Odyssey Re Holdings Corp. Q2 2008 Earnings Call Transcript

Odyssey Re Holdings Corp. (ORH)

Q2 2008 Earnings Call

August 1, 2008 10:00 am ET

Executives

Don Smith - SVP, General Counsel and Corporate Secretary

Andy Barnard - President and CEO

Scott Donovan - EVP & CFO

Analysts

Ron Bowman - Capital Returns

Mark Dwelle - RBC Capital Markets

Josh Shanker - Citigroup

Presentation

Operator

Good morning and welcome, ladies and gentlemen, to the Odyssey Re Holdings Corp's second quarter 2008 conference call. At this time, I'd like to inform you that this conference is being recorded and that all participants are in a listen-only mode. At the request of the company, we will open the conference up for questions and answers after the presentation.

I would now like to turn the conference call over to Don Smith, General Counsel and Corporate Secretary. Please go ahead, sir.

Don Smith

Thank you. Good morning. Odyssey Re's results will be discussed this morning by our President and Chief Executive Officer, Andy Barnard, and by Scott Donovan, Executive Vice President and Chief Financial Officer of the company.

The following discussion may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Some of these statements may relate to risks and uncertainties. Actual results may be materially different from those contained in or suggested by such forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the company's filings with the Securities and Exchange Commission.

And now, Andy Barnard will open the discussion. Andy?

Andy Barnard

Thank you, Don. Good morning, everyone. Business in the property/casualty insurance and reinsurance marketplace continues to become more challenging as soft conditions predominate. We are pleased with the book of business written year-to-date at Odyssey, but we expect continued downward pressure on rates, terms and conditions will cause our premium volume to drop off more sharply in the quarters ahead.

This quarter, our combined ratio of 98.7% included several points for catastrophe events in China as well as some strengthening of directors and officers' reserves for potential losses arising from the credit crunch. Otherwise, our business has performed generally on track with expectations.

On the investment front, we continue to generate realized gains at a healthy rate, though our interest income has suffered from declining rates on the large cash position we hold in the portfolio.

Across our four operating divisions, increasing competition is the order of the day. In the Americans, our casualty reinsurance business is down significantly. Year-to-date, casualty premium volume in both the treaty and facultative segments of the U.S. reinsurance book are off around 30%.

Our business has been shrinking due to the combined effects of increased ceded retentions and the increased pace of reduced or non-renewed shares and respot the continued price leverage. Some of this decline has been offset by an increase in property business, largely due to our participation on some new Florida quota share business at June 1st.

In EuroAsia, our results were again hit this quarter by catastrophe events, particularly in China. Premium volume has grown this year, largely due to the appreciation of non-dollar currencies. As of July 1st, the renewal of this portfolio is virtually complete for the year.

In the London Market, we've continued to focus on writing retro session business where capacity is filled relatively tight. In the Syndicate, net premiums have declined again due to a combination of our letting business go in the face of excessive rate pressure as well as an increase in our purchase of reinsurance.

Finally, in the U.S. insurance division, premiums were flat year-over-year. We expect overall premiums in this division will begin to decline more sharply over the next year. As we have recently relinquished, one of our larger program is to our competitor offering lower rates, higher commissions and more flexible underwriting authority. This particular program represented about 10% of the annual volume in our U.S. insurance division or about 2.5% of Odyssey Re's global premium income.

In today's market environment, it is unlikely we will find attractive replacement opportunities of similar size. Also, of interest in this division, our crop business is expected to perform acceptably despite the Midwest floods. As we have limited exposure in the state affected. Across the entire company, we continue to expect our net premiums may decline by up to 10% for the full year.

On a more positive note, we continue to hold high confidence in our ability to generate continued growth in book value per share, relying increasingly on the investment performance of our team at Hamblin Watsa. Odyssey Re is the dual-engine enterprise, combining the disciplined global underwriting platform with the unique investment capability.

We've compounded booked value per share at approximately 20% per annum since 2001. We've done so by taking a long-term approach, focused on value investment opportunities often at the expense of quarterly operating earnings. This strategy has worked well in the past, and we are confident that it will be rewarding in the future.

Now, let me turn the call over to our Chief Financial Officer, Scott Donovan, to walk you through more detail of the quarter's results. Scott?

Scott Donovan

Thank you, Andy, and good morning.

The second quarter results are highlighted by pre-tax income of $101 million, resulting in after-tax income of $65 million. During the quarter, our book value per share increased by 0.7% or $0.29 per share to $40.61 per share. Over the last 12 months, our book value per share has increased 34.2%. After-tax operating income for the second quarter was $36 million or $0.54 per share compared to $67 million or $0.93 per share in the second quarter of 2007.

Operating earnings declined due to reduced underwriting income, which was impacted by increased cat activity and lower investment income in the quarter.

Net income for the quarter was $65 million or $1 per share compared to net income of $146 million or $2.02 per share in the second quarter of last year. The decrease in net income was the result of reduced realized gains and net investment income as well as a reduction in underwriting income. The second quarter of 2007 included an after-tax realized gain on the sale of Hub International of $78 million.

Looking at premium activity for the second quarter 2008 compared to 2007, gross premiums written were $566 million for the quarter, an increase of 2%. Our insurance business was flat, while our reinsurance business increased 4%. Gross premiums increased primarily in our EuroAsia division, substantially offset by a decrease in our Americas division.

The EuroAsia division gross premium increase of 26% was mostly due to foreign exchange rate movements and a modification to our premium estimation process which had no impact on earned premium. Excluding the impact of exchange rate movements and the modification to our premium estimation process, consolidated gross premiums would have declined nearly 4%.

During the second quarter, our net premiums written and net premiums earned were fairly stable. Our retention ratio in the second quarter declined to 89% from 91% in the second quarter of 2007. For the full year, we expect that our net premiums may decline by as mush as 10%. In terms of premium composition, 55% of our gross premium was derived from non-U.S. markets compared to 49% in the second quarter of 2007.

Regarding product mix, 48% of our business in the quarter was in the casualty lines, 44% was in property and 8% was in marine, aviation, surety and other specialty classes. Insurance as a percentage of our business volume was 31%, which is basically unchanged from a year ago.

For the quarter, our combined ratio was 98.7% versus 93.9% in the second quarter of 2007. Included in the combined ratio for the quarter is $36 million or 6.9 points of current year cat losses. These losses include an additional provision for the first quarter snowstorm in China of $18 million, plus a $7 million provision for the second quarter China earthquake. The impact of prior period loss development during the quarter versus the second quarter of 2007 was unchanged at approximately $6 million or 1.2 points.

Looking to our four operating divisions: In the Americas, we experienced a decline of 13% in gross premiums written during the quarter compared to last year, reflecting difficult conditions across the U.S. reinsurance market. Casualty gross premiums declined by $29 million or 32%, and faculty and casualty declined by 38%, while property grew by 34%. The Americas combined ratio for the quarter was 97.8%, which included 4.2 points from current year catastrophe losses and 1.6 points from adverse loss development.

We continue to reserve current year D&O at higher levels in expectation of increased loss activity associated with the ongoing turmoil in the financial sector.

In EuroAsia, our gross premiums written for the quarter increased by 26%, primarily due to favorable foreign exchange rate movements and a system change in the premium estimation process, which did not impact earned premium. On a constant exchange basis and without the change in the premium estimation process, the change in gross premiums written would have been negligible.

The combined ratio for the quarter was 106%, which included 17.7 points from current year catastrophe losses, including the China snowstorm and China earthquake, and 4.7 points from adverse loss development mostly related to an increase in loss activity on non-catastrophe property risk business.

For the London market division, gross premiums written decreased 3% for the quarter compared to the second quarter of 2007. The decrease primarily relates to our insurance business, which is facing competitive market conditions in most of its business lines. London market had a combined ratio of 90.3% for the second quarter, which includes 7.6 points of favorable loss development related to reserve releases on property and other short-sales lines of business.

Our U.S. insurance division gross premiums written increased 3% in the quarter. We experienced increases in several programs, while reflecting a continued decline in our healthcare segment. The division's combined ratio of 95.1% for the quarter includes minimal reserving actions related to prior years.

Investment income net of expenses for the second quarter was $65 million pre-tax, which represents a decrease of 24% compared to the second quarter of 2007. The decrease is mainly attributable to the lower interest rate environment impacting our large cash and short-term positions and lower income from our equity investees. Overall, our portfolio yield declined to 3.3% from 4.69% in the year-ago quarter.

Net investment realized gains in the quarter were $46 million pre-tax or $0.46 per share after-tax compared to $121 million pre-tax or $1.09 per share after-tax in the second quarter of 2007. The quarter included $36 million of gains from sales of fixed maturities and $15 million of gains in derivatives from short sale positions. During the quarter, we liquidated credit default swap positions with a notional value of $180 million for proceeds of $40 million and recorded a realized gain of $4.9 million.

As of June 30th, 2008, the carrying value of the remaining CDS portfolio was $205 million with a notional amount of $3.9 billion. The average term to maturity was 3.1 years. As a reminder, the credit default swaps may be extremely volatile. Market value and their liquidity may vary dramatically, either up or down in short periods. And their ultimate value will therefore only be known upon their disposition. Operating cash flow for the quarter was $15 million compared to $2 million in the second quarter 2007.

Now turning you attention to certain balance sheet line items. Total invested assets were $7.9 billion at June 30th, 2008, an increase of 1% from the yearend 2007. Invested assets for common shareholders' equity currently stands at 3-to-1, and our investment portfolio now equals $123 per share.

Cash in short-term investments of $2 billion represent approximately 26% of the total invested assets. Equities, including equity investees, were $1 billion, representing 15% of the portfolio. Additionally, we have investments in both equity index and common stock total return swaps, which provide an economic hedge against the broad market downturn.

Our fixed income portfolio, which is primarily U.S. Government securities, was valued at 4.3 billion as of June 30th. 90% of this portfolio was rated AAA with only a minimal amount of securities rated below investment grade.

During the quarter, our after-tax unrealized gain position decreased by $42 million to $16 million. The change was primarily attributed to the recognition of realized gains in our fixed income portfolio and an increase on longer-term rates, partially offset by an appreciation of value of our common stock portfolio.

Finally, with respect to capital management, our debt to capital ratio at June 30th was approximately 15%, which is well within our acceptable levels. During the quarter, we purchased approximately 3.6 million shares of our common stock or 5.3% of our outstanding shares at March 31st, 2008, at a cost of approximately $133 million.

Subsequent to June 30th, as of July 25th, we purchased approximately 513,000 shares at a cost of $19 million, bringing the total amount of shares purchased to 8.9 million at a cost of $324 million, which equates to an average purchase price of $36.54 per share.

Lastly, the Board of Directors of Odyssey Re Holdings Corp. has approved a 20% increase to our quarterly common stock dividend to $0.075 per share.

I will now turn the call over to Anola for your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We'll take our first question from Ron Bowman.

Ron Bowman

Hi, good morning.

Andy Barnard

Good morning, Ron.

Ron Bowman

Hi. I have sort of a handful of questions, not in any particular order. Andy, you mentioned the U.S. insurance program that didn't meet your base rate returns and it's giong to somebody else. What line of business was that?

Andy Barnard

That was in professional liability, Ron.

Ron Bowman

Okay. Thanks. Does that include med mal, as you define it?

Andy Barnard

No.

Ron Bowman

Okay. Not med mal. Okay. Andy, the cat losses from your Asia business, Scott, you mentioned an $18 million number from the snowstorm and $7 million from the earthquake. The $18 million from the snowstorm, is that an incremental loss in Q2 associated with the Q1 event?

Andy Barnard

Yes, Ron, this is Andy. Yes, that was incremental.

Ron Bowman

Okay. Could you remind us what you put up in the first quarter for that incremental?

Andy Barnard

$10 million.

Ron Bowman

$10 million? Okay.

Andy Barnard

So, we have about $28 million, $29 million carried in reserve for that [venture] presently.

Ron Bowman

Okay. And I'm curious, on both the snowstorm and the quake, this I assume is reinsurance business that you write. And is it a common ceding company for both of these losses?

Andy Barnard

There are multiple ceding companies. Actually, the earthquake is largely from a global company that had interests insured in China, whereas the snowstorm losses are exclusively from a variety of Chinese companies that we had relationships with for some year.

Ron Bowman

Got you. In education, the Chinese insurance companies that buy reinsurance new, how do they buy? Do they come to Singapore with the broker? Is it a direct purchase? Just sort of would you enlighten me?

Andy Barnard

The excess of loss business tends to exclusively be done through brokers. As I mentioned, Ron, we've had through our EuroAsia operation, extensive relationships from China from some time. And so, we know these companies directly, but the business is usually transacted through a broker for excess of loss. Some of the proportion of business might be on a direct basis.

Ron Bowman

And do they use like the global alphabet brokers?

Andy Barnard

Yeah (inaudible).

Ron Bowman

Got you. When these events happened, did you immediately know you're going to have, not that you knew, but you sort of suspected you're going to have losses in this ballpark? Were there any lessons learned as far as the losses were greater or lesser than you had thought?

Andy Barnard

I think it's fair to say the losses are a bit more than we would have expected. And we are examining the business in China and the exposures there. These were snowstorms of historic proportions and they took place over multiple period. So, in some cases, there are more than one event that has been reflected in these numbers. So, maybe perhaps similar to the U.K. flood situation that affected some reinsurers last year.

Ron Bowman

Okay. Thanks a lot for your help on that.

Andy Barnard

Ron, I think --.

Ron Bowman

I shall re-queue, all right.

Andy Barnard

Yes, why don't you?

Ron Bowman

Understood.

Andy Barnard

Okay.

Don Smith

Thank you.

Operator

We'll take our next question from Mark Dwelle with RBC Capital Markets.

Mark Dwelle - RBC Capital Markets

Hi. Good morning, gentleman. A couple of questions. On a couple of occasions, you kind of gave some guidance in terms of premiums being down 10%. Is that 10% for the balance of the year or such that the full year-to-date could be up to 10% down?

Andy Barnard

We're saying the full year could be up to 10%. Obviously, since we are down about 2.5% to date, that would involve significant acceleration in the downward direction. I mentioned that one particular program to provide a little bit of enlightenment as to why we would continue to offer up that sort of outside parameter, I would say at this point, Mark, in terms of how much we could be down on the net premium side.

Mark Dwelle - RBC Capital Markets

And that was net, not gross?

Andy Barnard

That was net. So, it's factored in. In our insurance operations, in several places, we have increased the purchase of reinsurance, some of which will sort of kick in, in the mid year. So, you'll see some further reduction of our net to gross ratio, I would expect, as we move through the year.

Mark Dwelle - RBC Capital Markets

Okay. And the second question relates to the investment income line. The run rate for that this year has been noticeably below last year, and I understand with the yield, a portion of that makes sense. Can you give us some insight in terms of both last quarter and this quarter, you commented in terms of the equity investments that you'd been receiving dividends. How are those run this year relative to last year to help understand some of that change?

Scott Donovan

Yes, Mark, it's Scott. Why don't I just give a couple of points of reference? The other invested assets for the second quarter '08, approximately $6 million of investment income; same quarter last year, approximately $12 million. Let's look at first quarter this year, about $9.9 million. So you can see there has been a lot of variation in that amount.

Mark Dwelle - RBC Capital Markets

Sure.

Scott Donovan

Okay.

Mark Dwelle - RBC Capital Markets

And it will probably be fair to say that if the kind of run rate and investment income is down maybe $20 million year-over-year, maybe a quarter of that, with obviously the variability of quarter, related to these other investments, whereas the bulk of it is just straight declines in yields?

Scott Donovan

I think that's fair to say, Mark. Obviously, there is a downward trend on both. So, that's it.

Mark Dwelle - RBC Capital Markets

I know Hamblin Watsa is the one that mainly steers the bus on that. Would you have any expectation of a greater deployment of that cash into, I'll say, better yielding instruments over the balance of the year?

Andy Barnard

Not necessarily, Mark. As we've indicated on numerous occasions, we like having a large cash position. It's difficult to predict when we will find the opportunities to invest it. And in general, the investments would be looked at in terms of their overall return potential, not just the current yield that they might produce.

Mark Dwelle - RBC Capital Markets

And then the last question I had, I guess he had returned to you as a result of Fairfax's decision to increase their ownership of Advent. You had had some funds that Lloyds released back to you. That won't have any meaningful impact on other income or anything, will it?

Andy Barnard

Will not.

Mark Dwelle - RBC Capital Markets

Okay. That's my only questions.

Don Smith

Okay.

Operator

(Operator Instructions)

We'll take our next question from Josh Shanker with Citigroup.

Josh Shanker - Citigroup

Mark asked most of my questions. But I just thought maybe you could give some color, the market is down 15% year-to-date. Your equity portfolio, is that probably about 12% year-to-date? I'm wondering if you can talk about how your money is being deployed in equities?

Scott Donovan

Yes, Josh, it's Scott. We hold large individual positions and certain equity positions based on total return opportunity. I don't know what --.

Andy Barnard

Yeah, Josh. I mean this is Andy. You know if you have access to our filings, you would be able to see what some of our larger positions are, and you would see that they have done very well in the quarter. And that's what's being reflected in the proponents.

Josh Shanker - Citigroup

So, that's actually appreciation. That's not deploying more cash, new cash of equities?

Scott Donovan

No, that is absolutely appreciation.

Andy Barnard

There has been some deployment, but it's a combination in particular.

Josh Shanker - Citigroup

Okay. And then Mark had asked everything I want to know. Thank you.

Andy Barnard

You're welcome.

Operator

We'll take our follow-up question from Ron Bowman with [Capital Returns].

Ron Bowman - Capital Returns

Hi. Couple of questions on the CDS. Scott, I couldn't let it down fast enough. The sales of $180 million notional amounts, $40 million of proceeds, $4.9 million realized gains, that's the second quarter lead figures?

Scott Donovan

That's correct.

Ron Bowman - Capital Returns

Okay. So, $40 million of proceeds, $4.9 realized gain. So, am I to assume that was sort of the realized gain attributable to movements during the second quarter? I mean cost on those CDS positions weren't $35 million or am I mixing the quarterly and the historic movement?

Andy Barnard

I think you're mixing. The $4.9 million is the mark-to-market benefits arrived in the second quarter.

Ron Bowman - Capital Returns

Okay. Thanks. And then is the current CDS position figure of about $205 million, what was the $205 million?

Andy Barnard

That's the carrying value of our CDS as so far June 30th.

Ron Bowman - Capital Returns

Okay. So, that was for June 30th?

Andy Barnard

That was the mark-to-market value.

Ron Bowman - Capital Returns

You didn't give us any July 25th figures.

Andy Barnard

I did not.

Ron Bowman - Capital Returns

Okay. With such good results, Andy, what is the company's best rating? I know Crum got upgraded. Is there a prospect for an upgrade or --?

Andy Barnard

While, I mean we are A rated upgraded with A.M. Best. So, our capital ratios are very, very strong. Amit, you know we have been buying back stock. And I think the story with A.M. Best, as with all the rating agencies, is you had headwinds in the industry that they perceive. So, we'd like to think that we are deserving of an upgrade. But, of course, we want to anticipate that there will be one in the near-term.

Ron Bowman - Capital Returns

Okay.

Andy Barnard

So --.

Ron Bowman - Capital Returns

And then my last question, in the crude analysis of looking at how much stock you bought back in the second quarter, 1.2 million shares per month, and then you compared that number with 500-somewhat K for a partial month of July. I assume that the July purchases were part of like 10b-5 restricted plan to buy when you would otherwise be blacked out. Would that slower pace be attributable to sort of a more restrictive program under a 10b-5 or is indicative of something else? Thanks.

Andy Barnard

I'd think it would under a more restrictive program.

Ron Bowman - Capital Returns

Okay. Thanks again and continued good luck.

Andy Barnard

Thank you.

Scott Donovan

Thank you.

Operator

If there are no further questions, this concludes the conference call for today. Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 888-203-1112 for domestic or 719-457-0820 for international. Put an ID number of 1627904.

This concludes our conference call for today. We thank you all for participating, and have a nice day. All parties may disconnect.

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