Arch Capital Group Ltd (ACGL) 2008 Q4 法說會逐字稿

Good day ladies and gentlemen and welcome to the fourth quarter 2008 Arch Capital Group earnings conference call. My name is (inaudible) and I will be your operator for today. At this time, all participants are a listen only-mode. (Operator Instructions)

Before the Company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws.

These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.

For more information on the risks and other factors that may affect future performance investors should review periodic reports that are filed by the Company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements which are in the meaning of the Private Securities Litigation Reform Act of 1995.

The Company intends the forward-looking statement in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the Company's current report on Form 8-K furnished to the SEC yesterday which contains the Company's earnings press release and is available on the Company's website.

I would now like to turn the presentation over to your host for today's conference, Mr. Dinos Iordanou and Mr. John Vollaro. Please proceed.

Good morning everyone and thank you for joining us today. The fourth quarter was a challenging finish to a difficult year for financial services companies with economic conditions being the worst we have experienced in many decades.

In view of this challenging environment, Arch on an operating basis had an acceptable quarter in general and a good year from an underwriting perspective. Our investment performance while acceptable on a relative basis was not as good on an absolute basis.

Our annualized return on common equity was 10.9% for the quarter and 15.8% for the year. Both the quarter and year results were affected by cat losses caused by Hurricanes Gustave and Ike.

A significant part of the losses emanated from our onshore and offshore energy book of business, a sector that we increased our exposures post Katrina, Rita and Wilma in 2005 as rates increased substantially. For the year, we achieved a combined ratio of 95%.

Our book value per share was $51.36, down from $53.04 at September 2008 and $55.12 as of the end of 2007. The decline in the quarter and the year is attributed to unrealized investment portfolio losses which we continue to believe are for the most part transient and we expect to recover most of them over time.

Having said that, we're not pleased when we have a decline in book value per share which, along with return on equity, we use as our main report card. Putting things into perspective, however, over the past seven years we have grown book value per share at a compounded annual rate of 16%.

Over this period, our shareholders have benefited from their long-term commitment to us and from our disciplined focus on underwriting and conservative investment approach. Our cash flow from operations at $166 million for the quarter and $1.13 billion for the year continues to be strong.

Our investment view continues to be conservative, both on credit and duration and our portfolio has been constructed as such. For all of 2008, our investable assets returned a negative 200 basis points in original currency and a negative 280 basis points factoring in FX movements. Our expanded supplement and John Vollaro in his comments will provide more details on the portfolio's construct.

Our gross written premium for quarter was flat at $825 million with reinsurance gaining $21 million in production or approximately 8.5% and insurance being down approximately $27 million or approximately 4.5%. On a net basis, reinsurance was up 24% and insurance was down approximately 3% for a group increase of approximately 6.5%.

Our reinsurance operations wrote a major contract with an effective date of December 31 at the client's request. Absent this transaction, the reinsurance group's volume will have been down approximately 5% on gross written premium and up 7% on net written premium.

Our property facultative business which commenced operations almost two years ago has reached critical mass with a monthly premium run rate of approximately $5 million. More importantly, they have reached their return on equity goals one year ahead of schedule.

From a mix of business point view in our insurance operations, property; marine and aviation were flat and professional liability premiums were slightly down with programs and executive assurance volumes increasing slightly. Our insurance group continues to reduce their writings in casualty, health care and surety lines.

Similarly, our reinsurance operations continued to decrease their casualty writing significantly. Today our casualty business represents approximately 30% of our reinsurance volume versus approximately 40% in 2007. Conversely, our volume in property and property cat has grown to approximately 49% of our volume versus 38% a year ago. Our reinsurance volume in marine aviation was essentially unchanged.

Now let me share a few thoughts on the insurance market environment and our January 2009 business. Clearly, the underwriting environment is improving. This improvement is more evident in our reinsurance business where the flight to diversification and the finite capacity of availability in the cat area has created a good trading environment.

We see buyers who are more willing to introduce new names to their treaties and were a bit less loyal to their long-standing reinsurers, irrespective of the share these reinsurance offered them in the past. Buyers today are not as likely to maintain large participations with a single reinsurer as they have in the past.

Over time, this change in buying behavior will benefit Arch, giving us opportunities to penetrate new clients and also to expand our geographic reach. On the insurance side, rate improvements were mixed. Short-tail lines such as E&S and global property that have cat exposure are getting rate increases. The same holds true for both onshore and offshore energy.

The D&O area is achieving double-digit rate increases overall with financial institutions being the strongest sector. Professional liability rates for small accounts are flat to slightly down, an improvement from the trend we have seen in prior quarters.

Casualty, health care and large accounts, professional liability continue to be very competitive. While rate declines have moderated from double digits to mid to upper single digits, it is an improvement but from our perspective, additional corrective action is required to stabilize these lines.

Looking ahead, we expect the underwriting environment to continue improving. Having said that, the current economic conditions will have a negative effect on our customers.

Rate improvements will not necessarily translate into more premium revenue as the exposure base is negatively affected by reduced payroll sales, TIV's etc. In addition, some customers are limiting their purchases due to affordability by retaining more risk themselves or buying less limits.

For the US property casualty industry, where premium revenue statistics exist going back to the beginning of last century, premiums for the industry were down 0.6% in '07 and are projected to be down 0.8% for '08. This is the first time since 1932 and 1933 that the industry has experienced negative premium growth for two consecutive years. The last time premium growth was negative on a single year was 1943.

As the market improves and with our capital position being excellent and the various measures, we are very well-positioned to benefit from opportunities in either the insurance or reinsurance markets. Before I turn it over to John for more commentary on our financials, let me update you on our PML aggregates.

As of February 1, 2009 our 1 in 250 PML aggregate from a single event expresses a percentage of common equity was slightly below a 25% self-imposed limitation. With that, let me turn it over to John.

Thank you Dinos. Good morning everyone. Our 2008 financial results were acceptable considering the insurance environment, the financial turbulence in the overall market and the third worst catastrophe year in industry history.

Despite these challenges, we produced an operating ROE of 16% per year. Although book value decline by about 3% during the fourth quarter due to marked to market adjustment, we believe that these adjustments will be substantially recovered over the next few years.

With that said, I'll briefly walk you through the components of our financial results. Before I start though, I would like you to please note that for the reasons discussed in the release, all earnings per share data for the fourth quarter of 2008 are on a pro forma basis.

Dinos has already commented on some detail on the premium volume. But as usual, there are a few additional noteworthy items.

Our segment mix remained relatively constant in 2008 with premiums written by the insurance segment representing about two-thirds of our gross volume and reinsurance the balance, while property and other short-tail lines represented approximately 47% of our net premium volume. With regard to premium growth rates, it should be noted that the reinsurance group wrote a large property-oriented quota share which Dinos mentioned that incepted at December 31 '08 and that included the transfer of the related unearned premiums of approximately $33 million.

The unusual renewal date resulted in our booking what would have been a January 1, 2000 renewal in 2008. This obviously will negatively impact premium growth rates and comparisons to the first quarter of 2008 in 2009.

On a consolidated basis, the ratio of net to gross written premiums in the fourth quarter of 2008 increased to roughly 75% from 70% in the 2007 quarter. That's primarily resulting from the nonrenewal of the Flatiron treaty.

On a reported basis, we ceded only $4 million of written premium to Flatiron in the fourth quarter of '08 compared to $35 million in the prior year quarter. On an earned basis, premiums ceded under this treaty amounted to $21 million for the fourth quarter of '08 in comparison with $76 million ceded during the 2007 quarter.

The override and estimate profit commission reported on the treaty with Flatiron are reflected as a reduction of acquisition expenses of the reinsurance segment and this improved the expense ratio of that segment by 100 basis points in the 2008 quarter while the impact on their expense ratio in the comparable 2007 period was 410 basis points.

The change in ceding commission was primarily due to a lower level of earned premium in 2008 and the effect of higher loss estimates from Hurricane Ike in the fourth quarter. The unearned premium remaining on business ceded to Flatiron was approximately $18 million at year-end 2008.

Turning to our operating results, our consolidated combined ratio was 101.2% in the 2008 quarterly period, which was 17 points higher than the comparable '07 quarter. 2008 underwriting results include 22 loss ratio points, mainly from the reestimation of claims from catastrophic events, primarily Hurricane Ike, while the effects of cat losses in the 2007 quarter were not significant.

In addition, the loss ratio was also affected by an increase in large individual risk losses as well as from an increase in our 2008 loss picks for intermediate and long-tail business. The sum of these impacts was partially offset by a higher level of favorable reserve development net of related adjustments which totaled $116 million in the 2008 quarter and $32 million in the fourth quarter of 2007.

Approximately 43% of the net favorable development in 2008 quarter was from long-tail lines with the balance coming from short and medium-tail lines. The development primarily was from the 2002 to 2005 accident years.

In general, reported and paid claim activity for business written in prior years across most lines of business continued at better-than-expected levels and IBNR and ACRs combined represented approximately 71% of total loss reserves at quarter-end. The consolidated expense ratio was 210 basis points higher on a quarter-over-quarter basis, primarily due to an increase in the acquisition expense ratio.

Most of this increase was due to the eliminations of the Flatiron treaty discussed earlier. The operating expense ratio was essentially unchanged as a decrease in the reinsurance segment's ratio was offset by an increase in the insurance groups.

The increase in the insurance segment's operating expense ratio reflected charges of $2.8 million or 40 basis points on a consolidated expense ratio for costs incurred as part of an expense reduction initiative that will primarily benefit the expense ratio beginning in 2009. Turning to investment results, in the 2008 quarter, pretax net investment income per share rose by approximately 5% on a quarter-over-quarter basis to $1.79. On a sequential basis, net investment income per share decreased by 4% primarily due to the effects of lower risk-free rates available in the markets.

The increase in investment income per share on a quarter-over-quarter basis was due to a higher level of average investable assets and the accretive effects of share repurchases earlier in the year. The growth in investable assets primarily resulted from the continuation of strong cash flow from operations during 2008.

This quarter's cash flow brings to total float produced since the recapitalization of the Company to just under $10 billion. After reflecting cash flow and financial market turbulence which I will comment on in detail in a moment, investable assets on a reported basis stood at approximately $10 billion at year-end and the portfolio remains well positioned.

Taking into account yields, realized and unrealized gains and certain investments accounted for under the equity method, the total pretax return on the portfolio excluding the effects of FX movements was slightly negative at 76 basis points for the fourth quarter of 2008. As we have indicated in prior calls, we excluded FX from this calculation because most of the investments in foreign securities are held as a hedge against our insurance obligations denominated in foreign currencies and for which there is a corresponding credit in earnings.

The average credit quality of the portfolio remained high at AA+ and the reported duration was relatively short at approximately 3.6 years. I would like to caution everyone that given the current state of credit spreads in the market, that the correlation of the interest rate sensitivity between treasuries and non-treasuries securities has changed dramatically. And accordingly, the conventional duration calculation for non-treasuries securities may not be appropriate for evaluating interest rate sensitivity of our or any other portfolio for that matter.

During the quarter, we did extend the portfolio's duration using interest rate futures based on our view at that point in time of potential interest rate movements over the short-term. The portfolio continues to be comprised primarily of high-quality fixed income with essentially no investments in hedge or private equity funds and no direct exposure to public common or preferred equities. In addition, we continue to have no CLO's, CDO's or credit default swaps in the portfolio.

We have as we have done over the last several quarters, included additional information on the asset-backed, mortgage-backed and commercial mortgage-backed portions of the portfolio as well as a schedule of the 10 largest corporate names in our bond portfolio. We hope this data is useful and I encourage you to review it.

In addition to that data included in the release, I would like to share with you some additional information that we have used to gauge downside risk on a part of the portfolio. For instance, in the non-agency commercial mortgage-backed sector of our portfolio, in stress testing the value of these securities over a three-year horizon, we would break even on an economic basis today, even if cumulative default rates reached 50%, a very high level by almost any standard. In the bank loan area, cumulative default rates would have to rise to 60% over the next three years and recoveries would have to be reduced to 50% from a long-term average of 70 to 75% to bring the economic returns on the loans to zero.

I would also like to take a few minutes, if you will indulge me, to share our thoughts with you on one of key topics of the day other than temporary impairments or as it's infamously now known, OTTI. First, it is important to understand that when we at Arch take an OTTI provision, that amount does not necessarily reflect our view of the economic value of the security.

For example, if a bond has a market value that is substantially below cost and meets the criteria therefore for OTTI and if we expect to recover most but not all of the principal on the security in the future, we may have to record an OTTI charge which is then reflected in the financials as a realized loss based on the market value of the security. It should be noted that in our case, this is no impact on book value per share of capital as our portfolio is all marked to market and that is the accouting used by the rating agencies.

But to illustrate the point I made a second ago, hypothetically if we have a security with a cost of $100 and a market price of $50 and an expected realizable value of 90, we would record an OTTI provision or a realized loss as it would be reflected of $50, not $10. The point I'm trying to make is that OTTI losses, which are recorded as realized losses, are not necessarily realized losses.

In my view, the accounting rules involved are not consistent with the economic reality in the current environment because the OTTI rules are based on an implicit but flawed assumption that the market price of a security is always a reasonable proxy for its actual value or, if you will, that the markets are always efficient. I hope that this additional information regarding OTTI is useful to you and I think it is certainly something people should bear in mind in particular in the current environment.

Let me quickly turn now to our financial condition. Our balance sheet remains in excellent shape and our financial flexibility remains strong with total capital amounted to approximately $3.8 billion at December 31.

At year-end, debt represented approximately 10% and hybrids represented less than 9% of our total capital. From a liquidity standpoint, the hybrids are all perpetual preferreds while our revolving credit borrowings mature at August of 2011 and our long-term bonds mature in 2034.

We began 2008 with a significant level of excess capital and we continue to hold a very comfortable cushion over the capital required to maintain our current ratings. Our liquidity is also at a very healthy level as cash, short-term investments and treasury and agency securities represent about 23% of our investable assets.

The strong capital and liquidity position should allow us the necessary flexibility to take advantage of insurance market and/or investment opportunities that may arise provided as always that they meet our risk-reward requirements. With respect to capital management, we currently have $450 million remaining under our current share repurchase authorization.

However, given the current financial market conditions and the potential for attractive opportunities in the insurance and reinsurance markets, we are continuing to take a wait-and-see approach to further share repurchases. That concludes our prepared remarks and (inaudible) will take questions now.

(Operator Instructions) Jay Gelb, Barclays Capital.

Thanks very much and good morning. First I just wanted to circle back on your commentary about potentially the impact of price increases being offset or the benefit of price increases being offset by the impact of the recession. What does that translate into in terms of your outlook for premium growth in 2009?

We don't give guidance and in essence, we don't even try in this Company to project the future. My commentary was basically there is always a confusion between rate increases and premium revenue and the two independent forces moving at their own pace, depending on the environment.

Let me give you a specific example. You might have an electrician that used to run 15 crews with 15 trucks and approximately 60 employees, four in each truck. And you might park five of them in New York. That means you've got five vehicles off your exposure base and you've got probably one-third of the payroll and probably one-third of your sales going down. In essence, your exposure is down.

You might be getting 10, 15% rate increase on that account per unit of exposure but at the end of the day, you're going to end up with 20% less premium. So that was my commentary and usually I like to look at history, not that always history predicts the future, but history has a way to repeat itself.

It is really amazing that is the first time that we're going to have on the US P&C market, we're going to have two consecutive years with negative premium growth and it didn't happen until 32 and 33. I'm not saying -- I'm not predicting that the environment is that of the Depression era but I think you -- we're having a difficult time understanding how much our customers are going to purchase and for good reason.

We don't try to predict the future. What we instruct our guys to make sure is that we stick to our underwriting guidelines, we price our products correctly and we try to manage our operations that we have a balance between revenue expense from that perspective and then you know, you play a game good good, I think good things will happen. The scoreboard is going to be right at the end.

Just to follow-up on that, directionally do you think Arch could show positive premium growth in 2009?

Yes, I think you know that's -- that is a possibility because there is -- in that mixture, you have to put the other variables that are surrounding us. There are companies, that they have less capacity because maybe their capital bases has been impaired.

Don't forget, a significant amount of the excess capital has disappeared because of the revaluation of the asset size of the balance sheet. And there's a few companies that they have I would call distressed situations that they are working from out.

In essence, there is -- even though I don't like to use the phrase 'flight to quality,' you know there is some movement from customers from what they perceive to be better companies today than what they perceive their most strong companies were a year ago or two.

Good point. And then, John, on the OTTI commentary, will Arch be adopted FAS 159 in 2009 so that unrealized gains and losses show up in the same line as realized (multiple speakers)

No.

Are you saying that whatever the marks are, whether or not they go through OTTI, (multiple speakers) doesn't impact book value?

Correct. And the way the rating agencies view our Company and many others, not all of them, there is a difference. In our case, everything is marked to market. That comes out of capital and that is how that is viewed.

It's all -- when you do take an OTTI provision in our case, it's simply geography. You're just moving a number that instead of going straight to the balance sheet, it's running through the realized gains account before instead of the unrealized gain account.

They always view us on a GAAP basis, where there is companies they view on a statutory basis and you get a different answer on a statutory basis.

Understood. For the OTTI, is Arch adopting FAS 159?

No, we're not adopting FAS 159.

Thank you.

Vinay Misquith, Credit Suisse.

Could you add some color on why you chose to write the large quota share reinsurance contract so early in the season rather than waiting a little bit longer for pricing to rise?

That's a good question. As I said before in other calls, first of all, we try to service our long-standing customers and make sure that we have available capacity for them throughout the years. In this particular case, I think the transaction was very beneficial to us.

It not only gave us significant premium revenue, but also on a PML basis, this particular transaction didn't need much of the PML because there is a portion of the deal that gives you attritional losses. And also geographically, this particular situation because it is a national contract didn't add a lot to our peak zones.

It was a very attractive transaction. We had a relationship with this client predominantly on the cat area and on an excess of loss basis in the past. In essence this year, we have less PML exposure on this same client than we had a year ago.

From that perspective, we didn't use as much as we used a year ago. But we're not going to abandon clients waiting for June 1 or July 1. Our commitment to our clients is that we want to get an acceptable rate for a good return for our shareholders and be there for them throughout the year. So that is basically our approach to the business.

Fair enough. I just want to understand correctly, this is not atsignificantly (inaudible) to our PML for this year and so did not (inaudible) restrict you from writing any more business (multiple speakers)

That's correct. As a matter of fact, for this same client, it reduced -- our last year's PML based on an excess of loss position that we had on the client was higher than the PML we have today through this (inaudible)

Fair enough. The second question was on primary insurance.

I'm just curious as to why the accident year loss ratio (inaudible) was about 102 point -- I'm sorry -- the accident year combined ratio ex cats was about 102.6%.

We have moved up the accident years because let's face it -- rates have been coming down now for a few years. And also, you remember early in the year, we had one-off losses, especially in the -- not cat-related losses, large losses in the property area. John, you want to add something to it?

How did you get the 102? Because that's (multiple speakers)

That's within the primary insurance segments. So you have 108.6, you add back the 9.2 of favorable (multiple speakers)

Yes, okay. Within the (multiple speakers) segments, I thought you were talking consolidated.

Yes, and then minus the 14.1 for loss cats.

The biggest impact there would be one, the specific risk losses that we cited and those predominantly occurred in the insurance group; and secondly is what Dinos said. We have clearly been moving up on the longer-tail lines. We're writing less of them but in particular on the casualty area, we have moved it up as rates have moved down and to a lesser extent on the professional liability lines that we would consider long-tail.

Those have been moving up too. So it's a combination of the two. I think probably if you took the specific large losses out, you're probably looking at maybe 4 or 5 points on that ratio.

Fair enough. So it should be high 90s versus --

Correct.

One last question, if I may. Curious about your investment in the bank loan funds as to why that investment went up this quarter?

Sure. You know, we made those investments through external managers and that is why we have to account for them on an equity method. Second, some of these managers, they had some leverage, 1.5 to 1, 2 to 1 in some cases.

And us and some other participants chose to de-lever these investments because we have the liquidity, we can hold them. This is secure bank loans. The fact that we have marked them down and I believe we marked them down to $0.50 on a dollar, we're down $0.52 from original valuation.

That is not what our belief is, that these bank loans will return. So we still feel very, very comfortable with the investments and by de-levering them, now we can hold them to maturity and we're going to benefit from the returns these bank loans over time they're going to give us.

Plus these additional investments generally, we got even more protection than we have on the first set. So not only are they coming in where we think the valuations are really attractive, even more attractive than they were before, but we also in a more protected position than we were on the originals.

Did you get those at $0.52 on the dollar or was it a higher valuation?

You've got to go -- it's not just one transaction. There's several transactions. We did get them at significant discounts and also we got seniority to the original investors. Of course, we were an original investor too. But for these tranches, we got more seniority. So all in all, we felt these were attractive investments for us.

Matthew Heimann, JPMorgan.

A couple of quick ones, I hope. Just with respect to the PML, I would just be curious how the PML, if it's slightly less than 25% now, would change based on what we know about pricing today if you went through the year and your portfolio did not change at all. Would that come down a couple hundred basis points more than that and am I thinking about that correctly?

I don't really understand the question.

Let me restate it then. I guess my thought process is with pricing going up, rate per exposure is getting better. So presuming -- well I guess it depends on whether customers retain risk or not, but I would just be curious based on what you have seen through 1-1 if customer behavior is the same combined with pricing, whether or not your PML would stay flat if you just renewed your portfolio (multiple speakers)

Now I understand where you are going. PML is an exposure based calculation. You run your data set, how many buildings youinsure, what locations they have and under various scenarios of different storms, you come up with a probability of what the loss is going to be. That has nothing to do with how much you charge.

Of course in this environment, and I think our average increase in pricing for Southeast wind was approximately 15%. So if we renew the entire portfolio exactly as we had it a year ago, which is not always the case because we move layers, we go higher, we go lower etc., so it changes that.

But hypothetically, if we would have renewed exactly the same,we would have 15% more premium because the effective rate increase was 15%. Having said that, you see different changes (by program).

For example, we just talked about a large contract that we took from 100% excess of loss buying cat capacity that the Company decided to do both, buy some cat maybe at a higher level and also buy a quota share for surplus relief and also cat protection. And that changes the economics of the deal. You still get attractive returns and you get much bigger premium and you don't use as much PML.

You're thinking of it sort of in the sense of the aggregate loss or the P&L on the business, whereas when we set that PML number, that is set purely on a loss number.

All of that was helpful. It was just a poorly worded question. I was actually more simplistically -- if you just assume the premium collected was the same, rolled the rate through if rates are up 10 to 15%, is it fair to say a 24% PML simplistically becomes 22? Is it that easy to think about that way?

Yes, if you retain the same amount of premium. But if your premium goes up, your PML would remain constant.

Sorry. Poorly worded.

It's my Greekness. Sometimes I don't understand.

It's my German-ness. So the other question I have -- I will try to sneak two more, if I could then. Just when I compare where you're marking your RMBS and CMBS non-agency debt, is it fair to assume that the vast majority of the difference between the marked to market relative to par is frankly a function of subordination?

That's the primary mover. You have other factors and we have outlined them in the release. They're all there and you have obviously studied them. The other things such as the weighted average loan to value and other factors affected but yes, I would agree that the primary move, difference between the two would be the difference in credit support.

That's helpful. The only other question I have was I just wanted to make sure on Ike that at this point, there's no more retention left on any of the primary exposure.

On the primary side (multiple speakers) on the primary side we haven't attached our cat cover yet. But we're very close to it.

So everything but the (multiple speakers) the offshore -- this is on the onshore. The offshore, we have attached the cat cover but we have significant -- we only penetrated the cover by I think 15%. So we got tremendous room.

From the insurance perspective, there's very little movement that might happen. Movement can happen on the reinsurance side. But I believe we set up our reserves extremely conservative, I think very conservative especially on the offshore because there's a lot of uncertainty on the offshore.

Even though the surface damage, how many platforms got damaged totally or partially, early on didn't give us a significant amount of loss, it's the underground destruction of the wells. And the big question as to are these wells going to get redrilled or are they going to be plugged and abandoned and you get significant variability in the answer as to what reserves you're going to set.

In the prior hurricanes, Katrina for example, only a little over 10% of the wells got redrilled. The rest of them, they were plugged and abandoned. A lot of our reserves, we said that a significant number north of 60 or 70% will be redrilled.

The problem with it is we don't know what's going to happen. Clients have 18 months to make those determinations. Price of oil, if it stays where it is, probably you're going to have a lot of plug and abandonment versus redrilling.

If oil goes to $70, $80, $90, $100, you know you make a different determination. So -- but we wanted to make sure we put this behind us and we calculated in my view in a conservative way and we put the reserves up and we feel very comfortable where we are.

(Operator Instructions) Josh Shankar, Citigroup.

Good morning. So let me play devil's advocate a little bit. In addition to the declining economic conditions, some of your competitors -- and I hear from a lot of industry personnel about the rampant degree of unfair competition or at least price gouging coming from some wounded players in the marketplace. How widespread is this and how does that affect the idea of margin improvement or are we just waiting for these firms that are struggling to capitulate?

There's some of that happening, people willing to not gouge, but cut. This is fire sale. I wouldn't say gouging, but more fire sale.

They're willing to hold onto accounts. They've been long-standing accounts. They can't sell them on stability and vision and great claims service, so they sell them on a deep discount and it affects the business.

We shy away from those situations when we get into that. It only affects new business, Josh, because a lot of our existing customers, they're not looking for their renewals to go to these facilities. So our competition for our own business is going to go to other strong carriers.

It's their renewals that they might be moving as new business to others that fight happens and we shy away from it. Having said that, it has an effect in the market and at some point in time -- they can't do it forever. Eventually the accident year numbers are going to start showing it and they're going to get weaker and weaker.

You can't sell below cost for a long period of time. Even in a business that has three, four year duration, you can do it for a year or two or even three. But at the end of the day, it's going to start percolating through the numbers. And as long as we are disciplining our underwriting, we're willing to wait it out and that's what we are doing right now.

One way to think about it, Josh, is if you take a long-tail line and you cut the premium enough eventually, when your losses start to emerge, it starts to look like a short-tail line.

In terms of new bids, how willing are competitors seeming to go with some of the injured parties that you're competing against?

It can get nutty. We had one -- I'll give you one example. There was pricing an on excess order that the market price from about six competitors was somewhere between $400,000 to $550,000. That is a reasonable range and one company did it for $128,000. That's nutty to me.

All right. Well appreciate the examples and good luck.

It's one-off. You can't translate that. These things happen occasionally but it can get really nutty.

Ian Gutterman, Adage Capital Management.

First just a follow-up from (inaudible) question on the insurance accident year. I thought, John, you also mentioned in your commentary some change in the picks in certain of the longer-tail lines (multiple speakers) talk about that impact?

You know what we do on the longer-tail lines is the way we're looking at it is we have a base year which we're rolling forward all the time, and then we're looking at the effective rate change. And when I mean that, the rate change, not just the premium change but the change it takes into account in terms of deductibles, limits all that.

And then of course we factor in loss trend, which will move around for different lines. It depends on where you are what you're looking at. And since rates have been declining in certain areas -- casualty, some of the professional lines over the last year or so -- we have obviously been moving the picks for those up. And as you move through the year, it's going to have more impact on your earned premium late in the year than it will early in the year as you write the new business.

That makes sense. I just want to make sure it was more of the pricing impact as opposed to that -- I think some other companies have talked about having to raise their accident year to put an extra cushion on the liability or something like that.

Ian, as a matter of fact, I think because of our starting years being back in '03, some of them are coming down. As a matter of fact, we have readjusted and [we] might have even toned down what you otherwise do to an accident year.

If you are losing 15, 20% rate and you have some trend, you can really move a 60 loss ratio by 10, 12 points just on the 20% rate movement alone. You know, the fact that they're not moving that much is because if we thought it was 60, the original number maybe was closer to 45 or 50 and you get into a different (multiple speakers)

But we have a systematic way of looking at that by each class of business, sit down with our actuaries, and we look at all the years and how they are evolving and we are always looking to factor in changes in pricing we have experienced. This is actual pricing based on our book of business that we know and we measure on a quarterly basis.

The flip side of it is obviously the lines that we have seen the largest rate erosion in, we have shrunk the most. So the book is shifting. More of it is toward short-tail. So some of that impact gets muted if you can't translate it directly. But that is what drove it.

Actually that response leads into my follow-up which is, for the year in insurance, it looks like you're at 98, 99. I know there were some large losses, so maybe it's more from mid-90s. But again, that it is an ex-cat accident year and cats do happen. With normal cat load, maybe that is closer to 100.

Should you be cutting back even more in the insurance lines until price hardens up and shift the mix for this year more towards reinsurance and wait until the AIG's and so forth start acting more responsibly before you start going [into the] insurance again?

We're not -- you can't (inaudible) do nothing. You've got markets, customer relationships etc. We try to really get acceptable returns with everything that we do. But there is no absolute.

You can't go from $4 billion to $1 billion and back to $5 billion automatically as such. We try to manage within the realities of running an operation. You have employees, customer relationships, agents, broker relationships etc. but not making the mistakes that we're going to be writing business that have no returns.

Plus if you looked at the lines, the areas where most of the craziness you're referring to is going on, we have cut the most.

(multiple speakers) very fair.

So the diversified books, some things are going up. we're seeing rate increases in some lines now. In the areas where pricing has really continued to go down, we have really cut back a lot.

Our casualty book in insurance in 2004 was the biggest sector. I think we were maybe 20% plus and now it's less than 10% of the mix in the insurance group. That is the casualty.

So we have really, really changed the mix and it didn't happen yesterday. It happened over a period of time. But if you go back and see some of our numbers in '04, you'll see a totally different mix than what we have today.

Very fair. Then if I can ask on the bank loans, again just to clarify. When I'm looking in the supplement, at the end of '07 you had $235 million and for the year you had something around $175 million of marks on that. So that would take it down to 60. You ended the year at 300. That means you added about $250 million to that (multiple speakers) right?

If you go back, we started to really -- we added early in the first quarter and into the second quarter, we added a fair amount. And then of course we added some more in the third. There's about $90 million (inaudible) was referencing was in the third quarter. The balance, most of it was earlier in the year.

Can you tell us more about what these loans look like or are they (inaudible) by industry mix or collateral or things like that? Just some kind of better sense of --

First of all, they're pretty well diversified across industries, although they're sort of tilted right now towards the defensive areas given the recessionary environment like health care, things like that. These are senior loans, all secured.

They're floating-rate. If you looked historically as I said when we stress test them, you have to get -- to lose money particularly from here, you have to get a combination of a very, very high default rate and a very low recovery rate to cause these things to have economic losses from where we sit right now.

The spreads they're getting are all floating. Remember, these are amortizing loans for the most part. I can't say that 100%. So they are paying in many cases and coming down.

Some of -- a little bit, there is about 30 or 40% of these loans are in Europe. So you have got some FX in that 175 number too. So I want you to keep that in mind a little bit. It's not all just purely write-downs.

So when you look beyond the surface and then start looking at what is there, and you look at it from an economic standpoint as opposed to -- yes, we're very cognizant of the importance of the marked to market. But at the end of the day, it's economics that drive us and we still think from an economic standpoint, it makes sense to be there.

That makes sense. I just want to understand better just so we can get comfortable with it. Are the loans mainly to private companies, public companies?

It's a combination. It's probably more private than public.

Are those companies rated? I'm just trying to get a sense of (multiple speakers)

Some will be rated, some wouldn't. I don't have that data available. We will think about in the next supplement and/or the press release maybe we will get additional data for everyone.

(inaudible) if they were all say LBO loans, just because they're senior loans or they're all LBO's

Yes, they're all senior secured loans-- that's one characteristic (multiple speakers)

Because that obviously is a lot different types (multiple speakers)

Absolutely.

That's really what I was hoping to get a little more information on. Again, like I said, next quarter maybe that would help.

I think that's fair. We will think about what kind of data can be useful.

Very good. Thank you guys.

Mark Dwelle, RBC Capital.

Most of my questions have been answered. But I had one quick numbers question. You had mentioned what the operating cash flow was for the quarter and the year. Did you have that again (multiple speakers)

Yes, it was $166 million for the quarter and $1.139 billion for the year.

Thank you. The last question that I had was considering that you put up a pretty decent combined ratio in reinsurance and a lot of your peers did as well, despite a fairly heavy load of catastrophes both in the US and globally, how sustainable do you think further rate increases are absent some further increase in demand?

It's a complicated question. You've got to understand, a lot of the cat business is capacity, availability and the supply and demand.

What you don't see in the marketplace today is most of the cycles that provided capacity, they're not there. Significant capacity from what we will call the fully funded, unrated vehicles is not there. There are still some operating and they have capacity.

And there hasn't been a significant amount of issuance of cut bonds. So in essence, it's not just the asset side of the balance sheet that reduces available capacity, but also of these peripheral or alternative facilities, they're not in operation.

So for that reason, I think the available capacity got reduced. The demand has not changed. That allows prices to go up. And of course when you have a cat event like it was the third worst cat year in history, always has an effect on the market.

It was not a disastrous year from that perspective, but most that participated in that business, their cat book paid above average cat losses for the year, as it happened with us. For us, our shrink was only approximately $100 million.

So you know, in a good year, we will make 100 better. So we will be 200 from where we are at today. And on a year like this, we will be 100 worse based on the PML's and the aggregates that we take.

But you take that lumpiness because the return at the time is attractive. So it was not a disastrous year for us. It was above normal cat activity. We paid for it and we move on to the next year.

Thank you. That's a helpful response.

Operator, I think our allotted time is over. We passed the one hour. So if there are no more questions, we would like to thank our listeners and look to talk to them three months from today.

You have no further questions.

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