Good day, ladies and gentlemen, and welcome to the third quarter 2010 Arch Capital Group earnings conference call. My name is Jennifer, and I'll be your operator for today. At this time, all participants are in listen-only mode, and 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'll be happy to assist you. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Dinos Iordanou and John Hele. Please proceed.
Thanks, Jennifer, and good morning, everyone, and thank you for joining us today. Our performance for the third quarter was acceptable as we continue to operate in a challenging environment, both for us but also for our customers. Our annualized return on average common equity was 12.3%, which, in our view, is reasonable for current market conditions. These returns were not negatively impacted by major cat activity and benefited from favorable prior year reserve development. The New Zealand earthquake was a minor event for us and was contained well within our expected cat load for the quarter. We continue to estimate that under current insurance market conditions and current investment environment, we are achieving on a normalized basis a 9%-10% ROE on business written for the 2010 underwriting year.
This return is realistic given operating and financial market conditions, even though it does not meet our long-term targets. In our most important measure for creating shareholder value, which is our ability to increase book value per share, we had an excellent result. A very good total return on our investments, acceptable operating returns on our underwriting activity, and share repurchases helped increase our book value per share to $89.24, which is up 22.2% from year-end 2009, 8.7% from June 30th, 2010, and 28% from a year ago. From an underwriting point of view, we achieved a 90.4 calendar year combined ratio, which in our view is 6-8 points better than a normalized accident year combined ratio, which we estimate to be in the 97%-99% range.
Cash flow from operations remain healthy at $267 million, even though our current book of business is declining and our prior year's book is maturing. In addition, our mix of business have moved more to our short-tail lines than in the past, which have faster claim payment patterns that affect cash flow. From a production point of view, our gross written was down 11%, and our net written premiums were down about 12.5%. Our insurance operations were down 19% as they continue to pursue a strategy of reducing writings in long-tail lines, while moving to more XOL contracts on property business and property cat business. 90% of the reduction in volume is attributable to casualty lines as a result of the difficult market conditions we're operating under.
Our ratio of pro-rata to XOL business is now 43%-57%, as compared to 52%-48% as of a year ago. The actions we have taken in our insurance business, which I just referred to, had an exaggerated effect on written premiums, but a modest impact on overall profitability and a beneficial effect on returns. On quota share contracts, terms and conditions continue to remain basically stable, with most of the rate erosion occurring at the primary business level. Our insurance group continues to emphasize and move their book to less volatile lines and to reduce their writings in the long-tail lines. Over the past five years, our net written premium for short-tail lines in the U.S. and Canada increased by 50%, while our long-tail business decreased by 16%, with casualty leading the way with a reduction of 70%.
Despite these actions, due to the challenging market conditions that exist, margins continue to be under pressure. Rate changes in the U.S. range from a +3% to -10%, depending on the line of business and size of account, except for offshore energy, where increases were in the 20%+ range. In the aggregate, across all of our insurance lines, rates were down approximately 3% for our book of business, which was the same level of rate change we quarter in the second quarter of 2010. Our capital management philosophy has not changed. We intend to continue to return excess capital to our shareholders as long as we see attractive opportunities to deploy in our business. As you can see, share repurchases for the third quarter were light as we are more cautious with our capital position during the hurricane season.
Since the inception of our buyback program, we have invested over $2 billion in our own shares, which is one and a half times the amount of common equity we raised from shareholders over the past nine years. This reflects a culture of shareholder focus that we're very proud of. As of September 30, we still have $487 million available authorization for share repurchases and expect to return to a more normal pace of repurchases in the fourth quarter. Before I turn it over to John for more color on our financial results, let me share a few thoughts on our cat writings and PML aggregates. As of July 1, 2010, our running 250 PML from a single event was $809 million or 18.4% of common equity, up from $797 million at April 1st, 2010.
This PML is for the Florida Tri-County area and is our largest PML area as expected. Our Northeast wind area PML stands at $756 million, up slightly from $733 million as of April 1, 2010. Both zones are significantly below a 25% of equity self-imposed limitation. With that, I'm going to turn it over to John for more commentary on our financials, and after John, we'll open the call for your questions. John?
Thank you, Dinos. For the 2010 third quarter, property and other short tail lines represented approximately 49% of our net premium volume compared to 45% in the 2009 third quarter. On a consolidated basis, the ratio of net to gross was 77%, compared to 78% for the same period a year ago. Our overall operating results for the quarter reflected a combined ratio of 90.4%, compared to 90% for the same period in 2009. The third quarter loss ratio for 2010 included $24 million, or 3.9 points of current accident year cat activity, compared to $5.3 million or 0.7 points in the 2009 third quarter. The 2010 third quarter cat activity was primarily related to the New Zealand earthquake, mainly in the reinsurance segment. As of the end of the 2010 third quarter, the provision for the first quarter cat events, which included the Chilean earthquake, did not change materially.
Both the insurance segment and the reinsurance segment experienced a lower level of attritional loss activity compared to a year ago, primarily in the property lines of business. The 2010 third quarter combined ratio reflected 5.9 points or $37 million of estimated favorable development, net of related adjustments, compared to 7.7 points or $56 million in the 2009 third quarter. The prior year development in the third quarter of 2010 reflected favorable development primarily in property and other short tail lines, as well as the reinsurance segment casualty business and the insurance segment Executive Assurance from earlier years. The current accident year loss ratio, excluding large cat events, reflects the lower level of attritional loss activity previously mentioned, as well as the overall impact of the reduced writings of casualty business that Dinos mentioned.
The 2010 third quarter expense ratio of 33.1% was 3.7 points higher than a year ago, primarily reflecting lower premium volumes as well as changes in the mix of business and changes to the ceded reinsurance structures in the insurance segment. On a per share basis, pre-tax net investment income was $1.77 in the 2010 third quarter, compared to $1.60 for the same period a year ago and $1.70 in the second quarter of 2010. This growth reflects the accretive impact of the share repurchase program more than offsetting lower reinvestment yields. Total return from the investment portfolio was 3.61% in the 2010 third quarter. Excluding foreign exchange, it was 2.94% in the quarter. The net total return benefited from lower interest rates as well as from the devaluation of the US dollar against many global currencies.
The impact on book value was offset by a net $65 million increase to the liabilities for currency movements reflected in the income statement. The duration of the investment portfolio increased slightly to 3.11 up from 2.90 at the end of the second quarter of 2010. The increase in duration during 2010 reflects a slight change in yield curve positioning, which benefited the total return as interest rates have fallen. We are carefully monitoring the potential impact of the quantitative easing, now known as the QE2, which is expected to start in the fourth quarter, and we have maintained our ability to move quickly if required due to rising interest rates. We continue to be conservative with regard to the credit outlooks and maintain a double A plus average credit quality on the portfolio.
Our balance sheet is conservatively positioned with total capital of $5.1 billion at September 30th, up from $4.8 billion at June 30th, which reflects the limited share repurchase activity during the quarter, the operating earnings, and the overall investment results. The cumulative share repurchases since 2007 added $0.70 to the diluted operating earnings per share, or 2.8 points to the ROE. Our debt plus hybrids represent approximately 15% of our total capital, well below any rating agency limit for a targeted rating. Last quarter, we gave you a slightly wider range of estimated excess capital to reflect the growing percentage of capital reflected in accumulated other comprehensive income, known as AOCI. To be more specific this quarter, as of September 30th, we estimate that including AOCI, we hold approximately $900 million-$1.1 billion above our targeted capital level based on current rating agency models with an appropriate buffer.
If we exclude AOCI, our excess capital position would be $500 million-$700 million. Our liquid cash, short-term investments in US Treasuries represent about 23% of our investable assets. With these comments, we are pleased to take your questions.
Jennifer?
Before taking any questions, management wants to 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 that 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 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-GAP measures of financial performance. The reconciliation to GAP 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. Ladies and gentlemen, if you have a question, please press star followed by one on your telephone. If your question has been answered or you would like to withdraw your question, press star followed by two. Questions will be taken in order received. Please press star one to begin. Your first question comes from the line of Jay Gelb from Barclays Capital. Please proceed.
Thanks and good morning. I just wanted to follow up on the excess capital position. In terms of what Arch would consider the available excess capital in terms of deploying that into share repurchases, should we be thinking about the $500 million-$700 million range ex AOCI?
Yeah, I think that's more of a safe number, too. AOCI can move and it has volatility, especially in the market that we're operating in and the economic environment that we're facing. If things stabilize, we might change our view. For the time being, we don't. It's that old expression is just don't count your eggs until they hatch. That's our approach to it.
Right. Now, that doesn't assume any further retained earnings going forward, right? What-
That is correct.
Okay.
That is correct. That's on a static number as of the end of the third quarter of this year.
Right. How quickly should we think that Arch might look at deploying that excess capital into buybacks?
Well, it will depend as where our share price is and where the market is going. Based on those two parameters and our ability also to operate within the safe harbor in share repurchases, it will determine as to how much we can do on a quarterly basis.
Right. The other thing I just wanted to follow up on is the reinsurance growth. The premium year-over-year declined, if my numbers are right, around 40% on a gross written basis in reinsurance in the fourth quarter of 2009. My sense is that you're lapping an easier comparison for the fourth quarter of 2010. Is that the right way to think about it? Maybe the decline won't be as much.
No, you can't. At reinsurance, we look deal by deal. We look at the market. The major shifts on our book on the reinsurance, I'll give you the big picture, is that at the zenith of our reinsurance activity was back in 2004, 2005. The reinsurance group was about $1.6 billion. We're tracking on activity of close to half of that as of today. More importantly, the reinsurance group is mostly property today and property cat, 70% of what we do is in that territory. We still view the property-property cat area attractive. I wouldn't just try to see year-over-year comparisons because don't forget, a lot of the casualty business we had in 2009, it was already gone in 2009, from 2008 to 2009. The 2009 to 2010, it might be totally a different comparison for the fourth quarter.
Right. I guess what I'm saying is, should we anticipate the overall premium volume of the reinsurance business declining even more or now that you're down to just a couple of-
No, it's probably. We don't give guidance, so I'm not going to guide you on an answer. Let me give you the parameters. The drastic reduction in our premium volume in the reinsurance group is being predominantly casualty, long tail lines, and some professional liability. A lot of those reductions already have happened. We're down to very little remaining. The pieces that remain is business that we like. As a matter of fact, some of them we're growing, such as trade credit or some other areas that we believe the profitability meets our target requirements. It's not an easy comparison for us because we will look at the merits of our expiring book and make those determinations over the next three months. Probably the reductions will be less than what we had a year ago.
The business that we have is business that we like, and we don't see significant price erosion going on.
Right. The mix shift has already occurred.
The mix shift already occurred. That's correct.
Perfect. Thanks very much.
You're welcome.
Your next question comes from the line of Beth Malone from Van Sterling Securities. Please proceed.
Okay, thank you. Good morning. I have a question on your tax situation. We've heard constantly here that people are looking at changing the tax status for companies located in Bermuda, and some companies have relocated. Just what is your strategy towards that, and are you considering relocating?
We're happy where we are. I can't predict what the U.S. Congress will do with tax policy for companies in the U.S. Let me remind you, we're a foreign corporation with U.S. subsidiaries. It might affect some of the activity we have with our U.S. subsidiaries. It's very hard to shadow box a shadow. At the end of the day, it depends what happens, and then we'll take action depending on that activity. For us, as we've said many times before, the Neal bill that gets a lot of publicity will have a limited effect in what we do because there is too many moving parts. Excise taxes might go down, and underwriting profitability tax might go up. Depending on the current market position, probably the effect on the overall tax for the company will be insignificant.
Okay, thank you. Then one other question on your investment portfolio. Would you be comfortable increasing your exposure to alternatives and other more, I guess you'd call them aggressive type investments? Because you're well below what the rating agencies would be comfortable with already. With the yield so low on traditional type of fixed income securities, what's your strategy for that?
Let me give you more of a philosophical answer, then I'll turn it over to John to tell you a little more specifically as to how we think about this. At the end of the day, we never want to be aggressive in the investment strategy that we have. We view investments as a necessary part of what we do in our business. Of course, when you have excess capital and your primary business, which is the underwriting business, is not in the best part of the cycle, you look to try to enhance that. We're only going to enhance it by taking conservative, measurable investment risk. People who buy our stock are shareholders. They don't make the determination to own Arch because we're brilliant investors. I think we're very good investors. We like to be well above average in that, but in a conservative fashion.
We want people to buy our stock because they think we're good underwriters, and we can make very good underwriting decisions. That's the philosophy that guides us as to what we're going to do with $12.5 billion of investable assets in tough times like now that we're in the down cycle. John, you want to add anything to it?
Sure. We mentioned in the press release as well as you'll see it in the investment side under investable assets, we are increasing our, they're labeled other investments by accounting and credit funds and some equity securities. Credit fund's a little over $200 million, about $200 million in equity securities and others. These are a series of portfolios that we're looking at in natural resources and some basic equities, some emerging market debt. These are still under 3.5% of the total portfolio, but we think these offer some nice attractive opportunities right now, relative to other opportunities that are available to us. As Dinos said, this will always be quite a conservative portfolio across the board in total. We're just taking this opportunity now to pick some spots to play. Okay. All right. Thank you.
Your next question comes from the line of Vinay Misquith from Credit Suisse. Please proceed.
Hi. Good morning.
Hi, Vinay.
Was this quarter's results favorably impacted by some extraordinarily lower level of large property losses?
Oh, yeah. It was a quarter that both on the reinsurance side and insurance side, and it wasn't just property. I think it was aviation too, and short tail related. The attritional activity was better than expected and especially from large type of losses. In a company like ours, we write a lot of these specialty covers, you can get quarters that they behave as such. Yeah, I think we've mentioned this on prior calls, that as our book is shifting more to shorter tail lines of business, property and other things, it's going to be a little more volatile from quarter to quarter in terms of what happens. If a building burns down or if it doesn't, and that flows through.
Sure. That's great. Did I hear you right when you said that the normalized combined ratio with cats would be about 97%-99% ex-favorable development?
Yeah. Normalized cat activity. Yeah. If you take normalized cat and eliminate favorable reserve development from prior years, you look at the business you're writing today, based on the investment climate that we have, new money invested, we believe that the ROE is in the 9%-10% range, and the combined ratio is somewhere between 97%-99%.
Annual rates coming down, do you see that sort of declining to the mid to high single digits next year?
Well, don't forget, I can't predict what's going to happen next year. Don't forget, our mixes continues to change. We try to move to lines of business that give us better returns. Not trying to predict the mix. It's very hard to answer that question. Not every single line of business is experiencing price reductions. Some lines have stabilized, and they're in the slight positive from a rate point of view. Of course, we have a lot of lines that still in the negative, and you have trend working against you, and that directs you to continue changing your mix of business. As you've seen, some of our areas of growth came from unusual or areas that we found more profitability in the last year or two, and then we took advantage of those opportunities.
Sure. One last question. Could you comment on frequency and severity trends, please?
The frequency trends, they continue to be favorable. Severity is starting to stabilize and inching up a little bit. Those trends, they're positive in nature. The big question there, Vinay, is do you believe that they're going to continue, do you think that they might change in the future? That's a judgment different managements and reasonable people can get to different conclusions. Some people might be more optimistic than we are, and they will think that this thing will continue forever. Others, they say, "Well, enjoy it for the years that it happened. It's going to get to more normalized over the future." We watch those numbers. Our actuaries spend a lot of time on looking at frequency and severity trends, and we do it by IBNR family to each one of our product lines. In general, the environment is still good.
Sure.
From that perspective, from the frequency severity perspective.
Right. Has frequency now stabilized at very low levels?
Yes.
Okay. Has frequency really at all-time lows now versus the past?
I'm sorry. I didn't get the question.
Are frequency levels at all-time lows now versus the past?
Yeah. Well, it depends how far back you go. For the past I would say five to 10 years, yeah. The trends have been very favorable now for four or five years in a row.
Okay. That's great. Thank you.
You're welcome.
Your next question comes from the line of Joshua Shanker from Deutsche Bank. Please proceed.
Yeah. Thank you. I wanted to ask this question, what's happening in the national accounts business? You grew it well last year, and it seems like in this quarter there was this different pullback in premium volume. Is there more competition there? What's happening exactly?
Well, it's not pullback. We lost a couple of major accounts. I mean, the national accounts business is a lumpy business. You're writing, it's the big accounts that come with big premiums, a lot of it is retrospectively rated and high service intensive kind of business. We had one major account that through a merger, we lost the opportunity to participate and you're going to get that lumpiness on a quarter-to-quarter basis, because when you're hunting for elephants, sometimes you shoot them and sometimes you don't.
Well, I was thinking maybe you can clarify. I thought it was kind of sticky business because nobody wants their employees to have to change their servicing.
Absolutely. It's very sticky business. When you have a merger of two large companies and they're going to merge the program, and it happened to be two different carriers, the acquiring company didn't want to change, and unfortunately, the client we had was being acquired, so in essence, we lost the opportunity. Some cases, you're going to lose some of these accounts also on the basis that underwriting, they might want to extract terms that you might not be willing to do. You have to have the willingness to walk away from business if you believe that the profitability is not consistent with your long-term targets.
Yeah. That's a very good answer. Do you have an opinion as to the degree to which some competitors of yours are saying that pricing is perhaps showing some signs of improvement. Obviously, you don't agree with that. To what extent do you think, where are we in the cycle? How long before there is some sort of pricing term?
Well, I didn't say I disagree with them. It depends where they are. Overall, I think, and as you've seen it, we believe the environment is more negative than positive. On different sectors, especially if you're in the small account business, et cetera, there is more pricing power for those accounts. We see with our program business, you've seen it. The smaller the account and the more dependent on distribution, that it doesn't have a lot of competition, you have more price stability. The larger the account, that's where most of the mega battles go on with premiums being cut significantly. We have readjusted our posture and the book of business over the last four, five years because these trends are not new trends. These trends, they continue now for about four or five years. We haven't seen an uptick yet that is significant in pricing.
When that happens, it is because there is stress in the system and the reverse will happen. The small accounts are not going to get the significant increases because probably they price reasonably well, and it's the larger accounts that they're going to get the most significant increases. The volatility of the business will depend by size of account. It always happens. In every cycle I went through, larger accounts, usually they're more volatile on the way down and on the way up in pricing.
Thank you for the color.
Your next question comes from the line of Matthew Heimermann from JPMorgan. Please proceed.
Hi, good morning, Dinos and John.
Hi, Matt.
Hi. Couple questions. First, I was wondering if you could, with respect to the, sorry, I'm mumbling this morning. Executive Assurance, the premium declines there. Was any of the decline related to accounts maybe reverting back that you picked up during the financial crisis that reverted back to pre-crisis carriers, or was all of that driven by just pricing indications?
Well, I will attribute most of it on account selection and pricing, especially on the financial institutions and commercial D&O space. Within, we have a terrific team underwriting, and we allow them to make those judgments. There's been pressure on pricing, and we don't believe that's justifiable. Some of our competitors think it's still very good business, we have walked away from accounts.
Okay. Then, with respect to the PML or the excess capital, I guess, as I think about, at this point it seems like with the mixed shift, PML is probably the biggest or disproportionate driver of your excess capital. One, do you think that's correct? Two, I would presume that you probably, in this type of environment, don't want to go right up against the 25% threshold. Given that if something did happen, you probably wanted to have room the next day to write business. My other question would be, is that a correct assessment as well?
In general, yes. We always want to maintain our capital requirements on the A-plus level by the rating agencies, plus a cushion above it that the combination of expected earnings for a year plus the cushion will give us enough room that if we have the one in 250 event, we begin the year and we end the year with A-plus capital adequacy based on the rating agencies' models. In essence, your question is correct. I want to be standing, even if I get a little wounded. It might be a small flesh wound. Be able to capitalize the day after a major event. That's the way we've been running the company for the last nine years. As long as this management team is around, it will continue to be in that fashion.
Yeah, Matt, I want to clarify that so you understand that when we talk about our excess capital, this is the amount above our target rating for capital, which is A-plus. Plus the buffer that Dinos just spoke about.
The numbers we give you are above that. Our targeted level is the rating plus a buffer.
Yeah.
The buffer is there if there is a big cat event. That plus the earnings in the year, we have lots of capital left to write the business.
Yeah, I guess I'm just trying to translate that into an easier metric for us on the outside to look at. That's why I was wondering whether it was reasonable to think about in the current environment given cap prices have come down, that they're probably 25. Is that fair then, that 25 is probably too aggressive?
I don't view 25 as too aggressive. You're also right. If pricing was better, you will see us more on the As in new terminology, being overweight than underweight.
Okay. Under.
We're a little bit underweight right now and probably is because of pricing.
Which would impact our excess capital. We would tend to use some of that more for going to 25% if that was good returns.
Yeah
other things.
Okay. Realized I'm splitting hairs here. The other question, just John, to follow up on your yield curve positioning comment relative to potential changes in the bond market related to quantitative easing. I think you're talking more about the consequences out over the next 12 months than what the bond market has already done, I think, in response to potential easing. I guess could you just give us a sense of tactically how you think you're positioned today relative to any increase or I guess what's your base case for how the yield curve may change over the next 12 months? If you reposition, where would you likely expect those changes to come across durations?
Well, we increased the duration this year, these past few quarters, primarily through buying slightly longer treasuries. We did that so that they're liquid and they're easy to sell out of if you need to quickly, or you can always add a derivative on top if we want to move quite quickly and then go shorter. The reason is it's very hard to predict what the impact of this is going to be. If QE2 works well, like I think the Fed hopes it does, then rates are going to go up. It may not. We're uncharted territory here. We're trying to be well-positioned no matter which option happens.
I guess maybe a different way to ask that question. I guess today, are you disproportionately exposed to a parallel shift in the curve relative to flattening or vice versa?
No, I wouldn't say disproportionately. I guess it depends on your baseline. We're spread out evenly. The whole duration's 3.11, it's spread out over the next period of time to get you that sort of duration. It's not super barbelled or anything, if that's what you're thinking about.
Yeah, that's what I was asking. All right. Much appreciated. Thanks, guys.
Your next question comes from the line of Brian Meredith from UBS. Please proceed.
Yeah, good morning. Two questions. First one back on the excess capital. I'm just wondering your appetite potentially to take on some additional debt here given the incredibly low rate environment and potentially using that for excess capital and buy back stock.
We don't aspire to that philosophy. In the way we construct the balance sheet, we always want to have room for debt and hybrid in case of the unusual event. Because we believe that if the market turns on a dime because of something big, and we have competitors that they're in difficulty from a capital point of view, we'll be able to take advantage of that opportunity without us having the necessity to go and reissue common stock. Also depending where the cycle is, we have
Much more of a willingness to have more financial leverage on the balance sheet. In a good cycle, I don't mind financial leverage going up to 30% or thereabouts. Where in the soft cycle, I'd rather have less financial leverage than most, because it gives me that flexibility. At the end of the day, you have to be preparing for the day after a major event. Not only our philosophy about keeping excess capital, but also how the capital structure is constructed is very important to us. For the time being, we want to continue to have low financial leverage on the balance sheet.
Brian, even though nominal interest rates are at relatively low rates, the spread over Treasuries is not at an all-time low.
Right.
It's getting better slowly throughout the year, but not something you'd say, "I've got to rush out and do this. This is the deal of a lifetime." I think we work off the spread when Arch issues debt. We immunize it with matching Treasuries on either side. The net cost to the shareholder is only the spread.
Okay. You focus the spreads. Great. Then the second one, on the 9%-10% ROE Dinos, I guess a couple questions there. One, what are you assuming with respect to investment yields? Are you assuming whatever the yield is in your current portfolio? Is that new money yields? Then also, what do you assume with respect to trend in that number?
We're assuming new money invested yield.
Okay. Which is below where you are right now.
I'm sorry?
Which is probably below where your current portfolio yields are right now, right?
Yes. Not significantly below, because in the company, when I talk to our chief investment officer, et cetera, he's able to maintain Don't forget our portfolio turns significantly every year. We got $3.5 billion-$4 billion turning over between new cash flow and things maturing. He's finding opportunities to maintain close to our embedded yield. We view that as the normalized capital that you're going to use to write that business. Not our total, including the excess capital, because that'd be fooling you on the calculation. Also, what is the normalized yields on new money invested? That's the calculation we go through when we give you those numbers. That's why in my prepared remarks, I says normalize.
Okay. Excellent. Thank you.
You're welcome.
Your next question comes from the line of Mark Dwelle from RBC Capital Markets. Please proceed.
Yes, good morning. A couple questions. First, building on the answer to the last question. Your preferreds come up for redemption early part of next year. To the extent that you decide to redeem those, would you be just diverting then funds from common stock buybacks in order to do that, or would you be more looking in terms of a refinance there?
If we redeem them, it's because we have the ability to replace them with the same kind of securities at a lower cost. If that happens, the option to call them is ours. We're going to exercise only that option if I can improve the economics, but I'm not changing the capital structure.
Okay. That's helpful. Second question is, you commented in the report about exiting the aviation market. There was a fairly sizable reduction then in the amount of business written in the marine aviation, the energy line. Was all of that reduction simply the aviation going away, or was a portion of that declines in those other items that are in that segment?
It was predominantly the commercial aviation and some space business. Our decision to exit it was more as to what we think the prospects of that business is over a 30-year period of time. We didn't think that when you put the good years, the bad years, and you mix it all together, the return over a long period of time is not good enough for us.
Okay. That was actually going to be my follow-up question. I'll stop there. Thank you.
You're welcome.
Your next question comes from the line of Jay Cohen from Bank of America Merrill Lynch. Please proceed.
Thank you very much. Three questions. Last quarter, you had mentioned that some of your casualty reserves in the most recent accident years had shown some deficiencies, and I'm wondering if you can update us on that. Did you see a similar thing this quarter?
No. There was no change in our casualty reserves for this quarter. Basically what we said last quarter was we had something specific to a big account we wrote back in the 2003, 2004 year. Then it was a little bit on the Executive Assurance E&O area because of Madoff related. That's the only thing we talked last quarter. None of that had any effect on this current quarter.
That's great. Second question. Another management team in a conference call earlier today suggested that they were seeing less of a trend of standard insurance companies taking business from the E&S market. That trend was declining. Are you seeing any signs of that happening in your business given that you are a big E&S player?
Well, it is off a bit, let me tell you, in the last 2 years, it was a massacre. They haven't seen anything on the E&S that they didn't like to write it on an admitted basis. That movement has happened already. The E&S market will shrink and expand based on the cycles, and right now, it has shrunk enough, in my view, maybe more than it should have. I wasn't on the call, I don't know whom you're referring to, if it's a directional issue, I think it's accurate. That it's less now than it was maybe 6 months, 1 year ago. It's still happening. It's not zero, directionally, there is a little less of that.
That's great. The last question, broker remuneration. What's happening there as far as overall commissions?
Well, there is pressure for increased commissions. At the end of the day, you negotiate on account by account, and you got to factor that in your pricing. If you look at our numbers, probably year-over-year, and you got to adjust for mix, which is hard. You don't have all the clarity that we have. We're probably paying close to another point or so in commission if you take it product by product. That effect, it wasn't just overnight. It happened over the last couple of years. When premium volume for the whole industry is coming down, and this is the 4th year in a row we're going to have less premium written, there is more pressure for the brokers and agents to be asking for a little more on commission, and eventually finds its way into our financials. There is pressure there.
Jay, in our published ratios, if you look at the long-term trend, it's what Dinos just mentioned, plus this mix. It's quite a big impact because we're shifting to much smaller business, SME type businesses, mid-size accounts, and that really has quite an impact.
Right. Great. Thanks for clarifying it.
Your next question comes from the line of Keith Walsh from Citi. Please proceed.
Hey, everybody. How you doing? Most of my question's been asked and answered, just one, if you can comment on what are you seeing out there in the competitive market regarding terms and conditions on policies? I'm hearing a lot of deterioration going on there. Thanks.
The terms and conditions were not an issue in the last three, four years prior to the last year. It's in the last year, 18 months. The softening of rates, it was mostly pricing. Prices that were coming down, but terms and conditions, they were pretty stable. We've seen the beginning, well, it's not today, it's been for about 18 months or so. We've seen the beginning of the erosion of terms, but it's not in the same fashion of craziness we've seen in 1998 or 1999 or 2000. What the future will bring is anybody's guess, but there is more pressure, more requests by clients, the brokers for broadening terms. In some cases, some companies acquiesce to them.
Thanks a lot.
Your next question comes to the line of Ian Gutterman from Adage Capital. Please proceed.
Hi. First quick one, can you remind me on the fac side what limits you write to?
Which side?
On the facultative business, how big a limit do you offer?
On the property fact?
Yes.
Yeah. Net or gross?
I guess net.
On net is $25 million.
Okay.
Our gross line is $100 million.
Okay. Obviously that's been a very favorable line as far as experience this year. What's sort of a normal, if you will, a normal once a year type of back quarter? Is that several $25 million losses? Assuming it's not from a cat or something.
Our average limit on that business is a little less than $12 million.
Okay.
We don't write a lot of accounts with the big net. We haven't yet had a $25 million loss. It's lumpy business, but we've been at it now for over three-plus years, and we have done very well. I think we have one of the best teams, and they're very good underwriters, and we're happy with the product line and what they do for us in the marketplace.
Okay. No, agreed it's a very good business. I was just trying to get some sense of the sensitivity if we do have a back quarter at some point.
As we said, this quarter actually was better because we didn't have any large, what we would call attritional losses.
Okay, great. If I can take another stab at the excess capital. John, if I just do some math here, the 18% PML you discussed is obviously $800 million of P&L over $4.4 billion of equity. If I take that to your 25% limit, that's $3.2 billion of equity. $800 over $3.2, which implies a $1.2 billion difference. That implies if I take away the $900 million-$1.1 billion of excess, that your cushion you're talking about is only $100 million-$300 million. Is that right?
No.
Did you put the expected earnings over a year?
Well, I'm saying, if we had a big cat event tomorrow.
No, the calculation is you take the
Why do we have to assume that the earnings come in in a year?
The goal is we want to have it over a 12-month period, we would recover enough to have the business. We get to count the expected earnings that will flow out from our book of business.
Okay. The other area you have to go, Ian, is from a rating point of view is you total capital, not just common equity capital.
Agreed.
You left some $625 million out of that equation because we got $300 million long-term debt, and we have $325 million of perpetual prefers. That counts as capital. You can't ignore that as part of the calculation as to what is your rating agency capital requirement and how do you go about it.
When you're talking about an excess, I thought you gave the PML target as a % of equity. When you're talking this excess-
That's what we-
Is that including debt capacity or is that just equity?
No, no, it's total capital.
I mean the excess number, the $900 to $1.1, is that including your unused debt capacity? Or is that $900 to $1.1 of excess equity, plus you have excess debt capacity on top of that?
No, let's start from the beginning. At the end of the day, rating agencies, they look at all your total capital you're operating with. The common, prefer, and debt, 30-year debt that you get credit for.
What you have today.
What you have today. Okay? In essence, that's the part that we allocate to the operating units, and that's the part that we got to give them some cushion to operate above it. The fact that we chose 25% of common equity as a target is immaterial to that calculation.
It's a risk measure.
That's a risk measure. It's a risk tolerance measure, I don't count my long-term debt and my perpetual as my own capital. In essence, I don't want to take risk on that. I'm only taking risk on the common equity.
When it comes to the PML.
Right. If you do your calculations now in the same fashion you've done them with common, you get to the same place as we are.
No, that's fine. I understand that part. I guess what I'm concerned about is, if I took $1 billion out of your equity. If I assumed you did a $1 billion buyback tomorrow, just for argument's sake.
You go from $800 divided by $3.4 billion, you'd be at a 23% PML. Then if you had an $800 million event the next day, the $3.4 goes down to $2.6, which would be 30% of equity. Knowing the way the rating agencies work, although you and I would argue that you should have a year to earn back and get back to your 25%, realistically people say.
No, you think that happens. Don't forget, you got to add up the other capital that I get credit for it, right?
Sure.
This is a company who writes two and a half billion of premium, and if you do the calculations correctly, you will know that I will still have 8-plus adequate capital.
Plus, Ian, this target is our target, Arch's target as a percentage of common equity that we set as a risk measurement system. It wasn't dictated by the rating agencies to us. Rating agencies will, in major events, they do give you some time to recover because not everybody calls. We have the time to repair our balance sheet, and they take that into account in all their ratings when they look at it.
Okay. I guess I'm trying to do this math on the fly here, but your 25% equity limit is about a 21% of capital limit. Is your rating consistent with a 21% limit, or are you able to go up to a 25% of capital and still maintain your rating?
We can go to 25% of capital and still maintain our rating.
Okay. That was the part that was unclear. Okay. Thank you.
Your next question comes from the line of Gregory Locraft from Morgan Stanley. Please proceed.
Hi, guys. Wanted to get a sense on, from a bigger picture perspective, the mix of business between reinsurance and insurance. Bear with me. As you guys really shrink the reinsurance business based on your commentary, the total overall book seems to be more and more skewed towards insurance, not because you're growing insurance, but because it's shrinking less. My question is that that segment has not generated nearly the profitability for the last couple of years that the reinsurance segment has. How should we be thinking of that mix shift, or do you even think of it at your level going forward over the next several quarters and years?
We think about it, we don't have any targets for it because at the end of the day, you got to allow the business to run independent and see what is available in the market and what they're writing. All I can tell you is that the major adjustments in reinsurance have taken place already. Unless the property and property cat business, which is a possibility, goes extremely negative and is unprofitable, then you will see further actions from the insurance. Other than that, I think you're probably getting more closer to a steady kind of run rate there. Having said that, insurance had significant shift. Even though volume-wise, it might not be noticeable to you, when you look at the portfolio from the inside out, you will see that we're writing a lot more small to medium-size accounts than ever before.
We're in lines of business that they were insignificant a few years ago, and they're more significant today. That give us pretty good profitability. Collateral protection, for example, it's an area that we've been in it since the beginning. This is a company we have in Kansas City. It writes predominantly a GAP program. For those of you who don't understand what the GAP program is, you buy an automobile and you buy your insurance. Let's say it's on a lease, and then you have an accident, or the automobile is stolen. Then your primary insurance, under the comprehensive, will give you the Blue Book amount, and that might not be good enough for the balance you have on the lease. The GAP program covers that differential. That business has been a small part of what we did. We went through the financial crisis.
It performed extremely well, now there is more opportunities to grow it, we have chosen to grow it in the last year and a half, with excellent results. There is transformation in our book of business, that it might not be totally visible to you. It happens based on what we believe the ability allows us to get an adequate return. Now, having said that, probably because of certain lines of business, which they're more volatile, property cat, there's more volatility on those. You have a higher return expectations. Since we do more of that on the reinsurance side, over the long term, I can tell you our reinsurance operations will have better ROEs than the insurance operations. Having said that, there will be more volatility on top line for the reinsurance group.
They will grow exponentially in the good times, they will probably shrink significantly in the soft to maintain that ability for us to have the higher ROE performance.
Okay. You had mentioned just now in the thoughtful answer that the ROE in reinsurance is higher than insurance. I guess that's across the cycle. Why is that? What structurally is the reason?
Well, structural, the reason is because there is more volatility on that business, for that reason, your return expectations have to be higher. I'll contrast that to a low frequency, low severity type of business. I will probably accept a 10, 12% ROE because it comes steady with very low volatility over a long period of time. I will not.
Property cat
Property cat over a long period of time with the same ROE expectations. My ROE expectations have to be in the 20s for that type of business.
Okay. Embedded in your pricing models, there's a lower ROE expectation in insurance given the more predictable income stream from that segment.
In general, that is correct. You got to go line by line and product by product.
Right. Okay, great. Then just a miscellaneous question. How do you guys think about the mortgage put back and foreclosure issue? Anything we should be concerned about in your particular book or no?
Not from a liability point of view. It's a non-event for us in our book of business. Having said that, maybe we might get a little uptick on the investment side because in essence, when PIMCO and BlackRock, et cetera, they're doing this on behalf of clients, and I'm sure somewhere on our mortgage-backed security portfolio, we may have an issue. We might get a little benefit. It's insignificant. It's nothing that worries us.
So far in the MBS, CMBS world, the pricing hasn't really fundamentally changed with all this noise in the paper so far. We'll have to wait and see how it all develops. Okay. Last, just your thoughts on Solvency II. Does it have any impact to you, and what do you think it does to the marketplace?
Well, they haven't finalized it all. Two things that are clear is that capital requirements will go up more on the life sector than on the P&C sector. When capital requirements go up, if you're a reinsurer, which is another form of capital for potential clients, it might give us some opportunities to deploy some capital when that happens, especially in Europe, for companies that they might not want to access the capital markets, and they might want to do it through reinsurance. For us, Solvency II, other than the administrative bureaucratic processes that it might add a little cost, is more of a positive from a capital point of view because we are a company through our reinsurance operations that is willing to be a capital provider to clients that they need it through reinsurance contracts.
I think it's still early to understand the amount of the impact. All firms, European firms, including our European subs, are working on the quantitative impact study number 5. That's due at the end of October, and that'll be assimilated and gone through. In the next year, they'll probably recalibrate the models once again. Everyone will have a better idea as to what it will be. I think the general consensus is it's going to result in higher capital, and will be interesting for how European mutuals and others look at this. We think there could be an opportunity here for reinsurance solutions to help with that.
Okay, great. Thanks for the answers.
There are no further questions at this time, and we'll now turn the call over to Mr. Dinos Iordanou for closing remarks.
Thanks, everyone. Thanks, everyone, for attending. I know it's lunchtime, so enjoy your lunch.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.