Before the company gets started with this 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 their 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 this call to be subject to the safe harbor created thereby.
Management also will reference some non-GAAP measures of final performance. The reconciliation of these measures to GAAP and definition of operating income can be found in the company's filings within the SEC and are also available on the company's website. Good day, ladies and gentlemen, and welcome to the Arch Capital Group Ltd. investor call on the acquisition of United Guaranty Corporation. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Constantine Iordanou. Sir, you may begin.
Thank you, Emily. Good morning, everyone, and welcome to our call. We're very pleased that we have reached an agreement to purchase United Guaranty from AIG. When this transaction closes, it will make us the largest private mortgage insurance company, and it will allow us to deploy our excess capital into a high return business. On a pro forma basis, and with just a simple combination of our companies, mortgage insurance will absorb approximately one-third of our capital and contribute approximately 50% of our earnings. At this time in the cycle, we like the mortgage sector because we believe that the mortgage insurance earnings are more stable and predictable than P&C earnings.
This might change over time as the primary insurance and P&C reinsurance cycle changes, but at this point in time, we view the MI space as more attractive on a risk-reward basis than many of the business lines in our core insurance and reinsurance business. The mortgage insurance industry's history has not been stellar, and some of the problems can be linked to the monoline structure of the industry, which has proven vulnerable to their own version of credit risk. In our view, most of the past problems are attributed to very loose underwriting standards practiced by the entire industry for quite a bit of time. We believe that this PML can be effectively managed through prudent risk selection and conservative capital management. United Guaranty under the AIG umbrella has been a strong proponent of risk-based pricing and data analytics, which we strongly agree with and religiously practice ourselves.
By coupling the talents and capabilities of both companies, we believe it will give us a competitive advantage in managing the PML risk in the mortgage insurance business. From a risk management point of view, as we have done since our formation, we will maintain risk aggregation limits in accordance with prudent capital management balanced across our three business segments. Both organizations have developed capital market mechanisms and reinsurance purchases to manage PMLs, and we will expect this market leadership to continue. I'm going to turn now the call over to Mark Lyons, who will give you the key transaction metrics. After Mark, we will ask Marc Grandisson, who is also here on the call with us to give you a bit more on the strategic rationale. Then we will come back and answer your questions. With that, here it is, Mark.
Great. Good morning, all. I'd like to address a few topics to help clarify things a bit. First, what did we purchase exactly? Well, we purchased the United Guaranty U.S. primary mortgage operation along with UGC Asia. Additionally, to clarify, Arch will assume the 50% quota share that has been provided by AIG to United Guaranty. AIG will terminate that quota share contract on a run-off basis and keep the cash flows and exposures on a 50% basis emanating from policies that incepted during 2014 through 2016. Arch, beginning at closing, will assume 100% of the UGC policy exposures written as a result. This is value not immediately evident by examining the UGC S-1/A filed with the SEC earlier this year. What is the consideration? The consideration is $3.42 billion.
This amount consists of approximately $622 million of cash from internal resources, $200 million from our revolver facility, $925 million of debt, up to $700 million of preferred and $975 million of ACGL common stock. I'll come back and clarify the common stock in a moment. This translates to a cash payment to AIG of up to $3.5 billion. There are some wrinkles though, that make it a bit less straightforward. I'll discuss those now. First, there is the possibility that UGC will dividend to AIG pre-closing up to $250 million. This will have the effect of lowering the consideration paid by Arch to $3.172 billion, but AIG would continue to receive the $3.42 I alluded to before. It's just that $250 million would come from a dividend from UGC. Of course, that dividend would commensurately lower UGC's book value as well.
Therefore, assuming a $250 million dividend for a moment, the price paid by Arch would be $3.172 billion. The preferred issuance would commensurately drop to $450 million from $700 million, and the cash component would be approximately $2.2 billion. Furthermore, there is a collar structure involving the $975 million of common stock. Within a plus or minus 7.5% band, the number of shares will adjust in order to keep the dollar value fixed. Outside of the collar, the number of shares remain constant, but the value per share can fluctuate up or down. The common is actually a common equivalent form of preferred, which has no coupon and no voting rights. It will convert to common in a 10:1 ratio upon being sold.
There is also a lockup provision that permits AIG to begin selling the common equivalent preferred beginning six months after closing, with a lockup expiring at 18 months. AIG at closing is expected to be an approximate 10%-11% shareholder of ACGL. What's our view of some of the financial benefits? Well, the classical measures are all positive. We expect significant EPS accretion and ROE expansion by the end of the first year. Additionally, the transaction is expected to be accretive to book value per share by the first year and is expected to recover on a tangible book value per share basis by two years post-closing. There is a no financing condition within our agreement, so we have put in place a facility to secure the expected capital markets execution coming from acquisition debt and preferred stock financing.
We are extremely pleased with the defensive risk management that has been put in place and will be put in place by UGC and AIG prior to closing. As you may be aware, UGC has executed already two capital market transactions known as Bellemeade One and Bellemeade Two, that help to wall off the potential downside risk of pre-crisis exposures. Bellemeade One provides cover for performing loans effective between 1/1/2009 and 3/31/2013. Bellemeade Two provides cover for performing loans on policies effective prior to 1/1/2009. Additionally, aggregate excess of loss protection will be put in place pre-closing that provides extreme tail risk protection for performing loans effective between 1/1/2009 and 12/31/2015 inclusive. These then provide a portfolio more akin to any new company in the U.S. mortgage insurance space. With that being said, I'd like to now turn it over to Marc Grandisson.
Thank you, Mark. Good morning. From a strategic and operational standpoint, we are fortunate to be combining two operations that have a similar culture of innovation, strong risk management processes, a diversified client base, and a focus on providing value to its customers. We will be building from much common ground, and this will allow us to dedicate our efforts to get the benefits from the enhanced scale of the joint operations. Both Arch and UGC have well-developed data analytics and a history of innovation that will allow the companies to be market leaders in risk management in the future. We are attaining scale at an opportune time with the acquisition of a significant book of business from the post-2008 quality origination years. In addition, as Mark mentioned, their pre-2009 book is well protected by an innovative risk-sharing structure, Bellemeade Two.
We've said many times, and you heard Dinos say it as well today, that we believe the economics of the U.S. MI insurance industry have been very favorable since 2009. With United Guaranty, we are acquiring not only a market leader, but a company that shares our core principles of price, cycle, and risk management. Our values are aligned, and the combined companies will enhance Arch's global footprint and breadth in the U.S. MI industry. With this, Dinos, I'll turn it back over to you.
Okay, Emily, we're ready for questions.
Thank you. If you have a question at this time, please press star then number 1 on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Your first question comes from Amit Kumar. Your line is open.
Thanks, and good morning, and congrats on the deal. Just maybe a couple of questions. The first question I was getting last night was maybe a discussion on the legacy reserves for UGC. I'm sure you did a deep dive and you talked about some protection. Maybe just talk about it a bit more so that we can have comfort around those numbers.
Well, UGC has managed their book effectively. We were impressed by their thought process and also we were impressed by the innovation with the Bellemeade One and Two transactions that, in essence, walled off any adverse development that it will emanate from the prior year. We got very comfortable with the old book, which is only approximately 18% of the outstanding liability. When you look at the United Guaranty's book, 82% is post-crisis exposures, 18% is pre-crisis exposures. The pre-crisis exposures, they've been walled off by these two transactions. Marc, you want to add something to it?
Two things to add to this. First and foremost, one of the key elements of the due diligence was to sit down with the claims and understand the claims processes. We're very, very impressed by it. They have a very active and very solid operation, as you would expect. I think that, in addition, we have also insight into our own book of business. We were competing with them as a result of the PMI. We have the data from the PMI runoff that we are effecting on behalf of the liquidator over there. We have a good sense for where the pre-2009 roll rates or claims are developing, and they're actually developing favorably as you've heard on many calls. It's the same as you would expect for our friends at UGC. We're very, very comfortable there.
Amit, I'll just throw in one other thing back to the Bellemeade transaction, because it doesn't attach its statement reserves. It's higher. I think the important thing to keep in mind is if there's a future economic problem, the issue isn't known claims, in my opinion. The issue is currently performing loans that become non-performing loans, and this is what this cover provides. As you know, the statutory accounting model does not permit that kind of estimation on the balance sheet, and this provides thoughtful cover for that.
Got it. That's helpful. The second question, I will re-queue after this. Dinos, I think in the past you had talked about maybe somewhat of a self-imposed limit of 25% capital to any risk. MI is now sort of one-third, and I'm just trying to figure that out in terms of looking at the broader new Arch and the various pieces. What other areas probably get pulled back in terms of trying to meet that requirement? Maybe just help us on, if we were to fast forward, how should we think about capital allocation for MI versus reinsurance versus insurance?
Yeah. Very, very good question. You're absolutely correct. Our original goal was to have balance within all of our operations, with approximately 25% of our capital being allocated to the MI space. Having said that, it's not very often that you will find something to merge with of the quality that we have found in United Guaranty and get you exactly to 25%. The fact that we're at 35% today is still a very comfortable level for us based on where we think the mortgage insurance marketplace is and the returns that we expect from that. As I said in my prepared remarks, we're going to maintain this balance over the years. We're not going to allow the MI to dominate Arch. At the end of the day, Arch will always be a major reinsurer, a major insurer, and a major mortgage insurer.
We will use all tools available, capital market tools, reinsurance availability in the marketplace, and potentially investors that they want to partner with us to manage the risk to the tolerances that us and our Board is comfortable with. There is no change in philosophy, so to speak. For this transaction and for the next few years, we'll probably be committing a bit more to the MI space, but that's where the highest returns exist. I want to assure you that we're not going to lose sight of aggregations and PMLs and be comfortable with how much of that we have on the balance sheet. Marc and Mark, anything to add, or?
No, you hit all the points.
Well said.
Well said, indeed. That's all I have for now. I will re-queue. I'm sure there are lots of other questions. Thank you for all the answers.
You're quite welcome.
Your next question comes from Ryan Burns. Your line is open.
Oh, great. Thanks for taking the call. Just had a question on, AIG may take a pre-dividend out. Will you guys need to add capital to the mortgage insurance underwriter? Again, if I'm looking, UGC has a lower ratings than Arch MI. Just want to get your thoughts there.
Not at this point in time, we're cognizant to maintaining a very strong capital position. As the business evolves and emerges in 2017 and 2018, we will always re-examine our capital position based on our ratings. If there is a requirement at that point in time for us to add capital, we will do so. We will always try to maintain a bit of excess capital in all of our operations for two reasons. One, it's a good safety margin to have, even though it might hurt you a little bit on the return on equity. Second, if there is market opportunities that emerge, you want to be able to take advantage of them, and you don't want to stretch your balance sheet to the point that it doesn't give you that flexibility to maneuver.
Third, it's also important, we have a lot of constituents. The rating agencies are a very big constituent that we need to have very good relationships with them. Usually, we have open dialogue with the rating agencies on capital needs and capital management. It's all in the mix. For closing this transaction, what we have presented to you, it give us comfort that we don't need to put significant capital into UGC.
Okay, great. Then will you guys-
Marc, there are a few things that we're going to add, Ryan, just to let you know. The key driver for capital level in the U.S. mortgage space is to be PMIER compliant, which we are currently, and UGC is also currently at this point, PMIER compliant. I think what we have in addition to the PMIER compliance to deal with as a benefit to being part of a group like Arch, is their abilities to leverage in other parts of the company, perhaps through reinsurance, to leverage some of the excess capital that some units may have within it. At this point in time, we don't believe that we need to do anything in terms of the influx of capital into UGC.
Okay, great. Then just quickly, do you guys plan on merging the, I guess, the statutory entities? Then I'm just trying to figure out from, I know cost efficiencies. UGC is running at about a 27% expense ratio legacy. I guess Arch is, in my books, around 50. I guess, how quickly can the combined MI piece be in that sub-30 range?
Well, it will take a bit of time. The transaction wasn't done based just on synergies. We're buying a very good business. I think at a reasonable price, it's good for AIG, and it's good for us. They have significant talent. We were impressed with the people that we have met. We haven't met everybody with the two independent companies. But for the people that we have come in touch with, we were positively impressed with the quality of that personnel. If you're going to do a transaction purely on the basis that one plus one makes two, and you're going to get significant number of synergies, and that's what drives the deal, in my view, that's a bad deal. At the end of the day, this deal works very well for us on the basis that, yes, we're going to get some synergies. That's obvious.
It's going to be done in a thoughtful way. We have created a team of senior executives from one side with senior executives from our side that they will deal with all the transition issues and what it will look like after closing, once we close. Plus, we don't expect one plus one to be two. At the end of the day, I think the economics work very well on one plus one makes 1.7 or whatever. Yeah.
Okay, thanks. Over to you.
Your next question comes from Al Copersino. Your line is open.
Thank you very much. I appreciate it. I have a couple questions. The first one is just following up on that last question on cost and synergies. As you purchase UGC, are you in fact purchasing, say, the back-office operations of UGC?
Well, there is a team that is going to deal with all those issues. We have some projections in our numbers. Yes, there might be in many different areas. It's not just.
Back office.
Back office. It's also there is projects on both companies on innovation of improving underwriting efficiency by using analytics, et cetera. At the end of the day, it's not going to happen overnight. It might be gradual over time. We both have goals, for example, to improve through analytics our ability to underwrite maybe seven, eight, nine mortgages per day per underwriter. Where actually, United Guaranty is better than us right now. We're in the four, five files per underwriter. They're a little higher than that. At the end of the day, there is going to be a lot of consolidation issues we got to deal with. Our eye is to create efficiency, not only immediately after the transaction, but going out two, three, four years from today, how can we be the most efficient company on the space with the highest customer service possible?
Great. Thank you. One other, if I could, just to follow up. This might be more of a qualitative question, I guess. The MI industry appears to have reached intra-industry pricing stability that has not always been the case. I'm curious if your thought is that if the benefits of a deal such as yours, Arch is not known for giving away business. You guys price business very responsibly. Will the benefits of a deal like this accrue mainly to your shareholders? Do you think you will share some of the benefits with the banks and the end customers? What impact do you think this deal may have on pricing?
Well, don't forget, one of the reasons we did the transaction, in the space, in the primary MI space, there were only two companies who believe that risk-based pricing is an important ingredient to incorporate into your operations so you can assess risk properly and you price it properly. That was United Guaranty and us. As a matter of fact, they were ahead of us. They introduced risk-based pricing way back in, I believe, in 2009, 2010. We introduced risk-based pricing only about a year and a half ago. From that perspective, it fits very well with our culture that this is another specialty line of business in our view with long tail.
Our attitude in pricing long-tail business, you better get your underwriting right up front and not wait until your actuaries and or your claims people tell you didn't get your pricing right up front. We do put a lot of emphasis on that. The benefits of all that, they will go to our shareholders. Now, there is a few differences in approach. I'll give you an example. I think on singles, we were probably a company that has the lowest percentage of their book in singles. I don't know what the future will bring. I think United Guaranty had a bigger percentage of their book in singles. I think you're going to probably see that coming down closer to what our numbers are. We both focus, and culturally are aligned to appropriately price risk, use all the tools in the toolkit, including in-depth analytics.
I think we're the very good United Guaranty, and hopefully, that will rub off on us. Not that we're not that very good, but sometimes you got to accept on the marketing side and on the customer satisfaction side, they were probably a little better than we are. I think we're going to incorporate that into our future operations. They're very customer centric. They have 1,800 relationships in the marketplace, which is very important.
Yes
you spent a lot of time in the due diligence with the people, what is your view on it?
Culturally, I think that the one thing that is very common to us, and I said that in my remarks, is the pricing and risk and cycle management. They have showed, and we've seen it in the numbers, the willingness and ability to react to market pricing. The market share will go up and down if they don't think the returns are appropriate in the business. I think they have a very ROE, or they call it economic value added calculation that's akin to a ROE calculation, whereby they react almost immediately to pricing reaction in the market.
Which is, again, testament to not being a top-line focused operation and being bottom-line focused, which I think is also a factor in being part of a bigger multi-line outfit, which speaks to the viability over the long term, we believe, of an MI being part of a multi-line, having multiple sources of income and earnings.
Hey, Al, Mark Lyons. One other thing I would add is that with risk-based pricing, as Dinos' alluded to, being the only two companies doing it. There's that real trade-off of real exposure to price. What's critical, and both companies have it, are indices that measure the quality of the portfolio over time. That will be reflected by are we having better credit related policies on the books? Both companies have that, and it's going to be critical, and each company manages by it. It's a critically important tool.
That's very thorough. Thanks so much, guys. I appreciate it. Dinos' comments on the singles business was also quite helpful. Thank you.
Your next question comes from Charles Sebaski. Your line is open.
Good morning.
Morning.
Hi.
First question. Given you guys just said you and UGC are the only companies out there doing risk-based pricing, does that create any regulatory hurdle for this combination?
We don't believe so. We file our plans with the regulators. We get approval. We file in almost every single state, and we have approval in most. There is only exception of a couple. United Guaranty does exactly the same. It's a highly regulated business. We don't believe that is a problem in the marketplace. As a matter of fact, on the P&C side In the auto business or in the property casualty, in a lot of segments, it's been happening for many years. The only industry that had a very simple pricing tool, it was the mortgage insurance business by using just purely credit score and LTV to price their business, which we believe it's the inappropriate way to assess price to the risk. Yeah.
Okay. I guess on the growth prospects, obviously this is a growth piece for your guys' business due to the scale of UGC. If I look at UGC over the last few years, profitability's been getting better, but top line premium writing is kind of flat. I guess what I'm wondering is, did you kind of buy an annuity here? Does the combined mortgage business at Arch going to be at-
We're not just buying an annuity. We're buying a company who believes in the same way we believe as to how you make money in the risk business. You properly price the risk. You don't focus on just top line. You focus on bottom line. At the end of the day, you continue to find growth opportunities by navigating the company into different sectors. I don't care if these sectors might be on the reinsurance side, on the insurance side, or on the mortgage side. The fact that United Guaranty was disciplined in their pricing and in their approach of assessing risk, I attribute that to their leadership. I mean, Donna has been a phenomenal leader for United Guaranty. I view that extremely positive.
It tells you something about the fabric of the company, their DNA, and it has a lot of similarities to what we do at Arch.
Okay.
Let me add, Charles, it's Marc Grandisson here. The two things I said in my comments, but sometimes the comments get overlooked and not really listened attentive to. It's really an innovation and disruptor. The ability for UG to have done what they've done with risk-based pricing and in our discussions with them, there's a willingness and ability to be innovative in delivering the credit risk to the market, the way we are thinking about this. Clearly, in the future, that technology and data analytics and innovation capabilities is something that will be enhanced dramatically.
The second thing which is not to be overlooked, and we have a very healthy book of business that they've written, and they've attached to their book of business in 2009, and that is going to come to a significant extent to our shareholders for the foreseeable future.
The industry in the past. They fought the old war that market share, it was what drove a lot of their senior management decisions. At the end, they ignore underwriting. When you ignore underwriting, you go and pay dearly. Hopefully, the last war was fought and lost, and the new war is going to be fought and won because people are going to pay attention to properly price their business.
I know. I wasn't trying to nitpick on calling my reference to an annuity. I was just curious if the market share of UGC, given its size, just that mortgage insurance has been such a growth driver to Arch over the last 3 or 4 years. I just wondered, does that pricing discipline and the current market position allow that business to expand from its pro forma Arch UGC? That's what I was trying to understand. That's why maybe annuity was-
Well, it has potential to grow, but you got to bring it back within the boundaries of risk management. As I said, I'm not going to expose the balance sheet to undue PML risk. We do not roll the dices here. We're very cognizant of our responsibilities to our shareholders and the capital that they provide. However, if we find the opportunities to do more, and we've done it in our history through Flatiron or with Watford or other mechanisms, we might bring additional third-party capital into the mix. The thing that makes it important for us, those who have the underwriting capabilities and the technology and the systems, they're going to be in the driver's seat in looking at how much profit they can provide. Now you couple that with different capital structures.
Maybe I can't get the full loaf because that will be unprudent from a risk management point of view, but I can continue to manufacture and sell the product and offload it and get paid fees and profit commission through other structures. All of that is going to be in the mix. At the end of the day, that innovation exists within Arch today, and we've seen a lot of evidence of that innovation existing within United Guaranty. I think the combination is going to be fantastic.
Thank you. What's one final, on the DTA, could you give any color or commentary on what the value of that DTA is to Arch, given your tax structure.
Yeah. Well, Chuck, I think I can be very quick related and say, to Arch, it's of no value. We're doing a 338 (10) election and the DTA stays with AIG.
Excellent. Thanks a lot for the answers, guys.
Thanks, Chuck.
Your next question comes from Jay Gelb. Your line is open.
Thanks. Good morning. Just to start off with a couple numbers questions. What's the tangible book value of the business being acquired?
They have no goodwill or intangibles on the book, so their book and tangible is the same.
That's what I thought. I was just trying to square that with your comment that the deal will be recoverable to Arch's tangible book in two years.
Okay. Two different things. There's two different things. What's the balance sheet of the company we're acquiring, and then what is the purchase price paid on Arch's balance sheet on goodwill versus intangibles? Two different things. I answered the question about what we're acquiring, UGC, and it has no goodwill. Is that?
Yes. Could you go through the second part, Marc, in terms of how we think about what goodwill and intangibles goes on Arch's balance sheet?
Well, I'm not going to go through the whole amount, and I can tell you we're still working through the purchase GAAP accounting aspects as we speak. There's going to be a fair amount of excess purchase price that's subject to being intangible and being amortized, as opposed to sitting on the balance sheet as goodwill.
Okay.
That's in the process of being finalized.
I see. There will be amortization expense from this deal.
Right
in Arch's earnings? Okay.
Correct.
We don't have that yet.
Right. We have a range of views of it, we got to sit down and arm wrestle with our accountants.
Okay. The 35% accretion to run rate EPS, is that based on if the two companies were put together today on a pro forma basis, or is that looking out at some point in the future?
It's a kind of at a longer-term average from 2017 forward.
It's a hybrid
straight line it for you.
Average, yeah.
It'll fluctuate. It'll actually increase, but it's a good way to think about it.
Does that assume steady state legacy Arch MI earnings or essentially that growing over time, which is what I would think it is?
I think one question, I'll kick it off to probably to Mark. It would assume some view towards what Dinos alluded to, which is the mix of monthlies and singles likely to be altered.
As well as accounting for some overlap in some client, which is not tremendously the case, but there's some overlap in some clients, recognizing fully that we may not be able to be 100% of the delivery. We'd like to be, we'll make the case to our clients, but it may not happen. They may want to diversify away a bit from the combined entity. Some of the assumptions are in our numbers that you see.
Yeah.
We have assumed we're going to lose some volume because of company overlap, us and United Guaranty might be too big a market share for a specific customer. Then a reduction in the singles.
Right.
In the usual Arch way, we're not going to try to overpromise and underdeliver. We try to be conservative in our projections.
I appreciate that, the conservative outlook. Cost synergies on page nine of the presentation, I believe it does say significant cost synergies, I just wanted to circle back on that.
Well, we anticipate some, we would expect them to be realized partially in 2017, probably a little more in 2018, then probably run rating out at that point. Admittedly, a bit of a swag at this point until the integration team really goes through the detail, as Dinos alluded to. I don't want to go into specifics, Jay, let me tell you, it's not an overpromise.
Last one, I promise. Tax saving opportunity on the current United Guaranty business carries an effective tax rate in the 30s. Arch overall is in the mid-single digit range. I'm wondering if there's an opportunity there as well that's taken into account for your accretion expectation.
Just keep in mind that we'll use the same tools that we use in our property casualty space and have done in our mortgage operation to date, which is utilizing our internal quota share capabilities to aid in capital management and in the topic you asked about.
Makes a lot of sense. Thanks.
Thank you.
Your next question comes from Ian Gutterman. Your line is open.
Dinos, it's earlier in the day, so my question is, what was for breakfast?
Well, listen, I was the best short order cook in a Greek diner. I could have done one case of eggs, which is 36 dozen, in about an hour or so.
Ian, you're supposed to be the last question on the call.
I thought I would be, actually. Before my serious questions, I did some research on Greek diners, Dinos. We can talk about that sometime.
Well, listen, you can be my partner.
I know. It would be the fourth leg of the stool.
I don't think my board is interested in Greek diners. Maybe I am, but not them.
My first question is, I'm sure this is something out of the tip of your fingers, but maybe, after the deal closes on a go-forward basis, just how to think about risk in the MI business, right? We're so used to, on the P&C business, talking about PMLs and how to think about zones and occurrence versus per event and things like that. Now that MI is obviously going to be such a big part of the business, I think it would be helpful, even given you mentioned the cap bonds and the reinsurance, just some framework down the road to help us think about how you manage the tail and how much capital you have deployed in the tail. Something equivalent to 1 in 250 is X% of our capital, I think, would be helpful to investors trying to understand the risk.
Right. We haven't settled to the exact characteristic, what is a 1 in 250, 1 in 500, et cetera. Let me give you the flavor around it. S&P, for example, says their capital at the A level in the MI space, on the basis that home prices decline by 37% and defaults on all mortgages are at 14%. 14% of every single mortgage defaults, and at the same time, you have a 37% price reduction in home values. We are having similar models, that we look at where unemployment rate might go, where price reductions might go, what the claim ratio might be. Basically, we're managing to those kind of extreme events in the 1 in 250 PML. We haven't decided yet because I haven't had that discussion with my board, will we make that information publicly available or not.
I can assure you, internally, every quarter, we make those calculations. François Morin, who is our Chief Risk Officer, and our board is aware of the numbers. That's what guide us in not only in our capital structure, but also how much risk we want to take on the balance sheet of Arch. If it's still good business, but we don't want to take aggregation that is above what is prudent, then I said, we might create other vehicles for us to continue to be of service and get fees out of that activity.
Exactly.
Let me approach that a little differently and give you a P&C analogy.
Okay.
In the P&C space, when you get a soft market to a hard market on a policy year basis, you can pretty much get a good sense of how it's going to run because you see pricing, you see attachment point changes, so forth and so on. In the mortgage space, when more of a macroeconomic event hits, it cuts across policy years. I think on average, you should say if there's a macroeconomic event hitting in year X, it's going to go back to years X minus four, X minus five in a decreasing way.
Sure.
If it has a 30% loss ratio impact on the current year, it might be 20% on the prior year before that, and 15%, and then 10%, because there's simply fewer policies still outstanding to impact it. Current minus four, current minus five, I think is the way, if you're thinking in a modeling sense, how to think about it.
Got it. Okay.
Ian, important for you talking about the last war versus the new war. If the industry did not make what I would think classic mistakes of not focusing on underwriting up front, the stress scenario I described, which is for S&P, is an A level of capital requirement. The 14% claim ratio, we will never have been reached even in the last crisis if no-verification and Alt-A loans were not underwritten by the MI companies.
Of course.
The data will show you that to you. If you take the old data, we have the runoff of PMI, we have all that information. If you go to Bloomberg and you see on the historical default rates by type of loan, you'll find out that the big problems, they were with no-verification and Alt-A. I'm not saying they are the only problems. There were other things that they were problematic, over-inflated appraisers, some fraud, et cetera. Even with that in all in, just eliminating Alt-A's and no-verification loans, you will never get to double-digit claim ratio.
That tells you that this industry today is in much better shape than it ever was, not because where the economic cycle is and where housing prices are, but I think hopefully. Too many people put their hands on the stove and they got burned, and hopefully those tuition bills, they will be put to good use going forward. I will assure you that as long as I run this company or my colleagues here, they're running this company, we're not going to make those tragic mistakes of the past. We're not volume driven. We're profitability, underwriting driven, and bottom line driven. That's what we believe is being, at least what we've seen in the last four or five years, the thesis, and not only the thesis, but the performance of United Guaranty. They were focusing on the same things we're focusing.
Exactly. Just to move on to the accretion math, Mark, I just want to understand. Is the reason we get to 35% down the road but not day one, I assume, is a little bit like what you were saying a few minutes ago, right? Is just because you don't capture 50% of the 2014 to 2016, I'm going to make up a number, maybe you're getting two-thirds of UGC's earnings day one, and it's 100% by year five. Is that sort of conceptually the right way to think about it? If so, can you-
Yeah, that is the right way to think about it, because as you know, it's a quote, "Shows risk attaching." A lot of it is monthly business at the same time that's coming over. Yeah, that ekes its way in, but its growth and impact in 2017, 2018, and 2019 is material.
Yeah.
Its flow impact is material.
Right. Can you give us a sense of how much of their earnings, if I was just looking at AIG's report essentials, how much of their earnings do you get in 2017? Is it five years till you get to 100%? Six years, seven years? What's the right way to think about that?
When you mean, say, 100%, you mean when do you get?
Meaning that-
50% delta value?
Right. When that's completely run off and you have sort of everything.
I think it's closer to four to five to be 90+%.
Four to five. Okay, great.
Don't forget, it's 2014, 2015, and 2016, right?
Right. Yeah.
That space.
2014 it will be almost gone 5 years from today. 2016 you will have. That's a good rough number, right?
Okay, got it. Related to that, I assume the accretion assumes no change in, or essentially no buyback where if you didn't do a deal, there probably would've been buyback down the road. Can you give us a sense, given how much excess capital is deployed into this, how long does it take to sort of rebuild to a normal cushion? Is that 2 years, 3 years? Maybe less?
It's not going to be 3, it's going to be probably more like 2 years. I don't think we'll have buybacks in 2017. 2018 is up in the air. At the end of the day, I told you, I'm also very cognizant that when I make commitments independent, if it's to regulators, rating agencies and all that, I live up to my commitments. At the end of the day, we're going to maintain those commitments.
Got it. Just 1 final technical question. The shares that will convert, when do those become eligible to convert? Is the expectation that AIG will convert this upon closing or that it takes a year or 2? How does that work?
Well, I can't speak for AIG behavior.
Okay.
What I can speak to is what the lockup provision is in the contract.
Right.
There's a lockup until six months.
Okay.
There's points along the way where that expands, but it's cumulative, and it expires at 18 months. What AIG chooses to do with that is completely up to them.
While they're making up their mind or until the lockup hits, will those be in your fully equivalent shares, or do they not become fully equivalent shares until they exercise?
They are in.
They are in. Okay. We don't have to really worry about their timing. We should just put them into shares for you guys.
Yeah.
Okay, great. Thank you.
You got to think of it as equivalent shares, et cetera. AIG is a small company. That's a value to them, and I'm sure within the lockup provision, they're going to exercise good care in the way they're going to maximize their income.
Right. No, I was just thinking sometimes when companies issue converts, like those old ESUs or whatever, you can keep them out of the share account for a few years. I wanted to make sure it wasn't one of those.
No.
Okay, great. Thank you.
Thanks, Ian.
Your next question comes from Justin Moorer. Your line is open.
Morning, guys.
Hi, guys.
Just quick, with the rating agencies, I'm assuming you talked to them in terms of expectations of ratings?
Yeah. I'd say we have indications as opposed to set determinations. Our expectation is we retain our S&P A+. Best is still in the process of discussion. Fitch, we expect to maintain our A+ FSR. I think the debt rating is being examined. Moody's is likely to move us to an A2 from an A1.
Got it. Okay. Then just in terms of timing closure, just given the CMG PMI kind of got dragged out, how do you think about that in terms of?
This is a different scenario. We got to go to Form A process through the states. This is mostly North Carolina and Wisconsin, then the GSEs, Fannie and Freddie. The timeframe we said by year-end, maybe early part of 2017 is reasonable place to be for closing.
Okay. Got it.
It's different than
The PMI was in receivership, and there was a bankruptcy procedure, et cetera. These are two healthy, well-performing companies and at the end of the day, it should be a shorter process.
Got it. Thanks, guys. Congrats.
Your next question comes from Ryan Burns. Your line is open.
Oh, sorry. Thanks, guys. Just one quick clarification. Just want to make sure I understand what the UGC quota share economics. If I look at the AIG supp, I want to say that the operating income was $644 versus the S-1, which I want to say was $550 or so. Does that explain what the quota share is taking out?
Their S-1, my understanding of their S-1/A is it reflects the UGC book as well as the assumption of AIG on the consolidated way on the 50% quota share. It's a blend, and their mix is going to be a little bit different because they've been on the quota share longer, since 2014.
Got it. Okay. Thanks, guys.
Thank you.
Your next question comes from Quentin McMillan. Your line is open.
Hi. Good morning. Thanks very much, guys. I just wanted to quickly ask about the sort of the market share gain or loss. What do you guys think the insurance in force for your book is going to be as a percentage of the overall market on a pro forma basis, if you can take a stab at that?
When.
-comfortable-
When.
Hello?
Yes, when.
Sorry. As of the closing of the transaction, whether that's the end of this year or the beginning of next year, when the book sort of turns over before the full amount of AIG shares over the next four to five years are even earned in. Where do you sort of think you'll stand at that point?
When we close, all you got to do is just take our market share and theirs and put it together, and that's what it is. The actions are going to happen in 2017, 2018, and beyond. We don't know. As a combined entity, we'll probably have 29% market share. We view that that is going to come down to maybe in the low 20s over a 3-year period of time. Like I said, all things being equal, the only thing I'm trying to emphasize is that other than the comments I made on the singles, we want to maintain customer relationships. At the end, the customers have things to say, too.
It would have been imprudent for us to assume that all customers are going to love us and they're going to say they love United Guaranty and they love Arch, and then they're going to maintain all the relationships. Some relationships we might lose or readjust. At the end, we're going to try to do the best we can to maintain good relationships with a very broad and expansive customer base that United Guaranty had. Over 1,800 customers.
Quentin, let me just clarify because there's a difference between the IIF, the insurance in force mix, and the NIW mix. The NIW, which is the standard market share view, is I like to call it the onion skin layer of new business coming in. That's your incremental to the IIF as opposed to the in force business. On a rule of thumb basis, Arch's IIF is a smaller percentage than its NIW because of the growth. It's the reverse, I would think, for UGC, that their market share has been dropping, so their in force should be relatively larger on a relative basis.
Okay, that's really helpful. I just wanted to sort of tie that thought together, and I know a few different people have asked about sort of the growth prospects going forward. In terms of RateStar, it seems like you're obviously targeting better, more profitable business. I'm sorry, the same ROE, kind of faster growth business. If the IIF is sort of coming from high 20s down to low 20s, which is the prevailing sentiment as you announced this, how do we think about sort of the growth of RateStar? Are we going to sort of meaningfully tail off, or do you look to continue to grow RateStar at a very fast clip and maybe more singles as the portfolio sort of turns away from some of the business that you maybe don't want?
I think RateStar is not a growth engine. RateStar is a pricing engine, and it just so happens that it is able to select and better select risk within the risk spectrum. For that reason, we are able to pick, we believe, the best risk part of any grid that will be crudely done on the rate card basis. In terms of what happens one quarter or two quarters after the integration, the closing is done, they have a risk-based pricing, we have a risk-based pricing. Our expectation is we will have the best of both worlds, and it just allows us to be better risk selectors in the marketplace. Again, RateStar or their risk-based pricing model were not growth engine. They are really meant to slice and dice the data more refinedly and get better risk-adjusted returns.
Great. Thank you very much, guys.
Josh.
Your next question comes from Josh Shanker. Your line is open.
Yeah, thank you for taking my question, everyone. Everyone hear me okay? Unfortunately, I am on a cell phone.
Yeah, it's fine. Josh E. M. Shanker.
Yeah. I hope so. Anyways, I think for the past 2 years, the question you've gotten most often is, are you going to buy UGC? This is not a new story in many ways, and that you've always been very complimentary of our business and whatnot. Yesterday, the deal got announced. If we think about the last couple of years, is the deal more attractive now given where P&C markets are? To put it another way, has your outlook for P&C diminished so much that the best thing you can do with your $3 billion is to put into MI? How does the rest of the market affect your incentive to do this transaction right now?
Well, what you said was absolutely correct. Our interest in United Guaranty, it wasn't a recent interest. We were disciplined with that. At a reasonable price, this is a company that we would like to have because of a lot of other ingredients. Like we said, you heard me many times talk about culture, pricing culture, underwriting culture, and we found that. As a matter of fact, I'm happier today with the transaction than when I actually made my first call to Peter because when we got in, and they allow us to kick the tires and all that, we have confirmed what we suspected, and it was all true. Having said that, your other comment is almost correct, too. The P&C world, especially the reinsurance world, is on, I don't know, 12, 13 consecutive quarters of giving up rate.
I think there is price correction that needs to happen on the P&C side, and it hasn't happened yet, and I hope it will. We're not going to wait. You never fight Mr. Market. Mr. Market, it will be whatever it is, then you got to navigate within that marketplace. We view the MI space a better place to be right now. Again, within risk management tolerance, I kind of keep emphasizing that. We're not abandoning our P&C and our reinsurance there. Our P&C and reinsurance business is very core. It's our engine who got us the ability to do this transaction, and we will continue to be a big participant in that in a prudent way. When the pricing improves, we'll do a lot more on that side, too. If it doesn't, we're going to be defensive.
That's a real implication, Josh, that over time, depending upon the opportunities and the cycles, been pretty much non-correlated cycles between them. There could be massive insurance and reinsurance margins, and the questions you're asking is, why is mortgage insurance only 16% or 17% of your capital? It's going to fluctuate depending upon relative market conditions.
Given that you're now the market share leader, do you find the GSEs or think when it comes to STACR transactions, whatnot, you're a less desirable counterparty because you're already getting a lot of flow through the standard channel?
Well, at the end of the day, I think we have very good relationships with the GSEs. The GSEs, especially when they look at the bulk transactions, they look also at the balance sheets of the providers, and it's not just us. It's other reinsurance companies, et cetera. We're very high quality from a capital point of view. Arch will have in excess of $10 billion of total capital between common, preferred, and long-term debt. I think it's a good place for the GSEs to be to have the entire balance sheet of Arch behind those transactions.
Okay. I'm going to take that as no change. Good luck and congratulations.
Yeah. Thanks, Josh.
Thank you, Josh.
Again, if you have a question, please press star one on your touch-tone telephone. Your next question comes from Kai Pan. Your line is open.
Thank you and good morning.
Hi, Kai.
Hi. First question on debt. What's your debt capital ratio post-merger? What are you comfortable with, and how much of the debt is going to be issued onshore, which you probably have some tax deductibility?
Well, let me give you from a perspective of Moody's, because there are certain equity credits, like when you issue preferreds, and so forth. It's in the 24%.
24%.
24%. We anticipate the longer tenured debt to be issued onshore.
Okay. All right. That's great. The second question, I want to push a little bit harder on the reinsurance deal, is that out of the $360 net earnings in 2015 for UGC as one, how much that you would give, like you expect to retain on day one?
You said a reinsurance question? The $360 million they were referencing, which I think was 2015's number.
Yeah
is net of the quota share.
Okay, that amount, if everything else constant, that's the amount you.
Right.
Okay.
Kai, when there's valuation metrics out there on price to book or price to earnings and so forth, and it's applied to a 360, it implicitly assumes that the 50% quota share is always in effect. Only 50% retained by UGC. It misses the valuation associated with the reinsurance that we're assuming.
Okay. Over time, everything else being equal, the earnings will grow because you retain more on your own balance sheet.
That's correct.
Everything else being equal, yes.
Okay, great. My last question is on the management retention. What's your plan for management retention for both UGC as well as your own MI business and also Dinos, I don't know if this still impacts your retirement planning.
Well-
That's a mouthful.
I'll address the retirement. March of 2018, the CEO job will go to Marc Grandisson. That's our plan. We plan for everything in this company, including succession. I'm not going away. I have an agreement with our board and with Marc, et cetera. As Vollaro retired in 2009, and you see him all the time, and he's an advisor to the company, and he's been doing a phenomenal job for us for now another seven years since his retirement. I'm going to be in that mode. I'll be around, I'll be the chairman of the company. I will continue to advise Marc on a lot of issues. I'll be involved, more of a part-time basis, with whatever assignments I get from Marc. At the end of the day, that's what you get with Arch. You get continuity. We don't make abrupt decisions and we move on.
It's the model that has been working very well for us. We prepare our people for succession in every job that we have within the organization. No change in the plans, but I've been a little more expansive as to be truthfully honest with everybody on the call as to what we were always internally been planning now for four or five years. Marc? Yes. Thanks for that, Dinos. I think in terms of the executives from UG and the Arch MI that we have, we have very capable collective of leaders and deep management throughout.
As Dinos mentioned already, there's an executive integration group that's been formed, three from UGC, three from Arch Capital Group, that will go through that and make sure we have the best people in the best place, and we retain talent in the appropriate places so we can be running even faster after closing.
That's great. Thank you so much, and good luck.
Thank you.
Thank you.
I'm not showing any further questions. I would now like to turn the conference over to Mr. Constantine Iordanou for closing remarks.
Well, thank you, Emily. Thank you, everybody. I know we took a lot of your time, but we appreciate the support, and we're looking forward to integrating two great companies as soon as we get approval to close. Thank you and have a wonderful day.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect.