Arch Capital Group Ltd. (ACGL) Earnings Call Transcript & Summary

Greetings to everybody out on the line. This is Mark Dwelle, Head of Insurance Research for RBC Capital Markets, and I'm pleased to welcome everybody to the RBC Virtual Financials Conference. Let me start by thanking all the participants, both managements and investors, for their patience and support as we put this together. Big props to our conference team and sales for making everything happen in such a short period of time. We did some of these yesterday, and we had pretty good feedback, so hopefully, today will be just as good. Given the number of businesses that are asking people to work from home and take other measures, probably there's somebody out there on the line who's sitting in their [ bathrobe ] listening to this right now. So a coffee mug toast to those of you who are managing to pull that off. Some quick rules of the road before we get into the main discussion. Online participants, please note that you can ask questions using the question box on the left side of the webcast browser. Yesterday, I noticed that there was a little bit of a lag on these showing up in my dialogue box, so don't be shy about getting those questions in there early. That way, they'll pop up on my screen so that I can get them asked straight away. Definitely want to try to make this as interactive as we possibly can. I'm going to lead off with a some -- a couple of topics of general interest, and then we'll go to questions from the line or back to my question list as time allows. We'll call time at about 10:30. So joining me today, we have François Morin, who's been Arch's CFO, for just about 2 years now. He's been with Arch for 9 years in total. Before that, he was in the actuarial division at Tillinghast, which back then was part of Towers, and then it was part of Willis, and then it's soon to be -- going to be part of Aon. So if you have any questions about the Bornhuetter-Ferguson method or any other actuarial questions you've been burning to ask, maybe today is your chance.

But with that, let me get into the regular part of our show. Obviously, the question that's been on market's minds for the last 2 weeks at least is the coronavirus, the impact that, that's had on equity markets, impact on interest rates. Can you just talk for a minute about how these factors might impact Arch? Any direct exposures, lines of business that might be subject to claim, any indirect exposures, just kind of how you're thinking about it at this point?

Yes. Thanks, Mark, and thanks for having me today. I think everybody is trying to understand a bit more what's going on, and certainly, it changes daily. But yes, for sure, that's something that we've been looking at and actually had a Board meeting last week and where we went through it all -- all those topics with our Board. I will say from a -- from an industry point of view, I would argue, it's still very early to know how things are going to play out. So it's hard to -- for any one of us to come up with a definitive answer. But certainly, the one line of business that I think most people are in agreement on is around event cancellation, which certainly is a direct exposure that the participants in that market will probably be more exposed to early on. We're not a big player in that space. That's generally more of a Lloyd's London type of exposure, and we're definitely not a leader in that sector. So shouldn't be a big issue for us at this point. And then we get into A&H, travel. There are other lines of business that we can argue or know for a fact that are directly linked to this pandemic or this issue. The one thing that is a bit of an unknown is whether the governments -- whether there's edicts that come into play from governments and what that means to the contract [ holding ] ability to travel, if you're not allowed to travel the -- some general policies get into play. So it's -- I think it -- there's a lot of -- the wide range out there, what it could be or what the losses or the exposure might be down the road for us. So I think we're certainly aware of it, but we're not -- it'll take some time for everything to play out. And then down the road from there, the indirect exposure could be maybe even more problematic for some companies, but again, very early. An example that we go back to is the health care industry, if there is misdiagnosis or bad treatment in some medical facilities, does that create liability exposure, et cetera. And that would take -- definitely could take quite a bit of time to resolve itself. But early days still. As we all know, there's new -- news that show up on our Bloomberg, et cetera, every minute, every day, so it's a fluid situation. And quickly, on the investment side, I think most companies, including us, would not be overly exposed to this issue. Certainly, I think there's credit -- potential credit issues on the fixed income side, which -- with the reduction in the treasuries may offset a little bit of each other, so we'll reassess that at the end of the quarter. And we don't really have a huge equity portfolio, so yes, we'll take some hits there. But I don't think it's going to be a huge issue, at least at this point for the insurance industry, at least on the P&C side.

That's helpful. I mean I think -- and I know, at least in my conversations, and I think -- I mean, yes, insurance companies have fixed income portfolios, and we'll expect to see some yield erosion over time as portfolios roll and so forth. The other side of the coin is, is that you all have big bond portfolios that are going to make substantial gains with interest rates as low as they are, book values are going to go up and provide some additional capital cushion to the extent realized ultimately. And yes, there's a little bit of a natural shock absorber in just how all this unfolds. I feel like investors are focusing more on the downside of the future earnings than on the upside of the present book value benefits.

Right. And that's fair. And -- but on that one, I would -- I think we will certainly be thinking about if we're not making the investment return, we should be making the underwriting income. And yes -- I mean, so ultimately, as long as we [ make ] our returns in one shape or another, I think that's what we need to do. But it will put -- yes, we'll put some pressure and maybe make it for a more sustained, improving pricing environment, which is not the same that it's a -- we all know that it's not always a perfect correlation. But as insurers reflect the reality of the lower interest rates and how that -- what that effectively takes away in terms of float and the ability to earn on that float, we should be looking to make that -- those returns on the underwriting side.

That's actually a good segue to probably my next major question that investors have is really just the pricing environment began to turn positive during the course of the second half of 2019. Several areas that Arch is involved in are doing pretty well. Some areas are still lagging a bit. What are you seeing right now? How are things continuing to evolve in the pricing environment? Are we still in the fairly early innings of the game? Maybe some updated thoughts on -- in that area.

Yes, we think so. I agree with your comments. We saw the same. Certainly, second half of -- third quarter, we saw a good production, good rate improvement, good rate environment, which did accelerate in the fourth quarter. And so far through the first quarter, we're seeing similar types of improvements. So we're bullish on that front. I think we're -- it looks like it's going to be a good start to 2020. And I think with what's been happening in the last week or so, I think that'll just provide an even more [ juice ] or more impetus to sustain this positive environment. So I think that's all good. We would have said -- we would have thought it would have been there with us for all of 2020. Whether it's sustainable for a longer period, time will tell. But this latest event, I think, will just be another reminder that there's bad stuff out there that can happen, and we need to remain disciplined in how we price the product in some lines, even though property, for example, it will be directly impacted by this event. I think collective way thing be the -- we would argue that all of this pricing across the board needs to improve, some things more than others. But I think there's hope that this will be with us for a bit longer.

There was a comment that came up on our -- in our discussion yesterday with one of your competitors, and they had observed -- I mean, insurance is the way that companies manage risk. And when times are uncertain, that doesn't cause people to usually cut their coverages, certainly if related to an event that many people view as reasonably short term in nature. If anything, it makes people look more carefully at what exposures they have and look for ways to do their own risk management. So who knows that we won't see actually some improvement in demand, certainly nothing that would erode it in a major way.

Right. That's fair. But the one thing that I would say, and it's more in the supply on -- and I think we've touched on it at other conferences and on our last earnings call, the one thing that we -- is -- gives us a bit of pause and how much improvement is needed in this and based on what people -- what companies reported at Q4 and the general sentiment that things are improving. It's still related to insurance companies, in general, reporting fairly favorable results. So there's -- doesn't seem to be tremendous pain in the system quite yet or at least on a published basis. So that's the one thing that we still are trying to resolve or trying to connect the dots, where some companies are reporting pretty, again, good, solid results, low 90s in terms of combined ratios, and yet, they are saying that they're pushing for more rate. And that's the one thing that seems to be -- there seems to be a little disconnect, at least on a reported basis. Maybe they feel there's more pain that is yet to flow through the numbers. But at this point, that's the one thing that we would caution everyone to think or say, well, how sustainable is this improvement. Truly -- how truly is this sustainable given that we're not -- at least in aggregate, the industry is in a -- is in shorter capital, isn't really having seeing a lot of adverse -- prior year adverse development. And yes, there have been caps, but we haven't had the really big, I'd say, capital event. We've had lots of earnings events. So we put it all together, that's the one thing that we're still not -- that we would -- I think time will tell throughout as we go into 2010 -- 2020, how things are going to play out there.

Yes, I think that's an important difference relative to, say, the hard market of 2002 through 2005. I mean there, you had balance sheets that generally had sizable below-the-water holes in them, and it took several years to unwind that. Well, clearly, some companies have had pockets of reserving issues. In general, the information systems are better, companies have kept up closer along the way. Have taken intermediate actions to -- not necessarily without paying, but there's -- I don't have the sense that anybody is particularly one bad cat away from being capital stressed. It's really a matter of getting back to ROEs that are solid double-digit ROEs and acceptable to investors and return cost to capital. So I think that's a very good point. Maybe turning over, I've got a question on the line which kind of aligned with one of the questions I was going to ask anyway. Just -- you guys obviously -- mortgage insurance is a big part of the overall portfolio. I guess where are we in the mortgage insurance cycle? I mean I would suppose interest rates going down as they have, that could actually be a little bit of a boost in the short run, at least for demand, although I guess there's credit and other pieces of the puzzle. What can you share there?

Yes. I think -- I mean, there's a lot of things working in our favor with lower interest rates. The one maybe goes a little bit against us is an elevated refinance activity, which we saw in the second half of 2019. And if rates remain that low or even go lower, we would probably see more of that. Although at some point, the benefit just isn't there for people to keep refinancing their homes every 12 to 18 months. So we'll see how that plays out. But certainly, in a lower interest rate environment, affordability is up. The credit characteristics -- and again, considering that the unemployment rate stays really low, as it is right now, I think we've got a lot of good demographics, again, working in our favor. People have jobs, they pick their payments, their credit history improves over time. They can afford a bit more home or at least their debt-to-income ratio goes -- it goes down. So there's a lot of good things that I think work in our favor. One of the issues, though, that we want to be -- keep an eye on for us is the supply of homes. I mean, as you know, our entry-level homes is really our bread and butter, the first-time buyer that needs the product to afford his or her first home. We're a bit -- well, we're well behind the level of supply that we need to put everybody in homes. So just got to watch out a little bit for price wars or people coming up with a bit of -- elevating the price of the homes. But we'll keep an eye on that, and we're fairly very confident that things are behaving rationally in this environment. So at this point, yes, we're very, very bullish on how things are -- how the housing market is looking and how it's performing.

No, it's definitely -- I don't know, we -- I spent a lot of -- yesterday, it was the RBC Financials Conference. So obviously, the banks and things are presenting. Obviously, they have different issues because they have to worry about net interest margins and all that type of stuff. But all of them are definitely expressing that there's demand for loans that people want to buy, view this as a good time to buy or refinance. And as mortgage insurers, as long as the credit quality holds up, that's historically the big risk, not whether the volume is a little better or a little worse, but are the loan standards being maintained. And I would think, anyway, with interest rates at such low levels, banks have to keep diligent. They're not making much money in the first place on the loans. They certainly can't afford a lot of credit lost when you let a mortgage go at 3%.

Absolutely. And the other thing I'll add to that is the GSEs are very much behaving like they said they would. And in this potential evolution of their structure or their ownership or if they have -- or if they're serious about trying to go back to being public entities, they have to demonstrate that they're serious about credit and not taking on more than they're able to or want the price for. So that also works in our favor. I mean there's no pressure to expand or limited pressure, I'd say, to expand the credit box. There's always some areas where we're reevaluating things as we go, and that's just good business. But to us, it's always been around the product, and the product is -- remains as it's been for the last 10-plus years without Alt-As and subprimes and all these types of bad loans without income verification, et cetera, if we remain solid at that the front end with the underwriting, we -- again, we think there's a lot of room for us to participate and then enjoy the robust housing market.

Yes. No, I'm going to thank you, too. It was an unrehearsed segue. We've got Mark Calabria speaking -- Head of the FHFA is speaking on our conference at midday today. So anybody on the line, including yourself that wants to listen into his remarks, I'm certainly looking forward to it. And that's another vector that could be potentially a positive for the sector. Let me just throw out a quick reminder to those on the line, if you have any questions that you'd like me to ask, certainly pop them through using that question box in the left corner of your screen. Until I see my screen repopulate, I'll ask another 1 from my list. You recently did a deal to acquire Barbican Holdings. We've seen a couple other smaller deals in recent years, the Aspen Re and binding and insurance specialties. The deal recently for the -- the name -- I'm drawing a blank on the name, the political risk business. Maybe just take a minute and talk about...

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That's it. Yes. Talk about how you're thinking about M&A? What you're seeing? What kind of the strategy in thinking is with these deals?

Yes. I think, well, we built out the 3-legged stool approach a few years ago with the introduction of the mortgage segment. And we've always felt that we had a -- we were pretty much in most, if not all of the segments that we felt we wanted to play in. And recognize that there's some areas we could be better. But ultimately, we were just looking for always contemplating or looking for places that we can improve, either get scale or efficiencies and improve our distribution. And certainly, around Barbican, that was very much the play there, I would say, where 2 things that we -- that came to mind with that acquisition. One was around Lloyd's, as we all know, has had its struggles the last, let's say, 5 years or so, maybe a bit longer. An elevated expense ratio problem for most, if not all participants in that market. And maybe not enough sound or good underwriting at the front end, but in a soft market environment for sure. So the 2 things that we liked about Barbican, one was they had -- it gave us a bit more scale. And they're bigger, and combining it with our existing syndicate just made it -- gave us a bit more scale, it gave more relevance for the brokers, gave us the ability -- will give us the ability to lead on some programs. There's also some consortium business that we're leading, so that'll provide some fees. And the other thing that I think is maybe just as important if not more important is the fact that they had built a very -- they'd evolved their platform or the structure to really draw third-party capital and bring in them to support their operations or their syndicates. So we were curious about that. We feel that that's an area that we want to grow a little bit, leverage our underwriting expertise while relying on third-party -- supporting or using third-party capital to support our -- the growth and then the business we're in. And the fact that they've done it in a good way, I think, was intriguing to us. So that was, I'd say, the second part of the proposition that we liked. And were able to reach terms with the seller, and here we are today. So we're extremely happy with the -- with this acquisition. It was very much a strategic acquisition, but as it -- I mean, time -- it's still a bit early. But 6 months in, since we announced the transaction in July, I want to say that maybe the improving marketplace is something that we had fully baked into our projections. So I think we may have some additional tailwind that work in our favor on this one.

That's a helpful update. I mean, certainly, we'll see as time goes on. But between the fee income, the presence at Lloyd's, I mean I think all of those are good extensions that could pay dividends over time. We've got a question here from the line, and this is kind of jumping back to the P&C pricing environment. The question is basically are you seeing much activity from competitors exiting or curtailing certain lines of business? Is that creating dislocation that's an opportunity for you? And are you seeing any notable increases in just overall submission flow, particularly in some of your more specialty-oriented lines?

Yes. I think people pulling out -- I think, there's been a lot of at Lloyd's for sure, but I would say those have been typically smaller teams and without the scale, without the presence to really drive the market. So -- I mean, not surprising, may have had a couple of bad years in a row of poor underwriting performance. And then at some point, management teams decided to cut the cord and let the -- shut down some of those units. So I think that's -- I mean, that happens pretty -- throughout the cycle and now people that are seeing what kind of results those -- some of those teams have generated. I think there's not a whole lot of options in front of them, so shutting them down is definitely one that we've seen a lot of over the last few months. Now going back and we -- I mean, AIG and Lloyd's both really retracting or pulling capacity out of the market, which started sometime in 2019, second half of 2019, for sure, has been very helpful for us and everybody. I think it just helped us achieve a certain level of rigor in the pricing process and the underwriting, the discipline is there and we don't see really any signs of people not behaving in the rationale way at this point. I think most people, we can always do better, but at a high level we're seeing business being transacted at -- risk-adjusted rates that are a bit more [Audio Gap]

And from the line, this is a pretty interesting idea. Just some of the banks, and we've seen this in Italy, have talked about allowing homeowners a moratorium or suspension of mortgage payments for a period of time related to coronavirus, of course. How would that work with MI? I guess you would grant that same forbearance, and they would just roll over -- resume whenever the payment cycle resumed. Is -- maybe it's too soon to ask, I don't know. Any thoughts?

No, but it's -- I mean it's happened with hurricane. So if -- and maybe it becomes a national thing. But certainly, in hurricane-hit areas, as recently as 2 years ago, people were -- the banks and the government there, FHFA et cetera, can agree that they provide forbearance to the homeowners for 60 days, 90 days, depending on how long this thing lasts, I think it's early, as we all know, because, hey, maybe people are working from home, but they'll still get a paycheck. Now production industries that -- where people definitely need to be in the office or in the shop to do -- to produce the product. And maybe the credit -- or the trade slows down, there's less production. So maybe people get laid off for months, who knows. We'll see how that plays out, but that -- we would certainly -- I mean, that's been done in the past. So not for us to decide who and when these things may become or programs may become declared, but we -- I mean, it wouldn't be a total shock that they get it down the road.

Right. Okay. Well, that's helpful. I see from the clock that we're getting to the top of the hour. The half of the bottom of the hour, I guess. This isn't the P&C clock, it ends -- it starts at the bottom, not at the top. So with that, I'm going to take the opportunity to thank you for participating. You can -- will -- everybody will give virtual applause at this point, wherever they all are sitting. And we look forward to catch up with you again at first quarter earnings, if not before. So thanks very much.

Thanks, Mark.

Thank you.

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Indeed.