Good day, ladies and gentlemen, and welcome to the Arch Capital Group first quarter 2017 earnings conference call. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require operator assistance during the conference, please press the star then the 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 risk 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'd now like to introduce your host for today's conference, Mr. Constantine Iordanou, Mr. Marc Grandisson, and Mr. Mark Lyons.
Sirs, you may begin.
Thank you, Chanel. Good morning, everyone, and thank you for joining us today. This is our first quarter to include the combined results of Arch MI and United Guaranty, and we are very pleased with the early days of our integration process. Mark will discuss the integration in more details in a few minutes, but let me say that we are happy with the progress achieved in the first quarter. Although it is still early, we are very pleased with the resilience of the United Guaranty Corporation's customers as they make the transition to our systems and platform, maintaining the strong relationships they achieved with United Guaranty over the years. As we discussed last quarter, our guiding principles for the integration of these companies is to find and deploy the best parts of each organization on a going-forward basis.
I am referring not only to our most important resource, the people who come to work for us every single day, but I'm also including the operating systems, pricing approach, and algorithms, along with all back office functions that they provide customer service. Our number one task is to create a high-quality experience for our customers as we continue to enhance Arch MI's position as a market leader that should earn good returns through the cycle and for many years to come. One additional benefit or opportunity that had come to Arch as a result of the acquisition of United Guaranty is the opportunity for us to move our headquarters of our global services group to North Carolina.
Consolidating the operations over time in one location increases our flexibility to fill jobs that are lost through attrition in other parts of the country to a lower cost environment. Now, turning to first quarter results, our reported combined ratio on a core basis, Marc will define that in a moment, improved by 7.7 points from the first quarter of 2016, led by excellent results in the mortgage segment, offset by the effects of higher attritional and catastrophe losses in our property and casualty segments. Accident year results declined in both our insurance and reinsurance segments, reflecting soft market conditions.
Our mortgage segment improved its accident year combined ratio quarter-over-quarter to 50.4% from 65.8%, 15.4 points of improvement in the first quarter of 2016 as the tailwinds of better credit quality and scale drove excellent profitability at Arch MI U.S. Tellingly, our mortgage segment went from representing only 7% of net earned premiums on a core basis in the first quarter last year to 24.6% for the first quarter this year, nearly identical to the earned premium for our reinsurance segment in the first quarter of 2017. Loss reserve development remained favorable in each of our segments, which in the aggregate reduced our combined ratio by eight and a half points. There are no significant changes in the property casualty operating environment from last quarter. Marc Grandisson will elaborate on what we see in each of these markets in a few minutes.
On an operating basis, we produce an annual return on equity of 10.3%, while on a net income basis, we earn a return on equity of 12.6% for the first quarter of 2017. Net investment income per share for the first quarter was $0.69 per share, up $0.13 sequentially from the fourth quarter of 2016, primarily due to the assets that came over, with the acquisition of United Guaranty. Our annualized pre-tax investment income yield was 2.13% for the first quarter of 2017, just slightly above the level observed in the fourth quarter of 2016. As you know, we manage our investment portfolio on a total return basis, which on a local currency basis was up 170 basis points for the quarter and 164 basis points if we exclude the effects of foreign exchange.
Our book value per common share at March 31, 2017, was $57.69 per share, a 4.5% increase from the fourth quarter of 2016 and a 16.4% increase from the first quarter of last year. Mark Lyons will give more details on the components of the change in book value per share in a few minutes. Before I turn the call over to Marc Grandisson, I would like to discuss our PMLs, which declined modestly from January 1st. As of April 1st, 2017, our largest 250-year PML for a single event in the Northeast was down to $473 million, or 6% of common shareholder equity. This is the lowest we ever had it in our history. Our Gulf of Mexico PML was at $383 million, and our Florida Tri-County PML decreased to $386 million.
I will now turn it over to Marc Grandisson to comment on our operating units and market conditions. Marc, over to you.
Thank you, Dinos. Good morning to you all. Before I review market conditions across our segments, I am pleased, as Dinos alluded to earlier, to report that the integration of UG and Arch MI is going very well with focus on high customer service to maintain or improve our relationships. While the strength of the combined entities is already apparent, we are working diligently to unify the USMI operations, and most notably, we have decided to base our U.S. mortgage insurance headquarters in North Carolina. We believe that there will be additional opportunities to realize efficiencies without jeopardizing our customer relationships, and we will keep you informed as those efforts materialize over the next several quarters. At the end of our first quarter as a combined global MI company, our expense ratio for the segment declined to 29%.
Over the next few years, we are targeting a mid-20s expense ratio in the segment as the business matures. Our new insurance written, or NIW, was $12.7 billion for the first quarter, an increase of 8% over the same quarter in 2016 on an as-if combined basis. We estimate that Arch USMI's market share remained in the mid-20s for the first quarter of 2017, consistent on a pro forma basis with a 26% market share indicated last quarter. The current premium yield was essentially unchanged with the last quarter's level. Over 75% of our NIW came through our risk-based pricing platform. Rising interest rates in the fourth quarter reduced the volume of refinance activity and accordingly led to an improved level of persistency, which came in at 77%. The purchase market accounted for 85% of our volume this quarter.
The overall quality of the risk written is still very strong and stable, with average FICO scores of 743 and our monthly singles mix at 82% and 18% respectively, meeting our post-acquisition objectives in the quarter. Arch also continued to build on its position in the U.S. GSE risk-sharing transaction with approximately $2.2 billion of risk in force at the end of the first quarter of 2017. Arch remains a lead market for this type of risk transfer execution. Finally, our Australian mortgage insurance relationship continues to generate a good flow of business and contributed roughly $4 million of profit for the quarter. As this business is all single payment upfront, its contribution to profit should grow with time as premiums are earned over the life of the mortgages. Moving on to the P&C insurance world, which represents 50% of our own premium.
As we have indicated on prior calls, market conditions remains challenging. Rate decreases have slowed somewhat but are still broadly less than loss trend. This is especially true for larger excess accounts, which tend to be more commoditized. The rate change differential between our segments is wide, reaching 410 basis points in the U.S. for the first quarter, a positive 140 basis points rate change for the lower volatility line, and a negative 270 basis points for our cycle-managed business. As a result of that market dichotomy, all of our P&C segments continue to move towards smaller accounts and more specialized areas of the market, and are walking away from accounts when returns are not acceptable. In our primary U.S. P&C insurance operations, we had margin erosion of 70 basis points for all lines in the first quarter.
To borrow an expression from Dinos, we have seen what's cooking in the kitchen before, and we don't like the taste of that meal. Turning to reinsurance, which represents about 25% of our earned premium this quarter, it's a similar story in that we continue to focus on the few opportunities that have relative rate strength and more favorable returns while we are de-emphasizing the more commoditized segments as rate and loss trends continue to erode margins. Reflecting on the current trends in the broader reinsurance market, I am reminded of the old adage that I heard often from Paul Ingrey, "Volume is vanity, profit is sanity." Allocating capital judiciously is a cornerstone of our corporate mandate. As we sit here today, mortgage represents one-third of our allocated capital, 25% of our net earned premium, and 70% of our underwriting gains at a mid to high teens ROE.
We're happy to have the flexibility to allocate capital across our three platforms to the markets which are generating good returns, and we believe that this flexibility allows Arch to generate alpha with more stable returns for its shareholders. With that, I'll hand this over to Mark to cover the detailed financial results.
Thank you, Mark, and good morning, everyone. Given that this is the first full quarter after the UGC acquisition, I am going to provide more focus on that associated impact on the call today. First, though, I'll highlight just a few items about this quarter, but as a reminder, the usual quarterly topics can be found in the earnings release in the associated financial supplements. Okay. Now I'll make some summary comments for the first quarter, all on a core basis. As Dinos referenced earlier, the term core corresponds to Arch's financial results excluding Watford Re, whereas the term consolidated includes Watford Re. Claims recorded in the first quarter from 2017 catastrophic events net of reinsurance recoverable and reinstatement premiums were $12.3 million, or 1.2 loss ratio points compared to 0.5% in the first quarter of 2016 on the same basis, mostly emanating from within our Reinsurance segment.
The activity was primarily driven by Australian Cyclone Debbie and various other smaller events around the globe. Again, we believe that this result continues to highlight our property cat underwriting discipline as actual reported losses on cat events continue to correlate with the exposure reductions that have been implemented over the last several years. As for prior period pure net loss reserve development, approximately $83 million of favorable development was reported in the first quarter, led by the Reinsurance segment with approximately $57 million favorable, the Insurance segment of about two million favorable, and the Mortgage segment providing nearly $24 million of favorable development.
Nearly all of the Mortgage segment favorable development emanated from the U.S. portfolio and a meaningful portion, or $8.2 million, stemmed from favorable development resulting from subrogation recoveries on mostly second lien and other portfolios that came over as part of the UGC acquisition and that are in fact runoff operations. These subrogation recoveries have been reflected in UGC's historical results over time and could continue this year and in future years, depending upon the associated claims management of the files. The Reinsurance segment net favorable development was across most underwriting years for short and medium-tailed lines, and predominantly from the 2003 through 2013 underwriting years for long-tailed lines. The calendar quarter combined ratio on a core non-Watford base basis was 78.8%, and when adjusting for cats in prior period development, the core accident quarter combined ratio was 86.1% compared to 92.4% in the first quarter of 2016.
The Reinsurance segment accident quarter combined ratio excluding cats of 97.6% compared to the first quarter of 2016's 94.2%, while the Insurance segment's accident quarter combined ratio excluding cats was 97.8% compared to 94.9% in the first quarter of 2016. Both results reflect higher loss picks due to current difficult market conditions. The reported Insurance Group accident quarter excluding cat loss ratio increased approximately 150 basis points quarter-over-quarter, and after controlling for large attritional losses and mix changes increased approximately 70 basis points, which Marc Grandisson referred to earlier. Competitive conditions in the PC markets, however, were more than offset by the continued improved profitability of the Mortgage segment, amplified with their net earned premium being a larger proportion of the total.
The mortgage segment's accident quarter combined ratio improved 14.4 points, as Dinos referenced, quarter-over-quarter, and their net earned premium represented nearly 25% of the total core net earned premium compared to only 7.4% in the corresponding quarter of 2016. Remember that in the mortgage segment, accident quarter has a different connotation than in PC, and is more similar in concept to claims made businesses in the PC space since the notice of default defines the assignment to the appropriate quarter. Similar to last quarter, there were some expense costs in the first quarter resulting from the UGC acquisition. You may recall that since the acquisition occurred at year-end 2016, only the balance sheet was impacted in the fourth quarter, not the income statement. This quarter, we have a full income statement reflection of the combined portfolios.
As for the referenced expenses, the company incurred $15.6 million of such pre-tax expenses related to the UGC transaction in the quarter, as compared to $25.2 incurred serially in the fourth quarter of 2016. The sources of costs were different, however, as this quarter, the costs emanated from UGC acquisition-specific bonuses, severance, and outplacement costs, and trailing UGC transaction legal costs. More specifically, the UGC-specific bonuses and transition compensation costs totaled $6.8 million pre-tax, and severance and outplacement costs totaled $8.2 million, resulting from reduction in force actions taken on January 31st and March 31st, affecting approximately 205 employee positions and 60 contractors. The actual salary compensation recognized in the first quarter associated with these employees involved in the risk in-force efforts was $4.1 million.
Given that the January 31st reduction in force only had one month of salary expense reflected in the quarter, and the March 31st reduction in force had a full quarter of salary expense reflected, a $5.7 million quarterly run rate savings of salary expense is anticipated. We will comment in future quarters about any other actions taken and their financial impact, but these figures reflect only the impact of reductions in force that have already been implemented. Given the nature of these expenses, we have excluded them from operating income as they are not indicative for our true underlying performance. I'd also like to remind everyone that we issued approximately 12.8 million common equivalent shares to AIG as part of the UGC purchase price.
They had an insignificant impact last quarter on average common shares outstanding, given the 12/31 closing date, but had a material impact this quarter as the diluted weighted average common shares outstanding increased to approximately 139 million shares this quarter versus 125.4 in the fourth quarter of last year. I bring this up because I still see analyst reports and conversations still utilizing pre-common share equivalent numbers. We're using that in all our statistics, and we recommend you do, too. As respects the effective tax rate with our changing portfolio and geographic mix, I provided full year 2027 indications on the last call that the expected tax rate on pre-tax operating income would likely be in the low to mid-teens range.
In the first quarter of 2017, our tax rate on pre-tax operating income was 14.4%, with 100 basis point additional reduction to 13.4% stemming from a change in GAAP accounting affecting stock compensation. I'd like to point out that we expanded our U.S. primary mortgage insurance disclosure in the financial supplement to provide enhanced information by book year or underwriting year for the P&C analysts for loss reserves, insurance in force, risk in force, and delinquency rates, as well as aggregate NIW splits between monthly and single premium policies, as well as providing our PMIER sufficiency ratios on a consolidated U.S. MI entity basis. I also want to highlight the difference between the U.S. primary mortgage division's gross versus net risk in force. At the end of the quarter, the gross risk in force is $60.6 billion, whereas the net risk in force is 28% lower at $43.6 billion.
As we have consistently implemented in all our segments, our ongoing mortgage strategy is to maximize profitability while simultaneously protecting the balance sheet. The existing quota shares that are in place, along with the existing and ongoing excess of loss and capital market protections, provide this aggregate and tail risk balance sheet protection we seek. As for after-tax operating income EPS accretion realized in the first quarter of 2017 from the UGC acquisition, we examined our results with and without the impact of the UGC acquisition, giving due consideration to associated debt financing interest costs, preferred stock dividend charges, and intangible amortization. The realized beneficial accretion from the transaction was nearly 25% on a reported basis. Just to remind everyone, we had previously provided long-term operating income per share run rate accretion indications over a multi-year period of being in the 35% area.
It is important to reemphasize that this long-term reportable accretion is expected to accelerate as the 2017 and later book years become more impactful on a net basis in future quarters, as the benefits from reductions in force and other actions, such as duplicative system eliminations over time, are also realized in future quarters. On a GAAP basis at March 31st, our total debt to total capital ratio was 20.6%, and total debt plus preferred to total capital is 27.7%, which is down 100 basis points from year-end 2016. This leverage reduction was due to our growth in common equity as our debt and preferred levels were unchanged from year-end. Consolidated operating cash flows were down $111 million relative to the first quarter of 2016.
The first quarter operating cash flow was generally lower on a seasonal basis, the timings of higher retrocessional and reinsurance premiums from our reinsurance and mortgage groups, respectively, drove a majority of that change. We did not purchase any shares during the first quarter of 2017 and don't anticipate repurchasing any during the balance of 2017. As a reminder, our remaining authorization is $446.5 million, which has been extended through year-end 2019. Dinos mentioned our growth in book value per share of 4.5% from last quarter, it's important to note that this stemmed from both strong underwriting and strong investment performance. With these introductory comments, we're now pleased to take your questions.
Operator, we're ready for questions.
Thank you. If you have a question at this time, please press the star then the one 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. If you're using a speakerphone, please lift the handset. Our first question comes from Jeffrey Dunn of Dowling & Partners. Your line is now open.
Thank you. Good morning.
Hi, how are you, Jeffrey?
Good, thank you. I was hoping to get a little bit more color on the incurred loss development in the MI side this quarter. First, can you give a better idea in terms of the improving claim rates? Are you seeing that from your late-stage bucket or more of the mid and early-stage delinquencies?
I think on the U.S. side, you're going to see that. Remember, that's kind of a report quarter view. We're not seeing that, or we're not recognizing it as much in the more recent report quarters as it would be for ones a little more aged. I think, Jeffrey, part of what we might want to discuss, given the size of it, is that, I've mentioned that most of it's coming from the U.S. business. About $1 million came on the reinsurance side, so it's kind of insignificant. There was, on subrogation, on a cash received basis, on the establishments to normalize our accounting policies between the two consolidated entities now. Subrogation reserves put up. These are normal course, but they were scattered between first lien and second lien and other portfolios that were there. They've been there historically. They're there now.
The fact that most of it is in runoff doesn't mean that they're going to dissipate. They'll fall off a lot more slowly over time. Hopefully that answers your question.
Your comment about the favorable roll rates is more on the subrogation HELOC exposure, not necessarily the primary book?
No. Well, the primary book, yeah. You're still seeing some improvement, they're not coming from the 2016 report quarter. I believe it's 2015 and a little bit backwards.
Okay, the 12 plus. All right. On the current period provision, can you give us an idea of the incidence assumption for the new notices and how that compares to maybe the pro forma result a year ago?
I actually don't have that in front of me. You're talking about the claim rate?
Yeah. The initial claim rate assumption on the new notices.
Jefferies, I think that's going to have to be something we channel back through Donald Watson to you. Sorry, I simply don't have that in front of me.
Okay, great. Thank you.
Thank you. Our next question comes from the line of Kai Pan of Morgan Stanley. Your line is now open.
Thank you, good morning. On the MI expense saving opportunities, it looks like if you look at legacy Arch as well, UGC, the other operating expenses add up to about $60 million, and this quarter's down to $40 million. Is that run rate going forward, or there are, say, other opportunities? The other way to ask it is that you're targeting a 25% expense ratio over time, now it's 29%. You think that improvement's more coming from the absolute dollar amount reduction, or more from the top-line premium growth?
Let me give it a shot, and I'll give it to Marc to get into the details. We didn't make projections even though internally, we have certain things in mind because I want our teams, as they integrate, to do it in a fashion that improves our long-term opportunities to be as efficient and as effective without affecting customer service with our competitors. Having said that, a lot of it is going to come from redundancy in personnel that it will get eliminated over time. Marc gave you a number. In the first quarter, we have eliminated approximately 270 positions. On April 1st, there was an additional 97, which is going to be as part of our report card we're going to share with you in the second quarter, not knowing what else is going to happen in the second quarter.
I'm not putting undue pressure on our people to hit certain numbers. Our instructions, Marc and I, is do the right thing with the idea that if we don't need certain individuals, see if we can reassign them into other jobs, look as we lose in attrition in other parts of the organization. That's one of the reasons we even moved our global services headquarters down there because it allows us to manage the workforce in a much more efficient basis. We're not just focusing on United Guaranty. We're looking at every operation, and we do that as a matter of course independent if we made an acquisition or not. That's the prudent way of managing. In addition to that, you got to get into systems and back rooms and not just headcounts, but where does that headcount reside and is a cost differential.
For example, a New York job is much more expensive than a North Carolina job, and a job in the Philippines is even less expensive than a job in North Carolina. There will be additional savings. We don't know how to push the pencil and make calculations, but we don't like to promise things to influence good judgment. We'd rather report after we take the actions than trying to hit a particular number.
Yeah. I think what I would add in terms of the question, the top line is not going to change significantly just by virtue of being an MI portfolio. It's very sticky, it's very straightforward. A lot of monthlies coming in depending on our market share. For the remainder of the year, for foreseeable future, we don't see much change. It's really, to answer your question more directly, what Dinos did, it's going to be really as a result of absolute dollar reduction as opposed to premium related ratio.
We are, I'll add, Kai, as Mark alluded to, wouldn't be felt as much in 2017, which is probably the model question you're asking.
Right.
On a longer term basis, as the impact of the AIG quota share, 50% quota share on 2014, 2015, 2016 underwriting years starts to lessen, and we're writing 2017, 2018, where it's 100% without the quota share coming in, that'll start to flip and you'll see increasing growth on a net basis for your denominator.
Without changing the personnel.
Correct.
You know the quota share has a 30% seat, so at some point in time, that it will revert to our benefit.
Okay. That's very clear.
If I'm the 25 is not We think we're going to be, over time, below that number. At some point in time, we say, hey, 25 is something that we're trying to achieve, 25% expense ratio. It can even be better than that over time. All I want is efficient operations with good customer service. At the end of the day, we want to not have an unlevel playing field with our competition. We monitor that. How do they do things? Are they better than us? What things we need to do to improve? I don't want to have a structural disadvantage. Traditionally, over the last 15 years, we didn't allow that in our operations, and we won't allow it in the MI space either.
Correct. Yeah.
Great. Is there a restatement in terms of the legacy, like a large MI, like expenses?
I guess there's two things you could think of. I wouldn't say there's a reclass associated with the intangible amortization, where in the mortgage space or others, we had it more above the line. Now we have it below the line. Because it was our goal to be very transparent on the UGC tangible amortization, it only makes sense to make that a corporate-wide approach. Yes, there would've been a reclass, and that's why some of the prior year may look a tiny bit different than it was when you looked at the numbers last year. It's a good catch.
Okay. Lastly, just remind us what's the lockup period for the AIG preferred shares and do you have a call flexibility or first right to repurchase that shares?
It is identical to when the SPA was signed, which is a third at six months, two-thirds cumulatively at 12 months, and 100% cumulatively at 18 months.
Yes, sir.
Do you guys have the capital flexibility to participate?
Yes, we do.
All right. Thank you so much.
Thank you. Our next question comes from the line of Elyse Greenspan of Wells Fargo. Your line is now open.
Hi. Good morning. When you guys announced this deal with UGC in August, you guys had said about 50% of earnings would come from P&C and mortgage. I know we have the underwriting income, which shifts to about 70% in mortgage. Would you say that the mortgage market has gotten better or the P&C market's gotten worse than the view that you had, I guess, when you announced this deal and laid out those metrics to us in August?
I mean, you're looking at it in the very short time. In the short time, your question is, and your conclusion is correct. I think the P&C, both insurance and reinsurance, has deteriorated because we're not getting rate increase to keep up with trend. In essence, is eroding, that means you're going to write a little less than you wanted to, the profitability might not be a little less than what you want to. Having said that, I think every indication on the MI space is that things are better. Delinquencies, they're better. In essence, the credit box has not deteriorated, is as good as it was at that time.
You got to take our comments on the long term, because in everything that we do, we have a long-term view and we make judgments as to where we're going to play, how much capital and resources we're going to allocate on the long-term view. Right now, I can tell you, green lights on MI, amber, not red, but amber lights on the P&C, both insurance and reinsurance. Having said that, I can't predict the future. I don't know if the P&C cycle changes and at what time it's going to change. I can tell you, don't forget, our roots, the P&C, it doesn't mean we're not going to do a lot on the P&C space given the right market opportunity. We're not reducing the group capability from an underwriting perspective.
As a matter of fact, I think it's fair to say we have a bit of overcapacity in underwriting talent, which we're going to maintain. The cost associated with that is insignificant when you weigh it versus the opportunity when the market turns. Is it going to turn two years from today, three years from today? I don't know. I can tell you, when it does, we're going to know it, we're going to take advantage of it, we will have the people. We're not going to be chasing people to take advantage of it. Anything you want to add, guys?
Yeah, just one quick thing, because I think it's easy to get lost in the sauce. It's a good observation. That's the underwriting gain or loss, Each of those businesses have a little different durations. Reinsurance group may have more property cat, The insurance group may have longer tail lines, it's a higher proportion, they're bringing in more investable assets, and so forth. When you look at underwriting, if you brought interest income in, it would be skewed a little bit-
Differently
differently away from mortgage.
Okay, great. Dinos, following up on your comments, you mentioned loss trends on the property casualty side. Do you think if we start to see a higher level inflation, which it seems like you and some of your peers are pointing to, do you think the industry will take price to combat higher inflationary levels?
I don't know. You're thinking very logically. That's a mistake in our business. The emotions that drive markets is fear and greed. Right now, I don't see greed out there. I see some concern, I don't see fear. Yes, there is some concern. As a matter of fact, I think the canary in the coal mine is the commercial auto liability, who has a short tail, and is starting to percolate and bubble up in a lot of places. You see it on the riders of commercial auto. You see it in penetrations on the umbrellas which is part of the mix when you ride excess liability umbrella, you're covering that portion of the risk too. You're seeing a reaction in the reinsurance market, it's not easy to find auto carve-outs anymore, The pricing is going up.
Is that an early indication that maybe GL might be a problem in the next year or two, and then workers' comp maybe later on, and might create that environment that people say, "Hey, we got to adjust pricing in all three lines going forward?" I don't know. We can't predict the future, but I can tell you there is stress in the system because it requires more rate increases than we're getting, and we're not keeping up with the trend. It sounds to me like 1998, 1999 all over again, that the frog is in the happy water, but the temperature is going up.
I think in addition, I would just add to what Dinos just said, the other dimension about the fear and greed is that underwriters or companies underwrite also with the assumption of what the interest rates are going to be in the future. The inflation goes up and interest rate goes up accordingly, if not more, it generates all kinds of different behaviors. I would argue that even in this day and age, in the last two to three quarters, there is probably an expectation of rate increasing in the future that might explain why some of the pricing is still softening as we speak. There's a lot of stuff, there's a lot of things moving in the marketplace. There's more than one just number that really drives everything.
Okay, great. Do you guys have a forecast for mortgage industry NIW for 2017, and what share that would be for Arch?
We have expectations, and then we do follow the MBA and the Freddie and Fannie, and we look at what they do and what they produce. We would look the same data that you're looking at. In terms of NIW, we have, of course, no projection we think we're going to be accomplishing, but we're not at liberty to share that. Frankly, we're going to be reacting to whatever market situation presents itself in the next year or so. We don't spend much time, if you will, projecting what NIW is going to be in the market. We have a good place, a good positioning with our clients, and we try to do the best thing. As we said before, our market share over time, we expect might decrease in the low to mid-20s. That also could be something that happens by attrition.
Yeah.
A lot of things are moving.
The pleasant surprise for us, I don't know if it's a surprise, it was basically, we didn't see much overlap between Arch MI and United Guaranty. There was only one major customer that both of us were significant participants, and they reduced our combined share just slightly in the first quarter. There was no other change from any other major customer. That's why I talk about the resilience of the customer base of United Guaranty. Basically, we are trying to do the best job possible, not only to maintain the service at a very high quality, but also improve upon it. That's what I've been emphasizing to our staff. That's why I said, "Let's not focus on integration, of cost savings up front at the expense of customers.
We're going to focus on excellent customer service, and over time, we're going to get very efficient in how we provide that." I think you can do both if you're a well-managed company.
Okay, thanks so much, and congrats on a great start to the year.
Thank you.
Thank you. Our next question comes from the line of Sarah DeWitt of J.P. Morgan. Your line is now open.
Hi, good morning. Just first a follow-up on the share buyback. I think you said you wouldn't buy back any stock in 2017. Just to clarify, if AIG did sell you would not participate?
Well, there's optionality in there. It's a decision tree, basically. As I stated, overtly, other than those possibilities, we're not going to be going out.
Buying back shares
Buying back shares.
Yeah. Our theme there, Sarah, is we always want to have flexibility on the balance sheet. Right now, our debt and hybrid is at about 27 point something %, of which about 4.5% or so is short-term revolving facility. That doesn't give us a lot of capital credit with the rating agencies. At some point in time, my first action with excess capital, maybe I can reduce that down, then we'll revisit the share purchase in 2018 and beyond. Don't forget, I don't know when AIG is going to decide to sell, I can't answer that question. If they're selling in 2017, we probably could likely who would not participate. If it's 2018, it's an open question.
Okay, great. Thank you. Separately, I wanted to get your thoughts on some of the practices of the insurance brokers. Chubb was critical of some of their practices, particularly in London, said there could be regulatory or customer backlash, now they're being investigated by the FCA. I just want to get your thoughts on some of the practices, do you see any regulatory risk with your current distribution channel?
Listen, at the end of the day, distribution cost is part of the business. It's been always part of the business. Some people view it as transactional. I think it's more than that. Some of it is transactional. Some of it is advice and counsel, et cetera. It's all buried into some number. The ultimate arbiter of if that's fair or unfair or sustainable is the customers themselves. They know that both our revenue and the broker's revenue comes from only one source. It's out of premium they pay. If they don't like what's going on, they have ways to change that. At the end, that's a customer decision. Now, you asked the regulatory question. We believe, at the end of the day, that the insurance and reinsurance business is highly competitive and we're strong believers in the free market.
At the end of the day, if the customer is satisfied and nobody's doing anything that is illegal, which the regulator has a say in it, let the market decide if it's fair compensation or unfair compensation, the buyer of the product is the person who counts the most.
Okay, great. Thank you.
Thank you. Our next question comes from the line of Nicholas Mesick of KBW. Your line is now open.
Hi, good morning, guys.
Good morning.
Last year you discussed the way to think about mortgage earnings volatility as the micro or underwriting decision and the macro changes. Now you assigned two-thirds of the volatility on the micro and one-third on the macro. Given the different composition of the book today with the UGC acquisition, how would you expect a change in either of those sensitivities?
Actually, what I said last year, it was 70/30, not 66% and two-thirds and 33% and one-third.
Sorry.
I'm sticking to that 70/30 because we did analyze a lot of back data through the financial crisis as to what was causing defaults. We compare it with other environments. For example, what happened in Canada, where all day, no verification loans, et cetera, they were not allowed, and there was a minimum of 5% down payment requirement. If you go historically and you see the performance of the Canadian book of business, it was much different even with the same economic conditions, not only affecting the U.S. but affecting Canada, and what the outcome of that business. The 70/30 hasn't changed. What I'm saying, what we're seeing, I think the ability of MI companies to go back to the very loose underwriting standards that were common during the financial crisis in 2006, 2007, 2008, in the future, they'll be much more difficult.
First of all, managements, they saw companies go bust, so they're more resilient on the risk management side of the business. More importantly, I think the technology is much better today in analyzing individual mortgages and attributes that affect that. Also, more importantly, the GSEs, both Fannie and Freddie, with the PMIER approach, and as regulators of MI companies, they're a lot more resilient in their approach of maintaining stability on the balance sheets of the companies that they provide them the counterparty risk.
I think right now, exactly, David, what's going on, there's no change from last year because really what drives the losses, and we've seen historically, is the products that were offered in the marketplace. We've seen no change in the products offering. To echo what Dinos just said about the GSEs being really wary or at least very attentive to what's happening in the marketplace, they had an increase for the discounted LPMI business as of last year, recognizing that that might represent a bit more risk to the system. There's really a heightened level and still a high level of scrutiny and attention paid to the product that are delivered in the business. No change from last year.
Okay. Thank you both, Dinos, apologies for misquoting you.
Well, no, I just like It's my test as I'm getting old, I'm 67, that I'm still sane. I haven't.
You're 67. That's two-thirds, one-third.
That's age.
Just one follow-up. Last quarter, you referenced your door being broken down by people wanting to get a piece of your business through reinsurance. Just wanted to check on the status of the door and in turn, demand for the reinsurance of your portfolio, in particular, the MI book.
It hasn't changed, like I said, we're here to feed our shareholders first, and then if we have extra, we can be charitable to others. This is good business. Within our risk management limitations, we will continue to have our shareholders in mind first, and then our reinsurance partners and others second.
Okay, thanks, and enjoy lunch.
Thank you.
Thank you.
Thank you. Our next question comes from the line of Josh Shanker of Deutsche Bank. Your line is now open.
Yeah. Good morning, everybody, or almost end of the morning.
Morning.
Hi, Josh.
Hi there. Following up on the last question, I want to know why it does or does not make sense to think about MI the same way we think about CAT. Is there a PML that you have, maybe you're not going to tell us what it is, but do you calculate something like that?
Yes, we do. You got to think on the concept of what is a ruinous event, right? A severe recession, housing prices collapsing, et cetera. We build these models that we model, then we calculate what, based on the book that we have, what the macroeconomic effect of those events. They don't happen like a hurricane that happens in one day, and you know the next day. It's going to be more gradual, but at the end of the day, if you're riding the business, you got to be cognizant of that. We model that, and we have a tolerance, and the tolerance is no different that we don't want to commit on these, what I will call catastrophic events, more than a probability of us of losing 25% of our common equity capital. That limitation is still there. It's a Board limitation.
I mean, myself and the rest of the management team, in our discussions with our Board, they say we want to know what is the maximum loss that you're willing to have on a stress scenario. We want to understand what that stress scenario is all about, and that's how we build our model around it. Mark, you want to elaborate?
The only thing I want to add, Josh, it's not exactly like a cat book of business because you're going to have future premium coming in. You have to factor in an S&P type of PML. That's what Dinos is alluding to. We have to factor that in because it's part and parcel of what we're assuming as part of the policy. The policies, those that don't default continue paying premium for the future, and we take the credit for that as well. Just want to make sure it's not a one-off event, as Dinos said, that happens overnight. It's an over two or three-year period development. We take an S&P type of approach.
Josh, I think just one other thing. It's a good question, especially given the relative size of it to our organization. Thinking-wise, you got to learn from the past. I mean, anything that erupts that can cut across underwriting years. We learn from asbestos in the GL. We learn from environmental in the GL.
D&O
D&O. Anything that can signal it, you can break it down that these lines have at least a component of CAT. I think more so in the mortgage space, but we think about that in every line of business.
Let's just take a scenario. I look at the business right now as not only well underwritten but also well-priced.
Yeah
Even if pricing were to decline, it still might be well underwritten on the mortgage-by-mortgage level, therefore avoiding the risk of a quote, unquote, "catastrophe.
Well, you're not avoiding the risk, totally the risk of catastrophe, because even well underwritten business, if you have higher unemployment, you're going to have hardships. Your default rate is going to go up. If you're going to have house prices collapse, that means the claims that you're going to have, they're going to cost you more. At the end of the day, those you can't avoid. That's the part, and I put that round number of 30% of the problem in the past crisis was macroeconomic events, which affected, for example, the Canadian book of business. It didn't cause companies, their profitability suffer, but they were still profitable, and they didn't go out of business. What caused collapses in the U.S., it was all these crazy stuff like how do you underwrite a no-verification loan? You don't know the information you're getting is correct.
How do you factor in these old days or 110 LTV stuff? There was a lot of craziness that went into the mortgage space at that time.
When the cat market gets irrational, Arch can say, "Look, someone else can underwrite this business. There's 100 other companies who know how to write property cat and let them chase the market down." When you're only one of-
Exactly right
When you're only one of 57 participants, what does that mean when the market gets irrational?
Well, the market gets irrational, that means you got to maintain your discipline. Our hallmark as a company is that we have been disciplined underwriters. As long as I breathe, this team, which I have 1,000% confidence is they're going to be disciplined underwriters. It's our DNA. For better or worse, it's our DNA. The Arch DNA is disciplined underwriter. Be patient, disciplined, and at the end of it. Thank God we got a board who understands that.
I never had a discussion with my board that says, "Oh, your volume is suffering or" They never talk about volume. They do talk about profit and margin, and are you taking undue risk. That we talk all the time.
Josh, the one thing that's unfair to really compare it to a cat because a cat, in January 1st, I don't know that there's going to be a hurricane in September that hits Florida.
Right.
If I'm running mortgage and we have indeed in our company have the proper early warning systems in terms of risk quality, we can actually take actions way ahead of things percolating up. It's a decision as to where we put the red line or the yellow line as to when we start de-emphasizing it. We do have access to that information. Frankly, Dinos has said this in prior calls, if the people that were running the business in 2006, 2007, 2008, had heeded those calls and those points and those clear indication signals in the marketplace, they wouldn't have put themselves in that position. It's not like you wake up one day and the risk quality was as good as it gets, and overnight everything goes down by 20% and the unemployment goes from five to 25.
You have a lot of products that are newer. You have time to react.
PMI was recognizing segments of their business into what we would call the red line.
Yeah
All the way back in 2004, they did not take action. As a matter of fact, they increase their participation in everything that their monitoring systems, it was showing red. Meaning Alt-A, no-doc loans, they became 28% of their book of business because a lot of the customers, especially Countrywide, et cetera, it was threatening them. It says, "You don't write all the bad, you're not going to get the good." Well, I said this before, you give me three glasses of Kool-Aid and one has cyanide in it, I'm not drinking it. Even though the other two, they're very refreshing and I'm very thirsty, I'm not drinking it. Basically, that's what the industry did. They were given three glasses, one had cyanide in it, and they down all three of them.
I appreciate the image.
I don't want to be graphic, I tell you, when you're running a company and you got your shareholders' capital, and you got 3,500 employees in your hand, you got to feel like I feel. You got to be very responsible, not only for the capital, but also for the welfare of the employees.
Josh, that was three Kool-Aids, not three bourbons. Just, yeah.
The bourbon would neutralize it, I'm sure.
One other thing, if I could, Josh, and Dinos.
Yeah
Mark have talked about this before, but the history was that the MIs took all the risk on their balance sheet, 100% in, 100% retained.
Right.
That's clearly not part of our strategy. That's the strength of the PC side. We can't think any other way than simultaneously managing balance sheet. Maybe Dinos, I'll kick it to you, but the benefit of going to capital markets and reinsurance as a leading indicator unto itself.
You always have to have a loop to the market. By purchasing reinsurance and capital markets products. You always have a compass as to how other people think about the product. Are you pricing it well or not? If you can't shed risk in an effective way, that tells you're the patsy. You better start shutting the doors because you're not doing the right thing.
Thanks for all the answers, I think I've been very unfair to Ian, I appreciate the time.
Thank you. Our next question comes from the line of Brian Meredith of UBS. Your line is now open.
Yeah, thanks. A couple quick ones here. First, Mark, can you tell us what was the impact of the AIG quota share on your premium this quarter? Just kind of trying to figure out kind of going forward how that's going to kind of play out.
Yeah, we have that. Okay, hang on.
Well, you want to know the cession to the AIG?
Yeah, the cession to the AIG quota share.
Yes. Okay.
Was there anything unusual in this quarter that would have elevated it versus what it would look like going forward?
No.
No.
Okay.
Yeah. I'm trying to give you a ratio because I think that's what you're after. Bear with me.
Oh, you don't want to give him the amount, eh?
Just give me the U.S. dollar.
I'm an SOB when it comes to Okay.
Brian, he doesn't want to give you the amount. He has it in front of him.
About-
70%.
20. About 20%. Let me go up here.
No, exactly.
Let me go up here.
You have a ceded premium.
Yeah. It's about 70% of the ceded premium. I was going to give it to you of the net, but that's easier. Yeah.
About 70% of the ceded premium is the AIG. Okay.
Yeah.
Just trying to figure that looks going forward. That's kind of generally think about it, kind of just gradually kind of trending downwards over the next couple of years.
No.
No?
I would think that would, over the next three to five quarters, could be trending up and then trail down because of the nature of the monthlies and the way they get recognized.
Don't forget, the quota share covers '15-
'14.
2014, 2015, and 2016. The United Guaranty book goes all the way to 2007, 2008. We still have mortgages all the way back from 2007, 2008. They're still paying premium. It's not as easy to calculate it, but a lot of the old stuff will be coming off more of the newer stuff. Depends on the persistency of those years, the 2014, 2015, and 2016. We think that calculation is going to probably increase it a little bit, and then it will come down later.
Gotcha. Okay. Helpful. Then, second question, I'm just curious. When you talked about the expense savings, could we expect some in some of the other areas, reinsurance, insurance also, just given the relocation of the services of businesses operation?
The relocation, we're not going to just take a lot of people and relocate. We have attrition, right? Attrition usually is around 10% in our operations worldwide. Basically, we lose roughly about 300 positions every year. We decided that North Carolina is a better place for some of these back rooms that premium audit, some clearance systems, some booking things, et cetera. Gradually, we'll be moving. We lose a job here, instead of replacing it in a, I don't know, high-cost environment, we go into a lower-cost environment. That process has been with us all along. We have operations in Nebraska. We have operations overseas in other parts of the world. That's ongoing. The reason I mention it is because North Carolina, based on our statistics, it has about a 30% cost advantage from New York, New Jersey, California, let's say.
Over time, we're not trying to displace people, as we lose people, we'll be moving that. Gradually, you're going to see the benefit coming through. We do that on our day-to-day operations. As a matter of course, we do that all the time. That's what our managers are getting paid to do, make sure that we're cost effective.
Gotcha. The last question, I wondered if you could give us your perspective right now on the political landscape with respect to the mortgage insurance business, particularly related to the FHA. If you get some changes going on there, what do you think the potential is for market share kind of shift back to the private MI, what do you think UGC or Arch could get?
It's very hard to predict. Clearly, the FHA has more market share than they need to. You're not going to hear that only from me, from
Everyone
MI CEO will say that. It should be in the private sector, not on the taxpayer. Having said that, I don't know what they're going to do. The share of VA, FHA in combination is probably a little north of 55%. That's way too much, in my view, to be on the public back.
I think what I would add to this is there are a lot of things that we also have available to us in terms of providing MI insurance
Not only to primary, but there's clearly still an ongoing focus on deleveraging the GSEs and the MI to the third party to private capital. That is not stopping. It's actually most likely going to be accelerating over the next year or two. The one thing that we're thinking about collectively is we're agnostic as to, in general, how we would allocate the capital in terms of primary MI or CRTs to the extent that it shifts to that direction. We're essentially able and willing to provide the risk on a private basis either which way the FHFA decides to go. Right now, we don't see any cause to be concerned in terms of the existence of the MI industry as it is.
We believe that the CRTs that we've been participating on are going to grow in size, and it's not going to be most likely instead of the MI primary, it's going to be in addition to the MI market.
Got you. Great. Thank you.
Thank you. Our next question comes from the line of Ian Gutterman of Balyasny. Your line is now open.
Dinos, my first question is when you're planning these moves to North Carolina.
What's for lunch? Let me tell you.
No. Okay, well tell me.
It's at the request of Marc Grandisson. It will be grilled halloumi cheese from Cyprus with tomato, cucumber on pita bread, and that's the sandwich for the day. He's salivating already. Get to your question so you can go and eat.
My first question was, when you made this decision to move all these people to North Carolina, did you make sure there was a good Greek restaurant in the neighborhood for them?
I have a few cousins who might be interested in going down to open a Greek diner down there. I'll leave it up to them.
I actually had a couple questions on the P&C business, just on MI quickly first to maybe ask a little bit of a takeoff on Josh's question and your response about the crazy conditions in the U.S. 10 years ago. Australia sounds like it's kind of getting to that point, I know you've obviously bought some reinsurance to help manage your exposure there, how concerned are you about the Australian market right now? Just the HPA seems crazy, and you hear all these anecdotes about things going on to get loans and get houses and so forth.
Well, you're always concerned on everything you do, but I'm not fearful of the Australian business for two reasons. First and foremost, there seems to be a little frothy housing prices in two major cities. Right? Having said that, the frothiness is on loans that they're larger than what we insure. These are in the three quarters of a million and up market. When you look at it from an exposure point of view, the things that we insure, the more on the lower size of homes. The Australian market is also a full recourse market, which is different than the U.S. In that sense, the individual is responsible for repaying the loan beyond the ability of the residual value of the house to make up for the loan over time. It's a different characteristic to the market.
In addition to that, I think the APRA, which is their regulator, regulates both insurance and also the banks. They have some strict rules about what loans get approved, and the stress test they put them to be able to qualify for the loan. It's a 200 basis point stress test on every loan on interest rates movement because a lot of the loans in Australia are adjustable. They don't have these 15 and 30 year fixed rate mortgages. Mark, you want to elaborate further on it or? I would agree with that. I think the portfolio, as a result as well, Ian of the current, we're also looking at the same process.
We have an economist who we spend a lot of time reviewing, and he confirms exactly what Dinos said, which is there's a couple of areas, spots of frothiness, but it's confined to the larger dwellings or larger condominiums, and also a lot of investors coming from outside. They pay cash. They don't buy insurance. Exactly. Even if they were to, what we tend to focus on are the lower risk, and we don't do the investors loan as much. We've curtailed and shifted the portfolio towards the more single dwelling, owner-occupied house down under. To your point, we still, despite all this, went out and bought a quarter share and we've got partners there to help us in case we would be a bit too optimistic. We don't think we are, but just to be prudent in terms of right-sizing the whole portfolio.
We're cautiously optimistic. We're comfortable.
Got it. That makes a lot of sense. On the P&C business, Mark, the insurance segment, the reserve releases were pretty de minimis this quarter. Was that less sort of gross releases, or was it sort of the normal amount of releases and there were some adverse in pockets offsetting it?
I think the latter. I think that we are seeing as I said in my comments, as Dinos and Mark both alluded to, the market we're seeing pick up in severity in the market across lines of business. Certainly it started in commercial auto, you've heard that story more than once.
The auto component in umbrellas-
Exactly
as well.
There's a lot more coming. We are of the mind that it's going to get a bit worse before it gets better again. We tend to take, as usual, a prudent approach to reserving. We might take a bit more long to recognize what looks like good news. Frankly, a lot of people around our clients, we've seen it, some of them have, we believe, recognized too early good news and are in a position to having to redirect or recorrect that, and we would like to avoid that at all costs. That's a little bit of, in some activity, in severity, some activity and some losses coming through, but certainly a holistically, corporately more prudent view on the ultimate reserve development.
Ian, that's a direct benefit from the multi-platform we have.
Yeah.
That the holding company guys see. You can see other ceading companies and steer-
That's right, yeah
on the insurance that way.
Yeah.
Understood. Sort of similar to that is the higher accident years in both the insurance and the reinsurance. Other than, I guess, probably the elevated FAC losses, is this sort of a reasonable run rate given where rate and mix is? I mean, unless the mix changes pretty dramatically.
It's the best case for the current accident year. Listen, the first year is a self-grading exam, and we try to do the best we can, but I can tell you, things are not as good as they were a year ago, and for that reason you got to recognize some on the current accident year, right?
Yeah, Ian, again, that what I just talked about, the reserve development, what transpired in the last quarter informs us in going forward as to what we think the ultimate underlying fundamentals of the business is. As you heard, we're losing margin, and it's being eroded as we speak, it behooves us to do the right thing, which is to be, again, that much more prudent on the current accident year. That's what you're seeing right now.
Got it. Then just finally on that, Dinos, I think you mentioned earlier some may be rhyming with parts of the late '90s, and the one thing I guess I noticed looking at reserves across the industry, I'm assuming you guys have looked at these sort of trends.
Yeah.
It looks like the initial IBNR has been coming down every year for the past three, four, five years, and it's now getting to a pretty low point. Do you agree with that trend? Does that concern you that even though loss trend's been benign the last five years, it seems to be now reflected in IBNR?
Yeah.
I'm asking from an industry standpoint, not Arch.
Give me another month or two. We're going to finish our study. I do this macro study with Donald Watson about the industry reserve levels and all that. I look at cash flows, underwriting cash flows, et cetera. Give me a little time, then we'll share that study with you. Maybe that might be my five minute in Investor Day, because the guys wanted me to only have five minutes with you guys.
Good luck with all that.
On this, or?
They want to put me with a chef, so I'll be grilling.
Yeah. The Albacore.
At the end of the day, I think it's an interesting question.
Yeah.
Yes. It feels to me from other indications. Let me give you an example. I won't mention names because it's embarrassing. We lost an account that it was a high deductible account that, in essence, it was about $10 million in premium, and we lost it to a competitor for $3. To me, it is the definition of insanity.
Yeah.
I mean, either you're totally naive, you don't know what you're doing, or you can beat me by going to $9. You don't have to go from $10 to $3 to get the account. That means they're uninformed, don't understand what they're doing, and the brokers are taking advantage of them because I can tell you, they never knew that the expiring premium was probably $10 million.
The other thing, Ian, on that won't be in their renewal pricing monitor.
Of course.
When it raises to four, it's a 33% increase.
Right.
Exactly. It's funny how that works. All right. Thank you guys, appreciate it.
Thank you.
Thank you. Our next question comes from the line of Jay Cohen of Bank of America Merrill Lynch. Your line is now open.
Actually, my questions were answered. I tried to hit the right buttons to remove myself, but I failed. Thanks for all the information. Great call, guys.
Thank you.
Thank you.
We'll continue to try to perform for the shareholder.
Thank you. I would now like to turn the conference over to Mr. Dinos Iordanou. Dinos?
Well, thank you all for your attention, and looking forward to talking with you next quarter. Have a wonderful afternoon.
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect.