**UNITED STATESSECURITIES 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 theQuarterly Period Ended September 30, 2004**

 

**Commissionfile number     0-15886**

 

**The Navigators Group, Inc.**

(Exact name of Registrant asspecified 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 addressand former fiscal year, if changed since last report.)

 

Indicate by check mark whether the Registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject 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 October 27, 2004 was12,625,706.

 

 

----

 

**THENAVIGATORS GROUP, INC. AND SUBSIDIARIES**

 

**INDEX**

 
| Part I.  FINANCIAL INFORMATION:                                                                                  |   |
|------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                             |   |
| Item 1. Financial Statements                                                                                     |   |
|                                                                                                             |   |
| Consolidated  Balance Sheets   September 30, 2004 (unaudited) and December 31, 2003                    |   |
|                                                                                                             |   |
| Consolidated Statements of Income (unaudited)  Three Months Ended September 30, 2004 and 2003               |   |
| Nine Months Ended September 30, 2004  and 2003                                                              |   |
|                                                                                                             |   |
| Consolidated  Statements of Stockholders’ Equity   September 30, 2004 and 2003 (unaudited)             |   |
|                                                                                                             |   |
| Consolidated Statements of Comprehensive Income (unaudited)  Three Months Ended September 30, 2004 and 2003 |   |
| Nine Months Ended September 30, 2004 and 2003                                                               |   |
|                                                                                                             |   |
| Consolidated Statements of Cash Flows (unaudited)  Nine Months Ended September 30, 2004 and 2003            |   |
|                                                                                                             |   |
| Notes to Interim Consolidated Financial  Statements (unaudited)                                                  |   |
|                                                                                                             |   |
| 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

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**Part 1****.****           FinancialInformation**

##### **Item 1**.           Financial Statements

**THENAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

*($ inthousands, except share data)*

 
| ** **                                                                                                                        | ** **   | **September 30,  2004** | ** **   | **December 31,  2003** | ** **   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------------|-------------------------|--------------|------------------------|--------------|
| *** ***                                                                                                                      | *** *** | **(Unaudited)**         | *** *** | *** ***           | *** *** |
| **ASSETS**                                                                                                                        |         |                    |         |                   |         |
| Investments  and cash:                                                                                                            |         |                    |         |                   |         |
| Fixed  maturities, available-for-sale, at fair value  (amortized cost: 2004, $688,993; 2003, $577,904)                            |         | $                       | 699,828      |                   | $            | 588,545 |   |
| Equity  securities, available-for-sale, at fair value (cost: 2004, $17,708; 2003,  $11,977)                                       |         | 19,198                  |         | 13,446                 |         |
| Short-term  investments, at cost which approximates fair value                                                                    |         | 104,794                 |         | 83,202                 |         |
| Cash                                                                                                                              |         | 16,029                  |         | 8,399                  |         |
| Total  investments and cash                                                                                                       |         | 839,849                 |         | 693,592                |         |
|                                                                                                                              |         |                    |         |                   |         |
| Premiums in  course of collection                                                                                                 |         | 155,209                 |         | 128,676                |         |
| Commissions  receivable                                                                                                           |         | 2,829                   |         | 3,970                  |         |
| Prepaid  reinsurance premiums                                                                                                     |         | 138,957                 |         | 102,141                |         |
| Reinsurance  receivable on paid losses                                                                                            |         | 17,787                  |         | 26,270                 |         |
| Reinsurance  receivable on unpaid losses and loss adjustment expense                                                              |         | 469,428                 |         | 350,441                |         |
| Federal  income tax recoverable                                                                                                   |         | —                  |         | 8,747                  |         |
| Net deferred  income tax benefit                                                                                                  |         | 17,292                  |         | 15,195                 |         |
| Deferred  policy acquisition costs                                                                                                |         | 28,540                  |         | 24,720                 |         |
| Accrued  investment income                                                                                                        |         | 6,906                   |         | 5,546                  |         |
| Goodwill                                                                                                                          |         | 5,128                   |         | 5,093                  |         |
| Other assets                                                                                                                      |         | 10,578                  |         | 15,067                 |         |
|                                                                                                                              |         |                    |         |                   |         |
| Total assets                                                                                                                      |         | $                       | 1,692,503    |                   | $            | 1,379,458 |   |
|                                                                                                                              |         |                    |         |                   |         |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                    |         |                    |         |                   |         |
| Liabilities:                                                                                                                      |         |                    |         |                   |         |
| Reserves for  losses and loss adjustment expenses                                                                                 |         | $                       | 909,507      |                   | $            | 724,612 |   |
| Unearned  premium                                                                                                                 |         | 287,450                 |         | 238,803                |         |
| Reinsurance  balances payable                                                                                                     |         | 139,518                 |         | 97,583                 |         |
| Federal  income tax payable                                                                                                       |         | 1,821                   |         | —                 |         |
| Payable for  securities purchased                                                                                                 |         | 12,737                  |         | 12,857                 |         |
| Accounts  payable and other liabilities                                                                                           |         | 24,872                  |         | 15,575                 |         |
| Total  liabilities                                                                                                                |         | 1,375,905               |         | 1,089,430              |         |
|                                                                                                                              |         |                    |         |                   |         |
| 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: 12,625,706 for 2004 and 12,535,360 for 2003 |         | 1,263                   |         | 1,254                  |         |
| Additional  paid-in capital                                                                                                       |         | 153,881                 |         | 151,765                |         |
| Accumulated  other comprehensive income                                                                                           |         | 8,752                   |         | 8,537                  |         |
| Retained  earnings                                                                                                                |         | 152,702                 |         | 128,472                |         |
| Total  stockholders’ equity                                                                                                  |         | 316,598                 |         | 290,028                |         |
|                                                                                                                              |         |                    |         |                   |         |
| Total  liabilities and stockholders’ equity                                                                                  |         | $                       | 1,692,503    |                   | $            | 1,379,458 |   |

 

See accompanying notes tointerim consolidated financial statements.

 

3

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**THENAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

*($ andshares in thousands, except net income per share)*

 
| ** **                                        | ** **   | **Three Months Ended  September 30,** | ** **   |
|---------------------------------------------------|--------------|--------------------------------------------|--------------|
| ** **                                        | ** **   | **2004**                                   | ** **   | **2003** | ** ** |
| *** ***                                      | *** *** | **(Unaudited)**                            | *** *** |
|                                              |         |                                       |         |   |   |
| Gross  written premium                            |         | $                                          | 151,178      |   | $ | 139,632 |   |
| Revenues:                                         |         |                                       |         |   |   |
| Net written  premium                              |         | $                                          | 65,992       |   | $ | 70,631 |   |
| Decrease in  unearned premium                     |         | 9,145                                      |         | 3,906 |   |
| Net earned  premium                               |         | 75,137                                     |         | 74,537 |   |
| Commission  income                                |         | 1,121                                      |         | 23 |   |
| Net  investment income                            |         | 6,881                                      |         | 4,634 |   |
| Net realized  capital gains                       |         | 271                                        |         | 349 |   |
| Other income  (expense)                           |         | (127                                       | )            | 139 |   |
| Total  revenues                                   |         | 83,283                                     |         | 79,682 |   |
|                                              |         |                                       |         |   |   |
| Operating  expenses:                              |         |                                       |         |   |   |
| Net losses  and loss adjustment expenses incurred |         | 49,247                                     |         | 48,526 |   |
| Commission  expense                               |         | 8,773                                      |         | 9,194 |   |
| Other  operating expenses                         |         | 16,014                                     |         | 13,539 |   |
| Interest  expense                                 |         | —                                     |         | 68 |   |
| Total  operating expenses                         |         | 74,034                                     |         | 71,327 |   |
|                                              |         |                                       |         |   |   |
| Income  before income tax expense                 |         | 9,249                                      |         | 8,355 |   |
|                                              |         |                                       |         |   |   |
| Income tax  expense (benefit):                    |         |                                       |         |   |   |
| Current                                           |         | 4,225                                      |         | 4,195 |   |
| Deferred                                          |         | (1,256                                     | )            | (2,148 | ) |
| Total income  tax expense                         |         | 2,969                                      |         | 2,047 |   |
|                                              |         |                                       |         |   |   |
| Net income                                        |         | $                                          | 6,280        |   | $ | 6,308 |   |
|                                              |         |                                       |         |   |   |
| Net income  per common share:                     |         |                                       |         |   |   |
| Basic                                             |         | $                                          | 0.50         |   | $ | 0.74 |   |
| Diluted                                           |         | $                                          | 0.50         |   | $ | 0.73 |   |
|                                              |         |                                       |         |   |   |
| Average  common shares outstanding:               |         |                                       |         |   |   |
| Basic                                             |         | 12,612                                     |         | 8,535 |   |
| Diluted                                           |         | 12,679                                     |         | 8,691 |   |

 

See accompanying notes tointerim consolidated financial statements.

 

4

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**THENAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

*($ andshares in thousands, except net income per share)*

 
| ** **                                        | ** **   | **Nine Months Ended  September 30,** | ** **   |
|---------------------------------------------------|--------------|-------------------------------------------|--------------|
| ** **                                        | ** **   | **2004**                                  | ** **   | **2003** | ** ** |
| *** ***                                      | *** *** | **(Unaudited)**                           | *** *** |
|                                              |         |                                      |         |   |   |
| Gross  written premium                            |         | $                                         | 508,756      |   | $ | 455,526 |   |
| Revenues:                                         |         |                                      |         |   |   |
| Net written  premium                              |         | $                                         | 235,616      |   | $ | 223,295 |   |
| (Increase)  in unearned premium                   |         | (10,989                                   | )            | (17,180 | ) |
| Net earned  premium                               |         | 224,627                                   |         | 206,115 |   |
| Commission  income                                |         | 3,608                                     |         | 2,748 |   |
| Net  investment income                            |         | 19,408                                    |         | 13,847 |   |
| Net realized  capital gains                       |         | 588                                       |         | 1,235 |   |
| Other income                                      |         | 267                                       |         | 728 |   |
| Total  revenues                                   |         | 248,498                                   |         | 224,673 |   |
|                                              |         |                                      |         |   |   |
| Operating  expenses:                              |         |                                      |         |   |   |
| Net losses  and loss adjustment expenses incurred |         | 138,391                                   |         | 135,857 |   |
| Commission  expense                               |         | 29,840                                    |         | 28,698 |   |
| Other  operating expenses                         |         | 44,066                                    |         | 37,734 |   |
| Interest  expense                                 |         | —                                    |         | 251 |   |
| Total  operating expenses                         |         | 212,297                                   |         | 202,540 |   |
|                                              |         |                                      |         |   |   |
| Income before  income tax expense                 |         | 36,201                                    |         | 22,133 |   |
|                                              |         |                                      |         |   |   |
| Income tax  expense (benefit):                    |         |                                      |         |   |   |
| Current                                           |         | 14,184                                    |         | 8,765 |   |
| Deferred                                          |         | (2,213                                    | )            | (3,807 | ) |
| Total income  tax expense                         |         | 11,971                                    |         | 4,958 |   |
|                                              |         |                                      |         |   |   |
| Net income                                        |         | $                                         | 24,230       |   | $ | 17,175 |   |
|                                              |         |                                      |         |   |   |
| Net income  per common share:                     |         |                                      |         |   |   |
| Basic                                             |         | $                                         | 1.93         |   | $ | 2.02 |   |
| Diluted                                           |         | $                                         | 1.91         |   | $ | 1.99 |   |
|                                              |         |                                      |         |   |   |
| Average  common shares outstanding:               |         |                                      |         |   |   |
| Basic                                             |         | 12,584                                    |         | 8,515 |   |
| Diluted                                           |         | 12,688                                    |         | 8,640 |   |

 

See accompanying notes tointerim consolidated financial statements.

 

5

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**THENAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

*($ inthousands)*

 
| ** **                                        | ** **   | **Nine Months Ended  September 30,** | ** **   |
|---------------------------------------------------|--------------|-------------------------------------------|--------------|
| ** **                                        | ** **   | **2004**                                  | ** **   | **2003** | ** ** |
| *** ***                                      | *** *** | **(Unaudited)**                           | *** *** |
| Preferred  Stock                                  |         |                                      |         |   |   |
| Balance at  beginning and end of period           |         | $                                         | —       |   | $ | — |   |
|                                              |         |                                      |         |   |   |
| Common stock                                      |         |                                      |         |   |   |
| Balance at  beginning of year                     |         | $                                         | 1,254        |   | $ | 851 |   |
| Shares  issued under stock plans                  |         | 9                                         |         | 4 |   |
| Balance at  end of period                         |         | $                                         | 1,263        |   | $ | 855 |   |
|                                              |         |                                      |         |   |   |
| Additional  paid-in capital                       |         |                                      |         |   |   |
| Balance at  beginning of year                     |         | $                                         | 151,765      |   | $ | 40,141 |   |
| Effect of  SFAS 123 for stock options             |         | 754                                       |         | 547 |   |
| Shares  issued under stock plans                  |         | 1,362                                     |         | 883 |   |
| Balance at  end of period                         |         | $                                         | 153,881      |   | $ | 41,571 |   |
|                                              |         |                                      |         |   |   |
| Treasury  stock held at cost                      |         |                                      |         |   |   |
| Balance at  beginning of year                     |         | $                                         | —       |   | $ | (236 | ) |
| Shares  issued for vested stock grants            |         | —                                    |         | 236 |   |
| Balance at  end of period                         |         | $                                         | —       |   | $ | — |   |
|                                              |         |                                      |         |   |   |
| Accumulated  other comprehensive income           |         |                                      |         |   |   |
| Net  unrealized gains on securities, net of tax   |         |                                      |         |   |   |
| Balance at  beginning of year                     |         | $                                         | 7,871        |   | $ | 9,499 |   |
| Change in  period                                 |         | 139                                       |         | (8 | ) |
| Balance at  end of period                         |         | 8,010                                     |         | 9,491 |   |
| Cumulative  translation adjustments, net of tax   |         |                                      |         |   |   |
| Balance at  beginning of year                     |         | 666                                       |         | 233 |   |
| Net  adjustment for period                        |         | 76                                        |         | 480 |   |
| Balance at  end of period                         |         | 742                                       |         | 713 |   |
| Balance at  end of period                         |         | $                                         | 8,752        |   | $ | 10,204 |   |
|                                              |         |                                      |         |   |   |
| Retained  earnings                                |         |                                      |         |   |   |
| Balance at  beginning of year                     |         | $                                         | 128,472      |   | $ | 120,787 |   |
| Net income                                        |         | 24,230                                    |         | 17,175 |   |
| Balance at  end of period                         |         | $                                         | 152,702      |   | $ | 137,962 |   |
|                                              |         |                                      |         |   |   |
| Total  stockholders’ equity at end of period |         | $                                         | 316,598      |   | $ | 190,592 |   |

 

See accompanying notes to interimconsolidated financial statements.

 

6

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**THE NAVIGATORS GROUP, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFCOMPREHENSIVE INCOME**

*($ in thousands)*

 
| ** **                                                                                                                                      | ** **                                                              | **Three Months Ended  September 30,** | ** **   |
|-------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------|--------------------------------------------|--------------|
| ** **                                                                                                                                      | ** **                                                              | **2004**                                   | ** **   | **2003** | ** ** |
| *** ***                                                                                                                                    | *** ***                                                            | **(Unaudited)**                            | *** *** |
|                                                                                                                                            |                                                                    |                                       |         |   |   |
| Net income                                                                                                                                      |                                                                    | $                                          | 6,280        |   | $ | 6,308 |   |
| Other  comprehensive income (loss):                                                                                                             |                                                                    |                                       |         |   |   |
| Change in  net unrealized gains (losses) on securities, net of tax (benefit) expense of  $4,073 and $(1,908) in 2004 and 2003, respectively (1) |                                                                    | 7,564                                      |         | (3,749 | ) |
| Change in  foreign currency translation gains, net of tax (benefit) expense of $(89) and  $100 in 2004 and 2003, respectively                   |                                                                    | (165                                       | )            | 186 |   |
| Other  comprehensive income (loss)                                                                                                              |                                                                    | 7,399                                      |         | (3,563 | ) |
|                                                                                                                                            |                                                                    |                                       |         |   |   |
| Comprehensive  income                                                                                                                           |                                                                    | $                                          | 13,679       |   | $ | 2,745 |   |
|                                                                                                                                            |                                                                    |                                       |         |   |   |
| (1)                                                                                                                                             | Disclosure of  reclassification amount, net of tax:                     |                                       |         |   |   |   |
|                                                                                                                                            | Unrealized holding gains  (losses) arising during period                |                                       | $            | 7,740 |   | $ | (3,477 | ) |
|                                                                                                                                            | Less: reclassification  adjustment for net gains included in net income |                                       | 176          |   | 272 |   |
|                                                                                                                                            | Net unrealized gains  (losses) on securities                            |                                       | $            | 7,564 |   | $ | (3,749 | ) |

 

See accompanying notes to interimconsolidated financial statements.

 

7

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**THE NAVIGATORS GROUP, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFCOMPREHENSIVE INCOME**

*($ in thousands)*

 
| ** **                                                                                                                    | ** **                                                              | **Nine Months Ended  September 30,** | ** **   |
|-------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------|-------------------------------------------|--------------|
| ** **                                                                                                                    | ** **                                                              | **2004**                                  | ** **   | **2003** | ** ** |
| *** ***                                                                                                                  | *** ***                                                            | **(Unaudited)**                           | *** *** |
|                                                                                                                          |                                                                    |                                      |         |   |   |
| Net income                                                                                                                    |                                                                    | $                                         | 24,230       |   | $ | 17,175 |   |
| Other  comprehensive income:                                                                                                  |                                                                    |                                      |         |   |   |
| Change in  net unrealized gains (losses) on securities, net of tax expense of $75 and $165  in 2004 and 2003, respectively(1) |                                                                    | 139                                       |         | (8 | ) |
| Change in  foreign currency translation gains, net of tax expense of $41 and $258 in  2004 and 2003, respectively             |                                                                    | 76                                        |         | 480 |   |
| Other  comprehensive income                                                                                                   |                                                                    | 215                                       |         | 472 |   |
|                                                                                                                          |                                                                    |                                      |         |   |   |
| Comprehensive  income                                                                                                         |                                                                    | $                                         | 24,445       |   | $ | 17,647 |   |
|                                                                                                                          |                                                                    |                                      |         |   |   |
| (1)                                                                                                                           | Disclosure  of reclassification amount, net of tax:                     |                                      |         |   |   |   |
|                                                                                                                          | Unrealized  holding gains arising during period                         |                                      | $            | 521 |   | $ | 1,002 |   |
|                                                                                                                          | Less: reclassification  adjustment for net gains included in net income |                                      | 382          |   | 1,010 |   |
|                                                                                                                          | Net  unrealized gains (losses) on securities                            |                                      | $            | 139 |   | $ | (8 | ) |

 

See accompanying notes to interimconsolidated financial statements.

 

8

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**THENAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

*($ inthousands)*

 
| ** **                                                                                    | ** **   | **Nine Months Ended  September 30,** | ** **   |
|-----------------------------------------------------------------------------------------------|--------------|-------------------------------------------|--------------|
| ** **                                                                                    | ** **   | **2004**                                  | ** **   | **2003** | ** ** |
| *** ***                                                                                  | *** *** | **(Unaudited)**                           | *** *** |
| Operating  activities:                                                                        |         |                                      |         |   |   |
| Net income                                                                                    |         | $                                         | 24,230       |   | $ | 17,175 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities: |         |                                      |         |   |   |
| Depreciation  & amortization                                                              |         | 893                                       |         | 1,222 |   |
| Net deferred  income tax (benefit)                                                            |         | (2,213                                    | )            | (3,807 | ) |
| Net realized  capital (gains)                                                                 |         | (588                                      | )            | (1,235 | ) |
| Changes in  assets and liabilities:                                                           |         |                                      |         |   |   |
| Reinsurance  receivable on paid and unpaid losses and loss adjustment expenses                |         | (110,504                                  | )            | (41,894 | ) |
| Reserve for  losses and loss adjustment expenses                                              |         | 184,895                                   |         | 92,788 |   |
| Prepaid  reinsurance premiums                                                                 |         | (36,816                                   | )            | (58,046 | ) |
| Unearned  premium                                                                             |         | 48,647                                    |         | 74,625 |   |
| Premiums in  course of collection                                                             |         | (26,533                                   | )            | (21,951 | ) |
| Commissions  receivable                                                                       |         | 1,141                                     |         | 201 |   |
| Deferred  policy acquisition costs                                                            |         | (3,820                                    | )            | 790 |   |
| Accrued  investment income                                                                    |         | (1,360                                    | )            | (1,486 | ) |
| Reinsurance  balances payable                                                                 |         | 41,935                                    |         | 47,537 |   |
| Federal  income tax                                                                           |         | 10,568                                    |         | 3,137 |   |
| Other                                                                                         |         | 11,273                                    |         | 1,877 |   |
| Net cash  provided by operating activities                                                    |         | 141,748                                   |         | 110,933 |   |
|                                                                                          |         |                                      |         |   |   |
| Investing  activities:                                                                        |         |                                      |         |   |   |
| Fixed  maturities, available-for-sale                                                         |         |                                      |         |   |   |
| Redemptions  and maturities                                                                   |         | 118,753                                   |         | 5,677 |   |
| Sales                                                                                         |         | 225,858                                   |         | 191,899 |   |
| Purchases                                                                                     |         | (457,892                                  | )            | (287,825 | ) |
| Equity  securities, available-for-sale                                                        |         |                                      |         |   |   |
| Sales                                                                                         |         | 3,646                                     |         | 1,607 |   |
| Purchases                                                                                     |         | (8,916                                    | )            | (1,480 | ) |
| Change in  payable for securities                                                             |         | (120                                      | )            | 3,965 |   |
| Net change  in short-term investments                                                         |         | (15,123                                   | )            | (27,642 | ) |
| Purchase of  property and equipment                                                           |         | (1,446                                    | )            | (1,339 | ) |
| Net cash  (used in) investing activities                                                      |         | (135,240                                  | )            | (115,138 | ) |
|                                                                                          |         |                                      |         |   |   |
| Financing  activities:                                                                        |         |                                      |         |   |   |
| Repayment of  bank loan                                                                       |         | —                                    |         | (5,500 | ) |
| Proceeds  from Employee Stock Purchase Plan                                                   |         | 434                                       |         | — |   |
| Proceeds  from exercise of stock options                                                      |         | 688                                       |         | 426 |   |
| Net cash  provided by (used in) financing activities                                          |         | 1,122                                     |         | (5,074 | ) |
|                                                                                          |         |                                      |         |   |   |
| Increase  (decrease) in cash                                                                  |         | 7,630                                     |         | (9,279 | ) |
| Cash at  beginning of year                                                                    |         | 8,399                                     |         | 13,443 |   |
| Cash at end  of period                                                                        |         | $                                         | 16,029       |   | $ | 4,164 |   |
|                                                                                          |         |                                      |         |   |   |
| Supplemental  disclosures of cash flow information:                                           |         |                                      |         |   |   |
| Federal,  state and local income tax paid                                                     |         | 3,597                                     |         | 5,761 |   |
| Interest  paid                                                                                |         | —                                    |         | 252 |   |
| Issuance of  stock to directors                                                               |         | 60                                        |         | 72 |   |

 

See accompanying notes to interimconsolidated financial statements.

 

9

----

 

###### **THE NAVIGATORS GROUP, INC.  ANDSUBSIDIARIES**

 

**Notes to Interim Consolidated Financial** Statements

*(Unaudited)*

 

**Note 1. Accounting Policies**

 

The interim consolidated financial statementsare unaudited but reflect all adjustments which, in the opinion of management,are necessary to provide a fair statement of the results of The NavigatorsGroup, Inc. and its subsidiaries (the “Company”) for the interim periodspresented on the basis of accounting principles generally accepted in theUnited States of America (“GAAP”).  Allsuch adjustments are of a normal recurring nature.  All significant intercompany transactions andbalances have been eliminated.  Thepreparation of these financial statements requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of the financialstatements and the reported revenues and expenses during the reportingperiods.  The results of operations forany interim period are not necessarily indicative of results for the fullyear.  These financial statements shouldbe read in conjunction with the consolidated financial statements and notescontained in the Company’s 2003 Annual Report on Form 10-K.  Certain amounts for prior periods have beenreclassified to conform to the current period’s presentation.

 

**Note 2. Reinsurance Ceded**

 

The Company’sceded earned premiums were $84,858,000 and $65,184,000 for the three monthsended September 30, 2004 and 2003, respectively, and were $237,565,000 and$174,299,000 for the nine months ended September 30, 2004 and 2003,respectively.  The Company’s cededincurred losses were $69,907,000 and $32,888,000 for the three months ended September 30,2004 and 2003, respectively, and were $194,095,000 and $96,393,000 for the ninemonths ended September 30, 2004 and 2003, respectively.

 

**Note 3. Segment Information**

 

TheCompany’s subsidiaries are primarily engaged in the writing and management ofproperty and casualty insurance.  TheCompany’s segments include the Insurance Companies, the Lloyd’s operations andthe Navigators Agencies, each of which is managed separately.  The Insurance Companies consist of NavigatorsInsurance Company, which includes a branch in the U.K. (the “U.K. Branch”), andNIC Insurance Company and currently are primarily engaged in underwritingmarine insurance and related lines of business, contractors’ general liabilityinsurance, and professional liability insurance.  The Lloyd’s operations underwrite marine andrelated lines of business at Lloyd’s of London. The Navigators Agencies are underwriting management companies whichproduce, manage and underwrite insurance and reinsurance for both affiliatedand unaffiliated companies.  All segmentsare evaluated based on their GAAP results.

 

TheInsurance Companies and the Lloyd’s operations are measured by taking intoaccount net premiums earned, incurred losses and loss adjustment expenses (“LAE”),commission expense and other underwriting expenses.  The Navigators Agencies’ results includecommission income less other operating expenses.  Parent and other operations includeinter-segment income and expense in the form of affiliated commissions, incomeand expense from corporate operations and consolidating adjustments.  Each segment also maintains their owninvestments, on which they earn income and realize capital gains or losses.

 

10

----

 

Financial data by segmentfor the three months ended September 30, 2004 and 2003 was as follows:

 
| ** **                                         | ** **   | **Three Months Ended September 30,  2004** | ** **   |
|----------------------------------------------------|--------------|-------------------------------------------------|--------------|
| ** **                                         | ** **   | **Insurance  Companies**                        | ** **   | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations (1)** | ** ** | **Total** | ** ** |
| *** ***                                       | *** *** | **($ in thousands)**                       | *** *** |
|                                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Gross  written premium                             |         | $                                               | 107,318      |   | $ | 45,004 |   |   |   | $ | (1,144 | ) | $ | 151,178 |   |
| Net written  premium                               |         | 44,904                                          |         | 21,088 |   |   |   |   |   | 65,992 |   |
|                                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Revenues:                                          |         |                                            |         |   |   |   |   |   |   |   |   |
| Net earned  premium                                |         | 51,541                                          |         | 23,596 |   |   |   | — |   | 75,137 |   |
| Commission  income                                 |         | —                                          |         | 300 |   | $ | 7,797 |   | (6,976 | ) | 1,121 |   |
| Net  investment income                             |         | 6,225                                           |         | 649 |   | 2 |   | 5 |   | 6,881 |   |
| Net realized  capital gains (losses)               |         | 326                                             |         | (55 | ) | — |   | — |   | 271 |   |
| Other income  (expense)                            |         | (7                                              | )            | (378 | ) | 258 |   | — |   | (127 | ) |
| Total  revenues                                    |         | 58,085                                          |         | 24,112 |   | 8,057 |   | (6,971 | ) | 83,283 |   |
|                                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Operating  expenses:                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Net losses  and LAE                                |         | 35,401                                          |         | 13,846 |   | — |   | — |   | 49,247 |   |
| Commission  expense                                |         | 11,682                                          |         | 4,067 |   | — |   | (6,976 | ) | 8,773 |   |
| Other  operating expenses                          |         | 1,780                                           |         | 3,425 |   | 9,616 |   | 1,193 |   | 16,014 |   |
| Total  operating expenses                          |         | 48,863                                          |         | 21,338 |   | 9,616 |   | (5,783 | ) | 74,034 |   |
|                                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Income  (loss) before income tax expense (benefit) |         | 9,222                                           |         | 2,774 |   | (1,559 | ) | (1,188 | ) | 9,249 |   |
| Income tax  expense (benefit)                      |         | 2,871                                           |         | 971 |   | (460 | ) | (413 | ) | 2,969 |   |
| Net income  (loss)                                 |         | $                                               | 6,351        |   | $ | 1,803 |   | $ | (1,099 | ) | $ | (775 | ) | $ | 6,280 |   |
|                                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Identifiable  assets (2)                           |         | $                                               | 1,247,123    |   | $ | 467,998 |   | $ | 15,721 |   | $ | 33,039 |   | $ | 1,692,503 |   |
|                                               |         |                                            |         |   |   |   |   |   |   |   |   |
| Loss and LAE  ratio                                |         | 68.7                                            | %            | 58.7 | % |   |   |   |   | 65.5 | % |
| Commission  expense ratio                          |         | 22.7                                            | %            | 17.2 | % |   |   |   |   | 21.0 | % |
| Other  operating expense ratio                     |         | 3.4                                             | %            | 14.5 | % |   |   |   |   | 6.9 | % |
| Combined  ratio                                    |         | 94.8                                            | %            | 90.4 | % |   |   |   |   | 93.4 | % |
|                                                    |              |                                                 |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)Includes inter-segment eliminations.

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

 

11

----

 
| ** **                                         | ** ** | **Three Months Ended September 30,  2003** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                         | ** ** | **Insurance  Companies**                        | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations (1)** | ** ** | **Consolidated  Total** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**                       | ** ** |
|                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Gross written  premium                             |       | $                                               | 100,097    |   | $ | 47,005 |   |   |   |   | $ | (7,470 | ) | $ | 139,632 |   |
| Net written  premium                               |       | 54,831                                          |       | 15,800 |   |   |   | — |   | 70,631 |   |
|                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Revenues:                                          |       |                                            |       |   |   |   |   |   |   |   |   |
| Net earned  premium                                |       | 57,529                                          |       | 17,008 |   |   |   | — |   | 74,537 |   |
| Commission  income                                 |       | —                                          |       | 136 |   | $ | 7,990 |   | (8,103 | ) | 23 |   |
| Net  investment income                             |       | 4,207                                           |       | 422 |   | (2 | ) | 7 |   | 4,634 |   |
| Net realized  capital gains                        |       | 217                                             |       | 132 |   | — |   | — |   | 349 |   |
| Other income  (expense)                            |       | (82                                             | )          | (98 | ) | 443 |   | (124 | ) | 139 |   |
| Total  revenues                                    |       | 61,871                                          |       | 17,600 |   | 8,431 |   | (8,220 | ) | 79,682 |   |
|                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Operating  expenses:                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Net losses  and LAE                                |       | 37,732                                          |       | 10,794 |   | — |   | — |   | 48,526 |   |
| Commission  expense                                |       | 14,189                                          |       | 3,108 |   | — |   | (8,103 | ) | 9,194 |   |
| Other  operating expenses                          |       | 1,461                                           |       | 2,049 |   | 8,610 |   | 1,419 |   | 13,539 |   |
| Interest  expense                                  |       | —                                          |       | — |   | — |   | 68 |   | 68 |   |
| Total  operating expenses                          |       | 53,382                                          |       | 15,951 |   | 8,610 |   | (6,616 | ) | 71,327 |   |
|                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Income  (loss) before income tax expense (benefit) |       | 8,489                                           |       | 1,649 |   | (179 | ) | (1,604 | ) | 8,355 |   |
| Income tax  expense (benefit)                      |       | 2,726                                           |       | — |   | (146 | ) | (533 | ) | 2,047 |   |
| Net income  (loss)                                 |       | $                                               | 5,763      |   | $ | 1,649 |   | $ | (33 | ) | $ | (1,071 | ) | $ | 6,308 |   |
|                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Identifiable  assets (2)                           |       | $                                               | 829,161    |   | $ | 348,052 |   | $ | 17,266 |   | $ | 25,649 |   | $ | 1,153,101 |   |
|                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Loss and LAE  ratio                                |       | 65.6                                            | %          | 63.5 | % |   |   |   |   | 65.1 | % |
| Commission  expense ratio                          |       | 24.7                                            | %          | 18.3 | % |   |   |   |   | 23.2 | % |
| Other  operating expense ratio                     |       | 2.5                                             | %          | 12.0 | % |   |   |   |   | 4.6 | % |
| Combined  ratio                                    |       | 92.8                                            | %          | 93.8 | % |   |   |   |   | 92.9 | % |

 

----

(1) Includes inter-segment eliminations.

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

 

12

----

 

Financial data by segmentfor the nine months ended September 30, 2004 and 2003 was as follows:

 
| ** **                                         | ** ** | **Nine Months Ended September 30,  2004** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                         | ** ** | **Insurance  Companies**                       | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations (1)** | ** ** | **Total** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**                      | ** ** |
|                                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Gross  written premium                             |       | $                                              | 326,755    |   | $ | 186,471 |   |   |   | $ | (4,470 | ) | $ | 508,756 |   |
| Net written  premium                               |       | 145,614                                        |       | 90,002 |   |   |   |   |   | 235,616 |   |
|                                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Revenues:                                          |       |                                           |       |   |   |   |   |   |   |   |   |
| Net earned  premium                                |       | 156,506                                        |       | 68,121 |   |   |   |   |   | 224,627 |   |
| Commission  income                                 |       | —                                         |       | 863 |   | $ | 23,884 |   | (21,139 | ) | 3,608 |   |
| Net  investment income                             |       | 17,538                                         |       | 1,844 |   | 6 |   | 20 |   | 19,408 |   |
| Net realized  capital gains (losses)               |       | 707                                            |       | (119 | ) | — |   | — |   | 588 |   |
| Other income  (expense)                            |       | 6                                              |       | (368 | ) | 629 |   | — |   | 267 |   |
| Total  revenues                                    |       | 174,757                                        |       | 70,341 |   | 24,519 |   | (21,119 | ) | 248,498 |   |
|                                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Operating  expenses:                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Net losses  and LAE                                |       | 100,669                                        |       | 37,722 |   | — |   | — |   | 138,391 |   |
| Commission  expense                                |       | 39,069                                         |       | 11,910 |   | — |   | (21,139 | ) | 29,840 |   |
| Other  operating expenses                          |       | 3,967                                          |       | 9,654 |   | 27,314 |   | 3,131 |   | 44,066 |   |
| Total  operating expenses                          |       | 143,705                                        |       | 59,286 |   | 27,314 |   | (18,008 | ) | 212,297 |   |
|                                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Income  (loss) before income tax expense (benefit) |       | 31,052                                         |       | 11,055 |   | (2,795 | ) | (3,111 | ) | 36,201 |   |
| Income tax  expense (benefit)                      |       | 9,892                                          |       | 3,869 |   | (852 | ) | (938 | ) | 11,971 |   |
| Net income  (loss)                                 |       | $                                              | 21,160     |   | $ | 7,186 |   | $ | (1,943 | ) | $ | (2,173 | ) | $ | 24,230 |   |
|                                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Identifiable  assets (2)                           |       | $                                              | 1,247,123  |   | $ | 467,998 |   | $ | 15,721 |   | $ | 33,039 |   | $ | 1,692,503 |   |
|                                               |       |                                           |       |   |   |   |   |   |   |   |   |
| Loss and LAE  ratio                                |       | 64.3                                           | %          | 55.4 | % |   |   |   |   | 61.6 | % |
| Commission  expense ratio                          |       | 25.0                                           | %          | 17.5 | % |   |   |   |   | 22.7 | % |
| Other  operating expense ratio                     |       | 2.5                                            | %          | 14.2 | % |   |   |   |   | 6.1 | % |
| Combined  ratio                                    |       | 91.8                                           | %          | 87.1 | % |   |   |   |   | 90.4 | % |

 

----

(1) Includesinter-segment eliminations.

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

 

13

----

 
| ** **                     | ** ** | **Nine Months Ended September 30,  2003** | ** ** |
|--------------------------------|------------|------------------------------------------------|------------|
| ** **                     | ** ** | **Insurance  Companies**                       | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations****(1)** | ** ** | **Consolidated  Total** | ** ** |
| ** **                     | ** ** | **($ in thousands)**                      | ** ** |
|                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Gross  written premium         |       | $                                              | 311,324    |   | $ | 169,480 |   |   |   |   | $ | (25,278 | ) | $ | 455,526 |   |
| Net written  premium           |       | 160,289                                        |       | 63,006 |   |   |   | — |   | 223,295 |   |
|                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Revenues:                      |       |                                           |       |   |   |   |   |   |   |   |   |
| Net earned  premium            |       | 154,537                                        |       | 51,578 |   |   |   | — |   | 206,115 |   |
| Commission  income             |       | —                                         |       | 480 |   | $ | 23,713 |   | (21,445 | ) | 2,748 |   |
| Net  investment income         |       | 12,406                                         |       | 1,413 |   | 20 |   | 8 |   | 13,847 |   |
| Net realized  capital gains    |       | 642                                            |       | 593 |   | — |   | — |   | 1,235 |   |
| Other income  (expense)        |       | 6                                              |       | 116 |   | 980 |   | (374 | ) | 728 |   |
| Total  revenues                |       | 167,591                                        |       | 54,180 |   | 24,713 |   | (21,811 | ) | 224,673 |   |
|                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Operating  expenses:           |       |                                           |       |   |   |   |   |   |   |   |   |
| Net losses  and LAE            |       | 102,602                                        |       | 33,255 |   | — |   | — |   | 135,857 |   |
| Commission  expense            |       | 40,931                                         |       | 9,212 |   | — |   | (21,445 | ) | 28,698 |   |
| Other  operating expenses      |       | 3,964                                          |       | 5,895 |   | 23,813 |   | 4,062 |   | 37,734 |   |
| Interest  expense              |       | —                                         |       | — |   | — |   | 251 |   | 251 |   |
| Total  operating expenses      |       | 147,497                                        |       | 48,362 |   | 23,813 |   | (17,132 | ) | 202,540 |   |
|                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Income  (loss) before income   |       |                                           |       |   |   |   |   |   |   |   |   |
| tax expense  (benefit)         |       | 20,094                                         |       | 5,818 |   | 900 |   | (4,679 | ) | 22,133 |   |
| Income tax  expense (benefit)  |       | 6,361                                          |       | — |   | 207 |   | (1,610 | ) | 4,958 |   |
| Net income  (loss)             |       | $                                              | 13,733     |   | $ | 5,818 |   | $ | 693 |   | $ | (3,069 | ) | $ | 17,175 |   |
|                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Identifiable  assets (2)       |       | $                                              | 829,161    |   | $ | 348,052 |   | $ | 17,266 |   | $ | 25,649 |   | $ | 1,153,101 |   |
|                           |       |                                           |       |   |   |   |   |   |   |   |   |
| Loss and LAE  ratio            |       | 66.4                                           | %          | 64.5 | % |   |   |   |   | 65.9 | % |
| Commission  expense ratio      |       | 26.5                                           | %          | 17.9 | % |   |   |   |   | 24.3 | % |
| Other  operating expense ratio |       | 2.5                                            | %          | 11.4 | % |   |   |   |   | 4.8 | % |
| Combined  ratio                |       | 95.4                                           | %          | 93.8 | % |   |   |   |   | 95.0 | % |

 

----

(1)Includes inter-segment eliminations.

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

 

TheInsurance Companies’ net earned premium includes $7,670,000 and $7,442,000 ofnet earned premium from the U.K. Branch for the three months ended September 30,2004 and 2003, respectively, and $23,849,000 and $23,442,000 of net earnedpremium for the nine months ended September 30, 2004 and 2003,respectively.

 

14

----

 

**Note 4. Comprehensive Income**

 

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

 

**Note 5. Stock-Based Compensation**

 

In December 2002, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) 148, *Accounting for Stock-BasedCompensation, Amendment of FASB Statement No. 123.*  The provisions of this statement providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  The provisions are effective for financialstatements for fiscal years ending after December 15, 2002.

 

SFAS 123, *Accounting for Stock-BasedCompensation,* establishes financial accounting and reportingstandards for stock-based compensation plans. In the fourth quarter of 2003, effective January 1, 2003, theCompany adopted the fair value recognition provisions of SFAS 123.  Under the modified prospective method ofadoption selected by the Company under the provisions of SFAS 148, compensationcost recognized in 2003 and subsequent is the same as that which would havebeen recognized had the recognition provisions of SFAS 123 been applied fromits original effective date.  Results for2003 have been adjusted herein.  Prior to2003, the Company accounted for its stock compensation plans under therecognition and measurement provisions of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB 25”), and related interpretations, with certain pro forma disclosures asrequired by SFAS 123.  APB 25 requirescompensation expense to be recognized only if the fair value of the underlyingstock at the grant date exceeds the exercise price of the option.

 

Stock based compensation is expensed as theawards vest.  The amount charged toexpense for stock grants was $275,000 and $309,000 for the three months ended September 30,2004 and 2003, respectively and $922,000 and $795,000 for the ninemonths ended September 30, 2004 and 2003, respectively.  The amount charged to expense for stockoptions was $276,000 and $191,000 for the three months ended September 30,2004 and 2003, respectively, and $754,000,and $592,000 for the nine monthsended September 30, 2004 and 2003, respectively.  Stock appreciation rights resulted in expenseof $107,000 and $545,000 for the three months ended September 30, 2004 and2003, respectively, and income of $152,000 and expense of $1,718,000 for thenine months ended September 30, 2004 and 2003, respectively, all of whichwere included in other operating expenses for the periods indicated.

 

In addition, $30,000 and $18,000 wereexpensed for the three months ended September 30, 2004 and 2003,respectively, and $90,000 and $72,000 for the nine months ended September 30, 2004 and2003, respectively, for stock issued annually to non-employee directors as partof the directors’ compensation for serving on the Company’s Board of Directors.

 

**Note 6. Application of New Accounting Standards**

 

In January 2003, the FASB issuedInterpretation No. 46, *Consolidation ofVariable Interest Entities.* Interpretation 46 requires variable interest entities to be consolidatedby their primary beneficiaries.  Theadoption of this interpretation did not have any effect on the Company’sfinancial condition or results of operations. In December 2003, the FASB revised Interpretation 46 primarily toclarify certain requirements, ease some implementation problems and add newscope exceptions.  The result of therevisions tend to make it more likely that potential variable interest entitieswill be identified and consolidated.  Theadoption of the revision to Interpretation 46 did not have any effect on theCompany’s financial condition or results of operations.

 

In September 2004, the FASB approved issuing a Staff Position todelay the requirement to record impairment losses under Emerging Issues TaskForce Issue No. 03-1 (“EITF 03-1”).  Theapproved delay applies 

 

15

----

 

to all securities within the scope of EITF03-1 and is expected to end when new guidance is issued and becomeseffective.  The Company will review thenew guidance when it becomes available.

 

**Note 7. Lloyd’s Syndicate**

 

We record our pro rata share of Lloyd’s Syndicate1221’s assets, liabilities, revenues and expenses, after making adjustments toconvert 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 endof three years.  We record adjustments torecognize underwriting results as incurred, including the expected ultimatecost of losses incurred.  These adjustmentsto losses are based on actuarial analysis of syndicate accounts, includingforecasts of expected ultimate losses provided by the syndicates.  At theend of the Lloyd’s three year period for determining underwriting results foran account year, the syndicate will close the account year by reinsuringoutstanding claims on that account year with the participants for the account’snext underwriting year.  The amount toclose an underwriting year into the next year is referred to as the “reinsuranceto close”.  The reinsurance to closetransactions are recorded in the fourth quarter as additional written andearned premium, losses incurred, loss reserves and receivables, all in the sameamount.  No gains or losses are recorded on the reinsuranceto close transactions.

 

Lloyd’s Syndicate 1221 has stamp capacity of£150.0 million ($273.8 million) in 2004 compared to £125.0 million ($200.3million) in 2003.  Stamp capacity is ameasure of the amount of premium a Lloyd’s syndicate is authorized to write asdetermined by the Council of Lloyd’s. Syndicate 1221’s capacity is expressed net of commission (as is standardat Lloyd’s) of approximately 21%.  TheSyndicate 1221 premium recorded in the Company’s financial statements is grossof commission.  The Company participatesfor 97.4% of Syndicate 1221’s capacity for both the 2004 and 2003 underwritingyears.  The Lloyd’s operations includedin the consolidated financial statements represent the Company’s participationin Syndicate 1221.

 

The Company provides letters of credit toLloyd’s to support its Syndicate 1221 capacity. If the Company increases its participation or if Lloyd’s changes thecapital requirements, the Company may be required to supply additional lettersof credit or other collateral acceptable to Lloyd’s, or reduce the capacity ofSyndicate 1221.  The letters of creditare provided through the credit facility which the Company maintains with aconsortium of banks.  The credit facilityagreement requires that the banks vote whether or not to renew the letter ofcredit portion of the facility each year. If the banks decide not to renew the letter of credit facility, theCompany will need to find other sources to provide the letters of credit orother collateral in order to continue to participate in Syndicate 1221.  The renewal amendment executed in November 2003renewed the letter of credit facility for a two year period expiring in November 2005.  The bank facility is collateralized by all ofthe common stock of Navigators Insurance Company.

 

**Note 8. Income Tax - Valuation Allowance**

 

The Company’s valuation allowance relating toits foreign operations decreased by $572,000 and $2,056,000 in the three andnine months ended September 30, 2003, respectively, relating to thereduction in the loss carryforward at the Company’s foreign operationsresulting from income generated by these operations in 2003.  At September 30, 2003, the Company hadloss carryforwards remaining at its foreign operations amounting to potentialfuture tax benefits of $2,473,000, along with a valuation allowance equal tothose benefits.  Although the foreign operationswere profitable in the first nine months of 2003, the valuation allowance wasreleased only to the extent of those profits since, in management’s judgment,future profitability at that time remained uncertain.  This process continued for the first ninemonths of 2003.  Due to the continuedprofitability and projected favorable market conditions for the foreseeablefuture, it was determined in the fourth quarter of 2003 to be more likely thannot that the deferred tax assets resulting from the foreign net operating losscarryforwards will be realized. Therefore, the remaining valuation allowance related to the foreignoperations was released in the fourth quarter of 2003.

 

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The Company also had state and localoperating loss carryforwards amounting to potential future tax benefits of$4,523,000 and $3,274,000 at September 30, 2004 and December 31,2003, respectively.  A valuationallowance was established for the full amount of these potential future taxbenefits due to the uncertainty associated with their realization.

 

**Note 9. Commitments and Contingencies**

 

The Company is not a party to or the subject of anymaterial pending legal proceedings which depart from the ordinary routinelitigation incident to the kinds of business conducted by the Company, exceptfor a suit concerning the draw down of letters of credit.  In 1997 and 1998, Navigators InsuranceCompany entered into certain reinsurance contracts with a reinsurer.  In accordance with normal business practice,Navigators Insurance Company had secured this exposure with letters of credit.In April 1999, Navigators Insurance Company drew down the letters ofcredit, in good faith and consistent with their terms.  The liquidator of the reinsurer had commencedsuit in Australia, seeking to void the draw downs.  Navigators Insurance Company appealed thosedenials and continued settlement discussions. The settlement discussions resulted in a Settlement and CommutationAgreement (the “Agreement”) between Navigators Insurance Company and thereinsurer.  As a result of the Agreement,all reinsurance treaties between the parties have been commuted and thelitigation proceedings against Navigators Insurance Company have beendiscontinued.  Navigators InsuranceCompany was adequately reserved for the settlement which had no material impacton the accompanying financial statements.

 

**Note 10.  ReinsuranceRecoverables**

 

At September 30, 2004, the Company hadreinsurance recoverables of $22.2 million, consisting of reinsurancerecoverables for ceded losses and loss adjustment expenses of $15.9 million andceded unearned premium of $6.3 million, due from Converium Holding Ltd. andsubsidiaries (“Converium”).  Therecoverables result from several run-off and active excess and pro-ratareinsurance agreements with Converium expiring through the beginning of 2005that cover principally marine and energy risks for Navigators Insurance Companyand the Lloyd’s operations.  Recoverableamounts at September 30, 2004 recorded by Navigators Insurance Company andthe Lloyd’s operations were $2 million and $20.2 million, respectively.

 

Converium reported that its 2004 second quarterfinancial results were impacted by reserve strengthening and certain intangiblewrite-offs resulting in a net loss for the 2004 six-month period.  Converium reported that its 2004 thirdquarter financial results continued to reflect an operating loss.  On October 13, 2004, Converium announcedthat it closed its shareholder rights offering which raised approximately $420million of capital.  Converium is ratedB++ from A.M. Best and BBB+ from S&P.

 

The Company continues to periodically monitor thefinancial condition and ongoing activities of its reinsurers, includingConverium, in order to assess the adequacy of its allowance for uncollectiblereinsurance.

 

**Item 2****.****                       Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Note on Forward-Looking Statements**

 

Some of the statements in this Quarterly Report onForm 10-Q are ‘‘forward-looking statements’’ as defined in the PrivateSecurities Litigation Reform Act of 1995.  Whenever used in this report, the words “estimate”, “expect”, “believe”or similar expressions are intended to identify such forward-lookingstatements.  Forward-looking statementsare derived from information that we currently have and assumptions that wemake. We cannot assure that anticipated results will be achieved, since resultsmay differ materially because of both known and unknown risks and uncertaintieswhich we face. We undertake no obligation to publicly update or revise anyforward-looking statements, whether as a result of new information, futureevents or otherwise. Factors that could cause actual results to differmaterially from our forward-looking statements include, but are not limited to:

 

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•             the effects of domestic and foreign economicconditions, and conditions which affect the market for property and casualtyinsurance;

 

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

 

•             the effects of emerging claim and coverageissues on our business, including adverse judicial or regulatory decisions andrulings;

 

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

 

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

 

•             unexpected turnover of our professionalstaff;

 

•             changing legal and social trends and inherentuncertainties in the loss estimation process that can adversely impact theadequacy of loss reserves and the allowance for reinsurance recoverables,including our estimates relating to ultimate asbestos and environmentalliabilities and related reinsurance recoverables;

 

•             risks associated with our continuing abilityto obtain reinsurance covering our exposures at appropriate prices and/or insufficient 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, obtainnew business and to retain existing business consistent with our expectations;

 

•             the possibility of downgrades in ourclaims-paying and financial strength ratings significantly adversely affectingus, including reducing the number of insurance policies we write generally, orcausing clients who require an insurer with a certain rating level to usehigher-rated insurers;

 

•             the risk that our investment portfoliosuffers reduced returns or investment losses which could reduce ourprofitability; and

 

•             other risks that we identify in futurefilings with the Securities and Exchange Commission.

 

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

 

*The following discussion andanalysis of our financial condition and results of operations should be read inconjunction with our consolidated financial statements and accompanying noteswhich appear elsewhere in this Form 10-Q. It contains forward-lookingstatements that involve risks and uncertainties. Please see ‘‘Note onForward-Looking Statements’’ for more information. Our actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of various factors, including those discussed below and elsewhere inthis Form 10-Q.*

 

**Overview**

 

We are an international insurance holding companyfocusing on specialty products for niches within the overall property/casualtyinsurance market. Our largest product line and most long-standing area ofspecialization is ocean marine insurance. We have also developed specialtyniches in professional liability insurance, and in 

 

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specialtyliability insurance primarily consisting of contractors’ liability coverages.We conduct operations through our insurance company subsidiaries, theNavigators Agencies and our Lloyd’s operations. Our insurance company subsidiaries consist of Navigators InsuranceCompany, which includes a United Kingdom Branch, and NIC Insurance Companywhich writes excess and surplus lines. The Navigators Agencies consist of five wholly-owned insuranceunderwriting agencies which produce business for our insurancesubsidiaries.  Our Lloyd’s operationsinclude 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 Syndicate1221 through two wholly-owned Lloyd’s corporate members.

 

While management takes into consideration a widerange of factors in planning the Company’s business strategy and evaluatingresults of operations, there are certain factors that management believes arefundamental to understanding how the Company is managed.   First, underwriting profit is consistently emphasizedas a primary goal, above premium growth. Management’s assessment of our trends and potential growth inunderwriting profit is the dominant factor in its decisions with respect towhether or not to expand a business line, enter into a new niche, product orterritory or, conversely, to contract capacity in any business line.  In addition, management focuses on managingthe costs of our operations.  Managementbelieves that careful monitoring of the costs of existing operations andassessment of costs of potential growth opportunities are important to ourprofitability.  Access to capital alsohas 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 opportunitiesare particularly constrained by regulatory capital requirements and ratingagency assessments of capital adequacy. For example, we contributed $95.0 million of the approximately $110.8million in net proceeds we received from the October 2003 equity offeringto the statutory surplus of Navigators Insurance Company in order to positionthe Company to be able to capitalize on domestic and international insurancebusiness opportunities that management believes will be profitable.

 

Although not a financial measure, management’sdecisions are also greatly influenced by access to specialized underwriting andclaims expertise in our lines of business. We have chosen to operate in specialty niches with certain commoncharacteristics which we believe provide us with the opportunity to use ourtechnical underwriting expertise in order to realize underwriting profit. As aresult, we have focused on underserved markets for businesses characterized byhigher severity and low frequency of loss where we believe our intellectualcapital and financial strength bring meaningful value. In contrast, we haveavoided niches that we believe have a high frequency of loss activity and/orare subject to a high level of regulatory coverage requirements, such asworkers compensation and personal automobile insurance, because we do notbelieve our technical expertise is of as much value in these types ofbusinesses. Examples of niches that have the characteristics we look forinclude bluewater hull (which provides coverage for physical damage to, forexample, 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 tomitigate the financial impact of severe claims on our results by conservativeand detailed underwriting, prudent use of reinsurance and a balanced portfolioof risks.

 

Our revenue is primarily comprised of premiums,commission and investment income. Our insurance company subsidiaries derivetheir premiums primarily from business written by the Navigators Agencies. TheLloyd’s operations derive their premiums from business written by NUAL. TheNavigators Agencies and NUAL receive commissions and, in some cases, profitcommissions and service fees on the business produced on behalf of ourinsurance company subsidiaries and others.

 

Over the past three years, we have experiencedgenerally beneficial market changes in our lines of business. As a result ofseveral large industry losses in the second quarter of 2001, the marineinsurance market began to experience diminished capacity and rate increases,initially in the offshore energy line of business.  The marine rate increases began to level offin 2004.  Specialty liability losses havealso resulted in diminished capacity in the market in which we compete, as manyformer competitors who lacked the expertise to selectively underwrite thisbusiness have been forced to withdraw from the market.  Rates continue to increase in our specialtyliability business, albeit at a slower pace. In the professional liability market, the enactment of the 

 

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Sarbanes-OxleyAct of 2002, together with recent financial and accounting scandals at publiclytraded corporations and increased frequency of securities-related class actionlitigation, has lead to an invigorated interest in professional liabilityinsurance generally. These conditions resulted in rate increases in 2002 and 2003as well as an overall improvement in policy terms and conditions for ourprofessional liability line of business. The professional liability business has experienced single digit premiumrate decreases in 2004.  We believe thatthe professional liability market will continue to see 2004 rates decrease incertain areas, including directors and officers coverages.

 

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

 

**Industry Investigations**

 

The insurance industry recently has become thesubject of increasing scrutiny with respect to insurance broker and agentcompensation arrangements and sales practices. The New York State Attorney General has filed a civil complaint againsta large insurance broker alleging, among other things, that so-calledcontingent commission arrangements conflict with the broker’s duties to itscustomers and that the broker and several insurers for whom it producedbusiness engaged in anti-competitive practices in connection with insurancepremium quotes for commercial property and casualty insurance.  The New York State Attorney General’s ongoingindustry-wide investigation may expand to include additional companies in boththe property and casualty and life and health insurance businesses as well asother sales practices.    Similar legaland regulatory proceedings and investigations have been commenced by otherregulatory bodies in other states and additional regulatory bodies may commenceactions in the future.  Theseinvestigations and proceedings could result in legal precedents and newindustry-wide legislation, rules or regulations that could significantly affectour industry and may also continue to cause stock price volatility for companiesin the insurance industry.

 

**Critical Accounting Policies**

 

It is important to understand our accountingpolicies in order to understand our financial statements. Management considerscertain of these policies to be critical to the presentation of the financialresults, since they require management to make estimates and assumptions. Theseestimates and assumptions affect the reported amounts of assets, liabilities,revenues, expenses, and related disclosures at the financial reporting date andthroughout the reporting period. Certain of the estimates result from judgmentsthat can be subjective and complex, and consequently actual results may differfrom these estimates, which would be reflected in future periods.

 

Our most critical accounting policies involve thereporting of the reserves for losses and loss adjustment expenses (“LAE”)(including losses that have occurred but were not reported to us by thefinancial reporting date), reinsurance recoverables, written and unearnedpremium, the recoverability of deferred tax assets, the impairment of investedassets, accounting for Lloyd’s results and the translation of foreigncurrencies.

 

***Reserves forLosses and LAE.***  Reserves for losses and LAE represent anestimate of the expected cost of the ultimate settlement and administration oflosses, based on facts and circumstances then known. Actuarial methodologiesare employed to assist in establishing such estimates and include judgmentsrelative to estimates of future claims severity and frequency, length of timeto develop to ultimate, judicial theories of liability and other third partyfactors which are often beyond our control. Due to the inherent uncertaintyassociated with the reserving process, the ultimate liability may be differentfrom the original estimate. Such estimates are regularly reviewed and updatedand any resulting adjustments are included in the current year’s results.

 

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***ReinsuranceRecoverables.***Reinsurance recoverables are established for the portion of the loss reservesthat are ceded to reinsurers. Reinsurance recoverables are determined basedupon the terms and conditions of reinsurance contracts which could be subjectto interpretations that differ from our own based on judicial theories ofliability. In addition, we bear credit risk with respect to our reinsurerswhich can be significant considering that certain of the reserves remainoutstanding for an extended period of time. We are required to pay losses evenif a reinsurer fails to meet its obligations under the applicable reinsuranceagreement.

 

***Written andUnearned Premium.***Written premium is recorded based on the insurance policies that have beenreported to us and the policies that have been written by agents but not yetreported to us. We must estimate the amount of written premium not yet reportedbased on judgments relative to current and historical trends of the businessbeing written. Such estimates are regularly reviewed and updated and anyresulting adjustments are included in the current year’s results. An unearnedpremium reserve is established to reflect the unexpired portion of each policyat the financial reporting date.

 

***Deferred TaxAssets.*** We haverecorded valuation allowances related to deferred tax assets resulting fromcertain net operating loss carryforwards due to the uncertainty associated withthe realization of the deferred tax asset related to certain of our foreign,state and local operations. Our foreign operations were profitable in 2003resulting in a portion of the valuation allowance being simultaneously releasedto the extent of the first nine months of 2003 profits.  Due to the continued profitability andprojected favorable market conditions for the foreseeable future, it wasdetermined to be more likely than not that the deferred tax assets resultingfrom those net operating loss carryforwards will be realized, therefore theremaining valuation allowance related to the foreign operations was released inthe fourth quarter of 2003.

 

***Impairment ofInvestment Securities.*** Impairment of investment securities results in a charge to operationswhen a market decline below cost is other-than-temporary. Management regularlyreviews our fixed maturity and equity securities portfolios to evaluate thenecessity of recording impairment losses for other-than-temporary declines inthe fair value of investments. A number of criteria are considered during thisprocess including, but not limited to: the current fair value as compared tocost or amortized cost, as appropriate, of the security; the length of time thesecurity’s fair value has been below cost or amortized cost, and by how much;and specific credit issues related to the issuer and current economicconditions. In general, we focus our attention on those securities whose marketvalue was less than 80% of their cost or amortized cost, as appropriate, forsix or more consecutive months. Other factors considered in evaluatingpotential impairment include the current fair value as compared to cost oramortized cost, as appropriate, our intent and ability to retain the investmentfor 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 thecost basis of the underlying investment. Significant changes in the factors weconsider when evaluating investments for impairment losses could result in asignificant change in impairment losses reported in the consolidated financialstatements.

 

***Accounting forLloyd’s Results.***We record our pro rata share of Lloyd’s syndicate assets, liabilities, revenuesand expenses, after making adjustments to convert Lloyd’s accounting to U.S.GAAP. The most significant GAAP adjustments relate to income recognition. Lloyd’ssyndicates determine underwriting results by year of account at the end ofthree years. We record adjustments to recognize underwriting results asincurred, including the expected ultimate cost of losses incurred. Theseadjustments to losses are based on actuarial analysis of syndicate accounts,including forecasts of expected ultimate losses provided by the syndicate. Atthe end of the Lloyd’s three-year period for determining underwriting resultsfor an account year, the syndicate will close the account year by reinsuringoutstanding claims on that account year with the participants for the account’snext underwriting year. The amount to close an underwriting year into the nextyear is referred to as the ‘‘reinsurance to close.’’ The reinsurance to closetransactions are recorded in the fourth quarter as additional written andearned premium, losses incurred, loss reserves and receivables, all in the sameamount. There are no gains or losses recorded on the reinsurance to closetransactions.

 

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***Translation of ForeignCurrencies****.*Financialstatements of subsidiaries expressed in foreign currencies are translated intoU.S. dollars in accordance with SFAS No. 52 *Foreign CurrencyTranslation* issued by the FASB. Under SFAS 52, functional currency assets and liabilities are translatedinto U.S. dollars using period end rates of exchange and the relatedtranslation adjustments are recorded as a separate component of accumulatedother comprehensive income.  Functionalcurrencies are generally the currencies of the local operatingenvironment.  Statement of income amountsexpressed in functional currencies are translated using average exchangerates.  Gains and losses resulting fromforeign currency transactions are recorded in “other income (expense)” in theCompany’s Consolidated Statements of Income.

 

**Results of Operations and Overview**

 

The following is a discussion and analysis of ourconsolidated and segment results of operations for the three and nine monthsended September 30, 2004 and 2003. All per share figures contained in this section are calculatedbased upon the diluted number of shares.

 

Our 2004 and 2003 third quarter and nine monthoverall results of operations reflect increasing premium rates as a result ofimproved market conditions beginning in late 2000 that continued through 2003and at a reduced rate through the third quarter of 2004.  Net income for the three months ended September 30,2004 and 2003 was $6.3 million or $0.50 per share and $6.3 million or $0.73 pershare, respectively.  Net income for thefirst nine months of 2004 and 2003 was $24.2 million or $1.91 per share and$17.2 million or $1.99 per share, respectively. The net loss from Hurricane Ivan, which occurred in September 2004,reduced net income by approximately $3.3 million or $0.26 per share in the 2004third quarter.  The Hurricane Ivan netloss amount is inclusive of expected reinsurance recoveries and related costfor reinsurance reinstatement premiums.

 

We experienced premium growth as measured by netearned premium in the third quarter of 2004 of $75.1 million compared to $74.5million in the third quarter of 2003, a 0.8% increase.  The 2003 third quarter and nine month period includedapproximately $8.6 million of earned premium as a result of a commutationagreement with a former member of the marine pool whereby Navigators InsuranceCompany, retroactively to January 1, 2003, increased its participation inthe marine pool from 70% to 80% for the 2003 underwriting year.  Excluding this commutation, net earnedpremium increased 13.9% primarily due to business expansion and, to a lesserextent, increased premium rates.  The9.0% increase (13.7% excluding the commutation) in net earned premium for thefirst nine months of 2004 compared to the same period in 2003 was also due tobusiness expansion and premium rate increases. The Company’s combined ratios, which is a measure of underwritingprofitability, for the third quarter and first nine months of 2004 were 93.4%and 90.4%, respectively, compared to 92.9% and 95.0% for the third quarter andfirst nine months of 2003, respectively. The combined loss and expense ratios for the 2004 third quarter and ninemonth period were increased by an aggregate 6.5 and 2.2 combined ratio points,respectively, for the net loss from Hurricane Ivan.

 

Cash flow from operations increased in the firstnine months of 2004 to $141.7 million from $110.9 million in the first ninemonths of 2003, a 27.8% increase, contributing to the growth in invested assetsand net investment income.  Cash flowfrom operations in the third quarter of 2004 increased to $48.5 million, a 7.1%increase over the 2003 third quarter.

 

Consolidatedstockholders’ equity increased 9.2% to $316.6 million or $25.08 per share at September 30,2004 compared to $290.0 million or $23.14 per share at December 31,2003.  The increase was primarily due tonet income of $24.2 million for the first nine months of 2004.  Net income was $6.3 million and othercomprehensive income was $7.4 million for the third quarter of 2004.  Other comprehensive income (loss) consists ofthe change in both after-tax unrealized gains and losses on investments andafter-tax currency translation gains on the Company’s foreign operations.

 

**Revenues****.**  Grosswritten premium increased to $151.2 million and $508.8 million in the thirdquarter and first nine months of 2004, respectively, from $139.6 million and$455.5 million in the third quarter and first nine months of 2003,respectively, an 8.3% increase for the three months and an 11.7% increase forthe nine months.  The following tablesets forth our gross and net written premium and net earned premium by segmentand line of business for the periods indicated:

 

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| ** **                    | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|
| ** **                    | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                    | ** ** | **Gross  Written  Premium**          | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** | **Gross  Written  Premium** | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** |
| * *                      |       | **($ in thousands)**            |       |
| Insurance Companies:          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | $                                    | 48,413     |   | 32.0 | % | $ | 15,576 |   | $ | 17,862 |   | $ | 45,716 |   | 32.7 | % | $ | 28,691 |   | $ | 27,322 |   |
| Specialty                     |       | 39,025                               |       | 25.8 | % | 20,677 |   | 22,824 |   | 33,861 |   | 24.3 | % | 14,933 |   | 19,900 |   |
| Professional Liability        |       | 18,723                               |       | 12.4 | % | 6,703 |   | 5,692 |   | 12,428 |   | 8.9 | % | 3,182 |   | 2,680 |   |
| Assumed from Lloyd’s     |       | 1,056                                |       | 0.7 | % | 1,056 |   | 4,271 |   | 7,746 |   | 5.5 | % | 7,733 |   | 7,320 |   |
| Other (includes run-off)      |       | 101                                  |       | 0.1 | % | 892 |   | 892 |   | 346 |   | 0.2 | % | 292 |   | 307 |   |
| Insurance Companies Total     |       | 107,318                              |       | 71.0 | % | 44,904 |   | 51,541 |   | 100,097 |   | 71.6 | % | 54,831 |   | 57,529 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lloyd’s Operations:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | 39,807                               |       | 26.4 | % | 18,941 |   | 22,075 |   | 39,243 |   | 28.1 | % | 12,945 |   | 14,806 |   |
| Other                         |       | 5,197                                |       | 3.4 | % | 2,147 |   | 1,521 |   | 7,762 |   | 5.6 | % | 2,855 |   | 2,202 |   |
| Lloyd’s Operations Total |       | 45,004                               |       | 29.8 | % | 21,088 |   | 23,596 |   | 47,005 |   | 33.7 | % | 15,800 |   | 17,008 |   |
| Intercompany elimination      |       | (1,144                               | )          | -0.8 | % | — |   | — |   | (7,470 | ) | -5.3 | % | — |   | — |   |
| Total                         |       | $                                    | 151,178    |   | 100.0 | % | $ | 65,992 |   | $ | 75,137 |   | $ | 139,632 |   | 100.0 | % | $ | 70,631 |   | $ | 74,537 |   |

 

Note: Certain amounts for the prior period have been reclassified to conformto the current period’s presentation.

 

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| ** **                    | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------|------------|-------------------------------------|------------|
| ** **                    | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                    | ** ** | **Gross  Written  Premium**         | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** | **Gross  Written  Premium** | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** |
| ** **                    | ** ** | **($ in thousands)**           | ** ** |
| Insurance Companies:          |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | $                                   | 159,412    |   | 31.3 | % | $ | 61,219 |   | $ | 59,124 |   | $ | 149,080 |   | 32.7 | % | $ | 73,227 |   | $ | 70,572 |   |
| Specialty                     |       | 110,739                             |       | 21.8 | % | 60,229 |   | 65,728 |   | 97,475 |   | 21.4 | % | 51,558 |   | 62,311 |   |
| Professional Liability        |       | 51,982                              |       | 10.2 | % | 19,080 |   | 14,199 |   | 37,987 |   | 8.3 | % | 9,454 |   | 6,186 |   |
| Assumed from Lloyd’s     |       | 4,398                               |       | 0.9 | % | 4,191 |   | 16,554 |   | 26,164 |   | 5.8 | % | 26,151 |   | 15,500 |   |
| Other (includes run-off)      |       | 224                                 |       | 0.0 | % | 895 |   | 901 |   | 618 |   | 0.1 | % | (101 | ) | (32 | ) |
| Insurance Companies Total     |       | 326,755                             |       | 64.2 | % | 145,614 |   | 156,506 |   | 311,324 |   | 68.3 | % | 160,289 |   | 154,537 |   |
|                          |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lloyd’s Operations:      |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | 168,564                             |       | 33.2 | % | 81,979 |   | 64,918 |   | 145,708 |   | 32.0 | % | 54,260 |   | 47,912 |   |
| Other                         |       | 17,907                              |       | 3.5 | % | 8,023 |   | 3,203 |   | 23,772 |   | 5.2 | % | 8,746 |   | 3,666 |   |
| Lloyd’s Operations Total |       | 186,471                             |       | 36.7 | % | 90,002 |   | 68,121 |   | 169,480 |   | 37.2 | % | 63,006 |   | 51,578 |   |
| Intercompany elimination      |       | (4,470                              | )          | -0.9 | % | — |   | — |   | (25,278 | ) | -5.5 | % | — |   | — |   |
| Total                         |       | $                                   | 508,756    |   | 100.0 | % | $ | 235,616 |   | $ | 224,627 |   | $ | 455,526 |   | 100.0 | % | $ | 223,295 |   | $ | 206,115 |   |

 

Note: Certain amounts for the prior period have been reclassified to conformto the current period’s presentation.

 

24

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**Gross Written Premium**

 

Insurance Companies’ Gross Written Premium

 

*Marine.* The marine gross written premium for the third quarter of 2004increased 5.9% compared to the third quarter of 2003 partially due to theapproximate 3.0% increase in premium rates resulting in higher premiums on newand renewal business. The generally improved pricing environment resulted inNavigators Insurance Company increasing its writing of new business.  Navigators Insurance Company obtains itsmarine business through participation in the marine pool managed by theNavigators Agencies. Its participation in the marine pool was 80% in the firstnine months of 2004.  NavigatorsInsurance Company’s participation in the insurance pool was retroactivelyincreased from 70% to 80% effective January 1, 2003 in the 2003 third quarterwhen it entered into a commutation agreement with a former pool member.  The marine gross written premium for thefirst nine months of 2004 increased 6.9% compared to the first nine months of2003 partially due to the approximate 3.7% increase in premium rates resultingin higher premiums on new and renewal business.

 

*Specialty.* This business consists primarily of general liability business forsmall general and artisan contractors as well as other targeted commercialrisks.  The specialty gross writtenpremium for the third quarter of 2004 increased 15.3% compared to the thirdquarter of 2003 primarily due to the approximate 6.9% increase in theconstruction liability premium rates resulting in higher premiums on new andrenewal business. The increase in the specialty gross written premium for thefirst nine months of 2004 of 13.6% compared to the first nine months of 2003was primarily due to the approximate 18.5% increase in the Californiaconstruction liability premium rates resulting in higher premiums on new andrenewal business.  The number ofCalifornia construction liability in-force policies decreased significantlyover the last year as a result of our efforts to scale back the number of smallartisan policies we write.  The newbusiness and the rate increases resulted from a tightening market forCalifornia contractors’ liability insurance.

 

*Professional Liability.* Our insurance company subsidiaries writeprofessional liability insurance, primarily consisting of directors andofficers liability insurance for privately held and publicly tradedcorporations. In 2002, the professional liability business was expanded toinclude errors and omissions insurance and employment practices liabilitycoverages.  The professional liabilitygross written premium for the third quarter and first nine months of 2004increased 50.7% and 36.8%, respectively, compared to the third quarter andfirst nine months of 2003, reflecting the expansion of this business.  Premium rates for this business decreasedapproximately 10.4% and 5.5% in the third quarter and first nine months of 2004compared to the third quarter and first nine months of 2003, respectively,following an approximate 28.0% increase for the twelve months ended December31, 2003.  The 2004 premium ratedecreases are reflective of softening market conditions.

 

*Assumed from Lloyd’sOperations. *During 2002 and 2003, the Insurance Companiesparticipated in quota share treaties written by the Company’s Lloyd’soperations.  The participations includedmarine and energy business.

 

Lloyd’s Operations’ GrossWritten Premium

 

*Marine.*The**marine gross written premium for the thirdquarter and nine month period of 2004 increased 1.4% and 15.7%, respectively,compared to the same periods in 2003.  Theincreases were due to expansion of the business.  The premium rates for the three months andnine months ended September 30, 2004 were down approximately 2.0% and up 1.1%,respectively, compared to the same periods in 2003.

 

*Other. *Other consists of engineering andconstruction gross written premium which provides coverage for constructionprojects including machinery, equipment and loss of use due to delays and ofonshore energy

 

25

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premium which principally focuses on the oiland gas, chemical and petrochemical industries with coverages primarily forproperty damage and business interruption.

 

**Ceded Written Premium****.**  Inthe ordinary course of business, we reinsure certain insurance risks withunaffiliated insurance companies for the purpose of limiting our maximum lossexposure, protecting against catastrophic losses, and maintaining desiredratios of net premiums written to statutory surplus. The relationship of cededto written premium varies based upon the types of business written and whetherthe business is written by our insurance company subsidiaries or the Lloyd’soperations.

 

Ceded written premium forthe 2004 and 2003 third quarters was $85.2 million and $69.0 million, respectively,or 56.3% and 49.4% of the gross written premium, respectively.  The 2004 third quarter’s ceded premiumincludes $2.2 million of reinstatement premium on reinsurance treaties fromceded losses resulting from Hurricane Ivan. The 2003 ceded written premium reflects an increase in the premium cededunder the specialty business reinsurance treaty for the period from April 1,2003 to September 30, 2003 which provided a statutory capital benefit.  The reinsurance treaty change had no impacton net income or stockholders’ equity. The ceded premium for 2003 also reflects a decrease in ceded premiumresulting from a commutation agreement with a former member of the marine pool.

 

The ceded written premiumfor the first nine months of 2004 and 2003 was $273.1 million and $232.2million, respectively, or 53.7% and 51.0% of gross written premium,respectively.

 

**Net Written Premium**.*** ***Net written premium decreased6.6% in the third quarter of 2004 and increased 5.5% in the first nine monthsof 2004 compared to the third quarter and first nine months of 2003.  The 2003 third quarter includes net writtenpremium of $11.8 million recorded by the Company as a result of a commutationagreement with a former member of the marine pool whereby the Company, in thethird quarter of 2003, retroactively increased its participation in the marinepool from 70% to 80% for the 2003 underwriting year.  Exclusive of such commutation, the 2004 thirdquarter and nine month period net written premium increased 12.1% and 11.4%,respectively, compared to the same periods in 2003.  The increase to the net written premiumresulted from expansion of the business and rate increases on new and renewalbusiness.

 

**Net Earned Premium**.  Net earned premium increased 0.8% in thethird quarter of 2004 and 9.0% in the first nine months of 2004 compared to the thirdquarter and first nine months of 2003. Without the affect of the commutation with the former pool member, thenet earned premium for the 2004 third quarter and nine month period increased 13.9% and 13.7%,respectively, compared to the same periods in 2003.  The increases resulted from the increased netwritten premium.

 

**Commission Income****.** Commission income from unaffiliated business increased to $1.1 millionin the third quarter of 2004 from $23,000 in the third quarter of 2003 and to$3.6 million in the first nine months of 2004 from $2.7 million in the firstnine months of 2003.  The increasesresulted from the increased profit commissions on the Lloyd’s operations andfrom the decrease in the 2003 third quarter’s commission as the result of acommutation with a former marine pool member.

 

**Net Investment Income****.* ***Net investment income increased 48.5% in the 2004 third quarter and40.2% in the first nine months of 2004 compared to the same periods in 2003 dueto the increase in invested assets resulting from positive cash flow stemmingfrom the increased premium volume and the proceeds from our October 2003 commonstock offering.  Our net proceeds from theoffering amounted to $110.8 million.

 

**Net Realized Capital Gains****(Losses)****.** Pre-tax net income included a $271,000 net realized capital gain for thethree months ended September 30, 2004 compared to a capital gain of $349,000for the 2003 third quarter.  On anafter-tax basis, the net realized capital gain was $177,000 or $0.01 per shareand $272,000 or $0.03 per share for the 2004 and 2003 third quarters,respectively.  Pre-tax net incomeincluded $588,000 of net realized capital gains for the nine months endedSeptember 30, 2004 compared to $1,235,000 for the first nine months of

 

26

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2003. On an after-tax basis, the net realized capital gains were $382,000 or$0.03 per share and $1,010,000 or $0.12 per share for the first nine months of2004 and 2003, respectively.

 

**Other Income/(Expense)****.** Other income/(expense) for the third quarterand first nine months of 2004 and 2003 consisted primarily of foreign exchangegains and losses, and inspection fees related to the specialty insurancebusiness.

 

**Operating Expenses**

 

*Net Losses and Loss AdjustmentExpenses Incurred. *The ratios of net losses and loss adjustment expenses incurred to netearned premium (loss ratios) for the 2004 third quarter and nine month periodwere 65.5% and 61.6%, respectively, compared to 65.1% and 65.9% for thecomparable periods in 2003.  The 2004third quarter was adversely impacted by $2.9 million of net losses fromHurricane Ivan which, along with the affect of the $2.2 million of reinstatementpremium caused by the ceded Hurricane Ivan losses, increased the loss ratio forthe third quarter and first nine months of 2004 by 5.6 and 1.9 loss ratiopoints, respectively.  The loss ratiosfor the third quarter and first nine months of 2004 were favorably impacted by1.6 and 2.3 loss ratio points, respectively, for a redundancy of prior yearloss reserves in our Lloyd’s operations. The first nine months of 2003 was negatively impacted by 1.4 loss ratiopoints for loss activity related to run-off lines of business, all of which occurredin the first six months of 2003.

 

The following tables setforth our net loss reserves by segment and line of insurance business and thetotal case reserves and incurred but not reported (“IBNR”) reserves as ofSeptember 30, 2004 and December 31, 2003:

 
| ** **                           | ** **   | **September 30,  2004**   | ** **   | **December 31,  2003** | ** ** |
|--------------------------------------|--------------|---------------------------|--------------|------------------------|------------|
| *** ***                         | *** *** | **($ in thousands)** | *** *** |
| Insurance Companies:                 |         |                      |         |                   |       |
| Marine                               |         | $                         | 126,872      |                   | $          | 110,698 |   |
| Specialty                            |         | 143,762                   |         | 114,167                |       |
| Professional Liability               |         | 15,369                    |         | 7,059                  |       |
| Assumed from Lloyd’s Operations |         | 17,733                    |         | 14,323                 |       |
| Other (primarily run-off business)   |         | 23,546                    |         | 24,390                 |       |
| Total Insurance Companies            |         | 327,282                   |         | 270,637                |       |
|                                 |         |                      |         |                   |       |
| Lloyd’s Operations:             |         |                      |         |                   |       |
| Marine                               |         | 107,753                   |         | 100,936                |       |
| Other                                |         | 5,044                     |         | 2,598                  |       |
| Total Lloyd’s Operations        |         | 112,797                   |         | 103,534                |       |
|                                 |         |                      |         |                   |       |
| Total net loss reserves              |         | $                         | 440,079      |                   | $          | 374,171 |   |
|                                 |         |                      |         |                   |       |
| Total net case loss reserves         |         | $                         | 177,384      |                   | $          | 154,531 |   |
| Total net IBNR loss reserves         |         | 262,695                   |         | 219,640                |       |
|                                 |         |                      |         |                   |       |
| Total net loss reserves              |         | $                         | 440,079      |                   | $          | 374,171 |   |

 

At September 30, 2004, theIBNR portion of the net loss reserves was 59.7% of our total loss reservescompared to 58.7% at December 31, 2003.

 

27

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At September 30, 2004, a 10%change in the net loss reserves would equate to $44.1****millionwhich would represent an after-tax charge to net income of $28.7 million or9.1% of stockholders’ equity.  Lossreserve estimates are reviewed each quarter to evaluate whether the assumptionsmade continue to be appropriate.  Anyadjustments that result from this review are recorded in the quarter in whichthey are identified.

 

 Our reserving practices and the establishmentof any particular reserve reflect management’s judgment concerning soundfinancial practice and do not represent any admission of liability with respectto any claims made against us.  Noassurance can be given that actual claims made and related payments will not bein excess of the amounts reserved. During the loss settlement period, it often becomes necessary to refineand adjust the estimates of liability on a claim either upward ordownward.  Even after such adjustments,ultimate liability may exceed or be less than the revised estimates.  The increase in net loss reserves is also afunction of the growth in premium volume over the past two years.

 

Our loss reserves includeamounts related to short tail and long tail classes of business. Short tailbusiness means that claims are generally reported quickly upon occurrence of anevent, making estimation of loss reserves less complex. Our longer tailbusiness includes our specialty liability and professional liability insurance.For the long tail lines, significant periods of time, ranging up to severalyears or more, may elapse between the occurrence of the loss, the reporting ofthe loss and the settlement of the claim. Generally, the longer the time span between the incidence of a loss andthe settlement of the claim, the more likely the ultimate settlement amount canvary from the original estimate.

 

*Specialty Liability and Professional Liability.* Substantially all of our specialty liabilitybusiness involves general liability policies which generate third partyliability claims that are long tail in nature. A significant portion of ourgeneral liability reserves relate to California construction liability claims.Reserves and claim frequency on this business may be impacted by legislationimplemented in California, which generally provides consumers who experienceconstruction defects a method other than litigation to obtain construction defectrepairs. The law became effective July 1, 2002 with a sunset provisioneffective January 1, 2011 and provides for an alternate dispute resolutionsystem that attempts to involve all parties to the claim at an early stage.This legislation may impact claim severity, frequency and length to settlementassumptions underlying our reserves. Accordingly, our ultimate liability mayexceed or be less than current estimates due to this variable, amongothers.  There were 1,007 specialtyliability claims open at September 30, 2004.

 

The professional liabilityclass generates third party claims, which also are longer tail in nature. Theprofessional liability policies provide coverage on a claims-made basis,whereby coverage is generally provided only for those claims that are madeduring the policy period. Our professional liability business is relativelyimmature, with our first writing of the business in late 2001. Accordingly, itwill take some time to better understand the reserve trends on this business.  Our professional liability loss estimates arebased on expected losses, actual reported losses, evaluation of loss trends,industry data, and the legal, regulatory and current risk environment becauseanticipated loss experience in this area is less predictable due to the smallnumber of claims and/or erratic claim severity patterns. We believe that wehave made a reasonable estimate of the required loss reserves for professionalliability. The expected ultimate losses may be adjusted up or down as theaccident years mature.  There were 279professional liability claims open at September 30, 2004.

 

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The following tables setforth our net loss and LAE loss reserves for our specialty constructionliability and professional liability businesses for the periods indicated:

 
| ** **                       | ** ** | **September 30, 2004**     | ** ** |
|----------------------------------|------------|----------------------------|------------|
| **Type of  Business**            | ** ** | **Net Reported  Reserves** | ** ** | **Net  IBNR** | ** ** | **Total  Net Loss  Reserves** | ** ** | **% of IBNR  to Total Net  Loss Reserves** | ** ** |
|                             |       |                       |       |   |   |   |   |   |   |
| Specialty construction liability |       | $                          | 23,149     |   | $ | 105,271 |   | $ | 128,420 |   | 82.0 | % |
| Professional liability           |       | 442                        |       | 14,927 |   | 15,369 |   | 97.1 | % |
|                             |       |                       |       |   |   |   |   |   |   |
| Total                            |       | $                          | 23,591     |   | $ | 120,198 |   | $ | 143,789 |   | 83.6 | % |

 
| ** **                       | ** ** | **December 31, 2003**      | ** ** |
|----------------------------------|------------|----------------------------|------------|
| **Type of  Business**            | ** ** | **Net Reported  Reserves** | ** ** | **Net  IBNR** | ** ** | **Total  Net Loss  Reserves** | ** ** | **% of IBNR  to Total Net  Loss Reserves** | ** ** |
|                             |       |                       |       |   |   |   |   |   |   |
| Specialty construction liability |       | $                          | 20,365     |   | $ | 83,450 |   | $ | 103,815 |   | 80.4 | % |
| Professional liability           |       | 159                        |       | 6,900 |   | 7,059 |   | 97.7 | % |
|                             |       |                       |       |   |   |   |   |   |   |
| Total                            |       | $                          | 20,524     |   | $ | 90,350 |   | $ | 110,874 |   | 81.5 | % |

 

*Asbestos and Environmental Liability.* Our exposure to asbestos and environmentalliability principally stems from marine liability insurance written on anoccurrence basis during the mid-1980s. In general, our participation on suchrisks is in the excess layers, which requires the underlying coverage to beexhausted prior to coverage being triggered in our layer. In many instances weare one of many insurers who participate in the defense and ultimate settlementof these claims, and we are generally a minor participant in the overallinsurance coverage and settlement. Further, since most of our policies wereissued after the industry was apprised of asbestos exposures, many of thepolicies on which we participate have exclusions that may preclude coverage. Inaddition, many of our asbestos and environmental claims have been inactive forseveral years.

 

In the fourth quarter of2003, Navigators Insurance Company increased its gross and net asbestosreserves for losses by $77.6 million and $31.6 million, respectively.  As a result, gross and net incurred lossesincreased by the amount of the respective reserve increase.  The $31.6 million of net asbestos lossesincluded $25.7 million of uncollectible reinsurance.

 

The reserve action was the result of a review of asbestos-relatedexposures conducted by the Company.  TheCompany’s management was notified in late January 2004 that an asbestos claimwould likely have to be settled for a significantly greater amount thanpreviously anticipated.  As a result ofthe unexpected adverse development on this individual claim, the Companyretained a leading independent consulting firm in this area to assist in theidentification of its potential exposure to asbestos claims from policieswritten directly as well as those reinsured to Navigators Insurance Companyfrom prior members of the Company’s insurance pools. The Company’s increasedreserves relate primarily to policies underwritten by the Navigators Agenciesin the late 1970s and first half of the 1980s on behalf of members of the pool,consisting of excess liability on marine related business and aviation productsliability, including policies subsequently assumed by Navigators InsuranceCompany pursuant to reinsurance arrangements with pool members who exited thepool.  Following the

 

29

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Company’sand the independent consulting firm’s recent review, the Company increased itsgross and net loss reserves for asbestos exposure to $78.5 million and $32.1million, respectively, at December 31, 2003.

 

Loss development activityfor asbestos related exposures in the third quarter and first nine months of2004 has not been significant.

 

Loss development activityfor environmental losses in the third quarter and first nine months of 2004 hasgenerally consisted of oil spill claims on marine liability policies written inthe ordinary course of business by the Insurance Companies.

 

The following tables setforth our gross and net loss and LAE reserves, and claim counts for ourasbestos and environmental exposures, which we believe is subject touncertainties greater than those presented by other types of claims:

 
| ** **                | ** **   | **Three Months Ended  September 30, 2004** | ** **   |
|---------------------------|--------------|--------------------------------------------|--------------|
| ** **                | ** **   | **Asbestos**                               | ** **   | **Environmental** | ** ** | **Total** | ** ** |
| *** ***              | *** *** | **($ in thousands)**                  | *** *** |
| **Gross of Reinsurance**  | ** **   | ** **                                 | ** **   | ** ** | ** ** | ** ** | ** ** |
| Beginning Reserve         |         | $                                          | 78,497       |   | $ | 8,680 |   | $ | 87,177 |   |
| Incurred Losses & LAE |         | (85                                        | )            | (1,052 | ) | (1,137 | ) |
| Calendar Year Payments    |         | 83                                         |         | (347 | ) | (264 | ) |
| Ending Reserves           |         | $                                          | 78,329       |   | $ | 7,975 |   | $ | 86,304 |   |
|                      |         |                                       |         |   |   |   |   |
| **Net of Reinsurance**    |         |                                       |         |   |   |   |   |
| Beginning Reserve         |         | $                                          | 32,092       |   | $ | 2,232 |   | $ | 34,324 |   |
| Incurred Losses & LAE |         | (35                                        | )            | (489 | ) | (524 | ) |
| Calendar Year Payments    |         | 65                                         |         | (154 | ) | (89 | ) |
| Ending Reserves           |         | $                                          | 31,992       |   | $ | 1,897 |   | $ | 33,889 |   |
|                           |              |                                            |              |  |  |  |  |  |  |  |  |

 
| ** **                | ** **   | **Nine Months Ended  September 30, 2004** | ** **   |
|---------------------------|--------------|-------------------------------------------|--------------|
| ** **                | ** **   | **Asbestos**                              | ** **   | **Environmental** | ** ** | **Total** | ** ** |
| *** ***              | *** *** | **($ in thousands)**                 | *** *** |
| **Gross of Reinsurance**  | ** **   | ** **                                | ** **   | ** ** | ** ** | ** ** | ** ** |
| Beginning Reserve         |         | $                                         | 78,472       |   | $ | 6,800 |   | $ | 85,272 |   |
| Incurred Losses & LAE |         | (18                                       | )            | 1,192 |   | 1,174 |   |
| Calendar Year Payments    |         | 125                                       |         | 17 |   | 142 |   |
| Ending Reserves           |         | $                                         | 78,329       |   | $ | 7,975 |   | $ | 86,304 |   |
|                      |         |                                      |         |   |   |   |   |
| **Net of Reinsurance**    |         |                                      |         |   |   |   |   |
| Beginning Reserve         |         | $                                         | 32,083       |   | $ | 1,153 |   | $ | 33,236 |   |
| Incurred Losses & LAE |         | (10                                       | )            | 734 |   | 724 |   |
| Calendar Year Payments    |         | 81                                        |         | (10 | ) | 71 |   |
| Ending Reserves           |         | $                                         | 31,992       |   | $ | 1,897 |   | $ | 33,889 |   |
|                           |              |                                           |              |  |  |  |  |  |  |  |  |

 

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| **Type of Business** | ** ** | **Claim Count  January 1, 2004** | ** ** | **New Claims  During Period** | ** ** | **Claims Settled  or Resolved  During Period** | ** ** | **Claim Count  September 30, 2004** | ** ** |
|----------------------|------------|----------------------------------|------------|-------------------------------|------------|------------------------------------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | ** **                       | ** ** | ** **                    | ** ** | ** **                                     | ** ** | ** **                          | ** ** |
| Environmental        |       | 86                               |       | 30                            |       | 18                                             |       | 98                                  |       |
| Asbestos             |       | 108                              |       | 33                            |       | 20                                             |       | 121                                 |       |
| Total                |       | 194                              |       | 63                            |       | 38                                             |       | 219                                 |       |

 

Our management believes thatthe reserves for losses and loss adjustment expenses are adequate to cover theultimate cost of losses and loss adjustment expenses on reported and unreportedclaims.

 

*Commission Expense.* Commission expense paid to brokers andagents is generally on a percentage of the gross written premium and is reducedby ceding commissions the Company may receive on the ceded writtenpremium.  Commissions are generallydeferred and recorded to deferred policy acquisition costs to the extent that theyrelate to unearned premium.  Commissionexpense declined****as a percentage of earned premiumin the third quarter and first nine months of 2004 compared to the 2003 thirdquarter and first nine months generally as the result of a decline incommissions paid to brokers and agents coupled with the receipt of cedingcommissions from reinsurers.  Thedecrease in the commission percentage reflects lower commission rates and atrend among the major brokers to charge a flat fee to some of their majorclients as opposed to a percentage of the premium.  Under flat fee arrangements, the amount ofpremium normally is correspondingly reduced since no commission is being paidto the broker by the Company.

 

*Other Operating Expenses.* The 18.3% and 16.8% increase in otheroperating expenses in the third quarter and first nine months of 2004,respectively, compared to the same periods in 2003 is attributable primarily toemployee related expenses resulting from expansion of the business coupled withthe increased costs incurred to comply with Section 404 of the Sarbanes-OxleyAct of 2002.

 

*Interest Expense.*  Theoutstanding loan balance was paid in October 2003 from a portion of theproceeds from the Company’s common stock offering and no additional borrowingshave been made subsequently, therefore no interest expense was recorded in thethird quarter and first nine months of 2004.

 

**Income Taxes**. The income tax expensewas $3.0 million and $2.0 million for the third quarter of 2004 and 2003,respectively.  The effective tax ratesfor the 2004 and 2003 third quarters were 32.1% and 24.5%, respectively.  The first nine months of 2004 and 2003 hadincome tax expense of $12.0 million and $5.0 million, respectively, resultingin an effective tax rate of 33.1% and 22.4%, respectively.  As of September 30, 2004 and 2003, the netdeferred Federal, foreign, state and local tax assets were $17.3 million and$15.2 million, respectively.

 

The Company’svaluation allowance relating to its foreign operations decreased by $572,000and $2,056,000 in the three and nine months ended September 30, 2003,respectively, relating to the reduction in the loss carryforward at the Company’sforeign operations resulting from income generated by these operations in2003.  At September 30, 2003, the Companyhad loss carryforwards remaining at its foreign operations amounting topotential future tax benefits of $2,473,000, along with a valuation allowanceequal to those benefits.  Although theforeign operations were profitable in the first nine months of 2003, thevaluation allowance was released only to the extent of those profits sincefuture profitability remained uncertain. This process continued for the first nine months of 2003.  Due to the continued profitability andprojected favorable market conditions for the foreseeable future, it wasdetermined in the fourth quarter of 2003 to be more likely than not that thedeferred tax assets resulting from the foreign net operating loss carryforwardswill be realized, therefore the remaining valuation allowance related to theforeign operations was released in the fourth quarter of 2003.

The Companyalso had state and local operating loss carryforwards amounting to potentialfuture tax benefits of $4,523,000 and $3,274,000 at September 30, 2004 andDecember 31, 2003, respectively.  Avaluation

 

31

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allowance was established forthe full amount of these potential future tax benefits due to the uncertaintyassociated with their realization.

 

**SegmentInformation**

 

Following are the financialresults of the Company’s three segments: Insurance Companies, Lloyd’s Operations and Navigators Agencies. Weevaluate the performance of each segment including Navigators Agencies,primarily based on underwriting results. Other items of revenue and expenditure, including net investment incomeand realized capital gains and losses, are included herein based on the legalentity where they are recorded.  Ourunderwriting performance is evaluated separately from the performance of our investmentportfolios.  Certain amounts for theprior period have been reclassified to conform to the current period’spresentation.

 

***Insurance Companies***

 

Our two insurance companysubsidiaries are Navigators Insurance Company, which includes a United KingdomBranch, and NIC Insurance Company, collectively referred to as the InsuranceCompanies. Navigators Insurance Company is our largest insurance subsidiary andhas been active since 1983. It specializes principally in underwriting marineinsurance and related lines of business, specialty liability insurance andprofessional liability insurance. NIC Insurance Company, a wholly ownedsubsidiary of Navigators Insurance Company, began operations in 1990. Itunderwrites similar types of business but on a non-admitted or surplus linesbasis and is fully reinsured by Navigators Insurance Company.  The Navigators Agencies produce business forour insurance company subsidiaries.

 

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Following are the results ofoperations for the Insurance Companies for the three months and nine monthsended September 30, 2004 and 2003:

 
| ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                       | ** ** | **($ in thousands)**             | ** ** |
| Revenues:                        |       |                                  |       |                                 |       |   |   |   |   |
| Net earned premium               |       | $                                     | 51,541     |                                 | $          | 57,529 |   | $ | 156,506 |   | $ | 154,537 |   |
| Net investment income            |       | 6,225                                 |       | 4,207                                |       | 17,538 |   | 12,406 |   |
| Net realized capital gains       |       | 326                                   |       | 217                                  |       | 707 |   | 642 |   |
| Other income                     |       | (7                                    | )          | (82                                  | )          | 6 |   | 6 |   |
| Total revenues                   |       | 58,085                                |       | 61,871                               |       | 174,757 |   | 167,591 |   |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| Operating expenses:              |       |                                  |       |                                 |       |   |   |   |   |
| Net losses and LAE               |       | 35,401                                |       | 37,732                               |       | 100,669 |   | 102,602 |   |
| Commission expense               |       | 11,682                                |       | 14,189                               |       | 39,069 |   | 40,931 |   |
| Other operating expenses         |       | 1,780                                 |       | 1,461                                |       | 3,967 |   | 3,964 |   |
| Total operating expenses         |       | 48,863                                |       | 53,382                               |       | 143,705 |   | 147,497 |   |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| Income before income tax expense |       | 9,222                                 |       | 8,489                                |       | 31,052 |   | 20,094 |   |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| Income tax expense               |       | 2,871                                 |       | 2,726                                |       | 9,892 |   | 6,361 |   |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| Net income                       |       | $                                     | 6,351      |                                 | $          | 5,763 |   | $ | 21,160 |   | $ | 13,733 |   |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| Loss and LAE ratio               |       | 68.7                                  | %          | 65.6                                 | %          | 64.3 | % | 66.4 | % |
| Commission expense ratio         |       | 22.7                                  | %          | 24.7                                 | %          | 25.0 | % | 26.5 | % |
| Other operating expense ratio    |       | 3.4                                   | %          | 2.5                                  | %          | 2.5 | % | 2.5 | % |
| Combined ratio                   |       | 94.8                                  | %          | 92.8                                 | %          | 91.8 | % | 95.4 | % |

 

33

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Following are theunderwriting results of the Insurance Companies for the three months endedSeptember 30, 2004 and 2003:

 
| ** **                           | ** ** | **Three Months Ended September 30, 2004** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **Net  Earned  Premium**                  | ** ** | **Losses  and LAE  Incurred** | ** ** | **Underwriting  Expenses** | ** ** | **Underwriting  Gain(Loss)** | ** ** | **Loss  Ratio** | ** ** | **Expense  Ratio** | ** ** | **Combined  Ratio** | ** ** |
| ** **                           | ** ** | **($ in thousands)**                 | ** ** |
|                                 |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |       | $                                         | 17,862     |   | $ | 13,222 |   | $ | 4,785 |   | $ | (145 | ) | 74.0 | % | 26.8 | % | 100.8 | % |
| Specialty                            |       | 22,824                                    |       | 15,749 |   | 6,516 |   | 559 |   | 69.0 | % | 28.5 | % | 97.5 | % |
| Professional Liability               |       | 5,692                                     |       | 3,450 |   | 915 |   | 1,327 |   | 60.6 | % | 16.1 | % | 76.7 | % |
| Assumed from Lloyd’s Operations |       | 4,271                                     |       | 1,997 |   | 1,241 |   | 1,033 |   | 46.7 | % | 29.1 | % | 75.8 | % |
| Other (includes run-off) business    |       | 892                                       |       | 983 |   | 5 |   | (96 | ) | 110.2 | % | 0.6 | % | 110.8 | % |
| Total                                |       | $                                         | 51,541     |   | $ | 35,401 |   | $ | 13,462 |   | $ | 2,678 |   | 68.7 | % | 26.1 | % | 94.8 | % |

 
| ** **                           | ** ** | **Three Months Ended September 30, 2003** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **Net  Earned  Premium**                  | ** ** | **Losses  and LAE  Incurred** | ** ** | **Underwriting  Expenses** | ** ** | **Underwriting  Gain(Loss)** | ** ** | **Loss  Ratio** | ** ** | **Expense  Ratio** | ** ** | **Combined  Ratio** | ** ** |
| ** **                           | ** ** | **($ in thousands)**                 | ** ** |
|                                 |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |       | $                                         | 27,322     |   | $ | 17,251 |   | $ | 8,230 |   | $ | 1,841 |   | 63.1 | % | 30.1 | % | 93.2 | % |
| Specialty                            |       | 19,900                                    |       | 14,486 |   | 5,053 |   | 361 |   | 72.8 | % | 25.4 | % | 98.2 | % |
| Professional Liability               |       | 2,680                                     |       | 1,608 |   | 330 |   | 742 |   | 60.0 | % | 12.3 | % | 72.3 | % |
| Assumed from Lloyd’s Operations |       | 7,320                                     |       | 4,773 |   | 2,026 |   | 521 |   | 65.2 | % | 27.7 | % | 92.9 | % |
| Other (includes run-off) business    |       | 307                                       |       | (386 | ) | 11 |   | 682 |   | NM |   | NM |   | NM |   |
| Total                                |       | $                                         | 57,529     |   | $ | 37,732 |   | $ | 15,650 |   | $ | 4,147 |   | 65.6 | % | 27.2 | % | 92.8 | % |

 

----

NM = Not meaningful

 

34

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Following are theunderwriting results of the Insurance Companies for the nine months endedSeptember 30, 2004 and 2003:

 
| ** **                           | ** ** | **Nine Months Ended September 30, 2004** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **Net  Earned  Premium**                 | ** ** | **Losses  and LAE  Incurred** | ** ** | **Underwriting  Expenses** | ** ** | **Underwriting  Gain(Loss)** | ** ** | **Loss  Ratio** | ** ** | **Expense  Ratio** | ** ** | **Combined  Ratio** | ** ** |
| ** **                           | ** ** | **($ in thousands)**                | ** ** |
|                                 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |       | $                                        | 59,124     |   | $ | 37,691 |   | $ | 16,044 |   | $ | 5,389 |   | 63.7 | % | 27.2 | % | 90.9 | % |
| Specialty                            |       | 65,728                                   |       | 44,551 |   | 19,361 |   | 1,816 |   | 67.8 | % | 29.5 | % | 97.3 | % |
| Professional Liability               |       | 14,199                                   |       | 8,581 |   | 2,661 |   | 2,957 |   | 60.4 | % | 18.7 | % | 79.1 | % |
| Assumed from Lloyd’s Operations |       | 16,554                                   |       | 8,942 |   | 4,963 |   | 2,649 |   | 54.0 | % | 30.0 | % | 84.0 | % |
| Other (includes run-off) business    |       | 901                                      |       | 904 |   | 7 |   | (10 | ) | 100.3 | % | 0.8 | % | 101.1 | % |
| Total                                |       | $                                        | 156,506    |   | $ | 100,669 |   | $ | 43,036 |   | $ | 12,801 |   | 64.3 | % | 27.5 | % | 91.8 | % |

 
| ** **                           | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **Net  Earned  Premium**                 | ** ** | **Losses  and LAE  Incurred** | ** ** | **Underwriting  Expenses** | ** ** | **Underwriting  Gain(Loss)** | ** ** | **Loss  Ratio** | ** ** | **Expense  Ratio** | ** ** | **Combined  Ratio** | ** ** |
| ** **                           | ** ** | **($ in thousands)**                | ** ** |
|                                 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |       | $                                        | 70,572     |   | $ | 42,503 |   | $ | 21,011 |   | $ | 7,058 |   | 60.2 | % | 29.8 | % | 90.0 | % |
| Specialty                            |       | 62,311                                   |       | 43,791 |   | 17,980 |   | 540 |   | 70.3 | % | 28.9 | % | 99.2 | % |
| Professional Liability               |       | 6,186                                    |       | 3,887 |   | 1,404 |   | 895 |   | 62.8 | % | 22.7 | % | 85.5 | % |
| Assumed from Lloyd’s Operations |       | 15,500                                   |       | 9,633 |   | 4,474 |   | 1,393 |   | 62.1 | % | 28.9 | % | 91.0 | % |
| Other (includes run-off) business    |       | (32                                      | )          | 2,788 |   | 26 |   | (2,846 | ) | NM |   | NM |   | NM |   |
| Total                                |       | $                                        | 154,537    |   | $ | 102,602 |   | $ | 44,895 |   | $ | 7,040 |   | 66.4 | % | 29.0 | % | 95.4 | % |

 

The Insurance Companiesexperienced a decrease in net earned premium of 10.4% and an increase in netearned premium of 1.3% when comparing the third quarter and first nine monthsof 2004 to the third quarter and first nine months of 2003, respectively.  Excluding the affect of the commutationagreement with a former pool member described above under the caption “InsuranceCompanies Gross Written Premium –Marine”, the net earned premium increased 5.3%and 7.2%, respectively, when comparing the third quarter and first nine monthsof 2004 to the same periods in 2003. Approximately 8.3% and 12.7% of the net earned premium recorded in thethird quarters of 2004 and 2003, respectively, and approximately 10.6% and10.0% of the net earned premium recorded in the first nine months of 2004 and2003, respectively, is a result of the Insurance Companies participating onreinsurance treaties supporting the Lloyd’s operations’ marine and energybusiness.

 

The2004 and 2003 third quarter and first nine months underwriting resultsgenerally reflect the favorable industry market conditions over the last threeyears coupled with the favorable loss trends in the aforementioned quarterlyperiods.  The 2003 expense ratio forprofessional liability business reflects the start-up nature of this operationat that time.

 

Thenet loss to the Insurance Companies from Hurricane Ivan of approximately $3.1million, increased the 2004 third quarter and first nine months marine combinedratios 16.2 and 4.9 ratio points, respectively, and

 

35

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theInsurance Companies combined ratios 5.7 and 1.9 ratio points,respectively.  The third quarter andfirst nine months of 2003 incurred losses included $(0.4) million and $2.8million, respectively, of incurred loss activity on run-off businessprincipally related to the assumed reinsurance business which reduced theInsurance Companies’ loss ratio by 0.7 loss ratio points in the 2003 thirdquarter and added 1.8 loss ratio points to the Insurance Companies’ 2003 ninemonth combined ratio.

 

Thepre-tax yield on the Insurance Companies’ investment portfolio approximated4.0% and 4.4% at September 30, 2004 and 2003, respectively.  The declining portfolio yields reflect theoverall declines in interest rates up until the first quarter of 2004.  Net investment income increased in the firstnine months of 2004 compared to the same periods in 2003 due to strong cashflows and $95 million of statutory surplus contributions in the 2003 fourthquarter.

 

***Lloyd’s Operations***

 

TheLloyd’s operations consist of NUAL, which manages Lloyd’s Syndicate 1221,Millennium Underwriting Ltd. and Navigators Corporate Underwriters Ltd. BothMillennium Underwriting Ltd. and Navigators Corporate Underwriters Ltd. areLloyd’s corporate members with limited liability and provide capacity to Lloyd’sSyndicate 1221. NUAL owns Pennine Underwriting Ltd., an underwriting managingagency with offices in Manchester, Leeds and Basingstoke, England, whichunderwrites cargo and engineering business for Lloyd’s Syndicate 1221.  The Lloyd’s operations and Navigators Management(UK) Limited, a Navigators Agency which produces business for the UnitedKingdom Branch of Navigators Insurance Company, are subsidiaries of NavigatorsHoldings (UK) Limited located in the United Kingdom.

 

Lloyd’s Syndicate 1221 hasstamp capacity of £150 million ($273.8 million) in 2004 compared to £125million ($200.3 million) in 2003.  Stampcapacity is a measure of the amount of premium a Lloyd’s syndicate isauthorized to write as determined by the Council of Lloyd’s. Syndicate 1221’sstamp capacity is expressed net of commission (as is standard at Lloyd’s) ofapproximately 21%. The Syndicate 1221 premium recorded in the Company’sfinancial statements is gross of commission. The Lloyd’s marine business had been subject to intense pricecompetition beginning in the mid-1990’s. The pricing competition showed somesigns of stabilizing in 2000 and prices increased from 2001 through 2003 andagain at a more modest pace in the 2004 first quarter. Lloyd’s presents itsresults on an underwriting year basis, generally closing each underwriting yearafter three years. We make estimates for each underwriting year and timelyaccrue the expected results. Our Lloyd’s operations included in theconsolidated financial statements represent our participation in Syndicate1221.

 

Lloyd’s syndicates reportthe amounts of premiums, claims, and expenses recorded in an underwritingaccount for a particular year to the companies or individuals that participatein the syndicates. The syndicates generally keep accounts open for three years.Traditionally, three years have been necessary to report substantially allpremiums associated with an underwriting year and to report most relatedclaims, although claims may remain unsettled after the underwriting year isclosed. A Lloyd’s syndicate typically closes an underwriting year by reinsuringoutstanding claims on that underwriting year with the participants for the nextunderwriting year. The ceding participants pay the assuming participants anamount based on the unearned premiums and outstanding claims in theunderwriting year at the date of the assumption. Our participation in Lloyd’sSyndicate 1221 is represented by and recorded as our proportionate share of theunderlying assets and liabilities and results of operations of the syndicatesince, (a) we hold an undivided interest in each asset, (b) we areproportionately liable for each liability and (c) Syndicate 1221 is not aseparate legal entity. At Lloyd’s, the amount to close an underwriting yearinto the next year is referred to as the reinsurance to close. The reinsuranceto close amounts represent the transfer of the assets and liabilities from theparticipants of a closing underwriting year to the participants of the nextunderwriting year. To the extent our participation in the syndicate changes,the reinsurance to close amounts vary accordingly. The reinsurance to closetransactions are recorded in the fourth quarter as additional written andearned premium, losses incurred, loss reserves and receivables, all in the sameamount. There are no gains or losses recorded on the transactions.

 

36

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We provide letters of creditto Lloyd’s to support our participation in Syndicate 1221’s capacity. If weincrease our participation, or if Lloyd’s changes the capital requirements, wemay be required to supply additional letters of credit or other collateralacceptable to Lloyd’s, or reduce the capacity of Syndicate 1221. The letters ofcredit are provided through the credit facility which we maintain with aconsortium of banks. The credit facility agreement requires that the banks voteby November 10th of each year whether or not to renew the letter of creditfacility. If the banks decide not to renew the letter of credit facility, we willneed to find other sources to provide the letters of credit or other collateralin order to continue to participate in Syndicate 1221. The renewal amendmentexecuted in November 2003 renewed the letter of credit facility for a two-yearperiod expiring in November 2005.  Thebank facility is collateralized by all of the common stock of NavigatorsInsurance Company.

 

Following are the results ofoperations of the Lloyd’s operations for the three and nine months endedSeptember 30, 2004 and 2003:

 
| ** **                          | ** **   | **Three Months Ended  September 30,** | ** **   | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|--------------|---------------------------------------|--------------|--------------------------------------|------------|
| ** **                          | ** **   | **2004**                              | ** **   | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| *** ***                        | *** *** | **($ in thousands)**             | *** *** |
| Revenues:                           |         |                                  |         |                                 |       |   |   |   |   |
| Net earned premium                  |         | $                                     | 23,596       |                                 | $          | 17,008 |   | $ | 68,121 |   | $ | 51,578 |   |
| Commission income                   |         | 300                                   |         | 136                                  |       | 863 |   | 480 |   |
| Net investment income               |         | 649                                   |         | 422                                  |       | 1,844 |   | 1,413 |   |
| Net realized capital gains (losses) |         | (55                                   | )            | 132                                  |       | (119 | ) | 593 |   |
| Other income (expense)              |         | (378                                  | )            | (98                                  | )          | (368 | ) | 116 |   |
| Total revenues                      |         | 24,112                                |         | 17,600                               |       | 70,341 |   | 54,180 |   |
|                                |         |                                  |         |                                 |       |   |   |   |   |
| Operating expenses:                 |         |                                  |         |                                 |       |   |   |   |   |
| Net losses and LAE                  |         | 13,846                                |         | 10,794                               |       | 37,722 |   | 33,255 |   |
| Commission expense                  |         | 4,067                                 |         | 3,108                                |       | 11,910 |   | 9,212 |   |
| Other operating expenses            |         | 3,425                                 |         | 2,049                                |       | 9,654 |   | 5,895 |   |
| Interest expense                    |         | —                                |         | —                               |       | — |   | — |   |
| Total operating expenses            |         | 21,338                                |         | 15,951                               |       | 59,286 |   | 48,362 |   |
|                                |         |                                  |         |                                 |       |   |   |   |   |
| Income before income tax expense    |         | 2,774                                 |         | 1,649                                |       | 11,055 |   | 5,818 |   |
|                                |         |                                  |         |                                 |       |   |   |   |   |
| Income tax expense                  |         | 971                                   |         | —                               |       | 3,869 |   | — |   |
|                                |         |                                  |         |                                 |       |   |   |   |   |
| Net income                          |         | $                                     | 1,803        |                                 | $          | 1,649 |   | $ | 7,186 |   | $ | 5,818 |   |
|                                |         |                                  |         |                                 |       |   |   |   |   |
| Loss and LAE ratio                  |         | 58.7                                  | %            | 63.5                                 | %          | 55.4 | % | 64.5 | % |
| Commission expense ratio            |         | 17.2                                  | %            | 18.3                                 | %          | 17.5 | % | 17.9 | % |
| Other operating expense ratio       |         | 14.5                                  | %            | 12.0                                 | %          | 14.2 | % | 11.4 | % |
| Combined ratio                      |         | 90.4                                  | %            | 93.8                                 | %          | 87.1 | % | 93.8 | % |

 

TheLloyd’s operations have been experiencing business expansion coupled withimproving underwriting results as a result of the generally favorable marketconditions for marine and energy business since late 2001 through 2003, and toa lesser extent in 2004.  Net earnedpremium revenues were reduced by $4.3 million and

 

37

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$7.3 million in the third quarter of 2004 and2003, respectively, and by $16.6 million and $15.5 million in the first ninemonths of 2004 and 2003, respectively, for business ceded to the InsuranceCompanies.

 

Thenet loss to the Lloyd’s operations from Hurricane Ivan which approximated $2.0million increased the Lloyd’s operations 2004 third quarter and first ninemonths combined ratios 8.0 and 2.8 ratio points, respectively.  Excluding the impact of Hurricane Ivan, the2004 and 2003 third quarter and nine month underwriting results generallyreflect the favorable industry market condition over the last three yearscoupled with favorable loss trends in the quarterly periods.  The loss ratio for the third quarter andfirst nine months of 2004 was favorably impacted by $1.2 million or 5.1 lossratio points and $5.2 million or 7.6 loss ratio points, respectively, forredundancies in prior years Lloyd’s operations’ loss reserves.

 

Thepre-tax yield on funds in the Lloyd’s operations’ investment portfolioapproximated 1.7%, and 2.1% at September 30, 2004 and 2003, respectively, whichare reflective of the declining interest rate environment up until the firstquarter of 2004.  Generally, funds investedat Lloyd’s have been invested with an average duration of approximately 1.4years in order to meet liquidity needs.

 

Theprovision for income tax expense for the third quarter and first nine months of2003 reflects the reversal of $572,000 and $2,056,000, respectively, of apreviously established deferred tax asset valuation allowance.  The valuation allowance was reversed up untilthe third quarter of 2003 only to the extent of taxable profits.  The remaining valuation allowance wascompletely reversed in the 2003 fourth quarter since it was determined that itwas more likely than not that the remaining deferred tax asset resulting fromnet operating loss carry-forwards will be realized.

 

***Navigators Agencies***

 

TheNavigators Agencies produce business for our insurance company subsidiaries.They specialize in writing marine and related lines of business, specialtyliability insurance and professional liability coverages.

 

Eachof the Navigators Agencies underwrites marine and related lines of business forNavigators Insurance Company and three other unaffiliated insurance companies,which comprise a marine insurance pool. Marine insurance policies are issued byNavigators Insurance Company with the business shared with other pool members.Navigators Insurance Company had an 80% participation in the pool for businesswritten with effective dates in 2004 and 2003.

 

NavigatorsSpecialty, a division of a Navigators Agency, produces business exclusively forour insurance company subsidiaries. It specializes in underwriting generalliability insurance coverage for small general and artisan contractors andother targeted commercial risks, with the majority of its business located inCalifornia.  Navigators Specialty alsowrites surety, commercial multiple peril, commercial automobile and personalumbrella insurance.

 

NavigatorsPro, a division of a Navigators Agency, specializes in underwritingprofessional liability insurance and began producing directors and officersliability insurance exclusively for our insurance company subsidiaries in thefourth quarter of 2001. In late 2002, Navigators Pro introduced additionalproducts to complement its directors and officers liability coverage. Theproducts include employment practices liability, lawyers professional liabilityand miscellaneous professional liability coverages.

 

38

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Following are the results ofoperations of the Navigators Agencies for the three and nine months endedSeptember 30, 2004 and 2003:

 
| ** **                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**             | ** ** |
| Revenues:                                          |       |                                  |       |                                 |       |   |   |   |   |
| Commission income                                  |       | $                                     | 7,797      |                                 | $          | 7,990 |   | $ | 23,884 |   | $ | 23,713 |   |
| Net investment income                              |       | 2                                     |       | (2                                   | )          | 6 |   | 20 |   |
| Other income                                       |       | 258                                   |       | 443                                  |       | 629 |   | 980 |   |
| Total revenues                                     |       | 8,057                                 |       | 8,431                                |       | 24,519 |   | 24,713 |   |
|                                               |       |                                  |       |                                 |       |   |   |   |   |
| Operating expenses:                                |       |                                  |       |                                 |       |   |   |   |   |
| Other operating expenses                           |       | 9,616                                 |       | 8,610                                |       | 27,314 |   | 23,813 |   |
| Total operating expenses                           |       | 9,616                                 |       | 8,610                                |       | 27,314 |   | 23,813 |   |
|                                               |       |                                  |       |                                 |       |   |   |   |   |
| Income (loss) before income tax expense  (benefit) |       | (1,559                                | )          | (179                                 | )          | (2,795 | ) | 900 |   |
|                                               |       |                                  |       |                                 |       |   |   |   |   |
| Income tax expense (benefit)                       |       | (460                                  | )          | (146                                 | )          | (852 | ) | 207 |   |
|                                               |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss)                                  |       | $                                     | (1,099     | )                                    | $          | (33 | ) | $ | (1,943 | ) | $ | 693 |   |

 

Commission income generallyconsists of inter-segment management fees and profit commissions received frominsurance premiums of the Insurance Companies for marine, specialty andprofessional liability business as well as business from unaffiliated insurancecompanies in the marine pool.

 

Net investment income isearned on invested funds.  Other incomegenerally represents fee revenues earned for services on behalf of thirdparties.

 

Other operating expensesconsists of compensation and general and administrative expenses incurred inconnection with underwriting, administrative and claims services performed onbehalf of the Insurance Companies and unaffiliated insurers participating inthe marine pool.  Such costs have beenincreasing each year commensurate with servicing the growth in the overallincreased premium volume that has been generated for the Insurance Companiesand unaffiliated members of the marine pool.

 

Income tax expense (benefit)includes federal and state income taxes related to the taxable income or lossof the Navigators Agencies.

 

**Off-BalanceSheet Transactions**

 

Therehave been no material changes in the information concerning off-balance sheettransactions as stated in the Company’s 2003 Annual Report on Form 10-K.

 

39

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**TabularDisclosure of Contractual Obligations**

 

Therehave been no material changes in the information concerning contractualobligations as stated in the Company’s 2003 Annual Report on Form 10-K.

 

**Investments**

 

Theobjective of the Company’s investment policy, guidelines and strategy is tomaximize total investment return in the context of preserving and enhancingshareholder value and statutory surplus of the insurance companysubsidiaries.  Secondarily, an importantconsideration is to optimize the after-tax book income.

 

Theinvestments of our insurance company subsidiaries must comply with theinsurance laws of New York State, the domiciliary state of Navigators InsuranceCompany and NIC Insurance Company. These laws prescribe the type, quality andconcentration of investments which may be made by insurance companies. Ingeneral, these laws permit investments, within specified limits and subject tocertain qualifications, in federal, state and municipal obligations, corporatebonds, preferred stocks, common stocks, real estate mortgages and real estate.

 

Ourinsurance company subsidiaries’ investments are subject to the direction andcontrol of their respective boards of directors and our finance committee, andare reviewed on a quarterly basis. The investments are managed by outsideprofessional fixed-income and equity portfolio managers. Current investment objectivesare to maximize annual after-tax income while preserving and enhancing capitaland statutory surplus. The insurance company subsidiaries seek to attain theseobjectives by investing in municipal bonds, U.S. Government obligations,corporate bonds, mortgage-backed and asset-backed securities and common stocks.Our insurance company subsidiaries’ investment guidelines require that at least90% of the fixed-income portfolio be rated “A-” or better by a nationallyrecognized rating organization. Up to 25% of the total portfolio may beinvested in equity securities that are actively traded on major U.S. stockexchanges. Our insurance company subsidiaries’ investment guidelines prohibitinvestments in derivatives other than as a hedge against foreign currencyexposures or the writing of covered call options on the equity portfolio.

 

TheLloyd’s operations’ investments are subject to the direction and control of theboard of directors and the investment committee of NUAL, as well as our financecommittee, and represent our share of the investments held by Syndicate 1221.These investments must comply with the rules and regulations imposed by Lloyd’sof London and by certain overseas regulators. The investments are managed byoutside professional fixed-income portfolio managers. The performance of theinvestment managers is reviewed quarterly. The investment managers forSyndicate 1221 seek to attain the investment objectives by investing ingovernment obligations, corporate bonds and mortgage-backed and asset-backedsecurities.

 

Themajority of the investment income of the Navigators Agencies is derived fromfiduciary funds invested in accordance with the guidelines of various stateinsurance departments. These guidelines typically require investments inshort-term instruments. This investment income is paid to the members of themarine pool, including Navigators Insurance Company.

 

Thefollowing tables show our cash and investments as of September 30, 2004 andDecember 31, 2003:

 

40

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| **September 30, 2004**                                                                                       | ** ** | **Fair  Value**           | ** **    | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Cost or  Amortized  Cost** | ** **   |
|--------------------------------------------------------------------------------------------------------------|------------|---------------------------|---------------|------------------------------|------------|---------------------------------|------------|------------------------------|--------------|
| ** **                                                                                                   | ** ** | **($ in thousands)** | ** **    |
| Fixed maturities:                                                                                            |       |                      |          |                         |       |                            |       |                         |         |
|                                                                                                         |       |                      |          |                         |       |                            |       |                         |         |
| U.S. Government Treasury Bonds, GNMAs, U.S.  Government non-guaranteed agencies and foreign government bonds |       | $                         |  263,730 |                         | $          |  3,559                     |       | $                            |  (1,352 | ) | $ |  261,523 |   |
|                                                                                                         |
| States, municipalities and political subdivisions                                                            |       | 124,949                   |          | 2,866                        |       | (339                            | )          | 122,422                      |         |
| Mortgage- and asset-backed securities (excluding  GNMAs)                                                     |       | 165,730                   |          | 2,181                        |       | (228                            | )          | 163,777                      |         |
| Corporate bonds                                                                                              |       | 145,419                   |          | 4,551                        |       | (403                            | )          | 141,271                      |         |
|                                                                                                         |       |                      |          |                         |       |                            |       |                         |         |
| Total fixed maturities                                                                                       |       | 699,828                   |          | 13,157                       |       | (2,322                          | )          | 688,993                      |         |
|                                                                                                         |       |                      |          |                         |       |                            |       |                         |         |
| Equity securities - common stocks                                                                            |       | 19,198                    |          | 1,942                        |       | (452                            | )          | 17,708                       |         |
|                                                                                                         |       |                      |          |                         |       |                            |       |                         |         |
| Cash and short-term investments                                                                              |       | 120,823                   |          | —                       |       | —                          |       | 120,823                      |         |
|                                                                                                         |       |                      |          |                         |       |                            |       |                         |         |
| Total                                                                                                        |       | $                         | 839,849       |                         | $          | 15,099                          |       | $                            | (2,774       | ) | $ | 827,524 |   |

 
| **December 31, 2003**                                                                                        | ** ** | **Fair  Value**           | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Cost or  Amortized  Cost** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                                                                                   | ** ** | **($ in thousands)** | ** ** |
| Fixed maturities:                                                                                            |       |                      |       |                         |       |                            |       |                         |       |
|                                                                                                         |       |                      |       |                         |       |                            |       |                         |       |
| U.S. Government Treasury Bonds, GNMAs, U.S.  Government non-guaranteed Agencies and foreign government bonds |       | $                         | 221,919    |                         | $          | 4,107                           |       | $                            | (1,385     | ) | $ | 219,197 |   |
| States, municipalities and political subdivisions                                                            |       | 88,093                    |       | 2,599                        |       | (116                            | )          | 85,610                       |       |
| Mortgage- and asset-backed securities (excluding  GNMAs)                                                     |       | 141,831                   |       | 1,614                        |       | (373                            | )          | 140,590                      |       |
| Corporate bonds                                                                                              |       | 136,702                   |       | 4,509                        |       | (314                            | )          | 132,507                      |       |
|                                                                                                         |       |                      |       |                         |       |                            |       |                         |       |
| Total fixed maturities                                                                                       |       | 588,545                   |       | 12,829                       |       | (2,188                          | )          | 577,904                      |       |
|                                                                                                         |       |                      |       |                         |       |                            |       |                         |       |
| Equity securities - common stocks                                                                            |       | 13,446                    |       | 1,554                        |       | (85                             | )          | 11,977                       |       |
|                                                                                                         |       |                      |       |                         |       |                            |       |                         |       |
| Cash and short-term investments                                                                              |       | 91,601                    |       | —                       |       | —                          |       | 91,601                       |       |
|                                                                                                         |       |                      |       |                         |       |                            |       |                         |       |
| Total                                                                                                        |       | $                         | 693,592    |                         | $          | 14,383                          |       | $                            | (2,273     | ) | $ | 681,482 |   |

 

41

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Allfixed maturity and equity securities are carried at fair value. The fair valueis based on quoted market prices or dealer quotes provided by independentpricing services.  At September 30, 2004and December 31, 2003, all fixed maturity and equity securities held by us wereclassified as available-for-sale.

 

Weregularly review our fixed maturity and equity securities portfolios toevaluate the necessity of recording impairment losses for other-than-temporarydeclines in the fair value of investments. In general, we focus our attentionon those securities whose market value was less than 80% of their cost oramortized cost, as appropriate, for six or more consecutive months. Otherfactors considered in evaluating potential impairment include the current fairvalue as compared to cost or amortized cost, as appropriate, our intent andability to retain the investment for a period of time sufficient to allow foran anticipated recovery in value, specific credit issues related to the issuerand current economic conditions.

 

Whena security in our investment portfolio has an unrealized loss that is deemed tobe other-than-temporary, we write the security down to fair value through acharge to operations. Significant changes in the factors we consider whenevaluating investments for impairment losses could result in a significantchange in impairment losses reported in the consolidated financialstatements.  There were no impairmentlosses recorded in our fixed maturity or equity securities portfolios for thethree or nine months ended September 30, 2004 and 2003.

 

Thefollowing table summarizes all securities in an unrealized loss position atSeptember 30, 2004 and December 31, 2003 showing the aggregate fair value andgross unrealized loss by the length of time those securities have continuouslybeen in an unrealized loss position:

 

42

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| ** **                                                                                                      | ** ** | **September 30, 2004**    | ** ** | **December 31, 2003**      | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| ** **                                                                                                      | ** ** | **Fair  Value**           | ** ** | **Gross  Unrealized Loss** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized Loss** | ** ** |
| ** **                                                                                                      | ** ** | **($ in thousands)** | ** ** |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| Fixed Maturities:                                                                                               |       |                      |       |                       |       |   |   |   |   |
| U.S. Government Treasury Bonds and GNMAs, U.S.  Government non-guaranteed Agencies and foreign government bonds |       |                      |       |                       |       |   |   |   |   |
| 0-6 Months                                                                                                      |       | $                         | 113,110    |                       | $          | 453 |   | $ | 51,249 |   | $ | 521 |   |
| 7-12 Months                                                                                                     |       | 982                       |       | 13                         |       | 15,059 |   | 864 |   |
| > 12 Months                                                                                                  |       | 27,450                    |       | 886                        |       | — |   | — |   |
| Subtotal                                                                                                        |       | 141,542                   |       | 1,352                      |       | 66,308 |   | 1,385 |   |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| States, municipalities and political  subdivisions                                                              |       |                      |       |                       |       |   |   |   |   |
| 0-6 Months                                                                                                      |       | 13,660                    |       | 162                        |       | 6,340 |   | 58 |   |
| 7-12 Months                                                                                                     |       | 7,930                     |       | 157                        |       | 1,508 |   | 38 |   |
| > 12 Months                                                                                                  |       | 1,363                     |       | 20                         |       | 648 |   | 20 |   |
| Subtotal                                                                                                        |       | 22,953                    |       | 339                        |       | 8,496 |   | 116 |   |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| Mortgage- and asset-backed securities (excluding  GNMAs)                                                        |       |                      |       |                       |       |   |   |   |   |
| 0-6 Months                                                                                                      |       | 44,359                    |       | 182                        |       | 45,381 |   | 341 |   |
| 7-12 Months                                                                                                     |       | 3,536                     |       | 25                         |       | 1,135 |   | 26 |   |
| > 12 Months                                                                                                  |       | 788                       |       | 21                         |       | 138 |   | 6 |   |
| Subtotal                                                                                                        |       | 48,683                    |       | 228                        |       | 46,654 |   | 373 |   |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| Corporate bonds                                                                                                 |       |                      |       |                       |       |   |   |   |   |
| 0-6 Months                                                                                                      |       | 34,593                    |       | 174                        |       | 25,049 |   | 123 |   |
| 7-12 Months                                                                                                     |       | 2,432                     |       | 42                         |       | 7,124 |   | 191 |   |
| > 12 Months                                                                                                  |       | 5,424                     |       | 187                        |       | — |   | — |   |
| Subtotal                                                                                                        |       | 42,449                    |       | 403                        |       | 32,173 |   | 314 |   |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| Total Fixed Maturities                                                                                          |       | $                         | 255,627    |                       | $          | 2,322 |   | $ | 153,631 |   | $ | 2,188 |   |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| Equity securities - common stocks                                                                               |       |                      |       |                       |       |   |   |   |   |
| 0-6 Months                                                                                                      |       | $                         | 2,562      |                       | $          | 189 |   | $ | — |   | $ | — |   |
| 7-12 Months                                                                                                     |       | 461                       |       | 50                         |       | — |   | — |   |
| > 12 Months                                                                                                  |       | 1,406                     |       | 213                        |       | 1,892 |   | 85 |   |
|                                                                                                            |       |                      |       |                       |       |   |   |   |   |
| Total Equity Securities                                                                                         |       | $                         | 4,429      |                       | $          | 452 |   | $ | 1,892 |   | $ | 85 |   |

 

Weanalyze the unrealized losses quarterly to determine if any of them areother-than-temporary.  The aboveunrealized losses have been determined to be temporary and generally resultfrom changes in market conditions.

 

43

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Thefollowing table shows the composition by National Association of InsuranceCommissioners (“NAIC”) rating and the generally equivalent Standard & Poor’s(“S&P”) and Moody’s ratings of the fixed maturity securities in the Company’sportfolio with gross unrealized losses at September 30, 2004.  Not all of the securities are rated byS&P and/or Moody’s.

 
| **NAIC  Rating** | ** ** | **Equivalent  S&P  Rating** | ** ** | **Equivalent  Moody’s  Rating** | ** **            | **Unrealized Loss**       | ** ** | **Fair Value** | ** ** |
|------------------|------------|---------------------------------|------------|--------------------------------------|-----------------------|---------------------------|------------|----------------|------------|
| **Amount**       | ** ** | **Percent  to Total**           | **Amount** | ** **                           | **Percent  to Total** |
| ** **       | ** ** | ** **                      | ** ** | ** **                           | ** **            | **($ in thousands)** | ** ** |
|             |       |                            |       |                                 |                  |                      |       |           |       |   |   |   |   |
| 1                |       | AAA/AA/A                        |       | Aaa/Aa/A                             |                  | $                         | 2,220      |           | 96         | % | $ | 243,665 |   | 95 | % |
| 2                |       | BBB                             |       | Baa                                  |                  | 102                       |       | 4              | %          | 11,962 |   | 5 | % |
| 3                |       | BB                              |       | Ba                                   |                  | —                    |       | —         |       | — |   | — |   |
| 4                |       | B                               |       | B                                    |                  | —                    |       | —         |       | — |   | — |   |
| 5                |       | CCC or lower                    |       | Caa or lower                         |                  | —                    |       | —         |       | — |   | — |   |
| 6                |       | N/A                             |       | N/A                                  |                  | —                    |       | —         |       | — |   | — |   |
|             |       |                            |       | Total                                |                  | $                         | 2,322      |           | 100        | % | $ | 255,627 |   | 100 | % |

 

AtSeptember 30, 2004, the gross unrealized losses in the table directly above arerelated to fixed maturity securities that are rated investment grade, which isdefined by the Company as a security having a NAIC rating of 1 or 2, a S&Prating of “BBB–” or higher, or a Moody’s rating of “Baa3” or higher.  Unrealized losses on investment gradesecurities principally relate to changes in interest rates or changes insector-related credit spreads since the securities were acquired.  Any such unrealized losses are recognized inincome, if the securities are sold, or if the decline in fair value is deemedother-than-temporary.

 

Thescheduled maturity dates for fixed maturity securities in an unrealized lossposition at September 30, 2004 are shown below.

 
| ** **                             | ** ** | **Unrealized Loss**       | ** ** | **Fair Value**        | ** ** |
|----------------------------------------|------------|---------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **Amount**                | ** ** | **Percent  to Total** | ** ** | **Amount** | ** ** | **Percent  to Total** | ** ** |
| ** **                             | ** ** | **($ in thousands)** | ** ** |
|                                   |       |                      |       |                  |       |   |   |   |   |
| Due in one year or less                |       | $                         | 503        |                  | 22         | % | $ | 101,666 |   | 40 | % |
| Due after one year through five years  |       | 377                       |       | 16                    | %          | 45,051 |   | 17 | % |
| Due after five years through ten years |       | 184                       |       | 8                     | %          | 17,345 |   | 7 | % |
| Due after ten years                    |       | 1,030                     |       | 45                    | %          | 42,882 |   | 17 | % |
| Mortgage- and asset-backed securities  |       | 228                       |       | 9                     | %          | 48,683 |   | 19 | % |
|                                   |       |                      |       |                  |       |   |   |   |   |
| Total fixed income securities          |       | $                         | 2,322      |                  | 100        | % | $ | 255,627 |   | 100 | % |

 

Expectedmaturities may differ from contractual maturities because issuers may have theright to call or prepay obligations with or without call or prepaymentpenalties. Due to the periodic repayment of principal, the mortgage- andasset-backed securities are estimated to have an effective maturity ofapproximately 4.7 years.

 

44

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Ourrealized capital gains and losses were as follows:

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **($ in thousands)**             | ** ** |
|                       |       |                                  |       |                                 |       |   |   |   |   |
| Fixed maturities:          |       |                                  |       |                                 |       |   |   |   |   |
| Gains                      |       | $                                     | 271        |                                 | $          | 376 |   | $ | 1,935 |   | $ | 1,689 |   |
| (Losses)                   |       | (45                                   | )          | (134                                 | )          | (1,760 | ) | (309 | ) |
|                       |       | 226                                   |       | 242                                  |       | 175 |   | 1,380 |   |
| Equity securities:         |       |                                  |       |                                 |       |   |   |   |   |
| Gains                      |       | 45                                    |       | 327                                  |       | 511 |   | 329 |   |
| (Losses)                   |       | —                                |       | (220                                 | )          | (98 | ) | (474 | ) |
|                       |       | 45                                    |       | 107                                  |       | 413 |   | (145 | ) |
|                       |       |                                  |       |                                 |       |   |   |   |   |
| Net realized capital gains |       | $                                     | 271        |                                 | $          | 349 |   | $ | 588 |   | $ | 1,235 |   |

 

The following table details realized losses in excess of $200,000 fromsales and impairments during the first nine months of 2004 and 2003 and therelated circumstances giving rise to the loss:

 
| **Description**                        | ** ** | **Date of  Sale**         | ** ** | **Proceeds  from Sale** | ** ** | **Loss on  Sale** | ** ** | **Impairment** | ** ** | **Holdings at  September 30, 2004** | ** ** | **Net  Unrealized  Loss** | ** ** | **# of Months  Unrealized Loss  Exceeded 20%  of Cost or  Amortized Cost** | ** ** |
|----------------------------------------|------------|---------------------------|------------|-------------------------|------------|-------------------|------------|----------------|------------|-------------------------------------|------------|---------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                             | ** ** | **($ in thousands)** | ** ** |
| Nine months  ended September 30, 2004: |       |
|                                   |       |                      |       |                    |       |              |       |           |       |                                |       |                      |       |                                                                       |       |
| None                                   |       |                      |       |                    |       |              |       |           |       |                                |       |                      |       |                                                                       |       |
|                                   |       |                      |       |                    |       |              |       |           |       |                                |       |                      |       |                                                                       |       |
| Nine months  ended September 30, 2003: |       |
|                                   |       |                      |       |                    |       |              |       |           |       |                                |       |                      |       |                                                                       |       |
| (1)                                    |       | 2/13/03                   |       | $                       | 425        |              | $          | (252           | )          | —                              |       | —                    |       | —                                                                     |       | 6 |   |
| (2)                                    |       | 9/3/03                    |       | $                       | 357        |              | $          | (222           | )          | —                              |       | —                    |       | —                                                                     |       | 12 |   |

 

----

(1) Issuer was a major utility company which had adeteriorating balance sheet, underperforming overseas operations and areduction in its dividend.

(2) Major tobacco company stock adversely affectedby concerns over litigation.

 

**ReinsuranceRecoverables**

 

AtSeptember 30, 2004, the Company had reinsurance recoverables of $22.2 million,consisting of reinsurance recoverables for ceded losses and loss adjustmentexpenses of $15.9 million and ceded unearned premium of $6.3 million, due fromConverium Holding Ltd. and subsidiaries (“Converium”).  The recoverables result from several run-offand active excess and pro-rata reinsurance agreements with Converium expiringthrough the beginning of 2005 that cover principally marine and energy risksfor Navigators Insurance Company and the Lloyd’s operations.  Recoverable amounts at September 30, 2004recorded by Navigators Insurance Company and the Lloyd’s operations were $2million and $20.2 million, respectively.

 

45

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Converiumreported that its 2004 second quarter financial results were impacted byreserve strengthening and certain intangible write-offs resulting in a net lossfor the 2004 six-month period.  Converiumreported that its 2004 third quarter financial results continued to reflect anoperating loss.  On October 13, 2004,Converium announced that it closed its rights offering which raisedapproximately $420 million of capital. Converium is rated B++ from A.M. Best and BBB+ from S&P.

 

TheCompany continues to periodically monitor the financial condition and ongoingactivities of its reinsurers, including Converium, in order to assess theadequacy of its allowance for uncollectible reinsurance.

 

**Liquidity and Capital Resources**

 

Cashflow provided by operations was $141.7 million and $110.9 million for the ninemonths ended September 30, 2004 and 2003, respectively. The positive operatingcash flow in the first nine months of 2004 and 2003 was primarily due to thenet written premium.  Operating cash flowwas used primarily to acquire additional investment assets.

 

Investedassets and cash increased to $839.8 million at September 30, 2004 from $693.6million at December 31, 2003. The increase was primarily due to the positivecash flow and the $110.8 million of net proceeds received from the common stockoffering in October 2003.  Net investmentincome was $6.9 million and $4.6 million for the three months ended September30, 2004 and 2003, respectively, and $19.4 million and $13.8 million for thenine months ended September 30, 2004 and 2003, respectively.

 

Theyield of the portfolio, excluding net realized capital gains, was 3.5% atSeptember 30, 2004 compared to 3.9% at September 30, 2003 reflecting theprevailing interest rates. As of September 30, 2004 and December 31, 2003, allfixed maturity securities and equity securities held by us were classified asavailable-for-sale.

 

AtSeptember 30, 2004, the weighted average rating of our fixed maturityinvestments was ‘‘AA’’ by Standard & Poor’s and ‘‘Aa’’ by Moody’s. Webelieve that we have no significant exposure to credit risk since the fixedmaturity investment portfolio consists of investment-grade bonds. At September30, 2004, our portfolio had an average maturity of 5.0 years and duration of3.7 years. Management continually monitors the composition and cash flow of theinvestment portfolio in order to maintain the appropriate levels of liquidityto ensure our ability to satisfy claims.

 

Wehave a credit facility provided through a consortium of banks. The creditfacility provides for an $80.0 million letter of credit facility which wasincreased from $55.0 million in November 2003. The credit facility also provided for a $9.0 million line of creditfacility which was fully utilized prior to the October 2003 common stockoffering.  As required by the creditfacility agreement, the line of credit was fully paid from a portion of theproceeds from the common stock offering thereby eliminating the line of creditportion of the credit facility.  The letterof credit facility is utilized primarily by Navigators Corporate UnderwritersLtd. and Millennium Underwriting Ltd. for our participation in Lloyd’sSyndicate 1221. The credit facility agreement requires that the banks vote byNovember 10th of each year whether or not to renew the letter of credit portionof the facility. If the banks decide not to renew the letter of credit portionof the facility, we will need to find other sources to provide the letters ofcredit or other collateral in order to continue our participation in Syndicate1221.  The renewal amendment executed inNovember 2003 renewed the letter of credit facility for a two-year period.  At September 30, 2004, letters of credit withan aggregate face amount of $78.4 million were issued under the letter ofcredit facility.

 

Thebank credit facility is collateralized by the common stock of NavigatorsInsurance Company. It contains covenants common to transactions of this type,including restrictions on indebtedness and liens, limitations on mergers andthe sale of assets, maintaining certain consolidated tangible net worth,statutory surplus and other financial ratios. At September 30, 2004, we were incompliance with all covenants.

 

46

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AtSeptember 30, 2004, our consolidated stockholders’ equity was $316.6 million or$25.08 per share compared to $290.0 million or $23.14 per share at December 31,2003. The increase was primarily due to net income of $24.2 million for thenine months ended September 30, 2004. The other comprehensive loss in 2004 resulted from unrealized losses inthe Company’s investment portfolio due to a rising interest rate environment.

 

Ourreinsurance has been placed with various U.S. and foreign insurance companiesand with selected syndicates at Lloyd’s. Pursuant to the implementation ofLloyd’s Plan of Reconstruction and Renewal, a portion of our recoverables arenow reinsured by Equitas (a separate United Kingdom authorized reinsurancecompany established to reinsure outstanding liabilities of all Lloyd’s membersfor all risks written in the 1992 or prior years of account).

 

Weprimarily rely upon dividends from our subsidiaries to meet our holding companyobligations. The dividends have historically come primarily from NavigatorsInsurance Company. At December 31, 2003, the maximum amount available for thepayment of dividends by Navigators Insurance Company during 2004 without priorregulatory approval was $21,032,000. Navigators Insurance Company did not pay any dividends in the first ninemonths of 2004.

 

Webelieve that the cash flow generated by the operating activities of oursubsidiaries will provide sufficient funds for us to meet our liquidity needsover the next twelve months. Beyond the next twelve months, cash flow availableto us may be influenced by a variety of factors, including general economicconditions and conditions in the insurance and reinsurance markets, as well asfluctuations from year to year in claims experience.

 

##### **Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

##### ** **

There have been no material changes in the information concerningmarket risk as stated in the Company’s 2003 Annual Report on Form 10-K.

 

##### **Item 4. Controls and Procedures**

##### ** **

(a)          The Chief Executive Officer and Chief Financial Officer of the Companyhave evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under of the Securities Exchange Actof 1934, as amended (the “Exchange Act”) as of the end of the period covered bythis quarterly report. Based on such evaluation, such officers have concludedthat as of the end of such period the Company’s disclosure controls andprocedures are effective in identifying, on a timely basis, materialinformation required to be disclosed in our reports filed or submitted underthe Exchange Act.

 

(b)         Therehave been no changes during our third fiscal quarter in our internal controlover financial reporting that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financial reporting.

 

**Part II -Other Information**

 

**Item 1.****                                   LegalProceedings**

 

TheCompany is not a party to or the subject of any material pending legalproceedings which depart from the ordinary routine litigation incident to thekinds of business conducted by the Company, except for a suit concerning thedraw down of letters of credit.  In 1997and 1998, Navigators Insurance Company entered into certain reinsurancecontracts with a reinsurer.  Inaccordance with normal business practice, Navigators Insurance Company hadsecured this exposure with letters of credit. In April 1999, Navigators

 

47

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Insurance Company drew down the letters ofcredit, in good faith and consistent with their terms.  The liquidator of the reinsurer had commencedsuit in Australia, seeking to void the draw downs.  Navigators Insurance Company appealed thosedenials and continued settlement discussions. The settlement discussions resulted in a Settlement and CommutationAgreement (the “Agreement”) between Navigators Insurance Company and thereinsurer.  As a result of the Agreement,all reinsurance treaties between the parties have been commuted and thelitigation proceedings against Navigators Insurance Company have beendiscontinued.  Navigators InsuranceCompany was adequately reserved for the settlement which had no material impacton the accompanying financial statements.

 

**Item 2.****            UnregisteredSales of Equity Securities and Use of Proceeds**

 

None.

 

**Item 3.****                                   DefaultsUpon Senior Securities**

 

None.

 

**Item 4.****                                   Submissionsof Matters to a Vote of Security Holders**

 

None.

 

**Item 5.****                                   OtherInformation**

 

There have been no material changes in the procedures by which securityholders may recommend nominees to the Company’s board of directors.

 

**Item 6.****                                   Exhibits**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | ** ** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                 |       |       |
| 10-1            |       | Form of Stock Grant Award Certificate and Restricted Stock Agreement  for the 2002 Stock Incentive Plan (approved at Annual Meeting of Shareholders  held May 30, 2002)                                                                                                                                                                                                                                                              |       | *          |
| 10-2            |       | Form of Option Award Certificate for the 2002 Stock Incentive Plan  (approved at Annual Meeting of Shareholders held May 30, 2002)                                                                                                                                                                                                                                                                                                   |       | *          |
| 10-3            |       | Agreement with Jane E. Keller                                                                                                                                                                                                                                                                                                                                                                                                        |       | *          |
| 11-1            |       | Statement re Computation of Per Share Earnings                                                                                                                                                                                                                                                                                                                                                                                       |       | *          |
| 31-1            |       | Certification of CEO per Section 302 of the Sarbanes-Oxley Act                                                                                                                                                                                                                                                                                                                                                                       |       | *          |
| 31-2            |       | Certification of CFO per Section 302 of the Sarbanes-Oxley Act                                                                                                                                                                                                                                                                                                                                                                       |       | *          |
| 32-1            |       | Certification of CEO per Section 906 of the Sarbanes-Oxley Act (This  exhibit is intended to be furnished in accordance with Regulation S-K item  601(b)(32)(ii) and shall not be deemed to be filed for purposes of section 18  of the Securities Exchange Act of 1934, as amended, or incorporated by  reference into any filing under the Securities Act of 1933, except as shall  be expressly set forth by specific reference). |       | *          |
| 32-2            |       | Certification of CFO per Section 906 of the Sarbanes-Oxley Act                                                                                                                                                                                                                                                                                                                                                                       |       | *          |

 

48

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|   |   | (This exhibit is intended to be furnished in accordance with  Regulation S-K item 601(b)(32)(ii) and shall not be deemed to be filed for  purposes of section 18 of the Securities Exchange Act of 1934, as amended, or  incorporated by reference into any filing under the Securities Act of 1933,  except as shall be expressly set forth by specific reference). |   |   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|

 

----

* *Included herein*.

 

49

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   | The Navigators Group, Inc.                            |   |
|--------|-------------------------------------------------------|--------|
|   | (Registrant)                                          |
|   |                                                  |
| Date:  | November 4, 2004                                      |   | /s / Paul J. Malvasio |   |
|   | Paul J. Malvasio                                      |
|   | Executive Vice President  and Chief Financial Officer |
|        |                                                       |        |  |  |

 

50

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**INDEX OF EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | ** ** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                 |       |       |
| 10-1            |       | Form of Stock Grant Award Certificate and Restricted Stock Agreement  for the 2002 Stock Incentive Plan (approved at Annual Meeting of Shareholders  held May 30, 2002)                                                                                                                                                                                                                                                              |       | *          |
| 10-2            |       | Form of Option Award Certificate for the 2002 Stock Incentive Plan  (approved at Annual Meeting of Shareholders held May 30, 2002)                                                                                                                                                                                                                                                                                                   |       | *          |
| 10-3            |       | Agreement with Jane E. Keller                                                                                                                                                                                                                                                                                                                                                                                                        |       | *          |
| 11-1            |       | Statement re Computation of Per Share Earnings                                                                                                                                                                                                                                                                                                                                                                                       |       | *          |
| 31-1            |       | Certification of CEO per Section 302 of the Sarbanes-Oxley Act                                                                                                                                                                                                                                                                                                                                                                       |       | *          |
| 31-2            |       | Certification of CFO per Section 302 of the Sarbanes-Oxley Act                                                                                                                                                                                                                                                                                                                                                                       |       | *          |
| 32-1            |       | Certification of CEO per Section 906 of the Sarbanes-Oxley Act (This  exhibit is intended to be furnished in accordance with Regulation S-K item  601(b)(32)(ii) and shall not be deemed to be filed for purposes of section 18  of the Securities Exchange Act of 1934, as amended, or incorporated by  reference into any filing under the Securities Act of 1933, except as shall  be expressly set forth by specific reference). |       | *          |
| 32-2            |       | Certification of CFO per Section 906 of the Sarbanes-Oxley Act (This  exhibit is intended to be furnished in accordance with Regulation S-K item  601(b)(32)(ii) and shall not be deemed to be filed for purposes of section 18  of the Securities Exchange Act of 1934, as amended, or incorporated by  reference into any filing under the Securities Act of 1933, except as shall  be expressly set forth by specific reference). |       | *          |

 

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*  *Includedherein.*

 

51

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