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ACE Limited (NYSE:ACE)

Q4 2008 Earnings Call

February 4, 2009 8:30 am ET

Executives

Helen M. Wilson – Director, Investor Relations

Evan G. Greenberg – Chairman, Chief Executive Officer

Philip Bancroft – Chief Financial Officer

Brian Dowd – Chairman, ACE USA

John Keogh – Chief Executive Officer, Overseas General

Timothy Boroughs - Chief Investment Officer

Analysts

Jay Gelb - Barclays Capital

Brian Meredith - UBS

Thomas Mitchell - Miller Tabak & Co., LLC

Matthew Heimermann - J.P. Morgan

Jay Cohen - Banc of America/Merrill Lynch

Josh Shanker - Citigroup

Steven Labbe - Langen McAlenney

Mark Lane - William Blair & Company, LLC

Ian Gutterman - Adage Capital

Vinay Misquith - Credit Suisse

Operator

Good day and welcome to ACE Limited fourth quarter year end 2008 earnings conference call. (Operator Instructions)

For opening remarks and introductions, I would like to turn the call over to Helen Wilson, Director of Investor Relations. Please go ahead, ma'am.

Helen M. Wilson

Thank you and welcome to the ACE Limited December 31, 2008 fourth quarter earnings conference call.

Our report today will contain forward-looking statements. These include statements relating to general economic and insurance industry condition, our financial outlook and guidance, our investments in our variable annuity reinsurance business, business strategy and practices as market conditions evolve, competition, our stock price in the capital markets, pricing and exposures, losses and reserves, all of which are subject to risks and uncertainties. Actual results may differ materially.

Please refer to our most recent SEC filings as well as our earnings press release and financial supplement, which are available on our website, for more information on factors that could affect these matters.

This call is being webcast live and will be available for replay for one month.

All remarks during the call are current at the time of the call and will not be updated to reflect subsequent material developments.

Now I'd like to introduce our speaker. First, we have Evan Greenberg, Chairman and Chief Executive Officer, followed by Phil Bancroft, our Chief Financial Officer. Then we'll take your questions. Also with us to assist with your questions are several members of our management team.

Now it's my pleasure to turn the call over to Evan.

Evan G. Greenberg

Good morning. The fourth quarter was a difficult finish to a difficult year for all financial services companies, ACE included, as economic conditions worsened and financial markets suffered the worst period we have experienced in many decades.

Given this environment, on an operating basis, ACE had a good quarter. Our property, casualty and accident and health operations performed well. Our life reinsurance business did not.

After-tax operating income in the quarter was $624 million or $1.87 a share. For the year, operating income was $2.6 billion, down about 4% from prior year. Our combined ratio for the quarter was just below 87% and, in our judgment, simply an excellent result. We had good contributions from both underwriting and investment income.

Net income in the period was $20 million, impacted by other-than-temporary impairment losses of about $440 million. Our portfolio is of high quality and over 94% fixed income related. About twothirds of the OTTI is related to interest rate spreads, not true credit impairments, and in our judgment, the vast majority will recover in time.

Our investment portfolio is conservatively constructed and appropriate for a global company like ACE that invests its U.S. dollar holdings from a number of jurisdictions, both U.S. and not. We have provided you with more disclosure around our portfolio composition in our supplement, and Phil will provide more detail.

You know ACE is unique in that we are one of the few truly global P&C companies, and this has been and is a tremendous source of strength and opportunity. As I have said many times, we're also an underwriting company. We take risk and accept its attendant volatility as long as we understand the risk and are paid an adequate price to take it. In this quarter, we experienced the volatility that can accompany the business activity of a global risk-taking organization.

Our book value declined in the quarter by 6% and 10% for the year. The decline in the quarter is attributed to investment portfolio related losses - which, again, we believe were largely transient - foreign exchange losses, and a realized fair value-related loss associated with the GMIBs and our life re business.

To put this in perspective, even with this year's market and economic conditions, our book value has grown at a compounded annual growth rate of 12% the last five years. Our long-term shareholders benefit from the fact we're a global, disciplined, risk-taking organization.

Our variable annuity reinsurance business had a difficult second half of the year, the fourth quarter in particular. As you know, this is a cat-like portfolio, though a different kind of CAT. It has two unique characteristics - duration and potential for reversal of loss. In our original models when we price the business, this kind of event is a 1 in a 100 years. Even with this kind of second half, we earned $107 million of operating income in '08 on this portfolio, though we produced about $400 million of net loss, which is within our range of tolerance for an infrequent and large cat.

Our current projected future annual operating income run rate is between about $120 and $140 million, so the payback period can be reasonably quick. During '09 we can experience more volatility given equity and interest rate markets. Again, Phil will provide some more detail around this point.

Operating income in the quarter benefited from positive prior period development of about $250 million pre-tax, which included a $70 takedown of a reserve on a single large structured transaction that expired during the quarter. $160 million of the prior period was short tail related and about $45 million of this is from '04 and '05 cats and other prior cats.

Our prior period number also includes the results of our annual and the State of Pennsylvania's biannual reviews of our A&E reserves and other runoff liabilities. As a result, we incurred a charge of about $50 million pre-tax.

Our expense ratio in the quarter was up about 1.4% over the prior year. The ratio was flat in North America, down in global re, but up in international, which was driven by our A&H business, including the consolidation of Combined. Excluding the impact of A&H, our expense ratio was up less than a point in international and flat in total.

We are well capitalized, our balance sheet is in good shape, and our operating cash flow was strong, almost $1 billion for the quarter and over $4 billion for the year. During the quarter, as you know, a number of the rating agencies expressed a favorable view of ACE's capital position.

Turning to growth and underwriting during the quarter, I want to make a few comments. Total company net written premiums were up about 8%. Adjusting for foreign exchange, net written premiums were up about 13%. Our P&C net written premiums shrank 1%, but on a constant dollar basis, adjust for foreign exchange, they grew about 3%. Our insurance business grew, while our reinsurance business shrank.

The underwriting environment is improving. Rates firmed through the quarter and continued to do so into January. Globally, for the business we renewed in the quarter, rates went from minus 6% in the third quarter to flat in the fourth. The rate of change varies by territory, greatest in North America, followed by the London company market, Australia, and Latin America.

Our rate to exposure improved and so did the quality of our portfolio, particularly in North America and U.K. retail. We're beginning to benefit from a flight to quality and where rate is adequate we are writing more business, beginning to improve our position on accounts, and gaining share. While still choppy, the overall market is moving and reacting to a need to raise rates, but not as fast as we are. Where rate is not adequate, we are walking away - and in some classes we're continuing to shed business.

I might add, while rate to exposure is improving, exposure is declining due to recession. This means better margins, but not necessarily more premium. Let me add some more color around this.

In the fourth quarter on a constant dollar basis, our global retail P&C business, that's ACE USA and ACE International, grew 10%, while our London and U.S. wholesale business shrank 15%. In North America, we have substantially more opportunity to quote business as a result of market turmoil. Submissions are up significantly, though our quote to close ratios have dropped modestly.

In those lines were rate is adequate, we are benefiting from the weakness of others by improving our position on accounts, moving into primary lead or first excess position, for example, in excess casualty, D&O, environmental and medical liability. We're also gaining new business in certain lines where we already enjoy a strong lead position, such as RE&O business and risk management division, which was down in the fourth quarter due to a single large transaction last year, but had its best fourth quarter and January 1 for new business in a number of years.

On the other hand, there are classes where our retention rates and new business writings were impacted by continued inadequate pricing, such as both large account and cat-exposed property, E&S casualty, and, due to recession, construction-related business.

Overall, U.S. retail rates went from minus 3.5% in October to plus 2% in December and in January plus 5%. Retention rates dropped a bit, impacted by our pricing actions and recession, but were reasonable at about 86.5% on a premium basis. Our U.S. wholesale business shrank in the quarter, again, primarily due to inadequate pricing in E&S casualty and cat-related property. For our wholesale book, rates went from minus 5 in October to plus 8 in December and about plus 5 in January.

Our Bermuda-based insurance business had a very good quarter, with net premiums up 6%, driven by D&O in particular, and this a clear example of flight to quality.

Turning to international, in the fourth quarter our P&C business in original currency experienced its best quarter of the year, up 6%, while A&H was up 15%. Asia and Latin America both grew double digit in P&C and A&H. In international, P&C rates went from minus 3 in the third quarter to plus 1 in the fourth.

Our reinsurance business shrank during the fourth quarter; however, for January 1, global re had reasonable growth on a treaty year basis - not to be confused with book basis - and that was because of improved pricing. This is the first time this business has seen growth in a few years. Rates that were declining all year moved to flat or modestly up in many classes at January 1, though most U.S. casualty pricing remained competitive.

We gained revenue from improved signings due to competitor weakness and more clients looking for a reinsurance solution to solve a capital need. In reinsurance, we are noticing more clients willing to pay more, though in most cases not dramatically more, to have ACE on their program.

Overall, the bottom line, rate to exposure is improving, rates are firming and in my judgment will continue to firm as the year goes along. How fast, what lines and where, I cannot predict with certainty, but as they do, we will gain share and that equals growth. On the other side of the coin, recession is impacting exposures and clients insurance budgets and this, along with foreign exchange, will negatively impact premium growth rates.

With that said, while the environment is complex and clear visibility is difficult, both the rate environment and our growth rates in January are in line with what we contemplated when we provided '09 guidance in December. We remain optimistic about the year.

Again, our balance sheet is in very good shape, and we believe opportunity is growing as a result of the flight to quality to a company like ACE that has the balance sheet, the geographic presence, and the product [inaudible].

We're continuing to invest in and enhance our capabilities to take advantage of market opportunities. We're continuing to invest in people and infrastructure to grow our presence and lines of business globally, where we see an opportunity for ACE to grow share at reasonable terms. We're also continuing to invest in our enterprise risk management capability, our systems and data environment, and our research and development capabilities.

Finally, we're prepared that this difficult economic and financial environment will be with us for some time. This is a nimble organization and we can adjust rapidly to both threats and opportunities.

With that, I'll turn the call over to Phil, and then we'll come back and take what I know will be your many questions.

Philip Bancroft

Good morning. Let me pick up where Evan left off and provide some more detail on some of the items.

Book value was reduced by realized and unrealized losses in our investment portfolio, foreign exchange, and a loss related to our GMIBs. On an after-tax basis, realized and unrealized losses from our investment portfolio were about $1 billion, resulting from the marked-to-market impact of credit spreads and global equity markets during the quarter. Investment grade spreads widened by 150 basis points in the quarter and high yield spreads widened by 500 basis points. Global equities declined over 20%.

After-tax realized losses from our investment portfolio were about $400 million. We provided detailed information on the realized investment losses on Page 24 of the supplement. We estimate that approximately $30 million of these realized losses relate to actual credit impairments. The remainder of the loss is price related.

Realized and unrealized losses were determined as of 12/31/08. We have no significant asset classes that were reported based on values at an earlier date. For example, we have no lags in our reporting and everything was right up to year end.

For the unrealized losses in the portfolio, we believe our strong liquidity and continuing positive cash flow support our view that we'll hold our highly rated fixed income investments until they recover their value as they approach maturity.

Our global equity holding, representing about 2% of the portfolio, are actively managed and they're highly diversified.

Our global asset allocation is consistent with our liabilities and our tax, capital management and regulatory considerations. U.S. dollar investments represent about 80% of the global portfolio, with about a third in our U.S.-based entities and two-thirds in our overseas operations, including Bermuda. Investments in our non-U.S. operations are currency matched with insurance liabilities and are invested in taxable securities.

Our investment portfolio continues to be predominantly invested in publicly traded, investment grade fixed income securities and is well diversified across geographies, sectors and issuers. The average credit rating is double A, with nearly two-thirds invested in triple A securities. The duration of the portfolio is 3.6 years.

As we've said, we don't invest in CDOs or CLOs or complex credit structures, and we don't use leverage in the portfolio. We also do not provide credit default protection.

Our exposure to hybrid fixed income securities of U.K. and European banks and financial institutions is about $350 million, and these are not preferred securities. Our global exposures to bank preferred securities is $45 million.

As you know, we've experienced significant movement in foreign exchange rates. Major currencies in the quarter declined between 15% and 20% against the U.S. dollar. These declines reduced our book value by about $300 million.

Our realized losses also include about $200 million relating to the increase in the net fair values of the GMIBs. The loss was primarily due to year end long-term Treasury rates, which we believe are at historic lows and not, in our judgment, representative of realistic long-term rates. In fact, these rates have already risen 70 basis points since year end.

It's important to say that while this business is considered a derivative for technical accounting purposes, we feel that our operating income, which includes the results of insurance accounting, is a more meaningful way to look at the business. Operating income [per VA] was also negatively affected by the drop in the S&P 500.

We completed our quarterly actuarial review, which resulted in several changes to our VA reserving model. The most significant changes were made to our mortality and annuitization rate assumptions. And I've mentioned that, as you know, we have all of our - or substantially all  of our actuarial reviews reviewed by third-party actuaries during the course of the year.

Financial flexibility at the holding company level remains strong given our operating company's dividend capacity and low levels of debt refinancing risk over the next five years. Our debt to total capital leverage ratio of about 18% at year end continues to be conservative relative to our current rating levels.

We have a 21% investment in Assured Guarantee or AGO at year end, which we carry at a book value of $397 million. As you know, AGO is planning to close on the acquisition of FSA from Dexia in 2009. When the acquisition closes, our investment will be reduced to between 9% and 11%, and that will require us to change our accounting from the equity method to marked-to-market.

I'd also mention our tax rate of 22% is somewhat higher than it's been running, and it's just a function of the tax jurisdiction where we earn our underwriting income.

Net loss reserved declined in the quarter by about $890 million due primarily to foreign exchange of about $700 million. Year to date, net loss reserves increased about $500 million.

With that, I'll turn the call back to Helen.

Helen M. Wilson

Thank you. At this point we'll be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Jay Gelb - Barclays Capital.

Jay Gelb - Barclays Capital

I want to touch base on the 2009 earnings guidance in terms of some of the components in terms of how you get to your range. Can you give us a sense on expectations for premium volume, investment income, and could you, maybe, Phil, go through that life business annual run rate on earnings? I didn't know if that was for the whole segment or just some portion of it.

Evan G. Greenberg

We've given the extent we're going to provide of guidance. It is on an EPS basis and we did put cats with it. The rest of that we leave to you guys to put what you think, but we gave you the bottom line. And the run rate on - and Phil can speak more about it - but the run rate was on the VA only.

Jay Gelb - Barclays Capital

Not including the acquired Combined business, right?

Evan G. Greenberg

Definitely not.

Jay Gelb - Barclays Capital

And then can you update us on your view on the directors and officers in Arizona's missions market in terms of ACE's current penetration there and whether you feel your reserves are adequate going forward?

Philip Bancroft

Yes, we feel our reserves are adequate going forward, of course. And we think we are - I assume you're referring to the financial crisis and all of that and our reserves do contemplate our exposures as we know them to be. We did strengthen our reserves through the year and so all of our exposure, as we know it, is reflected in our current accident year and even the prior year because we took reserves in '07 loss ratios.

Jay Gelb - Barclays Capital

And then separate, I don't know if you have an estimate for Claus losses, the European storm?

Evan G. Greenberg

You know, right now, on the insurance side it doesn't appear consequential to us. And on the reinsurance side, reports are coming in. We don't write a major portfolio in Europe. We're not one of the major writers of cat there; we do write cat. And we'll have some losses, but I don't expect it to be anything huge.

Operator

Your next question comes from Brian Meredith - UBS.

Brian Meredith - UBS

First, Evan, looking at the overseas general [action], your combined ratio ex cat, it looks like it was running right around 98% in the quarter. It's been trending up pretty nicely. I'm wondering, was anything unusual in the quarter or is that kind of the combined ratio we should be expecting in the business now that the combined [A&H] business is in there?

Evan G. Greenberg

Would you repeat that about what your numbers calculate to?

Brian Meredith - UBS

Yes. I get an action year loss ratio ex cat of, call it, 58.5, and then add the expense ratio and I get to like a 97.9 in your overseas ex cat, ex -

Evan G. Greenberg

Yes. I think you didn't do the expense ratio right, just for your information, but I'm going to respond on the loss ratio, because you used the average expense ratio for overseas gen and tagged it to a loss ratio. Well, remember, the A&H runs a lower loss ratio, higher expense ratio. P&C is the opposite, okay?

Brian Meredith - UBS

Okay.

Evan G. Greenberg

So it is not running a combined that high in the P&C internationally.

The P&C loss ratio has ticked up a bit. It continues to because of what is the rate environment and trending of losses at the same time, so it's natural the business would. Other than that, not really, just, you know, there's been some noise in short tail, but nothing of concern. The combined in the P&C is running quite well.

Brian Meredith - UBS

And then, next one, Evan could you talk about your trade credit exposure internationally? I think you guys write that business. What you think about that business and kind of what loss experience could look like.

Evan G. Greenberg

Yes. And I assume you want me to talk about political risk as well?

Brian Meredith - UBS

Yes.

Evan G. Greenberg

I thought so. It seems to be the flavor of the month. You know, the trade credit book we write is a structured trade credit book. And, as you say, it's trade credit; it's not domestic credit. It's not a huge book of business. We write it on an excessive loss basis and that is we write it for companies where they have very good credit analysis capabilities themselves, the insureds do, and we take excess of their own retentions. We're very selective on how we do it. Our limits are fairly modest.

It runs a certain frequency of loss, and right now it is exactly as we expected. The claims in this period would be a bit higher than they would traditionally because of the economic conditions. The business is short term. We can get on and off of this business very, very quickly and change and adjust, and we do. Our loss ratio pegs, they contemplate losses and development in an environment like this, and there is nothing that we have seen to date that is outside of our expectations of loss for the business. And it's not running any temperature or anything like that.

The political risk business, the character, the nature of it is different than the trade credit and I'll talk about that for a little bit. We have modest exposure in many of the countries that are in the news and that you might be concerned about, and we're not in a lot of the sectors in those countries that are receiving attention, that might be more sensitive. We have no claims of any size reported or pending at this moment. We always have a watch list. We're always reviewing our portfolio and, in fact, what I'm telling you is based on the most recent review we've just done in the last couple of weeks of this business.

We've been getting off risk in a number of countries of concern. Our exposures have been rapidly running off. We have IBNR for this business. We have reinsurance for the portfolio. We insure mostly CEN, that is, the kinds of risks we take. We also do contract frustration. We insure both debt and equity. It's all against sovereign action, not commercial disputes. We insure risks typically that generate hard currency and for any country, those are the last to have a problem. The business has conditionality within it - waiting periods, deductibles. We have a very good track record in recovery.

And again, we're just not seeing - our book is very clean and we're not seeing claims at this point or notices of loss, and I'm confident about it. We do have IBNR for the business, and I just, at this point, from everything I can see, I don't see a problem on the horizon in political risk.

Brian Meredith - UBS

And just one point of clarification on guidance. I just want to make sure it does not include any anticipated reserve releases?

Philip Bancroft

No, it does not.

Operator

Your next question comes from Thomas Mitchell - Miller Tabak & Co., LLC.

Thomas Mitchell - Miller Tabak & Co., LLC

Well, if we take the $250 million improvement in prior year reserves out of the picture, your operating EPS for the quarter looks like it would have been closer to, let's say, $1.30 or so. And I'm assuming - but I didn't see anything in your report so I think I should ask - is there some factor related to the catastrophes that took place in the third quarter that carried over into the paid claims in the fourth quarter that would have, without the reserve for lease, would have made that a tougher quarter and that you don't expect that in 2009?

Philip Bancroft

Well, I'd say two things. First of all, I don't think you mean paid claims; I think you mean incurred claims. And we had $66 million of cats from the third quarter storms as a development in the fourth quarter. And if you took out cats in prior period, we ran around a 93 combined ratio, and I think that's a pretty good result.

Did you have anything further?

Thomas Mitchell - Miller Tabak & Co., LLC

Well, no. I just wanted to make sure that - so you would say that the 725 to 825 would be consistent with a continuing underwriting ratio similar to the fourth quarter?

Philip Bancroft

No, I didn't say that. But the 725 to 825 is our guidance, and we are comfortable with our guidance.

Operator

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

Matthew Heimermann - J.P. Morgan

The first question I had was just to understand what's happening in the investment portfolio. Were you a net seller of any of the non-U.S. holdings, mortgage backs or other investments, or were those declines all marked-to-market?

Philip Bancroft

Well, they were both marked-to-market and FX. There was a big FX component, especially in the non-dollar U.S. That's primarily what caused the change. Actually, free cash flow went into that category, but it was more than offset by the FX.

And with respect to the MBS, when the government made their announcement they were going to purchase agency MBS, the yields in the sector declined and so we took advantage of that to move into corporates and munis. So they were just tactical moves.

Matthew Heimermann - J.P. Morgan

The other thing, Evan, just with respect to kind of the underwriting behavior this quarter, you seem to be seeing much better pricing in your book than others, and you talked about having to walk away from some business. Did you have to walk away from more business than you did in the third quarter to kind of ensure you got the pricing you wanted?

Evan G. Greenberg

Yes. And, you know, maybe it would help if I give a little color around that. Do you want some data points on it?

Matthew Heimermann - J.P. Morgan

That'd be great.

Evan G. Greenberg

In the USA, I'm going to distinguish a little bit - because I think others have this same question  between what business grew, the businesses where we grew, versus some of the business that we shrank, and give you in those categories some examples on lines of business what happened.

Overall, first of all - we'll take ACE USA as the example for our retail business - ACE USA had a retention rate and it's on a premium basis - and I realize there's a bunch of discourse going on about how do you account retention; this is on a premium basis - in the fourth quarter we ran about an 86.5% retention and in January about an 87% - 87.2%. And, you know, that's a couple of points impacted, we would say, by our action on pricing.

On the other side of the coin, for ACE USA in total, in October our prices were down about 3.5%. In December they were up 2% and in January they were up 2%. Now, I'm going to give some examples on lines that were up and some lines that were down.

Umbrella access, our retention rate was 88% in fourth quarter and 92% in January, and rates there moved from a minus 2.3% in October to about a 5.7% positive in January. And if you look at the trend month by month, it kind of went along with that.

Our risk management business had a retention rate of about 87% in the quarter and about 86.5% in January, and their rates went from a minus 7.5% in October to a plus 3% in December and about a 1.5% in January.

Our professional liability business, it ran retention rates in the 90s in the quarter, and that's both E&O, D&O, and FI. And rates went from a minus 2% in October to a plus 13.5% in December and in January they were about a plus 6%.

And our medical business ran retention rates in the 90s, and there we went from sort of a negative in October in terms of rate to flat to up in December and January.

Now on the other side of the coin, the business that shrank was really lines like marine cargo, large account property, small comp, and in those lines, if I took marine cargo, we did get, even though the business shrank, on what we retained, because we're driving rate, we got a 7% increase. And on large account property that shrank overall, our rates changed from a minus 2% to a plus 5% between October and January. And the small comp business, which is a competitive business, was minus 5% in October and the rates went to flat in January.

So maybe that gives you a little color around that.

Matthew Heimermann - J.P. Morgan

It's fair to say, too, that whatever you're losing in premium from walking away is being made up on the margin side, it seems.

Evan G. Greenberg

I think so. And, you know, our new business - in January, our risk management business, our environmental, our professional liability, our medical, those all had really record new business months in January.

Matthew Heimermann - J.P. Morgan

Okay. The last question, if I could sneak it in, is just, Phil, on the GMIB side, can you just give us some color into whether or not consumer behavior is tracking along with expectations, I guess specifically with respect to either annuitization rates and surrenders?

Philip Bancroft

Yes. As we did our study, one of the things that we saw is that the annuitization rates that we're seeing as experience is emerging is better than we originally expected and that was one of the adjustments that we made in our model.

Evan G. Greenberg

But, you know, I'm going to add there, that was on our business. When we priced it, we were very conservative in the rates.

We don't really see yet the industry's annuitization rates, whether they're better than they expected them to be. We can't tell you that. And remember, we don't start paying out until '13 on the business.

Operator

Your next question comes from Jay Cohen - Banc of America/Merrill Lynch

Jay Cohen - Banc of America/Merrill Lynch

I just want to ask you about the claims side. Relative to the economy, I've heard different dialogue about what that might mean from a claims standpoint. Have you noticed anything in the fourth quarter, whether it's U.S. or outside the U.S., from a claims standpoint that you can sort of suggest is due to the economy?

And then secondly, what would you expect to see going forward given the global recession from a claims standpoint?

Evan G. Greenberg

You know, it's a little early. I'm going to let Brian and John maybe give some comment on it. It's a little early. We don't see - you know, obviously, everybody does in the professional liability area; we've been watching it develop all year and before that, which is, you know, financial crisis related. As far as recession goes, we're seeing more exposure-related reduction impact. The claim trend comes later and we will expect to see that. We're in deflationary times and that will be a benefit on one hand. On the other side of the coin, frequency and severity in certain lines can pick up, and we anticipate that. But I don't believe we're seeing much of that yet.

John or Brian, you want to add to that?

Brian Dowd

I guess I would add in the U.S. there's often conversation about workers comp and what the effects of recession would be. We monitor both our internal data as well as industry data, and to date we haven't observed any increase in either claims frequency or claim severity.

NCCI studies show that at the beginning of recessions you actually see a reduction in frequency, and the theory there is the newer, less-trained workers are the first laid off and you're left with more experienced, reliable workers. Toward the end of recession as expansion begins, you actually start to see some severity go up. They're the workers who have higher wages and have long durations of outages. So you start to see maybe some uptick in severity at the end of a recession.

But to date, we actually haven't seen any meaningful changes from our expected ranges on workers comp.

John Keogh

And I would just add, on the international side, maybe to pick up on Evan's point about exposure is really what we're seeing first. We really haven't seen anything on the claims side, but are watching it carefully.

But having been in Germany and France just last week talking to our client base over there, I mean, they're pretty consistent with the U.S. economy as you talk to the clients. The fourth quarter, the manufacturers in Europe saw their orders drop off a cliff and are now anticipating major cutbacks in terms of their production, major cutbacks in people, perhaps closing facilities in 2009 in response to what they saw at year end. So that we're seeing already come through in terms of the impact on exposure.

So while we're getting rate improvement on our business, it's not necessarily in all cases translating into premium increases.

Jay Cohen - Banc of America/Merrill Lynch

Just on the political risk, Evan, can you talk about the reinsurance program you have in place protecting that business?

Evan G. Greenberg

Yes. It's done on a proportional basis. We have two books - we have a London book and we have a - we write it out of London and we write it out of Bermuda. On the Bermuda book it's a [quota share] ground up with a major reinsurer, unnamed. And in the U.K. it's a combination of a quota share and a risk excessive loss program. But in both cases and between the two units there is close coordination so we never overalign ourselves. We have clear guidelines about ACE retentions.

And on average, which is I think what you really want to know, our net retention is in the modest double-digit millions. It's in the teens, on average. And in London it's lower and in Bermuda a little higher.

Operator

(Operator Instructions) Your next question comes from Josh Shanker - Citigroup.

Josh Shanker - Citigroup

I was curious about the OTGI charges on spread widening. I assume you think that they're going to recover. Why did you choose to account for it with an OTTI mark?

Philip Bancroft

You sound like my boss. Yes, what we've done in the portfolio is we've looked at the duration, how long the account's been underwater, the severity of the decline in price, and we view a dramatic and significant decline in price to be at least indicative of an issue. So we go further than that. We look at ratings and credit issues. On the mortgage-backed securities we're looking at underlying cash flow. And it's a judgment to make, but the more severe the decline in the value, the more likely we were to impair it.

Josh Shanker - Citigroup

Second question, I noticed some changes in the investment portfolio. I just thought maybe you could give us some philosophy behind that. I assume you're selling Treasuries or you were selling Treasuries and you were buying single A bank debt. I'm wondering if you want to talk about anything else you're doing and what you're thinking?

Philip Bancroft

Tim, you want to cover that?

Timothy Boroughs

Sure. I think, as Phil mentioned, the Fed announced in November a plan to buy mortgage-backed securities. Those yields fell dramatically and when they did we took advantage of that and did a tactical shift into corporates and into munis.

I think generally speaking I'd make just a couple of points on strategy and that is that I don't think we're considering or contemplating any major change in strategy from our conservative approach, where we're really focused on a high value for liquidity. Given the weakness in the economy and the severity of that weakness, we would expect short-term rates to be low for an extended period. And this will certainly affect the way we think about our duration management of the fixed income portfolio.

Also, we believe that the government efforts to provide liquidity and stabilize the banking system will help to bring down private borrowing costs, and I think it's from this perspective we feel credit spreads, which have now begun to narrow, will continue that trend in the weeks and months ahead.

Josh Shanker - Citigroup

One other item - and feel free to extrapolate; it's slightly more controversial and I'm happy for you to take it where you want - I'm curious where the derivative liability mark is for the GMD, bNG [and IB] books at this point right now, cumulative.

Philip Bancroft

Cumulative. Let's see. The cumulative fair value of liability is about $820 million.

Josh Shanker - Citigroup

For both together?

Philip Bancroft

Yes.

Operator

Your next question comes from Steven Labbe - Langen McAlenney.

Steven Labbe - Langen McAlenney

I was curious if you could give us just what are the latest NARs for the annuity reinsurance business?

Philip Bancroft

You know, we've been going around about this and one of the things that we've talked about is that's not a real meaningful number. We're working on disclosure for the 10-K that we think will help better dimension the risk that we have and how we think about it, so I'd prefer to have you look at that and then we'll address any questions when you're through it.

Steven Labbe - Langen McAlenney

Okay. Within that same business, I was curious as to whether or not you were growing the traditional mortality based life reinsurance business?

Evan G. Greenberg

We're trying to. And, you know, we, I think, probably like yourselves, we expect that there is an opportunity there. So far to me it's growing a little more slowly than we expect or would anticipate, and so we'll see how the year unfolds with that. But I do think there's an opportunity in the future because life companies have a capital need, they have all their triple X problems, and life mortality pricing ought to be better. You ought to be able to earn a reasonable ROE. But if we can see a decent double-digit ROE, then we're not going to write the business. And I think that says it all.

Steven Labbe - Langen McAlenney

Just as it regards the professional liability business, it seems like you have a lot of opportunities there. I was just wondering if account year loss picks in the fourth quarter changed at all relative to the full year?

Evan G. Greenberg

We increased in the U.S. We didn't increase internationally. We increased internationally in the third quarter. I think that says it.

We increased in the U.S., we increased in the international in the third quarter, brought both up on an accident year basis to what we think reflects our ultimate liability.

Steven Labbe - Langen McAlenney

Where does that accident year loss ratio reside these days for that business?

Philip Bancroft

I know what you want to know - the number - but I'll give you the literal answer. It resides in international; it resides in North America in the P&C business. I'm not giving out the loss ratio.

Operator

Your next question comes from Mark Lane - William Blair & Company, LLC.

Mark Lane - William Blair & Company, LLC

On claims inflation, so what has happened with your claims inflation assumption for 2009 versus three months ago? You said you haven't seen anything, but what's contemplated in your expectations for this year?

Evan G. Greenberg

We really didn't change our assumption rates for '09. As you can imagine, casualty business, in particular, that's longer tail and I don't think that inflation rate is that impacted by, obviously, commodity prices or any of that. We didn't adjust our property or short tail development, our rates for trending. You might argue well, you'll see commodity prices go down. I'll argue on the other side you'll see frequency and potentially severity because of housekeeping and other matters. Those will tick up on the other side and no one knows with certainty. So we didn't adjust. We did not change them.

Mark Lane - William Blair & Company, LLC

And then the second quarter, Phil, so this earnings impact on the [GMI BGD GMBD], so is the right way to think about this that the '08 earnings contribution was the $107 million and then in some sort of base case scenario for '09 the earnings contribution would be that $120 to $140 range?

Philip Bancroft

That's right. That's from an operating standpoint. And obviously, to the extent that markets change, that'll be impacted.

Mark Lane - William Blair & Company, LLC

And then the last question is regarding the guidance. I understand that there's no explicit expectation of reserve releases in your guidance but when you look at the run rate for the fourth quarter and taking out the favorable development and adding something back for the higher than expected losses in the life reinsurance business, I find it very difficult to get into your range. Is your strong reserve position or your view on claims inflation give you the confidence to continue to expect strong margins if you're not anticipating some reasonable level of development or things continue to go the same way that you would expect to see some development or how do you think about it?

Philip Bancroft

We do not project any favorable reserve development in our numbers. Obviously, our reserves are adequate and have no - just that, they are adequate. And so when we put together guidance, they don't consider an explicit reserve release. We gave you an EPS range and it is based on the calendar year number we expect, which is made up of all parts and pieces. I know you want more explicitly, and I'm not going there.

Operator

Your next question comes from Ian Gutterman - Adage Capital.

Ian Gutterman - Adage Capital

I just wanted to follow up, I guess, for Phil, the earlier question on the impairment. Can you just maybe in a little bit more detail talk about the impairment policy because I guess, just when I look at your impairments for the year relative to your unrealized, to be honest, it's higher than even a lot of the life companies percentage wise. It seems you're more aggressively impairing things which obviously is conservative, but I want to understand why that's the case.

Philip Bancroft

Well, I can't tell you why it's the case that you believe we're more conservative than others. I mean, we think we've been very thoughtful. We've looked in detail security by security. And as I say, if the security is underwater by more than 40% for some length of time, we would tend to impair something like that.

There's different judgments that can be made and it's very judgmental. If an equity is underwater for more than 12 months, we consider it impaired. And, you know, as we look at it, right, one of the things that we do, for example, on our mortgage-backed securities, we say well, if they're trading at 70 and we do a cash flow test and it shows that we're going to maybe get to 92, the rule is that you don't mark it to 92. It's impaired because of the fact that it goes to - because the recovery is expected to be 92, and then you mark it to 70. And, you know, there's a fair amount of that in our mark.

So I can tell you, as I said, we're looking at the duration of how long things have been underwater and how severe [inaudible] the client is, our judgment on recovery. You have to look at it security by security and that's how we've made our judgments.

Ian Gutterman - Adage Capital

Is there any more detail you can give us within - you gave us for Q4 the breakout by investment grade versus high yield, MBS and so forth, do you have those numbers for the year? I'm just curious how much of the fixed income -

Philip Bancroft

I think it's actually on Page 24 in the supplement and it's on the right hand side.

Ian Gutterman - Adage Capital

Right. I guess I was looking on Page 25 you give within fixed income for Q4 and it's mostly high yield in Q4. I was wondering for the year was that also the case that it was mostly high yield or was it the other asset classes?

Philip Bancroft

I would say it's similar, but what we'll do is we'll include the prior year in the 10-K.

Ian Gutterman - Adage Capital

And then just quickly, I know there's a lot of questions that come up on the [inaudible] risk. Evan, if you could just maybe even further talk a little bit about sort of - I think people maybe - there's a lot of uncertainty about actually what causes losses because we haven't really seen many events in a long time. Can you just talk a little bit about sort of, you know, if we hear of an event and there's, whatever it is, a $50 million claim out there, what exactly does that mean for you given not just your reinsurance but subrogation and things like that? What kind of a bottom line impact is that at the end of the day or, if you want to think of it differently, maybe, you know, what kind of environment does it take for this to be, you know, equivalent to a cat-type event where we're talking about more than a couple hundred million dollars.

Evan G. Greenberg

Okay. A cat-like event, in my mind, would really be a contagion, number one, going across many countries or number of countries. It would be either currency markets lock up, governments nationalize or expropriate. We're not big in the energy sector. One of the reasons we're not is when commodity prices, when they were really rising, we know the governments were tearing up contracts and renegotiating them, and we certainly weren't going to get in the middle of that.

But you would see nationalization within an industry or expropriation within an industry or government, potentially, in certain areas. We don't do general bond issues, but where there is debt guaranteed by a government, where they might repudiate that and say they're going to renegotiate all debt. Those would lead to claims.

Recovery rates are generally quite high in this business. We support banks as one of our classes of insureds where they take on a certain amount of exposure and, on some of those loans that they might make, it's related to a specific property or business. Where there is government exposure, we will take part of that loan exposure. The banks generally never want to declare a default and have us involved in the claim. They care about the ongoing relationships. They care about many other factors that, frankly, we don't care about except getting our money back.

And it's very hard ultimately to gain access to multilateral agencies in the future for loans or to others, if you have outstanding claims of recovery against members of the Berne Union and ACE is a member of the Berne Union.

Our recovery rate - we haven't had that many claims, but where we have our recovery rate has been a very important factor in the ultimate net loss on the business.

Ian Gutterman - Adage Capital

And then just to clarify again, talking about a contagion, is one country having a major nationalization scenario a cat event or does it really have to be multiple major countries?

Evan G. Greenberg

For the most part it has to be multiple major countries. I mean, we could paint a crazy scenario that Brazil, where we have, you know, quite a bit of exposure, nationalizes everything, but I think that's possible, but that's also - well, it's not the same frequency; it's also, you know, that's sort of like talking about the meteor striking the planet or our total net amount at risk in variable goes down because everybody in the United States dies.

So I think you can go far enough out on that tail, but we could from one country, you could generate some substantial losses. It's very few countries and they're much more highly rated countries. But even in that case I have a very hard time, you know, we have a hard time seeing that and we manage the limits pretty carefully.

Ian Gutterman - Adage Capital

So it sounds like, frankly, we still should be worrying more about the weather or the earth shaking than about political risk?

Evan G. Greenberg

I think so. You know, I'm not going to tell you - it's a risk business and we are in a riskier environment. And I'm not Pollyanna-ish about it; none of us are. And we do ultimately expect claims in this business. But I think we manage with that in mind and while of course it can present some volatility in your earnings and that, I don't see any of that at the moment. I'm not parsing words about it. That's our up-to-date knowledge, a thorough knowledge, of our portfolio.

You know, I do want to go back on one - I think it was asked by Mark - on guidance and I want to give a little better answer to that.

There are many things impacting guidance this year. It made it more difficult to do guidance; that's why we also gave a broader range. We're in a much more difficult external environment and we are a global company. And we had to make our own judgments around what do we think is going to happen in terms of rate increases and how will that benefit our portfolio; what kind of competitive environment are we going to have.

We had to make our judgments around foreign exchange and whether foreign exchange rates as we currently see them will be the foreign exchange rates as the year goes along, you know, when you're looking at guidance in November or December and you're looking at foreign exchange movements like we haven't seen before. We have expense management. We have cats. We were outside the expected in '08 versus '09.

So there are a lot of ingredients that went into it that were more volatile and more uncertain in this period than have been in other periods. And all of that went into our guidance, into our own projections for our budgets for the year, which, in turn, produces the guidance to you, and that's also why we have a broader range around that guidance. And I wish, you know, I could be more explicit than that, but I hope that gives you a little more color, Mark. I don't think I gave you a great answer.

Operator

Your last question comes from Vinay Misquith - Credit Suisse.

Vinay Misquith - Credit Suisse

Within the life insurance and reinsurance business, the life and annuity benefit expense ticked up. Could you help us understand how much of that was because of the VA business and how much of that is a one-time expense because the equity markets fell versus how much is an ongoing expense?

Philip Bancroft

Expense, be careful because the combined is all of it. Yes, I would say that I think the better way to look at it would be that we did have a one-time event - or maybe not one-time, but market-driven event - and I think the best thing to do would be go back to Evan's point about the run rate, the $120 to $130.

Evan G. Greenberg

You're talking expenses, though, right?

Vinay Misquith - Credit Suisse

The life and annuity benefit expense of $154 million that was up significant this quarter versus the last few quarters, which were running about $84 million.

Philip Bancroft

That's principally VA that's causing that increase.

Vinay Misquith - Credit Suisse

And would that be more like a one-time item or will that also continue to next year?

Evan G. Greenberg

Well, you tell us what the equity markets are going to be in particular in the benefit ratio. Interest rates more impact the fair valuing in the net income line. You know, you tell us what that volatility is going to be and we'll tell you the number.

Vinay Misquith - Credit Suisse

So if things stay the way they are, would that number be flat next year versus this year? I mean, that was more my concern.

Evan G. Greenberg

We anticipate it will be flatter. I gave you what the natural run rate of the business is.

Philip Bancroft

From an income standpoint.

Evan G. Greenberg

I can tell you there can be some volatility around that depending on market behavior.

Vinay Misquith - Credit Suisse

The second question [inaudible] seems to be trying to be more [inaudible] on the pricing front and you have seen maybe some business move away from you in the near term. How do you foresee things happening in the future? Are clients paying out for quality security or are they more willing to save money by going to another carrier?

Evan G. Greenberg

Both flavors. There's some lines of business that is just pure commodity where, you know what, you put up capacity and a price and there are 20 guys who do it and it just doesn't matter. And the client isn't so security driven, and they'll just take the price. There are many line of business, however, where your balance sheet, where your presence, where your capabilities in terms of service really are a necessary part of the insurance buy. And in those lines of business - and, by the way, those are more sensitive lines in many cases and there ACE does have a distinguishing feature and our discipline in pricing impacts us far, far less.

And then there are two kinds of clients, those who right now - and I understand it because of particularly recessionary pressures and this and that - they want to find, you know, they view insurance as another expense and they're going to pay as little as possible for it. And in those cases, we're also trying to offer those clients, while we're being disciplined in pricing, cheaper alternatives, with deductibles or coinsurance or coverage changes where they can afford it within their budget. You've got to recognize the times you're in, so that as well.

Operator

And that concludes our question-and-answer session. I'd like to turn the conference back over to Helen Wilson.

Helen M. Wilson

Thank you for your time and attention this morning. We look forward to speaking with you again at the end of next quarter. Thank you and good day.

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Source: ACE Limited Q4 2008 Earnings Call Transcript
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