Executives
Jon Levenson – EVP
Ed Noonan – Chairman, CEO
Jeff Consolino – President, CFO
Jeff Sangster – EVP, Chief Accounting Officer
Analysts
Jay Cohen – Bank of America
Matthew Heimermann – JPMorgan
Ian Gutterman – Adage Capital
Ryan Byrnes – Langen McAlenney
Amit Kumar – Macquarie Capital
Michael Nannizzi – Goldman Sachs
Mike Zaremski – Credit Suisse
Brian Meredith – UBS
Matt Carletti – JMP Securities
Validus Holdings, LTD (VR) Q3 2012 Earnings Conference Call October 26, 2012 9:30 AM ET
Operator
Good day, ladies and gentlemen, and welcome to the third quarter 2012 Validus Holdings Limited earnings conference call. My name is (Shantilay) and I will be your facilitator for today's call.
At this time, all participants are in listen-only mode. We will be facilitating and question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to your host for today, Mr. Jon Levenson, Executive Vice President. Please proceed.
Jon Levenson
Thank you. Good morning and welcome to the Validus Holdings conference call for the quarter ended September 30, 2012. After the market closed yesterday we issued an earnings press release and financial supplement which are available on our website located at validusholdings.com.
Today's call is being simultaneously webcast and will be available for replay until November 9, 2012. Details are provided on our website.
With me on today's call are Validus' Chairman and Chief Executive Officer, Ed Noonan; Validus President and Chief Financial Officer, Jeff Consolino; and Validus Executive Vice President and Chief Accounting Officer, Jeff Sangster.
Before we begin, I would like to remind you that certain comments made during this call may be deemed forward-looking statements as defined within the US federal Securities laws.
These statements address matters that involve risks and uncertainties, many of which are beyond the company's control.
Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements and, therefore, you should not place undue reliance on any such statements.
More detail about these risks and uncertainties can be found in the company's most recent annual report on Form 10-K and quarterly report on Form 10-Q both as filed with the US Securities and Exchange Commission.
Management will also refer to certain non-GAAP financial measures when describing the company's performance. These items are reconciled and explained in our earnings release and financial supplement. With that, I turn the call over to Ed Noonan.
Ed Noonan
Well, thank you, Jon, and thank all of you for taking the time to join us today. It's been another outstanding quarter for Validus Group reflecting both light catastrophe activity and the fundamental strength of our business model.
We are very pleased to report an annualized return on average equity of 23.3% and a 19.2% annualized operating return on average equity during the quarter as well as growth in book value per share including dividends of 6.1%.
Our net income for the quarter was $207 million bringing our net income for the first nine months of the year to $499 million. Each of our operating businesses had excellent performance. Validus Re had a 51% combined ration for the quarter and Talbot 83.2%.
We benefited from a quiet catastrophe environment and a lower level of individual risk losses during the quarter as well as $24 million in favorable development to Validus Re and $26 million in favorable development for Talbot.
There is nothing out of the ordinary in our reserving activity and our leases are in line with prior years.
Our AlphaCat subsidiary continued to gain traction in the market. Written premium was relatively light in the quarter but investor response continues to be quite good.
While this was a quarter with light catastrophe activity, our results are not simply the results of chance. We have positioned ourselves to be a significant player I the best priced risk classes and are benefitting from two industry leading franchises we built along with people, platform and the technology to outperform in both good times and bad.
The other big development in the quarter is our announcement that Jeff Consolino will be stepping down as President and CFO effective February 15th of next year to join American Financial Group.
Jeff has been a great partner in the development of our business and, while I'll miss his daily council, he'll continue to provide his insight and advice as a member of our board of directors effective from our meeting next week.
We will bifurcate Jeff's responsibilities with Jeff Sangster assuming the role of CFO. Jeff has been with us almost from the start and has been grooming for the CFO role over the last year as part of our normal succession planning.
Many of you know him already from his investor relations work and our finance function will not miss a beat with Jeff's leadership.
John Hendrickson will join us as a Director of Strategy, Risk Oversight and Corporate Development. John has been a part of Validus since before we even wrote the plan to raise capital for the company and has chaired our audit committee since our founding.
John started his career as an investment banker to the industry, spent nine years with Swiss Re including five on Swiss Re's executive management board and founded his own merchant bank and advisory firm, SFRI. John Hendrickson will also remain on our board of directors.
We're very pleased to make this two appointments from within our company as it's a good indication of the depth and quality of management across the organization. With John and Jeff Sangster, we'll continue to charge ahead with the same entrepreneurial culture and disciplined financial management that's made us successful.
So with that, I'd like to turn the call over to Jeff Sangster and Jeff Consolino to review our results in more detail.
Jeff Consolino
Thank you, Ed. This is Jeff Consolino. As always, I am pleased to be here to share our financial results with you. Before I introduce the customary succession of our financial results, which again this quarter were superb, I also want to address the other press release from last evening describing our plan to CFO transition.
As announced last evening and as described by Ed, in February 2013 I intend to step down my role as President and Chief Financial Officer at Validus and transition my role at Validus from being a member of executive management to one of being a board member.
I have been involved with Validus for over seven years, ever since we commenced raising $1 billion in support of a business plan designed to bring much needed capacity to a market reeling from the losses of hurricanes Katrina, Rita and Wilma.
In this period, we've gone from that business plan to the point where I parochially believe that we are the very best company in our industry segment.
This career decision for me is a profoundly personal one. Bermuda has been a wonderful place for my wife and I to raise our young family. However, when faced with the opportunity to relocate to the United States and work with another company that I have a very long history with, setting the a valid CFO succession plan into motion made the most sense to us.
Most of you on this call know Jeff Sangster and many will know John Hendrickson. With this transition effected, I am confident that Validus will continue moving forward seamlessly.
Now on to the quarter. I'm going to review our financial results at the bottom line level and then Jeff Sangster will provide the details of our results of operations and financial position.
Our third quarter net income available for Validus shareholders was $207.3 million. This is $2.11 per diluted common share. Net operating income available to Validus was $170.6 million, or $1.74 per diluted share.
Diluted book value per share at quarter end was $36.27 after considering the $0.25 per share dividend in the quarter we grew by 6.1% on the second quarter diluted book value per share of $34.43.
Examining our shareholder value creation over a longer timeframe, we've grown diluted book value per share plus accumulated dividends by 13.8% annually since formation and 13.4% annually since our July 2007 initial public offering.
Let me now transition the financial discussion to Jeff Sangster who will share further details. Jeff, you're in.
Jeff Sangster
Thanks, Jeff. Speaking of more details of the quarter's results of operation, total managed gross written premium increased by 2.1% to $399.5 million from $391.1 million. This is an increase of $8.3 million over the prior year's quarter in dollar terms.
The increase is a result of increased gross premiums written in the Talbot segment offset by a reduction of managed premiums in the AlphaCat segment.
Net operating income for the AlphaCat segment, up $17.9 million, increased by approximately $5.4 million or 43.7% from $12.4 million in the prior year quarter. The $12.4 million represents the Validus share of the total net operating income from AlphaCat Re 2011 in that quarter.
Both AlphaCat Re 2011 and AlphaCat Re 2012 contributed meaningfully in the quarter to the growth of our client franchise and also contributed fee income to our bottom line from managed third-party capital equal to $6.7 million for the quarter.
Our quarterly combined ratio was 69.9%, including our last ratio of 32.7%. During the quarter, we incurred two notable loss events: (US Drugs) of $22 million representing 4.6 percentage points of a loss ratio and hurricane Isaac of $15.2 million, representing 3.2 percentage points of a loss ratio.
Accident year loss ratio excluding catastrophes and change in the prior accident year was 35.4% compared to 51.3% in Q3 2011. Favorable development in the quarter was $49.8 million which benefitted the loss ratio by 10.5 percentage points.
Our gross (inaudible) at quarter-end stands at $1.16 billion and our net (inaudible) at $1.05 billion. We allocated $13.7 million from the reserve for potential development on 2010 and 2011 events to deep water horizon and (inaudible) earthquake and (inaudible) earthquake.
As a result of the deep water horizon allocation, the 2010 (RDA) balance has been fully allocated and we expect no future activity on the 2010 (RDA). Our (IBNR) now stands at 46.9% of our $2.25 billion net loss reserve.
Now on underwriting results, I'm going to comment on our quarterly investment results including the non-controlling interests and our balance sheet.
Our consolidated investment portfolio is $6.69 billion of September 30th. This includes the consolidation of (inaudible) investments for which there is an offsetting 90% non-controlling interest.
Net investment income for the quarter was $25.5 million for a quarterly annualized effective yield of 1.68%, a decrease of one basis point and the Q2 2012 annualized effective yield of 1.69%.
In the quarter, we realized $9.1 million in investment gains, a net unrealized investment gain in the quarter of $86.3 million on a consolidated basis. This was driven primarily by the (Pac Re) investment portfolio, which contributed $62 million to the unrealized gain on a consolidated basis.
The amount of (Pac Re) unrealized gain, which is attributable to the non-controlling interest, was $55.8 million, leaving a net bottom line gain attributable to Validus of $6.2 million.
The duration of our investment portfolio continues to be short at 1.61 years as of September 30th.
Our total stockholder's equity at September 30th is $4.1 billion and total capitalization is $4.64 billion. Our financial leverage remains very low with debt to capital at quarter-end of 5.3% and debt and hybrids together as a percentage of capital of 11.6%.
From June 30th through October 23rd we've repurchased an additional 1,174,628 shares for an aggregate purchase price, including commission, of $38.4 million. We have $122.3 million remaining under our authorized share repurchase program as of October 23rd.
We are on schedule to close the Flagstone transaction in the fourth quarter and plan to be back in the market with repurchases after closing. We will reassess our capital position after the close of the Flagstone transaction in the January renewal season.
As our track record has shown, we will prudently manage capital while maintaining a capital buffer and flexibility to pursue the market opportunities which may present themselves in 2013. Now back to Ed.
Ed Noonan
Thanks, Jeff. Let me give you some further color on our (inaudible) results the Flagstone integration after which we'll be happy to take any questions you may have.
Starting with Talbot, we continue to be in a good pricing environment, although by no means a hard market.
Year-to-date, we have generated rate increases across our portfolio of 3.3%. In general, classes that have sustained losses over the last few years are the best performing with international property and onshore energy up by over 11%.
Competition is not excessive in the short-trail process at (Lloyds) as our overall level of rate change by class ranges from negative 2% to positive 12%.
Given the general competitive environment and the state of the global economy, most of Talbot's growth in the quarter has come from rate increase activity. The global economic downturn has had a meaningful impact on shipping and commerce.
Consequently, there is less new business coming into the market. At the same time, Talbot's renewal retention ratio has increased materially.
Our deal rate levels has caused us to be underweight direct in facultative property business for several years, particularly for US residents. We see rates now reaching attractive levels in some of the major markets and we would expect this to be a key growth area for Talbot going forward.
We also continue to see growth from our emerging markets through our (inaudible) and Singapore offices.
Turning to Validus Re, it was obviously an outstanding quarter as you would expect given the absence of cat losses. We're very proud of our ability to generate underwriting profits in the worst of years while delivering excellent results when cat losses are low.
Regarding loss activity in the quarter, Validus is not a major player in the crop market. We write a high layer access of loss account, which is well diversified by state and pell. Our crop loss of $22 million was in line with our expectations and we believe we may see the chance to grow this book next year.
We're in the process of integrating the Flagstone portfolio as we speak. The integration is going very nicely in large part due to the professionalism and cooperation of Flagstone's management.
We will be renewing all business as Validus Re starting in January 1st and I wanted to take a minute to describe the process by which we're building the combined portfolio.
Our (VCap) system allows us to run our optimization routines across the combined Validus and Flagstone portfolio. Our goal is to maximize our underwriting profit relative to our risk constraints.
This process yields the optimal portfolio by client and by layer and moves us out toward the efficient frontier. We know that as we go into the live market our outcomes will vary but by having disciplined targets at such a granular level, our underwriters will be able to achieve the best possible outcome.
Toward this end, the reaction from clients and brokers has been very gratifying. The thing we hear most often is clients' desire that we keep our combined lines on their programs.
Combining our deep research and analytic skills with responsive underwriting and a $5 billion plus capital base makes us one of the most important markets for catastrophe risk in the world.
Our ability to integrate our (side cars) and top layer facility into customer solutions makes us a go-to market for clients and brokers. Finally, our dual rating upgrade this year reinforced the strength of our franchise.
As you know, we were significantly underweight (Austral Asia) earthquake risk before last year's events as our geoscience research caused us to view rates as significantly inadequate.
It's gratifying to see the industry come around to our view and adjust rates appropriately. We would observe, however, that the market does not seem to fully understand the change in seismicity arising from last year's events. This informs both our pricing and risk taking and has caused us to make significant changes in our portfolio construction.
Despite being underweight in Asia, we enjoy excellent relationships with the major Japanese customers based on longstanding personal relationships, the quality of our analytical research and the consistency and capacity we do provide.
I spent some time in Asia over the last few weeks and thought it would be helpful to share some thoughts on the Asian market and our position there.
Our Asian operations for both Validus Re and Talbot are based in Singapore with catastrophe risk predominantly underwritten in Bermuda. Both operations are four years old and we have well-developed infrastructure with excellent people.
Premium from Asia is dominated by the Japanese and Australian accounts although Southeast Asia and China are growing rapidly as you'd expect. There's still a great deal of (proratery) insurance bought in Asia and this is not typically a good fit with our appetite.
Today, pricing in the Japanese market is generally quite sound. The Japanese seeding companies behaved exactly as one would have hoped post event and reinforced the long-term nature of their relationships.
Our position in Japan is quite strong as we've paid our claims very quickly and we did not run from the market post even unlike some other major reinsurers. Rather, we increased our capacity in Japan post event.
Across the Asian market, there are seeding companies whose claims from last year's event are not getting paid. The problem is predominantly with local Asian reinsurers. As a result, there is growing concern over willingness to pay on the part of reinsurers. That benefits companies like Validus. Our size and claims paying performance make us a very attractive market.
Australia is the other well-developed market in the region. This is much more of a trading environment and while prices are currently very good Australia always seems to be prone to major reinsurers doing odd things with big capacity that tends to cap the prices in the market.
In the past, it was predominantly European reinsurers. However, the reinsurance market (de jour) is one of the largest American-based reinsurers. Consequently, our Australian portfolio is more likely to be an accordion based on the competitive environment.
Flagstone was also active in (Austral Asia) and we have ample capacity for the combined portfolio. We broadly see a better rating environment than Asia with the Chinese market continuing to develop and we will continue to grow our presence in the region through both Validus Re and Talbot of Singapore.
More broadly, as you've heard us say before, we're firm believes in size and scale in the catastrophe business. We see the catastrophe market undergoing structural changes that will make it significantly harder to compete as a generalist or smaller player.
The Flagstone portfolio gives us the ability to meaningfully grow our business in a period of sound pricing in an otherwise crowded market.
We think all of this adds up to significant competitive advantage and will continue to yield superior returns to our shareholders.
Lastly, on a more topical subject, I'd like to touch on hurricane Sandy and our best current view of potential outcomes. Any coastal landfall is likely to be in the form of a strong tropical storm or mild Category 1 hurricane.
There are a few factors that make this a potentially significant event. First, ocean temperatures off the eastern seaboard are a few degrees above normal for this time of year.
Second, Monday is a full moon with astrological ties at their high level for the month. And finally, the energy associated with the confluence of a very large storm interacting with a Canadian low pressure system could yield extraordinary amounts of precipitation mostly in the form of rain.
These factors suggest potentially higher storm surge and beach erosion. At this point the damage potential will rise from down trees and loss of power and (invasion) along the coast line and moderate levels of wind damage with potentially serious flooding affecting commercial risks.
As far as residential risk, we would expect losses to have similar attributes to hurricane Irene, some wind damage but with much of the residential loss not covered by private insurance due to loss from flood.
One caveat is that like Irene there is the potential for extra contractual exposure arising from governmental involvement in interpretation of insurance coverage, particular as regards deductibles.
Our meteorological team views the likely landfall as being the Delmarva Peninsula, however, I would caution that there is a 200 mile margin of error for forecast four to five days out, so the entire northeast corner is still in play.
Using the best historic storm pass proxies, we would expect that Sandy is unlikely to be a large economic event of the industry. And in the absence of other information between now and landfall, we expect it to be measured in the low to mid single digit billions of insured loss.
Before taking your questions, I'd like to observe that this is Jeff Consolino's penultimate earnings call, so I will wait until next quarter to fully pay him tribute. Therefore, I'd ask that you refrain from spontaneous applause during Jeff's answers to your questions.
Operator, with that, we'd be happy to take any questions that …
Question-and-Answer Session
Operator
(Operator Instruction) Your first question comes from the line of Jay Cohen – Bank of America.
Jay Cohen – Bank of America
First one, in Talbot, the acquisition cost ratio was quite a bit higher than it had been. I'm wondering what's going on there.
Jeff Sangster
By way of background, Talbot receives their premium net of acquisition costs and during the quarter we reexamined our approach to estimating the gross up that we apply. In that process, we applied a higher degree of precision doing so at a contract level rather than at a line level.
The result was a gross up of (inaudible) written and acquisition costs in the quarter of $14.8 million. This is a one-time only adjustment and has no bottom line impact.
Impact on a forward basis, the acquisition ratio impact should be minimal as the reestimation applies to several years. So the $14.8 million over a period of about five years is relatively minimal and don't anticipate that changing estimations going forward.
Jay Cohen – Bank of America
The second question, you look at the premiums written in Validus Re and the growth rate has been pretty volatile. This was a bigger drop this quarter than we had expected. I'm wondering if you can give us some color behind that.
Edward Noonan
Yes, Jay, our job is to construct the portfolio to maximize expected returns relative to the excepted level of volatility and some quarters that translates into very significant premium writings. Other quarters there's not as much business that hits our screens.
I wouldn't interpret that into any particular trend line so much as just the movement at July 1st. Specifically as we looked at our portfolio, we really started to back off just a bit on some of the national accounts type business in terms of its efficiency and utilization of capital across our whole portfolio.
So I wish I could tell you that I could give you a good trend line to work form but I think Validus Re is prone to having a bit of a lumpy business from time to time.
Operator
Your next question comes from the line of Matthew Heimermann – JPMorgan.
Matthew Heimermann – JPMorgan
The I guess question on Flagstone just can you give us a sense of how you might tweak that portfolio? My working presumption, assumption would be that they probably have more European exposure than you probably like to keep and I'm just curious given their financial condition whether there's some business in the US that quality wise is not up to snuff, so just any thoughts there would be helpful.
Ed Noonan
First, I think you're right about the European business. They had an asset type that included more (prorate) business, more risk excess of loss business, more regional central European type customers. That really doesn't tend to play well to our risk appetite. And so I would expect to see that diminish considerably.
In the US I would say that we're in a very disciplined market and it's a syndicated market. So the market clear on prices are good and so Flagstone's portfolio is representative of that market and, therefore, there's nothing wrong with pricing across their portfolio.
As we look at it, it's – we construct our portfolio differently and, therefore, some of the attachment points and, in fact, some of the (seedings) that they're on are less attractive to us.
So our job, as I mentioned, is to take the two portfolio as they exist today and optimize the profitability coming out of that relative to risk constraints. And so our expectation is that while most of the business is very well priced, we wouldn't expect to keep all of it. We won't seek to keep all of it I guess is a better way of saying it.
But I think we have the free option on all with the extent that it meets our appetite. So I think you're right. I don't think it's underpricing in the US and I don't think it's quality of seeding company, just different appetite and from our standpoint that will get reflected starting on January 1st as we underwrite the combined portfolio.
Matthew Heimermann - JPMorgan
Then any thought to – any thought or updates, I should say, on just what balance sheets that book might end up on at this point or is that still to be determined?
Ed Noonan
Validus Re.
Matthew Heimermann - JPMorgan
I guess then as a follow-up to that, does combining the two portfolios and getting extra looks at the market potentially create incremental opportunities for AlphaCat on top of this?
Ed Noonan
Yes, absolutely, absolutely. There's business that – when we build on the Validus Re portfolio, there's business that we'll look at and say well priced doesn't fit our portfolio parameters but it might be very attractive to any number of the Validus Re or Validus Group side cars or to layer facility. And so we do expect that AlphaCat will get some opportunities as a result of that.
Matthew Heimermann - JPMorgan
So when we get to your one-one update with your 4Q call, it's probably not unrealistic to think about the AlphaCat existing portfolio probably changing similar to what your core Validus portfolio assumption is plus some incremental opportunities arising out of this.
Ed Noonan
I think that's right and I think though you really have to go out through at least June 1. There's certainly some Florida business in there that we think will probably fit some of our side cars for AlphaCat but, yes, I think you'll start to get an indication in the January 1 results.
Matthew Heimermann - JPMorgan
Then just on the acquisition expense in Talbot, that had a lot more value than I was expecting this quarter. The development was better. But the acquisition ratio popped up a bit and I wasn't sure if that was related to a mix of business this year or with the favor of development if you had to give back some seeding commissions and that was the issue, just a little color there.
Jeff Sangster
Yes, that was related to (another deal) we did of the gross estimate that we do of Talbot to get our net premiums as we receive them. They're net of acquisition costs to gross those up.
And so in reviewing those and in doing so at contract level, we made a one-time adjustment of $14.8 million, which increased gross premium written and acquisition cost, so that's something I view as non-recurring, one-time only and not really having an impact on the ratio going forward.
Matthew Heimermann - JPMorgan
Then where – just with respect to the marine growth you saw in Talbot, just what was the incremental opportunity of that? Is that more of the same of what we saw in the first half?
Jeff Sangster
Actually, partially – two stories there. One is the piece that I just mentioned. Most of that was in the marine mine, so that $14.8 million also grossed up the premium in the marine min primarily.
And then, yes, there was incremental opportunities organically growing, as you said, largely similar to what we've been seeing earlier in the year.
Operator
Your next question comes from the line of Ian Gutterman – Adage Capital.
Ian Gutterman – Adage Capital
Ed, can I just follow up on the Sandy comments? The low to mid single digit billions, dose that imply an event that reaches a reinsurance market or no? That usually tends to be on the cusp at that point.
Ed Noonan
Yes, not much, Ian. It will depend and certainly it would be shocking if any of the major buyers, the big, larger companies, got into the reinsurance program. The retentions are typically $10 billion industry event or higher.
You might have some of the regional companies get into the reinsurance companies, particularly those in the Maryland, New Jersey area, based on the current storm track. But at least as it stands today, wind is not going to be a devastating issue and so it will be very much like Irene and much of that really should be flood.
And in this case, depending on the current storm track, you have probably greater penetration of the national flood insurance program than you had in Connecticut and places like that in Irene. And so hopefully we won't see the same kind of issues that arose where there was no coverage under their traditional insurance policy. They hadn't bought flood insurance and so there was a lot of pressure applied there by governmental agencies to find coverage.
Ian Gutterman – Adage Capital
So that makes it sounds more that it is a commercial event than a residential event, just given the flooding (inaudible) cover on the residential side.
Ed Noonan
I think there's a potential for that. I think about the commercial exposure being particularly chemical and energy plants starting from the lower – the upper end of the Delaware bay right up through the (inaudible) New Jersey area where you have significant industrial installations that are very, very close to the shore line where a flood (and innovation) could lead to significant business interruption losses and a lot of that will depend on when the storm comes ashore relative to high tides.
But I think there is at least a chance that you could have material commercial losses as a result.
Ian Gutterman – Adage Capital
Then just the last question on that topic, one thing about it versus Irene, as I recall Irene was a hug the coast type of storm that hit a lot of states, the whole eastern seaboard. Because this is approaching from the east it's just going to maybe hit a couple states and go straight inland. What I then suggest would be maybe lesser damage than Irene.
Ed Noonan
I might, although obviously if you think about Irene, the states that it hit were all on the western side of the storm and the strongest wins are typically on the eastern side of the storm.
So as Irene raked up the coastline from the Carolinas, onshore wasn't subject to the strongest winds for the most part. In this case, we have a storm that’s actually approaching perpendicular to the shoreline. You will have the strongest winds coming ashore and potentially coming ashore and most densely populated areas along the northeast corridor.
Ian Gutterman – Adage Capital
Then just lastly on Flagstone, I see the vote schedule for the very end of November. How much time do you need to close in there and get your regulatory approval? I guess I'm a little surprised you're so confident you can rate a combined portfolio (run on).
Jeff Sangster
Yes, we are – as you said, the vote is scheduled for November 28th. We are expecting the final couple of regulatory approvals to come in around that time as well, so anticipating a close either late November or very early December.
In terms of the combined portfolio, that work has already been ongoing for a couple of months and we went into the major conferences this fall with a view on how we were going to renew that business and fully coordinated that with the Flagstone folks. So we've been messaging on that to clients through September and October.
Ian Gutterman – Adage Capital
So Luxenberg isn't going to be delayed or anything like that.
Jeff Sangster
Luxenberg is not a delay.
Operator
Your next question comes from the line of Ryan Byrnes – Langen McAlenney.
Ryan Byrnes – Langen McAlenney
Flagstone used to write some cat aggregate treaties; wanted to get your thoughts on I guess renewing those types of businesses or what your thoughts are on aggregate treaties.
Ed Noonan
Yes, as a general rule – and I'll put emphasis on general – we're not a big aggregate excess market. It tends not to fit well against our portfolio. It tends – in our view, we never feel as though we're getting properly paid for the aggregate risk. It introduces multiple events into one cover which starts to create significant modeling complexity that we don't think the market factors in properly in every case.
So we do write some aggregate cover, not very much. I mean, our crop portfolio, there's some aggregate excess in there but we're not in general a company whose appetite tends towards that.
Ryan Byrnes – Langen McAlenney
And then quickly, I guess the past two years, reserve releases were higher in the third quarter. Is there – do you guys do a more thorough I guess study of reserves in the third quarter or is that trend that I should be noticing?
Ed Noonan
You’re right to observe that the third quarter has been higher over the last few years. We do fairly comprehensive actuarial work every quarter. I think the June actuarial work tends to start to point us in a direction. As you get out into the third quarter, you tend to have both a better initial view of the current year as well as a more fully developed view of prior years.
And so it isn't necessarily a concerted process that leads to it but I think it's just a natural byproduct of our actuarial work and the timing of it that we tend to see the same phenomena of the third quarter has tended to be higher reserve releases each of the last few years.
Jeff Sangster
Historically that had been more pronounced in the Talbot segment as you move towards closing off on a (large) basis at three-year Europe account.
Operator
Your next question comes from the line of Amit Kumar – Macquarie Capital.
Amit Kumar – Macquarie Capital
First of all, just going back on the discussion regarding capital management, did I hear this correctly? Did you say the repurchase will start next year or if the deal closes then it starts in December?
Jeff Sangster
Yes, we will be back in the markets after close in December assuming a late November, early December close as we mentioned.
Amit Kumar – Macquarie Capital
The other question I had was if you (inaudible) Page 34 in the P&Ls and I guess post acquisition can you sort of talk about how you think about the capital flexibility in one-one and the level of potential buyback at that point if you fast forward post Flagstone acquisition?
Ed Noonan
We do have excellent capital flexibility today. When we look at the combined portfolio, we have ample capital to write very dollar in the combined portfolio. We don't expect to write every dollar in the combined portfolio and so that would tend to imply that our capital flexibility would only increase as we get out.
But we're kind of a mind to let's get through the January 1 portfolio, see what the market looks like, see how much of the business we keep and what we expect to keep the rest of the year. Then when our board comes together in February we'll be in a better position to set a capital management course for the rest of the year.
Amit Kumar – Macquarie Capital
And I guess one last question on the P&L page, I noticed that the Chinese economy numbers are meaningfully higher than others and I guess some of that might have to do with (Lloyds) and how they think about it. Is that right?
Ed Noonan
It's entirely based on (Lloyds) and a change through the RDS where the Chinese economic (press) scenario, the hard landing scenario wraps in parts of South America because of their interrelatedness with the Chinese economy.
We're pretty religious about this, so we just follow the RDS instructions and add up limits exposed. It's -- in some cases in the past we've looked at RDS' and said, hey, we want to bring that down. Let's go buy facultative on (inaudible).
In this particular case, I don't think that we view that this is – despite the fact that it's a larger number – that's a pretty remote set of circumstances all under one scenario and I wouldn't expect us to do anything to modify that number. We're not going to go out and hedge it in some way.
We think it's an extremely conservative RDS on (Lloyds) part and we're fine with that. But we don't feel as though that causes a risk management issue for us.
Operator
Your next question comes from the line of Michael Nannizzi – Goldman Sachs.
Michael Nannizzi – Goldman Sachs
I guess one question is how do we think about the underlying here? Certainly better than we have at Re; how much of that is just a lack of lumpy losses that you wouldn't consider cats and how much of that is manifestation of the ability to push through better pricing?
Jeff Consolino
If you think about the underlying loss ratio, as Jeff Sangster outlined, we are definitely sitting a little bit below trend. If you go to the supplement, and I believe the page is 24 when you get there – yes it is 24 – what you'll see by segment is you really have to look at this by segment.
The underlying loss ratio on Validus Re is $22.7 million is right in the neighborhood that we said we would expect for the underlying non-cat accident year loss ratio. AlphaCat has had a run of being loss free for several consecutive quarters, which I think you would probably expect.
And then in the Talbot segment, what you do see is that the loss ratio is a little bit below trend. It's sitting there on an underlying basis, a little bit under 50% whereas the norm has been closer to the mid 50s.
A lot of that is just an absence of attrition and non-event losses. And then also there is some factor from the $14.8 million premium gross up that Jeff Sangster identified as part of that acquisition cost study.
So all in all, I think this quarter has seen better than trend underlying loss ratio. We can't control whether that will persist or not but it's not totally divorced from where our expectations are.
Michael Nannizzi – Goldman Sachs
Then just one question on capital, so you were rolling into one line. You're going to be repositioning some part of the Flagstone book it sounds like. How should we think about now you'll have this combined capital base?
You'll have accumulated more capital in the fourth quarter from (inaudible) just from the fact that you won't be deploying capital in anticipation from transaction close plus if you're deploying less capital into the business at 1/1 I would imagine that either you're going to have a higher run rate or just a stop to start accumulation of capital to deploy.
How should we think about that as we go into December and then more holistically into next year?
Ed Noonan
Yes, Mike, as I mentioned earlier, we do hope that the fourth quarter gives us more excess capital to think about – but the key driver for us will be looking at how the combined portfolio shakes out at January 1st. That will give us very good indication as to market pricing, our effectiveness in deploying our capital.
And once we see that, by that time we'll have fourth quarter results and a good view of the market for the year and we'll be in a position to start to make the forecast that we need to set in place our capital management program for 2013.
So we're probably a few months away and I would expect that you should anticipate seeing from us the same type of behavior you've seen in the past. We're not big fans of lugging around excess capital just for the sake of having capital.
And therefore, we'll continue to right size our capital through our business opportunity set and in so doing look to keep our ROEs up.
Operator
Your next question comes from the line of Mike Zaremski – Credit Suisse.
Mike Zaremski – Credit Suisse
So in regards to the joint ventures platform, Ed, in the prepared remarks you said investor response continues to be quite good. So is that positive outlook subject to certain pricing levels?
So for example, what if prop cat pricing was down at January 1st through June 1st renewals?
Ed Noonan
Yes, so there's a few different segments within AlphaCat where we manage third-party capital. If pricing were down meaningfully then I would suspect that we would probably see less capital interest in side cars, for example.
Our sense though is that a lot of the money coming into the market is coming from institutional investors, pension plans and endowments. It's coming in at the high layers of risk and their required return on capital is meaningfully lower than the traditional reinsurance market. They're offering a bit less of a product as well to the extent that there's no reinstatement typically associated with it.
But their return on capital requirements are lower, so I suspect that there's a little bit of cushion there that you wouldn't expect to see that capital suddenly turn and leave if rates come off a bit. I suspect that will remain and probably continue to grow its importance to the segment.
I think what will tend to drive that capital out or to reduce it, better said, is upward movements in interest rates where their required return on capital gets tougher to be satisfied.
Mike Zaremski – Credit Suisse
Would you say there is any economic benefit to Validus to writing within the joint venture structure versus just keeping it all for yourself and not writing in the joint venture?
Ed Noonan
Oh, no, actually the joint venture is usually strategic to us. The ability is to provide top layer risk to clients. Top layer risk is very inefficient on our balance sheet. It's a capital hog, if you would.
And so in this case, (Pac Re), our top layer facility, allows us to structure broad solutions for clients that work on the Validus Re balance sheet and also allow us to provide top layer coverage that otherwise wouldn't be attractive to Validus Re.
Similarly, down at the low layers, particularly in places like Florida, our appetite for low layer Florida business is finite and so having the side cars available both to write first layer Florida risk, reinstatement premium covers, et cetera, is purely complementary to the Validus Re portfolio and, therefore, very strategic in nature.
So what I would say is that in each case we expanded our overall portfolio as a result of those side cars and if those side cars went away I wouldn't presume that Validus would immediately say, great, we'll keep all this business ourselves just because it doesn't fit our portfolio nearly as well as it does the dedicated facilities.
Mike Zaremski – Credit Suisse
Separate question, could you talk specifically about the pricing and your outlook for pricing in aviation, marine and war on terrorism, in those three categories?
Ed Noonan
Aviation rates are off a couple of percent in London. We primarily write the aviation insurance in the largest part of the aviation reinsurance (inaudible). Rates are off a couple of percent there.
What we've been doing is shifting from airline accounts towards products and operations. We think the airline accounts at this point are just too cheap in general. So aviation I’m not terribly negative about but just reduce the aviation account and we've shifted it around.
Remind me the other classes you're interested in comments on.
Mike Zaremski – Credit Suisse
Marine and then war and terrorism. I think war and terrorism are one line.
Ed Noonan
Yes, war and terrorism we think of as actually two different classes but that's fine. We can talk about them in the same context. We see competition there but not crazy competition.
Again, the war and terrorism accounts are off just about 2% year-to-date. Our position in those markets is excellent and the terrorism market in particular. I think at this point we've got the biggest market share in (Lloyds) on the terrorism account.
But we don't tend to build tremendous vertical exposure. We tend to build our exposure horizontally. And so we write all over the world and we're not – it's not just a New York, London, Frankfurt-based exposure set.
So I think we feel pretty good – actually, we feel very good at this rate level for terrorism and war risk. And the war risk business, it's not a huge marketplace. We've been a leader in it for as long as Talbot has existed. And we're at a point in time where at any moment you could see a big upward spike in war risk premium just based on geopolitical events.
In the marine classes in general, cargo continues to be an attractive account. Rates are OK. They're essentially flat. Results have been good. The whole business obviously has been badly adversely affected by (Costa Concordia) and one other claim in the market over the last year.
Rates have ticked up a bit there, not as much as you would have liked post a big event like that. But (Costa Concordia) essentially Carnival will be paying for it at their renewal and the rest of the market has perhaps rightly said that's not an event that should be spread across the whole market. It's a unique event.
So home rates are holding flat maybe up a point or two. You'd like to see a bit more than that but once the Carnival renewal comes up again I think we'll probably be reporting higher overall rate increase activity.
But I'd say in general the marine lines are flat and performance there is OK. It's not – certainly not negative. It's in an acceptable range, not as exciting as we'd like it to be.
Mike Zaremski – Credit Suisse
I guess the last one on crop impact in 4Q.
Ed Noonan
Yes, at this point we've got our best estimate as to what our crop exposure is and but we know that it will be late in the fourth quarter, probably early January before we start to get better granular insight from the clients. And so that number could move but based on the total amount of exposure that we have to the class, I don't think that we would expect to see any meaningful or material moves. It's just not that big a class to us.
Operator
Your next question comes from the line of Brian Meredith – UBS.
Brian Meredith – UBS
First one, Ed, any near-term opportunities from the incremental policy takeout down in Florida for you guys from a reinsurance perspective?
Ed Noonan
No, we will pick up – a couple of our reinsurance clients in Florida we will pick up additional premium. As we've talked about in the past, Brian, we're very, very credit sensitive on Florida companies.
We want companies that are well capitalized and will be in business the day after a big event. And so there's a relatively small number of Florida domestics that meet that criteria. Fortunately, some of those are winners in the takeout.
New takeout companies starting up, the jury is out at this point as to whether they would meet our underwriting criteria. So we'll see some pickup but I wouldn't expect to see us doing quota shares of companies doing takeouts.
Brian Meredith - UBS
Then the second question for Jeff. Since the close of the (Pac Re) transaction, I'm just curious what the (appeca) is or what your demand you're coming in for maybe additional (Pac Re) type companies being set up.
Jeff Consolino
Early in the year, Brian – this is Jeff Consolino – we indicated that we are continuing to build our AlphaCat business and that's across the whole board. We have, for example, the 2011 side car which will be expiring by terms and we are moving forward and determining what to do with those renewals, which we think have value.
We have (Pac Re), which thus far has been a really strong success, as Ed indicated on this call and a previous call and our feeling is that we can deploy much more limit in (Pac Re) where the investors provide more capital, so we view that as attractive.
And then also, across the spectrum, institutional interest in this business, whether you call it an asset class or what you call it, has never been higher and I know there's a lot of buzz out there about that.
But we're involved in a number of conversations about building that out and we're in the position since we see effectively all of the worldwide limits that's placed in cat to be able to dissect the market to what's available and what kind of return for profile that has for investors and structure things accordingly.
So we're moving forward, really, on all fronts, Brian, and the AlphaCat team is in place and their mandate is to build the segment into a more meaningful part of our overall business.
Operator
Your next question comes from the line of Matt Carletti – JMP Securities.
Matt Carletti – JMP Securities
Just a follow-up on Brian's question, actually; a high level – could you give us your best estimate of Validus with (Pac Re) and AlphaCat at fully ramp out versus a Validus of the past without it? What increment that might have on the ROE profile?
Jeff Consolino
We're not all the way wrapped out yet. Jeff earlier gave a number for our fee income in the quarter, which is incremental. You could annualize that and get a sense of where it would be for the year, which is helpful.
But we really believe that the winning strategy in this market is to manage this outside capital in conjunction with the reinsurance platform. We've got the underwriters who can sort the business.
We've got the systems that can properly write it and segment it and I think if I project forward, notwithstanding the incumbents here, you would expect that the companies with our kind of profile will have a strong competitive advantage and we're not going to stop pressing that advantage until we have a bigger business there.
So I think we're just at the very beginning of the curve as to what you could see from a company like us.
Matt Carletti – JMP Securities
One of your competitors that has been doing it for a long time and has a big business there said at time that they think it's going to change their ROE profile by three to four points. Is that any reason why that wouldn't be the case for Validus or are you being materially one side or the other of that?
Jeff Consolino
We take a back seat to nobody. You did point out though that they've been at this for a very long time and, frankly, we think they have some pretty advantageous structures in place that bring on strong benefits like our structures bring us benefit.
This market is going to evolve. (Inaudible) flows right now seem to be much more institutional rather than company focused and the goal will be to gather assets and a bigger level of assets will drive more fee income and higher ROE.
I would love to achieve the level that you said but let's get us halfway there first and then we'll work on the other half.
Ed Noonan
Just following up on that, though, I would say that in addition to the side car vehicles, (Pac Re), et cetera, we do also access third-party capital using (quota share) reinsurance that has very attractive terms to us and increases our ROE in two ways.
First, we get paid commission up front and a profit commission on it. And second, it allows us to optimize our use of capital in the business. And so I don't – I wouldn't say that we're at 3% to 4% but when I think about all of the third party capital that we underwrite on behalf of or use in our business, it's not that hard for me to imagine getting there in the near future.
Operator
Your next question comes from the line of Matthew Heimermann – JPMorgan.
Matthew Heimermann – JPMorgan
Just I think we're all pretty comfortable making our own assumptions about FSR for 2013, 2014 just on a full-year basis. But could you just give us a sense of if we close early December what impact, if any, we should expect – we should model in for 4Q? I would just assume, if anything, it's more likely to be a little bit of a negative impact than a positive one outside of any purchase gain.
Jeff Consolino
I'm struggling for what negative impact you would see for …
Matthew Heimermann - JPMorgan
From an earnings standpoint, I didn't know if they were going to – I would assume that potentially you might have a little bit more earnings running through – or excuse me, expenses running through in 4Q than might be normal.
Jeff Consolino
I think that is a fair point. Upon the closing, a lot of those transaction costs, which we're estimating at $20 million, will become due and payable there. As you know, we pull that out of operating income, so that would be a net operating difference and we've already reflected that in our estimates of pro forma book value per share.
Matthew Heimermann - JPMorgan
So that will be more (expressly) pulled out next quarter and then as a consequence, the question is moot.
Jeff Consolino
I think we've given you an accurate depiction. When we announced the deal, we indicated this would add $0.50 a share in intangible book value and a little bit less to diluted book value. But that fully reflects transaction costs through that no matter where the geography is on the income statement.
Matthew Heimermann - JPMorgan
I was just more concerned about if we needed – just making sure we weren't knuckle heads and screwed up our 4Q estimates. And so when you reported – that was noise.
Jeff Consolino
Yes, we'll report operating excluding those costs.
Matthew Heimermann - JPMorgan
And just a question for Ed. There was a lot of retro – there was a trick in retro demand in 2012 because of all the 2011 events. I would assume that with capital having rebuilt and the fact that we're talking about cat prices potentially declining at 1/1 that that demand probably goes away, at least some of it, in 2013.
Is there any risk that some of that capacity gets reallocated into more traditional cat? And if so, is that a material amount of capacity to think about?
Ed Noonan
I don't think that it's likely that much of that will get translated into traditional cat because the reason it's in retro is that it typically – retro is a one-shot cover. The business has to be collateralized. And so it's high rate online business. It makes sense to do it on a collateralized basis.
If you move that over into traditional reinsurance, now you have to provide a reinstatement for an additional premium. And when you talk about having to provide two limits, the collateralized market suddenly doesn't work very well.
Now some of it could come into the marketplace as the first event cover with traditional reinsurance providing second event. But I wouldn’t expect to see it all roll over by any means.
Operator
Your next question comes from the line of Ryan Byrnes – Langen McAlenney.
Ryan Byrnes – Langen McAlenney
Just want to get your thoughts on special dividends versus share repurchases, especially as obviously your multiples improved recently and I guess how you view those against each other.
Ed Noonan
Yes, I think our logic has been easy to date because we've been buying back shares below book value, which is frankly something that we do gleefully. At the point now that we're at today, special dividends are on the table. The ordinary dividends are on the table. Share buybacks are on the table.
It's all really a function of what is the most efficient way to return capital to shareholders. And so there's all sorts of theoretical debates about buying shares slightly above book value, looking at one or two quarters at what your book value will be.
We go through all those exercises ourselves but I think the short answer, Ryan, is that everything is on the table.
Operator
Your next question comes from the line of Michael Nannizzi – Goldman Sachs.
Michael Nannizzi – Goldman Sachs
Maybe, Ed, you could address is when you think about the genesis in the managed cat program and the talents internally that helped cultivate that, if you talk about where that platform is today versus where you want it to be and respectfully with Jeff's departure how you plan to put that together, maybe just talk about other people, obviously including yourself, around the table that are there to shepherd that process forward.
Ed Noonan
First, I would say that AlphaCat, the team that you're talking about, is a free standing team of people that have been with us for, in (inaudible) case, since the day we started the company.
We've augmented that with some talent from other places, including Goldman Sachs. In fact, Jeff Consolino has been overseeing that for the last couple of years, but we're a small company. There's pretty much nothing that goes on that we're not all involved in.
And so Jeff has had I think a very good, positive impact. But that team is the one that's out there raising the capital every day. It's the one out there underwriting the portfolio every day. And so they'll miss Jeff's oversight and involvement, as we all will, but I think that they will plug into John Hendrickson very well and John has a good deal of background and experience in this sector from Swiss Re days.
And we'll continue raising capital and building that portfolio and business and adding resources to it as we have to date. So I don't expect to see any change at all on that. Again, it's a free standing team that will continue doing what they do.
Jeff Consolino
Let me just pile on to that. No one accomplishes anything great on their own and we do think we're accomplishing something great there. Like I said, (inaudible) exception to that.
The AlphaCat team I think distinguishes itself and why we think we've got a winning strategy in this area is because a lot of what we're selling is the expertise that's resident in the broader reinsurance company.
And so what is our secret sauce? It's the market access that our underwriters bring. It's the technology that we develop for the reinsurance company and it's – this is something that works because of Validus' totality, not because of any individuals, even those individuals we've hired from Goldman Sachs.
Operator
At this time, there are no further questions in the audio queue.
Ed Noonan
Well, thank you very much and thank you, actually, for everybody's involvement and questions. Obviously a great quarter with both light cat activity but also the strength of our business shining through. We'll come back and talk next quarter on Jeff Consolino's last call about how the transition is going and we'll have better color commentary for you on the marketplace. But I'd just like to thank everybody for taking the time to join us this morning. Bye now.
Operator
Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.
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