Ready to get started with the next presenter. We have Dinos Iordanou from Arch. He's the CEO and Chairman. He's been with Arch since the beginning of the company, essentially, initially running the insurance group and now, of course, the whole company for quite a while now. Prior to Arch, he was at Zurich, Berkshire, and AIG. He has been associated with a number of good companies, and he has built a pretty impressive business at Arch. What I want to start with, Dinos, when you think about Arch, again, you are really the main architect of the company. What you've built is a company with a very distinct culture that is hard for a lot of us to see from the outside. I think it's important as you develop the company and seeing the earnings, that culture is a big part of it.
I want you to describe kind of what the culture looks like at the company.
Yeah. That's a great question. Understanding the DNA of the place. At the end of the day, when you step back and look at the insurance business, it's a business that manufactures one product. What it manufactures is a series of decisions. When our people come to work every day, they make decisions. It could be underwriting decisions, it could be actuarial decisions, it could be claims decisions. That's the only product that we manufacture. Now, you depend on the quality, ability, and expertise of people, because those decisions have financial consequences as they're made on a day-to-day basis. Our founding principle is betting on people with knowledge and ability, but also betting on people that they're very collaborative. We have this strong belief within Arch that two minds are better than one, and three are better than two.
Even though every one of us is responsible for our business, sharing thoughts, ideas, and collaborating well within the organization creates, I think, the ability to have less defects in your product, making better decisions, avoiding the big mistakes than if you don't have that collaboration. The lone rangers that have been in the business for 25 years, and I know what I'm doing and leave me alone need not apply for Arch. They can find other places to work. They don't fit with us. We like to see people that they have that collaborative attitude. Second, I think when you give your pen to these decision-makers, you have to develop trust.
To me, trust develops over this system that we have that we trust you, but we verify what you do, and the more that we verify, the more we trust you, and it continues to build that trust. We're an organization that audits a lot. We try to make sure that the audio and the video matches. If people tell us, "This is what I'm doing," when we go and look, it's exactly what they're doing. The more of that that we discover, it creates more comfort with our abilities to achieve the results that we achieve. It's the most critical part that makes me sleep at night because it's a scale business. I mean, trust is a scale business. You got all these people making decisions, and basically, they have your checkbook. They're writing checks every day.
A bad decision usually costs you in the tens of thousands, sometimes in the hundreds, sometimes in the millions. At the end of the day, eliminating, creating a cultural system. We also have a system of rewarding people on the same basis that the shareholders get rewarded. A shareholder gives you their money, hard-earned money, and they're in it forever. That's the speech I give to our guys. We have to be in it forever. What we mean is that our incentive compensation has to align the interest of the employee with the interest of the shareholder. That's why we have the uniqueness in the way we look at every underwriting year, and we pay people based on that performance, and we calculate that performance, yes, early on, but continue the calculations all the way to the 10th year.
After 10 years, we all know that the performance for the shareholder and the performance for the employee is going to be on the same basis. We're not arguing, did we have the right reserve or did we put the right IBNR, et cetera, in order for people to have the ability to manipulate numbers in order to get a bigger bonus or a bigger incentive compensation. I think that's the two critical foundations of our culture. Believe me, the system works because if you're not a collaborative, contributing person, the system expels you. Kind of you feel uncomfortable, and you go and find employment some other place.
You've been in this business a long time. You've never been shy to share your opinions on issues, and I wanted to ask you what your outlook is for, I guess, both the commercial insurance business and the reinsurance business over the next one or two years.
Well, we're in three sectors. You did not ask Mortgage Insurance.
I'm going to get to that.
Oh, you're going to get to it. Okay.
Yeah.
Let me stick with the Insurance and Reinsurance. Clearly, I think it's better today where the cycle is to be in the Insurance business. The Reinsurance business is coming under a little more pressure, a little more of headwinds. There's reasons around that, we can get into it if you would like me. Looking at the Insurance side alone, we've seen the effect already of excess capital in the Reinsurance market, especially for the Cat risk and the property risk, which have spillover already into the Insurance sector. The only sector that is not gaining rates, actually is losing from a rating point of view, is the first-party lines, Property and Property Cat on the Insurance side. Everything else pretty much is at level playing field from a rating point of view. They're getting at least the same rates as a year ago.
In some cases, small, medium-sized accounts, you're getting rate increases that they're at or a little bit above of loss cost inflation. I would characterize the insurance business a healthy environment because we're at a good level, and the reporting numbers are starting to show that. The reinsurance side is not under pressure from this new influx of capital that came into the property and property cat, but also, I think it's under pressure on all other lines for two reasons in my view. One is that most primary companies have reasonable balance sheets. There's not big reserve holes. I think they have enough capital. In essence, they have the ability to retain more risk on their own books. If you're a reinsurer and you're begging for that business because your main customers, they want to buy less, then you have to induce that.
Usually, it means that you got to offer terms and conditions and prices that they're attractive to the buyer. I think there is a negative arbitrage now from the reinsurers to a positive arbitrage to insurance. So far, it has not affected the psyche or the behavior on the insurance side. I think the differential is they're starting to earn the additional ceding commissions and the better pricing. I think they're keeping themselves, and they haven't given it to the customer base yet. Usually when you get reinsurance to be attractive, eventually that will have an effect on the primary rates. We haven't seen that yet, but that's my fear that over the next year or two, et cetera. We'll really be at the bottom of the cycle, and that's when accidents do happen, bad decisions get made.
When bad decisions get made, eventually they translate in financial calamities here and there, and then you're going to have the rebirth, which is the market change and the cycle change. I've been in the business since 1976, so it's quite a few years. Not quite 40, but a year or two. Pretty soon 40 years. I've seen four major cycles. Every time there's many different reasons, but one of them was chief reinsurance that fuel unreasonable competition on the primary side. I always describe it as it's the equivalent of sending gamblers to Vegas with somebody else's money. They're going to have a lot of fun, but I don't think the guy who provides the money is going to have a lot of fun.
Yeah.
Yeah.
Let's talk about mortgage insurance as well, because it is a newer part of your business via an acquisition last year and some of the reinsurance activities that you've been in. Describe the market conditions you're seeing, and also how those compare to what you thought they might look like when you made the investment.
We studied I think the day after Lehman went down. I had to pick up my chief investment officer from underneath his desk. He didn't have a helmet, but he was underneath his desk.
Yeah.
We thought that there might be opportunities in the mortgage. We didn't know where it was going to be in investments or somewhere. We started to study it. We saw the calamity that happened in the mortgage insurers at that time. Also, we saw the kind of mistakes that they were making. We started with a lot of research for a couple of years, and then in 2010, started to write first as a reinsurer the mortgage business. Then we were, I think, fortunate to find the opportunity to buy the assets of PMI out of bankruptcy court and CMG later on. Even though it's new to us, we have been studying the sector for about at least five, maybe a little longer, years.
Our view from the beginning, and it hasn't changed very much, is that a lot of improvements have been made, both environmental improvements, that's the microeconomic outlook where housing prices are, where unemployment is and is going, affordability, et cetera. It's very helpful to the mortgage insurance business. The pricing that was instituted by the GSEs. Now I think the new evolution, which is the PMIERs, the new capital requirements, which from our perspective, they're positive, which is going to force us and our competitors to start pricing our product on a risk-based basis instead of having that simple, stupid rate chart and try to apply it across the board. In stepping back, I think the projections we're making about the environment itself and is it good to be in that business hasn't changed, with two exceptions.
One, we underestimated how long will it take for us to close a transaction. It was the birth of a giraffe. I think humans is nine months pregnancy. I think giraffes are 14 or 15 months, and it took us five quarters to close. Had to go through bankruptcy court, and then we had to go through the GSEs, and then we had a change in administration when the FHFA was going through that change. By the time we got approved, we lost at least three quarters. In a business that you have a good environment, it's a good pond to fish in, losing three quarters' time, I think it cost us some money. That was part of the negative from the experience.
Less of that, more recently, I think some of the actions that the FHA is taking with reducing 50 basis points the cost of mortgage insurance for what we consider a low-income, high-risk kind of pools. Even though it's not going to have an immediate effect on the rest of us because we don't usually go after that business, I think it will be a negative in the long term because some of our competitors, they might have written some of that business. The overlap is small, by the way. I looked at the numbers. This is at 620, 640 credit score with a 3% down payment. They used to pay 135 basis points for MI, now they'll be paying 85 basis points for MI. It overlaps at about 6, 7% with the credit union business, which is our CMG subsidiary.
That's where most of our volume is coming, and about 13% on the bank channels are the mortgage originators. Long term, I think that would be a negative. For the time being I don't think it's affecting much of what we're doing. The environment is good. It's a high ROI business. It requires discipline. I think that's the trademark of our company. If you're a disciplined underwriter eventually you will do good in every segment of the insurance business, including the MI. The latest example, and I talked about it in our call yesterday, the upfront single premium market got extremely competitive, and we've done very little in the fourth quarter for the simple reason that we got to price our products for an adequate return for our shareholders. If we can't do it, we might as well give the money back to the shareholder.
The other big topic out there is M&A. It's obviously heating up. You're a company that arguably has a fair amount of excess capital. You have a higher multiple than others. It seems you are a logical participant, but potential participant in the M&A. How do you feel about the environment now and the potential for deals?
Well, I guess the M&A fever has gone up a few notches, right? There is reasons for it. I view the companies that they're looking for new dating partners. It's either smaller enterprises that structurally they were required either by the rating agencies and the customer base to maintain a higher capital than needed for the business in order for them to be relevant. If your company only produces $500 million or $600 million or $700 million worth of premium, and to be relevant, you've got to maintain $1.5 billion-$2 billion in capital, very hard to make your returns. If you dividend the excess capital out, you're going to get pressure from the rating agencies, and you're going to get pressure from the customers.
I don't want to do business with somebody who truly only needs $600 million, $700 million, $800 million of capital to operate for that book of business. For those, I think they're going to look for partnerships. It allows something to get bigger. The bigger you are, you have less of an issue with this particular problem that I described, and it allows the excess capital to be returned to shareholders over time. The second is mono-line anything, in my view, as a business proposition, it doesn't have a good historical outcome. I don't care if it's bond insurers, I don't care if they were mortgage insurers. I don't care if there is mono-line reinsurers. Even the large ones that they were dominant, and I'm talking about Munich Re and Swiss Re, they look to get into the insurance business, and they have significant part of their operations in the insurance business.
Anybody who is just purely reinsurance with the headwinds coming, they'll be looking to see if they can do something with either acquiring an insurance operation or acquiring something that is different than what they do. We don't feel that we need to do a deal. At the end of the day, over the years, we were very patient in building the company, and we've done what I would call small acquisitions. Most of our acquisitions, they were below the radar screen. We don't make big announcements. We've done the Ariel Re thing with building an office in Zurich. We build a property cat team over time. We look for talent, because let's go back to your first question. How do you make better decisions and how do you create value for shareholders? You got to find the talent.
The talent got to have an environment that it can operate and apply their knowledge and expertise, then you're going to get good results. Our growth has come through that. The biggest one we've done is the MI, and even that, it was mostly buying assets, no old liabilities. The thing that I hesitate when it comes to M&A is the cultural aspect of the combination. I'm probably one of the few CEOs that have gone through that exercise in a significant way. In my prior life, I had the task of consolidating the Zurich operations in North America, which included all the acquisitions they made and run independently for years. Maryland Casualty, Fidelity & Deposit, Universal Underwriters, Empire Fire and Marine, Zurich North America, and Zurich Canada, all of that. Believe me, Mark Lyons, our CFO, and I, we work both there and here.
Later on, the Home Insurance Company transaction with the renewal rights acquisition of that. Believe me, when you take the investment bank's nice little books, and it says, "These are the synergies," then you go out and try to do it, there is two different outcomes. At the end of the day, merging cultures, merging systems, merging customer relationships is not an easy thing to do. Believe me, I give credit to a lot of guys that they have done it well. I think my good friend, Jay Fishman, is probably the best in doing that. Travelers has done a great job. There is not a lot of mergers that you can point to that the initial thought process and the outcome actually materialize.
The other one that comes in mind is, I think, the strategic acquisition of ACE of the FCL licenses, et cetera, have propelled that to a global company of significant size.
That was the Cigna acquisition for those who don't remember.
Yeah. It was the FTL licenses they were looking after. Everything they had in the U.S., they tried to dispose. Brian Duperrault, who is a good friend, we grew up together at AIG, did a great job. Evan has done a terrific job ever since in building that into an organization. Believe me, it's tough to do.
Yeah.
Yeah.
When I talk to a number of other companies, and they talk about wanting to do something different in their reinsurance business with something with alternative capital, many of them say, "We'd like to do something like Watford Re.
Good.
Talk to us about Watford Re. Not everyone is familiar with it. Just talk quickly about the structure. Do you see a threat from some of these other companies that want to duplicate that structure?
I'm not paranoid, there's threats on everything. At the end of the day, Watford Re is an idea that I think has a lot of merit. Here is a company that has a certain type of shareholder that is willing and able and understands that they can take both risk on the insurance side and risk on the investment side of the balance sheet. Once you have that client, you can construct the structure like Watford Re, with them understanding what the structure is. From our perspective, when we looked at Arch as the underwriting managers for Watford Re, when we looked at Highbridge, which is the investment manager for Watford Re, we're bringing two very good organizations with very good track record to do the underwriting on one side and do the investments on the other side.
The fact that Highbridge can produce better returns, of course, with higher risk, than the traditional insurance enterprise who has a lot of limitations by regulation and the rating agencies. You got to be in fixed income, it has to be investment grade, et cetera. It gives them a competitive advantage, especially today when we have a very low interest rate environment. I was looking at a lot of business that we rejected at Arch. We've done the work, we rejected it on the basis that when we apply new money invested yields to the underwriting, the returns that were not in the double-digit area, they were in the single-digit. For that reason, we couldn't underwrite them.
Now you take the same business and you say, "If I can achieve a 4% or 5% or 6% return on the investments," the return on equity now gets enhanced significantly. That's the principle behind the structure. It only works if you can convince the rating agencies that the quality of the underwriting and the quality of the investment manager, they're going to be as such that they're willing to give you an A-minus rating. Without the A-minus rating, you can't operate.
For us, we made long-term commitments to the facility. We provided some of the senior management of the personnel that resides with Watford Re. The CEO was one of our senior executives. We provided a couple of their senior underwriters because most of the underwriting is done by us. All of the underwriting is done by us, but they have a fiduciary responsibility to oversee the underwriter and also oversee the investment manager. It's not two entities that they run independently. If you think about it's kind of a virtual company. It has its management structure, a CEO, a CFO, a chief risk officer, a few auditing underwriters. Arch provides the underwriting for them, and then the investment manager is provided by Highbridge, JPMorgan. It's a very efficient structure. They only pay us a fee for-
Right
only the business that is successful. We do all this work, wanting to get a fee if they're successful. For us, that fee helps us because I do the work anyway for Arch, and if it doesn't fit me, because then I used to throw it in the trash can. I had a lot of embedded work that I had no revenue for. It didn't come easy. It was an idea that we had, me and my management team, and we worked on it for a year and a half. We invested in the company. 11% is owned by us. I personally put a little bit of money in it. It's disclosed on the proxy. I have $5 million personal investment in the company because I believe in the concept, and I believe in the strategy.
For the investors, they said, "We like Highbridge, and now I can invest in a company who also is going to give me float at zero cost if Arch can underwrite this business at 100 or less combined.
Right.
Right? Yes, it costs them some fees, but it's all included in that 100 combined. In essence, they're borrowing flow at zero interest rate, and they will share with us in Highbridge profit commissions at the end. That's a win-win situation. That's, in five minutes or less, a lot of work we've done over the years in trying to accomplish that. The discussions and the commitments we made to the rating agencies, they were significant. We're going to honor those. Our reputation is on the line, and I think it's good for our shareholders, and I think Watford Re will be a successful enterprise.
Actually, exactly five minutes. I was watching the clock. It brings us right to the end of the presentation.