Good day, ladies and gentlemen, welcome to the first quarter 2011 Arch Capital Group Ltd. earnings call. My name is Modesta, 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, 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. 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. Certain statements contained in the call that are not based on historical facts or 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 host for today, Mr. Dinos Iordanou, Mr. John Hele. Please proceed.
Thank you, Modesta. Good morning, everyone, thank you for joining us today. The first quarter catastrophic events were yet another clear reminder that we're in the risk business. Considering the magnitude and number of these events, our performance was acceptable in absolute terms and superior relative to peers that are similarly engaged as we are in underwriting catastrophe business. I continue to be pleased with the discipline exhibited by our insurance and reinsurance underwriting teams in executing our overall underwriting strategy. Our strategy has been to stay within our risk management tolerances and only accept and underwrite risks that are priced appropriately on a risk-adjusted basis in order for us to achieve the required returns relative to the risk assumed. Our performance in the first quarter emphasizes the good execution of that strategy.
Our total catastrophe losses for the quarter were $178.7 million, with the Japanese quake contributing $79 million, the New Zealand quake adding $65 million, and the balance coming from the first quarter Australian floods and Cyclone Yasi. Our annualized return on average common equity was 0.8% on a reported basis, which was negatively affected by the above-mentioned cat losses, which exceeded our quarterly cat load by a significant amount. By our own estimation, we continue to believe that in the current underwriting and investment environments we operate in, on a normalized basis, we are still able to achieve approximately 9% ROE on an underwriting year basis. This is essentially the same ROE we achieved for the 2010 underwriting year. Our investment performance for the quarter was good, with a total return of 1.5% achieved for the quarter.
Despite a slight upward movement in treasury rates, we were able to achieve this very good result. As a result of this good performance, despite the cat losses, we were able to increase our book value per share to $91.02, which is an increase of 18.3% from a year ago and 1.2% sequentially. From an underwriting point of view, we achieved 110 combined ratio for the calendar quarter, which we believe is approximately 13 loss ratio points worse than our normalized accident quarter combined ratio. Cash flow from operations remained good at $225 million. The broad market environment continues to be competitive, with most long-tail product lines having plenty of capacity available and which continue to experience slight price declines. In the property and property cat areas, the environment is improving, with the greatest improvements today reflected in international cat-exposed businesses.
From a premium production point of view, our gross written premiums for the quarter were up 1%, and our net written premiums were basically flat. Our insurance operations were up 2% on a gross written premium basis and flat on a net written premium. Our insurance operations were flat on gross written and down approximately 1% on a net written basis. During the quarter, in our April 1 renewals, we saw no significant change in market conditions in most of our reinsurance business, with what I mentioned before, property cat area being the only exception. We continue to see pressure from cedants to increase ceding commissions, and in general, we saw a reduction in primary rates, which affect all of our pro-rata businesses of approximately 4%.
We also noted that the clients are continuing to look for opportunities to switch from pro-rata contracts to excess of loss in order to maintain a larger amount of net premiums on their books. In our cat business, we saw increased submission activity as a result of clients seeking to move to more secure capacity and brokers anticipating an increase in demand due to the implementation of RMS 11. The implementation of RMS 11 has not yet been adopted by the broad market as the vendor continues to field test and make modifications. We expect this process to be finalized in the next few months and by mid-year. 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 expected returns.
We are starting to see some of these opportunities, both in our existing product offerings as well as on our new product initiatives, which has helped us to stabilize premium production. Our insurance group continues to emphasize and move their books of business to smaller accounts and to less volatile lines, with an emphasis on reducing their exposure to U.S. casualty business. Two areas with significant volume reductions in the first quarter were executive assurance and aviation. We continue to see the market granting rate declines in segments of the D&O product line that we cannot support. Of course, as we have stated in prior calls, we have exited the commercial aviation business. Our exit from the aviation business happened in the second quarter of 2010, so the second quarter of this year will be the last one that will materially affect year-to-year premium comparisons.
We saw increased activity and opportunities across our business segments and resulted in premium increases in international professional liability, international casualty, including motor business, national accounts, and lenders products. We continue to monitor the primary casualty in a sector in the U.S. as we continue to see price increases in isolated areas, but we're not yet at a point to switch from defense to offense, as we still believe that the improvements today will not produce adequate returns. During the first quarter, our board increased our share repurchase authorization by $1 billion and extended the time horizon in which to execute the authorization to the end of 2012. In the first quarter, we purchased 2.7 million shares for an aggregate value of $237 million, which represents an average price of $88.25 per share. So far, in the second quarter, we have not repurchased any shares.
With these repurchases, our remaining available authorization stands at $992 million. I would like to reiterate that our capital management philosophy has not changed. We will continue to return excess capital to our shareholders until such time that we can profitably deploy it in our business. 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 April 1st, under RMS 10, a one in 250 PML from a single event was $726 million, or 18.1% of common equity. This represents roughly the same exposure amount as of a quarter ago and a slight increase as a % of common equity due to the reduction of our common equity from our share repurchases.
Under RMS 11, based on the current iteration of the model, our preliminary estimates of PML for one in a 250-year event will increase approximately 32% in the Northeast zone, 22% in Florida Tri-County zone, and by 29% in the Gulf. Under this scenario, our largest PML will be the Northeast zone with $955 million or 24% of common equity, which remains within our risk management limits. With that, I'm going to turn it over to John for his comments, and after John, we will take your questions. John?
Thank you, Dinos. Good morning. I will now cover some of the financial highlights of this interesting quarter. For the 2011 first quarter, property and other short tail lines represented approximately 47% of our net premium volume, compared to 50% in the 2010 first quarter. However, on a trailing 12-month basis, the ratio is about the same at 45%-46%. On a consolidated basis, the ratio of nets to gross was 79%, roughly the same as a year ago. Our overall operating results for the quarter reflected a combined ratio of 110%, compared to 96.4% for the same period in 2010. The 2011 first quarter loss ratio included $179 million, or 28.2 points of current accident year cat activity, compared to $58 million, or 8.7 points in the 2010 first quarter.
The Australian floods and Cyclone Yasi had a gross impact of $44 million, net impact of $33 million, which came in at the low end of our previously announced estimated indicated range of $30 million-$60 million. The New Zealand earthquake was booked at $86 million gross, $65 million net, which came in at the higher end of the range of $35 million-$70 million. While Japan property losses were booked at $86 million gross, $63 million net, which compares to our previously announced one in 100 PML for Japan of approximately $60 million. Japanese marine and personal accident losses were $16 million net and were not included in the P&L calculations. The cat losses in the 2010 first quarter were primarily related to the Chilean earthquake.
The 2011 first quarter combined ratio reflected 9.2 points, or $58 million of estimated favorable prior year reserve development, net of related adjustments, compared to 4.4 points or $30 million in the 2010 first quarter. The prior year development in the first 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 from the 2002-2005 underwriting years. In particular, the favorable development included $15 million related to reductions for prior year named cat events. Overall, our reserve position continues to be reasonable to slightly conservative. The 2011 first quarter current ac year combined ratio, excluding large cat events and net favorable development, was 99.9% in the insurance segment and 75% in the reinsurance segment, both consistent with results of a year ago.
The 2011 first quarter expense ratio of 32.1% was 0.4 points lower than the 2010 first quarter, benefiting from a lower level of contingent commission expense and certain costs which were incurred in the 2010 first quarter that did not reoccur. The impact of these items were partially offset by the impact of a lower level of premiums earned in the 2011 first quarter. On a per share basis, pre-tax net investment income rose to $1.89 in the 2011 first quarter, compared to $1.67 the same period a year ago, and $1.81 in the fourth quarter of 2010. Income for the 2011 first quarter included $0.08 or $4 million of expected non-recurring dividend income. Our embedded pre-tax book yield before expenses was 3.36% in the 2011 first quarter, down from 3.52% at year-end, which reflects lower reinvestment rates and a shorter duration.
Total return of the investment portfolio was 150 basis points in the 2011 first quarter, compared to a loss of seven basis points in the 2010 fourth quarter. Excluding foreign exchange, it was 114 basis points in the quarter. The total return in the first quarter benefited from good returns on our equities and other alternative assets, partially offset by a slight increase in interest rates during the period. We recorded net foreign exchange losses of $37 million, which results from revaluing our net insurance liabilities required to be settled in foreign currencies and resulted from the weakening U.S. dollar in the quarter. This should be compared to the 36 basis points contribution to total return from foreign exchange on our investment portfolio, which offsets this income statement loss in the equity section of the balance sheet.
Throughout the past few quarters, Arch continued to allocate more assets to equities and alternative investments. Our allocation to equities was approximately 3.5% of our investable assets at quarter end, while alternative investments and equity method investments were 6.6% of our investable assets. 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 double A plus. The duration of our investment portfolio decreased to 2.73, down from 2.83 at year-end. For the 2011 first quarter, our effective tax rate on pre-tax operating income was 2% and -1.5% on pre-tax net income. Our expected range for 2011 for pre-tax operating income is 1% to 3%. Certain factors can always cause the tax rate to fall outside this range.
Our balance sheet continues to be conservatively positioned with total capital at $4.7 billion at March 31st, 2011, down from $4.9 billion at year-end, reflecting the share repurchase activity during the quarter. In the quarter, we repurchased 2.7 million shares for $237 million at an average price per share of $88.25, which added $0.16 to our 2011 first quarter ending book value per share. Our debt plus hybrids represents approximately 15% of our total capital, well below any rating agency limit for our targeted rating. Our book value per share ended up the quarter at $91.02, up 1.2% from year-end and 18.3% from a year ago.
Our excess capital position, which we define as the rating agency actual capital in excess of the required capital for an A-plus rating plus a buffer, was estimated to be at least $600 million at the end of last year under RMS 10 and including AOCI. The reduction in capital, mainly due to share repurchases in the quarter, brought this down by approximately $200 million to $400 million. The final implementation of RMS 11 and the rating agencies' reaction to this one model may also have an impact on our excess capital position. It is too early to estimate this impact. With these comments, we are pleased to take your questions.
Ladies and gentlemen, if you have 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 Jay Gelb with Barclays Capital. Please proceed, sir.
Thanks. Good morning. 2 issues I'd like to cover if I could. First, in terms of the pace of share buybacks, you mentioned that Arch had not repurchased any stock in the second quarter yet. I'm trying to figure out if that's a signal you think that you're going to have the ability to write more business or if it's driven more by the implementation of RMS. That's the first one in terms of the outlook for share buybacks. The second one is, can you talk about more broadly in terms of the expectations for the June and July reinsurance renewals for the U.S. and in terms of what your expectations are there? Thanks.
Okay. On the first one, usually when we're in the closed window, we put a 10b5-1 plan, and the parameters we put didn't allow us to purchase any shares. It doesn't mean that we're not going to continue to look for opportunities for us to return excess capital to shareholders. Our usual pattern, though, is we do more in the first and fourth quarters, and we do less in the second and almost none on the third, on the basis that the hurricane season is on the third quarter, and we want to make sure that we know the outcome of the season before we go back and accelerate the share repurchases. No real change in strategy yet. Too early to tell if RMS 11 will have a significant impact or a slight impact.
We're in discussions with them and also with the rating agencies, and we'll know that, and we're factoring into our calculations to derive as to how much excess capital. We still have excess capital on the books, even though there were not a lot of earnings in the first quarter, and we did repurchase quite a bit in the first quarter. No change in strategy on that. Your second point, you're focusing mostly on the cat business. All I can tell you is that the environment is better today both significantly better on the international property cat area and better for domestic, especially Florida and Northeast. As I said in my prepared remarks, I think there is two factors by our own estimation that is causing that. There is more need for more secure capacity.
Some buyers, they rather do business with the A-plus companies than the A or A-minus companies if they can get more capacity out of them. Two, they're anticipating demand because the PMLs will escalate with RMS 11 will increase. We haven't seen that effect as of yet in the marketplace because everybody is dragging their feet in implementing RMS 11, and there is kind of a delay effect to it. It's already affecting the market because the ask even on great programs is slight negative or flat by the brokers and on not so great programs, you're getting rate increases even for U.S. Too early to tell, but June, July. By the next call, I think we'll have more clarity on that issue. John, you want to add anything to that or?
Yeah.
John, go ahead.
Just to follow up on that quickly. Sorry, John. Some of the brokers have come out and said slightly negative to flat for the June, July reinsurance renewals. Do you think that's a reasonable expectation? We've been hearing elsewhere from some other reinsurers of much higher expectations for rates.
You're asking me to guess. I don't know how the market will react. If I had to bet, I'm not a betting man. I like my dollars in my pockets, I don't bet. I would say probably will be flat to up as an outcome, not negative to flat. Yeah. We're still at the bid-ask spread of the process here. I think, it takes a little more time before you get some clarity where the market's going to settle.
The retro market is very hard right now. Not a lot of capacity in the retro market. Some participants, their capacity is driven or derived because they can buy retrocessional protection. Absent of that, you might have some players that might not have enough capacity to deploy, your supply-demand balance changes, especially with RMS 11 pushing PMLs up. In essence, pushing demand up. The buyers, they're resisting accepting it, and they're trying to rope a dope, delay, and hoping it will go away. I don't think it's going to go away. It will get readjusted, but it will have an effect in the market, and the effect will be positive.
Very thorough. Thank you.
Your next question comes from the line of Dan Farrell with Sterne Agee. Please proceed.
Thank you and good morning. Just a quick follow-up on the models and the PML numbers that you gave. To what extent do those PMLs also factor in the other modeling companies and your own internal assumptions? When you went through the exercise, how do you decide how to weight each model in your own internal views when you come up with your own results?
Well, we underwrite on a combination of models and adjustments we make to the models, and that's been our history. We don't take any one model and derive all of our decisions out of it. For consistency in reporting to you the PMLs, so you can have a point of reference that is consistent on a quarter-to-quarter, year-over-year basis, we always use RMS in its purest form without any modifications our cat teams will do by using either AIR or our own internal modifications that we do. Two different things. I report to you purely on RMS, and those escalations is using our data sets, running it on RMS 10 and RMS 11, and getting the numbers. And you've seen that it's around high 20s, low 30s, the escalation from one to the other.
These are still preliminary, though.
Right.
This is still underway. Our teams are still in discussions with RMS on all this. We thought it'd be good to at least share with you where we're at at this moment.
Right. It doesn't mean that's what we use to underwrite. Our underwriting process is much more complicated than that, and we don't talk too much about that. We like to enjoy the results we have been enjoying in underwriting cat business for 10 years, we try to be as secretive as we can.
That's helpful. I think even if they're preliminary, those numbers are certainly helpful to provide, so thank you. Just one other follow-up. Can you talk about your purchases of any retro cover yourselves in the first quarter?
We had purchased retro cover that gave us, as you can see, there is a gross and net outcome, and I think we put it on the press release. The likelihood of us renewing that, depending on what prices are, is small right now because we'd rather be a seller than a buyer right now based on where the prices are.
Okay. Thank you very much.
You're welcome.
Your next question comes from the line of Dean Evans with KBW. Please proceed.
Yeah, thanks. I was first wondering if you could sort of just touch on the three losses a bit. What could cause them to drift upwards or could cause us to see increased loss numbers there? I guess if you'd be willing to comment, what % of contracts for each of them are kind of booked at the full limits? Just any color you could give on those angles would help.
Well, you have the spreadsheet in front of you, John. I don't know if we do. Let me give you the first broad question. I don't think the losses, at least for the reinsurance world, might have significant escalation. The one event that has the most potential is the Japanese quake, and the contingent business interruption, it's an area that it might swing. It's not going to be a significant number in the scheme of things. If you believe the industry loss is somewhere between $25 billion-$35 billion. They insure industry loss being between $25 billion-$35 billion. With heavy contingent business interruption losses, you might be on the upper end of that scale, and you might be on the lower end if that is not a significant factor. I don't think it's going to change things significantly.
Now on the contracts we have, yes, some contracts we have booked to if we believe that the limit is gone, we booked a full limit, and some of them we have not. It was a process that we went through identifying all the contracts we had information that we had from brokers and cedents, also using other methodologies like market share based on industry loss. From model, putting it together, we came up with our booked estimate.
Okay. That helps a bit on that. Second question, shifting gears, if I could. Looking at the reserve development, even stripping out the $15 million from the named cat events, it does seem a little bit higher than maybe the historical run rate the past year or so. Could you give a little additional detail? You touched on it a bit in prepared comments, but maybe just a little additional detail on where the reserve development's coming from, what accident years and some of the specific business lines.
Yeah. Before I turn it over, let me give you a general comment, and then I'll turn it over to John, who can give you maybe a little more detail. The cat event came from both Chile, I think-
Australia
Australia flood. In the Australia floods, you remember we had two events. We had a December event, and then we had a January event. When we were booking the losses for closing the fourth quarter of a year ago, we put quite a bit more than we needed on the December event. Upon reflection, we had to release that. It was more losses coming from the January event, not the December event. The Chile was an overestimation by us, and the losses didn't develop. Put that aside. That's a one-off. It happens. You try to be conservative in setting up your estimate. Let's face it, quakes are very hard to estimate until you get all the information. Now, the 2002 and 2005 years in casualty reinsurance, they're really performing extremely well for us.
Since there has been at least six years and maybe up to
More
eight and nine years on the earlier years, we have more certainty. As those diagonals on the triangles getting developed, I think you might be getting outside the point estimate range that you're allowed, then for that reason, we had to release the rest of it. With that, I'll turn it over to John to give you a little more color on the specifics you asked.
Yeah. Well, certainly Arch takes its time when looking at casualty. I think history's shown that you can be a little too optimistic on these lines sometimes. We tend to wait some time for it. These 2002 to 2005 years in reinsurance, really, we do our audits. We look at what's happening and developing, and we felt it was appropriate to release these years from 2002 to 2005. We also had property cat had prior year favorable development, both in Chile, and also in Australia floods, but also just general, other than the large named cats, we have a cat load for just smaller cats, those just released and really came through on a flow-through basis. Those were the largest points. The property happened both in reinsurance and also on the insurance side.
Other than the 15 that it was specific to the two events. We had more property-
Bit more
we had more property releases both on insurance and also on the reinsurance side.
Okay. That's very helpful. Thinking about the casualty reserves a bit, when do you start to get comfortable about some of the more recent accident years there, like the '06, the '07, the '08? As of right now, are you seeing the same types of favorable trends that you've seen from the '05 and earlier from those years?
No, you're getting into years that we have concerns, not comfort. When you get into the '08, '09, '10 years, we have concerns. Not with us, but in looking at the aggregate accident year numbers that the industry has booked and all that, if I have to guess, probably if you see any development in those years, it won't be positive, it will be negative development. Meaning people, they're going to have to add to it, not release from it. We're in that peculiar period of time in our business that the rate reductions now, they've been almost five years or so. There's been rate reductions coming going back to '05, '06. At some point in time, rate reductions have a way of eroding margins. Even if you have thick margins, it becomes thinner. At some point in time, they get to be negative.
People don't always recognize that. At the same time, you have the old years, the 2002, 2003, 2004, 2005 years, that they're getting more mature. Cases get closed. You don't have that many open cases. You're carrying a lot of IBNR. The actuaries are looking at it, the accountants are looking at it. It says, "What are you doing with this? You've got to release it." If there is no claims, there is no claims. We're in that peculiar period of time that you're going to see releases coming from the good underwriting years, especially for those who haven't released them yet. At the same time, you're going to see current accident years maybe not being booked exactly where they need to be. That's what makes cycles.
At some point in time is when that pain comes in, with the current accident years being unacceptable, that you're going to see the broader market to turn. The market is trying to get this uplift. The rate reductions, they have been small. There is a lot of pockets that you're getting increases. You got to look hard for them to find them. It's not a broad market. It's basically, I would call it more of a bottoming and a recognition that things have to improve, otherwise there's going to be blood on the street. That's our point of view about the market, where it is.
You remember that you can have casualty lines, you can have some fun things pop up seven years from the year. To answer your question, our 2010, well, 2017, we will be cautious and wait to let those fully mature.
Okay. That's borne out by your history, and we appreciate that. Thank you for the thoughtful responses.
Your next question comes from the line of Brian Meredith with UBS. Please proceed.
Yeah, good morning.
Hi, Brian.
Dino, there's a couple of questions. Most of the growth this quarter, a lot of it, I think, was coming from casualty lines. I need to point out a lot of that's in the international side. Just wondering, what's the difference in the market dynamics over there, and why are you seeing better pricing in some of those other casualty lines?
Don't translate that as optimism. It was opportunistic. Most of the casualty increases came from energy casualty related business and marine liabilities, and it was more of the aftermath of Deepwater Horizon. There were programs coming up, and most of it was rate increases. In essence, and my guys, they told me three times yesterday when I was preparing for this call, says, "Keep telling them it's one-off, because don't let them think that it will repeat itself quarter after quarter." That's that part.
Professional liability.
Professional liability. It's a team of underwriters. If you've been watching us closely, we hire about, I would say, a year ago, 5 quarters ago, they came from Lloyd's. They underwrite a professional liability for small and medium-sized enterprises. They have a terrific track record with extreme profitability through the years. It took him some time to get accustomed to us and our systems and get traction, and that's where that business is coming from. That is more, I would say, has more potential to be having more growth depending where the market goes. We're pleased with both areas. This is not a broad movement on the casualty lines in the international arena that we think the environment is much better. When we find certain opportunities because of an event and we can take advantage of it's in our nature to do that.
They're already in this professional liability, mainly in continental Europe for the SME type businesses.
Right.
Next question, just quickly on the capital management and excess capital. You talked about it being in excess of kind of where the S&P levels are. I'm curious, when you talk about excess capital or you talk about that, are you factoring in ability to take, call it a one in 100-year PML loss and still be able to write business without raising equity capital, or how should we think about that?
Well, it's the same formula we had in the past. We take the rating agencies require capital at our rating. We look at how much capital we have. We add to that capital what one year's earnings will be, we subtract from it the one in a 250-year event, that gives us the cushion that I can begin and end my year with a one in 250-year event with my required capital. The rest of it, I consider excess.
Excellent.
You got estimated earnings that you're comfortable with. You know you're going to eat up the earnings for the year if we have an event. I need to have a little extra above it because the event might be, I don't know, twice our earning potential, whatever it is. I account for that. Basically that gives me the rest as excess capital.
Perfect.
Brian, that's what I refer to as our targeted rating plus a buffer.
Got you.
Right.
That's great. Thank you.
Your next question comes from the line of Mark Dwelle with RBC Capital Markets. Please proceed.
Yeah. Brian actually took one of my questions. The other question that I had is, within the investment portfolio, the cash and short-term investment component continues to rise fairly sharply. Obviously, we've had a little bit of a reversal in short and medium-term rates. Is there any plan to deploy any of that on a little longer term basis? I know you commented in terms of adding to the equity exposures, but it seems like the liquidity end of it is you're still keeping an extremely short duration there.
Yeah. I don't think our outlook is changing. We want to be short in the current environment. We're in the camp, and we don't know if we're right or wrong, but at least we tell you how we think. We're in the camp that we're afraid interest rates will go up, not down. That will have, if you're long in duration, it has a devastating effect on your portfolio. What we're doing. It's also difficult for you as analysts to go quarter to quarter and see what investment income is. Not only are we putting some more into equities, but also we're putting more money into sometimes segregated funds that we're forced to account on the equity method, even though some of the investments in those funds might be fixed income type of investors. If we own them outright ourselves, they'll probably count as investment income.
Because of the structure of the transaction, we have to account for them on an equity method. We focus more on our total return and how well we do quarter after quarter, not the accounting, because every time we get with accountants, it's a three Advil discussion with me, because they got so many rules. I'm a reasonably smart guy, reasonably. Take that with a grain of salt. I get confused with all the accounting rules. They got so many, it's beyond my comprehension sometimes.
Mark, Arch always believes in running a conservative investment portfolio. It's a fascinating time when a conservative portfolio may not mean investing in long-term treasuries. It's sort of the opposite way. We think being shorter is the correct approach today for the risks that are out there, and we'll have to wait and see if we're proven right or not. Going long right now just doesn't appear to be a good risk return trade-off.
Okay. Thanks for the clarification. Thanks.
Your next question comes from the line of Jay Cohen with Bank of America Merrill Lynch. Please proceed.
Thank you. Good morning.
Hi, Jay. How are you?
I'm great. The continued healthy level of favorable reserve development, even excluding some of the named cat favorable development you talked about, I guess suggests that the claims environment hasn't changed all that much. I'm wondering if you could talk about that, what you're seeing from a claims frequency standpoint and newly arising claims.
Well, don't forget, a lot of our favorable reserve development is coming from the years that both the frequency and severity, they were very favorable. The frequency trends are still positive, meaning that we don't see an uptick in frequency. We're starting to see a little bit of an uptick in severity. Of course, what you need to worry about is not only what we see, but how you project into the future, because it's not CPI that causes us problems. It's wage inflation that it will cause problems. It's medical inflation that we already have in the numbers that causes problems.
Most importantly, it's socioeconomic inflation as to how 12 jurors in a box, they're going to determine if half a million or a million dollars is a little bit or a lot of money when they have to determine pain and suffering or anything of the other theories that the plaintiffs bring forward. I think that period of time that we had low frequency and low severity, it will reverse itself. Especially when people feel more wealthy, I think the numbers all of a sudden, even when they have to calculate pain and suffering, go up. We call that socioeconomic inflation. Very, very hard to predict, but you got to have your eyes open.
That's why in maintaining our claim process true to what's going on in the environment, every single open case we have has to get reviewed at least once a quarter and get readjusted to all the new information we have, independent if it's changing case law or new reality. In order for us to be able to derive our needed pricing going into the future on an as-needed basis. It's not an easy process. That's what makes this business more interesting. Not having the right reserves is not just embarrassing when you have to make a reserve addition. It's problematic because it might be guiding your underwriting to be pricing the business at not adequate rates because you didn't get your reserves right.
That's why we looked at not only our own data, but we looked at a lot of industry data, in order for us to have a point of view on pricing that allows us to feel comfortable for the business we put on the books.
That's helpful. I guess, just to follow up on that, on the property side, we certainly read a lot about commodity price inflation and building materials, whether it's steel or lumber or roofing shingles. Has that shown up at all in property claims?
No, because labor cost, which is a big component, is so much down. It's more unemployed construction workers. I think the construction industry is the hardest hit industry. Listen, I'm in the midst of building a house. I gave my wife an unlimited budget, and she's exceeding it. I can tell you, when I negotiate with these guys, we get prices that even my GC says they're unbelievable today. I know firsthand that it's a good buying opportunity. If somebody wants to build a new factory, this is the time to do it. If somebody wants to renovate a home, this is the right time to do it, in my view. That can change quickly. You get unemployment, you get new construction permits. If we're going to start getting into street and roadwork, and you will see that escalate very, very quickly.
Great. Thanks for the answers.
You're welcome.
Your next question comes from the line of Matthew Heimermann with J.P. Morgan. Please proceed.
Hi, good morning, everybody.
Hi, Matt. How are you?
I'm well. Thank you. Hopefully, these will be quick. I'll give them to you first. A lot of other commentators or managers of companies have suggested that they've made tweaks to the models over the years. Therefore, that's going to mitigate the impact that RMS 11 might have on these folks. I'd just be curious on if that's something you did internally, because based on the numbers you gave, it didn't necessarily sound like it was dramatic if that was the case. Then, how believable some of the other commentary we may have heard is. Then just quickly, remind us what alternative markets business is, and also just the national accounts. That's one following up on Brian's question. That's another area that popped after several quarters of pretty significant reductions. Just some context there.
Okay. Let me start. Three questions. Let me start with the first one. The first one. First, the numbers we gave you is purely running the model at its purest form, okay? That's the comparison. Usually, I think the statement others made, also what we do within our shop is correct. Very few shops that they will run the model and underwrite without any modifications. We always had modifications, especially in Florida. Our cat teams had a different point of view about damageability in inland areas versus the models. It steer our underwriting posture in a different direction than others. I can't tell you as to what other modifications others make. I knew our guys, they were modifying their approach to underwriting, especially in Florida. Some of that comes from the experience we have with different storms.
If I take you back to 2004, Charley entered from the Gulf and exited into the Atlantic, I can tell you he did more damage exiting than entering Florida. If you go back and see what happened, people are going to tell you it was a narrow storm, the width of the eye wasn't that wide, et cetera. What difference does it make? Here it is. Here's a storm that was doing a lot of damage in the middle of the state than it was doing on either one of the coasts. Our guys, in their thinking and modifying things, they change their underwriting approach. It wasn't just that storm. They do a lot of analysis. The statement that others make that they do modify the models is correct, we do it, I'm sure others doing it as well.
Alternative markets is predominantly self-insure programs that buy rented captives. We have a captive capability in Bermuda. This might be a collection of clients that they want to self-insure most of their primary risk. Most of their primary risk is GL auto liability and workers' comp, they might be taking maybe the first $250 or maybe half a million of each and every loss, then they will buy a bit of the excess and maybe some aggregate protection to protect around the captive. We're in that business because we have the capabilities of managing all that. In national accounts, it's a similar business, exactly that, GL auto workers' comp, written for a single entity, a very large corporation that they want to self-insure quite a bit of their primary risk.
A lot of them, they will take $250 on each and every loss and/or half a million. When I say primary, is the first $1 million of risk on the GL and auto and then statutory, of course, on the workers' comp. That's what we do on those two areas. A lot of this business, it has some underwriting risk, is more limited. You're underwriting the buffer, in some cases, you're underwriting the aggregate stop that you might put. To be successful in this business, you have to be very good in service because it's a service-intensive business. I think we're small in the sector. We're not as big as the Zurich or the Travelers or the Hartford or AIGs, et cetera. For the clients that we attract, we give very good service, our retention percentages are very high.
Thanks for that, Dino. Just following up on the first question on the PML then, is it fair to say then that the, I forget exactly what the number was, but relative to your, it was 24% of capital, the 955.
If we take it at its face value, yeah.
Realistically, we're probably splitting the difference somewhere.
It could be. Don't forget, it's only for our Northeast zone. A lot of zones around the world, we don't have that much exposure. The zones that it will affect us a bit is the Northeast and maybe a little bit in Florida. We still have quite a bit more capacity in Florida. The changes on the quake was they were minimal.
Matt, it's John. This is still under review. We're in discussions with RMS to truly understand all the various components of this. We still stress preliminary, but thought we would just give you an indication.
Okay. Much appreciated. Thanks.
Your next question comes from the line of Greg Locraft with Morgan Stanley. Please proceed.
Yeah. Hi. Thanks, guys. Just again, on this RMS model. If I seem to recall, I think you all had excess capital a couple of quarters ago in the $600 million range at the midpoint?
Correct.
Okay. If I now run it forward, we've had a heck of a quarter in terms of the storms. You guys were very aggressive and continue to be aggressive in buying back capital, and then the PMLs went up. It's not a stretch to say your excess capital is less than $600, right?
Well, we said it's already-
400
$400, and it might go even below that depending on the RMS 11 implementation.
Okay. That $400, I apologize that I missed that number. That $400 is without RMS or is with RMS?
It's based on the old RMS model.
Right, on RMS 10.
Okay. Then RMS, you take the PML from a 726 to a 955. Why wouldn't I just assume that 400 goes down by another 200-ish?
Well, that's a simple mathematical approach to it. It depends what the rating agencies are going to do with the new PML. Is that going to require additional capital or not? The rating agencies in their capital model, they're not looking at just one event. They're looking at the aggregation or the aggregate exposure that you have over multiple events within the same year. It's not as simplistic as doing that calculation.
There are also multiple models.
Right.
Which the rating agencies are still learning about all this, as we are with RMS 11, so we need some time to sort all of this out.
Right. Don't forget, that's my own calculation as to how I determine the cushion. It's not what the rating agencies want. I go far beyond the rating agencies' requirements. If I don't believe 955 is the right number and I'm going to modify my internal models and let's say that number is 800, that's what I'm going to use. There is still a question as to how much safety we need to have in the way I calculate excess capital.
No, I totally appreciate that. You guys have always had tremendous levels of excess capital, and I guess I'm sort of surprised at the rate of decline in six months in your levels of excess capital. I sort of wonder, in a world without retro, how do your peers and how do people manage going forward?
Listen, it depends how they count. Also, don't forget, I bought aggressively in the first quarter because I took shares back because I thought it was the right thing to do for shareholders. When I combine my shares at pretty attractive prices, I knew based on the events that our earnings, they're going to be skimpy or nonexistent, right? As it really happened. When you get three major events in one quarter, we're lucky to be in the plus, right? At the end of the day, you got to know your book of business, you have to understand your capital position, and manage accordingly. We will never run this company thin on capital.
We will always have the cushion that we like to have to handle, in our view, a one in 250 event, and begin the year and end the year with the required capital the rating agencies want for a rating. The whole principle around that methodology is that I want to be on the dance floor when if you have a one in 250 event, which in our estimation, depends which part of the world. If it happens in Florida, it's an $80 billion-$100 billion event. I can tell you have a totally different market, and I want to be one of the companies participating on the aftermath of that.
That's why we're conservative with that's why we're conservative also in our capital structure, by only having about 15% of our capital in hybrid securities debt and hybrids which allows me to quickly access the debt markets if I need to. The opportunity to expand dramatically is there.
Okay. Thank you very much.
You're welcome.
Your next question comes from the line of Matthew Carletti with JMP Securities. Please proceed.
Hi. Thanks for taking my question. Real quick, just wanted to circle back to the share repurchase discussion. I know you talked about how maybe changes in the RMS model play into that, as well as obviously capital levels. How much does the recent expansion evaluation in the shares temper your appetite at all for repurchase going forward?
Well, Matt, we have that formula that we use all the time. It's a grid that it looks at what ROE can I produce by writing business, and what is the multiple to book value that I combine my shares. Of course, when it's less than, it's a very easy decision. When it's more than, you got to go through the calculation. As long as our recovery is three years or less, we still believe that share repurchase is the right way to return excess capital. Of course, you got to look also what the outlook is for the business, what you expect for things to happen in the future, et cetera, as part of that calculation. On a pure price of 112, we're trading at about 112, 113 times book. It's still attractive for us to buy shares back.
All right. Thanks.
Your next question comes from the line of Ian Gutterman with Adage Capital. Please proceed.
I guess it's good afternoon now.
Well, you're always in the back of the room, so you'll be
Dino, I feel like I have to clean up some of the questions.
Okay.
The PML thing, I think people are beating around the bush, if I can ask a little bit more directly.
Sure.
I think if we take a face value that 955 RMS, noting historically, your PML tends to go up into wind season a little bit. Maybe that goes over $1 billion and you're over 25%, on paper anyway. I guess the real question that people are trying to ask at is, if CAT rates really are up 10% or more at mid-year, do you have the ability to grow exposure, or are you just looking to maintain exposure and take the price increase?
No. Don't forget, the one thing you missed, usually you are a careful listener, I said Northeast.
Understood. Your plan usually goes-
Northeast is not going to get affected. Northeast doesn't go up for us in June and July. Florida has the propensity to go up, or the Southeast. There is still quite a bit of capacity for us to use depending on pricing, and there is no limitations other than are we getting the right rate on international CAT, where we see a lot of opportunities, or in quake zones anywhere in the world, which also we believe we have significant additional capacity.
I guess I'm looking traditionally, though, Dinos. It seems the past few years, Q1, the peak PML has been Northeast, and then when it becomes Q2 and Q3 and it becomes Florida, that number-
Florida
has been larger than the Northeast numbers. I'd expect that 955 to go up traditionally.
Well, the 955 is the Northeast. The Northeast usually doesn't go that much up in the middle of the year. What we have is what we have.
I just meant that Florida tends to surpass Northeast.
Yeah. If we adopt Don't forget, the percentage in Florida was less than Northeast. Northeast, if you recall, it was 32%, where Florida was 28%. Even with that, we have capacity to go to $1 billion. There is plenty of capacity there. I wouldn't worry about it.
You feel you can grow exposure if the opportunity is there?
You tell me the prices, I can tell you how much I can do.
Got it. Okay. Just to clarify Matt's last question on the repurchase, I think last call you said, $115-$120 a book was the governor, and as you mentioned, you're pretty close to that. Is that grid based on with stated book or ex the unrealized gains? Because ex unrealized gains are FC over your grid.
Stated book.
It is stated. Okay. Do you worry, though, the fact that unrealized gains are a meaningful component and if we saw a little rise in treasuries, all of a sudden you're over your target price there? Does that make you a bit nervous?
No, because economically, you would get it back. I mean, unrealized gains, it's your entire portfolio you got to worry about, not just unrealized gains. What difference does it make if they're unrealized or realized? At the end of the day, your bond portfolio is exposed to that reality, and you got to calculate. As a matter of fact, when we do our scenarios, you guys, meaning analysts, have a tendency to worry only about the cat events. I worry about a 200 basis points movement on interest rates, a parallel movement, that it can happen within 5 or 6 months. We might have an event like that. To me, that's a cat event.
What it does to your balance sheet.
Which is why we run with a buffer as well. I mean, the buffer could be for a big hurricane or a massive spike in interest rates.
Okay. Well, that's why I was wondering if that would make you slow the repurchase, because if we did see that move in interest rates, you would have, in hindsight, have bought it back too high.
Don't forget, I'm still within all the cushions that I talked about. Even a 200 parallel move on a bond portfolio for us cost us approximately $700-some million, which we will recover on the 2.7 years of duration we have. Still, if it happens rapidly, I have a lot of competitors that they're a lot more wounded than I am, and also their recovery period is a lot longer than mine. The magnitude is going to be greater, and the recovery period is going to be longer. I think I'm in great shape.
Okay. Fair enough. Just some quick numbers ones, hopefully. Reinstatements in the quarter, what were they, and what segment were they in?
Re-
I think in the press release you mentioned there were some reinstatement premium.
For our retro purchases, we have to pay.
Right. How much was that, I guess, is what I'm wondering.
Well, we got, Matt, just about $4 million.
I think it was about less than four. It was about three and a half million dollars.
Yeah.
Yeah.
That was received or paid?
Well, paid.
Paid.
In some cases.
That was received in reinsurance.
In reinsurance on some contracts.
Yeah.
Also we had some that we paid. That was the net-net.
Yeah.
Got it. Okay. Then were there any losses from any of those large property losses like Gryphon or any of the other things like that in the quarter?
Nothing material.
No.
Okay.
It was raining. It's all included.
And the-
If it was material, we would have highlighted it.
That's what I thought. I just wanted to double-check. Then your remaining cat cover for international events for the year, where are you on that? I don't know if you renew that on January 1 or July 1, but given we've had so many significant events, do you have enough cover for the remainder of the year, or do you have to look to buy more?
No, we have plenty for the remainder of the year.
Okay.
As a matter of fact, our insurance group, there is no event that they even got close to even attaching me a cat cover. We're one of the companies that we just gave them premium. We're not going to give them any losses.
Perfect.
It's not perfect. I mean, when you pay for something, you want to get something in return.
Well, I understand, but it's better than the other way.
Right.
All right. That's all I have. Thank you, guys.
Your next question comes from the line of Joshua Shanker with Deutsche Bank. Please proceed.
Thank you. Sorry, it's running late, gentlemen.
No, not a problem. You got in the back of the line again, huh?
Yeah, they get me sometimes.
Save the best for last.
In terms of the aviation business, I think you guys started to shrink that business a while back, and it's coming to premium now. How long should we expect the premium to shrink for in that line of business as you move away?
With the aviation, I think last year in the second quarter, we had about maybe $13 million-$14 million gross and about $4 million-$5 million net. Don't hold me to the decimal point. I'm going by memory. That would be the last component that you would have something that is not renewing coming up because we're out of that business.
For commercial and general aviation.
Right.
When we think about the property, energy, marine, and aviation line, that should stabilize going forward?
Yes. After the next quarter.
By the amount that we just talked about.
Right.
Executive assurance versus professional liability. While they're not the same customers, they're often the same underwriters who are participating in those lines. Can you sort of explain?
No.
-differentiation?
No, no, I'll shout.
Go ahead. Please explain.
No, they're two different units. A professional liability underwriter is a different set of underwriters than a D&O underwriter.
No, I'm talking about your competitors. You're competing with the same competitors in both those businesses.
No. That's correct. Yes. Okay.
In terms of the market trend, are competitors getting more aggressive in executive insurance and they're lightening up? Why is there this bifurcation happening?
Well, if you're pricing the business on experience, you can justify being more aggressive in this market. If you're pricing the business on exposure, I think you ought to be more cautious. That's our point of view, our underwriter's point of view. Listen, I'm not saying we're right and they're wrong or vice versa. It's a difference of opinion. I have faith in our underwriting teams that they're calling it with caution, and we're giving up some volume. At the end of the day, believe me, I want to grow this business, but I want to grow it in the appropriate market. Right now, both on financial institutions and in some commercial D&O segments, what we see is not acceptable to us. That's the reason we chose to shrink it.
Josh, you're seeing a shift between regions because we're decreasing executive assurance in the U.S., but you're seeing what Dino spoke about, the professional liability in SMEs growing in Europe.
Very good. Finally, on the Aon loss expected for the next quarter, will you get an opportunity to reinvest for potentially higher rates there? Is there an opportunity as well as a loss there?
Well, listen, we're a participant in Sun Investment, I don't have preview of their underwriting, I can tell you, the underwriters that they write, all of their business is in the cap business, the cap business is improving. At the end of the day, we go with basically whatever activity they decide to do.
Okay. Thank you very much.
You're welcome.
Our final question today comes from the line of Vinay Misquith from Credit Suisse. Please proceed.
Hi. Misquith. Yeah, that's interesting. Two questions. The first is on retro. You seem to have bought more retro this quarter. Was that just rein statement premiums? When do your retro purchases expire, and would your PMLs go up because of that?
The PML, we don't calculate on the basis of retro purchases. Okay? By the end of the day, we eat our own cooking. At the end of the day, we go with the capacity that Because there is no certainty that always you're going to be having the ability to buy retro, and you don't know at what price. From the PML perspective, it will have no effect on us. As a matter of fact, like I said, we don't anticipate that the pricing will be attractive for us to repurchase. The likelihood is that for next year, we won't have retro protection.
Sure. Fair enough. Did you buy more in the first quarter?
No. It's whatever we bought. It was a program that we renew year after year.
Okay, great. The second question is on share repurchases. Is some of the decision not to buy shares in the second quarter because of maybe waiting for higher pricing later on, or is it just purely the valuation of the stock?
No. As I said, when the window is closed, we put a plan, a 10b5-1 plan, and then you got to set your parameters. The stock price moved, and when it went beyond, the agent couldn't purchase anything because it was outside the parameters. After the earnings release, I think the window opens in two days, tomorrow. We can resume, depending where our share price is, to repurchase shares. Don't read into the fact that we didn't buy any in the closed window that our desire, or our strategy has changed on share repurchases. It's just that it happened as such because of the 10b5-1 parameters that I put.
Sure. The fact that you are willing to buy back stock, would that mean that you think that the cycle turn is further away?
Well, no. It's capital, right? At some point in time, I got to account for it. If it's excess, unlike the first quarter, we had no earnings. We're anticipating that you're going to have earnings in the second quarter, third quarter, and fourth quarter. I hope in your model, you have us earning some money. That's what we're here for. At the end of the day, we should be building additional excess capital through earnings, and then you need to do something with it. It's not an indication as of yet as to where the market is. What I said, we still believe. It's not a broad market trend. I think there is this expression, we're starting to see some green shoots in some of the casualty lines, but they're isolated and they're specific. The property cat, especially international property cat, is improving.
Florida, you heard the prior commentary. We're going to wait, but there is more positive movement even for the cat business in the Southeast. We're optimistic that it's going to be a better environment. Is that an environment that allows us to deploy oodles of money? I don't know as of yet. Share repurchases, the beauty of it is you can turn the faucet on and off, and it's at your own volition. At the end of the day, we can monitor where the market goes, react to it, and we can continue purchasing at the same level or stop if we think that there is really tremendous opportunities for us to deploy the capital in the business.
Okay. Thank you very much for your answers.
You're welcome.
Ladies and gentlemen, this concludes today's question and answer session. I would now like to turn the call back over to Mr. Iordanou for closing remarks.
Well, thank you for listening to us, and enjoy your lunch, everybody.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.