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

Right. So jump right into the session here. First, I'd like to say thank you, Francois Morin, CFO of Arch Capital Group for joining us. Very much appreciate you being here.

Thanks for having me.

So I've been starting these conversations off with a more broad strategy question, and I'll do the same here. So first, I just wanted to get your updates on what you're most focused on in the business, key strategic objectives, particularly as we think through the next year?

Yes, thanks again. Good morning, everyone. I'd say we are at a quite an interesting time in the market, right? We see a lot of good opportunities in all 3 segments in which we operate in. So I'd say the focus for us for '24 is all about capital allocation, right? And that's something that we think have been very focused on forever. And kind of keeping that focus on deploying the capital in the best opportunities that give us the better returns, I think we'll -- is really how we think we'll win the game, right? So I'd say that's absolutely top of mind. And part 2 is market discipline. We've enjoyed very good conditions for a few years now. And those have gotten better, certainly in the reinsurance front for us in the last year plus. We expect those to remain very strong in '24. So and again, in the theme of capital allocation, but also kind of where do we push the hardest, I think that's going to be very important to us in '24.

So I want to focus in on that specifically in the reinsurance. Could you maybe first help us think through what's happened over the last year. And certainly, we all see the rate numbers, but maybe also just terms and conditions and the way your bulk has shifted. And why all of that is such an opportunity for Arch?

Yes, I'd say broadly speaking, I call it, 2023, the year of property, right? I'd say we have grown -- and if I go back in 5 years ago, we were a fraction of the size of what we are today on the reinsurance front. Footprint was -- but the footprint was kind of the same, right? The platform we have, the U.S., Bermuda, Europe, I think, was very much the same. But the market just wasn't nearly as good. The market got a bit better, certainly starting in '19, '20, the last few years. And you saw us write more property even in '22 but '23, right, I think, certainly, property cat became a big theme and something that we were able to execute on and that was, I'd say, quite a game changer. So as we think about property in general, both cat and non-cat, '23 was certainly a year where we did a lot more. But I'd say the market was there for us. I mean I think of property facultative, property fact, for example, for us, which is pretty -- has become quite a sizable part of our non-cat business. The market has just really done -- just exploded. So it's been really good on that front. And then I bring in kind of the other lines of business where now we're expecting property to remain very strong, but there's -- we do a lot more than just property. So casualty is an area both, call it, professional lines, the D&O angle, which has maybe not -- as may have peaked, I'd say, maybe coming down a little, but there's a lot more to casualty that we do that we think has opportunities for us as we look into '24. So I think we're very positive about the broad kind of sector in reinsurance in general. And then within that, there's always some pockets.

So I definitely want to come back to the points you're making on casualty. Before I leave property, I was interested if you could talk a bit about the supply and demand dynamic in particular. And I know as people are watching interest rates drift down a little bit, they're thinking through, well what's the sensitivity to all of this to interest rates? Is it more than that? What are the structural things that are impacting it?

Yes, I'd say capacity, in general, is pretty stable. I think there's been some pain in the last few years around -- certainly cats have been sizable and there's been the interest rates moving up has created some pressure on the mark-to-market for some companies. So I think there's been -- '23, knock on wood, will end up being a very solid year for the whole industry or for the whole sector and that has certainly helped incumbents and existing players kind of bulk up or again, I'd say, fix some issues with their balance sheets. There was a little bit of a pullback on the third-party capital that took place in '22, along for the last few years. Is some of that coming back in? We think so, not in a systematic or major way, but we think there's a little bit more supply coming through from third-party capital. Does that impact the discipline? Does that impact kind of how the market behaves? We don't think so at this point. I think there's still very, very telling signs that discipline is there, people are not kind of chasing the business. So I think it's -- those -- it makes for a healthy market. And back to your question on -- just quickly, as you wanted to touch on terms and conditions, which are part of the story, I'd say, it's not -- when the market corrects in a major way like it did on the property side, a year ago, I think it's just human nature that the terms and conditions end up being quite strict. I mean, quite expensive. I mean the changes, it's a massive step-up in terms of conditions. You look at it back a year later, sometimes some of the terms and conditions that were put in place are actually didn't really apply, but people just -- it's kind of throw everything at it and it sticks and you just have it. There may be a little bit of a pullback in '24 as people are a bit more realistic about, well, what are we actually kind of -- what's the understanding here of the transaction, what do I need in terms of protection and what are the reinsurers kind of willing to give in on. So there could be a little pullback, but we don't think it's -- our view is that it's gone very, very hard. So even if we get back a little, it's not going to be a game changer.

Understood. And I think a big part of the conversation too has been around the demand for reinsurance. And certainly, higher retentions and so forth were taken this year and it was a particularly tough year for certain types of smaller catastrophes. How are you seeing all of that manifest itself in the opportunity around year-end this year?

Yes. I think there's -- we paid the price and others did as well. I'd say, going back a few years where the aggregate covers that were kind of intended to cover frequency of events were very much a part of the market. And we would argue, I think, probably underpriced to -- and the experience shows it. So the market, in general, I think, has -- the reinsurance community has pulled back from that type of product. With the right word, I'd say in a little bit of a transition where people are trying to factor in all the climate change and everything that goes with how do you think about the risk that you're assuming from the property side. So that -- kind of that product for the time being, I'd say, is probably not really available. You're right, with the market, the reset, retentions went up. What we see happening, though, and that was always part of our thinking, was primary companies have gone through both on the personal and on the commercial line side, have gone through a pretty extensive revaluation process to come up with the right values on the insured -- the right insured values. And it's homeowners, I mean, I'm sure most people here will notice that when their renewal comes up for their homeowners policy, the home prices -- the value they put on the house has gone up quite substantially in the last year. And commercial is always a -- it's a more complicated kind of exercise. Certainly, when you have multiple locations, you got to think through of all the interdependencies, you have BI, you have tons of other coverages that impact the insured values. But that whole process of revaluation has gone through. Is it done? We don't think so, but there's a lot of it that's actually now starting to flow through the numbers. So when we -- you get back to a property cat. program, the carriers are realizing that, hey, now my TIV has gone up from -- by a quite healthy percentage in the last year, which means I need to buy more coverage. We think that additional demand will effectively kind of mean more limits being purchased at the top end of the programs. Some carriers may try to bring down their retentions. We'll see how that plays out. But we do expect a bit more demand for the product just based on, again, the fundamental just revaluation process that's going on.

Yes. So I want to come back -- before we leave reinsurance, just come back to the casualty. I think you all have been sort of maybe recognizing some of the things that were problematic around casualty over the last several years. And you've also more recently maybe been the first to say that you're seeing some progress and potential momentum behind price in that market. So would love to hear you unpack that a little bit. And is that something that is actually going to happen in '24 or overall, [indiscernible]?

I mean I don't have the crystal ball, but we're -- that's certainly our view is that casualty has gone -- there's more pain to be recognized on the casualty side. We think the extent to which the soft market years have been the ultimate kind of loss picks have been recognized on those years is we think there's more to come. And ultimately, when that is done, that is effectively reflected in the financials. I think companies will recognize that there needs to be just a different reset, the different starting point of where -- what the exposure is. So it always starts -- always, but I mean in this case, we think the primary companies are the ones that truly are leading the charge, right, recognizing that when I write a policy that has and it could be any subsector of the casualty market, understanding the exposure and then we get into what impacts the ultimate performance. Again, it's inflation concerns, it's courts reopening after COVID. There's -- as we know, there's a lot of factors that impact the performance of that line of business in general. I think now we're seeing more data coming through. We see it both on our primary operations. We see it through our reinsurance operations as well. So we're positive that this data that's coming through will impact how people perceive the risk that they're assuming. They'll have to charge for it, obviously. And you're seeing it already come through in kind of the rate changes that are being published by some -- the surveys in the industry where we're seeing a re-acceleration of casualty rate -- effective rate changes and in the second half of the year. So I think there's more to come. We don't expect it to be a stair-step like property was at 1/1, but we think there is a good rationale to get us to where we think it may end up over the next, call it, couple of years.

How would you describe like the return profile of that opportunity versus cat? It's pretty different in terms of the volatility so not directly comparable. But I mean, how do you think through the opportunity there versus what you've got in property cat?

I mean it's -- I mean, we like to play in both. Obviously, we're not really, at this point, from the Arch side, we've got capital to work with. I think we've been able to generate internal -- internally kind of capital base has grown. So I think that gives us the ability to really be able to play in a meaningful way in both sectors. Our property guys will keep writing the property as long as they feel like they're getting the rate that they think they -- is necessary to given the exposure we're writing and the same thing on the casualty. So no question that on a on a peak zone kind of very specific property deal, you might get better expected returns, but we also recognize, to your point, that it's more volatile. So we think we deserve that. We try to get that. On the casualty side, certainly, we factor in a bit more investment income. And with the rates going up, I think that's a positive. So when we look at the whole thing, they're closer than you think in terms of absolute returns, given the investment income angle on the casualty side, which is meaningful.

Interesting. Okay. So let's move over to the primary business. Maybe just a broad question for starters there. What are you most focused on when you think about that business and the opportunities still ahead?

Yes. I think our insurance practice or insurance segment has really transformed itself from 5 years ago where we were -- we certainly were not satisfied with the performance that we were getting out of that market or that segment. But by the same token, we -- if we're being totally transparent here, I mean, we all know that it wasn't a really good market either. So at some point, there's only so much you can do given the market that's in front of us, and we play a lot of defense and we also feel like we were more realistic or very realistic about kind of the expectations around combined ratios or initial loss picks. So I think that was the reality back then, that the whole market, and you've seen it through the rate changes, rate increases in most lines of business on the primary side come through in the last 3 to 4 years. Those in some lines have tempered. And yes, we've all heard about D&O and cyber in some places where rates are maybe coming down a little but we're still very much active in those lines. We think the relative measurement is important, but the absolute measurement is maybe more important, right? So ultimately, are we hitting our targets? Are we hitting the returns that we think are required for this line of business? And for the most part, we are still very much active in those lines of business. So that's kind of what we're focused on really is understanding -- I mean, I don't want to say it's easy, but it's easier for sure when you price a risk, and you're at the renewal and you show up and the next year, like the market is trending in the direction that we're going to get 20% more rate on the same exposure, it's easier for the underwriter to make the call and say, yes, I want it again, and I want more of it. When rates start going the other way, I mean, there, you're going to have to have a bit more discipline around when do we say no, when do we kind of pull back? And that's what we've, I think, hopefully been -- I think we've been able to do a lot of that over the years. We're not in that -- this is not the time for that yet. I'd say maybe in some subsegments where there is a bit of pressure, but for the most part, we still see 2024 being very positive on the rate side for the insurance group. And then it's a matter of kind of again, capturing the better accounts, being selective and kind of putting the capital to work.

Got it. So you touched on in some there already. But with the net investment income picking up, certainly, commercial insurance ROEs for the industry broadly have gotten to a pretty strong place. Why isn't that translating into the kind of competitive pressure you might expect? And is it in certain pockets? How do you avoid that?

Well, we certainly don't tell -- our underwriters are focused on combined ratios. We can at the group or at senior levels do look at returns, which obviously impact how much capital we think we want to deploy in a certain segment. The flip -- the response to your question, I mean, I usually like to flip it on its head and say, well, how come rates were so bad in 2015 to 2019 when interest rates were at kind of all-time lows or very low? So that whole kind of view that interest rates should have a meaningful impact on the rates we charge is -- makes a ton of sense, but in reality, doesn't really seem to follow. And my view is that it's more around just how much capital is in the space and whether people perceive that it's going to be attractive and whether -- how competitive they want to be. So at this point, there is not an oversupply of capital in the industry, on the insurance side, for sure, and broadly speaking. And we feel that what we're seeing is competitors being very -- again, very disciplined in how much capital they're willing to deploy given the uncertainties around the lines of business. And for those reasons, like investment income is a nice add-on, but doesn't really factor in at this point into the pricing levels quite yet.

Got it. So I wanted to circle back on the financial lines, particularly D&O. You mentioned some pricing pressure that's there. Could you help us think through that? I mean, I hear you absolute, as long as it's still in a good place, it's great. I think we've seen some of the securities class action lawsuits tick up. And some of the loss trend things are sort of maybe getting a little worse just as pricing is coming down. How do you navigate that? Why are you comfortable still sort of playing where you do?

Yes. I'd say -- I mean, my view, our view is that certainly, a lot of the additional -- I mean, the markets that -- we had new entrants. A little bit on the heels of what people perceive to be very good, well-priced years on the D&O front. And a lot of that demand for the product was driven by IPO activity and SPAC and de-SPAC activity, which pretty much dried out in the last year plus, right? May pick back up in '24. But the last 1.5 years or so have been relatively quiet on the IPO transaction liability front. And those new entrants that had been established were looking for a way to get some premium, right, to justify their existence a little bit. So that's where you saw the most pressure is certainly on the excess commercial -- large commercial D&O on excess layers where it's relatively simple or not overly complicated to show some capacity and participate in those programs, which brought down the pricing. And that's been really, I'd say, the main area where you see more pressure. I think a lot of the private D&O asset manager, there's other categories within the D&O space that didn't nearly move nearly as much as a large commercial did. And there are still accounts that we like. I mean, to your question on like class actions and how do we think about that. We think that's certainly something we're watching. It's never a perfect science. I mean, sometimes there's a flurry of activity on that front and some of them stick, some don't. But we're certainly aware that it's something we need to -- well, we always have been tracking it, but it's certainly gone up in the last, call it, 6 to 9 months. And being selective in how you deploy capacity limits where you play in the towers is, I think, a way that you can certainly minimize the downside and be kind of still generate good returns.

Got it. Let's shift gears over to mortgage insurance. Maybe first, I want to ask you about some of those transactions that you made an announcement on recently, but maybe first, just broad view on the state of that market, credit quality and what you're seeing in some of the leading indicators?

Yes. I mean we -- it's been terrific for us. I think mortgage has done extremely well. What we see today is certainly a book of business of in-force business that has performed extremely well. We think, based on again, what we have in front of us, will perform extremely well. Home prices is, to us the -- obviously, it matters tremendously in the performance of that book. Home prices have gone up. So the people building up equity in their house is critical to the long-term profitability of that book, so that was excellent. We had some concerns, some doubts earlier this year, at the start of the year when maybe the economic data was suggesting that there could be time for a pullback or a recession. Here we are almost a year later, and things have not played out as we thought they could. So that's certainly something that we are benefiting from. And with mortgage rates being at the level they are today, what we see is a book of in-force business that will stick with us for a long time. So there's a lot of value that's embedded in that book of business. High credit quality, again, persistency is at an all-time high and no kind of macroeconomic kind of signs that kind of have us really concerned about the performance of that book. The downside, obviously, as we say, well, what's good for the in-force book is not always good for the new originations, and we see that because originations are down. The market is what it is. There's not a whole lot of people buying new homes or refinancing. But even though -- those that are, we think, are still doing extremely well. Good credit quality, I mean, a bit of pressure on some of the other metrics like loan to value, debt to income, those kinds of things. But all in all, we're very happy with the mortgage segment and the prospects of it. And our view is that, at some point, mortgage rates will come down, and then we'll kind of -- I mean kind of open up the origination market a little bit and give us a bit more of new business.

Makes sense. So recently, you terminated some of the -- I think it was Bellemeade securitization transaction. So I just wanted to see if you could give a brief background on what was done there. And if there's any financial impacts you need to consider?

Yes, I'd say this was very much in reaction to the S&P capital model that has got finalized in mid-November. So, I mean, big picture, the capital model, specifically for the mortgage business, changed quite substantially. The old model was a bit -- was more punitive. So capital requirements were definitely higher, more granular, so very much loan by loan, very, very, very detailed model. And as a result of that, there was -- given that the capital requirements were quite substantial in the old model, the purchasing of Bellemeade security is going to effectively buy more reinsurance, which effectively, this is excess of loss reinsurance was an attractive proposition for us, right? So managing our capital requirements through the purchase of reinsurance protection was a benefit to us. With the new model, the game has changed quite substantially. The capital requirements, the gross or the ground-up capital requirements have gone down and the protection, the value we get on the capital on the S&P side in terms of the credit we get on the capital from those protections from those Bellemeade transactions effectively went away. So for us, we had an option to exit that we had the ability to exercise. So we've made -- we announced our intention, at least at this point to call those transactions, but it's really around the credit or the recovery -- expected recovery we're getting from the S&P model. In terms of financial impact, it's somewhat de minimis. I mean it's accretive, but it's over a number of years. And in the grand scheme of the Arch kind of family, it's not really going to move the needle enough to kind of disclose it or it's positive, yes.

Understood. One of the themes that I think investors have been particularly interested in is just you've got this mortgage business. You've been releasing some of these COVID vintage reserves that were put up, and it's providing you more capital to go after the reinsurance opportunity. And so the question for you is really where are we in sort of the life cycle of that theme? I mean there's already been a fair amount released. You certainly had fantastic mortgage earnings this last quarter. Is there still a runway there? Or do you sort of have this capital and now it's about going after the reinsurance?

Well, the mortgage side, I mean, we don't know. I mean, the one thing -- I mean, we've said it publicly is the reserve releases for the COVID cohort of loans or mortgages or delinquencies is pretty much done. So we -- whatever we set up in terms of reserves, those delinquencies that were reported to us right after COVID, like call it, 2020, those have pretty much been all released as those loans have cured and gone out of forbearance programs. Since then, though, I mean -- and you've seen that a little bit in our initial loss pick, your assumptions around claim rates, we've been a little bit more conservative than we had been historically. So we started the years -- people asked us, where are those releases coming from? I mean, when we reserve for new delinquencies in the quarter, we have a view on kind of ultimate performance of those loans. And we had been -- there was some concern around, again, home prices coming down and maybe unemployment picking up. So there's a couple of things that we were looking at that had us a little bit worried and that's why we booked some of those reserves at a higher level in the last, call it, 12 to 18 months. Does that materialize? At this point, it looks like some of that is actually running off favorably. So there may be more favorable reserve element coming through. We don't plan on it. It just happens based on kind of the experience. But if that generates into more earnings and more capital for us to deploy either in the mortgage segment or in others in either insurance or reinsurance, absolutely, I mean we'll do that, obviously. And that's going to, I think, I wouldn't call it a secret sauce, but that's what you get with the Arch story is being quite capable across 3 segments to move the capital in and out and deploy it in the right -- in the better opportunities, we think that's what makes us different and hopefully better.

So, in the same vein, I wanted to ask you on capital management broadly. Certainly, you've got this reinsurance opportunity. We were all focused on that. What are some of the other ways that you'll look to deploy capital?

Well, that's the focus, right? Right now, it's -- we got a great market. We know we won't be here forever. We are working day and night to make sure we maximize the opportunity or maximize the returns from that opportunity. We'll reassess -- well, we'll reassess, it's something we do constantly. But we'll have another data point after the 1/1 renewals, right? That will -- That will be telling in how -- where the market is heading, how do we think about the capital we have? Do we need more? Do we have enough? Do we have too much? What do we do with it? Right now, I think we recognize it's a market in transition. So we wanted to make sure that we don't want to miss an opportunity. So let's kind of hold on to the capital, let's put it to work. And I mean, a lot of green lights in all the metrics we look at. So there's really not -- as long as we like the returns and the pricing, our units are doing the best they can to write that business, again, the mortgage story has been tremendous in helping us kind of not have to go out and find other sources of capital. I think we're very comfortable with our capital position. But we'll go through that next step and then reassess what it may mean for us.

Understood. I wanted to ask another question on net investment income. I mean, certainly, there's a lot of maybe more sensitive and impactful things going on in the margins in your businesses. But could you update us on where the new money yields are relative to portfolio yields, how that dynamic is trending? And are there any opportunities in terms of allocation and [indiscernible]?

Yes. Sure. I mean maybe a little pullback in the fourth quarter into where the rates are. But big picture, right, there's about 150 bps difference between our book yield and the new money yield. So when we think about wherever that new money yield, I mean, moves over time, we think there's still room for us to as we -- as new -- as maturities come through and we roll the money over, I think we'll -- we should be able to even -- we will have a better book yield or a higher book yield and that's -- I think that's certainly a positive. The one thing, though, that we are -- have been, I think, investing time and energy in, in the last couple of years has been more proactive on the, call it, the private side of the investment kind of story. So alternatives, private loans, kind of the where we think that there's better given our stature and we can make better -- bigger commitments. We can get better terms. We can get more better expected returns that way than just strictly through the public markets, I think, is a way that we're trying to optimize and kind of generate higher returns. So a little bit more risk maybe to some people. I would say, well, it's risk that we should be taking on anyway given our size. I think we can take on that risk, liquidity concerns or I don't think we'll -- unlikely that we'll -- there'll be a run on the bank on Arch tomorrow, and we'd have to liquidate everything. So I think we're taking the right steps to again, just kind of realizing that we were at a certain size, we have the ability to do it. And while still maintaining a discipline that we see ourselves as being an underwriting company first, right? We're not a -- give us the cash so we can invest it. Yes, we need to invest it, but we need to retain our principles around being superior underwriters, and leverage the investment side as well as best we can.

Understood. Well, we're at time. So I'll stop it there, and thank you very much.

Thank you.