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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, ladies and gentlemen, and welcome to the Q4 2017 Arch Capital Group Earnings Conference Call. 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. [Operator Instructions] As a reminder, this conference call is being recorded.
Before the company gets started with its update, management wants to first remind everyone that certain statements in today’s press release and discussed on this call may constitute forward-looking statements under the Federal Securities Laws. These statements are based upon management’s current assessment and assumption and are subject to a number of risks and uncertainties.
Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the Company’s current report on Form 8-K furnished to the SEC yesterday, which contains the Company’s earnings press release and is available on the Company’s website.
I would now like to introduce your hosts for today’s conference, Mr. Dinos Iordanou; Mr. Marc Grandisson; and Mr. Mark Lyons. You may begin.
Thank you, Crystal. Good morning, everyone, and thank you for joining us today for our fourth quarter earnings call. As many of you know, this is my last earnings call as CEO of Arch Capital, and I could not be more proud of the team and organization that we have built over the past 16 years. We announced our CEO transition plan two years ago, and I’m very pleased with the work Mark and the entire executive team have done to position Arch for the challenges they will face in the future.
In our 16 years as a company, we have come a long way. We have taken an idea to build from Scrooge a specialty insurance and reinsurance platform that can generate superior risk-adjusted returns and we have done that. We also saw an opportunity after the financial crises to add a new segment, mortgage, that profitably diversifies our company, and we have achieved that also. Through the PNC cycle, Arch has produced average annual returns of 16% and book value per shareholder average returns of 16% and book value per share was growing 10 times from $6.03 a share in March of 2002 to $60.91 per share at December 31, 2017. And a share price of $87 before this call from a split adjusted $8.84 back in 2002.
On my own, I cannot have accomplished these results, but with the help of many people, much has been accomplished. The challenge for all of us was to improve the intellectual capability of the company and its ability to manufacture, as I always say, profitable decisions. Most companies do not pay enough attention to the most important asset they possess, their employees. Here at Arch, it’s the foundation of our success. For Arch, the question has been how do you create a culture in a cyclical business that not only empowers, but also helps our employees to make the best decision that they can.
You have to care for them, you have to share knowledge, you have to teach, you have to reward them. You have to provide an opportunity for employees to constantly learn and transfer knowledge up and down the organization as well as across segments and channels. The more knowledge your employees possess, the better decision-makers they are and that is what produces outstanding results. You have to believe in the success of the team over the success of the individual, and you have to be willing to challenge and be challenged. Collaboration is the secret sauce that enables crisp execution and achieving extraordinary results. For the past 16 years, I’ve had the honor and privilege to help lead Arch and to have a hand in its formation, and success is one of my greatest personal achievements.
I’m now passing the baton over to Marc, and I’m confident that we will see not only a continuation of the culture that has made Arch successful, but that also I expect the future of Arch will be enhanced under his leadership. To take an analogy out of car racing, which I’m a fan of, Mark, here are the keys baby. The Ferraris are in the starting position; the fuel, ready to go. Achieve greatness, my friend.
Thank you, Dinos. Wow. You’ll see me on my Vespa in Bermuda. Stay with the Italian team. But good morning to you all. I’ve had the privilege of working with Dinos for more than 16 years, and I feel it’s appropriate to pause on this earnings call. Dinos’ 59th consecutive earnings call and to express a big thank you from all of us at ACGL. Thank you for your leadership, for the values and culture that you’ve helped to establish here at Arch. Enjoy your family with the two newest additions, Marielle and Evelyn, Mr. Grandpa.
Turning to the quarter and year-end review, 2017 brought catastrophe losses of about $135 billion to the industry and caused Arch shareholders about $386 million. For the year ended December 31, 2017, Arch produced after-tax operating income of $427 million or $3.21 per share or 5.7% operating return on equity.
On a net income basis, the results are slightly better as the company reported $566 million or $4.07 per share for the year ending December 31, 2017, producing a net return equity of 7.2%. Our investment returns were good this quarter. As you probably know, we manage our investment portfolio on a total return basis, which in U.S. dollar basis was a positive 79 basis points for the quarter, 71 bps on a local currency basis. Our book value per share in the quarter rose, as Dinos mentioned, to $60.91, an increase of 10.4% for the full year. And our risk management structure and diversified business platforms performed as designed in the face of challenging P&C market conditions and significant cat activities.
One year into our acquisition of UGC, we are pleased with the contribution that our mortgage segment makes to our returns and value creation. Our group wide insurance in force or IIF grew to $352 billion at year-end 2017 from nearly $360 billion the prior year. Helped by the UGC, acquisition grows written premium grew 142% to $335 million for the fourth quarter of 2017 versus fourth quarter of 2016 for the entire mortgage segment.
Reinsurance sessions to our Bellemeade Re insurance link securities and other third-party reinsurers as well as targets reductions in U.S. single business and Australian reinsurance led to a sequential decrease of 6% in net premiums written to $272 million for the fourth quarter of 2017. Earned premium worldwide grew 2% in the fourth quarter to $280 million as a result of growth in our insurance in force.
For our primary U.S. mortgage business, NIW of $14.4 billion in the fourth quarter of 2017 was down from $17.7 billion in the third quarter. Part of this decline is due to normal seasonality in the fourth quarter, but it also reflects our efforts to manage growth in the higher loan-to-value above 95 mortgages and our ongoing conservative approach to the pricing of singles. We estimate that our market share of NIW in the U.S. for the fourth quarter of 2017 was just below 21%, which is consistent with our expectations we discussed since completing the acquisition of UGC.
Mortgage market conditions remained favorable in the U.S., however, competition is increasing in the CRT space as well as in the primary mortgage insurance market. While we are being marginally more selective in our underwriting, the overall quality of the risks written are strong, and the mortgage segment should continue to generate risk-adjusted returns above our long-term target of 15%.
Next, turning to our property casualty operations in our reinsurance segment, specifically. As you have already heard on a number of calls this quarter, rate increases in the property cat lines were not nearly as robust as many of us hoped, given the significant cat in 2017. We saw a few opportunities to put capital to work at the January 1 renewals, but not enough rate movement to warrant a material increase in our writings.
Rates across our reinsurance portfolio were up 2.5%, including 5% to 7.5% for our cat book. As you can see, it’s a positive, albeit tepid starting point for the year. Returns for cat business are low by historical standards and in our view, do not fully capture risk volatility in this line of business. For the fourth quarter of 2017, gross premiums written rose about 5% in our reinsurance segment over the same quarter in 2016 and 2% on a net basis. The growth came primarily from our specialty businesses, including international motor treaties, while other lines, such as our property x cats were reduced. Our reported combined ratio for the reinsurance segment was 94.5 in the fourth quarter on a core basis, excluding Watford Re.
Turning to our insurance segment. Gross premiums written of $768 million in the 2017 fourth quarter were 8.5% higher in 2016 fourth quarter, while net premium in insurance were 10.1% higher at $513 million. The higher level of net premiums written reflected increases in national accounts, travel and growth in two of our newest programs, areas where we currently see opportunities in U.S. insurance.
Focusing on P&C insurance market overall conditions, they remain challenging, although we have seen rates stabilize and improving in some lines in the fourth quarter, particularly in property, commercial auto and some casualty lines. Our current view of the market is cautiously optimistic. We are seeing a slight upward movement on the pricing side with some margin expansion. However, after considering changes in terms and conditions and other factors that can influence claims trends on an absolute basis, rate levels are not sufficient to support the allocation of more capital to our insurance segment, especially given our opportunities in the MI segment.
Next, I would like to discuss our PMLs. As we mentioned last quarter, we’re also reporting to you our exposure to mortgage risk from a systemic stress event what we call a realistic disaster scenario, or RDS, it stood at 17% of tangible common equity at the end of the fourth quarter. We have begun using tangible rather than stated equity as a result of the UGC acquisition, as we believe that is a more appropriate and prudent risk management yardstick.
Our net property cat exposures are substantially the same as last quarter with our 1 in 250 year PML for the peak zone, the U.S. Northeast, at 6.5% of tangible common equity. In summary, we are always preparing for opportunities as the market presents, but we remain disciplined in allocating capital to the various units to maximize risk-adjusted returns for our shareholders.
Now here’s Mark with a more detailed financial analysis of the quarter, Mark.
Great. Thank you, Marc, and good morning to all. On today’s call, I’m going to comment on the fourth quarter results as usual. I’m also going to focus on some unusual accounting impacts and one-off charges, driven by U.S. tax reform and other items in this busy, busy quarter.
Okay. So now into some summary comments for the fourth quarter, all on a core basis, and just as a refresher, the term core corresponds to Arch’s financial results, excluding Watford Re, whereas the term consolidated includes Watford Re. So core losses recorded in the fourth quarter from 2017 catastrophic events net of reinsurance recoverable and reinstatement premiums were $800,000 or nearly 1/10 of the loss ratio points compared to 4 loss ratio points in the fourth quarter of last year on the same basis.
The activity was primarily driven by the California wildfires, pretax estimate of $68.4 million, along with approximately $69.1 million of reductions associated with the third quarter Hurricanes, Harvey, Irma and Maria. The reductions in the third quarter hurricane estimates resulted from lower industry loss estimates from outside vendors in conjunction with our own lower than expected reported claims volumes.
Most of the reduction emanated from the reinsurance group, both of facultative and treaty and overall, estimates for Harvey and Maria were reduced whereas Irma remained relatively flat. As for the California wildfires, we see more exposure from the Northern California fires versus Southern California roughly 3:1 and see this primarily as a reinsurance event for us.
With respect to net pure loss prior period favorable development, approximately 54 million or 4.9 loss ratio points was recognized in the quarter compared to 6.5 loss ratio points in the fourth quarter of last year. This net favorable development was led by the reinsurance segment with approximately $32 million favorable, while the mortgage segment provided approximately $20 million of favorable development.
The calendar quarter combined ratio on a core basis was 82.5% compared to the fourth quarter of 2016 is 88.3%. The core accident quarter combined ratio, excluding cats, was 87% even compared to 90.7% for last year’s fourth quarter. The reinsurance segment accident quarter combined ratio, excluding cats of 103.2%, includes two unusual items and the comparison to the fourth quarter of 2016 needs one unusual item comment.
The two items impacting the 2017 accident quarter are one. The non-recurring 1% federal excise tax or FET, associated with the fourth quarter intercompany loss portfolio transfers previously announced, which resulted in a 5.3 point increase to the reinsurance segment expense ratio through the acquisition line.
And second, the reinsurance group incurred approximately 2 combined ratio points of negative impact associated with the former Gulf Re operation over the prior year’s comparable quarter. The item affecting the fourth quarter of last year, was a large retrocessional recoverable of approximately $11.5 million that had no counterpart in the fourth quarter of 2017 and represents a 4.6% combined ratio point impact. Taking all of these items into account, results in a 95.9% fourth quarter, accident quarter combined ratio, which therefore, represents only a 20 basis points increase over the adjusted fourth quarter from last year.
Moving on to the insurance segment. The accident quarter combined ratio, excluding cats, was 99.7%, which included 2.2 loss ratio points of large attritional losses relative and higher than the fourth quarter of 2016, along with the flat expense ratio. This is approximately 130 basis points higher than the comparable accident quarter in 2016. This is a loss ratio increase and primarily represents higher loss mix due to our view of competitive marketplace conditions on an earned basis.
The competitive conditions experienced in the insurance and reinsurance segments were more than offset by the continued strong profitability on the mortgage segment, amplified by their net earned premiums being the larger proportion of the total. The mortgage segment’s accident quarter combined ratio have improved to 47.1% from 54.8% quarter-over-quarter, and their net earned premiums represented nearly 26% of the total core net earned premium compared to only 9.6% in the fourth quarter of 2016.
The accident quarter loss ratio of 25% was negatively impacted by approximately $10.4 million of charges primarily associated with higher delinquency stemming from the third quarter hurricane events, a catch up of 2017 reported losses from one lender and a small adjustment of a loss reserves on parity between our East and West operations. The accident quarter loss ratio after taking these items into account would have been 21.3%.
I’d also like to point out that subsequent to the UGC acquisition, which closed at the end of last year, the 2017 accident quarter loss ratios for the mortgage segment has sequentially been as follows from first to fourth quarter: 21.5%, 19.5%, 20.6% and this quarter’s 21.3% on an adjusted basis.
The expense ratio improved from 37.9% in the fourth of last year to 22.1% this quarter. On a sequential basis, for the third quarter of 2017, however, the expense will ratio increased by 150 basis points from 20.6%. This was primarily driven by an increase in the amortization of deferred acquisition expenses. Remember, that is the closing of the UGC transaction at last year end, all deferred acquisition expense were written off to zero. They are now rebuilding and being amortized into income.
Moving on to other unusual financial statements in this busy quarter. Let me begin by discussing three items that have been included as reflected within operating income. First, as I noted earlier, we executed a onetime intercompany loss portfolio transfer this quarter and incurred to $13.6 million of federal excise taxes or approximately $0.10 per share.
Second, we established a $10 million valuation allowance against our UK insurance syndicate deferred tax asset this quarter were $0.07 per share. Third, as discussed earlier, the mortgage segment recognized approximately $10 million plus of pre-tax charge and $6.8 million after-tax charges, representing $0.05 a share. All in, these one-off items with an operating income as described totaled $0.22 per share.
Shifting to an update on integration cost associated with the UGC transaction. The original combined workforce has been reduced by approximately 30% as of year-end 2017 along with 120 contractors. There was $1 million of severance-related cost in the quarter, totaling $14 million for the full year. And the run rate of quarterly pure salary savings is $9.5 million or $38 million on the annual basis.
The vast majority of employee-related savings has now been realized with any additional future benefits likely being a system integration-oriented. As for the beneficial accretion, stemming from the acquisition of UGC, on an EPS basis, we examined the full year performance in the overall company, the mortgage segment and UGC incremental vision. And adjusting for normal level of cat losses shows the earnings accretion projected to reach 35% within three year period has been nearly 75% achieved just one year later.
Total investment returns for the quarter was a positive 79 bps on a U.S. basis, as Marc mentioned, and 71 basis points on a local currency basis. Returns on equities, alternatives and non-investment rate fixed income primarily drove the return. The full 2017 year total return was 5.87% on a U.S. dollar basis. Investment duration was 2.83 years at the end of this year, down sequentially from 3.14 years in anticipation of inflationary pressures.
Operating cash flow on a core basis was a negative $32 million, primarily due to an increase in net paid losses spending mostly from third quarter cat activity, the return of cash collateral associated with a large longtime customer and the timing of tax payments between both the quarters.
As for taxes, we incurred a $21.5 million charge this quarter that results from the change in the U.S. corporate tax rate from 35% to 21% on our deferred tax asset. This has been excluded from operating income since this is not reflected of operational performance.
The effective tax rate in the quarter or pretax operating income was 15.4%, excluding the impact of the changing U.S. tax rate I just commented about and 17.6% for the full 2017 year on the same basis. Now we don’t like to give guidance, but there has been so much havoc in the third and fourth quarter of this year. We’d like to provide our view. The 2018 tax rate, our pretax operating income is expected to between 11% and 14%.
Although this range results from various scenarios tested, actual results could still fall outside this range, depending on the level and location of income or loss, the level and location of catastrophic activity and varying tax rates in each jurisdiction. As respects financial leverage, we repaid another $25 million down on the revolving credit facility this quarter. And that, combined with strong earnings, continue to improve our leverage ratios.
During the quarter, we also issued 100 million of Series A preferred at 5.45% and redeemed all of the remaining $92.6 million of Series C 6.75% preferred, but with the clearing date of January 2, 2018. As a result, there was a two day overlap of having both Series C and Series F outstanding. So we just for that overlap results in a GAAP, debt plus preferred ratio of 25.8% at year-end 2017 versus 28.7% at year-end 2016, which is a 290 basis improvement in that leverage.
The ongoing preferred dividend amount is $10.4 million a quarter, which will result in $4.4 million of lower dividend amounts in 2018 than in 2017. We did not repurchase any shares during the quarter, and our board authorization remains at $446 million plus.
On a personal note, Dinos, we have been working together now for about 35 years, and I’m still waiting for you to get something right. I’m kidding. But seriously, because of your leadership, the company is smarter, our families are happier and each one of us is a whole lot more wealthy. So thanks very much for your leadership, Dinos.
You’re welcome, Mark.
Now with that, we are happy to take your questions.
Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan from Wells Fargo. Your line is open.
Hi, good morning. First off, congratulations Dinos on your retirement. It’s obviously been a great job for all of us working with you through the years. To the quarter, my first question, is either of your two segments, was there any kind of current accident in your catch up in terms of the margin specifically, the loss ratios and how do we think about, just given the market commentary that you’ve provided still being pretty defensive, I would say, in both insurance and reinsurance. How do you think about the margin profile in both of those businesses, as we look out to 2018?
Elyse, its a good question. I think we’re prepared for that one, obviously. I think there was somewhat of a small margin expansion in the fourth quarter of this year. It’s clearly that we’ve seen it. We think it’s about 30 bps in our portfolio, maybe its 50 bps. It’s a positive – it’s small, but it’s a positive and it’s also in the heels of 2.5 years of margin compression. So that you have to keep that in mind that a one quarter change does not repair 2.5 years of margin depression. That’s what we are cautiously optimistic.
It’s holding in January, our initial discussion with our team is that – the market is holding of the right level, the same as it was in last quarter. Essentially if you talk to our team, they’ll tell you that 2017, the last quarter of REIT changes pretty much meant that 2017 was a wash. So we sort of have a stable year versus 2016. And this is what’s behind our commentary about the market. So it’s holding, slightly improving. And clearly, there has been the recent improvement at that level, but it’s also an improvement in ROEs and returns in margins.
And a lot of it – that’s not have a whole lot to do with the REIT level themselves. A lot of it has to do with the tax rate changes, specifically in the U.S. and as well as their interest rate environment that we see all around us, right. So those two together account for about 200 basis points of pickup in return. So historically, we told you we have about a 7% to 9% ROE. This was middle of 2017. So I think we’re probably moving towards the higher end of that range, but the one thing that I mentioned that I really want to impress upon you, these are all quantifiable changes, risk changes in trend and losses.
There’s a lot of stuff out there that’s called terms and conditions, and a lot of it has been given away over the last 2.5 years to 3 years. And we don’t necessarily factor that very well into our calculations. And the trend has been going up. The trend was 1.5% at closing and on 2% for this year. So that’s why we’re cautious because, yes, we’re seeing some compression and margin expansion. The last quarter, it seems to be holding up at the January level – the January 1 renewal, but there’s a lot of uncertainty as to where are we starting from and what it will it mean for the next – for the remainder of 2018.
I will just add Elyse, we talked about that as a management team. When you look backwards, the actual risk it takes never works in a soft market. It’s always worse than you think, and its terms and conditions as Mark highlighted. So that’s where our gray hair comes from. We’ve been through a wealth of these things that you have to be thinking more conservatively.
It’s prudent. From an old guy, it’s always prudent when you can calculate something. Then I think in my 42 years in the business, the effect of the change in terms and conditions never really mathematically can get factor. It’s prudent to be a bit more cautious, and I think what Mark and the team have done for determining the accident year is prudent, in my view.
And Elyse, again, this is just one quarter worth of information and we’ll have to wait another three to four years to see whether that – these numbers are holding up to what we think there holding up. And that also means that we fit 2013 through 2017 at the right level, which one could argue that’s not everything is probably as rosy as people might think. The proverbial bond maybe a little bit out of the bond, as Dinos would like to say.
Okay, great. And then my second question, in terms of on capital, when you guys announced that you do see deal on, you effectively said that you weren’t going to be buying back stock for 2017. As we think about 2018 and just capital, obviously, there’s some potential few minor changes related to your mortgage business. You also, with the laps, the AIG quarter share, only runs for 2014 to 2016. So you are holding on to more mortgage business. How do you guys think about that holistically? And could we see Arch buying back some stock in 2018?
So right now, the best – as best we can tell is we would return capital to shareholders if we didn’t see opportunities. And frankly we’re seeing opportunities and clearly MIS is one glaring area where we think the returns are appropriate. So right now where we stand is we have opportunities that may develop or may not develop, and it behoove us to keep the capital at least hold it behind so that we can maybe able to deploy it in this year and in the subsequent years. That’s really what I would – Mark, you want to add something?
Yes. I would just add Elyse. This was six months ago. The idea of retraining if we could and deploy it would have been tougher. Now it’s – we’re training about 142% of book. I think as of this morning, over three years, that’s 12%-plus, getting closer. Not at, but closer to where we are. So it’s not impossible, but we’re looking to deploy our businesses, first and foremost.
Exactly. On the PMIER note, that’s a good question you’re asking. It’s going to be asked. Currently, we don’t see any change in our capital plan. We’re totally everything is in line. It’s going to be some changes. We can’t talk about it, but totally within the planning budget. So it’s nothing to talk about.
Okay. Thanks so much. I appreciate the color.
Thanks.
Thank you. Our next question comes from Kai Pan from Morgan Stanley. Your line is open.
Thank you and good morning. I would congratulate Dinos on the retirement and I think a long-term shareholders owe you a deep debt of gratitude and you leave the company in good hands and I’ll miss your commentary on the souvlaki, gyros as we approach the lunch time.
Yes. They’re going to bring me back just to pick up the menu every quarter. Because I don’t think they’re expert on Greek food, but I am.
Right. So that might add in 1 bps point 0 expense ratio, I guess. So my question is on the pricing outlook. It looks like the January renewals have been sort of modest increase. Given what you know today, what’s your outlook for May renewals? And how much rate increase you would need for you to get back in the property cat reinsurance business or increase riding on that?
Yes. We talked about last quarter, I think, the number I put in the ground for it to make its valuable. In terms of to get back to historical returns, we wouldn’t want from a property cat perspective. Not perspective because of the volatility around it, we would have won about 30% of increase. And now where we are, we probably gained anywhere between 5% to 10%. So we would need not in a significant amount of REIT increases though. So one thing I tell you about the middle of the year, this is property cat exposure business insurance or reinsurance. They are very, very similarly in terms of REIT needs.
It’s too early to tell. I think there’s a lot of adjusting for position in the marketplace. One thing that surprised us, I’ll tell you for January 1. And it might be another reason why we’re a bit conservative in our comments is that capital does not seem to go away at all. If anything, I think capital has been increased at the 1/1 renewal, and its – the capital has committed for one year. So maybe we would expect a very similar round of REIT change by midyear. We think it should be much bigger than this, much higher than this, but we may not be able to get this because of the microeconomic forces of supplying demand of capital, essentially.
Okay. That’s great. And then switch to MI. Just I have a couple of questions there. One is a delinquency going up for the quarter sequentially because you think the impact from hurricanes will be one time rather than long-term trends in terms of delinquency trends. And then the second, what’s your run rate do you think on your like expense ratio as well as the acquisition ratio? It’s like 2017 will be a good run rate going forward?
Yes. Delinquencies are getting better, and we have our delinquency – the case of delinquency that we have on our portfolio, if you exclude to your point the recent storm, it’s still decreasing. And sequentially, as is with everybody else in the sector, we have seen a blip about 3,200 new claims. We think it’s kind of hard to see through all the claims specifically, but we estimate about 3,200 claims from the storms. You acquired right, it’s a blip. It went up from one quarter. We expect the cure rate for those claims, as you heard from other people to be very, very high. A typical delinquency now that we see that’s non-hurricane related probably cures to the tune of 87% to 92%.
The ones on the storms are going to be – we expect north of 95%, but you’re right. So blip, we have to recognize it. There were some reserves put aside for this as a result of that event. But we are expecting this to be a blip and go away. As of the recent, I think, Mark, we have already decreasing claims. We have 3,200 at the end of the year. At the end of January, I believe, we already had 400 accrued.
So we expect it to be fully curing. Also, we should know, you probably heard about some other call, that Fannie and Freddie had put programs to stay any delinquency to give people credit and give some leniency on their payment of the storm. To recognize, the duress under which they are for the storms. So anything that we hear and see indicates that it certainly will repeat itself and that will be a blip that goes away in the large part.
And Kai, if Marc didn’t mentioned, I apologize if you did, when you adjust for those hurricane-related without the delinquency rate, it’s 1.97. It’s virtually flat with the prior quarter. So that really accounts for it. As far as your second question on the expenses, for the quarter, the segment was 20 little over 22. We have to keep in mind, is yes, we’re growing on premium and you got the AIG quota share session starting to wane marginally a bit. But as I commented on in the prepared comments, the deferred acquisition costs were written to zero on the UGC transaction. So they’re building backup and being amortized. So I would not to get crazy guidance, but I would say as best, it would marginally improve from the 22.1%. So best I can do for it.
Okay, great. Thank you so much.
Thank you. Our next question comes from Meyer Shields from KBW. Your line is open.
Good morning. Congratulations to Dinos on phenomenal career and well deserved retirement.
Thank you.
One quick question, just in terms of modeling. Do we have sense as to how much the acquisition expense ratios have been impacted not counting the fourth quarter LPT for excise taxes?
The only real impact you’re really seeing of significance is in mortgages as we talked about. I mean, there is some growth in NWP as Marc delineated on a written basis, but the PC side is really not to date, has not really impacted it’s really the mortgage side.
Okay. And can you – I’m not sure how to ask this, but can you talk about the…
I’m sorry, Meyer, yes, you did have a second point, as now I can just point out to me. The FET on the $13.6 million was reflected in the reinsurance groups acquisition ratio, and it was all expense.
So it’s 5 points plus.
Right. Okay, I got that. Thank you. I was wondering if you could talk about the analog to trend in the mortgage insurance business whether that’s changing. You talk a little bit about pricing getting more competitive.
Yes. The trend in loss trend really the equivalent for the MI is the trend in credit riskiness of the underlying policy holder or mortgage insurance policy. And so this one, we’re not seeing a significant amount of changes in the regular – to the average lender, borrower. But having said this, if you look at the overall MI portfolio, there is an increase, for instance, a 95 and above LTV.
So you do have an underlying riskiness of the portfolio that has changed over the last two years. So the singles were already there. They’re not necessarily more risky. They’re just different their economic discussion, in which we have lowered, as you know. But the two elements are not getting riskier in the marketplace or the 95 plus LTV, which I mentioned, which I’ll supported by the GSEs. And the second one is the DTI above 43, which is another one that is encouraged by the duty to serve aspect of the overall mortgage risk providers.
So these two elements are not actually not insignificant, right? I think the DTI over 43 is about 20% of the NIW for the MI industry, and the 95% plus LTV has grown to 12.5%. So the overall riskiness of the portfolio is increasing as a result of that specific phenomenon. But if you look at – it’s actually buffered to some extent by house prices appreciation going up and affordability still being at the very healthy level. The DTI for the average borrower is still below 30%, which is lower than historical values. So I think at the margin, the volatility around the expected, I guess, has been increasing a little bit. You don’t have necessarily an average risk are going up significantly. Does that make sense?
It does. It’s very helpful. Thank you so much and good luck.
Let me just a little color. What Mark said is absolutely correct, but I want you to understand that a risk price methodology adjust for the riskiness. And for that reason, a reduction in exposure has been mostly in the 95 LTV and above and, of course, singles that we have been mentioning for the last three quarters. Just a little more color.
Thank you, Dinos.
Thank you. Our next question comes from Brian Meredith from UBS. Your line is open.
Yes, thanks and also congratulations Dinos on retirement and just as an outstanding career. My question first is on the MI business, I’m just curious your thoughts on the competition that you kind of highlighted. Do you anticipate the tax reform will have any incremental pressures with respect to pricing in the MI business?
I think, at high level, Brian, I think once – investors look at returns after tax. Most of the U.S. MI provider of capital of U.S. MI business are U.S. based, therefore, U.S. taxpayers. So I would expect, in general, so that should means, everything else being equal, which is never is, that the returns would increase for the U.S. MI provider. Therefore, the question is, is that – will they be okay with this? Will investor expect a higher return? Or did the risk change in any significant way?
So I think all else being equal, I would expect the market has been such not only in MI specific, it’s also P&C in any market, for that matter, phenomenon that if there’s more money left after you pay the tax, man that there was an adjustment for returns. So we would expect to have some kind of effect. I don’t think we’re seeing it quite yet, because as we all know, collectively, there’s PMIERs 2.0 on the horizon. And done my taper somewhat what happens over the next six or seven quarters. We don’t have a crystal ball, as you know, but all else being equal, when tax rate goes down, when there’s more money available for shareholders, and everything else being equal, which would expect price to go down slightly. Yes, we would.
And I’m just curious, Marc, on your 15% kind of return assumption is based on minimum that you’re looking in the MI business. What is the tax rate that you’re assuming on that?
Mark, you mean, just pretty [indiscernible] It hasn’t changed…
Yes. We would expect that incremental benefit now, Brian, of course, the 35% to 21% that we have, it’s all U.S. we have a U.S. tax group that goes beyond mortgage, of course, it’s all very – everybody talks about the other U.S. stock companies benefiting enormously. If you have other U.S. based income you are benefiting too, just as we are.
And Brian, we said we are meeting the 15% return, which means my implication is above that.
Right, right. I was just thinking it’s 35% with the tax rate you were using and I guess it will 21% not kind of your blended tax rate with the quarter share offshore.
Well, before we were paying 35%, there was a quarter share to ARL for capital management purposes, so that would blend into 17.5% absent FET on the other side. Now I’d say, 25% for what’s in the U.S. and then there is a quarter share although we have to weigh that with the B tax that comes into play as well. So we’re somewhat similar – in a similar position after tax then we were before if not improved slightly as Mark mentioned.
Perfect. And then another one, just curious your Watford, looking the results you continue to have fairly high combined ratio this year. What is the kind of outlook right now for Watford as we think about it?
I think it’s purpose, it still very much alive, I mean, we have other guys coming up with total return reinsurance still as of yesterday I believe it was announced in the marketplace. So I think that one thing that happen to Watford is that they were essentially participating on the property cat portfolio and so to happen to run into the 2017 cat as well. So the question is, was this appropriate then we can look back and be money, money quarter back. But at the core of what Watford is doing, we are – there is no much change for it purpose and it’s still very much alive and what it’s doing.
The reinsurance play as you guys remember what initially what we are trying to do get Watford into there is been a shift over the last six quarters, as I mentioned the reinsurance market terms and conditions got progressively worse since we established Watford Re. There is a push for Watford to become more of an insurance provider in the U.S. And that will certainly help those kinds of combined ratio and volatility specifically around their results.
I think another variety. A good characteristic to keep in mind is, they are north of 50% – I think they have 55% in the quarter direct on their own paper rather than being [indiscernible]
Got it, helpful. And then last just quick one here, in the MI business, Marc, is it possible to give us what the kind of reduction you see on AIG quarter share kind of look like in 2018 versus 2017?
In a premium sense.
Yes, the premium, just like most of the growth in that obviously right is the AIG…
It’s not a big follow up as you think.
Okay.
Brian, overall annually, it’s only in the tens of millions.
Got it. Thank you.
Welcome.
Thank you. Our next question comes from Amit Kumar from Buckingham Research. Your line is open.
Thanks and good morning and I’d also like to echo my congrats to Dinos for being leading one of the top value creator franchises out there. Two questions, the first question is going back to the discussion on the insurance AYLR and I think you mentioned there was some movement from the attritional losses. Can you just maybe just flush that out a bit more in terms of how we should think about the underlying LR trend going forward. And does it drop off or there is some volatility continue going forward?
Let me start it. I think the ongoing movement over the last few years and Marc has highlighted in the past of smaller policies lower limits continues to constrict the volatility, which is part of the game plan. And large attritional losses you still occasionally get we got it from the fourth quarter of last year, you got it again this year. It seem to be a common theme on insurance and reinsurance on the onshore energy being the exposure that’s generating that, which is requiring different actions associated with it because you have to have a common view of that across. So I think the corrections for that are going to go – take a long way for stabilizing. And you could never say never, but that’s a high capacity business that can hit you with large pops.
And just to be clear, there wasn’t any adverse movement netting out against favorable movement in reserves?
No, insurance was basically flat.
Yes, it was basically flat. But some plus or minus but overall it’s not.
Not so material, okay. I guess the only other question I have is, maybe a broader question. And this is for Marc, based on the transition I was curious, this obviously has been in the pipeline for sometime in terms of the overall. Have there been times when you thought differently then Dinos and strategically how do you think about Arch from here going on forward.
The best question, the best way to answer that, I’ll ask Dinos to chime in to confirm what I’m going to say. But I think the Mark Lyons, myself and Dinos work together for over 16 years. We’ve had our differences and our agreements and disagreements, but by and large, I think over time we find ourselves a lot more agreeing on things and not. I think we’re both – and three of us come from the very rational – very economically rational way to analysis businesses and make decisions. And I think that’s something that is sometimes missed or that you should appreciate that. And I think Dinos would echo this, the strategic visions or the strategic play that we have did and we did over the 16 years were not – Dinos was certainly the proponent and the one publically advocating and talking about them. But all these things were really done and claim to as we talk together jumble our results were very instrumental on this as well.
So I think that we all grew together in that environment and had more success then failures, I mean, we don’t do everything right. But I think the overall – I think we grew to agree more together not because I came to his view or he came to my view is because if you look for the truth and look for the right rational thing to do, we sort of come up to the same or very often the very similar conclusion. That’s what I have noticed over the last 16 years.
Let me give you my two cents on it. What Marc says absolutely correct. First and foremast with a very collaborative management team and beyond that we’re very collaborative with our Board of Directors. So, the alignment is to where we are going to, yes, we do the groundwork, the management team does the groundwork. And Marc mentioned himself and Mark Lyons and me, but there were others. There is Nicolas and there is Maamoun and I can go on and on and on and there is Pres and on and on and on.
So there is collaboration in examining what the opportunities and where we are going to go. And the good thing about it, is that when we arrive at a decision then beyond is about execution is not about – if I step back and I look at the past 16 years, I would put a 95% plus agreement between the senior management team and the board ratification of where we wanted to go. The other 5% I don’t – I will never call it as a major disagreement, but directionally maybe a little more to the right and a little more to the left. And then at the end we agree as to how we’re going to do it. And I expect the future to be pretty much in the same direction.
Having said that, let me also address the other aspect of what we are as a company. We’re opportunistic. So I don’t know what opportunities will be detected in two years from now, three years from now, four years from now. But I can say me – my duties as a Director and being on the board – and the management team operationally, which occasionally bring ideas up to the board as to what we’re going to do. That collaboration is going to continue, but I can tell you what the future is going to say, if there is a change in strategy. If there was a change, is because based on our opportunistic approach to the business, we see an opportunity in the future that it wasn’t present today or in the past as we’ve done with the mortgage. None of us thought we’re going to be in the mortgage insurance business when we started in 2002 all the way until the financial crisis. And then after that, we saw the opportunity. We worked on it first as a reinsurer and then later on, we said, there’s more value to be a primary insurer and we took and the acquisition to get us there.
So I don’t – I mean, it’s a very important question, but I think we’ve done a great job in not only transitioning leadership and building from within, which basically it’s another one of our foundations – a lot of senior managers, they grow within the Arch culture, and we like to promote from within. And we don’t rely significantly ongoing and bringing outside talent, but it makes it easier later on to execute the strategy because everybody’s in alignment. And I believe because we do have that collaborative culture. Listen, John Vollaro officially retire in 2009, right? I don’t think anybody here thinks he ever retired.
Like I said, yes, you do retire, you don’t in our operational, John was never operational. I will never be operational. The management team’s responsibility is to be operational and make all those decision, but they’re for consultation. People they’re going to call, we’re going to discuss things. We’re going to discuss them at the board. And at the end, I don’t anticipate major changes unless the market dictates this because there is an opportunity that none of us is seeing today, but we might see the future. Marc?
Great. I agree with you.
I’m interest. There are the bunch of shrinking violates on the measurement.
I will stop here. Thanks, again. And I’m sure Lyons is following. So I will stop it.
Thank you. Our next question comes from Geoffrey Dunn from Dowling & Partners. Your line is open.
Thank you, good morning. I wanted to dig into the credit development on the MI front a little bit more. Stripping out some of the things you’ve highlighted, it looks like you’re still running and incidents maybe up around 12%. Can you confirm where you are in your incident assumptions on new core notices? And if it is still above 10%, what does it take to get you down there?
Actually we – the reason ones are getting below 10%, but we were about 12.5% over the last two, three quarters. So we’ve crossed it, but it’s a one quarter, Geoff. So who knows if it’s holds up there.
So you have touched down on your assumption to 10%?
No.
It’s just for the cats.
Yes. For cat – yes, I make point on the cat for the – lower than 5% of what we expect right now. It’s still early to tell that…
See, I’m talking on the core number.
The regular stuff. Yes. We’re slightly below 10%. For the recent, last few quarters of delinquencies that’s what we expect ultimately.
Great. And then with respect to the PMIERs cushion. How much of a drag on the cushion whether there’s quarter from the hurricane notices?
Well, the hurricanes pretax load was really not that large, so you can kind to deduce that is not a big deal. It was south of $5 million.
South of a $5 million capital drag?
No. South of $5 million cat reserve provision.
No, no. I’m talking about capital drag on the PMIERs ratio.
The PMIER is $72.5 million of drag. We had to put a sign for the new notices. That’s the question. Sorry, Geoff, we didn’t get that.
All right. And then my last question is obviously, you’re running the highest cushion in the industry right now with respect to PMIERs. It’s going to go even higher to get these notices out of the inventory. Post PMIERs 2.0, what type of cushion do you expect to run?
We can’t be talking about this. You know we’re under an NDA. You of all people should know this.
I’m not looking for the capital level. I’m looking for the relative cushion. Is it the 10% or the 20% cushion or whatever Post PMIERs 2.0 says?
We’re unable to tell you this, but we can tell you this, Geoff. We’ll have to get there. When you finalize – it’s going to be $5 million this year. We’re going to have the final thing. This will be more like a second quarter call discussion.
All right. Thanks.
Thank you. Our next question comes from Jay Cohen from Bank of America Merrill Lynch. Your line is open.
Thank you. My questions were answered. I feel like I should make a comment about Dinos. So I was involved – I worked on the IPO of Arch, so it just goes back many years. At that point, many of you remember there was a lot of companies come in public and being formed, and they all sounded reasonably good. Good risk management, good underwriting, good management teams, and the question would often come up, well, which ones are the best. And I would tell people like ask me about 15 years and I’ll have a good answer. Well, I think we have our answer now. Congratulations, Dinos. Thank you.
My eyes are getting watttery now.
Thank you. Our next question comes from Ian Gutterman from Balyasny. Your line is open.
Thank you. I’ll just follow up with there, which is, as I recall, around that same time Dinos, you and John will remember these meetings well. Everyone giving you a hard time about Zurich and questioning your ability to be successful at Arch, I think a lot of people regret they haven’t given a board on sooner or so.
Listen, I make pleasure on making – proving people wrong.
That’s – it’s a get motivator. My first tenancy question is Kai kind of stole my thunder here a little bit, Marc. But my first question is, will the menu change next quarter?
Well, I don’t know. My duties going forward is – board duties, choosing the menu for the calls. I won’t participate on the calls, but I’m going to be talking to the chefs as they’re going to offer for lunch. And, of course, I’ll be available for golf games and dinners, especially if I don’t have to pick up the tab. So you know my number, so if it’s the golf games with good dinners, and I’m always available.
My follow-up question for you on that, Dinos, is in your prepared remarks where you talked about Arch’s secret sauce, I thought that was just tzatziki.
Tzatiki’s too – this is my mother’s secret sausage – I mean, secret sauce, which is a lot better than tzatziki. Tzatziki, every Greek restaurant has it.
That’s good. So series questions, last quarter we had a discussion about cats. I’m sure you recall about the so-called missing losses and the modern agencies never being right in the first time and all ways being too low and how it will play out. And it seems that the way is played out is actually the modeling estimates were too high for once, and everyone is releasing reserves just three months out. So I’m curious now that you had some more time to assess, what do you think – what are the implications for that? I mean, is there a reason to believe there’s some – there was a flaw in the models and we might see them be high in the future again like this? And we need to reassess how we think about hurricane risk? Or it’s just – this was an anomaly in every once in a while, they’re going to be way too high?
Yes. So if you look at that loss, Ian, we thought about it, and most of the uncertainty and change in our ultimate were in the reinsurance segment. So if you look at our loss, the difficulty in analyzing this loss was how widespread it was among many primary companies. And then soon – clearly, it was not as concentrated as we thought it was. So this became clear to us after repeated discussion what our clients on the reinsurance side, I’m talking. Insurance side, we haven’t changed much of our view. It’s still the losses are the losses. We have them and it’s not going away in the sense that there were – there’s less in that estimate. But on the reinsurance side, I’m going to say that collectively as an industry, that might explain some of the exuberance that we’ve seen on other calls or in the January 1 renewal that loss is largely an insurance loss. So that made it a lot harder. We are insurance with most of our capacity on the cat is allocated to their reinsurance. So it was very hard at the end of last quarter to re-evaluate what loss have are coming from.
So I’ve asked our team in Bermuda to see what kind of return period that are we looking at for those kinds of losses. And we’re in the one to 20, one to 30 years, so it’s not as unusual as you might think it is. So, I guess, I would just describe it to the fact that the losses spread out, and the losses in California, which could have been more concentrated, actually didn’t know it’s a significant loss. But is not significant enough that it will have that much of an impact on certainly under reinsurance segment and on the broader marketplace. So I think it’s still possibly also too early. There might be some losses that develop afterwards. There might be some creep of the policy language that may change things. These are things that we’ll level have to see how they develop. But so far, you’re right. I think that missing losses are not missing. They were probably not there to begin with, specifically on the reinsurance side. Dinos, you want something to add?
Yes, I will pick up on what Mark said. I mean, yes, the losses in the aggregate, I mean, it’s three losses and then you have the California fires and all that. It’s still over $100 billion – It’s still over $100 billion. So this is not what I would call a small event. But as Mark said, most of the absorption of these losses came by the primary riders. And for that reason, the reinsurance market and especially some of the – what you will call alternative capital did not get hurt as much as potentially could have been hurt. And for that reason, that capacity remain in the marketplace and it got easily reloaded, et cetera. And that has an effect as to how you’re going forward to with the rate.
I don’t know if Mark and in his comments was more specific. In the primary property arena, we’ve seen gradually improvement on the pricing that is not diminishing. It’s happened in December and it’s continuing in January. And at the end of the day, I anticipate – he’s going to continue because that’s where they heard is. Most of the losses they’re getting paid by the primary companies. Now it didn’t affect to reinsurance as much and for that reason, I think there’s capacity is plentiful. And rates have not escalated based on what we were anticipating. Mark mentioned 5% to 10%, which is not – what we want. If you was 30%, you would have met our threshold. You would have seen us writing a lot more cat business than…
The only chapter we haven’t seen I think the last is Maria loss in Puerto Rico. That’s the only one I would say we throw back that you, Ian, and saying it’s still not too early, but we still have to see how that one develops. I think Harvey and Irma are pretty much pin down right now.
Let me just throw in once again. I know you asked an industry question, as it relates to Arch, especially with Dinos and Marc’s comments about the primary side. In the prepared remarks, they’ve comment that the reinsurance releases treaty and facultative. As facultative is the sister process, rest by portfolio similar to insurance. But attachment point saves you there. And the primary guys are ground up whereas the facultative unit is very skilled where to attach.
First, I guess, I was trying to ask something a little bit different, I guess more than sort of the pricing impact or there temper is the more about – it seems like damageability across the events, across all three events was a lot less than we all would have thought. And to be honest, Marc, it’s not just the reinsurance that’s a primary, it’s been Harper release, Allstate release, Travelers release in big dollars, right? So everyone seems like just damageability per claim there’s been a lot less in the miles expect, I’m wondering if there’s some – is that an anomaly? Or do we think there’s something meaningful on their that might make us reassess how we about cat risk?
Well, the only think I would tell you Ian is, I live in Florida, I mean Marco Island and the eye hit right over my house et cetera. My house had very little damage maybe $20,000 because is build with a new standard. So it’s a Cat 5 type of a home. And for that reason, the damage I had it was by new. But I can tell you when I drive around Marco Island, most of the roof damage has not been repaired yet. There are still tarps and believe me, there is price escalation. I have a neighbor that he lost 30 tiles in his roof and the cheapest price it got to repaired it was $4000 that’s over $100 a tile, I mean he says, I’m not getting water in the house, so I’m going to repair it, because I’m going to wait for prices to come down, but there is – there’s still – there might be a little creep that we haven’t seen yet.
Got it. Thank you guys.
Thank you, Ian.
Thank you. And I’m showing no further questions from our phone lines. I would now like to turn the conference back over to Mr. Dinos Iordanou for any closing remarks.
My only closing remarks thank you all it’s being a pleasure work with you over the years. And remember I’m available for golf games and I’m available for dinners. So I’ll see you around. Thank you very much.
Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may all disconnect, and have a wonderful day.