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Executives

Stan Galanski – President and CEO

Paul Malvasio – EVP and CFO

Analysts

Jason Basel [ph] - Philadelphia Financial

Scott Heleniak - RBC Capital Markets

Paul Newsome - Sandler O’Neil and Partners

The Navigators Group, Inc. (NAVG) Q2 2008 Earnings Call Transcript July 29, 2008 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2008 The Navigators Group, Inc. conference call. My name is Katie, and I’ll be your coordinator for today. At this time, all participants will be in a listen-only mode. We will be conducting a question-and-answer session towards the end of this conference. (Operator instructions) Before we begin, the company has asked that I read the following statements.

We will 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’s base on current available information that involves risks and uncertainties. The company's actual results could differ materially from those anticipated in forward-looking statements. We refer you to the company's most recent Form 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 would like to now turn the call over to your hosts for today, Mr. Stan Galanski, Chief Executive Officer, and Mr. Paul Malvasio, Chief Financial Officer. Sir, you may proceed.

Stan Galanski

Thanks. Good morning, and welcome to the second quarter of 2008 earnings teleconference for the Navigators Group, Inc. Yesterday afternoon, we announced that our second quarter of 2008 earnings were $17,421,000, a reduction from $24,375,000 in the second quarter of 2007. And that our year-to-date net income was $40,671,000, which is 8% less than the comparable 2007 period.

In these challenging times, we are very happy with our underwriting results, particularly, with the combined loss and expense ratio of 90.4% for the quarter and 89.8% for the first six months of the year. Our results were adversely impacted by net realized capital losses of about $8 million and by a modest underwriting loss for the quarter at our Lloyd’s Syndicate.

We continue to feel very good about the fundamentals of our business. Paid loss activity continues to run well within our expectations. And the quarterly results include favorable loss development from prior underwriting years. While we are encouraged by our paid and incurred loss emergence patterns, we are committed to maintaining prudent levels of loss reserves for future claims. And our net IBNR increased by 5.5% during the quarter.

Premium growth was slightly better than expected for the quarter, with gross written premium up 1% and net written premium up 8%, compared to the second quarter of 2007, led by strong premium growth in our marine and energy units. While there’s no question that the pricing environment continues to soften, we are comfortable that our underwriters are making prudent risk-taking decisions in terms of risk quality, rate per exposure, and policy terms and conditions.

In a few minutes, Paul Malvasio will provide an overview of our financial performance. First, I’d like to comment on our operations and the marketplace.

The marine and energy division of Navigators Management Company, which underwrites on behalf of Navigators Insurance Company, had a very solid quarter. Gross written premium was up 10%, and net written premium was up 20%, compared to second quarter 2007. More importantly, the combined loss and expense ratio was 81.4% for the quarter, reflecting a relatively low level of loss activity. Those of you who follow us will recall that we had an unusually high level of large loss activity during the first quarter of 2008, which sometimes happens in the marine business. The second quarter is much more consistent with our expectations based upon our experience over the last 30 years.

While premium levels were down slightly in London and New York, our regional offices in Seattle, San Francisco, Chicago, and Houston had good production during the quarter, particularly in marine liability, which is our largest marine product line.

In the aggregate, marine rates were down just under 5% during the quarter, with the steepest reductions coming in offshore energy in cargo. The increase in net written premium reflects our decision to reduce the amount of quarter share reinsurance purchased in 2008. We also underwrite marine and energy business at Lloyd’s where market conditions were very similar to those facing the insurance company.

Gross written premium for this segment at Lloyd’s was up 7% over the second quarter of 2007, with strong growth in marine liability and cargo. One reason for our growth is we are increasingly acting as a leader in the Lloyd’s market for marine liability business where we have traditionally acted more as a following market. This is a result of a couple of additions made to our marine liability team at the Lloyd’s Syndicate over the past year as well as the personnel changes among market competitors.

As a leader, we are in a better position to establish the rate levels and terms, and to obtain a larger share of the risk placement. Our marine underwriting results at Lloyd’s were impacted by a couple of potential large claims during the quarter, which contributed to an increase in the quarter’s loss ratio to 65.5% for our overall Lloyd’s unit. Again, we are taking what we believe to be relatively conservative, but realistic views of the current underwriting years based upon our assessment of market conditions and industry loss trends.

In terms of market conditions, marine and energy business globally, the greatest pricing pressure is, as I said, for offshore energy business as a result of consecutive benign catastrophe loss years in 2006 and 2007. While there appears to be ample capacity overall in the market, there were a number of June and July 1st renewals that had difficulty procuring adequate Gulf and Mexico Windstorm limits at the proposed market terms. Our estimate is that the industry has experienced about $1 billion worth of offshore energy claims over the last 12 months, much of which stems from underwater pipeline and construction risks. We have a relatively modest participation on those types of operations, but these losses should contribute to maintaining price discipline among the offshore specialists.

We are encouraged about the pricing environment for the bluewater hull business, largely as a result of issues with the Scandinavian market, which has traditionally been one of the more aggressive markets for this product line. Marine is a tough business, but we know it well and have a high degree of confidence in the caliber of our underwriting claims teams in the US and Europe.

Navigators Specialty had another quarter of solidly profitable results with a combined ratio of 88.9%. We continue to experience favorable loss emergence patterns on the construction business, and loss activity in the other lines has been well within our expectations. Not surprisingly, gross and net written premiums were down 8% and 7%, respectively, largely reflecting the impact of the construction slowdown on our western states construction book, which was down about 14% from the second quarter of 2007.

There are really two distinct components to this book of business. Our small artisan contractor book continues to show substantial premium growth, and the rate levels on that book are pretty much flat with expiring. These are very small accounts, generally around $2,000 in annual premium, and are heavily in the repair and remodel segment of the business with limited exposure to new construction. Our more traditional book consisting of general contractors and larger artisans is experiencing much greater competitive rate pressure, with rates down about 15% during the quarter. That’s the reality of the California construction market, and we anticipate that competitive pressure to continue.

Our primary casualty unit was up about 10% for the quarter as we continue to expand our distribution east of the Rockies. During the quarter, we announced a new unit within the primary casualty that focuses on the life science segment, underwriting products and include product liability and international clinical trials coverage. This unit is being led by a well known specialist in this niche, and we expect that we’ll have a strong synergy with the D&O business that we currently underwrite for life science companies.

The excess casualty division was down 6% from the second quarter of 2007, reflecting renewal price change of about 7% downward in that product line. Our existing excess business is largely produced by wholesale brokers, and during the quarter, we announced the formation of a unit that will focus on developing unsupported or monoline excess casualty policies with retail insurance agents. We’re very excited about this opportunity to further diversify our distribution network in conjunction with our larger middle market initiative, NAV PAC, which targets property casualty business for middle market risks in defined issues.

Navigators Pro had an excellent quarter with a combined ratio of 88.7% on a combined basis between the insurance companies and our Lloyd’s Syndicate, and with gross written premium volume about flat with the second quarter of 2007. In the United States, our D&O business was up about 5% for the quarter, and our E&O business was up 17%. E&O rates were down about 2.5% for the quarter, which was slightly less than the prior four, five quarters, and hopefully could represent a flattening in market. E&O renewal rates were down about 7% for the quarter. During the second quarter, we opened the D&O underwriting unit in Stockholm, which we believe will be a good market for us over the long term.

We continue to feel good about our limited potential exposure to what we broadly defined as subprime, which includes a variety of operations ranging from subprime automobile lenders to homebuilders. During the quarter, we received one new notice of a potential claim. We continue to believe that subprime losses will have an impact on the industry’s E&O results, particularly in the segments like financial institution E&O and investors management E&O, which were segments we have elected not to participate in.

We have invested in a number of new units and product lines over the past five years as part of our diversification strategy that have been successful and have grown to become important parts of our company. At the same time, we pride ourselves on walking away from opportunities and markets, in which we believe trading conditions to be inconsistent with profitable underwriting results.

At the end of the quarter, we closed two of our regional offices in the United Kingdom, located in Manchester and Basingstoke, and entered into a renewal rights transaction with a major UK-based multi-line insurer to provide for the orderly closure of the offices and the transfer of the book of business. These two operations focused on developing cargo business outside of the London market, and frankly, the trading condition has made it difficult for us to achieve the results we had hoped for when we opened those offices several years ago.

Additionally, we made the decision to discontinue underwriting a book of property and liability insurance for small UK-based niche businesses, which we entered into about two years ago. Once again, the margins simply did not appear as attractive as we had hoped upon entering the business, and our expectations for the future competitive environment caused us to conclude that our capital is better deployed elsewhere, such as in our D&O stored up in Stockholm and in the life science industry initiative.

Also during the quarter, we reviewed the processing efficiency and productivity of the support unit for our San Francisco based specialty operations, and reduced headcount in that unit. We were able to do so because of technology improvements we introduced over the last two years.

The combined impact of all of these actions reduces annualized employee cost by about $3 million. Severance and other termination expenses included during the second quarter contributed about one point to our expense ratio.

We continue to emphasize the importance of cost control through expense management, implementation of enhanced technology, and productivity initiatives. Equally important and to avoid any confusion, we will continue to invest in new initiatives that make sense to us as underwriters and that we believe have real potential for profitable growth.

Clearly, the current market is a lot more challenging than it was 12 or 24 months ago. We try hard to avoid looking at the world through rose-colored glasses that emphasized what Peter Drucker termed ‘intellectual integrity’, the ability to see things as they really are. We have a high degree of confidence in the ability of our underwriters to make the right calls, and we put pressure on them not to write business unless it meets their standards for quality and pricing. Similarly, while write downs related to potential impairment of investments are the reality of the world in which we live, we continue to have a high degree of confidence in the quality of our investment portfolio.

Finally, we also announced yesterday that Frank McDonald will be coming onboard on August 5th, and will replace Paul Malvasio as Chief Financial Officer upon his retirement from Navigators on August 15th of this year. Paul and I did our first and (inaudible) conference call together back in the first quarter of 2004 after he joined Navigators in the fourth quarter of 2003. Looking back, we really were a much different company in those days. To put it in perspective for you for the 2003 year, our net income was $7.7 million, our total assets has just passed $1 billion for the first time, and our book value per share was a little over $23. We are grateful to Paul for his many contributions during his time at Navigators, not the least of which is the quality of our earnings releases.

We are also delighted to welcome Frank McDonald to the company. Many of you know Frank either from his most recent position as Chief Financial Officer of ACE USA, or previously in his role as Chief Financial Officer of PMA Capital. Frank has a great track record of accomplishment in the insurance industry, and has the rare distinction of being both a CPA and a CPCU, which is the professional designation for chartered property casualty underwriter. We believe he is the right guy to take the baton from Paul, and help stir Navigators in the coming years.

So with that, I’ll turn it over to Paul to provide you with an overview of the financial results, and then we’ll take your questions.

Paul Malvasio

Thanks, Stan. I’ll briefly comment on some of the financial data.

Per share earnings, we are $1.34, excluding realized capital losses in the 2008 second quarter, compared to $1.41 in the 2007 second quarter. After tax realized capital losses includes $5.5 million or $0.32 per share from payment losses, which consisted of writing down the cost of 16 common stocks in our equity securities portfolio to a market value at the end of the second quarter. Such write downs had no impact on shareholders equity of book value per share since all our investments are marked to market at each balance sheet date.

At the end of June, the equity portfolio was $68 million, and there were 40 equity securities at the total of 76 in unrealized loss utilization, with the largest single unrealized loss at $600,000.

Investment assets at June approximated $1.8 billion, with the average quality of our fixed income portfolio was double A with a duration of approximately 4.3 years. Since the beginning of the year, we have allocated approximately $105 million to high quality tax exempt securities, which now represents approximately 39% of our fixed maturities investments, versus 30% at the beginning of the year. As a result, the effective tax rate on then investment income was 25.4% in the 2008 second quarter, compared to 28.2% in the 2007 second quarter.

Net investment income increased 8% and 12%, respectively, in the second quarter and six-month period especially due to strong cash flow. On an after tax basis, the increases were 12% and 16% given the increased allocation to exempt securities.

Cash flow from operations was $133.4 million in the six months, versus $111.7 million for the comparable 2007 period. The 2008 second quarter and six months combined ratios were 90.4 and 89.8, respectively. The 2008 second quarter operating expense ratios, as Stan mentioned, includes about one point increase for severance and termination costs related mostly to the discontinuance of our UK property business and closure of our UK branch offices in Manchester and Basingstoke. The 2008 second quarter commission ratio also includes about 6/10 of a point increase for (inaudible) commission adjustment for our Lloyd’s operation.

Prior period savings were $10.6 million and $24.3 million for the 2008 second quarter and six-month period, which reduced the combined ratio of 6.5 points and 7.6 points, respectively. The savings in the Insurance Company approximated $11.7 million, and these savings were across the board in each of the lines of business, while our Lloyd’s operation had a deficiency of about $1.1 million from prior periods.

The loss activity for Lloyd’s operations marine and energy business was unfavorable in the second quarter since it included about a $2.5 million offshore energy loss. At June 30, 2008, approximately 64% of the $847 million of loss reserves were from the current but not reported losses, versus about 66% at the end of 2007.

At June 30th, reinsurance recoverables of paid and unpaid losses on our balance sheet approximated $857 million, compared $896 million at the end of 2007. As we continue to retain more of our business net from the recovery to the 2005 hurricane payments from reinsures. Approximately $134 million or 16% of the $857 million of reinsurance receivables at the end June relates for recoveries for the Katrina and Rita losses in 2005. Book value per share was $40.20, and statutory surplus was $593 million at the end of June.

And with that, we can stop and answer any questions you might have.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Jason Basel [ph] from Philadelphia Financial. Please proceed.

Jason Basel - Philadelphia Financial

Hello. Good morning, and best of luck to you, Paul.

Paul Malvasio

Thanks, Jason.

Jason Basel - Philadelphia Financial

Just a quick numbers question, how much cash did you hold at the holding company level?

Paul Malvasio

I don’t have the number here, but I’d say our round numbers are about $40 million.

Jason Basel - Philadelphia Financial

Okay. So similar to first quarter.

Paul Malvasio

Yes.

Jason Basel - Philadelphia Financial

A general question, did you notice any change in the inflow of business opportunities from some incoming carriers who might be under some financial rating strain in the last three or four months?

Stan Galanski

Jason, that’s a tough question for us because that’s very so much by segment. The answer in certain product lines will absolutely be yes, but I wouldn’t say that makes them a material change in our business. It depends so much by the various product lines.

Jason Basel - Philadelphia Financial

Okay. And just trying to understand how you think about reinsurance, the company, in general, has utilized more its own capital over the past couple of years and seeded less. As reinsurance rates for you continue to get more attractive, is that a consideration and how much is heat? Is there still a need to utilize more of your own capital?

Stan Galanski

Well, I’ll take, I guess, the first step, then invite Paul to jump in. I think first of all, as we’ve grown in the surplus of the company, we’re certainly more comfortable taking risks. I think when you look back at the historical performance of Navigators, we are an underwriting company. I think our underwriters have a gross line mentality, and they look to make an underwriting profit on every single deal. So when you have a strong underwriting culture, you feel comfortable taking risks. Okay.

There’s certainly severity lines of business that we are in, whether you consider that D&O or offshore energy, or excess casualty, that required limits, and if they require more limits on a pro-risk basis, then we’re comfortable putting up net. So there’s always going to be some measure of reinsurance in the program.

When it gets down to quota share reinsurance, how effective are we at recovering our costs on the program? What’s the market like and what’s the tradeoff of that premium, which you are seeding to the quarter share reinsurance for the losses? We look at that all the time as well as the cost of the excess loss. So I think every product line that we have, we go through a process of looking at what our net appetite for risk is and what the alternatives are in the market, and try to make the best decision.

Jason Basel - Philadelphia Financial

So within that framework, looking forward, is it reasonable to assume that you continue -- that as rates stand now, you can continue to utilize the same level of reinsurance you had, if not a little less, as you get more comfortable with the new products?

Stan Galanski

Well I think we have a track record of doing that. That’s for sure, but I would also say it’s difficult for us to forecast what the behavior of the reinsures are. I actually believe that the reinsures have been reasonably disciplined over the last couple of years.

Jason Basel - Philadelphia Financial

Great. Fair enough. Thanks a lot.

Operator

(Operator instructions) Your next question comes from the line of Scott Heleniak from RBC Capital Markets. Please proceed.

Scott Heleniak - RBC Capital Markets

Hi. Good morning.

Stan Galanski

Hi, Scott.

Paul Malvasio

Hi, Scott.

Scott Heleniak - RBC Capital Markets

I noticed that the growth is a little bit better than we thought. I know it’s on the marine side, Lloyd’s, and US, just wondered if you could talk more about that, just some of the product categories, the geographies. Kind of what you’re saying now that maybe you’re able to achieve that growth now versus a couple of quarters ago.

Stan Galanski

Well one of the things the result does, particularly at Lloyd’s, is sometimes it takes a while for recorded premiums to actually hit the books. Okay. And a good example of that would be on cargo shipments of oil, whereas you can imagine the value of those shipments has dramatically increased over the last 18 months, 15 months. And as that gets recorded, there maybe an estimate on an account, and then when it’s actually trued up, you’ll have more premium because there’s a higher rating base. Okay. So that’s one aspect of -- I think one of the things is helpful.

Secondly, I think we have been very successful in both the US insurance companies and our Lloyd’s Syndicate in developing our marine liability business. That’s our biggest business, traditionally, in the insurance company, in our marine book. It’s something we’re known for, and as we move more into that kind of ability to be a leader in the Lloyd’s market that is very helpful to us.

So I’d say those three things probably stand out in my mind as to these factors.

Scott Heleniak - RBC Capital Markets

Okay. And then on the D&O and E&O side, pricing for -- I heard pricing has come back quite a bit for the financials. Does that change your decision making on kind of where you stand with writing those kinds of policies? In other words, has the pricing come back to levels where it starts looking interesting again or is that just something you like to kind of wait in the sidelines for?

Stan Galanski

Scott, it never really looked interesting, thus, since we’ve gone into the business in 2001. I’m sure it’s a good market for somebody. We’ve never seen it as an area that we tend to focus in. As you know, our D&O appetite is really in the micro-cap to mid-cap companies. We like the tech area, and that’s not to say you won’t see us on a Fortune 500 risk on an excess placement, but I don’t -- we have no plans in that FI [ph] sector.

Scott Heleniak - RBC Capital Markets

Okay. And then following, can you comment -- any significant cap losses in July so far? I know we had Dolly or Mississippi barge that went down. Any major losses that you are aware of in July so far?

Stan Galanski

On Dolly, we run our model on that, and it looks -- the model would make it look like a very minor, hypothetical event, and we’re not aware of any claims at this point coming out of it for us.

And on the barge, I think a lot of that is typically insured into the international group of P&I clubs. And they have a significant self-insure retention, and after which it hits their reinsurance program. We, like many others, participate on it. So we want to see if that turns into a loss, but --

Paul’s waving his hand. He may know more than I do on that one.

Paul Malvasio

I just know that we’re very high access. So it’s unlikely we should get (inaudible) losses.

Stan Galanski

Thanks.

Scott Heleniak - RBC Capital Markets

Okay. Thanks a lot guys.

Operator

Your next question comes from the line of Paul Newsome from Sandler O’Neil and Partners. Please proceed.

Paul Newsome - Sandler O’Neil and Partners

Good morning. Congratulations, Paul!

Paul Malvasio

Thanks.

Paul Newsome - Sandler O’Neil and Partners

Just want to see if you had any thoughts on M&A. It’s usually given the big prices we’ve seen for a couple of similar or somewhat similar specialty companies.

Stan Galanski

Paul, you take this one.

Paul Malvasio

From my observation, if I do the Math on the one transaction, we would worth $100 a share, so.

Paul Newsome - Sandler O’Neil and Partners

Well, it’s always good to have a (inaudible) question.

Stan Galanski

I don’t think we’ve got a track record and 2-1/2 times book for anything. So we’ll stay in the sidelines if that’s the market price.

Paul Newsome - Sandler O’Neil and Partners

What are you doing at the moment? Are you looking or you’re not looking, or you’re just -- you stated you were (inaudible) what you’re thinking.

Stan Galanski

Well, we’ve always had the best success in terms of bringing teams of people into the organization. And Paul, you’ll recall for us, there were two acquisitions of -- become significant for us. Our Lloyd’s managing agency, which we bought in 1998, Mander Thomas & Cooper, which now is Navigator’s underwriting agency. And what was called Anfield [ph], which is really was the basis of what we’ve built as Navigators Specialty.

So look, acquisitions can work. Those happen to be MGAs. Beyond that, we’ve really done it, I guess, more organically by focusing on teams of people that we get our homework on, and felt -- with the culture, and be able to come in and hit the ground running. And more often than not, we’ve been thankful that we’ve been able to get that right.

So we’re always opening opportunities. As you know, there’s a lot of things getting shopped and what ifs out there. So you just to get a look at it, and see if anything makes sense to you.

Paul Newsome - Sandler O’Neil and Partners

Fair enough. Thanks. Thank you.

Operator

At this time, we’re sure you have no further questions. So I’d like to now turn the call back over to management for closing remarks.

Stan Galanski

Well, thanks very much. It’s a busy earnings period. We appreciate you taking the time and for your interest in Navigators. Thanks much.

Operator

Ladies and gentlemen, thank you for your participation to today’s conference call. You may now disconnect and have a wonderful day.

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