XL Group's CEO Discusses Q2 2012 Results - Earnings Call Transcript

| About: XL Group (XL)

XL Group plc (NYSE:XL)

Q2 2012 Earnings Call

August 7, 2012 5:00 pm ET

Executives

David R. Radulski – Investor Relations

Michael S. McGavick – Chief Executive Officer

Peter R. Porrino – Executive Vice President and Chief Financial Officer

Gregory S. Hendrick – Executive Vice President and Chief Executive Officer - Insurance Operations

James H. Veghte – Executive Vice President and Chief Executive Officer - XL Group's Reinsurance Operations

Analysts

Jay Gelb – Barclays Capital

Matthew Heimermann – JPMorgan

Jay Cohen – Bank of America/Merrill Lynch

Michael Zaremski – Credit Suisse

Joshua Shanker – Deutsche Bank

Josh Stirling – Sanford Bernstein

Robert Glasspiegel – Langen McAlenney

Vinay Misquith – Evercore Partners

Michael Nannizzi – Goldman Sachs

Meyer Shields – Stifel Nicolaus

Randy Binner – FBR Capital Markets

Ian Gutterman – Adage Capital Management, L.P.

Operator

Good afternoon. My name is Shirley, and I will be your conference operator today. At this time, I would like to welcome everyone to the XL Group plc Second Quarter 2012 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Please be advised that this conference is being recorded.

I would now like to turn the call over to David Radulski, XL's Director of Investor Relations. Please go ahead.

David R. Radulski

Thank you, Shirley, and welcome to XL Group's second quarter 2012 earnings conference call. This call is being simultaneously webcast on XL's website at www.xlgroup.com. We've posted to our website several documents, including our quarterly financial supplement.

On our call today, Mike McGavick, XL Group's CEO, will offer opening remarks; Pete Porrino, XL's Chief Financial Officer will review our financial results; followed by Greg Hendrick, our Chief Executive of Insurance Operations and Jamie Veghte, our Chief Executive of Reinsurance Operations, who will review their segment results and market conditions. Then we'll open it up for questions. Among those also available for questions are Susan Cross, our Global Chief Actuary; Sarah Street, our Chief Investment Officer and Steve Robb, our Controller.

Before they begin, I'd like to remind you that certain of the matters we'll discuss today are forward-looking statements. These statements are based on current plans, estimates, and expectations. Forward-looking statements involve inherent risks and uncertainties and a number of factors could cause actual results to differ materially from those contained in the forward-looking statements, and therefore you should not place undue reliance on them.

Forward-looking statements are sensitive to many factors, including those identified on our Annual Report on Form 10-K, our quarterly reports on Form 10-Q, and other documents on file with the SEC that could cause actual results to differ materially from those contained in the forward-looking statements. Forward-looking statements speak only as of the date at which they are made and we undertake no obligation publicly to revise any forward-looking statement in response to new information, future developments, or otherwise.

With that, I'll turn it over to, Mike McGavick.

Michael S. McGavick

Good evening. Tonight, we are pleased to discuss XL's second quarter results. Results with intermediaries have us greatly encouraged, and make no mistake. We are not yet where we want to be across the board, but our actions are taking hold and we are beginning to see emerge the target book we have discussed with you before. So while our work continues in absolute and relative terms this is a very solid quarter.

To give you a sense of what you can expect from this call. First, I'm going to give you a high-level look at these results, including a brief discussion of our reserve releases, I'll then briefly touch on pricing in the quarter, and then we'll turn to two noteworthy topics; the effect of drought impacting so much of the United States and the developing issues around LIBOR. I'll then turn it over to Pete for a closer discussion of our financial results and to Greg and Jamie to get more granular on our insurance and reinsurance performance.

Now, first to our overall results. As you saw in our release for the second quarter we reported fully diluted operating earnings of $0.71 per ordinary share and an annualized operating ROE of 9.1%. Again, this is a solid result, especially at this point in the cycle and at this point in XL's improvement. All of this translates to fully diluted tangible book value per ordinary share of $30.65, which is up 3.6% in the second quarter and 8.3% higher than where we began the year. We improved our loss and combined ratios in both insurance and reinsurance and reported a total P&C combined ratio of 90.8% more than four percentage points better than the second quarter last year.

And most notably, our insurance results continued their recent improvement. The Insurance segment combined ratio ex-cat, ex-PYD improved 98.5%, which is obviously still higher than we would like, but trending in the right direction.

It is also good to observe that this is the sixth consecutive quarter in which insurance produced a better accident year loss ratio ex-cats. So, as I say, we are delivering on the margin expansion, we expected. Meanwhile, Reinsurance delivered a combined ratio of 72.6%, another really stellar result.

Turning briefly to pricing; broadly, we continue to see improvement across the vast majority of our lines, especially in insurance and this progress has accelerated through the quarter.

On reserving, as you'll recall, the second quarter is one in which we regularly perform an in-depth reserve review, and you've already noted in our materials this review again resulted in sizable releases totaling $101 million a positive development in the quarter.

Now I'll touch on a couple of issues of note. First, with respect to the ongoing drought conditions; as you'll recall our exposure to risks in crop insurance have reduced over recent years, and while we do have some exposure that exposure is manageable and even in extreme conditions for us being unpleasant, but modest earnings event. Jamie will have more detail. Second with respect to LIBOR, I know there are a lot of questions on this topic, particularly as we are [writing] of relevant coverage both in the U.S. and abroad. Unfortunately, the reality is it's just too early to tell how this will play out.

And finally, I do want to recognize one change in our leadership team that's the addition of Eileen Whelley as our new Chief Human Resources Officer. Eileen has a deep resume, including top HR leadership positions both inside and outside of the Insurance sector and she is already taking a principal role in our ongoing mission to build on what I truly believe is the most talented group of risk professionals in the industry.

So, as I said at the start, we are encouraged by the results we've reported today. They demonstrate our continued progress and are directly tied to our focus on improving margins, while meeting the needs of our clients.

With that, I'll turn it over to Pete to discuss the financials in more detail.

Peter R. Porrino

Thanks, Mike and good evening. Operating income for the second quarter was $222 million or $0.71 per share on a fully diluted basis compared to operating income of $243 million or $0.75 a share in the second quarter of 2011.

Fully diluted tangible book value per share grew $1.07 in the quarter and $2.34 year-to-date. Our P&C combined ratio was 4.1 points better at 90.8% in the same quarter last year. Our accident year ex-cat combined ratio was 93.7% or 5.7 points better than the same quarter last year, due to a reduction in non-cat large loss activity. Our Catastrophe losses decreased by $8 million from the second quarter of 2011 and totaled $61 million in Q2 2012, mostly in the Insurance segment.

Top line growth was slower in the quarter due to the impact of FX in certain areas of targeted non-renewal. Excluding the impact of foreign exchange the Insurance segment gross premiums written increased by 4.2% and the Reinsurance segment decreased by 3.4%. The same percentages on a net premiums written basis were an 8.1% increase for insurance and a 1.9% decrease for reinsurance. The Insurance segment movement includes a positive shift in business mix towards top performing lines, which Greg will expand on. The reinsurance decrease is due primarily to selective cancellations and the timing of renewals.

During the second quarter we completed our normal semiannual detailed review covering virtually all of our loss reserves across our Property and Casualty business lines. There were no material changes in approach or methodology. Prior year development in the quarter was a favorable $101 million or 7.2 loss ratio points. This reflects favorable development of $43 million and $58 million in the Insurance and Reinsurance segments respectively.

Positive movements came from the Casualty and U.S. Professional Insurance lines, as well as casualty reinsurance lines, partially offset by strengthening mainly in Insurance International Professional, and excess and surplus lines. You will note that our interest expense for deposit liability accretion in the consolidated statements of income in the financial supplement increased by $19 million this quarter. This is due to an annual review of our runoff structured products business, which resulted in higher interest charges due to changes in expected cash flow timing on certain structured workers compensation contracts that are accounted for as deposits.

The net loss this quarter related to that reserve review was less than $10 million since there was positive reserve development on contracts accounted for as reinsurance. That positive PYD is included in the $58 million, I previously mentioned for the Reinsurance segment.

Our combined $299 million of operating expenses for the second quarter was up 12.4% or $33 million year-over-year. This is on track with the full-year expectations we communicated earlier in the year. The year-over-year increase arose principally from cross supporting our strategic initiatives and higher compensation costs from both, growth and headcount associated with new business initiatives and certain severance costs.

At $188 million net income on the P&C portfolio in the second quarter was 12.2% below the prior year, due primarily to lower new money rates, as well as cash outsourced from the investment portfolio.

The P&C gross book yield at the end of the quarter was 3.1%. We achieved an average new money rate on our P&C portfolio in the quarter of 2.2%. We expect net investment income will remain under pressure given interest rate levels and our estimate that approximately $3.4 billion of P&C assets with an average gross book yield of 2.8% will mature and paid down over the next 12 months.

Our net income from investment affiliates was $17 million, down $34 million from the prior year. This is driven by an especially strong prior year quarter from our investment management affiliates compared to solid results this quarter.

Realized losses on investments were $12 million compared to realized losses of $10 million in the prior year quarter. Our realized losses include $28 million in OTTI charges, which is consistent with the prior year quarter.

The total return of our entire portfolio was 1.4% for the quarter and contributed to book value growth with the positive mark-to-market of $131 million. This was driven by decreasing rates, particularly in the U.S. which were partially offset by widening credit spreads.

The P&C fixed income duration decreased by 0.2 years from the end of the first quarter to 2.9 years due to the accumulation of cash and cash equivalents in the portfolio given the heightened risks associated with the continuing turmoil in Europe, at least the end of the first quarter the life portfolio duration increased by 0.1 years to 8.6 years.

Our fixed income holdings in Eurozone countries are again listed in our financial supplement. We continue to have negligible exposure to sovereigns, and financial institutions in the peripheral countries. Our $400 million exposure to Eurozone banks, including $143 million in covered bonds remains largely to national champions in northern Europe. Through targeted sales and maturities, we reduced our Eurozone holdings by $173 million during the quarter, principally in the financial sector.

We bought back $125 million of our ordinary shares in the second quarter purchasing and canceling 6.1 million ordinary shares at an average cost of $20.44, leaving $525 million available for purchase under the current program. We continue to balance new business opportunities with the attractive economics associated with share repurchases and we are not looking to add to our surplus capital position.

I'll now turn it over to Greg to discuss our Insurance segment results.

Gregory S. Hendrick

Thanks, Pete and good evening. Tonight I'll cover the Insurance segment results for the quarter, provide an update on the corrective actions we're taking in our challenged businesses, comment on our recent talent changes and provide a summary of current market conditions.

Starting with results, I'm happy to share that we made progress again this quarter both on profitable growth and more importantly on continued improvement in accident year combined ratio. And while I'm pleased with our improved performance, we remain focused on operating Insurance segment at a lower combined ratio.

Insurance segment's combined ratio, excluding cat and prior year development of 98.5% improved by 5 points relative to second quarter of last year, driven primarily by the current year loss ratio. Our combined ratio for the quarter was 99.1% or 1.2 points higher than the same quarter last year, driven by 1.6 point increase in the operating expense ratio. This is largely due to increased compensation costs related to continued upgrades in our talent as well as expansion in a number of our businesses.

On the loss side, the current accident loss ratio excluding cats was 65.8% improving by 6.8 points year-over-year. As Mike mentioned, this marks the sixth consecutive quarter of improved accident quarter ex-cat results.

Our reported loss ratio of 66.2% reflected cat activity of 4.9 points as the second quarter of 2012 was impacted by $49 million in cat losses and reinstatement premiums compared to only $13 million in the second quarter of 2011. This was largely driven by a single risk loss in each of the Midwest tornadoes and the China earthquakes. This cat activity is partially offset by prior year reserve releases of $43 million or 4.5 points in the quarter compared to $64 million last year.

Insurance gross premiums written grew by $114 million or 8.9% in the quarter after normalizing for foreign exchange and the planned non-renewal of one large foreign account. While this growth reflects success in our targeted new businesses, such as political risk and North America construction we also had strong growth in some of our higher-margin businesses including U.S. Professional and Marine & Offshore Energy.

The second topic is an update on the businesses that we have been referring to as challenged. The combined ratio for the challenged businesses in the quarter was 125.7% and in the remainder of our book we reported a 90.6 combined ratio. Prior year reserve changes namely strengthening in the challenged businesses and releases in the performing businesses explained much of this variance.

If you look at performance on an accident year basis, excluding cats, the second quarter combined ratio in the challenged business drops to 105.6%, while the remainder of the book reported 96.2% combined ratio. As we indicated earlier in the year, the quarterly improvement of the challenged businesses will have some volatility given the nature of large risk insurance.

Our shift towards businesses with the higher margin has resulted in the challenged businesses representing a smaller portion of the segment. In fact for the second quarter on a net premium written basis, adjusted for foreign exchange, challenged businesses shrunk by 11%, while performing businesses grew by 15% as compared to this quarter last year. This was not by accident.

Some of the corrective actions we discussed last quarter. Management of cat capacity, deemphasizing guaranteed cost, workers compensation and re-underwriting our New York contractors’ general liability portfolio are having the intended consequences from a top line perspective. And we expect the benefits from our activities will lead to continued margin expansion with time.

Clearly, we still have work to do, but with new leaders and disciplines in place for many of these businesses we’re confident that we are implementing the right strategies to turn these books around.

Moving on to talent, we further enhanced our teams throughout this segment in the quarter. We added to our already strong insurance leadership with the arrival of Jason Harris, Head of International Property and Casualty. We expanded our regional excess casualty team with the addition of new underwriting talent in Dallas, Philadelphia and Kansas City. We recruited a cyber liability team with underwriters in New York, Atlanta and Chicago. We also broadened our E&S capabilities by adding umbrella and excess casualty underwriting expertise. In our distribution network team added new talent to improve our local presence in Mexico and Spain.

Finally, let's turn to current market conditions. In the second quarter we once again saw positive rate indications in all of our business groups, with an overall segment rate increase of 4%. To put this in a context, we haven’t seen a rate increase of this magnitude since 2003. Further 20 out of 24 businesses in the Insurance segment saw large rate increases in the second quarter when compared to the first quarter of this year. Not only did we see 6% rate increases in our North American P&C portfolio, led by double-digit rate increases in our property and E&S businesses, but our international P&C portfolio was also up nearly 3%.

In specialty lines, we saw an increase of 5% led by marine and offshore energy, and in our professional book rates were up 2%, including 3% in our U.S. D&O business. As we indicated last quarter, this return to gradual sustained rate improvement is something we've been expecting and we believe it must continue given the industry's insufficient investment returns, particularly in long tail lines of business.

And while we are pleased with these pricing improvements, we still face a competitive marketplace where underwriting experience and discipline coupled with improved analytics, are critical to selecting the best risks. While rate continues to be a very important factor, expansion of margin is our ultimate measure of success.

And now to Jamie to discuss Reinsurance results.

James H. Veghte

Thanks, Greg, and good evening. The Reinsurance segment had an excellent quarter of underwriting results with a combined ratio of 72.6%, producing an underwriting profit of $120.9 million. These results were impacted by prior year reserve releases of $58.4 million and cat losses in the quarter of $11.2 million, net of reinstatement premiums. Excluding the impact of these items, our combined ratio was 83.2%, which compares favorably to the combined of 90% in the second quarter of last year on the same basis.

During this quarter, $46.6 million of prior year releases were released from our U.S. business unit which does a major reserve review in the second and fourth quarters of each year. While $34.9 million of these releases were from casualty lines, we remain very cautious on recent underwriting years and the majority of these releases were from the 2005 underwriting years and prior.

On a year-to-date basis, this segment has a combined ratio of 77.4%, which compares to the 112% combined last year. Excluding the impact of cat losses and prior year development, the six month combined of 85.9% compares favorably to the 88.9% in 2011.

With respect to top line, gross premiums written in the quarter were $452.4 million, a 4.2% reduction from the second quarter of 2011. Our year-on-year premium saw reductions in our North American, European and Latin American business units and a significant increase from XL Re Bermuda driven by increases in our Japanese cat portfolio and a changed inception date on one large treaty. The reductions in our other profit centers were driven by selective cancellations, share reductions and some timing differences.

Turning to market conditions, we were broadly pleased with the mid-year renewals, though the rate of increase on Southeast wind renewals were below our expectations. Our risk-adjusted improvement on this book was 5% below the 8% to 10% we expected and quoted going into the renewal season. There was abundant capacity available in both traditional and non-traditional forms to play substantial programs in the market.

Notwithstanding this we would point out that this is a portfolio that had a very healthy increase in the 2011 mid-year renewal and remains the most attractive component of our cat portfolio as measured by rate adequacy in our pricing system. On the long-tail side our position remains highly defensive as we continue to navigate through an improving, but still competitive primary and reinsurance market environment.

Finally with respect to our crop book you'll recall 2011 was our final year as the fronting carrier for the Heartland Crop program due to the sale of the agency. We continued this year as a quota share reinsurer of the new owner and through the second quarter this year we have booked $11.6 million of net earned premium at a technical combined ratio of 82.7%, which does not include operating expenses. This was driven principally by the solid performance of the winter weak component of the portfolio. Our projected premium for the year is $58 million from this source and we do protect the book with stop-loss reinsurance attaching at a loss ratio of 110%, we buy 40 points to cover with 5% co-participation up the pillar.

In addition, we write a book of aggregate stop-loss business on this class out of our Bermuda business unit. There our total aggregate limits are $41 million with just over 50% of the book attaching that loss ratios of 130% or higher.

With that, I'll turn it over to David for Q&A.

David R. Radulski

Shirley, please open the lines for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Jay Gelb with Barclays. You may ask your question.

Jay Gelb – Barclays Capital

Thanks and good afternoon. Mike before everyone goes out and starts raising their estimates dramatically that insurance combined ratio underlying of 98.5%, I think it was the best in eight quarters. What’s your expectation in terms of being able to repeat that level going forward?

Michael S. McGavick

Well. First, Jay thanks for the question. Your perspective is a good one. I think I mentioned on our call last quarter that well I feel that things are going directionally correctly and we’re very pleased with the progress. If I go back kind of in the fourth quarter, I felt that well some of the long-term issues in some of the challenged businesses were coming home to roost, that we were actually a bit on the unlucky side.

In the sense that a lot of stuff all happened at once, and I think I would put this quarter in the same context in the reverse. I think this was a favorable quarter. I think, at this point we are well on the way in a lot of the corrective actions we’ve undertaken and we would expect results to be improving and we have said so. Could this one have been a bit luckier just as the fourth quarter of last year was a bit more unlucky?

Could be, so our attitude is look, as long as we’re continuing to deliver on the activities that we plan, as long as we continue to see the margin improve in the way in which we would expect we will be pleased. And given that we’re in the large loss business we should expect some volatility quarter-to-quarter, but directionally this is consistent with our actions, we would just say that it'll take a bit more time before we say there is less luck and more of our actions really taking hold in the book. Greg, you might want to add something to that, but that’s the basic sense we would have around here we feel good, would we say this is absolute proof? No, we wouldn’t say that yet.

Gregory S. Hendrick

No, I totally agree Mike.

Jay Gelb – Barclays Capital

Okay. And then a separate one on crop, Jaime, for the reinsurance exposure, what's the potential maximum possible loss in the second half of '12 from the crop reinsurance exposure?

James H. Veghte

Okay. Thanks Jay. Maybe I'll give you perhaps a bit more information than you just asked, so some of the information others may be wondering about will get answered as well. There are two components to our crop exposure, the first is Heartland, it’s the only proportional contract we write. We write at 30% quota share on that book of business with a 7.5% commission.

We expect $57.8 million of premium on a gross basis to be booked during the year. We buy stop-loss cover of 95% of [40x] of 110. So assuming that we totaled the stop-loss cover, the exposure would be the 10% retention, which would be $5.8 million, the 5% co-par up the stop-loss which would be another $1.15 million and the 7.5% commission, which would be 4.3. So that would be $11.25 million of underwriting loss.

The book is 50% corn, 18% soy, 20% wheat and 12% cotton and other. The largest states are Minnesota at 21%, which is a very good yield state so far; Texas at 12%, followed by South Dakota at 11%, Nebraska at 11%, Illinois at 8.5%, and Kansas at 8%. The book is split 50-50 between states in the Tier 1 category and Tier 2 and the way the government program works with the 500% gross loss ratio Tier 1 is capped at 194 and Tier 2 at 150. I'd also remind you as I mentioned in my opening remarks 20% of the book is in the winter wheat category which is already done and performed very well.

We also overlay both the corn and the soy states against the U.S. state progress report and mapped our portfolio with states that have greater than 50% rating of poor or very poor. And in corn our book is 19% in that category versus what we believe in industry number of 24% and soy is 19% versus 21% for the industry.

So, bottom line on this book as we think it will be extremely difficult to go through the top of our stop-loss program and therefore the answer to your question is the downside risk is about $11.25 million to $11.5 million depending on when the premium comes out for that part of the portfolio. The stop-loss portfolio out of Bermuda is a little bit more difficult to measure at this point in the growing season. As I mentioned, we have $41 million of total in-force aggregate, ranging in attachment points from just over 100 all the way up to 140, 150 but I picked 130 as sort of key demarcation retention for what I kind of view as maybe the downside in the industry.

So, about half the book attaches at 130 or above and about half below. We have got no noticeable loss on a provisional basis for many of our customers. We have nine customers in that portfolio and frankly most of them are very reluctant to give us much information at this point. So, we will know a lot more by the end of the third quarter, but if you wanted the total Armageddon downside it would be the in-force aggregate on the stop-loss and the figures I have quoted on Heartland.

Jay Gelb – Barclays Capital

The 41 plus an underwriting loss of '11?

James H. Veghte

Right.

Jay Gelb – Barclays Capital

Okay. Thanks. And if I can sneak one more and Mike on the LIBOR exposure, I understand it's early days on D&O, but maybe you can give us a perspective on the mix of business in terms of exposure to large integrated financial companies as a percentage of the book?

Michael S. McGavick

Yeah let's have Greg walk through some of the details that we can give, but again I just want to underscore this one is going to take a while to sort out and it's going to be really interesting to see how much if any winds up being covered loss as opposed to a big market mess. Anyway, Greg?

Gregory S. Hendrick

Thanks Mike. Thanks Jay. We know at this juncture the government investigations and resulting litigations involving the finance institutions are ongoing, and in some instances at very early stage. Because it's a developing event, it will take some time for us to come up with any kind of precise loss estimate.

However, let me give you a brief macro perspective some general coverage observations and some facts around our professional portfolio. From a macro perspective, the uncertainty begins the lack of clarity around how many of the institutions engaged in the saying of LIBOR, were not following established guidelines. That uncertainty is amplified by the inability at this point in time to establish the specific culpability of a particular insured.

And further the amount of U.S. securities exposure through U.S. exchange ADRs would also impact any loss potential given they follow the level of class actions outside of North America. If we shift to the general coverage observations standard D&O policies issued to public companies typically exclude coverage for regulatory fines and penalties.

In addition, entity coverage in a public D&O policy does not protect against antitrust allegations. And finally, Side A coverage response only if a company cannot indemnify an individual director or officer, and looking at our professional insurance portfolio, our mix of business helps us navigate any potential exposure as well. We have a blend of primary and excess as well as the strong geographic distribution.

As with the case of our entire portfolio, the financial institutions book has a blend of Side A, full coverage D&O and E&O. In fact, over half of our large financial institutions exposure is Side A only, which is a far more limited coverage potential. Specifically, to our international financial institutions business, we reduced our average limit by 20% over the last few years, which will mitigate any potential loss severity. The only thing I can add is, as you would expect Jay, we are monitoring the situation very closely.

Jay Gelb – Barclays Capital

Thank you.

Operator

Thanks. Your next question comes from Matthew Heimermann with JPMorgan. You may ask your question.

Matthew Heimermann – JPMorgan

Hi, thank you. Good evening everybody. First question is just, could you may be quantify just the large, how much of the improvement year-on-year you would attribute to the large loss side and then we can kind of do our own math in terms of the mix shift and kind of reworking the portfolio?

Michael S. McGavick

I am going to turn that over to Greg in a moment. But it isn't just large loss that’s improved here. Without question, we are seeing the impact of our re-underwriting and the mix shift as every bit is important as what's going in the large losses. The other thing I would add is our improvement in a large loss performance wouldn’t all be arbitrary. We've been changing the way we’re underwriting, changing the way we’re putting limits into the market and changing the way we’re using reinsurance. So the difference between large loss performance in the quarter or a year ago in this quarter wouldn’t only be fortuity, it would also be actions that we have undertaken.

Gregory S. Hendrick

Yes, there is a lot of moving parts ins and outs, the main drivers last this quarter last year were in our satellite and our marine portfolio, and this year there's one in property and one in upper middle market, but roughly two points of benefit quarter-over-quarter.

Matthew Heimermann – JPMorgan

Okay. Thanks for that. It wasn’t implying that there it was just luck, in the question.

Michael S. McGavick

No, no, I was just essentially the fact that I said there is luck in there somehow, or at least we feel that way and we didn’t want to think it was – that’s all that’s going on here, sorry.

Matthew Heimermann – JPMorgan

That’s fair. I guess just with respect to the life, I mean this is something I think we revisited from time-to-time over the past couple of years, but just with the life reinsurance portfolio, with kind of the financial system or companies within the industry starting to repair their balance sheets little bit.

Any new thoughts in terms of kind of end game for that business and I'd just be curious if you could maybe talk a little bit about the equity you've allocated to that, when we think about what the returns how much that might be dampening the returns that are being generated on the P&C side or kind of obfuscating those from coming to the surface?

Michael S. McGavick

Yeah, I'll start, this is Mike and I'll turn it over to Pete. The bottom-line is there are some improvements, as you say there is some rationalization going on among the life players and that really has our attention. We would love to think that as conditions become clear or improve that there would be alternatives to just a slow run up. At the same time, we want to be very thoughtful, economic oriented stewards of your money and this thing has some particular challenges with respect to GAAP and in terms of sort of true economics that we have to pay very close attention to as we consider alternatives.

Now, we have always said, hey, if someone has a great idea, we are all ears. We continue to have folks reach out and share their ideas with us, none of those has yet caused us to go forward, but we are going to keep pushing, because we do see it as something that in the end is not a part of our future and the sooner that's true I think the better for all of us. And obviously, the portfolio that is connected with being in this run-up is part of what gives us this very unfortunate and I think to some degree unfair nexus to what's going on over in Europe and the sooner that misimpression is shed the better the firm will be. But to get a little more specific I'll turn it over to Pete.

Peter R. Porrino

Thanks Michael, you have covered the most of it extremely well, you covered all of it very well. But I will try and add just a little bit more there. So, one thing Matt that is difficult to see from what we put on the financial supplement is what's there is a total, is a total amount of capital that's been ascribed to the life book, but we use that capital in our P&C business as well.

So, it isn't as simple as just taking the return on the $1.9 billion and saying I can go and if I remove that the impact on the ROE would be easily calculated. So, we've taken a look at it. If you look at a rating agency capital, if you look at an economic capital derivation you'll find that it is materially, materially less than the $1.9 billion.

That being said, I mean, I will just echo what Mike said, it is not something that we are looking to keep long-term. We do think right now with all that's going on in Europe it is a difficult transaction to see happen in near term. That being said, we've got our doors opened for as Mike said, interesting conversations.

Matthew Heimermann – JPMorgan

Okay. Thanks for that.

Operator

Thank you. Your next question comes from Jay Cohen. You may ask your question. And you are from Bank of America/Merrill Lynch

Jay Cohen – Bank of America/Merrill Lynch

Yeah. Thank you. Just two maybe smaller number questions. First, I guess it was Pete, you had mentioned that there were some severance expenses in the overheads. Can you quantify that for us?

Peter R. Porrino

Sure Jay. It's year-to-date about $5 million.

Jay Cohen – Bank of America/Merrill Lynch

Evenly split in the quarters roughly?

Peter R. Porrino

Yeah, roughly.

Jay Cohen – Bank of America/Merrill Lynch

Okay. And on the reinsurance side I believe you mentioned there was one large treaty where there was I guess a timing difference or the inception had changed. And I'm wondering does that impact the comparison in the second half of the year?

Gregory S. Hendrick

Certainly in the Latin America it will Jay because, actually just a couple of accounts change their anniversary date from June 30 to July 1, so they become Q3 events, so that's all about $11 million.

Jay Cohen – Bank of America/Merrill Lynch

So if those are renewed as it would obviously aid the comparison in the third quarter from a top line standpoint?

Gregory S. Hendrick

Correct.

Jay Cohen – Bank of America/Merrill Lynch

Great. That’s all I got. Thank you.

Operator

Thank you. Your next question comes from Mike Zaremski with Credit Suisse. You may ask your question.

Michael Zaremski – Credit Suisse

Thanks. As a follow-up to some of the earlier margin questions would you say a majority of the underlying improvement is from business mix changes? I know Mike earlier in the prepared remarks you said that the challenged businesses, I'm not sure if you meant premiums, I'd have to read back through it, but it fell by 12%. Did that accelerate from last quarter or from previous quarters?

Michael S. McGavick

Yeah. First of all, I think the basic answer to your question is yes. I would say it's more than half and I would say I expected to decelerate over the course of the last half of the year. And we have talked about this before. The reality is that as you start working your way through the book, it all depends on the timing by business, by line, by account, and when you get your mix on that renewal and get to work it. And obviously those things that you don't like that you get off, you get an immediate reduction in your risk and those things that you feel you can modify to have better terms you get a reduction in your risk going forward from that point. And as the book works its way through, we would expect to be able to confidently say that more of it has to do with our actions than with simple flow of fortuity during the quarter.

Again, one of the things I emphasized when we talked about all this at the end of the year and called out ourselves on this idea that we had a handful of challenged businesses was, one, I think unfortunate results of doing that was that people thought maybe we were just getting started on this work when in fact we've been working and focused on these businesses and all of our businesses throughout last year.

So some of these we would have already started the process of re-underwriting going back now more than a year others got more attention over the course of the last half year So you kind of almost have to and we do by the way internally, we chart it out by business, by action and by expected benefit of that action over the timeframe of getting to the renewals and having those actions take hold in the market.

And so every quarter we would expect to be able to more confidently say that a still greater percentage of the result is due to our actions and where we think we've been fortunate, we’ll say so, where we think we have been unfortunate, we’ll say so. That’s the nature of the large risk we take on.

I guess I'd only make one other point, by the end of the year I don't expect to be talking anymore about challenged businesses as a separate reporting item. All of our businesses go in and out of favor depending on market conditions that are unique to them and depending on the new issues that may arise in the industry. We view it ourselves as governing these 35 separate businesses and where they'll each stand at any moment, will be something we'll discuss with you as much transparency as we can, but through the end of the year we'll keep you up-to-date on our progress, so that you can track it, after that I think it just all goes back together it's XL and hopefully by then we are all as excited as we are about this quarter.

Michael Zaremski – Credit Suisse

Okay, then one follow-up then on the challenged businesses and hopefully we won't be talking about this going forward, but in the prepared remarks, I thought I had heard the delta, the combined ratio delta between the challenged and the performing businesses being wider versus last quarter, was that correct or maybe the challenged businesses are just smaller, so even today is wider, didn’t have as big of an impact?

Michael S. McGavick

It’s true, it’s wider all-in, but that’s because the movement that we saw that was meaningful in the quarter really had to do with prior year development. We had positive prior-year development on our better businesses, but on the challenged businesses we did have some adverse development, so you saw a widening perception of GAAP, but on an accident year basis, they are actually coming together.

Michael Zaremski – Credit Suisse

Okay. And lastly…

Michael S. McGavick

On an accident year, ex-Cat, basis they are coming together.

Michael Zaremski – Credit Suisse

Okay. And lastly, is there anyway for us do you think about alternative investment income in the next quarters, is it too early to tell?

Michael S. McGavick

I would say it's too early to tell, but you can look at our information we've disclosed what’s disclosed either on a month or a one-month or a quarter lag, so you can, you know the market better than we do, so you can predict that probably as well as we can if not better.

Michael Zaremski – Credit Suisse

Thank you very much, for your answers

Operator

Thank you. Your next question comes from Josh Shanker with Deutsche Bank. You may ask your question.

Joshua Shanker – Deutsche Bank

Thank you very much. I don’t know want to use the word challenged businesses, so maybe I want to talk about the business that you allowed leave the company. Everyone's talking about prices going up here. What do you think the rate increases could have been on the businesses that you let go off and would those have a better rate increases than the business that you are keeping that you think is a better quality business in general?

Michael S. McGavick

Well. I am going to just give a general observation and turn over to Greg. The general observation would be that if we thought we could get rate and if we thought that rate was the cure, we would write the piece of the business. We believe though that there are accounts out there that have been a part of the portfolio that we simply think the best answer is that we part ways. When we see it that way we are going to call that chart and move on and that’s why you see part of the remixing coming from business we are walking away from as opposed to simply care by a rate. Often the way that happens is we'll put the price out there in the market that we think is appropriate to the risk and the market will take the risk at a lesser rate than that and so it goes. I'll turn it over to Greg for specific color.

Gregory S. Hendrick

Yeah, I break it into three parts one would be our international property book where we know for a fact that rate's not there. So we are gaining about, we got about 3% in the quarter the business that we shared was flat to down 10% and so we know that we are not missing out on rate. Shift a little bit to our E&S book where we are getting rate in fact double digit rate. And there I would say we've kept a few pieces of the business, but within that business is a mix of things that rate can cure and things that rate can't cure. So we are keeping the business where we get the rate and shedding it out. There some is just structurally not efficient which rate doesn't really matter and I would say in our US MR business the guaranteed workers' compensation book would be an example there. The only thing that matters there is getting the right level of deductible and the right coverage for us. And so they could put 30% more rate on it, it doesn't matter. It's not going to be a profitable piece of business in our opinion.

Joshua Shanker – Deutsche Bank

Is there any way that you can quantify retention among large accounts in a way that I would understand?

Gregory S. Hendrick

Well, our retention overall, I'll give you the color, our retention overall for this segment is 82%.

Joshua Shanker – Deutsche Bank

How does that compares with the past?

Gregory S. Hendrick

That's down from the prior year of about 86% in the quarter and most importantly, particularly in our international property book we are down below 60s there. So we would spend all day doing every business, but that's kind of a marker of the spread and the further spread point I gave you is also E&S, which is probably most of you know, we usually run in the 40% or 50% retention ratio if you're running a good book because there is a lot of turnover there. We're down in the high teens on that book. So it's a widespread by business, but we're down and I think that's the right sign, because as you know, when you are getting down on those low 80s you know you're pushing the rate just about the right amount, you're not going too hard, you're not going too soft.

Joshua Shanker – Deutsche Bank

Well. Thank you. That’s all very helpful, great quarter.

Gregory S. Hendrick

Thank you.

Operator

Thank you. Your next question comes from Josh Stirling with Sanford Bernstein. You may ask your question.

Josh Stirling – Sanford Bernstein

Hi, good afternoon. And congratulations on the progress you have been making, no doubt a lot of heavy lifting. I was hoping that we could talk a little bit more about the business you have been growing in and just the two questions are on casualty professional lines.

If I am reading this correctly it's something up like 17% year-to-date, and I would love to get a sense of your view of sort of the current profitability and attractiveness of this business given some competitors seem to be taking and also talking about taking prices up dramatically in some segments, including D&O and perhaps some areas of E&O, and some concern about just whether recent vintages have been as profitable as everyone had originally thought?

Gregory S. Hendrick

Thanks Josh. Let me start with the professional piece and the 17%, I believe you're quoting the net number.

Josh Stirling – Sanford Bernstein

Yes.

Gregory S. Hendrick

So the biggest portion of the book that we have is our U.S. D&O business and while I cited a 2.5% rate increase, we don't follow a practice of underwriting here where there is a blanket rate increase mandated on an entire book of business. So it’s a very lumpy rate increase. There is great risks that are renewing at flat and there is also risk that we are getting a lot more than the 2.5% I said. As we get that rate, we’re hitting our benchmark of where we want to be on that business. So part of it in the professional lines is business on our biggest book coming in at the right profitability level.

The other piece of it is we are retaining more of that business now. From April 1, we changed our session on our professional reinsurance to keep more of what we think as a profitable book. So you get the two pieces acting together there on the net premium number.

Josh Stirling – Sanford Bernstein

That’s great. That’s was going to be one of my other questions. So have you guys made similar changes across a lot of your other businesses, because to drive some of these net to gross differences?

Gregory S. Hendrick

That’s the main driver of where we’re retaining more in the quarter, that the property reinsurance also renewed and we paid more money, but ceded the same expected margin away, but it isn’t of a dramatic variation like you saw on professional.

Peter R. Porrino

But Josh, the one thing I would add to Greg, if there was, I think Greg mentioned one contract that was a large program that was 100% ceded that was, so that also drove our ceded ratio.

Josh Stirling – Sanford Bernstein

That's great and if I could just ask sort of the color question that comes to mind on other specialty which has a similar maybe net-to-gross issue, but even our earned premiums base is growing relatively materially. I'd love to get some color around sort of the political risk business you are putting on as well as surety and trade credit and if you guys have any sort of European exposures on that liability book we should be thinking about anticipating or you have been frankly underwriting around to avoid? Thank you.

Gregory S. Hendrick

Sure. On the other specialty, the political risk business is the biggest piece, it's not adding, we haven’t written anything with exposure to continental Europe to answer your question directly. It’s more spread around countries that are transitioning, in my language from emerging to merged economies. So it's a very well spread book, it's very early days of course as well, but it’s a very well spread book in terms of exposures. We have also started up the inland marine line of business as well in North America, which I believe falls into the other specialty as well, so those are the two biggest pieces of that bucket.

Michael S. McGavick

And again, the one comment that I would make Josh, we made it last quarter as well, those lines do not map to when we talk about our specialty business, for example, they don't necessarily map. That is more of a, I'll call it a U.S. statutory line of business than it is the way we actually run our business.

Josh Stirling – Sanford Bernstein

Okay. Great, thanks for the time.

Operator

Thank you. Your next question comes from Bob Glasspiegel with Langen McAlenney. You may ask your question.

Robert Glasspiegel – Langen McAlenney

I think this is related to Josh's last question. Good evening everyone. Your press release yesterday Barbara Luck joining you highlighted that you are touting a new risk appetite for large primary casualty accounts. I didn't know whether there was more of a PR press release or a signal to the analyst community that you are in more of a growth mode on large primary casualty. If you are in a growth mode, I'd like to hear that amplified?

Peter R. Porrino

Sure. Thanks Bob for the question. We are and this is one caveat I'd give to and I have another strong reason why we need to stop just trying to segment out challenged businesses from perform and just talk about what's going in XL Insurance as a whole. U.S. risk management and primary casualty is one of our challenged businesses, and the challenges come from the prior underwriting activities.

We added Ken Riegler and Jay Lefkowitz late last year, Barbara is part of that team, I am a pretty frugal person, I am not fond of paying for people that aren't going to produce on the bottom line so that is a very deliberate growth mode for that business where we are looking to the right kind of risk management in primary casualty business where on the risk management side you get the right kind of structures around captives and self-insured retentions.

On the primary casualty there will be a flavor towards kind of the companies that have international exposure where we can add value with our global network so that's a deliberate growth that we will execute on.

Robert Glasspiegel – Langen McAlenney

Okay, so it is a change in this little segment that you want to be more aggressive?

Michael S. McGavick

This is Mike, Bob. You and I would have talked about these lines of businesses even go back to days at C&A. I think that the risk managed account business is an attractive business and one that fits very naturally with the kinds of clients we take on around the shop.

And the fact is that our risk management operation, our U.S. risk management operation had previously I think missed a couple of important themes to the plot; number one, generally speaking stay away from guaranteed cost business it isn't that attractive and I certainly think that would have been something we would have talked about in the past you and I; and second that if you're going to be in the risk managed account business you need a couple things.

First, you need a lot of people with proven track records in the space who have both the knowledge and the relationships to execute the business plan and that we have been attracting and we are very pleased to have these folks having joined our team with the kinds of track records that they have. And then second you have to look at your own portfolio and your own unique skill set and say what is that we can do uniquely for clients with these folks on board and there we looked at the kind of innovation and the global footprint that we have and we say there are clients in the house who already like XL where we can make a big difference for now that we have this expertise.

So, that's where we're headed and that's where it's all done. So, in the narrow context it will be a chain story away from one kind of business toward another and as the netting effect of that goes into the past it will be a growth story overall.

Robert Glasspiegel – Langen McAlenney

Thank you very much.

Operator

Thank you. Your next question comes from Vinay Misquith with Evercore Partners. You may ask your question.

Vinay Misquith – Evercore Partners

Hi, good evening. See first question is on the margins in the so-called challenged business. Do you think you are pretty close to reaching your profitability by the year-end or do you think some more actions will be required for next year?

Gregory S. Hendrick

Quite simply, Vinay, the answer to that one, this is Greg. The answer is no, they're not, at 105.6 combined ratio we're not where we need to be. That's not the target combined ratio we have for these businesses. So, there is still actions that we've already taken that need to earn through and some further actions that we have planned to happen in subsequent quarters need to have us and move us, much lower than we are now.

Vinay Misquith – Evercore Partners

Okay. Fair enough. And just as a follow-up to that seems that the top line growth is slowing and that's a good thing because you are pulling back the amount of underperforming businesses, should we expect that slower top line growth to continue for the next one year as you [reaching] the portfolio to a more profitable business.

Michael S. McGavick

I would say and as part of the commentary from the last question from Bob was there are businesses that are in the challenged category at the moment whereas this U.S. risk management and primary casualty we just discussed were submission flow by the way is much higher than its ever been before and we are winning the accounts as we speak. As you pull down guaranteed comp business you are pulling down high premium items and you are putting on U.S. risk management business where the net premium impact also is going to be lower, but as they are successful they'll move.

So that I would not project a fixed growth pattern based on what you are seeing. I will end by saying absolutely that right now for us in the insurance segment. If given the trade between top line and profitable margin we are going for profitable margin. Where the market goes I don’t know, that's another component of why I can't give you a direct answer on what we see for the quarters ahead.

Vinay Misquith – Evercore Partners

Sure. Fair enough. And just on the expense part of that equation since we are seeing the global economy slowing and then the significant portion of your premiums are in Europe. Do you have some levers on the expense side that you can pull to reduce the expense ratio? Thanks.

Michael S. McGavick

Yeah, this is Mike. The answer to that is yes, as we've been making these investments which we have been doing for the last couple of years. We've been constantly looking for how the investments allow us to operate in a more efficient way, and we believe as we get into the back half of the year, it's time for the reasons you cite the continued economic uncertainty, what's going on and the difficult challenges our European client space, and just the need to get to the level of returns through expanding margin that we've promised we'll be taking a very hard look in the back half of the year as to what we can do in addition to accelerate the benefits and advantages that are created by these investments, some of which are about inside and we'll be continuing investments.

Some of which were about enhanced leverage of our platform, and those would be places where we might be able to start capturing some of the advantage, so that will be an intense examination that Pete and others in the firm will be leading in the back half of the year.

Vinay Misquith – Evercore Partners

That’s helpful. Thank you.

Operator

Thank you. Your next question comes from Michael Nannizzi with Goldman Sachs. You may ask your question.

Michael Nannizzi – Goldman Sachs

Thanks. First off, Greg, thank you so much for that additional disclosure on a crop, that was a granularity was really helpful, so thanks for that. One question I had is on non-cat property insurance, what sort of rate change are you seeing there right now and just a quick follow-up?

Michael S. McGavick

You are looking for that from reinsurance or insurance or both?

Michael Nannizzi – Goldman Sachs

Mostly on the insurance side, because it looked like that’s where premiums fell a bit on a year-over-year basis.

Gregory S. Hendrick

Yeah, you have to split it into two pieces, in North America we were just over 10% ratings.

Michael S. McGavick

Positive

Gregory S. Hendrick

We just are over 10% rate increase.

Michael Nannizzi – Goldman Sachs

Right, okay.

Gregory S. Hendrick

And in the international property piece we are at the 6% rate increase in the quarter, so both, one in North America far exceeding any increase due to trend. And in international, a very positive sign, and this is the first quarter, I'm happy to report that we actually had some very meaningful positive rate in the international book.

Michael Nannizzi – Goldman Sachs

Okay. I guess a question as to, rate was higher, but the premiums you wrote in that business were down and then whereas in a line like professional liability, and I totally understand the comment about a big large mostly ceded contract, but on a net and gross basis it look like professional liability premiums were higher and rates there seem like they were maybe not as good. So, I am just trying to understand we can't see on the insight the decisions that you are making there just trying to understand contextually what's happening in those two areas that's causing that kind of disparity from the outside to be there?

Peter R. Porrino

So, if you look at the gross basis on the other property

Michael Nannizzi – Goldman Sachs

Yeah.

Peter R. Porrino

That's almost entirely driven to the dollar most by that one large contract that we referred to before. When you get down to net line it is lower that's related, partly there is a bit of net premium associated with that contract, but also there is as I did refer there is an increased cost to the cat cover and the risk cover that we bought at May 1, as well as some re-instatement in premiums associated with both of the losses in the quarter the Midwest quake and the Italian earthquakes.

Michael Nannizzi – Goldman Sachs

Got it. So on the PL for professional liability for a second, so where is that business now on sort of underlying combined basis like is it kind of where you wanted to be or are you still a few quarters away from the rate action that will get you there? Thanks for the answers.

Peter R. Porrino

So, the professional book, as you break it apart, particularly for D&O would be in the mid-90 combined, mid low-90s to mid-90 combined ratio. We have other smaller niche books that we've talked about before which fall into these challenged business categories. Our design and select that will be much closer to 100% combined ratio so that's kind of the split of the book by the combined ratios.

Michael Nannizzi – Goldman Sachs

Great, thank you.

Operator

Thank you. Your next question comes from Meyer Shields with Stifel Nicolaus. You may ask your question.

Meyer Shields – Stifel Nicolaus

Thanks. Good evening, everyone. Mike, you mentioned when you were talking about capital management, I guess, balancing share repurchases with other opportunities and I was wondering whether you could discuss if the opportunities that are being presented now compared to a year ago are shaping expectations for how the overall insurance market is going to play out for the next couple of years?

Michael S. McGavick

That's a really hard question. I have been generally pleased with what we're seeing reported by primary carriers in terms of rate change. So I think there is a positive story continuing there. I have been a little bothered as you heard Jamie say by the fact that the reinsurance marketplace in terms of rate didn't meet our expectations in this most recent period and I'm hopeful that the Reinsurance community will remain disciplined given that our absolute returns remain very difficult given the interest rate environment and that's the piece that yield environment, depressed yield environment remains the most important fact that seems to me it is still be not sufficiently addressed by the insurance and reinsurance marketplace.

So that piece will continue to give me pause on performance. At the same time, it is the case that we have pockets of very profitable activity that we would like to grow and we have opportunities to remix our book to a more profitable level that we think are already starting to influence the results. So, for us maintaining some investment in those activities is very intelligent positioning of the firm for what we hope will be an improved market over time, maybe not spectacularly improved but moving forward with I think some appropriate discipline.

In balance though, we can't get away from the fact the trading where we're trading, buying in our shares is a very positive economic benefit to our shareholders. You saw us increase our repurchase in the quarter beyond what we would have forecasted at the beginning of the year and as a result the net will keep balancing those out. Sorry my voice is starting to go, but we’re pleased with the progress we are marking. We're going to continue to invest in businesses where we see good margin.

Meyer Shields – Stifel Nicolaus

Okay, that was very thorough. Thank you. And one quick numbers question if I can. Did foreign exchange contribute at all to the reserve releases in the quarter?

Michael S. McGavick

No.

Meyer Shields – Stifel Nicolaus

Okay. Thank you very much.

Operator

Thank you. Your next question comes from Randy Binner with FBR. You may ask your question.

Randy Binner – FBR Capital Markets

Hi, thank you. I guess just as a follow-up on the buyback question. There was an incremental increase, but it still seems very small relative to our estimate of capital capacity. And so I kind of wanted to get some color on how we might think about that in the back half of the year and in particular if the hurricane season is something that you want to kind of way to see passed before that allocation would get bigger or if we would continue to be kind of this very gradual increase?

Michael S. McGavick

This is Mike with my new voice. One of the things that I've noticed in working with Peter since you have to shout to be heard your voice goes a little quicker in the day than it used to. So I am going to turn it over to Pete since I blame him for that fact. The one, what I would tell you is look we said that we viewed the 400, which we had forecast as a four, assuming things went according to plan. We’ve said that as margin expands if we continue to see margin expansion that that would give us additional flexibility and we’ve said that we will continue constantly to evaluate the trade-up to try and make the right decision for our shareholders now and in the future and by that we don’t mean just immediate future but the medium term future as well.

Peter R. Porrino

So Randy, the only thing I would add two things to that, first we do not typically stop buybacks because we are entering winter season. So I would be view as likely to continue and I would also say it is likely to be incremental we don’t see we have, we are working hard to try and be a little bit maybe predictable is not the right word, but just a little bit more even handed and how we go into buybacks and so without getting into too much on specificity I expect that we’ll do something in the third quarter and I would expect that going forward to the rest of the year it would be comparable slight – possible slight increase but that’s it.

Randy Binner - FBR Capital Markets & Co.

Okay. That’s helpful. I want to sneak another one in, just because I thought it was interesting, Mike you mentioned that there is, in the life business, one of the previous questions had to do with offloading that run off risk, which is always difficult and you mentioned there is challenges at kind of economics versus accounting and I want to understand your comment better is it a challenge that you might lose the DAC associated with that business or are you saying that you think the economics are better than what you get with accounting. I’d be interested for more color on kind of what that comment meant kind of accounting versus economics and challenge of offloading that risk.

Peter R. Porrino

Yeah, Randy, this is Peter, let me try and take that. The issue is not DAC per se. DAC is fine. We haven’t seen any material changes in our expectations of how that book is running off clearly as Mike said it’s a book that does has no future at XL. The question about economics and GAAP has to do what I said little bit early as well with what the economic capital is, right and there literally is $1 billion difference between what some would say economic capital is and what you would see us disclose as our GAAP capital.

So, when you think about economic returns versus accounting returns you have to take that basically into account, right. There is $1 billion difference. Well, that’s two different things. I don’t think we’ll ever be at a type of place that we’ll make decisions based on accounting results, we’ll make them on economic results, right but the pure fact is it’s a life reinsurance portfolio it’s an annuity reinsurance, it is very different than a primary portfolio, right. There are costs that are different for to buy a reinsurance block in order to buy a primary block. So, again, we are welcome to have conversations with people, but at the same time we do look at the economics of any transaction that we would enter into.

Randy Binner - FBR Capital Markets & Co.

Okay. That’s great. Thank you.

Operator

Our final question comes from Ian Gutterman, Adage Capital. You may ask your question.

Ian Gutterman – Adage Capital Management, L.P.

Hi, great. Thanks. I just want to clarify one more time what’s going on the accident year and the Insurance businesses because I guess it feels like there are two different things going on where you’ve obviously shown a lot of overall improvement and you said there was some good luck helping out, but when I look at the challenged business at [1056] that actually got worse from last quarter and I would have thought if anything the luck would have helped that businesses given some of the lumpy stuff in there. So, what made that part of the business actually get a little worse sequentially?

Peter R. Porrino

Ian, this is Pete, sorry. Just I’ll turn to Greg, but my first comment is when you start looking at a block of business the size of what our challenged businesses are we are going to have noise all over the place, okay. And that really, that has a lot to do with what happened in this quarter versus a prior quarter. Greg?

Gregory S. Hendrick

The accident year loss ratio ex-cat was 69.9 this quarter, up just slightly from 69.2 in Q1 of 2012. So, minor deterioration and none it had any one chunk it’s a lot of little things.

Peter R. Porrino

Yeah. There was actually a change in the allocation of expenses as well in Q2 versus Q1 that drove that a little bit. But again, that I think is more because of just the absolute size of what’s in the challenged businesses.

Ian Gutterman – Adage Capital Management, L.P.

That makes sense and then similar question. The reinsurance improvement obviously you had excellent quarter. Was that, I guess, two things, I know one is the expense ratio came down a lot from sort of a normal Q2 type level was – and given the investments you are making, I guess, that’s surprising a little bit. Was there something one-time in the expenses or you are doing better than expected and on the loss side was that just very favorable large losses?

Gregory S. Hendrick

Let’s take one at time. On the expense side, Ian, on the operating expenses, our actual expenses went down by about 3.6% principally from compensation and professional fees and our net earned premium went up by 10.8%. So that drove a significant reduction in the operating expense. On the acquisition expense, there was a lot of small things, but the biggest was you are absolutely correct a one-time event, but that was a Q2 2011 event where we paid a very large profit commission to one of our large North American customers.

On the loss ratio side, about a two point improvement and that’s broken down really between two items, Griffin last year at $6.4 million and a warehouse loss in Latin America again in the second quarter of last year for $2.2 million that equals about a two point improvement in our combined ratio and our loss ratio.

Ian Gutterman – Adage Capital Management, L.P.

Okay. So that roughly 30% expense ratio for the first half, is that a reasonable run rate?

Gregory S. Hendrick

It’s hard to say, a lot of that will depend on business mix. We have written a lot more cat business, which should reduce the acquisition expense ratio overall. But it’s a very lumpy portfolio, we could write one large deal with a large commission and it would move things slightly. It doesn’t mean there is necessarily a massive change in either our strategy or the market environment.

Ian Gutterman – Adage Capital Management, L.P.

Got it, got it. Okay. And Peter, I’ll try on one more and if this is a long answer I’ll take it off line, but it’s a short answer, hopefully, you can give it quickly. Can you one more time do the deposit book business caused that $90 million of interest expense, is essential because that was – that you saw what we would normally call adverse development instances booked as a deposit, it shows up as higher interest expense or are you seeing something else?

Peter R. Porrino

So that’s pretty much what we are saying, the loss amount is cat and has been cat and so there is no increase in the total amount of losses that we are going to pay into the contract, but since the ultimate underlying that are going up. We will be paying our share faster than what was assumed previously. So it literally is an acceleration of payment, the amount of payments has not changed.

Ian Gutterman – Adage Capital Management, L.P.

Okay. So it’s just a discounting issue, a PV issue?

Peter R. Porrino

Yes.

Ian Gutterman – Adage Capital Management, L.P.

Got it, okay. Thank you.

Operator

Thank you, and at this time, I’ll turn the call over to the speakers for closing remarks.

Michael S. McGavick

This is Mike. I just want to thank everybody for taking the time and the interest especially as the Insurance and Reinsurance sector earnings season winds down. We obviously are feeling very good around here about the progress we are making, this is as I said at the beginning, a solid result whether that – at on a relative or absolute basis, and well the call has focused on some of the reasons that we – none of us should get ahead of ourselves as we would not because we believe in the end we can do still better and we are absolutely driven to deliver that result.

We are pleased with the progress, but we are nowhere near satisfied and we won’t be satisfied both until the results are wonderful and until we can tell you and look you in the eye and say that and the results are exactly what we’d expect given everything we are up to. So we are pleased with the progress and look forward to talking to you next quarter.

Operator

Thank you and this does conclude today’s conference. We thank you for your participation. At this time, you may disconnect your lines.

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