Good day, ladies and gentlemen, and welcome to the Q4 2017 Arch Capital Group earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the Federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.
For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K, furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website.
I would now like to introduce your hosts for today's conference, Mr. Constantine Iordanou, Mr. Marc Grandisson, and Mr. Mark Lyons. You may begin.
Thank you, Crystal. Good morning, everyone, and thank you for joining us today for our Q4 earnings call. As many of you know, this is my last earnings call as CEO of Arch Capital, and I could not be more proud of the team and organization that we have built over the past 16 years. We announced our CEO transition plan 2 years ago, and I am very pleased with the work Marc and the entire executive team have done to position Arch for the challenges they will face in the future. In our 16 years as a company, we have come a long way. We have taken an idea to build from scratch a specialty insurance and reinsurance platform that can generate superior risk-adjusted returns. And we have done that.
We also saw an opportunity after the financial crisis to add a new segment, mortgage, that profitably diversifies our company. We have achieved that also. Through the P&C cycle, Arch has produced average annual returns of 16% and book value for shareholders growing 10 times from $6.03 a share in March of 2002 to $60.91 per share at December 31, 2017, and a share price of $87 before this call from a split adjusted $8.84 back in 2002. On my own, I cannot have accomplished these results, but with the help of many people, much has been accomplished. The challenge for all of us was to improve the intellectual capability of the company and its ability to manufacture, as I always say, profitable decisions. Most companies do not pay enough attention to the most important asset they possess, their employees.
Here at Arch is the foundation of our success. For Arch, the question has been, how do you create a culture in a cyclical business that not only empowers, but also helps our employees to make the best decisions that they can? You have to care for them, you have to share knowledge, you have to teach, you have to reward them. You have to provide an opportunity for employees to constantly learn and transfer knowledge up and down the organization, as well as across segments and channels. The more knowledge your employees possess, the better decision makers they are, and that is what produces outstanding results. You have to believe in the success of the team over the success of the individual, and you have to be willing to challenge and be challenged. Collaboration is the secret sauce that enables crisp execution and achieving extraordinary results.
For the past 16 years, I've had the honor and privilege to help lead Arch and to have a hand in its formation and success is one of my greatest personal achievements. I'm now passing the baton over to Marc, and I'm confident that we will see not only a continuation of the culture that has made Arch successful, but that also I expect the future of Arch will be enhanced under his leadership. To take an analogy out of car racing, which I'm a fan of, Marc, here are the keys, baby. The Ferraris are in the starting position, their fuel ready to go. Achieve greatness, my friend.
Thank you, Dinos. Wow. In Bermuda, you'll see me on my Vespa in Bermuda. To stay with the Italian theme. Good morning to you all. I've had the privilege of working with Dinos for more than 16 years, and I feel it's appropriate to pause on this earnings call, Dinos' 59th consecutive earnings call, and to express a big thank you from all of us at ACGL. Thank you for your leadership, for the values and culture that you've helped to establish here at Arch. Enjoy your family with the two newest addition, Marielle and Evelyn, Mr. Grandpa. Turning to the quarter and year-end in review. 2017 brought catastrophe losses of about $135 billion to the industry. Cost Arch shareholders about $386 million.
For the year ended December 31, 2017, Arch produced after-tax operating income of $447 million or $3.21 per share for a 5.7% operating return on equity. On a net income basis, the results are slightly better as the company reported $566 million or $4.07 per share for the year ending December 31, 2017, producing a net return on equity of 7.2%. Our investment returns were good this quarter. As you probably know, we manage our investment portfolio on a total return basis, which in U.S. dollar basis was a positive 79 basis points for the quarter, 71 basis points on a local currency basis. Our book value per share in the quarter rose, as Dinos mentioned, to $60.91, an increase of 10.4% for the full year, and our risk math and structure and diversified business platforms performed as designed in the face of challenging P&C market conditions and significant cat activity.
One year into our acquisition of UGC, we are pleased with the contribution that our mortgage segment makes to our returns and value creation. Our group-wide insurance in force or IIF grew to $352 billion at year-end 2017 from nearly $316 billion the prior year. Helped by the UGC acquisition, gross written premium grew 142% to $335 million for the fourth quarter of 2017 versus fourth quarter of 2016 for the entire mortgage segment. Reinsurance sessions to our Bellemeade III insurance-linked securities and other third-party reinsurers, as well as target reductions in U.S. single business and Australian reinsurance led to a sequential decrease of 6% in net premiums written to $272 million for the fourth quarter of 2017. Earned premium worldwide grew 2% in the fourth quarter to $280 million as a result of growth in our insurance in force.
For our primary U.S. mortgage business, NIW of $14.4 billion in the fourth quarter of 2017 was down from $17.7 billion in the third quarter. Part of this decline is due to normal seasonality in the fourth quarter, but it also reflects our efforts to manage growth in the higher loan-to-value above 95% mortgages and our ongoing conservative approach to the pricing of singles. We estimate that our market share of NIW in the U.S. for the fourth quarter of 2017 was just below 21%, which is consistent with our expectations we discussed since completing the acquisition of UGC. Mortgage market conditions remain favorable in the U.S. However, competition is increasing in the CRT space as well as in the primary mortgage insurance market.
While we are being marginally more selective in our underwriting, the overall quality of the risks written are strong, and the mortgage segment should continue to generate risk-adjusted returns above our long-term target of 15%. Next, turning to our property casualty operations and our reinsurance segment specifically. As you have already heard on a number of calls this quarter, rate increases in the property cat lines were not nearly as robust as many of us hoped, given the significant cats in 2017. We saw a few opportunities to put capital to work at the January 1 renewals, but not enough rate movement to warrant a material increase in our writings. Rates across our reinsurance portfolio were up 2.5%, including 5% to 7.5% for our cat book. As you can see, it's a positive, albeit tepid starting point for the year.
Returns for cat business are low by historical standards and in our view, do not fully capture risk volatility in this line of business. For the fourth quarter of 2017, gross premium written rose about 5% in our reinsurance segment over the same quarter in 2016 and 2% on a net basis. The growth came primarily from our specialty businesses, including international motor treaties, while other lines such as our property ex-cat were reduced. Our reported combined ratio for the reinsurance segment was 94.5 in the fourth quarter on a core basis, excluding Watford. Turning to our insurance segment, gross premiums written of $768 million in the 2017 fourth quarter or 8.5% higher than in 2016 fourth quarter, while net premium in insurance were 10.1% higher at $513 million.
The higher level of net premiums written reflected increases in national accounts, travel, and growth in two of our newest programs, areas where we currently see opportunities in U.S. insurance. Focusing on P&C insurance market overall conditions, they remain challenging, although we have seen rates stabilize and improving in some lines in the fourth quarter, particularly in property, commercial auto, and some casualty lines. Our current view of the market is cautiously optimistic. We are seeing a slight upward movement on the pricing side with some margin expansion. However, after considering changes in terms and conditions and other factors that can influence claim strength on an absolute basis, rate levels are not sufficient to support the allocation of more capital to our insurance segment, especially given our opportunities in the MI segment. Next, I would like to discuss our PMLs.
As we mentioned last quarter, we're also reporting to you our exposure to mortgage risk from a systemic stress event, what we call a realistic disaster scenario or RDS. It stood at 17% of tangible common equity at the end of the fourth quarter. We have begun using tangible rather than stated equity as a result of UGC acquisition, as we believe that it is a more appropriate and prudent risk management yardstick. Our net property cat exposures are substantially the same as last quarter with our one in 250-year PML for the peak zone, the U.S. Northeast, at 6.5% of tangible common equity. In summary, we're always preparing for opportunities that the market presents, but we remain disciplined in allocating capital to the various units to maximize risk-adjusted returns for our shareholders. Now, here's Mark with a more detailed financial analysis of the quarter. Mark?
Great. Thank you, Mark, and good morning to all. On today's call, I'm going to comment on the fourth quarter results as usual, but I'm also going to focus on some unusual accounting impacts and one-off charges driven by U.S. tax reform and other items in this busy quarter. Now into some summary comments for the fourth quarter, all on a core basis. Just as a refresher, the term core corresponds to Arch Financial results excluding Watford Re, whereas the term consolidated includes Watford Re. Core losses recorded in the fourth quarter from 2017 catastrophic events, net of reinsurance recoverable and reinstatement premiums, were $800,000, or nearly one-tenth of a loss ratio point compared to four loss ratio points in the fourth quarter of last year on the same basis.
The activity was primarily driven by the California wildfires, pre-tax estimate of $68.4 million, along with approximately $69.1 million of reductions associated with the third quarter hurricanes, Harvey, Irma, and Maria. The reductions in the third quarter hurricane estimates result from lower industry loss estimates from outside vendors in conjunction with our own lower than expected reported claims volumes. Most of the reduction emanated from the reinsurance group, both facultative and treaty. Overall estimates for Harvey and Maria were reduced, whereas Irma remained relatively flat. As for the California wildfires, we see more exposure from the Northern California fires versus Southern California, roughly 3 to 1, and see this primarily as a reinsurance event for us.
With respect to net pure loss prior period favorable development, approximately $54 million, or 4.9 loss ratio points was recognized in the quarter compared to 6.5 loss ratio points in the fourth quarter of last year. This net favorable development was led by the reinsurance segment with approximately $32 million favorable, while the mortgage segment provided approximately $20 million of favorable development. The calendar quarter combined ratio on a core basis was 82.5% compared to the fourth quarter of 2016's 88.3%. The core accident quarter combined ratio excluding cats was 87% even compared to 90.7% for last year's fourth quarter. The reinsurance segment accident quarter combined ratio excluding cats of 103.2% includes two unusual items, and the comparison to the fourth quarter of 2016 needs one unusual item comment.
The two items impacting the 2017 accident quarter are, one, the non-recurrent 1% Federal Excise Tax or FET associated with the fourth quarter intercompany loss portfolio transfers previously announced, which resulted in a 5.3-point increase to the reinsurance segment's expense ratio through the acquisition line. Second, the reinsurance group incurred approximately two combined ratio points of negative impact associated with the former Gulf Re operation over the prior year's comparable quarter. The item affecting the fourth quarter of last year was a large retrocessional recoverable of approximately $11.5 million that had no counterpart in the fourth quarter of 2017 and represents a 4.6 combined ratio point impact. Taking all of these items into account resulted in a 95.9% fourth quarter accident quarter combined ratio, which therefore represents only a 20 basis points increase over the adjusted fourth quarter from last year. Moving on to the insurance segment.
The accident quarter combined ratio excluding cats was 99.7%, which included 2.2 loss ratio points of large attritional losses relative and higher than the fourth quarter of 2016, along with a flat expense ratio. This is approximately 130 basis points higher than the comparable accident quarter in 2016. This is a loss ratio increase and primarily represents higher loss picks due to our view of competitive marketplace conditions on an earned basis.
The competitive conditions experienced in the insurance and reinsurance segments were more than offset by the continued strong profitability of the mortgage segment, amplified by their net earned premiums being a larger proportion of the total. The mortgage segment's accident quarter combined ratio improved to 47.1% from 54.8% quarter-over-quarter, and their net earned premiums represented nearly 26% of the total core net earned premium, compared to only 9.6% in the fourth quarter of 2016. The accident quarter loss ratio of 25% was negatively impacted by approximately $10.4 million of charges, primarily associated with higher delinquencies stemming from the third quarter hurricane events, a catch-up of 2017 reported losses from one lender, and a small adjustment to put loss reserves on parity between our East and West operations. The accident quarter loss ratio, after taking these items into account, would've been 21.3%.
I'd also like to point out that subsequent to the UGC acquisition, which closed at the end of last year, the 2017 accident quarter loss ratios for the mortgage segment has sequentially been as follows from first to fourth quarter: 21.5%, 19.5%, 20.6%, and this quarter's 21.3% on an adjusted basis. The expense ratio improved from 37.9% in the fourth quarter of last year to 22.1% this quarter. On a sequential basis to the third quarter of 2017, however, the expense ratio increased by 150 basis points from 20.6%. This was primarily driven by an increase in the amortization of deferred acquisition expenses. Remember that at the closing of the UGC transaction at last year-end, all deferred acquisition expenses were written off to zero. They are now rebuilding and being amortized into income.
Moving on to other unusual financial statements in this busy quarter, let me begin by discussing three items that have been included as reflected within operating income. First, as I noted earlier, we executed a one-time intercompany loss portfolio transfer this quarter that incurred $13.6 million of federal excise taxes or approximately $0.10 per share. Second, we established a $10 million valuation allowance against our U.K. insurance syndicate deferred tax asset this quarter or $0.07 per share. Third, as discussed earlier, the mortgage segment recognized approximately $10 million plus of pre-tax charges and $6.8 million of after-tax charges, representing $0.05 a share. All in, these one-off items with an operating income as described total $0.22 per share.
Shifting to an update on integration costs associated with the UGC transaction, the original combined workforce has been reduced by approximately 30% as of year-end 2017, along with 120 contractors. There was $1 million in severance-related costs in the quarter, totaling $14 million for the full year, and the run rate of quarterly pure salary savings is $9.5 million or $38 million on the annual basis. The vast majority of employee-related savings has now been realized with any additional future benefits likely being system integration oriented. As for the beneficial accretion stemming from the acquisition of UGC on an EPS basis, we examined the full year performance of the overall company, the mortgage segment, and UGC incremental addition. Adjusting for a normal level of cat losses shows the earnings accretion, projected to reach 35% within three-year period, has been nearly 75% achieved just one year later.
Total investment returns for the quarter was a positive 79 basis points on a U.S. basis, as Marc mentioned, and 71 basis points on a local currency basis. Returns on equities, alternatives, and non-investment grade fixed income primarily drove the return. The full 2017 year total return was 5.87% on a U.S. dollar basis. The investment duration was 2.83 years at the end of this year, down sequentially from 3.14 years in anticipation of inflationary pressures. Operating cash flow on a core basis was a negative $32 million, primarily due to an increase in net paid losses stemming mostly from third quarter cat activity, the return of cash collateral associated with a large longtime customer, and the timing of tax payments between the quarters.
For taxes, we incurred a $21.5 million charge this quarter that results from the change in the U.S. corporate tax rate from 35% to 21% on our deferred tax asset. This has been excluded from operating income since it is not reflective of operational performance. The effective tax rate in the quarter on pre-tax operating income was 15.4%, excluding the impact of the change in U.S. tax rate I just commented about, and 17.6% for the full 2017 year on the same basis. We don't like to give guidance, but there's been so much havoc on the third and fourth quarter of this year. We'd like to provide our view that 2018's tax rate on pre-tax operating income is expected to be between 11% and 14%.
This range results from various scenarios tested, actual results could still fall outside this range, dependent on the level and location of income or loss, the level and location of catastrophic activity, and varying tax rates in each jurisdiction. Respects financial leverage, we repaid another $25 million down on the revolving credit facility this quarter, and that, combined with strong earnings, continued to improve our leverage ratios. During the quarter, we also issued $100 million of Series F preferred at 5.45% and redeemed all of the remaining $92.6 million of Series C 6.75% preferred, but with a clearing date of January 2nd of 2018.
A result, there was a two-day overlap of having both Series C and Series F outstanding, you adjust for that overlap results in a GAAP debt plus preferred ratio of 25.8% at year-end 2017 versus 28.7% at year-end 2016, which is a 290 basis point improvement in that leverage. The ongoing preferred dividend amount is $10.4 million a quarter, which will result in $4.4 million of lower dividend amounts in 2018 than in 2017. We did not repurchase any shares during the quarter, and our board authorization remains at $446-plus million. On a personal note, Dinos, we have been working together now for about 35 years. I'm still waiting for you to get something right. No, I'm kidding. Seriously, because of your leadership, the company is smarter, our families are happier, and each one of us is a whole lot more wealthy.
Thanks very much for all your leadership, Dinos. You'll clearly be missed.
You're welcome, Mark.
With that, we'll happy to take your questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star and then the 1 key on your touch tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, to ask a question, please press star and then 1 now. Our first question comes from Elyse Greenspan from Wells Fargo. Your line is open.
Hi, good morning. First off, congratulations, Dinos, on your retirement. It's obviously been a great job for all of us working with you through the years. To the quarter, my first question, in either of your two segments, was there any kind of current accident year catch up in terms of the margins, specifically the loss ratios? How do we think about, just given the market commentary that you've provided, still being pretty defensive, I would say, in both insurance and reinsurance, how do you think about the margin profile in both of those businesses as we look out to 2018?
Okay, Elyse, a good question. I think we were prepared for that one, obviously. I think there was somewhat of a small margin expansion in the fourth quarter of this year. That's clear that we've seen it. We think it's about 30 basis points on our portfolio, maybe it's 50 basis points. It's a positive. It's small, but it's a positive, and it's also on the heels of two and a half years of margin compression. You have to keep that in mind that a one quarter change does not repair two and a half years of margin compression. That's why we're cautiously optimistic. It's holding in January. Our initial discussion with our team is that the market is holding up the rate level the same as it was in the last quarter.
Essentially, if you talk to our team, they'll tell you that at 2017, the last quarter of rate changes pretty much meant that 2017 was a wash. We sort of have a stable year versus 2016, this is what's behind our commentary about the market. It's holding, slightly improving. Clearly there is an improvement at that level. There's also an improvement in ROEs and return in margins. A lot of it does not have a whole lot to do with the rate level themselves. A lot of it has to do with the tax rate changes, specifically in the U.S., as well as the interest rate environment that we see all around us. Right? Those two together account for about 200 basis points of pickup in return. Historically, we've told you we have about a 7% to 9% ROE.
This was middle of 2017. I think we're probably moving towards the higher end of that range. The one thing that I mentioned that I really want to impress upon you, these are all quantifiable changes, risk changes and trend and losses. There's a lot of stuff out there that's called terms and conditions, a lot of it has been given away over the last two and a half to three years, we don't necessarily factor that very well into our calculations. The trend has been going up. The trend was 1.5%. It's closing in on 2% for this year. That's why we're cautious because, yes, we're seeing some compression, margin expansion. The last quarter, it seems to be holding up at the January 1 renewal.
There's a lot of uncertainty as to where are we starting from and what it will mean for the remainder of 2018.
I would just add, Elyse, that we've talked about that as a management team. When you look backwards, the actuarial arithmetic never works in a soft market. It's always worse than you think, and it's terms and conditions as Marc highlighted. That's where our gray hair comes from. We've been through enough of these things that you have to be thinking more conservatively.
It's prudent from an old guy. It's always prudent when you can't calculate something, I think in my 42 years in the business, the effect of the change in terms and conditions never really mathematically can get factored. It's prudent to be a bit more cautious, I think what Marc and the team have done for determining the accident year is prudent in my view.
Elyse, again, this is just one quarter worth of the information, we'll have to wait another three to four years to see whether these numbers are holding up to what we think they're holding up. That also means that we've picked 2013 through 2017 at the right level, which one could argue that not everything is as probably as rosy as people might think. The proverbial barn may be a little bit out of the barn, as Dinos would like to say.
Okay, great. My second question, in terms of capital, when you guys announced the UGC deal, you effectively said that you weren't going to be buying back stock for 2017. As we think about 2018 and just capital, obviously there's some potential PMIER changes related to your mortgage business. You also are with the lapse of the AIG quota share only runs for 2014 to 2016. You are holding on to more mortgage business. How do you guys think about that holistically, and could we see Arch buying back some stock in 2018?
Right now, as best we can tell is we would return capital to shareholders if we didn't see opportunities. Frankly, we are seeing opportunities, and clearly MI is one glaring area where we think the returns are very appropriate. Right now where we stand is we have opportunities that may develop or may not develop, and it behooves us to keep the capital or at least hold it behind so that we can maybe able to deploy it in this year and in the subsequent years. That's really what I would Mark, do you want to add something?
I would just add, Elyse, if this was six months ago, the idea of returning if we couldn't deploy it would have been tougher. Now we're trading about 142% of book.
I think as of this morning, over three years, that's 12+%. It's getting closer, not at, but closer to where we are. It's not impossible, but we're looking to deploy in our businesses first and foremost.
Exactly. On the PMIER note, that's a good question you're asking. It's going to be asked. Currently, we don't see any change in our capital plan. Everything is in line. It's going to be some changes. We can't talk about it, but they're totally within plan and budget, so it's nothing to talk about.
Okay, thanks so much. I appreciate the color.
Thanks.
Thank you. Our next question comes from Kai Pan from Morgan Stanley. Your line is open.
Thank you. Good morning. I would congratulate Dinos on the retirements. I think long-term shareholders owe you a deep debt of gratitude. You leave the company in good hands, and we'll miss your commentary on the souvlaki gyros as we approach lunchtime.
Yeah. They're going to bring me back just to pick up the menu every quarter.
Yes.
I don't think they're experts on Greek food, but I am.
Sure am.
All right. That might add in one basis point to your expense ratio, I guess. My first question is on the pricing outlook. It looks like the January renewals have been sort of modest increase. Given what you know today, what's your outlook for mid-year renewals? How much rate increase you would need for you to get back in the property cat reinsurance business or increase writing on that?
Yeah, we talked about last quarter, I think, the number I put in the ground to make it valuable in terms of to get back to historical returns we would want from a property cat perspective precisely because of the volatility around it, we would have wanted about 30% increase. Now where we are, we probably gain anywhere between 5%-10%. We would need not an insignificant amount of rate increases. One thing I'll tell you about the middle of the year, and this is property cat exposed business insurance or reinsurance. They are very similarly in terms of rate needs. It's too early to tell. I think there's a lot of adjusting for position in the marketplace.
One thing that surprised us, I'll tell you for January 1, and it might be another reason why we're a bit conservative in our comments, is that capital did not seem to go away at all. If anything, I think capital has been increased at the 1/1 renewal, and the capital is committed for one year. Maybe we would expect a very similar round of rate change by mid-year. We think it should be much bigger than this, much higher than this, but we may not be able to get this because of the microeconomic forces of supplying the amount of capital, potentially.
Okay. That's great. Then switch to MI. Just have a couple questions there. One is the delinquency going up for the quarter sequentially because you think the impact from those hurricanes will be one-time rather than long-term trends in terms of delinquency trends. Then second, what's your run rate do you think on your expense ratio as well as the acquisition ratio? Is like 2017 will be a good run rate going forward?
Yeah. Delinquencies are getting better, and we have our delinquencies, the case of delinquents that we have on our portfolio. If you exclude, to your point, the recent storms, it's still decreasing. Sequentially, as is with everybody else in the sector, we have seen a blip, about 3,200 new claims we think, because it's kind of hard to see through all the claims specifically, but we estimate about 3,200 claims from the storms. You are quite right. It's a blip. It went up from one quarter. We expect the cure rate for those claims, as you heard from other people, to be very high. A typical delinquency now that we see that's non-hurricane related probably cures to the tune of 87%-92%. The ones on the storms are going to be we expect north of 95%. You're right. It's a blip. We have to recognize it.
There were some reserves put aside for this as a result of that event. We are expecting this to be a blip and go away. As of recent, I think, Mark, we have already a decrease in claims. We had 3,200 at the end of the year. At the end of January, I believe we already had 400 that cured. We expect it to be fully curing. Also, you should know, you probably heard about it from other call that Fannie Mae and Freddie Mac had put programs to stay any delinquency to give people credit and give some leniency on their payment of the storm, to recognize the duress under which they are for the storm. Anything that we hear and see indicates that history will repeat itself, and there'll be a blip that goes away in a large part.
Kai, if Mark didn't mention, I apologize if he did. When you adjust for those hurricane related ones out, the delinquency rate is 1.97, virtually flat with the prior quarter.
Exactly.
That really accounts for it. As far as your second question on expenses, for the quarter, the segment was a little over 22.
What you have to keep in mind is, yes, we're growing on earned premium. You got the AIG quota share cession starting to wane marginally a bit. As I commented on in the prepared comments, the deferred acquisition costs were written to zero on the UGC transaction, they are building back up and being amortized. I would, not to give crazy guidance, but I would say at best, it would marginally improve from the 22.1. That's the best I can do for you. Okay, great.
Thank you so much.
Thank you. Our next question comes from Meyer Shields from KBW. Your line is open.
Good morning. Congratulations to Dinos on a phenomenal career and a well-deserved retirement.
Thank you.
I'm sorry. One quick question, just in terms of modeling. Can we get a sense as to how much the acquisition expense ratios have been impacted, not counting the fourth quarter, LPT for excise taxes?
The only real impact you're really seeing of significance is in mortgage, as we talked about. There is some growth in NWP, as Mark delineated in a written basis. The P&C side, to date, has not really impacted. It's really the mortgage side.
Okay. I'm not even sure how to ask this.
I'm sorry, Meyer. You did have a second point, as Donald Watson just pointed out to me. The FET on the $13.6 million was reflected in the reinsurance group's acquisition ratio. Yes. It was all expensed. Five points, yeah. So it's five points.
Right. Okay. No, I got that. Thank you. I was wondering if you could talk about the analog to trend in the mortgage insurance business, and whether that's changing. You talked a little bit about pricing getting more competitive.
Yep. The trend in loss trend, really the equivalent for the MI is the trend in credit riskiness of the underlying policyholder or mortgage insurance policy. For this one, we're not seeing a significant amount of changes in the regular, especially the average lender, borrower. Having said this, if you look at the overall MI portfolio, there is an increase, for instance, in 95 and above LTV. You do have an underlying riskiness of the portfolio that has changed over the last two years. The singles were already there. They're not necessarily more risky. They're an economic discussion, and which we have lowered, as you know.
The two elements that are getting riskier in the marketplace are the 95-plus LTV, which I mentioned, which are supported by the GSEs, and the second one is the DTI above 43, which is another one that is encouraged by the duty to serve aspect of the overall mortgage risk provider. These two elements are actually not insignificant, right? I think the DTI over 43 is about 20% of the NIW for the MI industry, and the 95% plus LTV has grown to 12.5%. The overall riskiness of the portfolio is increasing as a result of that specific phenomenon. It's actually buffered, to some extent, by house prices appreciation going up and affordability still being at a very healthy level. The DTI for the average borrower is still below 30%, which is lower than the historical value.
I think at the margin, the volatility around the expected, I guess, is increasing a little bit. You don't have necessarily an average risk going up significantly. Does that make sense?
It does. It was very helpful. Thank you so much, and best of luck.
Let me just a little color. What Mark said is absolutely correct, but I want you to understand that a risk price methodology adjusts for the riskiness. For that reason, a reduction in exposure is being mostly in the 95 LTV and above, and of course, singles that we have been mentioning for the last three quarters. Just a little more color. Yep, exactly right. Exactly right. Exactly right, Dinos. Right.
Thank you. Our next question comes from Brian Meredith from UBS. Your line is open.
Yeah, thanks. Also congratulations, Dinos, on the retirement. This is an outstanding career. Question first is on the MI business. I'm just curious your thoughts on the competition that you kind of highlighted. Do you anticipate that tax reform will have any kind of incremental kind of pressures with respect to pricing in the MI business?
I think at a high level, Brian, I think investors look at returns after tax. Most of the U.S. MI provider of capital of U.S. MI business are U.S.-based, therefore U.S. taxpayers. I would expect in general, that should mean everything else being equal, which it never is, that the returns would increase for the U.S. MI provider. Therefore, the question is, will they be okay with this? Will the investor expect a higher return, or did the risk change in any significant way? I think all else being equal, I would expect the market has been such, not only in MI specific, it's also a P&C in any market for that matter, phenomenon that if there is more money left after you pay the tax man, that there is an adjustment for returns. We would expect to have some kind of effect.
I don't think we're seeing it quite yet because, as we all know collectively, there's PMIERs 2.0 on the horizon, and that might taper somewhat what happens over the next six or seven quarters. Problem we have is we don't have a crystal ball, as you know, but all else being equal, when tax rate go down, when there's more money available for shareholders, everything else being equal, then we would expect price to go down slightly. Yes, we would.
I'm just curious, Mark, in your 15% kind of return assumption, the base minimum that you're looking for in the MI business, what is the tax rate that you're assuming on that?
Mark, I mean, it's pretty much.
Yeah.
It hasn't changed for them, you know.
Yeah. We would expect an incremental benefit now, Brian.
Right.
The 35%-21% that we have, it's all U.S. We have a U.S. tax group that goes beyond mortgage, of course. It's all buried in.
Right.
Everybody talks about the other U.S. stock companies benefiting enormously. If you have other U.S.-based income, you're benefiting, too, just as we are.
Brian, we said we're meeting the 15% return, which means by implication, it's above that.
Right. I would just say it's 35% with the tax rate you were using, and I guess it'll be 21%, not kind of your blended tax rate with the quota share offshore.
Well, before we were paying 35%, there was a quota share to ARL for capital management.
Right
purposes. That would blend it to 17.5% adds from the FET on the other side. Now it's at 21% for what's in the U.S., there's a quota share, although you have to weigh that with the B tax that comes into play as well. We're somewhat in a similar position after tax than we were before, if not improved slightly, as Mark mentioned.
Good summer number work, yeah.
Got it.
Yep.
Perfect. Another one, just curious here. Watford is looking at their results, continue to have fairly high combined ratios here. What is the kind of outlook right now for Watford as we think about it?
I think its purpose is still very much alive. We have other guys coming up with total return reinsurance still as of yesterday, I believe it was announced in the marketplace. I think that one thing that happened to Watford is that they were essentially participating on the property cat portfolio, and it sort of happened to run into the 2017 cat as well. The question is, was this appropriate? We can look back and be Monday morning quarterback. At the core of what Watford is doing, there's not much change for its purpose, and it's still very much alive in what it's doing. The reinsurance play, as you guys remember, was initially what we're trying to do, get Watford into. There's been a shift over the last six quarters.
As I mentioned, the reinsurance market in terms and conditions got progressively worse since we established Watford Re. There's a push for Watford to become more of an insurance provider in the U.S., and that will certainly help those kinds of combined ratio and volatility specifically around the results.
I think another, Brian, a good characteristic to keep in mind is they are north of 50%. I think they were 55% in the quarter direct on their own paper rather than being fed into the areas.
That's right.
Got you. Helpful. Last, just quick one here in the MI business. Marc, is it possible to give us what the kind of reduction in the cede on AIG's quota share kind of will look like in 2018 versus 2017?
In-
Premium or yeah.
In a premium sense?
Yeah, the premium. Most of the gross to net obviously, right, is the AIG.
It's not as big a fall-off as you think.
Okay.
Brian. Overall, annually, it's only in the $tens of millions.
Got you. Thank you.
Welcome.
Thank you. Our next question comes from Amit Kumar from Buckingham Research. Your line is open.
Thanks, good morning.
Morning.
I'd also like to echo my congrats to Dinos for leading one of the top value creator franchises out there. Two questions. The first question is going back to the discussion on the insurance AYLR, and I think you mentioned there was some movement from the attritional losses. Can you just maybe just flush that out a bit more in terms of how we should think about the underlying LR trend going forward, and does it drop off or does some volatility continue going forward?
Well, let me start it. I think the ongoing movement over the last few years that Mark has highlighted in the past of smaller policies, lower limits, continues to constrict the volatility, which is part of the game plan. Large attritional losses, you still will occasionally get. We got it the fourth quarter of last year. You got it again this year. It seemed to be a common theme on insurance and reinsurance on onshore energy being the exposure that's generating that, which is requiring different actions associated with it, because you got to have a common view of that across. I think the corrections for that are going to go, I think, a long way towards stabilizing.
You can never say never, but that's a high capacity business that can hit you with large pops.
Correct.
Just to be clear, there wasn't any adverse movement netting out against the favorable movement in reserves?
Overall, I think we still have a favorable-
In insurance.
In insurance?
Oh, insurance was basically flat.
Yeah, flat.
Yeah. It was basically flat.
Some plus, some minuses, but yeah, overall it's flat. Yeah.
Nothing material. Okay. I guess the only other question I have is maybe a broader question. This is for Marc. Based on the transition, I was curious, this obviously has been in the pipeline for some time in terms of your role. Have there been times when you thought differently than Dinos? Strategically, how do you think about Arch from here going on forward?
I think the best way to answer that, I'll ask Dinos to chime in to confirm what I'm going to say, but I think that Mark Lyons, myself and Dinos worked together for over 16 years. We've had our differences and our agreements and disagreements, but by and large, I think over time, we found ourselves a lot more agreeing on things than not. I think we both. The three of us come from a very economically rational way to analyze businesses and make decisions.
I think that's something that is sometimes missed or that you should appreciate that, I think Dinos would echo this, the strategic visions or strategic plays that we've had and we did over the last 16 years, were not Dinos was certainly the proponent and the one publicly advocating and talking about them, but all these things were really done and came to as we talked together, John Vollaro was also very instrumental in this as well. I think that we all grew together in that environment and had more successes than failures. I mean, we don't do everything right.
I think the overall, I think we grew to agree more together, not because I came to his view or he came to my view, it's because if you look for the truth and look for the right rational thing to do, we sort of come up to the same or very often, a very similar conclusion. That's what I've noticed over the last 16 years.
Let me give you my two cents on it. What Marc says is absolutely correct. First and foremost, we're a very collaborative management team, and beyond that, we're very collaborative with our board of directors. The alignment as to where we're going to go, yes, we do the groundwork. The management team does the groundwork. Marc mentioned himself and Mark Lyons and me, but there were others. There's Nicolas and there is Maamoun, and I can go on and on. There is Price, and on and on. There is collaboration in examining what opportunities and where we're going to go.
The good thing about it is that when we arrive at the decision, then beyond it's about execution, it's not about-- If I step back and I look at the past 16 years, I would put a 95% plus agreement between the senior management team and the board ratification of where we wanted to go. The other 5%, I will never call it as a major disagreement, but directionally, maybe a little more to the right and a little more to the left, and then at the end we agree as to how we're going to do it. I expect the future to be pretty much in the same direction. Having said that, let me also address the other aspect of what we are as a company. We're opportunistic.
I don't know what opportunities will be detected in two years from now, three years from now, four years from now. I can say, me, my duties as a director and being on the board, and the management team operationally, we occasionally bring ideas up to the board as to what we're going to do. That collaboration is going to continue, I can't tell you what the future is going to say if there is a change in strategy. If there is a change, it's because based on our opportunistic approach to the business, we see an opportunity in the future that it wasn't present today or in the past, as we've done with the mortgage.
None of us thought we're going to be in the mortgage insurance business when we started in 2002, all the way until the financial crisis. After that, we saw the opportunity. We worked on it first as a reinsurer, later on we said, "Oh, there is more value to be a primary insurer," and we took the steps and the acquisition to get us there. I mean, it's a very important question, I think we've done a great job in not only transitioning leadership and building from within, which basically is another one of our foundations. A lot of our senior managers, they grow within the Arch culture, we like to promote from within, we don't rely significantly on going and bringing outside talent. It makes it easier later on to execute the strategy because everybody's in alignment.
I believe because we do have that collaborative culture. Listen, John Vallaro officially retired in 2009, right? I don't think anybody here thinks he ever retired.
No.
Right? Like I said, yes, you do retire, you're not operational. John was never operational. I will never be operational. The management team's responsibility is to be operational and make all those decisions, they are for consultation. People are going to call, we're going to discuss things, we're going to discuss them at the board. At the end, I don't anticipate major changes unless the market dictates this because there is an opportunity that none of us is seeing today, we might see it in the future. Mark.
Agree with you. Yep.
Yeah.
Yes.
That's it.
That's a great answer.
Amit, there aren't a bunch of shrinking violets on the management team.
Yeah.
I'll stop here. Thanks again, and I'm sure Ian is following, so I'll stop here.
Oh, yeah. He's right there.
Thank you. Our next question comes from Geoffrey Dunn from Dowling & Partners. Your line is open.
Thank you. Good morning.
Hi.
I wanted to dig into the credit development on the MI front a little bit more. Stripping out some of the things you highlighted, it looks like you're still running an incidence maybe up around 12%. Can you confirm where you are in your incidence assumptions on new core notices? If it's still above 10%, what does it take to get you down there?
Well, actually, the recent ones are getting below 10%, but we were about 12.5% over the last two, three quarters. We've crossed it, but it's a one quarter, Jeff, who knows if it holds up there.
You have touched down on your assumption to 10%?
No.
It's just for the CATs.
The CAT. I made the point on the CAT for the lower than 5%. That's what we expect right now. Still early to tell.
I'm talking on the core number.
The regular stuff. We're slightly below 10%. Yes. For the recent last few quarters of delinquencies. That's what we expect ultimately.
Great. With respect to the PMIERs cushion, how much of a drag on the cushion was there this quarter from the hurricane notices?
Was it?
Well, the hurricane's pre-tax load was really not that large, you can kind of deduce that it's not a big deal. It was south of $5 million.
Yeah.
South of a $5 million capital drag?
No, south of $5 million CAT reserve provision.
Well, the capital drag, no, I'm talking it's the.
No, I'm talking the capital drag on the PMIERs ratio.
The PMI, $72.5 million of drag we had to put aside for the new notices. That's the question. Sorry, Geoffrey, we didn't get there.
My last question is, obviously you're running the highest cushion in the industry right now with respect to PMIERs. It's going to go even higher as you get these notices out of the inventory. Post PMIERs 2.0, what type of cushion do you expect to run?
We can't be talking about this. You know we're under an NDA. You of all people should know this with your experience in this.
I'm not looking for the capital levels. I guess I'm looking for the relative cushion. Is it a 10% cushion? Is it a 20% cushion to whatever PMIERs 2.0 says?
We're unable to tell you this, we can't tell you this, Jeffrey. We'll have to get there. When we finalize, you know it's going to be by middle of this year, they're going to have the final thing. This will be more like a second quarter call discussion.
All right. Thanks.
Thanks, Jeffrey.
Thank you. Our next question comes from Jay Cohen from Bank of America Merrill Lynch. Your line is open.
Thank you. My questions were answered. I feel like I should make a comment about Dinos.
Yeah, you should.
I was-
[crosstalk]
I was involved. I worked on the IPO of Arch. This goes back many years. At that point, many of you remember, there was a lot of companies coming public and being formed, and they all sounded reasonably good. Good risk management, good underwriting, good management teams. The question would often come up, well, which ones are the best? I would tell people, like, "Ask me in about 15 years, and I'll have a good answer." Well, I think we have our answer now. Congratulations, Dinos. Thank you.
Thank you.
Oh, well said. Thank you. Wow.
I'm getting all merry. I know my eyes are getting watery now.
Thank you. Our next question comes from Ian Gutterman from Balyasny Asset Management. Your line is open.
Hi. Thank you. I'll just follow up what Jay said there, which is, as I recall, around that same time, Dinos, and you and John will remember these meetings well, everyone giving you a hard time about Zurich and questioning your ability to be successful at Arch, and I think a lot of people regret that they didn't get on board sooner.
Listen, I take pleasure on proving people wrong.
That's a great motivator, isn't it?
Yeah.
Absolutely.
Yeah.
My first tongue in cheek question is, Kai kind of stole my thunder here a little bit, Mark, but my first question is, will the menu change next quarter?
Well, I don't know. My duties going forward is board duties, choosing the menu for the calls. I won't participate on the call, but I'm going to be talking to the chefs as to what they're going to offer for lunch.
You know, if I-
Of course, I'll be available for golf games and dinners, especially if I don't have to pick up the tab.
That's right.
So-
You know my number. If it's good golf games, if it's good dinners, and I'm always available.
Okay.
My follow-up question for you on that, Dinos, is in your prepared remarks where you talked about Arch's secret sauce, I thought that was just tzatziki.
The tzatziki is true. This is my mother's secret sauce, which is a lot better than tzatziki. Tzatziki, every Greek restaurant has it.
Yeah. Okay, that's good. Serious questions. As I'm sure you recall, last quarter, we had a discussion about the cats, about the so-called missing losses and the modeling agencies never being right the first time and always being too low, and how would this play out. It seems that the way it's played out is actually the modeling estimates were too high for once, and everyone's releasing reserves just three months out. I'm curious, now that you've had some more time to assess, what are the implications for that? Is there reason to believe there was a flaw in the models, and we might see them be high in the future again like this, and we need to reassess how we think about hurricane risk? Is it just this was an anomaly, and every once in a while, they're going to be way too high?
Yeah. If you look at that loss, Ian, we thought about it. Most of the uncertainty and change in our ultimates were in the Reinsurance segment. If you look at that loss, the difficulty in analyzing this loss was how widespread it was among many primary companies. Clearly, it was not as concentrated as we thought it was. This became clear to us after repeated discussion with our clients on the Reinsurance side, I'm talking. Insurance side, we haven't changed much of our view. It's still the losses are the losses. We have them, and it's not going away in the sense that there's less in estimate. On the Reinsurance side, I'm going to say that collectively as an industry, that might explain some of the exuberance that we've seen on other calls or in the January one renewal.
That loss is largely an insurance loss. That made it a lot harder. Most of our capacity on the cat is allocated to the Reinsurance. It was very hard at the end of last quarter to really evaluate where the losses were coming from. I've asked our team in Bermuda to see what kind of return period that we're looking at for those kinds of losses. We're in a one to 20, one to 30 years, so it's not as unusual as you might think it is. I guess I would just ascribe it to the fact that the losses spread out, and the losses in California, which could have been more concentrated, actually, it's a significant loss, but it's not significant enough that it will have that much of an impact certainly on the Reinsurance segment and on the broader marketplace.
I think it's still possibly also too early. There might be some losses that develop afterwards. There might be some creep of the policy language that may change things. These are things that we'll have to see how they develop. So far, you're right. I think that the missing losses are not missing. They were probably not there to begin with, specifically on the Reinsurance side. Dinos, you want to add?
I will pick up on what Marc said. Yes, the losses in the aggregate, it's three losses, and then you have the California fires and all that. It's still over $100 billion.
Sure. Yes.
It is still over $100 billion. This is not what I would call a small event.
No.
As Marc said, most of the absorption of these losses came by the primary writers. For that reason, the reinsurance market, and especially some of the, what you would call alternative capital did not get hurt as much as potentially could have been hurt. For that reason, that capacity remained in the marketplace, and it got easily reloaded, et cetera. That has an effect as to how you are going forward with the rate. I do not know if Marc in his comments was more specific. In the primary property arena, we have seen gradual improvement on the pricing that is not diminishing. It happened in December, and it is continuing in January, and at the end of the day, I anticipate it is going to continue because that is where the hurt is. Most of the losses are getting paid by the primary company.
It did not affect the reinsurance as much, and for that reason, I think capacity is plentiful and rates have not escalated based on what we were anticipating. Marc mentioned 5%-10%, which is not what we want. If it was 30%, it would have met a threshold, you would have seen us writing a lot more cat business than
The only chapter we have not seen, I think the last of, is the Maria loss in Puerto Rico. That is the only one I would say I would throw it back at you, Ian, in saying it is still not too early, but we still have to see how that one develops. I think Harvey and Irma are pretty much pinned down right now.
Yeah.
I guess-
Ian, let me just throw in one thing. I know you asked an industry question, but as it relates to Arch, especially with Dinos's and Marc's comments about the primary side.
Yeah.
In the prepared remarks, made the comment that there were reinsurance releases, treaty and facultative.
Facultative is a sister process. It's a risk map portfolio, similar to insurance. Attachment point saves you there.
Yep.
The primary guys are ground up, whereas
Interesting
the facultative unit is very skilled at where to attach.
No, for sure. I guess I was trying to ask something a little bit different, I guess, more than sort of the pricing impact or the return periods, but more about, it seems like damageability across the event, across all three events, was a lot less than we all would've thought. To be honest, Marc, it's not just the reinsurance, it's the primaries. I mean, The Hartford released, Allstate released, Travelers released, and big dollars.
That's true.
Right? Everyone's release, it seems like just damageability per claim has been a lot less than the models expected. I'm wondering if there's some Is that an anomaly or do we think there's something meaningful in there that might make us reassess how we think about cat risk?
The only thing I would tell you, Ian, is, you know, I live in Florida. I mean, Marco Island, the eye hit right over my house, et cetera. My house had very little damage, maybe $20,000, because it's built with the new standards.
Okay
It's a Category 5 type of a home. For that reason, the damage I had, it was minute. I can tell you, when I drive around Marco Island, most of the roof damage has not been repaired yet.
Okay.
There's still tarps, believe me, there is price escalation. I have a neighbor that he lost 30 tiles on his roof, the cheapest price he got to repair it was $4,000. That's over $100 a tile. He says, "I'm not getting water in the house, so I'm not going to repair it because I'm going to wait for prices to come down." There might be a little creep that we haven't seen yet.
Yeah.
Yeah.
Yeah. All right, got it. Thank you, guys. Enjoy lunch.
Thank you.
Thank you.
Thank you. I am showing no further questions from our phone lines. I would now like to turn the conference back over to Mr. Constantine Iordanou for any closing remarks.
My only closing remarks, thank you all. It's been a pleasure working with you over the years. Remember, I'm available for good golf games, and I'm available for dinners. I'll see you around. Thank you very much.
Thanks, Dinos.
All right.
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program, and you may all disconnect. Everyone have a wonderful day.