Good day, ladies and gentlemen, and welcome to the Q3 2015 Arch Capital Group Earnings Conference Call. My name is Emma, and I will be your operator for today. At this time, all participants are on listen-only mode. We will conduct a question-and-answer session towards the end of the conference. If at any time during the call you require assistance, please press star zero and an operator will be happy to assist you. As a reminder, this call is being recorded for replay purposes. 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 Law. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainty.
Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts or 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 it's available on the company's website.
Now I'd like to turn the call over to Mr. Dinos Iordanou and Mr. Mark Lyons. Please proceed.
Thank you, Emma. Good morning, everyone, and thank you for joining us today. Our third quarter earnings were driven by solid underwriting results, while investment returns were impacted by decline in the equity markets. Group-wide and on a constant dollar basis, our gross written premium increased by nearly 4% in the third quarter over the same period in 2014, while net written premium was up approximately 1% as underwriting actions in our insurance and reinsurance business were offset by growth in our mortgage business. Changes in foreign exchange rates reduced our net written premium on a U.S. dollar basis by approximately $21 million or 2.4% of our volume in the quarter.
On an operating basis, we earn $126 million or $1.01 per share for the third quarter, which produced an annualized return on equity of 8.6% for the 2015 third quarter versus a 9.7% return on equity in the third quarter of 2014. Looking at it from a trailing 12 months ending in September 30, 2015, after-tax operating income available to Arch common shareholders produced a 9.9% return on average common equity, while net income available to common shareholders produced an 11.6% return on average common equity. On a net income basis, we earned $0.60 per share this quarter, which was lower than operating income, primarily due to realized investment losses. Net income movements on a quarterly basis can be more volatile as these earnings are influenced by changes in foreign exchange rates and realized gains and losses in our investment portfolio.
Our reported underwriting results remain satisfactory as reflected in our combined ratio of 89.7 and were aided by a low level of catastrophe losses and continued favorable loss reserve development. Net investment income per share for the quarter was $0.54 per share, up $0.01 sequentially from the second quarter of 2015. The strengthening of U.S. dollar impacted total return on the company's investment portfolio, which declined 31 basis points for the 2015 third quarter. Our operating cash flow, excluding Watford Re, was $359 million in the third quarter as compared to $319 million in the same period a year earlier, primarily reflecting a higher level of premium collections. Our book value per common share at September 30, 2015, was at $47.68 per share, a slight increase from the second quarter of 2015 and an increase of 8.3% from September 30, 2014.
With respect to capital management, we continue to have capital in excess of our target level. However, we did not find many opportunities to repurchase shares in the third quarter that would meet our previously stated criteria for share repurchases. As you may recall, our philosophy with respect to share repurchases is based on the relationship of expected returns to the premium to book value, with the exception that we could earn the premium back over a reasonable period of time. Considering the underwriting environment we're operating in and the returns we're achieving, we believe that it would take more than 3 years to recover the premium paid. With respect to overall market conditions, reinsurance industry pricing remains under pressure. Today, we have not yet seen significant erosion in the insurance business, with the exception of certain lines, which I will discuss in a moment.
We believe, however, that the ability to buy reinsurance by us and our competitors on favorable terms will eventually lead to more competitive conditions across the insurance industry in the future. As we have discussed in prior calls, there are several areas in the insurance sector that are experiencing increasingly more price competition. They are E&S property, global property, large accounts, professional liability lines, including D&O, especially in the foreign markets, as well as marine, aviation, and energy, business lines in which we continue to reduce our exposure and our participation. Turning back to our quarterly results, the insurance segment's gross written premium on a constant dollar basis grew 5.6% and 2.8% on a net written basis in the quarter over the same time period in 2014, with most of the growth coming from our construction and national accounts, travel, and accident and health business units.
Mark will comment further on premium volume in a few minutes. In our reinsurance segment, we responded to soft underwriting conditions by reducing gross written premiums on a constant dollar basis by approximately 2% over the same period of a year ago. Increased cessions primarily to Watford Re in the quarter led to a further reduction in our net written premium, also on a constant dollar basis of 6% for the quarter-over-quarter comparison. Our mortgage segment includes primary mortgage insurance written through Arch MI in the U.S., reinsurance treaties covering mortgage risk written globally, as well as GSE credit risk sharing transactions. Beginning in 2015, third quarter, the current quarter, new credit risk transactions now follow insurance accounting, which Mark will discuss in a few minutes.
Gross written premium in the mortgage segment were $74.7 million in the third quarter 2015, or a 12.5% increase than in the same period, same quarter in 2014, driven primarily by growth in Australian mortgage reinsurance premium, along with Arch participation on GSE credit risk sharing transactions. Net written premium grew 14.3% over the same period to $66.4 million, as we retain a higher percentage of Australian business written in 2015. Our U.S. mortgage insurance operations produce approximately half of the segment's net written premium in the third quarter, with $24 million coming from the credit union channel and approximately $8 million of premium written from the bank channel. Of note this quarter, underwriting income for the U.S. operations move into the positive territory with about $2 million of underwriting income in the quarter, reflecting the slow but steady progress we're making in this area.
We continue to make progress in the expansion of the bank channel, as Arch MI has approved 835 master policy applications from banks, and more than 350 of these banks have submitted loans to Arch MI for underwriting. In the third quarter of 2015, we reached a modest milestone when new insurance written within the bank channel of $1.8 billion surpassed our credit union production of $1.4 billion of new insurance written. While we continue to see good opportunities in mortgage reinsurance, the GSE risk sharing transactions issued by Fannie Mae and Freddie Mac are becoming an important component of our mortgage segment's revenues. We pioneered one of the first of these structures over two years ago by building upon the expertise of our mortgage team and working with the GSEs to provide insurance coverage.
Since we're talking about innovation in the sector, it might be worth a minute now to discuss the introduction of RateStar to mortgage lenders last week. We began this project approximately five quarters ago with a goal to develop a more robust risk-based pricing tool that in many ways will parallel what we do across our entire enterprise and is a hallmark of the Arch underwriting group approach. To us, the current rate card approach, which uses just two factors, FICO scores and loan-to-value ratios, while very important variables, oversimplifies the issue. Our team reviewed the very rich proprietary data that we acquire from PMI and other available industry data that would allow us to establish an appropriate price for the recent exposures assumed. RateStar will enable us to more effectively allocate capital and calculate the appropriate risk-based returns on mortgage insurance at the individual loan level.
While this may be a relatively recent innovation for the mortgage insurance industry, with United Guaranty the first to introduce a risk-based pricing tool, this approach has been utilized in our other lines of business within Arch for many years. As many of you know, the return on risk-based capital serves as the basis of our incentive compensation plan. Our underwriters are paid on the basis of what profit they produce on allocated capital. We are pleased that we are now at the point where we are making the appropriate filings and where appropriate, seeking regulatory approval for mortgage insurance and expect to introduce this into the marketplace during December of 2015. Let me now turn back to the overall market conditions. Across all of our markets, insurance, reinsurance, and mortgage conditions are competitive to varying degrees.
Arch's diversified mix of business and our willingness to exercise underwriting discipline should allow us to continue to generate acceptable returns. Group-wide, we believe that on an expected basis, that the present value ROE on the business we have written this year will continue to produce an underwriting year ROE in the range of 10%-12% on allocated capital. Before I turn it over to Mark, I would also like to discuss our PMLs. As usual, I would like to point out that the cat PMLs aggregates reflect business bound through October 1st, while the premium numbers included in our financial statements are through September 30th, and that the PMLs as reflected net of reinsurance and retrocessions. As of October 1st, 2015, our largest 250-year PML for a single event remains in the Northeast at $509 million, or approximately 9% of common shareholders' equity.
Our Gulf of Mexico PML decreased to $473 million as of October 1st. Our Florida Tri-County PML also decreased to $414 million. I will now turn it over to Mark to comment further on our financial results, and after his comments, we will come back and take your questions. Mark?
Great. Thank you, Dinos. Good morning, all. As was true on last quarter's calls and the last few quarters, my comments to follow today are on a pure Arch basis, which excludes the Other segment, that being Watford Re, unless otherwise noted. Same as in previous calls, I will be using the term core to denote results without Watford Re, and the term consolidated when discussing results that includes Watford Re. Okay. The core combined ratio for this quarter was 89.7%, with 2.3 points of current accident year cat-related events, net of reinsurance and reinstatement premiums, compared to the 2014 third quarter combined ratio of 88.5%, which reflected a lower level of cats at 1.6 points.
Losses recorded in the third quarter from 2015 catastrophic events, net of reinsurance recoverables and reinstatement premiums, totaled $18.8 million versus $14.2 million in the corresponding quarter last year, primarily emanating from the Chilean earthquakes and the California fires, along with various smaller events. The 2015 third quarter core combined ratio reflects 7.1 points of prior year net favorable development, net of reinsurance and related acquisition expenses, compared to eight points even of prior period favorable development on the same basis in 2014's third quarter. This results in a core accident quarter combined ratio excluding cats for the third quarter of 94.5%, compared to 94.9% in the third quarter of last year. In the insurance segment, the 2015 accident quarter combined ratio excluding cats was 95.8%, compared to an accident quarter combined ratio of 98% even a year ago.
This 220 basis point improvement was driven by 150 basis point reduction in the loss ratio and a 70 basis point reduction in the expense ratio, with the loss ratio decrease reflecting lower large loss attritional activity than was the case in the third quarter of last year. Taking this into account, the insurance segment accident quarter loss ratio was slightly higher this quarter versus the third quarter of 2014. The reinsurance segment 2015 accident quarter combined ratio, again excluding cats, was 94.6% compared to 90.6% in the 2014 third quarter. As noted in prior quarters, the reinsurance segment's results reflect changes in the mix of premiums earned, including a continued lower contribution from property catastrophe and other property businesses. This quarter, most of the combined ratio increase relative to the third quarter of 2014 stemmed from the expense ratio and from a marginally higher level of larger attritional losses.
The mortgage segment 2015 accident quarter combined ratio, excluding cats, was 82.5% compared to 88% for the third quarter of 2014. This decrease is predominantly driven by the continued low level of reported delinquencies benefiting the loss ratio associated with the CMG business we acquired in 2014, along with excellent credit experience to date on business written since the acquisition. Some of the benefit on the CMG business is offset by the contingent consideration earn-out mechanism negotiated within the purchase agreement. As we commented on last quarter, an accident quarter approach to the mortgage business is not have the same meaning it does on the PC side because of the way the business works and the way the accounting works.
The insurance segment accounted for roughly 16% of the total net favorable development this quarter and was primarily driven by medium and longer-tailed lines, predominantly from the 2007-2012 accident years. The reinsurance segment accounted for approximately 78% of the total net favorable development in the quarter, excluding associated impact on acquisition expenses, with approximately 39% of that due to net favorable development on short-tail lines concentrated in the more recent underwriting years, and the balance due to net favorable development on longer tailed lines, predominantly from underwriting year 2009 and prior. The remaining 6% of the net favorable development emanated from the mortgage segment, which reflects the continued improvement in the U.S. book delinquency rate.
Approximately two-thirds of our core $7.3 billion of total net reserves for losses and loss adjustment expense are IBNR and additional case reserve, which still continues to remain fairly consistent across both reinsurance and insurance segments. The core expense ratio for the third quarter of 2015 was 34.2% versus the prior year's comparative quarter expense ratio of 33.5%, partially driven by a 3.6% decrease in net earned premiums. I will discuss each segment's expenses shortly. The insurance segment's expense ratio decreased 70 basis points to an even 31.0% for the quarter compared to 31.7% a year ago. The net acquisition ratio decreased 90 basis points, whereas the operating expense ratio increased by only 20 basis points. The insurance segment net acquisition ratio reduction continues to reflect materially improved treaty ceding commissions on an earned basis associated with quota share contracts ceded.
It's important to note, however, that on a written basis, the front-end gross commission ratio worldwide actually decreased 50 basis points, whereas the average quota share cede commission ratio improved a substantial 260 basis points, which as you will recall, is identical to the benefit achieved last quarter. These overall net acquisition improvements, however, will continue to be felt as these ceded written premiums are earned over the next few quarters. The reinsurance segment's expense ratio increased from 32.6% in the third quarter of 2014 to 35.6% this quarter, primarily due to a 12.2% lower level of net earned premiums, a higher level of treaty cede commissions, and a slight increase in operating expenses. Although serially, the expenses actually dropped compared to last quarter.
The net acquisition ratio increased 100 basis points due to market forces, whereas the 200 basis point increase in the operating expense ratio is almost exclusively driven by the net earned premium reduction mentioned earlier. I commented on last quarter, separating components of the expense ratio can be a little fallacious because of the accounting does not go back and reflect the reimbursement of operating expenses contemplated in the cede commission itself. The ratio of net premium to gross premium on our core operations in the quarter was 73.1% versus 75.5% a year ago. The insurance segment had a 72.2% ratio compared to 74.2% a year earlier, whereas the reinsurance segment had a net-to-gross ratio of 72% in the quarter compared to 75.8% a year ago, primarily reflecting increased sessions to Watford Re as a reinsurer.
Our U.S. insurance operations saw a 60 basis point effective rate decrease this quarter net of ceded reinsurance. As commented on the last couple of quarters, the pricing environment is quite different for short-tailed lines versus longer-tailed lines, as Dinos also referred to. Our short-tailed first-party lines of business had an effective 4.4% rate decrease for the quarter compared to a 30 basis point effective rate increase for the longer tail third party lines, both on a net of ceded reinsurance basis. Looking more deeply, some lines incurred rate reductions, such as an 8.9% decrease in property and an 8.1% decrease in high capacity D&O business. While others enjoyed healthy increases, such as +6% in our low capacity D&O lines and a 4.1% increase in our program businesses. Also, our lower capacity D&O lines have now achieved 17 consecutive quarters of rate increases.
Turning to our continuing market cycle management, the insurance group worldwide reduced gross written premiums in the highly competitive and volatile lines of E&S property and global property by 12%, and in energy and marine by 15% quarter-over-quarter. By contrast, lower volatility lines of contract binding and travel expanded north of 20% on a gross basis, partially offset by a decline in program business due to purposeful underwriting actions. As stated in last quarter's call, some volume impacts were a result of underwriting actions taken on two programs, whereas another program administrator has been purchased by a competitor, and the premium loss impact will be felt beginning next quarter. Lastly, as Dinos has already stated, the insurance segment's construction business saw growth this quarter. However, much of this book has project policies and odd time policy terms, which can result in lumpy premium volume quarter-to-quarter.
The reinsurance group has only had 9% of its net earned premium represented by property cat this quarter, and property cat net written premiums were reduced by another 11% quarter-over-quarter, reflecting our view of that marketplace. Additionally, the property other than property cat line had a net written premium decrease of roughly 6% this quarter, and the reinsurance group also reduced net volume again in motor quota share and crop hail by approximately 20% in response to market conditions. The mortgage segment posted a 75.2% combined ratio for the calendar quarter. The expense ratio, as expected, continues to be high, as the operating ratio related to our U.S. primary operation will continue to be elevated until proper scale is achieved.
The net written premium, $66.8 million in the quarter, is driven by the $31.2 million from our U.S. primary operation and $35.6 million of net written premium for our reinsurance mortgage operations, primarily. This segment also had $3.6 million of other underwriting income for the quarter versus approximately $1 million in the comparative quarter last year due to our GSE credit risk sharing transactions. This quarter marks the first time that we have reflected some mortgage risk-sharing transactions with insurance accounting rather than derivative accounting treatment. The net written premium this quarter under insurance accounting totaled $2.2 million, whereas legacy risk-sharing transactions shall continue to be accounted for as derivatives. That is reported in other underwriting income.
One should also note that mortgage reinsurance premium growth is driven by the fact that the Australian business is a single premium market as opposed to the United States, which is predominantly a monthly premium market. At September 30, 2015, our total mortgage segment risk in force is $10.3 billion, which includes $6.5 billion from our U.S. mortgage insurance operation, $3 billion even through worldwide reinsurance operations, and approximately $800 million primarily composed of the GSE risk-sharing transactions. Our primary U.S. mortgage operation found $3.2 billion of new insurance written during the quarter, which was approximately 57% through the bank channel and 43% via credit union clients. The weighted average FICO score for the U.S. primary portfolio remains strong at 737, and the weighted average loan-to-value ratio held steady at 93.2%.
No state's risk in force represents more than 9% of the portfolio, and our U.S. primary mortgage insurance company is operating at an estimated 10.2 to 1 risk to capital ratio as of the end of September. The other segment, that being Watford Re, reported a 99.4% combined ratio for the quarter on $125 million of net written premiums and $99.2 million of net earned premiums. As a reminder, these premiums reflect 100% of the business assumed rather than simply Arch's approximate 11% common share interest. As for business sourcing, approximately 29% of the $131 million in gross written premium this quarter was written directly on Watford paper, with the remainder ceded by Arch affiliates. It should be noted, however, that this sourcing mix can vary materially quarter-to-quarter.
The total return on our investment portfolio was a reported negative 31 basis points on a U.S. dollar basis this quarter, primarily reflecting declines in most areas other than investment-grade fixed income. Total return was negatively impacted from the strengthening U.S. dollar and most of our foreign-denominated investments. Excluding foreign exchange, total return was a positive 4 basis points in the quarter. On a year-to-date nine-month perspective, total return was a positive 76 basis points on a U.S. dollar basis and a positive 173 basis points excluding the effect of foreign exchange. Our embedded pre-tax book yield before expenses was 2.1% as of September 30, compared to 2.18% at December 31, 2014. While the duration of the portfolio lengthened slightly to 3.42 years. The current duration continues to reflect our conservative position on interest rates in the current yield environment and tactical moves in the fixed income portfolio.
Reported net investment income in the quarter was $0.54 a share, or $67.3 million, versus $0.53 a share in the 2014 third quarter, or $72.2 million. As always, we evaluate investment performance on a total return basis, and as such, invest in asset sectors which may not generate above the line net investment income. Interest expense for the quarter on a core basis was $12 million, which is more consistent with our normal quarterly run rate versus last quarter and the third quarter of 2014 that were affected by periodic adjustments for a certain loss portfolio transfer. Our effective tax rate on pre-tax operating income available to our shareholders for the third quarter was an expense of 5.7%, compared to an expense of 2.5% in the third quarter of 2014.
Approximately $1.8 million or 22% of this quarter's tax represents a true up to bring the first half of the year to this now higher effective tax rate. Reflecting this, the nine-month or annualized effective tax rate is 4.5% on pre-tax operating income. As always, and as demonstrated this quarter, fluctuations in the effective tax rate can result from variability in the relative mix of income or loss that occurs or is projected by jurisdiction. Our total capital was $7.05 billion at the end of this quarter, which is virtually flat with total capital as of June 30, 2015, and December 31, 2014. Approximately $522 million remains under our existing buyback authorization as of the end of this quarter. Our debt-to-capital ratio remains low at 12.6%, and debt plus hybrids represents only 17.2% of our total capital, which still continues to give us significant financial flexibility.
As Dinos has mentioned, we continue to estimate having capital in excess of our targeted position. Book value per share was $47.68 at the end of the quarter, up 4.6% relative to the end of the year of 2014. The change in book value per share this quarter primarily reflects the company's continued strong underwriting results. With that said, we are now happy to take your questions.
Okay, thank you. Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your touch tone telephone. If your question has been answered or you wish to withdraw your question, press star followed by two. Press star one to begin. Please stand by for your first question. Your first question comes from the line of Amit Kumar from Macquarie. Please go ahead.
Thanks, and good morning, and congrats on the quarter.
Thank you. Thank you, Amit.
Just maybe one or two questions. Number one is going back to the discussion on RateStar. There was some confusion in the marketplace when the press release came out as to what it means for pricing and your competition. Can you talk a little more about it and without obviously giving away the secret sauce, talk about the expected ROEs, and maybe talk about how should we think about the adoption rate of RateStar going forward. Thanks.
Well, as Coca-Cola will never reveal their formula, we won't reveal our formula either. At the end of the day, we're in the underwriting business, and I think the more robust analytics you have in the way you allocate capital and price risk exposures, the better off you are as an organization. This effort is towards that goal. We're trying to go from a more simplistic approach to pricing mortgage risk to something a bit more sophisticated that we introduce other variables in the decision-making and in essence, affecting the pricing. Now, it doesn't mean we're going to abandon the rate card. The rate card is out there, and there is some bank channels, some customers, they prefer that, and basically they will only do business on that basis. We will continue to do that.
Also there is other channels that they prefer to go to a more sophisticated pricing methodology that more appropriately allocates the right premium to the exposure, and we're going to go forward with that where appropriate. You're going to continue to see us having both the rate card and RateStar, and only the marketplace will tell us as to how much of which is going to be used over time.
Got it. That's helpful. The only other question I have is going back to the discussion on capital management, and again, it's a high-quality problem. I'm not sure the capital is burning a hole in your pocket. Would you consider other avenues to return capital or are we not there yet? How should we think about that?
Well, that's the million-dollar question. At the end of the day, yeah, we always consider other avenues. Having said that, there is also the unknown that you might want to have a little bit of ammunition in case opportunities come as the market turns. So it's more of a complicated issue for us. What was not complicated in this quarter was that we usually stick to a meeting, and when we make the calculations, we felt that it might take four to five years to earn back the premium we're going to pay when we purchase shares, and we said, "Let's not do that. Let's see what other opportunities we have or other avenues." Having said that, we're going to have those discussions both internally as a management team and also with our board when we meet, and we'll make determinations at that time.
Okay, fair enough. That's all I have. Thanks for the answers.
You're welcome.
Thank you. Our next question is from the line of Michael Nannizzi from Goldman Sachs. Please go ahead.
Thanks so much. Just a couple hopefully quick ones on the U.S. MI on the MI business. Can you talk about how much of your NIW in the quarter was singles versus monthly premium?
Mark, you have those numbers, so why don't you.
Yeah, it was approximately 24%, that would've been singles.
Okay. The RateStar is relevant to the monthly business, I take it?
Yes. Predominantly, yes. You can apply it on both sides. Even when you do singles, you get granular mortgage by mortgage attributes. You can apply that. At the end of the day, when you go to single, you try to look at your return, what kind of a price you are going to get, and that is why you saw a significant reduction in us for the quarter as to how much we wrote in singles.
Got it. Then if we were to think about the RateStar versus the rate card, I am guessing for some types of business, it is going to be cheaper, and for others, it is not going to be. Is there any way to kind of think about?
What type of business is exposure? Michael, is exposure. Let me turn it over to you, and you tell me the difference, right? If you have two loans, about 750 FICO and 90 LTV, but one borrower has a coverage ratio of 35 and the other one 25, which one loan would you prefer, right?
At the end, how do you reflect that in your pricing? I am not going to get into all the algorithms that we have because then it is not only you listening, our competitors are listening.
Right. I understand
Introducing additional variables. You've seen it in a lot of other P&C lines. You've seen it a lot on the selection of risk in the automobile business. Progressive is very good and famous for it, GEICO, et cetera. At the end, it makes for a better return for shareholders and probably a fairer charge to the consumer based on their own risk characteristics.
Got it. Okay. Just last one on that, not about the algorithm, but for the players or for your customers that do accept or prefer RateStar, have you seen a meaningful change in submission volume?
We haven't yet introduced it to them. We finished the project. We made the press release. That's why I've talked about it. Our sales force is in discussions with the marketplace and starting to introduce it. At the end of the day, we're going to continue having both rating engines available, and it will be up to our customers to choose which one they prefer.
Got it. Thank you so much for that, James. Appreciate it. Really quick, Mark, I was just looking at Watford written premiums versus reinsurance ceded premiums, and there's a sort of growing gap there. Is Watford or is the insurance sub or segment ceding business to Watford, or is Watford picking up business from outside of Arch as the difference?
Well, as I commented on a growth space, which is the way to look at it, 29% of it is coming natively on their paper. We're continuing to get Arch Re affiliates and Arch Insurance to be sending over either a retroco ession or reinsurance. I think this quarter goes slightly more proportionally from the insurance segment.
Got it. Last one on the reinsurance expense ratio, just trying to sort of think about that a little bit. It sounds like the expense ratio to procure business for reinsurance is going up. That's probably a tailwind to the insurance expense ratio. That's going to raise the acquisition cost I guess, for reinsurance. You have an offset from Watford because I'm guessing the same dynamic exists between Watford and the reinsurance company. How should we think about, do those things neutralize each other, or is there more of a headwind or more of a tailwind from those sort of intercompany transactions?
Well, your observations are right. The net impact is really market force driven, and there is some element of Watford that is reflected on the fees, reflected in acquisition expense. As Watford continues to grow and sessions, that will continue to be more meaningful as an offset, which I think is the question you were asking.
It's probably close to neutralizing, but not quite. You still could perhaps see a net increase, but nowhere near the increase it would be without the existence of those.
Let me add something to your question from a different perspective. At the end of the day, our intellectual factory that produces great results is the underwriting talent that we have within the reinsurance group. This management team, me down to Grandisson and Lyons and Papadopoulo, et cetera, we strongly believe that we have very good underwriters, talented underwriters. Independent if the market might not allow us to utilize them at 120%, which we usually do, we're not willing to send those underwriters back into the marketplace for our competitors to hire, et cetera. I never saw a company have problems because their expense ratio went up maybe a point or two. I've seen old companies having a lot of difficulty when their loss ratio balloons by five, 10, 15, or 20 points. You've got to understand, that's our philosophy.
Yes, we expect our managers to manage expenses, and there is attrition within the organization. We're not willing to let go good talent just because we can't utilize the factory at full capacity. That, to us, the underwriting staff we have is our intellectual factory that produces a profit, and I'm going to hold on to that.
Yeah. One other technical point, Michael, because what Dino's just talked about is a core principle, really, for us. On the technical side, there's a little bit of a difference in shift. The treaty business is falling off a bit more, whereas the facultative is not, and that has the direct sales force. You get a little bit of that weighting pushing it up as well.
Got it. Thank you both so much for the answers. Really appreciate it.
You're welcome.
Thank you. Our next question is from the line of Ryan Tunis from Credit Suisse. Please go ahead.
Hey, thanks. Dino, your point, I guess, on the tiered pricing is that it allows for better risk selection. That makes sense. There still seems to be a concern in the market, I guess, if you look at how some of the stocks have acted in the past week or so, that if you're successful at implementing tiered pricing, competitors may follow, and that would then lead to broader pricing pressure. I guess I'm just curious if that's also a concern of yours. Do you think more tiered pricing in general from the industry could lead to pricing pressure?
I don't believe it will because the other factor you haven't factored in is what expected returns different, us and our competitors are looking for. Better selection doesn't mean that you have lower your return expectations. All you're doing is pricing more appropriately the type of exposures you're getting. This is not about reducing pricing in the marketplace. This is about assigning the right price to the right exposure. At the end of the day, our return characteristics, they're no different if we use the rate card or RateStar. Having that in mind, it would tell you that basically the whole effort was to improve how we think from an underwriting point of view, not to gain market share as some people I've heard comments to that effect.
If we wanted to do market share or reduce prices, the easiest way to do it is take the rate card and you shave a few bips in each one of the categories, and I don't have to be spending a lot of brain power with a lot of our people over a number of thousands of man-hours in developing something that is more sophisticated. I think there is misunderstanding in the marketplace, but eventually, for those who know Arch and know our underwriting approach, they will understand that at the end of the day, we're trying to be better in the way we're going to select and price risk appropriately, which is the foundation of this company.
Got it. I guess my follow-up then is just talking about assigning the right rate to the right exposure. In doing that, is there a segment of the marketplace that you envision Arch MI becoming quite a bit less competitive in that comes to mind?
Yes. There's going to be segments we're going to become more competitive and segments we're going to become less competitive. If you expect a certain return from the pie and now the pie is cut a little differently, you're going to have the pluses and the minuses. Now the question is, are you getting a lot more on the pluses and a lot less on the minuses, and what kind of return you're going to have with that? Only time will tell, but we're more comfortable with our ability to price the exposures better by using more variables than just FICO score and LTV.
Thanks, Dino. Good luck.
Thank you.
Thank you. Our next question comes from the line of Sarah DeWitt from J.P. Morgan. Please go ahead.
Hi, good morning.
Good morning, Sarah.
The GSE growth opportunity sounds pretty interesting for you. How can we think about sizing that? If we look out over the next five years, what % of overall earnings do you think that could be?
Mark, do you want to take a shot at that? I mean,
Over the next five years. My crystal ball is difficult only at five months. Still, we do view it as a positive opportunity, and I think one way you should think about it is that the advent now of Fannie joining Freddie on this. It seems that because they're expanding and looking for others to participate in this, they're going through the effort to establish a broader market, which gives credence to the fact that they're here to stay, and it's not just a transitional thing. With Freddie continuing to do this and Fannie continuing to do this, we do think it's an exciting opportunity. It's definitely going to be a growing piece. Now, as long as pricing stays sane, we will continue to be participants in that growing marketplace. So far on the Fannie deals, they've all had the same structure.
They've all been two and a half points, excess of a half point on the subject loans that are out there. This is why it's difficult. We don't know how those structures are going to change over time. Are there going to be higher attachments, lower attachments? It's very difficult to put your thumb on volume, let alone how much of these are going to be pushed out into the marketplace. We view it as an exciting opportunity for us.
Yeah, they might change to go to first loss. Right now, it's excess of loss, so using insurance terms. This is an evolving area, but the demand is robust.
Okay, great. Thanks. Then just on MI broadly, are you able to be more competitive on price because you have a diversification advantage versus your mono line competitors? Or is that not a consideration?
That is not a consideration.
Great. Thank you.
You're welcome.
Okay, thank you. Our next question comes from the line of Vinay Misquith from Sterne Agee CRT. Please go ahead.
Hi, good morning.
Oh, I didn't know you changed your name, Vinay.
Well, the first question is on RateStar once again. What % of lenders do you think will use RateStar, and is it the smaller lenders versus the larger lenders?
On your first question, I don't have a clue. I can't even project that. On the second question, I would say most likely the small lenders will be more adapting to the RateStar than the larger lenders. The larger lenders, they like the more simplicity of the rate card, and they have a lot of power in the marketplace, et cetera. Small lenders are trying to find niches so they can penetrate the market. That's purely forward guesses on my part. Only time will tell once we introduce this. Yeah.
Okay. That means that this thing could take some traction to get through the book just because the larger lenders, I guess, make up a bigger portion of the total business, correct?
That's correct.
Okay. My view of this is that the higher FICO scores were subsidizing the lower FICO scores. The new rate, the RateStar will sort of reduce pricing for the higher FICO scores and raise pricing for the low FICO scores. Do you worry that, since 60% of your business is in the higher FICO score business, that this could lead to higher competition amongst peers and sort of reduce the profitability for the larger pieces of the business?
No, you're going in the wrong direction, Vinay. If it was just FICO scores, you didn't need to go and make all this effort to create a RateStar with multiple algorithms. It's other characteristics. There is rich data in the loans being provided to us by the lenders. Who is the borrower? Is co-borrower? What location is the house? Blah, blah, blah. I'm not going to get into all of the stuff that within. If it was purely FICO score, you don't need to. You have LTV, and you have FICO score, and then if you want to make higher FICO scores cheaper, you take a few points of your rate card, and you accomplish that. That's not what it's all about. I'm surprised as to how much confusion is in the minds of people as to what this is all about.
This is a product that it will allow us to take other characteristics of a loan and find what we believe is a more appropriate price for the exposure that we're assuming.
Yeah, Vinay, this is just a more sophisticated class-rated plan, just like you have on the PC side, an analogy. Let's not lose the fact that there's already been discrimination between risks within each MI of, I'll use your example, of high FICO people. The analogy is schedule rating. You have a filed plan, but you have schedule rating where you can deviate for individual risk characteristics, and I think that's been pretty meaningful, up to 20% or 25%, to reflect characteristics of each risk. It's already been occurring with the old rate card that there is discrimination between risks. This is simply, we believe, a better way to do it and a more consistent way to do it.
Okay, that's helpful. Just as a follow-up to this mortgage insurance, I just noticed that the premium growth has slowed a little bit recently, especially on the earned premium side and also on the written premium side. Curious as to what's happening there, since you're now recording the GSE premiums also as written, correct?
The part you didn't mention is our reduction in the singles.
Okay. The change in the trajectory, I would say it came 100% out of our reduction in the singles.
It's a good time, Vinay, for me to correct something that I said before. I had said that singles were 24% in the quarter, I misspoke. It's 21%. I believe, the trajectory, but our view of that continues to drop. I agree with Dinos's comment.
Do you have a sense for what % of the business it was last year? Was it a much higher % last year?
Yeah. I don't have an exact figure in front of me, but it was substantial.
Okay. All right. Thank you.
It was the first time we did it last year.
Yeah.
Actually, pricing on singles a year ago, it was more acceptable to us. I think as the last three, four quarters emerged, it became more competitive marketplace because we have some competitors. They're trying to gain market share through singles. We don't view that a good place to be, and we're disciplined when it comes to underwriting.
Okay. All right. Thank you.
You're welcome.
Thank you. Our next question comes from the line of Jay Gelb from Barclays. Please go ahead.
Thank you. I may have missed it, but did you mention your Tianjin loss?
Insignificant.
Well, first off, it's not a cat, so we didn't reflect that within-
Right
the cat load. It's just not that large for us, Jay.
If it was anything notable, we would've put something out, but it's not notable within our numbers.
There is some exposure from the reinsurance side and the insurance side. As you know, the uncertainty surrounding these things is quite large. The ability to get in and check things out has really just begun recently. There's a lot of volatility around it, so you never know.
Okay. Did you add some IBNR just in case?
It's-
We always do, believe me.
It's contained within our standard attritional IBNR, yeah.
Okay, perfect. Thank you for that. The other question I had was on the tax rate. 13% in the third quarter, you said that was a true-up. What do you feel a normalized tax rate is going forward, since historically it's been in the low single digits?
Well, first off, longer term implies I know what jurisdictions is going to be giving me profits on a go-forward basis. That really does fluctuate from quarter to quarter. You're looking at the tax rate on net income as opposed to the tax rate on operating. It's just the simple arithmetic of it. You've got the tax rate on pre-tax operating income, and to convert over to net income, it's really the realized losses. You got the same tax dollars with a smaller denominator. That's the arithmetic of it.
Right
to push to get up to 13. Our current view on operating of a trailing 12-month type view on operating income is likely to be 4ish%. 5ish%.
I would say between 4% and 5%. That's the better way to look at it. Don't look on net income in one quarter.
Realized gains.
Look at it from a trailing 12 months. Then you got more of the net income. You can add all the tax, then it will give you a better feel as to what the percentage is.
Okay. That's fine. It just bounced around a little. I just wanted to.
Yeah
quantify that. On the buyback, with the stock now trading around 1.6 times book, it sounds like Arch is really not going to be in the market for buybacks. Is it?
I didn't say that. I said something different.
I must have misunderstood you.
I never said I'm not going to be in the market, right?
Okay. That valuation seems to be a pretty important parameter. How should we think about it?
Yeah. Valuation is very important. We look at it based on the prospects of what returns we get on the business we write. If my recovery period elongates and we're starting getting uncomfortable over three years, then we shy away from it. It has nothing to do with how we feel about the stock or It's just purely our approach to it. That approach might change. I don't know what my discussions with wiser guys, that's why I got pretty wise guys on my board to give me advice, and what perspective they're going to have. Based on what I said, we might sit on excess capital because there also might be opportunities for us to deploy in a different fashion in the marketplace.
Also, Jay, as you know, we move our mix of business and our capital around depending on what the opportunities are. We talked earlier about the real opportunities in the GSE credit risk sharing space. Hypothetically, if that increased at a higher rate than we had anticipated, or we had other opportunities around the world, that mixture might increase our view of forward ROE by 200 basis points or something, which is going to come into the equation of time to payback.
Of course. If the stock were valued instead at, let's say, at 1.5x book, would that have been within your range of viewing it within the three-year payback period?
It could be. It's hard for me to project into the future. It's like you're describing a guy who can read the obituary pages five years from today, and he finds his name there. That's not a good place to be. We make those decisions, and we're flexible on a quarter-to-quarter basis. We have unknowns, and when we have unknowns, sometimes we hold back a little bit. For example, the mortgage GSE opportunities, and I think Sarah is the one who asked the question, and I couldn't answer it because I know the opportunity is big, the demand is there, but I don't know how big it's going to be. I don't know how much of our capital we want to allocate to that.
When I have unknowns, I'd rather say, "I got unknowns, and here is how we're thinking, but there might be opportunities." I know you want to build your models and project a year out, a quarter out, and all that, but I don't operate on that basis. I'm trying to make sure that our underwriting units, they make the right decisions based on the latest information they have. If I have excess capital, it's not burning holes in my pocket. Unless somebody's trying to put his hand in my pocket and take it, and then I will cut it, that's not a problem. It's a good problem to have.
That's right. Thank you.
Okay, thank you. Our next question comes from the line of Kai Pan from Morgan Stanley. Please go ahead.
Thank you. Thank you for sticking past your souvlaki lunchtime. First, one.
The souvlaki sandwich is on the grill.
All right. Do you have any exposure to Volkswagen and potential exposure of Volkswagen and the Hurricane Patricia?
Insignificant.
Okay, that's great. On property cat, January 1 pricing, what's your outlook? You have reducing the business quite a bit over the past few years. If the market stabilize, would you becoming more interested in writing more business there?
Well, listen, our whole market is putting the right price based on the risk exposures we underwrite. If the market improves, we're going to write more. Our appetite has not disappeared. There were times that we were committing 20%, 21%, 22% of equity capital to that line on a PML basis, and we're down to now nine, and actually for Florida, and Gulf of Mexico, which is less than that. Our appetite, it will depend on the market pricing. Now, predicting what's going to happen on January 1, who knows? If I had to guess, it will probably be as stable where it is today, because I think even for those that they participate, the new capital that comes in, even with no real cat, the returns are not super juicy.
That's a sad statement to say, when there is no cats, you don't have super juicy, because what do you do when you have the cat, right?
Kai, I would also add, you used the term, if it stabilizes. It depends what you mean by stabilizes. Improving doesn't mean stabilizing to me. If the rate cuts stay, there's no more rate cuts, and it stays at a 0% change. We've been shedding volume given that relative level. I wouldn't expect our business to increase if it stays at the level that it is today. It would have to improve, not merely stabilize.
Okay. You're not expecting any sort of meaningful price increases from current levels?
Nothing I see in the horizon now that is telling me to anticipate price increases. We don't make decision on anticipation. We make decision as to what we see in the marketplace.
Okay. That's great. On sort of management succession. Dinos, you have a great track record since founding the company, and I'm sure you're excitedly running the business as is today. I don't know if the company has mandatory retirement age, is the board considering a succession planning, and how do you think about it?
We have succession planning in every senior position we have is part of our process within the Comp Committee. Their responsibility is, and my responsibility as CEO, is not only preparing my successor, but also each one of our key positions has one or two successors ready from within. That process is not new. It's been in place now for over 10 years. Having said that, if you read my contract, it goes all the way to the end of 2017, actually March 1st of 2018. I can sign the 10-K if I decide to just become the chairman. No decisions have been made. There is an existing succession plan within the company that is part of the responsibility of our board, and they take it seriously, and we talk about it at least once a year in the Comp Committee.
That's great. Well, thank you so much for the answers.
You're welcome.
Thank you. Our next question comes from the line of Meyer Shields from KBW. Please go ahead.
Thanks. I'll try and be quick. I know it's getting late. Dinos, I think you did a great job of laying out the point of the RateStar program. If you're allowing lenders to choose between RateStar and the rate cards, doesn't that just invite adverse selection?
If you allow them to have both, yes. Basically, what we're telling lenders, you can either have one or the other.
Oh, okay. They don't have.
You can't have the rate card and then price it that way and then price it on the other way and go back and forth. It's either you choose to participate with us on the rate card, or you choose to participate with us on the RateStar.
Okay. That helps. What is the loss trend in the insurance segment that corresponds to the 60 basis point sort of premium or rate decline?
I'm sorry, could you? The 60 basis points rate decline.
Right. I am trying to get the credit running.
It is probably short lines outweighing the increases we get on long tail lines. That is exactly what it is. As I stated, it is about 4.4% down on the first party lines, I think I said 30 or 40 basis points up on the third party lines.
Right. No, I understand.
Our volume on the short tail lines is small, you got to do weighted average, right?
Right. I'm just trying to get the sort of weighted average loss cost trend that corresponds to that.
If you remember your algebra one, Meyer, you got all the information you need.
Yeah. The four was I'm sorry.
The 4.4% is not in excess of loss trends. It's the pure effective rate change. You need to layer on top of that to do a loss ratio conversion from period A to period B, what your estimate of loss trends is. As we said in the past, it varies widely by line of business.
Okay. Thanks a lot.
We go through those calculations. When we say 60 basis points, there's a lot of work behind it to come up to that. I'm being surrounded by actuaries. Usually, we're pretty technical when it comes to that stuff.
That sounds like a nightmare, but good luck.
Okay. Thank you. Our next question comes from the line of Jay Cohen from Bank of America. Please go ahead.
Yes. Thank you. Maybe a bigger picture question on the mortgage business. I believe, Dinos, in the past, you've said that when this business gets to scale, that I think the segment earnings could be as much as a third of the overall company's earnings. Is that still a view that you believe is accurate?
Yeah. That's an accurate view. I also said that it will take three to five years to get to that point. We believe that, yes, we have potential to be earning $150 million, $200 million annually from the mortgage business, but it's got to get to maturity, and we're not there yet.
Right. Maybe a bit more technical. When I look at the, as you get scale in this business, the expense ratio comes down. I'm assuming the bulk of that shows up in other operating expense ratio. Should the acquisition expense ratio also improve over time, or should that be relatively stable?
Well, that should improve.
Yeah.
On the U.S. mortgage side, it's really a sales force-
Right
That's there. You're going to have those fixed costs, and you write more volume, it should drop. A sales force is constant, right? I mean, we're not adding. Once you get to a steady state on your sales force, maybe you add one person here and there, and then there is a little bit of increase, cost of living adjustments, et cetera, incentive compensation. That's more of a steady number. Then as you're building volume, your expense structure on a percentage basis is going to improve. Jay, just to clarify on your first question. Yes, with longer term view is mortgage could be a materially significant piece of our net income or our underwriting gain or loss. But that's the mortgage segment in totality. That is not necessarily U.S. MI.
You got the reinsurance segment, and as we said, the increasing contributions from the GSEs, it's in totality.
Right.-
Yep
That's what he asked. He didn't ask about anything.
Yeah. No, it was the segment. That's what I figured.
Right. Okay.
Right.
Fair enough. Very helpful. Thanks, guys.
Thank you.
Thank you. Our next question comes from the line of Brian Meredith from UBS. Please go ahead.
Yeah, thanks. I'll be quick also. Just quickly, Mark, I don't know if I caught it, but last quarter when you talked about the difference between on the insurance side, your ceded benefit that you're getting on the ceded on the acquisitions or commission ratio versus what your increase you're paying, I think it was like 60 basis points in the written. Was it similar this quarter, the spread?
Yeah. On the quota share treaties that dominate the sessions, it was a 260 basis point spread of, well, actually, let me restate that. Improvement in the ceded commission by 260 basis points, 3Q to 3Q. Last quarter, 2Q to 2Q had exactly the same improved spread difference.
At some point in time, that would disappear because once we cycle over 4 quarters, it's over until in comparison, quarter-to-quarter.
Right. You keep getting the gain, but the difference will go away.
Right. Therefore, your acquisition expense ratio should probably continue to come down in the insurance space.
Yes.
Year-over-year for at least the next couple of quarters.
On the earnings, yes.
Barring no change on the front-end direct commission.
Got you. Exactly. Okay. My second question, I guess bigger picture also, if I look at your overall business, reinsurance return on equity probably continuing to kind of come down here with the rate pressure, insurance may be flattish to down. Is the increase in the mortgage insurance that you're seeing growth, kind of when you look out here, is that enough to continue to offset the decline you're seeing in the reinsurance ROEs to keep it stable?
Well, it's a difficult question to answer because it depends on the volume. Two things I got to tell you. Don't underestimate how good our reinsurance guys are. They're finding other avenues, not all of their business is these, what I would say, large client under a lot of pressure business. They're finding niches here and there to still be relevant and have good returns. At the end of the day, yes, if our mortgage business continues to grow, it might offset it. I don't know that because I can't project volumes. We don't spend time thinking about volumes, and that's why we're not trying to be avoiding the questions. To us, future projections and that, we don't spend a lot of time on those.
What we spend a lot of time is to analyze what we have and how we're going to behave quarter to quarter, based on the market conditions that we see every quarter.
Yeah. Let me just add a little bit to that, Brian. The insurance group, when it comes to math, is 60%-65% of the net written, which will then find its way into earnings. Their margins have continued to improve, as was this quarter as well. Some of that is on the loss ratio side that we've seen, some of that is on the question about the seed commission overrides. We expect continuing contributions from the insurance group, which as I said, is 60% to 65% of the weight.
Got you. Great. Thank you.
Okay. Thank you. Your next question comes from the line of Ryan Burns from Janney. Please go ahead.
Great. Thanks. Good afternoon, guys. Just one question from me. Just trying to figure out why your Tianjin loss was immaterial. It seemed to kind of affect most of your competitors. Just wanted to see if you guys avoided certain risks or coverages that kept you away from these losses, or if it were just simply luck. I'm imagining it's more the former.
Well, you can call it luck, you can call it good underwriting or a combination of both. When you give me the choice, I'd rather be lucky than good, but I think we're both lucky and good.
Okay. Thanks, guys.
Thank you.
Okay. Thank you. Your next question comes from the line of Rob Huff from Wells Fargo Securities.
Yeah. Thanks for squeezing me in here. When I look at your balance sheet, it looks like your revolving credit borrowings went up by about $239 million in the quarter. When I look at your calculation of leverage, you don't seem to be including those in your leverage numbers. Are these Watford borrowings, or is something else going on here?
Yeah, you found it.
Yeah, I love it when you answer your own question.
Okay.
Exactly right. It was a $239 million increase in borrowing from revolver on Watford. Since we consolidate, of course, we have to reflect that on our balance sheet. You are also correct that our capital composition exhibit is for non-Watford. You hit it exactly.
Okay. I do not know if you can discuss what they need the money for and if these borrowings are non-recourse to Arch.
Non-recourse to Arch is their borrowings, and they are using them for investments.
Okay.
Their business plan always included, I think, one and a half times leverage.
Up to.
Up to one and a half. It's a company with over $1 billion of capital. They will probably borrow up to $400 million or $500 million and use it in their investment strategies. We're not responsible for the investments. We're only responsible for the underwriting side.
Okay. All right. Thanks very much.
You're welcome.
Okay. Thank you. Your next question comes from the line of Ian Gutterman from Balyasny.
Hi. Thank you. Dinos, I think Kai called you a little old earlier. I was a little surprised by that.
He did. Listen, I've been old for a long time. I got the AARP card like 15 years ago, yeah.
I hope you burned it, that's a different discussion.
I did. I actually threw it in the garbage. I was so mad when I got it.
Good. First, to follow up that last question, is the reason Watford needs or chooses to use debt to get to their asset leverage because they're behind plan on float, and they thought they would have been there on float and they're replacing it with straight debt or?
No. Listen, these are questions for Watford.
Okay
what I'm telling you is that they believe there might have been opportunities now based on what they see in the market and they say, "Hey, we can put some leverage on it and can buy some stuff.
Got it. Okay.
Ian, just that use of leverage was there from day one on the initial business plan.
Okay.
No need to go out and borrow when you haven't even deployed your own capital yet.
Right.
Yes, we're starting to generate a float for them. Our premium plans, we've been hitting based on the original plan. There is float coming in from our underwriting activity.
Exactly. That's what I wanted to make sure about. Okay, good. The first question I was going to ask before that was, on the capital discussion, can you remind me, you guys have obviously never paid a dividend, whether it be ordinary or special. Sort of remind me why you guys are averse to dividends. Is it a tax thing? Is it just-
It is-
You don't like the commitment of it, or?
Well, you're forcing a tax bill to your shareholders, right?
Right.
Once you give the money, if the next day you get an opportunity, you got to go and borrow to take advantage of it. We always like to have a little bit of excess capital. Maybe we have a lot of excess capital, but right now it's not at the level that is really giving me a lot of angst. Even though excess capital is only earning 2.5%, 3%, or thereabouts. It is what it is. Like I said, we talk to our investors and some of our investors, they're opposed to a special dividend. They think that over time, it might not be in the next few quarters, it might be in the next year or two, we'll find the right opportunity and deploy capital. Don't forget, we were talking about excess capital, et cetera.
Our mortgage business is a new business for us. We only started it about four or five years ago, it really is getting scale now. If I didn't find that opportunity with our guys, it was predominantly Marc Grandisson who discovered based on our discussions with our investment department and me, et cetera. We wouldn't have that opportunity to deploy today in excess of half a billion of capital into that business. Everybody tries to say, "Oh, if I have this magic balance sheet that is always in balance," that would be utopia. I'm a realist. There is no such a thing as utopia. We try to do the best we can.
Very fair. I just wanted to make sure I was remembering correctly. On MI, just a couple quick things. One, I don't think this has come up yet, I believe there's a lot of talk about just pricing changing in the bank channel. I think it's more in the community bank channel, if I'm correct. That sort of some of the banks are sort of, I guess, jealous of the credit union success, right? Saying, since the crisis, things have changed and the credit union is not necessarily a better channel than a regional bank anymore, given changes in lending standards, why are we charging so much more for MI in the bank channel, therefore we should cut rates to bring it more in line with the credit union experience. Is that happening or is that being discussed?
If so, just what are your thoughts on that?
Listen, I don't know if it's being discussed because I haven't really specifically talked to a sales force about that. You're right. Some of the community bank experience is being better than what I would call the large regionals or the national. The data shows it. That's why I said before that maybe some of the RateStar might be more adaptable to these community banks, which have similar characteristics to the credit unions. They're closer to their customers. They know them well. They're in the community. They know who is who. To a great extent, they spend more time and effort in approving mortgages. How do you reflect that? That's our secret sauce.
Got it. Very fair. Just lastly on the RateStar thing is, I guess what's interesting to me, I'm not asking you to give us the secret sauce here, but just, I always thought about FICO being, again, I know it maybe had some missteps in the crisis, but that arguably was because of lending standards, maybe more than FICO itself, right? When you look at auto insurance, that FICO is the best predictor of whether you're going to get into an auto accident, it seems like it's a pretty powerful variable. What do you see as the flaws in FICO?
We're not eliminating FICO, Ian. FICO is very powerful.
No, right.
Yes.
What are the flaws in it that mean it'd be improved?
loans survival is very powerful.
Okay.
there is other attributes that they have predictive ability and value. By ignoring them, is it two borrowers or one co-borrowing? Is it coverage ratio? 30, 40, or 50. I can go on and on, into the other things that what territory you're in, what do you think about the housing market in that territory, et cetera. I'm not going to go and tell everybody as to what we've done with this, we've done a lot of work. We believe that it's a I wouldn't say smarter because that's arrogant. I think it's a different way of looking. I think it's a better way, in our view, to assign the right price to mortgage risk.
No, that makes sense. I guess, maybe if I ask this a slightly different way. Is your sense that FICO is maybe explaining it? I'm just going to make up numbers here. Is FICO so good that it was explaining 90% of the difference in borrowers, and this gets you the last 10%? Or was it maybe two-thirds, and this gives you a whole another third? You know what I mean? I'm just trying to get a sense of.
Yeah, I don't know.
How significant the improvement is.
I don't know from the work. I've seen some of their work, I participate in some of their discussions. I can't put a percentage or predictability on any one attribute. I can tell you, FICO is a very important piece. LTV, for some risk, is very important. For other risks, it might not be.
Okay.
Like a young couple, two MBA students that, college sweethearts, both have pretty good jobs. They can only scrub together a 5% payment because.
Sure
They want to live in a bigger house because they have a lot of income. The LTV may not be as critical, and they might have super FICO scores. These other attributes. You might price that loan differently than a simple rate card.
Got it. Makes sense. Thanks for the explanation.
Okay.
Okay, thank you. Your next question comes from the line of Charles Sebaski from BMO Capital Markets. Please go ahead.
Thanks. I didn't think I was going to get in today. I appreciate it.
Well, Charles, you've been very patient, I think you're the last question, we'll give you all the time you want.
Chuck, yeah, it's good. You're this call's caboose.
Excellent. I guess, the first is on the GSE business. Obviously, you can't predict how the flow on that risk sharing is going to come in the future or how much. I guess at the current pricing and structuring level, is there any other constraints other than the flow from the GSE for how you guys would participate at current pricing? Is there aggregation or other issues that might halt that as it comes online?
No, it's two issues you got to think about this. The number one issue is the GSE is they're gonna put this in the market. That's known. There's a lot of pressure by Congress to de-risk and not be the credit providers for loans beyond the mandatory 20% down payment, maybe all the way down to 40%. That's why we've been hesitant on volumes. A lot of this goes to the capital markets. It depends what pricing they're getting from the capital markets. What both GSEs, Fannie and Freddie, are doing, they're developing two parallel markets. They're developing the insurance reinsurance market. It fluctuates. Sometimes they allocate 20%-30%. The rest of it goes to the capital markets. We have no control as to what those allocations.
If the capital markets become expensive, maybe they will start allocating 30%, 40% to the insurance markets. Believe me, what happens in the capital markets, it also affects the pricing that comes onto the insurance and reinsurance market. The reason they're doing that, they believe that by creating two avenues and two different source of capital responding to this credit risk, it's good in the long run. It might create more stability for them because they have two different paths to shed credit risk into the private domain instead of the government taking it. I don't know which way it's gonna go. Right now, we believe that with insurance accounting being introduced and the innovations that we have worked very closely with the GSEs there, and their willingness, and they're talking to a lot of others within the insurance and reinsurance business.
I don't know how many they have the expertise to do it, but some do. I think this is going to be a new market for the insurance, reinsurance business. It can be substantial over time.
Chuck, the other thing that makes it difficult to predict, as Dino said, Dino was describing more how Freddie Mac has done it, where it's the same notional base of loans And capital markets and the insurance reinsurance industry share on that same set. Fannie has done it a little bit differently, but they're using capital markets and the reinsurance market, but it's a different pool. What's gone out to the Fannie deals has been exclusively a pool that went to the reinsurance industry, and a separate pool may have gone to the capital markets. They may not continue doing it that way. They may wind up doing it similar to Freddie. There's a lot of different parameters that make the projections difficult.
It's a young emerging market, and a lot of it is because the Congress, in general, they want Fannie and Freddie to de-risk. For that reason, we feel optimistic that the demand is always gonna be there. Now, is it gonna go 100% to the capital markets? I doubt it. Now, what percentage comes to the insurance reinsurance versus the capital markets is in their hands, and you got two big customers here, and they hold all the cards. Yeah.
I guess I'm not asking you to predict what they are going to put out. I guess what I was trying to understand is what is your constraints, right? I mean, conceptually, Fannie and Freddie could put out more risk than you guys could possibly take, or the insurance market, just through the size of the-
Right
the portfolio. What is your guys' constraints if we read that Fannie is accelerating their-
As we do with every line of business that we have, we have a, think of it as a PML, and how much of our equity capital we want to risk. There is a constraint, and we have developed, actually, maybe we're the only ones. I don't know if our competitors do that or not. I have no idea. I'm sure from a risk management point of view, they do something of that sort. We do calculate on a quarterly basis what the PML values we have for the mortgage business. That will be a constraint at some point in time. When we reach the upper limit of the available PML, that will be a constraint for us. We got other vehicles. We might create a sidecar at that time. We might use our knowledge and ability and underwriting ability and the systems we have.
Don't forget, you got to have good systems to price loan by loan, et cetera, to introduce other capital providers into the sector with us, as we've done with Watford. We can do a mortgage Watford, so to speak. We have a lot of flexibility. We're nowhere near yet of having that constraint. For the time being is we got freedom to operate, and we got plenty of capital to deploy, and it's not violating any of our PML criteria that the board sets as to how much risk you're gonna take in any particular. I don't care if it's cat risk or mortgage risk or D&O risk. In our risk management principles, we have limits that we wanna take.
I guess finally on RateStar, are you guys first in the trying to use a more automated multivariate pricing model here? If you are, what's the lag time or the lead time? If you guys are pitching this out into the market to the originators and your competitors go, "Oh, uh-oh, Arch is a leg ahead of us here now on this," what's the lead time you guys have on this kind of product?
Well, I don't know. We're not the first. United Guaranty, part of AIG, introduced risk-based pricing first. Probably they've been out for about a year now. They were ahead of us. Maybe it's longer than a year. Basically, we agree with the approach. It's fundamental to underwriting. Now, how acceptable it's gonna be to the marketplace and all that, I don't know. It seems that United Guaranty, they have some penetration, and they have acceptability of it for quite a few of the states, from an approval point of view. We're optimistic.
I appreciate all the answers. Thank you very much, guys.
Thank you.
Thank you.
Okay, thank you. Now I'd like to turn the call over to Dinos Iordanou for closing remarks.
Thank you for listening to us. It was a little longer. It was mostly mortgage. I almost forgot that I'm in the insurance and reinsurance business. We're looking forward to be speaking to you next quarter. Have a wonderful afternoon.
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