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Endurance Specialty Holdings Ltd. (NYSE:ENH)

Q1 2009 Earnings Call Transcript

May 7, 2009 8:30 am ET

Executives

Gregg Schroeder – SVP, IR and Corporate Development

Ken LeStrange – Chairman, President and CEO

Mike McGuire – CFO

Mike Angelina – Chief Risk Officer and Chief Actuary

David Cash – Chief Underwriting Officer

Analysts

Keith Alexander – JP Morgan

Sam Hoffman – Lincoln Square Capital

Jay Cohen – Bank of America/Merrill Lynch

Ian Gutterman – Adage Capital

Edward Gong [ph] – Rivershore Investment

Operator

Good morning everyone, and welcome to the Endurance Specialty Holdings first quarter 2009 earnings results conference call. This call is being recorded. Your lines will be in 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 Gregg Schroeder, Senior Vice President of Investor Relations and Corporate Development. Please go ahead.

Gregg Schroeder

Thank you Rachael, and 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 we 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 10-K and other documents on file with the SEC that could cause actual results to differ materially from those contained in forward-looking statements. Forward-looking statements speak only as of the date on which they are made and Endurance undertakes no obligation publicly 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.

Ken LeStrange

Thank you Gregg. Good morning and welcome to our call.

The results we reported last night represented a good start towards accomplishing our financial goals for 2009. We delivered strong underwriting results and the contribution of our investment portfolio to our income exceeded our expectations. Operating income was $88.2 million in the quarter representing an annualized operating return on equity of 16.6%. Book value ended the quarter at $34.34 per share, an increase of 3.9% from year end. Book value per share growth plus dividends for the quarter was 4.6%.

During the quarter, we continued to execute our cycle management strategy by allocating our resources and capital to lines of business and markets where improved pricing and terms and conditions indicate appropriate returns to the risk that we take. At the same time, we continue to reduce our exposure in areas not meeting our standards. Endurance has shown great discipline in managing this cycle over the past seven years and we have aggressively adjusted our mix of business as we seek returns. We are beginning to see the classic signals that foreshadow an improving market climate for underwriting. We have already begun to benefit from improving markets as they appear.

While reinsurance and insurance markets are stabilizing and in some cases improving, the current underwriting environment requires caution and discipline due to at times irrational competitive pressures. Endurance's breadth of product offerings, strong capital position, and talents of people position us well for any potential reordering of the industry which may take place over the next several years.

I will now turn the call over to Mike McGuire who will cover our first quarter results in more detail.

Mike McGuire

Thank you Ken, and good morning everyone.

We are pleased to report a good start to the year with solid underwriting and investment income, strong book value growth, and stabilization of our investment portfolio values. For the first quarter, Endurance earned net income of $78.3 million and $1.24 per diluted common share, up almost 10% on a per share basis. Operating income for the first quarter of 2009 was $88.2 million and $1.40 per diluted common share, up about 7% on a per share basis. Our annualized net income ROE is 14.7% and our annualized operating return on equity is 16.6% for the quarter.

Our gross and net written premiums were down a little over 9% with net written premiums of $585.2 million, down about $58 million from the first quarter of 2008. Approximately one quarter of this decline was due to the strengthening of the US dollar, most of which was felt in our reinsurance segment. Also contributing to the decline in premiums was our exit from California workers compensation insurance and the UK property insurance.

In our agricultural insurance line, declines in commodity prices were offset by rate increases to account for commodity price volatility experienced last year and growth in policies in force by over 10%. Our other insurance lines experienced growth as we continued to successfully retain clients, while gaining new business through our expanded underwriting platforms and from new opportunities created by the distress of several large competitors.

In our reinsurance segment, net written premiums declined in the quarter largely due to foreign exchange and non-renewals in our marine line that were partially offset by growth in casualty, property and catastrophe lines, as we have seen stabilizing conditions in casualty and strong rate increases in property and catastrophe lines. Later in the call, David Cash will provide additional details on the market conditions we are seeing.

Our combined ratio was 92.2% in the first quarter of 2009, up 7.8 points from the first quarter of 2008, largely due to a 7.3 point increase in our net loss ratio. The increase in our loss ratio was largely due to a higher level of attritional loss reserves established for our short tailed lines to reflect the potential claims from a number of smaller loss events. Individually, we do not expect it to be significant to the company, but collectively have resulted in a slightly higher level of reported loss activity compared to the first quarter of 2008. The existence of reported losses early in our accident year and in partial year's earned premium tend to push up the accident year loss ratio in the quarter as they're generally additive to our attritional loss reserves, until the accident years matures and we have a better sense for the entire year's actual losses. Our reserving approach in this regard has not changed from prior areas.

Looking at prior period reserves, our first quarter results included $39.3 million or 10.4 points of favorable prior-year preserve development similar to the $41 million or 11 points of favorable development experienced in the first quarter of 2008, albeit from different segments. Mike Angelina will discuss our current and prior year reserves in more detail later in the call.

In our insurance segment, results benefited from favorable loss reserve development, including $11 million from better-than-expected settlements of a 2008 crop year and $26 million from our property and portions of our casualty insurance. The expense ratio in our reinsurance segment picked up several points largely due to increased expenses in our agricultural line. Part of this increase is due to reductions in third-party expense reimbursements, including the impact of reduction in US federal crop insurance program reimbursements.

In addition, over the last year, we continued to expand our capabilities to the hiring of additional agricultural insurance underwriting and claims professionals to better position the company for growth in this business line. These investments are already paying off. We have seen growth in policy counts, strong retention rates and efficient handling of significantly increased claim volumes year-over-year. Based on the seasonality of the earnings of agricultural premiums, which is more heavily weighted to the second, third and fourth quarters, we expect the increase in expense ratios to moderate somewhat throughout the year as premiums are earned. On the reinsurance side, results were impacted by much slower favorable reserve development year-over-year and from increases through attritional loss reserves related to short tail lines that I mentioned earlier.

Moving to investments, the first quarter was one of continued market volatility and stress. Yet our conservative positioning and active portfolio management resulted in relatively stable valuations and a positive total return of 95 basis points. Net investment income of $64.6 million in the first quarter, up $17.7 million or 37% from the year ago. The increase was largely driven by the positive performance of our alternative investments in high yield loan funds compared to losses posted in the first quarter a year ago. This increase was partially offset by lower yields on our fixed income portfolio as we continue to shorten duration and reinvest cash flows into very high-quality government backed securities. We recognized net investment losses of $8.9 million in the quarter, including OTTI charges of $12.1 million, partially offset by gains from sales of $3.2 million.

From a balance sheet point of view, our investment portfolio value was relatively stable and our net unrealized investment loss increased by a modest $3 million in the quarter. Our investment portfolio continues to carry an average credit rating of AAA. This quarter we have provided some additional information demonstrating the underlying quality of our non-agency CMBS and RMBS portfolio. The supplemental portfolio information can be found on slides eight and nine of the earnings call presentation that was posted on our website last night in addition to a regular financial supplements.

I would like to highlight three items that you can see on slides eight and nine. First, the majority of our non-agency mortgage exposure, the 2005 vintage and earlier. Second all our exposure with the exception of a $30 million very seasoned high yield CMBS portfolio is comprised of the most senior bonds and their respective capital structures. Third in order for the value of the principal and the securities to fall below market prices, at March 31, default rates on the underlying mortgages would need to be between 40% and 95%, with 45% to 80% severity depending on collateral type and vintage. As you can see on slide eight and nine, current cumulative losses to date are less than 1% and delinquencies greater than 60 days range on average from 1.5% to 8.5%, well below the levels implied by current market prices.

During the quarter, we took advantage of some short term market strength to reduce our corporate bond holdings by approximately $100 million with the majority of the reductions coming in the financial sector. Our largest corporate security is only $18 million and only five of our top 25 corporate holdings are financial issuers. In the quarter, we increased our investments in government-backed securities by approximately $550 million, mainly in FDIC backed corporate issues.

In addition, the strategy we began implementing in the second half of last year to significantly shorten the duration of our fixed income portfolio has preserved book value as rates have increased in 2009. Although we're starting to see some initial signs of stability in the credit market, we believe it is too early to declare a bottom, as downside risk remains elevated given the continuing deterioration in the global economy and the banking system. Housing and high levels of consumer and corporate leverage remained serious problems. As a result, in the near term, we expect to maintain our conservative position. Although we're sacrificing some yield in the short term, we believe this is a prudent approach. We remain well positioned to take advantage of higher yields when we see more signs of stability and reduced downside risk.

We ended the first quarter strongly capitalized with total shareholders equity of nearly $2.3 billion and total capital of $2.8 billion. Our diluted book value per share ended the quarter at $34.34, up 3.9% at year-end. Gross diluted book value plus dividends paid was 4.6%. Although we did repurchase a small number of shares in the quarter, we did not expect to repurchase significant amounts of our shares in the near term; given the continued uncertainty and distress in the capital markets, and our expectation that underwriting conditions will improve throughout the year.

I will now turn the call over to Mike Angelina to discuss our price monitoring and loss reserves.

Mike Angelina

Thank you Mike and good morning everyone.

With regard to the pricing environment, for the first quarter of 2009, our overall rate monitoring indicated an increase in pricing across our entire portfolio of 4% compared to the 8% decrease we observed in calendar year 2008. We also noted this quarter that terms and conditions are improving slowly. The observed price movement is more pronounced on the reinsurance side as rates have increased by 5% versus a decrease of 8% observed in 2008. The rates in the insurance segment are also moving towards a more favorable position, now showing a slight decrease of 1.5% in 2009 versus 9% decrease we observed in 2008. It is also worth noting that renewal premiums comprises of approximately 85% of our year-to-date written premiums, allowing us the benefit of insights that only come with long planned history and the attended knowledge gleaned from our many years of underwriting on the claims side.

Turning to our loss reserves, in the first quarter of 2009, our loss reserves across all prior periods developed favorably in total by $39.3 million, driven by the insurance segment. Approximately $10.7 million of this favorable development is due to our agricultural insurance line of business for the 2008 accident year and the claim settlements were better than expected. The remaining $26 million of favorable development observed this quarter in the insurance segment is split evenly between the short and the long tailed lines of business. For the short tail lines of business, favorable development arose due to lower than expected lower claims activity, while the favorable development in the insurance long tail lines of business is largely driven by our Bermuda-based casualty line.

Within the reinsurance segment, we experienced modest favorable development this quarter as claims emergence across all lines was for the most part in line with expectations. In prior quarters, claims activity was significantly below expectations and sometimes nonexistent on the catastrophe exposed short tail lines of business. In our property and other short tail lines and both our insurance and reinsurance segment, we are booking the 2009 accident year at 57% loss ratio, against what would be a small premium base of $180 million. Included in the 2009 accident years is $79 million of IBNR relative to $23 million of case incurred.

We're also holding approximately $170 million of IBNR for the 2008 accident year relative to the $296 million of case incurred losses and $100 million of IBNR for accident years 2007 and prior across our short tail line business. In February, we released the annual update of our global loss development triangle. Our loss triangle provides an excellent means of gaining a better understanding of the drivers of our historical loss reserve emergence and the quality of our current reserve position. Inception to date, our reserves have developed favorably by approximately $700 million.

This emergence is principally driven by three areas or reserving groups, with the first two areas accounting for over 90% of Endurance's historical total loss developments. The first group is our short tail and agriculture lines of business, which are characterized by a quick feedback mechanism. The second group is our Bermuda-based casualty insurance line with significant IBNR still remaining. And lastly but to a much lesser extent is the D&O business in our reinsurance segment from the early accident years.

Starting with the short tail in the agriculture line, this group of reserves represent 430 million or 61% of the $700 million of historical favorable loss emergence. We have talked in great length on past calls about our reserving process and have provided a fair amount of detail regarding ICNR and IBNR and loss ratios for short tail lines of business. By definition, the feedback mechanism for these lines is very quick and any aggressive or conservative levels of IBNR reserves will self adjust in just a few quarters. This also explains why we had in the past typically recorded favorable development from prior accident years in the first half of the calendar year and favorable development from the current accident years in the second half of the calendar year when events or claims do not materialize.

The second category which represents over $200 million or approximately 30% of the historical favorable emergence arose from our Bermuda-based casualty line comprising of healthcare liability, excess casualty and professional liability. A significant portion of this business is written on claims made for the Bermuda occurrence form with average attachment points ranging from $40 million for healthcare to between 180 and $200 million for professional lines and excess casualty. The inception to date pay loss activity in these lines is $38 million with an additional $88 million of case reserves relative to the $1.5 billion of inception to date annual earned premium. This results in undeveloped incurred loss ratio of 8.5% over the 7.5 accident years.

With regard to the total Bermuda casualty business, we currently hold approximately $750 million of IBNR. It is worth noting that the historical favorable development of $200 was observed in action years 2002 through 2005 where we still have $250 million of IBNR remaining against only $30 million of case reserves. It is also worth mentioning that in the non-D&O reinsurance long tailed classes of business, reserve movement has been relatively flat. In particular, the other casualty class, which represents the non-motor liability and non-workers compensation classes, we have $122 million of cases reserves. In addition, we have increased these case reserves by 32% or $39 million for what are commonly known as additional case reserves or ACRs.

These ACRs are established by our own claims department and are supplemental to those reserves reported to us via ceding companies and reflect the proactive claims handling approach that we have taken to reserve this and our other casualty lines of business. We are pleased with the pricing of this business particularly in the earlier years. Due to the occurrence coverage and the true long tailed nature of these exposures, we have not released IBNR as might be suggested by standard industry reporting patterns, as we have taken a more cautious view of the reserve development rather than be too aggressive with our reserve releases.

Across all of our businesses, we believe that our current reserve position is strong, and when coupled with our conservative investments portfolio and actually liquidity, we feel we are in an excellent financial position relative to the risks in our portfolio, from both an economic capital and a rating agency point of view. From a competitive advantage perspective, having a strong and durable balance sheet in addition to a balanced and well diversified underwriting portfolio with expanding, profitable and sustainable businesses, we feel we are in an excellent position for future success.

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

David Cash

Thank you Mike and good morning everyone.

In my portion of the call I will provide market commentary on the following product areas; agricultural insurance (inaudible) insurance, middle-market insurance and catastrophe insurance.

In the first quarter, Endurance produced a 92.2 combined ratio even if we experienced an attritional short tail industry losses. Given that the market is still in a very competitive phase, this represents a nice start to the year. Moving to individual markets, the first quarter was a good one for our agricultural insurance team. During the quarter, our 2008 reinsurance year continued to develop positively given that 2008 generated more than two times normal levels of claims activity, it is very satisfying to see the case reserves posted in Q4 2008 turn out to be more than adequate in 2009.

Focusing on the 2009 reinsurance year, our agricultural insurance team grew insurance policies in force 11% year-over-year against the backdrop of industry growth on the order of 1%. Against this policy growth, commodity prices were down in March on a year-over-year basis by 30% plus. Offsetting commodity price reductions for 2009 we have seen some reallocation of crop planting in particular away from cotton and a higher load incentive rates for revenue products in response to increased commodity price volatility. Overall, the load for higher future price volatility probably added 10%, 15% to 2009 rate level revenue products. A combination of lower starting prices for 2009 and an increase load for volatility certainly suggests that we start to see 2009 crop year in a better place than it was in 2008. While it is true that the agricultural industry has seen reductions in the US federal subsidies, we continue to believe that our agricultural insurance is well positioned to capitalize on opportunities in 2009.

Moving to our 14000 [ph] insurance business, 2009 is shaping out to be a competitive year, yet still represents opportunities for growth. Over the last two quarters, we have seen a steady flow of new business opportunities. Year-over-year, our new business submissions flow has grown by over 300% in the excess casualty and professional lines of business. While it can't be said that all new business opportunities are well priced, we have been able to find attractive new opportunities. In this area of business, there has been much talk about a coming market correction. If history is any guide, casualty market corrections do not tend to occur until the end of a long downward slide in pricing terms and conditions. As of today, it does not appear to us that the world attrition has been taking place with respect to price and yet we see this being ceded by (inaudible). Until that event occurs, we will underwrite conservatively in the space while continuing to position the company for future opportunities.

The preceding negative US side we all believe that even in this sub market disciplined companies can still find tranche of opportunities to underwrite. Time will tell but it is my view that 2008 and 2009 underwriting year for the casualty business had the potential to perform well for Endurance. Given the historic performance of this book on our global loss triangle, we believe we're well-positioned to weather this competitive period of time.

In the middle-market insurance space, conditions continue to be mixed. In the property lines of business, pricing is starting to move up and programs are becoming harder to write. It is certainly increase opportunities for our underwriters. On the casualty side, competition remains tough. There are occasional signs of large standard line carriers pulling back from this space but such instances are relatively infrequent and often the gap is filled different standard lines later.

The second bright spot in the middle market comes from the specialty program space where some well-regarded managers are starting to look for new homes. As we know, this is a notoriously tough portion of the insurance market; with that said, there is still very effective program managers out there. Given our full range of onshore capabilities, we are seeing a plethora [ph] of opportunities in this area.

Finally turning to the property catastrophe reinsurance market, we are beginning to see signs of price hardening that range from modest versus the Japanese risk to be very pronounced US market. Unlike 2006, where price increases were the result of financially damaged reinsurers seeking to rebuild their balance sheet, these price increases have a slightly different feel to them. Reinsurers appears to be behaving in a discriminating manner, there are no signs of panic on the part of the insurers and there is a broad movement to limit line sizes. The end result is the competition on the part of season to acquire capacity. Our sense is this situation will last comfortably into next year.

In Japan, our team was able to grow our book of business about 30% as of April 1 with the increases driven in part by a greater visibility in the region to our Singapore presence. It was also facilitated by an apparent pullback in Japan on the part of European and London reinsurers. In the US, we expect a every significant mismatch between supply and demand for peak (inaudible). The early indications support our view that the prices in that market will be up between 20% and 40% depending on layer, and that the renewals seasons will be a late one this year as the market seeks to find new pricing points. In closing, I would just say we continue to feel good about our prospects. From our perspective, clearly we continue to see a full range of underwriting opportunities and have both the drive and underwriting discipline to identify and pick up good new business in this tough marketplace.

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

Ken LeStrange

Thank you David.

Towards the end of the earnings season, I'm sure you're all fatigued in trying to sort out the reality of property-casualty market conditions and what strategies the companies you follow are likely to pursue. I would like to share with you some of the factors that I see shaping the industry in which we function.

The commodity nature of our industry is the fact pricing power over time is elusive and the terms of trade are often set by the most naïve and aggressive participants in the market. The cost of goods that we sell is unknown to us at the time of sale and any pricing decision must be approached with caution. At Endurance, we founded the company with this perspective foremost in our mind, and have executed our underwriting strategy accordingly. You can see evidence of this in our thoughtful approach to pricing in reserving and our mix changes over the years, particularly in the reinsurance segment, where we currently write less than half of the non-cash reinsurance premium we achieved in our peak year of 2003.

I have been pleased and to be candid surprised with the discipline I have seen at a number of peer companies, particularly in Bermuda. Management's ability and willingness to not grow during a soft market and the investment community's support of that philosophy is in my view a relatively recent and very positive phenomena in our business. Our markets are clearly at an inflection point driven by deteriorating underwriting standards and results, realized and unrealized investment process, and the effects of a global recession. We're beginning to see rational industry response to these problems but in a spotty and inconsistent way.

The largest most financially impacted industry players are clearly losing business and market share but through a combination of their desire to retain eroding business and competitors desire to grow, often the prices are even lower, particularly in casualty business where pricing technology is the poorest and the financial exam is self graded, perhaps for a while. Against this backdrop, we're maintaining our underwriting discipline.

Looking forward, I am both optimistic and realistic. It appears that over the next few years, there will be a fundamental restructuring and reallocation of market share in the global reinsurance and specialty insurance places. Over this time period, I think clear winners and losers will emerge. Through our strong balance sheet, robust reserve position, excellent risk management, our mature underwriting technology, broad distribution platforms, and experienced people, I'm confident that Endurance will be a winner.

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

Gregg Schroeder

Rachael?

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Keith Alexander with JP Morgan.

Keith Alexander – JP Morgan

Hi. Good morning guys. I was wondering if you could provide more color on the accident years loss ratio in reinsurance and in particular how much did attritional loss reserves impact the quarter? Was there anything else in the number?

Mike Angelina

Sure, hi. Keith, it is Mike Angelina. A couple of things on this. I guess the first point I would like to make is the premium base is small in the first quarter. The second is we have talked about – Mike McGuire has talked about, we don't reduce IBNR dollar for dollar as lost activity emerges versus companies that may just peg a loss ratio and just kind of treat it as a certain loss ratio and reduce IBNR. The third point is when we look at where 2007, 2008 and 2009 have developed, last year, 2008, there was about $14.5 million dollars of attritional losses at this time. This year there is about $22 million, $23 million, a little bit higher on the attritional loss activity size, and again we did not reduce IBNR for that. Secondly on the IBNR side, IBNR last quarter or last year was 69 million. This year we are at 79 million, again $10 million higher. We had some activity in terms of clout, in Europe, we thought it was prudent with some reserves up and nothing happened. Things came out better than expected throughout the quarter and through our normal preserving process, we will see the benefits of that.

Keith Alexander – JP Morgan

Thanks. That helps clarify it for me. My next question is I was wondering if you could talk about how you plan to allocate your cat aggregate in 2009 in terms of primary versus reinsurance, January versus mid year, and then net to gross exposure?

David Cash

Sure. Hi, Keith, it is David. For mid year, we obviously have the Florida renewals, then we have a cluster of renewals at 7/1. They are all primarily US renewals. Our underwriting posture this year will be similar to prior years in that our first priority is writing the cat product. And second priority is working with clients we consider to be more personalized focus, smaller more regional, so that won't change year-over-year. We haven't yet made our final decisions about allocating capital between Florida and the rest of the US, and frankly we still don't have enough pricing point to make that call decisively. But overall I expect our wind exposure to remain roughly unchanged year over year. You will see some shift away from quarter shares from lasted to this year, that will increase margins, reduce premium a little bit. The wild card still frankly right now is price level. We have had at this point that I think two or three sets of firm order terms from Florida and then more than that one large, other small. So we have got a long way to go before we have full visibility in pricing in that market and that is yet not any real pricing visibility into 7/1. Our sense is it will be up just given the early data points but it'll take time to tell.

Keith Alexander – JP Morgan

And one last question and I will jump back in the queue, how do you expect mix to change over 2009 and into 2010? And how much unearned premium remains in the workers comp business?

Ken LeStrange

Historically the mix changes, the answer candidly is we are not sure. It really depends on how markets perform. Even with the a particular line of business like casualty, we see very different underlying climate say in Bermuda versus the onshore environment in the specialty space, sometimes even on the same account. So it is a very, very choppy and turbulent market right now, which does possess a lot of opportunities, but I think right now we're just watching very carefully what is going on. We have our teams in place, our offices, our technology in place. We are seeing incredible level of submissions just to give you a feel in the US specialty space. On an annual basis, we are seeing over 18,000 submissions now and that number is growing, that is an annual number, on the property side 16,000. Given our view of the market conditions, our hit ratios relative to the submitted business are about 9.5% in casualty and about 12.4% on property where certainly conditions are getting better quickly. I would also point out on a down to quote level, we are only writing about 40% to 45% of what we choose to quote, so we feel that business we really don't even spend time on because obviously the prices are long. So I'm pretty excited actually about the potential for an increased underwriting climate this year and it is showing up in some material places. I really can't predict and take us even to the back half of this year, let alone 2010.

Mike McGuire

I will take your question, this is Mike McGuire, your question on unearned premiums in the workers comp line, it is in the neighborhood of $60 million at the end of the quarter. That business is running off pretty quickly throughout the year.

Keith Alexander – JP Morgan

Thank you for your responses.

Operator

Your next question comes from the line of Sam Hoffman with Lincoln Square Capital.

Sam Hoffman – Lincoln Square Capital

Good morning. I just had two quick questions. On the workers comp business, is that all going away, how much of it was in California, and is there anything else that you're writing in workers comp?

David Cash

Hi Sam. It is David. Under the insurance line, the workers comp was in the California book of business, in the last date of policy down was February 28 I think it was and that business is all going to go away and there is no other insurance business – no other workers comp business in the insurance line. We do write workers comp on the reinsurance side on a cat basis and on a traditional basis and that is obviously not changed by this.

Sam Hoffman – Lincoln Square Capital

Okay. And then related to that, you grew your casualty insurance and reinsurance business significantly in the quarter, was that partially to replace the reduction in workers comp?

Ken LeStrange

Sam, this is Ken. We really don't think that way at all. The growth in the casualty lines insurance would be stemming from really two places, our Bermuda platform where the financial distress being experienced by two of the most significant contributors of capital to that segment, they are being pulled off the programs, their line sizes are being reduced, and businesses coming into the market has not been shown for some time. In the excess casualty area, just by way of example, our submission counts are up 300% year-over-year at this point and they're climbing, less extreme, but very significant increases in professional lines as well. We were also very pleased in our US-based business to begin to get some traction on a very attractive part of the market for us which is healthcare. We have done that in Bermuda for seven years, we're focusing on a smaller type of client, basically community hospitals, clinics, things like that, and we had a really tough 2008 as we started that business. We wrote very little but the distress, the economic distress at one of the our major competitors there, has really caused a lot of clients to switch to us. So that has been helpful.

David Cash

Maybe the one thing to add is that workers comp book of business comes down or actually does restore some capital for us to write in California, so probably the one kind of pickup thought would be in our GIC insurance book of business and also on the reinsurance side. But maybe just to echo Ken's point, it would be so nice if we could turn one line of business off and turn another one off at recommend and the reality is our decision to leave California was driven by the fundamentals of that market. What other opportunities come to us is obviously completely independent of that market.

Ken LeStrange

Couple of other thoughts Sam. We have seen some growth in our professional line segment, that is largely environmental liability, really good book of business, and we're seeing some nice opportunity again because of the distress of some of the big market competitors and you did ask about casualty treaty. And I must tell you over the last several years, our casualty treaty book of business has really shrunk, and we like that business. We think we understand it quite well. There is fewer and fewer good opportunities like that for long. It has changed and is requiring to see with certain kinds of programs this would be big national programs, region companies and specialty companies that we are supporting, seems to be a nice opportunity for us.

Sam Hoffman – Lincoln Square Capital

In the casualty business that you are growing, what are the pricing trends and trends in terms and conditions?

David Cash

Sorry, this is David. I will focus my comments primarily on what I call the excess for 2000 casualty and that is a market that has been talked about a lot. At the bottom of those programs, you typically have some of the most challenged underwriters out there, and I think everyone has remarked on the fact that those bottom layers are going for prices that are less than last year. In fact we saw some fourth quarter premium results from the NAIC, there are some examples of companies dramatically being trumped there, probably not just policy count down, but because their premium is down.

The thing that has been satisfying particularly for Bermuda underwriters is the excess layers have generally helped price health terms and conditions. And we have seen in places increases in price in that space often flat. There'll be the occasional program that comes into that market with pricing that is unacceptable and our strength has been often the brokers start that placement with the three most challenged underwriters and feel they can build the tower above it; often that approach breaks. And so what I think what we're experiencing I think others have communicated is sort of a disconnect that exists in the market. The only people that have sort of fallen between are some of the newer underwriters in that space are sort of in a sense aggressively trying to put themselves on placement and they run the risk of in a sense pricing within the spaces more challenged to the incumbent. But for those that are prepared to follow a disciplined excess model, pricing is good, and flat in places out.

Sam Hoffman – Lincoln Square Capital

And then finally on aerospace and marine, your premium shrunk by 66% in the quarter, is that just a quarterly blip and do you expect to make that up during the remainder of the year?

David Cash

The driver there, it has been marine really. Marine is a line of business that we have been quoting back from some time. Remember years ago we pulled off of offshore energy which sort of is an allied line there. Our marine book and one that we shut down last year and we have not completely runoff but it is smaller. On the aerospace side, premiums are probably down a little bit there too but not much. The driver is in marine.

Sam Hoffman – Lincoln Square Capital

Okay, thanks.

David Cash

You're welcome.

Operator

Your next question comes from the line of Jay Cohen with Bank of America/Merrill Lynch.

Jay Cohen – Bank of America/Merrill Lynch

Good morning. A couple of questions. I guess on the investment side, the high yield funds, my assumption is did well in the first quarter, particularly the latter half of the first quarter, but my sense is that in the second quarter, those funds must still be doing quite well. Do you have any sense kind of quarter to date of what those investments are looking like?

Mike McGuire

Yes, Jay. It is Mike McGuire, thanks for the question. Certainly the first quarter was a positive one for both our high yield loan portfolio's and the alternative portion of the portfolio and our initial read on the second quarter both on our fixed income portfolio as well as the alternative portfolio is that the markets continue to do well in the second quarter. I think it is certainly early days in the second quarter to declare a point of view on what the quarter is going to look like but certainly early signs are positive.

Jay Cohen – Bank of America/Merrill Lynch

But no numbers quarter to date at this point?

Mike McGuire

We had some initial indications but it wouldn't be – it wouldn't mix up as well – tidbits of those information at this point.

Jay Cohen – Bank of America/Merrill Lynch

And you probably talked about this in the past but kind of other investments what's the rough breakdown between the high yield funds and other alternatives?

Mike McGuire

It is about 85 million would be high yield and about 200 million would be in diversified portfolio of other funds.

Jay Cohen – Bank of America/Merrill Lynch

Okay. That is helpful. On the agricultural business, when are the – I guess a logistics question, when are the prices set for the summer plantings? Is it March or April?

David Cash

Hi Jay. It is David. March has been considered to be sale close. Through the month of March they track the future commodity price on the various crops. And the average price achieved during the month of March on that future price versus the sale close versus the end of the year is used for selling prices. Then in the month of April, you have process of actually making federal sessions and so that is sort of another significant month and it is more to do with your reinsurance strategy more than anything else. And then the (inaudible) in the month of March, as you're watching the future prices of commodities, those prices were lower, in some cases significantly. But the other thing to track is just the volatility in that future price and that depending on how volatile the price is, that is loaded into the premium that is charged for the year. And the change over last year was the base price went down in that month but the volatility of that future price was up. So we got the reduction in price which is obviously reduced premiums offset a little bit by that volatility charges calculated.

Jay Cohen – Bank of America/Merrill Lynch

So if we want to get some sort of valuation of the business over the summer, we should really be looking at the prices of these products, of these commodities starting really in March. So if there is some sort of pickup, assuming it is not a yield drop along with that pickup, that would generally be a good thing for you guys obviously?

David Cash

Yes. You know what we found last year is when the pricing went down, that was sort of – we feel that impact. Yield historically is considered to be the bigger issues, drought was considered to be the bigger issue. And the thing you're trying to follow and I'll be honest, it is not an easy thing to pick up on a Bloomberg string and as you looking for the futures price, there is kind of four key commodities, corn, cotton, soy and wheat, and you looking at the futures price sort of in the month of November. And in the end, the futures price and actual price will converge but that is going to be watched.

Jay Cohen – Bank of America/Merrill Lynch

Got it. And then if I could sneak in one more, on the workers comp side, I guess you have seen some other companies Zenith, Employers Direct, even AFG have issue with their combined ratios and the margins in that business, how have your loss ratios and your combined ratios held up, annuity runoff, but clearly you could still have losses and how that is holding up?

Ken LeStrange

Hi, this is Ken. Actually it has held up very well. As we suggested in prior calls, our positioning in that market I think is quite a bit different than Zenith, so it is a respectable company, we just had a different point of view in terms of the size and nature of accounts that we wanted to pursue. And we have really stayed within our frequency and severity expectations right through the current day. Our decision to exit that business was really anticipatory. We had recently in February the unbound decisions on (inaudible) I can't say that we knew that when we made the decision but we certainly saw the pressures to increase benefits and we had also seen some modest changes in frequency and severity even on our kind of benign book. So we wanted to do this call it early and we did.

There is a wide range, the California, the WCIRB indicated rate changes where I think roughly 23% and yet I think it is good to consider what they reported is the range for the potential price increase that they really need. A lot of it does hinge on whether these unbound decisions get over turned, the Commissioner of insurance in California has filed an amicus brief, there is a lot of political and social pressure I think to keep rates low, and I think there is also a realization that if you know the old system re-emerge, fraud and a lot of litigation and that kind of thing, benefit increases, that inevitably will cause a problem. But we're watching it with interest but we feel very, very good about our reserves here.

Jay Cohen – Bank of America/Merrill Lynch

That is great. I will jump back in the queue. Thank you.

Operator

(Operator instructions). Your next question comes from the line of Ian Gutterman with Adage Capital.

Ian Gutterman – Adage Capital

Hi, guys. A number of things I just needed clarification, some of them went too fast and some to be honest I didn't quite understand. First, Mike, did you say that the property loss ratio picked for the year was 57%, is that right?

Mike Angelina

That is correct.

Ian Gutterman – Adage Capital

What was that last year? And the year before that? I was kind of curious how it compares.

Mike Angelina

Sure. When you look at that last year it was about 42%.

Ian Gutterman – Adage Capital

Okay.

Mike Angelina

And it was probably about 48% to 50% in 2007.

Ian Gutterman – Adage Capital

Okay. And so that 15 point increase then, the extra 8 million of attrition and timing of IBNR are you talking about or is it something else?

Mike Angelina

That is exactly it. There is a couple of things going on. One is the premium base is smaller than it was last year. Last year our property earned premium was about 200 million, this year it is about 180. So we had higher levels of attrition which we did not reduce IBNR for. That caused an increase of about 8 to 9 points on the loss ratio and then the IBNR was about $10 million higher which again got 8 to 9 points on the loss ratio side. So that would be kind of the 42 to 57.

Ian Gutterman – Adage Capital

Okay. And then so that is this for the first quarter, you're not saying you booking the whole year 57 then?

Mike Angelina

Absolutely. That is right.

Ian Gutterman – Adage Capital

I know the fact that Q1 issue we have every year but I thought the way you guys do it is you sort of stick your pick for the year in the first quarter and you adjust it throughout the year and it sounds like this time you said adjusted it upwards?

Mike Angelina

Yes, actually, we did not stick with it. We actually we start at a loss ratio, we start with IBNR, but if attritional losses are higher than expected and something happens, we actually boost the loss ratio up and I think we said this – we are trying to say this time that we do not reduce IBNR dollar for dollar as attrition losses happen. Other companies might just say the loss ratio peg is 40% and if case incurred is 20% , then IBNR will make up the other 20%. We kind of look at IBNR levels and then if attritional losses are a little bit higher, we will actually up the loss ratio. The other thing that happens with some clarifications and a few other things we felt it was prudent to put up a little bit more IBNR this quarter and that is the additional eight points of loss ratio which is about $10 million from last year to this year.

Ian Gutterman – Adage Capital

I understood it. I just wanted to probe it, and that is what I was trying to say. Okay, so essentially if I – would it be fair to maybe not the whole 18 million, at least part of the 18 million if I wanted to – I'm trying to look at an accident year ex cat, part of that 18 million as a so-called cat number, so actually your ex cat looks high because that was zero for cat because you haven't – you know what I mean?

Mike Angelina

That is exactly right. That is right.

Ian Gutterman – Adage Capital

Okay.

Mike Angelina

Yes. A more normalized number would probably be yes.

Ian Gutterman – Adage Capital

So over the course of the year if we have attritional losses then that 57 is going to come down significantly throughout the year?

Mike Angelina

Yes. If the remaining quarters – the year turns as expected. And there is less – the issue this quarter is there was noise in the first quarter in terms of loss activity, normally we might see in the second quarter and the third quarter.

Ian Gutterman – Adage Capital

Okay. And the other property numbers I was trying to understand, you said there is 117 of IBNR related to 2008 left and if I know it's right that was 157 last quarter, so what happened to the 40 million, because none of it seemed to flow through releases, you had that many new cases come through?

Mike Angelina

No. we don’t' any new cases come through. What may have been in the 157 is kind of the IBNR we had established for hurricane Ike and Gustav. It translated into case reserves or pay losses.

Ian Gutterman – Adage Capital

Okay. But there was no – okay I (inaudible) IBNR was ex that cat, was ex Ike and Gustav I thought. I thought that was only for more the attritional smaller type events.

Mike Angelina

I don't have last quarter's information in front of me.

Ian Gutterman – Adage Capital

I guess I was confusing that. On the casualty side, can you give me a sense on first let's say on the property, all the attritional losses and so forth and this extra IBNR was solely or mostly in reinsurance, correct?

Mike Angelina

Could you repeat the question, sorry?

Ian Gutterman – Adage Capital

The increased attrition and IBNR for property was mostly or solely in reinsurance? Correct?

Mike Angelina

For the most part in reinsurance area, yes.

Ian Gutterman – Adage Capital

Okay. Can you help me on the insurance side, why I would have thought as California become the smaller part of the mix, I know there is still some premium earning, but I thought actually your expenses are coming down in insurance book and instead they're going up?

David Cash

Premiums or losses? Sorry again?

Ian Gutterman – Adage Capital

Say that again, sorry?

David Cash

Which financial measure, I couldn't hear, premiums come down or accident year losses come down?

Ian Gutterman – Adage Capital

Accident year loss ratio. Actually I guess I'm looking at combined, so part of that is probably the expense increase but…

Mike Angelina

Our accident year combined ratio quarter over quarter actually went down by a point.

Ian Gutterman – Adage Capital

What, may be my – I have numbers wrong, what you have is the accident year for insurance?

Mike Angelina

Accident year combined ratio on the insurance side for the first quarter last year was about 106 and it is about 105 in the quarter this year.

Ian Gutterman – Adage Capital

Okay. So we had the large losses last year I guess I was ticking out what you said at the time for your large losses.

Mike Angelina

And with respect the attrition loss question, as Mike said, most of that was in our reinsurance segment. We did have one large loss on the insurance property side, but it would have picked up the accident quarter loss ratio on the insurance side, but within the property insurance unit, that current quarter loss was more than offset by favorable emergence from the short tail property insurance reserves from the year end.

Ian Gutterman – Adage Capital

Okay. Then on the prior period, I mean obviously prior period is variable, I am talking of following the same pattern every quarter, but I guess I'm a little surprised on the reinsurance kind of gets back a little bit to the attritional IBNR you have left from last year and just also just what you've seen on the casualty side over time, what exactly changed? You said there is a – that claims trends are in line as opposed to below expectations? I mean what changed there, because I guess I was a little surprised at the lack of development on the reinsurance side?

Mike McGuire

Ian, it is Mike McGuire. I think one important thing to notice between the first quarter of 2009 versus the first quarter of 2008, that 2007 was a relatively quiet year in terms of short tail loss activity. So to see the reserves come down very soon after the 2007 accident year in the first quarter of 2008 makes sense. When you look at 2008, it was a much more active year on the short tailed events, so as we closed at the end of the first quarter, not that we saw any kind of real negative development on the 2008 accident year, it was more a sense of caution on the much more active year that 2008 was and keeping reserves to a level that we found was appropriate until we get better visibility on how the 2008 years ultimately develops.

Ian Gutterman – Adage Capital

Okay. And my last one and then maybe I'll hop back into the queue is, can you talk a little bit more about the growth in casualty, especially the excess casualty I guess to be honest I get nervous about growing excess casualty at this point of the cycle and with the liberal administration that seems bent on increasing litigation costs?

David Cash

Yes, it is David again. In some ways you go back to Sam's question earlier when we talked about what we're seeing in that marketplace. The excess casualty market place, we are talking about a large syndicated insurance programs of 14,000 companies that have a pretty wide range of exposures. And certainly within those companies there is an exposure to form of tort things that are out there, which statistically find with the losses that get to our layer is often sort of a shocking and surprising element to them. And having a legal environment that is maybe aggressive and exacerbates that. But the real kind of key thing that we look for clients that we have always managed, a strong what I will call sort of risk engineering programs, and where we think we know particularly what their backlog of circumstances are. It is important thing to remember a lot of these are in our current reported from. With the sort of claims made, with a little bit of a look back, you can see what is sort of in the pipeline for these clients in terms of potential litigation, and so yes it is maybe more perilous environment at the underwriting end, but we think our underwriting process reflects that. We are particularly troubled by the pricing that we see on the risk that we write but we acknowledged in that marketplace there is possibly aggressive competition, and as we have been in that market long time, we kind of know which ones are sort of yes and which ones are not. And then that is what we form thesis, it is material. I tend to follow that more closely and argue down state by state basis for healthcare. For excess casualty the kind of the starting point is really getting a firm handle on whether the response you're dealing with has the right national presence in place, and is a sensitive clean history to work from.

Ian Gutterman – Adage Capital

I guess my concern David though is one, given where yields are writing, long tailed business you're not getting – if pricing is flattish which I think is what you said, and for the last two years, one thing how casualty pricing is inadequate, flat to me doesn't seem good enough to write more, and then with yields being down, the return is even lower, seems excess casualty pricing used to be up 20%, 30%, just to a layman you know what I mean, what am I missing?

David Cash

I sort of I hear the question. I think probably the right starting point the only one that allows here in triangles for those lines of business, very difficult, very, very positive and that maybe I say except – obviously you don't have to accept my word for it. That marketplace is a very – presented very wide range of clients and our point of view is always been if you underwrite selectively you can pick good from bad. There are sucker punches down the but there are many clients who have been in the market place for 20 years and have an unblemished record that are presenting prices that are more than acceptable either with what I call pricing erosion. And if you look at our book overall, we are not a big cash player. I always think of ourselves as sort of somewhere from short to medium. I just I wouldn't be prepared to continue to ground as we move out of that market entirely. California comp, I think that was the right call, here I think we are doing the right thing here.

Ian Gutterman – Adage Capital

Okay, fair enough. Thanks guys.

David Cash

You are welcome.

Operator

Your next question comes from the line of Edward Gong [ph] with Rivershore Investment.

Edward Gong – Rivershore Investment

Right. Thanks for taking my question. I just wanted to make sure I understand the answer you actually gave to some analyst's question regarding new business additions. I think you said something about your hit ratio I guess being 9.5 or thereabouts in casualty and properties, so we just call – so just call it 11% all in, and you then you said something later about 40% to 45% of I guess quoted business being actually written at the end of the day. So if I do the math, does that mean of the new business commissions, that you end up only writing 4% of them, is that the right way to think of it?

Ken LeStrange

I think the math roughly gets you there, and what I was trying to point to frankly is what can happen to this platform in the event that pricing really does get attractive on a broad basis. The business is already coming in, we are choosing to really quote on a small number, a relatively small number of the whole submission count, and then we do kind of select those accounts where we think the pricing is right, we know the business or whatever, are down to quote ratios is actually pretty good, where we chose to focus our capacity. So in a hard market, a classic hard market, these hit ratios that I quoted to you could easily double and could also tripe over a period of time.

Edward Gong – Rivershore Investment

Okay. And then if I could – thanks, and then just another clarifying question regarding the Florida market, it sounds like you guys are monitoring that very closely, so are you saying that you're feeling pretty positive about the development of the Florida market, the mid year renewals that can lead to claims of 30% price increases?

David Cash

Yes sure. This is David again. In Florida, obviously it is a strange market. As I said, it is sort of heavy kind of overlay of regulatory kind of involvement. From that place it seems we're seeing signs that are moderately positive although it is hard to tell if (inaudible) true long-term impact on that market. We're focused on for now in the marketplace as we have had all the business that is going to come up June 1 submitted to us and we have reviewed it. There is (inaudible) had our conversations, done our analysis, and we are now in the process of the market providing quotes to those clients, and we have had a few instances of clients come back with firm order terms, essentially they say, you will transact on this basis.

One very large client came back and submitted trade at price increases of 20% to 40%. It is a client that is a large and sort of a bit of bellwether for that market, and our perception is that quotes that have been going out since that point have reflected that pricing increase of 20% to 40%. And it seems unlikely you will see the market pullback from there. It is not universally true to have one small account can skew a price increase. The next couple of weeks is going to pretty key and I would frankly expect some of that information to be leaking out to some of those trade presses.

Ken LeStrange

Another interesting thing that is happening is we tend to put a time limit on our quotes, they need to be taken up within a amount of time, and this has been unusual, certainly against the last couple of years. Some of the states are coming and going. So that indicates to us that the brokers and their clients are having a hard time finding a clearing price for their programs.

Edward Gong – Rivershore Investment

Okay. All right. Thanks a lot guys.

David Cash

You're welcome.

Operator

We have now reached the allotted time for Q&A. I would now like to turn the call back over to Ken for any closing remarks.

Ken LeStrange

Thank you for your time and attention. It has gone on pretty long today. We're really happy actually with our first quarter and we see some very positive trends ahead of us, but as we have shared with you before, we are cautious underwriters and we want to make sure that the business that we are underwriting has the returns that we are seeking and pretty jazzed about the next few calls we have in terms of what we will be talking about in terms of market conditions. Thanks for your time and attention.

Operator

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

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Source: Endurance Specialty Holdings Ltd. Q1 2009 Earnings Call Transcript
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