Arch Capital Group Ltd. Q1 FY2020 Earnings Call

Good day, ladies and gentlemen, and welcome to the Arch Capital Group First Quarter 2020 Earnings Conference 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. Operator provided instructions. 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 by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference Mr. Marc Grandisson and Mr. François Morin. Sirs, you may begin.

Thank you, Shannon, and good morning to you. It would not be an understatement to say that the coronavirus has changed the world since our last call with you just three months ago. Fortunately, at Arch we are entering this period with the investments we have made in our P&C business beginning to pay off, while our mortgage group navigates through the current turbulence. If you work long enough in the insurance business, like I have, you are bound to experience the industry cycle, its highs and its lows. As management, we have to keep our eye on the goal which for Arch is generating sustainable growth in book value per share. The current stress in the financial and insurance markets reminds us of changes that can occur to which we need to adapt. While we are still early in the assessment of our direct and indirect claims exposure to the coronavirus, it is clear that this event will be a significant industry loss and will result in profound changes. However, dislocation often leads to opportunity. As you know, one of Arch's strategic principles from inception has been cycle management. We are embarking in this new market environment with both a strong financial foundation and the creative ability of our more than 4,200 employees that position us for the opportunities that will emerge. Turning to the quarter. We saw improving conditions in our P&C businesses, while our mortgage operations continued to produce good results. Strengthening P&C market conditions remain evident, even as the economy contracts. We have seen a rise in our submission activity along with accelerating rate increases across multiple lines of business in Q1 and it is continuing here in Q2. Our belief in the continuing hardening of the P&C market is due to the need our industry has to address the accumulation of risk factors over the last five years of soft market conditions. These risk elements are: one, future claims and covered litigation related to COVID-19; two, a heightened perception of risk in general; three, economic uncertainty; four, a continuation of low interest rates and the dampening effect on investment returns; five, a potential for shortfalls in casualty reserves; and six, reduced availability of retro and alternative capital in general. These risk elements are all in play today and are likely to lead insurance companies to be more cautious in allocating capital to risk. In our insurance group, our strategy remains to be selective and pick our spots in this improving market. The rising rates environment and dislocation in the markets have allowed us to grow profitably in the past two years in many sectors, such as E&S property, D&O and E&S casualty. On a reported basis, we saw our margins improve this quarter as our accident combined ratio ex-cat of COVID and PYD improved to 97%. In our reinsurance business, pricing is also improving and we continue to observe tightening of terms and conditions in many lines. The value of reinsurance as a capital protection tool has been enhanced by the recent events. The hallmark of our reinsurance group remains the dynamic allocation of capital to contracts that will provide appropriate risk-adjusted returns, while helping clients with solutions that are tailored to their needs and was a large factor in our growth this quarter. Switching now to our mortgage insurance segment, the industry is facing its first significant test since the fundamental reforms and product improvements that were adopted following the global financial crisis or GFC. As you know, Arch MI is a data and analytics-driven company and our investment in the sector was predicated on a new and better MI operating model than the industry employed prior to 2008. Now, pricing is more precise, products and documentation are better and the MI industry buys protection against downside. In addition, another change in the industry can be seen in the aggressive government actions taken in the early stages of the pandemic directed at helping borrowers stay in their homes. The GSEs' forbearance program and the unemployment benefits programs provide unprecedented support that should enable borrowers to cure delinquencies as the economy improves and will result in fewer losses. As noted in our quarterly HaMMR report, the MI industry is far better positioned for a recession than they were in 2008. At that time, mortgage insurance portfolios were facing a housing market that was significantly overbuilt, risky mortgage products and less creditworthy borrowers. More than two-thirds of mortgage insurance written in 2007 would have been uninsurable during the last 10 years. And finally, there was a speculative bubble in home prices. Mortgages filed under the FHFA's forbearance programs were estimated at 5.85% of the GSE mortgages as of April 26. This program allows homeowners to suspend mortgage payment for six months, which can then be extended for up to another six months. While initially recorded as delinquencies under GAAP, our data on forbearance programs utilized in recent natural catastrophes indicates that almost all of these loans cure by providing borrowers time to return to work. Over the next few quarters, rising delinquency rates under GAAP should lead to elevated loss ratios in the MI segment. Furthermore, once the forbearance programs expire, the GSEs have instituted a sturdy list of remedial solutions that once again will enable loans to be back-performing. We realize that this pandemic-led recession will be different than a GFC. But based on what we can see today, our view is this is an earnings not a capital event for Arch. It is worth noting again that even if this recession is worse than we currently expect, we hold significant reinsurance protection on our risk in force that would moderate our net losses even in a more severe recession. While some of our reinsurers' quota share attaches at first-dollar loss, and that is known from our Bellemeade securitization, we will provide up to an additional $3 billion of excess and loss protection if this becomes a recession worse than what the industry experienced in a GFC. Lastly, turning to our investment operations. We believe that interest rates are likely to stay at historically low levels for the foreseeable future and that will over time require insurers to improve their underwriting margins through price increases. In our investment strategy, as in our underwriting approach, we have maintained our focus on risk-adjusted total return which enabled us to avoid much of the negative impact of the pandemic on our investments this quarter. As perception of risk increases, so does the cost of capital and underwriting discipline becomes important. Again, recent world events remind us that risk is always present, that insurance premiums must include an adequate margin of safety and that reinsurance plays an important role in protecting capital and returns. In summary, through Arch's cycle and risk management principles and fortified by our conservative balance sheet, Arch is prepared for this crisis and is well-positioned to continue to build on its track record of book value growth. In closing, I want to thank all of our employees around the world, as they are responsible for the success of Arch, and are working tirelessly throughout the world to meet the needs of our insurers. Thank you. With that, I'll turn the call over to François.

Thank you, Marc, and good morning to all. We, at Arch, hope that you are in good health in these difficult and uncertain times. This quarter, in anticipation of some of the questions you may have, I will try to elaborate in more detail on some notable items in addition to the regular discussion of financial items. I recognize this may take a bit longer than usual, so please bear with me. Now on to the first quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis which corresponds to Arch's financial results, excluding the other segment i.e. the operations of Watford Holdings Ltd. In our filings, the term consolidated includes Watford. After-tax operating income for the quarter was $189.8 million, which translates to an annualized 7.1% operating return on average common equity and $0.46 per share. Book value per share decreased to $26.10 at March 31, a slight reduction of 1.2% from last quarter and a 12.9% increase from one year ago. The defensive posture of our investment portfolio ahead of the COVID-19 crisis served us extremely well in preserving our capital base relatively intact during the stressed economic environment of recent months. I will elaborate on this in more detail later on. Outside of the losses related to the COVID-19 pandemic, which impacted our first quarter results, our underwriting groups fared very well this quarter with strong growth and generally improving underwriting results through our property casualty insurance and reinsurance operations. Given the unusual circumstances and breadth of the pandemic, we have classified COVID-19 losses as a catastrophe. However, as you saw in the financial supplement, we have also provided the segment level detail of our current estimates to assist with the analysis of the underlying performance of our book of business. We expect to follow this approach until the end of 2020 at a minimum. Losses from 2020 catastrophic events in the quarter, not including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at $31.8 million or 2.0 combined ratio points compared to 0.6 combined ratio points in the first quarter of 2019. The losses impacted both our insurance and reinsurance segments and were primarily due to various U.S. severe convective storms, U.K. storms and floods, and Australian bushfires. We recorded approximately $87 million of COVID-19 losses across our P&C operations, split 41% to insurance and 59% to reinsurance. While it is still very early and we have extremely limited information to accurately quantify our potential exposure to the pandemic, we believe that it was prudent to establish a certain level of IBNR reserves for occurrences through March 31, based on policy terms and conditions including limits, sublimits and deductibles. These reserves were recorded across a limited number of lines of business, such as property, where we have a very small number of policies that do not contain a specific pandemic exclusion and/or explicitly afford business interruption coverage under a pandemic, and trade credit. As regards the potential impact of COVID-19 on our mortgage segment and our estimation process at this time, we believe it's important to make a distinction between our U.S. primary mortgage insurance unit which we refer to as USMI and the rest of this segment which includes our international book and our portfolio of GSE credit risk transfer policies. For USMI pursuant to GAAP our estimates are based only on reported delinquencies as of March 31, 2020. However, given the potential effect of the pandemic, we elected to book reserves at a higher level of confidence within our range of reserve estimates for such known delinquencies. The financial impact of this increased level of conservatism was approximately 5.2 loss ratio points across the segment. For the rest of this segment, the loss-reserving approach we use is more consistent with traditional property casualty techniques where loss ratio picks are set at the policy level and are able to consider future delinquencies on business already earned. This quarter in response to the potential impact from the pandemic across our portfolio, we adjusted our loss-ratio picks for some policies, which resulted in an increase of 6.8 loss-ratio points to the overall segment results. Based on the information known to date and economic forecast, we believe the adjustment across the non-USMI book is prudent and consistent with a moderately severe stress level. As we look towards the remainder of 2020 for our USMI unit, we are expecting the delinquency rate to increase progressively from the current level as more borrowers request forbearance on their mortgage loans under the CARES Act. As mandated by GAAP, we expect to record loss reserves on these delinquencies which will most likely translate into an increase in our levels of incurred losses over the coming quarters. Over time, we would expect many of these delinquencies to cure and revert back to performing loans as the economy returns to a more normal state. At this time, we do not have enough visibility to predictably forecast the rate at which forbearance delinquencies will be reported to us. Cures are ultimately turned into claims on an annual, let alone a quarterly basis. That said, based on our current analysis which tells us that the pandemic will represent an earnings event for our mortgage segment and not a capital event, our current expectation is that our pretax underwriting income for the entire mortgage segment will be minimal for the remainder of 2020, i.e. from the second through the fourth quarter of 2020. However, there is likely to be variability in underwriting income between quarters based on the timing of receipt of notice of defaults. Turning to prior period net loss reserve development, we recognized $17.8 million of favorable development in the first quarter net of related adjustments or 1.1 combined ratio points compared to three combined ratio points in the first quarter of 2019. All three of our segments experienced favorable development at $0.8 million, $11 million and $6.1 million for the insurance, reinsurance, and mortgage segments respectively. We had excellent net written premium growth in the insurance segment of 33.4% over the same quarter one year ago. The insurance segment's accident quarter combined ratio excluding cats, which as a reminder include COVID-19 losses, was 97.1% lower by 310 basis points from the same period one year ago. Approximately 190 basis points of the difference is due to a lower expense ratio, primarily from the growth in the premium base over one year ago. The lower ex-cat accident quarter loss ratio primarily reflects the benefits of rate increases achieved throughout most of 2019 and the first quarter of 2020. As for our reinsurance operations, we had a significant transaction in the quarter which affected the comparability of our underwriting results: an $88 million loss portfolio transfer written and fully earned in the period in the other specialty line of business. Absent this transaction, net premiums written would have been 57.2% higher than the same quarter one year ago. This net written premium growth was observed across most of our lines and includes a combination of new business opportunities, rate increases, and the integration of the Barbican reinsurance business. While the loss portfolio transfer had a minimal impact on the overall combined ratio for this segment, a decrease of approximately 50 basis points, its impact on each of the loss and expense ratio components was more observable with a resulting increase of 400 basis points to the loss ratio and a decrease of 450 basis points to the expense ratio. Overall, the growth and underlying performance of our reinsurance segment was very good this quarter. The mortgage segment's combined ratio was at 44.1% including the 12-point loss ratio impact resulting from the increased level of conservatism in our overall segment reserve estimates discussed earlier. The expense ratio was higher by 240 basis points over the same quarter one year ago reflecting reductions in profit commissions on ceded business and higher compensation costs and employee benefits. Total investment return for the quarter was negative 80 basis points on a U.S. dollar basis as the defensive positioning of our portfolio served us extremely well in this difficult period. Given some of our fund investments are reported on a lag, typically three months, their first quarter performance will be included in our second quarter financials. The duration of our investment portfolio was slightly lower than last quarter at 3.19 years compared to 3.40 years at December 31, but remains overweight relative to our target allocation by approximately 0.35 years. Most financial markets had a positive return in April which should help reverse some of the results we observed in the first quarter. The effective tax rate in the quarter on pretax operating income was 10.5% and reflects the geographic mix of our pretax income and a 110 basis point benefit from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. Turning briefly to risk management. Our natural cat PML on a net basis increased to $680 million as of April 1, which is approximately 7% of tangible common equity and remains well below our internal limits at the single event 1-in-250-year return level. With respect to capital management, we remain committed to maintaining a strong and liquid balance sheet. During the quarter, we repurchased approximately 2.6 million shares at an aggregate cost of $75.5 million. While we have a meaningful remaining share authorization under our current program, we do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remained strong with our PMIERs sufficiency ratio at 165% at the end of March 31, 2020, which reflects the coverage afforded by a Bellemeade mortgage insurance linked notes. These structures provide approximately $3.1 billion of aggregate reinsurance coverage as of March 31, 2020. Finally, to echo Marc's comments, I'd like to give a special shout out to our more than 4,000 colleagues around the world that have demonstrated a tremendous amount of creativity, patience, resilience and compassion with clients and business partners, the communities they live in, their families and loved ones and each other over the last seven-plus weeks. They are the essence of what Arch is all about and I couldn't be prouder to be part of such a great team of individuals. Thank you. With these introductory comments, we are now prepared to take your questions.

Operator provided instructions. Our first question comes from Elyse Greenspan with Wells Fargo. Your line is open.

Thanks. Good morning. My first question is on the mortgage segment. So, I heard you say that it's still difficult to put your hands around what the total loss could be within MI. But you did say that you expect no underwriting income for the next three quarters. So, if I look at what you guys might have been expecting, it seems like, and look at what you've generated right in the back few quarters of 2019, that translates maybe into about an $800 million vicinity loss. Now the reason why I go there is your RDS that you disclosed at the end of last year for that business was around 8% of your tangible equity. So the numbers seem within the same ballpark of each other. So, am I triangulating correct that you're assuming that this loss could be equivalent to your RDS, or am I missing something in putting those thoughts together?

Yes. I think, thanks Elyse for the question. I think that the two numbers appear to be the same level, but they're actually coming from a different source. The $800 million that you referred to, that could be, let's say, a number for the next three quarters will be incurred losses. And against that you have to put premium. And if you look at our RDS scenario, we actually look at the rollout of all the claims paid in the future and we offset it by all the premiums that we would receive and this is what constitutes the PML. So they're very different. One is a net P&L impact. The other one is the incurred loss of the $800 million you mentioned the first time around.

So the $800 million is the losses that you expect over the balance of the next three quarters, not the — I thought you had said it wouldn't generate any underwriting income?

Yes. Just to clarify, it's really a difference between the next nine months versus the full runoff of the in-force portfolio. As we think of the remainder of 2020 what the comment I made was really underwriting income meaning premiums minus losses minus expenses. And we're saying we don't expect a whole lot of underwriting income for the remainder of 2020. When we think about the RDS, fundamentally to get to a similar, let's say, an $800 million number that you quote of RDS, what that would mean would be a much larger incurred loss because we expect to have material premium flows or premium income coming to us in future calendar years which may be five, seven, 10 years. So, it's just the RDS is really a full comprehensive premium and gain/loss underwriting income across the full runoff of the in-force portfolio.

Okay. And then within the RDS, can you remind us what are the assumptions for delinquency rates as well as housing price depreciation and how we think about you guys coming to that 8% loss figure?

Yes. There are many assumptions, but at a high level decrease in house prices 25% below fundamentals, so 25% from now going down and staying there for two to three years. Interest rates shooting up 7% or 8%—these are two major ones. Unemployment of course lasting longer. The length of time that our RDS is stressing our portfolio when we go through it is a much longer period than even the 2007 crisis would have generated. To the delinquency equivalent, it's something more like a 9% ultimate claims rate. It's hard for me to parse out what is delinquency versus conversion to claims. So, at a high level we prefer to think in terms of claims rate. So, the portfolio as it stands right now, if you run it off and 9% of it were to default that will be equivalent to the RDS net that we have which is significantly above what we expect right now just for your benefit which is significantly above what we expect to happen for the next 12 months.

And then one last one on the guide for the lack of underwriting income for the year-end mortgage, and you—do you guys assume that you're going to have to use some of your ILS the Bellemeade securities, or at this point you do not think you might attach into any of those covers?

Well, two things for clarification. First of all, the Bellemeade protections amortize over time. But there's a trigger on them that basically once you exceed a certain level of delinquencies, they stop amortizing. And we expect that will happen most likely sometime in 2020, and maybe in the second quarter, maybe in the third quarter, maybe later. That will basically freeze for some period the amount of cover that is available to us, and would remain most likely for the duration of each of those structures. But to answer more directly to your question, we do not expect under most scenarios that we would trigger the coverage provided by the Bellemeade protection. So the $3 billion of excess of loss cover that we talk about, we know is available, we know it's there. But at this time under most scenarios, we don't expect to pierce the attachment where we would actually start to receive coverage or cede some of our exposures.

Okay. Thank you for all the color.

You're welcome.

Welcome.

Operator provided instructions. Our next question comes from Jimmy Bhullar with JPMorgan. Your line is open.

Thanks. Good morning. So just first a question on the MI business. Your assumption of no underwriting income for the rest of the year, does that reflect primarily you having to reserve at the level that reflects delinquencies given GAAP rules, and not—the comments suggested you think ultimate defaults will be lower given forbearance and cure rates will be higher. So is it primarily because of just you having to reserve at the level that reflects delinquencies, or is it also a reflection of your views on ultimate defaults?

Yes. It's certainly more the former. We do expect the reality given the forbearance programs that have been in place is that we expect a higher than normal flow of delinquencies to be reported to us. Some people are just taking advantage of the programs just to be safe and they'd rather just play safe and not take the risk of falling behind on their mortgage payments. So what we expect will happen, we haven't seen much of it yet but we do expect—that will pick up in Q2 and Q3—that we will have to receive these delinquencies. When we come to the end of Q2, we'll have to assess what kind of reserves we'll set on those delinquencies. We'll make determinations on the probability that those will actually cure based on the information we'll have in front of us at that time. It's too early today to tell you what that will look like. But certainly based on the fact that we expect an elevated number of delinquencies to be reported to us that will by nature trigger us to reserve for those delinquencies and we'll incur some losses. Whether those will translate into claims paid ultimately, we don't know. Time will tell, but that's really just how we think that the accounting will work at least in the next few quarters.

And then on business interruption you mentioned provisions in most of your contracts that actually exclude losses because of pandemics or viruses. I'm assuming you're talking about primary contracts. On the reinsurance side, should we assume that if your clients are paying either because there wasn't a provision or because they lose a case and then a lawsuit you would have to be on the hook to the extent you provided coverage as well?

Yes. The comment had to do with insurance, where the vast majority of what we do has an exclusion for viral events—a virus exclusion. On the reinsurance side, it's still early. We still have to figure out what the BI losses are going to be if they come to fruition for our clients. Then they'll have to go through and say whether there's protection on the risk or quota share or excess of loss on a cat basis. This is going to play out over the next several quarters. A lot of contracts have hours clauses for those kinds of events. There'll be a lot of discussions back and forth as to when do we start counting, how do we count them. So there's a lot more uncertainty. A lot of contracts are not written to cater for those kinds of events. There's not a specific virus protection. It's really meant primarily to be a property coverage by and large from a cat-excess loss perspective. So people will have to sift through the language and see what it means to each and every one of them.

Okay. And then just lastly on the acceleration of growth in your insurance and reinsurance premiums, how much of this is pricing versus you potentially gaining share or just increased demand for some of the lines that you're in?

At a high level about 15% of the increase in premium came through acquisition. Barbican is definitely one of them. We also acquired a team on credit and surety from Aspen towards the second half of last year. That's about 15%. Twenty-five percent is due to rate. The rate increase this quarter across our P&C was between 5% and 10%, so it's actually better than the fourth quarter of 2019. The rest 60% is truly growth in exposure—new business, one-offs or unique situations or opportunities, one of which François mentioned in his comments.

Okay. Thank you.

Sure. You're welcome.

Our next question comes from Mike Zaremski with Credit Suisse. Your line is open.

Hey, good afternoon. Sticking with MI. Can we talk about capital requirements? Capital charges for loans in non-payment are usually materially higher than for performing loans. I know I saw it in the prepared remarks, you said that the PMIERs sufficiency ratio is well in excess of 100%. Is the FEMA designation kicked in? It means that it will allow Arch and other MIs to potentially hold less capital, or just how should we as investors think about the capital requirements and how that could play out over the next three to 12 months as nonperforming loan levels or deferred loan levels increase?

To answer your question, yes, it's actually in the wording in PMIERs that when there's a FEMA-designated zone, the capital requirements for delinquencies are reduced by 70%. Given that all 50 states have actually been declared FEMA disaster zones, currently we are adjusting at the end—starting at the end of March and going forward, we're adjusting the PMIERs capital requirements to reflect that haircut on the capital charges for delinquent loans. There's a bit of a discussion going on with FHFA around how long that will be available. I think the industry and FHFA are working together on that and the GSEs to come up to clarify everything. I think there's a bit of technicality and maybe it wasn't perfectly considered or awarded in the wording of the PMIERs, but still we expect that the haircut on the capital charges will remain in place until we have more visibility on how many of those loans will cure and go back to performing.

And does that play into why Arch has decided most likely not to repurchase stock for the remainder of the year? I guess this is a broader question. It feels like prior to COVID, you guys were playing more offense than most carriers. Does COVID change the playbook? And is the lack of MI earnings and maybe some of the clarification of capital why you're not purchasing stock when it's trading below book value?

I'd flip it a little bit. I'd like to think we played a fair amount of offense in Q1 on the P&C side. We like optionality. The fact that we have a strong balance sheet, we want to keep it that way. We want to be able to take advantage of opportunities that may surface. So does COVID change the playbook? Not per se, but we think there will be a fair amount of disruption through the end of 2020 and maybe beyond. So that's really—the Arch playbook is to preserve optionality and be ready to execute on those opportunities.

Clearly, we had played the MI market. We still are in the market and very involved. We were by and large allocating a lot of capital to MI, but it's something we adjust as the market develops. As we look through the first quarter and our business reviews, it's clear that opportunities are there. Our first mission is to deploy capital in insurance underwriting. I think our shareholders want us to deploy capital toward insurance underwriting, and I think we have an increased level of opportunities that wasn't there six or nine months ago. Capital becomes very important as we go through the next year or so, and we'll be able to deploy it and make hopefully great returns for our shareholders.

So we should continue to expect the non-MI operations to continue playing offense and growing at a fairly fast pace?

Based on what we see in terms of terms and conditions and opportunities, yes, we should expect that to happen—absent the market getting a bit softer in terms of GDP and exposure stagnating for a while. By and large, our focus is to play more offense on the P&C side, both insurance and reinsurance.

Thank you.

Our next question comes from Yaron Kinar with Goldman Sachs. Your line is open. Yaron, your line is open. Please check your mute button. Our next question is from Ron Bobman with Capital Returns. Your line is open.

Don't worry Yaron, they'll circle you back in I am sure. Thanks. Hope you're well. I had a couple of questions. The mortgage business and the reinsurance purchases and in particular the Bellemeade notes. I'm wondering prospectively, do you think that the capacity will be there to sort of continue to be put in place? And is the game plan to sort of continue to, as best you can, buy like-sized and like-structured protections for the mortgage book and in effect put that through into primary pricing on the mortgage book?

I don't know when it's going to come back. We expect the market to come back. There was a healthy market and level of interest before COVID-19. We would expect that to return when things go back to some more normal state, but the timing is uncertain. If it does come back, the decision will be economic. If it fits within our return and risk profile, we would continue doing those transactions the way we did. We might do more or we might do a bit less depending on pricing and recovery. Our risk management view is we like to have some downside protection and these structures are useful in events like this. So there is a price and conditions where it becomes difficult, but we would expect to continue doing them within reason.

Thanks. I have a cat reinsurance market question. Are there going to be many instances where primaries have cat towers and cat protections that are peril-defined as natural catastrophes, or is this narrow peril listings in the reinsurance treaties such that because the pandemic isn't deemed or classified as a natural cat there would not be stated coverage in a reinsurance treaty?

You have a variety of contracts—quota share and risk excess. It's different in the U.S. versus international. We expect a lot of discussions because I'm not sure it's as natural-peril specific as you think. It was a softer reinsurance market for a while, and when that happens conditions tend to be a bit broader than one would expect. People have to review contract language to see what applies.

Okay. Thanks a lot. Good luck, gentlemen. All the best.

Thank you.

Our next question is from Yaron Kinar with Goldman Sachs. Your line is open.

Thank you. Hopefully you can hear me now?

Yes, we can.

Yes.

Great. Good morning everybody. First question on MI. Have you been able to book the U.S. MI using a consistent methodology that was used by the rest of the MI book? What would the loss ratio look like this quarter?

Roughly speaking, if we extrapolate for the year for the U.S. MI we're saying the remainder of the year is going to be, call it, 100 combined ratio just to be on the safe side. If you annualize the minus 25% expense ratio, ballpark, it gets you a 75% loss ratio plus or minus.

Okay. And would the GAAP accounting basically make the results in the MI business progressively worse quarter-over-quarter, or do you expect it to be flattish in the breakeven range through the rest of the year?

Very hard to know. It depends on how quickly the delinquencies are going to show up. If all the delinquencies show up in Q2, you could see a scenario where people missed their first mortgage payment on April 1 and their second on May 1. Along the way they told their servicer that they want to take advantage of the forbearance program, and we could expect a significant amount of delinquencies to show up in Q2 and possibly in Q3. It could flip-flop. The timing of delinquencies will dictate volatility from quarter to quarter in 2020 on how the calendar-quarter loss ratios will look.

Okay. If I turn to insurance, can you talk about the programs business and how you'd expect that to perform both from top line and margin perspective in the face of COVID?

It's not really workers' comp exposed. The lines that could be exposed are property, and almost all the policies exclude virus events. So that should not be a significant contributor to the loss experience on the programs business.

Okay. Thank you very much.

Welcome.

Our next question comes from Phil Stefano with Deutsche Bank. Your line is open.

Yes. I was hoping you could give some commentary on your thoughts around the flow of new business for MI this year. How does this feel like purchase originations versus refi originations are going to shake out? And maybe within that you can embed a commentary around what you see with pricing. Risk-based pricing and rates react in real time to changes in the economic environment. Does it feel like we're starting to see that come through as the flow of business?

Three questions. On origination going forward, industry consensus seems to be 20% less production this year. We have about a 35% penetration from the MBA perspective and 45% private MI share, so about an 18% to 20% decrease. For refinancing, we continue to see a lot of refinancing due to historically low mortgage rates, and there's pent-up demand for purchases. I think house prices may go down but likely not as much as some expect—possibly single-digit percentage declines—because of pent-up demand which helps purchasing. On pricing, we are adjusting risk-based pricing and assumptions. We're making adjustments as appropriate across the industry. We expect others to raise expected losses in their pricing as well.

When we think about the expected returns that you're seeing in MI, have they changed materially? And maybe insurance is a better place or a better lever to be exercising at this point to put capital to use—any thoughts around that?

Two years ago MI provided superior returns for us. We've ranked capital allocation across businesses and have shifted as relative returns change. Our loss expectations have modified somewhat, so depending on pricing going forward, we'll see how that falls out. The returns from the P&C unit have been improving and are higher in relative position for capital allocation now.

Got it. Thank you and be well.

Thank you.

You too, thanks, Phil.

Our next question is from Meyer Shields with KBW. Your line is open.

Great thanks. I do feel like I'm beating a dead horse here. But does your first quarter COVID reserve in P&C assume that the policy requires direct physical damage but doesn't have a virus exclusion? Does that assume that that's a definite defense?

I'll start. It's very early, but where we have taken some reserves on property there are a very small subset of our policies that don't have an exclusion. For those we felt it's prudent to expect losses to come through and we booked IBNR to go against those policies. Those are generally outside of the U.S., in the U.K., in Canada on the insurance side. We also have a small amount in some property facultative deals that may specifically cover pandemic and we expect that some of those certificates will have to respond. So it's mostly in insurance and a little bit in reinsurance. For the U.S. there's no question you need property damage to have BI respond. There are proposals that people want to make coverage retroactive and challenge that. We'll see how far that goes, but for the time being we don't have reserves on those. We relied on policy wording to make our assessments of reserves on BI.

Additionally, there are other lines such as trade credit where we proactively reflected the expectation of increased claims; we adjusted loss ratios specifically. For most property we did granular, policy-level/reservations. For other lines we used loss-ratio approaches where historically losses emerge from such events.

Okay. That's very helpful. The second related question: what sort of events would constitute second quarter COVID-related P&C losses?

We have to go through the insurance companies evaluating every claim. This is not easy to do from 30,000 feet. It will take a while before things get sorted out. A couple things: presumption of workers' comp coverage is part of that. There will be a lot developing and potential litigation. It's going to take a while to sort out how losses accumulate and whether they contribute toward reinsurance recoveries. So I don't expect the ultimate picture to be available by Q2; this will take longer.

This is going to be a slow-developing catastrophe loss.

Absolutely. Thank you so much, guys. That's very helpful.

Thanks, Meyer.

Our next question comes from Brian Meredith with UBS. Your line is open.

Thanks. First, Marc, can you tell us what is the status of the Coface investment? And if indeed the transaction goes through, should we anticipate some type of impairment charge on close given where Coface stock is relative to your agreed investment?

Everything is too early at this point in time. They are evaluating and we made the investment with a long-term strategic vision. They themselves have been proactive and credit quality underwritten through the end of last year is different than in 2008. We still have regulatory processes to go through and we expect to receive clarity toward the end of the year. We're monitoring closely.

Got you. And then my second one, on MI: if I think about the lawsuits you guys are seeing potentially for the rest of this year, what does that mean for 2021 as far as MI results? How far are we into the deductible on the Bellemeade transactions? How much additional could there potentially be in 2021?

It's very premature. The answer will depend on the level of delinquencies and how quickly they get to us. With the economy reopening, people go back to work. By fourth quarter 2020 some loans may be current. A reasonable expectation for 2021 is that we should do better than 2020; the loss ratio should come down, but not to 2019 levels. Some claims that convert from delinquencies may pay late in 2021 given forbearance durations and processes. So 2021 should be better than 2020 but not as low as 2019.

Got you. What I'm trying to do is scale how much additional loss could we potentially have before you hit the Bellemeade deductibles—what's kind of a worst case there?

We've looked at a variety of economic scenarios: internal RDS stress tests and external scenarios such as Moody's S3 and S4. Under most scenarios we don't expect to attach the Bellemeade transactions. In particular S4 gets very close. We might start attaching a few years down the road in severe stresses. In short, under most scenarios we don't expect to pierce the Bellemeade attachments, but the protection is available if things get much worse.

At a very high level, our Bellemeade retention is about $1.5 billion to $1.6 billion. That gives you a sense for how much losses we'd need to go through to start to get some recovery. That should give you a benchmark. We will clarify more as appropriate in future disclosures.

Great. Thank you.

Sure. Thanks.

Our next question comes from Mark Dwelle with RBC Capital Markets. Your line is open.

Yes. Good morning. On MI, as you're contemplating within the guidance of no earnings for the balance of the year, are you assuming a case average per reserve similar to what you've been reserving at, or something more similar to after hurricanes or something of that nature?

We apply a forbearance rate and then we apply conversion from forbearance to claims. Severity is pretty close to 100% on most of those cases. It's more binary: the two big variables are the forbearance rate and our view of conversion from forbearance to claim, which is very uncertain.

Within that then, are these being evaluated on a case-by-case basis, or are you applying a formula to all of the losses that whatever some particular bank presents you over some period of time?

It's a bit early to know exactly how everything will play out. We expect more delinquencies. We would expect a higher cure rate on those than in a normal economic environment. It's the product of forbearance, cure rate and severity that gives the total incurred loss in the quarter. We will look at them differently than we would in a regular quarter, but we will evaluate case-by-case as needed and apply modeling at the loan level.

To be clear, we do go at the individual loan level with the risk characteristics and apply assumptions and shocks on unemployment and house price index. We run lifetime projections and come up with an ultimate projection of claims. That's a bottom-up approach and we verify it with top-down approaches such as Moody's S3 and S4 scenarios. They converge reasonably well.

And suppose I'm an individual and I default beginning in April and May and get recorded as a delinquency in forbearance in June. I take advantage of the six-month requirement. Will you be able to release that reserve back as quickly as October at the end of six months which would offset any additional adds you otherwise take in the fourth quarter for people newly delinquent or further delinquent?

Correct. If the borrower cures and they strike an agreement with their servicer to manage missed payments (for example, add them at the end of the mortgage period), the reserves we had put up on that loan would be reduced to zero and we would reverse them. If many borrowers cure by the fourth quarter, we could see reversals of the reserves accumulated in Q2 and Q3. Timing is uncertain and it depends on when delinquencies are reported and how borrowers elect to use the programs.

Just to clarify, second and third quarter you would think of as reserve accumulation and then perhaps beginning in the fourth quarter you would start to see offsets develop assuming people follow that pattern?

Yes, assuming the pattern where someone enters forbearance earlier and returns to current status in the fourth quarter. But the timing is uncertain and it could be more elongated across quarters.

Be cautious when comparing to 2007/2008. Here we expect more front-loading of reported delinquencies this time, which could mean more activity from a loss perspective in the next couple of quarters than in the GFC, which took two to three years to peak.

Understood. Thank you. Very helpful.

Sure.

Our next question comes from Geoff Dunn with Dowling & Partners. Your line is open.

Thanks. Good morning.

Good morning, Geoff.

First a technical question on PMIERs. Are forbearance loans treated the same way from an aging standpoint meaning that you'll get that asset charge progression as well, or is it just that initial point-in-time asset charge? It seems there's confusing interpretations out there on that front.

We couldn't quite hear; you were not coming through very loudly, but in general it's uncharted territory for the GSEs. There are a lot of discussions among MIs, the GSEs and FHFA to figure out the specifics. I don't have a definitive answer for you at this moment.

Is that any better? What I was asking is are forbearance loans subject to the aging asset charges on the PMIERs or are they just held at a point in time that initial charge? It seems some of the language out there has been confusing and up to interpretation.

Yes, it's unclear and under discussion. We don't have a definitive answer at this time.

Okay. I'm still trying to piece together your underwriting outlook for the remainder of the year. It sounds clear that incident assumptions will be below a normalized level because of the potential for cure activity. It seems like the implication is that your forbearance expectation is a lot higher than the near 6% number we've seen from April 26. It's maybe two or three times that if I'm looking at the math right. So what are some of the higher level assumptions that get you to that level of loss activity—unemployment, home price declines, et cetera?

You're right that forbearance we don't think stays at 5% or 6%. Our modeling is more like a 15% peak for forbearance. The conversion from forbearance to claims is the biggest unknown; we use something between one-in-seven to one-in-ten conversion in different scenarios. Industry ultimate claims rates in current vintages are closer to 7% to 8%, so a 14% or 15% is not outlandish under stress. The Moody's S3 type scenario is a model reference and it's roughly where our assumptions converge.

Are you suggesting the incident assumption will be higher than normal or lower than normal? You said 14% or 15%.

Higher than normal. If normal is 7% ultimate, we are modeling something in the one-in-seven to one-in-six range for stressed scenarios.

My last question on reinsurance strategy: the ILN market is hot right now. Does that create any interest in looking at a traditional quota share reinsurance to supplement ILN strategy longer term?

Everything is on the table, based on economics. The Bellemeade transactions were efficient and provided capital relief; we expect those markets to come back. If ILNs are not available, other ways to protect the portfolio such as traditional reinsurance would be considered.

Yes, everything is on the table and we will consider traditional reinsurance agreements if they make economic sense.

Okay. Thank you.

Geoff, I think you asked about MSRs as well; we're starting to evaluate all these things. Nothing is fixed but everything is under consideration.

Our next question comes from Ryan Tunis with Autonomous Research. Your line is open.

Hey, thanks. I'm trying to unpack that answer to the last question on the forbearance to claims rate being higher. If I heard that correctly, your modeling that gets to breakeven is assuming that conversion from forbearance to claims is actually higher than, say, a random default notice you received in December?

Yes. That's true.

This is a model and a stress test given the uncertainty. It is an opinion and conservative.

That's conservative relative to how most people think. One thing I noticed that gave you granularity is you've got these three buckets: three or four months delinquent, five to 11 months, and 12 plus. Is there expected pressure as these delinquencies age? Do you recondition the expected loss and could that be a source of pressure later in the year?

It's not a high number of claims—our reserves are about $250 million currently. A lot of the delinquencies are older vintages and have been in and out of delinquency. If there is pressure, it will impact prior book years that are currently in delinquency, because some were delinquent before 2020 and may be in worse positions. So earlier vintages could be impacted as well.

And on the premium yield number: how much of that was helped this quarter by any single premium activity? And has the outlook changed given elevated refinancing activity? I'm not sure about the composition change.

It was about 10% to 15% of premium for the quarter attributable to refinancing activity.

Okay. Thank you.

Welcome.

I'm not showing any further questions at this time. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.

Thank you very much everyone. Stay safe out there. We're looking forward to have more to report and talk about at the second quarter. In the meantime be good. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect.