NOTE 1. ORGANIZATION & SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying consolidated financial statements of The Navigators Group, Inc. and its subsidiaries have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP” or “U.S. GAAP”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting periods. Certain amounts for the prior year have been reclassified to conform with the current period presentation. Unless the context requires otherwise, the terms “we,” “us,” “our,” or “our Company” are used to mean The Navigators Group, Inc., a Delaware holding company established in 1982, and its subsidiaries. The term “Parent Company” is used to mean The Navigators Group, Inc. without its subsidiaries.

Organization

We are an international insurance company with a long-standing area of specialization in Marine insurance. Our Property and Casualty (“P&C”) insurance business primarily offers general liability coverage and umbrella & excess liability coverage to commercial enterprises through our U.S. and Int’l Insurance reporting segments. We have also developed niches in Professional Liability insurance, through our Directors & Officers (“D&O”) and Errors & Omissions (“E&O”) divisions. We also provide reinsurance products through our Global Reinsurance (“GlobalRe”) business.

We operate through various wholly-owned subsidiaries, including Navigators Insurance Company (“NIC”), inclusive of its United Kingdom Branch (“U.K. Branch”), and Navigators Specialty Insurance Company (“NSIC”), both of which are U.S. insurance companies, and Navigators Underwriting Agency Ltd. (“NUAL”), a Lloyd’s of London (“Lloyd’s”) underwriting agency that manages Lloyd’s Syndicate 1221 (“the Syndicate”) in the U.K. and is the underwriting company of Navigators Holdings (U.K.) Ltd. (“NHUK”). Our Company controls 100% of the Syndicate’s stamp capacity.

In May 2016, our Company received authorization from the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”) for a new U.K. based insurance company, Navigators International Insurance Company Ltd (“NIIC”), which is a wholly-owned direct subsidiary of our Parent Company, and has been fully capitalized in compliance with the terms of the authorization from the PRA.

Significant Accounting Policies

Cash

Cash includes cash on hand and demand deposits with banks, excluding such amounts held by the Syndicate included as Funds at Lloyd’s (“FAL”), which are classified as short term investments.

Investments

As of December 31, 2016 and 2015, all fixed maturity and equity securities held by our Company were carried at fair value and classified as available-for-sale. Available-for-sale securities are debt and equity securities not classified as either held-to-maturity securities or trading securities and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income (“AOCI”) as a separate component of stockholders’ equity. Fixed maturity securities include bonds, mortgage-backed and asset-backed securities. Equity securities consist of common stock, exchange traded funds and preferred stock.

Other invested assets consist of investments our Company made in certain strategic companies which are accounted for using the equity method of accounting. In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our Company’s proportionate share of the net income or loss of the companies. Changes in the carrying value of such investments are recorded in Other income. In applying the equity method, we use the most recently available financial information provided by the companies which is generally three months prior to the end of the reporting period.

Short-term investments are carried at fair value. Short-term investments mature within one year from the purchase date.

All prices for our fixed maturities, equity securities and short-term investments are classified as Level 1, Level 2 or Level 3 under the fair value hierarchy, as defined in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification 820 (“ASC 820”).

Premiums and discounts on fixed maturity securities are amortized into interest income over the life of the security using the interest method. For mortgage-backed and asset-backed securities, anticipated prepayments and expected maturities are utilized in applying the interest rate method. An effective yield is calculated based on projected principal cash flows at the time of original purchase. The effective yield is used to amortize the purchase price of the security over the security’s expected life. Book values are adjusted to reflect the amortization of premium or accretion of discount on a monthly basis. The projected principal cash flows are based on certain prepayment assumptions, which are generated using a prepayment model. The prepayment model uses a number of factors to estimate prepayment activity including the current levels of interest rates (refinancing incentive), time of year (seasonality), economic activity (including housing turnover) and term and age of the underlying collateral (burnout, seasoning). Prepayment assumptions associated with the mortgage-backed and asset-backed securities are reviewed on a periodic basis. When changes in prepayment assumptions are deemed necessary as the result of actual prepayments differing from anticipated prepayments, securities are revalued based upon the new prepayment assumptions utilizing the retrospective adjustment method, whereby the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The investment in such securities is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. Such adjustments, if any, are included in Net investment income for the current period.

Realized gains and losses on sales of investments are recognized when the related trades are executed and are determined on the basis of the specific identification method.

Impairment of Invested Assets

Management regularly reviews our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of securities.

Our Company reviews the magnitude of a security’s unrealized loss compared to its cost/amortized cost and the length of time that the security has been impaired to determine if an unrealized loss is other-than-temporary. If warranted as a result of conditions relating to a particular security, our Company will also review securities with declines in fair value resulting from a headline news event involving the issuer, a headline news event involving the asset class, the advice of our external asset managers, or economic events that may impact the issuer to determine if an unrealized loss is other-than-temporary. The depth of analysis performed is dependent upon the nature and magnitude of the indicators of other-than-temporary impairment present in regards to each impaired security.

For Equity securities, our Company performs a fundamental analysis of the issuer, including an evaluation of the mean analysts’ target price, to assess the likelihood of recovery of our cost basis in the security. Management also assesses the likelihood of future cash flows, dividends and increases to dividends, all of which affect the securities eligible for our equity strategy and therefore our intent to hold the security. If an equity security is deemed to be other-than temporarily-impaired, the cost is written down to fair value with the loss recognized in earnings.

For Fixed maturities, our Company assesses the underlying fundamentals of each issuer to determine if there is a change in the amount or timing of expected cash flows. Management compares the amortized cost basis to the present value of the revised cash flows using the historical book yield to determine the credit loss portion of impairment which is recognized in earnings. All non-credit losses where we have the intent and ability to hold the security until recovery are recognized as changes in OTTI losses within AOCI.

Specifically for structured Fixed maturities, our Company analyzes projections provided by our investment managers with respect to an expected principal loss under a range of scenarios and utilizes the most likely outcomes. The analysis relies on actual collateral performance measures such as default rate, prepayment rate and loss severity. These assumptions are applied throughout the remaining term of the deal, incorporating the transaction structure and priority of payments, to generate loss adjusted cash flows. Results of the analysis will indicate whether the security is expected ultimately to incur a loss or whether there is a material impact on yield due to either a projected loss or a change in cash flow timing. A break-even default rate is also calculated. A comparison of the break-even default rate to the actual default rate provides an indication of the level of cushion or coverage to the first dollar principal loss. For securities in which a tranche loss is present and the net present value of loss adjusted cash flows is less than book value, credit impairment is recognized in earnings. The output data also includes a number of additional metrics such as average life remaining, original and current credit support, over 60 day delinquency and security rating. The significant inputs used to measure the amount of credit loss recognized in earnings were actual delinquency rates, default probability, severity and prepayment assumptions. Projected losses are a function of both loss severity and probability of default, which differ based on property type, vintage and the stress of the collateral.

Foreign Currency Remeasurement and Translation

The functional currency of each of our operations is generally the currency of the local operating environment, except for our Lloyd’s business which is United States Dollar (“USD”). Transactions in currencies other than an operation’s functional currency are remeasured into the functional currency and the resulting foreign exchange gains and losses are reflected in net Other income (expense) in the Consolidated Statements of Income. Functional currency assets and liabilities of foreign operations are translated into USD using period end rates of exchange and the related translation adjustments are recorded as a separate component of AOCI. Consolidated Statements of Income amounts expressed in functional currencies are translated using average exchange rates.

During the first quarter of 2014, the Syndicate revised its foreign exchange accounting methodology from reporting its financial position and results using three functional currencies British Pound Sterling (“GBP”), U.S. Dollars (“USD”) and Canadian Dollars (“CAD”) to one functional currency, the USD. The USD was chosen as the single functional currency as the majority of the Syndicate’s insurance business has been and continues to be transacted in USD. This cumulative change in remeasurement resulted in a 2014 immaterial correction of $10.0 million ($6.6 million after-tax) in AOCI, on the Consolidated Balance Sheets, offset by a gain in Other income in the Consolidated Statements of Income.

Premium Revenues

Written premium is based on the insurance policies that have been reported to us and the policies that have been written by agents but not yet reported to us. We estimate the amount of written premium not yet reported based on judgments relative to current and historical trends of the business being written. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. An Unearned premium reserve is established to reflect the unexpired portion of each policy at the financial reporting date.

Substantially all of our business is placed through agents and brokers. We record estimates for both unreported direct and assumed premiums. We also record the ceded portion of the estimated Gross written premiums and related acquisition costs. These estimates are mostly for our Marine and Energy & Engineering products written by our International Insurance (“Int’l Insurance”) reporting segment as well as our Accident & Health (“A&H”) and Latin American (“LatAm”) business written by our GlobalRe reporting segment. Such premium estimates are generally based on submission data received from brokers and agents and recorded when the insurance policy or reinsurance contract is written or bound.

The earned gross, ceded and net premiums are calculated based on our earning methodology, which is generally pro-rata over the policy period or over the period of risk if the period of risk differs significantly from the contract period.

Reinsurance Ceded

In the normal course of business, we purchase reinsurance from insurers or reinsurers to reduce the amount of loss arising from claims. Management analyzes the reinsurance agreements to determine whether the reinsurance should be classified as prospective or retroactive based upon the terms of the reinsurance agreement and whether the reinsurer has assumed significant insurance risk to the extent that the reinsurer may realize a significant loss from the transaction.

Prospective reinsurance is reinsurance in which an assuming company agrees to reimburse the ceding company for losses that may be incurred as a result of future insurable events covered under contracts subject to the reinsurance. Retroactive reinsurance is reinsurance in which an assuming company agrees to reimburse a ceding company for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance.

Ceded reinsurance premiums net of ceding commissions and ceded losses are reflected as reductions of the respective income or expense accounts over the terms of the reinsurance contracts. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the reinsurance contracts in force. Reinsurance reinstatement premiums (“RRPs”) are recognized in the same period as the loss event that gave rise to the reinstatement premiums. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Ceded Unearned premiums and estimates of amounts recoverable from reinsurers on paid and unpaid losses are reflected as assets. Provisions are made for estimated unrecoverable reinsurance.

Deferred Policy Acquisition Costs

Costs of acquiring business are deferred and amortized over the period that the related premiums are recognized as revenue. Such costs (e.g., Commission expenses, Other underwriting expenses and Premium taxes) are limited to the incremental direct costs related to the successful acquisition of new or renewal business. The method of computing deferred policy acquisition costs limits the deferral to their estimated net realizable value based on the related Unearned premiums and takes into account anticipated losses, loss adjustment expense (“LAE”), Commission expenses and Operating expenses based on historical and current experience, as well as anticipated investment income.

Reserves for Losses and Loss Adjustment Expenses

Unpaid losses and LAE are determined on: (a) individual claims reported on direct business for insureds, (b) from reports received from ceding insurers for assumed business and (c) on estimates based on Company and industry experience for incurred but not reported (“IBNR”) claims and LAE. Indicated IBNR reserves for losses and LAE are calculated by our actuaries using several standard actuarial methodologies, including the paid and incurred loss development and the paid and incurred Bornheutter-Ferguson loss methods. Frequency/severity analyses are performed for certain books of business. The Reserve for losses and LAE has been established to cover the estimated unpaid cost of claims incurred. Such estimates are regularly compared to indicated reserves and updated and any resulting adjustments are included in the current year’s results. Management believes that the liability recognized for unpaid losses and LAE is a reasonable estimate of the ultimate unpaid claims incurred, however, no representation is made that the ultimate liability will not differ materially from the amounts recorded in the accompanying Consolidated Financial Statements. Losses and LAE are recorded on an undiscounted basis.

Earnings per Share

Basic earnings per share (“EPS”) is computed by dividing Net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the basic EPS adjusted for the potential dilution that would occur if all issued stock options were exercised and all stock grants were fully vested.

Depreciation and Amortization

Depreciation of furniture and fixtures, electronic data processing equipment and computer software is provided over the estimated useful lives of the respective assets, ranging from three to seven years, using the straight-line method. Amortization of leasehold improvements are provided over the shorter of the useful lives of those improvements or the contractual terms of the leases, ranging from five to ten years, using the straight-line method.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the cost of acquiring a business enterprise over the fair value of the net assets acquired. Our Company’s recorded indefinite lived intangible assets represent acquired stamp capacity in the Syndicate. Goodwill and indefinite lived intangible assets are reported at carrying value and are tested for impairment at least annually, and when permitted by the applicable accounting guidance, qualitative factors are assessed to determine whether it is necessary to calculate an asset’s fair value when testing an asset with an indefinite life for impairment. Goodwill and indefinite lived intangible assets are considered impaired if the estimated fair value is less than its carrying value and any impairment loss is measured as the difference between the implied fair value and the carrying value. Our Company did not recognize an impairment of goodwill or the indefinite lived intangible assets for any of the years ended December 31, 2016, 2015 and 2014.

As of December 31, 2016, the carrying value of goodwill and indefinite lived intangible assets was $6.5 million, which is $0.3 million less than the carrying value as of December 31, 2015, $6.8 million. Changes in the carrying value of the goodwill and indefinite lived intangible assets are due to amortization and fluctuations in currency exchange rates between the USD and the GBP.

Income Taxes

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. Future realization of the tax benefit of an existing deferred tax asset ultimately depends on the existence of sufficient taxable income of the appropriate character within the carryback/carryforward period available under the tax law. In determining whether a valuation allowance is needed, management considers the timing of the reversal of each deferred tax asset as well as expected future levels of taxable income, amounts of taxable income in carryback years, and tax planning strategies. Additional information regarding our deferred tax assets can be found in Note 9, Income Taxes.

Current and Pending Accounting Pronouncements

As of January 1, 2016, we adopted the following accounting pronouncements, which did not have a material effect, singly or in the aggregate, on our Consolidated Financial Statements:

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Accounting Standards Update 2015-03 – Interest – Imputation of Interest (Subtopic 835-30) – Simplifying the Presentation of Debt Issuance Costs, which is effective for fiscal years beginning after December 15, 2015. The new pronouncement was issued to simplify presentation of debt issuance costs.

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Accounting Standards Update 2015-05 – Intangibles – Goodwill and Other – Internal Use Software (Subtopic 350-40) Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, which is effective for fiscal years beginning after December 15, 2015. The new pronouncement was issued to provide guidance to customers about whether a cloud computing arrangement includes a software license.

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Accounting Standards Update 2015-07 – Fair Value Measurement – (Topic 820) Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its equivalent) (a consensus of the Emerging Issues Task Force), which is effective for fiscal years beginning after December 15, 2015. The new pronouncement was issued to ensure that all investments categorized in the fair value hierarchy are classified using a consistent approach.

The Financial Accounting Standards Board has issued the following new pronouncements that may have an impact on our Company and we are assessing the future impact of these updates on our Consolidated Financial Statements:

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Accounting Standards Update 2016-01 – Financial Instruments (Subtopic 825-10) – Recognition and Measurement of Financial Assets and Financial Liabilities, which will be effective for fiscal years beginning after December 15, 2017. The new pronouncement was issued to make targeted improvements to the presentation of financial instruments. We expect the adoption of this pronouncement to have limited impact to our financial statements.

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Accounting Standards Update 2016-02 – Leases (Topic 842) – Amends the recognition of a right-to-use asset and lease liability on the statement of financial position of those leases previously classified as operating leases under the previous guidance, which will be effective for fiscal years beginning after December 15, 2018. The new pronouncement was issued to improve transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. We expect the adoption of this pronouncement to result in limited changes to our total assets and total liabilities.

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Accounting Standards Update 2016-09 – Compensation – Stock Compensation – (Topic 718) – Improvements to Employee Share-Based Accounting, which will be effective for fiscal years beginning after December 15, 2016. The new pronouncement was issued to simplify employee share-based accounting. We expect the adoption of this pronouncement to simplify our reporting but not have a material effect to our financial statements.

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Accounting Standards Update 2016-13 – Financial Instruments – Credit Losses (Topic 326) – amends the measurement of credit losses on financial instruments not accounted for at fair value including loans, debt securities, reinsurance receivables and any other financial assets, which will be effective for the fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. We expect the adoption of this pronouncement to have limited impact to our financial statements.

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Accounting Standards Update 2016-15 – Statements of Cash Flows (Topic 230) – Classification of Certain Cash Receipts and Cash Payments amends how certain cash receipts and cash payments are presented in the statement of cash flows to reduce existing diversity in practice. We expect that the adoption of this pronouncement will not have a material effect on our financial statements.

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Accounting Standards Update 2016-16 - Income Taxes (Topic 740) - Amends current guidance by eliminating the exception for an intra-entity transfer of an asset other than inventory. Under the new standard, an entity should recognize the income tax consequences when the transfer occurs. The guidance prescribed is effective beginning fiscal year 2018, including interim periods. We expect that the adoption of this pronouncement will not have a material effect on our financial statements.

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Accounting Standards Update 2016-17 - Consolidation (Topic 810) - Amends the consolidation guidance concerning the evaluation of interests in variable interest entities. The accounting standards update requires a reporting entity to include interests held by related parties under common control proportionally when assessing whether it holds a variable interest in a VIE. The prescribed guidance is effective beginning in fiscal year 2017, including interim periods. We expect that the adoption of this pronouncement will not have a material effect on our financial statements.

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Accounting Standards Updated 2016-18 - Statement of Cash Flows (Topic 230) - Requires that amounts generally described as restricted cash and cash equivalents be included within total cash and cash equivalents in the Statement of Cash Flows. The guidance prescribed is effective beginning in fiscal year 2018, including interim periods. We expect the adoption of this pronouncement to have limited impact to our financial statements.

There were no additional accounting pronouncements that are expected to have an impact on the Consolidated Financial Statements upon adoption.