The following discussion should be read in conjunction with the consolidated financial statements and related notes beginning on page F-1. This discussion contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those anticipated in the forward looking statements as a result of various factors described in this report.

Consolidated Results of Operations

For the year ended December 31, 2008, Argo Group reported net income of $62.9 million, or $2.05 per fully diluted share. In May 2008, the Company completed the acquisition of Heritage. Included in the Company's consolidated results of operations for the year ended December 31, 2008, is seven months of activity specifically attributable to Heritage. Net income for the year ended December 31, 2007 was $143.8 million, or $5.58 per fully diluted share, including an extraordinary gain resulting from the Merger of PXRE and Argonaut Group of $66.3 million, or $2.57 per fully diluted share. Net income for the year ended December 31, 2006 was $106.0 million or $4.82 per fully diluted share. The following is a comparison of selected data from the Company's operations:

                                                          Years ended December 31,
(in millions)                                         2008          2007          2006

Gross written premiums                              $ 1,601.5     $ 1,180.9     $ 1,155.6

Earned premiums                                     $ 1,127.1     $   859.8     $   813.0
Net investment income                                   150.2         134.3         104.5
Fee income                                               13.6            -             -
Realized investment and other gains (losses), net       (35.1 )         5.9          21.2

Total revenue                                       $ 1,255.8     $ 1,000.0     $   938.7


Income before income taxes and extraordinary item   $    86.4     $   119.8     $   163.0
Provision for income taxes                               23.5          42.3          57.0

Income before extraordinary item                         62.9          77.5         106.0
Extraordinary item                                         -           66.3            -

Net income                                          $    62.9     $   143.8     $   106.0


Loss ratio                                               64.3 %        61.3 %        58.8 %
Expense ratio                                            36.2 %        38.1 %        35.1 %

Combined ratio                                          100.5 %        99.4 %        93.9 %

The increase in consolidated gross written premiums and earned premiums for the year ended December 31, 2008 as compared to the same periods in 2007 and 2006 was primarily attributable to the operations of Argo Re and Heritage, coupled with premium growth in the public entity products written in the Commercial Specialty segment. Earned premiums resulting from Heritage were $183.4 million from the date of acquisition through December 31, 2008. Earned premiums resulting from Argo Re were $52.4 million for the year ended December 31, 2008 compared to $1.0 million for the year ended December 31, 2007. Argo Re began operations during the third quarter of 2007. Earned premiums for the public entity products written in the Commercial Specialty segment increased $36.7 million from $77.0 million for the year ended December 31, 2007 to $113.7 million for the same period in 2008. The increase in earned premiums for the public entity products was primarily attributable to the expansion into the New England area as a result of an acquisition. During the year ended December 31, 2008, competition across virtually all products the Company offers continued to increase with respect to pricing. For year ended December 31, 2008, pricing continued to decline moderately. Earned premiums for the year ended December 31, 2008 were reduced by $3.5 million for net reinstatement premiums related to property catastrophe reinsurance contracts as a result of hurricane activity in 2008.

Consolidated net investment income increased for the year ended December 31, 2008 as compared to the same periods in 2007 and 2006 due to higher invested asset balances resulting from positive cash flows from operations and due to invested assets acquired in the Merger and Heritage transaction. Total invested assets at December 31, 2008 were $3,779.6 million; net of $215.8 million of invested assets attributable to Heritage's Trade Capital providers. Total invested assets as of December 31, 2007 were $3,582.8 million, including $750.3 million acquired as part of the Merger. Additionally, invested assets totaling $173.5 million were classified as "Assets held for sale" as of December 31, 2007. Total invested assets were $2,534.0 million as of December 31, 2006.

Consolidated fee income represents commissions and other fees earned by the Company for the non-risk bearing activities. Fee income is generated by the Commercial Specialty segment as a result of business placed with other insurance companies. In addition, the International Specialty segment generates fee income from managing third party capital for certain syndicates at Lloyds. Consolidated fee income was $13.6 million for the year ended December 31, 2008.

Consolidated gross realized gains were $22.1 million for the year ended December 31, 2008, as compared to $12.4 million and $23.0 million in 2007 and 2006, respectively. Included in gross realized gains for the year ended December 31, 2006 was $8.4 million from the sale of a strategic investment and a realized gain of $7.6 million from the sale of a real estate holding. Consolidated gross realized losses were $57.2 million, $6.5 million and $1.8 million for the years ended December 31, 2008, 2007 and 2006, respectively. Included in consolidated gross realized losses for the years ended December 31, 2008, 2007 and 2006 were write downs of approximately $51.3 million, $2.3 million and $1.2 million, respectively, from the recognition of other-than-temporary impairments on certain investment securities.

Consolidated losses and loss adjustment expenses were $724.9 million for the year ended December 31, 2008, compared to $526.9 million and $477.6 million for the same periods in 2007 and 2006, respectively. Included in loss and losses adjustment expenses for the year ended December 31, 2008 was $72.3 million in losses resulting from hurricane activity in the United States during the third quarter of 2008. Losses and loss adjustment expenses for 2008 also include $22.5 million in property losses resulting primarily from severe weather during the second quarter of 2008 and $18.9 million of losses in certain casualty lines of business resulting from higher than expected severity in the fourth quarter of 2008. Prior accident year net favorable loss reserve development recognized during 2008 was $61.2 million of which $31.8 million related to property lines of business. This favorable development included: (a) $14.3 million from the 2006 and 2007 accident years within the U.S. operations, (b) $12.5 million from the PXRE non-catastrophe lines and (c) $5.0 million from 2005 PXRE catastrophe reserves. Net favorable development across casualty lines of business totaled $29.4 million and resulted from: (a) $27.5 million of favorable development in general and other liability lines of business primarily related to accident years 2005 and prior, (b) $13.8 million of net favorable development within workers' compensation and commercial multi peril lines primarily related to accident years 2006 and prior, (c) adverse development of $6.8 million in commercial auto liability lines for the 2006 and 2007 accident years, and
(d) net adverse development of $5.2 million for asbestos and environmental reserves.

Consolidated losses and loss adjustment expenses for the year ended December 31, 2007 included $30.3 million of net favorable development. The favorable development was primarily concentrated in the Excess and Surplus Lines segment due to lower claim counts and severity for the 2004 through 2006 accident years and lower frequency and severity within the Commercial Specialty segment for the 2002 through 2006 accident years. Partially offsetting this favorable development was $22.2 million of reserve strengthening in the Run-off Lines segment, primarily due to the Company strengthening the reserves for the asbestos and environmental exposures by $26.0 million in the third quarter of 2007. Additionally, the Company recorded approximately $32.2 million in additional losses and loss adjustment expenses for the 2007 accident year due to higher than expected losses, primarily in the Excess and Surplus Lines and the Commercial Specialty segments.

The following table summarizes the above referenced reserve development as respects to prior year loss reserves by line of business for the year ended December 31, 2008:

                                                                      Percent of
                                    2007 Net       Net Reserve         2007 Net
       (in millions)                Reserves       Development         Reserves

       General liability           $     837.9   $         (30.0 )          -3.6%
       Workers compensation              494.6               0.7             0.1%
       Commercial multi-peril            164.4             (13.6 )          -8.3%
       Commercial auto liability         110.2              17.2            15.6%
       Special property                   30.8             (10.8 )         -35.1%
       Auto physical damage               18.1              (9.9 )         -54.7%
       Medical malpractice                 2.1              (0.4 )         -19.0%
       PXRE legacy                       198.6             (17.5 )          -8.8%
       Heritage                             -                3.5              n/a
       All other lines                     6.6              (0.4 )          -6.1%

       Total all lines             $   1,863.3   $         (61.2 )          -3.3%

The favorable development as related to total net reserves for loss and loss adjustment expenses as of December 31, 2007 represents 3.3%. The reserve movement depicted above in commercial auto liability and auto physical damage represents movement between those specific lines business for a product the Company provides effectively as one form of coverage. Aside from the favorable development in the auto physical damage line of business, resulting from the shift of reserves between commercial auto liability and auto physical damage, the special property line had the largest percentage change with a decrease of 35.1% as compared with carried reserves for the special property line of business as of December 31, 2007. Special property is a short-tailed line of business. As such most claims are reported and subsequently settled within a relatively short period of time from the date of loss. Therefore, the Company was able to attach a high level of credibility to the actual loss emergence patterns and consequently revise its estimate as to ultimate losses for prior accident years. The revised estimate for the PXRE Legacy net loss reserves totals $17.5 million and is similar to special property, in that the tail is short and ultimate loss estimates are revised based on loss emergence. The general liability line of business had the greatest magnitude of favorable prior accident year loss development with $30.0 million of favorable emergence subsequent to December 31, 2007, driven in large part from the restatement of Excess and Surplus Lines reserves for the 2004 and 2005 accident years. However, the $30.0 million of favorable development over twelve months represented only 3.6% of the Company's general liability reserve balance at the beginning of the year.

Consolidated losses and loss adjustment expenses for the year ended December 31, 2006 included $44.9 million of favorable development on prior accident years across all lines and segments. Partially offsetting this favorable development was higher than anticipated reserves for the 2006 accident year of $29.1 million due to higher than anticipated claims in the property, transportation and other liability occurrence lines.

In determining appropriate reserve levels as of December 31, 2008, the Company maintained the same general processes and disciplines that were used to set reserves at prior reporting dates. No changes in key assumptions were made to estimate the reserves since the last reporting date; however, the maturation of claims since the last analysis provided a basis to assign greater credibility to emerged loss development patterns. Consistent with prior reserve valuations, actuarial estimates were refined to assign alternate weights to the different loss forecasting methodologies in order to respond to any emerging trends in the paid and reported loss data. These modifications to the analysis varied depending on whether the line of business was short-tailed or long-tailed and also varied by accident year.

When determining reserve levels, the Company recognizes that there are several factors that present challenges and uncertainties to the estimation of loss reserves. Examples of these uncertainties include growth over the last several years in both the Excess and Surplus Lines and Commercial Specialty segments, and changes to the reinsurance structure. The Company's net retained losses vary by product and they have generally increased over time. To properly recognize these

uncertainties, both internal and independent actuarial reviews relied, to a large extent on the paid and incurred Bornhuetter-Ferguson methodologies, which generally produce higher projections of ultimate losses than the other methods. Compared with other actuarial methodologies, the paid and incurred Bornhuetter-Ferguson methods assigned the smallest weight to actual reported loss experience, with the greatest weighting assigned to an expected or planned loss ratio. The expected or planned loss ratio has typically been determined using various assumptions pertaining to prospective loss frequency and loss severity. In setting reserves at December 31, 2008, the Company continued to rely most heavily on the paid and incurred Bornhuetter-Ferguson methods; however certain additional weighting was assigned to other actuarial methods to recognize the most current trends emerging in paid and reported loss data.

For general liability business, the Company increased its premium volume significantly from 2002 through 2006. This growth occurred in both the Excess and Surplus Lines and Commercial Specialty segments. The premium increases derived from both organic growth and acquisitions. In setting loss reserves, internal and external actuaries assumed that the new business may not perform as well as renewal business and that prior year loss development patterns may not be representative of future loss emergence. The actuarial assumption that new business may not perform as well as renewal business is primarily predicated on the basis that the new insurance company offers a lower price or better terms and conditions than the incumbent carrier. Further, the incumbent carrier has the benefit of historical experience and loss characteristics of the insured. Thus, the actuarial methods utilizing the assumption that new business would generate a higher loss ratio were assigned more weight. The Company's loss reserve estimates gradually blend in the results from other methodologies over time. For general liability estimates, more credibility is assigned to the Company's own loss experience approximately 60 to 72 months after the beginning of an accident year. Over the course of time, the Company has recognized that the new business growth from 2002 through 2006 exhibited similar underwriting and profitability characteristics as the Company's renewal book. Further review and analysis of the data in the fourth quarter of 2008 suggested that favorable loss experience on the new business growth continued to emerge in the fourth quarter of 2008. Thus the Company reduced its ultimate loss estimates for general liability lines of business for the 2003, 2004, 2005 and 2006 accident years.

Another factor that was considered in setting loss reserves at December 31, 2008 was the impact of the Company's reinsurance protection. The Company's excess of loss reinsurance coverage has varied by product. For most general liability products, the net per occurrence retention increased from $250,000 to $500,000 on September 1, 2002 and then to $1,000,000 on October 1, 2006. When loss reserves were initially established, the Company expected a greater number of large claims in the $250,000 excess of $250,000 layer of coverage. In 2006 and again in 2007, after a review of reported large loss activity, the Company began to recognize that the increased retention in the $250,000 excess of $250,000 layer did not have as material an impact on net retained losses as had originally been contemplated. Furthermore, the decision to increase net retentions had a favorable effect on net loss ratios. In the fourth quarter of 2008, as part of the Company's internal actuarial review of reserves, the Company continued to observe lower than expected large loss activity in the $250,000 excess of $250,000 layer of coverage and further reduced its loss estimates for the 2003 through 2005 accident years.

For property business, the Company's loss reserve estimates also blend in the results from other actuarial methodologies over time. In contrast to general liability estimates, full credibility is assigned to the Company's loss experience approximately 24 to 36 months after the beginning of an accident year, where loss reporting and claims closing patterns settle more quickly. The Company's loss experience receives partial weighting in the estimates 12 to 24 months after the beginning of the accident year. As such, the Company recognized favorable loss experience for the 2005 and 2006 accident years in 2007. Likewise, during 2008, the Company recognized favorable loss experience deriving from the 2006 and 2007 accident years.

In determining appropriate reserve levels for the year ended December 31, 2008, the Company maintained the same general processes and disciplines that were used to set reserves at prior reporting dates. No changes in methodologies were made to estimate the reserves since the last reporting date; however at each reporting date the Company reassesses the actuarial estimate of the reserve for loss and loss adjustment expenses and records its best estimate. Consistent with prior reserve valuations as claims data becomes more mature for prior accident years, actuarial estimates were refined to weigh certain actuarial methods more heavily in order to respond to any emerging trends in the paid and reported loss data. These modifications to the analysis varied depending on whether the line of business was short-tailed or long-tailed and also varied by accident year. The Company takes into consideration several factors in establishing its best estimate of net reserves for losses and loss adjustment expenses. While prior accident years' net reserves for losses and loss adjustment expenses for some line of business have developed favorably during 2007 and 2008, this does not infer that more recent accident years' reserves also will develop favorably; pricing, reinsurance costs, the legal environment, general economic conditions and many other factors impact management's ultimate loss estimates. For accident years 2007 and 2008, pricing for our products was under intense competition and management's expectation is that profitability for certain lines of business decreased accordingly as loss costs have not decreased proportionately.

For the Run-off Lines segment, in determining appropriate reserve levels, the Company maintained the same general processes and disciplines that were used to set reserves at prior reporting dates. No changes in key assumptions were made to estimate the reserves since the last reporting date; however the maturation of claims for twelve additional months since the date of last report provided the actuaries with a basis to assign greater credibility to emerged loss development patterns.

Consolidated loss reserves were $2,996.6 million (including $183.3 million of reserves attributable to Heritage's Trade Capital providers), $2,425.5 million (which excludes $135.7 million of loss reserves which are classified as "Liabilities held for sale") and $2,029.2 million as of December 31, 2008, 2007 and 2006, respectively. Management has recorded its best estimate of loss reserves as of December 31, 2008 based on current known facts and circumstances. Due to the significant uncertainties inherent in the estimation of loss reserves, there can be no assurance that future loss development, favorable or unfavorable, will not occur.

Consolidated underwriting, acquisition and insurance expenses were $407.1 million, $328.1 million and $285.1 million for the years ended December 31, 2008, 2007 and 2006, respectively. Included in consolidated underwriting, acquisition and insurance expenses for the year ended December 31, 2008 was $63.0 million resulting from Heritage. Included in consolidated underwriting, acquisition and insurance expenses for the year ended December 31, 2007 was $10.2 million of additional compensation expense resulting from the acceleration of the vesting of certain share-based payment arrangements prior to the Merger. Additionally, included in consolidated underwriting, acquisition and insurance expenses was $18.8 million resulting from the operations of PXRE for the period from the closing date of the Merger through December 31, 2007.

Consolidated interest expense and other were $37.4 million, $25.2 million and $13.0 million for the years ended December 31, 2008, 2007 and 2006, respectively. Consolidated interest expense increased to $29.9 million for the year ended December 31, 2008 compared to $20.9 million and $13.0 million for the same periods in 2007 and 2006, respectively. The increase in interest expense for the year ended December 31, 2008 as compared to 2007 was due to the inclusion of a full year of interest on the junior subordinated debentures acquired in the Merger with PXRE, coupled with $1.1 million in interest expense related to Heritage indebtedness assumed in May 2008. Included in consolidated interest expense and other for the year ended December 31, 2008 was $6.4 million in expense related to the generation of fee income. Fee income is generated by the Commercial Specialty segment as a result of business placed with other insurance companies. The International Specialty segment generates fee income from managing certain syndicates at Lloyds. Also included in consolidated interest expense and other for the year ended December 31, 2008 was $0.6 million resulting from the net change in fair value on derivative reinsurance contracts, compared to $3.5 million for 2007. Foreign currency exchange losses on transactions that are settled in currencies other than U.S. Dollars were $0.5 million for the year ended December 31, 2008 compared to $0.7 million for the same period in 2007.

Consolidated provisions for income taxes were $23.5 million, $42.3 million and $57.0 million for the years ended December 31, 2008, 2007 and 2006, respectively. The consolidated income tax provision for the year ended December 31, 2008 represents the income tax expense associated with the Company's operations based on the tax laws of the jurisdictions in which they operate. Therefore, the consolidated provision for income taxes represents taxes on net income for the Company's United States and United Kingdom operations. Additionally, the Company's tax rate for 2008 was impacted by fluctuations in foreign exchange rates within the International Specialty segment.

Segment Results

The Company is primarily engaged in writing property and casualty insurance and reinsurance. Prior to the Merger, Argonaut Group classified its business into three ongoing reporting segments: Excess and Surplus Lines, Commercial Specialty (formerly known as Select Markets) and Run-off Lines. PXRE classified its business prior to the Merger into two reportable property and casualty segments:
Catastrophe & Risk Excess and Exited Lines.

Subsequent to the Merger, the Company evaluated its reporting segments and management determined that the Company would have three ongoing reporting segments: Excess and Surplus Lines and Commercial Specialty segments (which were previously included in Argonaut Group's ongoing reporting segments), and the Reinsurance segment (formerly known as International Specialty - see discussion below). Additionally, the Company has a Run-off Lines segment for products that it no longer writes. Amounts applicable to prior periods have been reclassified to conform to the presentation followed in 2008.

With the acquisition of Heritage in May 2008, management determined that the results of the operations of Heritage defined a new reporting segment. Management determined that "International Specialty" most accurately described the activities of this segment. The results of operations of Argo Re and other reinsurance programs constituted a new reporting segment, "Reinsurance". Management believes this segment structure better reflects the current operations and future business plan of the Company. Amounts applicable to current and prior periods for Argo Re and the international reinsurance programs have been reclassified to the Reinsurance segment.

In evaluating the operating performance of its segments, the Company focuses on core underwriting and investing results before consideration of realized gains or losses from the sales of investments. Management excludes realized investment gains and losses from segment results, as decisions regarding the sales of investments are made at the corporate level. Although this measure of profit
(loss) does not replace net income (loss) computed in accordance with GAAP as a measure of profitability, management utilizes this measure of profit (loss) to focus its reporting segments on generating operating income, which excludes realized gains and losses on sales of investments.

Excess and Surplus Lines. Excess and surplus lines insurance carriers focus on risks that the standard (admitted) market is unwilling or unable to underwrite due to the unique risk characteristics of the insureds or the lack of insurers offering such coverage, which may be caused by physical perils, the nature of the business or the insured's loss experience. The Company, through Colony, Argonaut Specialty and Argo Pro, its three platforms, is able to underwrite these risks with more flexible policy terms at unregulated premium rates to the extent the business is underwritten on an excess and surplus lines basis. Colony provides commercial liability, commercial property and products liability coverages to commercial enterprises, including restaurants, artisan contractors and manufacturers. Argonaut Specialty provides primary general liability, excess/umbrella coverage and property lines of business for risks the admitted market chooses not to underwrite. Argonaut Specialty's risks are typically larger than Colony's and it utilizes a smaller distribution platform. Argo Pro focus on professional lines coverages, including allied medical, errors and omissions and environmental. During 2008, the Excess and Surplus lines segment established an additional platform, Argo Pro, to expand its professional lines product offering. Additionally, during 2008, the Argo Pro platform was expanded through the acquisition of Insight Insurance. Insight Insurance is a specialty . . .