Earnings Call Transcript - ESNT Q2 2023

Operator, Operator

Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Essent Group Second Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

Phil Stefano, Vice President, Investor Relations

Thank you, Rob. Good morning, everyone, and welcome to our call. Joining me today are Mark Casale, Chairman and CEO; and David Weinstock, Chief Financial Officer. Also on hand for the Q&A portion of the call is Chris Curran, President of Essent Guaranty. Our press release, which contains Essent's financial results for the second quarter of 2023, 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 with the SEC filed on February 17, 2023, 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, CEO

Thanks, Phil, and good morning, everyone. Earlier today, we released our second quarter 2023 financial results, which continue to benefit from our high-quality insurance portfolio and favorable credit performance. Rising interest rates continue to drive higher investment income and elevated persistency, which supports the growth of our in-force portfolio despite pressure on new business volumes. Our long-term outlook in housing remains constructive as we believe that demographic-driven demand and low inventory should provide foundational support to home prices. While there is still uncertainty surrounding the U.S. economy, we remain confident in our robust capital position and the strength of our buy, manage, and distribute operating model. And now for our results. For the second quarter of 2023, we reported net income of $172 million compared to $232 million a year ago. As a reminder, our results last year were favorably impacted by the release of certain reserves associated with COVID-related defaults. On a diluted per share basis, we earned $1.61 for the second quarter compared to $2.16 a year ago, and our annualized return on average equity was 15%. As of June 30, our insurance in force was $236 billion, a 9% increase compared to a year ago. Our 12-month persistency on June 30 was 86%, and approximately 75% of our in-force portfolio has a note rate of 5% or lower. We expect that the current level of rates should support elevated persistency through the back half of this year. The credit quality of our insurance in force remains strong, with a weighted average FICO of 746 and a weighted average original LTV of 92%. Embedded HPA continues to benefit our business as the mark-to-market on the in-force portfolio mitigates the risk of claims, especially in light of the supply constraints in housing inventory. On the business front, our industry remains competitive, while the pricing environment remains constructive. We continue to focus on optimizing our unit economics and leveraging our proprietary scoring engine, EssentEDGE, and selecting and pricing long-tail mortgage credit risk. Overall, we remain pleased with the business we are writing and the related expected returns. We continue to execute upon our diversified and programmatic reinsurance strategy while focusing on optimizing our cost to reinsurance. During the quarter, we successfully executed the tender of two seasoned ILN deals, which retired $637 million of bonds that did not provide any regulatory or economic capital credit. Also last week, we priced our ninth Radnor Re ILN transaction, selling $281 million of bonds covering production from August of last year through the first half of 2023. Our belief remains that access to multiple sources of capital is a key element of our operating model, and we are pleased with the executions of both the tender and the latest ILN deal. As of June 30, Essent Re's third-party annual rate run revenue is approximately $80 million, while our third-party risk in force is approximately $2 billion. During the quarter, Essent Re continued to capitalize on the current environment to optimize returns and contribute to the profitability of our franchise. Cash and investments as of June 30 were $5.4 billion, and the annualized investment yield for the second quarter was 3.5%, up from 2.5% a year ago. Our new money yield in the second quarter approximated 5%, providing continued tailwinds for our investment portfolio. As a reminder, for every 1-point increase in the investment yield, there is a roughly 1-point increase in ROE. We continue to operate from a position of strength with $4.7 billion in GAAP equity access to $1.4 billion in excess of loss reinsurance and over $1 billion of available holding company liquidity. With the trailing 12-month underwriting margin of 78% and operating cash flow of $697 million, our franchise remains well-positioned from an earnings, cash flow, and balance sheet perspective. Our strong financial performance affords us the ability to take a balanced approach between capital deployment and distribution. This includes the approximately $93 million associated with the Title acquisition we completed at the start of the third quarter. Similar to when Essent Re started, we view Title as a long-term and attractive call option for the future growth of the Essent franchise. Year-to-date through July 31, we repurchased approximately 1.1 million shares for $46 million. Further, I'm pleased to announce that our Board has approved a common dividend of $0.25. We continue to see our dividend as a meaningful demonstration of the confidence we have in the stability of our cash flows and the strength of our capital position. Now let me turn the call over to Dave.

David Weinstock, CFO

Thanks, Mark, and good morning, everyone. Let me review our results for the quarter in a little more detail. For the second quarter, we earned $1.61 per diluted share compared to $1.59 last quarter and $2.16 in the second quarter a year ago. As Mark previously mentioned, our second quarter 2022 results benefited from the release of approximately $63 million of reserves associated with COVID-related defaults from 2020. Net premium earned for the second quarter of 2023 was $213 million and included $17.7 million of premiums earned by Essent Re on our third-party business. The average base premium rate for the U.S. mortgage insurance business in the second quarter was 40 basis points, consistent with last quarter. The net average premium rate was 33 basis points in the second quarter of 2023, down 1 basis point from last quarter due primarily to the net impact of the successful ILN tender Mark discussed. Ceded premium increased to $39.5 million in the second quarter compared to $33.6 million in the first quarter, largely due to the tender. Net investment income increased $2 million or 5% in the second quarter of 2023 compared to last quarter due primarily to higher yields on new investments and floating rate securities resetting to higher rates. Other income in the second quarter was $8.1 million, which includes a $2.7 million gain associated with the fair value of embedded derivatives and certain of our third-party reinsurance agreements. This gain was largely due to a decrease in our derivative liability, resulting from the reduction in outstanding insurance-linked notes from the completed tender offer. This compares to a $368,000 decrease in the fair value of these embedded derivatives in the first quarter of 2023. The provision for loss and loss adjustment expense was $1.3 million in the second quarter of 2023 compared to a benefit of $180,000 in the first quarter of 2023 and a benefit of $76.2 million in the second quarter a year ago. At June 30, the default rate was 1.52%, down 5 basis points from 1.57% at March 31, 2023. Other underwriting and operating expenses in the second quarter were $42.2 million, a decrease of $6 million from the first quarter. The first quarter included higher transaction costs associated with our Title acquisition and higher payroll taxes associated with the vesting of shares and incentive payments, which historically occur in the first quarter. The operating expense ratio was 20% this quarter, a decrease from 23% for the first quarter. We continue to estimate that other underwriting and operating expenses will be approximately $175 million for the full year 2023, excluding expenses associated with the Title acquisition and related transaction costs. Income tax expense in the second quarter of 2023 includes $5.3 million of net discrete tax expense associated with prior year tax returns. For the balance of 2023, we currently estimate income tax expense will be a 15.2% annualized effective tax rate. During the second quarter, Essent Group paid a cash dividend totaling $26.5 million to shareholders, and we repurchased $29.5 million of shares under the authorization approved by our Board in May 2022. As Mark noted, our holding company liquidity remains strong and includes $400 million of undrawn revolver capacity under our committed credit facility. At June 30, we had $425 million of term loan outstanding with a weighted average interest rate of 6.87%, up from 6.52% at March 31. At June 30, 2023, our debt-to-capital ratio was 8%. During the second quarter, Essent Guaranty paid a dividend of $90 million to its U.S. holding company. Based on unassigned surplus at June 30, the U.S. mortgage insurance companies can pay additional ordinary dividends of $278 million in 2023. At quarter end, the combined U.S. mortgage insurance business statutory capital was $3.2 billion with a risk-to-capital ratio of 10.5:1. Note that statutory capital includes $2.2 billion of contingency reserves at June 30. Over the last 12 months, the U.S. mortgage insurance business has grown statutory capital by $181 million, while at the same time paying $300 million of dividends to our U.S. holding company. As Mark noted, effective July 1, 2023, Essent U.S. Holdings acquired all of the outstanding shares of the capital stock of Agents National Title and all of the membership interest of Boston National Title, for $92.6 million in cash. The acquisition was funded using existing cash and short-term investments, and the purchase price is subject to customary post-closing adjustments. Now let me turn the call back over to Mark.

Mark Casale, CEO

Thanks, Dave. In closing, our capital position, liquidity, and underlying results remain strong. The high quality of our portfolio and strong employment are driving credit performance while our interest rates are benefiting the persistency of our in-force book and investment income. This strong operational performance continues to generate excess capital, which we will deploy using a measured approach between investment in growing our franchise and distribution. We remain confident in our buy-managed and distributed operating model and believe a measured approach to our capital is in the best long-term interest of Essent and our stakeholders. Now, let's get to your questions.

Operator, Operator

And your first question comes from Mihir Bhatia from Bank of America.

Mihir Bhatia, Analyst

I wanted to start by asking about the reinsurance transaction. Are these the first of these vectors that you've done? Did they have an impact on premiums in the quarter? I think one of your competitors talked about that a little bit, having done them for the first time this quarter. Just wondering if you could maybe give us some color on that? Just the economics of the transaction, how you expect it to impact future quarters ceded premiums or premium rate.

Mark Casale, CEO

Regarding the tender, about $8 million of it was due to additional ceded premium for this quarter, which explains the increase you noticed. Looking ahead, we anticipate roughly $40 million in savings, leading to an overall reduction of approximately $30 million in ceded premium in future years. The deals we executed did not significantly contribute to PMIERs capital or economic capital credit, so we are not planning to pursue other deals at this moment. This situation was quite unique as these transactions were affected by the COVID default, presenting a strong opportunity to optimize our reinsurance costs, which we had discussed in previous quarters.

Mihir Bhatia, Analyst

Got it. That's quite helpful. Now that the transaction is closed, can you discuss your initial focus on the Title business? How quickly do you anticipate the integration will proceed, assuming there is significant integration to be done? What can we expect in the near term from that business in terms of revenue or other high-level insights?

Mark Casale, CEO

Yes, we just completed the acquisition a little over a month ago, so we're just beginning the integration process. We're treating these as divisions within Essent Title. The integration will be quite extensive. I likened this acquisition to our purchase of the Triad platform back in 2009, which involved bringing in a solid operating platform and skilled personnel, but we were essentially a startup at that time. The title business we acquired isn’t a full startup, but it does have some startup-like traits. We intend to approach it similarly, focusing on building out necessary infrastructure improvements. This will involve investments and a long-term strategy. As I mentioned earlier, think of this as a call option for investors. It represents 2% of our GAAP equity and is part of a 3-, 5-, or 10-year program. This is an opportunity to establish another significant operating business, but it won't materialize overnight. When we launched Essent and began building in 2009, we did our first loan in 2010, but we didn’t break even until 2012. So, from a financial standpoint, this won't contribute much initially, and I wouldn't expect significant modeling for the next 12 to 18 months as we work to get it set up for future growth on both the agency and lender services sides. These smaller companies are exactly what we were looking for—a startup-type platform to develop further. However, in the near term, I wouldn't project much financially.

Operator, Operator

And your next question comes from the line of Rick Shane from JPMorgan. Your line is open.

Rick Shane, Analyst

Look, you guys have been consistently innovative both from an operational perspective, but also in terms of your use of technology. We are arguably on the cusp of maybe the next really significant technology evolution in terms of machine learning and AI. I am curious as a data-heavy company, but also a midsized business with midsized resources, how you will take advantage of this and how you're pursuing this? And particularly, anything you're seeing through your venture portfolio that's intriguing.

Mark Casale, CEO

Yes, Rick, let me break it down for you. We've been utilizing artificial intelligence and machine learning in our MI operations for quite some time, and most of our platform is now cloud-based, which offers significant cybersecurity protection. While the cloud provides us with substantial computing power, it also comes with costs that we must manage carefully. As I mentioned before in relation to reinsurance, we need to optimize our IT costs since our resources aren't limitless. Overall, we’re in a strong position with MI, and we plan to implement improvements. We are currently leveraging our underwriting engine for automated processes that enhance efficiency, reducing the input needed from underwriters while increasing their analysis capacity. However, we’re aware that we may face diminishing returns, given we only have 400 employees on the MI side, so efficiencies are limited to improving the model itself. On the Title side, operational risk is the top concern, followed by regulatory and credit risks, which are less significant compared to MI. Our claim rates are low because we have effective processes in place, meaning we don't face much credit risk. The operational risks are very people-intensive, so we're exploring whether we can apply insights from MI to improve efficiency in Title. Adopting technology in this area is complex and will take time, necessitating investments to gain better control over our operating platform and data. Smaller companies often rely on generic software and larger datasets, but for our long-term success over the next 5 to 10 years, we need to take control, similar to what we’ve achieved in MI where our proprietary data was vital for developing our pricing engine. Regarding our ventures, we are currently evaluating some funds focused on artificial intelligence. These funds do not operate within financial services, so our goal is to determine what insights we can gain that are applicable to our industry. We have seen some promise in certain portfolio companies, but we recognize we’re just beginning to explore the possibilities. Our venture efforts are aimed at discovering opportunities that will enhance our core operations, and with two core business areas in Title and MI, the potential benefits from our venture initiatives should be significant moving forward.

Operator, Operator

And your next question comes from the line of Bose George from KBW. Your line is open.

Bose George, Analyst

Actually, I wanted to ask just about the ILN transaction you did. How would you compare the execution in the ILN market with what you're seeing in the XOL, just the traditional reinsurance market?

Mark Casale, CEO

We had strong execution in the ILN sector, significantly better than last year and closer to 2021 levels. However, the key point about reinsurance is not just the quarter-to-quarter pricing. While we performed well this quarter, the market was favorable, and we capitalized on that. The real importance lies in the sustainability and longevity of the reinsurance market, especially given its managed and distributed operating model. We are focused on ensuring continued availability and recognizing that a robust financial service framework relies on multiple sources of capital. We feel increasingly optimistic about the sustainability of the reinsurance market as we progress quarter by quarter. The market has faced challenges before, such as in 2020 when it briefly shut down but reopened later. Last year posed another significant test, marked by volatility and rising rates that caught many off guard. Despite predictions of a downturn, we successfully executed XOL, ILN, and venture deals, indicating the market was still active, though at higher prices. Now, the environment has shifted markedly over the past year; inflation has eased, HPA has stabilized or slightly grown in certain areas, and credit remains strong. I believe investors are aware of this, and it wouldn't be surprising to see new entrants in the ILN market, as it seems like an opportune time to engage with that segment.

Bose George, Analyst

Okay, great. That's helpful. And a couple of little modeling question. The other income line item was up, what was driving that?

David Weinstock, CFO

Yes, the safe line stock. Other income has a few factors contributing to it, but I would say the main reason for the increase is related to derivatives. We experienced a significant derivative gain this quarter, while last quarter reflected a small unfavorable valuation. So, that will fluctuate with the derivatives.

Bose George, Analyst

Okay. Great. And then actually, just the share count was down a little bit as well. So just curious what drove that?

Mark Casale, CEO

Yes. We’ve repurchased 1.1 million shares this year. We started in March due to the uncertainty with the KB index. We believe that purchasing shares at 90% to 95% book value is beneficial for growth in book value per share. So, that was a significant factor.

Operator, Operator

Your next question comes from the line of Doug Harter from Credit Suisse. Your line is open.

Doug Harter, Analyst

Mark, can you talk about the pricing dynamics you saw in the second quarter and kind of whether that changed kind of over the course of the quarter?

Mark Casale, CEO

We didn't see a significant change in prices, which continue to trend upward. Our average premium on new insurance written increased in both the first and second quarters, with possibly a bit more pricing pressure on the tails in the second quarter and less base increases. We believe we are positioned well, as we mentioned earlier. Although it remains a competitive market, normalized prices are within a 12% to 15% range, assuming a claim rate of 2% to 3%. Given the current uncertainties, particularly with a potential recession in 2024, we anticipate that while consumers are currently financially stable, smaller businesses may begin to face layoffs, which could affect the market. There are still opportunities for price increases from a market perspective, and we aim to maintain a mid-teens market share. Optimizing pricing to sustain this share is critical, and the industry has performed well in this area. The narrative that the industry lacks discipline is misleading; we have always been disciplined. Factors driving this change include improvements in credit quality, enhanced reinsurance strategies, and advancements in pricing engines. These innovations have significantly altered the industry over the last decade, allowing us to adapt pricing strategies more effectively, especially during uncertain times like the COVID pandemic. The flexibility provided by these pricing engines has empowered the mortgage insurance sector to implement pricing strategies that were previously unfeasible, enhancing our ability to manage credit risk in a competitive environment.

Operator, Operator

Your next question comes from the line of Eric Hagen from BTIG. Your line is open.

Eric Hagen, Analyst

Maybe kind of a bigger picture question here, I mean if loss rates across the industry stay this low into early 2024, mid-'24. How do you see that potentially changing the competitive dynamic like in the industry itself as we look to next year? Like the fact that everyone seems to be generating excess returns with loss rates being this low, I mean, how do you see that affecting pricing, competition maybe even your own policy towards capital return as we look to next year?

Mark Casale, CEO

Yes, that's a great question. I don’t think it will affect pricing, Eric, because we are pricing based on a normalized 2% to 3% credit. The results are influenced by the economy, which is beyond our control. If losses improve, that will create more excess capital, leading to various choices, such as returning it to shareholders through dividends or buybacks or investing outside of the core business. I believe this will be the core outcome. Given the dynamics, if losses decrease, it’s important to note that these decisions are based on actuarial models. We don’t adjust pricing from quarter to quarter based on short-term loss trends. Additionally, due to competitive pricing dynamics, if prices are lowered to attract more business, competitors can easily match those adjustments. This illustrates the complexities surrounding pricing strategies. With the information available, everyone can see market trends, so any temporary gain from lower pricing would essentially just mean giving away value rather than pursuing pricing that reflects long-term economic returns of 12% to 15%. The extra cash from a reduced provision leads to questions about how to allocate that capital. Looking at the bigger picture—not just on a quarterly or yearly basis—how companies utilize their excess capital will determine the winners and losers in the mortgage insurance market. This judgment can't be made each quarter; it will unfold over the next three to five years. Some companies may opt to return all capital and limit their options, while we are focused on reinvesting and growth. We believe that over the long term, increasing book value per share is essential, having grown at 19% per year since going public. This will become more challenging as we grow larger, but it will push us to effectively utilize capital to continue that growth. A lower provision would give us more cash to pursue this objective.

Operator, Operator

Your next question comes from the line of Geoffrey Dunn from Dowling & Partners. Your line is open.

Geoffrey Dunn, Analyst

I fell off for a minute, so I'm not sure if I missed this, but can you provide the dollar impact of the tender offers on ceded premium this quarter?

Mark Casale, CEO

$8 million, I think, was an additional ceded premium.

Geoffrey Dunn, Analyst

And then I wanted to follow up on pricing. And so, I understand your pricing for the longer-term credit, normalized credit. How do the mechanics of investment yield and higher interest rates affecting cost of capital factor into that? Obviously, we're thinking forward to when, let's say, it's a soft landing and the economic expectations get better. I'm trying to understand kind of the puts and takes that might help sustain pricing at these improved levels versus what might be given back as economic expectations hopefully improve?

Mark Casale, CEO

Yes, that's a good question. Historically, our yields have been in the 2% to 3% range, but putting new money to work at 5% is a significant increase in terms of both nominal dollars and unit economics. However, for pricing, we typically use a more normalized investment yield, closer to 3%. We don't factor that into our pricing; it's primarily driven by credit. We analyze pricing on an unlevered basis and don't consider the cost of debt significantly since we don’t have much debt. If the economy improves, I’m not convinced that pricing would decrease. It's hard to believe that would happen. When pricing is based on a normalized approach, considering a claim rate of 2% to 3%, the capital we hold, and usual expenses and investment income, it should guide us in maintaining good economics. We need to avoid pushing it down to the levels we saw at the end of '21 and '22, which we have criticized. That’s part of the reason we will continue to seek new opportunities to allocate capital, as we want to avoid following the market down. One of our competitors is part of a much larger insurance firm that excels at capital allocation, allowing them to maneuver in and out of the market effectively. While we can’t adopt their strategy due to our lack of experience in the P&C sector, having options for capital allocation helps us remain disciplined. I can't really comment on others' views. From my perspective, having two or three loans out of 100 go bad doesn’t seem overly aggressive; it appears pretty standard. When you mention one percent, you might be slightly miscalculating that figure. A small increase could easily skew that number. When pricing fell to that level, it almost suggested that the expectation was even less than one percent. So, it was challenging to justify the numbers as I see them. Our perspective has been consistent for some time, considering the credit criteria of our portfolio, which is solid but still has a high loan-to-value ratio. Therefore, I believe our assumption is quite reasonable.

Operator, Operator

There are no further questions at this time. I will now turn the call back over to management for some final closing remarks.

Mark Casale, CEO

Thank you, operator, and thanks everyone for participating today, and have a great weekend.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.