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

Well, it depends on all the mitigating things that have been put in place, right? One of them is -- I think there's a lot of tools in the toolbox for all these mortgage originator to extend, refinance, so many things they could do to make the loan being more acceptable and favorable and actually digestible by the homeowners provided they went back to work. I would expect this to happen to some extent if the forbearance program played the way they should be playing out, and then we fully expect them to do as does a GSE. So yes, we should see a fair amount of cures going through if that works the way that's described here, right, which is working the way it should be working. And in addition, I think that what is comforting, and you touched upon this, Josh, in your comments, is that the house prices have increased over the last 1 year, 1.5 years and continue to increase as we speak. There's a lot of pent-up demand in housing. There's only 2 -- about 2 months' worth of inventory available for people to purchase homes. And I think you need about 5 or 6 months to make it like a regular market. So we are really in the short end of the supply for the housing. So which means that if somebody were to not be able to get that forbearance -- out of forbearance into the new refinancing in a better situation to be able to cure its default or delinquency or you bring back to being current, there's always the option of selling the home, right? You could probably sell the home now at better price even than you could have had -- could have done it last year. So that also helps in terms of ultimate claims for us. So I think there's a lot of mechanism, mitigation meeting factor as we go towards -- working through those forbearance out into more being current. And even if that were not to happen, we're encouraged that the more the housing price will help mitigate largely whatever cannot be resolved after that. So it's all pretty positive.

All right. Let's switch -- you want to say anything, or we stop -- or go to insurance. Let's go to insurance. And this number hasn't quite been updated to the end of the fourth quarter because you reported just a day ago, but it's going to be basically the same, I calculate from inception through 3Q '20, the combined ratio in aggregate for the insurance business was a 99.2. 19 years into the company's -- Obviously, it's much better right now. Certainly the fourth quarter, you did very well on the insurance combined ratio. Why should we expect over the next 5 to 10 years, the current pricing environment aside, that this is a much better than breakeven underwriting business? What was inhibiting a better underwriting margin the previous 19 years? And what's different for the next 5 years or 10 years?

That's a really good question, Josh. And I think it was -- it's a combination of things. Market choices, market conditions, ability to deploy capital in the marketplace, maybe making a few choices differently than should have been made with not full information. But I think it was -- what I want to tell you, and this is really the right question is what has changed. And I think that there's a lot that has changed over the last 2, 3 years. And as I said yesterday on the call, I'm very, very pleased -- we're very pleased collectively at the executive level and the Board as to what happened in the insurance group. I think they've been tremendous in improving the IT, improving the data analytics, improving the processes, the claims, the way they did approach claims and their ability and their willingness to be more urgent in seizing opportunities in hardening areas. And frankly, the other thing that also really helped us this year, and there's a bit of timing, a bit of good looks, as I would say to you, Josh, that we're able to expand our footprint in London through the Barbican acquisition, which has been a very, very positive place to be. And we had a couple of things to fix in London, and we largely fixed them. It's becoming now a huge and a very sizable contributor to what we do on a quarterly basis. And to top it all off, and then we have all these good momentum building in the company last 2 years. I mean, you can talk to anybody on the insurance group, and they will tell you that we did a lot of things to really improve the platform and improve the way we look at things and analyze the risk. And now we have a hard market. So really good timing to bank on this. I mean the insurance groups, the way it's structured, the way it thinks right now is different than it did historically. And I think I will describe it in no large -- no insignificant part to Nicolas, who is, as you guys know, from -- on the reinsurance side, he's now got promoted to president this year. Nicolas brought a little bit of this reinsurance feel of things and focusing on things for the insurance group. And I think it helped them a tremendous amount. So I think we have a really, really solid story on the insurance side. I think that the improvement is real. We can see it culturally as well as financially. And we have a video spread around the network yesterday that I was able to watch all the insurance guys talking. And you can see the enthusiasm and the willingness to flex into this market and understanding that we have all made this -- all this good investment. And to take advantage of them, I think it is real. And I think it's a -- I think that -- I'm encouraged. I think that we've done a lot of good work, and I'm excited. I think the insurance group is in a really, really good position.

If I look at the 2020 loss fix, I mean I have to make some assumptions, but I estimate even when excluding the COVID reserves that paid to incur ratio in the P&C businesses is sub 50% for 2020. Maybe you're going to say that's not the case. That's -- I get about 40%. Has something changed in the tail length of the average type of business that you're writing or is it a conservative fix? Am I the right ballpark about how low the paid to incur ratios are? What's going on right now?

I mean nothing's changed in a dramatic way. I think, certainly, if you're looking at the -- on a year -- policy year basis, I mean, the numbers should remain pretty consistent with what you've seen in the past. But if you look at the aggregate of the portfolio, when you're growing, I think some of the numbers that you're quoting are just kind of start -- may be a bit distorted, right? So I think there's a little bit going at when paid to incurred on an aggregate basis in a growth mode, I think, should come down, and that's what we're seeing. But in terms of loss fix, we're -- yes, there's a lot of good positive signs around terms and conditions improving slightly and rates moving up above greater than loss trends and as we keep reminding everyone, I mean, it's got to take a bit of time for those to truly earn in. And for those reasons, I think we're -- I like to think that it's better to start with maybe loss fix that are maybe on the high side and who knows how it plays out, and but at least we don't have to fill up the void or you have to close the gap if it doesn't work or doesn't materialize in the way that we think it can or should.

Okay. Two questions on compensation, one from me, one from an investor. If you asked me 10 years ago to explain why Arch was successful, I've always pointed to what I would call a bespoke compensation model where everybody's compensation is tied to the long-term performance. But in 2003, Arch had about 1,000 employees or -- no, I should say, 600 employees. And it was -- now you guys are like 4,500 employees or something to this extent. It's much easier to design a bespoke compensation model in a smaller organization. As the markets change right now, can Arch continue to apply the lessons of its initial compensation model to a much bigger workforce? Are people going to be tied in for a decade going forward today? And can you make more money working at Arch than working at one of your competitors?

Okay. So there's a lot of quick questions out there. I think it's the best place to work. I mean, I've been here for 20 years. I love this place, so I'm not going anywhere, so neither is François. I think in terms of compensation, Josh, the interesting thing in all this is we haven't changed our compensation plan. It's been running for 20 years, and it still continues. And this is still what our employees are compensated on, and they understand it. And I think the only thing that would have been different is possibly in the beginning you had more people making decisions and that we hired earlier on. And probably those people were more likely to be in a compensation on the performance bonus plan, like this traditional 10-year that we talked about, Josh, 4-year payout and based on ROE, with a cap at 2 and all these beautiful things. I think just now, I think in terms of percentage, we have -- we have more people on the plan, but less of a percentage because there's a lot less people that we believe are intimately involved in the underwriting, right? We have the infrastructure to -- that we've built over time. So not everybody has to be in that plan, although these individuals who are not necessarily on the underwriting function also have a performance-related bonus paid on a yearly basis. And we've established this, and it's been explained to them on a yearly basis as to why they're getting that multiple. I think the other thing that we would have as well, part of our compensation, Josh, that you won't be surprised, has been a really good retaining mechanism is our stock price, right? Our stock price has done very, very well, maybe not so good over the last year, 1.5 years, but over the last 15, 20 years, it's done extremely well. And that's a really, really strong retention mechanism one. When you look at people, say, comparing themselves with other people who were doing on a dollar basis. But then when you add -- I mean, some of our competitors did not do as well on the stock price. And when you start accumulating all the stock and stock options that some of our employees have received, I think that they are in a really good position, much better than they would be in the other industries -- other competitors, presumably that would pay more on a cash basis. So I think the story is twofold, right? We still have underwriting first. It's still on that basis. We buy less amount of percentage of our employees, but still a very large amount of our underwriting team. Most of them are on this performance plan. It's paying as it pays out every year. I just think that in addition to this, we have the stock price, it has been a really, very good story. And that really helps solidify wanting to be here. And Josh, one last thing I will tell you that is also being more and more clear to me as I got into this for 20 years I've been here is that, once you've been in Arch and you've worked through a cycle management philosophy of not running the business when it's bad and really focusing on rate. It's really difficult to transfer into some other place. I mean, it's difficult for you to unsee cycle management. And I think the true Arches, the true Arch bleeding blue, if you will, find this is a place that's more rationally, more economically rational than other places would be. That sort of helps us to keep those who are really believing in the story. That's really an important part of our story as well as you know. It goes beyond just that short-term bonus payout, it also is interwoven with that increase in stock price because people do believe in that story. So long story, this is an important discussion that we have all the time. And I think it's worked out pretty well over time. And for those that they don't work for, you won't be surprised to say that oftentimes, we don't mind if they go somewhere else because they're probably not or hardly buying into that story. So...

So along the question on the stock price. I have your question from an investor, who notes that the management comp plan is highly aligned with book value per share growth. But Arch has pivoted into some more cyclical and volatile earnings streams in the investors word over the past, let's call it, half decade, which the market might be viewing as lower multiple businesses. The investor wants to know if that has caused a disalignment between management compensation and investor performance and if management compensation should be more aligned with stock price appreciation than the book value per share growth.

I mean, I'll talk to it and François will correct me if I'm wrong, but I don't -- I won't get the numbers exactly right, Josh, but our long-term plan on the stock is, yes, you're right, has variability around the book value growth, which we still believe to this day is what's going to make a difference over time. It could be, as we all hear about, and then in the short-term, it's a voting machine, the market -- the stock market in the long-term, it's a weighing machine. So we still believe in that principle. That's a core principle of what we're built on is to grow book value, presumably above -- consistently above the cost of capital. And I think we've achieved that almost without fault. It's a part of our history. And we still believe this is the way to generate shareholder value and sustainable shareholder value. But in addition to this, the executive team, there is a modifier for stock price. So there is a modifier that comes in at the end just to make sure and to echo the question or to follow-on a question that was asked. There is an adjustment that has been made for stock price appreciation or our performance versus the peer group. So it is there. There is something in there to make sure that everything is kept in check. And frankly, I want everybody to understand this, it's very important. The plan is, as such, but the comp committee can decide to change it. It's still under the purview of the compensation committee to make that decision whether it is appropriate in that year to follow what has been filed in terms of -- this is the guidelines on which we are operating. And I think the comp committee, as you guys know and you guys know us at any length, our Board of Director is really keen on performance, and we're really in tuned to what's happening in the stock price. And also because are shareholders themselves and also on our performance. So a lot of checks and balances going at Arch. It's not a one size fits all. And it's not -- everything is made to be within certain guardrails as to what we should expect, but there's always a healthy amount of pragmatism around it and ability to weigh in from the comp committee. So I think everything is pretty much aligned there.

One question a little bit out there. I guess, about 18 months ago, you guys acquired Barbican, I think that's part of the idea was that Arch will become a major player, at least a competitive player in the third-party capital business for people who want to participate in insurance markets. This year, I mean, maybe you didn't control the timing, particularly, but you bought in Watford, a third-party business. Is Arch going to be a major player in the third-party capital market? And what are you doing to affect those changes, especially in a period of time where maybe you want to cook your own eating -- or eat your own cooking, I should say, because pricing is so good.

Yes. I think that the Watford and whatever else we do at Barbican that we're not -- we don't advertise, but I think our -- if you look at the capital we have under management, it's north of $1 billion when you collect everything all together. So we are still very much in the fray. We just don't talk about it because it's not our style to just talk about it. And then we understand that this is also in building mode. So we actually grew fund asset on the management of the cat side this year. We were actually on the receiving end in 2020 and 2021, actually, because we were on the receiving end of new capital and existing partners who wanted to flex more into their cat market and other kinds of markets. So we are -- and Watford was certainly third-party capital coming into give it to us and say, you can manage it in a different way to Watford is to team up. You guys know we teamed up with 2 other private equity firm to bring more stability to this. If anything, I think this sort of solidifies because Watford was a bit left out there in the public domain. I think there's a misunderstanding and misappreciation, frankly, for what that platform could create. So we said, well, let's not lose sight of what it is and what it could create for not only shareholders of Arch, but also for our clients. We were very cognizant of that. So we said let's bring it home and really solidify the capital base and make sure we can still provide good underwriting expertise for that platform, the same way we're doing for the other property cat. So if anything, I think you're going to see it grow slowly over time as we have over time. We just don't advertise it a whole lot. In third-party capital it's a really, really important piece of what we do. And Barbican was actually a great place for us to grow into London, which was something we were looking to do anyway. So it's been a really good thing. I think more to come for us is what I was saying to everyone.

Well, I have a lot more questions, but unfortunately, not a lot more time. So that's the way the cookie crumbles. I appreciate you both and the investors appreciate your time. It's going to be an interesting year. As I say most at the end of these calls, please do what you can [indiscernible] limited, try and inoculate your employees as soon as possible, so you guys get back to work in a normal sort of way. I'll wait in line, and we'll see what happens and this is what we will all do. But you seem in Bermuda, I suppose, for you guys, it's a little bit easier than some places.

Yes. It is.

So stay safe, regardless, and we'll talk soon. Thank you.

Great. Thank you, Josh.

Thanks, everyone.

Take care, bye-bye.