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Validus Holdings (NYSE:VR)

Q1 2014 Earnings Call

April 25, 2014 10:00 a.m. ET

Executives

Jon Levenson – EVP

Edward Noonan – Chairman and CEO

Jeffrey Sangster – CFO and EVP

Analysts

Amit Kumar – Macquarie Research

Matthew Carletti – JMP Securities

Michael Nannizzi – Goldman Sachs Group

Jay Cohen – BofA Merrill Lynch

Meyer Shields – Keefe, Bruyette, & Woods, Inc.

Brian Meredith – UBS Investment Bank

Ryan Byrnes – Janney Montgomery

Ian Gutterman – Balyasny Asset Management

Sarah DeWitt – Barclays Capital

Operator

Welcome to the Validus Holdings, Ltd. First Quarter 2014 Conference Call. My name is Yolanda and I will be the operator for today's call. (Operator Instructions) Please note that this conference is being recorded.

I will now turn the call over to Executive Vice President, Jon Levenson. Jon Levenson, you may begin.

Jon Levenson

Thank you. Good morning, and welcome to the Validus Holdings' conference call for the quarter-ended March 31st, 2014. After the markets closed yesterday, we issued an earnings press release and financial supplement, both of which are available on our website located at validusholdings.com. Today's call is being simultaneously webcast and will be available for replay until May 9th of 2014. Details are provided on our website.

Leading today's call are Validus' Chairman and Chief Executive Officer, Ed Noonan; and Validus' Chief Financial Officer, Jeff Sangster.

Before we begin, I would like to remind you that certain comments made during this call may be deemed forward-looking statements as defined within U.S. federal securities laws. These statements address matters that involve risks and uncertainties, many of which are beyond the company's control.

Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements and, therefore, you should not place undue reliance on any such statements. More detail on these risks and uncertainties can be found in the company's most recent annual report on Form 10-K and quarterly report on Form 10-Q, both as filed with the U.S. Securities and Exchange Commission.

Management will also refer to non-GAAP financial measure when describing the company's performance. These items are reconciled and explained in our earnings release and financial supplement. With that, I turn the call over to Ed Noonan.

Edward Noonan

Well, thank you Jon, and good morning everyone and thanks for taking the time to join us today.

I'm happy to report another excellent quarter for Validus Holdings. During the quarter, we have $162 million in net income which represent the 17.7% annualized return on average equity. We grew our value per share including dividends by 12.6%, an excellent start for the year.

While our competitive market slightly above our business, the result reflect the outstanding quality of the risk portfolio we've assembled. Each of our three operating business reported strong profit in the quarter with our underwriting units generating a combined ratio of 68.3%.

We are executing on the strategy that we laid out the day we started the company. That is as the poll of acceptably price risk shrinks, we reduce our writings and head our portfolio to protect the balance sheet and rank size our capital for the opportunity.

I'll talk about that in more detail later, but first Jeff Sangster will walk you through the financial results in detail, after which I'll provide more detailed commentary on the business and competitive condition.

Jeff?

Jeffrey Sangster

Thanks, Ed, and thank you all for joining the call today.

The first quarter produced a strong financial result for Validus due to a relatively quiet catastrophe quarter and earnings power of our global platform. First quarter net income available to Validus common shareholders with $162.4 million or $1.66 per diluted common share. Net operating income available now with common shareholders is $146.1 million or $1.49 per diluted common share.

Annualized return on average equity for the quarter was 17.7% and annualized operating return on average equity for the quarter was 15.9%. Book value per diluted common share of quarter end was $37.58, an increase of 4.6% from December 31st, 2013 inclusive of dividends.

Speaking more detail for the quarter results of operations and financial position, total gross premiums written for $1.012 billion for the quarter, a decrease of $92.8 million or 8.4% from $1.105 billion in Q1 2013. The decrease was due to a combination of declining rates in various classes as well as non-renewable certain contract or pricing returns are unfavourable.

The decrease is primarily driven by a decrease in the Validus Re segment of $69 million or 9.2% over the prior year's quarter to $679 from $748 million. The decrease in gross premium written was primarily due to a reduction in catastrophe excess or loss treaties in the property line of $50.7 million and the reduction in the marine mind of $8.5 million in excess with (indiscernible) did a new composite business and $15.3 million of business written by our new trade credit team.

At large, our quarter share of the agriculture business was non-renewed in the quarter. And as a result, the net premium written in this mind are virtually unchanged at $150.3 million compared to $152.8 million for Q1 2013. That agriculture business written in the quarter has been booked to 100% combined ratio, a practice we plan to continue until later in the year on the results that's even become more clear.

The AlphaCat segment gross premium written decreased by $12.2 million or 12.6% from $96.5 million to $84.2 million. The Talbot segment experiences more decrease of $2.8 million or 1% from $93.5 million to $297 million.

Our quarterly combined ratio was 68.3% including a loss ratio of 33.7%. During the quarter, we incurred no notable loss events over the $30 million notable loss threshold. Favorable development from prior years was $39.4 million primarily from nonevent reserves.

The prior period developments benefited the loss ratio by 8.2 percentage points. Active loss ratio excluding changes in prior accident years for the quarter was 41.9% compared to 39.7% in Q1 2013. Our gross IBNR at quarter end stands at $1.46 billion which is 49.80% of our $2.9 billion total loss reserve and our net IBNR is $1.2 billion.

Beyond underwriting results, I'll comment on the AlphaCat contribution to earnings, general and administrative expenses, the quarterly investment results and our balance sheet.

Before getting into the AlphaCat results, I'd like to highlight, one of the AlphaCat highlight fund which was consolidated in the financial statement in 2013 was deconsolidated during the quarter due to increase third-party investment and Validus share, therefore dropping below to 50% threshold for consolidation.

As a result, Validus share of earnings for this one is now included in the income from operating affiliates along with our other non-consolidated affiliates.

Turning to the results of the AlphaCat segment. AlphaCat contributed $15.7 million to net income in the quarter, net of noncontrolling interest. AlphaCat's contribution to Validus net income is comprised of the following components. Validus share of manager fees in the quarter by AlphaCat is $5.8 million, while the AlphaCat sidecars and ILS funds contribute $6.7 million of income in the new quarter. This contribution is the combination of income from operating affiliates and consolidated AlphaCat entities.

In addition, there was a small accounting gain of $1.4 million on the deconsolidation of the ILS fund referring to earlier. PaCre contributed $4.8 million in the quarter which is including our share of unrealized gains in the PaCre investments retained by Validus for $4.7 million. Offsetting the above components are expenses incurred by AlphaCat managers of $2 million, which brings the total net income contribution to $15.7 million.

Group general and administrative expenses for the quarter decreased by $5.8 million over the prior year to $74.4 million from $80.3 million in Q1 2013. The primary driver of the decrease was a reduction in Flagstone-related expenses incurred in the year.

Our consolidated investment portfolio is $7.8 billion as of March 31st, 2014. Net investment income for the quarter was $23.4 million for quarterly annualized effective yield of 1.29%, a decrease of two basis points from the Q4 2013 annualized effective yield of 1.31%. Duration of the portfolio is 1.61 years at March 31st, up slightly from 1.60 years at December 31st.

In a quarter, we recorded $3.7 million in realized investment gains and $55.7 million in unrealized investment gains on a consolidated basis. Unrealized investment gains are driven by the PaCre investment portfolio which contributed $46.7 million to unrealized gains. This was offset by a 90% noncontrolling interest of $42 million leaving a net unrealized gains attributable to Validus of $13.7 million. Our investment treasury has decreased by $243.8 million in the quarter and an increase to allocation to asset-backed security and commercial mortgage backed securities by $114.8 million and $22.3 million respectively and funded our share repurchase program.

Total shareholder's equity available to Validus at March 31st is $3.65 billion and total capitalization available to Validus at March 31st is $4.44 billion.

Debt to capital at quarter-end was 5%, and debt and hybrids together as a percent of capital were 15.8%, a marginal increase in financial leverage from December 31st due to our share repurchase activity. During the quarter, we repurchased 5,366,672 shares, an average price of $36.77 per share with a total of $197.3 million leading approximately $356.7 million remaining in our existing share repurchased authorization.

We continue to have a substantial capital margin above our target risk appetites and are currently focused on completing our outstanding share repurchase authorization. With that, I'll turn the call back to Ed.

Edward Noonan

Well, thank you, Jeff.

Let me begin by talking about our business with Talbot underwriters. Talbot's premium written work eventually flat year on year. We saw rates down across our portfolio by 3.5% in the quarter. This was driven by rate decreases and aviation treaty and property treaty. The book of our (indiscernible) in the range of positive 3% to minus to 4%.

We continue to see growth in Talbot Singapore, Dubai and Latin American operation. Well, these territories, they're also competitive. They're good opportunities for Talbot's products and less developed markets. Talbot also has one of the huge opportunity for growth, which is the U.S. market. In addition to growing our U.S. based accounts in London, we currently write $53 million of energy terrorism, property and marine business out of our New York office, which is very broad opportunities to grow the U.S. account by continuing to add additional classes on the ground.

This will add up to ensure the same underwriting standards and discipline that has made it so successful in London. There wasn't a great deal of loss and activity in the market during the quarter. The Malaysian airlines jet disappearance was the most noteworthy. We have declined the all-risk policy (indiscernible) as we felt the pricing was inadequate. We did participate on the aviation more policy, however.

By way of background, aviation policies contain a clause that allows persuading the laws between the old risk and more policies when the cause of loss is undetermined. Well, we weren't thrilled with the implication of the clause. We believe it was most important that the market respond quickly in paying the claim to the insurer. We'll also pick up the loss in our aviation treaty account. However, in the aggregate, the loss is under $10 million for the group.

On a class of business level, our war and terror account was holding up quite nicely. We see more competition on secondary territories, but few risk pricing is holding up relatively well. There are more opportunities coming from the Ukraine and Russia as a result of recent events. However, we're picking and choosing rather carefully in these territories.

Invoking the 50-50 clause can push forward the Malaysian jet loss into the aviation more market is at the effective stabilizing rate, which we expect the whole study through July 1. In general, the marine and aviation more market is competitive above the new entrance, but we feel very confident as a result of our position is a long-term leader in the class.

The property direct and (indiscernible) business is seeing a bit more competition as a result of a good year and more capacity in the market. Rates remain generally attractive in the class, however, and we expect to continue to judiciously grow the account.

During (indiscernible) Validus in a very strong quarter with virtually no event loss activity of anything. The principal areas of renewal on April 1 were Japan and United Kingdom. We saw both market as being a bit more competitive on price than we had expected, but we continue to pair exceptionally well on signing which allows us the biggest lines on the most attractive program.

Increasingly, we're hearing from clients and brokers that they're looking to consolidate their reinsurance panels focusing on a smaller number of larger participants. Catastrophe reinsurance is a scale business, and this place one of our key strength.

To actually gain on the horizon for Validus Re is the Florida renewal on June 1st. We don't forecast great movements but we expect a very competitive market. Florida is ground zero for ILS funds for deployed capital until we expect to see a significant component of ILS money put to work.

In the past, I've said that we believe ILS managers were acting rationally and their pricing reflected a lower cost of capital. We no longer hold Validus as a universal vehicle. We see some managers with genuine expertise behaving at a rational manner consistent with their cost of capital.

However, we see other managers that have raised very large polls of money going beyond the rationale economic behaviour and attempting to put money to work. A key dynamic of the quarter for Validus is what we've been able to achieve with the use of repossession and reinsurance.

I mentioned earlier that our strategy has always been to deploy our capital holding where we believe we are appropriately paid for the risk. As the poll is attractively price derivatives contract, we have reduced our writings. We maintain our customer relationships, so our typical path is to reduce our line on accounts rather than on renew.

As a (indiscernible), we rightsize our capital to the opportunity at hand as evidence by a repurchase of $200 million of stock during the quarter. If you read our risk disclosure, the key probable maximum loss estimates, or PMLs, are down materially on April 1 versus January 1.

The most widely cited metrics, the one in 100-year U.S. windstorm is down $105 million or roughly 13%. This reduction reflects the completion of the most comprehensive repossession program we've ever had in the company. I won't go into all of the details, but the key points are as follows.

We purchase $450 million of limits on an ultimate net loss basis. That means the coverage responds the Validus' loss and not in index product. We're coming on a worldwide basis for key perils of earthquake. We purchase both the current and aggregate coverage. The aggregate protection is important for situations such as 2011 or the 2004 and '05 hurricane seasons where multiple name storms caused significant reinsured losses.

And finally, the attachment point for the protection repurchase is significantly lower than we have historically done. The results of these purchases is a meaningful shift in Validus' risk position. Four or five years ago, we were happy to run PMLs that were 23% to 24% of equity as we probably pay for the risk.

As catastrophe rates have weakened, our willingness to carry risk on our balance sheet has decreased. Today, our one in 100-year PML is 17% of equity reflecting current pricing in the market. We've maintained our importance in the market as well as strong profit potential while taking a much more defensive posture on risk.

Talbot is also a beneficiary of the alternative reinsurance capital and secured a highly efficient collateralized multi-pillared reinsurance cover for their property exposures, not only the direct property book, but also their onshore and increasing construction business. Different capital providers have different return expectation and sometimes that's a competitive negative force, other times it's very clearly a positive. In our purchasing of outlook protection, we see it as clearly a positive.

The other competitive dynamic in the catastrophe market is the inclusion of terrorism and property capacity programs. This started in January 1st in a small number of cases that seems to be getting a bit of traction. We've now renewed a number of programs over this issue. There are some cases where we're getting paid and were provided the coverage. But some reinsurers are rapidly losing discipline on this issue.

Frankly, this is a bad idea for the market and ultimately a bad idea providers of reinsurance. The inclusion of terrorism and cash covers means that reinsurers need to be willing to run massive terrorism on major cities or run out of cash capacity much more quickly. That's just to serve the market way.

Providers of reinsurance and a current space catastrophe treaty is not the best means of purchasing protection against terrorism. The definition of loss doesn't match up well with terrorism event and so the buyer is not well-served by this approach either.

The definition of events and relationships between events can and likely will prove to be very murky and subject to disagreement and potential dispute if terrorism is covering for additional catastrophe treaty.

We believe buyers are best served by purchasing reinsurance in an aggregate basis as this vessel on coverage within terrorism exposure. We have one of the largest terrorism footprints in the global market and consequently we've developed truly unique tools for model and manage the risk and will continue to push back against practices that forget the lessons that the market had already learned a great cost.

Finally, I thought I'd try to give you some preliminary commentary on this thinking of the South Korean ferries. We have tremendous sympathy for the families as well as all of South Korea as they endure this national tragedy. Our exposure on this law arises from the PNI policy and the passenger liability coverage. Using the statutory payment schedule for the victims, we do not expect this to be anywhere near in notable loss for Validus group.

As PNI limit purchase was only $10 million, there's not a risk that the removal of wreck will spiral upwards as we've seen a lot of major marine losses such as Costa Concordia.

With that, I'll be happy to entertain any questions you may have.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions)

Your first question comes from Amit Kumar. Your line is open.

Amit Kumar – Macquarie Research

Thanks, and good morning.

Two questions, first of all, I guess given the lack of meaningful reported cats in Q1 and a meaningful decline in PMLs, how much bigger is your excess capital position versus, I guess, year end? If you assume normal cat losses, how much of that flows into a bigger than expected buybacks?

Jon Levenson

Good morning, Amit.

As you know, we haven't historically disclosed our excess capital position. We determine our excess capital position on the full year basis, and so we look a year forward. Given that we're only one quarter into the year and only about 40% of the way, not quite 40% of the way through our current share repurchase authorization, we don't anticipate making any changes to that in the near future.

We obviously had anticipated some of the decline in the top line and the PML in Q1. So, some of that is baked into the $500 million authorization that we have announced back in February. So we'll see how the next couple of quarters go, but I don't anticipate making any changes. And we'll be back and in touch if we look to make changes after the third quarter.

Amit Kumar – Macquarie Research

Okay. I guess the only other question is Ed mentioned about the size. What is the relevant size in the marketplace? You have been involved in a number of acquisitions in the past. Can you sort of refresh us on the thought process and then looking at opportunities in the marketplace? Is it more financial or is it sort of geared towards getting market access? Do you still see any specific areas in which you might want to expand via a transaction?

Thanks.

Edward Noonan

Thank you, Amit.

I think in terms of relevance with $3.7 billion in equity and $4.4 billion in capital, we feel as though we have the size and scale of our customers. We clearly believe we have the size and scale to be one of the elite group of providers in the catastrophe reinsurance space. So I think we feel good about our position there and we don't feel any particular need to be bigger, to be relevant.

As far as M&A activity, we're focused on executing our strategies. And as I mentioned, we think their scenarios for growth in Talbot that we think are attractive internationally as well as in the U.S. There are something worth to come along and facilitated growth in one of those areas that included (indiscernible).

Other than that, anything else we want to do would be kind of in the opportunistic category, and we've done that in the past. So we're very successful to get to the heart of your question as far as current activity on the island. We read the papers like everybody else was interested in -- frankly, wish the parties involved would ask some for whatever (indiscernible).

But we don't see ourselves at this point in time as being a consolidator and believe it's just for the sake of consolidation.

Amit Kumar – Macquarie Research

Thanks for the clarification and good luck for the future.

Edward Noonan

Thank you.

Operator

Our next question is from Matt Carletti. Your line is open.

Matthew Carletti – JMP Securities

Thanks. Good morning. Just a couple of questions, the first, Ed, is I think it was last quarter you had commented on kind of the state of property cat pricing particularly focused on kind of flooded renewals and saying that thinking we're approaching the floor, maybe there's one more round of rate declines and just technically you can't go terribly much further.

Can you maybe update your thought on that change? Have we gotten any closer to that floor?

Edward Noonan

I'm starting to think we might be heading for the basement. There's two source of the competition in the Florida market. There's the traditional reinsurance market and there's the ILS money.

I think the truly disruptive factor in the market right now is ILS money. I made a comment that we've always viewed the ILS manager business behaving rationally. I can't honestly say that what we're seeing in Florida right now. I mean we have large ILS managers who are simply saying, "Whatever they quote will put out multi-hundred million dollar line of 10% less."

I think it's not a good model. I think alternative capital is extremely valuable for the industry and we're worried that now we're getting into an old repeated phase where if your compensation is based on simply deploying capital to limit, your incentives are different.

That's frankly how markets get in trouble and get overheated. I don' t think that investors can fully appreciate that the expected loss cost that are driving evaluations in the ILS phase don't line up with the expected loss cost that professional reinsurance come up with on the same account.

And so, they're starting out with the disadvantage on pricing and then coming in on the yield on capital in the aggregate (indiscernible). I don't think that's actually appropriate compensation for the risk. Regarding the market in general, I'm not as worried, I think. Long-term buyers outside of Florida value the large traditional reinsurers. I think Florida companies value the traditional reinsurers very heavily.

But as I said, Florida is ground zero for ILS money and it's behaving in a way that I think it's frankly ultimately bad for the ILS market.

Matthew Carletti – JMP Securities

That's very helpful. And just my only other question is kind of the footprint to that, which is where are you seeing the best growth opportunity? I mean you mentioned a couple of lines within Talbot specifically that you're seeing opportunities. But as we look forward, whether it'd be the balance in '14 or beyond, where should we expect to see Validus have a bigger share?

Jon Levenson

This is Jon, Matt. I think some of the specialty reinsurance line still has good growth. It's not market growth. It's not because we see the market as being expanding or holding some unique opportunity when capturing more strategic initiatives that we've been working on for some time. And so we expect to see good growth and especially reinsurance later this year, early next year of fairly meaningful scale.

We think that as I say, the U.S. market is the world's biggest. We really have never scratched the surface of it in our direct insurance operations. And while the rate of increase per pricing in the U.S. is slowing, it's still positive, rates are broadly attractive in the U.S. And so, I would expect to see us expanding our footprint in the U.S. as a growth source.

The overseas territory, Singapore or Latin America, easy to kind of underestimate because the aggregate dollar involved aren't that much. But if you look at our direct insurance business today, we're driving 15%, 16% of our premium from those territories which is up from zero five years ago. So the growth in those markets continues to be attractive and we continue to expand our footprint there.

And so I think that's likely to be the case in the absence of significant events in the reinsurance market or the catastrophe space. I think that those tend to be the areas that we expect to grow in.

Matthew Carletti – JMP Securities

All right. Great. Well, I really appreciate the answers and congrats for the next years and best of luck for the rest of it.

Jon Levenson

Thank you very much, Matt.

Operator

Our next question is from Michael Nannizzi. Your line is open. Michael Nannizzi, your line is now open.

Michael Nannizzi – Goldman Sachs Group

Hello? This is Mike. Hello.

Edward Noonan

Good morning.

Michael Nannizzi – Goldman Sachs Group

Oh, can you hear me?

Jon Levenson

Yeah.

Michael Nannizzi – Goldman Sachs Group

Okay. Good. I'm sorry I have two lines here. I have a little bit of an issue. Okay.

So I guess just one question on -- you talked about the ILS market, I'm wondering, you guys are clearly -- you're picking your capital, you're deploying into your own shares because you don't see opportunities that meet your threshold. Are you seeing other carriers to choose instead to kind of push that capacity into lines where maybe alternative capital isn't reaching? So, maybe other cat risk or property risk and other geographies seeing an inflow of capital or maybe even outside of property. Are you seeing folks which is kind of seeking to deploy capital into the business in line where maybe historically they haven't had the same presence?

Thanks.

Edward Noonan

I think there is a bit of (indiscernible) the Japanese renewals, and to some extent the U.K. renewals were a good example of that. The ILS states to get no attraction in Japan. So it's a much more attractive market for traditional reinsurers. Japanese prices were up a bit this year. And frankly, they came off of really excellent prices. And so they're still very attractive. And so, I think we saw the marines (indiscernible) to try and get on the programs to expand this year. Our track record in Japan and having paid the loss and increasing our capacity after the earthquake puts us in excellent stand. So, that's coupled with the analytical research we've done in conjunction with our major Japanese clients leaves us in a pretty advantageous position and we tend to do extremely well on signing.

But our sense was that when you visited Tokyo, there are a lot of more reinsurers making this an encrypt this year than in the past years. I think the other areas, it appears as though casualty reinsurance is getting a bit attractive to people these days.

Certainly part of that is that short tail company is getting relatively low cost of capital because of the correlation benefits and part of it (indiscernible) because you're looking to put capital to work that you can't put to work in the catastrophe market. We're not in the casualty space. I can't express to view on it, as to whether it's attractive or unattractive. But we do see other reinsurers clearly extending their footprint there.

Michael Nannizzi – Goldman Sachs Group

I mean it's certainly nice to see the discipline. I think that's really positive to see.

Edward Noonan

Thank you.

Michael Nannizzi – Goldman Sachs Group

I guess another question I had, I'm trying to understand, I mean in your re-segment, and we've seen this from others, with pricing down, the attritionals are flattish. What goes into that the calculation of these attritional? I guess just simplistically, and I know this is off simplistic, but I would think that with pricing down that you would see attritionals rise, I guess, because you're pulling away from some business maybe a mix account with that. But I would imagine that the attritional on the cat business that you're no longer writing is still probably lower than the business than the non-cat business that you're keeping.

Maybe you can help me just understand. I'm actually having a little bit of trouble with it. Not just for you, but just generally.

Jon Levenson

By attrition, you're referring to our attritional loss ratio, right?

Michael Nannizzi – Goldman Sachs Group

Yeah, attritional loss ratio and valid history.

Jon Levenson

Yeah. So I think it has stayed relatively stable. The one thing that probably come in to the equation is that we're pushing our (indiscernible) higher understanding of the programs, and that's by its very nature will reduce that attritional.

But in terms of kind of what goes into that kind of the mechanics, really, what you see if you look at page 21 of the book, which is the normalized loss ratio. That can normalize attritional loss ratio is really the spinoff of the IBNR and I've got (indiscernible) in older years that falls into the positive development.

The other thing that goes into that line is the (indiscernible) of what we had. We had (indiscernible) this quarter.

Michael Nannizzi – Goldman Sachs Group

Got you. Okay. That make sense. And then I guess one last one on Talbot, the underlying property in the year was up a bit. Were there some large losses that's attached there that we didn't see in the past or where there some elevated level of something else? I mean we didn't catch.

Jon Levenson

The story primarily there is just the attritional loss ratio keep coming back to normal. It does run fairly quite through most of 2013 and kicked up in Q4 and we saw that again in Q1. We think of that as a reversion to the main. It was abnormally low and below our expectations for at least the first half of 2013. So really, the story there is just getting back to what was expected.

Michael Nannizzi – Goldman Sachs Group

Because that's like a, what you call it, a 70 current accident year pick, so with a normal expense load, is it implying that the property should be running on an actual basis in the '90s for Talbot?

Jeffrey Sangster

We tend to run almost everything in Talbot on a peak loss ratio basis (indiscernible).

Edward Noonan

Part of the reasons why Talbot reserves have burned off favourably overtime is we start with what has proven to be conservative assumptions and we do the same thing on virtually every class.

Michael Nannizzi – Goldman Sachs Group

Got it. Okay. Thank you very much for all your answers. I really appreciate it.

Edward Noonan

You're welcome, Mike. Thank you for your interest.

Operator

Our next question is from [Ronnie Bobman] (ph). Your line is open.

Unidentified Analyst

Hi.

Edward Noonan

Good morning, Ronnie.

Unidentified Analyst

Okay. So I have a couple of questions. On AlphaCat, I have two questions. What is the lockup that investors commit through and what frequency do you provide them evaluation statements?

Jon Levenson

That question sounds familiar. The evaluation, it is calculated and officially on a quarterly basis, and I think that's similar to others that are in the peer group. Lockup, I think it depends what fund, obviously the sidecars are lockup for the term to which that sidecar applies. So for example, the 2013sidecar with the 12-month vehicle that runs for the calendar year. And having run very clean, investors got their money back out of that very early this year and we're able to -- we're releasing that capital back to investors in the first week of January.

In terms of the funds, I guess the open-ended funds, they're more -- it depends when terms are different by funds. Some of those are funds that are specific to a single investor and others are multiple investors. And so there's not a single lockup that applies to all of those.

Unidentified Analyst

It sort of matches the liability duration, the underlying liability duration, is it?

Jon Levenson

Yes.

Unidentified Analyst

Okay. And then switching over to retro, you provided some description. I appreciate that. And I think you said your number is $415 million (indiscernible). That doesn't really only (indiscernible) and that the pillar cover is separate and distinct, and that relates to Talbot books.

Edward Noonan

That's right. Validus repurchase a current scenario for $450 million. Talbot buys a fairly larger reinsurance program, which included the collateralized pillar product.

Unidentified Analyst

Okay. In responding to Matt Carletti's question in the commentary about basement, did you want coming maybe for the month of July as well? Is it likely that the 17% PML could actually go lower once we pass those, in instance, May 31 and June 30 sort of expiration dates, a new business incepting the next day that the book could change materially now that 17 is even lower?

Thanks. That's it.

Edward Noonan

It's hard to know, Ron, because you can't extrapolate from Florida to the (indiscernible) because you have very different buying patterns at seven one. And frankly, it could also be that even with prices where they are, there are still attractive accounts in Florida as well as their portfolio. We may find one or two and increase with PML as a result of that.

So it's one of the reasons why one of the earlier questions I think was why not -- are you guys thinking about expanding share repurchase. We have the model portfolio or the reference portfolio that you assumed for the year. But, yeah, there's a lot in play and the PMLs could move in either direction depending on what we see in the market between now and July 2nd.

Unidentified Analyst

Thanks. Best of luck.

Jon Levenson

Thank you.

Operator

Our next question is from Jay Cohen. Your line is open.

Jay Cohen – BofA Merrill Lynch

Thank you. A couple of questions, if you end up having excess capital because you pulled back on underwriting risk, one other option is to take more risk on the investment side. At least one of your competitors discuss that on their first quarter call. Is that at all at your taking at this point?

Jon Levenson

I understand that line of thinking. At this point, we have stuck to our guidelines in terms of our investment approach and don't intend to make massive changes in our portfolio and big steps into more risky assets. That said, we're always evaluating what we're doing in that area. And as I mentioned earlier, we reallocated other treasuries into what we saw as more attractive asset classes in ABS and CNBS just with a continued challenges that treasuries are facing with the anchor of what it is.

So at the margin, we're constantly evaluating in terms of a wholesale change to take a percentage of our portfolio and move it into alternatives. We don’t do that happening. We've got the banking portfolio, which has performed very nicely. But that's the low investment grade. And so we think that where our portfolio is now is we're quite happy with.

Jay Cohen – BofA Merrill Lynch

Got it. And the second question in Validus Re, there was some adverse reserved development and specialty piece of it. I think it was cropped. If you could talk about what's happening there?

Jon Levenson

Yes, sure. Absolutely. As we said on the last call, we will through up the creativeness in the first quarter as this final calculation comes through. We ultimately put the crop business at 110.1 loss rate -- sorry, combined ratio for the full year 2013. And as a result, we had adverse development in the Validus Re specialty lines of $14.7 million in the quarter, and that's what you're seeing comes through there.

Edward Noonan

By way of color practice, we would look at every year. 2013 was a bit unusual because of the late freeze in California and adjusting claims was also hampered by the early winter across the Midwest. And so it was difficult to get a clear picture from our feeding companies because they were slow in adjusting the claims. Typically, we would expect that in the fourth quarter we have from perfect to pretty good handle on what the ultimate should be.

Jay Cohen – BofA Merrill Lynch

Got it. Thanks guys.

Operator

Our next question is from Meyer Shields. Your line is open.

Meyer Shields – Keefe, Bruyette, & Woods Inc.

Yeah, thanks. If I can follow up on that question. I guess we also saw some adverse development in Talbot segment and a huge drop on favourable development in Validus Re property. I'm hoping you could walk us through that.

Jon Levenson

Sure. There are a couple of items coming through there. First off, on the Talbot marine. There was development there on 2012 event where it was a morning failure and we have $6.8 million of development there, which is driving most of that change.

In terms of the Validus Re property, as I mentioned, sort of the specialty where I mention the crop. In terms of property, we did have one claim related to a single contract on windstorm Xaver from fourth quarter. This develops negatively in first quarter in tune of about $15.6 million.

That was offset by the cause of development on both the European and Calgary floods from 2013. So those are virtually offset each other. But that one big claim is really has offset what we've seen as the historical positive development coming from the Valery property line.

Meyer Shields – Keefe, Bruyette, & Woods Inc.

Okay. Is it appropriate to look at some sort of run rate of favourable development in terms of how you manage the reserving process?

Jon Levenson

No, our process is that we reserve appropriately, conservatively on a quarterly basis and as that IBNR funds off and it comes through the PPD. Obviously, the events are more specific to circumstances. And so they're quite lumpy in both directions, which hopefully they're developing positively as opposed adversely. But our reserves at the end of each quarter are our best estimate in that point in time. And as that estimate becomes more clear in the future, we threw out in that role through the future quarter earnings.

Meyer Shields – Keefe, Bruyette, & Woods Inc.

Okay. I understand. And if I can ask a sort of big picture of question about the sustainability of ILS-based competition -- and I'm not trying to commit to an individual number, but you talk about how a five and a quarter percent yield is inadequate. Is that still true if we talk about the portfolio diversification benefits or as a manager as opposed to underwriters?

Jon Levenson

Yeah. It's a great question, Meyer. I would say that there's clearly diversification benefit. But we've gone beyond that to the point where some fairly large, large capacity is being deployed in a way that is leaving money on the table, all right? They could get more money for their product and they're simply going to push it out the door as quickly as they can take it in. And so that suggest to me that in fact the market is overheated and there's too much money in it.

It's one thing to say, the yields are okay given diversification credit. That's five other quarter could easily be five and three quarters or six was a bit more disciplined, then you have to have wondered if maybe we're past the point of rational behaviour. So I can't really comment because obviously it varies from hedge fund or pension plan to pension plan and they all have their own asset mixes and five other quarter maybe great for some. But I don't think that -- and we have a lot of pension plan that we're close to and talk to.

We find that some of the most enlightened kind of get it and say, "Oh, this isn't the right time to enter this class. So this isn't the right time to expand on this class." Let's just keep our volume and wait until rates actually reflect the risk involve or at least reflective.

I think it's a bit unanswered because everybody's portfolio is different, but I think I can say on an absolute basis that we are -- there's money being left on the table just by kind of we practice.

Meyer Shields – Keefe, Bruyette, & Woods Inc.

Okay. That's very helpful. Thank you.

Operator

Our next question is from Brian Meredith. Your line is open.

Brian Meredith – UBS Investment Bank

Yes, thanks. Just quickly, the proportional property market, it looks like you lost a contract or something there. So if that's what's happening, also what's happening in the proportional property market? What are the dynamics there? I would have thought that we should keep retro. It might be an interesting market right now for you guys.

Jon Levenson

Brian, actually, Jeff is doing a track on them and we're thinking of the proportional contracts that we've lost. I'm …

Brian Meredith – UBS Investment Bank

The premium was down like 19%, I believe, year over year.

Jon Levenson

In proportional properties. Let me address the broader picture for you and I think first, you do make a good point. The ability to lay off risk in a cost effective way makes it more attractive to take on primary risk and certainly proportional reinsurance is primary risk.

The buyers of proportional reinsurance are on that as well, and so in buying reinsurance, a lot of that savings has already being passed directly to the original insurance company in purchasing just through competition. So we don't see an expansion of margin on a net basis in the proportional property market or at least not much of one as a result of the ability to lay it on cheaply.

Brian Meredith – UBS Investment Bank

Okay.

Jon Levenson

And on the specific, nothing -- no big single contract or same story that say, a couple of smaller contracts that we've came off where terms and conditions had deteriorated, but it's an accumulation of a couple of smaller contracts as opposed to something that's big and pervasive.

Brian Meredith – UBS Investment Bank

Got you. Another quick question for you. So when we think about cat fund pricing in the ILS market, how did it kind of work with the program structure here? If almost you see a big drop in the pricing of the cat bond or some type of ILS contract at a higher layers. Did that typically flow down through the whole program? Is that how it works?

Jon Levenson

There is a competitive knock on effect because when someone upsize their cap relative to prior year or buys one for the first time or just buys a big coverage in the ILS market, it compresses the capacity available through a (indiscernible) reinsurance market. And so, you find your insurers, you have to compete a bit harder when you share that business. And so I think it is a direct (indiscernible) but there certainly is an effect on pricing across the entire program.

Brian Meredith – UBS Investment Bank

Okay. Great.

And then last question, Ed, I think you kind of alluded to this in your prior comments. In looking at expanding in the U.S. on the primary side, given where we are in the marketplace, is it necessary if you really want to have an impact right now to make an acquisition and get that platform a lot quicker?

Edward Noonan

Another great question, Brian. If we could find the right company, we would do that, we would've done it already. Candidly, we've looked a lot and tried a couple of times. Not even if you find the right company. And in the interim or as an alternative, we've got essentially (indiscernible) underwriter, and so hence we've been building maybe underground presence in New York as it cover the syndicates to (indiscernible). That's less fulfilling than being able to move on a larger scale. And so I think it comes back to your point.

But if we found the right property, I think we would be a willing buyer. In the absence to that, we still feel like it's important to push ahead. And so, underwriting on behalf of the syndicate is the best way to do that.

Brian Meredith – UBS Investment Bank

Great. Thanks

Operator

Our next question is from Ryan Byrnes. Your line is open.

Ryan Byrnes – Janney Montgomery

Great. Yeah, thanks for taking my question guys.

Can you guys just maybe talk about, again, how rates in the property and I guess your recent retro-purchases, how that affect your expect returns. I just want to see how you've been able to reshape your portfolio and all the expected returns compared now versus last year, I guess, the year before?

Jon Levenson

Yeah, great question, Ryan.

One of the things that we do is we are continuously running optimization routines against our program, and that's not just on the inward business. We also look at the use of outward protection and how they best optimize their portfolio. And our goal in optimization is to always be willing to move close to the efficient frontier, or another way of saying maximizing returns for stated risk appetite.

Very clearly, the repossession we bought has -- both diminished our risk protection and also made the portfolio more efficient. That's couple with the result in the first quarter (indiscernible) outlook for the year has improved, simply because we've got bigger process and it was a cat three quarters, a bigger process and a much different risk profile as a result of hedging as we go through the rest of the year.

Ryan Byrnes – Janney Montgomery

But in terms of your expected returns, is it now a 12 versus 13? I'm just trying to figure out how the impacts of rate have impacted those expected returns?

Jon Levenson

So the repossession we've want those enhance our expected returns for the year. We never actually declared what our targeted ROEs, but yes the retro we purchased. Last year was we bought (indiscernible). It was about a push. Every year prior to that, retro was in the net cost list this year. The retro we bought enhances our expected returns.

Ryan Byrnes – Janney Montgomery

Okay. Great. That's all I have. Thank you guys.

Jon Levenson

Thank you, Ryan.

Operator

Our next question is from Ian Gutterman. Your line is open.

Ian Gutterman – Balyasny Asset Management

First, to follow up on that, that retro you purchased, was it from …

Jon Levenson

Hey, wait a minute. No good morning or anything?

Ian Gutterman – Balyasny Asset Management

I’m sorry. I apologize. Good morning or should I call you Eddie now maybe? I think it's a new thing.

The retro you purchased, was that from a traditional provider or alternative market?

Edward Noonan

Both, all collateralized 100% both traditional and capital markets provider.

Ian Gutterman – Balyasny Asset Management

Got it. And then the crop, you're saying not to buy the protection this year. Can you just talk about why?

Edward Noonan

It was an agreement. If you remember last year, when we started the crop business, we entered an agreement with third point where we -- there's crop underwriter and agreed to see part of the business to them.

Ian Gutterman – Balyasny Asset Management

Okay.

Edward Noonan

On a quarterly basis. Maybe we never disclosed that, so now I have.

Ian Gutterman – Balyasny Asset Management

I forgot.

Edward Noonan

Okay. Good. But this year, we did that last year and not this year.

Ian Gutterman – Balyasny Asset Management

Got it. And then my question on Florida, there were some press reports on citizens yesterday, what they're purchasing this year versus last year, and it looks like they're paying the same dollars in premium for significant more cover. And if you sort of reverse engineer the map so we know what they pay for the cat bonds. It looks like their traditional reinsurance is down more than a third in radar line. And that radar line is very low double digits, it looks like. A, it's my math and we should be accurate; and B, if so, why does not carry over to the rest of the private market? I assume Florida take our company, that things they have is a much better book in citizens. I would think in that book it keeps coming back and saying, "We want a better rate in citizen's (indiscernible)."

Jon Levenson

All good questions, Ian. As of 5:36 this morning, I have not seen longer terms on citizens. So their comments yesterday, we took our word as well but we don't have some broader terms, and so not much to talk about.

One thing I would say about citizens, I think everybody has to be mindful of. Citizens was not highly regarded for many years and that was reflected in their reinsurance pricing. And we've done a lot of work to this overtime on improving data quality. And today, actually citizens is top (indiscernible) in data quality in the state. So it's no longer between that and a lot of the depopulation activities. Citizens isn't the same company it was in the past.

That was reflected in some of the decrease activity last year and clearly again this year. Now I wouldn’t suggest to you that if in fact the rates decrease turns out to be a third, that's that warranted or that we kind of fall back in my earlier comment where you have ILS money and cap money. It's just a big point to wave. As a traditional reinsurer you say, "Well, I can't compete with them (indiscernible)."

But as far as the rest of the foreign market, each company is different. The concentrations within the state are different on how they impact reinsurers, their overall portfolio is different. So I think directionally, it's really indicative but it isn't necessarily the care where anybody can step up and say, "Well, Florida got this and we should get that, citizens got this discount, we should get that discount." Citizens is paying a much higher rates than the rest of the market in the past for their coverage.

Ian Gutterman – Balyasny Asset Management

I guess to be honest, I agree with you entirely. I guess the one thing that surprise me, which is the absolutely realign being in 11 or 12 that implied. But not only we're thinking again, it depends who you're buying at, we normally think about Florida now. Being high teams or even at the (indiscernible) for private companies. And I agree that citizens should improve. It's still just given their residual market. You would think that their risks are worse than the private risk that people choose and taken out because we think they're better.

Does that imply? The private market in Florida, should we be getting ten rate on line or high single digit?

Jon Levenson

No.

Edward Noonan

No, I don't think so. No, not at all.

Jon Levenson

We can take the map offline, but I think a couple of things that are happening there is the citizens is buying higher up and that's impacting the data online. What we're seeing in programs or like for like components of the program is directionally down but not in magnitude that you're describing.

Ian Gutterman – Balyasny Asset Management

Got it. Great. Thanks so much.

Operator

Our next question is from Michael Nannizzi. Your line is open.

Michael Nannizzi – Goldman Sachs Group

I'm back again. Sorry. Thanks for the prior answers.

I wanted to get your thought on what causes rationality to come back into the ILS market? Do you think in large events that causes people to lose principle that's maybe it's an unexpected given the fact that it's big or would it be a small or a series of small events where investors maybe don't understand their proximity to loss and then they end up taking some, or is it something else?

Jon Levenson

It's probably both. I don't by the way mean to kind of besmirch the ILS market in general or OILS managers. As I said there are some with genuine expertise that are deploying new capital in a rationale way, the large one aren't.

I think at some point investors, they do have to reup the (indiscernible) decision that they have launched the yield, their expected yield increase fairly dramatically. It's north 9% in 2012 and now it's barely north of 5% today.

Of course, I get the logic that you want an allocation to that because it's non-correlating with most of the capital market instruments. Logic doesn't necessarily hold but there are some logic to it. But I think at a certain point, people wants to look at this and say, "It's a triple B security, or triple B minus security. Why am I accepting this yield for it when I can do so much better on triple B or triple B minus security elsewhere?"

Or there could be a loss even where people are surprised with the fact, a, the outcomes are binary or, b, that there is an spectacular liquidity for capital that had been hit. And so the idea as well is just kind of (indiscernible) of my position back in a pretty expensive trade. Or c, just a pure surprise. That's a loss I didn't think I could take a time from.

Michael Nannizzi – Goldman Sachs Group

Right. I mean your point on correlation is that if there's a big (indiscernible) other asset classes would also see some impact of these losses large enough to create an event for structure security.

Jon Levenson

Yeah, I mean I think that's right. I think the idea that caps aren't correlated with other securities in general. When liquidity dries up, liquidity dries up. When yields move, yields move. And so there is clearly correlation in the asset class. The underlying risk may not be correlated but there clearly is correlation in the asset class.

If triple B suddenly move up 300 basis points, then your cap on portfolio will be working on a whole lot less than it was the day before. And so the correlations still holds despite the fact that the underlying risk class isn't fairly correlated with financial market.

Michael Nannizzi – Goldman Sachs Group

Great. And then just one last. I mean looking it forward is generally the impact of new capital and then come in capital as well to that extent. Does the dynamic in Florida feels in any way different this year or this renewal season or just generally over the last 18 months than prior episodes or kind of softness and hardness? Or is this just maybe a more exaggerated kind of version of the same story?

Jon Levenson

No, I think we're on a continuum. Frankly, there are still good Florida accounts that are attractively bright. I just think the (indiscernible). I think the only thing that is just according what's being on the continuum is having money being just kind of shovelled into the market. That's the only disruptive factor. But also (indiscernible), "Oh, wait a minute. I need to know that they'll be here next year," and if there's a big event or should I be placing 50% of my program with somebody who may or may not be around of interest next year. We may not have the capital they put to work next year.

So even that, there are some general governors on that, but that's the only kind of unusual aspect of the Florida market. And I sincerely don't mean to say that there's nothing attractive in Florida. There's still a reasonable full of attractive risk, but just that it's small.

Michael Nannizzi – Goldman Sachs Group

Great. Thanks for those answers. Again, I really appreciate it.

Jon Levenson

Mike, I just wanted to circle back to one of your earlier questions on the Talbot property loss ratio. One item I failed to mention was they had a non-notable loss in a fire and a construction project, which was net and close to $10 million, about $9.6 million, and that's about 4.5 loss ratio points. So that is a one-off event that's driving out loss ratio up a little bit.

Operator

Our next question is from Jay Cohen. Your line is open.

Jay Cohen – BofA Merrill Lynch

Yeah, maybe explore the issue of non-traditional capital. I guess with capacity risk, there's three things that need to be done. You have to access the risk, i.e., the brokers to underwrite the risk and then you have to figure out a way to finance the risk whether it's traditional capital or different form of capital.

And I guess in that last skill or last issue, are you (indiscernible) the brokers a little bit because clearly, you're in a position where you're able to decide that that's the financial risk. But the brokers too, they're managing cats on underwritings. They're doing the same thing.

Do you feel as if you're bumping up against the brokers from a competitive standpoint?

Edward Noonan

No, actually, not at all Jay. I think we tend to run almost everything with the brokers. Sometimes the best answer for their clients is to do a cap on. The brokers' job is to get the best for their clients. And so I think we're pretty respectful of that because of the broker (indiscernible) you do everything the way we would like you to be. But in general, I think we're more closely aligned than ever with the key brokers in the catastrophe market and work extremely well and kind of handling gloves them.

Jay Cohen – BofA Merrill Lynch

Great. Thanks, Ed.

Edward Noonan

You're welcome.

Operator

We have a question from Sarah DeWitt. Your line is open.

Sarah DeWitt – Barclays Capital

Hi good morning.

Jon Levenson

Good morning, Sarah.

Sarah DeWitt – Barclays Capital

I just wanted to follow up on the M&A on the island, given the target company is less chat focused and they have a U.S. insurance business, they have a Lloyds business, they have some specialty lines, why wouldn't that be attractive to you?

Edward Noonan

I'm sorry if said anything that suggested of you of relative attractiveness. That wouldn't have been my intent. I think in this case. Aspen is a good company. I think they had a nice track record. They've built an attractive business. And so, I wouldn't disagree with any of your assessment. This idea though, you're kind of getting into unfriendly situations and acquisitions.

We're not in favour with that. Sometimes it doesn't work out the way you think. That was all funny and cheap, by the way. We don't see ourselves kind of engaging in a situation like that though at this point. We kind of included this, having been successful in one unfriendly takeover and unsuccessful of another that you do an awful lot of work towards a very good end. And at the end of the day, there's a (indiscernible) need to pay a dollar more. And to get to that point, you probably have antagonized the board and management of this target company so much as they kind of fall into the camp of we'll do a deal with everybody other than you.

And so our view is that we wish the part is well and I have to go set on the side lines. But, yeah, I didn't mean to fall on the relative attractiveness of either company. I think (indiscernible) has done an excellent' job with the investment. They've built a really nice company.

And I think Jon will do with endurance. I think Jon's track records speaks for itself and I wouldn’t have anything other than good things to say about that.

Sarah DeWitt – Barclays Capital

Great. Thanks for the answer.

Edward Noonan

Well, thank you very much.

Operator

We have no further questions as this time. I will now turn the call over to Ed Noonan.

Edward Noonan

Thank you very much. I appreciate that you join us this morning because I'd say we're kind of executing the strategy we laid out for itself and we feel pretty good about it and good about our ability to grow book value in a pretty aggressive rate in the quarter. And so we look forward to reporting back on what we hope would be another successful second quarter.

Thank you.

Operator

Thank you ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.

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