We'll get started with the next presenter now. Very happy, once again, to have Constantine Iordanou, head of Arch Capital Group, with us. I had the opportunity, a little bit more than a decade ago, to work on the IPO of Arch. Back then, the company was largely a vision. They were building out the businesses and hiring very talented, experienced people. It's really remarkable to look back now, 10 years later, and see what this company has become. What will be really fun is to look at the next 10 years. At least for now and for the next couple of years, I'll turn it over to Dinos to give us an update on the company.
Good morning, everybody, and thank you, Jay. It's a pleasure to be here. You said another 10 years. I'm getting old. I don't know if I have 10 years, but yeah. With me up on the stage, I have Mark Lyons, which is our CFO. If you get into too many technical questions, he's here to bail me out as he usually does. Let's start a little bit with the financial highlights. Fourth quarter, not a great quarter because of Sandy. We had net income of about $13.7 million or $0.10 per share. On an operating basis, we had a loss of about $0.18 per share. The year was not bad. We had operating income of about $350 million and an effective ROE of 7.7%, independent of the Sandy losses we had in the fourth quarter.
Combined ratio was 95.4%, and it includes that 8.8 points of current year cat activity which the Sandy losses were $203 million. Book value, that's the measurement that we really pay a lot of attention to, and it's the measurement that determines my compensation, so it's dear to my heart. It was a decent year. We have grown book value per share at about 14%, and cash flow remains very strong at $921 million, and the total capital of the company is at $5.57 billion. What's new within Arch? First and foremost is mortgage initiative. We have been studying the mortgage market now since the financial crisis. We hire our first team back in 2009. Originally, for us, it was to set up a company which we have in Europe.
We have Arch Mortgage Insurance in Dublin, licensed to do business in the European Union and other parts of the world, and also enter the market through reinsurance transactions. More recently, we were examining what opportunities we had in the United States, and last week, we announced the intent for us to acquire CMG, MI, and the operating platform of PMI. This will allow us to enter the U.S. primary mortgage insurance business in the U.S. CMG focuses exclusively on the credit union business where PMI is more broadly to all lender market segments. Just to give you a little bit on size, CMG in the 2011 wrote about $90 million of premium, and the projection for 2012 is approximately the same.
The transaction as is structure, it will give us very limited exposure to pre-financial crisis exposures with basically us buying CMG on a stock transaction and buying the assets of PMI. In addition to that, we enter into 100% quota share, so in essence, we'll take 100% of the post-crisis book of PMI from 2009 to present, and we expect this transaction to close within the next 12 months. Other initiatives in our U.S. insurance operations, we have hired a strong team to enter the contract binding business. This is something that was on our wish list for many years. It's a good segment in writing very small accounts through the wholesale community. As the market is starting to improve and we found the right team to bring with us, we have entered that business as of January this year.
In experimenting with the web, we have announced a web-based travel accident insurance platform under the name RoamRight, and I invite you to go on the internet and navigate through the site. Very small now, but we have high expectations over time that travel accident, travel insurance in general, we have several products on it will grow through this internet initiative. In Canada, we converted our existing branch structure to a wholly rated subsidiary with an A-plus rating that will allow us in Canada to also enter the title insurance market. It's a small initiative for us right now, but it has possibilities for the future. In Europe, we have expanded our property facultative operations with adding people in our Zurich and London offices.
Most of you are aware with our transaction with Ariel buying a team that they're in the trade credit and surety reinsurance business. We also hire a team that underwrites international crop. All of them, they're in our Zurich office. On the life reinsurance, we continue to focus and expand on the mortality side of the reinsurance business, and that is starting to get some traction. Last year, we did approximately $40 million in this particular sector. A little bit on market conditions. We see a modest improvement in the U.S. with rate increases now above loss trend. It's a message you probably heard from other executives.
We monitor that, and we feel that this particular movement is not being caused by reserves issues in the business per se, but more by the recognition of most competitors that we have, including us, that investment income is not what it used to be. In essence, we need more rate, and we have to make more underwriting profit in order for returns to be adequate. More specifically, what we see in areas that they've been loss affected, for example, Northeast property because of Sandy, in the construction area, in some of the three-line retro national accounts, D&O where EPL and crime losses have been a problem, and of course, workers' comp. That's where we're seeing the most rate increases. In some cases, double digits or high double digits. On the other hand, in low volatility exposures, we see rates to be flat but also adequate.
For us, it's our program business, our lenders business, our A&H business, and we continue to try to grow in every one of these areas. In the excess and surplus lines world, we see more activity with more submissions coming in, both on the property and the liability lines, as more and more admitted carriers are changing their underwriting appetite on certain classes. These classes, in our view, belong in the E&S market to begin with, and through the competitive part of the cycle, they gravitate into the standard markets, but we've seen that flow. Unfortunately for us, even though we like what's happening on the property side, some of the casualty lines are not still at a rate level that is acceptable to us for the returns that we expect.
The underwriting margins are improving, as I said, in some cases, we're finding better return opportunities in some non-traditional sectors. Mortgage insurance and mortgage reinsurance is one area. Our expansion in the A&H area, which we view as a very attractive area. Again, on our life reinsurance on the mortality side of the business. The area that we have the most difficulty with, and we believe is still very competitive, independent of double-digit rate increases that we see in the market, is some of the primary casualty lines, excess and umbrella, excess liability. We still believe, and we might be a minority in the sector. Other people believe that these lines have corrected enough. In our view, those lines still require significantly more rate in order for us to be willing to grow our book of business.
In essence, even though workers' compensation is a state-by-state issue, in general, even though workers' comp is getting significant rate increases, we don't believe rates are still adequate for us to expand in those lines. This is a little bit about Arch and the DNA of the company. I put this slide from our beginning when we started, in 2002 all the way to now. The blue lines is our insurance activity, and the red bars is the reinsurance activity. As you can see, on the insurance, it was a gradual build-up all the way up to about 2006, 2007. When we experienced the market erosion and the softer part of the cycle, we kind of remained steady. That's independent of us adding new products, new geographies, and new lines.
In essence, in the same store sales, so to speak, we were actually shrinking for those years, and we kind of remained steady because of new initiatives. On the reinsurance side, we hit our highest level in 2005, and then as we witnessed price erosion, we reduced capacity significantly to be about half in 2010 from what we had in 2005. I think, if I had to do it all over again, 2006, 2007, they're panning to be very good years, and I think we were a little bit too quick in cutting our premium in those areas and withdrawing with some markets in that particular time. What you don't see in the bars is also the rotation we did as a company from large accounts to smaller accounts, and from being 80/20 casualty oriented in the early years to being about 55/45 now, casualty to property.
It was our determination as to where the profit margins were best for our shareholders, and we had the willingness and ability to navigate and make those changes. Very few companies will take their reinsurance premium from $1.6 billion to $800 million in the period of time we've done it. That shows you that we believe in disciplined underwriting as a company, and we're willing to give up top-line growth in order for us to maintain margins. For those of you who have been following us, I'm not telling you anything that you don't already know. Now, with 2011 and 2012, you're starting the company to grow again.
What's causing that is new initiatives, as I have mentioned, and also, at least for 2012, and as we see with January 1 renewals in 2013, we're sensing the market improvement, for the reasons that I just said. This has been our financial performance, and what I have shown here is our net income on average equity, both from an operating income point of view and from a net income point of view. A lot of analysts are asking us a lot of questions because, after the financial crisis, we have made some changes to our investment philosophy. In essence, we've always been a total return-oriented company. As you can see from this slide, prior to the financial crisis, the difference between operating ROE and net income ROE wasn't that different.
It has become much different after the financial crisis because of the changes we have made to our investment philosophy, with more of our assets being allocated to alternative investments and equities, et cetera. As you can see, the green bars, which is the return on equity on net income, it's significantly higher than the operating return. The reason I put it up is because we're getting a lot of questions by analysts as to why shouldn't you change some of your definitions as what's operating and not. We like to be pure and consistent over the years. We have no intention of changing anything. We do publish information on both, and it's up to you to make your own calculations and draw your own conclusions.
In another way of looking at it, this is the net investment yield versus our total return we have achieved over the last seven years or so. As you can see, after the financial crisis, and it's because of the change in our investment philosophy, our total return has been outpacing what our net investment yield is by a significant margin. Our book value per common share growth has been steady now for 11 years, compounding at about 18.1%. As I said when I started the presentation, that this is the most important measurement for me because my compensation depends on this. I think my kids can go to good colleges and great universities, because we've done reasonably well. My wife is pretty happy, on Valentine's Day, I can afford to buy the present that she wants.
For those of you that are shareholders, I think you've been pretty happy with this kind of performance over the last 11 years. In our fashion of conservatism is also our capital structure. Our capitalization is very strong. It has very little financial leverage. Our financial leverage between long-term debt and hybrid securities, the perpetual prefers, is only 13% of total capital. That gives us a lot of flexibility if we have opportunities because of the market change to deploy additional capital. We can access the capital markets in a fashion that it will not dilute our common shareholders and we're very proud of how we have managed our capital account over the years. From a liquidity point of view, we have ample liquidity and there is not an issue.
In summarizing, I can give time for questions, well, I'm sure you will have a lot based on our announcement. Our strategy hasn't changed. It's been consistent for 11 years. We have a disciplined approach to the underwriting cycle. We believe we ought to be writing a lot of business when the market is good and writing a lot less when the market is not good. Very easy to say, hard to do. Human nature is that underwriters want to always win and write the next account. It requires a lot of management attention to make sure that they remain disciplined on the P&C pricing cycle. We always maintain a conservative balance sheet on the asset side and it gives us the flexibility through the low leverage we have to take advantage of market opportunities.
When the market hardens, we need significant new additional capital, we can do it without diluting any of our common shareholders. Our returns have been strong on a risk-adjusted basis over the long term. To help us with point number 1, to know how to navigate the cycle and maintain that discipline within our underwriting ranks, we have a unique way of compensating our people. Most of you are familiar with it. We pay underwriters for long-term performance. Our incentive compensation is an ROE-based system. It pays underwriters on an underwriting year basis with some money that we give them early on, within three, four years of the underwriting year, with continuing calculations until 10 years. In essence, no year is closed for the underwriters until both us and the shareholders know exactly what happened with that underwriting year.
That is 10 years after we wrote the business. It's the fairest way to compensate people, in our view, and also is the way that you maintain the focus that the underwriters need to have, that at the end of the day, they're going to eat their own cooking. We give them all the ingredients, we give them the kitchen, and then they have to cook the meal. Once they cook the meal, they're going to eat from the same meal because that's what the shareholder does. With that, I will open it up for your questions.
Dinos, I'll start with one. On the last Davis transaction you announced, the mortgage insurance business, you're obviously taking some liabilities from the recent years, 2009, 2010. What kind of due diligence were you able to do on those liabilities that you're assuming? Even though things got certainly better after the crisis, one might be a little bit nervous about the 2009 year potentially.
Right. We've done extensive due diligence. As a matter of fact, Mark Lyons, head of the team. If that microphone is on, I'm going to turn it over to Mark. It's the first time in front of you, so he can give you a little bit of the detailed process that we went through in our due diligence for that particular block of business which is 2009, 2010, 2011, 2012.
Yeah. Great.
Got it.
Dinos, thank you. It shows you've mastered the art of risk transfer.
Yeah, the due diligence was quite extensive. Not only getting underneath the details of the business being written and the characteristics of the business being written, you can interpret from year to year to year how the underlying quality may have changed. Getting into the whole process of how they reserve, how they look forward, what are the macroeconomic variables that are key? How do they measure changes in P&C parlance of terms and conditions? In their case, the underlying credit characteristics of it. A whole ball of wax. We had access to a lot of industry information. We had a lot of access to their particular information, and we were able to come up with a set of things. We also reviewed all their actuarial analyses, the reviews from the outside auditors.
From the business, its characteristics, how it changed year by year, analytics, how they think, what they manage by, we got into the weeds on every one of those. We felt very good about it.
My other question related to the transaction, you had said on the conference call, it wouldn't really be accretive until, I think it was 2016. I'm not quite sure why it takes that long.
This is a business that it takes long to ramp up and there is an earning pattern. Don't forget, you have upfront expenses that you have to expense quickly. The accounting model, as a matter of fact, if I go back to I had a slide here. This is the ROE slide of our financial performance. When you look at 2002, what do we show there? 5% ROE? Okay. The ROE when I do our incentive compensation for the 2002 underwriting year is in north of 50%. That was the return that we earned in 2002, but the accounting model doesn't allow you to show the return. We believe the mortgage insurance business is north of 15% ROE, 20 to 1 capital to value at risk.
At the end of the day, as long as we write that business, we don't really care when it earns and where it shows. That's been our philosophy in running Arch, with any line. I don't care if it's in the P&C sector or mortgage insurance on the reinsurance sector. At the end of the day, we'll look at the transactions, what we do today. That's how we're going to get paid. What ROE we're going to at ultimate. Don't forget, the shareholder is in your stock at ultimate. There is some that they want to trade. They go in and out. We don't care too much about that. At the end of the day, that's not the game that we get paid to. We get paid to create value long term.
Everything that I think about is what we do today, not what the accounting effect is going to be today, but at ultimate, is that a good transaction or not? We feel very strong about the mortgage space right now. Mark, you want to add anything to that or?
Well, I think the only thing that I guess I could add to that is that we don't view this line any differently from a management perspective than any other P&C line. We're going to be overlaying. We're going to have Arch executives mixed with PMI's executives, but the top positions are Arch positions. The culture, the way we look at things, the dynamics, the way we measure, and the way we move capital in and out, and time and attention and people. We're going to manage the cycle, although in that it's more macroeconomic cycle as opposed to P&C where it's insurance cycle. We're not a monoline. We're not going to be chasing revenue because that's our only source of revenue stream. We're a diversified organization, and we're going to manage it in a fashion similar to every other line of business.
We believe if you have decent underwriting standards, we intend to do, this should be a profitable business for many years to come. The mortgage insurance space had self-inflicted wounds, that people threw out the underwriting manuals, and at the end of the day, they had to pay the consequence.
The other question I had related to the other two businesses really last year that you, in 2012, you started the mortgage reinsurance and then the motor reinsurance as well. They were sort of discussed as opportunistic plays on the market. Do you have any sense of how long those premiums will stick around for?
It's hard to predict because a lot in reinsurance is opportunistic, right? You don't own the business. You only own it contractually because somebody wants to cede it to you. At the end of the day, they can always take it back. The motivations sometimes of the buyer come from different angles. In both situations, that business was written by us as sort of a capital relief for the people that they actually own the business, because if you're the primary writer, you own the business. How long will it last? It will depend both on our determination what the profitability associated with that business, because we don't determine what happens on the underlying business day to day. They might be giving rate, or they might be gaining rate.
We have the ability once a year to review that and see if we like the business, continue to like it, and if that cedent is willing to continue ceding to us, of course, you have a continuation. I'm more optimistic about the mortgage insurance that it will continue because I think there is enough need for capital relief, and our insurance operations can provide that to some of our existing clients or new clients. I'm not as optimistic on the motor that it will continue to be as profitable as with him because we're starting to see tough competition, and this is all in the U.K. market. Hard to predict the future, but we never try to predict the future. We try to act as responsibly as we can on the present. We run the company on the present, not on the future. Yeah.
I think we're good.
Well, thank you for inviting us. Oh, just one more question.
Dinos, is the mortgage insurance business still very sensitive to rating agencies? If so, once you're in the business, is your capital kind of trapped in that business? Can you get it out as easily as you can put it in?
Two-part question. First is it sensitive to the rating agencies? Yes, but it's more sensitive to the GSEs. At the end of the day is Fannie and Freddie. Today, when you look at the space, there is unrated vehicles that they're acceptable to the GSEs and they're writing the business, so they have no rating for any rating agencies. Most of the others, they have very, very low, I think the highest rating is Baa1. When we close this transaction, we'll be the highest-rated mortgage insurer in the space. I think the GSEs have more impact as to what happens in the marketplace than actually the rating agencies. Over time, I think the rating agencies will have that influence, too. For the time being, because this business is, at least in the private sector, is in distress. Today, FHA writes 66% of all mortgage insurance.
It's only 34% that is in the private sector. We don't have to fight for the business. A lot of that business is going to come because I think the government wants to depopulate what they do and bring it into the private sector. Now, your capital is associated with how much business you write, and the degradation of that is usually around 4-5 years. Seven years in total, but most of it within 4-5 years. If you stop writing, capital is trapped, and it takes about 4-5 years for most of it to come out. Mark, you've done the curves and all that, you can add color to Michael's question.
Okay. I'd say as Dinos said, the GSEs are more paramount to establishing capital ratios and things of that nature. Getting money out, it's more going over to the state insurance departments. State insurance departments have things called contingency reserves on a statutory basis. It's formulaic, and there's ways to get it out, and there's ways that it's kept there. But it's considered a component, a segregated piece of capital. It's not some separate item in most states. It's allowed to be counted on your risk to capital ratios. It's allowed to be counted on a dividend out as the base upon which like a 10% dividend may go and so forth. It's effective monitoring tool, but it's flexible in that it's considered capital for other decision-making.
Thank you. Have a wonderful Valentine's Day