Arch Capital Group Ltd. Q4 FY2021 Earnings Call

Good day ladies and gentlemen, and welcome to Arch Capital Group's Fourth Quarter 2021 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. If anyone requires assistance during the conference, please use your touchtone telephone. As a reminder, this call is being recorded. Before the company begins its update, management wants to remind everyone that certain statements in today's press release and discussed on this call may be forward-looking statements under federal securities laws. These statements are based on management's current assessments and assumptions and are subject to various risks and uncertainties. Consequently, actual results may differ materially from those expressed. For more information on the risks and other factors that may affect future performance, investors should review periodic reports filed by the company with the SEC from time to time. Additionally, some statements in this call that are not grounded in historical fact are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends for the forward-looking statements in this call to be subject to the Safe Harbor created thereby. Management will also reference 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 by 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 hosts for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.

Thanks. Good morning and welcome to our fourth quarter earnings call. We ended a good year. Here with a great quarter on the year Arch generated a return on net income of 16.7%. And importantly, book value per common share grew by 10.7% with net earnings per share of $5.23. We accomplished these results despite elevated CAT activity and the short-term effect that substantial share repurchases had on our book value per share. Our ability to effectively allocate capital also contributed to our 2021 results. Whether opportunistically investing more resources into the most profitable pockets of our business or buying back $1.2 billion worth of our common shares fully, 7.7% of the shares outstanding at the start of the year. We remain committed to a capital management strategy that creates value for shareholders. I'd like to begin by sharing some highlights from our operating units. In our P&C insurance segment, net written premium grew 24% and earned premium grew 34% over the fourth quarter of 2020 as we earned in the rate increases of the past several quarters. Growth occurred across many lines with professional lines and travel exhibiting the strongest advances. Overall submission activity and rate momentum remained healthy and rate increases were above the loss trend. A change in business mix led to a slightly higher acquisition expense in the quarter. However, we believe that this increase belies the underlying return potential of the segment. More accurately, it is a reflection of the insurance group's outstanding job of positioning itself to act on the better opportunities available in today's market. Turning now to reinsurance, our shareholders continue to benefit from the extraordinary talents of this group, which grew gross written premium by 88% and net written premium by nearly 45% from a year ago. Overall, the reinsurance group grew in nearly every line, a reflection of our diversified specialty mix of business and our larger participation in quota share reinsurance, which allows us to participate in the improved premium rates more directly. Briefly on renewals at January 1st, while property cat rates were up broadly, the increases were not enough for us to deploy more capital into our peak zones. However, we found many opportunities to grow in the other 93% of our reinsurance business, which is specialty in nature, including property ex-cat. Finally, onto the mortgage segment, which again delivered excellent underwriting results, even as written premiums declined in the quarter. Seasonally, the fourth quarter, as you know, is lower for mortgage originations and rising interest rates further depressed refinance activity, reducing new insurance rhythm. However, our insurance in force, the ultimate driver of earnings, still grew modestly in the quarter mainly due to the lower refinancing activity. Credit conditions remain excellent in the U.S. with a strong housing market and demand for housing continuing to exceed supply. As most of you already know, home price appreciation remains robust across most of the country. This is a net positive for mortgage insurers as increasing borrower equity ultimately leads to a lower risk of default. Competition in this sector remains robust but stable, and we believe that the better credit quality of our recent originations compensates for marginally lower premium yields. We continue to focus on more stable returns available in higher credit quality business instead of broadly chasing top-line growth, a luxury afforded to us by our diversified model. Turning to the fourth leg of our stool, investment income contributions were up materially for the year, primarily due to alternative investments accounted under the equity method. These investments are primarily fixed income in nature, but because of the structure of our investments, their contributions are excluded from net investment income and our definition of operating income. Notwithstanding, these investments contributed $366 million or $0.92 per share for the full year. Over the past five years below the line, investment returns have added between 75 to 125 bps to our net ROE. But taking a step back to get more of a big picture view, we like the way our businesses are currently positioned. Within our P&C segments, we believe that P&C pricing and returns have more room to grow in this part of the cycle, and in the mortgage segment, insurance in force is benefiting from both solid credit conditions and good house price appreciation. Underwriting income for our P&C insurance and reinsurance segments expanded significantly in the fourth quarter. It's worth noting that if we were to include components of investment income that relate to the flow-generation from underwriting. P&C's contribution to Arch's earnings were roughly in balance. We believe that this balance improves the risk-adjusted returns for our shareholders. Our corporate culture of being patient in soft markets while maintaining an agile mindset is a key to our success and allows us to seize opportunities when the odds for success are more in our favor. Because different sectors have their own cycles, our disciplined defensive underwriting during the softer parts of the cycles is what has enabled us to grow faster than many of our peers in the current environment. We have begun to reap the benefits of the strong defensive posture we maintained from 2016 through 2019. The Winter Olympics are underway, and I found an analogy to our business in a somewhat unexpected place: the most exquisite and exciting game of Curling. You may or may not be aware that Curling has been dubbed chess on ice. And like insurance, it's much more strategic than the uninformed may realize. Curling is played over ten long ends or rounds. A defensive strategy is most common, patiently waiting for an opening to pivot to offense. Unfortunately, defending is not exciting. It's about minimizing your opponent's scoring opportunities and avoiding mistakes. But like insurance, patience is often handsomely rewarded because when an opponent makes an error, the skip knows that now is the time to pounce and all of a sudden, patience is out the door and action is in. Most games are won in that one crucial reversal of fortune. That's how we play the insurance cycle. One year at a time, patiently waiting for the market to give us that opening. And once we see it, we're all in, just like the last 2.5 years and counting. Don't ever let anyone tell you that Curling or insurance are not exciting. For 20 years, we've been committed to taking the long-term view of the insurance cycle, being thoughtful and balanced with our capital management strategy, and differentiating ourselves by being committed to a specialty model, all with the aim of enhancing shareholder value over the long term. Although every year is different and markets aren't always predictable, we've demonstrated that we can succeed in any market. So we're looking forward to what 2022 has in store for us.

Thank you Marc. And good morning to all. Thanks for joining us today. As Marc shared earlier, our after-tax operating income for the quarter was $493.3 million or $1.27 per share, resulting in an annualized 15.6% operating return on average common equity. Book value per share increased to $33.56 at December 31, up 3.5% in the quarter. For the year, our operating return on equity stood at 11.5% while our net return on equity was 16.7%, excellent results indeed. In the insurance segment, net written premium grew 23.7% over the same quarter one year ago. And the accident quarter combined ratio excluding prior year development was 91.2%, lower by approximately 240 basis points from the same period one year ago. The growth was particularly strong in North America, where a combination of new business opportunities and rate increases supported this profitable growth. One item to note this quarter for the insurance segment relates to the acquisition expense ratio, which was higher than in both the prior quarter and the same quarter one year ago. As we mentioned in the earnings release, some of this increase is related to premium growth in lines of business with higher acquisition costs such as travel. But it also reflects increased contingent commission accruals on profitable business, as well as lower ceded premiums in lines with higher ceding commission offsets. As we have said before, our focus remains on the returns we are able to generate from all our businesses, and we remain positive on the current pricing environment and the opportunities that should be available to us in 2022. For the reinsurance segment, growth in net written premium remains strong at 44.5% on a quarter-over-quarter basis. The gross written premium growth was driven by increases in our casualty, property other than property catastrophe and other specialty lines where new business opportunities, strong rate increases, and growth in new accounts helped increase the top line. For the full 2021 year, the ex-cat accident year combined ratio was 84.4%, improving by approximately 160 basis points over the 2020 year, a reflection of the underwriting conditions we have seen in most of the lines we write. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums stood at $72.3 million or 3.5 combined ratio points, compared to 9.4 combined ratio points in the fourth quarter of 2020. The losses came from a combination of fourth-quarter events including the December U.S. tornadoes, and other minor global events, as well as some development on events that occurred earlier in the year. Our estimate of our ultimate exposure to COVID-related claims decreased by approximately $3 million during the quarter. We currently hold approximately $195 million in reserves for this exposure. Two-thirds of which are recorded either as ACRS or IBNR. Our mortgage segment had an excellent quarter with combined ratio of 11.7%, due in part to favorable prior-year development of $72.9 million. The decrease in net premiums earned on a sequential basis was attributable to a combination of higher levels of premium ceded, a lower level of earnings from single premium policy terminations, and lower U.S. primary mortgage insurance monthly premiums due to lower premium yields from recent originations, which were of excellent credit quality. While approximately two-thirds of the favorable clean development came from losses related to better than expected cure activity and recoveries on second lien loans. We also saw favorable prior year development across our other mortgage units including our CRT portfolio and our international MI operations. Consistent with historical practice, we maintain a prudent approach to setting loss reserves, especially in light of the uncertainty we are facing with borrowers exiting forbearance programs and moratoriums on foreclosures. The delinquency rate for our U.S. MI book came in at 2.36% at the end of the quarter, more than 50% lower than the peak we observed at the end of the second quarter of 2020. Production levels were down from last quarter, certainly a typical outcome given the seasonality in new purchases, and also partially, as a result of the lower level of refinance activity due to higher interest rates. Offsetting lower origination activity in the quarter is the improving persistency rate now at 62.4%. We expect persistency to keep improving throughout 2022 on the heels of lower refinance activity. This bodes well for our insurance in force portfolio, and accordingly, the returns we can generate on our mortgage business. Income from operating affiliates stood at $40.6 million. Again, an excellent result primarily as a result of contributions from Coface and Somers Reef. We are pleased with the returns these investments have generated for us so far. Total investment return for our investment portfolio was 39 basis points on a U.S. dollar basis for the quarter. And net investment income was $90.5 million this quarter up slightly, in part due to slightly higher dividends on equity investments. The duration of our portfolio remains low at 2.7 years at the end of the quarter, basically unchanged from last quarter and reflecting our internal view of the risk and return trade-offs in the fixed income markets. Alternative investments representing just under 15% of our total portfolio performed well this year, returning 12.6%. The portfolio we have constructed has a slightly heavier bent towards debt strategies and should produce, we believe, returns that are relatively less volatile over time given the level of diversification across sectors and geographies. Amortization of intangibles was $33.1 million, up sequentially as a result of the acquisition of Westpac LMI and Somerset Bridge Group Limited which were completed in the third quarter. For your modeling purposes, we are currently forecasting an amortization expense of $110 million for the full 2022 year which is expected to be recognized evenly throughout the year. The effective tax rate on pre-tax operating income was 4.7% in the quarter, reflecting the geography mix of our pre-tax income and a 2% benefit from discrete tax items in the quarter. The discrete tax items in the quarter primarily relate to a partial release in evaluation allowance on certain international deferred tax assets. For 2022, we would expect our tax rate on pre-tax operating income to be in the 8% to 10% range based on current tax laws. Turning briefly to risk management, our natural account PML on a net basis stood at $748 million as of January 1 or 5.9% of tangible common equity, which remains well below our internal limit at the single event 1250 year return level. Our peak zone PML is currently in the Northeast U.S. On the capital front, we repurchased approximately 8.7 million common shares at an aggregate cost of $362.1 million in the fourth quarter. And as Marc mentioned, we repurchased almost 31.5 million shares at an average price of $39.20 in 2021. Our remaining share repurchase authorization currently stands at $1.18 billion. Finally, I wanted to take a quick moment to thank over our over 5,000 colleagues around the globe in what has certainly been a challenging period. Without their ongoing commitment to Arch and its constituents, we certainly wouldn't have been able to generate and report record earnings today as we closed the books on our 20th year. Your efforts and dedication are truly appreciated. With these introductory comments, we are now prepared to take your questions.

Thank you. If you have a question at this time, please proceed. Our first question comes from Elyse Greenspan of Wells Fargo. Your line is open.

Thanks. Good morning. My first question follows up on just some of Francois’ concluding comments going to capital management. Recognizing where your stock is today, can we just get some updated thoughts on how you guys think about share repurchases at these levels? And if at some point the valuation continues to expand, would you consider the use of a dividend to return capital to shareholders?

Well, as you know, our top priority is to put the capital to work in the business. And we're seeing plenty of opportunities to continue on our growth trajectory, so I'd say that remains the key focus. But as you saw last year, we've accumulated a bit of capital that we didn't have the options to deploy and put to work, so yeah, we did return a fair amount to shareholders last year. What ends up happening in 2022 is a bit of an unknown. We'll keep looking at our opportunities. Certainly, if you have the 1.3 times book multiple, that's something that we've looked at, and we talked about a three-year payback and how we look at share repurchases. But the business is doing very well, so I'd say that the current prices are maybe a little bit above where the three-year payback might come into play. But there are also other factors we consider, and I'd say, in regard to your final question, like, would we think about a dividend, that's something we discuss with the Board regularly. And right now, as you know, we haven't declared a dividend, but things could change down the road.

And then Marc, you mentioned that the earnings mix for allocating investment income between the segments is approximately 50-50. If you consider that for 2022, would that shift more towards P&C or mortgage? How do you foresee that earnings mix evolving in the upcoming year?

Yes, I think it will lean slightly towards Property & Casualty. Excluding catastrophic events and other factors, as you know. Overall, I would expect it to be around 50, maybe a bit more towards Property & Casualty as we move forward. Additionally, regarding the process of implementing some capital changes, I know we're in the middle of the comment period, but could you share some high-level thoughts on how those changes might impact Arch? Thank you.

Sure.

We are thoroughly examining this matter with a sizable internal team focused on it, as it impacts various areas including mortgage, catastrophe losses, and reserve risk, among other risk-related factors. There are numerous suggestions from S&B regarding their forward direction, and we plan to respond to their RFC in the coming weeks. In terms of the overall situation, there are both advantages and disadvantages, as is to be expected. We have been collaborating with them for the past few years to address certain issues, and it appears that some changes may be forthcoming. However, there are also some aspects that are unexpected and potentially more severe, and we will adapt as necessary. There is still some way to go before we achieve clarity on the ultimate implications for all parties involved.

Thank you.

You're welcome.

Thank you. Our next question comes from Josh Shanker of Bank of America. Please go ahead.

Thank you. I was hoping you might help us think about going forward. We have Somers, we have Coface. What sort of thoughts can you give us about the run rate goals for that unusual line and even the P&L and what sort of volatility should we expect from it?

Well, I would say that this quarter might be the first where there is clarity. It's more about recurring business as usual for both entities and also for premier and the other smaller investments that haven't had operating affiliates. As you know, we have over a billion dollars invested in these ventures. We made those investments because we believe they can provide good returns for us. On your side, regarding the return on equity you should anticipate from those businesses over the 2022 period with that billion dollars invested, I will leave it to you to make your own assessments and model it, but that's a way to think about it in terms of ROE.

And Josh, you actually have one that's coming from Coface, obviously, being a public company that's helpful to you guys and also in the rear. So you had a good sense of where we're going the next quarter. On the Somers, which is the old walk through it, I think it's fair to say that it would track a P&C return. It would tend to stand at this looking like a P&C insurance company. So I will describe those returns to help you give you a sense of the magnitude and the relative magnitude between the two.

And then in a little bit of shrinkage on the mortgage side of things, if you can talk about your rankings, mortgage reinsurance, insurance, share buyback. They're all attractive I know, where are the best returns right now?

I would say that mortgage is still just a medium for transactions. In the long term, there may be different factors at play, which is why I previously explained that you might position yourself in areas where the returns may not currently be as high, but there is a long-term rationale for doing so. Currently, I would rank mortgage as number one, followed by reinsurance as number two, and insurance in third place. The potential for improved investment income in the future will likely enhance the attractiveness of both insurance and reinsurance, although they are not very different from each other right now. In the past, there was a wider gap between them, but the hardening market in property and casualty has made them all quite favorable and appealing. Regarding the share repurchase, Francois mentioned the details of what we've acquired and our views on it. It's always an option, and as Francois noted, we are focusing on specific returns in terms of capital management. If we cannot find more enticing opportunities with higher returns, we will consider returning capital. However, I believe we currently have numerous opportunities available.

Thank you very much.

You're welcome.

Our next question comes from Tracy Benguigui with Barclays. Your line is open.

I would like to touch on the expense ratio. Francois, you mentioned increased contingent commission accruals on profitable business. And I'm assuming you mean with MGU maybe you could just walk us through how that structure works. I think there's a multiyear look-back period and where I'm going with it is essential, if there's a lot of in calculating that profit-sharing component, should we expect this profit-sharing component sticking around for a while to catch up with all the good work you've done on underwriting profitability?

There are various types of agreements with all our producers, both in the U.S. and internationally. Going into specifics would take considerable time, but generally speaking, if we report a lower loss ratio on certain business, it does result in a higher contingent commission, and that must be synchronized with how we accrue and report it for the quarter. Provided the business performs well, settlements occur over time along with adjustments. Overall, as long as the business is thriving and the loss ratio is significantly lower than it is now, we would anticipate consistent levels of contingent commission being maintained over time.

Got it. And then, on the same topic. I mean, basically, I'm just curious, what are you writing that costs you more besides maybe travel business? So I was looking at the changes in our business mix, basically something that pops up, maybe it's professional lines in insurance and reinsurance, it bounces around more quarter-to-quarter. So if you could just provide more context about the business mix changes that we're really driving at, as well as the direction of ceding commissions.

Certainly, that's a great question. Looking at the structure of our insurance group, we observe a similar phenomenon on the reinsurance side, albeit for different reasons. We're expanding our programs in the insurance sector and taking on some risks. In professional lines, we focus on private DNO and not-for-profit DNO, which tend to incur higher expense ratios compared to larger commercial enterprises. Additionally, we're increasing our presence in the UK, which also involves higher acquisition costs. Therefore, I believe the size of risks plays a significant role in our insurance operations. We also handle some cyber risks, mainly small ones, which tend to have a higher acquisition expense ratio due to their scale. This includes accident and travel insurance, which are also considered small risks. On the reinsurance side, as you know, there's a substantial difference with quota shares. The expense and acquisition ratios can vary significantly; for excess of loss, it might be around 10 to 15, but on a quota share basis, it could rise to 30 or 33. We have been expanding both in small risks on the insurance side and increasing our quota share participation in reinsurance. This reflects the costs associated with accessing the business we are pursuing.

So we're on the commission?

Say it again?

And if you could comment on the ceding commission.

The ceding commissions have been stable to slightly up on the reinsurance but not significantly. They are a bit more stable for the last year and a half than they have been in other harder markets, that's one thing that's really intriguing, but I guess it makes sense in terms of the economic returns in the pricing that's coming through on the primary side. But the increase itself in ceding commission is not what's driving the acquisition expense ratio, it's truly the type of business in the mix that we are writing.

Thank you.

Thank you.

Our next question comes from Mike Zaremski of Wolfe Research. Please go ahead.

Hey, great. Thanks. A follow-up on the maybe I'm reading too much into this, but on the increase in the expense ratio specifically, I believe probably the acquisition expense ratio, but maybe also the other portion of the expense ratio in the primary insurance segment. So I believe you said some of it was due to increased profitability or contingent commissions, but I guess if I'm looking at the overall combined ratio for that segment for the year, it was 96 and changed. And for the quarter was 93, I thought we were shooting for overall profitability being better than that in other years, or maybe even this year. So I didn't think profitability was much better than expected. Any thoughts there?

Well, you need to break it down by lines and business segments. The agreements don’t reflect the overall profitability. There are certain business segments that are performing exceptionally well, which increases commissions. Additionally, we are retaining more in some segments, which affects the economics. This means there will be lower ceding commissions in some areas, and we are retaining a higher net with an improved loss ratio moving forward. This also influences the overall acquisition costs. Overall, this quarter has had some fluctuations, but we aren't overly concerned at this point. It feels like temporary noise. We are still dealing with the pandemic's aftermath, and last year was significantly impacted by COVID with no travel, among other factors affecting our expense ratios. I believe our expense ratios are a bit elevated this quarter, but it’s not a major cost concern. Also, the numbers you are referring to include catastrophic events. Excluding those events gives a clearer picture of our unloading margins, which have improved from 95 to 91 this year. So, while there’s some debate on whether this improvement will continue, we have indeed seen better margins over the last year. I think your numbers were somewhat influenced by the catastrophic events.

No, you're correct. I should have perhaps excluded the cat events as you mentioned, but while the cat events are important, your point about the net to gross is valid.

Yeah.

Okay. And that's helpful. And maybe just switching gears to capital and inorganic growth, I guess one of the MIs hit the tape that they are potentially exploring a sale. If another MI buys another mortgage insurer is one plus one still less than two, or have dynamics you think maybe changed over recent years?

It's a good question because our understanding was that the GSEs suggest a preference for more diversification rather than less. We'll have to engage with stakeholders in Washington and Virginia to grasp their perspective on this. There isn't much benefit in combining two mortgage insurance companies, as the capital models and other factors are linear, meaning there's no significant saving of capital. We might experience some net loss in market share, similar to what we observed after acquiring UG. Thus, one plus one does not equal 1.5, and there may be a loss in market share, indicating one plus one doesn't equal two or more. I'm uncertain about future developments or others' intentions. Our core principle regarding mortgage insurance remains unchanged: a multi-line diversified platform is preferable, and that principle is here to stay. Some of the new S&P modeling seems to acknowledge this. In my view, it would be more sensible for these mortgage insurers to seek alternatives outside the mortgage insurance sector, but I'm not one to predict the future.

So that's helpful. You asked if the S&P capital model will provide increased benefits from diversification.

In general only MI, in general there's better diversity and credit, the more diversified you are, which again speaks to our model, which makes sense to us.

Thank you.

Thank you.

I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.

Well, thank you everyone. I want to thank our employees, as Francois mentioned as well, and sometimes they run the corners so make sure you take care of your loved ones this weekend. On to the next quarter.

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