Arch Capital Group Ltd.

Good day, ladies and gentlemen, and welcome to the third quarter 2020 Arch Capital Group earnings 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 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 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 gap 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 Grandison and Mr. Francois Morin. Sirs, you may begin.

Good morning, Liz, and welcome to our third quarter earnings call on Halloween Eve. You're in for a treat. In our results, you can see tangible evidence of the advantages of the ARCH model. By protecting our capital during the soft market years, we are well positioned as each of our segments leans into improving market conditions. Our underwriters are making the most of the hardening property and casualty market, while our mortgage insurance segment is benefiting from record mortgage origination activity this quarter. This year, for the first time in nearly a decade, We've been able to grow significantly and deploy more capital in our P&C businesses that provide acceptable expected returns. And due to our strong financial position, we have accomplished this while maintaining a strong presence in MI, which continues to deliver meaningful returns. Our ability to continually rebalance capital amongst our diverse businesses enhances our total underwriting returns. It also should decrease earnings volatility over time. Since our inception, we have believed in cycle management, and this strategy brings an added margin of safety to our collective underwriting activity. Allow me to elaborate on our third quarter results by touching on three key themes. One, growth. Two, margin improvement. And three, capital allocation. First, Let's talk about growth. In this quarter, net written premiums in our PNC units grew 25% in total, 17% in insurance and 38% in reinsurance over the same period a year ago. This growth was driven by rate improvements, but also reflects our ability to increase our participations where clients needed additional capacity. In the insurance segment, we continue to obtain strong rate increases in areas like property, DNO, and casualty. Group-wide, our rate increase for the third quarter averaged over 11%, and we believe this trend of increasing rates should continue through 2021. At Arch, we have always followed a simple rule. Our participation in the business should follow the direction of premium rates. As rates improve, We write more business. When rates decrease, as they did over the past several years, we write less. This strategy takes courage. You will often appear an outlier to the market, but being intellectually honest, disciplined, and applying our cycle management techniques is what we're all about at Arch. Obviously, the P&C market is broad, and all opportunities are not created equal. There are areas, such as workers' comp, where premium rates or conditions are not improving to the levels we believe are needed for an adequate return, and in those instances, we manage our appetite accordingly. Despite headwinds from the pandemic, our growth in insurance lines like E&S property, casualty, and professional lines are a great example of our platform's ability to flex into improved underwriting conditions. Our reinsurance unit has been able to lean into this hardening market both earlier and with more vigor than our primary operations. There are two main reasons for this. First, when a market transitions, needed rate increases compound up the insurance supply chain. Reinsurance is often a leading indicator of what's to come more broadly. Second, reinsurance can provide capacity quicker and in larger amounts, since it can put capital to work through clients' platforms. Of course, sheer growth is only one part of the equation of growing returns. Let's turn now to margin improvement. We all know that, mathematically, rate increases in excess of lost trends lead to margin improvement. The marketplace seems to be supporting the momentum of continued rate increases. We are in the early stages of seeing the benefits of rate-on-rate increases in our operating results. Simply stated, adding the two parts, growth and margin, will lead to better returns. Many factors are driving today's P&C markets. These include elevated natural cash loss activity in each of the past four years, weakened reserve positions from soft market years, lower investment yields, and a rising claim inflation. Add in a global pandemic that is still ongoing, and it's not surprising that market conditions are changing. Now, pivoting to MI. Our $33 billion of NIW in the U.S. in the quarter was a record for ARCH. Low interest rates are producing huge refinance activity and, unsurprisingly, some churn in our in-force business. However, MI premium rates remain above pre-COVID levels, and the continued high credit quality of borrowers is generally better than it was pre-pandemic. We continue to face uncertainties, such as the economy's health and how the pandemic may ultimately affect individual borrowers. However, we are optimistic that, among other positive factors, recent trends in the U.S. housing market will mitigate the effects of the pandemic. Finally, ARCH's ability and willingness to allocate and manage capital remains a key competitive advantage. We always think about balancing our capital deployment over five pillars into the insurance, reinsurance, MI, into our investment portfolio, and lastly, into our stock repurchase. Our job is to optimize risk-adjusted returns through capital allocation across these pillars. We see managing the five pillars being similar to coaching a basketball team. We're constantly looking at how we can distribute the ball, i.e., our capital, to the right players. For the past several years, we've been able to feed the big 7'7 MI guy down low and rely on him to get easy dunks. Now, as the playing field, i.e., the market, changes, we've adjusted our tactics slightly and are increasingly relying on our two hot shooters, reinsurance and insurance. MI will still score its fair share of points, but the PNC players are getting more open three-point looks and layups. In short, our game is becoming more complete and diversified. Our ability to adapt to the new conditions is what makes us stronger as a team. The market dynamics take me back in time. We have talked about Paul Ingray's underwriting clock that helps track and measure the phases of the insurance cycle. It's been central to our management philosophy since the beginning and is a helpful reference to understand the underwriting life cycle and assist us in gouging our risk appetite. I recently asked our underwriting teams where we were on the Ingray clock and the most common response was around 8 o'clock. If you take a look at the clock in our most recent annual report, you'll see that it's a very nice time to be at ARCH. There's a buzz among our underwriters because we've become the first call for so many of our clients. They know that we have the capacity, the expertise, and the desire to serve them. Now, I'll turn the coach's whistle over to Francois as he goes into more detail on our quarterly results, and I look forward to responding to your questions afterwards. Francois?

Thank you, Mark, and good morning to all. We at ARCH hope that you are in good health. On to the third 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 $120.3 million, which translates to an annualized 4.2% operating return on average common equity and 29 cents per share. Book value per share increased to $28.75 at September 30th, up 4.1% from last quarter and 12.2% from one year ago. The increase in the quarter was fueled by the continued strong performance of our investment portfolio and good underwriting results, taking into consideration the elevated catastrophe activity in the quarter and the uncertainty surrounding the current pandemic. Our property casualty teams continued on their path of solid growth and improved performance as we continue to see strong positive pricing momentum in their markets. Losses from 2020 catastrophic events in the quarter, including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at 203.3 million or 12.5 combined ratio points compared to 5.2 combined ratio points in the third quarter of 2019. The losses impacted both our insurance and reinsurance segments and include 191.4 million from a series of natural catastrophes in the quarter, including Hurricanes Isaias, Laura, and Sally, the Midwestern derecho, California wildfires, and other smaller events, as well as 11.9 million for losses related to the COVID-19 pandemic. The COVID-19 losses we recorded in the quarter were small, reflecting additional information that became available during the quarter, and represent our current assessment and best estimate of the ultimate losses for occurrences through September 30, based on policy terms and conditions, including limits, sublimits, and deductibles. As of September 30th, the vast majority of our COVID-19 claims are yet to be settled or paid, with close to 80% of the inception-to-date incurred loss amount recorded as incurred but not reported, i.e., IBNR reserves, or as additional case reserves within our insurance and reinsurance segments. As regards the potential impact of COVID-19 on our mortgage segment, we note that the delinquency rate at the end of the quarter was 4.69%, down from 5.14% at June 30th. Our current expectation is that the delinquency rate should be in the 5 to 5.5% range at year-end 2020. While we have seen many positive signs over the last few months that point us to a more favorable view of the ultimate performance of the USMI book, many of the uncertainties we identified on our last call remain. In particular, the potential impact from a second wave of infections, potential lockdowns, and the lack of an additional fiscal stimulus package or risk factors that we continue to monitor and evaluate on an ongoing basis. For these reasons, and consistent with our corporate reserving philosophy, we believe it is prudent to take a cautious approach in setting loss reserves across our MI book. In the insurance segment, net written premium grew 17.1% over the same quarter one year ago, a strong result demonstrating our ability to achieve profitable growth in this environment. Adjusting for the net written premium decrease observed in our travel, accident, and health unit, the year-over-year growth in net written premium would have been 26.5%. The insurance segment's accident quarter combined ratio, excluding CATs, was 94.1%, lower by 620 basis points from the same period one year ago. Approximately 300 basis points of the difference is due to a 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 XCAT accident quarter loss ratio reflects mixed change and the benefits of rate increases achieved over the last 12 months. Prior period net loss reserve development net of related adjustments was favorable at 1.1 million generally consistent with the level recorded in the third quarter of 2019. As for our reinsurance operations, we had strong growth of 38.4 percent 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 corridor combined ratio excluding CAATs stood at 83.1 percent compared to 92.8 percent on the same basis one year ago. The year-over-year movement is primarily driven by a more normal level of large attritional losses compared to a year ago and rate change activity over the last 12 months. Most of the remaining difference is explained by operating expense ratio improvements primarily resulting from the growth in earned premium. Favorable prior period net loss of the reserve development net of related adjustments was 40.8 million or 7.4 combined ratio points compared to 4.0 combined ratio points in the third quarter of 2019. The development was mostly in short tail lines. The mortgage industry had a record-breaking quarter in terms of NIW and we certainly followed suit with this quarter's NIW of $32.8 billion, a full 30 percent higher than our prior high watermark. Offsetting this record-level production was the high level of refinancing activity across our portfolio, with the net result being a slight reduction in our insurance and force. The combined ratio was 64.2 percent, reflecting the lower delinquency rate observed during the quarter. The trends we saw this quarter were favorable relative to last quarter, but the game is far from over. The expense ratio was slightly lower over the same quarter one year ago, and prior period net loss reserve development was favorable at 4.5 million this quarter. Total investment return for the quarter was positive 230 basis points on the U.S. dollar basis, as the strong recovery in the capital markets produced healthy returns across our entire portfolio. Returns in our equity and alternative investments contributed approximately 40% of the total return for the quarter. The duration of our investment portfolio remained basically unchanged from the prior quarter at 3.21 years. The effective tax rate on pre-tax operating income was 4.8% in the quarter, reflecting a change in the full-year estimated tax rate, the geographic mix of our pre-tax income, and a 10 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. We currently estimate the full-year tax rate to be in the 8 to 10 percent range for 2020. Turning briefly to risk management, our natural cap PML on a net basis increased to $918 million as of October 1, which at approximately 8.4% of tangible common equity remains well below our internal limits at the single event one and 250-year return level. The growth in the PML this quarter is attributable to our E&S property unit within the insurance segment, which increased its writings in an improving marketplace. On the capital front, The increase in interest expense this quarter was mainly the result of the issuance of the $1 billion senior notes we issued in June 2020. So far, we have been able to fund our recent growth with our existing capital base, and our balance sheet remains strong with a debt plus preferred leverage ratio of 23.1% that remains well within a reasonable range. As for our USMI operations, The mortgage insurance-linked notes market has recovered to a great extent from the lows we saw at the onset of the pandemic. Earlier this week, we priced our third Bellamy transaction of the year at terms that are getting closer to what we saw in 2019, both in structure and price. Our latest transaction will provide 6.5% of coverage in excess of a 2.5% attachment point, both expressed as a percentage of the risk and force. Including this transaction, the Bellamy structures currently provide approximately $3.9 billion of aggregate reinsurance coverage. The fact that this market has recovered as extensively as it has in just over seven months, with investors more and more comfortable with the exposure they are assuming, is quite telling and provides support to our current assessment of the health of the U.S. housing market. With these introductory comments, we are now prepared to take your questions.