AIFA. MI Primer Arch Capital Group Ltd. All rights reserved.

Transcription

1 AIFA March 3-4, 2014 MI Primer Arch Capital Group Ltd. All rights reserved.

2 Informational Statements The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward looking statements. This presentation or any other written or oral statements made by or on behalf of Arch Capital Group Ltd. and its subsidiaries may include forward looking statements, which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this presentation are forward looking statements. Forward looking statements can generally be identified by the use of forward looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" or their negative or variations or similar terminology. Forward looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. A non-exclusive list of the important factors that could cause actual results to differ materially from those in such forward-looking statements includes the following: adverse general economic and market conditions; increased competition; pricing and policy term trends; fluctuations in the actions of rating agencies and our ability to maintain and improve our ratings; investment performance; the loss of key personnel; the adequacy of our loss reserves, severity and/or frequency of losses, greater than expected loss ratios and adverse development on claim and/or claim expense liabilities; greater frequency or severity of unpredictable natural and man-made catastrophic events; the impact of acts of terrorism and acts of war; changes in regulations and/or tax laws in the United States or elsewhere; our ability to successfully integrate, establish and maintain operating procedures as well as integrate the businesses we have acquired or may acquire into the existing operations; changes in accounting principles or policies; material differences between actual and expected assessments for guaranty funds and mandatory pooling arrangements; availability and cost to us of reinsurance to manage our gross and net exposures; the failure of others to meet their obligations to us; and other factors identified in our filings with the U.S. Securities and Exchange Commission. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. All subsequent written and oral forward looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. We undertake no obligation to publicly update or revise any forward looking statement, whether as a result of new information, future events or otherwise. Some non-gaap measures of financial performance also may be referred to during this presentation. The reconciliation to GAAP and definition of operating income can be found in the Current Report on Form 8-K furnished to the SEC by Arch Capital Group Ltd. (the Company ) in connection with its most recent earnings press release, and is also available on the Company's website: From time to time, the Company posts additional financial information and presentations to its website, including information with respect to its subsidiaries, and investors and other recipients of this information are encouraged to check the website.

3 Arch History 2001 Arch Reinsurance Ltd. formed; first reinsurance bound 2002 E&S underwriter Arch Specialty Insurance Company acquired A.M. Best rates A Surety book purchased; Arch Indemnity Insurance Company acquired 2004 Specialty commercial lines in Europe and the U.K. started with approval of Arch Insurance Company Europe S&P rates A- (senior notes BBB- ) Fitch rates A- (senior notes BBB- ) 2005 Arch Insurance receives license in Canada Moody s rates A European operations expanded into Zurich; Flatiron Re (sidecar) formed A.M. Best upgrades to A 2007 Property Fac Re formed; purchased Wexford Underwriting Managers, a MGU of excess WC and employers liability; A&H underwriter Arch Re Denmark formed 2008 Joint venture between Gulf Investment Corp. and Arch Capital formed; Arch Reinsurance Europe Underwriting Limited formed S&P upgrades to A 2009 Lloyd s Syndicate 2012 approved; Arch Re Europe s operations expand to life reinsurance; insurance D&O division expanded; recruited mortgage business team Fitch upgrades to A Expansion of Accident & Health Group S&P upgrades to A Arch Mortgage Insurance Ltd. formed; expanding into global mortgage insurance and reinsurance 2012 Credit & surety reinsurance purchased from Ariel Re 2013 Arch Insurance Canada Ltd. formed; announced first insurance/reinsurance of Freddie Mac STACR transaction; announced intent to acquire CMG MI and operating platform of PMI A.M. Best upgrades to A+ Moody s upgrades to A1 Financial Results Along the Way March 30, 2002 September 30, 2013 CAGR BVPS²: $6.03 $ % Total capital³: $1.0bn $5.8bn 16.4% ¹ Financial Strength Ratings unless otherwise noted ² Excludes the effects of stock options and restricted stock units outstanding ³ Includes senior debt, preferred equity, and common stock (including AOCI)

4 Arch Strategy Diversified underwriting exposures Specialty line platforms in both insurance and reinsurance Diversified geographically and by line of business Expansion into mortgage business Focus on underwriting Talent intensive not people intensive Thorough risk assessment of underlying exposures Active cycle management Opportunistic underwriting Maintain conservative balance sheet Minimize investment risk Prudent reserving philosophy Low financial leverage and strong liquidity

5 Transaction Overview Primary Mortgage Insurance What we purchased: CMG MI CMG Mortgage Insurance Co. approximately $21.5 billion of insurance in force & 22,000 policies in force² CMG Mortgage Reinsurance Company - utilized for insurance coverage in excess of 25 percent PMI Information technology platform PMI Mortgage Assurance Co. Principal mortgage insurance operations center will remain in the San Francisco Bay Area CMG MI Purchase Terms Purchase price is composed of an initial payment of 80% of CMG MI s closing date book value and a contingent payment, or earn out, to be made at the third, fifth or sixth anniversaries up to a maximum of 150% of book value as of December 31, 2013 At closing, approximately $160 million was paid to the sellers The discounted 80% up front payment provides downside protection in the event legacy portfolio experiences losses Reinsurance of PMI s Front Book Arch Reinsurance Ltd. Quota share reinsurance PMI Mortgage Insurance Co. (In Rehabilitation) Book years As a component of the total purchase, Arch Reinsurance Ltd. entered into a 100% quota share reinsurance agreement with PMI Mortgage Insurance Co. for the non-delinquent business from book years 2009, 2010 and 2011 (the front book ) starting from July 1, 2012

6 Size and Composition of the Mortgage Market ` Originations ($bn) Share $124 9% $ % 8.0% 8% $57 $60 $54 $60 $69 $93 6.2% $83 $82 7% 6% 5% 4% 40 3% 2% 20 1% Credit Union Originations Credit Union Share 0% Credit unions have traditionally been very strong in refinance markets In recent years, credit unions have gained market share and outpaced the Mortgage Bankers Association ( MBA ) forecasts in purchase money growth Source: Callahan.

7 Private MI Share of Insured Market Historically, private MI dominated the insured market with an average market share above 50% Beginning in 2007, credit limitations, declining market policies and GSE loan level price adjustments (LLPAs, all-in pricing) drove more business to FHA Private MI market share is growing and moving back towards its historical average RELATIVE MARKET SHARE 90% 80% During the last 20 years, private MI has been above 52% approximately twothirds of the time 70% 60% 50% 40% 30% 20% 42% 33% 25% 10% 0% Sep 2013 Source: Inside Mortgage Finance, FHA & MICA. (a) Average. Total Private MI FHA VA Projected Steady State

8 Market Opportunity for Growth The overall mortgage market is smaller in size than in past year Market mix is shift to more of a purchase money mortgage market vs. refinance MI s have traditionally had a much stronger penetration rate in the purchase money market Even in a smaller mortgage market, mortgage insurance has room for growth MI PENETRATION RATE IS INCREASING $3,000 ~13% 20% 15% Mortgage Market ($ s in billions) $2,000 $1,000 10% 5% Penetration Rate $ est est. Purchase Refinance Private MI Penetration Rate 0% 1 Source: Inside Mortgage Finance, FHA & MICA Average. 9

9 Accounting Concepts / Key Industry Metrics Mortgage insurance 2013 Arch Capital Group Ltd. All rights reserved.

10 Operating Financial Model Relatively straightforward insurance accounting Unique accounting issues include the long life (persistency) of mortgage insurance policies, set premium rate, loss reserves established at the time of default (two missed monthly mortgage payments) Statutory accounting has some unique rules for mortgage insurance: risk-to-capital ratio, contingency reserves Gross Premiums Earned $100 IIF x Average Premium Rate Ceded Premiums (25) Premiums Ceded to Reinsurers Net Premiums 75 Less: Ratios Losses (30) Paid Claims + Change in Reserves Loss 40% Expenses (25) for Delinquencies Expense 33% Underwriting Income $20 Combined 73% Investment Income 15 Pre-Tax Income $35 Taxes (8) Net Income $27

11 Example of MI Coverage Assume that the initial property value is $200,000 and the initial loan is $180,000, creating a 90% loan-to-value mortgage and requiring MI coverage of 25% The borrower defaults on this property and at the time of foreclosure/sale there is $178,000 remaining principal on the mortgage, $5,000 of accrued interest expense. In addition, $1,000 of expense is incurred during the foreclosure process; total basis for the of MI coverage obligation is $184,000 ILLUSTRATIVE EXAMPLE MI Coverage Initial Property Value $200,000 Initial Loan Amount $180,000 Mortgage Foreclosure $178,000 Accrued Interest $5,000 Foreclosure Costs $1,000 Total Exposure $184,000 MI Coverage 25% Maximum MI Exposure $46,000 $184, ,000 92,000 46,000 0 $184,000 25% MI Coverage Lender Obligation

12 Key Industry Terms New Insurance Written (NIW) The aggregate principal amount of new mortgages insured in a given period. For example, if a company provided mortgage insurance on a $200,000 mortgage loan, the new insurance written would be $200,000 despite the actual risk insured being much less given that only a certain percentage of the mortgage is actually covered. Insurance in Force (IIF) The aggregate principal amount of loans insured by an MI, not the actual risk insured. For example, if an MI has insured 10 loans of $200,000 each, the insurance in force would be $2,000,000. In a given quarter, IIF levels are affected by new insurance written and insurance cancellations, which include cancelled policies, charged-off policies, and commuted policies. Risk in Force (RIF) Risk in force is the actual risk insured by the MI company, typically 20 30% of the mortgage loan balance at origination. This metric reflects the true liability to the MI, premium rates are priced off of insurance in force, not the risk in force. Notice of Default (NOD) A policy which has missed two consecutive payments which constitutes as event of default under the insurance policy Persistency Persistency is a trailing 12-month measure that reflects the percentage of insurance in force a year ago that is still on the books today. The calculation is typically the current insurance in force minus the new insurance written over the past 12 months, divided by the starting insurance in force a year ago. During times of low interest rates and/or strong home price appreciation, many loans refinance which results in low persistency. During times of rising interest rates and/or low home price appreciation, policies have a longer life and persistency is higher.

13 Key Industry Terms Net Written Premiums Actual new dollar premiums written in a quarter, net of any reinsurance. Premium pricing is based on insurance in force, with annualized basis points (with most payments made monthly), which are determined by the loan characteristics (primarily credit quality, LTVs and insurance coverage levels) charged on the original loan amount. Net Earned Premiums GAAP recognition of premiums; tends to track net written premiums closely given the high proportion of business where premiums are paid on a monthly basis, close to cash basis. Difference can be attributable to upfront single premiums and annual premiums that are amortized over the applicable periods. Net earned premiums can be affected by reinsurance, rescissions / claim denials, reinsurance commutations. Net Investment Income MI companies hold large investment portfolios to fund future claims. In higher claim environments, the insurer will shorten the duration of the portfolio, thereby lowering yield. Portfolio quality has historically remained quite high, as was required by the industry s long standing AA rating status. Incurred Losses Incurred losses reflect the reserve provisioning for new delinquencies and the aging of existing delinquencies. Other Operating Expenses Includes SG&A, deferred policy acquisition costs, claim investigation / surveillance costs and other costs. Interest Expense / Corporate Includes interest expense on corporate debt, corporate overhead and other income/expenses.

14 Key Industry Terms Book Year The year in which the loan is originated Report Year The year in which a loan goes enters delinquency status Report year is typically used to track cohorts of delinquent loans which represent a number of different book years Incurred but Not Reported (IBNR) Loss Adjustment Expense (LAE) A policy which has missed two consecutive payments which constitutes as event of default under the insurance policy Monthly Premium Mortgage Insurance The most common form of mortgage insurance Mortgage insurance premium is paid monthly along with loan principal and interest Monthly rate is one-twelfth of the insurance premium rate multiplied by the loan balance Single Premium Mortgage Insurance Mortgage insurance premium is paid once at loan origination Premium revenue is recognized over the assumed average life Unrealized premium revenue is recorded as Premiums Receivable 14

15 Statutory Accounting Terms Mortgage insurers statutory results provide the capital base off of which the state department s of insurance evaluate companies abilities to write new business Risk-to to-capital Ratio and Minimum Policyholder Position Historically, the risk-to-capital ratio was calculated as the total risk in force, net of reinsurance, divided by statutory capital (contingency reserves + statutory surplus). In 17 states, mortgage insurance companies are required to maintain a risk-to-capital ratio below 25 to 1 in order to write new business. The Minimum Policyholder Position is a statutory dollar minimum required that is calculated at the loan level (LTV affected), applying a charge based on the percentage of coverage provided, net of reinsurance. There are four states that use this metric rather than the risk-to-capital ratio. Contingency Reserves A statutory concept unique to mortgage insurance and financial guaranty companies. MI companies are required to establish statutory contingency reserves in an amount equal to 50% of net earned premiums. These reserves can not be withdrawn for 10 years, unless incurred losses exceed 35% of net premiums or released by means of an approved special dividend. Contingency reserves force MIs to build up capital in good years and it supports statutory surplus in challenging times. Importantly, if contingency reserves are drawn down to pay claims under catastrophic conditions (i.e. loss ratios above 35%), the related delayed taxes in statutory accounting are not due. Tax & Loss Bonds For tax purposes, under Section 832 of the Internal Revenue Code, additions to statutory contingency reserves are tax deductible, within certain limitations, which benefits near-term statutory capital levels. In order to deduct these contributions, a MI company must use the tax savings to purchase non-interest bearing bonds from the federal government tax and loss bonds. The purchase of zero coupon tax and loss bonds provides the MI company with liquid assets that support capital and defers tax payments to the future when contingency reserves are released. GAAP accounting does not differentiate Tax and Loss bond purchase from actual payment of taxes. Statutory accounting includes Tax and Loss Bonds in the investment portfolio as redeemable bonds until taxable income generated.

16 Loss Reserving to Loss Forecasting Loss Reserving (Pending Delinquencies) Consistent Assumptions Loss Forecasting (Future Delinquencies) Pending NODs (Known) New NODs (Estimated) Pending Claim Rate (Estimated) Claim Rate (Estimated) Risk Size of Pending NODs (Known) Claim Risk Sizes (Estimated) Risk Size of New NODs (Estimated) Claim Risk Sizes (Estimated) Claim Size Severity (Estimated) Severity (Estimated) 17

17 Calculation of Loss Reserves Loss Reserves = NODS (Known) Claim Rate X X (Estimated) Claim Size (Estimated) Report Year Claim Rate: Loan characteristics Geo concentrations (CA, NV, AZ, FL) Default aging Product Mix Report Year Claim Size: Risk Size on NODs (Geography/Product) Severity Gross Reserves Net Reserves Plus Incurred but Not Reported and Loss Adj. Expense Less reinsurance

18 Methodology for Loss Reserves Reserves are established only upon an event of default, which is defined as a failure to make the required mortgage payment for two consecutive months, resulting in a notice of default (NOD) Reserves are increased as the delinquency ages as the probability of an actual claim increases Example 1 Example 2 Loan Details $200,000 Loan Misses 2 Loan in 25% MI coverage Payments Foreclosure 90% LTV Loan Amount $200,000 $200,000 Coverage Percentage x 25% x 25% Frequency Factor x 11% x 92% Claim Rate x 95% x 95% Reserve Amount $5,225 $43,700 19

19 Contact Us Mark D. Lyons Executive Vice President and Chief Financial Officer Arch Capital Group Ltd. Wessex House, 5 th Floor Hamilton HM 12 Bermuda (441) MLyons@archcapgroup.bm Investor Inquiries: Donald Watson Executive Vice President, Financial Services Arch Capital Services Inc. 360 Hamilton Ave. Suite 600 White Plains NY (914) DWatson@archcapservices.com