Good day, ladies and gentlemen, and welcome to the second quarter 2011 Arch Capital Group Limited earnings call. My name is Modesta, and I will be your coordinator 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 and we 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 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.
Thank you, Modesta. Good morning, everyone, and thank you for joining us today. In the second quarter, we continue to see significant catastrophic activity, this time emanating primarily from severe weather events that occur in the United States in April and May. The level and intensity of these storms were unprecedented and a departure from historic patterns and serves us as another reminder that in the insurance business, significant natural catastrophes do occur and need to be priced for. I continue to be pleased with our underwriting approach and the discipline in which our insurance and reinsurance underwriting teams are executing our overall underwriting strategy. As the soft cycle has evolved, we have continually adjusted our book of business to lines and classes that are priced appropriately on a risk-adjusted basis in order for us to achieve the required return relative to the risk assumed.
As a result of executing this strategy on a trailing 12-month basis, our short-tail exposures have grown to be about half of our premium. Our medium tail is roughly 25% of premium volume, and our long tail has been reduced to approximately 25%. This is significantly a different book of business than we had several years ago. Our total net catastrophe losses for the quarter were $95 million, with North America weather-related losses contributing $79 million, and the balance coming from the re-estimation of our first-quarter catastrophe losses and the second-quarter New Zealand earthquake. Our annualized return on average common equity was 6.1% on a reported basis, which was affected by the above-mentioned cat losses, which exceeded our quarterly cat load.
By our own estimation, we continue to believe that in the current underwriting and investment environments we operate in, on an expected basis, we are still able to achieve approximately 9% ROE on an underwriting year basis. This is essentially the same level we estimated for the entire 2010 underwriting year. Our investment performance for the quarter was good, with a total return of 1.7%, aided by a slight improvement in treasury rates. As a result of our investment performance and despite the cat losses, we were able to increase our book value per share to $31, which is an increase of 13.3% from a year ago and 2.2% from a quarter ago. From an underwriting point of view, we recorded 100% calendar quarter combined ratio, which is an acceptable result in a period marked by above-average catastrophic losses.
Cash flow from operations remained solid at $222 million. The broad market environment continues to be competitive, with most long-tail product lines having plenty of capacity available and which are experiencing slight price declines. For us, these classes represent about 20% of our quarterly volume and 25% of our trailing 12-month premium volume. In the property and property cat areas, the environment improved with the best increases today reflected in international cat-exposed business. The book of business in total was roughly 54% of net premiums for the quarter and approximately half of our volume on a trailing 12-month basis. For medium tail lines, the environment is stable for some classes and improving for others. Our medium tail business was approximately 26% of this quarter's volume and 25% of the trailing 12 months volume.
From a premium production point of view, our gross written premium was up 12% and our net written premium were up 13%. Most of this production increase emanated from our reinsurance operations, which reported growth of 36% in gross written premium and 33% in net written premium. Part of this growth is attributable to one account that was renewed on a two-year basis, and adjusting for this account, the percentage increases would have been 25% and 21% respectively. Still a very strong performance. Most of the balance of the increase in written premium was in short tail and medium tail lines. Our insurance operations were up 3% on a gross written premium basis and 4% on a net written basis.
During the second quarter, we saw no significant change in market conditions, with rate levels for all lines of business either improving slightly or staying the same as in the prior quarter. The areas under the most pressure continue to be executive assurance and healthcare, with mid-single digit rate declines. All other lines report a flattish or slightly positive rate movements. In our reinsurance business, we saw good improvement in the property cat area, with average rate increases of 8% in the United States and 28% on average in international business, where increases range from as little as +5% to as high as 70%. Across our business segments, even in the most difficult markets, we always look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting standards.
We're starting to see some of these opportunities from both our existing product offerings as well as from our new product initiatives, which have helped stabilize premium levels. Our insurance group continues to emphasize and move their book of business to smaller accounts and to relatively less volatile lines, with an emphasis on reducing their exposure to the U.S. casualty business. The area with significant volume reductions in the second quarter was professional liability. This reduction in volume primarily resulted from the larger account sector of this business. As we mentioned on last quarter's call, we continue to monitor the primary casualty E&S sector in the U.S. Although we continue to see price increases in isolated areas, we remain in a defensive posture in this line as we still believe that the rate improvements today will not produce an adequate return.
I would like to reiterate that our capital management philosophy has not changed. We have consistently and will continue to return excess capital to our shareholders when we cannot profitably deploy it in our business. As is customary for us, during the hurricane season, we will temper our share repurchase appetite. Of course, should we find opportunities to buy our shares at very attractive prices because of market dislocations, we will continue to do so. Before I turn it over to John for more commentary on our financial results, let me update you on our PML aggregate management. As of July 1st, 2011, under RMS 10, our 1 in 250 PML from a single event was $740 million or 18% of common equity. This represents roughly the same level of exposure, and % of common equity as of last quarter's end.
We are continuing our process of reviewing RMS 11 and its various changes and have not yet finalized our examination at this point. However, under RMS 11, based on the current iteration of the model, our preliminary estimates of PML for 1 in 250 year events indicate that these exposures estimates, in comparison with the RMS 10, will produce increases which range between 10%-30%, depending upon the zone, with all of such preliminary amounts remaining within our risk management limits. With that, I'm going to turn it over to John for further commentary of financials. John?
Thank you, Dinos. Good morning. On a consolidated basis, the ratio of net premium to gross premium was 77%, about the same as a year ago. Our overall operating results for the quarter reflected a combined ratio of 99.6% compared to 90% for the same period in 2010. The 2011 second quarter included $95 million, or 14.8 points of current accident year cat activity, net of reinsurance and reinstatement premiums, compared to $7 million, or 1.1 points in the 2010 second quarter. The 2011 second quarter U.S. storms and New Zealand earthquake had a gross impact of $98 million and a net impact of $82 million. The re-estimation of the 2011 first quarter events of the Australian floods and Cyclone Yasi, the New Zealand earthquake, and the Japan earthquake and tsunami added $21 million gross and $13 million net to the second quarter provisions for the 2011 cat events.
The re-estimation was mainly driven by further claims development and contingent business interruption expected claims from the Japanese event. The 2011 second quarter combined ratio reflected 8.9 points, or $58 million of estimated favorable prior year reserve development, net of related adjustments, compared to 5.2 points or $33 million in the 2010 second quarter. The prior year development in the second quarter of 2011 reflected net favorable development primarily in property and other short and medium-tail lines, as well as in the reinsurance segment casualty business, mainly from the 2002 to 2005 underwriting years, and also included a $5 million reduction in the provision for the 2010 cat events. Excluding the cat activity in the quarter, we generally experienced better than expected claims emergence on most lines.
The 2011 second quarter current accident year combined ratio, excluding large cat events and net favorable development, was 101.8% in the insurance segment and 79.7% in the reinsurance segment, both consistent with results as of a year ago. The 2011 second quarter expense ratio of 32.5% was 0.8 higher than in the 2010 second quarter, resulting from higher costs, in part from billing the insurance accident and health business and foreign currency adjustments, as well as higher incentive compensation accruals. On a per-share basis, pre-tax net investment income rose to $0.63 in the 2011 second quarter, compared to $0.57 for the same period a year ago and $0.63 in the first quarter of 2011. Our embedded pre-tax book yield before expenses was 3.23% at the end of the 2011 second quarter, down from 3.52% at year-end, which reflects lower reinvestment rates and a short duration.
The total return of the investment portfolio was 165 basis points in the 2011 second quarter, compared to 150 basis points in the 2011 first quarter. Excluding foreign exchange, it was 154 basis points in the quarter. The total return in the second quarter benefited from good returns on fixed income assets, partially offset by negative returns on equities and some alternative assets. We recorded net foreign exchange losses of $18 million in the 2011 second quarter due to the weakening of the U.S. dollar against the euro and other currencies. These losses resulted from revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date. This should be compared to the 11 basis points contribution to total return from foreign exchange on our investment portfolio, which offsets some of this income statement loss in the equity section of the balance sheet.
Our allocation to equities was approximately a net 3.5% of our investable assets, including cash, at quarter end, while alternative investment and equity method investments were consistent at 6.3% of our investable assets. We continue to maintain the vast majority of our investable assets in very high-quality fixed income investment portfolio with an average credit rating of AA+. The duration of the investment portfolio was 2.87, about the same as 2.83 at year-end. We continue to maintain a shorter duration of our assets than our liabilities, which are approximately 3.5 due to the continued global uncertainty and potential volatility of interest rates. For the 2011 first half, our effective tax rate on pre-tax operating income was a benefit of 2.7% and 1.7% on pre-tax net income. The cat activity this first half year and low investment returns have resulted in a beneficial net tax position.
Our balance sheet continues to be conservatively positioned with total capital at $4.8 billion at June 30th, 2011, up from $4.7 billion at March. In the quarter, we purchased 0.9 million shares for $29.6 million at an average price per share of $33.51 at a ratio of 1.09 to the average book value during the quarter, which fits into our expected return of under three years at this profitability level. Our debt plus hybrids represent 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, up 2.2% from last quarter and 13% from a year ago.
Our excess capital position As the rating agency actual capital in excess of the required for an A+ rating plus a buffer was estimated to be approximately $300 million at the end of the 2011 second quarter under RMS 10 and including AOCI. Depending upon the final implementation of RMS 11, we would expect our excess capital to be reduced by an amount yet to be determined. We are comfortable with our capital position heading into the usual cat season. With these comments, we are pleased to take your questions.
Modesta, we're ready for questions.
Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your phone. If your question has been answered or you would like to withdraw your question, press star followed by two. Questions will be taken in the order received. Please press star one to begin. Your first question today comes from the line of Keith Walsh with Citi. Please proceed.
Hey, good morning, everybody.
Hi, Keith.
How you doing? Dinos, you mentioned underwriting ROEs remaining in the 9% range. I was just curious why that was. I would assume with the property cat, especially growth, that you were riding that well above the 9% you cited. It was a pretty sizable chunk this quarter. If you can just touch on that.
Yeah. You got to look at the entire book of business. You're absolutely correct. I think the prospects of better returns on that portion of our business is there. You have to also see where we're losing ground in the executive assurance and healthcare, even though it's a much smaller part of our business, we're still giving rate reductions, so you're losing ground there. The rest of the lines, even though we're seeing a little bit of an uptick on rates, flattish and maybe slightly up, I don't think they're keeping up with trend. Trend is still positive. When you put all that in and you put the positives and the negatives, we didn't see any movement in the profitability, I think that we're achieving on an underwriting basis.
9% is not really a target. At the end of the day, it is what we can achieve in this market.
Okay.
The other part is on the long tail lines, profitability is also dependent upon the new money yields. As you saw from John's commentary, our embedded yield on new money invested is coming down because as we reinvest funds, new cash flow, it's going down. That affects the ROE too, because even though the duration of liabilities on the long tail is still the same, you're earning a lot less on the float.
Okay. Then just thinking about new business growth in the property cat area, are you winning because of wounded competitors? Is that a major reason you're seeing new flow?
I wouldn't characterize it as such. I think in some parts of the world and even in the U.S., we never really pushed the envelope to our upper limit or our tolerance. We always had room, and we continue to have room to write more. Where we found the opportunities, independent if there were opportunities overseas or opportunities in the U.S., we did take advantage of it. At the end, we let the market determine where we have the best chances to get a good return, and that's where we go.
Thanks a lot.
Your next question comes from the line of Jay Gelb with Barclays Capital. Please proceed.
Thanks and good morning. Dinos, with the excess capital position potentially coming down a bit more with the implementation of RMS 11, does that mean ours could be more geared towards premium growth as opposed to share buybacks going forward?
I think we're going to do both. If we find opportunities for premium growth, we'll take them. That's our number one priority. We're in business to produce underwriting profits for shareholders. Where we have an opportunity to expand our business through underwriting, we're going to take those opportunities. Having said that, though, we're not going to keep excess capital on the balance sheet. Depending where the market goes, how this hurricane season fares for the industry and us, we're going to reevaluate where our capital position, and we'll continue with share repurchases if we can deploy the capital in the marketplace.
Jay, and because we're underlevered, if the market does turn more and it becomes quite hard, we have great capacity to increase writings if we see the ROE is there.
Right. Then how-
There's plenty of flexibility on the balance sheet. From a directional point of view, I don't think there's any change. It would be as steady as we go. In prior years, we kind of wait and see on the third quarter. Maybe our share repurchase has been the lightest usually in the third quarter because we want to see where the hurricane season takes us. We had significant activity usually in the fourth and first quarter. That pattern has been around for you guys for what, three, four years now or so since we started our buyback program.
Right. Okay. In the reinsurance segment, the 36% growth is reported. I mean. Big portion of that clearly was the renewal of a multi-year deal. You probably also had some reinstatement premiums coming in. On a normalized basis, what do you think that growth rate was in 2Q?
Well, on a normalized basis, I think it's in the 20% range. The reinstatement premiums, they weren't that significant. The one large deal is, I gave you the delta, it was like 11%, 36% versus 25%. That's a deal that has always been written on a two-year basis. For year-over-year comparison, it throws off our numbers a bit for you guys. You've known it for years, we skip a year and then it comes in. On an earn basis, it makes no difference because you're earning the premium over 24 months anyway.
All right. Just to follow up on the reinsurance segment, what do you think is a reasonable expectation for growth going forward? My guess is it wouldn't be in the 20s.
Yeah. Listen, if I was that good, I can predict the future. I'd be in Vegas, betting on the tables. I mean, it's whatever the market shows us. We don't shy away from underwriting and taking risk as long as we believe that there is profit in the transaction. We found opportunities in the first and second quarter of this year. We took advantage of those. If those opportunities continue to be presented to us, you'll see growth. If not, we're not ashamed to go back to our defensive underwriting posture and have no growth or even negative growth.
Okay. Thank you.
You're welcome.
Your next question comes from the line of Joshua Shanker with Deutsche Bank. Please proceed.
Yes, thank you. Hope all is well. I was wondering if you guys could detail a little bit on loss trends by line. We've had a few conference calls here and not getting a lot of detail, but everyone sort of agrees that loss costs are up a little bit. Maybe you could add a little bit of a detail to that.
Well, I can give you the ranges, Josh. We've seen as low as 2.5% in some lines, to as high as 6.1%, I think. You know our philosophy. We don't change trend projections on a quarterly basis. One set of data on another diagonal is not going to change those projections. Our actuaries, they take a longer-term view and they look at both frequency and severity, and they do it by what we call IBNR family or product line. We use that in pricing our business. The range is as low as 2.5 and as high as 6.1%. That's what we have by line of business. Of course, the highest is in the medical mal area. Executive Assurance has a high trend too because of severity.
That's a great answer. Thank you.
You're welcome.
Your next question comes from the line of Greg Locraft with Morgan Stanley. Please proceed.
Hi, thanks. Wanted to actually just take your temperature on, again, the capital side. I'm trying to understand. I know you have 300 today, and obviously we're entering an RMS 11 world. If it's just a normal hurricane season, how will things look into year-end and what impact does that have into the marketplace from pricing perspective into 2012 and beyond?
Well, to give me a little leeway to answer your question is, what is a normal hurricane season? Would you define that for me?
$18 billion is the average 10-year losses.
Having one hurricane with industry losses of about $18 billion?
Yeah.
For our book of business, it will probably be contained in our normal cat loads, so it won't have any effect on our capital.
Okay. Great. You're just trying to navigate from an RMS 10 to an RMS 11 world, and you'd feel pretty good about where you're sitting.
Don't forget, RMS 10 and 11 is just another recalculation on the same set of exposures, right? We've been operating with RMS 10 now for a couple of years. We have an idea as to what our exposure is. It's how you measure them et cetera. That's why we're very careful before we fully implement RMS 11, that we do understand all the changes that they have made to the model and we agree with them. Don't forget, even with RMS 9 or 10 or going back, we always made our own customary modifications ourselves. If you look at our cat management over the years, I think we get pretty good marks. I'm pretty confident in the ability of our teams to not only understand the external models, but also how they internally make tweaks to them in order to serve our underwriting needs.
That's the process we're going through right now. That's why I didn't want to just plug in RMS 11 without having a full understanding of what modifications they made. Do we agree with them and all that? Does the empirical data that we have jive with that, or do we have to make some of our own changes? John, you want to
Yeah.
You spent a lot of time with it, with the cat teams.
Greg, I think what's important when you look at us and also think about other people in the industry as well, is when we say RMS 10, as Dinos mentioned, it's how we have implemented RMS 10. We'd already done a lot of back tracking of various storms and how that mapped the model and had increased some exposures in certain areas. Likewise, with RMS 11, we are looking at it the exact same way. We are looking at their changes and the empirical research also from other vendors and looking at their research before we finalize and zero in on our final numbers. The percentages may be different from us, from other people. It also depends on where the locations are. The RMS 11 versus 10 raw models have changed quite a bit by regions.
It's going to depend a lot upon your book of business. This takes some time to make sure you're really comfortable with. Overall, we think we have sufficient capital for all this, and we'll continue looking to write some good business.
Yeah.
Okay.
There is no restriction in our ability to respond to market opportunities. We will stay within our risk management tolerance. We're not going to increase that. We're comfortable at 25% of common equity. We're going to manage the book within that. We're comfortable where we are today. RMS 11 will be implemented within the company shortly. We're in the process of doing it right now.
Finally, Greg, there's one point. When we say excess capital, that's from our target, our target number is A+, plus a buffer. The buffer is there to get through big storms or bad events in the world, that's how we run the company. Excess is really an amount above A+ and above a buffer. It's quite up there.
Okay, great. Just again on the capital side, how do you think of the impact of two events in the fixed income markets? One is higher interest rates. Let's just say they go up 100 basis points or 200 basis points. Secondly, would be sovereign downgrades on the U.S. side. How would that impact your thoughts around your excess capital position?
Well, I'll let you-
Yeah. The duration of our entire portfolio, which includes everything, is 2.87. If interest rates went up around the world, because we have business in other currencies, it would be about $300 million if you take our total investment portfolio and multiply that out by the 2.87. That's a very big move from where we are on the whole yield curve across the board. More likely you see this in Europe. It's not the whole curve moving for these countries. It's shorter term is moving up more. It's hard to predict, but I think we feel with our buffers we have versus our capital position, that we can withstand some pretty big shocks here that happen around the world. When it comes to sovereign downgrades, we don't have any exposure to the PIIGS or the risks in Europe.
It's very hard to predict secondary impacts on what would happen around the world to these things. The U.S. downgrade is also hard to predict what might happen. You may think rates may go up instantly. History showed that when Japan was downgraded from AAA to AA+ in 2001, the 10-year Japanese bond actually went down 24 basis points in the subsequent time. We're in a very bit of uncharted territory here. By being short is really one of the best protections, and being conservative on the credit quality.
Yeah. We do own a muni portfolio, which is a little over $1 billion in the U.S. The muni story is specific to each bond. We do a lot of the credit analysis within our walls. We just don't depend on outside advisors on that. We feel pretty comfortable where we are with our muni portfolio. Even in some states that there might be a lot of stress, et cetera, and there might be some municipal defaults. When we run that against what we own, we feel very comfortable with the positions that we have on the muni side.
Okay. Thank you very much.
You're welcome.
Ladies and gentlemen, once again, if you wish to ask a question, that's star one on your telephone. Your next question comes from the line of Matthew Heimermann with J.P. Morgan. Please proceed.
Hi. Good morning, everybody.
Yeah. Hi, Matt.
Hi. Sorry to beat the dead horse here on-
If it's not dead, we'll kill it.
Okay. Let's work towards that.
Okay.
I was just curious on kind of how RMS might impact a couple things. Specifically, just in terms of what's driving the increase, is there any specific region driving the increase in, I think last quarter, historically Southeast has been your biggest zone. Is that potentially going to change once you fully implement the new model?
Let me give you some preliminary color. We haven't finished all the analysis. It seems to us that it has less of an effect in Florida for us because of the changes that we were doing to how we were viewing Florida risks. It has more of an impact in Gulf states, meaning Louisiana, Texas, et cetera. Most of that is coming from the changes in storm surge, and also inland damage ability, going in 30, 40, 50 miles. When I gave you those ranges of 15%-30%, to be more precise, it was 14-something to 29%. The 29% it was mostly for the Gulf states, not for Florida.
I want to reemphasize again, these are preliminary numbers because we like to be very thorough, and our team is spending a lot of time and a lot of effort on not only implementing the model, but understanding it. We don't do things that we don't agree with. We got to get agreement as to what we're going to implement by our own cat teams.
Matt, there are three major areas that everyone has to analyze with the RMS 11. The first one is the shorter-term frequency. The model has a higher frequency assumed in the short term due to ocean warming, the cyclical ocean warming cycle. There's a long-term average of frequency over 100 years or more. There's a shorter term cycle, and it's deciding, do you really agree with that, and how do you want to implement that? The second is the vulnerability, or as Dinos mentioned, the further inland, how far the storms come in and what the damages are. The third is the storm surge. Getting comfortable with all those takes some time, and we're analyzing, we're running it, we're backtracking it versus prior storms, and also reading all of the empirical research and speaking with RMS to truly understand where they're at.
Then just taking this a little bit further. Is insurance or reinsurance, or is it similar between the two that's disproportionately responsible for whatever increase we'll see?
Well, you know that to a great extent on the reinsurance side, we take 100% net. We do buy some retro and some ILWs to protect different parts of our book, and we do that. That's more, I would call that managing PML aggregates. On the insurance side, we buy a lot of cat cover. There is scenarios that if you cycle over, let's say you take $75 million deductible or net retention on each storm, and you buy $325 million above it's only when you go over the $400 million. There is some scenarios that in our insurance group there is potential for us to be cycling over. Now there is two ways to deal with that. Either you reduce exposure and/or you buy more protection at a cost. You can always go and buy another $50 million or $100 million of protection.
That's the kind of evaluations we're going through, analyzing our book of business, and getting to an agreement. Don't forget, we're taking the risk. We got to agree to it. Working with RMS and their scientists in explaining everything that they have done to the model, and then we're going to make determinations. Right now, we're very comfortable with the exposures that we have and where we're at. We're spending a lot of time, and it's going to evolve. It's going to evolve over the next month or two. It has not changed what we have done in the cat business because that season is pretty much over after July 1st. Even at the worst possible escalation, if we did 30% across the board, it was still well within our tolerance. From that perspective, it didn't give us any angst.
It won't become an issue again until January 1. We have plenty of time to analyze and refine, and make determinations on the model.
Okay, that's helpful. If we just translate this back to the capital discussion.
How should we think about the proportionality of the increase in the PML relative to how much excess capital you have? Simplistically, one could come from it, and this is why I'm asking, but you could come with the approach and say, okay, well, excess capital is the difference between wherever you're one in 250 PML as relative to common equity versus what the required equity would be at 25. I think in reality, the models are more complicated. Could you give us a sense of how would that 300 look if it was up 10 versus up 30 or some kind of range of outcomes like that?
Let me reemphasize what John said before. Rating agency require capital, there is Arch Management require capital. We always calculate our excess capital on the Arch Management require capital, which is a bigger number than what the rating agencies require us for our current ratings.
The reason we have that buffer, as we call it, is because we always try to operate with the simple principle that I want to begin the year and end the year with rating agencies require capital by having enough of a buffer that if I have a one in 250-year event, or if I have a 200 basis points parallel movement on the yield curve, my balance sheet can absorb that shock, $500 million-$600 million, between the earnings of the year, potential earnings, and the shock, I begin the year and end the year with rating agencies require capital. That is a very conservative position. As the models become more robust, you're never going to eliminate the variability of the models around the mean.
As they become more robust, we're getting more and more confidence, that means we might not have to keep as much cushion as we have in the past. That's our own internal determination. That's why we're spending a lot of time in trying to understand the changes in the model and what these numbers mean, how much cushion do we need in order for us to be feeling comfortable. Right now, I can tell you based on preliminary numbers, I feel that maybe we won't need as much cushion to bridge us between what the rating agencies want from us and what Arch Management with a cushion needs. We haven't made those determinations yet because we're still in the process of analyzing. The principle, though, we're not going to change.
We want independent of all these stress events, independent if it's a financial event with a significant movement on the yield curve, 200 points parallel move on the yield curve, or a $50 billion or $60 billion or $100 billion storm. We want to be able to begin that year and end that year with rating agencies require capital, so our rating doesn't suffer. We will be the company that is going to be the go-to company by clients because financially, we will continue to be very extremely strong.
Matt, we aren't in a position yet to give you any guidance on how the excess capital rating agency model works because they work both with single and also aggregate, and how all these add up across the board and how we implement RMS 11 can have an impact on that. So that's why it's still too early for us.
No, that's fair. I appreciate the color, Dinos. Because I think what you're saying is very fair and very thoughtful in terms of how to think about capital, and there are definitely some yins and yangs to how you implement this, and it shapes your total view of capital. But I guess what we're struggling on this side is just to try to think about, and this might not be the right way to think about it, but just for a reference point, getting a sense of what the potential change in PML does to capital on a static basis. And so, if you held your buffer the same, and let's say if we just held things constant and the PML went up, let's say under RMS 10, let's just say you wrote more business. Well, that might not be fair.
Well.
How does that 300 change?
Well, it's a simple calculation, Matt. It's a simple calculation. If you take it in a simplistic way, as you put it, you take your worst-case scenario, 30% on $700 million is $210 million. The excess goes from 300 to 100.
Okay.
It's not as simple as that. I don't want you to leave with the idea that it is as simple as that. That's why we do spend time analyzing and understanding what we have. Don't forget, we don't run the company because we want to be right that we have this excess capital, this short in capital. We run the company on the basis we're taking good exposures appropriate for the size of balance sheet we have, independent of major events, financial events, catastrophic events, et cetera, we stand as strong or stronger than most of our competitors. That's the thought process. Because the day after, it's how you feel the day after of a major event that is critical to us.
We want to always be the company that is first able and willing to satisfy the needs of their existing customers because they continue to have capacity and also acquire new. It's all interrelated. It's our thought process about what kind of balance sheet we have, how much room we have on the balance sheet, what the financial leverage is of the balance sheet. It's all interrelated.
Yeah. Matt, we don't think this constrains our ability to grow this implementation of RMS 11 from the preliminary work we're doing. As I mentioned earlier, if we see great business around the world, we can issue some more debt and grow as dramatically. There would be a constraint, a local constraint. We may cap out to be at our 25% of common equity in one zone and then cap that out because we will never take too much risk in any one place, no matter how good the pricing looks. Overall, we don't think this is a business constraining implementation.
Okay. No, that's fair. The color is good. Thanks.
Your next question comes from the line of Jay Cohen with Bank of America Merrill Lynch. Please proceed.
Yes. Thank you. Three questions. I think they should be relatively short.
It's a special. Three for one, Jay.
Call it two and a half, maybe. On the investment side, if interest rates in the market stay where they are, when would you think that the book yield would equal the new money yield?
Well, we have a duration of three, it'll roll over. We're not only investing in treasuries, we're investing in a series of investments around the world as well, both in the U.S. and other places. It would be next year to the year after sometimes.
Okay. Second one, this is a short one. On the reinsurance side, the growth in the cat business, did some of that growth come from retro deals? I know there was obviously some demand in the market for retro cover.
No, we're not fond of retro. We don't write but a tiny little piece of retro. Sometimes we're buyers of retro, but not sellers. No, it came from traditional, the excess of loss opportunities, both internationally and domestically. There was also some re-shifting on our domestic book as to what part of the tower we participate. Our guys always look to see based on their own curves as to where they think they're getting the best rate in relationship to the capacity they put up. That's where the changes were. Of course, we wrote some medium tail business that we thought it was attractive, and it gave us good ROE characteristics.
Great. Thank you. The last question, you mentioned claims trends and that 2.5% to roughly 6%. I'm assuming that's what your assumption is for claims trends when you're pricing and reserving the business. I guess the question I had was, are you seeing any changes in the claims frequency? Anything in this quarter that suggests the trend might be changing, even if you're not changing your view from a pricing standpoint, does the data suggest the world is changing at all?
Well, Jay, you're conflicting me because you say trend and then you want me. Trend to me is something takes over a longer period of time, one quarter. As John said, I think in his prepared remarks, he touched upon that our expected claim emergence was lighter than what we
The Chilean cat event.
Yes. Put the cat aside. On the regular book, both on an incurred basis and on a paid basis. It's only one quarter. Do you change your view for everything you do? We don't. At the end of the day, when we talk about trend is more longer term, and looking at a lot more than just one quarter's data.
Okay. I probably misused the word trend then, I guess. It sounds as if there was no data, no new information this quarter which suggests a change in the environment, in the claims environment, frequency specifically.
Well, we do the trend analysis by, as I said, by line of business, usually once a year. It's not always at the same time. One quarter they will do one product line, next quarter they're going to do another product line, and they cycle over because you got to divvy up the work. What John said, though, we always look at, but we don't pay a lot of attention to it, is that, yes, we have an expectation every quarter as to how much emergence we're expecting and how much both on a paid and on an incurred basis. It was lighter than usual. On the other hand, I had other surprises. My attritional losses on property, they were a little higher than what I expected. That happens. One quarter you got attritional going up, another quarter you have attritional going down. It's not always coming smooth.
That's the reason we don't take an indication of one quarter and we say that's a long-term trend and everything is going to change and it's going to be based on that.
Got it. Thanks a lot. I appreciate it.
You're welcome.
Your next question comes from the line of Scott Frost with Bank of America Merrill Lynch. Please proceed.
Hi. You talked about you didn't have any exposure to Eurozone issues, no peripherals. Is that mainly in the sovereign portfolio or is it also in the corporate portfolio? Maybe if you just go over your exposure to Eurozone credits in your investment portfolio.
Well, in contracts that we have, we don't usually hedge positions. We have what we call a natural hedge. If I write contracts that I have to pay in euros and I get paid in euros in premium, we try to invest the reserves we have or the obligations that they're going to come in that same currency. Most of that we do by buying German bonds, some corporate, and we buy some gilts in the U.K. for the British pound.
My balance right-
You know.
We don't have Italian banks, Greek banks.
We have nothing. We got no Spanish or Italian or Portuguese debt or anything of that sort. None on our book.
No exposure to Santander, for example. I think that was in your Q, it must have been in a special structured issue or something like that.
Yeah, we have a covered bond from Santander.
Okay.
Which is backed by paying mortgages.
Right. I guess that's the thing. Is there some sort of breakout of just sort of issuer exposure in, I guess, Eurozone, especially peripherals, by what, however characterized? Is that something that you guys have provided or can give some color on?
Well, we just said that other than-
Euro.
In these areas, we don't have any.
Zero. Okay. All right. Thank you.
Your next question comes from the line of Ian Gutterman with Adage Capital. Please proceed.
Hi, Dinos.
Hi, Ian. This time you're not last.
I'm not. I guess I was too fast punching it. I'm sorry. I can go back and hold if you'd like. A comment you made to Jay, I guess, a minute or so ago about the attritional losses being up in FAC. Does that mean that you actually had improvement in your accident year sort of ex the FAC? Because that's been stable for a while.
No, I didn't say it was high. I said attritional losses in property, they were a bit up this quarter.
Is that in the insurance or the reinsurance?
It was in insurance.
Okay. That's why I'm wondering because you reported, I guess, a flat accident year ex cat, but if the attritional FAC was worse this year, there was actually sort of an underlying-
Yeah. Also you got to look at the change in mix, too.
Yeah. FAC
That's what I'm wondering.
It goes up and down a lot.
Yes. The change in mix is. Don't forget, our casualty business is coming down. The highest loss ratio is associated with long-tail casualty. When you're going to writing less of that, and then you're writing more in small accounts and short tail, who has a lower loss ratio. You can't go from one to the other unless you had a static book. You got to look at it by component.
No, understood. I just want to make sure that's what.
Yes.
-also driving change. It wasn't something new. Okay. Your comment at the beginning about the 9% accident year return across the book, how does that differ in insurance versus reinsurance? I assume it's higher in reinsurance.
Yes.
Can you give some magnitude, or are we double digits reinsurance?
No, I don't want to embarrass my guys.
Okay. Fair enough. I guess I'm just wondering if insurance is pulling its weight.
Listen-
Maybe it's just insurance.
Insurance is not a business you can navigate as well as reinsurance. Reinsurance, you can be a bit more opportunistic, and fluctuate volume in more significant ways than insurance. I can tell you, and also the reinsurance business has the cat business, which is probably the best performing sector in the market, which the insurance business doesn't have the benefit of it. It's a bit unfair to try to compare one with the other. One strategy is working. I would say our insurance folks are in the double digits, and our insurance folks are a bit less than the 9%.
Okay.
We look at it as a combined company, and those things will change depending on where the market is.
Understood. Then just my last one is, I think, John, when you're commenting about RMS 11 and the different drivers, I guess what surprised me, some data I saw recently, it seems most of the companies are talking about the storm surge and the inland wind being the main drivers. I guess what I had seen was that the actual biggest driver was this change in the short-term environmental impact, which I guess surprised me because I didn't think there was anything new in the science that would have made that worse since they introduced that five years ago. Is that consistent with what you guys see when you look at it? If so, is that where your biggest concern is?
Well, it's not really a concern on the frequency. AIR had already published documents and papers on this, and RMS is now agreeing with it. It's really the magnitude. I think people agree that the warmer sea surface temperatures, which is a cyclical. There's very different reasons why people think it's happening, but it has happened, and the data is quite clear that there is a higher frequency when the sea temperatures are warmer. There are other factors that can also drive it as well, the sort of El Niño effects and things like that. It's really the magnitude, I think, by which this frequency, where you come down versus the long-term trend, and that's been subject to some interesting discussions and debate.
On that piece, I think our teams are kind of coming down that we think there will be a more frequent event of these storms while the sea temperatures are higher in the cyclical time. You've got to go backtrack it against all of your data and really come to grips with this. I think all three of these are going to be interesting as companies across the industry analyze this and implement this.
Okay. No, fair enough. I certainly agree that there should be some component for it. It just surprised me that they really hyped it up a lot, and it doesn't seem that anything's really changed from what we learned in 2006. If anything, from what I understand, some of the scientists they work with have now refuted what they put out in 2006, so it just surprised me that that was the main driver. It just seems the most flimsy. There's not the data to support it like there is on the wind speed or the storm surge. Is that fair?
Ian, you will never get enough empirical data to feel 100% comfortable. That's why you got to make judgments on these things. You can get very smart people on both sides of the table, and they can have very good arguments. By definition, they both cannot be right, but the arguments can be very logical. That's why it's taking us some time to understand it and implement, because it will have implications as to what happens to us as a company and what happens to the marketplace.
Ian, I would not say that one is dramatically that much more important than the other because it depends upon where you are and where your coverage is at, where are your exposures, because these can have different impacts depending upon where you are.
Got it. Makes sense. Thank you. That's all I had.
I would just like to clarify on the prior question about our exposures in peripheral European countries. We still have the $35 million Santander covered bond in our portfolio. That's our only exposure.
Your next question comes from the line of Vinay Misquith with Evercore Partners. Please proceed.
Hi, good afternoon. Question on the property cat business. Since capital is rising around 10%-30%, those are the requirements, and pricing is up maybe 8%-10%, how do you look at the profitability of the business? Has the ROE actually improved, and how does it impact your decision to write less or more business?
Well, there is two areas that you got to look at. One is your absolute tolerance. That is a zonal tolerance that says is 25% of equity capital. That might only be affecting one or two or three zones. This is a big world. The second part is where do you see price improvements, especially in areas that you did not have significant participation in the past and it had nothing to do about your capacity from a balance sheet point of view to engage those areas, but you just didn't like the price. There is a lot of room for us depending what happens with pricing in a lot of zones. Japanese quake, South American quake, New Zealand, Australia, European wind, et cetera. In all those zones, we're still significantly under leverage or underweight.
The areas that we're getting close to our risk tolerance is mostly in the U.S., Northeast, Florida, maybe the Gulf Coast. You got to look at it from that perspective, too. Sometimes individual pricing gave us more opportunity to ride in parts of the world that we were not a significant participant in the past, and we took advantage of it.
Sure. Has some of the increase in the property cat reinsurance this quarter been from Japanese covers and non-U.S. covers?
Some of it was from international covers. Some of it was from the U.S., some of it was from international covers, yes.
Okay. The second question is on more general pricing. Where do you think we are in the cycle right now? Your retentions are rising. Just curious what's happening on the competitive landscape.
Well, no different what is said in the prepared remarks. I think we have pretty much bottomed out. I don't think there is significant pressure for further deterioration with the exception of a couple of lines. Having said that, in some lines getting 1% or 2% increases doesn't even keep up with trends, so you're losing ground on that basis. Our retentions for us is because Not because we like the business more. You're seeing a change in our retentions because in the shift on the book of business, the more we write in small accounts, which we keep 100% net, it will have an effect into the net to gross numbers. Where we buy the most reinsurance is on the large accounts, the Fortune 1000 type of accounts, and as we write less of that, you see the changes in the retentions.
Part of the retention is not a change in strategy to buy reinsurance in a different fashion, but is more as the outcome of the shift in the book of business that we write.
Okay. That's great. Thank you.
You're welcome.
Your next question comes from line of Ron Bobman with Capital Returns. Please proceed.
Hi. Evercore Partners stole one of my questions, but I have a question about Japan. The severity of the quake, I'm told, was not part of sort of the data set that the modelers had sort of previously put forth. I guess sort of the knock-on effect of it actually being an offshore quake yielding a tsunami, and the nature of the losses. Are there any sort of lessons learned, or just observations that sort of, your takeaway as a result of the Japanese quake and how losses are unfolding and the types of companies that are incurring losses at the insurance and I guess reinsurance level? Thanks a lot.
Well, hi. There is lessons learned. I think everybody, including us, was surprised about the devastation a tsunami can have. You've seen the pictures, and you've seen the force, et cetera. I think at some point in time, all that going to get recalculated into the models. It never really changed our view that we always view Japanese cat pricing to be inadequate. For that reason, and we were patient for many years because in the years that you had no events, any price looks adequate, right? You take in premium and you have no losses, so it looks adequate. It's only when the event happens. I think we benefited of having way below our norm tolerance for risk in Japan because of pricing. Has the pricing come up to the level that it makes us want to go in with both feet? Not yet.
We still have been very good corrections in the right direction. Also, I think not everybody has digested the total loss that is going to emanate from that because the business interruption and contingent business interruption issue, we still don't believe is a big issue, but it still has not been settled. We're only going to find out in the next two, three years as it evolves. I think you will see over time readjustments as to how those covers get priced. If it gets to the point that we think is attractive, we have plenty of capacity to come in. Right now, I think our appetite for Japan is limited.
Thanks. I have another sort of broader quake-related question. With some degree of probability of aftershocks producing meaningful insurance losses after an initial quake, how does anyone really get comfortable, and obviously, how does Arch get comfortable even entertaining participating on a program renewal that suffered a quake loss during its prior 12-month contract life?
Well, it's a complicated question, you do anticipate aftershocks. It's not proven to us that the aftershocks do significantly more damage to the existing damaged buildings. Usually, there is a lot of damage that happens when the quake happens, when a structure has significant damage, an aftershock is not going to change your loss potential. A lot of these buildings, they get declared total losses. They have to be demolished and rebuilt so the aftershock doesn't have a major effect. Our underwriters have empirical data and statistics, we know less about quakes than we know about wind. Wind is a much better area. In essence, you got to go with the long historical averages.
People who say that, "I wrote this cover for half, and I don't want to write it for 2x because I'm afraid of an aftershock," it sounds illogical to us. Unless they have significant scientific evidence that an aftershock is going to happen and it's going to be significant, and it will damage new exposures.
All right. Thanks a lot. Great job as you've always been doing.
Thank you.
Ladies and gentlemen, that does conclude our question-and-answer portion of today's call. I would now like to turn it back over to Mr. Dinos Iordanou for closing remarks.
Well, thank you all for listening to us, and we're looking forward to talking to you three months from today.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.