Good day, ladies and gentlemen and welcome to the Second Quarter 2017 Arch Capital Group Earnings Conference Call. At this time all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the Federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management 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 hosts for today's conference, Mr. Dinos Iordanou, Mr. Marc Grandisson and Mr. Mark Lyons. Sir, you may begin.

Thank you, Liz. Good morning, everyone and thank you for joining us today for our second quarter earnings call. Our performance for the second quarter was satisfactory as strong performance in the mortgage segment was partially offset by higher attritional losses in our Property Casualty business. On an operating basis, we produced an annualized return on equity of 8.5% for the second quarter of 2017 and 9.1% on a trailing 12-month basis. Return on equity based on net income was a little higher at 8.7% annualized for the second quarter and 10% on a trailing 12-month basis at June 30, 2017. Our book value per common share at June 30, 2017 grew to $59.60 per share, a 3.3% increase from March 31, 2017 and a 15.2% increase from a year ago. Now turning to second quarter results. Our reported combined ratio on a core basis, Mark Lyons will define in a moment what that means, improved to 7.2 points from the second quarter 2016, led by excellent results in the mortgage segment. Our mortgage segment improved its combined ratio quarter-over-quarter to 30% from 44% in the second quarter of 2016, primarily due to increased scale resulting from the United Guaranty acquisition and consolidation activities at Arch MI U.S. Integration of the U.S. primary mortgage operations continue to progress very well and is on or slightly ahead of targets that we have set. The combined sales force is fully integrated and is working well with all of our customers. With the exception of a few customers we discussed in our last quarter call we have not experienced any material changes in our bank or credit union relations in the quarter. There were no significant changes in the Property and Casualty operating environment from last quarter as weaker market conditions continue to…

Thank you, Dinos, and good morning to you all. The earnings contribution for mortgage is improving to be an offset to softening conditions we see in the property casualty sector. As Dinos has mentioned, integration of the U.S. MI companies are going well as the expense ratio for the MI segment improved to 22.5% at the end of the second quarter. Our new insurance written or NIW was $17.3 billion for the second quarter, a decrease of 11% over the same quarter in 2016 on a like-for-like basis, largely due to our decreased writings of single premium business. We continue to deemphasize single premium business in our U.S. MI primary sector because we are not satisfied with the current return profile. For the second quarter of 2017, single premium comprised just 14% of NIW versus 18% last quarter. While market share is important, Arch's focus is on producing the best risk adjusted returns for our shareholders. Since not all MI companies have reported their writings as of today so far, we estimate that Arch U.S. MI's market share remains in the mid-20s for the second quarter of 2017. More importantly to Arch, 80% of our NIW came through our risk-based pricing platform, which we believe generates better risk-adjusted returns than a simple rate card. Our expected ROEs for U.S. MI is still above our long-term target of 15%. The overall quality of the risks written remains very strong. A higher level of mortgage rates in Q2 has led to an improved level of persistency, which now comes in at 78%. We continued to experience favorable development in the U.S. MI reserves, consistent with what you have heard from our competitors. The trend of cured delinquencies outpacing new notices of delinquency is continuing. Arch wrote five new U.S. GSE, the government-sponsored…

Great, thank you, Marc and good morning to everyone. Given that my colleagues are a little long winded today, I'm going to try to talk like a New Yorker and blast through what I have to add. In so doing, first, I'll make some summary comments for the quarter all on a core basis and as a refresher the term core corresponds to Arch's financial results excluding Watford Re, whereas the term consolidated includes Watford Re. But I'd also like to point out that we've altered the chart on Page one of the earnings release. So that now, it provides income statement and combined ratio information for the quarter on both a consolidated basis and excluding Watford Re's results, all in one place for convenience purposes. I believe that there is still some confusion about how Watford's financial results really impact Arch, given that we consolidate them and this helps to provide more transparency. For additional clarity, if only the 11% ownership of Watford Re was reflected at our underwriting results, the resulting combined ratio for the quarter would be only 30 basis points higher than our core 82.2% combined ratio. Okay, so moving forward. Claims recorded in the second quarter of 2017 from catastrophic events net of reinsurance recoverables and related acquisition expenses was 2.3 loss ratio points compared to 4.1 loss ratio points in the second quarter of last year, on the same basis, mostly emanating from within our reinsurance segment. The activity was primarily driven by Australian Cyclone Debbie at our property facultative unit and various other events around the globe. As for prior period pure net loss reserve favorable development, 6.5 loss ratio points were reported in the quarter, led by the reinsurance segment with approximately $40 million of favorable prior period development, the mortgage segment…

[Operator Instructions] Our first question comes from Kai Pan of Morgan Stanley.

Well done Mark, and I timed you. You cut prepared remarks by 5 minutes.

Thank you. Glad I could do that for you.

First question is on the mortgage expense ratio. Is 22% a good run rate going forward, or there are more to come, given that some of these expense saving was still to come?

It's still early in the game. We've been there, we've been at it for 6 months. We're pleased like Dinos said, we're running on or slightly ahead of target. It's hard to see where it's going to end up in the long run, I think we'll be able to have a clear view of where we are probably by middle of next year. But if you look at our comparisons in industry, I think that anywhere from 18%, 19%, to 24% seems to be where everybody is landing. we certainly are ongoing. As, you know us, focusing on extracting as much scale as we can out of the operations. So we'll have a much better, good sense of the run rate by middle of next year.

And Kai, I would just add, this is a mortgage segment. Combined ratio, so it'll also depend on a relative mix of the GSE transactions, which attract just very low marginal cost to it.

Is that the 32, the $32 million of other operating expense in the quarter, is that the good run rate going forward or there's going to be sort of like a further improvement or reduction there?

Well if you look, are you talking MI specifically?

Yes.

Well, that's a little tougher. You wind up good, remember it's a ratio. So you've got, you're asking a numerator question. I think Marc answered the denominator answer when it was growing scale. Given some of the activities that are in place, I think it's likely to creep lower. But I don't have, I don't think it's appropriate to have a forecast going forward.

We try to manage the company as well as we can, lean and mean. We don't try to, we didn't do the transaction because some investment banker put on a spreadsheet some synergies that we have to achieve, et cetera. We believe that the activity so far is better-than-expected and there will continue to be some additional savings. Now, not knowing how much volume of business we're going to have, you don't know the ratio. But I think you will see, on just pure dollars, a little bit of improvement as we go back.

The one thing I would add finally to this is there's a lot of things going on at GSEs as you guys know, in Washington, a lot of things can be changing, which would mean having to beef up or increasing the amount of resources we have to allocate there or it could be a lot less. So there's a lot of moving parts as we speak. That's why we're trying to be as careful in answering that question to you.

Great. My second question on the reinsurance reserve release is that this quarter has been meaningfully lower than a year ago quarter. I just wonder is there anything on any trend that we should read into that?

My comments, I mentioned about comments on the ongoing trends and condition. We have seen, and I think you've heard from some other calls as well, that the loss trend is picking up in general in the marketplace. So we have seen some changes in development but not -- that significant. We're just trying to be more prudent in the way we're recognizing history and the actual experience. It has also helped us inform our current action year picks. So we're trying to be more prudent because there are a lot of things that, in addition to the loss trend, I did mention terms and conditions. So we're trying to do -- be appropriately prudent and careful in the way we're going about this.

And Kai, I would also add that the relative mix of the reinsurance reserves these days, because of our reduction in the PML, purposeful reduction, we don't have as much short-tailed release, it's longer-tailed lines and longer-tailed lines have more complexity to it and emergence, so for a data-driven company, as Marc alluded to and I will release it when it shows. But you got to be more prudent when you're dealing with longer-term lines.

And we talked last quarter, Kai, to remind you that also there was the Ogden 75 negative bps change and that has to be included in the data, which it affects a lot of our long-tail reserves.

Okay, great. And last one if I may. Your PML as well as RDS, when you consider your 25% shareholders' equity limit, do you simply add them up or you consider them separately given they're uncorrelated?

Well, they're uncorrelated. And we -- don't forget, we don't add them up because you got to -- there is a probability that they might happen the same year. But the different -- the property cat is usually an annual event, it happens immediately. The mortgage is not going to happen in one year. It's going to -- it will drift, it will be three or four years. It will be the recessional period that's going to affect us. So we don't quite add them up, but we're cognizant of where we are in either segment and we do an aggregate probability estimation and if we feel comfortable we continue to add exposure. And we don't, we reduce exposure. Where we are today is not an issue. Even if you add them up together is well within our tolerance, so we're not spending a lot of time thinking about that right now.

Great. Thank you so much.

Right.

Our next question comes from Elyse Greenspan with Wells Fargo.

Good morning. My first question, we've heard some companies kind of point to maybe a bit of a stabilization in the market, just from some of your introductory comments, it doesn't seem like you guys are seeing that. When you kind of look out towards the end of this year and even into next year, do you expect that we'll see any kind of change in the property casualty market, whether in insurance or reinsurance? With the caveat, obviously, we are still in the middle of one season.

When you look at it in the aggregate and if you look at it purely by rate, so to speak, it's fine as long as you ignore some sort of trend, right? I mean, there is always, if you think trend is zero negative that comment holds water, our competitors' comment. We don't believe in that. We believe that between the slight rate increases we get in a few segments and the rate decreases we get in other segments, when you look at trend, we're losing ground. Clearly, we're losing ground. And you saw it in the way we choose to publish our accident year numbers. So we tried to factor all that in. And we booked, our insurance grew about over 100 I think on the accident year for the first time in quite a few quarters. And it is our anticipation that the market is not giving up enough rate to overcome loss trend and improve margins. So the margins I think they're slightly deteriorating.

I think the market behavior, I think if you look at it in broad terms, it is still very, very competitive. There's a lot of appetite to grow books of business and new ventures and new approaches and new teams being moving around. So as we speak, we're not seeing that competition going away. We are also, as you're well aware, in the environment of excess capital globally and specifically in the P&C marketplace. So where we are right now, it's hard to see the future. But from where we sit, we are expecting a continuation of this for the foreseeable future.

And a lethal follow-up to Dinos' comments there, as a quip, you could equate that to Midas mufflers, pay me now, or pay me later. So a specialty business has a range, it depends where you are in that range. If you're on the upper end of it, there's less chance of adverse development down the road. If you're on the lower end of it, you have an increased chance of adverse development down the road, and different managers have different views of how they report.

The accident year numbers are self-grading exams, so you write the paper, you grade it and the professor comes 3, 4 years down the line, which is going to give you a real grade. So bear that in mind.

That's helpful color. On the property facultative reinsurance loss, how much of that went through the underlying number and how much hit your catastrophe losses?

There was 1 claim that it was from the cat. The rest of it, it was individual fire losses. And like I said, it was very unusual quarter for us, and we view that as an aberration. It's not, anything we look, either from an underwriting point of view, selection of risk, et cetera, or what has happened in the 10-year that we have been running that group, this was a surprise to us and an aberration. But no need for us to make any changes, either on underwriting guidelines and/or any concern that we have with the existing book of...

And Elyse, it is an excessive loss portfolio, so bear that in mind that it actually has given us way below longer-term expected losses for so many quarters. So once in a while, you'll have that volatile result. So that's something that we should expect. I think they've just been unusually favorable for such a long time it happens once in a while, excessive loss portfolio.

On average, we take around $10 million lines, and 3 for losses can get you $40 million quickly. Having said that, it's highly unusual on a single quarter to have four or five losses. We usually get one, we get two, sometimes we get none.

And the other color on that, Elyse, it's a little less than half that's cat related.

That's right.

I was just thinking about the underlying margin. And one last question, you guys called out international motor growth in the quarter. Was that in response to some rate increases following on Ogden was that just a material number? Just a little bit more color there.

A little bit of Ogden at least, absolutely so you can geographically sort of circle into where we are focusing in some of the efforts. But there are also other countries mainly in Europe that have had rate increases, or rate and terms and condition changes that are we believe favorable at this point in time, because so we are partnering up with companies out there and supporting them and providing them expertise and capacity to seize on the opportunity. So it's not only isolated to one area, but certainly the areas you mention about the Ogden rate is certainly a catalyst and one of the larger participation increase that we've seen in the last quarter.

But to your point, Elyse, the quota shares are unbounded but internal -- there's protective XOL, so it keeps that bounded. So quota shares are less impacted by Ogden and therefore, until we get clarity around what Ogden does, there's more of a slant towards the quota share business.

Okay. That's great color. Thank you very much.

Our next question comes from Meyer Shields with KBW.

I wanted to get in a little bit with the loss portfolio transfer that you mentioned. First of all, is there any sort of limitation on how conservatively you can set initial reserves for that relative to your typical practice?

Well it's, I'm sure everybody'll kick in here, but it depends on the, somewhat to the accounting and the accounting is driven by what kind of risk transfer there is. There's underwriting risk and timing risk. That is effectively internally a decision tree on the accounting treatment, depending upon those characteristics. So to the extent that there's not material underwriting risk, we don't put that through insurance accounting. It gets deposit accounting treatment. To the extent that it does get -- there's sufficient risk transfer and it does get insurance accounting treatment, we generally will, depending upon the deal, but as a broad statement, we'll book it very close to a breakeven and any margin associated with it gets accreted over the exposure period.

Meyer, a typical LPT to add to this, you'll have to have mirror accounting between all parties. Typically, whatever is transferred will be assumed by the other party and it will have to be recognized by both parties. It's not really any difference in booking the reserve, if you will. Over time, it might change, it might evolve, which might raise other questions. But certainly, at the beginning of it, there has to be a commonality of agreement as to where we think the loss reserves are to be. And whatever, if you are seeding more premium, then you are seeding also reserve the addition will be described as an expense for the over-the-top and you'll have to take it as a seeding company. So we're -- it's a very, very straightforward way to look at things. They used to be all the way in the past, 30 years ago, things you could do, but those days are over and it's very, very transparent.

Okay, that's very helpful, thanks. The second question, Marc, I guess, you talked about the spread of rate changes being pretty dramatic. Is there a similar spread in trend or is it just where those various product lines are performing now that's dictating the various rate changes?

There's a spread in trend absolutely, just by virtue and the 330 bps that I mentioned about the rate decreases, it's actually focused on the excess portfolio, which by definition, if you have a ground up 2% trend will have a leverage inflation ratio into it. So there is definitely, which is counterintuitive, Meyer, because you would expect rates to not go down as much when a trend has that much impact, but that's the nature of our business, we tend to have unfortunately sometimes doubling up on the negative impact against the loss ratio. That's what we've seen so far.

And let me add to what Mark said. At least in our shop, sometimes when there is negative trend, less losses being filed, whatever, we tend to ignore it. We kind of, I guess, we have difficult time accepting negative interest rates, I think we have a difficult time accepting negative trend. Some others, they, and believe me, smart people can argue this point and they can, they might be right. They say, well listen, look at the data, there is certain segments that indicate that we have a negative trend. And it's a philosophical point of view. I think our entire management team here, including our Chief Actuary, our senior program center managers, we don't allow negative trend to get into our pricing or reserving or anything of that sort. We don't like that. We don't like that concept.

And one of our tenets, Meyer, that's very important is as the trend changes, and we think it is somewhat changing in the underlying business, the uncertainty as to what impact it will have in the excess layer is magnified going forward, so we tend to be, as you know, a lot more careful, and we will tend to migrate towards more primary where there's a little bit more clarity into where that claim trend is going. And this is I think one of those situations in the market where trend is picking up a little bit somewhat, terms and conditions are also weakening, so we try to be a bit more careful in where we write the business.

[Operator Instructions]. Our next question comes from Brian Meredith with UBS.

Couple of questions here for you. First one, just back on the reinsurance and kind of a follow-on to Elyse's question about the underlying combined ratios there. It looks like if you strip out the facultative, or at least the additional facultative losses, your actually underlying combined ratio has improved on a year-over-year basis.

That's correct.

That's true.

That's great, that's better.

On the underlying basis, given the mixes because you've got the facultative unit, you've got the U.S. reinsurance unit and you got the Bermuda-based reinsurance unit, so a lot of that is mixture.

Got it, just wanted to clarify that. And then second question was on the deterioration you're seeing in your higher loss mix that you've got in your insurance segment, wondering, is it possible to quantify how much of that is related to terms and conditions loosening up? I think that's something that's just kind of hard to quantify.

It's hard to quantify at this point.

I mean there is a portion of it that is terms and conditions, there's more a portion of it that is actually the rate. I mean, what the indication is, what our actuaries believe the rate increase we need to get to maintain a certain loss ratio and if we're not getting that, you got to factor it with a higher accident year loss ratio. So I think it's a combination of both. But the terms and conditions is subjective, very, very, very hard for both underwriters and actuaries, even when I ask these questions to our claims people, they throw their hands up. Because they say, well, we're going to tell you when we see it. Well, the time they see this when there is a lawsuit and say you didn't have that clause, you wouldn't be able to -- we would have been able to defend ourselves. And with that clause, we can. So there is a loss that we got to pay because of language on the contract. So how do you factor that in mathematically is very difficult. But we take it into consideration. If you ask me, is a wild guess is what it is, but we factor some of it when the conditions go down. And you have to. If you're not looking for at-risk developments in future years you'd better try to get your accident year as close to what you believe it is today.

My experience on the contribution from terms and conditions is that as we get a weakening and softening market, the terms and conditions overwhelm the pure loss trend that you would have seen. So we're -- it's still not -- we believe, I believe the majority of the rate, the rate decrease as we see it, as we speak. But again to Dinos' comment, it's a judgment call at the end of the day. It's very difficult to quantify most of it.

And Bryan before you move on, I'd like to backtrack to your first question. You talked about the reinsurance mix and what the underlying is. From what you said, it sounded like you are leaning towards excluding all of the property facultative large attritionals when in fact, there's always a piece of that, that will be in there at all times. We tend to think of it, not only in a load basis, remember they're not a cat load driven unit, but it's always going to be something, so subtracting it all is too much.

I was actually just looking year-over-year, I was assuming the 2.7 points that you referred to in the second quarter 2016 is what you had. So the delta, that's all I was doing.

Yes.

And last one, Mark, I'm just curious, going back to Kai's question on the mortgage insurance unit, the decline in other underwriting expense you saw from the first quarter, is that inclusive of the $7.1 million of quarterly kind of salaries and benefits reduction? And what other kind of stuff went into that reduction in other underwriting expenses?

You have to be careful there because that -- the $7.1 million is the run rate as if we took UGC into our operation and did nothing. Brought them in and kept everyone and kept all the systems in place. You have to have a baseline. It's relative to that, it's forward-looking. So we will reap those $7.1 million on an ongoing basis if we hadn't -- versus having done nothing. So it's only a partial. So in the quarter, on salaries, it was $1.4 million of impact. I'm trying with that statement, Brian, I'm trying to give you a little bit of a run rate because you guys are always interested in that in your modeling.

Right, so it's $1.4 million. So I guess I'll go back to what was the difference between the 42 or 41.9 in the first quarter and the 32.2 in the second quarter, it's a big drop.

Okay. Hang on a second. Let me make sure I know where you're talking from.

Because you exclude the reseverancing stuff in those numbers, right?

Well, severance yes. Well, be careful. It's in the OpEx. So it's there. It's, we exclude it only in our definition of after-tax operating income per share, but it's reflected in the OpEx line in what you're referring to.

So it is in there? Okay.

Our next question comes from Ryan Tunis with Crédit Suisse.

Just following up on some of the increase in loss trend in insurance. I guess, what I'm trying to figure out is in some lines, we've clearly recognized the trend is a little bit elevated and that's being reflected in loss mix. Are you leaving room for, like if trend gets a little bit worse from here, is that in the loss pick or are we at a point where to the extent it deteriorates further from what you've already seen, we'll see further increases?

So I think currently, the answer to your question is yes, we would reflect a little bit more cushion and margin of safety if you will, loss ratio pick. In addition to this, it will make us be a lot more careful in writing more, and actually will make us deemphasize and walk away from a deal that we think are no longer providing us with that margin of safety. And that will be, this is an ongoing process, Ryan, right? It's back and forth as you go through the quarters.

Ryan, the point that Marc makes is very, very critical to our underwriting DNA here. If you're not willing to truthfully reflect, based on all the information you have, what the current profitability is on a particular line of business or a particular product line, you're bound to continue making mistakes going forward by not being truthful to yourself. If there is positive margin, negative margin, how big the margin is, et cetera. Because at the end of the day, these profit centers, they're going to determine if they're going to defend the book, if they're going to write more, if they're going to shrink the book. And all those determinations are done in our profitability review meetings that we do with every one of our profit centers and we're very, very religious in doing those. And you can do that and have 1 opinion, and when it comes to reserving, have a different opinion. So we, it's all intertwined and we speak from the same set of numbers and the same page, and it's all integrated between our pricing actuaries, our reserving actuaries, the profit center managers and our underwriters to make sure that we know where we're going. Do we always get it right, no. Nobody is perfect. But we try to be as truthful to ourselves as possible because that determines what is going to happen to us in '17 and '18 and '19.

Understood. And then I guess, just a follow-up for Dinos, I guess, in insurance, I mean you booked above 100 combined, in terms of what you're seeing from a trend standpoint, I mean, that feels like that could be a reality where things are going, going forward. I'm just curious, I mean, is that something you're willing to accept writing over a longer-term basis at worse than a 100 combined in the insurance segment?

It's not a question of accepting it. At the end of the day, listen, you can't shrink the company to zero. You're going to look for opportunities. Not every one of our product lines is at 100. Don't forget, we're not shooting for that number. We're recognizing that that's the outcome of the market. We're not happy about it. I'm not saying we're satisfied with that result. And we're taking actions to try to improve it. But go back to the comments that Marc Grandisson, it's very, very difficult in the market environment we have to go and get a four, five, six loss ratio points improvement. I mean, if you have underwriters who can do that, just send me names because I like to hire them. It's very, very, very difficult. You can't ignore. Now given a market change and I think if pain continues to push people to be more realistic about the actual results that are available in the marketplace today, you might see improvements. And between us, I don't think we're many years away from that. I think you're starting to see people to start recognizing that we're at the bottom, but at the bottom doesn't mean you need to grow at the bottom. You've got to see improvement and it has to go the other way before you can start opportunities to grow. That's the way we see the market, but it's a difficult market that you got to manage it, we're managing personnel expectations, expenses, customer relationships, broker relationships. It's not as simple as, well, let's cut the book in half because 100 is not an acceptable number.

And I'm not showing any further questions at this time. I would now like to turn the conference over to Mr. Dinos Iordanou for closing remarks.

Well, thank you, Liz. It's exactly 12, so it's lunchtime. So on the menu today is dolmades. So thank you, all, for listening. I'll see you next quarter.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect.