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Allied World Assurance Holdings, Ltd. (NYSE:AWH)

Q1 FY08 Earnings Call

May 09, 2008, 8:30 AM ET

Executives

Keith J. Lennox - IR Officer

Scott A. Carmilani - President, CEO and Chairman

Joan H. Dillard - Sr. VP and CFO

Analysts

Matthew Heimermann - J.P. Morgan

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2008 Allied World Assurance Company Earnings Call. My name is Tanya, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. [Operator Instructions].

I would now like to turn the presentation over to your host for today's call, Mr. Keith Lennox, Investor Relations Officer. Please proceed.

Keith J. Lennox - Investor Relations Officer

Thank you. Good morning, everyone, and welcome to Allied World's first quarter 2008 earnings conference call. Our earnings press release and financial supplement were issued last night after the market closed. If you like copies of either, please visit the Investor Relations section of our website at www.awac.com. Today's call will also be available through May 23rd as a webcast on our website and as a teleconference replay. The dial-in information for this replay is included in our earnings press release.

Before I turn the call over to Scott Carmilani, Allied World's President and Chief Executive Officer; and Joan Dillard, the company's Chief Financial Officer, I will remind everyone that statements made during today's call including the question-and-answer session, which are not historical facts, may be forward-looking statements within the meaning of the US Federal Securities Laws.

Forward-looking statements include all statements that do not relate solely to historical or current facts and can be identified by the use of words such as may, should, estimate, anticipate, intend, belief, predict, potential or words of similar importance generally involving forward-looking statements. These forward-looking statements are based upon the company's current plans or expectations, and are subject to a number of uncertainties and risks that could significantly affect current plans, anticipated actions, and the company's future financial condition and results. The uncertainties and risks include, but are not limited to those disclosed in the company's filings with the Securities and Exchange Commission. As a consequence, current plans, anticipated actions and future financial conditions and results may differ from those expressed in any forward-looking statements made by or on behalf of the company today.

Additionally, forward-looking statements speak only of the date they are made and the company assumes no obligation to update or revise any of them in light of new information, future events or otherwise.

Finally, during the call, management will discuss information regarding operating income, diluted book value per common share and annualized return on average equity, which are non-GAAP measures within the meaning of the US Federal Securities Laws. For more information and a reconciliation of these measures to the most directly comparable GAAP financial measures, please refer to our earnings press release issued last night and available on our website.

With that complete, I can now turn the call over to Scott.

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Thanks, Keith, and good morning everyone and thanks for being with us in today's call. Let me start out by saying that I am pleased that we're again able to report very strong results for the quarter while managing through challenging market conditions. Each of our business segments is facing these market conditions where we write business today. We continue to see rate declines across the board as a result of increased appetite of standard markets and abundant capacity. We are clearly operating in the down-slope of a soft market cycle. We see that as an opportunity to differentiate ourselves with underwriting expertise and the management of our business.

Joan will providing... will be providing more financial information in a few minutes, but let me start out by noting that despite these market conditions, Allied World continued to generate impressive results and produced meaningful book value and growth for our shareholders. Our diluted book value per share has increased to $45.44 at March 31, up almost $3 from December 2007. This equates to about a 27% increase on an annualized basis.

I am pleased to report that late in March we closed on the acquisition of our US Reinsurance company [inaudible], capitalizing with $500 million and receiving A rating from Amwest. We continued to build the US reinsurance platform and are in the process of bolstering the team with some new staff and transfer some of our Bermuda staff. While we had a late start to pursue business in 2008, we managed to... we did manage to underwrite about $5 million in new business in April on that platform.

We also continue to work hard on our US insurance initiatives that we have discussed in our last conference call. The US as everyone knows is the largest insurance market in the world and we are seeking to take steps in building a better access to distribution and bettering our specialty product capabilities. This will better position the company to grow value and sustain profitable business throughout the softer part of the market cycle, while readying ourselves for when the market conditions improve. Our goal is to identify niche businesses where we believe that profitable opportunities exist despite the current market and the trends. We believe this is the right time to take the steps with our US infrastructure that we are taking and bringing in talent to help identify and execute on our strategy. We believe… we will continue to update you as we progress on these initiatives.

In terms of production, our gross written premiums were down about 9.5% for the quarter. Our underwriters have remained disciplined and are maintaining their selectivity in focusing on opportunities where we believe pricing remains adequate for the risk that we are taking. Net premiums are down slightly less, mostly due to the increase of our casualty reinsurance treaty volume.

Looking at each of our segments, we see slightly different trends but overall a common scene. Individual brokers and clients are being... are aggressively seeking and searching for rate cuts, for what in some cases may be increased exposure.

Well, let me go through each of our segments, starting with Property. Our Property production is down the most, it is down 15% from prior year. This is probably where we are seeing the most egregious behavior in the market and where we have the biggest downturn in rates to exposures. To give you an idea, rates here are down 15% to 20% on average on the business we keep, and in many cases by more than 25% on the business we are not keeping.

As an example, prices of the commodities are up significantly, in some cases more than three-fold causing rates to be near inadequate for business interruption coverage on many energy related and like… and mining companies. Clients should be taking higher retentions paying better rates for coverage, or soon the only source for insurance capacity will be the large global giants and market share underwriters who don’t seem to pay attention to loss costs and claims until after the horses have left the barn. Market share underwriting is a loser’s game in the long-term. In the long run, you won’t see our Allied World in that business.

Loss costs, replacement costs and therefore insured values are going up significantly, not down, as some carriers d continue to drive down rates towards whether they would reflect that the cost of rebuild would be somewhere in the neighborhood of $150 to $200 a square foot. But we know today, the fact of the matter is it would cost more than double of that to build any house or building. It seems to be just disconnected. So we are taking appropriate actions where we need to, including non-renewing some significant accounts.

On the Casualty side, there is nothing much of a change from the end of 2007 here. We are beginning to hit low double-digit rate decreases because capacity in the market remains high and as a result rates continue to soften. We are still seeing some opportunities here, but hunting for them is a much bigger process and just plain hard work than it's been in a while. We are down just over 3% year-over-year with some mixed results in this business.

On the PL side, the FI or the financial institution underwriting for firms, as you would expect rates are going up here and they are going up significantly. We are not seeing a wholesale shift for professional liability rates in totality. It's really just affecting that class of business as a whole.

These reductions are mostly coming from our large account business in Bermuda and Europe, or somewhat offset by an increase in the business on smaller accounts in our US platform. As well, we are seeing some better signings on the healthcare business. Healthcare is an area where we are concentrating our efforts to specialize and be a stronger provider of products and services. In that, we’re just beginning to see success.

Back to Reinsurance, production is down about 10% on our Reinsurance segment mostly driven by our non-renewal professional liability treaties. We do continue to see... we do continue to non-renew accounts that don't need our underwriting requirements and primary companies are generally increasing some of their retentions or seeding a little bit less. But as I mentioned earlier, we are beginning to see some traction in our new US reinsurance platform and that's mellowed some of those results.

I wanted to touch on our subprime exposure because I know it's been important to people in the past and still remains important to everyone today. Regarding our exposure to subprime losses on our professional liability platform, we continue to see activity from fallout of the credit markets. From the beginning, we have actively engaged the team comprised of underwriters, claims, actuaries and our Chief Risk Officer to identify and track the company's potential exposure here. I can tell you at this time, based on the claims information received to date in assessment with their potential severity, an understanding where we attach and limits we offer, we really believe that our potential exposures to subprime losses are well within the current range of our loss picks and our carry reserves for the report period. This issue however is still in its early days and we will continue to act as we monitor and give you progress as it develops.

I'm going to conclude my remarks by noting that our operating net income for the quarter was $128 million, our ninth consecutive quarter of operating income in excess of $100 million. Additionally, our annualized ROE for the quarter was 23.5%, benefiting from our capital management initiatives at the end of 2007, when as you would recall we acquired 11.7 million of our shares from one of the founding shareholders, namely AIG. That represented over 19% of our outstanding shares at the time, and we will continue to leverage our strong ratings, our diversified product lines and operating platforms, along with our strong balance sheet as we maintain our underwriting discipline and pursue profitable opportunities that we believe will continue to enhance our competitive position and grow value for our shareholders.

Now, I'm going to turn it over to Joan for some of the financial results and highlights. Joan?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

Thanks, Scott. Good morning, everyone, welcome to the call. The first quarter of 2008 with another strong quarter for the company, and it feels good to start off the year in such a positive way.

As Scott mentioned, our diluted book value per share has increased to $45.44 at March 31, which represents a 27% increase on an annualized basis. Our operating income for the quarter was $128 million, a 6.2% increase over the $120 million for the first quarter in last year. And our net income was up 15% to $131 million. On a diluted per share basis, operating income per share was $2.49, that's up 28% from the prior year, again benefiting from our capital management actions at the end of 2007. Our underwriting income was up slightly in the first quarter at $59.5 million versus $58.2 million in the first quarter 2007. Now, while these results are consistent between the quarters, the composition between current and prior accident years is very different, which we'll outline as we go through each component.

The combined ratio for the quarter was 78.2%, which on a calendar year basis compares favorably to the 79.7% in the first quarter 2007. The loss ratio was 52.5% in Q1 '08, down 5.4 points compared to the 57.9% in the first quarter 2007. During the first quarter 2008, we recognize net favorable reserve development on prior accident years of $53.1 million, and that's the benefit of 19.4 points to the company's loss ratio for the quarter. Of this net favorable development, $33.2 million related to the 2005 windstorm. The remainder of the releases is split between the Property business and our Casualty book. Now by comparison, we recorded $26 million of favorable reserve development last year, which had a 9-point benefit to the company's loss and combined ratio for that quarter. Absent the prior year reserve adjustments, the loss ratio related to the first quarter 2008 was 71.9% compared to 67% for the first quarter 2007. And as you might expect, the lower rates on non-renewal business are one of the primary drivers for the increases in the current year loss ratio.

Our operating expenses increased by $10 million in the quarter, which results in an expense ratio of 15.9% or 4.3 point higher than the 11.6% operating expense ratio for the first quarter 2007. During the quarter, we added additional staff and some very key strategic positions in the US. I would note that $3.3 million of the quarter's personnel expense was related to one-time sign-on compensation for these key members of our team. And we also continued to incur additional expenses that are related to the amortization of the build-out and the systems enhancements in the US and Bermuda, and we have discussed that previously.

Turning to our individual segments, the Property segment generated $18 million of underwriting income for the quarter and benefited as well from $21.1 million in favorable reserve development from prior years. That included $10.5 million related to KRW. In the first quarter of 2007, we recorded a comparable $25.7 million of favorable development. Now, absent all this development for the quarter, the loss ratio was 82.2% and that's 9 points greater than the 73.1% we reported in the first quarter of last year. We experienced higher-than-expected reported loss activity in this quarter including losses from fires, and of course you've all noted the storms and the tornadoes in the US, as well as lower rates on the business as a whole.

In the Casualty segment, our underwriting income of $9 million was attributable to favorable reserve development. After that, the loss ratio for quarter one 2008 was 75.5% compared to 72% for the first quarter of 2007 where last year we had very little in the way of prior-year development. Again, the consistent theme here is that we have increased our current accident year loss ratios in response to our expectations that loss cost and frequency may rise due to the downturn in the economy. Also, I would like to note that in the Casualty segment, $2.1 million of those one-time personnel expenses that I mentioned are included in the Casualty segment and that's 1.9 points on the combined ratio.

In the Reinsurance segment, we're reporting underwriting income of $32.7 million for the first quarter '08, which includes $22.7 million of favorable reserve development relating to KRW. The ratios absent to prior-year development, 65.1% for the first quarter of 2008 compared to 59.4% for the first quarter of 2007 where we only had a small amount of prior-year development.

As Scott mentioned earlier, we continue to actively review and monitor the impact of the subprime mortgage market and the credit market downturn on our professional liability insurance policies and reinsurance contracts. At this time, we believe that based on the claims information received to date that our potential exposure to credit or subprime related losses is contained within our current carried IBNR. We have high attachment points on the professional liability policies, and on some policies we offer Side A only coverage. For example, in our insurance book, the average attachment on these policies is $126 million and the average limit is $12 million. For our Reinsurance business, this limit exposed to vary depending on the number of insurers affected and the terms of each of the treaties. The lion size for these treaties ranges from about $300,000 to $4.3 million. Through March, we've recorded case reserves of less than $4 million for any subprime related losses. In total, the company is carrying $2.6 billion of IBNR reserves, which include over $1 billion for professional lines exposures. And in total, our carried reserve position is about 4% over the mid-point of our range of estimates.

Let's look at investment performance. Net investment income for the quarter was $76.9 million, an increase of almost 6% versus last year. And that's primarily as a result of an increase in a dividend that we received from our global high yield bond fund. The dividend itself was $6 million and that was an increase of about $4 million versus last year. Our investment exposure to the subprime mortgages is still the same, it's limited to $2.8 million at March 31.

Now, in the first quarter, we recorded net realized gains of $3.5 million compared to net realized losses of $6.5 million last year. There are three major components to this $3.5 million net realized gain. First as Scott mentioned, we funded our US reinsurance company in the quarter with about $500 million. We sold securities and took the realized gains in our Bermuda company and then contributed the cash to the US company. So with that and increased sales of securities, we had gross realized gains in the quarter of $27 million. We also recognized $11.4 million of other than temporary impairments that were due to the spread widening on our mortgage-backed securities, all of which I might add are AAA rated. Third, we adopted FAS 159 in the quarter and chose to adopt fair value measurement for our hedge fund investment, and because of that we recognized a mark-to-market loss of $12.5 million, which is in the realized gains and losses line.

Concluding, our annualized operating ROE for the quarter was 23.5% and annualized net income ROE for the quarter was 24%. Again, let me reiterate probably for the fourth time that our returns continue to benefit from the capital management actions that we took late last year. Finally, I'll say that we continue to be very excited about the initiatives that are underway, which will build the manpower and the structure necessary to carry us to the next stage of our development. We are confident that we can advance these initiatives while we deliver attractive current returns and invest in the future of our company.

With that, I'll open it up for question. Operator?

Question and Answer

Operator

[Operator Instructions]. Our first question comes from the line of Matthew Heimermann with J.P. Morgan. Please proceed.

Matthew Heimermann - J.P. Morgan

Thank you. Good morning, everyone. Couple of questions, first was some numbers, some maybe big picture, which is just on the numbers side do you have any numbers just for what the larger losses were in the quarter?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

Sure, Matt. In overall terms, for example, there were quite a few storms and tornadoes and I characterized that the losses from the tornadoes in the US are in a range of $5 million to $10 million and we had some fire losses as… I always referred to them as the CNN losses, the headline losses like the MGM Mirage fire. There were other fires in the quarter, but in total the fires were approximately about $9 million.

Matthew Heimermann - J.P. Morgan

And did they disproportionately impact one segment versus another?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

Well, they were all in the Property segment, the direct business.

Matthew Heimermann - J.P. Morgan

Okay. All in direct, okay. That's helpful. The other question is the hedge fund portfolio, the values that I'm looking at in the supplement, did they include March or they lag by one month?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

No, they include March.

Matthew Heimermann - J.P. Morgan

Okay. And then I guess, Scott, if you can just talk maybe a little bit about the cash… I mean you've been frank with where you see the market and very realistic about where things are staying. I guess, with the Casualty business in particular, I mean the business looks like it's moving on an underwriting basis, so it’s pretty close to breakeven. How much runway do you feel like you have as you’re building up the niche businesses before you need to get even more conservative on that business?

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Good question, Matt. I think we have a fair amount of runway on the niche businesses because that's where we can differentiate with some underwriting expertise and come up with some products and services for clients that are... where opportunities exist for us to provide product and also make some money. We are making some adjustment to the large accountant portfolio, particularly in terms of the segments where we feel there is deterioration. We are not getting to real specifics line by line. We are either taking smaller lines or moving up towers or moving away from certain accounts where we feel there might be inadequate rate for the attachment. So, there has been some movement and there will be continued movement on the large account portfolio. And I wouldn't say we’re in hibernation movement, but we’re definitely in a more disciplined protectionist if you will. On the niche businesses where we see opportunities, we're definitely somewhere around there.

Matthew Heimermann - J.P. Morgan

Okay. And then on the large account stuff, is that going to the... where you pulling away, can... what type of markets are picking up the slack in that? Is that just bigger retentions by the players who've always been there or is there a new capacity even being dedicated to that?

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Well, there is some new capacity by older players who have I guess decided they like some of the excess markets better maybe than they do some of the primary markets or the lead markets. But there isn't a lot more new capacity than there was six months ago, it's about the same, but it's been... but it's there, it hasn’t shrunk, and the Europeans have done a little bit more.

Matthew Heimermann - J.P. Morgan

Okay. And then just a little bit more on the niche business. That's obviously… probably a lot lower average premium business than we'd see out of the Casualty business. And just in terms of... I think the picture you painted suggest that it's not like Casualty, it is probably going to be growing. But I guess is there enough opportunity you feel like near-term that you can kind of mitigate what's happening on the large account side?

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Sure. Lot less premium doesn’t mean less return. It also means there is less volatility in the risk too.

Matthew Heimermann - J.P. Morgan

Good point. And then I guess the last question, Scott, was, I was just in Bermuda last week and it seems a lot of management teams are kind of taking the view that they… given what's happening in capital markets that if we were to get a repeat of kind of the ’05 storms, no one wants to believe that the market will be as readily accessible and worth coming as they were back in 2005. Is that a view you would share when you.. as you think about capital?

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Yes, I… who would think that the capital markets would want to double-down, given their other issues in the marketplace and the economy. But I do feel that our company is well positioned to… for us should not be concerned by that and have adequate capital in the… even in the event of a big storm to be able to move forward and do it so nicely.

Matthew Heimermann - J.P. Morgan

Okay. I appreciate it, thanks.

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Sure.

Operator

[Operator Instructions]. Our next question comes from the line of Mark Serafin [ph] with Citadel. Please proceed.

Unidentified Analyst - Citadel

Hi, good morning. So there is somebody else out here. In the press release, you noted $33 million of reserves… releases related to the '05 windstorms. And then Joan, I thought you said $10.5 million of the release was related to KRW?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

Right. I meant the same thing.

Unidentified Analyst - Citadel

Am I missing something?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

No, in the break down, when I mentioned the $10.5 million, that was the segment price down.

Unidentified Analyst - Citadel

Okay. That was in the Property segment--.

Joan H. Dillard - Senior Vice President and Chief Financial Officer

And $22 million was in Reinsurance.

Unidentified Analyst - Citadel

All right. Got it. And then, when I look at the... I guess the sequential uptick in operating expenses across the segments, the increase in Casualty was I guess higher than I would have expected. I probably would have expected there to be more of an uptick Reinsurance. Why was that?

Joan H. Dillard - Senior Vice President and Chief Financial Officer

Well, the Casualty as I mentioned, those one-time sing-on expenses probably hit the Casualty segment more disproportionately. So of the $3.3 million in total, Casualty got $2.1 million of that. So that's a part of it. And then, we have had really some realignment in the Reinsurance area, which just lightened up the expenses for the quarter.

Unidentified Analyst - Citadel

Okay. So that re is not anything I should expect to continue, I mean I guess with respect to the investment in the Reinsurance platform?

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Right.

Unidentified Analyst - Citadel

Okay. And then help me square out what I'm seeing in the net investment income, like if I adjust for the high yield bond dividend, the yields look up sequentially and I don't know what else is going on with that with that… with book yields being down sequential and I thought that the hedge fund investment came through the realized gain loss line.

Joan H. Dillard - Senior Vice President and Chief Financial Officer

The hedge fund investment, the change in value, comes through the net realized gain and loss line. And actually, the high yield bond fund that we have, well, we consider it an alternative investment. I mean I guess it's not really a hedge fund, it is just a plain old bond fund. And actually, the dividend last year quarter one, it is always in quarter one of every year, was about $2 million and this year it was about $6 million. So if you back that out then really net investment income was pretty flat. Now of course remember, we spent $563 million to acquire the AIG shares. So, we’ve got a little bit less to invest. And again, there is some downward pressure on rate as we are going forward.

Unidentified Analyst - Citadel

Right. But even I looked at what the yield on cost was in the fourth quarter and then I looked at… compared it to what I calculated to be adjusted for the high-yield bond dividend in this quarter, because I don't think there was anything else going through in the last quarter, it was up sequentially, which was counter-intuitive to me with the book yields declining.

Joan H. Dillard - Senior Vice President and Chief Financial Officer

The book yield in quarter four was actually a little bit of anomaly. That was 4.9%.

Unidentified Analyst - Citadel

Yes.

Joan H. Dillard - Senior Vice President and Chief Financial Officer

And mathematically what happens is you take… your denominator is average assets, the beginning of the period, end of the period, and we bought back those AIG shares pretty late in December, probably mid-December. So, you’ve got the benefit of the investment income for the majority of the quarter, but you are only taking the arithmetic average of the asset. So, that drove up the yield number probably a little more than it would have normally. I think that might be part of the comparison problem.

Unidentified Analyst - Citadel

Okay. That is helpful.

Operator

[Operator Instructions]. There are no other questions at this time. I would now like to turn the call back over to Mr. Carmilani for closing remarks.

Scott A. Carmilani - President, Chief Executive Officer and Chairman

Okay. Thank you. And thank you, everyone, for taking time to get on the call this morning and participate. We look forward to talk to you in the next quarter and every quarter after that. Have a great day.

Operator

This concludes the presentation. You may now disconnect, and have a great day.

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