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

It's our pleasure today to have with us Arch Capital. We have Maamoun Rajeh, the Chairman, sorry, and CEO of Arch's Reinsurance business. And we also have Don Watson, EVP, Financial Services and also Head of Investor Relations. I'm pretty sure most of you are familiar with them, but just to kind of get the high level introductions out of the way. This is being structured as a webinar, so you'll be able to see us visibly throughout the hour. You will, however, have the opportunity to ask your own question. You have a few different methods. [Operator Instructions]

I will kick things off with the first question. Probably most topical right now in the moon is just the upcoming January 1 reinsurance season. So could you just level set things for us? What are you thinking right now from a pricing perspective? And if we can get the view on both the reinsurance and as well as the retro side of the business and how you think things might shake out from a pricing perspective.

Sure. Thanks, Elyse, and thanks for having me. It's great to speak, as always. Good afternoon, everyone. In terms of one, one, Elyse, this is for us as underwriters going to be the most interesting renewal season we've had in many, many years. And we think about kind of the components that are driving this that get to the price changes, we have a level of uncertainty that's heightened. We have supply that's in flux. And frankly, we have demand that's increasing. I mean the interesting thing about our business, as you know, is when rates go up, even when units of exposure stay constant, rating agencies require more capital. And for reinsurers, that's a great combination, when our capital is needed at the height or in an inflecting rate environment. So an interesting time to be solving problems and being -- having an underwriter head on. But specifically to your question, if we think about property and retro, I think first of all, it's important to keep in mind that property rates have been moving. I think coming into midyear '19, our expectations as to rate movements around the -- mainly the Florida renewal was maybe plus 10%, and the market ended up -- or at least our portfolio ended up closer to plus 20%. And so that momentum, I think, is going to carry through to 1/1 not in the same level. But I do believe 1/1/2020 will continue that rate -- the rate rises that we've experienced beginning at 1/1/20. Now let's keep in mind, in 1st of January, the portfolio and the deals that we get to renew are global, right? And so we -- you get a smearing. You don't get just peak zone capacity and you don't get just loss impacted accounts. You get really a mix of a global U.S. and international for the business. But I do expect cap rates will continue to rise probably in the U.S. low double digits, high single digits depending on the zone and the dynamics of the deal. In retro will be orders of magnitude higher than that. I mean I think seeing what is already being discussed and some of the transactions that are on the desk, our handicapping of it is kind of where we expect it to be. I mean we think about retro at Arch. We're not a large retro player. It's not the biggest thing that we do, but it is piquing our attention and has been for the last couple of years as the market's inflected. But we do expect to see something closer to twice the traditional reinsurance pricing, something in the order of 25%. And our book getting up to 30% or north of 30% would be the area that would make retro a bit more interesting for us at Arch.

That's helpful. And then also at January 1, right, there's a good portion of European business that renews. And so I know, right, in past years, we've -- kind of when we get the holistic number, renewals kind of seem more muted, right, because Europe hasn't moved. Do you think that European rates can move coming off of not just the frequency of cats, right, but also the COVID losses? Is there an environment where we think we can get some price in Europe so the overall plan is something -- in good level, positive direction?

Yes. I mean you touched on a good point there, Elyse, in terms of COVID. COVID's manifesting a lot more in the cat world outside of the U.S. than in the U.S. That's a variable that's coming into play in Europe, particularly. And they always seem to get the memo a little late over there. The market share dynamics are a little different, with the top 5 reinsurers really commanding a whole lot of market share and not wanting to yield much. But I do expect -- I mean, I think as our portfolio -- if I think about 1/1/20, our international portfolio, without any of these dynamics at play, we're up maybe, let's call it, flat to 3%. I do expect that it will increase. It probably won't increase to the same extent as the U.S. Demand plays a factor here, and the demand has been pretty static in Europe for a while. But we do expect that Europe will start to move. And for what it's worth, Elyse, at Arch, we've been -- underweight Europe for the better part of the last decade. And frankly, we've been wrong. I mean the events just haven't been there. But in the long term, I think we'll be long-term right. It's just not an area that -- the margins that you deploy capacity in Europe is just not where it should be.

And then thinking about alternative capital, right? We've heard about a good amount of trapped capital, primarily some from hurricane losses and then some also from COVID. How are you thinking about the trapped capital? And is that factored in when you talk about retro rates being up 25% to 30%? Is that the catalyst that you see there?

Yes. I think it's one-off. I mean if you think about retro and the retro that's coming out of ILS capacity, I mean, it's been in flux now for a while, right. Coming into 2020, it started to -- the first year I think that we saw some stabilization of the growth. And coming into 2021, I mean, anyone who has collateral at play, by -- will by and large trap that collateral. That would be the wise and responsible thing to do. And frankly, there's nothing sacrosanct about it. I mean that's just the way the product works. That's what makes that product relevant compared to a rated entity piece of paper. And so I think the fact that a good chunk of the worldwide retro markets, particularly the aggregate products provided by these ILS shops, and the fact that there's going to be trapped capacity and frankly, reloading with conditionality, I think capital providers and ILS managers together, they've gotten wiser. Claims have a way of teaching everyone a few things, right? And frankly, for the system, for the entire system, it's better. It's healthier to have a wiser group of capital coming in through the ILS side of things. So a demand for property cat, particularly in light of questions about views of risks and uncertain here on weather, all of that's coming together to just suggest that the ILS community won't be as -- at least won't be as prominent as they have been coming into 1/1. And the point that I always think about with ILS capital is that a lot of it's visible and a lot of it competes with us, and it's the thing that everybody kind of keeps tab off. But where it really is effective when it's in flux is where it sits behind traditional players. And we all know, over the years, there's been a lot of traditional players who've relied heavily on ILS capacity, and that's going to change their behavior in the market as well with that retro capacity going back.

That's helpful. And then as we think about the market on an overall basis, I think last year, we were hearing about this U-shaped market, right? Primary going up as well as retro and kind of reinsurance, the bottom of the U. So as you kind of put these comments together is -- do you think 2021 is -- and I know you're speaking more from the reinsurance side. But is 2021 still going to be a U-shaped market, where the U is higher? Or do you envision kind of that reinsurance working its way up so the market doesn't really feel like a U-shaped when we think about next year?

Yes. Again, I start from the premise that primary rates coming into the system is a healthy start. Healthy clients, more demand for reinsurers. It kind of just cascades that way in our favor. Now I speak from an Arch Capital perspective, the fact that our primary operation is getting the rate rises that we're seeing there, we'll deploy capital however it comes, wherever it's optimal. And from the reinsurance perspective, I do agree. Right now, the 1/1 pulse that I sense in the reinsurance community is, generally speaking, for anything that's pro rata, the community is going to contend to take on the primary rate changes and not yield shares off programs. The rest of the -- and so I think that will be somewhat orderly coming through. And net-net, reinsurers are in a better place coming into 2021 than before. Ceding commissions are -- and have had a trend of giving in favor of reinsurers a little bit, not wholesale. I mean if we think about it, ceding commissions are that great variable between prior hard markets and this hard market. It's probably in the order of magnitude of about 5 percentage points that are not in our camp that traditionally have been, high 20s versus low 30s. But the rest of the market should, at least I'd say the word should, on the reinsurance side, improve and inflect. But we can't control that, right? We'll see how that comes through. I think by and large, particularly if you think about cat and what's coming through cat, the community is probably graduating from low double-digit return on equity type numbers to maybe mid-double-digit ROE numbers, which I believe are healthy. And then on the retro side, if you're retro dependent and you look at a lot of the Lloyd's capacity, if capital is a constraint, which it's becoming increasingly so, that is a bit of a squeeze of having to buy retro. But shops such as ours who can pick and choose -- and frankly, in the past, we've been net buyers of retro. Today, we're probably going to be net sellers of retro. And so there is an opportunity for us to actually partake in the various segments here of the spectrum, where prices are inflecting.

And then what about maybe the last part of kind of the January 1 dynamics? What about demand? Do you sense that insurers are potentially going to change their programs from raising their deductibles or perhaps lowering their deductibles? Do you think there are just going to be changes to programs that could potentially lead to more or less business coming to the reinsurance market?

Yes. I think broadly speaking, Elyse, the sense I get from major clients is less change at 1/1. We don't want to change too much in our program. We don't want to change too much in our panel, which is exceptionally relevant to any newco starts. And I'm sure you might -- someone will have some question on that as well. But it's -- consistency of panel, consistency of program seems to be the emerging theme. Having said that, I think tolerance for volatility with our clients has gone down so that bodes well for demand. And here, it's sort of holistic solution products around whole accounts and structured solutions. We're having some conversations generally, and I'm sure others are around this one. Now it's early. It's funny. It's -- this will be a late renewal season. There are a lot of discussions. We're having a lot more discussions at this time last year in the last handful of years. But in terms of locking in deals and anyone sort of double lining pricing, we're still a ways off, and I think it's just going to be a late, late renewal season.

Okay. And then if we think beyond January 1, right, you kind of set the stage for thinking that we could see healthy rates in the U.S. and even perhaps some increases in Europe on the reinsurance side. As we think about the progression during the year, next year, so 4/1, the Japanese renewals. And then 6 and 7/1 in Florida. Do you envision this as a market where we'll continue to see hardening during the year and then even take us -- just as things sit today, take us to 1/1/2022? Like, do you envision this being a market that has lagged is where we could think about more than 1 year worth of firming?

Yes. Sure. I mean Japan, first of all, in April is an easy one because that's going to be an interesting one because, frankly, there's a lot of -- views of risk in Japan are changing. And that will be an interesting renewal and a good one, I think, for reinsurers. But I think when you step back and think about it, right, this market has been on the move for a number of quarters. Now in fact, if we think about Q3, Q3 would mark sort of the third annual compounding of rate rises. And not just that, but it's at an increasing pace. And so just rough orders of magnitude, I think if we looked at the rate rises that we saw in Q3 '19 relative to '18, there were sort of 2x that increase. And if we looked at the Q3 '20 versus '19, it was almost 2x the increases. And that varies very widely depending on E&S and standard markets. But -- so the momentum coming in is really accelerating. That's one. And I do think this notion that everybody's sort of sentiment matters and everybody is sort of converged on this notion that, first of all, it's broad-based, rate rises. And the idea that they will continue for some time is baked in, I think. Now a lot of things can change in a year looking at 1/1/22. But I am optimistic that this market does have legs, primarily on the insurance side, on the policyholder level, which always invariably will be good for reinsurers. And don't forget, a lot of what we do is pro rata business, right? We sit side-by-side with an insurer, providing our capacity next to them on a select insurance. And as we build that business and as you've seen us on the reinsurance side in Arch, over the last couple of years, I mean, we have grown. And I'm pleased when I see that we're never a top line shop, as you know, and we don't even have forecasts on telling our people what to do and what to expect. But as I see that business piling in, that's good quality business, and that has some time to earn through. And it's doing it at the right time, in my opinion.

If you had to compare this market, and I know every market is different, it does bear some similarities to post 2001 and also 2005. Would you pick one over the other? Or is it just there's just so many different variables today?

Yes. I think you characterized it. I think it's got elements of both, right? If you think about COVID, COVID has that 9/11 sense to it in terms of the number of products that have been impacted. The difference is COVID geographically has been global and isn't just limited to the U.S. Now ultimately, we'll find out how it all shakes out. And frankly, I feel a little bit better about COVID in terms of an industry loss today than I did 6 months ago. But nonetheless, that has a 9/11 feel to it. But the cat events and the frequency of cat events and the expansion of just outside of the U.S. really has the 2005 feel to it. The key difference for me from 2001 is you haven't really had that exploding capacity. You haven't had destruction of capital per se. And we've had a lot of M&A activity that's been sort of the great sweeper of some of these field projects, but haven't had that spectacular busts that we saw in 2001. And the existing community is healthier. It's there. The existing companies are probably best positioned to trade through this cycle this time around. So long way of saying, it's got a little bit of both, but it is unique in its own sense as well.

Great. And then a question that came in from an investor. I think we touched part on this earlier, but they just wanted to know if there were any change -- any major changes to terms and conditions for 1/1 or just 2021 in general. I know we kind of touched on the demand side of things. And then they also wanted to know, how is Arch treating COVID claims in 2020 on XOL treaties with respect to [indiscernible] clauses?

Yes. Yes. I'll hit the second first. Look, our portfolio and the excess loss, particularly property portfolio, is constructed deliberately in a way to reduce or minimize uncertainty. You will never be perfect. But we spend a lot of time deploying capital in programs that model better than the average program. This means we stay away from tech lines in terms of property cat. It means we stay away from large commercial. And so that bodes well both for the predictability, if I can say, the credibility of the modeling. But it also bodes well for anything like COVID. And so in the U.S., a large proportion of what we do on the cat is personal lines. And so we're not taking a blanket view of saying to our team go out and exclude communicable diseases on everything that you write. That's just not what we do, and that's not constructive to clients. But we do think about it. And certainly, our attention to it has been heightened. So we will underwrite the deals as we always have, and we will make the changes that are appropriate to those.

Okay. That's helpful. And then in the past, you guys have spoken about return on allocated capital, right, to your P&C business. And you, I think, a few minutes ago, made the point that you thought reinsurance [indiscernible] overall was going from a low double-digit ROE to a mid-double-digit ROE. I'm not sure. I think that might have been just industry comment versus an Arch-specific comment. But do you have a sense of -- correct me if I'm wrong on that. And then do you have a sense of the return profile for the reinsurance business that you would expect today if the pricing dynamics play out the way that you're expecting?

Yes. I mean do I have a sense? I have a very precise knowledge of it, for sure. I mean I think as a general statement, as a general statement, first of all, you know us well enough, I think, to know we deploy capital across segments even within the reinsurance group. And even when we talk about specialty lines within those specialty lines and within each line, we go down to the subsegment. I mean I was thinking we're just having a discussion around our agri book, for example, as one of our specialty lines. Our agricultural book is unrecognizable today versus where it sat just 3 years ago in the deployment of it. So there's a lot that goes into it. I don't want to dramatize it more than it is, but we do spend a lot of time down to a segment level of how -- where we kind of lean into and where we put exposures out there. And so yes, I mean, I think -- so having said that, I think generally speaking, if this momentum that we see kind of continues, for those that were in the low double-digit ROE area should end up in the mid-double digits. And in this interest rate environment, that's a phenomenal place to be, I think. And frankly, we haven't talked much about it, right? The interest rates are a big driver of what's going on here and on the sustainability of it and the need for it to continue because it's exceptionally hard to make up for, I don't know, 150 basis point reduction in discount rate on long tail lines because you take a deal that's 4-year durated. You just need -- you need 5, 6 points net of trend just to make up for that. And so that's another point that I think the market will slowly carve that back and ensure that underwriting margins kind of at least make up for that reduction that we're all experiencing in interest rates.

That's helpful. Before I go to the next question, just an FYI, we do see some other questions coming in. [Operator Instructions] So you kind of hit on one of my next topics, right? We spend so much time talking about what's going on with catastrophe rates that we don't -- we haven't really hit on what's going on with the long tail line. So on the casualty side, you make a valid point, right? With interest rates being so low, you're going to need to obviously push for more price on the longer tail lines as well. So can you just give us a sense of what you're seeing in casualty lines? And when you give us the pricing sense, can you give us a sense of which lines you view as much more attractive to Arch today from a growth perspective?

Yes. I mean, once again, I think the story begins and ends on interest rates on anything long tail. We do -- I mean, the market on the primary side is moving dramatically and -- in the larger segment, in the large E&S sort of commercial space. And that's needed and that's required. And the fact -- as I mentioned, the fact that we have those interest rates at the worst -- the lowest they've been in, I don't know, forever, 60 years, is a big impact on that segment of the market. And I think that's going to play out. I mean my -- the bottom line for me is underwriters will have to make a decision. Do you lean into that market now with substandard returns and hope that you can ride it out? Or do you say to yourself, no, I'm going to hold out and wait another year until the tide carries it above mark? And everyone's grappling with that. All shops are going to have to make a decision around that element because it's not -- it's fantastic on the insurance side and it is becoming more interesting. At least in the last half dozen years, this is a chance to really make up for some of our absence of long tail lines. And I should highlight that, Elyse. I mean the nice thing for us is we've been patient over the last 5 years. We haven't deployed, overextended ourselves, whether it's in property cat or in the reinsurance side, on long tail. And the long tail segments that we did play in are very different than third-party GL or professional lines. And so it gives us a chance to kind of step into that a little bit going forward. And I don't think we'll go crazy, but we will do more. As you'd expect us to as the market improves, we'll do more.

Okay. Great. I think there's a few questions that came in. But before I ask those, we do have a question from Heather Takahashi with Thrivent. So Brian, if you want to just unmute her line?

Can you hear me?

Yes.

So I've got a question on property cat and model changes. So could you talk about how your models have changed for property cat since 2017? And what do you think the industry has done? For example, if you were to have given the return period on Irma back in 2017 and then you were asked the same question again in 2020, would that number have changed? And what's your view of what the industry has done, if anything, with respect to models and expectations?

Yes. No, fair enough. And thanks for that, Heather. And you know as well as I do, right, solving for 1 or 2 event sets, when you think about just the loss adjustment expenses, differences in Florida between one event and another could be 15 points on its own, right? But the whole event set -- I mean, look, the nice thing about this business is you have a baseline model and you do what you -- and you get to overlay your view of risk onto that modeling. And every shop is going to do it differently, and everyone's going to have a view by territory, by parallel, maybe just across the board. And we've certainly -- we have our view. And our view, certainly, for us, is that you can't ignore the frequency of the events that we've seen recently. Having said that -- and I recall 2004, 2005, it's one of the things that we talked about earlier and the question is that, yes, 2005, a lot of shops waived the white flag and said Florida is uninsurable. And for 10 years, you could have made a lot of money in Florida. And so it's -- you got to avoid being very, very specific about it. But we do -- Heather, the one thing you wouldn't be surprised to hear is it takes -- it's taken a lot more of our time talking about these topics and embedding it into our modeling. And for the first time, I'd say we actually have a metrologist on staff. We haven't done that in the past. I think those insights are informative and helpful. We're never going to be that shop that builds an army of them, and we're not going to be that reliant on modeling. But ultimately, you take a view. And then the biggest lever that we have in terms of that is, in times of uncertainty, we -- your ultimate lever is how much you deploy it. And in times of uncertainty, we -- you deploy less. And if you look at our capacity, I mean, we've been sitting at the low single-digit percentage of our equity base in terms of -- globally at Arch in terms of P&L.

Maybe one thing to add to that, Heather. Just you get to it -- is a point that with this uncertainty that we have out there, you need more margin to cover the variability that you're having. And so yes, we've seen a lot of increased frequency this year. The last 3, 4 years, if you think about it, we have -- there's increased uncertainty in terms of whether the models are moving and adapting quickly enough. And so you have to get more margin, and that's really a factor of what's driving these rates.

The other thing, too, I wonder about is the whole assignment of benefits issue. So I was talking to one of the Europeans last week, and they're saying how excited they were about the price increases in Florida. And I asked, what about that big -- that slew -- that huge amount of Hurricane Irma EOB claims that came in over the summer, what do you think about that? And the guys -- it's a video conference call. So I could see the guy raise his eyebrows, like he had never heard this before. It was a strategy guy. It was the head of strategy. So you might be able to forgive him, but still, come on. So I'm wondering, like, are people factoring that stuff in, in the industry? Because I was surprised that he was surprised.

It sounds like someone's going to be paying some tuition bills. What do you think?

I think so.

Yes. I mean, Florida -- look, Florida has always been laced with issues that one has to think about, right? The next big event when companies can't pay their reinstatement premium or have to take their claims out to 1/3 -- and I'm being very -- I'm being provocative here intentionally, right? You have to outsource your claims payments. And everyone's going to look back and say, well, why don't you think about that? We do. And you're limited by how much capacity you're willing to tolerate in any one zone and the clients that you -- everyone's got a view, right? Every deal clears in Florida. Everyone's got their best favorite clients. But we try to have our own and we back test them and we audit them, et cetera, et cetera. And that's what you can do and then make the best bets that you can take.

Now I'll go back. [Operator Instructions] So one investor wants to know your views on the start-ups. Will they ruin the parade and put a dent in the hardening market?

Broadly speaking, I mean, I think it can, right? It can. But broadly speaking, I think the one interesting thing -- actually, first, taking a step back, right? Let's look at the capital that's been raised. When you think about the capital that's coming through, by my count -- and Elyse and others will have a better one here. But we're north of $12 billion. And the vast majority of that capital has been raised for and by existing platforms. Yes, some of that is newco, and some of it is still sort of aspirational capital. We saw the news on one of them, I think, yesterday and so on. So it suggests that maybe not everyone is going to clear through. But I think -- so that's one. I mean -- and two, I think the timing matters. In setting up a de novo in this time and building a team and getting ready with licenses and platforms, I can make a lot of jokes around this, but I won't. And just -- but it takes time. And so you question the relevance or the impact that those newcos are going to have at 1/1. And then broadly speaking, I remember back, I was one of the early Archees here. I remember when we were 5 of us in the office. At a time when we were -- we all knew each other, and we all worked together and still it was very challenging to get a company off the ground in a raging hard market. To assemble a team -- a disparate team in a COVID environment, putting your message out remotely and bringing a value proposition that doesn't exist with the likes of Arch and our peers, I think, is more challenging this time around. I don't suggest that those companies that have a quality team won't be successful. But I'm saying when -- about the impact in the short term. And if I take the Arch Capital hat off and I just put the reinsurer hat on, and it presents opportunities for us. This newco is set up. And by and large, they'd like to buy quota share capacity, and they'd like to protect the unlucky events in the early days. And so it works. It brings in business to the -- it brings in premium to the system. But over time, over time, yes, it could have an impact. I also note that a lot of these companies that have started up have PE backing, and we all know what PE's required returns are. And again, hopefully, that is a regulator as to how these companies deploy and how disciplined they're going to be. I think that's an important point to keep in mind. But net-net, from what we're seeing in the market, what we're hearing from brokers, the dialogue we have with our clients, and I'll say it, we're already in dialogue with our clients, right? It takes some time to -- for others to do that. By and large, clients want consistency. And if the panel is there to trade, and a lot of the panel will be there to trade, it's going to be hard to break in from a reinsurer perspective.

Okay. Great. We'll take a break from some of the sent-in questions to go back to someone on the line. Steven Gavios at Jennison. Brian, if you could unmute his line, please?

Thanks, Elyse, and thanks and Maamoun and Don for doing this for us. So 2 somewhat related questions. The easy one first. Maamoun you had said earlier that you didn't think reinsurance programs and panels were going to change much. Do you think shares are going to change much within those panels?

Yes. Well, do you know what? I like to think so because I think by and large, whether it's a client, a broker or an ILS capital provider, there's a flight to quality. And I think there's going to be a reasonable chance that A plus rated quality organizations are going to have a chance to flex out on the programs at the expense of others.

Okay. And now my bigger question. So your boss seems to think that he's Phil Jackson and he's debating whether to pass the ball off to Jordan, Pippen or Kerr. So as you guys sit around the table and, of course, you all know each other very well for a long time, how do you think about putting capital to work in the reinsurance business versus putting capital to work in the primary business, let alone the MI business?

Yes. Well, I'll be Michael Jordan. I always want the ball, right? I want to take the ball. I take the shot. And no, look, do you know what, as you can see, I'm in the office. Marc's next door and Nicholas is over there, and we spend a lot of time in this organization collaborating and thinking about it. And we're just wired to put the capital where it makes sense to put it to work. And there's a lot of insights and info flow, which, again, when you think about it as an established organization with 2 global entities, insurance and reinsurance, just the advantage of getting decision-making from these -- from those cross insights. And so we're constantly going to deploy capital in the places that makes most sense. And we're also fortunate in our organization, our size and our prospects, we -- it's not an or discussion either. A lot of these discussions are and discussions that we can do here and here and have some in reserve for if this story plays out, et cetera.

So I guess, my question is a follow-up. As you think about your 2021, obviously, there's a lot of uncertainties in that. Do you feel like you'd have enough capital from daddy to write the business you want to write or is Nicholas going to take it all from you?

No. I have plenty of capital. Plenty of capital to write what we want to write and...

Maamoun has sharp elbows, by the way.

I sat next to him. I know.