Earnings Call Transcript - ESNT Q2 2021

Operator, Operator

Good day and thank you for standing by. Welcome to the Essent Group Limited Second Quarter Earnings Call. And please be advised that today’s conference is being recorded. I would now like to hand the conference over to your first speaker today, Chris Curran, Senior Vice President of Investor Relations. You may begin, sir.

Chris Curran, Senior Vice President of Investor Relations

Thank you, Brian. Good morning, everyone. And welcome to our call. Joining me today are Mark Casale, Chairman and CEO; and Larry McAlee, Chief Financial Officer. Our press release, which contains Essent’s financial results for the second quarter of 2021, was issued earlier today and is available on our website at essentgroup.com. Prior to getting started, I would like to remind participants that today’s discussions are being recorded and will include the use of forward-looking statements. These statements are based on current expectations, estimates, projections, and assumptions that are subject to risks and uncertainties, which may cause actual results to differ materially. For a discussion of these risks and uncertainties, please review the cautionary language regarding forward-looking statements in today’s press release, the risk factors included in our form 10-K filed with the SEC on February 26, 2021, and any other reports and registration statements filed with the SEC, which are also available on our website. Now let me turn the call over to Mark.

Mark Casale, Chairman and CEO

Thanks, Chris. And good morning, everyone. Today we are pleased to report our second quarter earnings, which exhibited both strong performance and capital generation. Our results for the quarter reflect a favorable operating environment as credit continues to normalize and housing demand remains elevated. The economic engine of our business remains firmly in place as our high-quality earnings and cash flow for the quarter demonstrate the strengths of our buy, manage, and distribute operating model. Our outlook on our business remains positive as the underlying fundamentals of housing are strong, and we continue to make solid progress on the next generation of our EssentEDGE technology. On the housing front, strong millennial demand and historically low rates continue to provide positive underpinnings. As for EssentEDGE, we continue to enhance its utility by combining increased amounts of data with the use of artificial-intelligence-based models. We believe this capability will be a long-term advantage in pricing and managing credit risk. Now let me touch on our results. For the second quarter, we reported net income of $160 million as compared to $136 million last quarter. On a diluted per share basis, we earned $1.42 for the second quarter compared to $1.21 last quarter. Our annualized return on average equity for the second quarter was 16%. At June 30, our insurance in force was $204 billion, a 17% increase compared to $175 billion as of the second quarter a year ago. The credit quality of our second quarter NII was strong, with a weighted average FICO of 747 and loan-to-value ratio of 92%. Also, we continue to be pleased with credit performance as our default rate at June 30 was 2.96%, compared to 3.7% last quarter and 5.19% at the end of the second quarter a year ago. On the business front, we continue to focus on optimizing our unit economics. While the more tangible aspects of this include using ILNs to minimize loss volatility and ceding more business to Essent Re, we also continue to invest in technology-related initiatives. A platform like ours is technologically intensive as we need to seamlessly deliver pricing and services to thousands of customers located throughout the U.S. For example, we are nearing completion of migrating our platform to the cloud, which provides more data storage, processing, and computing power. This enables us to deliver our EDGE technology more efficiently, given the need to quickly analyze large amounts of data from a variety of sources and combine it with machine learning techniques. We believe that this will benefit our unit economics over time and optimize premium levels and credit costs. In fact, we also believe that customer efficiencies of using EDGE will deliver our best price to borrowers and challenge the industry practice of using the negotiated rate cards. At June 30, our balance sheet and capital were strong. With over $4 billion in GAAP equity, access to $2.4 billion in excess loss reinsurance, and over $800 million of available liquidity at the holding company, we are well positioned. Our most recent ILN transaction was our largest to date, where we obtained $558 million of reinsurance through the capital markets. Essent Guaranty remains the highest-rated monoline in our industry at A by Invest and AAA and BBB+ by Moody’s and S&P respectively. We remain pleased with our base business, which is an earnings and cash flow engine during positive economic environments. For example, for the first half of the year, our operating margin was 73%, and we generated $340 million in operating cash flow. Given the use of reinsurance, which enhances the sustainability of our business, there’s more certainty in the earnings power and capital generation of our franchise. While our practice has been to retain cash and invest, the strength of our business model enables a measured deployment of excess capital amongst business strategic investments and shareholders. We will continue to be thoughtful in deploying excess capital in doing what we believe is in the best long-term interest of the Essent franchise and our shareholders. Finally, given our financial performance during the second quarter, I am pleased to announce that our Board has approved a $0.01 per share increase in our dividend to $0.18. Also, in connection with our $250 million repurchase plan, we have bought back approximately 400,000 shares for a total of $18 million as of June 30. Similar to dividends, repurchasing shares is a tangible demonstration of the benefits of our model in generating capital. It also provides further balance in deploying excess capital between the businesses and redistribution to the shareholders. Now let me turn the call over to Larry.

Larry McAlee, Chief Financial Officer

Thanks, Mark. And good morning, everyone. I will now discuss our results for the quarter in more detail. For the second quarter, we earned $1.42 per diluted share compared to $1.21 last quarter and $0.15 in the second quarter a year ago. Our updated estimate of the annualized effective tax rate for the full year 2021 is 16% before consideration of discreet tax items. As a result, the tax rate for the second quarter was 16.1%. We ended the quarter with insurance in force of $204 billion, a 3% increase compared to $197 billion at March 31, and a 17% increase compared to $175 billion at June 30, 2020. Net earned premium for the second quarter of 2021 was $217 million and includes $13.3 million of premiums earned by Essent Re on our third-party business. The average net premium rate for just the U.S. mortgage insurance business in the second quarter was 41 basis points, down from 42 basis points in the first quarter. Persistency increased during the quarter to 58.3% at June 30, 2021, from 56.1% at March 31, 2021. The provision for losses and loss adjustment expenses in the second quarter was $10 million compared to $32 million last quarter. The provision for losses in the second quarter benefited from a decline in new notices of default and higher cure activity. During the second quarter, we received 4,934 new default notices, which is down 34% compared to 7,422 defaults reported in the first quarter. At June 30, our default rate decreased to 2.96% from 3.7% at March 31. Consistent with the fourth quarter of 2020 and the first quarter of 2021, we have reserved for new defaults reported in the second quarter of 2021 using our pre-COVID-19 reserve methodology. As a reminder, for new defaults reported in the second and third quarters of 2020, we provided reserves using a 7% claim rate assumption. This assumption was based on the expectation that programs such as the federal stimulus, foreclosure moratoriums, and mortgage forbearance may extend traditional default-to-claim timelines and result in claim rates lower than our historical experience. We have not adjusted these reserves previously recorded in the second and third quarters of 2020, which total $244 million as they continue to represent our best estimate of the ultimate losses associated with these defaults. Other underwriting and operating expenses in the second quarter were $41 million compared to $42 million in the first quarter. We continue to estimate that other underwriting and operating expenses will be in the range of $170 million to $175 million for the full year 2021. Essent Group Limited paid a quarterly cash dividend totaling $19.1 million to shareholders in June and repurchased $18.4 million of stock. Additionally, during the second quarter, Essent Guaranty paid a $100 million dividend to Essent U.S. Holdings. On June 23, we closed the Radnor Re insurance-linked note transaction which provides $558 million of reinsurance protection on approximately $14 billion of risk in force. This transaction pertains to risk on our new insurance written from August 2020 through March 2021, including the portion of risk written from August 2020 through December 2020, which was not covered previously by our quota share reinsurance agreement. From a PMIERs perspective, after applying the 0.3 factor for COVID-19 defaults, Essent Guaranty’s PMIER sufficiency ratio is strong at 174% with $1.3 billion in excess available assets. Excluding the 0.3 factors, our PMIER sufficiency ratio remains strong at 163% with $1.2 billion in excess available assets. Now, let me turn the call back over to Mark.

Mark Casale, Chairman and CEO

Thanks, Larry. In closing, we were pleased with our performance for the second quarter as we produced strong earnings and generated excess capital. Our buy, manage, and distribute model is operating on all cylinders and confidence in our economic engine is high. Combined with a strong housing environment, our outlook on our business is positive. Finally, we are excited about the progress that we are making with the next generation of EssentEDGE and its potential to be a game changer in evaluating and pricing credit risk. We continue to believe that combining AI with large quantities of data is where the financial services industry is moving, and we want Essent to be at the forefront of this. Now let’s get to your questions. Operator?

Operator, Operator

And the first question we have is from Mark DeVries with Barclays.

Mark DeVries, Analyst

Mark, where are you seeing the most attractive places to deploy your excess capital today? And what do you need to see to want to get more aggressive repurchasing of stock?

Mark Casale, Chairman and CEO

Hey, Mark. There are several factors at play here. If I take a step back, as we discussed last quarter and mentioned in the transcript, our approach to capital allocation is cautious yet effective. We continue to invest in the business, achieving a 17% year-over-year growth, which necessitates capital. We are also making some strategic investments in the ventures part of our funds, although it's a modest sum. Additionally, we've raised the dividend to return capital to shareholders. We announced a buyback plan last May, and as of recently, we've repurchased $50 million worth of stock. So, we're on track with that. I don’t believe there’s anything out of the ordinary we should be concerned about, Mark. These businesses may seem static as we report every 90 days, but our perspective on capital allocation is long-term. We plan to maintain this approach and seek out opportunities both within and outside the business while continuing to return capital to our shareholders. We see it as a balance of the best of both worlds, and we are eager about the options we have regarding capital at this time.

Mark DeVries, Analyst

Okay. It’s helpful. And next question, what percentage of the business is still coming from the rate card? For those lenders that haven’t moved to the pricing engines, what’s behind that? Is it still a technology systems issue, compliance, or where do you see that going longer term? Do you expect them to move to the engine?

Mark Casale, Chairman and CEO

Right now, around 70% of our business comes through the engine. Some lenders value the pricing power they get with negotiated cards over the mortgage insurers. We are currently discussing building APIs with two larger lenders, which will enable us to compete with negotiated cards. When lenders look for an MI price, they will use our engine, which now factors in 400 variables. This means we combine raw credit bureau information and mortgage data, analyze it through machine learning, and provide a price to the lender in three seconds, competing against a static rate card. We are confident in our chances because technology is advancing rapidly, and if we can establish ourselves in these situations, we believe we will perform well. We are motivated to invest in and enhance the engine since the future of credit is shifting towards effective credit selection, which was not always the case. Pricing used to be uniform, but now it varies across industries. We are adopting similar strategies in mortgage insurance. Although we just started rolling this out at the beginning of the year, if you consider the long-term perspective, investing in this technology and transitioning our platform to the cloud, which boosts our computing capacity, positions us for future success.

Operator, Operator

Next we have Rick Shane with JP Morgan.

Rick Shane, Analyst

Mark, you pointed out that the persistency is trending higher quarter-over-quarter, and that’s obviously a favorable inflection. The reality is that CPRs are still elevated and burnout seems to be taking a little bit longer than folks anticipated. When we think about PMI, it actually increases the incentive for borrowers to refinance versus a borrower who doesn’t have PMI. On one hand, that would suggest that burnout would take longer, but I’m actually wondering if that PMI refi incentive has actually pulled forward refinance in your book, and we should see burnout emerge more quickly than the overall market.

Mark Casale, Chairman and CEO

I hope you're right, Rick. I'm not entirely convinced, but I think your idea has merit; however, I would advise caution. The 10-year has bounced back slightly this morning, but considering its low level, I believe refinancings will continue to be high. From our perspective, the purchase market remains robust, and we expect its foundational strengths to persist. Millennials are a significant factor, with the highest age group being around 28 or 29, while the average age of first-time homebuyers is between 31 and 32. We're entering a favorable period, with nearly 5 million new potential homeowners expected to enter the market in the coming years. Although interest rates will have an effect, they are still low, even if they rise. There is considerable discussion about affordability, which is important; however, I believe that demand will remain strong. Over time, as interest rates increase, refinancings are likely to diminish, and I anticipate that loans will have a longer staying power. I don't expect changes to happen on a quarter-by-quarter basis. We believe we've reached a low point, and possibly, by the end of the year, we could see figures in the mid-60s. Nevertheless, I feel that the long-term fundamentals of housing are quite solid, which should support continued growth in our insurance portfolio. Does that make sense?

Rick Shane, Analyst

Yes. Look, it totally does. And it’s interesting because when I originally framed the question, I thought of it the opposite way in terms of it might extend burnout for you. So it’s interesting to get your perspective. Look, the reality is that the fundamentals that are driving high prepayments are favorable for credit. When you think about the three outcomes for a policy going to maturity, refinancing or a credit issue, the middle outcome is certainly a better outcome than credit problems.

Mark Casale, Chairman and CEO

I agree. And remember, when NIW is elevated, you have to expect that persistency is going to be low. There’s no free lunch. We’ve been talking about industry volumes at historic levels over the last two years. It’s not surprising that persistency is at such low levels. We think we’re always a little bit more levered to higher rates. I’d rather see the book; I’d rather see lower NIW and the book grow, persistency a little bit higher. That’s just better from a cost basis for us. Slow and steady kind of wins the race, but this is the environment we’re in, and I think we’re adapting well.

Operator, Operator

Next we have Mihir Bhatia with Bank of America.

Mihir Bhatia, Analyst

Maybe I’ll just start with a follow-up on your last comment, Mark. As persistency increases and returns to normalized levels, how much of a positive impact will that have on the expense ratio? Are we looking at around 1% or more like 3% to 4%?

Mark Casale, Chairman and CEO

It's difficult to assess using an expense ratio because that relies on the insurance calculations. When considering nominal costs, particularly regarding underwriting costs, a portion of our originations is non-delegated. If you're comparing $50 billion a year to $100 billion a year, there are significant savings. However, there's friction in managing all of that, leading to turnaround issues and challenges for customers. Last summer, there was a significant shortage of underwriters due to high volume, which created difficulties for both our employees and those of our customers. This situation is not sustainable. I believe the economics improve when we're more leveraged. Even with lower net insured volume, we can still see growth in insurance in force because persistency remains high, which is an often underestimated aspect of our model.

Mihir Bhatia, Analyst

Understood. And then just maybe broadening the discussion a little bit. You’ve talked a couple of times on previous calls about things you’re looking at outside core MI. As you think about the business long term, maybe give us an update on that. And talk about what you’re spending your time looking at outside of core MI? Are there particular segments or types of businesses that are most interesting?

Mark Casale, Chairman and CEO

We spend a lot of our time connecting our investments back to the core business. For example, EssentEDGE has really benefited us, especially in understanding machine learning technology and how to utilize data effectively, which we learned through one of our portfolio companies. The key focus is improving the core business through technology initiatives, such as moving to the cloud. While we are exploring new investments outside of our core business, those are more of a supplementary focus rather than the main driver. Our expertise in capital management and consumer credit can be applicable beyond mortgage insurance, but the overall industry is limited, with a size of around $1.3 to $1.35 trillion; we hold about 15% of that market. We must be cautious not to become overly concentrated in our core business, as we also have a responsibility to deliver returns to our shareholders. We believe we can grow outside of mortgage insurance while still providing value to shareholders. Although we are not rushing into new ventures, we recognize that our skills can be effective in other areas. Looking at the long term — over the next 3, 5, or even 10 years — we see value in growing Essent. Reducing capital solely for shareholder returns may be beneficial in the short term, but it risks long-term sustainability as it shrinks the company and the equity base. Credit is a crucial factor for businesses like ours, and growth can create further opportunities. We maintain a disciplined process for our investments and have the experience needed to build businesses successfully. This long-term perspective is important as we consider capital distribution and its significance for our shareholders. Our approach to capital allocation will be thoughtful and measured.

Mihir Bhatia, Analyst

Right. No, I appreciate that. And after you made all those comments, you still instituted the buyback when you thought it was appropriate. So I think shareholders get it. Okay. I will leave it there.

Operator, Operator

Next question we have from Bose George with KBW.

Bose George, Analyst

I don’t know if you said this in your prepared remarks. So what was the default-to-claim rate this quarter?

Larry McAlee, Chief Financial Officer

Bose, this is Larry. The default rate at the end of the quarter is that the number?

Bose George, Analyst

No, the default-to-claim rate that you had used for new notices this quarter.

Larry McAlee, Chief Financial Officer

Okay. There was no change, Bose, from what we assumed in the prior quarter. The initial default-to-claim rate is still around that 9% level that we’ve historically experienced.

Bose George, Analyst

Okay, great. And then can you just talk about the cadence for the margin over the next few quarters, just in terms of that, the base average premium number? Is that kind of at the 1 basis point decline in a quarter level?

Mark Casale, Chairman and CEO

Yes, Bose, I think we’re saying still at the end of the year kind of in that 40-ish range for the year. Could exit a little bit lower, but we are starting to see a little bit of a flattening out. We know there are a lot of moving parts there. I know everyone thinks through singles cancellation is one additive to it. The reinsurance cost is obviously a big cost to that, and that has started to level out as most of the book is reinsured. Again, I would expect me in the 40-ish range at the end of the year, probably could exit a little bit lower, but I think the premium levels are relatively stable at this point.

Bose George, Analyst

Okay. I have one more question regarding the regulatory changes with the FHFA and the risk-sharing market. Do you think that could gain more traction?

Mark Casale, Chairman and CEO

I’m sorry, risk-sharing in terms of the...

Bose George, Analyst

The...

Mark Casale, Chairman and CEO

No, just the other business that you do, the ACIS and where you invest in the... Yes, yes. Okay. Yes, we've been pretty active. Freddie Mac has been active the whole time in the market. We actually wrote the most business last year than we’ve ever. And it’s been a pretty good start this year too. So it’s mostly Freddie. If Fannie enters the market, certainly, that could expand it. That remains to be seen; I haven’t heard much about that from Fannie Mae at this point.

Operator, Operator

Next question we have from Douglas Harter with Credit Suisse.

Douglas Harter, Analyst

I know it’s relatively early still, but any early read on kind of how EssentEDGE is performing in terms of picking credit quality and delivering that better credit quality as you would expect?

Mark Casale, Chairman and CEO

Don’t view it purely as improved credit quality; instead, consider it in terms of enhancing premium levels. For instance, with a 700 FICO score, we may rate them above 700 and offer a slightly reduced premium, but we anticipate better credit loss outcomes. The unit economics of that loan would improve. Over the long term, this will positively impact our portfolio, although it’s marginal and relative to industry pricing. As we've mentioned before, our market share is between 15% and 16%. The focus should be on optimizing that premium in the long term. If our average premium is currently 40 and we can increase it to around 42 with slightly reduced losses, that will ultimately benefit our return on equity. Additionally, it enables us to select the credits we want. I still believe this is a challenging concept for the industry to understand, especially since we’ve heard competitors talk about their reliance on outdated rate cards. This indicates a lack of technology to compete effectively. If you're determined to price based on just a few factors instead of leveraging hundreds, it suggests a lack of progress. In the mortgage industry, having more data is beneficial, contrary to common belief. There is a specific pricing level in the industry; dropping below it may gain you market share temporarily, but competitors will quickly respond. Our goal is to secure and optimize our 15% to 16% market share and move forward.

Douglas Harter, Analyst

And I guess as you’re thinking about optimizing unit economics, are you looking to optimize the persistency for EssentEDGE as well? How do you think about that component?

Mark Casale, Chairman and CEO

Yes, definitely. There is a prepayment aspect to this. We are certainly lengthening the duration, which is significant. Regarding technology and unit economics, we've mentioned EDGE, which has aided us in optimizing our premium. There’s clearly a possibility to enhance performance concerning credit losses. When you incorporate extensive credit bureau data along with mortgage details, EssentEDGE acts as an underwriting system. I would not be surprised if we continue to advance that to automate some of the current underwriting processes, which will ultimately reduce costs. We have several initiatives in progress to provide our clients with a more self-service experience, making it more efficient and user-friendly, which in turn helps with expenses. We have discussed the affiliate reinsurance in relation to the tax rate. When managing our daily operations, our focus is on unit economics. We consider what measures we can implement to enhance premiums and reduce credit losses. Clearly, reinsurance has significantly aided our efforts to manage credit losses. We have specific plans for each element, and this is how we strive to execute our strategy daily.

Operator, Operator

And our last question will be from Ryan Gilbert with BTIG.

Ryan Gilbert, Analyst

First question, Mark, just going back to your comments around overall industry market share. Looking through that NIW data and comparing it to some of the estimates out there around 2Q ‘21 total originations, it looks like there was maybe a pickup in share for the overall industry in 2Q. PMI is taking a bigger piece of the overall pie. On the one hand, it’s within the realm of normal quarterly fluctuations. On the other hand, given really strong home buyer appreciation and maybe more first-time homebuyers, you might expect the PMI percentage of total originations to increase in the quarters and years ahead. So I just love your thoughts on what you’re seeing on the market and if you think that 15% of the total pie can increase going forward?

Mark Casale, Chairman and CEO

It's an important question, Ryan. We need to differentiate between purchases and refinances. The market share for refinances is typically much lower in mortgage insurance compared to purchases. Our share for purchases rose from 62% in the first quarter to 82% in the second quarter. It was 90% last month. Overall, you could see the penetration increase, which supports our persistency. As the focus shifts more towards purchases and away from refinances, our total volume might decrease, but the portfolio could expand slightly because it tends to be more stable. Therefore, it likely grows a bit more than in a market dominated by refinances.

Ryan Gilbert, Analyst

Okay. Got it. And on premium rate, just going back to your response to a prior question, it sounds like with potentially premiums flattening out over the course of 2021, do you think we could be hitting the last year of premium rate compression? Or should we anticipate lower premiums for the foreseeable future?

Mark Casale, Chairman and CEO

Some of this is just the math working its way through our records. The premium levels on new business are lower than they were four years ago, reflecting the pre-tax rate changes that are still being accounted for. I believe premiums will continue to decrease, but at a much slower pace as we approach a trough period. I'm not sure if we’ve reached that point yet, but I do think it will happen soon. It's important to note that part of this is due to the reinsurance costs we are incurring. The whole industry began reinsuring around 2018, and we are currently navigating through these premium rates. The compression in premiums might appear worse than it actually is when you take a broader view. We shouldn't get too fixated on this. Looking at the overall picture, our business had operating margins of 73% for the first half of the year, and we generated cash flow of $340 million. That's not something to measure in premium basis points. I understand the concerns, but we must recognize that this solid performance has allowed us to hold excess capital, which puts us in a strong position to allocate capital towards new ventures, return capital to shareholders through dividends and share repurchases. So even with current market valuations of 41 or 39, we will continue to maintain these margins.

Ryan Gilbert, Analyst

Yes, those are all valid points. I have one clarification question for Larry. Did you say that you did not change your reserve assumptions or your reserve levels for 2020?

Larry McAlee, Chief Financial Officer

That’s correct. Just to remind everybody, we assumed a 7% claim rate assumption on the new default notices we received in the second and third quarters of 2020 and recorded reserves of $244 million for those two quarters. We continue to hold those reserves and made no adjustments to them in the second quarter.

Ryan Gilbert, Analyst

Okay. And it looks like there was a $15 million favorable development in the second quarter. Was that related to pre-2020 reserves?

Larry McAlee, Chief Financial Officer

It was related to the pre-COVID period, which would be Q1 of 2020 and prior. We had moved back to our historical methodology in the fourth quarter of 2020. So it’s really the fourth quarter of 2020 and the first quarter of 2021 in prior periods.

Mark Casale, Chairman and CEO

Yes, think of it in three cohorts. First, we had the pre-COVID reserve model, then in the second and third quarters, we implemented a special reserve where we froze it. For the fourth quarter of last year, we returned to our normal reserve model. Most changes are related to the first and third parts of this, while we maintained the second part consistently. We've seen progress, but only 80% of the second quarter 2020 cohort has resolved, and we have 93% in the model. This is partly due to ongoing forbearance and the extension of the foreclosure moratorium. We mentioned last May, or in August when we booked it, that it would take 12 to 18 months before we would really see clarity, and that timeline is unfolding as expected.

Operator, Operator

And there are no further questions. I’m turning the call back over to the speakers. Chris?

Mark Casale, Chairman and CEO

Thanks, Brian. Thanks, everyone, for joining. I know that Friday in August, exciting times to talk about MI. But thanks for your participation, and I hope everyone has a great weekend.

Operator, Operator

Thank you, everyone. Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.