We got the management of Arch Capital, newly appointed CEO, Marc Grandisson, and CFO, Mark Lyons, both longtime leaders at this company. Several years ago, I was with you and Dinos. Dinos Iordanou is the outgoing CEO.
We had a typical meeting in Bermuda, I was struck how much you guys sounded alike. You kind of finish each other's sentences. He finishes your sentences more than the other way.
That's true.
I wasn't surprised when they made the announcement that you would be the next CEO. It seemed to me like a fairly smooth transition. Culturally, your whole management team is about the same way historically. I'm going to start with this topic. You've been with the company a long time.
Yeah.
You are wearing a different hat today.
Yeah.
I would not expect you to make a lot of changes, given what I just said.
Any new CEO wants to put their imprint on the company. I'll turn it over to you to say, how do you want to define your tenure as CEO?
Well, it's nice to be here. Thanks for having us here. Very nice comments on the call, like I told you, very touching, you said to Dinos. Listen, you are right. I've been here since the beginning. Really the core principle and strategy that we started operating on back in 2001 remain very cycle management focused, return driven, try to build a very successful specialty operations, which I think we've done, and I think we've been even successful in diversifying it further with the MI and even some of the stuff we've done in insurance and reinsurance over the years. I've been running the three operating unit for the last two years now. The transition's been two and a half years. I've been obviously building reinsurance and helping being instrumental, I believe, in building the MI company.
Working with insurance now, having one of our core lieutenants from the reinsurance team and now heading up the insurance, I think we had already, but it's going to be more of the same, which is cycle management, margin focus and whatnot. The one thing that we have going forward that's a newer thing for us, and we sort of got it from the MI, is this willingness and ability to do predictive analytics and being ever more focused on slicing and dicing data and try to be better at analyzing it, utilizing all the technology and all the knowledge that we can get access to.
When I was interviewing for the position, CEO position back in 2015, that was one thing I told the board of directors that I want to embark on, it really behooves us, and we need to do this to stay relevant and be better at what we do to try to improve. I think we have all the core cultural aspects of the company very well laid out. Cycle management, risk management, be innovative, diversified, being specialty focused. I think we need, not only us at Arch, but I think in the industry, you heard from Albert, you'll hear from a lot of people in the industry that we need to get better at bringing knowledge and information analysis to the underwriting. It's a bit of a bigger challenge for us.
We're not the Progressive or a GEICO, which tend to have more homogeneous lines of business to analyze. MI certainly would fall in that area. We acquired, as you know, UGC. UGC were the first ones to do a risk-based pricing module on the MI. We independently had started and did that. September of 2015, we had our first RateStar, so that we're already doing this predictive analytics on the MI. We started the same thing on the P&C side, on specialty lines. It's coming on two years now, and we have a team of about 10 individuals. We're going through line by line of business by line of business to try and get better and try to bring this to bear in the market. A lot more focus on this.
I'm not sure it's a departure from what Dinos would have done, but I think Dinos is retiring, so now I'm taking the baton. It's certainly a trend in the industry, and I'm then taking that on. The next thing that I think is also, again, a continuation of what we've done and Dinos certainly was endorsing four or five years ago, is to some expense savings and process management, try to make it more efficient. Our industry, as you guys all know here, also has structural inefficiencies that need to be addressed and all the harder for us as a specialty company. I think it's a challenge that as a company, we have to embark on and we're embarking on as we speak. Other than that, I think in terms of management and a lot less AIG stories without AIG. Probably similar Berkshire Hathaway stories.
Mark and I were both there as well. You're quite right. I mean, been with Dinos for 16 years, worked very closely with him, kindred spirit of sorts in terms of how we come about making decisions, which is always economically rational. I think from a same sort of place to start with economic rationality, being shareholder friendly and return driven, then what decision and what opportunities we'll have in the marketplace will dictate what happens to this company. Certainly the same thing, like cycle management, risk management, innovative and diversifying further while staying a specialty writer is what you should expect more of. I think we're in a good place right now.
We're of a size that probably enables us to, and in a market like MI, which enables us to put some money to work in other places, in investing in areas that I just mentioned, that will hopefully and more likely bear fruit over the next five or six years. Culture, you're right, it's not that much of a difference. I think Dinos is staying as chairman. Mark and I have worked together since the beginning of times as well. I think we've known each other and think alike. He ran insurance, very similar culture here. That's a long story. Too long?
Do you sense there's any concern among investors or clients or brokers that Dinos is stepping down as CEO?
I don't believe so. You could tell me.
I don't hear it from investors
out there.
I don't know if you hear it from the market at all.
No, I think that what we've done in terms of transition period and the way we've done it, kudos to Dinos and the board, it's been a long term. It's two and a half years of transition. I think people got used to it and are used to this. To your point, I was part of investor meeting way back in 2003 or 2004.
Right
I've been doing this ever since. I was publicly exposed with the Watford, raising the money. I don't think there's any surprise. I want to think I'm a known quantity, and probably not as known intimately as Dinos would be, but certainly I don't see anything there.
No, I think it's fine.
If I could add something to Jay on that is, the duality of our P&C platform, insurance buying reinsurance and reinsurance providing reinsurance, allows a lot of different views and contact points between insurers and reinsurers. There's a lot of different aspects in the business, but in terms of key capital management between those two, I think the management teams of both are pretty well-known to each other.
I agree. Yeah. True.
Your company, relative to other hybrid companies coming out of Bermuda, has undergone probably by far the most dramatic change over the past five years with the advent of the mortgage business. When you first were investing in that business, did you envision the extent of the change that we've now seen?
We did not see UGC come in at any point in time. That came as a surprise to us, and I think luck is the residue of design. I think we had seen, though, that the MI market was a very viable and ripe for a company like ourselves to come in. It had all the things that Arch is looking for. Blood on the street, people losing faith in the business, market hard, an opportunity to bring to bear solid management and risk management and cycle management. We're able to pick an asset that was up for sale, and we believe at a fair price. This is the CMG acquisition of 2011.
Sort of say, "Listen, this is going to be the third leg of the stool," like Dinos had mentioned way back then, it's going to be very fruitful and very beneficial, we're going to grow it carefully through time. It's a very great place to deploy capital going forward. With our risk management capabilities, there should be a very long term, like a long-standing place. There's a long-standing place for it within the Arch group. Had we planned that we would be acquiring UGC, becoming the largest provider of U.S. MI? Absolutely not. I think that speaks to the way that we're able to seize on opportunities as they come across, and that we're able to do this. I would say that if we hadn't done PMI or CMG way back in 2011, it would've been probably a bit more difficult to do UGC.
I can see why it's harder for competitors of ours around us to see between two, three, even two or three years ago, how do you get from being a P&C to get into that segment, which still left so many scars, you can see scars everywhere on Wall Street for those bad years. I think by virtue of having been in the space in 2010 and 2011 in a measured way, because the acquisition from CMG was about $300 million. Its acquisition wasn't a big, big bet we made that time. Well, we acquired a very good team, it allowed us to get familiarized with it, get familiar, understand, push, probe, have questions, have the board aware of what's happening, everybody in management team understanding what was going on.
It allowed us to have this familiarity that pushed us over the edge to be able to take on UGC, which was a much bigger acquisition, over $3 billion.
Even before the UGC acquisition, the business was producing some very good profit.
Very much.
The growth, the profitability.
Yes.
Frankly, it was much better than we had forecasted, and I assume my competitors as well. Again, before UGC, were you surprised how well that business did, or was that kind of what you were thinking of?
We were thinking that.
Yeah. Yeah, not surprised at all.
You held your card close to the vest.
It was a perfect storm. As Mark enumerated, there were a lot of forces, positive forces, all converging at the same time that made it very, very attractive. The one thing you'd mentioned, Jay, about we're a different company 5 years and change. Change can be viewed positively or negatively, and Mark commented how the P&C guys are benefiting from the analytics that really came from the mortgage side.
There's a lot going on the reverse. The P&C effectively is giving to mortgage. Being innately P&C guys, Mark, we as Dinos is, I am, we're bringing the mentality of specialty pricing, so risk appropriate to each, not these broad-based items. Secondly, managing tail risk, managing the balance sheet properly, and don't keep everything on balance sheet. The idea of not overtly managing the tail is so foreign to us. We're bringing that to the MI side. That commonality, I think, is important to note.
Is that behind some of your recent disclosure on sort of the realistic disaster scenario?
Sure. That's it. Certainly.
With UGC, and by the way, on the profitability of the mortgage business, I will say Donald Watson tried to tell me. I probably didn't listen well enough, but I got to mention that. With UGC, any surprises seem to be positive at this point. Anything in there that's been a little frustrating for you as you've run in that business?
I can't think of one. I think we were able to extract a lot of expenses out of it that we thought were there. I would even argue that we were surprised on the upside on this one to some extent. I would tell you that the capital markets execution that they brought along for the Bellemeade that they had done prior was as good as advertised and as good as we had thought. They came in and we saw the team and what they could do when we did the Bellemeade 3, as you guys know, last year. That execution was there, the knowledge was there. In terms of pricing, which would have been possibly a clash, right? They had Performance Premium, we have RateStar, it's two risk-based pricing developed independently. There was agreement across the platform like 90% plus on what happened.
At the margin, you change a few things here and there. So much so that now we're accumulating into one combined model. It's going to be more like the RateStar model, not because it's a better model, but because it's more updated and more current. It was more current. The team that developed Performance Premium that was there at UGC is now integrated within our unit. Even the executive team is pretty much half and half working closely together. The client's acceptance, which was something that we were a bit uncertain. You double down and you double up on share of a business from an origination perspective, and there weren't as much overlap as we could have feared. We had seen some of that when we were looking at their clients.
On all aspects, the UGC acquisition has been much better than we would have anticipated. That one we didn't see as well, if you will.
Yeah.
We knew we were getting a great book of business, not as much pre-2009 legacy, very well underwritten. We were happily surprised, by and large.
You were wrong.
With one on one, yeah. Yeah, that's true.
We'll take one error.
Yeah.
On the fourth quarter call, maybe this is for Mark Lyons, you discussed, and I want you to kind of explain it more, but increased risk in the MI business. Not necessarily for you, but you felt the risks were going up. I want you to talk more about that.
Marc, do you want to start? I can start if you want.
No, go.
I think it's not risk as much. Well, there's some risk increase, but I talked about competition increasing a little bit, and there are two clear areas of MI growth over the last couple of years that is ongoing and sort of showed us through the origination that came through in the fourth quarter. One is the DTI above 43, the other one is the-
Can you explain that for people? I'm not sure everyone kind of gets what's.
To have a conforming loan, you got to be 40.
Right.
Debt to income. You calculate how much you have available to pay for your debt service, the higher it is, obviously, the more of your income you need to spend for your mortgage. The higher it is, the riskier it is because the more you have to have aside to pay for your mortgage after you've paid for the common goods of milk, sugar, coffee, beer, whatever you pay, and other things. Yeah, exactly. It's gone up from being about 10% of the market over the last three years to about 21%. In and of itself, it's not a bad sign if you price appropriate for it. We still have very underlying, the borrowers still have a very good risk profile. By virtue of this being a little bit stressed, it's a little bit more risky in relative term.
In absolute term, we still have very good risk, it's relatively getting a little bit riskier. The higher the 95, again, you only put to 97%. Let's use 97%. You have a $250,000 home. You put 2% down or 3% down. You put $7,500 down. You have to finance the rest. You are providing, let's say, 30% coverage as an MI provider. It's a lot riskier than if somebody put 20% down and you're providing 25% coverage. I mean, that goes without saying, right? The person presumably who's done the 97% LTV does not have much to put down. Therefore, one could argue may have lesser ability to repay or be more strained, they tend to go in the DTI, those sometimes go hand in hand. You have a high DTI and a lower paid down payment opportunity.
The riskiness above 95 has gone from about being 2.5% of the market back in 2015 to being 12.5% of the market. Between these two, what we would consider a riskier aspect of the borrower profile, it's closing in on being about a third of the overall placement. There's some riskiness that's going in that direction. It's nothing to be fearful. It's now nowhere near back to the.
That was my question.
Oh, it's nowhere near back.
Do you think it's where it was?
The 21% of DTI above 43 is sort of historically coming, but it is a little bit above historical, but not that much dramatically above. The higher the 95 it's going, it's a little bit on a long-term range, I would argue. It got a bit weird in 2006 or 2007, worse than this. We're sort of reverting back to normal. It's always still at the relative gain as opposed to an absolute gain. Are we still getting the return? Absolutely. We're pricing appropriate for that. We believe that our RateStar grid, which is over a million different cells, accounts for those risks in a more finer way. We believe we're able to pick and choose among that 95 strata and above strata and the DTI above 43, the better risk.
Also for increased clarity for what Marc already said is that that's a commentary within mortgage?
The board mortgage is still our best performing segment.
Exactly.
Far none. This is saying within that segment.
Relative
There's some pockets that it's becoming increasingly competitive.
Yes.
I guess if you didn't have risk-based pricing, you probably wouldn't be able to accurately pinpoint where you wanted to play as well.
That's our argument.
Yeah.
I remember we turned back to you guys is to say, "If we're not getting it, who's getting it?
Right.
Why.
You talked about competition heating up a bit. Where is it coming from, this competition? Can you describe it a bit?
It's just the origination is coming through. This is what we're receiving as an MI company. This is sort of what being originated in the marketplace. The programs that GSEs are supporting in that sort of as a duty to serve. They have to provide services to borrowers from all walks of life, and they're trying to sort of direct the industry towards doing more of those programs. Helping bankers and saying, "We'll buy your loans, and then please do more of these programs, and we'll give you incentives to do this." By virtue of doing this, the market then receives more of those production through. We're sort of living off of what's being produced and originated at the mortgage level, and that's sort of a sign of what's happening right now in the marketplace.
It's not the borrower.
Right.
After we get to that's a shift in the borrower characteristics. It's not changes in the property characteristics. It's not the loan products to which MI attaches. Not IOs that are out there, no docs. Those kinds of crazinesses.
Yeah
Negative amortization and all that aren't there. It's a broadening of the credit spectrum.
Your market share is kind of at a level where you thought it would get to. Should we expect it to stay here, the market share? If it does, should we expect to see much growth in your written premium?
Let me take this. The second piece is important because this is the market that we're playing with. We're seeing, even though the mortgage origination from the MBA will tell you it's going down, there's going to be less refinancing because of the increasing rates. That's the expectation for the next two to three years. People that lived off of the refinancing in our industry a lot more than historical. We're more of a purchase product. Purchase because people who are first-time buyer kind of displace the refinancing. Typically, you refinance because you can get lesser, you have equity in your house, you realize it, you sort of walk away from the mortgage insurance product. Your LTV goes down below 80%. We're much more of a purchase market. The purchase market is actually going to stay stable. The MBA is projecting stable to slightly going up.
Our target market is stable to slightly going up for the next two, three years. We're not seeing the overall pie or the overall pond from where we fish to get smaller. In terms of our market share, I think we are really reacting to, and we put our grid out there. Our grid is out there in the marketplace, and it depends. The market forces will push business to us or push away from us, depending on the pricing that has been quoted by our competition. We certainly have tools and ways to dial up and down to redirect the portfolio the way we want it to be. We're not seeing major shifts in market share, not that we're thinking about it. If we were to, I'm going to take an extreme example.
If the whole market were to go to above 95 tomorrow morning, I would expect us to have much less of a market share, all else being equal, pricing not changing at all. We're not as much of a price taker in that we've been specialty now. We can actually direct pricing. We can actually, to your point, you said earlier, within the grid, there are a couple of areas where there's a bit perceived more fat because the market price is above the risk-based pricing. We might be able to dial in and up, but this is an interactive, dynamic process that we go through. Short answer tell you, I don't know where the market share is going to be. You have to tell me where the market conditions will be.
Yeah.
I will tell you.
For everybody out there that's more of a P&C analyst than MI analyst, the definitions of market share are so radically different. It would be the equivalent in P&C, close to equivalent of only looking at new business, ignoring all your renewal business, even though renewal business dominates your book of business. I like to make the analogy, it's the thin cover on the baseball that we're talking about, not the core of the baseball itself. Our calendar year market share, NIW, is about 45%. We said it would be 22%-23% within three years. None of this surprises us.
Yeah. The new business now that we have attached on the book is about one sixth of the overall risk in the portfolio. We have a lot of past business in the business that's been written prior year that's still generating income.
Any shift in market share wouldn't move your earnings in the near term much at all.
Correct.
Correct.
Right.
Very true.
We spent a lot of time on MI. We have to because it's a big business for you.
Sure.
I wanted to shift, but I wanted to make sure there were not other questions on this topic or others. Scott.
Can I go without a mic or?
We'll get one to you.
I don't mind.
We can hear you.
It's webcast, so let's wait for the mic.
What I want to make sure I understand is what you're seeing. You're seeing some layering in the MI market, right?
You're seeing higher LTV allowances and lower income requirements, but not enough to cause concern. Again, what kind of levels could you sort of give us a marker for what would cause you to pull back, or is that too granular?
I think that by virtue of us putting the RateStar grid on it, we're sort of saying to the market, this is what we'll take, those risk characteristics, and this is for the price we're going to take it. Those market shares on DTI above 43 and the LTV above 95 were underweight. We would have room. If the market goes up to the price, we have room to grow. We're underweight in those segments. We have internal risk management parameters for each. We know any of those boundaries, if you will.
When you talk about market share, again, the baseball analogy is you're saying new originations.
Yeah
is what you would take less of in the place with the originator.
Yeah. That's the definition the industry conventionally has used.
Right. Am I to understand that you would pull back from that, or you would stay there and use reinsurance? Is market share what net you retain, or is it what you might-
Well, it could be. There's not quite as much a robustness as there is in P&C of supply of reinsurance. It's also a developing market on the capital market side to lay off risk. Both are avenues. First and foremost, you're looking to sculpt the gross end of the portfolio with the right risk-reward characteristics.
Other questions? Right here.
You talk about the old book and the mortgage business. How long an old book will exist in your business? Is it 10 years? If a borrower comes up with less than 20% down payment and go with the mortgage insurance with you, how long that business will stay in your book?
Interesting. Okay. The right answer to this one is to look at the persistency that's in there in the portfolio. It's an unfortunate calendar measure. It's hard to predict in the future, right? The persistency right now is about 82%, which is about a six-year run. You have a turnover of over six years. It used to be 75%, so every four years. When the market was going through a refinance, when you refinance, the whole thing gets cut off, and then you just have to re-originate the policy and reprice it if they are still buying MI.
We went from a 75%, which is about four-year duration, if you will, to now about six-year duration right now because of the rates going up, and just as an aside, we would expect this to remain there, if not increase a little bit if the rates are going to go up 50 bps or 60-75 bps next year because it's obviously less willingness to point to refinancing. To us leads me to the third line, the third area of the business where we have told you we would be de-emphasizing somewhat because we didn't see the returns, and we were thinking about those rates going up, the singles. The singles, unlike the MI, don't cut off. You stay on a monthly payment. Once you get 78% of LTV, loan to valuation of the house, this mortgage insurance automatically gets canceled.
This is where it goes away. On a single, it never goes away. You own the risk for as long as you can. That means that you have to hold capital and resources aside for a lot longer time if they never refinance. A lot of the players did a lot of single in 2012, 2013, 2014. We felt was really appropriate because if you were thinking the rates would go down, then those people would just cancel, refinance, and that single premium now becomes a whole earned up front.
On the accounting recognition side.
On the accounting recognition
When they have monthlies, it's written and earned.
Exactly.
Boom. When you have a single, there's prescribed statutory earnings patterns associated with it. The more you have singles, the more your written premium can fluctuate quarter by quarter and slightly on the earnings.
That's right. I think I said give you enough about six, seven years by now.
Let's shift a little bit towards property and casualty. Your view of the market, and maybe because you have opportunities elsewhere, tends to be more sober than others out there. I wouldn't say negative, but realistic, maybe. I'm not sure of the word.
I know happy drugs.
Talk to me about kind of where your outlook is for the next two years. Let's talk about commercial insurance pricing. As you plan your budgets-
We don't do budgets.
We don't do budgets, we don't know what it's going to look like. We're just, I guess, going through the allocation of capital. Units come to us and say, "Hey, we'd like to allocate so much capital to this. What are you guys seeing these are return characteristics?" They are also themselves very sober about what's happening in the marketplace. The last numbers we looked at, and we talked about it yesterday on the call, we have seen some margin expansion on the last quarter of 2017. There is some margin expansion we've seen on our book of business, but it's not very big. It's in the 30 to 40 basis points. It's not very big. It's a good start. It's a baby step, we believe. We see some of it holding to some extent on the January renewal.
I will say that it's not across the industry, across the lines of business. It's focused more on those that one would expect were exposed to cat or had a cat exposure or cat loss. That's clearly driving the rate level to those areas. The problem is we also have a trend, a loss trend that's been picking up. If you look at 2013, 2014, if you look at every underwriting year, a policy year that we look back, the trend used to be in the one-ish percent. Now it's creeping up on 2%. We've had a double up of rate, a trend for the most recent policy year, Jay. We're both actuaries. If you look back at actuaries, we look back at the data we try to develop ultimately. But we only have data for 2017 that's not even two months old, really, right?
Right.
We're barely starting it. We don't know when it's going to end. There might have been, there might be, that's what we're cautious about. There might be a shift in the loss trend as we speak, that 2% trend that I think is happening for 2017 is actually 250 or 300. I don't know what it's going to look like in five or six years in a rising rate environment, claims being adjudicated for five years down the road. That's why we're very cautious. The key thing that you'll hear from us is we don't see the margin of safety. We get a 30 to 40 margin expansion in a mid 7.5% to 8% return. You need a lot of margin of safety to make it work.
Some of it is being captured, as we spoke yesterday on the call, between the interest rate environment increasing by 120 basis points and the tax. The tax really helped the U.S. industry. That's a couple hundred basis points of pickup, rate of return. That just takes us from seven to nine to maybe at the higher end of the range, seven to nine. With the backdrop of that trend and loss trend, not knowing where that's going to end up for the current year and not knowing how long will that percent increase carry on. Will it stick, will it hold? The last thing we will tell you, this is one thing that is a nightmare for us as actuaries and as managers, is what kind of terms and conditions, what have they done.
Yeah
Are we factoring it properly in the marketplace? We're cautiously optimistic. It's tepid. It's positive, but tepid, like I said yesterday. We see the same phenomenon, Jay, because we have so much time left on the P&C insurance, but the same thing on the reinsurance side. We recorded a 2.5% rate increase as of 1/1. We're not seeing the pickup of the rate level that we think are deserved or we need in the property cat. We think the main reason for this is oversupply, still of capital in the industry. In the end, you get a hard market when people go belly up, people go out of business, and it's a getting better kind of market, not a harder market.
Yeah.
At least for now.
From a planning point of view, as you kind of also asked, every line has different characteristics. Not everything moves together. Sea level doesn't all increase at the same time. It's not just the relative change in price, it's what's the absolute return before that.
That's right.
When we go through planning or capital allocation, it's more best guess on marketplace dynamics. If it's a 4% return and rates are up 50% and it goes to 6, you're still not growing. If you're 8 and you go to 12, whole different discussion.
That's right.
All right. We are out of time. That was fast. Thanks, guys, for coming. Look forward to future conferences like this. Thank you.
Great. Thank you.