Arch Capital Group Ltd (ACGL) 2014 Q3 法說會逐字稿

Good day ladies and gentlemen. And welcome to the third quarter 2014 Arch Capital Group earnings conference call. Before the Company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on the call may contain forward-looking statements under the Federal Securities laws. These statements are based upon management's current assessments and assumptions, and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports filed that are by the Company with the SEC from time to time.

Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the Company's current report on Form 8-K furnished to the SEC yesterday, which contains the Company's earnings press release, and is available on the Company's website. At this time all participants are in a listen-only mode. Later we will facilitate a question and answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes. I turn the call over to your hosts for today, Dinos Iordanou and Mark Lyons. Gentlemen, you may begin.

Thank you Francis. Good morning everyone, and thank you for joining us today. We had another excellent quarter with all of our units performing well from an underwriting perspective. Earnings were solid and were driven by excellent reported underwriting results. Our premium revenue grew by 2.5% on a net basis for the third quarter 2014 over the same period in 2013. Growth in insurance and mortgage business more than offset a decline in reinsurance net writings. On an operating basis we earned $1.05 per share for the quarter, which produced an annualized return on equity of approximately 10% for the 2014 third quarter, versus a 12% return on an operating basis in the third quarter of 2013. On a net income basis, Arch earned $1.64 per share this quarter, which corresponds to an annualized return of 15%, as foreign exchange and realized gains enhance our net results. Our reported underwriting results in the third quarter were excellent as reflected by a combined ratio of 88%, and we are rated by a low level of catastrophic losses, and favorable prior year loss reserve development. Net investment income per share on a sequential basis was flat in the quarter at $0.53 per share. Our operating cash flow for the quarter was $319 million comparing very favorably to $238 million in the same period last year. The total return of the investment portfolio was a negative 51 basis points for the quarter, inclusive of fluctuations in foreign exchange rates, and 21 basis points in local currency terms. Our book value per common share at September 30, 2014 was essentially flat at $44.04 per share, increasing by 0.7% sequentially, and 15% relative to the third quarter of 2013. In the quarter, we reinstituted our open market share repurchases, and spent $252 million in the third quarter. In addition, we have spent an additional $89 million from October 1 through October 29, for a total of $341 million for the last four months. The insurance segments grew as written premium grew by 6.4%, and net written premium grew by 7.4%. The growth emanated from the following divisions, Programs, travel and accident, E&S binding authority, and construction and national accounts business. Most of our organic growth is coming from small accounts with low limits, which should have lower volatility. On the other hand, competitive conditions in the property sector had negatively effective primary property rates, and accordingly our premium volume in those lines. In the primary markets in which our insurance group participates, we continue to obtain rate increases in most lines of business. Albeit slightly below the levels that we observed last quarter. Mark will give you more color on this later on. On the reinsurance side of the business, we have seen a continuation of softening in terms and conditions that we noted in prior quarters. From a production point of view, net written premium was down 16% in the quarter for the reinsurance group, primarily as a result of a nonrecurring large unearned premium portfolio, which as we described in a prior call was booked in 2013, and is not recurring in 2014. Gross premiums rose in the reinsurance segment by nearly 5%, with the growth in the segment arising from business we produced for Watford Re. Adjusting for the reduction of the unearned premium portfolio from last year and the business produced for Watford Re, reinsurance premiums would have declined by approximately 6% in the quarter if you compare like quarter-to-quarter. Our mortgage segment includes primary mortgage insurance written through Arch MI in the United States and reinsurance treaties covering mortgage risk, which is written globally including the US, as well as other risk bearing and structured mortgage businesses. As you may recall, our mortgage insurance business in the US serves two major markets, credit unions and banks and other mortgage lenders. Net written premium for the third quarter of 2014 was approximately $58 million, of which $32 million was written by Arch MI US, who tenders to the credit unions, banks, and other mortgage lenders. As we discussed in prior culls, Arch MI has a dominant position in the credit union sector, and is in the process of building out its client base with bank lenders. This past quarter a substantial amount of the growth came from single paid premiums. These are loans where the mortgage insurance premium is paid up front. As of today, we have approved more than 400 master policy applications from banks, and more than 100 of these banks have submitted loans for our approval. Of these approvals, 29 represent national accounts, and the balance are regional banks. We define national accounts as the Top 100 producers of mortgages. Of the Top 25 originators, we have approvals from 15 of them. Group-wide on an expected basis we believe the ROE on the business we underwrote this year will produce an underwriting year ROE in the range of 10% to 12%. As on a present value basis improvements in the insurance group, and the addition of the mortgage segment were more than offset by lower expected returns in the reinsurance segment. Before I turn it over to Mark, I would like to discuss our PMLs, as usual I would like to point out that our cap PML aggregates reflect business bound through October 1, while the premium numbers included in our financial statements are through September 30, and that the PMLs are reflected net of all reinsurance and retro sessions. As of October 1, 2014 our largest 250-year PMLs for a single event decreased slightly in the Northeast to $658 million, or 11% of common shareholders' equity, while Gulf PMLs also decreased slightly to $608 million, a Florida Tri-county PML new stands at $451 million. I will now turn it over to Mark to comment further on our financial results, and as customary as Mark concludes his remarks we will take your questions. Mark.

Thank you Dinos. And good morning. Before we get started I would like to just say a few words to define how I'm going speak about things for the balance of the call, so just bear with me on this. First is a reminder, the financial supplement shows consolidated financial statements that include our other segment, which is Watford Re, as well as providing other financials that excludes the other segment, and those are footnoted as such on each page of the supplement. Furthermore within the segment information of the supplement, we have provided a sub-total of Arch's core segments, that is insurance, reinsurance, and mortgage, without Watford Re, and also separately provided Watford Re's results posted alongside, in order to arrive at an Arch consolidated segment income statement view. The investment information section of the supplement however is completely shown excluding the other segment.

My comments to follow today are on a pure Arch basis, which excludes the other segment unless otherwise noted. For further clarity, although today's discussion will exclude Watford results as a segment. However, when Watford is used as a reinsurer by any one of our core segments, those sessions are reflected in Arch's underwriting results. Furthermore, since the definition of the word consolidated includes the results of Watford, I will not be using the term consolidated. Instead, just be aware that my comments refer to our core segments of business, insurance, reinsurance and mortgage combined as just discussed. This permits an apples-to-apples comparison with Arch's results a year ago.

Moving on with that defined, the combined ratio for this quarter was 88.5% with 1.6 points of current accident year cat related events, net of reinsurance and reinstatement premiums, compared to the 2013 third quarter combined ratio of 86.1%, which reflected 2.5 points of cat related events. Losses from 2014 catastrophic events net of reinsurance recoverables and reinstatement premiums totaled $14.2 million, primarily emanating from European storm Ella and Midwestern US tornado activity. The 2014 third quarter combined ratio also reflected 8 points even of prior year net favorable development net of reinsurance and related acquisition expenses, compared to 8.2 points of prior period favorable development on the same basis in the 2013 third quarter. This results in a 94.9% current accident year combined ratio excluding cats for the third quarter of 2014, compared to 91.8% active quarter combined ratio in the third quarter of 2013. In the insurance segment the 2014 accident quarter combined ratio excluding cats was 98% even, compared to an accident quarter combined ratio of 97.1% a year ago. This increase was primarily attributable to certain large attritional losses emanating from the European operations, in particular mostly from the aviation war line of business. These large attritional losses account for 170 basis points more of net earned premiums in the third quarter of 2014 than our large attritional losses in the corresponding quarter of 2013. The reinsurance segment 2014 accident quarter combined ratio excluding cats was 90.6%, compared to 94.8% in the 2013 third quarter, but represents a sequential improvement from the 92.1% combined ratio last quarter. As noted in prior quarters, the reinsurance segments results reflect changes in the mix of premiums earned, including a lower contribution from property catastrophe business. The insurance segment accounts this quarter for roughly 16% of the total favorable development excluding the associated impact on acquisition expenses, and this was primarily driven by shorter tailed lines from the 2006 through 2012 accident years.

The reinsurance segment accounts for approximately 83% of the total favorable development in the 2014 third quarter, again also excluding the associated impact on acquisition expenses. With approximately 40% of that due to net favorable development on shorter tailed lines concentrated in the more recent underwriting years, roughly 8% was attributable to medium tailed lines based throughout many underwriting years, and about 49% due to net favorable development on longer tailed lines primarily from the 2002 through 2010 underwriting years.

The mortgage segment accounted for approximately 1% of the total favorable development in the quarter, stemming mainly from our US primary operation concentrated in 2009 and prior. As has been consistent in the past, approximately 69% of our core $7.2 billion of total net reserves for losses and LAE are IBNR or additional case reserves, which as I have mentioned, has been consistent across time and across the main reinsurance and insurance segments. Expense ratio for the third quarter of 2014 was 33.5% versus the prior year's comparative quarter expense ratio of 32.4%. The increase in the operating expense ratio reflects the addition of our US mortgage insurance operations which is operating at a higher expense ratio until business hits a steady state, as well as the effect of incremental expenses due to certain platform expansions in the reinsurance and insurance businesses. The insurance segment improved to a 31.7% expense ratio compared to 33.1% a year ago, primarily reflecting a lower net acquisition ratio, driven mostly by materially improved treaty ceding commissions. The reinsurance segment expense ratio increased from 30.7% in the third quarter of 2013 to 32.6% this quarter, primarily due to a higher level of operating expenses and by higher ceding commissions incurred. Our US insurance operations achieved a positive 2.6% effective renewal rate increase this quarter net of reinsurance. A key point that can get lost in the averages is how different the pricing environment is for short tailed versus longer tailed lines. Our short tailed line of business had an effective 3.5% renewal rate decrease for the quarter, compared to a 4% effective renewal rate increase for the longer tailed lines, both on a net of reinsurance basis. These longer tailed line rate increases continued to be above our view of weighted loss cost trends. Looking more deeply some lines incurred rate reductions such as nearly 8% in property, and 4% in high capacity D&O, and others enjoyed healthy increases such as plus-10% in the lower capacity D&O lines, 7.5% increase in contract binding, and nearly a 6.5% increase in excess workers compensation. Also certain lines continued their momentum of achieving strong cumulative increases. For example our admitted loss sensitive businesses, as well as our lower capacity D&O lines, have achieved 13 consecutive quarters of rate increases. The private not-for-profit D&O unit has in fact secured double-digit increases for nine of those 13 consecutive quarters. The ratio of net premium to gross premium in the quarter was 75.5% versus 80.9% a year ago. The insurance segment had a 74.2% ratio compared to 73.5% a year earlier. This quarter's insurance segment net to gross becomes 76% when the impact of the Sparta renewal rates transaction, as discussed on last quarter's call, is removed. This continues to show the insurance segment's emphasis on writing smaller lesser volatile business, and keeping more of it net as a result.

In the reinsurance segment the net to gross ratio was 75.8% in the 2014 third quarter compared to 94.6% a year ago primarily reflecting sessions to Watford Re as a reinsurer, and other third-party retro purchases protecting the property book. The mortgage segment posted an 86.6% combined ratio for the quarter. The expense ratio as expected and as indicated earlier continues to be high, as the operating ratio relating to our US primary operation will remain elevated until proper scale is achieved. The net written premium of $58.5 million in the quarter is driven as Dinos has noted, by $32 million from the US primary operation and $26.5 million of net written premium from our reinsurance mortgage operations, which includes the 100% quarter share of PMIs 2009 through 2011 underwriting years, as part of the acquisition of the CMG companies and the PMI platform. At September 30th, 2014 our risk in force of $10.1 billion includes $5.5 billion from our US mortgage insurance operation, $4.5 billion through worldwide reinsurance operations, and $136 million to our risk sharing transactions. It is important to note that US operations utilize policy specific coverage ratios to determine risk in force from insurance in force figures. As you may recall, insurance in force represents the aggregate amount of the individual loans insured while risk in force incorporates the insurance coverage percentage. Outside of the US we followed market practice to estimate risk in force on a similar basis while for risk sharing transactions risk in force reflects our percentage participation within bound layers as well as the impact of contract limits. That is risk in force on risk sharing transactions does not exceed the contractual limits of liability involved. Our primary US mortgage insurance operation bound just shy of $2 billion of new insurance written during the quarter, which represents the aggregate of original principle balances of all loans receiving coverage during the quarter. The weighted average FICO score for the US and primary portfolio remains strong at 733, and the weighted average loan to value ratio held steady at 93.4%. No state's risk in force represents more than 10% of the portfolio, and our US primary mortgage insurance company is operating at an estimated 9.1 to 1 risk to capital ratio as of September 30, 2014. The other segment, i.e. Watford Re, reported a 100.2% combined ratio for the quarter on nearly $100 million of net written premium, and $34.8 million of net earned premiums. As a reminder, these premiums reflect 100% of the business assumed rather than simply Arch's approximate 11% common share interest, just due to the variable interest entity accounting election. Our joint venture Gulf Re produced a $7.8 million loss for the quarter, due to an unusually high frequency of large technical risk losses stemming from the Middle East. This is reflecting on the income statement within the other income line. The total return on our investment portfolio as Dinos has noted was a reported negative 51 bips in the 2013 fourth quarter, reflecting negative returns in our fixed income and equity sectors, along with the impact of the strengthening US dollar on our foreign denominated investments, while our alternative investment portfolio continued to perform well. Excluding foreign exchange, total return was a positive 21 bips in the 2014 third quarter. On a trailing 12 month basis ending September 30th, the total return has been a positive 3.30%, and excluding foreign exchange the return has been a positive 3.76%. Our embedded pretax book yield before expenses was 2.21% as of September 30, 2014, compared to 2.175% serially at June 30. While the duration of the portfolio lengthened slightly to 3.28 years from last quarter's 3.14 years. Fixed income duration can fluctuate due to tactical investment decisions, as opposed to long-term strategic shifts. The current duration continues to reflect our conservative position on interest rates in the current yield environment. Reported net investment income in the 2014 third quarter was $72.2 million, or $0.53 per share, versus $72.5 million in the 2014 second quarter, which was also $0.53 per share, and $66.1 million, for $0.49 per share in the corresponding quarter in 2013.

As always we evaluate investment performance on a total return basis and not merely by the geography of net investment income. Interest expense for the quarter was $4.2 million, which is a significant reduction from the last two quarters, this reduction is due to a favorable adjustment involving a certain large portfolio transfer, entered into effective January 2013. This deposit accounting transaction had a downward reevaluation in the quarter of the underlying ultimate loss, which resulted in an $8.2 million reduction in interest expense. The run rate interest expense which includes approximately $12 million from Arch's senior notes and a variable amount of Arch's revolving credit borrowings and some other items, is expected to be approximately $13 million per quarter for the foreseeable future.

However, reevaluations of the underlying ultimate loss attributable to this [loss--inaudible-audio break 40 seconds] --used to give us significant financial flexibility. We also continue to estimate having capital in excess of our targeted capital position. Book value per share as Dinos noted was $44.04, up 0.7% relative to June 30, up 10.6% relative to year end 2013, and up nearly 15% relative to one year ago at September 30, 2013. This change in book value per share this quarter primarily reflects the Company's continued strong underwriting performance, offset by unrealized losses on investments. With these introductory comments, we are now pleased to take your questions.

Francis, we are ready.

Thank you. Ladies and gentlemen, (Operator Instructions). Please stand by for your first question. That question will come from the line of Kai Pan with Morgan Stanley. You may begin.

Good morning and thank you for taking my call. First question is on buyback. Looks like you started buying back actually in a big way in more than a year. I just wonder what changes your thought process on that? Is that less opportunity for organic growth or acquisition growth, or you found your stock prices more attractive now?

Well, it is a good question. Let me give you the flavor and the decision-making process that we go through. Our excess capital was building rapidly, and at the same time because of the environment we have in the property cat area, with additional capital coming in, et cetera, it caused us to reduce our exposure into that sector. Usually we don't buy shares back in the third quarter, because of the potential storm activity, but with $450 million PML in Florida, that risk was a lot more manageable for us, so it cleared the way for us to look at our excess capital, and also look at the prospects for what is deploying the capital in business, we are not as optimistic in finding transactions for us that would be reasonable for our shareholders. We had a few that we attempted and we were in the mix. None of them materialized, being conservative in our approach of acquiring business. And the if I'm not able to deploy the capital into the business, then the next option is to returning to shareholders, and that is the thought process we went through, and we decided to initiate the buybacks even in the third quarter which is not a normal activity for us, for the reasons that I just mentioned, plus we felt that the price that we were buying the shares was pretty attractive in reinvesting in our business.

I would add to that following up on Dinos' very last point. From a valuation and attractiveness standpoint, we bought these back at 125% of book value. And you heard Dinos earlier in his comments talk about our forward look of our underwriting years. Not calendar years but underwriting years being 10% to 12%, so the arithmetic works.

So if the current conditions persists in term both your stock price and the prospect of business, would it be fair to say that you can return 100% of your operating earnings, and would that be a catch-up in the first quarter to match up the first half of the year?

That is not an unreasonable assumption.

Okay. That is great. And then just I just wanted to struggle with this question a bit. If you look back last 10 years your combined ratio averaged about 91%, yet your ROE is past 16%, and this year your combined ration is actually pretty good, 87%, yet ROE is low double-digits. I just wonder I mean investments probably play an important part of that, but is the current environment even with the pretty solid combined ratio, that you will be able to only achieve like low double-digit ROE, is that like the prospects at least in the near term?

No, you are doing comparisons without make adjustments for the E. There are periods of time that our shareholders' equity is in the right place, so in essence we don't have much excess capital, and there are periods of time for different reasons, that the equity we have is about what we need to run the business. Of course, when you have that it affects the ROE, because the R is the same, and the E is a larger number, is going to give you a smaller percentage on that.

It is management's responsibility, and I will take that on as my responsibility as a CEO, to make sure that we have a good balance between capital needed, the protection we need to have excess capital for various reasons that we explain in many of our prior calls, and take the excess capital and return it, and that was the activity you saw in third quarter potentially continuing into the fourth quarter, et cetera. So when you look at ROE, you have also got to look at the capital at the same time, and then you can make those comparisons about the quality of the business that we generate. We are happy with the quality of the business that we generate. Unfortunately, in a competitive market environment, especially in the reinsurance side, we don't think we are going to have as much of it as we would like.

So just clarify on that, is that your 10% to 12% current ROE sort of expectation, is that on allocated capital, or on what is your currently--?

It is on allocated capital.

Okay.

And we allocate capital to the business units at two notches above our financial rating. Our financial rating is A+, and we go to AA in the models to allocate capital to the units.

Thank you very much.

Thank you.

Your next question will come from the line of Michael Nannizzi from Goldman Sachs. You may begin.

Great, thank you. A few questions on the MI business. Could you talk a little bit about how much of that NIW, the billion that didn't come through the credit union was through the bank flow channel?

There was quite a bit for the bank channel, but it was on what we call prepaid single premium revenue, and you focusing just on the US primary MI or the global?

No, sorry to interrupt. I was thinking US MI, primary business. How much of that billion that isn't the credit union business would fall into that sort of flow business, flow bank channel?

The flow bank channel is still in its infancy. It was about I would say 10% to 15% of the total. The other 85% it was single premium prepaid MI.

Got it. Great. Thank you for that clarification. As far as that bank channel is concerned, as you continue to sort of scale up and you mentioned that you have relationships with all of the large banks, how do you see that progressing and when you think about like a target market share, and kind of where you are now, what sort of glide path do you anticipate to get there?

I'm an impatient guy, so if you ask for my perspective --[inaudible-35 second break in audio]

--if I have one, I apologize just because I can't hear. In terms of capital would you allocated to that business, do you anticipate sending more capital down to the MI or do you feel like at this point with the 0.1 to 1 that you are at a comfortable place to pace the growth that you expect for the foreseeable future? Thanks, and again I apologize for the cut-in.

At 9.1 we are probably the most conservative from a capital point of view from any one of our competitors in that space, and I don't anticipate sending more capital to MI until it is needed. We are not going to get through the steady state with PMIers for quite a bit of time. Mark, do you want to elaborate on that?

The wild card is the PMIers, and that marketplace is dynamic too, similar to the P&C side. It depends what the demand turns out to be. We will do it at that time. It could be that we need to put some additional capital, but we have to see what materializes here.

Great. Thank you.

The next question will come from line of Vinay Misquith from Evercore Partners. You may begin.

Good morning.

Hi, Vinay. How are you?

Okay, how are you? The first question is on the reinsurance side. Looking at the accident year loss ratio it is about 58% for the reinsurance division. That is lower than the 60% to 61% that you had in the first half of the year. Is the business exchange that is the removal of the Towers reinsurance premiums having a positive impact on your loss ratios?

Yes and yes. I will give it to Mark to give you more details. We did book that at a higher loss ratio and the mix is changing, but the mix change actually goes a little bit against us because we are not the having as much cat business, which usually we expect that loss ratio it is in the 40s, and would you have less of that, so there is a mix change. Mark, do you want to add more color?

I assume you are talking on accident quarter basis as opposed to --

Yes.

Well, to reiterate I think you have heard us talk about mix every quarter, and how mix can affect things. This is a great quarter of how mix has done that. Not just by line of businesses, but by the operations within the reinsurance group. We always talk about the treaty side and the property cat side, but we have a very profitable property facultative side. That really had outstanding results this quarter, and helped with that loss ratio.

So we would shouldn't take this 's number quarter as a new run rate for the future?

It is coming down to mix. I hate to do the forecasts that you are asking for. It will depend on what materializes. The reason I say that is because the property facultative book is not cat dependent. They don't lead with cat. They pick it up, it is all risks, but they are really looking for attritional underwriting, which they are very good at. Their results are not going to be impacted by what you are reading in headlines on cat business.

Fair enough. And on the primary insurance I will pose a similar question there. Now, was the large losses about 1.7 points -- is that --?

Well, the large losses emanate from the world risk book. You know what they are. You got the unlucky Malaysian Airlines hit twice, and then you have Tripoli, and now for that specific book it was much more in loss ratio points, but for the entire insurance group I think the effect was how much, Mark?

It was about 3.3 loss ration points of worldwide premium, and Vinay it was 1.6 at the corresponding quarter last time with similarly valued attritional loss sizes. So the difference between the two is 170 basis point of net earned premium that I referred to in my comments.

Sure.

You can never tell, but these things happen. I mean you get unusual losses occasionally. We don't view these recurring. But who the hell knows in this world, there are unknowns in this world. If they continue to occur we will reevaluate the underwriting posture.

Taken from a 10,000 feet up, this is a clear example to me of a large attritional loss, man made. Yes. A smoothing if you will, because this is a cat cover at the end of the day. And you will go 10 years of 5% and 6% loss ratio, and then there is going to be a 500% loss ratio moment, and then it is going to return back to 5% or 6% loss ratio points. Taken from that perspective you don't really view that as a recurrent item.

Fair enough. If I take that out of the numbers, the accident year loss ratio cat X-cat and the P&C primary insurance business was around 64.6 this quarter, and looking at the year ago quarter it was 64.0, so you have seen a slight uptick in the loss ratio. That was business mix, because I thought there was some margin improvement coming through the books?

Yes, there is some business mix. But we don't evaluate our businesses on loss ratio alone and then look independently at expense ratios, and look independent at the duration aspect and the investment income side. It is all it in totality. That is what return is. You can't really look at a loss ratio, without looking at the outstanding improvements that they have gotten on ceding commissions, which finds its way through the net acquisition ratio, and by the way it earns its way in, so that is in a forward sense because that is already baked in written those ceded commission improvements are going to continue to be baked in firstly, and secondly is not every treaty renews at the same time. Those treaties are renewed at periodic points throughout the year, so additional gains are possible.

And, of course, the duration of liabilities and investment income associated is part of the mix for when we may a total return determination. And you are not going to view high excess workers comp with very, very long duration the same way you are going to do E&S property that has no duration.

And this quarter the acquisition expense ratio went down in the primary insurance division. Was it because of ceding commissions, and should he would expect that to continue for the future?

That is the point I was really making you can't see it but the direct commissions paid up front really didn't change appreciably at all. So that whole balance is mostly I can't say exclusively, mostly driven by the increase in the ceding commissions.

Sure. Okay, thank you very much.

You're welcome.

Your next question will come from the line of Jay Gelb from Barclays Capital. You may begin.

I just wanted to follow back on the buybacks. It was a nice surprise to see the buybacks coming in the quarter, and then falling through the fourth quarter. I believe there was a comment saying that buybacks could be equivalent to annual operating earnings, but I just want to make sure before people start building that into their models, I just wanted to confirm whether that is sensitive to things like valuation, market opportunities, and anything else?

It is all in mix, Jay. I mean I think we can chew gum and walk at the same time. We don't make a decision, and that decision is permanent without looking at the environment. We look at our share price, we look at prospects where we deploy capital, we look at the business opportunities, et cetera. We look at our excess capital and how big that amount is. And then we make judgments. And beyond that, we make also a judgment in not only how much we need to return to our shareholders, but in what form we want to return it. It is not only share buybacks. If the share price gets to where it is appropriately priced in the marketplace, we might then do a dividend. So we take all of that into consideration.

I appreciate that. Thanks very much.

You're welcome.

The next question will come from the line of Jay Cohen from Bank of America. You may begin.

Yes, thank you. Question on the mortgage business. You guys suggested that some of the premium came from the single premium transactions. I'm just not as familiar with the mortgage business. So can you describe what exactly those are, and will the accounting on an earned basis be different because they were single premium transactions?

Yes, Jay, for clarification yes that would be the case. To the extent that they are single bullets, they will be earned over the ratable life. Think of it that way. And to the extent that they are monthlies, they will come in as written and as earned on a monthly basis. You will build up unearned premium reserve on the single bullets.

Do you guys care which form it comes in? Does it matter to you?

Yes and no. It depends on the price. At the end of the day. Single premium usually is not as attractive to us because it is competitively bid, et cetera. On the other hand, depending where the mortgage cycle is and interest rates, if you get a reduction in mortgage rates, and you have a significant amount of refinancing going, then that is an attractive product because [inaudible-90 second break in audio].

And next question in line comes from the line of Ryan Byrnes from Janney. You may begin.

Good afternoon, guys. Sorry, the call has been kind of breaking up a bunch, so I'm not quite sure what we were just talking about. But I is wondering if we could get, it also broke up earlier when we were talking about the interest expense, the pressure from the loss portfolio transfer from January of 2013. Just wanted to see how he would should think about that going forward? I think you may have answered it but the call broke up?

Okay, well, Mark will take it.

There hadn't been a question on that so you didn't miss anything. The $8.2 million that we reflected in our comments and in the earnings release is a portfolio transfer that was effective January 2013 on basically losses from 2000 to 2012. It was reevaluated subsequent to that, and there was a reduction in the ultimate losses. And the accounting requires that you go back and retrospectively looked at it, as if it always had that view. Think of the $8.2 million since it was recorded as a reduction to interest expense as an outlier, and that business is not recurrent, unless we decide in the future to have another valuation which changes the ultimate that there are no future changes to it, all you are going to see in future income statements is the accretion associated with that liability over its expected payout period.

And how often do you do a deep dive on that piece?

It is periodic. It could change, it could be semi-annual. Could be, it depends on what we are observing in the underlying information and the data.

Okay. Great. And then I apologize if this has been discussed as well, but the growth at Watford was very strong in the quarter. Probably better than most of us were anticipating. Get your thoughts on how close you guys are getting to a run rate there?

We don't really know because I can't predict the future. There has been a lot of interest on the facility, and the facility competes in the marketplace, and at the end of the day we have been pleasantly surprised about its acceptance so far. If it continues, if and you know it continues we can get to a steady state within two years instead of three.

And again just remind us what kind of underwriting leverage that vehicle can get, obviously thinking that it gets a little more aggressive on the investment portfolio side?

Well, I think it is a question you got to ask them, but I will give you my flavor. On a company with $1.2 billion of unencumbered capital you can go into the $500 million to $600 million worth of premium written 0.5 to 1, and be extremely safe, and pretty conservative with that. And that is what I would call steady state, and it might take a couple of years to get there.

Great. I appreciate that. Thanks Dinos.

Your next question will come from the line of Josh Shanker from Deutsche Bank. You may begin.

Thank you for taking my question late in the call. Hope everyone is well. Don is already castigated me a little bit that I don't know my accounting very well. I hope you can help me understand how the Watford non-controlling dividends and contributions work at the bottom of the P&L?

Sure. It is a good question, because it gets a little murky. You could tell by my opening comments that we have to phrase things in a certain way. Here is what I think you are missing, Josh. Is that in any company the common shareholders are going to be basically subsidizing the preferred costs. They are always deducted before you have net income available to common shareholders. Think of it as we are looking at it as to what is available to Watford's common shareholders and then you got to make the next step of what a is available to Arch's common shareholders. You are effectively going to have the 100% level down because of consolidation what is their net income, round one. Round two is the further deduction for the preferreds. Okay? And then you are at the point where you are taking the controlling interest into new account, which is roughly 11% and 89%. We need to take out 89%, so that we are left with the 11%. But since you already subtracted the preferreds to begin with, you are implicitly doing an 11/89 on those preferreds when you make that adjustment, I know this sounds a little confusing. But suffice to say those adjustments, the $10.3 million that is there, is the combination of the preferred costs and the net income split back 11/89.

So the preferred dividend of $4.9 million is included in the $10.3 million?

Yes.

Okay. Or is it net of the $10.3 million? Net of? Was there an Arch's share of Watford--?

Arithmetically forget conceptual for a minute. Arithmetically the $6.6 million, which was the net income at the 100% level, in combination with the $4.9 million on the preferred, that lumped together if you take 89% of that, comes to the $10.3 million, which is a signed reversal, because we are undoing it. So you are left with the $1.2 million of net income available to Arch after taking out non-controlling interest.

I think that after I think about it for 20 minutes, I will understand it perfectly.

It took me 20 minutes. Don't worry about it.

The other thing that I have done wrong apparently. is I am also miscalculating the operating tax rate. Seems to me that you had about $158 million of pretax operating income before dividends, and after I make those adjustments for the preferred dividend and the dividend to Watford and Arch's stake in Watford, I am still at about $158 million but operating income was $142 million after tax, which seems like you had a big tax bill on the operating side of the P&L. Maybe I'm wrong about that?

Yes, I can't figure out how you got there quite frankly. As I said --

But we know what our tax rate is.

We know what our tax rate is. We are at 2.5% on pretax operating.

What is operating tax rate versus group tax rate?

That real differential is the difference between 2.5 and 2.8 on net income versus pretax operating. So maybe we can have a side call I guess, but I'm kind of, I don't know what you did.

Alright. That shows that I guess I should go back to school.

Just call Mark and then go through it.

Alright. No worries. Thank would you very much. And congratulations on how Watford is coming along.

Thank you.

And your next question will come from the line of Ian Gutterman. You may begin.

Hi good morning Dinos.

I knew the back of the class would come.

My first question is, why did you usually have the calls on Friday. Do you have big plans for a Halloween lunch tomorrow?

No, I'm going down to UVA to watch my daughter play. She plays against Pittsburgh. They are 16-1 and ranked third in the nation. So pretty excited about it. And it is, baklava is not a good Halloween gift for the kids.

Good luck with that. I think some of ghosts and goblins have haunted the audio on the call today in revenge. I guess my first one Mark, do you have the split of how much of the Watford gross premium in the quarter was essentially Arch's source business you did to them versus third-party business from asset [accounting]?

We really never talk about that explicitly. When I can it will you is that it continues to build momentum, and we are happy with where it is. And this vehicle is really set up to be third-party reinsurance. Over time this is going to continue to be growing towards being Watford dominant.

Got it.

And I'm surprised, I'm surprised that being so smart that you can't figure it out. It is in the numbers.

I think I figured it out.

Okay, alright. If you figured it out, if you see gross versus net and then the 15%, all you have to do is reverse engineering and you figure it out.

I was just trying to confirm my math. But I will take it offline.

Okay, alright.

And by the way, your math is going to be predicated on fundamental assumptions that may not be true in the future, but I will wait for a future quarter for that one.

Alright, alright. The other question on that is there is picked up somewhere, I can't remember if it was the insider or simply sell side, suggesting that they will hit, Watford is going to hit $400 million by the end of the year. Any comment on that or--?

I believe when the article said was that on an underwriting year basis there is $400 million. So that doesn't mean by the end of the year. Another quarter. So but it points to you that it is going to be approximately $100 million a quarter for four quarters.

Okay, great. Any thoughts on the satellite -- the NASA loss the other day? Is that an industry event, or does that not have much?

It is $200 million or something. The only thing I know I'm not on it, so I'm okay.

Perfect. Perfect. And my last one this is where the audio cut out a little bit so I might have missed part of this. Back to the single premium MI just to understand that a little bit. Is that kind of like bulk business, not GSE book, but is it essentially bulk from the banks, or is this stuff you are writing on the side, or--?

It is an originator, where we take maybe one or two weeks of production and put it out, and he says would give me a price for you to write the mortgage insurance on this block. Here is all of the underlying loans that we have. And we are going to prepay it up front. Single premium instead of month. And a lot of these sometimes is paid by the borrower, because they include it into the price of the mortgage, and sometimes it is paid by the lender.

Okay. And is this just sort of something that makes sense given where you are building out the Company that it is a good way sort to get premiums on the books quickly to offset some of the expenses, and so way over time as you get more flow or is this --?

No, no we don't think it as such. The way we think about the mortgage business is that, you have flow business, you have these single premium business, you have other transactions we are doing in the reinsurance, the stacker and the transactions, et cetera. So we are not trying to, we look at the entire marketplace, and if we like a transaction we go after it. And we don't have a preconceived notion we have to have three of this and two of that and five of this. That is not the way we operate. You know us better than.

Just checking. My last clarification on that topic is Mark, I think when there was a question about how this flows through the accounting, I understand the earned part obviously, but on the written sounded like you said this still flows over 12 months? I thought if it was I think if that was single premium written, the written would have all hit this quarter to be earned over 12 months?

A single is hit all in one accounting period and then earned over the ratable life.

The ratable life. Not one year. It goes life.

But at the point from a written basis it is more up front than traditional MI that comes into the written 1/12 each month?

That's correct. The rest of it is monthly and is earned. It is written and earned all in the same month, yes.

Got it. Okay. Thank you so much.

You're welcome.

And the next question will come from the line of Meyer Shields with KBW. You may begin.

Thanks. I think I'm in the back of the back of the class.

You joined in, I guess there was an empty chair in back of the class, huh?

On the mortgage insurance side is the expense ratio different for the single premium business, the acquisition expense I mean?

I don't know if it is different there. You have your personnel. Your underwriters, and got a fixed base of expenses so at the end of the day, it is what it is. If you write it and you book it up front, you still have to service it over six or seven years. I haven't thought of it as expense ratio difference between a flow business versus that.

Okay. And going back to the insurance segment, I think if you started talking about some of the small account business where you are growing, being less volatile, does that cost anything in terms of the anticipated underwriting margin?

Actually, no. I mean it is not that, it is lesser volatile, as Dinos pointed out before. As a general rule it comes with a lower loss ratio and a higher acquisition cost.

Perfect. Thanks so much, guys.

Thank you.

At this time we have no further questions in the queue. I would like to turn the call back over to Mr. Dinos Iordanou for your closing remarks.

Thank you Francis. Thanks everybody for bearing with us, and we look forward to talking to you soon. [break in audio].