Arch Capital Group Ltd (ACGLN) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen and welcome to the third quarter 2011 Arch Capital Group earnings conference call. My name is Fab and I will be your Operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded for replay purposes. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical 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 companies current report on form 8-K, furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website. I would now like to turn the conference over to your hosts for today; Mr. Dinos Iordanou and Mr. John Hele. Please proceed.

Thank you, good morning everyone and thank you for joining us today. Our third-quarter results were satisfactory when we take into consideration that - the difficult market conditions that we operate in. Significant catastrophic activity continue in the third quarter. However, the level of this activity and resulting insurable damages were only slightly above our average expected Cat load for the quarter. As you may recall, the first 2 quarters experienced CAT activity and resulting losses that were significantly above average. A total net catastrophe losses for the quarter were about $60 million with $46 million coming from the current quarter events and $14 million related to net increases in loss estimates from the first and second quarter events. Our underwriting teams continue to execute our soft market strategy by emphasizing small accounts over large ones and focusing more on short tail businesses. The market is showing signs of slight improvement. However, we still see more opportunities for adequate profitability in the short and medium tail lines of business rather than the long tail business.

As more and more competitors are factoring into their pricing the skimpy returns available on new money investments, eventually pricing levels for long tail lines will improve. At least we hope so. In the meantime, we are continuing a defensive approach for these lines of business. As a result of these strategies our mix of business continues to shift towards more short tail and medium tail while our long tail business, on a trailing 12 month basis, remains approximately 25% of our book. Our annualized return on average common equity was 10.4% on a reported basis including a slightly negative effect of above average Cat activity and aided by prior year reserve releases. We continue to believe that in the current market environment, we are earning high single-digit ROEs on an underwriting year basis. This is essentially the same level of ROE performance we estimated for the 2010 underwriting year with slightly less earnings from investment income offsetting by slightly better underwriting results generated by adjustments to our mix of business.

Our investment performance for the quarter, including the effects to foreign exchange, was a total return of negative 23 basis points and September was a difficult month in the financial markets. As a result, our book value per share for the quarter increased slightly from $31 per share to $31.20 per share while book value per share from the year ago grew by 5%. From an underwriting point of view, we recorded a 94.3% calendar quarter combined ratio, which is an excellent result for the prevailing market conditions. Cash flow from the quarter remains solid at $310 million as claim trends remain favorable. The broad market environment is showing slight improvement across the board. From a rate standpoint, most lines of business move into positive territory. The exceptions were in executive assurance and medical malpractice, where we are still seeing rate reductions in the rate of 1.5% to 2% for the malpractice business and approximately 7% for executive assurance. Even with the slight improvement in the rate environment, significant more rate is needed in many lines in order to achieve adequate returns. For us, adequate returns are returns that produce 15% return on equity. In our view, based in part on the level of interest rates currently available, the longer tail lines need quite a bit more improvement in rate to become attractive.

From a premium production point of view, a gross written premiums were up 3.4% and our net rate in premiums were up 8.7%. The insurance group was up 1.6% on gross written premiums and 9.6% on net. The shift to smaller accounts and, in essence, lower limit policies, affects the net to gross relationships as we retain more net for this type of business. The reinsurance group was up 9.1% on a gross basis and 6.7% on a net basis. The entire increase is attributed to additional premiums from short and medium tail lines of business. Long tail lines continue to represent a smaller portion of the reinsurance segment book of business. In the current environment, even after the implementation of RMS 11, which impacted our capital requirements, we still are left with a very strong capital position. As always, we will prefer to deploy all of our available capital towards our underwriting activities. Unfortunately, the market at this point in time does not yet give us the opportunity to do so. As a result, we expect to continue our share repurchase program as we continue to accumulate additional excess capital through earnings. Before I turn it over to John for more commentary on our financial results, let me update you on our cat PML aggregates. As of October 1, 2011, under our version of RMS 11, our 1 in 250 PML from a single event was $972 million or 23% of common equity. This amount is for Gulf wind exposures while the northeast wind PML was at $870 million and the Tri-State County, Florida, PML was a $750 million. With that, I'm turning this over to John for more commentary on our financials.

On a consolidated basis, the ratio of net premium to gross premium was 80%, slightly higher than the 77% a year ago. Which was due to a change in the mix of business and some modifications in US ceded reinsurance treaties. Our overall operating results for the quarter reflected a combined ratio of 94.3%, compared to 90.4% for the same period 2010. The 2011 third quarter included $60 million, or 8.7 points, of current accent year CAT activity, net of reinsurance and reinstatement premiums, compared to $24 million or 3.9 points in the 2010 third quarter. The 2011 third quarter storms, including Irene and Danish flooding, had a gross impact of $51 million and a net impact of $46 million. The re-estimation of the 2011 first and second quarter CAT events are the Australian floods and Cyclone Yasi and the New Zealand earthquake made up most of the additional $11 million gross and $14 million net added to the third quarter provisions for the 2011 CAT events. We had little net impact from the Japanese earthquakes Zenkyoren revisions and have already reserved the material portion of that exposure.

In addition to the CAT activity, we experienced slightly higher attritional property claims in the quarter. The 2011 third quarter combined ratio reflected 8.5 points, or $58 million of estimated favorable prior year reserve development net of related adjustments, compared to 5.9 points or $37 million in the 2010 third quarter. The prior year development in the third quarter of 2011 reflected net favorable development primarily in property and other short tail lines. As well as in the reinsurance segment casualty business, mainly from the 2002 to 2006 underwriting years. Moreover, we gained experienced better than expected claims emergence on most lines. The 2011 third quarter current accident year combined ratio, excluding large CAT events and net favored development, was 99.9% in insurance segment, consistent with recent quarters. In the reinsurance segment, it was 83.8%, slightly higher than recent quarters due to non-CAT attritional property losses. The 2011 third quarter expense ratio for 32.1% was one point lower than in the 2010 third quarter, resulting primarily due to the higher level of net premiums earned in 2011 as well as nonrecurring contingent commission income in our reinsurance business, which more than offset a higher level of acquisition expenses related to favorable prior year reserve development.

On a per share basis, pretax net investment income was $0.68 in the 2011 third quarter, compared to $0.59 for the same period a year ago and $0.63 in the second quarter of 2011. Our embedded pretax book yield before expenses was 3.09% in the 2011 third quarter, down from 3.52% at year-end, which primarily reflects lower reinvestment rates. During the quarter, we slightly lengthened the portfolio duration to 3.17 from 2.87 at the end of June, 2011, with longer data treasuries to capture some of the expected gain from lower Treasury rates. Total return of the investment portfolio was minus 23 basis points in the 2011 third quarter, compared to positive 165 basis points in the 2011 second quarter. Excluding foreign exchange, it was a positive 38 basis points in the quarter. The total return in the third quarter benefited from good returns in treasuries, offset by negative returns on foreign exchange, equities, corporate fixed income due to widening credit spreads and some alternative assets. Alternative assets include bank loans, global and emerging market bond and multi-asset funds and energy investments. A substantial portion of this negative foreign exchange, credit spread, equity return and alternative asset return has reversed since September 30 to October 25, which demonstrates the volatile investment environment we now face and expect to face for the foreseeable future.

We continue to maintain the vast majority of our investable assets in very high quality fixed income investment portfolio with an average credit rating of AA plus. We recorded net foreign exchange gains of $60 million during the 2011 third quarter, mainly due to the strengthening of the US dollar. These gains resulted from revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date. However, this should be compared to the minus 61 basis points to total return from foreign exchange on our investment portfolio, which offsets this income statement gain in the equity section of the balance sheet. Which, together the liability gain, resulted in approximately a net $10 million reduction in book value. For the 2011 year-to-date, our effective tax rate on pretax operating income was a benefit of 3.3% and 1.5% on pretax net income. The CAT activity this year and low investment returns have resulted in the beneficial net tax position. Our preliminary estimates of the implementation of the new DAC accounting standard, required in January 1, 2012, should not materially reduce our book value and should not have a significant impact on operating earnings for 2012. These estimates are still preliminary and may change depending upon the final implementation of the standard.

Our balance sheet continues to be conservatively positioned with total capital of $4.9 billion at September 30, up from $4.8 billion at June 30. In the quarter, we purchased 0.7 million shares for $20.8 million and an average price per share of $31.77, a ratio of 1.02 to the average book value. Our debt plus hybrids represent 15% of our total capital, well below any rating agency limit for our targeted rating. Our book value per share ended the quarter at $31.20, up 1% from last quarter and 5% from one year ago. In the calculation of our target capital position, we have now implemented our version of RMS 11. The implementation of RMS 11 by Arch, which reflects the application and model with our own internal back-testing, increased SMP 8 plus required capital by approximately 5%. With the implementation of RMS 11, which in our estimation, should reduce overall model error. At this point in time, we have changed our target capital to be a double A level by SMP, which is a 2-notch buffer over the A plus rating. As of September 30, our actual capital is in excess of our target capital. With these comments we're pleased to take your questions.

Fab, we are ready for questions.

(Operator Instructions) Jay Gelb from Barclays Capital.

Thanks and good morning. I just wanted to follow-up on the last comment from John about the capital position and I know in the past, you've given us a sense of where you feel Arch's excess capital position is currently. Can you give us an update there?

The -- as we said, we've -- the implementation of RMS 11, the 5% number was approximately $200 million so if you take into consideration that $200 million has been eliminated, our position will be approximately $200 million less of what we had before plus the earnings for the quarter which we added. So in essence, our excess capital position hasn't changed that significantly.

Okay, so would it still be $100 million to $150 million plus whatever you have in retained earnings going forward? Is that the right way to think about it?

But -- and don't forget maybe a bit more because a new standard now of how we calculate excess capital is the 2 notches above our rating algorithm. So we are A+ Company; we calculate capital at the AA level and then including the additional requirement that RMS 11 gives us on the PML and then anything above that we consider excess capital. So we are in a very strong capital position and that's the reason we're going to continue with our share repurchasing plan until the market turns and then we can write a lot more premium. But as you've seen from my comments, even though things are improving, not to the level that we are going to step on the accelerator big time.

That makes sense. So in the second quarter and third quarter, share repurchase typically flows for Arch as we get into wind season, should we expect buybacks in 4Q to be similar to the pace that they were in the first quarter?

Well, yes, there is a lot of variables, price, price-to-book, where there is other opportunities, et cetera, but yes. Our most heavy (technical difficulty) share repurchasing traditionally has been the fourth quarter and first quarter for the reasons that you have already mentioned. In the third quarter, because of the significant expected cat activity, we don't do many share repurchases. So, yes, I would say we're going to go steady as we go as we've done in prior years.

Okay and then other people have asked this question on other conference calls in terms of the stabilization of commercial P&C insurance rates. Can you say the current situation is similar to what we saw in 2000 where we had a persistent level of slightly improving rates over time?

If you press me for a comparison, Jay, my memory is still good. I mean I'm getting older, but I still have a good memory. This looks like second quarter of 2000 to me; it has that same feeling. If you go back and you look at what happened with the prior cycle, we're starting to see some positive movement in rates in the second quarter of the year 2000. Don't forget, that continued for the third quarter and fourth quarter of 2000; it accelerated a little bit in '01 but we didn't really have a true market until the first quarter of '02. So even in those days, it took, what, seven quarters before we really got an acceleration. But there is no denying that when we look at our data and don't forget, Arch is not -- we're not a huge Company like Travelers, ACE, or Chubb that they have much broader basis for their comments.

Ours is what we see on a $3 billion book of business, not much bigger book of business. We see in every sector improvement, even in those that we're still giving out rate, we are giving out a lot less rate this quarter than a quarter ago. So, you can sense it. It is a gradual improvement and it's across all lines. The only 2 negative lines we had for the quarter; it was the malpractice area as I said in my prepared remarks and in the executive assurance in the D&O area. Everything else was either flat, slightly positive, or in the mid-single digits rate increases. Which is, listen, from where we were coming, I will take it.

Very helpful, thank you.

Mike Zaremski with Credit Suisse.

Any more color on the loss cost trends, specifically in reinsurance, the ex- in your ex-cat jumped quite a bit.

Okay, loss trends are benign. That's a broader comment and we usually measure that by frequency and severity in most of the lines; and they do it in both in our reinsurance business and the insurance business we try to get underneath and measure it on their underlying business because that's the only place that you can measure those trends. Having said that, we have segments of business that have volatility by nature, property fac is one, also the cat business, et cetera; and for the quarter we have -- we did experience higher than normal, what we will call, attritional losses. Some of them, they were flood losses; some, there were fire losses, but in essence, we have experienced -- and that, it will flow through the numbers and you might see that quarter after quarter. But it doesn't look to us like it's a trend. It is more as to what happened in a specific quarter.

And in fact, if you go back, Mike, and look quarter by quarter, last eight quarters, you'll see in the reinsurance segment when you take out cat losses and favorable reserve development that, that number is bouncing around a bit quarter to quarter. As we've moved to more shorter tail businesses and more property, you're going to see that things that aren't classified as a cat but we still had above average storm activity throughout the US and in other places. That's what you're seeing is that's bouncing around.

Okay, that's helpful and lastly, I see you've been lengthening the duration of the portfolio, 3.2 years now. Could you -- Are you guys expecting to continue extending and can you remind us the duration of the liabilities average book?

No, I don't think we have an -- we're going to continue to be rather short. That extension, it was more reaction to Fed comments and what we expected the yield curve to go to so it was more tactical in its execution rather than a change in philosophy.

Our average duration is 3.6 years, 3.5 years for the liabilities so we're still shorter than our overall liabilities. But in the third quarter, we felt that rates were going to come down so we tactically, as Dinos said, lengthened treasuries which paid off because rates did come down by the end of September.

Okay, thank you very much.

Keith Walsh with Citi.

Good morning, everybody. Dinos, in your RMS 11 update comments, I just wanted to be clear, with the PMLs you gave consistent with the view on the 2Q call of 10% to 30% increases and then I've got a follow-up.

Yes, yes. Don't forget, we never use any off-the-shelf product in its purity. We have our own proprietary adjustments that we do based on our own experience, et cetera. And as I said in prior calls, even way back in the '04 and '05 storms, we were making adjustments to models; it is not just the RMS model, it might be the AIR model which we also use. So we do pay a lot of attention to these outside models but at the end of the day, we make underwriting decisions and we take risk based on our own models.

Okay and then just on the excess capital. I think you'd alluded to that you prefer buybacks to writing new business at this point is what it seems like from what I heard, but --

No, no. Our preference is to write more business. However, I'm not going to write more business unless I get adequate returns. What I said is, in the current market environment, it doesn't allow me to be looking for 15%, 20% growth and that's the growth you need to start eating up your excess capital. So not having that opportunity that I've got to return capital to shareholders and right now based on where our share price trades, we still believe buying back shares is the best way to return that capital back to shareholders.

Right. I was going to ask you what type of rate increase do think you need to see when that switches over when writing new business becomes more attractive on an ROE business -- on an ROE basis relative to the buyback?

Well, it depends upon type of business; I will give you an example. Let's take -- we're not a big workers comp writer, right? But our price monitors show that in the comp line, we are getting with the very little we write, we are getting 6%, 7% rate increase. We don't get excited until we get to probably 30% rate increase. Because if you do the math, you need 30%, 35% rate increase for the comp line based on the yields we get on new money invested and a four-year duration ground up to take that 117% or 115%, 117% that the industry is performing at and bring it down to the mid-90s but because you need mid-90% in order to get to the mid-teens ROEs even on that line.

So our evaluation as to what we write by line of business, type of accounts goes through this analysis. What's the rating environment, not only just year-over-year changes, but on an absolute basis, what is the profitability associated with it? And how much more can we get in the marketplace if the rates there are adequate? Of course, there is limitations to that. I can tell you, we would feel that in the cat business rates are adequate but PML limitations doesn't allow you to write more.. So from the risk management point of view, we write up to our risk tolerance. So when I look line by line and where we see opportunities, we see opportunities, you see a little bit of growth in our business but it is not broad-based that allows me to deploy all the capital that I have.

Thanks a lot.

Josh Shanker with Deutsche Bank.

You said that executive assurance is getting a weaker pricing but it seems like you're still growing there, the pricing is still very attractive?

Don't forget, in executive assurance areas, we view it in 3 sectors, right? we have financial institutions, we have commercial D&O and then we have what we call private company not-for-profit, et cetera. And then in Europe, we write a lot of small-, medium-size enterprise, which a lot of it is private enterprises, et cetera. The latter part is where we are growing and that's the part of the business that we like. It fits with our strategy of writing smaller accounts and we believe the profitability for that segment of the D&O business is the best.

And so the rate that Dinos referenced was for large commercial D&O which we are shrinking.

And offset by opportunities in the smaller sectors?

(multiple speakers) That's correct.

And the second question, not too much on workers comp. I realized you're not a workers comp Company but you did try out the National Accounts business a bit and in your experience, how sticky is that business and if you guys eventually find it attractive, how early do you have to be to get into it in order to participate in the upside?

Well, it is sticky business, the --and it is a high service business. Because at the end of the day, most of the risk is taken by the client, right?

Well, not on the National Accounts. The workers comp in general, if rates got better would you have to take a loss initially to participate in the profit upside?

Well, I -- we don't think so, some people might. We don't think so because the market only goes up because there is more demand. And when there is demand, if you are a company with an A plus rating, good service capability and good market reputation, I think you will get your fair share. (multiple speakers) We might be fools, but we believe in that. I don't believe the fact that we're not writing as much guaranteed workers comp today will inhibit our ability to participate in the future.

I appreciate the candor. Thank you.

Matthew Heimermann with JPMorgan.

Hi Matt, my name gets mutilated, but I didn't think yours.

I figured given who else was on the line, I couldn't complain about it. (laughter) A couple of questions, one, maybe just to start out on the changes we are seeing in macro pricing. I guess, when I think back to, you said this reminds you of 2Q 2000 so just indulge me for a second here, but -- and at that point in time, there was a lot of [big] recognition that reserves were inadequate. And while it took, to your point, six quarters to seven quarters for rates to rise enough so that the returns on capital were adequate, the rate increases and exposure gains that were available were significant enough to really allow companies to grow 20%, 30%, even 50% in some cases per annum over a couple of years span. So I guess my question is if this plays out in a more incremental fashion, relative to the six quarters to seven quarters it took last time to get to return on capitals to target level, how long do think it will take this time?

I -- (multiple speakers) that's a tough question. I don't know. First of all, your comment is correct. There was, in the year 2000, there was a recognition that maybe reserves were short for the entire industry, not a real problem for most companies in the current environment. Having said that, I think there is more and more recognition today by management and eventually they reflect that in their underwriting strategies that we are going to be in a very low yield environment for quite a bit of time. At least there is nothing in the horizon that says that we are going to go back to the 5%, 6%, 7% returns on the investment portfolios that we were experiencing 10 years, 12 years ago. So there is different dynamics that cause the adjustment in pricing. I believe there is a recognition today by senior management and in that sense, is they are starting to push it down into the underwriting teams, that we need underwriting profit in order to get adequate returns. And I think that's why they are adjusting in price. How long will it take? I don't know. If I was very good at that I'd be in Vegas. (laughter)

I guess the follow-up question to that is, do have a sense in terms of the -- how -- whether, based on what you're doing internally or what your best guess is, based on what we are seeing in the market, what type of interest rate assumption you are seeing pushed down? Is it where portfolio yields are today? Is that where new money rates are today? Is it somewhere in between?

Well, it depends by company. I don't know, you have the ability to ask different companies what they do. I can tell you what we do. We only factor risk-free rate of return in new money; when we do both our -- we establish rates and also when we compensate our underwriting teams on incentive compensations. Any under- or over-performance from that by the investment department does not affect those calculations either for incentive compensation for our people and/or for rate making.

That's fair. And then John, when you were discussing excess capital, it sounded like when you were talking about the buffer to the AA that the target rating that you ran your buffer against potentially had changed. Did I hear that correctly and if so, what was the previous target?

We used to have a buffer where we took into account the one-in-250-year PML less the future earnings from that. But that was based a lot around model error and the potential for a large cat. And in thinking about this, the fact we've gone to RMS 11 which we think is now a better calibrated model, at least how we see it and how we've implemented it; and in thinking about how we want to hold a buffer, we like the overall AA or a 2-notch buffer because that reflects all the risks that we are taking in the firm. So we've got a better buffer now we think about it overall versus a one-dimensional buffer which is only the cat event. And so that's how we want to think about it at this time and run the Company on it.

The old [rule] -- it was my rule and it was simplistic. I said I want to begin the year and end the year with a major cat event with the same capital so I took potential earnings for the year, my PML and then the delta that says if I have in excess capital, I'm in good shape. Now I think we're getting a little more sophisticated in our calculation and is -- it might change in the future and if it does, we will always tell you as to how we calculate it. But right now, we feel pretty comfortable that we calculate required capital here internally. Management-required capital is 2-notches above what the rating agencies require [whereas] when we count excess capital anything above that.

Okay, thanks for the clarification. Have a good day.

Dan Farrell with Sterne, Agee.

Hi, good morning. Could you comment on your view on the new business versus renewal business pricing and the gap there. We had a company earlier today said that they thought the gap was closing.

Well, I don't have all -- we measured that so I'm going to go and I apologize, I didn't know I was going to get the question or I would have the specific numbers in front of me because we have a price monitoring system that compares what we get on new business versus renewals. In most areas today, your new business is anywhere from -- if renewal business is at 100, it is anywhere from 94 to 100, but clearly, we are getting less rate on new business than we are getting on our renewal business. But I don't have those numbers right in front of me to give you more specifics. It varies by line of business. But on average, I would say on a scale of 100 new businesses, it's at 94, maybe 95. And then renewal business, it would be at 100.

Thank you. That's helpful. Just one other quick item, you mentioned that the increase in the net-to-gross is driven a little bit by business mix and shift to smaller accounts; is that something we should continue to see of a net-to-gross shift up over the next few quarters?

Well, we are aiming for that but I don't -- I mean, we might have reached saturation in our ability to continue changing that because don't forget, we are not abandoning the larger account business because in a good market, that's where you make a lot of money. We are just more careful about pricing it today and in essence, competition takes some of these accounts. We never really went out and told any of our clients, any of the brokers that we do business, don't send us these large account business. It is just we're not competitive on that and in essence, over time, it becomes less and less part of the book.

I wish I can find the rates to grow that business because anything that we put out from a quotation on any account is something that we are happy about because if we're not happy about it, we shouldn't be doing it, right? So it is how much the market returns back to us -- that's been our attitude; yes, the recognition that smaller accounts perform better in the soft cycle is not only by us, it is probably by the entire P&C world. But at the end, do you really have the infrastructure to be able to do that and over the years, I think we've built good infrastructure that allows us to do it.

Thank you, that was helpful.

Doug Mewhirter with RBC Capital Markets.

Hi, good morning. Just had 2 questions. First on the revenue side, do you have any, based on your -- the mix of pricing and demand and maybe exposure unit to your writing, are there any, I guess, economic signs or tea leaves that you are seeing or indications whether you -- it seems to be there's more health in the economy or it is maybe the standstill or there were things that are still dragging on the demand side?

As I said, we are not such a large Company to have the broad view; you are asking a very broad question. I can tell you based on the limitations that a Company writes only $3 billion on an annual basis is that, in the construction sector which I think we have a good market share, we don't see yet an uptick. I keep talking about it. But I think that business is still hurting quite a bit and we don't see the demand upticking. In some other areas, we've seen a little bit of demand uptick but it is not broad enough to draw out economic conclusions about what's going on economically in the country. But if I had to guess and this is my guess, is I think we are just continuing to drift, the demand has not really increased to allow us to get more premium or more revenue because of increased demand.

Good, thanks. That's helpful and my second question deals with a different topic. I noticed the massive flooding in Thailand has hit the major part of the news cycle now and insured loss estimates seem to be climbing quite a bit. They started about well below $1 billion, I think, there might even be ones up as high as $2 billion industry loss. Is that a broader event that would impact the overall reinsurance market? I'm not quite sure of how the market is structured in Thailand. Is it -- are there a lot more local companies or would you see that -- those losses trickle into the general global Bermuda, Europe, Lloyd's type market?

I'm not the right person to answer this question because we have so little in that part of the world that I haven't really spent time studying it or so. But I'll do a little research on your behalf and then if you call Don on a subsequent call as an industry question so we can comment on it, I will shed some light to it but I've got to get back to my cat teams. All I can tell you is we don't have much exposure in that part of the world.

Okay, thanks. That's all my questions.

Court Dignan with Fidelity.

Congrats on another good quarter. You guys really managed to --

It was decent, I think.

Well, you guys managed the business really well for a long time now, so --. Actually, I had a question pertaining to capital allocation and maybe it is for John. So I know some people are getting pretty excited about what's being said about pricing conditions in certain markets. But actually (inaudible), Dinos did a pretty good job of summarizing the situation pretty well in his opening comments which is -- it doesn't really seem to be any seminal change in the total return economics of the business when you give proper consideration to all the factors. I guess my question is that, given where your shares are currently trading, it looks like you're basically buying, let's call it a 6.5% to 7% incremental earnings yield, and obviously, the repurchases aren't accretive on a stated book basis. I guess the math to me makes it a little hard argument to say that they're accretive on an intrinsic basis, so at what point do you consider shifting focus towards dividends either regular or special and away from buybacks?

Well, we (multiple speakers) -- because we always want a three year payback and how we think about this and if these expected returns, we'd have to go above 1.2 times to make it much longer than three years in terms of the -- not getting the payback so if we're trading just a little above our book value for the average book value for the quarter then we still like share buybacks.

Okay.

Our economic ROE calculation is, as I said in my prepared remarks, is still high single digits. When you put -- and I think we have something on our website, we have a grid that tells you potential ROE on the left and up on top multiple-to-book and where the three-year in recovery ends. And right now, I don't know if it is 1.2 times but it is 1.18 times or something like that and basically, until you guys give us more credit and shares go beyond 1.2 times book, it is not much for us to think about.

I guess I had it at 1.25 of book excess. But thanks, that's helpful. I have one follow-up, if I can.

Go ahead.

Along the lines of the great question posed by Matthew Heimermann of JPMorgan, I guess I struggle a little bit with the 2Q 2000 and subsequent six quarters to eight quarters analog although I'm sure it made Jay Gelb's day. The -- we can debate the numbers back and forth whether it be the industry's having total net reserves or spread adjusted cash flow or however you want to look at it. I guess, qualitatively though, I look around and I just don't see the Frontiers and Reliances out there. I guess the question is are they out there and I'm just not seeing it? Obviously, I wouldn't ask you to name names. Obviously, in that analog there was an event in New York that mattered as well, but it is an analog that I think I struggle with. I also think back to banking in 2007, 2008 when people were always we are going to have a downturn but they looked at the early '90s S&L Crisis and the worse it's getting. The reality is that the last cycle very rarely provides an adequate analog for the prospective cycle.

If -- every cycle is different and it happens for different reasons. Yes, the probability of companies going bust is probably a lot less today than it was in the year 2000 because usually companies go bust on reserve deficiencies, not a recognition that I can't get much yield on new money invested; and in essence, I've got to improve my underwriting so I can get underwriting profit, et cetera. I think what's driving a bit of improvement in the pricing is the realization that investment yields are so low that we've got to start thinking about underwriting profit. Which I can tell you in the entire '90s, nobody ever cared if you were publishing 100 combined, 102 or 104 in a business that had 6% or 7% return of -- on with a 2.7-to-one leverage and at 3.5 year to 4 year duration. I mean, when you do the math, it is pretty good returns.

And also in those days, the capital requirements if you go and -- you seem to be spending a lot of time on the math; the rating agencies, they were allowing us on a premium-to-surplus ratio to write a lot more premium to surplus. As things evolved and they got more sophisticated and the capital requirements have continuous increase and now the yields are going down, you have a much different environment. So I wasn't -- I'm not predicting that this is -- the question was, what does it feel like? And I said, my comment about second quarter of 2000, it was the first time in those days for different reasons that we saw the market starting to increase rates and improve rating environment.

And I see a consistency in that between second-quarter data that we have and third quarter. Everything is lifting up a little bit. If it was negative, it is a little bit less negative. If it was zero, it got to a positive and if it was slightly negative, it got to zero. So that's the only comment I am making. I can't predict the future. I don't know -- this might be like a jet on the runway and it is trying to lift off and it might be a false alarm, maybe get a little bump because it didn't have a flat runway and then it will come down again. I don't know, but we will see, time will tell.

I guess just as one follow-up to that. I think with the benefit of hindsight, we can go back and we actually conclude that a number of still remaining companies, still prominent companies, were actually technically insolvent in the second quarter of 2000; some that are going to report in the next 24 hours or so. I just -- do you think that anyone fits that description today? Because it seems like that it would be much harder to make the case.

Listen, my job is to run Arch; I spend most my time worrying about Arch. I haven't done extensive analysis in other companies, looking at their schedule piece and their reserves. I don't spend my time worrying about others. So you've got do that homework and you can draw your conclusions. But I -- one general comment and then we'll move onto the next question, is I think the industry, in general, is not significantly under-reserved like it was in the year 2000. And in my history in the business for the last 35 years that I've spent as a career, usually companies go bust when they are grossly under-reserved, and that does not exist today. So if I had to predict, I don't see a lot of insolvencies left and right.

Thanks for the comments, guys.

You're welcome.

Congrats.

Vinay Misquith with Evercore.

Hi, thanks, guys. I thought I would never get a chance. So since Court has exhausted all the cycle turn questions, let me just go back to basics on your business. The first question is on the buyback. And it seems that, at least looking at your PML, you have maybe about $150 millionof excess capital based on your one-in-250 PML. So curious as to how much of stock you would be willing to buy back given the flexibility that you want to maintain should the pricing in property cat remain strong January 1?

What -- like I said, we have excess capital. I'm not confirming how much you calculated, how much we are -- also we have the earnings for the fourth quarter so that's in addition. That is growing. And like I said before, Vinay, is it depends where I'm trading. If I'm getting these lousy multiples that I'm getting today, I would be more anxious to be buying more because I think I'm creating value for my shareholders. If I get a reasonable multiple for what we are, I might slow that down a bit and even consider other forms of return on capital. Right now though, where the market is, I'm going to be more patient because I don't know if January 1, it might be a much better environment; and if it is, I don't want to miss it because I said I don't have enough capital. If I'm going to err, I'm going to err on having more capital available than less.

But having said that, I don't see that. That's why we like share repurchases because you can change what you do on a weekly basis. If I write a check for an extraordinary dividend, the minute it goes out, I can't get it back where with share repurchases I can accelerate it or I can decelerate it based on as I monitor the market conditions. So I will stick with the comments that I said that our fourth quarter will be no different than what was done in prior quarters if you go a year ago, two years ago and three years ago.

And Vinay, I think we sleep a little better at night having some buffer because it's still a pretty volatile world out there with Europe and although US economy appears to be a bit more detached from it, it's still pretty volatile markets out there.

Sure. Fair enough. The second question is on the future -- some accident year margins; that's improved in the insurance operations this quarter year-over-year and it's been improving for the last couple of quarters. So is that business mix issues? And also, in reinsurance, you guys seem to be writing more cat business, more property business. Should we look at a combined ratio per an accident year basis going down for both insurance and reinsurance segments going forward?

Well, two things are constant, your first comment on insurance is correct. I think the change in the mix moving away from either limited or high volatility because they're writing a lot more in small accounts and also they have moved into short tail business. And of course, on the reinsurance side as we write more and more property cat and property fac, et cetera, we are introducing a bit more volatility. We like the business long term, but it will give you quarter-to-quarter volatility because attritional losses might go up and down; it is a better margin business, right? Because that's what we believe today the best margins are and for that reason we gravitated to that. I'd rather take the volatility with a better margin because over a long period of time, my -- I'm going to do better for the shareholder because -- but even with that, even we believe that a better mix that we have, the way we calculate things, we're still high single digit ROEs. Nothing really to get totally excited about, right?

Okay. That's fair. Thank you for your answers.

Ian Gutterman with Adage Capital.

Two follow-ups, first, what made the Gulf Coast pass Northeast and Florida as your peak PML or was that mainly RMS 11 or did you reshape the portfolio?

No, it was purely model driven.

Got it, okay, great.

By the way, Ian, you're always laughing at my question; if I was a professor, you're sitting in the back of the room, I would have flunked you. (laughter)

As I said, I like to hit cleanup, I guess. Get in [yield season], the next couple of questions are follow-ups. On the change in the capital required to AA, is -- does that give you more or less excess capital than if you had kept the old standard for this quarter of PML?

It was approximately the same. It depends what you do with the cat; we modeled it, it is no big difference, I think is more sophisticated way of thinking about it. Now, if I'm up 19% of risk tolerance on my PML, one gives me more; if I'm at closer to 25%, the other one gives me more so it depends how you run it and where you are on the PML.

Got it, okay.

Right? Because that was -- in the old model that was the determining number. If I pushed it way up on the PML then earnings and the Delta was the -- it required more and now I'm not. On the other hand, if my -- if I take a little less PML, it changes that.

Got it. Does it also reflect where we are in the cycle? I guess I'm thinking the old standard that included a year's worth of earnings, if next-January your returns are low, you obviously get less contribution from that than if next-January returns are higher.

You're raising a much more intriguing question, which the way I would tell you is that in the market conditions, let's say that if we are in a very good part of the market cycle, I will not keep any cushion. I will write all the way to my required capital by the rating agency because I have so much confidence in the business we write and this profitability. Why keep excess capital and not really maximize returns for shareholders? That's when we said we step on the accelerator and we write al the businesses we can. So this is for now and for the market environment that we are operating today and I think it is prudent in the way we think about it and it gives me comfort. Listen, my number one priorities, I want to sleep at night, right? I don't want to be turning and tossing. So if I feel good about sleeping at night then I think I have the right measurement. And right now believe me, we have enough excess to make me feel good about where we are.

All right. If you don't, they have pills for that now, Dinos. (laughter) My last one is just to follow-up on the repurchase commentary and John, I'm actually looking at the sheet and it looks like at a 9% ROE, it is 3.5 years at a 1.2 times; so it looks like maybe the cut-off is something like a 1.17 times or 1.08 or something and you're trading at 1.15 times. I mean, we're basically there. So if the stock moves $1 higher from here, are we turning off the buyback?

Well, it's the average ROE over the period in time, not your trailing. Because that was of September 30 and the 1.17 times to 1.2 times is the upper end of the range but we will continue to look at these options but you've got to average it out over the quarter.

Okay. So I guess what I'm getting at is if the market continues to get more enthusiastic about pricing and the stock goes up another 10% or more, and you get to the point where the math doesn't necessarily work, what is the option? Is it dividend? Is it -- and again, assuming it is not a hard enough market where we want to grow a lot, right? we are in this in-between land where pricing is up maybe a little bit more than loss trend, we don't grow a ton; the stock is too expensive to buyback, what do we do with the capital?

Well, listen, at the end of the day it is not a hard and fast rule. That would require another discussion between us and the Board. We told the Board we only buy it under a three-year or less recovery. If special dividends, which is not something that I prefer, because it loses that flexibility that I talked about that I can turn it up or down depending on what I see in the marketplace. One of the things that makes us what we are at Arch is the Paul Ingrey "light cruiser" strategy. we're agile, we adjust to things, both from an underwriting point of view, from what we do by line of business, et cetera, and that draws this into a category. If we get there, listen, I haven't seen 1.2 times book value for a long time. I keep dreaming about it. When I see it maybe we will have another discussion and then we'll -- we might make whatever determinations.

And then the other point is what's the ROE on the business [underwriting] in the quarter and January 1 may be better, may not be better. There's a lot of things; you question a lot of what-ifs and we've got to decide almost when we get there.

Got it. I guess the only thing I was thinking of is, I wonder if, again, if we get into a situation, maybe hoarding capital is the right strategy and turning off a buyback would make sense because if we really are within six quarters or eight quarters of a market turn, why not keep the extra capital rather than buying it back at a bad payback? Keep that capital so when the market does turn, you can write more business more quickly and if it is a short-term [direct] on ROE, who cares?

Right. I -- we agree with you. But give us a little credit, Ian. We model that. The reason -- don't forget, there's other ingredients on our capital structure that allows us quite a bit of flexibility. Our debt and hybrid-to-equity is very low. Even the minute somebody rings the bell and it says you're getting on the straightaway and we're going to write a lot of premium, I have the ability to raise, I don't know, three quarters of $1 billion to $1 billion of additional capital without diluting my common shareholders which is the last thing that I want to do. I didn't buy all the shares back because later on I want to dilute it. So that calculation we do continuously, to make sure that I never -- point in time, at no point in time, capital restrictions would not allow us to write as much good business as we can get our hands on.

Got it, very good. That's all I had. Thank you, Dinos.

Ron Bobman with Capital Returns.

Thanks. Should I ask this, operator or Don Watson to be put on the queue for next quarter's call? (laughter) I had one question remaining. The -- Dinos, why are large accounts executive assurance, do you know, rates stubbornly weak?

I wish I knew. I think -- I'm attributing to -- the class action activity is benign, and for that reason, probably some people, they get more optimistic. They are not going to have the significant losses emanating from these national class actions. Having said that, we made mistakes in other lines of business that makes us more cautious. For example, in the aviation business, commercial aviation, we didn't have major airliners go down; but the pricing got to a point that, at some point in time, even one or two incidents will take something from [thinly] profitable to extremely unprofitable. I'm suspecting that in the commercial D&O, maybe a slight change in environment; all of a sudden, you're going to have a lot of people with a lot of tears out there. So it is an attitude as to what do you view, where the overall rates are, and do you take into consideration what happened in the past and do you put some thought process into the improved benign activity.

But do you price purely that what's happening today, it is going to continue to happen in future. That's the same issue we had with RMS 11 which, you get a lot of different outcomes if you take two long patterns or if you take the short patterns, three years or four years and average that on cat activity. So you've got to make judgments. And in our judgment on the D&O world, I think rates are -- they shouldn't be continued to going down. I think that business should stay -- we are not saying it is unprofitable, but we continue to give up rate and we're giving it -- it's [shrunk] but it is still negative and that tells you a lot of people like that business in order for rates to continue to go down. There is a lot of capacity out there. But I -- at the end of the day, we are starting to be very cautious about that line.

Thanks a lot and since you brought it up, RMS, I think, also updated their European model middle of this summer. Is that going to change your -- have an impact on your pricing or rate expectations or desired rates for the January renewals?

It depends what the market reacts to. Don't forget, we were way underweight in European wind and we were way underweight on Japanese quake and others because we didn't like the rating environment. It wasn't just purely -- I think the model changes might cause the supply-demand to improve and if pricing goes up, it might give us more opportunities. But I'm not predicting that. I don't know when it happens and if it happens, we will react to it but we continue to be underweight in European wind because of the rates we can get.

Thanks and great job. Keep it up, please.

There are no further questions in the queue. I would now like to turn the call back over to Mr. Iordanou for closing comments.

Well, thank you, Fab. Thanks everybody for bearing with us for an hour and 15 minutes and we're looking forward to seeing you next quarter. Have a good day.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.