Arch Capital Group Ltd.

Good day, ladies and gentlemen, and welcome to the Arch Capital Group's first 2020 earnings conference call. At this time, all participants are in a listening mode. Later, we will go to the 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 its 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 their 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 for looking statements within the meaning of the private securities litigation reform back in 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 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. Sorry to meet you again.

Thank you, Shannon, and good morning to you. It would not be an understatement to say that the coronavirus has changed the world since our last call with you just three months ago. Fortunately, at Arch, we are entering this period with investments we have made in our PNC business beginning to pay off, while our mortgage group navigates through the current turbulence. If you work long enough in the insurance business, like I have, you are bound to experience the industry cycle, its highs and its lows. As management, we have to keep our eye on the goal, which for Arch is generating sustainable growth in book value per share. The current stress in the financial and insurance markets reminds us of changes that can occur to which we need to adapt. While we are still early, In the assessment of our direct and indirect claims exposure to the coronavirus, it is clear that this event will be a significant industry loss and will result in profound changes. However, this location often leads to opportunities. As you know, one of ARCH's strategic principles from inception has been cycle management. We are embarking in this new market environment with both a strong financial foundation and and the creative ability of our more than 4,200 employees that position us for the opportunities that will emerge. Turning to the quarter, we saw improving conditions in our P&C businesses while our mortgage operations continued to produce good results. Strengthening P&C market conditions remain evident even as the economy contracts. We have seen a rise in our submission activity along with accelerating rate increases across multiple lines of business in Q1, and it is continuing here in Q2. Our belief in the continuing hardening of the P&C market is due to the need our industry has to address the accumulation of risk factors over the last five years of soft market conditions. These risk elements are, one, future claims and coverage litigation related to COVID-19. Two, a heightened perception of risk in general. Three, economic uncertainty. Four, a continuation of low interest rates and their dampening effect on investment returns. Five, a potential for shortfalls in casualty reserves. And six, reduced availability of retro and alternative capital in general. These risk elements are all in play today and are likely to lead insurance companies to be more cautious in allocating capital to risk. In our insurance group, our strategy remains to be selective and pick our spots in this improving market. The rising rates, environment, and dislocation in the markets have allowed us to grow profitably in the past two years in many sectors such as ENS property, DNO, and ENS casualty. On a reported basis, we saw our margins improve this current quarter as our accident combined ratio XCAT or COVID and PYD improved to 97%. In our reinsurance business, pricing is also improving, and we continue to observe tightening of terms and conditions in many lines. The value of reinsurance as a capital protection tool has been enhanced by the recent events. The hallmark of our reinsurance group remains the dynamic allocation of capital to contracts that will provide appropriate risk-adjusted returns while helping clients with solutions that are tailored to their needs and was a large factor in our growth this quarter. Switching now to our mortgage insurance segment. The industry is facing its first significant test since the fundamental reforms and product improvements that were adopted following the Global Financial Crisis, or GFC. As you know, ArchMI is a data and analytics-driven company, and our investment in the sector was predicated on a new and better MI operating model than the industry employed prior to 2008. Now, pricing is more precise. Products and documentation are better, and the MI industry buys protection against downsides. In addition, another change in the industry can be seen in the aggressive government actions taken in the early stages of the pandemic directed at helping borrowers stay in their homes. The GST's forbearance program and the unemployment benefits programs provide unprecedented support that should enable borrowers to cure delinquencies as the economy improves and will result in fewer losses. As noted in our quarterly hammer report, the MI industry is far better positioned for recession than they were In 2008, at that time, mortgage insurance portfolios were facing a housing market that was significantly overbuilt. Risky mortgage products and less credit-worthy borrowers. More than two-thirds of mortgage insurance written in 2007 would have been uninsurable during the last 10 years. And finally, there was a speculative bubble in home prices. Mortgages filed under the FHFA's forbearance programs were estimated at 5.85% of the GST mortgages as of April 26. This program allows homeowners to suspend mortgage payments for six months, which can then be extended for up to another six months. While initially recorded as delinquencies under GAAP, our data on forbearance programs utilized in recent natural catastrophes indicate that almost all of these loans cure by providing borrowers time to return to work. Over the next few quarters, rising delinquency rates under GAAP should lead to elevated loss ratios in the MI segment. Furthermore, once the forbearance programs expire, the GFCs have instituted a sturdy list of remedial solutions that, once again, will enable loans to be back-performing. We realize that this pandemic-led recession will be different than a GFC, but based on what we can see today, our view, is this is an earnings, not a capital event for ARCH. It is worth noting again that even if this recession is worse than we currently expect, we hold significant reinsurance protection on our risk and force that would moderate our net losses even in a more severe recession. While some of our reinsurance is quarter share and attaches at first dollar loss, the index links note that from our Bellmeach securizations would provide up to an additional $3 billion of excess of loss protection if this becomes a recession worse than what the industry experienced in the GFC. Lastly, turning to our investment operations, we believe that interest rates are likely to stay at historically low levels for the foreseeable future and that will, over time, require insurers to improve their underwriting margins through price increases. In our investment strategy, as in our underwriting approach, we have maintained our focus on risk-adjusted total return which enabled us to avoid much of the negative impact of the pandemic on our investments this quarter. As perception of risk increases, so does the cost of capital, and underwriting discipline becomes important again. Recent world events remind us that risk is always present, that insurance premiums must include an adequate margin of safety, and that reinsurance plays an important role in protecting capital and returns. In summary, true to ARCH's cycle and risk management principles and fortified by our conservative balance sheet, ARCH is prepared for this crisis and is well positioned to continue to build on its track record of book value growth. In closing, I want to thank all of our employees around the world as they are responsible for the success of ARCH and are working tirelessly throughout the world to meet the needs of our insurers. Thank you. With that, I'll turn the call over to Francois.

Thank you, Mark, and good morning to all. We at ARCH hope that you are in good health in these difficult and uncertain times. This quarter, in anticipation of some of the questions you may have, I will try to elaborate in more detail on some notable items in addition to the regular discussion of financial items. I recognize this may take a bit longer than usual, so please bear with me. Now on to the first quarter results. As a reminder, and consistent with prior practice, the following comments are on a core basis, which corresponds to ARCH's financial results, excluding the other segment, i.e., the operations of Watford Holdings Limited. In our filings, the term consolidated includes Watford. After tax operating income for the quarter was $189.8 million, which translates to an annualized 7.1% operating return on average common equity and 46 cents per share. Book value per share decreased to $26.10 at March 31st, a slight reduction of 1.2% from last quarter and a 12.9% increase from one year ago. The defensive posture of our investment portfolio ahead of the COVID-19 crisis served us extremely well in preserving our capital base relatively intact during the stressed economic environment of recent months. I will elaborate on this in more detail later on. Outside of the losses related to the COVID-19 pandemic, which impacted on our first quarter results, our underwriting groups fared very well this quarter with strong growth and generally improving underwriting results for our property casualty insurance and reinsurance operations. Given the unusual circumstances and breadth of the pandemic, we have classified COVID-19 losses as a catastrophe. However, as you saw in the financial supplement, we have also provided the segment-level detail of our current estimates to assist with the analysis of the underlying performance of our book of business. We expect to follow this approach until the end of 2020 at a minimum. Losses from 2020 catastrophic events in the quarter, not including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at 31.8 million or 2.0 combined ratio points compared to 0.6 combined ratio points in the first quarter of 2019. The losses impacted both our insurance and reinsurance segments and were primarily due to various U.S. severe convective storms, UK storms and floods, and Australian bushfires. We recorded approximately 87 million of COVID-19 losses across our PNC operations, split 41% to insurance and 59% to reinsurance. While it is still very early and we have extremely limited information to accurately quantify our potential exposure to the pandemic, We believe it was prudent to establish a certain level of IBNR reserves for occurrences through March 31st, based on policy terms and conditions, including limits, sublimits, and deductibles. These reserves were recorded across a limited number of lines of business, such as property, where we have a very small number of policies that do not contain a specific pandemic exclusion. and or explicitly afford business interruption coverage under a pandemic, and trade credit. As regards the potential impact of COVID-19 on our mortgage segment and our estimation process at this time, we believe it's important to make a distinction between our U.S. primary mortgage insurance unit, which we refer to as USMI, and the rest of the segment, which includes our international book and our portfolio of GSC credit risk transfer policies. For USMI, pursuant to GAAP, our estimates are based only on reported delinquencies as of March 31, 2020. However, given the potential effect of the pandemic, we elected to book reserves at a higher level of confidence within a range of reserve estimates for such known delinquencies. The financial impact of this increased level of conservatism was approximately 5.2 loss ratio points across the segments. For the rest of the segment, the loss-reserving approach we use is more consistent with traditional property casualty techniques, where loss ratio picks are set at the policy level and are able to consider future delinquencies on business already earned. This quarter, in response to the potential impact from the pandemic across our portfolio, we adjusted our loss ratio picks for some policies, which resulted in an increase of 6.8 loss ratio points to the overall segment result. Based on the information known to date and economic forecasts, we believe the adjustment across a non-USMI book is prudent and consistent with a moderately severe stress level. As we look towards the remainder of 2020 for our USMI unit, we are expecting the delinquency rate to increase progressively from the current level as more borrowers request forbearance on their mortgage loans under the CARES Act. As mandated by GAAP, we expect to record loss reserves on these delinquencies, which will most likely translate into an increase in our levels of incurred losses over the coming quarters. Over time, we would expect many of these delinquencies to cure and revert back to performing loans as the economy returns to a more normal state. At this time, we do not have enough visibility to predictably forecast the rate at which forbearance delinquencies will be reported to us, cure, or ultimately turn into claims on an annual, let alone a quarterly basis. That said, based on our current analysis, which tells us that the pandemic will represent an earnings event for our mortgage segment and not a capital event, our current expectation is that our pre-tax underwriting income for the entire mortgage segment will be minimal for the remainder of 2020, i.e., from the second through the fourth quarter of 2020. However, there is likely to be variability in underwriting income between quarters based on the timing of receipt of notice of defaults. Turning to prior period net loss reserve development, we recognize 17.8 million of favorable developments in the first quarter, net of related adjustments, or 1.1 combined ratio points compared to three combined ratio points in the first quarter of 2019. All three of our segments experienced favorable development at $0.8 million, $11 million, and $6.1 million for the insurance, reinsurance, and mortgage segments, respectively. We had excellent net written premium growth in the insurance segment of 33.4% over the same quarter one year ago. The insurance segment's accident quarter combined ratio, excluding caps, which as a reminder include COVID-19 losses, was 97.1%, lower by 310 basis points from the same period one year ago. Approximately 190 basis points of the difference is due to a lower expense ratio, primarily from the growth in the premium base over one year ago. The lower XCAT accident quarter loss ratio primarily reflects the benefits of rate increases achieved throughout most of 2019 and the first quarter of 2020. As for our reinsurance operations, we had a significant transaction in the quarter which affected the comparability of our underwriting results, an $88 million lost portfolio transfer written and fully earned in the period in the other specialty line of business. Absent this transaction, net premiums written would have been 57.2% higher than the same quarter one year ago. This net written premium growth was observed across most of our lines and includes a combination of new business opportunities, rate increases, and the integration of the Barbican reinsurance business. While the lost portfolio transfer had a minimal impact on the overall combined ratio for the segment, a decrease of approximately 50 basis points, Its impact on each of the loss and expense ratio components was more observable with a resulting increase of 400 basis points to the loss ratio and a decrease of 450 basis points to the expense ratio. Overall, the growth and underlying performance of our reinsurance segment was very good this quarter. The mortgage segment's combined ratio was at 44.1%. including the 12-point loss ratio impact resulting from the increased level of conservatism in our overall segment reserve estimates discussed earlier. The expense ratio was higher by 240 basis points over the same quarter one year ago, reflecting reductions in profit commissions on seeded business and higher compensation costs and employee benefits. Total investment return for the quarter was negative 80 basis points on a US dollar basis as the defensive positioning of our portfolio served us extremely well in this difficult period. Given some of our fund investments are reported on a lag, typically three months, their first quarter performance will be included in our second quarter financials. The duration of our investment portfolio was slightly more than last quarter. at 3.19 years compared to 3.40 years at December 31st, but remain overweight relative to our target allocation by approximately 0.35 years. Most financial markets had a positive return in April, which should help reverse some of the results we observed in the first quarter. The effective tax rate in the quarter on pre-tax operating income was 10.5%, and reflects the geographic mix of our pre-tax income and a 110 basis point benefit from discrete tax items in the quarter. 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. Turning briefly to risk management, our natural cap PML on a net basis increased to $680 million as of April 1, which at approximately 7% of tangible common equity remains well below our internal limits at the single event one and 250-year return level. With respect to capital management, we remain committed to maintaining a strong and liquid balance sheet. During the quarter, we repurchased approximately 2.6 million shares at an aggregate cost of 75.5 million. While we have a meaningful remaining share authorization under our current program, We do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remains strong with our PMI or sufficiency ratio at 165% at the end of March 31, 2020, which reflects the coverage afforded by your Bellamy Mortgage Insurance Link notes. These structures provide approximately $3.1 billion of aggregate reinsurance coverage as of March 31, 2020. Finally, to echo Mark's comments, I'd like to give a special shout out to our more than 4,000 colleagues around the world that have demonstrated a tremendous amount of creativity, patience, resilience, and compassion with clients and business partners, the communities they live in, their families and loved ones, and each other over the last seven plus weeks. They are the essence of what ARCH is all about. And I couldn't be prouder to be part of such a great team of individuals. Thank you. With these introductory comments, we are now prepared to take your questions.