Greetings, welcome to the Markel second quarter 2010 earnings conference call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Steve Markel, Vice Chairman for Markel. Thank you, Mr. Markel. You may begin.
Thank you. I appreciate everybody joining the Markel conference call today. During our call, we may make forward-looking statements. Additional information about factors that could cause actual results to differ materially from those projected in the forward-looking statements is described under the captions "Risk Factors" and "Safe Harbor" and "Cautionary Statement" in our most recent annual report on Form 10-K and on quarterly report Form 10-Q. Our quarterly report Form 10-Q, which is filed on our website at www.markelcorp.com, also provides a reconciliation to GAAP of certain non-GAAP measures, which we may be discussing in our call today. The second quarter and six months of 2010 is off to a pretty good start. We're disappointed to report underwriting loss in the six-month period to the time of 102%. Four points of this is related to the Chilean earthquake and the Deepwater Horizon oil rig loss.
However, it's probably more important to note that pricing is still very weak in the property and casualty insurance sector. We, as everybody else in the marketplace, are struggling to get appropriate levels of price increases. The good news is that book value increased 3% at June 30th to $291.71, up from $282 at the end of the second quarter. Additionally, we have two other events that occurred in the quarter that I think are very important to note. First, we announced a couple of weeks ago our agreement to purchase Aspen Holdings and FirstComp Insurance Group, which we hope will close in the fourth quarter of the year. Aspen and FirstComp write approximately $300 million of specialty workers' compensation insurance through 9,000 retailers in 31 states.
This transaction will significantly increase the size and scale and scope of our specialty unit, where we market specialty insurance products to retail insurance brokers. We're hopeful not only to expand our workers' comp writings in more states and through other relationships within the Markel organization, but we're certainly hopeful to creating and delivering new and different specialty products to these 9,000 agents of Aspen. We're very excited about that. I think it's going to be a very favorable move for Markel and creates a little bit of enthusiasm to do something new and exciting. Additionally, in May, shortly after our shareholders meeting, we announced some executive management changes. Richie Whitt, Tom Gayner, and Mike Frawley became Co-Presidents of Markel. Additionally, Anne Waleski was promoted to the Chief Financial Officer. In today's call, our lineup will be slightly different.
After, well, in about two seconds, I'll introduce Anne Waleski, our Chief Financial Officer. She'll be followed by Richie Whitt, our new Co-President, to talk about operations, and Tom Gayner, Co-President and Chief Investment Officer and President of Markel Ventures, to talk about our investment activity. I'll follow it up to moderate the question and answers. Anne?
Thank you, Steve, good morning, everyone. I will follow the same format that Richie has in past quarters. I will focus my comments primarily on year-to-date results. I'll start by discussing our underwriting operations, followed by a brief discussion of our investment results, and bring the two together with a discussion of our total results for the six months. Moving right into the underwriting results, gross premium volume was up 1% at $1 billion for the first six months of 2010. Higher gross premium volume in the London insurance market segment, which was due in part to our acquisition of Elliott Special Risks in late 2009, was partially offset by continued competition across many of our product lines, particularly within the Excess and Surplus Lines segment. Net written premium was also up slightly to the prior year at $900 million.
Retentions were 89% compared to 90% in the prior year. Earned premiums decreased 9% compared to 2009 due to lower growth in net written premiums over the past several quarters. Our combined ratio was 102% for the first half of 2010, compared to 97% in 2009. The 2010 current accident year loss ratio was 71% compared to 69% in 2009. The increase is due in part to losses from the Chilean earthquake and the Deepwater Horizon drilling rig explosion, which resulted in $33 million or four points of underwriting loss in the first six months of 2010. Favorable redundancies on prior years' loss reserve decreased to $75 million, or nine points of favorable development, compared to $94 million, or 10 points of favorable development in 2009. The decrease was primarily due to less favorable development of prior years' losses in the London insurance market segment.
Our 2010 expense ratio increased approximately two points to 40%. The increase in the expense ratio is primarily the result of lower earned premiums and higher profit-sharing costs compared to the same period last year. Costs related to our One Markel Systems project, also referred to as Atlas, represent approximately two points on the combined ratio in both periods. Turning to the investment results, investment income was flat to 2009 at $133 million due to lower interest rates, which were offset by a larger portfolio. Realized gains were $13 million compared to $71 million of realized losses in 2009. The majority of the 2009 losses related to write-downs for other-than-temporary declines in the fair value of equity and fixed securities. Unrealized gains increased $61 million before tax in 2010 due to increases in fixed income securities, partially offset by decreases in equity.
Tom will go into further details in his comments. Looking at our total results for the first six months of 2010, we reported net income to shareholders of $63 million compared to $49 million in 2009. As Steve mentioned, book value per share increased 3% to approximately $292 per share at June 30th, 2010. Turning to cash flows in the balance sheet, I would like to make a few comments. Regarding cash flow, operating cash flow was $64 million in 2010 compared to operating cash flows of $115 million in 2009. In 2009, net cash provided by operating activities included the receipt of $34 million related to our 2008 federal income tax refund. Regarding the balance sheet, investments in cash held at the holding company were just under $940 million at June 30th, as compared to a little more than $1 billion at the end of the year.
The decrease from year-end is primarily due to the holding company funding stock repurchases and interest payments on debt. At this point, I will turn it over to Richie to further discuss operations.
Thanks, Anne. Good morning, everyone. I want to make a few comments this morning regarding our North American and international insurance operations. On future calls, Mike Crowley and I are going to share these duties. As Anne and Steve reported, we produced 102 combined ratio for the six months. While this does include four points of catastrophe losses, even at a 98 combined, that really does not meet the return hurdles we desire. The markets in the U.S. and internationally remain extremely competitive. In addition, the weak economic recovery is adversely impacting demand for insurance products. While the insurance market picture is a bit gloomy, we're extremely excited about the progress we're making in our businesses, and that's what really counts here. On the E&S side, One Markel continues to make great progress, and we're closing the gap on premiums.
After being down 11% on gross written premium in the first quarter, Excess and Surplus lines was down 5% in the second quarter. The combination of the One Markel platform, increased marketing initiatives, new products, and refreshed products is having the desired impact. We're gaining momentum and believe the second half of the year is going to be strong for us. Our specialty admitted segment continues to do well, and they're holding their own against the competition. Market conditions are really no better here, but we're combating them with a relentless focus on sales and service. Just a quick example, our business development specialists have made almost 500 face-to-face agency calls in the first half of the year, and that pace is going to continue for the rest of the year. In addition, we're extremely excited, as Steve said, about our recently announced acquisition of Aspen Holdings, Inc.
Aspen underwrites approximately $300 million of workers' compensation business in 31 states under the banner of FirstComp. They focus on small accounts and low to moderate risk classes and service the heck out of this business with highly automated underwriting and policy issuance processes. We believe that the Markel brand and financial strength can help them significantly grow the business. We believe there are enormous cross-selling opportunities in both directions. Luke Guinian has built a fantastic organization at Aspen. We welcome them to the Markel family. As Steve said, we should have that transaction closed by the end of the year, hopefully quite a bit earlier than just the end of the year. Despite a six-month underwriting loss as a result of the Chilean quakes and the Deepwater Horizon loss, Markel International is having a solid year.
Disasters like these are exactly why organizations purchase insurance. Neither of these losses were outside our risk management expectations. Mid premium volume was up about 8% in the first half of the year due to new product initiatives such as decline in trade credit and premiums from the 2009 acquisition of Elliott Special Risks coming online. Elliott is doing a fantastic job. We've just completed taking on the great majority of the business that's written by Elliott. We're going to be putting reinsurance behind that business. That's going to really help the premium volume in the second half of the year at Markel International. We continue to look for international expansion opportunities. We are going to be opening small offices in Hong Kong, Beijing, and Barcelona before the end of the year.
These represent long-term investments. We don't really expect them to add meaningfully to volume in the near term, but as I say, over the long term, they could be very significant for us. To sum it up, it's a slugfest out in the insurance markets right now, but we're gaining momentum on the premium side while maintaining our long-standing underwriting discipline. The insurance markets have been softening for over four years now. We believe that some of the more aggressive competitors and competitors with suboptimal platforms are going to start running out of options soon. I can't and won't try to predict when the market will turn, but while we wait, we will continue to strengthen and build our operations. We will be prepared to take full advantage of the turn when it happens. Thank you. Now I'll turn it over to Tom.
Thank you, Richard. Good morning, everyone. Thank you for joining us. My comments today will be brief. I'll speak for a moment about our results during the first half of the year. Then talk about our investment game plan for the second half and beyond. Additionally, as always, I will answer any questions you might have during the Q&A period. During the first half, we earned a total return of 2% on the investment portfolio. Equities were mildly negative at 0.9% compared to a 6.5% decline in the S&P 500. Fixed income was a positive 4.1%. This produced a total return for the portfolio of 3.1% in local currency. The foreign currency effect in the quarter was a negative 1.1%. The product of all these factors equals a 2% positive return for the portfolio. Those are the results.
More importantly, I'll now attempt to describe what we are doing going forward. First, in fixed income, we remain committed to owning the highest credit quality instruments that we can find and keeping our duration at the shorter end of the four to five-year range in which we operate. We're pleased with the returns we've earned in fixed income over the last few years, but we can do simple math. The prospective returns from today's low level of interest rates will not be as good in the next few years as what they have been in the recent past. If you're tuned into the financial markets these days, it seems like deflation is the headline story of our time. As is almost always the case, the genesis for the headlines is true.
True especially if you are looking in the rearview mirror of recent hard data as opposed to the unclear, unknowable, and imprecise future. All across the globe, we face persistent unemployment issues, the ongoing deleveraging of the economy, increased savings rates, and new labor pools from the developing world, which are creating more in the way of global supply than demand. All of these factors create pressure on prices and worries about deflation. These facts and worries can be seen clearly in the low levels of inflation expectations and interest rates. I don't hear bond bulls talking about things like the fact that Disney just raised the admission price and that tuition and medical bills, among others, continue to rise. A one-year Treasury now offers a yield to investors of approximately 0.3%.
You can get almost 10 times that if you commit money for 10 years since the 10-year yield is almost 3%. Neither one of those rates is acceptable to us. The popular idea of investing in bonds today strikes me as about the same as the chance of Dow 36,000 a decade ago. The arguments were well-reasoned and seemed plausible at the time. A bull market can make you believe some incredible things. Today, the multi-decade bull market has been in bonds, not equities, and I think that similar incredible ideas are out and about in the financial markets. I don't think that committing our capital for returns of roughly 3% is a good idea that will stand the test of time. In 1904, the New York City subway system opened with a fare of $0.05. The fare stayed the same for 44 years until 1948.
Over the next 62 years, prices increased regularly and now stand at $2.15. Investing in long-term fixed income instruments at today's interest rates makes sense if you think the coming decades will see the subway fare remain at $2.15 or thereabout. Personally, I'll take the over bet and invest your capital reflecting this view. We're not interested in locking up our capital for such low nominal returns. We maintain the fixed income holdings we must to match and protect our policyholders. Beyond that, we keep cash and fixed income in order to have the option of investing differently as market conditions change and different opportunities present themselves. During the first half of the year, we exercised some of that option as we continued our steady incremental purchases of minority interests in publicly traded equities, and we expanded the operations of our majority interest in the Markel Ventures, Inc.
Despite the negative 0.9% performance in the first half, the market value of our equity holdings actually increased from $1.3 billion at year-end to $1.4 billion at June 30th. This represents 49% of shareholders' equity and still leaves plenty of room for us to continue to increase our equity holdings. Markel Ventures completed two transactions during the second quarter. First, we acquired Solbern Manufacturing, a manufacturer of equipment for the food processing industry. Secondly, we formed Markel Eagle Partners in conjunction with the Eagle Organization. Eagle is a successful multi-generation real estate company in Richmond, Virginia, and Markel Eagle will pursue opportunities to apply intellectual and financial capital in the world of distressed real estate. There's a big inventory for us to work on. While these transactions are individually small, they represent an ongoing build-out and application of our traditional equity investment approach to majority-owned holdings.
We remain involved in several discussions, and I would expect that we would complete additional acquisitions of majority-owned businesses over the course of the coming year. Currently, in the romantically named section of the income statement called Other, you can see total revenues of $77 million for the first half of 2010 and expenses of $68 million. These operations are adding profits to the bottom line of Markel. To date, the Markel Ventures companies are contributing as expected, and we expect ongoing additions to the portfolio. Our capital commitment in this area is slightly north of $100 million, and the companies are producing double-digit percentage cash flow returns as we expected. For the rest of 2010 and beyond, we will continue to add incrementally to our public equity portfolio. We see attractive purchase opportunities.
There's a solid list of attractively priced global franchise companies that tend to pay dividends near the level of what we could earn on bonds. We'll get the capital appreciation and growth for free. There's also a good set of firms with demonstrated skills of outstanding capital allocation that we own and continue to buy. At the same time, as Richie mentioned, there's ongoing pressure on insurance premium volumes. As such, we will remain appropriately conservative in our equity allocation. We have our foot on the gas pedal, not the brakes, and yes, sudden accelerators, we know the difference. We are moving forward with positive allocations to higher yielding investments in public and private equity. It's just that we're driving forward inside a crowded garage. Aspen is joining and adding to our insurance operations. Richie and Steve spoke earlier and enthusiastically about the cross-selling and expansion opportunities that Aspen represents.
Our global insurance operations continue to grow and develop. We are continuing our ongoing operational and marketing initiatives in the U.S. Additionally, we expect to ultimately see a better economy and higher insurance rates. As each of those developments takes place, we can continue to move out of the parking garage and head towards a clear highway, if not the autobahn. Thank you as always for your interest in Markel, and I look forward to answering any questions you may have during the question and answer period. With that, let me turn it over to Steve.
Thank you, Tom. As you all know, Markel's financial model is to earn consistent underwriting profits and superior investment returns to build shareholders' value. While our 6 months results fall short on the underwriting side, we are optimistic that in the balance of 2010, we can still achieve that long-term goal. The investment outlook, that is the short-term investment outlook, as always, is very uncertain. However, we continue to be optimistic about our ability to earn solid long-term returns by investing in quality businesses, both public and private. With that, operator, I'd like to open the floor to questions.
Thank you. We'll now be conducting the question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, while we poll for questions. Thank you. Our first question is coming from the line of Amit Kumar with Macquarie Group. Please proceed with your question.
Good morning. Thanks for the call. Just starting with Aspen Holdings, I guess three quick questions. First of all, you talked about a $300 million top-line number. Do you expect to renew or keep on your books going forward?
Currently, Aspen's business is a mix of business that they retain in their own insurance company and business that they place with other insurance companies. The transaction probably will not close until sometime in the fourth quarter. So clearly, the impact in 2010 is virtually nothing. Very small. We will, however, start participating in some of their business as soon as we can. We have filings in a number of the states that we'll be able to start participating actually in the business probably before closing. But it will obviously, in 2011, be something less than that $300 million. The workers' comp market is also very competitive, and Aspen, not unlike the rest of the Markel organization, has a clear mission of earning underwriting profits. So from our perspective, it's not about the volume, but it's about pricing the business in order to make an underwriting profit.
That 300 could be something less when we look into 2011, some of it will be as it relates to what goes through Markel's books. In terms of earned premium, there's also a bit of a lag. If we write a policy in January, we earn it pro rata over the period. Even if we wrote the full $300 million, which we're not going to do in 2011, the impact on earned premium would be substantially less than that. It's really a part of a longer-term strategy that will pay dividends, hopefully, in the long run. In terms of the model for 2010, 2011, it's not going to move the needle in a huge manner.
Yeah. I think FirstComp, their carrier is keeping, I think, roughly $120 million of it today. We obviously will want to try to increase that. I think probably at the top end, we could get to $200 million of it, assuming it stays at the $300 million for 2011.
Got it. That's helpful. Just a related question, $135 million is what you're paying upfront. There's a contingent value component, which would, I guess, depending on estimates, loss reserves, and profit commissions, and there's an outstanding option to buy shares. What would that number add up to in sort of a best case scenario?
It's really unknowable at this point in time. Richie, there's really not a top side of it.
No.
I mean, other than zero at the top side. I mean, theoretically, if they settled all their reserves to zero, the number would be a very large number. Obviously, that's not going to happen.
I think the number that it's sort of pegged on in terms of their 12/31/2009 balance sheet would be roughly $47 million. If that balance sheet were ultimately to prove out to be exactly the numbers they had booked, I think it would be roughly $47 million. To the extent that balance sheet improves, the number can go up. To the extent the balance sheet proves to have some deficiencies in it, the number would come down.
When we close, we will be doing an actuarial evaluation of the loss reserves. For Markel's books at the date of closing, we will need to make an assessment of our view of those loss reserves. When we do that number will have some more clarity.
Yeah.
I think that's probably the best way to think about it.
Okay. That's very helpful. Just one question on the reserve development, and I will read to you. In your 10-Q, you talk about Italian med mal and Construction Professional in Australia. I presume this is the same med mal business, which some of the other companies in specialty space have also had adverse development. Is this the same book which a lot of other companies are facing issues, or is this a separate issue which you might be facing?
This is actually a different book. This is Italian medical malpractice. It was business we wrote in 2007 and 2008. We went into that market. We did a lot of work on the market. We went in feeling like we had a pretty good handle on what we were writing. It's Italian hospitals, and we canceled the program, ended the program fairly quickly, but we're still seeing development from that program. We've been out of that business since the beginning of 2009, but we're still seeing some development from it.
Does this relate to a TPA?
This is business we wrote through our Lloyd's syndicate. It's Markel International business written through the Lloyd's syndicate and medical malpractice business. One thing probably to just make sure, our U.S. medical malpractice book, obviously that book it was very profitable at the top of the hard market. A lot of people have realized that and have driven the rates down considerably, certainly from the peak in the U.S. We're still doing very well on our U.S. medical malpractice book, and that book continues going forward. The book that we're talking about, the med mal that we're talking about in the 10-Q, is that Italian program that we canceled at the end of 2008.
Right. This is the same book which I think American Financial Group and Argo were also talking about.
That I do not know. I haven't looked at their releases.
Okay. Just on the topic of adverse development. On the E&O book regarding the mortgage services, I think the number now is $34.1 million. You talk about one program. Does this additional adverse development in Q2 give closure to this issue, or is it still developing?
I wish I could say it puts a closure to it. We felt like we had a reasonable handle on the mortgage E&O book last quarter, and we had a projection in terms of how many claims we would see as we went forward. Honestly, we've seen more claims than we would have expected at this point from the 2007 and 2008 accident year. We have looked at it pretty hard. We've put up our very best number. I can't say at this point that we're absolutely certain. You're never certain on loss reserves. We approached this just like we do everything else, which is to be more likely redundant than deficient. It's a program that we no longer write. It is coming out of what was sort of, obviously a mortgage bubble.
It has proven more difficult to get our hands around it than maybe some of our more standard programs.
Got it. Okay. That's all. Thanks for the detailed answers. That's all for now.
Thank you. Our next question is from the line of Beth Malone with Wunderlich Securities. Please proceed with your question.
Okay, thank you. Good morning. The decision to acquire a workers' comp company is a little bit of a deviation from what your all's historic position has been on workers' comp. I wonder, is this part of a strategy to increase your admitted business and that part of Markel?
Hi, Beth. Thank you very much for the question. I think the answer to that simply is yes. We've been talking for a long period of time about the three different businesses in our recent sort of reorganization that's been focused on the international business, Markel Specialty, which is the retail business, and One Markel, which is really our wholesale business. When we reorganized all of our wholesale businesses into the five regions, that was really putting all of our wholesale businesses together under one banner. Really, at the same time, we talked about the desire to start putting an equal amount of focus and emphasis on the Markel Specialty businesses, which is specialty products that we can market through the retail channel. Absolutely, we want to build that business and think there's a huge opportunity for Markel in that space.
We've historically shied away from workers' comp because, broadly speaking, workers' comp is in fact a commodity product, and it's highly regulated by the states, and those are attributes that have made us somewhat fearful of getting too involved in workers' comp. Why we're so excited about Aspen and FirstComp is that they've carved out a specialty niche in the workers' comp market by focusing on small accounts with small agents in small rural communities. It's a platform that is web-based, excellent technology to enable the small agents in the small towns to get prices quickly and easily on the internet connections to the servers at Aspen. It's a unique niche within the workers' comp business that we believe is going to be pretty powerful for Markel going forward.
Do you anticipate that there's going to be cross-selling opportunities with the E&S book that you have that's often the smaller businesses?
E&S is the wrong label to use on that, but there's certainly a lot of specialty admitted products that can be marketed through those resources. We're writing children's summer camps today across the country through a network of retail agents. Near 9,000 new agents that we could offer that product to. The answer is yes, but not in the Excess and Surplus by the nature of that term. That is primarily a wholesale product. Yeah.
All right. Then on the Deepwater Horizon loss, has this changed your strategy towards the energy market or what kind of risks you're going to take or changed your reinsurance positions?
Absolutely not. In fact, the reverse. I think we're seeing more and more opportunities in that sector, and that's one of the very, very few places that we are able to get appropriate prices for the risks.
Yeah, that's actually a hard market right now. The only hard market I'm aware of is marine energy and liability. The loss, as I said, was inside of our sort of risk management expectations. So we continue to write in that market and are very comfortable writing in that market.
Okay. All right, then finally on the financial, it looked like financial D&O type risks because it's international. I was a little confused by the filing in that there was some business that you saw favorable development and some business that you saw unfavorable. I don't know if I have that right, but can you talk about where you see the financial markets? I think it's in the international sector.
I don't have it right in front of me, but the places we saw development in the first half of the year in international was, as we had talked about with Amit, was the Italian medical malpractice. I don't know if that was the same thing that was going on with some of the other companies out there, but it was medical malpractice, but a different market, the Italian market, where we saw some development. We also had Australian construction where we saw a little bit of development. We're not writing Australian accounts now, I think that will resolve some of those issues going forward. D&O and some of the other areas in our professional liability business in international have performed very well for us.
Just like everything else, pricing is tough in all of those lines. We still see good results coming out of our professionals such as D&O, and miscellaneous E&O on the international side. That helped to offset some of the poor development or poor results we saw out of the construction and the med mal.
Okay. Thank you.
Our next question is from the line of Mark Hughes with SunTrust Robinson. Please proceed with your question.
Thank you very much. Does the Aspen transaction suggest a more optimistic view about workers' comp in, I guess, the macro sense?
No. I don't know that I think workers' comp by itself is a great place to be, but I do think it's a huge market. We've looked for specialty areas within the comp market a number of times, and I think there are several. This is one that we've been able to react to. Broadly speaking, if you ask me, do I think I want to compete in the workers' comp market with the standard carriers and the standard business, the big risk and the like, I'd say no. Yes, I think this is the first time we've found one that was actionable, that was able to put us in a specialty area of that marketplace. It's specialty because it's small accounts through small agents in small towns, and a very limited number of business classes.
We're not writing roofers and a lot of classes where people are exposed to the more severe workers' comp losses. Now everybody, unfortunately, is exposed to bad losses in workers' comp, but these are the more tame classes in the field. It does give us now a base of knowledge, and hopefully we'll find a number of other specialties in the comp arena. It is a big market. I don't have the total U.S. premiums at the tip of my tongue, but I think it's plus or minus somewhere between $25 billion-$30 billion. It's been down a lot in the last couple of years because, of course, the comp premiums are a function of payrolls.
Right.
Pricing has been depressed for the last couple of years. It's not necessarily the best time to generically say, "Let's jump into the comp market," and we're going to be very cautious as we move into it. There are some specialty niches in that area, and we look to find them.
In terms of timing on any kind of turn in pricing, you don't have a particular view on that?
No. I wish I did. The investment world, as Tom was talking about, one of the historic problems of comp is a very long-tail business. When interest rates were higher, there were hundreds and hundreds of companies willing to write comp at 120% combined ratio to capture the investment leverage. That investment leverage isn't worth a whole lot today. If there's an area that there is medical inflation and seems that that's continuing, comp is at the forefront of medical costs still going up. There's a lot of things that one should be very cautious about workers' comp.
Just in surplus business, with new products, new marketing initiatives, I think you suggested the second half would be good for you. Is it possible that we see positive results in terms of gross premium in the second half?
That's certainly our goal. We were down 11, down five. We'd like that to turn positive before the end of the year. Talking to all our folks out in the field, I said it's a brutal market out there, but our guys are really excited about the opportunities that they see, the new products that we've put out there, the enhancements in products we've given them. They feel like the clients are taking notice and are looking for ways to do business with us. We certainly would love to see it be up by the end of the year, and that's the goal.
We do also have the sort of the wind is starting to get to our back with regard to our internal reorganization. We're continually improving on our service levels as we've conquered the various problems of our One Markel reorganization. That probably caused some headwinds over the last year for Markel. But the other factors, the pricing and our price discipline, as well as the soft economy, are certainly headwinds. And whether our service and our new products can overcome that is a bit of a speculation.
Yeah. I will say our people are optimistic, and they know that it's underwriting profits first at Markel. But I love to see the optimism they're showing and the enthusiasm they're showing with everything that we've done. I think they feel it. I think our producers are starting to see the power of the model we've put in place. And as Steve said, we've fixed a lot of the service issues we had initially. I think our service levels are at least back to where we were before, and hopefully we're charting new ground in terms of service levels from where we were. So, we're pretty optimistic for the second half of the year, but we're not kidding anybody. It's the same market we've been dealing with.
I think more importantly, Mark, we will be a survivor. We'll be one of the companies that's successful over the next five and 10 and 15 years. The insurance industry has historically had a reasonably high fallout ratio. The number of companies that have disappeared over the last 10, 15, 20 years is not immaterial. And we will be one of the survivors and one of the successful ones for the long term. But we can't tell what's going to happen in the next six months.
Thank you.
Thank you. As a reminder, if you have to ask a question, you may press star one. Our next question is from the line of Michael Nannizzi at Oppenheimer. Please proceed with your question, sir.
Thank you. Just first off, for Tom, in the second quarter, it looks like book value or AOCI saw about a $5 reduction. Can you just talk about what happened during the second quarter and what drove that change?
First, you'll have to remind me what AOCI is.
I'm sorry.
Oh, the comprehensive income.
Sorry about that. Yeah.
My day-to-day thinking, I can tell you that that isn't really what I look for. Obviously, the equity markets were soft during the quarter, during the year, I talked about that we were down 0.9%. While we were up about 9% in the first quarter, we were down about a shade more than 9% in the second quarter. I think that accounts for the bulk of the AOCI, which you describe.
Right. Okay. The underlying team loss. Okay. Was any of that related to, I imagine most fixed income securities marked up because of the yield environment. Okay.
Interest rates were down, we didn't have any credit problems.
Right. Got it. Then, just one question about the acquisition, if I could. I think maybe Steve, you might have said it before, I think I missed it was, what is the notional book value of Aspen and can we just get an understanding of what the balance sheet looks like a little bit?
I think the best way to respond to that is just to ask you to wait till we close because at closing we will have a comprehensive review of the loss reserves and the contingent commissions that are referred to in that contingent value right agreement. It will enable us to put out some numbers that make some sense. Aspen has previously been a privately owned business. They do have a number of shareholders but basically not been a public or a traded business. The financial statements that were audited were back in December 31 and to some extent, the number's a moving target as the year progresses.
I think we believe, though, that fundamentally the book of business is going to earn an underwriting profit for Markel, that certainly the loss reserves and the balance sheet that we put on our books when we close will be conservatively stated.
Great. Thank you. Then, just on the strategy, the purchase within Markel Specialty, do you expect to be writing then more bundled policies, like small business policies and filling out the product assortment that way? Or is kind of step 1 just that the initial cross-sell may be a general liability program or something of that nature? Or is the first step more the other way where you start with your legacy policyholders and look to sell them comp through Aspen?
I think step 1 is continue to grow Aspen and the business that they write today. They're only in 31 states. There's still some states out there that are on their wish list, we certainly want to make sure we support them and help them grow the existing book. Then we believe we can take some of our specialty admitted products to those 9,000 agents that Steve talked about. That's probably step 2 after we make sure we're helping them grow their book. Finally, we on the specialty admitted side, we write package policies. The only piece we don't have today is the workers' comp piece. Bringing that comp piece over to our day cares and our child, our summer camps, all those sorts of things makes a lot of sense. That's probably step 3.
That's the order we'll approach it in, and it'll take a little while to get to step 2 and 3 because we want to make sure we're supporting the Aspen folks in growing their business organically.
Great. Thanks so much, Richie. Then just one last one, if I could. Just on expenses. It looked like just from our first look here that the expenses was a little bit higher. I guess part of that's due to top line, maybe, and also within the E&S segment, the One Markel initiative. Can you talk about how you think about that run rate expense line within the E&S segment and also within Lloyd's, for example, where things are a little bit higher and then also within specialty and how Aspen might impact that? Thank you very much for answering all my questions.
Sure. Maybe I'll attempt that one a little bit. In terms of the expense ratio in Markel International this quarter, you have to be a little careful with that. We had over $10 million of reinsurance reinstatement premiums that are fully earned in the quarter as a result of the Deepwater Horizon loss. That pumps up the expense ratio. If you bring it down to more normalized level, I'm going to say 37, 38. Does that sound about right, guys? That's throwing things off on the international side. In terms of the U.S. side of the business, we've got pretty full bonus accruals up at the moment.
However, obviously we haven't had a stellar first half of the year, but we don't really dig into bonus accruals until we get to the third quarter because that's really when we're going to have a good idea of how the year is going to, within reason, where the year's going to land.
If we don't start making progress towards the sub 100 territory, some of those bonus accruals are going to come down, obviously. If we have a strong second half of the year, they'll stay in there. I think this year compared to last year, we're a little heavier on bonus accruals, but that could easily turn around if we don't start seeing a solid second half.
Great. The One Markel piece within E&S, I think you said 2 points. I mean, is that expectation that will likely continue?
Yeah, that's probably a pretty good run rate for the rest of the year.
Great. Thank you very much, Richie.
Our next question is coming from the line of Jay Cohen with Bank of America. Please proceed with your question.
Thank you. I've got several questions, and I can always re-queue if I run out of time. In the queue, you talk about going into, I guess, some sort of mediation with Guaranty Bank. I'm wondering, as you look at this relationship, what the chances are this results in some sort of charge to resolve this?
All I can say on that, Jay, is obviously we've had the contingency disclosure for several quarters now. We have started discussions with Guaranty, which of course, is positive that we're talking. We have reserved for, just like everything else we do at Markel, we try to be more likely redundant than sufficient. I don't think I can really say much more about that at this point, given kind of where we are with that.
That's fair. Second question, with Aspen. In the past, when you've made acquisitions, you didn't pay up for them, and you bought companies that had some underwriting issues, and you were able to fix them partly through shrinking the business. Would you characterize Aspen that way? In fact, if you could just talk about what the combined ratio has been for that business.
No, Aspen is very, very definitely not a fixer-upper, not in the style of a company that's been distressed in any form or fashion. Aspen has been growing, up until the last couple of years, was growing very, very rapidly. The last couple of years, their underwriting discipline has caused the premium volume to actually decline a bit. In terms of their desires, their increasing and retaining the business that they're writing has continued to be growing. To some extent because it was privately owned and had, I think, a couple of rounds of some private equity financing, but didn't have as much capital as it could use to build and grow the workers' comp business. It was both an underwriting manager and an underwriter, an underwriting manager has to live and die on commissions. I think they had some choices.
One, they could continue to raise money in the private markets and continue to slowly and gradually evolve from an underwriting manager to an underwriter. Or they could join forces with Markel and get the benefits of leveraging our resources as well as some of the cross-marketing opportunities. They have been recording on very, very significant underwriting profits for pretty much their whole history. I mean, they've had the occasional state that was ill-advised or something went wrong in, it's not a perfect record by any stretch of the imagination, but it's a very, very strong one.
Great. That's a helpful clarification. Then with Aspen, what's the exposure to California?
About half of their business is California. They've been recording in the past, respectable results in California, and they've been achieving significant rate increases as well in the last couple of years. One of the difficulties and why there is a contingent value aspect of this transaction is that the book is not 20-year seasoned. In some states, it's only three or four years old. In other states, it might be 10 years old. The book of business, as you know, workers' comp is a fairly long-tail business, and there's some uncertainty about what the ultimate reserves would be. Both of us, both Aspen and Markel, believe that the business is profitable. I think it's fair to say Aspen believes it's more profitable than we do. Therefore, there's a difference of opinion that will be resolved through this contingent value agreement.
Part of that is not knowing with precision that the small and rural and class of business they write are necessarily as much better than the average comp. If you look at loss development triangles for comp in general, it's not all that easy to pick it out for a book of business that exactly mirrors Aspen's underwriting style, which is small accounts and small towns. We'll over time learn that, and ultimately, the shareholders of Aspen will receive the appropriate compensation for those shares.
Got it. Then one last question, then I'll re-queue. Was there any spillover in the second quarter from the Chilean quake?
No. Those numbers have held pretty solid.
Then just one last, just a comment. When you talk about the quarterly results, you obviously tend to focus on, in this case, the first half. As a user of your financial statements, for me, and I assume it's with others, I would prefer to hear more comments on the quarter itself, which for us is the kind of the new information. Just again, a commentary. Do with it what you'd like.
Thank you, Jay.
Our next question is from the line of Mark Dwelle with RBC Capital Markets. Please proceed with your question.
Good morning. I think most of my questions have been answered. I think, Richie, you commented that, I think I heard you just say that more of the Elliott Special Risk premiums were going to be coming over onto Markel International's books over the second half of the year. Is that correct?
Yeah, that is. We obviously purchased Elliott in order to underwrite almost all of the business that they were producing. The various agreements they had with previous markets, the last of those came up in July. As of the 1st of July, we are retaining virtually all of that business, and then we've bought reinsurance where necessary behind that business. In the second half of the year, the Elliott business should pick up substantially.
Okay. By way of just thinking about that, I know historically, you usually retain a pretty high proportion of your risk. As far as where you're reinsuring that, is it significantly below your overall average or maybe it's the other way, are you retaining less than your overall average?
Retention should look pretty similar to our overall book on that business.
What sort of lines will be picked up as a result?
Policy limits, you mean? Or-
I just mean in terms of lines of business generally.
It's professional liability business. It's a lot of errors and omissions business, some product liability, and umbrella business. It's the kind of stuff we really like.
Okay. I think that's all my questions then. Thanks.
Our next question is from the line of Meyer Shields with Stifel Nicolaus. Please proceed with your question.
Thanks. Good morning, all. I apologize if I missed this. Is there any reinsurance protection against adverse development on Aspen's reserves, or is it just in terms of the ultimate purchase price?
Aspen has a meaningful amount of its own reinsurance, and it's been a participant in somewhat of a pool. They've had other companies writing the business in certain states, and they act as a reinsurer, and the same company participates in a reinsurance behind them. Over the years, Aspen has had a number of reinsurance treaties protect them. Going forward, after the acquisition, between now and the acquisition, Markel will start participating in some of those pools. After the acquisition, and as we evolve, more and more of the business obviously will become written on Markel paper, and we'll own the FirstComp paper that's being used, and we'll structure the reinsurance over time as it makes sense for Markel.
Okay, no policy particularly focused on the-
No, we didn't buy special coverage for that. The shareholders of Aspen are receiving a contingent value note that will reflect the ultimate development as it relates to the reserves.
Okay. That's helpful. On a related note, NCCI has a theory that during recessions, workers' compensation business is more profitable because the people most likely to get injured tend to lose their jobs early in a recession. They talk about that with regard to high hazard classes, I know you've described Aspen as basically being low hazard. I was wondering whether that sort of trend shows up at all.
Yeah. I'm not an expert in that, any comment I make is purely an opinion, not steeped in a lot of fact. Aspen's business, as you pointed out, is not the high hazard classes. I think there is some validity that in recession, if people are worried about their jobs and they have an injury, and they can keep their job, they're less likely to report a claim so that they can keep the job. Likewise, if someone has an injury and gets laid off and can't get another job, I think that claim is more likely than not to get worse. What the balance of power between those two forces is at any point in time, I don't know the answer to that.
I think the biggest impact on the comp market over the last several years has been the fact that payrolls are down a whole lot, therefore, the number of employees at work is down, the frequency is down because the number of employees are down.
Yeah. Absolutely. That's covering the market. On a related note, I know Aon's been talking about retaining all of its wholesale risk and running it through Aon offices in London, rather than sending it to third-party wholesalers. Is that affecting new business submissions for Markel at all?
Yeah. We've clearly heard about all that. I don't think it has a particularly huge impact on us, we'll see if they're able to accomplish it.
We did make some reductions to the profit-sharing provisions in the second quarter of 2009. That's where some of the variance in the current period is coming from I'm looking to see if she has them around the table.
Kate, we might catch you offline and help you out with that.
Okay. All right. Very good. Then just one other question. You got the new credit facility in place this quarter, $270 million. You mentioned that under certain terms and conditions, you can increase that to $350 million. Could you outline what those terms and conditions are?
I think it just has the typical accordion feature in it that we can bring additional banks in just to increase it to $350. I don't think there's anything particularly onerous in terms of terms and conditions to do that. It just gave us a little flexibility.
All right, very good. Maybe one corollary to that. When you do the Aspen deal, do you probably intend to tap that line of credit, or you look like you have pretty ample balance sheet liquidity. Would you tend to use cash on hand?
The current plan is to use cash on hand at the holding company.
Very good. Thanks so much.
Thank you. Our next question is a follow-up from the line of Amit Kumar with Macquarie. Please proceed with your question.
Thanks. Two quick questions, I guess, on Aspen. First of all, this deal was announced on July 12th. I'm wondering, did your actuaries look at the 2009 Schedule P or did they look at the six months 2010 loss triangles for them?
All of the above.
Okay. What was their view? Did they feel that there was a good cushion, were they at the midpoint? Maybe can you just give us some more comfort? I guess what I'm trying to ask is if you look at some of the other comp companies, recently they've added to reserves in Q2. They've talked about this phenomenon of medical costs which is being stretched because people are unemployed and they're not going back. I'm just trying to get some comfort that the same issues won't show up at FirstComp. That would be very helpful.
I think the answer is that the issues could very well show up at FirstComp. We do not believe they will. It's workers' comp business. What we have done is taken what we think is a measured look at the classes of business, the states they're writing in, their historical development, the way they handle the claims. We've looked at the individual claims files. We've done all of the normal due diligence things. As we know very well, in doing due diligence on another company, there is no way to do it perfectly. What we don't know, unfortunately, we won't know until we do know it. That's just a fact of life.
In doing the purchase, we've structured the purchase price with a contingent value agreement so that there's a very significant bridge between sort of a conservative and an optimistic view of the loss reserve and some other balance sheet items related to Aspen's balance sheet. From our perspective, the much, much more important issue is our assessment about our ability to make underwriting profits on a going-forward basis. We believe very strongly that in this small business market with small agents and small towns, that we will, with Aspen's platform, be able to write workers' compensation at an underwriting profit.
Okay. That's actually very helpful. Just a final question. Aspen has roughly 550 employees. Do you expect to retain all of those, or there could be some changes on the Aspen side from them?
I don't think there'll be any changes because of our acquisition of Aspen. In fact, if we're successful in building out new states and expanding Aspen's business, that number possibly can and should increase. We do no workers' compensation. In terms of skill set in underwriting, in terms of the claims handling, in terms of the processing of this business, there are very, very few opportunities for integration of operations. Clearly, when it comes to capital allocation and investments and some other corporate functions, cash management, and the like, we'll certainly seek to find some efficiencies in operations, but it's certainly not going to impact a meaningful number of people. To the extent that there are overlaps, my guess is that we'll find very, very good uses for those people. In terms of the employment count, the transaction by itself will not generate any headcount reductions.
Got it. Okay, thanks. Thanks for the detailed answer.
Thank you. Our final question today is a follow-up from the line of Jay Cohen of Bank of America. Please proceed with your question.
Yeah, thank you. Just a quick one. On the Markel International business, can you give us a sense if currency impacted the premium growth in the quarter?
The headline number, I think we were up 10%. If you took out currency, we were up 8%, and that was for the six months. Do we have it for the quarter?
I don't have it. I don't have it.
Jay, we can get it for you for the quarter, I think it benefited us two points for the six months. 10 versus 8.
Great. All right. Thanks, Jay. If you do have the quarter, that would be very helpful.
Okay.
Thanks a lot.
All right. Thank you.
Thank you. There are no further questions at this time. I would now like to turn the floor back over to management for closing comments.
Thanks very much. I'd like to thank all of you for your participation in today's call. As always, if you have any further questions or comments, don't hesitate to give us a call. Thank you very, very much for your loyal support of Markel. Have a great day.
This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.