Good day, ladies and gentlemen and welcome to the Quarter Three 2015 Arch Capital Group Earnings Conference Call. My name is Emma and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of the conference. [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 statement 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 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. And now I would like to turn the call over to Mr. Dinos Iordanou and Mr. Mark Lyons. Please proceed.

Thank you, Emma. Good morning everyone and thank you for joining us today. Our third quarter earnings were driven by solid reporter underwriting results while investment returns were impacted by decline in the equity markets. Group-wide and on a constant dollar basis our gross written premium increased by nearly 4% in the third quarter over the same period in 2014 while net written premium was up approximately 1% as underwriting actions in our insurance and reinsurance business were offset by growth in our mortgage business. Changes in foreign exchange rates reduced our net written premium on a U.S. dollar basis by approximately $21 million or approximately 2.4% of our volume in the quarter. On an operating basis we earned $126 million or $1.1 per share for the third quarter which produced an annualized return on equity of 8.6% for the 2015 third quarter versus 9.7% return on equity in the third quarter of 2014. Looking at it from a trailing 12-months ending in September 30, 2015, after tax operating income available to Arch common shareholders produced a 9.9% return on average common equity while net income available to common shareholders produced 11.6% return on average common equity. On a net income basis Arch earned $0.60 per share this quarter which was lower than operating income primarily due to realized investment losses. Net income movement on a quarterly basis can be more volatile as these earnings are influenced by changes in foreign exchange rates and realized gains and losses in our investment portfolio. Our reported underwriting results remained satisfactory as reflected in our combined ratio of 89.7 and were aided by a low level of catastrophe losses and continue favorable loss reserve development. Net investment income per share for the quarter was $0.54 per share up $0.01 sequentially from the second…

Great, thank you, Dinos and good morning all. As was true on last quarter’s call, and the last few quarters, my comments that follow today are on a pure Arch basis which excludes the other segment that being Watford Re unless otherwise noted. So, same as in previous call, I would be using the terms core to denote results without Watford Re and just on consolidated when discussing results that includes Watford Re. Okay, the core combined ratio for this quarter was 89.7% with 2.3 points of current accident-year CAT-related events, net of reinsurance and reinstatement premiums compared to the 2014 third quarter combined ratio of 88.5% which reflected a lower level of CAT at 1.6 points. Losses reported in the third quarter from 2015 catastrophic events, net of reinsurance recoverable or reinstatement premiums totaled 18.8 million versus 14.2 million in the corresponding quarter last year, primarily emanated from Chilean Earthquakes and the California fires along with various smaller events. The 2015 third quarter core combined ratio reflect 7.1 points of prior year net favorable development, net of reinsurance and related acquisition expenses compared to 8 points even of prior period favorable development on the same basis in 2014 third quarter. This result in a core accident quarter combined ratio excluding CATs for the third quarter of 94.5% compared to 94.9% in the third quarter of last year. In the insurance segment, the 2015 accident quarter combined ratio excluding CATs was 95.8% compared to an accident quarter combined ratio of 98% even a year-ago. This 220-basis point improvement was driven by 150-bp reduction in the loss ratio and the 70-basis point reduction in the expense ratio with the loss ratio decrease reflecting lower large loss attritional activity than was the case in the third quarter of last year. Taking this…

[Operator Instructions]. And your first question comes from the line of Amit Kumar from Macquarie. Please go ahead.

Thanks, and good morning and congrats on the quarter.

Thank you.

Thank you, Amit.

Just maybe one or, I guess one or two questions. Number one is, going back to the discussion on RateStar there was some confusion in the marketplace when the press release came out, as to what it means for pricing and your competition. Can you talk a little more about it and without obviously giving away the secret sauce, talk about the expected ROEs? And maybe talk about how should we think about the adoption rate of RateStar going forward? Thanks.

Yes, as Coca-Cola who’ll never reveal their formula, we won’t reveal our formula either. But at the end of the day, we’re in the underwriting business and I think the more robust analytics you have in the way you allocate capital and price, the risk of exposure, the better off you are as an organization. So, this effort is towards that goal. We’re trying to go from a more simplistic approach to pricing mortgage risk to something a bit more sophisticated that we introduce other variables in the decision making, in essence affecting the pricing. Now, it doesn’t mean we’re going to abandon the rate card. The rate card is out there and the there is some bank channels, some customers they prefer that. And basically they will only do business on that basis. We will continue to do that but also there is other channels that they prefer to go to a more sophisticated pricing methodology that more appropriately allocates the right premium to the exposure. And we’re going to go forward with that where appropriate. So, you want to continue to see us having both the rate card and RateStar and only the marketplace will tell us as to how much of which is going to be used over time.

Got it, that’s helpful. The only other question I have is going back to the discussion on capital management. And again, it’s a high-quality problem. I’m not sure the capital is burning a hole in your pocket. Would you consider other avenues to return capital or are we not there yet? How should we think about that?

Well, I mean, that’s the million-dollar question. At the end of the day, yes, we always consider other avenues. Having said that, there is also, we are known that you might want to have a little bit of ammunition in case opportunities come as the market turns. So, it’s more of a complicated issue for us. What was not complicated in this quarter was that, we usually stick to our knitting, and when we made the calculations we felt that it might take four to five years to earn back the premium we’re going to pay when we purchase shares. And we said, let’s not do that let’s see what other opportunities we have or other avenues. Having said that, we’re going to have those discussions, both internally as a management team and also with our board when we meet, and we’ll make determinations on that time.

Okay, fair enough. That’s all I have. Thanks for the answers.

You’re welcome.

Thank you. And our next question is from the line of Michael Nannizzi from Goldman Sachs. Please go ahead.

Thanks so much. Just couple of hopefully quick ones, on the U.S., on the M.I. business, can you talk about how much of your NIW in the quarter was singles versus monthly premium?

Mark, you have those numbers.

Yes, it is approximately 24% other than singles.

Okay. And the RateStar is relevant to the monthly business I take it?

Yes, predominantly yes.

You can apply them both sides. I mean, it’s because even when you do singles, you have, you get granular mortgage by mortgage attributes. So you can apply that. But at the end of the day, it is, when you go to single, you try to look at your return, what kind of a price you’re going to get and that’s why you saw a significant reduction in us, for the quarter as to how much we wrote in singles.

Got it. And then, if we were to think about the lead RateStar versus the rate card, what demographic - I mean, I’m guess for some types of business it’s going to be cheaper and for others it’s not going to be. So is there, like is there any way to kind of think about?

This type of business is exposure, Michael; it’s exposure. Let me turn it over to you and you tell me the difference, if you have, if you have two loans the both 750 FICO and 90 LTV, but one borrower has a coverage ratio of 35 and the other one 25, which one loan would you prefer right. And at the end, how do you reflect that in your pricing. I’m not going to get into all the algorithms that we have because then it’s not only you listening, our competitors are listening, so.

I understand.

But introducing additional variables, you’ve seen it in the a lot of other P&C lines, you’ve seen it a lot on the selection of risk in the automobile business, progressive is very good and famous for its Geico, etcetera. And at the end it makes for a better return for shareholders and probably a fairer charge to the consumer based on their own risk characteristics.

Got it, okay. And so, just last one on that not about the algorithm. But for the players or for your customers that do accept or prefer RateStar, have you seen a meaningful change in submission volume?

We haven’t yet introduced it to them. We finished the project we made the press release that’s why I talked about it. And our sales force is in discussions with the marketplace, and starting to introduce it. At the end of the day, we’re going to continue having both rating engines available and it would be up to our customers to choose which one they prefer.

Got it. Thank you so much for that Dinos, I appreciate it. And then really quick, Mark, on I was just looking at Watford written premiums versus reinsurance ceded premiums, and there is a sort of growing gap there. Are you, is Watford or is the insurance sub or segment ceding business to Watford or is Watford picking up business from outside of Arch as the difference?

Well, as I commented on a gross basis, just a way to look at it, 29% of it is coming natively on their paper. But we’re continuing to get Arch Re affiliates and Arch Insurance to be sending over either a retro session or reinsurance. And I think this quarter that was slightly more proportionately from the insurance segment.

Got it. Okay. And then the last one on the reinsurance expense ratio, just trying to sort of think about that a little bit. So, it sounds like the expense ratio to procure businesses for reinsurance is going up, so that’s a prior tailwind to the insurance expense ratio. But so that’s going to raise the acquisition cost I guess for reinsurance but then you have an offset from Watford because I’m guessing the same dynamic exists between Watford and the reinsurance company. How should we think about, do those things neutralize each other or is there more of a headwind or more of a tailwind from those sort of inter-company transactions?

Your observations are right. The net impact is really market force driven. And there is some element of Watford that it’s reflected on the fees, it’s reflected in acquisition expense. So, as Watford continues to grow that will become sessions that will continue to be more meaningful as it offset, which I think the question you were asking. It’s probably close to neutralizing but not quite. You still could perhaps see a net increase but nowhere near the increase it, would be without the existence of this.

Let me add something to your question from a different perspective. At the end of the day I, our intellectual factory that produces great results is the underwriting talent that we have within the reinsurance groups. And this management team, me down to Grandisson and Lyons and Papadopoulo etcetera, we strongly believe that we have very good underwriters, talented underwriters and independent if the market might not allow us to utilize them at a 120%, which we usually do. But we’re not willing to send those underwriters back into the marketplace for our competitors to hire, etcetera. So, I never saw a company have problems because their expense ratio went up maybe a point or two, I’ve seen all companies having a lot of difficulty when their loss ratio balloons by 5, 10, 15 or 20 points. So you got to understand that’s our philosophy. Yes, we expect our managers to manage expenses and there is attrition within the organization. But we’re not willing to let go good talent just because we can utilize the factory at full capacity. That to us, the underwriting step we have is our intellectual factor that produces the profit and I’m going to hold on to that.

And one of the technical points Michael is, what Dinos just talked about is the core principle really for us. But on the technical side, yes, little bit of a difference in shift, the treaty business is falling off a bit more and whereas the facultative is not. And that has a direct sales force. So you get a little bit of that waiting pushing it up as well.

Got it, thank you both so much for the answers really appreciate it.

Quite welcome.

Thank you. Our next question is from the line of Ryan Tunis from Credit Suisse. Please go ahead.

Hi, thanks. So, Dinos, your point I guess on the tiered pricing is that, it allows to better risk selection that makes sense. But there still seems to be a concern in the market I guess if you look on some that acted in the past week or so, that if you’re successful at implementing tiered pricing, competitors may follow. And that would then lead to broader pricing pressures. And I guess, I’m just curious if that’s also a concern of yours and do you think more to your pricing in general for the industry could lead to the pricing pressure?

I don’t believe we will, because the other factor you haven’t factored in. This was expected returns different us and our competitors are looking for. So, better selection doesn’t mean that you have lowered your return expectations. All you’re doing is pricing more appropriately to the type of exposures you’re getting. This is not about reducing pricing in the marketplace this is about assigning the right price to the right exposure. And at the end of the day our return characteristics, they’re no different if we use the rate card or RateStar. So, having that mind, it would tell you that basically the whole effort was to improve how we think from an underwriting point of view not to gain market share of some people, I heard comments to that effect, if we wanted to do market share or reduced prices, the easiest way to do is to take the right card and you shave a few bps in each one of the category. And I don’t have to be spending a lot of brain power with a lot of our people over number of thousands of man hours in developing something that is more sophisticated. So, I think there was misunderstanding in the marketplace but eventually for those who know Arch and know our underwriting approach, they will understand that at the end of the day we’re trying to be better in the way we’re going to select and price risk appropriately, which is the foundation of this company.

Got it. So, I guess my follow-up then is just talking about signing the right rate to the right exposure. And doing that is, is there a segment of the marketplace that you envision Arch M.I. becoming quite a bit less competitive in that comes to mind?

Yes, there are going to be segments, which are going to become more competitive and segments which are going to get less competitive. If you expect a certain return from the pie and now the pie is cut a little differently, you’re going to have the pluses and the minuses. Now, the question is, are you getting a lot more on the pluses and lot less on the minuses, which and what kind of return you’re going to have with that, only time would tell but when we were comfortable with our ability to price the exposures better by using more variables at just FICO score and LTV.

Thanks Dinos, good luck.

Thank you.

Thank you. Our next question comes from the line of Sarah DeWitt from JPMorgan. Please go ahead.

Hi, good morning.

Good morning, Sarah.

The GSE growth opportunity sounds pretty interesting for you. How would you think about sizing that and if we look out over the next five years, what percent of overall earnings you think that could be?

Mark, do you want to take a shot at that, I mean?

Over the next five years, my crystal ball doesn’t go in five months. But still, it is, we do feel it as a positive opportunity. And I think one way you should think about it is that the advent now of Fannie joining Freddie on this, and it seems that because they’re expanding and looking for others to participate in this, they’re going through the efforts of establishing broader market, which gives credence to the fact that they’re here to stay, it’s not just a transitional thing. So, with Freddie continuing to do this and Fannie continuing to do this, we do think it’s an exciting opportunity. And so, it’s definitely going to be a growing piece. Now, as long as pricing stays sane, we will continue to be participants in that growing marketplace. So far on the Fannie deals, they’ll all had the same structure they’ve all been 2.5 points excess of a 0.5 point on subject loans that are out there. This is why it’s difficult, we don’t know how those structures are going to change over time, how they’re going to be, higher attachment, lower attachment, so it’s very difficult to put your thumb on volume level and how much of these are going to be pushed out into the marketplace. But we view it as an exciting opportunity for us.

Yes, and they might change to go to first loss or, right now, it’s excess of loss so using insurance terms. But this is an evolving area but the demand is robust.

Okay, great. Thanks. And just on M.I. broadly are you able to be more competitive on price because you have a diversification advantage versus your model line competitors or is that not a consideration?

That is not a consideration.

Great, thank you.

You’re welcome.

Thank you. Our next question comes from the line of Vinay Misquith from Sterne Agee. Please go ahead.

Hi, good morning.

Well, I didn’t know you changed your name Vinay.

Well, the first question is on the RateStar once again. So what percentage of lenders do you think will use RateStar and is it the smaller lenders versus the larger lenders?

On your first question, I don’t have a clue. I can’t even project that. On the second question, I would say, most likely the small lenders would be more adapting to the RateStar than the larger lenders because the larger lenders they like their more simplicity of the rate card and they have a lot of power in the marketplace etcetera. Small vendors, they’re trying to find niches so they can penetrate the market. So, but that’s purely forward guesses on my part, only time will tell once we introduce this here.

Okay. So that means that this thing would take some traction to get through just because the larger lenders I guess make up bigger portion of the total business, correct?

That’s correct.

Okay. And I mean, my view of this was that the higher FICO scores were subsidizing the lower FICO scores. And so, the new rate, from the RateStar will sort of reduce pricing for the FICO scores and raise pricing for the lower FICO scores. Do you worry that since 60% of your business in the higher FICO score business that this could lead to higher competition amongst peers and sort of reduce the profitability for the larger pieces of the business?

No, you’re going in the wrong direction Vinay. If it was just FICO scores, you don’t need to go and make all these efforts to create a RateStar with multiple algorithms. It’s rather characteristics. There is rich data in the loans being provided to us by the lenders. Who is the borrower with co-borrower, what locations they have, blah, blah, blah, I’m not going to get into all of the stuff that within. If it was purely FICO score, you don’t need to make, you have LTV and you have FICO score, and then if you want to make higher FICO scores cheaper, you take a few points of your rate card and you accomplish that. So, that’s not what it’s all about. I’m surprised as to how much confusion is in the minds of people as to what this is all about. This is a product that it will allow us to take other characteristics of the loan and find what we believe is a more appropriate price for the exposure that we’re assuming.

Yes, Vinay, this is just a more sophisticated class rated plan, just like we have on the PC side in analogy. But let’s not lose the fact that it’s already been discrimination between risk with each M.I. of, I’ll use your example of high FICO people. The analogy is schedule rating, you have a file planned to have scheduled rating, where you can deviate for individual risk characteristics. And I think that’s been pretty meaningful up to 20% or 25% to reflect characteristic lead risk. So, it’s already been occurring with the old rate card that there is discrimination between risk, this is simply we believe a better way to do it and a more consistent way to do it.

Okay, that’s helpful. And just as a follow-up to this mortgage insurance I just noticed that the premium growth has slowed a little bit recently especially on the earned premium side and also on the written premium side. Curious as to what’s happening there since you’re now recording the GSE premiums also as written, correct?

It’s, the part you didn’t mention is a reduction in the singles. The change in the trajectory I would say, it came 100% out of our reduction in the singles.

And it’s a good time Vinay for me to correct something that I said before. I had said that singles were 24% a quarter, I misspoke, its 21%. So, I believe the trajectory and our view of that continues to drop. So I agree with Dinos’ comment.

Do you have a sense for what percentage of the business that was last year, was it a much higher percent last year?

Yes, I don’t have an exact figure in front of me but it was substantial.

Okay.

It was the first time we did it last year, and actually pricing on singles a year ago, it was more acceptable to us I think as the last three, four quarters emerged, it became more competitive marketplace because we have some competitors they’re trying to gain market share through singles, we don’t view that as a good place to be and with discipline when it comes to underwriting.

Okay, thank you.

You’re welcome.

Thank you. Our next question comes from the line of Jay Gelb from Barclays. Please go ahead.

Thank you, I may have missed it. But did you mention your tangent loss?

Insignificant.

Well, first off it’s not a CAT so we didn’t reflect that within the CAT load. And it’s just not that large for us Jay to…

To even, if it was anything inaudible we would have put something out but it’s not inaudible within our numbers.

But there is some exposure from the reinsurance side and the insurance side. And as you know, the uncertainty surrounding these things is quite large the ability to get in and check things out is really just begun recently. So there is a lot of volatility around it, you never know.

Okay. Did you add some IBNR just in case?

We always do.

But it’s contained within our standard attritional IBNR, yes.

Okay, perfect. Thank you for that. The other question I have was on the tax rate, so 13% in the third quarter that was you said that was a true-up. What do you feel a normalized tax rate is going forward since historically it’s been in the low single-digits?

Well, I think you should, well, first-off, longer term implies I know where, what your sections is going to give me profits on a go forward basis. And that really does fluctuate from quarter to quarter. But you’re looking at the tax rate on net income as opposed to the tax rate on operating. And just think, it’s just the simple arithmetic of it, you’ve got the tax rate on pre-tax operating income and to convert over to net income, it’s really the realized losses. So you got the same packed dollars with a smaller denominator, I mean, that’s the arithmetic to push it up to 13. So, but on a, our current view on operating like trailing 12-month type view on operating income is likely to be 4-ish percent 5-ish percent.

I would say between 4% and 5%. And that’s a better way to look at it. Don’t look on net income in one quarter, look at it from a trailing 12 months, then you got more of the net income, more of the - and then you can add all the tax and then it would give you a better feel as to what the percentage is.

Okay, that’s fine. It just bounced around, so I just wanted to quantify that. And then on the buyback so with the stock now trading around 1.6 times booked it sounds like Arch is really not going to be in the market for buybacks. Is it?

I didn’t tell you that. I said something different. I never said I’m not going to be in the market right.

Okay. I mean, that valuation seems to be pretty important parameter. How should we think about it?

Valuation is very important. But we look at it based on the prospects of what returns we get on the business we write. And if my recovery period, elongate and we starting getting uncomfortable over three years, then we shall wait from, there is nothing to do with how we feel about the stock it’s just purely our approach to it. And that approach might change, I don’t know what my discussions with wiser guys, that’s why I got pretty wise guys on my board to give me advice and what prospective they’re going to have. But based on what I said, we might sit on excess capital because there are some of the opportunities for us to deploy in a different fashion in the marketplace.

And also Jay, we as you know, we move our mix of business and our capital around depending on what the opportunities are. And we talked earlier about the real opportunities in the GSE credit rate sharing space. So hypothetically if that increased at a higher rate than we had anticipated or we had other opportunities around the world, that mixture might increase our view of four ROE by 200 basis points or something, which is going to come into the equation of time to payback.

Of course. If the stock were valued instead let’s say at 1.5 times book, would that have been within your range of viewing it within the three-year payback period?

It could be. It’s hard for me to project into the future. I mean, it’s like describing the guy who can read the obituary pages five years from today and he finds his name there. That’s not a good place to be. But we make those decisions and we’re flexible on a quarter to quarter basis. And we have unknown, and when we have unknown sometimes we go back a little bit. For example, the mortgage GSE opportunities, and I think Sarah is the one who asked the question and I couldn’t answer it because I know the opportunity is big, the demand is there but I don’t know how big it’s going to be. And I don’t know how much of our capital we want to allocate to that. So, when I have unknowns I rather say I got unknowns and here is how we’re thinking but there might be opportunities. Because I know you want to build new models and project year-out or quarter out and all that but I don’t operate on that basis. I’m trying to make sure that our underwriting team makes the right decisions based on the latest information they have. If I have excess capital, it’s not burning a hole in my pocket. So unless somebody is trying to put his hand in my pocket and take it and then I will cut it, that’s not a problem. It’s a good problem to have.

That’s right. Thank you.

Okay, thank you. Our next question comes from the line of Kai Pan from Morgan Stanley. Please go ahead.

Thank you, and thank you for taking past here over lunch time. So, first, around the…

Lucky sandwich is on the grill.

All right. Do you have any exposure to Volkswagen and potential exposure Volkswagen and the Hurricane Patricia?

Insignificant, insignificant.

Okay, that’s great. And then on probably CAT gen-1 pricing, what’s your outlook and you have reducing the business quite a bit over the past few years. If the market stabilizes, would you become more interested in write more business there?

Well, listen, a hallmark is putting the right price based on risk-exposure just we underwrite. If the market improves, we’re going to write more. Our appetite has not disappeared. There were times that we were committing 20%, 21%, 22% of equity capital to that line on a PML basis and we’re down to now 9% and actually for Florida, and Gulf of Mexico which is less than that. So, our appetite will depend on the market pricing. Now predicting what’s going to happen on January 1, who knows. If I have to guess, it would probably be a stable where it is today because I think even for those that they participate, the new capital that comes in, even with no real CAT. Their returns are not super juicy. And that’s a sub statement to say when there is no CAT, you don’t have super juicy because what do you do when you have the CAT, right.

Kai, I would also add, we use the term if it stabilizes, it depends what you mean by stabilizes. Improving doesn’t mean stabilizing to me. And if the rate cut stay, there is no more rate cut say zero percent change. We’ve been shedding volume given that relative levels, so I wouldn’t expect our business to increase if it stays at the level where it is today, it would have to improve not merely stabilize.

Okay. So, you’re not expecting any sort of meaningful price increases from current levels?

Nothing I see in our eyes now that is going to, that is telling me that to anticipate price increases. But we don’t make decision on anticipation. We make decision as to what we see in the marketplace.

Okay, that’s great. Then, on sort of management succession, Dinos you’ve been running, you had a great track since you founded the Company, and I’m sure you are excited running the business as of today. But I don’t know if the company has mandatory retirement age but is the board considering a succession planning and how do you think about it?

We have succession planning in every senior position we have with, it’s part of our process within the Com Committee. Their responsibility is and my responsibility as CEO is not only preparing my successor but also each one of our key positions has one or two successors ready from within. And that process is not new it’s been in place now for over 10 years. Having said that, if you’re at my contract, it goes all the way to end of ‘17 actually, March 1, ‘18, so I can sign the 10-K if I decide to just become the Chairman, but no decisions have been made. But there is an existing succession plan within the company that is part of the responsibility of our board, and they take it seriously and they - and we talk about it at least once a year in the company.

That’s great. Well, thank you so much for the answers.

You’re welcome.

Thank you. Our next question comes from the line of Meyer Shields from KBW. Please go ahead.

Thanks. I’ll try to be quick I know it’s getting late. Dinos, I think you did a great job of laying out the point of the RateStar program. But if you’re allowing lenders to choose between RateStar and the rate card, doesn’t that just invite adverse selection?

If you allow them to have both yes, but basically what we’re telling lenders, you need to have one or the other.

Okay.

You can’t have the rate card and then price it that way and then price it on the other way and back and forth. It’s either you choose to participate with us on the rate card or you choose to participate with us on the RateStar.

Okay, that helps. What is the loss trend in the insurance segment that corresponds to the 60 basis points sort of premium or rate decline?

I’m sorry, could you, the 60 bps rate decline?

Yes, I’m just trying to get a picture of the funding?

It’s probably short-lines at weighing the increases we get on long-tail lines.

That’s exactly what it is.

So, as I said, it’s about 4.4% down on the first party lines and I think I’ve said 30 bps or 40 bps up no the third party lines. And our volume on the short tail-lines, it’s small so you got to do weighted average, right.

Right. I’m just trying to, understood, get the sort of weighted average loss cost trend that corresponds to that?

If you remember, your Algebra I, Meyer, you got all the information.

I’m sorry, probably more...

The 4.4% is not in excess of loss trend, it’s the pure effective rate change. You need to layer on top of that to do a loss ratio conversion from here A to period B what your estimate of loss trends is. But as we said in the past, it’s very widely by line of business.

Okay, thanks so much.

And we go through those calculations, when we say 60 bps it’s a lot of work behind it to come up to that. And I’m being surrounded by actuaries usually we’re pretty technical when it comes to that stuff.

That sounds like a nightmare, but good luck.

Okay, thank you. Our next question comes from the line of Jay Cohen from Bank of America. Please go ahead.

Yes, thank you. Maybe a bigger picture question on the mortgage business, I believe Dinos in the past you’ve said that when this business gets to scale that I think the segment earnings could be as much as a third of the overall company’s earnings. Is that still a view that you believe is accurate?

Yes, that’s an accurate view. But I also said that it would take three to five years to get to that point. So we believe, yes, we have potential to be earning $150 million to $200 million annually from the mortgage business but it’s got to get to maturity and we’re not there yet.

Right. And then, maybe a bit more technical, when I look at the, as you get scale in this business, the expense ratio comes down. I’m assuming the bulk of that shows up in other operating expense ratio, should the acquisition expense ratio also improve over time or should that be relatively stable?

That should improve because and on the U.S. mortgage side, it’s really a sales force that’s there. So you’re going to have those fixed cost and you write more volume with your drop.

A sales force is constant right, I mean, we’re not adding, once you get to a steady state on your sales force, maybe you add one person here and there. And then there is a little bit of increased cost of living adjustments etcetera incentive compensation. But so, that’s more of a steady number. And then, as you’re building volume your expense structure on a percentage basis is going to improve.

And Jay, just to clarify on your first question. Yes, with longer term view, mortgage could be materially significant piece of our net income or our underwriting gain or loss. But that’s the mortgage segment in totality that it’s not necessarily USMI, you have the reinsurance segment. And as we said, the increasing contributions from the GSE, it’s in totality. That’s what you ask, you didn’t ask about anything.

Yes, no, it was the segment, that’s what I figured.

Okay.

Right, right, right, fair enough.

Very helpful. Thanks guys.

Thank you.

Thank you. Our next question comes from the line of Brian Meredith from UBS. Please go ahead.

Yes, thanks I’ll be quick also. Just quickly, Mark, I don’t know if I caught it, but last quarter when you talked about the difference between on the insurance side, your ceded benefit that you’re getting, ceded on the acquisitions or commission ratio versus what you’re, increase your paying, I think it goes like 60 basis points in the written. Was it similar this quarter, spread side?

Yes, on the quarter share treaties that dominate the sessions, it was 260-basis point spread of, or actually I think we saved that. Improvement in the ceding commission by 260 basis points 3Q-to-3Q and last quarter 2Q-to-2Q had exactly the same improved spread difference.

And at some point in time that would disappear because once we cycle over four quarters it’s over until, in comparison quarter to quarter.

We keep getting the gain but the difference took other way.

Right, right, so therefore your acquisition expense ratio should probably continue to come down in the insurance space?

You’re right.

For at least the next couple of quarters?

On the earnings yes.

Barring no change on the front-end direct commission.

Got you, okay. And then my second question, I guess bigger picture also, if I look at your overall business, reinsurance return on equity probably continuing to kind of come down here with the rate pressure insurance maybe flattish to down. Is the increase in the mortgage insurance that you’re seeing grows kind of when you look out here, is that enough to continue to offset kind of the decline you’re seeing in the reinsurance ROEs to keep it stable?

Well, it’s a difficult question to answer because it depends on the volume. But two things I got to tell you, don’t underestimate how good our reinsurance guys are. They’re finding other avenues not all of their business is this, what I would say large client under a lot of pressure business. They’re finding niches here and there to still be relevant and have good returns. So and at the end of the day, yes, if our mortgage business continues to grow, it might offset it. But I don’t know that because I can’t project volumes, we don’t spend time thinking about volumes and that’s why we’re not trying to be avoiding the questions but to us, future projections are not, we don’t spend a lot of time on those. What we spend a lot of time is to analyze what we have and how we’re going to behave quarter-to-quarter based on the market conditions that we see every quarter.

Yes, let me just add a little bit to that Brian. The insurance group, and when it comes to mass is 60% to 65% of the net written, which will then find us way into earnings. And there margins have continued to improve and one this quarter as well. And some of that is on the loss ratio side that we’ve seen and some is on like the question about the C-Commission overrides. So we expect continuing contributions from the insurance group which is I’d say 60% to 65% of the weight.

Got you, great. Thank you.

Okay, thank you. Your next question comes from the line of Ryan Burns from Janney. Please go ahead.

Great, thanks good afternoon guys. Just one question from me. I’m just trying to figure out why your tangent loss was immaterial. It seemed to kind of affect most of your competitors. I just wanted to see if you guys avoided certain risks or coverage that kept you away from these losses or if they were just simply luck, I’m imagining it’s more the former?

Well, you can call it luck. You can call it good underwriting or a combination of both. You can call it good underwriting or a combination of both. When you give me the choice, I’d rather be lucky than good. But I think with both, lucky and good.

Okay, thanks guys.

Thank you.

Okay, thank you. And your next question comes from the line of Rob Path from Wells Fargo Securities.

Yes, thanks for squeezing me in here. When I look at your balance sheet, it looks like your revolving credit borrowings went up by about $239 million in the quarter. But when I look at your calculation of leverage you don’t seem to be including those in your leverage number. So are these Watford borrowings, are these something else going on here?

Yes, you found it.

I love it when you answer your own question.

Okay.

That’s exactly right. It was $239 million increase in borrowing from revolver on Watford but since we consolidated of course we have to reflect that on our balance sheet. And you’re also correct that our capital composition exhibit is for non-Watford. So you hit exactly.

Okay. And I don’t know if you can discuss what they need the money for and if these borrowings are non-recourse to Arch?

Non-recourse to Arch is their borrowings. And they’re using them for investment.

Okay.

There are business plans always included, I think one and half times leveraged up to one and half. So, it’s a company with over $1 billion of capital. So, they would probably borrow up to $400 million to $500 million and use it in the investment strategy. We’re not responsible for the investments we’re only responsible for the underwriting side.

Okay, right, thanks very much.

You’re welcome.

Okay, thank you. And your next question comes from the line of Ian Gutterman from Balyasny.

Hi, thank you. Dinos, I think Kai called you a little old earlier, I was a little surprised by that but.

He did, listen I’ve been old for a long time. I got the AARP card like 15 years ago, so yes.

I hope you burned it but that’s a different discussion.

I did, I did, I actually threw it in the garbage, I was so mad when I got it but.

Good, good. So, first, to follow-up that last question, is the reason Watford needs or chooses to use debt to get to their asset leverage because they’re behind plan on float and they thought they would have been on float and they’re appraising that or?

I don’t, listen, these are questions for Watford. But what I’m telling you is, they believe there might have been opportunities now based on what they see in the market and they say hey, we can put some leverage on it and buy stuff.

Okay.

And Ian, just to add to that, use of leverage was there from day one on the initial business plan.

Okay.

But no need to go out and borrow when you haven’t even deployed your own capital yet, and not yet because float for that I mean, our premium plans would have been hitting based on the original plan so there is float coming in from our underwriting activities.

Exactly that’s what I want to make sure about, okay, good. So, my, the first question I was going to ask before I was, on the capital discussion, can you remind me, you guys have obviously never paid a dividend whether it, be ordinary or special. Sort of remind me sort of why you guys are averse to dividends, is it a taxing, is it just you don’t want the commitment of it or?

Well, I mean, you’re forcing a tax build to your shareholders right. And once you give the money, the next day you get an opportunity, then you got to go and borrow to take advantage of it. We always like to have a little bit of excess capital maybe we have a lot of excess capital. But right now, it’s not at the level that is really giving me a lot of angst. Even though excess capital is only earning 2.3% to 3%, there are about, it is what it is. But like I said they, we talked to our investors are opposed to special dividend. They think that over time it might not be in the next few quarters, it might be in the next year or two, will find the right opportunity and deploy capital. Don’t forget we were talking about excess capital etcetera our mortgage business is a new business for us. We only started it about four or five years ago, and it really is getting scaled now. So, if I didn’t find that opportunity with our guys, it was predominantly Mark Grandisson who discovered based on our discussions with our investment department and me etcetera. We wouldn’t have that opportunity to deploy today in excess of $0.5 billion of capital into that business. So, it’s, everybody tries to say if I have this magic balance sheet that is always in balance, that would be Utopia. But I’m a realist, there is no such thing as Utopia. We try to do the best we can.

Very correct. I just want to make sure, I was remembering correctly. Then on M.I. just a couple of quick things, one I don’t think this has come up yet. I believe there is a lot of talk about just pricing changing in the bank channel, I think it’s more of a community bank channel. If I’m correct that’s sort of some of the banks are sort of I guess jealous of the credit union success right, and saying since the crises things have changed and the credit union is not necessarily a better channel than a regional bank anymore given changes in lending standards and why are we charging so much more for M.I. and the bank channel. And therefore we should cut rates to bring it more in line with the credit union experience. Is that happening or is that being discussed and if so just, what are your thoughts on that?

Listen, I don’t know if it’s being discussed because I haven’t really specifically talked to our sales force about that. You’re right, some of the community bank experience has been better than the, what I will call the large regional or the national. And the data shows it. And that’s why I said before that maybe some of the rate store might be more adaptable to these community banks which have similar characteristics to the credit unions. They know they’re closer to their customers, they know them well. They’re in the community, they know who is who. And they, to a great extent they spend more time and effort in approving mortgages. So how do you reflect that? That’s our secret sauce.

Got it, very fair. And then just lastly on the RateStar thing is, I guess what’s interesting to me, I’m not asking to give us your secret sauce here but just I always thought about FICO things, again I know you maybe have some missteps in the crises but obviously was because of lending standards maybe more than FICO itself, right. And when you look at auto insurance that FICO was the best predictor of when you’re going to get into an auto accident. It seems like it’s pretty powerful variable, I mean, what do you see as?

Absolutely, but we’re not eliminating FICO. FICO is very powerful, yes. And known to value is very powerful. But there is other attributes that they have predictive ability and value. So, by ignoring them, is it two borrowers or one co-borrowing, is it coverage ratio, is it 30, 40, or 50. And I can go on and on and on into the other things that what character you’re in or what do, you think about the housing market in the territory, etcetera, etcetera, etcetera. And I’m not going to go and tell everybody as to what we’ve done with it but we’ve done a lot of work. We believe that it’s a, I wouldn’t say smarter because that’s arrogant. I think it’s a different way of looking. But I think it’s a better way in our view to assign the right price to mortgage risk.

That makes sense. I guess maybe if I ask at a slightly different way. Is your sense that that FICO is maybe explaining that was going to make up number share right? But if FICO is so good that was explaining 90% of the difference in borrowers, this gets you to last 10% or was it maybe two thirds and this gives you a whole another third, do you know what I mean. I’m just trying to get a sense of?

I don’t know because, I don’t know from the work, I’ve seen some of their work and I participate in some of their discussion. So I can’t put a percentage or predictability on any one attribute. But I can tell you FICO is a very important piece. LTV for risk it’s very important for other risks it might not be. Like a young couple, two MBA students that they college sweethearts, they both have pretty good jobs and they can only scrap together a 5% payment because they’re going to live in a bigger house because they have a lot of income. So, the LTV might not be as credible and they might have super fiber scores. And these other attributes and that you might price that loan differently than simple rate card.

Got it. That makes sense. Thanks for the explanation.

Okay.

Okay. Thank you. And your next question comes from the line of Charles Sebaski from BMO Capital Markets. Please go ahead.

Thanks. I didn’t think I was going to get in today. I appreciate your time.

Well Charles, you’ve been very patient. So I think you’re the last question and we’ll give you all the time you want.

Chuck, yes, it’s good. I think your this call is caboose.

Excellent. I just, the first is on the GSE business and obviously you can’t predict how the flow on that risk sharing is going to come in the future or how much. But I guess, at the current pricing and structuring level, is there any other constraints other than the flow from the GSE for how you guys would participate at current pricing, is there aggregation or other issues that might halt that as it comes online?

There are two issues, its two issues you got to think about this. Is the willingness of the, the number one issue is that GSE is, they’re going to put this in the market that’s known, there is a lot of pressure by Congress to de-risk and not be the credit providers for loans beyond the mandatory 20% down payment, maybe all the way down to 40%. Now, that’s why we’ve been hesitant on volumes. And lot of this goes to the capital markets. And it depends what pricing they’re getting from the capital markets. With both GSEs Fannie and Freddie are doing, they’re developing two parallel markets, they’re developing the insurance, reinsurance market that and it fluctuates sometimes they allocate 20% to 30%. And then the rest of it goes to the capital market. But we have no control as to what those allocations. If the capital markets become expensive, maybe they would start allocating 30% to 40% to the insurance markets, and believe me, what happens in the capital markets will also affect the pricing that comes on to the insurance and reinsurance market. The reason they’re doing that, they believe that by creating two avenues and two different source of capital responding to these, credit risk it’s good in the long-run. And it might create more stability for that because they have two different path to share credit risk into the private domain instead of the government taking it. So, I don’t know which way it’s going to go, but right now we believe that with insurance accounting being introduced and the innovations that we have worked very closely with the GSEs there, and their willingness and they’re talking to a lot of others within the insurance and reinsurance business, I don’t know how many they have the expertise to do it but some do. I think this is going to be a new market for the insurance reinsurance business, and it can be substantial over time.

And Chuck, the other thing that it makes it difficult to predict, as Dinos said, Dinos was describing more how Freddie Mac has done it, whereas the same notional data of loans and capital markets and the insurance reinsurance industry share on that same set. Fannie has done it a little bit differently. But the using capital markets and the reinsurance market, but it’s a different pool. So, what’s gone out to the Fannie deal has been exclusively a pool that went to the reinsurance industry. And a separate pool may have gone to the capital markets. So, they may not continue doing that way, they may wind up doing it similar to Freddie. So there is a lot of different parameters that, the projection is difficult.

It’s a young emerging market and a lot of it is because the Congress in general, they want Fannie & Freddie to de-risk. And for that reason, we feel optimistic that this is going to, the demand is always going to be there. Now, if you’re going to go 100% to the capital market, I doubt it. Now, what percentage comes to the insurance, reinsurance versus the capital markets is in their hands. And you got two big customers here. And they hold all the cost, so yes.

I guess, I’m not asking you to predict what they are going to put out, I guess what I was trying to understand is, is what is your constraints, right, I mean, conceptually Fannie & Freddie could put out more risk than you guys could possibly take or the insurance market just to the size of the portfolio. What is, you’re guys constraints if we read that Fannie is accelerating there?

As we do with every line of business that we have, we have a, think of it as a PML, and how much of our equity capital we want to risk, so there is a constraint. And we have developed actually maybe we’re the only ones, I don’t know if our competitors do that or not, I have no idea. I’m sure from a risk management point of view they do something of that sort. But we do calculate on a quarterly basis what the PML values we have for the mortgage business. And we have, that will be a constraint at some point in time. When we reach the upper limit of the available PML that would be a constraint for us. But we got other vehicles, we might create a cycle at that time, we might use our knowledge and ability and underwriting ability and the systems we have, don’t forget, you got to have good systems to price loan by loan, etcetera to introduce other capital providers into the sector with us as we’ve done with Watford, we can do mortgage Watford so to speak. So, we have a lot of flexibility. We’re nowhere near yet of having that constraint. So, for the time being, it is, we got freedom to operate and we got plenty of capital to deploy and it’s not violating any of our PML criteria that the board sets as to how much risk you’re going to take in any particular. I don’t care if its cap risk or mortgage risk or DNL risk we have in our risk management principles we have limits that we want to take.

And then, I guess, finally on RateStar, what is the, are you guys first in the trying to use a more automated multi-variant pricing model here? And if you are, what’s the lag time or the lead time if you guys are pitching this out into the market to be originators and your competitors go up, Arch is a leg ahead of us here now on this. What’s the lead time you guys have on this kind of product?

Well, I don’t know, we’re not the first. United Guaranty, part of AIG, introduced risk-based pricing first. Probably they’ve been out for about a year now. They were ahead of us maybe longer than a year. And basically we agree with their approach, it’s fundamental to underwriting. And now, how acceptable it’s going to be to the marketplace and all that, I don’t know. But it seems that United Guaranty, they have some penetration and they have acceptability of it in for quite a few of the states from an approval point of view. So, we’re optimistic.

I appreciate all the answers. Thank you very much guys.

Thank you.

Thank you.

Okay. Thank you. So, now I’d like to turn the call over to Dinos Iordanou for closing remarks.

Well, thank you for listening to us. It was a little longer. It was mostly mortgage. I almost forgot that I’m in the insurance and reinsurance business. But we’re looking forward to be speaking to you next quarter. Have a wonderful afternoon.

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a good day.