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Executives

Dinos Iordanou - Chairman, President & CEO

John Hele - EVP, CFO & Treasurer

Analysts

Jay Gelb - Barclays Capital

Mike Zaremski - Credit Suisse

Keith Walsh - Citi

Joshua Shanker - Deutsche Bank

Matthew Heimermann - JPMorgan

Dan Farrell - Sterne Agee

Doug Mewhirter - RBC Capital Markets

Court Dignan - Fidelity

Vinay Misquith - Evercore Partners

Ian Gutterman - Adage Capital

Ron Bobman - Capital Returns

Arch Capital Group Ltd (ACGL) Q3 2011 Earnings Call October 26, 2011 ET

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2011 Arch Capital Group Limited Earnings Conference Call. My name is Fab and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

Before the company gets started with its update, management wants to first remind everyone that certain 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 on 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 turn the conference over to your hosts for today, Mr. Dinos Iordanou and Mr. John Hele. Please proceed.

Dinos Iordanou

Good morning, everyone, and thank you for joining us today. Our third quarter result was satisfactory when we take into consideration the difficult market conditions that we operate in. Significant catastrophic activity continuing in the third quarter, however the level of this activity and resulting in trouble damages were only slightly above our average expected cat loads for the quarter.

As you may recall, the first two quarter experienced cat activity and resulting losses that were significantly above average. Our total net catastrophe losses for the quarter were about $60 million with $46 million coming from the current quarter events and $14 million related to net increases in loss estimates from the first and second quarter events.

Our underwriting teams continue to execute our soft market strategy by emphasizing small accounts for the large ones and focusing more on short tail businesses. The market is showing signs of slight improvement. However, we still see more opportunities for adequate profitability in the short and medium tail lines of business rather than the long tail business.

As more and more competitors are factoring into the pricing, the skimpy returns available for new money investments eventually pricing levels for long tail lines will improve; at least we hope so. In the mean time, we are continuing a defensive approach for these lines of business. As a result of these strategies, our mix of business continues to shift towards more short tail and medium tail while our long tail business on a trailing 12-month basis remains approximately 25% of our book.

Our annualized Return on Average Common Equity was 10.4% on a reported basis including a slightly negative effect of above-average cat activity and aided by prior year reserve releases.

We continue to believe that in the current market environment, we are earning high single-digit ROEs on an underwriting year basis. This is essentially the same level of ROE performance we estimated for the 2010 underwriting year with slightly less earnings from investment income offsetting by slightly better underwriting results generated by adjustments to our mix of business.

Our investment performance for the quarter including the effects of foreign exchange was a total return of negative 23 basis points as September was a difficult month in the financial markets. As a result, our book value per share for the quarter increased slightly from $31 per share to $31 20 per share, while book value per share from the year ago grew by 5%.

From an underwriting point of view, we record a 94.3 calendar quarter combined ratio, which is an excellent result for the prevailing market conditions. Cash flow from the quarter remained solid at $310 million as claim trends remain favorable. The broad market environment is showing slight improvement across the board.

From a rate stand point, most lines of business move into positive territory. The exception were in executive assurance and medical malpractice, where we’re still seeing rate reductions in the rate of 1.5% to 2% for malpractice business and approximately 7% for executive assurance.

Even with this slight improvement in the rate environment, significant more rate is needed in many lines in order to achieve adequate returns.

For us adequate returns is returns that produced 15% return on equity. In our view based in part on the level of interest rates currently available, the long tail lines need quite a bit more improvement in rate to become attractive.

From a premium production point of view our gross rates of premiums were up 3.4% and our net written premiums were up 8.7%. The insurance group was up 1.6% on gross return premiums and 9.6% on net. The shift to smaller accounts and in essence, lower limit policies, affects the net to gross relationships as we retain more net for this type of business.

The reinsurance group was up 9.1% on a gross basis and 6.7% on a net basis. The entire re-increase is attributable to additional premiums from short and medium tail lines of business. Long tail lines continued to represent a smaller portion of the reinsurance segment book of business.

In the current environment, even after the implementation of RMS 11, which impacted our capital requirements, we’re still left with a very strong capital position. As always we will prefer to deploy all of our available capital towards our underwriting activities. Unfortunately, the market at this point in time does not yet give us the opportunity to do so. As a result we expect to continue our share repurchase program as we continue to accumulate additional excess capital through earnings.

Before I turn it over to John for more commentary on our financial results, let me update you on our cat PML aggregate. As of September 1, 2011, under our version of RMS 11, our 1 in 250 PML from a single event was $972 million or 23% of common equity. This amount is for Gulf wind exposures while the northeast wind PML was $870 million and Tri-State County, Florida PML was at $750 million.

With that I am turning this over to John for more commentary on our financials. John?

John Hele

Thank you, Dinos and good morning. On a consolidated basis, the ratio of net premium to gross premium was 80%, slightly higher than the 77% a year ago, which was due to a change in the mix of business and some modifications in [US Cities] reinsurance treaties. Our overall operating results for the quarter reflected a combined ratio of 94.3% compared to 90.4% for the same period in 2010.

The 2011 third quarter included $60 million or 8.7 points of current accident year cat activity net of reinsurance and reinstatement premiums compared to $24 million or 3.9 points in the 2010 third quarter. The 2011 third quarter storms including Irene and Danish Flooding had a gross impact of $51 million and a net impact of $46 million.

The re-estimation of the 2011 first and second quarter cat events of the Australian floods and cyclone Yasi and the New Zealand earthquake made up most of the additional $11 million gross and $14 million net added to the third quarter provisions for the 2011 cat events. We have little net impacts from the Japanese earthquake as in [corn] revisions and have already reserved the material portion of that exposure.

In addition to the cat activity, we experienced slightly higher attritional property claims in the quarter. The 2011 third quarter combined ratio reflected 80.5 points or $58 million of estimated favorable prior-year reserve development net of related adjustments compared to 5.9 points or $37 million in the 2010 third quarter. The prior year development in the third quarter of 2011 reflected net favorable development primarily in property and other short tail lines. As well as in the reinsurance segment casualty business mainly from the 2002 to 2006 underwriting years.

Moreover, we gain experience better than expected claims emergence on most lines. The 2011 third quarter current accident year combined ratio excluding large cap events and net favorable developments was 99.9% in the insurance segment consistent with recent quarters. In the reinsurance segment, it was 83.8%, slightly higher than recent quarters due to non-cat attritional property losses.

The 2011 third quarter expense ratio of 32.1% was one point lower than in the 2010 third quarter resulting primarily due to the higher level of net premiums in 2011 as well as non-recurring contingent commission income in our reinsurance business which more than offset a higher level of acquisition expenses related to favorable prior-year reserve development.

On a per share basis, pretax net investment income was $0.60 in the 2011 third quarter compared to $0.59 for the same period a year ago and $0.63 in the second quarter of 2011. Our embedded pretax book yield before expenses was 3.09% in the 2011 third quarter, down from 3.52% at year end, which primarily reflects lower reinvestment rates. During the quarter we slightly lengthened the portfolio duration to 3.17 from 2.87 at the end of June 2011 with longer-dated treasuries to capture some of the expected gain from lower treasury rates.

Total return of the investment portfolio was minus 23 basis points in the 2011 third quarter compared to a positive 165 basis points in the 2011 second quarter. Excluding foreign exchange, it was a positive 38 basis points in the quarter. The total return in the third quarter benefited from good returns in treasuries offset by negative returns on foreign exchange, equities, corporate fixed income due to widening credit spreads and some alternative assets.

Our alternative assets include bank loans, global and emerging market bond and multi-assets funds and energy investments. A substantial portion of this negative foreign exchange, credit spread, equity return and alternative asset return has reversed since September 30th to October 25th which demonstrates the volatile investment environment we now face and expect to face for the foreseeable future.

We continue to maintain the vast majority of our investable assets in a very high-quality fixed income investment portfolio with an average credit rating of AA plus. We recorded net foreign exchange gains of $60 million during the 2011 third quarter mainly due to the strengthening of the US dollar.

These gains resulted from revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date. However, this should be compared to the minus 61 basis points to total return from foreign exchange on investment portfolio which offsets this income statement gain in the equity section of the balance sheet which together with the liability gain resulted in approximately a net $10 million reduction in book value.

For the 2011 year-to-date, our effective tax rate on pretax operating income was a benefit of 3.3% and 1.5% on pretax net income. The cat activity this year and low investment returns have resulted in a beneficial of net tax position.

Our preliminary estimates of the implementation of the new [DAK] accounting standard recorded in January 1, 2012 should not materially reduced our book value and should not a have significant impact on our operating earnings for 2012. These estimates are still preliminary and may change depending upon the final implementation of the standards.

Our balance sheet continues to be conservatively positioned with total capital of $4.9 billion at September 30, up from $4.8 billion at June 30. In the quarter, we purchased 0.7 million shares for $20.8 million at an average price per share of $31.77, a ratio of 1.02 to the average book value. Our debt plus hybrids represent 15% of total capital, well below any rating agency limit for our targeted rating.

Our book value per share ended the quarter at $31.20, up 1% from last quarter and 5% from a year ago. In the calculation of our target capital position, we’ve now implemented our version of our RMS 11. The implementation of RMS 11 by Arch, which reflects the application and model with our own internal back testing, increased SMP A-plus required capital by approximately 5%.

With the implementation of RMS 11, which in our estimation should reduce overall model error. At this point in time, we’ve changed our target capital to be a AA level by SMP which is a two notch buffer over the A-plus rating. As of September 30, our actual capital is in excess of our target capital.

With this comments we’re pleased to take your questions. Fab, we’re ready for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And your first question will comes from the line of Jay Gelb from Barclays Capital

Jay Gelb - Barclays Capital

Thanks and good morning. I just want to follow-up on the last comment from John about the capital position. I know in the past you have given us a sense of where you feel Arch’s excess capital position is currently. Can you give us an update there?

Dinos Iordanou

Yeah, as we said with the implementation of RMS 11, the 5% number was approximately $200 million. So if you take into consideration that that $200 million has been eliminated our position will be approximately $200 million less of what we had before plus the earnings for the quarter which we added. So in essence our excess capital position hasn't changed that significantly.

Jay Gelb - Barclays Capital

Okay. So would it still be $100 million to $150 million plus whatever you have in retained earnings going forward, is that the right way to think about it?

Dinos Iordanou

You know and don't forget may be a bit more because a new standard now of how we calculate excess capital is the two notches above rating algorithm. So we are an A+ company, we calculate capital by at the AA level and then including the additional requirement that RMS 11 you know gives us on the PML and then anything above that we consider excess capital.

So we are in a very strong capital position and that’s the reason we’re going to continue with our share repurchasing you know plan until the market turns and then we can write a lot more premium. But as you have seen from my comments you know even though things are improving not to the level that we’re going to step on the accelerator big time.

Jay Gelb - Barclays Capital

That makes sense. So in the second and third quarter share repurchase typically flows for Arch as we get into win season, and so we expect buybacks in 4Q to be similar to the pace that they were in the first quarter?

Dinos Iordanou

Well yeah, it is a lot of variables price, price-to-book where the Euro is trading, you know etcetera. But yes, our most heavy [Technical Difficulty] share repurchasing traditionally has been the fourth and throughout the first quarter for the reasons that we have already mentioned. In the third quarter, because of the significant expected cat activity we don’t do many share repurchases. So yeah, I would say we are going to go steady as we go as we have done in prior years.

Jay Gelb - Barclays Capital

Okay. And then two, other people have asked this question on other conference calls, in terms of the stabilization of commercial P&C insurance rates, can you say that the current situation is similar to what we saw in 2000 where we had a persistent level of slightly improving rates overtime?

Dinos Iordanou

If you press me for a comparison, you know Jay, and my memory is still good, I mean I am getting older, but I still have good memory. This looks like second quarter of 2000 to me. I have that same feeling; if you go back and look at what happened with the prior cycle, we are starting to see some positive [Technical Difficulty] rates in the second quarter of the year 2000. Don’t forget that continue for the third quarter and forth quarters of 2000; it accelerated a bit in ‘01 but we didn’t really had a true market until first quarter of ’02.

So you know even in those days it took what seven quarters before we really got an acceleration; but there is no denying that when we look at our data and don’t forget Arch is not – we’re not a huge company like Travelers or ACE or Chubb that they have much broader you know basis for their comments. Ours is what we see on a $3 billion business not a much bigger book of business.

We see in every sector improvement even in those that we still giving up rate, we are giving up a lot less rate this quarter than a quarter ago. So you know your consensus it’s a gradual improvement and it’s across all lines. The only two negative lines we had for the quarter it was in the malpractice area as I said in my prepared remarks and in the executive assurance in the D&O area. Everything else was either you know flat, slightly positive or in the mid-single digit rating process, we just listen from where we were coming, I’ll take it.

Operator

Your next question will come from the line of Mike Zaremski with Credit Suisse.

Mike Zaremski - Credit Suisse

Any more color on the loss-cost trends specifically in reinsurance, the X and your X cat’s cash jumped kind of quite a bit?

Dinos Iordanou

Okay. Loss trends are [benign]. You know that’s a broader comment and we usually measure that by frequency and severity of most of the lines and they do it, you know, both in our reinsurance business and in the insurance business we try to get underneath and measure it on the underlying business because, you know, that’s the only place that you can measure those trends. Having said that, we have segments of business that have volatility by nature. Property [fag] is one, of course of the cat business etc. and that for the quarter we have -- we did experience higher than normal, what we would call attritional losses. Some of them, they were flood losses, some -- they were, you know fire losses. But, in essence, we have experienced -- and that it will flow through the numbers and you might see that you know quarter after quarter.

But it doesn’t look to us that is, you know, it’s a trend. It’s more as to what happened in a specific quarter. We joined the --

John Hele

And in fact, if you go back Mike – let’s quarter-by-quarter last like a quarter as you’ll see in the reinsurance segment, when you take out cat losses and favorable reserve development that, that number is bouncing around the bit quarter-to-quarter, and as we move to more shorter tail businesses and more property, you’re going to see that -- things that aren’t classified as a cat but we still had above-average storm activity throughout the U.S. and other places.

So that’s what you’ve seen is bouncing around.

Mike Zaremski - Credit Suisse

Okay, that’s helpful. And lastly, I see you’ve been kind of lengthening the duration of portfolio 3.2 years now. Could you -- are you guys expecting to continue expending, and can you remind us the duration of the liabilities, average book?

John Hele

No, I don’t think we have one, you know we are going to continue to be rather short – to that extent and it was more of reaction you know to Fed comments and what we expected the yield curve to go to. So it was more practical in its execution rather than it changed in philosophy.

Our averaged duration is you know 3.6, 3.5 for the liability. So we are still shorter than our overall liability, but in the third quarter we felt that the rates are going to come down. So we tactically has Dino said that linked them with treasuries which paid off because rates did come down by the end of September.

Operator

Your next question will come from the line of Keith Walsh with Citi.

Keith Walsh - Citi

Hey, good morning everybody. Dinos, in your RMS 11 update comment -- I just wanted to be clear with the PMLs you gave consistent with the view on the 2Q call of 10% to 30% increases and then I have got a follow-up?

Dinos Iordanou

Yes. Yes, don’t forgot, we never use any of the shell product, but in its surety -- we have our own proprietary adjustments that we do based on our own experience, you know, etcetera, and as I said in prior calls even way back in the ‘04 and ‘05 storms we were making adjustments to model, that is not just the RMS model in my BBAIR model which we also use. So, we do pay a lot of attention to these outside models, but at the end of the day we make underwriting decisions and we take, you know risk based on our own models.

Keith Walsh - Citi

Okay. And just on the excess capital, I think you have alluded to that you prefer buybacks to writing new business at this point is what it seems like from what I heard, but --

Dinos Iordanou

No, no. Our preference is to write more business. However, I am not going to write more business unless I get at -- a good return. What I said is in the current market environment, it doesn't allow me to be looking for 15% to 20% growth. And that's the kind of growth you need to start eating up your excess capital.

So not having that opportunity, then I got to return capital to shareholders, and right now based on where our share price trades we still believe that buying back shares is the best way to return that capital back to shareholders.

Keith Walsh - Citi

Right. I was going to ask you what type of rate increase do you think you need to see when that switches over -- when writing new business becomes more attractive on a ROE business -- on an ROE basis relative to the buyback?.

Dinos Iordanou

Well, it depends a lot on the business. I will give you an example, let's take, we are not a big workers’ comp writer right. But our monitors show that in the comp line we are getting the very little we write, we are getting 6%, 7% rate increase. We don't get excited until we get to probably 30% rate increase because if you do the math, you need 30% to 35% rate increase for that comp line based on the yields we get on new money invested and a full-year duration you know ground up to take that 117 -- 115, 117 that the industry is performing at and bring it down to the mid 90s because you need mid 90s in order to get to the mid teens ROEs even on that line.

So, our evaluation on as to what we write by line of business type of accounts, goes through these analyses. What’s the rating environment, not only just year-over-year changes, but on an absolute basis, what is the profitability associated with it, and you know how much more can we get in the marketplace even the rates were adequate. Of course, there is limitations to that, I can tell you we feel that in the cat business rates are adequate but PML limitations doesn’t allow you to write you know more than x.

So from a risk management point of view, we write up to risk tolerance. So when I look line by line and where we see opportunities, we see opportunities -- you see a little bit of growth, you know, in our business but is not broad based that allows me to deploy all the capital that I have.

Operator

Your next question will come from the line of Joshua Shanker with Deutsche Bank.

Joshua Shanker - Deutsche Bank

Hi, there. You said that executive insurance is giving a weaker pricing but it seems like you are still growing there, the pricing still very attractive?

Dinos Iordanou

Don’t forget, in executive insurance there is -- we view it in three sectors. Right? We have financial institutions, we have commercial [DNO] and then we have what we call private company not for profit etc. And then in [short] we write a lot of small to medium size enterprise which a lot of it is private enterprises etc. The latter part is where we are growing and that’s the part of the business that we like. It fits with our strategy of writing smaller accounts and we believe that profitability for that segment of the business is the best. And so the rate of reference was for large commercial, which were shrinking.

Joshua Shanker - Deutsche Bank

And then offset by opportunities of the smaller sectors.

Dinos Iordanou

Exactly.

Joshua Shanker - Deutsche Bank

Okay. And talking about, not too much on workers comp or really its not on workers comp, maybe you did try out the national accounts business a bit and in your experience how sticky is that business and if you had eventually find that attractive, how early do you have to be to give into it in order for profit up side?

John Hele

Well it’s sticky business, and is a high service business because at the end of the day, most of the risk is taken by the client, right?

Joshua Shanker - Deutsche Bank

Well, not on the national comp, the workers comp in general. If rates got better would you have to take a loss initially to participate in the profit up side.

John Hele

Well I don’t -- we don’t think so. Some people might, we don’t think so because the market only goes up because there is more demand, and when there is demand, if you are accompanied with an A-plus rating, good service capability and good market reputation, I think you’ll get your fair share. We might be fools but we believe in that. I don’t believe in the fact that we are not writing as much guaranteed, of course workers comp today, will inhibit our ability to participate in the future.

Operator

Your next question will come from the line of Matthew Heimermann with JPMorgan.

Matthew Heimermann - JPMorgan

A couple of questions. One may be just to start out on kind of the changes we’re seeing in macro pricing. I guess when I think back to, you said this kind of reminds you to Q2 2000, so just indulge me for a second here a bit. At that point in time, there was a lot of big recognition that reserves were inadequate and while it took you to your point, you know, six or seven quarters for rates to rise enough so that the returns on capital are adequate. The rate increases and exposure gains that were available were significant enough to really allowed companies to grow 20%, 30%, even 50% in some cases over a couple of years span. So I guess my question is, if this plays out in a more kind of incremental fashion relative to the six to seven quarters it took last time to get your return on capitals to kind of target level, how long do you thing it takes this time?

John Hele

It’s a tough question. I don’t know. First of all, your comment is correct. There was -- in the year 2000, there was a recognition that may be reserves were short for the entire industry, not a real problem for most companies in the current environment. Having said that, I think there is more and more of recognition today. Why managements and eventually they reflect that in their underwriting strategies that we’re going to be in a very low yield environment for quite a bit of time. At least there is nothing in the horizon that says that we’re going to go back to the 5%, 6%, 7% returns on the investment portfolios that we were experiencing 10, 12 years ago. So there is different dynamics that cause the adjustment in pricing. I believe there is a recognition today by senior management and in that sense, it’s starting to push it down into the underwriting teams that we need underwriting profit in order to get adequate returns and I think that’s why they were adjusting in price. How long will it take, I don’t know. If I was very good at that, I’d be in Vegas, you know.

Matthew Heimermann - JPMorgan

I guess the follow up question of that is do you have a sense in terms of -- whether based on what are you doing internally or what your best guess is based on what we’re seeing in the market, what type of interest rate assumption you are seeing push down? Is it where portfolio yields are today? Is it where the money rates are today? Is it somewhere in between?

Dinos Iordanou

Well, it depends by company. I don’t know. You have the ability to ask different companies what they do. I can’t tell you what we do. -- rate of return in new money, when we do both our -- we stabilized rates and also when we compensate our underwriting teams on incentive compensation. Any under or over performance from that by the investment department does not effect those calculations either for incentive compensation for our people and/or for rate making.

Matthew Heimermann - JPMorgan

That’s fair. Okay. and then John, when you were discussing excess capital, it sounded like when you were talking about the buffer to the AA, the target rating that you ran your buffer against potentially had changed. Did I hear that correctly, and if so, what was the previous target?

John Hele

We use to have a buffer where we took into account the one in 250 PML was the future earnings, from that. But that was based a lot around model air and the potential for a large cap and in thinking about this, the fact we've gone to RMS 11 which we think is now a better calibrator model, at least how we see and how we've implemented it, and thinking about how we want to hold a buffer, we sort of like the overall AA or two notch buffer because that reflects all the risks that we’re taking in the firm. So we've got, sort of, a better buffer now we think about it overall versus a one dimensional buffer, which is only the cat event. And so that's how we want to think about it at this time and run the company.

Dinos Iordanou

The old rule was, it was my rule and it was simplistic. I said I want to begin the year and end the year with a major cat event with the same capital. So I took potential earnings for the year, my PML and then the Delta -- if I have an excess capital I mean would change. Now I think we are getting a little more sophisticated in our calculation and it might change in the future, and if it does we will always tell you as to how we calculate, but right now we feel pretty comfortable that we calculate required capital until internally. Management’s required capital is two notches above what the rating agencies -- and recount excess capital anything above value.

Operator

Your next question will comes from the line of Dan Farrell with Stern Agee.

Dan Farrell - Sterne Agee

Could you just comment on your view on new business versus renewal business in the GAAP there, we had a company early that said that they thought the gap was closing.

Dinos Iordanou

Well, I don’t have, we measure that you know, so I am going to go and I apologize I didn’t know I was going to get the question, that I will have the specific numbers in front of me because we have a monitoring system that compares what we get our new business versus renewals. In most areas today, your new business is anywhere from if renewal business is at a 100, is anywhere from 94 to a 100.

But clearly we are getting less rate on new business then we are getting on our renewal business and but I don’t have those numbers right in front of me to give you more specifics, it varies you know by line of business. But on average, I would say in a scale of a 100, new businesses is at 94, maybe 95 and then the renewal business it will be at a 100.

Dan Farrell - Sterne Agee

Just one other quick item, you have mentioned that the increase in the net to growth is driven a little bit by business mix and shift to smaller accounts, is that something we should continue to see of the net to growth shift up over the next few quarters?

Dinos Iordanou

Well, we were aiming for that, you know, but I mean we might have reached saturation in our ability, you know, to continue changing that, because don’t forget we are not abandoning you know the large account business because in a good market, that’s why you make a lot of money. You know, we are just more careful about pricing it today and in that sense you know competition takes some of these accounts.

You know we never really went out and told any of our clients, any of the brokers that we do business, don’t send us your large account business. It shows we are not as competitive on that and in that sense all the time it becomes less and less part of the book. I wish I can find the rates to grow that business because anything that we put out from a quotation on any account is something that we are happy about because if we are not happy about it, we shouldn’t be doing it.

Right, so it is how much the market returns back to us and you know that’s been our attitude you know yes the recognition that smaller accounts perform better in the cycle is not only by us, it is probably by the entire PNC world, but at the end do you really have the infrastructure to be able you know to do that and over the years I think we built good infrastructure that allows us to do it.

Operator

Your next question comes from the line of Doug Mewhirter with RBC Capital Markets.

Doug Mewhirter - RBC Capital Markets

Just had two questions. First on the revenue side, do you have any, based on your mix of pricing and demand and may be exposure units you are writing, are there any I guess economic signs or [T-leaves] that you are seeing or indications whether it seems to be there is more health in the economy or it may be the standstill or things are still kind of dragging on the demand side.

Dinos Iordanou

But as I said, we are not such a large company to have a broad view. You know asking a very broad question, you know I can tell you based on the limitations that a company writes only $3 billion on annual basis is that in the construction sector which I think we have a good market share you know, we don’t see yet an uptick, keep talking about it but I think that business is still hurting quite a bit and we don’t see the demand upticking.

In some other areas we’ve seen a little bit of demand uptick, but it’s not broad enough to grow broad economic conclusions about what’s going on economically in the country, but if I had to guess and this is my guess is I think we just continue to drift. The demand has not really increased to allow us to get more premium or more revenue because of increased demand.

Doug Mewhirter - RBC Capital Markets

My second question deals with a different topic. I know it’s the massive flooding in Thailand you know, hit the major part of the news cycle now and insured loss estimates seemed to be climbing quite a bit. They started well below a billion, I think there may be one as up as high as 2 billion industry loss. Is that a broader event that would impact the overall reinsurance market. I'm not quite sure of how the market is structured in Thailand is, there are a lot more local companies or would you see that those losses trickle into the general global Bermuda, Europe, Lloyds type of market?

Dinos Iordanou

I'm not the right person to answer this question because we have so little in that part of the world that I haven’t really spend time studying it or so, but I’ll do a little research on your behalf and then if you called on a subsequent call as an industry question, so we can comment on it. I’ll shed some light to it, but I got to get back to my cat teams all I can tell you is we don’t have much exposure in that part of the world.

Operator

Your next question will come from the line of Court Dignan with Fidelity.

Court Dignan - Fidelity

Actually I had a question pertained to capital allocation and maybe for John. I know some people are pretty excited about what’s being said about pricing conditions in certain markets, but actually thought Dinos did a pretty good job of summarizing the situation pretty well in his opening comments which is, it doesn’t really seem to be any seminal change in the whole return economics of the business when you give sort of proper consideration to all the factors.

And I guess my question is that given where your shares are currently trading, it looks like you are basically buying you know it is called a 6.5 to 7% incremental earnings yield and obviously the repurchases earned accretive on a stated book basis and I guess the math to me makes it a little hard argument to say that there are accretive on an intrinsic basis, so you know what point do you consider shifting focus towards dividends, either regular or special and away from buybacks?

John Hele

You know we have to be because we’ve always wanted a three-year payback and how we think about this and at these expected returns we’d have to be above 1.2 to make it much longer than three years in terms of the being not getting the payback. So if we’re trading just a little above our book value you know for the average book value for the quarter then we still like to share buy backs.

Dinos Iordanou

Our economic ROE calculation is as I said in my prepared remarks is still high single digits when you put and I think we have something on our website, we have a grid that tells you potential ROE on the left and up on top multiple-to-book and we are the three year in recovery. And right now I don't know if its 1.2 but its 1.18 or something like that and basically until you guys give us more credit and shares go beyond 1.2 times book is not much for us to think about but…

Court Dignan - Fidelity

I guess I added like 125 of book excess, yeah, thanks that's helpful; and one follow-up if I can?

John Hele

Go ahead.

Court Dignan - Fidelity

Along the lines of the great question posed by Matthew Heimermann of JPMorgan, you know I guess I struggle a little bit with the 2Q 2000 and subsequent six to eight quarters analog. Although I am sure I mean, [static] and you know we can kind of debate the numbers back and forth whether it be the industries having total net reserves or spread adjusting cash flow or how we want to look at it.

I guess qualitatively though I look around and I just don’t see sort of the frontiers or alliances out there. I guess the question is, are they out there and I am just not seeing it, obviously I will not see any names, you know obviously analog numbers you know there's an event in New York that mattered as well. But it’s an analog that I think I struggle with and also kind of think back to banking in 2007-2008 when people were always you know say you’re going to have a downturn, but you know it looked that the early 90s S&L crisis and now that its worst – the worst its getting; the other reality is that the last cycle very rarely provides an adequate analog for the prospective cycle?

Dinos Iordanou

Every cycle is different, and it happens for different reasons. Yes, the probability of companies going bust is probably a lot less today than it was in the year 2000, because usually companies go bust on reserve deficiencies, not a recognition that I can’t get much yield on new money invested and in that sense I got to improve my underwritings, so I can get underwriting profit etcetera. I feel what’s driving a bit of improvement in the pricing is the realization that investment yields are so low that we got to start thinking about your underwriting profit.

I can tell you in the entire 90s nobody ever care if you were publishing a 100 combined 102 or a 104 in a business that you had 6% or 7% return on with a 2.7 to 1 you know leverage and 3.5 to four year duration. I mean, when you do the math, you know it’s pretty good returns. And also in those days, the capital requirements if you go and you seem to be spending a lot of time on the math, the rating agencies that were allowing us on a premium to surplus ratio to write a lot more premium to surplus.

As things evolved and they got more sophisticated and the capital requirements have continuous increase and now the yields are going down, you have a much different environment.

So I am not predicting that this is – the question was what does it feel like and I said in my comment about second quarter, it was the first time in those days for different reasons that we saw the market starting to increase rates and improve rating environment and I see a consistency in that between second quarter data that we have in the third quarter. Everything is lifting up a little bit; if it was negative, it’s a little bit less negative, if it was zero, it got to positive and if it was slightly negative, it got to zero.

So you know that’s the only comment I am making. I can’t predict the future, I don’t know this might be like a jet on the runway and is trying to lift off and it might be a false one may be hit a little bump because they didn’t have a flat runway and then you come down again, I don’t know. But you know we’ll see, time will tell.

Court Dignan - Fidelity

I guess just one follow up to that. I mean with the benefit of hindsight we can go back and we can actually conclude that you know a number of still remaining companies, still prominent companies were actually technically insolvent in the second quarter of 2000, and some that are going to report in the next 24 hours or so. And do you think that anyone fits that description today because it seems like that we are much harder to make the case?

Dinos Iordanou

Listen, my job is to run Arch; I spend most of my time worrying about it. I haven’t done extensive analysis you know in other companies looking at their schedule piece and their reserves. I don’t spend my time you know worrying about others. So you got to do that homework and you can draw your conclusions.

But one general comment and then we’ll move onto the next question is, I think the industry in general is not significantly under reserve like it was in the year 2000. And in my history in the business for the last 35 years that I spent as a career, usually companies go bust when they’re grossly under reserved and that does not exist today. So if I have to predict, I don’t see a lot of insolvencies left and right.

Operator

Your next question will come from the line of Vinay Misquith with Evercore.

Vinay Misquith - Evercore Partners

Hi, thanks guys. I thought I would never get a chance. So since Court has exhausted all the cycle down questions, let me just go back to basics on your business. The first question is on the buyback and it seems that at least looking at your PML, may be about $250 million of excess capital based on the one and two 50 PML. So curious as to how much of stock you’ll be willing to buyback so that given the flexibility that you want to maintain should be pricing and property cat remain strong on Jan 1?

Dinos Iordanou

Well, like I said we have excess capital, I am not confirming how much you’ve calculated how much we are. Also we have earnings for the fourth quarter so that’s in addition that is growing. And like I said before Vinay is, it depends where I'm trading. If I am getting this lousy multiple that I am getting today, I’ll be more anxious to be buying more because I think I am creating value for my shareholders. If I get a reasonable multiple for what we are, I might slow that down a bit and even consider other forms of returning capital.

Right now though we have a market that is -- I am going to be more patient because I don’t know if January 1 will might be a much better environment, and if it is, I don’t want to miss it because I said “oh, I don’t have enough capital.” You know if I am going to earn -- if I am going earn, I am going earn on having, you know, more capital available then less, but having said that I don’t see that.

That’s why we like share repurchases because you can change what you do on a weekly basis. If I write a check for an extraordinary dividend the minute it goes out I can’t get it back where we shell purchases I can’t accelerate it or I can accelerate it based on yes if I monitor the market conditions. So, I will stick with the comments that I said that a fourth quarter will be no different than what was done in prior quarters, if you go, a year ago, two years ago or three years ago.

John Hele

And Hele, I think we sleep a little better at night having some buffer because it’s still a pretty volatile -- we are about there with European although the US economy appears to be a bit more detached from it, it’s still a pretty volatile markets out there.

Vinay Misquith - Evercore Partners

Sure, fair enough. The second question is on the future – accident can your margins that’s improved in the insurance operations this quarter year-over-year and it’s been improving from the last couple of quarters. So, is that business mix issues and also and reinsurance, you guys seem to be writing more tad business, more property business, should we look at the combined ratio for an accident (inaudible) basis is going down from both the insurance and the reinsurance segments going forward?

Dinos Iordanou

Well, two things are constant. Your first comment on insurance is correct. I think the change in the mix moving away from -- it eliminates some volatility because they are writing a lot more in small accounts and also they have moved into a short-retail business.

And then, of course, on the reinsurance side as we write more and more property cat and property fact etc. we will be re introducing a bit more volatility. We liked the business, long term but it will give you quarter to quarter, you know, volatility because attritional losses may go up and down. It’s a better margin business, right because that’s what we believe today the best margins are, and for that reason we gravitated to that.. I rather take the volatility with a better margin because over a long period of time, I am going to do better for the shareholders.

Of course but even with that even we believe a better mix, the way we are calculating, we are still high-single digit ROEs, nothing really to get totally excited about, right?

Operator

Your next question will comes from the line of Ian Gutterman with Adage Capital.

Ian Gutterman - Adage Capital

First, what made the gulf pass northeastern Florida as your peak (inaudible) was that mainly RMS 11 or did you reshape the portfolio?

Dinos Iordanou

No, it was purely model driven.

Dinos Iordanou

And by the way, you are always asking that question, if I was a professor with you sitting in the back of the room I would have flanked you!

Ian Gutterman - Adage Capital

As I said I like to hit clean up, I guess. Getting real, you’ll see the next couple of questions are follow-ups. So, on that change in the capital center to AA, does that give you more or less excess capital than if you have had kept the old standard for this quarter?

Dinos Iordanou

It was approximately the same, you know, it depends what to do with the cat. We model it, it’s no big difference, I think it is more sophisticated way of thinking about it. Now if up a 19% of risk tolerance on my PML, one gives me more, if I am at closer to 25, the other one gives me more, so, you know, it depends how you run it, and where you are on the PML. In the old model that was the determining number. If I pushed it way up, on the PML, then earnings and the delta, it required more and now on the other hand, if I take a little less PML, it changes that.

Ian Gutterman - Adage Capital

Does it also reflect sort of where we are on the cycle, I guess I am thinking, you know the yields (inaudible) that included a year’s worth of earnings, if actually returns are low, you also get less contribution from that than if actually returns are higher?

Dinos Iordanou

Well you are raising a much more intriguing question which, you know, the way I would tell you is that in a market, let’s say we are in the very good part of the marketplace, I will not keep any cushion. I will write all away to my required capital by the rating agency because I have so much confidence in the business, we write in this profitability why keep excess capital and not really maximize returns for shareholders.

So that’s when we said that we step on the accelerator and we write all the business we can. So, this is for now and for the market environment that we are operating today and I think it is prudent in the way we think about it and it gives me comfort.

Listen, my number one priority is I want to sleep at night. Right, I don’t want to be turning and tossing. So if I feel good about sleeping at night, then I think I have the right measurement and you know right now believe me, we have enough excess to make me feel good about what we are.

Ian Gutterman - Adage Capital

My last one is just a follow up on the repurchase commentary and John I am actually looking at the sheet and it looks like a 9% ROE, it’s 3½ years at 1.2 times, so it looks like may be the cut off is something like a 1.17 or 1.18 or something and you are trading at 115 I mean we are basically there. So if the stock moves a buck higher from here, are we turning off buy back?

John Hele

Well, see average ROE over the period of time, not your trailing because that was at September 30th and you know the 1.17 to 1.2 is sort of the upper end of the range, but we will continue to look at these options, but you got to average it out over the quarter.

Ian Gutterman - Adage Capital

I guess what I am going at is if the market continues to get more enthusiastic about pricing and the stock because up another 10% or more and you get to the point where the math doesn’t actually work, what is the option? Is it dividend, is it and again assuming it is not a hard enough market you know where we want to grow a lot right for sort of in this in between land where pricing is up may be a little bit more than last trend, we don’t grow a ton, the stock is too expensive to buy back, what do we do with the capital?

Dinos Iordanou

Listen at the end of the day, it is not a hard and fast rule, that will require another discussion between us and the Board, we told the Board we’ll only buy it at under a three-year or less recovery, if special dividend which is not something that I prefer because it loses that flexibility that I talked about that I can turn it up or down depending what I see in the marketplace.

One of the things that makes us what we are at here is the old (inaudible) strategy that will agile, will adjust to things both from an underwriting point of view, from what we do by a line of business et cetera and that draws this into that category. If we get there, listen, I haven’t seen 1.2 times book value for a long time. I keep dreaming about it and when I see it may be we’ll have another discussion and then we might make whatever determinations.

John Hele

And then the other point is you know what’s the ROE on the business already in the quarter and Jan 1 may be better, may not be better, there’s a lot of things, you questioned a lot of what ifs and we got to decide sort of almost when we get there.

Ian Gutterman - Adage Capital

Got it, I guess the thing I was thinking of it is I wonder if again if we get into a situation may be hoarding capital is the right strategy and turning off the buyback would make sense because if we really are within six or eight quarters of a market turn, why not keep the extra capital rather than buying it back at it that payback, keep that capital so when the market does turn, you can write more business, more quickly and if it’s a short-term reckoned ROE who cares?

Dinos Iordanou

Right, we agree with you but give us a little credit here, we modeled that and the reason, don’t forget, there is other ingredients on our capital structure that allows us quite a bit of flexibility. That and hybrid to equity is very low. So even the minute somebody rings the bell and he says you’re getting on this straightaway and we’re going to write a lot I have the ability to raise you know I don’t know three quarters of billion to a billion dollars of additional capital without you know diluting my common shareholders which is the last thing that I want to do. I didn’t buy all these shares back because later on I want to dilute it. So that calculation we do continuously to make sure that never point in time, at no important time capital restrictions would not allow us to write as much good business as we can get our hands on.

Operator

Your next question will come from the line of Ron Bobman with Capital Returns.

Ron Bobman - Capital Returns

I had one question remaining, why are large account executive assurance rates stubbornly weak?

Dinos Iordanou

I wish I knew, I think I am attributing to you know the class action activity is being benign and for that reason probably some people, they get more optimistic that they are not going to have the significant losses emanating from you know from this national class actions. Having said that we made mistakes in other lines of business that make us more cautious, for example in the aviation business, commercial aviation you know, yeah we didn't have major air liners that you know go down but their pricing got to a point that at some point in time even one or two incidents will take something from thinly profitable to extremely unprofitable. And I am suspecting that in the commercial D&O you know may be a slight change in environment all of a sudden you are going to have a lot of people with a lot of peers out there.

So its an attitude as to what do you view, where the overall rates are and do you take into consideration what happened in the past and do you put some thought process into the improved benign activity. But do you price purely that what's happening today its going to continue to happen in the future.

That's the same issue we had with you know RMS 11 which you get a lot of different outcomes if you take to long patterns or if you take the short patterns, three-four years and average that on cat activity so you've got to make judgments and in our judgment on the D&O world I think rates there you know they shouldn’t be continue to going down I think that business should stay, we are not its unprofitable, but we would continue to give upright and we are giving it a strong you know but still negative and that tells you a lot of people like that business in order for ways to continue to go down. There is a lot of capacity out there. But at the end of the day we are starting to be very cautious about that a lot.

Ron Bobman - Capital Returns

Thanks a lot. And since you brought it up, RMS I think also updated the European model in the middle of this summer, is that going to change your have an impact on your pricing or rate expectations, the desired rates for the January renewals?

Dinos Iordanou

It depends what the market reacts to, don’t forget we were way underweight in European wind and we were way underweight on Japanese quake and that is because we didn’t like the rating environment. It wasn’t just purely – I think the model changes might cause the supply-demand to improve and if pricing goes up, it might give us more opportunities, but I am not predicting that. I don’t know when it happens, and if it happens we will react to it. But we continue to be underweight in European wind because of the rates we can get.

Operator

And there are no further questions in the queue. I would now like to turn the call back over to Mr. Iordanou for closing comments.

Dinos Iordanou

Well, thank you. Thanks to everybody for bearing with us for an hour 50 minutes. We are looking forward to seeing you next quarter. Have a good day.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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