Arch Capital Group Ltd.

Q4 2023 Earnings Conference Call

2/15/2024

spk02: will follow at that time. 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 meeting 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 will also make reference to certain non-GAAP measures of financial performance. The reconciliation to GAAP for each non-GAAP financial measure 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 at .archgroup.com and on the SEC's website at .sec.gov. I would now like to introduce your hosts for today's conference, Mr. Mark Grandison and Mr. Francois Morin. Sirs, you may begin.
spk08: Thank you, Gigi. Good morning and thank you for joining our earnings call. Our fourth quarter results conclude another record year as we continued to lean into broadly favorable underwriting conditions in a property and casualty sectors. Our full year financial performance was excellent with an annual operating return on average common equity of .6% and an exceptional .9% increase in book value per share, which remains an impressive .2% if we exclude the one-time benefit from the tax asset we booked in the fourth quarter. The 3.2 billion of operating income reported in 2023 made it Arches most profitable year to date. Growth was strong all year as we allocated capital to our property and casualty teams. We short over 17 billion of gross premium and over 12.4 billion of net premium. And while most current growth opportunities are in the PNC sector, it's important to recognize the steady quality underwriting performance of our mortgage group. Although mortgage market conditions meant fewer opportunities for top-line MI growth, the business unit continued to generate significant profits totaling nearly 1.1 billion dollars of underwriting income for the year. As we have mentioned on previous calls, those earnings have helped fund growth opportunities in the segments with the best risk-adjusted returns, demonstrating that the discipline underwriting approach and active capital allocation are essential throughout the cycle. Our ability to deploy capital early in the hard market cycle is paying dividends as we own the renewals. A phrase I learned from Paul Ingray, a personal mentor and foundational leader of Arch, what Paul meant was quite simple. When markets turn hard, you should aggressively write business early in the cycle. This puts your underwriters in a strong position to fully capitalize on the market opportunity. By making decisive early moves,
spk06: you won because you grow alongside your clients who then want to
spk08: do more business with you. In some ways, the growth becomes self-sustaining, which explains part of our success throughout this hard market. At Arch, our primary focus has always been on rate adequacy, regardless of market conditions. Our underwriting culture dictates that we include a meaningful margin of safety in our pricing, especially in softer conditions. And we also take a longer view of inflation and rates. For these reasons, Arch was underweight in casualty premium from 2016 to 2019 when cumulative rates were cut by as much as 50%. I thought I'd borrow a soccer analogy to help explain the current casualty market. In soccer, players who commit a deliberate foul are often given a yellow card. Two yellow cards mean the player is ejected from the remainder of the match and their team continues with a one player disadvantage. Today's casualty market feels as though some market participants took to the field with a yellow card from a prior game. They're playing in match but cautiously not wanting to make an error that will put their entire team at a disadvantage. So while Arch sometimes plays aggressively, we've remained disciplined and avoided drawing a yellow card. At a high level, we must remember that casualty lines take longer to remediate than property. So if insurers are being cautious and adding to their margin of safety, we could experience profitable underwriting opportunities in an improving casualty market for the next several years. Now I'll provide some additional color about the performance of our operating units starting with reinsurance. The performance of our reinsurance segment last year was nothing short of stellar. For the year, reinsurance net premium written were $6.6 billion, an increase of over $1.6 billion from 2022. Underwriting income of nearly $1.1 billion is a record for this segment and significant improvement from the CAT heavy 2022. Reinsurance underwriting results remain excellent as we ended the year with an .4% combined ratio overall in a .4% combined ratio XCAT and prior year development. Both significant improvements over 2022. Turning now to our insurance segment which continued its growth trajectory by writing nearly $5.9 billion of net premium in 2023, a 17% increase from the prior year. While the business model for primary insurance means that shifts may not appear as dramatic as our reinsurance groups, a look at where we've allocated capital year over year provides meaningful insight into our view of the market opportunities. In 2023 the most notable gains came in from property, marine, construction and national accounts. The $450 million of underwriting income generated by the insurance segment in 2023 doubled our 2022 output as we continue to earn in premium from our deliberate growth during the early years of this hard market. Underwriting results remained solid on the year as the insurance segment delivered a combined ratio of .7% and a healthy .6% excluding XCAT and prior year development. Now on to mortgage. Our industry leading mortgage segments continue to deliver profitable results despite a significant industry-wide reduction in mortgage originations last year. The high persistency of our insurance-inforced portfolio which carries its own unique version of owning the renewals enables the segment to consistently serve as an earnings engine for our shareholders. The credit profile of our US primary MI portfolio remains excellent and the overall MI market continues to be disciplined and return focused. These conditions should help to ensure that our mortgage segment remains a valuable source of earnings diversification to arch. On to investments. Net investment income grew to over 1 billion dollar for the year due to rising interest rates that enhanced earnings from the float generated by our increasing cash flows from underwriting. The significant increases to our asset base provided tailwind for our creative investment group to further increase its contributions to Arch's earnings. Over the past several years Arch has leaned into both the hard market and our role as a market leader in the specialty insurance space. We have successfully deployed capital into our diversified operating segments to fuel growth while also making substantial operational enhancements to our platform including entering new lines, expanding into new geographies and making investments into new underwriting teams, technology and data analytics. Finally as we bid adieu to 2023, I want to take a moment to thank our more than 6,500 employees around the world who helped deliver so much value to our customers and shareholders. Our people are our competitive advantage and without their creativity, dedication and integrity, none of this would be possible. So thank you to team Arch. Francois.
spk07: Thank you Mark and good morning to all. Thanks for joining us today. As Mark mentioned, we closed the year on a high note with after tax operating income of $2.49 per share for the quarter for an annualized operating return on average common equity of 23.7%. Book value per share was $46.94 as of December 31, up .5% for the quarter and .9% for the year aided by the establishment of a net deferred tax asset related to the recently introduced Bermuda corporate income tax, which I will expand on in a moment. Our excellent performance resulted from an outstanding quarter across our three business segments, highlighted by $715 million in underwriting income. We delivered strong net premium written growth across our insurance and reinsurance segments, a 22% increase over the fourth quarter of 2022 after adjusting for large non recurring reinsurance transactions we discussed last year, and an excellent combined ratio of .9% for the group. Our underwriting income reflected 135 million of favorable prior year development on a pre tax basis, or 4.1 points on the combined ratio across our three segments. We observed favorable development across many units, but primarily in short tail lines in our property and casualty segments and in mortgage due to strong cure activity. While there were no major catastrophe industry events this quarter, a series of smaller events that occurred across the globe throughout the year resulted in current accident year catastrophe losses of 137 million for the group in the quarter. Overall, the catastrophe losses we recognize were below our expected catastrophe load. As of January 1, our peak zone natural cap PML for a single event, one in 250 year return level on a net basis increased 11% from October 1, but has declined relative to our capital and now stands at .2% of tangible shareholders equity well below our internal limits. On the investment front, we earned $415 million combined from net investment income and income from funds accounted using the equity method, up 27% from last quarter. This amount represents $1.09 per share. With an investable asset base approaching $35 billion, supported by a record 5.7 billion of cash flow from operating activities in 2023 and new money rates near 5%, we should see continued positive momentum in our investment returns. Our capital base grew to 21.1 billion with a low leverage ratio of .9% represented as debt plus preferred shares to total capital. Overall, our balance sheet remains extremely strong and we retain significant financial flexibility to pursue any opportunities that arise. Moving to the recently introduced Bermuda corporate income tax. As mentioned in our earnings release and in connection with the law change, we recognize a net deferred tax asset of $1.18 billion this quarter, which we have excluded from operating income due to its non-recurring nature. This asset will amortize mostly over a 10-year period in our financials, reducing our cash tax payments in those years. All things equal, we expect our effective tax rate to be in the 9% to 11% range for 2024, with a higher expected rate starting in 2025. As regards our income from operating affiliates, it's worth mentioning that approximately 40% of this quarter's income is attributable to non-recurring items such as COFAS' adoption of IFRS 17 and the establishment of a deferred tax asset at Summers in connection with the Bermuda corporate income tax. With these introductory comments, we are now prepared to take your questions.
spk02: Thank you. If you have a question at this time, please press star 1-1 key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press star 1-1 again. And if you are using a speakerphone, please lift the handset. One moment for our first question. Our first question comes from the line of Alyse Greenspan from Wells Fargo.
spk01: Hi, thanks. Good morning. My first question, thanks. Good, Mark. My first question, I wanted to expand on some of your introductory comments just on the casualty side. We've started to see some reserve additions this quarter and I think you alluded to that last quarter as being what was going to drive the market in turn. So how do you see it playing out from here? I know you said it should play out over the next several years. Could you just give us a little bit of a roadmap in how you think about this opportunity emerging for ARCH?
spk08: Yes, great. Great question. I think that we're observing our own book of business. We also look at all the information around. I think from an actuary's perspective, both Francois and I have maybe dusting off our actuarial diplomas, you rely on data that's historically stable or at least has some kind of predictability. And I think what we've seen over the last two, three years as a result of the pandemic, largely in the courts being closed and everything else in between all the uncertainty and then the bouts of inflation, there's a lot of data that's really hard to pin down and get comfortable with to make your prediction for what you should be pricing the business. As we all know, reserving leads to the pricing, right? By virtue of reserving and having the right number for the reserving, you then feed that into your pricing. So we're in a situation where people have lesser visibility about what the reserving will ultimately develop to. So I can totally understand our clients and our competitors having to adjust on the fly or having to adjust a little bit progressively, infimatively. The issue with casualty, at least as you know, is even if you have that information and you make some correction of corrective actions, it still takes a while to evaluate whether what you did was enough or was what you needed to do. So I think right now we have, you know, we already had a couple of, you know, rate increases in casualty starting in 2020. But I think that now we're realizing that maybe it's a little bit worse collectively as an industry than we thought. And there's a lot more uncertainty, a lot more, and inflation certainly, as we all know, is a big factor. So what I would expect right now is people will start, you know, refining their book of business. They will try to re-underwrite away from the source of inflation, you know, impacted lines. They'll probably push for rates. Some of them might kick some business to the E&S until such time as we have more stability in the reserving. Now the cost emerges as it relates to what your initial pricing, you know, assumptions was. And in casualty, that's why it takes several years. And if history is any indication, if you look back at the, you know, even the 8387 market and then the 0200, the 99, 2000 to 2003, it took three to four years from the start of that, even in the middle of it, to really get clarity. And the market got, you know, much harder, in fact, in 2004, 2005 than it was in 2002, just because you have to do the action and see what the actions did, what you thought. And I think that's what we're going to collectively as an industry are going through and we're seeing it with our clients. And that's really what's happening.
spk01: Thanks. And then my second question, you know, second quarter in a row, right, we've seen the underlying loss ratio within your reinsurance business come in, you know, sub 50. And, you know, you guys are obviously earning in right cat business, you know, within that strong weights last year, how should we think about the sustainability of, you know, a sub 50, you know, underlying loss ratio with it within your reinsurance book?
spk07: Well, I mean, we sustainability is a great question. I think you're absolutely right that we have more property premium that is more short tail and should have a lower loss ratio X cap than not right compared to other lines. You know, it's a good market. So obviously, profitability, you know, embedded in the business should be strong. But we send you back to kind of quarterly volatility, where sometimes, you know, we have a better than call it normal quarter, even as a function of the book, and sometimes not, there's going to be volatility. We said it before, we'll say it again, the 12 month kind of rolling average is to us a better way to look at it. And, you know, that's how we see it. But certainly, we, you know, we like the profitability in the book, and it should be, it should remain strong.
spk08: One thing I will tell you, Elise, for you probably heard on the other calls is that the market, the reinsurance market is continuing to improve somewhat into the So it is still a very, very good marketplace. So what it means for the loss ratio, I don't know, but certainly, we're seeing improvement.
spk01: And then just one last one on capital, right? I believe, you know, there was, you know, some pushes and pulls from the S&P capital changes on your capital, but should be positive, you know, relative to your mortgage business. Can you just, you know, help us think through your capital position? And, you know, relative to just organic growth opportunities you see at hand over the next year?
spk07: Well, certainly, I mean, S&P is one thing that we look at, we look at many different ways. I mean, we have different looks at capital adequacy. We have our own internal view, which drives really how we make our decisions. Rating agencies are an important factor. But, you know, I think more importantly is how we think about it. But you're right. I mean, no question that from the S&P point of view, we did, I mean, the change in their model was a net benefit. And that's reduced, kind of, you know, we give us, I'd say a bit more excess capital. But we, you know, we, and we look at it very carefully, we want to make sure that we're, we're, we're able to seize the opportunities that will be in front of us. And, you know, we see plenty for 2024. So, you know, right now we're very, you know, our main focus is growing the business and kind of deploying that capital into what's in front of us. And then we'll see how the rest of the year plays out.
spk02: Thank you.
spk06: Thanks.
spk07: You're
spk06: welcome.
spk02: Thank you. One moment for our next question. Our next question comes from the line of Andrew Kilgerman from TD Cowan.
spk05: Hey, good morning. First question, good morning. First question would be around M&A. We've seen a lot in the, in the media about other specialty players that could be acquired. Arch has been mentioned along with other companies. And I think that's And I know you can't comment on specific transactions and that you've talked a lot about 15% return on capital over time. But, but when you do transactions, could you give us a little color on what the parameters might be, what's really important to Arch when you do deals?
spk08: Yeah, on the M&A front, we're, we're very prudent and careful when we do, if we do anything. And I think historically, our historical track record is probably the best way to look at this. We'll look for something where our opportunities to earn a return is, with a proper margin of safety, it is fairly healthy. We're not, there's no, there's no desire to grow for growth sake in this company. It really has to do with the return on capital. And as Franco mentioned, the fact that we have opportunities to above 15% opportunities, you know, in this marketplace certainly makes it a little bit more harder. Having said all this, we might be, might make not exceptions, but there might be some other considerations as it relates to maybe a strategic, maybe a different kind of product, maybe a geography, or maybe, and we prefer that maybe a new team that can really bring the expertise on a non-running basis. So it's a very, very, you know, disciplined approach to M&A that we take. And we have the luxury because we're, you know, we have plenty of organic growth available to us. So something has to be very compelling for us to engage in those and also other risks, as you all know, that we don't want to take on necessarily. The number one is the culture. And we're very, very adamant about keeping, you know, our culture the way it is. And that's really something that quite oftentimes, the thing that makes the most, is probably the one that makes the most difference in whether or not we'll entertain an M&A or not.
spk05: That makes a lot of sense. You mentioned on the favorable developments that short-tail property was a big driver. So looking at insurance at 21 million favorable, reinsurance at seven favorable, just trying to understand, were there any large casualty offsets that might have played in? And if so, what would they be?
spk07: Yeah, well, there's no, I'd say, offsets. I mean, we look at each line on its own. There's always going to be pluses and minuses. And that then every single quarter, we look at the data, we react to the data, I think, as you can imagine, or I mean, very much a function of the type of business that we've written the last few years. In reinsurance, in particular, we've grown a lot in property. We've taken our usual, you know, same methodology, same approach to reserve. And, you know, that generated a little bit of redundancies or, you know, releases this quarter on the short-tail side. You know, there's always a little bit of noise on any line of business. Yes, we have a couple of, you know, sub lines or kind of sells and casualty where we had a little bit of adverse, absolutely. But it's not, I wouldn't call it an offset. I mean, we book every single line on its own. We react to the data. And then, you know, when numbers come up is what we end up with.
spk08: One thing I would add to this is our reserving approach at a high level is to typically recognize bad news quickly and good news over time. So, again, our philosophy hasn't changed at all in all those years.
spk05: Maybe if I could sweep one quick one in. You mentioned during the call that, you know, one of the growth areas in insurance was national accounts. What type of limits do you write on national accounts?
spk08: Well, it's statutory, right? So, and it's on an excessive loss basis. And these are lost. There's a lot of sharing of experience plus our monitors with clients. They tend to be larger clients. The national account is 90, 95% plus workers comp. It's really, you know, a self-insured sort of structure that that's of sort. We provide the paper and the actual the document to allow people to operate in their state because you need the required thing to be able to demonstrate that workers comp insurance as a protection. This is statutory. So, it's unlimited by definition. We have some reinsurance to protect some of the capping. That's really what it is.
spk05: Got it helpful. Thank you. Sure.
spk02: Thank you. One moment for our next question. Our next question comes from the line of Jim Mey Buller from JP Morgan.
spk04: Hey, good morning. So, first, just a question on the casualty business. We've seen significant growth in your property exposures with the hard since the hardening of the market or significant hardening the market since early last year. What are your views on just overall market trends on the casualty side? And are you comfortable enough with pricing in terms to increase volumes in that area?
spk08: Yeah, I think our comfort, great question, our comfort on the casualty liability in general, the more general liability, right? It's through professional lines. I think we're, you know, the market is turning or has more pressure on the primary side. So, I think that our focus right now is we're in the primary as they can see on our reinsurance, you know, what we did in the reinsurance for the last year. And we think the reinsurance market is a little bit delayed in reacting to what's happened, you know, as in some of the development that we see in some of the increase in inflation. And of course, we are putting that we mentioned. So, I think that we'll probably see, you know, first an insurance market that really takes it to heart, like I mentioned, all the remediation that they need to do. And I think their interest market will probably follow suit, you know, with their own possibly their own way to look at this. If the prior, you know, hard markets are any indication. On the reinsurance side, one thing that's a little bit beneficial at this point in time, and there's a reason why reinsurers are not reacting possibly as abruptly as they probably should, as in regards to the City Commission, is that we collectively understand as an industry that our clients, you know, are trying to make those changes. So, we're trying to, you know, go along with them and help them, you know, support them in their efforts. We'll see whether that's enough. You know, our team is a little bit waiting to see whether that develops. But I do expect this to also come around and also provide another opportunity for us to grow.
spk04: And then on mortgage insurance, I would have assumed that reserve releases would moderate over time and they've actually become even more favorable. And I think there's a shift in what's driving that. It used to be COVID reserves last year, and now it's stuff written post COVID. As you think about your, just want to get an idea on what are you assuming in your reserves that you're putting on the book right now? Are you assuming experience commensurate with what you're seeing in the market or is it reasonable to assume that if the environment stays the way it is, there's more room to go in terms of reserve releases?
spk07: Great question. I'd say reserve releases this year in general were, you know, somewhat driven by our, the views we had on the housing market at the start of the year, right? So, if you roll back the year, we were more concerned about home prices dropping fairly rapidly, recession, no soft landing, et cetera. So, the reserves we set, you know, call it a year ago, were very much a function of those assumptions. And they just didn't materialize throughout the year. So, throughout the year, we saw very strong or very well performing housing market. People are hearing their delinquencies much higher than we'd actually forecasted. Home prices are holding up and unemployment remains relatively low. So, you put it all together, I mean, it really, what transpired in 23 is very much a function of, the reserve releases reflect kind of how things, how much better they played out relative to what we thought a year ago. Where we are today, you know, at the 24 is certainly a bit more, I wouldn't call it, I mean, optimistic in the sense that we see, you know, good home prices and the solid housing market for 24. So, you know, on a relative basis, the reserves that we're holding today are not as high as they were a year ago. So, you know, if you extrapolate from that, is there room for as much in reserve releases going forward? Probably not, we just don't know. I mean, the data will again play out as it does and will react to it. But hopefully that helps you kind of compare and understand how, where we sit today versus a year ago.
spk04: Okay, thanks. And just lastly, your comfort with your reserves in your casualty book, despite all the industry wide issues, does that apply to the business that came over from Watford as well? Because that company obviously had a decent amount of exposure to casualty.
spk08: Oh, that's an easy one. Watford, really the underwriting is managed by our team here. So, the reserving
spk06: and... Thanks. Thank
spk02: you. One moment for our next question. Our next question comes from the line of Michael Zuremski from BMO.
spk06: Hey, good morning. First
spk03: question for Francois on Capital in regards to mortgage specifically. So, you know, my understanding of the mortgage reserving rules is that, you know, after a decade or so, you can start releasing a material amount of reserves. And mortgage obviously isn't growing now. So, I know, but you also have a Bermuda, you know, I think some capital there too. So, just curious, is there a material amount of capital coming or expected to come from releasing from the legacy mortgage business?
spk06: Okay, that's helpful. And sticking with
spk03: capital, did, you know, when Elise asked about, you mentioned the S&P capital model, but I don't think you actually gave any quantitative or, you know, the answers on the benefit because we'll meet...
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