Good day, ladies and gentlemen. Welcome to the third quarter 2011 Arch Capital Group earnings conference call. My name is Fab. I'll 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 you require operator assistance, please press star followed by zero. We will be happy to assist 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 now like to turn the conference over to your hosts for today, Mr. Dinos Iordanou and Mr. John Hele. Please proceed.
Everyone. Thank you for joining us today. Our third quarter results were satisfactory when we take into consideration the difficult market conditions that we operate in. Significant catastrophic activity continued in the third quarter. However, the level of this activity and resulting insurable damages were only slightly above our average expected cat load for the quarter. As you may recall, the first two quarters experienced cat activity and resulting losses that were significantly above average. Our total net catastrophe losses for the quarter were about $60 million, with $46 million coming from the current quarter events and $14 million related to net increases in loss estimates from the first and second quarter events. Our underwriting teams continue to execute our soft market strategy by emphasizing small accounts over large ones and focusing more on short-tail businesses. The market is showing signs of slight improvement.
We still see more opportunities for adequate profitability in the short and medium tail lines of business rather than the long tail business. As more and more competitors are factoring into their pricing the skimpy returns available on new money investments, eventually pricing levels for long tail lines will improve. At least we hope so. In the meantime, we're continuing a defensive approach for these lines of business. As a result of these strategies, our mix of business continues to shift towards more short tail and medium tail, while our long tail business on a trailing 12-month basis remains approximately 25% of our book. Our annualized return on average common equity was 10.4% on a reported basis, including a slightly negative effect of above-average CAT activity and aided by prior year reserve releases.
We continue to believe that in the current market environment, we are earning high single-digit ROEs on an underwriting year basis. This is essentially the same level of ROE performance we estimated for the 2010 underwriting year, with slightly less earnings from investment income offsetting by slightly better underwriting results generated by adjustments to our mix of business. Our investment performance for the quarter, including the effects of foreign exchange, was a total return of negative 23 basis points, as September was a difficult month in the financial markets. As a result, our book value per share for the quarter increased slightly from $31 per share to $31.20 per share, while book value per share from a year ago grew by 5%. From an underwriting point of view, we recorded a 94.3 calendar quarter combined ratio, which is an excellent result for the prevailing market conditions.
Cash flow from the quarter remains solid at $310 million as claim trends remain favorable. The broad market environment is showing slight improvement across the board. From a rate standpoint, most lines of business move into positive territory. The exceptions were in Executive Assurance and medical malpractice, where we're still seeing rate reductions in the rate of 1.5%-2% for malpractice business and approximately 7% for Executive Assurance. Even with this slight improvement in the rate environment, significant more rate is needed in many lines in order to achieve adequate returns. For us, adequate returns is returns that produce 15% return on equity. In our view, based in part on the level of interest rates currently available, the longer tail lines need quite a bit more improvement in rate to become attractive.
From a premium production point of view, our gross written premiums were up 3.4%, and our net written premiums were up 8.7%. The insurance group was up 1.6% on gross written premiums and 9.6% on net. The shift to smaller accounts and, in essence, lower limit policies affects the net to gross relationships as we retain more net for this type of business. The reinsurance group was up 9.1% on a gross basis and 6.7% on a net basis. The entire increase is attributable to additional premiums from short and medium tail lines of business. Long tail lines continue to represent a smaller portion of the reinsurance segment book of business. In the current environment, even after the implementation of RMS 11, which impacted our capital requirements, we still are left with a very strong capital position.
As always, we will prefer to deploy all of our available capital towards our underwriting activities. Unfortunately, the market at this point in time does not yet give us the opportunity to do so. As a result, we expect to continue our share repurchase program as we continue to accumulate additional excess capital through earnings. 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 September 1st, 2011, under our version of RMS 11, our one in 250 year PML from a single event was $972 million or 23% of common equity. This amount is for Gulf wind exposures, while the Northeast wind PML was at $870 million and the Tri-County Florida PML was at $750 million. With that, I'm turning this over to John for more commentary on our financials. John?
Thank you, Dino, and good morning. On a consolidated basis, the ratio of net premium to gross premium was 80%, slightly higher than the 77% a year ago, which was due to a change in the mix of business and some modifications in U.S. ceded reinsurance treaties. Our overall operating results for the quarter reflected a combined ratio of 94.3%, compared to 90.4% for the same period in 2010. The 2011 third quarter included $60 million, or 8.7 points of current accident year CAT activity, net of reinsurance and reinstatement premiums, compared to $24 million, or 3.9 points, in the 2010 third quarter. The 2011 third quarter storms, including Irene and Danish flooding, had a gross impact of $51 million and a net impact of $46 million.
The re-estimation of the 2011 first and second quarter CAT events of the Australian floods and Cyclone Yasi and the New Zealand earthquake made up most of the additional $11 million gross and $14 million net added to the third quarter provisions for the 2011 CAT events. We had little net impact from the Japanese earthquake Tohoku revisions and have already reserved the material portion of that exposure. In addition to the CAT activity, we experienced slightly higher attritional property claims in the quarter. The 2011 third quarter combined ratio reflected 8.5 points or $58 million of estimated favorable prior year reserve development, net of related adjustments, compared to 5.9 points or $37 million in the 2010 third quarter.
The prior year development in the third quarter of 2011 reflected net favorable development primarily in property and other short tail lines, as well as in the reinsurance segment casualty business, mainly from the 2002 to 2006 underwriting years. Moreover, we again experienced better than expected claims emergence on most lines. The 2011 third quarter current accident year combined ratio, excluding large CAT events and net favorable development, was 99.9% in the insurance segment, consistent with recent quarters. In the reinsurance segment, it was 83.8%, slightly higher than recent quarters due to non-CAT attritional property losses. The 2011 third quarter expense ratio of 32.1% was one point lower than in the 2010 third quarter, resulting primarily due to the higher level of net premiums earned in 2011, as well as non-recurring contingent commission income in our reinsurance business.
Which more than offset a higher level of acquisition expenses related to favorable prior year reserve development. On a per share basis, pre-tax net investment income was $0.60 in the 2011 third quarter, compared to $0.59 for the same period a year ago, and $0.63 in the second quarter of 2011. Our embedded pre-tax book yield before expenses was 3.09% in the 2011 third quarter, down from 3.52% a year in, which primarily reflects lower reinvestment rates. During the quarter, we slightly lengthened the portfolio duration to 3.17 from 2.87 at the end of June 2011, with longer dated Treasuries to capture some of the expected gain from lower Treasury rates. Total return of the investment portfolio was minus 23 basis points in the 2011 third quarter, compared to a positive 165 basis points in the 2011 second quarter.
Excluding foreign exchange, it was a positive 38 basis points in the quarter. The total return in the third quarter benefited from good returns on Treasuries, offset by negative returns on foreign exchange, equities, corporate fixed income due to widening credit spreads, and some alternative assets. Our alternative assets include bank loans, global and emerging market bond and multi-asset funds, and energy investments. A substantial portion of this negative foreign exchange, credit spread, equity return, and alternative asset return has reversed since September 30th to October 25th, which demonstrates the volatile investment environment we now face and expect to face for the foreseeable future. We continue to maintain the vast majority of our investable assets in a very high-quality fixed income investment portfolio with an average credit rating of AA+.
We recorded net foreign exchange gains of $60 million during the 2011 third quarter, mainly due to the strengthening of the U.S. dollar. These gains resulted from revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date. However, this should be compared to the minus 61 basis points to total return from foreign exchange on our investment portfolio, which offsets this income statement gain in the equity section of the balance sheet, which together with the liability gain, resulted in approximately a net $10 million reduction in book value. For the 2011 year to date, our effective tax rate on pre-tax operating income was a benefit of 3.3% and 1.5% on pre-tax net income. The CAT activity this year and low investment returns have resulted in a beneficial net tax position.
Our preliminary estimates of the implementation of the new DAC accounting standard, required on January 1st, 2012, should not materially reduce our book value and should not have a significant impact on our operating earnings for 2012. These estimates are still preliminary and may change depending upon the final implementation of the standard. Our balance sheet continues to be conservatively positioned with total capital of $4.9 billion at September 30th, up from $4.8 billion at June 30th. In the quarter, we purchased 0.7 million shares for $20.8 million at an average price per share of $31.77, a ratio of 1.02 to the average book value. Our debt plus hybrids represents 15% of our total capital, well below any rating agency limit for our targeted rating. Our book value per share ended the quarter at $31.20, up 1% from last quarter and 5% from a year ago.
In the calculation of our target capital position, we have now implemented our version of RMS 11. The implementation of RMS 11 by Arch, which reflects the application of the model with our own internal back testing, increased S&P A plus required capital by approximately 5%. With the implementation of RMS 11, which in our estimation should reduce overall model error, at this point in time, we have changed our target capital to be a double A level by S&P, which is a 2-notch buffer over the A plus rating. As of September 30th, our actual capital is in excess of our target capital. With these comments, we are pleased to take your questions.
Fab, we're ready for questions.
Thank you. Ladies and gentlemen, if you would like to ask a question, please key star 1 on your phone. If your question has been answered or you would like to withdraw your question, press star followed by 2. Questions will be taken in the order received. Please press star 1 to begin. Your first question will come from the line of Jay Gelb from Barclays Capital.
Thanks and good morning. I just wanted to follow up on the last comment from John about the capital position. I know in the past you've given us a sense of where you feel Arch's excess capital position is currently. Can you give us an update there?
Yeah. As we said, with the implementation of RMS 11, the 5% number was approximately $200 million. If you take into consideration that $200 million has been eliminated, our position will be approximately $200 million less Or what we had before, plus the earnings for the quarter, which we added. In essence, our excess capital position hasn't changed that significantly.
Okay. Would it still be $100 million-$150 million plus whatever you have in retained earnings going forward? Is that the right way to think about it?
Don't forget, maybe a bit more because a new standard now of how we calculate excess capital is the two notches above a rating algorithm. We're an A-plus company. We calculate capital at the double A level, then including the additional requirement that RMS 11 gives us on the PML. Anything above that we consider excess capital. We're in a very strong capital position and that's the reason we're going to continue with our share repurchasing plan until the market turns, then we can write a lot more premium. As you've seen from my comments, even though things are improving, not to the level that we're going to step on the accelerator big time.
That makes sense. In the second and third quarter, share repurchase typically flows for Arch as we get into wind season. Should we expect buybacks in 4Q to be similar to the pace that they were in the first quarter?
Well, yeah. There's a lot of variables. Price to book, where it's trading, et cetera. Yes, our most heavy share repurchasing traditionally has been the fourth and first quarter for the reasons that you have already mentioned. In the third quarter because of the significant expected CAT activity, we don't do many share repurchases. Yeah, I would say we're going to go steady as we go, as we've done in prior years.
Okay. Other people have asked this question on other conference calls in terms of the stabilization of commercial P&C insurance rates. Can you say the current situation is similar to what we saw in 2000, where we had a persistent level of slightly improving rates over time?
If you press me for a comparison, Jay, My memory is still good. I'm getting older, but I still have good memory. This looks like second quarter of 2000 to me. It has that same feeling. If you go back and you look at what happened with the prior cycle, we're starting to see some positive in rates in the second quarter of the year 2000. Don't forget, that continued for the third and fourth quarter of 2000. It accelerated a bit in 2001, We didn't really have a true market turn until the first quarter of 2002. Even in those days, it took what? seven quarters before we really got an acceleration.
There is no denying that when we look at our data, Don't forget, Arch is not a huge company like Travelers or ACE or Chubb, that they have much broader bases for their comments. Ours is what we see on a $3 billion book of business, not a much bigger book of business. We see in every sector improvement, even in those that we still giving up rate. We're giving up a lot less rate this quarter than a quarter ago. You can sense it. It's a gradual improvement and it's across all lines. The only two negative lines we had for the quarter, it was in the malpractice area, as I said in my prepared remarks, and in the Executive Assurance in the D&O area. Everything else was either flat, slightly positive, or in the mid-single digits rate increases.
Which is, listen, from where we were coming, I'll take it.
Very helpful. Thank you.
Your next question will come from the line of Michael Zaremski with Credit Suisse.
Hi, good afternoon. Thanks.
Hi, Mike.
Any more color on the loss cost trends, specifically in reinsurance? The accident year ex-CATs jumped kind of quite a bit.
Okay. Loss trends are benign. That's a broader comment. We usually measure that by frequency and severity in most of the lines, they do it both in our reinsurance business and the insurance business. We try to get underneath and measure it on the underlying business because that's the only place that you can measure those trends. Having said that, we have segments of business that have volatility by nature. property facultative is one, of course, the cat business, et cetera. For the quarter, we did experience higher than normal, what we would call attritional losses. Some of them, they were flood losses, some they were fire losses. In essence, we have experience and that it will flow through the numbers. You might see that quarter after quarter. It doesn't look to us like it's a trend.
It's more as to what happened in a specific quarter.
In fact, if you go back, Mike, and look quarter by quarter, the last eight quarters, you'll see in the reinsurance segment, when you take out cat losses and favorable reserve development, that number's bouncing around a bit, quarter to quarter. As we've moved to more shorter tail businesses and more property, you're going to see that things that aren't classified as a cat, but we still had above average storm activity throughout the U.S. and in other places. That's what you're seeing is this bouncing around.
Okay. That's helpful. Lastly, I see you've been kind of lengthening the duration of the portfolio through 3.2 years now. Are you guys expecting to continue extending, and can you remind us the duration of the liabilities average book?
No, I don't think we're going to continue to be rather short. That extension was more a reaction to Fed comments and what we expected the yield curve to go to. It was more tactical in its execution rather than a change in philosophy.
Yeah. Our average duration is 3.6, 3.5 for the liability. We're still shorter than our overall liabilities. In the third quarter, we felt that rates were going to come down, so we tactically, as Dino said, lengthened with Treasuries, which paid off because rates did come down by the end of September.
Okay. Thank you very much.
Your next question will come from the line of Keith Walsh with Citi.
Hey, good morning, everybody. Dino, in your RMS 11 update comments, I just wanted to be clear, were the PMLs you gave consistent with the view on the 2Q call of 10%-30% increases? I've got a follow-up.
Yes. Don't forget. We never use any off-the-shelf product in its purity. We have our own proprietary adjustments that we do based on our own experience, et cetera. As I said in prior calls, even way back in the 2004 and 2005 storms, we were making adjustments to models. It's not just the RMS model, it might be the AIR model, which we also use. We do pay a lot of attention to these outside models, but at the end of the day, we make underwriting decisions and we take risk based on our own models.
Okay. Just on the excess capital, I think you'd alluded to that you prefer buybacks to writing new business at this point, is what it seems like from what I heard.
No, our preference is to write more business. However, I'm not going to write more business unless I get adequate returns. What I said is, in the current market environment, it doesn't allow me to be looking for 15%, 20% growth. That's the kind of growth you need to start eating up your excess capital. Not having that opportunity, then I got to return capital to shareholders. Right now, based on where our share price trades, we still believe that buying back shares is the best way to return that capital back to shareholders.
Right. I was going to ask you, what type of rate increase do you think you need to see when that switches over, when writing new business becomes more attractive on an ROE basis relative to the buyback?
Well, it depends by line of business. I'll give you an example. We're not a big workers' comp writer, right? Our monitors show that in the comp line, the very little we write, we're getting 6%-7% rate increase. We don't get excited until we get to probably 30% rate increase. If you do the math, you need 30%-35% rate increase for the comp line based on the yields we get on new money invested and a four-year duration ground up to take that 117 or 115, 117 that the industry is performing at and bring it down to the mid-90s. You need mid-90s in order to get to the mid-teens ROEs even on that line. Our evaluation as to what we write by line of business, type of accounts, goes through this analysis.
What's the rating environment, not only just year-over-year changes, but on an absolute basis? What is the profitability associated with it, and how much more can we get in the marketplace if the rates, they're adequate? Of course, there is limitations to that. I can tell you we feel that in the CAT business, rates are adequate, but PML limitations doesn't allow you to write more than X. From a risk management point of view, we write up to our risk tolerance. When I look line by line and where we see opportunities, you see a little bit of growth in our business, but it's not broad-based that allows me to deploy all the capital that I have.
Thanks a lot.
You're welcome.
Your next question will come from the line of Joshua Shanker with Deutsche Bank.
Yeah. Good morning, everyone.
Hi, Josh.
Hi there. You said that Executive Assurance is getting weaker pricing, it seems like you're still growing there. The pricing is still very attractive?
Don't forget, in Executive Assurance, we view it in three sectors, right? We have financial institutions, we have commercial D&O, we have what we call private company, not for profit, et cetera. In Europe, we write a lot of small, medium-sized enterprise, which a lot of it is private enterprises, et cetera. The latter part is where we're growing, and that's the part of the business that we like. It fits with our strategy of writing smaller accounts, and we believe the profitability for that segment of the D&O business is the best.
The rate that Dino's referenced was for large commercial D&O, which we're shrinking on EA.
Offset by opportunities in the smaller sectors.
That's correct.
Exactly.
The second one, not too much on workers' comp. I realize you're not a workers' comp company, but you did try out the national accounts business a bit. In your experience, how sticky is that business? If you guys eventually find it attractive, how early do you have to be to get into it in order to participate in the upside?
Well, it's sticky business, and is a high service business. Because at the end of the day, most of the risk is taken by the client, right?
Well, not on the national accounts, on workers' comp in general. If rates got better, would you have to take a loss initially to participate in the profit upside?
Well, we don't think so. Some people might. We don't think so because the market only goes up because there is more demand. When there is demand, if you're a company with an A+ rating, good service capability, and good market reputation, I think you will get your fair share.
Okay.
We might be fools, but we believe in that. I don't believe the fact that we're not riding as much guaranteed core workers' comp today will inhibit our ability to participate in the future.
I appreciate the candor. Thank you.
Your next question will come from the line of Matthew Heimermann with JPMorgan.
Hey, good morning, everybody.
Hey, Matt. My name gets mutilated. I didn't see yours.
I figured, given who else was on the line, I couldn't complain about it, so. A couple of questions. One, maybe just to start out on kind of the changes we're seeing in macro pricing. I guess, when I think back to, you said this kind of reminds you of 2Q 2000, just indulge me for a second here. At that point in time, there was a big recognition that reserves were inadequate. While it took, to your point, six to seven quarters for rates to rise enough so that the returns on capital were adequate, the rate increases and exposure gains that were available were significant enough to really allow companies to grow 20%, 30%, even 50% in some cases per annum over a couple-year span.
I guess my question is, if this plays out in a more kind of incremental fashion, relative to the six to seven quarters it took last time to get to return on capital to kind of target level, how long do you think it takes this time?
It's a tough question. I don't know. First of all, your comment is correct. In the year 2000, there was a recognition that maybe reserves were short for the entire industry, not a real problem for most companies in the current environment. Having said that, I think there is more and more recognition today by managements, eventually they reflect that in their underwriting strategies, that we're going to be in a very low yield environment for quite a bit of time. At least there is nothing in the horizon that says that we're going to go back to the 5%, 6%, 7% returns on the investment portfolios that we were experiencing 10, 12 years ago. There is different dynamics that cause the adjustment in pricing.
I believe there is a recognition today by senior managements, in essence, is they're starting to push it down into the underwriting teams, that we need underwriting profit in order to get adequate returns, I think that's why they're adjusting in price. How long will it take? I don't know. If I was very good at that, I'd be in Vegas.
I guess the follow-up question to that is, do you have a sense in terms of whether based on what you're doing internally or what your best guess is based on what we're seeing in the market, what type of interest rate assumption you're seeing pushed down? Is it where portfolio yields are today? Is it where new money rates are today? Is it somewhere in between?
Well, it depends by company. I don't know. You have the ability to ask different companies what they do. I can tell you what we do. We only factor risk-free rate of return in new money when we do both when we establish rates and also when we compensate our underwriting teams on incentive compensation. Any under or over performance from that by the investment department, it does not affect those calculations either for incentive compensation for our people and/or for rate making.
That's fair. John, when you were discussing excess capital, it sounded like when you were talking about the buffer to the double A, that the target rating that you ran your buffer against potentially had changed. Did I hear that correctly? If so, what was the previous target?
Yeah, we used to have a buffer where we took into account the one in 250 PML, less the future earnings from that. That was based a lot around model error and the potential for a large CAT. In thinking about this, the fact we've gone to RMS 11, which we think is now a better calibrated model, at least how we see it and how we've implemented it. In thinking about how we want to hold a buffer, we sort of like the overall double A or a two-notch buffer, because that reflects all the risks that we're taking in the firm. We've got a better buffer now, we think about it overall versus a one-dimensional buffer, which is only the CAT event. That's how we want to think about it at this time and run the company on.
The old rule, it was my rule, and it was simplistic. I said I want to begin the year and end the year with a major CAT event with the same capital. I took potential earnings for the year, my PML, then the delta is as if I have an excess capital, I'm in good shape. I think we're getting a little more sophisticated in our calculation, and it might change in the future, and if it does, we'll always tell you as to how we calculate it. Right now, we feel pretty comfortable that we calculate required capital until internally. Management's required capital is two notches above what the rating agencies want us. We count excess capital anything above that.
Above that, yeah.
Okay. Thanks for the clarification. Have a good day.
Thank you.
Your next question will come from the line of Dan Farrell with Sterne Agee.
Hi, good morning. Could you just comment on your view on new business versus renewal business and the gap there? I think we had a company earlier today said that they thought the gap was closing.
We measure that. I'm going to go, and I apologize, I didn't know I was going to get the question, otherwise I'll have the specific numbers in front of me, because we have a monitoring system that compares what we get on new business versus renewals. In most areas today, your new business is anywhere from, if renewal business is at 100, it's anywhere from 94 to 100. Clearly, we're getting less rate on new business than we're getting on our renewal business. I don't have those numbers right in front of me to give you more specifics. It varies by line of business. On average, I would say in a scale of 100, new business is at 94, maybe 95, and then renewal business, it will be at 100.
Thank you. That's helpful. Just one other quick item. You mentioned that the increase in the net to gross is driven a little bit by business mix and shift to smaller accounts. Is that something we should continue to see the net to gross shift up over the next few quarters?
We're aiming for that. We might have reached saturation in our ability to continue changing that because don't forget, we're not abandoning the large account business because in a good market, that's where you make a lot of money. We're just more careful about pricing it today, in essence, competition takes some of these accounts. We never really went out and told any of our clients, any of the brokers that we do business, don't send us your large account business. It's just we're not as competitive with that. In essence, over time, it becomes less and less part of the book. I wish I can find the rates to grow that business because anything that we put out from a quotation on any account is something that we're happy about. If we're not happy about it, we shouldn't be doing it. Right?
It's how much the market returns back to us, that's been our attitude. Yes, the recognition that smaller accounts perform better in the soft cycle is not only by us, it's probably by the entire P&C world. At the end, do you really have the infrastructure to be able to do that? Over the years, I think we built good infrastructure that allows us to do it.
Thank you. That was helpful.
Your next question will come from the line of Douglas Miehm with RBC Capital Markets.
Hi, good morning. I just have two questions. First on the revenue side, based on the mix of pricing and demand and maybe exposure units you're writing
Are there any, I guess, economic signs or tea leaves that you're seeing or indications whether it seems to be there's more health in the economy, or it's maybe at a standstill or things are still kind of dragging on the demand side?
Well, as I said, we're not such a large company to have a broad view. You're asking a very broad question. I can tell you based on the limitations that a company who writes only $3 billion on an annual basis is that in the construction sector, which I think we have a good market share, but we don't see yet an uptick. I keep talking about it, but I think that that business is still hurting quite a bit, and we don't see the demand upticking. In some other areas, we've seen a little bit of demand uptick, but it's not broad enough to draw broad economic conclusions about what's going on economically in the country. If I had to guess, and this is my guess, is I think we just continue to drift.
The demand has not really increased to allow us to get more premium or more revenue because of increased demand.
Okay, thanks. That is helpful. My second question deals with a different topic. I noticed the massive flooding in Thailand has hit the major part of the news cycle now, and insured loss estimates seem to be climbing quite a bit. They started out well below $1 billion. I think there might even be ones up as high as $2 billion industry loss. Is that a broader event that would impact the overall reinsurance market? I am not quite sure of how the market's structured in Thailand. Is there a lot more local companies, or would you see those losses trickle into the general global Bermuda, Europe, Lloyd's type market?
I am not the right person to answer this question because we have so little in that part of the world that I have not really spent time studying it. I will do a little research on your behalf. Then if you call Don on a subsequent call, it is an industry question. We can comment on it. I will shed some light on it. I got to get back to my CAT teams. All I can tell you is we do not have much exposure in that part of the world.
Okay, thanks. That is all my questions.
Your next question will come from the line of Cord Dignam with Fidelity.
Hey, guys.
Good morning.
Good morning.
Congrats on another good quarter. You guys really managed the-
It was this, I think, but
Yeah. Well, you guys managed the business really well for a long time now. I actually had a question pertaining to capital allocation, and maybe it's for John. I know some people are getting pretty excited about what's being said about pricing conditions in certain markets. Actually, I thought Dinos did a pretty good job of summarizing the situation pretty well in his opening comments, which is that there doesn't really seem to be any seminal change in the total return economics of the business when you give proper consideration to all the factors. I guess my question is that given where your shares are currently trading, it looks like you're basically buying, let's call it a 6.5%-7% incremental earnings yield. Obviously, the repurchases aren't accretive on a stated book basis.
I guess the math, to me, makes it a little hard argument to say that they're accretive on an intrinsic basis. At what point do you consider shifting focus towards dividends, either regular or special, and away from buybacks?
Yeah. Well,
I have one follow-up.
We always want a three-year payback in how we think about this. At these expected returns, we'd have to be above 1.2 to make it much longer than three years in terms of not getting the payback. If we're trading just a little above our book value for the average book value for the quarter, we still like share buybacks.
Okay.
Our economic ROE calculation is, as I said in my prepared remarks, is still high single digits. I think we have something on our website. We have a grid that tells you potential ROE on the left and up on top, multiple to book, and where the three-year in recovery ends. Right now, I don't know if it's 1.2, but it's 1.18 or something like that.
Yeah.
Basically, until you guys give us more credit and shares go beyond 1.2 times book, it's not much for us to think about.
Yeah. I guess I had it at like $125 of book ex-OCI. Thanks. That's helpful. I had one follow-up, if I can.
Go ahead.
Along the lines of the great question posed by Matthew Heimermann of JPMorgan. I guess I struggle a little bit with the 2Q 2000 and subsequent six to eight quarters analog. Although I'm sure it made J.L.'s day. We can debate the numbers back and forth, whether it be the industry's IBNR to total net reserves or spread adjusted cash flow, or however you want to look at it. I guess qualitatively, though, I look around and I just don't see the Fremont and Reliance out there. I guess the question is, are they out there and I'm just not seeing it? Obviously, I wouldn't ask you to name names. Obviously, that analog, there was an event in New York that mattered as well.
It's an analog that I think I struggle with, and I also think back to banking in 2007, 2008, when people were always saying, "Oh, yeah, we're going to have a downturn," they looked at the early 1990s, S&L crisis, and that's as worse it could get. The reality is that the last cycle very rarely provides an adequate analog for the prospective cycle.
Every cycle is different.
Yeah.
It happens for different reasons. Yes, the probability of companies going bust is probably a lot less today than it was in the year 2000, because usually companies go bust on reserve deficiencies.
Not a recognition that I can't get much yield on new money invested, and in essence, I got to improve my underwriting so I can get underwriting profit, et cetera.
I think what's driving a bit of improvement in the pricing is the realization that investment yields are so low that we got to start thinking about underwriting profit.
Right.
I can tell you, in the entire '90s, nobody ever cared if you were publishing 100 combined, 102 or 104 in a business that had 6%, 7% return with a 2.7 to 1 leverage and a three and a half to 4-year duration. When you do the math, it's pretty good returns.
Right.
Also, in those days, the capital requirements, since you seem to be spending a lot of time on the math, the rating agencies, they were allowing us on a premium to surplus ratio to write a lot more premium.
Yeah
to surplus. As things evolved, and they got more sophisticated, and the capital requirements have continuous increase, and now the yields are going down, you have a much different environment. I'm not predicting that. The question was, what does it feel like? I said, my comment about second quarter of 2000, it was the first time in those days, for different reasons, that we saw the market starting to increase rates and improve rating environment. I see a consistency in that between second quarter data that we have and third quarter. Everything is lifting up a little bit.
If it was negative, it's a little bit less negative.
Right.
If it was zero, it got to positive. If it was slightly negative, it got to zero.
Right.
That's the only comment I'm making. I can't predict the future. I don't know. This might be like a jet on the runway, and it's trying to lift off, and it might be a false alarm. Maybe hit a little bump because they didn't have a flat runway, and it will come down again. I don't know.
We'll see. Time will tell.
I guess just as one follow-up to that. With the benefit of hindsight, we can go back, and we can actually conclude that a number of still remaining companies, still prominent companies, were actually technically insolvent in the second quarter of 2000. Some that are going to report in the next 24 hours or so. Do you think that anyone fits that description today? Because it seems like that it would be much harder to make the case.
Listen, my job is to run Arch. I spend most of my time worrying about Arch. I haven't done extensive analysis in other companies, looking at their Schedule P and their reserves.
Right
I don't spend my time worrying about others. You got to do that homework, and you can draw your conclusions.
Right.
One general comment, and then we'll move on to the next question is, I think the industry in general is not significantly under-reserved like it was in the year 2000. In my history in the business for the last 35 years that I spent as a career, usually companies go bust when they're grossly under-reserved.
Right.
That does not exist today. If I had to predict, I don't see a lot of insolvencies left and right.
Right. Thanks for the comments, guys.
You're welcome.
Congrats.
Your next question will come from the line of Vinay Misquith with Evercore.
Hi. Thanks, guys. I thought I'd never get a chance. Since Crow has exhausted all the cycle turn questions, let me just go back to basics on your business. The first question is on the buyback. It seems that, at least looking at your PML, you have maybe about $250 million of excess capital based on your 150 PML. Curious as to how much of stock you'd be willing to buy back, given the flexibility that you want to maintain should the pricing and property CAT remain strong January 1?
I said, we have excess capital. I'm not confirming how much you calculated, how much we are. We have the earnings for the fourth quarter. That's in addition. That is growing. I said before, Vinay, it depends where I'm trading. If I'm getting this lousy multiple that I'm getting today, I'd be more anxious to be buying more because I think I'm creating value for my shareholders. If I get a reasonable multiple for what we are, I might slow that down a bit and even consider other forms of returning capital. Right now, though, where the market is, I'm going to be more patient because I don't know if January 1, it might be a much better environment.
If it is, I don't want to miss it because I said, "Oh, I don't have enough capital." If I'm going to err, I'm going to err on having more capital available than less. Having said that, I don't see that. That's why we like share repurchases because you can change what you do on a weekly basis. If I write a check for an extraordinary dividend, the minute it goes out, I can't get it back. Where with share repurchases, I can accelerate it or I can decelerate it based on as I monitor the market condition. I will stick with the comments that I said that a fourth quarter will be no different than what we've done in prior quarters if you go a year ago, two years ago, and three years ago.
Yeah. Vinay, I think we sleep a little better at night having some buffer because it's still a pretty volatile world out there with Europe. Although the U.S. economy appears to be a bit more detached from it's still pretty volatile markets out there.
Sure, fair enough. The second question is on the future sort of accident year margins. That's improved in the insurance operations this quarter year-over-year, and it's been improving for the last couple of quarters. Is that business mix issues and also in reinsurance, you guys seem to be riding more CAT business, more property business. Should we look at the combined ratio on an accident year basis going down for both the insurance and the reinsurance segments going forward?
Two things are constant. Your first comment on insurance is correct. I think the change in the mix, moving away from, it eliminated some volatility because they're writing a lot more in small accounts, also they have moved into short tail business. Then, of course, on the reinsurance side, as we write more and more property CAT and property fac, et cetera, we're introducing a bit more volatility. We like the business long term, but it will give you quarter-to-quarter volatility because attritional losses might go up and down. Yeah. It's a better margin business, right? Because that's where we believe today the best margins are. For that reason, we gravitated to that. I'd rather take the volatility with the better margin because over a long period of time, I'm going to do better for the shareholder.
Even with that, even we believe a better mix than we have, the way we calculate things, we're still high single-digit ROEs. Nothing really to get totally excited about, right?
Okay, that's good. Thank you for your answers.
Your next question will come from the line of Ian Gutterman with Adage Capital.
Hi, guys. Few follow-ups.
Hi, Ian.
Few follow-ups. First, what made the Gulf pass Northeastern Florida as your peak PML? Was that mainly RMS 11 or did you reshape the portfolio?
No, it was purely model driven.
Got it. Okay, great.
By the way, Ian, you're always last in the question. If I was a professor, you sitting in the back of the room, I would have flanked you.
As I said, I like to hit cleanup, I guess.
Okay.
Given you'll see the next couple of questions are follow-ups. On the change in the capital center to AA, does that give you more or less excess capital than if you had kept the old standard for this quarter of PML?
It was approximately the same. It depends what you do with the CAT. We model it. It's no big difference. I think it's a more sophisticated way of thinking about it. Now, if I'm a 19% of risk tolerance on my PML, one gives me more. If I'm at closer to 25, the other one gives me more. It depends how you run it and where you are on the PML.
Got it. Okay.
Right? Because in the old model, that was the determining number. If I pushed it way up on the PML, earnings and the delta, it require more. On the other hand, if I take a little less PML, it changes that.
Got it. Does it also reflect sort of where we are in the cycle? I guess I'm thinking the yield standard that included a year's worth of earnings. If accident year returns are low, you obviously get less contribution from that than if accident returns are higher.
You're raising a much more intriguing question. The way I will tell you is that in a market, if let's say we're in the very good part of the marketplace, I will not keep any cushion. I will ride all the way to my required capital by the rating agency, because I have so much confidence in the business we ride and this profitability, why keep excess capital and not really maximize returns for shareholders? That's when we said it, we step on the accelerator and we ride all the business we can. This is for now and for the market environment that we're operating today, and I think it's prudent in the way we think about it, and it gives me comfort. Listen, my number one priority is I want to sleep at night. I don't want to be turning and tossing.
If I feel good about sleeping at night, then I think I have the right measurement. Right now, believe me, we have enough excess to make me feel good about where we are.
If you don't, they have pills for that now, Dinos. My last one is just to follow up on the repurchase commentary. John, I'm actually looking at the sheet, and it looks like at a 9% ROE, it's three and a half years at a 1.2x. It looks like maybe the cutoff is something like a 117 or 118 or something, and you're trading at 115. I mean, we're basically there. If the stock moves a $1 higher from here, are we turning off the buyback?
It's the average ROE over the period in time, not your trailing, because that was as September 30th. The 1.17-1.2 is sort of the upper end of the range, but we will continue to look at these options. You got to average it out over the quarter.
I guess what I'm getting at is if the market continues to get more enthusiastic about pricing it and the stock goes up another 10% or more, and you get to the point where the math doesn't necessarily work, what is the option? Is it dividend? Assuming it's not a hard enough market where we want to grow a lot, if we're sort of in this in-between land where pricing's up maybe a little bit more than the loss trend, we don't grow a ton, the stock's too expensive to buy back. What do we do with the capital?
Well, listen, at the end of the day, it's not a hard and fast rule. That would require another discussion between us and the board. We told the board we only buy it at under a three-year or less recovery. If a special dividend, which is not something that I prefer, because it loses that flexibility that I talked about, that I can turn it up or down depending what I see in the marketplace. One of the things that makes us what we are at Arch is the old Paul Ingrey light cruiser strategy. That we're agile, we'll adjust to things, both from an underwriting point of view, from what we do by line of business, et cetera, and that throws this into that category. If we get there, listen, I haven't seen 1.2 times book value for a long time. I keep dreaming about it.
When I see it, maybe we'll have another discussion then we might make whatever determinations.
Then the other point is, what's the ROE on the business we're running in the quarter, and January 1 may be better, may not be better. There's a lot of things. You're questioning a lot of what-ifs, we got to decide sort of almost when we get there.
Right.
Got it. I guess the only thing I was thinking of is I wonder if, again, if we get into that situation, maybe hoarding capital is the right strategy and turning off the buyback would make sense, because if we really are within six or eight quarters of a market turn, why not keep the extra capital rather than buying it back at a bad payback? Keep that capital so when the market does turn, you can write more business more quickly. If it's a short-term drag on ROE, who cares?
Right. We agree with you, but give us a little credit, Ian. We model that. The reason, don't forget, there is other ingredients on our capital structure that allows us quite a bit of flexibility. Our debt and hybrid to equity is very low.
Yeah.
Even the minute somebody rings the bell and he says, "You're getting on the straightaway and we're going to write a lot of premium," I have the ability to raise, I don't know, three quarters of a billion to $1 billion of additional capital without diluting my common shareholders, which is the last thing that I want to do. I didn't buy all these shares back because later on I want to dilute it. That calculation we do continuously to make sure that at never point in time, at no point in time, capital restrictions would not allow us to write as much good business as we can get our hands on.
Got it. Very good. That's all I have. Thank you, Dinos.
Thanks.
Your next question will come from the line of Ron Bobman with Capital Returns.
Thanks. Should I ask this operator or Donald Watson to be put on the queue for next quarter's call? My stat. I had one question remaining. Dinos, why are large account Executive Assurance D&O rates stubbornly weak?
I wish I knew. I think I'm attributing The class action activity is being benign. For that reason, probably some people, they get more optimistic that they're not going to have the significant losses emanating from these national class actions. Having said that, we made mistakes in other lines of business that makes us more cautious. For example, in the aviation business, commercial aviation, yeah, we didn't have major airliners go down. The pricing got to a point that at some point in time, even one or two incidents will take something from thinly profitable to extremely unprofitable. I'm suspecting that in the commercial D&O, maybe a slight change in environment, all of a sudden, you're going to have a lot of people with a lot of tears out there.
It's an attitude as to what do you view where the overall rates are, do you take into consideration what happened in the past, do you put some thought process into the improved benign activity, do you price purely that what's happening today, it's going to continue to happen in the future? That's the same issue we had with RMS 11, which you get a lot of different outcomes if you take two long patterns or if you take the short patterns, three, four years and average that on CAT activity. You got to make judgments. In our judgment on the D&O world, I think rates there, they shouldn't be continue to going down. I think that business should stay.
We're not saying it's unprofitable, but we continue to give up rate. It shrunk, but it's still negative, that tells you a lot of people like that business in order for rates to continue to go down. There is a lot of capacity out there. At the end of the day, we're starting to be very cautious about that line.
Thanks a lot. Since you brought it up, RMS, I think, also updated their European model middle of this summer. Is that going to have an impact on your pricing or rate expectations or desired rates for the January renewals?
It depends what the market reacts to. Don't forget, we were way underweight in European wind, we were way underweight on Japanese quake and others because we didn't like the rating environment. I think the model changes might cause the supply-demand to improve, if pricing goes up, it might give us more opportunities. I'm not predicting that. I don't know when it happens, if it happens, we'll react to it. We continue to be underweight in European wind because of the rates we can get.
Thanks, great job. Keep it up, please.
There are no further questions in the queue. I would now like to turn the call back over to Mr. Iordanou for closing comments.
Well, thank you, Fab. Thanks, everybody, for bearing with us for an hour and 15 minutes, and we're looking forward to seeing you next quarter. Have a good day.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.