Arch Capital Group Ltd (ACGL) 2006 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to the Arch Capital Group 2006 third quarter earnings conference call. My name is [Lateshia] and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the Company with the SEC from time to time.

Additionally, certain statements contained in the call that are not based on historical fact 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 could be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures on 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 web site.

At this time, I will now turn the presentation over to your host for today's call, Mr. Dinos Iordanou and Mr. John Vollaro. Please proceed, sir.

Thank you, Lateshia. Good morning everyone. Welcome to our third quarter call. As you can see from the numbers, we had an excellent quarter. As a matter of fact, it's the best quarter in the Company's history. Kind of ironic that a quarter a year ago, we had the worse quarter in our history. Clearly, the light CAT activity for the year so far was a very positive factor, but non-CAT business also contributed significantly to our outstanding results.

Our operating earnings increased to $200 million and our annualized return on equity for the quarter was 28%. That brings year-to-date annualized return on equity to 25%. These are spectacular numbers in our view. Our book value per share grew to $40.82 per share. Cash flow from operations continues to be strong at $427 million for the quarter and $1.25 billion for the year.

Our investment income passed the $100 million mark, a new milestone for the Company. Our gross return premium grew by 5% to over $1.1 billion and our net return declined by 5% to $747 million, in part due to increased sessions to our reinsurers, including Flatiron.

John will get into more details in a few minutes on our financials, so now let me make a few comments about the common market conditions in general and how our two units -- insurance and reinsurance -- are responding.

Clearly, the most attractive area from a pricing point of view is CAT-related business, starting with U.S. win exposure leading the way. Despite a very light storm activity year, we do not see any change in the fundamentals driving the excellent market conditions we're seeing. We continue to be bullish on this sector, but we intend to stay within the risk tolerance we have established based on our risk management principles.

The rest of the market is generally experiencing price reductions, ranging from low-single digits to up to 10%, and the size of rate changes varies by class of business. However, two constants are holding true. For most classes of business, the larger the premium, the greater the competitive forces, and to our pleasant surprise, terms and conditions are remaining stable. Our reinsurance group produced great returns aided by the benign CAT season. From an underwriting perspective, we made two shifts in how we approach the market based on what we saw in the July renewals.

First, in the Casualty area, we cut back our participation on reinsurance contracts where the underlying book of business is Fortune 1000 type of accounts, and shifted our emphasis to books of business comprised of small- to medium-size accounts.

Second, on Property and Property CAT-related businesses, we shifted more of our aggregate CAT capacity to an excess of loss basis where in the current environment, we believe the returns are more attractive. This shift, even though it causes a reduction in written premium, actually enhances profitability and returns per aggregate unit of CAT exposure committed.

Our Insurance group had a very strong third quarter as well as they continue to need to produce strong underwriting results and very good returns. We still find attractive growth opportunities in many sectors while pricing is still strong and our product offerings, distribution relationships and their territorial reach is an advantage. Gross written premium for the Insurance group grew by 22%, while their net written rose by 25%.

The largest contributed to this growth was our Property, Marine and Aviation unit, with an 86% gross written premium growth and 62% growth in net volume on an adjusted basis. The rate increases achieved in each of the property sectors -- E&S Property, Global Property, Offshore Energy and Technical Risks -- were 80%, 44%, 59% and 56%, respectively.

It is worth noting that the Insurance group achieved this growth with less CAT exposure this year than we had a year ago. The Casualty unit reduced their writings by 17% on a gross basis and 27% on a net basis. Rates for the unit were down 4% on primary business and 3% on excess business. Most of the reduction in volume came from the primary E&S contractor's book where we are seeing more competition, primarily from standard markets who are reentering that market.

Our Professional Liability business grew by 16% on a gross basis and 39% on a net basis. Rates were flat on an aggregate basis with large premium accounts seeing 5% to 10% declines and small accounts having low-single-digit increases. Most of our gross came from accounts that purchased low limits and that we have kept 100% net with almost all of this growth emanating from our European operations.

In Health Care, rate decreases moderated and we're 4% on average for the quarter. As you recall in our last quarter call, Health Care was in the 9% to 10% down trend; that trend has moderated. Premiums in this sector declined by approximately 13%, both on a gross and net basis due to a reduction in our participation in the large hospital sector where competition is increasing.

The Executive Insurance business grew by 8% on a gross basis and 5% on a net basis. Rates were down 2%. And for those of you that keep track of rates, this is the fourth quarter in a row that we have experienced decreases in the very modest 0% to 3% range compared to the double-digit reductions we saw in the two late quarters in '04 and the early two quarters in '05.

The Construction Surety and National Accounts unit grew 16% on a gross basis and 26% on a net basis with Surety leading the way. As we have reported in prior quarters, Surety rates remain stable and the sector is attractive due to a limited available capacity.

The Construction and National Accounts unit focuses on primary loss deductible and other loss-sensitive accounts, which in general have a lower volatility. Rates in this sector were down 10% on average, driven by California workers comp reductions that were consistent with industry rate decreases due to positive results and regulatory reforms. Finally, our Program business was up 3% on a gross basis and 15% on a net basis as we retained more of what we wrote on a selective group of MGAs that we manage. Rates in the aggregate were flat with five of our programs achieving modest increases, two having mid-single digit decreases and the balance that were flat.

Before I turn it over to John for a more detailed discussion of our financials, let me update you on our CAT exposures. As we mentioned in our last call, we have implemented RMS 6.0 in all of our operations. And in addition, I would like also to remind you that in determining our 1 in 250 year event P&Ls, we include all exposures we believe could accumulate in a given event, not just property exposures.

With that, as of September 30, the end of the quarter, our 1 in 250 P&L expressed as a percentage of common equity was 19%. As you may recall from our last call at June 30, the percentage was 22%. The change is primarily due to the substantial growth in common equity capital during the quarter. Our exposure is well within our self-imposed limit of 25% of common equity, and should market conditions remain attractive, and that's our expectation, we have room to increase our participation without changing the risk profile of the Company.

With that, let me turn it over to John for a more detailed financial discussion, and after that, we would be happy to take your questions. John?

Thank you, Dinos, good morning everyone. This was certainly an outstanding quarter from a financial perspective as we reported our highest annualized return on equity ever, driven by strong gross in investment income and excellent underwriting results. With that, I will briefly take you through the key components of our financial results, starting with the top line.

Consolidated net premiums written were down 5% as growth by the Insurance segment was more than offset by a decline in volume recorded by the Reinsurance group. It should be noted that the comparability of the Reinsurance segment's net premiums written on a quarter-over-quarter basis was affected by several items. First, the comparison was influenced by the effects of several unearned premium portfolios, both inward and outward, which account for approximately $17 million of the decrease in net premiums written. In addition, the 2005 period included approximately $18 million of reinstatement premiums recorded as a result of last year's hurricane activity, while obviously the 2006 period did not contain a significant amount of reinstatement premiums. Furthermore, premium volume in the 2006 period included approximately $9 million of negative adjustments to premium estimates on contracts written in prior years, while the 2005 quarter included approximately $6 million of positive premium adjustments related to such years.

For the first nine months of the year, consolidated net premiums written increased by approximately 5%, with Property business representing roughly 30% of the total compared to 24% for the 2005 period. Our Insurance group contributed 59% of gross premiums written and 53% of our net premium volume for the 2006 period.

There is one more item that I would like to comment on regarding the 2005 premium volume. As you may recall, the Reinsurance segment's volume in the fourth quarter of 2005 included approximately $100 million of one-off nonrecurring transactions related to last year's storm activity. With a little luck, 2006 catastrophe losses will continue to be light, and accordingly, opportunities similar to those that we seized in the fourth quarter of 2005 are unlikely to arrive in the fourth quarter of this year.

On a consolidated basis, the ratio of net to gross written premium decreased to 68% in 2006 from 75% in the 2005 quarter primarily due to business ceded to Flatiron Re, a dedicated reinsurance vehicle that we began ceding business to in January of this year. We ceded $78 million of Flatiron Re in the 2006 third quarter and $238 million for the first nine months of the year. Earned premiums ceded under this treaty is beginning to build and amounted to $52 million for the third quarter of 2006, about double the second-quarter level, bringing the amount of earned premiums ceded on a year-to-date basis to $96 million. The override estimated profit commission recorded during the quarter are reflected as a reduction of acquisition expenses of the Reinsurance segment and improve the expense ratio of the Reinsurance segment by 240 basis points in the quarter and 130 basis points for the first nine months of this year.

The consolidated combined ratio was 84.3 in the 2006 quarter. This result was primarily due to excellent accident year results, especially in Property and Marine business, driven by substantially higher rates and light catastrophic activity. Underwriting results in the 2006 quarter also benefited from favorable reserve development, which totaled $23 million compared with $31 million in the comparable 2005 period. The 2006 favorable development was primarily attributable to property and other short-tail lines of business. 2006 amounts are reflected net of a minor amount of development on the 2005 hurricanes. In general, reported and paid claim activity across most lines of business remained at better-than-expected levels.

Pretax net investment income in the quarter was approximately $102 million, or $1.33 per share before interest expense and preferred dividends and $1.18 per share after deducting these items. Net investment income for the quarter was approximately 71% higher than the comparable 2005 amount and 12% higher on a sequential basis. The substantial increase in investment income in both a quarter-over-quarter and a sequential basis was due to both the continuing significant growth in investable assets and higher yields. The growth in investable assets was primarily generated by strong cash flow from operations, which as Dinos mentioned, rose to $427 million for the 2006 first quarter. This brought cash flow for the first nine months of the year to approximately $1.25 billion, a 13% increase over the comparable 2005 level. As a result, investable assets increased to approximately $8.7 billion at September 30, and at quarter end, the ratio of investable assets to common shareholders equity was roughly 3 to 1. The average pretax yield of the fixed-income portfolio recorded in the first quarter was 4.78%. This represented an increase of 123 basis points over the comparable '05 level, while on a sequential basis, the yield was up by 28 BPS.

The portfolio continues to be comprised primarily of high-quality fixed-income securities with essentially no investments and hedge of private equity funds. The increased in investment in yield on a quarter-over-quarter basis primarily resulted from higher interest rate levels as the portfolio's average credit quality remained very high at AA plus.

In addition, we have continued to avoid most other forms of spread risk based on our current view of the risk reward relationship of these investments. During the quarter, the duration of the portfolio has increased to 3.2 years.

As you may know, we reestimate our tax rate based on our annual expected taxable income each interim period, and any adjustment that we make to the expected annual rate flows through earnings each quarter. The expected annual effective tax rate or pre-tax operating for 2006 was reduced to 5.3% at September 30 from 7.5% at June 30, primarily because of the low level of CAT activity. As a result of this, the effective tax rate for the quarter was 1.7%. The effect of applying the lower tax rate at September 30 to pre-tax operating income recorded during the first six months of the year resulted in a benefit of $0.10 per share in the 2006 third quarter.

In summary, book value per share rose to $40.82 at September 30, 2006, a 12% increase over the June 30, 2006 level, and a 21% increase from year-end 2005.

With that, we will take your questions.

(Operator Instructions). Matthew Heimermann, JP Morgan.

I had a quick question. First on the loss ratio, if I back out the development and compare third quarter to second quarter, the loss ratio looked like it ticked up quite a bit, like 1000 basis points by my estimates. And I would have thought, both in terms of earned premium mix, and also since there were no catastrophes, that sequentially, they should've been more similar. Is there something -- am I doing math wrong, or is there something else that would be driving that?

Partially, you're doing math wrong. It's more like it ticked up maybe a couple of hundred basis points when you back out expected CAT load and actual CATs in the quarter, which amounted to a little under $10 million. They weren't significant, but they had an impact.

The second part of the answer, you touched on. If you actually look at earned premium quarter-over-quarter on a sequential basis, it is a change in mix of premium. We actually have lower property earned premium. If you recall, again, we earned a lot -- we wrote a lot of business in the fourth quarter of 2005, most of which was going to be completely earned by the time we got to the wind season. So in terms of earned, there was a slight drop-off. That will probably reverse itself as we go through the rest of the year.

That $100 million that we talked about, that was opportunistic premium written in the fourth quarter of '05, was earned by the second quarter of '06. And in essence, it changes the mix a bit.

That makes sense. Thank you for the $10 million number as well. I guess the other thing is, you seem to be seeing some things in the market that are very consistent with what other companies are reporting. However, your response seems to be much different, both in -- your reduction in casualty reinsurance I would say is much more aggressive, as is kind of the pullback on the contractor side and the primary market. I was wondering if you could just talk about, give us a little bit more details into perhaps -- you mentioned standard markets, but maybe more specifically for both reinsurance and insurance, where the competition is coming from? Is it new entrants, is it companies getting into new lines of business or looking just to grow share in existing lines, things of that nature?

I think there are many factors causing it. If you believe our assessment, and that is how we see things, the larger the premium accounts, the more competition. And that's been -- for the 30 years I've been in the business, it's always the case. Usually when the market is starting to change, and it has started to change, the large premium accounts get more attention. Brokers market them more extensively, they try to compete with each other. Usually, you only win accounts if you can do a little better than the other guy. So we see that, and it's not particularly class-related, it's premium size related, and we have seen that. We see it on our Insurance group and we see it on the Reinsurance group.

Now, as our strategy has been from day one on the Reinsurance group, on the Reinsurance group, you continue to make forward bets. If you're buying on a treaty, not only you're committing to the current market environment, but you're committing to the market environment for the next 12 months, and our visibility is not as clear as some other people think it ought to be. So I tend to be more cautious, or we as a Company, and our reinsurance folks, they tend to be a little more cautious, because I cannot make those adjustments on a weekly or a monthly basis as I can do them on the Insurance group (indiscernible) underwriting account by account. So you might consider that maybe a bit more conservative than others, but listen. If you recall, I made that same call on the D&O two years ago, and we were wrong. We cut back significantly on reinsurance on the D&O lines because we were seeing in '04 and '05 double-digit reductions, and then that market stabilized. The good thing about us, we got our hands both on the direct side and the reinsurance side, and I can adjust. That's our view of the market and that's the reason we take in these kind of actions. On the Reinsurance side, I rather not have enough premium and to make sure that I have the right margins than the other way around.

Fair enough. Then just on the Reinsurance side, is your comment true both on proportional and excess?

Well, a lot of what we write on the reinsurance side is proportional. So in essence, our results are going to mirror the underlying business, assuming we don't get disadvantage on the ceding commission, and we're very careful about that. We want to support cedants that were equal partners. They make a dollar, we make a dollar; they lose dollar, we lose a dollar. We have that kind of philosophy in the way we approach that business. So it's more specific to uphold the business as you can see a mix on the Casualty side is predominantly proportional. And it's our view of what we believe might happen 12 months forward, but I don't know. The rates right now, they are still attractive for good returns, but I don't know where they're going to be 12 months from today, and I don't want to make that bet.

No that's fair, and I'm not complaining either. The other thing I was just going to say -- on the contractor side, is there any particular classes within contractors, or would you just say contractors across the board?

Well, as you probably recall, we wrote quite a bit of this business at very attractive rates and mostly what's cost-driven is residential wraps and contractors of all different kinds that they deal with residential, you know, construction. We started in '02 and '03, and maybe there were two or three companies writing it. As a matter of fact, early on in the process, I think only us, Berkshire-Hathaway and maybe a couple of others that were writing this business. Today, there might be 50 companies who have discovered the pricing, the terms and conditions are attractive, so you get more competition. And I would say the standard markets are coming back into the marketplace. These are accounts that they threw out in '02 and '03. Nobody was willing to write them. We did it, and now you have more competition. At the end, you have to stick to your underwriting guidelines, and if you write a little less and you maintain your margins, so be it, and that's our approach.

Okay, fair enough, now. Thank you.

Tom Cholnoky, Goldman Sachs.

Good morning. I guess I just want to go back to the accident year calculation, just so I understand it. I understand the business is running off. And so therefore -- sorry, one other quick question before I ask that one. Should I assume all of the CAT losses are in Reinsurance, or is there any split between Primary and Re?

Essentially, all of the CAT losses this quarter are reinsurance.

So in other words, the accident year kind of combined ratio, we came up in the third quarter for Reinsurance, which is obviously higher now that I understand the program, that's kind of where we should think about where you're pegging that, because obviously, our calculations showed about 600 basis points.

Tom, you always try to ask us to give you guidance.

No, I'm just saying, there's nothing else that would be distorting that number.

No, there's nothing else that's distorting that number, but it is subject to changes in -- mix of earned premium changes quarter to quarter, you can get slightly different answers.

Yes, but it should have trended up, given what happened with that one program?

It's not surprising.

Now, let me just understand the $100 million in the fourth quarter, so basically, and I know this sounds like guidance, but hopefully you'll look at it as more simplistic, which it's just simply that I take $100 million out of my '05 numbers to kind of figure out from there what you may or may not grow off of?

That's a reasonable way to look at it.

Just once again, check some calculations. If I make some of those adjustments at Reinsurance on that premium volume that you suggested, instead of being down about 33%, you would've been down about 25%. Is that roughly right?

I think that's correct, yes.

Okay. And then in terms of your net to gross, should we think in Reinsurance that that may start to increase a little bit in '07? You are starting to build a very nice capital base. And I guess the question is -- is the chance that you will be ceding less business out in '07 than you did in '06 and keeping more of your own cooking?

It depends on the line of business that was successful. The low limit, small accounts type of business, and I think we have -- we're concentrating more on that -- we tend to keep that 100%. We eat our own cooking. When you write high-limit business, especially in the Insurance group, in the first group, we keep 100% net, except with the Flatiron sessions. In the Insurance group, it's only when we put out $25 million or $50 million on some of the energy and technical accounts that we buy a significant amount of reinsurance to reduce our net risk to somewhere in the $10 to $15 million area, and that approach will not change. So not knowing, and we never try to predict this to where our growth is going to come, we try to have the freedom to navigate the market and go where we believe there is the best opportunity for us to write the business with the best margin and get the right return. That will determine net to gross. And it might change, but it's going to be minor shifts. it's not going to be dramatic shifts.

I guess I'm also focusing a little bit more on the, Reinsurance. Is there a chance that you will cede less business Flatiron next year?

Well, no. Our Flatiron agreement is a two-year agreement, and it's set at the 55/45 that we have disclosed.

It depends on how much business we write on the lines of business we cede to them. So again, it's sensitive to where you write the business.

Right. So, if you saw an opportunity to write more business you thought with higher margin and that you had a higher capital base, you're going to be constrained in your ability to retain that? You're going to have to send it to Flatiron?

That is correct.

I got, understand. So the net to gross in Reinsurance should stay relatively -- starting once again business mix shift changes --.

Yes. From where you're sitting, yes.

That's what's I'm trying to understand. I guess that was it. If I have something else, I'll, come back, but thank you.

Joshua Shanker, Citigroup.

Great quarter, congratulations. My first question is a bit of an inquiry into history. What happened the last time the hard market started to soften to the E&S line? You're talking about the standard carriers coming in and bidding on that business. What can we expect the longer-term playout for E&S in the next two years if history repeats itself?

Traditionally, the E&S market expands and contracts with the cycle, and we have seen that phenomenon today. A lot of standard accounts, if I can use that phrase, I don't know what's a standard or non-standard. To me, it's terms, conditions and price, but so be it. Insurance companies get caught either with inadequate rates because of rate suppression by regulators or because they didn't file proper rates, et cetera, and they see that business, they might be willing to do it, but they don't have the proper structure to do it within an admitted company, so they discontinue that business or they don't renew that business and it goes to the E&S market. The E&S market has freedom of rate of form, and they write it.

Over the years, companies adjust their filings, and listen, if I had the opportunity to write contractors at this rate, I will do it on an admitted basis because now I have to file a rate that satisfies the risk-reward relationship between the exposure and what I'm going to charge, and we are starting to see that. So I don't have in front of me some industry statistics, but we can dig it out for you, if you want to see what percent it becomes E&S at the peak of the cycle, and what that percentage for the total industry shrinks to when the market gets soft, and we're starting to see that phenomenon today. I think it was Bill Berkley in his call was commenting on the same. We see it and others E&S markets are seeing it, that standard markets are coming in. We are not saying they're taking accounts that are underpriced accounts. The accounts are pretty well priced, the brokers have an easier time writing it on an admitted basis. They don't have to file for -- collect the surplus lines tax and remit it. So there is advantages of being admitted. You're in the guaranteed funds in the residual market mechanisms when you write admitted, so there's advantages for people to write it admitted. And we've got the capability as a company to do both, but on an E&S platform, we are starting to see some drifting of that and we're not going to fight to keep it if it doesn't meet our profitability standards.

Certainly, well, I'll definitely take you up on that help to the history lesson later, but I appreciate that. My second question regards to programs. It seems like the only thing that's only slightly less popular than forming a property CAT reinsurance business right now is looking into picking up some programs. Are you seeing competitive bidding coming in form?

We have maintained -- we have eight programs, and we have maintained those eight now for over four years. We're looking in the market to see if we can find others to expand. But for whatever reason, we have not been successful. We are very happy with what we have. As a matter of fact, and let me tell that the pricing environment in the aggregate in our program businesses had been very good. First quarter '05, it was plus 4.6; second quarter '05, it was plus 1.4; third quarter '05, plus 1.9; fourth quarter '05, plus 2.3; first quarter of '06, it was at 1% and flat in the aggregate in the second quarter '06, and flat this quarter. So the rate environment maybe is not totally keeping up with trend, but it has been a lot more stable than anything else that we have seen.

Having said that, I think the good MGUs like stability, they like to be with carriers that they service them well. I think we are one of those companies, but we've found difficulty in finding others that meet our standards, even though I do have the desire to do it if I can find the right opportunities. John, you want to add anything else?

The only thing I would add to that, Dinos, is the programs we have with us now are all differentiated programs. In other words, this is not standard lines, they were all nichey businesses. I think a lot of what you're hearing is programs being shopped where essentially they're just competing with the standard lines carriers for standard types of business, and those are the guys who move around the most.

That makes a lot of sense. Thank you, I appreciate all of your help.

Vinay Misquith, Credit Suisse First Boston.

You seem to be moving from the Reinsurance segment, or you seem to be writing more business in your Primary insurance segment than your Reinsurance segment. Do you think that that's going to be the trend going forward given that pricing in Casualty is beginning to come off and you're seeing better opportunities, or are you more -- do you feel safer doing primary insurance than reinsurance?

Let me start with your last statement; I think it's correct. We have more comfort writing insurance than reinsurance because -- our reinsurance guys are a bunch of the smartest guys in the business. However, you're always one step removed from the risk, so your ability to get it right, especially in a declining market, becomes less and less. The cedants don't want to give you as much information, they want to arbitrage you because they want bigger ceding commissions -- all the kind of things that happen in a soft cycle. Having said that, and we've said this consistently for the last three years. When the market is very hard, you will see the reinsurance company probably have very, very good growth and take opportunities because they're in need, they're in demand and in essence, you can get your terms and price. When the market goes the other way around, the advantage is with the insurance companies. It's kind of a reverse arbitrage on the terms and conditions, because if you have a good business and you're going to share it with somebody, you want to have a little overwrite. And it might come either in the rate structure, or it might come on the contract structure, ceding commission, et cetera. And for that reason, we prefer the insurance.

On the insurance side also, it's a business that allows you, if you're in control of your underwriting staff, and we think we are, and you have the proper rate monitoring devices and underwriting reviews as we do, you can change behavior on a weekly or a monthly basis. I'm not bound by a contract, I don't have to take what has been written for a year. I can change signals through my branch system on a monthly basis, and that's what we try to do as a company. We try not to be good predictors of what's going to happen in the future, but hopefully we're good executors by recognizing what's happening and applying our underwriting discipline on a week-by-week basis. So your premise that, probably insurance will become a bigger part of our business in the next few years, is correct. The market turns again, and I think you can see our reinsurance company gets supercharged again and write a lot of premiums.

Could you comment on the opening of a reinsurance branch in Europe? How much do you plan to source from there, or is it a big part of your push into Europe?

The principle behind it, our reinsurance strategy has not changed. Basically, we like to underwrite out of a select number of offices. Right now, we have two and the one we opened in Europe, it will be our third one. There is a segment of business -- this is small-, medium-size, you know, companies in Europe writing indigenous European business that, for whatever reason, don't travel either to the U.S. or Bermuda to find their reinsurance support. And our only goal with our office in Europe is to be able to start penetrating that market. We have no targets. We don't run the Company on a premium target, we run the Company on margins, profitability margins and what they write. So the office will be small, but I cannot predict how big it's going to be. Only the market will tell us that. We will start with a handful of people, as we've done in many other places, both in insurance and reinsurance. We see how the market will respond to us being there and what kind of business we see and how profitable that business is, and then we will actually as need be. This is our way of trying to penetrate small-, medium-size business that are indigenous to the European territories.

That is wonderful. One final question on the growth. You've had some pretty stellar growth on your Primary Insurance operations, and that's in the face of declining pricing. Going forward, do you still see that same pace of growth, or do you think that's going to taper off.

You have to be careful about growth, and let me point you to our release. And if you go on page 19, that we have the nine-month aggregate of numbers for the Insurance group where the growth is coming, you will see it's coming from the right places where we see the better margins. Our Property went -- Property, Marine and Aviation went from $156 million at nine months '05 to $250 million. It's the best environment we have seen in that territory. In the Construction and Surety, we went from $170 million to $222 million, a significant growth. And then you see in our Professional Liability, we had significant growth. When you see casualty, we actually shrunk. We went from $207 million to $169 million. It's all in the release. If you analyze page 19, the Insurance segment information, you will see. And you take my commentary about what we see on small versus larger accounts where rate structure is holding better than others, you will see our audio and the video matches here. We're growing where we see the opportunities and we're not where we don't. So it's hard to predict where our growth is going to come because I cannot predict where the market is going to be six months, nine months, or a year from today. It might continue or it might slow down. It will all depend on market environments, and that's what we're promising our shareholders, and that's what we're promising our employees, that we're going to behave responsibly in the marketplace. And with that, that's why it's very hard for us to predict what's going to happen.

Alright and, sorry, one last point of clarification. I believe you mentioned that your California construction was part of your casualty book which you reduced this quarter. Is that correct?

We write contractors in two parts of our business. We have a unit which is -- this is the Construction Surety and National Accounts unit, which predominately write the larger accounts on a large deductible or loss-sensitive plans. This is primary business that is the workers comp, auto liability and general liability, and most of these clients are willing to take the first $0.5 million of each and every loss, either as a deductible or as -- on a paid loss or incurred loss retro plan. And then, the limit of liability we issue is $1 million. So it's low limits, has less volatility. The surety operations, because we have the same manager in that, even though it's a segregated business, we report it under that sector.

On our Casualty side, that's 98% E&S, and basically has two sectors. It has primary surplus lines, which we write different classes. It might be machine shops and also contractors, and we write excess and umbrella. And that, because it's E&S, is run by a different unit and a different manager. So my comments have to be taken into these two sectors, which they have different drivers and different characteristics. Where we saw most competition is on the primary E&S, and that's where we have reduced volume.

That's great. Thank you.

Jay Gelb, Lehman Brothers.

Thank you. I was hoping to focus in on two issues. The first is on the powerful net investment income growth. The growth is well in excess of the increase in average assets and the yields are headed higher, and it's great results. I am just looking for a little more clarification in terms of why the growth is so fast, just when we're not seeing increases in average portfolio yields from any other insurers.

One, it's a question of, you have older securities that were put on the books years ago going off. If you go back two or three years, we're looking at a 250, 300 basis point differential. So to a certain extent, you have some of the portfolio rolling off and being replaced by much higher yielding securities. That's part of it. Part of it you mentioned was investment income, and that accounts for the bulk of it. If you've tracked us now over the last two years, we have not changed the average credit quality. We have added some additional mortgage-backed securities, but we're still very underweight there and have a relatively modest amount of that type of security in there. So essentially, obviously, we're always looking for ways to improve the yield of the portfolio. We're looking at a lot of different items. If we were to get a return, for instance, to more normalized spreads, either in credit or other areas, you would probably see -- there's the ability there to bring more yield on. So there's nothing -- there are no hedge funds in there, there are no private equity funds, so there's -- if your sense is, is there a lumpy sense to this? There's nothing in that third quarter number that we would view as lumpy.

The other thing I'd like to add is, if you look at the growth or our investable assets, it has been better than most because the claim activity, paid claim activity, is better than expected and we have been growing. If you recall back when we started, I said our steady state will come like five, six years later when, as a percent of premium, we will have some $3.50 of investable assets to $1.00 of premium. For a casualty company, that is usually a good ratio when you get into steady-state. We're 3.2, 3.3-to-1 on premium, and we're 3.1 on capital. So at the end of the day, we're starting to reach that steady-state, but our cash flows, they continue to be extremely strong. That tells you a bit about how good the underwriting has been over the last five years.

Clearly. And then the second issue is just on capital management. It seems with perhaps the top line slowing a bit from premiums, you have the Flatiron sidecar set up, seem to be in very good standing with the rating agencies. Do you see a point in the near future where you get an excess capital position?

Well, it depends on what happens with storms and CATs. Don't forget -- we had one season of light CAT activity, and everybody is -- earthquakes can happen any day and we have another season. If things go well for another year, I can tell you, we will have probably excess capital, and even the rating agencies will agree with that. Don't forget, we have added in the first three quarters this year some $865 million to our capital, some of it with perpetual preferreds and most of it from our return on earnings. We have one more quarter to go, that position, you know, and then we'll see what happens next year. Our intent has always been very clearly stated, that we want -- we have a goal of getting better financial ratings by the rating agencies. They have their own time frame to do that. I think we have good discussions with all of them, and I will leave the decisions up to them to make. So that's a goal of mine, to be running up capital base at the AA-plus level, A-plus level. And then, anything that we have in excess of that, we'll find the proper way to return to our shareholders because that's where the capital belongs. At the end of the day, if I can deploy with proper returns to us, proper returns is 15% ROE, I could do much with it in the holding company. And that's stated policy; it has been consistent now from day one.

Great, thanks very much for the answers.

Jay Cohen, Merrill Lynch.

Thanks for the call, I like the way you guys handle this. My question relates to something you mentioned on the Reinsurance side where you have some shift going on from proportional to excess of loss. And I totally get that that's probably a more profitable model. But from a premium standpoint, there's a negative impact. And I'm wondering if you can describe how dramatic that shift is. Is it just in some areas, or is it a broader shift, which obviously would flow into '07 potentially?

Let me give you a hypothetical. This is not a specific account, but it's a hypothetical account. Let's say you're going to ride a Florida quota share on the property side that let's say has $100 million of premium. This is a homeowner's quota share, and that quota share, for arguments sake, has $200 million worth of an occurrence cap. So when you calculate your current aggregate for that quota share, you have $200 million of it. So if you're going to take 25% share of that, that means you're going to use $50 million of occurrence aggregate from a CAT perspectives, and you're going to receive $25 million of premium. When you write that contract, maybe the economics are still good, but you have to dissect it into its components. And maybe $0.40 of $1.00 is for CAT exposure, and $0.60 is for expenses and attritional losses and profits. So -- and I am making these numbers up. So at the end of the day, you've committed $50 million of CAT aggregate on that and you're going to retain $25 million, of which 40% of it goes for CAT exposure. That means there is $10 million of that pie that is for the CAT component. You can take the same account and write a -- be on a layer of $5 billion, excess of $25 billion industry loss, right, or -- and commit the same $50 million of occurrence capacity. And if the rate (indiscernible) on that is 25%, or 20%, whatever it is, you might get a lot more for the same amount. Now, in that scenario, instead of getting $25 million in premium, you're only going to get 10 up on top, but the profitability of that 10 probably be greater than what you got on the bottom.

Jay, the only area it really affects is essentially, we write most of the U.S. wind-exposed CAT out of Bermuda, so it only affects Bermuda, number one, in terms of the lines of business. So it would be between the property CAT line and the property other and the property line within that one component. It's not the whole book of business. Secondly, whether we write it pro rata or whether we write it excess, it depends on each and every transaction, so it's really hard to say whether that trend continues. If the trend continues that we think you get a much better return on capital by writing it excess, we're going to write it excess. We're going to go with the best margins and the best return on capital as -- not necessarily where the most premium dollars are.

And we don't measure just return on premium, we measure return on aggregate limit of exposure. Some companies don't do that, but we do. When we make determinations as to where is the best buck for our capacity, that's the way we think about it. Am I going to commit more aggregate limit, and how much money I'm going to get, and what the profit margin in that is.

All of those answers were very helpful.

We're going to make you an underwriter one day, Jay.

The next question is the tax rate. You may have mentioned this and I might have missed, but any sort of look forward into '07 and what kind of tax rate we should be thinking about?

Well, on the one for '07, what we've said now is the rate for the year we expect to be between 4 and 6 essentially for the rest of the year, and CAT activity drives that. So as you look into next year, and we always -- usually when we report our next quarter's earnings, we'll give you a sense of where we see it at that point in time. It's still early. But generally speaking at the beginning of a year, we'll take the standpoint that we expect -- and that based on the models, we'll look at what we expect average CATs to be, and that will help drive the tax rate. So, in terms of looking forward, it depends on your view and how you want to sort of forecast CATs into your model.

My assumption is, there's not going to be any CATs next year, so --.

Well, from your --.

Are you smoking tea leaves, or --?

If you're correct, we might have to hire you.

Alright, thanks for the answers, take care.

Adam Klauber, CCW.

With primary casualty softening, and you obviously write a fair amount of casualty in your insurance business, but the -- loss trend is still going upward. Would it be reasonable to assume that accident year loss ratios in the primary business are going to go up next year?

Yes, I think that's a fair statement.

Okay. The other question I had is, as far as the ceding commission from Flatiron, will we see that mainly in the third quarter similar to what we saw this quarter, or is that going to be spread out going forward?

Adam, on that, it's going to follow the earned premium. So, basically, you book it based on the expected profitability, and we look at their profitability exactly as we look at our own. And so, as earned premiums grow, as you saw from the second quarter, we basically almost doubled earned premium in the third quarter. Since this is -- we started writing and ceding this business 11/06, you would normally expect to see that earned premium continue to build, and therefore, the commissions we get from them as how they flow on the income will move with earned premium.

Great, thanks very much.

Ron Bobman, Capital Returns.

Thanks, congratulations on the quarter. You're not going to able to hire Jay because you just taught him enough to start his own sidecar. I had a couple of questions. You mentioned sort of the ebb and flow of business between the E&S market and the license market here in the U.S. or the admitted market, and I was wondering, are you fully licensed in the admitted side of the business so it --?

Yes. We have two nonadmitted companies, E&S companies, and we have two admitted companies. So from a licensing point of view, the Insurance group owns four sets of licenses -- two are admitted and two are nonadmitted. And we're in all 50 states on both.

Great, then I had a question. I think sort of early on in its life, you adjusted the quota share percentage with Flatiron, and I'm wondering what's transpired with market developments, is there a chance that you will actually -- Flatiron and you will sort of add capital to sort of support whether it be the current relationship of 55/45 and market opportunities?

First of all, the adjustment was for a very defined, specific period, as you may recall. It's from essentially the very end of June until the middle of August. So we have reverted back to the 55/45. As indicated in his prepared remarks, we're well within our own self-imposed limit from a risk management standpoint, so we have capacity to write additional business, should we so decide. I can't speak for Flatiron, whether or not they want to increase their participation. It will be totally up to them, but we certainly have the ability from our standpoint to take more CAT risk next year, if returns dictated it made sense.

And then one last question. Another company announced a relationship with -- I think it's David Ingrey, I assume that's Paul Ingrey's son -- and I was wondering if you have any involvement with his CAT underwriting entity?

No, we do not.

Okay, thanks a lot, and great quarter again, and continued good luck.

There are no additional questions in the queue. At this time, I will now turn the call over to Mr. Iordanou for closing remarks.

Well, thank you everybody. I am looking forward to sharing our views again in another quarter. Have a good day.

Thank you for your participation in today's conference. Ladies and gentlemen, this concludes the presentation. You may all disconnect and have a good day.