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

Yes. Good afternoon, everybody. Thank you for joining us with this session this afternoon -- this morning with Arch Capital's management team. I'm Mike Phillips, Morgan Stanley's property and casualty insurance analyst. And before we get started, let me get through the obligatory housekeeping items. So for important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com\researchdisclosures. And if you have any questions, please do reach out to your Morgan Stanley sales representatives. So thanks very much for that. And again, good afternoon. We have Marc Grandisson, CEO of Arch Capital; and David Gansberg, President and CEO of the Global Mortgage division here with us on the line for the next 30 minutes or so. Gentlemen, thanks so much for your time. I appreciate it. Also to remind the guys in the field, if you are out there, if you want to submit questions on the field, we can take those and I can read those off. So again, Marc and David, thank you very much for your time. We have about 30, 35 minutes, so it's going to go flyby, I'm sure, but thanks for your time.

We'll try to make it interesting for you, Mike. We'll try to make it interesting.

All right. Yes, I think you will.

All right.

Let's start off high-level stuff, right? You've talked about the 3-legged stool. Maybe kind of zone in on that a little bit and anything that's developed recently that would make you lean in one direction versus the other to -- on the 3 legs that we know about so well?

Yes -- no, I think it's more of the same. I think if anyone has looked at our results and our -- your writings and our focus in terms of where we are growing for the last 12 months or 5 quarters, it's pretty clear that our focus has been maintaining MI, even though we had to say at least a couple of quarters that were interesting, say, at least last year, turn out to be -- things turning out to be positive, which is a great place to be -- actually probably help maintain and we'll hear David talk about this a bit more. Help maintain probably sustainable, good growth and profit in the MI for a little bit longer than we would have otherwise have been exposed to had COVID-19 not happened. Didn't wish COVID to happen, but you have to look at finally the bright side of things and not all was negative. I think on the P&C side, I think we had tremendous growth, as you saw on the reinsurance side. I think it speaks to the testament of being able to react very quickly, very aggressively when market conditions do improve in a significant way and fashion. And I think insurance was not that far behind. I think that we had growth about 20%, 25% over the last trailing 12-month growth. I think it speaks to a couple of things, right? It speaks to the cycle management, Mike, that we're known to be very adaptive doing. We've been defensive on the P&C side for a while, having David doing wonders on the MI, really helping us reward the capital and invest in our P&C units to really set ourselves up for the time and opportunity that we are seeing over the last 5 quarters and sort of able to grow on the property -- on the P&C side, both insurance and reinsurance. And I think we were presumably more underweight than most people would expect us to be on the P&C side for the right reasons as we talked about the cycle. So I think the company now is adding on 3 legs, very strong actually, which is -- we haven't seen this in quite a while for our company. So we're pretty excited about the opportunity. And we get to choose as opposed to having sort of clear #1 and #2 in certain -- like, in 2017, 2018. I think now we have to really dig in and look at the opportunities that are out there and, say, "Where do we need to deploy more or less?" And that's exciting, right? Having more than 1 or 2 options to go to is great for us. And I think with the vision, right, as you know, of being diversified still, having a focus on specialty and that certainly has been a great story. I think the one thing I would add as well in terms of our growth and where we focus our efforts over the last couple of years is London, where our U.K. business has been made a few acquisitions. And I think the Lloyd's reaction to the market conditions of late has helped us tremendously grow in that platform, achieving some scale and really taking the opportunity that we're up there in the Lloyd's markets. That's also been another great win in our sale from that perspective as well. So a little bit of everything, a little bit of good looks, I would say, as well, and a couple of good opportunities in various segments. But I think we're hitting on all cylinders and having a good time. As I said and tell everyone, it's a great time to be at Arch right now. Arch is in a great place and the market is awesome. It's really fun. We can underwrite and say, yes, way more than we ever did over the last 5 or 6 years.

Thank you. That's good summary. Good high level. I guess maybe if we can zone in on David and MI for a second. As you said, Marc, you did pretty well there, even last year during the pandemic mortgage did -- how do you -- how can you summarize how strong the MI market is today?

It's been -- mortgage, it's been a great run, right? Clearly, it's been better than we really ever could have expected. And I think it's interesting now when Marc talks about how mortgage contributed some good results, while the P&C was in the soft part of the cycle. And now we're -- for the first time in a long time, there's competition for capital again, right? So it's -- we got, in the mortgage group, sharpened up a little bit, right? It's no longer capital plenty, right? We've got to make sure we can justify it and figure out where the best place is to put that capital. But as far as mortgage opportunities in today's market, it's still very positive place to be, right? Credit, while it took a step back during the pandemic, is right back on track. Conditions are very favorable for us. All macroeconomic conditions, demographic conditions are all favoring increased homeownership opportunities, strong credit. So even though the P&C business is revving up, mortgage is still strong, and we think it will still be a strong contributor to our earnings for a long period of time.

Good. Dave, do you see anything, I guess, on that business from either interest rates or any kind of regulatory issues that concern you?

I mean, not really. I think it's all positive. The one thing that -- I wouldn't say worries me, but it's something that I'd like to keep an eye on is the pace at which home prices are appreciating, right? So some home price appreciation is a good thing, right? Too much home price appreciation is not a good thing. And what we saw, right, going into the GFC was home prices increasing at unsustainable rates. And while I'd like to say we're not there, right, I don't even like to say housing words that start with the letter B and have 2 other Bs in there because it's a scary word and it causes alarm when it's not necessary. And we're certainly not there. But I'd say we're -- we need to watch, and we need to see what happens. And if it continues at the same pace, then it will be a different discussion, but for now, we're keeping a watch on there. I think the prospect of increasing interest rates, which we all think is coming, and frankly, we've all been thinking that for -- I don't even know how many years, should start to cool things down a little bit on the housing front. So I think it will self-correct, but that's the one thing that we're keeping an eye on for now.

Okay. Marc, where do you see the primary insurance commercial pricing today? It's been coming off a bit in the first quarter, and talk of maybe that continuing. But then we have fears on the loss trend side, maybe rising. So can you talk about the pricing environment in primary commercial lines today versus where -- maybe where you saw at the beginning of the year?

Yes, I think it's not coming off. I think people like -- I don't know why people are using that word, but I just want to make sure it's clear for everyone. I think that I always have to remind everyone that nothing is coming off. We just instead of making 20%, 25% rate increase, we're getting 14%, 15%. And we're still getting a very healthy rate level. And I would say it's a second round of rate increase, right, at least a second round. So we're getting rate on rate. So we clearly -- I believe, we've crossed the line where things are in a good direction, not 100% return where we would want to be back in 2020. But if you add another 10% to 12%, and we believe we should get to see another rounded rate increase, even perhaps into 2022. It's not going to be 15%, 20%. But even if we get 5% or 7% or 8%, it's still building upon that higher ground that we've reached as of now last year which is great news. And that, Mike, to me means that we also have sustainability in the profit and margin, forgetting for 1 second the market, everything else being equal, which never does, I know, but forgive me for 1 second. If you say, "All right. We're getting 2 or 3 rate increases. We're clearly 25%, 30%, in some instances 40% above where we were we head into that correction, if you will." Well, it's going to take a little while before it goes back to the level where it's no longer acceptable, right? So we're getting 2 or 3 more years out of that. So a hard market is not like 1 year on and then next year it's bad. It's actually -- it's a wonderful little developing story. It's more like a sitcom that has multiple season than just a one-and-done movie. And so I think right now what we're seeing is still the market, in general, is thinking rates up on the insurance side. The reinsurance side may be a different, so I'll take it in 1 second. So the rate is increasing on the insurance side. It did, as I mentioned on earlier calls, it did go first in the hard-to-place more difficult E&S market. We've seen it not creeping through the more broader marketplace, not to the same extent, right? The primary -- the smaller risks are more bespoke, more commercial are not -- do not need a 15% or 20% or 30% of an increase. But they're getting 5%, 6%, 7%, 8% which they weren't getting last year. So even though you may see a headline number decreasing in terms of positive rate increase, it's still going up and now it's spread out to more lines of business, which is a really good place to be. The one thing I will say, and this would be a question I'm sure you'll ask, Mike, is on the property cat space, I think it's gone up, but not to the same extent that we would have wanted to be going up. And then collectively, we're not the only ones who's saying that to you, obviously. And I think it's because of the capital that's there. There's still a lot of capital that's there that has different expectations, and that sort of dampens a little bit the impetus to get rate increases. Having said all this, the property cat market is probably 14% -- 13%, 14% return. It's not bad in and of itself. But I guess for us, at Arch, as you know we're not a -- we -- it is a part of what we do. It's not a larger part of what we do. But on the cat side of thing, to us, we need to get significant more return than that to get our appetite in a lot more interest in this space. Specifically, as David mentioned, when we have opportunities that are more stable and more predictable, such as the MI, where the returns are as well as good, if not better, than those kinds of returns. So -- but overall, I think the reinsurance is a little bit lagging in terms of price. I think that their insurance market -- and you see it in our insurance pricing and improvement in combined ratio. I think that our insurance is ground 0 for benefiting from the margin. Our reinsurance portfolio is also improving, but it's improving in the areas that are more specialty driven, a bit like our insurance portfolio. They're a bit more bespoke, and we're also seeing really nice increases there. So very excited, very exciting, thanks.

You mentioned a couple of times the specialty and E&S. Tell us how you define that and the makeup of that in your book. It's sort of a loose term that some people throw around, but it's different for different companies. So how do you guys define that there because that's a big piece of the rate environment?

To us specialty beyond the excess and surplus lines, which is typically the policy that is not -- doesn't find a home into the regular admitted marketplace because it's too difficult, because it sort of doesn't fit in a nice, little box in terms of the main admitted carriers. So you need to go outside. And when you do this, the rate -- you have more freedom of rates and conditions, right, because that risk needs a home. So the excess and surplus lines is, first, in kind of E&S specialty that we would think about. But specialty is also surety. Like, things that you need specific expertise. We like to think of those lines as though these were -- you need some thinking. It cannot be done by a machine. There's a lot of variability around that kind of risk that we do, and it doesn't lend itself to a very programmatic sort of pricing module. There's a lot that meets the eye. It's a talent-intensive line of business as opposed to process-intensive or system-intensive.

Good. The last couple of quarters we've seen -- and you've talked about it and other companies have, too, is some positive developments because of frequency. And I guess I'm curious to see what you think about how that's maybe changing as things open back up again. Where I sit today, we're really pulled back. Streets are crowded. Bars are crowded. Everything else is back to normal. So what are you seeing in your book in terms of frequency? Is that going away? And then if so, how does that factor into all your comments on the rate adequacy?

Yes. So frequency-wise, we've seen a decrease like everyone else has as a result of COVID-19. There's less activity, business activity, less friction, less losses. We definitely have seen this in our book of business. It's starting to come back again, but it's nowhere near. We're not seeing a pick up. We're expecting to get back to pre-COVID probably between now and the year-end in terms of frequency. There might be a little bit of a blur -- a little bit of an increase in the short term. We would expect things to pent up, maybe claims were not reported or things people did not know there was a problem with something that they have -- that they could have otherwise claimed against 6 months ago and now things get back to surface. So we're going to see a little bit pick up in frequency. But again, I think that from our perspective, we haven't really taking a lot of credit for it in our results for the last -- for 2020 and 2021 because we think that this is just temporary, but we didn't want to take full credit for that. And so we're sort of maintaining, we believe, a prudent more longer-term approach to the reserving level. So if we -- if things go back to some normalcy, we'll have some cushion there, we believe, in our reserve. And we should have a cushion to make sure we're not surprised. In terms of social inflation and inflation in general, it is clear that we're seeing labor cost going up and material costs going up, specifically on the first party. This is definitely happening. We have a surge on building a new house right now, so I can test it firsthand that is costing us much more beyond the regular drip on the budget. I think that things are costing more. It remains to be seen as temporary. I mean, I think things will get back to some normalcy at some point. But we may be in for a little bit of turbulence for the next 2 or 3 quarters. And I think that our game plan at Arch is to make sure we have the proper reserve, and we're not taking all the credit right away that we're protecting ourselves from that perspective. In terms of what it means for the future, we'll have to see how it develops in terms of whether it's long lasting. And if we believe it is long lasting, there's nothing yet to tell us, it's going to be sustainable for the next 4 or 5 years. But if it does happen, then the beauty of being in insurance is you price it on a yearly basis and you can change your assumptions and decide what you do and allocate capital differently based on what your beliefs are in terms of returns, and we'll have to adjust accordingly. We're not the only ones in there, right? The beauty of this is, this will be a market wide phenomenon. And the market has been pretty good at responding to those things of late. So we're encouraged by the discipline and the level of scrutiny the management and you, as investors, are putting on our industry as to make sure that our margins are sustainable and stable. So I think it's a good sign.

So what about inflation on the side -- on the nonprofits and the casualty side inflation? You've been in lot of talk about that recently. And I guess is it more to talk right now and fears of what may come, when courts and everything else look back up again and so you mentioned social inflation? Or do you see anything today that actually is kind of concrete proof that there is more casualty trend inflation than maybe there clearly was last year?

Yes. So I think we've talked about the recent trends we've seen on the claims from a liability perspective, policy-limited demands, right? Lawyers are a lot more aggressive in asking the full limit, hoping that you'll trip up so they can open the limits and make it unlimited. But that's not a new phenomenon, Mike. That's been going on for 3 or 4 years. The litigation funding is not going away. One would argue that they were probably idled with some of the money. I think we're not moving as fast so we could see some resurgence and sort in that segment. That does include -- but this is not really a recent phenomenon, Mike. This is not new. We've seen this for quite a while. In terms of what's happening right now, I think there is, obviously, less cases being tried. There's a lot of mediation, still a lot of indemnity and discussion going on, but by and large, the trial and everything is not -- has been slowed down. But again, most of what we settle on is does not to go to trial, right? We do a lot of stuff in mediation. So we're seeing a little bit of increase in there, but not the hyperinflation that people are talking about. And then we've also priced, historically -- that might explain why we've had these results closer to 100 combined for -- from 2017 to 2019 is we've priced with everything 3% to 4% trend from the ground up, and accordingly modifying it as you go in the excess layers, as we saw fit. So we haven't really seen or determined or changed our view of that at least at that point in time. We've taken more of a longer-term perspective, if you will.

David, you mentioned in one of your earlier comments, the B word with the housing market. Can you talk about how inflation may affect that mortgage business? Is that what you're referring to? Or are there any other aspects of inflation we should think about when we look at the MI business?

Sure. So inflation really has an interesting impact on MI. And I'll separate it into 2 components. The first is, what is the impact on your in-force portfolio? And I think it's actually positive, right, which is interesting and the opposite of the impact that we see on the P&C business. So inflation on an existing portfolio, especially when you have delinquent loans is actually a good thing, right? So if you've got a home that's delinquent and you see a little bit of inflation, the value start going up, it's a great way for that borrower to be able to get out of that home without generating a loss for the originator. So to the extent that you're in a period of time where you've got a large block of delinquent loans, a little bit of inflation is a good thing, right? It helps you solve the problem of delinquencies because it allows borrowers the option to sell their home. So that's actually good. And some of the studies we've done, right, that actually counterbalances, to some extent, the impact -- the negative impact on the P&C loss reserves. And then the second way to think about inflation is on the new business, right? So say, typically, our ability to write new business becomes a little more challenging because there's generally less new business. So with inflation comes higher interest rates, higher interest rates means less refinanced incentive for borrowers, right? So fewer people are refinancing. That means less opportunity for new business. And it also means for new purchases, higher cost, right? So affordability generally across the industry is still very positive. But when you start to see inflation, you see interest rates going up and you also see prices going up, that affects borrowers in terms of their monthly payment. So availability and affordability start to get compromised a little bit. So as we see inflation, as we see interest rates, I think we would expect the pace of new mortgage originations to slow down a bit. And most immediately, you're going to see that with refinances and then you may see a little bit with purchases as well.

It makes sense. I guess, sticking with you for a second, David, was there anything during the -- any kind of structural changes that were a result of the GFC that maybe helped the MI business during COVID shutdowns last year?

No, I think absolutely, right? So a number of structural changes. The first of which was just the introduction of underwriting discipline, right? You look at the quality of portfolios that were written in 2005, 2006, 2007. And you look at the GFC, right, a big part of the GFC was not about the impact of the economy. It was about how poorly underwritten the business was. So we learned underwriting discipline in the mortgage insurance business so that now if you look at our portfolio, it's pristine, right? The credit there is not nearly what it was in 2006, the last time we saw a financial stretch. So I think that's probably the most important condition. And we've actually gone back and looked, and we looked at business written precrisis. It was as much as 70% would not even be eligible today to get mortgage insurance. So you look at any of that no-dock, old-dock, low-dock business, some of the low FICO scores, some of the debt-to-income ratios, as much as 70% is not even eligible today. So to me, that's the biggest lesson and it's probably the simplest too, right? I mean, if you're in the insurance business, you got to be careful about what you underwrite, right? You can't underwrite unlimited risk stuff with the hope that home prices keep increasing, so it might bail you out of your problem, if you have one. So that's the thing. And then structurally, risk-based pricing is another big change, right? That's allowed the mortgage insurance industry to better match risk in the loans that they underwrite with the price that they charge. And now that went from an Arch-only innovation to an industry-wide phenomenon, so that certainly improved the industry. And it's also made people more aware, I think, of what kind of return they need to get. So I think we've, in essence, created a bit of a floor as to how low rates will go over time because with better allocation of capital to the mortgage insurance business and with the PMIERs requirements overlaying there, I think you've added a floor, and I think you've made a less volatile business over time. And then the extensive use of mortgage insurance-linked notes is another thing, right? That's going to reduce the volatility in the business. So I think a lot of the wild fluctuations in profitability that we saw during the crisis are not likely to happen today because it's a very structurally different business, both from the business that's written as well as the way that the companies are retaining risk. It went from a very much buy and hold to an accumulate and distribute to other people. So it's created a much better risk profile as well on a net basis as well as a gross basis.

Yes. Lots of good stuff, lessons learned, but certainly some good positive changes there. So thanks for that recap. Maybe switching gears for a second. You've done some investments in taking stakes in other insurance businesses, the Watford Re, Coface, things like that. And I guess can you talk about how you decide to go that route versus maybe kind of build things to what they do, would you build those from scratch on your own instead of kind of taking the investments?

Yes. I think Coface is an easy one because there's no way you can really build a platform of that kind, of that sort. We've looked at it, I think, 10 years ago. We've been reinsuring that business for quite a while. I understand it very, very well. And no, there's a lot of value in the primary side, right? And if you control the customer, it's a product that, frankly, is more European-based, right? I guess, some of our investors in the U.S. are familiarize -- familiar with it as they could be, and we'll make sure we get you guys more familiar with this over time. I think this is a really -- it's a bit of a moat-like kind of business. There's 3 -- in the top 3 providers, Coface was available at a good price. We felt a price that would give us a 10%, 11%, 12% ROE that we were looking for. It's a transformation story. It's got a lot of upside it could do. And we started with 29.5%, we'll see where it ends up in the end. But if you are us, you'd say, "Listen, the more diverse and specialty lines of business" -- it's another specialty lines, right, very, very bespoke, very, very unique to the extent that you can get into that space and overlay some cycle management over time, you have like a lot more the proverbial ponds to fish from. It should diversify your stream of income where you can feed yourself. So clearly, a very, very interesting proposition for us. Building it would have cost way more than anybody and anything we could have imagined. And we like the management team. I mean, David is also involved with those folks as well. He gets to know -- he's getting to know them. So over time, we'll see how it develops. So that's for Coface. Clearly, this is like a buy as opposed to a build. Watford was also a good opportunity. I think that the model -- I mean we don't do everything perfectly. There's a great recognition that being a publicly traded company with that kind of investment, credit profile, that didn't work. It wasn't getting to do justice and was sort of creating more questions and concerns for us and we needed to do so. We just took it privately and partnered with 2 solid partner of ours to really grow that platform, still very much value in that model. From our perspective, at Arch, as you know, Mike, one of our key things is to also increase our footprint in terms of third-party capital. And to the extent we can really get paid for what we do well. I mean, we're pretty good at capital management, but we want to think that we're pretty good at underwriting as well and probably the first and foremost in underwriting. To the extent that we can get paid for underwriting, then all the better. And I know David and his team are still doing very similar things in their own areas, trying to leverage their underwriting knowledge and underwrite on behalf of third parties. So that's also something that we would want to develop more of. And Watford is a really very nice vehicle for us and for those co-shareholders with us because they know us and they know we are recycle management and do what we do well. So without possibly down the road, less -- most likely with less investment risk and the market is allowing us to do those kinds of underwriting. I mean other things that David acquired -- David might have pushed for an acquisition in Australia, which you heard about. Again, a relationship that we know for some people that we know for at least 10 years. We know them very well, sole provider there for some of their products. All the acquisitions I will tell you, Mike, are -- first, they're not very -- they are not big. So they are manageable. And they are all with people we know very, very well and with whom we have good relationships. We know well and something very special and specialized about what they do. And once you add up to them, there's a reason for all of them, and I think they're part of very awesome moment. Frankly, most of what we did is nothing really that new to us, which is very important. It's nothing like -- it's not like we're going into a shoe-making business. We're still very much in insurance and in lines of business that we know very, very well. So...

That will be quite a diversification.

It would be.

Maybe I'll see what is the time here. Maybe one more on -- because you mentioned capital management. So thoughts today on that and all that comes with that, purchases and everything else that come with that umbrella of capital management, given where we trade today, still pretty far below pre-pandemic levels, which is a bit frustrating? So how you think about that as you look at your stock valuation today?

Well, I think David mentioned the fact that we're competing internally for all the units and trying to get the place in the sun and get a bigger piece of the pie. And I think we're -- the pie is growing. So we also have more opportunities for the capital. But also we're always evaluating. And again, for the first time in a little while, to your point, I mean, we know what's happening ahead of us, and we know that we have a 3-year payback. As you guys know, we should have had this now back of the minds, there's a grid that we utilize and the stock is at that level. So I guess, right now, we're always in the process of evaluating, does David want more capital, there's Maamoun, there's Nicolas who does the investment group, right? We been also trying to look at our investment group to see whether we could deploy a bit more of our capital. The returns are depressed, as we all know, but can we do more with that? And also -- and then at the end, when we say, well, maybe buying share is also -- would also be the next thing to do. But also, I think what we have currently, Mike, which is also nice from a capital management perspective is an 'and', it's not an 'or'. So we could do all of those things in a way. And that's actually a really, really nice place for us to be. And I think we have sort of full optionality from that perspective. And we're, as you know, very prudent, but very, very proactive in managing capital, including share repurchases as we did in the first quarter.

Okay. Well, good. Well, thank you. So we have, I think, time for, but thank you both very much for your time, Marc and David. Looking forward to the rest of the year how it plays out. So we'll be talking soon. Thanks so much guys for your time.

Thanks, Mike.

Thank you, Mike.

Yes. Good bye.