| NAVIGATORS GROUP INC Item 1A RISK FACTORS In addition to the items listed under "e Note on Forward-Looking Statements, "e following are certain risk factors related to the Company |
| Our business is concentrated in marine and energy and general liability insurance, and if market conditions change adversely, or we experience large losses in these lines, it could have a material adverse effect on our business |
| As a result of our strategy to focus on specialty products in niches where we have underwriting and claims handling expertise and to decline business where pricing does not afford what we consider to be acceptable returns, our business is concentrated in the marine and specialty liability lines |
| For the year ended December 31, 2005, our marine and energy line accounted for approximately 56dtta5prca of our gross written premiums and our specialty lines, consisting primarily of contractors &apos liability, accounted for approximately 27dtta0prca of our gross written premiums |
| If our results of operations from either of these two lines are less favorable for any reason, including lower demand for our products on terms and conditions that we find appropriate, flat or decreased rates for our products or increased competition, the reduction could have a material adverse effect on our business |
| We are exposed to cyclicality in our business that may cause material fluctuations in our results |
| The property/casualty insurance business generally, and the marine insurance business specifically, have historically been characterized by periods of intense price competition due to excess underwriting capacity as well as periods when shortages of underwriting capacity have permitted attractive premium levels |
| We have reduced business during periods of severe competition and price declines, such as withdrawing from the majority of our aviation business in late 1998, and grown when pricing allowed an acceptable return, as with entering the professional liability business in late 2001 |
| We expect that our business will continue to experience the effects of this cyclicality, which over the course of time, could result in material fluctuations in our premium volume, revenues or expenses |
| 28 — A N N U A L R E P O R T 2 0 0 5 _________________________________________________________________ We may not be successful in developing our new specialty lines which could cause us to experience losses |
| Since 2001, we have entered into a number of new specialty lines of business including professional liability, excess casualty, personal umbrella insurance, commercial automobile insurance, general liability for certain aspects of the hospitality industry and personal lines warranty coverage on underground fuel tanks excluding pollution coverage |
| We continue to look for appropriate opportunities to diversify our business portfolio by offering new lines of insurance in which we believe we have sufficient underwriting and claims expertise |
| However, because of our limited history in these new lines, there is limited financial information available to help us estimate sufficient reserve amounts for these lines and to help evaluate whether we will be able to successfully develop these new lines or the likely ultimate losses and expenses associated with these new lines |
| Due to our limited history in these lines, we may have less experience managing their development and growth than some of our competitors |
| Additionally, there is a risk that the lines of business into which we expand will not perform at the levels we anticipate |
| We may be unable to manage effectively our rapid growth in our lines of business, which may adversely affect our results |
| We have experienced substantial increases in premium in many of our lines of business over the past few years |
| For example, gross written premium in the specialty liability line increased 40dtta2prca from 2004 to 2005, 14dtta4prca from 2003 to 2004, 13dtta4prca from 2002 to 2003 and 109dtta8prca from 2001 to 2002 due to increased rates and underwriting more business |
| Gross written premium in the marine line for our insurance companies increased 11dtta1prca, 7dtta1prca and 9dtta6prca in 2005, 2004 and 2003, respectively, due to an increase in premium rates resulting in higher premiums on new and renewal business, as well as underwriting new business |
| In addition, since late 2001 we have been underwriting several new lines of business, including professional liability, commercial automobile and personal umbrella insurance |
| In December 2004, we hired a group of experienced underwriters to expand our excess casualty business, particularly the commercial excess and umbrella liability business |
| We formed Navigators NV in January 2005, a subsidiary of NUAL Navigators NV is located in Antwerp, Belgium, and focuses on transport liability, cargo and marine liability business |
| To control our growth effectively, we must successfully manage our new and existing lines of business |
| This process will require substantial management attention and additional financial resources |
| In addition, our growth is subject to, among other risks, the risk that we may experience difficulties and incur expenses related to hiring and retaining a technically proficient workforce |
| Accordingly, we may fail to realize the intended benefits of expanding into new specialty lines and we may fail to realize value from such lines relative to the resources that we invest in them |
| Any difficulties associated with expanding our current and future lines of business could adversely affect our results of operations |
| We may incur additional losses if our loss reserves are insufficient |
| We maintain loss reserves to cover our estimated ultimate unpaid liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period |
| Reserves do not represent an exact calculation of liability, but instead represent estimates, generally utilizing actuarial projection techniques and judgment at a given accounting date |
| These reserve estimates are expectations of what the ultimate settlement and administration of claims will cost based on our assessment of facts and circumstances then known, review of historical settlement patterns, estimates of trends in claims severity, frequency, legal theories of liability and other factors |
| Both internal and external events, including changes in claims handling procedures, economic inflation, legal trends and legislative changes, may affect the reserve estimation process |
| Many of these items are not directly quantifiable, particularly on a prospective basis |
| Additionally, there may be significant lags between the occurrence of the insured event and the time it is actually reported to the insurer |
| We A N N U A L R E P O R T 2 0 0 5 — 29 _________________________________________________________________ continually refine reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled |
| Adjustments to reserves are reflected in the results of the periods in which the estimates are changed |
| Because establishment of reserves is an inherently uncertain process involving estimates, currently established reserves may not be sufficient |
| If estimated reserves are insufficient, we will incur additional income statement charges |
| Our loss reserves include amounts related to short tail and long tail classes of business |
| Short tail business means that claims are generally reported quickly upon occurrence of an event, making estimation of loss reserves less complex |
| For the long tail lines, significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the reporting of the loss and the settlement of the claim |
| The longer the time span between the incidence of a loss and the settlement of the claim, the more likely the ultimate settlement amount will vary |
| Our longer tail business includes general liability, including California construction defect claims, as well as historical claims for asbestos exposures through our marine and aviation businesses and claims relating to our run-off businesses |
| Our professional liability business, though long tail with respect to settlement period, is produced on a claims-made basis (which means that the policy in-force at the time the claim is filed, rather than the policy in-force at the time the loss occurred, provides coverage) and is therefore, we believe, less likely to result in a significant time lag between the occurrence of the loss and the reporting of the loss |
| There can be no assurance, however, that we will not suffer substantial adverse prior period development in our business in the future |
| We may not have access to adequate reinsurance to protect us against losses |
| We purchase reinsurance by transferring part of the risk we have assumed to a reinsurance company in exchange for part of the premium we receive in connection with the risk |
| The availability and cost of reinsurance are subject to prevailing market conditions, both in terms of price and available capacity, which can affect our business volume and profitability |
| Our reinsurance programs are generally subject to renewal on an annual basis |
| If we are unable to renew our expiring facilities or to obtain new reinsurance facilities, either our net exposures would increase, which could increase our costs, or, if we were unwilling to bear an increase in net exposures, we would have to reduce the level of our underwriting commitments, especially catastrophe exposed risks, which would reduce our revenues and possibly net income |
| Our reinsurers, including the other participants in the marine pool, may not pay on losses in a timely fashion, or at all, which may increase our costs |
| Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, ceded reinsurance arrangements do not eliminate our obligation to pay claims to our policyholders |
| Accordingly, we bear credit risk with respect to our reinsurers |
| Specifically, our reinsurers may not pay claims made by us on a timely basis, or they may not pay some or all of these claims |
| The operations of the marine pool also expose us to reinsurance credit risk from other participants in the marine pool on business written through the 2005 underwriting year |
| From 1998 through 2005, all business underwritten by the marine pool was written with Navigators Insurance Company as the primary insurer |
| Navigators Insurance Company then reinsured its exposure in the marine pool to the other participants based on their percentage participation |
| From 1983 until 1998, Navigators Insurance Company was the primary insurer for some of the pool business in excess of its participation amount |
| As a result of this arrangement, we remain primarily liable for claims arising out of those policies written by Navigators Insurance Company on behalf of the marine pool even if one or more of the other participants do not pay the claims they reinsured, which could have a material adverse effect on our business |
| The marine pool was eliminated beginning with the 2006 underwriting year |
| 30 — A N N U A L R E P O R T 2 0 0 5 _________________________________________________________________ Intense competition for our products could harm our ability to maintain or increase our profitability and premium volume |
| The property and casualty insurance industry is highly competitive |
| We face competition from both domestic and foreign insurers, many of whom have longer operating histories and greater financial, marketing and management resources |
| Competition in the types of insurance in which we are engaged is based on many factors, including our perceived overall financial strength, pricing and other terms and conditions of products and services offered, business experience, marketing and distribution arrangements, agency and broker relationships, levels of customer service (including speed of claims payments), product differentiation and quality, operating efficiencies and underwriting |
| Furthermore, insureds tend to favor large, financially strong insurers, and we face the risk that we will lose market share to higher rated insurers |
| The entry of banks and brokerage firms into the insurance business poses new challenges for insurance companies and agents |
| These challenges from industries traditionally outside the insurance business could heighten the competition in the property and casualty industry |
| We may have difficulty in continuing to compete successfully on any of these bases in the future |
| If competition limits our ability to write new business at adequate rates, our ability to transact business would be materially and adversely affected and our results of operations would be adversely affected |
| We may be unable to attract and retain qualified employees |
| We depend on our ability to attract and retain qualified executive officers, experienced underwriters and claims professionals and other skilled employees who are knowledgeable about our specialty lines of business |
| If the quality of our executive officers, underwriting or claims team and other personnel decreases, we may be unable to maintain our current competitive position in the specialty markets in which we operate and be unable to expand our operations into new specialty markets |
| Increases in interest rates may cause us to experience losses |
| Because of the unpredictable nature of losses that may arise under insurance policies, we may require substantial liquidity at any time |
| Our investment portfolio, which consists largely of fixed-income investments, is our principal source of liquidity |
| The market value of our fixed-income investments is subject to fluctuation depending on changes in prevailing interest rates and various other factors |
| We do not hedge our investment portfolio against interest rate risk |
| Increases in interest rates during periods when we must sell fixed-income securities to satisfy liquidity needs may result in realized losses |
| A downgrade in our ratings could adversely impact the competitive positions of our operating businesses |
| Ratings are a critical factor in establishing the competitive position of insurance companies |
| Our insurance companies are rated by AM Best Company and S&P AM Best Companyapstas and S&Papstas ratings reflect their opinions of an insurance companyapstas financial strength, operating performance, strategic position and ability to meet its obligations to policyholders, and are not evaluations directed to investors |
| Our ratings are subject to periodic review by AM Best Company and S&P, and we cannot assure the continued maintenance of our current ratings |
| In October 2005, AM Best Company reaffirmed its "e A "e (Excellent) rating for Navigators Insurance Company and NIC Insurance Company |
| In February 2006, S&P reaffirmed its "e A "e (Strong) rating for Navigators Insurance Company and NIC Insurance Company |
| Because these ratings have become an increasingly important factor in establishing the competitive position of insurance companies, if these ratings are reduced, our competitive position in the industry, and therefore our business, could be adversely affected |
| A significant downgrade could result in a substantial loss of business as policyholders might move to other companies A N N U A L R E P O R T 2 0 0 5 — 31 _________________________________________________________________ with higher claims-paying and financial strength ratings |
| There can be no assurance that our current ratings will continue for any given period of time |
| Continued or increased premium levies by Lloydapstas for the Lloydapstas Central Fund and cash calls for trust fund deposits or a significant downgrade of Lloydapstas AM Best rating could materially and adversely affect us |
| The Lloydapstas Central Fund protects Lloydapstas policyholders against the failure of a member of Lloydapstas to meet its obligations |
| The Central Fund is a mechanism which in effect "e mutualizes "e unpaid liabilities among all members, whether individual or corporate |
| The fund is available to back Lloydapstas policies issued after 1992 |
| Lloydapstas requires members to contribute to the Central Fund, normally in the form of an annual contribution, although a special contribution may be levied |
| The Council of Lloydapstas has discretion to call up to 3prca of underwriting capacity in any one year |
| Policies issued before 1993 have been reinsured by Equitas, an independent insurance company authorized by the Financial Services Authority |
| However, if Equitas were to fail or otherwise be unable to meet all of its obligations, Lloydapstas may take the view that it is appropriate to apply the Central Fund to discharge those liabilities Equitas failed to meet |
| In that case, the Council of Lloydapstas may resolve to impose a special or additional levy on the existing members, including Lloydapstas corporate members, to satisfy those liabilities |
| Additionally, Lloydapstas insurance and reinsurance business is subject to local regulation, and regulators in the United States require Lloydapstas to maintain certain minimum deposits in trust funds as protection for policyholders in the United States |
| These deposits may be used to cover liabilities in the event of a major claim arising in the United States and Lloydapstas may require us to satisfy cash calls to meet claims payment obligations and maintain minimum trust fund amounts |
| Any premium levy or cash call would increase the expenses of Millennium Underwriting Ltd |
| and Navigators Corporate Underwriters Ltd, our corporate members, without providing compensating revenues, and could have a material adverse effect on our results |
| The Lloydapstas of London market is currently rated "e A "e (Excellent) by AM Best and "e A "e (Strong) by S&P We believe that in the event that Lloydapstas rating is downgraded below "e A- "e in the future, the downgrade could have a material adverse effect on our ability to underwrite business through our Lloydapstas Operations and therefore on our financial condition or results of operations |
| Our businesses are heavily regulated, and changes in regulation may reduce our profitability and limit our growth |
| Our insurance subsidiaries are subject to extensive regulation and supervision in the jurisdictions in which they conduct business |
| This regulation is generally designed to protect the interests of policyholders, as opposed to insurers and their stockholders and other investors, and relates to authorization for lines of business, capital and surplus requirements, investment limitations, underwriting limitations, transactions with affiliates, dividend limitations, changes in control, premium rates and a variety of other financial and nonfinancial components of an insurance companyapstas business |
| Virtually all states require insurers licensed to do business in that state to bear a portion of the loss suffered by some insureds as the result of impaired or insolvent insurance companies |
| The effect of these arrangements could reduce our profitability in any given period or limit our ability to grow our business |
| In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and some state legislatures have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies |
| Further, the National Association of Insurance Commissioners, or NAIC, and state insurance 32 — A N N U A L R E P O R T 2 0 0 5 _________________________________________________________________ regulators are re-examining existing laws and regulations, specifically focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws |
| Any proposed or future legislation or NAIC initiatives may be more restrictive than current regulatory requirements or may result in higher costs |
| In response to the September 11, 2001 terrorist attacks, the United States Congress has enacted legislation designed to ensure, among other things, the availability of insurance coverage for terrorist acts, including the requirement that insurers provide such coverage in certain circumstances |
| The Terrorism Risk Insurance Act of 2002 ( "e TRIA "e ) established a program under which the federal government will share the risk of loss from certain acts of international terrorism with the insurance industry |
| As a result, we will be prohibited from adding certain terrorism exclusion clauses to the policies written by insurers in our group that write business in the US While these insurers are protected by federally funded terrorism reinsurance as provided for in TRIA, there is a substantial deductible that must be met, the payment of which could have an adverse effect on our results of operations |
| Potential future changes to TRIA could also adversely affect us by causing our reinsurers to increase prices or withdraw from certain markets where terrorism coverage is required |
| TRIA, which expired at the end of 2005, was extended on December 22, 2005, when the Terrorism Risk Insurance Extension Act of 2005, or TRIEA, was enacted |
| TRIEA extends TRIA through December 31, 2007 |
| The deductible for each insurer has been increased to 17dtta5prca and 20prca of direct earned premiums in 2006 and 2007, respectively |
| For losses in excess of an insurerapstas deductible, our participating insurers will retain an additional 10prca and 15prca of the excess losses in 2006 and 2007, respectively, with the balance to be covered by the Federal government up to an aggregate cap of dlra25 billion in 2006 and dlra27dtta5 billion in 2007 |
| The inability of our subsidiaries to pay dividends to us in sufficient amounts would harm our ability to meet our obligations |
| We are a holding company and rely primarily on dividends from our subsidiaries to meet our obligations for payment of interest and principal on outstanding debt obligations and corporate expenses |
| The ability of our insurance subsidiaries to pay dividends to us in the future will depend on their statutory surplus, on earnings and on regulatory restrictions |
| For a discussion of our insurance subsidiaries &apos current dividend-paying ability, please see "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources "e included herein |
| We and our underwriting subsidiaries are subject to regulation by some states as an insurance holding company |
| Such regulation generally provides that transactions between companies within our consolidated group must be fair and equitable |
| Transfers of assets among affiliated companies, certain dividend payments from underwriting subsidiaries and certain material transactions between companies within our consolidated group may be subject to prior notice to, or prior approval by, state regulatory authorities |
| Our underwriting subsidiaries are also subject to licensing and supervision by government regulatory agencies in the jurisdictions in which they do business |
| These regulations may set standards of solvency that must be met and maintained, such as the nature of and limitations on investments, the nature of and limitations on dividends to policyholders and stockholders and the nature and extent of required participation in insurance guaranty funds |
| These regulations may affect our subsidiaries &apos ability to provide us with dividends |
| Catastrophe losses could materially reduce our profitability |
| We are exposed to claims arising out of catastrophes, particularly in our marine insurance line of business |
| We have experienced, and will experience in the future, catastrophe losses which may materially reduce our profitability or harm our financial condition |
| Catastrophes can be caused by various natural events, including hurricanes, windstorms, earthquakes, hail, severe winter weather and fires |
| Catastrophes can also be man-made, such as the World Trade Center attack |
| The incidence and severity of catastrophes are inherently unpredictable |
| Although we will attempt to manage our exposure to such events, the A N N U A L R E P O R T 2 0 0 5 — 33 _________________________________________________________________ frequency and severity of catastrophic events could exceed our estimates, which could have a material adverse effect on our financial condition |