Flagstone Reinsurance Holdings Limited Q1 2008 Earnings Call Transcript

Flagstone Reinsurance Holdings Limited (FSR)

Q1 2008 Earnings Call

May 6, 2008 9:30 am ET

Executives

Brenton Slade – Director of Investor Relations

Mark Byrne - Chairman

Gary Prestia - Chief Underwriting Officer - North America

James O'Shaughnessy – Chief Financial Officer

Analysts

Susan Spivak - Wachovia Capital Markets

Joshua Shanker - Citi

[Sarah Pabloopa] - Lehman Brothers

Ron Bobman - Capital Returns

Presentation

Operator

Good day, my name is Achia and I will be your conference operator today. At this time I would like to welcome everyone to the Flagstone Reinsurance Holdings First Quarter 2008 Earnings Conference Call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Brenton Slade.

Brenton Slade

Good morning ladies and gentlemen. Thank you all for joining us on the call today. With me are our chairman Mark Byrne, Gary Prestia our Chief Underwriting Officer for North America and James O’Shaughnessy our Chief Financial Officer.

Before I turn the call over to Mark, please let me remind everyone that statements made during this call, including the questions and answers, which are not historical facts, may be forward-looking statements within the meaning of the US Federal Securities Laws.

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

On that note, I’ll now turn you over to Mark Byrne.

Mark Byrne

Organizationally we had a productive start to the year, with the announcement of further additions to our global infrastructure. We made two notable announcements: the first is our intention to subscribe for a controlling stake in Imperial Re in South Africa and second the intended acquisition of a minority stake in Alliance Re from current shareholders.

Imperial Re, which we will rebrand with the Flagstone name at closing, is one of only two domestic reinsurers in South Africa; it’s a young company and has a dynamic management team; the lack of an internationally recognized rating has been an obstacle to growth for them, and it’s an obstacle we can fix; so, we’re excited about the potential of this company both in South Africa and the broader region.

Imperial Holdings, who will be our partner going forward, is a well-respected South African transportation conglomerate.

Alliance Re is a more established company based in Cyprus and managed by its founder Cutter Hempsey. His book of business is complimentary to ours and we’ve extended quota share and typical resources to Alliance.

In many countries of the Middle East and North Africa region we expect our relationship with Alliance to speed our progress.

Both of these strategic initiatives dovetail with our strategy of adding further diversification to our global portfolio and gaining local access and talent in growing in attractive markets. Having local talent on the ground allows us to source business we might not otherwise see, and thus enables us to analyze more risks on a global basis and be selective in choosing the risks we write.

Having built up what we think is the leading cap-modeling program in our industry, we are no focuses on achieving scale at non-cap analysis and underwriting to support our Suisse platform, and also our new Dubois based facultative platform.

When it comes to sourcing and selecting risks we believe our global platform second to none.

We now have over 270 employees globally, with an underwriting team of 23 underwriters, 9 actuaries, and 16 cap modelers. This team is supported by an R&D group of 89 professionals composed of scientists, software architects, and programmers; within the organization we have 79 advanced degrees, doctorates, and masters degrees.

We’ve made a pretty serious bet on technology here and we feel this will bear dividends as we develop our business.

Our investment for the quarter was a positive 0.32%, marking everything to market, as is our method; that’s obviously not satisfactory but it’s better than many other investors fared in a difficult environment.

Our multi-asset class strategy focused on diversification continues to perform since inception as expected, with reasonable rates of return and impressively low volatility. April and May have seen recoveries in the equity markets and today we’re up to about a 1.9% total return for he year, as I speak.

We regard the increase in diluted book value per share, measured over intervals of three years, as the best single measure of our performance for shareholders. Since the founding of the company that growth of 17.6% of dividends, which is above our 17% long-term target.

Since our reinsurance book is exposed to catastrophes, our results will not be smooth from quarter-to-quarter and we don’t issue earnings guidance; however as our diversifying business lines and geography continue to become more significant to our overall book, our earnings variability is decreasing.

With that summary, I’ll turn the call over to Gary.

Gary Prestia

David Brown is traveling on business today, but wrote some comments for this call and asked that I pass them along to you.

Our underwriting results for the first quarter were very strong, as we managed to steer clear of the larger industry losses and produced a loss ratio of 29.4% for the quarter. We maintained our momentum from 2007 and were able to grow our business in a careful and tactical manner over the quarter by continuing to provide world-class value added service to our clients.

I’d like to take a moment to discuss three ways we generate intelligent growth in a competitive market with softening prices.

First, the global network of offices we have been building since we started Flagstone are showing their value. A meaningful part of our growth comes from business that we would not have ever seen without our offices and places such as Switzerland, Dubois, and Puerto Rico. This business meets our hurdle returns and is attractively diversifying from our renewal business.

Secondly, we continue to work with our existing clients and grow relationships where appropriate. It is important to understand that renewal for us involves a complete re-analysis and re-underwriting of each renewal risk. In a softening market this includes the discipline process of not renewing risks with inadequate pricing and by way of example, we non-renewed over 16% of our prior year business in the first quarter of 2008. This does not include other changes where we redeployed capacity to different layers of a renewal program, based on our analysis of the risk reward based on current data and terms.

We were successful in redeploying this capacity to more attractive programs and maintaining anticipated underwriting profitability at levels consistent with our long-term return on equity goal.

Finally, we continue to provide industry-leading service, which makes us a favorite market with brokers and clients. Having produced a potential new business and identified the risks we like, it is this reputation that enables us to achieve meaningful shares of our selected risks.

This reputation for service and technical ability was most recently recognized when we were voted the Number 2 PNC reinsurer in a poll conducted by Reactions US Insure magazine, placing us between the giants Gen Re an Swiss Re.

As a result of these and other factors, we marginally increased our production on a year-over-year basis, which was a pleasant surprise. This was accomplished despite increased competition, declining prices in most major markets and most major lines of business and increased retention of premium by ascendance.

We have mentioned this before, but we do not have any internal premium targets and the staff underwrites strictly on the basis of expected margin.

With this in mind, we are very pleased with the composition of our portfolio. We continue to manage our exposures diligently and our conservative approach is evident with our 1 of 100 year PML of $377 million and our 1 in 250 year PML of $430 million. The proximity of these two numbers demonstrates our focus on mitigation our exposure to large industry events.

Even in the most extreme of modeled events, our balance sheet should remain very strong.

Our franchise and position in the global reinsurance market, coupled with a solid balance sheet, positions us to grow within the market and to generate shareholder value over the long term.

With a birds eye view of the market, to varying degrees we are seeing underwriting discipline prevailing within the marketplace, at least for our targeted lines of business. Pricing is generally in line with our expectations. We have been impacted to some degree by increases in our US clients’ retentions, which have reduced the amount of premiums they are seating. Increased retentions, however, do tend to make the associated risk more remote, so it is important to look at the overall return on equity rather than just rate online.

In addition, there was some modest weakening of rates in Europe. The increased retentions have been offset by purchases of additional limits by many clients, however.

The first quarter of 2008 was quite active in terms of natural catastrophes and risk losses impacting the industry, which were geographically diverse. These events included Windstorm Emma in Europe, tornado, and freeze losses in the United States, property, and energy per risk events across the globe; however, despite this increase in frequency, it has still been relatively quiet for Flagstone as most of these events were retained within our claim company retentions.

It would be disingenuous to suggest that there is not an element of some luck in these misses, but there is also an identifiable level of judgment for which we can fairly take credit. We have not, to date, been big participants in the risk markets, because we have felt that prices didn’t adequately reward us for the exposure and where these risks are CAT exposed, we felt we can get a better price for them in the broader CAT market.

Looking forward, we think that prices will soften further in the US, but remain at technically adequate levels. Internationally we don’t see rates declining as much, as in some markets they are already at or close to technical levels. Some smaller international markets are below technical minimums and we have significantly curtailed our exposure in these regions. Despite this, we are confident our global platform will produce attractive opportunities for us to continue to deploy our capital in an attractive, risk-adjusted return.

With that, I’ll now pass the mic over to James to discuss the financials.

James O'Shaughnessy

The following are some highlights in the financial aspects of our first quarter results of 2008:

The quarter ended with diluted book value per share of $14.08, adjusted for dividends have increased by 15.3% over the last 12 months and 1.8% since year- end 2007.

To better align the company’s operating and reporting structure with its current strategy as a result of the strategic significance of Island Heritage, which is a Flagstone group, and given the relative size of revenues of Island Heritage, we revised our segment structure effective January 1, 2008 by adding an insurance segment which includes Island Heritage.

Island Heritage, as you know, is a Caribbean property insurer based in the Cayman Islands which targets the property insurance market, insuring private homes, condominiums, and office buildings from its headquarters in the Cayman Islands and via licensed agents in the Caribbean.

As we consolidated Island Heritage from July 1, 2007, we do not have comparisons over the prior period quarter.

Consolidate underwriting income was $45.8 million for the quarter, up 74.1% relative to the same quarter last year. Our consolidated gross written premiums were $242.2 million, up 17% from the first quarter of 2007 and up 8% excluding the impact of Island Heritage.

Growth is primarily due to a strong property CAP renewal, growth in our specialty lines, and the inclusion of Island Heritage. Offsetting these were premium adjustments on proportion contracts, higher ascendant retentions and the non-renewal of contracts that did not meet the company’s profitability objectives.

Consolidated earned premiums were up 34% for the quarter, relative to the same quarter last year, due to an increased earned premium base and up 27% excluding the effects of Island Heritage.

Loss activity in the first quarter was somewhat benign for CAT reinsurers, but certainly an active quarter for attritional cap losses and for major risk losses around the world. Our improved loss ratio for the current quarter, compared to Q1 2007, was primarily due to the prior year quarter absorbing net losses from Windstorm Carol of approximately $29.3 million.

In the current quarter our consolidated net favorable reserve development and CAT events from prior periods was $4.8 million, as our ascendants continue to reevaluate their estimates of their exposures to those events.

Our net paid claims in the quarter were $20.1 million, compared to approximately $3.7 million of the first quarter of 2007.

Turning to our G&A expenses:

Our G&A ratio for the first quarter was 19.56%, an increase of 5.1% from the last year’s quarter. This was primarily due to the cost of additional staff and infrastructure as we continue to build out our global operations and enhance our technology platform and also the addition of Island Heritage.

Moving to the investment portfolio:

Our total cash and investments increased to $1.9 billion at March 31, 2008 and our fixed income portfolio remains at a very high quality, with a weighted average rating of AA+ and a duration of 1.8 years.

At March 31, 2008, our investment portfolio on a risk basis was comprised of 75% global fixed income and cash and cash equivalents, 17% equities and the balance in other investments. Our typical risk allocation is expected to be about 55% global fixed income and cash and cash equivalents and 45% other multi-asset classes.

We maintain high cash and cash equivalent balances of 37% for total cash and investments, which provide us with the flexibility to invest in sectors where we believe we are getting more than adequately compensated for the risks we are taking.

Our net gains and losses on investment, which represent movements and a fair value of the portfolio for the quarter, plus realized gains and losses from the sales investments, was a $-12.4 million for the quarter, compared to $4.5 million gain in Q1 2007.

The key components for the current quarter were losses on our equity portfolio of $37 million, partially offset by gains in our fixed maturities of $17 million and gains on our commodity positions of $8 million

At March 31, 2008, we have no exposure to credit risk as a holder of subprime investments, our CDOs of subprimes’ and we hold all day securities valued at approximately $12.6 million. The company does not permit subprime investments by any of its external investment managers.

Our exposure to traditional mono-line insurers emanates from our acid back holdings. We have securities with credit enhancement from the traditional mono-line insurers that amount to $5.6 million at the end of Q1. We do not have any CLO or CDO exposures in our portfolio.

I am pleased to say our balance sheet is as strong as ever. Our shareholders equity at the end of March was $1.2 billion and total assets of $2.2 billion.

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

………..

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Susan Spivak of Wachovia.

Susan Spivak - Wachovia Capital Markets

I was hoping you could go into a little bit more detail about your diversification and the strategy and just an update as to which lines that you’ll be in and how far away from the traditional property CAT business you think you’ll be in by year-end.

Mark Byrne

Sure that’s fine, I’ll respond to that. This is Mark speaking.

I would expect that our medium term goal is to see the property CAT component of what we do go to about 50%: it’s about 68% today and it was probably 95% in our first six months of operation so, we’re moving that meter about 10 points a year I would say.

We always knew it would take longer to build the non-CAT business than the CAT business and so we’re satisfied with that progress and obviously we’re not going to do anything to achieve for that 50-50 mix, but I would expect that that’s about where the balance will seem best to us, because the property CAT business remains on a pure ROE basis, probably the best price business we can write, and at the same time it’s also obviously the most volatile business we can write.

So, we think that roughly a balance between the CAT and the non-CAT is going to be the appropriate mix for us for the long run.

This year, Guy Swain who is with me today and his team in Switzerland got off to a great start. I guess I would forecast that we might see the business written in Switzerland, all of which is non-CAT, comprise something like 18% to 20% of our total this year and that’s up from just about nowhere a year ago, so that’s quite good progress.

Our Dubois office is off to a very nice start. We were licensed in September of last year and we saw about 90 opportunities before the end of last year.

We’re very pleased with our operations in Puerto Rico, where we have two strong, experienced underwriters on the ground, looking at Latin America, South America and Spanish speaking Caribbean business for us.

We think we have a couple of different angles on diversification: the first one being getting globally diversified with the CAT book. I don’t want to sound like a broken record, but I think all of you know we have less of an emphasis on Florida, and the Gulf, and the US in general, that just about any company you would cover in Bermuda. I think the US represents about 35% to 45% of our overall business today and not all of that is CAT.

We’re diversifying the CAT book and we’re diversifying the business lines. As far as the diversifying business lines, so far we have meaningful participations in non-airline aviation, some marine as well as in the marine exposures, satellite, we have some satellite, and we’re building our capabilities in the facultative business, focusing on engineering projects and petroleum: we would expect to be able to be a full-fledged player in that market by 01/01/2009, so that’s one of the big initiatives for this year.

I hope that’s a comprehensive enough answer to your question. Did I miss something?

Susan Spivak - Wachovia Capital Markets

Yes, no, no, no, that’s very helpful, thank you very much for your answer.

Operator

Your next question comes from Joshua Shanker – Citi.

Joshua Shanker - Citi

Your market commentary is more up beat than a lot of your competitors. I want to know if you believe that you’re looking in generally different places in the market at this point I’m sure you’ve listened to some of your competitors: how do you parse what you’re seeing versus what they’ve been talking about?

Mark Byrne

I’ll have a go at that Josh, it’s Mark.

I think it was 2006 the December economists came out and said, “This is an interesting year because this is the year that the countries outside the OECV are more than 50% of the worlds GNP. All the countries we think of as emerging together have emerged and I believe it’s right to say that when our competitors see nothing but gray clouds and rain, they’re looking at those 32 countries in the OECD and we’re looking at a broader world.

Certainly that’s a part of the answer to your question. We’re looking at a world with 200 countries in it and their looking at a world with 32 countries.

I think another part of it is that it’s fun to be at the size we are. We’re something like 1% of the worlds reinsurance today, so that the market portfolio and hence the evolution on price on the market portfolio doesn’t have to really be of much interest to us. Our portfolio can be much, much different from the market and it is much different than the market.

At this scale, at say the $1 to $2 to $3 billion scale, I think we have the flexibility to decide not to do entire regions or entire lines of business entirely. I think if you’re one of the very, very biggest guys you really don’t have that kind of flexibility, you kind of have to feed the machine.

I think that’s the second thing, is that the evolution of price in our portfolio can be quite different than the markets, because the content of our portfolio is quite different than the market.

Joshua Shanker - Citi

If I can make a suggestion, the supplement in the future, if you really dug into geography maybe it would show a differentiation that the market could perceive going forward.

Mark Byrne

Sure Josh, that’s a good suggestion. We’ll look at disclosing the geographical break down. I should think annually would be more useful than quarterly, because of the renewal cycle and so on, but we could look at disclosing a geographical break down and I don’t see any reason we can’t do that by next quarter.

Joshua Shanker - Citi

The other question I had, do you see any opportunities in the markets location on the investment side that you would ramp up in terms of more non-traditional type investing as a P&C company?

Mark Byrne

The last thing you said is very telling. We’re a P&C company, not a hedge fund. I think what you won’t see us do, I promise, is try to pick the bottom of the credit cycle. Personally, if I was still a hedge fund, I’d probably be trying to do that today.

I think a lot of money will be made on the way back up in the credit cycle and none of it will be made at Flagstone, because that’s not our business.

I do think that some of the asset classes that have been weak performers this year kind of are trailing the US and I would say an example of that would be emerging markets equities and would be asset classes that we wouldn’t mind seeing a slightly larger allocation to. But, I think what we’ll see is a shift in the risk portfolio, if you divided it all into very traditional assets and then more unusual assets.

I think you’ll see a shift in risk portfolio of 5% to 7% and we’re in the midst of doing that: I’d rather not be specific, because we are in the midst of doing that, but it’s not going to be a big swing. You might see the bond portfolio get down from 50 to 55, but you won’t see a big swing and you won’t see a swing in your credit.

Operator

Your next question comes from [Sarah Pabloopa] of Lehman Brothers.

[Sarah Pabloopa] - Lehman Brothers

Could you provide an update on your outlook for the mid-year reinsurance renewals and what types of opportunities you’re seeing from potential changes in Florida?

Gary Prestia

So far and we do have a good number or the June and July 1 renewals in, because the market did start a bit earlier. We are seeing as a result concerns about the ability for the Florida hurricane CAT fund in particular to pay that many of the companies, the mono-line Florida companies and other companies, are buying a lot of reinsurance related to Florida, more this year than we saw last year.

In the many meetings that we taped, I can only recall one saying that they were buying less reinsurance in the private market this year than they bought last year; this was even after acknowledging that, again, the CAT fund is not going to change as we know it for this year, or remain at the 90% coverage level and tickle will not be reduced by $3 billion.

We are finding the additional interest. We have also found, leading up to the mid-year, that many of the fair plans in the coastal pools, in the coastal states, are buying significantly more coverage this year; this particularly has been the traditional companies, the national homeowner type writers have continued to pull back so many of these risks are lining up in the coastal pools and we’re finding that many of the coastal pools themselves are buying meaningfully more. We’ve seen anywhere from $3 to $500 million more of additional reinsurance requested for those pools.

That’s fairly typical of what we’re seeing. There was a bit of a delay with respect to the Florida legislature concluding its deliberations as of last Friday, but now that we know the outcome of that, all the programs with respect to Florida, in particular, are moving ahead on the basis of no change in the CAT fund coverage and are just refining what they’re going to be buying in the voluntary market; but we would estimate that that’s probably up by about 20% to 25% over last year in terms of the overall limits, based on just a very early glimpse of that.

Does that answer your question?

[Sarah Pabloopa] - Lehman Brothers

Great, thanks yes. In terms of the expense ratio, the G&A expense ratio was roughly stable versus the fourth quarter. Do you see this as a steady state level?

Mark Byrne

We don’t allocate G&A and we look at G&A internally as a percentage of shareholders equity and we target 6.5% and we’ve been achieving that target.

Now, we have a very low cost platform, because so many of our jobs are located in Atlanta, Canada and in India, but we offset that low cost platform by investing more than just about anybody in technology.

I think last year, of our total G&A which was something in the mid-$80 million range, at least $30 of it is things that we could have categorized as R&D if we’d wanted to, we probably could have even capitalized them if we’d wanted to; we’re not doing that, we’re writing everything off as we write it, but if we have 60 programmer’s and their writing code and you don’t capitalize any of it, you will have a G&A expense to bear and the benefits are, we think, absolutely there and they get reflected in the loss costs over time.

That’s the way we look at G&A and our target is 6% to 6.5% and we’re determined to stay at or below that target. But, since our premium writings, I think Gary mentioned in his comments, we really re-underwrite every renewal from scratch and that means we often move up or down layers in a program if we are renewing it: that makes our premiums relatively difficult to predict and therefore the conventional G&A ratio relatively difficult to predict.

I don’t see how, if we decide to move from working layers to CAT layers, we’re then supposed to turn around and fire 50 people in India and then when we move down to the working layers we hire them back. I don’t see how, exactly, we take the G&A and make it stay extremely stable, given our strategy of re-underwriting the layers every year.

I think you will find it’s stable and I’m sure you will hold me accountable to it at 6% to 6.5% of shareholders equity.

[Sarah Pabloopa] - Lehman Brothers

Could you provide an update on your appetite for M&A?

Mark Byrne

Our appetite for M&A is in several categories. Right now our whole sector is trading terribly and our stock is trading below diluted book value, we think that’s bizarre, but so are so many of our competitors that we kind of accept that as an industry phenomenon.

In that environment, I don’t think this is the kind of environment in which we would look to do big deals. I think there are really three categories: we wouldn’t look to buy something big when our stock is trading where it’s trading today and we don’t feel the need for anything big. We think we’ve pretty much built out a pretty complete global platform absent to Asia, we don’t have anything really in East Asia yet; with that one exception, we think we’re pretty close to done on the development, so we don’t feel the need to do something big.

Smaller kind of tuck in acquisitions, things like Imperial down in South Africa, we think that’s very attractive as a way to show up in a new market with partners, not pay some enormous premium, and at the same time end up with feet on the ground in a whole subcontinent that we think can be quite additive.

This almost sort of semi-organic our bolt-on acquisitions we think are quite interesting. The other kind is obviously, mergers with giants, and we haven’t really entertained like that, but you know we’re all big shareholders in the company and if the right opportunity comes along we’re not going to be defensive about it, but we think this is not an environment in which great big deals probably make a lot of sense to many people.

So, we’re focusing on our organic strategy and small acquisitions that can tuck in and basically become thoroughly integrated into Flagstone quickly and hopefully without much pain.

Operator

Your next question comes from Ron Bobman of Capital Returns.

Ron Bobman - Capital Returns

I guess I’d be curious to know, Gary, your view on how the reinsurance issue, the prop CAT reinsurance issue will view the opportunity to write some of the citizens risk. I think I read that they got approval to make a $150 million, I think, premium spend to cover this season. I was curious to know what you thought the industries sort of view would be about the attractiveness of that right.

Gary Prestia

It is at the market, we’ve seen it, and it’s approximately $446 million of limit that’s being placed. That is a 10% sliver of a $4.4 billion stretch which runs alongside; this is citizen’s co-participation in the CAT fund. In other wards the 10% versus the 905 that’s provided by the CAT fund. It is this so-called slipper layer; it’s going in the mid-20s right on line.

I think generally speaking there are respected markets that are both leading it as well as supporting it. We have found it reasonably to modestly attractive. That is , not very attractive, so likely to and again this is not finalized as yet, in all likelihood this will be a smaller participation for us, not a significant one, because we find it just making hurdle, but not very attractive to want to do a lot of it.

I would suggest that others may also find it in that kind of range of pricing.

Ron Bobman - Capital Returns

What was your last point? I lost you.

Gary Prestia

I was saying that others may also find it in that range of pricing, that is more to be a moderate sized to smaller sized line.

Operator

There are no further questions at this time. I would now like to turn the call back over to Mr. Brenton Slade for closing remarks.

Brenton Slade

I would like to just take this time to thank everybody for listening to the call. One last reminder, which is that a replay of this conference call will be available on our financial section of our website at www.flagstonere.bm.

Thank you very much everyone and have a great day.

Operator

Thank you for your participation in today’s conference. This concludes the presentation.

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