Arch Capital Group Ltd.

Good day, ladies and gentlemen, and welcome to the first quarter 2021 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 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 assessment 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 hosts for today's conference, Mr. Mark Grandison and Mr. Francois Morin. Sirs, you may begin.

Thanks, Liz. Good morning, and thank you for joining our earnings call for the first quarter of 2021. The power of ARCH's diversified strategy is evident again this quarter as we have strong underlying earnings across our three operating divisions and a 7.8% operating ROE despite the cat events. Pricing is attractive in almost all of our insurance markets and more than meets our cost of capital thresholds. As a result, we expect the next several quarters to continue to show improved underwriting margins due to the compounding of rate-on-rate increases and the rebalancing of our mix. Importantly, the market is showing discipline in maintaining its momentum, and the recent cap losses are likely to keep upward pressure on rates. Our three primary areas of focus for 2021 are, one, continuing our growth in the sectors where rates allow for returns that are substantially more than our cost of capital, two, Optimizing our MI mortgage insurance book as it transitions from forbearance to recovery on its way back to normalcy in the next few quarters. Our notices of default are leveling and the quality of recent production is excellent. Three, actively managing our investments and capital to enhance our returns over the longer run. The past quarter, P&C premium renewal rates increased across a broader spectrum of lines, including several that did not show movement as recently as the third quarter of 2020. We also expect to see exposure growth as the economy recovers more fully, which in turn should further spur increased revenues and profits. On the MI front, housing has emerged as one of the stronger economic sectors due to a combination of positive house price appreciation with good affordability for homeowners. Although mortgage interest rates have increased modestly, they remain low compared to historic levels and continue to fuel strong demand for the purchase market. Finally, it's worth noting, and Frosso will cover it in more detail, that there's also some good news on the investment side as yields have increased slightly in 2021. For ARCH, every 25 basis points increase in yield should result in about a 50 basis point increase in our return on equity. Now let's dive into the businesses a bit more. Turning first to PNC Insurance, we are very optimistic about the prospects across our specialty insurance group for 2021. This past quarter, the higher level of premium earned from the post-2019 written period is one of the main reasons why our underlying combined ratio continued to improve. About two-thirds of the improvement was due to lower loss ratios as a result of the impact of rate increases, as well as to underwriting actions we have taken over the past several years. The other third of the improvement was driven by a lower expense ratio. In Q1, we observed a plus 11% rate increase on a global basis, solidifying the momentum for improving margins in P&C. We are now in the fifth consecutive quarter of rate increase in excess of lost costs, as evidenced by our current underlying combined ratio of 93.3 percent versus 97.1 percent in the same quarter last year. Adding to the rate improvement already mentioned, we've seen lower claims activity over the last four quarters. Nevertheless, we continue to be prudent by maintaining what we believe to be an appropriate safety margin in our reserving approach. One of our key principles is that we are cautious when recognizing favorable news, but react quickly to adverse signs in the data. Next, on to our reinsurance segment. We had another quarter of improving profitability fundamentals. Our training 12-month accident year combined ratio, XCAT, has improved significantly from a year ago. We again had a meaningful increase in net premium written of 25%. In the first quarter, we estimate that our effective rate change or rate over trend was roughly plus 8 percent. As with insurance, we expect these rate improvements to continue to be reflected in our underwriting results for the next several quarters. As you can see from our total premium growth in property over the last year, we continue to believe that risk-adjusted returns are more favorable in a non-CATXL property arena. our reinsurance group incurred 146 million of cat losses in a quarter, which was within our expectations, given the type of event and where we have historically positioned our property cat exposures. Let me explain a bit more. Strategically, we allocate more catastrophe capital towards homeowners and smaller commercial portfolios because we believe, one, they have homogeneous risk characteristics, two, the data used to model their exposure is of better quality, and three, policy language tends to have less variability than with larger commercial exposures. We believe that there is less uncertainty in the expected catload of homeowners and smaller commercial portfolios. As a consequence of this portfolio construction bias, when a medium-sized storm such as URI has between $14 and $16 billion in losses that affects personal lines more markedly, we would expect our market share to be around 1%. And last, But certainly not least, mortgage. Overall, our mortgage group is very well positioned to produce good earnings as a reinvigorated U.S. housing market is promising in 2021 and beyond. In the first quarter, ArchMI U.S. new insurance written was $27 billion, around 60% above the same period last year, and new loan originations are tracking towards another very strong year. As you know, Last year saw a refinancing boom, which meant significant turnover in our insurance in force. Our first quarter analyzed persistency was up from the 54% we experienced over the last 12 months, as interest rates rose earlier this year. If mortgage rates continue to rise, we would expect persistency to gradually return to the longer-term range of 75%, which would be a net positive, as we would hold more of the recent higher credit quality higher risk adjusted return portfolio on our books for longer. Looking next at our delinquency inventory, we still expect a large portion to cure based on many factors, including the strong equity position of our current DQ inventory. 94% of delinquent policies have over 20% of equity. We also had good news in March as a run rate for new notices of default was nearly back to 2019 levels, at about 10,000 new annuities per quarter. Outside of the U.S., we increased our writings in Australia as the housing market remains strong there. We like the long-term opportunity in Australia as demonstrated by our announcement to acquire Westpac's LMI business in March. The agreement allows us to free up capital even as we build our Australian presence and diversify our earning streams at attractive risk-adjusted returns. To borrow a sports analogy for this quarter, with a nod to our friends at COFAS, this market feels a little like the last legs of the Tour de France. We just went through the mountainous section, came out among the leaders, and a lot of riders struggled to keep pace. Now, as we roll towards Paris, we can continue to build on our lead while remaining mindful of protecting our position and energy. We can't go all out and be reckless as several stages of the race remain. However, our team is in great shape. We have many great riders working together to ensure we're ultimately smiling in that beautiful yellow jersey on the Champs-Élysées. As usual, our focus is on finishing the race with grace and winning for our sponsors, our shareholders. Now I'll turn it over to Francois.

Thank you, Mark, and good morning to all. Thanks for joining us today. 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. On the transaction we announced late last year to acquire Watford in partnership with Warburg Pincus and Kelso, to use Mark's cycling analogy, our team has been pedaling hard in anticipation of the closing, and we are down to the last few kilometers before we reach our final destination. I will provide a bit more color on its status in a few minutes. As you will have seen by now, we had a very solid quarter despite the severe winter storms, with after-tax operating income for the quarter of $239.8 million, or 59 cents per share, and an annualized 7.8% operating return on average common equity. Book value per share increased to $30.54 at March 31st, up 0.8% from last quarter. In the insurance segment, net written premium grew 20% over the same quarter one year ago, 28.4% if we exclude the impact of the pandemic on our travel, accident, and health units. The insurance segment's accident quarter combined ratio excluding CATs was 93.3%, lower by 380 basis points from the same period one year ago. The improvement in the 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. In addition, the expense ratio was lowered by approximately 80 basis points since the same quarter one year ago, primarily due to the growth in the premium base. As for our reinsurance operations, we also had strong growth of 25.3% in net written premium on a year-over-year basis, 40.8% if we adjust for an $88 million loss portfolio transfer, that was recorded in the first quarter of 2020. The growth was observed across most of our lines, but especially in our property other than property catastrophe line, where strong rate increases and a few new accounts helped increase the top line by 84.3%. The segments accident quarter combined ratio excluding cats stood at 84% compared to 91.3% on the same basis one year ago. Once we normalized for the one-time impact of the loss portfolio transfer, the improvement in the XCAT accident year combined ratio was 590 basis points, which is almost entirely attributable to a corresponding improvement in the loss ratio. The overall expense ratio remained relatively unchanged, again, after adjusting for the LPT. Losses from 2021 catastrophic events in the quarter net of reinsurance recoverables and reinstatement premiums stood at 188.3 million, or 10.5 combined ratio points, compared to 7.4 combined ratio points in the first quarter of 2020. These were primarily as a result of the North American winter storms Uri and Viola in February, and consistent with our earnings pre-announcement two weeks ago, close to 80 percent of the losses came from our reinsurance segment with the rest attributable to the insurance segment. We remain comfortable with our level of loss reserves for COVID-19 claims, which remained essentially unchanged from prior estimates. Approximately 65 percent of the inception to date incurred loss amount sits within our incurred but not reported IBNR reserves or as additional case reserves within our insurance and reinsurance segments. The key performance indicators we tracked to help us assess the ultimate impact of COVID-19 on our mortgage segment keep trending in a favorable direction. Chief, of course, being the delinquency rate, which came in at 3.86% at the end of the quarter. ArchMI had another excellent quarter in terms of production, and with refinance activity leveling off from prior peaks, we saw our insurance inform remain relatively stable with an increase from our international book offset by a small decrease in our USMI book. The combined ratio for this segment was 42.4%, reflecting the lower level of new delinquencies reported during the quarter. Both the loss and expense ratios were slightly lower than the pre-pandemic levels experienced in the same quarter one year ago. As a reminder, I wanted to remind everyone of the seasonality that exists in the reporting of operating expenses across our underwriting segments, investment expenses, and at the corporate level. Given all incentive compensation decisions, including share-based awards, get approved by our board of directors in February of each year, the first quarter has generally been the quarter with the highest level of operating expenses, and we do expect the current year to follow this pattern. Overall, with the underlying improvements in both of our P&C segments and mortgage segment fundamentals returning to pre-pandemic levels, we are excited by the prospects for each of the three legs of our stool. Our objective to deliver a well-balanced return to our shareholders with meaningful contributions from each of our underwriting segments should become more and more apparent as we move forward. I've kept my segment-level comments a bit shorter than usual in order to give a bit more color in the performance of our investment portfolio this quarter and on the new line in our income statement titled Income Loss from Operating Affiliates. As regards the investment portfolio, total investment return for the quarter was a negative 18 basis points on a U.S. dollar basis. Our defensive positioning with a short duration and limited credit exposure relative to our benchmark helped us withstand headwinds we experienced on the heels of an 80 basis point increase in the 10-year treasury rate during the quarter, which was a main factor in the negative 56 basis point price return on our portfolio during the quarter. Net investment income was $78.7 million during the quarter, down 9.3% on a sequential basis. This decrease, while certainly affected by lower available interest rates and higher investment expenses, due to incentive compensation payments and investment management fees, is also very much the result of deliberate portfolio actions taken over the last few quarters. Specifically, we continue to maintain a short duration on our portfolio, 2.71 years at the end of the quarter, based on our internal view of the risk and return tradeoffs in the fixed income markets. We also continue to deploy additional capital to alternative investments, the returns from which are generally not reflected in investment income. Finally, we also transformed some short-term investments this quarter into our 29.5 equity ownership in COFAS, as well as an investment in corporate-owned life insurance policies. Again, both items whose returns are included in operating income but are not reflected in net investment income. Equity and net income of investment funds accounted for using the equity method and realized gains from non-fixed income investments returned approximately $154 million during the quarter and were key contributors to the growth in our book value. Now, on to income from operating affiliates, which we are including in our definition of operating income. This quarter, in addition to our share of the quarterly results of investments we have made in operating affiliates, being primarily those from Premier Holdings at this time, we also benefited from an initial non-recurring gain we made at closing of our acquisition of a 29.5% ownership stake in COFAS for approximately $74.5 million. Consistent with our accounting policy under equity method accounting, we will report our investment in COFAS on a quarter lag. As regards the Watford transaction, shareholder approval was obtained in late March, and we are awaiting a few final regulatory approvals before we can close a transaction, hopefully over the next few weeks. As we disclosed earlier, we expect our ownership of Watford to increase to 40% at closing. The effective tax rate on pre-tax operating income was 10.6 percent in the quarter, reflecting changes in the full-year estimated tax rate, the geographic mix of our pre-tax income, and the benefit from discrete tax items in the quarter. We currently estimate the full-year tax rate to be in the 10 percent to 12 percent range for 2021. Turning briefly to risk management, our natural camp PML on a net basis decreased to $778 million as of April 1, which at approximately 6.7 percent of tangible common equity remains well below our internal limits at the single event one and 250-year return level. Our peak zone across the group changed from the Florida tri-county area to the northeast, reflecting our view of better opportunities given the current rate environment. Our balance sheet remains strong, and our debt plus preferred leverage stood at 22.1 percent at quarter end, well within the reasonable range. On the capital front, we repurchased approximately 5.3 million shares at an aggregate cost of 179.3 million in the first quarter. Our remaining share repurchase authorization currently stands at $737.3 million. With these introductory comments, we are now prepared to take your questions.