events or circumstances except as required by law.

I will now turn the call over to your host, Stan Galanski, President and Chief Executive Officer; and Ciro DeFalco, Chief Financial Officer. You may begin your conference.

Stanley A. Galanski

Thank you very much. This is Stan Galanski, and thank you for joining us for this morning's call.

Yesterday afternoon, we announced net income of $13.9 million for the first quarter of 2013, up 76% from $7.9 million for the first quarter of 2012. An improving competitive environment characterized by single-digit renewal rate increases for most of our specialty product lines, gross written premium increased by 14.6% over the first quarter of 2012 led by our property casualty segment, which was up 40% for the insurance company.

Net written premium was up nearly 11%, a slightly lower growth rate than gross written premium largely due to the mix of business in the quarter. The combined ratio was 97.9% for the first quarter of 2013, a 2-point improvement from first quarter of 2012 with the improvement coming from our expense ratio, which was 33% for the quarter, our lowest quarterly expense ratio since fourth quarter 2011.

Our Lloyd’s unit had another solid quarter with the combined ratio of 91.6%. Our insurance company business had a combined ratio of 99.9% for the quarter, which is importantly trending in the right direction with the smallest combined ratio since the third quarter of 2011. Book value per share was $63.46, up 1.4% from year-end.

Turning to our business unit performance. Our global Marine business generated $104.5 million of gross written premium, and was profitable, with a combined ratio of 96.1% compared to 108.9% in the first quarter of 2012, which concluded the Costa Concordia loss.

Gross written premium was down 15% for the quarter. The largest factor impacting our premium volume in Marine was our decision to reduce our participation on the reinsurance program for the International Group of P&I clubs, which renewed in February.

While the attachment point of that reinsurance program increased to $70 million, we were one of a handful of existing participants that opted to either reduce or terminate participation on the program in response to a relatively modest increase in pricing and an influx of new capacity on the program.

Separately, we continue to push for above-market rate increases on Bluewater Hull business, both in London and in the U.S. And as a result, our premium volume for Hull was down compared to the first quarter of 2012.

Finally, with regard to the Deepwater Horizon loss in late 2009, you may have read of an appellate court ruling in March that allows BP to access Transocean's liability insurance program despite all hold harmless agreements contained in the contract. Back in the first quarter of 2010, we made the decision to fully reserve all of our exposure to Deepwater Horizon, for both the physical damage and energy liability coverage provided to the various interests involved with the platform, despite the apparent contractual limitation of liability. As a result, this court decision has no impact on our quarter as we had previously been fully reserved.

Last month, Colin Sprott joined Navigators to lead our Global Marine practice based in London. Colin is no stranger to our Marine underwriters and is working closely with the Marine leadership team in London and the U.S. in strategies to foster profitable growth in what is our most long-standing area of specialization.

We're a recognized leader in Marine and Energy Liability in both London and the U.S., and we're a market leader in Cargo and Specie in London. One of for Marine opportunities is to increase our cargo portfolio in the U.S.

Turning to our Property Casualty business, NavTech, our first-party energy, engineering and power generation unit, had a very solid quarter with a combined ratio of 53.6% and gross written premium growth of 22%. Net written premium was actually down for the quarter, resulting from a large quota share that we put in place beginning in January 2012 to reduce the potential volatility associated with the Offshore Energy business.

The Offshore Energy market remains very competitive with ample capacity for most risks. As result, Offshore Energy pricing was pretty much flat for the quarter. However, available premium to the industry is increasing as result of both increases in insured values and increased exploration and production activity globally.

Downstream Energy and Operational Engineering business experienced mid-single digit rate increases, reflecting ongoing industry loss activity in these classes, most of which we've avoided. We continue to experience favorable loss emergence in NavTech and benefited from several reserve reductions on existing claims.

Navigators Re generated $92 million of gross written premium for the quarter, up 25% from the first quarter of 2012, and generated a modest underwriting profit. We experienced strong growth in our Accident and Health and Latin American treaty reinsurance business. Property insurance premium was down slightly for the quarter, reflecting the reduction of our quota share block as terms in the market were surprisingly competitive, evidenced by new multi-year placements with what, in our view, were incredibly thin margins and significant profit sharing requirements.

Our excess of loss profit book [ph] remained at a stable premium level, with rates generally improved in the range of 10% to 30%. Navigator's Specialty, our E&S unit, had a terrific quarter, with gross written premium up 56% and a combined ratio of 89.3%.

We are benefiting from both rate increases as well as from exposure increases reflecting increased payrolls for construction-related risks and increasing sales figures for manufacturing accounts. We are also the beneficiary of re-underwriting of both Primary and Excess business by a number of our competitors for reacting to poor loss experience, stemming from underpriced business written over the last 4 or 5 years.

Navigators Specialty is a dedicated channel for U.S. wholesale brokers. Earlier this week, we announced the addition of a Professional Liability product line to that unit, focusing on Miscellaneous Professional Liability in certain specific professional segments. And we promoted Henry Lopez, who's been running our central and western state field operations to lead that unit. That announcement has been enthusiastically received by our wholesale brokers.

Turning to Management and Professional Liability, the financial results for the quarter were disappointing and we continue to gain confidence that our profit improvement strategies for the U.S. D&O business are working.

First, looking at D&O, we strengthened reserves for our U.S. business by $3.5 million in response to 3 claims from the 2010 underwriting year. While the amount of that the strengthening was modest, given the relatively small net earned premium for the quarter, it resulted in an underwriting loss. We remain very encouraged by loss emergence patterns for the 2011 and 2012 underwriting years, which reflect revised underwriting strategies put in place beginning in 2009.

Our international D&O business underwritten in London and Scandinavia continues to grow and perform very well. That business remains quite competitive with renewal rates down slightly for the quarter at acceptable technical rating levels. We remain committed to this product line globally and expect improved performance in the U.S. portfolio.

During the first quarter, we made a number of changes to our U.S. Professional Liability insurance business. First, we made the decision to exit the small law firm Professional Liability business and are working to ensure an orderly transition of that portfolio to a new carrier.

Second, we made the decision to focus our Miscellaneous Professional Liability business through the wholesale distribution channel, moving the management accountability for the product in Navigators Specialty as I referenced a few minutes ago. This led to the departure of 5 members of our U.S. Professional Liability underwriting team. As you may recall, while this business has grown over the past 4 years, it's failed to achieve an underwriting profit during that time and we believe these actions will lead to improved performance over the next 12 months.

Third, we reaffirmed our commitment to the design professional, Architects & Engineers Professional Liability product, which has performed reasonably well since we entered that space 3 years ago. Our focus in Professional Liability is no different than it is on our other product lines, which is to achieve a consistent underwriting profit. And we view these 3 steps as important milestones on the road to that objective.

Our international Professional Liability business was up slightly for the quarter but fell short of underwriting profit, and rates for international E&O were down about 1 point for the quarter.

Finally, I would like to comment on a changing competitive climate in which we operate. Over the last week or so, much has been written and said about Berkshire Hathaway's recent sidecar or portfolio arrangement with Aon for a slice of their Lloyd's business, as well as recent executive movement among several insurers. In anticipation of your question, I wanted to share our perspective.

As an underwriting-driven organization, we elect to compete based on the quality of our intellectual capital with the belief that our expert underwriters with strong, long-term relationships, will outselect the market over the intermediate to long term. So for us, broker-managed coverholder arrangements are inconsistent with that objective and our experience is that such arrangements have generally not been sustainable over time.

However, the willingness of a high-quality professional reinsurer to enter into such an arrangement can be viewed as a very bullish perspective on near-term market conditions of an informed and savvy player. At the same time, several of our competitors are either engaged in an M&A process or are working through the integration of a recent acquisition. Those type of situations create instability. We seek to capitalize on that instability by providing agents and brokers with consistent and reliable expert underwriters who have the authority to make decisions at the local level, and who are externally focused on their business rather than distracted by internal political matters.

While specific competitors and their approaches will change, we believe Navigators is well-positioned in our chosen specialty niches, to weather short-term competitive challenges are providing long-term stable capacity, expert underwriting and fair claim service to our policyholders.

And with that, I'll turn the call over to Ciro for a review of our financial performance.

Ciro M. DeFalco

Good morning, everyone, and thanks, Stan. Our first quarter net income of $13.9 million or $0.97 per diluted share reported yesterday after the market close includes net operating income of $10.8 million or $0.75 per share and net realized gains of $3.1 million after tax or $0.22 per share.

First quarter's combined ratio of 97.9% includes a reported loss in LAE ratio of 64.9% and an all-in expense ratio of 33% split between net commissions of 13.1% and other operating expenses of 19.9%.

The quarterly consolidated results includes $4.4 million of underwriting results -- underwriting profits, I apologize, with the $4 million of that coming from our Lloyd's syndicate.

Net investment income of $13.7 million remained flat in the quarter and up $2.4 million compared to the same period last year, primarily due to a decrease in current year investment expenses.

Net realized gains were $4.8 million pretax or $3.1 million after tax. These realized gains were primarily from the sale of select CMBS securities and certain equity securities.

Our portfolio's unrealized gain position decreased $1.8 million in the quarter, with $7.1 million of losses from fixed income securities offset by $5.3 million of gains on equities. The investment portfolio value at March 31, 2013, remained flat at $2.4 billion with an annualized book yield of 2.33%, which compares to 2.02% for the same period last year and 2.32% for the fourth quarter of 2012.

Market yield on yield-to-worst basis at the end of the first quarter was 1.71% versus 2.12% for the same period last year. However, it was up from 1.50% in the fourth quarter of 2012. Annualized total return for the portfolio was 2.7%, up from 1.09% in the fourth of 2012 but down from 4.88% for the same period last year, with the year-over-year change coming from a swing in unrealized.

Our conservative investment portfolio has maintained its AA average credit quality rating with a slightly longer duration of 4 years as compared to the 3.7 years for the same period last year. This increase in duration comes from the purchase of longer dated visible bonds during the quarter.

Our stockholders' equity at March 31, 2013, was $896 million -- $896.8 million, up from $879.5 million at year end and $818.2 million at March 31, 2012. Book value per share increased by $0.85 in the quarter to $63.46, or an increase of 1.4% with net income contributing $0.99 per share offset by net unrealized investment losses of $0.13 per share. On a year-over-year basis, book value per share has increased by $5.2 or 8.6%. Finally, net cash flow from operations was a positive $4.3 million for the quarter.

With that, we can now open the call for your questions. Thanks.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Max Zormelo with Evercore Partners.

Max Zormelo - Evercore Partners Inc., Research Division

I just have a couple of questions. The first one was about the investment income. I noticed the yield loss, roughly flat sequentially. I know Ciro just mentioned that, that's because of lower investment expenses. I wanted to know what -- if you can quantify that for me. And then secondly, I noticed the duration went up quite a bit to 4 years. Are you changing the philosophy of the investment or is that just a temporary bump up given the risk of writing rate?

Ciro M. DeFalco

Okay. I'll take the first part of the question first, and that is the investment expenses last year included $4.5 million, the first quarter of the Equitas settlement, and that's the number that's driving the difference. Okay? So the absence of that in the current year. Regarding our philosophy, no. There's been no fundamental change in our strategy. However, we had an opportunity to purchase some municipal bonds that had attractive yields and they had -- and where they were on the curve was in the 5- to 8-year period on the maturity timeline, and that's the only reason. So it's not a fundamental shift. I would consider it just a -- I would call it a probably a momentary shift in where it is, but not fundamentally attached to any strategy shift.

Max Zormelo - Evercore Partners Inc., Research Division

Okay, that's helpful. Second one was on the -- I didn't know when -- if you could remind me, when do you do your reinsurance purchasing? Is it in the first quarter or is it April 1?

Stanley A. Galanski

Both. Our Marine reinsurance program renews January 1 and our excess casualty, would be our largest Property Casualty program per se, renews April 1.

Max Zormelo - Evercore Partners Inc., Research Division

Okay. Any cost saves from that this year?

Ciro M. DeFalco

Was your question in cost increase?

Max Zormelo - Evercore Partners Inc., Research Division

No, no, no, cost saves. Any savings from that?

Stanley A. Galanski

No. Nothing material to talk about. We increased our net retention slightly on our Marine, not our Energy business. On a lower layer on the Marine program where the real impact, when you look at the impact of the reinsurance reinstatement premiums, is just trading dollars. So that keeps a little bit more net written premium on Marine sticking to our bones as opposed to being ceded, but it's kind of a wash in the net financial outcome. And no significant changes on the other tree.

Max Zormelo - Evercore Partners Inc., Research Division

Okay. Then I wanted you to dig a little bit more into what you said about U.S. -- the Professional Liability business, exiting the small law firms business. What is the size of that? And secondly, if you are to exit, would you still have to keep the reserves on your books?

Stanley A. Galanski

Yes, you sure do. It's about a $20 million portfolio for us and as I say, we just thought it didn't make sense. We've worked very closely with the MGA who has handled that portfolio for us to improve the profit over the years and our view is, it's just not a good long-term bet. That over the course of a cycle, there are probably more efficient ways to deploy capital, and we'll work to transition that.

Max Zormelo - Evercore Partners Inc., Research Division

Okay. And then, so no change on the philosophy on the share repurchases, you're still not buying back any this year, correct?

Ciro M. DeFalco

As of this moment, we have no intention of repurchasing shares, that's correct.

Operator

[Operator Instructions] Our next question comes from Randy Binner with FBR Capital Markets.

Jason Oetting - FBR Capital Markets & Co., Research Division

[

This is Jason Oetting calling on behalf of Randy this morning. My first question is on the $4.1 million of unfavorable development. Can we get a bit more color there? Maybe if you could just talk about what specific business line this is coming from and what accident years these are relating to?

Ciro M. DeFalco

Okay, I could give you a little snapshot. It's a split, it's a net $4.1 million. The strengthening is largely Professional Liability and it's mostly in the U.S. insurance company. So it's prior underwriting years, it's 2010 and prior for Professional Liability. And there was some prior-year underwriting releases from the syndicate, our Lloyd's syndicate, that net 1.

Jason Oetting - FBR Capital Markets & Co., Research Division

Okay, that's helpful. And then obviously, you had a bit of improvement in the expense ratio this quarter. Maybe could you just talk a little bit about what you thought was driving that result? And now granted, these numbers bounce around a little bit from quarter to quarter, but do you think that's sustainable? Should we kind of look for a bit of improvement going forward?

Stanley A. Galanski

Well, yes, I think that's right. I think from our perspective, if you look at our expense ratio on a quarter-to-quarter basis over the last, let's just say, 2 years to maybe 10 quarters, there's been a fair amount of volatility and it's largely due to the impact of reinsurance, reinstatement premiums on large Marine or Energy loss. And as I mentioned earlier in the call, when we put a quota share in on our global offshore energy business, the real rationale behind that was to kind of reduce some of that volatility. And then secondly, going forward, increasing our retention to avoid trading those dollars on a -- on really the lowest layer of our Marine excess of loss reinsurance program. Again, take some of that volatility associated with the RPPs out. Because at the end of the day, we did hit those layers with losses and you very may well continue to. And if you don't, expect us to keep the business anyhow. So I think that is helpful, the expense ratio, and those should be sustainable.

Jason Oetting - FBR Capital Markets & Co., Research Division

Okay, very good. And then turning to the U.S. D&O, I believe that there was a bit of optimism there, somebody said improved performance. Can you just talk about the -- what sort of pricing you've been getting and pricing outlook, as well as annual reserve dynamics?

Stanley A. Galanski

Yes, the pricing looks pretty good on the U.S. D&O. I think on Primary business, of course, which we have significantly shrunk our Primary portfolio, where well over 85% of our portfolio is excess and reasonably high excess for small accounts. I mean we're in the small- to mid-cap market, we're not a big player in the Fortune 5 market. And so when I say that, attaching excess of $50 million or $60 million or $70 million is a reasonably high attachment point on that portfolio. And I do think that's a direct correlation to the improved experience and the improved emergence we're seeing in the '11 and '12 years. The difficulties we had in the U.S. D&O market really came out of Primary business, much of it West Coast business, very much tech-focused coming out of the '08, '09 and' '10 underwriting years. And of course, with the passage of time, there are less of those outstanding claims. When we began implementing a corrective action strategy on that book in 2009, okay, we started to shrink premium, because we either nonrenewed business in classes where we didn't think it made sense to stay in or geographies, or move to much higher attachment points as we did on our new business. So we think the underwriting strategy works out based on what we see in the '11 and '12 emergence but you will have a little bit short-term volatility in that as you earn, premiums are lower, and will take some time to rebuild the portfolio. But we've got a fair amount of confidence in our underwriting team and thank God, the emergence patterns are looking pretty good to us on the '11 and '12 years.

Operator

Our next question comes from Amit Kumar with Macquarie Capital.

Amit Kumar - Macquarie Research

Just I guess 2 quick follow-up questions. The first question is, going back to the discussion on D&O. The 3 claims, which you talked about, were they from the small law firm line or was that a different line, that wasn't clear?

Stanley A. Galanski

That's a different line. For D&O, that is directors and officers liability. Law firm Professional Liability, we refer to as E&O business. So while you'll see in our segment reporting, when we talk about Professional Liability, it's both. The 3 D&O claims which contributed to $3.5 million were in the management liability line, part of our management Professional Liability practice. And just to comment on those, is we saw some activity on those 3 claims and decided to go let it flow through in the quarter rather than to say it's part of IBNR. That's a management judgment and our view is we want to make sure we have adequate IBNR sitting in our portfolio.

Amit Kumar - Macquarie Research

Got it, that's helpful. The only other question I had was, in your opening remarks, you talked about crop [ph], you also commented about competition. Can you just remind us where does your excess of loss kick in for the primary guys and how do you feel about that just based on the recent discussions surrounding the crop conditions?

Stanley A. Galanski

It's actually all over the board. Our excess attachments vary by contract. Remember, we're not an ensurer, we're a reinsurer of this business, so we'd look at various structures on various programs. Both is pretty well spreads geographically across over, I don't know, 25 or 30 states. And when you look at those states, the big ones are Illinois, Nebraska but there's places that might surprise you in there, North Dakota, Mississippi, South Dakota, so it's a pretty well-spread [indiscernible] with a variety of attachment points. How do we feel about the crop market in general? As I say, the quota share, we're disappointed that the influx of new capacity seem to make terms a little more competitive than we thought were appropriate. So as a result, we wrote a little bit less of that business, but I think the excess of loss market is certainly well within what our technical price expectations were. Again, we look at the business on return periods and so on and we think we're happy with where we are in the book today.

Amit Kumar - Macquarie Research

And just based on the discussion on late planting and the discussion on corn. How does -- how do you view that would impact you, guys?

Stanley A. Galanski

That is a technical question beyond my farming expertise. We'll have to get back to you on that. I really need [indiscernible] to comment on that.

Ciro M. DeFalco

We can have one of our specialist to consult with that and then we can give you a detailed answer.

Operator

Our next question comes from Robert Paun with Sidoti & Company.

Robert Paun - Sidoti & Company, LLC

Stan, you spoke about the growth expectations in the Marine cargo business. Can you just expand on what you're seeing in that business in terms of rates and competition? And maybe you can just talk about what makes that line attractive right now.

Stanley A. Galanski

Well, I think the industry has done pretty well, and it's an area that we do very well in, in London and I cite that as an area where our U.S. team has just really not focused. As you know, Robert, if you look at the portfolio, most U.S. Marine insurers, their largest product line is typically ocean cargo insurance and the second largest U.S. Marine product line is pleasure craft, yacht and personal watercraft. We're not in that personal watercraft market at all and in our U.S. underwriting agencies, we write a very small amount of cargo business despite the amount that is there. Our take on that -- and by the way, as you know, it's a significant business for us in Lloyd's where we are a market leader, some of that exposure is U.S. exposure. But I guess our take on it is, while the large account cargo business was driven down in pricing over a 3- or 4-year period going back 4 or 5 years, that the competitive dynamics are changing there. And again, as a niche player, we like to find specific subsegments of a product line that makes sense to us and it's an area we're looking at. It's a big market and it's not one we put a lot of attention on and we think it can add some value to our portfolio.

Robert Paun - Sidoti & Company, LLC

Okay, that was helpful. Also on the casualty business, it's shown pretty strong top line growth. Was it both on the Primary and Excess side or was one stronger than the other?

Stanley A. Galanski

The excess was definitely stronger. We wrote a couple of significant construction-related contracts during the quarter in our excess casualty area. And again, that's where I think we've seen the most destabilization in the marketplace that has driven more business through the wholesale community. And as we expanded our teams over the -- our underwriting team over the last 3 or 4 years, they've been very well-positioned to respond to that, moving up and down in attachment points as appropriate. Although I must say, we're really proud of what our Primary Casualty team is. As you recall, for a number of years, we had a very significant amount of small artisan contractors in California underwritten through an MGA that we mutually parted company, I don't know, 15 or 18 months ago. And I think that came, has done a masterful job of balancing that portfolio, which is today far less dependent on western states construction. There is a nice balance of other states in the portfolio, as well as real estate exposures and manufacturing. So the investments we've made in that E&S platform, both Primary and excess, are -- they've really paid off, the underwriters are doing a very nice job, but the excess was definitely a stronger area of growth in the quarter. That's to take nothing away from the job the Primary team did.

Operator

And I'm currently showing no further questions at this time. I would now turn the call back over to Mr. Stan Galanski for closing remarks.

Stanley A. Galanski

Well, thank you, very much. We appreciate your interest in the company and your time on the call today. Have a great day and a great weekend.

Ciro M. DeFalco

Thank you.

Operator

Thank you, ladies and gentlemen, that does conclude today's conference. You may all disconnect, and have a wonderful day.

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