Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

XL Group (NYSE:XL)

Q3 2012 Earnings Call

November 05, 2012 5:00 pm ET

Executives

David R. Radulski - Senior Vice President and Director of Investor Relations

Michael S. Mcgavick - Chief Executive Officer and Director

James H. Veghte - Chief Executive of Reinsurance Operations and Executive Vice President

Gregory S. Hendrick - Executive Vice President and Chief Executive of Insurance Segment

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

Analysts

Jay Adam Cohen - BofA Merrill Lynch, Research Division

Vinay Misquith - Evercore Partners Inc., Research Division

J. Paul Newsome - Sandler O'Neill + Partners, L.P., Research Division

Michael Zaremski - Crédit Suisse AG, Research Division

Michael Nannizzi - Goldman Sachs Group Inc., Research Division

Ian Gutterman - Adage Capital Management, L.P.

Matthew G. Heimermann - JP Morgan Chase & Co, Research Division

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

Operator

Good afternoon. My name Shirley, and I'll be your conference operator today. At this time I would like to welcome everyone to the XL Group plc Third Quarter 2012 Earnings Call. [Operator Instructions] Please be advised this conference is being recorded.

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

David R. Radulski

Thank you, Shirley, and welcome to XL Group's Third Quarter 2012 Earnings Conference Call. This call is being simultaneously webcast in XL's website at www.xlgroup.com, and we posted to our website several documents including our quarterly financial supplement.

On our call this evening, you will hear from Mike Mcgavick, XL Group's CEO; Jamie Veghte, our Chief Executive of Reinsurance operations; Greg Hendrick, our Chief Executive Insurance operations; and Pete Porrino, XL's Chief Financial Officer.

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

Forward-looking statements are sensitive to many factors, including those identified in our annual report on Form 10-K, our quarterly reports on Form 10-Q and other documents on file with the SEC, that could cause actual results to differ materially from those contained in the forward-looking statements.

Forward-looking statements speak only as of the date of which they are made, and we undertake no obligation publicly to revise any forward-looking statement in response to new information, future developments or otherwise.

With that, I turn it over to Mike Mcgavick.

Michael S. Mcgavick

Thanks, Dave. Welcome to our third quarter call. Obviously, this call comes in a difficult time. We know a lot about the third quarter, and I've been looking forward to sharing it with you. What we don't know a lot about is the event that occurred just last week with Sandy, which I'm sure is on all of your minds.

The first thing to say with respect to Sandy is the most important truth about being in the risk business. It is sadly often about human misery. Our thoughts go out to those who are still suffering.

To respect your obvious curiosity about Sandy, we'll start the call with a brief discussion of what we know. Following this, we'll discuss the third quarter in our usual way, and then we will take your questions.

With Sandy, we know you are working hard to understand the answers to 3 basic questions: how big is the industry loss; what is the XL loss going to be; and is this a market changing event of some kind. I will comment on how we're thinking of the markets after Sandy, Jamie will give our perspectives on the early industry loss estimates as well as what he can on XL Re. And I'll ask Greg to talk more about what we're seeing in our insurance book from Sandy at this point.

Of course, the reality is that no one really knows anything with certainty about Sandy from an overall point of view at this stage. I would point out that even the external risks modeling group we work with most closely has not yet posted its own industry estimate.

In terms of the broader market. I do not think Sandy ends up being a capital event for the industry, at least based on what we are seeing so far. But while Sandy might not change the industry's capital position, I do believe that this may change the industry's perception of risk. When this is all said and done, I don't think any of us are going to feel that people were as well insured as they could have been. I don't think people will feel that the region was as well prepared as it could have been as several leading elected officials have already said. And in the end, I believe the underwriting community will have to we think with care what they should charge for risks in a region with such a complex concentration of values exposed to such storms.

Now I'll turn it over to Jamie for his comments on Sandy.

James H. Veghte

Thanks, Mike. We've had very little specific information from our customer base. Those dialogues are just beginning. We have seen the ranges of industry loss estimates from various sources. And as Mike mentioned, one of the prominent modeling companies has not released an estimate, and it's due out with information for us to work with tomorrow.

Our instinct is that the industry loss will be at the top end of the published ranges, $20 billion or above. This loss really highlights the concentration of values in the region, a loss of perhaps $20 billion to the industry or above from the storm that was classified as post-tropical cyclone as it came ashore is remarkable.

We will have exposure from several sources and clearly a $20 billion market loss. It's a significant loss to the reinsurance market broadly. However, we typically do not provide significant capacity on lower layers of New England mutual companies, principally due to our historic concern over winter storm exposure. Our capacity on those accounts would typically be skewed to the middle and upper parts of the program.

We do write a variety of national accounts. After Katrina, a number of nationwide commercial carriers increased their retention significantly. And given the uncertainty around the impact of flood and BI on commercial carriers, it's too early to predict the precise impact on individual clients. We will also have potential exposure from our North American profit center from both the treaty, which is a non-CAT property treaty book, and some facultative exposures.

We do buy retrocessional coverage but at a very higher attachment point, and our expectations will be that the retro program will not come into play other than some, perhaps, small proportion of recoveries. So broadly, our gross loss will be our net loss. Greg?

Gregory S. Hendrick

Thanks, Jamie. I'll cover 3 topics around Sandy: our reported notices of loss to date, the reinsurance coverage we have in place and the generic loss example.

First, after 1:00 this afternoon, we have set up 175 potential claims comprised partly of loss notifications from clients and partly based on reports from brokers and the media as a result of Sandy. This covers a wide range of risks from small claims in our general aviation book to reports from some of our large property clients.

As perspective, based on prior catastrophes, of these initial loss notifications, roughly 50% in term to claims payable by XL Insurance, as often the losses have not reached deductible, attachment point or self-insured retention of the policy. We are in the very early stages of the claims adjusting process and have adjusters moving to the impacted locations as we speak.

Next, I'll turn to the reinsurance protection that we have in place for our property exposures. First, we place a property per risk coverage attaches at $25 million and runs to $600 million for our large property exposures. We retain 45% of the first $15 million of limit, which translates into a retention of $32 million per risk, and we have multiple reinstatements for each layer.

In a per-event basis, we buy U.S. catastrophe program, which attaches at $100 million and exhausts at $450 million. Within the first $100 million of limit, we retain 40%. And as a result on losses of $200 million or greater, we retain $140 million. This cover protects all of our property lines of business and has 2 limits available in any one treaty year, none of which have been used to date.

We also have in place various reinsurance covers that protect specific portfolios, which could lower our net loss where they to come into play. Let me be clear, at this point it's too early to tell whether any of these reinsurance covers will be impacted by Sandy.

The difficulty of loss estimation is best brought to light using a specific loss example. As always, our clients' confidentiality is our utmost priority, so I've taken one of our largest loss notifications and made the location and insured information generic. The risk is real estate-driven with a large location in downtown Manhattan and numerous locations in the region. Based on our modeling and post-event processes, we have identified 15 locations in the impacted areas. In total, the insured value for the entire schedule is over $1 billion, and XL's full loss limit is $250 million. As a result of our underwriting approach to flood, we provided $25 million flood supplement and we bought $15 million of facultative reinsurance covering flood and other perils.

In terms of damage, we do know the lower Manhattan location had substantial water in the basement and the recovery process at that location began on Wednesday of last week. We have adjusters at or on the way to all these locations. But at this point, we do not have a loss estimate. It is worth noting that business interruption and contingent business interruption losses resulting from flood are included within the flood limit and not in addition to this sublimit. In short, even in the worst-case scenario, our loss from this risk as a result of flood cannot exceed $10 million. Mike?

Michael S. Mcgavick

Thank you both. With that, we'll turn to our third quarter results. Our third quarter results are solid and in line with what we have been suggesting would happen.

Our margins expanded, resulting from 3 main drivers. First, and this pleases us most, is the fact that our underwriting operations on an ex-CAT ex-PYD basis provided the real substance of our improvement. With our Insurance segment delivering a 70 -- or excuse me a 94.7 ex-CAT ex-PYD combined ratio, this is directionally consistent with our work and what we're trying to do. We are delighted to see it coming through.

Second, we have fewer catastrophes in the quarter, which was of course helpful. This has been true at XL as it has been true around the industry, at least until Sandy.

And third, we have positive PYD. While it's relatively light in this quarter, it was a nice contributor. You'll recall that next quarter is the one in which we take a deep examination of our reserves, and we'll see what that reveals.

Of course, you'll want to know is this how we'll perform from now on. We'd say there's still work to do. But every day, we are moving further along. More of this positive trend is a result of our actions and less of it is fortuity. Still, we'd say that we are not done with our re-underwriting until we are regularly delivering a combined ratio of around 90%. Reinsurance continues to deliver, with an 86% combined ratio in the third quarter. While this is up from the nearly 79% combined ratio in the third quarter a year ago, only 5.4% of this difference is driven by the $26 million in crop losses, an amount in line with what we forecast to you in our second quarter call, in addition to some modest CAT activities. Crop, as we have previously discussed with you, also explains our lower reinsurance premiums written, reflecting the decision last year by a leading agricultural MGA to be purchased by another reinsurance firm.

All in, we reported an overall P&C combined ratio of 92.2%. This is 9 points better than our quarter 3 last year.

We had significant gains in our Investment Portfolio mark-to-market. And as a result, our fully diluted tangible book value per share is now at $32.82. This is up 7% in the quarter and is 16% higher than where we began the year. We think our 7.7% ROE for the year-to-date, given the overall economic environment and the lower turn on interest rates, is solid. Is it where I want -- is it we where we want it to be? No. But again, we're on the right path, and this is directionally consistent with everything we have shared with you.

So all of these indicators are pleasing us. At the same time, you would guess that -- we would guess that you might be curious about what is going on with the top line. This is a bit more complicated, so let me spend a moment on it, and then Greg and Jamie will expand on this further.

We did see good growth in the quarter when you take to account 3 factors that offset it. The first has been mentioned before, the crop book that was sold affecting reinsurance premiums written. Second was the impact of the re-underwriting of our European property operations, where we have been willing to shed underpriced business. And third, foreign exchange. Excluding these 3 factors, our overall growth rate was 5%, and we are growing strongly where we are profitable and thus remixing the business toward more profitable lines.

Turning briefly to pricing. We continue to see improvement across the vast majority of our lines, especially in Insurance. And this progress has accelerated in the quarter. In some lines, we are now seeing the compounding benefits of rate-on-rate year-over-year. So you can see that for the third quarter, XL had a terrific result, we're very pleased and we are driven to continue this kind of progress.

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

Peter R. Porrino

Thanks, Mike, and good evening. Operating income for the third quarter was $188 million or $0.61 per share on a fully diluted basis compared to operating income of $89 million or $0.28 per share in the third quarter of 2011.

Our P&C combined ratio was 9.4 points better at 92.2% in the same quarter last year. Our accident year combined ratio was 94.7% or 8.3 points better than the same quarter last year due to a lower level of both CAT activity and non-CAT large losses.

Prior development in the quarter was a favorable $37 million or 2.5 loss ratio points, with $36 million of this favorable development attributable to the Reinsurance segment.

As we have outlined on previous earnings calls, Q3 is what we refer to as an actual versus expected quarter for our entire Insurance segment and our U.S. Reinsurance business. The $36 million redundancy in our Reinsurance segment in the quarter related to our non-U.S. Casualty and other shorter-tail Reinsurance businesses where we review reserves quarterly with more comprehensive assumption updates performed annually. We experienced positive movements in our property, marine and aviation lines.

Our operating expenses for the third quarter were up 23.4% year-over-year, driven by higher compensation costs and, to a lesser extent, certain severance costs and costs supporting our strategic initiatives. The overall operating expense increase is higher than the recent run rate almost exclusively due to the impact of improving financial results on our performance-based compensation plans and our pay-for-performance culture. We think this is exactly the right compensation philosophy to drive XL forward and incentivize and reward our colleagues.

It's important to note that in the third quarter of 2011, the exact opposite occurred and compensation costs were reduced due to the same performance-based measures. Excluding these variable compensation cost, we expect operating expense levels to be in line with what we have communicated to you since the fourth quarter of 2011 earnings call.

The total return of our investment portfolio was strong at 2.5% for the quarter. This contributed to book value growth, with a positive mark-to-market of $521 million. This is driven primarily by significant tightening of credit spreads most notably on our structured credit portfolios.

At $166 million net investment income on the P&C portfolio in the third quarter was 20.9% below the prior year due primarily to lower reinvestment rates. There was also significant decline in P&C net investment income of 11.7% from the second quarter. There were 4 primary drivers of this quarterly decline, 2 that you would expect based upon our published book yields: lower reinvestment rates between maturing bonds and new money rates and also higher cash levels held by us given the heightened tail risks emanating out of Europe over the summer.

Two other factors impacting this quarter's net investment income were reduced income on our inflation-protected portfolio due to lower inflation in Q2 and accelerated premium amortization on our agency mortgage-backed securities due to lower rates in an environment of ongoing quantitative easing.

We expect net investment income will remain under pressure given interest rate levels. The P&C gross book yield at the end of the quarter was 3%, down from 3.1% at the end of Q2. The average new money rate on our P&C portfolio was 1.9%. We estimate that approximately $3.8 billion of P&C assets with an average gross book yield of 3.2% will mature and paid down over the next 12 months. We've added further details on this in our financial supplement at the bottom of Schedule 3.

Our net invest -- our net income from investment affiliates was $9 million, down $15 million from the prior year. This was driven by a weak second quarter from our investment manager affiliates compared to strong results in the prior year quarter, which have benefited from the sale of our -- of one of our manager affiliates.

As previously discussed, our investment manager affiliate results are reported on a one-quarter lag. The alternative and private investment portfolios had satisfactory results.

Realized losses on investments were $6 million compared to realized losses of $62 million in the prior-year quarter. The third quarter results included $13 million in OTTI charges compared to $67 million in the prior-year quarter. Our effective tax rate in the quarter was lower than historical levels due to both several discrete items and a re-estimation of our expected full year effective tax rate from 12% to 11%.

We continue to buy back our ordinary shares, purchasing and canceling 5.3 million ordinary shares at an average cost of $23.44 in the third quarter. For the year-to-date, we have repurchased 16.2 million ordinary shares at an average cost of $21.63, leaving $400 million remaining available for purchase under the current program.

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

Gregory S. Hendrick

Thanks, Pete. Tonight I'll cover the Insurance segment results for the quarter, the performance of certain businesses, recent talent changes and current market conditions.

Beginning with the results, I'm pleased to report that we continue to make measurable improvements, as our combined ratio for the quarter is 95.3% or 17 points lower than the same quarter last year. To put this into perspective, this is our best performance since the fourth quarter of 2008.

On the loss side, our reported loss ratio of 63.3% was 19.2 points better than last year. Limited CAT activity accounts for 7.2 points of this improvement as we incurred $10 million in CAT losses during the quarter, largely from hurricane Isaac, compared to nearly $70 million in the third quarter of 2011.

Prior-year development accounts for 2.4 points of improvement as there was some strengthening in the third quarter of 2011 as opposed to a small release this quarter.

But most importantly, our current accident quarter loss ratio excluding CATs were 62.6%, improving by 9.6 points year-over-year. While much of this improvement is driven by very strong results in our North American and international property books, we continue to see measurable progress in many of our businesses. In fact, our accident core loss ratio, excluding large account property business, improved by 2.5 points year-over-year.

Given the inherent volatility in quarter results, it's important to note that our current accident year ex-CAT loss ratio stands at 66.5% through 3 quarters, an almost 7-point improvement over last year.

Insurance gross premiums written grew by $28 million or 2.5% in the quarter after normalizing for foreign exchange. This growth reflects continued success in our targeted new businesses such as Political Risk, North American Construction and E&S, as well as increase in opportunities in our core Hartford professional portfolio.

I'll say in this growth is our measured underlying discipline where we're reducing writings in those businesses with unacceptable margins such as guaranteed cost workers' compensation, international property and selected programs.

This leads into an update on the 7 businesses we have previously referred to as challenged. The combined ratio for the challenged portfolio in the quarter was 90.1%, benefiting from strong results in our international property book. Excluding international property, the combined ratio of the remaining challenged businesses was 103.3% on a calendar and accident year basis, which is an improvement of what we reported in the first and second quarters of this year.

This improvement reflects our continued execution of corrective underwriting actions, many of which we have discussed in previous quarters, as well as improved pricing of more than 5% this quarter. Both the challenge and the performing portfolios had improved accident quarter loss ratios relative to the second quarter of this year, as well as the third quarter of 2011.

It's important to note that while we continue to improve or surgically remove poor performing sublines, we are strategically growing other components of the challenged businesses such as property, railroad and umbrella lines in our E&S book, large risk management business in our North American primary casualty book, as well as new programs in our select professional portfolio.

As noted last quarter, to be in line with how we manage our businesses, we're going to shift our future discussions away from the collection of businesses we identified as challenged at the beginning of the year and going forward will focus on any sub-portfolio in any business that needs corrective action.

In particular, we've decided to close our upper middle-market business in North America. We have retained the portfolio of environmental-related property and casualty business, as well as a few accounts that will transition to a risk management policy. We will continue to write upper middle-market accounts in many of our businesses. But in particular, any clients that have growing international operations as our global network allows us to deliver a unique offering to the market.

Moving on to talent. We continued to enhance our teams throughout the segment. We added Chris Dougherty as CFO and David Vavrasek as Head of HR to our already strong Insurance leadership.

We appointed Ian Brandt [ph] as Chief Underwriting Officer of our IPC Property business, and he joined us in just 2 weeks. We added Alfred Bergbauer and Barbara Luck to our North America Primary Casualty management team. We also added underwriting talent to our marine team in Chicago, our international casualty team throughout Europe and the U.K. and we opened a new international upper middle-market underwriting office in Leon, France.

Finally, let's turn to current market conditions. In the third quarter, we saw a repeat of the second quarter, with positive rate indications in most of our businesses and overall segment rate increase of just over 3%. North American Property & Casualty continues to show the most strength, with rate increase by almost 8% led by double-digit rate increases in our Excess Casualty and E&S businesses. Our overall professional portfolio also had another solid quarter, with increases of nearly 3%.

In the quarter, 20 out of our 24 businesses generated rate increases, and the only disappointment was a 2% rate decrease in our international casualty portfolio. We remain convinced that positive rates is needed broadly, and in particular our long-tail lines of business, given persistently low investment returns.

In summary, I am proud of what our Insurance team has accomplished through 3 quarters. While a degree of fortuity helped, particularly in our short-tail portfolio, the hard work of the last year has already showed through in our improved results. However, we are still short of our ultimate goal and I can assure you that XL will continue to focus on underwriting diligence as expansion of margin continues to be our utmost priority.

And now to Jamie to discuss Reinsurance results.

James H. Veghte

Thanks, Greg. XL Re had a very good quarter with a combined ratio of 86%, producing an underwriting profit of $67 million. This compares to a combined of 78.8% in the third quarter of 2011. Our result was positively impacted by $35.7 million of prior-year reserve releases, which compares to $39.8 million a year ago.

Excluding the impact of both prior-year reserve releases and CAT losses, the segment had a combined ratio of 88%, which compares to the 80% achieved in the third quarter of 2011.

The quarter was also impacted by $26 million from the drought conditions impacting our U.S. crop portfolio. As we mentioned in our last earnings call, the 2 sources of exposure to the drought are from our U.S. and Bermuda profit centers. The loss in the quarter breaks down to $20 million of reserves for the Bermuda stop loss book and $6.1 million from our U.S.-based proportional book, specifically the Heartland Crop account.

In both cases, we've reserved the book at levels above the range as suggested by the impacted clients. We are confident that the potential for significant deterioration in the fourth quarter is unlikely.

Turning to top line. Gross written premiums in the quarter were $417 million, which compares to $619 million in the third quarter of last year. As we have advised, the Heartland program converted from a primary facility with significant reinsurance ceded to a reinsurance assumed treaty this year. So year-on-year gross written premium comparisons are misleading in this case.

If you use the net premium written from Heartland in 2011 to do a like-for-like comparison, our gross written premium last year would have been $436 million, so we reduced by 4% in the quarter year on year. This 4% drop was due to selected cancellations in the U.S. and Latin American portfolios. On a year-to-date basis, again adjusting Heartland in 2011 to the same treatment we currently have, our gross written premium would have moved from $1.73 billion to $1.85 billion this year, an increase of 6.9%.

Turning to market conditions. We spoke of our midyear renewals on last quarter's call and I would again describe them as satisfactory although, candidly, we did not get the level of risk adjusted improvement in the U.S. CAT book that we quoted and expected.

We've attended a number of industry conferences over the last 2 months, and the expectation until last week was for a reasonably smooth renewal season in the property CAT space, with the benign hurricane season potentially having some downward pressure on U.S. pricing.

With the impact of Sandy, there's now some question as to how the rest of the year will develop. If as we expect the upper end of the industry loss estimates becomes reality, I would have to expect year-end pricing to be impacted.

One of the characteristics of the CAT market is it responds very quickly to major market events. While there is abundant capacity available, the typical placement process on large accounts requires a clearing process on the pricing for market leaders to unlock this capacity fully. This is a heavily syndicated market and no one can forecast with precision what will take place at year end, but I suspect assumptions about year-end pricing have been adjusted over the course of the last week. Ours certainly has.

On the long-tail side, I would reiterate Greg's comments. While we see general improvement in the pricing environment based on our audit work and negotiations with clients, there remains plenty of room for additional progress before we would declare the market as rate-adequate based on in-current investment yields. In addition, we continue to see customers absorb additional retention, both vertically, through co-participation or in cases entire treaties dropped. During this particular quarter, our U.S. Casualty team lost an $11 million premium account due to the ceding company absorbing the entire treaty at renewal.

Overall, we are very pleased to produce an excellent underwriting result, and we look forward to an action active renewal season.

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

David R. Radulski

Shirley, please open the lines for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Jay Cohen with BofA Merrill Lynch.

Jay Adam Cohen - BofA Merrill Lynch, Research Division

Just a couple of questions. One thing, just to confirm, the -- on the Reinsurance side, the CAT losses, those are separate from the crop losses?

James H. Veghte

Correct.

Jay Adam Cohen - BofA Merrill Lynch, Research Division

Okay, great. Second, these are relatively short. The second question, the premiums in the business that you dropped, the upper to middle-market business on the Insurance side, what kind of premiums are we talking about there? Should we be adjusting our models for that?

Gregory S. Hendrick

It's Greg Hendrick. All in, when you keep the business that we wanted to keep, the environmental and the risk management components too, is about $50 million of premium. I don't think -- we will -- we are growing in other areas, I don't think that's a major number, but that's what the previous portfolio of pure middle-market North America business was.

Jay Adam Cohen - BofA Merrill Lynch, Research Division

That's great. And then just last question. PC investment income. You'd obviously talked about some of those issues that impacted this quarter was a big drop off from the last quarter. I was just wondering if you could talk about what an ongoing number looks like? How much of what you saw this quarter was unique to this quarter and would not be ongoing?

Peter R. Porrino

Sure, Jay. It’s Pete. So let me break it into the 4 components that I spoke about. The drop in yields, I mean, that's going to continue to recur. That was about 1/3 of the decrease. The adjustment on the fixed securities would have been another 1/3. In essence, the inflation underlying that tips [ph] went from 1% in the prior quarter to just under 0 on average in the second quarter. So that was also about 1/3. The agency amortization would have been a little bit less than a 1/3. Again, it's -- I mean, I certainly can't predict what's going to happen, but it doesn't feel like they're going to -- rates are going to continue to drop enough to continue to change the amortization of those. And the last piece, which is the smallest one, was the cash and that cash is already being put back to work in the investment portfolio.

Operator

Your next question comes from Vinay Misquith with Evercore.

Vinay Misquith - Evercore Partners Inc., Research Division

So just to clarify on the net investment income once again. Would this quarter's number be the run rate for the future? Or are you seeing that there was some onetime items in that?

Peter R. Porrino

So I would say it's not a run rate, the one caveat that I would give you is that there will be pressure on investment income just because of reduced yields, right. And so the number is going down quarter-to-quarter, but 3 out of the 4, I would say, were not run rate items. So I would expect it not to be -- it would not to be a run rate just make sure you think about the drop in yields and how that's going to flow through.

Vinay Misquith - Evercore Partners Inc., Research Division

Sure. So you're saying that the base number is slightly higher. But from that level, we'll have a lower investment income going forward? I mean, is that the way to think about it?

Peter R. Porrino

It would be higher than the $166 million certainly, right? But at the same time, there will be continued pressure on the net investment income.

Vinay Misquith - Evercore Partners Inc., Research Division

Good, that's helpful. The second question is for Hurricane Sandy, and thanks for giving some detail on the Reinsurance program. But trying to wrap my head around on the primary Insurance operations last year for Hurricane Irene, you had about a $200 million gross loss, about $100 million net loss. Just want to get a sense for -- where things are right now the industry loss estimate is about $20 billion for Sandy. It was about $4.3 billion for Irene. Simplistically, just multiplying it by 4 seems too simple. Can you help us understand how we should think of scaling it?

Gregory S. Hendrick

This is Greg Hendrick. First of all, Vinay, you can't scale it. Every event is a unique event, the pattern of the storm, where the exposures are, where the water piles up, in this particular case, unfortunately for so many people. But let me give you a little bit of color, so hope I can explain why I think these are totally unrelated. First, the $200 million and $100 million was from Irene and Lee combined, both. There was -- there were a bit losses that triggered out of Lee that because of all the saturation from Irene produced flooding. Second, it was dominated by 2 large corporate insurance where we were the lead carrier. In other words, we issued 100% of the policy in the United States. We booked as gross the 100% loss from those locations and then cede off to the captive or the coinsurers a portion of that loss. As of this point in time, there aren't any notifications that look anything like what we had on those 2 losses in Irene and Lee. Clearly very early days, that's not a promise or commitment. It's just what the facts are as I have them at the moment. So those are couple of reasons why you really can't draw parallels from one to the other.

Operator

Our next question comes from Paul Newsome with Sandler O'Neill.

J. Paul Newsome - Sandler O'Neill + Partners, L.P., Research Division

I actually was hoping we could step back from hurricane Sandy and just kind of get some big picture comments thinking about the quarter. 7% ROE probably not where you want to be, but the combined ratio is actually, kind of where you are, is not bad at all. So can we talk about steps, longer term, to get you to a cost of capital?

Michael S. Mcgavick

Yes, this is Mike. Clearly, as I said in my comments, 7.7% ROE is not where we want to be. We do think that the -- that it's critical to continue to expand our margins so that we can get back to double-digit ROEs. And that's very much the drive we are on. We have said that we thought we could drive meaningful margin expansion in this quarter and that we thought we could get through more acceptable returns on an absolute and relative basis in the next year. To me, this quarter is a very much in line with that thinking. We've shown a continued willingness to buy a bit more back in on the capital side than we had forecasted at the beginning of the year, which is in line with the stronger earnings we've been able to deliver. We have been able to continue to drive down the combined ratio, particularly in our Insurance operation, where it was not where we wanted, and we very much like the trend there as well especially when combined with what we're seeing in rate across the book. So taken as a whole, these are exactly the actions that we expected to be able to get us back to the levels you described. And there's nothing that I would change in what we're doing to deliver that result. We just have to keep at it with real rigor and real discipline. And then as we work our way back through the book and get the chance at the rate that we've been describing we're getting, the math starts to continue to change in the direction we all desire. So we're very pleased.

Peter R. Porrino

Paul, it's Pete. I'd only add that as these marks continue to -- bad choice of words, but pile up, it's just hitting us and everyone else in the industry. It is going to get tougher and tougher to achieve the corporate ROEs that we've talked about because those were all been sort of ex-AOCI [ph] and the numbers that we're publishing included.

J. Paul Newsome - Sandler O'Neill + Partners, L.P., Research Division

Fair enough. But is this -- could you talk about maybe just as we think about getting to cost of capital, is rate or how much is it rightsizing the business relative to the capital?

Michael S. Mcgavick

I'm going to give you a couple of general comments and then I'll call any of my colleagues to add. The most important thing from our point of view, the thing that we have to make our true north star is our underwriting results. We are driven at this company operating somewhere around 90% as a combined ratio. We believe that is achievable. We believe that we're working on exactly the right things to deliver that. Once you get there, it's possible, I suppose, that the continued diminishment of investment yield, it's slow erosion, combined with if it were to continue, continued adding of capital due to marks, you could get to an equation that doesn't get you there, but I'd be a bit surprised by that. In the end, with the marks having reversed themselves so severely, it seems to me that that's going to be pretty fluid. You still have Europe pouncing around out there. And somewhere out there, who knows where or with what impetus, you're going to have some kind of normalization around interest rates. So we have to plan our life around what we can control. And our best things to control are continuing, as we have said, to not add to capital, it's not our intention over time. And then, at the same time, experience profitable growth at the kinds of levels which we have described here. And at the same time, get ourselves to kind of a nice combine. I think that equation is a very healthy equation over time. And that's what we continue to do bit by bit. But I don't think where we are calls for any change. It calls for continuing to do what we know we're doing.

Operator

And our next question comes from Mike Zaremski with Credit Suisse.

Michael Zaremski - Crédit Suisse AG, Research Division

In regards to the LIBOR issue, we know that at least one reinsurer put up IBNR reserves due to casualty class reinsurance policies. Do you have an updated view on potential LIBOR claims? And related, have reserves been increased in international lines which are exposed to LIBOR? And I have one follow-up.

Michael S. Mcgavick

Yes, Mike, I'll comment. Generally, you've seen some information in the marketplace about programs in recent calls, I know. Just to be clear, we are not participants in those types of programs. Obviously, we write and write a good book direct D&O exposure. And I'm going to turn it over to Greg to comment on our particular book and what -- frankly, we're not seeing it.

Gregory S. Hendrick

Yes, I'll be brief. Mike, as I said last quarter, there's so many variables that play here. We are just -- we're not able to give an estimate of losses. But what loss there is to be covered is very uncertain, as well as how the coverages might apply. We are in the process through the fourth quarter reserve review that we are going down and diving into each insured, the potential exposure and our coverage around it. And we'll work through the process as we go through the fourth quarter. Of course I would not hold that out. There was a promise that we will have it solved in the fourth quarter completely, but that is a process we're going through at the moment. There's unfortunately no update at this time other than we're not able to put out certain number around it.

Michael S. Mcgavick

I would just add that from the time of the financial crisis in 2008 because of the unusual circumstances in line with what we have learned over the years, going back to Sarb-Ox and so on, we have maintained the clash load. We maintained it through Madoff. We've maintained -- and then it seems like every couple of years the industry seems to give us something else to maintain it for. That clash load currently is around 20 points on the loss ratios in that segment of our business. And whether LIBOR will in fact take a bite out of that, it's hard at this stage to tell. It's just -- when you're looking at it risk by risk rather than as a clash event, it is very hard to know how this will play out.

Michael Zaremski - Crédit Suisse AG, Research Division

Okay. That's helpful. And lastly for Pete, the tax rate looked low this quarter, what drove that? And should we -- what should we think about for 4Q if Sandy losses come through?

Peter R. Porrino

So as I said in the call, there were -- it was a series of discrete items and then it take down from 12% to 11% for the annualized -- for the expectation for the annual, right. So that would be the number that we would say we would have expected for the fourth quarter. It would have been the 11% rather than the 12%. And the other difference would have been discrete items. We settled an open exam favorably and a couple of other smaller items. The complication here, of course, is the way -- is the right question on Sandy, right, and what does this mean. It all has to do with what legal entities the business resides in. So to the extent that the losses would be predominantly in Bermuda, that would take our effective tax rate up for the quarter, right, because we'd have losses without any tax benefit. To the extent that they're in taxable jurisdictions, it would have less of that negative impact. So I can't -- since we don't know what the Sandy losses are, we surely don't know what they are by legal entities. So it's too soon to tell. My expectation all in is that it will drive our effective tax rate up. But to how much, that I can't say.

Operator

Our next question comes from Michael Nannizzi with Goldman Sachs.

Michael Nannizzi - Goldman Sachs Group Inc., Research Division

So this point, given the uncertainty around Sandy, I mean, how are you thinking about buybacks for the fourth quarter and kind of capital deployment in that sense? And I imagine it's sort of a wait-and-see or does this kind of your capital deployment program sort of supersede that? And there's just one follow-up.

Peter R. Porrino

So this is Pete, Mike. So if you go back and look, certainly over the last year or so, you have seen that it is -- we have tried to be consistent with our buyback program. We are very, very comfortable with our capital levels. So we have bought back in quarters when other companies don't, right, when suppose they win quarters. And we've also bought back -- if you look at last year, we bought back $670 million of stock, and that we had significant catastrophe losses impacting our results. So we don't see any -- as of now we don't see this as a stop buybacks.

Michael Nannizzi - Goldman Sachs Group Inc., Research Division

Got it. That's really helpful. And then I have one question. I mean, in terms of -- I mean, there's obviously another storm potentially coming, who knows what sort of impact it will have, but I have one question about business interruption. If you have a business interruption event from the last storm. And then before that's cleared, you have another event, how do you account for or how does the industry account for the time if the second event delays the interruption period?

Gregory S. Hendrick

Mike, it's Greg Hendrick. Certainly the answer is going to depend on policy by policy, what the form says. We have some policies written under our own form. We have some business written on broker manuscript forms, and we have some of our smaller businesses in E&S and programs where each policy is slightly different. In general, the history has been that when you're not able to differentiate between the damage that was caused and it's exacerbating existing damage, that will be picked up as part of the original loss event. But it will be a case-by-case, and we saw it in 2004 in Florida with all the intersecting storms. It became more and more difficult to determine what loss went to what storm. You did the best you can and get the adjusters out there as fast as you can, to set the baseline. But by and large, it goes back to the original event if it extends the waiting period.

Michael Nannizzi - Goldman Sachs Group Inc., Research Division

Got you. And then just one last one maybe for Mike on -- you mentioned the 90% combined ratio goal and you talked about a double-digit ROE. I just kind of looking at the numbers, I find it hard to get to a double-digit ROE with a 90% combined overall. And then maybe I'm just doing something wrong, but is it -- if it's not yield, because the investment income is kind of what it is, is it operating leverage or some other -- is there another lever that allows those 2 kind of data points to meet?

Michael S. Mcgavick

I already answered it. It is operating leverage.

Operator

Our next question comes from Ryan Burns with Lane McLaney [ph].

Unknown Analyst

Quickly on your accident year loss ratio, excluding CATs, in the Insurance segment, where there any takedowns from first half of 2012 reserves?

Gregory S. Hendrick

Yes, there was. We had booked, based on what we had seen at the end of the fourth quarter of 2011, particularly on our short-tail lines, what we thought was an appropriate loss ratio on the Property business roughly speaking was about 3 points in the quarter for Q1 and Q2.

Unknown Analyst

For Q1 and Q2. Okay, got you. And then, I guess quickly, I guess holistically, obviously, with rate increases and lower loss cost inflation, as well as I guess re-underwriting the books, is there a targeted on accident year loss ratio? Or where is your target, or I guess where's the ultimate goal? Where can you guys drive this do you think?

Michael S. Mcgavick

Well, on a combined overall, we're seeking to push down to 90. When we budget around here, we don't count in PYD. The losses in the past we have reserved to what we think is appropriate, and then it develops as it develops. So when we set our budgets, we have in mind an accident year 90 is the target that we're driving towards.

Operator

Our next question comes from Ian Gutterman with Adage Capital.

Ian Gutterman - Adage Capital Management, L.P.

Pete, can I get one more clarification on the rest of income, I'm still a little confused. The inflation impact in MBS, are you -- it seems you're saying those were sort of catch-ups and that's why they're not run rate going forward? I mean, I would think of inflation is lower going forward too.

Peter R. Porrino

No. So separate -- I'll have Sarah chime in here, but separate the tips adjustment from the agency-backed ones. So the tips adjustment is whatever the inflation rate was in the prior quarter, rolls through that income. So if inflation is 1%, right, you get a certain amount of return, and at 0% you get another amount of return. For us, that delta was about $8 million in the current quarter.

Ian Gutterman - Adage Capital Management, L.P.

And why wouldn't it be $8 million again next quarter if inflation stays low? Inflation is not rebounding.

Peter R. Porrino

Well, because -- so quarter-to-quarter we've already recognized the fact that it was at 0. So if it's at 0 again next quarter, the quarter-to-quarter delta would be 0 because it depends.

Ian Gutterman - Adage Capital Management, L.P.

Got it. So there's a catch-up then. Okay, got it. And the MBS is similar, it's a onetime adjustment. If it stays where it is, it's not going to cause an incremental?

Peter R. Porrino

If it stays where it is, it would not cause an incremental.

Ian Gutterman - Adage Capital Management, L.P.

Perfect, okay. And then Jamie, on the $20 billion or more estimate on Sandy, do have any thoughts on personal versus commercial break down of that?

James H. Veghte

Yes. I mean, you've seen a lot of commentary out there that's suggesting it's sort of 60-40, personal and commercial. My own view is that in the end it's going to grow to be more of commercial lines loss than personal. So again, my opinion only flip it, say 60-40 commercial to personal.

Ian Gutterman - Adage Capital Management, L.P.

Interesting. And then on pricing impact. Obviously, I can understand why you would drive pricing in the Northeast and on national accounts or Northeast-heavy. Do you think it's going to have much of an impact on sort of regional Florida-only, Gulf-only type capacity as well?

James H. Veghte

Who knows, Ian? All I can say is that, as I said before, there was a lot of discussion earlier in the fall in the convention circuit about downward pressure on U.S. rates. And again, as I said, it's a heavily syndicated market. A couple of bad actors can't keep rates down. I just simply think that people are going to reevaluate where their pricing will be now that we've had this episode. And I'm not sure I can forecast what it's going to do region by region. Just suffice it to say that the atmosphere has changed over the last week.

Ian Gutterman - Adage Capital Management, L.P.

Got it. And Greg, would you mind answering a question from an insurance perspective? The Fortune 100-type property accounts, I assume, will get pricing. Anything beyond that you're think about at this point?

Gregory S. Hendrick

Well, I think Mike touched on it. Anything with a great deal of uncertainty on the tail will have to be reexamined and looked at and gives you more confidence to your underwriters to go out and seek those rate increases that we need to get. We've had a lot of momentum in our E&S line of business. We expect that to continue now, but it will be a case-by-case. What is of interest to me, Ian, is the read through the -- through to long-tail lines, to everybody starts to wake up that we've been in this low investment return period that we're pricing the risk probably below where we need to be at, and then we get a little more oomph behind that momentum as well. But time will tell.

Operator

[Operator Instructions] Our next question comes from Matthew Heimermann with JPMC.

Matthew G. Heimermann - JP Morgan Chase & Co, Research Division

Jamie, first question for you, just a comment you made on retention. I mean, if you're not the only company to mention that retention trend, to some extent it feels like it's been ongoing for the last several years or just maybe not gotten as many headlines on the casualty side as perhaps on the property side where people were doing it more to mitigate spend and balance out rate increases when they were thinking about purchasing. So I guess with companies having -- being more comfortable writing that business and prices going up, is this a trend you expect to continue to see on the reinsurance side? And if so, should we think about there's something that's coming disproportionately from kind of the large nationwide-type writer? Or is this something you worry about spilling in maybe into some of the smaller regional companies who we might normally think about as more consistent in their buying?

James H. Veghte

I worry less so about those companies, Matthew. They tend to be more conservative in their balance sheet management. But clearly, with larger companies, the retention trend has been there for 5 years or so. And frankly, if you look at loss cost and so forth that hasn't been an irrational decision. I do think we'll have opportunities to write business going forward. There is always new opportunities, companies going into new lines of business trying to buy reinsurance as they ramp up. But I don't view large account, casualty reinsurance, as something that may necessarily bounce back as hard as it has in other past hardening markets.

Matthew G. Heimermann - JP Morgan Chase & Co, Research Division

Okay. And then when we think about your book at like what percentage of the book is kind of safe versus -- and in plays, so a little bit too dramatic of a word. But is probably -- what part of your book is immune versus to be determined as your going out.

James H. Veghte

Well, let's talk about what happened to our casualty book overall over the last 5 years, and it's for a variety of reasons. And I would say retention is probably been not the biggest one, frankly. The largest recently has gotten smaller, it's because we just don't like the return profile of the portfolio. So we are down, really, particularly in the U.S., to those companies that we believe in the long run have a good earnings potential based on their underwriting expertise and so forth. I don't view those accounts as necessarily more at risk by increased retention. It's not the very, very, very largest national writers. It's a variety of companies. But we produce the portfolio more around return profiles than retention, although retention has been an issue.

Matthew G. Heimermann - JP Morgan Chase & Co, Research Division

Yes. And I guess part of my rational for asking this was just I want to get a sense, right. We've seen some business remixing over the last couple of years, which had a net favorable impact on loss ratio and also risk-adjusted return, we would argue. So I guess is that potentially -- is that trend, which I had kind of thought about being potentially played out, is there potentially more room to go there?

James H. Veghte

I'm not sure. We're going to have to see how the market evolve. We love the Casualty business. It's just been -- based on our -- the way we price the business, which is a very realistic view of primary rates coupled with duration matching, the liability profile of that book against investment profile, it's just hasn't been as attractive as the short-tail lines business over the last 4, 5 years. It's not to say it can't come back. If we go back -- again, we've said this before, there's a big difference from the way we view rate adequacy on a CAT book and the way we view it on the Casualty book. And the Casualty market, we're attached to the hip to the primary market because we are writing quote sharing insurance working, et cetera. I don't necessarily -- again, I don't necessarily think we're predisposed to go one way or another. We remix the business based -- the book of business, based on what we see out there. It's just so happened over the last 5 years, shortening the tail of the book has been the only rational way forward as we've seen it.

Matthew G. Heimermann - JP Morgan Chase & Co, Research Division

That's fair. And then just on the -- I guess for Greg, just on the short-tail book impact on the first half loss re-estimation, I wasn't quite sure since you've said short-tail specific, how I should translate that just into the quarter, if you could bottom line that. And then would that be all the favorable year-over-year impact you talked about in the short tail? Or was there any other kind of frequency benefit as well?

Gregory S. Hendrick

Sure. The impact in the quarter from Q1 and Q2 is about 3 points. So we had 3 points better performance based on the reserve that we have put up for Q1 and Q2 on the short-tail lines. There isn't anything else that comes to mind that would have impacted the loss ratio significantly.

Ian Gutterman - Adage Capital Management, L.P.

Okay. So in the press release, when you talk about improved large loss activity year-over-year, that's -- I should think about that tying directly to 300.

Michael S. Mcgavick

300?

Gregory S. Hendrick

To 3 points.

Matthew G. Heimermann - JP Morgan Chase & Co, Research Division

To the 300 basis point improvement, yes.

Gregory S. Hendrick

Yes, sorry. Yes, 300 basis points, yes.

Operator

Our final question comes from Josh Stirling with Sanford Bernstein.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

So listen, I'd love to just get a sense. When you think about suggesting that your intuition has the modeled estimates rising to $20 billion or so level in the industry, sort of playing out at that level, is there anything in your data that's driving that? Or is this just sort of your intuition having sort of seen this story before in thinking about the various biases of the models with respect to [indiscernible]

James H. Veghte

Josh, it's largely intuition. But based on what we've [indiscernible]

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

Then the final question, I think this is probably for Greg. A very helpful example of a typical policy. I was just trying to make sure I understood. So you suggested, I think, that the gross sublimit was $25 million for a $1 billion schedule of insured value? Is that per-facility charge? Or is that for the entire customer and all the potential flood exposures, only $25 million?

Gregory S. Hendrick

Josh, it was $250 million gross sublimit for all risks. It's $25 million flood for all locations sublimit.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

Okay. So hypothetically...

Gregory S. Hendrick

And then we further bought that down with facultative reinsurance of $15 million down to $10 million.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

I see. So as a practical matter, when a policy like that, assuming it's not all non-wage and you'd be thinking of that the $10 million -- for net to you guys, $10 million of exposure, but you might see an industry loss associated with something like hypothetically a $25 million in each of the facilities assuming they all weren't in the same place is the right way to think about how that might that stack up?

Gregory S. Hendrick

$25 million across all the locations, not each and every.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

So I'm sorry to be slow here, but so you're saying that even with all $1 billion of exposure, there would only be sort of 2.5% of the total amount would be available for flood even if multiple exposures were impacted -- or multiple locations?

Gregory S. Hendrick

Correct. And Josh, sorry to interrupt, let me -- I just want to make sure I'm clear. This is an example from the largest loss notification that we have so far. So it is not meant to be typical of the risks that we have reported as part of the $175 million, right? This is the largest of the bunch. So don't read across $10 million each and every loss notification.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

Well, actually I was impressed it was so small.

Michael S. Mcgavick

I think you’re listening [ph] now, Josh.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

Yes, is that the net -- is this what's driving -- is this driving your thought that people are going to come out of this and feel like they've been underinsured and even large commercial accounts that probably thought they were on top of these issues?

Gregory S. Hendrick

This is certainly a case for the large commercial business. The personal lines, which of course is the more tragic of the story because it affects so many more people, is a combination of what's going to be covered by the flood program, what's going to be covered by private carriers. And when that's all added up, how much of the loss will actually be reimbursed by some form of insurance.

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

Right. And just for clarity, this would cover business interruption and similar purchases, CBI, where you sell that as well?

Josh Stirling - Sanford C. Bernstein & Co., LLC., Research Division

As a result of -- of losses resulting from flood, yes.

Operator

And at this time, I'll turn the call back over to speakers for closing remarks.

Michael S. Mcgavick

Well, it's a feeling I've had many times in our industry, and I know those of us at this table are feeling it now. It's a strange set of emotions, on one hand we were looking very much forward to reporting this quarter to you because it is -- it speaks, I think, well to the progress that the firm is making and the trajectory that we're on. At the same time we have this new event, and that event has a number of really terrible elements that we're watching around the region and even some in this room are experiencing, so it's a difficult effect. But at the same time, we just want to give you our views because as clearly as we could. We appreciate that you've been patient with us with respect to Sandy. I've just -- it isn't that much that one can know at this stage. And we can promise that we will be back to you as soon as we feel confident we have our arms around it with as much clarity as we can give.

So thank you very much for your time tonight, and we look forward to paths crossing soon.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: XL Group Management Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts