Good day, welcome to W. R. Berkley Corporation's third quarter 2011 earnings conference call. Today's conference is being recorded. The speaker's remarks may contain forward-looking statements. Some of the forward-looking statements can be identified by the use of forward-looking words, including, without limitation, believes, expects or estimates. We caution you that such forward-looking statements should not be regarded as a representation by us that the future plans, estimates, or expectations contemplated by us will in fact be achieved. Please refer to our annual report on Form 10-K for the year ended December 31st, 2010, our other filings made with the SEC for a description of the business environment in which we operate and the important factors that may materially affect our results. W. R.
Berkley Corporation is not under any obligation expressly disclaims any such obligation to update or alter its forward-looking statements, whether as a result of new information, future events, or otherwise. I would now like to turn the call over to Mr. William R. Berkley. Please go ahead, sir.
Thank you very much, Karen. We had a good quarter. We were pleased with our results. It's roughly a year since we told you we expected the market to start to turn, we were going to begin to put pressure on raising prices. Unfortunately, we were early in that process, we, in fact, went through basically starting at year-end. We continued that process. We've had now our third successive quarter of increasing prices. It's been somewhat erratic, although generally month after month, with some variation at the end of each quarter where our competitors were competing for volume more aggressively, where we've been able to deliver those price increases somewhat more slowly than I have expected, but not significantly.
We've said that we expect by year-end price increases, looking back, will be 5%-8%, I think it'll be a little above the bottom of that level, we won't get to that 8%, I don't think, at the end of the year. The environment continues to be competitive, but nothing approaching where it was a year ago. I'll first turn over the report on our operations to Rob, then Gene will talk about the financials, then I'll give an overall view. Rob?
Thank you. Good morning. Catastrophe activity persisted through the third quarter, leaving 2011 a year to be remembered, or perhaps for some, a year they would like to forget. Clearly, the uptick in frequency of cats is forcing many industry participants to reexamine how they define their PMLs. Additionally, the value that geographic spread brings to a property portfolio has become questionable given the number of severe events that have occurred around the world over the past several quarters. Unfortunately, the casualty market is not a prettier picture. Our ongoing expectations that the industry's casualty accident year loss ratios are on the rise continues to become a growing reality. Aggressive pricing over the past several years, combined with increasing loss trends, is proving to be a recipe for significant deterioration in industry results. Finally, the current interest rate environment is having a gradual, yet building negative impact on overall returns.
Some of the lines of business that stand out as being amongst the most competitive are in the excess casualty and excess professional liability space. In particular, public company D&O seems to be leading the charge when it comes to irrational pricing. Unfortunately, a common characteristic amongst these lines is the lack of loss frequency, as well as a longer period of loss development. Consequently, carriers may be lulled into a temporary, yet false sense of comfort with inadequate rates due to the lag in time before their portfolio's true loss costs become apparent. In spite of these challenges that I've mentioned, there is a rapidly growing level of evidence that would support we are in the initial stages of a noteworthy change in market conditions.
The commentary we have been hearing in the marketplace regarding the need for action as it relates to both pricing and risk selection is finally beginning to convert into a change in behavior. This shift in behavior is visible through the increasing amount of business that is being thrown out of the standard market into the specialty market, as well as carriers' ability to achieve rate increases without sacrificing renewal retention ratios and continued growth in the assigned risk plan policy count. While this pace of change is not uniform across all territories and product lines, it remains clear that this is an increasing trend spreading throughout the industry. Additional encouragement can be drawn from the growth in auto premium activity, which would appear to be stronger today than it has been in several quarters.
This apparent strength in auto premium is a clear sign that the financial health of our insureds has improved. The company's net written premium for the quarter was approximately $1.13 billion. This represents an increase of 14% over Q3 2010. The main contributors to this growth, as in the past several quarters, were our specialty and international segments. More specifically, our operations that serve industries as well as economies that continue to maintain significant momentum. Furthermore, the balance of our operations are in general no longer shrinking, and in many cases are finding opportunities for modest growth. The company's price monitoring showed an improvement in rate of 3% for the quarter compared to the corresponding period in 2010. Additionally, it's worth mentioning rates were up approximately 3.5% in the month of September.
One should also take note that this is the third quarter in a row where we achieved a growing level of rate increase. The renewal retention ratio remained at approximately 80%, providing evidence that the quality of the book is not eroding as we achieve rate improvements. The loss ratio for the quarter was a 64.8, which includes 4.8 points of storms. This level of storm activity is notably above our historic experience and was primarily driven by losses stemming from Hurricane Irene, as well as an unusually high level of weather-related activity, principally in the Midwest. Our expense ratio for the third quarter was a 34.3. This represents an improvement of roughly half a point over the second quarter. We anticipate this trend continuing as our earned premium builds. To make a long story short, the company generated a combined ratio of a 99.1 for the third quarter.
Having said this, when you adjust for abnormal catastrophe as well as reserve takedown, the business continues to run at just under 100. The company's balance sheet remains strong on both sides of the ledger. In particular, when it comes to our loss reserves, we continue to believe that it is not advisable to presume that future loss trends will remain as benign as they have been over the past several years. More specifically, we tend to be measured with our initial loss picks and recognize this caution as the book develops. This approach continues to be evident through the results of our quarterly individual operating unit actuarial analyses, leading to 19 quarters in a row of positive group reserve development. The property and casualty insurance industry continues to be one that seems to have to learn the hard way.
It has become increasingly apparent over the past few quarters that the painful lesson resulting from irresponsible underwriting has in fact arrived. It is this bittersweet reality that is driving the apparent change in behavior that we're observing at an ever-increasing pace. The need for additional rate continues to remain painfully obvious and is finally beginning to be accepted and acted upon. Over the past few years, the company has remained focused on underwriting discipline, as well as investing in existing operations and selectively starting new ones. As a consequence of this activity, our shareholders have patiently endured an increasing expense ratio. Having said this, it remains our belief that we are on the cusp of receiving a return on this investment. It is our strong view that the company remains particularly well positioned to disproportionately take advantage of this change in the market. Thank you.
Gene, you want to pick up now with the numbers?
Okay, Bill. Thanks. Well, first, just back to premiums for a moment. The 14% growth in premiums that Rob mentioned, that was led by the international segment. That international segment was actually up, net premiums were up 34% for the quarter. That's primarily a result of strong growth in our new Lloyd's operation, as well as our Asia Pacific branch. Approximately four points of the 34% increase for international was due to changes in foreign exchange rates. The specialty alternative market and regional segments were each up 15%, as all of those segments have benefited from ventures that we've formed over the last five to seven years. Our regional segment, where we formed fewer new ventures over that time period, was up 2%.
Gross premiums were up 16.5%, slightly higher than net premiums, and that's again due to the fact that we're ceding a greater portion of the business written by some of our newer companies. The overall combined ratio was 99.1%, up 3.7 points from a year ago, and that's primarily a result of the higher catastrophe losses that Rob described. Catastrophe losses represented 4.8 loss ratio points this year compared to 2.3 loss ratio points a year ago. Total catastrophe losses were $51 million, and that included $32 million for the regional segment, $6.5 million each for the specialty and reinsurance segment, $5 million for international, and $1 million for alternative markets. We had favorable reserve development of $56 million in the quarter, and that compares with $51 million in last year's third quarter. The impact was 5.3 loss ratio points in both periods.
All five of our business segments reported favorable development in the third quarter of this year, with the majority attributable to the specialty segment. The underlying loss ratio before cats and reserve releases was 65.2. That's up just four tenths of a point from a year ago, as price increases and changes in business mix have basically offset any changes in loss cost. That gives us an overall combined ratio of 99.1 and an accident year combined before cats of 99.5. Our quarterly paid loss ratio was 61.5, unchanged from a year ago, and our operating cash flow was up 32% to $269 million. You've probably heard by now that the FASB has issued new guidance on deferred acquisition costs, and we plan to adopt those new rules on January 1, 2012. We do not expect the new guidance to have a material or significant impact on either our expenses or our operating earnings in 2012.
However, the initial adoption of this new standard will result in a reduction of the deferred acquisition asset on our balance sheet and a corresponding decline in book value. We've estimated that the adjustment to book value will be less than $0.30 per share. Net investment income was $114 million in the quarter. That's down 4% from $119 million a year ago. Investment income for the fixed maturity portfolio, including invested cash, was $123 million, unchanged from a year ago. The annualized yield for the fixed income portfolio was also unchanged, even though our average duration remained at three and a half years.
Far, we've been able to maintain the yield on the fixed income portfolio, in part because the decline in Treasury yields has been somewhat offset by wider spreads for non-Treasury products. Secondly, we've been able to invest a slightly higher portion of our cash flow in both corporate and agency mortgage-backed securities. With respect to merger arbitrage, our in-house account broke even in the third quarter, and our externally managed account reported a loss of $3 million. That compares with arbitrage earnings of $14 million for both accounts in the third quarter of 2010. Investment funds reported a loss of $8 million in the quarter. That compares with a loss of $19 million a year ago. Within that, energy related funds, which are carried at fair value, reported a loss of $12 million, while real estate and other funds reported earnings of $4 million.
The energy fund losses reflect primarily the impact of lower oil prices on companies for which the fair value estimates are closely related to the price of oil. Realized gains from the sale of investments were $21 million in the quarter, and our unrealized investment gains before tax were $632 million at September 30th. We repurchased 4 million shares of our own stock in the third quarter, and that brings us to a total of 5.1 million shares so far in 2011. Finally, that gives us an annualized return on equity of 8.4% in the quarter and 10% for the first nine months of 2011.
Thanks, Gene. We're pretty pleased that the prices continue to move upward. Opportunities in our market are increasing as standard markets push aside some of the business. All is not perfect. Some areas of the business, such as workers' comp, have double-digit price increases. Other areas are still seeing virtually no increase. Overall, there's no question the market turn is definitive. It's here. Almost all our lines of business are having those price increases. Terms and conditions are getting a bit better here and there, opportunities in the specialty areas are beginning to increase. We're pleased by all that. The rate of our growth is mainly being shown as our new entrants, or they're not so new anymore, have gained traction and are adding to our bottom line.
We continue to have several companies that we've added in the past year in the technology area, a reinsurance enterprise that will start up in the U.K., and we continue to work towards broadening our horizon in areas of the business that offer the opportunity for us to achieve our 15% plus return. We think we still can attain that. While Treasury yields have come down dramatically, the spreads on mortgage-backed securities and corporates have gotten wider, and thus investment returns have gone down a bit, but not nearly so much as it would look when you examine Treasury yield curves. I think we disagree with several of our competitors who've elected to lower the quality of their portfolio in order to gain the yield. We don't think that the world is as wonderful as it might be.
While we believe the economy is going to get stronger and we're optimistic, we today, as always, have felt we take our risk in the insurance business, not on our portfolio. Therefore, we've maintained the quality of our fixed income securities, not going down in quality, maintaining that AA average portfolio rating giving up on occasion, as I've said before, some of that liquidity. We've been able to maintain our yield, although clearly, if business gets a lot better and cash flows increase, we will give up something on that yield. It wouldn't surprise me if our new investment yields were down 5% or 8% over the next 12 months if we had. Because we weren't a corporate investor in a significant way, or a real estate investor in a significant way, we had lots of room in the portfolio.
We are still maintaining basically the same duration and the same portfolio quality as we had before, and we've been able to do that and still keep the yield virtually unchanged. Business still is gaining traction, and especially in our new units, or newer units, and we're pleased. It's looking like the cyclical turn is getting stronger, and we're optimistic. With that, Karen, we'd be happy to answer questions.
Thank you, sir. Ladies and gentlemen, if you have a question at this time, please press star followed by the number 1 key on your telephone. If your question has been answered or if you decide to remove yourself from the queue, you may press the pound key. Our first question comes from the line of Amit Kumar from Macquarie.
Thanks, and good morning. Just going back to your comments on the cycle turn, there is this debate. Are market conditions currently similar to Q2 2000 when we had Unicover and several other issues, which resulted in modest pricing improvement over several quarters? I was curious what you thought were the similarities and sort of the dissimilarities versus Q2 2000.
Well, first of all, the market really had very little turn until October of 2000, when Reliance and Frontier went out of business. When Reliance and Frontier went out of business, Unicover was a prelude to Reliance and Frontier going out of business, and a lot of other things happening. Every cycle has its own qualities. Today is so different than any cycle we've had before because of the financial debacle that we've seen in the prior several years and the extraordinary volatility in markets. There was no place to hide. People who had aggressive investment portfolios, some had severe problems, although not so much in the property casualty business. The opportunities to invest your money became challenging. I think that this is a bit different than the 2000 cycle.
I would say that if you look at pricing, standard line pricing is down between 15% and 18% from peak. Specialty line pricing is probably down 25%. That said, pricing at its peak gave us great returns and great underwriting results. Along with that, with investment returns down significantly overall, and you're looking at an industry that's probably not making money. I think the driver of pricing and cyclical turn is always the same, and that is a fear of a total loss of profitability. Sometimes it's individual events that bring about that fear. Sometimes it's an examination of trends.
I think right now what it is, it's the loss of redundancies in people's reserves, the beginning to see recent year deficiencies develop, and I think you've seen a few companies report deficiencies in their current year, and I would guess that you're going to start to see a number of other companies in the past couple of years find their reserve positions were established at deficient levels, and they're going to have to start to recognize those deficiencies. Between that situation, which means they've got a problem with their pricing in a significant way, and lower investment income, I think you're going to find a number of companies, especially those companies that claim they were focused on these great information technology driven basis, are going to find that their past data wasn't as accurate as they thought.
One of the things that happens, and it always is a keystone of change in cycle, is the data you relied upon didn't prove to be accurate. In this case, the data of the reserve levels you put up for the current accident year, I think, is going to prove to be deficient. I think, for example, the current accident year for the industry is probably 110, and worse for workers' compensation. I think few people are putting up anything like those numbers.
Got it.
I think that there's a lot to come. No, I think the cycle turn is different, but I think for those companies who've adequately reserved, the opportunities are going to be fabulous.
That's very helpful. Just related to that, on competition, you mentioned this competition, aggressive competition in excess casualty and liability for quite some time. I'm curious, is it like a specific set of companies, is the trend line still downwards on that, or do you see an inflection point approaching in terms of that reversal?
Rob talk about it first because I need to be restrained and not throw stones at anybody. I'm going to let Rob talk first, and I'll probably add some things. My lawyer is shaking his head, telling me that was very good. Rob, go ahead.
The answer is, I share this may not be particularly helpful, but it really depends on the part of the excess casualty space or excess professional space. Generally speaking, there are parts of those marketplaces that are as competitive today as they were 12 months ago. Some of that has been created by participants in those markets that are not particularly knowledgeable on the subject matter, and it hasn't occurred to them the problems that they're creating for themselves. Others have withdrawn from those lines of business, but it seems as some withdraw, others turn up and try their hand at it. We are not seeing the shift there that we are seeing in other areas. Once again, partly having to do with the lack of frequency in some cases and partly having to do with the length of the tail.
Having said this, it is our expectation that over the next couple of quarters, you're going to start to see the level of anxiety start to increase with many that have jumped in without looking to see if there's any water in the pool.
I guess I would add a little bit and say that I think that there are two groups that are the most aggressive competitors. The small companies that won't be around to make up for their mistakes. They're there and very aggressive. Their strategy is, don't worry about interest rates. They'll average back at 5% or 6%, and you can discount them based on those numbers, and you're going to hold the reserves a long time. They're aggressive pricers. Those people will be out of business. Then there are the big companies who use outdated statistical information. Ultimately, you need to make a profit, and we think much of this pricing is right about to change. It's always the last part of the business to change. Then it changes at a very rapid pace.
It's the last part because you don't see those losses for a while.
Okay, thanks. Thanks for the answers.
Yes.
Thank you, sir. Our next question comes from the line of Vinay Misquith of Evercore Partners.
Hi, good morning.
Good morning, Vinay.
On the new business, just curious as to what ROE you're getting on the new business. You've grown your top line quite significantly. Do you think that the pace of the growth this quarter is sustainable?
Well, first of all, we know we have carefully said we can't say it's new business anymore because some of this business has been here for a while. If you look at the company, all but three of the units have been here since 2009. We can't say it's new anymore. That business represents a large part of our business for this year. It's more than 10% of our business. It's going to grow a lot more. These people were patient and sitting by the side. We would expect, if anything, that will represent an accelerating portion of our business and of our growth. Some of these teams of people who joined us wrote $300 million, $400 million, $500 million of business before they joined us. Given pricing levels, we're happy to write $40 million of business in each of the first few years they were with us.
We would expect those teams of people will write a lot more business as opportunities present themselves. I think that that's going to be a real generator of a very substantial amount of growth. We have three units that we started, one in 2010 and two in 2011. The two in 2011 contributed zero premiums. We would expect that will be different in 2012. The one in 2010 really is just beginning to get any traction at all.
What sort of ROEs do you think that you're getting on this business? Because the argument we hear from the other side is that prices are going up, but with rates down, that the ROEs are still high single digits.
We would not enter into any business where we didn't think very comfortably we could get a 15%-plus return. In the good parts of the cycle, which we think we're entering now, 15%-plus means the plus side of that substantially. Our expectation is that's where we'll be. I would tell you that I'll give you a better assessment of that next year, and we'll probably be able to give you our view. I would be more than disappointed if we weren't able to deliver those kinds of ROEs starting, beginning the second half of next year on companies that have been running for a period of time.
Yeah, that's great. Just a follow-up, when do you think we'll be able to see margin improvement from rate increases?
I'm sorry, could you repeat your question?
You are right now getting rate increases of 3%. You said you're hopeful to get rate increases of around 5% by the end of the year. When do you think that margins will expand because pricing is rising in excess of loss cost trends?
Well, for instance, in September, price increases averaged 3.5%. We expect prices are going to continue to rise, I would expect that that will continue. I would think that margins will continue to improve, really, every month, frankly, as that continues.
Sure. What are loss cost trends right now? Are they in the 3% range or 3%-5% range right now?
This is Rob. As far as loss cost trends go, it really depends on the product line that we're talking about. Obviously, certain product lines are more exposed to variables that may be experiencing larger amounts of inflation or trend these days. Generally speaking, historically, unless there's going to be a change that I'm advised of, we don't get into what our trends are that we're using or assuming by line of business.
I think the biggest issue with loss cost is the mix of medical costs involved, medical cost is the real question. It's a real unknown at this point. You've got the government trying to shove medical cost inflation every place except there, simultaneously, you've got lots of pressure on the entire medical provider segment of the global business trying to deal with that. I think that's the big unknown.
Okay. Thank you.
Welcome.
Thank you. Our next question comes from the line of Vincent D'Agostino of Stifel Nicolaus.
Good morning.
Good morning.
I guess for Robert Berkley, Jr., looking at the expense ratio, we've talked about the expectation for that to improve as the newer startups gain scale. If we just assume that there's no additional startups at full scale, what ballpark range would you ideally like to see the expense ratio at? If there's any sense of how long it would take to get there with the current structure, I just have one follow-up.
Let me just comment one thing. That is, you have to remember that the expense ratio follows earned premium, not written premium. Second of all, our view has always been the same, that is, this isn't an expense ratio business. This is a loss ratio business. We view as when you take out commissions and you take out taxes, license, and fees, expenses are sort of 10 points or less. When you look at that 10 points or less on an earned basis, you'd expect the savings there just aren't going to move the needle much.
Our expense ratio was comfortably below 30 points of the harder part of the market in the last cycle.
Okay. We would anticipate Go ahead, Rob. We would anticipate an expense ratio in that same area.
Just to look on a follow-up. Let's say that the low interest rate environment continues out to 2014, 2015, maybe not as low as today, but let's just say less than optimum. Would you envision any structural change to the portfolio allocations? I'm not sure if high dividend yielding equities start to look a little more attractive. I know you said that at least in the current environment, you're not looking to change, but if that environment is, I guess, sustained longer.
We've in fact invested some money, relatively modest amount, in high dividend equities, probably $300 million or $400 million. It's certainly something we would consider. I think that every day in this volatile world, you make decisions on where you think you're going to go and what you're going to do, and try to assess the riskiness of those decisions and the capacity to adjust. Finding ways that give you flexibility, financial security, and adjustment is important. We're looking at every kind of option from high dividend equities to various kinds of direct lending.
Thanks. That's very helpful.
Thank you. Our next question comes from the line of Joshua Shanker of Deutsche Bank.
Everyone.
Good morning, Josh.
Good morning. You made comments, I don't want you to repeat, if it's a repeat of a question, we'll just go to the next one. You were talking about the competitive landscape, I'm looking at a lot of companies reporting, including yourself, whose premiums are ahead of
Our premium and price increases. I'm wondering who's losing premium in this market. Not specifically, but by class, maybe.
I think that there's a few things going on. I think first of all, you're seeing some people just withdraw from the marketplace, who are getting out of the business, who are electing not to participate. You're seeing some of that. In bits and pieces everywhere, in areas of specialty business, you're seeing people who, as Rob commented, are just finding the business wasn't as profitable as they thought. You're finding those opportunities are there. You're finding some people in the standard market who are getting out of certain areas. I think it's across the board. I think that clearly, if you look at the total amount of business of our growth, a substantial amount of the growth, Josh, has been overseas. A big part has been our Lloyd's syndicate in Australia and Southeast Asia, it's a relatively modest amount.
Our domestic business has grown, but it's not a huge number. I don't think it's anything dramatic at the moment.
Okay, thank you. The other question, I'm just following up your comments that you said that you thought the newer businesses would be 15% ROE businesses, but much higher when the market would turn for them. Is the legacy business not performing as well as those newer businesses?
No, I don't think that. I think the legacy businesses were much higher return businesses than 15% when the market got hard. What I'm suggesting to you is that the businesses we got in, we have the expectations that they will do as well as the legacy businesses.
Do you think right now the ROE of the legacy business or the newer business is higher?
Every business we got in, we think has the same expectation. You want to add to that or no? When we get into a new business, we talk to teams of people. We sit and look and examine the industry they're in, the lines of business they want to write, and examine what we know about it and what we think the returns will be in various phases of the cycle. Our expectation is we don't want to do things that we think will dilute our overall return. It'll dilute our return when the businesses are entered because obviously you have to build up to scale. In a soft cycle, it takes time to build up to scale, more time than it would in a hard cycle.
In a hard cycle, you can get up to scale in 18 months or two and a half years, maybe. In a soft cycle, it could take you four years. Once you get up to that scale, you start to end up doing the same kinds of returns as the legacy business. Obviously, something may change, and one might do better and one worse, but basically, we think they'll both do the same.
The extent to which excess capital is dampening returns right now?
We were pretty aggressive in buying back stock. Clearly, we have some excess capital. If we continue to grow at the pace we're growing, I'd be surprised if we at least don't continue to grow at a relatively rapid pace. We won't have that much excess capital. We'll be able to generate enough capital to maintain good ratios, but we won't have a huge amount of excess capital. I think we have probably $500 million of excess capital now. If the opportunity came to buy stock back at an attractive price or to make an acquisition at an attractive price, risk-adjusted, that's fine. We don't think we're going to have huge amounts of additional redundant capital. We have enough now to put us in a position to take advantage of any opportunity.
Well, thank you for all your answers.
Thank you, sir.
Thank you. Our next question comes from the line of Michael Grasher of Piper Jaffray.
Thank you. Good morning, everyone.
Good morning, Michael.
Rob, you had some comments about growth in auto premium activity. Just curious, what about exposure units? Then I guess, how about exposures overall, whether it's a higher utilization rate in commercial auto or payrolls in comp? Are you experiencing improvements anywhere in terms of exposures?
The answer is yes. We are seeing that in many of our insureds, whether it be workers' compensation and payrolls are on the rise, in part because of people adding positions or adding to staff. We also are seeing people adding power units to their schedules as far as commercial auto. Then generally speaking, much of our activity that is based off of receipts, we are seeing that either the initial estimate was overly conservative or things are working out better than had originally been anticipated. It is a better situation than what was expected as far as exposure.
Okay. Any area, I guess, accelerating?
Quite apparent in workers' compensation, but we are seeing it in some other areas as well. Comp would probably be the one area that we've taken the greatest note of.
Okay. With regard to comp, in big picture here, is there a mix change, I guess, with clients where maybe excess comp demand goes higher as changes occur on the primary side, be it price or any reforms that are occurring on the state level?
Look, it's certainly possible as primary comp rates go up, people become more interested in alternative market solutions, and by extension, they may be exploring the excess comp market to provide some cover above whatever their retention is, if you will. At this stage, we have not seen that movement. Quite frankly, workers' compensation for the average person walking down the street is a pretty good deal. It's going to be a less good deal tomorrow, but I don't think that reality has really come through yet, driving that change in behavior and that exploration into alternative solutions.
We also should add that excess comp is getting to be a little more expensive since it's one of those lines that relies on discounting. The interest rates people are using to discount have come down a lot. Therefore, the pricing for excess comp has gone up and probably ought to go up a lot more.
Okay. Is there a preference from your standpoint, just in terms of which direction you would take that business on or prefer to take that business on?
Which I'm not sure
Between the excess comp and the primary.
We want to take it on wherever we're going to get the best margins.
Okay. Thank you.
Thank you. Our next question comes from the line of Michael Nannizzi of Goldman Sachs.
Thank you. Just a question. You mentioned at the business level, overall, are rate increases outpacing loss trend? Do you feel like you're seeing that in your aggregate book?
I would say that at the moment, they're just now slightly higher than loss trend. I think that directionally, that they're accelerating and loss trends are not accelerating at the moment, although they've been up significantly from where they were, let's just say, a couple of years ago. Understand that the volatility that you all see in the marketplace and you see in the economy can change that. We don't know a lot about what's going on as far as the government's policies on Medigap Plus and so forth, and that's the big thing that we worry about. In addition, you've got lots of variabilities in the whole economic picture. Today, loss costs are not quite as rapidly increasing as pricing, and pricing seems to be increasing at a faster rate. It's not our primary worry right now.
We're okay with that, clearly everything about the economic picture is more variable today than it's been in the past.
Great. Thank you. Just one question on small versus large accounts. Can you talk about where the competition is more severe? You talked about small versus large insurers, but on the accounts themselves, can you talk about how the landscape is different among those two groups?
Rob. Thank you. Mike, it's Rob here.
Rob.
To make the trend continue as it has been for probably the past couple of years now, that there continues to be far greater competition around large accounts versus small accounts. Presumably, in part, that is because people's anxieties, some market participants of making sure they hit their budgets and they start doing things like providing large account discounts, which quite frankly, never made a whole lot of sense to us. Yeah, the greater competition does continue around the larger accounts. The breaking point had been sort of around $100,000. I would suggest that it's probably down to $75 or so, maybe even closer to $50.
The one thing is even starting to see a few large accounts would be a big change. That hasn't happened yet, but when it does, that would be a really big change because that really means that people are saying volume is not as important as it was. It's one of the things we watch for carefully.
Great. Thank you very much. If I could, one last one, this is just more kind of in the business question. If your business is not very cat exposed overall, like relative to the market, and insureds have decent loss experience, the policyholders themselves. What is the conversation like when you are looking to raise rates 3% or 5% to them? You're accounting for loss trend or low interest rates overall, how does that result in them accepting a higher premium? Thanks.
I think for starters, not many folks look forward to the opportunity to pay more for anything.
Right
generally speaking. Having said that, we do try and encourage people to take a look back and think about where their rates are today and what we're asking for compared to what they were a few years ago. The reality is that we've been losing ground for some period of time, and at this stage, we need to capture some rate in order to have an organization that can make the. We are not embarrassed about representing to our partners on the distribution side as well as our insured, that we are in business to make a return, and that is our expectation. If that means we need to raise our rates, we will do so.
While it's not received with open arms, I think generally speaking, people understand that we are entitled to get some rate, particularly given what has happened with rates over the past several years.
I think that honestly, Michael, the discussion about rates is a minimal discussion when it's 3%-5%.
Okay.
In fact, most everybody you talk to has seen prices come down substantially, as Rob pointed out. In addition to that, they recognize the fact that interest rates are down, everything else is down, all of which is how we make money. I think it's a reasonable and okay discussion. I think that the discussion will not be as easy if you're pushing for a lot higher rate. In fact, on the lines where you're pushing for a lot higher rate, in general, you can show them that people are losing money. Here are the industry numbers.
Got it. That helps a lot. Thank you very much.
Thank you. Our next question comes from the line of Gregory Locraft of Morgan Stanley.
Hi, good morning. Wanted to just pursue the, I guess, the pace of change in terms of this particular cycle turn. You mentioned a 15% ROE beginning, I guess, back half of next year. If I look back at 2000-2002, 2003, the ROE didn't go above 15% until 2003. I'm wondering what, in particular, is making this rate of change in the market bigger than in the previous cycle turn?
Good morning, Greg. It's Rob here. I think first of all, we are sharing with you our expectations, but it's not a perfect science. Trying to hang one's hat on any 90-day period for such a significant change, I think would suggest that there's a greater level of precision than really exists. That is our best estimate. Second of all, I think if you go back and you look at the period that you were referencing, much of the lag that we faced in achieving the type of returns that were mentioned earlier had to do with some negative reserve development that we had encountered from prior years. If you back the reserve development out, my suspicion is, while I don't have the specific numbers in front of me, that is going to get you into the neighborhood that was being suggested earlier.
Okay, great. That's very helpful. Thank you.
Pleasure.
They saved me from talking, Greg, since I was still in charge when we had those negative developments.
Great, thanks.
Thank you.
Thank you. Our next question comes from the line of Jay Cohen of Bank of America.
Good morning, Jay.
Good morning. Just to clarify that last commentary. I thought when you were talking before, when you threw out that 15% ROE, that's what I thought you were talking about kind of the pricing on some of these newer ventures, what you hope to achieve.
I did.
Okay. On a reported basis with the earned premium effect, it seems a lot less likely you'd see an actual reported 15% ROE in 2012 anytime.
Yeah, we were talking, the question that was asked that I had answered that question about was, when did I expect on an underwriting year these companies to achieve that? I answered, starting in the second half of next year, which wouldn't be reported for the 12-month period. That wouldn't be reported until, if you will, June 30, 2013, would be achieved by then. I think that the point Rob made is true, and that is, I can't tell you whether you're going to get price increases of 5%, 6%, 7%, or 8% in the fourth quarter of this year. I can't tell you what you're going to get next year. I can tell you directionally where things are going.
I can tell you that my anticipation next year is that you're going to get another 8%-10% price increases next year, maybe even a little more. That's how things look, and you'll get better returns by a substantial amount.
Got it
the marginal increase in prices. We're also talking about the newer companies. I think the older companies that have been around for a while are going to start to gain more traction also as time goes by. I would anticipate us being able to do better. Yes, you are correct. I was trying to answer Mr. Locraft's question as he presented it and not get into a, I said this, or whatever.
Right. Just want to make sure I understood where you were coming from. That's helpful. Just a question on two segments where the growth rate accelerated quite a bit. One Reinsurance, which looked like maybe it was an easy comp there. The other one was Alternative Markets, which can jump around a lot. I was wondering what's going on in both of those segments.
Yeah. Yeah. I think that, in fact, the growth in the pieces, the Reinsurance part, which grew by $16 million, again, a fairly small dollar amount, which was basically our treaty business just expanded. Also some of it was our participation in a Lloyd's syndicate, and that accounted for it. The Alternative Market business growth. That really has to do with two things. One, the pools that we participate in, where the premium just flows in and flows back out. The other area has to do with our accident and health business, particularly medical stop loss, where we have continued to experience a meaningful amount of growth.
Got it. Just on the Reinsurance business, because I see a year ago premiums were down about 20%, and I remember there being something that negatively affected that business.
Yeah. That was one particular transaction where there was some return premium. That was just an unusual thing.
Okay. In other words, going forward, is a 15% number a reasonable number to think about, or is that a bit inflated because of that comparison?
I think that the comparison was a bit inflated, number one. Number two, more than an insignificant part came from our participation in this Lloyd's syndicate.
Got it. Second question. On the capital front, certainly on a premium to surplus ratio, you look really well capitalized. From a debt to capital standpoint, I guess you're bumping up just over 30%. Is there a range or a limit that you think about when it comes to leverage?
We've told the rating agencies that we'll stay within 25%-35%. We ought to be, based on what we said, sort of at the higher end of that range now. We're not at the higher end. We're right at the midpoint. We have short-term flexibility there. If a great opportunity came, we'd have plenty of borrowing power as long as we demonstrated to the rating agencies that would come down. We told them that range has been the range we've put forth to them for an extended period of time, which is that 25%-35% range. I think we have capacity. We certainly have plenty of people who would be willing to lend us money. As we look at the world today, we have plenty of capacity to expand.
We were opportunistic in buying back stock because we viewed the cycle each quarter as being more definitive. Our stock traded down in the quarter, we took advantage of it.
Great. Last question. In the investment funds, I know that's reported, at least many of them, on a one-quarter lag. At this point, do you have any visibility into the fourth quarter number?
There are only two funds to report, one of which is okay and one of which is negative. One of the quirks which we knew when we changed how we reported is, especially in the oil and gas fund, we invested in a group that did venture type investing, not quite development investing. Once those investments proved out, the companies that we invested in became public companies. When those public company stocks go up and down as the volatility in the marketplace with oil and gas prices changing, we reflect those unrealized gains and losses through our income statement. If we owned the same stocks just as investments, they would just be changes in our unrealized gains and losses in the portfolio. That's really the problem we're facing.
We knew it when we said, look, it didn't make sense not having these funds as part of our income statement. It gives us a little more volatility in that area, and unfortunately, that one fund accounts for a big part of the loss in the funds. In fact, I think it accounts for more than all the loss. Yeah. It's more than 100% of the loss of the funds.
Got it.
All it is two successful investments that became public companies. As oil prices go up and down, their stocks went up and down a lot.
Perfect.
I might add, it's back up again. That'll be in the first quarter.
Great. All right, thanks for the answers.
Yes, sir.
Thank you. Our next question comes from the line of Adrian Meli of Eagle Capital.
Hey, guys.
Hey, Adrian.
Two quick questions. First question is, do you have any opinion on This cycle would considerably look like past cycles, or if you'd see a lot of capital coming in, if we're in a world where banks can't earn reasonable ROEs, will capital switch over to insurance or should it look like other cycles?
I would be surprised if it looked differently. I think the people who put money in after Hurricane Katrina have not had a good experience. A number of companies out there are not doing well, and they're going to show bad results. I think it's going to look with the historic returns we've seen before. In fact, I think more and more people who want to put their capital in the business want to put it in ways that keep them from being locked up. They want to have it in special purpose vehicles. I think less real capital is going to go in the industry. If anything, primary writers like we are, ought to have a better opportunity.
Okay, great. If we look at the way you've morphed your business in the last few years in the new units, and we compare it to the last cycle, I think you wrote ROEs in the high 20s at the peak of the last cycle. You're bigger now in terms of your divisions. Would you expect, given your business mix, if the last cycle repeated itself, would the ROE approach the same levels, be higher or lower given your current business mix?
You just wanted me to lift Rob off because the reason they weren't higher last time is because we had some reserve deficiencies we had to make up at the beginning of the last turn of the cycle. We're fortunately not in that position now. I would guess that we'd have a faster acceleration of our returns and our peak returns probably would not be nearly so long in the coming, but I don't think would be much different.
Great. Thanks, Bill.
Thank you. Our next question comes from the line of Brian Meredith of UBS.
Yeah, good morning. Just a couple of quick ones here for you. The first one, Rob, I think in the beginning you talked about some tightening in terms and conditions. I'm just curious if you could elaborate on that and do you expect much tightening in terms of conditions in this firming marketplace we're in, similar to what we saw in the last cycle turn?
Yeah, actually, maybe I don't think I commented on terms and conditions, but I'm glad you brought it up. That was a good point. Just by business migrating out of the standard market into the specialty market, that on its own is going to be tightening up terms and conditions on the exposures that go from one part of the marketplace to the other. Certainly, it is our expectation that you will see policy wordings getting tightened up, coverages getting tightened up, attachment points being adjusted, deductibles, et cetera. The short answer is yes, we are beginning to see the early signs of that once again as business migrates from standard to non-standard market, and we expect we'll see more.
Okay, great. That stacks, I guess, help kind of looking forward with any kind of a loss cost inflation, if it does kick up.
I beg your pardon?
I guess that should help offset any loss cost inflation if we get any kind of going forward.
Certainly, it is very helpful to the rate you're getting for the unit of exposure.
Great. Thank you.
Thank you. Our next question comes from the line of Bob Farnam of Keefe, Bruyette & Woods .
Hi there. Good morning.
Morning, Bob.
Is there anything that you worry about that could potentially derail the market turn?
Bob, you've known me a long time. Every day, I worry all the time about all kinds of things. I think that the greatest fear you have is people who believe their numbers in a way that leads them to wrong conclusions. It doesn't require someone with an infinite amount of capital to derail a line of business or a group of agents. Reliance and Frontier weren't huge companies, but they certainly had a huge impact on long-haul trucking. Frankly, a lot of companies who are relying on automated underwriting systems and have tried to remove people are going to not make quick enough decisions when trends change because trends take time to get into automated underwriting systems. That will slow down, in some cases, those companies' responses.
Hopefully management in those enterprises sort of override the system and say, "Hey, that doesn't count." I think that most serious managers in the business know prices have to go up, and they're being driven by poor results, and they look at their reserve development and say, "We may have had past years with redundancies. We no longer do." If anything, it looks like, you don't have to admit to yourself that it is, but it looks like there's some current year deficiencies. As long as people face those realities, for most companies, it's within their realm to solve their problems. I think that's the situation. You always can have a company or two that deceive themselves, and it can slow the change.
Delaying it longer than you think.
Yeah. I would be surprised, frankly, if in fact, I think we may be a little too pessimistic as opposed to too optimistic.
Okay. Thanks for that.
Thank you. Our next question comes from the line of Michael Nannizzi of Goldman Sachs.
Thanks. Sorry, just a couple of follow-ups if I could. Bill, one thing I just want to follow up with is your question on the 5%-8% decline in yields if you continue to grow. I was just trying to understand, is that kind of a percentage of the current yield in the book or?
Yeah. In other words, our 4%, Michael, will go down by two-tenths of 3.8.
Oh, it's like 20 basis. Got it. Okay.
Right.
That makes sense. Just when you look at kind of what other folks have said during these conference calls, there's been positive commentary about commercial rates in the U.S. Just wondering why your regional segment hasn't seen some of that, or maybe it has, and it's just a mix issue, if you could comment on that.
I'm going to let Rob take that. Go ahead.
My understanding is that others have been commenting on their pricing as it relates to business insurance. When you look at that portfolio and you compare it to our portfolio of risks, it would be probably similar to our regional group in particular.
Right.
The regional group has been achieving rates that are above the blended rate for our group overall.
Okay. Not seeing exposure growth, I guess. Is that the offset?
When I talk rate, I'm talking about number of dollars we create for an apples-to-apples unit of exposure.
Right. Okay.
The premium count is not going through the roof. To make a long story short, to give you a number, it was slightly over 5% for our regional group in the quarter, was the rate increase.
Okay.
To rate, if you will.
Right. Does that mean that exposure units were down?
Yes.
Okay.
Modestly.
Got it. Bill, if you're looking at the environment now, you're talking about like 5% now and kind of growing to maybe double digits next year. What would you place of the odds of just a period of 5% growth in rate? I mean, instead of seeing momentum take it up higher to 10%, I mean, is that something that can happen that you think is possible? Do you feel like it's just a matter of time before rates have to continue to move higher?
I think the answer is, when you look at just comp, for instance, to get the line to where it's break even, including investment income today.
That line of business is having something slightly more than 10% increase in rate now, you probably need another 8%, in addition, another 8%-10% next year.
Right.
Just to get the line of business to be a break even. You got to remember, comp has a lot of inflation with medical costs and loss costs. I think you've got something, other lines of business, to get to where they're profitable industry-wide, need those kinds of additional price increases. I think that I'd be shocked if it stayed at just 5%. It was 5% more on top of the 5% possible.
Got you. Okay.
I would think it's going to be 8% to 10% more on top of the five. We'd have to look.
Got it. That makes sense. Okay. That helps. Thank you so much. Thanks for answering my follow-ups, too.
Yes.
Thank you. Our next question comes from the line of Keith Walsh of Citi.
Hey, good morning, gentlemen.
Good morning.
For Bill, in one of the last prior questions, I should say, you alluded to the marginal increase in returns from higher rates. Maybe if you could just embellish on that a little bit, talking about marginal returns on what relative to ROE and combined ratio from increasing rates. Thanks.
Well, I think the reality is, it's rate increase minus loss costs, minus expenses. I think that if you say, for simplistic sake, your expenses are going to go up by 3%, that's insignificant. That's three-tenths of a percent on your rate base. Loss costs go up by 3%. Anything you raise your prices more than, let's say, between 2.5% and 3%, are going to give you additional margin. If you get 5%, you're going to add, let's just say two points to your margin. If you can go up 8%, you're going to add in round numbers five points to your margin. I think the question Mike asked, which was a real critical one, which is, everything you get over 3% is going to be a real improvement in your combined ratio, or industry-wide, a diminishment of your losses.
I think that that's a really critical question, Keith, I think that's why it's so sensitive to how well you can get prices up. I think that is the heart. I think there's a difference between September's 3.5 and the average for the quarter of 3 tells you directionally what's going on. It was Actually, things are getting better, I think that it's why I'm really incredibly optimistic about where things go, because that marginal trend is the critical number in profitability. 5% is huge when compared to 3. I think that any question is right on.
Thanks a lot.
Thank you. Our next question is a follow-up from the line of Jay Cohen of Bank of America.
Thanks. Not to get too granular, you suggested just recently that the regional business was seeing increases of around 5%. You also said that workers' comp, you were getting more like a double-digit increase. I assume most of that's in the either regional or alternative market business. It suggests that the specialty business is kind of well below that 3% still. Is that accurate? I guess it partly reflects some of the D&O, which you said was still pretty competitive. Could you reflect on that?
I think that, first of all, a big part of that comp business is in that regional business. I think that that's part of it. Second of all, I think that when you look at the specialty business, there is a piece of the specialty business that's not getting price increases, then there's lots of other parts that are getting substantial price increases. I think that one of the problems with being an analyst is you're trying to get, Gene and I were talking about it this morning, you're trying to come up with a specific analytic number that won't add up the way you're getting at it. In fact, I'm giving you information that's analytic from our pricing monitors, okay? It's a matrix pricing monitor that comes up with those numbers.
To give you your answer, I'd have to spend a lot of time trying to break apart all the pieces. You want to add to that, Rob?
Yeah. I think that if I understood your question correctly, Jay, obviously, as we suggested, depending on the product line, we're getting a different level of rate increase. The comment about workers' comp, maybe it was lost, the significant rate that we're talking about achieving is really around the line of excess comp, we are getting a meaningful amount of rate on just primary comp. I would suggest on a blended basis, primary comp's probably running at about five or so, and excess comp is something north of that.
Got it. That's helpful. Thanks.
Thank you, sir. I show no further questions in the queue at this time.
Okay. Thank you all very much. I think that I appreciate it, and if anybody has any other questions, feel free to give Karen or Gene a call, and have a great day.
Ladies and gentlemen, thank you for your participation in today's conference. This does.