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Arch Capital Group Ltd. (NASDAQ:ACGL)

Q4 2012 Earnings Call

February 12, 2013 11:00 am ET

Executives

Constantine P. Iordanou – Chairman, President and Chief Executive Officer

Mark Donald Lyons – Chief Financial Officer and Executive Vice President

Analysts

Vinay Misquith – Evercore Partners

Amit Kumar – Macquarie Capital (NYSE:USA), Inc.

Michael Millette – Goldman Sachs

Josh Shanker – Deutsche Bank Securities

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Jay Gelb – Barclays Capital

Ian Gutterman – Adage Capital

Scott Frost – Bank of America Merrill Lynch

Michael Nannizzi – Goldman Sachs Group Inc.

Operator

Good day ladies and gentlemen and welcome to the Fourth Quarter 2012 Arch Capital Group Earnings Conference Call. My name is Keith and I’ll be your operator for today. At this time, all participants are in a listen-only mode. Later on we will conduct a question-and-answer session (Operator instructions)

As a reminder, today’s conference is being recorded for replay purposes. Before the company gets started with its update, management wants to first remind everyone that certain statements in today’s press release and discussed on this call may constitute forward-looking statements under the Federal Securities Laws. These statements are based upon management’s current assessments and assumptions and are subject to a number of risks and uncertainties.

Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time.

Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby.

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

And with that, I would now like to turn the conference over to your hosts, Mr. Dinos Iordanou and Mr. Mark Lyons. Please go ahead gentlemen.

Constantine P. Iordanou

Thank you, Keith. Good morning, everyone, and thank you for joining us today. The fourth quarter from an earnings point of view was negatively impacted by the catastrophic activity of super storm Sandy for which we recorded approximately $200 million of net losses.

On a more positive note as we announced last week, we have entered into a definitive agreement to purchase CMG MI and the operating assets of PMI. We will comment on this transaction and on Sandy later in this call.

On an operating basis, we lost $0.18 per share for the quarter bringing our annual operating earnings per share to $2.54 for the year, which produced a 7.7% return on equity. Our reported underwriting results were significantly affected by Sandy as we recorded a combined ratio of 112.4% with Sandy contributing 26 points to that combined ratio. While our investment performance for the quarter including the effects of foreign exchange was a total return of 80 basis points.

For the year, our total return on investments inclusive of foreign exchange was excellent at 5.88%. Our cash flow for the quarter was good at $190 million, an increase of $80 million over the year ago quarter. Our book value per common share decreased slightly to $36.19 mainly as a result of the impact of Sandy and the temporary effects of share repurchases.

On a year-over-year basis, our book value per share increased by 14%, an excellent result. We also had very strong premium growth for the quarter, which I will comment in a few minutes. On the market, the market environment continues on a path of modest improvement across the Board. We estimate that for our insurance business the rate increases in the quarter exceeded our estimated loss trend by approximately 230 basis points in the aggregate.

These improvements on a line by line basis range from minus 100 basis points to plus 1,200 basis points. The movement of business from the admitted markets back to the E&S markets is continuing. This provides us with additional opportunities. However, on an absolute basis, most long tail casualty business, based on the current interest rates environment still require more rate improvements to meet our return requirements. On a consolidated basis, gross premiums were up 16.3% and net premiums were up 20%.

Looking at growth by segment, the Insurance Group’s premium rose by approximately 5.6% on a gross basis and 7.2% on a net basis. And similar to last quarter, slightly over one half of the increase in gross return premium was due to increased rates and the balance was due to additional exposures.

The Reinsurance Group premium volume was up 51.5% on a gross basis and 50.6% on a net basis. These increases primarily resulted from several opportunities that we capitalize on during the past three years namely, UK motor reinsurance and mortgage insurance as we discussed last quarter and increased activity in our property cat and property fac operations.

Superstorm Sandy had a localized effect on rates primarily on loss driven accounts in the northeast, but had little other effect elsewhere around the country. Group-wide on an expected basis, the return on equity on the business we rode this year will produce an underwriting year return on equity in the range of 10% to 12%. The underwriting margin improvement that I mentioned earlier will not affect the expected return on equity as the improvement in expected underwriting result has been largely offset by the reduction in expected investment yield.

During the fourth quarter, we repurchased 3.9 million shares at a cost of $172 million. We remain in an excess capital position and we expect to still be in an excess capital position after the mortgage transaction closes. As always, our position is to return excess capital to shareholders unless we can deploy it effectively in our business.

As a result, we expect to continue with our share repurchases at a level approximately equal to our quarterly earnings for the first half of the year and we’ll follow the same approach to share repurchases in the coming quarters as we have done historically.

Now, let me update you on our cat PML aggregates. As of January 1, 2013, our largest 250-year PMLs for a single event were basically unchanged with $867 million in the Northeast or approximately 18% of shareholders equity, $862 million in the Gulf where Florida Tri-County PML now stands at $602 million.

Before I turn it over to Mark for more commentary on our financial results, as I indicated early, I have a few additional comments on our recent announcement. During the quarter after an extensive due diligence process, we enter into a definitive agreements with CUNA Mutual and PMI for the purchase of CMG MI and the operating assets and infrastructure of PMI.

The transaction is expected to close in the latter part of this year as it is subject to obtaining approvals from insurance regulators, the Arizona receivership court, and the GSEs, as well as customary closing conditions. This transaction will provide us with an approved operating platform and nationwide licenses that would allow us to participate in the mortgage insurance space on a direct basis.

This new operation will complement our existing reinsurance capabilities and our European-based mortgage capabilities. We expect to continue to support our value customers in the mortgage insurance space as a stable long-term reinsurer. And of course, we would enter the mortgage insurance business on a direct basis in the United States following the closing of the transaction.

We’re looking forward to partnering with CUNA Mutual, who will continue to service their credit union customers on our behalf. We’re also pleased with the opportunity to hire the existing employee workforce of PMI. We intend to create a stable employment environment for them for many years to come.

We believe that the combination of Arch executive management and PMI’s senior management together with a strong capital position and disciplined approach to underwriting will create an enduring enterprise in the mortgage insurance space.

Although, the transaction is not expected to be accretive to earnings for the first two years subsequent to closing, we believe that the mortgage insurance business will be profitable over the long-term, and we expect that this transaction will meet or exceed our target return levels, and we’ll create long-term value to our shareholders.

With that, I’ll now turn it over to Mark, to comment further on our financial results. Mark?

Mark Donald Lyons

Great. Thank you, Dinos, and good morning all. The consolidated combined ratio for this quarter was 112.4% with 25.8 points of current accident year, cat related events that reinsurance and reinstatement premiums, compared to the 2011 fourth quarter combined ratio of 89.7%, which reflected 10.5 points of cat related events also net of reinsurance and reinstatement premium.

The 2012 fourth quarter reflected 26.1 combined ratio points from Superstorm Sandy with the balance emanating from minor adjustments to other 2012 cat events, such as the first quarter 2012 U.S. storms and first quarter Southeast Australian floods.

Our best estimate of the Sandy loss is consistent with our December 19 press release and reflecting approximate 60%, 40% mix for our reinsurance and insurance segments respectively. The 2012 fourth quarter consolidated combined ratio also reflected seven points of prior year net favorable development, also net of reinsurance and reinstatement premiums with acquisition related expenses, compared to 15 points of prior year favorable development into 2011 fourth quarter.

This resulted in 93.6% current accident year combined ratio excluding cats for the fourth quarter of 2012 compared to 94.4% in the fourth quarter of 2011. Over 90% of the net favorable development in this quarter was from the reinsurance segment, with approximately two-thirds of that due to favorable development and short tailed lines concentrated in the more recent underwriting years, roughly 8% for medium tailed lines spaced throughout many underwriting years and about 25% favorable development on longer tailed lines primarily from the 2004 to 2008 underwriting years.

The remaining net favorable development comes from the insurance segment and was mainly driven by shorter tailed lines predominantly from the more recent accident years. Similar to prior periods, approximately 69% of our total net reserves for loss and loss adjustment expense were $7.1 billion are IBNR or additional case reserves, which is a fairly consistent ratio across both the reinsurance and insurance segments.

On a consolidated basis, the 2012 calendar year produced a 95.4% combined ratio on a reported basis compared to 98.3% for 2011, representing $99 million improvement in underwriting income and reflecting the lower level of catastrophic activity than in 2011.

The 2012 expense ratio improvement reflects in part the expense control initiative instituted over the last few years, mostly in the 50 bips improvement in the operating expense component. The full accident year 2012 combined ratio excluding cat was 94% compared to the full accident year of 2011, combined ratio of 93.6%.

Overall, on a consolidated basis, the full 2002 year saw $433 million of gross written premium growth, or 12.6% and $375 million, or 14.2% on a net basis. About two-thirds of this growth in gross written premiums came from the reinsurance segment and one-third from the insurance segment. On a consolidated basis, the ratio of net premium to gross premium in the quarter was 75.3% versus 73.1% a year ago.

In the reinsurance segment, the net to gross ratio was approximately equal to one year ago at 92% and the insurance segment was a 68% ratio compared to 67% a year ago, as a result of our strategy to grow the lesser volatile smaller account businesses and reduce our exposure in the higher severity businesses.

In the reinsurance segment, the 2012 accident quarter combined ratio excluding cats was 83.9% compared to 83% even in the 2011 fourth quarter. The reinsurance segment result this quarter reflect – as Dinos mentioned, changes in the mix of business on a written basis with a higher contribution from mortgage reinsurance lines, UK motor, and property insured tail businesses than in the fourth quarter of 2011.

Additionally, this quarter saw some escalation in recorded our reinsurance crop losses for accident year 2012, which the company does not classify as cat losses, based on additional reports from cedent plus our own additional case reserves. Lastly, this quarter had 1.9 points of bonus accrual adjustments stemming from favorable prior year development, the restated accident quarter combined ratio without this effect was 82%.

The 2012 fourth quarter results for the reinsurance group has been true in the last two quarters, includes the effect of the April 2012 acquisition of the International Credit & Surety operations of Ariel Re based in Zurich, Switzerland. This acquisition accounted under purchase accounting rules contained an unknown premium reserve that was not included in the premiums written, but is reflected in premiums earned on an ongoing basis.

Net premiums earned for this quarter included approximately $17 million from this acquisition with the remaining December 31, on a premium reserve of approximately $34 million to be about 50% earned over the next two quarters and the balance substantially earned within one year after that.

In the insurance segment, the 2012 accident quarter combined ratio, excluding cats was 100.4% compared to 100.9% a year ago. The fourth quarter of 2012, however, contained one expense ratio point of bonus accrual adjustments as a result of prior-period favorable reserve development. The accident quarter combined ratio is 99.4% when this effect is removed.

The insurance segment had net written premium growth predominately emanating from the U.S. operations. This U.S. growth came from programs, executive insurance, and lender product units with a continued reduction in U.S. casualty lines and declines in the tech risk line across all geographies. The programs unit saw growth primarily from two large existing programs along with growth from a newer program, which we regained back in the first quarter of 2012.

Net investment income in the 2012 fourth quarter was $0.53 per share, substantially unchanged from the $0.53 per share in both the 2012, third and second quarters. Our embedded pre-tax book yield before expenses was 2.6% as of December 31, compared to 2.8% as of September 30.

The duration of the portfolio lengthened slightly to 2.06 years from 2.9 years as of September 30. As Dinos mentioned, the total return on the portfolio was 80 basis points in the 2012 fourth quarter with emerging market investments and some high-yield corporate bonds augmenting the returns in our core investment grade fixed income portfolio.

Excluding foreign exchange, total return was 67 basis points. Our exposure to Eurozone countries is listed in the financial supplement with minimal exposures to countries currently undergoing severe economic hardships.

The 2012 year total return on the portfolio was 5.88%, including the effects of foreign exchange, compared to 3.81% in the 2011 year. Excluding foreign exchange, the full year return was 5.59% compared to 4.1% in the 2011 year. Our effective tax rate on pre-tax operating income for the full 2012 year was a benefit of 3.8% compared to an identical benefit of 3.8% in the full 2011 year.

The impact of Sandy produced underwriting losses, thereby reducing our full year effective tax rate. As a result, fluctuations in the effective tax rate result from variability and the relative mix of income or loss reported by jurisdiction. Current quarter preferred dividend expense of $5.5 million was identical for the third quarter of 2012, but less than a $6.5 million of preferred dividend expense occurring in the 2011 fourth quarter.

As discussed on last quarter’s call, this reduction relative to the fourth quarter of 2011 is due to the refinancing of our preferred shares by retiring our series A and B classes and replacing them with a more cost effective series C class. The $5.5 million is the true quarterly run rate.

Our total capital was $5.57 billion at the end of the 2012 fourth quarter compared to $5.75 billion at the end of the third quarter, and $5 billion at year end 2011, with the decrease in the current quarter largely due to the effects of $172 million of share repurchases. This represents 11.6% increase in capital from year end 2011 and our debt-to-capital ratio remains a low 7.2% and debt plus hybrid represent only 13% of our total capital giving a significant financial flexibility.

At the end of 2012, we continue to estimate having excess over our targeted capital position. Book value per share decreased $0.60 to $36.19 versus $36.79 in the fourth quarter reflecting primarily operating results and the short-term effects of share repurchases. Book value per share, however, has increased by 13.9% relative to year end 2011.

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

Question-and-Answer Session

Operator

(Operator Instructions) And your first question is from the line of Vinay Misquith with Evercore Partners. Please go ahead.

Vinay Misquith – Evercore Partners

Hi, good morning.

Constantine P. Iordanou

Good morning, Vinay.

Vinay Misquith – Evercore Partners

First, from the mortgage insurance perspective, what are the long-term ROAEs that you’re looking at? Is it 15% or is it higher than that?

Mark Donald Lyons

Well, I would say is 15% and it can be better than that. But let’s keep it up 15%, we’re happy with that.

Vinay Misquith – Evercore Partners

Sure. And you’re saying that the accretion will only happen in maybe 2015 as this transaction goes through?

Constantine P. Iordanou

The accretion will not happen until actually 2016. But we estimate this to close at by probably third and fourth quarter of this year, there is a process we have to go through. So the first full year of operation would be 2013, second year would 2014. So those two years, we don’t expect any accretion and then after that we expect to be accretive in 2016. Mark, you want to add anything to that?

Mark Donald Lyons

No, I agree. Just a clarification that the first two full years are 2014 and 2015.

Constantine P. Iordanou

Right.

Vinay Misquith – Evercore Partners

So 2014 and 2015, no income and 2016 will be okay, great. And also looking at the amount of capital that you plan to invest, you’ve planned to spend about $300 million. Do you think that you can up-size that based on the opportunities out there, or is it too early right now?

Constantine P. Iordanou

Well, it will depend on the opportunities. Traditionally, as a company we always want to operate all of our units with a strong capital position, as a commitment we made to customers, as a commitment we made to the rating agencies, as a commitment we made to our employees. So depending on how well that business and how good our penetration is in the market, we will make sure that we have adequate capital supporting that business.

Vinay Misquith – Evercore Partners

Sure, fair enough. The second question is on growth. Your top line growth in the primary insurance segment was lower than some of your peers has been. I’m just curious as to your perspective as to where pricing is right now and where you would like it to be, so that you could significantly ramp up the top line?

Constantine P. Iordanou

I think where we differ with some of our competitors is on the very long tail lines when you factor in new money yield to the duration of the liabilities and you do those calculations. Even though some of these lines are getting actually the bigger rate increases, we still don’t see them needing our returns.

And for that reason, we’re holding back our units in writing more. And to be more specific is, some of the primary casualty line, some of the excess and umbrella lines, we’re being very cautious about it. And it’s excess workers comp, the workers comp line, we’re being more cautious about these lines because of where interest rates are. Mark, if you want to add to it or…?

Mark Donald Lyons

Yeah, Dinos, I would say, just echoing what Dinos said, the casual lines over the last couple of quarters have gotten 12% to 14% to 15% increases. But the way we look at it though as we stated before, it’s – what’s the absolute return those increases give us, not just the fact that they’re increasing. We still think that has a long way to go.

Just to give you a little insight, our specialty casualty unit in the month that just went by, we’ll look forward, only wrote a couple of hundred thousand dollars of new business, why? Because we don’t yet forgetting those kinds of increases, but the absolute margin isn’t there yet. So we could make the same comment on excess work comp. We could make the same comment on another longer tailed lines of business.

Vinay Misquith – Evercore Partners

Sure.

Constantine P. Iordanou

But I don’t want to mislead you. I think the market is improving. So we’ll not disagree with some of our competitors’ comments. It’s just maybe it’s our view and the absolute profitability of certain classes that differs. And we’ve been always a patient company because on premium revenue, because to tell you the truth, we love to grow high percentages if the market allows us. But we will not hesitate to shrink, if we don’t think we’re getting the right rates.

So it’s a mixed bag right now. We got segments, we’re bullish and we’re letting the units grow. And then we have segments we are not bullish and we are actually shrinking. The combination of that though is giving us a growth which is not – I’m not disappointed. I think 7% on the net and about 5% on the gross on the insurance group is – in this market environment, it’s not a bad result. And from, I mean, the first quarter, I can talk about January 1, I think our growth in January 1, business was even a little higher than that. But one-month doesn’t make it quarter over year. So in essence, the momentum is going in the right direction as far as we’re concerned.

Vinay Misquith – Evercore Partners

So just one follow-up on that, just curious as to what do you think the trade-off is by being more conservative now versus some of your peers saying, we want to write the business now and on the next renewal will it take pricing up?

Constantine P. Iordanou

Well, I mean that’s a strategy that sometimes it works and sometimes it doesn’t. If you like to be a profit to see what’s going to happen sometimes best things happen to you, because you might be reading the obituary pages and you find your name on it. And so I don’t like to predict the future.

What we see, we instruct our units, this is the market that you’re operating. What you see today, you take actions today, and if that changes tomorrow, you have the right to change your approach. And that’s why we’re a company that pays very little attention to premium budgets.

Our units, they get capital allocation on a quarterly basis. We reevaluate that based on market conditions and we expect that agility from our operating units to be able to adjust and reflect what’s happening in the market. So that formula has worked for us for 10 years and I’m not going to change it.

And that strategy that you just talked about; isn’t just a forward look in the insurance market, it’s a forward look in the economy. So the idea that the economy would have recovered enough that customers would be willing and able to pay a big rate increase a year hence is also a bet we don’t quite believe in yet.

Vinay Misquith – Evercore Partners

Okay, that’s helpful. Thank you.

Operator

Your next question is from the line of Amit Kumar with Macquarie Capital. Please go ahead.

Amit Kumar – Macquarie Capital (USA), Inc.

Thanks, and good morning.

Constantine P. Iordanou

Good morning, Amit.

Amit Kumar – Macquarie Capital (USA), Inc.

Just a couple of follow-ups on the prior discussion; on the USMI business, if you factor and own out, what would the deal equate on a price to book basis?

Constantine P. Iordanou

Well, we want to pay a true book value, so the earn-out will give a fair price, based on how the book evolves over the next two, three years. And that’s what we negotiate it.

Mark Donald Lyons

Yeah. And that has to – the pudding on that as the in force business is tracked over that period of time. It will indicate an additional payment or no…?

Constantine P. Iordanou

It could be a lot more, it could be a lot less, but we’ll let the book evolve. And if it’s more way, we don’t mind paying it. At the end of the day we’re getting the value out of it.

Amit Kumar – Macquarie Capital (USA), Inc.

I guess that leads to the related question, does that tell us something about the state of the market with so many companies trading below book in the insurance land. If you’re willing to look at other segments, I mean, is that sort of overreaching, what state of the cycle is or…?

Constantine P. Iordanou

Well, it has nothing to do with the cycle. We’ve been in this space now since 2009, Andrew Rippert which is the subject matter more senior expert in our operations was hired over three plus years ago, originally was for us to see we have reinsurance opportunities and later on to evolve into insurance opportunities, while here in the United States and also in other parts around the world, European union, Australia and other parts of the world.

So this was a strategic move by us. But in our way, we try to do it, as we acquire talent and as we find opportunities to acquire additional talents, licenses et cetera. So it goes in that continuum. And it has nothing – we view this a long-term play. Mortgage insurance has been around for a long time and with the exception of four, five years that unfortunately bad underwriting decisions were made by most in the space.

If you examine the history of the product, it’s being a profitable line as long as you remain disciplined in underwriting.

Amit Kumar – Macquarie Capital (USA), Inc.

Yeah, it makes sense. Final question and this goes back to your remarks regarding capital. How do you think about the capital needs for this business? I just – what I’m trying to ask is the deal is done and then you sort of ramp up. At that point of time, how much capital – sort of range of capital would you need and how would that play against capital management, let’s say, for 2014 and 2015. I’m trying to sort of think of some sort of a relative proposition?

Mark Donald Lyons

Well, I think fundamentally, you have to think about capital a little differently. First of all, any final capital decision is going to be a function of two things really. It’s the implied business plan and our growth and the opportunities we see and also discussions we have with GSEs and perhaps other regulators. But it’s not really a premium-to-surplus ratio or reserve-to-surplus ratio. It’s a view of what’s called really risk in force so to capital.

And the industry has generally been operating around a 20 to 1 ratio and there’s variations on that for different kinds of businesses and so forth. But 20 to 25 is what, for once, what’s going on right now. A lot of the key competitors in that space are 23 to 25 to 1. And that’s the ratio, I mean the risk to the capital. So 20 to 1 would be 5%, 25 to 1 would be 4%. But again, that’s going to be a buildup over time directly as a function of our business plan.

Amit Kumar – Macquarie Capital (USA), Inc.

Got it. So if I simply add up the risk in force numbers, I can easily come up with the capital number?

Mark Donald Lyons

That’s correct.

Amit Kumar – Macquarie Capital (USA), Inc.

Okay. That’s all I have for now. Thanks so much for all the answers.

Operator

Your next question is from the line of Michael Nannizzi with Goldman Sachs. Please go ahead.

Michael Nannizzi – Goldman Sachs Group Inc.

Thanks. Just one question on the reinsurance side is, we heard other carriers talk about just low level of non-Sandy, large losses in the fourth quarter. Did you see that on the reinsurance side at all in the fourth quarter?

Constantine P. Iordanou

Yes, I think the quarter was good other than Sandy. We saw that.

Michael Nannizzi – Goldman Sachs Group Inc.

So I mean, if we were to back out the crop losses that we’re in the underlying and the impact of sort of benign 4Q on that front, would it generally offset each other or just trying to think about what underneath this sort of noise, the underlying sort of look like reinsurance?

Constantine P. Iordanou

Yeah, I would thing that’s a reasonable approach, backing out the crop. The crop is really outlier in this quarter out of the reinsurance segment. We could always talk about – there is always going to be a few large clients that come through here and there. So I would say that’s a fairly reasonable approach.

Michael Nannizzi – Goldman Sachs Group Inc.

Okay, great. And then second question on the portfolio, I guess I mean it looks like the turnover is pretty high, I’m guessing it’s not the entire portfolio that’s turning over a may be subset. Could you just give us a little of color on, what the strategy is there and where this activity is the source of the realized gains that you seen over the last few quarter?

Constantine P. Iordanou

Well, a lot of that strategy is that, first the subset is generally in the treasury auction space. So the treasury auctions would come up and we will participate perhaps to varying degrees. So yes, that would be a source of some of the realized gains. But it’s really done for liquidity purposes as well that over time the view of the yields of it, when you’re holding it for a while, it changes in the marketplace. But to your core question, it’s really the treasury auction space is the core source of turnover.

Mark Donald Lyons

And let me add to that, our philosophy is for total return. So we’re not going to hold some of this to maturity just for the simple reason that we can be clipping the coupons all the time. You will see opportunities that we can make a trade, our investment department will make the trade and I know you guys like investment income versus realized gains. But at the end of the day, we don’t really care too much. As long as our book value per share keeps going up, eventually what you consider core earnings versus non-core earnings – earnings are earnings. So at the end of the day, we like that approach.

Michael Nannizzi – Goldman Sachs Group Inc.

Got it. I guess the question is how much turnover? So it look like, if I just add all the cash that was up for the year, it looks like you’ve got about twice the total portfolio turning over in a given year, so roughly every six months. I’m guessing that’s not right, I’m guessing there’s a small sleeve of the portfolio that’s turning over, maybe three or four or five times. Is that what that – I mean is that level of turnover?

Constantine P. Iordanou

Yeah, there is some portions of the portfolio, actually they have turnover six times. So…

Michael Nannizzi – Goldman Sachs Group Inc.

Got it, okay. Great, thank you.

Operator

Your next question is from the line of Josh Shanker with Deutsche Bank. Please go ahead.

Josh Shanker – Deutsche Bank Securities

Just following up on Mike’s question, the reinvestment of the TALF assets, what’s that going to do to yield in the coming year?

Mark Donald Lyons

Well, the TALF had – first talk about what it does by not being there as opposed to what it’s reinvested in. There’s a two-pronged impact. You do have reduction in net investment income. But you also have reduction on interest expense, because this is a levered investment, it had some debt associated with it.

So that was roughly a reduction of a million and change on interest expense and it was about two changes I think on the net investment income on a run rate quarter. Where that gets reinvested, it’s – you should, I guess really look at it as a distribution across all our asset classes. We can’t say the TALF numbers went specifically to this investment, specifically to a different investment.

Constantine P. Iordanou

We have an asset allocation. It goes to the different buckets and they get funded by either things that they mature, things that we trade, or things that come – do. So we don’t specifically say, we’re going to take the TALF asset and we’ve got to put it in this place. It gets into the mix and then the investment department would say, where do we have obligations? Like, we in our alternative asset classes, we have probably close to half a billion or one funded yet commitment.

So when we get the calls from these managers, then we have an obligation to fund. So sometimes we will go to alternatives and if there is no calls for alternatives, we’ll put them into the regular portfolio.

Josh Shanker – Deutsche Bank Securities

Sorry, I guess, more specifically in numbers is, I’m trying to figure out what the impact will be in the coming year. I assume the TALF assets were generally high yielding compared to other stuff in the portfolio or maybe that’s incorrect?

Constantine P. Iordanou

It was high yielding, yes. The nature of it – it was…

Josh Shanker – Deutsche Bank Securities

So can we talk about the difference between the bet yield and what’s available to you in the market right now, I suppose?

Constantine P. Iordanou

Well, it depends on which sector, right? The TALF yield was in the low double-digits. I don’t know if it was 12% or 15%, they’re about, but we have high yield investments in alternative space, which is exactly that. So I don’t know if we’re going to utilize all of it in the year or not. Every month, when we sit with the investment committee and our Chief Investment Officer, we decide where based on the asset allocation we have in the different assets classes where they’re going to put it.

So it’s very hard just to tell you, is this going to reduce the investment yield by a point, I mean by 10 basis points or five or three or it will be neutral. My guess will probably be neutral.

Mark Donald Lyons

I think Josh, the one thing you perhaps should not do is look exclusively backwards at some of the net investment income or even of the total returns, because asset allocation mix has changed over time. It’s not necessarily reflected immediately, and as Dinos said, there are still unfunded commitments that clearly wouldn’t be reflected in the financial statement. So it’s got to be whether view towards a changing mix as approved by our finance committee that gets into some of these alternatives.

Josh Shanker – Deutsche Bank Securities

Okay, that’s helpful. I guess the other question, looking the numbers maybe it’s just a crop. But it feels me of the accident year numbers in 2012 were higher combined ratio of the 2011 when you adjust for the luck of the good weather. Is that wrong or how do you view the two…?

Constantine P. Iordanou

Well, you got to see the mix as to there is that equation, and also you got to see as to where we choose to book the accident year. We’re not anxious to be aggressively booking good accident years. Even though that I indicates that we can, if we wanted to we just we feel nobody is taking their hand in our pocket taking the money out. So if it comes in the future, it will come in the future.

Josh Shanker – Deutsche Bank Securities

Okay, thank you very much.

Constantine P. Iordanou

You’re welcome.

Operator

Your next question is from the line of Meyer Shields with Stifel, Nicolaus. Please go ahead.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Thanks. When you talk about the excess capacity of excess capital that you believe you have, is that…?

Constantine P. Iordanou

We know we have, we don’t believe…

Meyer Shields – Stifel, Nicolaus & Co., Inc.

I’m sorry, I didn’t mean to…

Constantine P. Iordanou

Yeah.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Make any such implications. Does that allow you to make riskier higher yielding investments in general?

Constantine P. Iordanou

Well, our approach to investments is, the investment department gets a capital allocation depending on the asset classes that and the amount of assets that we allocate in each one of the asset class. So yes, in general, in theory, the more capital you have, excess capital, it allows you to be in more asset classes that require more capital allocation.

But we sit down with the investment department and we make those allocations and then we know what the capital grow will be, because at the end of the day, we’re very, very fond of our ratings and we don’t want to do anything to jeopardize those.

Mark Donald Lyons

And just for the sake of clarity, assuming nothing else changed, you’d wind up with the excess – if nothing else changed other than the ships to some of these other investments. The level of excess capital would drop because of the distribution of those assets getting a higher capital charge.

So as we look at our excess capital, it’s fully adjusted for forays into riskier investments.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Okay. So that makes perfect sense. When you look at the return potential for casualty lines, the ones that you where you are pulling back. Is that anticipating sort of a risk free investment return or…

Constantine P. Iordanou

Yeah, that is our approach. Our approach is if you have a five-year duration or seven-year duration business, some of these lines, they get – some of them they get excess come, it might even be 12 or 10-year duration. We apply the risk free rate to the calculation, yes.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Okay, thanks for clarifying that. Can you comment at all on the year-over-year decline in the fourth quarter reinsurance segment reserve releases?

Constantine P. Iordanou

I didn’t view it as a decline. At the end of the day, we do it ground up. A lot of their releases, they were short tail. I think two-thirds of it, it was all short tail. And we haven’t looked very hard on the long tail in this particular quarter. So, I wouldn’t read anything into it.

Mark Donald Lyons

And also you’re probably comparing it with the fourth quarter of last year whereas, I think the reserve releases over the course of 2012 have been probably7 relatively consistent as to back of the loans, but…

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Yeah, I was looking year-over-year, but this certainly is basically flat with prior quarters?

Mark Donald Lyons

Yeah, but it’s whatever comes out of the analysis.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Right.

Constantine P. Iordanou

And then you make judgments along the way, yeah.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Okay, great. Thanks very much.

Operator

Your next question is from the line of Jay Gelb with Barclays. Please go ahead.

Jay Gelb – Barclays Capital

Thanks. Good morning, everyone.

Constantine P. Iordanou

Hi, Jay.

Mark Donald Lyons

Good morning, Jay.

Jay Gelb – Barclays Capital

Can you talk about the ROE potential for the new differentiated types of programs you’re putting on? I mean, you talk about the purchase commitment for the mortgage insurance business, for example, I know you’ve gotten – you’ve had that business in Europe already and then of course, the UK motor reinsurance and trying to get a sense of what the ROE profile of those programs are relative to the rest of your book?

Constantine P. Iordanou

Well, don’t forget, in the mortgage insurance space, we believe that is a 15% ROE business and any can be better. It depends on your underwriting discipline and selections et cetera. Having said that, the UK motor is not quite as good as that, but it’s double-digits. And as we said in prior calls, if it drops below that we will be willing to walk away from it, if we can’t get double-digit returns. So that’s where those businesses are.

Now, we have a high ROE business in other segments small announce, but for example, we just launch facility on the Internet to sell travel accident insurance directly. And if you go and decide is called RoamRight, you’d be able to see our offerings.

Of course, it might take years before it become significant, but those businesses have pretty high ROEs and we’re excited about it. These things that we usually have incubation for sometime until we put them out, I think we did put a press release on that.

Mark Donald Lyons

Yes, we did. Yes, we did.

Constantine P. Iordanou

On RoamRight, yeah.

Mark Donald Lyons

And this had 27,000 hit so far and they’re extending the reach into other aggregators, but Dinos is right. And with the Internet play, there is some cost efficiencies.

Jay Gelb – Barclays Capital

I see, okay. And then I had to jump on the call a little late. I don’t know if you talked about the outlook for share buyback in the second half of 2013 or is that just kind of weighing through it catastrophic activity influence?

Constantine P. Iordanou

We commented on that. So I don’t want to bore everybody. If you read my prepared remarks, you will see it.

Jay Gelb – Barclays Capital

Thanks very much. Take care.

Operator

Your next question is from the line of Ian Gutterman with Adage Capital. Please go ahead.

Ian Gutterman – Adage Capital

Hi, good morning, Dinos.

Constantine P. Iordanou

Good morning, always in the back of the class?

Ian Gutterman – Adage Capital

I tried to get in the front, but Vinay and Amit had taken up all the seats, they roped them off, so I couldn’t get there.

Constantine P. Iordanou

Okay.

Ian Gutterman – Adage Capital

A few clarifications, first the MIY, is it not accretive at first years? Is there an amort that’s higher initially and then drops off or is it just the way the growth comes in? What’s the math there?

Mark Donald Lyons

Well, I think it’s pretty straight forward. It’s a labor intensive business. There’s a lot of infrastructure that’s needed for repurchasing and in addition to that with the employee forces in order to utilize that infrastructure. So just think of it as having over a short period of time, an employee force that outstrips the revenue generation and then that reverses itself.

Ian Gutterman – Adage Capital

Even though you’re acquiring a few years of in force?

Mark Donald Lyons

Well, that’s correct. But what you look at is, the first couple of years, you have more of the in force run off, I’ll call it.

Ian Gutterman – Adage Capital

Okay.

Mark Donald Lyons

While the other one, the new business is ramping up. So one, kind of helps offset the other, but doesn’t entirely offset it.

Ian Gutterman – Adage Capital

Got it, okay. And then a couple of numbers ones, I think you mentioned the crop impact. I didn’t catch a number – about how much was that impact?

Mark Donald Lyons

In the quarter, it was underwriting gain or loss. It was almost $8 million.

Ian Gutterman – Adage Capital

$8 million okay. And do you have the reinstatements for this quarter end and last year Q4?

Mark Donald Lyons

Last year’s, well I have to get back. But this year, the reinstatements – you’re talking Sandy reinstatements?

Ian Gutterman – Adage Capital

Exactly.

Mark Donald Lyons

It was about 10.

Ian Gutterman – Adage Capital

10.

Mark Donald Lyons

Between 10 and 10.5 in this quarter.

Ian Gutterman – Adage Capital

Got it, and then just the last one, just – address to tell us again, I got a little confused. I think, Mark you said it was about $2 million or so quarter of investment? And then Dinos said, it was a 12% yield and it looks like a balances around $200 million. So $200 million of 12% yield would have be like $6 million of quarter, so what am I missing?

Mark Donald Lyons

Well, you have to get into the details. But it wasn’t be entire TALF. We, over the course of the year depopulated some of that mostly in the second half. So it wasn’t going to zero even in the fourth quarter would have had a partial reflection of it.

Constantine P. Iordanou

As deals that were coming off, it was throughout the year. So your calculation, you math is correct, but incorrect in the degradation of those amount. We can give you the details as to how it happened over the year. It wasn’t all done in the fourth quarter.

Ian Gutterman – Adage Capital

Got it, that makes sense. Okay, that’s all I have. Thanks.

Operator

(Operator Instructions) And your next question is from the line of Scott Frost with Bank of America Merrill Lynch. Please go ahead.

Scott Frost – Bank of America Merrill Lynch

Yeah, I want to go back to your risk to capital assumptions for the CMG. Are you seeing that you’re going to run this over 20 risk to capital…?

Constantine P. Iordanou

Yeah, 20 or less.

Scott Frost – Bank of America Merrill Lynch

20 or less, okay, all right. So we’re planning to go back down to sort of the industry leaders were doing pre-crisis absorption over the mid teens, so that…?

Constantine P. Iordanou

Yeah, it could be a little higher than that. But so it would be a conservative capital position. I think that’s what that business needs. You need some conservative underwriting and good capital allocation.

Scott Frost – Bank of America Merrill Lynch

Okay. Okay, thank you.

Operator

And your next question is a follow-up from Meyer Shields of Stifel. Please go ahead.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Thanks. Just wondering, do you when you’re going to start breaking out mortgage interest in the third segment, in that first quarter or after the deal closes?

Constantine P. Iordanou

It’s after the deal closes. Once the deal closes then the immediate – the following quarter, we’re going to break it up.

Mark Donald Lyons

Which in all likelihood with the first quarter of 2014.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Okay.

Constantine P. Iordanou

But it can be the fourth quarter. We’re close by the third quarter. But I don’t know. First quarter 2014, I think is a safe bet.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Okay. So I can procrastinate on that one?

Constantine P. Iordanou

I didn’t get into the names and all that, but Marc Grandisson will be the executive in charge of this segment. He already runs all of our reinsurance and then of course I did mention Andrew Rippert which is the most senior subject matter expert responsible for all of what we do in that space.

And then David Gansberg will be our CEO at the PMI and CMG MI facilities.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Okay. Is there that rule of thumb that we can use in terms of, if there’s an extra $100 million of catastrophes in the quarter, what the impact would be on variable compensations?

Constantine P. Iordanou

The $100 million, it is coming from cats. It doesn’t have a huge impact because our compensation system, even though it’s purely ROE based, it spreads cat earnings and cat losses on a rolling five year average. We don’t want anybody to either get hurt or benefit. I don’t want them to bet their ranch for one year and then the next year, I have the major loss.

So if our entire book of business deteriorates by a $100 million, I can give you the math surrounding that, because our incentive compensation is pretty straight forward. We are in 8% of that that’s the cliff at 15%, they get a 100% or 23%, of ROE they get 200% and they get 400% if we get into their the high 30s, and they may get nothing if we’re below 8%. So, what 100 million on the entire book does to ROE, it will give you the answer.

Mark Donald Lyons

Just to augment that a little bit, description was for the majority within the group of cat, which is in the reinsurance group, the minority let’s say 20% restaurants. The reinsurance group doesn’t smooth, because they already have smoothing, the healthy renewing covers and the cat program that they have.

Constantine P. Iordanou

This is on the insurance side?

Mark Donald Lyons

On the insurance side, so it’s getting aware that $100 million got felt within the group. It’s either smoothed over five years on the reinsurance side or if it’s really head the cat program response and therefore limits the impact of that.

Meyer Shields – Stifel, Nicolaus & Co., Inc.

Great, that’s very helpful. Thanks very much.

Operator

Your next question is a follow-up from Michael Nannizzi with Goldman Sachs. Please go ahead.

Michael Nannizzi – Goldman Sachs Group Inc.

Just one quick one, and I think Mark you talked or Denis I guess talk about the PMLs in the net change from last year. Just was curious of property cat premiums and reinsurance and also non-cat property were bit higher in 2012 versus 2011, Q4 versus Q4?

How should we thing about the cat load in reinsurance if that’s a fair question? And does that change a lot from what we might have thought it would have been before that?

Constantine P. Iordanou

I mean as we said, we allocate on the basis on the insurance the insurance versus reinsurances if I have five pennies of cat, I give four to the reinsurance group and one to the insurance group. So that’s our allocations. And then we leave it up to the cat teams to determine, which zones, how much as long as we don’t exceed the 25% to capital ratio that we superimpose from corporate down to the operating lines.

So as you see, sometimes you will see some changes like the gulf was our high zone a quarter ago. Now it’s the northeast. We’re a little underweight in Florida. We had only $602 million in Florida. Sometimes we were even higher on a lesser capital a couple of years back.

But those are the determinations of our cat underwriting teams as they see what comes in and do they like the rates et cetera. And in a lot of other zones, we’re not totally utilizing our capacity either because the available business is not there and/or we don’t like the rates.

I’m talking about Japanese quake or wind or South American quake or Australian, New Zealand, whatever part of the world, we’ll be in very, very under weighed because in Europe for win because we don’t like the rating environments.

And that’s individual company. We’re not thinking that we’re smarter than anybody else. We just have a different opinion. Other people who provide the capacity think they’re getting adequate rates. Our guys don’t feel they’re getting adequate rates, so we don’t utilize a lot of that capacity.

Michael Nannizzi – Goldman Sachs Group Inc.

Great, thank you so much for answering follow-up.

Constantine P. Iordanou

You’re quite welcome.

Operator

And ladies and gentlemen, we have no other questions. So I’ll turn the call over to Mr. Iordanou for closing remarks.

Constantine P. Iordanou

Thank you all for your patience, and looking forward to speaking to you three months from today. Have a wondering day.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you very much for joining us. You may now disconnect.

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