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NAVG > SEC Filings for NAVG > Form 10-K on 14-Feb-2014All Recent SEC Filings

Show all filings for NAVIGATORS GROUP INC



Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward-looking statements that involve risks and uncertainties. Please refer to "Note on Forward-Looking Statements" and "Risk Factors" for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K.


We are an international insurance company focusing on specialty products within the overall property and casualty insurance market. Our largest product line and most long-standing area of specialization is ocean marine insurance. We have also developed other specialty insurance lines such as commercial primary and excess liability as well as specialty niches in professional liability, and have expanded our specialty reinsurance business since launching Navigators Re in the fourth quarter of 2010.

Our revenue is primarily comprised of premiums and investment income. We derive our premiums primarily from business written by wholly-owned underwriting management companies which produce, manage and underwrite insurance and reinsurance for us. Our products are distributed through multiple channels, utilizing global, national and regional retail and wholesale insurance brokers.

We conduct operations through our Insurance Companies and our Lloyd's Operations segments. The Insurance Companies segment consists of Navigators Insurance Company, which includes a United Kingdom Branch (the "U.K. Branch"), and Navigators Specialty Insurance Company, which underwrites specialty and professional liability insurance on an excess and surplus lines basis. All of the insurance business written by Navigators Specialty Insurance Company is fully reinsured by Navigators Insurance Company pursuant to a 100% quota share reinsurance agreement. The insurance and reinsurance business written by our Insurance Companies is underwritten through our wholly-owned underwriting management Companies, Navigators Management Company, Inc. ("NMC") and Navigators Management (UK) Ltd. ("NMUK").

Our Lloyd's Operations segment includes Navigators Underwriting Agency Ltd. ("NUAL"), a Lloyd's of London ("Lloyd's") underwriting agency which manages Lloyd's Syndicate 1221 ("Syndicate 1221"). Our Lloyd's Operations primarily underwrite marine and related lines of business along with offshore energy, professional liability insurance and construction coverages for onshore energy business at Lloyd's through Syndicate 1221. We controlled 100% of Syndicate 1221's stamp capacity for the 2013, 2012 and 2011 underwriting years through our wholly-owned subsidiary, Navigators Corporate Underwriters Ltd. which is referred to as a corporate name in the Lloyd's market. We have also established underwriting agencies in Antwerp, Belgium, Stockholm, Sweden, and Copenhagen, Denmark, which underwrite risks pursuant to binding authorities with NUAL into Syndicate 1221. We have also established a presence in Brazil and China through contractual arrangements with local affiliates of Lloyd's.

While management takes into consideration a wide range of factors in planning our business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how we are managed. First, underwriting profit is consistently emphasized as a primary goal, above premium growth. Management's assessment of our trends and potential growth in underwriting profit is the dominant factor in its decisions with respect to whether or not to expand a business line, enter into a new niche, product or territory or, conversely, to contract capacity in any business line. In addition, management focuses on controlling the costs of our operations. Management believes that careful monitoring of the costs of existing operations and assessing the costs of potential growth opportunities are important to our profitability. Access to capital also has a significant impact on management's outlook for our operations. The Insurance Companies' operations and ability to grow their business and take advantage of market opportunities are constrained by regulatory capital requirements and rating agency assessments of capital adequacy. Similarly, the ability to grow our operations at Lloyd's is subject to capital and operating requirements of Lloyd's and the U.K. regulatory authorities.

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Management's decisions are also greatly influenced by access to specialized underwriting and claims expertise in our lines of business. We have chosen to operate in specialty niches with certain common characteristics which we believe provide us with the opportunity to use our technical underwriting expertise in order to realize underwriting profit. As a result, we have focused on underserved markets for businesses characterized by higher severity and lower frequency of loss where we believe our intellectual capital and financial strength bring meaningful value. In contrast, we have avoided niches that we believe have a high frequency of loss activity and/or are subject to a high level of regulatory requirements, such as workers compensation and personal automobile insurance, because we do not believe our technical underwriting expertise is of as much value in these types of businesses. Examples of niches that have the characteristics we look for include offshore energy which provides coverage for physical damage to, for example, high value offshore oil drilling rigs, and Directors and Officers ("D&O") insurance which covers litigation exposure of a corporation's directors and officers. These types of exposures require substantial technical expertise. We attempt to mitigate the financial impact of severe claims on our results by conservative and detailed underwriting, prudent use of reinsurance and a balanced portfolio of risks.

For additional information regarding our business, refer to "Business-Overview", included herein.


Our ability to underwrite business is dependent upon the financial strength of the Insurance Companies and Lloyd's. Financial strength ratings represent the opinions of the rating agencies on the financial strength of a company and its capacity to meet the obligations of insurance policies. Independent ratings are one of the important factors that establish our competitive position in the insurance markets. The rating agencies consider many factors in determining the financial strength rating of an insurance company, including the relative level of statutory surplus necessary to support the business operations of the company. These ratings are based upon factors relevant to policyholders, agents and intermediaries and are not directed toward the protection of investors. Such ratings are not recommendations to buy, sell or hold securities. We could be adversely impacted by a downgrade in the Insurance Companies' or Lloyd's financial strength ratings, including a possible reduction in demand for our products, higher borrowing costs and our ability to access the capital markets.

For the Insurance Companies, Navigators Insurance Company and Navigators Specialty Insurance Company utilize the financial strength ratings from A.M. Best and S&P for underwriting purposes. Navigators Insurance Company and Navigators Specialty Insurance Company are both rated "A" (Excellent - stable outlook) by A.M. Best and "A" (Strong-stable outlook) by S&P. Syndicate 1221 utilizes the ratings from A.M. Best and S&P for underwriting purposes which apply to all Lloyd's syndicates. Lloyd's is rated "A" (Excellent - stable outlook) by A.M. Best and A+ (Strong - stable outlook) by S&P.

Debt ratings apply to short-term and long-term debt as well as preferred stock. These ratings are assessments of the likelihood that we will make timely payments of the principal and interest for our senior debt. It is possible that, in the future, one or more of the rating agencies may reduce our existing debt ratings. If one or more of our debt ratings were downgraded, we could incur higher borrowing costs and our ability to access the capital markets could be impacted.

We utilize the senior debt ratings from S&P. Our senior debt is rated BBB (Adequate) by S&P.

Critical Accounting Estimates

We prepare our financial statements in accordance with GAAP, which requires the use of estimates and assumptions. The following accounting estimates are viewed by management to be critical because they require significant judgment on the part of management. Management has discussed and reviewed the development, selection, and disclosure of critical accounting estimates with the Company's Audit Committee. Financial results could be materially different if other methodologies were used or if management modified its assumptions.

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Our most critical accounting policies involve the reporting of the reserves for losses and LAE (including losses that have occurred but were not reported to us by the financial reporting date), reinsurance recoverables, written and unearned premium, the recoverability of deferred tax assets, the impairment of investment securities and accounting for Lloyd's results.

Reserves for Losses and Loss Adjustment Expenses

Reserves for losses and LAE represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known less the amount paid to date. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, judicial theories of liability and other third party factors which are often beyond our control. No assurance can be given that actual claims made and related payments will not be in excess of the amounts reserved. During the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates.

The numerous factors that contribute to the inherent uncertainty in the process of establishing loss reserves include: interpreting loss development activity, emerging economic and social trends, inflation, changes in the regulatory and judicial environment and changes in our operations, including changes in underwriting standards and claims handling procedures. The process of establishing loss reserves is complex and imprecise as it must take into account many variables that are subject to the outcome of future events. As a result, informed subjective judgments as to our ultimate exposure to losses are an integral component of our loss reserving process.

Our actuaries calculate indicated IBNR loss reserves for each line of business by underwriting year by major product groupings using standard actuarial methodologies which are projection or extrapolation techniques: the loss ratio method, the loss development method and the Bornheutter-Ferguson method. In general the loss ratio method is used to calculate the IBNR for only the most recent underwriting years or in the absence of any statistical data upon which to estimate ultimate losses while the Bornheutter-Ferguson method is used to calculate the IBNR for recent years where a statistical basis exists for that computation with the loss development method used for more mature underwriting years. When appropriate such methodologies are supplemented by the frequency/severity method, which are used to analyze and better comprehend loss development patterns and trends in the data when making selections and judgments. Each of these methodologies, which are described below, are generally applicable to both long tail and short tail lines of business depending on a variety of circumstances. In utilizing these methodologies to develop our IBNR loss reserves, a key objective of management in making their final selections is to deliberate with our actuaries to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them. This process requires the substantial use of informed judgment and is inherently uncertain as it can be influenced by numerous factors including:

Inflationary pressures (medical and economic) that affect the size of losses;

Judicial, regulatory, legislative, and legal decisions that affect insurers' liabilities;

Changes in the frequency and severity of losses;

Changes in the underlying loss exposures of our policies;

Changes in our claims handling procedures.

For non-statistical claim events, i.e., where historical patterns are not available for applicable, expert judgment by claims professionals with input from underwriting and management are used. Such instances relate to the IBNR loss reserve processes for our Hurricanes losses and our asbestos exposures.

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A brief summary of each actuarial method discussed above follows:

Loss ratio method

This method is based on the assumption that ultimate losses vary proportionately with premiums. Pursuant to the loss ratio method, IBNR loss reserves are calculated by multiplying the earned premium by an expected ultimate loss ratio to estimate the ultimate losses for each underwriting year, then subtracting the reported losses, consisting of paid losses and case loss reserves, to determine the IBNR loss reserve amount. The ultimate loss ratios applied are the Company's best estimates for each underwriting year and are generally determined after evaluating a number of factors which include: information derived by underwriters and actuaries in the initial pricing of the business, the ultimate loss ratios established in the prior accounting period and the related judgments applied, the ultimate loss ratios of previous underwriting years, premium rate changes, underwriting and coverage changes, changes in terms and conditions, legislative changes, exposure trends, loss development trends, claim frequency and severity trends, paid claims activity, remaining open case reserves and industry data where deemed appropriate. Such factors are also evaluated when selecting ultimate loss ratios and/or loss development factors in the methods described below.

Bornheutter-Ferguson method

The Bornheutter-Ferguson method calculates the IBNR loss reserves as the product of the earned premium, an expected ultimate loss ratio, and a loss development factor that represents the expected percentage of the ultimate losses that have been incurred but not yet reported. The loss development factor equals one hundred percent less the expected percentage of losses that have thus far been reported, which is generally calculated as an average of the percentage of losses reported for comparable reporting periods of prior underwriting years. The expected ultimate loss ratio is generally determined in the same manner as in the loss ratio method.

Loss development method

The loss development method, also known as the chainladder or the link-ratio method, develops the IBNR loss reserves by multiplying the paid or reported losses by a loss development factor to estimate the ultimate losses, then subtracting the reported losses, consisting of paid losses and case loss reserves, to determine the IBNR loss reserves. The loss development factor is the reciprocal of the expected percentage of losses that have thus far been reported, which is generally calculated as an average of the percentage of losses reported for comparable reporting periods of prior underwriting years.

Frequency/severity method

The frequency/severity method calculates the IBNR loss reserves by separately projecting claim count and average cost per claim data on either a paid or incurred basis. It estimates the expected ultimate losses as the product of the ultimate number of claims that are expected to be reported and the expected average amount of these claims.

Actuarial loss studies are conducted by the Company's actuaries at various times throughout the year for major lines of business employing the methodologies as described above. Additionally, a review of the emergence of actual losses relative to expectations for each line of business, generally derived from the annual loss studies, is conducted each quarter to determine whether the assumptions used in the reserving process continue to form a reasonable basis for the projection of liabilities for each product line. Such reviews may result in maintaining or revising assumptions regarding future loss development based on various quantitative and qualitative considerations. If actual loss activity differs from expectations, an upward or downward adjustment to loss reserves may occur. As time passes, estimated loss reserves for an underwriting year will be based more on historical loss activity and loss development patterns rather than on assumptions based on underwriters' input, pricing assumptions or industry experience.

The following discusses the method used for calculating the IBNR for each line of business and key assumptions used in applying the actuarial methods described.

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Generally, two key assumptions are used by our actuaries in setting IBNR loss reserves for major products in this line of business. The first assumption is that our historical experience regarding paid and reported losses for each product where we have sufficient history can be relied on to predict future loss activity. The second assumption is that our underwriters' assessments as to potential loss exposures are reliable indicators of the level of our expected loss activity. The specific loss reserves for marine are then analyzed separately by product based on such assumptions, except where noted below, with the major products including marine liability, cargo, P&I, transport and bluewater hull.

The claims emergence patterns for various marine product lines vary substantially. Our largest marine product line is marine liability, which has one of the longer loss development patterns. Marine liability protects an insured's business from liability to third parties stemming from their marine-related operations, such as terminal operations, stevedoring and marina operations. Since marine liability claims generally involve a dispute as to the extent and amount of legal liability that our insured has to a third party, these claims tend to take a longer time to develop and settle. Other longer-tail marine product lines include P&I insurance, which provides coverage for third party liability as well as injury to crew for vessel operators, and transport insurance, which provides both property and third party liability on a primary basis to businesses such as port authorities, marine terminal operators and others engaged in the infrastructure of international transportation. Other marine product lines have considerably shorter periods in which losses develop and settle. Ocean cargo insurance, for example, provides physical damage coverage to goods in the course of transit by water, air or land. By their nature, cargo claims tend to be reported quickly as losses typically result from an obvious peril such as fire, theft or weather. Similarly, bluewater hull insurance provides coverage against physical damage to ocean-going vessels. Such claims for physical damage generally are discovered, reported and settled quickly. The Company currently has extensive experience for all of these products and thus the IBNR loss reserves for all of the marine products are determined using the key assumptions and actuarial methodologies described above. Prior to 2007, however, as discussed below in the sensitivity analysis, the Company did not have sufficient experience in the transport product line and instead used its hull and liability products loss development experience as a key assumption in setting the IBNR loss reserves for its transport product.

Property Casualty

The reserves for property and casualty are established separately for each major product line, such as offshore energy, excess casualty, and accident and health reinsurance. Within Primary Casualty, the reserves are established separately for construction and non-construction risks. Our actuaries generally assume that historical loss development patterns are reasonable predictors of future loss patterns and deploy a variety of traditional actuarial techniques to develop a reasonable expectation of ultimate losses. However, there are a number of products for which the company has insufficient experience so as to generate credible actuarial projections. In those instances, we typically evaluate overall industry experience and rely on the input of underwriting and claims executives in setting assumptions for our IBNR reserves. We also attempt to make reasonable provisions for the impact of economic, legal and competitive trends in projecting future loss development.

A substantial portion of our Primary Casualty loss reserves are for liability policies issued to contractors, many of which are operating in California and other western states which have experiences significant amounts of litigation involving allegations of construction defect. Accordingly, contractor liability claims are categorized into two claim types: construction defect and other general liability. Other general liability claims typically derive from worksite accidents or from negligence alleged by third parties, and frequently take a long time to report and settle. Construction defect claims involve the discovery of damage to buildings that was caused by latent construction defects. These claims take a very long time to report and to settle compared to other general liability claims. Since construction defect claims report much later than other contractor liability claims, they are analyzed separately in an annual actuarial loss study.

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We have extensive history in the contractors' liability business upon which to perform actuarial analyses and we use the key assumption noted above relating to our own historical experience as a reliable indicator of the future for this product. However, there is inherent uncertainty in the loss reserve estimation process for this line of business given both the long-tail nature of the liability claims and the continuing underwriting and coverage changes, claims handling and reserve changes, and legislative changes that have occurred over a several year period. Such factors are judgmentally taken into account in this line of business in specific periods. The underwriting and coverage changes include the migration to a non-admitted business from admitted business in 2003, which allowed us to exclude certain exposures previously permitted (for example, exposure to construction work performed prior to the policy inception), withdrawals from certain contractor classes previously underwritten and expansion into new states beginning in 2005. Claims changes include bringing the claim handling in-house in 1999 and changes in case reserving practices in 2003, 2006 and 2011. During 2010 and 2011, we also significantly increased our claims staff and improved our claims procedures, which has allowed the Company to respond more quickly to reported construction defect claims. The Company is closely monitoring the impact of these effects on the adequacy of our case and IBNR loss reserves. After analysis of the factors above, Management believes that our reserves remain adequate to address our exposure to construction defect losses, but given the uncertainties noted above, there is a risk that our reserves for construction defect losses may ultimately prove to be inadequate, perhaps in a material manner.

Offshore energy provides physical damage coverage to offshore oil platforms along with offshore operations related to oil exploration and production. The significant offshore energy claims are generally caused by fire or storms, and thus tend to be large, infrequent, quickly reported, but occasionally not quickly settled because the damage is often extensive but not always immediately known.

Primary Casualty insurance provides primary general liability coverage principally to corporations in the construction, real estate and manufacturing sector. Excess casualty insurance is purchased by corporations which seek higher limits of liability than are provided in their Primary Casualty policies.

Specialty assumed reinsurance provides proportional and excess of loss treaty coverage for several niche lines: Accident & Health ("A&H"), Agriculture, Latin America, and Professional Liability. The A&H reinsurance line primarily provides reinsurance coverage for large individual medical claims that occur with small frequency. The Agriculture reinsurance line primarily provides reinsurance coverage related to crop insurance schemes, most of which are sponsored by governmental bodies in the U.S. and Canada. The Latin America line primarily provides reinsurance coverage for individual risk and catastrophic property exposures, liability exposures, and surety bonds in Central and South America and the Spanish-speaking Caribbean. The Professional Liability line primarily provides reinsurance coverage for exposure related to medical malpractice and other miscellaneous professional liability policies.

Professional Liability

The professional liability policies mainly provide coverage on a claims-made basis mostly for a one-year period. The reserves for professional liability are analyzed separately by product. The major products are Directors' and Officers' Liability and Errors and Omissions Insurance. For Directors' and Officers' Liability, we evaluate and set loss reserves separately for primary policies for U.S. corporations; excess policies for U.S. corporations; and international companies.

The losses for D&O business are generally very severe and infrequent, and with some cases involving securities class actions. D&O claims report reasonably quickly, but take years to settle. In addition, our potential liability to pay a covered claim depends upon whether we have issued a primary policy, in which case the cost of defense is a large component of the ultimate loss, or an excess policy at a higher attachment point, in which case our policy is not impacted until the covered claim has exceeded the coverage available in the other policies that our policy is in excess of. Our loss estimates are based on expected losses, an assessment of the characteristics of reported losses at the claim level, evaluation of loss trends, industry data, and the legal, regulatory and current risk environment. Significant judgment is involved because anticipated loss experience in this area is less predictable due to the small number of claims and/or erratic claim severity patterns. As time passes for a given underwriting year, we place additional weight on assumptions relating to our actual experience and claims outstanding. The expected ultimate losses may be adjusted up or down as the underwriting years mature.

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Lloyd's Operations

Reserves for the Company's Lloyd's Operations are reviewed separately for the marine, property and casualty, and professional liability lines by product. The major marine products are marine liability, transport, marine energy liability, cargo, specie and marine reinsurance. The major property and casualty products . . .

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