Constantine Iordanou - Chairman and CEO Marc Grandisson - President and COO Mark Lyons - EVP and CFO.
Geoffrey Dunn - Dowling & Partners Kai Pan - Morgan Stanley Elyse Greenspan - Wells Fargo Sarah DeWitt - J.P. Morgan Nicholas Mezick - KBW Josh Shanker - Deutsche Bank Securities Brian Meredith - UBS Ian Gutterman - Balyasny Jay Cohen - BankAmerica Merrill Lynch.
Good day, ladies and gentlemen, and welcome to the Arch Capital Group First Quarter 2017 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 assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.
For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with 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 like -- 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. Sirs, you may begin..
Thank you, Chanel. Good morning, everyone, and thank you for joining us today. This is our first quarter to include the combined results of our Arch MI and United Guaranty and we are very pleased with the early days of our integration process.
Marc will discuss the integration and more details in a few minutes, but let me say that we are happy with the progress achieved in the first quarter.
Although, it is still early, we are very pleased with the resilience of the United Guaranty Corporation's customers as they make the transition to our systems and platform maintaining the strong relationship they achieve with the United Guaranty over the years.
As we discussed last quarter, our guiding principles for the integration of these companies is to find and deploy the best parts of each organization on a going forward basis.
I am referring not only to our most important resource, the people who come to work for us every single day, but I'm also including the operating systems, pricing approach, and algorithms, along with all back office functions that they provide customer service.
Our number one task is to create a high quality experience for our customers as we continue to enhance Arch MI's position as a market leader that should earn good returns through this cycle and for many years to come.
One additional benefit or opportunity that comes to our results of the acquisition of United Guaranty is the opportunity for us to move our headquarters of our Global Services Group to North Carolina. A Global Services Group manages a lot of the back office work for our insurance, reinsurance, and mortgage businesses.
And consolidating the operations over time in one location increases our flexibility to fill jobs that are lost through attrition in other parts of the country to a lower cost environment.
Now, turning to first quarter results, our reported combined ratio on a core basis, Mark will define that in a moment, improved by 7.7 points from the first quarter of 2016, led by excellent results in the mortgage segment offset by the effects of higher attritional and catastrophe losses in our property and casualty segments.
Accident year results decline in both our insurance and reinsurance segments, reflecting soft market conditions.
Our mortgage segment improved its accident year combined ratio quarter-over-quarter to 50.4% from 65.8%, 15.4 points of improvement in the first quarter of 2016 year as the tailwinds of better credit quality and scale drove excellent profitability at Arch MI U.S.
Tellingly, our mortgage segment went from representing only seven point percent of net earned premiums on a core basis in the first quarter last year to 24.6% for the first quarter of this year, nearly identical to the earned premium for our reinsurance segment in the first quarter of 2017.
Loss reserve development remained favorable in each of our segments which is -- which in the aggregate; reduce our combined ratio by 8.5 points. There were no significant changes in the property-casualty operating environment from last quarter. Marc Grandisson will elaborate on what we see in each of these markets in a few minutes.
On an operating basis, we produce an annual return on equity of 10.3 % while on a net income basis, we earn a return on equity of 12.6% for the first quarter of 2017.
Net investment income per share for the first quarter was $0.69 per share, up $0.13 sequentially from the fourth quarter of 2016, primarily through the assets that came over with the acquisition of United Guaranty.
Our annualized pretax investment income yield was 2.13% for the first quarter of 2017 just slightly above the level observed in the fourth quarter of 2016.
As you know, we manage our investment portfolio on a total return basis which on a local currency basis was up 170 basis points for the quarter and 164 basis points, if we exclude the effects of foreign exchange.
Our book value per common share at March 31, 2017 was $57.69 per share, a 4.5% increase from the fourth quarter of 2016 and at 16.4% increase from the first quarter of last year. Mark Lyons will give more details on the components of their change in book value per share in a few minutes.
Before I turn the call over to Marc Grandisson, I would like to discuss our PML which decline modestly from January 1st as of April 1st 2017 our largest 250 year PML for a single event in the Northeast was down to 473 million or 6% of common shareholders' equity. This is the lowest we ever had in our history.
Our Gulf of Mexico PML was at 383 million and Florida Tri-County PML decreased to 386 million. I will now turn it over to Marc Grandisson to comment on our operating units and market conditions.
Marc, over to you?.
Thank you, Dinos and good morning to you all. Before I review market conditions across our segments, I am pleased as Dinos also alluded to earlier to report that the integration of UG and Arch MI is going very well with our focus on high customer service to maintain and improve our relationships.
While the strength of the combined entity is already apparent, we are working diligently to unify the U.S. MI operations and most notably, we have decided to base our U.S. mortgage insurance headquarters in North Carolina.
We believe that there will be opportunities and additional opportunities to realize efficiencies without jeopardizing our customer relationships and we will keep you informed as those efforts materialize for the next several quarters. At the end of our first quarter, as a combined global MI company, our expense ratio for this segment declined to 29%.
Over the next few years, we are targeting a mid-20s expense ratio in the segment as the business matures. Our new insurance written or NIW was 12.7 billion for the first quarter, an increase of 8% over the same quarter in 2016 on an average combined basis. We estimate that Arch U.S.
MI market shares remained in the mid-20s for the first quarter of 2017 consistent on a pro forma basis with a 26% market share indicated last quarter. The current premium yield was essentially unchanged with the last quarter's level, over 75% of our and NIW came through our risk based pricing platform.
Rising interest rates in the fourth quarter reduced the volume of refinance activity and accordingly led to an improved level of persistency which came in at 77%, purchase market accounted for 85% of our volume this quarter. The overall quality of the risk return is still very strong and stable.
With average FICO scores of 743 in our monthly singles mix at 82% and 18% respectively meeting our post acquisition objectives in the quarter. Arch also continued to build on its position in the U.S. GSE de-risking transaction with approximately 2.2 billion of risk in force at the end of the first quarter 2017.
Arch remained lead market for this type of risk transfer execution. Finally, our Australian mortgage insurance relationship continues to generate a good flow of business and contributed roughly $4 million of profit for the quarter.
As this business is all single payment upfront its contribution to profits should grow with time as premiums are earned over the life of the mortgages. Moving onto the P&C insurance world which represents 50% of our earned premium. As we have indicated on prior calls, market condition remains challenging.
Rate decreases have slowed somewhat, but are still broadly less than last trend. This is especially true for larger access accounts which tend to be more commoditized. The rate change differential between our segment is wide reaching for 410 bps in the U.S. for the first quarter.
A positive 140 bps rate change for the lower volatility line in a negative 270 bps for our cycle managed business. As a result of that market economy, all of our P&C segments continue to move toward -- towards smaller account and more specialized areas of the market and are walking away from accounts when returns are not acceptable.
In our primary U.S. P&C insurance operations, we had margin erosion of 70 basis points for all lines in the first quarter. To borrow an expression from Dinos, we have seen what's cooking in the kitchen before and we don't like the taste of that meal.
Turning to re-insurance which represents about 25 % of our earned premium this quarter, it's a similar story and that we continue to focus on the few opportunities that we have relative strength and more favorable returns while we are deemphasizing the more commodified segments as rate and loss trends continue to erode margin, affecting on the current trends in a broader reinsurance market.
I am reminded of the old adage that I heard often from Paul Ingrey volume is vanity, profit is sanity. Allocating capital judiciously is a cornerstone of our corporate mandate. As we sit here today, mortgages represent one-third of our allocated capital 25% of our net earned premium and 70% of our underwriting gain at a mid-to-high teens ROE.
We're happy to have the flexibility to allocate capital across our three platforms to the markets which are generating good returns and we believe that this flexibility allows Arch to generate alpha with more stable returns for its shareholders. And with that I'll hand this over to Mark to cover the detail financial results..
Thank you, Marc and good morning everyone. Given that this is the first full quarter after the UGC acquisition, I am going to provide more focus on the associated impact on the call today. First of all, I’ll highlight just a few items about this quarter.
But as a reminder the usual quarterly topics can be found in the earnings release and the associated financial supplement. Okay, now I'll make some summary comments for the first quarter on a core basis as Dinos referenced earlier.
The term core corresponds to Arch’s financial results excluding Watford Re, whereas the term consolidated includes Watford Re.
So claims recorded in the first quarter of 2017 catastrophic events that have reinsurance recoverable reinstatement premiums were 12.3 million or 1.2 loss ratio points compared to 0.5% in the first quarter of 2016 on the same basis, mostly emanating from within our reinsurance segment.
The activity was primarily driven by Australian cyclone Debbie and various other smaller events around the globe.
Again, we believe that this result continues to highlight our property cat underwriting discipline as actual reported losses on cat events continue to correlate with the exposure reductions that have been implemented over the last several years.
As for prior period, pure net loss reserve development, approximately $83 million of favorable development, was reported in the first quarter led by the reinsurance segment with approximately $57 million favorable, the insurance segment of about $2 million favorable and the mortgage segment providing nearly $24 million of favorable development.
Nearly all of the mortgage segment favorable development emanated from the U.S. portfolio and a meaningful portion or $8.2 million, stem from favorable development resulting from segregation recoveries on mostly second-lien and other portfolios that came over as part of the UGC acquisition and that are, in fact, runoff operations.
These segregation recoveries have been reflected in UGC's historical results over time and could continue this year and in future years, depending upon the associated management of the files.
The reinsurance segment, net favorable development, was across most underwriting years for short and medium tailed lines and predominantly from the 2003 to 2013 underwriting years for long-tailed lines.
The calendar quarter combined ratio on a core non [Indiscernible] basis was 78.8% and when adjusting for cats in prior period development, the core accident quarter combined ratio was 86.1% compared to 92.4% in the first quarter of 2016.
The reinsurance segment, accident quarter combined ratio, excluding cats of 97.6% compared to the first quarter of 2016 94.2%, while the insurance segment's accident quarter combined ratio excluding cats is 97.8% compared to 94.9% in the first quarter of 2016. Both results reflect higher loss specs due to current difficult market conditions.
The reported insurance group accident quarter excluding cat loss ratio increased approximately 150 basis points quarter-over-quarter. And after controlling for larger additional losses and mix changes, increased approximately 70 bps, which Marc Grandisson referred to earlier.
Competitive conditions in the PC markets, however, were more than offset by the continued improved profitability of the mortgage segment, amplified with their net earned premium of being a larger proportion of the total.
The mortgage segment's accident quarter combined ratio improved 14.4 points, as Dinos referenced, quarter-over-quarter and their net earned premium represented nearly 25% of the total core net earned premium compared to only 7.4% in the corresponding quarter of 2016.
Remember that in the mortgage segment, accident quarter has a different connotation than in PC and it is more similar in concept the claims made businesses in PC space since the notice of default defines the assignment to be appropriate in the quarter.
Similar to last quarter, there were some expense costs in the first quarter resulting from the UGC acquisition. You may recall that since the acquisition occurred at year end 2016, only the balance sheet was impacted in the fourth quarter, not the income statement. This quarter, we have a full income statement reflection of the combined portfolios.
As for the reference expenses, the company incurred $15.6 million of such pretax expenses related to the UGC transaction in the quarter as compared to $25.2 million incurred serially [ph] in the fourth quarter of 2016.
The sources of cost were different, however, as this quarter, the cost emanated from UGC acquisition-specific bonuses, severance and replacement costs and trailing UGC transaction legal costs.
More specifically, the UGC specific bonuses and transition compensation costs totaled $6.8 million pretax and severance and outplacement costs totaled to $8.2 million resulting from reduction in force actions taken on January 31st and March 31st, affecting approximately 205 employee positions and 60 contractors.
The actual salary compensation recognized in the first quarter associated with these employees involved in the risk-in-force efforts was $4.1 million.
Given that the January 31st reduction in force only had one month of salary expense reflected in the quarter and the March 31st reduction in force had a full quarter of salary expense reflected, a $5.7 million quarterly run rate savings of salary expense is anticipated.
We will comment in future quarters about any other actions taken and their financial impact, but these figures reflect only the impact of reductions in force that have already been implemented. Given the nature of these expenses, we have excluded them from operating income as they are not indicative for our true underlying performance.
I'd also like to remind everyone that we issued $12.8 million approximately, 4.8 million common equivalent shares to AIG as part of the UGC purchase price.
They had an insignificant impact last quarter on average common shares outstanding, given the 12/31 closing date, but had a material impact this quarter as the diluted weighted average common shares outstanding increased to approximately 139 million shares this quarter versus 125.4 billion in the fourth quarter of last year.
I bring this up because I still see analyst reports and conversations still utilizing pre-common share equivalent numbers. We're using that in all our statistics and we recommend you do too.
As a respect to the effective tax rate with our changing portfolio and geographic mix, I provided full year 2017 indications on the last call that the expected tax rate on pretax operating income would likely be in the low to mid-teens range.
In the first quarter of 2017, our tax rate on pretax operating income was 14.4% with 100 basis points additional reductions of 13.4% stemming from a change in GAAP accounting affecting stock compensation. I'd like to point out that we expanded our U.S.
primary mortgage insurance disclosure in the financial supplement to provide enhanced information by book year or underwriting year for the PC analyst. For loss reserves, insurance in forced, risk-in-force and delinquency rates as well as aggregate NIW splits between monthly and single premium policies, as well as providing our P.
Meyer efficiency ratios on a consolidated U.S. MI entity basis. I also want to highlight the difference between the U.S. primary mortgage division's gross versus net risk-in-force. At the end of the quarter, the gross risk-in-force is $60.6 billion, whereas the net risk-in-force was 28% lower at $43.6 billion.
As we have consistently implemented in all our segments, our ongoing mortgage strategy is to maximize profitability while simultaneously protecting the balance sheet.
The existing quarter shares that are in place, along with the existing and ongoing excess of loss and capital market protections provide this aggregate and tail risk balance sheet protection we see.
As for after-tax operating income EPS accretion realized in the first quarter of 2017 from the UGC acquisition, we examined our results with this and without the impact of the UGC acquisition, giving due consideration to associated debt finance interest cost, preferred stock dividend charges and intangible amortization.
The realized beneficial accretion from the transaction was nearly 25% on a reported basis. And just to remind everyone, we have previously provided long-term operating income per share run rate accretion indications over a multiyear period of being in the 35% area.
It is important to reemphasize that this long-term reportable accretion is expected to accelerate, as the 2017 and later book years become more impactful on a net basis in future quarters and as the benefits for reduction in force and other actions such as duplicative system eliminations overtime are also realized in future quarters.
On a GAAP basis, at March 31st, our total debt to total capital ratio was 20.6% and total debt plus preferred to total capital is 27.7%, which is down 100 basis points from year end 2016. This leverage reduction was due to our growth in common equity as our debt preferred levels were unchanged from year end.
Consolidated operating cash flows were down $111 million relative to the first quarter of 2016. The first quarter operating cash flow was generally lower on a seasonal basis and the timings of higher retrocession and reinsurance premiums from our reinsurance and mortgage groups, respectively, drove a majority of that change.
We did not purchase any shares during the first quarter of 2017 and don't anticipate repurchasing any during the balance of 2017. As a reminder, our remaining authorization is $446.5 million, which has been extended through year end 2019. Dinos mentioned our growth to book value per share of 4.5% from last quarter.
It's important to note that this stemmed from both strong underwriting and strong investment performance. And with these introductory comments, we're now pleased to take your questions..
Operator, we're ready for questions..
Thank you. [Operator Instructions] And our first question comes from Geoffrey Dunn of Dowling & Partners. Your line is now open..
Thank you. Good morning. I was hoping I could get a little bit more color on the incurred loss development in the MI side this quarter.
First, can you give a better idea in terms of the improving claim rates, are you seeing that from your late stage bucket or more of the mid and early stage delinquencies?.
I think on the U.S. side, you're going to see that never that kind of a report quarter view and we're not seeing that well we're not recognizing it as much in the more recent report quarters as it would be for once a little more aged.
But I think just part of what we might want to discuss given the size of it is that and I've mentioned that most is coming from the U.S. business, about 1 million came from the reinsurance side, so it's kind of insignificant.
But there was on subrogation, on a cash receipt basis, on the establishment that normalized our accounting policies between the two consolidated entities now.
So subrogation reserves put up, these are normal course, but they were scattered between first lien and secondly lien and other portfolios that were there and they've been there historically that are now. The fact that they're most of it is in one-off doesn't mean that they're going to dissipate; they'll fall off a lot more slowly over time.
So hopefully that answers your question..
So your comment about the favorable rates is more on the key lock exposure, not necessarily the primary book?.
No. Well the primary book, yes you're still seeing some improvement, but they're not coming from the 2016 report quarter. I believe it's 2015 and a little bit backwards..
Okay. So the 12 plus, right.
And then on the current period provision, can you give us an idea the incidence assumption for the new notices and how that compares to maybe the pro forma result a year ago?.
Actually, I don't have that in front of me, but -- so you're talking about the claim rate?.
Yes, the initial claim rate assumption on the new notices?.
Jeff, I think that's going to have to be something we channel back through [Indiscernible]. Sorry I simply don't have that in front of me..
Okay, great. Thank you..
Thank you. And our next question comes from the line of Kai Pan of Morgan Stanley. Your line is now open..
Thank you and good morning.
So the MI expense saving opportunities it looks like if you look at legacy Arch as well UGC the other operating expenses add up to about $60 million and this quarter is down to 40, is that run really going forward or there's say other opportunities or the other way to ask it is that you're targeting at 25% expense ratio overtime now it’s 29%, you think that improvements more coming from the absolute dollar amount of reduction were up more from the topline premium growth?.
Let me give it a shot and I’ll give it to Mark to get into the details.
But we don't want -- we didn't make projections even though internally we have certain things in mind because I want our teams as they integrate to play in a passion that improves our long-term opportunities to be as efficient and as effective without affecting customer service with our competitors.
Having said that, okay, so a lot of it is going to come from redundancy in personnel that it will get eliminated overtime. Mark gave you a number in the first quarter we have eliminated approximately 270 positions, on April 1st there was an additional 97.
We’re just going to be as part of our report card, we're going to share with you in the second quarter not knowing what else is going to happen in there in the second quarter because I'm not putting undue pressure on how people to hit certain numbers.
Our instructions Mark and I is do the right thing with the idea that if we don't need certain individuals see if we can re-assignment into other jobs, low guest as we lose in attrition in other parts of the organization.
And that's one of the reasons we even move of our Global Services headquarters down there because it allows us to manage the workforce in a much more efficient bases and we're not just focusing on United Guaranty, we're looking at every operation and we do that as a matter of course independent if we made an acquisition or not.
That's a prudent way of managing. In addition to that, you've got to get into systems and back rooms and not just headcounts, but where does that headcount reside and is of course differential.
For example, the New York job is much more expensive than a North Carolina job and a job in the Philippines is even less expensive than a job in North Carolina and we look at that as a global organization. So there will be additional savings.
It's not that we don't know how to push the pencil and make calculations, but we don't like to promise things to influence good judgment. We rather report after we take the actions that trying to hit a particular number..
And I think what I would add in terms of the questions, the top line is not going to change significantly just by virtue of being MI portfolio. It's very sticky, it’s very straightforward, a lot of monthly coming in -- depending on our market share. But for the remainder of the year, for the foreseeable future, we don't see much change.
So it's really to answer your question more directly which Dinos did it that’s going to be really as a result of absolute dollar reduction as opposed to premium related ratio..
We are -- Kai as Mark and we wouldn't be felt as much in 2017 which is probably the model question you are asking.
For a longer term basis, as the impact of the AIG quota share, 50% quota share on 2014, 2015, 2016 underwriting years starts to lessen and we're writing 2017, 2018 towards 100% without the quota share coming in that will start to flip and you'll see an increasing growth on a net basis for your denominator..
Without change in the personnel.
Correct..
And the quarter has at 30% seat, so at some point in time that it will revert to a benefit..
Okay. That's very clear..
If we -- and that 25 is not -- we think we are going to be overtime below that number, but at some point in time, we say 25 is something that we're trying to achieve 25% expense ratio, but you can even be better than that overtime. All I want is efficient operations with good customer service.
And at the end of the day, we want to not have an un-level playing field with our competition so we monitor that. How do they do things and they are better than us? What things we need to do to improve? And I don't want to have a structural disadvantage.
And traditionally, over the last 15 years we didn't allow that in our operations and we won't allow within the MI space either..
Okay. And is there a restatement in terms of the legacy like Arch’s MI like expenses..
I guess there's two things I would say there's a reclass associated with the intangible amortization where in the mortgage space, others we had more above the line. Now we have below the line. So because with our goal to be very, very transparent on the UGC tangible amortization. It only makes sense to make that a corporate wide approach.
So yes, would have been a reclass and that's why some of the prior year may look a tiny bit different than it was when we look at the numbers last year, so it's a good catch..
Okay.
Lastly, just remind us what's the lockup period for the AIG preferred shares and like do you have a capsule flexibility or first write to repurchase that shares?.
It is identical to when the SBA was signed which is a 36 months, two-third cumulatively at 12 months and 100% cumulatively at 18 months..
And do you guys have the capital flexibility to participate?.
Yes, we do..
All right. Thank you so much..
Thank you. And our next question comes from the line of Elyse Greenspan of Wells Fargo. Your line is now open..
Hi. Good morning. When you guys announced this deal with UGC in August, you guys had said about 50% of earnings would come from P&C and mortgage and all of the underwriting income which shifts to about 70% in mortgage. Would you say that the mortgage market has gotten better or the P&C market has gotten worse than the view that you had.
I guess when you announced this deal and laid out those metrics to us in August..
Well, you look at it in a very short time. Let me -- in the short time, your question is -- and your conclusion is correct. I think the P&C, both insurance and reinsurance, has deteriorated because we're not getting rate increases to keep up with trends.
So, in essence, it's eroding, so that means you're going to write a little less than what you wanted to and the profitability may not be a little less than what you want to. Having said that, I think every indication on the MI space is that things are better.
Delinquencies, the better, and in essence, the credit box has not deteriorated, is as good as it was at that time.
So -- but you got to take our comments from the long-term because we -- in everything that we do, we have a long-term view and we make judgments as to where we're going to play, how much capital and resources we're going to allocate on the long-term view.
And right now, I can tell you, greenlight is on MI, amber, not red, but amber lights on the P&C, both insurance and reinsurance. Having said that, I can't predict the future. I don't know if the P&C cycle changes and at what time it's going to change.
But I can tell you, don't forget, our rules to the P&C and it doesn't mean we're not going to do a lot on the P&C space, given the right market opportunity. We're not reducing the group capability from an underwriting perspective.
As a matter of fact, I think it's fair to say we have a bit of overcapacity in underwriting talent, which we're going to maintain. The course associated with that is insignificant when you weigh it versus the opportunity when the markets change. Is it going to turn three years from today, three years, I don't know.
But I can tell you, when it does, we're going to know it, we're going to take advantage of it and we will have the people, we're not going to be chasing people to take advantage of it.
Anything you want to add, guys?.
Just one quick thing. I think it's easy to get lost in the sauce. It's a good observation. That's the underwriting gain or loss, but each of those businesses have a little different duration. So, reinsurance group may have more property and cat, so the insurance group may have longer tailed lines, every portion to bring in more assets and so forth.
So you look at on the writings, you brought interest income and, it'll be skewed to a bit, differently away from mortgage..
Okay, great.
And then Dinos, following up on your comments, you mentioned loss trends on the property casualty side, do you think if we start to see a higher level inflation, which it seems like you and some of your peers are pointing to, do you think the industry will take price to combat higher inflationary levels?.
I don't -- no, you're thinking very logically and that's a mistake in our business. Although more interested very markets is fear and greed. And right now, I don't see greed out there, I see some concern, but I don't see fear. Yes, there is some concern.
As a matter of fact, I think that [Indiscernible] in the coal mine is being commercial auto liability, who has a short tail, and is starting to percolate and bubble up in a lot of places. You see it on the riders of commercial auto, you see it in penetrations on the umbrellas which is part of the mix when you write excess liability umbrella.
You're covering that portion of the risk, too. And you're seeing a reaction in the reinsurance market. It's not easy to find auto carve outs anymore or the pricing is going up.
So, it's not an early indication that maybe GL might be a problem in the next year or two, and then Worker's Comp maybe later on and Mike that create a verb the people they say, we've got to adjust pricing in all three lines going forward. I don't know.
We can't predict the future, but I can tell you, there is stress in the system because it requires more rate increases than we're getting. And we're not keeping up with the trend and it sounds to me like 1998, 1999 all over again that the frogs in the happy water, but the temperature is going up..
I think in addition I would just add to what Dinos has said, the other dimension of fear and greed is that underwriter of companies underwrite also with some kind with the assumption of what interest rates are going to be in the future.
So, the inflation goes up and interest rate goes up accordingly, if not more, you might generate all kinds of different behaviors. I would argue with that even in this day and age, in the last two, three quarters, there is probably an expectation of rate increases in the future that might explain why some of the pricing is still soft as we speak.
So, there's a lot of stuff, a lot of things moving the marketplace. So, there's more than one number that drives everything..
Okay, great.
Do you guys have a forecast for mortgage industry NIW for 2017 and what share that would be for Arch?.
We have expectations and we do follow the MDA and the Freddie and Fannie and we look at what they do, what they produce. So we would stop the same data that you're looking at. In terms of NIW, we don't have -- we have, of course, projections. And we're accomplishing that we're not at liberty to share that.
And frankly, we're going to be reacting to whatever market situation present itself in the next year or so. So, we don't spend much time, if you will, projecting what NIW is going to be in the market. We have a good place and good positioning with our clients and we try to do the best.
And as we said before, our market share over time, we expect might decrease in the low to mid-20s. So, that's also could be something that happens by attrition. It's not moving..
It's a pleasant surprise for us. I don't know if was basically, we didn't seem much overlap between Arch MI and United Guaranty. There was only one major customer that we both of us will significant participants and they reduced our combined share just slightly in the first quarter.
There was no other change any other major customer and that's why I talk about the resilience of the customer base of United Guaranty. And basically, we are trying to do the best job possible to not only to maintain the service at a very, very high quality, but also improve on it and that's what I've been emphasizing to our staff.
That's why I said let's not focus on integration of cost savings upfront at the expense of customers. We're going to focus on excellent customer service. And over time, we're going to get very efficient in how we provide that. And I think you can do both if you're a well-managed company..
Thank you..
Okay. Thanks so much. And congrats on a great start to the year..
Thank you. And our next question comes from the line of Sarah DeWitt of J.P. Morgan. Your line is now open..
Hi, good morning. Just first of a follow-up on the share buyback, I think you said you wouldn't buy back any stock in 2017.
So, just to clarify, if AIG did sell, you would not participate?.
Well, there's optionality in there. It's a decision tree, basically. So -- but it's as I stated, but we're not going to be buying overtly. Other than those possibilities, we're not going out and buy back shares..
Yes, our team there Sarah is, we always want have flexibility of the balance sheet. Right now, our debt and hybrid is at about 27 point something percent, of which about 4.5% or so is short-term revolving facility. That doesn't give us a lot of capital credit with the rating agency.
So, at some point in time, my first action with access -- with excess capital, maybe I can reduce that down and then we'll revisit this year and purchase in 2018 and beyond. Don't forget, I don't know when AIG is going to decide to sell, and so I can't answer that question.
If the selling and 2017 will probably would likely we will not participate, but if it's all 2018, it's an open question..
Okay, great. Thank you. And then separately, I wanted to get your thoughts on some of the practices of the insurance brokers. I'm sure it was critical some of their practices, particularly in London and so there could be regulatory our customer backlash and now they're being investigated by the FCA.
So, just trying to get your thoughts on the practices and GT&E [ph] regulatory risk with your current distribution channel?.
Listen. At the end of the day, distribution cost is part of the business, been always part of the business. Some people view it as a transactional. I think it's more than that. Some of it is transactional, some of it is advised and counseled, et cetera and it's all very into some number.
The ultimate arbiter of if that's fair or unfair or sustainable is the customers themselves. They know that both our revenue and the broker's revenue comes from only one source, it's out of premium they pay. So, if they don't like what's going on, they have ways to change that. But at the end, that's a customer decision.
Now you ask the regulatory question. We believe, at the end of the day, that the insurance and reinsurance business is highly competitive and we're strong believers in the free market.
So, at the end of the day, if the customer is satisfied and nobody is doing anything that is illegal with the regulator have a say in it, let the market decide if it's fair compensation or unfair compensation and the buyer of the product is the person who counts the most..
Okay, great. Thank you..
Thank you. And our next question comes from the line of Nicholas Mezick of KBW. Your line is now open..
Hi, good morning guys..
Good morning..
Last year, you discussed the way to think about mortgage, earnings volatility as the micro or underwriting decision and the macro changes. Now you assigned two-thirds of the volatility of the micro and one-third on the macro.
Given that different composition of the book today with UGC acquisition, how would you expect a change in either of those sensitivity?.
Actually, what I said last year was 70/30, not 66 and two-thirds and 33 and one-thirds. And I'm sticking to that 70/30 theory because we did analyze a lot of that data through the financial crises as to what was causing defaults and we compare it with other environments.
For example, what happened in Canada where all day no verification loans, et cetera, they were not allowed and there was a minimum of 5% down payment requirement and illegal historically and you see the performance of the Canadian book of business, it was much different even with the same economic conditions not only affecting the U.S., but affecting Canada and what the outcome of that business.
So, the 70/30 hasn't changed and what I'm saying -- what we're seeing, I think, the ability of MI companies to go back to the very lose underwriting standards that were common during the financial crisis in 2007 -- 2006, 2007, 2008. In the future, that would be much more difficult.
First of all, management, they saw companies [Indiscernible], so they're more resilient on the risk management side of the business. And more importantly, I think the technology is much better today in analyzing individual mortgages and attributes that affect that. And also, more importantly, the GSEs, both Fannie and Freddie, with the P.
Meyer approach and as regulators of the MI companies, they're a lot more resilient in their approach on maintaining stability on the balance sheets of the companies that they provide them the counterparty risk..
But right now, exactly what's going on. There's no change from last year, because clearly what drives the losses than we've seen historically is the products that were offered in the marketplace.
And we've seen no change in the products offering and to echo what Dinos has said about the GSEs being really wary or at least very attentive to what's happening in the marketplace, had an increase in the sort of discounted LPMI business over last years, recognizing that that might represent a bit more risk to the system.
So there's really a heightened level and still high level of scrutiny and attention paid to the product that our deliberate in the business. So no change from last year. .
Okay. Thank you both and Dinos apologies for escorting [ph] you..
Well, no, I just like -- it's my test as I'm getting old -- I'm 67 that I'm still saying..
Just one follow-up, last quarter, you referenced your door being broken by people wanting to get a piece of your business through reinsurance.
Just want to check on the status of the door and in turns demands for the reinsurance of your portfolio, in particular the MI book?.
It hasn't changed, but like I said, we're here to feed our shareholders first. And then if we have extra, we can reach out level to others. This is a good business. Within our risk management limitations, we will continue to have our shareholders in mind first and then our reinsurance partners and other segments..
Okay. Thanks. And enjoy lunch..
Thank you..
Thank you. And our next question comes from the line of Josh Shanker of Deutsche Bank. Your line is now open..
Yes, good morning everybody or almost end of the morning..
Hi Josh..
Following up on the last question, I wonder why it does or does that make sense to think about MI the same way we think about cat.
Is there a PML that you have and maybe you're not going to tell us what it is, but did you calculate something like that?.
Yes, we do. We have -- you've got to lean on the concept of what is [Indiscernible] event, right? A severe recession, housing prices collapsing, et cetera. And we build these models that we model and then we calculate what based on the book that we have what the macroeconomic effect of those events.
They don't happen like the hurricane that happens in one day and the next day, it's going to be more gradual. But at the end of the day, if you're writing the business, you got to be cognizant of that.
But we model that and we have a tolerance and the tolerance is no different that we don't want to comment on these, what I will call catastrophic events more than a probability of us losing 25% of our common equity capital. So that limitation is still there. It's a book limitation.
I mean, myself and the rest of the management team in our discussions with our Board, they say we want to know what is the maximum loss that you're willing to have on a stress scenario. And we want to understand what that stress scenario is all about. And that's how we build our model around it.
Marc, you can elaborate?.
The only thing I want to add, Josh, is not exactly as a cat book of business because you're going to have future income in so you have to factor in an S&P type of PML, so this is what Dinos has been alluded to. We have to factor that in because it's part and parcel of what we're assuming as part of the policies.
The policies, those that done default continue paying premium for the future and we have credit for that as well. So, just want to make sure it's not one event, one of them and like Dinos said, it happens overnight. It's an over two or three-year period development and we take an S&P type of approach. .
And just, and I think this one other thing. It's a good question, just given the relative size of its organization. But thinking wise, you got to learn from the past. I mean anything that erupts that can cut across underwriting years.
We learned from asbestos and GL, we learned from environmental and the GL, we learn from -- anything that could signal it, we can break it down his lines have a lease component of cats. I think more so in the mortgage space, but we think about that in every line of business..
So, let's just take a scenario. I look at the business right now not only well underwritten but also well priced. And even if pricing works, the clients still might be well underwritten on the mortgage-by-mortgage level, therefore, avoiding the risk of "catastrophe".
To what extent--?.
You're not avoiding the risk totally, the risk of catastrophe. Because even well underwritten business, if you have a higher unemployment, you're going to have hardships, your default rate is going to go up. If you could have house prices collapse, that means the claims that you're going to have, they're going to cost you more.
So, at the end of the day, those you can avoid. That's a part -- and I put that a round number of 30% on the problem and the past crisis was macroeconomic events. With [Indiscernible], for example, the Canadian book of business but it didn't cost companies their profitability suffer, but there were still profitable and didn't go out of business.
What caused collapses in the U.S.; it was all of these crazy stuffs like how do you underwrite an old verification law. You don't know the information you getting is correct. How do you factor in these old days? Or 110 LPV stuff and there was a lot of craziness that it went to the mortgage space at that time..
So, when the cat market gets irrational, Arch can say, look, someone else can underwrite this business, there's 100 other companies who know how to write property cat let them chase the market down. When you're only--.
Exactly right..
When you're only [Indiscernible] participants, what does that mean when the markets gets irrational?.
When the market gets irrational, that means you got to maintain your discipline. Our hallmark as a company is that we have been disciplined underwriters. And as long as I breathe, this team which I have 1000% confidence is, they're going to be disciplined underwriters. It's our DNA. For better or worse, it's our DNA.
The Arch DNA is disciplined underwriting. Be patient, disciplined and at the end of it. And thank God, we got a Board who understand that. I never, never had a discussion with my Board that says, your volume is suffering or -- they never talk about volume. They do talk about profit and margin and are you taking undue risk. That we talk all the time..
Josh, it's unfair to really compare to cat, because a cat and generally, for us to achieve to be hurricane in September that hits Florida. But it's underwriting mortgage and we have indeed in our company have the proper early warning systems in terms of risk quality, we're going to actually take actions way ahead of things percolating up.
If the decision as to where we put the redline or the yellow line as to when we start deemphasizing it, we do have access the information.
And frankly, and Dinos said this in prior calls, if the people that we're in business in 2006, 2007, 2008 had heeded those calls and those points and those clear indication signals the marketplace, it wouldn't have put themselves in the position.
So, it's not like you wake up one day and the risk quality was as good as it gets and overnight everything goes down by 20% and the unemployment goes from 5% to 25%. I mean you have a lot of products and you have time to react..
PMI was recognizing segments of their business into what we will call the red line, all the way back in 2004. And they did not take action. As a matter of fact, they increase their participation in everything that they are monitoring systems were showing red.
Meaning all -- loans became 28% of their book of business because a lot of the customers, especially, countrywide, et cetera, it was threatening them. You don't right, you're not indicated that good. Well, I said this before, you give me three glasses of Kool-Aid and one has cyanide in it, I'm not drinking it.
So, even though the other two they are very refreshing and I'm very thirsty, I'm not drinking it. And basically, that's what the industry did. They were given three glasses, one had cyanide in it, and they down all three of them..
I appreciate the [Indiscernible]..
I don't want to be graphic, but I tell you, when you're running a company and you got your shareholders capital and you've got 3,500 employees in your hands, you got to feel like I feel. You got to be the responsible, not only for the capital, but also for the welfare of the employees..
And Josh, that was three Kool-Aids, not three Bourbon..
The Bourbon will neutralize it, I'm sure..
But one other thing, if I could, Josh, Dinos and Marc have talked about this before, but the history was that the MIs took the risk on the balance sheet, 100% in, 100% retained. That's clearly not part of our strategy, that's the strength of the PC side.
We can't think any other way than simultaneously manage balance sheet and maybe Dinos take it to you, but the benefit of going to capital markets and reinsurance as a leading indicator unto itself..
You always have to have a loop to the market. So, by purchasing reinsurance and capital markets products, you always have a compass as to how other people think about the product, are you pricing that will enough. If you can shed risk in an effective way that tells you you're the patsy.
So, you better start shutting the doors because you're not doing the right thing..
Thank you for all the answers. I'm unfair to Ian. So, [Indiscernible]..
Thank you. And our next question comes from the line of Brian Meredith of UBS. Your line is now open..
Yes, thanks. A couple of quick ones here.
First, Mark, can you tell us what was the impact of the AIG quota share on your premium this quarter? And just kind of figure out kind of going forward how that's kind of way out?.
Okay, hang on..
Well you want to know the session to the AIG?.
Yes, the session today on quota share.
Anything unusual this quarter that would have elevated it versus what it would look like going forward?.
No..
Okay..
I'm trying to give you a ratio, if I think if that's what you're after. So, bear with me..
You don't want to give him the amount?.
Could you give me the dollar?.
All right, that's okay..
He doesn't want to give you the amount; he has it in front of him..
About 20%. Let me go up here. Yes, it's about 70% of the ceded premium. I was going to give it to you of the net, but that's easier..
So, 70% is ceded premium with AIG. Okay. I'm trying to figure that looks going forward. So, that's kind of -- generally think about kind of gradually trending downwards over the next--.
No, I would think that would, over the next three to five quarters, can be trending up and then trail down because of the nature of the monthly and--.
Don't forget, the quota shares covers 2015 -- 2014, 2015 and 2016. So, the United Guaranty book goes all the way to 2007, 2008. We have -- we still have mortgages all the way back from the 2007, 2008. They're still paying premium. So, it's not as easy to calculate it, but a lot of the old stuff becoming more of the newest stuff.
There is not going to be a lot of -- depends on the persistency of those years, the 2014, 2015 and 2016. We think that calculation is going to probably increase it a little bit and then it will come down later..
Got you. Okay, helpful.
And then secondly, just curious, when you talked about the expense savings, could we expect some in some of the other areas, reinsurance, insurance, also just given the relocation of the services of business operation?.
Well, the relocation, it's not that -- we're not to just going to take a lot of people and relocate. We have attrition, right? Attrition usually is around 10% in our operations worldwide. So, basically, we lose roughly about 300 positions every year.
We decided that North Carolina is a better place for some of these back rooms that premium audit, some clearance system, some booking things, et cetera. So, gradually, we'll be moving -- we lose a job here, instead of replacing it in, I don't know, high cost environment, we go into a lower cost environment. And that process is being with us all along.
I mean, we have operations and Nebraska. We have operations overseas in other parts of the world. So that's ongoing. The reason I mentioned it is because North Carolina, based on our statistics, is about -- has about 30% cost advantage over other -- from New York, New Jersey, California, let's say.
So, over time -- and we're not trying to displace people, but as we lose people, we'll be moving back. So gradually, you're going to see that benefit coming through. But we do that as -- on our day-to-day operations, as a matter of course, we do that all the time.
I mean that's what our managers are getting paid to do, make sure that we're cost effective..
Got you. And then the last question. I wonder if you can give us your perspective right now on the political landscape with respect to mortgage insurance business and particularly related to the FHA.
And if you get some changes going on there, what do you think the potential is for market share kind of shift back to the private MI and what do you think UGC or Arch could get?.
Well, it's very hard to predict, very hard to predict. Clearly, the FHA has more market share that they need. So, I mean, you're not going to hear that only for me, for everyone, MI CEO say that. It should be in the private sector not on the taxpayer. Having said that, I don't know what they're going to do.
The share of VA, FHA in combination is probably a little north of 55%. So, that's way too much, in my view, to be on the public back..
I think what I would add to this is there a lot of things that we also have available to us in terms of providing MI insurance, only the primary, but there's clearly still an ongoing focus on deleveraging the GSEs and the MI to the third-party to private capital. That is not stopping.
It's actually most likely going to be accelerating over the next year or two. The one thing that we're picking about collectively is we're agnostic as to, in general, how we would allocate the capital in terms of primary MI or CRTs to the extent that it shifts to that direction.
But we're essentially more than willing to provide the risk on a private basis, either which way the FHA decided to go. But right now, we don't see any cost to be concerned in terms of the existence of the MI industry as it is. And we believe that the CRTs that we've been participating on are only going to grow in size.
And it's not going to be most likely instead of the MI primary is going to be in addition to the MI market..
Got you. Great. Thank you..
Thank you. And our next question comes from the line of Ian Gutterman of Balyasny. Your line is now open..
So Dinos, my first question is when you're planning these--.
What's the lunch let me know. It's at the request of Marc Grandisson, he will be grilled [Indiscernible] cheese from Cyprus with tomato, cucumber on pita bread and that's the lunch, the sandwich for today and he's salivating already. So, get to your question so he can go and eat..
Well, my first question was when you made the decision to move all these people in North Carolina, did you make sure there was a great restaurant in the neighborhood for them?.
I have a few cousins who might be interested in going down to open a Greek diner down there, but I'll leave it up to them..
Okay. I actually had a couple questions on the P&C business, but just on MI quickly first to maybe ask a little bit of a take up on Josh's question and your response about the crazy conditions in the U.S. 10 years ago.
Surely, it sounds given to the point and I know you've obviously bought some reinsurance to help manager exposure there, but how concerned are you about the Australian market right now and just the HPA does seems crazy and you hear of those anecdotes about things going on to get loans to get house and so forth..
Well, let me -- I'm not -- you're always concerned of everything you do. So -- but I'm not fearful of the Australian business for two reasons. First and foremost, there seems to be a little frothy housing prices in two major cities, right? Having said that, the frothiness is on loans that they're larger than what we ensure.
These are in the million -- 0.75 million and up market. So, when you look at it from an exposure point of view, the things that we sure, the more on the lower size of homes. And the Australian market is also a full recourse market, which is different than the U.S.
So, in essence, the individual is responsible for repaying the loan beyond the ability of the residual value of the house to make up for the loan over time. So, it's a different characteristic to the market.
In addition to that, I think, the -- [Indiscernible] the regulator, who regulates both insurance and also the banks, they have some strict rules about what loans get approved and the stress test they put them to be able to qualify for the loan.
It’s a 200 basis points stress test on every loan on interest rates movement because a lot of the loans in Australia, they're adjustable, so they're not -- they don't have these 15 and [Indiscernible] fixed rate mortgages.
So Marc, you want to elaborate further on it?.
I would agree with that protecting the portfolio as a result as well, are looking at the same process we have an economist who spend a lot of time reviewing and he confirms exactly what Dinos said, which is a couple of areas frothiness, but it's confined to the larger dwellings or larger condominiums and also a lot of investors coming from outside, which is--.
They pay cash, they don't buy insurance..
Exactly. And even if they -- what we tend to focus on the lower risk and we don't do the investors loan as much. So, we curtailed and shifted the portfolio towards the more single dwelling, owner-occupied house down under.
And to your point, we feel, despite all this went on about a quarter share and we have partners there to help us and in case we were a bit too optimistic, we don't think we are but just to be prudent in terms of rightsizing the old portfolio. So, we're cautiously optimistic, comfortable..
Got it. That makes a lot of sense. On the P&C business, Marc, the insurance segment, the reserve releases were pretty de minimis this quarter.
Was that we sort of gross releases or is it normal matter of releases and there were some adverse impacts offsetting it?.
I think the latter. I think what we are seeing, as I said in my comments and as Dinos and Mark both alluded to, the market we're seeing pickup and severity in the markets across lines of business and certainly, it started in commercial auto and story more than once..
And the auto component in umbrellas as well..
So, there's a lot more coming. We're of the mind that it's going to get a bit more, a bit worse before it gets better again. So, we tend to take, as usual, a prudent approach to reserving. So, we might take a bit more long to recognize what looks like good news.
Because frankly, a lot of people around our clients, we've seen that some of them have -- we believe, recognize too early good news in a position to having we direct or redirect that and we would like them to avoid that all cost.
So, there's a little bit of some activity and severity, selectivity and causes coming through but certainly realistically, corporately, more prudent view on the ultimate reserve development..
And Ian that's a direct benefit from the multiplatform we have and the holding company that you can see. So, you can see others ceding companies fear the insurance that way..
Understand. Then sort of similar to that is the higher accident years in both insurance and reinsurance.
Other than, I guess, probably the elevated losses, is this sort of a reasonable run rate given where rate mix is, also some mix changes pretty dramatically?.
As of the best guess for the current accident year. I mean -- listen, the first year is a self-grading exam and we try to do the best we can. And I can tell you, things are not they good as they were a year ago and I think the reason you got to recognize them on the current accident year..
Ian, again, that what I just talked about the reserve development and what transpired over the last quarter informs us in going for as to what we think the ultimate underlying fundamentals of the business. And as you heard, we're losing margin and this thing erode as we speak.
So, it moves us to do the right thing, which is to be, again, that much more prudent on the current accident year. That's what you see right now..
And then just finally on that, Dinos, I think you mentioned earlier, some may be running with parts of the late 1990s and the one thing I guess, to this looking at the reserves across the industry, I'm assuming you guys look at sort of this trends.
Looks like there's the initial IBNR has been coming down every year for the past three, four, five years and it's not getting to a pretty low point. Do you agree with that trend? Does that concern you that even the low stress of a benign the last five years; it seems to be now reflected an in IBNR? I'm asking from an industry--.
Give me another month or two. I'm going to finish our study. I do this macro study with Don Watson, about the industry reserve levels and all that; I look at cash flows -- underwriting cash flows, et cetera. Give me a little time and then we'll share that study with you.
Maybe that might be might five minute in Investor Day because the guys want me to only have five minutes with you guys. They want to put me with the chef, so I'll be growing, but at the end of the day, I think it's an interesting question. Yes, it feels to me, from other indications. Let me give you an example.
I won't mention names because it's embarrassing. But we lost an account, right? That it was a high deductible account that, in essence, it was about $10 million in premium and we lost it to a competitor for $3 million. To me, it's the definition of insanity.
I mean, either a totally naive, you don't know what you're doing or you can beat me by going to $9 million. You don't have to go from $10 million to $3 million to get the account.
So, that means [Indiscernible] don't understand what they're doing and the brokers are taking advantage of them because I can tell you, they knew that the expiring premium was probably $10 million..
And the other thing Ian on that that will be in the renewal pricing monitor next year, in the basis for 33% increase..
Exactly. Funny how that works out. Thank you guys. Appreciate it..
Thank you..
Thank you. And our next question comes from the line of Jay Cohen of Bank of America Merrill Lynch. Your line is now open..
Actually my questions were answered. I tried to hit the right button to remove myself, but I failed. So, thanks for the information. Great call, guys..
Thank you, Jay. We'll continue to try to perform for the shareholder..
Thank you. And now I'd now like to turn the conference over to Mr. Dinos Iordanou..
Well, thank you all for your attention and looking forward to talking with you next quarter. Have a wonderful afternoon..
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now all disconnect..