Flagstone Reinsurance Holdings Ltd., Q1 2010 Earnings Call Transcript

Executives

Brenton Slade - CMO

Mark Byrne - Chairman

David Brown - CEO

Patrick Boisvert - CFO

Analysts

Amit Kumar - Macquarie

Ian Gutterman - Adage Capital

Flagstone Reinsurance Holdings Limited (FSR) Q1 2010 Earnings Call May 4, 2010 9:30 AM ET

Operator

Good day ladies and gentlemen, and welcome to Flagstone Reinsurance Holdings first quarter 2010 earnings conference call. My name is Towanda and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

It is now my pleasure to introduce you to your host for today's conference, Brenton Slade, Flagstone's Chief Marketing Officer. Brett, please proceed.

Brenton Slade

Thank you very much Towanda and good morning ladies and gentlemen. Thank you all for joining us on our call today. With me are our Chairman, Mark Byrne; David Brown, our CEO; and Patrick Boisvert, our CFO. Before I turn the call over to Mark, please let me remind everyone that statements made during this call including the questions-and-answers, which are not historical facts maybe forward-looking statements within the meaning of the US Federal Securities Laws.

Forward-looking statements contained in this presentation may differ from actual results. We therefore caution that you should not place undue reliance on such statements. We speak only as of the dates on which the statements are made and the company undertakes no obligation to update or revise publicly any forward-looking statement whether as a result of new information, future events or otherwise.

On that note, I’d now like to turn the call over to Mark.

Mark Byrne

Thank you, Brent. Good morning ladies and gentlemen. We had a good start to 2010 with positive results in a quarter in which we saw a numerous global catastrophes impact the industry. This quarter our basic book value increased 3.4% and on a dilutive basis 2.1%, which are good results given the loss activity.

Our belief in strong risk management and in creating opportunity to diversification continues to prove itself and we remained focused on our goal of producing strong results through superior technical underwriting and becoming a leading underwriter in short-tail and reinsurance. Our strategy of leveraging our global platform and leading the industry in utilization of proprietary analytics, in addition to our strong broker and customer relationships has created a foundation for these results.

During the first quarter, we continued to refine and integrate our global platform and the spread of quality business we generated is a direct result of this worldwide reach. Our diversified and technologically savvy approach also affords us the ability to efficiently scale our business as attractive opportunities arise, while reducing expense ratios as we mature.

To-date, we have worked diligently at building up a significant infrastructure and we are now at the point of being able to create efficiencies and streamline the structure rather than grow it. In this manner, we continue to look at lines of business that we are not currently writing and might like to add in a methodical manner.

However, our current conclusion is that, we are satisfied that we are in the best-priced lines of business and are sufficiently diversified in the short-tail sector of the industry. As trends and pricing changes in the market, we’ll be ready to enter intelligently as the opportunity is attractive.

Further to the organizational update, I’d also like to mention that to more fully reflect the completed integration of our Lloyd’s operation, Marlborough into the Flagstone Group, we’ve just now announced that we’re re-branding Marlborough Underwriting Agency effective today, and it will now be called Flagstone Syndicate Management Limited.

Besides the underwriting operations, Flagstone Syndicate Management also manages some runoff business as well as access start up funds or manager of third party syndicates, such as our Apollo Syndicate announced in the fourth quarter last year. We’re excited about this opportunity that this operation provides as well a diversified stream of non-core [legacy] income.

With regard to our investment portfolio, we generated 0.8% for the quarter from our assets, as we’ve remained conservatively positioned and comfortable with our high quality portfolio of nearly 90% fixed income securities and cash. Our focus in recent quarters has been on a stable capital base on which we underwrite and this provides us with the advantage of being a high quality credit to our clients and counterparties. We believe this along with technical expertise and leading client service gives us an added edge, allowing us to see preferential business in turn.

As a significant shareholder in Flagstone, we continue to diligently manage our capital. This quarter gave us the opportunity to buyback some stock in a private transaction at an attractive price, which had the added benefit of not decreasing our float. We continue to pay close attention to capital management and weigh the benefits of either buying back stock or deploying capital into attractive underwriting opportunities. Another consideration is maintaining a comfortable capital cushion for rating agency purposes in order to continue to be the high quality credit we’re serving to become.

Finally, we believe markets in several lines of business are potentially firming and maybe opportunities to deploy some of our capital cushion into these new lines of business, if we see a significant potential long term value for our shareholders. That said, we are very pleased with our current capital position and operating opportunities and remain optimistic about the reminder of the year.

Now, David has some thoughts to share.

David Brown

Thanks, Mark and good morning everybody. We’re very pleased with our financial results for the first quarter of 2010. From an underwriting perspective, we performed well despite the occurrence of multiple international cats, including winter storm Xynthia in France, the Australian hailstorms and of course the earthquake in Chile. The only individually material loss to us was from Chile and we still believe that our initial published estimate of $50 million net is a reasonable.

However, we also believe that the overall industry loss from this event will continue to develop towards a higher end of the range of industry estimates and out of caution we’ve recorded a net reserve of $55 million against this event. Although, loses were not material to us in part, as we’d adjusted our portfolio to reflect the increased [venerability] of the lower [license] market that is being demonstrated by events in the last two years.

Despite these events, Flagstone’s emphasis on technical underwriting and risk management allowed us to produce the loss ratio of 58.8% and an underwriting profit of $16.3 million. Our premiums written to capital ratio is purposely and consistently at the high-end of our peer group and this leverage is employed intelligently and cautiously.

Thanks to the significant amount of premium generated by our diversified global platform and the significant opportunities that we were able to offset losses with earned premiums and produced a superior loss ratio as measured over annual periods. We believe that our accident year loss ratios since our inception are amongst the best in our industry. Our risk is managed tightly and as of March 31, our one in 100 net PML was $263 million and a one in 250 PML was $230 million.

We’re pleased with the renewable book of business and the new business generated and written for the first quarter. We achieved some modest net growth at January 1, due to better than expected signings, which is a result of the continued hard work we’ve devoted to broker and client relationships around the world.

Although there seem to be sufficient capacity in the market, generated from recovery in capital markets and a benign CAT year in 2009, we saw generally disciplined underwriting with overall global rates only marginally pressured downwards. Overall, our gross premiums written increased 11%.

Our international book of business, which continues to account for roughly half of our geographic exposure, sold rates levels hold flat to down 5%. We carefully grew our North American portfolio in the quarter of renewal by approximately 20%. Exposure grew by a similar amount in part due to repositioning on different layers as the North American portfolio so decreases of approximately 8% in average rate.

Model expected losses declined inline with these future reductions in underlying exposures of our clients as well as the known changes in the commercial vendor model loss estimates. Consequently, on a risk adjusted basis, both internationally and North America, affected net rates are closer to flat in the business we’re able to write.

At the end of the quarter, Japanese programs came up to renewal and we continued to maintain a significant yet cautious portfolio of business there. Renewal rates were flat to down 5% year-to-year for both wind and earthquake, although our exposure was lowered as well, resulting in a net 2% reduction in rates.

Our specialty lines business tends to renew throughout the year rather that only at one-one, for the business we did generate in the first quarter was attractive. However, aviation rates still refused to increase adequately in our opinion and we have seen clear signs of the energy market was softening to the point it was cooking back in exposure, due to some competitive markets making a move from market share at the expensive profitability.

Marlborough or Flagstone Syndicate Management citizen as now known continues to generate business at Lloyd’s and the short-tail specialty lines of targets and has materially added to our diversification. As always, we are extremely selective and diligent about the risks free write and despite the overall top line growth, we have substantially curtailed some lines of business where the returns are modest and the capital will be more profitably deployed in lines of business providing higher risk adjusted margins.

Due to our growing reputation of innovation and technical expertise, we’ve continued to see attractive one-off deals that enables to grow our specialty segment and deals that are outside the normal TC treadmill continued to be a target for us.

Lastly, I’d like to touch on explosion of subsequent loss of the deepwater horizon oil rig and we go for Mexico. Although this was a second quarter event, we’ll have a limited amount of exposure to this loss.

We write some NGO business out of Lloyd’s, however, as I just mentioned; we’ve scaled back this exposure recently due to pricing in terms falling below except two levels. This is a complex loss and will take some time to come to resolution. So, given our limited exposure, this loss will be well within our expected quarterly load of such events.

We look forward to the upcoming mid-year renewals and are already working in a significant number of submissions. We expect the renewals to be orderly and disciplined much the same as we had one-one, with similar levels of rate change.

However, Chilean earthquake loss as a high-end of estimated industry losses as we think it will, in addition to the continued worsening of the deepwater horizon loss, these will be significant losses in the reinsurance market and we hope should stop the softening of insurance rates and may be even lead to some firming in some lines.

Now I’d like to handover to Patrick to review the quarter’s financial results in greater detail.

Patrick Boisvert

Thank you, David and good morning everybody. As David mentioned, our gross premiums written increased by 11% in Q1, 2010 compared to the same period last year excluding the impact of reinstatement premiums, which were $4 million in the current quarter. Our three business segments contributed to that increase, but more importantly, they all contributed positively [current net] income this quarter despite the significant level of cat activity globally.

Our premium retention was 81% this quarter, compared to 79% a year ago. As discussed in prior calls, we expect to gradually reduce the level of premium ceded in preposition of premiums written as the year progresses. The first quarter combined ratio with 98% driven by higher cat loss activity resulting in $77 million of losses in our property catastrophe line business net of reinstatement premiums and with retrocession.

During the current quarter, we recorded favorable development from prior catastrophic events of $7.6 million based on updated estimates provided by clients and brokers. In addition, we undertook our scheduled Q1 review of actual assumptions to take into account our loss development experience since inception.

As a result of revised expected loss ratios and loss development factors coming in better than initially expected based on our experience, we recorded an additional $17.1 million of favorable reserve development. As we move forward, we will place more emphasis on our internal claims emergence experience and perform such review in the first quarter of each year.

Moving on to investments, our total return for the quarter was 0.8% mostly driven by the positive performance of bond markets. Our portfolio today has an average duration of 2.5 years and AA plus average credit ratings. Our net investment income this quarter was slightly lower than in the last two quarter due to lower amortization income on our TIPS portfolio, which was offset by higher realized and unrealized gains.

Finally, during the quarter we repurchased 3 million shares in a private transaction for a consideration of $33.6 million. Our sale to equity as of March 31, 2010 was just over 1.2 billion and our diluted book value per share was $14.25.

With that summary of the financials, I will now pass it over to the operator to open the lines for questions-and-answers.

Question-and-Answer Session

Operator

Thank you, Patrick. (Operator Instructions) Our first call is coming from Mr. Amit Kumar with Macquarie.

Amit Kumar - Macquarie

Maybe just starting with the deepwater horizon issue, you said it’s a complex loss. Maybe just talk a bit more about the insurance, reinsurance issues and maybe also expand on what’s your thoughts are on the rates in the offshore energy market going forward?

David Brown

Amit, its David. Let me answer the second part first. As I said during the call, we’ve pulled back some in the energy market as I think about 15 major risks that we used to write in London we non-renewed in the first quarter, because so rates were down in some cases we saw a 20% to 30% reductions over prior. We felt in terms we’re getting too loose. So that market particularly was not doing very well and we pulled back. I think we post this loss already, business in the market is showing surprisingly affirming we see rates come back we hope to level that we can support so that’s the view on the rate.

In terms of loss itself, it’s complicated because, in a rig like this there is operators, there is owners, there are multiple owners, many other parties they’re evolved at, should have performed, they didn’t performed. So when you look at all of the place in that it’s complicated to actually see where the exposure will lie. And then secondly, the consequent loss of what will happen with these oil slick, so a loss not just from the fire and subsequent collapse and sinking of the rig, but also now the pollution and as that hits the coast in Florida, I mean this morning I think CFO was saying from Florida, was advising residents on the coast there to take photographs of that properties before the slick hits and then afterwards so that they can pursue -- presumably, BP and others through any loss they think is result of the pollution.

That’s why I’m saying it’s complicated. It’s going to be very widespread, potentially affecting many policies on our liability basis and also many first party policies where people believe they have coverage, and I think it will take a long, long time for the true extents of this to emerge.

Amit Kumar - Macquarie

I guess, what you heard is that that the oil spill is self-insured and hence there might not be any coverage even if, lets say, the oil spill reaches at the coast and then there are subsequent losses. Do you have any additional thoughts on that?

Mark Byrne

The oil spill is self-insured to extend is BP, but I’m sure not to the legal system is going to be other people, I think 65 percent is BP and those of the policies, two of the policies and though what I’m saying, I mean is really that there are policies, so that the policy is issued to be [paid to others].

There are other possible losses out there, damage to shore line, damage to properties, business interruption caused by the slick and people may claim against BP a little bit, but they might try for payment on loan policies for such losses and I noticed this morning that there’s a call to increase the pollution limit at usually $75 million and it’s gone up like $10 billion, it was announced today they’re going to increase the limit of how much people can claim for losses closed by solution. So this is a lot of moving parts and I can – jokingly I said in a meeting earlier, I think, the fluid of oils to Florida is probably equal to the fluid of oil that comes to coast. I think there will be a lot of question over this and it will be in the coast for a long time is my thinking.

Patrick Boisvert

One of the continuing challenges to rates in the energy sector is that there is dedicated capital that only right energy. We right more or less were tactical allocates of capital to that business, but there are people who considered themselves energy underwriters only and yet the company’s that were riding insurance and reinsurance to many times bigger than us, for example BP.

So they tend to buy only one is under prices and they properly capable to exception whether it’s under priced and one should price it correctly as people try to do in 2009 they just don’t buy it anymore and so in this case that’s were talked to their decrement because it look like most of the loss of it will accrued to the owners of the rig rather than to their insurers or reinsures, but I think if the insurers or reinsures, but I think if the insurers or reinsurers try to place this risk correctly, the outcome would be just at their premium volumes would collapse and there are few players in the market they don’t have the discipline to do that.

Amit Kumar - Macquarie

Maybe just sort of moving on to the market conditions in terms of the hurricane season, can you sort of talk about what’s your take is on the Hurricane Cat Fund issue and how do you see that sort of playing out in the future and how would that impact your writings?

David Brown

Well, as you know, maybe sort of instate to that the 2 billion tick away in the cat fund is being reduced and it’s been state to begin several times the intense of the time is to keep reducing that on up planned basis. So my expectation is that a substantial portion of the written cap fund we go away overtime as far it tries to see more of this risk into the commercial reinsurance market and niche interest markets. From year-to-year, it’s changed I think, but I do believe that’s the general philosophy that’s been expressed by the Florida market.

Amit Kumar - Macquarie

How do you think that impacts you going forward in terms of your premium volumes?

Patrick Boisvert

Obviously, to the extent that the capital isn’t providing the reinsurance than it should be posted for other and we expect to grow there. I think you ever think you can’t ignore further either is the premium rates simply going up. One the issues in Florida has been that companies going for the reinsurance, which we believe is correctly priced if not they were not able to charge enough money up front to that policyholders and we’ve seen rate increases in the last year at 30% increases to 15% that can be achieved and the full run rate of those increases are now coming through and company is just still far in increases. So what we believe is fundamentally over time, the Florida market should correct itself, absence some strange footsore intervention, we think it’s heading generally in the right direction.

David Brown

It’s quite interesting that we have several companies before into receivership in 2009 in cat for year. So if your business model doesn’t work when the wind doesn’t flow, how is it going to work when the wind doesn’t flow, so the rates are clearly inadequate at the primary level in Florida?

I think the bigger threat would be the rather dangerous legislative proposals that we’ve seen, two of which are -- one of which is to have the federal government guaranteed state cap fund, we hope that’s going nowhere and the other one would be to extend the National Flood Insurance Program to include Hurricanes as well, which is in bill that’s passed in the House, but again what we understand from the political analysis is that unlikely to be in the final form and I believe the Obama administration is against it, nonetheless predicting the weather is easier than predicting political processes. So, that would be obviously a significant impact on the industry.

I lastly would add, little less about Florida then just about any cat writer you can find and as a result if impacted Florida ratings that would be unpleasant for us, but not as unpleasant as it would be for somebody that’s more concentrated in Florida.

Amit Kumar - Macquarie

Very quickly on the reserves releases, I think you mentioned that going forward you will look at the internal analysis was there on external analysis here and maybe, if you can just talk about the ranges, the high-low and the character reserves versus the external actuarial analysis the range?

David Brown

Yes, we have published that we do have reduced on annually, getting to our Board, well, I would say is, generally, they’re always coming very close to our own estimates, there is nothing than a significant difference between telling us to do external analysis on their carry reserves. So just to be clear, when we started a company we basically did reserves based on development patterns using industry statistics and we’ve now had four years of our own experience and our own experience as you seen has been better than industry.

We now believe, we have enough credible history to form our own loss development patterns based upon our own experience rather than industry and this is the first time we’ve done that. So Q1 of this year, we professionally done that hence to release and respectively Q1 of every year, so we’ll review that process annually at the same time

Amit Kumar - Macquarie

Final question on capital position in M&A. As per your comments, you’re getting increased signings on some accounts and I said I wanted to revisit what you said previously in terms of perhaps being a $3 billion to $5 billion capital player and how that might benefit? What are your thoughts on M&A at this point onwards and how do you see your sort of standalone profile developing overtime?

Mark Byrne

Sure, I’ll take that one. This is Mark. I think what I said with respect to $3 billion to $5 billion is our capital deployment philosophy would be to continued to deploy capital as long as we can earn of return commercially with our target returns, which is mid-teens and that when we couldn’t deploy capital in that kind of returns, our goal would be the return if the shareholders buy a special dividends or share repurchase.

Share repurchase can also be attractive of course even if we do have with underwriting opportunities, when the discount to book value is quite high as it is throughout whole sector right now. So we have done some of that in there first quarter, but generally the philosophy is deploy all the capital you can’t earn mid-teens and then look to return to shareholders and I think that was asked question how big you think you can be and still earned mid-teens returns and answer to that question would be on today’s market $3 billion to $5 billion, that is we think we have enough ideas for either getting increased signings, getting new lines of business or operating in new jurisdictions that we would be able to continue to achieve that level of growth.

As far as M&A is concerned, we’ve seen several, it’s now cookie cutter for transactions and when you’ve got two companies trading at 80% of book value and they’re in different business and you put them together you do generate access capital, which can be very accretive if the shares achieved.

So there’s a lot logic in companies considering the deals like that and I think there has been so many conversations that have happened and three or four deals that have happened that it’s clears that probably will be some more that activity, but it doesn’t make sense to do a merger between what we think there’s a mid to high-teens business with someone who is in a 10% business or an 8% business, that makes no sense from the Flagstone shareholder perspective. Well, it’s got to be a merger would have to be with somebody that we thought was in a good business or where we thought we could somehow change things to get their kind of returns to our kind of returns.

So right now we have no conversations ongoing and we consider our job is management to look at anything that comes across to train some, but we’re not spending our nights sitting of thinking about M&A and we think the arguments were launched in some quarters about sort of $1.5 billion companies not being liable or obviously self serving by the people who are launching those arguments and we do have the highest premium growth rate, I think in the peer group over four years and the second lowest loss ratio depending upon what you look that. So that’s not for me like winning the game, it’s not like being extremely liable and so we’re not panic about finding a merger partner.

Operator

Our next call is from Ian Gutterman of Adage Capital. Mr. Gutterman, please proceed with your call.