XL Group's (XL) CEO Mike McGavick on Q4 2016 Results - Earnings Call Transcript

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XL Group plc (NYSE:XL) Q4 2016 Earnings Conference Call February 1, 2017 5:00 PM ET

Executives

David Radulski - IR

Mike McGavick - CEO

Pete Porrino - CFO

Paul Brand - Chair, Insurance Leadership Team and Chief Underwriting Officer

Greg Hendrick - President, Property & Casualty

Analysts

Kai Pan - Morgan Stanley

Brian Meredith - UBS

Meyer Shields - KBW

Ian Gutterman - Balyasny

Paul Newsome - Sandler O'Neill

Josh Shanker - Deutsche Bank

Randy Binner - FBR

Operator

Good afternoon and welcome to our conference call. [Operator Instructions] Please be advised this conference is being recorded.

Now I would like to turn the call over to David Radulski, XL Investor Relations. Please go ahead.

David Radulski

Thank you, Shirley. Welcome the XL Group Limited's fourth quarter and full-year 2016 earnings conference call. Our call today is being simultaneously webcast at www.xlgroup.com. We posted to our of website several documents, including our earnings press release, our quarterly financial supplement and presentation slides we’ll refer to in our call. On our call today Mike McGavick, XL Group's CEO, will offer opening remarks. Pete Porrino, XL's Chief Financial Officer, will review our financial results, followed by Paul Brand and Greg Hendrick, who will review insurance and reinsurance segment results and market conditions respectively, we'll then open it up for questions.

Before we begin, I'd like to remind you that certain of the matters we discuss today are forward-looking statements. These statements, including any estimates on losses resulting from recent natural catastrophes, are based on current plans, estimates and expectations, all of which involve risk and uncertainty. And a number of factors could cause actual results to differ materially from those contained in the forward-looking statements. Therefore, you should not place undue reliance on them.

Forward-looking statements are sensitive to many factors including those identified in our most recent reports on Forms 10-Q and 10-K as well as 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.

Our call today also includes non-GAAP financial measures including operating net income, operating ROE measures that are based on operating net income, net income excluding the contribution from the GreyCastle Life Retro Arrangements and fully diluted tangible book value per share. Explanations and reconciliations of these measures to the comparable GAAP measures are included in our earnings materials posted to our website and in the earnings release included as an exhibit to today's Form 8-K announcing our fourth quarter 2016 results.

And with that, I turn it over to Mike McGavick.

Mike McGavick

Good evening and thank you for joining our call. Tonight I'll share highlights of the fourth quarter while giving some overall perspective on how we view the full-year 2016, then Pete will discuss the financials and as this was the last quarter when Paul had responsibilities for insurance, we’ll have the pleasure of hearing him give his insurance perspective one more time. And then Greg will go through the reinsurance highlights. We stumbled out of the gate with a lousy first quarter and it was a tough catastrophe year throughout particularly in the fourth quarter. At the same time as the year developed, our underlying strength continued to emerge and we finished the year feeling very good about where we are going. Let me give you a couple of examples. First, as Paul and Greg will detail, in a tough market, we grew premium in both insurance and reinsurance and we accomplished this growth without sacrificing quality as our grinding focus drove further underwriting improvement. For Q4, our PNC accident year ex-cat loss ratio was 58% and our accident year ex-cat combined ratio was 89.1%. In both cases these are some of the best quarterly results in these metrics in at least 20 quarters. That's a solid trend that we will work to continue.

Of course given the fortuity that can occur in any single quarter as we have discussed, we view our results on an annual basis to be more accurate gauge of our progress. And for the full year, PNC accident year ex-cat loss ratio and combined ratio was a 58.7 and 90.7 respectively. Again some of the best results in these metrics at XL in over ten years. At a segment level, insurance lowered the 2016 accident ex-cat loss ratio to 61.4% and reinsurance produced a 2016 accident year loss ratio of 63% including the noted level of catastrophes. And our focus on efficiency continued throughout the year, with operating expense of 8.3% favorable versus the prior year quarter. So as we review the full year, while we find it frustrating in many ways, we can see the underlying strengths are there and as the year developed grew stronger. Perhaps even more important however is that throughout this challenging year, our colleagues’ dedication to client service never wavered. By the end of 2016, these efforts were recognized in numerous ways, including our claiming the number one spot for industry product innovation from Advisen, earning first place across nearly every metric in the most recent Gracechurch survey of the London market and on being awarded highest in customer satisfaction amongst commercial insurers in the J.D. Power North America 2016 survey.

So in totality and especially with the dedication of our colleagues in mind, we like the way we are positioned for 2017. Before I turn it over to Pete, I want to comment on two other items that I'm sure are on your mind; expectations for share buyback and our plans in relation to Brexit. In terms of buybacks, as we look at 2017 we would expect at this point to complete not less than $700 million in buyback. As you'll recall this was also the amount we forecast for 2016. In reality, we ended 2016 having bought back just over $1 billion worth of shares. So we obviously continued to view buyback as one of the better uses of our capital and will act accordingly as long as the right conditions persist, but we expect to do no less than 700 million. And then second in terms of Brexit, in the last few days, you've seen more clarity on some process and substance and some signs of recognition that a mutual arrangement covering financial services might be in everyone’s interest. It is even possible that the eventual outcome might look like it is today. I personally hope that will be the case. That said the timeline remains in doubt as does the outcome. And in any case there will be a long transition.

To put it simply, we at XL Catlin will not wait to give our clients certainty that we will be able to continue to serve them as we do today. And in this we have some core advantages we can utilize. First is the fact that we have tremendous global flexibility. Second, we had already taken the step a few years back to transition our main UK carrier to an SC making relocation within the EU far simpler. I want to emphasize that we are not announcing a specific plan today, but I want to signal we will not be waiting for an outcome to be imposed with little time to react, better to be on the front foot. We intend to take advantage at the right time of the flexibility we have built. Finally, as I said at the start, this is the last quarter that aligned to the operating model we had been working under since the transaction. I want to thank Paul Brand and Kelly Lyles for their leadership of the insurance segment throughout this exciting and demanding time. We’re really excited to see what Paul will do next in his new role as the Chairman of the [indiscernible], our new innovation program and equally excited by Kelly leading our client and country operation. Our new PNC operating model went into effect January 1 and it is already having the desired impact with a more efficient decision making and closer alignment between the business and our clients. And of course next quarter you'll be hearing from Greg as a leader of our entire PNC underwriting operations. And I know he's going to continue to do great things. So in summ [ph], in many ways this was a humbling year and I know it was deeply frustrating for our shareholders. But with the advantage of doing this past year in totality and seeing how it shaped what we can produce in 2017 we're excited about what comes next.

With that I'll turn it over to Pete.

Pete Porrino

Thanks Mike and good evening. Operating net income for the fourth quarter was $128 million or $0.47 per share on a fully diluted basis compared to $195 million in 2015 or $0.65 per share. Operating net income for the full year was $461 million or $1.63 per share. This includes deal related integration costs of $59 million for the fourth quarter 2016 as compared to $73 million for the same quarter last year. For the full year we incurred integration costs of $222 million as compared to $156 million in 2015 bearing in mind that we closed the Catlin transaction in May of 2015. Now turning to our quarterly slide presentation, Slide 5 illustrates the comparison of fourth quarter 2016 operating earnings per share compared to last year. You can clearly see that heightened catastrophe activity masked the improvement in our accident year ex-cat result. And now turning to Slide 6, we provide a normalized view of our full-year operating ROE excluding integration costs and net unrealized investment gains or losses which include adjustments to normalized timing and seasonality as well as naturally varying elements of our results. We start with our operating ROE excluding unrealized gains. Since we are providing a year to date figure at the end of the year, there is no meaningful adjustments of timing or seasonality element. We adjust our income from affiliate assets to catastrophes to normalize the naturally volatile parts of our operation. With these adjustments, our operating ROE excluding unrealized gains for 2016 was 8.9%.

We've also included the progression of this annualized year-to-date metric by quarter for 2016. We recognized this slide has limitations but we hope that you find it informative. And as we said last quarter, our use of analyst estimates in the normalization is not an endorsement of their accuracy. Our net income attributable to common shareholders for the quarter was $305 million or $1.12 per share on a fully diluted basis compared to $229 million or $0.76 per share for the same quarter in 2015. And for the full year, $441 million or $1.56 per share compared to $1.2 billion or $4.15 per share in the prior year. This variance was largely driven by the impact of our life derivative along with the scale of our interest in ARX in the prior year. As we have previously discussed, our net income is impacted by the mark to market movement of the derivatives that transfer the economics of the assets backing our second quarter 2014 life reinsurance sale transaction. And as always this amount has no impact on comprehensive income or operating results. Our natural catastrophe losses, net of reinstatement premiums for the fourth quarter totaled $246 million as we announced on January 9 or 10.1 loss ratio points for the quarter compared to $108 million or 4.6 loss ratio points in the same quarter of 2015. Paul and Greg will expand on this area later.

Operating expenses continued to improve compared to the prior year and remain in line with our previously announced estimates for operating expense levels as provided in our 8-K filed in June of 2016. We continue to believe that our operating expenses excluding integration expenses for 2017 will decline again compared to 2016 consistent with the estimates we previously provided of $1.77 billion to $1.84 billion. If the pound and euro stay at the current levels we expect to be closer to the bottom of that range. As you're aware this is a ground up valuation quarter for us. Prior year net development resulting from the fourth quarter ground up review was a favorable $106 million or 4.3 loss ratio points for the quarter compared to net favorable development of $121 million or 5.1 loss ratio points for the same quarter in 2015. This reflects favorable development of $24 million from the insurance segment and $82 million from the reinsurance segment. For the full year, development was a favorable $302 million split $92 million from insurance segment and $210 million from the reinsurance segment or 3.1 loss ratio points compared to $307 million with 3.7 loss ratio points in the prior year.

Property and casualty combined ratio for the quarter was 94.8% or 2.5 points higher than the same quarter last year and the full year’s 94.2% was 2.2 points higher than the prior year, driven by higher catastrophe losses. Our combined ratio excluding prior-year development and natural catastrophe losses for the quarter was 89.1%, 3.7 points lower than the fourth quarter of 2015. This reduction is driven by decreases in all three components; loss ratio, acquisition cost ratio and general expense ratio. The full-year’s 90.7% was lower by 2.4 percentage points compared to 2015. As you can see in the financial supplement, our operating effective tax rate excluding discrete items was 16.6% for the quarter and 10.7% for the year. Both are high than what was expected at September 30 due to our fourth quarter earnings being in higher tax jurisdictions than previously estimated largely due to catastrophe losses. We also had non-recurring tax benefits in the quarter and year that reduces those rates to 0.7% and 4% respectively. Fully diluted book value per share declined by 4.8% in the fourth quarter resulting from negative mark to market movements on our fixed income portfolio reflecting the recent rise in interest rate. Fully diluted book value per share grew by 2.2% in the full year.

Turning to the investment portfolio and as usual my comments will exclude the Life Funds Withheld Assets. Net investment income was $161 million compared to $172 million for the prior year fourth quarter. During the fourth quarter, our average new money rate was 2% and since election in the US, modestly about that. At the end of December, the gross book yield of the fixed income portfolio was 2.4% and the duration of the total investment portfolio increased marginally to 3.4 years due to the increase in market interest rates and remains short of our liability duration benchmark. We anticipate that net investment income will continue to remain under pressure given the current low interest rate environment and from lower cash flow as a result of our share repurchase program. We are approximately $3.7 billion of assets of book yields of 2.5% rolling off over the next 12 months. Net income from affiliates was $48 million for the quarter compared to net income of $15 million in the prior-year quarter due to positive hedge fund performance compared to the prior year quarter. Results were also driven by a net $14 million benefit resulting from the rebalancing of the investment portfolio as we change concentrations in certain individual positions as part of the normal course partially offset by a decline in value within operating affiliate. Unrealized net gains were $0.4 billion at the end of the quarter. The total return on investments was negative 1.1% for the quarter in original currency and on a year-to-date basis the total return on investments was 2.8%.

And with respect to capital management, we continued to execute share buybacks during the fourth quarter. During the quarter we repurchased 4 million shares for $145 million at an average price of $35.94 per share leaving $449 million available for purchase under our share buyback program. For the full year we have purchased 30.2 million shares for $1.05 billion at an average price of $34.73. As Mike said, we will continue to manage capital in close alignment with economic and operational factors.

Now I’ll turn it over to Paul to discuss our insurance underwriting results.

Paul Brand

Thanks Pete. This evening, I'll cover the results for the segment, provide an update on current market conditions and premiums, and finish with some comments on our new insurance organization. First the results, the segment produced a calendar quarter combined ratio of 98.2 % and a full-year combined ratio of 96.9% which happens to be the same ratio as we produced in the quarter and full year for 2015. Higher cat experience were 126 million in the quarter driven largely by Hurricane Matthew and the recent earthquake activity in New Zealand compared to 68 million in Q4 2015, was offset by prior year reserve releases of 24 million and by material improvements in the underwriting expense ratio of 3 points and the accident year ex-cat loss ratio of 0.5 points. On accident quarter ex-cat basis the combined ratio was 92.3% compared to 95.7% in Q4 2015 and 93.3% for the full year compared to 95.4% reported in 2015.

For Q4, we reported an acquisition ratio of 12.8% compared to 13.9% in Q4 2015, and 13.5% reported for the full year. For the quarter, this is better than the guidance we provided in Q1, driven largely from a change in business mix as we tune the portfolio, more net deals in some of our larger risk management businesses as well as ceded adjustment related to a prior quarter. As a result of this prior quarter adjustments, we would expect future quarters to be closer to full year 2016. In addition, we reported an operating expense ratio of 17.6% for the quarter and 18.4 % for the year. Both of which were roughly 2 points lower than the prior-year quarter and year. Finally, our net accident year ex-cat loss ratio of 61.8% for the quarter and 61.4% for the year, reflecting 0.5% improvement over Q4 2015 or 1.1 improvement over 2015, largely reflecting the re-underwriting work we started last year.

Pricing remained consistent with what we've seen throughout the year at just under negative 3% for the quarter and full year. Our casualty lines were flat for the year as meaningful increases in E&F, North America construction and environmental lines were mostly offset by moderate rate of decreases in our excess casualty line. Our professional businesses were down 2%, driven by our US professional D&O book just partially offset by lower single digit rate increases and outside the lines. Our specialty businesses were down 3% driven by continued competitive conditions in the aviation and marine Lines. And our energy, property and construction businesses were down 6%, driven by a low-double digit reductions in the energy book during the first half of 2016. Insurance gross premiums written in Q4 increased by 6.9% or 160 million year-over-year and increased by 8.7% when normalized for foreign exchange. For the full year, gross premiums written increased by 14.9% or 1.25 billion, driven largely from the Catlin acquisition as 2015 results only reflect seven months of the combined entity.

When we look at both legacy organizations and normalize for foreign exchange, [indiscernible] in 2015 and it’s a one-off positive during the quarter, our growth was approximately 4% for the full year. Whilst 2016 was a challenging year, we continued to focus on customer service and development of new products and solutions. We know that investing in innovation and talent and focusing our efforts on how we do business are the cornerstones of success over the long term. Being recognized as the top achiever on Advisen's Pacesetter Index, being named highest customer satisfaction on large insurers in J.D. Power Survey of North America [indiscernible] are evidence that we are on the right track.

Moving on to the organizational changes. As Mike mentioned, we adopted a new PNC operating model effective the January 1. I'm very happy to share that the model has been fully executed according to plan. [indiscernible] in its new structure and there's been no adverse impact on our clients or brokers as the majority of their contacts remain the same. And while the impetus for the new model was greater accountability, clearer roles and improved decision making, it had also drive improvements in efficiency. In summary, we have delivered another quarter of underwriting profitability despite market conditions and higher cat activity. We have achieved our strongest quarter of organic growth. Our company and our colleagues were recognized by numerous industry awards and publications and we successfully realigned our operating model to deliver greater flexibility, faster decision making closer to our client. Finally I just want to say on behalf of Kelly and myself that whilst we are both looking forward to our new roles, it has been an honor to lead the insurance segment over the past two years. With the hard work from a great group of colleagues we achieved an enormous amount. Not only did we successfully bring the two companies together, continue to grow the business and achieve several awards along the way, we did so without jeopardizing our long streak of profitability. And as we hand over the leadership to Greg, we feel strongly that the segment team is extremely well positioned to deliver continued improvement in our results.

I’ll now turn to Greg to discuss reinsurance results.

Greg Hendrick

Thanks Paul. Today I’ll discuss the results for the quarter, provide further detail on our catastrophe losses for the year and summarize current market conditions. Beginning with the results, the reinsurance segment produced strong underwriting performance with the calendar quarter combined ratio of 87.1% compared with 79.1% for the fourth quarter of last year. The result of the quarter experienced favorable prior-year development, lower accident quarter ex-cat loss ratio and an improved expense ratio offset by a high level of catastrophe losses. For the full year we achieved an 88.4% combined ratio, up from 81% last year with similar drivers noted for the quarter. Reserve releases in the quarter totaled 82 million compared to 93 million a year ago. As Pete noted, the fourth quarter is a full evaluation quarter and reserve releases were absorbed across all classes of business. In particular, our property catastrophe and casualty treaty portfolios had the largest releases.

The reinsurance segment produced an accident quarter ex-cat loss ratio of 49.4%, which compares to 50.2% in the fourth quarter of 2015. The decrease was driven by the absence of large loss in the quarter offset predominantly by a small impact from a change in mix of business and market conditions. Expense ratio decreased 3.5 points to 32.3% in the fourth quarter compared to 35.8% for the same quarter last year. This decrease was driven equally by lower operating expenses as the impact of our expense synergies continue to earn through and lower acquisition costs as the purchase accounting adjustment continues to diminish. Catastrophe losses totaled 120 million net of reinstatement premiums during the quarter compared to 39 million in the fourth quarter of last year. The cat activity during the quarter was driven by Hurricane Matthew and the New Zealand earthquakes in November. A number of other small events were offset by reduced estimates of the Fort McMurray fires and China floods from earlier in the year. For the year, property catastrophe losses net of reinstatement premium for this segment totaled 306 million, up from 63 million in 2015. Our loss experience is driven by 60% increase in industry insured losses and a higher portion of these losses due to the reinsurance market. Our market share of the events impacting XL Catlin was unchanged relative to 2015. Despite this level of catastrophe activity, for the year, our property catastrophe portfolio was profitable with a 65% combined ratio.

Turning to topline, gross written premiums for the quarter was $536 million, up from $206 million in the fourth quarter of 2015, with the increase driven by a large multi-line quota share with one of our core clients. Excluding this treaty, our topline would have decreased to 176 million driven by cancel business as we continue to maintain underwriting discipline. For the full year, on the combined portfolio after adjusting for foreign exchange and a large treaty in the fourth quarter, we grew our topline nearly 4%. Shifting to market conditions, we are operating in a challenging training environment in most of our classes. Our rate decreases continue to decelerate in most lines and regions and as noted last quarter, we appear to be reaching the bottom in many classes of business. For the full year, rates across the segment were down approximately 3%. Our global catastrophe portfolio was down 5% for the year significantly less than the 8% decrease we experienced in 2015 and the remainder of the property treaty book rates were down 2.5%. And our casualty business renewed flat over last year and the remainder of our classes were flat to down low-single digits.

Shifting to the recently completed January 1 renewals, rates were down 1.3% across the portfolio. Property cat rate globally were down 3.5% with international rates down more and US rate down less than the compass of 3.5%. Our casualty treaty book was up 1% and the remainder of the business was flat to down 2%. In summary, the fourth quarter and full year results are respectable for the reinsurance segment. Underwriting teams continue to an excellent job growing profitable business and finding new opportunities while maintain underwriting discipline. As Charles Cooper takes over the segment, I'm confident that he and the entire team will continue to build a market leading reinsurer.

I'll now turn it back to David.

David Radulski

Thank you. And Shirley you can open the lines for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Kai Pan with Morgan Stanley. Go ahead with your question.

Kai Pan

First, good luck to Paul for the new position and David for your retirement. My first question is on the cat, you talk about like the underlying improvements that you're making great strides in that. But [indiscernible] have introduced quite a bit of volatility. Do you consider the 6.7 points of cat load in 2016 as your normalize year and are you considering any measures or actions to reduce that volatility?

Greg Hendrick

This is Greg. Let me - I’m going to step back and say given the 16 years, it's reasonable for us to review our historical cat activity and put this year into context. And we find 2016 to be an unsurprising year. Let me share with you some of the observations that provide perspective around three main areas. First a look at our cat loss history from 2006 forward. Second, put ’16 in the context of that history. And third, some factors that influence the variability of catastrophe losses in a given year. So let me turn to the cat loss history, we combined the reported net catastrophe losses after reinstatement premiums from each legacy firm starting with the 2006 accident year. We started with 2006 as I believe the events of 2004 and 2005 radically changed the market in terms of insurance coverages and reinsurance structures. Over that 11 year period between 2006 and 2016, our net catastrophe losses ranged from zero in 2006 to 1.4 billion in 2011. Now this wide range is indicative of the variability of the skewed distribution of an annual catastrophe loss level.

The mean loss over this period was 443 million. We have not adjusted these losses for numerous factors including subsequent reserve releases, change in exposure of different reporting guidelines. So if I shift over and give you a little context for 2016, we see that 2008, 2010 and 2013 all had a roughly similar annual industry insured cat losses of this year. In those three analog years we incurred between 473 million and 639 million of cat loss. Our 2016 catastrophe loss experience of 636 million fits within the range of outcomes in years of similar industry losses. And to your question, Kai, we believe the industry loss totals from this year are above the median of the industry loss disruption. The variability of a given year of net cat loss at XL Catlin can be affected by any number of factors but four main one. First, the location of events within a given year will drive different results in our book. Events occurring at peak peril territories tend to have reinsurance [indiscernible] at higher industry events relative to non-peak geographies. Second, within our large risk insurance portfolio, specific location losses can vary greatly by event. We referred to this in the past as the pinpoint loss effect. And outcomes are driven by whether a particular location is or is not affected by the event. And third, how we record our catastrophe losses has changed over the years since the acquisition of Catlin. In our insurance segment, we record all weather driven losses, regardless of the event size as catastrophe losses. In reinsurance, we continue to report events that are larger than 5 million to XL Catlin as catastrophe losses given the difficulty of tracking small cat events. And fourth, changes in our outward reinsurance protection will change the shape of the net catastrophe loss distribution.

Given our recent cat bond issue, let me just briefly pause here and give you an update on our outward cap protection as well. As a reminder, we predominantly buy reinsurance that protects the entire group and make use of quota share, catastrophe occurrence, catastrophe aggregate, accessory bonds to protect our portfolio. For 2017, we have used the reinsurance market to reduce our exposure to certain peak natural catastrophes. This is predominantly achieved by increased issuance of our Galilei cat bonds, which now total 1.875 billion. Based on today's exposure, the increased protection offset by potential NOI and portfolio growth will reduce our North American windstorm tail exposure by roughly 20% to 30%.

Our total reinsurance program for ’17 would not materially change our net position if applied to the 2016 events. Taking all these observations together, Kai, I think while 2016 was higher than what we would typically expect in a year, it was an unsurprising outcome based on the industry losses and our net cap profile.

Kai Pan

Well, that's very comprehensive. So, you’re basically comfortable with your current risk profile?

Greg Hendrick

Yes.

Kai Pan

Okay. Then my second question is a technical one. There is discussion about, in the UK Motor, they’re discussing the discount rate, so-called [indiscernible] rates. I just wonder your exposure there if the discount rates are reduced to for example to 1%, what’s the impact on your reserve?

Pete Porrino

Sure. Kai, this is Pete. I’ll take that one. So for the benefit of those of you that are not studying UK Motor trends these days, [indiscernible] tables are used by the UK courts to calculate lumpsum awards in bodily injury cases and are calculated at specified discount rate, discount rates. A reduction in the discount rate translates into an increase in the present value of the lumpsum award. So the general expectations at the current rate, which is 2.5% and has been in place since 2001, will be reduced, it was supposed to be reduced in January. It's been put off so far till February.

It's been delayed a couple of times, but I would say there is significant uncertainty around how far that reduction is going to go. Classes of business impacted by this, by the lumpsums are UK Motor bodily injury, UK employers’ liability and UK public liability with UK Motor having the largest impact. And we’re not a large rider of UK Motor business. We do have some exposure from business written on a non-proportional reinsurance basis. We scaled this portfolio significantly back, beginning in 2009 and its periodic payment orders or PPOs became more prevalent and more costly. Our UK gross motor premiums are now under $10 million and our undiscounted reserves are about just over $300 million.

So what the impact right of the reduction in the discount rate? First, I’d say not all reserves will be impacted by a change in discount rate, including all the existing PPOs already in payment. And we would expect some shift away from PPOs should lumpsum settlements increase because of reduction in the discount rate. Taking these factors into consideration, we believe the level of our held reserves to the subject classes of business provides a reasonable provision for UK bodily injury claims, even anticipating a reduction in the current 2.5 discount rate down towards 0%.

It should be noted that larger reduction to this discount rate are possible, including to negative real rates, right, so that the present value of the payment is actually greater than the sum of the future payments that you would make as counterintuitive as that would be. We view those scenarios as less likely, but they would place a drag on favorable prior year development within the reinsurance segment. Impacts on insurance segment are expected to be modest due to the low level of UK bodily injury claims in our portfolio as well as reinsurance protections.

Operator

Thank you. Your next question comes from Brian Meredith with UBS. You may ask your question.

Brian Meredith

Yes. Thanks, everybody. Mike and Pete, I'm just curious, could you give us some color on the potential for kind of corporate income tax reform in US, border tax, what the potential implications are for you, how are you thinking about it? What, as outsider, should we be kind of looking at to evaluate what it could potentially mean for you?

Mike McGavick

Yeah. This is Mike, Brian. Look, it's been said elsewhere and I just completely agree, running these companies isn't just about tax. We’re sure we're thoughtful about it. We should be stewards of our shareholders' equity. But that's not how we compete and it’s not how we win business. And the idea that reform is going to be a huge competitive disruption, I really think that idea is nonsense. Look, we're absolutely for lowering the rates in the US. The US has been at a global tax disadvantage and anything that stimulates US economic activity is a plus. Going to be more to ensure, and of course as it relates to our US taxes, we would pay less.

Other questions that are floating around as you've mentioned like border adjustments or the NEO bill, it just seems to me to be very premature. It's not exactly clear what will be proposed, it's not exactly clear what will result from what will be no doubt a very complex legislative process. I will say this though. The idea of exporting your risks is a good idea and the idea of it making it more expensive and more difficult to do so is not a way to grow your economy, but rather a way to retard growth. It seems to me that that will become evident in the discussion ahead and we're certainly going to make sure that that is clearly understood.

One other point I'd make on this, remember, the companies with whom we're mostly competing are global, not US domestics. And I don't see that changing very much. So overall, we're comfortable with the way we approach tax, we’re comfortable with our competitive position. Absolutely, no matter, what comes.

Brian Meredith

Great. Thanks. And then Pete, I just wanted a clarification here or just make sure we’re looking at the right way. So if I look at your operating expenses for 2017, excluding the integration charges sitting here like $1.794, is that the right number to look at versus where you're kind of guiding to the 1.77 billion?

Pete Porrino

So I think if I go back ex, did you say, ex-integration?

Brian Meredith

Ex-integration, yeah, ex-integration exactly.

Pete Porrino

Right. So ex-integration, I think we're a little bit less than that the way I did the math. I think I had 1.842 [ph] if I remember correctly. And that is the number that you would then use to compare it to what was in the 8-K that we put out, as I said, the 1.77 to 1.84.

Brian Meredith

Got you. So effectively think of operating expenses as the integration is roughly flat ’17 over ’16?

Pete Porrino

No. I think that would probably be down. As I said, unless FX changes, I think we’ll be down closer to the lower end of that range. So again, to summarize this year, we’re at about 1.84 and next year, the range is 1.77 to 1.84 and as I said in my remarks, FX stays the same, we'd expect to be at the lower end of that range.

Operator

Thank you. Our next question comes from Meyer Shields with KBW. Your line is open. Go ahead with your question.

Meyer Shields

Thanks. One quick question with regard to that. Pete, have you done anything for the lock-in current foreign exchange rates?

Pete Porrino

So we did put a hedge on for UK rates. What I would say is the accounting for that will not show up in expenses. We did that on an economic basis. Right. So, but the answer is yes, we did put a lock in.

Meyer Shields

Okay. That’s helpful. If you take a step back now, and you said, look at the ultimate rationale for the cap and I understand it was increased relevance, can you talk how that’s played out so far through in 2016?

Mike McGavick

Yeah. I would note a number of things. First of all, think about the way the year ended and the production we had, the growth that we had in the fourth quarter. We saw that growth strengthening throughout the year. We felt we could see the difference in the quality of risk we're being presented and the quantum of risk we're being presented. And I think I used those statistics on our last call that we saw submissions going up. We saw quotes going up, which says we were finding the business attractive, but we were actually seeing our binding go down a bit, because we weren’t finding the quality of business. That's our underwriters doing a great job and our market presence giving us more to work with and that is now yielding growth.

And when we have this very efficient base that we have built, which was enabled by the transaction, neither company separately could have gotten to this level of efficiency. We have real operating leverage on that growth. So this positions us to continue to improve our company's results and I think it's really, and I would just also point to all the awards, I mean that is the market telling us, they prefer us, that they find us extremely effective. And then there's one final point I would make and I think this is a really important one because I hear a lot about volatility, Kai opened it with the question around cat. So I thought Greg answered to it. But I would note there's been two other sources of volatility that have caused this, particularly back in the XL past, some real noise. Let me talk about large losses for a second. With regard to large losses, this is where the combination with Catlin has really helped. We have a larger and more diversified portfolio of risks.

We've been able to design more efficient reinsurance structures. These portfolio changes have resulted in greater capacity to absorb large losses and you all know from some of the other calls that have been held over the course of 2016, there was a lot of large loss activity and we saw too and much of that is syndicated risk, but we were able to absorb, so we weren't immune from what was going on in the sector, but we were able to absorb those large loss impacts and still produce an accident year ex-cat result that demonstrated improvement over the prior year.

So while we recognize the volatility of business and all underwritten there could be more severe outcomes in 2016, but with the year that was this heavy and large losses to produce an improved accident year ex-cat loss ratio really shows the power of the diversification and our ability to lessen volatility for our shareholders. So we're very pleased with the way the portfolio is performing. Obviously, other sources of volatility would be in the utility side, which is really not affected one way or the other by the transaction. But if you talk about those three areas, affiliates, which is just ordinary market events; if you talk about what we've done on large losses, and we talked about the profitability and the comfort we have with our cap book, it’s a very attractive firm.

Operator

Thank you. Our next question comes from Ian Gutterman with Balyasny. You may ask your question.

Ian Gutterman

Hi. Thank you. I guess first, I was hoping you expand a little bit more on the cap bond purchase and what it means for your capital in addition to volatility, I mean, 20% to 30% reduction in PML seems pretty significant. What does that do to capital flexibility going forward?

Pete Porrino

So, Ian, this is Pete. On the capital side, it does reduce the required capital that we would hold. We've taken that into account when we've talked about what we are committing in the buyback. That would just echo what Mike said. But the cat bond purchase was part of that calculus.

Ian Gutterman

Got it. And then also related, just to follow up on Mike's point about being able to absorb large losses and so forth, does reducing the PML make you think any differently about buying protection lower down?

Mike McGavick

[indiscernible] and its diversification benefit by itself. So, as you know, the lower down you buy, the less efficient the purchase and the more you’re giving up in earnings. So as we look at, we're very confident with the way that portfolio is performing. We're always testing out different ideas and where we find one that's economic, we do it. But in general, we're pleased with the way the portfolio is able to allow us to put out these kinds of limits and absorb the expected losses that come with them.

Ian Gutterman

Got it. And does the cost of buying that cap bond, do we need to think about any impact that might have on the accident year going forward or does that sort of get absorbed with the other rebalancing you did?

Greg Hendrick

Ian, its Greg. There’s a lot of moving parts to -- that's one transaction that would drive the ceded premium. It’s a multi-year transaction. The earned ceded will go up a little bit, but there's other things we're doing that will drop it. So in isolation of itself, yes, it would move it a tiny bit, but all the moving parts, there shouldn't be a material change.

Ian Gutterman

Got it. Okay. And then Greg, just to follow up on and the reinsurance growth in the quarter, can you tell us a little bit more about that quota share treaty you did?

Greg Hendrick

Absolutely not. But, as you know, we don't talk about individual client claims or the specific treaties, but let me give you a little bit generally about this treaty. It's only going to have a little bit of lower margin than the rest of our corresponding portfolio, but also lower downside risk relative to our overall portfolio. So there is a little bit of a good trade there. The result of this treaty, like every single treaty, as you know, is variable. We would anticipate that we have a minimal increase in our overall loss ratio, minimal being less than a point and our acquisition ratio would increase, but would be offset just equally by a decrease in our operating expense ratio. So there isn’t a big change in the economics of our portfolio and that’s why we felt it was a good opportunity to solidify and to Mike’s earlier conversation, I can wholeheartedly tell you we would not have seen this transaction at XL or Catlin, we only saw because we are XL Catlin.

Ian Gutterman

Great, Greg. And just to clarify, is this something that's like a one-off type thing or just something we would expect to renew a year from now or you said it was multi-year. So I guess, there wouldn’t be a renewal next year, but down the road, is it just a one-off thing that we won't see again?

Greg Hendrick

And you’re listening well to what I'm saying. Multi-year was in the cap bond, the cap was multi-year. This is an annual transaction. Customer ordering insurer can decide not to go forward. Certainly, we try to enter into those pure one year trades. We have a belief that we will trade forward, but I can't guarantee that we’ll trade through it.

Ian Gutterman

Of course. But okay, I just wanted to get a sense of expectation. Okay. And then just lastly, Pete, can you give us a little more detail that 14 million of rebalancing in the affiliates, what exactly was going on there?

Pete Porrino

Sure, Ian. There were two things, two parts of the 14 million. One was, in our hedge fund portfolio, we have a philosophy of having concentrated positions for most, but not all of that portfolio and we did have a position that we concentrated more in, in the current quarter and that concentration in the US GAAP rules require that we move it into affiliates from non-affiliates and so that was the one direction. The other one was just a reduction in the value in our operating affiliate portfolio.

Ian Gutterman

Does that change or influence what we would think the run rate of affiliates would be going forward?

Pete Porrino

I don't think it would be enough to move it. I mean when you do move one of those, you take the unrealized and it becomes realized. To give you an order of magnitude, it was slightly under 30 million. But again, that would never be the run rate. That would be the cumulative catch up. And then, there was a equal going the other way on the operating affiliates.

Ian Gutterman

Okay. And is there any updated thoughts, I like to ask this question about the future of the investment affiliates business and whether it might make sense to monetize any more of those going forward?

Pete Porrino

Yes. So we look at all of our affiliates, both the hedge funds and the manager affiliates. I think your question is more on the manager affiliates or was it on or all of the affiliates?

Ian Gutterman

On the investment managers, correct.

Pete Porrino

Right. We look at them all the time, that’s all I could say, Ian. There is somewhere between 6 and 12 in that bucket right now. It is more competitive field than it used to be I would say. And so we're challenged to make new investments in there and we talk about monetization and you will probably see some from time to time, but only one is economically advantageous for us.

Operator

Thank you. Our next question comes from Paul Newsome with Sandler O'Neill. Your line is open. Go ahead with your question.

Paul Newsome

Good evening everyone. I've started to look at your company on a all-in combined ratio basis, but what I mean is, I’m just forgetting yourself on that, I'm just looking at losses and expenses relative to premium, everything, operating integration as such. And so, I get the loss ratio commentary. But I'd like to ask a question about what I look at as your all in expense ratio, which for the year this year was about 37%. If my math is right, a couple of points of that is integration expenses which maybe go away in the next two or three years, but I'd like to know where that expense ratio goes all in, in your view, in the long term, not 2017, not even necessarily 2018, but to be truly competitive, were do you want to bring those all in expenses?

Pete Porrino

So, Paul, its Pete. Let me first. I think actually looking at it quarterly is useful or not and when I look at those numbers, I do a couple of adjustments that you may or may not have done. One, I take out the purchase accounting adjustments that are flowing through there and the other thing I do is, as you mentioned, I take out the integration, right. We started this year so the end of last year, the fourth quarter of last year, that number I have is 37.5%. Okay. This quarter, it’s 34.5%. Right. So that's where it's going. We talked about the reduction in the expenses year-to-year right.

If you use the lower, the lower in that range, that would be a reduction of something in the $70 million range if I’m not mistaken, which is about another 70 basis points. As Mike talked about and Paul and Greg as well, we think that we have room to grow in this franchise, even in today's market conditions. I would tie our expense base. It's not fixed, but it's not hugely variable either. Okay other than the commission and brokerage line on our operating expenses. And so I think we can continue to move that number down over time. I'm not at this point ready to go and give you a number for where we think it will be in a few years, but I certainly think it's going to be less than 34.5.

Operator

Thank you. Our next question comes from Josh Shanker with Deutsche Bank. You may ask your question.

Josh Shanker

Yeah. Thank you very much. I just want to talk about the 2016 cat experience and how that informs your risk management for 2017. Is the cat protection that you're purchasing a response, is it part of a longer term strategy for a different pattern of volatility of loss merchants?

Greg Hendrick

So Josh, its Greg. No, it's not a response to the 2016 as I noted in the answer for Kai earlier. The purchase that we made, particularly on the cap don't change what the ’16 year would have been with that in place. There are some other minor changes we’re making that would tweak it a little bit, but not materially. We're constantly growing this portfolio. We’re constantly going to what the risk reward. We saw in that, particular in the cap on market as issuance started to decrease, we saw prices decreasing there. We saw an opportunity to be able to take off a bit of a tail of our distribution in the peak territories at a pretty economic price.

So we took advantage of that. It definitely was not. There's nothing in ’16 that informed us about that purchase. It was more about just how we best manage our tail exposure. We're always thinking about things we can do around the whole shape of the curve. Mark van Zanden, who runs our underwriting capital management spends all the time on this topic with his team. At the moment, we don't see anything that we saw that disturbed us that felt we were out of size market share that there was something wrong with that distribution. And so we haven't changed anything in the kind of the median down portion of our distribution.

Josh Shanker

So if you're being opportunistic, given where the pricing is for protection here, does it make sense to be a less volatile underwriter, I realize XL is in the business of taking on risk. In this part of the cycle, should XL offload as much volatility as possible, given the potential that's cheap to do so or is there some cycle management thoughts here on how you buy reinsurance?

Mike McGavick

So I think it's much around that the opportunity economically exists in that tail of the curve. We don't believe it exists nearly as much down in the mean or the median of the curve. There's a lot less opportunity there to be able to trade opportunistically in that part of the curve. So we think we've got it balanced right, given the current state of the market, given what we can charge on both the inwards insurance and inwards reinsurance pricing and balance it with what we can do on our side. So I don't think it's a universal economic benefit that can be achieved up and down that curve right now.

Operator

[Operator Instructions] Our next question comes from Randy Binner with FBR. You may ask your question.

Randy Binner

Thanks. Yeah. So back to expenses and the integration expense fall-off going back to the 8-K, that was going to be 60 million to 70 million in the first two quarters of 2017. So I think I asked this question last time, those are still scheduled to fall off in the first half of ’17. There's nothing that's changed there.

Pete Porrino

That's correct, Randy. It's Pete. There’s nothing that’s changed.

Randy Binner

And then jumping to the big reinsurance topline, I guess the only other question I’d have there, did I hear that you said that was with an existing partner, meaning is it -- was that all new or was that kind of an expansion of an existing relationship, just kind of following up on Ian's question.

Greg Hendrick

Sure, Randy. It’s Greg. Yeah that’s expansion of existing relationship with a very meaningful client we already have.

Randy Binner

Okay. And then just jumping to the bottom line of reinsurance, which was really good. So your loss ratio ex-cat and reserves is low, it's lower than I would have thought and I guess I don't, how should we think about that pick in sustainability. Your commentary on rates reaching a bottom broadly seems not out of step, but different than some stuff I read in the trade publications and so I just, I imagine more pressure on a big reinsurance business than what these numbers are showing. So how, what keeps me from running that fourth quarter loss ratio ex-cat and reserves just through the model going forward.

Greg Hendrick

So there's a lot in that one, Randy. Let me see if I can break it down for you. One that tweaks me, the numbers I gave you around what's going on in the book is about our portfolio. So that’s our rate decrease, not what's happening in the broader marketplace. So it's entirely conceivable that a big broker could issue a report that surveys across the whole piece of the market and we don't have certain exposure to certain things that drive rate decreases and so ours are lower. So it's not unusual to see that a little bit of that disconnect. And it's always, to me, there's always a lot of judgment and call around. We just feel that we're near the bottom because we saw not only the rate decreases I cited, but also as we got to the end of the year, there were things coming back to the marketplace to be repriced or to be, not be placed at all. And so it's not a market where you can drop any price in to the market place.

So that's one piece of that. I would always say for reinsurance, there should always be used in kind of the annual distribution right, there is this we’ve talked about before in our ex and your ex-cat loss for reinsurance, we have those as I talked about in my catastrophe answer, those cats under 5 million end up in that hat bucket and we tend to view like everything else we do here. We tend to be pretty quick takers of bad news and slow realizers of good news. And so in that bucket, there's always the seasonality of the exposure, which tends to happen in the back half of the year and there's a lag in reporting that comes from our clients. So always look at the annual rather than just the fourth quarter, quarter over quarter over quarter accessing our cat for insurance is not a great metric, try and use that annual number.

Randy Binner

That's perfect. Actually just one more back to expenses, when you say bottom of the range on the 177 to 184, is that the more conservative end of the range or the happy end of the range?

Pete Porrino

That's the happy end, that’s closer to the 177.

Operator

[Operator Instructions]

David Radulski

Thank you, Shirley and that completes our Q&A for the evening. And now some comments from Mike.

Mike McGavick

Just a couple of things. First, obviously, we've been pleased with the trends and we're encouraged about next year. Very, very excited and we're just incredibly proud of the recognition that our colleagues have earned. It’s very impressive. I did want to close with two additional observations. Of course, Abbe Goldstein has now joined us to be our future head of IR. I want to thank many of you who took calls and took the opportunity provided to Abbe and through Abbe to Pete, I and others in your candor and your guidance is always appreciated and we try to take it to heart, given that this was not a year in which our shareholders experienced what we believe they deserve to cause them to experience next year. So we are working -- in 2017, so we are working incredibly hard to do that.

And finally, I want to acknowledge David Radulski. This will be his last conference call as our Head of IR giving way to Abbe. Dave’s been with us for 16 years, provided tremendous and loyal service and we appreciate it very much and we wish you well David on whatever comes next. With that, we look forward to seeing you around the trail.

David Radulski

And that concludes the call.

Operator

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

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