**FORM 10-Q**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

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

 

**For the Quarterly Period Ended     June 30, 2004**

 

**Commission file****number     0-15886**

 

**The Navigators Group, Inc.**

(Exact name of Registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **13-3138397**                     |
|-----------------------------------------------------------------|------------|------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (IRS Employer  Identification No.) |
|                                                            |       |                               |
| **One Penn Plaza, New York, New York**                          | ** ** | **10119**                          |
| (Address of principal executive offices)                        |       | (Zip Code)                         |
|                                                            |       |                               |
| **(212)   244-2333**                                       |
| (Registrant’s telephone number, including area code)       |
|                                                            |       |                               |

 

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

 

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

 

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

 

Thenumber of common shares outstanding as of July 30, 2004 was 12,595,624.

 

 

----

 

**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

 

**INDEX**

 
| Part I.  FINANCIAL INFORMATION: |                                                                                                         |
|--------------------------------------|--------------------------------------------------------------------------------------------------------------|
|                                 |                                                                                                         |   |
|                                 | Item 1.  Financial Statements                                                                           |   |
|                                 |                                                                                                         |   |
|                                 | Consolidated Balance Sheets  June 30, 2004 (unaudited) and  December 31, 2003                      |   |
|                                 |                                                                                                         |   |
|                                 | Consolidated  Statements of Income (unaudited)  Three Months Ended June 30, 2004 and 2003               |   |
|                                 | Six Months Ended June 30,  2004 and 2003                                                                |   |
|                                 |                                                                                                         |   |
|                                 | Consolidated  Statements of Stockholders’ Equity  June 30, 2004 and 2003 (unaudited)               |   |
|                                 |                                                                                                         |   |
|                                 | Consolidated  Statements of Comprehensive Income (unaudited)  Three Months Ended June 30, 2004 and 2003 |   |
|                                 | Six Months Ended  June 30, 2004 and 2003                                                                |   |
|                                 |                                                                                                         |   |
|                                 | Consolidated  Statements of Cash Flows (unaudited)  Six Months Ended June 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.  Changes in Securities, Use of  Proceeds and Issuer Purchases of Equity Securities             |   |
|                                 |                                                                                                         |   |
|                                 | Item 3.  Defaults Upon Senior Securities                                                                |   |
|                                 |                                                                                                         |   |
|                                 | Item  4.  Submissions of Matters to a Vote of  Security’ Holders                                   |   |
|                                 |                                                                                                         |   |
|                                 | Item  5.  Other Information                                                                             |   |
|                                 |                                                                                                         |   |
|                                 | Item 6.  Exhibits and Reports on Form 8-K                                                               |   |
|                                 |                                                                                                         |   |
|                                 | Signature                                                                                                    |   |
|                                 |                                                                                                         |   |
|                                 | Index of  Exhibits                                                                                           |   |

 

2

----

 

**Part 1****.****          ****Financial Information**

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

**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

*($ in thousands, except share data)*

 
| ** **                                                                                                                        | ** **   | **June 30,  2004** | ** **   | **December 31,  2003** | ** **   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------------|-------------------------|--------------|-----------------------------|--------------|
| ** **                                                                                                                        | ** **   | **(Unaudited)**         | ** **   | ** **                  | ** **   |
| **ASSETS**                                                                                                                        | *** *** | *** ***            | *** *** | *** ***                | *** *** |
| Investments and cash:                                                                                                             |         |                    |         |                        |         |
| Fixed maturities, available-for-sale, at  fair value (amortized cost: 2004, $647,648; 2003, $577,904)                             |         | $                       | 646,979      |                        | $            | 588,545 |   |
| Equity securities, available-for-sale, at  fair value (cost: 2004, $18,271; 2003, $11,977)                                        |         | 19,626                  |         | 13,446                      |         |
| Short-term investments, at cost which  approximates fair value                                                                    |         | 91,223                  |         | 83,202                      |         |
| Cash                                                                                                                              |         | 13,526                  |         | 8,399                       |         |
| Total investments and cash                                                                                                        |         | 771,354                 |         | 693,592                     |         |
|                                                                                                                              |         |                    |         |                        |         |
| Premiums in course of collection                                                                                                  |         | 156,463                 |         | 128,676                     |         |
| Commissions receivable                                                                                                            |         | 2,396                   |         | 3,970                       |         |
| Prepaid reinsurance premiums                                                                                                      |         | 138,727                 |         | 102,141                     |         |
| Reinsurance receivable on paid losses                                                                                             |         | 23,215                  |         | 26,270                      |         |
| Reinsurance receivable on unpaid losses and  loss adjustment expense                                                              |         | 424,787                 |         | 350,441                     |         |
| Federal income tax recoverable                                                                                                    |         | 373                     |         | 8,747                       |         |
| Net deferred income tax benefit                                                                                                   |         | 20,020                  |         | 15,195                      |         |
| Deferred policy acquisition costs                                                                                                 |         | 32,253                  |         | 24,720                      |         |
| Accrued investment income                                                                                                         |         | 6,590                   |         | 5,546                       |         |
| Goodwill                                                                                                                          |         | 5,133                   |         | 5,093                       |         |
| Other assets                                                                                                                      |         | 11,809                  |         | 15,067                      |         |
|                                                                                                                              |         |                    |         |                        |         |
| Total assets                                                                                                                      |         | $                       | 1,593,120    |                        | $            | 1,379,458 |   |
|                                                                                                                              |         |                    |         |                        |         |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                     |         |                    |         |                        |         |
| Liabilities:                                                                                                                      |         |                    |         |                        |         |
| Reserves for losses and loss adjustment  expenses                                                                                 |         | $                       | 844,443      |                        | $            | 724,612 |   |
| Unearned premium                                                                                                                  |         | 296,403                 |         | 238,803                     |         |
| Reinsurance balances payable                                                                                                      |         | 130,655                 |         | 97,583                      |         |
| Payable for securities purchased                                                                                                  |         | 3,108                   |         | 12,857                      |         |
| Accounts payable and other liabilities                                                                                            |         | 16,155                  |         | 15,575                      |         |
| Total liabilities                                                                                                                 |         | 1,290,764               |         | 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: 12,595,624 for 2004 and 12,535,360  for 2003 |         | 1,260                   |         | 1,254                       |         |
| Additional paid-in capital                                                                                                        |         | 153,320                 |         | 151,765                     |         |
| Accumulated other comprehensive income                                                                                            |         | 1,354                   |         | 8,537                       |         |
| Retained earnings                                                                                                                 |         | 146,422                 |         | 128,472                     |         |
| Total stockholders’ equity                                                                                                   |         | 302,356                 |         | 290,028                     |         |
|                                                                                                                              |         |                    |         |                        |         |
| Total liabilities and stockholders’ equity                                                                                   |         | $                       | 1,593,120    |                        | $            | 1,379,458 |   |

 

See accompanying notes to interim consolidated financial statements.

 

3

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**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

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

 
| ** **                                        | ** ** | **Three Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| * *                                          | * *   | **(Unaudited)**                       | * *   |
|                                              |       |                                  |       |   |   |
| Gross written premium                             |       | $                                     | 161,626    |   | $ | 141,192 |   |
| Revenues:                                         |       |                                  |       |   |   |
| Net written premium                               |       | 73,689                                |       | 61,631 |   |
| Decrease in unearned premium                      |       | 1,625                                 |       | 3,633 |   |
| Net earned premium                                |       | 75,314                                |       | 65,264 |   |
| Commission income                                 |       | 1,361                                 |       | 1,486 |   |
| Net investment income                             |       | 6,625                                 |       | 4,552 |   |
| Net realized capital gains (losses)               |       | (105                                  | )          | 669 |   |
| Other income                                      |       | 266                                   |       | 415 |   |
| Total revenues                                    |       | 83,461                                |       | 72,386 |   |
|                                              |       |                                  |       |   |   |
| Operating expenses:                               |       |                                  |       |   |   |
| Net losses and loss adjustment expenses  incurred |       | 45,392                                |       | 43,291 |   |
| Commission expense                                |       | 10,040                                |       | 8,876 |   |
| Other operating expenses                          |       | 14,620                                |       | 12,417 |   |
| Interest expense                                  |       | —                                |       | 87 |   |
| Total operating expenses                          |       | 70,052                                |       | 64,671 |   |
|                                              |       |                                  |       |   |   |
| Income before income tax expense                  |       | 13,409                                |       | 7,715 |   |
|                                              |       |                                  |       |   |   |
| Income tax expense (benefit):                     |       |                                  |       |   |   |
| Current                                           |       | 4,951                                 |       | 3,437 |   |
| Deferred                                          |       | (579                                  | )          | (1,879 | ) |
| Total income tax expense                          |       | 4,372                                 |       | 1,558 |   |
|                                              |       |                                  |       |   |   |
| Net income                                        |       | $                                     | 9,037      |   | $ | 6,157 |   |
|                                              |       |                                  |       |   |   |
| Net income per common share:                      |       |                                  |       |   |   |
| Basic                                             |       | $                                     | 0.72       |   | $ | 0.72 |   |
| Diluted                                           |       | $                                     | 0.71       |   | $ | 0.71 |   |
|                                              |       |                                  |       |   |   |
| Average common shares outstanding:                |       |                                  |       |   |   |
| Basic                                             |       | 12,587                                |       | 8,516 |   |
| Diluted                                           |       | 12,647                                |       | 8,650 |   |

 

See accompanying notes to interim consolidated financial statements.

 

4

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#### **THE NAVIGATORSGROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS****OF INCOME**

*($ and shares in thousands, except net income pershare)*

 
| ** **                                        | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                        | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                        | ** ** | **(Unaudited)**                     | ** ** |
|                                              |       |                                |       |   |   |
| Gross written premium                             |       | $                                   | 357,577    |   | $ | 315,894 |   |
| Revenues:                                         |       |                                |       |   |   |
| Net written premium                               |       | 169,624                             |       | 152,664 |   |
| (Increase) in unearned premium                    |       | (20,135                             | )          | (21,086 | ) |
| Net earned premium                                |       | 149,489                             |       | 131,578 |   |
| Commission income                                 |       | 2,488                               |       | 2,725 |   |
| Net investment income                             |       | 12,527                              |       | 9,213 |   |
| Net realized capital gains                        |       | 317                                 |       | 887 |   |
| Other income                                      |       | 394                                 |       | 588 |   |
| Total revenues                                    |       | 165,215                             |       | 144,991 |   |
|                                              |       |                                |       |   |   |
| Operating expenses:                               |       |                                |       |   |   |
| Net losses and loss adjustment expenses  incurred |       | 89,144                              |       | 87,331 |   |
| Commission expense                                |       | 21,068                              |       | 19,503 |   |
| Other operating expenses                          |       | 28,052                              |       | 24,195 |   |
| Interest expense                                  |       | —                              |       | 184 |   |
| Total operating expenses                          |       | 138,264                             |       | 131,213 |   |
|                                              |       |                                |       |   |   |
| Income before income tax expense                  |       | 26,951                              |       | 13,778 |   |
|                                              |       |                                |       |   |   |
| Income tax expense (benefit):                     |       |                                |       |   |   |
| Current                                           |       | 9,958                               |       | 4,571 |   |
| Deferred                                          |       | (957                                | )          | (1,660 | ) |
| Total income tax expense                          |       | 9,001                               |       | 2,911 |   |
|                                              |       |                                |       |   |   |
| Net income                                        |       | $                                   | 17,950     |   | $ | 10,867 |   |
|                                              |       |                                |       |   |   |
| Net income per common share:                      |       |                                |       |   |   |
| Basic                                             |       | $                                   | 1.43       |   | $ | 1.28 |   |
| Diluted                                           |       | $                                   | 1.42       |   | $ | 1.26 |   |
|                                              |       |                                |       |   |   |
| Average common shares outstanding:                |       |                                |       |   |   |
| Basic                                             |       | 12,570                              |       | 8,505 |   |
| Diluted                                           |       | 12,671                              |       | 8,633 |   |

 

See accompanying notes to interim consolidated financial statements.

 

5

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**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

*($ in thousands)*

 
| ** **                                       | ** ** | **Six Months Ended  June 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                  |       | 6                                   |       | 1 |   |
| Balance at end of period                         |       | $                                   | 1,260      |   | $ | 852 |   |
|                                             |       |                                |       |   |   |
| Additional paid-in capital                       |       |                                |       |   |   |
| Balance at beginning of year                     |       | $                                   | 151,765    |   | $ | 40,141 |   |
| Effect of SFAS 123 for stock options             |       | 478                                 |       | 401 |   |
| Shares issued under stock plans                  |       | 1,077                               |       | 446 |   |
| Balance at end of period                         |       | $                                   | 153,320    |   | $ | 40,988 |   |
|                                             |       |                                |       |   |   |
| 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                                 |       | (7,424                              | )          | 3,741 |   |
| Balance at end of period                         |       | 447                                 |       | 13,240 |   |
| Cumulative translation adjustments, net of  tax  |       |                                |       |   |   |
| Balance at beginning of year                     |       | 666                                 |       | 233 |   |
| Net adjustment for period                        |       | 241                                 |       | 294 |   |
| Balance at end of period                         |       | 907                                 |       | 527 |   |
| Balance at end of period                         |       | $                                   | 1,354      |   | $ | 13,767 |   |
|                                             |       |                                |       |   |   |
| Retained earnings                                |       |                                |       |   |   |
| Balance at beginning of year                     |       | $                                   | 128,472    |   | $ | 120,787 |   |
| Net income                                       |       | 17,950                              |       | 10,867 |   |
| Balance at end of period                         |       | $                                   | 146,422    |   | $ | 131,654 |   |
|                                             |       |                                |       |   |   |
| Total stockholders’ equity at end of period |       | $                                   | 302,356    |   | $ | 187,261 |   |

 

See accompanying notes to interim consolidated financial statements.

 

6

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**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

*($ in thousands)*

 
| ** **                                                                                                                                        | ** ** | **Three Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| ** **                                                                                                                                        | ** ** | **(Unaudited)**                       | ** ** |
|                                                                                                                                              |       |                                  |       |   |   |
| Net income                                                                                                                                        |       | $                                     | 9,037      |   | $ | 6,157 |   |
| Other comprehensive income (loss):                                                                                                                |       |                                  |       |   |   |
| Change in net unrealized gains (losses) on  securities, net of tax (benefit) expense of $(6,566), and $2,042 in 2004, and  2003, respectively (1) |       | (12,194                               | )          | 3,696 |   |
| Change in foreign currency translation  gains, net of tax expense of $12, and $199 in 2004, and 2003 respectively                                 |       | 22                                    |       | 368 |   |
| Other comprehensive income (loss)                                                                                                                 |       | (12,172                               | )          | 4,064 |   |
|                                                                                                                                              |       |                                  |       |   |   |
| Comprehensive income (loss)                                                                                                                       |       | $                                     | (3,135     | ) | $ | 10,221 |   |
|                                                                                                                                                   |            |                                       |            |  |  |  |  |  |

 

----

| (1)    |   | Disclosure of reclassification amount, net of  tax:                              |   |   |    |   |   |
|--------|--------|----------------------------------------------------------------------------------|--------|--------|---------|--------|--------|
|   |   | Unrealized holding gains (losses) arising during period                          |   | $      | (12,361 | )      | $      | 4,257 |   |
|   |   | Less: reclassification adjustment for net  gains (losses) included in net income |   | (167   | )       | 561    |   |
|   |   | Net unrealized gains (losses) on securities                                      |   | $      | (12,194 | )      | $      | 3,696 |   |

 

See accompanying notes to interim consolidated financial statements.

 

7

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**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME**

*($ in thousands)*

 
| ** **                                                                                                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                                                                                       | ** ** | **(Unaudited)**                     | ** ** |
|                                                                                                                                             |       |                                |       |   |   |
| Net income                                                                                                                                       |       | $                                   | 17,950     |   | $ | 10,867 |   |
| Other comprehensive income (loss):                                                                                                               |       |                                |       |   |   |
| Change in net unrealized gains (losses) on  securities, net of tax (benefit) expense of $(3,998), and $2,073 in 2004, and  2003, respectively(1) |       | (7,425                              | )          | 3,741 |   |
| Change in foreign currency translation  gains, net of tax expense of $130, and $158 in 2004, and 2003 respectively                               |       | 241                                 |       | 294 |   |
| Other comprehensive income (loss)                                                                                                                |       | (7,184                              | )          | 4,035 |   |
|                                                                                                                                             |       |                                |       |   |   |
| Comprehensive income                                                                                                                             |       | $                                   | 10,766     |   | $ | 14,902 |   |

 

----

| (1)    |   | Disclosure of reclassification amount, net of tax:                      |   |   |   |   |   |
|--------|--------|-------------------------------------------------------------------------|--------|--------|--------|--------|--------|
|   |   | Unrealized holding gains (losses) arising during period                 |   | $      | (7,242 | )      | $      | 4,479 |   |
|   |   | Less: reclassification adjustment for net  gains included in net income |   | 183    |   | 738    |   |
|   |   | Net unrealized gains (losses) on securities                             |   | $      | (7,425 | )      | $      | 3,741 |   |

 

See accompanying notes to interim consolidated financial statements.

 

8

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**THE NAVIGATORS GROUP, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

*($ in thousands)*

 
| ** **                                                                                 | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                                 | ** ** | **(Unaudited)**                     | ** ** |
| Operating activities:                                                                      |       |                                |       |   |   |
| Net income                                                                                 |       | $                                   | 17,950     |   | $ | 10,867 |   |
| Adjustment to reconcile net income to net  cash provided by (used in) operating activities |       |                                |       |   |   |
| Depreciation &  amortization                                                           |       | 561                                 |       | 656 |   |
| Net deferred income tax                                                                    |       | (957                                | )          | (1,660 | ) |
| Net realized capital (gains)                                                               |       | (317                                | )          | (887 | ) |
| Changes in assets and liabilities:                                                         |       |                                |       |   |   |
| Reinsurance receivable on paid and unpaid  losses and loss adjustment expenses             |       | (71,291                             | )          | (11,697 | ) |
| Reserve for losses and loss adjustment  expenses                                           |       | 119,831                             |       | 53,748 |   |
| Prepaid reinsurance premiums                                                               |       | (36,586                             | )          | (43,146 | ) |
| Unearned premium                                                                           |       | 57,600                              |       | 63,490 |   |
| Premiums in course of collection                                                           |       | (27,787                             | )          | (38,037 | ) |
| Commissions receivable                                                                     |       | 1,574                               |       | 166 |   |
| Deferred policy acquisition costs                                                          |       | (7,533                              | )          | (2,402 | ) |
| Accrued investment income                                                                  |       | (1,044                              | )          | (1,301 | ) |
| Reinsurance balances payable                                                               |       | 33,072                              |       | 35,849 |   |
| Federal income tax                                                                         |       | 8,374                               |       | 915 |   |
| Other                                                                                      |       | (287                                | )          | (1,011 | ) |
| Net cash provided by operating activities                                                  |       | 93,160                              |       | 65,550 |   |
|                                                                                       |       |                                |       |   |   |
| Investing activities:                                                                      |       |                                |       |   |   |
| Fixed maturities, available-for-sale                                                       |       |                                |       |   |   |
| Redemptions and maturities                                                                 |       | 88,242                              |       | 2,316 |   |
| Sales                                                                                      |       | 136,955                             |       | 116,323 |   |
| Purchases                                                                                  |       | (295,894                            | )          | (185,809 | ) |
| Equity securities, available-for-sale                                                      |       |                                |       |   |   |
| Sales                                                                                      |       | 2,292                               |       | 476 |   |
| Purchases                                                                                  |       | (8,169                              | )          | (423 | ) |
| Change in payable for securities                                                           |       | (9,749                              | )          | (709 | ) |
| Net change in short-term investments                                                       |       | (1,552                              | )          | (1,865 | ) |
| Purchase of property and equipment                                                         |       | (965                                | )          | (872 | ) |
| Net cash (used in) investing activities                                                    |       | (88,840                             | )          | (70,563 | ) |
|                                                                                       |       |                                |       |   |   |
| Financing activities:                                                                      |       |                                |       |   |   |
| Repayment of bank loan                                                                     |       | —                              |       | (3,500 | ) |
| Proceeds from Employee Stock Purchase Plan                                                 |       | 434                                 |       | — |   |
| Proceeds from exercise of stock options                                                    |       | 373                                 |       | 20 |   |
| Net cash provided by (used in) financing  activities                                       |       | 807                                 |       | (3,480 | ) |
|                                                                                       |       |                                |       |   |   |
| Increase (decrease) in cash                                                                |       | 5,127                               |       | (8,493 | ) |
| Cash at beginning of year                                                                  |       | 8,399                               |       | 13,443 |   |
| Cash at end of period                                                                      |       | $                                   | 13,526     |   | $ | 4,950 |   |
|                                                                                       |       |                                |       |   |   |
| Supplemental disclosures of cash flow  information:                                        |       |                                |       |   |   |
| Federal, state and local income tax paid                                                   |       | 1,577                               |       | 3,709 |   |
| Interest paid                                                                              |       | —                              |       | 184 |   |
| Issuance of stock to directors                                                             |       | 60                                  |       | 72 |   |

 

See accompanying notes to interim consolidated financial statements.

 

9

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**THE NAVIGATORS GROUP,INC.****  AND SUBSIDIARIES**

 

**Notes to Interim Consolidated FinancialStatements**

*(Unaudited)*

 

**Note 1.****  Accounting Policies**

 

Theinterim consolidated financial statements are unauditedbut reflect all adjustments which, in the opinion of management, are necessaryto provide a fair statement of the results of The Navigators Group, Inc. andits subsidiaries (the “Company”) for the interim periods presented on the basisof accounting principles generally accepted in the United States of America(“GAAP”).  All such adjustments are of anormal recurring nature.  All significantintercompany transactions and balances have beeneliminated.  The preparation of thesefinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosures ofcontingent assets and liabilities at the date of the financial statements andthe reported revenues and expenses during the reporting periods.  The results of operations for any interimperiod are not necessarily indicative of results for the full year.  These financial statements should be read inconjunction with the consolidated financial statements and notes contained inthe Company’s 2003 Annual Report on Form 10-K. Certain amounts for prior periods have been reclassified to conform tothe current period’s presentation.

 

**Note 2.****  Reinsurance Ceded**

 

The Company’s ceded earned premiums were $79,328,000and $62,015,000 for the three months ended June 30, 2004 and 2003,respectively, and were $152,707,000****and$109,115,000 for the six months ended June 30, 2004 and 2003,respectively.  The Company’s cededincurred losses were $59,370,000 and $35,968,000 for the three months endedJune 30, 2004 and 2003, respectively, and were $124,188,000 and$63,505,000 for the six months ended June 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 and NIC Insurance Company and currently are primarily engagedin underwriting marine insurance and related lines of business, contractors’general liability insurance, and professional liability insurance.  The Lloyd’s operations underwrite marine andrelated lines of business at Lloyd’s of London.    The Navigators Agencies are underwritingmanagement companies which produce, manage and underwrite insurance andreinsurance for both affiliated and unaffiliated companies.  All segments are evaluated based on theirGAAP results.

 

TheInsurance Companies and the Lloyd’s operations are measured taking into accountnet 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 include inter-segmentincome and expense in the form of affiliated commissions, income and expensefrom corporate operations and consolidating adjustments.  Each segment also maintains their owninvestments, on which they earn income and realize capital gains or losses.

 

10

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Financialdata by segment for the three months ended June 30, 2004 and 2003 was asfollows:

 
| ** **                                         | ** ** | **Three Months Ended June 30, 2004** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Insurance  Companies**                  | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations (1)** | ** ** | **Total** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**                 | ** ** |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Gross written premium                              |       | $                                         | 107,608    |   | $ | 54,308 |   | $ | — |   | $ | (290 | ) | $ | 161,626 |   |
| Net written premium                                |       | 46,565                                    |       | 27,124 |   | — |   | — |   | 73,689 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Revenues:                                          |       |                                      |       |   |   |   |   |   |   |   |   |
| Net earned premium                                 |       | 51,782                                    |       | 23,532 |   | — |   | — |   | 75,314 |   |
| Commission income                                  |       | —                                    |       | 501 |   | 8,155 |   | (7,295 | ) | 1,361 |   |
| Net investment income                              |       | 5,829                                     |       | 791 |   | — |   | 5 |   | 6,625 |   |
| Net realized capital gains (losses)                |       | 176                                       |       | (281 | ) | — |   | — |   | (105 | ) |
| Other income                                       |       | 74                                        |       | 5 |   | 187 |   | — |   | 266 |   |
| Total revenues                                     |       | 57,861                                    |       | 24,548 |   | 8,342 |   | (7,290 | ) | 83,461 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                |       |                                      |       |   |   |   |   |   |   |   |   |
| Net losses and LAE                                 |       | 32,558                                    |       | 12,834 |   | — |   | — |   | 45,392 |   |
| Commission expense                                 |       | 13,242                                    |       | 4,093 |   | — |   | (7,295 | ) | 10,040 |   |
| Other operating expenses                           |       | 989                                       |       | 3,193 |   | 9,093 |   | 1,345 |   | 14,620 |   |
| Total operating expenses                           |       | 46,789                                    |       | 20,120 |   | 9,093 |   | (5,950 | ) | 70,052 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) before income tax expense  (benefit) |       | 11,072                                    |       | 4,428 |   | (751 | ) | (1,340 | ) | 13,409 |   |
| Income tax expense (benefit)                       |       | 3,543                                     |       | 1,550 |   | (252 | ) | (469 | ) | 4,372 |   |
| Net income (loss)                                  |       | $                                         | 7,529      |   | $ | 2,878 |   | $ | (499 | ) | $ | (871 | ) | $ | 9,037 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Identifiable assets (2)                            |       | $                                         | 1,158,875  |   | $ | 463,300 |   | $ | 14,682 |   | $ | 32,160 |   | $ | 1,593,120 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Loss and LAE ratio                                 |       | 62.9                                      | %          | 54.5 | % |   |   |   |   | 60.2 | % |
| Commission expense ratio                           |       | 25.6                                      | %          | 17.4 | % |   |   |   |   | 23.0 | % |
| Other operating expense ratio                      |       | 1.9                                       | %          | 13.6 | % |   |   |   |   | 5.6 | % |
| Combined ratio                                     |       | 90.4                                      | %          | 85.5 | % |   |   |   |   | 88.8 | % |

 

----

(1)           Includesinter-segment eliminations.

(2)           Doesnot cross-foot due to inter-segment eliminations

 

11

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| ** **                                         | ** ** | **Three Months Ended June 30, 2003** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Insurance  Companies**                  | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations (1)** | ** ** | **Consolidated  Total** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**                 | ** ** |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Gross written premium                              |       | $                                         | 101,345    |   | $ | 46,391 |   | — |   | $ | (6,544 | ) | $ | 141,192 |   |
| Net written premium                                |       | 43,804                                    |       | 17,827 |   |   |   |   |   | 61,631 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Revenues:                                          |       |                                      |       |   |   |   |   |   |   |   |   |
| Net earned premium                                 |       | 46,608                                    |       | 18,656 |   | — |   | — |   | 65,264 |   |
| Commission income                                  |       | —                                    |       | 216 |   | 8,287 |   | (7,017 | ) | 1,486 |   |
| Net investment income                              |       | 4,094                                     |       | 444 |   | 14 |   | — |   | 4,552 |   |
| Net realized capital gains                         |       | 307                                       |       | 362 |   | — |   | — |   | 669 |   |
| Other income (expense)                             |       | 65                                        |       | 199 |   | 276 |   | (125 | ) | 415 |   |
| Total revenues                                     |       | 51,074                                    |       | 19,877 |   | 8,577 |   | (7,142 | ) | 72,386 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                |       |                                      |       |   |   |   |   |   |   |   |   |
| Net losses and LAE                                 |       | 30,870                                    |       | 12,421 |   | — |   | — |   | 43,291 |   |
| Commission expense                                 |       | 12,592                                    |       | 3,301 |   | — |   | (7,017 | ) | 8,876 |   |
| Other operating expenses                           |       | 1,357                                     |       | 1,892 |   | 7,562 |   | 1,606 |   | 12,417 |   |
| Interest expense                                   |       | —                                    |       | — |   | — |   | 87 |   | 87 |   |
| Total operating expenses                           |       | 44,819                                    |       | 17,614 |   | 7,562 |   | (5,324 | ) | 64,671 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Income (loss) before income tax expense  (benefit) |       | 6,255                                     |       | 2,263 |   | 1,015 |   | (1,818 | ) | 7,715 |   |
| Income tax expense (benefit)                       |       | 1,969                                     |       | — |   | 226 |   | (637 | ) | 1,558 |   |
| Net income (loss)                                  |       | $                                         | 4,286      |   | $ | 2,263 |   | $ | 789 |   | $ | (1,181 | ) | $ | 6,157 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Identifiable assets (2)                            |       | $                                         | 774,851    |   | $ | 318,851 |   | $ | 14,967 |   | $ | 27,584 |   | $ | 1,081,317 |   |
|                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Loss and LAE ratio                                 |       | 66.2                                      | %          | 66.6 | % |   |   |   |   | 66.3 | % |
| Commission expense ratio                           |       | 27.1                                      | %          | 17.7 | % |   |   |   |   | 24.4 | % |
| Other operating expense ratio                      |       | 2.9                                       | %          | 10.1 | % |   |   |   |   | 5.0 | % |
| Combined ratio                                     |       | 96.2                                      | %          | 94.4 | % |   |   |   |   | 95.7 | % |

 

12

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Financialdata by segment for the six months ended June 30, 2004 and 2003 was asfollows:

 
| ** **                                         | ** ** | **Six Months Ended June 30, 2004** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                         | ** ** | **Insurance  Companies**                | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations (1)** | ** ** | **Total** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**               | ** ** |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Gross written premium                              |       | $                                       | 219,437    |   | $ | 141,466 |   | $ | — |   | $ | (3,326 | ) | $ | 357,577 |   |
| Net written premium                                |       | 100,710                                 |       | 68,914 |   | — |   | — |   | 169,624 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Revenues:                                          |       |                                    |       |   |   |   |   |   |   |   |   |
| Net earned premium                                 |       | 104,964                                 |       | 44,525 |   | — |   | — |   | 149,489 |   |
| Commission income                                  |       | —                                  |       | 563 |   | 16,087 |   | (14,162 | ) | 2,488 |   |
| Net investment income                              |       | 11,313                                  |       | 1,195 |   | 3 |   | 16 |   | 12,527 |   |
| Net realized capital gains (losses)                |       | 381                                     |       | (64 | ) | — |   | — |   | 317 |   |
| Other income                                       |       | 13                                      |       | 9 |   | 372 |   | — |   | 394 |   |
| Total revenues                                     |       | 116,671                                 |       | 46,228 |   | 16,462 |   | (14,146 | ) | 165,215 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                |       |                                    |       |   |   |   |   |   |   |   |   |
| Net losses and LAE                                 |       | 65,268                                  |       | 23,876 |   | — |   | — |   | 89,144 |   |
| Commission expense                                 |       | 27,387                                  |       | 7,843 |   | — |   | (14,162 | ) | 21,068 |   |
| Other operating expenses                           |       | 2,187                                   |       | 6,229 |   | 17,698 |   | 1,938 |   | 28,052 |   |
| Total operating expenses                           |       | 94,842                                  |       | 37,948 |   | 17,698 |   | (12,224 | ) | 138,264 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Income (loss) before income tax expense  (benefit) |       | 21,829                                  |       | 8,280 |   | (1,236 | ) | (1,922 | ) | 26,951 |   |
| Income tax expense (benefit)                       |       | 7,021                                   |       | 2,898 |   | (392 | ) | (526 | ) | 9,001 |   |
| Net income (loss)                                  |       | $                                       | 14,808     |   | $ | 5,382 |   | $ | (844 | ) | $ | (1,396 | ) | $ | 17,950 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Identifiable assets (2)                            |       | $                                       | 1,158,875  |   | $ | 463,300 |   | $ | 14,682 |   | $ | 32,160 |   | $ | 1,593,120 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Loss and LAE ratio                                 |       | 62.2                                    | %          | 53.6 | % |   |   |   |   | 59.6 | % |
| Commission expense ratio                           |       | 26.1                                    | %          | 17.6 | % |   |   |   |   | 23.6 | % |
| Other operating expense ratio                      |       | 2.1                                     | %          | 14.0 | % |   |   |   |   | 5.6 | % |
| Combined ratio                                     |       | 90.4                                    | %          | 85.2 | % |   |   |   |   | 88.8 | % |

 

13

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| ** **                                         | ** ** | **Six Months Ended June 30, 2003** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                         | ** ** | **Insurance  Companies**                | ** ** | **Lloyd’s  Operations** | ** ** | **Navigators  Agencies** | ** ** | **Parent &  Other  Operations(1)** | ** ** | **Consolidated  Total** | ** ** |
| ** **                                         | ** ** | **($ in thousands)**               | ** ** |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Gross written premium                              |       | $                                       | 211,227    |   | $ | 122,475 |   | $ | — |   | $ | (17,808 | ) | $ | 315,894 |   |
| Net written premium                                |       | 105,458                                 |       | 47,206 |   | — |   | — |   | 152,664 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Revenues:                                          |       |                                    |       |   |   |   |   |   |   |   |   |
| Net earned premium                                 |       | 97,008                                  |       | 34,570 |   | — |   | — |   | 131,578 |   |
| Commission income                                  |       | —                                  |       | 344 |   | 15,723 |   | (13,342 | ) | 2,725 |   |
| Net investment income                              |       | 8,199                                   |       | 991 |   | 22 |   | 1 |   | 9,213 |   |
| Net realized capital gains                         |       | 426                                     |       | 461 |   | — |   | — |   | 887 |   |
| Other income (expense)                             |       | 86                                      |       | 214 |   | 538 |   | (250 | ) | 588 |   |
| Total revenues                                     |       | 105,719                                 |       | 36,580 |   | 16,283 |   | (13,591 | ) | 144,991 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                |       |                                    |       |   |   |   |   |   |   |   |   |
| Net losses and LAE                                 |       | 64,870                                  |       | 22,461 |   | — |   | — |   | 87,331 |   |
| Commission expense                                 |       | 26,741                                  |       | 6,104 |   | — |   | (13,342 | ) | 19,503 |   |
| Other operating expenses                           |       | 2,503                                   |       | 3,846 |   | 15,203 |   | 2,643 |   | 24,195 |   |
| Interest expense                                   |       | —                                  |       | — |   | — |   | 184 |   | 184 |   |
| Total operating expenses                           |       | 94,114                                  |       | 32,411 |   | 15,203 |   | (10,515 | ) | 131,213 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Income (loss) before income tax expense  (benefit) |       | 11,605                                  |       | 4,169 |   | 1,080 |   | (3,076 | ) | 13,778 |   |
| Income tax expense (benefit)                       |       | 3,635                                   |       | — |   | 353 |   | (1,077 | ) | 2,911 |   |
| Net income (loss)                                  |       | $                                       | 7,970      |   | $ | 4,169 |   | $ | 727 |   | $ | (1,999 | ) | $ | 10,867 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Identifiable assets (2)                            |       | $                                       | 774,851    |   | $ | 318,851 |   | $ | 14,967 |   | $ | 27,584 |   | $ | 1,081,317 |   |
|                                               |       |                                    |       |   |   |   |   |   |   |   |   |
| Loss and LAE ratio                                 |       | 66.9                                    | %          | 65.0 | % |   |   |   |   | 66.4 | % |
| Commission expense ratio                           |       | 27.6                                    | %          | 17.7 | % |   |   |   |   | 25.0 | % |
| Other operating expense ratio                      |       | 2.5                                     | %          | 11.1 | % |   |   |   |   | 4.8 | % |
| Combined ratio                                     |       | 97.0                                    | %          | 93.8 | % |   |   |   |   | 96.2 | % |

 

----

(1)Includes inter-segment eliminations.

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

 

TheInsurance Companies’ net earned premium includes $8,612,000 and $8,244,000 ofnet earned premium from the UK Branch for the three months ended June 30,2004 and 2003, respectively, and $16,174,000 and $16,000,000 of net earnedpremium for the six months ended June 30, 2004 and 2003, respectively.

 

**Note 4.****  Comprehensive Income**

 

Comprehensiveincome encompasses net income, net unrealized capital gains and losses onavailable for sale securities, and foreign currency translationadjustments.  Please refer to the‘Consolidated Statements of

 

14

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Stockholders’Equity’ and the ‘Consolidated Statements of Comprehensive Income’, includedherein, for the components of accumulated other comprehensive income and ofcomprehensive income, respectively.

 

**Note 5.****  Stock-Based Compensation**

 

InDecember 2002, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) 148, *Accounting for Stock-Based Compensation, 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.

 

SFAS123, *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 Issuedto Employees* (“APB 25”), and related interpretations, with certainpro forma disclosures as required by SFAS 123. APB 25 requires compensation expense to be recognized only if the fairvalue of the underlying stock at the grant date exceeds the exercise price ofthe option.

 

Stockbased compensation is expensed as the awards vest.  The amount charged to expense for stockgrants was $286,000 and $210,000 for the three months ended June 30, 2004and 2003, respectively and $647,000 and $486,000 for the six months endedJune 30, 2004 and 2003, respectively. The amount charged to expense for stock options was $278,000 and$195,000 for the three months ended June 30, 2004 and 2003, respectively,and $478,000, and $401,000 for the six months ended June 30, 2004 and2003, respectively.  Stock appreciationrights resulted in expense of $69,000 and $851,000 for the three months endedJune 30, 2004 and 2003, respectively, and income of $259,000 and expenseof $1,200,000 for the six months ended June 30, 2004 and 2003,respectively, all of which were included in other operating expenses for theperiods indicated.

 

Inaddition, $30,000 and $18,000 were expensed for the three months endedJune 30, 2004 and 2003, respectively, and $60,000 and $36,000 for the sixmonths ended June 30, 2004 and 2003, respectively, for stock issuedannually to non-employee directors as part of the directors’ compensation forserving on the Company’s Board of Directors.

 

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

 

InJanuary 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Entities.*  Interpretation 46 requires variable interestentities to be consolidated by their primary beneficiaries.  The adoption of this interpretation did nothave any effect on the Company’s financial condition or results ofoperations.  In December 2003, theFASB revised Interpretation 46 primarily to clarify certain requirements, easesome implementation problems and add new scope exceptions.  The result of the revisionstend 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.

 

**Note 7.****  Lloyd’s Syndicate**

 

Werecord our pro rata share of Lloyd’s Syndicate 1221’s assets, liabilities,revenues and expenses, after making adjustments to convert Lloyd’s accountingto U.S. GAAP.  The most significant U.S.GAAP adjustments relate to income recognition. Lloyd’s syndicates determineunderwriting results by year of account at the end of

 

15

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three years.  We record adjustments to recognizeunderwriting results as incurred, including the expected ultimate cost oflosses incurred.  These adjustments tolosses are based on actuarial analysis of syndicate accounts, includingforecasts of expected ultimate losses provided by the syndicates.  At the end of the Lloyd’s three year periodfor determining underwriting results for an account year, the syndicate willclose the account year by reinsuring outstanding claims on that account yearwith the participants for the account’s next underwriting year.  The amount to close an underwriting year intothe next year is referred to as the “reinsurance to close”.  The reinsurance to close transactions arerecorded in the fourth quarter as additional written and earned premium, lossesincurred, loss reserves and receivables, all in the same amount.  No gains or losses are recorded on thereinsurance to close transactions.

 

Lloyd’sSyndicate 1221 has stamp capacity of £150.0 million ($273.8 million) in 2004compared to £125.0 million ($203.5 million) in 2003.  Stamp capacity is a measure of the amount ofpremium a Lloyd’s syndicate is authorized to write as determined by the Councilof Lloyd’s.  Syndicate 1221’s capacity isexpressed net of commission (as is standard at Lloyd’s) of approximately21%.  The Syndicate 1221 premium recordedin the Company’s financial statements is gross of commission.  The Company participates for 97.4% ofSyndicate 1221’s capacity for both the 2004 and 2003 underwriting years.  The Lloyd’s operations included in theconsolidated financial statements represent the Company’s participation inSyndicate 1221.

 

TheCompany provides letters of credit to Lloyd’s to support its Syndicate 1221capacity.  If the Company increases itsparticipation or if Lloyd’s changes the capital requirements, the Company maybe required to supply additional letters of credit or other collateral acceptableto Lloyd’s, or reduce the capacity of Syndicate 1221.  The letters of credit are provided throughthe credit facility which the Company maintains with a consortium ofbanks.  The credit facility agreementrequires that the banks vote whether or not to renew the letter of creditportion of the facility each year.  Ifthe banks decide not to renew the letter of credit facility, the Company willneed to find other sources to provide the letters of credit or other collateralin order to continue to participate in Syndicate 1221.  The renewal amendment executed inNovember 2003 renewed the letter of credit facility for a two year period.

 

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

 

TheCompany’s valuation allowance relating to its foreign operations decreased by$854,000 and $1,484,000 in the three and six months ended June 30, 2003,respectively, relating to the reduction in the loss carryforwardat the Company’s foreign operations resulting from income generated by theseoperations in 2003.  At June 30,2003, the Company had loss carryforwards remaining atits foreign operations amounting to potential future tax benefits of$3,046,000, along with a valuation allowance equal to those benefits.  Although the foreign operations wereprofitable in the first six 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 continued profitabilityand projected 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 carryforwards will be realized, therefore the remainingvaluation allowance related to the foreign operations was released in thefourth quarter of 2003.

 

TheCompany also had state and local operating loss carryforwardsamounting to potential future tax benefits of $3,801,000 and $3,274,000 atJune 30, 2004 and December 31, 2003, respectively.  A valuation allowance was established for thefull amount of these potential future tax benefits due to the uncertaintyassociated with their realization.

 

**Note 9.****  Commitments and Contingencies**

 

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

 

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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 has commenced suit in Australia, seeking to voidthe draw downs. If the liquidator were to prevail in its action to void theletters of credit, our maximum exposure would be approximately $4.0 million. Wefiled motions seeking a prompt dismissal of the liquidator’s claims inAustralian court in June 2003, which motions were denied. We have appealedthose denials and are vigorously defending our position along with continuingsettlement discussions. The appellate court ruled that the case needs to befully tried before an appeal can be pursued. Although we believe that we have strong defenses against these claimsand a reasonable possibility of defeating the liquidator’s claim and that theliquidator’s assertions run counter to prevailing Australian and United Stateslaw, there can be no assurance as to the outcome of this litigation.

 

**Note 10.****  Reinsurance Recoverables**

 

AtJune 30, 2004 the Company had reinsurance recoverablesof $21.5 million, consisting of reinsurance recoverablesfor ceded losses and loss adjustment expenses of $15.5 million and ceded unearnedpremium of $6.0 million, due from Converium HoldingLtd. and subsidiaries (“Converium”).  The recoverablesresult from several run-off and active excess and pro-rata reinsuranceagreements with Converium expiring through thebeginning of 2005 that cover principally marine and energy risks for NavigatorsInsurance Company and the Lloyd’s operations. Recoverable amounts at June 30, 2004 recorded by NavigatorsInsurance Company and the Lloyd’s operations were $1.2 million and $20.3million, respectively.

 

InJuly 2004, Converium publicly announced that their2004 second quarter financial results were impacted by reserve strengtheningand certain intangible write-offs and that the company would explore alloptions for maintaining strong capitalization. Both A. M. Best and S&P immediately announced ratings downgrades of Converium and its operating subsidiaries from A to A- withnegative outlooks.

 

TheCompany is monitoring the financial condition and ongoing activities of Converium to determine if any actions, including the needto record an allowance for uncollectible reinsurance, are appropriate.

 

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

 

**Note on Forward-Looking Statements**

 

Someof the statements in this Quarterly Report on Form 10-Q are ‘‘forward-lookingstatements’’ as defined in the Private Securities Litigation Reform Act of1995. Forward-looking statements are derived from information that we currentlyhave and assumptions that we make. We cannot assure that anticipated resultswill be achieved, since results may differ materially because of both known andunknown risks and uncertainties which we face. We undertake no obligation topublicly update or revise any forward-looking statements, whether as a resultof new information, future events or otherwise. Factors that could cause actualresults to differ materially from our forward-looking statements include, butare not limited to:

 

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

 

•      changes in the laws, rules and regulations whichapply 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;

 

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

 

•      unexpected turnover of our professional staff;

 

•      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 ability toobtain 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 (includingacts 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 portfolio suffersreduced returns or investment losses which could reduce our profitability; and

 

•      other risks that we identify in future filingswith the Securities and Exchange Commission.

 

Inlight of these risks, uncertainties and assumptions, any forward-looking eventsdiscussed in this Form 10-Q may not occur. You are cautioned not to place unduereliance on any forward-looking statements, which speak only as of theirrespective dates.

 

*The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with ourconsolidated financial statements and accompanying notes which appear elsewherein this Form 10-Q. It contains forward-looking statements that involve risksand uncertainties. Please see ‘‘Note on Forward-Looking Statements’’ for moreinformation. Our actual results could differ materially from those anticipatedin these forward-looking statements as a result of various factors, includingthose discussed below and elsewhere in this Form 10-Q.*

 

**Overview**

 

Weare an international insurance holding company focusing on specialty productsfor niches within the overall property/casualty insurance market. Our largestproduct line and most long-standing area of specialization is ocean marineinsurance. We have also developed specialty niches in professional liabilityinsurance, and in specialty liability insurance primarily consisting ofcontractors’ liability coverages. We conductoperations through our insurance company subsidiaries, the Navigators Agenciesand our Lloyd’s operations.  Ourinsurance company subsidiaries consist of Navigators Insurance Company, whichincludes a United Kingdom Branch, and NIC Insurance Company which writes excessand surplus lines.  The NavigatorsAgencies consist of five wholly-owned insurance underwriting agencies whichproduce business for our insurance subsidiaries.  Our Lloyd’s operations include NavigatorsUnderwriting Agency Ltd. (“NUAL”), a Lloyd’s of London (“Lloyd’s”) marineunderwriting agency which manages Lloyd’s Syndicate 1221.  We participate in the capacity of Syndicate1221 through two wholly-owned Lloyd’s corporate members.

 

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Whilemanagement takes into consideration a wide range of factors in planning theCompany’s business strategy and evaluating results of operations, there arecertain factors that management believes are fundamental to understanding howthe Company is managed.   First,underwriting profit is consistently emphasized as a primary goal, above premiumgrowth.  Management’s assessment of ourtrends and potential growth in underwriting profit is the dominant factor inits decisions with respect to whether or not to expand a business line, enterinto a new niche, product or territory or, conversely, to contract capacity inany business line.  In addition,management focuses on managing the costs of our operations.  Management believes that careful monitoringof the costs of existing operations and assessment of costs of potential growthopportunities are important to our profitability.  Access to capital also has a significantimpact on management’s outlook for our operations.  Our insurance company subsidiaries’operations and ability to grow their business and take advantage of marketopportunities are particularly constrained by regulatory capital requirementsand rating agency assessments of capital adequacy.  For example, we contributed $95.0 million ofthe approximately $110.8 million in net proceeds we received from theOctober 2003 equity offering to the statutory surplus of NavigatorsInsurance Company in order to position the Company to be able to capitalize ondomestic and international insurance business opportunities that managementbelieves will be profitable.

 

Althoughnot a financial measure, management’s decisions are also greatly influenced byaccess to specialized underwriting and claims expertise in our lines ofbusiness.  We have chosen to operate inspecialty niches with certain common characteristics which we believe provideus with the opportunity to use our technical underwriting expertise in order torealize underwriting profit. As a result, we have focused on underservedmarkets for businesses characterized by higher severity and low frequency ofloss where we believe our intellectual capital and financial strength bringmeaningful value. In contrast, we have avoided niches that we believe have ahigh frequency of loss activity and/or are subject to a high level ofregulatory coverage requirements, such as workers compensation and personalautomobile insurance, because we do not believe ourtechnical expertise is of as much value in these types of businesses. Examplesof niches that have the characteristics we look for include bluewaterhull (which provides coverage for physical damage to, for example, highlyvalued cruise ships) and directors and officers liability (which covers litigationexposure of a corporation’s directors and officers). These types of exposuresrequire substantial technical expertise. We attempt to mitigate the financialimpact of severe claims on our results by conservative and detailedunderwriting, prudent use of reinsurance and a balanced portfolio of risks.

 

Ourrevenue is primarily comprised of premiums, commission and investment income.Our insurance company subsidiaries derive their premiums primarily frombusiness written by the Navigators Agencies. The Lloyd’s operations derivetheir premiums from business written by NUAL. The Navigators Agencies and NUALreceive commissions and, in some cases, profit commissions and service fees onthe business produced on behalf of our insurance company subsidiaries and others.

 

Overthe past two years, we have experienced beneficial market changes in our linesof business. As a result of several large industry losses in the second quarterof 2001, the marine insurance market began to experience diminished capacityand 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 theSarbanes-Oxley Act of 2002, together with recent financial and accountingscandals at publicly traded corporations and increased frequency ofsecurities-related class action litigation, has lead to an invigorated interestin professional liability insurance generally. These conditions resulted inrate increases in 2002 and 2003 as well as an overall improvement in policyterms and conditions for our professional liability line of business.  The professional liability business hasexperienced single digit premium rate decreases in 2004.  We believe that the professional liabilitymarket will continue to see 2004 rates decrease in certain areas, includingdirectors and officers  coverages.

 

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Ourbusiness is cyclical and influenced by many factors.  These factors include price competition,economic conditions, interest rates, natural or man-made disasters (for examplehurricanes and terrorism), state regulations, court decisions and changes inthe law. Additionally, because our insurance products must be priced, andpremiums charged, before costs have fully developed, our liabilities arerequired 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.

 

**Critical Accounting Policies**

 

Itis important to understand our accounting policies in order to understand ourfinancial statements. Management considers certain of these policies to becritical to the presentation of the financial results, since they requiremanagement to make estimates and assumptions. These estimates and assumptionsaffect the reported amounts of assets, liabilities, revenues, expenses, andrelated disclosures at the financial reporting date and throughout the periodbeing reported upon. Certain of the estimates result from judgments that can besubjective and complex, and consequently actualresults may differ from these estimates, which would be reflected in futureperiods.

 

Ourmost critical accounting policies involve the reporting of the reserves forlosses and loss adjustment expenses (“LAE”) (including losses that haveoccurred but were not reported to us by the financial 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.

 

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

 

***ReinsuranceRecoverables.*** Reinsurance recoverablesare established for the portion of the loss reserves that are ceded to reinsurers. Reinsurance recoverablesare determined based upon the terms and conditions of reinsurance contractswhich could be subject to interpretations that differ from our own based onjudicial theories of liability. In addition, we bear credit risk with respectto our reinsurers which can be significantconsidering that certain of the reserves remain outstanding for an extendedperiod of time. We are required to pay losses even if a reinsurerfails to meet its obligations under the applicable reinsurance agreement.

 

***Writtenand Unearned Premium.*** Written premium is recorded based on the insurance policies that havebeen reported to us and the policies that have been written by agents but notyet reported to us. We must estimate the amount of written premium not yetreported based on judgments relative to current and historical trends of thebusiness being written. Such estimates are regularly reviewed and updated andany resulting adjustments are included in the current year’s results. Anunearned premium reserve is established to reflect the unexpired portion ofeach policy at the financial reporting date.

 

***DeferredTax Assets.***We have recorded valuation allowances related to deferred tax assets resultingfrom certain net operating loss carryforwards due tothe uncertainty associated with the realization of the deferred tax assetrelated to certain of our foreign, state and local operations. Our foreign operationswere profitable in 2003 resulting in a portion of the valuation allowance beingsimultaneously released to the extent of the first nine months of 2003profits.  Due to the continuedprofitability and projected favorable market conditions for the foreseeablefuture, it was determined to be more likely than not that the deferred taxassets resulting from those net operating loss carryforwardswill be realized, therefore the remaining valuation allowance related to theforeign operations was released in the fourth quarter of 2003.

 

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***Impairmentof Investment 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.

 

***Accountingfor Lloyd’s Results.*** We record our pro rata share of Lloyd’s syndicate assets, liabilities,revenues and expenses, after making adjustments to convert Lloyd’s accountingto U.S. GAAP. The most significant GAAP adjustments relate to incomerecognition. Lloyd’s syndicates determine underwriting results by year ofaccount at the end of three years. We record adjustments to recognizeunderwriting results as incurred, including the expected ultimate cost oflosses incurred. These adjustments to losses are based on actuarial analysis ofsyndicate accounts, including forecasts of expected ultimate losses provided bythe syndicate. At the end of the Lloyd’s three-year period for determiningunderwriting results for an account year, the syndicate will close the accountyear by reinsuring outstanding claims on that account year with theparticipants for the account’s next underwriting year. The amount to close anunderwriting year into the next year is referred to as the ‘‘reinsurance toclose.’’ The reinsurance to close transactions are recorded in the fourthquarter as additional written and earned premium, losses incurred, lossreserves and receivables, all in the same amount. There are no gains or lossesrecorded on the reinsurance to close transactions.

 

***Translationof Foreign Currencies****.***Financialstatements of subsidiaries expressed in foreign currencies are translated intoU.S. dollars in accordance with SFAS No. 52 *ForeignCurrency Translation* issued by the FASB.  Under SFAS 52, functional currency assets andliabilities are translated into U.S. dollars using period end rates of exchangeand the related translation adjustments are recorded as a separate component ofaccumulated other comprehensive income. Functional currencies are generally the currencies of the localoperating environment.  Statement ofincome amounts expressed in functional currencies aretranslated using average exchange rates. Gains and losses resulting from foreign currency transactions arerecorded in “other income (expense)” in the Company’s Consolidated Statementsof Income.

 

**Results of Operations and Overview**

 

Thefollowing is a discussion and analysis of our consolidated and segment resultsof operations for the three and six months ended June 30, 2004 and 2003.

 

Our2004 and 2003 second quarter and six month overall results of operationsreflect increasing premium rates as a result of improved market conditionsbeginning in late 2000 that continued through 2003 and at a reduced ratethrough the second quarter of 2004.  Netincome for the three months ended June 30, 2004 and 2003 was $9.0 millionor $0.71 per diluted share and $6.2 million or $0.71 per diluted share,respectively.  Net income for the firstsix months of 2004 and 2003 was $18.0 million or $1.42 per diluted share and$10.9 million or 1.26 per diluted share, respectively.

 

Weexperienced premium growth as measured by net earned premium in the secondquarter of 2004 of $75.3 million compared to $65.3 million in the secondquarter of 2003, a 15.4% increase, primarily due to business expansion and, toa lesser extent, increased premium rates. The 13.6% increase in net earned premium

 

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for the first six months of 2004 compared to thesame period in 2003 was also due to business expansion and premium rateincreases.  Underwriting profitabilityduring such periods, as measured by the Company’s combined ratios for thesecond quarter and first six months of 2004 of 88.8% and 88.8%, respectively,has also improved****compared to95.7%  and 96.2% for the second quarterand first six months of 2003, respectively.

 

Cashflow from operations has also increased in the first six months of 2004 to$93.2 million from $65.6 million in the first six months of 2003, a 42.1%increase, contributing to the growth in invested assets and net investmentincome.  Cash flow in the second quarterof 2004 increased to $66.4 million, a 68.1% increase over the 2003 secondquarter.

 

Consolidatedstockholders’ equity increased 4.3% to $302.4 million or $24.00 per share atJune 30, 2004 compared to $290.0 million or $23.14 per share atDecember 31, 2003.  The increase wasprimarily due to net income of $18.0 million partially offset by the othercomprehensive loss of $7.2 million for the first six months of 2004.  Net income was $9.0 million and othercomprehensive loss was $12.2 million for the second quarter of 2004.  The other comprehensive loss in 2004 resultedfrom unrealized losses in the Company’s investment portfolio due to a risinginterest rate environment during the second quarter of 2004.  Other comprehensive income (loss) consists ofthe change in both after-tax unrealized appreciation on investments andafter-tax currency translation gains on the Company’s foreign operations.

 

**Revenues.**  Grosswritten premium increased to $161.6 million and $357.6 million in the secondquarter and first six months of 2004, respectively, from $141.2 million and$315.9 million in the second quarter and first six months of 2003,respectively, a 14.5% increase for the three months and a 13.2% increase forthe six months.  The following table setsforth our gross and net written premium and net earned premium by segment andline of business for the periods indicated:

 

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| ** **                    | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|
| ** **                    | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                    | ** ** | **Gross  Written  Premium**          | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** | **Gross  Written  Premium** | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** |
| ** **                    | ** ** | **($’s in thousands)**          | ** ** |
| Insurance Companies:          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | $                                    | 51,573     |   | 31.9 | % | $ | 20,384 |   | $ | 20,834 |   | $ | 49,644 |   | 35.2 | % | $ | 21,475 |   | $ | 20,974 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Specialty                     |       | 37,484                               |       | 23.2 | % | 19,041 |   | 21,365 |   | 31,721 |   | 22.5 | % | 12,726 |   | 19,461 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Professional Liability        |       | 18,227                               |       | 11.3 | % | 6,903 |   | 4,697 |   | 12,994 |   | 9.2 | % | 3,323 |   | 2,079 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Assumed from Lloyd’s     |       | 288                                  |       | 0.2 | % | 229 |   | 4,878 |   | 6,820 |   | 4.8 | % | 6,820 |   | 4,606 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other (includes run-off)      |       | 36                                   |       | 0.0 | % | 8 |   | 8 |   | 166 |   | 0.1 | % | (540 | ) | (512 | ) |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Insurance Companies Total     |       | 107,608                              |       | 66.6 | % | 46,565 |   | 51,782 |   | 101,345 |   | 71.8 | % | 43,804 |   | 46,608 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lloyd’s Operations:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | 47,793                               |       | 29.6 | % | 23,978 |   | 22,325 |   | 39,897 |   | 28.3 | % | 15,438 |   | 17,791 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other                         |       | 6,515                                |       | 4.0 | % | 3,146 |   | 1,207 |   | 6,494 |   | 4.6 | % | 2,389 |   | 865 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lloyd’s Operations Total |       | 54,308                               |       | 33.6 | % | 27,124 |   | 23,532 |   | 46,391 |   | 32.9 | % | 17,827 |   | 18,656 |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Intercompany elimination      |       | (290                                 | )          | -0.2 | % | — |   | — |   | (6,544 | ) | -4.7 | % | — |   | — |   |
|                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                         |       | $                                    | 161,626    |   | 100.0 | % | $ | 73,689 |   | $ | 75,314 |   | $ | 141,192 |   | 100.0 | % | $ | 61,631 |   | $ | 65,264 |   |

 

Note:  Certain amounts for the prior period havebeen reclassified to conform to the current period’s presentation.

 

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| ** **                    | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------|------------|------------------------------------|------------|
| ** **                    | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| ** **                    | ** ** | **Gross  Written  Premium**        | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** | **Gross  Written  Premium** | ** ** | **%** | ** ** | **Net  Written  Premium** | ** ** | **Net  Earned  Premium** | ** ** |
| ** **                    | ** ** | **($’s in thousands)**        | ** ** |
| Insurance Companies:          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | $                                  | 110,999    |   | 31.0 | % | $ | 45,642 |   | $ | 41,262 |   | $ | 103,364 |   | 32.7 | % | $ | 44,536 |   | $ | 43,250 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Specialty                     |       | 71,714                             |       | 20.1 | % | 39,552 |   | 42,904 |   | 63,614 |   | 20.1 | % | 36,625 |   | 42,411 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Professional Liability        |       | 33,260                             |       | 9.3 | % | 12,376 |   | 8,507 |   | 25,559 |   | 8.1 | % | 6,272 |   | 3,505 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Assumed from Lloyd’s     |       | 3,342                              |       | 0.9 | % | 3,135 |   | 12,283 |   | 18,418 |   | 5.8 | % | 18,418 |   | 8,180 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other (includes run-off)      |       | 122                                |       | 0.0 | % | 5 |   | 8 |   | 272 |   | 0.1 | % | (393 | ) | (338 | ) |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Insurance Companies Total     |       | 219,437                            |       | 61.3 | % | 100,710 |   | 104,964 |   | 211,227 |   | 66.8 | % | 105,458 |   | 97,008 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lloyd’s Operations:      |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                        |       | 128,757                            |       | 36.0 | % | 63,038 |   | 42,843 |   | 106,465 |   | 33.7 | % | 41,315 |   | 33,106 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other                         |       | 12,709                             |       | 3.6 | % | 5,876 |   | 1,682 |   | 16,010 |   | 5.1 | % | 5,891 |   | 1,464 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Lloyd’s Operations Total |       | 141,466                            |       | 39.6 | % | 68,914 |   | 44,525 |   | 122,475 |   | 38.8 | % | 47,206 |   | 34,570 |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Intercompany elimination      |       | (3,326                             | )          | -0.9 | % | — |   | — |   | (17,808 | ) | -5.6 | % | — |   | — |   |
|                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                         |       | $                                  | 357,577    |   | 100.0 | % | $ | 169,624 |   | $ | 149,489 |   | $ | 315,894 |   | 100.0 | % | $ | 152,664 |   | $ | 131,578 |   |

 

Note:  Certain amounts for the prior period havebeen reclassified to conform to the current period’s presentation.

 

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**Gross Written Premium**

 

Insurance Companies’ Gross Written Premium

 

*Marine.* The marine gross written premium for thesecond quarter of 2004 increased 3.9% compared to the second quarter of 2003partially due to the approximate 6.3% increase in premium rates resulting inhigher premiums on new and renewal business. The generally improved pricingenvironment resulted in Navigators Insurance Company increasing its writing ofnew business.  Navigators InsuranceCompany obtains its marine business through participation in the marine poolmanaged by the Navigators Agencies. Its participation in the marine pool was80% in the first six months of 2004 and 70% in the first six months of2003.  Navigators Insurance Company’sparticipation in the insurance pool was retroactively increased to 80%effective January 1, 2003 in the 2003 third quarter when it entered into acommutation agreement with a former pool member.  The marine gross written premium for thefirst six months of 2004 increased 7.4% compared to the first six months of2003 partially due to the approximate 4.5% increase in premium rates resultingin higher premiums on new and renewal business.

 

*Specialty.* This business consists primarily of generalliability business for small general and artisan contractors as well as othertargeted commercial risks.  The specialtygross written premium for the second quarter of 2004 increased 18.2% comparedto the second quarter of 2003 primarily due to the approximate 14.4% increasein the construction liability premium rates resulting in higher premiums on newand renewal business. The increase in the specialty gross written premium forthe first six months of 2004 of 12.7% compared to the first six months of 2003was primarily due to the approximate 20.8% increase in the California liabilitypremium rates resulting in higher premiums on new and renewal business.  The number of California constructionliability in-force policies decreased significantly over the last year as aresult of our efforts to scale back the number of small artisan policies wewrite.  The new business and the rateincreases resulted from a tightening market for California 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 liability coverages.  Theprofessional liability gross written premium for the second quarter and firstsix months of 2004 increased 40.3% and 30.1%, respectively, compared to thesecond quarter and first six months of 2003, reflecting the expansion of thisbusiness.  Premium rates for thisbusiness decreased approximately 7.0% and 4.0% in the second quarter and firstsix months of 2004 compared to the second quarter and first six months of 2003,respectively, following an approximate 28.0% increase for the twelve months endedDecember 31, 2003.  Such 2004premium rate decreases are reflective of softening market conditions.

 

*Assumed from Lloyd’s Operations.** *Since 2002, the Insurance Companies have participated in quota sharetreaties written by the Company’s Lloyd’s operations.  The 2003 participation included marine andenergy business.  In 2004, our insurancecompany subsidiaries participated only on the onshore energy business writtenby the Lloyd’s operations.

 

Lloyd’sOperations’ Gross Written Premium

 

*Marine.***The**marinegross written premium for the second quarter of 2004 increased 19.8% comparedto the second quarter of 2003 primarily due to the increased capacity providedto Syndicate 1221 by Navigators Corporate Underwriters Ltd. and MillenniumUnderwriting Ltd.  The marine grosswritten premium for the first six months of 2004 increased 20.9% primarily dueto the increased capacity provided to Syndicate 1221.  The premium rates for the three months andsix months ended June 30, 2004 were similar to those for the same periodsin 2003.

 

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*Other.** *Other consists of engineering and construction gross written premiumwhich provides coverage for construction projects including machinery,equipment and loss of use due to delays and of onshore energy premium whichprincipally focuses on the oil and gas, chemical and petrochemical industrieswith coverages primarily for property damage andbusiness 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.

 

Cededwritten premium for the 2004 and 2003 second quarters was$87.9 million and $79.6 million, respectively, or 54.4% and 56.3% of the grosswritten premium, respectively.  The 2003second quarter’s ceded premium reflects an increase in the premium ceded underthe specialty business reinsurance treaty for the period from April 1,2003 to September 30, 2003 which provided a statutory capital benefitprior to the completion of a public equity offering in the 2003 fourthquarter.  The reinsurance treaty changehad no impact on net income or stockholders’ equity.

 

Theceded premium for the first six months of 2004 and 2003 was $188.0 million and$163.2 million, respectively, or 52.6% and 51.7% of gross written premium,respectively.

 

**Net Written Premium**.*** ***Net writtenpremium increased 19.6% in the second quarter of 2004 and 11.1% in the firstsix months of 2004 compared to the second quarter and first six months of 2003as a result of the increase in the gross written premium.

 

**Net Earned Premium**.  Net earned premium increased15.4% in the second quarter of 2004 and 13.6% in the first six months of 2004compared to the second quarter and first six months of 2003 as a result ofincreased net written premium from rate increases and new business generated in2004 and 2003.

 

**Commission Income****.** Commission income from unaffiliated business decreased by 8.4% in thesecond quarter of 2004 and 8.7% in the first six months of 2004 compared to thesecond quarter and first six months of 2003 as a result of the 10% decrease inthird party pool member participation in the 2004 periods compared to the sameperiods in 2003.

 

**Net Investment Income****.***** ***Net investment income increased 45.5% in the 2004 second quarter and36.0% in the first six 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 2003common stock offering.  Our net proceedsfrom the offering amounted to $110.8 million.

 

**Net Realized Capital Gains****(Losses)****.** Pre-tax net income included a $105,000 netrealized capital loss for the three months ended June 30, 2004 compared toa capital gain of $669,000 for the 2003 second quarter.  On an after-tax basis, the net realizedcapital gain (loss) was ($68,000) or ($0.01) per share and $561,000 or $0.06 pershare for the 2004 and 2003 second quarters, respectively.  Pre-tax net income included $317,000 of netrealized capital gains for the six months ended June 30, 2004 compared to$887,000 for the first six months of 2003. On an after-tax basis, the net realized capital gains were $206,000 or$0.02 per share and $738,000 or $0.08 per share for the first six months of2004 and 2003, respectively.

 

**Other Income/(Expense)****.** Other income/(expense)for the second quarter and first six months of 2004 and 2003 consistedprimarily of foreign exchange gains, and inspection fees related to thespecialty insurance business.

 

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**Operating Expenses**

 

*Net Losses and Loss Adjustment Expenses Incurred. *The ratios of net losses and loss adjustment expenses incurred to netearned premium (loss ratios) for the 2004 second quarter and six month periodwere 60.2% and 59.6%, respectively, compared to 66.3% and 66.4% for thecomparable periods in 2003.  Such lossratios for the second quarter and first six months of 2004 were favorablyimpacted by 1.9 and 2.7 loss ratio points, respectively, for a redundancy ofprior year loss reserves in our Lloyd’s operations.  The second quarter and first six months of2003 were negatively impacted by 2.1 and 2.4 loss ratio points, respectively,for loss activity related to run-off lines of business.

 

Thefollowing tables set forth our net loss reserves by segment and line ofinsurance business and the total case reserves and incurred but not reported(“IBNR”) reserves as of June 30, 2004 and December 31, 2003:

 
| ** **                           | ** ** | **June 30,  2004**   | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| ** **                           | ** ** | **($ in thousands)** | ** ** |
| Insurance Companies:                 |       |                      |       |                        |       |
| Marine                               |       | $                         | 122,816    |                        | $          | 110,698 |   |
| Specialty                            |       | 133,399                   |       | 114,167                     |       |
| Professional Liability               |       | 12,053                    |       | 7,059                       |       |
| Assumed from Lloyd’s Operations |       | 18,047                    |       | 14,323                      |       |
| Other (primarily run-off business)   |       | 23,223                    |       | 24,390                      |       |
| Total Insurance Companies            |       | 309,538                   |       | 270,637                     |       |
|                                 |       |                      |       |                        |       |
| Lloyd’s Operations:             |       |                      |       |                        |       |
| Marine                               |       | 104,507                   |       | 100,936                     |       |
| Other                                |       | 5,611                     |       | 2,598                       |       |
| Total Lloyd’s Operations        |       | 110,118                   |       | 103,534                     |       |
|                                 |       |                      |       |                        |       |
| Total net loss reserves              |       | $                         | 419,656    |                        | $          | 374,171 |   |
|                                 |       |                      |       |                        |       |
| Total net case loss reserves         |       | $                         | 170,775    |                        | $          | 154,531 |   |
| Total net IBNR loss reserves         |       | 248,881                   |       | 219,640                     |       |
|                                 |       |                      |       |                        |       |
| Total net loss reserves              |       | $                         | 419,656    |                        | $          | 374,171 |   |

 

AtJune 30, 2004, the IBNR portion of the net loss reserves was 59.3% of ourtotal loss reserves compared to 58.7% at December 31, 2003.

 

AtJune 30, 2004, a 10% change in the net loss reserves would equate to $42.0****million which would represent an after-taxcharge to net income of $27.3 million and 9.0% of stockholders’ equity.  Loss reserve estimates are reviewed eachquarter to evaluate whether the assumptions made continue to be appropriate.  Any adjustments that result from this revieware recorded in the quarter in which they 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

 

27

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exceedor be less than the revised estimates. The increase in net loss reserves is also a function of the growth inpremium volume over the past two years.

 

Ourloss reserves include amounts related to short tail and long tail classes ofbusiness. Short tail business means that claims are generally reported quicklyupon occurrence of an event, making estimation of loss reserves less complex.Our longer tail business includes our specialty liability and professionalliability insurance. For the long tail lines, significant periods of time,ranging up to several years or more, may elapse between the occurrence of theloss, the reporting of the loss and the settlement of the claim. The longer thetime span between the incidence of a loss and the settlement of the claim, themore likely the ultimate settlement amount can vary 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 legislationrecently implemented in California, which generally provides consumers whoexperience construction defects a method other than litigation to obtainconstruction defect repairs. This legislation may impact claim severity,frequency and length to settlement assumptions underlying our reserves.Accordingly, our ultimate liability may exceed or be less than currentestimates due to this variable, among others. There were approximately 1,000 specialty liability claims open atJune 30, 2004.

 

Theprofessional liability class generates third party claims, which also arelonger tail in nature. The professional liability policies provide coverage ona claims-made basis, whereby coverage is generally provided only for thoseclaims that are made during the policy period. Our professional liabilitybusiness is relatively immature, with our first writing of the business in late2001. Accordingly, given the relative immaturity of this business, it will takesome time to better understand the reserve trends on this business.  Our professional liability loss estimatesare based on expected losses, actual reported losses, evaluation of losstrends, industry data, and the legal, regulatory and current risk environmentbecause anticipated loss experience in this area is less predictable due to thesmall number of claims and/or erratic claim severity patterns. We believe thatwe have made a reasonable estimate of the required loss reserves forprofessional liability. The expected ultimate losses may be adjusted up or downas the accident years mature.  Therewere 223 professional liability claims open at June 30, 2004.

 

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Thefollowing tables set forth our net loss and LAE loss reserves for our specialtyconstruction liability and professional liability businesses for the periodsindicated:

 
|                             |   | **June 30,  2004**     |   |
|----------------------------------|--------|-----------------------------|--------|
| **Type of  Business**            |   | **Net  Reported  Reserves** |   | **Net  IBNR** |   | **Total  Net Loss  Reserves** |   | **% of IBNR  to Total Net  Loss Reserves** |   |
|                             |   |                        |   |   |   |   |   |   |   |
| Specialty construction liability |   | $                           | 21,968 |   | $ | 97,841 |   | $ | 119,809 |   | 81.7 | % |
| Professional liability           |   | 271                         |   | 11,782 |   | 12,053 |   | 97.8 | % |
|                             |   |                        |   |   |   |   |   |   |   |
| Total                            |   | $                           | 22,239 |   | $ | 109,623 |   | $ | 131,862 |   | 83.1 | % |

 
|                             |   | **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.

 

Inthe fourth quarter of 2003, Navigators Insurance Company increased its grossand net asbestos reserves for losses by $77.6 million and $31.6 million,respectively.  As a result, gross andnet incurred losses increased by the amount of the respective reserveincrease.  The $31.6 million of netasbestos losses includes $25.7 million of uncollectible reinsurance.

 

The reserve action was theresult of a review of asbestos-related exposures conducted by the Company.  The Company’s management was notified inlate January 2004 that an asbestos claim would likely have to be settledfor a significantly greater amount than previously anticipated.   As a result of the unexpected adversedevelopment on this individual claim, the Company retained a leadingindependent consulting firm in this area to assist in the identification of itspotential exposure to asbestos claims from policies written directly as well asthose reinsured to Navigators Insurance Company from prior members of theCompany’s insurance pools. The Company’s increased reserves relate primarily topolicies underwritten by the Navigators Agencies in the late 1970s and firsthalf of the 1980s on behalf of members of the pool, consisting of excessliability on marine related business and aviation products liability, includingpolicies subsequently assumed by Navigators Insurance Company pursuant toreinsurance arrangements with pool members who exited the pool.  Following the 

 

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Company’s and the independent consultingfirm’s recent review, the Company increased its gross and net loss reserves forasbestos exposure to $78.5 million and $32.1 million, respectively, atDecember 31, 2003.

 

Lossdevelopment activity for asbestos related exposures in the second quarter andfirst six months of 2004 has not been significant.

 

Lossdevelopment activity for environmental losses in the second quarter and firstsix months of 2004 has generally consisted of oil spill claims on marineliability policies written in the ordinary course of business by the InsuranceCompanies.

 

Thefollowing tables set forth our gross and net loss and LAE reserves, and claimcounts for our asbestos and environmental exposures, which we believe issubject to uncertainties greater than those presented by other types of claims:

 
|                      |   | **Three  Months Ended  June 30, 2004** |   |
|---------------------------|--------|---------------------------------------------|--------|
|                      |   | **Asbestos**                                |   | **Environmental** |   | **Total** |   |
|                      |   | **($ in thousands)**                        |   |
| **Gross of  Reinsurance** |   |                                        |   |   |   |   |   |
| Beginning Reserve         |   | $                                           | 78,479 |   | $ | 7,377 |   | $ | 85,856 |   |
| Incurred Losses & LAE |   | 55                                          |   | 1,580 |   | 1,635 |   |
| Calendar Year Payments    |   | 37                                          |   | 277 |   | 314 |   |
| Ending Reserves           |   | $                                           | 78,497 |   | $ | 8,680 |   | $ | 87,177 |   |
|                      |   |                                        |   |   |   |   |   |
| **Net of Reinsurance**    |   |                                        |   |   |   |   |   |
| Beginning Reserve         |   | $                                           | 32,091 |   | $ | 1,733 |   | $ | 33,824 |   |
| Incurred Losses & LAE |   | 15                                          |   | 575 |   | 590 |   |
| Calendar Year Payments    |   | 14                                          |   | 76 |   | 90 |   |
| Ending Reserves           |   | $                                           | 32,092 |   | $ | 2,232 |   | $ | 34,324 |   |

 
|                      |   | **Six Months  Ended  June 30, 2004** |   |
|---------------------------|--------|-------------------------------------------|--------|
|                      |   | **Asbestos**                              |   | **Environmental** |   | **Total** |   |
|                      |   | **($ in thousands)**                      |   |
| **Gross of  Reinsurance** |   |                                      |   |   |   |   |   |
| Beginning Reserve         |   | $                                         | 78,472 |   | $ | 6,800 |   | $ | 85,272 |   |
| Incurred Losses & LAE |   | 66                                        |   | 2,244 |   | 2,310 |   |
| Calendar Year Payments    |   | 41                                        |   | 364 |   | 405 |   |
| Ending Reserves           |   | $                                         | 78,497 |   | $ | 8,680 |   | $ | 87,177 |   |
|                      |   |                                      |   |   |   |   |   |
| **Net of Reinsurance**    |   |                                      |   |   |   |   |   |
| Beginning Reserve         |   | $                                         | 32,083 |   | $ | 1,153 |   | $ | 33,236 |   |
| Incurred Losses & LAE |   | 25                                        |   | 1,223 |   | 1,248 |   |
| Calendar Year Payments    |   | 16                                        |   | 144 |   | 160 |   |
| Ending Reserves           |   | $                                         | 32,092 |   | $ | 2,232 |   | $ | 34,324 |   |

 

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| **Type of Business** |   | **Claim  Count  January 1, 2004** |   | **New Claims  During Period** |   | **Claims  Settled  or Resolved  During Period** |   | **Claim  Count  June 30, 2004** |   |
|----------------------|--------|----------------------------------------|--------|-------------------------------|--------|-------------------------------------------------|--------|--------------------------------------|--------|
|                 |   |                                   |   |                          |   |                                            |   |                                 |   |
| Environmental        |   | 86                                     |   | 12                            |   | 5                                               |   | 93                                   |   |
| Asbestos             |   | 108                                    |   | 6                             |   | 3                                               |   | 111                                  |   |
| Total                |   | 194                                    |   | 18                            |   | 8                                               |   | 204                                  |   |

 

Ourmanagement believes that the reserves for losses and loss adjustment expensesare adequate to cover the ultimate cost of losses and loss adjustment expenseson reported and unreported claims.

 

*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 thatthey relate to unearned premium.  Commissionexpense declined****as a percentage of earned premium in the second quarter andfirst six months of 2004 compared to the 2003 second quarter and first sixmonths, generally as the result of a decline in commissions paid to brokers andagents coupled with the receipt of ceding commissions from reinsurers.  The decrease in the commission percentagereflects lower commission rates and a trend among the major brokers to charge aflat fee to some of their major clients 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 17.7% and 15.9% increase in otheroperating expenses in the second quarter and first six months of 2004,respectively, compared to the same periods in 2003 is consistent with revenuegrowth and attributable primarily to employee related expenses resulting fromexpansion of the business.

 

*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 thesecond quarter and first six months of 2004.

 

Income Taxes. The income tax expense was$4.4 million and $1.6 million for the second quarter of 2004 and 2003,respectively.  The effective tax ratesfor the 2004 and 2003 second quarters were 32.6% and 20.2%, respectively.  The first six months of 2004 and 2003 hadincome tax expense of $9.0 million and $2.9 million, respectively, resulting inan effective tax rate of 33.4% and 21.1%, respectively.  As of June 30, 2004 and 2003, the netdeferred Federal, foreign, state and local tax assets were $20.0 million and$5.9 million, respectively.

 

The Company’s valuation allowance relating to its foreign operationsdecreased by $854,000 and $1,484,000 in the three and six months endedJune 30, 2003, respectively, relating to the reduction in the loss carryforwardat the Company’s foreign operations resulting from income generated by theseoperations in 2003.  At June 30,2003, the Company had loss carryforwards remaining at its foreign operationsamounting to potential future tax benefits of $3,046,000, along with avaluation allowance equal to those benefits. Although the foreign operations were profitable in the first six monthsof 2003, the valuation allowance was released only to the extent of thoseprofits since future profitability 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 allowancerelated to the foreign operations was released in the fourth quarter of 2003.

 

The Company also had state and local operating loss carryforwardsamounting to potential future tax benefits of $3,801,000 and $3,274,000 atJune 30, 2004 and December 31, 2003, respectively.  A valuation allowance was established forthe full amount of these potential future tax benefits due to the uncertaintyassociated with their realization.

 

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**SegmentInformation**

 

Followingare the financial results of the Company’s three segments:  Insurance Companies, Lloyd’s Operations andNavigators Agencies. We evaluate the performance of each segment includingNavigators Agencies, primarily based on underwriting results.  Other items of revenue and expenditure,including net investment income and realized capital gains and losses, areincluded herein based on the legal entity where they are recorded.  Our underwriting performance is evaluatedseparately from the performance of our investment portfolios.  Certain amounts for the prior period havebeen reclassified to conform to the current period’s presentation.

 

***Insurance Companies***

 

Ourtwo insurance company subsidiaries are Navigators Insurance Company, whichincludes a United Kingdom Branch, and NIC Insurance Company, collectivelyreferred to as the Insurance Companies. Navigators Insurance Company is ourlargest insurance subsidiary and has been active since 1983. It specializesprincipally in underwriting marine insurance and related lines of business,specialty liability insurance and professional liability insurance. NICInsurance Company, a wholly owned subsidiary of Navigators Insurance Company,began operations in 1990. It underwrites similar types of business but on anon-admitted or surplus lines basis and is fully reinsured by NavigatorsInsurance Company.  The NavigatorsAgencies produce business for our insurance company subsidiaries.

 

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Followingare the results of operations for the Insurance Companies for the three monthsand six months ended June 30, 2004 and 2003:

 
|                             |   | **Three  Months Ended  June 30,** |       | **Six Months  Ended  June 30,** |   |
|----------------------------------|--------|----------------------------------------|------------|--------------------------------------|--------|
|                             |   | **2004**                               |       | **2003**                             |   | **2004** |   | **2003** |   |
|                             |   | **($ in thousands)**                   | ** ** |
| Revenues:                        |   |                                   |       |                                 |   |   |   |   |   |
| Net earned premium               |   | $                                      | 51,782     |                                 | $      | 46,608 |   | $ | 104,964 |   | $ | 97,008 |   |
| Net investment income            |   | 5,829                                  |       | 4,094                                |   | 11,313 |   | 8,199 |   |
| Net realized capital gains       |   | 176                                    |       | 307                                  |   | 381 |   | 426 |   |
| Other income                     |   | 74                                     |       | 65                                   |   | 13 |   | 86 |   |
| Total revenues                   |   | 57,861                                 |       | 51,074                               |   | 116,671 |   | 105,719 |   |
|                             |   |                                   |       |                                 |   |   |   |   |   |
| Operating expenses:              |   |                                   |       |                                 |   |   |   |   |   |
| Net losses and LAE               |   | 32,558                                 |       | 30,870                               |   | 65,268 |   | 64,870 |   |
| Commission expense               |   | 13,242                                 |       | 12,592                               |   | 27,387 |   | 26,741 |   |
| Other operating expenses         |   | 989                                    |       | 1,357                                |   | 2,187 |   | 2,503 |   |
| Total operating expenses         |   | 46,789                                 |       | 44,819                               |   | 94,842 |   | 94,114 |   |
|                             |   |                                   |       |                                 |   |   |   |   |   |
| Income before income tax expense |   | 11,072                                 |       | 6,255                                |   | 21,829 |   | 11,605 |   |
|                             |   |                                   |       |                                 |   |   |   |   |   |
| Income tax expense               |   | 3,543                                  |       | 1,969                                |   | 7,021 |   | 3,635 |   |
|                             |   |                                   |       |                                 |   |   |   |   |   |
| Net income                       |   | $                                      | 7,529      |                                 | $      | 4,286 |   | $ | 14,808 |   | $ | 7,970 |   |
|                             |   |                                   |       |                                 |   |   |   |   |   |
| Loss and LAE ratio               |   | 62.9                                   | %          | 66.2                                 | %      | 62.2 | % | 66.9 | % |
| Commission expense ratio         |   | 25.6                                   | %          | 27.1                                 | %      | 26.1 | % | 27.6 | % |
| Other operating expense ratio    |   | 1.9                                    | %          | 2.9                                  | %      | 2.1 | % | 2.5 | % |
| Combined ratio                   |   | 90.4                                   | %          | 96.2                                 | %      | 90.4 | % | 97.0 | % |

 

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

 
|                                 |   | **Three  Months Ended June 30, 2004** |   |
|--------------------------------------|--------|--------------------------------------------|--------|
|                                 |   | **($ in thousands)**                       |   |
|                                 |   | **Net  Earned  Premium**                   |   | **Losses  and LAE  Incurred** |   | **Underwriting  Expenses** |   | **Underwriting  Gain(Loss)** |   | **Loss  Ratio** |   | **Expense  Ratio** |   | **Combined  Ratio** |   |
|                                 |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |   | **$**                                      | 20,834 |   | **$** | 12,423 |   | **$** | 5,660 |   | $ | 2,751 |   | 59.6 | % | 27.2 | % | 86.8 | % |
| Specialty                            |   | 21,365                                     |   | 14,485 |   | 5,877 |   | 1,003 |   | 67.8 | % | 27.5 | % | 95.3 | % |
| Professional Liability               |   | 4,697                                      |   | 2,832 |   | 969 |   | 896 |   | 60.3 | % | 20.6 | % | 80.9 | % |
| Assumed from Lloyd’s Operations |   | 4,878                                      |   | 2,728 |   | 1,723 |   | 427 |   | 55.9 | % | 35.3 | % | 91.2 | % |
| Other (includes run-off) business    |   | 8                                          |   | 90 |   | 2 |   | (84 | ) | NM |   | NM |   | NM |   |
| Total                                |   | $                                          | 51,782 |   | $ | 32,558 |   | $ | 14,231 |   | $ | 4,993 |   | 62.9 | % | 27.5 | % | 90.4 | % |

 
|                                 |   | **Three  Months Ended June 30, 2003** |   |
|--------------------------------------|--------|--------------------------------------------|--------|
|                                 |   | **($ in thousands)**                       |   |
|                                 |   | **Net  Earned  Premium**                   |   | **Losses  and LAE  Incurred** |   | **Underwriting  Expenses** |   | **Underwriting  Gain(Loss)** |   | **Loss  Ratio** |   | **Expense  Ratio** |   | **Combined  Ratio** |   |
|                                 |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |   | $                                          | 20,974 |   | $ | 11,115 |   | $ | 6,973 |   | $ | 2,886 |   | 53.0 | % | 33.2 | % | 86.2 | % |
| Specialty                            |   | 19,461                                     |   | 14,246 |   | 5,174 |   | 41 |   | 73.2 | % | 26.6 | % | 99.8 | % |
| Professional Liability               |   | 2,079                                      |   | 1,352 |   | 393 |   | 334 |   | 65.0 | % | 18.9 | % | 83.9 | % |
| Assumed from Lloyd’s Operations |   | 4,606                                      |   | 2,757 |   | 1,391 |   | 458 |   | 59.9 | % | 30.2 | % | 90.1 | % |
| Other (includes run-off) business    |   | (512                                       | )      | 1,400 |   | 18 |   | (1,930 | ) | NM |   | NM |   | NM |   |
| Total                                |   | $                                          | 46,608 |   | $ | 30,870 |   | $ | 13,949 |   | $ | 1,789 |   | 66.2 | % | 30.0 | % | 96.2 | % |

 

----

NM = Not meaningful

 

34

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

 
|                                 |   | **Three  Months Ended June 30, 2004** |    |
|--------------------------------------|--------|--------------------------------------------|---------|
|                                 |   | **($ in thousands)**                       |    |
|                                 |   | **Net  Earned  Premium**                   |    | **Losses  and LAE  Incurred** |   | **Underwriting  Expenses** |   | **Underwriting  Gain(Loss)** |   | **Loss  Ratio** |   | **Expense  Ratio** |   | **Combined  Ratio** |   |
|                                 |   |                                       |    |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |   | $                                          | 41,262  |   | $ | 24,469 |   | $ | 11,258 |   | $ | 5,535 |   | 59.3 | % | 27.3 | % | 86.6 | % |
| Specialty                            |   | 42,904                                     |    | 28,802 |   | 12,845 |   | 1,257 |   | 67.1 | % | 30.0 | % | 97.1 | % |
| Professional Liability               |   | 8,507                                      |    | 5,131 |   | 1,744 |   | 1,632 |   | 60.3 | % | 20.5 | % | 80.8 | % |
| Assumed from Lloyd’s Operations |   | 12,283                                     |    | 6,945 |   | 3,722 |   | 1,616 |   | 56.5 | % | 30.3 | % | 86.8 | % |
| Other (includes run-off) business    |   | 8                                          |    | (79 | ) | 5 |   | 82 |   | NM |   | NM |   | NM |   |
| Total                                |   | $                                          | 104,964 |   | $ | 65,268 |   | $ | 29,574 |   | $ | 10,122 |   | 62.2 | % | 28.2 | % | 90.4 | % |

 
|                                 |   | **Three  Months Ended June 30, 2003** |   |
|--------------------------------------|--------|--------------------------------------------|--------|
|                                 |   | **($ in thousands)**                       |   |
|                                 |   | **Net  Earned  Premium**                   |   | **Losses  and LAE  Incurred** |   | **Underwriting  Expenses** |   | **Underwriting  Gain(Loss)** |   | **Loss  Ratio** |   | **Expense  Ratio** |   | **Combined  Ratio** |   |
|                                 |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Marine                               |   | $                                          | 43,250 |   | $ | 25,252 |   | $ | 12,781 |   | $ | 5,217 |   | 58.4 | % | 29.5 | % | 87.9 | % |
| Specialty                            |   | 42,411                                     |   | 29,305 |   | 12,927 |   | 179 |   | 69.1 | % | 30.5 | % | 99.6 | % |
| Professional Liability               |   | 3,505                                      |   | 2,279 |   | 1,074 |   | 152 |   | 65.1 | % | 30.6 | % | 95.7 | % |
| Assumed from Lloyd’s Operations |   | 8,180                                      |   | 4,860 |   | 2,448 |   | 872 |   | 59.4 | % | 29.9 | % | 89.3 | % |
| Other (includes run-off) business    |   | (338                                       | )      | 3,174 |   | 14 |   | (3,526 | ) | NM |   | NM |   | NM |   |
| Total                                |   | $                                          | 97,008 |   | $ | 64,870 |   | $ | 29,244 |   | $ | 2,894 |   | 66.9 | % | 30.1 | % | 97.0 | % |

 

The Insurance Companiesexperienced net earned premium growth of 11.1% and 8.2% when comparing thesecond quarter and first six months of 2004 to the second quarter and first sixmonths of 2003, respectively.  Approximately9.4% and 9.9% of the net earned premium recorded in the second quarters of 2004and 2003, respectively, and approximately 11.7% and 8.4% of the net earnedpremium recorded in the first six months of 2004 and 2003, respectively, is aresult of the Insurance Companies participating on reinsurance treatiessupporting the Lloyd’s operations’ marine and energy business.

 

The 2004 and 2003 secondquarter and first six months underwriting results generally reflect thefavorable industry market conditions over the last three years coupled with thefavorable loss trends in the aforementioned quarterly periods.  The 2003 expense ratio for professionalliability business reflects the start-up nature of this operation at that time.   The second quarter and first six months of 2003 incurred lossesincluded $1.4 million and $3.2 million, respectively, of incurred loss activityon run-off business principally related to the assumed reinsurance businesswhich added 3.0 and 3.3 loss ratio points to the Insurance Companies 2003second quarter and first six months combined ratios, respectively.

 

The pre-tax yield on theInsurance Companies’ investment portfolio approximated 4.0% and 4.6% atJune 30, 2004 and 2003, respectively. The declining portfolio yields reflect the overall declines in interestrates 

 

35

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up until the first quarterof 2004.  Net investment incomeincreased in the first six months of 2004 compared to the same periods in 2003due to strong cash flows and $95 million of statutory surplus contributions inthe 2003 fourth quarter.

 

***Lloyd’s Operations***

 

The Lloyd’s operationsconsist of NUAL, which manages Lloyd’s Syndicate 1221, Millennium UnderwritingLtd. and Navigators Corporate Underwriters Ltd. Both Millennium UnderwritingLtd. and Navigators Corporate Underwriters Ltd. are Lloyd’s corporate memberswith limited liability and provide capacity to Lloyd’s Syndicate 1221. NUALowns Pennine Underwriting Ltd., an underwriting managing agency with offices inManchester, Leeds and Basingstoke, England, which underwrites cargo andengineering business for Lloyd’s Syndicate 1221.  The Lloyd’s operations and Navigators Management (UK) Limited, aNavigators Agency, which produces business for the United Kingdom Branch of NavigatorsInsurance Company are subsidiaries of Navigators Holdings (UK) Limited locatedin the United Kingdom.

 

Lloyd’sSyndicate 1221 has stamp capacity of £150 million ($273.8 million) in 2004compared to £125 million ($203.5 million) in 2003.  Stamp capacity is a measure of the amount of premium a Lloyd’ssyndicate is authorized to write as determined by the Council of Lloyd’s.Syndicate 1221’s stamp capacity is expressed net of commission (as is standardat Lloyd’s) of approximately 21%. The Syndicate 1221 premium recorded in theCompany’s financial statements is gross of commission.  The Lloyd’s marine business had been subjectto intense price competition beginning in the mid-1990’s. The pricingcompetition showed some signs of stabilizing in 2000 and prices increased from2001 through 2003 and again at a more modest pace in the 2004 first quarter.Lloyd’s presents its results on an underwriting year basis, generally closingeach underwriting year after three years. We make estimates for each underwritingyear and timely accrue the expected results. Our Lloyd’s operations included inthe consolidated financial statements represent our participation in Syndicate1221.

 

Lloyd’ssyndicates report the amounts of premiums, claims, and expenses recorded in anunderwriting account for a particular year to the companies or individuals thatparticipate in the syndicates. The syndicates generally keep accounts open forthree years. Traditionally, three years have been necessary to reportsubstantially all premiums associated with an underwriting year and to reportmost related claims, although claims may remain unsettled after theunderwriting year is closed. A Lloyd’s syndicate typically closes anunderwriting year by reinsuring outstanding claims on that underwriting yearwith the participants for the next underwriting year. The ceding participantspay the assuming participants an amount based on the unearned premiums andoutstanding claims in the underwriting year at the date of the assumption. Ourparticipation in Lloyd’s Syndicate 1221 is represented by and recorded as ourproportionate share of the underlying assets and liabilities and results ofoperations of the syndicate since, (a) we hold an undivided interest in eachasset, (b) we are proportionately liable for each liability and (c) Syndicate1221 is not a separate legal entity. At Lloyd’s, the amount to close anunderwriting year into the next year is referred to as the reinsurance toclose. The reinsurance to close amounts represent the transfer of the assetsand liabilities from the participants of a closing underwriting year to theparticipants of the next underwriting year. To the extent our participation inthe syndicate changes, the reinsurance to close amounts vary accordingly. Thereinsurance to close transactions are recorded in the fourth quarter asadditional written and earned premium, losses incurred, loss reserves andreceivables, all in the same amount. There are no gains or losses recorded onthe transactions.

 

Weprovide letters of credit to Lloyd’s to support our participation in Syndicate1221’s capacity. If we increase our participation, or if Lloyd’s changes thecapital requirements, we may be required to supply additional letters of creditor other collateral acceptable to Lloyd’s, or reduce the capacity of Syndicate1221. The letters of credit are provided through the credit facility which wemaintain with a consortium of banks. The credit facility agreement requiresthat the banks vote by November 19th of each year whether or not to renewthe letter of credit facility. If the banks decide not to renew the letter ofcredit facility, we will need to find other sources to provide the letters ofcredit or other collateral in order to continue to participate in Syndicate1221. The renewal 

 

36

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amendmentexecuted in November 2003 renewed the letter of credit facility for a twoyear period expiring in November 2005.

 

Followingare the results of the Lloyd’s operations for the three and six months endedJune 30, 2004 and 2003:

 
|                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                |   | **($ in thousands)**                   |   |
| Revenues:                           |   |                                   |   |                                 |   |   |   |   |   |
| Net earned premium                  |   | $                                      | 23,532 |                                 | $      | 18,656 |   | $ | 44,525 |   | $ | 34,570 |   |
| Commission income                   |   | 501                                    |   | 216                                  |   | 563 |   | 344 |   |
| Net investment income               |   | 791                                    |   | 444                                  |   | 1,195 |   | 991 |   |
| Net realized capital gains (losses) |   | (281                                   | )      | 362                                  |   | (64 | ) | 461 |   |
| Other income                        |   | 5                                      |   | 199                                  |   | 9 |   | 214 |   |
| Total revenues                      |   | 24,548                                 |   | 19,877                               |   | 46,228 |   | 36,580 |   |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Operating expenses:                 |   |                                   |   |                                 |   |   |   |   |   |
| Net losses and LAE                  |   | 12,834                                 |   | 12,421                               |   | 23,876 |   | 22,461 |   |
| Commission expense                  |   | 4,093                                  |   | 3,301                                |   | 7,843 |   | 6,104 |   |
| Other operating expenses            |   | 3,193                                  |   | 1,892                                |   | 6,229 |   | 3,846 |   |
| Interest expense                    |   | —                                 |   | —                               |   | — |   | — |   |
| Total operating expenses            |   | 20,120                                 |   | 17,614                               |   | 37,948 |   | 32,411 |   |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Income before income tax expense    |   | 4,428                                  |   | 2,263                                |   | 8,280 |   | 4,169 |   |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Income tax expense                  |   | 1,550                                  |   | —                               |   | 2,898 |   | — |   |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Net income                          |   | $                                      | 2,878  |                                 | $      | 2,263 |   | $ | 5,382 |   | $ | 4,169 |   |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Loss and LAE ratio                  |   | 54.5                                   | %      | 66.6                                 | %      | 53.6 | % | 65.0 | % |
| Commission expense ratio            |   | 17.4                                   | %      | 17.7                                 | %      | 17.6 | % | 17.7 | % |
| Other operating expense ratio       |   | 13.6                                   | %      | 10.1                                 | %      | 14.0 | % | 11.1 | % |
| Combined ratio                      |   | 85.5                                   | %      | 94.4                                 | %      | 85.2 | % | 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.  Net earned premium revenues were reduced by$4,878,000 million and $4,606,000 million in the second quarter of 2004 and2003, respectively, and by $12,283,000 million and $8,180,000 million in thefirst six months of 2004 and 2003, respectively, for business ceded to theInsurance Companies.

 

The2004 and 2003 second quarter and six 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 second quarter andfirst six months of 2004 was favorably impacted by $1.3 million or 1.9 lossratio points and $4.0 million or 2.7 loss ratio points, respectively, forredundancies in prior years Lloyd’s operations’ loss reserves.

 

37

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Thepre-tax yield on funds in the Lloyd’s operations’ investment portfolioapproximated 1.7%, and 2.4% at June 30, 2004 and 2003, respectively, whichare reflective of the declining interest rate environment up until the firstquarter of 2004.  Generally, fundsinvested at Lloyd’s have been invested with an average duration ofapproximately 1.3 years in order to meet liquidity needs.

 

Theprovision for income tax expense for the second quarter and first six months of2003 reflects the reversal of $854,000 and $1,484,000, respectively, of apreviously established deferred tax asset valuation allowance.  The valuation allowance was reversed upuntil the 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 ofthe Navigators Agencies for the three and six months ended June 30, 2004and 2003:

 
|                                               |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                               |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                               |   | **($ in thousands)**                   |   |
| Revenues:                                          |   |                                   |   |                                 |   |   |   |   |   |
| Commission income                                  |   | $                                      | 8,155  |                                 | $      | 8,287 |   | $ | 16,087 |   | $ | 15,723 |   |
| Net investment income                              |   | —                                 |   | 14                                   |   | 3 |   | 22 |   |
| Other income                                       |   | 187                                    |   | 276                                  |   | 372 |   | 538 |   |
| Total revenues                                     |   | 8,342                                  |   | 8,577                                |   | 16,462 |   | 16,283 |   |
|                                               |   |                                   |   |                                 |   |   |   |   |   |
| Operating expenses:                                |   |                                   |   |                                 |   |   |   |   |   |
| Other operating expenses                           |   | 9,093                                  |   | 7,562                                |   | 17,698 |   | 15,203 |   |
| Total operating expenses                           |   | 9,093                                  |   | 7,562                                |   | 17,698 |   | 15,203 |   |
|                                               |   |                                   |   |                                 |   |   |   |   |   |
| Income (loss) before income tax expense  (benefit) |   | (751                                   | )      | 1,015                                |   | (1,236 | ) | 1,080 |   |
|                                               |   |                                   |   |                                 |   |   |   |   |   |
| Income tax expense (benefit)                       |   | (252                                   | )      | 226                                  |   | (392 | ) | 353 |   |
|                                               |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss)                                  |   | $                                      | (499   | )                                    | $      | 789 |   | $ | (844 | ) | $ | 727 |   |

 

Commission income generallyconsists of intersegment 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-Balance Sheet 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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**Tabular Disclosure of ContractualObligations**

 

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

 

**Investments**

 

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 and controlof their respective boards of directors and our finance committee, and arereviewed on a quarterly basis. The investments are managed by outsideprofessional fixed-income and equity portfolio managers. Current investmentobjectives are to maximize annual after-tax income while preserving andenhancing capital and statutory surplus. The insurance company subsidiariesseek to attain these objectives by investing in municipal bonds, U.S.Government obligations, corporate bonds, mortgage-backed and asset-backedsecurities and common stocks. Our insurance company subsidiaries’ investmentguidelines require that at least 90% of the fixed-income portfolio be rated“A-” or better by a nationally recognized rating organization. Up to 25% of thetotal portfolio may be invested in equity securities that are actively tradedon major U.S. stock exchanges. Our insurance company subsidiaries’ investmentguidelines prohibit investments in derivatives other than as a hedge againstforeign currency exposures or the writing of covered call options on the equityportfolio.

 

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. Current investment objectives are tomaximize pre-tax income while preserving and enhancing capital. The investmentmanagers for Syndicate 1221 seek to attain these objectives by investing in governmentobligations, corporate bonds and mortgage-backed and asset-backed securities.

 

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.

 

40

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The following tables showour cash and investments as of June 30, 2004 and December 31, 2003:

 
| **June 30, 2004**                             |   | **Fair  Value**      |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  (Losses)** |   | **Cost or  Amortized  Cost** |   |
|----------------------------------------------------|--------|----------------------|---------|------------------------------|--------|---------------------------------|--------|------------------------------|--------|
|                                               |   | **($ in thousands)** |    |
| Fixed maturities:                                  |   |                 |    |                         |   |                            |   |                         |   |
|                                               |   |                 |    |                         |   |                            |   |                         |   |
| U.S. Government Treasury Bonds and GNMAs           |   | $                    | 236,013 |                         | $      | 2,382                           |   | $                            | (3,331 | ) | $ | 236,962 |   |
| States, municipalities and political  Subdivisions |   | 119,925              |    | 1,402                        |   | (1,413                          | )      | 119,936                      |   |
| Mortgage and asset-backed (excluding GNMAs)        |   | 155,364              |    | 986                          |   | (1,996                          | )      | 156,374                      |   |
| Corporate bonds                                    |   | 135,677              |    | 2,846                        |   | (1,545                          | )      | 134,376                      |   |
|                                               |   |                 |    |                         |   |                            |   |                         |   |
| Total fixed maturities                             |   | 646,979              |    | 7,616                        |   | (8,285                          | )      | 647,648                      |   |
|                                               |   |                 |    |                         |   |                            |   |                         |   |
| Equity securities - common stocks                  |   | 19,626               |    | 1,509                        |   | (154                            | )      | 18,271                       |   |
|                                               |   |                 |    |                         |   |                            |   |                         |   |
| Cash and short-term investments                    |   | 104,749              |    | —                       |   | —                          |   | 104,749                      |   |
|                                               |   |                 |    |                         |   |                            |   |                         |   |
| Total                                              |   | $                    | 771,354 |                         | $      | 9,125                           |   | $                            | (8,439 | ) | $ | 770,668 |   |

 
| **December 31, 2003**                         |   | **Fair  Value**      |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  (Losses)** |   | **Cost or  Amortized  Cost** |   |
|----------------------------------------------------|--------|----------------------|---------|------------------------------|--------|---------------------------------|--------|------------------------------|--------|
|                                               |   | **($ in thousands)** |    |
| Fixed maturities:                                  |   |                 |    |                         |   |                            |   |                         |   |
|                                               |   |                 |    |                         |   |                            |   |                         |   |
| U.S. Government Treasury Bonds and GNMAs           |   | $                    | 221,919 |                         | $      | 4,107                           |   | $                            | (1,385 | ) | $ | 219,197 |   |
| States, municipalities and political  Subdivisions |   | 88,093               |    | 2,599                        |   | (116                            | )      | 85,610                       |   |
| Mortgage and asset-backed (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 June 30, 2004and December 31, 2003, all fixed maturity and equity securities held by uswere classified 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 and abilityto retain the investment for a period of time sufficient to allow for ananticipated recovery in value, specific credit issues related to the issuer andcurrent 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 six months ended June 30, 2004 and 2003.

 

Thefollowing table summarizes all securities in an unrealized loss position atJune 30, 2004 and December 31, 2003 showing the aggregate fair valueand gross unrealized loss by the length of time those securities havecontinuously been in an unrealized loss position:

 

42

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|                                               |   | **June 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           |   |                    |    |                        |   |   |   |   |   |
| 0-6 Months                                         |   | $                       | 156,981 |                        | $      | 1,665 |   | $ | 51,249 |   | $ | 521 |   |
| 7-12 Months                                        |   | 12,153                  |    | 517                         |   | 15,059 |   | 864 |   |
| > 12 Months                                     |   | 13,158                  |    | 1,149                       |   | — |   | — |   |
| Subtotal                                           |   | 182,292                 |    | 3,331                       |   | 66,308 |   | 1,385 |   |
|                                               |   |                    |    |                        |   |   |   |   |   |
| States, municipalities and political  subdivisions |   |                    |    |                        |   |   |   |   |   |
| 0-6 Months                                         |   | 67,104                  |    | 1,349                       |   | 6,340 |   | 58 |   |
| 7-12 Months                                        |   | 179                     |    | 16                          |   | 1,508 |   | 38 |   |
| > 12 Months                                     |   | 1,384                   |    | 48                          |   | 648 |   | 20 |   |
| Subtotal                                           |   | 68,667                  |    | 1,413                       |   | 8,496 |   | 116 |   |
|                                               |   |                    |    |                        |   |   |   |   |   |
| Mortgage- and asset-backed (excluding  GNMAs)      |   |                    |    |                        |   |   |   |   |   |
| 0-6 Months                                         |   | 110,731                 |    | 1,799                       |   | 45,381 |   | 341 |   |
| 7-12 Months                                        |   | 2,935                   |    | 155                         |   | 1,135 |   | 26 |   |
| > 12 Months                                     |   | 1,113                   |    | 42                          |   | 138 |   | 6 |   |
| Subtotal                                           |   | 114,779                 |    | 1,996                       |   | 46,654 |   | 373 |   |
|                                               |   |                    |    |                        |   |   |   |   |   |
| Corporate bonds                                    |   |                    |    |                        |   |   |   |   |   |
| 0-6 Months                                         |   | 61,690                  |    | 1,216                       |   | 25,049 |   | 123 |   |
| 7-12 Months                                        |   | 896                     |    | 83                          |   | 7,124 |   | 191 |   |
| > 12 Months                                     |   | 4,685                   |    | 246                         |   | — |   | — |   |
| Subtotal                                           |   | 67,271                  |    | 1,545                       |   | 32,173 |   | 314 |   |
|                                               |   |                    |    |                        |   |   |   |   |   |
| Total Fixed Maturities                             |   | $                       | 433,009 |                        | $      | 8,285 |   | $ | 153,631 |   | $ | 2,188 |   |
|                                               |   |                    |    |                        |   |   |   |   |   |
| Equity securities - common stocks                  |   |                    |    |                        |   |   |   |   |   |
| 0-6 Months                                         |   | $                       | 2,973   |                        | $      | 55 |   | $ | — |   | $ | — |   |
| 7-12 Months                                        |   | 437                     |    | 22                          |   | — |   | — |   |
| > 12 Months                                     |   | 1,554                   |    | 77                          |   | 1,892 |   | 85 |   |
|                                               |   |                    |    |                        |   |   |   |   |   |
| Total Equity Securities                            |   | $                       | 4,964   |                        | $      | 154 |   | $ | 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 theCompany’s portfolio with gross unrealized losses at June 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                             |   | $                     | 7,813  |           | 94     | % | $ | 413,043 |   | 95 | % |
| 2                |   | BBB                             |   | Baa                                  |   | 472                   |   | 6              | %      | 19,966 |   | 5 | % |
| 3                |   | BB                              |   | Ba                                   |   |                  |   |           |   |   |   |   |   |
| 4                |   | B                               |   | B                                    |   |                  |   |           |   |   |   |   |   |
| 5                |   | CCC or lower                    |   | Caa or lower                         |   |                  |   |           |   |   |   |   |   |
| 6                |   | N/A                             |   | N/A                                  |   |                  |   |           |   |   |   |   |   |
|             |   |                            |   | Total                                |   | $                     | 8,285  |           | 100    | % | $ | 433,009 |   | 100 | % |

 

AtJune 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.

 

The scheduled maturity dates for fixed maturity securities in anunrealized loss position at June 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                |   | $                    | 561    |                  | 6      | % | $ | 113,754 |   | 26 | % |
| Due after one year through five years  |   | 1,374                |   | 17                    | %      | 73,162 |   | 17 | % |
| Due after five years through ten years |   | 1,543                |   | 19                    | %      | 58,545 |   | 14 | % |
| Due after ten years                    |   | 2,811                |   | 34                    | %      | 72,769 |   | 17 | % |
| Mortgage- and asset-backed securities  |   | 1,996                |   | 24                    | %      | 114,779 |   | 26 | % |
|                                   |   |                 |   |                  |   |   |   |   |   |
| Total fixed income securities          |   | $                    | 8,285  |                  | 100    | % | $ | 433,009 |   | 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 5.7 years.

 

44

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Ourrealized capital gains and losses were as follows:

 
|                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                |   | **($ in thousands)**                   |   |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Fixed maturities:                   |   |                                   |   |                                 |   |   |   |   |   |
| Gains                               |   | $                                      | 1,225  |                                 | $      | 824 |   | $ | 1,664 |   | $ | 1,313 |   |
| (Losses)                            |   | (1,698                                 | )      | (154                                 | )      | (1,715 | ) | (175 | ) |
|                                |   | (473                                   | )      | 670                                  |   | (51 | ) | 1,138 |   |
| Equity securities:                  |   |                                   |   |                                 |   |   |   |   |   |
| Gains                               |   | 466                                    |   | 1                                    |   | 466 |   | 3 |   |
| (Losses)                            |   | (98                                    | )      | (2                                   | )      | (98 | ) | (254 | ) |
|                                |   | 368                                    |   | (1                                   | )      | 368 |   | (251 | ) |
|                                |   |                                   |   |                                 |   |   |   |   |   |
| Net realized capital gains (losses) |   | $                                      | (105   | )                                    | $      | 669 |   | $ | 317 |   | $ | 887 |   |

 

The following table details any relatively large realized loss fromsales and impairments during the first six months of 2004 and 2003 and therelated circumstances giving rise to the loss:

 

***($ in thousands)***
| **Description**                      |   | **Date of  Sale** |   | **Proceeds  from Sale** |   | **Loss on  Sale** |   | **Impairment** |   | **Holdings  at  June 30, 2004** |   | **Net  Unrealized  Loss** |   | **# of  Months  Unrealized Loss  Exceeded 20%  of Cost or  Amortized Cost** |   |
|--------------------------------------|--------|-------------------|--------|-------------------------|--------|-------------------|--------|----------------|--------|--------------------------------------|--------|---------------------------|--------|-----------------------------------------------------------------------------|--------|
|                                 |   |              |   |                    |   |              |   |           |   |                                 |   |                      |   |                                                                        |   |
| Six months ended June 30, 2004: |   |              |   |                    |   |              |   |           |   |                                 |   |                      |   |                                                                        |   |
|                                 |   |              |   |                    |   |              |   |           |   |                                 |   |                      |   |                                                                        |   |
| (1)                                  |   | 5/7/04            |   | $                       | 12,227 |              | $      | (192           | )      | —                               |   | —                    |   | —                                                                      |   | — |   |
|                                 |   |              |   |                    |   |              |   |           |   |                                 |   |                      |   |                                                                        |   |
| Six months ended June 30, 2003: |   |              |   |                    |   |              |   |           |   |                                 |   |                      |   |                                                                        |   |
|                                 |   |              |   |                    |   |              |   |           |   |                                 |   |                      |   |                                                                        |   |
| (2)                                  |   | 2/13/03           |   | $                       | 425    |              | $      | (252           | )      | —                               |   | —                    |   | —                                                                      |   | 6 |   |

 

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(1)          USTreasury Note sold as a result of anticipated interestrate increases.

 

(2)          Issuer was a major utility company which had a deteriorating balancesheet, underperforming overseas operations and a reduction in its dividend.

 

**Reinsurance Recoverables**

 

AtJune 30, 2004 the Company had reinsurance recoverables of $21.5 million,consisting of reinsurance recoverables for ceded losses and loss adjustmentexpenses of $15.5 million and ceded unearned premium of $6.0 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 June 30, 2004recorded by Navigators Insurance Company and the Lloyd’s operations were $1.2million and $20.3 million, respectively.

 

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InJuly 2004, Converium publicly announced that their 2004 second quarterfinancial results were impacted by reserve strengthening and certain intangiblewrite-offs and that the company would explore all options for maintainingstrong capitalization.  Both A. M. Bestand S&P immediately announced ratings downgrades of Converium and itsoperating subsidiaries from A to A- with negative outlooks.

 

TheCompany is monitoring the financial condition and ongoing activities ofConverium to determine if any actions, including the need to record anallowance for uncollectible reinsurance, are appropriate.

 

**Liquidityand Capital Resources**

 

Cashflow provided by operations was $93.2 million and $65.6 million for the sixmonths ended June 30, 2004 and 2003, respectively. The positive operatingcash flow in the first six months of 2004 and 2003 was primarily due to theincreases in net written premium. Operating cash flow was used primarily to acquire additional investmentassets.

 

Investedassets and cash increased to $771.4 million at June 30, 2004 from $693.6million at December 31, 2003. The increase was primarily due to thepositive cash flow and the $110.8 million of net proceeds received from thecommon stock offering in October 2003. Net investment income was $6.6 million and $4.6 million for the threemonths ended June 30, 2004 and 2003, respectively, and $12.5 million and$9.2 million for the six months ended June 30, 2004 and 2003, respectively

 

Theyield of the portfolio, excluding net realized capital gains, was 3.5% atJune 30, 2004 compared to 4.1% at June 30, 2003 reflecting theprevailing interest rates. As of June 30, 2004 and December 31, 2003,all fixed maturity securities and equity securities held by us were classifiedas available-for-sale.

 

AtJune 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. AtJune 30, 2004, our portfolio had an average maturity of 5.4 years andduration of 4.0 years. Management continually monitors the composition and cashflow of the investment portfolio in order to maintain the appropriate levels ofliquidity to 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 ofcredit facility which was fully utilized prior to the October 2003 commonstock offering.  As required by thecredit facility agreement, the line of credit was fully paid from a portion ofthe proceeds from the common stock offering thereby eliminating the line ofcredit portion of the credit facility. The letter of credit facility is utilized primarily by NavigatorsCorporate Underwriters Ltd. and Millennium Underwriting Ltd. for ourparticipation in Lloyd’s Syndicate 1221. The credit facility agreement requiresthat the banks vote by November 19th of each year whether or not to renewthe letter of credit portion of the facility. If the banks decide not to renewthe letter of credit portion of the facility, we will need to find othersources to provide the letters of credit or other collateral in order tocontinue our participation in Syndicate 1221. The renewal amendment executed in November 2003 renewed the letterof credit facility for a two-year period.  At June 30, 2004, letters of credit with an aggregate face amountof $78.7 million were issued under the letter of credit 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, statutorysurplus and other financial ratios. At June 30, 2004, we were incompliance with all covenants.

 

46

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AtJune 30, 2004, our consolidated stockholders’ equity was $302.4 million or$24.00 per share compared to $290.0 million or $23.14 per share atDecember 31, 2003. The increase was primarily due to net income of $18.0million partially offset by the other comprehensive loss of $7.2 million forthe six months ended June 30, 2004. The other comprehensive loss in 2004 resulted from unrealized losses inthe Company’s investment portfolio due to a rising interest rate environmentduring the second quarter of 2004.

 

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 Navigators InsuranceCompany. 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 sixmonths 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.

 

##### **Item3.**           Quantitative and QualitativeDisclosures About 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 andProcedures

 

(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-14(c) and 15d-14(c) under of the Securities Exchange Actof 1934, as amended (the “Exchange Act”) as of the end of the period covered bythis annual report. Based on such evaluation, such officers have concluded thatas of the end of such period the Company’s disclosure controls and proceduresare effective in identifying, on a timely basis, material information requiredto be disclosed in our reports filed or submitted under the Exchange Act.

 

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

 

**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, NavigatorsInsurance Company drew 

 

47

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downthe letters of credit, in good faith and consistent with their terms. Theliquidator of the reinsurer has commenced suit in Australia, seeking to voidthe draw downs. If the liquidator were to prevail in its action to void theletters of credit, our maximum exposure would be approximately $4.0 million. Wefiled motions seeking a prompt dismissal of the liquidator’s claims inAustralian court in June 2003, which motions were denied. We have appealedthose denials and are vigorously defending our position along with continuingsettlement discussions. The appellate court ruled that the case needs to befully tried before an appeal can be pursued. Although we believe that we have strong defenses against these claimsand a reasonable possibility of defeating the liquidator’s claim and that theliquidator’s assertions run counter to prevailing Australian and United Stateslaw, there can be no assurance as to the outcome of this litigation.

 

**Item2.****                                   Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities**

 

None.

 

**Item3.****                                   DefaultsUpon Senior Securities**

 

None.

 

**Item4.****                                   Submissionsof Matters to a Vote of Security Holders**

 

OnMay 27, 2004, the Company’s stockholders voted for the following matters at theannual stockholders’ meeting:

 

a)              The election of eight (8) directors to serveuntil the 2005 Annual Meeting of Stockholders or until their respectivesuccessors have been duly elected and qualified.  The results of the voting were as follows:

 
| **Name**               |   | **For**    |   | **Withheld** |   |
|------------------------|--------|------------|--------|--------------|--------|
|                   |   |       |   |         |   |
| Peter A. Cheney        |   | 11,593,342 |   | 318,384      |   |
| Terence N. Deeks       |   | 11,620,292 |   | 291,434      |   |
| Robert W. Eager, Jr.   |   | 11,593,342 |   | 318,384      |   |
| Stanley A. Galanski    |   | 11,619,692 |   | 292,034      |   |
| Leandro S. Galban, Jr. |   | 11,334,437 |   | 577,289      |   |
| John F. Kirby          |   | 11,665,077 |   | 246,649      |   |
| Marc M. Tract          |   | 8,722,498  |   | 3,189,228    |   |
| Robert F. Wright       |   | 11,565,642 |   | 346,084      |   |

 

b)             The ratificationof the appointment of KPMG LLP as the Company’s independent auditors which wasratified with 11,822,377 votes for, 68,249 votes against and 21,100 votesabstaining.

 

**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.

 

48

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**Item6.****                                   Exhibitsand Reports on Form 8-K**

 

(a)                        Exhibits:

 
| **Exhibit No.** |   | **Description  of Exhibit**                                                                                                                                                                                                                                                                                                                                               |   |   |
|-----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|            |   |                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| 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). |   |   |

 

----

* *Includedherein*.

 

(b)                       Reports on Form 8-K:

 

On May 6, 2004, the Company furnished a Form 8-K relating to its pressrelease announcing its first quarter 2004 earnings.

 

49

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SIGNATURE

 

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

 
|   | The Navigators Group, Inc.  |   |
|--------|-----------------------------|--------|
|   | (Registrant)                |
|   |                        |
| Date:  | August 5, 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**                                                                                                                                                                                                                                                                                                                                               |   |   |
|-----------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|            |   |                                                                                                                                                                                                                                                                                                                                                                      |   |   |
| 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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*  *Included herein.*

 

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