HCC Insurance Holdings, Inc. (NYSE:HCC)
Investors Conference Call
June 07, 2012 09:30 am ET
John Molbeck - CEO
Bob Rosholt - Chairman
Mark Callahan - EVP & Chief Underwriting Officer
Bill Burke - EVP & COO
Michael Donovan - President, HCC Aviation
Simon Button - Energy Underwriter
Andy Stone - President, HCC Global Financial Products
Craig Kelbel - EVP, A&H
Bill Hubbard - President and CEO, HCC Specialty
Adam Pessin - President and CEO, HCC Surety
Tony O'Connor - Property Treaty Reinsurance
Chris Williams - President
Mike Schell - EVP, Property and Casualty
I am waiting for my queue. In case you haven't figured it out, we are going to be talking about the world not sitting quietly today. Good morning and welcome to HCC’s Investors Conference. My name is John Molbeck and I am the CEO of HCC.
First, I would like to thank you for your commitment of time to participate today; not only the time for the meetings, but the travel time that many of you had to experience getting back and forth to where you really live. We seldom have the opportunity to interface with so many of the owners of our company and we also welcome everybody that’s joining us today by webcast as well as Bob Rosholt the Chairman of the Board. We have a full schedule for you today as you would expect having dealt with me before and we promise you will have a better understanding of both the industry and HCC specifically; you know what that is.
Why a conference and not an Investor Day? An Investor Day is typically a monologue by executive management. What we are going to do today is you will have the opportunity to hear from a number of our underwriters about their individual lines of business. You will be able to ask some questions after each of their presentations. In addition, at the conclusion of the conference there will be general question-and-answer session where you can ask, again you can ask questions on the underwriters or executive management.
To set the stage, I will review for you today the HCC model and then we’ll go part of our strategic plan; the factors which differentiate HCC; our performance versus our peers and our targeted return on equity. Why now; because the market is changing as evidenced by several successive quarters of price increases. Why now; because the market is very fragile. One event, even a psychological event such as an unsuccessful terrorist event could change the market almost overnight.
The world does not sit quietly, Wall Street, Middle East, China, Greece, Hurricanes, Tornadoes, floods and quakes are in news. HCC is well positioned to handle unknown challenges despite any turmoil that may take place whether at the hand of man or God. To demonstrate this, our Chief Underwriting Officer, Mark Callahan will show you how we can handle these challenges. His presentations include the results of the model severe stress scenarios including a dramatic interest rate rise, a three standard deviation underwriting loss and both happening at the same time. And again, you will have the opportunity to ask questions.
Throughout the presentation today, we will be comparing HCC to our peers. We will attempt to contrast, compare and differentiate HCC. We performed well in the past compared to our peers and we believe we will continue to perform well into the future; you of course would be the judge.
As I said before, the market is changing, prices are improving. Through May, preliminary results are, gross written premium was up 6% year-to-date. Net written premium up about 5%, new lines of business which Bill Burke will be addressing later accounted for about 1% of that change. We only have losses through the month of April, but they were consistent with the first quarter.
One thing that differentiates us from the pack is our margins are already good. However, some companies are feeling stressed. We measure stress by what we call the crunch ratio which is a sum of the pay loss ratio and the expense ratio. Once you get to 100%, you begin to take cash out of your coffers to pay your operating expenses.
As you can see by this slide, as of the end of 2011, four companies were already over 100%. If you look at the first quarter results of 2012, of the nine peer companies represented here, six of them presented the information which will allow you to calculate the crunch ratio. Four of those six companies were over 100%. You have to have the cash to pay the bills from somewhere. Most likely, that cash will come from your investment portfolio.
A logical response to the poor crunch ratio is a reallocation of capital to more profitable lines, but more profitable lines for that company. We’re seeing this reallocation of capital, we’re seeing companies exit from certain lines of business and we see a greater opportunity for profit. The beneficiary of this is companies with low expense ratios and we will talk more about that later.
Our goals today are to simplify for you what may appear complex, to demonstrate the strength of our management team and more importantly our underwriters, and to demonstrate the strong position of HCC regardless of the environment. But before we do that, I think it will be helpful for you to understand the HCC model. What is it that we are all about? What's the fabric of our strategic plan?
We target a combined ratio of 85% over any five year period. We forecast this year combined ranging from 85% to 88% but over any five year period, we've been able to achieve an 85% combined ratio. A flat management structure that results in lower costs, quicker decisions, more responsive management while at the same time still maintaining operational control; a decentralized, but skilled subsidiary management; you will see that later today; an expense ratio in the top quartile of our peers; focus on specialty businesses that do not compete during cycles with the admitted market; a focus on businesses that require technical expertise and businesses that are not easy to enter or exit and a focus on businesses that are largely uncorrelated and not dependent upon reinsurance.
We will talk about reinsurance later today. But in reality HCC could buy no reinsurance and continue in business without any reinsurance. What that would do, is that potentially increase the volatility so we buy reinsurance to reduce the amount of volatility and we will demonstrate the lack of volatility HCC’s had over a long period of time.
We also have highly rated insurance companies; that's part of our fabric. We've always had highly rated insurance companies as long as I have been with the company. A plus by A.M. Best, AA by Fitch, and AA S&P. Different than many, many companies, we don't put out big limits; so our limits control by its very nature limits volatility. And finally, we manage our aggregate exposure closely and we closely monitor it. So that's the fabric of what HCC does, that's part of the model which helps you understand where we are trying to go with our business. We believe HCC is a unique company. One of the characteristics that makes HCC a unique company as I said before, is the highly rated insurance companies.
This slide here shows you our rating and you will notice where A plus rating only one company having higher rating from A.M. Best than HCC. And I have identified for you in this slide in bold red those companies we consider our peer companies. And we define the peer company as a company that we compete for business with in one of our segments or a company that we compete with for talent.
So those are the companies we define as our peer companies. And if you've been following our investor presentations for a long, long time, those are the same peer companies we identify ourselves with each year. So I think you can see lots of other comparisons of peer companies and they compete with. They compare us to companies that we have nothing in common with. We don't compete with, but these really are the people that we compete with.
Just below that is a slide which shows our rating with S&P. We are one of three AA rated S&P companies. You'll note the other two are substantially larger than HCC. Before I go any further, I would like to thank V.J. Dowling. This is a V.J. Dowling slide. He gave us permission to use this slide and a few others in the presentation.
Another characteristic that makes HCC unique is we really are a specialty insurance company. We have strong long-term fundamentals and market leadership. A high percentage of our business is renewal because we are specialty insurance company and as I said before, our businesses not flow back and forth to the admitted market. Renewal book generally produces a better underwriting result than a book we are going out to write new business. I mean logically if you have been writing an account for a number of years you know all the characteristics of that account. You have the information available to you; you know what the loss ratio is.
And if you think about it, it’s a lot easier, it’s a lot less expensive to put a renewal account on the books than to go out and produce some new piece of business that ties back into our expense ratio. Everyday our underwriters exercise independent thought and judgment in order to be successful. There are no manuals. They can’t look it up. These gentlemen will be here to explain that to you in greater detail later. So it takes technical expertise and market knowledge.
But importantly, we are a market leader in a number of our businesses. In the aviation, Michael Donovan leads a significant portion of fixed and rotor wing aircraft in the United States. Internationally, we are a leader of government and military fleets as well as regional fleets where we can avoid US passenger liability.
In the Energy business Simon Button leads 70% of the business we write with an average line of 5%. We are D&O leader; Andy Stone and his European colleagues lead many difficult placements and a one of a handful of underwriters who have the technical expertise rating in reputation to lead primary and first excess layers.
Craig Kelbel leads our A&H segment where we are the leader in the medical stop-loss business and we have been for the last decade. Bill Hubbard will speak to you about our leadership in the sports and entertainment business, leading such events is the NCAA Final Four, The World Baseball Classic, several major studios as well as high profile entertainers and athletes.
Finally we are a leader in the commercial surety business, but with a little bit different twist. We are leader by geography. So we lead in the West Coast, we lead in the Middle Atlantic quarter and Adam Pessin will talk to you about expanding our geographic leadership in this business.
Just to refresh your memory, these are insurance segments, US Property & Casualty, Professional Liability, Accident & Health, US Surety & Credit and International. The speakers that are speaking today as identified by these red circles are responsible for these lines of business. That represents over 80% of the premium volume of HCC.
How well have we done? This slide is a visual display of our performance as an underwriter over the last five years. You can see that we have better than a 10 point advantage in expense ratio and an 8 point advantage in the combined ratio. As to loss ratio, we believe all good underwriters gravitate towards the mean. If you think about it, if we’re all selling the same product, why would somebody pay me a $1.10 and pay somebody else a $1? They are not; when they have perfect information, they’re going to pay a $1, so good underwriter’s results revert to the mean. Bad underwriter’s results don’t revert to the mean.
So if you look at this, why is HCC’s loss ratio slightly higher? Mix of business. Our medical stop-loss business consistently has a loss ratio in the mid-70s, but our expense ratio is significantly lower than the industry average and the combined ratio is excellent. You will hear more about this great franchise from Craig Kelbel later.
Let’s look at the combined ratios both in an accident year and a GAAP basis for 2011. None of our competitors had a better accident year combined ratio than HCC and only RLI had a better GAAP combined ratio.
We often talk about the lowest expense ratio among industry peers and yes, how do you do it, I mean, how are you 10 points better than everybody else in the business. Its not accident, it’s by design. We avoid businesses with inherently high commissions and other expenses, so you haven’t seen us in the commercial auto business; you haven’t seen us in the workers’ comp business. If we are to be in these businesses or if we were to give our pen away to others where we would have to pay them and overwrite commission of 7.5% to 15% plus a percentage of the profits by virtue of a profit commission, we would not be able to achieve one of the [tenants] that's in our model.
There's no way we would be able to achieve an 85% combined ratio over any five year period of time. We employ highly qualified underwriters which allows underwriting decisions to be made at the business level; therefore we don't need a branch office system. We do not need a regional office system. We don't have to invest in all that bureaucracy because we allow the underwriting decision to be made at the lowest possible level where we have the expertise.
So nothing is submitted to the branch office or regional office. If there is something submitted, there's a very flat home office management structure especially it's insurance. So you have Mike Schell sitting over here, you have Chris Williams to my right, myself, Mark Callahan and Bill Burke. That's the insurance management structure. We have less than 1% of the businesses submitted for home office approval and the only time that it is if it’s a political issue.
So it’s a highly sensitive account like writing the D&O for AIG after the government took them over, probably a good thing to check with us to see if we want to do that or if somebody wanted to exceed the authority that they had for either a limit or an aggregate exposure in an earthquake zone for example.
We are headquartered here in Texas. You probably don't know a lot about Texas if you don't live here but you do probably realize it’s a very good tax jurisdiction both personally and corporately. Salaries are a lot less than they are across the country; expenses for running operation are a lot less. It’s a very, very good legal environment. So if our operation which we have roughly 400 people headquartered well, more accounting Dallas we would probably be closer to 500 people located in Texas.
If we were to move those people into New York, Connecticut, Boston, Chicago the expenses running our business would be significantly greater. And lastly, we access our international business through our London office and I can’t over stress this. You will see a number of the peer companies setting up offices in Dubai, Singapore, Hong Kong, Rio.
We can access that same business out of the UK operation. We are specialty insurance company, if somebody wants to play specialty business they are going to go to a double AA rated S&P company and they are going to come into London market, if they are looking for capacity on a difficult risk they are going to come to the London market. We don’t have to set up our business all across the globe to see this business.
It’s not that we don’t get a big thrill out of having HCC in 55 jurisdictions, it doesn’t do anything for you to shareholders and it really doesn’t do anything for us, it allows us to have management control over the underwriting in the business. So we have avoided that structure.
The other problem you have with setting up offices in all these third world countries is that you have to deal with the legal jurisdiction, you have to deal with OFAC, you have to deal with all the attended problems and you have to deal with the court system in all those countries.
The UK well it might not be perfect, it’s pretty damn good place to operate. Most importantly, the characteristics that makes us different is our underwriting talent. This slide reflects our executive and underwriting management. The executive management’s job is to stay out of the way of the underwriters. And I think we are trying to do a good job of that but the underwriters might disagree with you from time to time.
I would like to point out two people on the slide, Craig Kelbel, 35 years in the industry, 13 years with HCC; Michael Donovan also 35 years in the industry and 29 years with HCC. One of the reasons I want you to think about this slide is when our underwriters present today, you’re going to see similar slides about their operations.
You will note the stability of our underwriting talent. We’re virtually no turnover in underwriting talent. It’s one thing to have a stable underwriting team when your combined ratio is a 100. It’s quite difficult to have a stable underwriting team when your combined ratio is in the mid-80s. Mid-80 underwriters can move, mid-100 underwriters keep their head down and try and keep their job.
How we’re able to attract the underwriters is because of our compensation policy. It’s important that our compensation policy be understood, be fair, be communicated and consistent. So how do we pay for our underwriters, we pay for performance. We don’t pay for premium volume. If you are running your company and you wanted to pay somebody big for their results, you want to pay them, you want to make money and let them make money when you make money. That’s the basic premise of our compensation policy.
Underwriters receive a bonus which is a percentage of pretax underwriting profit. Generally, a pool for the underwriters is 10% for that individual unit’s pretax underwriting profit. Investment income is excluded. So there is no benefit to go out and write a lot of premium so that you can generate the investment income on that book of business. So it’s pure, pure underwriting profit. There is no benefit of increasing your gross written premiums for the sake of writing more premium. Two-thirds of their bonus is paid in cash, one-third is paid in cliff vest and restricted stock.
So if we have a year and underwriters performance as measured by the home offices the combined ratio of 85%, and we pay out a bonus based on 85%. One-third of that is held back, say, for four or five years depending on the line of business.
At the end of that period of time, we true up that number. If the 85 business let's say is a 100 we call back that one third. If the 85 turns out to be 70 we pay them the difference. That attracts underwriting talent. A lot of the teams that Bill Burke is going to talk about today, we acquired from peers and we were able to acquire them not because they had a bad combined ratio but because the company did poorly and they did not have well designed compensation plan.
So the good guys that work for peer companies can leave and the bad guys stay in the peer companies. That's the differentiating factor between HCC and our peer companies. The cliff vested stock as I said is subject to call back.
Tony O'Connor writes a CAT book. Tony O'Connor had some CATs last year. Tony O'Connor didn't get a bonus last year, sorry Tony. And why does it work. It works with HCC consistently makes an underwriting profit.
So if we were a company that averaged a 100% combined then we would have to come up with some other bonus pools in order to be able to pay our underwriters. And you would be very unhappy with us because we wouldn't be paying for performance; we would be paying them stay bonuses. And that's not what we do.
Let's talk about performance versus peers. The most important metric that the board looks at is compounded growth in book value per share. So this is a chart and on the vertical access it shows the average book value per share growth over a five year period of time.
On the horizontal access it shows the volatility of that result. So as the further to the right you go the more volatile that result is. So if you look at this and you can see on the CB which is Chubb. Chubb had about 11.4% average return on book value per share but they had a volatility of about 9%. There it is.
Now if you look at HCC, HCC had 11.5% growth in average book value per share but had a volatility of 3%. So what this graph tells you is that we continue to perform at the top of the scale but with substantially less volatility than any of the peers.
As a confirmation of this, let's look at a few slides VJ Dowling has developed. And he uses a concept which he calls his value creation which is compounded growth in book value per share plus dividends. You can see HCC under a total value creation concept over a 15 period of time does pretty well. Does even better over the last 10 years. Over the last five years it does even better. Now why are there more companies because a lot of the companies weren't in existence in 15 and 10.
Over the last year we didn't do quite as well but it’s a little misleading, so if you think about it. In 2011, we bought back $375 million of our stock at prices below book value but above tangible book value per share. So that's going to have an impact on your total value creation calculation. And there's a few anomalies. If you look at the companies to the left of HCC, you'll notice such things as one time dividends and sales of subsidiaries which have affected the results in the short-term. And you'll also see AIG doubling their profit in 2011 because of the $17 billion release of tax valuation which effectively doubled their earnings in 2011.
So over the long-term these special items will even out and HCC will continue to outperform our peers. Let's look a little further. Let's look at combined ratio and volatility. So now the vertical axis represents the average combined ratio with the best performance at the top of the scale and the worst performance at the bottom.
And then if you go vertically it represents a volatility with the most volatile results on the left hand side and the least volatile results on the right hand side, so where you want to be? You want to be in that top right corner, high performance low volatility and you will see even on a combined ratio basis HCC is at the top as far as performance in the top and frankly even better. So how does it look on a shorter period of time five years give you a guess, we are in that top right hand corner. So I think this proves to you that no matter how you look at it we outperformed peer companies with substantially lower volatility than our peers.
You often ask me what is the return and equity target for HCC, so let me show you. The bottom red line represents the risk free rate. We defined the risk free rate as a 90 day T-Bill rate. The blue line is HCC’s actual performance and average return on equity from the period 2000 to 2011. The delta or the difference between the two is a number that we are looking at or our average return on equity minus the risk free rate. If you do the calculation, you will find out that our average return above the risk free rate for the entire period of time is 9.9%. HCC’s targeted return on average equity overtime is 10% above the risk free rate.
And we believe this is a goal that we can achieve. How do we use our capital? Most importantly, we’d like to grow organically. We can grow organically by product, by geography and as a result of an improving economy. Bill Burke will talk about product, Adam Pessin will talk a little bit about geography but it extends to all our lines of business and all of our segments and the economy is something that we’ve been living with everyday for the last five years.
When there is a general increase in economic activity, HCC will grow the business and continue to produce acceptable margins and grow the bottom line. We anticipate that it will happen but we can’t tell you exactly when. We can use our capital to attract new underwriting team, but usually it's not a tremendous demand on capital. We tend to acquire underwriting teams of two to five people as oppose to some people who acquire underwriting teams of 50 people and why.
If we were to acquire an underwriting team of 50 people to write D&O business in Hartford, Connecticut, you might think that those 50 people would feel compelled to write business. Bill will go into two of our new lines of businesses and how we address those today but we’re not really interested in putting big teams of people on there and say don’t write any business because that’s not human nature.
Acquisitions. We remain active in the M&A market. It hasn’t been very attractive. There is a dislocation between what the seller wants and what we want to pay but we still remain active. We’ve seen every deal that’s out there and we’re not apologetic for not making any acquisitions because we haven’t seen any that we could discuss with you and feel good about that we made that acquisition.
Dividends. This week we announced our 65th consecutive dividend. And 2011 was the 15th consecutive year where we increased our dividend.
Share repurchases. In 2012, we repurchased $126 million in shares and since June of 2010, we repurchased $535 million in shares at an average cost of $29.67. Those are some of the uses of our capital.
Before we go into Aviation, I want to make a final comment about our investment approach. We remain conservative but we made a minor change. We've decided to invest about 5% to 10% of our investment portfolio in high-yield dividend stocks and bank loans. This diversifies our portfolio and shortens our duration, without impacting the portfolio's average rating.
I'm sure at this point you have questions for me, but I'd like you to hold them till the final question-and-answer session because I anticipate that many of the questions you're likely to ask will be answered by the underwriters on the panel. Now, to our underwriters and our stress test. I'd like to introduce Michael Donovan, our first panelist. Michael is responsible for Aviation business, which was the first focus of HCC. Michael?
Thank you, John. Thank you very much and good morning everyone. As John mentioned, my name is Michael Donovan. I am the President of Houston Casualty Aviation. As John showed in the previous slides, I have 35 years of aviation insurance experience, of which 29 of those 35 years have been with Houston Casualty. That gives me I think the distinction of being the current longest serving employee of the company.
More importantly to me this morning, when I was brushing my teeth, I realized that I'm almost halfway towards qualifying for my own personal jubilee. And with the recent celebrations and events over the weekend, I have to tell you excitement is building for me. And so, everyone in this room in 30 years' time we'll be back here and it'll be beer and wine on me. So I just want to get that out of the way right now. So, anyway.
So this morning I would like to just spend 10 minutes or so just to explaining to you some of the specific differences between our three Aviation divisions. Not so much as far as why we write business through three aviation companies. How we see the business, the different types of business that we write, the different approach to underwriting in each types of business. And I think just as importantly, what sets us apart from our competition.
When HCC was established in 1974, aviation was the foundation of the company. And so for the past 38 years, the Aviation division has provided consistent, creative and diverse coverage to global network clients. Houston Casualty Aviation consists of three companies, namely Avemco, U.S. Specialty and Houston Casualty. Each of these companies is unique in their approach and execution of their aviation business. And I will go into some of the specific differences in just a moment.
Our growth and success has been achieved through the support and experience of our managers, our underwriters, our claims adjustors and our technical support staff. Many of our underwriters and support staff have been with the company for over 20 years. And in fact, if you look at the senior underwriter management structure for each of the three aviation companies, you can see that many of these key decision makers have been in the aviation business for over 25 years, and during that time have worked with either Avemco, U.S. Specialty or Houston Casualty anywhere between 15 to 20 years.
This degree of employee tenure and experience within our three aviation companies allows us to confidently and successfully navigate our aviation book through the periodic cycles of our business. In total, we have about 100 employees who provide us underwriting, claims handling and technical support services, which between them supports an average annual premium of $155 million involving approximately 40,000 policies.
So why do we have three aviation companies? Well, in 2011, these three aviation divisions of HCC wrote $155 million of aviation premium, which is split $88 million of U.S. business and $67 million international. In order for us to achieve diversity and flexibility within our aviation book, it's very important for us to look at each class of business differently. And to that end, we have three separate and distinctive insurance companies, all providing aviation insurance coverage, but each one approaching and underwriting the business in its own unique way.
So, let me give you a brief overview and a reminder of some of the key differences between each of these three aviation companies. The first company which I'm going to talk about is Avemco. Avemco was founded in 1961 and acquired by Houston Casualty in 1997. Avemco is one of the oldest and widely recognized aviation insurance companies within U.S. In addition, they have the distinction of being the only direct aviation insurance company in the U.S.
So instead of discussing with an agent or a broker or negotiating with an agent or a broker your business and have him negotiating on your behalf, you can actually talk directly to an Avemco underwriter. In addition, an aircraft owner can obtain certain quotes directly online through the Avemco online coaching system. In terms of the type of business, Avemco caters only to the private business and pleasure segment of the U.S. aviation industry.
They do not like any commercial business whatsoever. And all the businesses that Avemco writes is domiciled within the U.S. From an underwriting perspective, their underwriting is performed on a matrix rating basis. So it's a very, very standardized format of rating. In terms of the size of Avemco, Avemco issues on average 28,500 policies each year with an average annual policy premium of $1,150 each policy. So that's the first company.
The second company that I talked about is U.S. Specialty. U.S. Specialty was acquired by Houston Casualty in 1997 also. And the only thing that U.S. Specialty has in common with Avemco, other than being owned by HCC, is that they also only write U.S. domiciled aircraft. However, beyond that, there are minimal similarities between the two. For example, all the business that USSIC or U.S. Specialty receives comes through licensed brokers and agents.
Also whilst U.S. Specialty does write some private business and pleasure policies, which is what Avemco writes, the majority of the business that U.S. Specialty writes is considered both commercial and specialty business. So for example, helicopters, cargo carriers, commercial fixed wing operations, that type of business would typically form a part of the commercial book.
Whilst on the specialty side, the specialty business would typically involve unique classes such as war birds, classics. It's going to be war birds, antiques, classic aircrafts, as well as transitional pilots. Each of the USSIC policies is individually underwritten and customized based on the unique requirements of the aviation operator. And each policy is rated on a semi-matrix basis, which allows for greater flexibility to meet the individual requirements of the commercial and specialty risks.
On average, and again, just comparing the size of company, on average USSIC issues around 11,500 policies each year with an average annual policy premium of $4,500 per policy. The third and final company is Houston Casualty. All of our international business is written by Houston Casualty. In fact, the aviation business written by Houston Casualty spans back to the formation of the company in 1974. And over the past 38 years, HCC has become an established and recognized market leader in the international aviation community.
Now, the international business comes to Houston Casualty through a variety of different sources. Typically, it would be (inaudible) brokers, local brokers, reinsurance brokers, local insurance companies, reinsurance companies, as well as various direct relationships that we have with regional insured’s. At the last count, Houston Casualty wrote business in 70 countries, spanning from Azerbaijan to Zimbabwe. From a premium volume perspective, our largest geographic regions are traditionally Latin America, Africa and the Pacific Rim.
The business that Houston Casualty writes is very diverse and includes classes of aviation such as military, government and police operations, second and third tier airlines, commercial onshore and offshore helicopter operations, and passenger charter operations, as well as cargo airlines. In addition, Houston Casualty quotes and leads very unique and specialized risks such as dirigibles and UAVs.
However, not all risks are attractive to Houston Casualty. There are classes that we don't write. Classes that we don't consider would be, for example, and as John mentioned earlier, U.S. airlines of any size; major flag airlines, and a flag airline would be something like a British Airways, a Qantas or a Lufthansa; major manufacturers, for example Boeing Airbus or [Trent Whitney]; and airports. We don't consider airports.
Now most of the business that Houston Casualty writes and leaves is written on a participating on a quota share basis. And this is strictly because of the size of the limits and exposures on the international account is fairly significant. In contrast, however, both Avemco and USSIC writes and retain a 100% of the business that they write. And that's simply because their limits and exposures are much smaller and much more manageable.
In terms of size in comparison to Avemco and U.S. Specialty, Houston Casualty issues around 375 policies each year with an average annual policy premium of $200,000 each policy. And all of the rating of this business, because of the uniqueness of the clients, is again totally customized based on the unique exposures of each risk.
Areas of recognized leadership; so each of the three companies that I've just described are recognized as market leaders and experts in certain classes. For example, Avemco with over 60 years of writing private aviation risks are considered to be one of the most knowledgeable and respected insurers within that class. U.S. Specialty's area of market recognition is their specialty group. They are the largest insurer of war birds, antiques and classic aircrafts within the U.S., and they're recognized as a worldwide expert in this very, very specialized filed.
Houston Casualty is considered the market leader of military, government and police aviation policies on a worldwide basis. Types of aircrafts, for example, the military book would typically range from fighter jets such as F-5s to heavy transport aircrafts such as Hercules, reconnaissance aircraft, as well as an assortment of training aircraft.
In addition, the military book and police accounts include and involve a number of western and Russian built helicopters that are used for a number of challenging and very varied uses. In addition to that, Houston Casualty is recognized as the market leader on second and third tier airlines, as well as commercial helicopter operations.
So what sets Avemco, U.S. Specialty and Houston Casualty apart from our competition? Well, several factors. First of all, we have very experienced and knowledgeable underwriters, claims managers and support staff. Secondly, it's our creative and often unique approach to underwriting the traditional and more challenging risks. So, in another words, looking at the risk differently, rating it differently, and maybe looking at different transference of risks.
In addition, we provided a reliable and consistent line of aviation insurance products now for over 35 years. Whilst we're always looking for opportunities to grow the business, we would never sacrifice integrity and underwriting discipline that the Aviation division has always subscribed to. And finally, it's really our ability to provide a consistent profit to the company and shareholders every year, despite the cyclical and often challenging nature of our business.
Okay, historical results; since 1974 Houston Casualty has written well over $3 billion of aviation premiums; with almost $2 billion of that having been written during the last 10 years. The past 10 year loss ratio of 58.8 compared to the prior 2001 loss ratio of 63.5 was achieved as a result of improved market conditions, greater geographical spread and increased diversity throughout our entire aviation portfolio.
Okay, moving onto the most recent financial results, whilst the gross written premium in 2011 was down slightly from 2010 and net written premium as you can see for the same period grew as we increased our retention on the international portfolio which continued to provide profitable and consistent results. So if we then compare the first quarter of 2011 against 2012, we can begin to see the benefit of the increase in both the net written premium and the earned premium following our decision in April of 2011 to increase our retention on the Houston Casualty book.
So in closing, I would just like to say that whilst we are always looking for opportunities to grow our aviation business, our overall gross written premium is always going to fluctuate, its always going to fluctuate based on the degree of competition and opportunities. However, our ultimate goal of each and every underwriter would always be to maintain the same underwriting fundamentals, the philosophy and the discipline whilst we folks on the bottomline underwriting budgetary goals.
So that kind of hope gives you a general summary of the three companies and I am quite happy to answer any questions if anyone has any.
Hey Michael, a quick question for you, over here Michael. On the international book where the premium, the average premium is much larger perhaps you could provide us some perspective on the competitive forces in that marketplace; it would seem because of the premium size that there will be a natural attraction of other companies to that marketplace trying to write that business and perhaps with that as a background give us a sense of how pricing is on that side of that business?
The international account is really broken down into several segments; from the military book to the airline book to the helicopter book. There was some level of pressure on that business; we find the areas in which we have recognized leadership and let’s talk about for example, the military book, which is an area that does provide a lot of premium, but equally it’s an area where if you are underwriting incorrectly the fallout could be significant and so whilst Houston Casualty who has been a leader in that business for I am going to say close on 15 plus years now as a recognized leader and we probably lead 90% of that business. It’s not as much because of the pricing, it’s because of our knowledge and our experience in how to handle the claims and how to handle the politics, the culture; it’s a very different style of underwriting.
And so really for us, yes of course price is important, but really we are recognized as a leader in that class and we are able to maintain a consistent position because of our experience and because people have recognized our ability to negotiate with obviously a non-commercial part of the business and that’s really taken a number of years to get to that point.
In terms of rest of the business, there is competition in different parts of the world on that book and obviously we look for opportunities and we’re going to continue to focus on the business that is providing acceptable returns and so it’s just kind of taking each step as it comes.
Well two things that are unique about the aviation business, one is Michael gets a fee for leading the business which is not normal in other class of business. And another thing is aviation businesses I think the only class of business left that has tier pricing. So if you are the leader and you are AA rated company, you get one price; and if you are a follower and you don’t have an equal rating, you may well get another price. Now you know that you’re getting a different price and your decision whether or not you want to participate because it is a capacity market.
Who, just to give us a sense were other tier-one underwriters of the business?
Well, it really depends on the class of the business. I mean, there is, on international business, it could be, I mean, if you look at London, it could be anyone from, for example, Allianz, it could be Excel, it could be Global, it could be Charters, but again those underwriters, some of them do write the business we write and then some of course would lead the business that we write and then they would lead the business that we don’t write. So it’s kind of very much a cross section.
Mike, I just wanted to ask on the, you mentioned, you’ve kind of highlighted that Avemco is the only direct aviation company. I just want a sense of why would that be the case or other companies don't establish direct businesses and how much of Avemco’s business is direct?
Well, 100% of their business is direct. None of their business goes to agents or brokers. To be honest, its taken Avemco 60 years to really refine this and they are the most recognized and they are literally the premier specialist private insurer within the US; and to be honest, I mean other markets have tried in the past, but have not been out to get the market impact or the customer impact that Avemco has always been able to maintain. And I think that unless you've had the experience and the history that Avemco has now sustained its going to be very, very difficult to be able to duplicate that.
And in other insurance markets, you've got, either you pay commissions or you advertise to make sure your awareness or your customer awareness is high, is there an advertising element of this business?
Absolutely, I mean that's really for Avemco, I mean them getting their name out into the public domain is almost the same as the broker going out and representing you to 15 different markets.
If you were a pilot, you would know Avemco. There are probably not a pilot that flies a fixed wing aircraft with a propeller on it that doesn't know Avemco and that its pretty in-depth advertising program. Because of time, we can catch up some more aviation questions later, but I think we ought to go to Tony now so we can keep this moving. Tony?
Thank you. Just a general background; my name is Tony O'Connor and I head up the Property Treaty Reinsurance division for HCC. I have been in the industry now for over 22 years working both the Lloyds of London underwriting market and also the company market. I joined HCC just under three years ago, with two of my underwriters, they are very experienced, and worked close with me for the last seven years.
Just a general overview of our portfolio; we’ve got approximately $130 million of income. We have been generally property catastrophe treaty excess of loss underwriters. Our portfolio splits around 50% North America and about 50% international. We believe we are having this good geographical spread in the medium to the long-term it will produce the greatest profits. And we will analyze a bit later exactly how our account has performed.
2010, our first year of underwriting; over 300 catastrophes, over $43 billion of losses, and throughout 2011 was the highest among international CAT losses ever. The Chilean earthquake in February, over $8 billion, the largest international quake loss, followed by the New Zealand loss late in the year and a whole raft of medium-to-smaller sized losses, so a great year for us to begin our portfolio.
2011, our second of underwriting; we have 325 CAT’s over $116 billion losses and still counting and arguably the worst year on record or potentially the second worst year. If you look at some of the claims, three international CAT over $12 billion; the Japan earthquake of $35 billion, the second largest loss ever, only Hurricane Katrina being greater; Thai floods, $12 billion to $20 billion and still counting; New Zealand, $12 billion plus whole after smaller international losses. Not to be undone by this, the USA had the highest number of tornado losses ever over $20 billion; one of those tornadoes at $8 billion, the largest ever tornado; so a great second year of operation.
So how do we perform? Well, in 2010, we’ve earned income of just over $47 million and with the vast international losses we still produced a loss ratio of just 58% and still turn in the underwriting profit of just over $7 million.
2011, arguably the worst year ever in insurance history for catastrophe losses; we still turn in an impressive 80% loss ratio with just a small underwriting loss. If we take 2010 and 2011 combined, those two bad years, we still turn a profit of just under $4.5 million. Fast forward to first quarter 2012, with just $22 million of premium, we produced (inaudible) profit of just over $14 million. So year-to-date first quarter, the property treaty account is $18.5 million in profit.
So how do we compare to our peers? If you look at this graph, it shows statutory losses as a percentage of the company’s equity for both the 2010 and the 2011 underwriting years. The blue line illustrates the effect on 2010 and the red line is 2011. You can see from this slide that in 2010, the average CAT losses as a percentage of equity was sort of 5% to 10%. In 2011, it was close to 15% to 20%. [HEC] which I’ve highlighted in the red circle there, we massively outperformed our peers.
So what's our strength? The one way to truly judge how good a proxy treaty CAT underwriter is; it’s held like the boom in events of severity of losses. We are one of the very few people in the world who can turn around and say that during 2011 and 2012 we still return an underwriting profit, very few re-insurers would be able to say that.
As you look at the last slide, 2011 for us was an earnings event with approximately 1% of our equity versus 12% to 15% of our peer group and some re-insurers being well over 20%. Some of the things that make us different; we have the willingness and ability to walk away from business if we’re not happy. We walked away from our two largest US clients, the first during this year. One was a major farm bearer with considerable tornado exposure. We walked away from the level when the pricing wasn’t adequate. That decision at hindsight has saved us millions of dollars in potential losses. We walked away from another major US client, a rate deduction; we would not support a rate deduction.
In the international arena, we walked away from the largest Japanese mutual. It paid of a 50% increase. We walked away because we felt compared to the other companies within the region it didn't pay enough. We are one of the only people in the world to walked away from that major account. That makes us very different.
We are able to manage our aggregates through any cycle. Initially we decided we are going to re-underwrite some of the levels of our portfolio. We are going to save some (inaudible) later in the year, we think there will be better return and on that instance the we cut back our US aggregate by over 14% and Europe on just over 23%.
Another thing that makes us different, our underwriters, they underwrite the insurance company. They do not use proprietary model to determine whether or not it’s a lot of risk. We look at the proprietary models; we don't need that influence underwriting decisions. As an example, some of the major Texas or Florida accounts you've seen in the press, we declined both of those. It moves that perfectly well, it's got fantastic pricing but in the event of a major catastrophe we think it would severally underperformed compared to other worldwide companies within the region.
Again our client selection has enabled us to outperform our peers. The AA rating has huge benefits. Clients in the event of a major catastrophe want the comfort; want the security knowing that the last person to pay would be the best weighted carrier. The top end of the programs, we think have the highest margins that are where we like to play, for us it’s a huge advantage.
How do we manage our aggregates? At the beginning of any underwriting year, we determine in each of the countries and regions around the world how much aggregates we wish to deploy, we don’t fill in every part, we don’t maximize it for every single country. And as you can see there as an example U.S. [wind], Europe [wind] and Australia [wind] the various tops of levels and comfort we have in those regions. On top of our writings, we purchased $86 million of catastrophe protection in an event of a major CAT this gives a great comfort and it protects our surplus.
So how do we manage our aggregates? We have two methods, we analyze in our RMS 1 fund in 250 but we also have an internal PML. We monitor aggregates that are highest of the RMS number or internal PML. And our internal PMLs are based on a 100% exposures. And in many circumstances our internal PMLs are higher than RMS and at that stage we stop writing. This ensures we do not overexpose in any one given region.
What’s the state of the market but as you expect after 2011 the whole after losses the conceivable rates improvements around the world with areas having significant losses in excess of 50% and some areas without the losses paying around about 5% plus. We achieved a high average rate than our peers. One simple reason, we focus most of our capacity to the mid to the top layers. The highest rate increases were given on the highest layers, the smallest on the lower layers. That was mainly due to the minimum pricing for capacity that was required.
The change in the RMS model has had some impact depending on the company, depending on their use of the model or depending whether or not to use a blended approach. But we have seen some opportunities on the back of the change in RMS.
Our competitors, we’ve seen some of our competitors, some of them major reinsurers cutting back in Japan, cutting back in Europe, cutting back in USA. There is not a lot of new conventional capacity out there. The new capacity tends to come from the capital markets.
So what's our future, we have a fantastic base of over 500 clients. We do have the ability to expand a portfolio if we believe the pricing and if we believe the market is right and throughout the summer period would go, we would analyze our portfolio and then we will make a decision whether or not it's right to increase in 2013.
Our underwriters were rewarded in the bottom line. There was zero incentive for any of those to grow the top line because we rewarded purely on the bottom line.
We have seen some increase in demand because of the pricing modeling. We still think that will further enhance going forward. And most importantly, our AA security, some of the highest in the world gives us an advantage. A lot of our clients demand, they want they want better security that gives us huge options in the future to expand if we want to.
That concludes my presentation, any questions?
Question -And-Answer Session
What do you expect your average renewal rate for June, July US renewals to be?
It depends you are looking at the float and (inaudible) that have been flat to plus 5 and that is being lowered than typically specifically the US and that is because one, the floating rates environment is very, very high. And two, there has been an influx from the capital markets which help keep the prices down but overall when the top lads depends double digits in Florida its still pretty good. We still expect minimum 5% to 10% in the US business, thank you.
You put out the PML limits, do you have limited in terms of percent of equity that you have your PMLs that you are going to disclose or is that?
We disclose it in our Investor Presentation, one in 250 top is 5% and 100 to roughly 2.5% we haven’t approached those levels. The way that aggregates work is at the corporate office, the Chief Risk Officer, the Chief Underwriting Officer determines the over all aggregate for the company and then that is allocated back to lines of business depending upon the return on capital. And so for HCC we are not close to those numbers yet.
We are not approaching those numbers but that’s our risk appetite at the moment and one thing about the property tree business is we built overtime a portfolio businesses. This is just another part of our portfolio. We don’t want it to ever overwhelm the overall portfolio and I would say the maximum percentage of the total premium volume of HCC will be 10% and it’s about half of that right now.
So if I understand this right, Tony you joined the company three years ago?
Yeah, in 2009, that's correct.
And can you give us the background of why you decided to do that? Did HCC have these lines before just a little bit of case study of underwriting team that joined HCC?
Yeah. I have been with HCC for over 15 years as a reinsurer. And my previous homes are reinsured and I have led some of their property business and some in the energy business. I know the management of HCC very well. They know me very, very well. My results prior to joining HCC were excellent. My results were right in HCC business were excellent and rather than HCC looking specifically to get into property treaty business, HCC approached me on the fact they knew me well and they knew my results.
And who were you working for at that time?
I started with at nine years at Transatlantic Reinsurance Company, working at London, New York Corporations, I then set up with Lloyd's Syndicate to Argenta Syndicate I was there for six years and then I went to a company to work in Berkshire to head up their worldwide property treaty and they transformed into the entire syndicate which was (inaudible) because of the HCC.
Now were you collecting a part of the profit pool in net comp structure or what was the motivation to leave what you were doing before?
To write on a bigger scale. The opportunity we always had, AA security is usually beneficial, to have the opportunity to grow to the level, and have the autonomy and backing from the management to grow how we would like to see you, much more flexibility.
As this book-of-business grows and you start to approach both the premium and PML thresholds that you guys have set at the company, would it alter your philosophy around capital management and the timing of buybacks?
I really don't think that as we look at the overall portfolio of business and as we look at our strategic plan, we pretty much figured out where we are going to go with this business over for the next five years. So I really don't think it will have any effect on it. We have been very fortunate that we bought all the reinsurance we wanted to buy at very attractive prices. When we went into the renewal market this year for reinsuring this account we were told that we had to make decisions in like five minutes or otherwise the capacity was going to go away.
But the fact of the matter is our results were so good at the reinsurance at the end they wind up to participate on the program. So we are very comfortable with where we are. I think investors think because we are in the property treaty business the catastrophe losses over the last two years have hurt the company. In fact, we made a profit and one of the things we wanted to point out to you today as in two worst years in history 2010, 2011 we've actually made a little bit over $4.5 million underwriting profit.
And you can see by the numbers in the first quarter what happens when you are having normal catastrophe at a period of time it’s a pretty significant gain. So I think the volatility that it puts on the book is minor compared to the overall and I think we have it planned out that we are not going to let the property treaty book overwhelm all the other specialty businesses we are in.
Simon? Simon has been looking forward to this for a long time.
You are welcome. My name is Simon Button and I am the head of the Energy Underwriting at HCC. You would be pleased to hear I'm the last Brit on the panel, so I am going to talk hopefully you understand everyone is talking about. To say I want to give you a brief insight into who we are and what we do. First the introduction, I am the head of the energy team that works in underwriting since 1984. I have worked at both the company in the Lloyd's market and joined HCC in 2000 when the London operations commenced.
I am assisted by Dave Shepherd another 25 year plus veteran of energy insurance. Dave comes from an energy claims background given us a clear insight into that side of the business. We also have two support underwriters completing the team.
We are represented in one location only London, why is that? Well, London’s the center of the energy insurance world. It’s estimated that 80% of global upstream energy insurance resides or passes through London. This profile has increased in recent years, a trend we expect to continue. We underwrite all of our business through brokers and each of the major brokers have their energy division based in London.
The Lloyd's market alone underwrites over 60% of worldwide upstream business. We participate on subscription or shared basis without the carriers. On average we take 5% of the business we write, we write without this which allows us to dilute costs share expertise and resources.
We aren’t represented elsewhere in the world why not; well in our view operating additional locations brings few advantages but brings extra expense dilutes market share, internal competition and confusion to intermediaries. Why does London continues to dominate? We see list of advantage and change in this policy. Our understanding is for example results in another major hub Singapore have been very poor and a lot of carriers there are looking to withdraw capacity.
So to summarize we are tight centralized and focused units, easy to manage and highly cost effective. This slide illustrates our results between 2005 and 2009. And also shows the impacts of hurricanes Katrina and Rita in 2005. I should point out after this dates its high between 2000 and 2004 we had a combined loss ratio of that period of 43%.
Katrina and Rita resulted in combined energy market losses of over $8 billion; with each alone being the largest sector loss ever recorded to-date. For some context this compares to an annual global energy upstream premium that’s on around $2 billion per annum.
For HCC, this contributed to a loss ratio of 190% in 2005. Following these losses, the market hardened through 2006, allowing us to impose wholesale coverage and processing changes. As an example, for the first time, annual limits on wind perils were implemented.
We use this opportunity to increase the size of the book and capitalize our market difficulties. As you can see, this policy has resulted in strong results for 2006 and beyond. The next item highlighted by this slide is the result for 2008, hurricane Ike. Ike caused an estimated insured energy loss of over $3 billion. However the changes imposed by us resulted in a positive result for that year with a loss ratio of 43%.
Turning to more recent years, this slide demonstrates that the possible trend for HCC has continued despite difficult years for the energy market generally. 2010 was notable for claims to the energy market emanating from the deepwater rise and disaster in the US Gulf. Losses on this accident is still unwinding, however it is likely to now be the largest energy non-wind loss in history overtaking the Piper Alpha tragedy of 1988.
For us, this loss is fully developed with no further deterioration possible due to our conservatives for the insurance purchasing and to our limited exposure to liability placements potentially impacted by events surrounding this claim.
2011 as in the words of [Willis] and I quote being the worst on record for energy non-winds storm losses. We have not been immune to this however we have managed to successfully navigate through this period and achieve the strong result for the 2011 year. 2012 to-date trending positively against recent years. The offshore trading market post (inaudible) we are now safe than ever we believe we may be starting to see the benefits floating through its underwriting results.
If you look at the combined figures from 2005 including Katrina recently we can report on the following. Net earned premium $377 million, loss ratio of 43.3 and the underwriting profit just under $90 million. To get some context in these figures we can do some outline and analysis comparing ourselves to Lloyds. If you remember Lloyds writes around 60% of this market class and they report their figures publicly.
We don’t account on the same basis but it gives an insight into how some others [aren't] necessary doing as well as us. So I go back to slides for the 2005 year when we had our loss ratio of 190%. Lloyd's reported a 300% loss ratio. For 2008 hurricane Ike we had a loss ratio of 43%, Llyod's reported a 118%.
For 2010, we had our loss ratio of 22% and Lloyd's is currently reporting 67.5 as I said earlier we expect substantial deterioration due to losses around the deepwater rising events. If you look at the seven years combined figures, our number 47% lowest in that period in time, 76% again with development for potential worsening. If we look into some further detail of the large (inaudible) the last couple of years. We can see continued volatility with risk losses totaling up to $8 billion.
And that's in the absence of the Gulf of Mexico loss in that period of time. Again for context, we believe upstream annual premiums to be in the region of around $3.5 billion. For comparison, we can see our claims figures on the right after reinsurance for these results for these losses, resulted in losses of under $10 million, even though we got a market share of around 3.5% of worldwide premium.
So what makes up the portfolio we underwrite? The majority of our book is short tail offshore business; for example, oil platforms, pipelines and infrastructure. We focus on quality of assets, the safety record of the insured and strong relationships. We also write upstream onshore business; for example, drilling rigs, production assays, pipelines for storage. We don't cover the underwriting of downstream books; for example, refineries, petrochemicals or oil sands.
Around 10% of our book is offshore construction, which is a long tail and has historically been a difficult account for our profitability. To keep balance in this book, we keep our participation small and reinsure extensively. We are highly selective and have experienced very profitable results.
We also underwrite a small and selective book of offshore drilling contractors subject to extensive reinsurance. We avoid or reinsure liability exposures where possible, and this segment comprises less than 2% of our book as a whole. It was this stance on liabilities and drilling contractors that was the driver behind our loss experience from the deepwater Horizon event being negligible.
I'm often asked about our exposure to fracking as growing concern surrounds issues in the industry and to insurers. We do not write environmental liabilities from gradual pollution as a separate market for this and we don't participate in it. We underwrite just under 500 accounts and have a maximum gross line of $75 million. Although this has substantially reduced both facultative and treaty reinsurance.
We underwrite on three platforms. The first two have given us access to our double A rating, a real advantage valued by our sophisticated customer base and through lawyers, which gives access to licensing, which by way of example allows us to underwrite business in Canada where we have a sizeable presence. We have an average line size of 5% and rarely participate with more than 10%, which reduces our overall exposure to any one unforeseen event.
Turning to our geographic profile; we can see that the majority of our business emanates from North America. This chart is based on domicile of the insured and is not necessarily representative of exposure by region, where the largest areas are North America and Europe equally. You can see that we have limited involvement in certain geographies such as Africa, even though these are important hubs in hydrocarbon production.
The reason for this is the lack of transparency and increased acquisition cost doing business in these regions. Unless we can see and understand what we are underwriting, understand the local legislation, and feel we are equal (inaudible), we don't participate. We don't write treaties or delegate it to authorities, and (inaudible) ability to increase market penetration and allows us to maintain control over rating and exposure management.
We continue to be a major player in the U.S. Gulf of Mexico wind market. For 2012, this segment comprises around 12.5% of our portfolio. This slide shows a map of the Gulf overlaid with both theoretical and actual storm tracks. Every policy we underwrite is modeled using these tracks, as is the portfolio to each scenario. We help develop and utilize the (inaudible) offshore model, the output of which is used increasingly by the reinsurance market to benchmark their clients.
We continue to monitor development of the [RMS] offshore product, but currently do not believe it to be fit for purpose. Since 2005, we have written this book based on the highest of either a highly conservative 50% of total aggregate written or the [Equicap] modeled output, whichever is the greater. For 2011, we can see that the worst case Equicap 1 in 250 scenario is below our internal case.
We also compare ourselves with Lloyd's, which measures its syndicates using its own model. By this measure, only 19% of the exposure written by us is at risk. We believe this system is flawed and exposes Lloyd's to significant downside from a wind event. For context and reference, Hurricane Ike resulted in a loss of 30% of our aggregate written in that year.
So where is the market today? For 2012, we estimate we're right at top line of just over $130 million. This year will be our highest by this measure as being driven by increased rates and by higher risk awareness from our client base post-Macondo. When combined with high product price and healthy client balance sheets, this is creating more premium dollars for the market.
We have been in the positive pricing environment since Macondo with average rate rises of 7.5% in 2011 and 5% in 2012. Gulf of Mexico wind for this period has been flat. Price of last two years as both demand and supply have remained stable during this time. As stated previously, we have a loss ratio of 47% compared to Lloyd's figure of 76%. Once you add in the Lloyd's expenses and deterioration, the market is in the words of their regulator, and I quote, 'Energy is marginal at best'.
This language and a continued management attention to the volatile class is kept focused very much on the sector and prevented aggressive competition on new entrants. I should also mention there's a current disconnect between original pricing and the cost of reinsurance. Whilst the direct market has experienced rate increases around 12.5% over the last two years, reinsurance prices have risen by close as 30%. This is along with a significant increase in retentions is putting additional squeeze on margins.
So where do we see the future heading? Well, we see continued upward pricing continuing for at least the next 12 to 18 months, although a fourth wind-free may bring pressure to this sector for next year. We perceive continued market-imbibed nervousness with a feeling, as Tom said earlier, that we're only one major loss away from substantial market hardening.
We see fewer carriers in future, with smaller players unable to continue lacking economies of scale and unable to operate without reinsurance capacity, increasing the only economic to larger underwriters. We continue to look at subclasses. We're often asked about renewables. Forms a very small part of our book. It's a very high competitive book of business with European markets being extremely aggressive in this space.
We continue to monitor but don't expect to grow in the foreseeable future. Offshore liabilities, market capacity for this is hard post Macondo. This is leading to an improved market, although we believe the market is still in transition and we're waiting to see before entering. Downstream, i.e., petrochemicals and refining. We exited this market in 2011 after eight very successful and profitable years.
Our excess book of business will become difficult to defend against aggressive markets determined to achieve market share when the market turns, and we think we're starting to see signs of it. We are ready to move back in and capitalize. So in summary, we believe we have a proven track record of above average results, a balanced and conservative exposure profile, focused and selective underwriting with low fixed costs, and the scale or flexibility to change as the market dictates.
Thank you. That's my presentation. I'll happily take any questions.
Simon, it took you about three years to earn back the '05 loss. Given the compensation structure at HCC, what does that mean for your team's payout over that period of time? And if Hurricane Rita were to repeat again, given where exposures and pricing and terms are today, what would be the outcome seven years later?
Well, obviously it was difficult post the loss in terms of earnings. That's the price we pay. I think, for example, the Hurricane Ike gives us more representatives than Katrina and Rita. We and the market learned a lot of lessons in posing limits, changing pricing, and there's been further changes made. Post-Ike, the market is a lot more restrictive than it was. The model obviously hasn't been tested yet, but I'm confident that any loss would be even more containable than Ike was for us and we should be profitable through that.
One thing that Simon mentioned but since you're not in the business every day, it may not be clear, in 2005, if you're writing an offshore energy account, let's say there was $100 million limit. It was a $100 million limit any one occurrence. After KRW became a $100 million limit any one occurrence and in the aggregate. So in 2005, when you had three hurricanes come in, you could be exposed to three losses. The market made a substantial change. So when Simon was talking about 2008, that's why the results were materially different.
And in terms of earning back comp structure, 2006 very profitable, 2007 very profitable, but still had not earned back the '05 loss. Hope you and your team make lots of money. I'm just curious about what that means for HCC and how compensation works after a year of multi-year loss to pay back.
I came back in 2006. We put the new program in 2006, and 2006 we put the claw back into the program, okay. So the way that it works now it's unfair to investors to have profits in 2005, 2006 and be completely wiped out in 2007. So we've addressed it through the compensation program.
Simon, both you and Tony talked about the benefits of the rating and the balance sheet. Are you getting paid more for the high ratings of the company or is it just giving you a different look at the business?
It gives us a different look. We don't have differential pricing in our market, but it allows us to outpunch our way. To be honest, it gives us the top of the slip. Our clients are very advanced, very sophisticated. They want as much AA on their balance sheet as possible in terms of insurance. So it gives us a real competitive advantage but not in pricing.
Tony is it the same answer for you. Are you getting something on price because of the rating?
It is actually the same.
Well, again, we'll have a chance to revisit any other questions at the conclusion of the entire presentation. I'm Craig Kelbel. I oversee the A&H division of HCC. I'm going to go through a slide that kind of walks us through the evolution of the A&H segment. It really started back in May of '96 when HCC acquired LDG. LDG had about $100 million book of business medical stop loss business, which actually started the medical stop loss division.
At that time, we retained 5% and we ceded 95% of the risk. Actually, Chris Williams, the President of HCC, was our reinsurance broker at that time. So I've known Chris a long time and he is very familiar with our book of business. The next acquisition was in February of 1998 where we acquired GIR, which was a major general underwriter in Atlanta, which now is the headquarters for the A&H division. It had approximately $80 million of medical stop loss business.
If we move up to December of '99, we announced the acquisition of Centris Group with U.S. benefits. It had approximately $200 million of medical stop loss. And I actually was employed there before I joined HCC for approximately 10 years. In December of '99, HCC benefits close with approximately $200 million in premium, which we kept 25% of that business and we ceded 75%. It had not yet seen the influx of the business that we acquired with Centris. We saw that through the year 2000.
So when you get to the end of the December of 2000, we closed with $400 million of medical stop loss business in force. December of '03, we ended up with $500 million, primarily organic growth. We also changed our reinsurance program where we kept 50% of it and ceded 50% off to reinsurance. If you move forward to January of '05, that's where HCC benefits was with the NGO owned by HCC was merged into HCC Life Insurance Company and where we kept a 100% of the risk from there forward.
December of '05, HCC acquired an NGO called Perico. We also, at the same time, acquired another life insurance company, renamed it Perico Life Insurance Company in a primarily small group business, group employers, the size of less than 100 lives. The next larger acquisition was in October of '06. HCC life acquired the Allianz book of business. They exited the A&H business here in the U.S., which was approximately $300 million of business. $180 million of that book of business was medical stop loss.
The other product lines were HMO reinsurance and excess coverage. In January of '08, we acquired an MGU in Indianapolis called MMU. We renamed it HCC Life Medical Insurance Services. It writes primarily two lines of business, travel medical for individuals traveling into foreign countries from the U.S. to foreign countries or foreigners coming into the U.S. for healthcare coverage. And the other product it primarily sells is short-term medico, which is GAAP covered.
Individuals in between jobs, laid off, out of school that need temporary medical coverage. In July of '11, Perico Life's operation was combined with HCC Life to make better use of our capital. We didn't see a need to have two life insurance companies primarily selling the same product to the same market. In December of this year -- of last year, we ended up with over $800 million of enforced business and over $100 million of pretax profit; the first year that we've exceeded $100 million of pretax profit.
This is the organizational chart for the A&H division. You'll see that most of the folks have lots of years of experience. Most of us will be approaching our jubilees soon. We, at the team, has also been together for the duration. We've went through a lot of acquisitions. A lot of these individuals came to us through the acquisition. As an example, Mark Sanderford, who is our CFO, Larry Stewart, our Chief Underwriting Officer, Suzi Johnson, our Claims Specialist, we're all GIR employees.
J. Ritchie, Mark Carney were the old Centris or U.S. Benefits employees. David Grider was also a former GIR employee. So you can see that when we do acquisitions of companies, we look for the management team that can help us continue to grow the book of business in the A&H part. If you look at our financial results over the last few years, our premium from '10 or '11 grew around 7%.
Our loss ratio generally operates in a pretty narrow range, if you look over these years, within a point or two, just fairly predictable through lot of effort and a lot of hard work. In 2012, we began again to buy reinsurance. We now have a layer in excess of $6 million any one loss in 12 months to un-limit it. The reason why we bought reinsurance as a result of changes by PPACA, employers now have to offer to their employees’ unlimited lifetime maximums.
So we thought it was best to buy some protection for a larger run rate catastrophic claim. Having said that, the largest claim we've ever had has been $2.3 million. If you look at the current state of the market, you will see our new business has grown in '10 to '11. And certainly in the first quarter of '11 to '12, it grew fairly dramatically. But primarily driven by we wrote one large group of a pool of employers of approximately of $30 million. If we remove that, you will see our new business year-over-year is fairly consistent.
You'll also see our proposal activity has been strong. Even in the first quarter, it's declined some but some of that decline is as a result of taking Perico Life's proposal activities to all in one company. So we don't see the same group in two different companies. We only see it in only one company now. Our premium persistency continues to be at higher levels. I think John mentioned it, we know more about our in-force business.
We think we have one of the higher premium persistency in the marketplace, that's by design because it performs generally a little bit better than our new business and we just know a lot more about it. If you look at average rate-to-rate; it’s been fairly consistent, a little bit less than ’12 but we measure really the effective rate increase which takes into consideration change in deductibles, lasers or plan changes. We've seen an increased amount of activity employers increasing their deductible to buy down their rate increase. So a typical employer might have a $50,000 deductible to avoid a rate increase they might move that deductible to $60,000. There has been an awful lot more of that in the last 12 to 18 months.
The market continues to shift from MGU model. There used to be if you went back 10 years probably 200 or so different entities where you could go get a medical stop-loss. That's been reduced significantly to primarily direct writers. Let's say the market generally is made up of less than 10 that are in the market consistently these days.
The markets are also experiencing planned administrator consolidation. You will find the administrator is small mom-and-pop shops are now being bought or acquired by the larger administrators. We do a considerable amount of business with what we would call in our segment the Bookers which is Blue Cross, United CIGNA and Aetna. So we write on top of those plans.
Generally, an employer is looking to for divisions of checks and balances so they have a broker, they have a payer and they will have a re-insurer. Each one of them are kind of watching out for their wellbeing in plan design catastrophic claims and the management of their overall healthcare cost.
We've also seen a considerable increase of brokers’ commitment to self funding as an option. The self funded as a way in which to finance your healthcare has grown over the last few years; brokers seem to be gravitating to it. If you again went back 10 years, our business 10 years ago probably came 70% from administrators and 30% from brokers. Today, those numbers are reversed, 70% of our business comes directly dealing with brokers and 30% through plan administrators.
Our advantages in the marketplace; clearly, we are recognized as an industry leader. If you look at our long-term experience, we offer a pretty consistent underwriting approach. We are dependable, our rating certainly help us in our long-term relationships that we have with producers and brokers.
Consistent with HCC’s philosophy, we have a very flat management structure. We don’t have a lot of different layers to go to; if a client or a broker wants an answer they can call directly to a decision maker they don’t have to call a marketing person, that person calls an underwriter and then they have to go backwards in that communication back to the producer. So we are very keen on talking directly to our clients which could be the producers, could be the clients themselves in negotiating a deal that we think works for us and them.
We have a very large book of business for many years, so it’s very credible. We think it’s gives us an advantage to price at different levels, different options that an employer might choose. By our organizational chart, we certainly have a high level of experience in this business and we also have claims control programs that our competitors generally wouldn’t have. We have a preliminary claim, specialty claim unit to identify catastrophic claims that we think that the claim cost has been considered is higher than it should be or is higher than usual customer. Those two units have saved us $20 million in claims each for the last three years.
We also have a direct relationship with Mayo Clinic; one of the kind for in the self funded business. We use them primarily to help us evaluate transplant, not because they necessarily the lowest cost facility, but they have the best outcomes, which is an important part in delivering healthcare. It’s not only what you pay, but it’s also the outcome of the services you receive, especially for catastrophic losses.
And lastly, we have an ownership of Life Trac, which is a specialty transplant network, which prearranges prices for liver transplants, heart transplants, so that we can control our overall cost for those large catastrophic claims.
As we all know, we have the affordable Healthcare Act that’s being implemented over a period of time. I am sure you are all familiar about the Supreme Court is currently reviewing it and trying to consider whether or not some of those provisions are constitutional or not. We would expect an answer from them sometime in the latter part of June, first part of July. I have been told it will either be a Monday or Tuesday, I am not sure why, but so, every Monday and Tuesday you should watch out for an answer; if it’s not, its not supposed to happen at the end of the week.
Quite frankly, we don’t know what the outcome is, but if you looked at the current legislation, stop-loss is not considered to health insurance under the act. It’s important; we don’t have a loss ratio restriction, because we are not considered to be a health insurance, because we don’t offer coverage directly to an employee or participant, we cover an employer for their losses under ERISA plan.
Employers are, we think are expected from what we can read in our discussions with, employers will continue to offer benefits under the group structure that currently exists. Generally, the reforms now have applied to things that don’t really come into the pricing of our stop-loss product. Our average deductible now is about $90,000; most of the changes under the reform, really are smaller items that don’t affect catastrophic losses which were our claims that we cover.
Clearly, there is increased scrutiny on stop-loss on the small employers, less than 50 lives which is like 2% of our current covered lives. There is a number of states as you probably recently read California which has introduced legislation which would say, we think a group of less than 50 lives maybe self fund is not the place that they should be, and they are also concerned about limiting the people that might participate in the exchanges that are being set up in a variety of states. They don’t want the self funded their business so to speak to cherry pick the better groups and for the exchanges to be left with the more poor performing losses.
It will be interesting to see how that legislation in California goes, but as you could see it’s a very small part of our premium and clearly not our focus. Our average size case is over 500 lives and continues to get larger. We generally don’t operate in the smaller group market. We will, but it’s not a focus for us.
New Jersey also has regulation for the small group market and as you probably read NAIC has a model act regarding thresholds for self funded. That model act is, there has been one in existence for many years less than five states currently have adopted that model act. So the NAIC shouldn’t be confused as regulatory agents that can make the states adoptive and they merely may suggestions. We would expect that they are going revise their model in the near term and again we are not sure what the result will be, but we think again it focuses in a market that we is not a large percentage of our current premium.
And that’s it; I will be glad to take any questions any of you have or not?
With self funded plans becoming increasingly popular with the environment; are either Aetna or CIGNA laying the ground work to possibly play a part in the market, in the stop-loss market?
Well, Aetna has been in the market for a number of years. They recently bought a very large third party administrator, Meritain which is a large producer of ours that we continue to do business. We do business with Aetna as a payer in the self funded market and have for a number of years. So we don't necessarily threaten each other in anyway.
How about CIGNA?
CIGNA is well. We do less business with CIGNA. If you looked at the Blue Cross, United and Aetna we probably do comparable business. CIGNA we do a little bit less. I think they are less involved in the self funded market.
Okay. With that, we will take about a 10 minute break and we will get right back at it. Thank you for your attention.
Thank you and good morning. My name is Chris Williams. I am the President of HCC. As we announced about a year ago, John will be retiring in May of next year and as part of our succession plan, I will be taking over as CEO. We are very fortunate that in March of this year we hired Bill Burke, who is a 35 year insurance veteran and Bill is going to lead off the next session in regards to the new business lines. Bill over to you.
Thank you, Chris. I wanted to talk to you a little bit about the new lines of business. Over the years, Houston Casualty has grown by making acquisitions and team hires while also driving organic growth.
As you can see in this slide, acquisitions have formed a nucleus of our segments, for examples as Craig outlined earlier, acquisitions were a key to our Accident & Health segment. Other examples of acquisitions we have made include two MGAs in 2001 which helped form the core of our US Property & Casualty segment; the MAG acquisition in 2002 which brought industry leading D&O teams and four different acquisitions from 2004 to 2009 as we developed our US Surety operation.
Team hires have also played an important role in our growth, for example Energy and Property Treaty as you heard from both Tony and Simon, have now grown to each roughly a $130 million of gross written premium lines of business. Credit, which is now roughly a $57 million gross written premium business and our Property DIC team which while they only have $11 million of gross written premium, they round out our property product offerings. We use both acquisitions and team hires as a base from which to drive organic growth.
As we consider acquisitions and team hires, we target first different lines of business. We want lines of business which have high growth potential and/or synergy with our existing operations; lines of business which require underwriting expertise where we can manage the limits in a controlled manner, both with and without the use of available reinsurance and then we have little or no correlation with our existing businesses.
A couple comments about our use of reinsurance; John mentioned that we’re not dependent on reinsurance. For new lines of business, we prefer to have our re-insurers partner with us in developing the new line. And on an overall basis, we use reinsurance to reduce our earnings volatility, but we could write without it.
For acquisitions and team hires, in addition to considering the lines of business characteristics, another key is the people. As we have mentioned, we want experienced, best-in-class underwriting and the claim staff to be successful. Ideally, we would be in a centralized location or in several different locations, but not in a wide geographic spread.
Finally, in keeping with our core principles, we only want operations which have the potential to make strong underwriting profits. For both acquisitions and team hires, we use a return on equity target of 10% or more above the risk-free rate as John showed earlier to be achieved after the startup phase of the particular operation.
Let’s talk about the environment. We have three principle concerns as we consider M&A opportunities. Economic return; which we addressed a moment ago, where we look for a return on our equity. Execution risk; can we successfully incorporate the firm we are buying and realize both the expense synergies and revenue opportunities. And then will the staff of the target firm fit into the culture of HCC; will that become contributing assets or problems; Craig talked through some of the strategy that we had within the Accident & Health division and how they address both the execution risk and the culture fit.
Growing our own operation versus buying a firm can often reduce or eliminate the economic return, execution risk and culture concerns we otherwise have. The team hires we discussed earlier including energy, property treaty and credit are examples of benefits of team hires. Another example is our Lloyd’s syndicate. We acquired a syndicate in 2005 for a total investment of $6 million. Lloyd’s syndicate provides significant value and development of an international book.
Our syndicate has been a critical part of our growth of our international segment to a business with over $500 million in gross written premium. Recent purchases of Lloyd’s vehicles have cost $225 million or more and subjected the buyer to a high level of economic return and execution risk which we were able to avoid by building our own.
We have seen a steady flow of potential M&A transactions over the last few years including most of the insurance company entities that ultimately sold. We are interested in doing M&A transactions, but have not seen any viable candidates over the last few years due to one or more of the following reasons; economic return below our target, unrealistic expectations from the seller and entrenched management.
At the same time, we continue to see positive team hire opportunities. In the next few slides we want to review three new teams that we hired in 2011. First, we started with a primary casualty operation in May of 2011 hiring an experienced team that is located in Chicago and Los Angeles. Their initial focus is on three classes of business where we believe we can be profitable today. Contractors, construction projects and real estate.
Future growth will come in these three classes and in other classes as rates improve. As you can see, we've had a high volume of submissions, 6,900 submissions since May of 2011. So there is demand for our capacity even with the depressed construction and industry environment over the last 12 months.
We can pick the accounts we want. As you can see from the number of accounts that we have bound. We quote on order of 5% of the business that we receive and we get orders on roughly 25% to 30% to 35% of the business that we quote. As the rate environment and coverage terms improve we can increase the number of accounts that we bought.
Excess Casualty. We're also able to hire an experienced team for excess casualty in early 2011 with the main location in Chicago along side the primary casualty. They have a slightly different class focus from primary casualty due in part to the larger limit provided in excess versus primary and due to the competitive environment.
As with the primary casualty we are seeing a good flow of submissions and increasing rates again as you can see with the 2,600 submissions and 97 accounts bound since inception through the first quarter of ’12. Before I talk about the technical property area, I think it's important to note as you look at these three recent team hires in casualty and property that we are able to attract experienced, high quality staff.
Strong underwriters want to come to work for HCC due to our track record of success, our focus on underwriting excellence and our ability to develop unique products. Technical property is a similar positive story as seen in the casualty lines. We hired a very experienced team who started writing in the first quarter of 2011.
We have a target industry class segments again where we are in petroleum, petrochemical, chemical and process industries. And we have a good submission flow that is again allowing us to pick the accounts and layers where we want to participate. The benefits of our technical property group are that they are engineers by background and so writing this type of business fits right into their expertise level.
If we turn over to look at the financial results, our first quarter 2012 premium volume for casualty has exceeded the full year 2011 writings. Technical property is off to a slower start than casualty due to the timing of when accounts renew in the market, but this will change as we go through the year.
While our overall expense ratio is an industry leading 25%, these operations have a higher expense ratio due to the nature of startup operations. This is shown through the higher combined ratio that you see here. This will continue to improve as we move forward in 2012 and then on into 2013.
From a $17 million in gross written premium for 2011 we are forecasting $60 million in gross written premium for 2012. We have established strong operations in each of these lines. We will see good results in 2012 and are well positioned for future growth both in the current market environment and as rates improve further.
Our longer term objective for these lines of business is to grow to $300 million or more in gross written premium. Our track record of driving organic growth shows that we can be successful in these lines of business.
Here are some historical examples of where we have driven growth. As seen in the top left hand chart, we acquired a credit team in the US and London in 2005 and they will have over $57 million of gross written premium in 2012.
As Tony spoke about, we started a property treaty operation in London in 2009 and have grown it to $130 million of gross written premium as shown in the top right hand chart.
Bottom left, we hired a London energy team in 2000 and have grown the business to $130 million of gross written premium.
Bottom right, we acquired an MGA with D&O teams in the US and Spain in 2002 and have grown the business to $465 million of gross written premium.
We will continue to look to drive organic growth through both M&A opportunities as well as through team hires. And we see good opportunities overtime in both of those areas. That’s the part of my presentation. So if you have any questions, I would be happy to take those now.
Where do the teams come from you just hired the two casualty teams and the property team, where they’re coming from?
They come from different organizations. So we are constantly in the marketplace looking for different teams. So sometimes they will come from other insurance companies if they are in the business and sometimes they will come from an MGA type of an operation.
Are you [barred] from saying specifically where it came from, it came from a large competitor?
One came from Navigators and one came from Starr Tech or C.V. Starr.
When you asked him whether you can get your 10% GAAP returns how long of a historical period you look at to make that deliberation?
As long as it takes to make it work.
It depends upon the business. You know in certain lines of business again with what you saw in the property treaty business we were able to get to a profitable place quicker. In similar lines where we have to put more infrastructure into place initially to make sure we can manage the business it might take a bit more longer.
Yeah, when we look at it where you see when they present a business plan, a business plan not from their other employers but business plan from how they see the business and traditionally it is three to five year and you see it makes sense during that timeframe.
When you describe the ROE target is that as a stand alone entity or are you baking in any capital efficiency when you put that under HCC's book I presume would take a little less equity and otherwise if it was just a single line of business?
We look at the rate of return on the individual business by itself and that we would be a fully loaded rate of return from that business.
So when we look at a company and let's assume if we are going to buy something. We look at it completely independent and see what that return is. However in the background we are looking at what synergies that line of business might, how it might be attractive to us and what we try and do is not pay for any of the synergies that we create in the process. In the last five years it has been very difficult because private equity has been overpaying. Its coming back to little bit right now where people are a little bit more realistic about pricing expectations as far as MGAs and that type of operation not as far as entire companies.
So what the incremental ROE will be higher than 10% above the risk free rate or is that the right way to think about the incremental?
Well it could be but our threshold really has been about 10% above the risk free rate. Now you have to anticipate what you believe the risk free rate is which is not always that easy these days.
John, how long is the incubation period before you when you bring a new team on before you look for them to hit your ROE hurdle?
I mean as a general rule three years. These guys have been in the business really. They are just finishing their first year. I suspect we will be making an underwriting profit by the end of this year, fourth quarter of this year, so I think they will be a little bit ahead of plan. I think the market’s going to; right now the market is okay, I think it's going to cooperate.
Is that typically a bunch of scaling up process or is it a market turning and getting the pricing?
Well, we assume that the market is going to stay static whenever we hire a team of people. And so if the market does improve then that's just got additional benefit over and above that. So when we looked at the primary and excess casualty, we assumed a static market through 2000 and I think then it would have been ’13, maybe ’14. And the market is improving.
You can see the flow of business that they are getting. There's obviously a demand there for the capacity and we are just picking the accounts that we want to write that we can write profitably.
So it's like a process of renewals collecting enough of the accounts that you know are profitable.
Looking forward which lines of business if you find the right teams might you like to add to HCC’s portfolio and the flip side of that you know which lines of business for whatever reason we might probably never see HCC in?
Well, you know you won't to see us in comp and you know you won't see us in auto and I doubt you’ll see us in medical malpractice. So those are three lines of business that really doesn't fit our strategy. What we are really focusing on now without getting into the details of this because its not something that want to advertise to our competition, but we have a number of businesses that we effectively can sell more than one product by selling that business.
And we have a number of internet platforms which we use in both what Bill Hubbard does in the Specialty and what Adam Pessin does in the Surety business and what some of these new teams do. We are really focusing on being able to deliver a multiple products through the same website and I think you will see a lot of that in 2000 or doing it now probably by mid 2013 we'll be talking about some pretty significant in terms of if we are talking about $60 million there's probably a couple of hundred million dollars worth of business that we can harvest in the next couple of years if we do this right.
Just one question on M&A strategy. You talked about a few of the successes here, kind of the new ventures and recent successes, do you have any examples of acquisitions you've done that maybe took longer to get off the ground but it were ultimately successful or businesses where you said look this is not going to work, we need to move on and just kind of talk about how much rope you give to these acquisitions and you know…
Well, a couple of things, I will give you two examples. Sun Employers workers’ comp company we bought it roughly in 2000; we decided we want out of it in 2001. It was a specialty workers’ comp business but that’s just be us. So really there is no such thing, because when you are competing with AIG and ACE and all these big guys and they are selling multiple products against you and you have to go out and get rate filings we just couldn’t compete in that environment.
We figured it out pretty quickly and we got out of that business. Craig talked about the acquisition of MNU and we bought this travel accident business at exactly the wrong time because when the financial crisis hit a lot of people stopped travelling overseas.
So that business well it’s making money hasn’t ramped up the way we thought it would ramp up and we do still think it’s a great business and once the economy improves a little bit, we could easily double the volume in that business in a relatively short period of time so that’s the two examples.
Can we move on? Again, we will give you question, we are not going to leave here until we answer all of your questions or at least try to but we just want to keep on going. So Bill you want to lead this off.
Sure. Good morning my name is Bill Hubbard, I am the head of the HCC Specialty and I have been with HCC since October of 2001 when HCC purchased my former company Asu International. As this slide highlights the key underwriters of HCC Specialty business units. I've been in the industry a very long time. And many have been with HCC a very long time. This long journey and our ability to attract proven underwriting teams is something that I am personally proud of.
HCC Specialty has featured in the 2011 Annual Report that was recently distributed. There is lots of information in there on the history of our businesses and our timelines on how we've grown. So I will try not to repeat that information and hopefully give you something fresh perspectives on our operation.
Starting with, but I think is our strategy. There are five main components to the HCC Specialty Strategy that near totality I believe make us unique. Not evidenced by the previous slide is that we have a deep talented bench of underwriters. The key individuals behind the leaders of our business is average 17 years of industry experience.
While not all of our products that neatly into this definition, it is our goal to add lines and grow lines that are reflective of this. Of those areas that don’t, we strive to differentiate ourselves from competitors by utilizing the superior financial strength of HCC and actually adhering to not just paying service to stringent underwriting discipline.
Many of the businesses when HCC specialty aligns that are written by MGUs that HCC has acquired over the years. Uniquely, I believe, many of these MGUs have maintained [career] relationships and we write a significant amount of business on third party paper.
Utilizing third party paper allows us to write business beyond what would be a prudent risk of HCC capital and allows us to not overly expose HCC to reinsurance recoverables, even if these recoverables are with insurers, reinsurers of the highest quality.
I believe our operation is a very savvy utilizer of reinsurance. Many of the products we write require extremely large limits and lend themselves to layered structures. We have an impeccable line of reinsurers that we’ve built up over the years.
In fact, we’ve twice made the Berkshire Hathaway Annual Report. First time was for their participation on a very large Alex Rodriguez disability policy and the second was for their involvement on the NCAA final four cancellation.
As you know, Mr. Buffet is never short on glowing comments regarding (inaudible) in the great business he runs. I just wanted all of you to know that we’re directly responsible for some of that great business that he gets credit for and if he ultimately does succeed Mr. Buffet he owes us. We try to control distribution in variety of ways. In addition to the affirmation use of third party paper, we limit the brokers we will deal with and in lines it will have a significant number of competitors such as Primary Casualty.
If a broker wants access to our superior financials then they cannot spin our wheels. We are ready, willing and able to work with the brokers solve their clients' needs but they must produce or they can take their business elsewhere. Our ability build placements that is access capacity and solve one of a kind unique problems makes us an attractive one stop shop for many brokers.
Many of our businesses have a panel of brokers who are secure enough to put us in front of their clients. This enables us to directly negotiate coverages that dovetail to the terms and conditions that are acceptable to us, the particular needs of an insured.
For example our top two architect and engineer underwriters both come from engineering backgrounds. They are able to speak the clients' language and hone in on what is unique about the particular case. This is of great benefit to generalist broker and fosters tremendous trust and loyalty.
We invest a lot of time and energy into what I call non traditional networks. Like our peers, we are members of NAPSLO, [RIMS] and another oversubscribed industry organizations. Where we are different is with our involvement as key members of organization such as The Promotion Marketing Association where we sit on the board, The Sports Lawyers Association where we have served on the board and the University Of Massachusetts Sport Management Alumni Association.
These organizations provide us unparalleled access to individuals who are actually making the decisions on the use and purchase of our products. For example, the UMS program is globally recognized as the leading producer of sports industry decision makers. There are currently over 3,000 alums, many at the highest levels of the sports industry. At this time, we have 11 underwriters on staff who are graduates of this program. This enables us to call upon this vast alumni network in a number of ways that are beneficial to us.
We have made significant investments in technology. For example, we have built an online special event liability system. We mark it as total event. In 2011 through this system we quoted, bound and processed over 8,000 policies, requiring about two underwriters. We remain active in the pursuit of bolt-on into complimentary acquisitions, and we aggressively pursue cross-selling opportunities wherever synergies exist.
Two examples which are in development are a combination of general liability/professional liability policy, and a combination contractors professional/pollution liability policy. A couple of examples of proven packages of coverage that are generating incremental profitable premium for us are kidnap and ransom, written in conjunction with key person disability, separately key person disability, and/or kidnap and ransom being written with Craig's MIS operation, an event cancellation bundled with special event liability.
Contingency and disability, rating remains strong for larger limit risks. This is typically placements that are $50 million plus. Limits less than that. It can be a significant bit of pressure on the rates. Commercial package, a significantly positive outcome in commercial package for us is a 15% cumulative year-to-date rate increase we've been able to achieve on our lumber program. In casualty, we are seeing some rate increases in the shorter tail areas of casualty.
However, the longer tail areas such as products are still being pressured. There's still a glut of competition in the professional liability/public entity space. We absolutely see competition chasing the top-line. Both areas would greatly benefit from U.S. macroeconomic recovery as this would boost rate bases and tax bases respectively. The market is just not allowing us to grow in this area right now and we're just biding our time.
As you can see, this is a very diverse mix of products that we have spread over our six operating divisions. We do not believe it's replicated by any of our competitors. We don't think any of them has a comparable mix of these products. And I'd like to briefly touch on a few of what I believe are the more interesting lines. These being sports disability and three of our contingency products, kidnap and ransom, event cancellation and film production.
I think there's no doubt that we are the leader in this. We're writing coverages for major league baseball, individual major league baseball teams, the NBA, NFL, NHL, NCAA, various soccer leagues, including MSL, English Premier League, Spain's La Liga and Germany's Bundesliga. The coverages we provide in this space, these are our four main products. PTD, this is a product that generates the most premium in this space. It's coverage that provides for per game or per day indemnity excess of awaiting period.
This is mainly a team purchase product. Couple of notable, no longer enforced policies we've written in the past, policy that [Ajit] helped us out on. That was $97 million purchase by the Texas Rangers. We did an $85 million policy on New York Yankees for Derek Jeter. From Boston we'll take our premium wherever we can get it. We're not proud.
Our PTD is a coverage that pays a lump-sum typically after a one-year wait for a career ending injury or illness. This is often purchased by players to protect their future value and by sponsors who have a lot invested in marketing campaigns. A few interesting risks that are long expired, our $50 million placement on Tiger Woods for the benefit of Nike, a $30 million policy Reebok took out on Shaquille O'Neal, and a $5 million policy Bryan Berard purchased for himself.
Why Bryan Berard? Does anyone know who Bryan Berard is? Well, he's a hockey player and I'll get to this. So we've all heard how athletes say it's not about the money, that they play for the love of the game. 99.99% of the time, this rings hollow. Bryan Berard is the one athlete who did not just say it, he actually proved it. Since none of you know who he is, he was a star defenseman with the Toronto Maple Leafs back in the late 90s.
In 2000, he took a stick to the eye, lost sight in the eye and was forced to retire. Smartly, he had placed a PTD policy with us. Two years after we paid him, Berard made a successful comeback with the New York Rangers. Since he was no longer permanently and totally disabled, he signed his twice-a-month paycheck over to us, and within a year and a half he paid us back in full. Hockey players, very good rights.
Critical asset protection, accidental death, we write a lot of this for teams. These coverages are typically in place for short periods of time, times when players are being underwritten for traditional life insurance. CAP is a product we pioneered in the late 90s as an upgrade to AD. CAP provides coverage for any death, including from sickness that occurs during the policy period.
A couple of interesting policies, again, which are no longer in force, are Alex Ovechkin, $75 million policy for the Washington Capitals and $80 million placement, the San Antonio Spurs secured on Tim Duncan. Limit's a key for us. The limit really truly sets us apart. As we all know, professional athlete salary, there's no recession in sight. They continue to go up. And we anticipate that our ability to the largest limits will continue to become an even better greater advantage for us.
Kidnap and ransom, our market is high net worth families and non-Fortune 500 corporations. We do -- there is some competition on the bigger corporations as the premiums tend to be chunkier, and then people do chase it. We're really not even that heavy in the Fortune 1000. Anything less than that is really our sweet spot. We have no stand-alone marine piracy. We don't think that is a business that is sustainable.
Our minimal exposure to marine piracy comes from families, wealthy families that are going on cruisers or chartering yachts. K&R insured’s, as you can imagine, are most concerned with how we're going to respond in a time of need. Having a topnotch crisis response team is critical, and I believe ours is one of the best. Our team is comprised of former FBI agents and Special Forces veterans with years of experience. Over the years, they have successfully handled 530 incidents in over 60 different countries for us.
Event cancellation, this is a product that responds to the cancellation, abandonment, postponement or relocation of an event for a non-excluded cause that is beyond the control of an insured. We insure virtually any event that you can think of, Super Bowl, MCAA Championships, the Grammys, Academy Awards, Kentucky Derby, Indy 500, World Cup, both Soccer and Rugby, Olympics, and some of the leading concert tours that go around and take place around the world.
We also insure some of the world's largest trade shows and conventions, including both the democratic and republic and national conventions. And I don't know if you can draw any conclusions from this, but the democrats pay whatever price we set, no questions asked, and they borrow money from premium financed companies to pay us. So -- not true, I made that up.
Life events, this is weddings, bar mitzvahs, sweet sixteen's. It's a growing area for us. We've sort of found a niche in these seven-figure budgets for anniversaries, bar mitzvahs, sweet sixteen's. It's a little decadent but they do buy insurance. Again, the $50 million limit puts us in the driver's seat on a lot of placements, and our ability to access capacity in the reinsurance market, again, drives much of this business.
Film production, it's interesting cover. It's got some property elements to it. We insure prop sets, wardrobes, faulty negatives. Faulty negative is less important a coverage as shooting now is mostly done digitally. Another aspect of this coverage is covering essential elements. Essential elements are many distribution deals require that a Tom Cruise movie actually has Tom Cruise in it, or a Cameron directed film is actually directed by him.
So they'll buy insurance making sure that those elements provide the acting and/or directing services. We insure all the films that Fox, Disney and Viacom do on an annual basis. We write some independent films out of our London operation. This is usually small European films. As you can see here, the largest budgeted film we ever did was $332 million. And if anyone's in the mood for some trivia, or if anyone can take a guess as to what that film may have been?
Good guess but it's Pirates of the Caribbean: On Stranger Tides. Our largest grossing film at $2.8 billion is probably a little easier one for someone to guess; Avatar. And while we've had five Academy Award nominations for Best Picture since 2010 -- we like to take credit for it -- we've had one winner. Anyone want to venture what our one winning film was? The Hurt Locker.
I think this slide highlights what I had said earlier, the use of third-party paper. I think it also clearly shows the profitability of these lines. These 2010 and 2011 figures are indicative of our overall historical results, and we fully anticipate a positive future for these two divisions.
In summary, I hope you get out of this that the products we write are in fact difficult. There's a not a lot of markets out there writing kidnap and ransom, event cancellation, film, professional athlete disability, and certainly not altogether. Hope you were able to appreciate that this business does require unique specialists, and that we have them. This business is -- we apply science wherever we can, but there's a lot of art to what we do.
A lot of these businesses are not actuarially driven. And again, you need these skill and experienced underwriters in order to do that. I think we've -- hope I've shown that we are very well diversified in some very niche lines, and that we're leading the way in these areas.
And if anyone has any questions?
Hey Bill. So I was struck by a couple of slides where you talk about these very large gross limits. And then you talked about using third-party paper. So can we just step back and clarify none of these large limits are being written on HCC's paper with reinsurance behind it? They're all being written on behalf of someone else, or can you walk us through?
It's a combination. HCC's AA rating matters to the professional sports leagues. It's especially important in Major League Baseball. Some of our event cancellation limits, on occasion we have put big limits behind HCC. By way of example, there's just a big event we just renewed that they required their broker to go to market.
And in order to reach the price point they wanted to use, we would need to access reinsurance. It really wasn't of the quality that we would want to put behind HCC paper. So we just built a placement to sort of satisfy that need. Some of that might have been behind third-party paper. We might have issued some direct coverage in that as well. So each situation is unique.
And on the kidnap and ransom, is that done on an agency basis or is that done also on HCC's paper?
That is done predominantly on HCC paper.
But we might have a 20% line in the first 15 million and have no exposure at all excess of $100 million placement. On the (inaudible) we might place it all with highly rated reinsurance. But I would say a normal maximum line is about 3 million.
HCC's retaining line.
Both in this line of business, as well as the Aviation business, we saw an increase -- a decrease in the premiums ceded between 2010-2011. How has the business performed for the cedents, and why aren't you retaining as much as possible all the time?
Well, the business have performed very well for the cedents. I think we have a locked-in profitable premium but it comes with a lot of volatility. Sports disability, it's a difficult line. You don't have a big spread population base, and the limits are very, very vertical. When an athlete is in a car accident, it's a big loss.
So the decision to retain a lot more between 2010, 2011 is more motivated by --
It was more attractive to cede the business away.
Well, we're not going into lines of business. There's several lines of business where we get ceding commissions of 50% to 60%, and we get a profit commission on top of that. We won't talk about those particular ones because we like that relationship and we want to keep it that way. So basically, with a zero loss ratio in the business, it has to be pretty close to zero loss ratio in the business for us to make more money than ceding it. So that's historical. That's because we've been able to produce good results. If the ceding commission wasn't as great as that, then we might look at it differently. But right now, it just doesn't make any sense to keep it.
And they were just less those contracts in 2011 than they were in 2010, I guess?
No. 2010, we started assuming some K&R business, took us -- we put it under HCC paper. But you're also looking at market changes at the same time. So it's a combination of factors. On the Aviation business, as Michael said in his earlier -- we made a definite decision to retain more. Adam?
My name is Adam Pessin and I manage the U.S. Surety business for HCC. Today I'm going go through the U.S. Surety and Credit segment. For perspective, US Surety and Credit segment generated roughly $225 million in gross written premium in 2011.
I am going to start with the US Surety business. US Surety for HCC has grown from zero in 2003 to roughly a $170 million business which makes us the sixth largest writer of surety in the US. HCC entered the business in 2004 with the purchase of my prior employer American Contractors Indemnity and followed that up a year later in 2005 with the purchase of United States Surety Company. Both were mono-line surety companies with fairly limited capital bases.
We expanded the surety business with two bolt-on acquisitions of mono-line companies in 2007 and 2009. Those effectively rounded out the portfolio from a product offering and in some cases geographic sense to give us more scale.
I think it’s important to note that a significant majority of senior management remains from the pre-acquisition period. The background we all had running companies with limited capital made us fairly resourceful in figuring out a way to generating an underwriting profit. That background’s been valuable and really we continue to execute the same strategy focusing on small-to-mid size surety risks.
That differs somewhat to our competitors where really we have many competitors that offer limits well into the nine figures and frankly the only way you can rationalize the same is relying on some PML models that may or may not prove adequate.
Then if you look at pricing, our prior history as a really independent surety company at limited capacity made us look at pricing differently than many of our competitors and really that still exists today. If you query the market for surety agents and brokers, they will tell you that HCC has a focus on achieving adequate rates that’s generally not present in our competitors. To give some financial background, since inception US sureties are in roughly $1 billion net earned premium and over $220 million of underwriting equating to a combined ratio of 78%.
As I mentioned before, continuity of management as really everybody has mentioned here has been a key to our success as well. The perspective of operating those smaller companies has been invaluable and served us well. We’ve also been able to add selective personnel to very senior positions from other surety and P&C organizations. We are fortunate to have a very qualified team that are really subject matter experts in their areas that they underwrite and they have significant experience performing acquisitions and more importantly integrating them.
Next we will review the surety financial results. You have the full year 2010 versus full year 2011 and then first quarter of 2011 versus quarter of 2012. First, I will just comment on the premium environment. It’s fairly significant competition in the US surety market within most if not all our underwriting product segments. We’re witnessing very aggressive behavior on the commercial side of the business as companies attempt to replenish topline decreases caused by the weak US construction market.
On the loss side, we really built the structure of our business model, including how we purchase reinsurance to mitigate the significant volatility that’s present in many of our competitors, US Surety business. The result is, our loss ratios will rarely drop below the mid-teens, but the trade-off is our surety business should very seldom produce combine ratios exceeding 100%.
Next, we’ll talk about components of our business. The US surety market is roughly -- two-thirds of the US surety market is related to contract surety or construction. Our waiting is significantly less with just slightly over a third of our business related to contract surety. We maintain less weighting in contract surety versus the industry, mainly as a result of just our perception of greater opportunities to grow outside the contract surety space which historically has been very crowded with competition.
Our business is really a mix of what I’ll call traditional and specialty accounts. The vast majority of U.S. surety, contract surety premium is what I’ll call traditional. Traditional, defined as providing surety based on the indemnity of bond principles, often including the indemnity of owners of privately held companies.
Unlike many of our competitors, we rarely write bonds for privately held companies without the indemnity of individual owners. It’s probably a good analogy is the bacon and egg breakfast; the chicken has involvement, but the pig’s fully committed; we want full commitment from our bond principles.
Specialty accounts can be defined as those that are generally supported with collateral in the form of cash, letters of credit, marketable securities and real estate or other control mechanisms like disbursement of contract proceeds. We believe we are the largest writers of specialty contract surety in the US.
What that mix of traditional and specialty does is it ultimately relates to a much smaller limit profile and higher average contract surety rates than compared to our peers. That also means that small limit profile were less exposed to what is now beginning to be an increasing claims severity environment beginning to develop within the industry.
We think we are resourceful when it comes to claims and subrogation handling which is really key in this business. We are tough, but fair when it comes to claims and subrogation. The fact that we secure a fair amount of collateral upfront on certain risks plus our diligent pursuit of subrogation opportunities typically translates into a higher subrogation recovery rate for us versus our competitors.
We believe we have a significant ability to expand our business; really a meaningful portion right now of our contract surety writings are focused in the Western US and Mid-Atlantic. We take sort of a novel approach to geographic expansion and I think it’s somewhat common sense rather than just a identifying a place on the map and interviewing candidates over say a two months period and picking the best of the lot, we tend to be more patient and focused on finding the right individual or right team of people that can operate within our business model and if it’s in a geography where we have a limited presence, all the better.
Next I will move to Commercial Surety. Within the industry commercial is really defined as everything that's not contract. Commercial surety is roughly one-third of the US surety business, but almost two-thirds of our business. Historically, as I mentioned before we've seen better opportunities in the Commercial segment which has led us to have a different business mix than the surety industry at large.
As I mentioned previously, we are witnessing very aggressive behavior in the commercial side of the business as companies attempt to replenish the topline decreases due to the tepid US economy and especially in the construction segment. We believe some of our competitor’s underwriting and pricing behavior is unsustainable and will inevitably flow through results within the next 24 months.
A majority of our Commercial Surety business is associated with small limit business that's really significantly aided by efficient business processes and technology, unlike bills review where we talked about some pretty exciting particular products. There is not a lot of sizzle to what we do on this Commercial Surety side. It’s a day-to-day business, managing a large volume of transactions, be a good distribution, technology and efficient business process. It maybe easy in the short run for our competitors to gain market share through aggressive pricing and underwriting practices, but it’s very difficult for them to achieve our margins unless you are leveraging technology and work flow.
As with our contract business, although we have a greater concentration in Commercial Surety, we have a market leading position in the Western US; we have significant ability to expand that geographically as the market allows. Within the short run, we don't see a huge amount of opportunity, but ultimately there are niche opportunities that will present themselves.
Next I will move onto the US Credit business. HCC’s first full year of operation in the credit business was 2006 and today it’s roughly a $60 million business producing very favorable combined ratios. Our credit business is led by a very experienced management team, managed by Mark Reynolds who is based in New York. They showed their expertise by delivering underwriting income during 2008 and 2009 during the global financial crisis, something that many of our competitors can't say. HCC Credit operates out of New York and London. The London market is the largest single distribution point for HCC’s categories of trade credit and political risk business.
Here we have the financial results for the US Credit business 2010 versus 2011 and first quarter 2011 versus first quarter 2012. The trade credit and political risk results were excellent in 2010 and 2011 and really although significant capacity has returned to the market over the past 24 months, pricing conditions as compared to pre-crisis levels still remain somewhat favorable given concerns over the Eurozone.
Just to give you a breakdown of the US Credit business, roughly 85% is trade credit and 15% is political risk. We tend to focus on short-to-medium duration coverage; to give you an idea the average duration of the insurance portfolio is roughly two years. As I mentioned before, the business is managed out of New York, but literally two-thirds of the business comes via the London market.
We’ve been able to successfully temper volatility by buying risk attaching reinsurance which some of our competitors buy it on a different basis. And also very stringent and perpetual country and debtor limit management.
I think its worth to note again produced underwriting income during the global financial crisis and then just some financial stats. Since inception, US Credit has earned nearly $180 million of net earned premium and over $30 million of underwriting profit with a combined ratio of roughly 81%.
I will conclude just with a couple of takeaways on the US Surety and Credit segment. Inception to-date US Surety and Credit has produced nearly $1.2 billion of net earned premium at a combined ratio of less than 80%. Both the US Surety and Credit business models are structured that less volatility than most of our peer companies. And it’s consistent what you have heard from others, we focus day-to-day on generating underwriting profit not over market share and topline metrics and are willing to walk away from business when it doesn’t really meet our risk reward appetite.
Really in sum, we’ve build the segment over the past eight years organically and via acquisition. This segment is a meaningful part of HCC as evidenced by the roughly $40 million of underwriting profit that it generated in 2011.
With that, I will take any questions.
I was wondering what attracted you to the surety company of the Pacific civic acquisition. I just remember looking at their statutory results and it didn’t seem like they made a whole lot of money especially compared to your track record, was it geography; do they have certain client relationships?
Really, it was a surety company in the Pacific; frankly, it was a failing company. We bought it for the ability to price that business adequately. It was failing because it didn’t price their product adequately. So what we did which was fairly novel, we actually merged it into our other insurance company which gave us the ability to use our rate structure and effectively more than double the premium base of renewal of that business. That was the rationale.
Okay. So you like that, where they were in the market than with their client relationships, you just thought you can handle it better?
We could and we could price the product appropriately.
Given the turmoil that’s going on in the Euro, maybe you could give us some examples of the types of exposures when you talk about trade credit and political risk credit, how we should be thinking about this as some of these countries are under extreme duress and how it might correlate with some of the results you might report?
Okay. I think Mike is actually going to take; Mike Schell who is the Chief P&C Officer is going to answer that question.
I work with HCC Credits; I’ll take this question. And basically [Greg], we run a diversified business and the rest of it is higher at times and lower at times and part of the diversification is not just better credit, it’s per country credit.
Now each month, we have a review of all the countries where we have $60 million or more limits and we have about 30 countries each month that makes that list. And Europe, to answer your question, the countries that have the largest limits are United Kingdom and Turkey which I am counting in Pan-European and Russia and the reasons why two countries you might not expect to be there is a lot of the business that we do that you are talking about is commodity related.
On the PIIGS countries, the only country that we have with more than $60 million of limit is Italy at $61 million and on Greece, it’s not $60 million, but we look at Greece a lot for obvious reasons and on Greece we have $52 million of gross limits, $25 million of net limits and biggest single debtor exposure we have is very a large tobacco processing business in Greece and obviously there is elevated risk for all Greek debtors, but tobacco process is going to be one of the more stable of a volatile group of exposure. So that’s what I would say, we look at the exposures per country, per debtor, we maintain balance and that’s what we do.
Good morning. My name is Andy Stone and I am going to walk through HCC Global. I am going to describe the two main parts of HCC Global and then I am going to touch on a subset that I know you have interest in.
If you look at the screen, those two areas form the main parts of HCC Global that was acquired in 2002. In the 2002 acquisition US D&O and International D&O made up HCC Global. If you look at the US D&O and I am not going to restate every bullet point here, I am just going to touch on the ones that need to be expanded on. 75 employees to $356 million in premium in 2011, very efficient, I have a slide later on to demonstrate why we are so efficient in the US.
$356 million in premium, to put that in perspective in 2002 in our first year with HCC $75 million in premium. D&O as a percentage of gross written premium, we have all the capabilities to write Errors And Omissions, Fiduciary Liability, Employment Practices and Fidelity but D&O still represents the main part of our portfolio.
International D&O. The area of diversified financial products which was never a part of HCC Global, it is now a part of HCC Global. Diversified financial products is private equity liability, investment advisors and hedge funds. It was part of a separate subsidiary. It was the producer of the adverse development in 2011, it is now under our wings, it is being re-underwritten and I have a slide later which I will go through all of that.
If you look at the financials, for full year 2011 from 2010 nothing to note, it's down about 10% that's due to rate reductions and if you look at the first quarter of 2011 to 2012, there were up from 2011 to 2012 first quarter that's not due to rate increases but the rate environment has stabilized. So we are hoping that 2011 was the end of a number of years of decreases.
The reason it’s up in 2012 was just due to a couple of junky pieces in new business not due to the rate environment. Let’s go into why the US D&O team is different. No titles or corporate ladders to climb. We don’t have any titles; we have that group of underwriters, senior underwriters that have been with us for as indicated 20 plus in industry, 10 plus with HCCG.
All those underwriters have their own books of business. They underwrite their books of business they are not looking to get a new title to have a number of reports reporting to them. They underwrite their own book of business including myself. [Richard Fay] is that list he is not an underwriter but he is the head of our claims and he has been here since our organization was founded.
Steve [Gagliano] and Christine [Motivano] down in the bottom sort us out interesting story about Christine [Motivano]. She came here about five years ago; she was a regional Vice President for a large insurance company in D&O. She had 60 people reporting to her, she sort us out, she gave up her title, she gave up her authority, she gave up her reports and she underwrites a book of business and she couldn’t be happier but she sort us out. Zero turnover in public company D&O, one retirement but we are not counting that.
Why we like the environment, why the environment is good I am going to focus on some seven years of fallen rates but as I said the first quarter we have turned flat in our environment, little description on securities claims. In public company D&O the main exposure is a securities claim. So we discussed that part of our loss side and we look at it on and if you look at average number of security claims for year 1997 to 2010 was a 194, 188 in 2011 so basically on average for the last period of time, but if you look within those 188 claims, 33 of those were Chinese from the first mergers and then in the US we were on zero of those accounts. And if you’re 43, where M&A bump up claims, which is typically not a severity claims. So the profile of the claims in what is our largest exposure, is still pretty good.
The next part, the legal environment has helped us over the last ten years. Ten years ago, the big parameter for us is when a securities claim is filed and it goes to the motion that is dismissed. If the motion dismissed is granted, we’re in good shape of the motion, the dismissed is denied. Then we have to sit down and we have bigger problem. 10 years ago, 30% to 32% of these securities claims were granted motion dismissed and during the last five years, it’s been between 40% and 45%. That’s significant.
Turning to the international D&O, the two folks who run it there have been here since founding and they have a strong team underneath them and you can look at the next slide. Of note on the financials, you know, from 2010 to 2011, I went from $97 million to $108 million. That’s not really due to the environment changing over there. It’s more to some products that we got off the ground in the last four or five years actually, gaining steam and getting a couple million dollars here and there and producing. So we’re still waiting for the market to turn. There are some changes. I will go over in the next slide but that’s just good, locking and tackling. The loss ratio, if you know the loss ratio in 2011 for full year, that’s due to positive development during that year.
Involvement in national D&O business in 2002 has been very profitable, very competitive and new competitors other than the last couple of years in the credit crisis 2007, 2008 internationally we didn't really have a lot of D&O claims that mostly E&O claims over there.
Okay as I said competition is still fierce over there in international, mostly due to the historically very attractive loss ratios. In the market over there, what has happened is the financial institutions have stabilized. We would like to see that turn even further but they have at least stabilized and then certain lines of coverage the Chinese IPOs, the company is exposed in the Portugal, Italy, Ireland, Greece, Spain regions also are stabilizing.
Diversified financial products, as I mentioned it is private equity, investment advisor, general partnership liability, hedge funds and clause of the adverse development in 2011. The large part of where that came from is from primary private equity liability. It is now all of that business is running through my facility and it is being re-underwritten every single account is going through me.
We targeted a certain deductible increases, premium increases and to churn out at least 30% of the business. And as you can see in the first quarter results, we churned out close to 40% of the business, decrease the average limit from 5 to 3.9, big deductible increases and unadjusted rate increase of 10% of premium. What unadjusted means is we haven't made any adjustment for deductible increases or terms and conditions changes.
Competitive advantages, when we started our business in our deal books, we started with centralized authority. We started with an underwriter compensation system in 1999 that stayed true, have not wavered and what that means is no underwriter has any method of compensation that's based on any quantity of business whether its renewal business or new business.
And risks election, in our original deal book we had risk selection, what does risk selection mean, to us it means two things, to our competitors who have talked about risk selection in the years since it means only one thing. People think of it as picking the winners from the losers and yes that's the start of it, picking the winners from the losers. But the second layer of risk selection is you can't always pick the winners from the losers.
So what you need to do is you need to take an industry, a balance sheet, an income statement and apply a lower limit to a risk selection that looks like its in a higher risk category and that's the way we've been able to, we think that's the main driver in this last point that since 1999 we believe that with all carriers would at least $25 million in limits, we are the only carrier until this most recent current year to have not suffered a $25 million D&O loss and that's due to we believe the second layer of selection.
My last tasty slide is just shows, take a look at that, $4 billion of premium since HCC acquired us. Pay loss ratio of 17%. So you can imagine what that's contributed to the investment portfolio, and investment income on top of the rest of the results. That's an important slide. With that if there are any questions other than what accounts I maybe on which I am not allowed to discuss I would be happy to take any questions.
I think you highlighted some of the consistency of the underwriting teams in the US side. If I am not mistaken you lost one of the executives Matt Fairfield some time ago and can you walk us through how the organization responded to that and if there's any negative consequence to that?
Yeah, if you want to go back, if everybody has a slide I can't go back on to it, but, yeah good question. Matt Fairfield and I founded the business back in 1999. In 2010 Matt was restless and decided to go elsewhere. Prior to him leaving Matt in conjunction with us, in conjunction with Houston took the two folks who had worked with him since the very beginning and made them the co leaders of the facility. So although we were disappointed to see Matt leave, the fact that he tapped on the shoulder to the two folks that had worked with him in that 11 year period since the founding made us even more excited knowing that Matt was leaving but to have those two folks lead the organization.
Yeah, our biggest effect was in London. We lost several underwriters in London and had a little bit of a setback on the premium in the business there. They hired a guy Paul Reiner who is noted in there for running London and we are actually doing better in London now in 2012 than we were prior to a couple of folks who left when Matt left in 2010.
My question is actually a broader compensation question but it’s probably particularly related to D&O. I heard one-third of compensation is subject to call backs and I am wondering if that’s true broadly across the business or if that’s dependent on the tail of the business?
No, there is one-third of the compensation is in restricting stock both in the US for the HCC D&O book and the same thing is true on in the international book. No reason for there to be any change. We are going to do it again or…
My name is Mark Callahan and I am the Chief Underwriting Officer for HCC and I am going to talk to you talk a little bit about enterprise risk management today. Enterprise Risk Management cuts a broad swath across HCC covering our executive management, underwriters in our field, risk modeling groups and our board. Today we are going to talk about one aspect of ERM.
Basically, how HCC performs in an extremely stressed environment. We'll look at HCC's financials under a severe increase in interest rates and a three standard deviation moving our loss ratio. The results of these test magnifies the strength of HCC when placed under stress. HCC has a risk management and underwriting culture exemplified by the presentations you witnessed today. It's built upon the foundation of a solidly constructed balance sheet and investment portfolio.
This trades drive growth in book value per share as well as producing strong liquidity, positive operating cash flow, a stable investment portfolio and consistent investment yields. We believe these trades will allow HCC to outperform and capitalize on new opportunities in periods of both normalcy and stress. This strength is also reflected by the commentary provided our rating agencies, and the ratings earned by HCC including S&P's view of our enterprise risk management capabilities as strong.
(Inaudible) is embedded across all levels of our organization through the interaction and integration of three crucial elements. Each of these touches turns and is affected by the others. Processes and guidelines, whether these are investment, security, underwriting or other areas. Second, the establishment of risk tolerances and risk appetites such as the great catastrophe aggregates, maximum limits or volatility thresholds. This is tied together through analysis and modeling through such as internal audits, dashboards, class reports and economic capital modeling.
Today we are going to dive deeper into just one aspect of economic capital modeling. In general, there are five key risks embedded in economic capital models for insurance company, asset risk, underwriting risk and reserve risk, credit risk for reinsurance collectability and operational risks.
The stress as we are going to review focus on three of these. Asset, underwriting and reserve risk. In general, asset risk relates to the mark-to-market impact caused by changing rates as well as default risk of investments. Underwriting risk and reserve risk combined impact loss ratio whether these be through unforeseen events or unforeseen reserve strengthening.
To reflect these stress scenarios, today we are going to share the results of an exercise performed in conjunction with (inaudible) our outside money manager using their enterprise capital return and risk management methodology.
This chart provides some background on why we want to look at stress scenarios. Historically, the insurance industry has been impacted by periods of both rising interest rates and rising combined ratios. Rates during the Carter presidency rose by over 500 basis points for the 20 year treasury, with corresponding impacts across the fixed income universe.
Given the current interest rate environment, we would love to have the crystal ball predicting win and how far interest rates would rise. Unfortunately, we don’t. We do believe HCC would be subject to a rising interest rate environment at some point in the future, we just don’t know when.
Following the spike in interest rates, the industry saw its combined ratio increase by approximately 25 points. While the point of this exercise is not focused on the increase in loss ratios, we do want to show these results as part of the analysis. We refer to the combined effects of increasing interest rates and rising combined ratios as the Carter-Reagan scenario. In the last soft market, the industry saw loss ratios increase to 115%, though some insurers fared worse, including some of our peers who averaged over 130% for the period. Clearly, there can be winners and losers at market inflection points.
Changes to combined ratios can also be magnified by a firm's exposure to inflation. There are several points in recent history where combined ratio increases were preceded by periods of inflationary pressures. HCC's businesses are diversified and have limited susceptibility to inflation. Why are we less susceptible to inflation? We don't write workers' compensation or medical malpractice. This was referenced earlier by John. Also, the loss drivers in our more significant lines aren't tied to personal injury.
And as a result, our business mix remains shifted towards a shorter tail. One comparative measure of the length of our tail is the ratio of net reserves to net earned premium. In 2011, this was 126% for HCC and 184% as an average across our peers. This is indicative of the shorter tail of HCC's businesses. We've talked about comparative measures throughout today, and exposure to inflation is relevant, given the current economic and market environment.
We told you a little bit about the scenarios that we're going to test. Essentially, we are compressing into one period increases to both interest rates and combined ratios. Understanding our business and the environment that impacts it will enable HCC to take advantage of opportunities in periods of flux. A quick note on models. We leverage the expertise of our partners in addition to utilizing internal proprietary models developed over the last several years.
This portfolio of models provides insight into the risk facing HCC and enables deeper discussions on how we manage and mitigate these risks. We also recognize that models are simply a representation of our business and should be just one of the tools used in evaluating our strategy. The GR&E model contemplates the guidance provided earlier this year in our fourth quarter earnings call.
Our guidance was provided in ranges, so we've started with a combined ratio assumption of 88%, which is towards the higher end of the range. The base case also includes a moderate rise in interest rates in 2013, 25 basis points for taxables and 15 for tax exempts, as well as 2014 where another 50 and 30 basis points are added. From this base, we begin to stress the model.
First, interest rates are stressed progressively over the five-year period by another 550 basis points and 400 basis points for tax exempts. Second, the combined ratio is increased by varying amounts over the period, starting around 10 points in year one and increasing to 29 points in year three. As I stated earlier, while this exercise is really focused on the knock-on effects of an increasing rate environment, our exhibits include the results of the underwriting stress by itself or completeness.
As one would expect in this scenario, GAAP equity is lower than the base case as a direct result of higher combined ratios. We also look at a combined scenario. The combined scenario is simply that, the combination of rapidly rising rates and spiking combined ratios over the same period, the Carter-Reagan scenario. In year three, the three-standard deviation move increases the combined ratio to 117% on top of the increases in year one and two.
Given the diversity of our businesses, this short tail for many of our lines and our integrated risk, enterprise risk management, we view this as an extremely remote underwriting result. To reiterate a basic point about this exercise, HCC is starting at a combined ratio of 88%, which simply has us lined up in a better starting position than our peers. For comparison, HCC had a combined ratio in 2011 of 90.8%, while our peers averaged 101.4%.
To illustrate what the underwriting stress means over the period, we've highlighted the difference between the combined ratio in the base case and the underwriting stress scenario. The cumulative impact over the five-year period put into this model is $1.6 billion, a significant deviation. Again, this should be viewed as a remote scenario used to test the strength of our operations. You'll see in our later slides that HCC's GAAP equity remained strong even under these scenarios.
What do the results of the model show us? In short, continued growth in GAAP equity, growing liquidity, positive movement in operating cash flow, and increasing investment income despite the changing environment. Basically, HCC will be able to withstand a three standard deviation move in loss ratio on top of the other stresses, and will be able to take advantage of the increase in pricing that will inevitably follow these types of events. Looking at these individually, liquidity is both positive and increasing over the period.
In this chart, liquidity represents the funds available from operating cash flow and the maturing of investments. To talk a little bit about what the slide shows, the blue bar represents the base case and the orange bar the underwriting stress scenario. The green bar, identified as rate rise, reflects the results of an increasing rate environment. The fourth yellow bar identified as combined, again, it's simply that, the combination of rapidly rising rates and spiking combined ratios over the period, the Carter-Reagan scenario.
In the short-term, our liquidity remains above $525 million and continues to rise over the period to $1.3 billion in the combined scenario. HCC benefits from an asset portfolio constructed to have a fairly consistent level of assets maturing each year. This is guided by the prudent application of investment guidelines as part of our integrated enterprise risk management philosophy. I'll pause to give you another second to look at the slide before moving on. Subsequent slides will follow the same format.
Higher new money yields on investments as our portfolio matures and new cash flows are invested increase our investment income from $210 million currently to between $350 million and $415 million by the end of the investment period. In short, increasing yields will provide a positive benefit to our book value over a longer time horizon. Our strong operating cash flow is also evident under either stressed environment. While our operating cash flow exceeded $400 million over the last several years, the GR&E model uses a conservative starting point of $300 million for operating cash flow.
Importantly, operating cash flow remains significantly positive in all scenarios, which allows us to invest in new money yields. Further, HCC would not be required or forced to redeem assets before they mature. This would likely be divergent from our peers, some of whom are already showing negative operating cash flow in today's environment, referenced earlier in John's presentation. In fact, the interest rate rise scenario actually provides stronger liquidity, investment income and operating cash flow when compared to the base case.
However, an obvious result of increasing interest rates is a rising level of unrealized losses. During the final three years of the projection period, these grow to average close to $750 million and directly impact our GAAP equity, as you'll see in the next slide. In the combined stress scenario, the orange bar, HCC would see GAAP equity bottom out around $2.8 billion due to the impact of unrealized losses. I'm sorry, the yellow bar here. Even here, GAAP equity exceeds our current level of $3.3 billion by the end of the period.
Equity rises to over $3.5 billion, while HCC continues to pay over $350 million in dividends during the period. These results are significantly impacted by the level of unrealized losses. We've overlaid these on this chart for comparison. Recall that HCC will be able to hold securities until their maturity, given our strong operating cash flow and liquidity.
In the rate rise scenario represented by the green bars, we actually see GAAP equity rebound from the impacts of the mark-to-market impacts to approach the result of the base case where we end the period here at $4.9 billion. HCC has ample GAAP equity under these examples to remain a strongly capitalized and well rated insurance company that is able to react to opportunities that we believe would arise following these types of events.
If I can take a moment to highlight what makes HCC unique and will allow us to capitalize on our opportunities going forward. It starts with our underwriting culture and continues with enterprise risk management. Enterprise risk management is a process by which we challenge our assumptions, strategy and perceptions through a lot of interaction analysis and models. This is a small part of what we showed you today.
Another item, our strong balance sheet and financials, it takes everyone pulling together to hit the results, which has put us in the top quintile of our competitors, highlighted earlier in John's presentation. These two characteristics embedded in our core DNA allow HCC to outperform in both times of normalcy and stress. The world does not sit quietly. A theme you've heard throughout the day.
As you've seen from the results of this exercise, even if the world screams, HCC is positioned to deliver positive returns to shareholders and strong security to our policyholders. This is reiterated by the views of our rating agencies, Standard & Poor's AA, Fitch AA, and A.M. Best A plus.
Thank you very much for your time and attention. We'll take any questions if there are any from the audience.
Thank you, Mark. I'd like to open up by thanking everyone very much for attending our conference today. We had a couple of specific intentions in mind here. One of them was to try to simply what is a fairly complicated company, and hopefully we've been able to achieve that. And also to differentiate HCC from our peers, and I think if there's been a theme you've heard today, it's we've tried to compare where we think do things little bit differently. We have seen an improving rate environment.
I think since 2011 there's been rate improvement in most lines, and the guys today have spoken about that. What are HCC's strengths? Well, I think you would have to agree the experience and the skill of the people you've heard today, I think, demonstrates we've got plenty of strength there. The 10 presenters, the 2,000 staff we've got around the world, I think, all indicate that HCC's got a very, very deep bench. We have talented underwriters and talented underwriters want to come to work for HCC.
As Andy described, people solicit us to come and want to join us. Bill Hubbard's operation sees people who want to come and join him as well. Our expense ratio, something that we guide very dearly, 10 points better than our peers. And something that as John described, it certainly helps living here in Texas but it's something that we focus on very, very intently. The rating agencies, Mark touched on that. I believe having gone through the series of rating agency meetings this year with John and my other colleagues; they've certainly put us through the paces.
But I think we've been able to prove to them that we're worthy of the ratings that they give us. Now, constant level of profitability has grown our book value and allows us to be opportunistic in areas such as our stock buybacks, in hiring teams, or in doing acquisitions if we see any that makes sense to us. Our operational discipline is a strength that I think has also been highlighted today through our enterprise risk management in detail, analytical capabilities as Mark described earlier.
Another strength is, John touched on this, is the fact that we are market leader in many lines. This enables us to write more profitable business at better terms and at better rates than some of our peers. How do we perform? Well, we've gone through a very interesting environment here. We've gone over the last five years where it's been a soft declining market.
As Tony said -- decided to go into the catastrophe business in 2010, it was possibly the perfect storm, but if you look at the results in 2010 and 2011 combined, we've performed extremely well. We're now into a positive changing rate environment. One hopes this continues but I think we're very well poised there and I think you've heard some of our lines of business describe where that's going. We've been a consistent strong performer in all of these environments.
And again, it's the team that we've got at HCC that's enabled us to do it. What does that mean? It means that we're poised for even greater success on our platform with what we've got, with the people that we've got, with what we have here. In a world that does not sit quietly, HCC has shown strong performance and is poised and positioned for even greater success in the quarters and years ahead. Thank you.
The world does not sit quietly. Thank you for your attention. I'd like to say two things before we get into general questions. One, I'd like to thank Doug Busker, who's the VP and Head of our Investor Relations. He's done an excellent job getting you here, and you've done an excellent job getting you here. So we do appreciate that. And Debby Riffe, who has arranged all this in her spare time.
So she was here yesterday at six and left -- I don't know when she left at nine o'clock and she was here this morning before six. So we can't do it without all the people from HCC contributing. So we do appreciate that. With that, we'd like to answer most day here as long as you will. I'll stay here as long as you will.
If there is any questions you want to answer, we're still on webcast, so it's still [FT]. So ask away. Mr. [Greg Peters]?
So I thought it was a very productive use of time for you to bring out the senior managers of your business units. One hole in the presentation schedule or the topics discussed would have been just the reserving philosophy that goes behind each of the business units. And I'm trying to figure out a way that you could sort of give us a sense of what's going on from a reserving perspective in each of the units in a fairly short brief way. But that's -- I'm thinking about outstanding reserve questions, especially given the volatility of last year, maybe you could give us some sense of how you guys approached that.
Well, we have a consistent reserving philosophy. We talk about it each quarter. We review our reserves on a periodic basis, which is basically public information. And you know where we stand relative to the point estimate. We are comfortable with our reserve position in each of the segments and I don't know what else we have to say about that.
For example, is Andy setting the reserves in his book of business and then its reviewed at the corporate or how does that work?
Well, Richard and Andy’s book of business who runs the claims, sets the reserves, we have a reserve policy. It's then reviewed by management, quarterly we sit down with Andy and Richard and we go claim by claim through the reserves going back from the 2002 year, Actuarial does its own independent review of the reserves and then there's a meeting between accounting actuarial operations and we review the reserves at the corporate level and then reserves reviewed by the audit committee and the reserves are reviewed at the board level.
And then one about Tony’s group; is Tony sitting?
Well, CAT’s are a little bit different. CAT’s are to be, CAT’s are very difficult to reserve because when there's a CAT out there and you write a CAT book you assume you are going to have a portion of the CAT. So we might, we tend to be, we think we are put up numbers that maybe too high but we really don't know because if you write a worldwide book and there's a CAT out there, we assume now we have some percentage of that and we run our models to try and determine what that is.
But that, he puts up the original numbers. Tony can tell you we question his numbers. We go through them in great detail. I mentioned before that we have strong operational controls. The management group meets with each subsidiary once a quarter and goes doing a lot of things, one of them is we go through the detail, triangles and losses by line of business. Everything is not perfect and we wouldn't have a DFP issue but we spend a lot of time reviewing those numbers and we try and it's an estimation business and we try and make the best estimate all the time.
John, going back to you opening comments on ROE target 10 points of above risk free. Can you give us a little more color how we should think about that is at every year sort of target four to five years and over the cycle average how do you think about that?
If I was to framing for you I think a five year period of time we would be able to achieve that. I think we are going to come relatively close to that this year, not going would but I certainly think it’s possible in may be this year or certainly in the near future especially with a little help from rate increases I think it’s realistic target.
One of the things we try to do in the stress scenario because one of the questions some of the people in this room have asked me and our management is your investment portfolio, the length of your investment portfolio what happens if interest rates dramatically rise and so we started this process before, we did it not just with GR–NEAM. GR–NEAM is Generally New England Asset Managers so those of you who don’t know and we also did with Goldman Sachs and we did an analysis sort of our investment portfolio and we find out in a rapidly rising investment environment we actually do better than we thought we did and probably better than you thought we did. So then we put the underwriting risk in there to seek and look at a peer underwriting risk of three standard deviations following a one, two and its prior to that. That’s something like what is it Mark 92% loss ratio.
That translates from the 117% to a 92% loss.
So in our history I think I don’t know we are much more a company I think the highest loss ratio we’ve ever had is about 78%. So we don’t know how we can get there but we want to test it anyway.
Very impressive results, help me understand why you are using 85 or mid 80s target last year. It seems like maybe you are leaving a little bit under table of business that would still be profitable and you would actually make more profits and grow book value per share faster?
Well, let's look at a couple things. We don’t tell the underwriters to write 85. Okay? What happens, we sell the underwriters to underwrite and when we tell them to underwrite, they have a certain way of looking at that business and because we have diversified portfolio of business, when you put it all together, it ends up at 85, okay?
As we grow businesses and as we add legs to the stool, we might develop a strategic plan, which is ever revolving thing that says we think the market allows us now to maybe remove that target to 88. But if I am going to move that target to 88, if the company is going to move that target to 88, I got to tell you why that’s better few than it was a 85. I couldn’t tell you that before today.
I maybe able to tell you that as we look into the future. So I think your point is well taken. We certainly could, we can tolerate a higher combined ratio if I can do other things that would also generate more profitable investment portfolio, other things like that. So we are not (inaudible) to that. We just haven’t been able to find a way to go ahead and add to that portfolio to give us a better result until just about now.
When you talk about the 10% above risk free rate target, do you care about the breakdown between investment income and underwriting profit within that?
Well, if you look at our numbers we are kind of unusual and that two-thirds of our profitability is underwriting profit and one-third is investment profit. If you look at most of the peer companies, it's either in the reverse and many of our peer companies don’t make any underwriting profit. It’s all investment profit. We would like to make, we would like that to have more balance. I frankly think it could be 40% underwriting profit and 60% investment profit overtime. But it’s not going to happen overnight. We're not going to get into businesses just to grow the investment profit because we're really not a premium seeking company. The real difference between HCC and the peer companies is everybody says they're looking for underwriting profit. That's bull.
Most companies are trying to grow their business, irrespective of whether they make an underwriting profit. We have that battle internally in this company. I won't lie to you and say we never had that as an issue. But I can tell you, management's focus on one thing is making bottom-line underwriting profit. So growing -- being a bigger company is great, but we don't want to be a bigger company at the expense of losing money.
Thanks. I have a follow-up question on combined ratio, but from the standpoint of management compensation. So I understand that managers get compensated with a bonus pool based on underwriting profit. But what is the break or what stops an underwriter from saying, hey, if I write more business at a 90% or 95%, there's still underwriting profit there, my pool will be bigger, why don't I do that?
I don't know of any underwriters we have in this company that are smart enough to figure out how they can move an 85% combined ratio to a 90% combined ratio. Generally when you see people do that, they start losing money.
Okay. So John, I think I heard you say earlier that the industry was rotating into lines where the expense ratios are lower, and that that was a good scenario or HCC would benefit from that, and then would come back to that. And if I heard you correctly as well --
Well, what I was trying to say -- I don't know what I did say. But what I was trying to say is I think the market is changing. And I think what's happening is if you take an individual company and they have a crunch ratio that's over 100, their Board's going to say, what are you guys doing. And so, they're going to look at their capital allocation by lines of business. And I think when that happens, some of these companies will withdraw from line so business.
And if they exit a line of business and they had a 100% combined because they had, let's say, a 40% expense ratio, we might be able to get into that same business, even at the same price because we have a 25% expense ratio and have a 15% margin. I think we're seeing that right now in the primary casualty business. I think we're seeing that in several other lines of business. So that's what I meant to say.
Thanks. I like you do a lot of the work on cash flow and paid losses. Excluding cats, do you think your operating cash flow will begin to rise within the next two years?
Our operating cash flow has averaged over the last several years about $400 million plus, and I don't see any reason for it to be less than that, excluding major cats.
Okay and just one follow-up. When you look across your lines of business, what would you say are the two or three that need more rate today and how long will it take you to get that rate?
The lines of business and the lines of business you didn't hear us talk about today are basically the surplus lines businesses that we have, miscellaneous, EPLI. Bill talked a little bit about public risk. Those lines of business remain extremely competitive for different reasons. And those are the lines of business which need more rate than our true specialty lines of business, which is about 85% of our overall book.
So if you go into the process how you generate if the guidance range is? Is it a straight budget roll-out for you, then apply some range to that, or is it more of a high-level decision with the Board with the budget as an input?
It begins with a budget roll-out, okay. So we have a pretty lengthy and sophisticated process as far as developing the budget. That's reviewed at the management level. It's presented to the Board roughly in December. We agree on that. We discuss it with the Board, and the Board approves it, and then we put it into our guidance. The range is, if we're talking about earnings per share, it's basically the same range we have been using for a number of years.
If you think about it, I think we're one of three companies in the industry that actually provides guidance. So you're damned if you do and you're damned if we don't. If we didn't provide you guidance, you'd say, aha, something's going on. And so, we just assume bite the bullet, provide you the guidance and live with it. So we're comfortable with where we are at least through May.
Okay, thank you.
Well, thank you once again for your attention. Lunch is served in the room immediately next door. And I look forward to Chris holding the next one of these investor conferences relatively soon. Thank you.
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