Arch Capital Group Ltd.

Good day, ladies and gentlemen, and welcome to the fourth 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 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 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.

Thank you, Liz. Good morning and welcome to our fourth quarter earnings call. Overall, we are pleased. with the current market conditions and the opportunities available to ARCH as we close out 2020 and spring into 2021. One of our fundamental principles is that achieving growth and book value per share above the cost of capital over the long run is the best way to create and sustain shareholder value. We believe we delivered on that front in 2020. Our disciplined underwriting and diversified business model enabled ARCH to grow its year-end book value per share by 5.4% over the third quarter and by 14.7% for the last 12 months. We responded to broadly hardening market conditions and, as a result, all three of our segments grew their premium writings in a quarter. In particular, the hardening markets allowed for significant growth within our P&C units, increasing our net premium written for the P&C by 32% for the full year. On the whole, for 2020, we achieved an operating profit of $557 million and grew book value to $30.31 per share. Now, as most of you know, cycle management is core to who we are. ARCH leans strongly into improving markets because history has shown that times like these are when superior risk-adjusted returns gradually compound and accelerate book value growth. And ARCH is positioned to significantly expand as others de-risk, rethink their underwriting strategies, or even retrench. As we look at the opportunities ahead for ARCH, I'm reminded of a situation in hockey that is exciting for any fan. In hockey, you get a one player advantage if the other team takes a penalty. It's called a power play. When that happens, a few things need to be kept in mind as you deploy your specialty power play unit to try and improve the odds of scoring. You need to have a clear five-on-four strategy. You need to be defensively savvy enough to not forget to protect your own zone. And you need to have a sense of urgency because the clock will tick down and you will soon be back to even strength. These are the few moments that make a difference in a hockey game. The advantageous position we find ourselves in is similar to that hockey power play where the odds are in our favor. I'm proud of how our team performed last year. during the challenges of 2020. Now, after spending a good portion of the last several years in a defensive position, we're embracing a more offensive mindset. Here's what that looked like in the fourth quarter. Let's begin with our insurance segment. Across our worldwide insurance group, renewal rate changes increased approximately 12%, up 200 bps from the prior quarter's rate changes. Our fourth quarter growth occurred in many lines, with D&O, property, energy, and marine all exhibiting strong advances. E&S casualty and our alternative markets business also grew this quarter. We believe that rate momentum in these lines is healthy, and we also see it building in other lines, albeit at a slower pace. Increasing margins helped improve our insurance accident year XCAT loss ratio, which decreased by 4.6 percentage points in the fourth quarter. As you may know, the full effects of increased rate levels can take approximately five quarters to become fully reflected in underwriting margins, so today we are earning the higher rates from the past year. In addition, our operating expense ratio has benefited from rising production this past year. We are pleased with the continuing progress achieved by our insurance group in the last two years. Turning next to our reinsurance segment. Underwriting results were significantly better than the fourth quarter of 2019, despite the impact of $94 million worth of cap losses. While market conditions are not uniformly strong in the reinsurance sector, dislocation from other carriers that are reducing their positions is creating pockets with hardening rates that ARCH is well positioned to capitalize on. Reinsurance also benefits from the underlying insurance market rate increases through its clients. For 2020, we grew reinsurance net written premium by 53% with the two main areas of growth being non-cap property and specialty. At the January 2021 renewals, we saw continued rate increases in most areas. However, we agree with the market consensus that property cap pricing moves were more subdued than expected or hoped as capacity for that risk still remains strong. we maintain a cautious approach to this business. Our mortgage segment delivered good returns in both the fourth quarter and for the entire year, despite the economic headwinds. We are confident in the continued earnings strength of this segment, and frankly, the uncertainty we were facing during the early stages of COVID has been largely mitigated. Both premium rates and the credit quality of the new insurance written improved in 2020, And accordingly, the return on capital for our new USMI business is essentially back to 2018 level, which was a strong year. Here's why MI has done well this past year. First, housing markets have remained strong despite the difficult economic conditions. Second, the government forbearance program achieved largely what it was intended to do, which was to provide financial respite to many homeowners. And third, Credit criteria in the mortgage sector tightened in 2020, and as you know, credit quality is a critical factor in determining underwriting profitability. On a side note, just yesterday the FHFA announced that the forbearance program has been extended an additional three months, which should help further mitigate the risk in our delinquency inventory. The delinquency rate of our portfolio decreased by 50 bps sequentially in the fourth quarter, At year-end, roughly two-thirds of our delinquent loans were in the government-sponsored forbearance program. We currently estimate that 89% of delinquent borrowers in our portfolio at year-end have at least 10% equity in their homes. And as we have discussed on prior calls, the amount of equity in a home is a single most important factor in determining MI losses as it plays a significant role in mitigating claim activity. We are cautiously optimistic that delinquencies will continue to cure as vaccines enable the economies to reopen. Importantly, record home purchases in the U.S. in 2020 supported a 5% price appreciation nationwide, while historically low interest rates accelerated housing and refinance demand. This enabled ArchUS to report record NIW of $38 billion in the fourth quarter of 2020, up nearly 60%. from the same period in 2019. Our outlook for continued growth in 2021 remains positive. Turning back to the current phase of the PNC cycle, there are three conditions that we believe will persist and help sustain the improved underwriting environment. One, social inflation and reserving problems are now starting to apply pressure for companies that haven't been prudent enough. Two, anemic investment yields require a sharper focus on underwriting profit. And three, a return to a post-COVID world should accelerate economic activity and increase the demand for insurance. Each of these conditions will put pressure on results for the industry. Our conservative approach to reserving over the past several years means that we are well positioned to drive results in P&C going forward since we expect our future returns to better reflect current and forward pricing. Finally, with better visibility into the overall economic conditions, and with more clarity on the mortgage and P&C prospects, along with our strong capital generation, we see a compelling opportunity to invest in our shares at very attractive returns. Franco will talk to it in a moment. This recent share repurchase is a testament to our capital strategy and designed to enhance shareholder value over the long term. we still have ample resources to deploy towards new growth and feel confident in our team's ability to be creative in order to capitalize on the opportunities before us. This is a time in the game where our cycle management strategy allows us to play offense and deploy capital dynamically to generate above-average returns. And now I'll turn the game commentary over to Francois.

Thank you, Mark, and good morning to all. We at ARCH hope that you are in good health and that 2021 is off to a good start. On to the fourth 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 $230.4 million, which translates to an annualized 7.7% operating return on average common equity and $0.56 per share. For the year, her operating return on average common equity stood at 4.8%, while her return on average common equity stood at 11.8%. Book value per share increased to $30.31 at December 31st, up 5.4 percent from last quarter and 14.7 percent from one year ago. Again, an excellent result despite the strong headwinds from catastrophe losses this year, which is a testament to the resilience of our operations and our superior diversification strategy. Losses from 2020 catastrophic events in the quarter including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at 156.4 million, or 9.4 combined ratio points, compared to 2.2 combined ratio points in the fourth quarter of 2019. The losses impacted both our insurance and reinsurance segments, primarily as a result of a series of natural catastrophes in the quarter, including hurricanes Delta and Zeta, and other smaller events, as well as adjustments to our estimates for events that occurred earlier in 2020. Our best estimate of ultimate losses for COVID-19 for occurrences through December 31 remained essentially unchanged from prior estimates. As of December 31st, the vast majority of our COVID-19 claims are yet to be settled or paid, with approximately two-thirds of the inception to date incurred loss amount recorded as incurred but not reported, IB&R reserves, or as additional case reserves within our insurance and reinsurance segments. As regards the potential impact of COVID-19 on our mortgage segment, as Mark alluded to, the delinquency rate at the end of the quarter was 4.19%, down from 4.69% at September 30th. We are encouraged with a downward trend in delinquency rates over the last few quarters, which continue to come in significantly better than our earlier forecasts. Our latest assessment of the situation assumes a progressively improving economy in 2021, which should bode well for the housing sector and the performance of our book as we move forward. In the insurance segment, net written premium grew 21.6% over the same quarter one year ago, 29.6% if we exclude the impact of the pandemic on our travel, accident, and health unit. The insurance segment's accident quarter combined ratio excluding CATs was 93.6%, lower by 800 basis points over the same period one year ago. Approximately 360 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 continued lower levels of travel and entertainment expenses. The lower ex-cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business. Prior period net loss reserve development, net of related adjustments was favorable at $1.2 million. As for our reinsurance operations, We had strong growth of 44.9 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 CATS stood at 82.1 percent compared to 92.3 percent on the same basis one year ago. The year-over-year movement is primarily driven by rate change activity over the last 12 months and a more normal level of large attritional losses compared to a year ago. 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 reserve development net of related adjustments was 40.5 million or 6.9 combined ratio points, compared to 4.9 combined ratio points in the fourth quarter of 2019. The development was mostly in short tail lines. The mortgage industry had a second consecutive record-breaking quarter in terms of mortgage originations, which allowed ArchMI to produce $38 billion of NIW in the fourth quarter, a full 15.9% higher than our prior high watermark. With refinance activity leveling off from prior peaks, we saw our insurance and force increase by 2.5% across the mortgage segment. The combined ratio was 45.1%, reflecting the lower level of new delinquencies reporting during the quarter. The expense ratio was slightly lower over the same quarter over one year ago, and prior period net loss reserve development was favorable at 8.2 million this quarter, mostly from our second lean runoff portfolios. Improving investor sentiment enabled Arch to issue two Bellamy transactions during the fourth quarter at terms that are getting closer to pre-pandemic levels. You will recall that we discussed our 2020-3 transaction on the last call, an on-the-run deal covering our production from June through August of 2020. Our latest transaction, Bellamy 2020-4, provides additional protection on mortgages we insured in the second half of 2019 and already covered by our 2020-1 Bellamy transaction by effectively reducing the original retention from 7.5% to 1.85% of the risk and force. At EREN, The Bellamy structure has provided approximately $4 billion of aggregate reinsurance coverage. Total investment return for the quarter was positive 246 basis points on a U.S. dollar basis, and we ended the year with our investment portfolio producing a 7.77% total return. While our fixed income portfolio generated an excellent return of 188 bps in the quarter, Contributions from our equity and alternative investments were also significant and represented approximately 40 percent of the total return for the quarter. The duration of our investment portfolio decreased modestly to 3.01 years at year end, reflecting our ongoing positioning of the portfolio towards shorter-term maturities. The effective tax rate on pre-tax operating income was 6.8 percent in the quarter, reflecting changes in the full-year estimated tax rate, the geographic mix of our pre-tax income, and a benefit from discrete tax items in the quarter. We currently estimate the full-year tax rate to be in the 10 to 12 percent range for 2021. Turning briefly to risk management, our natural cap PML on a net basis decreased slightly to $860 million as of January 1, which, at approximately 7.4 percent of tangible common equity remains well below our internal limits at the single event one and 250-year return level. The decrease in our peak zone PML this quarter is mostly attributable to our E&S property unit within the insurance segment, where we reduced property aggregates in the Florida tri-county peak zone and made selective additions to our reinsurance purchases. Our balance sheet remains strong, and our debt-to-plus-referred leverage ratio stood at 22.1% at year-end, well within a reasonable range. Finally, on the capital front, we repurchased approximately 251,000 shares at an aggregate cost of $8 million in the fourth quarter of 2020. It is worth noting that we have since repurchased an additional 2.6 million shares at an aggregate cost of 83.6 million in the first quarter of 2021 under a Rule 10b-5 plan that we implemented during this quarter's closed window period. Our remaining share purchase authorization currently stands at 833 million. With these introductory comments, we are now prepared to take your questions.