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

Hello, everyone. Good afternoon, and welcome to the next presentation with Arch Capital. We're pleased today to be joined by Marc Grandisson, CEO; François Morin, CFO; Don Watson, EVP, Financial Services and Head of Investor Relations. And I want to thank the 3 of them for taking the time out today to be with us. The format today is going to be a fireside chat with Q&A. If anyone is listening online and would like to ask a question, please send that to me. It is [email protected].

So I will kick things off. I think very topical these days for investors is just the impact of COVID-19 on the industry. And obviously, that impacts many different businesses throughout March. So maybe if we start on the property casualty insurance side of things. We've been hearing about this being the largest loss ever for the industry. I'd be interested to get your views on this topic. And do you guys have some thoughts, recognizing it's still a fluid situation, given your presence on the primary and the reinsurance side, how we could see this loss transpire into both primary as well as certain percentage of losses that might hit the reinsurance market?

Okay. Elyse, this is Marc. So good to hear your voice. Hopefully, we get to see each other at some point in 2020. And thanks for everyone dialing in and listening to us. So I'll start and sure François will complete some stuff I may be missing. So this is truly, as everybody knows, a significant loss. Pretty hard to pin down what size of losses for the industry because I don't think that we have a really clear, obviously, picture as to what and -- what lines of business it will impact and how widespread it will be, and finally and not insignificantly, how long it's going to last. So the longer it lasts, obviously, the deeper the impact will be. It's hard for us to see what size of losses. I think there's a couple of more immediate or the early stages of loss indication were easier to identify. One of it is the contingency market, obviously, that people talk $15 billion to $20 billion, I think, sizable loss. Obviously, it's a smaller market. It's a small market in the grand scheme of things but concentrated with -- really exposed to those kinds of events. So it's a little bit "easier to identify." The rest of it is finding its way through the market. And from our perspective at Arch, which is probably the best way for me to start talking to it, because we have a little bit more visibility on this one ourselves, the initial numbers that we came up with for the first quarter had to do with -- I'll run through at a high level, not the numbers, but the areas: some BI exposure from a very small portfolio in the U.K., which did not have a virus exclusion; some Canadian program that had some cancellation-related coverages; some trade credit exposure. There was also some surety loss, some surety initial loss, but nothing really to speak of that was solid and concrete. A lot of it had to do with sort of built on expectations that the result for the remainder of the year will be a little bit more and a higher loss ratio as we go forward. On the reinsurance side, we had -- this is where trade rate came in. On the property cat side, I don't -- I think it was too early. It is still quite early to see how the losses will accumulate, and if they do, whether they will be recovered from the cat itself or the excess of loss protection of treaties that are in place. It's a little bit clearer on a quota share basis. So a few reinsurance company have provide quota share protection to insurance companies. These transactions tend to follow the fortune of the -- we tend to follow the fortune of the client, and we tend to have a dollar -- a probably, perhaps, with sort of equivalent recovery. In terms of our U.S. exposure on the property side, which is probably a bit more interesting because of all the legislative pressure, or shall I say, headlines in the papers, we have said on the call, and we want to emphasize it again, that 98% of our policies have a physical damage specific -- physical -- direct physical damage coverage, and 94% plus of our policies have a virus exclusion. And this is not -- and it also reflects the kind of business that we write. I think that the larger risk around the world, the larger cedents around the world probably have wider, broader coverage. On the insurance side, we tend to focus on a smaller side of the risk. And so the policies are probably more standardized. A lot of them will have an ISO or an equivalent standardized language with some virus exclusion or indirect physical damage. And for the rest of the portfolio that could be impacted in the U.S., workers' comp, for instance, is a good place to look at. And also, including some other property business that we have written that did not necessarily have virus exclusion, we would be excess of the business interruption sub-limit in large parts on the property side. And workers' comp, we're also excess. So from our vantage point, and it's really as a result of our defensive posture for the last 5 or 6 years, we will have losses, obviously, like everyone else, but we believe that our portfolio is a little bit less representative of the broader marketplace. And this is just by the design of the portfolio with no foresight as to what COVID or COVID-type of event could create to our portfolio. Which leaves me now to say, well, on the front, in terms of industry, my belief is that this loss feels [ that it ] does feel like Katrina because in the sense that it's a large loss and it will probably be disproportionately -- will affect companies disproportionately. Not everyone will have an equivalent market share that you will describe to it on those regular cat circumstances, which makes it a lot harder for all you guys to evaluate. And certainly for us, as a provider of reinsurance, some clients will have more exposure than others, and that will create a lot more uncertainties on the numbers that we'll be generating. In terms of the split between insurance and reinsurance, I would say that my expectation is that the insurance industry in the U.S. will take a larger share, and it's really as a result of the last 20 years, the insurance companies in the U.S. have had higher and higher retention. They're a lot less reliant on reinsurance, much to the chagrin into all our reinsurance underwriting teams in the U.S. So we tend to think it's 60 or much more exposure on the insurance side than on the reinsurance side. I think internationally, it's the opposite. I think that international companies have been historically buying more reinsurance at probably lower level of attachment. So I would expect overall, maybe a 50-50. But this is, again, Elyse, really, really early, really high level. With -- granted based on the portfolio we have, not as well informed as perhaps the other big participant in the marketplace would see. So on that note, I'll turn to François if he has more comment to add.

Nothing to add, Marc.

That's fair as well.

That's very thorough. Maybe shifting gears and sticking kind of with COVID from a different angle to your mortgage insurance business. That's obviously been a very profitable business for Arch through the years and obviously heading into some uncertain times. And you guys did lay out at least an initial outlook for the impact that the economic slowdown could have on that business on your last earnings call, by effectively saying that there would be minimal underwriting income for the balance of the year. And then just a few questions, I think, just to get some clarity surrounding on the assumptions there by just realizing, obviously, that everything is fluid. If you could just maybe give a sense of the delinquencies versus actual claims that you guys are assuming within that projection. And then could you give a sense of the severity associated with the losses that you're thinking right now? Recognizing that obviously it's an ongoing situation.

Yes. Let me start. I think the -- what we're trying to tell people effectively is there's -- for 2020, we just expect a spike in delinquencies. I think it's just, with the forbearance program that's in place and just the severity of the unemployment rate or how quick that's really -- how quickly that's transpired and then what we think it means for the economy in the short term, at least, the reality is we do expect a fair amount of delinquencies to be reported to us starting in Q2. And most likely, there will be more in Q3 and Q4. And just based on the accounting rules, we'll have to set up case reserves for those. Now many of them will be under -- many of these delinquencies will be under forbearance programs, which means that they're effectively protected for a year. There's no -- we can't pay a claim on those for a year. They can't be evicted. They can't be foreclosed on, et cetera. So what we're just seeing happen in pretty much for the remainder of the year is effectively just a surge in delinquencies. And I'd say not much else at this point because we won't be paying claims. That will take time. That will probably be into '21 and '22. But to answer your question, Elyse, around kind of what are we -- what's the scenario? Is yes, we're thinking delinquency rates could -- at this point, could be in the 15% range. That's really what's kind of, at a high level, underlying our projection of no underwriting income for the remainder of 2020 for the mortgage group. Now so far, and it's very, very early, but the indications, and there's weekly statistics that get published, it looks like we're not at that level yet. So that's at least somewhat encouraging, but we're not -- again, very early. So not sure. We're not ready to change that forecast, certainly not until the end of the second quarter. So that's kind of how we think about it. And then if the economy, depending on how the economy recovers, whether there's any recovery in the fourth quarter or if it only really gets going in a meaningful way in 2021 and what it means for people getting job -- their jobs back and whether they can actually exit their forbearance program or plan, and -- with income and just being able to become current on their mortgage loans, we'll see how that plays out in 2021. But at this time, we're -- we've done some modeling, and we're pretty comfortable that it's not going to be -- and we said it on the call, but it's really just going to be an earnings event for us and not a capital event. So I'll stop here, and maybe Marc wants to chime in, or Don, but...

Yes. The only other thing I would add to this is, in the call, we're not trying to describe any accuracy per se because it's so early. Even 3 weeks ago feels like a lifetime at this point in time as we look back. But we're trying to get a gauge or an evaluation, a rough idea to what could happen and what it could look like. And we had independently looked at some of our modeling and looked outside, the third-party vendor with third-party modeling that Moody's had put together. And we felt that one was roughly in the same areas as to we -- as the one that we would expect generally to be, at that point in time, nice expectations. And based on that one, we said, listen, based on that one, this could be some volatility from quarter-to-quarter. Ultimately, when everything is said and done because, as you know, Elyse, mortgage insurance takes a long time to develop, both on paid claims and getting premium, that we felt, yes, this is -- this was an S3 that we call about. This was a level of pressure on the system that we felt was indicative and a good place to start from a prudent perspective. And even on that basis, we think, based on the modeling we made, there are always scenarios where it could be deviating from it. But we felt that it was a good place to tell you that, well, don't expect much earnings or income from this year in the book of business. Sort of puts sort of like a ring-fencing around what, at that point in time, we thought the losses could develop like. And since then, I will echo what François said. We know the forbearance from the -- sort of the MBA had a survey came out last week. We had Black Knight, I believe, late last week. It's a 6% to 7% range of forbearance ratio. This is -- I want to put in perspective that the 15% that François has mentioned. So at this point in time, it looks like it's a little bit less. We're ramping up a bit less rapidly than we expected. I mean it remains to be seen if it holds back -- if it holds there. And that -- but the one thing I would also tell you, which is of interest to us, obviously, is that the 6% or 6.5% that is now the forbearance rate, 1/3 of those folks are still paying their mortgage. So it's not technically delinquent. Even though we receive them as forbearance, they are not technically delinquent because they're still current. So the "true" forbearance number is close to 4%, 4.5%. So it makes us feel a bit better, but it's still early, like I said. So really, S3 on the call was an attempt to put some kind of rough range around as to what -- how bad it could get.

That's helpful. And maybe just one quick follow-up just to try to kind of ring-fence the outlook. So you guys on the call also pointed to the fact, right, that as furloughed workers go back to work, right, we could see a good percentage of these loans that become delinquent actually cure. So when you came on to your outlook for the next 3 quarters, are you assuming any significant cure rate? Or if it does play out right, that a good portion of these notices actually cure, that would more come into results in 2021?

I think the way -- I'll let François ask a little bit about it. Just quickly, Elyse, the problem with the modeling is very -- beyond the fact that there's a lot of uncertainties, and not even including the government intervention and all the various ways they want us to remediate all these -- or no, they want to service or to remediate all these forbearance as they come out, possibly, hopefully, out of forbearance, is that you can have -- the forbearance can stay there. People could choose to be on the forbearance for 6 to 8 months. At that point, we won't be able to take it down until such time as they all came out of forbearance and become current again, which could take a little while. So we'll have a little bit of a in-between period where we'll have to let the forbearance come through. Maybe some become delinquent, some stay forbear -- as a forbearance claim. And then it will take a lot before we see it evolving and ultimately resolving itself either way, being cure or becoming a true delinquency the way we understand it, and eventually makes its way, even itself possibly curing down the road or also becoming a claim, ultimately. François, you want to say some few words?

Well, no, exactly what I was going to say. I think it's a bit of a sort of an unknown here because forbearance programs are, to some people, maybe a bit of a free pass. So it's hard to know how people are going to exactly behave. And you read articles or read an article this morning where people -- or, I guess, were put into forbearance programs without their knowledge, and that prevented them from buying a new truck, and they didn't like it. So there's a lot of secondary kind of implications that will have to get resolved over the coming months. And that's just -- we just don't know. So I think it's -- or to be overly precise with forecasts of when the cures are going to show up, when -- by quarter is becoming a bit early. I mean it's a bit too precise -- or we don't have the precision at this point.

Okay. That's helpful. And shifting gears a little bit because, obviously, there is -- where -- there seems to be an emerging hard market in many areas of the property casualty sector. And so maybe if we first want to just touch, come back to your insurance business. Just touching on that from a couple of angles, just the pricing opportunity you see emerging. And not to make it a 2-part question, but at Arch, you guys have really focused on getting that business to like a mid-90s underlying margin. You guys got pretty close in the first quarter. And I would imagine with some good pricing momentum, that could probably help put you at that target.

Yes. I think it's a very fair statement, Elyse. And we've been working hard at improving things for ourselves operationally, underwriting-wise and all the things in between. And the market is also very important, right? The market has accelerated the momentum in price increase. You've heard it everywhere, and we've seen it ourselves, and we continue to see it on the insurance, and now it's catching on in a little bigger way on the reinsurance side. So I think you're right. I mean for the same amount of risk that you write -- forgetting COVID for 1 second because that will create a bit more top line volatility in terms of premium earnings and written for the next probably year. But everything else being equal, which never is, I know, but everything else being equal, if you have -- if you're at 100% combined ratio, and you're getting a 10% increase, your combined ratio will go down significantly as a result of that. The one thing I will be cautioning everyone though is combined ratio is one dimension on a return on equity basis, which you know, Elyse, we're very keen on. At the same time, the pricing is going up, but the interest rate are going down. So that also would put a little bit of a dampening on our returns. So the 95% combined, which is -- it will be a nice place for us to be, but it would have been a nicer place to be when interest rate were 2.5% to 3% for the 5-year. As it is right now, less than 1%. So the 95% is not where it used to be, so as some people say all the time. So I just want to make sure we -- but I guess, the point to us, it's always about seeking and getting to the place where the returns are where we want them to be or we would want them to be to write a bit more. And as a result of some price increase on insurance and reinsurance, you saw our increase in written premium, I think that tells the story more than anything else I could tell you on this call. The fact that we're growing our top line is a great indication at Arch Capital Group that we are seeing returns improving to a large extent. So François, anything else you want to add?

No.

So I guess maybe to put in a little bit different perspective, just sticking still with reinsurance for a second. Does this feel like one of the -- we're approaching one of the better reinsurance markets since Arch has been around? Or is there another time period that you could compare this market to? Just so we could get a full sense of the opportunity you see out there on the insurance side.

Yes. I think some folks out there have seen it, and I feel the same way. And if you ask our underwriting team, I think that it feels a little bit light after 9/11. I mean 2 terrible events, COVID and 9/11, obviously, but creating a lot of uncertainties and the heightened risk perception, which is really what moves markets, right? Losses can move markets, but oftentimes, they don't. We've got a couple of cats over the last 10 years that did not move the needle either way on the pricing. I think that this one is different because it's, again, another nonmodeled loss. We've had so many of those, and there's sort of another one that you add on to the pile, and it creates more uncertainty. And we also -- so we treated risk uncertainty, unmodeled losses, you don't know. You heard me say earlier, we don't really know how it's going to develop and which line of business it will impact. And in this case, it looks like one -- like [ Walter ] said, it will impact way more than we could imagine, and it's much broader, much deeper in terms of what lines of business it's impacting, which creates a little bit more anxiety, if you will, if you're in underwriting or a provider of capital or a Board of Director. So it feels a little bit like 9/11. We also had a little bit of momentum building as we had in 2001, an event occurs that really pushes not things over the edge because it's not a great analogy, but really pushes things a step further, maybe a bridge too far, people say. Well, at that point in time, let's take a breather, let's take a step back, let's reevaluate what we have, let's rethink the way we price and provide risk to the marketplace. And that was very similar to 9/11. And very much like 9/11, the early -- I was there counting our losses when I was at my prior job, and it was very difficult to evaluate. It was very, very difficult to understand. We didn't have clarity or visibility. It took like 2 or 3 months, and 9/11 was done in a day, right? The losses occurred in 1 day then we start accounting it. This one is ongoing. We don't know when it's going to end, and we don't know the intensity. So I would even argue it's World Trade Center, like a slow-developing World Trade Center. So it feels like this, which, to me, indicates a few things. Some -- unfortunately, some of our competitors may have booked a business that are overly exposed or not properly protected or not enough protected, which will make losses become capital events and will create probably more extreme or more striking reactions from their underwriting. But it will take a while to develop. And again, I'm sure, Elyse, I'll sit here and François will sit here with you in a year from now, and I'm sure we'll have discovered some other thing that has happened as a result of COVID-19 that we did not foresee. But everything else indicates that we're going to have a severe reprice of the capital. No more people are going to be accepting 6% or 7% return, I think, because there's recognition that we need to price better. We need to provide the coverage better. We need to know and be a bit more careful in the way we provide capital to the marketplace.

That's helpful. And then maybe shifting gears a little bit, getting more into reinsurance. We've heard, it seems like there is some pretty good pricing momentum within the Florida market. We're obviously a few days away from the 6/1 renewals. And then I've also heard that there could be a good amount of trapped capital related to COVID, which could have an impact on reinsurance, I would think, heading into 2021 and the January renewal. So just have kind of a short-term June 1 pricing view, and then how you think reinsurance market can play out heading into 2021.

Yes. So we are not a big cat player. As you know, Elyse, it's one of the lines we do. It's a very profitable line for us. And I think right now, we're seeing rates getting even better than I thought last week. So this is a really, really fluid marketplace, Elyse. It's moving almost daily. We're, for the first time, hearing with one anecdote I shared with some of your clients earlier today, that a very blue-chip company buying a cat cover, has done it for years and years, was overplaced, no issue placing it for the first time in years, had to do a shortfall because it was missing capacity to fill the gap. So that is a strong indicator of distress or stress on the part of the traditional reinsurance marketplace. So that's a good sign in terms of this market is not as reliant as it was once late '90s, early 2000, on the retro market. But certainly, the alternative capital being satisfied or being comfortable with a 6% to 7% return had helped, I would argue, temper or at least put the rates down and somewhat tempered them down for a while. I think that's going to go away, and that capital is 1:1. There's not much diversification to that capital. So that trapped capital not being there to support the overall cat market, or being there at a much higher increase will push through the supply chain of capital, further increase as you go down the supply chain of capital. So we heard that 50% of capital will be trapped as a result of that event. So we'll see how that shakes out. There's still capital available out there. There will be still people wanting to get into the business. But I think that there are -- there is still some need to assess, evaluate what's happening before we have a significant amount of capital coming in from the alternative side I'm talking about now. Because they've been burned once, if not twice before, so there's a little bit of the healthy level of skepticism and pragmatic -- pragmatism from them from that perspective. So everything is indicating an ongoing hard market and very tightening of terms and conditions. And I would even argue that clients tell us, on the reinsurance side at least, that they're going to probably buy more because they also have more risk, they feel more risk, they feel a little bit more exposed. So shrinking of supply of capital with increased demand, you've done microeconomics, Elyse, that means price should go up.

That's helpful. And I think we have time for one last question, but maybe to, in a way, tie it all together. You guys started off by saying, right, COVID is an earnings event and not a capital event for Arch. You guys did pause your buybacks with a whole host of other insurance carriers with earnings. And so it seems like that's more to help you guys play offense on the property casualty side. And then is that kind of thought process [ to ] be paying attention to when considering a potential return to buying back the shares?

I mean yes, the share buyback pause, I'd say, was really -- we wanted to make sure we had a good -- we're able to assess everything that was in front of us. So I think it's important for us to know all the exposures that we have. And even like Marc said, 3 weeks ago, was -- the world was a bit different. So we weren't in a position to know everything that was in front of us. So it is prudent to just take a little bit of a break there. But -- and also what's transpired in the last 3 weeks is improving P&C conditions. So that, we want to have all the tools in the toolbox available to us, and having a strong capital base is certainly one of those. So as we move into 6/1 and 7/1s and beyond, we want to be able to play offense as needed and where we think the return will be attractive to us, and that starts with having a strong capital base. So we'll be looking to work -- to put that capital to work.

That's helpful. And we have approached the end of the time period. Before we end things, do appreciate, like the mortgage update, that things do seem to be better, what you guys had said on your conference call. But is there anything else you just want to make sure investors walk away with? Any kind of concluding comments, either Marc or François?

Nothing other than we're pretty bullish on the P&C market. We think that our mortgage insurance perspective is still also a very improving market, I mean, for the reasons that are obvious. We think we have a really good, solid credit base. The borrower base is pretty strong. And [ it seems we're both in adversity ], we still have a lot of reinsurance. So I think the model that we've built, we're very, very, very happy. It's a resilient model. It's held well, which allows us to see these opportunities in the future. We're pretty happy with where we are right now.

Okay. And we're at the end of time. I just want to take the time to thank Marc and François and Don. And if anybody wanted to ask any questions, please reach out to Don Watson within Investor Relations. You can also reach out to me if I can give any help to you. And I also just want to thank Arch Capital for participating today. Thank you. And this does conclude today's webcast.

Thanks, Elyse. Thank you.