Q1 2021 Arch Capital Group Ltd Earnings Call
[music].
Good day, ladies and gentlemen, and welcome to the first quarter 2021 arch Capital Group earnings Conference call.
At this time all participants on a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time.
If anyone should require assistance during the conference. Please press Star then zero on your Touchtone telephone.
As a reminder, this conference call is being recorded.
So for 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 managements 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 to forward looking statements on 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.
A 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 introduce your host for today's conference Mr. Mark Grandison and Mr. Francois line, Sir you may begin.
Thanks Liz.
Good morning, and thank you for joining our earnings call for the first quarter of 2021.
The power of arch is diversified strategy is evident again this quarter as we had strong underlying earnings across our three operating divisions and a seven 8% operating Roe for.
Despite the cat events.
Pricing is attractive and almost all of our insurance market.
And more than meets our cost of capital thresholds.
As a result, we expect the next several quarters to continue to show improved underwriting margins, partially due to the compounding of rate on rate increases and the rebalancing of our mix.
Importantly, the market is showing discipline in maintaining its momentum and the recent cat losses are likely to keep upward pressure on rates.
Our three primary areas of focus for 2021 are one continuing our growth in the sectors where rates allow for returns that are substantially more than our cost of capital too.
Optimizing our <unk>.
Mortgage insurance book as it transitions from forbearance to recovery on its way back to normalcy in the next few quarters.
Our notices of default are leveling and the quality of recent production is excellent.
Three actively managing our investments in capital to enhance our returns over the longer run.
The past quarter.
P&C premium renewal rates increased across a broader spectrum of lines, including several that did not show movement as recently as the third quarter of 2020.
We also expect to see exposure growth as the economy recovers more fully which in turn should further spur increased revenues and profit.
On the MA front housing has emerged as one of the stronger economic sectors due.
Due to a combination of positive house price appreciation with good affordability for homeowners, although mortgage interest rates have increased modestly they remain low compared to historic levels and continue to fuel strong demand for the purchase market.
Finally, it's worth noting and profit will cover it in more detail that there's also some good news on the investment side as yields have increased slightly in 2021.
For arch every 25 basis points increase in yields should result in about a 50 basis point increase in our return on equity.
Now, let's dive into the businesses a bit more.
Turning first to P&C insurance.
We are very optimistic about the prospects across our specialty insurance group for 2021.
This past quarter, the higher level of premiums earned from the post 2019 written period is one of the main reasons why our underlying combined ratio continued to improve about two thirds of the improvement was due to lower loss ratios as a result of the impact of rate increases as well as to underwriting actions.
We have taken over the past several years the other third of the improvement was driven by a lower expense ratio and.
In Q1.
We observed a plus 11% rate increase on a global basis solidifying the momentum for improving margins in P&C. We are now in our fifth consecutive quarter of rate increase in excess of loss cost as evidenced by our current underlying combined ratio of 93, 3% versus 97 one.
<unk> in the same quarter last year.
Adding to the rate improvement already mentioned, we've seen lower claims activity over the last four quarters. Nevertheless, we continue to be prudent on maintaining what we believe to be an appropriate safety margin in our reserving approach one.
One of our key principle is that we are cautious when recognizing favorable news, but react quickly to adverse findings on the data.
Next onto our reinsurance segment we.
We had another quarter of improving profitability fundamentals, our trailing 12 month accident year combined ratio ex GAAP has improved significantly from a year ago. We again had a meaningful increase in net premiums written of 25%.
In the first quarter, we estimate that our effective rate change or rate over trend was roughly plus 8% as with insurance. We expect these rate improvements to continue to be reflected in our underwriting results for the next several quarters as you can see from our total premium growth in property over the last year.
We continue to believe that risk adjusted returns are more favorable in a non cat XL property arena.
Our reinsurance group incurred $146 million of cat losses in the quarter, which was within our expectations given the type of event and where we have historically position on our property cat exposures, let me explain a bit more.
Strategically, we allocate more catastrophe capital towards homeowners and small commercial portfolio is because we believe one they have homogeneous risk characteristics to the data used to model their exposure is a better quality and three policy language tends to have less variability than with larger commercial exposures.
We believe that there is less uncertainty in the expected cat load of homeowners in smaller commercial portfolios as a consequence of this portfolio construction bias.
On a medium size storms, such as jewelry and between 14 and $16 billion on losses that affects personal lines more markedly we would expect our market share to be around 1%.
And last.
But certainly not least.
Mortgage.
Overall, our mortgage group is very well positioned to produce good earnings as a reinvigorated U S housing market is promising in 2021 and beyond in the first quarter arch M. I U S. New insurance written was 27 billion around 60% above the same period last year and new low.
On originations are tracking towards another very strong year.
As you know.
Last year saw a refinancing boom, which meant significant turnover in our insurance in force our first quarter annualized persistency was up from the 54% we experienced over the last 12 months.
As interest rates rose earlier this year, if mortgage rates continue to rise we would expect persistency to gradually return to the longer term range of 75%, which would be a net positive as we would hold more of the recent higher credit quality higher risk adjusted return portfolio on our books for longer.
Looking next at our delinquency inventory.
Still expect a large portion to cure based on many factors, including the strong equity position of our current <unk> inventory, 94% of delinquent policies have over 20% of equity.
We also had good news in March as a run rate for new notices of default was nearly back to 2019 levels at about 10000, new <unk> per quarter.
Outside of the U S. We increased our writings in Australia as the housing market remains strong there we like the long term opportunity in Australia as demonstrated by our announcement to acquire Westpac's LMI business in March the.
The agreement allows us to free up capital, even as we build our Australian presence and diversify our earnings streams at attractive risk adjusted returns.
To borrow a sports analogy for this quarter.
With a nod to our friends at Colfax This market feels a little like the last leg of the tour de France.
We just went through the mountainous section came on and it came out among the leaders in a lot of writers struggled to keep pace now.
Now as we roll towards Paris, we can continue to build on our lead while remaining mindful of protecting our position in energy. We can go all out and directors at several stages has several stages a day rates remain however, our team is in great shape, we have many great writers working together to ensure we're ultimately.
But these smiling in that beautiful yellow Jersey on a <unk>.
As usual our focus is on finishing the rates with grace and winning for our sponsors our shareholders.
Now I will turn it over to Francois.
Yes.
Thank you Mark and good morning to all and thanks for joining us today.
Onto the first quarter results as a reminder, and consistent with prior practice.
The following comments are on a core basis, which corresponds to arches financial results. Excluding the other segment I E. The operations of Watford Holdings Ltd.
In our filings the term consolidated includes one for it.
On the transaction, we announced late last year or to acquire Watford in partnership with Warburg Pincus and Kelso to use March cycling analogy. Our team has been pedaling hard in anticipation of the closing and we are down to the last few kilometers before we reach a final destination.
I will provide a bit more color on its status in a few minutes.
As you will have seen by now we had a very solid quarter. Despite the severe winter winter storms with after tax operating income for the quarter of $239 8 million or <unk> 59 per share.
And an annualized seven 8% operating return on average common equity.
Book value per share increased to $30 54 at March 31.
Zero, 8% from last quarter.
In the insurance segment net written premiums grew 20% over the same quarter one year ago.
28, 4%, if we exclude the impact of the pandemic on our travel accident and health units.
The insurance segment's accident quarter combined ratio, excluding cats was 93, 3% lower by 380 basis points from the same period, one year ago.
The improvement in the ex cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business.
In addition, the expense ratio was lower by approximately 80 basis points since the same quarter, one year ago primed.
Primarily due to the growth in the premium base.
As for our reinsurance operations. We also had strong growth of 25, 3% and net written premium over on a year over year basis, 48%. If we adjust for an $88 million loss portfolio transfer that was recorded in the first quarter of 2020.
The growth was observed across most of our lines, but especially in our property other than property catastrophe line or a strong rate increases and a few new accounts helped increase the top line by 84, 3%.
The segment's accident quarter combined ratio, excluding cash stood at 84% compared to 91, 3% on the same basis, one year ago.
Once we normalize for the onetime impact of the loss portfolio transfer the improvement in the ex GAAP accident year combined ratio was 590 basis points, which is almost entirely attributable to a corresponding improvement in the loss ratio.
The overall expense ratio remained relatively unchanged.
Again after adjusting for the LPT.
Losses from 2021 catastrophic events in the quarter net of reinsurance recoverable and reinstatement premiums stood at $188 3 million or 10, five combined ratio points compared to seven four combined ratio points in the first quarter of 2020.
These were primarily as a result of the North American winter storms jewelry and viola in February and consistent with our earnings pre announcement two weeks ago close to 80% of the losses came from our reinsurance segment with the rest attributable to the insurance segment.
We remain comfortable with our level of loss reserves for COVID-19 claims, which remained essentially unchanged from prior estimates approximately 65% of the inception to date incurred loss amount.
Within our incurred but not reported <unk> reserves or as additional case reserves within our insurance and reinsurance segments.
The key performance indicators, we track to help us assess the ultimate impact of COVID-19 on our mortgage segment keep trending in a favorable direction.
Chief of course, being the delinquency rate, which came in at 386% at the end of the quarter.
<unk> had another excellent quarter in terms of production and with refinance activity leveling off on prior peaks, we saw our insurance inform remain relatively stable with an increase from our international book offset by a small decrease in our U S book.
The combined ratio for this segment was 42, 4%, reflecting the lower level of new delinquencies reported during the quarter.
Both the loss on expense ratio was were slightly lower than the pre pandemic levels experienced in the same quarter one year ago.
As a reminder, I wanted to remind everyone of the seasonality that exists on the reporting of operating expenses across our underwriting segments investment expenses and at the corporate level.
Given all incentive compensation decisions, including share based awards get approved by our board of directors in February of each year. The first quarter has generally been the quarter with the highest level of operating expenses and we do expect that current year or to follow this pattern.
Overall with the underlying improvements in both of our P&C segments and mortgage segment fundamentals returning to pre pandemic levels. We are excited by the prospects for each of the three legs of our stool.
Our objective to deliver a well balanced return to our shareholders with meaningful contributions from each of our underwriting segments should become more and more apparent as we move forward.
I've kept my segment level comments, a bit shorter than usual in order to give a bit more color on the performance of our investment portfolio this quarter.
And on the new line in our income statement titled income loss from operating affiliates.
As regards the investment portfolio total investment return for the quarter was a negative 18 basis points on a us dollar basis.
Our defensive positioning with a short duration and limited credit exposure relative to our benchmark helped us withstand headwinds we experienced on the heels of an 80 basis point increase in the 10 year treasury rate during the quarter, which was a main factor in the negative 56 basis point price return on our portfolio during the.
<unk>.
Net investment income was $78 7 million during the quarter dying down nine 3% on a sequential basis.
This decrease while certainly affected by lower available interest rates and the higher investment expenses due to incentive compensation payments on investment management fees.
It is also very much the result of deliberate portfolio actions taken over the last few quarters.
Specifically, we continue to maintain a short duration on our portfolio to seven one years at the end of the quarter based on our internal view of the risk and return on tradeoffs in the fixed income markets.
We also continue to deploy additional capital to an alternative investments.
Returns for them, which are generally not reflected in investment income for.
Finally, we also transform some short term investments this quarter into our $29 five equity ownership in <unk> as well as in investment and corporate owned life insurance policies.
Again, both items, whose returns are included in operating income, but are not reflected in net investment income.
Equity and net income of investment funds using the accounted for accounted for using the equity method and realized gains from non fixed income investments returned approximately $154 million during the quarter and were key contributors to the growth on our book value.
Now onto income from operating affiliates, which we are including in our definition of operating income.
This quarter. In addition to our share of the quarterly results of investments. We have made on operating affiliates being primarily those from Premier Holdings. At this time. We also benefited from an initial non recurring gain we made at closing of our acquisition of a 29, 5% ownership stake in Colfax for.
Approximately $74 5 million.
With our accounting policy under equity method accounting, we will report our investment in coal fast on a quarter lag.
As regards to warn for transaction shareholder approval was obtained in late March and we are awaiting a few final regulatory approvals before we can close a transaction hopefully over the next few weeks as.
As we disclosed earlier, we expect our ownership of offered to increase to 40% at closing.
The effective tax rate on pretax operating income was 10, 6% in the quarter reflected changing reflecting changes in the full year estimated tax rate the geography mix of our pretax income and the benefit from discrete tax items in the quarter.
We currently estimate the full year tax rate to be in the 10% to 12% range for 2021.
Turning briefly to risk management, our natural cat <unk> on a net basis decreased to $778 million as of April one.
<unk> had approximately six 7% our tangible common equity remains well below our internal limits at this single event one in 250 year return level.
Our peak zone across the group changed from the Florida Tri County area to the northeast, reflecting our view of better opportunities given the current rate environment.
Our balance sheet remains strong and our debt plus preferred leverage stood at two one at 22, 1% at quarter end well within the reasonable range.
On the capital front, we repurchased approximately five 3 million shares at an aggregate cost of $179 3 million in the first quarter.
Our remaining share repurchase authorization currently stands at $737 $3 million.
With these introductory comments, we are now prepared to take your questions.
Thank you if you have a question at this time. Please press the Star then the one key on your Touchtone telephone.
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If you are using a speaker phone please Mr handset.
Okay.
Our first question comes from Joseph <unk> with Deutsche Bank.
Yes, thanks, and good morning.
No.
The idea of rate adequacy is something that's gotten a lot of airtime.
With people focusing on the second derivative of the pricing move I was hoping you could just talk about how you see.
Rate adequacy from your perspective, primarily as an insurance question, but reinsurance would it be appreciated as well.
In my mind it feels like the messaging is that exposure growth will help to carry.
The baton.
On how the potential biking analogy, but.
Yeah.
Yes.
Move to the plants on the tailwind of pricing that we've seen.
And push forward for the next leg.
It's a good question and I'll try not to stay away from the cycling analogy myself.
I think very at a very high level the rates keep on being really really healthy 11% as is above the loss the loss cost trend as we mentioned earlier.
We started seeing this last year on our first quarter. So.
On a second round if you will.
A round of rate increases, while we had some rate increases last year on those policies that are currently being renewed or where are we in the first quarter had another set of rate increases. So I think where we are right now the market is really psychologically the market is in <unk>.
Great rate increases minded and.
Being careful in the way to deploy capital.
And I think if you look back on where we came out in 2018 19 years, where our combined ratio was in the way it has been developing and training for our last six quarters I think the storytellers itself. The fact that we are indeed getting rate above loss cost trend and that also finds its way into our calendar combined ratio.
On a quarterly basis.
There's more to go we put our first quarter Prime last year is in the first quarter paint. This year, we'd be surprised that we have another coat of paint.
Given over the next.
Several quarters.
Remains to be seen how much how much more will be but certainly anything we have at this point in time is helps improving the margins.
Okay.
Switching gears a bit to look at mortgage.
The incident rate assumptions were high single digits, something like eight 9% as we talked through that.
Second half of 2020 results can you just let us know where about youre looking at booking that now and maybe weave in some of the.
Some additional color commentary around what exactly it means optimizing our book as we kind of migrate from the forbearance world to a more traditional operating environment absence.
I think we have a first on the optimizing we have.
A very substantial market share in the U S and we will very soon have a very decent one in Australia as well I think it's really too.
Go towards the area, where the better returns are.
And we grew a little bit.
On the last half of 2020.
We see the opportunity of the market is coming back to some more normalcy. So I think our game plan will be to as we were doing in 2019 as we were heading into 2022 and it will be relying on our bids based pricing to make sure. We pick the best area of the marketplace to make sure. We are enhancing the returns as we go as we go forward in terms of <unk>.
On a roll rate for the new annuity this quarter. If you remember last quarter was $9 for this quarter, we booked it for the U S. EMEA at nine 1%, so slightly better than the last quarter.
We we did not.
Our sort of out of the predicting business of where it's going to end up at the end of the year in terms of the delinquency rate, but you see it going to 386% this quarter, which is.
Way way way better than we would've anticipated sitting here a year ago.
Okay, hopefully a quick follow up on the <unk> is.
Is there any any clarity on the GSE limitations on dividends out of the operating entities I mean any sense on when this will be lifted.
Well great question. So there is a moratorium that's in place till the end of June.
We are certainly hopeful that the moratorium will expire and not be extended.
Not nothing definitive there is discussions going on but the certainly from our side. The hope is that on the second half of the year we would.
Be able to.
Start dividend ing, some some of the capital from.
From our U S on my operation.
Thanks.
Yes.
Our next question comes from Elyse Greenspan with Wells Fargo.
Hi, Thanks.
Good morning, My first one on just one on.
On last quarter's call.
Me too.
I believe your property casualty business is generating returns in the double digits and mortgage on kind of getting back to the 15% level, obviously, some noise in the quarter, Wisconsin.
The investment items your investment income items, you pointed to but.
Do you guys broadly.
For your business is generating returns on.
In the double digits on mortgage kind of around that 15% level.
Yes.
Our view has not changed in terms of expectations of what we have written.
From what we said last quarter at least very much in line.
Okay. That's helpful and then on the underlying side on your.
For prepared remarks.
I alluded to continue.
Underlying margin improvement.
On a really good job over the past few years of rejiggering the business mix and we're seeing that come through in both insurance and reinsurance so was that comment implied that.
On the back three quarters of the year on.
Line basis.
Would be better relative to the queue line with a year over year comment yet on.
Directionally, how should we think about the margin in insurance and reinsurance.
Yes, it's all related to the the price increase that the market will.
Pushed through right over the next several quarters, but.
Certainly the earnings that we're seeing currently in the first quarter right at least some of it was at lower pricing.
And the last year and on the free.
For the year in and per quarter and that kept on getting better as we went towards the end of 2020 and into 2021. So we should all everything else being equal expect an expected on the margins to be to be expanding and if there is more rate increases than we should hopefully see this and non op model nothing.
Nothing we will see them in the numbers right away, but certainly the feeling in the.
The momentum is building to get more.
On more margin improvements yes.
And then in terms of mortgage right you guys had pointed to kind of getting back to the 35 for 45% combined ratio for.
<unk> for the quarter whitesville firmly within that range.
Based on what you know today. The fact that you mentioned Mike on level of me notice day the following.
Would you expect that.
The combined ratio for that business would continue to trend better during the next three quarters relative.
So what you reported in Q1.
Well couple of points on that I think just to clarify the comment that I think I made was.
Paulette.
The 35 to 45 range was.
Meant to be more of a call it over the cycle kind of steady state not in a stress environment.
A reasonable combined ratio.
Do we feel work on in that environment, Yes, delinquency notices mark touched on ethanol, they're backed up being roughly 10000 a quarter. So that's.
Yes, that's a good sign.
The combined ratio in the on.
On the last three quarters of the year be lower than it was in first quarter. A COVID-19. We were not we don't know I think some of it will certainly be a function of reserve.
Releases, if theres any we just again.
We'll have more clarity on that once forbearance programs expire or get.
People come out of that.
So I think at a high level were we the range that we put out there is we're still very comfortable with could we beat data could we come in a bit lower I guess.
We'll see when the data shows up but.
Certainly yes.
It's not inconceivable.
Okay, and then one last line.
Hey, Jeff Hey, this morning announced on Weeknights refi options for low income families.
Help us think about how that could impact.
On the back book within our mortgage insurance portfolio.
Yes, I think to me the other questions about the FHA FHFA and all the various government.
On a policy that could be put out there I think we're on the receiving in and react to it and what we have at heart.
<unk>.
Our risk based pricing is really making sure that we are.
Allocating capital.
And supporting.
The policies that meet our threshold return thresholds I think that.
We still believe that the.
Even though there are some pushed to become get more affordable housing available to folks which were encouraging.
There is still a very healthy level of appreciation for the risk.
In Washington, So, we're not overly concerned with that and most of the targeted markets that are.
That are towards these policies are geared towards.
Would be the lower FICO and most likely the higher ltvs, which is not typically where we are more.
Most competitive and most focused on at this point in time, so we're not losing sleep over this lease.
Okay. Thanks, Mark I appreciate all group Thanks Elyse.
Sure.
Our next question comes from Jimmy <unk> with Jpmorgan.
On a couple of questions first on the.
<unk>.
<unk> business.
Yeah.
I think most speakers on Lindsay for the burner.
So first on the online business can you talk about delinquencies, obviously have improved a little bit they are still fairly elevated and it seems like a lot of this has to do with this government forbearance programs versus actual hardship on the part of the borrower, but if you could just talk about what your view is and I think you addressed a little bit of revenue.
<unk> equity in homes and stuff.
And then secondly on your COVID-19 related reserves.
Last quarter, you gave a number that around 70% or so we're still the <unk> and you haven't had much in the way of additional losses recently, so just wondering.
What the likelihood is that that number might be.
Overly conservative now given the economy is opening up and the chances of reserve releases related sales.
Yes, so on the forbearance clearly.
We have a different spin on new that you would have obviously on the on the delinquency rate of 386% I think it's a pretty.
Please.
Good place to be.
We're not still still none of the COVID-19 some of the potential issues that could develop in just looking very very good obviously, but this is not out of it completely.
On the three 6% by two thirds of our delinquencies are actually in the for payment Forbearance program.
And of those who are in those forbearance programs and equity and 90%.
94% of them actually have more than 10% of equity. So yes. There is this accounts the delinquency counts staying.
In India inventory.
We still have an extension of the forbearance martyrium until until the end of June extensive for it.
But potentially could be extended and thats all with the idea that.
On the <unk> and sort of the governments agencies won the homeowners to get back on their feet.
So it is helping is maintaining a little bit higher level of uncertainty because of forbearance is still there.
I don't know, 100% how are they going to turn out.
But.
We still have many cure that that's occurred out of the forbearance that we're.
Put it in their back in April and May of last year right.
Two thirds of them.
Pure now back into.
Back into current being current so on one hand, yes. It shows a higher number in terms of delinquency, but when you look at being two thirds forbearance program, which is very helpful for the homeowners on the heels of a high level of equity.
This is all things considered a very reasonable place for us to be and we think it's going to get most likely to get better throughout the end of the year and go back to <unk>.
Wichita core delinquency, which is a one for 135% which is more like what we have historically seen at least as of late as of the end of 2019 on.
On that once about two and for the Colgate question, Yes.
Yes on Jimmy on the on the COVID-19, yes.
I mentioned that quickly I think we're still at 65% and IBM on ACR is.
Growth.
Through.