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Endurance Specialty Holdings Ltd. (NYSE:ENH)

Q3 2008 Earnings Call

November 7, 2008 8:30 am ET

Executives

Gregory Schroeter - Vice President of Investor Relations and Corporate Development

Kenneth J. LeStrange - Chairman of the Board, President, Chief Executive Officer

Michael J. McGuire - Chief Financial Officer

Michael E. Angelina - Chief Actuary, Chief Risk Officer

David S. Cash - Chief Underwriting Officer

Analysts

Susan Spivak - Wachovia Capital Markets, LLC

Ian Gutterman - Adage Capital

Matthew Heimermann - J.P. Morgan

[Lee Feingold] - Fox-Pitt Kelton

Jay Cohen - Merrill Lynch

[Steven Wan - Trilogy Advisors]

Alain Karaoglan - Banc of America Securities

Operator

Welcome to the Endurance Specialty Holdings third quarter 2008 earnings results conference call. This call is being recorded. Your lines will be in a listen-only mode during the presentation. You will have an opportunity to ask questions after the presentation. Instructions will be given at that time. I would now like to turn the call over to Greg Schroeter, Vice President of Investor Relations and Corporate Development.

Gregory Schroeter

Welcome to our call. Hosting today’s call will be Ken LeStrange, Chairman, President and Chief Executive Officer, Mike McGuire, Chief Financial Officer, David Cash, Chief Underwriting Officer, and Mike Angelina, Chief Actuary and Chief Risk Officer.

Before turning the call over to Ken, I’d like to note that certain of the matters that will be discussed here today are forward-looking statements. These statements are based on current plans, estimates and expectations. Forward-looking statements involve inherent risks and uncertainties and a number of factors could cause actual results to differ materially from those contained in the forward-looking statements. Forward-looking statements are sensitive to many factors including those identified in Endurance’s annual report on Form 10K and other documents on file with the SEC that could cause actual results to differ materially from those contained in the forward-looking statements. Forward-looking statements speak only as of the day on which they are made and Endurance takes no obligation publically to update or revise any forward-looking statement whether as a result of new information, future developments or otherwise.

I would now like to turn the call over to Ken LeStrange.

Kenneth J. LeStrange

Welcome to our third quarter earnings call. The third quarter of 2008 will be remembered as one of the most significant times in economic history. We have witnessed the destruction of a massive amount of wealth and the demise or crippling of some of the largest and well respected financial institutions in the world, unprecedented government intervention in private industry on a worldwide basis, and perhaps most importantly a crisis in credibility and confidence has impacted every constituency having contact with the financial services industry.

A global recession seems likely and may have already begun, and some fear that a depression is greater than a remote possibility.

Third quarter has taught the world a great deal about risk. Our industry has been affected in ways that were unimaginable a few months ago. Investment losses and the impact of Hurricanes Ike and Gustav have severely damaged some insurers and reinsurers. Capital in the industry has declined significantly as a result.

Against this backdrop I am pleased with how Endurance has performed in absolute and relative terms. From a catastrophe perspective our book of business performed within our risk tolerances and expectations. We saw no surprises in our portfolio and we were able to assess our exposure quickly and accurately. No losses were experienced in our insurance bucket. The portfolio adjustments we implemented in 2006, in particular relating to offshore energy and reinsurance for specialty property insurers, served us well.

Our investment portfolio while affected by the financial markets generally performed very well on a relative basis. To date our strategy has been to assume risk in our company through our underwriting activity and to invest our portfolio in a conservative manner to ensure our financial strength and our ability to fulfill our promises to our clients.

Over the last seven years we have not seen an appropriate reward/risk ratio that would compel us to assume greater investment risks than we have. As a result our fixed income portfolio has a short duration of about three years and an average credit rating of AAA. We have not seen a material level of downgrades or other indicators of deterioration in the quality of our investments.

Our alternative investment portfolio has performed in line for this investment category and has outperformed the equity markets and high yield bond funds year-to-date.

When one considers the effects of Hurricanes Ike and Gustav and the decline in the fixed income and equity markets on the insurance industry, Endurance’s year-to-date decline in book value per share of 3.9% compares favorably to our peers and is a validation of our enterprise risk management.

I will now turn the call over to Mike McGuire to review our financial results and capital position.

Michael J. McGuire

Our reported results for the third quarter were in line with our earlier pre-announcements. We reported a net loss in the quarter of $99.4 million and $1.79 per diluted share. Our operating results which excludes realized investment and foreign exchange gains and losses was a loss of $56 million or $1.04 per share. For the first nine months of 2008 Endurance earned net income of $81.8 million and $1.10 per diluted share. Operating income was $138 million and $1.99 per diluted share.

As noted in our earlier announcements, the third quarter’s results were negatively impacted by Hurricanes Ike and Gustav as well as from mark-to-market losses in our alternative and fixed income investment portfolio.

Our combined ratio was 112.6% in the third quarter and 96.7% year-to-date compared to 79.6% and 81.6% in the same periods of 2007. Several items influenced the current quarter’s combined ratio. The largest influence on our combined ratio came from $140 million in net pre-tax losses from Hurricanes Ike and Gustav which added 28.1 points to our combined ratio in the quarter and 10.7 points year-to-date. Excluding Ike and Gustav, our combined ratio would have been 84.5% for the current quarter and 86.2% year-to-date.

Our losses from Ike and Gustav were contained within our reinsurance segment, the majority coming from our catastrophe line of business with a small amount of losses from our property reinsurance line. We are pleased with our results in this space especially given our prominence in the property catastrophe market. Year-to-date even with the hurricane losses our catastrophe line of business has generated a combined ratio under 100%.

Our combined ratio was also impacted by favorable prior year reserve development of $18.4 million in the quarter and $115.6 million year-to-date. Favorable prior year reserve development improved our combined ratio by 3.6 points in the quarter and 8.7 points year-to-date. Our results this quarter were also impacted by $19 million of favorable current accident year reserve development.

Finally, during the quarter our agriculture insurance business saw improved crop growing conditions and some recovery from Midwest flooding partially offset by reductions in commodity prices. The overall impact of these items was a reduction in our expected loss ratios for the year. Year-to-date our agriculture insurance business has generated a combined ratio of approximately 95%.

Moving to the top line. Gross written premiums for the third quarter were $624.1 million, an increase of 47.5% over the third quarter of last year. The growth in premium was largely driven by the agriculture line in our insurance segment where we wrote $196 million of premiums in the quarter. These writings were largely from winter crops.

Our insurance segment also experienced growth in professional and property lines but saw declines in workers’ compensation as we are beginning to take a more cautious stance in the California workers’ compensation market.

Within our reinsurance segment excluding $21.4 million of reinstatement premiums in our catastrophe line of business due to Ike and Gustav, premiums were down slightly mainly due to reductions in our casualty reinsurance line.

Turning to investments. Virtually all categories of the equity and debt markets exhibited negative performance during the third quarter. The S&P 500 declined 8.4%, investment grade corporate declined 7.5%, and structured credit markets declined in a range of 2% to 5%. Commodity and currency markets also exhibited extreme volatility. Absent the 100% allocation to US treasuries it would have been very difficult to avoid losses this quarter.

We continue to be pleased with how our portfolio has held up in the face of unprecedented market volatility. Our net investment income was $27.4 million compared to $62.6 million in the third quarter of 2007. Our investment income this quarter included $32.8 million of mark-to-market losses from our alternative investments representing a -8.9% return during the quarter. Although disappointing in absolute terms, on a relative basis this result is comparable to various hedge fund indices and has outperformed equity investments and high yield bonds year-to-date.

Our fixed income portfolio continues to carry an average rating of AAA. 52% of our total cash and invested assets are in cash or in securities backed by the US government. 25% of our portfolio is in non-agency residential and commercial mortgage and asset-backed securities with AAA average ratings and strong underlying subordination. 17% of our portfolio is in highly rated investment grade corporate, foreign government and municipal government securities. The remaining 6% of our portfolio represents our holdings of alternative investments and high yield bank loan funds.

During the third quarter our investment results including all realized and unrealized losses and net investment income was a loss of $74 million. This represents only 1.3% of our total cash and invested assets and 2.9% of our total shareholders’ equity as of June 30, well within our capital and risk management tolerances.

On the capital management front we continued to actually manage our balance sheet, repurchasing 2.2 million shares for $70.1 million. Year-to-date we have repurchased 3.9 million shares for a price of $134.6 million. This represents approximately 7% of the beginning of the year shares outstanding.

We ended the third quarter with total capital of $2.7 billion down $243 million from year end largely driven by share repurchases, dividends and unrealized investment losses offset by year-to-date earnings. Our diluted book value per share was $33.68 up $0.87 from a year ago and excluding the $1 per share of dividends we paid over the last 12 months. Our change in book value represents an increase of approximately 6% from a year ago.

We remain extremely well capitalized with strong rating agency capital levels. Our liquidity position is exceptional with large amounts of cash, over $1 billion of expected annual investment portfolio cash flows, a $1.2 billion credit facility, $150 million of available equity, and strong operating cash flows.

As Ken stated, it is clear that the financial and competitive landscape of our industry has changed dramatically. Although we have prudently managed our balance sheet to optimize our long-term cost of capital, it is clear that the opportunity cost of capital and the cost of obtaining new capital have increased. We have incorporated this view into our planning and return targets for 2009. We are well positioned with excellent financial strength and liquidity, strong ratings and experienced people, and we are ready to take full advantage of the market opportunities ahead of us.

I will now turn the call over to Mike Angelina.

Michael E. Angelina

Our launch ratio for the current accident year was 77% which translates into a 105% combined ratio for the first nine months of 2008. The 2008 combined ratio is comprised of 104% for the insurance segment and 106% for the reinsurance segment. The 2008 loss ratio includes 11 points due to Hurricanes Ike and Gustav. Excluding catastrophes, the 2008 loss ratio is about 10 points higher than our current view of accident year 2007. This is consistent with industry loss ratio trends and is driven by the following factors.

First, mix changes. Particularly due to the agriculture insurance business which we are currently booking at a 95% combined ratio accounts for 4 points. Additionally, grade level softening in most of our lines of business accounts for approximately 4 loss ratio points and our reserving philosophy for short tail lines of business in particular accounts for the remaining 2 to 3 loss ratio points. Across both segments our non-catastrophe book loss ratio for our short tail lines of business is 40% for accident year 2008 versus 34% for accident years 2006 and 2007 on a non-cap basis.

As we had discussed in our prior calls, it is our process to initially establish IBNR reserves based on both the catastrophe and the attritional portions of the loss estimates and then replace expected losses with actual losses based on our emergence pattern. As a result of this methodology we typically hold more IBNR for attritional losses than others but feel this approach while prudent is appropriate. For the 2008 accident year in addition to our provision for Ike and Gustav, we are holding $150 million of IBNR for both the catastrophe and the attritional losses.

With regard to the pricing environment for the first nine months of 2008 our overall rate monitoring indicated a decrease in pricing across most of our business lines. Along with decreases in pricing in the first three quarters of 2008 we saw softening terms and conditions across most of our reinsurance lines while the insurance lines were more mixed. In the first nine months of 2008 we continued to shift our mix of business and non-renew business that no longer met our profitability target in order to maximize our opportunities in response to the then prevailing market conditions.

Both our insurance and our reinsurance businesses in Bermuda experienced high single-digit price decreases during the first nine months of 2008 on what is a large base of renewal premiums. However we have begun to see signs of market hardening in some of these businesses.

For the US insurance businesses the pricing was more challenging in the first three quarters of 2008 especially for certain types of property risks where the industry pricing did not appear to support the amount of capital consumed, particularly with regard to the rating agency capital.

In the US reinsurance area we also saw mid-single-digit rate decreases for both property and casualty risks through September 30, 2008. However the business we wrote during that period is still within an acceptable return relative to the required capital. It is also worth noting that the renewal premiums comprised approximately 90% of our year-to-date premium in this area. We have a long history with many of our US reinsurance clients and we’ve accumulated much experience from years of underwriting and claims audit.

As we enter what will be a very different market, we have refined our underwriting targets to be more reflective of both the actual and the opportunity costs of new capital and the correlation to other lines within the Endurance group. In our refinement we also considered regulatory and rating agency capital needs along with our corporate return requirements.

Our loss reserves across all prior periods which include the first six months of the 2008 accident year developed favorably in total by $37 million in the third quarter of 2008 with the majority arising from the insurance segment. Approximately $19 million of this favorable development is attributable to accident year 2008 with virtually all of the favorable emergence arising from our short tail lines of business as the actual loss experience was less than expected for the premiums earned in the first half of the year.

The remaining $18 million of favorable development observed this quarter arises from accident years 2007 and prior with the development being driven by the insurance segment. This favorable development arose from our long tail health care liability line as claims activity was significantly below expectations.

For our casualty lines in both our insurance and our reinsurance segments IBNR reserves represented approximately 81% of our total long tail reserves of $2 billion. Our Bermuda-based casualty insurance line has $750 million of this IBNR versus $60 million of case incurred losses. Exception to date, the book loss ratio for long tail lines of business in our reinsurance segment is about 63% across all accident years or within a point of initially priced.

It is a testament to our enterprise risk management culture that throughout the subprime and the current financial market crisis we have not experienced any significant adverse development in our casualty reserves. While we will have exposures, we currently believe that our expected losses are adequately contained within our current IBNR levels.

Next quarter as we release our loss development triangles you will once again have your own chance to perform your own perspective on our IBNR levels.

I would now like to turn the call over to David Cash.

David S. Cash

As you know, the third quarter was a challenging one in just about every way. On my portion of the call I will focus my comments on the following areas: Endurance’s exposure to Hurricane Ike, the year-to-date performance of ARMtech our crop insurance operation, changes in the underlying underwriting environment for large casualty and property insurance risks, and anticipated market conditions and Endurance’s expected underwriting posture as we enter 2009.

The 2008 hurricane season. After two years during which no significant hurricanes made US landfall, Hurricane Ike hit the Galveston/Houston area as a very large Category 2 hurricane. What Ike lacked in terms of intensity, it more than made up for in terms of size and duration. The nature of the storm was such that it generated offshore energy losses, onshore personal lines and commercial lines losses in Texas, as well as flooding losses as far away as Illinois and Ohio.

Given the complexity of the storm it is not surprising that today there are still differences in opinion within the industry as to the ultimate size of the storm. Our working assumption is that Hurricane Ike will turn out to be a $20 billion industry event but almost certainly makes Ike one of the 10 largest hurricanes on record and a big enough event to cause some hardening in the catastrophe market on its own.

For Endurance, Hurricane Ike represented a good test of the changes we made to our catastrophe underwriting and risk management strategies in 2006. At that time we discontinued a number of classes of catastrophe exposed business, both reinsurance and insurance and reallocated that capacity primarily to our property catastrophe line of business.

In addition, for the last two years we’ve focused our property catastrophe business on writing smaller regional personal lines underwriters, the same companies that bore the brunt of Hurricane Ike. Notwithstanding the skew in our portfolio towards personal lines reinsurance clients, our portfolio performed very well through the event. Our combined hurricane losses net of reinstatement premiums were $140 million, a very good number when one considers that our current in force cat premiums are $315 million. Hurricane was a validation of our underwriting approach for cat risk and makes us feel confident in our catastrophe portfolio heading into 2009.

ARMtech crop insurance. The 2008 crop year started off with some rough weather. The Midwest floods and the early drought conditions in Texas and California both had the potential to turn into very significant losses for the crop insurance industry. As the year played out, neither the floods nor the drought conditions proved to be too serious.

The damaged crops were replanted in the Midwest and experienced strong growing conditions for the balance of the season. In Texas and California the drought conditions eased materially in the third quarter. If those two nemeses were not enough for a combination of careful use of the federal sessions program and timing, the Texas cotton crop dodged a bullet in the form of Hurricane Ike.

From a harvest perspective the 2008 year looks to be on track to record a normal yield level for the industry. That fact alone should ensure that the industry and ARMtech have a satisfactory year. The only issue that remains to be resolved for the industry is that of price levels. There’s still approximately 25 days of price discovery remaining before we will know the prices that will be used to compute farm revenues for purposes of establishing losses under revenue assurance policies.

For the crop insurance industry the question has always been the following: To what extent are price movements driven by changes in expected yield levels? To the extent the price changes simply reflect a change view of the expected yield at harvest time the changes tend to offset each other. In a year such as 2008 where there are some material external forces at work it’s what’s clear that this offset will exist.

For purposes of reserving the ARMtech book of business we took the more conservative position that yield and price levels would not balance each other out. As a result of the approach we took we believe that our year-to-date projected combined ratio of 95% remains a good estimate even with some recent price erosion in the futures market.

The large risk property and casualty insurance market. The distress that the financial services sector experienced in the third quarter created some unexpected fallouts in the P&C insurance industry in general and the potential for some significant opportunities for companies such as

Endurance. The most critical aspect of the most recent turbulence in our industry will be the challenges that several large specialty underwriters have experienced.

As these challenges play out there will likely be significant opportunities for specialty underwriters such as Endurance to pick up those individual clients and businesses. As of today we are seeing the following types of activities in response to these significant events.

In the large risk insurance market we are seeing brokers and clients take a much more conservative approach to assigning large lines to individual insurers. Further the lead positions on program are often being changed allowing the market to re-underwrite and reprice risks. This approach of restructuring and re-syndicating placements will likely continue for some time.

While our small risk businesses had been placed previously with an insurer that is now viewed as financially challenged brokers, agents and program managers are increasingly looking to form new relationships in order to ensure themselves a durable insurance report.

On the human resource side we are increasingly being approached by individuals from distressed companies to discuss the possibility of joining Endurance. It appears there’s a flight to safety taking place and it will have an increasing impact as we move into 2009. As some of the large underwriters go through a lengthy period of right sizing, companies such as Endurance are ideally positioned to capitalize on the changes and dislocations that will certainly occur.

In the short term we have and will continue to see some aggressive price reductions on the part of the most challenged underwriters. That said, we are starting to come out the other side of these reductions with clients increasingly opting to renew their programs at flat to increased pricing in order to place their business with companies that are not surrounded by financial uncertainty.

At Endurance we’ve experienced the shift in a number of areas. For large Fortune 1000 casualty insurance clients our new business flows have grown materially and our bound new business volumes are up over the first half of 2008 even as we are increasing our pricing targets.

On the agricultural insurance side independent agents are beginning to reach out to ARMtech to establish relationships in advance of the 2009 crop year. We expect our financial stability and client service to attract this business as it moves from its current providers. Program managers, risk retention groups and managing agents are increasingly concerned about their exposure to troubled insurers. These non-broker and agent sources of business are traditionally very conservative when it comes to their insurance partners. As a result we’ve seen an increasing flow of high quality opportunities in this area.

Finally, in the commercial property markets we are seeing clients grow increasingly cautious about which insurance carriers they use which reduction and acceptable capacity in the market will likely lead to increased prices on all catastrophe exposed risks in the US, something that will benefit both our property insurance and reinsurance businesses.

Endurance’s underwriting posture for 2009. Based on what we know today we expect the most likely scenario is a staggered from of market hardening starting in the reinsurance market and then bleeding over into the insurance market. We believe that some markets will experience the hardening more abruptly than others. The catastrophe reinsurance and Fortune 1000 insurance markets stand out. For smaller risk grade we expect the changes will filter down more slowly.

As we prepare for the year end the key underwriting issues that Endurance is focused on are as follows.

Capital management. The concept of capital consumption is most firmly imbedded in the reinsurance market where most companies manage their portfolios to rating agency capital constraints. This consideration has the potential to create significant pressure to increase catastrophe prices throughout 2009.

Client quality. In both our insurance and reinsurance segments we view potential market hardening as an opportunity to improve the quality of our book of business. On the insurance side this means ensuring we’re seeing all the business our producers generate while on the reinsurance side this means paying particular attention to our most attractive markets and strongest insurance partners.

Monitoring the market. Endurance is actively underwriting 30+ classes of business across six major markets. As a result we spend considerable time monitoring our markets for news and underwriting opportunities. Our goal is to ensure that we’re allocating resources and efforts to the right markets at the right time. If we balance the various demands on our capital well we can expect Endurance to emerge from this market greatly strengthened.

With that I’ll turn the call over to Ken for his concluding remarks.

Kenneth J. LeStrange

Looking forward to January 1, 2009 and beyond we believe that the insurance and reinsurance markets will present Endurance with many opportunities to leverage our existing infrastructure and to expand our specialty businesses. It is difficult to predict where and to what degree markets will harden but we are already seeing positive signs and greater demand for our products and services from our clients.

I would like to share with you what we believe will be the most significant drivers of a potentially improved underwriting and pricing environment. For those in the insurance industry needing capital, reinsurance may at this time be the best and perhaps only alternative available. Reductions in the net profitability of many insurers combined with the significant decline in industry shareholders’ equity would indicate a need for direct insurance industry participants to increase rates.

Industry investment returns for 2009 are likely to be volatile. For insurers and reinsurers we anticipate that underwriting profitability will need to be the driver of return on equity. With a greater focus on the amount and quality of counterparty risk we expect to see a broader syndication of insurer and reinsurer counterparty risks. As a result of changed views of borrowing capacity in Florida, we expect significantly greater demand for private reinsurance market capacity.

Issues faced by financially impaired insurance industry participants have the potential to drive a significant redistribution of business to other specialty insurers and reinsurers and a corresponding reconsideration of pricing associated with that business.

Against this backdrop I’m excited about how Endurance is positioned. Endurance possesses exceptional financial strength and liquidity while providing a level of transparency related to our financial position that is highly valued by our various constituencies and particularly our clients.

We have a leading global reinsurance platform with strong capabilities in property, cat and onshore platforms in the US, Europe and Asia. We also have leading capabilities in a number of specialty reinsurance products. Our insurance platforms in Bermuda and in the US are well positioned and have an operating motto that is quite scalable. We expect to see in 2009 the value of our investments in a wide variety of specialty insurance lines.

Our clients and distribution networks are reaching out to Endurance as a go-to market to provide them with the risk transfer capacity that they need. We have identified the ways we intend to optimize the returns on capital in the current and coming environment, and Endurance’s employees are poised to utilize their ample skills to maximize the benefits in the new market conditions for both Endurance and its clients.

As we look at the potential market opportunities coupled with the global franchise we’ve built, we are very excited and well equipped to respond to the opportunities and challenges of the coming year.

Operator, I’d now like to open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Susan Spivak - Wachovia Capital Markets, LLC.

Susan Spivak - Wachovia Capital Markets, LLC

You talked about the returns that even in the competitive market that we’ve had relative to your acquired capital has been satisfactory. Now we all know the cost of capital has gone up dramatically so what I’m trying to get a handle on is how much do rates need to rise just to stay even with a year ago? And to follow up on that, with the debt and equity markets seemingly closed how do you measure your cost of capital and how much business do you think you can write going forward on your current capital base?

Michael J. McGuire

I think there are several questions imbedded in that but let me give it a shot. As I said in my prepared remarks, we’ve spent a lot of time over the years constructing a balance sheet that establishes a very good cost of capital for ourselves. So I think the main change that we’ve seen is certainly the lack of availability of any new capital for companies that would need it and we feel very comfortable with our existing capital position that is financed for the long term.

Yet the opportunity cost of deploying that capital has increased and while I wouldn’t say how much we need to raise prices we’re certainly incorporating a medium term view of the higher cost of capital into our return expectations for the year. How much we see in the coming year is certainly going to be dependent upon the thousands of individual underwriting decisions and prospects that we see. But certainly we’re seeing pretty meaningful changes to our return targets as we look into 2009.

Susan Spivak - Wachovia Capital Markets, LLC

Mike, how much of that opportunity cost increased while you run your numbers and talked to your underwriters about January 1?

David S. Cash

Let me take a crack at it; maybe just to draw a distinction. In the period post 2005 there was a significant sense that people’s view of risk was wrong and the likelihood of loss was wrong so there was a need to reprice then to reflect that change of view of loss potential and then additionally need to reprice to reflect the cost of capital. So it’s sort of a two-fold thing. If we look at the market today we can certainly see it in places where our view of losses may go up just to reflect the recession but it’s nowhere near as significant as the change that occurred post 2005.

So the question as to how much to move our cost of capital up in many ways is driven by how constrained competitors feel they are with respect to capital. So our goal is really to push the cost of capital up internally as high as we can and still clear the market. Today we don’t know what that answer will be. We think in the cat lines of business that could be 10% or 20% rate increases. It might be beyond that. In some lines of cat it might not quite be that. Our sense in the non-cat driven reinsurance lines is probably the rates won’t go up quite that much to begin with. It’ll be some sort of staggered kind of lagging increase.

Our goal is to try and make sure that we don’t over reach in terms of rate but at the same time manage to make our book look as attractive as possible in terms of the mix of business and the clients. It’s sort of necessarily a kind of cyclical thing in terms of figuring out what the number is. That’s why we spend so much time just trying to read what the market is doing. The industry events that just occurred are a good indicator of where we should go. But I expect most of the course of correcting in terms of the sense of establishing the cost of capital will occur in the first two weeks of December.

Susan Spivak - Wachovia Capital Markets, LLC

As you look at what you know now, what do you see the business mix between insurance and reinsurance for 2009?

Kenneth J. LeStrange

I don’t think we’d be in a position to give you some guidance on what the mix changes will be between insurance and reinsurance. I think I’d like to underscore that it’s a pretty dynamic picture out there and depending upon the news that comes in the 30+ business lines that we’re operating in we’ll be deploying capital accordingly.

Operator

Our next question comes from Ian Gutterman - Adage Capital.

Ian Gutterman - Adage Capital

I was hoping you could clarify a little bit. Renaissance sounded a little bit more concerned about the impact of these revenue covers given where prices are going. Could you just talk about why you still think you’re okay with that? Do you have more of these contracts where there’s sort of the yield threshold to trigger revenue cover?

David S. Cash

The process of trying to picture final loss for the year is right now we’re in a phase where there’s a difference of opinion on what the final yields will be for the industry and based on that in the sense we probably have a slightly different view of final yields that what the commodities price market would be. If our view turns out to be correct, we think there’ll be support under the price levels for commodities going to year end. If we’re wrong, then what we think our projected yields will be will go up.

What we’re saying, this is maybe a little bit sort of circular, is that we’ve created a way of reserving our book at the moment where there’s an offset will run to our favor if that view of what the commodities market thinks of yields and we think of yields proves to be wrong.

In terms of the overall mix of our book of business we’re probably about 70% revenue assurance type products, we tend to be very careful about using the federal sessions to manage that risk where we think we have crops that have extreme volatility. So in the case of Ren they take a different view on how to use federal sessions. They could feel more exposure to commodity prices than we would say we are right now.

A slightly garbled response. It’s incredibly hard to work through the offset between yield and commodity price right now but we think we are in the right spot today.

Ian Gutterman - Adage Capital

Just remind me of your exposure to soybeans? It seems that’s where there’s the greatest yield risk.

David S. Cash

It’s a relatively small part of our portfolio. I don’t have the number right in front of us. We are skewed towards cotton which is more stable; then it would likely be corn after that. I’m going to pick a number like 20% for soy. It could be less than that.

Ian Gutterman - Adage Capital

On the workers’ comp pullback, I think we talked about this a little bit before, but given the opportunities elsewhere does it make sense to write any of that next year or maybe a better way to say it is to ramp it down as quickly as you can given that pricing isn’t going up there the way it is going to be elsewhere and it would free up capital to write other business?

Kenneth J. LeStrange

I actually agree with your statement there. We’ve been working with our underwriting partner in terms of our positioning for ’09 and you’ll see in this quarter that we’ve dropped our writings in a reasonably significant way.

Going forward we have a very cautious demeanor to the workers’ compensation climate in California despite the projected rate increases and so forth. We think there are other things working on that system too that may impact the profitability negatively going forward. I would say that we’re not seeing signs of that yet. I want to be quick to mention that. But as we mentioned time and time again, we would tend to exit early rather than late on the California comp market.

Ian Gutterman - Adage Capital

One of the things I’m thinking about as far as what kind of response we get not just at 1/1 but as the year plays out next year, there’s obviously contracts where you either reinsure AIG or you’re on a tower where AIG is a lead and you’re behind them. The blunt of my concern would be being above them in a tower, reinsuring them that as they’re losing people and so forth, their ability to service their clients the way they used to and to administer claims and all those sorts of issues gets to be more troubling. Ken, obviously you’ve talked a lot about in the past picking your clients well. Do you think we might have an issue?

Kenneth J. LeStrange

[Inaudible] very modest demand of assumed reinsurance from AIG in a couple of very targeted areas that we monitor very closely. In terms of the tower observation, that’s a very astute observation and one of the underwriting criteria that we’re applying today is looking down in the tower for what the security will be as we renew or write new business. I would have caution about players that would be potentially in distress below us from a claims handling and other perspectives, so we’re applying that insight to our underwriting and positioning in our excess casualty business, D&O, in our Bermuda platform as well as onshore.

Ian Gutterman - Adage Capital

I’m thinking there might be some clients who feel some loyalty to AIG and want to stay with them and maybe with the broker launch to help them stay with them. Do you think in those cases we might see issues where the rest of the companies that fill out that tower say we just don’t want to allocate our scarce capacity to that business when we can allocate to someone who’s a stronger lead?

Kenneth J. LeStrange

I wouldn’t be surprised to see that phenomenon. I have in fact observed some signs that are consistent with that observation.

Operator

Our next question comes from Matthew Heimermann - J.P. Morgan.

Matthew Heimermann - J.P. Morgan

Question just on the crop. One of the things I’m struggling to get my arms around is just with all the price movement we’ve seen to date, is it fair to think about maybe the delta between where prices are today and will settle out over the next 30 days or so relative to what they looked like in the first quarter as kind of being indicative of what would happen to your book if nothing changed year-on-year?

David S. Cash

I’ll try to answer that maybe indirectly. Crop prices right now are probably down about 25% over the beginning of the year. It’s not true crop-by-crop. That price reduction has in part come with sort of a changed view of what the yield will be. There’s a sense that yields will be up. There was some concern at one point yields would be down that drove prices very high.

That change reached the balanced yield with price is one that generally crop insurers find fairly easy to manage within their book. It tends to mean that the revenue products come in reasonably on target and what you tend to look at in that environment where the price is sort of being offset by yield move is if you have significant yield losses which create prices going up that seems to be a worse scenario than having normal yields with the price coming down.

In terms of where we are today right now, my perception of the disconnect that exists out there is probably three or four weeks ago the federal government came out and said crop yields were expected to be at sort of a bumper crop this year, maybe 100% to 105% of normal. A portion of the last part of the commodity price weakening we think we’ve seen over the last month comes from the market I think seeing that 105% and saying there’ll be a little bit of a surplus in the market, so the prices will offset to the downside.

Our perception internally is that we’re not going to have a glut. We’re probably at a normal yield or maybe a little bit below normal yield. What that would normally mean is if your yield comes in about right and you don’t have a sort of crazy exogenous thing like corn subsidies going away or whatever, you tend to get an offsetting impact and you only really start to worry about your product having a significant loss if yields are sort of closer to 90% frankly. That number may be a little bit too conservative. We feel we’re in that kind of range where price and yields offset.

We think that some of the recent price movement to the downside reflects maybe a slightly sort of elevated view of yield levels. From our perspective if it turns out yield levels are at 105% of expected, that’s probably a better answer for us but we’re not counting on that. If the market starts as if actively in a sense price in a recession, that might change things. But don’t forget, these crops are in a sense almost physically settled at the end of the year. It’s not quite a physical settlement. We price off the futures market but by the time you get to the end of the season, the futures market and the kind of physical settlement market should have all but converged.

Matthew Heimermann - J.P. Morgan

I actually was thinking about the question as I look into ’09. That’s all helpful color [inaudible] and it built on what Ian was asking about, but I was actually trying to look a little bit more forward just in trying to make sure I don’t screw up my ’09 expectations.

David S. Cash

I think I know understand that question. If I get that one wrong, then you can take me out and shoot me.

Crop prices this year were pretty elevated. There was the strong sense that prices were higher this year than they might be next year, and if price levels go down 10% next year, then the starting point for establishing your premium for next year on the revenue products goes down 10%, and actually on yield products it goes down 10%. I think you could look at that and sort of draw the conclusion there.

The flip side is our Ag team is being successful this year even in their kind of transition year at adding clients. I think we grew our policy count this year about 10%, maybe a bit more than 10%. We think a lot of our competitors next year will be under quite a bit of pressure. There are some large companies that have agricultural insurance operations that may well experience some sort of flight away so I’m not betting against our guys continuing to build their position in the market next year.

Matthew Heimermann - J.P. Morgan

I wanted to follow up on Ian’s other question on the workers’ comp. Is this something we should effectively think about being in a runoff at this point going forward? Should we expect this to kind of go to zero and how quickly?

Kenneth J. LeStrange

That decision has not been made but our statements earlier I think should color your thinking. There are some forces at work in the California comp market apart from the expected price increases at WCIRB and the State of California and such that we’re watching very closely. That really attends to benefit levels and other changes in the system there that may prove to be detrimental to insurers. I think when we do our earnings for the fourth quarter can give you a clear signal as to what to do and think about with regard to the workers’ comp business, but I think that would be premature right now.

Matthew Heimermann - J.P. Morgan

Related to that, previously this has been a line before market conditions changed where you potentially would have contemplated expanding if you saw a similar state situation develop as you did in California? Is there any pressure to maintain some type of relationship with your MGA just to ensure you have access down the road? Is that at all going to weigh into the thinking?

Kenneth J. LeStrange

No. None whatsoever. Actually we have encouraged them to introduce carriers, and this was several years ago, to the model that they’re running so that they would have support prospectively for their business model even if Endurance was not supporting it. So I think that issue is not a factor at all nor do we see any opportunities in other states at this time.

Matthew Heimermann - J.P. Morgan

There are obviously a lot of things moving and pieces are falling into place that could lead to a much better market than any of us probably anticipated even three months ago. What could go wrong from here that either leads to less firming or effectively no firming? What’s on your mind in terms of risk there?

Kenneth J. LeStrange

That’s a great question. I think, personal opinion, insurers have been slower than I would have expected to realize the changed environment from a capital point of view, from a risk point of view, from a capacity point of view. Most companies in our spaces, reinsurance and insurance, do a lot of their financial planning at this point in the year for the coming year. We frankly at Endurance had to tear up our plans from just a month ago and start all over given the changed environment, and obviously it’s a more pleasing environment than we had counted on for ’09.

I think that at the ground level insurer behavior is going to be an important bellwether. Some that I’ve talked to get it and are actively planning to price their business more fully in ’09 than they do today. One very large prominent company, the CEO has declared no price decreases so that’s a good thing. I think having a floor on the system would be a good thing.

Another thing that I do worry about is what happens with some of the distressed companies. Right now in the onshore insurance business we see them as a key driver of competitive behavior. They are fighting very fiercely to maintain their business, and how long that persists and whether it persists into ’09 will be a big factor because to a degree it does set a tone for the entire competitive dynamic.

I have also seen a couple of very large insurers who apparently view this as an opportunity to claim market share, being more aggressive than I think they need to or should be in terms of pricing business in this quarter. Whether or not that continues if it does continue, I think it will be a dampening environment factor.

On the reinsurance side I feel pretty confident now that what we’re seeing is consistent with the psychology and thinking of at least many re-insurers. I think part of the industry reinsurance has been more disciplined than the frontend through the last part of this cycle in terms of price and terms and conditions. As I mentioned earlier in the script that has really squeezed many insurers in terms of their net profitability.

I think reinsurers will have the discipline and prices will go up I think in the aggregate and then that will be a further impetus for I think insurers to have the resolve to raise their own prices. It will probably be a staged market turn much like we saw in ’06. I don’t think it’ll be a big bang like the post 9/11 environment in terms of a very broad and consistent market correction. It’ll be led by reinsurance and I think insurance will follow.

On the insurance side I think the Fortune 1000 or large risk business will lead; small risk business will lag in terms of the market turn.

Operator

Our next question comes from [Lee Feingold] - Fox-Pitt Kelton.

[Lee Feingold] - Fox-Pitt Kelton

Can you provide some color on how your alternative investment portfolio did in October and how you would expect that going forward into ’09?

Michael J. McGuire

We’ve only received some initial indications on the portfolio so at this point we’re not ready to put out a number in terms of what our alternative portfolio did, but at a macro level I would say that we’re seeing results consistent with the broad hedge fund indices that are out there at this point. As a reminder, the alternative portfolio of our investment portfolio is about 6% in total so it hasn’t been a large portion of our investment allocation but we’re certainly seeing results there that I’d say are broadly consistent with the major tracking indices.

Operator

Our next question comes from Jay Cohen - Merrill Lynch.

Jay Cohen - Merrill Lynch

You mentioned just now Ken that in ’06 there was sort of a staged improvement in market conditions and as I recall in ’06, I forget if you were one of the companies but certainly some companies essentially withheld some capacity early in the year expecting things to get better as the year progressed. As you think about the 1/1 renewals, is that something you are considering?

Kenneth J. LeStrange

Your memory is quite good. In fact we felt that the market at 1/1/06 had not corrected to the degree it was necessary to take into account the heightened capital requirements from rating agencies and the modeling changes which had not really been released yet but we were aware of as we underwrote our January 1, ’06 business. It is also important to note that what turned out in terms of the market hardening was it was largely insurance and DIC driven basically for Florida and California only in terms of the areas that were affected.

As we look at 1/1/09 we’re feeling that the reinsurance renewal season will be late. We are starting to work on business now but we don’t think the terms and conditions will resolve themselves until pretty late in the game. Therefore we’re watching what the market is doing quite closely and trying to draw a lot of information to our underwriting leaders and our actuarial leaders to make sure that we have a good view of that.

I wouldn’t say overtly that we are intending to reserve capacity at 1/1/09. I would rather say that we have developed a point of view in terms of what we need to obtain in terms of pricing and return on equity against our capital, and as David said if the market clears that, that will be fine. If it doesn’t, then we would be happy not to deploy capacity if that’s the case.

I want to stress too we are thinking very carefully about our clients’ needs and objectives against this backdrop as well. This is a time where many of them do need us and we want to be in a position to respond well to their needs.

Jay Cohen - Merrill Lynch

You also alluded to this in your script, but the Florida hurricane catastrophe fund and their potential inability to borrow money. I guess AM Best has come out and commented on that as well. You mentioned it could help drive demand for reinsurance for private market solutions. When would you see that? Isn’t that more towards the middle of the year or would you see some of that at 1/1?

David S. Cash

We queue very little of that at 1/1. Right now we know that some industry groups have had dialogue for Tallahassee both Department of Insurance but also at the government level and that dialogue so far is being I wouldn’t call it unsatisfactory but there’s no clearly message as to what’s going to happen. I think there’s this sense that the FACF won’t be there either in the size it is or maybe not at all. I would expect that message to be crystallized somewhere in kind of March. That’s my working guess right now. It has to be then; it can’t be later.

Kenneth J. LeStrange

If I could jump in, I’ve met with a number of Florida clients and prospects. These would be Florida only homeowners’’ companies and they’re obviously very close to what’s going on in Tallahassee. The current view, this is of last week, is that actually the legislative issues may not be resolved until deep into May and that’s one of the worries that they have. There’s a very unusual dynamic taking place in Florida and the rules of the game once again are going to be I think completely changed. How that plays out we don’t know but we’re obviously very close to our clients and we’re trying to stay abreast of changes with the government, the Department of Insurance and other constituencies to make sure we position appropriately.

Jay Cohen - Merrill Lynch

Do the AM Best views on this impact buying decisions or do you think it will? In other words, are your clients listening to what AM Best is saying?

David S. Cash

Many would. Some would listen less. There are some companies in Florida that have a sort of [DynaTech] rating. It wouldn’t really matter for them. But the large writers, they would certainly pay attention to what AM Best is saying. Typically those writers tend to buy more reinsurance. A number of them tried to position themselves not to be overly exposed to Florida but when they’re exposed to Florida they manage that risk pretty aggressively.

This is one place where I think uncertainty strongly plays to the reinsurance market’s favor. It would be a different matter if the reinsurance market has already had contingent commitments down already. They don’t in that space so it gives us a tremendous amount of flexibility to respond really as late as June 1 or even July 1 in terms of setting our portfolio. It creates a pretty tough environment for the insurers there, all kinds of insurers. But for us and our shareholders it’s a pretty good spot to be in.

Operator

Our next question comes from [Steven Wan - Trilogy Advisors].

[Steven Wan - Trilogy Advisors]

Given the 1/1/ renewals, can you talk about what kind of percentage of the books is going for renewals? Also given the dynamics of California workers’ comp and crop, can you looking at the top line maybe tell what the premium growth’s going to be for the next two years? And how the price increase is going to impact your share buy-back?

Kenneth J. LeStrange

We historically in going forward have not provided guidance on revenue and even if we did, I would say that this current market dynamic would compound any estimates right now. We can provide some visibility around that I think when we do our fourth quarter earnings call in February.

In terms of the amount of business that comes up at 1/1, most of the international reinsurance has an effective date of January 1 so on both the property cat and the risk business is a big anniversary season. Our US reinsurance book is less skewed to 1/1. That happens later in the year for us.

David, do you have some percentages you’d like to provide?

David S. Cash

On the reinsurance side around 25% to 30% of our book is renews for January 1. As Ken said, the international is skewed towards it on the cat side; a little bit less on the US side. The balance of the book is sort of spread out evenly in the second and third quarter, and then smaller in the fourth quarter. We’re expecting sort of a solid market at 1/1 and by the earnings call we’ll probably have an indication as to what pricing levels did. But I’m not expecting to have a good sense on price levels until really I’d say December 15 frankly.

Kenneth J. LeStrange

On the question regarding share repurchases, we have a Board of Directors meeting the week after next and that is one of the subjects we’ll be discussing with our Board. I would say that things that are influencing that discussion are certainly the state of capital markets and the potential inability to raise new capital is important in terms of considering our share repurchase strategy. The relative benefit buying back stock versus deploying capital in other ways, underwriting activities and the like, is another part of that dynamic.

Actually looking back my view is that we have been perhaps an industry leader in returning capital to our shareholders both through share repurchases and dividends. My personal take is that does not seem to have been valued as much as I would have expected it to in the environments that we’ve had in the past.

So we’ll have that discussion with the Board and again when we do our earnings call for the fourth quarter we’ll give you some visibility as to what our plans for share repurchases will be.

I want to be quick to mention that we were active in the third quarter despite it being hurricane season and that was an opportunistic decision that we made that I think has worked out well for us.

Operator

Our last question comes from Alain Karaoglan - Banc of America Securities.

Alain Karaoglan - Banc of America Securities

Ken, following up on your last comment, one, I will tell you that on our end the share repurchases have been appreciated. But in terms of your point about the volatile capital markets, the rating agencies being inconsistent, is that leading you to need more capital than you would have maybe a year or a year and a half ago and therefore do you have to earn a return on that capital and the price increases have to be that much more than it would have been otherwise from your point of view on your pricing?

The second question relates to the Fortune 1000 companies. One of the major players that has been having difficulties has been what I hear underpricing the business in the past couple of years. So getting the business at the prices they were charging in fact may not be very attractive let alone getting the business if we’re reducing prices. So don’t prices need to go up significantly for these Fortune 1000 companies to be attractive to you?

Kenneth J. LeStrange

Two excellent questions. I’ll address the capital question first. Rating agency constraints are important I think for all reinsurers and certainly for Endurance. We monitor our rating agency capital levels quite often and we make adjustments accordingly. We have certainly more than adequate capital for the ratings that we have and desire and we have above or beyond that of additional capital just to make sure so to speak. One of the things that obviously we’re watching is the effects of the investment portfolio. That has been very volatile from day-to-day, week-to-week and that does influence our thinking.

Your question about the prospective return on underwriting activities is right on the mark. We are viewing our capital as more scarce, more dear, more exposed to risk perhaps than we did as we started ’08. We cannot count on a level of investment return that we might have felt that we could get in prior periods given the nature of the disruption there. So prices do need to go up meaningfully and I would say particularly for the peak zones as we see them as a company. I think that that cognition is fairly broad now amongst reinsurers. We’ll see how it plays out in terms of market dynamics.

On the Fortune 1000 business, the distress that particularly one significant player is experiencing is unprecedented. I can’t recall a situation where a company this large and this prominent has experienced what they’re going through right now.

Our view, this is an Endurance and a persona point of view, is that they are being quite competitive in terms of attempting to retain their business and I would also offer that our view is that in general that portfolio business; I’m talking about onshore specialty in the US, not international business per se or accident health business or the other activities; the P&C specialty business on a broad basis is underpriced.

This is one of the reasons that our onshore operation grew less quickly than we wanted it to as we established it. That market was much more competitive as the years wore on than we expected it to be.

So in the near term I think the behavior of that institution, underwriters within it, are actually accelerating a softening market in many ways. It’s only where I think you have sophisticated risk managers, treasurers, CFOs, a need for big limit capacity where I think you see a different pattern emerging where in some cases it doesn’t matter what price that institution offers; they’re being removed or they’re being cut back very, very significantly. This is something that we have been watching and working through going back to the last weeks of August.

David, you have a couple of follow ups?

David S. Cash

I’d just add a little bit more on the Fortune 1000 transactions. Often we will see aggressive pricing. What’s important to note is in a generally softening market the tower tends to follow that softening of the lead layer. What we’re starting to see now and have been seeing for a few months now is that where that softening occurs, the tower itself doesn’t reduce t heir price above that. So you have a disconnect. You have sort of a very unreasonable price at the bottom and the economic cost is borne by that one company. The tower above it holds the price flat or at times moves the price up.

So don’t let your concern about that one company color your perspective on that whole sort of opportunity. There’s no doubt that the dynamics around that segment make it likely to harden in an attractive way over the course of this year. You wouldn’t want to step away from it but the point is well taken.

Operator

There are no further questions at this time. I’d now like to turn the call back over to Ken LeStrange.

Kenneth J. LeStrange

Thank you for your time and attention today. We tried to be very thorough in terms of describing the elements of our third quarter financial performance. ’09 is shaping up to be a very different year than we had planned for just a couple of months ago and we are quite excited at Endurance about the level of opportunity this will present to our company and an ability to distinguish ourselves very positively. I look forward to speaking to you in February when we report our fourth quarter earnings and we’ll give you market update at that time in terms of how January 1 turned out. Take care.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Endurance Specialty Holdings Ltd. Q3 2008 (Qtr End 9/30/08) Earnings Call Transcript

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