Arch Capital Group Ltd (ACGLN) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Arch Capital Group's third-quarter 2016 earnings conference call. (Operator Instructions) As a reminder, this conference call is being recorded.

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 will also make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the Company's current report on Form 8-K, furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website.

I would now like to introduce your host for today's conference, Mr. Dinos Iordanou, Mr. Mark Grandisson, and Mr. Mark Lyons. Sirs, you may begin.

Thank you, Andrew. Good morning, everyone, and thank you for joining us today for our third-quarter earnings call. Before I comment on the quarter's results, I wanted to note two items.

First, this October represents Arch's 15th year anniversary, and I would like to express my gratitude to our employees, whose dedication and commitment has built this successful Company over the last 15 years. Our employees are not just our most important asset; they are critical to producing the market-leading performance that we have seen these past 15 years, and I would like to say thank you to all of them.

Second item I want to comment on is about our pending acquisition of United Guaranty Corporation. As you know, Arch has agreed to purchase United Guaranty for approximately $3.42 billion. Early indications from the GSEs and regulators have been positive and we are hoping that the acquisition will close late in the fourth quarter of this year, which will minimize the disruption to our distribution partners in the mortgage lending space as well as the employees of United Guaranty, who will benefit from this timing as they transfer to Arch benefits and health care coverages as of January 1, so they don't have to deal with split-year deductibles and all the other complications that a different date might produce.

Now, turning to these quarterly results, we had a good quarter. Our reported combined ratio on a core basis, which Mark Lyons will define in a moment, improved to 86.5% for the third quarter as catastrophe losses were light at $10.7 million. Loss reserve development continues to remain favorable in each of our segments, which in the aggregate reduced our combined ratio by 8.8 points in the quarter.

There were no significant changes that we see in the property-casualty operating environment in the last quarter. In our insurance segment we saw a slight deterioration in rates across some sectors, particularly in the high access and short-tail areas. But rates were generally stable in most other lines, while the mortgage insurance environment remains both stable and healthy. Marc Grandisson will give you more details on what we see in each of the markets in a few minutes.

On an operating basis, we produced and annualized return on equity of 8.8%, while on a net income basis we earned an annualized return of equity of 15.3% for the quarter. As we have told you in previous quarters, net income movements can be more volatile on a quarterly basis, as these earnings are influenced by changes in foreign exchange rates and realized gains and losses of our investment portfolio.

Net investment income per share for the quarter was $0.53 per share, down $0.04 sequentially from the second quarter of 2016. Despite volatility in the investment in foreign exchange markets this year, on a local currency basis, total return on our investment portfolio was a positive 88 basis points, and 91 basis points if we include the effect of foreign exchange in the quarter.

Our operating cash flow was very strong at $421 million in the third quarter as compared to $359 million in the third quarter of 2015. Our book value per common share at September 30, 2016, was $53.62 per share, a 3% increase sequentially from the second quarter of 2016 and 12.5% increase from the third quarter of a year ago.

While some segments of our business have become more competitive, we believe that Groupwide, on an expected basis, the present value ROE on the business written in the 2016 underwriting year should produce ROEs in the range of 10% to 12% on allocated capital.

Before I turn the call over to Marc Grandisson, I would like to discuss our P&L's, which are essentially unchanged from July 1. As usual, I would like to point out that our cat PML aggregates reflect business bound through October 1, while the premium numbers indicated in our financial statements are through September 30. And then the PMLs are reflected net of reinsurance and retrocessional covers.

As of October 1, 2016, our largest 250 PML for a single event remains the Northeast at $488 million or 7.4% of common shareholders equity. I think this is the lowest percentage ever for us. Our Gulf of Mexico PML was at $418 million, and our Florida Tri-County PML increased slightly to $405 million.

I will now turn it over to Marc Grandisson to comment on the operating units and market conditions. And after that, I think Mark Lyons will share the financial returns in detail before we come back to take your questions. Marc?

Thank you, Dinos. Good morning to all.

In the third quarter we saw continued softening of conditions in the broad P&C world, particularly in the more commoditized lines; and, as Dinos mentioned, a stable MI marketplace. Our P&C units, both insurance and reinsurance, produced acceptable combined ratios as our underwriters focused on specialty lines, where knowledge and expertise differentiates this selection.

As you are all aware, we continued the buildout of our MI segment in the third quarter where returns are attractive.

Turning first to our primary P&C insurance operations, which represent about 60% of our total premium: rate changes in our US operations were relatively stable in the third quarter at a negative 110 basis points versus a negative 120 basis points last quarter. As in previous quarters, most of what we at Arch call our controlling low volatility segments -- which includes travel, A&H, contract binding, construction, and program business -- had rate changes that were in a slightly positive range, 50 bps; while our cycle manage segments, which includes property, marine, energy, and casualty, experienced single- to double-digit rate decreases.

Unfortunately, rate decreases are becoming widespread across more business units and have been building over the last few quarters. Increasingly, our business mix is moving towards smaller specialty risks, which have historically performed better in soft markets, given that they are less exposed to competitive pressures of the broad commercial liability and short-tail markets.

Globally, property P&C markets remain also under pressure from a rate level perspective. In the UK, rate changes across all our product lines averaged negative 5% this quarter, leading us to shift further towards portfolios of smaller risk with lower volatility.

Areas of opportunity within the insurance sectors were limited, with modest growth recorded in the third quarter in our construction and national accounts, travel, and alternative markets line. Most of the growth came because we took advantage of dislocation in those areas; yet our executive assurance property and marine businesses are areas where rate levels lead us to a continuing defensive strategy of reducing risk.

Market conditions in our reinsurance group, which is 30% of our premium volume, remain competitive. Our teams have to be very selective given the conditions in their operating environments.

But Arch's history is that our underwriters have been able to find opportunities that still meet our target returns. This quarter, specialty areas such as agriculture and motor grew, while short-tailed segments, such as property cat and marine, experienced significant rate decreases. And we accordingly decreased our writings in those segments.

Our strategy at Arch has been to focus on niche areas of opportunities where, as I said earlier, we believe that knowledge and experience gives us an edge. For that reason, and given the tough market conditions, in any one quarter our premium mix changes -- sometimes significantly.

Turning to our third leg, our MI segment, which is this quarter 9% of our premium, but a growing percentage of our premium earned: we estimate that our market share of primary NIW in the US rose to about 10% or 11% in the third quarter from 9% market share in Q2. In addition, we continued our market leadership in underwriting new US GSE risksharing transactions, which stood at $2 billion of notional limits in force, and we continued to see good volume from our Australian primary insurance relationship.

Notably this quarter, we elected to purchase a quota share on our Australian business to help manage the risk profile of our global MI exposure. While returns on this business remain attractive, we believe it is prudent to manage for potential adverse results. And we assess this risk much like we do in our other lines of business in the P&C sector, where we typically purchase protection to limit our aggregate exposures.

Our US MI operation increased its NIW 36% to $8.75 billion during the third quarter of 2016, of which approximately 79% came through the bank channel. It should be noted that there is seasonality in the level of mortgage origination. Historically, the second and third quarter have significant higher production then the first and fourth quarters. Our return expectation across our MI segment remains in excess of our long-term ROE target, and we expect that for the foreseeable future.

And with that, I will hand this over to Mark to cover the detailed financial results. Mark?

Great. Thank you, Marc, and good morning, all. As was true on previous calls, my comments that follow today are on a pure Arch basis, which excludes the other segment -- that being Watford Re -- unless otherwise noted. I will continue to use the term core, as Dinos mentioned in his notes, to denote results without Watford Re and the term consolidated when discussing results including Watford Re.

As Dinos commented, we announced the UGC acquisition in August for a consideration of approximately $3.4 billion, subject to a potential dollar-for-dollar reduction from any pre-closing dividend by UGC to AIG and subject to potential fluctuation due to the collar structure around our common equivalent preferred component. Financing and integration activities are proceeding smoothly as we push for a year-end closing.

Before I review our financial results, let me update you on our recent financing activities during the third quarter. The first is the issuance of 18 million 5.25% Series E noncumulative for preference shares in late September, which raised net proceeds of approximately $435 million, which will be used primarily towards funding the UGC acquisition.

Secondly, we negotiated a syndicated bridge loan facility in support of the UGC acquisition of $1.375 billion, the potential use of which has been commensurately reduced for the aforementioned preferred stock issuance. Thirdly, we began efforts to renew our existing credit facility towards increasing the capacity to $850 million, which includes a $500 million unsecured revolving credit tranche and a $350 million secured letter of credit tranche. The new facility has been signed this week, expires in five years, and gives us access to additional capital for the UGC acquisition and for general corporate purposes. Please refer to our publicly available SEC filings for more detail.

Okay. With that said, the core combined ratio for this quarter was 86.5%, with 1.3 points of current accident year cat-related events, net of reinsurance to -- reinstatement premiums compared to the 2015 third-quarter combined ratio of 89.7%, which reflected 2.3 points of cat-related events. The losses from 2016 cat events recorded in the third quarter, net of recoverables and reinstatement premiums, totaled $10.7 million versus $18.8 million in the third quarter of 2015.

These third-quarter cat losses stem mostly from within our reinsurance operation and reflect a series of small events around the globe, with no single event concentration. The 2016 third quarter core combined ratio reflects 8.8 points of prior-year net favorable development compared to 7.1 points of prior-period favorable development on the same basis in the 2015 third quarter.

This results in a core accident quarter combined ratio, excluding cat, for the third quarter of 94% even as compared to 94.5% accident quarter combined ratio in the third quarter of 2015. In the insurance segment, the 2016 accident quarter combined ratio excluding cats was 97.9% compared to an accident quarter combined ratio of 95.8% a year ago and 96.3% serially last quarter. This 210 basis point increase between the third quarter of 2016 versus 2015 was driven by 130 basis points in the loss ratio and 80 basis points in the expense ratio.

The loss ratio we increase was primarily attributable to certain large attritional losses emanating from our US operations. After adjusting for the incremental difference in large attritional losses, the accident quarter loss ratio this quarter is virtually flat with the prior year's quarter.

The reinsurance segment 2016 accident quarter combined ratio, exclusive of cats, was 96.5% compared to 94.6% in the third quarter of last year and versus 98.4% serially last quarter. The combined ratio reflected the impact of several excess property facultative losses that occurred during the quarter.

The mortgage segment 2016 accident quarter combined ratio was 60.7% compared to 82.5% for the third quarter of last year. This decrease is predominantly driven by favorable trends related to claim rates and claim sizes and the continued expense ratio improvement in our US primary MI book, due mostly to growth along with beneficial mix changes towards GSE credit risksharing transactions.

There was, however, one transaction this quarter in the mortgage segment which distorts the quarter-over-quarter comparison. Retrocessional coverage was purchased on certain Australian LMI business with loan to values greater than 90% that extended back to the inception of the underlying agreement, which was May of 2015. As a result, ceded premiums this quarter contained an additional $34 million of catch-up [cessions], which served to commensurately understate net written premiums for the quarter.

Regarding prior-period development, the insurance segment accounted for roughly 18% of the total net favorable development in the quarter, and this was primarily driven by longer and medium-tailed lines from the 2007 through 2012 accident years, partially offset by some accident year 2015 property loss development from our UK operations.

The reinsurance segment accounted for approximately 79% of the total favorable development in the quarter, with roughly 45% of that due to net favorable development on short-tailed lines concentrated in 2012 to 2015 underwriting years -- and the balance due to net favorable development on longer-tailed lines emanating across most underwriting years prior to 2013.

The mortgage segment contributed about 3% of the total net favorable development, which translates to a 3.2 point beneficial impact to the mortgage segment loss ratio -- again resulting from continued lower-than-expected claim rates.

The overall core expense ratio for the quarter was 33.4% compared to the prior year's comparative quarter of 34.2%. This 80 basis point improvement is driven mostly from the improved acquisition expense in the reinsurance and mortgage segments, with the latter benefit largely being aided by a higher proportion of GSC business receiving insurance accounting treatment, which has lower acquisition expense.

Additionally, corporate expenses included approximately $6.8 million or about $0.055 a share of nonrecurring costs associated with the UGC transaction. These costs reflect investment banker fees; bridge loan facility fees; along with related legal, accounting, rating, and SEC fees.

Core cash flow from operations was approximately $421 million in the quarter versus approximately $259 million in the third quarter of 2015. This was primarily due to a lower level of net paid losses this quarter versus last year's quarter.

Core pretax investment income in the 2016, as Dinos mentioned, was $66.3 million or $0.53 per share versus $67 million or $0.54 per share quarter over quarter and sequentially versus $70.4 million or $0.57 per share. The decrease on a sequential basis was primarily due to the effect of low interest rates on fixed income securities available in the market and unfavorable inflation adjustments on US TIP securities.

As always, we evaluate investment performance on a total return basis and not merely by the geography of net investment income, as exemplified by the $96 million of core realized gains in the quarter. That being said, total return was a positive 88 basis points this quarter, which reflects the impact of foreign exchange at a positive 91 basis points on a local currency basis. This return was led by strong equity, noninvestment-grade fixed income, and alternative investment results.

Our effective tax rate on pretax operating income available to our shareholders for this quarter was an expense of 6.5% compared to an expense of 5.7% in the corresponding quarter of 2015, driven by an increased proportion of US-based income. This quarter's 6.5% effective tax rate includes 50 basis points or roughly $800,000 relating to a true-up of the prior two quarters' tax provision to the estimated annual effective tax rate reflected here. As always, fluctuations in the effective tax rate can result from variability in the relative mix of income or loss reported by jurisdiction.

Our total capital was $8.24 billion at the end of 2016 third quarter, up 8.5% relative to last quarter, and up 2.6% when excluding the recent $450 million preferred stock issuance discussed earlier. Our debt to capital ratio this quarter remains low at 10.8%, and debt plus hybrids represents 20.2% of our total capital, which continues to give us significant financial flexibility.

We continue to estimate having capital in excess of our targeted position. We did not purchase any shares this quarter under our authorized share buyback program, which has remaining authorization of $446 million at quarter's end. Dinos mentioned book value, so I will not.

And with these introductory comments, we are now pleased to take your questions.

(Operator Instructions) Elyse Greenspan, Wells Fargo.

Do you have just any kind of initial insight into what your potential fourth-quarter losses would be from Hurricane Matthew?

Yes, early estimates -- and it is quite early -- is that it would be within our cat load. And let me remind everybody, our cat load is about $40 million a quarter.

So what we see -- on a model basis, we get a number close to the cat, but when we see the actual claim reporting activity, it's much lower. So it's too early for us to narrow that number, but it looks to us like it's within the cat load.

Okay. And then would that be more of a split insurance versus reinsurance, or is that too early to say?

Right now it looks like it's a 50%/50% allocation between the two -- about half of it coming from our insurance operation, and half of it coming from our reinsurance operation.

Okay. And then just in terms of the cat load, that $40 million, I believe, has been fairly consistent. And you did reference your PMLs have been coming down at the lowest level, I guess, that you guys have ever been at. So why overall do you think your cat load for the Company isn't coming down, when you think about it that way?

Well, I don't think the PMLs came [up] dramatically. They have been the lowest, but if you look at last quarter versus this quarter, the PMLs -- they came down by a few million bucks on $450 million or $500 million. It's a rounding error, so I don't -- you know, we estimate the cat load based on two parameters: what is the aggregate PMLs, and also what kind of pricing we're getting.

In addition to this, as a result of deemphasizing high excess and then reshaping the portfolio, you could still have an average that is somewhat more stable but the PML could change dramatically. So the shape of our curve has changed as we have gotten away from the high risk excess area, specifically on the cat reinsurance.

Okay. And then one question. In terms of the UGC financials that you guys disclosed with the deal, the accretion -- double digits in the first year and then 35% [about] or so in 2017: are you guys planning on taking the intangible amortization through earnings? So are those accretion figures including intangibles?

That reflects -- yes, that reflected an estimate of the mix between goodwill and intangibles at the time. As we work through towards closing and getting much more clarity on what's goodwill versus amortizable intangibles, that will modify it. In fact, I think you can see some of that in the prospectus supplement that we had for the preferred offering. You know, some accounting rules around it, but there was more refinement on the intangibles.

And whenever we go to the markets next -- and that will have a pro supp -- you might see an adjustment there. What matters is what it is at closing, and we are working with our auditors to fine-tune that.

Okay, great. And then one last question. We are a couple of weeks away from the presidential election. Dinos, I was just hoping if you could just give some high-level views on potential impact of the election overall, just on the insurance industry. Thank you very much.

I don't know. I guess it depends on what happens with who the President is going to be, Congress; and are they friendly to the business environment or unfriendly? Without knowing that, it's -- the big issue for the insurance business is going to be on appointment of judges, how the Supreme Court it will be.

And it's a slow process, but if we continue in the path of the last eight years, I can tell you that the future is going to be more challenging for the business, and we've got to adjust to it. Because at the end of the day, that's what awards get determined -- not only in the cases that they get litigated, but also the cases that they get settled, because the settlement values go up based on the attitude of the Court. So not knowing what's going to happen, hard to predict.

Okay, thank you very much, and good luck with getting the UGC deal closed.

Kai Pan, Morgan Stanley.

First question -- good morning. First question on UGC: now you have like two months after the announcement to speak with external clients to the banks. And is there any indication in term of a potential market share loss because of concentration issue? And how does that compare with your initial thought? And any -- any offsetting factor internally on the expense saving side? You can offset some of those?

Well, let me answer the first one. I will get Marc Grandisson to get on the second part of your question.

But on the first one, first and foremost, you've got to understand that we are running independent of each other. We're still two independent companies. We're going to come together after closing.

So our discussions with the market and the clients is separate from the UGC discussions with the market and the client. No indications yet that there is any discomfort about what they do with us or what they do with that.

Once we close and we become one Company, we will revisit that issue. But nothing so far that indicates any significant overlap that it might be problematic.

Actually -- yes, this is Marc now. Actually part of the due diligence sort of highlights to us that there is not as much overlap as we might think. But again, the proof is going to be in the pudding after we close the books, and we go represent to some of those that are -- that have -- that we may have overlap on. It's too early to tell right now.

In terms of the expense savings or working through the operations, we have teams that are dedicating -- working very, very diligently to try to assess and, first and foremost, try to understand what both sides have in terms of system and operations and structure to see how we can make something that will be unique and cohesive as we go forward after the closing. We have been making good progress in that direction.

At that point in time, we are not so focused on -- to address your question specifically, on the expense savings or what (inaudible) there. We are, as we said in August, not doing that transaction for that reason.

First and foremost, we think there will be some. We don't know how much it's going to be. Our team are also going through that process. And the savings might come not necessarily on a linear basis. We will have to integrate and get things together. So it's very hard for us to tell you anything more than this at this point in time.

And Kai, it is Mark Lyons. Let me just add that when we are doing our economic analysis of this deal, and when we -- and we communicated on our call in August about this transaction -- we actually anticipate some falloff of market share. So to the extent that there is some marginal falloff, it wouldn't surprise us. And in fact, it's been contemplated.

Okay. Mark, any estimates on additional interest expense for the fourth quarter?

Well, I think you can -- whether you call it interest expense or not, you can take your 5 and a quarter times the $450 million and add that in. As far as -- we are really not in a position yet to discuss timing or extent of any additional offering. But we are striving towards closing at year-end, so there's two months to accomplish quite a bit.

That's good. And then my second question is really on the core loss ratio, the deterioration year-over-year. You explained that with some higher level of attritional losses in both insurance and reinsurance segments. I just wonder, do you consider this year's large attritional losses sort of normal, or just higher than, like, exceptionally good results from last year?

No, on the insurance group, it was a surety loss that we have accounted for it to its full extent. Surely is a volatile business by nature. Occasionally, it will give you that volatility. One quarter you have a big loss then two or three quarters of no losses.

So I don't -- you know, we look at the book, and the composition of the book, and the long-term performance, making judgments as to how healthy or unhealthy that book is. So one quarter of event doesn't really gives you a trend, so to speak.

On a similar case with the reinsurance, this is excess of loss property fac transactions. And occasionally, that's where you're in business; you take in the volatility from your clients, so when it happens, it comes to your books. But that particular unit has been a big, big moneymaker for us, and it continues to be. So I don't attribute that as a trend.

In fact, we looked at the last -- the trailing 12 months accident combined ratio adjusted for all these large losses, and it's actually very, very stable, which is what we care for. Like, to do Dinos's point, one quarter does not make a trend. And where we are right now, we are very comfortable and very happy with the stability, actually, of the accident year combined ratio.

And, Kai, just one more thing to add to Dinos's note about the reinsurance side: the facultative group has been enormously profitable. By its nature, short-tailed excess position is going to be volatile. Any given quarter could be volatile.

In our view, there was roughly 2.5, a little more, of long-term loss ratio points that may have been excess of what you normally would see, which translates -- if you go back and do the arithmetic, it pushes you to about a 60 or a 59.9 on the adjustment for the loss ratio for the reinsurance group totality, versus 59 the prior year. So that's a 90 basis point movement.

Great. Thank you so much for all the answers.

Quentin McMillan, KBW.

I just wanted to touch on the UGC acquisition. You have a footnote in here that it is dependent on closing the execution of an excess of loss agreement between AIG and UGC. I just wanted to ask if you guys have any clarity at this point on that reinsurance transaction -- sort of, maybe, what it will be protecting you guys against in the future? This is not the Bellemeade Re I or Bellemeade Re II. I'm talking about the third excess of loss agreement -- what it's going to protect in the future, and maybe if you have gotten that in place at this point?

A couple layers there. First layer of answer is that between AIG and Arch, we have agreed on terms and conditions of it. It is not yet signed because we need approval of the GSEs. That's a requirement, and that is part of our discussion with them now. So that's the first point.

So I would say significant progress on that aspect. Secondly, it's an aggregate excess of loss that -- there's a couple of layers involved, but it's effectively 2009 through year-end 2016 coverages. It's an out-of-the-money cover that in the aggregate provides quite a bit of capital relief from the viewpoint of S&P.

And who is going to bear the original cost for that? Is that going to be paid for by Arch, by AIG, or a combination?

It is effectively paid by UGC at closing, so it's an applied book value reduction for the ceded premium.

Okay, great. And then can you help us -- in terms of the investment yield of the portfolio, when UGC is added in, what is sort of the current yield and/or duration of the UGC portfolio? And how much uplift might that have on the overall Arch portfolio? And will you be using the extended duration of the UGC premiums to extend your own duration or change anything in the overall investment portfolio going forward, maybe starting in Q1 2017?

Let me start, and I will ask Dinos to say a few words, too. First off, once the closing occurs, the management of that will transfer, of course, to AIM, which is our internal -- our Arch Investment Management.

The coupons on that book is higher. It's about 3.3%, I think, maybe 3.5% as the average coupon. It's a lot of credit book in there, which could be reshaped.

So I think some of that is timing. I would expect it to conform more towards Arch's approach of total return, and not just getting lost in the sauce of coupon income. That will morph over time, probably throughout the course of 2017.

Yes, it will probably take at least two or three quarters for our investment professionals to make whatever changes we feel that are appropriate. But at the end of the day, it's going to be -- it's going to look more like the Arch duration and credit quality than what exists today.

Okay. And just a quick follow-up: the coupon in the UGC book you said is about 3.3% average. What is the Arch current average coupon?

Closer to 2%.

Okay, thank you so much, guys.

Michael Nannizzi, Goldman Sachs.

Just a couple quick ones. Mark, maybe on the investment portfolio, the yield or the investment income ticked down sequentially; looks like there was some seasonality last year consistent with that. Is the third -- is there anything that we should think about that is not run rate from third quarter? Maybe some mortgage-backed security payouts, or something along those lines that would cause that not to be consistent?

(laughter) Every quarter there is -- it's always a new story. So I wouldn't look at it in a trend sense.

Okay.

That is my total return comment. Clearly, our investment group harvested some gains; hence the approximately $100 million of realized gains I noted. So, again, based upon our total return approach.

So you get those gains, and you put some of them back in to -- the extent to which it is put back into fixed income, you've got to deal with new money rates there.

Got it, okay. So you got some harvesting there. Okay. That helps. Thanks.

And then how should we be thinking about the tax rate? Looks like -- so guessing the MI impact has caused it to lift here over the last few quarters. How should we be thinking about that longer-term once you integrate UGC?

Okay, good question. First I will -- a slight correction to what you said. Mortgage was contributory to that, but remember, our mortgage segment is very broad, and some of that is out of Bermuda and other jurisdictions. And the US MI operation clearly was contributing a positive underwriting gain at this point.

So they were contributory, but let's not overlook -- the facultative unit we talked about on the property side, the insurance group, and the onshore reinsurance group all were profitable and contributing income. So it's really the composite of those, Michael, that actually inched up the effective tax rate.

The second part of your question, with UGC, we have talked about it on our call about UGC. We plan on having it, subject to approval, of course, with the GSEs, a quota share facility in place. So only roughly half of those exposures and gains will be resident in the US jurisdictions. So it's going to have an uplift, but probably not the slope of uplift that you might be contemplating.

Okay. How can you tell what I was contemplating? Did you look inside my --?

I reverse engineered the first part of your question.

I thought that -- it was -- that felt invasive.

(laughter) It was the tone of your voice.

Ah, yes. Thanks.

And then last, really, a quick one: the Australia quota share -- can you talk about how you are thinking about that on the forward? Is that notionally the right amount that we should be covering in? I would just love to get a little bit more color on the thought process there (multiple speakers)

The thought process is more important than the actual specific transactions. When -- with everything we do, we have an overlay of the risk management. We look at our capital, how much risk is prudent for us to carry; and at the end of the day, we look for ways to manage that. And reinsurance is one way to do it.

So we look at it from a global perspective: how much MI business we have, how much we will retain net to our books. And then the rest of it we reinsure out. And that is the attitude with everything that we do. It's not on the MI side; it's also on the P&C side, both reinsurance and insurance.

And as we said in prior calls, going forward, after the acquisition is completed with United Guaranty, we will be looking at the MI book, including the US book, and buying the appropriate aggregate protection to make sure that we have, from a risk management point of view, the proper parameters. We always think about PMLs. We think about PMLs also not on the P&C side only, but also on the mortgage side. And that will drive a lot of our decisions doing a Bellemeade III, doing an aggregate excess of loss for different years.

As Mark told you, the transaction we have with AIG will have a 2016 and prior -- 2009 to 2016. So all those years are taken care of, so to speak. And then for us is what we do for 2017, 2018, 2019, as we go forward.

But that is the philosophy. And it's no different than what -- how we run the Group for the last 15 years: measured approach to pricing properly, and then also making sure we don't take too much of a meal, independent of how profitable that meal is.

A right-before-lunchtime comment. I think that is totally fair.

As you can tell from my voice, I'm a little bit under the weather, so the meal for today is avgolemono, which in Greek means egg lemon soup. That's the only thing that cures a common cold.

I won't try to pronounce that. (laughter) Thank you so much.

Sarah DeWitt, JPMorgan.

Wanted to get your latest outlook for mortgage insurance market conditions. One area of concern I hear sometimes is that we are late in the credit and economic cycles. So how much longer do you think mortgage insurance returns will be good for?

We don't see anything that clouds the horizon. I think it's pretty clear. All the indications is that it's a stable market. Pricing has been stable. The environment is good.

We are projecting housing prices to be going up somewhere between 3% and 5% next year. There is certain states, especially the energy states, that there might be some issues. But that's what RateStar is all about. We look at -- and adjusting our pricing on the basis of what the risk components are.

But long-term we view the market to be very healthy, and there's no indication for us that it's going to change in the next few years.

Okay, great. And then additionally, do you expect any FHA rate cut before the election? And what would be the implications of that for you?

I have no idea what the FHA will do. And you know, I don't like to guess at the end of the day.

A lot will depend on the actuarial work that is going to be done to see what their capital requirements -- if they are meeting the minimum standard. That report usually comes out in mid-November or so forth, so on. But I -- we don't anticipate anything before the election. But you never know after the election.

Once they take an action, then we can gauge what that might mean. But without them doing something, it's very hard to predict.

Okay, great. Thank you.

Charles Sebaski, BMO Capital.

First is on -- there was a report recently regarding the GSE and some of the risksharing, and regarding some bondholders that are raising issue regarding credit quality from reinsurance and the GSEs offloading that. Do you have any thoughts, or have you had any conversations with a GSE? Is there any real legitimacy to the amount of risk transfer change going on? Appreciate your thoughts.

No, I -- we don't -- basically, the GSEs are interested in having two avenues: the cash market and also the reinsurance market. Their allocation has been pretty constant, so to speak -- about 25% to 35%, depending on the quarter, to the reinsurance market; and then the rest of it, 65% to 75% in the cash market. And they have been consistent with that approach.

Now, I don't believe they have any concerns about the creditworthiness of reinsurers, because at the end of the day, they make the selection as to whom they are going to allocate these transactions to. So as a matter of fact, for the GSEs it's [terrific] by looking at the credit quality of the reinsurance and allocate what portion of the deal they want to allocate to any particular individual.

All right. Then I guess on the insurance business, on the low vol, you guys had pretty nice growth in some of the travel and accident and some of the other products. And it seems to be marketplaces -- that there's lots of interest in the low vol business today. I was curious if you are seeing any additional increase in competition, and whether or not your growth is coming from new programs coming out, or just kind of grinding it out doing good work with the existing business? Any color on that?

Yes, these are product lines that -- don't forget, when we built Arch, we got into product lines that nobody wanted to do back in 2002, 2003, 2004, because some of them, they can be slow growth unless you make a major purchase. These things -- it requires patience and perseverance to make them meaningful over time.

Yes, depending on the cycle, there is more competition or less competition. But more importantly, with these kind of products, you have to have a long-term view and a long-term commitment. And it will take time to build volume.

It doesn't fit with the thesis of instant gratification. You don't get that with these kind of products. So we've been very patient, and we have grown some businesses from nothing to a reasonable size. Our lenders business grew over the years from some $20 million to over $100 million in premium.

And we try to find these little nuggets that we work over time to give us more control of our portfolio. And as Marc Grandisson said -- and I will turn it over to you for his comments -- that low volatile business is what we like to build most of our insurance group.

Not abandoning the other segments, because the other segments -- even though they are volatile, in certain market conditions you can make a lot of money. If the market is very hard, you know, we will write a lot of the covers that we are not willing to do today. It's not bad business; it's just bad priced business. When the price improves, they're good business.

On travel side, I think I would echo what Dinos just said, obviously; but in addition, we have a couple of new transactions that we have entered into programs and have been very, very nice going so far. But we also are investing. And it's also a very intense technology play, and we are always on the look to build that aspect of the book of business.

Because to your point, it is low volatility. It is also -- it derives -- it's sticky, a lot stickier than other business could be. So we are definitely focusing ever more on this. And I think the reflection of the premium in our effort -- this is sort of a reflection of our efforts in this space, and I think you should expect more in the future.

Thanks a lot for the answers, guys.

Ryan Byrnes, Janney.

Just had one question. I guess post UGC deal, does your PML tolerance change at all? Essentially, are you still willing to risk 25% of the total capital? Or is that just of the property capital -- sorry, property-casualty capital going forward?

No, no, it's total capital. It hasn't changed.

No change.

No change.

There is no change, really.

Great, that's all I had. Thanks.

Brian Meredith, UBS.

First one -- I'm just curious. There was a big transaction that was announced of another MI company. What do you think the possibilities are of market share shifts as a result of that? Could that be a positive for you all?

I don't know. The -- you're talking about a transaction with a Chinese ownership.

Yes.

So I think that's an appropriate question to ask to the distributors of the product. I mean, this is for banks to determine if they want to continue to do business or not, but not for us.

So I wouldn't know. I have no -- I haven't the faintest idea if their reaction will be positive or negative.

Okay, great. And then just my second question: in the news there's been a couple of articles that you guys have hired some pretty high profile business in the legacy business. Can you guys talk to me about your views on the legacy business and opportunities?

Yes, I think that we have a -- certainly one individual that joined us, and that was obviously publicly discussed. We are exploring at this point. We are really looking around and trying to see whether there is something to be done there, whether it's Arch or not.

We have all the things on the table. We are exploring what is out there. But certainly we had -- we did an LPT last quarter, as you remember. We do think the space has -- you know, lends itself to a level of heightened interest at this point in time.

I think we are certainly in a place where rates have been going down in certain sectors, and some clients may have -- may be running out of patience and tolerance for some books of business, and certainly we are always -- Dinos and I are always looking forward to provide services and products in the marketplace that will help the industry. And that's certainly one area.

But it's -- we're still -- we are working through it. And when we have something, we will obviously let you know.

We will announce the details. But listen, the theme here is every time you come out of a soft market -- and eventually we will come out of a soft market -- there is repair work that needs to be done. And we want to participate in the repairing.

Makes sense. And then just lastly, I know you talked a fair amount about the retro you bought on the Australian book. I know you guys have great analytics and stuff. Was there anything behind it that you looked at the housing prices in Australia? I know there's a lot of talk about -- people think they are really peaking out here. Any concerns there?

No concern whatsoever. This is more from an aggregation point of view, how much you want to have from an overall MI book of business. Because the reinsurance that they participate on the deal -- they got pretty good return characteristics. They are going to make some good money on it.

At the end of the day either you add a lot of capital to your balance sheet, and you might have maybe a little over commitment to one line of business versus others, or you try to keep the balance. And this was more balancing, from our perspective.

Great. Thanks, Dinos. Feel better.

I'm going to try.

Josh Shanker, Deutsche.

UK pricing down 5% -- I sort of associate the UK with a lot of specialty markets. Is that experience leading the market down, or is that lagging the market? And do we need to be worried about another step downward in pricing for the market in general? Most of your competitors have not been so grim about pricing conditions.

The UK market is extremely competitive and has been for a long time, especially the traditional Lloyd's placement in the international business and open brokerage. So that is -- that's going on, that's been going on for a little while. So it's not new, Josh.

But in terms of leading where it's going to go, unfortunately, I'm afraid that we will have to experience the further rate decreases going forward. I think there's a lot of competition ahead in the London market and the UK market more broadly. So -- but again, things may change. And some event happen, it may change things overnight.

But there certainly is a lot of competition out there. We don't see anything ebbing at this point in time.

If you don't merge them correctly, you can't make good pricing judgments going forward. And we want to say what we see, and you guys make the judgments, if others -- they are not willing to talk about it.

Josh, I would add -- and it's publicly available information: by their own account, Lloyd's has about a 3% on the current underwriting year, about a 3% to 4% return expectation -- return on capacity. So that tells you something about the absolute rate levels.

If we put on our 1997 to 2001 hats, how hard is it to keep the team together in a soft market? And how do you keep everybody content when you can't make money in the business?

I think the shifting in our book of business -- I mean, people are working extremely hard to transform, or to just gradually over the cycle -- as we try to do -- as we've been working on for the last 10 years, to shift towards low-volume in total business takes a lot of work and a lot of effort. So I would just say that it's just a shifting and realigning our expertise and our assets or our people towards different lines of business.

Things are transportable across lines of business. It's not like an excess D&O can only do excess D&O. There's a lot of stuff that that person can -- and has the culture and the understanding as to how we do cycle management. So we try very hard to keep those people and keep them busy doing other things.

This is on the insurance and on the reinsurance.

It's across the P&C units.

And there's still a lot of deferred comp they have to earn that they would lose if they left, I would imagine.

Yes, there is a big component of that. But that is -- only that is. At the end of the day, they know over their career with us, they're going to have good years, and they're going to have some not-so-good years. But overall, if they produce for our shareholders, they are going to make very good money. And for those that have been here, and we have a pretty stable management, they have done extremely well.

Well, good luck in hard times.

Jay Cohen, Bank of America.

This will be quick: my questions were answered. Thanks for the call.

Thanks, Jay.

Thank you.

Ian Gutterman, Balyasny.

The menu is avgolemono, Ian.

I heard. My question was taken. I had think of something else to ask you. (laughter) Does it usually help with colds, or no?

Yes -- you know, it is Greek penicillin. You do add lemon soup, it's Greek penicillin.

So I actually wanted to follow up on Ryan's question about the PML limits. And obviously you are so far away, it's not really an issue. But if the market did get better, I guess I'm surprised you would say 25% of the whole balance sheet, because that essentially would suggest you are using 25% of [pmers] capital to write cat, if you ever got to that point.

You're talking about our PMLs in the MI business, or the PMLs on the property cat business?

On the property cat, when you answered Ryan that (multiple speakers) 25% for everything.

Well, no, the 25% is what our Board allows us to risk, assuming we like the pricing and the risk/reward relationships. The fact that we are at 7.4% today is an underwriting judgment the management team is making. It's not a restriction by book.

Sure.

But if rates quadrupled tomorrow, I can go to 50% of capital exposure on PML without going back to my Board, and says, hey, that 25% is too low, and you got to change it. And if we change it, we are going to come and tell you, because I think shareholders need to know what kind of exposure you take.

Don't forget -- and I don't know what other MI companies do, but we do PML calculations on PMI business also. And it's a requirement by our risk committee of the Board -- you know that every quarter, we will talk about how much is our PML on our MI business. And that's the reason we had all these discussions about how much reinsurance -- both total share, or aggregate excess of loss, or transactions like Bellemeade I, Bellemeade II, or similar type of transactions that we might do in the future.

So all of that is around understanding that we have one simple principle that drives our risk management philosophy, that independent of what event happens, we have to not injure the balance sheet to the point that we are not in a very strong competitive position the day after.

Exactly. That's what I was trying to get at, because I guess when I heard 25% of everything as a limit, I guess I thought that that is essentially at the P&C capital would be whatever that would be, 35% or 40%, or something like that. So see what I was getting at?

Not quite. If it's 25% -- at 25% of equity capital, it's a limit -- it's a pretty safe limit for adverse conditions. You're talking about in 1 in a 250 type of events.

So the PML calculations that we do for our MI business -- it is somewhat even worse than the recent financial crisis we have passed. We have gone back all the way to the Depression era and factor in the lot of available -- and skimpy available statistical information -- to come up with some reasonable assumptions as to how things might look like if we have events of that nature. And we still want this Company not only to survive, but to be in a strong competitive position the day after.

Fair enough. The other thing I was going to ask you is I think you mentioned some surety losses are part of the attritional. Can you just remind me how your approach that business? Is it sort of vanilla construction bonds? Does it tend to be sort of commercial surety, or --?

It was a construction bond -- is a surety. One of our contractors messed up, and we had to step in. And you saw lot of presses. Some stadium up in Connecticut.

Got it, got it. And is it residential or commercial?

It's commercial. Commercial surety.

Okay, okay. So there's --.

The building was a baseball stadium.

It's contract surety but a commercially (multiple speakers)

Where I was going with it is: how do you think about clash with MI? I know there's not direct clash, but it's something that --.

No, surety and MI -- there is no clash there, because these are all --.

Well, bad credit cycle, right? (multiple speakers)

-- between the investment portfolio and that.

Fair, okay.

And that's why we don't do resi -- our MBS [won't] clash with what we do in the mortgage.

MI. Yes.

And we consider that in part of our mix, how we manage the Company.

Got it, got it. All right. I think that's all I had, thanks.

Thank you. Ladies and gentlemen, this now concludes our question-and-answer session. I would like to turn the call back over to management for closing remarks.

Well, thank you for listening to us. And we're looking forward to talking to you next quarter. Have a wonderful afternoon.

Ladies and gentlemen, thank you again for your participation in today's conference call. This now concludes the program, and you may all now disconnect at this time. Everyone have a great day.