Good day, ladies and gentlemen, and welcome to the third quarter 2014 Arch Capital Group earnings conference call. Before the company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. At this time, all participants are in a listen-only mode. Later, we will facilitate a question and answer session. If at any time during the call you require assistance, you may press star zero and an operator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes. I now turn the conference over to your hosts for today, Dino Iordanou and Mark Lyons. Gentlemen, you may begin.
Thank you, Frances. Good morning, everyone, and thank you for joining us today. We had another excellent quarter with all of our units performing well from an underwriting perspective. Earnings were solid and were driven by excellent reporter underwriting results. Our premium revenue grew by 2.5% on a net basis for the third quarter 2014 over the same period in 2013. Growth in insurance and mortgage business more than offset a decline in reinsurance net writings. On an operating basis, we earned $1.05 per share for the quarter, which produced an annualized return on equity of approximately 10% for the 2014 third quarter versus a 12% return on an operating basis in the third quarter of 2013. On a net income basis, Arch earned $1.64 per share this quarter, which corresponds to an annualized return of 15% as foreign exchange and realized gains enhanced our net results.
Our reported underwriting results in the third quarter were excellent, as reflected by a combined ratio of 88% and were aided by a low level of catastrophic losses and favorable prior year loss reserve development. Net investment income per share on a sequential basis was flat in the quarter at $0.53 per share. Our operating cash flow for the quarter was $319 million, comparing very favorably to $238 million in the same period last year. The total return of the investment portfolio was a negative 51 basis points for the quarter, inclusive of fluctuations in foreign exchange rates, and 21 basis points in local currency terms. Our book value per common share at September 30th, 2014, was essentially flat at $44.04 per share, increasing by 7/10 of 1% sequentially and 15% relative to the third quarter of 2013.
In the quarter, we reinstituted our open market share repurchases and spent $252 million in the third quarter. In addition, we have spent an additional $89 million from October 1 through October 29th, for a total of $341 million for the last four months. The insurance segment's gross written premium grew by 6.4%, and net written premium grew by 7.4%. The growth emanated from the following divisions: Programs, Travel and Accident, E&S Binding Authority, and Construction and National Accounts business. Most of our organic growth is coming from small accounts with low limits, which should have lower volatility. On the other hand, competitive conditions in the property sector had negatively affected primary property rates and accordingly, our premium volume in those lines. In the primary markets in which our insurance group participates, we continue to obtain rate increases in most lines of business.
Albeit slightly below the levels that we observed last quarter. Mark will give you more color on this later on. On the reinsurance side of the business, we have seen a continuation of softening in terms and conditions that we noted in prior quarters. From a production point of view, net written premium was down 16% in the quarter for the reinsurance group, primarily as a result of a non-recurring large, unearned premium portfolio, which, as we described in a prior call, was booked in the third quarter of 2013 and is not recurring in 2014. Gross premiums rose in the reinsurance segment by nearly 5%, with the growth in the segment arising from business we produce for Watford Re.
Adjusting for the reduction of the unearned premium portfolio from last year and the business produced for Watford Re, reinsurance premiums would have declined by approximately 6% in the quarter if you compare like quarter to quarter. Our mortgage segment includes primary mortgage insurance written through Arch MI in the United States and reinsurance treaties covering mortgage risk, which is written globally, including the U.S., as well as other risk sharing and structural mortgage businesses. As you may recall, our mortgage insurance business in the U.S. serves two major markets, credit unions and banks, and other mortgage lenders. Net written premium for the third quarter of 2014 was approximately $58 million, of which $32 million was written by Arch MI U.S., who tenders to the credit unions, banks, and other mortgage lenders.
As we discussed in prior calls, Arch MI has a dominant position in the credit union sector and is in the process of building out its client base with bank lenders. This past quarter, a substantial amount of the growth came from single paid premiums. These are loans where the mortgage insurance premium is paid upfront. As of today, we have approved more than 400 master policy applications from banks, and more than 100 of these banks have submitted loans for our approval. Of these approvals, 29 represent national accounts, and the balance are regional banks. We define national accounts as the top 100 producers of mortgages. Of the top 25 originators, we have approvals from 15 of them.
Group wide, on an expected basis, we believe the ROE on the business we underwrote this year will produce an underwriting year ROE in the range of 10%-12%, as on a present value basis, improvements in the insurance group and the addition of the mortgage segment were more than offset by lower expected returns in the reinsurance segment. Before I turn it over to Mark, I would like to discuss our PMLs. As usual, I would like to point out that our CAT PML aggregates reflect business bound through October 1st, while the premium numbers included in our financial statements are through September 30th, and that the PMLs are reflected net of all reinsurance and retrocessions.
As of October 1st, 2014, our largest 250-year PMLs for a single event decreased slightly in the Northeast to $658 million or 11% of common shareholders' equity, while Gulf PMLs also decreased slightly to $608 million. Our Florida Tri-County PML now stands at $451 million. I will now turn it over to Mark to comment further on our financial results, and as customary, after Mark concludes his remarks, we will take your questions. Mark?
Great. Thank you, Dinos, and good morning. Before we get started, I'd like to just say a few words to define how I'm going to speak about things for the balance of the call, so just bear with me on this. First, as a reminder, the financial supplement shows consolidated financial statements that include our other segment, which is Watford Re, as well as providing other financial that excludes the other segment, and those are footnoted as such on each page of the supplement. Furthermore, within the segment information of the supplement, we have provided a subtotal of Arch's core segments, that is insurance, reinsurance, and mortgage, without Watford Re, and have also separately provided Watford Re's results posted alongside in order to arrive at an Arch consolidated segment income statement view. The investment information section of the supplement, however, is completely shown excluding the other segment.
My comments to follow today are on a pure Arch basis, which excludes the other segment unless otherwise noted. For further clarity, although today's discussion will exclude Watford's result as a segment. However, when Watford is used as a reinsurer by any one of our core segments, those sessions are reflected in Arch's underwriting results. Furthermore, since the definition of the word consolidated includes the results of Watford, I will not be using that term, the term consolidated. Instead, just be aware that my comments refer to our core segments of business, insurance, reinsurance, and mortgage combined as just discussed. This permits an apples to apples comparison with Arch's results a year ago.
Moving on with that defined, the combined ratio for this quarter was 88.5%, with 1.6 points of current accident year CAT-related events, net of reinsurance and reinstatement premiums compared to the 2013 third quarter combined ratio of 86.1%, which reflected two and a half points of CAT-related events. Losses from 2014 catastrophic events, net of reinsurance recoverables and reinstatement premiums totaled $14.2 million, primarily emanating from European Storm Ela and Midwestern U.S. tornado activity. The 2014 third quarter combined ratio also reflected 8 points even of prior year net favorable development, net of reinsurance and related acquisition expenses, compared to 8.2 points of prior period favorable development on the same basis in the 2013 third quarter. This results in a 94.9% current accident year combined ratio, excluding CATs for the third quarter of 2014, compared to 91.8% accident quarter combined ratio in the third quarter of 2013.
In the insurance segment, the 2014 accident quarter combined ratio excluding CATs, was 98% even compared to an accident quarter combined ratio of 97.1% a year ago. This increase was primarily attributable to certain large attritional losses emanating from our European operations, in particular, mostly from the aviation war line of business. These large attritional losses account for 170 basis points more of net earned premiums in the third quarter of 2014 than large attritional losses in the corresponding quarter of 2013. The reinsurance segment 2014 accident quarter combined ratio excluding CATs, was 90.6%, compared to 94.8% in the 2013 third quarter, represents a sequential improvement from the 92.1% combined ratio last quarter. As noted in prior quarters, the reinsurance segment's results reflect changes in the mix of premiums earned, including a lower contribution from property catastrophe business.
The insurance segment accounts this quarter for roughly 16% of the total favorable development, excluding the associated impact on acquisition expenses, this was primarily driven by shorter-tailed lines from the 2006 through 2012 accident years. The reinsurance segment accounts for approximately 83% of the total favorable development in the 2014 third quarter. Also excluding the associated impact on acquisition expenses, with approximately 40% of that due to net favorable development on shorter-tailed lines concentrated in the more recent underwriting years. Roughly 8% was attributable to medium-tailed lines spaced throughout many underwriting years, and about 49% due to net variable development of longer tailed lines, primarily from the 2002 through 2010 underwriting years. The mortgage segment accounted for approximately 1% of the total favorable development in the quarter, stemming mainly from our U.S. primary operation concentrated in 2009 and prior.
As has been consistent in the past, approximately 69% of our core $7.2 billion of total net reserves for losses and LAE are IBNR or additional case reserves, which as I've mentioned, has been consistent across time and across the main reinsurance and insurance segments. The expense ratio for the third quarter of 2014 was 33.5% versus the prior year's comparative quarter expense ratio of 32.4%. The increase in the operating expense ratio reflects the addition of our U.S. mortgage insurance operations, which is operating at a higher expense ratio until business hits a steady state, as well as the effect of incremental expenses due to certain platform expansions in both our reinsurance and insurance businesses. The insurance segment improved to a 31.7% expense ratio compared to 33.1% a year ago, primarily reflecting a lower net acquisition ratio driven mostly by materially improved treaty ceding commissions.
The reinsurance segment expense ratio increased from 30.7% in the third quarter of 2013 to 32.6% this quarter, primarily due to a higher level of operating expenses and by higher ceding commissions incurred. Our U.S. insurance operations achieved a positive 2.6% effective renewal rate increase this quarter net of reinsurance. A key point that can get lost in the averages is how different the pricing environment is for short-tailed versus longer-tailed lines. Our short-tailed lines of business had an effective 3.5% renewal rate decrease for the quarter, compared to a 4% effective renewal rate increase for the longer-tailed lines, both on a net of reinsurance basis. These longer-tailed line rate increases continued to be above our view of weighted loss cost trends.
Looking more deeply, some lines incurred rate reductions such as nearly 8% in property and 4% in high capacity D&O, and others enjoyed healthy increases such as +10% in our lower capacity D&O lines, 7.5% increase in contract binding, and nearly 6.5% increase in excess workers' compensation. Certain lines continued their momentum of achieving strong cumulative increases. For example, our admitted loss-sensitive businesses as well as our lower capacity D&O lines have achieved 13 consecutive quarters of rate increases. The private not-for-profit D&O unit has in fact secured double digit increases for nine of those 13 consecutive quarters. The ratio of net premium to gross premium in the quarter was 75.5% versus 80.9% a year ago. The insurance segment had a 74.2% ratio compared to 73.5% a year earlier.
This quarter's insurance segment net to gross becomes 76% when the impact of the SPARTA renewal rights transaction discussed on last quarter's call is removed. This continues to show the insurance segment's emphasis on writing smaller, lesser volatile business and keeping more of it net as a result. In the reinsurance segment, the net to gross ratio was 75.8% in the 2014 third quarter, compared to 94.6% a year ago, primarily reflecting sessions to Watford Re as a reinsurer, another third party retro purchase is protecting the property book. The mortgage segment posted an 86.6% combined ratio for the quarter. The expense ratio, as expected and as indicated earlier, continues to be high as the operating ratio relating to our U.S. primary operation will remain elevated until proper scale is achieved.
The net written premium of $58.5 million in the quarter is driven, as Dinos noted, by $32 million from our U.S. primary operation and $26.5 million of net written premium from our reinsurance mortgage operations, which includes the 100% quarter share of PMI's 2009, 2011 underwriting years as part of the acquisition of the CMG companies in the PMI platform. At September 30th, 2014, our risk in force of $10.1 billion includes $5.5 billion from our U.S. mortgage insurance operation, $4.5 billion through worldwide reinsurance operations, and $136 million to our risk-sharing transactions. It's important to note that U.S. operations utilize policy-specific coverage ratios to determine risk in force from insurance in force figures. As you may recall, insurance in force represents the aggregate amount of the individual loans insured, while risk in force incorporates the insurance coverage percentage.
Outside the U.S., we followed market practice to estimate Risk in Force on a similar basis, while for risk-sharing transactions, Risk in Force reflects our percentage participations within bound layers, as well as the impact of contract limits. That is, Risk in Force on risk-sharing transactions does not exceed the contractual limits of liability involved. Our primary U.S. mortgage insurance operation bound just shy of $2 billion of New Insurance Written during the quarter, which represents the aggregate of original principal balances of all loans receiving coverage during the quarter. The weighted average FICO score for the U.S. primary portfolio remains strong at 733, and the weighted average Loan-to-Value ratio held steady at 93.4%.
No state's Risk in Force represents more than 10% of the portfolio, and our U.S. primary mortgage insurance company is operating at an estimated 9.1 to 1 Risk-to-Capital Ratio as of September 30th, 2014. The other segment, i.e. Watford Re, reported a 100.2% combined ratio for the quarter on nearly $100 million of net written premium and $34.8 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 due to the variable interest entity accounting election. Our joint venture, Gulf Re, produced a $7.8 million loss for the quarter due to an unusually high frequency of large technical risk losses stemming from the Middle East. This is reflected on the income statement within the other income line.
The total return on our investment portfolio, as Dinos noted, was a reported negative 51 basis points in the 2014 third quarter, reflecting negative returns in our fixed income and equity sectors, along with the impact of the strengthening U.S. dollar on our foreign denominated investments, while our alternative investment portfolio continued to perform well. Excluding foreign exchange, total return was a positive 21 basis points in the 2014 third quarter. On a trailing 12-month basis ending September 30th, the total return has been a positive 3.30%, and excluding foreign exchange, the return has been a positive 3.76%. Our embedded pre-tax book yield before expenses was 2.21% as of September 30th, 2014, compared to 2.175% as yearly at June 30th. While the duration of the portfolio lengthened slightly to 3.28 year from last quarter's 3.14 years. Fixed income duration can fluctuate due to tactical investment decisions as opposed to long-term strategic shifts.
The current duration continues to reflect our conservative position on interest rates in the current yield environment. Reported net investment income in the 2014 third quarter was $72.2 million or $0.53 per share versus $72.5 million in the 2014 second quarter, which was also $0.53 per share, and $66.1 million or $0.49 per share in the corresponding quarter in 2013. As always, we evaluate investment performance on a total return basis and not merely by the geography of net investment income. Interest expense for the quarter was $4.2 million, which is a significant reduction from the last two quarters. This reduction is due to a favorable adjustment involving a certain large portfolio transfer entered into effective January 2013. This deposit accounting transaction had a downward reevaluation in the quarter of the underlying ultimate loss, which resulted in an $8.2 million reduction in interest expense.
The run rate interest expense, which includes approximately $12 million from Arch's senior notes and a variable amount of Arch's revolving credit borrowings and some other items, is suspected to be approximately $13 million per quarter for the foreseeable future. However, reevaluation of the underlying ultimate loss attributable to this needs to give us significant financial flexibility. We also continue to estimate having capital in excess of our targeted capital position. Book value per share, as Dinos noted, was $44.04 up 0.7% relative to June 30th, up 10.6% relative to year-end 2013, and up nearly 15% relative to one year ago at September 30th, 2013. This change in book value per share this quarter primarily reflects the company's continued strong underwriting performance, offset by unrealized losses on investments. With these introductory comments, we are now pleased to take your questions.
Frances, we're ready.
Thank you. Ladies and gentlemen, to ask your questions, you may press star one on your touchtone telephone. If your question has been asked or you wish to withdraw your question, you may press star two. Please stand by for your first question. That question will come from the line of Kai Pan with Morgan Stanley. You may begin.
Good morning. Thank you for taking my call. The first question is on the buyback. Looks like you start buyback actually in a big way in more than a year. I just wonder what changed your stock process on that. Is that less opportunity for organic or acquisition growth, or you find your stock price is more attractive now?
It's a good question. Let me give you the flavor and the decision-making process that we go through. Our excess capital was building rapidly, and at the same time, because of the environment we have in the property CAT area with additional capital coming in, et cetera, it caused us to reduce our exposure into that sector. Usually, we don't buy shares back in the third quarter because of the potential storm activity. With $450 million PML in Florida, that risk was a lot more manageable for us. It cleared the way for us to look at our excess capital and also look at the prospects of us deploying that capital in the business. We are not as optimistic in finding transactions for us that they're reasonable for our shareholders. We had a few that we attempted, and we were in the mix.
None of them materialized, being conservative in our approach of acquiring business. If I'm not able to deploy the capital into the business, then the next option is to returning to shareholders. That's the thought process we went through. We decided to initiate the buybacks even in the third quarter, which is not a normal activity for us for the reasons that I just mentioned. Plus, we felt the price that we were buying the shares, it was pretty attractive in reinvesting in our business.
Let me just add to that, Kai, following up on Dinos' very last point. From a valuation and attractiveness standpoint, we bought these back at 145% of book value. You heard Dinos earlier in his comments talk about our forward look of our underwriting years, not calendar years, but underwriting years, being 10% to 12%. The arithmetic works.
If the current condition persists in terms both your stock price and as well as the prospects of the business, would you feel to say that you can return 100% of your operating earnings and would that be a catch up in the fourth quarter in particular to match up the first half of the year?
Yeah, that's not an unreasonable assumption.
Okay. That's great. I just want to struggle with this question a little bit. If you look back last 10 year, your combined ratio average about 91%, yet your ROE is +16%. This year, your combined ratio actually pretty good, 87%, yet ROE is low double digits. I just wonder, investment probably play important part of it, but just, is the current environment, even with this pretty solid combined ratio, that you will be able to only achieve like a low double digit ROE? Is that like the prospects, at least in the near term?
No, you're doing comparisons without make adjustments for the E. There is periods of time that our shareholders' equity is in the right place, so in essence, we don't have much excess capital, and there is periods of time for different reasons, that the equity we have is about what we need to run the business. Of course, when you have that, it affects the ROE because the R is the same and the E is a larger number, it's going to give you a smaller percentage on that. It's management's responsibility, and I'll take that on as my responsibility as a CEO, to make sure that we have a good balance between capital needed, the protection we need to have excess capital for various reasons that we explained in many of our prior calls. Take the excess capital and return it.
That was the activity you saw in the third quarter, potentially continuing in the fourth quarter, et cetera. When you look at ROE, you also got to look at the capital at the same time, and then you can make those comparisons about the quality of the business that we generate. We're happy with the quality of the business that we generate. Unfortunately, in a competitive market environment, especially in the reinsurance side, we don't think we're going to have as much of it as we would like.
Just to clarify on that, your 10%-12% current ROE expectation, is that on allocated capital or on what's currently on your balance sheet?
It's on allocated capital.
Okay.
We allocate capital to the business units at two notches above our financial rating. Our financial rating is A plus, and we go to double A in the models to allocate the capital to the units.
Thank you very much, Dinos Iordanou.
Thank you.
Your next question will come from the line of Michael Nannizzi from Goldman Sachs. You may begin.
Great. Thank you. Just a few questions on the MI business. Can you talk a little bit about how much of that NIW, the $1 billion that didn't come through the credit union was through the bank flow channel?
There was quite a bit for the bank channel, but it was on what we call prepaid single premium revenue. Are you focusing just on the U.S. primary MI or the global
No. Yeah, I'm sorry to interrupt. No, I was thinking Arch MI primary business. How much of the $1 billion that isn't the credit union business would fall into that sort of flow business or flow bank channel?
The flow bank channel is still at its infancy. It was about, I would say, 10%-15% of the total. The other 85%, it was single premium prepaid MI.
Got it. Great. Thank you for that clarification. As far as that bank channel is concerned, as you continue to sort of scale up and you've mentioned now you have relationships with the large banks. How do you see that progressing? When you think about like a target market share and kind of where you are now, what sort of glide path do you anticipate to get there?
Well, I'm an impatient guy, if you ask for my.
If I have one, again, I apologize just because I can't hear. In terms of capital that you've allocated to that business, do you anticipate sending more capital down to the MI, or do you feel like at this point with that 9.1 to one that you're at a comfortable place to pace the growth that you expect for the foreseeable future? Thanks. Again, apologies for the cut in.
Okay. At 9.1, we're probably the most conservative from a capital point of view from any one of our competitors in that space. I don't anticipate sending more capital to MI until it's needed. We're not going to get to the steady state with PMIs for quite a bit of time. Mark, you want to elaborate on that?
Yeah. The wild card is the PMIs, and that marketplace is dynamic too, similar to the P&C side. It depends what the demand turns out to be, and we'll do it at that time. It could be that we need to put some additional capital over the next few years, we have to see what materializes.
Yeah.
Great. Thank you.
Your next question will come from the line of Vinay Misquith from Evercore Partners. You may begin.
Hi. Good morning.
Hi, Vinay. How are you?
Good. How are you? The first question is on the reinsurance side. Looking at the accident year loss ratio ex CATs, about 58% for the reinsurance division. That's lower than the 60, 61% you had in the first half of the year. Is the business mix change, hence the removal of the towers, reinsurance premiums having a positive impact on your loss ratios?
Yes and yes. I will give it to Mark, who will give you more details. We did book that at a higher loss ratio, and the mix is changing, but the mix change actually goes a little bit against us because we are not having as much CAT business, which usually the expected loss ratio, it is in the 40s. You have less of that, so there is a mix change. Mark, you want to add more color to it?
Sure. Vinay, I assume you are talking on an accident quarter basis as opposed to-
Correct.
basis.
Yes.
Other than to reiterate, I think you have heard us talk about mix every quarter and how mix can affect things, and I think this is a great quarter of how mix has done that. Not just by line of businesses, but by the operations within the reinsurance group. We always talk about the treaty side and the property CAT side, but we have a very profitable property facultative side that really had outstanding results this quarter and helped with that loss ratio.
We shouldn't take this quarter's number as a new run rate for the future?
It's coming down to mix. I hate to do the forecast that you're asking for. It'll depend on what materializes. The reason I say that is because the property facultative book is not CAT dependent. They don't lead with CAT. They pick it up in some old risks, but they are really looking for attritional underwriting, which they're very good at. Their results are not going to be impacted by what you're reading in headlines on CAT business.
Okay. Fair enough. On the primary insurance book, a similar question. Now, was the large losses about 1.7 points? Did I hear that correctly?
Well, the large losses emanate from the war risk book. You know what they are. You got the unlucky Malaysia Airlines hit twice, you have Tripoli. Now for that specific book, it was much more in loss ratio points. For the entire insurance group, I think the effect was, how much, Mark?
Yeah. In total, it was about 3.3 loss ratio points of worldwide premium.
Right.
Vinay, it was 1.6 at the corresponding quarter last time with similarly valued attritional loss sizes. That difference between the two is 170 basis points of net earned premium that I referred to in my comments.
Sure.
Yeah. You can never tell, but these things happen. You get unusual losses occasionally. We don't view these recurring, but who the hell knows in this world. If they continue to recur, we're going to reevaluate our underwriting posture.
Vinay, take it from 10,000 feet up. This is a clear example to me of a large attritional loss.
Man-made
Yeah. A smoothing, if you will, because this is a CAT cover at the end of the day. You're going to go 10 years of 5% and 6% loss ratio, then there's going to be a 500% loss ratio moment, then it's going to return back to 5 or 6 loss ratio points. Take it from that perspective, you don't really view that as a recurrent item.
Right. Fair enough. If I take that out of the numbers, the accidental loss ratio ex CATs in the P&C primary insurance business was around 64.6% this quarter. Looking at it at the year-ago quarter, it was 64.0%. You're seeing a slight uptick in the loss ratio. Was that business mix? Because I thought that there was some margin improvement coming through the book.
Yeah. There is some business mix. We don't evaluate our businesses on loss ratio alone, then look independently at expense ratio, then look independent at the duration aspect and the investment income side. It's all in totality. That's what return is. You can't really look at a loss ratio without looking at the outstanding improvement that they've gotten on ceded commissions, which finds its way through the net acquisition ratio. By the way, it earns its way in. That's in a forward sense because that's already baked in written. Those ceded and commission improvements are going to continue to be baked in, firstly. Secondly is not every treaty renews at the same time. Those treaties are renewed at periodic points throughout the year, additional gains are possible.
Yeah. Of course, the duration of liabilities and investment income associate is part of the mix for when we make a total return determination. You're not going to view high excess workers' comp with very long duration, the same way you're going to do E&S property who has no duration.
Sure. This quarter, the acquisition expense ratio went down in the primary insurance division. Was that because of ceding commissions, and should we expect that to continue for the future?
That's the point I was really making. You can't see it, but the direct commissions paid up front really didn't change appreciably at all. That whole balance is mostly, I can't say exclusively, mostly driven by the increase in the ceding commissions.
Sure. Okay, thank you very much.
You're welcome.
Your next question will come from the line of Jay Gelb from Barclays Capital. You may begin.
Thank you. I just wanted to follow up on the buybacks. It was a nice surprise to see the buybacks coming in the quarter, and then flowing through the fourth quarter. I believe there was a comment saying that buybacks could be equivalent to annual operating earnings. I just want to make sure before people start building that into their models, just want to confirm whether that's sensitive to things like valuation, market opportunities, and anything else.
It's all in the mix, Jay. I think we can chew gum and walk at the same time. We don't make a decision, and that decision is permanent without looking at the environment. We look at our share price, we look at prospects where we got deployed capital. We look at the business opportunities, et cetera. We look at our excess capital and how big that amount is. We make judgments. Beyond that, we make also a judgment in, not only how much we need to return to our shareholders, but in what form we want to return it. It's not only share buybacks. If our share price gets to where it's appropriately priced in the marketplace, we might then do a dividend. We take all that into consideration.
All right. I appreciate that. Thanks very much.
You're welcome.
Your next question will come from the line of Jay Cohen from Bank of America. You may begin.
Yes, thank you. Question on the mortgage business. You guys suggested that some of the premium came from these single premium transactions. I'm just not as familiar with the mortgage business. Can you describe what exactly those are, and will the accounting on earned basis be different because they were single premium transactions?
Yes, Jay. For clarification, yes, that would be the case. To the extent that they are single bullets, they will be earned over the rate of a life, think of it that way. To the extent that they are monthlies, they'll come in and as written and earned really
On a monthly basis.
On a monthly basis. You're going to build up unearned premium reserve on the single bullets.
Do you guys care which form it comes in? Does it matter to you?
Yes and no. It depends on the price at the end of the day. Single premium usually is not as attractive to us because it's competitively bid, et cetera. Depending where the mortgage cycle is and interest rates, if you get a reduction in mortgage rates and you have a significant amount of refinancing going, then that's an attractive product because.
Proceed with your question. Okay. Next question in line comes from the line of Ryan Burns from Janney. You may begin.
Good afternoon, guys. I'm sorry, the call's been kind of breaking up a bunch. I'm not quite sure what we were just talking about. It also broke up earlier when we were talking about the interest expense, the pressure from the loss portfolio transfer from January 2013. I just wanted to see how we should think about that going forward. I think you may have answered it, the call broke up.
Okay. Mark will take it.
Yeah. Actually, Ryan, there hadn't been a question on that, you didn't miss anything. The $8.2 million that we reflect in our comments and in the earnings release is a portfolio transfer that was effective January 2013 on basically losses from 2000 to 2012. It was reevaluated subsequent to that, it was a reduction in the ultimate losses. The accounting requires that you go back and retrospectively look at it as if it had always had that view. You should think of the $8.2 million, since it was recorded as a reduction in interest expense, as an outlier, that piece is not recurrent. Unless we decide in the future to have another valuation which changes the ultimate liability.
Assuming that there's no future changes to it, all you're going to see in future income statements is the accretion associated with that liability over its expected payout period.
Okay. How often do you do a deep dive on that piece?
It's periodic. It could change. It could be semi-annual. It depends on what we're observing in the underlying information in the data.
Okay. Great. I apologize if this has been discussed as well. The growth at Watford was very strong in the quarter, probably better than most of us were anticipating. Just want to get your thoughts there on how close you guys are getting to a run rate there.
Well, we don't really know because I can't predict the future. There has been a lot of interest on the facility, and the facility competes in the marketplace. At the end of the day, we've been pleasantly surprised about its acceptance so far. If it continues, we can get to a steady state within two years instead of three.
Again, just remind us what kind of underwriting leverage that vehicle can get. Obviously, thinking that it gets a little more aggressive on the investment portfolio side.
Well, I think it's a question you got to ask them, et cetera. I'll give you my flavor. I think on a company with $1.2 billion of unencumbered capital, you can go into the $500 million, $600 million worth of premium written 0.5 to one and be extremely safe and pretty conservative with that. That's what I would call steady state, and it might take a couple of years to get there.
Great. No, I appreciate that. Thanks, Dinos.
Your next question will come from the line of Joshua Shanker from Deutsche Bank. You may begin.
Thank you for taking my question late in the call. Hope everyone's well. Don has already castigated me a little bit that I don't know my accounting very well. I wonder if you can help me understand how the Watford non-controlling dividends and contributions work at the bottom of the P&L.
Sure. It's a good question because it gets a little murky. You could tell by my opening comments that we got to phrase things in a certain way. Here's what I think you're missing, Josh, is that in any company, the common shareholders are going to be basically subsidizing the preferred costs. They're always deducted before you have net income available to common shareholders. Think of it as we're looking at it as what's available to Watford's common shareholders. Then you got to make the next step of what's available to Arch's common shareholders. You're effectively going to have at the 100% level down because of consolidation, what's their net income? Okay, round one. Round two is the further deduction for the preferred. Okay? Then you're at the point where you're taking the controlling interest into account, which is roughly 11% and 89%.
We need to take out 89% so that we're left with the 11. Since you already subtracted the preferred to begin with, you're implicitly doing an 1189 on those preferred when you make that adjustment. I know this sounds a little confusing. Suffice it to say, those adjustments, the $10.3 million that's there, is the combination of the preferred cost and the net income split back 1189.
The preferred dividend of $4.9 is included in the $10.3?
Yeah.
Okay. Is it net of the $10.3, or is net of? Was there Arch's share of?
Arithmetically, forget conceptual for a minute. Arithmetically, the $6.6, which was the net income at the 100% level, in combination with the $4.9 million on the preferred, that lumped together, if you take 89% of that, comes to the $10.3 million, which is a sign reversal because we're undoing it. You're left with the $1.2 million of net income available to Arch after taking out non-controlling interest.
Okay.
Okay?
I think that after I think about it for 20 minutes, I'll understand perfectly.
Hey, it took me 20 minutes. Don't worry about it.
The other thing that I've done wrong, apparently, is I've also miscalculated the operating tax rate. It seems to me that you had about $158 million of pre-tax operating income before dividends. After I make those adjustments for the preferred dividend, the dividend to Watford and Arch's stake in Watford, I'm still at about $158 million, operating income was $142 million after tax, which seems like you had a big tax bill on the operating side of the P&L. Maybe I'm wrong about that.
Yeah. I can't figure out how you got there, quite frankly. As I said.
We know what our tax rate is.
Yeah, we know what our tax rate is.
We can tell you.
We're 2.5% on pre-tax operating.
It was operating tax rate versus group tax rate.
Yeah. That real differential is the difference between 2.5 and 2.8 on net income versus pre-tax operating. Maybe we could have a side call, I guess, but I don't know what you did.
All right. That just shows I should go back to school.
Yeah. Just call Mark and then go through it.
All right. No worries. Thank you very much, and congratulations on Watford's coming along.
Thank you.
Your next question will come from the line of Ian Gutterman. You may begin.
Hi. Good morning, Dinos.
I knew the back of the class will come.
My first question is, you usually have these calls on Friday. Do you have big plans for Halloween lunch tomorrow?
No. I'm going down to UVA to watch my daughter play. She plays against Pittsburgh. They're 16 and one and ranked third in the nation, so pretty excited about it.
Baklava is not a good Halloween gift for the kids.
All right. Well, good luck with that. I think some of the ghosts and goblins have haunted the audio on the call today in revenge. I guess my first one, Mark, do you have the split of how much of the Watford gross premium in the quarter was essentially Arch source business ceded to them versus third party business from outside the company?
We really never talk about that explicitly. What I can tell you is that it continues to build momentum, we're happy with where it is. This vehicle is really set up to be third party reinsurance. Over time, this is going to continue to be growing towards being Watford dominant.
Got it.
Ian, I'm surprised that being so smart, you can't figure it out. It's in the numbers.
Well, I think I figured it out, but I just wanted to.
Okay. All right. Okay. If you figure it out, if you see gross versus net and then the 15%, all you have to do is reverse engineering, and you figure it out.
Okay. I was just trying to confirm my math, but I'll take it.
Okay. All right.
By the way, your math is going to be predicated on fundamental assumption that may not be true in the future, but I'll wait till a future quarter for that one.
All right. The other question on that is there was picked up somewhere in the, I can't remember if it was The Insider or someplace else, suggesting that Watford's going to hit $400 million by the end of the year. Do you have any comment on that, or?
I believe what the article said, it was that on an underwriting year basis, there is $400 million. That doesn't mean by the end of the year, another quarter. It points to you that it's going to be approximately $100 million a quarter for four quarters.
Okay, great. Any thoughts on the satellite, the NASA loss the other day? Is that an industry event, or does that not have much-
It's $200 million or something. The only thing I know, I'm not on it, I'm okay.
Perfect. My last one, this is where the audio cut out a little bit, so I might have missed part of this, but back to the single premium MI, I guess, just to understand that a little bit, essentially, is that kind of like bulk business? Not GSE bulk, but is it essentially bulk from the banks, or is this stuff you're writing?
Yeah, it's an originator who will take maybe one or two weeks of production and put it out, and he says, "Give me a price for you to write the mortgage insurance on this block. Here is all the underlying loans that we have, and we're going to prepay it up front." Single premium instead of month. A lot of these, sometimes it's paid by the borrower because they include it into the price of the mortgage. Sometimes it's paid by the lender.
Okay. Is this just sort of something that makes sense given where you are building out the company, that it's a good way to sort of get premiums on the books quickly to offset some of the expenses and then.
Oh, no.
over time as you get more flow, or is this?
No, we don't think it as such. The way we think about the mortgage business is that you have flow business, you have these single premium business, you have other transactions we're doing in the reinsurance, the STACR and transactions, et cetera. We look at the entire marketplace, and if we like a transaction, we go after it. We don't have a preconceived notion we have to have three of this and two of that and five of this. That's not the way we operate. You know us better than that.
Okay. Just checking. Just my last clarification on that topic is, Mark, I think when there was a question about how this flows through the accounting, I understand the earned part, obviously. On the written, it sounded like you said this still flows over 12 months. I guess I would have thought if it was-
No
single premium written, the written would have all hit this quarter to be earned over 12 months.
A single is hit all in one accounting period and then earned over the rate of life.
The rate of life, not one year. It goes, right?
Very true. Okay.
Yeah.
Okay. The point is, from a written basis, it's more upfront than traditional MI that comes into the written 1/12 each month.
That's correct. The rest of it is monthly and it's written and earned all in the same month. Yeah.
Got it. Okay. Thank you so much.
You're welcome.
Your next question will come from the line of Meyer Shields with KBW. You may begin.
Thanks. I think I'm in the back of the class.
Well, you joined in. I guess there was an empty chair in the back of the class, huh?
Absolutely in the class. Last question on the mortgage insurance side, is the expense ratio different for the single premium business? The acquisition expense, I mean.
Well, I don't know if it's different. You have your personnel, you got your underwriters, you got a fixed base of expenses. At the end of the day, it is what it is. If you write it and you book it up front, you still have to service it over six, seven years. I haven't thought of it as, is expense ratio a difference between a flow business versus that.
Okay. Going back to the insurance segment, I think, as you started talking about some of the small account business where you're growing, being less volatile, does that cost anything in terms of the anticipated underwriting margin?
Actually, no. It's lesser volatile, as Dinos' pointed out before. As a general rule, it comes with a lower loss ratio and a higher acquisition cost.
Okay, perfect. Thanks so much, guys.
Thank you.
At this time, we have no further questions in the queue. I'd like to turn the call back over to Mr. Dinos Iordanou for your closing remarks.
Thank you, Frances. Thanks, everybody, for bearing with us, and we're looking forward to talking to you again.