Skyward Specialty Insurance Group, Inc. Q1 FY2023 Earnings Call

Good day, and thank you for standing by. Welcome to the Skyward Specialty Insurance Group conference call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Natalie Schoolcraft, Head of Investor Relations. Please go ahead.

Thank you, Amanda. Good morning, everyone, and welcome to our first quarter 2023 earnings conference call. Today, I am joined by our Chief Executive Officer, Andrew Robinson; and Chief Financial Officer, Mark Haushill. We will begin the call today with our prepared remarks, and then we will open the lines for questions. Our comments today may include forward-looking statements, which by their nature involve a number of risk factors and uncertainties that may affect future financial performance. Such risk factors may cause actual results to differ materially from those contained in our projections or forward-looking statements. These types of factors are discussed in our press release as well as in our 10-K that was previously filed with the Securities and Exchange Commission. Financial schedules containing reconciliations of certain non-GAAP measures, along with other supplemental financial information, are included as part of our press release and available on our website, skywardinsurance.com under the Investors section. Now, I will turn the call over to Skyward's CEO, Andrew Robinson. Andrew?

Thank you, Natalie. Good morning, everyone, and thank you for joining us. Q1 was another solid performance, and we're pleased with our continuing strong financial and strategic momentum. Specifically, gross written premiums grew approximately 28% in the quarter. Mark will talk more about premiums, but at a high level, we continue to benefit from broadly favorable market conditions and strong execution across our underwriting divisions. Our adjusted combined ratio was 90.3%, inclusive of catastrophe losses and adjusted operating income of $15.5 million or $0.42 per diluted share. We were minimally impacted by first quarter convective storms with catastrophe losses of only 1.8 points on the combined ratio and well within our retention. We continue to realize pure rate in the high single digits, above our loss cost inflation estimates. We also continue to generate very strong cash flow from our operations. This last quarter, we invested our new money at 5.3%, all into our core fixed income portfolio. We achieved an adjusted return on equity and tangible equity of 13.3% and 16.5%, respectively, for the quarter. We believe that this result, together with our strong growth, further reinforces the financial momentum we expect will continue in 2023. Strategic investment in our business portfolio continues as evidenced by our recent inland marine and global agriculture launches, and we continue to add A+ talent and invest in technology to amplify the capabilities of our underwriters and claims professionals. I'll talk more about this later. With that, I'll turn the call over to Mark to discuss our financial results in greater detail. Mark?

Thank you, Andrew. For the quarter, we reported net income of $15.6 million compared to $16.3 million for the first quarter of 2022. As Andrew noted, on an adjusted operating basis, we reported income of $15.5 million or $0.42 per diluted share compared to $19.8 million, or $0.61 per diluted share for the same period a year ago. In the quarter, gross written premiums grew by 28%. Every underwriting division grew in Q1, with notable performance in our transactional E&S, global property and agriculture, Professional Lines, surety, and captives divisions, each up over 20%. Net written premiums grew approximately 49% to $202 million in the quarter compared to $135 million in the first quarter of 2022. The first quarter of '22 net written premium was impacted by the restructuring of a global property quota share reinsurance. Adjusting for this transaction in '22, the net written premium retention of 56.1% in the first quarter of '23 is consistent with the prior year quarter. Moving on, the adjusted combined ratio of 90.3% includes an overall accident year non-cat loss ratio and an improved expense ratio compared to the first quarter of '22. The 2.4 point improvement in the current accident year non-cat loss ratio to 61.1% was driven by the runoff of higher loss ratio exited business and the changing mix of business. We had no prior accident year developments in the quarter. During the quarter, catastrophe losses were $3.2 million and accounted for 1.8 points on the combined ratio. The catastrophe losses were primarily from wind, hail, and tornadoes in the South and Midwest compared to the first quarter of '22, which was not impacted by catastrophe losses. The expense ratio improved 1 point compared to the first quarter of 2022 driven by a higher earned premium base and increased commission and fee income. Investments in the business were lower than planned, and we expect a higher run rate for the remainder of the year. Partially offsetting the expense ratio improvement were slightly higher acquisition costs driven by the change in our business mix I just highlighted. Now turning to our investment results. Net investment income decreased $10.5 million to $4.6 million in the quarter compared to the same period of 2022. The net investment income from our core fixed income portfolio more than doubled to $6.3 million from $3 million in the prior year quarter, driven by an improving portfolio yield and a significant increase in the invested asset base. Our core fixed income portfolio is now $673 million, up from $607 million at December 31, 2022. As Andrew noted, we continue to deploy cash flow to this portfolio given the attractive yield environment. During the quarter, we invested about $38 million in the portfolio at 5.3% without increasing duration. For the quarter, the average book yield on our core fixed income portfolio was 3.7% compared to 2.7% this time last year. The decrease in our net investment income in the quarter was generated by our opportunistic fixed income portfolio. Both first quarter of '23 and the first quarter of '22 were significantly impacted by equity mark-to-market adjustments. During this past quarter, the marks were negative compared to the positive marks in the first quarter of 2022. Despite the volatility we've experienced over the last 2 quarters, the inception-to-date return for this portfolio is approximately 8%. This portion of our investment portfolio has decreased as we continue to deploy cash to our core fixed income portfolio. I want to touch briefly on the commercial real estate market and the regional banking sector as it relates to our investment portfolio. Exposure to the economically sensitive parts of commercial real estate, including office and retail, is less than 3% of our total investments, and we do not have any concerns about this portion of our portfolio. Regarding regional banking, during the quarter, we recognized realized losses of $1.5 million net of tax related to SVB and Signature Bank. At March 31, 2023, we had minimal direct exposure. At March 31, we had over $285 million in short-term and money market investments resulting from strong operating cash flow of over $100 million as well as the IPO proceeds. During the quarter, our yield on short-term investments was slightly north of 4.5%. As we've discussed, we will be deploying this liquidity into our core fixed income portfolio. During the quarter, we closed a new credit facility that provides us with capacity of up to $150 million, of which we drew $50 million to pay off our term loan. The new facility gives us plenty of financial flexibility. Our leverage ratio is currently 20% and provides us with significant debt capacity. Lastly, regarding our May 1 property catastrophe renewal. The renewal was orderly and consistent with our plan for 2023, and we're pleased with the price and the terms. The new treaty provides $28 million of cover in excess of a $12 million retention. Previously, we had a $10 million retention. The $12 million attachment point is actually lower on a modeled return period than our expiring cover, and the current cover is well in excess of a 1 in 250-year event.

Thank you, Mark. From an underwriting profitability perspective, we had a very strong quarter. Growing at 28% is no small feat, particularly given our expressed focus on executing our Rule Our Niche strategy. We are meticulously building our business with a view towards long-term durable positions and top quartile underwriting performance. Let me highlight 2 areas with very strong growth in Q1. In transactional E&S, we grew over 100% this quarter. This division has been built around a core team I've personally known for over 15 years, whose long-term underwriting performance has been outstanding. This division writes a true surplus lines general liability and property book of business that is reasonably short tail, low frequency, and moderate-to-high severity with typical policy sizes of $30,000 to $40,000. This is a part of the market where real understanding of exposure is required, it's too large and complex for binding authority, yet below the level that is subject to large price swings that the larger account part of the market can have. Our property focus in this division is non-cat coverage for which fire is the principal peril. We write primary-only with 60% of the policies limit entirely contained within our cover. The submission flow has been incredibly robust, and the terms and conditions are extremely attractive. Now more than ever, when our distribution partners are stressed with cat-exposed account placements, they need real technical expertise and problem-solving on the non-cat technical E&S risks. Our strong growth and substantial underwriting contribution this division generates comes without additional volatility to our business. Turning to surety, our growth this past quarter was over 50%. The backbone of our growth is the outstanding talent we have brought on, all of whom bring a very strong market following, which in turn has allowed us to add seasoned and well-understood books of business. The talent has come to us because of our unique culture and desire to invest in this division. Our growth is born out of this team's creativity and solutions that the principles that we bond, and the distributors that we support, view as distinctive and hugely valuable. We invested in and implemented an entirely new surety platform in record time, enabling efficient growth and providing us with analytics we believe are among the very best in the industry. Today, this is a hugely valuable division generating excellent results. While I highlight these 2 divisions, I view our efforts in every division and every unit and the quality and distinctiveness of our underwriting and claims teams in the same way. We continue to build a highly valuable specialty carrier for the long term. And while time will tell, I and our leadership team believe we are doing this the right way. To amplify the points above as it relates to the current quarter, we again achieved a total average rate increase in the high single digits, higher than our estimated loss cost inflation. We are not overweight in the lines that received huge rate increases over the last 2 to 3 years, such as public D&O, excess, habitational cyber, and others, many of which needed those huge rate increases due to years of underpricing relative to loss cost inflation. And we similarly should not see the big downdraft as prices moderate. Our discipline regarding pricing is evident in our new business as we now close in on nearly 3 years of driving new business pricing at or above the pricing of our in-force book. We believe that our new business contribution to our underwriting margins is at a level consistent with our renewal book. Retention, too, remains steady in the high 70s, again, an indication that we're striking the right balance on rate and retention. Submission flow remains robust and was over 25% as compared to the prior year. Market conditions, by and large, remain orderly with pricing still attractive across most of the parts of the E&S and specialty markets where we compete. That said, there is no question that social inflation is real and measurable, particularly as it relates to personal injury. We are watching the loss costs very closely and managing our excess exposure across our book. We believe that in a rational market, this should be a continued impetus for pricing increases. To wrap up, Skyward's position is strong and improving, and we'll continue to invest in our business to further our trajectory towards top quartile performance. We have a strong first quarter and it's a great start to the year.

Our first question comes from Tracy from Barclays.

Andrew, you mentioned that you're seeing pure rate in the high single digits. If you included part of the exposure that acts like rate, what would pricing look like?

Thank you for the question, Tracy. In the first quarter, our exposure increased a few points, which we were very pleased to see. Many people discuss the part of exposure that behaves like rate, and we definitely experience that in our business. However, we prefer not to claim it since it's difficult to pinpoint. Overall, it seems to account for about one extra point this quarter, but again, it's challenging to identify that specific aspect. The more significant takeaway for us this quarter is that we noticed a solid increase in exposure, which is a very encouraging sign for our business portfolio. It appears that there was a slight economic recovery reflected in our results during the first quarter. As you rightly observed, there's likely some rate increase associated with that recovery.

Okay. Great. And also Andrew, per prior conversations, I think you guys took a more cautious view that if property pricing increased meaningfully, the insurers would just retain more. Can I just assume that did not happen? Any kind of preview you have on property for the second quarter would be helpful.

That's a good question. It did happen. I mentioned earlier that we've been leading, especially in the global property sector where we've been strong in our pricing for transactional E&S. We observed instances in global property where our clients seemed to be at their limit regarding risk retention. Interestingly, although we didn’t significantly increase exposure in our book in Q1, much of the growth came from underlying values, effectively increasing exposure. A big chunk of this was driven by price adjustments, and we raised our attachment points, meaning our net exposure wasn’t considerably high. We're noticing some of this trend in Transactional E&S as well, and we are definitely expanding units in that area. Additionally, we see that clients are taking on higher retention points and larger portions in terms of sub-limits or co-participations, likely because pricing has reached a point where they must make those trade-offs.

And second quarter, are you? Yes, go ahead.

You asked about that, and I appreciate it. We feel positive about our growth in the second quarter, which aligns with our performance in the first quarter. However, we've noticed a decline in available market units for the second half of the year. Even if growth continues during this time, its overall contribution to our company's growth will be smaller. Additionally, while we aren't primarily focused on catastrophic writing, we do have some exposure in our global property portfolio, especially in the first half of the year. The second half typically involves more technical risks, which differs in terms of competitiveness. In summary, we are more confident in our growth prospects for the first half of the year, with the second quarter mirroring the first, but we may see a slight decline in the second half. However, this doesn't mean we won't experience robust growth during that time.

Our next question comes from Matthew from JMP.

I would like to expand on Tracy's question and take a broader view of all the underwriting divisions. The 28% growth is impressive and better than we anticipated at the start of the year. How should we approach the rest of the year in terms of identifying opportunities, and are there any areas where we should be cautious? It seems that there were instances in the first quarter that were more opportunistic, and we may not be able to rely on those going forward.

Yes, Matt, thanks for the question. Look, I'd start off by answering your question as we're pretty focused on the quality of our growth. And I will say that as it relates to us, the way that we grow, the way we think about our business is pretty darn disciplined. We're not necessarily an opportunistic writer. It's not to say that there is not some opportunistic rights in our first quarter; there were. But I would not sort of tilt what happened in the first quarter as it being driven by a bunch of opportunistic rights. I think we made a number of great investments in our business. You've heard from us in terms of the talent that we brought in areas like professional liability or transactional E&S or surety. And you can see the growth in those areas coming through. So our efforts are being rewarded. We're doing things the right way. That said, look, if you're trying to build a durable, high-quality book of business, and you hit a 28% growth in the first quarter, that's pretty darn outstanding. I think that it's hard to keep that up over the course of a full year. It's not to say that we couldn't. I think we feel that the second quarter will be a strong second quarter. We can see that already. I do think that the second half of the year, we're going to have strong growth, whether it's something that is north of 20 like it was in the first half of the year. That's not necessarily what we're planning for. And quite honestly, if we achieve it, that would be fantastic. But we won't put a lot of opportunistic business into our book. We're trying to build this for the long term. I think the quality of our growth is something that I would just highlight to you that is a key focus for us. Hopefully, as we look out 2 or 3 years from now, much of the business that we put on to the books sticks to our ribs because it was put onto our books the right way under the right terms and conditions, where they were looking to a company like us to give them a good solution. And I'm hopeful that time will bear out that what I'm describing to you is actually the sort of the characteristic of the growth that we're putting on here in 2023.

That's really helpful. I'd like to go back to the pricing commentary regarding loss costs broadly. As you consider the different underwriting divisions, are there specific areas that you feel optimistic about? Perhaps you observe inflation easing or loss costs improving while pricing remains steady? Conversely, are there areas where you might be more cautious, either regarding loss costs or where pricing might need to increase? I'm trying to get a sense of which areas are more favorable for you and where you might be applying more caution or discipline.

I'm concerned about social inflation related to personal injury, as it's an important issue to monitor. We communicated in the first quarter that we undertook a full account quota share on auto, not because we dislike our auto performance, but because we're facing a macro trend that requires us to be cautious while continuing our current strategy. We may not have excess exposure to personal injury, but it's possible that it could be written over our primary $1 million limit. For instance, I feel confident about most areas, but in our first-quarter writings, auto accounted for about 18% of our gross written premiums, down from 22% or 23% last year. This indicates a more cautious approach to growth, and we are also being more careful on the net side by having that protection in place. There are definitely still significant opportunities, but we are cautious due to macro concerns and the behavior of certain MGAs and fronted solutions that don’t seem to recognize the same risks we do. In terms of our medical stop loss, A&H business, professional liability lines, private company management liability, and property, we feel confident about the loss cost environment, our technical pricing, and the rate increases we are implementing each quarter.

Our next question comes from Meyer Shields from KBW.

This is actually Derek on for Meyer. So my first question is on the operating expense ratio, which came in a lot lower than we had expected. And I know you had called out premium leverage and lower investments kind of impacting that. Is there anything else unusual in there that lowered the expense ratio? And as your investments kind of accelerate throughout the year, how should we think about that expense ratio throughout the year?

Yes, that's a great question. There were three main factors that contributed to a lower expense ratio this quarter. First, as you noted, we had increased premiums which provided us with better leverage. Second, our expense ratio includes certain fees regarded as contra expenses, which increased slightly in the first quarter. There were some seasonal factors and benefits that may not occur again. Lastly, we faced delays in some planned investments, which impacted our expectations. Although this delay is beneficial in one respect, it may also postpone some of the growth we anticipated. Those were the three main contributors.

Okay. That's really helpful. And then my second question is going about the global property. Obviously, property pricing is probably well in excess of loss trends. And you said you didn't add much exposures in the first quarter. Can you just help us think about the maximum exposures you're willing to take on for global property, maybe as a percentage of the business or premiums given your focus on kind of limiting underwriting volatility?

Yes, I think our team in global property does not have a practical limit on how much they can write. They are familiar with most of the accounts in the addressable market, and as you might recall, we write around 100 accounts currently. We plan to add some more, but the main focus is on the quality of what we write. I recognize that there is a lot of discussion in the industry about many players aggressively writing property, and we definitely see great opportunities in that area and are taking advantage of them. However, that doesn't necessarily mean we will write a lot more. If you look at the overall profitability of the property industry, it raises some questions, especially beyond the catastrophe reinsurers today. Thus, we are still selective in our approach. We are not restricting our team, but we maintain a conservative stance regarding catastrophe risk, which is evident in the size of our catastrophe program and attachment points. If the market conditions persist, we will continue to grow in that space, but we are not planning to dramatically increase our exposure or change our business profile, not because of constraints but simply due to our operating strategy.

Our next question comes from Gregory Peters from Raymond James.

So Andrew, I was listening to your comments around the reinsurance, you said the new program renewed million ex $12 million.

Correct.

Let's consider the current situation. Given your growth in transactional areas like E&S and global property, how do you think the upcoming summer weather and potential hurricanes in the third and fourth quarters will impact your ability to achieve full retention in any given quarter, especially with the various changing factors at play?

Yes, that's an excellent question. To clarify our catastrophe program, a $12 million retention equates to roughly a 1 in 10-year return period considering all risks. It's a fairly conservative threshold. Reflecting on my experience, I want to highlight that we did not activate our program last year despite a significant event, whereas others did engage their catastrophe programs. The only incident that affected us was a unique storm in Louisiana a few years ago that only slightly impacted our program, which had a much lower threshold. This indicates that we have faced numerous challenges, including winter freezes and various storms, yet our impact has been minimal and wouldn’t trigger a $12 million retention today. Identifying specific events is challenging, but when assessing our exposure, we consider the frequency and severity of multiple catastrophic events. We do have some coverage for second and third events that is below the $12 million retention as a safeguard against these occurrences. This approach is distinctive to how we handle catastrophe coverage, and it's worth noting that if a series of events occurs, that might lead to an attachment at lower thresholds.

That makes sense, especially the drop down on the second and third events. Can I pivot to discuss the results on the opportunistic fixed income? You briefly mentioned some of the exposures, such as the banks. So I have two questions. As you consider the opportunistic fixed income for the remainder of the year, it seems like given the market conditions, there will be some challenges. I'm curious if you have any insights on that.

Okay. Well, that was a lot, Greg. So the way I look at the opportunistic, I think it's worth framing first that the returns inception-to-date on the portfolio have been strong at right about 8%. I mean, we like the portfolio. The anomaly that we deal with is the volatility due to the accounting and the structure in which we invest. Let me add 2 more points to your question. I think it's worth emphasizing that in light of the current yield environment where we are today and where we have been for the better part of the year. All of our new money is going to core fixed income, and that portion of the portfolio is now, meaning the opportunistic, is less than 15% of the total portfolio. When you talk about the different buckets, I think you're referring to other commercial mortgage loans. Frankly, the decrease there is we got paid on one of our loans. So that's the reason it's down. Does that help?

That does. I'm not sure I've got clarity on how to model this going forward. And not the mortgage loan piece, the opportunistic fixed income piece, but I guess, given the market cautious is probably the best course of action.

Yes. And we'll take it offline, and I can get into the different components of the portfolio. And when we file the Q, you'll get some more clarity on the different pieces, if that helps.

I would like to add an important point. I think Mark mentioned this earlier, which is crucial for us to convey that we don’t just superficially examine the allocations. We understand the underlying exposures, and there is minimal exposure to office buildings, real estate, and retail. If you consider this in terms of economic sensitivity, we are very pleased with what we have. We appreciate the quality and nature of our CMBS, which are primarily short-term loans, mostly bridge loans. This allows us to view them with greater confidence and clarity, which we do.

Our next question comes from Paul Newsome from Piper Sandler.

Congratulations on the quarter. Two reasons that the growth in the first quarter being kind of above plan, well above plan. Does that have any implications for as we think prospectively the combined ratio and maybe the allocation between loss and the expense ratio? I think of properties having generally a lower combined ratio, but surety tends to have a higher expense ratio. Is there enough of a change with the unexpected growth that we could see something materially change in the composition of the combined ratio?

Yes, that's a great question. Our general view is that we need to wait a couple of quarters before making any conclusions. There's a mechanical aspect at play here, as the written premium has skewed towards certain divisions, which are performing better in terms of contribution and loss ratio. However, this is on a written basis and it will take some time to earn through. We want to observe the trend for a couple of quarters before we make any declarations about the impact on our loss ratio. The inputs we provided pre-IPO regarding our expectations for the ex-cat accident year still hold. We may need to adopt a more conservative stance as the data develops, taking time to see if our portfolio continues to evolve in those areas of our business before we can fully capture that in our accident year assumptions.

Great. Maybe a shift to a longer-term question. I know you are always looking to build new products and new divisions. Any update on that as we go into 2023, which obviously wouldn't affect this year much, but it really has the potential to impact the upcoming years?

Yes, it's a great question. I wouldn't say that we're pausing; that's not the right way to describe it. What I will say is that we've become a magnet for the best talent in our industry, and there's no doubt about it. After this call, I'll be interviewing an excellent candidate from one of our divisions. We have many opportunities to enhance what we already have in place. One area where I'm hopeful to see growth and development is in captives. We have some insights on how we can advance that. With the addition of inland marine and Ag in the first quarter, we also included some lines late last year, particularly in AAC. We believe we have plenty of potential for growth and can likely add talent to support what currently exists. Typically, I would give you a heads up on one or two projects we are working on, but I think those are still early in development, so I can't provide specifics on what to expect from us just yet.

And our final question comes from Mark Hughes from Truist Securities.

On the commercial auto, have you noticed any changes in performance, particularly regarding the frequency or severity of claims? I believe you've mentioned your efforts to mitigate risks. Is that starting to show up in your business portfolio?

Yes. Let's take a step back. We have three main components in our commercial auto portfolio. The first is specialty transportation, primarily intermodal trucking. We've often discussed our use of technology, which we believe sets us apart in underwriting and claims. We also have risk exposure through our captives, shared with the captive participants. Additionally, there's a specific program where we hold a significant stake in the business. Regarding claims frequency, it's not surprising that we benefited during the COVID period, and it's returning to expected levels. As for severity, it is definitely up; we can quantify it and attribute it to factors like social inflation. The positive news is that we are managing to price ahead of our loss cost inflation, which is around 9% to 10% for our auto book. Overall, this situation doesn't support the long-term sustainability of this line of business. Changes will need to occur. We've noticed some MGAs and fronted solutions acting irresponsibly, overlooking exposure features and loss cost inflation. It’s only a matter of time before their reinsurers realize this approach is flawed. If there's an opportunity for us to take advantage of this, we will. Currently, we are pleased with our portfolio and are being strategically selective. While we are more defensive compared to other parts of our business, we believe this is the right stance. We're not raising any alarms about our business; we feel confident and are doing the right things, though we must acknowledge the broader macro context that cannot be overlooked.

Yes. Understood. Appreciate all that detail. And I think you've touched on this, but to surety, do you think surety grows faster, same pace, a little more slowly than the overall top line this year?

This year, we will likely reach around a $100 million surety business if the market remains stable. This is a significant size for surety, and we take great pride in it. However, as we continue to grow year after year, it becomes increasingly challenging. What sets us apart and gives us confidence is our ability to attract exceptional talent. When these talented individuals join us, the business they previously served tends to follow them. We're growing in a way that resembles book rolls, but it’s not exactly that. We're able to bring in outstanding underwriters that we are familiar with and appreciate. If this trend continues, we can maintain our growth, although it becomes harder as we scale up. At our current size, we are becoming one of the top surety companies in the country, specifically in our market segment, which has a limited number of competitors. So, my response is that it can be both more challenging and yet still possible for us to maintain growth if we keep attracting the great talent we have.

I would now like to turn it over to Natalie for closing remarks.

Thanks, everyone, for your questions, for participating in our conference call and for your continued interest in and support of Skyward Specialties. I am available after the call to answer any additional questions you may have. We look forward to speaking with you again on our second quarter earnings call. Thank you, and have a wonderful day.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.