Grown-Up Bermuda Class Of 2005 Members Stick To Core Disciplines

ARIEL RE: ADEQUATE CAPITAL FOR 2010 MARKET

Nov. 4, 2005

Initial Capital: $1 billion

2009 Shareholders Equity: $1.8 billion

What Hasn't Changed? George Rivaz, chief executive officer of Ariel Holdings, identified a "quantitative discipline" as an unwavering characteristic of Ariel's approach since inception. "To build a strong risk management and a strong portfolio management approach into the heart of the business–that was the plan from Day 1," he said, adding that an interest in diversifying the business as opportunities arose over time was also there from the start.

Recent examples include the launch of credit and surety reinsurance operations in a branch in Zurich and the opening of a representative office in Brazil, which is also offering surety and trade credit reinsurance underwritten by the Zurich team initially.

Some highly qualified specialists became available at a time of some stress in the underlying market, Mr. Rivaz noted, explaining that the market opportunity for the new business arose from worsening economic conditions and credit issues around the globe, which coincided with the prospect of signing on a team of experts formerly from Swiss Re that came to Ariel looking for a new platform.

"They have built a set of analytics and models that we believe give us a real advantage in underwriting and risk management for those lines," Mr. Rivaz said, noting that further expansion at Ariel is most likely to take place where the company sees a similar combination of analytical depth–consistent with the starting philosophy–and a market opportunity.

What Has Changed? Mr. Rivaz–an original member of the Ariel team who became CEO in March when founder Donald Kramer stepped down from that position–said two key moves to broaden the base of the business occurred in 2007, when Ariel acquired Atrium Underwriting, its Lloyd's platform, as well as the purchase of a shell company in the United States to launch a U.S. specialty insurance business.

Mr. Rivaz described Atrium's acquisition as the much more substantial move, with the manager of Syndicates 570 and 690 bringing casualty, non-cat property and professional liability insurance and reinsurance business, as well as specialties like marine and aviation coverage.

He noted that while Ariel recently opted to sell the U.S. business–which became known as Valiant–to First Mercury for $55 million (see related article, http://bit.ly/a37VKt), Atrium continues to thrive and is an important contributor to Ariel's bottom line.

According to the latest full-year financial statements for the holding company, roughly one-third of Ariel's $644 million in 2009 gross written premiums came from Lloyd's, with most of the remainder originating from Ariel Reinsurance Ltd., the Bermuda-based reinsurance operation. While Atrium contributed $45 million to total net income of $351 million, Valiant had a $5 million loss on its bottom line.

"The Atrium acquisition was a key strategic move. It changed the balance of our business," said Mr. Rivaz, noting that property-catastrophe reinsurance written premiums now make up about half the total.

He said another important milestone in Ariel's short history was the payment of a $422 million dividend. "We provided a cash return back to our original investors earlier this year on the back of our substantial growth in book value and particularly strong profitability in 2009," he noted.

The Capital Question: The dividend payment suggests that Ariel's board and management team believe its current capital base of roughly $1.2 billion is the right size for the business it sees in the current market. Mr. Rivaz, who is non-executive chair of Ariel Re and Atrium, confirmed the view.

"We expect to maintain in excess of $1 billion surplus, and we're 'A-minus' rated [by A.M. Best]. Those criteria meet most clients' requirements fairly comfortably," he said. "I don't think there's any raising of the bar that's cutting us out from opportunities."

"Indeed, the flipside is that there are limitations on the size of opportunities" in the current market, he added, explaining that most clients are very focused on diversifying their reinsurer panels. "They want to [have] a substantial number [of reinsurers] and to keep shares down [for each of them], so the opportunities may be the right size for us."

Competitive Advantages: Mr. Rivaz looks beyond the "Class of 2005″ when asked who he views as his peers when assessing Ariel's advantages, including other smaller and mid-cap Bermuda reinsurance-focused insurance and reinsurance groups.

"Where we perceive our competitive advantage is [in having] built the quantitative focus, particularly in the Ariel Re business, quite deeply into the organization. It's very well integrated–with underwriting, with risk management, with modeling, with portfolio management all working closely together."

"And that goes from the bottom to the top," he added, noting his sense that "everybody in the organization believes in it and has an appropriate degree of confidence" in the quantitative approach to the business, while still being mindful of model weaknesses.

"We built the right systems, but as important [is that] we have a focus and have a commitment to trying to apply rational economic principles to everything we're doing. We're quite resistant to just taking a market view and doing what everybody else does," he added.

What's Next? Ariel has little interest in "pure consolidation transactions" despite constant talk about merger-and-acquisition activity in Bermuda, Mr. Rivaz said.

"Lots of people talk to us, [but] we really look to evaluate each opportunity on the same kind of rational economic basis as we would apply when underwriting or investing our assets," he said. "If we saw a combination of complementary businesses that would further our diversification objectives, and would do so at terms that made sense for both parties, of course, we'd be interested in that sort of a transaction."

Outside of that, he said Ariel's scale is sufficient. "Returns embedded in the business are quite attractive for our investors….We don't see a huge benefit to be achieved in combining with a similar business on our own."

That said, however, "you have to look at each proposition on its merits," Mr. Rivaz added. "If somebody else wanted it badly enough, and was in a position to make the economics work for our investors, it goes without saying that we'd evaluate that."

What About The United States? "I don't think we have any fundamental philosophical difficulty with it," Mr. Rivaz said, when asked whether Valiant's sale signals that Ariel has ruled out the possibility of ever having a physical location in the United States.

"In the case of Valiant, it was really a short- and medium-term economic issue," he explained, pointing to the financial strain of funding a startup coupled with Ariel's uncertainty about conditions in the U.S. casualty insurance market.

With earnings considerably lagging expenses, "we were trying to dust off the crystal ball and figure out when conditions would be improving to an extent where we could expect Valiant to fulfill its potential and start to deliver substantial positive returns back to the group. And it's really hard to see when that is," he said.

"In the absence of confident expectation of conditions changing, it made sense to take up other options–to arrange the sale to someone who had the commitment and perhaps a stronger sense of the way that the [casualty] cycle is going to work," according to Mr. Rivaz.

On more familiar ground, he agrees that pricing is also weakening in the property-catastrophe reinsurance market. "The saving grace is that it is coming off very high peak levels," he said. "So we haven't been put into a position where large parts of our U.S. business are overly squeezed on profitability in absolute terms yet."

On the downside, he noted, the view that weaker 2010 renewal prices remain at high levels in historic terms is widely held. "So most people in the business are quite intent on staying and defending portfolios–and there are always some looking to grow."

"That's putting the pressure on," he said.

With a downward price trend likely to continue absent significant loss activity, Ariel's response will be careful selection of bits of the portfolio that are adequately priced for the risk assumed, he noted. While seeking to hang onto those pieces, "there will be layers and programs where prices get pushed too hard–and we have to withdraw capacity for their exposures," he said.

What Will Ariel Look Like In 2015? "The easiest thing to say is that we certainly don't have a plan that in five years time we're going to be this size, or even that we're going to be doing X,Y and Zed," Mr. Rivaz responded when asked for his future vision of Ariel. "I think it's a big mistake in the insurance business to try to be too deterministic about your future. It's really dependent on what happens to markets in regard to losses, and thereafter to pricing."

"Our sense is we want to be a very flexible and responsive player, and we will alter the commitment of our capital across businesses. We will acquire, or form, or grow business over time, and we'll also dispose of and shrink businesses," he said, pointing to the Valiant divestiture as an example of the latter.

FLAGSTONE: STRIVING TO BE THE BEST UNDERWRITER

Incorporated: Nov. 10, 2005

Initial Capital: $715 million

2009 Shareholders Equity: $1.2 billion

What Hasn't Changed? "One thing we wanted to adhere to was a heart-stop limitation on how much aggregate exposure we would assume," according to Gary Prestia, chief underwriting officer for North America at Flagstone Reinsurance, pointing to a hard cap on the level of exposure–set at 60 percent of equity capital–as part of the core operating philosophy.

"It is a belt-and-suspenders approach," he said, noting that the extra measure of conservatism applies in addition to probable-maximum-loss measures that come out of Flagstone's catastrophe models.

Since inception, Flagstone executives, including CEO David Brown, have touted the firm's analytical prowess, pointing to the development of proprietary catastrophe models that offer real-time portfolio simulations. During an investor conference last year, Mr. Brown said he believed Flagstone has the "industry's largest supercomputer," operating at "seven teraFLOPS," referring to a measure of computer operating efficiency.

"From a technology perspective, we certainly view ourselves as being a competitor to RenaissanceRe in some markets," Mr. Prestia told NU, referring to the well-regarded modeling capabilities of the property-catastrophe reinsurer started up in the wake of Hurricane Andrew. "We have a lot of respect for what they have accomplished," he said, noting that Flagstone's accomplishments over a very short time frame have the 2005 startup quoting on the same business as its older competitor in many global markets.

"We may not be able to put out quite as substantial a capacity line as they can, but certainly in terms of timeliness, willingness to lead or to provide terms and conditions, we're on par in many markets" with established competitors, he said.

Flagstone's turnaround time can be as little as 24 hours, but more typically 48, Mr. Prestia said, noting that being a high-level service provider has remained at the forefront of Flagstone's approach to the business since the early days.

Noting that Flagstone has won more than a half-dozen industry awards for service (from reinsurance publications)–at least one in each of the last four years–he said "developing close, long-term relationships with clients and brokers is important to the process" as well.

"Obviously, it's still very much a face-to-face and a person-to-person business that we're in," he said. "We don't have a U.S. person in our Martnigny, [Switzerland] office trying to market to German, Italian or French companies. We have underwriters who speak the languages [and] are well-known in their markets."

"We empower them locally, but we still have a referral process," he added, explaining that embedded controls ensure underwriting and pricing decisions remain consistent with Flagstone's unchanged operating philosophy.

"Our core strategy was to be the best underwriter and to produce pure excellent underwriting results," said Brenton Slade, Flagstone's chief marketing officer.

Comparing Flagstone's combined ratios against Bermuda companies, including those beyond the Class of 2005, the company typically ranks among the three lowest, the executives noted. An accompanying chart compiled by NU shows that historical full-year combined ratios have never exceeded 89, with more typical results in the 70s.

What Has Changed? With a goal of having a diversified book of business– spread globally and across multiple lines of short-tail business–Flagstone purchased Marlborough Underwriting Agency Ltd. from Berkshire-Hathaway in 2008. Now called Flagstone Syndicate Management Ltd., it is the managing agent for Syndicate 1861–a specialist syndicate focused on excess marine, energy and aviation risks.

Mr. Slade explained how other locations for expansion have been selected, putting more than 500 employees in 14 offices worldwide. The two largest–in Halifax, Nova Scotia and Hyderabad, India–provide operational support in areas like research and development, cat modeling, finance and accounting, he said, noting that both locations were picked for cost efficiencies.

"Wages are reasonable, and more importantly, those areas have large talent pools of educated, skilled professional workers," he said. "That gives us a step up, compared with having all those people in Bermuda, where you have immigration hurdles, and it's very expensive."

Turning to offices that have been set up for business development purposes, he said Flagstone has selected regions underserved by existing reinsurers–"where there was room for us to move in, to source quality business and grow," he said. Among these offices are one in Puerto Rico, which serves Central and South America and the Caribbean, South Africa for Sub-Sahara Africa, Dubai for the Middle East and North Africa, and Martigny for continental Europe.

"Having somebody from London in a bowtie and a Bowler hat show up and try to compete" in Latin America "just doesn't work," Mr. Slade said, highlighting the competitive edge gained by "having locals who speak the language and are culturally aligned with the regions they serve."

Validus Holdings, with 14 offices in nine countries, is Flagstone's nearest rival in terms of global reach among the Class of 2005. While the two have run neck-and-neck in terms of premium growth rates over time, Flagstone has grown organically–unlike Validus, which acquired IPC Re with the goal of creating a "market leading" enterprise.

"We can literally source more risks than almost anyone"–in particular, risks that would not normally come to Bermuda, Mr. Slade said. "In many places we turn away–by a significant ratio–more business than we bind. What we want to do is see the most risks we possibly can, and then underwrite the best ones," he added, citing Flagstone's historically low loss ratios.

The Capital Question. Noting Flagstone's comparatively high premium leverage ratios, Mr. Prestia said he believes the fact the company hasn't been overcapitalized relative to its writings has helped it maintain profitability.

With capital at roughly $1.2 billion as of year-end 2009, Flagstone's ratio of gross premiums-to-equity hovered around 80 percent for the last two years, compared to 40 percent for 2005 classmates.

"We haven't had a huge amount of excess capital that has needed to be serviced by writing business. That has allowed us to be selective," he said.

"We've been able to be very efficient with the capital we have, by not only writing the property-cat but diversifying into other lines," he added, noting that Flagstone's overall book is now split 50 percent to property-catastrophe business and 50 percent non-catastrophe.

What About the United States? In 2009, Flagstone set up Mosaic Underwriting Services, a New York-based agency placing marine liability and energy business on behalf of Flagstone Syndicate, but no admitted or non-admitted casualty insurance company, like predecessors RenRe and Montpelier (from the Class of 2001).

Flagstone has the ability to write direct business through Lloyd's in the United States, and has occasionally written some U.S. property programs through both Flagstone Syndicate and Apollo 1969–a Lloyd's joint venture with a team of underwriters formerly from Heritage Underwriting, in which Flagstone has a 25 percent stake.

"We frankly have liked the results of the U.S. reinsurance business better than the primary insurance business over the last several years," Mr. Prestia said, noting the better relative profits of property reinsurers.

He also said that while Flagstone constantly looks at U.S. casualty reinsurance, that's also not an attractive market to enter right now.

What's Next? Like Ariel's Mr. Rivaz, Mr. Prestia acknowledged softer pricing conditions in the property-catastrophe market but offered a recent statistic from broker Guy Carpenter that puts U.S. cat pricing at about the 2008 level–or roughly 75 percent of its ultimate pricing.

"U.S. property-cat remains the most attractive business in the world from a margin perspective," he said.

While Flagstone will remain a major cat market, the company is already making decisions to cut back in certain areas as prices drop. "We're not hesitant about reducing lines or coming off where we feel the risk-reward relationship is not appropriate, and where we can't meet some minimal level of hurdle returns," Mr. Prestia said, noting that Flagstone shaved a $50 million book of commercial aviation business down to less than $15 million, and more recently pulled back from workers' compensation catastrophe business.

Looking ahead, he predicted more of Flagstone's growth will come from outside the United States or in specialty lines, unless a market-changing, major catastrophe event improves U.S. property-cat pricing.

What Will Flagstone Look Like In 2015? Based on the progression over the last five years, "I would say we will have double the premium and double the size of capital if we continue the same trend–organically, without acquiring anyone," Mr. Prestia said.

"Starting out with $715 million of capital, we have approximately $1.4 billion today. Starting with $0 premium, we have nearly $1 billion of premium now," he said, justifying his view.

Mr. Slade added that "all decisions we make in the future will be motivated by what's in the best interests of our stakeholders rather than some other factors, such as global domination. We're probably one of the most shareholder-aligned companies because of significant investments our principals have in the company," he said, noting that executive compensation is closely linked with book-value growth.

That means Flagstone "will make decisions that result in shareholder value going forward and not decisions that are based on growth for the sake of growth."