SCOTTISH RE
Moderator: Scott Willkomm
07-29-05/7:30 am CT
Confirmation #7550420
Page 1
SCOTTISH RE
Moderator: Scott Willkomm
July 29, 2005
7:30 am CT
Operator: Good morning. My name is (April) and I will be your
conference facilitator. At this time I would like to welcome
everyone to the Scottish RE Second Quarter 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 period. If you would like to ask a question
during this time simply press star then the number 1 on your
telephone keypad. If you would like to withdraw your
question press star with the number 2 on the telephone
keypad.
Thank you. I would now like to turn the call over to Ms.
Elizabeth Murphy. Ms. Murphy, you may begin your conference.
Elizabeth Murphy: Good morning everyone and welcome to Scottish RE Group
Limited Second Quarter conference call. We will begin the
call with comments about the company's financial results and
give an overview of the development of the company's
business. At the conclusion of prepared remarks we will take
your questions.
SCOTTISH RE
Moderator: Scott Willkomm
07-29-05/7:30 am CT
Confirmation #7550420
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There will be a recording of this call available after 1:00
pm today running through August 11. Instructions on how to
access the recording were included in your conference call
invitation with today's earnings release. Also, a replay of
the call can be accessed on our Web site,
www.scottishre.com.
Before we begin the financial overview please keep in mind
that certain statements that we make are forward looking
statements within the meaning of the Federal Securities
laws. And management cautions that forward-looking
statements are not guaranteed and that actual results could
differ materially from those expressed or implied.
Last night Scottish RE reported that net income for the
quarter ended June 30, 2005 was $1.6 million or 3 cents per
diluted ordinary share, as compared to $28.7 million or 77
cents per diluted ordinary share for the prior year period.
Net income for the six months ended June 30, 2005 was $35
million, or 76 cents per diluted ordinary share as compared
to $38.8 million or $1.04 per diluted ordinary share for the
prior year period.
Net operating earnings were $19.7 million or 42 cents per
diluted ordinary share for the quarter ended June 30, 2005
as compared to $18.1 million or 49 cents per diluted
ordinary share for the prior year period.
Net operating earnings were $46.6 million or $1.01 per
diluted ordinary share for the six months ended June 30,
2005 as compared to $34.7 million or 93 cents per diluted
ordinary share for the prior year period.
Net operating earnings is a non-GAAP measurement. We
determined net operating earnings by adjusting GAAP net
income by realized gains and
SCOTTISH RE
Moderator: Scott Willkomm
07-29-05/7:30 am CT
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losses and the change in value of embedded derivatives as
adjusted for the related effects of the amortization of
deferred acquisition costs and taxes.
While these items may be significant components in
understanding and affecting the company's consolidated
financial performance, the company believes that the
presentation of net operating earnings enhances the
understanding of its results of operations by highlighting
earnings attributable to the normal recurring operations of
its reinsurance business. However, net operating earnings
are not a substitute for net income determined in the course
of (unintelligible).
Total revenue for the quarter ended June 30, 2005 increased
to $503.8 million from $226.9 million for the prior year
period, an increase of 122%. Excluding realized gains and
losses and the change in fair value of its added
derivatives, total revenue for the quarter increased to $525
million from $214 million for the prior year period, an
increase of 145%.
Total revenue for the six months ended June 30, 2005
increased to $1.1 billion from $406.1 million for the prior
year period, an increase of 171%.
On a linked quarter basis, premiums earned decreased to
$438.6 million in the second quarter of 2005 from $465.2
million in first quarter 2005. In Q1, approximately $40
million of additional premium was earned on 2004 treaties
that remains opens to new business in quarter one 2005.
In addition, 41 premiums earned included approximately $17
million of premiums due from retrocessionaires. We expect
premiums earned will grow in the third quarter by 8% - 10%
over Q2 previous.
SCOTTISH RE
Moderator: Scott Willkomm
07-29-05/7:30 am CT
Confirmation #7550420
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Excluding realized gains and losses and the change in fair
value of embedded derivatives, total revenue for the quarter
increased to $1.1 billion from $400.4 million for the prior
year period, an increase of 175%.
Total benefits and expenses increased to $510.6 million for
the quarter from $199.9 million, an increase of 155%. For
the six months ended June 30, 2005 total benefits and
expenses increased to $1 billion from $367.8 million, an
increase of 172%.
The increases were principally driven by the acquisition of
the ING individual life business and growth in the company's
reinsurance business in North America.
The impact of the ING reacquisition and purchase accounting
adjustments for the (unintelligible) of that block on a
quarterly basis as we assimilated during the course of 2005
frustrates one's ability to accurately analyze the company's
benefits ratio.
In light of this opaqueness, on our first quarter conference
call we attempted to give guidance with respect to our
benefits and acquisition expense ratios, excluding the
acquisition accounting noise. On a normalized basis we would
expect our benefits ratio to range from 73% to 75% for the
full year and our acquisition expense ratio to range from
20% to 22%. The sum of the two ratios should range from 93%
to 96% for the full year 2005.
The change in fair value of embedded derivatives is a
non-cash item that was influenced in the quarter by the
decrease in risk free interest rates and the increase in
credit spreads during the period.
SCOTTISH RE
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07-29-05/7:30 am CT
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The company's operating expense ratio, which is the ratio of
operating expenses to total revenue excluding realized gains
and losses and the change in value of embedded derivates for
the last 12 months ended June 30, 2005 was 4.8% as compared
to an operating expense ratio of 6.7% for the year ended
December 31, 2004.
The company's total assets was $10.3 billion as of June 30,
2005. The core investment portfolio comprising fixed
maturity investments, preferred stock and most of the cash
and cash equivalents totaled $5.6 million at an average
quality rating of AA-, an effective duration of 3.6 years
and a weighted average book yield of 4.6%. This compares
with a portfolio balance of $4.3 billion and average quality
rating of AA-, expected duration of 3.8 years and an average
booked yield of 4.2% as of December 31, 2004.
You may remember from last quarter that the growth in our
invested assets was principally driven by the receipt of
$850 million from our ordinary holdings securitization.
Funds withheld with interest totaling $1.9 billion at an
average quality rating of A and effective duration of 5.2
years and a weighted average book yield of 5.8% at June 30,
2005. This compares with a total of $2.1 billion with an
average quality rating of A+ and effective duration of 3.9
years and an average book yield of 5.2% at December 31,
2005. The market value of the funds withheld with interest
amounted to $1.9 billion at June 30, 2005.
On a trailing 12 month basis, the company's return on
average equity measured by dividing net operating earnings
by average shareholders equity excluding the effects of
FAS115 and the change in fair value of embedded derivatives
was 11.2%. If the company has not experienced adverse
mortality
SCOTTISH RE
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07-29-05/7:30 am CT
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reports, its return on average equity for the last 12 months
would have been approximately 12.5%.
Our book value for share at June 1, 2005 was $23.74 as
compared to $21.60 per share at December 31, 2004. Our fully
diluted book value per share excluding the effects of FAS115
and the embedded derivatives was $20.13 as of June 30, 2005,
compared to $19.43 at December 31, 2004.
Fully diluted book value per ordinary share is a non-GAAP
measure based on total shareholders equity from the assumed
proceeds from the exercise of outstanding options or - and
other convertible securities, divided by the sum of shares
options and warrants outstanding and the number of shares
required upon the conversion of convertible securities. The
company believes its fully diluted book value for ordinary
share more accurately reflects the book value that is
attributable to an ordinary share.
At this time I'm going to turn the call over to Scott
Willkomm to discuss our financial and operating results for
the quarter.
Scott Willkomm: Thank you Elizabeth. Good morning and thank you all for
participating on this call on short notice.
The results for the second quarter were negatively impacted
by higher than expected mortality this quarter with much of
it reported to us by our customers in their June session
statements. This adverse mortality depressed net income and
net operating earnings by approximately $11.2 million after
taxes or 24 cents per diluted share.
We are disappointed with these results. Unfortunately a
greater than expected number of large claims in North
America caused us to miss our earnings
SCOTTISH RE
Moderator: Scott Willkomm
07-29-05/7:30 am CT
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expectations for the quarter. However it's important to put
this in context and recall that we are in the business of
accepting risk. While we pick a long-term outlook when
developing our expected returns, fluctuations in mortality
can lead to short-term earnings volatility in any reporting
period.
If there wasn't any volatility, ceding companies would be
less interested in reinsuring their business. Our job is to
minimize that volatility to acceptable levels over the
long-term.
When comparing quarter two mortality to quarter one
mortality, one could conclude that the higher level in
quarter two was due to severity. The total number of claims
in the second quarter was marginally less than what we
experienced in the first quarter and was consistent with
expected levels.
However in the second quarter, we received three very large
claims that together totaled $5.3 million. In total, we
received 16 more claims in the second quarter than we
expected, with claim amounts in excess of $500,000. That 16
includes the three that I mentioned before. This higher than
expected number of large claims, which we define as claims
in excess of $500,000 did not come from any one ceding
company and were not concentrated in any one block or
segment of our business.
We anticipate that our claims experience will revert to more
expected levels, but the nature of our business is such that
our results will continue to be subject to mortality,
volatility that can impact our results in a positive or
negative manner.
Let me attempt to answer some of the obvious questions about
our claims experience by comparing quarter two's experience
with quarter one's
SCOTTISH RE
Moderator: Scott Willkomm
07-29-05/7:30 am CT
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experience. When referring to dollar amounts of claims in
this statistical information, I will quote everything on a
net or after retrocession basis.
The first question is, what have you observed that suggests
that quarter two's higher mortality was a severity issue?
Observation number one, on an enterprise wide basis, the
total number of claims in quarter two was marginally less
than quarter one and consistent with expected levels.
Observation number two, on an enterprise-wide basis, in
looking at claims with amounts ranging from $1 and $99,000,
the total number of claims in quarter two was approximately
4% less than quarter one and the aggregate dollar amount of
claims in quarter two was approximately 2-1/2% less than
quarter one. In addition the average claim amount in this
band was approximately $21,000 in both quarters.
Observation number three, on an enterprise-wide basis,
quarter two claims in the $100,000 to $249,000 band were
consistent with quarter one's experience.
Observation number four, on an enterprise-wide basis once
again, the number of quarter two claims in the $250,000 to
$500,000 band was approximately 8% higher than quarter one
and the dollar amount was approximately 26% higher in
quarter two when compared to quarter one.
Observation number five, on an enterprise-wide basis, the
number of quarter two claims in excess of $500,000 was 30%
higher than in quarter one and the aggregate dollar amount
of claims in quarter two was approximately 17% higher than
quarter one.
Finally, observation number six, we were adversely impacted
by three very larger claims in the quarter which totaled
approximately $5.3 million,
SCOTTISH RE
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07-29-05/7:30 am CT
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comprised of two claims with net exposure of $2 million each
and one claim with net exposure of $1.3 million.
In one of the $2 million claims, the insured was a 48 year
old professional who died of a brain tumor that was
diagnosed seven to eight months before his death.
Substantially all of the risk Scottish RE was exposed to
arose from a policy issued in late 2002. After receiving the
claim notification our underwriters reviewed the case and
determined that prudent underwriting standards were followed
by the primary company when the policy was issued.
In the case of the second $2 million claim, the insured was
a 66 year old individual who died of lung cancer and the
policy was originally issued in 1996.
In the case of the $1.3 million claim, the insured was a 62
year old individual who had a number of policies issued
during the years 1991 to 2001. And that individual died of
cancer.
Let me digress for a moment and say a little bit about our
retrocession program and why it is important to note the use
of the word net exposure when talking about Scottish RE's
exposure to very large claims.
One of the very large claims that cost Scottish RE $2
million in quarter two illustrates the effectiveness of our
retrocession program. This claim exposed the Scottish RE
group to approximately $16 million on a gross basis and the
life insurance industry as a whole to over $40 million. In
other words, this individual had over $40 million of life
insurance. However, our standard retrocession arrangement
together with the special retrocession program we put in
place in connection with the ING RE acquisition reduced the
firm's exposure to $2 million.
SCOTTISH RE
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07-29-05/7:30 am CT
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Claim exposures of this size are not the norm at Scottish RE
but do appear in our portfolio risk from time to time. Less
than 2% of Scottish RE's $13.9 million reinsured life
insurance policies have benefit amounts in excess of
$500,000. Accordingly, even with our conservative risk
management framework, some degree of mortality volatility
will always exist.
Let us return to some of the obvious questions. Question
number two might be, what is the significance of higher
severity versus a higher frequency of claims?
Life insurance risks come with inherent volatility.
Volatility associated with severity will occur from time to
time and more often the smaller the accounting period.
The important thing to note is that severity can cause a
material earnings deviation over a specific time period
based upon a handful of events that happen to occur at that
time. Assuming that this does not become the norm from
quarter to quarter, it is not indicative of anything wrong
in the business. That is not to say that one bad quarter in
terms of frequency is indicative of anything wrong either as
that volatility may occur as well.
Question number three, do you know what ceding company or
companies were responsible for the adverse mortality
experience? In any given quarter, we can analyze the premium
and claims information that each of our customers reports to
us. We examine that data and compare it to what we expected
in the period. We use that information along with historical
information on the account to manage our business.
SCOTTISH RE
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07-29-05/7:30 am CT
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In quarter two, a number of accounts reported claims to us
in excess of what we would have expected. But no one company
represented a majority of that adverse experience.
Question number four, is it reasonable to expect some
mortality volatility? The answer is yes. If there was no
degree of volatility, ceding companies would be less
interested in reinsuring their business and paying
reinsurers to accept that risk.
Mortality results can exhibit volatility especially when
viewed in a less than annual cycle. In general, in terms of
the number of claims, volatility tends to be reasonably
symmetric around expected levels.
In terms of aggregate dollar amounts of claims, volatility
tends to be less symmetric. In general, we expect more good
quarters of mortality experience than bad quarters and that
has been the experience at Scottish RE. This is driven by
expecting relatively few large claims in any given quarter.
Unfortunately people do not always die in even patterns
linked to accounting periods. And while it is possible to
get more claims than expected in a given quarter, it is
impossible to have less than zero. Therefore, there is a
limit to how low mortality can be in a quarter due to
favorable volatility, but a fairly wide range to how adverse
mortality can affect the results in one quarter.
Question number five, how does Scottish RE mitigate
mortality volatility and manage this downside risk? Scottish
RE has employed a number of techniques to reduce the
potential volatility in its portfolio of risk. We minimize
volatility by limiting our per life exposures and
maintaining very robust retrocession programs. Furthermore,
we purchase special retro coverage to minimize potential
volatility that can arise from per life retentions that are
greater than
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our own, and we purchase catastrophe and clash coverage to
protect ourselves from events beyond our control.
Our organic Scottish RE US block has a per life maximum
retention of $500,000 for all new business reinsured by us
through December 31, 2004. All new business originated since
that time has been subject to a $1 million for life maximum.
This is one of the lowest per life retention in our
industry.
In connection with the ERC acquisition, per life amount in
excess of $1 million were retroceded and in connection with
the ING acquisition, per life amounts in excess of $2
million were retroceded.
In addition, we limit our pool shares so as to minimize our
exposure to mortality experience in any one individual
company. And finally we buy catastrophe coverage to protect
the company from natural and manmade catastrophes including
things like earthquakes, tsunamis and terrorism events and
clash coverage to protect the company from unknown
accumulations of risk on any one life.
Question number six, what does this quarter's mortality
results mean for next quarter? We would expect third quarter
mortality to return to normal levels, although we cannot
guarantee that. In addition, we do not see any adverse
mortality trends developing.
Question number seven, what does this quarter's mortality
experience say about your pricing? We price our business
based upon reasonable best estimate mortality assumptions.
We have had many quarters at Scottish RE that produced
mortality that was favorable when compared with the expected
levels. Just as that would not lead us to believe that our
mortality was
SCOTTISH RE
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07-29-05/7:30 am CT
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necessarily conservative, this quarter's experience does not
lead us to question our pricing assumptions as well.
As mentioned, the inherent nature of our business is we
expect to have many quarters when we have mortality on
target for favorable relative to expected levels and
occasional quarters that are adverse and use up the
favorable results as we trend towards meeting our pricing
expectations in the long-term
We completed a comprehensive experience study on all
business priced and assumed by Scottish RE during the period
of 2000 to 2003. And that was reviewed by an international
actuarial consulting firm. The overall result of that study
demonstrated that Scottish RE's mortality experience on that
specific block was 95% of expected levels.
Question number eight, did the adverse mortality come from
one of your acquired blocks? Yes and no. The adverse
mortality experience was spread rather evenly throughout the
entire Scottish RE book of business, whether organically
originated or acquired.
Question number nine, what are you doing about this
mortality spike and are you reexamining your pricing model
and assumptions? We constantly review our business to
identify any potential underperforming accounts and take
appropriate decisive action relating to that. This quarter
is no exception.
We have over 30 underwriting audits that are scheduled and
are taking place during the course of 2005. We are in the
process of updating all of our mortality studies and through
the ING acquisition have invested in increased staffing
around mortality research. We continually challenge our own
assumptions and models both at a micro and macro level in
order to assure that we meet out pricing expectations in
total.
SCOTTISH RE
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We also continue to be diligent in our auditing of cedents
and monitoring of experience and we are proactive at
depricing or terminating treaties that we feel are not up to
pricing standards. This helps us to minimize the number of
poor performing treaties in our portfolio.
Question number ten, what is your actual to expected
mortality statistic? Claims came in at about 6% higher than
expected levels in quarter two and were spread between each
of our blocks of business. And on an inception to date
basis, mortality is running just about 100% of expected
levels as a result.
So let us slightly change topics and discuss some of the
trends we are seeing in our business more broadly. In our
traditional solutions business we added $38-1/2 billion of
new traditional life reinsurance volume during the quarter,
bringing total 2005 new business to $87.5 billion. This
compares quite favorable with the $64 billion we produced in
all of 2004.
In addition, we quoted on 30 traditional opportunities in
the period and won 19 in the second quarter. On a year to
date basis, this brings total quotes to 92 with 61 wins and
compares well to last year when we had 72 wins for the
entire year of 2004. Quoting activity has stabilized now
that the burst of new business activity in the immediate
past ING acquisition period has returned to more normalized
levels.
Our production goal for 2005 in the traditional solutions
business volume was to originate between $100 and $110
billion of new business and has as we've said in the past we
do not sacrifice quality in return for production goals. On
a year-to-date basis we have declined to participate in 29
quoting opportunities and more than half of the 31 losses we
had were as a result of price.
SCOTTISH RE
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07-29-05/7:30 am CT
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As of June 30, 2005, the company had slightly more than $1
trillion of life reinsurance in force, covering
approximately 13.9 million lives with an average benefit per
life $74,000 in North America.
In our financial solutions business we measure progress by
measuring the GAAP reserves that we hold on our balance
sheet. Reserves for the final - for the financial solutions
business line increased to $3.5 billion as of the end of
second quarter in comparison with $3.4 billion at the end of
2004.
While quoting activity has been brisk we are very selective
in pricing potential new spread transactions. On a same
store basis, growth spread on fixed annuities, which is the
largest part of our financial solutions business, decreased
to 151 basis points from 164 basis points in the prior
quarter and 155 basis points in the second quarter of 2004.
Over the past year, the yield on the assets backing these
transactions dropped by 8 basis points, reflecting the
investment of new premium and cash flows and market yields
that are lower than current portfolio yields. Crediting
rates decreased by 4 basis points during this period.
In our international business, premiums in the quarter were
approximately $27.9 million, which is a slight decline from
the $28.7 million that we reported in the same quarter last
year. Total revenue in Q2 '05 decreased modestly to $30.4
million as compared to last year's second quarter results as
well.
As you are aware, we have taken the opportunity over the
past 18 months to review the pricing of our international
business and have chosen not to renew business that does not
meet our return and risk management hurdles. We expect the
international business to continue to grow and support
significantly
SCOTTISH RE
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wider margins than our North American business. And in
addition, the non-US markets are experiencing some of the
capacity constraints that we see in North America which
presents both growth opportunities as well as attractive
pricing positions.
On July 6, we issued $125 million of non-cumulative
perpetual preferred stock. The preferred stock has a fixed
rate dividend of 7.25% for an initial five year period.
After the initial period the security is callable at par and
can be remarketed at a lower rate or may convert to a
floating rate security.
The issue is listed and traded on the New York Stock
Exchange under the symbol SCTPRV. This security is
structured to achieve maximum equity treatment from all of
the ratings - the perspective ratings agencies. And
incorporating this security into our capital structure
provides - or has enabled us to reduce our overall cost of
capital and add real economic value to Scottish RE.
On July 18, Scottish RE entered into a $200 million credit
agreement with a syndicate of lenders. This agreement is an
unsecured three year facility that allows the company to
issue letters of credit and borrow for working capital,
capital expenditures and general corporate purposes.
The credit facility may be increased at the company's option
to $300 million. This credit package increased the size of
available funding at reduced cost to the company and
represents a further step in the efficient management of our
capital and liquidity.
Now let us turn to earnings guidance. Our guidance for
fiscal year 2005 has been - had been $2.75 to $2.95 per
share - per diluted share. While higher than expected claims
in the second quarter negatively impacted our earnings in
the
SCOTTISH RE
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quarter to the tune of about 24 cents per share, there has
been no change in the underlying fundamentals of our
business and the earnings power of the company. Accordingly
we do not expect to change our outlook for growth and new
business profitability.
Furthermore, other than adjusting for the mortality
shortfall in the quarter, we do not expect to adjust our
guidance range. In other words, our revised guidance for
fiscal 2005 is now $2.51 to $2.75 per share.
Since the company reported net operating earnings of 60
cents per share in quarter one and 42 cents per share in
quarter two, we would expect the company to earn between
$1.49 and $1.69 per share in the second half of '05. We
would expect that between 42% and 44% of that six month
expected earnings will emerge in quarter three and between
56% and 58% will emerge in quarter four.
I'd like to conclude the prepared remarks on today's
conference call by saying that despite the negative impact
of claims volatility during the quarter, for us at Scottish
it is business as usual. The business fundamentals and
earnings power of the company has not changed and we
continue to believe that market conditions and the
competitive advantages that we enjoy provide us with
tremendous growth opportunities.
All of us at Scottish are excited about our prospects for
the rest of the year and into the future. And we thank you
for your continued support and interest in the company.
At this point we'll conclude our prepared remarks and take
your questions. Operator?
SCOTTISH RE
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Operator: At this time I would like to remind everyone in order to ask
a question please press star then the number 1 on your
telephone keypad. We'll pause for just a moment to compile a
Q&A roster.
Your first question comes from the line of Andrew Kligerman
with UBS.
Andrew Kligerman: Thank you very much. I guess the first question would be
that historically you - it's bounced around a fair amount
but you had reported mortality at roughly 95% to 98% of
expected. Going forward should we be thinking more in the
vein of 100%, you know, in line pricing every quarter as
opposed to the more favorable quarters?
Scott Willkomm: Yes Andrew, why don't I answer that so I don't lose track of
your question.
Andrew Kligerman: Yes.
Scott Willkomm: I think that the answer to your question is correct. As you
may recall from a number of our prior conference calls, over
the past 8 to 12 quarters, our expected mortality - actual
to expected mortality has been between 98% and 99% or so of
expected level.
And I think we have on numerous occasions indicated that our
expectations and our internal planning is that we would
expect 100% of expected. That is where we would expect
things to converge over time as the company matures. So your
answer - the answer to your question is yes.
Andrew Kligerman: Great. Scott, on the benefits ratio - and this one I'm
struggling with. Because last quarter on the benefits ratio
spiked up to 78% and I had asked - we had asked, you know,
from a normal - of what had typically been 70%, 71%, we had
asked, you know, is this going to be a new run rate? Is this
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problematic? And the company's response was no. This is a
reflection of the new ING business in the 75% to 80% ratio.
Now earlier Elizabeth Murphy said the guidance going forward
is 72% to 75%. So at this stage I'm uncomfortable with that
guidance. Could you help me reconcile that?
And secondly, there was a big reporting issue in this
quarter where the ratios were off due to (Serry Adam)
estimates involving in the ING transaction. What happened
there with the reporting? Why is it that, you know, by May
of '05 you weren't able to accurately reflect the policy
counts and so forth?
So, they're both kind of reporting orientated but the first
one is more along the lines of, you know, where actually
should we expect the benefits ratio?
Scott Willkomm: Well the guidance we gave of the 73% to 75% is where we
would expect the benefits ratio to be on a run rate basis. I
think that the benefits and acquisition expense ratios are
noisy, principally due to purchase accounting or acquisition
accounting adjustments that will be made quarterly as we
continue to digest the ING block.
Andrew Kligerman: Okay so that'd be...
Scott Willkomm: The ING block is made up of two pieces effectively. It's
made up of the in force business, in other words policies
that were issued prior to the purchase date of December 31,
2004 and 2005 new issues, which would be defined as policies
that were issued after the purchase date.
As you may recall, when we agreed to acquire the business in
October - mid-October of 2004, ING working together with us
cancelled or terminated all
SCOTTISH RE
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open treaties for new business. Typical cancellation
provisions ranged from 90 days to 120 days on most treaties.
So a portion of those treaties would have remained open for,
you know, parts of the months of January and February.
Policies that are issued prior to the purchase date, in
other words policies issued prior to December 31, '04, are
accounted for under purchase accounting principles. And
policies issued after the purchase date are accounted for as
new business.
When we closed our first quarter, reports from ceding
companies did not include a complete analysis of the split
between the first year premiums, between '04 issued policies
and '05 new issues. This is not unusual as companies
generally submit detailed reports with a bit more of a lag
than the summary reports that they submit at the end of a
reporting period.
And the 2005 new business is business that is also written
on existing treaties. This is generally not an issue if you
aren't accounting for these differently as you do under an
acquisition where you have some accounted for under purchase
accounting or acquisition accounting and others accounted
for under typical FAS60 treatment.
Okay so for quarter one - let me just sort of try to round
out the thought for you. For quarter one we used our best
estimate to split or allocate the first year premiums
between '04 and '05 issues. After receiving electronic
policy level details, the actual split was a bit more
weighted towards '04 than '05. And this resulted in more
business being accounted for under purchase accounting
methods than the original estimate than we had made.
The change in FAS60 benefit reserves were decreased and the
change in deferred acquisition cost increased by an
equivalent amount as the new
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business estimate was revised to effect that split. The net
result was a wash but the geography is changed and in some
respects I think as we I think tried to highlight on the
last call that if you sum the benefit ratio and the
acquisition cost ratio and compare that over periods you
will see the sum of the two is more consistent because of
some of that geography moving back and forth.
It's further complicated by the fact that the ING
transaction was structured in a unique fashion as a negative
ceding commission transaction. So it is almost
counterintuitive almost as looking in a mirror and seeing
just the opposite picture of what you would expect. So that
is why you have this noise. It has nothing to do with
reporting other than receiving more precise information to
make these allocations.
In the past the typical practice of companies making an
acquisition and applying purchase accounting principles or
P-GAAP to the acquisition, typically you made one adjustment
late in the year or at the end of the year before you
finalize your P-GAAP accounting adjustments. With the change
in accounting principles and materiality standards and the
like, it's more common today to make periodic changes on a
quarter basis as, you know, it seems appropriate.
So that's what's driving this. And, you know, unfortunately
it does create noise in a simple benefits ratio analysis.
Andrew Kligerman: Scott, should - I guess just staying with the two questions,
it sounds like what you're saying here is this is an
accounting issue that is very unique relative to this
transaction. So I shouldn't worry that it would extrapolate
to other types of accounting. This is a unique circumstance?
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Scott Willkomm: This is specific to P-GAAP principles for acquisitions of
these types of blocks.
Andrew Kligerman: And then this prior guidance of 75% to 80% of benefits
ratio, I mean were you guys kind of confused as you had seen
one two numbers or why that original guidance then? You
know, why...
Scott Willkomm: Based upon the information we had at the time, in terms of
the split between the benefit ratio and the acquisition
expense ratio, that's what we were observing. As we have
more data now on a (Serry Adam) basis where we actually have
electronic files for all the policies, we are able to just
make that a bit more of a precise assessment and have
brought that down a tad there. And it's offset in many
respects just by the acquisition expense.
Andrew Kligerman: Okay, and then just in terms of the number of lives now that
Scottish RE may insure. How many lives do you have on books?
Scott Willkomm: About - it's about 14 million.
Andrew Kligerman: Fourteen million.
Scott Willkomm: Thirteen point nine.
Andrew Kligerman: And you're, you know, and you're comfortable with the
pricing of this? In other words there were some, you know,
somewhat severe items here. But, you know, are you concerned
that there is a possibility that maybe they were just, you
know, some policies are mispriced?
Scott Willkomm: No, I don't think so. You know, the, you know, if you think
about some of the anecdotal points, a 48 year old guy, you
know, whose policy was issued in
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2002. It was extensively underwritten. You know, diagnosed
with a brain, you know, a brain tumor seven, eight months
ago and dies, you know, in second quarter of this year. That
is, you know, one of the risks that we are in business to
absorb.
It did not come out of specifically the ING block. In fact
when people tend to have very large face amounts they tend
to have multiple policies with multiple carriers. So we
actually saw claims in a couple of places. We saw a little
bit in ING, a little bit in the ERC block as well. And we
may have actually seen a little bit of this in our organic
block because it was '02 issue.
So I don't think that that, you know, indicates any issue
with respect to the pricing there. The overall, you know,
number of claims in the quarter was consistent with what we
see on average over, you know, the past half dozen or so
quarters. It was consistent with what we saw in quarter one.
And as you can see with some of the comments on the
stratification of claims there was a small number of claims
in excess of $500,000 that pushed the needle in the wrong
direction.
Andrew Kligerman: And then just a last question. You indicated in your
comments earlier Scott that there was some products in your
international business that you chose not to renew. Are you
- are there any concerns there internationally or do you
feel pretty good about the health of the business abroad?
Scott Willkomm: We, you know, we've - it's not so much the product as much
as the pricing on certain treaties. We've gone in and
repriced and in many cases renegotiated in terms of trade
over the past 18 to 24 months to eliminate those
transactions which just generally don't meet our return or
written parameters.
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So I think we've done a pretty thorough cleaning through
that. And you can see that the reduced level of premiums
over what we would have had say two years ago for example.
So remember, you know, and I think we make this point from
time to time. The key thing is focusing on quality over
quantity. So we have specifically, you know, priced
ourselves out of some transactions in that space in order to
cull the book if you will of some stuff that we really
weren't too fond of.
Andrew Kligerman: Okay. Thanks a lot for answering all the questions.
Scott Willkomm: Sure, thank you.
Operator: Your next question comes from the line of John Nadel with
Fox, Pitt, Kelton.
John Nadel: Hi, good morning Scott. I joined a little bit late so I
apologize if I'm going to ask a question or two that you may
have already covered.
Could you, you know, I guess there's some cynics, you know,
especially given the, you know, the first quarter and now
second quarter performance of both RGA and you and, you
know, and maybe even some reserve charges taken by a few
others who are, you know, smaller players in the life
reinsurance business.
You know, what do you say to folks who - who are now, you
know, maybe have some reason to believe that the life
reinsurers have been adversely selected against by the
direct writers?
Scott Willkomm: Well I - I would make one correction John. This is the first
accounting period in which we've had an adverse mortality...
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John Nadel: Yeah, I'm sorry.
Scott Willkomm: A rise, you know...
John Nadel: Yeah, first quarter, I meant that with respect to RGA sorry.
Scott Willkomm: Well, I, you know, I think that, you know, it's a good
question to ask though. I think it's fair to say that, you
know, in our opinion with the due diligence that we do
before we accept new business in terms of our prepricing
underwriting assessments with our ongoing monitoring of the
business that is coming through to us and quite frankly our
willingness to terminate or cease accepting new business
from companies who aren't playing by those parameters allows
us to manage away from potential, you know, bad behaviors if
you will, whether it's, you know, termed adverse selection
or whatever you want to call it from some of the primary
companies.
Let me also ask Cliff Wagner to add a little color from his
chair.
John Nadel: Sure.
Cliff Wagner: Good morning John.
John Nadel: Good morning Cliff.
Cliff Wagner: If we had seen a bunch of these claims in the early duration
of the policies then that would - that might indicate that
there is some anti-selection going on. But a lot of these
claims are much older (unintelligible) an early duration.
John Nadel: Yeah.
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Cliff Nagel: And as Scott said we do quite a bit of auditing our clients
that are currently underwriting (unintelligible). So I don't
see this as a trend towards anti-selection against the
reinsurers.
John Nadel: Okay. And specific - in the quarter, what was -- you may
have already mentioned this -- what was actual to expected?
Scott Willkomm: It was about 6% greater than expected levels on a group wide
basis.
John Nadel: Okay. And then just a question on the guidance Scott. I
think when you guys originally provided your guidance of the
$2.75 to $2.95 there was an inherent assumption in there for
a equity capital raise in the - I guess in the second half
of the year. And maybe it was even a little bit later than
that.
Scott Willkomm: Right.
John Nadel: With the perpetual preferred having been completed, I guess
two questions. One, do we need any equity or does that
satisfy your capital needs?
And two, you know, even if we adjust for the 24 cents this
quarter, I would have maybe expected you to reduce your full
year guidance by something slightly less than the 24 cents,
which would have accounted for the, you know, maybe the
positive differential to earnings in the costs assumed
related to an equity - a common equity raise versus a
perpetual.
Scott Willkomm: That's a mouthful.
John Nadel: Sorry about that.
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Scott Willkomm: That's okay.
John Nadel: It - did I - I hope I got that out reasonably well.
Scott Willkomm: I think I know what you're trying to ask.
John Nadel: All right.
Scott Willkomm: I think I do. I think that, you know, we assumed that the
equity offering would occur in the second half of the year.
That is correct. And the, you know, you have a couple of
thoughts that in I - working in either direction. While the
perpetual preferred offering reduces, you know, the amount
of equity that we might - or amount of capital if you will.
John Nadel: Shares.
Scott Willkomm: That we need to raise in the aggregate. And it reduces
obviously the denominator. It also reduces the numerator in
terms of the reinvestment of the proceeds of the offering.
So there probably is a little bit of offset in there. But,
you know, I think that getting it to that precise a - an
equation that's probably, you know, probably going to be a
bit more of a challenge.
John Nadel: Yeah.
Scott Willkomm: When both of those items come into the equation.
John Nadel: Okay.
Scott Willkomm: So I think there is some offsetting effects in that respect.
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John Nadel: And so - but to be clear, the 125, is that - that's the
capital needs this year?
Scott Willkomm: Not necessarily although when we indicated that we were
seeking to add $20 million of - and I'm going to rephrase
it. Instead of just equity I'll call it high equity credit.
John Nadel: Yeah, yeah.
Scott Willkomm: We naturally would incorporate into that a tag, a cushion if
you will, you know, for, you know, support of the new
business writing volume and that.
So you know, the perpetual preferred goes an awful long way.
I'm not at this point, you know, fully convinced it goes all
the way, because our new business volumes are coming in at
levels greater than we had planned when we built the capital
plan for '05.
John Nadel: Okay.
Scott Willkomm: But as we see the volume come through in the third quarter
that will probably give us a much clearer picture of that.
Now I should add that there are opportunities to add core
capital if you were a high equity credit capital without
creating incremental share dilution. So, you know, there are
a few more tools in the toolbox these days than there were
12 months ago when we were starting to put this stuff
together.
So our key objective of course is to maintain a conservative
level of capital for ratings and other counter party reasons
but also to be efficient in how we do that such that we can
maximize the return on investment for investors.
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John Nadel: Okay. And then just two quick - real quick, you know,
dotting Is and crossing Ts if you will. If I look at the
collateral finance expense this quarter is that a good run
rate?
Scott Willkomm: Yeah, yeah it is.
John Nadel: Okay. And then secondly what percentage of your quarter end
reserves are IDNR?
Scott Willkomm: Cliff is going to look - try to look that up for you right
now.
Cliff Wagner: We don't...
Scott Willkomm: You may not have that at your fingertips right there.
Cliff Wagner: I don't have that at my fingertips here.
John Nadel: Okay. I can follow up.
Scott Willkomm: We can circle back around there.
Cliff Wagner: We don't generally look at IDNR as a percentage of the
reserves we own because it's, you know, it's a percentage of
claims that we expect have incurred but not been reported.
But the reserves for life business is a little more of a
formulaic where they'll keep increasing. So again a, you
know, looking at any kind of relationship between IDNR and
reserves, that will change over the life of a given block of
business anyway.
John Nadel: Okay, all right. I'll follow up with you offline on that.
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Scott Willkomm: Okay
John Nadel: Terrific. Thank you.
Scott Willkomm: Thank you.
Operator: Your next question comes from the line of Jeff Hopson with
AG Edwards.
Jeff Hopson: Hi good morning. Just to kind of address the anti-selection
issue a little bit more, would there be a concern that the
primary industry itself is being I guess too aggressive on
preferred classes over time and in particular on large
cases?
Cliff Wagner: I don't think that the - that they are necessarily any more
aggressive than they have been in the past. I mean there is
always pressure on the direct writing companies to - well
particularly with the larger policies to get the best, you
know, the best rates that they can. You know, whether that's
pushing them to a more preferred class or, you know, less of
an extra rating for the impaired.
But I don't think it's really changed. It's changed because
of the preferred classes so, you know, again you just have
to be diligent in your underwriting audit and you've got to
focus on those to, you know, just to make sure that
companies are within bounds or within the guidelines that we
set up. But that's nothing new to the industry.
Jeff Hopson: Okay. Very good. Thank you.
Operator: Your next question comes from the line of Jeff Schuman with
KBW.
Jeff Schuman: Good morning. Could you give us a little color on how the
ING fact book performed in the quarter?
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Scott Willkomm: No. Because we don't quite frankly Jeff have it broken out
that way. I think that the key thing to keep in mind is that
the ING fact book was predominantly capacity related. It was
not shop facultative or substandard in nature.
So, you know, the reason that we bought the special
retrocover was really to bring down the per life retention
and the potential volatility from large policies as opposed
to anything on the underwriting side.
Jeff Schuman: Okay. Well I mean I was curious given that it was sort of a
large case problem. How big does that book loom now in terms
of your book of larger exposures?
Scott Willkomm: Well I think we mentioned - I don't know if you heard this
in the prepared remarks that less than 1% of our policies in
force are for $500,000 and greater. So it's a very, very
small amount of the overall book of business, those 14 or so
million individual lives.
Jeff Schuman: Okay. And I know Elizabeth touched on this a little bit. But
I was wondering if you could just review for us again the
sort of the progression of earned premiums particularly in
North America. I guess there were some reasons why it was
inflated a bit in the first quarter and came down the second
and it was up for the year, but I didn't quite follow the
detail.
Scott Willkomm: Well the key thing in the first quarter, this is principally
driven by the effects of the ING block. Remember we agreed
to buy the business - I think we announced the deal in the
middle of October. And working with ING about a week later,
couple weeks later, all open treaties, you know, were
cancelled or terminated for new business.
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There was a, you know, typically you have a 90 to 120 day
notice period before you cancel. So some of the '04 treaties
remained open in the first month or so, month and a half of
Q1. So there was incremental volume coming in from those
policies that were issued under those open treaties. And
those were all priced into the transaction economics. So...
Jeff Schuman: Okay. So the sequential progression basically represents you
getting out from under some treaties. You didn't necessarily
want to be on at those terms. Okay.
Scott Willkomm: Yeah and so the, you know, you come back to Q2 where you
didn't have those open treaties really around of any
consequence and then from that we can expect to see the
growth progression. So that first quarter number was a bit
inflated by the flop over from those open treaties in the
first month or so of the quarter.
Jeff Schuman: Okay so we grow sequentially from here?
Scott Willkomm: Yeah, we grow sequentially from here roughly in the 8% to
10% range to Q2 - Q3 over 2 and then in the mid double
digits Q4 over 3 as we see some of the seasonal patterns in
the premium flows come through.
Jeff Schuman: Okay. And then you talked a little bit about the
international business. But I was wondering if you could
sort of update us there on the perspective of where we go
from here. I mean we've been kind of in a (unintelligible)
month repositioning period.
Scott Willkomm: We - I didn't have this in my prepared remarks. But the -
and that's a very good question.
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We have been focused since the tail end of last year or
effectively the beginning of this year on typically
developing from a growth perspective the UK and Irish
markets where the old worldwide even though it was situated
in the UK really didn't not participate to any meaningful
extent.
We have been actively seeking to develop that business. We
won our first set of treaties in the second quarter. Those
really didn't contribute anything because they are brand new
treaties and effectively going into production. So we'll
start to see some of that come through the income statement
as we go into the second half of the year. So we've been out
there effectively kind of as we did when we started our
domestic mortality operation, you know, knocking on doors
and actively quoting on a lot of opportunities.
And so the UK and Irish markets are areas of focus for us in
the near term as well as continuing to deepen our business
in Asia about 25% in the aggregate of our foreign premiums
comes from Asia with probably about half of that coming from
Japan. That right now comes through the London market.
We're in the process of evaluating and have applied to open
a representative's office in Singapore, which we hope will
get approved in the next few weeks time. And we have
retained the services of an individual to run that business
for us in the region. He come from one of our competitors
and at the appropriate time we'll bring him out of the cloak
of darkness into the light once our licensing is approved
there.
So those are the near-term areas of growth. We - you are
correct. We've been repositioning but pretty much since the
tail end of last year, beginning of 2005 we have been
actively pursuing growth in those markets.
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Jeff Schuman: And I'm sorry. But I guess I'm a little confused about the
trajectory here. Can you - is this the kind of thing where
the bottom line is going to build simply as you layer in new
business? Or are you still running off some stuff that would
cause maybe a steeper ramp up the hill back to the kind of
level of earnings you had historically?
Scott Willkomm: No. We're not running off appreciably anything at this point
in time. Now it's rebuilding effectively.
And you know, we're running at a higher expense loading in
the UK which is I think depressing the underlying earnings
power of the business as we have been in this quarter. And
it should be completed in the third quarter. We've been
working on a very intensive, you know, financial improvement
project in that business.
Jeff Schuman: Okay. Thanks a lot.
Scott Willkomm: Mm-hm.
Operator: Again, if you would like to ask a question, please press
star 1 on your telephone keypad.
Your next question comes from Al Capra with Oppenheimer.
Al Capra: Good morning. I had a question about the combined North
American entities. And that is, have you looked at any
potential concentration of pool participation amongst the
three companies and was there any of that say in the first
or second quarters? Or do we expect some level of that say
in excess of your 25% pool participation level going
forward?
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Scott Willkomm: We really - I don't think we see that really except
anecdotally at the margin Al, nothing that's really
statistically significant. There wasn't much overlap between
the book of business that we had originated at Scottish.
There's a little bit but not a ton of it, with what the
business ING had and the business that ERC had.
So they actually all fit together reasonably well and don't
accumulate on top of one another. So we really don't see
that except incrementally at the margin.
Al Capra: And then on a more narrow basis in terms of just exposures
per life, perhaps a more likely overlap on that basis.
Maybe, maybe not. But could you comment on that as well?
Scott Willkomm: Well we - that's - in some respects that's why we had the
different per life retention that are covered by
retrocession. We, you know, we look at our in the aggregate
- our exposure to any one individual. And we seek to
minimize that A, first by knowing what it is and B, by
retroceding the excess out to our various retro pools.
So that's something that we've spent an awful lot of time
doing, not just in connection with these deals, but just as
we've grown the business over time. We have an internal
system that does that type of work and use that every time
we look at a new treaty for example, if we're just quoting a
new piece of business, making certain that we aren't
accumulating risk on lives that are coming through those
treaties. And if so, putting that, you know, that excess
amount into the retrocession market.
So, you know, it's something that we spend a lot of time.
And then, you know, as well we - for those rare occasions
when we don't know that we are exposed on a life because of
perhaps poor information or something of that nature, we
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have, you know, facilities such as the clash coverage that's
designed to protect us for those unknown accumulations.
Al Capra: Okay, and then one additional question on the capital. Could
you give us a sense for just looking forward what sort of
RBC type of capital you have available for new business? And
also talk about where you are within certain of either your
- the warehouses or your credit line or maybe even the
potential for securitization going forward in terms of the
capacity to write new business and to support growth.
Scott Willkomm: We - yeah. From a capital perspective we have a very
comfortable amount of capital on the balance sheet depending
upon, you know, under the various different formulas that
different constituencies use. You know, different rating
agencies use different formulas either hybrid formulas or
their own formulas.
Then you look at the, you know, the liquidity that the
company has. And the company has significant liquidity. In
no particular order we have our multiyear credit facility
that is 200 that we can have an accordion feature we can
take up to 300. We have not utilized any of our Stingray
facility, which is 325, which is available to us over, you
know, the next ten years time. We have other incremental
liquidity that's on the balance sheet itself.
As you might imagine we are very active in pursuing
securitization of reserves as we have in the past. And, you
know, we have, you know, effectively a dedicated team now
that spends 80% of their time on those types of activities.
So in fact they are out on the road today talking to a party
about that very concept.
So that's something that is an important factor in the
overall capital and liquidity picture. In our view,
securitization is going to become more and
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more not only important, but beneficial as we increase the
velocity of money if you will that ultimately, you know, the
return on the invested capital in the business.
Al Capra: Okay, thank you.
Scott Willkomm: Mm-hm.
Operator: Your next question comes form the line of Saul Martinez with
Bear Sterns.
Saul Martinez: Hi, good morning. A couple of questions if we could drill
down on a couple of details. The stratification information
that you gave was very helpful. I think you said 16 or more
claims than usual above $500,000. Just to get a sense of the
order of magnitude, how many claims do you typically get
above that amount in a quarter?
Scott Willkomm: Normally above, you know, let me do it this way because I
just have it in front of me this way Saul. In the $500,000
to $1 million band we get about 29 claims per quarter. And
in the million plus band we get about 11 to 12. It's
actually 11-1/2.
Saul Martinez: Okay, so about 40 on a normal quarter. In this quarter you
more or less were about 16 above that?
Scott Willkomm: That's correct.
Saul Martinez: Okay. Anything - just a follow up question. Any prelimin -
anything you can share in terms of any preliminary
discussions you may have had with the rating agency and any
concerns that they may have about mortality trends?
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Scott Willkomm: We talked with the rating agencies about this and I think
that it's in general most of the folks that we talked to at
the rating agencies are life actuaries and are both schooled
in and familiar with the possibility that from time to time
one may have an increase in mortality experience over the
long duration of a given piece of business. So I think that
there is a level of comfort there with respect to that. So I
think in general this is something that the rating agencies
understand.
I think furthermore because we have been very active in
securitizing our business, the - the rating agencies in
general have, you know, significantly more transparency
vis-a-vis our book of business than may of other competitors
as they have rated our securitizations and our structured
finance facilities, you know, have examined the various
modeling work done by the Millimans and Tillinghasts of the
world in connection with those transactions. And their level
of information with respect to our book of business is, you
know, quite significant I think relative to some other
companies.
Saul Martinez: Great, thanks a lot.
Scott Willkomm: Yep.
Operator: At this time there are no further questions. Miss Murphy are
there any closing remarks?
Scott Willkomm: No, at this time we'd like to thank everyone for joining us
and we look forward to speaking with you on the next
quarter's call.
Operator: This concludes today's Scottish RE Second Quarter Earnings
Release conference call. You may now disconnect.
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Moderator: Scott Willkomm
07-29-05/7:30 am CT
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END