Good day, ladies and gentlemen, and welcome to the Quarter Two 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 0, and we'll be happy to assist you. As a reminder, this conference is being recorded for replay purposes. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the Federal Securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.
For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website.
I would now like to turn the call over to your hosts for today, Mr. Dinos Iordanou and Mr. John Hele. Please proceed.
Thank you, Jennifer, and good morning, everyone, and thank you for joining us today. Our performance for the second quarter was reasonable in light of the challenging environment in which we're operating. Our annualized return on average common equity was 13%, which in our view is an acceptable result. These returns benefited from light cat activity for the quarter and favorable prior year reserve development while they were negatively impacted by the Deepwater Horizon losses in the Gulf of Mexico. We continue to estimate that under the current market conditions, we're achieving a 9%-10% return on equity on business written in the current underwriting year. This return is realistic for the current environment, it does not meet our long-term goals. In our most important measure for creating shareholder value, which is our ability to increase book value per share, we fare very well.
At $82.07, our book value per share increased 12.4% from year-end 2009 and 6.7% from March 31, 2010. From an underwriting point of view, we reported a 90% calendar year combined ratio, which in our view is five to seven points better than the normalized accident year combined ratio of 95 to 97. Cash flow from operations remain healthy at $206 million, even though our current book of business is declining and our prior year's book is maturing. In addition to that, our mix of business have moved to more short tail than in the past, which also affects claim payment patterns. It accelerates the pay losses. From a production point of view, our gross and net written premium were both down about 10%. All of the reduction was attributable to our reinsurance operations.
Our reinsurance group continues to pursue a strategy of reducing writings in long-tail lines while moving to more XOL contracts on short-tail business. In addition, it should be noted that the 2009 second quarter included a large property cat contract, which is written on a 2-year basis that negatively affected the quarter-over-quarter comparisons. On July first, property cat rates were down 5%-15%, with a few late deals being written at better rates than January 1 and last year's pricing. On quota share contracts, terms and conditions remain basically stable, with most of the rate erosion occurring in the primary business level. The actions we have taken in our reinsurance business, which I just referred to, have an exaggerated effect on written premiums, but a more modest impact on overall profitability and a beneficial effect on returns.
Our reinsurance group continues to emphasize and move their books of business to less volatile lines and to reduce their writings in the casualty lines. Despite these actions, due to the challenging market conditions that exist, margins continue to be under pressure. Rates in the U.S. market range from a +2% to -9%, depending on the line of business and size of account. Across all lines, rates were down 3% for our book of business as it compared to a decrease of 2% recorded in the first 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 do not see attractive opportunities to deploy it in our business.
With our share price trading below book value in the second quarter, we repurchased 3.6 million shares at an average price of $73.83 for a total of $269 million. On June 30th, 2010, we have $541 million authorized for future share repurchases, and our excess capital is estimated to be in the range of $600 million-$900 million. Before I turn it over to John for more coloring on our financial results, let me share a few thoughts on our cat writings and PML aggregates. We continue to find the East Coast wind opportunities still attractive, even though pricing has come down from a year ago. We chose to deploy about 8% of our available PML capacity due to the change in rates.
As of July 1st, 2010, our 1 in 250 PML from a single event was $797 million, or 19.6% of common equity, up from $674 million on April 1st, 2010. This PML is for the Florida Tri-County area, which is our largest PML zone, as we have expected. Our Northeast wind area PML stands at $733 million, up slightly from $719 million we had as of April 1st, 2010. Both zones are significantly below our self-imposed 25% of equity limitation based on our risk management guidelines. With that, let me turn it over to John for his comments, and then we'll come back to handle your questions. John?
Thank you, Dinos. For the 2010 second quarter, the property and other short tail lines represented approximately 46% of our net premium volume. However, adjusted for the 2-year property cat contract written in the 2009 second quarter, the comparable percentages are 48% for the second quarter 2010 versus 46% in the 2009 second quarter. On a consolidated basis, the ratio of net to gross was 76%, the same as a year ago. Our overall operating results for the quarter reflected a combined ratio of 90% compared to 87.2% for the same period in 2009. The second quarter loss ratios for both 2010 and 2009 included little to no cat activity. As of the end of the 2010 second quarter, the provision for the first quarter cat events, which included the Chilean earthquake, did not change materially.
The 2010 second quarter loss ratio also reflected physical damage net losses of $15 million or 2.4 points from the Deepwater Horizon rig that was not booked as a cat loss. The 2010 second quarter combined ratio reflected 5.2 points, or $33 million of estimated favorable development, net of relative adjustments compared to 8.8 points or $62 million in the 2009 second quarter. The prior year development in the second quarter of 2010 reflected favorable development primarily in property and other short tail lines, partially offset by adverse development in casualty after the mid-year reserve review in the insurance segment.
The 2010 second quarter expense ratio of 31.7% was 1.5 points higher than a year ago, reflecting lower premium volumes year-over-year, as well as changes in the mix of business and changes to the reinsurance ceded structures in the insurance segment. The second quarter expense ratio was about the same as the first quarter of 2010. On a per-share basis, pre-tax net investment income was $1.70 in the 2010 second quarter compared to $1.60 for the same period a year ago and $1.67 in the first quarter of 2010. The growth reflects the accretive impact of the share repurchase program offsetting lower reinvestment yields. Total return of the investment portfolio was 1.74% in the 2010 second quarter. Excluding foreign exchange, it was 2.22% in the quarter.
The total net return benefited from a deliberate $135 million natural short position that we took against the EUR. The duration of the portfolio increased slightly to 2.9, up from 2.77 at the end of the first quarter of 2010, principally in the Treasury space. However, the overall duration of the asset portfolio at 2.9 is still less than the estimated overall duration for the liabilities, which we feel is appropriate given the, quote, "unusually uncertain economic outlook." We continue to be conservative with regard to the investment outlook and maintained a double A plus average credit quality on the portfolio.
Our balance sheet is conservatively positioned with total capital of $4.8 billion at June 30th, the same as at March 31st, which reflects the share repurchase activity during the quarter totaling $269 million. The cumulative share repurchases added $0.63 to the diluted operating earnings per share or 3 points to the ROE. Our debt plus hybrids represent approximately 16% of our total capital, well below any rating agency limit for our targeted rating. As Dinos mentioned, as of June 30th, we estimate that we hold approximately $600 million-$900 million above our targeted capital level based on current rating agency models with an appropriate buffer. Our liquid cash, short-term investments, and US Treasuries represent about 22% of our investable assets. With these comments, we are pleased to take your questions.
Jennifer, ready for questions.
Ladies and gentlemen, if you wish to ask a question, press star followed by one on your telephone. 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 Keith Walsh from Citigroup. Please proceed.
Hey, good morning, everybody. First within the commentary in the press release that had some adverse development in the 2003 to 2005 accident years in the insurance segment. Maybe give us a little more color on that, and I've got a couple follow-ups. Thanks.
Sure. We do profitability reviews in all of our profit centers pretty much every year, some of them on a six-month basis. At the same time we do profitability reviews, we also always look at the reserve position we have on a profit center by profit center. As you probably recall, that in our excess and umbrella segment in the insurance group, we had a couple of large losses that we took, total limit losses. Of course, once you do that, the case incur and paid for that year changes, and then the actuaries in reviewing that, they will establish a new projected loss ratio peak. That's what happened with that segment. We allow our actuaries to always review all of our reserves and where they believe that we have a different outcome than we thought, we make the adjustments. That's what happened in that particular case.
John, you have anything further on that?
Yeah. Well, being an actuary, we tend to blend these in over time. We looked at the loss development patterns in excess casualty and strengthened in the 2003 to 2005 accident years, and especially casualty, the frequency resulted in some general strengthening across the board. Just really truing up to be on track for where we think that these will end up.
Okay. The second question. You mentioned 10% ROE on 2010 written business. Are there any specific lines where you can achieve more robust returns? Then I've got a final one.
Yes. That's a blended. There is lines of business that in the low single digits, nothing to write home about. Your question is why don't you get out of it? It's not that easy to get out of all business, especially on the insurance group. You've got to maintain the infrastructure, you've got to maintain market relationships, you've got to continue to service customers. We still believe the best returns are still in the property cat area and some of the A&H lines, some of our low limit professional liability business that we write on a claims-made basis. Those, they're in the probably double digits, mid double-digit ranges. Of course, in order to average down to 9% or 10%, that means there is other lines that they're not carrying their weight.
We try to be realistic, That's how we navigate as to what we want to write and what we want to reduce in writings over the year. These are open discussions we have with our pricing actuaries and the profit center managers in each one of our units. It's part of our capital allocation process and also resource allocation as to where to allocate more resources, underwriting personnel versus where we through attrition might be shrinking personnel.
Then my last question around contingent commissions. I think you've probably seen the two largest distribution partners out there saying they will take them. At what point are you in your discussions with them to reinstating those types of payments? Thanks.
Yeah. We're always in discussions on contingent commissions. There is some cases when there is benefit in the overall approach to us that we will do some, and there is cases that we're going to refuse it. At the end of the day, there's got to be some value to both parties in order to do it. If it makes us more efficient on contingent because they're providing us either better information to underwrite or more efficient way to transact the business, then those efforts will be rewarded. We're not interested in paying just contingent commissions just for the asking. Let me share a couple of statistics, a little more flavor, even though it wasn't in your question. We monitor our total commission and our gross commission in the insurance group year. It was 14.8% in 2009 and 14.7% in 2010.
Of course, you got to get into the granularity and you got to see the mix of business and different books have different commissions, et cetera. In the aggregate for the corporation, in totality, that's where the numbers. When you look on our submission activity, we were flat. We got 27,000 submissions in 2009, and we have 27,000 submissions in the second quarter this year. From an activity point of view, we're seeing the same business, from a total commission payout, at least on a gross basis. We've been staying even. On a net basis, our commission, of course, went up by 1.7%, but that's structural changes to our reinsurance structure and how much ceding commission you're getting and are you moving from quota share reinsurance to excess of loss. There is a lot of moving parts in those calculations.
We monitor all that, and we make the appropriate decisions. John, anything to add to it or?
No, I think that's well covered and we continue to remain disciplined across the board as we write these and
Thank you very much.
Your next question comes from the line of Joshua Shanker from Deutsche Bank. Please proceed.
Yeah. Thank you. I want to talk just a little bit about more on the expense associated with the prepayment of the Ginnie Mae interest-only CMBS bonds. I'm trying to understand how much interest you're earning off those bonds to sort of put in relationship to the scale between the charge and the interest that you're receiving on those bonds.
Yeah. We have approximately, what, it's about 100-
About $100 million.
$100 million.
Of these IOs.
Of these IOs, interest only bonds. These.
Is that par your purchase price?
That's our amortized value today.
Right.
Okay.
Okay. The effective yield is a little north of 10%.
Yeah
on those bonds. Of course, at the end of the day, as we receive these cash payments on a monthly basis, part of it is for the yield, and part of it is to pay down the principal.
Okay.
Between principal and payments. The 3.7 is associated with our change in the prepayment pattern.
Yeah.
I think we have a more conservative.
Going on, we bought these very late 2008 and 2009. How the accounting works is you check how the prepayments are happening on these, and you true up in a quarter to fix the amortization as you go more or less than anything. $3.7 million over 100 over the last few quarters isn't a great deal of change.
It is a great deal of change, yes?
It is not.
Oh, it's not. Essentially, you received probably about $2.5 million of interest on this quarter. Is that reasonable?
Yeah.
I'm just trying to understand, because I don't know this industry at all, the extent to which there's a risk that that would repeat itself.
Well, unless patterns change significantly.
Yeah
no risk. Basically, we took a different approach to it than in the first couple of quarters that one of our outside investment managers they were taking in recording these. We believe that unless there is a change in the patterns, a significant change in the pattern, there will be no further adjustments. We don't anticipate a change in the pattern. We like these kind of bonds. The prepayment schedules and default, it affects the pattern. We haven't seen anything. When we stress test these things, they still produce very high yields, even at 3x change in default rate. We're very comfortable with the investments on their own, and I think we're getting the accounting to where we're very comfortable with.
Appreciate it. Can you discuss some claims emergence patterns you're seeing on the '08 and '09 executive assurance book?
That was related to the financial crisis out of our London book.
Some in the U.S. book from this credit crisis.
Right. The combination of those, we put some additional reserves for the D&O lines for those. Again, part of this is our quarterly reviews. When we look at the reserves, and we go in a granular basis and see what got reported, what potential for some of these cases to materialize in losses, we make those judgments, and we adjust our reserves.
At this point, this is IBNR not the case?
Yes.
Are the increases severity related or frequency related?
It's probably both. In a couple of cases, a couple of made-up cases, we put some. I would consider that more severity. There is no significant appreciable change in number of claims reported on the frequency side. In the aggregate, we put some money up.
Thank you for your candor.
Your next question comes from the line of Dean Evans from KBW. Please proceed.
Yeah, thanks. I was wondering first, I guess if you could just give some more details on the decline in the reinsurance segment. First off, I guess, could you give a little more clarity as to how large the two-year property cat contract was from last year? Second, also, really was the decline just more related to pricing, or was it trimming the book, or what was the blend there?
Well, there is a few things. I'll give you some general color and have follow-ups if that doesn't answer your question. First, the contract. The contract is for a large client. It's about $43 million-$44 million, thereabouts. It's a two-year contract. We look at it every two years. We bound this two years ago, it was written premium last year, not this year. The following year, if we renew it will show up again next year. Now, on what is happening in the reinsurance segment, with the exception of a lot of the short tails that, especially property cat that we do on excess of loss, we're a company who prefers quota share contracts. We try to align our interest with the interest of the ceding.
For that reason, a lot of our decisions, if we're going to continue on a contract or not, is our view as to what's happening with the underlying primary business and where rates go in that sector. In the casualty area, we've been reducing consistently now for the last 4 or 5 years, and we continue to do it to almost nothing. I think our reinsurance operation in Bermuda has very little, probably less than $30 million, and we write a little more out of our U.S. reinsurance operations, et cetera. It's our view about the pressure that casualty business is feeling on the primary sector. Of course, we're not a big excess of loss writer on the casualty side. Similarly, on the property side, some of the quota share opportunities for this year, we felt rates were coming down significantly, especially on international, national kind of accounts.
For that reason, we chose to reduce some writings in that area. That's what's going on the reinsurance side. We'll continue to remain disciplined, and we'll react to the market conditions. If we have to give up some volume to maintain margins, we're prepared to do so.
Okay. No, very helpful. Good color. My second question, kind of a bit of a numbers question, but looking at the other expenses, it seems that they're always a bit higher in the second quarter. What is sort of the driver behind that and-
You got a little bit of incentive calculations. Usually we got to pay our underwriters, right? That usually has an effect. When you look at our expenses, the expense ratio went up, and most of it is coming from the change in the reinsurance structures. Even though our gross commission, which is the commission we pay on individual deals out, hasn't really gone up. On a net basis, it has gone up because we're not getting as much ceding commission. Also, in the second quarter, if you read our proxy statement, that's when we do all the equity grants and share appreciation rights to the troops. That hits in the second quarter.
Yeah. There's an accounting provision that for some portion of those, we have to book all in the, when it's given, not spread out over time. That's why there's a bump in Q2. You see it again last year or the year before. There's this bump of other operating expenses.
Yeah. It's for us old guys. I think the provision is that if you are eligible for retirement. Don't get any wrong ideas. I'm still a very young 60, so don't get any ideas, but accountants think that we're eligible for retirement, so they accounted for it.
I put it all right away. Right.
Okay. That makes perfect sense. I guess my last one, just sort of a quick numbers question. You did mention in your discussion that the rig losses were booked as non-cats, and I think that was $15 million.
Yeah.
The cat events that were in there, what was that? That $7 million, I believe, related to?
Yeah, about a $1.1, $1.2.
Yeah. Some of the Tennessee storms and some of the smaller wind storms that affected players. For us, it was not that big an event.
There was no movement on the Chilean earthquake. It was like less than a $1 million movement negative coming down. It was not a cat event for us this quarter.
Okay, perfect. That's all I had. Thank you.
Thank you.
Okay. Next question comes from the line of the name is Keith from Credit Suisse. Please proceed.
Hi. Good morning.
Good morning.
On the adverse reserve development, just curious as to whether the higher casualty claims you're seeing from the 2003 to the 2005 years, how do you think your reserves hold up versus peers? Was it just that you decided to raise your loss picks rather than take down IBNR when you saw the numbers?
Well, I don't know what peers booking those years. All I can tell you is we have raised our reserves. Raising the reserves doesn't mean that those years are unprofitable for us. They're still profitable years for us, but not to the extent that we originally thought. In that sense, it's our own view that the '03 and '05, at least for us in that segment, in that profit center, the results are not going to be as robust as we originally thought.
Okay.
I don't know. I don't have inside information on everybody else's accident year by line of business to give you a comparison.
Sure. Could you give us a sense for the IBNR for the company as a whole? How has it changed this quarter versus last quarter?
We're still at 68%, which I believe is about the same as a quarter ago. It hasn't changed at all. Even though somebody will argue as our earned premium is coming down and we're writing less, maybe that should be changing a bit, we haven't changed it.
Okay. Fair enough. The second question was on the Deepwater Horizon loss. How much of that would you say is a normalized loss? I believe that was $15 million or 2.4 points.
What do you mean normalized?
Do you think this was a higher loss than you would normally expect in the quarter?
No. Listen, when you get an event like that, which is significant, this is not an unusual loss for us to take. At the end of the day, it's lumpy. You write offshore energy accounts, you put in big limits. You get it on the reinsurance, you get it on the insurance. It could have been $30 million, and it wouldn't be a surprise to us. Depends what you write, and did you get hit on that particular account. Of course, you know our philosophy is, both on the insurance group, we have a maximum net position that we take, especially on first party coverage, that you have to write big limits, which continues to be no more than $15 million any one risk. On the reinsurance side, we take much smaller lines, because you might get hit from multiple clients.
When you have a big loss that all the layers go, you might get it from two, three or four cedants, and you get a small portion of each one's loss. It was not an unusual loss for us. It's lumpy, and some quarters you're going to have it, and some quarters you're not going to have it.
Sure. Which segment did that come from?
It's offshore energy sector.
Both reinsurance and insurance.
Right.
Oh, it's both reinsurance and insurance. How much came from reinsurance versus insurance? Do you have?
It's about 10 from reinsurance and five net from insurance.
Right.
Okay, great. Sorry, one last follow-up with respect to the adverse reserve development. Just curious, does that mean that there's a lower probability that your reserves develop favorably from the past for those years? Or do you still think that you've been more conservative putting reserves up, and there is still a possibility that as time goes by, those reserves may be redundant?
Well, you're asking a question that only the data can answer in future quarters. We'll react to the information that comes through. When we get another diagonal on the triangles, we make those determinations. Like I said, we spend a lot of time making sure that we try to get the reserving right because that affects what action we're going to take in the marketplace. If you don't get reserves right, you're not going to price your business right. At least you won't know if there is profitability or not in the business that you're underwriting. It's part of our fabric when we do profitability evaluations in all of our units to make sure that there is an in-depth analysis and discussion as to what our reserve position is and what we believe each one of these years' profitability is. It's through that process.
We do react, I think, faster on negative news and slower on positive news because that's a better way to see it. You guys get very excited on minor adjustments if they're negative. If they're positive, you forget about them. For that reason, we try to be as cautious as we can.
Particularly the longer tail lines. We try to be very disciplined when the developments come in to book them in and be cautious on taking them down because it's a very long tail line, and it's a bit lumpy from time to time. You'd rather have the reserve there than not.
Yeah. Vinay, listen, I think we're a reasonably good company, but we're not perfect. We're not going to get everything perfect. We don't profess to be a perfectionist. Yeah.
That's good. I appreciate your candor. Thank you.
You're welcome.
Your next question comes from the line of Jay Gelb from Barclays Capital. Please proceed.
Thanks, and good morning. First, on the year-over-year comparisons for gross written premium growth, the reported number was a decline of 10% overall for the company in Q2. Am I right in saying if you back out that two-year reinsurance contract written in the second quarter of last year, it would have been down six on a reported basis?
Yes and no. It depends how you do it. The proper way to do it is you got to split that contract into two and says, if it was annual contracts, it would've been like $21.5 million and $21.5 million. If you do that calculation, I think you'd be right.
Okay.
Right. Because you can't say, I have it in one year, and I won't have it in the next year. Because in essence, the accounting rules doesn't allow you to say, "Hey, I got two payments, but I got all the cash up front, and it's $21.5 million each time.
Oh, I see. On the reported results, the full impact, the benefit was in the second quarter of last year, nothing in [audio distortion].
That is correct. When you go on the earnings pattern, it doesn't change that. A two-year contract, you're going to earn over two years, where a one-year contract, you're going to earn in one year.
I understand. Okay. Then second on the Deepwater Horizon, is there any exposure up at all for liability?
Yes, there is exposure for liability and basically there is a lot of contractual issues that need to be resolved, et cetera. At the end of the day, there is four or five parties that they might be involved, and depending on what we get from our insurance and reinsurance participants, there might be some exposure there. Having said that, it is way too early. Clearly, most of the liability goes to BP when you look at all the contractual agreements. On the other hand, there is some other companies who probably have liability, either because they made equipment that fail and/or they provided services that they were not, and there is a dispute as to some of the facts.
There's a very long way to go, I think.
That's right.
before you get clarity as to what the exposures are there.
I see. Finally, on the excess capital position. At the midpoint, that's about 20% of common equity, which seems pretty substantial. To what extent can the share buybacks help to draw that down in light of the company probably still earning well over $400 million this year?
Listen, I think we've been friendly to shareholders so far. At least that's the feedback I get. Usually, we like to be a little quieter in the third quarter because that's when we have exposure to the cat season. We like to be more conservative and keep a lot of excess capital on the balance sheet to see exactly what happens. Even though we're very comfortable with our underwriting and long-term patterns, when you're writing cat business, any one year can be a year of surprises. Having said that, fourth quarter, depending where we trade, we'll probably get back to our policy of returning excess capital to shareholders. That discussion always happens in every board meeting we have on a quarterly basis in our investment committee and our finance committee at the board level.
It's a critical question as to what do you do with your capital structure and how do you deploy excess capital. Clearly, I don't want to give it to our underwriters and try to spend it in the wrong place if there is not an opportunity for them to write profitable business. That's not the place we want to put it.
Right. Would it be aggressive to expect Arch to complete the share buyback authorization this year?
Hard to tell, based on a lot of the rules, it's difficult to do that much in one quarter. There's limitations as to how much you can buy, et cetera. For that reason, absent of for whatever reason, a significant reduction in price and availability of a block trade of some sort, it's very hard to find that much.
Right. Makes sense. All right. Thanks very much.
You're welcome.
Your next question comes from the line of Matthew Heimermann from J.P. Morgan. Please proceed.
Hi. Good morning. I have a couple-
Hi, Matt.
Hopefully they're pretty quick. Gross versus net on Horizon?
The gross was-
22, I think.
No, it's more than that. We'll look at that number. The gross and net on reinsurance, it was the same.
Yeah.
I believe 22 was the gross on insurance and net to five, so it might be 32 to 15.
Okay, perfect. Then, with respect to the management liability reserve change, was any of that related to increased defense cost assumptions?
No. It's not a specific reserve attributed to that. It was an evaluation of putting more on the 2008, 2009 year based off the financial crisis. It's kind of a bulk number.
Okay. Just to clarify, is that management liability stuff, just where are you attaching?
Well, these are excess placements predominantly. We're not a primary writer. We believe that in order to get to us, it will go through a lot of layers. People can be optimistic, people can be pessimistic on these things. We see it with our set of eyes, and we have very good people who understand that business. Based on our pricing actuaries, the evaluation of our claims department, and our underwriting, and what we've seen, we put up the bid in 2008 and 2009.
No, that's fair.
But-
That's fine. I just was curious about that topic specifically.
Yeah, Matt, I've got the right number. It's 29, was the gross.
Oh, on the Horizon?
Yeah, on the Horizon.
Right.
The insurance, it was 17 to five, and then the reinsurance was 12 to 10.
Okay, perfect. Just two other ones. Just a quick comment on the travel accident line, an area of growth that slowed down. The other question was on the reserve development and just reserve development generally. Does any of the assumption changes on the insurance side affect how you think about the reinsurance side?
Yes and no. Listen. The reinsurance side, we look at every single contract that we have. Some of these contracts, especially old quota share contracts, they have a lot of underlying data coming from our cedants that they might have their own patterns. We will reserve based on those patterns because there is significant credibility to that information. Having said that, we will always have also kind of the sixth sense to evaluate a product line, how the marketplace is doing on the product line for the accident years. Are we significantly different, and why? If we can't explain it, then we got to make adjustments. That's why we hire outside actuaries also to review our reserves from a holding company's point of view, to make sure that we don't stray in the wilderness without having all information feeding into our reserve decisions.
As we mature, we promise the street we're going to release our triangles, which are going to come in August. I think I deserve a little vacation, so I'm leaving next week and the week after. When I come back, hopefully they will let me look at them before we put them up. In August, you're going to see our triangles. We'll tell you that it's still a blend. We don't depend 100% on our own data, but more and more of our own data affects our reserve positions.
No, that's fair. Just on the travel accident.
The travel accident, it's been a good business for us. It's been a good business for the industry. It's difficult to grow it organically, and we're doing the best we can-
Understood
to try to grow the business. Yeah.
Okay. All right. Thanks much.
Your next question comes from the line of Beth Malone from Wunderlich Securities. Please proceed.
Okay, thank you. Good morning. Question on the investment portfolio. You mentioned that you were starting to write up more of the short-tail business in your total book, I was wondering, are you making any changes to your investments portfolio as a consequence?
Not at the time being. Let's talk about a little bit because we have a philosophy on how we deal with our investable assets. We bucket those into three categories. First, we got the reserve, the company capital. Third, we have borrowed money. On the borrowed money, $300 million of bonds we have. When we got those funds, we only wanted to be subject to the spread. In essence, we invested them in the same duration. Where we make judgments is where should we be with the funds that they have for reserves. Those, we match duration of liability. If duration of liabilities in our reserves changes, we will change that component. Where we adjust the view that we have on the economy, that should we be longer or shorter from our liability durations, we do with the equity capital of the company.
We've been shorter in duration than what our liabilities are. Right now, we're probably, I would say, call it six months to three quarters of a year shorter than the duration because we don't like the economic environment and we believe that being more conservative and not taking duration risk, even though it comes at a small cost to shareholders, it's a better position to be than being long at this point in time.
We also make sure, in addition to matching the duration, that the key rate durations that were matched with cash flows from buckets 1, 2, 3, 4, 5, 6, so that it's not just matched on an average number, it's matched across the board. We also keep a good portion liquid, in case there's a large cat event comes through from property cat, that we can have the ability to pay in a pretty rapid timeframe.
Okay, thank you. One other question. On the Transocean event, you said it was not defined as catastrophic, and I was just curious as to why it might not be.
Well, we consider cat activity to be natural cats, not man-made cats. It's a catastrophic event, but it's man-made. An explosion in a refinery or a blowout in a well, et cetera, it's not what we consider a natural catastrophe. This is not a hurricane or a tornado or a hailstorm or a wind or an earthquake. That's where we make the distinctions. You might prefer the expression, some companies call it man-made cats or attritional cats. They use different phraseology. For us, always our cat numbers is what comes from natural catastrophes.
Okay. As regards to the Transocean, I assume you've seen improved pricing in the energy market as a consequence in the second quarter?
Hmm. Slightly on the first party, but it's still disappointing, not much on the liability side. That tells you that the market is pretty soft. An event like this, even though the liability questions are still unanswered, we have not seen any movement on the liability side, which is disappointing.
Okay. All right. Well, thank you very much.
You're welcome.
Your next question comes from the line of Brian Meredith from UBS. Please proceed.
Yeah, good morning, everybody. Dinos, just a quick question. The Neal Bill has been getting a lot more talk recently, some speculation that it may pass here. I guess my question is, what do you think about that? Do you think it can pass? Number two, are you doing anything at Arch to potentially prepare yourself in the event that does happen, and to minimize any financial impact?
For first question, I don't know. Washington does a lot of strange stuff. Clearly the Neal Bill is a protectionist bill. If you can see from who is behind it, is predominantly a few domestic insurance, trying to serve their own interests at the expense of policy holders and the consumer. What you see is behind the Citizens for Affordable Rates is a much broader coalition of people. Having said that, every company looks to make sure that it has the proper structure and tries to maximize its ability to serve its customers at their lowest possible cost. We're one of those companies. At the end of the day, our interest is to provide a lot of cat capacity to the U.S. at the best possible prices. I don't know what the future will bring, but we're prepared.
I guess my question would be then, what do you think the financial impact would be today if something went through?
It's going to be minimal because unbeknownst to not knowing what they will pass, we still pay a lot of tax when you consider the excise tax and the risk transfer tax that we paid on the business we write in the U.S. Don't forget, a lot of our income is coming from investing our capital, which is offshore, and investing some of our reserves that are offshore. That is not going to change.
Okay, great. Second question, Dinos. Can you talk about the interest rate environment right now? Looks like it's going to be low here for a little while. As a result, have you changed kind of your return thresholds that you think about that you can achieve? Particularly when you look at underwriters and allocating capital down and what kind of return on capital they need to achieve, have you lowered the return assumptions?
What we do in the investment department and how we price business are two different things. Our underwriters, they're required to produce a return based on the risk-free rate of return of new money invested. In essence, in a lot of cases today, and maybe that's why we're pessimistic on casualty business or long duration business, is because when you look at the risk-free rate of return, three year, five year T-bills, you're not getting much in return. That's what our pricing actuaries are instructed to factor in when we develop our rates. It's probably affecting us by being less optimistic as to how much return we can have on a risk-free basis in writing business. That's reality. I mean, you can't escape reality. The reality is that the returns are going to be very skimpy moving forward.
15% return on capital. When you're talking to underwriters, you're not telling them we need to make a 15% return on capital. It's something a lot lower than that now. Where maybe a couple years ago it was higher.
Listen, we have not officially, through our discussions with either our underwriters or our board or our shareholders, have changed our long-term goal of achieving 15% return over a long period of time. Having said that, we always said that there are going to be years we're going to give you high teens, even 20% or more, and there are going to be years we're going to be in the single digits. If this environment stays for a long period of time, which we don't believe it will. At some point in time, I think interest rates, they're going to move up. I don't know exactly when. The 15% might be unrealistic if we have a prolonged period of time.
Like a Japan scenario.
For-
20 years, the rates stay at two.
two or 3% interest rates. I'm not that smart to predict interest rate movements into the future. I think, that discussion we always have with our senior people. At the end of the day, I can tell you, earning nine or 10 in today's environment is pretty difficult. It's not an easy thing to do, and we believe we're earning it.
Great. Thank you.
Your next question comes from the line of Jay Cohen from Bank of America Merrill Lynch. Please proceed.
Yes, thank you. Good morning.
Hi, Jay.
Hey, Dinos. Two questions. The first is, if you could comment maybe more broadly on claims trends in general, the frequency of claims being reported. Obviously, even though we've kind of zeroed in on some of this adverse development, overall, you're still having favorable development, which suggests still favorable trends. Secondly, I'm going to zero actually in on the adverse development for another second. What you've seen, whether it's from the 2003, 2005 year in the casualty business or the more recent years in executive assurance, has any of that made you rethink where your pricing is today on those lines of business?
Well, let me take with the last part, I'll go to the first part. That, no. As a matter of fact, we were reducing casualty writings way back in 2005, 2006, actually. Not because we had any reported claims, because we just didn't like the pricing environment. The rate reductions, they were significant, et cetera, at the end of the day, we just, factoring industry loss ratios and how much rate we were giving, we didn't find that business to be the most attractive. From that perspective, no surprise. Same comment for our D&O business. It's not a surprise. It's just further detail evaluation of the financial crisis and making adjustments to it. Now, your first question, I will John, do you want to comment on it, I'll come back to it.
Generally, in this quarter, if you took the expected claim activity that we would have, we were favorable across the board in sort of a total aggregate sense. We had some positive development because in total we were positive, but we thought it was appropriate to flag the areas that also had some adverse development to give you a clearer picture into what's going on within our business. We think that's important to do. This adverse development, it has to be balanced with the fact that overall, we still had a total positive development in the entire quarter, and it's just part of the ongoing process. Every quarter or every six months, we review the trend and what's going on, and we adjust. There's positive and there's negatives on an ongoing basis as we move forward.
Yeah. On the frequency and severity, frequency has been steady and has been better than expected for quite a bit of time, we don't see significant change in frequency trends. The severity is ticking up a little bit, but not anything to write home about. From a pricing point of view, when we calculate trend, our actuaries actually, they're looking at the long-term patterns, we still have, I would tell you we have more than 3% trend in most of our lines when we factor in as to what pricing we need in order for us to get adequate returns.
Yeah.
Great. Thanks for the answers.
Hey. Your next question comes from the line of Ian Gutterman from Adage Capital. Please proceed.
Hi.
Hi, Ian. You're always towards the end. You're the rabble-rouser who sits in the back of the room.
I try to be patient and let others get their questions in, so if I take up too much time, it won't offend anyone. Just a little bit more on the adverse development. Just maybe from a different angle. The executive assurance, I guess the only thing that surprised me a little bit about that was not so much that you've shown it, but that many of your peers have protested rather fiercely that the credit crisis claims are kind of not that big a deal, and everything's coming in favorable, and we're all too worried about it. You actually have become the outlier, showing some adverse development there. Do you have any thoughts?
The only thought is we like independent thinking.
Okay. Do you see anything that refutes the claims that many others are making that this is all blown over by?
Listen. You can sit around the table, and smart people can come to two different conclusions. Do you put some Madoff related? When you look at contracts that were issued out of the London Market, et cetera, especially for some of the feeder funds that they might not have done the proper due diligence, et cetera, we think there might be potential for exposure there. There is people that they say, "No, that's not going to happen." They choose not to put any money. We have a different opinion. It's independent thinking. Different people will sit on the same set of facts and come up with different conclusions. We're comfortable where we are.
Because you can say historically, European courts haven't been that big on these things. On the other hand, there's a trend now of some countries starting to be a bit more consumerist in their findings. We'd rather err on the more conservative end of that, and we'll see how things develop over a period of time. That's going to take some time to sort itself out.
Okay, great. That makes sense. I appreciate that approach versus the hoping for approach. The other one that I don't think we discussed as much, I think there was a lot of discussion on the casualty insurance. I was wondering if you could talk a little bit more about the casualty reinsurance from recent years. What would have happened in recent year casualty that would be developing adversely already?
Well, it's not anything that is coming and developing. It's our view that the 2008, 2009, maybe the 2010 year is not going to be as good as the industry thinks it is. In essence, we try to be ahead of the trend and make sure we have enough reserves up, so I don't have to spend my life explaining why I have adverse development.
Fair enough. Any specific lines in casualty that showed up on the reinsurance?
No.
General.
Listen, the audio and the video has to match. We're telling you we're not writing a lot of casualty. That means we don't like it today. We can't say, "Well, we're going to do wonderful well in 2008, 2009," but we don't want to write a lot of that business. We got to match your story. What we believe is that these are not the most attractive years, and for that reason, you'd rather be more cautious as to what reserves you're putting up.
Okay. That makes sense. Then my last one, I have to ask the accident year question again I guess. Again, the reinsurance, I look at the accident year ex cat. Your first half is high 70s, around an 80. It's the best first half you've ever had in the history of the company in reinsurance, the accident year ex cat.
Right.
Why would that be, given the environment we're talking about? I know you said most of-
The Abuga business is probably 70%-plus short tail, and there is no cats and there is no-
Traditional is low.
Traditional is being low, and my hands are tied as to you can't put that much in reserves on short tail lines. It is what it is. It's lumpy business. Some quarters will surprise you one way, and some quarters will surprise you the other way.
I guess, in the numbers I gave you, that 79%-80% had four points of Deep water, and I didn't even strip that out.
No, I understand, it's short tail, Ian.
Okay.
This is not an actuarial exercise. It is what it is.
A building burns down or it doesn't.
Yeah.
No, I understand. I guess where I get confused on it is when I look at your first half 2010 versus first half 2009 earned premium, which is where I would think we should see it. Your overall earned is down 21%, your casualty is down 24%, and your property and short tail are down 20%. There's not that much of a difference. That doesn't look like a big mix shift to me.
Don't forget. You can't look at the sequential change. You got to look at the overall book of business and how much is short tail versus. The short tail runs on its own. There's no actuary says, "I'm going to book this at 50, 60, or 70 loss ratio." The short tail book, it is what it is. Either you have attritional losses or you don't have them, et cetera, and you got to let it run through the book. You can't imagine of things that might happen and put up reserves on short tail business. That's why you're going to get some lumpiness. When your book is probably 70% short tail, you're going to have that.
Okay, fair enough.
The short tail builds up over time, as has been happening the last year or so. The mix of the risk of the book is becoming shorter tail, and so it's slowing out on an ongoing basis now.
Right.
If we don't have the claims.
If you look at our first quarter of 2009, the property and other short tails for reinsurance was 73.5% of the book, and 26.5% was casualty. This second quarter of 2010, 77.9% is property short tail and only 22% is casualty. If you go back, let me take you back to, let's say, 2007. If I look at 2007, it was 63% short tail, 36% casualty. If I go a year back, in 2006, it was 54% to 46%. There's been shifting over time. At the end, the key number is, if 78% of what you write in reinsurance is short tail, it's going to run itself, and it's going to be lumpy. Some quarters are going to be very good, some quarters might not be as good.
Hopefully, our underwriting is good enough that overall, for the whole year, we're going to have pretty good numbers.
Okay, fair enough. I'll follow up with you offline. Just when I do the numbers on earned premium, I get first half of last year was 29% casualty, and first half of this year was 28% casualty. That's why I'm having trouble. Maybe we'll follow up offline.
Well, it could be on the earning pattern, depending if I had some property that These are the written premium that I mentioned to you. Net written premium, it's the numbers that I mentioned to you for 2010, 2009, 2007, and 2006.
All right, got it. All right, thanks.
Your next question comes from the line of Justin Nawahi from HMI Capital. Please proceed.
Hi, thanks. My question's been answered. Thank you.
You're welcome.
Your next question is a follow-up question from Vinay Misquith. Please proceed.
Hi. Just the 9%-10% ROE you said that you have on your current business, is that based on the current interest rates?
It's based on the current returns we get on the investment portfolio.
Okay, great. If rates are flat because they were down now versus the first quarter, should we expect the ROE to go down next year versus this year?
Well, if pricing environment doesn't change, yeah, that would be a good conclusion to get to.
It doesn't-
Of course, if the pricing environment changes and maybe we can make a little more money on the underwriting side, that will be different. I don't expect the pricing environment to improve. I'm not as optimistic as some others are on changing. I think 2011 is going to be a tough year, and probably 2012 will be a tough year because I haven't seen enough blood on the street yet for people to change. The market change on fear, and there is no fear yet out in the marketplace.
Sure. Okay. Thank you.
Thank you, Vinay.
There are no further questions. I will now turn the call back over to Mr. Constantine Iordanou for closing remarks.
Well, thank you for your patience, and we went a bit over time. Next time I'll speak faster so we can do it in an hour. Have a good day, everybody. Thanks.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.