Arch Capital Group Ltd.

Good day, ladies and gentlemen, and welcome to the second quarter 2020 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only 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 touch-tone telephone. As a reminder, this conference call is being recorded. Before the company gets started with its updates, 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 risks 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 available on the company's website. I would now like to introduce your host for today's conference, Mr. Mark Randison and Mr. Francois Morin. Sirs, you may begin.

Thanks, Liz. Good morning and welcome to our second quarter earnings call. On a reported basis, ARCH had an acceptable quarter despite COVID-19-related economic disruptions. Our operating results were good from the underlying accident year XCAT combined ratio perspective as each segment that benefited from the recent rate improvements. All three segments are poised to seize the opportunities to grow based on the underwriting returns outlook. Consequently, this quarter, rate improvements continue to enable us to expand our writings in our property casualty units as we increasingly achieved acceptable risk-adjusted returns. We know from experience that this environment is an appropriate time to raise additional capital so that we can more significantly take advantage of this hardening PNC market. As we have discussed in previous earnings calls, we continuously rank order our capital allocation opportunities among and within the units, and today, PNC insurance and reinsurance prospects have moved up the scale, even as MI returns improved at the same time. To be sure, we are experiencing unprecedented times across our world and the insurance industry. There is still much uncertainty from the pandemic and its ultimate impact. The P&C industry faces emerging claims trends, the possibility of long-lasting lower investment returns, and a strain from on-model cap losses and chronic underpricing from the soft market years. This new reality points to the need for further premium rate increases for the foreseeable future. While not all lines are fully attractive on an absolute basis, the positive momentum is evident and has accelerated through the second quarter. Turning to our operating segments, I'd like to begin with the mortgage insurance segments. Reported delinquencies were 5.1% at June 30, 2020, and came in better than our expectation last quarter, which was at the early onset of the COVID-19 pandemic. As you may recall from our call last quarter, given the uncertainty surrounding COVID-19, we were forecasting more pressure on the housing market and a more pessimistic view of the economy than is indicated by the latest delinquency data. As we stand today, we believe that the USMI industry has been benefiting from a combination of solid credit quality of the post-2008 crisis originations, two, favorable supply and demand imbalance in housing inventory, as well as three, strong and swift government intervention to help homeowners. As a result, we're seeing better than expected delinquency rates emerging this quarter, even as rates are at elevated levels, reflecting the recessionary environment. Our current incurred loss view equates to a claim rate slightly above 5% on newly reported delinquencies. While this claim rate is significantly higher than what we have seen from claim rates on the previous hurricane forbearance programs, it is also significantly lower than what the industry experienced in the GFC and reflects the better underlying conditions I mentioned earlier. Because of the current economic conditions, the credit quality of our new insurance-written business, as measured by average FICO scores and loan-to-value, is stronger than a year ago. Mortgage lenders have tightened underwriting standards, and the higher quality of loans originated is a direct benefit to us. We saw record mortgage originations fueled by the historically low mortgage rate, and that has created surges in both refinancing and purchase activities. Its favorable financing environment is supporting home prices. We see prices rising around 5% on an annual basis across the U.S. Despite the weakened economy, we estimate that the mark-to-market homeowners' equity in the vast majority of our policies is in excess of 10%. The level of equity, as a reminder, has proven to be a strong indicator of a borrower's propensity to default, i.e., The higher the equity, the less likely a default will happen in turning to a claim. Turning now to our P&C businesses. First, let's talk about COVID-19, which is affecting many lines at the same time and developing much more slowly than a natural catastrophe. Adding to the uncertainty is the fact that many coverage issues have yet to be resolved. All of this informs how we approached our reserving for COVID-19 within our P&C segments, based on a bottom-up approach to develop our view of ultimate losses. Francois will cover this in more detail in a few minutes. Moving on to the P&C business environment, starting with insurance. We see a growing number of opportunities as net premium written grew 7% in the quarter for the unit, despite the fact that our travel premiums decreased materially due to the pandemic. Excluding travel, our insurance NPW growth would have been approximately 17%. Most of our growth was generated in the E&S casualty, E&S property, professional lines, and especially lines written out of London. About two-thirds of that increase came from exposure growth and the balance from rate. Our overall insurance renewal rate change was plus 8.5% up significantly from plus 5.5% in the first quarter. Earned premium that we wrote at higher rate levels over the last several quarters helped lower our quarterly accident year combined ratio XCAT to 96.1% from 99.4% for the same quarter in 2019. In summary, our insurance group's main mission right now is to grow in those lines where conditions improve enough to allow for an appropriate risk-adjusted return, and the market is allowing this ever more. Over to the reinsurance segment now. We had very strong premiums growth at plus 50%, reflecting ongoing dislocations and improvements in the marketplace. Growth opportunities presented themselves across the vast majority of our business lines. Property cap NPW was up 153%, other properties was up 70%, and casualty was up 35%. Partially upsetting this growth were declines in our mortar quarter share net premium written due to the impacts of COVID-19 exposure decreases. Generally, our reinsurance segment is able to seize on opportunities earlier than our insurance segment. We're also incrementally increasing our capital allocation to our property cash sector. However, our PML usage is still substantially below what we could deploy if return expectations were to get to the levels we saw in 2006. Our reinsurance action quarter combined ratio XCAT improves to 87.5% from 92.2%. over the same period in 2019. This partly reflects our opportunistic underwriting strategy and capital allocation over the last two years, but also is a reflection of the benign attritional loss experience relative to the prior year's quarter. To summarize for our P&C operations, after several years of cycle-managing our portfolio, we are well-positioned to deploy more capital at attractive returns. As we expect our investment returns, our outlook remains cautious as we believe the economic recovery could be slow and take several quarters to develop. Accordingly, underwriting performance should be the driver of earnings for the industry in the near term, which we believe should help sustain the momentum of increasing premium rates. From a capital standpoint, we are in a strong position and we have room to grow with our clients after many years of playing defense. In other words, our core principle, again, of active cycle management exercised by our team has positioned us to move much more aggressively into a growing number of improving lines. Last but not least, we want our shareholders to know that our employees' hard work and our clients' strong relationships over the last three months were critical in getting us through these tough times. And for that, a huge thanks to all of them. With that, Francois, we'll take you through the financials.

Thank you, Mark, and good morning to all. We at Arch hope that you are in good health. On to the second 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 $16.6 million. which translates to an annualized 0.6% operating return on average common equity and 4 cents per share. Book value per share increased to $27.62 on June 30th, up 5.8% from last quarter and 12.1% from one year ago. The increase in the quarter was fueled by the strong recovery in the capital markets. Outside of the losses related to the COVID-19 pandemic, our underwriting groups continued on their path of solid growth and improving results as we benefited from the generally improving property casualty markets. Losses from 2020 catastrophic events in the quarter, including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at $207.2 million, or 13.5 combined ratio points compared to 0.5 combined ratio points in the second quarter of 2019. The losses impacted both our insurance and reinsurance segments and include 173.1 million from the COVID-19 pandemic, as well as 34.1 million for other catastrophic events, including losses related to civil unrest claims across the U.S. The losses we recorded in the quarter for COVID-19 across our P&C operations were split 45% insurance and 55% reinsurance. These loss estimates incorporate additional information that became available during the quarter and represent our current assessment and best estimate of the ultimate losses for occurrences through June 30th. based on policy terms and conditions, including limits, sublimits, and deductibles. We are confident that the approach we took to develop these estimates is conservative and are comfortable with our estimates as they currently stand, but needless to say, we continue to monitor the pandemic and its effects as they play out, and we will adjust our estimates as necessary in the coming quarters. As of June 30th, The vast majority of our COVID-19 claims are yet to be settled or paid, as approximately 90% of the incurred loss amount has been recorded as IBNR, incurred but not reported, reserves, or as additional case reserves within our insurance and reinsurance segments. In the insurance segment, the loss reserves we recorded this quarter for the pandemic were primarily attributable to exposures in our North American unit, across the national accounts, programs, and travel lines of business. In the reinsurance segment, the majority of the losses came from the property catastrophe, accident and health, and trade credit lines of business. As regards the potential impact of COVID-19 on our mortgage segment, it is important to mention that our estimates for our U.S. primary mortgage insurance book are based only on reported delinquencies as of June 30, 2020, as mandated by GAAP. As we discussed on the last call, our expectation at the end of the first quarter was for the delinquency rate to progressively increase throughout the remainder of the year, with a resulting expectation that underwriting income for the overall segment would be minimal for the remainder of 2020. While we did see such an increase in reported delinquencies in the second quarter, the current delinquency rate of 5.14% is approximately 30 to 40% lower than what we expected it would be when we developed our forecast at the end of the first quarter. While that is a positive sign for the ultimate performance of the book, we are also aware that many uncertainties remain. including the rate of conversion from delinquency to cure or claim, which we expect to be different than under more normal conditions. In addition, it is extremely difficult to predict how reported delinquencies and forbearance, which represent approximately two-thirds of total current delinquencies, will behave over time, given the lack of historical data that is directly applicable to the current economic reality which includes elevated unemployment rates, historically low interest rates, solid home price levels, and unprecedented government intervention. As we look towards the remainder of 2020 for our USMI business, in light of the developments we have observed during the second quarter, our current expectation is that pre-tax underwriting income for the remainder of 2020 for the entire mortgage segment will remain positive with a combined ratio in the 70 to 80% range, slightly better than the result we reported this quarter. In summary, while we are still faced with significant economic uncertainty, our expectations for the mortgage segment are definitely more positive than what we thought only a few weeks back. In the insurance segment, net written premium grew 7.1% over the same quarter one year ago, a strong result given the material impact COVID-19 has had on some of our businesses, such as our travel and accident unit. As Mark said, if we exclude this line, the year-over-year growth and net written premium would have been 16.9%. The insurance segment's accident quarter combined ratio excluding cats was 96.1%, lower by 330 basis points from the same period one year ago. Approximately 90 basis points of the difference is due to our lower expense ratio, primarily from the growth in the premium base from one year ago, and reduced levels of travel and entertainment expenses this quarter. The lower ex-cat accident quarter loss ratio primarily reflects the benefits of rate increases achieved over the last 12 months. Prior period net loss reserve development, net of related adjustments, was favorable at 2.1 million, generally consistent with the level recorded in the second quarter of 2019. As for our reinsurance operations, we had strong growth of 50.3% in net written premiums on a year-over-year basis, which 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. The segment's accident quarter combined ratio excluding CAAT stood at 87.5% compared to 92.2% on the same basis one year ago, a 470 basis point reduction. The year-over-year movement is primarily driven by a more normal level of large attritional losses compared to a year ago, which explains approximately 330 basis points of the difference. and the impact of the non-renewal of a large transaction from a year ago, which contributed approximately 50 basis points. Most of the remaining difference is explained by operating expense ratio improvements resulting from the growth in earned premium. Favorable prior period net loss reserve development net of related adjustments was strong at 28.9 million, or six combined ratio points, compared to 3.1 combined ratio points in the second quarter of 2019. The benefit was mostly in short tail lines. The mortgage segment combined ratio was 80.9%, reflecting the increased level of reported delinquencies in the quarter, as mentioned earlier. The loss ratio in the quarter is based on an assumed claim rate on newly reported delinquencies for our USMI book, of slightly above 5% combined with an average expected future claim value or severity that is approximately 50% higher than claims we settled and paid in the quarter. This difference is explained by the fact that the distribution of the newly reported delinquencies carry a higher average outstanding loan balance as a higher proportion is for mortgages from the more recent origination years and from states that have higher loan values, such as California, Florida, and New York. The expense ratio was lowered by 100 basis points over the same quarter one year ago, reflecting lower operating costs, including reduced levels of travel and entertainment expenses. Prior period net loss reserve development was minimal. This quarter had $0.2 million favorable. Total investment return for the quarter was positive 372 basis points on a US dollar basis as the strong recovery in the capital markets produced healthy returns across our entire portfolio. The duration of our investment portfolio remained basically unchanged from the prior quarter at 3.18 years. The effective tax rate on pre-tax operating income resulted in a benefit of 0.9% in the quarter reflecting a change in the full year estimated tax rate, the geographic mix of our pre-tax income, and 110 basis point expense 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. We currently estimate the full year tax rate to be in the 9 to 12 percent range for 2020. Turning briefly to risk management, our natural cap PML on a net basis increased to $832 million as of July 1, which at approximately 8% of tangible common equity remains well below our internal limits at the single event 1 in 250-year return level. The growth in the PML this quarter is attributable to both E&S property within our insurance segment and property lines within our reinsurance segment, reflecting our ability to deploy more capacity to opportunities that safely exceeded our return thresholds, some of which were slightly tempered by additional reinsurance purchases. As you know, we issued $1 billion of 30-year senior notes at the end of the second quarter, enhancing our capital base and furthering our objective of maintaining a strong and liquid balance sheet. Our debt plus preferred leverage ratio of 23.8%, remains within a reasonable range. As discussed on the prior call, we paused our share repurchase activity since the start of the pandemic, and we do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remains strong with our PMIR sufficiency ratio at 161% at the end of June, which reflects the coverage afforded by your Bellamy Mortgage Insurance Link notes. In late June, we were able to obtain $528 million of coverage on our enforced book for the second half of 2019. Our ability to execute this transaction highlights the credit quality of our enforced book and further protects our balance sheet should an extreme sale event materialize. The Bellamy structures provide approximately $3.1 billion of aggregate reinsurance coverage at June 30, 2020. With these introductory comments, we are now prepared to take your questions.