Odyssey Re Holdings Corp. Q4 2008 Earnings Call Transcript

Odyssey Re Holdings Corp. (ORH)

Q4 2008 Earnings Call

February 20, 2009 10:00 am ET

Executives

Don Smith – Senior Vice President, General Counsel and Corporate Secretary

Andy Barnard – President and Chief Executive Officer

Scott Donovan – Executive Vice President and Chief Financial Officer

Analysts

Doug McGregor – RBC Capital Markets

Amit Kumar – Fox-Pitt Kelton

Ron Bobman – Capital Returns

Presentation

Operator

Good morning and welcome ladies and gentlemen to the Odyssey Re Holdings Corporation Fourth Quarter 2008 Conference Call. At this time, I would like to inform you that this conference call is being recorded and that all participants are in a listen-only mode. At the request of the company, we will open the conference up for question and answers after the presentation. I will now turn the conference over to Don Smith, General Counsel and Corporate Secretary.

Don Smith

Thank you, [Stacy], good morning. Odyssey Re's results will be discussed this morning by our President and Chief Executive Officer, Andy Barnard, and by Scott Donovan, Executive Vice President and Chief Financial Officer of the company.

The following discussion may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Some of these statements may relate to risks and uncertainties. Actual results may be materially different from those contained in or suggested by such forward-looking statements.

Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the company's filings with the Securities and Exchange Commission.

And now Andy Barnard will open with discussion. Andy?

Andy Barnard

Thank you, Don, and good morning everyone. We are gratified to report our fourth quarter and full year results have been rewarding. For the full year, book value per share has grown over 23%. This performance is directly traceable to the success of our investment manager, Hamblin Watsa, navigating the turbulent financial markets experienced over the last 18 months.

Our combined ratio for the year has come in at 101.2%, between Ike and the China snow storms we added about nine points to the ratio for 2008.

As we look forward into 2009, we expect the market will continue to firm. While we are a long ways away from a hard market, forces are in place to bring about some meaningful improvements in trading conditions.

Property catastrophe exposure is leading the way, particularly in the United States. We are seeing signs of price stability in the casualty markets, though we believe this area continues to demand significant caution after years of rate attrition. After the January 1st renewal season, in the Americas division, our reinsurance portfolio is relatively flat with a year ago. We have continued to trend exposure in the casualty classes, particularly excess casualty lines.

Our property portfolio, written in the Americas, is up at year-end, though our exposure has been reduced. We have deliberately held back in the deployment of peak zone capacity in anticipation of a hardening in the property catastrophe market as the year progresses.

Insurity, which we write principally on an excessive loss basis, we have raised the attachment points under our contracts to help insulate us from an expected increase in losses. In the casualty facultative business at January 1st, rates have begun to stabilize. We are also seeing an increase in submissions, as more business moves around the market and feedents are generally seeking to reduce their risk appetite.

In our Euro-Asia division, at January 1st across the various markets, terms and conditions were reasonably stable with slight increases in some of the major CAT programs. In general, the market has become less willing to accommodate further softening.

For programs that have suffered losses, significant improvements have been available. In the trade credit sector, we've reduced our portfolio despite significant commission reductions and rate increases, given concerns about a prolonged economic downturn.

In our London reinsurance operations, we took advantage of new opportunities in the retro session market, and we also benefited from improved terms and prices in the marine excessive loss business.

At our Lloyd syndicate, where we focus on non-U.S. casualty insurance, conditions remain competitive. We are beginning to see positive movement in the financial institution sector, but we believe much more is needed.

Finally, our U.S. insurance division continues to build out its capability, particularly in the D&O, multi-peril crop, and environmental fields. We will be patient, to avoid expanding too rapidly in advance of a solid market turn. However, when the turn comes, we will be well positioned to grow rapidly.

For the entire company in 2009 at this point, we project our net premium volume to be down about 10%. Some of this is driven by the relative strengthening of the dollar against the pound, sterling, and the euro. This is also more of a static market forecast, based on the conditions we see today. As many have suggested, it is possible we will experience a progressive improvement in market conditions throughout 2009, in which case we might expect upside to this projection.

Under most scenarios, we remain optimistic that Odyssey Re will do well over the long term. Our formula depends on the combination of disciplined underwriting with value investing to produce superior long-term returns. Any given quarter or year may under produce, but we are confident that over time, this approach yields the best results.

Since 2001, we have compounded book value per share at an annual rate of over 20%. Our investment strategy has served both to protect us from the downward currents that have grabbed many others, while also providing significant upside opportunities. There is, however, no guarantee as to how it will perform in the future.

And with that, let me turn the call over to our Chief Financial Officer, Scott Donovan. Scott?

Scott Donovan

Thank you, Andy, and good morning. Our fourth quarter financial highlights were highlighted by pre-tax income of $157 million, resulting in after-tax income of $107 million, an annualized return on common equity of 16.4%. During the quarter, our book value per share increased by 8.6% or $3.59 per share, to $45.37 per share; while our shareholders equity grew from $2.6 billion to $2.8 billion.

For the full year 2008, after-tax net income was $543 million, with a return on common equity of 20.5% and an increase in book value per share of $8.59 or 23.4%. After-tax operating income for the fourth quarter was $24.9 million or $0.42 per share, compared to after-tax operating income of $59.5 million or $0.85 per share in the fourth quarter of 2007.

Our operating earnings were unfavorably impacted by adverse foreign exchange rate movements. Additionally, net income declined 29% mostly due to reduced income from our other invested assets and lower yield on cash, cash equivalents, and short-term investments.

Net income for the quarter was $107 million or $1.80 per share, compared to net income of $243 million or $3.48 per share in the fourth quarter of last year. The decrease in net income was a result of reduced operating income as discussed earlier, and lower realized gains.

During the quarter, foreign exchange rate volatility continued as a result of the global financial crisis. Our net income this quarter included a foreign exchange net after-tax loss of $48 million, principally resulting from the euro to British pound conversion in our Lloyd syndicate and a weakening of the euro and the British pound versus the U.S. dollar.

This loss was comprised of an operating loss of $30.7 million after-tax or $0.51 per share, and realized investment losses of $17.3 million after-tax or $0.29 per share. Unrealized foreign exchange gains recorded in other comprehensive income increased by $17.5 million after-tax or $0.29 per share; together, the income statement impact and the change in unrealized for the quarter, negatively impacted shareholders equity by $31 million or $0.51 per common share.

Looking at premium activity for the fourth quarter of 2008 compared to 2007, gross premiums written were $494 million, a decrease of 6%. Reinsurance business was the primary contributor to the decline. Gross premiums written decreased in Euro-Asia, the Americas, and the U.S. insurance divisions, partially offset by an increase in the London market division.

The decrease of 22% in Euro-Asia was largely due to a system change in premium estimation process, which impacted premiums written only and to a lesser extent, foreign exchange movements. The gross premium decrease of 8% in the Americas division was primarily attributable to the continuing decline in casualty lines. U.S. insurances decline of 3% was driven by continued competitive conditions and the medical professional book of business.

These declines were partially offset by a 20% increase in the London market division, which benefited from growth in the syndicates medical professional business.

In terms of premium composition, 50% of our gross premium was derived from non-U.S. markets, compared to 51% in the fourth quarter of 2007. Regarding product mix, 48% of our business in the quarter was in casualty lines, 43% was in property, and 9% in marine, aviation, surety, and other specialty classes. Insurance as percentage of our business volume was 38%, compared to 33% a year ago.

For the quarter, our combined ratio was 93.9% versus 93.7% in the fourth quarter of 2007; included in the combined ratio for the quarter were $37 million or 7.4 points of current year CAT losses, net of reinstatement premium. These losses include additional provisions, net of reinstatement premiums of $17 million for Hurricane Ike, which brings the total Ike loss to $127 million, and $10 million for the first quarter snow storm in China.

The quarter also benefited from $7.4 million of prior year loss reserve releases. Our combined ratio for the 2008 year was 101.2% and included catastrophe losses of $227 million or 10.9 points, net of reinstatement premiums.

Looking to our four operating divisions; in the Americas the combined ratio for the quarter was 101.2%, which included 5.8 points of favorable current year CAT development and 19.5 points from adverse loss development, principally attributable to an increase in asbestos reserves of $20 million. Additionally, we continue to reserve current year D&O and higher levels and the expectation of increased loss activity associated with the ongoing turmoil in the financial sector.

In Euro-Asia, the combined ratio for the quarter was 86.2%, which included approximately 14 points from current year catastrophe losses, net of reinstatement premiums, and benefited by 8.6 points from favorable prior year loss development.

For the London market division, gross premiums were increased 20% for the quarter, compared to the fourth quarter of 2007. The increase reflects a 33% increase in the medical professional business. Net premiums written increased by 15% during the quarter, primarily due to the increase of gross premiums, partially offset by increased utilization of reinsurance in the fourth quarter; as a result, net retention decreased to 80% from 83.5%.

London market division had a combined ratio of 73.5% for the fourth quarter, which included 26.1 points of favorable prior period loss development, due to loss reserve releases on property within the reinsurance book and Lloyd's syndicate liability business, partially offset by current period CAT losses of $10.5 million or 12.5 points, net of reinstatement premiums, primarily attributable to Hurricane Ike.

Our U.S. insurance division gross premiums were decreased 3% in the quarter. We experienced increases in several programs, including crop and commercial auto, which were offset by a continued reduction in our medical professional segment. Net premiums written declined 10% during the quarter, due to the decline of gross premiums and the increased utilization of reinsurance.

As a result, the net retention ratio declined to 74.6% from 80.1% in 2007. The division's combined ratio of 107.2% for the quarter included $20.1 million or 20.5 points of current year CAT losses, primarily Gulf of Mexico offshore energy losses from Hurricane Ike and favorable loss development of 12.4 points, principally attributable to reserve releases for medical professional and general liability.

Investment income, net of expenses for the fourth quarter was $54.9 million pre-tax, which represents a decrease of 28.7% compared to the fourth quarter of 2007. The decrease is mainly attributable to our equity in reported losses from other invested assets and from lower yields on cash, cash equivalents, and short-term investments. Overall, our portfolio yield declined to 2.75% from 3.94% in the year ago quarter.

During the quarter, a substantial portion of our U.S. portfolio was liquidated, with the proceeds reinvested in U.S. municipal tax advantage securities, and to a lesser extent, equity securities. As a result of this portfolio restructuring, the yield on our overall portfolio at December 31, 2008, was projected to be 4.1% or 5% on a tax equivalent basis. The yield is only an indication and will be affected by future movements in short-term rates and portfolio activity.

Net investment realized gains in the quarter were $127 million pre-tax or $1.38 per share after-tax, compared to $282 million pre-tax or $2.63 per share after-tax in the fourth quarter of 2007.

The current quarter included a gain of $256 million from S&P Index swaps and total return common swaps, which were unwound during the quarter, a gain of $190 million substantially from the sale of U.S. Treasury securities, a gain of $41 million from foreign exchange forward contracts, and a gain of $35 million from credit default swaps, partially offset by other-than-temporary impairments of $256 million, primarily from equity securities and mark-to-market losses and bonds with convertible features of $90 million.

Operating cash flow for the quarter was negative $126 million, compared to positive $4 million in the fourth quarter of 2007. The decrease was primarily attributable to $173 million of tax payments, most of which relates to tax gains on a monetization of credit default and total return swaps.

Our total capital amounted to approximately $3.3 billion at December 31, 2008, with debt representing less than 15% of total capital, which is well within our acceptable levels. Our senior notes mature in 2013 through 2021 and our preferred stock is perpetual.

Total invested assets and cash were $7.9 billion at December 31, 2008, which is slightly higher than where we started the year, vested assets to common shareholders equity currently stands at 2.9 to 1 and our investment portfolio now equals $131.01 per share.

Equities, including equity investees were $1.7 billion at year end, representing 22% of our portfolio. Our fixed income portfolio valued at $3.9 billion as of December 31st, includes municipal securities $2.3 billion, foreign government securities $0.8 billion, and U.S. Government securities $0.4 billion, 82% of the fixed income portfolio is rated AAA and 8% of our securities are rated below investment grade.

As of December 31, 2008, the carrying value of the remaining credit defaults swap portfolio was $83 million, with a notional amount of $1.8 billion, the average term to maturity was 2.5 years. As a reminder, the credit default swaps may be extremely volatile and the market value and liquidity may vary dramatically, either up or down in short periods. Their ultimate value, therefore, will only be known upon their disposition.

At the end of the quarter our after-tax unrealized gain position was $75 million, an increase of $90 million from September 30, 2008. The change was primarily attributable to unrealized gains in our fixed income portfolio and OTTI losses previously and unrealized.

Finally, with respect to capital management, during the quarter, we did not purchase any shares of our common stock and the total amount of shares purchased since the inception of our repurchase program in 2007 remains 12.1 million shares at a cost of $446 million, which equates to an average purchase price of $36.79 per share.

I will now turn the call over to [Stacy] for your questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). Your first question comes from Doug McGregor – RBC Capital Markets.

Doug McGregor – RBC Capital Markets

Hi, good morning. I just wanted to confirm a few numbers that you mentioned in your preamble, Scott. First, you said that there was about 19 1/2 points within the Americas of adverse asbestos development, but you said that was gross asbestos development. Did you also mention that there was 5.8 points of favorable development within that same division?

Scott Donovan

Yes, let me go through the numbers, Doug. The Americas division combined ratio is 101.2, and there's two different things going on. First, we had favorable development on current year CAT, and that primarily was a release of Ike-related reserves that we had established in the third quarter.

Okay, on top of that we saw unfavorable loss development of 19.5 points. A component of that included $20 million of strengthening for asbestos, the remainder there Doug, would have been for other years, other types of losses.

Doug McGregor – RBC Capital Markets

Okay thanks, and second, if you could – you mentioned with your investment reallocation to a lot of munis, you said that it was a 4.1% yield and you said it was a 5% taxable equivalent?

Scott Donovan

That is correct.

Doug McGregor – RBC Capital Markets

Is that for the whole portfolio or just the fixed income allocation?

Scott Donovan

No, that would be the entire portfolio, so you're comparing the 4.1% for the entire portfolio with a tax equivalent of 5% for the entire portfolio.

Doug McGregor – RBC Capital Markets

Okay, that's helpful, and I guess any thought on buy-backs. I mean it looks like your premiums aren't anticipated to – they might be flat even in a best case scenario, and it sounds like you're looking at it a little bit down.

Are you looking at buy-backs or do you want to sort of keep maybe a little extra capital in reserve for any anticipated improvement?

Andy Barnard

On that point, we still have approximately $150 million outstanding under our existing buy-back authorization. We do think that Odysseys' long-term prospects are very favorable, but we're going to balance any additional buy-backs against our view of market prospects.

As we've said, right now we have not seen a whole lot of market hardening other than in the property CAT area. As the year goes by, that's something that we're going to be watching closely. So there is the possibility that we may buy back more stock, but there are a lot of different considerations that go into that decision making.

Doug McGregor – RBC Capital Markets

Okay, thanks a lot. That's all of my questions.

Operator

(Operator Instructions). We go next to Amit Kumar – Fox-Pitt Kelton.

Amit Kumar – Fox-Pitt Kelton

Thanks. Just going back to the top line guidance of 10%, I think in the opening comments you also mentioned that some part of that is based on the exchange rate too. Can you sort of give some more clarity on that number?

Andy Barnard

If we look at exchange rates this year, at least where they are right now versus what they were as we were recording premiums last year, the dollar is stronger against the euro and the pound. Those are significant currencies for us, so we would expect based on the way things stand today that on a comparative basis, our dollar denominated premiums emanating from overseas will be lower than they were in 2008.

So that was the reason why we drew attention to the foreign exchange component in the top line. Beyond that, as I said, looking at the way the market is today, we think that we will grow on the property side, but we will continue to exercise caution on the casualty side of our business pending further market improvements, and so as we've gone through the full company, division by division, unit by unit, taking into account foreign exchange differences this year versus last year, it leads us to as of today, to think about 10% as a reasonable number that we would be down.

Amit Kumar – Fox-Pitt Kelton

And in terms of the mix, I think you said a 48/43 split between casualty and property, where do you see that by end of '09, just based on the rate increases and as you said, sort of retrenching in some of the lines?

Andy Barnard

It may be that property will continue to increase as a share of the total. I mean I wouldn't give you – I'm not going to say it will be 50/50 or 49/51, but I think that the trend as of today is on the property side, you're getting more – particularly in the United States – you're getting more premium for the same exposures so there's organic growth in the property premium, and to the extent that we perceive opportunities in that field further on down the year as being even more attractive, we may decide to increase our capacity slightly.

Amit Kumar – Fox-Pitt Kelton

That's helpful, and in terms of we've talked about growth prospects and what I think you've said over time, is that you're more focused on sort of looking at organic or maybe acquiring teams instead of any meaningful acquisitions, etc., and you have been in a somewhat relatively quieter on that front compared to a lot of people moving around.

Is there, what's the top process there? Do you think that you have the requisite or the talent already, on board, and hence so you don't really need to acquire any, or maybe if you can just sort of comment?

Andy Barnard

Well we believe we have the requisite talent, we believe we have the platform that is sufficiently flexible to enable us to expand when market opportunities do present themselves. We do look at teams; we have hired additional people over the last year to bolster some of our departments and to add some new capabilities.

However, as mentioned in the liability side in particular, the market has yet to become very exciting and so we're not going to get too far ahead of where the market is, in terms of adding new underwriting capability.

Amit Kumar – Fox-Pitt Kelton

That's helpful and maybe two quick questions, on the financial D&O side, maybe if you could just give some more color as to what you're seeing in your book and what one should expect going forward?

Andy Barnard

In terms of?

Amit Kumar – Fox-Pitt Kelton

The financial institutions and based on what has happened recently in the market place, maybe in the claims or claims notices, etc.

Andy Barnard

Well we track our claims notices, which is really largely in our – an issue in our U.S. reinsurance book, with our treaty and facultative clients. We track the class actions that have been filed against companies that have had issues that we have through reinsurance involvement with and we use that information to assist us in making some decisions about additional provisions.

As you know, we have been adding to our sort of run rate on D&O for some time now to give us some extra provisioning for the liability fallout from the credit crisis. On the premium side, there has been movement. Obviously, prices have gone up in that area, we're not sure that they're going up enough, so it's not an area that we've sought to significantly ramp up our activity in today.

We think prices could move up quite a bit more to provide adequate risk margin for the exposure that exists in that field. So it is one of those areas where there is a hardening market as we speak, but we're not convinced that it is hardening enough to warrant significant expansion into that field.

Amit Kumar – Fox-Pitt Kelton

That's helpful, and the last question if I may. You mentioned on the medical professional side, you said something about that the competitive pressures, could you just sort of maybe expand on that a bit? Is it rate or something else going on?

Andy Barnard

It is primarily rate driven. There can be some softening in terms and conditions in that field, but the medical professional area is one that has done exceptionally well over the last half dozen years and not surprisingly, it's attracted a lot of competition and rates – we're into our third or fourth year of declining rates in that area, so it has been subject to competitive pressure for some time.

Rates may not be falling sharply as they have been over the last several years, but it still is an area that is experiencing downward pressure and as a result, we're allowing that book to shrink while those trends continue.

Amit Kumar – Fox-Pitt Kelton

Okay, thanks so much for your answers.

Operator

And we'll go next to Ron Bobman – Capital Returns.

Ron Bobman – Capital Returns

Good morning Andy and Scott. Congrats on a great, great year. I had three questions, Andy, would you describe how much reinsurance you might provide to AIG and if that amount is changing, or if your view on it is changing at all?

Andy Barnard

Well that's an easy one, Ron. We do not provide any reinsurance to AIG.

Ron Bobman – Capital Returns

Okay, keeping it quick, the next question was, what sort – did you see any sort of meaningful pick up in the line sizes that you were, I don't know if allocated is the right word, but I guess the line sizes that you were assigned in the 1/1 property CAT renewals. Was sort of the resulting signing, is larger than sort of the yield that you've enjoyed in years past?

Andy Barnard

Marginally, on the margins Ron, that would be the case because we manage our property catastrophe exposure relative to our aggregate capacity. It really doesn't matter that much as to what signing we get on any one individual program.

Of course, some programs we perceive to be better opportunities than others and on those, we would seek to have higher signings, but also when you take into account and here I'm talking really about the U.S., the expectation that there will be improved opportunity as we move through the year, as we think supply is going to be more strained.

We're not necessarily seeking a lot of higher signings in the property CAT area at this particular renewal.

Ron Bobman – Capital Returns

Okay and my last question, was any indication, as far as sort of rate expectations for – I think it's April 1 that Japan and Korea are the big renewal markets in property CAT, any sort of early indications to what's going to happen in those markets if my dates are right?

Andy Barnard

Not really. I think I would – my expectation would be that there may be some modest upward pressure in Japan and in Korea. In Japan of course, you have the fact that the Japanese currency is one of the few that has really appreciated against the dollar and in that respect, it may put some pressure on supply if companies decide to maintain sort of a dollar based capacity.

However, the Japan catastrophe experience has not been terrible over the recent past, and therefore, I don't expect dramatic changes. I would not expect rates to go down in Japan, but how much they might go up I would expect it to be in sort of the modest category that we saw in Europe in January 1.

Ron Bobman – Capital Returns

Okay and how much do you rate there, is my last question?

Andy Barnard

In Japan? Our book is about $30 million.

Ron Bobman – Capital Returns

And is it weighted one way, quake versus wind?

Andy Barnard

It's more wind, but we have a significant – there isn't a huge difference in the aggregate exposure that we have between quake and wind in Japan.

Ron Bobman – Capital Returns

Okay, thanks a lot and best of luck. Hope it continues.

Andy Barnard

Thank you.

Operator

(Operator Instructions). We have a follow up question from [Doug Merwitter] – RBC Capital Markets.

[Doug Merwitter] – RBC Capital Markets

Hi Andy, I just wanted to follow up on the medical professional lines. It was just kind of interesting, you mentioned the medical professional line in U.S. insurance were very competitive in your continue to strengthen that business, but correct me if I'm wrong, I thought I heard that you actually saw some opportunities through your London branch or London business through the same lines.

Was that just a different segment of it or did I hear wrong or?

Andy Barnard

No, no, that is non-U.S. medical malpractice. That's in a different marketplace.

[Doug Merwitter] – RBC Capital Markets

Yes, that's what I assumed, and Scott, if I could just ask I guess a naive accounting question, the currency fluctuations on how you account for them, I would imagine that the, I guess the dollar value of your euro based loss reserves has gone down.

How does that – does that get a kind of different leaf from the dollar value of your euro based euro denominated investment assets?

Scott Donovan

If you're talking about just the syndicate, the answer would be yes, the Lloyd's syndicate, because the functional currency within the Lloyd's, and not to get too technical, but the functional currency within the Lloyd syndicate is the pound.

So with the euro strengthening significantly against the pound, that conversion from euro reserves to pound reserves within the syndicate gave rise to a loss, which is recorded in other income and expense. When that then is translated from the pound to the U.S. dollar for reporting purposes, it's picked back up in OCI, okay? So it has everything to do with where the functional currency is, and then the translation from that functional currency.

[Doug Merwitter] – RBC Capital Markets

Okay so some of that – some of those currency translation charges and other income or other expense, were just a way you account for reserves then?

Scott Donovan

Exactly right and largely offset when it was then translated from the functional currency, again in this case, the syndicate being the pound to the U.S. dollar.

Andy Barnard

It's all geography under technical accounting rules.

[Doug Merwitter] – RBC Capital Markets

Okay, thanks. That's all my questions.

Operator

If there are no further questions, this concludes our conference call for today. Ladies and gentlemen, if you do wish to access the replay for this call, you may do so by dialing 888-203-1112 or 719-457-0820, with an ID number of 5489334.

This concludes our conference call for today. Thank you for your participation.

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