Arch Capital Group Ltd.

This conference is scheduled to begin shortly. Please continue to stand by. Thank you for your patience. Thank you. Thank you. Thank you. Good day, ladies and gentlemen. And welcome to the third quarter 2021 Arch Capital Group earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct 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 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 Grandison and Mr. Francois Morin. Sirs, you may begin.

Thank you, Liz. Good morning and welcome to our third quarter earnings call. We are pleased to have delivered solid results this quarter as our operating units generated a 9.3% annualized operating return on equity in a 12.5% annualized net income ROE despite an active catastrophe quarter. Sorry, guys. Premium ratings and rate growth remain strong in our P&C unit. driving solid fundamental earnings, while our mortgage insurance unit again produced excellent results. The current market conditions allow us to demonstrate the value of our diversified platform and underwriting strength as they provide us with plenty of opportunities to deploy capital and generate an expected return on equity in the mid-teens. In the broader PNC arena, we continue to see the market hardening along with ample evidence that our industry is addressing the adequacy of pricing across most sectors. The trajectory and market acceptance of rate increases reinforce why we remain optimistic that improved economics in the PNC market will be sustainable for some time. As you know, the PNC industry is facing many degrees of uncertainty. Heightened catactivity in four of the last five years, rising inflation, COVID's ongoing influence on a global economy and enduring low interest rates. When faced with escalating risks, underwriters need both rate increases and conservative loss estimates in order to build adequate margins of safety into premium levels. With our agile underwriting, established teams, and strong capital position, we are well equipped to grow into this improving market. Turning now to our operating units. We'll begin with insurance, where our early focus on strengthening our underwriting capabilities and seizing recent market opportunities is working. Gross written premiums continue to grow substantially, up 32% over the same quarter in 2020, and our accident year combined ratio, XCAT, improved to 90.5%. This is another indication of the progress we have made in our specialty insurance business. We have been leaning into this hardening market for two years now, as rate increases remain well above the long-term lost cost trends and have spread to more lines than last year. Overall, 2021 rates are up around 10% compared to 2020, and we expect that the benefit of higher premium levels will be realized well into 2023, enhancing our expected returns for that period. This quarter had many bright spots, including positive rate increases have accelerated in lower limits account. These lines have previously lagged the increases in larger accounts. That is no longer the case. Two, our early focus on Lloyds and business in the UK has improved our scale and our economics in this market. Three, some of our business lines that were most impacted by COVID, like travel, are recapturing some of the lost volume as both business and consumer travel increases. In summary, our specialty insurance group is making the most of the current opportunities. Pivoting now to our reinsurance group. It delivered strong growth in the quarter with gross written premiums up nearly 25% over the same period in 2020. On a net basis, reported growth was only a modest 3% versus the same quarter in 2020 due to a catch-up in sessions to Watford following the purchase of the company with our partners at July 1st. Franco will provide more detail during his comments, but absent this one-off transaction, reinsurance net written premium growth was still very strong at 30%, and our outlook remains favorable as, similar to insurance, we're experiencing broad rate increases in our specialty and casualty reinsurance lines. In the quarter, our reinsurance segment reported a combined ratio of 106%, reflecting the effects of the third quarter caps, primarily IDA, and the central European floods, but reinsurance's accident year combined ratio, XCAT, is excellent at 83.2%. There are signs that property market rates could adjust higher due to CAT fatigue, as you've likely heard on other calls this quarter. The recent five-year period of elevated losses from catastrophes proves an important insurance adage. Losses don't know the level of the premium. There are also early indications that retrocessional and aggregate excess of loss protections are becoming increasingly hard to come by, and we believe that this will be reflected in higher property rates broadly. As you know, we were and remain judicious in the deployment of our CAAT PML, which was effectively flat in the third quarter. At less than 6% of our tangible equity, we remained underweight in net property cut exposure, and we will deploy more capital to the line if expected returns improve above our target. It's too early to make a call on a January 1st renewal process, but pricing in this sector is heavily influenced at the margins, and if ILS or other capacity phase, there is a possibility for significant rate corrections and increased engagement on our part. In the meantime, our reinsurance teams are demonstrating their agility and, like insurance, are leaning hard into the markets where returns are most attractive. Thirdly, our mortgage group continues to deliver exceptional returns. It generated $234 million of underlying profit in the third quarter and continues its impressive rebound from lost concerns associated with the pandemic. On September 30th, Insurance in force of $457 billion for the segment was up modestly. Further good news is that notices of default have declined to pre-pandemic levels at September 30th, which is a good indicator of improved conditions. Additionally, loans in forbearance continue to decline as federal programs conclude, and we remain cautiously optimistic that most of these loans will ultimately cure. Rising home prices have broadly increased homeowner equity, and you'll recall our position that equity levels are the best indication of whether a delinquency will ultimately result in a loss. We estimate that 98 percent of our loans and forbearance today have at least 10 percent equity, providing significant protection against potential losses. Overall, the EMI market remains competitive but rational and our business continues to generate returns on capital in the mid-teens. Mortgage originations continue at a pace similar to last year's record origination volume, and credit quality remains excellent. As you know, in all of our operations, we actively manage capital to enhance shareholder returns. The strong results in our mortgage segment have enabled us to optimize our capital structure via increased reinsurance sessions through our Bellamy Mortgage Insurance linked notes, as well as traditional reinsurance. Additional reinsurance purchases enable us to reallocate capital toward faster-growing areas in specialty, property, and casualty lines, while enhancing our return profile in MI by reducing required capital. MI remains a very attractive business for us. Now, a point of pride and interest to us, and perhaps to you all, is that last Saturday, October 23rd, ARCH celebrated its 20-year anniversary. So I want to say to our investors, thank you for believing in us, and to our employees, past and present, thank you for your contributions to ARCH for the last 20 years and our clients for showing support and conviction in our capacity to provide products to you. Finally, the PGA Tour is in Bermuda this weekend, so golf is top of mind. A golf tournament is interesting in that It takes place over several days and therefore consistency is critical. You have to be sure to pick your spot and lower your score. But if you want to make the cut, you have to limit the bogeys early so that you can play more aggressively in the stretch. And then once you get to the weekend, you can play with a bit more freedom and really try for the birdies and eagles. At this point in the cycle, we feel we've made the cut and now we're focused on really taking advantage of our positioning to make sure we end up at the top of the leaderboard. Francois?

Thank you, Mark, and good morning to you all on this first day of the Butterfield Bermuda Championship here in Bermuda. Thanks for joining us today. Before I provide more color on our solid third quarter results, you will have observed that while our earnings release still makes a distinction between core and consolidated for purposes of comparison to prior periods, there is no difference between the two presentations this quarter. As we discussed on the last call, the closing of the Watford transaction on July 1st gave rise to a reconsideration event, and as a result of our updated VIE analysis, we no longer consolidate the results of Watford in our financial results. Our 40% share of Watford's results is now reported in the income from operating affiliates line, and there is no longer a need to make a distinction between core and consolidated results in our financials. As Mark shared earlier, our after-tax operating income for the quarter was $294.7 million, or 74 cents per share, resulting in an annualized 9.3 percent operating return on average common equity. And book value per share increased to $32.43 at September 30th, up 1.3 percent in the quarter. a very solid result in light of the catastrophe activity that was much higher than the long-term average for this quarter, which we estimate at over $45 billion in insured losses for the P&C industry, approximately three times the average third quarter CAT losses observed over the last 10 years. This quarter, I wanted to first give you some additional detail on the results of our reinsurance operations, which were impacted by the want for an acquisition, especially on the top line. As part of the agreement signed at the beginning of the year with our co-investors in Watford, we committed to ceding varying percentages of the premium written by our Bermuda and U.S. treaty reinsurance operations to Watford, effectively enhancing the existing business model to also serve as a sidecar for ARCH. While the retrocession agreements were effective as of the start of the year, Their signing was contingent on the transaction closing, which delayed their recognition in our income statement until this quarter. As a result, the third quarter seeded written premium reflects a catch-up of approximately $161.2 million from the first half of the year. The impact of the premium catch-up adjustment on underwriting income for the reinsurance segment was minimal. Growth in gross written premium remained strong at 24.6% on a quarter-over-quarter basis, and growth in net written premium would have come in at 29.5%, adjusting for the Watford catch-up. The growth was observed across most of our lines, but especially in our casualty, other specialty, and property other than property catastrophe lines, where strong rate increases in growth and new accounts helped increase the top line. The segment's accident quarter combined ratio excluding CATs stood at 83.2 percent compared to 83.1 percent on the same basis one year ago. On a year-to-date basis, the ex-CAT accident year combined ratio has improved by approximately 250 basis points over the same period last year, reflecting the improving underwriting results in most of the lines in which we write. In the insurance segment, Net written premium grew 40 percent over the same quarter one year ago, and the segment's accident quarter combined ratio excluding CATs was 90.5 percent, lowered by approximately 360 basis points from the same period one year ago. Excellent results across the board, which demonstrate the progress our insurance segment has made over the last three-plus years in improving its performance, and provide us with optimism on the underlying quality of our franchise going forward. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums stood at $335.9 million for 17.4 combined ratio points compared to 12.5 combined ratio points in the third quarter of 2020. As noted in our pre-release, our P&C operations were impacted by Hurricane Ida, the European flooding events of July, as well as a series of other events across the globe. Our mortgage segment had an excellent quarter with a combined ratio of 26.2%, reflecting favorable prior development of $48.4 million, about half of which came from USMI, from better-than-expected cure activity in pre-pandemic delinquencies and recoveries on second lien loans. and the other half from our CRT portfolio and international MI. The decrease in net premiums earned on a sequential basis was primarily attributable to lower levels of single premium terminations in the quarter for USMI business and to a lower level of called CRT transaction than what was observed in the second quarter. Recall the second quarter benefited from higher earned premiums due to an unusually high number of CRT transactions being called, which we highlighted as effectively being a non-recurring event. The delinquency rate for our USMI book came in at 2.67% at the end of the quarter, a material reduction from the peak we observed at the end of the second quarter one year ago. We had another solid quarter in terms of production, mostly from the purchase market, and with refinance activity coming down from prior levels, the insurance in force for our USMI book grew slightly. The increase from last quarter in the insurance in force of our international mortgage unit is mostly the result of the acquisition of Westpac Lenders Mortgage Insurance Limited in early August. Although income from operating affiliates grew significantly to $124.1 million, It is worth noting that approximately $95.7 million of the total is attributable to a one-time operating gain resulting from the acquisition of a 40% stake in Watford, which was offset, in part, by a realized loss upon deconsolidation with a resulting net income gain of $62.5 million. The remainder of the operating income from affiliates represents our share of the net income generated this quarter by our operating affiliates, which consists primarily of Watford, COFAS, and Premier. Total investment return for our investment portfolio was de minimis on a U.S. dollar basis for the quarter. Net investment income was $88.2 million during the quarter, down by $1.2 million on a sequential basis this driven by lower coupons on fixed maturities and lower income on consolidated funds. The duration of our portfolio remains low at 2.68 years at the end of the quarter, reflecting our internal view of the risk and return tradeoffs in the fixed income markets. Equity and net income of investment funds accounted for using the equity method produced $105.4 million during the quarter. more than half of the total income generated by our investment portfolio, and a key contributor to the growth in our book value. As we discussed on prior calls, we have increased our allocation to alternative investments in the last few years, and these funds now represent approximately 12 percent of our total portfolio at the end of the quarter. We are also very pleased with their performance so far this year, which stands at 13 percent year to date. Of note, Had we included income from funds using the equity method in our definition of operating income, our reported operating ROE would have increased by 3.2% on a year-to-date basis to 13.3%. While these funds' returns are potentially more volatile than core fixed income strategies, we believe the incremental returns they provide more than compensate for the liquidity constraints and volatility that are usually associated with them. The effective tax rate on pre-tax operating income was a benefit of 0.7 percent in the quarter, reflecting changes in the full-year estimated tax rate, the geographic mix of our pre-tax income, and an 8.2 percent benefit from discrete tax items in the quarter. The discrete tax items in the quarter primarily relate to a partial release in a valuation allowance on certain UK deferred tax assets. Now a quick comment on the two acquisitions we closed on this quarter, Westback and Somerset Bridge. You will have seen that in accordance with purchase gap, we established approximately 337.4 million of intangibles and goodwill this quarter, most of which will be amortized through our income statement going forward. To help with your modeling efforts, we now expect our amortization expense to be approximately 25 million in the fourth quarter of this year, and 21 million quarterly throughout 2022. On the capital front, we redeemed all of our outstanding Series E non-cumulative preferred shares for 450 million on September 30th. Separately, we repurchased approximately 9.7 million common shares at an aggregate cost of 386.9 million in the third quarter. If we include the additional common shares we have purchased in the fourth quarter, The year-to-date totals are now approximately 24 million shares, or 5.9% of the common shares outstanding at the beginning of the year, for $917.7 million. Some of the additional share repurchases in the fourth quarter were effectuated under the new share repurchase authorization of $1.5 billion approved by our Board of Directors earlier this month. As we have said since our formation 20 years ago, our core operating principles are anchored in active cycle and capital management. We believe this quarter results demonstrates our ability to execute on this philosophy and leads us to invest in opportunities where we believe the returns are most attractive. At recent prices and with the prospect of improving returns, We believe buying back our shares continues to represent another compelling value proposition for our shareholders without compromising our capital flexibility nor lessening the quality and strength of our balance sheet. With these introductory comments, we are now prepared to take your questions.