Gabriella Nawi – SVP, Investor Relations
Jay Fishman – Chairman & CEO
Jay Benet – CFO
Brian MacLean – President & COO
Bill Heyman – Vice Chairman & Chief Investment Officer
Greg Toczydlowski – President of Personal Insurance
Jay Gelb – Barclays Capital
Matthew Heimermann – JP Morgan
Keith Walsh – Citi
Michael Nannizzi – Oppenheimer
Jay Cohen – Bank of America Merrill Lynch
Cliff Gallant – KBW
Brian Meredith – UBS
Paul Newsome – Sandler O'Neill
The Travelers Companies, Inc. (TRV) Q2 2010 Earnings Conference Call July 22, 2010 9:00 AM ET
Good morning ladies and gentlemen, and welcome to the second quarter earnings review for Travelers. We ask that you hold all questions until the completion of formal remarks, at which time you'll be given instructions for the question-and-answer session. As a reminder, this conference is being recorded on Thursday, July 22, 2010.
At this time, I would like to turn the call over to Ms. Gabriella Nawi, Senior Vice President of Investor Relations. Ms. Nawi, you may now begin.
Thank you, Frank. Good morning and welcome to the Travelers discussion of our second quarter 2010 results. Hopefully all of you have seen our press release, financial supplements and webcast presentation released earlier this morning. All of these materials can be found on our website at www.travelers.com under the investor section.
Speaking today will be Jay Fishman, Chairman and CEO; Jay Benet, Chief Financial Officer; and Brian MacLean, President and Chief Operating Officer. Other members of senior management are also in the room available for the question-and-answer period. They will discuss the financial results of our business and the current market environment. They will refer to the webcast presentation as they go through prepared remarks, and then we will open it up for questions.
Before I turn it over to Jay, I would like to draw your attention to the explanatory note on page one of the webcast. Our presentation today includes forward-looking statements. The company cautions investors that any forward-looking statement involves risks and uncertainties and is not a guarantee of future performance. Actual results may differ materially from those projected in the forward-looking statement due to a variety of factors. These factors are described in our earnings press release and in our most recent 10-Q and 10-K filed with the SEC. We do not undertake any obligation to update forward-looking statements.
Also in our remarks or responses to questions we may mention some non-GAAP financial measures. Reconciliations are included in our recent earnings press release, financial supplement and other materials that are available in the investor section on our website, travelers.com.
With that, here is Jay Fishman.
Thank you, Gabby. Good morning, everyone and thank you for joining us today. Given the very substantial second quarter weather losses for the entire property casualty industry of course for us, we were pleased with our performance this quarter reporting net income of a $1.35 per diluted share, an increase of 6% from last year's quarter and a return on equity of 10.1%. Recognizing that our operating income of $1.39 per diluted share is about $0.11 below consensus estimates, I would like to make the following observations. First, the $0.11 differential equates to approximately $50 million after tax. I point out that for the first six months of the year we have an excess of $1.3 billion.
Secondly, the shortfall was attributable to second quarter weather losses which aggregated $285 million after tax or $0.58 per diluted share. To put that cost in context, we estimate for catastrophes for the second quarter included in our previously provided guidance was $92 million after taxes or $0.19 per diluted share. As best as we can tell consensus estimates included $0.22 per diluted share for second quarter catastrophe losses. To put the first half weather losses in context, we have already recorded $597 million of after tax catastrophe losses or $1.19 per diluted share. The methods used to estimate our expected annual catastrophe losses indicate an expected annual loss of $390 million after tax or $0.80 per diluted share for the entire 2010 year. So we have been after just six months we are now well in excess of our expected annual loss estimate for the full year.
Recognizing that we do not control the timing of weather, we just take these events in stride. There have been periods where catastrophe losses have been exceptionally low such as in 2006 and 7 and there were times when they ran abnormally high. We praise our product for the long term and weather will occur when it does. We do not believe this high level of catastrophe loss is in any way a result of changed underwriting standards or reinsurance practices and Brian is going to have more to say about our cap losses later.
Third, the quarter also benefited from $251 million or $0.51 per diluted share of favorable reserve development. Again as best as we can tell consensus estimate s for the quarter included $0.23 per diluted share of favorable reserve development. And just a reminder because development is so unpredictable we do not include it in any of our guidance. In terms of the operating environment for the second quarter, we remain quite pleased with our performance in our personal insurance segment both auto and home owners.
Given the amount of discussion at this time last year on our agency auto business, we are particularly pleased with the improving rate of change of policies enforced in personal insurance. Profitability in the first half improved versus last year and we are pleased that the actions taken to improve profitability which we spoke to you about this time last year are coming through in the results.
In our commercial businesses the operating environment really remained very similar to last quarter. Retention rates remained quite strong and rate on renewal business remained positive but it was at a lower level than in the first quarter. The negative impact of the economy on net written premiums has moderated somewhat from recent quarters and we are hopeful that this bodes well for future economic growth. We repurchased $1.4 billion of our common stock in the quarter and since the second quarter of 2006 we have now repurchased over $12 billion of our common stock. As these actions demonstrate, we continue to execute successfully in the marketplace, generate solid earnings and return excess capital to our shareholders.
Given that municipal bonds have been receiving a lot of attention lately, we felt we would take a few minutes this morning to have Bill Heyman take the truth strategy and the tactical positioning behind our muni portfolio and demonstrate why we are comfortable with what we own. Our investment team has applied to our municipal portfolio the same very thoughtful approach to risk and reward that served us exceptionally well during the capital market crises over the last several years. I am sure you will find it helpful.
And with that let me turn it over to Jay.
Thanks, Jay. There are a few points based on the data contained on pages 4 through 7 of the webcast that I would like to highlight this quarter. First is our strong balance sheet. All capital leverage and liquidity measures remained at or better than target levels. Second is the repurchase of $1.4 billion of our common shares this quarter and the payment of $173 million in common stock dividends. This brings a total cash we returned to our shareholders to $3.1 billion in the first half of this year.
Holding company liquidity of $2.4 billion at the end of the quarter down as planned from the $3 billion we held at the beginning of the quarter due to our share repurchase activity and the timing of dividends from our operating companies to our holding company. Another quarter in which we increased both value per share, operating performance, ex-cats [ph] and favorable prior year reserve development but including that investment income that was in line with our expectations.
Another quarter of net favorable reserve development in each of our segments mostly driven by business insurance where we are announcing better than expected loss results with property, worker's comp and commercial auto product lines and recent accident years and where we have reestimated unallocated loss adjustment expense reserves given recent loss results. And finally a double-digit ROE and operating ROE despite the record second quarter cap losses. I would also like to point out that we successfully renewed our cat treaties this quarter, keeping essentially the same structure but at a modestly lower cost. The new treaties are outlined on several pages on the webcast and are described more fully in our second quarter 10-Q which has been filed earlier today. So let us have Brian now discuss our operating performance.
Thanks, Jay. Before I go into the business-specific results, a few comments on this quarter's catastrophe losses. As Jay mentioned, this was the highest level of second quarter catastrophe losses in our history so obviously a different weather quarter and it is on the heels of high first quarter catastrophe loss. In this quarter the activity was not of a national headline variety but it was a very active quarter with numerous significant events.
Page 8 lists out the 14 industry-designated cats for the second quarter of 2010 with initial property claim services or PCS essence [ph]. Although 14 second quarter events are not unusually high for the industry, the severity of the number of these events is clearly out of pattern. The initial industry estimates of 3.6 is very preliminary and based on reported activity to date. This will obviously develop up and we are confident that once fully developed this will be one of the largest industry catastrophe second quarters. As we look at our level of losses, we are confident that they are not a result of changes in our mixed business, selection process, geographic footprint, or public grant and we do not see anything that would indicate a fundamental change in weather patterns.
Slide 9 displays our first and second quarter catastrophe loss ratios for the last six years or since our first full year post merger. It shows that for 2010 both quarters were significantly above average level. Within the previous five years with the exception of the second quarter of 2008, catastrophe weather losses were relatively mild. Accordingly, we do not see 2010 as a trend but just another data point which we will factor into our assessment of risk and reward. So we are going to stay in the weather business and we will continue to actively manage our closure.
Now let me shift to discussing the segment results and I will start with business insurance. When excluding catastrophe unpredictability, underwriting income was very strong driven by continued favorable prior year reserve development. In the current year, loss trend continued to be fairly benign and consistent with our expectations. The renewal rate change on premium for the first half of the year has been slightly positive but is below loss trend and less than expected. So the impact on margins is slightly more than we anticipated.
Overall, net written premiums were down slightly in the quarter, but not down as much as earlier in the year. The negative impacts of the economy on our insureds, which we see in lower exposures and reduced audit premium continued but have moderated from earlier levels.
So, now I will turn to pricing, and if unpredictability has been the message with the weather, stability is the message in our aggregate domestic commercial insurance pricing.
Slide 11 grasps our renewal premium change and splits out the [inaudible] rate and exposure change components. The short story here is that nothing is really changing. Overall renewal premium change on guaranteed cost business was essentially flat, with a modest improvement in exposure change, offsetting the modest decline in rate change. These overall trends are fairly consistent on an individual business basis, but as always, there are differences, and I would like to highlight a few things.
Starting with Slide 12, and select accounts. We have been getting some good premium increases and retentions have been consistent, but a few points below where we historically have been. New business has been mixed with strong results in smaller accounts, but in the fourth quarter of 2009 and the first quarter of 2010, lower new business levels in Express Plus.
In the second quarter, we moderated our pricing strategy and believe this helped boost our Express Plus new business in the quarter. On the renewal book, we typically work 90 days in advance. So, any impact on retention will start in the third quarter. Overall, we continue to feel very good about our Select Express platform and how we are positioned in this market.
In commercial accounts, retentions have remained very strong and the renewal premium change has improved modestly, going from a slight negative to a slight positive.
If you look at the commercial accounts chart at the bottom of page 13, you can see that there's essentially flat premium change as a result of improving exposure changes and slightly lower rate changes. When negotiating the renewal, we are negotiating both the pure rate and total premium with the accounts. As the impact of the economy on our customers' exposures has become less negative, it has become increasingly more difficult to negotiate a rate increase, especially when it would result in an overall premium increase.
New business results for commercial accounts were down compared to the prior year quarter. In the second quarter of last year, our new business writings benefited from the marketplace disruption caused by the financial distress of several of our competitors. Absent this impact, the results reflect a normal seasonality of our business. Our new business flow has stabilized at record levels, with quote rates slightly and close rates down slightly. Given these dynamics, we continue to be very pleased with our new business performance.
In other business insurance, retentions have remained very strong or price change for both the rate and exposure have moved more significantly than the overall commercial business. These pricing impacts are primarily driven by our large property business, with some significant softening in rates but improvement in exposure. As competitive pressures in this class of business increased in the coming quarter driven by ample reinsurance capacity and a benign 2009 hurricane season, we made a conscious decision to maximize our retention on this business and not push rates on large property accounts. Similarly large property new business became increasingly more competitive with aggressive concessions to expiring terms and conditions frequently required to motivate accounts to leave their current carrier and we are not willing to make these concessions.
In summary, we continue to prudently manage each of our businesses and adjust our actions to the unique needs. But in the aggregate, the results are not different than our recent experience, that is, solid retentions, relatively stable pricing, and a strong flow of new business opportunities.
In the financial, professional, and international insurance segment, the core underwriting margins were generally stable in the quarter as the marginal rate gains essentially offset slightly increasing loss trends. Additionally, the underwriting margins benefited from a reduction in surety reinsurance cost associated with prior year reinsurance [trading].
Net written premiums, after adjusting for the impact of changes in foreign exchange rates were down for the quarter. In some of our management liability lines of business and in some of our international lines, we believe pricing is not consistent with our profitability targets, so our writings in those lines are down.
Turning to production statistics on page 16, although renewal premium change is slightly negative in both management liability and international, for most of the businesses contained here, we have achieved positive rate gains.
Turning to personal insurance. In agency, auto, our underwriting margin, after adjusting for the impact of tax, and prior year developments, improved quarter-over-quarter, as rate gains once again outpaced loss cost trends. Within agency, property, we have been speaking to you for sometime regarding the slight margin compression, driven by year-over-year increases in the cost of materials, primarily asphalt shingles. As the rate gains we achieved in recent quarters continue to earn through our property business, we have crossed an inflection point, where in the second quarter our rate improvement outpaced loss cost trends.
Agency, auto new business improved in the second quarter as we reintroduced our 12-month policy. As we have become more confident in our new business products and are consistently within target returns, we felt it was appropriate to reintroduce a longer term policy. The aggregate timing impact of this additional six months of written premium was about $30 million in the quarter. As the rollout of this product is completed, the impact on our new business written premiums will increase throughout 2010. More significantly, we are pleased with the improving rate of change in policies in force. We believe the PIF change is a result of our improved competitive position compared to third and fourth quarter of 2009.
Agency, property production results for the quarter continued to be strong in spite of the difficult housing market. Quarter-over-quarter PIF growth was at the highest level since third quarter of 2007. Retention improved two points, and new business is up 15% compared to the same quarter last year.
Given the expansion in core underwriting margins and the strong topline trends in these products, we are very pleased with both our current and going forward marketplace position in personal insurance.
So, let me sum it up. Weather has been bad. But it's a big part of our business, and the one thing we know for sure is that it will change. The commercial marketplace, both domestic and international is fairly stable. We obviously wish it was improving, but we feel great about our position and are confident we will maximize the opportunity. And in personal insurance, we are encouraged by the trends both for us and the industry.
With that, let me now turn it over to Bill Heyman to discuss our tax-exempt portfolio.
Thanks Brian. Since municipal securities have received considerable attention in the press, I thought I would spend a few minutes discussing the sector in general and our portfolio in particular. As you know, we have a tax-exempt portfolio of about $41 billion. You may not know that of that about $7 billion consists of bonds which have been pre-refunded, which means they have been [inaudible] maturity or their first call date usually with US treasury securities. Still the $34 billion remaining constitutes about half of our fixed income portfolio.
The first observation I make is that we have fortunately always starting long before credit cards became an issue, viewed taxes and credits as credits first, without regard to any advantages or taxes [inaudible]. While optimization of the alternative minimum tax provides a target allocation, it's not a bucket we feel we must fill regardless of quality. And a general obligation of the school district competes with the corporate bond or mortgage-backed security for investing dollars. We scrutinized closely not only the creditworthiness of the issuer but the nature of the obligation. For example, in some cases, revenue bonds could be stronger than [GOs] and vice versa. Furthermore, where issuers have enhanced their creditworthiness with bond insurance, we've always ignored it. The result was that several years ago, when the bond insurers more or less simultaneously lost their AAA ratings, we did not make portfolio changes.
The result of high credit underwriting standards means that our portfolio does not closely resemble the broad market. For example, we own about 23 million of municipal healthcare revenue bonds, or about one-tenth of 1% of our portfolio. Such bonds represent roughly 7% of the broad market and since 1970, 39% of all municipal defaults have been in the healthcare sector. Conversely, we are overweighted in pre-refunded bonds, states and local general obligation bonds and water and sewer bonds. Recent focus on general obligation bonds relates to the potential for these bonds to be treated like senior unsecured debt with bondholders becoming general creditors alongside employees, retirees and vendors.
The general credit [at construct] is most descriptive of general obligation bond issued by states and general funds act like pools collecting revenues from a wide range of taxes and paying salaries, making pension contributions, paying vendors, as well as servicing their general obligation debt.
In contrast, this construct is probably not descriptive of many local general obligation bonds. We expect that in its premises where there is a many local GOs would be treated as secured creditors based upon legal presidents and the provisions of Chapter 9 of the bankruptcy code which provides that the security interest in special revenues remains valid and enforceable in bankruptcies.
As you know most school district general obligation bonds are specifically authorized by voters and validate issuance [ph]. This authorization allows the pledge of ad valorem taxes to be levied on all taxable property within the school districts without limitation as to greater amount. The collection of these taxes is generally segregated in the debt service fund outside of the general fund and these funds can only be used to service the authorized debt and are not available that can ask the general purposes of this school.
The unlimited in nature and segregation of this debt service, tax revenue contrast sharply with the school districts other property tax revenues which are statutorily limited and commingled with its state peoples funding and used for operations. In addition to assembling the portfolio selectively, we manage it actively. The portfolio contains approximately 8000 discrete securities but have only 925 issuers. They're over 50,000 issuers in the municipal markets.
We have general obligation bonds of (inaudible) 75 cities, there are over 5300 in the Bloomberg database. So we feel we know our cities well. We monitor closely financial position and operations of our credits, while it is true that we are basically buying to hold investors. We have in the past year reduced often substantially, positions and issuers with credit worthiness as in our view deteriorated. So I would add we believe it even those issues we sold are overwhelmingly likely to pay every dollar on time.
As we demonstrated two years ago with our mortgage portfolio, we do not blindly rely on ratings, but it is nonetheless worth noting that roughly 50% of our municipal portfolio holdings which are not funding having an average AAA rating from Moody's S&P and Fitch, compared to only 17% of the broad market. Almost 96% are rated AA3 or higher, only 4%, 4.3% are rated A or lower compared to 33% in the index.
Rating agencies are looking at the same challenging economic budget and spending dynamics affecting state and local governments that all of us are, yet the ratings of our holdings remain very strong. A recent publication my Moody's points out that over the entire period 1970 to 2009, the riskiest 20% of municipal issuers measured by ratings accounted for 86% of all defaulters. Our portfolio contains approximately $7.2 billion in state general obligations with only about $330 million in the headwind [ph] states of California, Illinois and New York.
The table in the webcast contains the aggregate holdings and the average ratings of our top 16 states. With the exception of our holdings from California which averages AA2, the average rating for each state is AA1 or higher. The general obligation bonds of the top five states totaled $1.4 billion. All that said we have purchased very few big state GOs in recent years and have sold a few recently.
The other slide in the webcast presents the runoff of our state GOs based on current market yields for those borrowers and the coupons structure of our holdings nearly 70% of our state GOs will mature or will be called by 2015. For local general obligation bonds from the top five states totaled $6.4 billion and the revenue bonds from these states totaled $3.6 billion.
Our general obligation bonds and issuers other than states consists towards school district exposures with the moderate number of counties, cities, community college districts and other special districts. As we just discussed the nature of these obligations is such that most could be considered as obligations sent through by a pledge or revenue from ad valorem property taxes levied without limitation to greater amount.
As we have discussed previously a fixed income portfolio exist first and foremost to ensure our commitment to our policy holders. We underwrite the invested risks assumed in our portfolios with careful consideration of the tradeoff between risk and returns. Just as in the other fixed income assets, we do not reach for yield in our municipal portfolio in attempt to outperform our benchmark, lose investment manager's compensation or for any other reason. We expect our fixed income assets, including our municipal portfolio, to provide adequate risk adjusted returns and support our insurance operations in pursuit of maximizing wealth for shareholders over the long term. Obviously, history may not be indicative of the future and ratings cannot be relied upon with certainty, but we believe our portfolio is strong and we wouldn't trade it for anyone else's. We can certainly have losses in our municipal portfolio, and even material losses, but even due to the prism of recent events, we feel very comfortable with what we own.
Let me turn it over now to Jay Benet.
Thanks, Bill. Well, let's discuss updated guidance for the full year. We've got information on Page 22 of full year 2010 fully diluted operating income per share, which has now been refined from the previous range of $5.20 to $5.55 to a new range of $5.20 to $5.45, which is a $.10 reduction of the upper-end of the range that primarily resulted from commercial-renewal premium increases in 2010, not meeting our original expectations which we believe is attributable to the impact of the continuing difficult economic environment. In round numbers, this range for operating income should still translate into an operating return on equity of approximately 11% as we've said before.
We continue to anticipate some accident near-loss ratio deterioration on a consolidated basis for full year 2010, ex cuts, as we expect loss-cost increases to modestly outpace projected earned-rate increases in our commercial businesses for the full year. So in your modeling, please remember that the second half of last year included favorable re-estimations of current year-loss ratios for first half 2009 losses, so quarterly loss ratio comparisons for 2010 versus 2009, must take this into consideration.
We're now assuming cut losses of $835 million after tax or $1.71 per diluted share, which incorporates our actual cut losses to the first half and our original estimates for the second half of the year, no further estimates of prior year reserve development, either favorable or unfavorable, below single-digit decrease in average investment assets ex unrealized gains and losses, resulting from a reduction of holding company liquidity due to the share repurchases of full-year share repurchases of $4 billion, and a weighted average diluted share count after share repurchases in employee equity awards of approximately 487 million shares.
So with that, why don't we open it up for Q&A?
(Operator Instructions) Our first question comes from the line of Jay Gelb from Barclays Capital. Please proceed.
Jay Gelb – Barclays Capital
Thanks. My first question is on the pace of the share buybacks. Choblers repurchase a $3 billion of stock in the first half of this year, I believe the guidance is for $4 billion for the first year, you have the still almost $4 billion left in the existing authorization. I was just trying to get a sense of why the pace may slow or might that just be a conservative outlook. And my second question has to do with the economy. It appears that we're lacking some of the more challenging comparisons, so I'm trying to get a sense of how much of a benefit the stabilizing economy could be and whether Travelers feels the consumer raised prices as exposures increase? Thanks.
Jay, thank you. First on the share buyback, we have historically scaled back in the third quarter, a pending, obviously, catcheese and of course it seems to us like we've already endured two quarters of that season already. My recollection was that the original estimates of share buyback included in the guidance was $3 billion, $4 billion and – $3.5 billion to $4 billion. And essentially we are still largely on that target for the moment. We may alter that as we go into the quarter, depending upon second half of the year that is, depending upon earnings, depending upon whether our reserve development can extend to the course and all that. But nonetheless, it's a plan that we embraced beginning of the year and for the moment we're sticking to it.
Your second question and maybe Brian and I will ham and egg this a little bit. We certainly can't approve this to you, it's largely anecdotal. It's from sitting with conversations with our field folks and I'm speaking now about your question regarding the commercial insurance environment.
Our census is that there isn't anything that has particularly changed competitively. You all seem to be fixated all the time, have some company or companies change their pricing strategy or tactics, we certainly don't see that and have no evidence of it.
What we are hearing from our field folks is that as exposure is leveling out and it was – a comment I made earlier was that it looks as though exposure is trying to get back to zero broadly speaking in the commercial lines businesses is that it's getting more challenging to get rate increases.
If you're a customer you really don't focus on the granular dynamics that make up your price, your premium. You're really not all that worried about how much is exposure and how much is rate change and all that nonsense, what you as a customer tend to look at is, is my premium going up or down in its simplest form and as exposure flattens out to the extent that you try and get rate gains you're asking for a premium increase in this economic environment or census is that it's getting just more challenging to pass that rate increase on.
There is more or little more resistance both from the intermediaries, the agents and brokers as well as the customers to accepting meaningful rate increases. Now it's interesting, we didn't present the data but we certainly do look at the distribution of rate gains in our middle market business each and every quarter. We've shared that with you previously and to the extent they are lost dynamics at work to the extent that an account has loss experience, that's different more problematic than what it had originally been expected. We do get rate gains. There are still significant accounts where we'll see a plus five or even a plus 10 rate gain but it largely is loss driven. It's not in effect margin or profitability driven.
So, I'd love to hear if Brian has any comment but our census is that the margin picture broadly in our commercial businesses is modestly deteriorating, that it's and that is that our ability to get rate in the aggregate is a little bit less than what you're experiencing broadly speaking in loss trends.
So that's the way that we would I think I'd answer.
I mean one of the phrases that I'd emphasize that Jay just used is this economic environment. So we certainly wouldn't want to make the statement that as long as exposures are coming up we can never get rate changes. If you think of where the psyche of our typical commercial customer is today they saw the economy take a big dip, they saw their business by and large take a big dip.
The good news is, if we look at our total portfolio they're kind of back to not dipping anymore. They're not yet back to growing or anything close to robustly growing and in that mindset they saying they're going – again, loss experience being neutral we're going to struggle with premium increases. So that's the dynamic we're seeing today.
In the context of returns in our business you always got to go back to where are we from a profit margin perspective. When we went back, you go back to the guidance that we gave at the beginning of the year, which obviously contemplated normal tax and no reserve development, the return on equity that we were projecting for the year was about 11% and in the context of the environment we're in, both the investment environment and important to remember the investment environment combined with the economic environment, that's a pretty good return.
It's difficult for us to plead that profitability measures in our business are inadequate and as a consequence we need to improve margins in this investment and economic environment to the extent that we're capable of producing an 11% return on equity we feel pretty good.
So, we continue to try and keep rate where most importantly where the loss experience demonstrates that we should and to the extent that we can improve our profitability dynamic as we move forward we'll continue to do that but it's not as if we're starting from a point of impaired profitability in any way, it's a pretty strong franchise and a pretty strong profit picture in the context of that environment.
Our next question comes from the line of Matt Heimermann from JP Morgan.
Matthew Heimermann – JP Morgan
Hi good morning everybody. A couple of questions for Bill. One, I was just curious if you could comment on the performance of the other investment income line this quarter and what drove that, just a little surprising given what macro is happening in the investment environment.
Then second, just with respect to the municipal portfolio I guess if someone wanted to play devil's advocate, a lot of the defenses of the municipal securities market around rating, average credit quality, things like that or things that were made for the mortgage market. So I guess if you had to be realistically bearish on your portfolio or the market probably what would you point to as kind of the bigger risk?
Okay let's take them in order. In terms of the other assets, the results of the quarter where it could be the more [ph] to strong distributions in private equity, cash flow from the portfolio for the first six months was about even that means distribution equal capital contributions, which is better than we would have expected and there was a lot of net investment income gain in the results that we saw.
Hedge funds made money but not very much, made a couple of points better than the broad index. Our hedge fund portfolio was only about 470 million, it was 1.6 billion at the time of our merger. And frankly we find it difficult to put an ex-ante facto, which managers will do well and which won't. So we have handful of relationships of longstanding.
In real estate, a lot of our funds had marked down properties probably excessively and the first half of the year reflected a balance in evaluations excluding municipals. I agree with you, one can argue both sides of the equation forcefully.
We think about this issue everyday but I would add we're not talking our book because we can't get out of where we are. If we decided that instead of 34 billion, forget the (inaudible) for the moment instead of 34 billion it ought to be 20 billion or 25 billion. The quality of our holdings would permit us to make that adjustment and the market is very firm, frankly it's firm, it's very firm even in credits we wouldn't buy.
In terms of the risks in the sector and I think I alluded to this at investor day in May. I think the risks are less of economic default but even with states with big budget problems are when you analyze them is not very heavily taxed.
The risks are that some jurisdictions will seek, if a court allows them, it may not to, repudiate their debt simply because they choose not to increase taxes or cut budgets.
I think with respect to larger jurisdictions the possibility of it is pretty remote. It is one thing to only have access to the capital market at a higher price and frankly most jurisdictions haven't even faced that penalty yet. It is another to lose access to the capital market altogether, which is what would happen in a political repudiation.
So I agree, the issue is not free from doubt and our take on it can be disputed but it's not (inaudible).
Our next question comes from the line of Keith Walsh from Citi Group.
Keith Walsh – Citi
Good morning everybody. A couple of questions here, just to follow up on the exposures, trend looks better. How do we reconcile that with sort of the negative data that we've been seeing coming out of small businesses whether it's lending, business optimism, new business startups. And then if you could also touch on the trends you're seeing within auto premiums and then I've got a follow-up for Bill, thanks.
I'll take the first and I'll ask Greg to take on the second. First I think our exposure data is actually largely in sync with what we see as to GDP changes broadly. We're not seeing growth, what we're actually seeing is a leveling out and I think that there are some measures that would suggest that the economy is actually expanding modestly. There are some that would suggest that – there are some that would suggest that that it has flattened. And that's largely at this point what our aggregate data say.
There will be some pluses and some minus in various businesses. But the exposure change that we saw in the second quarter across all of our commercial businesses in the aggregate was getting close to zero. And I think if you asked anyone from an economic perspective what do they see, they would largely say that at the very least we flattened out. So we don't see it as in consistent, maybe there is something else that you see, but that's kind of our take on.
Keith, on the second piece, did you ask about auto or audit?
Keith Walsh – Citi
Okay, and this is Brian. On the audit premium side, we've talked about the numbers before at the depth of – in the normal environment, we're going to see something like three to five points of positive on the audit premium side.
Around the end of last year, very beginning of this year, we were running about a point negative and we are close to back to zero. So we're at a – at a really modest negative number. So pretty consistent with that that same view on the exposure change numbers. So still negative, but close to back to a plus number. Now, again in normal world, we'd look for a plus three to five so.
And that's less about – (inaudible) speak to that point about being it less about the economies and the way our policies work.
Well, yes, there's obviously that audit premium has a lot to do with the psychology of the buyer and how the product is even sold. And the natural course is that the buyer is going to understate exposure slightly and we pick it up on the backend on the exposure and so we're always playing that game. So that leads to the normal three to five.
And so that one makes snapback –
Somewhat unpredictable because we're doing with a psychology of our buyers and their willingness in effect you have a carry for a period of time, premium relative to expose your change, we of course factor that into our pricing, it's not a surprise to us. But that one may snapback faster because it is predominantly psychologically driven more than the overall genuine exposure which really is an economic dynamic.
Keith Walsh – Citi
That's very helpful. And then, Bill, you started to touch on the some munis, but what I really want to know is who holds the senior position here, is it the bond holders or is muni workers, pension payments and healthcare benefits, where is that dollar going to go to if that has to, if we come down to that?
Well, we think in issuers below the state level bond holders. At the state level, less clear.
Keith Walsh – Citi
Our next question comes from the line of Michael Nannizzi from Oppenheimer. Please proceed.
Michael Nannizzi – Oppenheimer
Thank you. Just had a question about the FPII segment and to reserve development there, can you talk about that development relative to your management liability business in particular, the depository institutions? And I have one follow-up, thanks.
Sure. And, I guess, I'd direct you back to the conversations we've had previously about the credit crunch analysis and I'd say that probably the way that we're at it is it's stable. So hasn't been a lot of change.
The release probably comes from six or eight years from '01 to '08 and the actuaries go through the data every quarter and they are making lots of estimates and judgments based on a lot of – a lot of cases that are still really at a state of infancy. So I would think, broadly speaking, no change.
Michael Nannizzi – Oppenheimer
Okay. And then, I know, that disclosure last year, you had mentioned 26 institutions that had been closed, do you – can you update a little on the exposure there and any changes or any new institutions?
You mean clinically on the institutions that have been taken over?
Michael Nannizzi – Oppenheimer
Yes. So far this year, I think we've got probably close to a 100 institutions that are being taken over about 96. We've got 33 of both.
Michael Nannizzi – Oppenheimer
You – first you said we got.
There's been 96 institutions the FDIC has taken over. We're on about 33 of those, our average expose limits to those are about $4.5 million. So broadly speaking, it's developed since last year as we would have expected it to.
Michael Nannizzi – Oppenheimer
Great, thank you. And then, just if I could one follow-up on personal lines, the – Brian you had mentioned on that slide at $3.6 billion I think in CAT expectations for the second quarter and Travelers' number in the second quarter is about $440 million. Am I looking at that in the midst about 10%? I just want to understand is it just different estimate base or how should we think about that? Thanks.
The $3.6 billion on the industry slide is – comes out of PCS, property claimed services, and that is purely the kind of initial data that they've gotten from carriers. And in some cases, for some events that happened literally three or four weeks ago, so very, very immature data. That will develop up fairly dramatically.
History would suggest.
History would suggest, yes. And just the way the claim process works.
I'd make a very important point. We don't utilize PCSF in the mix to make our estimates of losses from those events. Our losses are based upon what you're accruing are based upon claim notices, claims filed, and our people on the ground. So it's – the important point here is that while we believe that history again suggest the PCF data will develop negatively, historically, our estimates have actually been pretty good relative to catastrophe points.
Because, obviously, what we're trying to do is, is as quickly as possible, take our claims data and make any actuarial estimate of what the ultimate will be. And PCF does that overtime, but it takes them longer. So it's really tough to do any kind of industry relativity right now. And then, obviously, you've got geographic distribution underneath that that you got to look at. But, so we will scrutinize that as the data becomes available. But, you know, all we know is it's a big industry event and it was a big quarter for us.
Michael Nannizzi – Oppenheimer
Okay, thank you for answering all my questions.
Our next question comes from Jay Cohen – Bank of America Merrill Lynch. Please proceed.
Jay Cohen – Bank of America Merrill Lynch
Yes, thank you. A couple of questions. I guess, first maybe, big picture on the reserve development. I guess if you've looked at your accuracy, you almost think you guys aren't that good of setting reserves, given how redundant things have been. If you can talk more specifically about what's happening.
I know it's going to vary by line and by segment, but is it more of a frequency issue or a severity issue, that's the first question. And then, secondly, maybe for Bill on the other investments. It looks like the return this quarter annualizes around 12%. And I've probably asked this before, but what would you consider the normalized return on those investments?
Jay, Brian's going to answer your question on the reserve development. But, I'll just make an observation that we really try hard to get it right, because the issue is actually how we priced our product to the extent that we end up overstating our loss costs going into a product offering than we're pricing it higher that we otherwise would have to and we become less competitive relative to someone who takes a different view. So it always feels good when it happens.
Of course, it feels terrific when your results are impacted this way and certainly it's a whole lot better than underestimating the loss cost, which means, you're under pricing your product and that's really a disaster. But we really try hard to get it right, because in the end, what we're about is trying to grow a business and getting it right is what's going to help us do that the best. Now your points are relevant, we've had a long stretch year of significant development and Brian or Jay or –
I can (inaudible). When you look at the components that makeup the reserve development, frequency continues to be behaving in a way that when you go through the reserve setting process, you come up with as soon as what frequency is going to be and it's behaving better than that. And that's been a trend that's been going on for a while.
When actuaries and finance people are looking at what the reserve process should be as it relates to favorable frequency and work with their business partners in terms of pricing and everything. If you look at what the current trends are, you wonder are things are going to get better than they are when you're at a favorable position.
And sometimes you just look at it and say, “Well, they're pretty good. And I can't imagine them getting better and sometimes they do.” So that's been a part of it. We're in a very low inflationary environment today. And looking out several years as to what severity is going to be, it's just a little bit of a change in the inflationary outlook is going to have an impact as well. So you have to go back to what's the some base upon which all of this is being done and on a gross basis, our reserves are in excess of $50 billion. So that's absolute level of these changes in terms of percentage point are very, very low. But given the nature of that reserve base, they impact the income statement as you've seen but as Jay said, each one of these quarters, we're doing best estimates of what we see out there using all the information and there's the changes. We just update the reserves.
And Jay, this is Brian, so two other points. Because if you look at where the development has come from not just in this quarter but over a good period of time, I'd say two things. First on the liability side where we had a lot of favorable reserve development, one of the toughest things to estimate that over time is where that sort of environment fell in and what the sustainable impact of that is. And so, that's been a big variable driving our improvement and at the same time, over and again, this is a five to six-year kind of statement.
We've done a lot in our liability claim process that we think has helped the way we do business and service our customers and we think that's had a pretty strong impact there. But it takes time to see the impact of those things coming through the lost data and so that's been driving it. And then the other area is workers' comp which has continued, again, I always say this with comp – very much a state-by-state gain. But in the aggregate where we play, we continued to see some favorable moves there and frequency dynamics that Jay Benet talked about but comp would be an area where that's really been true – just trying to look at those frequency trends and project forward what do we think they're going to be in the future.
Jay Cohen – Bank of America Merrill Lynch
That's great and the other investment return?
Yes, I think that one has to speak the various sectors rather than generalize for other investments. I think from owned real estate unleveraged, one article it makes, need the high single-digits leveraged real estate that has funds, low double-digit hedge funds, low double-digit private equity – maybe a little more. And therefore, our blended return depends on our allocation of those asset classes.
Obviously one has to rethink all those returns. If we are in a protracted period at very low interest rates, we may all – all of us is going to be stuck in the mindset in what these assets are going to make in the world before 2008. But those are of course fact numbers.;
Jay Cohen – Bank of America Merrill Lynch
So based on what you just said, the returns in this quarter weren't terribly overstated at all?
They are generalizing as a blend of number there. What we would hope to make over a statistically significant time period which unfortunately is more than a quarter.
Our next question comes from the line of Cliff Gallant from KBW. Please proceed.
Cliff Gallant – KBW
Good morning. Billing, actually off of on that is Jay's question a little bit in terms of loss cost trends, I'm just wondering about to what degree are you seeing favorable loss cost trends whether it be from deflation or even falling frequency? And to the extent that you are, how confident would you be to really act upon that in terms of your forward pricing? You know, I think of the personal auto industry 10 years ago where, in other words, we were about to experience several years of abrupt defalling frequency and I think some of the more aggressive companies like Progressive had wished that they had been able to fully anticipate that to really grow their book. And I'm curious how you would take that in terms of going forward?
Well, first, I'd observe that this is very much line-by-line specific. There are long-tail lines where you take a deep breath obviously before you embrace an emerging trend. And I'm going to make an example, in workers' comp, we are still contemplating meaningful medical inflation. We're not pricing our product. We talk all the time that benign lost cost and inflation, you should always be excluding medical work in medical portion of workers comp. But we assume a robust inflation rate and we'll obviously see how that works out.
Generally speaking, I think a couple of individual exceptions Brian talked about, asphalt shingles which a number of carriers have highlighted because it's a by-product price of oil. That loss cost trends severity have, broadly speaking, been awfully benign. That doesn't mean zero. It doesn't mean that we don't see some embedded inflation in lines of business. And we, as the shorter the tail of that business is, the more we're willing to embrace it and incorporate it into our pricing because if we're long, it doesn't take long before we can reprice the product. The same thing holds true for frequency.
In many lines of business, there has been a long-term systemic decline in frequency and I would actually say that it's gotten – well we've been chasing it. You ask the question all the time as frequency comes down, is it making a new level or is it going to return back to previous levels, not only in from a pricing perspective but also from the reserving perspective as well. I think the same thing holds true to the extent that these are shorter-tail lines of business. We're pretty aggressive in embracing and to the extent that they are longer-tail, we're a little more reluctant to move in that direction.
I think one of the things that's affected workers' compensation, I can't prove. It's just the data that we look at is that as our economy has moved increasingly to a service-based environment, frequency and workers' comp has come down. They've done another great surprise to people. And so that sort of a dynamic, that element, if you feel more comfortable embracing so it's very line specific. And I think it's difficult to generalize if there's a line that you're particularly interested in, you can attempt to answer.
I mean, Cliff, you're really getting to the core of the puzzle we're trying to solve each and everyday in the marketplace. Do we understand why lost trends are changing? First of all, can we see it granular as possible where they're changing and breaking out. And then, the real trick is understanding lie. The generality would be the better we feel about our ability to understand why something is changing, the more confident we're going to be factoring into our pricing. Where you get in trouble as you see a pattern and you don't understand why, you need to start extending the patterns. Well, we could talk – it is as Jay said, it's very much a line-by-line…
And I do think though culturally, as a matter of the institutions and the way actually I was thinking and in this organization, you would characterize us as not pushing the edge. If there's, and again, particularly in longer-tail lines, you take a great risk when you make an assumption unless the changing trends embrace it, price your product, reserve for it, and find longer holiday yields, not only underpriced but under reserved boat. So I just think culturally here, we're not an organization that instinctively pushes the edge.
Our next question comes from the line of Brian Meredith from UBS.
Brian Meredith – UBS
A couple of quick questions here. First, looking at the business insurance action, your combined ratios, extra cash underlying, shifting from loss ratio aside, it looks like when you adjust for the current period development last year, it's up about 200 basis points year-over-year. Is that pretty consistent with who we should expect your going forward, given you comments about continued acts and the perpetration over the year?
Brian, I'm trying to do the math in my head.
Brian Meredith – UBS
I think what you said was about 62 last year in the second quarter. That's the current period.
Yes, I would say pretty close to that.
This is Jay Benet. I mean, the thing that we'd urge you to do or to everyone to do is look at last year's combined ratio, look at last year's loss ratio, a component in its totality for the year because of the re-estimation that took place in the third and fourth quarter. So the best proxy for what the loss ratio was for coming into 2010 would be the full year 2009 loss ratio. And then we said, we would expect some margin compression from that and so far, what you've seen is the first six months.
That would be the mechanical comparison that you would want to do, recognizing that in any period, non-capital-related weather is also going about to round and there's going to be some noise from other large loss activity or whatever. But that would be the base information to be taken a look at.
Brian Meredith – UBS
And then also, the business insurance, your G&A expenses, even if you add back the benefit you had the second quarter last year down, feel its extensively year-over-year, anything unusual going on there or is there some expense initiatives going on?
Well, we're always closely managing expenses and there is the timing of some expenses that will take place with various quarters, one year versus the next. So I wouldn't say there's anything in particular going on there, other than we're always watchful of our expenses.
Brian Meredith – UBS
Right. And then the last question, you talked about pricing and how you want to adjust it for – obviously what's going on with lost causes, et cetera, but what about interest rates right now? I mean, it seems like interest rates are going to be low here for a while longer. How can you adjust pricing for interest rates or can you in the current marketplace?
Bill and I spend a lot of time talking about the environment, and it's very possible now that what we're in an extended period of time at where we are. And as a consequence, we are beginning to think meaningfully about what the implication of that is for our business. And that not only gets to pricing of our product but return expectations, capital embedded in our business, ways in which the capital is used. It's a broad question that gets well beyond, are you pricing adequately? Again, in this environment, these interest rates were able to generate round numbers and 11% return on equity. Now you begin to ask yourself the question, if riskless rates are where they are and spreads are where they are, then what are reasonable returns and what can be expected and how to we deploy our capital (inaudible) in a different environment. Whereas the – I would say the early stages of those discussions, that they are serious discussions that would you take your place irregularly.
Our next question comes from the line of Paul Newsome from Sandler O'Neill. Please proceed.
Paul Newsome – Sandler O'Neill
Good morning, and thank you for taking the call. First question, I think accurately heard that you are issuing annual policies for your personal (inaudible). And if that's the case, I'm a little bit curious in this strategy. Historically, I think if that is a sort of a top-of-the-market kind of strategy to hold on to your business as opposed to a bottom-of-the-market strategy. Given on the upside, you would typically want to be able to re-price your product as far as you can. Am I just wrong on that or is there a different subtlety here to that strategy that I'm missing?
Hey Paul, this is Greg Toczydlowski. I guess the answer to that question, you got to kind of start of it off where we began and we started driving a sophisticated product out in the marketplace about five years ago. And underneath that was our first (inaudible) in the predictable modeling. So as we needed to stay nimble and adjust that product, we kept the shorter-term contracts as we moved forward and become very confident in that new business pricing. And that, in combination with the demand base from our agents and customers based on the profile that we're trying to attract, we think it was prudent to issue the annual policy at this point in time. And again, as Jay talked about, some of the underlying dynamics of the personal insurance business, we feel terrific about acquisition right now.
Paul Newsome – Sandler O'Neill
My second question is back to the current returns. And I agree that 11% ROE, and especially relative to your peers, is a good result. The question I have is , is that does this in your mind suggest that essentially the market – the market largely ignores the interest rates where they are today and their profitability? And or is this in your view, a view that is essentially the hurdle rate has fallen for the industry because I would imagine that the hurdle if anything has gone up given volatility, uncertainty, the CAT losses. And the stock market seems to be behaving – the stock market looks like its behaving, the hurdle rate for the industry has risen over the cycle?
I understand the question, I think, anyway. I, at first, I certainly don't think that the insurance industry ignores investment returns as we price our products, we are driven by available investment returns in the marketplace. When – shortly after the crisis, when the world sort of settled back down and we were confronted with a different kind of fixed income environment than had existed , the real question was will you go into knee jerk react to a changing interest rate environment, causing disruption to agents, brokers, customers and all of your distribution. Who are you going to take a deep breath and see what would happen to investment returns over time.
I've spoken about this earlier, it was our decision to take this in the longer view and not to knee jerk. Now 18 months ago and attempt to drive pricing up in some very dramatic fashion, I think that would have been not only highly disruptive, but candidly not very successful. That would be a strategy that I think would have failed. Now I think, and again, this is how we perceive it, you can certainly ask other companies what their view is. It may very well be that this economic malaise, such as it is, is longer rather than shorter and it may very well that this investment environment is a consequence, longer rather than shorter. And we are in, as I said the early stages of really thinking through the implications of that. It's a long view – we speak about returns over time. We try hard not to get tangled up and candidly this quarter, next quarter. But we managed this business to generate returns over time, and one of the questions that we long to ask ourselves is, in the investment environment that's available and given other investments? We recognize that we compete against other investments, including investments that are fixed income.
We have land numbers of 3% yield at the moment, what are the implications of that? How do we think about our company? And what do we strive to produce for investors in a very different investment environment that existed even a couple of years ago. And it's a very legitimate question and we're ankle-deep in it at the moment as we try and weigh our weight through it. It's complex. Obviously, no one company can adopt the strategy that's disruptive in the marketplace and thinks somehow that it will be successful. We operate in a very competitive environment. So you have to balance all of those factors. More to follow, I just know immediate, clear answers about that issue, but a very relevant question.
Miss Nawi, I will now turn the call back to you. Please continue with your presentation or closing remarks.
Thank you very much for joining us this morning. If anybody has any additional questions, you can reach either myself or Andrew Hersom, Investor Relations Department. Thank you and have a good day.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a great day, everybody.