Arch Capital Group Ltd (ACGL) 2008 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to the third quarter 2008 Arch Capital Group earnings conference call. My name is Sandy 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 today's 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 release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessment and 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 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 will also 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 turn the presentation over to your host for today's conference, Mr. Dinos Iordanou and Mr. John Vollaro. Please proceed.

Thank you Sandy. Good morning everyone and thank you for joining us today. I'm sure you will all agree that the past few months have been challenging for all sectors of our economy but more so in the financial services area. Entire fortunes have been lost and companies that only a few months ago were considered pillars of financial strength have either failed or were forced to merge to avoid failure or require billions of dollars of government funds in order to remain in business.

The magnitude of the deleveraging of the global financial system and the speed in which it's happening is breathtaking. Given the difficult market conditions and the numerous pitfalls challenging the financial services industry in the past few months, we are pleased with our third quarter performance.

Our annualized return on common equity was 7.6% for the quarter and 17.4% for the first nine months of 2008. Both the quarter and the year-to-date results were affected by the cat losses caused by hurricanes Gustav and Ike. Book value per share was at $53.04 down from $55.12 as of year-end 2007 mainly due to mark to market adjustments on our investment portfolio. Over time, we believe that we will recover this temporary loss of book value per share.

Our net premium volume was essentially flat for the quarter with insurance up slightly and reinsurance down slightly. Our cash flow from operations at $382 million in the quarter and $973 million on a year-to-date basis continues to be very strong. It not only provided us with a source of future earnings growth, it also reflects positively on the quality of our underwriting and reserve strength.

I might be stating the obvious but in times like this, I would like to reemphasize what we are all about. We're first and foremost a specialty underwriting company with a deep bench of experienced specialty underwriters and a broad distribution capability throughout the world.

Our investment and capital management functions are there to support our underwriting operations by providing a strong and stable balance sheet with enough flexibility to allow us to take advantage of underwriting opportunities when they are available. I would like to emphasize that this has always been our approach, not a recent reaction to the current environment.

I believe we are on an inflection point in the cycle not dissimilar from those of us that are gray and old to the mid '70s when the stock market collapse created a hard market. The new realities in the financial markets need to be factored into our approach to the business going forward.

Capital is even more precious today and significantly more costly and the economic environment that we operate in is riskier today than yesterday. Our risk selection pricing and risk management practices must reflect these fundamental changes.

In both our underwriting and investment activities, we have always believed in taking a measured amount of risk and that approach has served us well in these difficult times. This quarter we reported approximately $100 million in realized losses, most of which results from mark to market adjustments that reflects the current market pricing dislocation and not our belief of the ultimate outcome.

Having said that, due to our conservative approach, our balance sheet continues to be one of the strongest and most flexible in the P&C specialty business. We're strongly capitalized with ample liquidity and are ready to respond to any opportunity.

Now a few thoughts on the current market conditions. The combination of the state of the financial markets which has reduced the amount and availability of capital in the industry and the acute financial difficulties that some major competitors find themselves in as a result of this has begun to affect market conditions positively.

It is too soon to predict the level of correction or the velocity of correction but we are encouraged by the early signs. For example, in some lines of business, rate declines have become rate increases. Submission activity has increased significantly for us and we are sensing a flight to quality by both customers and brokers.

In addition, teams of experienced and talented underwriters are becoming available as they see career opportunities with strong and stable carriers. Further, changes in the valuation of many companies will also create buying opportunities.

Our views on expanding our business have not changed. We continue to prefer in order of importance -- one, growing a business organizationally through our existing staff; two, adding underwriting capabilities to them through the acquisition of teams and books of business; and three, when it fits a previously discussed criteria through acquisition. Given the appropriate opportunity, we will utilize all of the above to expand our business.

Yesterday we announced that my good friend and partner and current CFO, John Vollaro, will have a new role with the Company starting April 1, 2009. His contributions to me as a partner and to Arch and it's shareholders were invaluable. But I am pleased also -- I am almost very pleased that under his new assignment as Senior Adviser to Arch, we will continue to benefit from his wisdom, experience, knowledge and advice for at least the next three years and beyond and I want it to be a long beyond the three years.

I'm also very pleased John Hele has accepted our offer to join our organization on April 1, 2009 as our next CFO. John as CFO of ING is leaving a great position with one of the largest financial institutions in the world. His and his family's desire to relocate back to North America as well as the quality of Arch as an organization allowed us to attract such a high caliber individual. I'm looking forward to working closely with John for many years to come.

Before I turn it over to John -- and you're getting confused by how many John's we have -- for a more detailed commentary on our financials, let me update you on the PML aggregates. As of October 1 our one in 250 PML for a single event expressed as a percentage of common equity was approximately 25% of equity with Tri-County Florida and Northeast windstorm continuing to be the largest exposed zones. The increase from our last report which was at 23% was entirely due to the reduction of common equity this quarter. John?

Thank you Dinos and good morning everyone. Before I briefly walk through the key components of our financial results, I would like to add to Dinos's comments on yesterday's release.

First of all I would like to express my gratitude to Dinos and the Board for giving me, albeit at an advanced age, the opportunity to continue to contribute to Arch's future success, something I am highly confident of. For those of you with whom I've worked over the past seven years, I have enjoyed the experience immensely and I hope that we can continue our relationship in my new role.

I'm also pleased that we are able to bring a highly qualified individual, John Hele into the Company and I look forward to working with him to ensure a smooth transition to the CFO role. Now let's get back to the business at hand.

Dinos has commented a little bit on premium volume but as usual, there are a few additional noteworthy items. On a trailing 12-month basis, premiums written by the insurance segment represented about 69% of our gross volume and 60% of our net volume while property and other short tail lines continue to represent about 44% of our net premium volume.

On a consolidated basis, the ratio of net to gross written premiums in 2008 increased to approximately 77% from 70% in the 2007 quarter primarily as a result of the nonrenewal of the Flatiron treaty. On a reported basis, we ceded a de minimus amount of written premiums to Flatiron in the third quarter of 2008 compared to 51 million in the prior year quarter.

On an earned basis, premiums ceded under this treaty amounted to $26 million for the third quarter of '08 in comparison with 68 million ceded during the 2007 third quarter. The [override] in estimated profit commission recorded on the treaty with Flatiron are reflected as a reduction of the acquisition expenses of the reinsurance segment which improved the expense ratio of that segment by 110 basis points in the 2008 quarter while the effect on the expense ratio in the comparable 2007 period was 260 basis points.

The change in ceding commission was primarily due to the lower level of earned premium in 2008 and the effects of claims from Hurricanes Gustav and Ike on profit commissions. The unearned premium on business ceded to Flatiron was approximately $35 million at September 30, 2008. Most of the ceded premium yet to be earned and the related fees including profit-sharing if there is any will be reflected in earnings primarily in the fourth quarter of this year.

Turning to our operating results, our consolidated combined ratio was 105.3 in the 2008 quarterly period which was 20 points higher than the comparable 2007 quarter. 2008 underwriting results include 19 points of estimated claims from catastrophic events primarily Hurricanes Gustav and Ike.

The 2008 cat losses were 17 points higher than in the comparable 2007 period. In addition, the loss ratio was affected by an increase in several large individual risk losses, primarily in short tail lines as well as to an increase in our loss picks for intermediate and long tail business.

This was partially offset by an increase in the amount of favorable reserve development net of related adjustments which totaled $55 million in the 2008 quarter and $50 million in the third quarter of 2007. Approximately 57% of the net favorable development in the 2008 quarter was from short and medium tail lines. In general, reported and paid claim activity across most lines of business continued at better-than-expected levels and IBNR and ACRs remained at approximately 73% of total loss reserves at quarter-end.

The consolidated expense ratio was 30 basis points higher on a quarter-over-quarter basis due to a slight increase in the acquisition expense ratio. The operating expense ratio on a consolidated basis was unchanged as a decrease in the reinsurance segment's ratio was offset by an increase in the insurance groups. The increase in the insurance segment's operating expense ratio primarily resulted from charges of approximately $5.7 million or 80 basis points on the expense ratio for costs incurred in connection with actions that have been undertaken as part of an expense reduction initiative.

Turning to investment results in the 2008 quarter, pretax net investment income per share rose by approximately 14% on a quarter-over-quarter basis to $1.86. On a sequential basis, net investment income per share increased by 5%.

The increase in net investment income per share on a quarter-over-quarter basis was primarily due to a higher level of average investable assets. This growth resulted from the continuation of the strong cash flow from operations.

This quarter's cash flow brings total float produced since recapitalization of the Company to approximately $9.6 billion. After reflecting share repurchases and financial market turbulence which I will comment in detail in a moment, investable assets on a reported basis declined slightly to approximately $10.1 billion at September 30 and the portfolio remains very well-positioned.

Taking into account yields, realized and unrealized losses and certain investments that we account for under the equity method, the total pretax return in the portfolio excluding the effect of foreign exchange movements was a negative 2% for the third quarter of 2008. We've excluded the foreign exchange adjustments in this calculation because most of the investments in foreign securities are held as a hedge against our insurance obligations denominated in foreign currencies and for which there is a corresponding credit in earnings.

The average credit quality of the portfolio remains high at AA+ and the reported duration remained relatively short at approximately 3.4 years. The portfolio continues to be comprised primarily of high-quality fixed income securities with essentially no investments in hedge or private equity funds and no direct exposure to public equity securities. In addition we have no CLOs, no CDOs, or credit default swaps in the portfolio.

We have as we've done over the past several quarters included additional information on the ABS, MBS, and CMBS portions of the portfolio. In addition we have added a schedule of our 10 largest corporate names in our bond portfolio. We hope that this data is useful to you and I encourage you to review it.

We've also provided in the release a rough estimate of the total return of the portfolio through October 22. Please note that this estimate was derived without the benefit of our quarterly control procedures and therefore may be subject to significant variability. As I'm sure you know, credit spreads have continued to widen this month and this was the primary driver of the month to date return.

Our balance sheet remains in excellent shape and our financial flexibility remains strong with total capital amounting to approximately $4 billion at quarter-end and with debt and the hybrids representing less than 20% of total capital. The hybrids are all perpetual preferreds while our revolving credit borrowings mature in August of 2011 and our long-term bonds mature in 2034.

We began the year with a significant level of excess capital and at September 30 we continue to hold a comfortable cushion over the capital required to maintain our current ratings. Our liquidity is also at a very healthy level as cash, short-term investments and treasury and agency securities represent about 22% of investable assets.

In addition, we currently project that the fixed maturity portfolio will generate cash from income maturities and collections of approximately $400 million in the fourth quarter of 2008 and $1.5 billion in 2009. Our strong capital and liquidity positions should allow us the necessary flexibility to take advantage of insurance market and investment opportunities that may arise as a result of the chaos that continues to affect financial markets.

With respect to capital management, during the early part of the third quarter of 2008 we repurchased approximately 1.9 million common shares for consideration of $124 million which represents an average price per share of roughly $66.14. For the quarter, share repurchases net of accretion, reduced book value per share by approximately $0.40.

Since the inception of the repurchase program in the first quarter of 2007, total share repurchases have represented approximately 85% of our net income during that period. We currently have approximately $450 million remaining under our current share repurchase authorization. However, given current financial market conditions and the potential for attractive opportunities in the insurance market, we're currently taking a wait-and-see approach to further share repurchases.

In summary, for the first nine months of the year, our operating return on equity was 17.4%. Our book value per share as a result of the extreme financial market conditions declined 4% including the effects of share repurchases and 1% excluding them. And with that, we will open it up to questions.

(Operator Instructions) Joshua Shanker, Citigroup.

In terms of the first question I have is -- we are getting a lot of very positive commentary on the insurance space. In terms of allocation for 2009, when would you have to decide how much capital you want to allocate toward insurance versus reinsurance and sort of set your business mix up for the upcoming opportunities?

The opportunity is there on both sides. We see opportunities on the insurance side but also we see significant opportunities in the reinsurance side. In a time that capital is precious, reinsurance is a form of capital for some of our customers and we're going to take advantage of both opportunities.

The flexibility you get with Arch is that even though we are significant Company when it comes to management, we are a close group that we can make adjustments literally on a week or a monthly basis. So we're going to react to the opportunities and what the returns are going to be based on what we believe the better opportunity is and that's where we're going to put our capital.

Josh, one of the things -- again, go back to Dinos mentioned earlier, we haven't changed our view of the world since day one. And on day one, we believe this was a cyclical business. So we restructured the Company in a manner that we can actually -- the capital can be allocated very, very easily. There is no need to move capital among units in order to support the writings.

Okay and then the question I would have at that point is looking back at the peak of the last (inaudible) hard market I guess, let's call it second half of '04, the Company's premium surplus level was around 1.5 times. Not to say that we are predicting a revolution in the world of insurance and reinsurance here, but do you think that where you are right now but below 0.7 to one you can get up above one within a year? If the opportunities present themselves, can you deploy that capital that quickly?

Well, if the opportunities are there, yes, absolutely. At the end of the day, it has to do with what is available, how can you get it and at what prices you are going to get that business. But we have a lot of room on the balance sheet for us to take advantage of that.

Finally, I was pleasantly surprised with the results from the equity ownership of the bank loan portfolio. I must admit, I was a little worried about it going in. How is that performing? And it surprisingly did better than I thought it would. Can you talk a little bit about that?

The thing to remember about that -- and that's not to say that it's not going to be subject to the volatility we're seeing in the marketplace. But there's two components of it. One is income and then one is movements.

These are floating-rate loans, floating over LIBOR. So you've had some dramatic moves within LIBOR which has moved the income as well as the other side of the equation. And that's not to say, Josh, that in the fourth quarter we can't get some volatility on that book of business.

So you know the spread duration is shorter which helps, number one. But having said that, there could be some more volatility there. We still sort of like the underlying assets. These are secured assets so whenever your -- our view in general is which we have some direct corporate exposure which most corporates are unsecured as opposed to other forms of loans which have hard assets specifically backing them, we sort of like that equation.

Very good. Well, John, congratulations on the new move. I hope as a Senior Adviser we will be seeing plenty of you in the future.

Thank you.

Susan Spivak, Wachovia Securities.

I echo the comments, John. Glad to still be working with you. I was just hoping Dinos and John, you could give us just a little more color on what's going on with the whole -- the impact of the fall-out from AIG and some of your specific markets. Are you getting significant increases in submissions? Is it more that you're hiring the teams of people? Or just give us an update what is going on.

I don't want this call to be about AIG. I want it to be about Arch (multiple speakers)

Of course but (multiple speakers)

It's all of the above. Let me start with the business first. We have seen increased inquiries and submissions in our reinsurance business as people, they're looking for more capacity especially for January 1. That is why in my prepared remarks I was more cautious because there's a lot of time between now and January 1. So we don't know where that goes but it's encouraging.

And also we got significantly more submissions in our insurance operations. Yes, we are in discussions with underwriters and teams and they're not specific from AIG. I don't want to make this let's attack AIG. That's not what it's all about. But people in general, they're looking for opportunities and if you are a strong company -- we are -- or you are perceived to be a strong company, and we are that too, people will send their resumes to us and of course we always look to add to our capability.

The other thing that works in our favor is that we distributed and we have quite a few offices in strategic locations where some of the major competitors are having difficulty they are and it makes it easier from the perspective that some employees might come and work for us and only thing they have to do is get out of the same subway station and/or same bus and instead of going in one building, they're going across the street. So that makes it easy without relocations etc., etc.

So I feel we're well-positioned. We're not going to do it in a wholesale manner. We've got to estimate as to what the market opportunities are. But anytime I can get my hands on talent, you know, we will always do that because talent in the end is going to make you a winning company.

Right, okay. That's great, Dinos. Thank you so much for the answers.

Vinay Misquith, Credit Suisse.

John, congratulations on your move (multiple speakers)

You can't get rid of me, Vinay (multiple speakers) you can't get rid of me.

I will be happy that you're with the firm. Dinos, a question for you on the opportunities on the primary insurance versus reinsurance. First of all, some have speculated that this is more of a reinsurance hard market than a primary insurance hard market. So if you could comment on that, number one.

Number two is that the AA rated reinsurers are saying this is a flight to quality therefore business should come to us. You are a A rated reinsurer though my assumption is that you're better than that. But just in terms of the business you're getting versus the AA reinsurers, do you think it's more of a primary insurance play for you than the reinsurance play?

As I said, it's both. On the insurance side, it's not across the board. It's not yet on small accounts etc. but it is on larger accounts and specialty accounts that you don't have a lot of participants especially with some companies that they are in difficulty that they were dominant. So that's what we see and we're starting to see that on the insurance.

On reinsurance is -- we're pleasantly surprised. It's more of a capital issue for some of the insureres and they are anticipating that maybe they won't have all the capital that they will need. The capital markets, they're closed to everybody so in essence their only avenue to capital is through reinsurance and we see that.

Now the other part of your question was on ratings and I don't want to really try to diminish what the rating agencies do. I always try to keep great relationships with them. But the market is responding in an unusual way in my view on ratings. There are companies that they have higher ratings than us that their paper might not be acceptable to some companies or companies wouldn't [write excess] of them etc. where our paper even though is A across the board from AM Best, S&P and Moody's, is readily acceptable to all.

As a matter of fact, our reinsurance brokers do not hesitate to send us additional submissions because we are perceived to be a very strong carrier from a financial perspective. You know, hopefully over time the rating agencies will recognize that. But like I said, they have their hands full with a lot of other issues to be focusing on Arch.

And you know again, not to go overboard on the rating agencies, but I think recent events taught a lot of people that just looking at ratings is not really the way to go. We buy as well as sell reinsurance and I know on our committee, we just don't look at ratings. Ratings is one factor but we're going to look at a whole lot of other factors and essentially come up with our own rating in terms of who we will use when we buy reinsurance.

So I will tell you we haven't seen it. We are seeing people come to us. We are perceived as one of the stronger more stable companies so I think that -- it's more important to have that perception than to have a rating in this environment.

Fair enough and John for you on the large loss activity, if you could just give us a number on that on the primary insurance side because the accident (inaudible)

It's probably about five points in the loss ratio.

Five points and so should we look at it more of a onetime item or recurring(multiple speakers)

That's a question we always ask ourselves. You can get severity happening in any given quarter on large limit losses and the question is, is that indicative of something or is it going to quiet down in the fourth quarter? We believe it will quiet down the fourth quarter and so it shouldn't repeat itself. But we will have a better handle on that in three months.

Fair enough. One last question if I may. So it seems that business is wanting to move. Do you see a trend in terms of higher pricing too on the business that is moving?

Yes, I mean basically the market is not responding to the movement of business at the same expiring rates. As a matter of fact, that's one of the reasons that you have not seen a lot of near-term cancellations because there is a short rate penalty they have to -- the 10% on the unearned premium plus potentially a readjustment to the price because the carriers that you're going to move it to -- and it's not just only us. It's other companies that are looking for better pricing.

The combination of that caused some insureds to wait until anniversary to move their business. But you know we sensed that early on from the submission uptake on the activity. We got submission activity that is much higher. You know in a lot of our sectors in the insurance group -- and we measure that on a weekly basis to know -- it's allocation of resources and where you put emphasis. So it is at improved pricing.

Was that because that business was underpriced relative to your readings or do you think that there's now more of an opportunity so people want a better price?

It depends on your return characteristics. Our return characteristics, they're 15% ROE. So it essence we're looking to price the business with that kind of a return characteristic and as I said in my prepared remarks, we've got to also readjust now.

Cost of capital has gone up significantly and the environment that we operate is riskier, riskier from the perspective that a lot of our insureds, they are going to be under the same financial pressures that a lot of the businesses are going through. And now that reflects to is it less maintenance? If you are issuing credit products like surety or others, you've got to be more vigilant about the availability of credit and what it does to your customers.

So we're operating in a riskier environment and you have got to make adjustments. The beauty of Arch is that we still are nimble as a Company and we can deliver these messages to our underwriting staff very, very quickly and make those adjustments. Now will the market respond to our needs, that is a totally different question. Early on for me to have a definitive answer to that, hopefully by the next quarter I will have more tangible evidence.

We like the taste of what's happening. This is the buzz around it. It is not a (inaudible) that we have bound with significant rate increases in order for us to say that this is really a change. It is signs, the positive, early on we need another quarter before we know.

Matthew Heimermann, JPMorgan.

Best wishes, John. Is it you wanted to stay or you just couldn't get away?

Would you repeat that Matt?

Was it that you want to stay or you could not get away?

I think it's a combination of both. He's a lot bigger than I am.

I have a chainsaw in the garage. (multiple speakers)

I definitely -- I wanted to stay obviously. I was kidding and I'm really pleased at Dinos willing to put up with me for a few more years here.

Well hopefully we won't make it too hard on you. I had really just one question and that question was clearly when you think about the look of the Company in the past hard market, much more casually focused, the property exposure was less of an issue from a leverage perspective and it would seem if we get a broad turn that clearly those other areas you could lever up very quickly. My question is just how big of a constraint is the PML to really taking the property business forward if that is kind of the first opportunity that presents itself, particularly given what you wanted to do with the (inaudible) business already?

We have risk management principles that we're not going to violate. I never want to -- I don't really care how attractive the opportunity is that if you get it wrong you can really kill the Company. I don't think AIG would have been in the place they are today if they had a little more worry about the downside risk than just purely focusing on the upside risk.

The one major lesson that I learned when I worked for Buffett when I was at Berkshire Hathaway and he once told me he says son, spend 95% of your time worrying about the downside risk and only 5% about the up and if you do that, things will work out. So the 25% of equity rule is a very good rule for us. Models, they're not -- they have no precision that we can feel comfortable with.

So you've got to build cushion around that etc. So that -- I don't think we're going to change our posture to that. Having said that, we still are big participants in that market and within those limitations, we will try to take as much advantage of it as possible.

Given what's going on in the market, I think it's a function there of making sure we get the return opportunities within the capital [link] to allocate that giving us the best returns. I think we won't be alone in that. I think a lot of people are going to step back and say the cost of capital has gone up and I want to allocate capital I have available to this area to the best possible returns.

That's fair. I guess the one follow-up I would have to that then is that one of the factors I see as compelling to why certainly in the reinsurance and property areas of the reinsurance market that you should get increases, all the capital markets declined. I kind of wanted to ask a question about contingent capital or non-traditional capital support to you, maybe not too dissimilar to Flatiron. But how practical in this environment are those type of vehicles to assist companies like yourself in expanding your appetite without exceeding risk tolerance (multiple speakers)

If we can re-create it, we will do it. But I can tell in the (current) state where the capital markets are, we don't see an avenue to it. I'm not so sure that even cat bonds, they are going to be a relief to the need. And don't forget, the excess -- the perceived excess surplus that the industry has, it might disappear between the third and fourth quarter through mark to market adjustments. It could be in the aggregate somewhere between 50 to $100 billion of adjustments to balance sheets.

Yes, they might be temporary. But when you look -- if everybody looks at their year-end capital they have available to operate and how the rating agencies are going to look at it, there's going to be less capacity in the marketplace. And that's what we believe the 1/1 renewals I think they're going to be better renewals than a year ago.

I mean we're probably as well-positioned as anyone to do that if it was possible. We're certainly not counting on it. We think it's (difficult) given the difficulty for capital, to access capital, it's pretty unlikely that you're going to see a lot of sidecar capital come into the business.

That is what I thought. But I appreciate the color and the thought behind it. That's all I have. Thanks much guys.

Jay Gelb, Barclays Capital.

First I had a question on capital management. Should we take your commentary on share buybacks to mean that we shouldn't be modeling in any share buybacks for 2009?

If you tell me where the market is going to go, I can answer the question. If my thesis proves to be correct, the market will improve significantly. That's a good assumption. Our first preference always is to take all of our excess capital and deploy it in the business at acceptable returns. That was our thesis from the beginning.

When we are unable to do that then we said the best place for that capital is to go back to shareholders. So you know it's kind of a chicken and egg question. If I have clear vision that I can utilize that capital into and deploy it in our business at attractive returns, that's where the capital is going to go. That's what we get paid. We get paid as underwriters and if we find underwriting opportunities with good returns that's what we should be doing and we shouldn't be worrying about share repurchases.

On the other hand if the market doesn't respond in the way I would like it to and I believe it will, then we can always go back and buy shares back. So very, very hard to for us to predict the future and it's very hard. That's why we don't give guidance and that's why we can't help you with your models.

Okay and then separate issue on looking at the investment marks on page 12 and 13 of press release, can you talk about your comfort level? If I'm reading it right, CMBS portfolio (mark to) market about $0.97 cents and the asset-backed securities, the main portion of it, the autos, credit cards, rate reduction bonds, then the the other -- the sum total of that (multiple speakers) $0.97 just kind of given where we are in the market.

We talk about this all the time and we're looking at this all the time. So we're pretty comfortable with the quality where we are and we've stressed that (inaudible) most of this. Interestingly enough in October, RMBS have actually -- was one of the -- to date in October anyway, RMBS was doing much better than many other sectors of the spread market.

CMBS did come under some more pressure. But if you look at as opposed to focusing on the marks, I think one of the reasons the marks are where they are is when you look at some of the metrics behind them such as the loan to value and the subordination, you can see these securities at least the ones we have, we feel were in a pretty good shape.

The ABS for instance, we have looked at scenarios where you've got to really -- unemployment on credit cards for instance, you could double unemployment and it wouldn't have any impact even on the overcollateralization that protects you. You've got to go 3, 4x on unemployment from where we are to really impact these securities. They're short duration, they're throwing off cash and continue to throw off cash. We feel pretty good about the ABS, the MBS and the RMBS in the portfolio.

Tom Cholnoky, Goldman Sachs.

John, I guess you will be able to hit them a lot further and straighter now.

Tom, if that happens, I'll be really pleased but I'm not betting on it.

Dinos, I wanted to go back and talk to you about acquisitions and just try to get a sense how we should think about your appetite and also your ability to finance. I guess where I'm getting at is how big of an acquisition could you make? Second, as you acknowledge the capital markets are not very accommodating right now, if this were something beyond your immediate cash available -- the available cash you have, would you consider issuing stock or -- just talk a little but more in detail about that. Then also from an accretion standpoint, would something have to be accretive immediately or would you be willing to have something be not accretive right away?

Let me start by restating the obvious. You know, acquisitions is the third in order of importance in our playbook how to grow the business. Number one is organic, number two finding teams of books of business, number three is acquisitions.

Having said that, we understand our limitations. Our balance sheet is strong. It has excess capital but it's not significant to make a large acquisition. So it is small because it's just a unique opportunity, we probably can do it and pay cash. If it's larger, meaning in excess of $1 billion or $2 billion, in essence then we have to issue stock. It's got to be stock.

But having said that, in my view it has to be accretive. We will not -- we have a Company that has a very strong balance sheet with a lot of clarity to it. We've got to go through the four factors that really get us excited around acquisitions. Number one, if it fits the business model we have. Number two, its strategic meaning is in the lines of business we want to be. Number three, we can see through the balance sheet. Number four, the culture has to be similar to ours.

And at the end, we look at the price. The price has to make sense. In a market like this, you never know what opportunity might show up. We're not spending a lot of time and effort in trying to pick out acquisition opportunities. I think we're spending a lot of time and effort trying to expand our business more in the traditional fashion so organically or finding teams and enhanced products that we have in distribution and underwriting capability in the marketplace. But I wanted you all to know that if given the right opportunity, we will not take acquisitions off the table.

Are there any assets at AIG that you might be interested in?

So far, the only -- to our understanding in our sector, they only put two assets up. They're 59% (ownership) of TransAtlantic and we believe HSB (inaudible) will be coming up shortly. You know, we will look at them but it's a lot of factors. It depends -- of course (inaudible) are much better assets than TransAtlantic because of its structure etc.

TransAtlantic is a more difficult transaction because it's only 59% of the company. I'm not so sure they want to sell their whole company. It's a more complicated situation. But we will probably take a look at both.

Great, thank you.

Brian Meredith, UBS.

John, glad to hear you're sticking around for a little longer here.

Thanks Brian.

You didn't hear me Brian, a lot longer.

A lot longer, a lot longer, that's great.

If you keep bringing it up, it keeps getting longer.

Keeps getting longer and longer. Like I said, did you lose a bet with Dinos? Let's see, Dinos, question here, loss costs. If I think about the last couple of cycle turns that we' had, one of the key ingredients there was that you had an acceleration of loss costs and you had balance sheets that were overstated because reserves were obviously very deficient. I'm wondering what (role that)component that is going to have in this cycle turn and can we really get a hard market here without that component? Maybe you can refresh us on what happened in the 1970s.

Let's start with the 1970s. I was a rookie and wet behind the ears then. But I'm a student of this business so I like to understand why cycles happen and what caused them etc. There was less regulation in the insurance business in the '70s, meaning that there were different rules from a statutory point of view as to how much in equities you can hold in your investment portfolio.

A lot of companies they were caught with significant investments in equities. We had the market correction in 1973, 1974. Literally companies went to sleep writing two to one and they woke up writing four to one. So, at the same time, loss ratios, they were deteriorating.

So the balance sheets, they were viewed solid because the asbestos environmental issues, they were not yet in the horizon. But overnight the market really turned and '75, '76, '77 they were very good years in the insurance business and in my view, the market turning was because not just loss costs was going up and loss ratios were starting to inch up because the asset side of the balance sheet was remarked and a lot of capital went out.

Now today I think what you said is absolutely correct. The companies are coming all out of a hard cycle, the cycle actually starting to turn in the last probably 10 quarters or so with rate reductions, call it two and a half years. It depends by line. We're starting to see accident year loss ratios to inch up to the point that most companies barely have the ability to have adequate returns. And most companies have stated returns anywhere from 10, 12% ROE to 15% over a long period of time. And the business without a correction, it was performing in my view in the low double digit area.

So, we're having a little bit of a sign that loss cost is going up but there was excess capital and for some companies as you see with reserve releases, they were in strong reserve positions. But all that is changing for two reasons. One is that your ability for the asset side of the balance sheet to contribute significantly is not as good as it was in prior cycles because interest rates are going to be very, very low. And two, overnight in two quarters we might lose the perceived excess capital. So to me it has a lot of similarity to what happened in 1973, 1974 and what emerges as a good three years after that.

Brian, let me just add because unfortunately as I admitted earlier, I'm a lot older than he is and so I actually went through that period. But two things to keep in mind vis a vis this cycle versus the ones you're kind of used to which were driven more by horrible results rather than anything else.

One is as of the beginning of the year and I'm not sure how this is updated, but believe it or not the industry had just short of $300 billion in the stock market. So you know, that's a big number that is going to come out of capital accounts for the industry as a whole.

The second which is different and I did go through that it and Dinos hit it right on the head, it wasn't pricing per se that did it. It was purely capital. This time and this is the first time that I can remember this really happening, capital availability is severely constrained. So that in my view has an impact on how people think.

So there is the pure capacity that is represented by capital and then there is the willingness to use capacity and the fear that what happens if something goes wrong. So I'm not saying that's necessarily going to drive it but those are factors I think you have to take into account when you sort of look at the entire mosaic or what it is that changes a market.

Okay and then a last question here kind of adding onto Tom's question about M&A and then even just generally capital and the ability to get capital. What is you all's willingness to potentially tap your original founders or partners for some opportunities to your capital? Maybe that's one area you can actually get capital for an acquisition or to really ramp up growth.

I think I can speak at least for Hellman and Warburg which we know them well etc. I think they think -- I hope they still think highly of us. At least last information I have, they think highly of us. Yes, that's an avenue for us and there might be other private equity firms given the right opportunity.

So it has to do with the opportunity where we can find the capital, what the cost of that capital is going to be and what alternatives we have. And you factor all that in before you make a decision.

Mark Dwelle, RBC Capital Markets.

A lot of my questions have kind of already been covered but I had one other additional point I wanted to touch on. When you described your PML's, both of the higher risk items you mentioned were both wind related. Do you have a similar level of PML exposure to things like quake or is that a dissimilar one?

We measure a lot of different PML's. A quake PML is significantly lower than the 25% of common equity. I don't have the number right in front of me but it's probably in the 16, 17% or thereabouts.

Okay, thank you. The second question I had, several of your lines, particularly the construction, is very economically sensitive. Have you seen any I guess particular fall-off in demanded in that area just as it relates as an economic influence?

Yes, in different sectors. In the construction business, we do two things. One is we write a lot of I would say medium-sized business but for us the large accounts or larger contractors on a loss sensitive basis. In essence, they take big deductibles or big self-insure retentions for their programs. There we have not seen any reduction of opportunities.

Yes, maybe their payroll is going down a bit and maybe they have a little less activity etc. But also there is other carriers that they're having difficulty that they were in that sector and in essence for us it creates opportunities because it's not because the sector in itself is growing but the movement from one carrier to the other gives us the opportunities. Where we have seen significant reduction is on the (inaudible) contractors we write on a [surplus] lines basis.

There we have seen -- and as you can see, our casualty volume on the insurance group is down like 40% or so and some of it is coming from that because we're sensing significant reduction in work in those sectors. I'm talking about the electricians and plumbers and drywall guys etc. that you know -- if one was competitive, as of a few months ago and we didn't like the pricing, so some of it was our own underwriting posture that caused us to write less. But also we have seen less activity of that. (multiple speakers) a lot of it was relating to residential.

Ian Gutterman, Adage Capital Management.

First, I have to say I was very surprised when I read the release yesterday. I didn't think you looked a day over 63.

Thanks Ian, with friends like you --

Dinos, about the market -- all the things you said for why the markets are harder make a lot of sense and I agree with every one of them. My concern is that wounded animals don't go down without a fight and the early reports for AIG is being aggressive in places to defend their turf and when business is moving -- because of that, business is moving without price increases or at least in certain areas. So I guess my question is when we have the next call in January, what are the chances that we hear you come back and say we tried to get pricing and we need pricing but between AIG being competitive and a few of our competitors getting weak in the knees and not holding the line and just trying to take business from AIG rather than take it with a price increase, things didn't turn out the way we had hoped?

That's one of the possibilities. You know we have seen some defensive moves by some of our less fortunate competitors in trying to hold onto the business and they do it through price. But how long can you continue to do that?

If your thesis comes to be correct and there is a possibility that that is what plays out, I think the cycle will deteriorate but we will come out of it with more velocity in a shorter period of time. We never try to predict the future. It's very hard for us to predict the future.

So we gear our operations to be more responsive to the opportunities, respond to what the market gives you and if we have got to do less, so be it. We're not ashamed to report 5, 10, 15% reductions in volume if it's the right thing for us and our shareholders and if we can grow by 20, 30 or 40%, we will do that also independent if we get criticized sometimes by the rating agencies.

Do you thank you again if -- and I'm hoping it doesn't. But if that scenario plays out the way I suggested maybe it could, what is your appetite? If we're getting pricing similar today, is that worth growing given as you said what's changed with the cost of capital and the risky investment portfolios (multiple speakers)

We want to grow if we believe we are returning at least 15% return on equity. So on the capital committed, that is what we want to do. If that doesn't happen, where my share price is, I will take our excess capital and buy myself back through share repurchasing rather than trying to chase business that gives me single digit ROEs. I am not in that game.

Do you think most of your book today on an accident year basis is priced at at 15 ROE?

On average, there is some above and some below. But on average I think my book of business is around that, yes.

So to grow the book then you need pricing to go up. If pricing stays steady you'll probably stay about flat?

Yes.

Do you think that again, going back to the scenario I laid out where things don't materialize as we hope at January 1, could this be something like what we saw in property after Katrina where January 1 was disappointing but then the momentum built throughout the year as the capacity shortfall became more apparent?

Listen, I can give you -- we're trying to predict the path of a hurricane. Sometimes (multiple speakers)

Ian, if you recall -- because you were all over it back in '01 as we went into '02. It started in property and the velocity of price changes really in casualty didn't really starts to come until you got to the middle of '02 and in towards '03. It may sort of roll as you're -- it might roll by line. It's going to depend.

It depends what people feel in their pockets. You have shortage of available capital capacity. People, I don't think they're going to operate on the basis -- you see two months ago everybody was operating on the basis we have excess capital so whatever we can write is not a problem. There is not a capital issue here.

So I can write as much as I want in any sector I like. I think you're going to see more rationing now. And any time you ration those capital decisions, prices go up and you know I'm expecting that. If it doesn't happen, we'll got back to the old playbook, being conservative (multiple speakers)

In certain areas of the reinsurance business, we are seeing sort of a different mentality among the brokers. It is no longer (multiple speakers) change totally from things have to go down to things are going up. So there's other anecdotal evidence but the proof will be in the pudding and as Dinos said, we prefer to act on actual observable data rather than trying to prognosticate what is going to happen.

(inaudible) my final question where I was leading with all this is again, if we don't see things up as much as we would like in January, would it makes sense for you guys to actually go for your insurance book to start buying a lot more reinsurance knowing that it's reasonably priced right now? If you have the courage of your convictions that this market needs to harden, you go buy the reinsurance now and when things harden later in the year, you have locked in what will then be cheap reinsurance to grow your insurance book aggressively.

You're making a presumption that reinsurance -- a bunch of dumb people around. I haven't seen a lot of them. I compete with them and I think the reinsurance market has been very disciplined.

And at the end of the day, you buy reinsurance because you want to manage horizontal and vertical accumulations, not because you want an arbitrage -- I don't think there is that significant arbitrage in the reinsurance business. So if that happens of course we will -- I always want to buy things cheaper and cheaper. But that's not a big part of our strategy.

Our sense is right now that that is not what's going on in the reinsurance market.

To be honest, by arbitrage it means so much that it's poorly priced business that that's free lunch but arbitrage meaning that if this turns out to be a great market opportunity, you're going to want as much capacity as you can get and one of the ways to do that is to buy reinsurance before the pricing of reinsurance goes up a lot.

They may have a different view of what kind of returns they want and what their cost of capital is than we do. That's possible and if that is the case, then we certainly are not afraid to buy reinsurance.

Ron Bobman, Capital Returns Advisors.

Congrats. I just wanted to check, Dinos, when Buffett made that statement to you, did he start out by saying 'son'?

I don't recall exactly what he said but (multiple speakers) was 1987 or 1988. I was much younger. I was 37 and (multiple speakers) I had dark hair etc. I don't know how much you know about Mr. Buffett but he is -- for his employees, he's always -- he treats them like a father. If he likes you -- and I hope he did like me for the five years that I worked for him -- but he always gave me very, very good and solid advice. And I listened to every word he said.

I am sure it is a treasured experience. I had a question about the implications for reinsurers of a book business, primary business that was underwritten by a company in distress and sort of what are the implications for the reinsurer, the performance of that in-force book, the ongoing assumption of business for current treaties and sessions that are sort of on an ongoing basis? What are the thoughts, the practices, the limitations, the vulnerabilities to reinsurers that have that situation of a distressed ceding Company?

You always worry about -- don't forget. You know independent if you're on a pro rata or on excess of loss, at the end of the day, the performance of the claims department that is going to handle the claims from the primary insurer will determine the outcome for both you and the cedent. And usually companies when they're in distress and they start losing personnel -- so in essence the aggregate quality of that personnel diminishes -- it doesn't fare well for their book business, how it's going to perform and also if you're participating on that book as a reinsurer what portion of that loss is going to come to you. It's always a concern to us and we look at it. We audit and we try to make sure but you know in general terms, that is usually what happens.

Ron, it's part of the underwriting process to evaluate how solid the company or underwriting is. Sometimes you can protect yourself somewhat through terms and conditions, the reinsurer can structure things. But it's an important underwriting consideration when you are evaluating whether or not to reinsure someone.

In some cases it works into your favor and I have seen it on companies who actually you know went under, so they were in liquidation where if losses, they're significantly higher, particular claims significantly higher that the guarantee fund protection which stops at $300,000, the liquidator will get better settlements because of the fear that if the claimant waits out towards the end, he might get nothing versus a partial payment and I have seen that happen. But that's more rare.

If you get a company that went under and you got a $10 million claim and you don't know if there's going to be enough funds for you to get your $10 million, you might settle for five or even less just to get an early resolution to that before the money runs out. But overall it's always negative to be in that position.

How about litigation, claims that are in litigation and are obviously being reviewed I don't know by a jury or a judge? Do you think the popular press and the coverage of AIG's woes will on average result in litigation outcomes worse than they would otherwise have accomplished by virtue of (multiple speakers)

It's very hard to predict that. Don't forget. 98% of claim activity is settled. It's only a very small percentage that gets adjudicated. So I don't -- I can't talk on behalf of how juries, they will think of things. But it's not going to change the dynamics significantly.

Okay, thanks again. And John, best of luck and thanks for everything you have contributed; much appreciated.

Thank you.

Steven Labbe, Langen McAlenney.

John, I will reiterate the last comment (multiple speakers)

Thank you, thank you.

John, I will reiterate that last comment. Thank you very much and congratulations.

Thank you.

I was wondering if in your risk management committee as it relates to your own reinsurance buying if you have made any changes recently in the list of your acceptable partners.

Luckily for us we have been very, very particular in terms of that list particularly where it pertains to any kind of business that has got any kind of a tail to it. We haven't had to make any major changes.

But as I said, we have always been proactive. We have always paid more attention to all the factors surrounding a company's financial health, not just its credit rating or financial strength rating. So we haven't had to do that but we are always watching very, very carefully.

We meet every single quarter and we review everybody on the list. We have always tried to take a pretty measured approach to how much reinsurance recoverable we want from any one name regardless of how strong we perceive them to be. So we are in pretty good shape.

I know other people have taken -- some of the people you might be alluding to off their list. I mean we have seen some people not only have they come off a reinsurance list but other people won't write excess of them in an environment like this because they are afraid of the drop-down problems that when a company, that's primary, has problems and you've written excess over them it causes or can cause problems for the excess carrier. So we look at it -- we look at reinsurance, we look at who we write excess over and we try to be proactive instead of reactive.

Is there -- recognizing your earlier comments about the rating agencies, is there a minimum rating that you have regardless of again your comments earlier?

Yes, we will start with the rating but the rating won't -- you might have someone with a high rating and we might limit the amount of business we're going to do with them or not do business with them at all (multiple speakers) or the classes. Or you might -- someone else where -- and we've had instances -- I won't name names -- where the rating was fine but we looked at the balance sheet and it wasn't the right side of the balance sheet that caused us concern, it was the left side of the balance sheet that caused us concern. So we did business with them but only on the basis that we would have security.

Where we have concerns, our view has always been if we can get security, that helps us keep the portfolio diversified from a reinsurance standpoint. But we're not going -- one, we're not going to put all our eggs in one basket but we're also not going to accept people on the list for the benefit of diversity if we're not comfortable with the underlying credit.

Okay, thank you very much.

Jay Cohen, Merrill Lynch.

Well, my questions have actually been answered but I feel like I should say congratulations to John and just say you have been a great spokesman for Arch and you've done a great job as Chief Financial Officer. I think I speak for everyone when I say we have learned a heck of a lot from you over the years.

Last point I would make is I think the transition here is pretty impressive. It looks like -- I don't know John Hele very well but his credentials are quite good and I think it was managed remarkably well. So that's it.

Thank you very much and on John Hele, you can talk to some of your -- maybe your older Merrill colleagues. They might remember him because he worked there for a while.

Absolutely.

Thanks, Jay. Operator, I think we have no more questions?

Thank you. There are no more questions.

I appreciate everybody giving us the opportunity to share our thoughts with you today and we are looking forward to seeing you in three months. Have a good afternoon.

Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a great day.