Good morning, everyone. I'm Jay Gelb from Barclays Capital. Thanks for sticking with us. It's our great pleasure to have Arch Capital with us today. Arch Capital is a Bermuda-based property casualty insurer and reinsurer with one of the strongest track records of consistent book value growth in the property casualty insurance sector. With that, it's my pleasure to turn it over to Arch Capital's Chief Executive Officer, Dinos Iordanou, who's going to tell us more about Arch Capital. Thank you.
Thanks, Jay. Good morning, everybody. Usually they put me towards the end of the day, then there's nobody in the room because everybody wants to go home. Finally, we got a morning session which is great. Our lawyer said we have to put the prayer up, the SEC prayer, but I'm not going to read it. It will take most of the time, it's in your books. Pay attention to it. Let me just talk mostly about Origin. I know some of you know us, but I always try to begin every presentation with our strategies being the same as the playbook that gave us a great 10 years so far. I want to focus on it again, for all of you who don't know us, to see what we're all about.
It's a company that when we created it 10 years ago, we focused on a few simple things. One, that we wanted to be talent intensive, meaning that our people will make the difference in the marketplace. Their knowledge, their ability, their expertise will differentiate us. In order to do that also, we said that we have to align the way we compensate these executives, to align their interests with the interest of the shareholder, and also give them the ability not only to come and work for us but stay with us. I can tell you our turnover ratio in 10 years, since 2001, we're celebrating our 10th year anniversary on November 21st this year, it's been the best in the industry. For our senior underwriting ranks, our turnover has been less than 5% over the years.
Also we want to always, in a cyclical business, make sure that we're going to manage through the P&C pricing cycle and have that kind of discipline. You have good talent, you align them compensation-wise, you give them instructions and directions from the top to allow them to manage the cycle, good things happen to you. Also, we always would like to maintain a very conservative balance sheet. We try to limit our investment risk. Most of you invest in us because of our underwriting skills, not because we're going to be the next Warren Buffett in the world. We have a cautious reserving philosophy, for two reasons. It gives comfort to our buyers of our product about the stability of the balance sheet.
It gives a lot of comfort to our shareholders that at the end of the day, by having a cautious reserving philosophy, which influences how you price your product in the marketplace, we have a better chance of pricing our product correctly. If you get your reserves wrong, you're going to get your pricing wrong. It compounds over the years, and that's a slippery slope. We like to also have a low financial leverage and strong liquidity, and we have demonstrated that over the years. That strategy, it's been the same for 10 years. It's a very simple playbook. We try to be religiously following it. Because of that, and our focus to specialty line platforms that allow us to get better returns. If you look at industry statistics, specialty line underwriters over the years, they have done a little bit better than standard lines underwriters.
It allowed us to generate very good returns over the time period. Little bit about second quarter, our financial highlights. This year has not been a tremendous year for the business. Pricing is towards the bottom of the cycle. We had unusual catastrophic events that affected people, including us. Even with that, not that we're proud with these kind of returns, the first quarter we had an operating return on average equity of 6.1%. Book value per share grew to $31, which is still a good record, increasing 13-plus % from a year ago. Combined ratio was just around 100, and that included 14.8 points of cat activity. In our company, we don't believe the if not for this and if not for that.
We try to underwrite and you know you're going to have cat activity at different parts of the cycle in different years, and you have to price and account for it. We don't use that as an excuse, in relative terms, we've done better than most of our competitors. Our investment income had a pre-tax yield of 3.06%. Nothing to write home about, in this environment, that's an acceptable return. Our cash flow, which is an indication as to how well you reserve and also what your Claims paying activity continues to be very strong at $222 million for the quarter. Total capital deployed in the business is $4.84 billion as of the end of the second quarter.
Our production for the first time, for those of you who have been following us, as we have been practicing cycle management, we would either flattish or declining in revenue for now, approximately almost 20 quarters. It's been four and a half, five years since. The second quarter of 2011, it was the first time that we saw opportunities. Some of them came in isolated books of business, we took advantage of it, we saw an increase in production for the first time after a long period of time of about 12% in the second quarter of 2010. Don't take that as a predictor of what's going to happen in the future.
Our whole underwriting posture is to look for opportunities and only accept the business that we believe will give us an acceptable return, and if that means that we're growing or if that means we're shrinking, so be it. We're not a company who focuses a lot of their activity on top line. We do focus a lot on the bottom line. Our mix hasn't changed. It's about 65% now insurance versus 35% reinsurance. In the early years, it was exactly the opposite, and it might change again. If the market turns, you can deploy a lot more capital in the reinsurance business a lot quicker, so we might go to a 50-50 or some other split. We don't have a predetermined thought or a target as to what that mix should be.
It's only what the market allows us to underwrite, that will determine what our mix of business is. We do, though, pay a lot of attention to have a diversified book of business, as you can see, both geographically, not yet to our satisfaction, but more importantly, by specialty lines of business, we have a diverse book of business. Over time, we'd like to get bigger in Europe and Asia, given better market conditions, I think we're going to achieve that. Too much U.S.-centric. Of course, the U.S. is the biggest market, and that's also our Origin. As we find the opportunities to grow in the future, you will see even a better balance from a geographic point of view. New initiatives, not many, but they're important. We continue to make sure we have more tools in the toolkit. We licensed a new Canadian insurance subsidiary.
We're growing our business in Canada. It's a little over $100 million now. It was almost nothing five years ago. Also, this new Canadian subsidiary has the license for title insurance, we're investigating. It's not a big initiative for us, but at some point in time, it will be another new source of revenue for us. We're growing our A&H business, especially travel accident, we have created a life reinsurance unit that is focused predominantly on mortality-only risk. You've seen this slide before if you've seen presentations in the past. I use this when I talk to our underwriters around the country. On the far left and on the far right, we like to really grow the company, and we get very defensive when we're in the middle. Right now, where I circled, that's where we are. The industry is drifting at the bottom of the cycle.
I have some industry information that is trying to be predictive as to when we're going to get out of the insurance cycle, I'll share a few thoughts on that in a few minutes. Right now, we are practicing in the company what I would call defensive honor. What does that mean for us? On the reinsurance side, we reduce lines, so we don't have a significant exposure that any one particular contract will create a lot of hurt on us. In the insurance side, we increase reinsurance purchases, especially if we believe that will eliminate volatility on the book. We shift the portfolio to lower volatility lines. What do we mean by that? We write more primary with small limits, and we try to stay away from the Fortune 1,000 business that has traditionally more volatility.
It gives you significant opportunity to make a lot of money in the hot market. Likewise, it gives you significant opportunity to have tears in the soft market. We don't like to be having tear for our eyes as a company, so we try to stay away from that business. On our investment approach, again, being conservative, we have been very careful with the duration. As a hedge to inflation, our duration is a little less than three years, which is less than our liability duration. In essence, we're investing shareholders' equity at almost zero duration. We continue as a hedge against a recession to have a high credit quality portfolio. From a capital management point of view, we maintain a low financial leverage. You will see numbers that allows us a lot of flexibility, given an opportunity of the market to change.
Also, when we have excess capital, we try to return it to you for two reasons. That's where it belongs to begin with, if we can deploy it in our business. Second, and more important, I don't want to put undue pressure on our underwriters to try to return on excess capital that we have in the company, that the market would not allow them to deploy profitably. That supports our underwriting discipline by not allocating excess capital to the operating units, but returning it to you, the shareholder. I always put this up because I think first, it's a demonstration of our discipline. Second, it's a demonstration where we make mistakes. Third, I think it tells a little bit about the DNA of the company.
If you were a shareholder, you will say that it's great that we had a disciplined underwriting approach, as you can see on the reinsurance side, and also at the insurance side, after the 2004 year, as rates starting to come down, we started switching from long-tail lines in the reinsurance I'm presenting here, excess liability, primary liability, professional liability, and D&O. Then on the insurance, I'm only presenting the liability lines, excess and primary GL. The reason I don't split that on reinsurance, a lot of our contracts might have multiple lines in it, and it's very hard to get accurate data. This is a good representation. The mistake here is, if we knew then what we know today, we started exiting some of these lines two years too early.
You will find out that 2005 and 2006, they're very good years for long-tail lines. We're a little wiser today. We weren't as smart at that time. I rather do these type of mistakes than staying in too long. At the end of the day, if we're truthful in judging our performance, even though the company has done extremely well, that was a loss opportunity. It happened on both sides of the house. It did not only happen in reinsurance, it happened in insurance. At the end of the day, it's the same principles of how we evaluate the business, how we underwrite, and how we monitor not only what happens within our book of business, but what happens in the environment that we're competing with. We were a bit too early, and we admit to it.
On the other hand, we do have the discipline to make significant changes to the portfolio if we believe that a particular lines. Over $800 million in long-tail casualty for the reinsurance group and down to a little over $150 million. That's a significant change. Not many companies have the discipline, but more importantly, the stomach to do that. On the assets, not a lot of changes. I took a snapshot of end of 2009, and a snapshot of what we are as of the end of the quarter. Where I'm going to point to you is that for the first time, we're starting to put some money into the equity. We had almost zero equity in 2009. Now we have about 4% of the portfolio. This category, other, which I have at the bottom, which is approximately about half a billion dollars.
It's a lot of special funds that we find opportunities for us to pick up additional yield without really changing very much our conservative approach of short duration and high credit quality. We're allocating some assets to a little more riskier segments, but they do give us significantly more ability to earn a high yield, and on a risk-adjusted basis, we believe that enhances the portfolio. As you can see, most of what we do on the asset side is not dramatic. We don't like dramatic changes. We try to do everything with a lot of caution. On capital management, as I mentioned before, we have built up significant excess capital. As the soft market came upon us, we started reducing volume and exposures. We saw fewer growth opportunities to deploy that capital.
As we continue to reassess the market conditions vis-à-vis how much capital we have, we always cognizant that excess capital can be a problem, both from an underwriting point of view, as underwriters get paid on return on capital. If you give them too much and there is no opportunity to underwrite for it, they're going to do dumb things that you might not like. Second, I think, beyond sending the right message to the underwriters, we need to return the capital to its owners, which is the shareholders. Through June 30th of 2011, we have done $2.5 billion of share repurchases. Just to give you how dramatic that was, we have approximately now after our three-for-one split, 132 million outstanding shares. Over our share repurchases period of time from beginning to now, we purchased a little bit in excess of 100 million shares.
That's how dramatic that share purchase program was. A little bit about where we are in the cycle and how we see things. It's a lot of information on this slide. I always try to understand the environment surrounding us, and I'm going to focus you on a couple numbers. First, the black diamonds, that represents the return on the ROE the industry has achieved for the US P&C business, which is something that we can get very good statistics. The orange is what we will call within Arch, underwriting return. You're going to have a return on the capital, that's shareholders' capital. You don't have to write any premium to have a return, just invest the money. When we deduct that, everything else that is earned is because of the underwriting activity. Every single time when underwriting returns were negative, less than zero, we had a market turn.
As a matter of fact, with the Lehman, AIG, and to a lesser extent, Hartford, XL issues, and the financial crisis of 2008, as you can see, in 2008, we got all the way to zero. For some of you that you've been monitoring the industry, the first quarter of 2009, there was an uplift. We were getting rate increases, and there was a market reaction, which very quickly dissipated. It was like a refreshing cloud in the Sahara desert that it rained for about a minute and a half, and then it disappeared because spreads came back in, everybody's balance sheet starting to heal, and all of a sudden we went like drunken sailors cutting each other's throat in the competitive environment. Well, that's the insurance business. I've been in it almost 37 years, so I've been through quite a few of these.
2009 numbers, 2010 numbers, and mostly 2011, which we don't have through the increased catastrophic activity, I think it's going to bring the underwriting return closer to zero. I'm not so sure, the year is not out yet, but I don't think 2011 is going to be as good. Not that 2010 was terrific, but it's not going to be as good as 2010, so we're going to get closer to zero. In my view, and I don't know when it's going to happen, if it's at the end of 2012 or sometimes in 2013, we get underwriting return to go below zero, that will cause a market turn. It's been traditionally very predictable or very predictive that when that happens and you see the 1985, 1986 cycle, you see the mini 1992 cycle, and of course, the 2001 cycle.
Just a little bit of information and at least one company's view as to how we see where the cycle go. We'll prepare from a balance sheet point of view, we'll prepare from an underwriting point of view, the number of people we have, et cetera, in all of our units to take advantage if that opportunity is presented to us. Our capitalization is very strong. Here's our capital structure. $4.1 billion in common equity. We have about $400 million of, $300 is long-term and $100 short-term debt, and then $325 million of hybrid perpetual preferred stock for a total capital of $4.8 billion. We have tremendous liquidity. We have strong positive cash flows. In this, based on the reserves that we have and how much premium we're writing, there is quite a bit of excess capital in this structure. Our financial performance is being terrific.
Even my mother likes it, which is very hard to satisfy her. I thought my father was demanding. My mother is even more than my father. 19.4% compounded growth of our book value per share. By the way, that's the measurement that I get compensated. There is a few others, but this is the most important. The senior management team, at least me and our CFO and our Chief Investment Officer We get compensated on the basis and our ability to grow book value per common share. This is the value creation for the shareholder, in our view. As we compare ourselves for total value creation, I think we've done extremely well, and with a very low volatility. Standard deviation is fantastic. Annual total value creation, which in our vocabulary is the return on equity plus dividends paid.
As we pay no dividends, the shares return on equity for us has been terrific over the last 10 years. Let me summarize, and then I will take your questions. We have executed what I started with, a disciplined approach on a very simple playbook. Our playbook is not very complicated. Hire very good people, make sure they have the knowledge, ability, and the expertise, and only participate in those sectors that you bring something to the table. We don't venture into areas that we lack the talent and the expertise. To me, that's a lot of discipline. Second, understand that the business is cyclical. Prices go up or down, and sometimes the margin might be acceptable, sometimes it's not. Have the willingness as a company to give up top line, in order for you to protect your bottom line. Over the years, we were able to do that.
What's important here is that not only the senior management team and our middle management understands that, but because of the way our board operates, and they're so very much involved in the underwriting process. We are the first company who has created a board level committee called the underwriting committee. After all, we're an underwriting company. For the last 10 years, at my request, we had a board level committee that views all the underwriting strategy that we try to deploy in the marketplace, and more importantly, the execution of that strategy through quarterly monitoring, and reviews of all of our profit centers. When you have that alignment all the way from the board, senior management, to middle management, to the underwriters on the street, it allows for the company to move in one direction. In practice, the discipline that is required in a cyclical business.
We have maintained a conservative balance sheet in both our assets and also in the structure of the capital structure with very low leverage. The reason is it gives us a lot of flexibility to grow significantly given the right opportunity without having to dilute our common shareholders. The way we are today on that balance sheet, we probably have room for about $1 billion to add in debt and hybrid securities, and without affecting our A+ rating with the S&P. That is a tremendous tool that it can deploy very quickly, independent where your share price is trading. Right now, our share price is trading so low, it gives me headaches every night. In relative terms, maybe we're doing better than a lot of our competitors, but in absolute terms, it makes me cry. What's the matter, Jay? You didn't like that?
It's great. Keep going.
I think all this talent we put together, the embedded value in the reserves, because they cover a nominal value. The liquidation value of the company is less than what we're trading. How can I be happy as a CEO when that's the reality of the capital markets today? One day we're going to get rewarded. We have maintained that conservatism in the balance sheet for that opportunity because even though I said we don't focus on top line, we want to grow more than our competitors, but in the right times. Our promise to shareholders is that you will get a bumpy ride with us. In the soft years, you're going to see top-line revenue coming down. In the good years, you're going to see hyper-growth.
I will not be happy in a good market environment from the same underwriters who gave me minus 10% and minus 15% in growth, that I was very happy that I'm not getting 20% or 30% growth in the good days. That's what we have tuned up the company to have the ability to do. From the balance sheet, but also from our retention of our underwriting teams in all of our profit centers. You probably seen our expense ratio spike in the last two, three years. We've done that on purpose. I wasn't willing to take my best underwriters and put them out on the street for some competitor to hire them because my expense ratio was going to go up 1% or 2% or 3%. At the end of the day, that's the factory. What we manufacture is a bunch of decisions.
The guys who make those decisions is our underwriting teams that come with their knowledge and expertise, and you want to maintain that within your walls. It gives them the stability for their jobs. At the end of the day, that's the guys who are going to write a lot of premium for us, given the right market conditions. We have generated strong risk-adjusted returns, as you've seen. It's based on this simple strategy. More importantly, and I would never want to underestimate that as an underwriting company, our alignment of compensation, which pays the underwriters based on the return that they're going to achieve for shareholders on an underwriter year basis, it's been a strong driver of performance. At the end of the day, you bring home the bacon, you can have bacon and eggs. You don't bring home the bacon, you can have just sliced bread.
We like bacon and eggs. As you can see my physique, I've been eating a lot of that. With that, I appreciate you having me, and we'll open it up for questions.
While we're passing the mics around here, Dinos, I don't know if you had any initial thoughts coming out of the Monte Carlo reinsurance rendezvous?
I just came back yesterday from Monte Carlo, which is the beginning of the discussions, especially for the cat business, and also the reinsurance renewals as to what's going to happen for the coming year. I would summarize it into this. If you were a seller, you wanted more rate. If you were a buyer, you were expecting flattish or slightly down. That was the discussion between the parties. The brokers in between, they said, "As long as you don't cut my commission, I'm happy." At the end of the day, it was an uneventful, for me at least, Monte Carlo, with still another indication that the market had hit the bottom and is drifting there, and we're looking for some catalyst for it to lift. I don't see any yet in the marketplace.
What I put up on industry statistics, it might take another year or a year and a half to create that kind of pain when it's starting to flow through the reported numbers, and we haven't seen that yet. Absent of that, we need either a major catastrophe or some financial event that it will reduce the asset side of the balance sheet, which will cause exactly the same imbalance between supply and demand. If I had to predict, I think it might be just kind of a flattish, maybe on the cat business, slightly up on January, but on the liability business, nothing to write home about. We will continue, at least as Arch, to practice our defensive underwriting strategy.
That's great. Thanks, Dinos.
Yeah.
How much in additional hurricane losses would be required to make the pricing market for next year really attractive?
In my view, you need $30 billion-$40 billion. That capital has to exit the business. An event of that size, I think it will have not only an immediate effect on the property and property cat business, but I think it will start influencing the liability lines. Don't forget, in some liability lines, we have seen improvements. I think the workers' comp business in the U.S. is starting to improve. There is rate increases coming. Some of the small package policies, they're starting to get rate increases. Our program business, we see rate increases. We did have the ability to write some contracts for motor in the U.K. That market has corrected and priced. There is, what do they call that? Green shoots or something? I'm not a farmer or a landscaper. There is some of that happening in the marketplace. It's not broad-based.
It is not broad based. You need something like that. If you get a spike on interest rates, which I don't think is going to happen anytime soon based on the Fed's policy, if you do, that creates issues. If we have a collapse of the financial system in Europe, which is a possibility. There were a lot of people scared Monday morning when the French banks, they were trading 10%, 12% below the Friday's numbers. Some people very much worried about not just Greece, but Italy having difficulty in their bond offerings. Yeah.
The European reinsurers being less aggressive because of what's happening in Europe?
I haven't seen signs of being more or less aggressive, but I have seen signs of concern, and a lot of discussion at the CEO and management board level that they are cognizant of that and worried about it. When that translates in action on underwriting business, it might be a time delay, but I haven't seen that concern as of yet. It's only at the senior level. The same thing in the U.S. I think senior managements understand that in the current interest rate environment, 100 combined of two years ago, it's the equivalent of a 94 combined today. The math is very simple, right? You write a $1 over premium, you spend $0.30 in expenses, you have $0.70 to invest, and you got approximately a four-year duration if you're writing long-tail business. That's 2.8% for every 100 basis points, four times seven, right?
If we lose 200 basis points of yield, which we have in the last couple of years, you're talking about six combined ratio points. I can tell you that hasn't translated yet from CEO, CFO, chief underwriting officers to the desk underwriter, who still continues to believe that as long as I underwrite and I get a 98 or 99 combined ratio, things should be good. When the numbers start coming out and people are having very low single-digit ROEs, I think that is going to come home to roost, and the adjustments will be made, and that's when you have a market turn. All of a sudden, they're going to say, "Hey, your permissible combined ratio is not 100, it's 95, and you better underwrite to it." That means you got to raise prices and try to make more on the underwriting side.
Until those instructions get out to the troops, it's not going to happen. Hard to predict, but I'm more optimistic today about a market turn in the next couple of years. It's not going to take that much longer than that.
Yeah. Thanks, Dinos. Can we go to slide 12 and ask a couple follow-up questions.
Sure
on the property casualty cash flow, which is a great slide, so thank you for putting that together. Couple follow-up questions. Where you see business being written today on an underwriting accident year basis that'll roll into the earned premiums next year, are we going to see the underwriting number go negative in 2012 based on what you're seeing today for the industry? Secondly, whether it's 2012 or 2013, what are you shooting for for your outperformance versus the industry as you're trying to write business today?
Okay. Well, yes, I truly believe that when we look at 2012 numbers, the underwriting return is going to be at zero or negative, meaning that the market is going to be looking to correct itself. Today, if you eliminate reserve releases, which is the hay we put in the barn three, four, five, six years ago, and now gets released as the triangles start to dictate. For some companies, it's already got to the point that they don't have much in excess reserves that they're going to release. The accident year numbers are nothing to write home about. They're very low single, 4%, 5%, 6% ROE. That is degradating at least two, three points every year. 2011 is not on this chart, and 2012 is not on this chart. You can make projections. I think by 2012 or 2013, we're going to have that.
Our approach at Arch is being, this is the average of the industry. This is one balance sheet, is looking at it as one balance sheet. For us, our approach is being that if you're willing to give up top-line growth, and you have decent underwriters from a knowledge, ability, and intellect, you're probably going to let the most unprofitable business go first and keep your most profitable. It only allows you to really get to maybe 6%, 7%, 8% ROE. In truthfulness, if you ask me what we're underwriting to as a company today, it's maybe that 7%, 8% return on equity for the business that we write today.
You can go to zero, you play that defensive game hoping that the other guy who made more mistakes than you starts getting into financial difficulty, then it gives you the opportunity to capitalize on the hard cycle.
Okay.
That's been our approach.
Thanks, Dino. I'm afraid we're out of time. We're going to continue the discussion in the breakout in the Gibson Suite. Please thank me in joining Dino.