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Year-to-date financial results

With the unprecedented turmoil in the financial markets it will come as no surprise to you that, like many other insurers, AEGIS is having a tough year. We recently shared our unaudited September 30th results with your Board of Directors and the RMAC and we would now like to share them with you.

Current year losses are $83 million higher than we expected largely due to changes in our excess liability ultimate loss estimates based on our June actuarial reserve study and a recent D&O claim arising from the troubled financial markets. Overall, prior year losses have seen $43 million in adverse development. This includes $105 million in new California wildfire excess liability claims, which were partially offset by favorable loss development in the D&O and property lines. Hurricanes Gustav and Ike have resulted in only minor onshore claims to AEGIS. Our offshore underwriting through Lloyd's incurred roughly $40 million in net hurricane losses (which is about what they had planned for the year). Finally, our premium revenues through September were only about $5 million less than last year's level for the same period as soft market conditions persisted through the first three quarters.

In September, we reported that, because the portion of our overall portfolio invested in financial sector holdings was minimal, our portfolio was not significantly affected by the troubles of some notable institutions then in the news (e.g., Lehman Brothers, Merrill Lynch, AIG and Washington Mutual). Since then, the equity markets as a whole and most other investments have been battered. AEGIS's return through September 30th on the portion of the portfolio we had allocated to equities (approximately 20%) was -16.9%. Our roughly 80% allocation to fixed income securities and cash produced only a 0.1% return. Overall, the total return on our portfolio through the first nine months was -3.4%. The combined effect of our underwriting results and negative investment returns produced a $230 million drop in surplus to $850 million, at the end of the third quarter.

Through the years AEGIS has built its surplus for the express purpose of absorbing unexpected negative results. The surplus has done its job and AEGIS's financial condition remains strong. We must now take positive steps to preserve and rebuild the surplus in an orderly fashion for the future, and to maintain our favorable ratings from AM Best and Fitch. This will require a proactive approach.

With respect to our investment portfolio, given the reduced surplus level and the dim prospects for equity returns in the short to medium term, we have recently sold a large portion of our equity investments. Only about 6% of our portfolio is now allocated to equities and these remain primarily in "fund of fund" hedge funds that have had about one-half the volatility of straight equity investments during 2008, returning -9.7% for the year to date. The funds received from the sale of our other equity investments are being reinvested in laddered U.S. municipal fixed income securities. We are currently working with our investment advisors on further allocation changes to improve our risk/return profile for 2009 and beyond with a focus on capital preservation and, to the extent possible, more predictable returns. We plan to review a revised investment allocation structure with the Investment Committee and our Board of Directors in early January.

On the underwriting side, we must apply appropriate price increases on renewing excess liability policies. As we discussed at our most recent Policyholders' Conferences, our excess liability rates have not kept pace with loss trends and the rising cost of managing claims. As to the extent of the necessary pricing increase expected on the overall excess liability book, we cannot give a standard percentage increase, as we do not underwrite in a one-size-fits-all way. We know you expect AEGIS to determine your premium based on your company's unique characteristics and we intend to continue that practice.

We will also consider aggregate and sublimit alternatives for the excess liability policy to deal with issues like the 2007-2008 California wildfires, which may result in AEGIS absorbing multiple limit losses. We are studying these matters with a new RMAC task force comprised of Mike Anderson, John Ireland, Robert Moussaid and Terry Novatnack as well as senior members of the AEGIS underwriting and actuarial teams. We also plan to consult our major brokers and reinsurers on the advisability of these alternatives. Finally, on an account-by-account basis, we expect to decrease the limits of liability and propose higher retentions for members with propane, liquid pipeline and E&P operations.

One of the purposes of our reinsurance purchases is to limit surplus stress. Beginning in the spring of 2008, we conducted a top-to-bottom analysis of our reinsurance programs and conducted an RFP review among the major reinsurance brokers for both our U.S. and London operations. Among other things, we are looking for ways to combine these two programs to achieve scale economies where appropriate. We believe this will result in better coverage at reduced overall cost. We currently are in the market for our January 1 casualty renewals and exploring various reinsurance alternatives to further protect surplus. I should hasten to add that we have never allowed reinsurance considerations to impact our mutual underwriting philosophy and that will not change. We look forward to sharing the results of these efforts with you as the renewals are finalized.

We are confident that the steps we are taking will stimulate the growth of surplus, support our business plan, help preserve our favorable ratings and promote the long-term growth and health of your company.

Finally, we are grateful for the strong, ongoing support of the membership. Your active participation as we have made necessary strategic adjustments over the years is a great strength of this mutual enterprise.