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The Navigators Group, Inc. (NASDAQ:NAVG)

Q1 2008 Earnings Call

April 29, 2008 8:30 am ET

Executives

Stanley A. Galanski – President and Chief Executive Officer

Paul J. Malvasio – Executive Vice President and Chief Financial Officer

Analysts

Paul Newsome – Sandler O’Neill + Partners, L.P.

Scott Heleniak – Ferris, Baker Watts, Incorporated

Charles Gates – Credit Suisse

Operator

Great day, ladies and gentlemen and welcome to the First Quarter 2008 Navigators Group Incorporated Earnings Conference Call. My name is Katina and I will be your coordinator for today. At this time all participants are in listen-only mode. We will conduct a question and answer session towards the end of this conference. (Operator Instructions)

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 currently 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 Form 10-K 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 would now like to turn our presentation over to our host for today’s call, Mr. Stan Galanski, President and Chief Executive Officer. Please proceed.

Stanley A. Galanski

Good morning. Thank you. I would like to welcome you to the first quarter earnings teleconference of The Navigators Group, Inc. I’m here with Paul Malvasio, our Executive Vice President and Chief Financial Officer.

Yesterday afternoon we announced record quarterly net income of $23,250,000 for the first quarter of 2008, an increase of 18% from the first quarter of 2007. In what has become an increasingly competitive marketplace, that has been made even more challenging as a result of the credit crisis and construction slowdown, we are quite pleased with the underwriting results produced by the quarter and with the financial performance of the organization. In these turbulent investment times it is very comforting that our investment portfolio continues to perform well, with investment income up 16%.

Our first quarter combined ratio of 89.2% was a slight improvement from the first quarter of 2007. The net loss ratio for the first quarter was 56.8%, a 1.6 point improvement from the first quarter of 2007. And the paid loss ratio for the quarter was 32.7%. We continue to experience favorable loss emergence, resulting in reserve releases of $13.8 million during the quarter from prior underwriting years, largely coming from our construction liability business and our Lloyd’s operations. While we experienced favorable loss emergence, our net loss reserves increased by over $37 million during the quarter and our net IBNR reserves now exceed $565 million.

It comes as no surprise that as price competition increases premium levels come under pressure. Our gross written premium for the quarter was down 5%, although our net written premium was up 8% for the quarter. Our net written premium growth results from the strategy introduced a couple of years ago to selectively increase our net retentions on specific core product lines commensurate with the growth in the policy holder surplus of the company. I will cover premium levels and pricing trends for each of our business units in a few minutes.

Our expense ratio for the first quarter was 32.4%, up from 31% in the first quarter of 2007. This was the result in an increase in net commissions for both our insurance companies and at Lloyd’s. And that’s party attributable to a decrease in the amount of quota share reinsurance purchased in our marine and energy business. We enjoy reasonably attractive ceded commissions on our quota share reinsurance so a reduction in the amount of quota share reinsurance purchase tends to push up the net commission ratio. Our non-commission operating expense ratio was up slightly for the quarter.

Turning to our business units, marine and energy business continues to be our largest product line representing almost 55% of the gross written premium for the first quarter. We conduct this business both in our insurance companies and at Lloyd’s. Looking first at our insurance company operations, the marine and energy had a difficult quarter producing a very rare underwriting loss as a result of a handful of large losses during the first quarter, which pushed the combined ratio to 106.7% for the quarter.

We are well known for our marine liability expertise, which protects companies for claims for bodily injury and property damage resulting from their marine operations. Marine liability claims tend to be characterized by severity rather than the frequency of many small claims. We remain very confident in the quality of our underwriting decisions and the caliber of our liability portfolio and do not anticipate a fundamental change in the level of claims activity or a likely reoccurrence of this level of claims activity over the balance of the year.

Conversely, our Lloyd’s operation had a superb quarter generating a combined ratio of 84.3% for the quarter, with the marine and energy business at Lloyd’s producing a combined ratio of 78.1%. Gross written premium was down both in the insurance companies and at Lloyd’s by 5% and 4% respectively. Renewal rates were down about 1% for the marine and energy business in the insurance company and down about 4% at Lloyd’s.

The most competitive marine and energy line is offshore energy where rate decreases of 10% or more are not uncommon. Net written premiums were up for both the insurance company and Lloyd’s as a result of our decision to purchase less quota share reinsurance in 2008. We have always been a significant buyer of quota share reinsurance and our decision to reduce the amount of quota share for 2008 reflects our view of the profit potential of the business, the reinsurance terms in the market, and the fact that our policy holder surplus has increased significantly over the past few years. This led us to the conclusion that for our marine and energy business in 2008, it made sense for us to buy less quota share and retain more business net.

Navigator Specialty had a terrific underwriting result for the quarter, with a combined ratio of 79.4% compared to 89.5% in the first quarter of 2007. This included about $7.3 million of reserve releases from prior underwriting years during the quarter as we continued to experience favorable loss emergence on our construction liability business.

Clearly, the slow down in construction activity has impacted Specialty’s top line, as gross written premium was down 12% for the quarter and net written premium down about 1%. A good example of the slow down is in our construction wrap-up product, which provides general liability insurance for new construction projects on the basis of a single policy that insures all contractors on that project with a single limit of liability. By definition these are non-reoccurring policies as the initial policy covers the project from inception through completion. In the first quarter of 2007 we wrote about $11 million of this business compared to just over $3 million in the first quarter of this year.

Renewal rates on our construction business were down a little over 9% for the quarter. The exception is the small artisan contractor segment, which continues to show growth at rate levels that are pretty much flat. The aggregate gross written premium for our primary casualty business, including the construction segment, was down about 14%, which was slightly below our expectations.

Our excess casualty business was up about 5% for the quarter despite renewal reductions of about 4.5%. We remain comfortable with the technical rate levels for our excess casualty business and continue to look for opportunities to expand this portion of our specialty portfolio. That is also the case with our personal umbrella business, for which gross written premium was up about 15% for the quarter.

You will notice in this quarter that we have split out our commercial middle market business from the results of Navigator Specialty. We made the decision to do so based upon the management reporting structure of the business and the fact that much of our specialty business is excess in surplus lines business produced by wholesale brokers. The middle market business is largely admitted property casualty business that is produced by retail insurance agents and brokers. And organizationally, this unit reports up to the head of our marine and energy business, where we see significant cross selling and cross marketing potential.

Our strategy in this unit is to identify profitable niches within the admitted market that fit our specialty orientation. Some examples of this in our current portfolio include armored cars, swimming pool contractors, and tow truck operators. Currently we underwrite this business from a single location in Schaumburg, Illinois. During the quarter we brought on Jim Kerriger to head up this division. He will be based in Parsippany, New Jersey, and we anticipate over time adding middle market underwriters in a select number of our existing regional offices in the United States and continuing to identify other specialty property casualty customer segments within that admitted market. Navigators Pro generated a combined ratio of 99.5% for the insurance companies and a point or so better for the international business written at Lloyd’s.

We continue to take a conservative view of the current underwriting year, reflecting our belief that the industry is likely to experience increased levels of securities class action litigation in 2008 and 2009 as a result of both the credit crisis and overall turbulence in the stock market. While we are comfortable that our underwriting strategy and risk selection practices insulate us from much of this exposure, there is inherent uncertainty in the current economic environment.

We also saw a little bit less new business in the quarter, given the reduced level of IPOs and special purpose acquisition incorporation activity. As a result, gross written premium for our U.S. D&O business was down about 11% for the quarter, with renewal rate reductions of 5.6%. Our U.S. E&O business, as well as our international D&O and international E&O business underwritten at Lloyd’s, continue to show growth despite low to mid-single digit renewal price change.

During the quarter we introduced two interesting new products within Navigators Pro: Tech InNAVation and SPAC InNAVation. Tech InNAVation targets the professional liability exposures for information technology companies while SPAC provides customized D&O coverage for special purchase acquisition corporations.

I am please to report that there have been no adverse developments in the notices that we have received for sub-prime claim related activity during the quarter.

During the quarter we also implemented a new policy administration system for the public company D&O business, which we believe over time will contribute to increased efficiency and improved customer service through faster policy issuance. This was a system built in-house by our own application developers and we hope to deploy this type of technology for our other products as well.

I would like to comment on two press releases that we issued yesterday following our earnings release.

In one we announced the hiring of Clay Bassett as Chief Underwriting Officer, which is a newly created position. With the growth that we’ve achieved over the past few years and the breadth of our current products, we believe it was time to formalize and fill a corporate position focused on underwriting strategy and quality. Clay has a wealth of underwriting experience, both as an insurer and reinsurer and we fully expect his work with our profit center executives will help assure that underwriting integrity, pricing discipline, and the quality of risk selection remain at best-of-class levels.

Secondly, we announced that Paul Malvasio, who has been our EVP and Chief Financial Officer, will retire from the company on August 15. Since his arrival, Paul has been a driver of quality throughout the organization and transparency in our financial reporting. As a matter of fact, we began our first quarterly conference calls together back in the first quarter of 2004. Paul has been instrumental in the growth of our balance sheet, both with our 2006 debt offering and our 2005 secondary equity offering, and he’s touched so many areas of the company during his tenure here. We are all very grateful for his contributions and his professionalism, and while we look forward to working with him over the summer, we wish him the best.

And with that, I’ll turn the call over to Paul. Best introduction you ever had, right?

Paul J. Malvasio

Thank you, Stan. I’ll just comment on some of the financial data.

The prior period savings for the 2008 first quarter was $13.7 million, which reduced the combined ratio by 8.8 lost ratio points. Approximately $8.5 million was from the insurance companies, mostly for construction business relating to accident years 2006 to 2004, and $5.2 million from our Lloyd’s operations for marine and energy business, mostly from accident years 2005 to 2002. More details on our reserves and prior year savings will be contained in our Form 10-Q filing, which we expect to occur by Thursday of this week.

The 2008 first quarter losses include accident year losses of $7.2 million for two marine insurance claims in the insurance companies: a liability loss for the sinking of a fishing vessel, and a hull loss for fire damage, also to a fishing vessel.

Our Lloyd’s property book also incurred $900,000 of UK flood claims in Selsey, England, during the quarter and such accident year losses increased the company’s 2008 first quarter loss ratio by 5.2 loss ratio points.

Turning to the balance sheet, approximately 64% of the $885 million in net loss reserves at March 31 were from current but not reported losses compared to about 66% at the end of 2007.

Invested assets at the end of March approximated $1.8 billion. The average quality of our fixed-income portfolio remains at AA with a duration of approximately 4.2 years. The pre-tax investment yield for the 2008 first quarter was 4.2% and the effective tax rate on net investment income was 26.4%. Substantially over, our mortgage-backed and asset-backed securities are rated AAA. The company does not own any collateralized debt obligations or collateralized loan obligations or asset-backed commercial paper. Additional investment portfolio details are contained in the supplement to our press release.

At March 31 reinsurance recoverables and paid and unpaid losses brought down our balance sheet approximately $851 million, which declined by about $45 million, or 5%, compared to the end of the year, as we continue to retain more business net and recovered 2005 hurricane loss payments from re-insurers. Approximately $145 million, or 17%, of the $851 million reinsurance receivable amount at March 31 relates to recoveries from Katrina and Rita.

Earnings per share increased 17% to $1.36 per share for the 2008 first quarter compared to $1.17 per share for 2006. Book value per share was $40.29 at the end of March and statutory surplus was $584.5 million. The company repurchased 136,026 shares of common stock at an average cost of $53.82 per share during the 2008 first quarter. Approximately $22.7 million remains available for stock repurchases under the buy-back program.

With that, I would like to turn it back to Stan, or just open to questions.

Stanley A. Galanski

Operator, you can open it up.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question will come from the line of Paul Newsome representing Sandler O’Neill. Please proceed.

Paul Newsome – Sandler O’Neill + Partners, L.P.

Good morning. I was hoping you could talk a little bit more about the California contractors business and I think many of us were pleasantly surprised to see the very good results, especially given that ROI results in that business, which I think are quite similar to yours, I think were quite poor. Is there something special that was happening here other than that the reserve releases, and maybe talk to what you think the accident year is going to turn out to be.

Stanley A. Galanski

I’ll take the first stab at that, Paul. I really can’t comment on, you know, another competitor’s specific underwriting results because I don’t know what their reserving practices are or how their forms or risk appetite may differ from ours.

But I would, I guess, just start off by saying that our portfolio is probably a little bit unique because traditionally we have avoided writing large developments where there are 1,000 homes or the 500 homes, and our traditional competency has been in the residential contractors doing luxury homes, typically 12 or 15 and under. And that kind of has a different experience—in our experience we show a different underwriting result on that than I guess the overall portfolio of what you could write out there.

And secondly, over time we’ve kind of developed this small artisan book, which I think continues to perform very, very well for us. So I think our California construction business is what it is. We saw a real turn in the results back in 2003 and, candidly, those trends continued and have been very favorable.

A number of things happened then and some of that I think you can attribute to Senate Bill 800, some of it you can attribute to changes in the policy terms and conditions, which remain, despite changes in the pricing. And, candidly, some of it, I think, just reflects a little bit more of a conservative judiciary in California.

Now it’s very difficult to quantify the value of any of those things, but I think when you add them together they contribute to patterns that continue to be evident in our loss emergence.

Paul Newsome – Sandler O’Neill + Partners, L.P.

Great. Thank you. And congratulations, Paul.

Operator

(Operator Instructions)

Your next question will come from the line of Scott Heleniak representing Ferris, Baker Watts. Please proceed.

Scott Heleniak – Ferris, Baker Watts, Incorporated

Hi, good morning. Just a couple of quick things. Could you talk about—I know in the release you talked about buying less reinsurance in some of the mature lines and obviously you’re doing that in marine. Can you talk about some of the other lines, specifically, and what sort of time periods you would consider to be mature. Are these things from the 2003-2004 time frame when you started the diversification, or is it a little bit further than that.

Stanley A. Galanski

Well, I think number one would probably be the easiest example would be our D&O business. You know, when we launched Navigators Pro back in the fall of 2001 we had a very significant quota share. We actually ceded 85% of the business. And over the next few years we increased our retention every year. So, you know, you get to a point when you’re probably at maturity, but that’s a product that, you know, I think today, after being in the business for whatever it’s been now—6 ½-7 years—we feel we understand it pretty well, because obviously it’s a claims-made product, and the experience has been very good. And so I think that over time we got to a level of comfort with that.

You know, conversely, we’ve added some new products in the last couple of years, like our primary casualty unit in Chicago and inland marine, which clearly you don’t have as much attraction, or as much track record with, and our view is to take some time before you take substantial increases.

Paul J. Malvasio

Just add to that, the other areas in the California construction business, back in 2002-2003, our net retentions were $125,000. It’s now up to $1 million. We’ve gradually increased the retentions. And you’ll see us talk about that in the Q because we went from 500 to a million dollars effective April 1 last year. That’s been a real home run for us in terms of all the underwriting profits from that business.

Stanley A. Galanski

Keep in mind, also, during that time, say from 2002 to now, the policy holder surplus in the insurance company almost tripled. So you’re looking at a much more robust policy holder surplus with which to take risks.

Paul J. Malvasio

Right. And we’ve been writing that business since 1995.

Scott Heleniak – Ferris, Baker Watts, Incorporated

Okay. And so do you have any idea what does that do to your one and two hundred fifty year loss event—potential loss—since you’re buying less reinsurance on the marine side?

Paul J. Malvasio

That’s easy. Basically we’re protected by an excess of loss program, so that hasn’t changed. You’ll see in the Q, we’ll give you what we think our gross--what we think is our reasonably worse-case scenario in what we’re calling the one and two fifty year storm where I think the numbers are round numbers like $220 [million] gross and $30 million net to us, which includes all the reinstatement premiums. So buying less reinsurance really doesn’t affect our exposure with respect to the storm losses.

Scott Heleniak – Ferris, Baker Watts, Incorporated

Okay. I just wanted to make sure that didn’t change. And do you have your Lloyd’s stand capacity, what that is versus last year. And also can you talk about some of the rate environment internationally where you’re writing business overseas and in Canada and how that compares with the U.S.

Paul J. Malvasio

I’ll do the stand capacities, Stan can do the business. Round numbers it’s 123 [pound] Sterling versus 140 [pound Sterling] the year before. And we’re in the early stages to decide what 2009 would be. And that won’t really be filed until November this year.

Stanley A. Galanski

And the second part of your question, Scott, I think in the marine business, it’s essentially a global business for us so there are less geographic issues than there are overall global pricing trends. Marine by it’s nature is shipping and so it’s kind of a global marketplace.

The place where it would play out for us has been the professional liability business, which generally have much lower rates outside of the U.S. because of perceived much more exposure. You just don’t have the class action appetite—class action environment—that you do in the U.S. courts. And rates are lower there, renewal rate pricing, but it’s not a significant issue. I would say a slightly lower level than the U.S.

Scott Heleniak – Ferris, Baker Watts, Incorporated

Okay. Fair enough. Congrats again, Paul.

Operator

Your next question will come from the line of Charles Gates representing Credit Suisse. Please proceed.

Charles Gates – Credit Suisse

Hi. Good morning. Hey, where was the middle market business before?

Stanley A. Galanski

Navigator Specialty.

Charles Gates – Credit Suisse

Okay. That was the first question. Two, could one of you drill down on what the middle market business comprises—what it is?

Stanley A. Galanski

You bet. You know, we got into this business probably the early part of 2002, maybe late 2001. And Charlie, if you recall back, at that point, essentially our non-marine business to the company was almost all California construction liability. And this was our first attempt at diversification and we opened up an operation in suburban Chicago which focused more on retailers and on admitted business, but still kind of had the specialty edge to it. And at that point in time—as it is today—much of the Illinois construction market was written on an admitted basis because it didn’t have the same construction defect stigma or loss experience that the western states had.

So, in contrast to the excess in surplus lines business, which, you know, the retailer broker goes through the wholesale broker to get to the market, this is an environment where the retailer goes straight to the market and there are a lot of regional companies that compete for that business. What we’ve tried to carve out is not to be a commodity play--to be all things to all people—but rather to find those things that are kind of specialty admitted, kind of on the border line between E&S and the admitted market, where the quality of underwriting makes a difference, where we can get our rate and do some neat products things.

One example of that for us has been the armored car business, where we’ve written the specie, or the cash in transient coverage, for years in our Lloyd’s syndicate, but never looked at the U.S. casualty business. And the fact that it is armored car sometimes will detract other markets and give you less number of competitors fighting for that business.

That’s kind of what we look to achieve there and we believe there are opportunities to do it elsewhere. But it really is a little bit of a different business and there’s a lot of cross sell opportunity with the retail agents and brokers that we do business within marine and inland marine.

Charles Gates – Credit Suisse

Why is there less competition in that business?

Stanley A. Galanski

Inherently there’s not. Because on what you seek to write. So if you’re really writing kind of cookie-cutter business that anybody at any company would do, you would have more competition. But if you kind of focus on niches, you can identify areas that not every market in the world would do.

Charles Gates – Credit Suisse

On the armored car, it’s basically because people are afraid that you’ve got guys walking around with guns?

Stanley A. Galanski

That would be one reason. Some people have reinsurance treatise exclusions for it. But there are just certain classes that would have a stigma to them. And some of them are clearly excess in surplus lines classes. Like, I don’t know, adult entertainment centers or some of the dicier areas in the social service business. So, again, we try to look at things and identify opportunities where having some knowledge and having a special product makes a difference. It’s not always easy, but you try to find those kind of areas. Look, you compete on the strength of your relationships and the quality of your underwriting and all those good things, but again, we tend to focus on areas where you can look at what the broad industry outcome is, in property casualty.

But even within that if you drill down, there are winners and there are losers. And some of the winners are big winners and some of the losers are big losers.

Charles Gates – Credit Suisse

Do you insure adult entertainment centers? [laughter]

Stanley A. Galanski

In our middle market operation, that would be an E&S class and I’m sure we have some of that.

Charles Gates – Credit Suisse

Okay. I guess the other question—if you could elaborate briefly on—I didn’t fully understand, basically, what you said about the contractor liability competitive environment in response to Paul’s question. Could you go through that one more time please?

Stanley A. Galanski

Okay. I think that was a question less about the competitive environment than how our loss experience is.

Charles Gates – Credit Suisse

Okay, define the competitive environment.

Stanley A. Galanski

Rates are down 9%. We tell you that, look—the exposures are down. Because simply in areas like construction wrap-up new projects, there are simply less of them to do. There are some, but there are far less. And a contractor that might have anticipated doing $15 million in receipts a year ago might be coming in with $8 million in receipts today. So in general, you have negative price pressure and you have reduced exposures, in terms of what you actually develop your premium base on. The amount of work that that contractor anticipates doing in the coming 12 months.

My comment, I guess, on the exception to that, has been the small artisans. And I think we talked about this last quarter; these are the small of the small. Many of them are Joe Smith DBA Joe’s Painting, or whatever, that tend to be more in the remodel and repair segment and we do that business, actually, through the Internet. It either fits the underwriting template or it doesn’t. And we found that area to remain strong and that there has been much less rate pressure on it. It kind of is what it is.

Charles Gates – Credit Suisse

Thank you very much.

Operator

With no further questions in the queue I would now like to turn the call back to Mr. Stan Galanski for closing remarks.

Stanley A. Galanski

Thanks very much for your time today. We know there’s a lot of competition at 8:30 in the morning during the earnings period and we appreciate you taking the time to join us for the call. Thanks.

Operator

Ladies and gentlemen, thank you for participation in today’s conference call. This concludes your presentation. You may now disconnect. Good day.

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