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

Well, that's an ongoing discussion, right? I mean it's something -- we just wrapped up Board meetings last week. It's something that we do constantly every -- it's part of our day-to-day conversations. But at a high level, no question that back in March, we were like many others. And I think we were very uncertain around what the future held for us, so we felt that the prudent thing to do was to hold on to as much capital as we could because we just didn't know how the pandemic would play out. And then -- so that was really, I'd say, the first step in the process, holding on to a bit more capital as a defensive measure going into the pandemic. And then we realized -- and we had some thoughts anyway before then, that '20 -- the second half of 2020 and '21 we thought were going to be better markets for us to deploy capital. And we just decided to act on it late in the second quarter, to access a bit more capital to deploy in the marketplace and not knowing what the conditions would be like in terms of capital raising in the second or third or fourth quarter. We just thought the timing was appropriate for us to raise $1 billion. Happy we did it and at pretty attractive terms. And here we are looking forward to -- we've already deployed some of it in the business. But the mission really for our guys is to look for opportunities to deploy more of that capital as we enter 2021. And we think the market will be there for that. And if it's not, then it will be -- we'll reevaluate everything we do around -- as part of our ongoing analysis of share buybacks. If we can't deploy that capital in the business, then we'll be more than happy to return it to shareholders. But at this time, not knowing -- again, not having all the details in front of us, but we'll have more visibility into that later on this year. And we'll be active either way, whether we deploy it in the business or return it to shareholder or -- shareholders will -- that's our #1 mission is to be efficient capital allocators. And I don't think that will change going forward.

Got it. I guess one factor you didn't touch upon in your capital deployment is your MI experience, which looks like it's been faring better than expected. So how much pause on your capital deployment is attributable to the MI book?

Well, certainly a lot of it. No question that early in the pandemic -- we went into the pandemic and we didn't expect it was going to be a pandemic. But we have been very, very comfortable and confident that our underwriting and the business model we have for the mortgage group was as good as it -- I mean as good as it turned out to be. So when people started asking questions, are we back to another repeat of the crisis, we were very -- right from the start, we knew that it was a different -- totally different situation. And we had a lot of confidence that it would not play out to be as bad as what it was 10, 12 years ago. That said, it was still new and we -- government intervention. There's a lot of things that took place that minimized the losses to our industry. But because of the uncertainties, that certainly forced us or made us think a bit harder about share buybacks. And that certainly contributed to the pause or the fact that we stopped buying back shares in the -- at the end of March. But since then, it's another -- we've had a few quarters of positive signs. We're not over the hump yet. This is by no means a done deal, but we are certainly more optimistic that things will work out well or won't be -- and we said it a few times, we think it will be an earnings event and not a capital event for us, and we still believe in that very much so and maybe even -- not much of a capital -- of an earnings event. So again, time will tell, but as things -- if we keep getting more and more positive signs that the mortgage industry is going to perform well even through the pandemic, then it will give us more reassurance that we can be even more active around capital management decisions.

Got it. So I think we touched on the buybacks. But I guess just given the optimism on pricing, to what extent would you be preserving capital versus deploying underwriting capacity in areas that meet your risk-adjusted return hurdles?

Well, I mean not every line of business is at the level that we would like it to be, but it's getting more and more at that level for many -- most of -- many of our lines. So there's a few areas still that we're -- we need more rate to really deploy a ton of capital or deploy maybe very aggressive in those lines. But at a high level, I'd say that we have the capital we need now to be able to deploy -- to be as active as our underwriters feel they want to be or can achieve the returns that we demand of them. We have the capital to do that for the foreseeable future. So if it ends up being that '21 gets to be even better or harder than we think it may be, then we'll see how much capital -- if we need additional capital. But for the time being, we feel we're in a good position to go through the next few innings of the pandemic. And we think we've been relatively prudent in terms of reserving and what it means for us on the P&C side. Hopefully, the mortgage keeps performing well. And then as we enter, again, '21, we'd like to think we've got lots of room for us to deploy a lot more capital.

Got it. And what's interesting is that for P&C insurers, they actually take more risk on the liability side than the asset side. But if you look at your earnings track record, investment income eclipse underwriting income, excluding cats and PYD. And I'm just wondering, given the unprecedented near-0 interest rates, do you think you'll get to the point where underwriting income becomes a more meaningful contributor to earnings?

It has to, no question. It's something that we -- you could generate relatively -- I mean reasonable returns in the last few years, if you adjust for cats and PYD with certainly not as -- it's been a soft market, so not nearly as good as they need to be in the long term over the cycle. But still, I think people were able to produce reasonable returns basically on the heels of investment income because underwriting returns really haven't been there. And now that investment income is -- we feel is going to be depressed for the foreseeable future, no question that the underwriting income has to step up or has to be the main source of income across the group. And we're not alone in that. I think all companies -- and maybe some companies are even -- I think companies that have relied even more so on investment income may feel a bit more pressured to adjust their underwriting model to generate those kind of returns on the underwriting side. But yes, no question that across the industry, underwriting income has to become a more meaningful part of the picture.

Okay. So with that being said, how many points on the combined ratio would you need to get there to make up for that difference?

Again, a few -- a typical line of business. And you say -- you write that one-to-one and maybe -- I mean some lines you write on less than that, depending on the leverage you can employ. But one-to-one and you're saying you're losing -- even if you're losing just 100 bps of investment income over a 3-year duration, there's your math. I mean it's at least 3 points of underwriting on the combined ratio that you have to find some -- you have to find in the combined ratio if you're just -- and yes, there's, I mean, taxes and everything. But big picture, that's -- I mean it's a material difference that has to be made up. And in some lines, we are making it. And that's why in others, we're saying yes, the rate improvement is there. But we feel it has to be even more pronounced for us to really make up not only what's been lost in prior years in terms of underwriting profitability but also make up for that loss of investment income we've seen in the last 6 months.

Got it. I'm just going to remind folks to submit questions. And hopefully, I'll be taking some questions, but I'll warm it up and continue asking from my prepared questions. Maybe just shifting from the earnings side, underwriting earnings side, low interest rates to your investment portfolio, how does low interest rates reshape your asset allocation posture?

Well, it's a difficult game, right? We at Arch have always said, listen, we're an underwriting shop first and we like to enhance our ROEs. Our view is that we can enhance our ROEs by providing -- with the investment side and generate some additional income or returns from the underwriting side. So we're not -- we haven't -- we never really relied in a material way on the underwriting -- on the investment side to really produce superior ROEs. It's been an underwriting game for us and that remains so. But there's still, call it, a basic minimum of investment income that we need to generate. And now we're -- in the old days, we could easily generate that with a pretty vanilla investment strategy of treasuries and corporates, high quality, investment grade, and you'd be -- you'd kind of be there. Now that feels that it's even harder to do that with those types of basic investment instruments. So we're trying to -- and we have to and I'm sure others are as well, we're trying to be a bit more open to alternative types of investments. It doesn't have to be necessarily kind of long-dated kind of PE-like investments. It could be -- there's some credit strategies out there that have a bit more structure that we -- where we can still generate a fair amount of investment income but generate a bit more yield as well without being locked in for an extremely long period and not having any kind of liquidity. So it's a balance, I'd say. We are, again, more open, more on the lookout for those kinds of opportunities. But recognizing that we -- bottom line and ultimately for us, underwriting has to drive it and investments are there -- is there to help us out along the way.

Got it. So let's talk about alternative capital. I don't even like using that term. I like to call it third-party capital because it's really permanent, here to stay. But there's a lot of talk now about that third-party capital being trapped or I like to call trapital. But new capital is coming in. So do you think that it's going to reload the trapped capital? Or is this new capital really going to be incremental to the overall mix?

That's a good question. I think the trapped capital, I think that there's been movement certainly. I think some of the investors in alternative capital, ILS funds have been -- maybe some of them have been disappointed in the performance of some markets in the last few years. And they're reassessing the value or the partnerships they have with -- in place. And I think there's certainly been a movement to a better -- or high-quality houses to partner up with. So that's something that I wouldn't say necessarily is people pulling out. It's maybe just a shift in where they're deploying their capital. In terms of the new capital, I mean, yes, there's a lot of speculation, I guess. There's a lot of people that have -- are interested in entering the space at this time. It feels like it's an opportune time to deploy capital in the insurance -- in the P&C insurance industry. We'll see how that plays, but I don't think -- I mean we haven't lost a whole lot of capital, I don't think, as an industry. I mean yes, there's COVID, and some of the bigger companies have taken on some material -- I mean pretty large losses. And if we add up all the -- if we agree or if we assume that COVID is going to be $50 billion and then -- or whatever, and then there's still nat cat that aren't -- there's -- it's been an active season so far. So there's more losses to come on that front. But at a high level, I think the industry is still -- in terms of capital, is pretty healthy. So it's not like there's tons of opportunities, I think, for new entrants to come in and deploy a lot of capital that is -- has vanished. I think the capital base is still very strong. So as people think about new vehicles or new ways to deploy capital, it's -- I don't think it will make a big difference in where we're at today because most of the established players are still pretty active in this space.

Got it. Maybe moving on to MI. Arch's mortgage delinquency rates are trending near 5% and is lower than what you had expected in the first quarter. So how much do you cautiously attribute this better-than-expected trend to the pent-up demand in housing versus government stimulus measures?

Well, it's hard, right? You know exactly why it's doing everything is better, no question. And again, as I said earlier, we were comfortable that our book had performed well in an adverse -- or in a stressed scenario. The reality is, on the early days, it was -- there was -- unemployment spiked up quite rapidly, which is something we look at and has an impact on the performance of the book, although we realized relatively quickly that unemployment did not affect our book of insurers as bad as maybe the broader population. So that's something that, I'd say, worked in our favor. Maybe it was -- I think we take some credit for that because that was considered in our underwriting. But for sure, the reality of a strong housing environment in terms of good demand and the home prices going up at a reasonable, if not even maybe higher than what people expected or what they saw coming, works in our favor. And that's always something we've said from the get-go is home prices are, by far, the most important variable in the performance of the book. If people have equity in the home, they find a way to either make their payments or at least there's, for them, an opportunity to sell the house without realizing a loss. So that's something that we are -- we've known all along. And it's actually playing out very strongly in these -- in the last few months. Yes, I mean the elevated unemployment benefits, I'm sure, helped along the way. And there's reasons to believe that the people that took up forbearance, signed up for forbearance plans will exit those plans without really being delinquent. So there's -- we'll know more in the coming months. But for the time being, I think we're pleased that we're -- it's been a somewhat stronger-than-expected housing environment across the U.S.

Got it. And this conversation just flew by. We only have about a minute left. So maybe I'll just put you on the spot, François, and ask any type of bold predictions for 2021, either for Arch or for the industry.

Well, we're bullish. I think across all 3 of our segments, we see the market coming to a realization that the business has been underpriced. I think the buyers, the sellers, everybody realize that there's more risk out there. And ultimately, that creates a bit of fear in the system, which we think will give us the ability to hopefully enjoy a solid, if not we don't like to say a hard market like you do. I think it's a -- I would say it's a taboo word, but it's an improving marketplace. And we'd like to think that it'll be there with us for '21 and beyond. And we'd like to think it's there for a solid stretch ahead of us.

Excellent. Well, thank you so much, François. Really enjoyed speaking to you.

Thank you. Thanks, everyone.

Okay. All right. Bye now.