Good day, ladies and gentlemen. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby.
Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to turn the presentation over to your hosts for today, Mr. Dinos Iordanou and Mr. Mark Lyons. Please proceed.
Thanks, Glenn. Good morning, everyone, and thank you for joining us today. We had an excellent first quarter from an underwriting perspective, and we were also successful in launching two strategic initiatives this past quarter. We entered the U.S. direct mortgage insurance marketplace and also became a reinsurance manager for Watford Re. I will comment further on this initiative shortly, but first, let me share a few observations on the quarter. Earnings were solid and were driven by excellent reported underwriting results, aided by low catastrophe activity. On a consolidated basis, our premium revenue grew by approximately 11% on a gross written basis and nearly 12% on a net written basis, although we were a few noteworthy items, which I will get to in a minute.
On an operating basis, we earned $1.20 per share for the quarter, which produced an annualized return on equity of 12.1% for the first quarter 2014, compared to 12.9% for the same quarter in 2013. On a net income basis, earned $1.30 per share this quarter, which corresponds to an annualized rate of 13% return on equity. Our reported underwriting results in the first quarter were excellent, as reflected by a combined ratio of 84.7%, and were aided by low level of catastrophe losses and favorable loss reserve development. We also benefited from improved accident year performance in our U.S. reinsurance group, which was more than offset by an increase in the accident year combined ratio in the reinsurance group. It is worth noting that there were three components to the increase in the reinsurance group's accident year combined ratio.
In the first place, the mix of business changed, with the group writing less property cat business, which has a lower expected loss ratio. Secondly, our reinsurance group, over the past 12 months, found more casualty and professional liability business, both in the U.S. and internationally, which met our return thresholds. Thirdly, because some of these casualty business we underwrote has a longer duration, which should produce excellent economic returns, we follow our historical practice of reserving very long-tail business at a more conservative level. The longer the tail, the more conservative is our loss pick, and historically, this approach has worked very well for us. No need for us to change that methodology, and we chose not to. Net investment income per share on a sequential basis was flat in the quarter at $0.49 per share.
Our operating cash flow for the quarter was approximately $200 million, a bit less than the $205 million from the same period last year. The total return on the investment portfolio was 100 basis points for the quarter, inclusive of fluctuations in foreign exchange rates. Our book value per common share at March 31, 2014, rose to $41.53, increasing by 4.3% sequentially and 10.3% relative to first quarter of a year ago. Let me return to the strategic initiatives I mentioned earlier. As you know, we, along with the Highbridge Principal Strategies, a subsidiary of JPMorgan Chase & Co., launched a newly formed multi-line reinsurer, Watford Re, in late March, with $1.1 billion of initial capital. Arch invested approximately 11% of the common equity and will serve as the Watford Re's reinsurance manager.
Mark will go into more detail on the accounting for Watford when he gets to his prepared remarks. Despite the late start in the first quarter, Watford Re was only formed in the last few days of the quarter, Arch ceded $32.2 million of premiums to Watford Re. We believe that this new venture will benefit shareholders of both Arch and Watford Re. Our mortgage segment includes primary mortgage insurance written through Arch MI in the U.S. and internationally, reinsurance treaties covering mortgage risk, which is written globally, as well as other risk-sharing and structured mortgage business. Our mortgage insurance business in the U.S. serves two major markets, credit unions and banks, and other mortgage lenders. Arch US MI represents about 40% of the $43.3 million of net written premium in the first quarter of 2014, most of which is attributed to the credit union sector.
As we discussed on prior calls, in the banking sector, we continue to build our client base. As of last week, we had received over 100 master policy applications from banks, of which 98 have been approved. 13 of these approvals represented national accounts, and the rest are regional or local banks. The number of master policies is increasing each month, with March approvals double February's rate, and April's running at two and a half times the March rate. Of course, approvals are the first step in this process. It takes time to integrate systems and then get into the bank's rotation in order to receive new mortgage insurance policies. Our sales force is working hard on this, and they are incented to achieve their sales targets over time.
In the primary markets in which our insurance group participates, we continue to obtain rate increases above loss trend, slightly above the levels that we observed last quarter. In our U.S. insurance operations, we achieved rate increases in the quarter that provided 120 basis points of expected margin improvement, which was better than the last quarter. We continue to see our best opportunities in some sectors of the E&S market and in our binding authority and program businesses. In these areas, we have seen steady improvements in pricing and steady gain in exposure units, which contributed to our solid growth in the first quarter. Although we did observe the large account casualty and professional liability guarantee cost segments coming under more pricing pressure in this first quarter of 2014. We currently remain a minor player in these sectors.
The reinsurance side of the business, we have seen a continuation of softening in terms and conditions that we noted in our prior quarter's remarks. As you have heard on other calls, the property cat area remains under pressure, primarily due to the alternative capacity that has entered the market. For the first quarter, we experienced approximately a 15% reduction in property cat rates on a gross basis. As we reported on the last quarter's call, cedents are aggressively requesting additional ceding commission on quota share contracts of between 2%-4%, and reinsurance buyers continue to shift business through excess of loss treaties. Let me remind you again, since we're both an insurance and reinsurance enterprise, should we experience pain in our insurance segment, we stand to benefit from the improvement in terms of on our insurance operations as we are significant buyers of reinsurance.
From a production point of view, gross written premium in the reinsurance segment grew by 14.8% over the same period last year due to two significant treaties written in 2013 on a risk attaching basis, as well as some new international casualty treaties. Net written premium increased just 5% over the same period due to additional retro purchases and our sessions to Watford Re. The insurance segment grew premium by 6% on a gross basis and 8% on a net basis. Most of our growth is coming from low-limit accounts. In our loss-sensitive business, which is National Accounts and Construction , mostly written on large deductible loss sensitive basis.
Group-wide on an expected basis, we continue to believe the ROE on the business we underwrote this quarter will produce an underwriting year ROE in the range of 11%-13% with ROE improvements in the insurance group results offset by deterioration in the reinsurance group, primarily due to lower cat rates. The higher reserving rates for the casualty business in the current accident year will not affect the underwriting ROE at Ultimate in our reinsurance business. 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 April 1st, while the premium numbers included in our financial statements are through March 31st, and that the PMLs are reflected net of reinsurance purchases and retrocessions.
As of April 1st, 2014, our 250-year PMLs for a single event decreased to $705 million in the Northeast, or 11% of common shareholders' equity. This is the lowest level, I think, I believe in our history. While Gulf PMLs also decreased to $624 million. Our Florida Tri-County PML now stands at $488 million. We note that these reductions reflect a change in catastrophe models from RMS Version 11 to Version 13, as well as opportunistic retrocession purchases that we chose to buy. I will now turn it over to Mark to comment further on our financial returns and results. After his prepared comments, we will entertain your questions. Mark?
Great. Thank you, Dinos, and good morning. As you've noticed by now, we've made some changes to our reporting format. We added two new segments in addition to our prior insurance and reinsurance segments, as well as modified some line of business definitions. The new segments are mortgage business and the colorfully named other segment. The mortgage business segment encompasses both insurance and reinsurance across U.S. and international operations, and additionally, any risk-sharing transactions with the GSEs or banks would be contained here. Previously, mortgage insurance, reinsurance, and risk-sharing transaction results were reported within the reinsurance segment. That is no longer the case, and we have provided apples-to-apples comparatives so you can properly reference prior periods.
The second new segment, called Other, currently reflects the Watford Re results, which is a new Bermudian Class 4 reinsurer with an A-minus AM Best rating, and as Dinos said, a $1.13 billion in total capital. Arch acts as Watford's underwriting manager, while Highbridge, a subsidiary of JPMorgan, manages Watford's investments. Even though Arch only holds an 11% minority interest in the common shares of Watford Re, along with some warrants, we have consolidated 100% of their results in Arch's financial statements with a requisite offset reported as non-controlling interest. We have consolidated Watford not due to our percentage ownership, but due to the accounting rules of variable interest entities or VIE. Therefore, Arch's consolidated statements now reflect Watford's assets, liabilities, cash flows, revenues, and other income statement items at a gross 100% level, with the corresponding approximate 89% non-controlling interest removed as a single-line offset where appropriate.
Unlike other segments, Watford has its own operations and accordingly has its own assets, investment strategy, and management. We will present Watford's results inclusive of its invested performance. The other change we made within our financial presentation is our definitional grouping of products within the insurance segment. Some lines are broken out more finely than before, whereas others are combined with previously provided lines. In both cases, groupings were made with an eye towards our line of management accountability in conjunction with materiality levels. Now I'll proceed to report on our financial results for the quarter. At this point, the financial results of ACGL, with or without Watford Re, are not materially different from each other, since Watford only had $2.2 million of net earned premium.
Over time, however, as Watford Re grows, they will become more significant, and I will make some comments that include or exclude their results as appropriate in those future quarters. The only comment of significance this quarter is to point out that ACGL's cash increased approximately $1.1 billion. This is predominantly due to the capital raise for Watford Re in late March, and that Arch is consolidating Watford. For this quarter, I will make financial comments that include Watford, since they don't move the needle at this time. The consolidated combined ratio for this quarter was 84.7%, with six tenths of a point of current accident year cat events, net of reinsurance and reinstatement premiums, compared to the 2013 first quarter combined ratio of 84.6%, which reflected 1.5% of cat-related events.
Cat losses occurring in the 2014 first quarter represented $5.5 million net of reinsurance, recoverable and reinstatement premiums emanating from various events. The 2014 first quarter consolidated combined ratio also reflected 9.5 points of prior year net favorable development. Compared to 7.1 points of prior period favorable development in the 2013 first quarter. 86% of this net favorable development was from the reinsurance segment, with nearly 75% of that due to net favorable development on short-tailed lines, primarily associated with the more recent underwriting years. Approximately 20% of the reinsurance segment's favorable development was attributable to longer-tailed lines, mostly emanating from the older 2003-2005 underwriting years. The remaining 5% of the reinsurance segment's net favorable development was attributable to medium-tailed lines throughout many underwriting years.
The insurance group accounted for 14% of the aggregate net favorable development, which was almost entirely driven by short-tailed lines in recent accident years. Similar to prior periods, approximately 68% of our total net reserves for loss and loss adjustment expenses of $7.2 billion are IBNR or additional case reserves, which is a fairly consistent ratio across both the reinsurance and insurance segments over time. Therefore, the current accident quarter consolidated combined ratio, excluding cats, for the first quarter was 93.6%, compared to 90.2% accident quarter combined ratio in the first quarter of 2013. In the reinsurance segment, as Dinos has already commented on, the 2014 accident quarter combined ratio excluding cats was 92.6%, compared to 79.7% in the corresponding quarter of 2013, and 85% in the 2013 fourth quarter serially.
The reinsurance segment's results this quarter reflect a reduction of property cat writings on a gross basis, with additional retrocessional support as well, along with an increase of casualty business driven by a large U.S. professional liability treaty and some European excess of loss contracts. In the insurance segment, the 2014 accident quarter combined ratio excluding cats improved to 94.8% compared to 97.9% a year ago, showing continued improvement in margin expansion that has been aided by the lesser volatile, smaller account strategy implemented over the last half dozen years. Also on a consolidated basis, the ratio of net premium to gross premium in the quarter was 82.2% versus 81.9% a year ago.
In the reinsurance segment, the net to gross ratio was 85.9% in this quarter, compared to 93.8% a year ago, primarily due to the changing mix of business on a written basis and the increased uses of retrocessional covers as previously mentioned. The insurance segment had a 74.7% net to gross ratio compared to 73.2% a year ago, as a function of the lesser volatility businesses that they continue to expand upon. The consolidated expense ratio of 34.0% this quarter is 2.5 points higher than the 31.5% expense ratio reported in the first quarter of 2013. This is largely driven by increased acquisition expenses in the reinsurance segment, along with operating expenses related to our U.S. primary mortgage insurance operation. The insurance segment expense ratio was flat with the first quarter of 2013.
As respects pricing levels, the U.S. insurance operation, as Dinos mentioned, achieved a net 120 basis point margin expansion in the quarter over the corresponding quarter of 2013. Margin expansion to, as a reminder, as we report it, represents the excess of written effective rate increases over estimated loss trends. Margin expansion continued in our program, casualty, and construction and national account businesses, while contracting slightly in healthcare and property. We are continuing to see a lower level of loss cost inflation but are approaching these trends cautiously. Our new mortgage business segment posted an 81.3% calendar combined ratio for the quarter. The expense ratio of 59.4% is largely driven by front-ended operating expenses assumed during the PMI acquisition, such as staff and infrastructure, to support the acquisition of premium for the bank channel of our new U.S. primary mortgage operation.
The increase in net written premiums of $17.5 million this quarter is driven by premium gain from our new U.S. primary operation, mostly via the credit union channel, as Dinos mentioned, and by assumed premium emanating from the 100% quota share of PMI's 2009 to 2011 underwriting years as part of the aggregate acquisition of those platforms. Other reinsurance business added nearly $5 million of net written premium, offset by an approximate $11 million reduction from one reinsurance treaty. At March 31st, 2014, we held $5.3 billion of risk in force from our primary U.S. operations, an additional $5.5 billion through our mortgage reinsurance and risk-sharing operations. Risk in force is a standard measure of exposure in the mortgage insurance industry that generally represents approximately 25% of the total aggregate loan values.
It is this risk in force figure that forms the basis for capital ratios used by the GSEs regulators and rating agencies. This segment also experienced $1.2 million of net favorable development this quarter, which represents approximately three combined ratio points. This net favorable development mostly emanated from older report years that had better than expected emergence. The other segment currently contains the results of Watford Re. As I discussed previously, Watford Re was consolidated into Arch's financial statements at 100% level. Therefore, the $32.2 million of net written premium written by Watford this quarter represents 100% of all the business they assumed and not just Arch's 11% common share interest. Adjustments for the non-controlling interest are made in the single adjustment line to net income rather than each line on the income statement, balance sheet or cash flow statement.
Watford Re reported a 151.8% calendar combined ratio on a small net earned premium base of $2.2 million. Certain startup expenses associated with the formation of Watford were also reflected. These should be viewed as non-recurrent. Reported net investment income in the quarter was $0.49 per share, substantially unchanged from the 2013 first quarter of $0.48 a share. Our embedded pre-tax book yield before expenses was 2.27% as of March 31st, compared to 2.38% at prior year-end. The duration of the portfolio increased this quarter to 3.24 years, from 2.62 years as of year-end. The total return on the portfolio was 100 basis points in the quarter, with non-investment grade, fixed income, equities, and alternatives augmenting the returns on our core investment grade income portfolio. Excluding foreign exchange, total return was marginally different at 102 basis points in the quarter.
The effective tax rate on pre-tax operating income for the first quarter of 2014 was an expense of 1.7%, versus an identical expense of 1.7% in the first quarter of 2013. As always, fluctuation in the effective tax rate can result from variability in the relative mix of income or loss reported by jurisdiction. Arch's total capital was $6.8 billion at the end of this quarter, compared to $5.7 billion at the end of 2013's first quarter and $6.5 billion at year-end 2013. The $1.1 billion increase in total capital from a year ago is primarily driven by the $500 million debt raised in December of 2013, plus approximately $600 million of retained earnings over the last four quarters. Our capital structure now at March 31st is comprised of 13.2% debt, 4.8% preferred, and 82% even of common equity.
At the end of this quarter, we continue to estimate having capital in excess of our targeted capital position. As Dinos has just mentioned, book value per share, as a reminder, increased 4.3% in the first quarter, up to $41.53, which is also 10.3% higher than a year ago. The growth in book value this quarter is driven by the company's continued strong underwriting results. With these introductory comments, we are now pleased to take your questions.
Glenn, we're ready for the questions.
Ladies and gentlemen, if you would like to ask a question, you may do so by pressing star 1 on your touchtone phone. If your question has been answered or you would like to withdraw your question, please press star 2. Questions will be taken in the order received. Please press star 1 to begin. Our first question comes from the line of Amit Kumar, Macquarie. Please proceed.
Thanks, good morning, and congrats on another strong quarter.
Thanks, Amit, good morning to you and everybody else, by the way.
Just two quick questions. The first question goes back to your comment on capital and I guess declining PMLs and your two new initiatives. I was just wondering, maybe can you update your views on potential acquisition opportunities in the marketplace versus what you're building out right now? Does your view change if something presents itself, or are you more focused on MI and Watford Re right now?
Multiple questions. Let me start with, we're always focused intensely on everything that we run. I don't care if it's insurance, reinsurance, the MI or Watford Re. That focus is always going to be there, but it doesn't preclude us from also looking forward on other opportunities. Your question about M&A activity, yes, we are willing to look at opportunities presented in the marketplace, but still our preferred way is to build versus buy. We find that from a lot of different perspectives to be more attractive. Culturally, better selection, or at least the selection of people that we believe culturally fit with us, et cetera. There are some of those opportunities that we are pursuing now globally that will fit into that category. Of course, we will not say no to a potential acquisition if it fits our characteristics. Is it specialty business?
Does it fit with our DNA? Is the underwriting posture past and going forward a good fit with us? Maybe I'm very biased to culture within a company, and one thing that I'm extremely careful is not to change the culture that we have within Arch. I'm not saying it's better or worse than anybody else, but it is what it is, and it seems we have had very good performance over 12 years following that philosophy. I'm kind of the guardian of it. We're more of a difficult company to come to an agreement on an M&A opportunity because of all these issues.
Got it. That's actually very helpful. The only other question I have is on your MI platform. First of all, maybe this is a numbers question, but some other MI players, and again, I'm new to this, give sales metrics in terms of new insurance written, et cetera. Would that be in the Q, or how should we think about the sales metrics?
Well, we're going to be reporting that in our Q. Eventually, don't forget, this is our first attempt on the MI disclosure. As I said in last quarter, we're looking also from input as to what is going to help you as analysts viewing our business. Any suggestions you have or what kind of information it would be helpful to you to see, get with Donald Watson, who is the head of our investor relations. Then, if we find it appropriate, we'll improve disclosure in our press releases and supplemental data.
The overall approach of it is that we'll provide by at least as much as what's standard in the industry for that.
Got it. That's very helpful. I guess related to that, and this is my final question, any update on your views on the MI market? It is, I guess, my understanding that there have been some players who have attributed a slowdown, I guess, to the cold weather in Q1. There is some discussion, I guess, in that marketplace regarding the housing recovery. Any update would be helpful on the marketplace. Thanks.
Well, first, a little bit of a shameful plug on our people. If you go on our website, Arch Mortgage Insurance publishes a quarterly newsletter, which gets into a lot of these macro issues. I will encourage you, instead of taking everybody's time to get on the website, go to Arch MI, and look at the quarterly views that we have on the macro issues within the mortgage insurance space. It is clear that in the first quarter, refis have been reduced significantly on the basis that mortgage interest rates have gone up. I believe if you look at it from Inside Mortgage Finance , I think the reduction in refis was like 63% in the first quarter. Having said that, your persistency, there is no refis, goes up on the existing business.
Because a mortgage that gets refied, you're losing the premium, if it was already a cover mortgage to a new one that you're going to get under the refi. We're not projecting, at least in the data that we have, a significant change in volume on our credit union business. We expect some slowdown over the year because new originations are down and refis, they're way down. Now, the more difficult question for us, once, and that's why it's going to take three, four quarters for you guys to get a flavor of it's our penetration in the bank channel. Because we're early on in the process. We're signing these master agreements. We're starting to receive business, but it's a lengthy process. You've got to go through the process of filing and getting approvals on the master agreement.
The systems linkage has to be there, and then you're starting to get on the rotation to start receiving that business. Mark, anything else?
Yeah. I would just add, Dinos' really just outlined kind of a staggered approval process. I think what supplements that is the fact that the industry is dominated by monthly, not single premiums. Even when you get the approval, the business flow takes a while to build because of the monthly nature of the premium remittances.
Thanks for those answers.
Your next question comes from the line of John Hall with Wells Fargo. Please proceed.
Good morning, Dinos, it's Mark and the rest of the Arch team.
Morning.
Hi, John.
Hi there. I've got a question, Dinos, related to, I guess, the shifting business mix and the combined ratio in the reinsurance segment.
Right.
Have we sort of reached a steady state whereby the mix shift has occurred and the migration up in the combined ratio is, variable loss experience aside, we've sort of hit where we're going to be on a go-forward basis?
That's a tough question because I got to understand the mix that we're going to have going forward. I would say probably because of a bit of a conservatism we took on some of the business we wrote that had very long duration. I'm not talking about four or five-year duration. This is business that it will have maybe seven, 10, and some of it even beyond that duration. We're always very cautious when we price that business and also when we reserve that business. You can fool yourself early on, and we try not to. If you saw where our reserve releases came from casualty in the reinsurance sector, they came from the 2003, 2004, 2005 year. That tells you it was the same philosophy we had then, that, hey, let's not celebrate early on very long-term duration business.
Not knowing what kind of contracts I'm going to see in the future, I would tell you that we have reached that if the mix is exactly the same next quarter. In all probability, that will be probably down five or six loss ratio points if we go back to more of our normal mix that we had in prior quarters. It's a very difficult question to answer unless you have a scenario as to what we're going to write and what type of business going forward. Mark, you want to add a few points on that? You spent more time on that analyzing and.
Yeah, I'd be happy to, Dino. I think first thing, two points to make. I think the first one is that you really got to look not as much quarter to quarter, but perhaps what year to year would be like. I mean, the first quarter being at 79.7% last year, that was really an 82% for the year, and the fourth quarter ended at like 84%-ish or something. It's a little bit of an artificial movement. I think what's more important, and I think it's telling that since I changed jobs from the insurance group over and had a chance to really dig into the reinsurance group in this position, when you look backwards, either business emanating out of the U.S. or Bermuda reinsurance operation, not only was it an outstanding job of underwriting, it was an outstanding job of reserving.
When you look now versus then, it's the same chief actuaries, it's the same management of the segment. It's virtually the same in the holding company, which is what we're talking about here. It's one thing for a company to say, "We haven't changed anything on the reserve methodology." It's different to say, and compoundedly so, it's the same individuals involved with regard to consistency. I think that's an important point.
John, accident year in one quarter, especially the most recent quarter, it's a self-grading exam. Self-grading exams to something that it has more than, let's say, five-year duration, you're in fool's paradise. At the end of the day, look at me five years from today and you see how well we've done on that business. It makes it difficult for you guys to estimate, and I understand that. I think the historical performance, which is where Mark is pointing you, might give you an indication of the culture and also the methodologies that we go through in making these long-term reserve decisions that you have to make.
No, I appreciate that. Thank you, Dino. I guess the profit characteristics, when you talk about the target ROE, and the ROE you're achieving here, I guess there's a greater portion of the most recent quarter's business attributable to investment earnings.
That's correct. When you write a very long-tail line of business, there is a few of these. We have treaties that we have booked at 110 combined. We have treaties that we booked at 115 combined, depending on very long duration of liabilities. You're going to earn the adequate return because the investment income is going to come over many years. When you take those cash flows, net present value them back, and then you look at it from that perspective. That's why I made that comment that the 11-13 on an underwriting year basis, because that's the state that usually we make all of our decisions. When we bring all the cash flows, we wrote something, it's going to be revenues and expenses going out and claims going out over a long period of time.
We bring it all back to that underwriting year, then we make that determination, what is the expected return? That's what guides us. I mean, that's been the methodology, not only from a pricing point of view, but also from a reserving point of view. Usually, we'll start reflecting some of that depending on the longevity of the business. Maybe four or five years out, we take another look at it. We're not going to touch it for four or five years because it's too early. You got to allow the data to come in. You get more confident, and you say, "Hey, maybe my reserves are a little higher than they should have been." The beauty about reserves, nobody sticks their hands in your pocket and takes the money out. It's in a bank account. They're earning interest and dividends on our behalf.
At the end of the day, when you recognize them in your financial statements, it becomes data-driven, but data-driven from our perspective needs to have some conservatism in it.
Right. John, one of the key principles in any part of the market cycle that we've operated on is that we're driven by the economics of a deal or a transaction, not the accounting of it. I think the best example of that would be excess workers' compensation, which the green light decision on that is more of a function of the interest rates more than the underlying pricing in some cases, because it's a 16-18 year duration business. It's super sensitive to changes in interest rates and is dominated by the investment return. That will book poorly. That might be booking at a 120 or 130, even in a good market, but it'd be a killer on a return basis.
I appreciate that. I just have one point of clarification. In your prepared comments, Dinos, you mentioned that rate in primary market was above loss trend, but you didn't mention what that number was. I was wondering if you could share that.
Well, we said 120 basis points improvement. In the last quarter, we said it was 80 basis points. I think the rate increase on average, I think in the last quarter was 3.8%. This quarter, I think it was 4.0%. 20 basis points came just from that. There is a little bit of the trend improvement. When it comes to trend improvements, we are a very hard bunch of guys to convince. We look at it, we look at the improvement, but we don't factor it a lot on our published numbers until we're from, what's the town?
Missouri.
We're from Missouri. It's got to prove itself. I can tell you, I look at a lot of these indications. I think the actuaries see a lot of me, and I don't know if they like it or hate it. I'm the only actuary in the room usually, and they're all around me. A lot of our indications, the positive, the trend indications better than expected. More importantly, we do an analysis on actual versus expected. We got these curves. Then we try to see what expected losses we expect from all the underwriting years for the quarter and how much has come in. Those have been extremely good, especially this quarter. One quarter can always fool you, but we have consistency in looking at actual versus expected and being very positive.
Great. Thank you very much, Dinos.
You're welcome.
Your next question comes from the line of Michael Nannizzi, Goldman Sachs. Please proceed.
Thank you. Let me just ask if I can, on the reinsurance book. Was there anything unusual in this quarter about the profitability of that book or, I realize the year-over-year are different because of mix, but just standalone this quarter, anything unusual about where the profitability came in?
Yes. The only thing unusual is that we expect less from the property cat from two points of view.
Right.
One is less volume, and second, probably a little less ROE because of the rate reduction. We're not happy about it. Listen, even the best management teams can't fight Mr. Market. Mr. Market is going against us in that particular segment. That's the only thing unusual. Everything else is as normal as anything. We look at transactions, we look at the potential profitability long-term. We don't care if it's short tail, medium tail, very long tail. As long as it makes the return characteristics, we do it. As Mark said, we don't really pay too much attention on the accounting.
Got it.
To add one thing there. I think to one of the intent to your question, no, there was no underlying influx of paid claims, reported incurred claims, frequency or severity that would have caused this and caused movements. No, there was nothing of that kind.
Great. Thanks. I guess, if we were to isolate the cat reinsurance book, what impact would the pricing that we've seen have on the attritional loss ratio? All else equal, would you expect that the attritional loss ratio in that book, given pricing, is now higher?
Well, listen, putting volume aside.
Yeah
putting volume aside, because there is a reduction in volume because it forced us to buy more retro. We felt it was advantageous for us to buy retro. The cost of capital of some of our retro providers is lower than ours. In essence, they allowed us to buy that in what we think on unexpected basis, at good price. Putting aside volume, we also believe that based on our own calculations, the ROE projections expectation on our cat book has gone down by two to three points. If we thought on a net basis, we had let's say, 15%-16% ROE last year, this year, it will be more like 12%-13% ROE.
Got it. Just overall, your book aside, why you're shrinking it, the expectation would be if pricing continues to recede in property cat business, that margin should fall, attritional loss ratio should rise. That would be the logical outcome.
In the cat business it feeds the fund. You don't have the land.
Right.
It's not going to show up. Let me remind you guys. We had very little exposure in Japan. We thought Japanese rates, they were ridiculously low. We didn't participate. Our PML in Japan before the quake was $75 million, and it was from international programs that we couldn't even avoid. We didn't have much of Japanese-only quake. That served us extremely well when that event happened, because at the end of the day, even though we looked foolish for 10 years, if there is no quake, there is no losses, any premium you wrote became profit.
Right.
We were proven right 10 years later. I have a lot of confidence in our cat teams. I think we have a great analytical team there, and great underwriting team. One area that I don't put my two cents in, and usually I like to in a lot of areas, is in the cat area, because I think those guys are better than me. I wish I can get as good as they are.
That's great. Thanks. I guess, metrics on the MI book, risk to cap, maybe different from other carriers just given the way you run that business, a breakout of primary to risk sharing and reinsurance. Then some demographic data on the profile of the book. Vintage, for example, would be helpful. Then just last one on numbers question. What were the startup costs in the quarter, just so we can try to think about what the business should run at excluding those costs that hit the first quarter? Thanks.
Yeah. It was roughly $2.6 million. Plus there was some unusual ones. You can see in our presentation, we have a line called Other Expense.
Oh, I'm sorry. Is that what?
That was MI.
You're talking. I'm sorry. MI startup costs.
The MI. Yeah, sorry about that. Yeah.
The MI startup cost, we have a sales force that came on board ahead of the transaction, and we've been expensing that. We have a lot of expenses in the first quarter from the sales force, which has no corresponding revenue attributed to it. Don't forget, we got two sales forces. One, which is the existing business, which is CUNA Mutual employees working on our behalf that they distribute through the credit union channel. Then our own sales force, who is trying to penetrate the bank channel, and other mortgage originators. All that. We can get you a number. I haven't added it all up. I'll get Mark Lyons, then we'll try to figure that number out.
One thing you need to understand about the totality of how this works is that.
there's like a shared services agreement that goes on that varies by quarter on what services were performed. We have everybody on the old PMI onto our payroll system now, there's offsets associated with various classes of work, accounting work, IT work, claims handling work, and so forth, that is measured, and there's metrics that determine what that percentage allocation is. Over time, there will be a shift, where it's going to be more resident in Arch. Right now, a lot of that is still pushed off as a credit against it really varies by quarter. Understandably, it's going to be a little hard for you to see through that. That's a little opaque.
That's the dominant driver of the OpEx from quarter to quarter.
Right. The one area you can focus that eventually is, I think we got about 40 people in the sales force. All that is going to be our cost. We're not going to share that because we're building, right? We're building. We have the sales force. The sales force is our expense. We're expensing it as we go. It's salaries, and benefits, et cetera. The revenue is going to come down the line. There is literally insignificant amount of revenue coming from the bank channel in the first quarter. It will be starting to show up in the second, third, fourth quarter. I don't know to what magnitude. It depends how effective we are. We're in a build-out stage.
Got it. Maybe better way to ask is, once you reach scale, and once you kind of reach critical mass, where do you think the acquisition and/or operating expenses should kind of run to?
It's hard to answer. If it's three years or more out, for the entire segment, it should be 20 or in the 20 area. That doesn't mean every unit within the mortgage business runs in that.
Right. Mm-hmm. I understand. Okay. Thank you.
Your next question comes from the line of Vinay Misquith, Evercore. Please proceed.
Hi. Good afternoon.
Hi, Vinay.
Yeah, it's lunchtime now. Well, the first question, just wanted to clarify on the reinsurance operations. About a 93 sort of accident year ex cats, that's the normalized, I mean, that's the new norm, correct? I mean, is that the way that we should think about that?
No, that's not the new norm I said you might be five or six points off.
Oh, this quarter was five or six points higher than the normal, you were saying?
Assuming no change. Like I said, you heard my comments, right? Assuming no change in the mix. If I write a lot of very long-tail business, because I continue to find opportunities there and bind those contracts, it might still be another quarter 92, 93. If I go back to more of a traditional mix, it will probably be at least 5 or 6 points lower than that. Mark just went through the evolution of this. It didn't come overnight. In the past, we were below 80. There has been some deterioration to that, which we will always reflect because of additional cost in ceding commissions. Then there is some deterioration to that because of change of mix, less short tail as a percentage of the total that has low accident year loss ratio on unexpected basis. I would say mid-80s is more of a number.
Let me caution everybody. It will depend on our mix.
Sure. Okay. That's helpful. The second question was on the MI business. You'd said that it would take about maybe 2 or 3 years to really gather steam and to contribute to the bottom line. It seems that even the new acquisition, that's actually having a small positive impact on the bottom line this quarter. Just curious as to whether you think that impact is going to increase even in the near term.
Again, it will depend as we start getting more business, how do we do with these books, target transactions. It's hard to predict, right? Don't forget, even though it's positive and it's good news, I think it's positive faster than we thought, right? We didn't expect to have positive earnings, especially with front-loaded expenses on this first quarter. The ROE associated with it is not yet acceptable to us. Long term, it's going to be much better. A lot of the other indicators, we're very, very pleased with, especially on the existing book that we have for credit union business. First quarter numbers was that the delinquency rates are coming down, and they're coming down significantly. On new delinquency rates in the quarter, they were down by 24.7%. That's a significant number.
The average cost per claim in one quarter was down by almost 20% from an average of $48,000 at year-end to $38,000 at March end. There is a lot of positive. I'm only talking about the U.S. MI, I'm only talking about what we do with the credit union business. There's a lot of positive indications because that is an existing book. We have it. We own the old, we own the current, and we're going to own the future. Those indications boil as that this is a good segment to be, and it's with very acceptable profitability.
Vinay, I would suggest simply, just think of it like this. The U.S. MI operation versus, I'll say everything else, reinsurance operations and everything else, has comparably outstanding loss ratios. The primary business has the drag of expense that we just talked about because of the front-end load nature where the reinsurance transactions do not.
Right. Okay. That's helpful. The $6.7 million from the 100% quota share from PMI, will that recur every quarter or is that a one-time deal?
No, it's every quarter. That's the business that's already on the books, usually this business takes, I don't know, six, seven years to run off, right? This is business they wrote right before they went into receivership. That will be 2009 to 2011. There is declining revenue coming over time because the mortgages that they get off of that is those that they achieve more than 78% loan to value and the mortgagee decides to interrupt the insurance, refis that they drop off. Otherwise, sale when the mortgage gets satisfied. Usually, the tail on these is about six, seven years. It will go out until 2016, 2017, taking 10 as the midpoint of this.
Okay. That's helpful. Thank you.
You're welcome.
Your next question comes from the line of Kai Pan with Morgan Stanley. Please proceed.
First on the investment side, the duration extended from 2.6 to 3.2. Is that related to now that you have longer duration liability on the, particularly on the reinsurance side?
Well, it's a combination. Yeah, a little bit of that. A combination also where we believe with at least our investment people believe where interest rates with the new Fed Chairman might or might not go. Duration for us usually gets concerning if we think that there is imminent rise of interest rates. We don't see that yet, at least for the next year or so, based on statements they made. We make that adjustment. Also we always match duration of reserve liabilities with assets covering those.
Would we expect this sort of higher duration than a higher investment yield?
Could you ask that again?
Higher duration.
With your longer duration of your investment book, is that the average sort of yield?
I don't think it's going to move the needle. We got $14 plus billion of investable assets. A few hundred million wouldn't move the needle that much.
It's also what's the steepness of the yield curve going to be quarter after quarter? It flattened out in the quarter just passed. That made you a little more indifferent to where you were.
Okay. Second question on Watford Re. Besides sort of your minority interest in the operation and what other economic benefits for Arch in term of the ceding commission or the others?
I mean, We get paid for that activity upfront as managers of reinsurance. Then we have a performance fee that we get at the end on underwriting performance, total return performance. That's the benefits that we get as an organization for that business that goes there.
In terms of accounting, where are those sort of booked in your income statement?
Yeah, acquisition.
Okay. Lastly is on the capital management. Now you have the MI and Watford Re behind you, the stock is trading at a 1.4x book, probably a little bit above your threshold. At the same time, you still have excess capital. What's your preferred way to deploy that excess capital, and have you considered a dividend?
Our preferred way is to deploy it in our business, and there is a few opportunities that we're still looking at. That hasn't changed. I haven't given it a lot of thought if we're going to do a dividend or share purchases because right now we're focused on the opportunities rather than how to return capital to investors. Let's face it, they're paying us to find the opportunities, and I'm spending a lot of time, and all of our people are looking at new opportunities. There is quite a few out there in the market.
Thank you so much for the answers.
You're quite welcome.
Your next question comes from the line of Ryan Burns, Janney Capital. Please proceed.
Great. Thanks for taking my questions, guys. Quickly on the Watford segment, how long should that take to get to scale? Because again, thinking from a reinsurance standpoint, you think it should be able to get to an underwriting premium dollars in a fairly quick manner.
I would think maybe three years or so. It's going to take at least two, maybe three years to get to scale. I mean, it depends on a lot of things, market conditions, et cetera, what the opportunity is. We don't force things. We're going to go with our obligation to them is to be prudent underwriting managers. That's what we got hired to be. Use the techniques that we have been using for Arch, look for the opportunities for them. If it takes two years, fine. If it takes three years, it's fine. As Highbridge is going to focus on the investment returns, I think they have the same approach. They have the long-term approach there.
Remember, this year is already just a nine-month year.
I'm sorry, because it was closed in-
They just bought it in March.
Sure. Certainly. Just my last question on the increased retro purchases for the prop cat book. It clearly looked like it had an impact on your one in 250 PMLs. Just wanted to see where in the risk curve you're seeking this efficiency. It certainly seems like it's at the one in 250 level, wanted to see how far lower that goes.
Well, I'll give you the 40,000-foot view to this because it's a little more complicated than that. We try to maintain the customer relationships that we have. There is more tendency because capacity is plentiful and available for a lot of the buyers to want you to play across the placement. They don't want you to pick and choose layers, et cetera. As usually, we don't like to be down on the frequency area. We believe this is a high rate on line areas that also have a lot more exposure from a frequency expectation. That's where we buy most of our retro. On the front end of the curve, we buy more retro. We don't like to be at the tail end of the curve, so even on a direct basis, we don't bring in that business.
We're not there to put a lot of PMLs or a lot of capacity on 2% or 3% rate on line business. We try to avoid that. Yeah. That's the general principle of our thought process. With that's where our cat team's going by the retro sessions.
Okay, great. Thanks for the answers.
Your next question comes from the line of Meyer Shields, KBW. Please proceed.
Hi, everyone. Thanks for sticking around for the late questions. Two quick ones if I can. One, when we look at the other segment, I guess I would have expected the income available to Arch to be about 11% of total. It's coming in a little bit less, I'm wondering what I'm missing there.
Well, it's not exactly 11%. It's within spitting distance of 11%. I'm not sure exactly what you're looking at because it's there.
I guess what I'm thinking, and maybe this is the accounting of it, that since you've got the 11% stake and you're collecting fees, that net impact should translate into a higher percentage.
Right. Part of it is geography, because this is Watford Re, the fees that we earn don't go to Watford Re, they go to Arch.
Okay, got it. That makes sense.
It's going to be non-numbers, right?
Right.
Right.
It would be the other segment that's showing up elsewhere.
The other segment is only going to be the investment, and that would be pari passu with any other investor in Watford Re. Fees and/or profit commission because of our performance as underwriting managers or Highbridge's investor managers and all that is not going to be on this line.
That's in the acquisition price.
We do sympathize because you're looking at the 100% numbers, and you got them in each line of account at 100%, and then there's one line that's an amalgamation of all the impact. That's the 89% subtraction. We don't make the rules. We got to follow them.
Right.
Yeah, absolutely understood. Just to follow up on Kai's question before, I understand that the flatter yield curve limits the benefits of the increasing duration. Why increase duration in the quarter?
For our belief as to where the yield curve is and where it's going. We elongated by almost half a year in duration. Our approach to duration is that we match liabilities on the reserves. This way, we don't take any risk there. When we borrow funds, we try to have the cost of those funds on the spread. In essence, by us borrowing $500 million, that pushes us to increase duration a bit. Then we use the shareholders' capital to vary duration up and down depending on how we view where the prospects and where the yield curve is going to go. That's the combination of all three principles in one. Like I said before, that's what pushed us, our investment people to move duration to the level that we have.
Okay. Thank you very much.
You're welcome.
Your next question comes from the line of Jay Cohen with Bank of America Merrill Lynch. Please proceed.
Yes. Thank you. I guess a question on Watford. The premiums that you ceded to Watford, is that basically a mirror image of your whole book, or were there only particular lines that were ceded?
No. To oversimplify, it was a few transactions. Some of it mirrors what we have, some of it doesn't. Don't forget, Watford wasn't in business. Think of it as, at least for the first quarter, we warehouse something that they might have written direct themselves, and then we ceded it back to them. We're the underwriting manager, so we said, "Hey, this will fit Watford." We didn't want to lose time and wait for them until they were in business. So we might have bound a piece of business, put it on Arch, and then we ceded to them when they were up and running.
That's helpful. Over time.
You're not going to see 100% cessions from Arch to Watford in future quarters. What you're going to see is some cessions from us because we're ceding to a lot of reinsurance, Watford being one of them. Also, you're going to see a lot of deals that Watford will write direct.
Also, Jay, back to the whole underlying theory of it. Although there's property cat that may be there as a piece of the overall portfolio, in all likelihood, it's always going to be a lesser percentage than what Arch would have, and therefore a longer duration on the liability stream of Watford versus the average of Arch.
In the casualty business, you will see to them, or I should say, they will write at the end of the day. Do you think that will be a lot different than the casualty business you have or will it have some similarities to it?
They're going to have Listen, it's the same underwriting standards, right? We view their advantage is that, I think we can assume a bit higher investment yield. I don't know transaction by transaction, but it might push you to maybe a little longer duration in liabilities type of business because that's where their advantage becomes greater. Only time will tell, as we see the transactions, either for us and the Watford come in, then our underwriting people apply our standards to come up to expected ROE and see where it fits.
Yeah. No, that makes sense. Thanks a lot.
You're welcome.
Your next question comes from the line of Brian Meredith with UBS. Please proceed.
Thanks. I have two questions here for you. First, in the mortgage insurance operations, where do you guys stand in getting on the platforms of the large national banks?
We got 13 already out of the top 40.
What about the big three? That's where a lot of it comes from.
Well, we're still in the process. I don't know exactly where we are, and I don't know who the top three in your mind are. We're not going to comment on specific relationships that we have. Believe me, our goal is to be in all top 40 over time, and we're working hard to get approval from all of them.
Okay, great. I guess my second question for you, Dinos, is I'm just curious. Increasing in casualty reinsurance business, although you listen to people in the market and they're talking about higher ceding commissions and a lot of capacity there. I'm just trying to understand why is all of a sudden the casualty reinsurance business that much more attractive? Is it because interest rates are up, call it 100 basis points year-over-year? Is there something else happening?
No. Listen, you got to look at it transaction by transaction. There is always this displacement in places. Four years ago, five years ago, it was the motor XOL in France because everybody was withdrawing, et cetera. We look at these opportunities. We don't like to talk much about it, as to where, because if I found a little vein with a little gold in it and I'm digging into it. I don't want every competitor to know what it is, and then they go and they mess up the market. Either you guys trust that we've got the underwriting skills to do that or you don't. I trust our people, and when they find the opportunities, and we look at the economics, if it fits, we do it.
As Mark said, we don't really care that much about the calendar year accounting issues because you can't make a decision to buy your insurance underwriter on calendar year numbers. You got to understand policy year, and you got to understand their underwriting year performance, and do you trust that they will do a good job in making those determinations?
Hey, Brian, I think you should think of it as a collection of well-thought-out transactions rather than sector bets.
Right.
Well said, Mark. You see, you're much smarter than I am.
Thanks.
More tired than you are.
Your next question comes from the line of Ian Gutterman, BAM. Please proceed.
Hi, good afternoon.
Hey, Ian, you're between me and my souvlaki sandwich, baby.
I know it's getting cold. I'm not as smart as Mark either, so I'm still confused on the reinsurance. I guess I don't understand why it should be so variable quarter-to-quarter. If we're looking at written ratios, I can get that, but the earn should be a reflection of what you've written over the last year or so, and I would think that's reasonably baked in for the next couple of quarters of what this mix change is, given casualty's been growing a lot the past few quarters and CATs been shrinking. I would think we kind of know for the next couple of quarters what it should be. Why might it switch a lot Q2 versus Q1?
Don't forget, you had Q1 versus Q1 of a year ago.
Right.
As Mark said, that thing was inching up along as we wrote those transactions.
Sure.
Some of these transactions we wrote in the third and fourth quarter. They're inching up as the earnings are coming through. Your statement is absolutely correct. Also you got to go back and see the sequential movement that we have done. The only change to that is what we've done in the first quarter, and mostly it was European kind of business, which was not as part of what it was coming from the third and fourth quarter last year. Don't forget, if you go and look at our statements and what we have reported, we talked about some of these transactions that they had a higher combined ratio on an expected basis, but very good return characteristics over time.
If the written patterns stay consistent with the last few quarters, then if I'm understanding right, we will see the accident years increase year-over-year, but not as much as the first quarter, but sequentially be reasonably similar to this quarter and the rest of it comes through from higher investment income because you're going longer tail. Is that fair?
That's correct.
Okay.
It might reverse itself and go the other way, depending if those transactions get renewed or not.
Sure
As when you get to the expiration.
Okay, great.
Ian, I think one thing we proved we do, and that is we try to take maximum advantage of what the market gives us. It changes from quarter to quarter, what it allows and what it gives us.
Right.
Agreed. I get that on a written. I just want to make sure I wasn't misunderstanding the earned.
You're absolutely, you're right onto it. That's why the comparison year-over-year sometimes has got to be supplemented by also the sequential change quarter-over-quarter.
Exactly. Got it.
Quarter after quarter.
Right. Yeah.
Got it. Then on the mortgage insurance business, I guess two questions there. One, from just the publicly available rate filings everyone has, it looks like you guys are priced lower than the market. A, is that accurate? B, sort of what's the thought behind that? Is that just an easy way to get established or something else?
The statement you made is incorrect.
Okay.
I have the table with our competitors, we're right on. There is not even a. Out of a table that is, it has one, two, three, four, five, six, seven, eight, 16 cells. Right? We are slightly lower in only one, not with all, right? In everything else, I think we're right in line with everybody else.
Got it. Okay. I'll have to take another look at that. I'm still learning this stuff too.
Yeah. I have Arch compared to MGIC, Genworth.
Okay
Essent and NMI, we have the grid. The grid I was referring to is the-
The rate card
the rate card. When you look at the rate card, there is only one cell that we slightly cheap. Every other cell is exactly the same as everybody else.
Got it. Okay.
The buyer paid sell as opposed to the lender paid.
Right.
Okay. Got it. Then just my last one, the STACRs that you've written through, how does that show up? It wasn't in the commentary of the premium. Was that in the premium this quarter, or does that show up somewhere else because it's derivative form, or how did that work?
Yeah, Ian, it doesn't. We've deemed it because of the way the loss side works. The loss severity is referential to a table. It has nothing to do with individual characteristics of the claim itself. We viewed it as a derivative. You're not going to see it anywhere in premium. Instead, it's closer to a mark-to-market impact each quarter, and it finds itself into-
It's an acquisition expense.
Yeah. It's an acquisition expense.
Where do we see that? Does that end up in operating? I'm just trying to figure out how to think about where that will show up in my model, basically. Is it an operating below the line? Where is it?
Yeah, it's underwriting. It's an acquisition expense. It's in underwriting.
It will affect the underwriting combined ratio, but it's in the acquisition expense.
It's in that Mortgage Insurance Segment.
Yeah.
Okay.
It's a derivative. At the end of the day, it's going to be income.
Got it. Okay. Is that because it's a derivative, might it be volatile based on what's going on with interest rates and such, or is it reasonably stable?
No, it's a derivative because if you look at these transactions. A portion of the STACR transactions is done in the cash market. They sold as bonds, right? Those trade on a daily basis. Then, you've got to market to that. It depends what that happens. How those bonds will trade, it will tell you if you can write a STACR transaction that over a long period of time will give you positive returns. Maybe in the first or second or third quarter, depending where the cash transaction trades, you might take a loss in the first quarter.
That's why I was trying to figure that out.
Right.
Okay. Got it. Okay. As that becomes material, I'm guessing you'll call that out if we have any of that one.
Right.
Okay.
We expect that to be positive. Don't forget, it's going to come over six or seven years, right?
Okay.
You're spreading it out.
Got it. Okay, thank you. Enjoy your lunch.
You want to pay for it?
We'll see. Maybe next time.
Okay. Thanks, Ian.
At this time, we have no further questions. I will now turn the call over to Mr. Iordanou and Mr. Lyons for closing remarks.
All right. Thanks, Glenn. Thank you, everybody, for attending. We are looking forward to speaking to you next quarter. Have a wonderful day.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect and have a great weekend.