Oct 31, 2012
Operator
Ladies and gentlemen, thank you for standing by and welcome to the Third Quarter 2012 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise.
After the speakers' remarks there will be a question-and-answer session. I would now like to turn the conference over to Mr.
John Molbeck, Chief Executive Officer. Sir, you may begin your conference.
John Molbeck
Thank you, Bonny, and good morning everyone. Before we start today's call, I'd like to say a few words about Sandy.
Many of you, your families and your colleagues have been impacted by Sandy. We pray the impact has been minor and that your lives will return to normal soon.
We're confident that our industry will respond appropriately. Joining me today on the call is Chris Williams, our President; Bill Burke, our Chief Operating Officer; Brad Irick, our Chief Financial Officer; and Mike Schell, our Chief Property and Casualty Insurance Officer.
Brad will provide a financial overview followed by Chris and Bill providing further insight into the quarter’s results. HCC had an excellent third quarter.
In fact, this quarter was the strongest quarter in HCC's history with record earnings. Importantly, the quarter was strong across all segments.
Another light catastrophe quarter certainly helped results but we experienced sustained positive pricing, good margins and continued strong cash flow all managed by our team of specialty professionals. During the quarter we had net favorable reserve development primarily in our professional liability and accident health segments, and Brad will discuss reserve development in more detail later.
Annualized operating return on equity was 14.2% for the quarter and 12.1% for the first nine months; both numbers are well in excess of our stated objective. Gross written premium increased 6% for the quarter and year-to-date and our GAAP combined ratio was a great 79.1% for the quarter and 83.3% for the first nine months.
These ratios include 1.4 percentage points of catastrophe losses in the quarter and 1.3% for the nine months. Our expense ratio for the quarter remained strong at 25.2% and book value per share increased year-to-date by 10% to $34.60.
Brad?
Brad Irick
Thanks John. Our investment portfolio has grown 11% to $6.7 billion since year end 2011 driven by our strong cash flows as well as a significant increase in unrealized gains.
Growth in the portfolio along with stable yields resulted in year-over-year growth in net investment income of 5%. Highlights of our investment performance include a long term tax equivalent yield of 4.8% and a book yield of 3.9%, both of which are unchanged from second quarter, a stable portfolio duration of 4.6 years consistent with second quarter, and an increase of $90 million in our unrealized gain position since June 30th.
We are pleased that our efforts to keep yields relatively flat without reducing the overall quality of the portfolio has been successful. We have accomplished this by taking advantage of our underwriting profitability and robust cash flows to invest longer term while maintaining sufficient short term liquidity.
Our recent investments in high dividend equities and bank loans have positively contributed to these efforts. Assuming rates and spreads remained consistent with our current levels, we expect book and after tax yields for the full year in line with our results through the third quarter.
I'd like to mention a slight change to our segments before discussing reserves. During the quarter we exited the HMO and medical excess reinsurance lines which were included as a component of Other in the A&H segment.
These two lines are now included as exited lines within Corporate and Other. All prior periods have been adjusted to reflect this change.
With respect to reserves, this quarter we completed reviews of our US property and casualty, professional liability and A&H segments. The A&H review was scheduled to be performed in the fourth quarter, however, in light of the segment change, we accelerated this review.
Based on our reviews, we recorded a net decrease to our loss reserves of $35 million. This includes favorable development of $26 million in professional liability and $11 million in A&H.
Within professional liability there were no adjustments to DFP reserves. The US Property and Casualty segment had net adverse development of $2 million.
In this segment the net amount included adverse development related to the E&O and public risk lines and favorable development related to aviation and other lines. Our actuarially indicated redundancy as a percentage of total reserves increased to 6.1% at the end of the third quarter from 4.3% in the prior quarter and the prior year.
The increase was driven by our professional liability segment, where continued low levels of paid and cash reserve loss activity resulted in an increase in the indicated redundancy to 8.9% from 5.9% in the same period last year. Operating cash flow of $496 million year-to-date is $208 million ahead of the prior year as a result of our growth and a favorable pay loss ratio.
Collateral from our surety business resulted in $80 million of positive cash flow for the year. We typically hold these funds for 12 to 18 months and are able to use these low cost funds to generate positive spreads and lower our borrowing costs.
Based on our results today we expect cash flow for the full year near to $600 million representing one of the best cash flow years in our history. Chris?
Chris Williams
Thanks Brad. As John and Brad has highlighted we had a very strong third quarter and first nine months of 2012.
A diversified book of non-correlated specialty businesses is producing very satisfactory underwriting results across all of our segments. We had low catastrophe losses, favorable prior year development and excellent current year non-cat combined ratios.
Our net loss ratio was 53.9% in the quarter compared to 69.9% in the third quarter of 2011 and 57.9% for the first nine months of 2012 compared to 67.4% for 2011. Retention rate across segments was 85% this quarter which compares to 83% for the third quarter of 2011.
We achieved an average rate increase for those lines of business where the measurement is meaningful of just under 3% for the third quarter which compounds on last year’s increase. In our International segment, net earned premium increased 7% for the quarter and 13% year-to-date driven by higher writing in our energy and property treaty businesses with favorable pricing for these products.
Our international segment generated a pretax profit of $71 million for the nine months of 2012 compared to a pretax loss of $5 million in the same period of 2011 primarily due to lower cat losses in 2012. Our Energy, Property Treaty, Property Direct and Facultative business have all been major beneficiaries of the benign cat year and have contributed to the segment’s excellent results this year.
We have also established lines of business in our international segment that are not exposed to property catastrophes. One of these lines is our professional indemnity business in the UK.
We have taken steps to leverage our underwriting and distribution advantages we have in our professional indemnity to write profitable UK general liability business. Our market leading Accident & Health segment continued its very strong performance as medical stop loss net earned premium increased 11% for both third quarter and year-to-date.
Brad mentioned that we exited the HMO medical excess reinsurance business this quarter. We sold the renewal rights of these businesses which allows us to focus our efforts on continued development of our important medical stop loss franchise.
Our Professional Liability segment net earned premium declined 6% for the quarter and 3% year-to-date as a direct result of our re-underwriting of the DFP book. The D&O market continues to improve.
Renewal rates for private D&O risks were up 7% to 8% and public D&O primary rates were up 3% with excess rates flat to down 1% to 2%. We have reduced peak exposures and average limits on many accounts in our D&O book.
On certain accounts we believed advantageous to do so we have increased attachment points or offered less full side D&O cover and more A side coverage. Our US Surety and Credit segment net earned premium was up 3% for the quarter and 1% year-to-date.
Our surety business has remained profitable year-over-year with a slightly improved loss ratio despite uncertainty in the construction business over the past several years. Our Contract Surety business bonds smaller more profitable contract work programs than most of our major competitors which has helped us to produce stable results.
The largest part of our commercial book is small limit, license and permit bonds which typically have very stable loss experience. Our surety business is very strong on the West and East Coast providing us with an opportunity for geographic expansion in other parts of the US.
Bill will now review the US Property and Casualty segment.
Bill Burke
Thanks Chris. The overall results for the US Property and Casualty segment for the first nine months of 2012 exceeded the 2011 results with both an increase in net earned premium of 2% for the quarter and 8% year-to-date along with an improvement in the loss ratio both for the quarter and year-to-date.
We are seeing rate increases across a number of lines in this segment including miscellaneous E&O, Marine, and DIC. In addition, we have been aggressively pushing rate increases in EPLI and have been able to achieve rate increases in excess of 10%.
Our aviation business continue to perform well even in a competitive market with a 5% increase in net earned premium year-to-date combined with lower 2012 loss ratios versus 2011. In the component of the US Property and Casualty segment labeled Other we have more than 15 lines of business including our sports and entertainment as well as the new lines of business we entered in 2011.
The three new lines had gross written premium of $10 million in the third quarter and $39 million year-to-date. Overall, the lines of business in other are performing well with net earned premium growth of 4% for the quarter and 20% for the first nine months combined with lower 2012 loss ratios versus 2011.
While our E&O lines are showing a $9 million or 16% decline in net earned premiums year-to-date, this is within our expectations due to actions taken to return this book to profitability. The year-to-date loss ratio excluding loss development is 60%, which shows that the issues are manageable.
Our results in public risk are mixed and we are taking steps to improve our performance including conducting an account by account review of the underperforming areas of our book. The underlying year-to-date loss ratio excluding cats and loss developments of 68% shows that we have areas of profitability in this class such as a state specific program we administer in the mid-west, which has produced excellent loss results for a long period of time.
We have increased our retention on this program which is driving the majority of the increased premium for pubic risk. John?
John Molbeck
Thanks Bill. This quarter AM Best reaffirmed our A class ratings and Fitch reaffirmed our AA rating as did S&P in May.
Our balance sheet remains solid and cash flow was strong and all of our segments are profitable. Our management transition is complete and Chris and Bill will be ready to take over at the end of the year.
Our results this quarter and this year have been excellent with or without catastrophes. We have exceeded our target return and equity to the first nine months and we anticipate that we'll exceed it for the year.
We remain a leader in many of our businesses, aviation, energy, directors and officers liability, surety and medical stop loss to name a few. This allows us to leverage our high renewal retention ratio and focus not on premium growth, but underwriting profit.
This August the Board declared HCC's 66th consecutive quarterly dividend and 2012 was our 16th consecutive year of dividend increases, and the Board announced a new $300 million stock buyback program. These actions reflect our attitude towards capital management.
Since the beginning of 2009, we have repurchased $586 million of our stock. Our GAAP combined ratio for the year is excellent at 83.3%, but it might be helpful to look at the combined ratio without the noise.
Our accident-year combined ratio excluding cats for the year is 84.5% compared to the same period last year of 85.4%. This reflects the underlying strength of our business.
I am often asked about whether we are in a hard market or a hardening market. As far as HCC is concerned it is business as usual.
We have good sound businesses and great people. We have outperformed our peers in all market conditions and loss environments.
We were optimistic at the beginning of the year, we have been optimistic during the year and we remain so. We have increased our annual guidance for 2012 to between $3.50 a share to $3.65 per share as detailed in our press release.
Bonny, with that I would like to open up the call to questions.
Operator
(Operator Instructions). Our first question comes from Ryan Byrnes of Macquarie Research.
Ryan Byrnes
Sorry that's Ryan Brynes from Langen McAlenney. Good morning everybody and congratulations on the strong results, John.
It is a pretty strong way to leave on, but the press release didn’t state there were any share repurchases in the quarter. Is that a change of philosophy or just unnoted there?
Brad Irick
Hi, this is Brad Irick. No change in philosophy and 400,000 shares purchased during the quarter.
Ryan Byrnes
And then quickly just with the reserve releases in the D&O book, I saw that there weren’t any changes to the DFP book, but I want to know was it more international weighted versus US public book or how did that -- was there any breakdown there?
John Molbeck
We haven't provided a breakdown, but I would say it was two-thirds international, one-third US.
Ryan Byrnes
And then my last one, just in terms of I guess it’s almost been a year since the DFP book had the kind of reserve issues, and I guess the re-underwriting is, how far long I guess are you in the re-underwriting process and how much further do you have to go? And just want to see I guess how successfully thought you were in terms of raising retentions and I guess how you were able to -- what their overall retentions were for that book in the past year?
Chris Williams
Yeah, this is Chris Williams. We are about two-thirds of the way through the process.
To give you some color on that, we are non-renewed about 30% of the book, we are averaging about a 50% increase in the deductibles, and we have been able to reduce the limits by 10%. So we will have more to update after the next quarter on that.
Operator
Thank you. Our next question comes from Michael Nannizzi of Goldman Sachs.
Michael Nannizzi
Just one question. What was the -- I just want to confirm that the accident-year loss ratio and the professional liability segment this quarter?
John Molbeck
We don’t have that information in front of us.
Michael Nannizzi
If I can get $26 million, I think then, I get like a 90, I just want to confirm if that's the right number and then just want to understand kind of what already --
John Molbeck
Well, if you think about it this way, I didn’t know you still existed Mike so it’s good to hear your voice.
Michael Nannizzi
Thanks.
John Molbeck
If you think about it this way we are running DFP that’s running in this year we are running at a 100% combined.
Michael Nannizzi
Okay. Okay, and then on the A&H segment the underlying loss ratio is 71.3% which is at the low end of range for the last couple of years.
Was there a unique margin improvement there or was that just something? I mean there have been quarters where you have been down in that range I am just curious.
John Molbeck
No, nothing unique has happened. The accident year loss ratio and professional liability is about 66%.
Michael Nannizzi
Okay. Oh in professional liability it was 66%.
John Molbeck
Yeah.
Michael Nannizzi
Okay, my mistake, okay. And then you paid down a bit of the credit line in the quarter, is that right?
I just haven’t been able to look at everything as close as I would like but I think I saw the debt number, the notes payable number come down I think the credit line rose up in there. Is that right?
Is it $42 million that was paid down or do I have my number wrong?
Brad Irick
This is Brad, yeah, the number moved down a little bit. I think we are 13.5% from a debt capital ratio closer to 15% I think last quarter.
Operator
Thank you. Our next question comes from Ray Iardella of Macquarie Research.
Ray Iardella
So a couple of question from me I guess maybe start off and hit on Ryan’s question about capital management. Just curious I know 400,000 shares repurchased but, any reason for the slowdown in repurchases relative to the strong earnings and strong cash flow?
John Molbeck
Not really, we have been optimistic we have been in a blackout period for a while because of earnings after the Board announced it so I think it’s just more of a happenstance than anything else. We remain opportunistic and will continue to do so for the foreseeable future.
Ray Iardella
Okay, any thoughts on valuation relative to the buyback and relative to book value, is that kinda how you guys look at it?
John Molbeck
We are kind of in the Warren Buffet class.
Ray Iardella
Okay, fair enough. Other question you know, I wanted to ask a little bit about the HMO medical excess business.
What kind of you know, purchase price did you get for the renewal rights?
Chris Williams
We simply sold the business off to a reinsurance partner of ours where based on their success of renewing that business there will be a small override to us.
Ray Iardella
Okay, so nothing, not surely recognized in the third quarter then?
John Molbeck
No, nothing will be recognized until next year.
Ray Iardella
Okay. And then I guess, you know, one last one from me in terms of the favorable development on the professional liability side.
What accident years were those from, if you could give us a breakdown that will be very helpful?
John Molbeck
Well we really won’t -- we are not give you the breakdown but we will tell you they’re of years 2006 and prior.
Ray Iardella
Okay. And one last one if I can.
The A&H business, now that you guys took out the HMO medical excess would it be possible for you guys to release the year-to-date loss ratios from 2Q and then the first quarter loss ratio for that segment?
John Molbeck
It is going to be restated.
Ray Iardella
Okay. All right fair enough.
John Molbeck
It will be - you will have that information.
Operator
(Operator Instructions). Our next question comes from Mark Dwelle of RBC Capital Markets.
Mark Dwelle
A lot of my question had been covered, but one other one was the other operating expense in the quarter was kind of elevated on a dollar basis. Is there anything unusual or infrequent in that number?
Normally run rate around $80 million.
John Molbeck
If you think about it as Brad mentioned earlier, we have invested a relatively insignificant but material amount of money anyway in dividend stocks and bank loans. And so BlackRock is doing that for us and so you are just seeing the natural uptick of that.
Mark Dwelle
That's the operating income, I meant operating expense?
Brad Irick
You are talking about other operating expense?
Mark Dwelle
Correct.
Brad Irick
Okay. This is Brad.
The - a couple of things there, one is we do have the FX impact that’s in that line item. You will see that broken out separately in the press release in the last page where we show the kind of non-operating elements to get to operating return.
So that's one piece of that. We do have strong earnings for the periods that does have an impact on compensation and bonus accruals.
So you will see that has an impact as well.
John Molbeck
We always like to be able to increase the bonus accrual, because we have good results.
Mark Dwelle
That’s fine, I am sure shareholders would do - tend to agree. The FX is about $4 million of that and so apart from the bonus there was nothing unusual other than that increased the run rate?
Brad Irick
No. And I think the $4 million, I think may be an after tax number that you [are quoting] [ph], it is more like a $7 million pre-tax.
Operator
At this time there are no further questions.
John Molbeck
Well, thank you operator and thank you everyone for joining the call. Our next call will be run by Mr.
Chris Williams, who will be CEO of the company so congratulations Chris, and everybody have a great day. Thanks.
Chris Williams
Thanks John.
Operator
This concludes today's conference call, you may now disconnect.