Foreign exchange losses, coupled with a decline in net investment income, shortened XL Capital’s (XL) second-quarter earnings. On Jul 28 the company reported results that missed our expectations. Earnings came in at $79.9 million, or $0.23 per share, versus $1.33 last year.

Excluding items, reported earnings were $162.6 million, or $0.47 per share, in comparison to $266.2 million, or $1.49, in the prior-year period. On a per share basis, earnings shrank by 68%. Earnings fell short of the Street’s expectation of $0.62 per share, whereas we had expected earnings of $0.65 per share.

Revenues fell 18.8% year over year to $1.73 billion, versus the $1.71 billion consensus. We had expected revenues of $1.6 billion.

Earnings were shortened because of a foreign exchange loss of $145.2 million that was due to deteriorating dollar value, coupled by a decline in net investment income.

Net written premiums fell 21% year over year to $1.08 billion, while gross written premiums dropped 16% to $1.5 billion. Though that’s a big drop, it is still an improvement over the first quarter of 2009.

Diversion of funds to safer, “low yielding” investment caused a decline in net investment income to $328.3 million, versus $440.4 million last year. The annualized return on ordinary shareholders’ equity, based on operating income, was 11.2%, versus 13.3% in the prior-year quarter. Unrealized investment gains of $800 million led to an increase in book value to $18.89 per share as compared to $15.02 at Mar 31.

In relation to the expense reduction initiative announced during the third quarter 2008, XL Capital recorded restructuring and asset impairment charges totaling $9.1 million during the quarter.

XL Capital plans to focus on those lines of business within its insurance and reinsurance operations that provide the best return on capital over the pricing cycle.

As such, XL Capital will be highly selective on new business, emphasize short-tail lines in the company’s reinsurance operations, exit other businesses (such as the Casualty facultative business), refrain from renewing certain insurance programs, as well as continue to reduce long-term agreements (within the insurance operations) in order to capture the benefit of improving pricing.

We expect that this selective exposure, coupled with lost business, will result in a reduction in both gross and net premiums written in 2009. Hence its top line growth will be restricted, though such negative impacts may be partially offset by the positive effect of hardening rates across most lines of business.

Thus, pending further positive developments, we recommend to Hold the shares.

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