Arch Capital Group Ltd. Q4 FY2022 Earnings Call

Good day, ladies and gentlemen. And welcome to Arch Capital Group Fourth Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed in 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 this call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report or Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin.

Thank you, Towanda. Good morning, and welcome to the fourth quarter earnings call for Arch Capital Group. Happy Valentine's Day to all. I'm pleased to share that for the fourth quarter of 2022, each of our three underwriting segments produced exceptional results. Our quarter's results were buoyed by a lower than average catastrophe loss experience, a significant favorable development in mortgage reserves, and a higher level of profitable earned premiums from our recent growth. This quarter demonstrates the power of our strategy, namely our management of the underwriting cycle across the diversified specialty portfolio with a prudent reserving and underwriting stance. Our P&C insurance underwriting teams continued to lean into hard market conditions, and our mortgage team delivered record underwriting income, which is again a direct result of our years as the established market leader there. For the full year of 2022, Arch generated over $1.8 billion of operating income with an operating return on equity of 14.8%. 2022 was our third consecutive year of sustained premium and revenue growth, supporting stronger and more stable earnings power for the near term. The net premium written growth from our P&C unit was exceptional. Reinsurance segment net premium written grew 51% for 2022 as the team seized on market dislocations, while our insurance segment grew a robust 21% on the year. We continue to see a broad array of opportunities to allocate capital where rates and terms and conditions allow for growth and attractive returns. Taking stock of where we are in the current market cycle, it's important to note that we have recorded premium growth significantly above the long-term industry average. Over the last four years, we've grown property and casualty net premium written threefold to nearly $10 billion from less than $3.6 billion in 2018, while overall rates increased cumulatively by over 40%. As we have stated previously, our cycle management strategy dictates that we maximize premium volume when rates are rising, which is precisely what we've done. While we expect to continue to allocate more capital to the P&C segments for the next several years, I wish to remind our shareholders that we capitalize on the attractive return opportunities in our mortgage insurance segment to the tune of $5.4 billion of underwriting income since 2017. These profits allowed us to redeploy capital into more accretive uses, including $2 billion worth of share repurchases since 2018 and the substantial growth in profitable P&C premium. Mortgage insurance has been vital to our ability to propel our P&C underwriting growth. Underwriting cycle management is core to our culture, and I want to take a brief detour into how we think about the underwriting cycle here at Arch. Here within simplification of the falling grade insurance clock is split into four stages. Stage one, at the onset of the hard market, we see rates increase dramatically and capacity withdrawn. Results on the previous soft market results only begin to show up in claims activity. Stage two is the beginning of the restoration phase, which is indicated by the second and sometimes third round of rate increases along with some improvements for the insurers in the terms and conditions as the industry adjusts its appetite and underwriting policies. Much of the focus during this stage is also geared to filling gaps in and replenishing reserve shortfalls from the soft years while showing rapid improvements. Stage three, the next period, is where rates gradually decrease often as a result of overreaction in stage two. Underwriting profits from the hard market years gradually show up in the results. This period can be lengthy and it usually allows for still profitable growth, especially for the disciplined underwriters. Finally, stage four is where the industry forsakes underwriting discipline and overly focuses on topline growth even as rate decreases accelerate. This is where Arch's culture of underwriting discipline is most apparent as we cut exposure and prepare for the return of stage one. Right now, we are at stage two in most lines. Some, for instance, property, are back to stage one since the fourth quarter. Understanding where you are at each point of the cycle for every product line and the nuances within each stage is critical to the timely allocation of capital to the areas of greatest opportunity. One of Arch's key sustainable advantages is the breadth of its capabilities across many specialty insurance lines, greatly enhancing our cycle management capabilities. A core strategic tenant of Arch is that underwriting acumen and discipline through the cycle drive superior risk-adjusted returns. Now I'd like to share some highlights from our underwriting units. We'll kick it off with reinsurance. For the fourth quarter, net premium written in the reinsurance segment was $1.5 billion, that's more than double the same quarter one year ago. Francois will cover the details. But much of this growth is because we were well positioned to capitalize on broad market opportunities as well as several one-off opportunities resulting from market dislocations emerging in the fourth quarter. It is worth noting that the fourth quarter growth does not include the January 1 property and property catastrophe renewals, which will be reflected in our next quarter's results. As you've heard, pricing for the January 1 renewals was strong. Cat pricing and terms both improved, leading to effective rate changes in the plus 30% to plus 50% range. We anticipate these trends will continue as we approach the mid-year property catastrophe renewal and should translate to strong property catastrophe premium growth in 2023 for Arch. Moving now to our insurance segment, where we continue to reap the benefits of the investments we've made in enhancing our specialty businesses in the UK and in the US. On the year, we wrote over $5 billion of net premium written, compared to $4.1 billion in 2021, with growth coming from a diverse mix of business. Underwriting performance continues to be excellent with an ex-cat accident year combined ratio of 89.6%. Rate increases, with a few exceptions, remain above loss cost trend, and we expect this strong momentum to continue for 2023. The insurance market remains rational and disciplined. We expect also continued opportunities due to the ongoing global uncertainties and remain optimistic that this disciplined behavior that we saw in the P&C industry for the last three years will persist as we move through stage two of the cycles. Next, our mortgage team had yet another acceptable quarter, capping off an excellent year. As we benefited from earnings from our embedded book as well as from favorable reserve development as cures on delinquencies exceeded our expectations. The mortgage segment delivered $374 million of underwriting income in the quarter and $1.3 billion for the year, an excellent contribution in a year where higher mortgage interest rates slowed new originations. Our insurance in force, the earnings foundation of the mortgage segment, grew to $513 billion at year-end 2022 as persistency increased due to higher mortgage rates. As expected, higher mortgage rates led to reduced new rate washes as mortgage rates touched 7%, the highest rates in 20 years. Looking broadly at the mortgage insurance industry's health, we have outstanding borrower credit quality and excess housing demand above supply, the US unemployment rate is near historic lows, and the borrowers' equity in their homes remains at very healthy levels. One thing worthy of mention is that the mortgage insurance industry is acting in a disciplined and responsible manner. In the face of these economic uncertainties, premium rates are increasing while underwriting quality remains strong. Finally, the interest rate increases we've seen in the last 12 plus months should help fuel our net investment income through 2023. We are poised to benefit from higher reinvestment rates coupled with the growth in invested assets. I've got auto racing on my mind lately, and when I look at our industry, I can't help but think that Arch is one of the best cars on the track. We know that winning the race comes down to more than having a great driver or the fastest car. There is much preparation, analysis, and looking at the conditions on the track as well as monitoring the other drivers. By recognizing the soft market conditions in 2017 and 2018, we avoided the mistakes others made early in the race when they might have burned tires or overheated their engines. The pricing began to improve in 2019, and we were able to take advantage of some of our competition's basket stuff and engine problems, and we took the opportunity to take more of a lead on the track by increasing our writings substantially. Then once we saw some clear track ahead of us, we were able to accelerate even faster. Today, we are firing on all cylinders and I know we've got the right crew to bring it home. Let's hand the wheel over to Francois before coming back to answer your questions.

Thank you, Marc, and good morning to all. Thanks for joining us today. I'm very pleased to share that once again, Arch had an excellent quarter on virtually every front. The year concluded with fourth-quarter after-tax operating income of $2.14 per share for an annualized operating return on average common equity of 28%. Book value per share was up 9.9% in the quarter to $32.62 and down only 2.8% on the year, a great result considering the impact raising interest rates had on our fixed income portfolio with a difficult year in equity markets and the elevated catastrophe activity we experienced this year. Turning to the operating segments, net premium written by our reinsurance segment grew by an exceptional 118% over the same quarter last year. Although this quarter, we had a few large one-off transactions that impacted our results and contributed $407 million to our net written premium. Adjusting for these transactions, our net premium written growth was still elevated at 61% for the quarter. These transactions are yet another example of the dislocated state of the insurance market where our strong balance sheet provides a significant advantage as we look to deploy meaningful capital to support ceding companies at terms that meet our target return expectations. More importantly, the underlying performance of the segment this quarter was very good with an ex-cat accident year combined ratio of 82.9% and a de minimis impact from current accident year capacity losses. Reflecting ongoing hard market conditions, the insurance segment also closed the year on a very good note with fourth-quarter net premium written growth of 17.4% over the same quarter one year ago and an accident quarter combined ratio, excluding catastrophe losses, of 89.6%. Most of our lines of business still benefit from excellent market conditions, both in the US and internationally, and our expectations for the coming year remain very positive. Our mortgage segment continued its run of quarters with results better than long-term averages as claim activity for the business remains low. While production volumes were down due to the lower level of originations in the market, we remain positive on the return prospects for this business. Net premiums earned were up slightly on a sequential basis as the persistency of our in-force insurance was at 79.5% at the end of the quarter, continuing to increase. The combined ratio, excluding prior year development, was 45% for the quarter and reflects our prudent approach to loss reserving, one of our key operating principles. Our underwriting income reflected $270 million of favorable prior year development on a pretax basis across all segments this quarter, which represents approximately $0.66 per share after tax. While most of this favorable prior year development, $211 million, came from the mortgage segment, mostly on claim reserves set up for COVID-related delinquencies in the 2020 and 2021 accident years at US mortgage insurance, it is worth pointing out that our P&C reserves also contributed to the overall results. Of note, both our insurance and reinsurance segments had another quarter of favorable reserve development, and the 2022 calendar year phase two incurred ratio for our P&C operations was 58.7%, its lowest level in more than five years. Both these metrics provide some insight into the adequacy of our loss reserves, which constitute an important element in the quality of our balance sheet. Quarterly income from operating affiliates stood at $36 million and was generated from good results across the board. Pretax net investment income was $0.48 per share, up 41% from the third quarter of 2022. Cash flow from operations, over $3.8 billion for the year, was strong, and when combined with the proceeds from maturities and sales of securities in a rapidly rising yield environment, contributed to the underlying performance of our investment portfolio. Going forward, with new money rates in our fixed income portfolio in the 4.5% to 5% range and a growing base of invested assets, we are well positioned to deliver an increasing level of investment income to help fuel our bottom line. Total return for our investment portfolio was 2.6% on a US dollar basis for the quarter, with all of our strategies delivering positive returns. The contribution to the overall result was primarily led by our fixed income portfolio, which benefited from relatively stable interest rates and tightening credit spreads. The overall position of our investment portfolio remains relatively unchanged as we remain cautious regarding duration, credit, and equity risk. Turning to risk management, our natural catastrophe PML on a net basis stood at $970 million as of January 1, or 8% of tangible shareholders' equity. Again, this remains well below our internal limits at the single event one in 250-year return level. Our peak zone PML remains at the Florida Tri-County region. As Marc mentioned, the PMLs we report represent a point in time estimate of the exposure from our in-force portfolio, and the premium associated with the January 1 renewals will be reported in our financials starting next quarter. On the capital front, we did not repurchase any shares this quarter as our assessment of the market opportunity in 2023 remains very positive, one where we should be able to deploy meaningful capital into our business at attractive returns for the benefit of our shareholders. Finally, as Marc mentioned in his remarks, the results we enjoyed this year across our operations were achieved through a thoughtful and deliberate execution of our cycle management strategy and a strong culture of allocating capital to the most profitable markets and opportunities. These results, which were an important contributor to us joining the S&P 500, were only made possible by the ongoing hard work and dedication of our over 5,000 employees across the globe. They deserve a tremendous amount of credit for making us who we are today, an industry leader with a stellar 20 plus year track record that is ready for the opportunities and challenges ahead of us. With these introductory comments, we are now prepared to take your questions.

Our first question comes from Tracy Benguigui with Barclays.

Your one in 250 PML to tangible equity of 8% as of 1/1 wasn't too dissimilar to your 7.7% as of September 30th. So I'm wondering what made you pause to incrementally take more exposure? Did that have anything to do with less retro capacity or your view of ROEs based on pricing for that incremental catastrophe exposure?

I think this number is interesting as it reflects one region, one area, and one sub zone. What isn't visible in the numbers, and we'll discuss more thoroughly during the Q1 call, is that we've increased catastrophe exposure across a broader range of sub zones, which doesn't come through in the Tri-County data. I want to remind you, Tracy, that the Tri-County renewal will be more significant and noticeable during the June 1 renewal. This is just the first step into it. We've also expanded our European exposure because the rate structure there appears favorable. Importantly, this will not be evident in that single number. It depends on the true increase in allocated capital to catastrophe. If you examine the overall number, which serves as a better reflection, there is indeed an increase that will correspond; you'll see that the premium increase alongside the capital allocation increase will be clear to you.

So as you look through the year, even though 25% is your maximum threshold, where do you think you could realistically land based on your risk appetite?

Tracy, our typical answer is, you tell me what the rate levels are like, and we'll tell you what we think we can do. We have a plan based on certain various levels of rate changes in terms of condition changes by zone and by region. And our team, as you can appreciate, is willing and able to operate on that basis. If you take a step back, I think the overall capital position of the company is we have plenty of opportunities to deploy. It's hard for us right now to see going all the way to 2025. But certainly, we have room to grow and we have the capital and the relationships to do so.

And also really quickly on the reinsurance side, in recent times, you focused more on quota share over excess of loss. So with hard pricing, where do you see the best opportunities? I'm thinking about lower ceding commissions on quota shares and the higher rate online on the excess of loss side?

So I think it's across the board. You just mentioned that we have improved economics both on the quota share in excess of loss. I think that the numbers you see in Q4, a lot of it has to do with our recent growth in the quota share that we've written. I think by virtue of the catastrophe excess of loss, as we just talked about a few months ago, increasing, I think that we would be in a position to increase our excess of loss contribution to the bottom line. But when the hard market is around, which we still see on the reinsurance side and the insurance and the P&C side, we tend to migrate towards a quota share. There's a few reasons for that. Number one, one of the big reasons that we like to talk about is, you inherit some diversification within that portfolio that you otherwise would not necessarily get from a net excess of loss perspective. And we really, really like this and we prefer to be closer to the rate change, right? When you're on a quota share basis, you’re side by side with a client as opposed to when you’re in excess of loss, you need to be relying on your sole pricing to make it work. So over time, when the market gets harder, I think you will expect us, as part of the cycle management, to underwrite more quota share versus excess of loss. This year, they're both pretty good.

Our next question comes from the line of Michael Zaremski with BMO.

I'll stick with the primary insurance segment, given I feel like most of the questions will probably be on reinsurance. The growth has been decelerating there a bit. Marc, we heard your prepared remarks, sounds like you're still excited, but maybe you can kind of talk about what's driving the deceleration, what are you guys seeing? I don't know if it's worth bifurcating between kind of E&S excess surplus lines versus non-E&S. I'm just curious if the discipline there is dissipating a bit more versus reinsurance?

In the fourth quarter, we are experiencing a situation that is likely to change in 2023. I believe opportunities will become more widespread than what we saw in the fourth quarter. It seems to have taken some time for the market to fully understand the implications for the overall landscape. Another market is definitely focused on improving returns on property pricing, and this is something that has been mentioned in other calls, which will affect a wider range of business lines beyond just property. Looking back at our 70% growth, that figure represents roughly three times the size of premiums from three or four years ago, indicating significant growth during the initial stages of our market. As we progress into the later stages, I think a 70% growth rate might equate to an additional 50% increase as seen in 2021 or 2020 when we started to engage more actively. This situation reflects a natural progression; after a point, it's challenging to push further, but we are continuing our efforts. A 70% growth rate is still substantially above the industry's average, which suggests that there are plenty of opportunities remaining. However, as we are now further along in the cycle, I anticipate a revival in growth, especially since insurance companies will need to raise prices due to property catastrophes and higher retention amid increased risk. We are participating in this shift alongside others in the insurance market, and we expect to see a renewed opportunity for growth in a firming market.

As a follow-up regarding the primary insurance segment, it seems like the opportunities may be in the property area, if I understand your comments correctly. When considering the segment's combined ratio, my notes suggest it was in the mid-90s. Is that still your expectation, or given the favorable market cycle, should we aim for a combined ratio in the lower 90s as a near-term objective?

We previously discussed the combined ratio target. The 95% target was established back in 2016-2017 when interest rates were significantly lower, and they have since declined further. This situation has led us to set lower combined ratio targets in recent years, which is reflected in our current strategy. We are still aiming for figures in the low 90s or even the high 80s because we anticipate that interest rates may decrease again in the next year or year and a half. Therefore, we are cautious about rapidly adjusting to the current interest rates, even though we are incorporating them into our pricing. Our approach is to maintain a long-term perspective, similar to how we address inflation trends, with the hope that rates will eventually lower. Thus, our ongoing target remains in the low 90s to high 80s to achieve the returns we believe we deserve.

Our next question comes from the line of Jamminder Bhullar with JPMorgan.

First, I had a question on the reinsurance business. If you look at your premium growth, even excluding the sort of large transactions, one-time transactions, you mentioned, the number is extremely strong and obviously, doesn't have the impact of 1/1 renewals in it. So what's really driving that and do you expect some of those factors that drove the strong growth to continue into '23 as well?

I mean the one thing that right from the get-go, I think you need to appreciate the quota share business is something that we might have written a deal in January 1 of 2022, and the premium gets written over the four quarters. So we're benefiting from that, that's showing up in each of the four quarters. If the underlying rate increases also from the ceding companies are higher than what we might have expected at the start, those get adjusted throughout the year. So a couple of factors basically, we're just following the fortunes of the companies. But still, I think our teams deserve a lot of credit for going after these opportunities, being responsive to client needs, providing good capacity with good ratings. Does that continue on in '23? We think so. We think the market is there, and the growth was not only in the quota share business; it's in the property and other specialty lines. Property and casualty is getting a lot of attention in the last few weeks, but still, I mean all lines of business, other specialty, casualty, marine, aviation, remain, I think all lines are in a position to really keep growing at a good clip in 2023.

And then just shifting on to mortgage insurance. Your loss ratio is obviously very good, but I think the loss pick did pick up a little bit in the fourth quarter. So is that more sort of national driven or is it more regional to where you're starting to see some maybe softening in the market in certain regions or states?

Well, we've navigated through the regional differences in our pricing. So I think we have constructed our portfolio that we're very happy with, staying away from what we perceive to be the more dangerous areas and underpriced areas. So I think that's kind of showing up in our performance over time. In terms of reserving, I'd say two things. One, the delinquency rates are still very low. So it's not like we're really seeing pressure at this point in terms of the higher level of delinquencies being reported, and the loss ratio pick is really more a function of us being a bit more prudent. I think there's a little bit of uncertainty with home prices; are they about to come down, and does that create some potential pressure? We think we're very aware of that, whether there's a recession, et cetera. But we're still very, very positive on the segments. It’s just a realization that this is maybe a likely riskier environment than we were in like a year or two years ago, and our reserves are going to reflect that.

Our next question comes from the line of Brian Meredith with UBS.

I have a couple of questions. First, Marc and Francois, you usually include the statistics for other regions such as the Northeast, Gulf of Mexico, and the UK in your 10-Qs. Could you provide those figures so we can get a better understanding of the growth we might expect at the 1/1 renewals? Also, could you focus on Europe? I know you have a strong operation there with many opportunities.

We reported a few additional regions, but I don’t have the specifics with me. However, to Marc's point, much of the growth we observed in the 1/1 renewals will likely come from regions where we were previously underrepresented. This growth will become apparent in Q1 premiums and throughout the rest of the year, although it will not significantly affect the P&L.

And then for my second question, Marc, when I reflect on the combined ratios from 2003 and 2004 after the last hard market, it seems like you're approaching those levels in the reinsurance business. Are we nearing a point where we might be seeing maximum margins in that sector? Perhaps you could achieve a bit more in 2023, but how much additional growth do you anticipate?

I don't know the answer to that. I like the comparison to 2002 or 2003. I would actually like to compare probably more like a combination of 2002, 2003, maybe 2004 in liability and maybe 2006 or 2007 on the property side. So I don't know what that means. We haven't blended growing the combined ratio that we had in this year, but that probably would be close to what we can do. I mean, look, there's a lot of things that are different this time around. The interest rates are lower than they were before internationally. More specifically, we're an international diversified reinsurance company. Hard to tell, but it's certainly going in a way of getting above our long-term ROE targets that's for sure, and that's really what drives us, as you know.

Our next question comes from the line of Yaron Kinar with Jefferies.

My first question, just looking at the ROE profile of the company, clearly, there's upwards momentum here. Can you maybe talk about, A, what the target would be, and B, if you'd see it coming more from net investment income or more from underwriting?

I believe there's potential for growth. The main opportunity lies in net investment income, particularly due to the leverage and the increase in interest rates that we experienced last year. It may take a bit more time for this to reflect in our financials. However, as we look ahead over the next 12 to 24 months, I believe there is leverage to be realized in our figures. Regarding the segment results, overall, mortgages have shown significant reserve releases, positively impacting our bottom line and reported ROEs. We remain confident that the fundamentals behind each of the three segments are strong and capable of delivering healthy results.

And then my second question, just looking at the insurance business, it sounds like you think that there may be some inflection to accelerating growth again in '23. Can you maybe help us think about the impact of the reinsurance market, kind of available capacity, cost of reinsurance, how that plays into the potential growth that you see for net premiums written in '23 in insurance?

Great question, Yaron. What we're going to see through 2023 is a recognition that the need for higher charges to insurers, to enable them to pay the reinsurers, is becoming clear. There is increasing retention, but insurance carriers are still absorbing more volatility, which indicates the need for higher rates, all else being equal. On the reinsurance side, business can change quickly with each renewal, but on the insurance side, it takes about a year to transition and reprice the entire business. I'm optimistic because this repricing will happen throughout 2023 and beyond. Additionally, companies will need to address terms and conditions to improve risk-sharing with insurers. Therefore, while there may be significant increases in reinsurance costs at the start of the year, we will have to integrate these changes into our plans and budgets moving forward. This may be a gradual process, but it will happen, which is why I remain optimistic.

And I apologize, I'm going to try and sneak one more in here. A clarification, when you talked about kind of targeting low 90s, high 80s combined ratio, was that a reported combined ratio in the insurance segment?

That's policy year target; effective it’s just expected, right, plus or minus, as you know, in our space, there’s volatility around the expected numbers, but this is long-term expected.

Because I think you've been running at kind of mid-90s. So where is that improvement coming from? Is it mostly just better rates and in risk selection?

Well, we're running at about 90 now, and I think that we still continue to see improvement in pricing. So that should help us get there somehow.

Our next question comes from the line of Ryan Tunis with Autonomous.

First question, I guess following up on Tracy. Could you give us some indication of, I guess, how you're viewing your overall catastrophe budget this year relative to '21 based on what you saw with 1/1 renewals? Should we expect the expected catastrophe ratio to be higher?

The catastrophe ratio is expected to increase, without a doubt. In 2022, our cat load was around $80 million per quarter, and now it's likely between $100 million and $120 million for the first quarter of 2023 based on our writings. We will monitor how this evolves throughout the year. Depending on how the renewals occur, there is a strong chance that it will continue to rise during the year. For the first quarter, based on our current portfolio, this is our outlook on exposure to catastrophe losses.

And then I’d one for Marc, I guess, on the man-made catastrophe side, which isn't something we've talked about too much. But I would think that's one of the better markets right now on the reinsurance side. And I guess just trying to size that, whether or not maybe some of the rate increases post-Ukraine if that can move the needle relative to property capital, just looking at your marine and aviation premium, it's actually pretty chunky relative to property catastrophe. So if you could just give us some indication of can that move the needle, is that something that we should be paying more attention to in terms of the markets you're seeing that are getting incremental firming that could help Arch?

I believe that events like the conflict in Ukraine create a distinct market for those types of risks. They are not typically included in broader catastrophe coverage. As a result of this event, there have been efforts to reclassify many war-related risks and reintegrate them into appropriate coverage categories, such as aviation war and marine war markets. There is significant activity and substantial rate increases in those areas. We are involved in this market, but it started out quite small. Therefore, while you may see some improvement, it might not be enough to significantly impact the industry as a whole, despite the fact that rate increases in those sectors are justified and substantial.

And then just lastly, the acquisition expense ratio has been kind of hard to pin down at Arch over the past few years, but it's gone up. Obviously, it sounds like there were some changes in terms of ceding commission structures, things like that at 1/1. Is there anything directional you can say about maybe how the acquisition expense ratios could move in '23 versus '22, or do we just kind of expect something relatively similar?

I don't think it will change much from its current state. Over the years, we've seen significant shifts in our business mix, especially with the growth of our insurance operations in the UK, which has higher acquisition costs and different reinsurance purchasing decisions. There are many reasons for the current situation. Our priority remains on bottom line returns; if we are paying more in acquisition costs, we anticipate achieving a lower loss ratio, which has indeed been the case. For your projections, I suggest using something similar to 2022 as a baseline, and we will provide updates throughout the year.

Our next question comes from the line of Elyse Greenspan with Wells Fargo.

My first question, I guess, is going back to the reinsurance margin discussion that came up earlier. So you guys have a flat PML, and you guys are seeing 30% to 50% rate increases in cat. Wouldn't that triangulate into margin improvement coming through in the reinsurance book in 2023?

It's great to see you here. Looking at the property characteristics, we've seen a notable improvement in returns. However, this will only gradually contribute to our bottom line, as it isn't our primary business. We believe this gives us the chance to grow significantly in 2023. It's difficult to quantify the additional potential, but the property catastrophe market shows considerable margin improvement.

Would you say, building on that, Marc, would you say that of all your business lines as you sit here today, the line with the best expected return in '23 would be catastrophe reinsurance?

There are several areas that we don't promote heavily that are performing very well and continue to improve. Some of these lines might even rival property catastrophe writing in size. We have many segments delivering strong returns. As mentioned on the call, this is an excellent period to engage in property catastrophe excess, truly an opportune time.

And then you said, on the PML discussion, you had mentioned, right, that we need to kind of see how things come together at June 1, that that could also be a good opportunity. What could derail this? Is it just alternative capital and more capital coming into the reinsurance space as you think leading up to June 1? And even when we think beyond that, what are you guys concerned about that could derail the uplift that we've seen in the catastrophe reinsurance market?

It's difficult to predict, Elyse. Regarding the third-party capital you mentioned, we are still in a wait-and-see phase. The US renewals represent a small part of the overall catastrophe writing for the year, so more developments are needed. Our Tri-County performance has improved, and Florida represents our biggest exposure. It's challenging to identify what might disrupt things. Considering the potential third-party involvement, I don't anticipate any major issues. There haven't been any catastrophes in the first half of the year, and it would benefit the industry to capitalize on the decreased catastrophe activity. It’s hard to discern any significant shifts at this moment; the market psychology seems to reflect an understanding of the necessary remediation in the property catastrophe sector at all levels. There’s a clear acknowledgment that we need to address this. One point to note is that we might experience slightly less than what some had anticipated or possibly a bit more than expected in price increases based on our observations. However, regarding core capital needs and the balance of supply and demand, I don’t foresee a major change. I realize that was a lengthy response, but that's my perspective.

Our next question comes from the line of Meyer Shields with KBW.

I hope this one covered. I missed about a minute of the call. But I was hoping it would be dig into the nonrecurring transactions in reinsurance. I'm assuming this was a retroactive reinsurance. And I was hoping you could talk about specifically the sort of risks or the lines of business that you're assuming, and maybe give us an update on what that market looks like now?

To keep it high-level, I see these as capital relief and capital support transactions for various reasons. Companies that have experienced significant growth and pressure from rating agencies seek capital relief, as do those looking to manage certain exposures. Just to clarify, these are not retroactive; they are all transactions accounted for under insurance or reinsurance standards, impacting our premium. You may have noticed their effect across multiple lines of business, including specialities, casualty, and some property. It's a diverse situation, but it's all happening in a dynamic market. Many companies are facing challenges right now and are seeking solutions. We believe we have a strong balance sheet and sufficient capital to assist them. We are uncertain if similar transactions will arise again since they tend to be irregular, but if they do come our way, we're open to evaluating them, and occasionally we do proceed with a few.

Second question on mortgage insurance, and I don't even know how to phrase this, but you put up very conservative reserves for mortgage insurance over the course of COVID. And I'm wondering how much of that unusual reserve is still there because clearly, speaking at least for myself, we haven't done a great job of forecasting reserve releases in that unit.

That's a great question, and it's becoming increasingly difficult to answer. In the early days, we made adjustments because many loans in our inventory were in forbearance, which complicated the distinction between forbearance and non-forbearance delinquencies. Over the past three years, the situation has evolved, and we now see the inventory as somewhat mixed. Thus, we don’t view the forbearance loans significantly differently from the others, although a few still remain in our inventory. To summarize, we don't quantify this directly every quarter anymore, but we recognize there's still some risk with COVID-related reserves, which is why we've retained them until we feel they are no longer necessary. This quarter, the data indicated it was the right time to acknowledge that we no longer need those reserves.

And Meyer, quickly, I think what Francois is saying is true for all lines of business, and historically, while we'll try to take a prudent stance on reserve to ensure we have enough and will let data speak for itself. And this one is very unusual, Meyer, right? The dynamics have been unlike anything else. It's when we have another one, we'll have a better playbook to use, but we just didn't know. And we still don't know, it’s still not over; forbearances are still coming back in. It's not totally gone yet. So that's what leads us to be that much more conservative. From the outside, it looks like we're conservative, but we think we’re being prudent and the data speaks for itself. And mostly, if it happens that we don't need it, then we'll adjust it based on the data we see.

We have a follow-up question from the line of Tracy Benguigui with Barclays.

I'm wondering what your outlook is on professional lines within your insurance segment? And particularly, what stage you would classify that business in when you went through your stages?

Tracy, do you include D&O in that, or are you looking for figures excluding D&O? Professional lines is a very broad market.

So my focus is more on D&O.

We expect to see similar trends in D&O as we observed in the last fourth quarter, although there might be some adjustments due to overall market conditions. The trend in large commercial D&O has been neutral to negative for the past three to four years. While there are reports of rate decreases in large commercial D&O, there is rationale behind it. We expect this rationalization to continue, supported by data validating current price points. In terms of smaller D&O, which we handle a significant volume of, the market remains very stable and healthy. However, smaller D&O policies are often not major revenue generators, frequently consisting of not-for-profit small policies where even a 5% increase translates to a minimal dollar amount. This segment has grown substantially over the last four to five years, becoming an important part of our business, and the competitive landscape appears healthy. Regarding large commercial D&O, SCAs have decreased by 25% to 30% in the past four years, indicating a decent market position. The IPO market has also stabilized after a period of volatility, and we have capitalized on numerous opportunities during times of heightened demand for capacity. We anticipate that D&O pricing will continue to normalize in the large commercial segment, which I would categorize as stage three. In contrast, the smaller D&O space seems to be in an early stage or stage three as well, remaining quite profitable despite some minor fluctuations in pricing.

I'm not showing any further questions in the queue. I would now like to turn the conference back over to Mr. Marc Grandisson for closing remarks.

Well, spend a good day with your loved ones, and we will see you in the next quarter. Thanks for listening, guys.

Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect.