XL Capital has suffered serious problems, but can it be turned around? David Sandham spoke to Mike McGavick, the CEO.

Mike McGavick is fighting to turn around XL Capital. After what he describes as the “baptism of fire” of his first months at the company since he joined as CEO in May 2008, the problems he faces remain formidable. I met McGavick on a grey February day in London. He wears a simple dark blue business suit with an XL pin in his lapel.

He looks a little red-eyed. He has just flown in, he tells me in his firm but high-pitched, hoarse voice, “to share with colleagues the difficult decision we have made to reorganise”. XL plans to cut its staff by 10% in 2009. About 360 people across the group will lose their jobs this year.

McGavick has spent much of the past nine months trying to clear up the mess he inherited. XL has been weighed down by a succession of problems.

In 2005 it was hit by a $830m loss on its 2001 Winterthur acquisition. A venture into financial insurance, SCA (now called Syncora) cost XL $1.775bn cash in 2008, including a legal settlement with Merrill Lynch over guarantees on Credit Default Swaps. XL’s decent underwriting performance has recently been overshadowed by investment losses of $1.7bn in the third quarter, and $1.2bn in the fourth quarter of 2008. XL’s share price has crashed from $80 in 2007 to around $4 or $5 now. Last December three ratings agencies downgraded the company.

McGavick has experience in turning a company around. In January 2001 he became CEO of Safeco, the Seattle-based insurance giant, which lost almost $1bn that year. At Safeco, an acquisition was “poorly handled”, and the balance sheet was damaged by “forays into industries beyond their ordinary reach,”

McGavick says. “At XL it is very much the same.”

He can remember days at Safeco, before the turnaround, when he thought “the sun was never going to shine again”.

At Safeco, McGavick adopted the following strategy: he reduced the dividend, wrote off goodwill from the acquisition, sold assets to reduce debt, and cut expenses and staff by 10%. The parallels with XL are clear. XL recently cut its dividend, wrote off $975m goodwill against its 1998 MidOcean acquisition, is de-risking its investment portfolio, and is reducing expenses and cutting staff by 10% this year.

McGavick admits that 2008 was XL’s worst year ever. Net loss for the year was $2.63bn. But he is relentlessly upbeat. His vision is of XL returning to its core values. At the heart of the company, he declares, is skilled traditional underwriting. The company must return to that traditional core.

There is something of the crusader about McGavick. Bad news and rumours are dismissed as “noise”. Faced with downgrades by ratings agencies, he goes over their heads and takes his message directly to customers and investors. “We are not relying on third party validation as much as we have done in the past,” he says.

McGavick gets angry at unjust claims against XL, as when a journalist recently claimed – falsely – that there was an “exodus” of underwriting staff from XL.

In fact, in 2008 “voluntary [underwriting] staff turnover was slightly below norms,” he says.

McGavick often waves his hands to make a point, and can get excited when challenged. At one point in the interview, he stops and apologises in case he is being “too aggressive”. Much of that ferocious drive is directed inwards. He often puts his hand to his brow to recall precise figures, or waves away an aide’s attempt to provide them to him. He wants to remember everything himself.

REBUILDING FAITH

McGavick has always been a fighter. His father was a politician. As a small boy of 10, in Seattle, Mike McGavick knocked on doors to help his father’s political campaign. He recalls that his Dad put him in charge of the committee for “pot holders” – oven gloves – that they were giving away free with the election campaign literature. He was raised as a Catholic, and his faith remains “very important” to him.

He followed his father into politics. In 2006, after leaving Safeco, he ran as a Republican for the US Senate. He lost, and returned to business, beating other candidates for the CEO position at XL. How does he compare business with politics? “In politics so much of the environment is external to you,” he says. “In business more is in your control.”

Although the measures he is taking at XL are firm, the company’s future lies largely in the hands of wider economic forces. One possible future for XL is the one McGavick is fighting for, in which his de-risking and cost saving measures restore confidence and the company returns to profitability.

But an alternative possibility also looms: a downward spiral of further investment losses and ratings downgrades. Serious ratings downgrades could threaten credit agreements and reinsurance contracts which reference them. Clients would worry about financial strength. XL would have less and less room to manoeuvre. At some point, run-off would beckon. McGavick says he is not looking at run-off options.

And when asked about the repeated rumours in the press that XL is for sale, and that Goldman Sachs has been searching for a buyer, McGavick is insistent. He is “exclusively focused on operating the company independently”. Is XL for sale? “No.”

Asked again, he replies: “That is a sentence. NO.”

David Sandham is Editor of Global Reinsurance

The noise

Despite XL Capital’s steep investment losses, its underlying underwriting has been solid.
XL’s underwriting business has been “historically very profitable”, says Robert DeRose, vice president, AM Best. In the year 2008, XL’s P&C combined ratio was 95.7%. For 2008, for the insurance operation gross and net written premiums were down modestly in a soft market (they decreased 2.3% and 4.8% to $5.3bn and $4.0bn, respectively). In reinsurance, the full year combined ratio was 90.4%, producing an underwriting profit of just under $400m on gross written premiums of $2.26bn.
In December, three out of four ratings agencies downgraded XL Capital. For example, Standard & Poor’s cut its rating on XL’s operational company to A, and on the holding company’s long term debt to BBB+. Steven Ader, primary credit analyst, Standard & Poor’s, believes XL’s core underwriting business is strong, but its “competitive presence has diminished” due to a string of problems - this “noise”. XL’s prospective performance has been affected by a “series of adverse charges” and most recently, by the “risk emanating from the investment portfolio,” he says.
AM Best was the one rating agency that did not downgrade XL last December, maintaining its A rating with a stable outlook, and telling the company it would not even take it to committee at this point. However, AM Best, had downgraded it in January 2008.
Have the ratings downgrades harmed XL’s core underwriting business? January 1 2009 renewals retentions for insurance were, McGavick says, “in the same range as 2008”. The effect of December’s ratings agency downgrades can perhaps be seen more in XL’s reinsurance business. Jamie Veghte, chief executive of reinsurance operations says that in the 1 January 2009 renewal season XL Re lost 11% of its reinsurance portfolio due to clients’ “security decisions”, which he says are “a result of the December rating agency action”.

LIQUID
Nevertheless, the problems at XL should not be exaggerated. Though shareholders equity has declined from $9.9bn (end 2007) to $6.6bn (end 2008), weighed down by $4.1bn of unrealised losses, the company is no AIG. Ader says XL has “strong liquidity”, and says that “no debt is due for a while”. DeRose agrees that liquidity at XL is “very strong at this point in time”.
XL has a $2bn Letter of Credit expiring 2010, but if that expires there
is further capacity in a $4bn LoC expiring 2012. Falls in ratings of two notches could require that XL post collateral on various bank revolvers that it uses for LoC issuance.
How successful will be XL’s corporate strategy regarding cost cutting and refocusing on core business? According to DeRose, that “remains to be seen”.
“XL’s investment portfolio is a risk to the rating,” says Ader. “There could be adverse earnings surprises.”