Good day, ladies and gentlemen, and welcome to the Arch Capital Group Second Quarter 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [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 the periodic reports that are filed by the company with 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. I would now like to introduce your host for today’s conference, Mr. Dinos Iordanou. Sir, you may begin.

Thanks, Abigail. Good morning, everyone, and thank you for joining us today for our second quarter earnings call. We had a good quarter on a relative basis, and I might say it was very acceptable quarter also on an absolute basis. In today’s market, we are emphasizing to our troops underwriting discipline, execution, and risk management in order to preserve capital and maintain balance sheet integrity. We continue to believe that our strategies of diversifying revenue streams and actively managing the allocation of capital will allow us to better navigate in this environment, which is challenging for all of us. As reinsurance returns have narrowed and as you can see in our second quarter financial statements, we are fortunate to have our other business segments, the primary property casualty segment and the mortgage segment contribute more meaningfully to our operating results. Our reported combined ratio moved to a bit under 90% for the second quarter, as catastrophe losses are at 4.1 points to our combined ratio. Loss reserve development remained favorable in each of our segments, which in the aggregate have reduced our combined ratio by nearly 9 points. There were no noticeable changes in the property casual operating environment from last quarter. There are some signs that reinsurance terms, especially ceding commissions may have bottomed out. In our insurance segment, we saw a slight deterioration in rates across some sectors, particularly in the excess capacity layers and short tail areas. But grades were generally stable in most of the lines, while the mortgage insurance environment remains very healthy. Marc Grandisson will give you more details on the segments in a few minutes. On an operating basis, we produced an annualized return on equity of 9%, while on a net income basis, we earned an annualized return on equity of…

Thank you Dinos. Good morning to all. The insurance industry returned to an average net hole of cash losses in the second quarter with insured claims estimated in a $13 billion to $15 billion range worldwide. As you know, Arch underwrites globally and we will pay a portion of these losses. However, previous underwriting actions taken in both our insurance and reinsurance segments help minimize Arch’s exposure to these events. You may have heard us discuss cycle management in previous calls, but I feel its worth repeating today that our appetite for assuming risk is directly related to our ability to earn an appropriate margin. In our view, it’s not prudent to grow lines of business, where the expected margins are not adequate relative to the risk assumed. The reinsurance industry continues to face dual headwinds from low investment returns available in the market and underwriting margin compression as rates failed to keep up with loss trends in many lines of business. Our focus remains on deploying capital judiciously and carefully in the B and C space, but we are continuing to redeploy aggressively in our mortgage or MI segments, where returns are very attractive and above our long term goals. We remain bullish on this sector and believe that returns will remain above our hurdle rates for the next several years. Within the U.S. mortgage MI sector, we estimate that our market share of the primary new insurance written or NIW in the U.S. was in a 9% to 10% range in the second quarter, up from 6.4% in Q1, as Arch MI continues to gain traction in the bank channel. The acceptance of RateStar, our risk-based pricing module, is a primary driver of this growth, and we believe it will allow us to earn better risk-adjusted returns. In…

Thank you Marc, and good morning, all. As – getting into the financial information, I guess, I will be the most verbose out of the three of us. So as was true on my previous calls, the comments that follow 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 to denote results without Watford Re and the term consolidated when discussing results, including Watford Re. However, due to an all industries clarification issued recently by the SEC regarding non-GAAP measures, our earnings release now emphasizes GAAP measures as some previous tables and commentary that used to be in the earnings release have been shifted into the financial supplement. So please read them together. Various examples are, on page 7 of the earnings release we now show the reconciliation from net income to after-tax operating income, where previously it was reversed. The point being is that, you start with the GAAP measure and not the non-GAAP measure. We also on page 1 of the earnings release now present consolidated underwriting results that includes Watford Re rather than the core underwriting results that previously had excluded it. Lastly, the schedule showing prior period development and cat losses by segment, along with the schedule displaying the components of net investment income and investment total return are now on pages 21 and 23 of the financial supplement, respectively. So hopefully that provides a little bit of a roadmap. Okay, with that said, the core combined ratio for this quarter was 89.9% with 4.1 points of current year cat-related events, which are net of reinsurance or reinstatement premiums, compared to the 2015 second quarter combined ratio of 87.9%, which reflected only 1.9 points of cat-related events. Losses recorded…

Abigail, we’re ready for questions.

Thank you ladies and gentlemen. [Operator Instructions] Our first question comes from Kai Pan with Morgan Stanley. Your line is open.

Good morning and thank you.

Hi, Kai.

Hi. These two loss portfolio transfer – transactions, can you give me more details about it for the one you commuted, what was the reason for that, and for the one you just booked? And so, how do – what attracted to you and deduce the other opportunities – similar opportunities?

Well, the first one we commuted, we always try to keep very good relationships with our clients. It was a client request, they wanted. And we felt the terms of commutation were attractive to us so we accepted it. The second is, in the normal course of business, we always look for transactions and this was a transaction presented to us. We liked economics, so we did it. Mark, you want to add to it?

I would add on the second one, it was really as a result of being intimately very familiar with the book of business. It’s a client that we have known for many years and years under which the LPT is – the year it’s covering, we actually had underwriting risk alongside with that party as well. That came as a result of a, again, a request by the client to seek and improve their capital ratios, and that’s really a – this is why it’s driven – that’s why it’s driven by.

Yes, it’s a capital relief situation here.

Do you see more similar opportunities?

Yes, we see activity in that sector as a matter of fact. But – we don’t make predictions as to, are we going to do any or not, because I haven’t the faintest idea if they are going to happen. The instruction to our guys is, you look at them, you like the economics, we do them, we got the capital. If you don’t like the economics we pass.

Yes, and Kai, it’s always tough – it’s a long runway on those. Hit ratios are low, but we continue to see them and entertain them.

Okay, that’s good. On the MI side, the Australian reinsurance transaction, is that considered like a one-off, or is it a continual relationship, in fact, could recur?

This is an actual ongoing relationship. It’s a quota share of a primary insurance book of business.

And it will continue until it gets cancelled.

Okay.

And it will continue until we gets cancelled.

Until we both cancel – both parties agreed to, kai.

Okay. Are there additional like growth opportunity with that client?

At this point we don’t perceive it. We have a very significant portion of their portfolio and we are sort of happy and very comfortable with that position.

Okay. Lastly, is on the – your REIT commentary in the insurance sector. It seems like it’s down like decelerates interim pricing decline. Could you give a little more color on the pricing dynamics there? And in this environment, how do you sort of manage your portfolio? It looks like your like core combined ratio actually improved in the insurance segment that you said mostly due to mix change? Will that be enough to keep the margin?

Well, it’s a complicated question. Let me give you the strata. We don’t give you the granular performance on each one of the sectors for obvious reasons. You listen, but so are competitors, et cetera, so we are not going to tell them everything that we do. But it’s true in our comments that the aggregate rate reduction across the entire renewal group was about 1.8%, that’s a 180 bps. And then, you factor in some loss claims trends. I mean, that’s not a good market to operate. Having said that, we have sectors that were very defensive, because that’s where we are seeing the significant rate of reductions. I mentioned in my remarks property lines, excess both in our P&L, professional and liability lines with the capacity players and at the end, there’s no- it’s fewer supply and demand. There is no differentiation in the product, et cetera, and it’s under pricing pressure. We try to manage those down. And we try to put more emphasis on a small to medium size business that we have more control on the rating and also the quality of the risk, et cetera. Now, I’m going to turn it over to Mark Grandisson, because he runs the insurance group now. He runs all of our operations. And he is more granular in growth with these decisions as he does the reviews with the profit terms, et cetera, to give you a little more flavor.

Yes, the flavor of actually given in the remarks. I did mention specifically the controlled and low volatility business, which is a small to medium size, where we have more intimacy and more influence over what’s happening in the firm in pricing. We are getting flat to single-digit rate increases in many instances. The ones that are more cycle managed, more open market, a lot more competitive, a lot more commoditized, this one had the single-digit 5% to 7% rate decrease. So – and as I mentioned also in my comments, the cycle managed one is the one where we get a little bit more willing and working harder to buy reinsurance to actually mitigate those rate decreases.

And I would just add on top, because Marc nailed it is the additional layer that we talked about the ceding commissions. So on the commoditized product lines, you manage your mix through increased reinsurance, and this is the environment you are getting – continuing those overrides that drops the bottom line and really help protect net income.

This is great. Okay. Thank you so much, guys.

Thank you.

Thank you.

Thank you. Our next question comes from Jay Gelb with Barclays. Your line is open.

We’ve heard some other reinsurers and perhaps even some of the brokers say that they view the reinsurance market as bottoming? Would you agree with that?

In general I do. Marc, do you want to add?

Yes, my comments on this is – I will be careful, because we don’t know again the future. There are certainly signs that reinsurance markets are pushing back on markets like property cap for instance. There is some layer that had to be repriced in the second quarter, because there was some – too much aggressiveness in trying to get the price down. So there is some pushback, it’s still going down, but not to the same level. In addition we have – we also have pushbacks from the market on getting increased ceding commissions. We are successful in getting a couple of points which Mark and Dinos mentioned before. But this is layering around 1% to 2% increase, but there is a lot of push to get more than that, so there’s still a lot of pushback from market at this point in time. What I tell our troops is, again, we are going to react to whatever we see in the marketplace. It could be a bottom. It could be a plateau before more damage is being done. It’s really too early to tell.

Yes, but you see shortfalls, that’s an indication that there is a pushback. If you can’t fill the placement and you have to go back with filling a shortfall. So there is signs that we are hitting the bottom. Listen, where interest rates are, where investment income is, you better make it on the underwriting. And if you are not making it in on the underwriting, you better pack it in and go and open a Greek diner, you make more money doing that.

Okay. The next topic I want to touch on is the mortgage insurance business. And based on our model looks like the underwriting profits from that could double this year compared to 2015, driven by the strong top line growth and improving margins? How big of a business can you envision this being over time?

First, you’ve two questions. One is you are projecting earnings. I don’t think your comment is actually totally correct. You have to understand that in our MI book, we have US MI, we have the Australian MI, which is more steady. We have GSEs, which is more steady. And then we have some early transactions. We had a couple of reinsurance transactions that did declining, because they are maturing. They are vintage 2012 and the duration is six or seven years, so towards the end of those. So I would say, yes, the contribution of earnings is going to grow, but it’s not going to be exponential the way that you put it. Having said that, the second part of your question is, do we like the sector? And, yes we do, and we are willing to contribute more of our capital, but we don’t want it to be totally the dominant exposure that we have. In the way we think about it, we want to have a balance over time between reinsurance, insurance, and mortgage. Having said that, in different parts of cycles, depending on which segment is the most attractive, the earnings may be coming heavier in one area and lighter in another area. But that’s the beauty of allowing us to navigate and allocate capital into our three businesses. At the end of the day, we will not be a 100% mortgage company. We won’t be a 100% reinsurance company, and we won’t be a 100% P&C company. But the market will determine, which sector is a little bigger or a little smaller for us, because at the end, we are only chasing margins. And if you are chasing earnings, you’ve to go where the earnings are.

Of course. On a mortgage insurance front, do you envision it being organic growth that drives this going forward, or is our attention in acquisitions in that space?

We are interested in everything. I mean, if we like a sector – but our history has been, let’s make sure that we have the right strategies that we can always grow organically and depend on that, because acquisitions, sometimes they happen, sometimes they don’t. And at the end of the day you don’t have – we don’t have a strategy that’s focusing on acquisitions for growth. Our strategy is focusing on, let’s see, if we can build it organically. But we are not excluding anything that – it might be thrown our way and is attractive to us. Marc, do you agree?

I do, yes.

Thank you.

Okay.

Thank you. Our next question comes from Michael Nannizzi with Goldman Sachs. Your line is open.

Thank you so much. One question Mark, just on the reinsurance business or the LPT specifically is, it seems like all of that was earned in the second quarter? Should we assume that there really isn’t a durable impact for the remainder of the year either in terms of top line or losses? And then secondly, should we assume that it renews again in the second quarter next year and we should see that lift in premiums again when that happens? Thanks.

Good question. To both of those, I used to view them as unique special events. Not recurrent and really not earnings that was fully – virtually fully earned right away. So, consider it a quarterly outlier.

Okay, so no –not expected to recur again?

There is no underwriting gain or loss. We booked it out at 100 combined.

Yes.

And at the end of the – that’s more an incremental on the flow, that is going to – it’s going to be there. But there’s – for all intensive purpose and for your model, ignore both of them.

Yes.

I mean, Michael, is it possible that a year from today we reevaluate the ultimate as favorable or what have you? Sure. Don’t think of it as a quarter by quarter impact.

Got it. Okay, great. Thanks. And then it looks like Watford premiums were down year-over-year? I was just curious, because it looked like cessions in the segments were up? So does that just mean that you’re ceding business to non-Watford entities or how should we think about that?

Well, I think, you’ve got – Marc already talked about it. If you’re looking at overall cessions, you have the insurance group continuing to cede a little bit more.

Yes.

I think in totality, it was roughly the same nested gross at an ACGL level. But the mixture between – you still got reinsurance guys are doing some retrocessions, but I think it’s mostly leveraging reinsurance in the – from the insurance sector side.

There’s not much change in the buying as well as on the reinsurance side as well, it’s very consistent.

Got it, okay. Just the net, like the dollar amount of cessions in the businesses was higher whereas the net premiums in your Other segment, which I assume is all Watford were down? So I was just curious if your strategy in terms of how much business you are placing with Watford was changing, or there’s some other distortion in there?

Let me take you back and then I will turn it over to Marc. At the end of the day, independently we are shipping premium out to third-party reinsurance or to Watford, it’s got to make economic sense. So we are not going to – if I can get it cheaper in the open market, I’m not going to give it to Watford just to maintain volume. I’m going to go and buy it from where is the most attractive place for me. Having said that, I don’t think we have changed anything strategically as to what we would do with what. Our responsibility with Watford is to be the underwriting managers and underwrite business that at the end of the day it’s going to give them flow as close to zero as possible. And when we find those opportunities, we do it and we will give it to them. And even the business produces returns that are acceptable to us, we won’t see it. We will keep it at Arch. So our philosophy and strategy has not changed.

Okay. Got it. Thank you. And just lastly, just back to mortgage for just a second, written premiums, both gross and net have increased nicely, guessing a lot of that is the GSE business, I mean, all of the business, but GSE seems to be growing more – earned premium has lagged that growth. So I’m just, I guess, I’m just try to figure out, how – yep.

I can answer some of that.

Go ahead, Marc.

The premium written – a lot of that – half of the growth actually comes from Australia and it’s a result of being the product single – legal premium upfront. You get all of the premium upfront and the earning pattern is extremely – it drags along. And also in the written premium for the rest of the units, there will be a lag in earnings, because we have to write the business and it takes a long time to write. And we have some singles as well on the Arch US MI. We did write some singles there. Not as much as the other guys in the world, but we did some. So there is definitely going to be a lag between the written by virtue of being single upfront, mostly from the Australian business.

The way that I think about is that, first, the mortgage business has a six or seven years earning pattern, right. The Australian market, a lot of it is single upfront, but it was still earned over six to seven years. So you have a lag in the earnings and lag on the income that is going to come over time. In the U.S., you see our numbers. We do about 20% to singles, 80% is the month. In the month that is booked and earned on a month by month. The singles that are written up front but they’re earned over six or seven years. So, as long as you monitor those two, it will give you a good ability to put both the earnings stream as it is going to come in and also the net income stream that is delayed. That’s why some people try – like to talk about embedded value in the mortgage sector, which is some of you might have models predicting what’s going to happen in the future.

And, Michael, just – I think you’re probably going to go back and you are thinking about how you’re going to protect this stuff on a go forward basis. I just want to clarify both Marc and Dinos talked about Australia being a singles market. I just wanted to make sure that you realize that the contract itself is not a big bullet single. It’s a contract over a whole set of singles that they accept one day after the other – after the other I think. So it is a book of business that has singles and something throughout the turn, not a big bullet single upfront.

We’re getting it every month.

It’s not a bulk transaction.

Yes.

But we’re not getting a little components month-by-month over seven years. We get it all up front.

Right, I got it. It’s not bulk.

So it is going to be one in one year – the premium is going to be booked in that particular year, but it is going to be booked month-by-month.

Yes, I understood. Its flow business and not both business, it just happens to be sold.

Yes.

Okay, got it. Great, thanks so much.

You’re welcome.

Thank you. Our next question comes from Clinton McMillan with KBW. Your line is open.

Hi, good morning guys. Thanks very much. Mark, you had a lot of information in there. Thanks for walking us through everything with a little bit of a more complicated quarter with a couple of those one-off things. But one thing that I wanted to understand just a little better is you mentioned the reserve development in the mortgage that had an offset in the contingent consideration reaching the nominal pay out cap? Can you explain that a little bit better for us sort of how the reserving works there and why you had this big – relatively bigger $11 million reserve development and it sounds like it’s an offset somewhere else in the balance sheet of it is not really a gain? Is that the right way to think about it?

Think of that more as an offset in the income statement. You got prior period development, in rough numbers is $10 million or $11 million, I think in totality. So it was $10 million or $11 million on a realized loss, is how it goes through – and then you’ve got the standard prior period development. So it has to be coming from the same sources, kind of like a profit commission sometimes does, with a loss ratio increase that might decrease the profit commission. Similarly here, you got the subject years of what we purchased. So it was continually lower delinquency rates and claim rates associated with those that dictates and indicates the reduction, because on the CMG transaction, we bought – with a provision, there was a stock purchase. So we initially paid 80% of book with an earn-out mechanism. And depending upon the actual performance, which is exactly what this is indicative of, we could pay out more up to 150% of the closing book value. We hit that nominally in our present value, but nominally this quarter, but it is directly related. So I’d say, it continues to have good performance as mostly shown through improved loss reserve development. You get an increase in the contingent consideration.

And from now, on anything that is positive, it continue, it sticks to our ribs. They have eight other that is done, yes.

Okay, that’s great. It’s very clear and really helpful. Thanks very much. Secondly, on the MI side as well, you mentioned 80% of the 75% of the bank channel – I’m sorry 76% of the bank channel came through RateStar? Obviously that’s having great success for you guys? Can you just talk to us about what you’re seeing the competitors now do in response to RateStar or maybe sort of what you expect the competitive environment to look like because of that?

Well, I don’t know what they’re going to do. And as far as we’re concerned at the end of the day, RateStar is the proper way in our view to price mortgages. There’s no different in the auto sector when you introduce many different variables to price risk appropriately and that’s what we’ve been doing. We’re pretty happy with not only the performance from a production point of view, but also when we go and back test what RateStar gives us versus rate card. So we still have the rate card. Our clients some 20% of our business and 50% of our business in the credit union channel is coming through the rate card. But we test both and what we like a lot about the RateStar is that first and foremost, the auto – variability around the mean is very narrow, and we like that. It gives you stability and more predictable earnings where the rate card has a much bigger variability. And now how competitors – they’re going to respond? I don’t know. I think the best way for them to respond is just – and I don’t want to give my competitors advice is go to a rate space pricing tool and make sure that they are pricing risk appropriately. I mean that’s – that’s the proper response. If they try to just cut rates on the rate card and all that is like somebody in the quicksand and they keep moving their feet.

The one thing I will add to this is the other one that’s a big competitor of ours is the FHA as you guys know, so that one is a government agency. That’s also even a harder for us to even figure what they’re going to do with the prices. I just want to make sure that I put it out there.

So the government is tricky to figure out. That’s unusual.

Exactly.

And if I could sneak just one more in – I’m sorry the valuation of a stock obviously is a high-quality problem to have. It has been up there and above what your three year return threshold would be for buybacks and I’m kind of assuming that’s why buybacks were limited in the quarter? Just assuming that we stay in this sort of heightened evaluation for the stock in the near-term over the long-term, how do you guys sort of expect to deploy capital or what might you do?

Well, I think you’re reaching a conclusion that it might be right or it might not be. It wasn’t as much the valuation of our stock, but it was more where we see opportunities in the marketplace and let’s face it. We’ve seen most of the opportunities in the MI space. So basically, we kept the powder dry for the reason that we can deploy more capital in the MI space and that was the main reason behind it.

And as Dinos alluded throughout the – it is the combination of things. We never have a bright line as you know on that. It’s more of guidance. And for most of the quarter, we traded, I’d say, little south of 1.4 to book value. So it’s kind of a little clear than that given the combination of things.

Okay, perfect. Thanks very much guys.

Thank you.

Thank you. Our next question comes from Josh Shanker with Deutsche Bank. Your line is open.

Thank you very much everyone. I want to look at the favorable development in the mortgage insurance segment? And understand I mean I realize that this is very low loss content business, but only in a short period of time, it almost took all losses out for the quarter? I mean what’s going on there? Is that one-time in nature? Is the business so good that it’s not showing any losses?

Josh, it’s been a continual march downward on the delinquency rates. And the associated claim rates as that come out of that. But remember this is really 2011 and prior. So there is vintage seasoning associated with this. So it’s not like the PC and it is really – you have to think of it as more of a report year view of the triangle.

This is CMG mostly, which is the credit union business. And we bought that company and we bought the reserves and we brought all of the assets and the liabilities that come along with it. We had that pricing mechanism, the adjustment that we talked about. And – but at the end of the day, you’ve got to watch the performance and performance was better than we even expected ourselves. Otherwise in the dumbest guy on two legs because what I negotiated didn’t work for me. It worked for them, because I’m paying a lot more for that company than if I would have taken 100% at book value at that time. In retrospect, if I knew what I know today, I would have negotiated better.

You cannot see us nodding here, Josh.

So if I look at the mortgage loss reserve, what percentage of it in broad terms is legacy business versus Arch MI business?

I don’t have that at my fingertips, but I would say, substantially.

Yes.

The vast majority is old stuff.

Okay. So the fact that the enough favorable development to negate your current accident year losses, so if we comparing apples-and-oranges, you have a huge back reserve and a small new go reserve?

That’s correct.

That’s right.

And remember Josh, we kind of alluded to it, I think of the prepared remarks that part of the original transaction was a quarter share on 2009 through 2011, I’ll call it back book. And so that is also experiencing some of the same aspects, so that wasn’t CMT, though that was PMI.

Right.

And do you have any reason to believe that business – that you can detect RateStar underwritten business as a better loss ratio than rate card business?

We price RateStar and rate card to give us the same ROE. So we have the same target. Now as we’re back testing both, because every month, I ask the guys and we back test – based on the volume that comes in and we underwrite. The only difference between the two – it’s not on expected return of equity. I think both of them are on an expected basis is they’re about the same and we did price both at about 15% ROE. The difference is that RateStar is – the RateStar produced business is very narrow – narrower around – it’s three to four ROE points up and down of the mean, where rate card is much wider. I’ll give you an example, if you had just used credit score is one variable that you’re going to test for. You’re testing the 750s in the rate card versus RateStar. The rate card even though the mean might be 15%. It may be as some business all the way up to 20%, 22%, and some other way to 70% or 80%, RateStar is more like 12% to 13% all the way up to 70% or 80%.

Okay. That makes sense. I appreciate the answers. If I’m right maybe I’ll be feeding the microphone to Ian right now. Let’s see what happens.

You are right on the write-up except you couldn’t predict our one-off transactions, and when you’re ready to predict our one-off transactions, I want you to call me because you and I are going to go to Vegas together.

I’ll make sure that I do that. Take care.

Thanks. Take care.

Thank you. Our next question comes from Amit Kumar with Macquarie.

Oh, man, this [indiscernible],. Ian – I’ll try to ask some intelligent questions now. This is a big thing for me. So very quickly these are more – most of my questions have been answered, but sort of big picture question. One is sort of tying in the comments in response to other questions. If returns were stable in reinsurance and insurance and if your MI business is growing rapidly, should we expect a slow trend up in the A line ROE, and if that is the case, does your book value grow at a faster clip than the industry all has been kept equal?

No, because your assumptions, I don’t think you’re totally listening to us correctly. We said that reinsurance is deteriorating, I mean still very good results, don’t get me wrong. But that is under pressure. So we’re losing ground there and we’re losing lesser ground in the insurance side. But in both of those sectors, we’re losing ground. So in essence, from a profitability point of view, they’re not going to have the same ROEs as before. And that the reason I didn’t change the $10 million to $12 million on an underwriting basis is because I’m offsetting what I’m losing on those two sectors by what I’m gaining through mix change on the MI sector and that’s the way that you have to think about it.

Yes, that’s a fair comment. I’m sure that Ian is already disappointed in me. The next question that I have is again on MI? With the Barron story coming out on Sunday and there’s been a lot of focus – a lot of – set of new investor feedback as well as some traditional investors? One question, which I was getting and this is sort of interesting, is the traditional P&C investors were asking, if things go south, wouldn’t ours be locked in? Unlike traditional P&C where you can cut back underwritings, pull back on the capital and then wait for the cycle to turn? It seemed that there was some fear on that thought process, where if Arch becomes bigger and bigger in MI, maybe a different class of investors cycle in and the traditional investors cycle out? But would you say to that in terms of if the cycle does turn, how easily can you sort of pullback or pullout or change your strategy?

Well, let me – it’s a very complicated question, but it’s a very good question because it talks about what you need to do from a risk management point of view from capital allocation, and also what the history has taught us in this particular sector. Let me start by pointing out to you that the performance on the bank channel versus the credit union channel was even – the worst year for the credit union channel through the financial crisis was 152 loss ratio. Nothing to write home about, but not catastrophic, right and what I’m sharing with you is information we have through the PMI transaction, right. On the bank channel, we have an excess of 300, 2X. When we examine that and we’ve done a lot of analysis on it, most of it wasn’t just economic conditions. Yes, economic conditions will have an influence and that’s the event that you have to plan for and make sure that from an aggregation point of view, you’re comfortable with how much risk that you take. It also tells you that if you don’t violate your underwriting guidelines, your performance either in down economic conditions – unemployment going to 15% and prices coming down by 25%, you can withstand all that, as long as you discipline on your underwriting side, because most of the delinquencies they came from fraudulent loans. Loans that there was very little verification the underwriting information was very suspect and on top of it very, very loose underwriting, people writing risk that they shouldn’t be taking that risk. Having said that is no different when you write long tail liability lines in the P&C world. If you’re pricing your workers’ comp at 20% or 30% below independent, if you stop writing tomorrow, you’re going to have that tail that is going to continue hitting regardless loss of elements year-after-year year, because the duration of those liabilities is probably even longer than the duration that you have on the MI space. The key to this business in my view and in all of our underwriters is to maintain discipline in accepting risk. The beauty of it is that even when you stop underwriting, let’s say your pricing is – and with risk-based pricing, maybe the market will reject your pricing and they’re going to find it cheaper from a set of competitors. You continue to have streams of revenue coming from what you underwrote properly in the prior year. And then the only thing that you need to worry about is the broad economic downturn. Increase in unemployment and price reduction in the housing market et cetera, and we test for that and we have cat loads and also that determines as to what size we want MI to be as part of the overall Arch family. So that’s where we are. Marc?

One thing different, I would say with casualty, and I totally agree with the analogy, is that we have a lot of tools that our – at our disposal that we can use to really assess and evaluate the origination at any given time. So we know what’s that we’ve been originated at any one point in time we can assess what the risk is in that portfolio and I would argue that an MI book of business has a lot more changes in a casualty book of business across all lines of business. Much more homogeneous much more stable and lot more predictive in terms of what you bring to the table by virtue of the variable you used to price. So it’s always a factor. Things can change after you’ve underwritten them. But certainly when you underwrite it, you have a very good sense with the quality what you’ve underwritten.

Yes, and then I’ll just add one more thing. Your premise is that all PC business can be decisions on an annual basis. As the market softens, you get an increased proportion of multiyear contracts, and this is an industry statement. And this is a differentiator between carriers. It’s a difference between having multi-years with legitimate re-underwriting abilities versus one where you’re locked in. And that’s becoming increasingly common and as that grows in proportion. It’s not as quite of a stark difference as you think.

Got it, that is actually very, very helpful. Thanks for the answers and good luck for the future.

Thank you.

Thanks, Amit.

Thank you. Our next question comes from Jay Cohen with Bank of America Merrill Lynch. Your line is open.

Great, thanks for that last answer. That was actually helpful. And question on mortgage insurance – shocking. When I look at the results for the quarter and I take out the favorable development, and I come to this kind of accident year of losses ratio, first of all, is that a reasonable concept in mortgage insurance?

Sorry to interrupt, you halfway through, Jay.

That’s helpful.

You’ve got to think of it as – it report here closer to a claims made view of business then in the current view. Accident year and claims made business really is report year and this is really the same thing.

You can reserve as long as you have a delinquency. And that’s – we don’t like the accounting model. We’ve talked about it in other calls. But at the end of the day, I’m not setting up the rules. I just play by the rules.

The trend I have seen in this ratio, which has kind of steadily come down. That’s not necessarily is kind of the – stepping to look at going forward?

Do you mean the delinquency rate or?

The loss ratio, excluding whatever you want to call it, the loss ratio that you’re reporting, excluding the prior-year development, which has gone from 30 down to 17, makes it hard for us to forecast that number. Is the more recent year – recent quarter is that a reasonable number to use?

It’s really – there is more mixture going on here than you think, Marc and Dinos talked before about the glide path difference on some of the old reinsurance contracts that are now running out. The insurance accounting treatment on a lot of the GSEs have a different loss expectation than does some of the primary U.S., so I hate to say it, but it does come down to a lot of mixture.

If we were pure primary MI, it would be easier for you because then you will see what the average claim cost is, which doesn’t move very much in the mid $40,000 range. And then you look at the delinquency and that is improving bit by bit, but because we have the Australian business, we have the GSE business and those depends what block it is getting it gets a lot more complicated

Got it. A bit of a modeling challenge for us certainly.

It’s all right. I mean listen, you got to have some challenges.

Jay, a high level to help you – the way we think about the run rate basis, the expenses is about 25% to 30% in a run rate, and then I think about it globally in the industry, a mature book of business and currently the loss ratio is anywhere, you see them report at 20% to 30%. It sort of gives you a range that is kind of hard to – it could be obviously if nothing happens. It could be significant below this, but trying to get a long-term average.

Okay.

That’s a way that we think about ultimate, yes.

Looking at the long-term average, exactly.

Got it. That’s helpful. The second question was on the contingent consideration? Mark, what was the cap that – what was up with the $159 million you said?

No, no, 150% of the stated value at closing.

Okay. Got it.

But it would have been unknown provision. Basically we will continue to be recalculating the book value based on the actual performance of the loan portfolio from the date of closing in prior.

So up until now, that basically has – helps your operating earnings and it was offset in the kind of the net income to some extent?

Yes, you have net income versus the realized.

Right.

So it’s operating versus net income.

Yes, but going forward it sounds like that offset on the unrealized loss, or realized loss, won’t be there to the same degree anyway. And therefore it’s just to flow through more right to net income?

You will as I commented, because the financial statements reflect more of the present value of it. So it increased over time like any interest unwinding.

Right.

Especially now if we capped out nominally, we’ll accrete towards the payment date. Plus we are required through GAAP accounting to – as it becomes more certain we have to drop the discount rate used in that present value cap. You get both forces causing additional effects in future calendar quarters.

They’re going to be small, so don’t get too overexcited.

No, but that makes sense. And then lastly, just on the political environment, you’re a fairly global company and it seems both parties have some issues with free trade. Are you, one, concerned about this? Two, are you doing anything to prepare for maybe a change from the trade environment?

Not specifically, because at the end of the day – listen free trade will affect that global GDP and global GDP will affect the revenue for the insurance sector. But having said that, because we are a highly regulated business, a lot of what we do is global, but it’s local from the regulation point of view. You operate and you need local licenses and you participate in the local market, et cetera. So I don’t see significant change in the way the insurance business is done, if there’s barriers that they put up. At the end of the day though, if GDP growth is very low, it will affect our ability to get revenue. It’s been always like that. You can track the growth on the P&C world of insurance and reinsurance with GDP and there’s a very, very good correlation there.

Great. As usual, helpful comments. Thank you.

Thank you.

Thank you. Our next question comes from Brian Meredith with UBS. Your line is open.

Thanks, I will be quick here. Just back on the MI business, just curious does the Australian reinsurance business have better economics than the US MI business? As that kind of comes in is that contributing to maybe the improved loss ratios and stuff we’re seeing? And then as an addendum to that, any other opportunities that you are seeing in the Australian markets?

So on the Australian market, right now the Australian transaction that we have is really like an insurance, a flow business that we’ve done with that partner of ours down under. That has not gotten a lot of earned premiums, so I wouldn’t describe a lot of pickup from that sector really. We’ve done in the past some reinsurance transactions that we – to go back to your point about the second question about opportunities, there were opportunities in the past, that’s also what got us to really focus more intently on Australia. We had quota share reinsurance transactions with a couple of players down there. But those – but since we have struck this significance, we believe relationship with that bank, we don’t need – we don’t feel like we have the need to do anything more in the segment.

Gotcha. So your tapped out in Australia and you wouldn’t do anything else?

For now the answer is we’re comfortable where we are right now.

Great. That’s helpful. And I’m just curious on the LPT transaction, just try to understand it, what kind of interest rate or return assumptions are you using when you’re doing a transaction like that to get the returns that you need?

Right now our units are doing pricing the – transactions or portfolios using a treasury free rate, by and large. That’s what we’re using, that’s how they compensate on when they calculate the ROEs.

So if you are doing 100 combined ratio, it means there is it virtually zero capital assigned to it? Okay.

No, capital no, there is no return. No return. The capital is allocated based – no underwriting return, right. The duration of liabilities of, let’s say, five years, there will be – take that five-year and that’s 1% or 5% pickup on the flow. Now when you look at the contract that we assigned capital to it and got to see what’s the upside, downside, and how much capital it goes, and you make those calculations. Don’t forget, some of these transactions, they have a limited risk transfer. Some of them have more risk transfer and that’s when we got to go through a test if this is going to be a deposit accounting or a reinsurance accounting. This one has enough risk transfer. But we are happy with it because of our familiarity of the book of business and our participation on the book of business as the quota share participant in prior years. Having said that, don’t misconstrue 100 combined that that might be the expected value of the contract over time. At the end of the day, you’re reserve conservatively, and if you are wrong, nobody is taking the money out of your pocket, you – the sale that we get it eventually.

Gotcha. And then last question, is there any update on your ability to kind of take advantage of opportunities from AIG and some of the other companies that have been doing reunderwriting? I know we have talked about that in the past?

We don’t target specifically any company. I mean, there is reunderwriting being done by many companies, including AIG and others. All I have to say is that, we’ve seen some increased opportunities in sectors that we believe we have good underwriting expertise. And we’re getting into the batter’s box so to speak. We haven’t been hitting a lot of doubles, triples, or home runs, maybe a single here and there, which tells you that the market hasn’t come up to our liking yet. But we have increased – the opportunities that we see have increased noticeable.

Great. Thank you.

Welcome.

Thank you. Our next question comes from Ian Gutterman with Balyasny. Your line is open.

It’s not Keftedes, is likely on the lunch menu today.

My first question was going to be about great diners, but given the call is getting long, I thought I hold off.

Are you ready to invest with me as I’m getting closer to retirement, I got to think of things to do. So are you ready?

Exactly. I would be open to a kind an offer, call my attorney. So I won’t ask about anything about MI, I want to stick to the other two legs of the stool. And probably a lot of these are number questions, this late. In insurance you talked about in the release of some of the adverse development from an energy casualty claim? Any color on that?

Yes. It’s Sempra Energy. It’s out of our Bermuda operation, where when you have a claim down there given the towers and the attachments and where we play, they are Wall Street Journal front page events. This was a gas leak explosion. The estimate is $660 million industry loss. We are on two layers, the lowest of which is excess of $265 million, and then we are on the – a piece of another layer above it. So we fully reserved it on a net basis, so it can’t move any more than where it is.

Yes, got it.

But it was a big loss for us. It’s a man-made disaster cat, we’ll call it that.

Exactly.

That’s I think you saw cat losses in the insurance group.

That’s what the Bermuda insurance market is. That’s exactly the kind of complex risk it attracts.

Right.

The next thing I was going to ask you is, did you – I thought this was an adverse development, it was a cat as well?

No, it’s not a cat.

It’s not in the accumulation of natural catastrophe was 60, but it was on the adverse of element.

Okay, that’s what I thought.

It would be a 14-year, 15-year.

And it just takes a while until those things are known, especially attachment points like that.

Sure. So my question on the cats and the insurance segment, I guess that was higher than I thought, and I just look back, I think the first time in a long time that cats and insurance having greater than reinsurance. I guess, I was just curious if there was anything unusual that caused that?

Nothing unusual. But – listen on the insurance side, you get on two buildings and you’ve $5 million or $10 million and then all of a sudden you kind of have $15 million. And we got an operation up in Canada. So I don’t know exactly the specific accounts, but it wasn’t a significant number of claims. It was a few claims. And don’t forget, we do not like personal lines. So for us to get hit, we got to hit on apartment buildings or a school, or something of that sort, and it’s very easy to get quote with $5 million on a couple of them. And all of a sudden, we’re not reporting tens of millions of dollars. I mean, at the end of the day, yes, you are slightly higher than reinsurance. But it was nothing unusual for us.

Those losses, Ian, we had in the second quarter were mostly insurance losses. So it was heavily – some of the reinsurance in Canada, but a lot of it outside was insurance more than reinsurance. And I will echo with what Dinos said. Having a small loss of cat load of about $10 million in insurance group is not having a variability of about $10 million is not a big deal for us.

Understood. I was just curious to know.

…within the variability.

It can happen. If you are in the wrong hospital or in the wrong apartment building and the wrong and you put $10 million up, you’re going to get hit. You get hit.

Yes. And just to relate to that just overall for the combined insurance and reinsurance business, just looking at the cats for the quarter was that basically line with the cat load you talked about, I think even a hair below.? A lot of the calls people are talking about this being an active cat quarter making it seem like this is much above average. Is that your view that this was an above the average quarter and you came in average or just an average quarter and people are kind of talking about making, seem like a bigger issue than it really was?

When you have a $13 billion to $15 billion worldwide, I would say slightly above average.

Okay.

I don’t – if you are up $10 million and you say $40 billion annual cat load worldwide as maybe the expected number. But I haven’t spent a lot of time. Maybe Marc, you have. I know there is a lot of statistics and we look at that. But I would characterize it as slightly above average. But not – this is not something that is not going to happen again.

It’s definitely is slightly, Ian, above average in the U.S. with the PCS numbers, they are not totally outside. The one thing that I would tell you in Canada is really, really outside of the norm. That’s really what [Multiple Speakers] most of our guys and it’s not really reflected in the cat load of anything that people right in general around the world.

Ian, I would offer that the perspective varies depending on whether your results were three times your cat load versus inside your cat load.

That’s kind of what I was getting at a little bit, okay. So my last one is just, Mark, if you could help me on the LPT math, I just want to make sure I’m doing this right? The 2.7% that you talked about was on the overall combined? But on the accident year, because the accident year is higher than the calendar year, the accident year was getting maybe 30 bps or so, so it was not that much of an impact, is that right?

Well, I would say, we did it on a calendar year basis.

But your accident year was a 98 something, so 100 verses a 98 doesn’t really change it too much?

Yes, that’s correct. [Multiple speakers]

Okay. So the question is, so when I get into the accident year, when I pull it out was still pretty close to a 98 may be a high 97s, that was up about three or four points, or even running, kind of curious what happened there, I know you mentioned some large losses, but was it just that or…?

No, I mean, when you take – yes, when you take there was a – we had a marine loss with a vessel that – it does Jubilee loss. So, we take that large attritional. That was pushing 300 bps I believe. So and there is a couple of other noise, but that really accounts for it.

Make sense, perfect. All right enjoy the cat events, talk to you next quarter.

Okay. All right. Thank you.

Thank you.

I’m showing no further questions. I would like to turn the call – conference back over to Mr. Dinos Iordanou for closing remarks.

Thank you all. Enjoy your lunch and we will talk to next quarter.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. You may all disconnect. Everyone have a good day.