Good day, ladies and gentlemen. Welcome to the Arch Capital Group third quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will be conducting a question and answer session. Instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.
For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. 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 will also make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website.
I would now like to introduce your host for today's conference, Mr. Dinos Iordanou, Mr. Marc Grandisson, and Mr. Mark Lyons. Sirs, you may begin.
Thank you, Andrew. Good morning, everyone. Thank you for joining us today for our third quarter earnings call. Before I comment on the quarter's results, I wanted to note two items. First, this October represents the 15-year anniversary. I would like to express my gratitude to our employees whose dedication and commitment has built this successful company over the last 15 years. Our employees are not just our most important asset, they are critical to producing the market-leading performance that we have seen these past 15 years. I would like to say thank you to all of them. Second item I want to comment on is about our pending acquisition of United Guaranty Corporation. As you know, Arch has agreed to purchase United Guaranty for approximately $3.42 billion.
Early indications from the GSEs and regulators have been positive, and we are hoping that the acquisition will close late in the fourth quarter of this year, which will minimize the disruption to our distribution partners in the mortgage lending space, as well as the employees of United Guaranty who will benefit from this timing as they transfer to Arch benefits and healthcare coverages as of January one so they don't have to deal with split year deductibles and all the other complications that a different date might produce. Turning to these quarter results, we have a good quarter. Our reported combined ratio on a core basis, which Mark Lyons will define in a moment, improved to 86.5% for the third quarter as CAT losses were light at $10.7 million.
Loss reserve development continues to remain favorable in each of our segments, which in the aggregate reduce our combined ratio by 8.8 points in the quarter. There were no significant changes that we see in the property casualty operating environment in the last quarter. In our insurance segment, we saw a slight deterioration in rates across some sectors, particularly in the high excess and short tail areas, but rates were generally stable in most other lines, while the mortgage insurance environment remains both stable and healthy. Marc Grandisson will give you more details on what we see in each of the markets in a few minutes. On an operating basis, we produce an annualized return on equity of 8.8%, while on a net income basis, we earn an annualized return of equity of 15.3% for the quarter.
As we have told you in previous quarters, net income movements can be more volatile on a quarterly basis as these earnings are influenced by changes in foreign exchange rates and realized gains and losses our investment portfolio. Net investment income per share for the quarter was $0.53 per share, down $0.04 sequentially from the second quarter of 2016. Despite volatility in the investment and foreign exchange markets this year, on a local currency basis, total return on our investment portfolio was a positive 88 basis points, and 91 basis points if we include the effects of foreign exchange in the quarter. Our operating cash flow was very strong at $421 million in the third quarter as compared to $359 million in the third quarter of 2015.
Our book value per common share at September 30th, 2016 was $53.62 per share, a 3% increase sequentially from the second quarter of 2016, and 12.5% increase from the third quarter of a year ago. While some segments of our business have become more competitive, we believe that group wide, on an expected basis, the present value ROE on the business written in the 2016 underwriting year should produce ROEs in the range of 10%-12% on allocated capital. Before I turn the call over to Marc Grandisson, I would like to discuss our PMLs, which are essentially unchanged from July one. As usual, I would like to point out that our CAT PML aggregates reflect business bound through October 1st, while the premium numbers indicated in our financial statements are through September 30. The PMLs are reflected net of reinsurance and retrocessional covers.
As of October 1st, 2016, our largest 250 PML for a single event remains the Northeast at $488 million or 7.4% of common shareholders' equity. I think this is the lowest percentage ever for us. Our Gulf of Mexico PML was at $418 million, and our Florida Tri-County PML increased slightly to $405 million. I will now turn it over to Marc Grandisson to comment on the operating units and market conditions. After that, I think Mark Lyons will share the financial returns in detail before we come back to take your questions. Mark?
Thank you, Dinos. Good morning to all. In the third quarter, we saw continued softening of rates and conditions in a broad P&C world, particularly in the more commoditized line, and as Dinos mentioned, a stable MI marketplace. Our P&C units, both insurance and reinsurance, produced acceptable combined ratios as our underwriters focused on specialty lines where knowledge and expertise differentiates risk selection. As you are all aware, we continued the build-out of our MI segment in the third quarter, where returns are attractive. Turning first to our primary P&C insurance operations, which represent about 60% of our total premium. Rate changes in our U.S. operations were relatively stable in the third quarter at a negative 110 basis points versus a negative 120 basis points last quarter.
As in previous quarters, most of what we at Arch call our controlling low volatility segments, which includes travel, A&H, contract binding, construction, and program business, had rate changes that were in a slightly positive range, 50 basis points, while our cycle managed segment, which includes property, marine, energy, and casualty, experienced single to double-digit rate decreases. Unfortunately, rate decreases are becoming widespread across more business units and have been building over the last few quarters. Increasingly, our business mix is moving towards smaller specialty risks, which have historically performed better in soft markets, given that they are less exposed to the competitive pressures of the broad commercial liability in short tail markets. Globally, property P&C markets remain also under pressure from a rate level perspective.
In the U.K., rate changes across all our product lines averaged negative 5% this quarter, leading us to shift further towards portfolios of smaller risks with lower volatility. Areas of opportunity within the insurance sectors were limited with modest growth recorded in the third quarter in our construction and national accounts, travel and alternative markets line. Most of the growth came because we took advantage of dis location in those areas. Yet, our executive assurance property and marine businesses are areas where rate levels lead us to a continuing defensive strategy of reducing risk. Market conditions in our reinsurance group, which is 30% of our premium volume, remain competitive. Our teams have to be very selective given conditions in their operating environments. Arch's history is that our underwriters have been able to find opportunities that still meet our target returns.
This quarter, specialty areas such as agriculture and motor grew while short tail segments such as property CAT and marine experienced significant rate decreases. We accordingly decreased our writings in those segments. Our strategy at Arch has been to focus on niche areas of opportunities where, as I said earlier, we believe that knowledge and experience gives us an edge. For that reason, given the tough market conditions in any one quarter, our premium mix changes sometimes significantly. Turning to our third leg, our MI segment, which is this quarter 9% of our premium, a growing percentage of our premium earned. We estimated our market share of primary NIW in the U.S. rose to about 10% or 11% in the third quarter from 9% market share in Q2.
We continued our market leadership in underwriting new U.S. GSE risk-sharing transactions, which stood at $2 billion of notional limits in force. We continue to see good volume from our Australian primary insurance relationship. Notably this quarter, we elected to purchase a quarter share on our Australian business to help manage the risk profile of our global MI exposure. While returns on this business remain attractive, we believe it is prudent to manage for potential adverse results. We assess this risk much like we do in our other lines of business in the P&C sector, where we typically purchase protection to limit our aggregate exposures. Our U.S. MI operation increased NIW 36% to $8.75 billion during the third quarter of 2016, of which approximately 79% came through the bank channel. It should be noted that there is seasonality in the level of mortgage origination.
Historically, the second and third quarter have significant higher production than the first and fourth quarters. Our return expectation across our MI segment remains in excess of our long-term ROE target. We expect that for the foreseeable future. With that, I'll hand this over to Mark to cover the detailed financial results. Mark?
Great. Thank you, Mark, good morning all. As was true on previous calls, my comments to follow today are on a pure Arch basis, which excludes the Other segment, that being Watford Re, unless otherwise noted. I will continue to use the term core, as Dinos mentioned in his notes, to denote results without Watford Re, the term consolidated when discussing results including Watford Re. As Dinos commented, we announced the UGC acquisition in August for a consideration of approximately $3.4 billion, subject to a potential dollar for dollar reduction from any pre-closing dividend by UGC to AIG and subject to potential fluctuation due to the collar structure around our common equivalent preferred component. Financing and integration activities are proceeding smoothly as we push for a year-end closing. Before I review our financial results, let me update you on our recent financing activities during the third quarter.
The first is the issuance of 18 million 5.25% Series A non-cumulative preference shares in late September, which raised net proceeds of approximately $435 million, which will be used primarily towards funding the UGC acquisition. Secondly, we negotiated a syndicated bridge loan facility in support of the UGC acquisition of $1.375 billion, the potential use of which has been commensurately reduced for the aforementioned preferred stock issuance. Thirdly, we began efforts to renew our existing credit facility towards increasing the capacity to $850 million, which includes a $500 million unsecured revolving credit tranche and a $350 million secured letter of credit tranche. The new facility has been signed this week, expires in 5 years, and gives us access to additional capital for the UGC acquisition and for general corporate purposes. Please refer to our publicly available SEC filings for more detail.
With that said, the core combined ratio for this quarter was 86.5%, with 1.3 points of current accident year CAT-related events, net of reinsurance, excuse me, reinstatement premiums compared to the 2015 third quarter combined ratio of 89.7%, which reflected 2.3 points of CAT-related events. Losses from 2016 CAT events recorded in the third quarter, net of recoverables and reinstatement premiums, totaled $10.7 million versus $18.8 in the third quarter of 2015. These third quarter CAT losses stem mostly from within our reinsurance operation and reflect a series of small events around the globe with no single event concentration. The 2016 third quarter core combined ratio reflects 8.8 points of prior year net favorable development, compared to 7.1 points of prior period favorable development on the same basis in the 2015 third quarter.
This results in a core accident quarter combined ratio, excluding CAT for the third quarter of 94% even as compared to the 94.5% accident quarter combined ratio in the third quarter of 2015. In the insurance segment, the 2016 accident quarter combined ratio excluding CATs was 97.9%, compared to an accident quarter combined ratio of 95.8% a year ago and 96.3% serially last quarter. This 210 basis point increase between the third quarter of 2016 versus 2015 was driven by 130 basis points in the loss ratio and 80 basis points in the expense ratio. The loss ratio increase was primarily attributable to certain large attritional losses emanating from our U.S. operations. After adjusting for the incremental difference in large attritional losses, the accident quarter loss ratio this quarter is virtually flat with the prior year's quarter.
The reinsurance segment 2016 accident quarter combined ratio exclusive of CATs was 96.5% compared to 94.6% in the third quarter of last year and versus 98.4% serially last quarter. The combined ratio reflected the impact of several excess property facultative losses that occurred during the quarter. The mortgage segment 2016 accident quarter combined ratio was 60.7% compared to 82.5% for the third quarter of last year. This decrease is predominantly driven by favorable trends related to claim rates and claim sizes and the continued expense ratio improvement in our U.S. primary MI book, due mostly to growth along with beneficial mix changes towards the GSE credit risk-sharing transactions. There was, however, one transaction this quarter in the mortgage segment, which distorts the quarter-over-quarter comparison.
Retrocessional coverage was purchased on certain Australian LMI business with loan to values greater than 90% that extended back to the inception of the underlying agreement, which was May of 2015. As a result, ceded premiums this quarter contained an additional $34 million of catch-up cessions, which served to commensurately understate net written premium for the quarter. Regarding prior period development, the insurance segment accounted for roughly 18% of the total net favorable development in the quarter. This was primarily driven by longer and medium-tailed lines from the 2007 through 2012 accident years, partially offset by some accident year 2015 property loss development from our U.K. operations.
The reinsurance segment accounted for approximately 79% of the total favorable development in the quarter, with roughly 45% of that due to net favorable development on short-tailed lines concentrated in 2012 through 2015 underwriting years, and the balance due to net favorable development on longer-tailed lines emanating across most underwriting years prior to 2013. The mortgage segment contributed about 3% of the total net favorable development, which translates to a 3.2 point beneficial impact to the mortgage segment loss ratio, again, resulting from continued lower than expected claim rates. The overall core expense ratio for the quarter was 33.4% compared to the prior year's comparative quarter of 34.2%. This 80 basis point improvement is driven mostly from improved acquisition expense in the reinsurance and mortgage segments, with the latter benefit largely being aided by a higher proportion of GSE business receiving insurance accounting treatment, which has lower acquisition expense.
Additionally, corporate expenses included approximately $6.8 million, or about $0.055 a share, of non-recurring costs associated with the UGC transaction. These costs reflect investment banker fees, bridge loan facility fees, along with related legal, accounting, rating, and SEC fees. Core cash flow from operations was approximately $421 million in the quarter versus approximately $359 million in the third quarter of 2015. This is primarily due to a lower level of net paid losses this quarter versus last year's quarter. Core pre-tax investment income into 2016, as Dinos mentioned, was $66.3 million or $0.53 per share versus $67 million or $0.54 per share quarter over quarter, and sequentially versus $70.4 million or $0.57 per share. The decrease on a sequential basis was primarily due to the effect of low interest rates on fixed income securities available in the market and unfavorable inflation adjustments on U.S. TIPS securities.
As always, we evaluate investment performance on a total return basis and not merely by the geography of net investment income, as exemplified by the $96 million of core realized gains in the quarter. That being said, total return was a positive 88 basis points this quarter, which reflects the impact of foreign exchange at a positive 91 basis points on a local currency basis. This return was led by strong equity, non-investment grade fixed income, and alternative investment results. Our effective tax rate on pre-tax operating income available to our shareholders for this quarter was an expense of 6.5% compared to an expense of 5.7% in the corresponding quarter of 2015, driven by an increased proportion of U.S.-based income.
This quarter's 6.5% effective tax rate includes 50 basis points or roughly $800,000 relating to a true up of the prior two quarters' tax provision to the estimated annual effective tax rate reflected here. As always, fluctuations in the effective tax rate can result from variability in the relative mix of income or loss reported by jurisdiction. Our total capital was $8.24 billion at the end of 2016 third quarter, up 8.5% relative to last quarter and up 2.6% when excluding the recent $450 million preferred stock issuance discussed earlier. Our debt to capital ratio this quarter remains low at 10.8%, and debt plus hybrids represents 20.2% of our total capital, which continues to give us significant financial flexibility. We continue to estimate having capital in excess of our targeted position.
We did not purchase any shares this quarter under our authorized share buyback program, which has remaining authorization of $446 million at quarter's end. Dinos mentioned book value, I will not. With these introductory comments, we are now pleased to take your questions.
Ladies and gentlemen, if you have a question for the speakers at this time, you may dial star, then the number 1 key on your keypad. That's star, then 1. If your question has been answered or if you wish to remove yourself from the queue, you may press the pound key. Our first question comes from the line of Elyse Greenspan from Wells Fargo. Your line is open.
Hi. Good morning. Do you have just any kind of initial insight into what your potential fourth quarter losses would be from Hurricane Matthew?
Early estimates, it's quite early, is that it will be within our CAT load. Let me remind everybody, our CAT load is about $40 million a quarter. What we see on a model basis, we get a number close to the CAT when we see the actual claim reporting activity is much lower. It's too early for us to narrow that number, but it looks to us like it's within the CAT load.
Would that be more of a split insurance versus reinsurance, or is that too early to say?
Right now it looks like it's a 50/50 allocation between the two. About half of it coming from our insurance operation and half of it coming from our reinsurance operation.
Just in terms of the CAT load, that $40 million, I believe, has been fairly consistent, and you did reference your PMLs have been coming down at the lowest level, I guess, that you guys have ever been at. Why overall do you think your CAT load, I guess, for the company isn't coming down when you think about it that way?
I don't think the PMLs came out dramatically. They've been the lowest. If you look at last quarter, this quarter, the PMLs, they came down by a few million on $450 million or $500 million. It's a rounding error. We estimate the CAT load based on two parameters. What is the aggregate PMLs and also what kind of pricing we're getting?
In addition to this, as a result of de-emphasizing high excess and then reshaping the portfolio, you can still have an average that's somewhat more stable, the PML could change dramatically. The shape of our curve has changed as we have gotten away from the high-risk excess area on specifically on the CAT reinsurance.
Okay. One question, in terms of the UGC financials that you guys disclosed with the deal on the accretion double digits in the first year and then 35% about or so in 2017, are you guys planning on taking the intangible amortization through earnings? Are those accretion figures including intangibles?
That reflected an estimate of the mix between goodwill and intangibles at the time as we worked through towards closing and getting much more clarity on what's goodwill versus amortizable intangibles that will modify it. In fact, I think you can see some of that in the prospectus supplement that we had for the preferred offering. Some accounting rules around it, there was more refinement on the intangibles and whenever we go to the markets next, that will have a pro sup, you might see an adjustment there. What matters is what it is at closing, and we're working with our auditors to fine-tune that.
Okay, great. One last question. We're a couple of weeks away from the presidential election. Dinos, I was just hoping if you could just give some high-level views on the potential impact of the election overall just on the insurance industry. Thank you very much.
I don't know. I guess it depends on what happens with the president is going to be Congress and are they friendly to the business environment or unfriendly? Without knowing that, the big issue for the insurance business is going to be on appointment of judges, how the Supreme Court it will be, and it's a slow process, but if we continue in the path of the last eight years, I can tell you that the future is going to be more challenging for the business, and we got to adjust to it because at the end of the day, that's what awards get determined, not only in the cases that they get litigated, but also in the cases that they get settled because the settlement values go up based on the attitude of the court. Not knowing what's going to happen, hard to predict.
Okay. Thank you very much, and good luck with getting the UGC deal closed.
Thank you.
Thank you. Our next question comes from the line of Kai Pan from Morgan Stanley. Your line is open.
Thank you, good morning.
Morning, Kai.
Good morning. First question on UGC. Now you have two months after the announcement speak with sort of external clients, the banks. Is there any indication in terms of a potential market share loss because of concentration issue? How does that compare with your initial thought? Any offsetting factor internally on the expense saving side you can offset some of those?
Well, let me answer the first one. I'll get Marc Grandisson to get on the second part of your question. On the first one, first and foremost, you got to understand that we're running independent of each other. We're still two independent companies. We're going to come together after closing. Our discussions with the market and the clients is separate from the UGC discussions with the market and the client. No indications yet that there is any discomfort about what they do with us or what they do with them. Once we close and we become one company, we'll revisit that issue, nothing so far that indicates any significant overlap that it might be problematic.
Actually, yeah, this is Marc now. Actually, part of the due diligence sort of highlight to us that there's not as much overlap as we might think. Again, the proof is going to be in the pudding after we close the books and we go represent to some of those that we may have overlap on. It's too early to tell right now. In terms of the expense savings or working through the operations, we have teams that are dedicating working very diligently to try to assess and first and foremost, try to understand what both sides have in terms of system and operations and structure to see how we can make something that will be unique and cohesive as we go forward after the close, we're making good progress in that direction.
At that point in time, we're not so focused on to address your question specifically on the expense savings or whatnot if they are there. We are, as we said in August, not doing that transaction for that reason. First and foremost, we think there will be some, we don't know how much it's going to be. Our team are also going through that process. The savings might come not necessarily on a linear basis, we'll have to integrate and get things together. It's very hard for us to tell you anything more than this at this point in time.
Kai, it's Mark Lyons. Let me just add that when we were doing our economic analysis of this deal, we communicated on our call in August about this transaction, we actually anticipate some fall off of market share.
Yeah.
To the extent that there is some marginal fall off, it wouldn't surprise us, and that's been contemplated.
Okay. Mark, any estimates on sort of like additional interest expense for the fourth quarter?
Well, I think, whether what you call it interest expense or not, you can take your five and a quarter, times the $450 and add that in. As far as we're really not in a position yet to discuss timing or extent of any additional offering, but we are striving towards closing at year-end, so there's two months to accomplish quite a bit.
That's great. My second question is really on the core loss ratio, the deterioration year-over-year. You explained that with some higher level of attritional losses in both insurance and reinsurance segments. I just wonder, do you consider this year's large attrition losses sort of normal and or just higher than sort of like exceptionally good results from last year?
No. On the insurance growth, it was a surety loss that we have accounted for it to its full extent. Surety as a line of business, by nature occasionally it will give you that volatility. One quarter you have a big loss, then two, three quarters or no losses. We look at the book and the composition of the book and the long-term performance in making judgments as to how healthy or unhealthy that book is. One quarter event doesn't really give you a trend, so to speak. On a similar case with the reinsurance. This is excess of loss, property facultative transactions, and occasionally that's why you're in business. You take in the volatility from your clients. When it happens, it comes to your books.
That particular unit has been a big money maker for us and it continues to be, I don't attribute that as a trend.
In fact, we looked at the last trailing 12 months accident combined ratio adjusted for all these large losses, and it's actually very stable, which is what we care for. Like Dinos' point, one quarter does not make a trend. Where we are right now, we're very comfortable and very happy with the stability actually of the accident year combined ratio.
Kai, just one more thing to add to Dinos' note about the reinsurance side. The facultative group has been enormously profitable by its nature. Short-tailed excess position is going to be volatile. Any given quarter could be volatile. In our view, there was roughly two and a half, a little more, of long-term loss ratio points that may have been excess of what you normally would see, which translates, if you go back and do the arithmetic, it pushes you to about a 60 or a 59.9 on the adjustment for the loss ratio for the reinsurance group in totality versus 59 the prior year. It's a 90 basis point movement.
Okay, great. Well, thank you so much for all the answers.
Welcome.
Thank you. Our next question comes from the line of Quentin McMillan from KBW. Your line is open.
Hi. Good morning, guys. Thanks very much. I just wanted to touch on the UGC acquisition. You have a footnote in here, that it's dependent on closing the execution of an excess of loss agreement between AIG and UGC. I just wanted to ask if you guys have any clarity at this point on that reinsurance transaction, sort of maybe what it will be protecting you guys against in the future. This is not the Bellemeade Re I or Bellemeade Re II. I'm talking about the third excess of loss agreement, what it's going to protect in the future, and maybe if you've gotten that in place at this point.
A couple layers there. First layer of answer is that between AIG and Arch, we have agreed on the terms and conditions of it. It is not yet signed because we need approval of the GSEs. That's a requirement, and that's part of our discussion with them now. That's the first point. I would say significant progress on that aspect. Secondly, it's an aggregate excess of loss that there's a couple layers involved, but it's effectively 2009 through year end of 2016 coverages. It's an out of the money cover that in the aggregate provides quite a bit of capital relief from the viewpoint of S&P.
Who is going to bear the original cost for that? Is that going to be paid for by Arch, by AIG, or a combination?
It's effectively paid by UGC at closing, so it's an applied book value reduction for the ceded premium.
Okay, great. Then can you help us in terms of the investment yield of the portfolio, when UGC is added in, maybe what is sort of the current yield and/or duration of the UGC portfolio, and how much uplift might that have on the overall Arch portfolio? Will you be using the extended duration of the UGC premiums to extend your own duration or change anything in the overall investment portfolio going forward maybe starting in Q1 2017?
Well, let me start and I'll ask Dinos to say a few words, too. First off, once the closing occurs, the management of that will transfer, of course, to AIM, which is our internal Arch Investment Management. The coupons on that book is higher. It's about 3.3, I think maybe 3.5 as the average coupon. It's a lot of credit book in there which could be reshaped. I think some of that is timing. I would expect it to conform more towards Arch's approach of total return and not just getting lost on the sauce of coupon income. That will morph over time, probably throughout the course of 2017.
Yeah. It will probably take at least two or three quarters for our investment professionals to make whatever changes we feel are appropriate. At the end of the day, it's going to look more like the Arch duration and credit quality than what exists today.
Okay. Just a quick follow-up. The coupon in the UGC book you said is about 3.3 average. What is the Arch current kind of average coupon?
It's closer to two.
Okay. Thank you so much, guys.
Thank you. Our next question comes from the line of Michael Nannizzi from Goldman Sachs. Your line is open.
Thanks so much. Just a couple quick ones. Mark, maybe on the investment portfolio, just the yield or the investment income sort of ticked down sequentially. Looked like there was some seasonality last year, sort of consistent with that. Is there anything that we should think about that's not sort of run rate from third quarter, maybe some mortgage-backed security payouts or something along those lines that would cause it not to be consistent?
Every quarter, it's always a new story. I wouldn't look at it in a trend sense.
Okay.
Back to my total return comment. Clearly our investment group harvested some gains, hence the approximate $100 million of realized gains I noted. Almost, again, based upon our total return approach. You get those gains, and you put some of that back in to the extent to which it's put back into fixed income, you got to deal with new money rates there.
Got it. Okay. You got some harvesting there. Okay, that helps. Thanks. How should we be thinking about the tax rate? I'm guessing the MI impact has caused it to lift here over the last few quarters. How should we be thinking about that longer term once you integrate UGC?
Good question. First of all, a slight correction to what you said. Mortgage was contributory to that, remember, our mortgage segment is very broad, some of that is out of Bermuda and other jurisdictions.
Fair point. Yeah.
The U.S. MI operation clearly was contributing positive underwriting gain at this point. They were contributory. Let's not overlook the facultative unit we talked about on the property side, the insurance group, and the onshore reinsurance group, all were profitable and contributing income. It's really the composite of those, Michael, that actually inched up the effective tax rate. The second part of your question with UGC, we've talked about it on our call about UGC. We plan on having it subject to approval, of course, with the GSEs, a quota share facility in place, only roughly half of those exposures and gains will be resident in the U.S. jurisdictions. It's going to have an uplift, probably not the slope of uplift that you might be contemplating.
Okay. How can you tell what I was contemplating? Did you look inside my
I reverse engineered the first part of your question.
I saw it. That felt invasive.
It was the tone of your voice.
Yes. Thanks. Last really quick one. The Australia quota share, can you talk about sort of just how you're thinking about that on the forward? Is that sort of notionally the right amount that we should be covering in? I'd just love to get a little bit more color on the thought process there, if that's possible.
Yeah. The thought process is more important than the actual specific transactions. With everything we do, we have an overlay of the risk management. We look at our capital, how much risk is prudent for us to carry, and at the end of the day, we look for ways to manage that, and reinsurance is one way to do it. We look at it from a global perspective. How much MI business we have, how much we will retain net to our books, and then the rest of it we insure out. That's the attitude with everything that we do. It's not only on the MI side, it's also on the P&C side, both reinsurance and insurance.
As we said in prior calls, going forward after the acquisition is completed with United Guaranty, we'll be looking at the MI book including the U.S. book and buying the appropriate aggregate protection to make sure that we have, from a risk management point of view, the profit parameters. We always think about PMLs. We think about PMLs also not on the P&C side only, but also on the mortgage side, and that will drive a lot of our decisions. Doing a Bellemeade III, doing an aggregate excess of loss for different years. As Mark told you, the transaction we have with AIG, we'll cover 2016 and probably 2009 to 2016. All those years are taken care of, so to speak. Then for us is what we do for 2017, 2018, 2019 as we go forward.
That's the philosophy and is no different than how we run the group for the last 15 years. Measure approach to pricing properly, and then also making sure we don't take too much of a meal independent how profitable that meal is.
A right before lunchtime comment. I think that's totally fair.
As you can tell from my voice, I'm a little bit under the weather, so the meal for today is avgolemono, which in Greek means egg lemon soup. That's the only thing that cures a common cold.
Well, I won't try to pronounce that. Thank you so much.
Thank you. Our next question comes from the line of Sarah DeWitt from JPMorgan. Your line is open.
Hi, good morning.
Hi, Sarah.
What did you get your latest outlook for mortgage insurance market conditions? One area of concern I hear sometimes that we're late in the credit and economic cycle. How much longer do you think mortgage insurance returns will be good for?
We don't see anything that clouds the horizon. I think it's pretty clear. All the indications is that it's a stable market. Pricing is being stable. The environment is good. We're projecting housing prices to be going up somewhere between 3% and 5% next year. Yeah, there is certain states, especially the energy states, that there might be some issues, but that's what RateStar is all about. We look at adjusting our pricing on the basis of what the risk components are. Long term, we view the market to be very healthy, and there's no indication for us that it's going to change in the next few years.
Additionally, do you expect any FHA rate cut before the election? And what would be the implications of that for you?
I have no idea what the FHA will do, I don't like to guess, at the end of the day. A lot will depend on the actuarial work that is going to be done to see what their capital requirements, if they're meeting the minimum standard. That report usually comes out in mid-November or so for so on. We don't anticipate anything before the election, you never know after the election. Once they take an action, we can gauge what that might mean. Without them doing something, it's very hard to predict.
Okay, great. Thank you.
You're welcome.
Thank you. Our next question comes from the line of Charles Sebaski from BMO Capital Markets. Your line is open.
Hello. Thank you. First, there was a report recently regarding the GSE and some of the risk sharing and regarding some bondholders that are raising issue regarding credit quality from reinsurance and the GSEs offloading that. Do you have any thoughts or have had any conversations with the GSE? Is there any real legitimacy to the amount of risk transfer change going on? Appreciate your thoughts.
No. Basically, the GSEs are interested in having two avenues, the cash market and also the reinsurance market. Their allocation is being pretty constant, so to speak, about 25%-35%, depending on the quarter to the reinsurance market. Then the rest of it, 65%-75% in the cash market. They're being consistent with that approach. Now, I don't believe they have any concerns about the credit worthiness of reinsurers, because at the end of the day, they make the selection as to whom they're going to allocate these transactions to. As a matter of fact, for the GSE is terrific by looking at the credit quality of the reinsurance and allocate what portion of the deal they want to allocate to any particular individual.
All right. I guess on the insurance business, on the LOVOL, you guys had pretty nice growth in some of the travel and accident and some of the other products, and it seems to be marketplaces that there's lots of interest in the LOVOL business today. I was curious if you've seen any additional increase in competition and whether or not your growth is coming from new programs coming out or just kind of grinding it out, doing good work with the existing business and any color.
Yeah. These are product lines that. Don't forget, when we built Arch, we got into product lines that nobody wanted to do back in 2002, 2003, 2004 because some of them, they can be slow growth. Unless you make a major purchase, these things, it requires patience and perseverance to make them meaningful over time. Yes, depending on the cycle, there is more competition or less competition. More importantly, with these kind of products, you have to have a long-term view and a long-term commitment. It will take time to build volume. It doesn't fit with the thesis of instant gratification. You don't get that with these kind of products. We've been very patient and we have grown some businesses from nothing to a reasonable size. Our lenders business grew over the years from some $20 million to over $100 million in premium.
We've tried to find these little nuggets that we work all the time to give us more control of our portfolio, and as Marc Grandisson said, I'll turn it over to you for his comments, that low volatile business is what we like to build most of our insurance group, not abandoning the other segments because the other segments, even though they're volatile, in certain market conditions, you can make a lot of money. If the market is very hard, we'll write a lot of the covers that we're not willing to do today. It's not bad business, it's just bad price business. When the price improves, they're good business.
On travel side, I think I would echo what Dinos' just said, obviously. In addition, we have a couple of new transactions that we've entered into programs that have been very nice going so far. We also are investing, and it's also a very intense technology play, and we are always on the look to build that aspect of the book of business because to your point, it's low volatility, it derives sticky, a lot stickier than other business could be. We are definitely focusing ever more on this. I think the reflection of the premium and our effort, this is sort of a reflection of our efforts in the space, and I think you should expect more in the future.
Good. Thanks a lot for the answers, guys.
Sure.
Thank you. Our next question comes from the line of Ryan Burns from Janney. Your line is open.
Great. Thanks for taking the question. Just had one question. I guess post-UGC deal, does your PML tolerance change at all? Essentially, are you still willing to risk 25% of the total capital, or is that just of the property casualty capital going forward?
No, it's total capital. It hasn't changed.
No change.
No change.
There's no change, really. Yeah.
Great. That's all I had. Thanks.
Thank you.
Thanks.
Thank you. Our next question comes from the line of Brian Meredith from UBS. Your line is open.
Yeah, thanks. A couple of quick questions here for you. First one, I'm just curious, there was a big transaction that was announced of another MI company. What do you think the possibilities are of kind of market share shifts as a result of that? Could that be a positive for you all?
I don't know. You're talking about a transaction with a Chinese ownership.
Yeah.
I think that's an appropriate question to ask to the distributors of the product. This is for banks to determine if they want to continue to do business or not, but not for us. I wouldn't know. I have the faintest idea if their reaction will be positive or negative.
Okay, great. Just my second question, in the news, there's been a couple of articles that you guys hired some pretty high-profile people in the legacy business. Can you guys talk to me about your views on the legacy business and opportunities?
Yeah, I think that we have certainly one individual that joined us, that was obviously publicly discussed. We're exploring at this point. We're really looking around and try to see whether there's something to be done there, whether it's Arch or not. We have all the things on the table. We're exploring what is out there. Certainly we did an LPT last quarter, as you remember. We do think the space lends itself to a level of heightened interest at this point in time. I think we're certainly in a place where rates have been going down in certain sectors and some clients may be running out of patience and tolerance for some books of business. Certainly we are always, and Dinos and I are always looking forward to provide services and products to the marketplace that will help the industry, and that's certainly one area.
We're working through it, when we have something, we'll obviously let you know.
We'll announce the details. Listen, the theme here is every time you come out of a soft market, eventually we will come out of a soft market, there is repair work that needs to be done.
We want to participate in the repairing.
Makes sense. Lastly, I know you talked a fair amount about the retro you bought on the Australian book. I know you guys have great analytics and stuff. Was there anything behind it that you kind of looked at the housing prices in Australia? I know there's a lot of talk about people think they're kind of really peaking out here. Any concerns there?
No concern whatsoever. This is more from an aggregation point of view, how much you want to have from an overall MI book of business because the reinsurance that they participate on the deal, they got pretty good return characteristics. They're going to make some good money on it. At the end of the day, either you add a lot of capital to your balance sheet and you might have maybe a little over-commitment to one line of business versus others, or you try to keep the balance, this was more balancing from our perspective.
Great. Thanks, Dinos. Feel better.
I'm going to try.
Thank you. Our next question comes from the line of Josh Shanker from BofA Securities. Your line is open.
Yep. It's almost not the morning anymore, I'll try and be quick.
Go ahead, Josh.
You mentioned that U.K. pricing down 5%. I sort of associate the U.K. with a lot of specialty markets. Is that experience leading the market down or is that lagging the market? Do we need to be worried about another sort of step downward in pricing for the market in general? Most of your competitors have not been so grim about pricing conditions.
The U.K. market is extremely competitive and has been for a long time, especially the traditional Lloyd's placement in the international business and open brokers. That's been going on for a little while, so it's not new, Josh. In terms of leading where it's going to go, unfortunately, I'm afraid that we'll have to experience further rate decreases going forward. I think there's a lot of competition ahead in the London market, in the U.K. market more broadly. Again, things may change and some event happen, it may change things overnight. There certainly is a lot of competition out there. We don't see anything ebbing at this point in time.
If you don't measure correctly, you can't make good pricing judgments going forward. We'd rather say what we see and you guys make the judgments if others are not willing to talk about it.
Josh, I would add, it's publicly available information. By their own account, Lloyd's has about a 3% on the current underwriting year, about a 3%-4% return expectation, return on capacity. That tells you something about the absolute rate level.
Mm-hmm. If we put on our 1997 to 2001 hats, how hard is it to keep the team together in a soft market and how do you keep everybody content when you can't make money in the business?
I think the shifting in our book of business, people are working extremely hard to transform or to just gradually over the cycle, as we try to do, as we've been working on for the last 10 years to shift towards LOVOL and controllable business, takes a lot of work and a lot of effort. I would just say that it's just a shifting and realigning our expertise and our assets for our people towards different lines of business. Things are transportable across lines of business. It's not like an excess D&O can only do excess D&O. There's a lot of stuff that that person can enhance the culture and the understanding as to how we do cycle management. We try very hard to keep those people and keep them busy doing other things. This is on insurance and on the reinsurance across the P&C units.
There's still a lot of deferred comp they have to earn that they would lose if they left, I would imagine.
Yeah, there is a big component of that's only that. At the end of the day, they know over their career with us, they're going to have good years and they're going to have some not so good years, overall, if they produce for our shareholders, they're going to make very good money. For those who've been here, and we have a pretty stable management, they have done extremely well.
Well, good luck in hard times.
Thank you.
Thank you.
Thank you. Our next question comes from the line of Jay Cohen from Bank of America Merrill Lynch. Your line is open.
Just be quick. My questions were answered. Thanks for the call.
Thanks, Jay. Thank you.
Thank you. Our next question comes from the line of Ian Gutterman from Balyasny. Your line is open.
The menu is of [uncertain]
I heard. My question was taken. I had to think of something else to ask you. Does ouzo help with colds or no?
Yeah. It's Greek penicillin. You add lemon soup, it's Greek penicillin.
I actually want to follow up on Ryan's question about the PML limits. Obviously you're so far away it's not really an issue, but if the market did get better, I guess I'm surprised you would say 25% of the whole balance sheet because that essentially would suggest you're using 25% of PML's capital to write CAT, if you ever got to that point.
You're talking about PMLs in the MI business or the PMLs on the property CAT business or on the London?
On the property CAT when you answered Ryan that the limit is still 25 for everything.
No, the 25% is what our board allows us to risk assuming we like the pricing and the risk/reward relationships, right? The fact that we're at 7.4% today is an underwriting judgment the management team is making, is not a restriction by board.
Sure.
If rates quadruple tomorrow, I can go to 50% of capital exposure on PML without going back to my board and says, "Hey, that 25 is too low and you got to change it." If we change it, we're going to come and tell you because I think shareholders need to know what kind of exposure you take. Don't forget, I don't know what other MI companies do, but we do PML calculations on VMI business also and it's a requirement by our A risk committee of the board, that every quarter we'll talk about how much is our PML on our MI business. That's the reason we had all these discussions about how much reinsurance both quota share or aggregate excess of loss or transactions like Bellemeade I, Bellemeade II, or similar type of transactions we might do in the future.
All of that is around understanding that we have one simple principle, that drives our risk management philosophy that independent of what event happens, we have to not injure the balance sheet to the point that we're not in a very strong competitive position the day after.
Exactly. That's what I was trying to get at. I guess when I heard 25% of everything as the limit, I guess I thought that that's essentially the P&C capital would be whatever that would be, 35 or 40 or something like that. Do you see what I was getting at?
Not quite. I mean, it's.
Okay
I mean.
Fair enough. I got you.
at 25% of equity capital, it's a limit. It's a pretty safe limit for adverse conditions. You're talking about in one in a 250 type of events. The PML calculations that we do for our MI business, it's somewhat even worse than the recent financial crisis we have passed. We have gone back all the way to the Depression era, and factor in a lot of available and skimpy available statistical information, to come up with some reasonable assumptions as to how things might look like if we have events of that nature. We still want this company not only to survive, but to be in a strong competitive position the day after.
Fair enough. The other thing I was going to ask is, I think you mentioned some surety losses are part of the attritional. Can you just remind me sort of how you approach that business? Is it sort of vanilla construction bonds? Does it tend to be-
Yeah
some commercial surety?
It was a construction bond.
Okay
surety. One of our contractors messed up, and we had to step in. You saw a lot of press. It's some stadium up in Connecticut, yeah.
Got it. Is it residential or commercial?
It's commercial surety.
Okay.
It's a building of a baseball stadium.
It's contract surety, but it's a commercial exposure.
Commercial exposure.
Okay. Where I was going with is, how do you think about clash with MI? I know there's not direct clash.
No. Surety and MI, there's no clash there because these are-
Well, back credit cycle, right?
Yeah. I think-
If you have a back credit cycle construction-
between the investment portfolio and that, and that's why-
Fair. Okay.
we don't do RMBS will clash with what we-
MI
mortgage.
Yeah.
We consider that in part of our mix, how we manage the company.
Got it. All right. I think that's all I had. Thanks.
Thank you.
Thank you.
Thank you. Ladies and gentlemen, this now concludes our question and answer session. I'd like to turn the call back over to management for closing remarks.
Well, thank you for listening to us, and we're looking forward to talking to you next quarter. Have a wonderful afternoon.
Ladies and gentlemen, thank you again for your participation in today's conference call. This now concludes the program, and you may all now disconnect at this time. Everyone have a great day.