Flagstone Reinsurance Holdings Limited Q2 2008 Earnings Call Transcript

Flagstone Reinsurance Holdings Limited (FSR)

Q2 2008 Earnings Call Transcript

August 5, 2008 9:30 am ET

Executives

Brenton Slade – Director, IR

David Brown – CEO

Mark Byrne – Chairman

James O'Shaughnessy – CFO

Analysts

Jay Gelb – Lehman Brothers

Josh Shanker – Citi

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Flagstone Reinsurance Holdings first [ph] quarter 2008 earnings conference call. My name is Silvana and I will be your coordinator for today. At this time all participants are in a listen-only mode. (Operator instructions) As a reminder, this call is being recorded for replay purposes. It is now my pleasure to introduce you to your host for today's conference, Brenton Slade, Flagstone's Director of Investor Relations. Brent, please proceed.

Brenton Slade

Thank you very much, Silvana. And good morning, ladies and gentlemen. Thank you all for joining us on the call today. With me today are Chairman, Mark Byrne; David Brown, our CEO; and James O'Shaughnessy, our CFO. Before I turn the call over to David, please let me remind everyone that statements made during this call, including the questions and answers, which are not historical facts, may be forward-looking statements within the meaning of the US Federal Securities Laws.

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

On that note, I’d like now to turn the call over to David Brown, our CEO.

David Brown

Thanks, Brent, and good morning everybody. As in the first quarter, our underwriting results were strong through the end of June and continue to be driven by fundamental results rather than reserve releases from prior periods. Again, we managed to grow our business in a careful and tactical manner over the quarter by continuing to provide world-class, value-added service to our clients.

Growing volume in a softening market is not a result that should be expected. And it’s important that our fellow shareholders understand our approach. As we mentioned last quarter, we generate intelligent growth in the competitive market in a number of ways. First, the global network of offices we have been building since we started Flagstone produce business we would never have seen without our offices in places such as Switzerland, Dubai, Puerto Rico, and now South Africa and Mumbai.

To be frank, much of the business we see does not meet our return hurdles and we reject over 90% of the business we see in many of these locations. The remaining business does meet our return hurdles and is attractively diversifying from our renewal business.

Secondly, we continue grow our relationships with existing clients where appropriate. But again, it’s important to understand that renewal for us involves a complete reanalysis and re-underwriting of each renewal risk. In the softening market, this includes a disciplined process of non-renewing risks with an adequate pricing and we continue to non-renew a high-teens percentage of our prior year’s business.

We also redeploy capacity with existing clients to different layers of renewal programs based on our analysis of the risk reward based on current data and terms. We were able to successfully redeploy this capacity to more attractive programs and maintain anticipated underwriting profitability at levels consistent with our long-term return on equity goal.

Finally, we continue to provide industry-leading service, which makes us a favorite market with brokers and clients. So having produced potential new business and identified the risks we like, it is this reputation, which enables us to achieve meaningful shares of our selected risks. This differentiating level of service is an important factor in winning and retaining participation on the most attractive risks we see.

We again increased our production on a year-over-year basis, particularly in the US where demand and discipline from reinsurers held up better than we had expected. An increasing proportion of our business is written on our Swiss balance sheet thereby effectively using the capital we’ve deployed there. We’ve mentioned this before, but we do not have any internal premium targets, instead underwrite strictly on the basis of expected margin.

With this in mind, we are very pleased with the composition of our portfolio. We continue to manage our exposure diligently and our conservative approach is evident with our one in 100 PML of 407 million and our one in 250 PML of 490 million. The proximity of these two numbers demonstrates our focus on mitigating our exposure to large industry events. Even in the most extreme of modern events our balance sheet should remain strong.

Our franchise and position in the global reinsurance market coupled with the solid balance sheet positions us to continue to grow within the marketplace and to generate shareholder value over the long-term. The second quarter of 2008 was active in terms of natural catastrophes and risk losses impact in the industry, which were geographically diverse. As a global writer, we were again impacted by some of these losses, but the diversification of our book showed its value in producing an overall attractive underwriting result.

Looking forward, we think prices will soften further United States, but remain at technically adequate levels. It is still declining, but not as much. As in some markets where they are already close to technical levels. Some smaller international markets are below technical minimums and we have significantly curtailed our exposure in these. Despite this, we are confident our global platform will produce enough attractive opportunities for us to continue deploying our capital at attractive risk adjusted returns.

I’ll now hand over the call to Mark for his comments.

Operator

I apologize, but it seems like his line has disconnected, Mr. Slade.

David Brown

Okay, I’m sorry. We’ve lost Mark. Let me just – I’ve got a copy of his comments here. Let me read them on his behalf until he joins us. We had a satisfactory quarter as diluted book value grew to $14.53 a share, growth of 3.4% inclusive of dividends. As you know, we regard increase in diluted book value per share measured over intervals of three years, the best single measure of our performance for shareholders.

Since the starting of the company the annualized growth is 17.3% inclusive of dividends, which is above our 17% target. Since our reinsurance book is exposed to catastrophes, our results will not be smooth from quarter-to-quarter and we do not issue earnings guidance. However, as our diversifying business lines continue to become more significant to our overall book, our earnings volatility should decrease.

The organization had a positive quarter as we continued to build out our unique global platform. We added additional talent and resources to the group and continued with plans to expand globally. We had previously announced our agreement to buy a 65% stake in Imperial Re, South Africa, and we have now finalized this transaction and begun integrating Imperial, which is now renamed Flagstone Reinsurance Africa Limited into our operations. We are excited to grow this business in an attractive but under-serviced location. We also have agreed to acquire a substantial minority position in Alliance Re of Cyprus. These steps are tangible progress in our diversification strategy.

Did I hear Mark just rejoined the call?

Mark Byrne

Yes, I have. I’ll go ahead and go on if I can?

David Brown

Yes, thanks.

Mark Byrne

Just at the end of the quarter we successfully purchased three-year reinsurance protection through our first public cap on Valais Re. Valais is a pioneering transaction in that it is indemnity based and global in scope, as well as being somewhat unusual in having been modeled in-house. The quality of our systems and modeling infrastructure were apparent and show the market that despite the relatively short history of Flagstone, we’ve been able to build a world-class industry-leading analytical framework. Furthermore, the fact Valais Re was issued into such difficult capital market is a testament to the quality of the portfolio, the systems and the team. We are committed to utilizing our capabilities in the capital markets.

Q2 2008 was fairly flat from an investment returns perspective, obviously disappointing, but the quarter was again marked by poor fixed income in equity markets and significant contagion on the credit market. Flagstone’s investment portfolio performance continued to show relatively low volatility with the total return for the quarter being 0.41% positive. Of the 14 asset classes in which we invest, the majority are showing negative returns for the year. And in hindsight the only way to have achieved significant capital growth this year was by holding cash or commodities.

We hold no subprime securities and only 15 million of Alt-A, which was a legacy portfolio from a previous manager. All of our external managers are under guidelines preventing the purchase of Alt-A or subprime backed instruments. We continue to expect modestly above average returns and below average volatility from our investment portfolio measured over time. The portfolio today consists in broad terms of 50% high grade bonds, 20% equities, 10% commodities, 12% cash, and 8% other. I bet someone is writing that down, so I’ll say it again. 50% bonds, 20% equities, 10% commodities, 12% cash, and 8% other. The other has a big component of global and US real estate.

I’ll now pass the microphone on to James to discuss the financials.

James O'Shaughnessy

Thank you, Mark. And good morning, ladies and gentlemen. The following are some highlights in the financial aspects of our second quarter results of 2008. Flagstone’s second quarter net income was $41.9 million. Our quarter ended diluted book value per share was $14.53, an increase of 17.9% over the last 12 months and 5.3% since year-end [ph] inclusive of dividends.

Consolidate underwriting income was $34.3 million for the quarter, up 447% relative to the same quarter last year. Our consolidated gross written premiums were $271.2 million, up 49.5% from the second quarter of 2007 and up 34.8 % excluding the impact of Island Heritage. Growth is primarily due to a strong property cat renewal, growth in our specialty lines, and the inclusion of Island Heritage. Offsetting these were higher cedent retentions and the non-renewal of contracts that did not meet our company’s profitability objectives.

Consolidated earned premiums were up 26.8% for the quarter relative to the same quarter last year due to an increase in the earned premium base and up 20.1% excluding the effect of Island Heritage. Loss activity in the second quarter was somewhat benign for cat reinsurers, but certainly an active quarter for attritional cat losses and for major risk losses around the world. Our improved loss ratio for the current quarter compared to Q2 2007 was primarily due to the prior year quarter absorbing losses from the UK flood of $31 million and New South Wales, Australia floods of $23.5 million, offset by Chinese winter storms in the current quarter of $14.4 million.

In the current quarter our consolidated net favorable reserve development and cat events from prior periods was $0.6 million, as our cedents continue to reevaluate their estimates of their exposures to those events. Our net paid claims for the quarter was $29.6 million compared to approximately $8.7 million for the second quarter of 2007.

Turning to G&A. Expenses increased $10.4 million over the same quarter last year, primarily due to the cost of additional staff and infrastructure as we continue to build out our global operations and enhance our technology platform and also the addition of Island Heritage.

Moving to the investment portfolio. Our total cash and investments increased to $2 billion at June 30, 2008. And our fixed income portfolio remains at a very high quality, with a weighted average rating of AA+ and a duration of 2.7 years. Our net gains and losses on investments, which represent movements in the fair value of the portfolio for the quarter plus realized gains and losses from the sales investments, were $9.3 million compared to $3.7 million loss in Q2 2007.

The key components for the current quarter were losses on our equities and real estate exposure portfolios of $31.3 million, and losses on our fixed maturities portfolio of $10.7 million, particularly offset by gains in our commodities of $31 million

I’m pleased to say our balance sheet remains in an excellent shape and our financial flexibility remained strong, with total capital amounting to $1.5 billion at quarter end, and with debt and hybrids representing approximately 16.6% of the total.

And with that summary of the financials, I will now pass it back to the moderator to open the lines for questions and answers.

Question-and-Answer Session

Operator

(Operator instructions) And the first question comes from the line of Jay Gelb from Lehman Brothers. You may proceed.

Jay Gelb – Lehman Brothers

Thanks, and good morning, everyone.

Mark Byrne

Good morning, Jay.

David Brown

Good morning, Jay.

Jay Gelb – Lehman Brothers

Thank you. I was hoping we could get a little bit more color on the second quarter gross written premium growth, what geographies that came from, and what – if you could give us a sense of what your PML is both on one in 100 and one in 250 for Florida, that would be helpful as well.

David Brown

Jay, this is David. The premium growth was fairly broad based. As we think I said earlier, we’ve seen growth from all of our offices in risk we haven’t seen before. It is true we were probably surprised a little by the quality of businesses we saw out of the US. It was better priced than we had anticipated and we tended to write a little bit more. By and large what was happening, as I’m sure you’re aware, is a lot of clients are retaining more, but in aggregate they are actually more capacity often at higher layers.

Jay Gelb – Lehman Brothers

And that’s been reasonably priced as we’ve seen. I think there was quite a bit of buying by the various coastal fair plans, and so growth in Florida, the southeast and the Gulf. And again, all of that coming from the new plans that are buying reinsurance for the first time and increased capacity from the existing clients.

Mark Byrne

Jay, this is Mark. I have a table here from which I can roughly give you some numeric feedback on that. Roughly the Caribbean business is just over doubled between the two periods, between looking at quarter two ’08 versus quarter two ’07. The European business actually shrunk about 40, the Japan grew about 20%, the US grew about 20%, and the worldwide programs and other grew about 50%. But I’m sure the one you are most interested in is the US and that’s about 20 – 25% higher than the year before.

Jay Gelb – Lehman Brothers

Is Florida and Gulf exposed states, is that a good proxy for them as well?

David Brown

Yes, I think so. And you asked the question about PML. We talked about the PML earlier if you didn’t hear, Jay. Our one in 100 PML is 407 million, one in 250 is 490. We don’t disclose the Florida component of that, but probably about 80% of that PML is driven by Florida. So it’s a meaningful component. Of course, the most important component of PML depends on which time of the year you’re talking to us. Having just completed June renewals, obviously there’s a lot of that Florida business that tends to make Florida more important part of that. Coming into October, which in UK renewals that will take an increasing percentage, but currently mostly driven by Florida.

Jay Gelb – Lehman Brothers

That’s helpful, thanks. And then on a separate issue, Mark, maybe you can talk a little bit about the investment returns to date. Given the past two quarters, do you feel any rebalancing might be required in the investment portfolio? And how is this sort of stacking up relative to I guess you would describe it as modeled results?

Mark Byrne

Sure. Well, modeled results of the portfolio that we have over the long run, over, say, three-year periods, are about 8% with about 5% volatility. Our actual results so far since we implemented the strategy are more like 6% annualized total return with about the predictive volatility of 5%. And I think another measure, Jay, is what other portfolio would we have if we didn’t have this portfolio, and if you said we would have 20% S&P and 80% Lehman aggregate. That’s a portfolio that we model just as a benchmark. We call that the conventional portfolio, one you might be more used to seeing. We’ve outperformed that portfolio by about 400 basis points since we implemented the new strategy and with lower volatility. So I think it’s a difficult environment to find anybody’s portfolio performing especially well, and we’re not obviously happy with a total return of zero. But I think you can find a lot of total returns out there that are worse than zero this year. And it hasn't caused us to rethink whether a diversified approach to a global portfolio with an important measure on risk is the right way to do it. We do think it’s the right way to do it, and it’s not probably something that we should expect to see quarter-by-quarter. But at the same time, there have been a lot of worse quarters than zero with low volatility or 0.41 with low volatility. So we think the strategy is fundamentally an improvement over traditional investment management and insurance companies, although obviously we would rather have a better quarter than we had.

Jay Gelb – Lehman Brothers

And is there – how often is the rebalancing in the portfolio essentially? If one target sector of the portfolio is down, do you have the flexibility to buy at lower levels?

Mark Byrne

Well, the actual optimization or the estimation of what is the optimum portfolio takes place twice a year, in May and November. The rebalancing of individual asset classes depends on really them getting out of balance relative to the target allocations. So that what happens if you end up selling the things that do very well over a two-quarter period of time and buying more of the things that underperform in order to achieve that balance. And then how frequently that happens is a function of the liquidity of the underlying asset. If we are holding a synthetic position in the S&P by a futures contract, we can obviously rebalance that as much as weekly if we wanted to, although we tend to do monthly. If it’s a less liquid asset, we would tend to do it more quarterly. So, between quarterly and monthly is how often the rebalancing takes place and twice a year is how often the re-estimation of the optimum portfolio takes place.

Jay Gelb – Lehman Brothers

That’s helpful. Thanks very much.

Operator

(Operator instructions) And the next question comes from the line of Josh Shanker from Citi. You may proceed.

Josh Shanker – Citi

Good morning, gentlemen.

Mark Byrne

Hi, Josh.

David Brown

Hi, Josh.

Josh Shanker – Citi

What does a full deployment of your capital into underwriting look like compared to where the business is right now? And given the current market conditions, how do you revise that into where you would want to be today?

Mark Byrne

I’ll take a stab at that and I’m sure David will want to add to it as well, Josh. The binding – there are several constraints on how much risk we can take with the capital that we have. As you know, we maintain three investment grade credit ratings. And each of the frameworks of the different rating agencies imposes a different constraint. In the case of AM Best, it’s the BCAR score. In the case of Moody’s and Fitch, it’s a Tail-VaR kind of constraint. Then we have a constraint imposed by the regulators under which we operate. And then we have our own internal risk tolerance and how much risk we would take if none of those other constraints applied. Today it’s one of the rating agency constraints is the binding factor. And one thing that would happen is two years from now when we are no longer a startup in the eyes of the rating agencies, this is sort of five years sandbox. Two years from now when we are no longer in that sandbox, the amount of leverage – operating leverage they would permit goes up by about 25%. The other thing that will drive our premium to surplus ratio up and in some ways are also our real risk to surplus ratio, but more the premium to surplus ratio up, will be as we continue to succeed in diversifying into specialty lines into geographic regions where we aren’t already, and as we grow things like South Africa, South America, Puerto Rico, the Caribbean, Mumbai, all the places that we are trying to find business that is diversifying, that also will bump up our premium to surplus ratio and the amount of real operating leverage we have without actually moving the rating agency test very much. So, over the next two years, the principal driver of an increase in operating leverage et cetera will be that second thing. And then there is sort of a one-time bump-up that we might expect in about two years time as we fall off this new company’s list, which of course we don’t think we belong on, but we haven’t been able to persuade anybody of that so far. So, that would be the two factors I would expect. We are roughly at 75% of the risk relative to capital, PML relative to capital, than we would be at if had no external constraints. So, a third more risk is about how much we could take if there were no externally binding factors.

Josh Shanker – Citi

Okay. And I guess –

Mark Byrne

David, you want to add to that at all?

David Brown

Yes, I agree – the other way I’d say that, Josh, to your question about fully deployed, it’s possible to be fully deployed, for instance, relative to the constraints by just writing risk in Florida to the point where your PML hits the limit and you can’t write any more business from a rating agency point of view. But as Mark points out, fully deploy it and then you can go to other zones where you are not exposed and where there is no correlation and you can write incremental risk there with little changing of the amount, and that’s effectively additional deployment of capital. So the question of full deployment of capital is a bit of an art, more than an art than a science, because you can't actually be at a limit but continue to write risk if it’s in diversifying zones. And that’s what we’re trying to do.

Mark Byrne

Let me point out that – let me also point out, Josh, there are two other dials here on the dashboard that we can turn. One is we can take a look at our financial leverage, which is today at 16.6%, and we’ve generally been targeting 20% and there is an active discussion about whether 23% would be a better number. So you might see us at some point increase the financial leverage by a modest value of few points from where it is today. And then the other thing you can do is buy more reinsurance and get a little bit more arbitrage driven in the strategy than we are today. Today we write pretty close to a net book, meaning we generally underwrite almost all of our risks with the intention of keeping those risks and we really buy reinsurance cover – not very much of it compared to others, and we buy it to really get the big industry events. In a world where financial capital for us, i.e., share capital or new subordinated debt etc. is very expensive in the current dislocated credit markets and capital markets. And at the same time, reinsurance cover seems relatively not expensive. You could make an argument that we should be buying a bit more reinsurance and using that as a base for underwriting a bit more insurance. So I don’t think you’ll see us go to a very arbitrage strategy, but I’m saying we’re spending $0.15 of every dollar of premium on reinsurance now. Maybe we should be looking at spending $0.20 or $0.22 of that dollar and writing a bit more. So those are two other ways to increase the leverage and they both work even in a soft but still adequate market.

Josh Shanker – Citi

Okay, I appreciate the detail. The other question, which I asked on previous conference call, did you think about China losses and talk about what you think the opportunity might be over there?

Mark Byrne

David, why don’t you grab that one?

David Brown

Okay. We gave some color on the China losses I think in our release. It was mainly from a couple of contracts. One, China based company and one reinsurer based outside China that we support. And presently we don’t have very large exposures relative to other zones in China. A lot of what we do is looking at the better companies there and developing our relationships. I think the growth in China in terms of the wealth of the asset growth is real and enormous, and the current penetration of insurance and its reinsurance is very limited, probably sub 1% [ph] in that country. And when you look at the potential asset growth there and the growth of wealth, and the fact that insurance penetration may grow to a more normal number in the 4% to 8%, which it is in the developed world, we see big opportunities there. And so we have our toe dipped in that water with a few clients. And we see attractive growth opportunities in the future. This is like much of our strategy. If you are looking at the US or Australia or the UK, Europe for your business, you see stagnant or decreasing economies and pressure on rates. If you look elsewhere in the world, we see growth economies; India, China, to some extent Latin America, South Africa. We see opportunities in those places and that’s why you see us concentrating in some of these far-flung places.

Mark Byrne

Jay, I’ll just chip in a word. I’m more bullish on India and South America and the other places where we are growing. Obviously that has a lot to do with why we are there. Just this year we had an experience where there were some losses in China. A number of Chinese renewals came up for renewal. The representation at the renewal was essentially that there weren’t expected to be losses from the earthquakes and winter storms. And after the renewal got placed, it was discovered by the marketplace that in fact there were fairly significant losses from those storms. So, that’s just one experience, but I would say so far we don’t find it to be as straightforward a place to do business as we would India.

Josh Shanker – Citi

And in terms of (inaudible) full deployment in India, how much more business could you be writing in India today and still be within your PML desires?

Mark Byrne

We are not writing very much business in India today at all. We are writing under $20 million of premium. So we could be five times bigger than the reinsurance market. But the other question is, in most of these growth economies is the real growth play, is the real strong play insurance or reinsurance. And that’s something we constantly evaluate as well. Right now I think we are at about – 90% of our premium is reinsurance premium. And I think I’d expect to see that percentage drip downwards 75% over time. So it may be that you are seeing us involved in some kind of play like that.

Josh Shanker – Citi

All right. Very good. I appreciate all the detail.

Operator

(Operator instructions) And at this time we don’t have any further questions in the queue. I would pass the call over to Mr. Brent Slade for closing remarks.

Brenton Slade

Thank you very much, ladies and gentlemen. Before I let you go, please let me remind you that a replay of this webcast will be available on our website from 12 noon today until midnight on September 5, 2008. Please visit the Investor Relations section of our website at www.flagstonere.bm for further details. That concludes the proceedings for today. We look forward to speaking to you again at the end of the next quarter. Have a great day.

Operator

Thank you, ladies and gentlemen. This concludes the presentation. You may now disconnect.

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Comments

[moneysurf:]

Well Done!

2008 Aug 18 11:20 AM