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Executives

David Radulski – Director, IR

Michael McGavick – CEO

Brian Nocco – EVP and CFO

Sarah Street – EVP and Chief Investment Officer, CEO of XL Capital Investment Partners Inc.

David Duclos – EVP, CEO of Insurance Operations

Greg Hendrick – Head of Bermuda Reinsurance Operations

Analysts

Jay Gelb – Barclays Capital

Vinay Misquith – Credit Suisse

Brian Meredith – UBS

Paul Newsome – Sandler O'Neill & Partners

Jay Cohen – Bank of America/Merrill Lynch

Ian Gutterman – Adage Capital Management

XL Capital Ltd. (XL) Q3 2009 Earnings Call Transcript October 28, 2009 5:00 PM ET

Operator

Good afternoon. My name is Lindy, and I will be your conference operator today. At this time, I would like to welcome everyone to the XL Capital Limited third quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions) Thank you. I would now like to turn the call over to Mr. David Radulski, XL’s Director of Investor Relations. Please go ahead.

David Radulski

Thank you, Lindy. Good evening and welcome to XL Capital's third quarter 2009 conference call. This call is being simultaneously web cast on XL's website at www.xlcapital.com. We've posted to our website several documents, including our quarterly financial supplement and our fixed income data supplement.

Before Mike McGavick, XL Capital's CEO offers his opening remarks, I like to remind you that certain of the matters we'll discus today are forward-looking statements. These statements are based on current plans, estimates and projections. 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 our Annual Report on Form 10-K, our quarterly reports on Forms 10-Q and other documents on file with the SEC, that could cause actual results to differ materially from those contained in the forward-looking statements.

Forward-looking statements speak only as to the date which they're made. And we undertake no obligation publicly to revise any forward-looking statement in response to new information, future developments or otherwise.

And with that I will turn it over to Mike McGavick.

Michael McGavick

Good evening. As always, I am joined on the call by XL senior leadership team, although there is an exception this quarter. Jamie Veghte, our Head of Reinsurance is recovering, recent reports recovering well from (inaudible) so he will not be with us. Greg Hendrick, the head of our Bermuda reinsurance operations is going to be filling in for Jamie on this call.

I'm pleased to share with you some of the results of XL’s continued resurgence, solid underwriting, careful expense management and proven reserving practices provided a very healthy combined ratio of 93.2% from the P&C operations in this third quarter.

Our book value per ordinary share rose by 26% in the quarter to $23.84, and our tangible book value per share rose by 30% to $21.36. Our total shareholders equity as of September 30 stood at $9.6 billion.

We are obviously pleased to report these numbers, but at the same time we noted a couple of areas were continued improvement would, I am sure, be appreciated by all. For example, gross written premiums in our P&C operations were in line with our most recent guidance. That still means that it was down 17% year-over-year. Now to be clear, this is due to global economic conditions, our owned planned reunderwriting, as we told you at the beginning of the year and the fact that it is a difficult time in the pricing cycle. But still we over time expect our company to grow as I'm sure.

Now continuing our strong performance given market conditions means we must remain vigilant in the face of challenging pricing conditions and we will. There are a couple of exceptions to the soft market. For example, we wrote more professional lines of insurance business in quarter three of ’09 than we did in quarter three of ’08.

We will not let pressure from either economic conditions or the underwriting cycle to deter us from taking on the right risks at the right price.

The second area obviously, which could use improvement is in our investment portfolio. This we have been hard at work on for more than a year. Our very strong Q3 operating income of $306 million or $0.89 per share was obscured by our recognition of $311 million in after-tax net realized losses mainly related to OTTI.

We continued the realignment of our investment portfolio to one more suited to a P&C company. We are well on our way to that goal and even in this quarter we did reap the benefits of $1.3 billion in improving marks in the quarter. Overall, I'm pleased that our third quarter results demonstrate to you what we are hearing from our customers and brokers everyday. XL stands ready to serve and to continue to succeed.

We are seeing their submissions, we are leading their programs, and we are committed to leading their needs for their January renewals and beyond. Bluntly, we are committed to being the best insurer and reinsurer that we can be.

Before I hand it over to Brian to discuss our financials, I would like to thank Brian for his dedicated service to XL in times of great change. We all here at XL wish him the very best personally and professionally and all of us at XL, and I think our shareholders particularly should appreciate his willingness to manage this CFO transition in such a professional way. Brian.

Brian Nocco

Thanks, Mike, and good evening. Operating income was $306 million or $0.89 per share for the third quarter with an annualized operating ROE of 16.7% compared to $108 million or $0.39 per share and 5.8% respectively in the prior year quarter.

Turning to our summary of financial results on slide four, total P&C underwriting income was $88 million for the third quarter compared to a loss of $95 million in the prior year quarter.

The P&C combined ratio during the third quarter of 93% benefited from favorable prior year development of $74 million with $8 million from the insurance segment and $66 million from reinsurance. Prior period favorable development in the same quarter last year was $93 million. Natural catastrophe losses in the quarter totaled $31 million, net of reinstatement premiums with $15 million from insurance, and $16 million from reinsurance. Natural catastrophe losses in the same quarter last year were $208 million, primarily due to hurricanes Gustav and Ike.

Foreign exchange markets in the third quarter were relatively stable. Our book value increased by $58 million due to FX, including a P&L gain of $17 million.

Turning to operating expenses, the $231 million for the quarter included $9 million in restructuring charges, whereas in the prior year quarter the total operating expenses of $319 million included $42 million in restructuring charges. Using constant exchange rates, our underlying operating expenses were $46 million lower this quarter than the third quarter of 2008.

Our paid-to-incurred ratio was at 139% in the quarter. Excluding prior year development, the paid-to-incurred ratio would be 127%. Paid-to-incurred in the quarter was impacted by payments of $47 million associated with selling – settling certain reinsurance of Lloyd's Syndicate via reinsurance arrangements. Excluding these RITC payments, the paid-to-incurred ratio would have been 122%.

The estimate of our underlying effective tax rate for the year declined 12% in the third quarter from 13% in the second quarter due to a change in the mix of geographies of our expected sources of profits. Net realized losses from investments were $326 million of which $322 million arose from OTTI.

Before handing of to Sarah, I would like to mention that our review today has covered no insurance reinsurance or investment exposure to (inaudible). Now, to Sarah to discuss our investment portfolio.

Sarah Street

Good evening. The aggregate mark-to-market for the third quarter consisting of realized and unrealized loss movements was an increase of $1.4 billion. Slide seven shows the key drivers of this positive result for both our P&C and life portfolios, which benefit from both a significant rally in both corporate and trust credit spreads, a modest interest-rate decline in the major currencies.

For the first time in a while, we saw an improvement in the values of our non-agency RMBS closing 150 million, and our hybrid securities continued their strong price recovery gaining $250 million over the quarter.

We no longer believe the CLO market to be distressed and have reverted back to the pricing vendors and brokers as our surprising source rather than the internal model valuations.

Our available to sale fixed income portfolio is now fully marked using third party [ph] prices. Turning to slide eight, our net investment income on the P&C general portfolio was $212 million, a decline of 28% compared to the prior year quarter and down 3% relative to last quarter. These declines has been driven by lower yields as we have $5 billion of our P&C general portfolio invested in floating rate securities and as a result the investment income continued to decline due to currently low levels of short term rates.

We continued to deploy cash given the improving market conditions, but we have limited purchases to high quality assets, principally agency CMBS, selected corporate names and municipal bonds. In aggregate, we achieved an average yield of 3.9% on these new investments, and the book yield on the P&C portfolio before expenses was 3.6% at the end of the quarter.

The duration of our P&C portfolio has increased slightly to 2.9 years as a result of these investments. So we remain focused on keeping duration at the shorter end of our range.

Net income from investment affiliates was 42 million. Again, primarily reflect the strong results from our alternative portfolio, which earned 5.7% for the quarter which is substantially above our normal quarter expectations as well as exceeding market indices.

As Brian mentioned we had net OTTI of $322 million for the quarter. Included in this amount is 210 million of impairment or our European credit exposure, which we hold in the form of various medium-term notes. As a result of the recent strong rally in European credit markets as well as some realized losses in the underlying forms of assets our discounted cash flow projections, including the reinvestment income declined to a point where we are forecasting a shortfall relative to the par value and coupon [ph] on the notes.

We took an OTTI charge to address this shortfall. In addition, we have recognized approximately 90 million of net impairments within our structured credit portfolio. The majority related to further deterioration on intrinsic values of lower rate, non-agency RMBS that we had previously impaired. One encouraging sign though is that the number of new impairments was nominal and the charge was driven largely by securities our processes had previously identified as impaired.

We remain focused on derisking our investment portfolio and transitioning it to one that is more typical of a P&C company. Today we have 54 percent in cash, government related and government supported assets. While our structured portfolio increased in size during the quarter to $9 billion that was due to purchases of agency CMBS, which our government supported as well as the favorable mark-to-market on the assets including the nonagency RMBS that I previously mentioned.

We reduced our exposure to more volatile assets by $400 million in the quarter, including $200 reductions in nonagency RMBS and CMBS principally due to financial cash flows. We are encouraged to see the gap start to narrow between the market prices and the estimates for intrinsic value of some of our more challenged assets.

We will continue to monitor this closely and will likely take action where we see price levels approach those close enough to be intrinsic values, when we consider selling to eliminate any downside risk. White line shows the aggregate progress we have made to reduce our allocations for a number of severely impacted or risk-asset classes since January 2008 totaling $9.1 billion. Last quarter, we shared with you our model comparisons between our actual P&C portfolio during the credit crisis, our current P&C portfolio and our targeted P&C portfolio compositions.

Have we held today's P&C portfolio at the beginning of 2007 through the end of March 2009, we estimate that we would have exposed the negative mark of approximately $1.8 billion compared to the actual P&C portfolio, which excludes negative marks of about $4 billion. Our targeted P&C portfolio would have experienced negative mark of under $1 billion in that same time frame.

To put another way, we estimate that we have achieved over 70% of the portfolio repositioning. We like to remind everybody that these are modeled comparisons, but based on the fact testing that we have done we are comfortable that these estimates are reflective of the overall results that we would have experienced.

Now, over to Dave to talk about our insurance operations.

David Duclos

Thank you, Sarah. In addition to covering insurance results for the quarter, I will provide an update on our D&O business including our view of sub-prime and Madoff-related exposures. And also provide commentary on market conditions and the strength of our franchise.

Insurance results for the third quarter were strong despite the challenging macroeconomic conditions impacting many of our clients, and the knockdown effects, which this and other factors are having on the market environment. Life renewal premiums being down as a result of exposure-based reductions globally, both underwriting income and revenues were better than expected. Our combined ratio of 98.6% for the quarter was eight points better than our Q3 2008 result of 106.6%, which was adversely impacted by hurricanes and (inaudible).

Adjusting for restructuring charges, the insurance segment’s Q3 ’09 combined ratio was 97.9%. Gross premiums written declined 15.8% or $192 million from Q3 2008, materially better than the first-half decline of 26%, and continuing the improving trends we saw in both the first and second quarters. An example of this improvement can be found in our US professional D&O book, where in the third quarter the book actually increased by 9% compared to Q3 2008.

Contributing to this result was the “Side A” endorsement agreement with NICO, where this book increased by 2% in September compared to declines that averaged over 45% during the first five months of the year. The gross premiums written variance for Q3 can be explained through planned underwriting actions.

A reduction in long-term agreements accounted for $85 million, the termination of two MGA programs accounted for $75 million, and changes in our environmental book accounted for another $16 million. The remaining difference was attributable to the strengthening of the US dollar as well as the continued global economic pressures and our push for rates.

Noticed what I didn’t say about premiums. This is not about the XL noise [ph] factor that we discussed at the end of 2008 and early 2009. And with the results we are announcing today, we expect to be singularly focused on our future.

Net premiums earned were down 13% or $136 million mostly due to the earn-through of lower gross premiums written as well as FX movements, which accounted for $26 million. On the loss side, our CAT activity for the quarter was limited to $15 million related to the recent Asian earthquakes and related tsunami events and as such these losses were fully covered within our CAT assumptions [ph] for the quarter.

Our Q3 2009 loss ratio of 69.6% was 10.2 points better than Q3 '08 again driven by lower CAT and large loss activity in the current year.

My last comment on financial results relates to our Q3 '09 operating expense ratio of 17.2%. While 1.1 points greater than Q3 '08 when normalized for non-recurring adjustments, including restructuring charges, the ratio was 16.1% for the quarter and 16.6% year-to-date. This is in line with expectations and reflect decisions that we made and communicated to you earlier in the year.

Now let us turn to sub-prime and Madoff. For D&O, E&O, and Fiduciary exposures there were three new sub-prime and nine new Madoff identified reported notices during Q3 ’09. As anticipated the number of new reported incidents has slowed down and we do not expect a substantial number of additional client counts in the near term related to these events.

Our focus going forward will be the regular monitoring of these matters through their ultimate resolutions. And while there has been a material number of court decisions involving sub-prime plans where courts have ruled in favor of our insurers. After conducting our most recent review, we believe that remains too early in the life cycle of these outstanding claims for XL to react to the positive trends. That said the current activity does give us confidence in our held reserve levels at this time.

Now, on to market environment. In a word, challenging. Due to the global economic conditions as well as the competitive environment we find ourselves in as an industry. While we have seen some modest improvement in rates in our books in the third quarter, achieving rates is challenging and has resulted in some losses. In effect, what we saw in Q3 was a continuation of the Q2 story in terms of rates.

And on an industry basis, we continue to see only selective hardening and the rate price gains which are achieved are often offset by reductions in ratable exposures tied to global economic conditions.

With that as a backdrop and despite the market challenges just described we continue to see clear and steady improvements in retention and new business submissions throughout the book. Q3 premium retentions continue in the high 70s for all business with casualty lines now in the mid-80s. This improving trend, which began midway through the first quarter, has continued throughout the second and third quarters.

Third-quarter pricing also shows modest but continued improvement with an aggregate price change of plus 1%. Price trends are improving across some lines of more meaningful increases reflected in both properties at plus 4 and casualty at plus 3.

The aggregate rate change for the month of September was plus 4%. While encouraging, we all know that one month does not make a trend. Given where we are in the market, we believe these results to be right where they need to be. Retentions and pricing are improving; loss activity is in line with if not slightly better than expectations. New business submission flow continues to increase. In fact, we saw more submissions in the first three quarters of 2009 than we did in the same period last year, and our staff attrition is now better than historical levels.

In summary, we remain focused on delivering value to our clients and brokers, while generating acceptable returns on the capital we have been entrusted. And with that over to Greg to discuss reinsurance.

Greg Hendrick

Thanks, Dave, and good evening. Reinsurance underwriting results for the third quarter were excellent with a combined ratio of 80.5% and a resulting underwriting profit of $76 million. This compares favorably to our performance in the third quarter of 2008, when we had a combined ratio of 105.4% and underwriting loss of $26 million.

Excluding the impact of catastrophes in prior year development, our combined ratio of 93.4% was down 1 point year-over-year. Gross premiums written for the quarter of $562 million and net premiums earned were $389 million. These represent year-on-year declines in the same period in 2008 of 18% and 20% respectively. 70% of the drop in gross premiums written was due to lower commodity prices, impacting our agricultural portfolio, the continued run off of the structured reinsurance portfolio and the reinstatement premium in the prior year quarter.

Most of the balance of the drop was the natural result of our continued vigilance for profitable underwriting. New business volume at close to $45 million helped to offset the premium drop, demonstrating the continuing strength of our franchise. Turning to market conditions, short-tail lines of catastrophe exposed regions continue to show improvement. In particular, a significant amount of our third-quarter catastrophe portfolio emanated from the United States.

On a risk-adjusted basis, we saw a 12% rate increase in this portfolio in line with our experience during the first six months of the year. The long tail lines of business continue to resist upward movement in most areas and classes. While financial institutions’ D&O had a positive rate growth across the globe, the reminder of the casualty classes were flat to down 2.5%. We continue to watch this part of our portfolio closely, and we will take further underwriting actions in order to achieve adequate returns at the upcoming renewals.

With respect to our life operation, we continue to manage the runoff of the various pieces of assets. During the quarter, this segment did report net income of $20 million. The sale of our US life operations remains on track for completion pending regulatory approval.

Finally, I like to end the commitment of our employee base is confirmed by the fact that our voluntary retention levels remain consistent with our historical experience. I believe the loyalty of our staff, brokers and customers combined with our stronger balance sheet and less risky investment portfolio leaves XL reinsurance very well positioned for January renewals.

And now, over to David for Q&A.

David Radulski

Lindy, please open the lines for Q&A.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is from Jay Gelb of Barclays Capital.

Jay Gelb – Barclays Capital

Thanks and good afternoon. My first question is on reserves, the paid-to-incurred level for the third quarter, I believe was 122% even banking out prior year development and reinsurance (inaudible)? Doesn’t that seem elevated? I mean is that too high and how should we think about that in terms of reserve adequacy?

Brian Nocco

This is Brian Nocco. I don't think you should think of it as too high. I mean keep in mind that the level of premium that we wrote in the years past was much higher than what is being written now, and so part of this is just the normal process of the reserves paying down from earlier years and taking in premium at lower levels. And I think while you are going to get some variability quarter-by-quarter, I don't think the 122% adjusted for the factors that we discussed is aberrantly high?

Michael McGavick

Jay this is Mike, I would add only one thought to that, and that is that if there has been absolutely no change to the deserving approach of philosophy at XL certainly during my tenure here, and in addition if there is anything that we are thinking about is more conservative view we have when it comes to inflation of (inaudible). So, there is no change in the historically conservative approach.

Jay Gelb – Barclays Capital

Okay, and then more broadly Mike, can XL generate P&C premium growth in 2010? Will 2009 be the last year of climbing premiums?

Michael McGavick

Well, certainly the factors that are driving decline at this time start to fall away. As we moved out of the long-term premiums, as we see our – the reunderwriting move into the past, I think that puts us on a solid footing. The question of growth though, would really have more to do with the market than will have to do with us. We are very conservative technically driven underwriter, and as you know the pricing environment has been difficult.

So, well, we have a few areas that we are certainly pushing where we think we have some opportunity to write profitable business. Several lines come to mind, where the professional (inaudible), several new initiatives come to mind like our upper middle market initiative, our INS [ph] initiative. These all give some opportunities to grab some profitable share, but whether that will result in actual – result in net top line improvement will really depend on market conditions and (inaudible).

Jay Gelb – Barclays Capital

(inaudible). My final question is on the investment portfolio. Does XL intend to exit the alternative assets as you simplify the investment portfolio?

Sarah Street

Hi, Jay. This is Sarah Street. No, we will still have an allocation to the alternative asset class. It will be a smaller size than it has been historically, but we still see a role for the alternative portfolio within a P&C portfolio.

Jay Gelb – Barclays Capital

What magnitude, 5%, 10%?

Sarah Street

It is in the 5%, 6% range.

Jay Gelb – Barclays Capital

Thanks very much.

Operator

Thank you. The next question comes from Vinay Misquith from Credit Suisse.

Vinay Misquith – Credit Suisse

Hi, good evening. The first question is on excess capital if any, and when would you be able to keep (inaudible) debt or preferred stock or maybe even your common stock?

Michael McGavick

Vinay, this is Mike. Look, we are constantly examining our capital position, and I would put it in a couple of ways of thinking about it. First I just have to stop for a second and acknowledge what a delightful question that is compared to some of the questions a quarter or two ago. I think that sets the first notion I would put in your mind in motion right.

The way I think about the economy now is that back in September and October if fell through the ice [ph]. And since then all of us are finding our ways forward on ice that were are little less trustworthy of. And as a result we are going to take a very conservative view because in the end our primary requirement to serve our clients and reward our shareholders is to maintain and improve our ratings. So that is the first consideration we look at this through, and we look at it through that concern with wary eyes, given all that has gone on in the global economy.

The second thought I have is that while I obviously am cautious about growth, there are nonetheless pockets of opportunity out there, and we want to make sure always that we are ready to take advantage of such opportunities, and third I will recommit to you as I have in the past if it is the collective judgment of our management team and board that we cannot put our shareholders money to work at appropriate returns, then we will look for ways to get that money back to shareholders as we see it appropriate given the concerns that I've just delineated. But you know, well from track record of companies that I have been involved with we take that last commitment very, very seriously.

Vinay Misquith – Credit Suisse

Sure. What sort of ROE are you targeting in the near term?

Michael McGavick

You know, we're still in the middle of our planning process for next year. So I think it is just inappropriate to give guidance at this stage, but I would tell you that we are awfully pleased with the performance of our underwriters in these difficult conditions really, really pleased.

Vinay Misquith – Credit Suisse

The second question is on the yields on the investment portfolio. I believe new money yield is at 3.9% and the old money yield, I believe at 3.5% is that correct, and so therefore if you start to move more of your cash into new money, should we see an up-tick in the investment?

Sarah Street

Your assumptions, your numbers were correct. The money that we are put to work this quarter, we achieved 3.9% and the book yield on the P&C portfolio at least at the end of the quarter was at 3.6%. As we put more new money to work, however, I would say we are managing the constant tensions between putting money to work and extending our duration out too far given the expectation that at some point I think the rates will rise.

Vinay Misquith – Credit Suisse

But as we put more money to work, hopefully net investment income will improve. Sure, and one last question if I may, on the life of the reinsurance business, some thoughts (inaudible), how should we look at that in the near term in terms of contributions to earnings?

Michael McGavick

The life business.

Vinay Misquith – Credit Suisse

Yes.

Michael McGavick

I would say the life business, which as you know the heart of the life business, which is the annuity business and the mortality and critical illness business we put in to run off, that will run off over many years in the absence of permutations or some kind of recapture, and therefore I think you can expect a continued result from the life business that is similar to what is being reported now.

As you also know we sold the accident and health business in France, which was small. That is out of the results and our US life business, we have an agreement to sell (inaudible) is quite small and so the projections for the life business should continue roughly in line with what you have seen recently.

Vinay Misquith – Credit Suisse

Thank you.

Operator

Your next question is from Brian Meredith with UBS.

Brian Meredith – UBS

Hi good evening. A couple of questions here. The first one, I'm curious looking at the insurance business and just the amount of seeded premiums, it looks like you are seeding less business away, and I would have thought with the books (inaudible) transaction that number would have actually gotten greater. Am I missing something?

David Duclos

Brian, this is Dave. Actually from a seeding perspective on a reinsurance basis, we have not any structural changes, material structural changes to our reinsurance programs that have been put in place from 2008 compared to 2009, and as a result of this the Berkshire transaction isn’t reflected in the reinsurance proceeding.

That is actually an expense item that we have. So, that is accounted for separately, so the Berkshire costs are not reflected in the seeding.

Brian Meredith – UBS

Okay. Terrific, and then Dave I wonder if you could comment a little bit about what your views of the professional liability market is going to here going forward. It seems like AIG has kind of got its feet under it right now and you know as they get more aggressive here going forward, what are your thoughts in that market?

David Duclos

Well, Brian, I guess as Mike alluded to it, it remains one alliance that from an insurance perspective we remain pretty bullish around given our results. So what we expect for 2009 and as we look forward, you know, we have been able to achieve a slightly better than a flat rate change through September in professional. Some parts of that operation we are actually seeing flush rates. In other parts like “side A” business, which is A, extremely profitable and B, very competitive. We are seeing some rates below flat, but we feel we have a very strong franchise.

It has been reinforced and endorsed certainly with the NICO and Berkshire endorsement, but the result turnaround for this business isn’t simply because of the Berkshire endorsement, we have are very, very good team. We have a business model that we believe adds value to the client and broker, and in a way we sort of take pride to the degree with the contrarian view we have from an underwriting perspective, and we see the dislocation in some cases from a professional standpoint is opportunity for us going forward.

You had mentioned a particular company. We don’t focus on any particular company. We continue to sell based upon what XL brings to the market, and frankly Brian it has been reinforced and staged relative to the value that brings to us. So we are very pleased with the recovery in this book of business. If you think about what we communicated to you in the first quarter, and we look for opportunities and ways to grow this business smartly as we proceed into 2010.

Brian Meredith – UBS

Okay, great. And then just back to Berkshire thing, where is that hitting, is that in the insurance operations, in the administrative expenses, corporate, where can we see it, would that be a reason maybe your expense ratio is a little bit high also?

David Duclos

It is slightly – it is reflected in our insurance results. And the cost obviously it is under fees and other income from an insurance perspective, but I would say from a P&L standpoint Brian, we continue to benefit from the investment we have made, i.e. because of the retention strengthening and because of how we are able to price that business, the costs associated with this are actually offset by the benefits that we are accruing from a profitability perspective.

Brian Meredith – UBS

Great. Thank you.

David Duclos

Thank you.

Michael McGavick

If I could underscore on that last point, I just want make a really important point. I know that there is a lot of reasons, when ranges like this coming into being. We didn't do it for perception. We did it to make more money.

Operator

Your next question comes from Paul Newsome with Sandler O'Neill & Partners.

Paul Newsome – Sandler O'Neill & Partners

Hi, mostly a housekeeping question here, here but most companies in the US benefited from CAT losses. It doesn't sound like your insurance operations and maybe your reinsurance benefited that much in this quarter, could you just walk through that for us how much you know was better than we typically have in the third quarter as we try to sort of get to some sort of run rate type of – sort of normal third quarter number?

Michael McGavick

This is Mike. Let me start, one of the – I would have thought the same thing before I had joined XL, I would have thought as somehow the whole place being very much defined by third quarter CAT. I got to tell you that it's just not the case, as I have learnt the book better that is so not the way it really works in insurance.

Certainly we have CAT loads and certainly they are seasonally sensitive, with operations all around the world, we could see CAT activities spread through the year. It is just not as concentrated as you might expect. And in reinsurance similarly, while certainly our Bermuda operations particularly have a CAT focus and US focus, that is one part of our reinsurance book, not our entire reinsurance story.

So it is a bit less than you might have thought going into understanding XL, and a bit more smooth across the year than you might have expected. With that I'm going to turn it over to Dave to talk about how we view the loss ratio in the quarter so that you get some perspective of where we really stand.

David Duclos

Yes, thanks Mike. And Paul, the first comment I would make specific to your question about CAT activity in terms of comparing insurance, the Q3 2009 CAT loss for insurance was $15.1 million on a net basis. In Q3 2008, that CAT number was $160 million. So a significant different story, a better story for us from a CAT perspective.

I would also want to say that how that translates into loss ratio is also very important. For the quarter, the third quarter, when you take out the prior year and CAT activity the comparison is 70.5 in 2009 compared to 80.7 in 2008. So we did see a materially improved loss ratio as a result of less CAT activity and also less attrition of large loss activity.

On a year-to-date basis in addition to the quarter numbers, we have 70.2 on a loss ratio totally stripped out, no CATS, no prior year as compared to 74.7 in 2008. So 4.5 point improvement on a peer loss ratio basis stripping CAT activity and prior year development and as an outcome and a story [ph], we feel very good about especially given the rate environment he just talked about.

So to answer your question, we did benefit from the lower CAT activity and lower loss ratio activity in the third quarter.

Paul Newsome – Sandler O'Neill & Partners

So how does translates as we think about particularly insurance operations, a 98 combined ratio, obviously you got some expenses to pull out of there related to restructuring, but are you at a comfortable level of ROE all things being equal on an operating basis in the insurance operation at that level?

Michael McGavick

All things being equal, and also assuming we are at the bottom of the cycle, and our rate activity would support that if you think about what has progressed from quarter-to-quarter starting in mid-2008. I do believe that is an acceptable expected ROE outcome, and you did point out something from an expense standpoint that we probably are operating somewhere around the 1 point, 1.5 point higher than we normally would again related to the restructuring charges that we took in the first quarter.

But given our mix of business long-tail and short-tail, and where we are right in the cycle, we feel very good about this outcome, and again in the context of this being at the bottom of the cycle.

Paul Newsome – Sandler O'Neill & Partners

So, I understand you should feel good about the fact the company is still around, but I am looking at the sort of 96, 97ish it looks like the range we are at today if you take all these one-timers out. That is okay at the bottom of the trough cycle.

Michael McGavick

I would think so, yes.

Paul Newsome – Sandler O'Neill & Partners

Thanks. That is great.

Operator

(Operator instructions) Your next question comes from Jay Cohen from Bank of America/Merrill Lynch.

Jay Cohen – Bank of America/Merrill Lynch

Yes, thank you. I just wanted to follow up on a earlier question, you were asked about sort of the retention in net to gross, you mentioned there was no change, but it looks like related to the year ago quarter, you kept a lot more risk and thus you saw net premiums written down a lot less than gross, and going back it looks like every third quarter that retention tended to go down. So what is the change from a year ago because there seems to be a change?

David Duclos

This is Dave, and I think this is more a reflection of the composition of the book of business. In particular, our casualty writings which are down, which carries a combination of a (inaudible) and then also the professional restructuring around our reinsurance that was effective 4/1 of this year. Those would be the only two specific issues that would drive any sort of ongoing change in terms of our seed.

Jay Cohen – Bank of America/Merrill Lynch

Okay. We should be looking at this change in net premiums written as a measure of how you guys are doing because that was actually pretty modest?

David Duclos

It is – and I think it is somewhat of an indication. We had a – I think the other phenomena here is we had a very short but steep spike down, if you will in late 2008, the first part of 2009 and as we talked about from a quarter standpoint, we have seen the premium retentions improve almost by 30% in a matter of six months. So that also plays into it a little bit.

Jay Cohen – Bank of America/Merrill Lynch

Got it. The next question, if you could just identify maybe on the gross or the net line, probably gross line, what the currency impact was for the overall company, if you can break it down by segment that would be helpful too. In other words, what were the constant dollar, what does the premiums do?

Michael McGavick

I'm not sure we have that at our fingertips at the moment. We'll comeback for that.

Jay Cohen – Bank of America/Merrill Lynch

Okay, and then the next question, rating agencies, will they look at the realized losses and sort of raise a flag. Is that going to be an issue for them or do you have a sense that they're pretty content with the balance sheet as it is?

Michael McGavick

As you know, we always let our rating agency friends speak for themselves, but we have had conversations with the rating agencies as these numbers became clear and we are very pleased with those conversations.

Jay Cohen – Bank of America/Merrill Lynch

Okay. I'll stop there. Thank you.

Operator

Thank you. Your final question comes from Ian Gutterman with Adage Capital.

Ian Gutterman – Adage Capital Management

Hi, I have some questions for Sarah on the portfolio side. I guess, first I'm looking at the financial corporate exposure, and you know, the non-hybrid portion, the senior and stuff that is about $3.5 billion is pretty much at par right now on average anyway, why not reduce that significantly at this point?

Sarah Street

Well, it all comes down to weighing up the investment income give up on those because they are bonds that we purchased some time ago, and generally they are in pretty high quality institutions, and that top of the capital structure. So, we are fairly comfortable with that versus the net investment income.

Ian Gutterman – Adage Capital Management

What about just the issue of concentration? I mean isn't that the bigger issue. I'd rather (inaudible) and just to not be so concentrated in one sector.

Sarah Street

We were reasonably comfortable with the level of financial institutions exposure that we have. I would tell you that I would actually given the improvement that we've seen in the prices of number it is a hybrid. That would be where I would seek to reduce my concentration risk more.

Ian Gutterman – Adage Capital Management

Okay.

Sarah Street

One of the important things is that lot of our financial institution exposure comes from the life portfolio, because we need to own long duration assets, and financial institutions are generally the issuers of the longer duration assets for the assets and liabilities matching. That has to be factored in.

Ian Gutterman – Adage Capital Management

Okay, sure enough. If I can ask for the opposite of that question, you have a large position of agency CMBS, has the policy done very well. Some people would argue that there has been a – a lot of people are hiding there and they're overvalued. Does that make sense to you, maybe diversify out of that some instances have been a good position for you and put it into something else?

Sarah Street

Yes, that's an issue that we debate on a regular basis with the investment committee. I think the key thing is that we are seeing significantly on the weight basis CMBS relative to most CMBS portfolios [ph]. So we have actually being pushing money towards the less forceful, less money towards than you would expect it in terms of both transitioning towards a P&C portfolio exactly because at this point they seem fairly valued, and we would not be surprised once the government purchase program in the second quarter or the first quarter next year I am convinced [ph] that we might see a little bit spread widening there. We would see more opportunity to actually put more money in agency CMBS.

Ian Gutterman – Adage Capital Management

Got it, okay, and my last one is can you just talk about the confidence you have in the ability to get recovery out of, I'm looking mainly at the CLOs, but I guess you could also argue about the subprime and Alt-A that is below investment grade, but those three asset classes have still significant, you know, significant negative marks and high below investment grade content. What's the story for these recoveries and without having to be impaired at some point?

Sarah Street

Well, obviously at the end of each quarter we do our impairment analysis, excluding looking at security by security basis and based off our assumptions at the end of the quarter, we had confidence that those assets would recover or otherwise we would have been required to make the (inaudible). We started to see prices improve quite dramatically in those assets, certainly on the CBOs where there is a large unrealized at this point.

I mean I think it's important to know, we work with a specialist manager and they have a pretty disciplined impairment approach factoring in both (inaudible) and it is based off that analysis that we've done the impairment up to date. In addition, we've actually have them run some scenarios for us using default rates that are considerably higher than what is being forecasted by the market, unless we might see some small additional losses within that portfolio if that happens. It's not material for us.

Ian Gutterman – Adage Capital Management

Okay, very good. Thank you.

Michael McGavick

You know, sometimes – this is Mike – one thing I would add to all of that is you know, what – you heard Sarah in her earlier opening comments refer to the real progress we've made towards getting to kind of the strategic asset allocation that we want to manage the portfolio on an ongoing basis, and I want to emphasize next year questions very strongly.

We are always going to be examining that portfolio for ways to accelerate our progress towards that as a destination. We understand that our North Star is not to grab yield, our North Star is to have a portfolio that is viewed as in the pack and not an issue and that's the real North Star we are driving.

Ian Gutterman – Adage Capital Management

I agree 100%, Mike. You've done a great job out of the only one that still stands out a little bit is financials. Everything else I think you made great progress on. Thank you.

Michael McGavick

We appreciate the comments and Sarah and her team have done a great job here. It's amazing when you think about the progress in here – and we just look for ways to make that progress happen even faster.

Ian Gutterman – Adage Capital Management

Thank you.

Brian Nocco

This is Brian Nocco. Let me get back to the question on the impact of FX rates on our premium volume, and I'll give you some statistics or data on that. First here today the impact on– and I only have it for the company as a whole. I don't in front of me have it by segment. Gross written premium was suppressed by $229 million, net written premium $164 million, and net earned premium $206 million. That's year-to-date. For the quarter same three numbers impact on gross premiums, $25 million, net written premium $19 million, and net earned premium $43 million.

Keep in mind that we also have somewhat of an offsetting impact on our expenses as you are working your way down the income statement, but specifically in response to the question those were the impacts year-over-year as a result of FX rates on the premium losses.

Operator

We have one more question from Jay Gelb with Barclays Capital.

Jay Gelb – Barclays Capital

Thanks. I just wanted to follow up on a prior question with regards to the gross retention within the P&C business. Year-to-date it is running at about 76%. I'm trying to get a sense. Is that the right run rate for the year and directionally would you anticipate that that detention increases in 2010?

Michael McGavick

Jay, I'm assuming you're directing that from insurance, but directionally that's –

Jay Gelb – Barclays Capital

What actually for the insurance and reinsurance combined.

Brian Nocco

Okay. Well, let me comment first and ask Greg to comment about on it from a reinsurance perspective. The retentions from an insurance perspective are actually now approaching close to 80, and again keep in mind that our plan – our initial plan assumptions was something less than that, actually several points less than that. Historically we've operated as we have indicated in the past, in the mid-80s, especially when you strip out the nonrecurring renewal for policies in that.

So we are quickly moving back to a spot exposure to historical level from a retention standpoint. I give you just a bit of caution relative to how soon will we get back there. It also relates to the comment Mike made earlier about growth. It's somewhat going to be dependent upon market conditions, and I guess just one example to sort of make this point. When we looked at third quarter large account impacts, the four largest impacts weren’t accounts we lost, but actually accounts that had their exposure basis reduced so much that our premiums written as compared to the prior year were actually down by over a half million dollars.

So, you know, again these are premium retention numbers and largely influenced by what happens from a macroeconomic perspective. Hard to try and quantify when you strip that out, but I would say that when you try and normalize for that fact, we're actually getting very close to what would be on an apples-to-apple basis a mid-80s number. So directionally, we do feel good about it from an insurance standpoint. I will now ask Greg to comment (inaudible).

Greg Hendrick

I think, looking at a nine month year-to-date number of 76% in reinsurance, as the capital comes back onto the balance sheet we can take a little bit more risk back on particularly in some of that driven line. But in general, across the whole book, we wouldn't expect that to change dramatically in the future.

Jay Gelb – Barclays Capital

Okay, so if I – so to summarize that would be insurance maybe up a little, reinsurance where it is.

Greg Hendrick

Yes, yes.

Jay Gelb – Barclays Capital

Thank you.

Operator

Thank you. I would now like to turn the call back over to your speakers for closing comments.

Michael McGavick

Yes, this is Mike. Just a couple of closing comments, obviously overall we are very pleased with the quarter, particularly with the operating results we produced here. This is very gratifying and I'm sure our people around the world will feel very proud. You all know very well that excellence is made up of things large and small, and during the quarter a few things happened that are not in the world of things, you know, that big a deal, but they were just reminders that through all that's gone on XL continue to do some really special things.

We climbed into the top 100 in the 2009 InformationWeek 500 at XL Re [ph] because of the quality of the systems improvements that have been made. We are proud of that. We showed up at 239 in the Greenest Big Companies in America in the Newsweek rankings. We're proud of that and it's small, but important at the formal meetings which Dave and I attended along with our European colleagues. We won the Best Booth Award [ph]. You know, excellence comes from a lot of things and these results are a lot of things done well by our colleagues around the world, and we are really proud of where we stand and working hard to get these last items out of the way for that excellence shines without further comments. Thanks for being a part of the call and we look forward to talking to you at the end of the year.

Operator

This concludes today's conference. Thank you for participating. You may now disconnect.

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Source: XL Capital Ltd. Q3 2009 Earnings Call Transcript
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