Arch Capital Group Ltd (ACGL) 2009 Q2 法說會逐字稿

Good day ladies and gentlemen and welcome to the second quarter 2009 Arch Capital Group earnings conference call. My name is Carmen and I will be your coordinator for today.

At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session toward the end of conference. (Operator Instructions)

Before the Company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties.

Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that might 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 forward-looking statements in the call to be subject to the Safe Harbor created thereby.

Management also would make reference to some non-GAAP measurements for 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 with the SEC yesterday which contains the Company's earnings press release and available on the Company's website. Ladies and gentlemen, this conference being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Iordanou and Mr. John Hele. Please proceed.

Thank you Carmen. Good morning everyone and thank you for joining us today.

On an operating basis, we had a very good quarter from both an underwriting and an investment perspective. Our reported underwriting results as reflected by the combined ratio of 87.2 was satisfactory in the current environment and was aided by light cat activity and favorable reserve development.

The total return on our investment portfolio was 320 basis points for the quarter in local currencies and 389 basis points including FX movements for the quarter. We remain cautious in our investment strategy as we believe that governmental responses and stimulus packages across the globe will eventually create significant inflationary pressures.

We also remain cautious of the effects of the global recession on credit worthiness. As a result, we have kept the duration of the portfolio short at approximately three years and continue to be very conservative on the credit quality of new money invested. John, right after me, will give you more detail on our investment portfolio and performance that we achieved in the second quarter.

Our annualized return on common equity was 18.6% and our book value per share grew by an impressive $6.15 to $60.76, an 11.3% increase from March 31, 2009 and 18.3% and increase from the end of 2008. Our cash flow from operations continued to be strong at $224 million for the quarter.

Now let me comment on the performance of our two operating units. Our gross written premium and net written premiums for the quarter grew 2.8% and 1.1% to $912 million and $694 million respectively.

On a quarter over quarter basis, our insurance group was up 2.4% on gross and down 0.5% site on net. The slight decrease in net writings was attributable to a change in business mix and adjustments to the structure of certain of our reinsurance placements.

Our reinsurance group gross written premium for the quarter were up 1.9% and their net volume increased by 3.7% due to the renewal of the large two-year cat treaty. Adjusting for this transaction, their volume was down 7% as reductions in casualty and nonstandard auto lines more than offset growth in property and property cat business.

We did have many additional opportunities in the quarter as more reinsurance buyers are diversifying their reinsurance panels and gravitating to more financially secure reinsurers. The environment for our reinsurance business was actually better than we had anticipated as we have seen a significant increase in business flow.

Although it has not yet translated into many new accounts, we are in good position to see growth in our reinsurance business should we see improvement in underlying pricing. The pricing environment generally continues to improve in both the reinsurance and insurance sectors.

In the quarter, our reinsurance operations continued to decrease their exposure to casualty and nonstandard auto business. And let me remind you that in our reinsurance group, we group together all of our D&O and professional liability lines as casualty business.

Conversely, our volume in property and property cat grew. This growth is coming from both our treaty and our facultative books of business. Our outlook with regard to price levers, profitability and growth continues to be positive for these lines of business.

Our insurance group recorded growth in travel and accident, executive [assurance] and loss-sensitive large construction accounts. The D&O growth results from both rate increases and new accounts penetration while travel and accident and large construction accounts are growing because of new market opportunities we see.

The new account penetration and opportunities were primarily due to the difficulties and countered by certain of our major competitors that participate in these sectors. Our program business was basically flat for the quarter as we continue to evaluate many opportunities but rarely find acceptable ones.

We continue to be cautious on primary casualty E&S and excess casualty as well as healthcare because of our view of the absolute rate levels we see in the market. We remain in a defensive mode on surety because of the economic environment.

We are continuing to substantially reduce our aviation and onshore energy exposures as we have not yet seen appropriate rate movement. If rates in these segments improve due to the recent claims activity affecting the industry, we are prepared to change course and increase our writings.

Let me now give you a bit of flavor on how we view the rate environment. We remain of the view that the best opportunities in the cat business are US SouthEast wind with rate increases in June and July ranging from 15 to 25% on average -- and of course we like US quake.

We have deployed significant aggregates in both of these sectors. Rates in offshore energy for Gulf of Mexico exposures have grown significantly, triple digits in many cases, which allows us to continue to commit PML to that zone. However, we have continued to see significant buying resistance from our customers. Our volume in this area, although flat on a quarter over quarter basis, was less than we anticipated and projected.

On the insurance side, the rate stabilization and improvements we saw in the first quarter of '09 continue in the second quarter. This trend is spreading to more lines of business. However with the effect of the credit crisis on claims inflation and the impact of low risk-free rates on the returns for certain types of business, we continue to believe that additional rate improvement is required in some lines.

Despite the improvement in the rate environment, current economic conditions are still having a negative affect on our customers. Rate improvements, while they will produce better risk adjusted returns, will not necessarily translate into more premium revenue as exposure bases are negatively affected by reduced payrolls, sales and insure values. We have seen this manifest itself as certain insureds are purchasing less limits and retaining more risk.

As you know from our recent press release, Dave McElroy joined our US insurance operations as President of the Financial and Professional Liability Products Group. We are extremely pleased that Dave has chosen to join our management team. His executive skills and extensive specialty knowledge will further deepen Arch's already strong talent pool in the executive assurance and professional liability lines of business.

Over the long term, we expect to expand our participation in these lines through Dave's leadership. Before I turn it over to John for more commentary on our financials, let me update you on our PML aggregates.

As of July 1, 2009 our one in 250 PML from a single event expressed as a percentage of common equity was 22%. That was one percentage point below April levels and below our 25% of common equity self-imposed limitation. The reduction was directly attributable to the increase in shareholders equity, not a reduction in the PML itself.

We are pleased that our capital position remains excellent under various measures and we have enhanced our ability to benefit from opportunities in either insurance or reinsurance as they become available to us on the market. With that, I'm going to turn it over to John and right after John, we will be ready to take your questions. John?

Thank you Dinos. Let me give some more details regarding the solid quarter for both sides of balance sheet.

First of all, our shorter tail to longer tail gross written business mix moved slightly to 51%/49% from 49/51% a year ago, reflecting a gradual shift for improved rates in property cat and a lessening focus on casualty. And the same ratio in net premium written was 48%/52% from 45/55% a year ago. The net to gross mix was 76%, about the same as last year.

When comparing quarter to quarter, gross written premium in the reinsurance segment, please note two items. Number one, the impact of the renewal in the second quarter 2009 of a two-year treaty of $42 million; and number two, the quarterly effect of the 2009 non-renewal of a nonstandard auto treaty impacting written premium by $12 million.

The combined ratio of 87.2% this quarter compares to 87.1% a year ago. Favorable reserve development improved the combined ratio by 8.8 points compared to 7.8 points a year ago.

The loss ratio of 57% in the second quarter reflected 8.9 points or $62 million, a favorable development in prior-year reserves; roughly the same as the 8.8 points or $62 million recorded a year ago. The 2009 development included the commutation of a nonstandard auto treaty by our reinsurance segment that had a net favorable impact on the loss ratio of 1.4 points or $10 million.

The net benefit to earnings was $6.1 million after consideration of the profit commission. Please note that this commutation was booked in the second quarter of 2009 but will negatively impact of our cash flows by $46 million in the third quarter. Approximately 60% of the total favorable development came from medium and long tail lines from the older accident years while 70% of this total development was in the reinsurance segment.

The insurance segment loss ratio of 68.9% reflects increases in expected loss ratios as well as a higher level of large loss activity in the surety and aviation lines than in the prior period, partially offset by the favorable development of 4.5 points, no cat activity and lower loss estimates for Hurricanes Ike and Gustav of 0.8 points.

The reinsurance segment loss ratio of 39.6% reflects favorable development of 15.4 points, no cat activity, an increased shift in the mix of business to shorter tail lines and increased loss estimates for Hurricanes Ike and Gustav of 3.6 points. The total acquisition expense ratio of 17.6% increased by 0.8 points from the prior year due in part to the expiration of the Flatiron treaty and a resulting lower level of profit commissions recorded in '09 under the treaty worth about 0.7 points.

Our lower level of acquisition expenses related to prior-year development in the quarter was offset by changes in the mix of business with higher acquisition expense business replacing lower acquisition expense business. The total other operating expense ratio of 12.6% reflects an improvement of 0.4 points from the prior year due in part to a nonrecurring expense recovery in the period and continued cost control in the insurance operations.

Such items more than offset the 0.5 points of expenses incurred related to an expansion of the insurance segment's presence in the executive assurance and professional liability lines of business. We expect this initiative will negatively impact the operating expense ratio of the balance of 2009.

Net investment income of $100.5 million was down from a year ago at $117 million but up from $96 million in the first quarter. As Dinos mentioned, the second quarter net investment income represents a book yield of 4.86%, down from 4.17 in the first quarter. While the duration of the portfolio remained constant at 3.02 (years) from the first quarter, lower available yields and high-quality assets have continued to impact the portfolio.

Yields on new money investments in the second quarter averaged approximately 3.5% with an average duration of three years. More important than investment income, however, is the total returns of the investment portfolio of $10.7 billion which was 3.89% in the second quarter in US dollars and 3.2% in local currency.

This brings the year-to-date total return to the portfolio to 5.03% in US dollars and 4.46% in local currencies. We saw a strong recovery in prices of asset-backed securities in the quarter as well as with the bank loan funds, credit related impairments of $20.7 million primarily due to continued deterioration in expected recovery rates on certain residential mortgage-backed securities. Arch's CMBS portfolio comprised mainly of older ventured CMBS's has continued to perform in the quarter and we recorded no impairments.

Our CMBS portfolio is AAA and we've had no downgrades in this portfolio. As a reminder, Arch adopted FAS 115-2 and FAS 157-4 in the first quarter.

Our shareholder equity increased to $4 billion at the end of June. The common shareholders equity of $3.6 billion represents $60.76 per share.

We did not buy back any shares in the quarter under our share repurchase plan. However, we will continue to monitor our share price and depending upon the upcoming storm season and the development of the economy, we will consider share buybacks under our existing remaining authorization of $450 million on an opportunistic basis. We currently estimate that our excess capital is approximately $400 to $500 million compared to what we target for the various rating agencies.

S&P recently modified its ratings of Arch with a positive outlook. Portfolio liquidity remains strong and we experienced a solid cash flow from operations of $224 million in the second quarter. Our operating ROE was 18.6% and the increase in our book value per share was 11.3% in the quarter, very solid metrics.

That concludes my remarks and we're pleased to take questions.

(Operator Instructions) Vinay Misquith, Credit Suisse.

First question on the primary insurance. The accident year combined ratio ticked up by four points and it's now running at 104%. If you could give us a sense of whether there were any one-time items in that. Plus this quarter, you really didn't have any cats. So what do you expect for the full year combined on an accident year basis in this segment?

Your question I guess is a sequential question, quarter over quarter. The first quarter to second quarter, yes, we had two losses that they were -- an aviation loss and a loss in surety that we booked in the second quarter. So that will have an effect on the accident quarter.

But you know, your question is even broader than that because if you look at the quarter over quarter movement, we have moved our accident years up based on our belief that the industry was giving quite a bit of rate in '07 and in '08. That's the premium you're running now, most of the premium you are running is coming from of course '09 but mostly '08 at this part of the year.

And we want to continue to be strongly reserved. So we have moved our view of accident years up and we have booked that at a higher level than we did a year ago.

So it's the combination of those two. One-time events for the quarter if you look at it sequentially, the first to the second quarter. But if you look at the movement from a year ago to this year, it's mostly our view that you have got to reflect in your accident years the reduction in rates that us and the industry have experienced in '07 and '08.

So since pricing is still not improving right now, should we expect higher accident combined ratio for the second half of this year and for next year?

Well don't forget -- the pricing in some sectors is improving and also our underwriting teams, they are changing mix. We try to gravitate where we believe there is a better return. And as you saw from my commentary, there's lines of business that we are shrinking and there's some lines of business that we are growing.

In the aggregate, we are kind of flat, no real movement either on a gross or net basis. So it's not that easy to conclude that our accident year will continue to go up because we're making adjustments based on the underwriting environment.

So I don't expect the accident year to be moving significantly. It depends on the market. If the market deteriorates further, we will recognize it. If it doesn't and it improves, we will also recognize it.

You mentioned that pricing is increasing. The question is, is it increasing in excess of loss cost trends?

Clearly in some lines, yes -- property, property cat, E&S executive assurance. In some of the lines, we have increases that keep us in line with trend. And in areas that we're not, that's the areas that we are trying to reduce writings as much as we can.

Of course it's very difficult to go to nothing and maintain infrastructure and people and relationships in the market. So you try to manage your volume and the mix that you have to optimize your portfolio to get the better results. In the meantime, you'd be a fool not to recognize and reserve the company appropriately by moving up the accident years.

Fair enough. Second question, if I may. On the construction business, if you could just give us some details as to what sort of business, what sort of new business you are writing there?

This is no different than what we mentioned in the past. Most of our construction business is made to larger accounts that -- they buy a lot of service from us and the coverage they buy is their GL, auto and workers comp primary program and they are maintaining a significant portion of that as self-insurance, maybe $250,000 each and every loss, maybe $0.5 million each and every loss.

So in essence, our underwriting is for the gap to get to $1 million but predominantly we are providing a lot of the services that come with the large accounts business that is loss sensitive. So the choice of some of these customers to come to us is because we're a very financially secure company and also we have a lot of expertise specialization which is critical to them as to how you manage their claims.

Because they're paying 90% of the cost on the claim. So -- and we want to grow that business. It's a national accounts business and also in the large construction accounts. That's where we see the growth.

So would it be fair to say that most of the risk is -- [that if it] lower risk business and most of the income comes from fee income from the source?

Well it's a combination. You take some risk on what we call the excess, the $0.5 million extra half or the 750, extra 250. Sometimes we reinsure a portion of it, sometimes we retain it depending what kind of pricing we get. And of course you get property and administration for administering their loss-sensitive portion of the program which is the bottom part.

Thank you for your answers.

Jay Gelb, Barclays Capital.

Dinos, can you talk about the new teams you have brought on board and what the opportunity is?

Well you call it a new team. We hire Dave. I've known Dave for a lot of years as a competitor. He's in my view one of the best executives in these professional liabilities D&O lines of business. We are always looking to improve talent.

My goal is to be hiring guys that are better than me and I've been looking lucky over the last 10 years. I hire a lot of them that are better than me.

So we hired Dave and he's building a bigger team. Don't forget, we were in that business and we have great guys already and you have seen seven, eight years of great performance from Arch on our D&O professional liability.

This is an opportunity for us to expand further. So I will leave it up to him. He is a senior executive, the size and scope of how big it's going to be is going to be -- of course with the holding company approval but it's up to him and Mark Lyons and the rest of the senior executives in the insurance group.

Every time we get an opportunity to get what we call world class talent, we will go out and do it, independent if the premium revenue will come immediately or over a long period of time. This is an investment in the future and we saw the opportunity, we took advantage.

Separately, can you talk about the opportunity to take profitable market share from some of the stressed competitors out there? Is it accelerating, is it stabilizing, is it decelerating?

Clearly, when you look at it from a submission activity flow of business, it has been significant to us both on the insurance and reinsurance sector, probably in the range of depending by product line 15 to 20% more flow of opportunities. We haven't translated that into a lot of premium revenue.

And that has a lot to do with the market, where it is. The market is not horrible but it's not robust that you can say hey, this is the time that I want to grow 10, 15, 20%.

The opportunities are there. We're seeing them, selectively we're picking our spots. But as I said, we've seen a lot on the reinsurance side and we chose to pass.

We just didn't like the rating environment in some of the opportunities. And likewise on the insurance group, I mean I like to grow my program business. But we look at 100 a year or maybe we do one or two in that.

So, you -- we're working on guys hard but they know the benefit of if they work hard -- but we make good decisions. At some point in time, we are going to benefit from the right revenue coming through. We're not a top line focused company. We're focused mostly on the bottom line.

Matthew Heimermann, JPMorgan.

A couple questions, if I may. First, could you quantify the aviation and surety loss just so we can see what the stripped down number is?

The surety loss, it was I think high single digit and the aviation, a little less than that on a net basis. So --

So maybe 10 to $15 million in total?

A little more than that.

The other question -- another question I had was can you talk a little bit about the structural changes to the reinsurance program that impacted property, marine in the quarter?

On the -- in the insurance group you mean, or --?

Yes, in the insurance segment; just some of the changes to your (inaudible) reinsurance.

We switched some quota share to excess of loss, so that will play with your net to gross relationships. But on how much would buy for protection, that hasn't changed significantly.

We like to have somewhere around $100 million of net retention per event on the insurance group and we buy protection all the way up to the 250 year event. So we don't have the potential of cycling over between. But the structure we changed a bit.

And then you mentioned that there was slight changes to Ike and Gustav estimates. Can you just give us where the total loss estimate stands today and how that contrasts with year end?

It was minor. I'll have John look it up and he will give you numbers. I think it was down a little bit on the insurance group and it was up on the reinsurance. But we have the numbers with. John (multiple speakers)

I'll ask the last one while we're here looking for that which is just with respect to general expenses overall -- and obviously you have had a number of things you have been using to help manage costs as the business volumes obviously for the whole industry have dissipated the last couple of years.

Have most of those gains come from just office relocation and things like that or --? I guess what I'm really curious to is how significant staffing levels really -- any changes have been there because I know you've been adding people in places but I would just be curious (multiple speakers) what's happening.

Net net, we haven't really -- we added people recently; probably around 60, 65 people. But we have taken out about 50 people a year ago. And also as we spoke in prior calls, we did make movements into lower costs jurisdictions.

We made a major move with a lot of people from Manhattan going to Jersey City. We put a claims center in Nebraska. We put a processing underwriting center in the Twin Cities -- Minneapolis, St. Paul.

So we have looked around to make the insurance group more efficient both from infrastructure but also personnel. And we will continue to manage the company in that fashion. If we have volume opportunities, we will grow staff. And if there is no volume opportunities, we will manage.

We try to do it by managing quietly through attrition. A good run company, you don't have to go through layoffs to manage your personnel needs.

Our turnover ratio on the insurance group is a little below the industry. The industry average I think is about 15%, ours about 12%. But 12% on 1000 people is 120 people a year and basically if you selectively -- it's not going to -- all your attrition is not going to come in the right places.

But selectively maybe half of it you might not have to replenish and you can make reassignments. So you can manage effectively and we hold our managers responsible in managing revenue and expense and we have an expectation for them to manage that.

This is John. I've got the numbers here. The total we've got at the end of June now is $306 million for Gustav and Ike, split $212 million in reinsurance and $94 million in insurance.

Brian Meredith, UBS.

Couple of questions here for you. First on the reinsurance sector, Dinos. I'm just kind of curious why we haven't seen [in that] the accident year loss ratio ex cat start trend downward as you moved more into property, property cat, more volatile lines of business where you historically see lower run rate loss ratios.

Well, we we book what we believe are -- it's a proper accident year. And don't forget, our cat load -- and [attritional] you might be different than some of the companies. As you have seen over the years, probably the last four or five years; early on, all of our reserve, positive reserve development came from the cat lines and it continues to come from the cat lines.

It's how we believe the cat business should be booked. We have -- what we believe the attritional loss ratio should be, we reevaluate that, we do studies once a year to make sure that we get that right.

And also we factor in, based on the latest models and all that, what's an expected cat load should be and that's the way we book it. And if we are -- the good thing about the cat business is you don't need a lot of actuaries eventually to tell you what your numbers are.

Within a year or two, you know. And if we got it wrong, we adjust it. So far we've been adjusting it downwards consistently and I like that, the taste of that instead of having to adjust it upwards consistently.

Is part of it possibly that the casualty loss ratios are heading up so it's kind of offsetting the (multiple speakers)

Well there is quite a bit of that. I think we have moved, depending on the line, accident year, loss ratios between the insurance and reinsurance group on some lines, anywhere from five to seven points and this is quarter over quarter, not sequential, but year-over-year. And that's what we are factoring in, rate reductions that we see in the marketplace.

John, quick question on the investment portfolio. I noticed a big slug of RMBS securities, non-agency RMBS securities hit this quarter. Is that the TALF program?

No, you noticed more RMBSs.

Yes, I believe there was non-agency RMBS, some '09 vintage. [I thought I saw that] in the supplement.

We have increased a slight bit there, but it's not (multiple speakers) also, prices have recovered a lot too.

It might be more of the price recovery but you know (multiple speakers)

Well there wasn't any in the first quarter supplement. That's why I'm asking (multiple speakers) '09 vintage, non-agency -- I guess it says MBS which I assume is your RMBS and you got $45.5 million of these and there wasn't any in the first quarter supplement.

We've been -- 2009, $45 million (inaudible) right but they are all AAA and they're shorter duration pieces that we're picking up that we saw as having some good value. TALF, we're hoping to participate but it would flow through this quarter and it's pretty small to date.

(inaudible) TALF, we have done I think four deals so far, roughly a little over $5 million of equity and the leverage was a little less than eight to one on average. We have done -- I think we got a CMBS deal, we did a credit card deal, we did an auto, motorcycle and a credit card deal.

Jay Cohen, Bank of America-Merrill Lynch.

Most of my questions have been answered. A couple of questions. I guess on the --

If most were answered, why have you got a couple?

I always have questions. I struggle to understand this industry on a daily basis.

So do I and I have been in it for 35 years.

You talked about the large account business on the construction side and some of this having a high self-insured retention. I guess I assumed to do that business, you need to have sort of a big claims infrastructure to manage that business through and my assumption for you guys is you don't have a big claims infrastructure, that you had outsourced a fair amount of this, whether it's Gallagher Bassett or others. And I'm wondering is that wrong and what has changed and why this business is attractive to you.

Well, it's absolutely -- you're absolutely correct. Our business model was not to build a huge claims adjusting staff and rent that. For this particular sector -- and we use Gallagher Bassett asset almost exclusively because we work together as two organizations, our underwriting folks with a lot of expertise and Gallagher Bassett's claims services, that they do have a lot of expertise in the construction segment.

And basically it's that combination that gives the comfort to our joint customers that they will get good claims service from very knowledgeable claim examiners. All of our business, in national accounts and construction, is done on what we call unbundled basis.

So when we sit down with a customer, we agree on the claims service and the provider and also we agree on the risk management services and the provider. Because sometimes we go outside to provide risk engineering services that you know -- it gives both us comfort because we are working with partners that we have a long-standing relationship and it gives comfort to the customers. Because they're comfortable with the service and the activity and they have a say in it because they're paying for that provider.

We pass through the cost. So they have a say as to do they want to ratchet up the Gallagher Bassett services or do they want to ratchet down and they pay for it.

So then I assume you wouldn't make a lot of money on sort of the claims services. That's just sort of -- you just pass along the cost but you don't (multiple speakers) have an extra margin there?

Right, the margin is on our profit and administration for -- and utilizing our admitted paper so they don't have to go and qualify themselves as self-insurers and have to do all the posting notices for workers comp or register all their trucks, their transportation vehicles etc.

That makes sense. And then secondly, I think on the reinsurance side, you talked about reducing premiums in the nonstandard auto business. I thought that business was doing pretty well industrywide. I'm wondering what about that business was less attractive to you.

It's nothing less attractive. We didn't say we're going to do it permanently. I will take you back a little bit in history.

You remember, we own a company called American independent which it was a non- standard auto company. I sold the company about five years ago because it was not core to what we do.

We had maintained a reinsurance arrangement with them that contractually they had to buy reinsurance, they had to buy it from us assuming that we agreed on terms. We had the right of first refusal and we continued to provide a lot of support through the reinsurance treaty and it was significant to us.

It was $80 million annually and it came down to $60 million and a little less in the last year. As terms and conditions deteriorated, we chose not to renew -- and it doesn't mean that the underlying business is not performing well.

It's that the reinsurance terms that they were willing to give us the premium were not acceptable to us. So it was not a partnership that if they made a dollar, we made a dollar and if they lose a dollar, we lose a dollar.

It was a little bit skewed to their favor and we just didn't like that arrangement and we ended it. If we find other opportunities in the marketplace that the economics work for us, we will be in that line of business.

Got it. I guess last point. I guess I did have more than a couple questions, sorry. On the capital standpoint, you obviously slowed the buyback program as many did.

It seems hard to imagine you guys not buying back some stock. In our view, we're not going to see a dramatic cycle turn here. I can't see top line growth accelerating too dramatically. It sounds as if you could generate a fair amount of excess capital in addition to what you already have.

But we've got the season coming, right? And my authorization is perpetual and why be ahead of myself? Listen, if there is an opportunity because some event happens, all the traders go on and they get drunk one night and share prices collapse significantly, as John said, we will buy very opportunistically.

But we're going to reevaluate that based on how we're going to see the market, what -- as we get get closer, right after the hurricane season, you get closer to year end, you've got a better view of what you anticipate to happen in January 1, we will reevaluate what our capital position is and we can make those decisions and I don't anticipate a lot of activity in the third quarter but stay tuned for the fourth quarter.

Great. Thanks for answers.

Next time, Jay tells me I have a lot of questions, maybe it will be only one or two.

Ian Gutterman, Adage Capital.

I never thought I'd get on with all of Jay's questions. I guess my first question is on McElroy's team, I guess really a couple of questions about that group.

Can you tell me a little bit more? I guess when I look at the numbers, your professional liability and executive assurance combined is about a quarter of your insurance book. And I assume you don't hire a whole big group of people to just grow it a little bit.

So is that going growing at 35, 40, 50% of your insurance book over time? If so, where is it growing?

Is this just the same types of business you are doing today and just more share within those arenas? Or are you looking to get into different parts of professional liability that maybe you didn't do as much before? Can you just tell me a little bit more about the strategy because it seems pretty --

Well it's getting bigger in what we already do. Maybe with a couple of new products that there is expertise that is coming with Dave and some of the people he's hiring. But this is a long-term play.

Let me give you the macro view here. The big players in D&O where -- and they still are, AIG, Chubb and XL and then after that, Travelers and Hartford. Some of these companies, they had issues. So in essence, there might be an opportunity for a new player to emerge as one of the top five all the time. We're not saying it's going to happen tomorrow or next week or next month or the next quarter.

So we saw that opportunity. Likewise I can give the same speech on the professional liability line. Now in this business, you don't get talent when you want it. It's -- only my wife finds all the clothes she wants because she goes into Bloomingdale's with my checkbook and then she gets anything she wants.

In this business, you have to get talent when it's available and often enough you are not going to find the talent at the most opportune time. But like I said before, we like to always focus on getting very good people to be part of our team, independent if it might cost us in the short run a couple of -- maybe a point of expenses etc.

Because these kind of initiatives for us, we view with a ten-year lens, not a quarter or annual or two-year lens. So if they told me [he] was interested to come and work for us for a year or two or three, I wouldn't have any conversations.

When Dave says I want to be part of your management team and I says this is not quite like the old AIG that you had to be permanent forever but I says you got to be at least 10 years and he said yes. Then, we had the right guy.

That's fair and to be honest, I'm not really concerned about the short-term expense this year. I guess I'm just trying to understand longer-term where you're going with this business and my sense was you were kind of writing more niche type stuff in professional liability and not the sort of business that the AIG (inaudible) and XL were targeting. So I was wondering if this meant you're broadening your appetite to compete in those areas.

Well it will broaden our appetite but also the market has got to give us proper rates. Broadening our appetite doesn't mean we're going to lose our underwriting discipline.

Okay, because I guess that was my last question on it is -- and I understand what you're saying about being patient. But on the other hand, professional liability does not seem like an area you're lacking for capacity right now.

Pricing arguably isn't going up as much as it should because it seems everyone is hiring a team to go write more professional liability. So I'm just wondering, do you agree with that? Is Dave's team just going to be sitting on their hands for a year because the opportunity is not there or do you disagree with that and think that maybe there's more opportunity or more lack of capacity than I perceive?

We see more opportunity on the D&O area than in the professional liability area and if Dave was on this call, (he) will tell you exactly the same. We are patient. At the end of the day, I don't know how many -- I say that to my Board all the way to every person who follows this company. And somehow even though we have demonstrated that's what we have for seven years, a lot of times people just don't believe it.

But I'm willing to warehouse talent for a year or two or three because I agree with your premise. Some of the larger accounts, professional liability business today is not attractive and we are not going to be aggressively going after it.

Having said that, we're still going to be looking for niche business. And once you have talent, you're going to find things to do, maybe not to the size that you would like to, but you're going to find profitable things to do in the marketplace.

And that combination of patience and willingness to take a little bit more of an expense hit for a year or two I think it would work to our advantage over a long period time. Our growth will be better than the industry over a ten-year period of time but it's going to come very lumpy.

You heard my speech before. Some years, we're going to be shrinking, some years we're going to be flat. And when we believe the market is extremely good, that's when you're going to see hyper growth out of us.

But in order to do that, you have got to have -- and I don't want to embarrass my people but I'm going to use the expression anyway. You've got to have the horses in the barn to do it. You can't run the race unless you have the horses.

Very good. Makes sense. Thanks Dinos.

David Samra, Artisan Partners.

Most of my questions have been answered. I have got just a couple quick financial questions. The currency loss through the P&L, is that mainly due to depreciation of the pound? Is that what caused that big loss?

Yes, it's mainly the pound.

And bit the euro.

A bit the euro but (multiple speakers)

But not -- mostly the pound.

Just getting back to a capital question that was asked earlier. If I go back in history over the last couple of years and I look at your shareholders equity, you're basically back up to peak levels that you hit sort of at the end of 2007 and in the meantime obviously premiums have sort of trailed off over that time period.

When you look at your capital position sort of putting aside any estimates that you may or may not have regarding your reserve position, but when you look at the capital position today and the excess capital that you have, are we at this point in the strongest position in terms of capital than we have been in the past?

I think we're reaching that point, that we might be at the highest. But don't forget, we have an aspiration for our rating to improve. We believe we already deserve it and we are starting to get indications that we are moving in that direction.

We always maintain excess capital even above what the rating agencies will require us for the ratings that they give us because we like to be conservative from a capital point of view. And then on top of it, we might have a bit excess.

The numbers that John shared with you is above even the cushion that we have. And if we don't believe we can deploy that capital in the business, either insurance or reinsurance, at some point in time it has to go back to shareholders and we will find a way to get it back -- share purchases, extraordinary dividend, whatever is the appropriate way to do it. Because we have that strong belief that excess capital belongs to shareholders, not to management to warehouses.

It's interesting -- I've been as you know following the company for a long time. And aside from a few extreme points in time where the share price relative to book value has been a little bit cheaper than where it is today. But today presumably with a lot of information out there, the price-to-book without any sort of extreme impact to the market is relatively low at a point in time where you have got probably your best capital position.

I just noted it as sort of an interesting juxtaposition just because if we're really going to wait through the hurricane season, we might not have the luxury of what we have today. Just a note.

Well maybe you can predict the future better than we can. I don't know where the market is going to go, I understand. Listen, we run the company focusing 98% of our activities on the underwriting, underwriting risk we take and the balance sheet to make sure that it's secure, the what-if scenarios from a risk management perspective. I don't watch the stock price on a daily basis. I'm not focused on that.

Maybe I should but at the end of the day, if we move book value per share consistently over the years, eventually we're going to get the proper valuation. I don't know where that is.

And for patient investors and we like to believe that most of our investors, they are patient with us, they're not trading in and out of the stock, that is what they would like us to do and that is what we are focusing our energies to do.

It's just interesting that the premium that the company deserves and has for most time periods -- this is what I'm trying to point out -- for most time periods, the company has always had their premium and today it looks like for whatever reason maybe the underwriting cycle is my guess, that the premium has sort of come off the share price. So, thank you for your time and taking my questions.

Steve Tabb (inaudible)

I see that the book value went up quite a bit more than the net earnings. The book value in the quarter went up $6.15 and net earnings were $2.43. That leaves $3.72 and is that primarily in the value of the assets owned by the company, the bonds, etc.?

That is correct. It was a recovery on the asset side.

That was quite a good recovery there. The other thing is you took quite a hit on the foreign exchange as a lot of other companies have in various industries. How is it working out do you see it this year and compared to what you're going to have from a year ago a quarter?

You've got to understand our strategy on -- we don't make any bets on foreign exchange. What we like to do as an insurance company is to make sure that our assets and liabilities, that we have -- they match and they match the currency that we're exposed to.

So for euro-denominated liabilities, we maintain euro-denominated assets and for British pound liabilities, we have British pounds. And basically that's almost kind of a natural hedge as long as you are maintaining your assets to your outstanding reserves and those reserves, they're accurate, you have a natural hedge.

And when it goes through the balance sheet, some of it you get the benefit on the asset side and the other one goes through the income statement. But at the end of the day when you look at it totality, one offsets the other.

Steve, so in the P&L, the liabilities move through the income statement whereas on the asset side, with a 3.89% return in the quarter in local -- in US dollars but 3.2% in local currency. So you can see how it's impacting both sides of the balance sheet.

My question was how does it look for this coming quarter?

The quarter just started. We don't focus to try to see currency movements.

Because they basically match.

Right. What we focus on is to make sure that we are properly matched, our liabilities and the assets we carry, they are on the same currency.

My last question is, I'm an investment advisor and own the stocks along with my clients. So my accent on dividends might be a little different. But I was wondering what the company's attitude is toward the dividend and dividend increases?

We have not paid dividends because our belief is that ordinary dividends, it's not a capital management tool on a capital intensive business like the insurance business. If you want to manage your capital, I think you can manage it if you have excess by using other tools to return it, either share buybacks depending where your share price trades. Or if you believe you're getting increasing value on the shares as they're trading, then you can do an extraordinary dividend.

Having said that, we do get calls. There's a lot of investors that they would like us to introduce an ordinary dividend. That question comes up in Board discussions. But so far, we haven't decided to introduce that because at the end of the day, it's not really an effective capital management tool for an insurance company.

I voice disagreement with it and especially with the new income tax rates on dividends the last couple of years. But I think it's -- some dividends should be paid. But thank you for your answers.

You're quite welcome.

Mark Serafin, Citidel.

It's Dan Johnson and Mark. Just a couple of questions please. On the nonstandard business that was wrapped up, what should we be thinking about that in terms of top line implications going forward for the next couple of quarters? And then I've got a follow-up to that.

Basically I think John gave you the numbers. It affects -- the year-over-year I think is about $12 million a quarter.

And then it's going to grind down about $15 million or so over the next couple of quarters. Then it's gone at the end of this year (multiple speakers)

We got two more quarters and it's done. That was a -- well it's not totally gone (inaudible) because you've got some APRP adjustments but it's going to be miniscule. It's bread crumbs off the table. Think about it third and fourth quarter and it's done.

The treaty that was just commuted now? Why doesn't it have an impact for the next four quarters? I must be missing something.

Well don't forget, we have commute -- don't forget, we didn't renew this treaty on January.

So this is (multiple speakers)

So it's only the comparisons from a year ago to now. So the premiums that were in last year's numbers --

Are not here.

And they're not here this year and they weren't in the first quarter, they weren't in the second and they will not be in the third and fourth. The commutation doesn't affect the year-over-year comparisons.

Commutation was -- here is the reserves we carry. We will give you discounted net cash and then you relieve us of all future liabilities and that's what a commutation is and we achieve that and we were carrying more reserves than we commuted. That's why we had a reserve takedown.

Great and on -- the second question is your outlook for the duration of the portfolio which you I believe brought down at the end of last year. What does your crystal ball say about what you want to do with that going forward?

I don't think we're moving the duration. It's been around three years, the first and second quarter. We were at 3.6 years in the fourth quarter (2008) and we made that adjustment and we brought it down.

And I think we're comfortable where we are now. You know our philosophy, Dan. We match liability duration, the reserves, and then we move up and down on shareholders equity and our shareholders equity is close to maybe -- I don't know -- six month duration or thereabouts.

What we bought in the quarter had an average duration of about three years.

Sort of a real-time question, what sort of yield is the market offering with your desired sort of AA credit quality and a three-year duration?

We got about 3.5% in the second quarter. I don't think this month there's -- that's significantly different. You've seen spreads up and down here and there. But on average, we're buying it (at 3.5%).

We kind of need the reference rate and/or maybe even spreads to open up a bit to get the sort of new money rate up to the average I guess would be another way to put it.

Right.

In order to actually grow the yield, we've got to get the reference rates up. Okay, last one then.

You make reference to the excise taxes paid and I'm sorry, I didn't have a chance to see if you had that in the prior quarter. But what was the thought in putting that into the press release? It's a reasonably small amount of money and not much of a change year over year?

It's more disclosure. I believe (multiple speakers) prior quarters, it's not a -- I think we had a few people who asked how much was it and we just decided to disclose it. It's not material.

I won't spend anymore time on that. Finally, the expense discussion, just want to try to flesh that out a touch more. You said the expense ratio will be going up in the near future.

I forgot the exact verbiage in the press release. But can you try to give us a better sense as to what you're thinking about in terms of dollar uplift there? Because obviously it's going to depend somewhat on what happens to the top line since you gave us more of a ratio comment than a dollar (multiple speakers)

That's why it's difficult to estimate that. But an easy calculation is just if you have 60 people and they're costing you approximately, all in, a couple hundred thousand on an annual basis each, you know what the number is. It's -- between salary, benefits, rent, equipment and all that, our average cost is about $200,000 a person and you can do the calculations.

Thanks for taking my questions.

You're quite welcome.

We have no further questions at this time. I would now like to turn the call back over to management for closing remarks.

Thank you everybody for being patient with us. We went a little over time today. We're not going to get paid overtime. But we're looking forward to seeing you and talking to you next quarter. Have a good day.