Arch Capital Group Ltd.

Good day, ladies and gentlemen, and welcome to the Arch Capital Group Fourth Quarter Earnings Conference Call. At this time, all participants are in a listening mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. Before the company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risk and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8K furnished to the SEC yesterday. which contains the company's earnings press release and is also available on the company's website. I would now like to introduce your hosts for today's conference, Mr. Mark Grandison and Mr. Francois Morin. Sirs, you may begin.

Thank you, Shannon, and good morning to you all. Once again, this quarter, strong earnings from our mortgage segment upset the effects of catastrophe losses in our property casualty segments. as ARCH produced an annualized operating return on equity of 8.8% and 10.7% for the 2018 fourth quarter and full year, respectively. Given the level of catastrophe losses across the globe in 2018, our results demonstrate, again, the value of our core principles of diversification, sound risk selection, underwriting discipline, and cycle management. Francois will provide more commentary on our financial results in a moment, but it's worth pausing for a minute to thank all employees at ARCH who are committed to meeting the needs of our clients while producing superior returns. Given the notable catastrophe events of the past two years, we will begin our discussion of market conditions with the January 1st renewal market and property cap reinsurance. As you may have heard on other earnings calls this quarter, on average, Property cat rate increases at Gen 1 were positive but below expectations given the record level of insured cat losses that were reported in the past two years. Across the industry, loss affected property accounts saw rate increases of 10% or more, while some property accounts in Europe were flat to down 5%. Hidden within the underlying property cat industry average rate changes, there are some signs of tightening capacity within the retro and facultative markets, but in many case rate levels relative to risk, remain inadequate to deploy additional capital from our perspective. At Arch, we believe that we enhance our odds of doing better than the industry average by allocating capital dynamically to areas with a better risk-reward tradeoff, and that disciplined underwriting and risk selection will remain at the core of what makes us and has made us successful. There is reason to believe that some rate improvement may occur throughout the year as the market absorbs the recent history of large CAT losses. However, uncertainty with respect to both the expected amount of capital and the return on capital within the property CAT market make it difficult to predict where CAT rates will be by year-end 2019. In the interest of time, I'm not going to review market conditions line by line, as I'm sure you have already heard about that on other calls this quarter. but I will instead address the underwriting environment in general. In our P&C segment, segments in some of our insurance lines, rate increases appear to be outpacing claim trends. But, as we have discussed in prior quarters, we continue to believe that the risk of claim inflation rising above its long-term trend is high, and we remain cautious in our allocation of capital and in setting our loss picks. The modest improvements in rates are concentrated primarily in a short-tail, cat-exposed business, in the U.S. commercial auto, and some areas of casualty. As always, we focus on the absolute level of risk-adjusted returns, not just relative rate changes. Turning now to our mortgage segment, the underwriting environment remains very attractive, with ongoing growth in our insurance in force producing strong increases in earned premium and will contribute to a future stream of earnings that is both stable and predictable. For the fourth quarter, our USMI New Insurance Written, or NIW, was $16.7 billion, a 16% increase over the same quarter last year, and the proportion of single premium business remained low at about 9% of NIW this quarter. Within our US primary business, the credit quality of loans insured remains excellent, and our key risk barometers are still at very healthy levels. To put this in historical context, our risk indices tell us that the current borrower's credit characteristics are still substantially higher, in fact, by roughly a factor of two relative to the borrowers of the late 90s and early 2000s. We have seen mortgages with greater than 95 loan-to-value grow slightly as a percentage of our NIW to about 16 percent in the fourth quarter, while credit quality, as indicated by FICO scores, remained high across our enforced book with a weighted average score of 743. As far as the new mortgage risk transfer programs with the GSEs, the so-named IMAGINE and EPMI facilities, we believe that these programs will continue to grow within our expectations, roughly at a modest 2% of total LIW for the market on an annualized basis. Briefly, with respect to our investment operations, higher yields available in the financial markets and growth in invested assets led to a 16% increase in net investment income in the fourth quarter over the same period a year ago. We remain underweight credit and interest rate, reflecting our cautious outlook. Moving to capital management, despite our exposure to PropertyCat in 2018, we were able to deploy some of our capital towards expanding our distribution capabilities deleveraging our debt and repurchasing our shares. As you know, we recently closed on acquisitions in the U.S. and the U.K. that are expected to expand our distribution base. Volatility in the equity markets also gave us opportunities to repurchase approximately $100 million of our common shares in quarters at attractive prices. As in all of our capital allocation processes, we employ a rigorous and disciplined assessment of available opportunities to deploy capital in order to generate long-term returns for our shareholders across all phases of the cycle. Turning now briefly to risk management, for the past few years and continuing into 2019, our property cat exposures remain at historically low levels, with our 1 in 250-year peak zone at about 4.5% of tangible common equity at January 1st. We have the ability and the capacity to deploy more capital to this sector if available returns improve to acceptable levels this year. For our clients and investors, our ability to increase our support in times of need is a significant benefit to the marketplace and a source, we believe, of long-term value creation for our shareholders. In our mortgage segment, our issuance of insurance-linked notes, known as Bellamy securities, have significantly reduced our shareholders' exposure to the tail effects on our business from economic recessions and have paved the way for a significant reduction to our risk profile despite growth in our insurance in force. With regards to PMIRs, as of December 2018, ArchMI's sufficiency ratio was 141% of the GFC capital requirements known as PMIRs, as I mentioned. It also exceeds the proposed GFC revisions under PMIRs 2.0, which is to be effective on March 31st, 2019. With that, I will turn it over to Francois. Francois?

Thank you, Mark, and good morning to all. I'd like to give you some comments and observations on our results for the fourth quarter. Consistent with prior practice, these comments are on a core basis, which corresponds to ARCH's financial results, excluding the other segment, i.e., the operations of Watford REIT. In our filings, the term consolidated includes Watford REIT. After-tax operating income for the quarter was $189.2 million. which translates to an annualized 8.8% operating return on average common equity and 46 cents per share. For the full year, our operating ROE stands at 10.7%, a solid result in light of the elevated catastrophe activity in the second half of 2018, and a pricing environment in the P&C sector that remains competitive. Book value per share was $21.52 on December 31st. a 1.7 percent increase from last quarter, and a 6 percent increase from one year ago, despite the impact of higher interest rates on total returns for the quarter and the year. Moving on to underwriting results, losses from 2018 catastrophic events in the fourth quarter, net of reinsurance recoverables and reinstatement premiums were 118.2 million, or 9.7 combined ratio points. These losses were predominantly the result of Hurricane Michael hitting the Florida Panhandle and the California wildfires, but we also felt the impact of other minor events across the globe. As for prior period net loss reserve development, we recognized approximately $74.4 million of favorable development in the fourth quarter, net of related adjustments, or 6.1 combined ratio points, compared to 4.6 combined ratio points in the fourth quarter of 2017. All segments were favorable, led by the reinsurance segment with approximately $33 million favorable, the mortgage segment also at $33 million favorable, and the insurance segment contributing $8 million. This level is consistent with the third quarter 2018 results as we continue to benefit from significant favorable development in our first lien portfolio in the mortgage segment where cure rates this year continue to be materially higher than long-term averages and expectations. The insurance segment accident quarter combined ratio excluding CATs was 98.3 percent, slightly lower than for the same period one year ago. Most of the improvement came from lower levels of attritional losses and acquisition expenses. The reinsurance segment accident quarter combined ratio excluding CATs stood at 96.2 percent compared to 103.2 percent on the same basis one year ago. As we mentioned on prior calls, we tend to look at trailing 12-month analyses in order to assess the ongoing performance of our segments, given the inherent volatility in the business that can emerge from quarter to quarter. The year-over-year comparison for the reinsurance segment is affected by a few notable items. First, as we mentioned on a previous call, Our acquisition expense ratio last year reflected the federal excise taxes associated with a large internal loss portfolio transfer. Second, our loss experience this quarter was impacted by a large attritional casualty loss arising from the California wildfires. And third, we had a noticeable amount of reinstatement premiums and premium adjustments this quarter that benefited our combined ratios. Once we adjust for these variations, the underlying performance of our reinsurance segment remains strong this quarter. The mortgage segment's accident quarter combined ratio improved by 1,410 basis points from the fourth quarter of last year as a result of the continued strong underlying performance of the book, particularly within our U.S. primary MI operations. The calendar quarter loss ratio of 2.1 percent in the fourth quarter of 2018 compares favorably to the 17.8 percent in the same quarter of 2017 due to substantially lower delinquency rates. Part of the difference is attributable to increased favorable prior development, which was approximately 320 basis points higher than last year. In addition, there was approximately $13 million, or 410 basis points, of favorable development on 2018 delinquencies due to very strong cure activity in the period. The expense ratio was 20.5 percent lower by 160 basis points than in the same period one year ago as a result of expense savings achieved. I'd like to remind everyone that due to the nuances of purchase accounting, the amortization of our DAC asset should continue to increase in 2019 by an amount that is approximately 8 million higher on an annual basis than 2018 levels, increasing acquisition expenses. These results highlight the contribution to our pre-tax underwriting income from the mortgage segment, which remains strong this quarter. After allocating corporate items such as investment income, interest expense, and income taxes to each segment, the mortgage segment's contribution to our 2018 net income decreases to approximately 75 percent of the total after normalizing our results for catastrophic activity. Total investment return for the quarter was a positive 51 basis points on a U.S. dollar basis and a positive 83 basis points on a local currency basis. These returns highlight the defensive, high-quality position of our fixed income portfolio and solid result in our alternatives portfolio in light of a volatile quarter across global financial markets. During the quarter, we continued to move away from municipal bonds and into corporate and government bonds, due to relative valuations. The repositioning of our portfolio during 2018, combined with the reinvestment of shorter maturity bonds and other swap activity at higher yields, generated higher investment income year over year. We extended the duration of our investment portfolio in the quarter to 3.38 years, up from 2.94 years on a sequential basis as global economies weakened. Operating cash flow on a core basis was a strong $384 million in the quarter, reflecting the solid performance of our units. The corporate effective tax rate in the quarter on pre-tax operating income was 16.8 percent and reflects the benefit of the lower U.S. tax rate, the geographic mix of our pre-tax income, and a 210 basis point expense from discrete tax items in the quarter. As a result, the effective tax rate on pre-tax operating income excluding discrete items was 14.7 percent this quarter, higher than the 9.9 percent rate last quarter. The difference from this rate to the numbers noted in our recent pre-release is primarily attributable to discrete items and a higher level of U.S.-based income, which triggered a true-up of tax accruals for the first three quarters of the year. As we look ahead to 2019, we currently believe it's reasonable to expect that the effective tax rate on operating income will be in the range of 11 to 14 percent. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. With respect to capital management, we paid down the remaining $125 million of our revolving credit facility during the quarter and we also repurchased 3.6 million shares at an average price of $27.11 per share and an aggregate cost of $98.2 million under a Rule 10b-5 plan that we implemented during this quarter's closed window period. Our remaining authorization, which expires in December 2019, stood at $164 million at December 31st, 2018. Our debt to total capital ratio stood at 15.5 percent at year end, and debt plus preferred to total capital ratio was 22.5 percent, down 390 basis points from year end 2017, and a full 620 basis points from year end 2016 when we closed the UGC acquisition. Finally, I would like to bring to your attention a change we are introducing in 2019 regarding our incentive compensation practices. As you know, equity grants made to employees had historically been awarded in May of each year. Starting this year, equity grants are expected to be awarded in the first quarter, subject to Board approval. As a result, we would expect a small distortion in the timing of our operating expenses. The impact of this change based on 2018 equity grants is an expected shift of approximately $11 to $13 million in operating expenses from the second quarter to the first quarter of 2019. Two-thirds of that expense is expected to be reflected within our operating segments with the remainder in corporate expenses and investment expenses. With these introductory comments, we are now prepared to take your questions.