Good day, ladies and gentlemen, and welcome to the first quarter 2012 Arch Capital Group earnings conference call. My name is Keisha, and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. If at any time during the call you require assistance, please press star zero and an operator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes. Before the company gets started with its update, management wants to first remind everyone that certain statements made in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.
For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to turn the call over to Dinos Iordanou and Mr. John Hele. Please proceed.
Thank you, Keisha. Good morning, everyone, and thank you for joining us today. We begun 2012 with good results, improved production, and a more positive outlook on market conditions. On an operating basis, we earned $113.7 million or $0.82 per share, which on an annualized basis represents a 10.4% return on equity. Our investment performance for the quarter, including the effects of foreign exchange, was good, and it totaled 187 basis points, and our reported underwriting performance was very good at a 90.1 combined ratio. This performance was aided by reserve releases from prior years, which came predominantly from short tail lines. Cash flow for the quarter was strong at $144.8 million, which was lower than the first quarter of 2011, due in part to a higher level of paid losses.
Our book value per common share was $33.33, a 4.9% increase from December 31, 2011, and includes the impact of the new DAC accounting standard. The market environment continued to show improvement across the board. From a rate change standpoint, almost all of our lines move into positive territory with rate increases, which are slightly above loss trend. In our U.S. insurance businesses, overall rates increased on a weighted basis by approximately 3%, which is slightly above our weighted average loss trend. Globally, rates for our insurance businesses were up approximately 2% on a weighted basis. In the traditional primary lines of business, we saw favorable rate movement with general liability up 7%, auto liability up 3%, umbrella liability up 6%, and workers' compensation up 5%.
As a specialty underwriter, our participation in these lines is limited, but I hope that these numbers gives you a flavor of the general market conditions that we are seeing. There were two exceptions to our overall positive rate trends. Our large accounts healthcare is lagging other lines with a 7% rate reduction, and executive assurance rates on the whole have remained essentially flat for the quarter. Even with improvements in the rate environment, given the level of investment yields currently available, we believe that longer tail lines still require substantial additional rate improvement to become attractive. In our reinsurance sector, rates continue to improve significantly in many areas throughout the world on a risk-adjusted basis in the property and property CAT lines, while all other lines remain basically unchanged. Although our reinsurance business benefits from an improvement in the underlying rate increases our clients achieve.
From a premium production point of view, we're seeing some benefit from an improving rate environment as more accounts meet our return standards. On a consolidated basis, gross written premiums were up 10.6%, and our net written premiums were up 13%. The insurance was up approximately 8.4% on a gross basis and 9.2% on a net basis. The reinsurance group was up 14.8% on a gross basis and 18.4% on a net basis. This increase has resulted from new opportunities in U.K. motor business that we spoke about last quarter, global property and property CAT business, and new participations on professional liability lines. Substantial rate improvements in global property catastrophe markets allowed us to participate in a more meaningful way around the world for the first time in our history in areas such as Japan, Australia, and New Zealand.
Group wide, on an expected basis, the business we wrote in the first quarter of this year will produce, based on our estimation, an underwriting year ROE in the range of 9%-11%. During the quarter, we did not repurchase any of our shares. As we mentioned last quarter, this decision was influenced by several potential opportunities that were presented to us, two of which we were successful in closing early in the second quarter. We are pleased to welcome our new colleagues at Trade Credit and Surety Team, which has joined us, and it will work out of our Zurich office and our Zurich operations. Historically, this group has written $80 million to $100 million of net premiums, although there is no assurances on how much of this business we'll be able to renew on Arch paper.
Today, we are pleased with the way the customer base has reacted to the transaction and the financial strength of Arch. We were also successful in closing an attractive mortgage reinsurance quota share contract. This contract, which covers new prime originations from October 1, 2011 to December 31, 2012, enables our ceding to expand their available capacity in a very attractive market for mortgage insurance. Since mortgage insurance is earned over many years and a significant portion of the underlying business is written on a monthly basis, most of the premium will be recognized in our income statement over the next three to four years. Both of these transactions were unusual and neither contributed to premium volume in the first quarter. We continue to have a number of potential one-off transactions in our pipeline.
These type of transactions have required long lead times, generally, the biggest obstacle to close them still remains the widespread between the bid and ask. As always, we are looking for opportunities to expand our underwriting capabilities organically. Today, we have been successful in several of our attempts. We view these as investments in talent and capabilities for the future, we are beginning to benefit from these initiatives. While the degree of success of these additions in the short term will depend on market conditions, we are confident that over the long term, they will prove to be successful and will contribute to the value of our enterprise. Our philosophy on capital management has not changed. We prefer to deploy our capital in our business absent the ability to do so, to return it to our shareholders.
Although the current operating environment is encouraging, we still do not have a clear visibility on the degree of improvement in market conditions or on our ability to close some of the deals that we are working on. As a result, we will continue to take a wait and see attitude with respect to share repurchases until we see the future with more clarity. Before I turn it over to John for more commentary on our financial results, let me give you an update on our CAT PMLs. As of April 1st, 2012, our largest 250-year PML for a single event were $860 million is in the Gulf area, and it represents approximately 19% of common shareholders' equity.
Northeast stood at $826 million, our Florida Tri-County PML now stands at $608 million or approximately 13% of common equity, which gives us an ample capacity for the upcoming Florida renewal season in June and July of this year. With that, I'll turn it over to John, after his comments, we will take your questions. John?
Thank you, Dinos, good morning. On a consolidated basis, the ratio of net premium to gross premium in the quarter was 81% versus 79% from a year ago, reflecting the relative growth in the reinsurance segment. Our overall operating results for the quarter had a combined ratio of 90.1% with 3.4 points or $23 million of current accident year CAT-related events, net of reinsurance and reinstatement premiums. Compared to the 2011 first quarter, which had a combined ratio of 110%, reflecting the 28.2 points or $179 million of CAT-related events, again, net of reinsurance and reinstatement premiums. The 2012 first quarter current accident year CAT events included the February and March U.S. windstorms and the Southeastern Australian floods.
In addition to these natural catastrophe events, the 2012 first quarter combined ratio reflects 3.7 points or $25 million for the Costa Concordia marine event and the Elgin oil platform event, net of reinsurance and reinstatement premiums. The Costa Concordia event was estimated at $19.6 million at the lower end of our previously announced range, as we now expect a total industry loss of approximately $1 billion. The 2012 first quarter combined ratio also reflected 7.1 points or $48 million of estimated prior year favorable development, compared to $58 million or 9.2 points in the 2011 first quarter. The net favorable development in the 2012 first quarter was driven by the reinsurance segment, with approximately 60% due to favorable development on short tail lines for more recent underwriting years and 40% due to medium and longer tail lines from earlier underwriting years.
The net slight adverse development in the insurance segment in the 2012 first quarter reflected an increase in loss picks due to claim development on a specific subset of our casualty book in older accident years and a small number of international D&O claims from recent accident years in our executive assurance book. Such adverse development in the insurance segment was substantially offset by better than expected claims emergence in property and other short tail lines. Our loss estimates for the 2010 and 2011 CAT events did not change materially in the 2012 first quarter. In the reinsurance segment, the 2012 accident year combined ratio, excluding CATs, was 82.8%, higher than the 75.3% in the 2011 first quarter, primarily due to the Costa Concordia and Elgin events noted above.
The reinsurance segment's results also reflect changes in the mix of business, with a higher contribution from the 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 99.7%, basically the same as the 99.9% a year ago. The expense ratio was 32 points in the 2012 first quarter, substantially unchanged from a year ago, with a slightly higher acquisition ratio reflecting a higher level of commissions related to prior year reserve development, offset by a lower other operating expense ratio which benefited from the higher level of net premiums earned. Net investment income in the 2012 first quarter decreased to $0.52 per share, or $74 million, compared to $0.59 a share or $80 million in the 2011 fourth quarter.
Our embedded pre-tax book yield before expenses was 2.76% in the 2012 first quarter, compared to 2.98% in the 2011 fourth quarter. As compared to the 2011 fourth quarter, the spread over Treasuries for many of our selected new investment asset classes reduced from the 2012 first quarter, during the 2012 first quarter, thereby reducing the investment income potential for new investments. We also now have a larger portion of our assets that have a lower yield but greater opportunity for total return. At the current yield curve, with the three-year Treasury at 40 basis points and continued relatively lower spreads, we are now reinvesting on an overall blended basis at between 2%-2.5% yield, but expect the total return to help with some upside.
We continue to remain short with the duration of 2.75 on a high-quality investment fixed income portfolio, which protects our capital in rising interest rate periods, but also further contributes to lower investment yields. The total return of the portfolio was 1.87% in the 2012 first quarter, compared to 82 basis points in the 2011 fourth quarter. Excluding foreign exchange, it was 1.6% in the 2012 first quarter, compared to 95 basis points in the 2011 fourth quarter. While certain components of total return are not reported in after-tax operating income, the total return generated in the 2012 first quarter was significantly in excess of the available fixed income yields and helped increase book value per share. Our exposure to Eurozone countries is again listed in the supplement with minimal exposure to the current countries of keen interest.
Foreign exchange losses were $21 million, or $0.15 per share, in the 2012 first quarter. However, when compared to the net 27 basis points return from assets held in foreign currencies booked in shareholders' equity, the approximate net impact of foreign exchange was a positive $12 million, or $0.09 per share to book value. Our effective tax rate on pre-tax operating income in the 2012 first quarter was a benefit of 1% compared to an expense of 0.8% in the 2011 first quarter. The effective tax rate on pre-tax income was an expense of 1.1%. The tax rate was impacted by realized gains, which are excluded from operating income. In the 2012 first quarter, we implemented the new accounting standard for deferred acquisition costs, which reduced our reported book value at December 31st by $36 million, or $0.27 per share.
The new accounting policy had an immaterial effect on operating earnings and was adopted retrospectively, so comparisons for prior periods would be on the same basis. In the first quarter, book value per share was negatively impacted by $0.25 per share due to the exercise of options, primarily related to grants made in 2002, which were about to expire. Notwithstanding such items, book value per share increased 4.9% due to operating earnings and total returns on investments. We did not buy back any shares in the first quarter due to potential business opportunities, as Dinos has mentioned. In April, we issued $325 million of Series C preferred shares with a five-year non-call period. We also announced the call of our $325 million of Series A and B preferred shares at par. The net savings in coupon costs is 120 basis points per year, or $3.9 million.
Taking into account all costs for issuance amortized over the five-year non-call period, we expect to save a net 63 basis points in annual costs over the next five years. Our total capital increased to $5.2 billion at the end of the 2012 first quarter, up from $5 billion at the end of 2011. Our debt plus hybrids represents only 13.8% of our total capital, giving us significant room to raise additional capital in the future at our targeted rating. We have an excess capital position that we hope to put to work at some point in the future. With these introductory comments, we are pleased to take your questions.
Ladies and gentlemen, if you wish to ask a question, please press star one. If your question has been answered or you wish to remove from the queue, please 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 Keith Walsh with Citigroup. Please proceed.
Hey, good morning, everybody.
Morning, Keith.
First question around executive assurance. You mentioned our last quarter call, I guess pricing difficult for several years there. Now you've got some adverse development. It appears the premium level has remained at a similar rate or similar amount. Can you just talk about some of the changes maybe you've made in the underlying types of business within this line, why you think it may be a better book going forward? I got a follow-up. Thanks.
Okay. We mentioned this in prior calls, too. Our emphasis has moved from we're doing less FY business and less commercial today, and we're more in the small to medium-sized enterprises and private and not-for-profit. Even though the volume is being steady, I think there is less of the former and more of the latter in our book of business. The reserve adjust that you mentioned, it's part of our usual concept of how we reserve the company. Early on, if we get a claim or two, even though we do have ample IBNR, a lot of cases we choose not to adjust IBNR downwards, and we allow that claim to go through, so it shows as adverse development from the prior year. I think that's a prudent way of doing it. At the end of the day, nobody's sticking their hand in our pockets and taking our money.
If in future quarters we don't need it's going to flow through. We're still cautious on the executive assurance sector, and in due course, I think we would like to grow that business, but we haven't rung the bell yet.
Keith, also the comments often on EA are about the U.S. market in terms of rate, and the reserve development came from an international policy form that it's just from a small specific group.
Okay, that's helpful. Just on the Florida renewal, you guys have substantial room within your PMLs as you indicated earlier. We've heard mixed things, I guess, on the six one renewal so far on the supply and demand side. What would be your view there, and is the rate adequate enough? Forget about the rate increases. The rate adequacy there that you'd want to deploy a lot of capital on the six one renewal. What kind of implied ROE are we talking about?
We always price the CAT business ROEs north of 15% because that's a risky proposition. You take in a lot of the volatility of your client's books of business, your expected ROE has to be high. Not knowing, it's a bit too early for rates to settle down, we expect to be a good season for Florida. As you know, we have the room. We presented the PMLs to you. Depending on the rate environment, we probably try to take advantage of the market opportunities that they presented to us. I can't predict. We don't try to predict the future. We just react to the opportunities as they're presented to us. I'm optimistic that we're going to get rate increases. There is RMS 11 that is affecting that. There is supply and demand issues.
At the end of the day, I think it will be a good environment.
Thanks a lot.
Your next question comes from the line of Ian Gutterman at Adage Capital . Please proceed.
Good morning, Dinos.
You're trying to get a high grade, you move to the front of the room instead of the back of the room, huh?
I'm getting old now, and my eyesight's starting to go. I need to sit a little closer.
Welcome to the club, my friend.
I guess first your comment about the business you run the quarter 9% to 11% returns. That's better than where it's been, but it's okay. Is that really enough to justify growing double digits in the quarter, or is it transitory?
If you see where the growth came. Let me go back. On the rate increases alone, you're gaining just slightly because, as I said, we're only slightly above trend. Call it a push, a slight positive. The improvement in the ROE is due to the growth that we've seen in some segments. For example, the property-property CAT area that we have grown, it's not priced at 9% to 11% ROE.
Sure.
Unexpected. It's the weighted average that is going up by give it a point or two, but it's coming from the new segments. I can tell you, we're not going to write the mortgage insurance at 9% to 10% ROE. Everything we do that is new to us has got to meet our return characteristics of 15% or better than that. You have to take it from that point of view. The overall book is improving, but it's improving because of the new opportunities which the price with a better ROE than the existing book we have with defending.
No, understood. I assume the marginal opportunities were higher than that. I guess I would have thought to fund those marginal opportunities, maybe you would have taken a finer brush to the renewal book that had some of the mid-single-digit returns and maybe tried to let some of that business go to people who are being more opportunistic these days growing.
Listen, you have to be in the market. There is customer relationships. There is market relationships. There is distribution relationships. We try to defend as much of our book as possible with the eye that we have to have an adequate return. We're just honest with our investors, and we try to tell them what we believe we're underwriting this business to. Listen, we don't get into granularity, but I have businesses that we're running today that they're very low single-digit ROEs, and the reason we haven't got out of them is because this is not like lighting the room with a switch on the wall, and you flip it on, and you flip it off. You got to take the long-term view. Some years you might accept lower ROEs because over the 10-year period of time, it will give you a lot of opportunities in the future.
It's not as simple as on and off.
Understood. Fair point. Just to follow up on Keith's question on the executive assurance growth. You mentioned it's the small and mid, the private, not-for-profit, and I understand historically that's a good book, but I think Chubb and some others have raised concerns that the performance in that segment is getting very competitive, and they're starting to see loss pop up. How comfortable are you that this is the right time to be growing that book?
We know the issues. I think we have very good underwriters. It's employment practices liability that is the major issue with the privately held and some of the not-for-profits. We have a lot of confidence in our underwriters to be making good judgments and good selections on that book. It's true with anything that you do. If it were so simple, everybody would be doing it, right? We understand the issues. Our people are all over it, and we still like those sectors.
All right. Last one, then I'll move back to the back of the class. The insurance book, the adverse development. I understand there's only sort of one-offs, but just if I look over time, that book has shown a lot smaller development than your reinsurance book, and it's tended to have these occasional cores where things pop up. Yet it's been written over time to a higher accident year combined, even normalized. It seems like it's a less profitable business in your reinsurance, yet it also has less development over time. Why is that? Why does the bulk of your development come from reinsurance and not insurance?
It's narrowed to the. I think it's a combination of two things. It's the sector. Most of it is contractors. I think the strain that the economy has brought upon them and the sector itself, especially in some difficult state like New York, is what caused some of the not as good a performance I would have expected from a specialty casualty book, because these are the books that they perform extremely well in the '86, '87, '88 cycle. Later on in this cycle, specialty casualty and umbrellas and even some of the excess liability didn't harden as much, it didn't give as much of the profitability that I would have normally expected. Our book has diminished to almost nothing.
In the meantime, when I see signs that I need to be cautious with the reserving, we're not shy about putting it up, because at the end of the day, it's the prudent thing to do in order for you, as the market turns, to know what the true profitability of this business is, that it's going to help you pricing as you go into the future. If you're not recognizing what the true profitability is, you might be misguided when it comes to making decisions going forward. I spend a lot of time. I'm a frustrated actuary. I think I'm a decent underwriter, but a frustrated actuary. They would not admit me to the academy. They want all these exams to pass.
I spend a lot of time with the actuaries, I get personally involved in understanding what their selections are going to be, why they're going to be. We spend a lot of time with the claims department, talking about what they see, what kind of cases, what's the outlook. We're cautious about it.
Great.
Listen, look at our record. We released over, I don't know, $1 billion of reserves over time. Every time we do a little adjustment here and there for 5 or $10 million, everybody has 42,000 questions.
No, understood. It's just the most of that $1 billion or whatever it is has come through reinsurance. I've never quite figured out why. It just seems that reinsurance business, I don't know if it's just you reserve that more conservatively initially or if it's just the way loss trends worked out. It's just hard to figure that out from the outside.
We have a signal. We don't want everybody to know about it.
Got it.
The way we price the business. Also you got to see that the insurance group is very well reserved.
Yeah.
We give you enough in the supplement and the Schedule P for you to look at it.
Great. Thank you very much.
You're welcome.
Your next question comes from the line of Michael Zaremski with Credit Suisse. Please proceed.
Thanks. I guess the problem with letting Ian go earlier in the queue is he picks off all the good questions.
He doesn't charge you, though, so it's okay.
That's true. The mortgage insurance contract, what type of volumes are you guys thinking? Is that a relatively new mortgage insurer or one that's been around for a while?
Well, our cede has been around for a long time, and they partner with us because they see the opportunities. We see the same opportunities, and they wanted to do more with our help. They have a lot of capability of their own and a lot of capacity of their own. Still the market was demanding more, and they want to do more. It expands their ability to have more customer relationships. It's all new business. It's going to be new originations from October 1, 2011 to the end. Our contract ends, and I don't know if they're going to renew or not, but it ends at the end of 2012, and it's for their prime book. The underwriting environment, the underwriting guidelines, and the environment, they're all extremely positive for that. We're excited.
As far as the volume is concerned, this has potential to be over the life of the contract, $80 million-$100 million. There is some contracts that they pay upfront, and some that is part of the monthly mortgage payment. It's kind of a retain and earn kind of a pattern. Usually you might get 65%-70% of the premium over the first three to four years, and then the rest of it trails all the way out to. It can go for 30 years, but in essence, the average mortgage is outstanding for about seven or thereabout. Hard to give you more specifics than that because we don't know either. As they're going to originate them, and we're going to take our slice as a quota share participant, and then we'll account for it as it comes in.
Okay. All right, and then lastly, John, in the prepared remarks, I think you alluded to some type of investment portfolio repositioning, but I'll admit I didn't quite follow. Is that correct or no?
Well, there's two things. Spreads to treasuries over most asset classes, single A bonds, mortgage backed securities, commercial mortgage backed securities, all narrowed quite a bit first quarter 2012 versus last year. That affected how we reinvested in our general blend of investments. We also are tending to put some more investments now into some funds that we view will have some more potential upside, but have perhaps lower investment yield right now because they may be accounted for at fair value option
We have more investments as you look on the balance sheet accounted for at fair value than compared to, say, a year ago. That'll come the quoted number might be a little less, but the total return should be a little better.
What types of investments would those be then?
Well, we've got some interesting investments, some funds where we're doing some mortgage servicing or some interesting loans that are going out. We're participating in. These are $50 million, $25 million, $30 million type single investments. As you add them up, we think these over the longer term will give us some better upside return than 40 basis points in three-year treasuries.
Okay. Thank you.
Your next question comes from the line of Jay Gelb with Barclays. Please proceed.
Thank you. I just wanted to get a sense first on the Costa Concordia loss. Is that included in your CAT numbers or no?
No. CAT is a natural catastrophe event and Costa Concordia is a man-made mistake. We wanted to break that out for you to have it clear for you.
Okay. Was that all in the insurance segment?
Costa Concordia was-
It will happen-
Between reinsurance and insurance. Just to be clear for you, on a net basis, Costa Concordia was about $6 million in reinsurance and the $13.6 in insurance. The Elgin was all in reinsurance.
I'm sorry, what loss was that?
The Elgin Oil platform. It's in the North Sea. I think it still has natural gas going into the air. It's not on fire anymore. It seems to be under control. They're building a relief well, we have a bid up just against that.
Okay. Can you talk about the PML you'll look to deploy for the Japanese earthquake season? I guess it's always earthquake season, for the 401 renewals.
Right. In Japan, our PML went almost from nothing to now about $260 million.
Okay. All right. That's helpful. Thanks so much.
Your next question comes from the line of Matthew Heimermann with J.P. Morgan. Please proceed.
Hi, good morning, everybody.
Hi, Matt.
Hi. I'm sitting in the back now.
Okay.
A couple of quick questions. Just back on the executive assurance , I guess what surprised me there was, I think you've spoken to the portfolio stuff adequately, but I was just surprised by the level of growth, and I didn't know if there were some new distribution relationships that turned on that potentially bolstered the numbers. It's just an easy comp with last year. That was the issue more than the trend I was struggling with.
Well, in the U.K., we have a new team, that would be new distribution relationships and a new underwriting team came about, John, what, 18 months ago?
Yeah, they've been, well, last year, they're getting up to speed now as renewals come up, they sell to the SME businesses in the U.K. and Europe.
Right. Other than that, it's just our existing staff and what we see in the marketplace.
Okay, that's fair. I think I just misunderestimated how that team would mature. I guess the other thing is, you mentioned in the commentary in the press release that you took down, that you did not, I think I read this right. You let a retro purchase from last year lapse. I guess I can't remember in all honesty whether that retro purchase was optimistic or kind of part of the core program. I was just wondering how that, I know it's non-peak zones, but how much protection that actually afforded you?
It wasn't big. I think it was a balance between what we had down in Florida versus in the Northeast. Sometimes we'll look at those opportunities. We might do a swap with somebody else that might be a little over line in Florida and might be a little, in our view, over line in the Northeast just to balance our PMLs. It's not significant. These things are in, usually what we do is in the $25 million-$50 million range. On the scheme of things, when you're putting out $800 million, $860 million PML, not significant.
Okay. That's fair. Then just when I think about where the portfolio yield is today versus reinvestment rates, if I'm doing my math right, it feels like if you're saying reinvestment's 2%-2.5%, it feels like if I'm doing the math right, you're within kind of 15 basis points of that. Is it fair to think about you kind of being pretty close to kind of the end of the reinvestment pressure at this point?
I would think so. I think we're finding a lot of opportunities to the combination of what we do with the high-grade fixed income and these alternative investments we do. If you blend it will give you better returns than that. The problem sometimes we have with the structures of some of these, some of them, they get accounted on an equity method. In that sense, if I wasn't part of the fund and I had it on my own, it might have been considered as investment income, but because I'm part of a fund, it comes in as realized or unrealized gain. It's difficult for you because you got to model us. We're more focused on total return because I get paid to move book value per share up. That's what I get paid to do.
At the end of the day, these operating earnings versus net earnings and all that, it's all well and good as long as book value per share keeps going up.
No, that's fair. I was focused more on the recurring side. The only other question I had was just.
I would just like to add that.
Yeah
The very high-quality stuff that we tend to put a lot in can be often toward the lower of that two to two and a half range.
Okay.
We're staying short as well. If spreads stay down and if we stay at 40 basis points or lord knows could be worse. I think it's very hard to forecast this right now in today's economy with so much going on. We're trying to take a balanced approach, as Dinos said, and go for total return, which we expect to be in that two to two and a half range. Where we actually end up each quarter going forward is going to be as things pull out.
I know. Okay. Fair. You might be close to the arithmetic mean, but that doesn't.
Yeah
Doesn't mean you might end up at the bottom depending on.
Right
What risk reward looks like. Okay.
Okay.
Just Aeolus has been a contributor to the other income line over the last couple of years, obviously, the size and the investment left in that vehicle has declined. I'm just curious if there's any guidance you could give us on how we should think about maybe the other income line changing on a go-forward basis relative to the past. I'm obviously thinking kind of the last three quarters, not the one or two quarters where we've had-
Well, we gave you the numbers. The remaining investment, call it book value at Aeolus is only approximately $10 million left. Basically, I would put a run off period of because we haven't reinvested on their new funds. This is the old one, and it's maybe another three, four quarters, and it's going to go to zero, right? If they have no losses, recognize that as income, and if there is losses, might go the wrong way. But-
Yeah
It's been a very successful investment. We invested $50 million. It was five years ago. We already received $83 million in, we made over 6% on our money over the five-year period, and we still have potentially another $10 million of book value that once they close their books will determine. It's going to be within the end of this year, maybe early next year.
Okay. That's helpful. I didn't realize all of that was still legacy, so.
Right.
All right. Thanks so much.
You're welcome.
Your next question comes from the line of Joshua Shanker with Deutsche Bank. Please proceed.
Good morning, everyone. Dinos, if you could comment on the PML in Japan or John, that's as of 4/1, I assume?
Yes.
Okay, that's fine. I know you're not here to speak for Aeolus, but to what extent was the Q1 loss a lag in reporting? To what extent is there unfavorable development, and is there anything from the tornadoes in end of February, early March associated with that?
They're not focusing on that kind of exposure.
That's what I was thinking.
Yeah.
The number we reported is the quarter lag. That's their Q4 2011.
Maybe, if you don't have a big problem with the tornadoes that hit, some have some larger issues. Would this be the kind of risk that would have pierced reinsurance layers five years ago?
What do you mean by that?
It seems to me, look, we had some huge tornadoes last year. These were sizable, but not nearly like the 2 Q11 ones. I'm surprised that a number of companies are reporting CAT losses associated with them on the reinsurance side. Did people buy more protection after 2 Q11 on tornado or those kind of losses? It just feels I'm wrong, these would have been losses.
Tornadoes, it's a peculiar animal as far as I'm concerned because depending who you're supporting, small companies versus small mutuals versus larger companies and what their retention is, you might be as a reinsurer, might be attaching relatively low attachment points. It's kind of random events. They might hit a whole neighborhood and you see it and happens to have a lot of exposure there, and all of a sudden it's going to get into the reinsurance layers. There is no good modeling on tornadoes. There is no good predictability. You might price the business well and still get hit because you just got unlucky that the tornado hit in the county that you wrote one of those county mutuals, and they got most of the losses.
What we try to do is try to balance the book by having spread of risk and understanding that we're going to get hit occasionally on tornado losses because that's the nature of the business. It's not a surprise to me that some reinsurers are getting hit with tornado losses. You see it to be kind of a random event that one might get hit and another one might not be, because that's the way tornadoes affect from a loss point of view.
As the Midwest gets more trashed because of tornadoes, do you think the market's unwittingly picking up more New Madrid risk?
I don't know the connection between the tornadoes and New Madrid.
Only geographic.
Well, New Madrid for us is very hard to model. As a matter of fact, it's the only zone that from a PML point of view, we use the 1 in 500 and not the 1 in 250. That's a peculiarity we have. We sometimes we're a little more strange than others. On the tornado side, all I tell our guys, and we do most of the tornado exposure out of our Morristown reinsurance office, is we try to get a good spread and not have concentrations and get unlucky because concentrations will give you two things, either no losses or significant losses. We don't like significant losses. It shows us as a company to be worse than our peers.
I appreciate all the fine points and everything. Thank you very much.
Your next question comes from the line of Meyer Shields with Stifel Nicolaus. Please proceed.
Thanks. Good morning. If I can start with a question for John. It looks like the impact when we look at the reserve development within the insurance segment, it looks like on a net basis, reserve development was slightly favorable, but there was a much bigger impact on acquisition expenses. I was wondering whether you've changed the relationships with your distribution force so that that sort of mismatch is not likely to recur going forward.
The impact on the acquisition cost was because of ceded relationships with adverse development. We had less credit coming in from profit sharing on reinsurance contracts. That's why the adjustment went.
It works both ways, actually. Sometimes favorable development might give them profit commission.
Yeah. There's a cost on the acquisition side.
Right. There is a cost on the acquisition side, too.
Oh, okay. Sorry. I misunderstood.
When you move the loss ratio, you got to look at these contracts, and sometimes it's a good thing for us, but also we might have to pay some of it as profit commission back to clients.
Right. Here it looks like you're paying maybe $10 for every dollar.
Right. Well, the credit system, because we're unfavorable we would have had profit commission credit come in. Now it's going back out.
Right.
Okay. All right, I get it. Thanks. Big picture question, I guess, for Dino. One indicator of or one potential indicator of further rate improvement would be companies that are behind the scenes, maybe in some trouble and looking for a bailout from better capitalized insurers. I'm wondering whether you're seeing any change in that over the past couple of years.
Meaning coming for surplus relief?
Just looking to be acquired.
Well, we've seen both. We've seen companies looking for partners, and it doesn't mean all of them they're in some sort of financial difficulty. Sometimes it does make sense from building industrial strength to merge a couple of companies. Also, we've seen companies both in Europe and here looking for kind of transactions that in my view, the kind of surplus relief kind of transactions. They don't have enough capital, can't access the capital markets, but through a major reinsurance contract might net down their net exposure. In essence, they get a pass from the rating agency. We've seen both. We haven't done any transactions because like I said the bid and ask is a lot of them they want to do these transactions sometimes, and their starting point is like 7%, 8% ROE. I don't want to waste my time.
My cost of capital is higher than that. I'm not going to do transactions just to put capital to work at 7%, 8%, 9%. If I'm going to do these transactions, they're going to be in the double digits. We've made proposals on a few at 12% ROE, and we couldn't get to close any of those.
Okay. It looks like if we look at the cohort of sellers in the aggregate, they're not desperate yet.
No. On the other hand, I don't think the capital markets are responding to them because I don't see a lot of them going out and trying to raise funds at I don't know, 8%, 10%. The reason they're in the reinsurance market for these kind of transactions is because they don't believe the capital markets probably will respond to them.
Okay. Thank you. That was very helpful.
You're welcome.
Your next question comes from the line of Vinay Misquith with Evercore. Please proceed.
Hi, all the way at the back of the line.
All right, Vinay.
Just a quick broad 50,000-foot question. Given that we've seen pricing stabilizing in many lines, of course, pricing is not up significantly in non-CAT exposed lines. Are you seeing some incremental opportunity in just normal property and casualty lines other than CAT exposed lines?
Yes. We've seen some on the professional liability sector, especially. We've seen us binding on some treaties, depending on who the underwriters are and what the book of business is, et cetera, that we wouldn't have done maybe two years ago, and I think that's the improved environment. We've seen that. The other thing we're seeing is, and don't make a lot out of this, I'm just going to share a statistic with you. Our E&S submission activity, quarter-over-quarter, it was up 9%. This is first quarter of 2011 versus first quarter of 2012. We've seen the signs that standard markets are looking at their books and what traditionally should've been maybe in the E&S market, they're throwing it in the E&S market, and we're seeing that activity.
We're binding more on the property side on the E&S, not as much on the liability side yet because we still don't like the rates as much. We've seen that movement. As a comparison, our year statistics from 2010 to 2011 for the full year, the E&S submission growth was only 2%. One quarter doesn't tell a whole year, so I don't get overly excited, especially. I think overall, we're seeing a little more of an opportunity for us to underwrite some business and make the cut, so to speak, where a year or two years ago they wouldn't.
No, fair enough. What level of price increases do you think are necessary within the industry for you to get more interested in writing more business, both on the casualty side and non-CAT exposed property?
I think you got to go line by line and sometimes state by state. We're not a big comp writer, but workers' comp needs a lot of work. You got to go by state by state. In some cases, you need 20% or 30% additional rate in order to make it at the 15% ROE. I think the umbrella business has a long way to go still. six, seven, eight, 10% rate increases ain't going to do it. You got to go line by line. I don't have all my cheat sheets here. The way we run the company, I think we share that with most of our investors, is that we have green, yellow and red lights on different books of business.
I think we're starting to see some red go to yellow and some of the yellow go to green, but it's not significant yet. We do that granular analysis when we sit with our profit centers, when we do the profitability reviews and review the business plans, which we start with the market environment and what we think the market pricing is. The question we try to answer, if we are the average underwriter, no better than, worse than the industry, do you want to be in this sector and how much would you write and would you give it a green light? That means write as much as you can. Or would you be a yellow? That means with caution you can write. If it's red, be very defensive.
Fair enough. In light of this, how do you look at the capital management? Do you think that the new opportunities in the reinsurance is sufficient for you to absorb all your capital that you're generating right now?
Not yet, but it's a question mark because we're working on things that I don't know what the outcome is going to be. It's very hard to answer that question. That's why I said I have a wait and see attitude. I think this market is changing, not because there is big balance sheet holes. This is not a balance sheet problem. It's not a reserve issue. Maybe some companies might have a little bit here and there that they might have to fix. It's mostly a return, market return. If you strip out the hay we have in the barn from prior years and we're eating from reserve releases, and you normalize CATs, the accident year ROEs are not yet that good. They need improvement and that's why you're seeing the market moving.
It's true that we probably have less red buckets than we had before. Yellow is growing and a few things slipping into green for us. If you like my analogies, I think, and I didn't do it percentage-wise, but I would say still 35%-40% is in the red as far as rule consent from an attractiveness point of view. I like a market cycle when everything is green and yellow and nothing in the red, and we're not there yet.
Yeah. So do we. Thank you very much for your help.
Your next question comes from the line of Jay Cohen with Bank of America Merrill Lynch. Please proceed.
Thank you. A couple of questions. The first is paid losses. I guess given the catastrophe activity of last year, I would have expected them to remain a little elevated, and at least relative to premiums, actually came down a little bit versus the last several quarters. I'm wondering, have you paid out the bulk of those catastrophes from last year already?
Not all of it. We have paid some. I don't think I have a cheat sheet here to go through, but I can tell you we're pretty quick with responding to clients' requests for payment. If there is no argument or dispute, we have a great reputation of paying on time. As a matter of fact, when we visited Japan, even though our exposure was very small, the Japanese congratulated us as to how quickly we were payers for their losses.
It's a mix change, I think, Jay, is what you're looking at.
Yeah.
That makes sense.
We can do an analysis, and we'll try to get percentages for you.
It doesn't move the needle too much, but that'd be helpful. The other question, Dinos, your comments on the, I guess, underwriting year ROE that you think you're writing business at now, which was improved a bit from where you had been. I assume the bulk or much of that improvement relates to business mix versus pricing that's exceeding claims costs.
Well, I think it's both. Business mix and also the lines that they're getting the rate increases are not losing ground to loss cost trend. In that sense, no line is getting worse, and some they're improving. That combination of plus the business mix, meaning where are we growing? Are we growing our property CAT, which is better than the numbers that we mentioned? It changes the weighted average. I would characterize our 2012 as we start. Market can change on us, and I make a fool out of myself trying to predict the future. Right now, as I see, we're probably at least one point, maybe two ROE points better than what I would think my underwriting year 11 is going to come in.
Got it. That's helpful. Thank you.
You're welcome.
Your next question comes from the line of John Hall with Wells Fargo. Please proceed.
Hello, everyone.
Hi, John. I think you're the last question.
Just in before the end of the wire there.
Right.
I've got a question on the mortgage insurance reinsurance agreement. From your comments, Dinos, it sounds like it starts in October, which means, I guess, if you closed it or signed it in April second quarter, we should see, what, three quarters worth of premium volume show up?
Yeah. You're going to see the fourth quarter, first quarter, and the second quarter. Don't forget, you got to stretch it out for 16 quarters.
Yes. You'll see written, the mortgage insurance comes in very slowly over time.
Yeah.
Okay. Is that going to be in the reinsurance other line? Geographically.
Yes. That's where we're going to book it. Yes.
Okay. Coincidentally, Radian put out a release that described a transaction very similar to the one that you were describing, Dinos. In their release, they said $50 million-$65 million of capital would be freed up. Any chance that's sort of a similar number of capital that you're deploying here?
Well, we keep our confidentiality promises to clients. We have no comment on that.
All right. Fair enough. On the PMLs, you offered a number for Japan. How about Australia and New Zealand?
John, you got those numbers here?
It's pretty small. I don't have that handy right now.
Fair enough. That's okay.
Japan, as I said, we moved, we got $260 on the earthquake, and we got about $75 on the wind, Japan wind. I don't think either Australia or New Zealand, the bigger numbers on that.
They're smaller.
Okay. All right. You just did mention them. I guess finally to close things out, on the international mortgage insurance deal that you've referenced a couple of times in a couple of different quarters, what's the log jam? What's the sticking point there?
I think we have agreements at the lower level and is working in our organization on the lower level. In their organization, they have to go through four or five layers before they can. That's what's holding it up. It's like an elephant baby pregnancy. Yeah. Banks sometimes or building societies work in a much slower pace than we do.
Got you. That elephant analogy doesn't sound very pretty. That's it. Thanks very much.
You're quite welcome.
There are no further questions in queue at this time. I would now like to hand the conference back over to Mr. Dinos Iordanou for any closing remarks.
Thank you all for bearing with us, and we're looking forward to seeing you and talking to you next quarter. Have a wonderful day.