Good day, ladies and gentlemen, and welcome to the second quarter 2012 Arch Capital Group earnings conference call. My name's Dave, and I'll be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question and answer session towards the end of this conference. If at any time during the call you require assistance, please press star zero and an operator will be happy to help you. As a reminder, this call 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 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 like to turn the call over now to your hosts, Mr. Dinos Iordanou and Mr. John Hele. Please proceed.
Thank you, David. Good morning, everyone, and thank you for joining us today. We had a terrific second quarter. Before I get into the details, I would like to address the management changes we have announced at Arch. Joining me on the call today are both John Hele and Mark Lyons. This will be John's last call as Arch CFO, as he's leaving to join another financial services firm. I would like to take this opportunity to thank John for his contributions to Arch over the past three years. We wish him the best in his new endeavors. I'm not going to re-welcome Mark Lyons, since he has been my partner for the past 30 years as we have worked together, first as insurance rookies at AIG, then on to Berkshire Hathaway, Zurich, and now of course, with Arch.
Mark calls it both a blessing and a curse that he has been with me for such a long time, it has been a great 30 years, at least from my perspective. In his new role as our CFO, the curse part will take precedence as he will be sitting right next to my office in Bermuda. We are also pleased that David McElroy will be replacing Mark as the Chief Executive Officer of our insurance group, and that Michael Murphy will become President of our U.S. underwriting operations and will also be our Chief Underwriting Officer for the Worldwide Insurance Group . I have tremendous confidence in these individuals and our entire senior management team in both our insurance and reinsurance group. Accordingly, we are well positioned at Arch to move our business forward based on the improvement we see in the market opportunities and market conditions.
All of these appointments once again demonstrate the deep bench we have built at Arch and our ability to promote first from within and to give all of our people the ability to grow professionally over time. Let me turn back to our quarterly results. On an operating basis, we earned $1.02 per share, which on an annualized basis represents a 12.3% return on equity. Our reported underwriting performance was excellent with a combined ratio of 87.2, while our investment performance for the quarter, including the effects of foreign exchange, was satisfactory with a total return of 63 basis points for the quarter. Cash flow was $252 million, an increase of $30 million over a year ago and $100 million over the past quarter.
Our book value per common share was $34.45, a 3.4 increase from March 31, 2012, and a 12.2% increase from a year ago. We also had very strong revenue increases for the quarter, which I will comment on in a few minutes. The market environment continues to show improvement across the board in our U.S. insurance business, where we have the strongest statistics both by volume and granularity. Rates increase on a weighted average by approximately 4%, which is 1% better than last quarter and slightly above our weighted averages loss trends. Two other trends of note are emerging in the U.S. insurance group. In our specialty lines, we achieved an average rate increase of 6%, our specialty business is a bit stronger than standard.
Our E&S submission activity increased year-over-year, another sign that standard lines underwriters are returning more business to the E&S market where it belonged in the first place. To us, these are indications that the market is moving into new territory of gradual improvement, although we cannot call it a trend as of yet. Even with a better rate environment, given the level of investment yields currently available and our view of rate adequacy on an absolute basis, we believe that longer tail lines still require substantial additional rate improvement to become attractive, at least to us. In our reinsurance segment, rates on a risk-adjusted basis continued to improve significantly in many areas of the world in the property and property cat lines, while all other lines remain basically unchanged, although our reinsurance business benefits from the underlying rate improvements occurring on the primary basis.
For the recent Florida renewals, we achieved mid-single-digit rate increases, and were able to deploy additional capacity. From a premium point of view in our insurance group, we are seeing some benefit from the improving rate environment as more accounts meet our underwriting standards. In the reinsurance sector, on the other hand, our new initiatives are bearing fruit and most of our growth is emerging from those initiatives. On a consolidated basis, our gross written premium was up 15.3%, and our net written premiums increased by 16.1%. Looking at growth by segment, the insurance group's premium rose by approximately 6.5% on a gross basis and 6% on a net basis, with slightly over one half of the increase due to increased rates. The reinsurance group premium volume was up 35.7% on gross and 32.6% on net.
These increases primarily resulted from new opportunities in U.K. motor mortgage insurance that we spoke about last quarter and from the global property and property cat lines of business. Groupwide, on an expected basis, the ROE on the business we wrote in the second quarter of this year will produce an underwriting year ROE in the range of 9%-11%. The rate improvement that I mentioned earlier will not affect the expected ROE, as the improvements in premium rates have been offset by reduction in expected investment yield. During the quarter, we did not repurchase any of our shares. As you may know, it is customary for us not to repurchase shares during the hurricane season unless there is a significant opportunity because of stock market factors unrelated to Arch.
Having said that, there is a reasonable likelihood that we will reinstitute our share repurchase activity in the fourth quarter of this year. Before I turn it over to John for more commentary on our financial results, let me update you on our cat PML aggregates. As of July 1st, 2012, our largest one in 250-year PMLs for a single event were $878 million in the Gulf, or 19% of common shareholders' equity, and $846 million in the Northeast. Our Florida Tri-County PML now stands at $645 million, just slightly above what we reported in the last quarter. With that, let me turn it over to John. John, again, thank you for your contributions.
Thank you, Dinos, good morning. On a consolidated basis, the ratio of net premium to gross premium in the quarter was 78%, essentially unchanged from the 77.5% a year ago. In the reinsurance segment, the net to gross ratio was 94% in the 2012 second quarter compared to 97% a year ago. This difference in the reinsurance segment was due to a fully funded quota share retro property cat treaty executed in the 2012 second quarter. Our overall operating results for the quarter included a combined ratio of 87.2% with 1.0 point, or $7 million, of current accident year cat-related events, net of reinsurance and reinstatement premiums. Compared to the 2011 second quarter, which included a combined ratio of 100% reflecting 14.8 points, or $95 million, of cat-related events, also net of reinsurance and reinstatement premiums.
The 2012 second quarter amount reflected second quarter U.S. storm activity, which primarily impacted the reinsurance segment, partially offset by reductions in estimates on 2012 first quarter cat events in the insurance segment. The 2012 second quarter also reflected favorable development on the 2011 and prior cat events, primarily in the insurance segment. The 2012 second quarter combined ratio also reflected 8.6 points, or $63 million, of estimated prior year net favorable development, compared to $58 million, or 8.9 points, in the 2011 second quarter. Approximately 70% of the net favorable development in the 2012 second quarter was from the reinsurance segment, with approximately 60% of that due to favorable development on short tail lines from more recent underwriting years and 40% due to medium and longer tail lines from earlier underwriting years.
The remaining 30% of net favorable development was from the insurance segment in the 2012 second quarter and was driven from short tail and medium tail lines, mainly from more recent accident years. In the reinsurance segment, the 2012 accident year combined ratio, excluding cats, was 81.5%, compared to 80.2% in the 2011 second quarter. The reinsurance segment's results in 2012 reflect changes in the mix of business with a higher contribution from U.K. motor business and some specific opportunities in medium and longer tail lines. In the insurance segment, the 2012 accident year combined ratio, excluding cats, was 103%, compared to 102% a year ago. The insurance segment's results in the 2012 second quarter reflect slightly higher attritional losses in medium tail lines.
The 2012 second quarter results include the effects of the April 2012 acquisition of the international credit and surety operations of Ariel Re, based in Zurich, Switzerland. The acquisition, which was not material to tangible equity, included $83.1 million of net unearned premiums, along with other insurance balances, and was accounted under purchase accounting rules. Under such rules, the unearned premium acquired is not included in premiums written but will be reflected in premiums earned. Net premiums earned for the 2012 second quarter included $17.3 million related to the unearned premium acquired, with the remainder primarily expected to be earned over a two-year period. Net investment income in the 2012 second quarter was $0.53 per share, or $74 million, compared to $0.54 per share, or $74 million in the 2012 first quarter.
Our embedded pre-tax book yield before expenses was 2.76% in the 2012 second quarter, the same as in the 2012 first quarter. We lengthened the duration of the portfolio slightly to 3.01 from 2.75 in the 2012 first quarter. The total return on the portfolio was 63 basis points in the 2012 second quarter, compared to 187 basis points in the 2012 first quarter. Excluding foreign exchange, it was 104 basis points in the 2012 second quarter, compared to 160 basis points in the first quarter. Our exposure to eurozone countries is listed in the supplement, with minimal exposure to the current countries of interest. Foreign exchange gains were $32 million in the 2012 second quarter.
When compared to the net 41 basis points loss on the investment portfolio from investments held in foreign currencies, which works out to be $50 million, recorded directly to shareholders' equity, the approximate combined net impact of foreign exchange was a negative $18 million, or $0.13 per share to book value. This net negative impact is due to the strengthening of the U.S. dollar against almost all major currencies. Our effective tax rate on pre-tax income in the 2012 second quarter was an expense of 0.3%, compared to a benefit of 2.4% in the 2011 second quarter. 2011 second quarter benefit reflected the tax effect of the second quarter cat losses, as well as a re-estimation of the full-year tax rate. Book value per share increased 3.4% to $34.45 in the 2012 second quarter due to operating earnings and total return on investments.
Book value per share has increased by 8.5% in 2012. As I mentioned in our last call in April, we issued $325 million of Series C preferred shares with a five-year non-call period. We also announced a call of our $325 million of Series A and B preferred shares at par. The net savings and coupon cost is 120 basis points per year, or $3.9 million. As previously announced, taking into account all costs for issuance over the five-year non-call period, we expect to save a net 63 basis points in annual cost over the next five years. In the second quarter, preferred dividends were higher than normal as we paid an overlap of dividends on the Series A and B classes and on the new Series C class for a short period.
Our total capital increased to $5.4 billion at the end of the 2012 second quarter, up from $5 billion at the end of 2011. Our debt plus hybrids represent only 13.4% of our total capital, giving us significant room to raise additional capital in the future at our targeted rating. At the end of the second quarter, we have excess capital over our targeted capital position. Today, after the market close, the 2011 Global Loss Triangles report will be published on our website. As Dinos has mentioned, I am leaving Arch to pursue another opportunity at a major financial institution. I very much enjoyed my time at Arch. I thank Arch for all that they have done for me, and I wish to reassure everyone listening that in the future I will switch to your side of the call being a very interested shareholder.
With these introductory comments, we're pleased to take your questions.
David, we are ready for questions.
Thank you, sir. Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your touch-tone telephone. If your question has been answered or you wish to withdraw your question, press star followed by two. Press one to begin. Please stand by for your first question. The first question comes from Michael Zaremski of Credit Suisse. Go ahead, please.
Hey, good morning.
Good morning, Mike.
Dinos, this may be a naive question, but I'm going to ask it still.
There is no naive questions. All questions are good and welcome.
Good to hear. Do you feel the results in the primary insurance segment are satisfactory given the current market environment? Or is there an initiative to maybe prune out underperforming businesses? I ask that because I'm looking at the accident year.
It's excellent questions. First, that's an ongoing process. A tree is never healthy unless it's pruned all the time. In essence, we look at all of our profit centers, and where we need improvement, we execute a strategy for improvement, and where we have satisfactory results, we try to grow that business. Having said that, based on the existing market conditions, the activity in our insurance group is acceptable to us, it's satisfactory. In a lot of segments, we're looking to grow. Rate improvement is coming. Don't forget, we always look at our business on a policy year basis, and one quarter's accident year doesn't tell the story about where we are from a profitability point of view.
One of the things that I have encouraged in past calls analysts to do is, since 50% of our book of business is short tail or medium tail, that might have attritional volatility in one quarter. A better measure to see if there is a margin improvement or margin contraction is to do a trailing 12 months calculations. I guess it might be you guys, I know you're very busy, and you might not be willing to do that, but it will give you a better indication. Specific to the Insurance Group, this quarter accident year, it was influenced by one-time attritional losses. We had two losses in the surety sector, that might give you the wrong impression about the healthiness of the underlying book. In answering the question, yes, some divisions of ours were defensive.
You can't totally exit the market, you take defensive posture, you write less business, you might move to smaller accounts, et cetera, and not allocate resources to grow that. In some other sectors, we're looking to grow.
Okay. That's helpful. John, maybe I missed this in the prepared remarks. Could you comment on the new money investment rate?
No, I didn't mention that. It's essentially about the same as for what we're looking at. I think we said about 2%-2.5%. We're not buying German bunds or things like that at negative returns. We have some opportunities here and there that is getting us into that range, which is a big spread over U.S. Treasuries. If you look at Treasuries today.
Yeah.
There's some call protected mortgages we're looking at and a few other things. We're also diversifying the book around the world with some other bank loan funds to get some investment income in. It's still a challenging investment environment.
Yeah. Our embedded yield hasn't moved.
No, it hasn't moved.
You saw it was 274, I think, on the first quarter. This quarter is exactly at the same level.
We've been able to maintain it through some of these other activities.
Okay, great. John, good luck at your new endeavors.
Thank you.
Thank you. Your next question comes from the line of Matthew Heimermann of J.P. Morgan. Please proceed.
Hi. Good morning, everyone, and best of luck, John.
Thanks, Matt.
I don't know why you want to go to the dark side of insurance, but that's another question.
No comment.
He likes challenges, Matt.
That's fair. I can appreciate that. I guess, first question I'd have is, you put in one of the press releases last night, the announcement of the Executive Management Strategy Committee, and I guess be curious just what the catalyst was for forming that group, because to some extent, I would have thought there probably was a similar group that already existed. Also whether or not what the rationale was for disclosing the formation of the group. I didn't know if there was some subtle message you were trying to send to all of us, or it's potentially I'm overreading.
Well, there is only one message. You're correct in your assessment. Even though I get this bad reputation sometimes as CEO that I lean a little bit on the dictatorial side, I'm not. I'm very collaborative guy, I try to get multiple people's opinion in the way we operate the company, and it's maybe my loud voice that gives me the bad reputation. We did operate as a company on that basis for years. Some of you, and that's why it's no surprise to you, knew that because you asked the question in other meetings, et cetera. The only nuance of us announcing it is usually in the past, it was kind of And the reinsurance guys, if the issue's coming up, strategic or acquiring a team, he was falling into the reinsurance sector, and me and the insurance boys, if he was on the insurance side.
When I say me, it's me and Vallaro in the past, and me and John Hele presently, and it will be John and Mark Lyons in the future. Now I think because where the market is going and also reviewing the activity we had in the last year, we've seen more and more of these calls and these opportunities, and I said, I think we'll benefit from the wisdom of putting both insurance and reinsurance and holding company personnel together in our discussions as to should we pursue this opportunity or not. Internally, it's not going to be a big change. It is business as usual. By putting it in an announcement, at least I'm telling the world that's the way we're operating. It's no surprise to anybody as to how we do things at Arch.
Then is it fair to read from that comment then that it kind of reflects that while we've talked specifically about some of the opportunities this year, credit, mortgage, reinsurance, what have you, that kind of that flow of things-
Yeah
it continues in a way that necessitates this.
Yes. It goes even beyond the six individuals that I have. That's just to air and get a first opinion on a particular opportunity. If we decide that we're going to pursue it, usually we get a little deeper, and we expand it. Our culture of managing by walking around is not changing. I talk to the guys all the time. I'm on the phone. To grin, I'm not, what I would say, a meetings and appointment guy. I hate meetings, and I hate appointments. It's free flow of information, free flow of communication. We talk to each other, and the conference room is anywhere from the coffee station all the way into the bathroom. At the end of the day, anywhere I have the opportunity to talk to our guys, that's the way we operate, and we're going to be as simplistic as that.
Fair enough. That's helpful. I guess, John, just on the mortgage reinsurance business, we've talked kind of in generality about how to think about this business in past calls. If we back out kind of the catch-up premium in the quarter, is that a reasonable kind of run rate to use for this business?
Yeah, because a lot of it's earned monthly, so it's pretty steady. It's not as lumpy, certainly for the contract we have for this year.
Okay. All right. That's helpful. Just from a margin standpoint, just combined ratio, does that from a mix standpoint help or hurt kind of the way we would've thought about margins in the past?
Well, the mortgage business has very good margins. The question is, when do you recognize it? We like to be conservative on the recognition of the margin. At the end of the day, nobody ever puts his hands in my pocket and takes out my money. By reserving conservatively, at the end of the day, you see how things go, and if things go better than you expected or as you expected, usually you have favorable development. This is a new line for us. We're very careful about how we analyze transactions, and also, we're very careful as to how we're booking these transactions, for the simple reason, we got to see how we will perform over years.
Okay. Thank you.
You're welcome.
Thank you. Next question comes from the line of Joshua Shanker at Deutsche Bank. Go ahead, please.
Good morning, everyone. I'll just add on to John. We hardly knew you. It just seems so quick. I'm sure I'll be seeing you in the future in your new digs. In looking at your investment portfolio, you guys took the lumps early on, I think. I look at your comparison. You probably have one of the lowest investment yields of any of your competitors out there. When I look at some of your competitors, even those located stateside, they're earning 3.5%, 4% yields, and they have tax-preferred securities. When you're thinking about strategy, when are they going to feel the pinch? Because they've been earning those yields for now three or four years, and it seems like nothing gets those yields down.
What's your strategizing in terms of when they're going to have to raise prices and you might see some business coming your way because you've already made those adjustments?
Listen, I don't know, Josh. How do I know? I don't go and spend my time analyzing somebody else's balance sheet and see what kind of investments they make. You know that if you're going to have a much higher yield, you're taking investment risk. At the end of the day, I don't have to tell you. You know that better than I do. We are conservative in our approach to investments on the basis that I think the people, our shareholders who buy our shares, they're not doing it because they think we're going to take undue risk in the investment side of the balance sheet to stretch earnings. They're buying our shares because they think we're prudent guardians of capital and good underwriters in the insurance business.
I think that's the kind of investor that we want, people who have confidence in our abilities to analyze risk, price it appropriately, and ride it prudently.
Josh, you also have to factor in thinking about our mix of business now being more shorter tail, our duration. We've been a little shorter, and we've been cautious on it as well. If you look at other competitors, you got to think through what business do they have? Are they longer tail or are they-
Look at duration of their business.
That's right. As we've shifted to more shorter tail, it's natural that our duration would be shorter, and therefore, we're going to have a slightly lower investment yield.
Yeah, of course. In thinking about 2013, a propensity to deploy capital into non-fixed income, would there be any change in your appetite?
Well, yes, I think we are allocating more into alternative investments, but it's not a significant amount of money. I would put it in the range of maybe $0.5 billion out of $12.5 billion in order for us to find other opportunities. Recently, I was in the Far East with our Chief Investment Officer, looking for different funds that maybe will present us opportunities for better return, and we're going to allocate a little more of that. It will be done the Arch way, conservatively done.
All right. We won't feel it as investors.
Not immediately.
Okay.
I hate boiling water. When I put my toe, I put it to make sure that maybe the edge of my skin gets burned, nothing more.
I'll take that analogy. I have a few more. I'll let someone ask him a question. Thanks.
Thank you. Next question is from Jay Cohen at the Bank of America. Please proceed.
Yeah, a couple of questions. I guess one numbers question, one bigger picture question. On the numbers side, John, can you talk about the amount of your fixed income portfolio that is maturing in dollars next year?
I don't have the exact number handy. Our duration is about three, and it's fairly evenly. It's not barbelled in how we do that. You just have to take an approximation on that.
Okay.
We can do some work. If that number is very important to you, we can.
Yeah.
Call John or Mark, we'll figure it out for you.
Yeah. It's fairly straightforward.
Yeah, I'll follow up. That'd be great. Thank you.
Yeah.
Then the second question for whoever wants to opine. It does feel as if the capital markets have played a pretty significant role in the reinsurance, specifically in the cat side. This year, it seems to be growing. How much of a threat do you see this being going forward?
Well, it depends on their return characteristics. At the end of the day, the cat business, it's a model business. Usually, you see significant expansion of capacity and either side cars and capital markets jumping in when they think there is really good returns. That thing disappears pretty quickly when they believe the returns are inadequate. Depending where these new opportunities come, hedge funds, pension funds, et cetera, and what their expectations for normalized returns in their business is, it might or might not affect as to what the opportunities are for us and the rest of the cat writers. Looking at what we--. You saw a volume. Our volume expanded. We wrote more in that. We wrote more at the same time that prices went up.
Maybe they didn't meet everybody's projections, but in a line that is on an expected basis having good returns, getting another 5% or 7%, it improves the environment for us. Having said, I can't predict the future. If a lot of cat bonds get created with low return characteristics, et cetera, it might take a slice of what we do away from us, but I haven't seen it yet. It's not in the billions and billions of dollars of PML capacity that the cat business requires even all these peripheries, they're not a significant part of the cat business.
That's great, Dinos. Thank you.
Mark, you want to add something?
Yeah.
This is Mark Lyons, by the way.
Yeah. From the perspective of a provider, this is one of the perspectives Dinos just said, I think it makes a lot of sense. From the perspective on a purchaser, which has really been our history in the Arch Worldwide Insurance Group, we've been very focused towards having indemnity covers. We've looked from time to time at the capital markets. We certainly don't want basis risk, but beyond us, I'm speaking on behalf of the purchasing side of the industry, you really have to evaluate what's basis risk. You have to evaluate cost up top and I think to a large extent, it's going to be increasingly model-driven. So the behavior of the purchaser is going to be just as important as the cost coming out from the provider.
That's a good point, Mark. Thank you. Just one quick one. I assume in your Arch Worldwide Reinsurance and Mortgage Groups, you don't write much related to agriculture?
We write a little bit. What's our total premium, $3 million, $4 million?
Yeah, $3 million.
We have some XOL on crop, but it's not a big line for us. We're not a big reinsurer of the agribusiness.
Got it. Thanks a lot.
Of course, we have a team and we're starting to write international crop business out of our team in Zurich, Switzerland, but that's non-U.S. exposures.
Got it. Thanks. Good luck, John, with everything.
Thanks, Jay.
Thank you. The next question comes from the line of Meyer Shields at Stifel Nicolaus. Please proceed.
Thanks. Good morning.
Hi.
I don't know if I'm reading too much into this, but I noticed on both the insurance and the reinsurance side, you're having decent growth in casualty. Dinos, you commented earlier that overall rates for longer-tailed lines don't look good. I was wondering if you could maybe talk about that a little bit.
You have to go back in our definitions. Let me remind you that the reinsurance group puts all professional liability, D&O, and what we would call liability business, either primary or excess liability into the same group of casualty. Don't read into it, that is sectors that we don't like. We continue to not like primary liability, excess liability, umbrella liability, all of that. Anything that we have done in the reinsurance group is more in the professional lines.
Okay. I guess you're comfortable with that.
Yeah. Could you speak a little closer because you're barely coming through?
No, not a problem at all. I'm trying to think of the way to ask it. Are you seeing rate improvement in the professional liability lines that you like?
It depends on the sector. The small accounts professional liability sector is still attractive to us, both on the insurance side and reinsurance side. The large accounts still requires, in our view, a significant rate. Mark run the insurance group, I'll turn it over to him. He might give you-
Let me just add on the reinsurance. We also had some Canadian treaty business in casualty written in the quarter. That was some of that in the reinsurance.
Right. Mark?
Yeah. On the professional liability side for the insurance group, we've had an initiative started about nine months ago out of the U.K., specifically focused on SME business. It went from virtually being nothing nine months ago to an annualized $20 million-$25 million, mostly because in the London markets, business follows well-known active underwriters. We have people with excellent track records who have fabulous distribution ties and know the business and manage the limits appropriately and so forth. To us, that's a good trade-off and it's a high net business because of its lesser volatility aspects.
Okay. Fantastic. Thanks so much.
You're welcome.
Next question is from the line of Vinay Misquith at Evercore Partners. Please proceed.
Hi.
Vinay, I thought my name was tough to do, but
Well, that naming pronouncing a British accent sounds even better.
Yeah.
The first question on the primary insurance operations. There seems to be a pickup in the loss ratio. I think you talked about it. I'm sorry I jumped on late. How much was the surety impact on the loss ratio this quarter, please?
Mark, what was it?
Yeah. Vinay, what we really have was, surety is a little bit of an odd duck, number one, because we evaluate surety like all our businesses on an underwriting year basis. It really becomes a bond effective date. When you have a surety event, it actually affects multiple underwriting years across the time that the contractor was given a work program size from us. The way the accounting works when the event occurs, it's considered discovered in that year. We've had two events that were "discovered" in 2012.
In the second quarter.
In the second quarter, that really have losses and underwriting decisions that have been scattered back over several underwriting years. That being said, the two losses that we're talking about on a net basis accumulate to about $13 million. The reserving actuaries went through and the overwhelming amount of that was additive to the totals that was there. As a result, taking that into account, I would say it's roughly $11 million of impact on basically two and a half loss ratio points when you cut through all of the detail.
Yep.
Okay. That's helpful.
That's right, Vinay. If you do trailing 12 months, it takes property losses and one-time events like that, and it smooths it out a little bit. It can give you a better indication as to if you have margin contraction or margin expansion.
Okay. Fair enough. Just looking at the trailing 12 months, just seems that the primary insurance operations is getting a combined ratio of around 103%, 104%. Do you think that's appropriate at this stage, or do you think that there's a scope for bringing that down?
It depends on the mix. Our mix is changing. I think it's a little less than 103%, 104%. I don't know how you got those numbers, at the end of the day, in the insurance group, we believe that our margins, they're probably at the lowest level of acceptability for us because we got a lot of segments that were on a defensive mode. Having said that, we're starting to see some of the profit centers now gaining more traction because with the rate increases and not having reserve issues to deal with, it allows us to gain back to the acceptable profitability. Don't forget, I'm still in the 9 to 11 ROE range, and that includes all of our business. We have significant sectors both in insurance and reinsurance that way north of that.
I can tell you, I have profit centers that they're barely keeping their head above water, probably earning 2%, 3%, 4%. The tough question there is: should you continue to do that? Well, I play defense on those. I try not to grow them, you don't want to exit because you exit, you might not have the opportunity to come back and reestablish market relationships, reestablish underwriting teams, et cetera. If long term, we believe that particular product is going to provide good profits for us, we look at it from a long-term perspective, we play defense in the tough times.
Okay. Fair enough.
That philosophy, I talked about it all the time, hasn't changed, and it's a balancing act. Yes, our reinsurance group is performing extremely better than the insurance group, that's true with the entire marketplace.
Yeah.
Mark, you want to add anything to it?
Vinay, I know Dinos has talked about this on many different quarterly calls, let me tell you, we are very active cycle managers. We view this like you would view a portfolio of assets. We constant reallocation, we have different defensive strategies, offensive strategies. Take for example, some of the numbers Dinos quoted in the specialty book in the U.S. getting 6%. This is our second consecutive quarter of having 100-plus basis points higher, at least, on loss inflation. You're not going to see that manifest itself into accident quarters or calendar quarters. That's an underwriting quarter basis, it bleeds itself in. You'll start to see the benefit of that especially if the pricing continues at this level in future quarters. That's the first thing.
The second thing is, some of the discussion of loss ratios and so forth, our evaluation, as you would expect, is cash flow based. Our return on capital that's updated every quarter based upon what actual achieved rates and other views takes everything into account. We're looking at the expense ratio componentry. As we write more of the smaller accounts, they come with lower loss ratios, higher acquisition costs. That is why we've been so meticulous on managing down the G&A piece of the expense ratio because we knew that those things would be lockstep. We're looking at all aspects of it, not just one element.
Okay. That's helpful.
Vinay, let me remind you, go back in history. In 2002, 2003, they thought of us as the dumbest company on the face of the earth. Then we got real smart, I guess. It was the same guys. I don't know. Maybe I had a baboon brain transplant somewhere in between, in 2005, 2006, 2007, we became a smart company. We call it like we see it. We're technocrats. We do a lot of analysis, and if we believe there is profitability in a particular group, I'm not afraid to turn the guys loose to go and get the business.
Okay. That's fair. Then one last numbers question. Just wondering, the premiums from the credit reinsurance team that you got from Ariel Re, did you guys record any written premium this quarter? Not earned, written.
John, you want to go through that again or?
No, there wasn't that much because they write business all mainly January 1 type business.
Okay, we should not expect any premiums for the balance of this year, but maybe January next year, correct?
Yes.
Okay, that's helpful.
In general. No, there'll be some written because the trade credit's written also a bit throughout the year.
Okay. That's all right.
I don't know all the surety treaties, if they're all
International surety
international surety, if it's all January 1, they might have. It's not going to be significant, Vinay.
Okay, that's helpful. John, all the best in your future life.
Good. Thanks, Vinay.
Thank you. Next question is from Ryan Burns at Langen McAlenney . Please proceed.
Hey, guys. Firstly, congratulations to everybody who's getting promoted or going on to newer and I guess maybe better things. Secondly, I wanted to give you a question. You mentioned that you're likely to resume your share repurchase in the fourth quarter. I just wanted to see if that's reflective of, I guess, fewer of the one-off underwriting opportunities that you guys have, I guess, announced recently.
Well, we still have an eye for those. Also look at the capital position. It's growing. You're having good earnings quarters. It keeps adding. Like I said, I didn't say I'm doing it. I said there is a good likelihood. That was the words. If nothing comes, we don't do transactions for the sake of doing transactions. We don't acquire teams for the sake of acquiring teams. It's a balanced approach. If we find a great team that fits our underwriting mode, we're going to bring them in. We don't really care about what part of the cycle. We're not trying to time a cycle or anything of that sort. If you have good athletes, good things will happen to you.
When we brought the people into our Executive Assurance area, it wasn't the best of times to say, "Oh, I want to really expand and run as fast as I can in that sector." When you get extremely good athletes, you want them on your team. That's been our approach, not knowing how many of those might or might not materialize. We got things in the hopper. I can't tell you as to what my capital position is, but if we have significant excess capital come the fourth quarter and there is nothing on the horizon, I'm going to invest on me.
Okay, great. Secondly, I think you guys mentioned that this quarter was the kind of the inflection point in your insurance operations where your rate increases were, I guess, outpacing your loss cost increases. Just want to get your thoughts as to when, I guess, on an earned premium timeframe where you think that inflection point will flow through.
Mark, go ahead. He's not only here on the insurance group, he's an actuary.
Okay.
in spite that
I'm surrounded by, I'm drowned by actuaries.
in spite that deficit, I'll attempt to answer the question. I think you should look at it mostly as probably first quarter of 2013 on. First of all, there's a lot of things that you have to make assumptions of. To the extent that these things don't continue, if this is a flattened out marketplace, you're not going to see them as readily. If it continues or the rate of increase in prices escalates further, it's going to compound itself. You're going to see it marginally in the next two quarters, and I'd say moderately into the first half of 2013.
Okay, great. Then can I actually ask that for the reinsurance segment as well or is that harder to calculate for you?
Yes. Don't forget, a lot of what we do in reinsurance, other than our excess of loss business, which is mostly in the cat area, it's quota share. Any market improvement in the primary benefits, it follows our reinsurance. If you're not changing ceding commission, so the betterment of the market by the cedant, it will reflect in your numbers as a reinsurer. It will be pretty much the same now. For us, the excitement of a market turn is the ability of a lot of the opportunities we see both either individual accounts in insurance and/or treaty opportunities on the reinsurance is to make the cut. A lot of times we put out terms and they're not accepted by the market. As the market improves, even though it's gradual, the improvement, a little more makes the cut. Don't forget, the advantage of Arch is twofold.
Number one, we have terrific people. When the market interacts with us, they're talking to knowledgeable underwriters, and that's important. Number two, we have pristine balance sheet. A plus $5.4 billion of total capital. People like to transact with us. We see a lot of the stuff that we want to see. The question is, can we be competitive enough, maintain a real margin for us, be competitive in order for us to win some of these? We see a little bit of that coming our way. Nothing that makes me jump up and down, but you can hear it from my tone, I think I'm a little more excited now than I was a year or two ago.
Okay, great. Thanks for the answers, guys.
Thank you. Next question comes from the line of Jay Gelb at Barclays. Please proceed.
Thanks. John, congratulations. We'll be talking to you soon on the MET calls. They don't give you much time off, do they?
No.
You're getting time off. It's a whole month.
I just want to clean up on a couple issues. Given the amount of business you're writing in the differentiated deals, the large deals, can you give us a sense of what you feel your excess capital position is currently?
Well, we're not going to be specific anymore on the exact amount. It's not a bad margin above where we target. We'll see how the earnings come out for the rest of the year. Moving into cat season, we never know. I think we're in a comfortable position.
All right. The target being?
S&P AA, two notches above our current rating.
Okay.
Yeah, we're A+. We run it at AA.
Got you. All right. On the, I guess, more of a numbers question on the reinsurance segment. If I'm looking at the $72 million of other specialty premiums that were in Q2, as well as the $26 million of other reinsurance, my sense is that's where the new deals are showing up. Is that?
Yes.
Is that the right run rate quarterly going forward in terms of net written premium volume?
Yeah, for as long as we keep the U.K. and motor around, and the crop. Hopefully, those might be picking up as the new crop guys and the international surety guys do some business from that. U.K. motor, we keep it as long as it's going to be profitable.
What's the earned premium look like on that? Is it ratable over four quarters, or is it stretched out more?
The motor is over four quarters. The mortgage is longer because you're earning it on a monthly basis.
Yeah.
The trade credit is normal, is like the motor.
Okay. The earned premium progression might be a little slower than the net.
Right.
Okay. All right.
Don't forget, you know that the one-time earn because of purchase accounting, that is not going to earn over 12, but it was over eight quarters. You got to make that adjustment. Right?
Right.
If you go back to the prepared remarks John had, the unearned premium, even though we took no written premium because of the accounting peculiarities, that unearned premium, which was only, I think, $17 million for the second quarter, it has a pattern that it goes out eight quarters.
Just to be clear for you, other specialty includes the U.K. motor and the crop business, whereas other, how we report this, the other includes the mortgage insurance.
Okay. That's helpful.
They're in two different sections.
Right. On the U.K. motor, for the primary companies, that's been somewhat of a challenging line. Do you have a stop-loss protection in place on your reinsurance contract?
It's a sliding scale kind of a deal, it gives us a lot of downside protection for upside profit commission we give to the ceding. We're very comfortable with that deal.
I figured. Okay. Thanks very much.
You're quite welcome.
Thank you. The next question is from Matthew Heimermann at J.P. Morgan again. Please proceed.
Hey, couldn't let the call end. This is just for my own edification, but just on surety, with all the talk around municipal bankruptcies and cities potentially exercising that option strategically, does that have any blowback impact on surety? I don't really know where a contractor-
No.
-municipal projects stand, but.
It's mostly the healthiness or unhealthiness of a contractor and how good and collectible is your collateral because it's that combination. On surety, you have different situations. Sometimes you might have a contractor who runs into financial difficulty. He might be competent to complete the job, but he's having difficulty with payroll, et cetera. In your claims process, you might extend credit to them and let them help them finish the project, so you don't have purely a surety loss. Then you work out based on how much collateral he has, and you collect from him. Sometimes the contractor, it's so weakened that he lost a lot of his personnel, et cetera, so you choose to throw them off the job, and then you bring a new one to complete it. It's a lot of different workouts in surety.
most of your losses usually come because a contractor is in trouble, not where the municipality is in trouble.
I understand that aspect of it. I guess I was wondering with respect to how a contractor who's in process on something would stand from a creditor standpoint if a municipality that had sponsored the project actually went into bankruptcy.
Matt, let me answer it a little bit differently. Besides the fact that we've ring-fenced our volume on that over time and not have as much, the thing you got to think about over a whole book of business is the relationship to a local contractor with the regional banks. That's where they're really getting their extension of credit, and I'll call their working capital base. We've spent a lot of time interacting with our D&O people who have more of a Side A approach, which is more of a bankruptcy credit risk perspective, and interacting with our surety people because they are underwriting the D&O on a lot of local and regional banks, at least had that experience, to try to make sure we identify pockets around the country where that could be an exposure, and we've avoided them as a result.
Okay. All right. That's helpful. Thank you.
Getting back to your concern, yeah, there is a little bit of concern that if that contractor doesn't get paid, so he's doing a lot of work for a municipality, and that municipality doesn't pay, and he gets tied up in court, that means his cash flows get affected. Now you're making a determination, should you extend credit to him so he can complete the job? The bond is not in play, but you're waiting for that fight because he got to win against the municipality, collect his money before he can reimburse you. Financial difficulties, independent if they come from the municipality or the contractor itself, they are a concern. We do continue to monitor all of our contractors from that perspective. What is their outstanding balances? Who is paying? Where the contracts are?
Is it the federal government or is it the municipal government or is it the state government? A lot of these projects that they get bonded usually is for public work.
Yeah. Okay. That's helpful. Thank you for that.
Thank you. We currently have no further questions, so I'd now like to turn the call back over to Mr. Dinos Iordanou for closing remarks.
Well, thank you all for attending. John, again, all the best in your new endeavors, and we'll hopefully even find some opportunities to do business together.
Thank you very much.
Yeah. Have a wonderful day. It's lunchtime, so enjoy your lunch.
Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.