Executives
David C. Radulski – Director of Investor Relations
Michael S. McGavick – Chief Executive Officer & Director
Simon Rich – Interim Chief Financial Officer
Sarah E. Street – Executive Vice President & Chief Investment Officer
David B. Duclos – Executive Vice President & Chief Executive Insurance Operations
James H. Veghte – Executive Vice President & Chief Executive Reinsurance Operations
Analysts
Jay Gelb – Barclays Capital
Joshua Shanker – Deutsche Bank Securities
Vinay Misquith – Credit Suisse
Paul Newsome – Sandler O’Neill & Partners, LP
Jay Cohen – Bank of America Merrill Lynch
Matthew Heimermann – JP Morgan
Brian Meredith – UBS
Ian Gutterman – Adage Capital
[Mahmut Resa – Bowman Capital]
Daniel Johnson – Citadel
XL Capital, Ltd. (XL) Q4 2009 Earnings Call February 9, 2010 5:00 PM ET
At this time I would like to welcome everyone to the XL Capital Limited fourth quarter and full year 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. As a reminder, this call is being recorded. I would now like to turn the call over to David Radulski, Director of Investor Relations.
David C. Radulski
Welcome to XL Capital’s fourth quarter and full year 2009 conference call. This call is being simultaneously webcast 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 portfolio data.
On our call today, Mike McGavick, XL Capital’s CEO will offer opening remarks. Simon Rich, our interim CFO will review our financial results followed by Chief Investment Officer Sarah Street who will discuss our investment portfolio. Dave Duclos, our Chief Executive of Insurance Operations and Jamie Veghte, our Chief Executive of Reinsurance Operations will review their segment results and market conditions. Mike will discuss our guidance for 2010. Then, we will open it up for your questions.
Before we begin I would like to remind you that certain matters that we’ll discuss 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 and therefore you should not place undue reliance on them.
Forward-looking statements are sensitive to many factors including those identified in our annual report on Form 10K, our quarterly reports on Form 10Q and other documents on file with the SEC that could cause actual results to differ materially from those contained in the forward-looking statements. Forward-looking statements speak only as of the date which they were made and we undertake no obligation publically to revise any forward-looking statement in response to new information, future developments or otherwise.
Now, in connection with our previously announced proposed redomestication to Ireland from the Cayman Islands, XL Capital has filed a preliminary proxy statement with the SEC. Investors and security holders are urged to read the definitive proxy statement related to the proposed redomestication when it becomes available because it will contain important information. We will not be taking questions with respect to the redomestication today and refer you to the proxy statement for additional information.
XL Capital, its directors and certain employees may be soliciting proxies from shareholders in favor of the proposed redomestication. You can find information about these individuals in XL Capital’s definitive proxy statement for the 2009 annual general meeting filed with the SEC on March 9, 2009. You can obtain free copies of the definitive proxy statement when it becomes available and other documents filed by XL with the SEC at both the SEC’s website and at www.XLCapital.com.
With that I turn it over to Mike McGavick.
Michael S. McGavick
The results we reported tonight confirm that XL is once again a market of choice for brokers and customers around the world. The evidence in clear, our P&C top line for the fourth quarter was within three points of the same quarter, last year a fairly remarkable result given our replanning at the beginning of 2009. As you can see in our highlights on Slide Three, our P&C combined ratio is a very solid 96.4% for the quarter and 93.6% for the full year.
But, what may be most remarkable is that we engineered this turnaround and maintained our underwriting discipline and historically prudent reserving standards in the depth of a continued soft market. By lowering our expense base and increasing both our efficiency and capital strength, we have certainly improved our current performance but perhaps more importantly, we have put XL in a position of competitive advantage to endure the soft market and for when the P&C markets turn the corner.
On the asset side we continued to realign our investment portfolio. We’ve worked down our legacy assets, primarily non agency RMBS and CLOs to a level where we can now move on from derisking to optimizing our portfolio. This means we see future OTTI on realized losses as being made as economics unfold rather than as a result of aggressive portfolio repositioning. So while we will certainly act rationally if we find good opportunities to sell we’d expect the book of our legacy positions now to wind down over time through natural cash flows and maturities.
This results in a portfolio more closely reflecting the traditional team C asset base, thus allowing the earnings from our P&C franchise to go towards building book value. Our book value did grow in the fourth quarter for the third straight quarter as we recorded a 3% increase in book value per share to $26.60 and a 4% increase in tangible book value per share to $22.13. Total shareholder equity increased from $9.2 billion to $9.4 billion in the fourth quarter.
For the full year our 2009 net income of $206.6 million compared to a 2008 net loss of $2.6 billion, a turnaround in deed. We generated an operating return on equity for the year of 13.5% and in 2009 our tangible book value per ordinary share grew by 72%. While no one can state with certainty when or how the underwriting cycle with turn, we believe the steps we have taken put XL in a position of significant strength. We are ready both to endure well the industry’s current challenges and take advantage of the opportunities that can come with a hardening market, whenever it comes.
With that, I’ll turn it over to Simon.
Simon Rich
Operating income was $235.8 million or $0.59 per ordinary share for the fourth quarter with an annualized operating ROE of 11.4% compared to $189.5 million, $0.57 per ordinary share and 12.4% respectively in the prior year quarter. Operating income for the year was $917.3 million resulting in an operating ROE of 13.5%. With the lower ROE for the quarter reflecting our growing shareholders’ equity.
Turning to our summary financial results on Slide Four; P&C net premiums earned were down 10.6 in the fourth quarter primarily due to the rolling effects of prior periods lower written premium. This rate of change is better than previous quarters reflecting the improving level of gross premiums written relative to the prior year that we have reported quarter-on-quarter this year. We expect the improving trends in net premiums earned to continue in to 2010.
The P&C combined ratio for the fourth quarter of 96.4% benefitted from favorable prior year development of $30.8 million compared to $268.3 million in the prior year quarter. The latter included a onetime benefit of $81 million from an agreement in connection with the business we acquired from Winterthur.
Our underlying combined ratio excluding prior development, natural catastrophes and restructuring costs was a full eight points better for the quarter than the prior year and was also 1.5 points better for the year as a whole. Our operating expenses of $289.1 million were $8.7 million higher than the prior year quarter however, the current quarter included $21.8 million in restructuring charges, $12.1 million more of performance related compensation than the prior year quarter, some costs related to the redomestication of our parent company to Ireland as well as being impacted negatively by foreign exchange rate fluctuations.
Our underlying expense base is now much lower than a year ago. In fact, our two restructuring initiatives are now essentially complete and are both within our initial cost assessment. We’ve captured the targeted savings and our guidance for operating expenses in 2010 reflects this lower run rate. Our tax charge for the quarter was $54.7 million. After adjusting for the impact of net realized gains and losses on investments, we have a low effective tax rate. The underlying effective tax rate was 21.5% for the quarter and 14.5% for the year.
The rate for the quarter reflected the impact of our yearend reserve review and also contained a number of non-recurring items which together resulted in a disproportionately high level of profits arising in higher tax jurisdictions. These items added $29 million to our tax charge for the quarter. But looking forward to 2010 we expect our underlying tax rate to be between 12% and 15% which is consistent with our guidance for prior years.
Our book value increased for the third consecutive quarter from $23.84 per share at September 30th to $24.60 per share at yearend with the main driver being our operating earnings. This was offset by net realized losses on investments in the quarter of $254.8 million net of tax. This total included $10.9 million from the sale of XL Re Life America, a transaction that closed in the quarter.
As set out on Slide Seven, we end the year in a strong capital position with over $12 billion in total capital, an increase of over 23% from the position at December 2008. We also have in excess of $1.5 billion of cash and investments at the holding company to maintain financial flexibility. In this regard, we are well positioned for 2010.
Now, over to Sarah to discuss our investment portfolio.
Sarah E. Street
We’ve made great progress on our derisking plans during the quarter. We took advantage of what we believed to be a technically driving rally in certain asset classes to reduce our holdings in a number of legacy positions. We sold $1.2 billion of assets including CMBS and non agency RMBS where we saw market prices encroaching intrinsic values but where the underlying collateral is still exposed to weak fundamentals.
We also reduced a number of the hybrid securities in the life portfolio through both sales and tenders. We have now reached 80% of our targeted P&C derisking in terms of reducing the potential negative mark-to-market if the market events of January 2007 through to March 2009 were to repeat themselves. As Mike mentioned, further reductions in remaining legacy assets principally non agency RMBS and CLOs will likely occur over time from natural cash flows, maturities and from sales where the economics make sense.
Slide Eight summarizes our derisking actions to date as well as for the full year. For 2009 we have reduced our exposure to volatile asset classes by $5.6 billion. Slide Nine compares to the current asset mix of the portfolio at the beginning of the credit crisis during 2007. We have a substantial reduction in non-agency structured credit and other risk assets. Given where we stand today, we are now focusing on the optimal realignment of the P&C portfolio rather than pure derisking actions.
The composition of the P&C portfolio is not as close to our strategic benchmark as we would like it to be but we are still somewhat defensibly positioned. The best example is that we are overweight government and related sectors and underweight high quality corporate. However, given where interest rates are currently low we will take our time and be patient to moving towards our strategic benchmark looking for attractive spreads and absolute yields that offer a good risk adjusted term.
I will also highlight that due to the decision to put the life portfolio in to runoff and given that we run these portfolios on a closely matched basis to the liabilities, we designated $546 million worth of Euro denominated long duration governments within our life operations as held to maturity which means that interest rate movements will no longer impact our book value from these holdings on a US GAAP basis.
Turning to the fourth quarter investment results, during the quarter the investment markets were relatively quiet leading to a positive mark-to-market of $112 million. Slide 10 shows the drivers of essentially spread tightening offset by increasing rates in both the US and the UK. Slide 11 shows our net investment income on the P&C and corporate portfolio was $233 million, a decline of 24% compared to the prior year quarter and down 2% relative to third quarter.
At the assets associated with the exited stretch of product businesses are a much smaller component of our portfolio now. We will now focus on P&C and corporate net investment income in 2010. Lower net investment income continues to be driven by the floating rate assets and defensive positions in cash and governments. The P&C book yield remains stable at 3.5% gross of expenses and duration is unchanged at 2.9 years.
We continue to prudently redeploy cash, sales receipts at maturity and achieved a blended reinvestment rate in the P&C portfolio of 3% in the quarter. Our net income from investment fund affiliates was $26 million reflecting strong 2.4% returns in our equity accounted alternative portfolio and a favorable first quarter mark-to-market impact from our private investments.
During the quarter we realized losses of $264 million including $121 million of OTTI charges primarily on what now are below investment grade non agency RMBS securities. Our net realized losses from sales as I talked about earlier was $132 million excluding $11 million related to the sale of XL Re Life America.
Now, over to Dave to talk about our insurance operations.
David B. Duclos
Insurance results for the fourth quarter were strong and exceeded the expectations we set in February 2009 despite the challenging macroeconomic conditions impacting many of our clients. Although renewable premiums remain down as a result of exposure based reductions globally, both underwriting income and revenues were better than expected. Our combined ratio of 98% for the quarter was five points greater than our Q4 2008 result of 93% which had been favorably impacted by prior year reserve releases and the Winterthur related gain Simon mentioned.
Adjusting for restructuring charges, the insurance segment’s Q4 ’09 combined ratio was a very respectable 96.2%. On a full year basis, excluding the benefits of prior year development and restructuring charges, we achieved a combined ratio of 99% in 2009 compared to a 104.2% combined ratio in 2008. Gross premiums written declined 5.9% or $64 million from Q4 2008. Significantly better than the first half decline of 26% and continues the improving trends we saw since mid February.
The small decline is due to underwriting actions, the termination of two MJ programs specifically, the continued global economic pressures and our push for rates, partially offset by increases in renewal, retentions and new business. Net premiums earned were down 7% or $66 million, mostly due to the earn through of lower gross premiums written as well as fx movements which accounted for $23 million.
On the loss side our strong Q4 2009 loss ratio of 64.4% reflects both very limited CAT activity and relatively low large loss activity in our property book. My last comment on the financial results relates to our Q4 ’09 operating expense ratio of 21.5%. While 1.4 points greater than Q4 ’08, when normalized for the restructuring charges, the ratio is 19.7% for the quarter and 17.7% year-to-date. This is in line with expectations and reflects decisions that we made and communicated to you earlier in the year.
Before I move on to market conditions a few words on subprime and Madoff. For these events the number of new reported incidents decreased significantly as we moved through 2009. Specifically, during the fourth quarter there was only one new policy notice added to the list of potential policy exposures that we were tracking related to subprime and the related credit crisis for years 2007 and 2008.
For Madoff there were two reported new notices in the fourth quarter. We will continue our regular monitoring of these matters through to their ultimate resolution and this most recent activity reinforces our confidence in current reserve levels.
Regarding the market, we continue to see clear and steady improvements in retentions and in new business submissions throughout the book and Q4 was no exception. Our premium retentions ended the year just under 80% for all lines despite the challenging market and economic conditions. With property and casualty lines in the low to mid 80s.
Fourth quarter pricing also showed modest but continued improvement with an aggregate price change of 1.4%. We saw more meaningful price increases reflected in professional plus 2% and aerospace plus 9%. Property rates were down 2% for the quarter. Looking forward to 2010 I can also share some preliminary insights. In [inaudible] we’re just under 50% of the book renews. On 1/1 we experienced strong retentions again across all product lines. Casualty at 88% and property at 86% based on accounts renewed to date. Indications in other regions are also at or near historical levels.
With regard to pricing, initial indications based on January 2010 renewals, reflect continued albeit small rate improvement. With the rate movement currently projected at 1% compared to a rate decline of -2% in January 2009. While we worked hard to keep loss business to a minimum in 2009 and we succeeded, during our January renewals we’ve been very successful at winning back some business that did move.
Looking back at 2009 what’s important is we can say one thing, we did what we intended to do this past year. Renewing existing books of business with improved rate outcomes, selectively writing new business at the right price, taking the necessary actions to lower our expenses and all while remaining disciplined in our underwriting and engaged with our brokers and clients.
Now, to Jamie to cover reinsurance.
James H. Veghte
Underwriting results for the segment were excellent with a quarterly combined ratio of 92.6% in challenging market conditions. This compares to a combined ratio of 79.6% in the fourth quarter of 2008. Excluding the benefit of prior year reserve releases we achieved a combined ratio of 97% which compares to 97.4% in 2008.
Turning to top lines, gross written premiums in the quarter were $133 million, 28% increase over 2008. However, excluding the impact of a computation on a structured products contract in 2008, gross written premiums in the quarter declined by about 5%. For the full year we had a combined ratio of 82.1% which compares favorably to the 90.4% combined in 2008. Excluding prior year releases, the combined ratio for 2009 was 96%, a 9.7 point improvement over 2008. This improvement relates primarily to our lower level of property catastrophe and risk losses in 2009 and a shift in business mix.
Gross written premium for the year declined 17.7% to approximately $1.9 billion reflecting competitive market conditions particularly in long tail lines. Net premiums earned for the year totaled approximately $1.6 billion, a 20% decline. As we’ve said repeatedly over the year we will shrink our portfolio when we don’t feel market conditions warrant deploying our capital. Overall, we are very pleased with our 2009 underwriting performance.
Turning to market conditions, we had a very successful January 1st renewals despite challenging market conditions. We entered the renewal season with $941 million of renewable premiums and ended up writing $1 billion a 6% increase. Almost 50% of this increase or $28 million of written premium was driven by recaptured business that we had lost at the end of 2008 due to security concerns by customers.
The remainder of the increase was driven by selected new business opportunities and increased CAT capacity in certain geographies. Broadly, we would describe the renewal season as competitive but orderly. Many firm orders came in quite late but the brokers has very little difficulty placing even in the largest of programs, providing pricing cleared the major lead markets.
We continue to see customers increase retentions and push for improved conditions. Direct CAT renewals to risk adjusted reductions of 7% to 10% in the US and average 5% on international accounts. Long tail lines while showing flat renewals globally remained a source of considerable concern for us. While the reinsurance market remains disciplined we are heavily impacted by conditions on the direct side where certain sectors of the market remain quite competitive.
With that, I’ll turn things back to Mike for guidance.
Michael S. McGavick
Before I go on I was handed a notes while my colleagues were speaking that I misstated our book value per share. I gather I said $26.60 when I mean to say $24.60 as you’ll have noticed in the notes. I apologize for any confusion. You should know by the way that the note came from Jacob Rosengarten, our Chief Enterprise Risk Officer so you know our processes are working well.
I will now turn to guidance. I’m sorry for that confusion. You can see from our guidance on Slide 15 of the presentation we believe we can continue providing solid results even through these difficult conditions that we expect in 2010. All guidance here is subject to the normal caveats, no unusual loss events and the other items you see referenced at the bottom of the guidance slide.
To start, we anticipate our gross premiums written in 2010 will be up low single digits from 2009. You’ll notice that net premiums earned may have some catching up to do as they will reflect 2009’s lower premiums written. P&C and corporate net investment income in the range of $800 to $950 million reflect both the current low interest rate environment and a level asset base and our expenses management efforts are on track and on time.
With all of these elements in place, we believe XL should generate a low double digit operating ROE in 2010. Now, we’ll open the lines for your questions.
Question-and-Answer Session
Operator
(Operator Instructions) Your first question comes from Jay Gelb – Barclays Capital.
Jay Gelb – Barclays Capital
On the guidance, just a couple of points, the net to gross went up about two points if you combine in terms of reinsurance segments for the full year. Should we anticipate that trend stays in place?
Michael S. McGavick
Clearly we would expect to improve over time because of course the biggest dips in premiums are acceding in to prior periods.
Jay Gelb – Barclays Capital
So the seated percentage will probably decline over time? Am I getting that right?
Michael S. McGavick
We have seated a bit less this year Jay but basically there is no deep change in our reinsurance purchasing philosophy. What you are seeing mainly is the changing in premium flows in to written according to the level of premiums written and of course our biggest declines were early in the year. Their influence will decline over time in terms of the GAAP between written and earned.
Jay Gelb – Barclays Capital
The return on equity guidance of double digits, that excludes potential prior year development or includes it?
Michael S. McGavick
We’ve never broken the sup parts out of how we make that guidance and wouldn’t want to get in to that now but we believe our job is to give you the best view we have of where we think we’ll be at the end of the year and that’s our view.
Jay Gelb – Barclays Capital
So all in low double digit ROE?
Michael S. McGavick
Again, we’ve never gotten in to all the various components that make it up.
Jay Gelb – Barclays Capital
Two other quick ones, is there any assumption in there of capital management over the course of the year?
Michael S. McGavick
I have to give you the same answer Jay. Again, we’ve never gotten in to the individual components that drive our view of where the year will end. If you want a general answer on capital management I’m happy to give it now, I expect it to come up. I give you the standard answer that I’ve given now for a number of quarters and really it reflects a philosophy that I’ve brought to these jobs since I’ve been in them and the first most important note in my view is shareholders money.
Our first test to how we approach capital management is do we have adequate capital relative to our ratings, to our rating agencies and our own view of the risks we take on so that’s the first thing we focus on and we think the market will be well aware, we’re certainly well aware that we’re in a very comfortable position at this point. While we don’t get in to specific degrees of excess, we obviously are getting very comfortable with our capital position.
So once we’re in that position the second thing we look at is can we put that money to work well given our hurtle return expectations at XL and then if we can we put it to work and if we don’t believe we can then we will return it to shareholders in whatever form we believe is most efficient. That consideration, the last two the tradeoff between the last two is still ongoing work and we’ll continue to think that through and when we have news we’ll announce it.
Jay Gelb – Barclays Capital
Then Jamie, can you just walk us through the one timer in the reinsurance, the structure product compact and what the impact that had on growth?
James H. Veghte
There was just a onetime computation in the fourth quarter of 2008 which reduced the written premium in the fourth quarter of 2008 so that provided a bit of a distorted picture relative to gross in written premium in this fourth quarter. But it was a return premium of some $30 million I believe, it could have been a bit more Jay in the fourth quarter of 2008 on that contract.
Jay Gelb – Barclays Capital
So on an apples-to-apples basis, it would have been around 5% year-over-year growth in the reinsurance segment?
James H. Veghte
No, it would have been a small reduction if you pull that computation out.
Operator
Your next question comes from Joshua Shanker – Deutsche Bank Securities.
Joshua Shanker – Deutsche Bank Securities
I’m curious about favorable development net or gross actually thinking about [inaudible]. How are 2008 and 2007 looking versus the years prior to that and how can we sort of breakup this favorable development if it’s possible to disclose that?
Simon Rich
Let me just talk about what we have and haven’t taken here. I think looking at the prior year developments that we have taken, over half of that comes from the short tail lines and we’ve taken I would say a cautious and limited view on the longer tail lines where we have reacted to that, it’s really coming from the 2002 to 2006 years. Any years later than that we just think will all the uncertainties out there we have to be very careful before we act on that and really on those years very little to date.
Michael S. McGavick
I would underscore that last point, we have a well earned reputation for prudence when it comes to reserving and certainly I’ve noted with I guess the right word would be interest or whatever some of the really significant releases by some others in the industry in this particular quarter. I would just tell you that our own view is that if we’re going to keep that prudence that we’re known for we just think for at least our own book, and this is not a comment relative to them, just ourselves, we think it is too early given the very noisy economic conditions in which we’re living and given the real specter of inflation we think it’s just too early to react to the very favorable actual reported numbers that we’re seeing. We just think this is going to play out over a bit of time.
Joshua Shanker – Deutsche Bank Securities
In terms of any strengthening for recent accident years?
Simon Rich
Very, very little for recent accident years.
Joshua Shanker – Deutsche Bank Securities
The other question which I think you said but just the numbers were coming through so fast, I’m wondering if Sarah can repeat the impact of the Life Re transaction had on the AOCI account or maybe the investment gain loss count?
Sarah E. Street
That is the decision we made to designate those assets as held to maturity?
Joshua Shanker – Deutsche Bank Securities
What’s the size of that pool and how did they move during the quarter?
Sarah E. Street
The pool in dollar terms is $546 million. When we moved them from available to sell to held to maturity they were in a realized gain of $50 million so we moved $50 million from available to sell over in to essentially held to maturity accounting.
Operator
Your next question comes from Vinay Misquith – Credit Suisse.
Vinay Misquith – Credit Suisse
On the capital position, I hate to beat a dead horse, but just curious as to whether your share repurchase program is by any chance being held back by the structured investment portfolio? Are you doing anything to get rid of it? You already sold a lot of it but I believe you were about 80% through so I was just curious about that?
Michael S. McGavick
No, I wouldn’t say that our primary concern with respect to making decisions around capital management relates to the investment portfolio at this game. Certainly we’re mindful that we’ve just come through a very bumpy period so we believe that caution for the near future is certainly prudent but it isn’t driven by what remains because we now have that portfolio down so far that we’re making the decision that we’ve emphasized tonight to shift from derisking to kind of letting the economics play out as they will.
I think that’s an indication of the confidence that we have in our capital position going forward. As a result, I think the capital management decisions would be made apart from what remains to be done. We’ll let time take care of that now as opposed to the more aggressive mindset that we acted on throughout 2009 and which led us to be able to drive more than $5 billion of such assets off the balance sheet.
Vinay Misquith – Credit Suisse
I believe you mentioned that you have $1.5 billion at the parent company in the form of cash. What’s the historical amount that you’ve had there and how much of it is excess cash sitting at the company right now?
Simon Rich
Just to clarify, what I said was we have $1.5 billion in terms of cash and investments. We, like many companies in these times of looking to maintain flexibility, we actively managing the levels of the cash at the parent company over the last I would say 18 months to two years and we are basically in the target zone that we set for that. Prior to that time the levels fluctuated a little more.
Vinay Misquith – Credit Suisse
My second question is on the investment portfolio, now that the derisking is done, are you planning on increasing the risk on your portfolio? I believed you mentioned something about moving up from government securities to more corporate. Could you give us a sense of new money yields versus the old money yields?
Sarah E. Street
Certainly over time we will be looking to increase we’re underweight with our investments in high quality investment grade credit relative to where we would want to be and that overweight comes from we’re in government and government related. The new money yields for the type of investment grade credit that we would want to buy today is about 3%. I will tell you that one of the reason why we’re not rushing in to do it today is that actually the book yield on the government and government related given that some of these are securities we bought some time ago have actually higher book yields on those. So at this point it doesn’t seem to make a lot of sense to us to sell government guaranteed or government issued paper to buy lower rated but still higher quality, A or AA rated paper in return. That’s why we’re going to take our time
Operator
Your next question comes from Paul Newsome – Sandler O’Neill & Partners, LP.
Paul Newsome – Sandler O’Neill & Partners, LP
I was wondering if solvency two efforts in Europe are going to have any impact on your capital for your European operations given the size of your European operations and the portion of your business?
Michael S. McGavick
That work is still in progress and I wouldn’t want to comment prematurely on it except to say one of the things I think is noteworthy is on the life side it appears that some of the early thinking in the solvency two life side it is a bit more dramatic. Of course, our block there is relatively small compared to the whole but that’s probably the one place that I’ve taken more note than anything else. For now, we’re still working on getting our internal model accredited and that is the work that we focus on.
Paul Newsome – Sandler O’Neill & Partners, LP
Your life operations are all offshore right? So none of the statutory changes in the US would have had any impact on the capital, is that correct?
Michael S. McGavick
As you probably have noted, we sold our US Life Re operations and now those operations in fact, yes are concentrated principally in the UK and Ireland.
Operator
Your next question comes from Jay Cohen – Bank of America Merrill Lynch.
Jay Cohen – Bank of America Merrill Lynch
Several questions, first a clarifying one, I think Simon you suggested on the tax issue that taxes were about $29 million higher than you expected. Was that due to just the non-recurring items or in general the higher tax rate all in?
Simon Rich
The $29 million is I guess the one off nature of the items in the quarter. Let me just put some color on that, it’s a timely question given the previous one. Much of the tax came from a reassessment of our yearend reserves and particularly I guess we had a higher focus on the level of reserves at a legal entity level cognoscente of our solvency two risk management efforts and the desire to get the right balance sheets in the right legal entities.
In terms of the outcome, what happened was that we ended up having a number of releases in higher tax jurisdictions and some strengthening in lower tax jurisdictions. The impact of that was the main part of the $29 million I was referring to. We wouldn’t expect a rebalancing of that nature to happen again and we very much view that as one off.
Jay Cohen – Bank of America Merrill Lynch
Then on the guidance, the investment income in total, is that something you can break out between the P&C business and the corporate? That would be helpful.
Sarah E. Street
Can we move to the next question and then we’ll come back to that.
Jay Cohen – Bank of America Merrill Lynch
I guess last question for me is in the reinsurance segment, there was much less favorable reserve development that we had been seeing and I’m wondering what accounted for that change if anything?
James H. Veghte
I don’t think anything in particular Jay. We go through our normal process in the fourth quarter. As Mike said previously, we’ve been very, very cautious with recent underwriting years and the releases is what we thought was prudent given the analysis we did.
Jay Cohen – Bank of America Merrill Lynch
Sarah at some point if you could again break out that investment income guidance between corporate and P&C that would be helpful.
Sarah E. Street
We’ll get back to you on that. To be honest we’re trying to move it towards that we’re looking at it on an aggregate basis because the corporate at this point is so small because it’s the legacy financial lines businesses that really we don’t see any real benefit of continuing to break it out so we didn’t have the guidance on that basis because we have combined the two together.
Operator
Your next question comes from Matthew Heimermann – JP Morgan.
Matthew Heimermann – JP Morgan
One numbers question and then maybe a broader picture question. I guess I’m struggling with how to think about the write kind of catastrophe load for your business today given all the changes you’ve gone through the last 12 to 18 months.
Michael S. McGavick
Let me give you a statistic, we have CAT load in the budget which obviously is based on a prior view applied to this mix of business and that amount for this year is about $240 million and that would compare to a 2009 budget of about $220 million.
Matthew Heimermann – JP Morgan
I guess my follow up question on that would be then so that’s about 4.7 points, I think historically if I look the 11 year average was like 6.6 so is that delta effectively changes the portfolio post KRW? That would kind of bring down the whole average over that period?
Michael S. McGavick
Our remix after KRW and our change in approach to class exposures has been rather dramatic and I think that would be an important consideration in that difference.
Matthew Heimermann – JP Morgan
Then just PML based on what you’re doing at 1/1 is that like in absent terms be up or down in 2010?
Michael S. McGavick
In absolute terms I believe it will be relatively flat. It might be slightly up because we did apply some more capital allocated to some of the catastrophe zones so I guess it would be slightly up but still well under the maximum we establish for potential loss.
James H. Veghte
I think we stated publically before that our risk appetite for what we call Tier-1 CAT exposure is 15% of shareholders’ equity. We have not fully utilized it over the last 18 months. But obviously that number is going to move as our balance sheet changes.
David B. Duclos
I’d add a little more color to Mike’s answer around how our exposure has changed quite a bit in the last four or five years certainly from KRW. We have reduced our Gulf of Mexico, inland marine and offshore marine exposure by 80% and we’ve rid ourselves of one program in particular where we were writing catastrophe cover specifically for small to midsized commercial accounts. So from an insurance perspective we have effectively reduced a significant proportion of our wind exposure in the most prone area in the US by over 50%.
Matthew Heimermann – JP Morgan
I guess big picture question for your Mike is just it feels like your time at company may be playing a lot more defense than offense. I guess now that things seem to be stabilizing from a capital standpoint and you’re through most of the hard work on the portfolio and the business, what are the priorities aside from the one that will remain nameless, what are kind of the big strategic priorities that you’ve got that you want to focus on over the next 12 to 24 months?
Michael S. McGavick
The most exciting thing for us is we now get the opportunity to do what we came together to do. I believe that even in these difficult times meaning relative to the insurance cycles there are always opportunities for a great underwriting company and XL’s history has shown it to be one of those. For example right now I would point out that we continue to see rate levels that encourages us to selectively write in our professional lines.
We see rate levels that continue to encourage us to apply a bit more capital in to some of the catastrophe zones. We continue to see rate levels that encourage us in the aviation space. So even though we would cite the overall trends as negative, there are opportunities for us to go out there and sell XL and that’s exactly what we’ll be doing.
Also, we have kind of an odd opportunity, it’s not huge but it’s meaningfully different from what the market is experiencing and that is of course during late 2008 and early 2009 when there were these concerns around XL there were some counterparties that chose to cut back their lines and even in handfuls of extreme cases not do business with us. Those are people who admired XL, also did so they said with regret and we’re able to go back to them now and say, “Remember how much you loved us.” And sure enough we’re seeing an opportunity to get back on lines of business with clients we know very well and very well the appropriate rate levels for.
That’s a little bit of a lift opportunity for XL that it’s kind of oddly gained but nonetheless beneficial. So when we look at the marketplace we see it was probably a little bit more excitement than maybe some do who might have different mixes of business or not have that odd little opportunity for lift. As we go through that what you’ll see us doing is continually trying to strengthen the franchise towards being more opportunistic where there are pockets of real rate opportunities.
That will be true throughout this phase of the cycle and then aggressively true as we see any sign of turn. We are building our capital, building our expense base and conditioning our people to be ready to take full and appropriate opportunities when that cycle turn comes. It’s about sticking to the soft market playbook in a very aggressive way, it’s about keeping real focus where we do have opportunities and making sure not to leave them on the table and then it’s about being ready and positioned to take advantage of what comes.
Who knows when it will come but we know it can’t last forever and we know how to great through this kind of period. It gets very exciting for us around here right now. I’ll say one last thought, having weathered what we’ve weathered we realize, all of us at XL realize the fact that our people stuck together and because our people stuck together our clients stuck with us by in large, that just sends a huge message to the marketplace about the resilience of this franchise.
It reveals to us excess capacity. We not only know we have additional capital which we could write, we talked about that earlier, but we also know as a company we have excess capacity as a group of people because as that burden recedes in to the long ago past, we still have the energy that it left behind and that energy will be applied to the benefit of our clients through innovation and through pursuing growth where we think it’s opportunistic. So if you were sitting in our places right now you’d be as excited as we are.
Operator
Your next question comes from Brian Meredith – UBS.
Brian Meredith – UBS
Mike, I was hoping you could give us a little bit of color behind the combined ratio guidance and insurance and reinsurance? For instance with reinsurance it’s a fairly decent drop in the combined ratio excluding prior year development from what we reported this year and what’s the thinking behind that as well as in the insurance area what kind of thoughts on loss costs deflation, kind of how did you come up with these numbers just generally speaking?
Michael S. McGavick
I would tell you that this is the third partial or whole budgeting cycle that I’ve been through at XL and each one I feel we do a better job of getting more and more realistic about where we’re starting from and what opportunities that pretends given what’s going on with rate and loss costs. I’m going to let Dave and Jamie comment specifically on their units but as I looked at it and as we as a collective reviewed the plans of our various businesses at a much more granular level than we’ve been able to do during the course of the first couple of years I’ve been here. I would tell you I have more confidence of this plan playing out as predicted than even I did at the beginning of last year and last year’s plan turned out to be somewhere between correct and maybe even a little pessimistic relative to what really happened. But, I’ll let Dave start and Jamie follow.
David B. Duclos
Brian, I guess I’d answer this question in a couple of different ways, first from a loss ratio standpoint we feel really good about the position we are in. As you can see when you strip out prior year and CAT activity we have stemmed the development upwards in terms of our accident year loss ratios and that’s a result admittedly in 2009 of no CAT activity, minimal or normal CAT activity, really no large property loss to speak of and we didn’t have a subprime load in 2009 which we did have in 2008.
Also though important to understand is we’ve got a mix shift in terms of our business. As an example, more of our business is written in the professional lines which earns a stronger ROE and also underwriting actions. For the last two years we’ve been taking tough actions around business that is marginal. Most of that work is now behind us so from a loss ration standpoint we feel pretty good about the fact that we think the loss ratio in 2010 is going to hold steady as to what we produced in 2009.
Now, specific to your question about inflation, when you look at all of our lines totaled up, our inflation assumption is just a little bit below 4%. We have not moved that. Keep in mind that we look at that and pay attention to it very carefully. I would draw your attention to the fact that we don’t have a lot of workers’ comp which at this point in time frankly we like. We are selectively looking to write comp business but on a percentage of book basis it’s pretty minimal. Professional again, it’s a big chunk of our business.
So from a loss ratio standpoint that gives you a little bit of color. The other piece to take in to consideration when you think about our combined ratio in 2010, we did a lot of work the last 18 months in addition to some of the work that Mike mentioned at the beginning of 2009 corporate wide around expense reductions we also did some specific in this segment that were communicated in the fourth quarter.
Our expenses from year-to-year are going to drop materially from 2009 to 2010. That’s going to flush through to the combined ratio. So, actually it’s a tough market, touch environment but in terms of how this franchise is positioned I would echo Mike’s comments, we feel a lot better about the position we are in today than we did 12 months ago and that has nothing to do with the financial crisis issue.
James H. Veghte
Brian, I think there are a couple of pieces your probably need to bear in mind. One is as it says on the slide there’s not prior year release related assumptions in those numbers. Secondly, we take no joy in shrinking this book of business but we have been because of the market conditions and our operating expense ratio while we’ve restrained operating expenses has gone up. I think that probably the biggest element to consider is that as we have reduced our position in the long tail markets property CAT becomes a much bigger percentage of our overall portfolio and has an effect on the loss ratio.
Brian Meredith – UBS
Just as far as your P&L thresholds, where do they stand right now? Are they still under the 15% to 20%?
James H. Veghte
15 was our Tier-1 [inaudible] as a corporation we have not fully deployed it.
Operator
Your next question comes from Ian Gutterman – Adage Capital.
Ian Gutterman – Adage Capital
I had a few questions on professional liability. I guess just for context can you give me a sense of the mix of your book between primary and excess and also A side versus other coverages?
David B. Duclos
First of all it’s almost evenly split between primary and excess and that has been historically the case for the last three or four years. I’d also say that our percent of FI business is pretty much the same on a unit or policy basis. It has increased on a premium basis in the last two years primarily because of the rate we’ve been able to attract and get from an FI perspective.
I would point out that the FI book within itself is well diversified. Maybe I’ll give you a couple of numbers that gives you some perspective in terms of the global professional book. 42% of it in D&O of which 29% is A side only and this is as of yearend 2009. 26% of the book is in E&O, 13% in our design program architects and engineers and then we’ve got about 15% to 20% in a combination of select, private and EPL and fiduciary.
We’ve got good balance from a primary excess standpoint. A good chunk of our business is A side only and we have a good diversification within the FI class. I’d also say one last comment, that we’re expanding our presence in Europe which is an objective. We’ve got a good position in the US that we’ve built up over the last five or six years and we’re focused on building out our European professional book as well which will give us more balance from a geographic perspective.
Ian Gutterman – Adage Capital
That actually led to some of what I wanted to ask about which is I understand that sort of the big subprime class action D notes have so far gone reasonably well for the industry and maybe some of us are too worried about that as a concern. I guess my question is I’ve been hearing more and more about losses in the non D&O line from the credit crises, not just E&O but fiduciary, some of the other banker lines, spreading that through other lines. Can you talk about are plaintiff’s lawyers trying to find backdoors when they’re getting the motion to dismiss on the D&O and they try to find a new way to attack and is that a concern we should be worried about?
David B. Duclos
First of all I really couldn’t speak to that primarily because don’t have that exposure. We’ve not seen that claim activity to develop.
Ian Gutterman – Adage Capital
Then my other question is about sort of where you place primary over excess? What are you seeing on the defense cost side? I guess that’s another area I’m seeing more pressure on when I talk to insurers and brokers that are watching defense costs not just eat up the entire primary layer on some of these high profile cases but even in to the first excess. Is that an issue for you guys?
David B. Duclos
It’s certainly something to pay attention to and we’re monitoring very closely and it all gets back Ian to making sure we get the proper rate for what the exposure is and defense costs is part of that equation. I would say that it hasn’t materially changed our underwriting appetite. We continue to strive for a pretty good balance between primary and excess but to your point we just need to make sure that we get the right rate for the excess policy.
Ian Gutterman – Adage Capital
Are you seeing any loosening of terms from your competition on the lower excess layers as far as being more open to dropping down and taking defense costs and things like that? We’ve seen a lot people drop down who are traditionally high excess and they’re trying to sort of compete with you guys with primary excess and I’m wondering if they’re doing it through terms?
David B. Duclos
Unfortunately, we’re at that point in the cycle Ian where you do see that occasionally. It hasn’t really caused us a material impact in terms of loss business but we are see incidents of where you’re seeing coverage form change.
Ian Gutterman – Adage Capital
Then my last one is Side A I guess we’ve typically thought of that as being sort of a safer coverage but again, I’m hearing some things where Side A is sort of being attacked more on the derivative claim side where normally we thought of Side O being mostly a bankruptcy policy and maybe some people are pricing it that way and not accounting for the derivative exposure. Is that a concern of yours?
David B. Duclos
It is not a concern with us. We’re committed to keep our Side A cover as it’s currently written. Again, you’re seeing the market do some things to try and dislocate business but it hasn’t had a material impact on our book of business. We’ve not necessarily seen any losses on the derivative basis that you speak too.
Operator
Your next question comes from [Mahmut Resa – Bowman Capital].
[Mahmut Resa – Bowman Capital]
A quick question on the investment portfolio and I think you might have mentioned this last quarter but what would the mark-to-market be which is currently running at $1.1 billion on the investment portfolio? What would it be if spreads blew out to where they were I guess at the highs?
Sarah E. Street
The way we’ve talked about it is that drawing the period from January of 2007 through to the end of March 2009 we have actual mark-to-market negative movement in the P&C portfolio of $4 billion. If that were to happen today it would be $1.8 billion.
Michael S. McGavick
And remember that the strategic asset allocation that we are driving towards runs through the same meat grinder would have a negative mark-to-market of about $1 billion. So when we say 80% of the way there we’re taking from the four to the one is the target and we’ve got that small amount to go.
[Mahmut Resa – Bowman Capital]
Would it be accurate to say that within the $0.69 that you guys reported on the operating basis, that includes both the restructuring charge of $12.1 million pre tax and the elevated taxes of almost $30 million so kind of $40 million on an after tax basis, that’s in the $0.69 number?
Michael S. McGavick
We try not to get in to the street versus this or that but as I sit back and look at it we got some modest benefit from fx but we had these two one times that are also in there as well and they are larger. That’s how I would look at it but that’s for you all to figure out. The answer to your question is yes.
[Mahmut Resa – Bowman Capital]
So Mike then the ROE guidance was sort of low double digit, is that pre or post capital management? I apologize if you’ve already answered that.
Michael S. McGavick
To be perfectly honest I didn’t answer that. What I said earlier is there are a number of inputs – the way we look at it is our job is to give the best assessment we have of where the year will end up and we never before nor will we get in to specific components of that guidance. As you’ll notice we give a very high level guidance to try and assist our investors in making their own judgments but we don’t chose to give the kind of precise or detailed judgment that some others do because we find our business a very difficult one and we think this is the right way at least for our comfort to provide that assistance to our investors.
Operator
Your last question comes from Daniel Johnson – Citadel.
Daniel Johnson – Citadel
I want to go back and retouch on Jay’s question about the reinsurance development in the quarter and I certainly understand that of course every quarter you assess reserves and make your best and most accurate judgments and I’m sure that’s what happened this quarter but the prior 11 quarters we were running about a $70 billion reserve release without a ton of volatility and this quarter it was $17, again to the positive. Can you go in to a little more detail as to sort of what was benefiting before that is not benefiting any more or is it a case that the same trends are benefiting but there was actually something that came up to absorb some of the positive benefits?
David B. Duclos
I think as I said before, we’re being very cautious on recent underwriting years. Just to give you a picture of the entire year and long tail lines of business, we released $22.8 million of prior year for the entire year. Of that only $62 million was for casualty business, the rest was short tail business and we released virtually no prior year reserves for 2008 and fairly modest for 2007. I think we’re just being cautious given some potential macroeconomic issues that some prognosticators are predicting like inflation.
Daniel Johnson – Citadel
I can appreciate that and think that would be prudent but it seemed like a relative sudden change in the fourth quarter or is there a more holistic development assessment that goes on in the fourth quarter than say your average normal quarter?
David B. Duclos
We go through two big reserve reviews a year. We obviously look at it every quarter but they would be in the second quarter and the fourth quarter. But there is no change in the way we approach the topic.
Operator
At this time I’ll turn the call back over to the speakers for closing comments.
Michael S. McGavick
We appreciate your being with us tonight. We know the shift to doing these calls after hours puts a bit of a strain on everybody but we can get the information straight to you so you can do your work so we hope that’s the best way to do it. We know you’ll give us your direct and candid feedback. I would just summarize we’re awfully pleased with where we stand at XL and very excited about where we go next.
I would just offer one last thought, I don’t like to bring up the experience at Safeco too much because so much of what we did there is not relevant and some of the players and challenges are different but I can tell you for the team that worked there and certainly for me and I know the team that works there, we don’t calculate our success as related to avoiding crisis. We’re pleased that we’ve done so and excited for where we stand but we really count our success when we are outperforming our competition in very significant ways and that’s what we really strive to do now. That’s the next phase of the adventure here at XL. Thanks for your time and we look forward to delivering on that ideal.
Operator
This does conclude today’s conference. We thank you for your participation. At this time you can now disconnect.
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