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Executives

W. Marston Becker - Chief Executive Officer

Joseph W. Roberts - Chief Financial Officer

N. James Tees - Executive Vice President, Finance and Investments of MCS

Analysts

Joshua Shanker – Citigroup

Rohan Pai - Banc of America Securities

Max Capital Group Ltd. (MXGL) Q3 2008 Earnings Call November 3, 2008 10:00 AM ET

Operator

Good day ladies and gentlemen and welcome to the third quarter 2008 Max Capital Group Limited earnings conference call. My name is Heather, and I’ll be your coordinator for today. (Operator Instructions)

The company reminds you that forward-looking statements that may be made in this call are intended to be covered by the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical fact, but rather reflect the company’s current expectations, estimates, and predictions about future results and events, and are subject to risks, uncertainties, and assumptions including risks, uncertainties and assumptions that are enumerated in the company’s most recent Form 10-K and other documents filed with the SEC. If one or more risks or uncertainties materialize or if the company’s underlying assumptions prove to be incorrect, actual results may vary materially from what the company projects. The company undertakes no obligation to update or revise publicly any forward-looking statement whether as a result of new information, future events, or otherwise.

I would now like to turn the presentation over to your host for today’s conference, Mr. Marty Becker, CEO.

W. Marston Becker

Welcome to everyone to Max Capital’s third quarter earnings call.

The third quarter for Max was true to two cities and there continued very positive growth and positioning of our underwriting platforms combined with the extremely difficult investing climate which overshadowed our solid underwriting performance in the quarter. Max’s underwriting platforms each continued to perform close to or better than planned for 2008. Importantly, this performance has been further enhanced by the positive development we’ve been having in our predominantly casualty oriented reserve base.

In Bermuda and Dublin, our insurance business is tracking very close to last year in gross written premium with a similar ceded re-insurance program. Loss picks for 2008 continue to look attractive and reserves on prior years remain 70% to 75% IBNR.

Our Bermuda/Dublin re-insurance business shows meaningful growth over 2007 principally from the agricultural business we discussed in previous quarters. The early year fears about Mid-western US rains and floods appear to have moderated, and recent forecasts predict that the agricultural business were in the year with a breakeven or positive combined ratio. Additionally, we’ve had nice re-insurance growth in our medical malpractice and workers’ compensation portfolios as well as planned declines in our professional liability and DNO book of business.

Max’s losses from hurricanes Gustav and Ike were well within expectations and attribute to the expertise for underwriting professionals and sound strategy in this market segment. Again, our traditional re-insurance reserves remain approximately 60% to 65% IBNR.

Max Specialty in its second year is moving nicely to maturity. Gross written premiums year-to-date are slightly ahead of expectations. We would estimate our year-end gross written premium will approximate $165 to $170 million versus our original plan of $155 million. Loss picks continue to be conservative and we are very pleased with the growing diversification of our business mix between property, casualty, and marine.

The additions in late 2007 of our Marine team and the establishment of Max Managers are wholly owned MGA focused on casualty business similar to what we write in Bermuda has enhanced this diversification, and as you know, diversification is the cornerstone of Max’s business strategy.

We remain on track to close on our fourth major underwriting platform Max Lloyd’s this month. The addition of the Lloyd’s platform gives Max a full complement of key underwriting platforms with experienced and proven teams at each domicile. Lloyd’s also provides us an attractive additional recruiting advantage for key specialty teams to add to our organization.

Most of our peers in their calls this month have been increasingly bullish on the prospects for an underwriting cycle turn and improvement heading into 2009. All indications we are seeing support that view with the shorter tier lines leading the way. There are some inconsistencies in present renewals, however, as some competitors with damaged franchises are attempting to retain business through aggressive pricing. Our view is that this will be short-lived, unsustainable, and will ultimately attract the scrutiny of regulators.

Aviation renewals are underway as we speak. Max has been receiving some premium increase, but more importantly, our participation has been increasingly valued as our strong combination of price terms and conditions have narrowed with program leads. Additionally, we have added quota share capacity to increase our aviation line size while generating fee income for Max.

Similarly, January 1 expectations for property catastrophe re-insurance are materially changed from just 60 days back. Both the storm losses from Gustav and Ike combined with the balance sheet losses for both primary companies and re-insurers appear to be having the effect of increasing demand and decreasing capacity which should move rates meaningfully higher. Max is well positioned in each of our platforms to take advantage of these trends on both our primary and a re-insurance basis.

Max investment results for the quarter were not immune to the extreme financial marketplace distress. Our fixed income portfolio continued to perform well and its bias towards higher quality issues protected us from most of the individual name trouble. Our MDS or alternative assets portfolio reflected the distress in the hedge fund world where unprecedented volatility and correlation generated losses beyond any previous expectation.

Max’s investment leverage of over 3:1 on surplus is typically an attractive enhancement for our business model. In a difficult investing climate such as this, it has obviously been a detriment in terms of dollar magnitude of downdraft and percentage decline in book value per share.

With the expanded underwriting platforms we now have and with expectations for 2009 underwriting opportunities to be more robust, we recently announced a reduction in our target range for alternative investments to 10% to 20% from 15% to 25%. At quarter end we are at 18.6% as we rebalanced our portfolio to a more market neutral absolute return bias. Significant detail in this rebalancing was posted on Max’s website as part of our October 13th press release on this topic. At quarter end, we would expect to be in the middle of our range, and should the underwriting climate improve as expected, you will likely see us adjust towards the lower end of our range and free up capital to use in underwriting.

As I mentioned in my opening, it’s been a quarter of two contrasts with improving underwriting opportunities and capabilities offset by very difficult investment returns.

I would now like to ask Joe Roberts, Max’s CFO and Jim Tees, EVP of Finance and Investments to provide greater detail on our financials.

Joseph W. Roberts

Our net operating loss for the quarter ended September 30, 2008, was $146.1 million or $2.50 per diluted share compared to net operating income of $68.4 million or $1.08 per diluted share for the same period in 2007. For the 9 months ended September 30, 2008, we produced a net operating loss of $63.7 million or $1.06 per diluted share versus net operating income of $243.9 million or $3.81 per diluted share of the same period in 2007. Diluted book value per share at September 30, 2008, was $21.88, a decrease of 14.5% from December 31, 2007, with all of this decrease occurring in the third quarter.

Overall, our underwriting businesses are operating broadly in line with our budgeted expectations for 2008. The decrease in net income is principally attributable to net losses of $145 million experienced by our alternative investment portfolio which had a negative 12.99% return for the third quarter and a negative 11.98% return for the 9 months ended September 30, 2008. Our alternative investment losses for the year-to-date accounts for a 9.7% decrease in diluted book value per share. Unrealized losses of $108.9 million on our fixed maturities portfolio contributed to a 7.3% decrease in diluted book value per share for the year-to-date.

Our net loss in 2008 includes approximately $50 million of losses related to catastrophic events. Net of reinstatement premiums of $7.4 million as compared to no CAP-related losses in the same period in 2007. Offsetting these losses were $88.6 million of net favorable development of loss reserves on prior year contracts, an increase of $31.5 million over the prior year period. These factors combined with the year-over-year decrease in alternative investments of $281.70 million are the primary net income variances from our 2007 results.

Gross premiums written for our Bermuda/Dublin re-insurance segment for the 9 month ended September 30, 2008, increased 22.2% from $308.8 million in 2007 to $377.5 million for the period. The increase is mainly due to our expansion into the agricultural product line during the first quarter 2008. Our premium activity for our re-insurance product is broadly in line with our planning expectations with agriculture, property, medical malpractice, and workers’ compensation liability premiums being the largest contributors to the gross written premiums for the 9 months ended September 30, 2008.

Adjustments to gross premiums written on prior year contracts decreased gross premium written by $35.2 million for the 9 months ended September 30, 2008, and are largely due to the effects of the slowing economy on our clients’ business plants. Reinstatement premiums of $7.4 million net of re-insurance ceded were recognized during the third quarter in respect to hurricane related losses. Re-insurance premiums ceded in our Bermuda/Dublin re-insurance segment increased 104.6% for the 9 months ended September 30, 2008, from $41.6 million to $85.1 million. This increase reflected our first-time purchase of protection on our agricultural business and additional quota share protection on our medical malpractice and workers’ compensation business related to increased assumed premiums.

Losses incurred for the 9 months ended September 30, 2008, include hurricane related net losses of $47 million and approximately $78.6 million of net favorable development on prior year reserves with the largest development in our property, professional line, and whole account lines of business. Hurricane related losses increased our loss ratio by 17.4 percentage points including the effect of reinstatement premiums, and favorable loss development reduced our loss ratio by 32 percentage points. Absent CAP losses and favorable loss development, our loss ratio for period was moderately higher than for the same period in 2007 largely affecting the softer pricing environment.

Turning now to our Bermuda/Dublin insurance segment, our gross premiums written in that segment declined 2.7% in the 9 months of 2008 versus the same period in 2007. The decline was consistent with our 2008 plan which anticipated softening pricing and premium rates and reflects our decision to decline renewals where prices and conditions do not meet our underwriting criteria.

Reinsurance premiums ceded decreased for the 9 months ended September 30, 2008, by 9.1% to $133.1 million compared to $146.4 million for the same period in 2007, with coverage in 2008 remaining consistent with the re-insurance program purchased in 2007 apart from minor reductions in the percentage ceded on a number of our quota share facilities.

Losses incurred for the 9 months ended September 30, 2008, were $108.8 million compared to $110.8 million for the 9 months ended September 30, 2007, a decrease of 1.8%. Losses incurred for the 2008 period include $5.4 million of hurricane related net losses and $6.1 million for property per-risk losses offset by $10 million of favorable development on prior period reserves.

Hurricane and per-risk losses contributed to an increase of 8.4 percentage points and favorable loss development contributed to a decrease of 7.3 percentage points to the both the loss and combined ratios for our Bermuda/Dublin insurance segment for the 9 months. Once again, absent reserve releases, our loss ratio for the 9 months period was moderately higher from the same period in 2007, again reflecting a softer pricing environment.

Our US specialty segment contributed gross premiums written of $134.2 million to our September 30, 2008 results. The rate of growth in premiums has leveled off toward the tail end of the third quarter, however, our premium volume remains in line with our 2008 plan as we continue to expand and diversify our client base. The growth in net premiums earned for the segment has now exceeded the growth in general and administrative expenses contributing to a reduced combined ratio.

No new life and annuity business was written in the third quarter of 2008. The increase in benefit expense for the 9-month period versus the same period of 2007 reflects the incremental benefit expense associated with the life and annuity businesses written during the last quarter of 2007 and the first half of 2008.

Cash provided by operating activities in the 9 months period was a strong $399.7 million compared to $297.1 million for the same period of 2007, largely reflecting the addition of gross premiums written in the period.

Decreased yields on our cash and invested assets contributed to the 1.1% decrease in net investment income earned in the 9-month period. Jim Tees will provide more color on our alternative investment returns for the period in just a moment.

The $9.6 million decrease in interest expense in 2008 is principally attributable to declining interest rates partially offset by an increase in the average outstanding debt for the period compared to the same period in 2007. In addition, the crediting rates on funds held from re-insurers was lower in the first 9 months of 2008 than in the same 2007 period.

Total general and administrative expenses were $95.5 million for the 9 months ended September 30, 2008, compared to $79.7 million for the comparable 2007 period. The increase principally relate to general and administrative expenses for our US specialty segment related to infrastructure growth, increased profession fees, and some losses on foreign exchange.

Let me turn to Jim Tees now for our discussion of alternative investments and other housekeeping items.

N. James Tees

Max, like our peers, did not escape the broad-based investment market meltdown that occurred in the third quarter and continued into October. For the quarter, our overall investment portfolio produced a negative return of 283 basis points driven by losses in our alternative investments that exceeded our dropdown expectations despite being generally aligned with or better than comparable benchmarks in returns from our investment classes.

Rather than spending a lot of time with performance data which we provided in our update on investment portfolio announcement and related presentation on October 13, 2008, I will provide some portfolio commentary and leave more time to answer your questions later on in the call.

Total invested assets amounted to $5 billion of September 30, 2008, representing a ratio of invested assets including cash to shareholders equity of 3.9:1. During more normal times, we believe that having higher investment leverage aids in managing through the underwriting cycle and it is a strategy that we pursued. Today, we are not in normal times and our investment performance is the principal contributor to our year-to-date loss. We have sought to adapt to the current investment climate by reducing our investment leverage and exposure to alterative investments and by increasing our cash balance.

At September 30, 2008, $4.1 billion or 81.4% of our invested assets consisted of cash and high-grade fixed maturity securities that have a weighted average credit quality rating of AA+ with more than 99% of our fixed maturities rated A or higher. Approximately 50% or $2 billion of this cash and fixed maturities portfolio is comprised of cash of $650 million or 16%, government and agencies approximately $850 million or 21%, and US agency NBS which is $525 million or 13%. Our corporate exposure $1.4 billion or 35% is diversified with over 200 different issuers with our largest single issuer being AAA rated and approximately 1.2% of this portfolio.

The remaining portfolio, $600 million, or 15% is comprised principally of AAA rated asset-backed securities, lateralized mortgage obligations, and commercial mortgage-backed securities. Sub-prime and Alt-A exposed mortgage-related securities is $68 million or 2% of the portfolio and has a weighted average life of approximately two years and continues to pay down. We continue to expect no principal losses on our sub-prime and Alt-A holdings.

Credit issues in the fixed maturities portfolio have been largely avoided to date and are minimal. We did take an impairment charge of $14 million on $15 million par value of Lehman bonds during the third quarter. Net investment income was $45 million for the quarter ended September 30, 2008, versus $50 million for the same period in 2007, a decrease of approximately 10% principally due to a current desire to hold more cash as well as due to the impact from lower yields.

Our high quality fixed maturities portfolio was not immune to widening credit spread, yet, still produced a return of 31 basis points for the 3 months ended September 30, 2008.

Alternative investments were $930 million or 18.6% of our invested assets. The alternative portfolio produced a negative return of 12.99% during the quarter ended September 30, 2008, resulting in a year-to-date negative return of 11.98%. The HFRI Fund of Funds Index which we believe is the most comparable benchmark for this asset class produced negative returns of 9.63% and 11.84% respectively over the same period. Last year, our alternative investments returned 1.19% in the third quarter and were up 12.18% in the 9-month period.

While all the focus is appropriately centered on current investment returns, during our existence, the alternative investment portfolio has contributed to total investment portfolio returns and to book value growth. Since January 1, 2007, and over the past 60 months, our alternative investment portfolio has produced compound annual returns of 2.96% and 4.94% respectively compared to HFRI Fund of Funds Index which has produced compound annual returns of negative 2.8% and positive 5% over the same period.

As previously stated, we have made a decision to reduce our target allocation to alternative investments with our new range being 10% to 20% of invested assets and the current target toward the middle part of the range. We are moving towards this target from fund redemptions and anticipate reaching our target in early 2009. In addition, we are re-balancing our portfolio in an effort to reduce the volatility of returns and lower our correlation and exposure to relevant market factors such as SMP, credit, and interest rates.

Very preliminarily for the month of October, we estimate that our alternative investment portfolio returned a negative 4% or a dollar loss of approximately $42 million. By way of comparison, the HFRI Fund to Funds Index return was negative 9.3% and the SMP 500 was down approximately 17% in October. Actions that we are taking to reduce our alternative investment exposure, specifically redemption and re-balancing to a more market neutral portfolio appear to be working.

Turning to reserves, our property and casualty loss reserves were $2.6 billion at September 30, 2008, an increase of approximately $300 million from $2.3 billion at December 31, 2007, with approximately 65% of these reserves being IBNR reserves. Our life and annuity benefit reserves were $1.2 billion at September 30, 2008, with a reserve balance that is unchanged in amount since December 31, 2007, with movements from claim payments, new business, and foreign exchange translation, all netting year-to-date.

We continue to generate solid operating cash flow and we believe that our capital position is strong. Shareholders equity at September 30, 2008, was $1.3 billion or $21.88 per fully diluted share versus $1.6 billion or $25.59 per fully diluted share at December 31, 2007. The decrease in book value year-to-date is principally due to net losses on alternative investments and net unrealized and realized losses from our fixed maturity portfolio.

As we said on last quarter’s call, we were more prudent in re-purchases of our stock during the third quarter 2008 repurchasing about 110,000 shares outstanding. Year-to-date through September 30, 2008, we have re-purchased approximately 3.9 million shares outstanding or 6.7% of shares outstanding as of the beginning of the year. Today, we have $73 million or re-purchase authorization from our board, however, given the current volatile investment environment and the potential for improved underwriting opportunities stemming from both the hurricanes and the industry wide investment performance during the third quarter, we do not anticipate making any further repurchases in 2009.

Finally, we have declared a dividend of $0.09 per share which is payable on December 1, 2008, to shareholders of record as of November 17, 2008.

I will now turn the call back to Marty for his final remarks.

W. Marston Becker

What we would like to do now is open up the call for questions. We ask you to bear with us because Joe, Jim, and I are in different locations, so we may pass a question back and forth during the period.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Joshua Shanker with Citigroup.

Joshua Shanker - Citigroup

First question, I would like to see your outlook for life re-insurance opportunities.

Joseph W. Roberts

Actually, the life re-insurance world is in the midst of producing more opportunities as life carriers like everyone else are having their respective balance sheet issues and they would like to do more portfolio transactions.

Joshua Shanker - Citigroup

And does that require you to be marketing ideas, are they coming to you, have you seen in-bound flow of people looking to buy stuff from you, are you looking to new products, what does that mean?

Joseph W. Roberts

My comment is based on in-bound queries about doing portfolio transactions similar to what we’ve done in the past with life carriers.

Joshua Shanker - Citigroup

And that would be principally around mortality and morbidity, would you guys be doing guaranteed benefits, where has that brought you?

Joseph W. Roberts

Where we typically have played has been more annuity like pension type products.

Joshua Shanker – Citigroup

And second question, there is this common theory of investing, buy low sell high, does it necessarily make sense right now, are you being reactive in lowering the share of the portfolio in alternatives or are you being proactive, and in terms of the way the rating agents look at assets that are mixed in, all things being for the same amount of assets, what sort of increased capacity do you have from choosing more traditional investing styles from pool of assets?

W. Marston Becker

We’re being very proactive and likely would be doing this even without the terrible third quarter simply with our growing book of traditional reserves and the growing strength and presence we have in our underwriting platforms, 15% is probably a more appropriate level as Max looks today. I think if you see us go down to the 10% level in alternatives, it’s totally a reaction of our view of being able to put that capital to work better through merging better underwriting opportunities vis-à-vis the returns in the investment markets, but I totally agree with your opening comment that this is a time probably to buy more absent other business considerations which frankly are more attractive.

Joseph W. Roberts

The rating agencies typically charge a higher charge on the non-traditional investments than they do in the traditional. So as you re-lever your alternative investments, it does provide more additional capital for underwriting purposes.

Joshua Shanker – Citigroup

And given your view of the marketplace, would you expect that 2009, whatever this means, you will have fully deployed your capital into underwriting where you can?

W. Marston Becker

Well, fully deployed the capital that has not continued to be held in MDS, but yes, our view at the moment is that 2009 is going to be increasingly attractive as the year progresses.

Operator

And your next question is from the line of Rohan Pai with Banc of America Securities.

Rohan Pai - Banc of America Securities

Just trying to get a sense, you said that the alternative investments carry a higher capital charge, could you give us a sense relative to your fixed income securities what the capital charge is on your hedged fund portfolio just so that we get an idea of how much capital could potentially be freed up?

Joseph W. Roberts

Well, it’s probably easier to compare it to equities and it would ordinarily take an additional 10% charge than equities would.

W. Marston Becker

And the fixed income typically carries a charge between 4% and 10% and the hedge funds are carrying a charge of 25%, so you can do the math, it’s a lot of capital.

Rohan Pai - Banc of America Securities

The second question, Marty, so we’ve been hearing about potential dislocation in the excess casualty and professional lines arenas you do, maybe difficulty with some of your larger competitors, is that something you’re seeing at this point or is it still mostly property CAP in the conversations.

W. Marston Becker

At this point, you’re not seeing it in pricing, part of it is some of the places that’s likely to come from or in what I would call desperation pricing mode as they work to retain their business, but logic would tell you, given the magnitude of the dislocation of both people and capital and the entities that have been most impacted in what their book of business is composed of is that’s going to be beneficial as to 2009 progresses for everybody else on rates.

Rohan Pai - Banc of America Securities

And then finally for Jim, the October performance seems much better than what the hedge fund indices, how much is attributable to changes in your portfolio diversifying and reducing volatility and how much is just the old portfolio that’s I guess performed better than the indices?

N. James Tees

Lot of it is part of our rebalancing and we had basically started doing some rebalancing in the third quarter, so you’re seeing the impact of us redeeming from starting underwriting funds that just don’t meet our volatility appetite and then as we seek to go to cash and as we see a better market, then we’ll start to actually rebalance in terms of adding some names that we think fit the portfolio appropriately.

Rohan Pai - Banc of America Securities

Are you in a position to give your long-term hedge fund return target, I think it used to be 8%, do you know what it would be now?

N. James Tees

We’re still in the early phases, but when we did a portfolio review and we’ve done some back testing, we still think that there is a reasonable probability is that this portfolio can go between 7% and 8%.

Operator

There are no further questions in queue at this time.

W. Marston Becker

We appreciate everybody joining us on the call. It’s been a pretty active quarter for Max and everyone else in the financial world. We really appreciate your participation, and while it has been a difficult investing quarter, further prospects are quite bright with the expanded underwriting platforms that Max presents today, and that we developed over these past 2 years. So, we should be well positioned to capture these opportunities and look forward to speaking with you again either when we’re out on the road on at our February call. As always, we would welcome individual queries, so feel free to call Jim or Joe or myself. Thank you very much.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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Source: Max Capital Group Ltd., Q3 2008 Earnings Call Transcript
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