Good day, ladies and gentlemen, welcome to the second quarter 2013 Arch Capital Group Earnings Conference Call. My name is Glenn and I will be your operator for today. At this time, all participants are in listen only mode. We will conduct a question and answer session toward the end of this conference. As a reminder, today's conference is being recorded for replay purposes. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the Federal Securities 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 will also make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I'd like to turn the call over to your host for today, Mr. Dinos Iordanou and Mr. Mark Lyons.
Please proceed, gentlemen.
Thank you, Glenn, good morning, everyone, thank you for joining us today. We had a good second quarter from just about every perspective, with the exception of unrealized losses in our investment portfolio due to the rising investment yields. Earnings were solid and our CAT claim activity was modest relative to the significant level of industry losses experienced this quarter. Across the group, our premium revenue was essentially flat in the quarter, although there was a lot of movement in the pieces that I will get to it in a few minutes. On an operating basis, we earned $0.99, which produced an annualized return on equity of 10.9% for the quarter. On a net income basis, we earn $1.26 per share, which corresponds to a 13.8% annualized return on equity.
For reasons that I mentioned on our last call, which I won't repeat again, ROE based on net income was again significantly better than ROE on an operating income basis. Our reported underwriting results in the second quarter were excellent, as reflected by a combined ratio of 87.4, and they were aided by better than average performance on our CAT underwriting, along with continued favorable reserve development on the rest of our book of business. Net investment income was $0.50 per share and essentially was flat on a sequential basis. Our operating cash flow for the quarter was $183 million, a $70 million decrease from the same period last year, due substantially to higher paid losses on prior year CATs, including Sandy. Our investment performance suffered this quarter due to a significant rise in rates and widening of credit spreads.
Of course, in the last 2 weeks, credit spreads have come back, but as of the end of the quarter, we did suffer a bit. As a result, our book value per common share decreased by 2.3% to $36.80, while it increased by 6.8% relative to the second quarter of a year ago. The insurance market continues on its path of recovery, with rates continuing to rise at roughly the same level as in the first quarter. In our insurance operations, which gives us a good indication because we have more granular data, we experienced rate increases in the quarter that, based on our estimations, provided approximately 150 basis points or expected margin improvement. This is on an underwriting year basis. Rate changes in the U.S. range from a negative 300 basis points to as high as a positive 1,100 points.
I would like to emphasize that most lines average a positive 500 to 1,100 basis points improvement. The movement of business from the admitted market back to the E&S market continues. Last quarter, we mentioned our expansion into the binding authority insurance business that caters to smaller E&S accounts written through the wholesale distribution channels. This particular group is off to a great start. They are producing an increasing level of business and have begun to leverage Arch's distribution platform to access more opportunities. We expect them to contribute more meaningfully to our operations going forward. In our view, on an absolute basis, while most long-tail casualty business still requires rate improvement to meet our return requirements, some segments To our encouragement are approaching rate adequacy within that block of business.
With regards to new versus renewal pricing, based on our monitoring systems, we saw no change on a relative basis from the indications that we shared with you in our last conference call a quarter ago. As the profitability of the primary insurers and our customers has improved, clients have, at times, pressed successfully for additional ceding commissions. Generally, one to two points is the additional ceding commission that they gain on quota share transactions. On a consolidated basis, in the second quarter of 2013, gross written premiums were down 1.1%, and net written premiums were down 1.2% year-over-year. Net written premiums of the reinsurance segment were reduced by 13.1%, while the insurance segment grew their net written premiums by 8%.
The reductions in the reinsurance segment stem from property CAT lines, other specialty, and mortgage businesses. The lower level of property CAT, net premiums written relative to the second quarter of 2012 was due to rate reductions as well as to a decrease in capacity deployed and an increased use of retrocessions. The insurance segment had a net written premium growth predominantly emanating from the U.S. operations, which represents approximately 75% of the worldwide volume this quarter. The U.S. operations grew net written premium by nearly 18%, partially offsetting strategic reductions elsewhere in the world. The U.S. growth came predominantly from our program business, national accounts, and our new contract binding business, as well as construction and a continued reduction in casualty lines, even though they're getting closer to meeting our return characteristics.
Construction and national account business had continued rate increases, very strong renewal retentions, strong new business generation, and we experienced ratable exposure growth in those sectors. Group wide, on an expected basis, we continue to believe the ROE on the business we wrote this year will produce an underwriting year ROE in the range of 11%-13%. The underwriting margin improvements that I mentioned earlier will influence expected ROE positively, while the recent improvement in investment yields did not have a significant impact on expected ROEs as of yet. Before I turn it over to Mark, let me update you on the status of our previously announced agreement to purchase certain assets of PMI and CMG. On June 20th, the Arizona Receivership Court approved the transaction. We're now working to obtain the necessary regulatory and other approvals required to complete the transaction.
As part of the process, we're continuing our discussions with the GSEs in order to obtain their approval of Arch as an eligible mortgage insurance carrier. If those approvals are obtained, it is estimated that the transaction will close during the end of this year. It is worth noting that our CAT PML aggregates reflect business bound through July 1st, while the premium numbers included in our financial statements are through June 30th. When you make the comparisons, you have to bear that in mind. As of July 1st, 2013, our largest 250-year PMLs for a single event declined moderately to $858 million in the Northeast, and it represents approximately 17.5% of common shareholders' equity, and $746 million in the Gulf, where our Florida Tri-County PML now stands at $606 million.
I'm going to turn it over to Mark to comment further on our financial results, and then we'll come back and take your questions. Mark?
Great. Thank you, Dinos, and good morning, all. Consolidated combined ratio for this quarter was 87.4%, with 4.8 points of current accident year CAT-related events, net of reinsurance and reinstatement premiums, compared to the 2012 second quarter combined ratio of 87.2%, which reflected only 1 point of CAT-related events. Losses from 2013 second quarter catastrophic events, net of reinsurance recoverable and reinstatement premiums, totaled $36.3 million, primarily emanating from the Moore, Oklahoma tornado and flooding events in Europe and Canada. The 2013 second quarter consolidated combined ratio also reflected 9.1 points of prior year net favorable development. Net reinsurance and related acquisition expenses compared to 8.6 points of prior period favorable development on the same basis in the 2012 second quarter.
This results in a 91.7% current accident quarter combined ratio, excluding CAT, for the second quarter of 2013, compared to a 94.7 accident quarter combined ratio on a like basis in the second quarter of 2012. The 2013 accident quarter combined ratio excluding CAT for the reinsurance segment was 81.2%, compared to 81.5% in the 2012 second quarter. In the insurance segment, the 2013 accident quarter combined ratio excluding CAT was 98.6%, compared to an accident quarter combined ratio of 103% even a year ago. The corresponding 2012 insurance segment accident quarter combined ratio, however, reflected a higher level of large attritional loss activity of roughly two and a half combined ratio points. Approximately 80% of the net favorable development in the 2013 second quarter was from the reinsurance segment, with approximately 43% of that due to net favorable development on short-tailed lines concentrated in more recent underwriting years.
Roughly 6% of the reinsurance segment's net favorable development was attributable to medium-tailed lines based throughout many underwriting years, and about 51% due to net favorable development on longer-tailed lines, primarily from the 2002 through 2006 underwriting years. The remaining 20% of net favorable development in this quarter was attributable to the insurance segment and was primarily driven by short-tailed lines in the more recent accident years and medium-tailed lines across various accident years. Similarly to prior periods, approximately 69% of our consolidated $7 billion of total net reserves for losses in LAE are categorized as IBNR or additional case reserves, which is fairly consistent across both reinsurance and insurance segments. On a consolidated basis, the second quarter of 2013 expense ratio was identical to the prior year's comparative quarter, with a marginally lower net acquisition ratio offset by a marginally higher operating expense ratio.
The marginal increase in the operating expense ratio reflects incremental expense due to certain platform expansions in both our reinsurance and insurance businesses and higher equity expense charges than in the second quarter of 2012. Our U.S. insurance operations achieved a positive 4.2% effective rate increase this quarter, which translates, as denoted, into a margin expansion of 150 basis points over the second quarter of 2012. This average ranged from having margin contraction in some units, such as healthcare and professional liability, up to a positive 890 basis point improvement in our energy casualty operation. Other areas of note in margin expansion were the executive assurance middle market, E&S casualty, and program businesses. These figures represent the excess of written effective rate increases over estimated loss trends and provide continuing evidence of improving market conditions.
Property lines experienced a low single-digit rate increase this quarter and therefore did not experience additional margin expansion. It's also important to understand that many insurance segment lines of business have experienced effective rate increases over an impressive amount of serial quarters. For example, although it's likely no surprise that wholesale and retail insurance property lines have seen eight to nine consecutive quarters of rate increases, it may not be apparent that other lines of business have experienced comparable results. Our specialty casualty, national accounts, workers' compensation businesses have experienced nine successive quarters of rate increases, whereas our executive assurance middle market and alternative asset protection books, along with our retail constructions units, have experienced eight consecutive quarters of rate increases. Lastly, our excess workers' compensation and umbrella books have enjoyed seven consecutive quarters of increases.
As always, we make capital allocation decisions based on our view of the absolute returns and not relative improvements alone. For example, although our insurance property businesses did not experience margin expansion this quarter, we continue to estimate healthy returns for this line. The ratio of net premium to gross premium in the quarter on a consolidated basis was 77.9% versus 78% even a year ago. In the reinsurance segment, the net to gross ratio was 91.5% in 2013 second quarter compared to 94.3% a year ago, reflecting more retro purchases protecting their property book. The insurance segment had a 71.3% net to gross ratio compared to 68.7% a year ago as a result of their ongoing strategy to grow the less volatile, smaller account businesses and reduce exposure in higher severity businesses.
The total return on our investment portfolio was a reported negative 159 basis points in the 2013 second quarter, primarily reflecting mark-to-market adjustments on fixed income securities. Excluding foreign exchange, total return was a negative 156 basis points in this quarter. This quarter, unrealized losses of approximately $260 million overshadowed realized gains of $12.7 million. The following commentary will focus on the unrealized. This quarter's unrealized loss of approximately $260 million is almost entirely due to changes in fixed income security valuations driven by the rising interest rate environment and widening credit spreads, particularly in corporates and mortgages. This unrealized loss for the quarter represents 2.5% of the March 31st, 2013, fixed income asset fair value. This percentage reduction ranged from a low of -1.3% for asset-backed securities to -3.4% for corporate bonds, although much of the portfolio clustered near a -2.5%.
It's worth noting that equities and alternative investments now account for 14.9% of investable assets as of June 30, 2013, versus 12.9% a quarter ago and 9.6% a year ago as of June 30, 2012. This allocation on a portfolio basis has the potential to ameliorate future impacts on fixed income securities from rising interest rates and widening credit spreads. Our embedded pre-tax book yield before expenses was 2.43% as of June 30, compared to 2.45% at March 31st, 2013. While the duration of the portfolio lengthened slightly to 3.04 years, which continues to reflect our conservative position on duration in the current yield environment. Our exposure to eurozone countries is listed in the supplement, with continued minimal exposure to countries undergoing severe economic hardship.
Reported net investment income in the quarter was $68.4 million, or $0.50 per share, versus $65.7 million in the 2013 first quarter, or $0.48 per share, and $73.6 million or $0.53 a share in the comparable quarter a year ago. Our effective tax rate on pre-tax operating income for the second quarter of 2013 was an expense of 3.3%, compared to a benefit of 0.3% in the second quarter of last year. Approximately 90 basis points or $1.3 million of the second quarter tax expense is associated with catch-up of the first quarter to this higher effective rate. Fluctuations in the effective tax rate can result from variability in the relative mix of income or loss reported by jurisdiction, along with forecast variances for the last six months of the 2013 year.
Our total capital was $5.63 billion at the end of this quarter, down 1.8% relative to March 31st, and up 1.1% relative to year-end 2012. During this quarter, we repurchased $15.5 million of our common stock at an average 1.33x multiple to March 31st, 2013's book value, which had a $0.03 impact on book value per share. Our debt-to-capital ratio remains low at 7.1%, and debt plus hybrids represent only 12.9% of our total capital structure, which continues to give us significant financial flexibility. We also continue to estimate having excess capital in excess of our targeted capital position. Book value per share was $36.80 at June 30, as Dinos denoted, which still represents a 6.8% increase relative to one year ago at June 30, 2012.
This change in book value this quarter primarily reflects the company's continued strong underwriting results, offset by the negative impact of rising interest rates and widened credit spreads on fixed income securities. With these introductory comments, we're now pleased to take your questions.
Glenn, we're ready for questions.
Ladies and gentlemen, if you would like to ask a question, please press star followed by one on your phone. If your question has been answered or you would like to withdraw your question, press star two. Questions will be taken in the order received. Please press star one to begin. Your first question comes from the line of Amit Kumar, Macquarie. Please proceed.
Thanks. Thanks and good morning. Two brief questions. First of all, just going back to the data points on pricing and new business on the insurance side. Those are very helpful. I was wondering if you could also broadly talk about the impact of exposure on those lines, maybe just on some of your larger lines, if you're seeing any meaningful impact on that side too.
Well, the exposure is customer by customer. Some customers, their business is starting to show some growth, and we've seen some improvements. It's not across the board. There are still a lot of customers that from an exposure point of view, where the economy is suffering. We're not seeing increased payrolls or increased sales, et cetera. When we do our rate calculations, they're all exposure-based rate calculations and comparisons. If your question is where the economy is going and if there is a lot more buying of our products, the answer is no. It's incrementally better than a year ago, but this economy is not moving at a high degree of new exposures. The customers, sometimes you can get them to purchase either additional layers or additional limits, and we don't see that either. They're pretty conservative in their purchasing.
I didn't phrase this question properly. I guess what I was trying to ask is that if rates are, as you said, are approaching adequacy, do you feel that exposure growth will still result in a positive sequential trend line? I guess that's what I was trying to ask, and I think in some ways you did answer the question.
From a rate point of view, the more business that you get close to adequacy to maintain the same ROE performance, then from that point on, you don't need extraordinary rate increases. You need rate increases that it will cover loss cost escalation. As long as we're covering trend or we're ahead of trend, then we're very happy to ride the business and continue to renew it. In prior calls, we talk about we have green lights, yellow lights, and red lines depending on the products that we put in the marketplace. We're seeing very few reds. They're more getting into yellow. That means ride it with caution, and more getting into green, which will allow our divisions to grow that business. Mark, do you want anything to add to it?
Thank you, Dinos. Just a potential clarification. In the insurance group in the U.S., it's 75% of the insurance group where we have all the deep detail. You kind of think of the aggregate rate versus premium growth this way, in the U.S. Rate was roughly 4.5%. It might be, to Dinos' points, a marginal increase in exposure on same store accounts. Maybe 4%-5% of that growth is new business, which is new aggregate exposure, but not growth in exposure within the existing accounts. The balance, because you're looking at net written premium, you have to take into account the change in the net to gross, which bumps up the increase in the change in net written.
You got to deduct the business that you have lost to get to your aggregate exposure.
Right.
Yes, you did answer my question. Sorry, I did not phrase it properly. The only other question I had was your discussion on excess capital. On another call earlier today, we were talking about third party capital, new capital, whatever you want to call it. Perhaps looking at other avenues including casualty reinsurance risk versus traditional prop CAT. I'm curious, A, what's your view on that? B, would Arch be interested in something like that potentially down the road? Thanks.
Well, first, my views are that capital formation will take different kinds of forms. It's more difficult from a buyer's perspective, a customer perspective, to create those structures on the casualty line. In casualty lines, due to the long nature of the tail, it requires more of a permanent capital. It's not capital that you can put in towards a period of time that is in need and then withdraw it when there is other ample capacity. My view is, eventually some of these structures even in casualty, they will be created, but it will have more permanency to the capital and all. Don't forget, in the casualty area, you need to have significant underwriting capability for the model to work. As a company, we're interested in those structures.
We had over the years, many different discussions with different parties, if we find the right structure that it benefits our shareholders, we'll do it. That's basically where we are.
Got it. Thanks so much for the answers.
Your next question comes from the line of Michael Zaremski, Credit Suisse. Please proceed.
Hi. Thanks. Maybe I'll just follow up on Amit's question, and I may be nitpicking here. Dinos, in the prepared remarks, I believe you cited primary insurance pricing trending in excess of loss cost by 150 basis points.
Yes.
I wrote down last quarter you had said it was trending in excess of loss cost by 300 basis points.
That's also correct.
Okay. Is the decline being driven by new entrants into the E&S marketplace? Maybe you can comment on why that's changed.
No. I think as Mark said, and I'll turn it over to him, you're not going to get rate increases escalating by eight, 10% forever. At some point in time you will see that the market works in peculiar ways. When certain lines of business, they get to rate adequacy. To us, rate adequacy is to produce 15% ROE. Once you get there, as I said, the only thing you need is you try to make sure that you're getting enough rate to cover the loss trend, because loss trend will escalate. As long as you're above it, you have an improved environment. I think in the aggregate, and Mark, you know the numbers better than I do, we probably lost on average about one point.
If we aggregate all of our business, the rate increases we got in the first quarter versus the rate increases we got in the second quarter, there might've been a one percentage point less in the second quarter. It's still an improvement because it's on top of what we got a year ago and two years ago. When you look at it from that perspective, the ROE on an underwriting year basis on that business we write today will be a little bit better, and that's what we try to estimate, that 150 basis points. Mark?
Right. That's a great point, and one of the reasons I talked about the serial changes for like eight or nine quarters. If you're at the right quarter, you're now approaching your third increase, which is why you're going to start to get to some of this adequacy. A lot of this still comes down to mix from one quarter to a different quarter. We would've had more insurance property, which flattened out a little bit more this quarter. If, for example, we felt that more of the E&S casualty business had gone over the goal line to 15%, that unit experienced 9.5% rate increases in the last quarter. We didn't open that floodgate yet, but as Dinos said, it's starting to approach that.
We start contributing some of that businesses, it goes over the goal line, you're going to see the effective rate changes increase because of the weighting impact of that unit.
Okay. That helps. Are you saying, Dino to Mark, that a lot of these lines have reached the rate adequacy, meaning a 15% projected ROE?
Well, we didn't say all. As I said, we still have product lines in the yellow, which just means you got to be selective, and we will caution. To us, a green light is a product line or a division that we believe that the marketplace is allowing them to underwrite to 15%. As I said, I gave that 11%-13% ROE, depending. The reason we give a range is because we don't know how the mix is going to come in. That means there is still a lot of business that is in the high single-digit ROE and low double digits in order to average 11 to 13.
We have lines of business that are in the green. We do have some in the red still. We still have more and more in the yellow.
Got it. Lastly, on investment income. You guys have done a good job on the book yield and on just overall investment income levels. Do you expect the recent rise in new money yields to be a material benefit on a prospective basis? Thanks.
Mark, you want to
Yeah. I think to kick that off, we view that the new money rates in this quarter compared to prior was about a 50 basis point move up. That's beneficial. The range Dinos's quoted, 11 to 13, all it really does is change the placement within that range, more than anything else. It depends on how sustained it turns out to be.
Yeah. We've been guarding against rising interest rates for a long time with keeping the portfolio short in duration, and also high credit quality. In essence, we might take the unrealized it, but it will unwind itself within the duration of the portfolio pretty quickly. If rates move up, it will be beneficial to us and I guess most of our competitors. It depends what happens to the underwriting side of the business. Will the underwriting then get adjusted because we're getting more yield or people say, "No, let's keep the same underwriting margin because any yield will be a margin improvement." I don't know. I can't predict the future, and I can't predict behavior, but I can tell you a rising interest rate environment, even though it's negative early on, it gets very positive for us.
Well, maybe I could just in more simpler terms then. If current interest rates stay where they are, and you talked about a 50 basis points increase in new money yields, do you expect the portfolio yield to increase by 50 basis points?
Well, again, it depends on what mix of business that we wind up with. You really have to layer on the duration of that on top of it.
Also, the portfolio turns over. Is what's coming off from the prior years, what's maturing and what gets reinvested. I can tell you, there is also a shift in our allocations as Mark to alternative investments and assets. That's the reason I went through that whole explanation why our net income is different than our operating income. As we're increasing allocations into alternative investments, including equities, et cetera, some of it is not going to come as investment income. It's going to come to us over time as realized capital gains.
It's not easy to answer your question with a simple answer and say, "Yeah, it's going to improve by 50 basis points." Looking at the fixed income portion of what we do and not taking into consideration how much is rolling off and coming and gets reinvested, anything that is new and we're putting in fixed income has a 50 basis points improvement. I don't know if that's a quarter of the portfolio or I haven't done those calculations.
Thank you.
You're welcome.
Your next question comes from the line of Michael Nannizzi, Goldman Sachs. Please proceed.
Thank you. I guess one question is within the reinsurance book. All else equal, would you expect to continue to reduce capacity that you're gearing towards property CAT as the year progresses? Would you expect to be moving that into either other areas of reinsurance or just taking the opportunity to write more insurance at the same time?
Listen. There is nothing that we do because we move from one to the other because we're in an excess capital position. Basically, all of our units can have all the capital they want as long as they can deploy profitably. Let's start with that.
Right
I'm not stressed out that I have to take from Peter to pay Paul. If Peter and Paul can give me very good returns, they get all the capital they want. Having said that, our market conditions will influence as to how much we do on the reinsurance sector, independent if it's U.S. CAT or international CAT or whatever. We look at transaction after transaction, and we see what we believe the profitability is and do we like it, then we write that business. As you can see, we're at 17.5% of common equity as the highest 250-year peak zone. We got plenty of room. We're authorized by the board to go all the way up to 25. From a capital point of view, from a capacity point of view, we have more.
It's only the market will allow us to do more or less. You're asking me to predict how the market is going to behave. I don't know. It depends on that behavior, we'll tell you that if rates continue to go down, we'll adjust accordingly, if the rates go up, we will adjust. Sometimes we're sellers, sometimes we're buyers. We did buy more this quarter. It gives us more protection. It smooths out the volatility within our book of business, we felt we were getting good deals. I'm sure the people who sold it to us, they also think they're good deals, people can have different opinion on that.
Got it. One question I had is, I saw recently the New York MTA floated an insurance bond which it sold to the capital markets. It seems to me, I could be wrong, I think it's one of the first either insurance market transactions or just specifically outside of property CAT reinsurance. Is that important as a development? Again, I realize it's very small. Is that something that these things sort of happen from time to time?
They will happen from time to time. It's not significant. Even in the CAT market today, which they've been at it since after Katrina, which is seven, eight years, it's not a significant part of the capital formation. Traditional capital and those type of transactions they're preferred by most customers. The sum of the specialized companies that they're unrated, fully collateralized vehicles, they're reissuing similar coverage as the rest of us, that is capacity that you have to worry about. The CAT bonds, they've been around for a long time, they're not a significant part of the business.
Got it. Great. Thank you.
Your next question comes from the line of Jay Gelb, Barclays Capital. Please proceed.
Thanks. I had a couple in terms of business volume trends. The first with the pullback in reinsurance premiums. I understand that reflects to some extent market conditions. I'm trying to get a sense of whether you think that you'll still see growth in your premium volume for the year. That's first for reinsurance. Then second, can you talk a little bit more about within the insurance segment, the growth in the program business and I'll have a follow-up.
Yeah. Well, let me start with reinsurance. Reinsurance it's a lumpy business, and it's hard to predict what's going to happen. Let me start. We had reductions in three sectors, right? One, it was mortgage, but that's kind of comparing apples to oranges. If you go back when we reported a year ago for the second quarter, you will know that we had a kind of an incoming portfolio because on the mortgage reinsurance, we had premiums from November, December, first quarter and second quarter that we book. The second part, it was the U.K. motor that we said, as long as we believe the business is profitable, we stick with it. If it's not, we'll let others do it. As you can see, there is more competition in that line. We have switched to write more excess of loss, not as much quota share.
That affects the premium production. I don't know if that's a predictor as to what's going to happen into the future. By its nature, you can write 1 or 2 new contracts, and you can change the trajectory. The reason we don't give guidance in all that is because I can't predict the future. Our whole principle is we're going to underwrite, and we have a big appetite, but it's got to have profitability before we do it. I'm not trying to avoid your question there, but I'm just telling you, Jay, how we operate. The second part was the insurance group. We believe we have a great program division. You heard from some of our major competitors who write the package business, and these are very good companies like Chubb, the Travelers, et cetera, and they're getting good rate increases.
That's the sector that our programs administrators compete with, because they write, even though the specialized covers for certain kind of customers, they're in that market. We have been experiencing very good rate increases, which in essence give us more revenue, but also new exposures, winning additional customers. That business is behaving extremely well for us for all the last 10, 11 years. We're glad that is growing. Binding authority business, which is the level below that, these are average $5,000 per policy premiums, the small E&S accounts. That business is going through market improvement from a rate point of view, and through the teams that we have, and also the very broad distribution capability that we have for other relationships that Arch has with wholesalers, is really going very well.
That unit, I think, is up to about $1 million a quarter a week in production, which is ahead of our projections.
One thing I can add, Jay, is that on the program business, as he has denoted in the contract binding business, and why I always bring mix up, the growth in that, if that's above average growth, it's going to really impact the growth in the net written because that's virtually 100% net business. Those kinds of things alter the net pretty dramatically.
Yeah. It's small limits. We keep it 100% net, it all sticks to the ribs.
Okay. Switching gears to capital management, the pace of buybacks has been pretty modest so far this year. Should we expect anything before 4Q?
No. Third quarter, we don't like to buy because of the CAT exposure that we have. That will be an issue in fourth quarter.
Understood. Thank you.
Your next question comes from the line of Vinay Misquith, Evercore. Please proceed.
Hi, this is-
Hi.
Vinay Misquith. How are you doing?
I thought they mistaken my name, sometimes they do it to you, too.
A few questions here. First is just a numbers question on the mortgage reinsurance and the U.K. motor. I presume those lower premiums will also negatively impact the third and the fourth quarter. Do you have a sense for how much it's going to negatively impact the third and fourth quarter for those two?
Well, the mortgage is a comparison issue.
Right.
You are comparing a fat quarter a year ago on a written, not on an earned basis. Basically, I don't think that has an effect as we move to the third, fourth, first quarter from a year-to-year comparison, right? The motor, it will be coming down about proportionally on the same basis for the third and fourth quarter because we have cut back our capacity in that line.
Sure. Do you have a number on that by any chance?
I don't have all the treaties in front of me calculating numbers.
Okay. Thanks. The second thing is actually more of a philosophical question. I think your company, and I think Dino has taken the stance that we'll wait for the market to turn, only when it's sufficiently turned, we'll sort of go off to growth. You hinted at the fact that more is green now versus red, and that's interesting. There's been some discussion out there that maybe we're reaching the end of the rate increases. Just a philosophical question. Do you think that you can actually now grow or take advantage of the opportunities, or do you think that now that pricing is reaching sort of adequacy, that there'll be more competition?
Well, you're asking me first a philosophical question. Let me answer that first and then get to the predictions, which I don't like to make predictions. On a philosophical point of view, this is the same playbook we've been running Arch for the last 12 years. Business is in the red. You better justify everything that you do. If it's in the yellow, you be very careful. If it's in the green, write as much as you can get to. Now, as I said, there is more in the yellow, and there is some moving into the green. That's why you see growth. That is more of a phenomenon in the United States. I don't think the European markets have moved yet. The price corrections, they're mostly in North America, in U.S., and a bit in Canada.
Having said that, once you get to rate adequacy in our view, and you're getting enough rate increases, maybe smaller than before, but it's ahead of trend, you'd be stupid if you're not trying to write as much as you can. We're going to have that approach. We're going to try to write as much as we can. Having said that, I don't know how the competitors are going to react. They might, because rates go up and down depending on what I do versus somebody looking at the same account from a competitor's point of view. If rates start going down, then you're going to see us pulling back again. Our whole mentality is, let's look at treaty by treaty on the reinsurance side, account by account on the insurance side, does it meet our return characteristics? Then we're not governed by volume.
We're not a volume-driven company. I have no production goals for any one of my divisions. They don't get compensated on production. They only get compensated on return on equity. It's my problem to make sure that our capital get utilized properly. If they can write a lot, I give them the capital. If they can write as much as that, I have to deal with the capital and excess capital issue at the holding company.
One other, Vinay, one other little insight would be, I had made the comment that the E&S casualty book was up 9.5% in the quarter, and there's been prior quarters where it's been similar. We just have chosen not to play in there yet because it hasn't gone into the green, but it's approaching it. There's been no evidence, strong evidence of that abating.
Okay, that's helpful. Just as a follow-up to that, your primary insurance operation, you only keep about 70% net. Do you think you're going to raise your retention on primary business now that it's improving?
Don't mislead yourself. That's a premium comparison, not a limit or exposure comparison. Remember, we chose to grow contract binding business, program businesses, lenders businesses, things that don't put out a lot of capacity, and therefore we take as frequency-based, and we're more comfortable taking that risk assumption in-house. The fact that D&O businesses and hospital professional businesses have capacity out to $25 million in the U.S. simply means we haven't deployed it as much, but they may still be reinsured to the same level until we're comfortable of where the returns are.
Right. If you've seen the trend for the last few quarters, our net to gross is increasing. We're getting more net because what we're actually selling is more low limits, primary small accounts business. That we keep 100% net. There's no reinsurance behind that.
To emphasize, Dinos' made the point before that this is U.S.-centric. Technically, the Bermuda insurance market has a lot of global, a lot of U.S. companies that are very complex, and they buy a lot of capacity. The businesses we're growing in the U.S. don't make it to Bermuda because they're very low limits. You're not seeing those kind of increases yet out of the Bermuda facility.
Okay, that's helpful. Just one last question, if I may. From the ROE of 11%-13%, what amount of that can we see sort of hit the bottom line as an operating return? Because you have excess capital and you have also the returns on the equity portfolio. How should we translate that into really the bottom line operating ROE?
Well, if you don't know how much excess capital I have, you can't make that calculation because we take the S&P AA level capital, and that's what we allocate to the operating units. Everything else, of course, we allocate some capital to the investment department. We expect alpha from the investment department for the capital we allocate. Don't forget, we do the ROE on the operating units on the risk-free rate of return when I allocate capital. It's the combination of that. Our excess capital is not significant. It's not 20% of the book. It fluctuates, but it's been around 10% of our total capital. You can do the calculation. It might affect it because the underwriting ROEs we do on allocated capital to the operating units.
The underwriters, they get compensated on that ROE, because I don't want to give them excess capital, bring down the ROE specifically to one division, and affect their compensation negatively because they're going to go out and try to find business to write, and then that's business that I don't want on the books if they don't have the proper return. We try to align their interest by giving them the right amount of capital, AA capital, let them operate, and we hold them responsible to the performance to that. It's an old formula. It works. It's like doing cheeseburgers on a Greek diner. I used to do them when I was in college.
All right. Thank you very much, Dino.
You're welcome.
Your next question comes from the line of Craig W.oker, Morgan Stanley. Please proceed.
Thanks. You guys released your global triangles in the quarter. Just wanted to see if there was anything in particular that you wish to call out. They look pretty strong and continue to be strong, and I don't know if there's any lines or anything that are worth mentioning.
Mark, do you have any? I like what we released, and I like the taste of that meal, too.
I have nothing to add.
Okay, great. Thanks, guys.
Thank you.
Your next question comes from the line of John Hall, Wells Fargo. Please proceed.
Thanks very much. Good morning.
Good morning, John.
Hey there, Dinos. In your commentary, you talked about the long tail casualty needing rate in some segments, but some hitting adequacy. I was just wondering if you could share what some of those segments were.
It's pretty simple. I think lead umbrella is still shy of adequacy. Don't forget, we still have ancient attachment points like auto attaching excess of $1 million and even long haul trucking sometimes attaching excess of $2 million, which is, to me, you're in the buffer area. We're not in the lead umbrella area. If you get over $25 million or so, and the area that we see on small medium-sized accounts and all that's the area that now that excess. It's still not the excess that goes to the global markets, Bermuda, London, et cetera, the Fortune 500 per se. Mid-America and those kind of accounts on the excess, they're starting to wet our appetite, where the lead umbrella is not yet where we want to be. Then we like some of the primary.
It's sector by sector is different exposures, different customer groups, but those are the primary E&S, the first $1 million of exposure over either deductibles or SIRs. You got the primary we like, and we got kind of mid-excess that we like. We don't like the umbrellas, lead umbrella, et cetera. We're watching it, and we're measuring it. I'm not saying we're right. It's just one company's opinion. That's what makes the marketplace. I do pay a lot of guys a lot of money to make sure that they keep monitoring, monitoring, and making decisions. We're not going to make everything and be correct in every decision we make, but we try very hard.
Great. Understood. I just want to ask about the mortgage insurance acquisition. I guess when you first started doing all your work, the field was not very crowded and the incumbents were pretty beaten up. By the time you close at the end of the year and then frictional startup and the like, it's going to be pretty far out there when you really start ramping up in that business. I guess the question is, will the opportunity that you saw 6 or 12 months ago be there in another 12 or 18 months?
Yes. We wouldn't have gotten into that in the permanency of such if we didn't think the runway is 7 to 10 years out. Don't forget, if I thought the market opportunity was temporary, I would have stuck just with reinsurance transactions so I can do them when they're needed, one or two or three years, and then move on when they're not needed. We view that marketplace, the need for good capacity with The field is not crowded. It's going to be six or seven of us in a field that it has potential to expand significantly, especially depending what our legislators do in Washington as they're trying to push more and more of the credit risk to the private market instead of Government-Sponsored Enterprises, et cetera.
FHA still is the predominant insurer with maybe, I don't know if they've dropped below 60% of the market, but they still have 60% of the market. In normal conditions, it's supposed to be the insurer of last resort or kind of the assigned risk, and they're in their 15%-18% market share. We got a long way to go, and we view the opportunity today as good as it was six months ago. We wouldn't have moved towards that if we didn't think this as a 7 to 10 year horizon in front of it. A lot of things can happen, and that might change, but that's our view for the present time.
Got it. Appreciate it, Dino. Have a nice weekend.
You too. Thanks.
Your next question comes from the line of Jay Cohen, Bank of America Merrill Lynch. Please proceed.
Thank you. A couple questions. Mark, can you talk about the difference now between the new money yields and your portfolio yields, assuming you're investing in a similar asset class?
Well, broadly speaking, we quoted the embedded yield on fixed income, which as Dino said, is a piece of the action at 243 bips, which is pretty flat serially from the last quarter. The 50 bips improvement that we quoted is really about all I'm prepared to really comment on. Since we're a total return-focused entity, and that's total return irrespective of the geography of where it's put and irrespective of the asset classes, it's hard for us to answer that question without the alternative investment side and everything else coming into play.
Well, we can make our own assumptions on the alternative. The fixed income is still a big portion of the portfolio.
You don't know how much is rolling on and off. Don't forget, you're getting maturities that you got to reinvest, so you got to see what the reinvestment. I don't have those numbers in front of me. Maybe we can do some calculations and share some comments. Give us a call, then we'll go through it with you.
My comment on geography is more, as more treasuries and other things are rolled, it's going to be higher coupons. You guys tend to focus more on the income statement, NII, which is going to get some benefit from it. As Dinos said earlier, over the term of the duration of the portfolio, it's going to unwind itself. Geography-based, you're going to see some improvements because of the higher coupons.
Right. I guess the second question is really a follow-up on the insurance pricing question, where you suggested that the price increase decelerated a bit in the quarter, but pointing out that it still did good to get increases above claims inflation, which is clearly true. I guess the concern that the equity markets have is that this is a trend we will see for the next two or three quarters, and whatever cushion there is in pricing is going away pretty quickly. My question to you is, while you did see that deceleration.
That's not.
Say that again?
That premise is not what we've said. Go ahead, finish the question.
Yeah, that's exactly the question. I mean, the question is, the tone that you're seeing in the market, the behavior you're seeing, do you see a big change in how your competitors have been behaving that would make you nervous that this slide, if you will continue?
No. We don't see aggressive behavior, so to speak, in the marketplace. I think people, they are pushing for improved terms and pricing on the primary markets. We see the trend that we mentioned, that the primary insurers don't want to share as much of that with the reinsurers. They say, "Hey, you guys had pretty good numbers for a long time. We need the improvement, so you got to stick to our ribs. Pay us a little more ceding commission if you want our business." We see that. This is an improving environment. On account, even though you're not getting the same rate increase that you got a year ago, it doesn't mean on an absolute basis is marginally better. As long as that continues, that's a good thing.
I hear about the second derivative BS and all that, and at the end of the day, maybe those are trying to be predictors of what's going to happen into the future. I don't know what's going to happen into the future. As long as we're getting, as an industry, and we are, we're getting price increases that they're ahead of claim inflation, I think things are getting better, not worse. There is no other way to interpret it. If people have a crystal ball and they say, "This now is going to go into a dive, and the rate increases are going to be below claims inflation," you can get into a different conclusion. There is no evidence in anything that we see or anything else that every competitor of ours reported that is pointing to that.
Great. That's helpful. If I could squeeze in one more question. The expense ratio on the reinsurance side, the G&A expense ratio was up a little bit. One of the things you mentioned in the release was some investments in that business. Can you talk more about that, exactly what that was?
It was two things. It's very simple. You guys read 8-K sometimes, but you don't pay a lot of attention to it. We did a big retention round at year-end. There is equity cost that is coming through. Especially if you're familiar with accounting rules, and believe me, I got so many accountants, I take three Advils every time I meet with them. If a lot of our employees, they're retirement eligible, you got to take that course in one year, immediately. You can't spread it over the five-year cliff vesting and all that that we had. Second, we had beefed up some of our teams, both on the starting to hire on the mortgage side and starting to hire in the life reinsurance sector, a few individuals.
Of course, on the insurance side, we brought a big team, which is starting to produce already in the contract binding business. The retention round was done for the right reasons. We have good employees and we want to retain them, and we create another obstacle for competition to take them. We're paying for it, and we're happy about it. That's the two explanations. There is nothing more into those numbers other than those two things.
Got it. That's really helpful. Thank you.
There are no further questions at this time.
Well, thank you for giving us the time and the opportunity. We're looking forward to seeing you and talking to you next quarter. Have a good afternoon.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect.