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Delphi Financial Group (NYSE:DFG)

Q2 2008 Earnings Call

July 23, 2008 11:00 am ET

Executives

Robert Rosenkranz - Chairman and Chief Executing Officer

Bernie Kilkelly - Vice President of Investor Relations

Donald Sherman - President and Chief Operating Officer

Bob Smith - Executive Vice President

Anita Savage - VP Finance

Analysts

Michael Grasher - Piper Jaffray

Randy Binner - FBR Capital Markets

Jukka Lipponen - KBW

Mark Finkelstein - FPK

[Robert Bobbins] - Capital Returns

Beth Malone - KeyBanc

Paul Newsome - Sandler O'Neill

Eric Berg - Lehman Brothers

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Delphi Financial Group Second Quarter Earnings Conference Call. At this time, all participants are in a listen only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. (Operator Instructions). As a reminder, today’s call is being recorded. And, your hosting speaker, Chairman, Rob Rosenkranz. Please, go ahead sir.

Robert Rosenkranz – Chairman and Chief Executing Officer

Thanks. I’d like to welcome all of you to Delphi Financial’s second quarter 2008 conference call. The earnings release was distributed last evening. It’s posted on the company’s website along with our second quarter financial supplement. The call is also being broadcast live at our website at www.delphifin.com.

Participating in the call with me this morning are Don Sherman, Delphi’s President and Chief Operating Officer; Bob Smith, our Executive Vice President; Anita Savage, VP Finance; Bernie Kilkelly, VP Investor Relations; and our colleagues at Reliance Standard Life, Safety National, and Matrix.

Bernie, would you please now read the Safe Harbor Statement.

Bernie Kilkelly – Vice President of Investor Relations

Thanks Bob and good morning everyone. For those listening to a replay of this call, it's being held on July 23, 2008. It contains time sensitive information that is current only as of this date.

Statements made in this call relating to the future operations, performance, goals and expectations of the company as opposed to historical facts are forward-looking statements under the Federal Securities Laws. These statements are based on assumptions and estimates by the company that are subject to various uncertainties and contingencies.

Discussions of these risk factors can be found in our second quarter earnings release yesterday, our first quarter Form 10-Q, and our 2007 Form 10-K. These factors could cause the company’s actual results to differ materially from those expressed in any forward-looking statements made during this call and should be considered carefully. The company specifically disclaims any duty to update forward-looking statements made in this call.

In addition, certain non-GAAP financial measures will be discussed on this call. The comparable GAAP financial measures along with reconciliations to such measures are contained in our second quarter earnings release and financial supplement accessible on the company’s website.

Now, I’ll turn the call back.

Robert Rosenkranz – Chairman and Chief Executing Officer

Thanks Bernie. Delphi had a solid second quarter driven by continued strong underwriting profits in our insurance business. We achieved operating earnings per share of $0.81 and an annualized operating return on beginning equity of 14.7%. We continue to have a very strong balance sheet and took advantage of our financial flexibility to repurchase almost a million shares during the quarter. This morning in our remarks we are going to cover four main topics.

First, I’m going to ask Don to review our second quarter results. Second, I’ll provide some additional detail on our second quarter investment performance, which improved from the first quarter, but continued to be impacted by volatile markets and continued low interest rates. Third, I will discuss the topic that we had been getting lots of questions about in the last few months, which is the potential impact of the downturn in the economy on our insurance business. And finally, I will discuss our outlook for the reminder of 2008. After our remarks, we will happy to answer any questions. Don?

Donald Sherman – President and Chief Operating Officer

Thanks Bob and good morning everyone. We were very pleased with the underwriting performance of our insurance businesses in the second quarter. Our group employee benefits combined ratio was 91.8%, down from 92.4% for the second quarter of last year. We continue to achieve better loss ratios from our disciplined pricing and underwriting at both Reliance Standard and Safety National.

Looking at premium growth, core group employee benefit premiums rose 4.5% to 324 million. Group life premiums at Reliance Standard increased 11% while disability increased 5%. Our premium growth at Reliance was impacted by a decline in core production and this resulted from maintaining our focus on pricing and underwriting discipline in the phase of a somewhat more competitive environment. Price competition has increased particularly in long term disability and in the large case market which we addressed with our integrated employee benefits effort. Delphi's philosophy has always been to focus on growing the bottom line and not just the top line, which we believe is the best way to build long term value. To this point in the economic cycle, we do not believe the challenging economy has had a material impact on our production since our coding activity has continued to increase in the low single digits in the quarter. Bob Rosenkranz will talk a bit later about our view of the potential impact of an economic slowdown on our insurance businesses.

RSL's disability premium growth was also affected by a decline in premiums from our turnkey disability division, CDS. Premiums at CDS were 12 million compared to 13.4 million in last year’s second quarter. For the first half of 2008, turnkey disability premiums were essentially flat with last year and we except this trend to continue for the second half. CDS is focused on adding new turnkey partners, which tends to have a long sales and implementation cycle. We continue to be excited about the long term growth opportunity at CDS, which does provide us with significant alternative distribution to the small case market.

At Safety National, excess workers compensation premiums and production declined in the second quarter as the market continues to flatten out after seven years of hard market conditions. We were encouraged, however, by the trends in the recent July renewal period, which were not reflected of course now in our second quarter results. July renewals are the second most important period for Safety, in which they typically write about a quarter of their business. In the most recent period, Safety had record high renewal ratios, which demonstrates the ongoing strength of our market position. We also achieved higher sales compared to last year’s July renewal period, which we believe is due to effective new programs put in place by the management team at Safety including the new Head of Sales, who joined last fall, Steve Luebbert.

Rates in the July renewal period decreased modestly, but we continue to achieve modest increases in the average self-insured retention. As you know this is the important point where the risk shifts from the employer to us and we’ve been able to raise this average attachment point over $500,000. This is up from an average of $300,000 in 2001. So we continue to feel good about the business we’ve written and are continuing to write. More importantly, we continue to see no signs that the market will soften significantly anytime soon since there continue to be substantial barriers to profitable entry into this market segment.

In our asset accumulation segment, at Reliance Standard Life, operating profits in the second quarter was 6.7 million compared to 8.8 million for the second quarter of last year. This decrease was due to a decline in investment income from assets allocated to the segment. Funds under management in this segment increased to about 1.2 billion at the end of June. This increase was driven by strong sales in the quarter of our traditional fixed annuities, which have benefited as bank CD rates have fallen. We had modest sales in the quarter of our new equity index annuity product.

As you probably know, the SEC recently issued a proposed rule that, if implemented, we will classify these index annuities as securities and require these products to be distributed through broker dealers by registered reps. There is still a lot of uncertainty about whether this rule will pass in its current form and even if it does pass there presumably would be a 12 month period before it became effective. We are reviewing the potential impact of this proposed ruling, what it would have on our ability to sell this product. In the meantime, we’re pleased with the strong sales of our traditional annuities and continue to maintain our low overhead opportunistic approach to this business.

Now, let me return to investment results. Investment income in the second quarter improved over the first quarter but continue to be below our expectations. Average invested assets for the quarter were up 3% from year ago and our tax equivalent yield was 5.4% in the quarter compared to 6.3% last year. The low yield was primarily due to lower returns from our investments in limited partnerships, limited liability companies and hybrid financial instruments, as well as our trading account where these returns are mark-to-market to the income statement. The overall return on these alternative investments was about 60 basis points in the quarter, which is an improvement from the negative 3% return in the first quarter of this year, but still below our annual budget of 10% or approximately 2.5% per quarter.

In the second quarter, the balance of our investment portfolio generated yields inline with our budget. Turning from the investment yields to total returns, the aggregate total return in our investment portfolio was nearly 100 basis points better than the Lehman aggregate. Most of this out-performance was attributable to the returns from our alternative investment portfolio, which are not correlated with the buy market. Bob Rosenkranz will provide some additional comments on our investment results shortly.

In the second quarter, we had aftertax realized investment losses of 12.7 million. This included 11.7 million in aftertax losses from other than temporary impairments or OTTI, primarily on bonds in our fixed income portfolio sprinkled across a number of sectors. We had a consistent methodical approach we use for classifying for OTTI, which is discussed on Page 59 of our 2007 Form 10-K. This process includes projecting ultimate losses in principal, shortfalls and expected cash flows, the financial condition and prospects of the issuer, and our ability and intent to hold this investment until recovery. We believe there is no substitute for seasoned judgments, so we don’t use a [formulated right line] approach for OTTI.

Our process and its application are reviewed by our outside auditors and the impairments we took in the second quarter reflect our best evaluation of the current market conditions. But the credit cycle continues to deteriorate and with $5 billion portfolio, we would expect to have some additional OTTI write-downs going forward.

Turning now to our balance sheet. Book value per share, excluding mark-to-market adjustments, was $24.91 at the end of the quarter, up from $24.34 at the end of 2007. At the end of June, we had $221 million in unused borrowing capacity on our bank facility and 84 million in financial assets of the holding company. So we continue to have excellent financial flexibility to support the growth of our businesses and build stockholder value through higher dividends and share repurchases.

In May, we announced an 11% increase in our cash dividend and in the second quarter we bought back 965,200 shares bringing our repurchases for the year to about $1.5 million. We currently have an authorization to repurchase an additional 1 million shares.

Now I am going to turn the call back to Bob.

Robert Rosenkranz – Chairman of the Board and CEO

Thank you Don. For a second topic today, I wanted to review our investment results in some more detail. As Don mentioned our results from the quarter were below our expectations primarily due to the performance of our alternative assets, which get mark-to-market through the income segment.

Delphi is historically allocated a portion of our investment portfolio these types of assets and over the past 8 or 9 years, these investments have added about 10% to our investment income while at the same time reducing volatility in the total return of the portfolio, also by about 10%. But total returns is not the whole story, we also need to manage volatility and quarterly operating earnings.

Historically, our alternative investments were not the source of excess of volatility, but this years turbulent markets have a different story. We planned to gradually reduce our exposure to these assets at the end of the June was 490 million down from 550 million at the end of March.

Fortunately, the market is a target rich environment today, offering generous spreads on fixed income assets for those able to do the intensive analytic work required. Thus we have been able to redeploy these proceeds with comparable yields. Assuming these opportunities persist, by year end we would hope to reduce our overall volatility to historic levels, which we can achieve by focusing on reductions from the most volatile managers.

We believe, we can maintain historic returns as well, but the process will not happen overnight. So far though we are making very good progress, as an example, we’ve purchased mortgage back securities with AAA ratings at deep discounts where we have the potentials to earn returns in low teens.

We are also seeing good opportunities in [municipals] where volatility of our quarterly results is likely to remain high this year. By next year we should be generating both the yields and volatility we have historically achieved.

We generally have a policy not to provide any performance or other data relating to our outside investment managers for proprietary and competitive reasons. But I would like to make an exception now, due to number of questions we have got in recently about one of our investment managers [DB Zorn] which has been in the news for the past few months. Zorn announced in February that they were closing their two largest investment funds and there have been news reports with the SEC who is investigating the firm.

We have no comment on the SEC investigation, but with regards to our relationship with Zorn we are not investors in this Zorn funds that had been in the news. Delphi has managed accounts with Zorn and which we participate in specific investments they originate. This is a highly diversified portfolio with over 120 different investments. The investments are primarily high yield fixed maturity securities such as corporate loans and we’ve also have some ownership interest in the limited partnership or in limited liability companies and equities.

At the end of the second quarter, our accounts were around 230 million, which is down from more than 300 million last year. This portfolio was not been a source of meaningful impairments, in the second quarter we had only 1.7 million and after tax OTT write downs from the five investments in the Zorn portfolio. As they wind down their main funds over the next three years and one of these investments we expect to our investments with them to run off as well.

For third topic, I want to talk briefly about the potential impact of the economic slowdown on our insurance business. We’ve spoken in previous calls about the analysis we have done on this topic is part of our overall Enterprise Risk Management work. This analysis has shown that there’s no significant correlation between changes in grows domestic product and overall premium of loss ratios. We’ve also done correlations between our own premiums and loss ratios and payroll data for the last seven years, again not showing significant correlations.

We believe that there are three main reasons for those, first, our product lines are well diversified, that one product makes up additional portion of percentage of our premium. Our three main lines disability, group life and excess workers' comp have different market cycles in different competitive environments.

Second their customer base is well diversified by industry and a significant percentage of our customers on industries they are less economically sensitive. For example almost two-thirds of safety national customer basis in government entities, health care, education hardly economically sensitive sectors. Our sales customer base is broadly diversified both industrially and geographically.

Finally we focus on smaller companies, which is where the vast majority of job growth has been in the past decade and which we expect to perform better in recession. Almost half of our sales premiums comes from customers with less than 500 employees over 90% by case account. So we continued to feel very good about our ability to grow premiums and earnings in recessionary environment.

We are also continuing to explore ways to enhance our growth by adding new products or new distribution channels either through potential acquisitions or internal product development. In the second quarter Safety hired a very experienced executive to head up market research and product development. Stephanie Bush came to safety after 20 years at Hartford, where among her roles she was responsible for all product development at Hartford’s Property/Casualty Company. She will head Safety National’s effort to build on its reputation and long standing relationships in the excess workers' Comp market and potentially expand the scope of its products offering.

Now for our final topic, I’d like to discuss our outlook for the remainder of 2008. We believe the strong underwriting results of our insurance business from the first half of 2008 are sustainable for the foreseeable future. While there could be some continued quarterly volatility on our investment income, we continue to expect operating earnings per share in 2008 to be in a range of $3 to $3.30.

Looking beyond this year we’re confident of our ability to achieve continued earnings growth in our insurance business. As I have discussed, we are working to reduce volatility on our investment income while at the same time earning attractive returns. We feel good about our ability to use our strong balance-sheet and our financial flexibility to build value for shareholders and support the growth of our business.

In closing, we had a solid second quarter, we are comfortable about the outlook for insurance business in the second half.

And now I’d like to take questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is from the line of Michael Grasher, Piper Jaffray. Please go ahead. One moment please. Mr. Grasher, and your line is open now.

Michael Grasher

Okay, good morning. A question around the competition at RSL, if you could give us a little bit more discussion around what you see, who is there and where the greatest amount of contestants are coming from?

Robert Rosenkranz

Good morning, Mike, it’s Don. What we are seeing at RSL is the traditional set of competitors who seemed to have sharpened their pencils somewhat. I’m not sure there is any one party that we would want to or should name saying this is a particular much more competitive pricing but just seems to be a sharper pricing point going on out there. And we are looking at the production we were a little below where we needed to be to derive the RSL premium where we would like. So, we’ve been at RSL with Larry and his team taking a look at the production situation, the competitive situation of evaluating what we are doing from an underwriting perspective to be sure we’re maximizing our opportunities to get our target profit margins and the best volume we can with that. So, we’re sticking to the pricing margin, first philosophy that we’ve always used.

Michael Grasher

So you think it’s driven more by the competitive landscape or just the tweaking within your own under writing?

Robert Rosenkranz

Well, I think, what you see in the second quarter production was an impact of the increased level of competition in the competitive landscape.

Michael Grasher

Okay. And, are these generally players maybe you could be more if generals, just are these player that are real players that will stick around or do you think that they run and hide once the market turns?

Robert Rosenkranz

You know this is for (inaudible) actually it’s more a kind of generalized modest softening in the market as opposed to a hand full of new entrance doing silly things.

Michael Grasher

Okay. And, then your comments around the OTTI interesting and I think more detailed and what I heard in some other calls, but you’re talking about $5 billion additional write-downs coming, is there any way to gage sort of the timing around that or is it, however the market dictates?

Robert Rosenkranz

Mike, I hope I didn’t say $5 billion and write-downs coming, we’re trying to say with a $5 billion portfolio, we’re going to have some exposure to additional OTTI particularly as the credit cycle, works its way through this process.

Michael Grasher

I’m sorry, I’ve missed my note here.

Robert Rosenkranz

Yeah let me screen through my notes to be sure I had said that in the right way.

Michael Grasher

Yeah, but in general is it market driven more than your analytic process?

Robert Rosenkranz

Well, there market conditions are real factor in our analytical process, but we do follow a very methodical, analytical process around when something should be categorized that other than temporary so I’d say it’s say it’s market driven, but it’s every that market factor is considered in the analytical process that includes our ability and intent to hold to maturity, the reliability, the ultimate principle and the present value of the cash flow.

Michael Grasher

Okay. And then final question just over on City National, do we have in -- for that matter any favorable development in the quarter.

Robert Rosenkranz

Donald, do you want to take that question?

Donald A. Sherman

Mike, although, the lost ratio in the annual version line of expectations the majority of the soft market years are experiencing last adverse development than in the past we did have couple of new large catastrophic clients over 2 million and some additional development on some, previously reported catastrophic claims but in the aggregate we have some pluses and minuses, but in aggregate the loss ratio was inline with our expectations. A few -- no significant, positive reserve -- there's no reserve seen we’ve been a positive reserve release on the earnings.

Michael Grasher

Okay. And then if you look to your reserve -- not reserve -- if you look at your open claims, what percent of open claims would actually be prior to 01, as a percentage of total open.

Donald A. Sherman

Well, Mike I don’t have that (inaudible) I will get that information on and I will relate back to you through Bernie.

Michael Grasher

Okay. Thank you.

Donald A. Sherman

Are you talking about actual case reserves, right?

Michael Grasher

Sure

Donald A. Sherman

I will get that information and we will get it back to you.

Michael Grasher

Thank you

Operator

And our next question is from the line of Randy Binner with FBR Capital Markets. Please go ahead.

Randy Binner

Hi everyone couple of questions first on looking forward to '09 earnings you have talked in the past about having 10% to 12% EPS growth I guess and I’m employing that still in place as a long-term goal, so that would be often new I guess lower now at $3 or $3.30 guidance for '08, is that correct?

Robert Rosenkranz

Yeah that’s correct.

Randy Binner

Okay. And then is one which have one numbers in the model so if you look at the group benefit segment and exclude Safety National premiums were up about 8% this quarter, versus lower than where they’ve been running I mean in the last few years. And so I think anecdotally we’ve touched on the fact that the market is competitive. It is and may be this combines with the CDS comments at the top of the call, you said you can totally understand. But I mean is there 8% level as this in number that we should think about going forward in the model or is there I mean is there any case that this may have been in an unusually low quarter, just from a growth perspective?

Robert Rosenkranz

Ran, well let me just point out one thing that I think was perhaps not fully emphasized. Our annuity reproduction in the quarter was $100 million up from $31, for the half it was $150 million up from 51. So we are in a way seizing the moment here, because despite opportunities in fixed income securities are way better now than any time in the last four or five years. And we’re seizing that moment to take advantage of our ability to move opportunistically in the annuity business. So premiums are not the only source of earnings growth here, but with that being said I would like Don to address the growth rate.

Donald A. Sherman

Randy, the 8% RSL from our analysis the pricing is on track and elapse rates are essentially on track so it is a production question for us and we think, we believe we can do better than our second quarter production number but it is a competitive market and we need to prove that to ourselves as well as others. So, the 8% that you’re seeing in there might be at the low end of our expectations but it’s not an unreasonable number.

Randy Binner

Okay, that’s very helpful. And just touching on the annuity production, have you produced and I apologize if this is broken out somewhere but have you produced any index annuities there as all annuity sales still fixed?

Donald A. Sherman

We have produced a modest amount of the equity indexed annuities I should be clear and say it is a form of a fixed annuity its just that the interest credit is indexed so its not a variable annuity it is a fixed annuity but the interest credit is indexed in our case to the S&P 500 and we did produce some modest amount of that in the second quarter.

Randy Binner

Understood. But if the SEC prevails what the S&A does get rid I guess of the marginal producer that’s not going to be a material change, I mean good old fashioned fixed annuities is where you are seeing strength and so there is not a lot of indexed annuities in the number that we saw this quarter?

Donald A. Sherman

That’s correct. There is not a lot and the traditional fixed annuities with the fixed interest credit is where the number -- where the strength of our production has been and continued to be in the second quarter.

Randy Binner

Great. And then, just real quick on credit and thank you for the good comments upfront. But, I just wanted to try and get little bit more color on where exactly the losses were taken and then potentially where you have been adding opportunities. So, I’m looking to page 9 of the statistical supplement, you mentioned that the impairments were kind of sprinkle across the few categories, any more color we could get on sub prime, Alt A, CMBS and possibly where the tranche in Vintage were and then from where you are adding to the portfolio, maybe where you have seen opportunities I think, AAA and RMBS was mentioned but is that sub prime or is that Alt A?

Robert Smith

I think we mentioned, Randy its Bob Smith that OTTI sprinkle across the number of sectors most of which were fixed income oriented and in some cases they were corporate loans and in some cases they were mortgage backed with a mix of underlying primarily I would say prime as opposed to sub prime or Alt A. We had one mortgage that we wrote down, hold on mortgage and that number we had one stock investment we wrote down and I think we alluded to the fact that it was a modest amount from this one manager. So, putting altogether it came from the couple of different sectors and just reflects generally some distress that’s out there in the environment, I mean, just think what happened to the GSCs in the quarter. When we talk about stress but I think going forward we will see a mark of OTTI and I suspect it will come from again across a number of sectors. Going forward I think, we are seeing opportunities in mortgage lend with high rated tranches with Alt A and in some cases with prime underlying those to us seem particularly attractive, we are buying them what we think a very attractive prices and yields. So, we think there is an opportunity there.

Randy Binner

Thank you very much.

Operator

Our next question is from the line of Jukka Lipponen, KBW. Please go ahead.

Jukka Lipponen

Good morning. An excess work as comp premiums were obviously down again what are their expectations going forward and who is sort of taking business if you will?

Donald A. Sherman

Good morning, this is Don and I’ll take a shot at it and then press our colleagues that safety would want to add color. In the quarter the premiums were down, we were as we said in our earlier comments are pleased with the results of July 1 renewals. We had very high retentions in the July 1 renewals, record high retentions and so we think that bodes well for our little better trend going forward. And we do think some of these new sales programs that we put in place and other things that the management team has worked on gives us a little better opportunity going forward. So, the market has really flattened out here, we don’t expect to see rate increases, we are continuing to see modest rate decreases. But, with the high retention ratio we think we could see the premiums flattening out. Mark Wilhelm or any of the other colleagues at Safety did you want add any color to that.

Mark Wilhelm

Yeah, thanks Don. This is Mark at Safety. The carriers that might be taking business from us are the same carriers we mentioned for a while Midwest Employers, AIG and some repackaged prior competitors. There isn’t anyone really new out there that’s coming after this particular initiative business. As was stated in the script we saw some pretty positive signs of 7/1. Steve Luebbert we have instituted some operational that have allowed better focus our efforts in terms of targeting new business. We have performed some customer surveys and established some advisory council and we have embedded some other initiatives in terms of cash traffic, medical management and loss control. All of these things combined allowed us to become more efficient and also more successful in targeting. As Don said the rate decreases are very modest we are still achieving attachment plan increases, the payrolls continue to be up in our sectors, our renewal retention is quite high, out hit ratio and 7/1 was very good. So, lot of positive things to point to you.

Jukka Lipponen

My second question then was with respect to RSL and you’re saying that the premiums are not necessarily impacted by the economy but if payroll growth is slowing within just your existing customers doesn’t that by definition put some pressure on your top line on premiums.

Donald A. Sherman

You’re accurate in saying it is a payroll based program what we were trying to say in our comments was that we don’t see that as having a major impact at this point and particularly we didn’t think we should point to that we don’t think its proper to point to that as the situation behind the production shortfall. And we are continuing to see steady to slightly growing payrolls in this but you’re right if the economy were to have our same case environment and our employer subset and impact of decreasing payrolls it would show up in premium growth. At this point we are not seeing that as a factor.

Jukka Lipponen

And my last question what are your intentions and expectations with the buyback?

Donald A. Sherman

Clearly, I frankly feel like we are in a very, very fortunate position as a financial institution to be thinking about how to optimize shareholder returns when a lot of financial institutions are in a position of wondering how they’re going to raise capital under the gun in order to survive. So, on the one hand I think this is a tremendous opportunity for us to buy the stock and we believe is a very deep discount from the underlying industrial value of this company. On the other hand we are in difficult times for financial institutions and we want to be very sure to maintain a very good safety margin in our capital, in our profile for the rating agencies. I know this is not a very precise answer to your question but it’s the kind of considerations that we are grappling where there is a management team here.

Jukka Lipponen

Thank you.

Operator

Our next question is from the line of Mark Finkelstein, FPK. Please go ahead.

Mark Finkelstein

Good morning. I’ve got a bunch of roughly sort detailed questions. I guess the first question is are all of the alternatives reported through June or do you have a reporting lag on summer part of the portfolio?

Donald A. Sherman

There is no lag.

Mark Finkelstein

Still all through June, perfect. And then do you have an expectation of what the alternative balance might look at year end, is there kind of budget of where you want to target it to get that down to?

Donald A. Sherman

Well, I would say first of all there is quite a difference I mean, the call was one bucket and to think of this bucket really does all the simplify. There are number of strategies in here which are very volatility associated with them, there are others that are quite bit more volatile. So, we are obviously targeting the more volatile strategies and managers for reductions and we think we can create a quite meaningful reduction in volatility without necessarily targeting a specific number. The other thing I wanted to give a flavor for is that this has been a big contributor roughly 10% of investment income is coming from this 5% of the portfolio and this has been roughly 10% increase in overall investment income I should say from the segment of the portfolio. So, we don’t want to shoot ourselves in the foot in terms of operating income and what we are trying to do is take advantages of opportunities in fixed income to add assets would comparable yield so what we have been earning historically from the alternatives. Well, clearly not going to get those yields without situations that involve some complexity and some risk because we are very careful and thoughtful analysis in sorting through lots and lots of opportunities its not something that we feel we can prudently do overnight. So, what I am trying to convey is that by the end of the year we would expect to be, hope to be in a position where the volatility and quarterly earnings results is brought the alternatives is brought down historic levels but have been certainly no problem for us and at the same time by taking advantages some of these fixed opportunities. The market place we can do that without compromising our ability to earn the kind of overall investment returns that we have enjoyed historically.

Mark Finkelstein

Okay. I guess just on the zone thing, I guess the balance that you disclosed of 230 is about $60 million and more than it was, I just curious from a geography standpoint how much of that 230 is in the 490 alternative balance at quarter end?

Donald A. Sherman

About 15% alternative.

Mark Finkelstein

15% of the 490?

Donald A. Sherman

Yea, is in the form of alternatives within this one portfolio.

Mark Finkelstein

Okay. And then, I guess just speaking about valuation of those assets, do you have the same degree of transparency into those assets that are in your managed account in terms of getting comfortable with how those are valued, I know that’s one of the issues that is being looked at with those funds?

Donald A. Sherman

Yeah, again it’s a separate account we know the individual assets have discussions with the manager continuously about the individual and as I think you know little over 120 different positions there so it’s pretty well diversified. And we review that portfolio I would say in final detail then we might with others so we feel pretty good about it the historic pattern there is that the round trips on this have been very satisfactory and have supported the marks that have been maintained over time. So, from a couple of different perspectives, we feel pretty comfortable with.

Mark Finkelstein

Okay. And then just going back to a comment you made in terms of I guess separating the alternatives from some of the other assets within what I call them our traditional fixed maturity portfolio. You said that there were some kind of vital area, I am just curious I mean are there other managers that you are using on the high yield portfolio that fall in to the same kind of category or is it more kind of on this one thing when you guys transitioned from kind of below investment grade traded securities to these portfolios?

Donald A. Sherman

I am not sure I understand the question, I am sorry.

Mark Finkelstein

I guess on a message you mentioned that it wasn’t just the alternatives that you are thinking about pairing down but some of the more volatile assets that I assume kind of also within the non-alternative piece of mixed maturity portfolio and I am just trying to get an understanding of what you are referencing and are there other kind of assets that are being managed outside of -- just were in the kind of fall into the same bucket?

Donald A. Sherman

No, I think basically if you think of I may have -- I think you did misunderstand my comment. What I was saying was that within the alternatives portfolio almost all of the managers involved there are using strategies which are involved a substantial amount of hedging in [non-matured] positions and trading account activity. And some of those strategies are more volatile than others and simply by reducing -- so what I was trying to suggest is that we don’t need to have or don’t have a specific dollar target. What we more have is a volatility objective, we want to get our volatility quarterly our results down to the kind of the levels that we have enjoyed historically. On the fixed income side, I think I was making almost the opposite point that for quite a number of years, we felt that you simply not getting paid for credit rates that it just was not being well compensated enough in the market and the reason we gravitated to alternatives and the reason they grew as much they did was a combination of their own excellent performance and the dearth of alternative opportunities. We are now seeing a lot of good opportunities in credit line then frankly some of these securities maybe move about to all of the we think in a long run, if you do your work properly you are going to get tremendous returns out of fixed income which as the benefit of being budget upon a quarterly basis for operating income purposes.

Mark Finkelstein

Okay. I think I understand the point now. Then just well, quick down the Safety I guess was there any favorable development in the quarter that benefited the combined ratio?

Donald A. Sherman

I think somebody asked that the answer is no.

Mark Finkelstein

No. okay, I missed it then. Thank you.

Operator

Our next question is from the line of [Robert Bobbins], Capital Returns. Please go ahead.

Robert Bobbins

Hi, good morning, I have the Safety question, I’m curious to know the movement any attack there I guess it’s an average role the movement in the attachment points sort of year over year into given multiyear number over 500K I think it used to be 300K multiple years ago I’m curious to know how it’s move to be year over year July versus July and then how that compares to loss cost inflation which highest in this predominantly medical or some meaningful portion it medical? Thanks.

Donald A. Sherman

Bob, this is Don Sherman, the attachment point has been growing in single digit so over the last year or two

Robert Bobbins

Okay, it’s good over time.

Donald A. Sherman

Yes here so many Bob’s around here I tend to call my wife Bob on occasion. [Multiple Speakers] the catch point has been growing in the single digits and that’s been true for the last let’s say 18 months on the claims cost medical is not a significant element the traditional (inaudible) process particularly around the cute medicals not a significant element of our loss cost, we tend to spend more let’s say 70 to 75% is in the indemnity benefit that statutorily determined wage replacement benefit that we would pay to someone for example they were totally and permanently disabled and the medical that we paid the minority of our claims cost that are medical tends to be more for example attendant care medical some one who is totally and permanently disabled and requires some one to take care of them change oxygen tanks those kinds of things. So, the inflation rate that we see in our claims cost is much more moderate than what you would have expect from an acute hospital medical trend number.

Robert Bobbins

Got you. And then annulated investment question so I guess 75 million of the warn allocations you bucket in the alternative number and the balance I guess the separate managed account. Are there any other actively managed strategy that you consider outside of alternatives that are sort of actively managed third party money that would not be of our tradition fixed income category.

Donald A. Sherman

Can’t think of one.

Robert Bobbins

Okay thank you very much. Best of luck.

Operator

Our next question is from the line of Beth Malone, KeyBanc. Please go ahead.

Beth Malone - KeyBanc

Thank you. Just a couple of question on the acquisition environment I guess you saw that Philadelphia consolidated think quite for over two times book value. And I was wondering what you thought about transaction from your perspective and what do you think it does to the market for acquisition opportunities in general on the insurance base going forward?

Donald A. Sherman

It is a good question for pros and cons. I mean in one way its very heartening to see that a quality specialized P&C operation we trade in a market as challenged as this one at more than twice what the stock was selling and it was actually 2.7 times books. So, I mean it’s a very good day a point. On the other hand, it’s been my experience that buyers are much quicker to adjust the price expectations then sellers are. So, when we put on our acquiring hat I much sure I love that as a data point it’s a difficult environment, we are looking at some -- we have tried to see what swings into it were relate to opportunities. But frankly with our stock at these levels our cost of capital is very high so its not, not easy first to get something done in this environment.

Beth Malone

So I guess, that price if some one offered you that price for Delphi you would have to think about it pretty hard?

Donald A. Sherman

Yes, I guess, I think we would.

Beth Malone

Okay. And just along these lines a little bit I understand the cost to capital issue but historically in the past you have been able to make some kind of strategic tuck in acquisitions in the disability business that has boosted the growth in the last two years and I was wondering its not a whole company kind of acquisition, are those opportunities out there or they really just one off kind of situations that that you were able to take advantages?

Donald A. Sherman

No, you cast away that and you see these kind of opportunities and we’re trying to be a lot more systematic in looking for them, Harry Ilg who was the most senior Insurance Executive in the Delphi world is now full time out there, I was with him in London and we visited a group of Lloyds underwriters and he has visited lots and lots of people on his own he has been spending time in New York doing the same thing. So we have a very senior executive beating the bushes in that department. As Stephanie Bush is really hit the ground running at safety in terms of a very disciplined new business, new idea generation effort at safety. We are exploring an expansion of our systems capabilities so that hopefully will be able to higher specialized underwriting teams and be able to support them with the IT infrastructure to underwrite effectively in lines that may offer very attractive opportunities in which we are not now engaged. So, the answer is that yes the search for opportunities of this kind is something that we have really intensified to having a lot more resources added and that’s part of our response to what is clearly somewhat softer market conditions in our core market place.

Beth Malone

Okay, thanks. And then, one more question on the investments I was wondering what exposure do you have to Fennie Mae and Freddie Mac on the preferred in the bonds?

Donald A. Sherman

We have very little there, I don’t think we have any preferred I think if we have a $5 million position and there are unsecured debt that they allot most of our exposure there is MBS there is an underlying portfolio of MBS which they have guaranteed. So, in the sense its one of these covered bonds that’s being bonded about so very little unsecured exposure there or exposure at that bottom of the capital structure either.

Beth Malone

And then, just one last question on the equity index annuities that you all have launched I guess recently and potential change in that business I understand it could change the whole dynamic of your being able to market profitably that products, if that comes from the past that you make that decision that its not an area you are going to focus on going forward because of this change. Would we see a charge as a result of that or cost of you know drilling abandoning that strategy or not.

Donald A. Sherman

Beth, this is Don. We do not have a significant production there at this point nor do we have accumulation of deferred cost that would raise to the charge level so now you would not see a chart.

Beth Malone - KeyBanc

Okay, thanks.

Operator

Okay. The next question is from the line of Paul Newsome of Sandler O'Neill. Please go ahead.

Paul Newsome

My questions were asked and answered. Congratulations on the quarter, guys.

Donald A. Sherman

Thanks Paul.

Robert Rosenkranz

Thanks Paul.

Operator

Thank you. Our next question is from the line of Eric Berg, Lehman Brothers. Please go ahead.

Eric Berg

Thanks very much. I would like to start with an investment question. In the prior quarter when the issue of these alternative investments first surfaced you indicated that these alternative investments. I think I have this right, part of a larger category of investments that included a trading account, as well as, a principal protected note and so you sort of have these three buckets as I understood the alternative investment the trusty account and the principal protected note. Do I have that original classification correct then are you still sort of thinking of all the securities in those three buckets.

Donald A. Sherman

Yes. You have that correct.

Robert Rosenkranz

Yeah but we are referring to the three bucket collectively as alternative investment.

Donald A. Sherman

The 550 that it started out and the 490 that it is now comprises those three subcategories that you mentioned.

Eric Berg

Okay that is helpful so to be absolutely precise because I think Bernie corrected me the whole thing all three categories combine comprise what you call alternative investment.

Donald A. Sherman

Yes that is correct.

Eric Berg

Okay, I wanted to clarify just to complete the discussion on investment you are carrying back in all three areas in the partnerships, in the trading account, and in the principal protected note, or where is the scaling back going to take place?

Donald A. Sherman

Well it is really going to take place in those strategies that produce the greatest degree of volatility of quarterly earnings. Because of the problem with this asset classes not the risk return profile. The risk return profile has been extremely good. It has been uncorrelated with bonds and with other things in our portfolio. It is added return while reducing overall enterprise risk on a market-to-market basis. So, this is not a hard view a problem, portfolio of problem strategy but there is a problem or an issue which is that it produces more volatility in quarterly results then we were the market is comfortable with, in a period like this when the markets are just hyper-volatile. And what we are trying to do is phase out of the most volatile parts of that portfolio whether regardless of the form in which they are expressed in order to have an overall balance that is a lot less volatile in terms of reportable earnings. In order to do that without compromising the level of earnings we have to find fixed income opportunities with very high yields associated with them. And we think that those opportunities are out there, it just requires a lot of diligence, a lot of analysis, a lot of sorting through in order to take advantage of that and that’s the process that I am describing that we are on our way toward and hopefully by the end of the year I mean, I’m saying I think this year we are going to have more volatility in quarterly results than we’ve had in the past, but by next year I hope to have the portfolio repositioned in a way that the quarterly volatility of earnings is back to the kind of levels we’ve enjoyed historically. And I hope to achieve that without compromising our ability to generate the investment returns that we have historically.

Eric Berg

Good. My next question relates to your broader EPS outlook. And our fear question or reference I believe he said new lower guidance. I don’t look cold, I will apologize if I missed this in over your prepared remarks on the news release, new lower guidance. Is there any?

Donald A. Sherman

We think Eric, this is Don. We took the contents of that question to mean when we knew lower when we talked about $3 to $3.30, at the first quarter call that was the new lower guidance, we are not changing that at this time.

Eric Berg

Great, that answers my question. And then I guess my third and final question relates to Reliance, (inaudible) operation is my last question. If the slowdown in sales, if I understood your response to earlier question, is the result really of increased competition and a change in sort of your underwriting stand of customers when you decline the customers we’re excepting and so forth. Do you have any sense or how long this, cum history or anyway that you could tackle this question? How long this increase competition could last and could you talk about to the extent that you have not specific initiatives that you’ve undertaken to try to boost sales at RSL?

Donald A. Sherman

This is Don again. Let me try to put it on a little perspective, where we ended up was at a point or two short on the revenue increase somewhere we would have hoped to be with RSL products. And think it as I mentioned earlier it is the production problem. And, so we are looking at, what we can do from understanding the impact of variables on driving our loss cost, as we always would look at impact of variables in driving our loss cost to be sure we are capturing the maximum amount of business, we can that will generate our target margins. So, we’re restudying the last development in the book and looking for opportunities to find our appropriate profit margin in more of the business out there. In terms of the cycle you are asking how long, we thought that pricing cycle might last, maybe Larry Daurelle or Chris at RSL would like to comment about what they are seeing in that competitive environment.

Larry Daurelle

Good morning, this is Larry Daurelle. Hi, Eric.

Eric Berg

Good morning Larry.

Larry Daurelle

I think, what we are seeing on the production side for the most part is just increased competition where the prices are being lowered, remember as both Don and Bob said, we are sticking to our pricing margin, which we have to the last hand full of years, in terms of hitting target prices, it seems as though the competition is going after top line with probably not much regards for bottom line and that is the pattern and that’s kind of cyclical Eric, and we see having flow in 6 and 9 in month periods. And, the competition comes in and out. So, this is nothing new and it is long as from my perspective the competition wants to buy top line.

Eric Berg

Okay. That’s helpful this is my perspective. Thanks to everybody.

Operator

And at this time we have no further question in queue.

Robert Rosenkranz

Well in that case, I just like to thank all of you very much for your participation in the call.

Operator

Ladies and gentlemen, that does conclude the conference. We do thank you for joining, for using AT&T Executive Teleconference. You may now disconnect. Have a good day.

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Source: Delphi Financial Group Q2 2008 Earnings Call Transcript
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