Arch Capital Group Ltd. ($ACGL)

Good afternoon, everyone. Thank you for joining us today. I'm Bart Dziarski covering diversified financials at RBC, stepping in for my teammate, Rowland Mayor. Thrilled today to be hosting Francois Morin, CFO of Arch Capital Group. Arch is a roughly $35 billion diversified insurer with insurance, reinsurance and mortgage insurance operations, and they were added to the S&P 500 in 2022. So -- Francois, welcome.

Thank you.

Thanks for joining us. Maybe we could start at a high level with regards to Arch's strategy. What are you focused on? And what would you say are your 3 engines of growth? And if you could tie into that capital allocation?

Sure. Yes, as you said, we are a kind of global property, casualty, specialty insurer and reinsurer. So what we focus on is what we would consider to be specialty lines of business. And by that, we mean lines of business where the underwriting expertise is key in the process. Yes, scale matters and being efficient and kind of having good processes is always a positive, but we think where we can differentiate and outperform the market will truly be in how we go through risk selection and certainly kind of the underwriting process. So for us, our platform is really divided into 3 key segments. One is commercial insurance, and that is predominantly done outside -- in North America and in Continental Europe. We have a reinsurance group that is more global in nature, somewhat centralized in terms of underwriting, but has broad access to global risks, Asia, North America and Europe and around the world. And finally, what maybe is the one differentiating factor at Arch compared to some of our peers is we have a mortgage insurance group or segment that is somewhat unique. A lot of the mortgage insurance companies that you may have heard of in the U.S. are monoline companies. So -- at Arch, we have the benefit. And when we talk about capital deployment of having this mortgage insurance company that -- or group that is part of a diversified group. And that really has been one area I'd say where we've been able to really do well is that has given us really a third vehicle really another way to deploy capital as we try to navigate through cycles. As you know, the insurance industry, particularly on the P&C side, can be very cyclical. And for us, the game is not about being a market share player. It's not about being the largest or the most efficient in any one line of business, but really where we think we can outperform is around being smart and thoughtful about where we play, where we deploy our capital in the right time in the market. Stepping back a number of years in the last soft market on the P&C side that really materialize more in the 2015 to 2019 years or so. The opportunities on the traditional insurance -- commercial insurance side were not really as exciting, and that's the time when we really grew our mortgage insurance presence, and that really, we thought -- that showed the value of the diversified platform we have. Since then, I think it's been a slightly different story where the P&C markets have done much better, the last few years, starting in '21 or so and through last year for sure, both insurance and reinsurance have done well. Our mortgage business has still done well, but has become less critical to the overall engine. So that's really how I present Arch to you all. It's really a business model that is founded around diversification, around cycle management, around capital deployment to what we perceive to be the best opportunities given the -- I mean, their respective cycles.

Got it. Thanks for that helpful overview. And maybe we can segue from that last point around there's concerns around being in a soft pricing cycle largely attributed to property at the moment. And so when you see that play out and the 3 engines within your business could be impacted. Like how do you think about deploying capital into those different businesses with that sort of broader pricing dynamic, if you will?

Right. It's an ongoing process, something we do regularly, quarterly, et cetera, like each of our business units is to ask with finding the right opportunities where they can put the capital to work. I'd say the one thing that maybe makes us a bit different than some of our peers, again, is we don't really set targets on premium, growth or capital deployment. Really, those are more a result and not an input, I'd say, in the process. So we at group make sure that we obviously have enough capital to be able to deploy. But each of the segments are really tasked with evaluating the opportunities. And if they perceive that the opportunities are good enough to put the capital to work and achieve the returns that we're expecting, there -- it's on them to really make that happen. But if the opportunities -- to your example, if property is one where they don't see the same level of profitability in the business, they are encouraged and we expect them to really pull back because at the end of the day, for us, it's really about delivering the bottom line results and the bottom line returns. So it's truly an evaluation ongoing between returns and kind of where is the best opportunity. In the last few years, we've been somewhat, I'd say, spoiled in that each 3 or all 3 of our segments have been generating very good returns. But as the market may soften, if it starts -- it has begun to soften and if it continues in that trajectory, we'll have to make decisions along the way to pull back in some lines and effectively deploy less capital, which will return to shareholders and with the expectation that we'll be able to deploy it down the road when the market is more attractive. So we're somewhat agnostic as to where we deploy the capital as long as it meets our bottom line expectations.

Okay. That's helpful. And could you unpack that last point a little bit? Because if you pull back from writing business, you're building excess capital. And could we think of a potentially fourth stool, i.e., capital return then in that dynamic? Like how should investors think about that this year or next year as part of the Arch story -- capital return?

Absolutely. I mean capital return is front and center for us at the moment. Again, stepping back, the last few years, we've grown at a quite rapid pace, specifically in reinsurance, where I think our premium volume went up 5x over 5 years. So it was a pretty steep growth rate in the last few years, that growth has tapered off. I mean, and we saw some numbers even we shrank in a few places last year. So in an environment where growth will be harder to come and it's -- not that we don't want to grow, but I think the opportunities for growth are more limited as in general, more the market is doing -- I mean, trying working hard to retain what they have, like there's no pull back in terms of capacity deployment. The reality is -- and we're still in an environment where the returns are very good. We're effectively building up excess capital at a pretty healthy pace. And the most important thing, we don't want to do is not waste that capital. So in the event and more likely than not that we won't be able to deploy it all, we'll return it to the shareholders.

Great. I think that makes total sense. I want to talk about reinsurance. So we just came through 1/1 renewals. Any takeaways from your perspective that you saw in that renewal cycle? And can you give us kind of unpacking a little bit of your mix within the reinsurance segment?

Yes. It was not unexpected, although the -- maybe the severity or the quantum of the rate decreases may be a bit higher than we would have expected, call it, back in September, right? So we were -- as we were planning the 1/1 renewals, we thought, yes, I mean, it's been -- we've had really 2-plus years of truly spectacular returns on the property side in particular. Like there is a significant reset in '23. So '23-'24, very strong pricing; '25, very good, although a midyear '25 started to inch down a little. So we were expecting some level of rate decreases at 1/1 this year. And it turned out maybe that they were a bit higher. There's more competition for that business than we expected. So not a big surprise. On the property side, very much a result again of the strong returns and whether it's third-party capital that incrementally coming into the space, but if I try to summarize it, to me, it's more that the incumbents that the existing players just wanted to retain the business, right? So you have 2-plus years of north of 20% returns, and that just creates more capital to deploy into the space. And I think that kind of fueled a little bit some of the -- some of these rate decreases. Other than that, the other lines of business behave as I think expected. We thought casualty would do maybe a bit better, not in the sense of the pricing but in terms of volume, in terms of opportunities that we thought we might be able to see. And again, some of that is not necessarily our decision. Sometimes it's the ceding companies that like the business as well. Pricing is good. They're comfortable holding on to a bit more of that business. They're not looking to transfer as much out. So some of it is not totally within our control. So -- we would have liked to see a bit more opportunities there. But still, what we saw was, I think, healthy, good returns. So we're happy with what we got. And for us, it's -- again, 1/1, as you know, is a big part of -- half of the business, effectively or so renews at 1/1. There'll be more to come, at 4/1, 6/1, 7/1. But even though returns are lower than they were a year ago, they're still very healthy, and that's the takeaway at this point.

Okay. That's a good color. And maybe just to get a little bit specific on the 1/1 renewals. Could you walk us through from a competition perspective, what you saw in property cat in terms of do you get the sense that like the bottom is forming? Or is competition still sort of elevated in there? What are your reads on the dynamics?

I mean the dynamic is somewhat similar to the last couple of years. I think there's more capacity, more competition in the upper layers. I think there's -- as you get to be more risk remote, I think carriers and third-party capital providers are -- get a sense of comfort that I can get some premium with somewhat limited risk. So there's been more competition there. I think where we typically play pretty much across the stack. So we're -- we'll play in different places. And we're -- certainly, we don't want to be in a position where we're just trading dollars. And I think with the reset we saw in '23, that is less the case than it used to be. The retentions are still high enough that we don't have that risk as much. So what we see is an area where the return periods are not as -- are a bit more attractive to us. So competition, I think, again, more so on the higher layers, in the lower layers, depends on the zone, depends on where people are playing, but nothing that was, I'd say, unusual.

Okay. Okay. Maybe we can turn to primary now. So you've announced some re-underwriting efforts, if you will, in the MCE segment. So can you maybe walk us through that and how we should think about the growth profitability outcome as a result of those re-underwriting efforts?

Yes. The re-underwriting was more, I'd say, in a piece of the business that came on the transaction, specifically with their programs division within the acquisition that we identified. We didn't necessarily want it, but it came with a transaction. It's something that was probably going to be -- I mean we looked at immediately and identified as an area that we probably downsized and that's what we did. So we effectively had some nonrenewal kind of actions that took place in the latter part of '24 and early '25. And those are being kind of earning in or they're going to start to materialize a bit more in our financial statements as we move forward. And that was more a decision of whether -- I mean, the -- as you know, the challenge sometimes with MGAs or program managers is alignment of interest and making sure that they underwrite the classes of business that are attractive to us. And there are some things that -- some of the programs that came with it that we just didn't feel comfortable with. So we acted on those pretty quickly. But that's kind of -- I want to say the decision, the actions have taken place. Now it's just a matter of kind of having that flow through the financials. But the core -- the asset that we were really that we wanted and we got our hands on was the true middle market business. And for us, like just in terms of scale, this is business, call it, middle -- again, not the Fortune 500 companies, but still sizable companies with what we call usually property led. So they will have generally sizable property exposure. It could be a hotel. It could be manufacturing plant. And where we play is more in the -- what we call the upper middle market with an average premium of, call it, $200,000 per policy. So it's still sizable with property with casualty exposures as part of the package. And that business has done well for us. So it was still for us a way to get into that business that is established and it's hard to build. We had thought about building that from scratch. But the distribution that you require to be present in all 50 states, et cetera, is a difficult thing to do. So for us, the acquisition we made was the right way to play the game at this point. So we're very happy with that. It's done well. Now as we kind of season it and we've been able -- we have 1 year of renewals under our belt. I think we're going to be -- our plans are really to try to make it better, make it a bit more sizable as part of the Arch family. And hopefully, we can do that in the not-too-distant future.

Great. Want to move towards industry reserves as a topic, and it's a concern for investors. You've spent time at Arch as Chief Risk Officer and Chief Actuary, so you've got a great lens on this. Can you walk us through reserving philosophy at Arch. And then secondly, like are you taking any actions? Have you looked at any past books in terms of that dynamic?

Yes, that's a great question. I think reserves are -- all companies, it's something that -- there's different ways to go about it. I think our view has been the most critical thing, and I know that's probably easier said than done, but is to be realistic from the first data point, right? So call it, the initial loss pick is probably what matters more than anything because we're big believers that reserving feeds into pricing and feeds into reserving. So it's that whole cycle that is so critical on how companies perform. If you walk into a line of business or you have a somewhat optimistic view of what types of risk you're underwriting, and the downside that maybe you take with that line of business, well, if you're optimistic there, it's going to mean that most likely you're going to maybe be one of the cheaper prices on the street, which will mean we'll grow that business and then you'll reinforce that decision early on that, yes, my loss pick was good and then -- you do that a few years, you accumulate a lot of exposure and then maybe you wake up 3, 4, 5 years down the road and realize that you were -- you missed the market a little. So we take the -- we challenge ourselves like constantly whether -- and it's more an issue. Mortgage is a different animal, but certainly on insurance and reinsurance to really think about both in loss trends like inflation is a key factor, certainly long-tail lines. How does that -- how do we think about it? We are big believers in having more of a long-term view of not being overly influenced by recent trends, whether they're favorable or unfavorable on loss cost trends. So we're trying really to have a long-term view on them. We stick with it. Certainly, the more years you accumulate, the more information you have, so that's a good thing. We think that's why like newer players are somewhat disadvantaged when they're starting a new line of business. But for us, it's the initial loss pick. And then it's -- our philosophy is reacted to bad news quickly and take as long as you can to react to the good news. So it doesn't mean because there's no claim that's being reported that it's all going to run well. But -- hope it does. But until we know for sure, we're just going to hold on to the reserves we have and maybe it takes 3, 5, 10-plus years to release the favorable news. But that's kind of been our mindset is react to the bad news as soon as you can. Good news, let's wait and see. And again, the reserves is just an estimate. So they'll play out over time, but there's no rush in our mind.

Okay. That's helpful. And do you see any lines from an industry level where just underwriters are getting in over their skis on their reserves or like some pockets? Or is it...

Well, I think commercial auto in general, has been maybe the most difficult line for many carriers. I think it's been the challenge around maybe the large jury awards and like loss trends that have been running hot for many, many years, even though pricing has been very good. I mean the rate increases have been strong, double digits, et cetera, but keeping up with loss trends has been a challenge. So are we closer to being about right or adequate, you hope so. But every time we say that, something else happens. So that's probably been the most difficult line. And you can point to oversized jury awards and the way law firms are playing the bar has been kind of a bit more aggressive trying to get larger settlements out of the carrier. So that's been something that we've been watching carefully. But for us, it's not a big thing for us. We don't do a ton of commercial auto, so that I think we've been able to avoid that for the most part. So I'd say that's probably the one that sticks out the most and then any kind of excess kind of business umbrella like businesses where, again, going back to my earlier point around the initial loss pick and assumptions you make about the loss cost inflation. And again, if you missed that early on, it finds a way to compound over time. So that can be a problem.

Okay. Got it. Helpful. I wanted to touch on alternative sources of capital, if you will, or new entrants, and there's MGAs, ILS. And how is Arch involved, if at all, within those dynamics? And can you walk us through that?

Sure. Specifically on MGAs, I mean we have been working with MGAs forever. I think for us right now, it's been a slightly -- it's a different strategy, different execution, the insurance side versus the reinsurance side. On the insurance side, for the most part, we have a handful of managers that we've dealt with or worked with for many years. And as you know, program managers, I talked about aligning incentives and that's certainly something we have to worry about and think about. But establishing a relationship with a program manager, it takes time and connectivity in the systems and aligning kind of underwriting authority, et cetera. So there's a lot of things that have to work well for the program to be successful. And the reality is it's a -- it's usually something -- it's not something you want to come in and out of each year, right? You go into a relationship with a view to being somewhat of a long-term commitment and that even though it's an annual decision, you want to kind of -- there's an investment you make to get it started, so you want to see that kind of produce some results for you. So -- we've had those, but the reality is we -- that hasn't really grown. I think the number of carriers or program managers we deal with has been relatively stable. And it gives us access to some lines of business or some distribution, some niches of business that we wouldn't get otherwise. So that's been our strategy. There's I think, the right place, the right time for program business to be part of the broader offering. But our preference is still to go out to the market with the Arch brand. We think it's better for us for the long term to be the brand that they know in the market. On the reinsurance side, it's a slightly different kind of story because -- as you think about our ability and willingness to really flex in and out of markets, more so on the reinsurance side as the market gets better. Partnering with MGAs we think, is a very efficient way to do that and then flex in and out of market. So you saw us kind of grow our property business significantly in '23-'24, in particular, in reinsurance. And a lot of that was through relationships with MGA. So as the market gets more attractive to us, and we think we have the ability to deploy more capital, we think doing that through MGAs that bring you that distribution is a very efficient way to do that as the market starts to -- not be as attractive, that's when we start to challenge some of those kind of decisions and say, well, maybe we pull back a little bit. So I think -- again, so we have, again, done a lot of business with MGAs over the years, but I'd say the reinsurance has been more cyclical with the underwriting cycle, whereas on the insurance side, it's a little bit stickier. And with -- but going forward, I'd say our preference would be more -- to be more, to lead more with Arch brands than MGA brands.

Okay. Got it. And within ILS, if we could just follow up, is that a dynamic that you're seeing? If so, what inning do you think we're in from the ILS market? Like how does Arch approach that segment of...

Yes. I mean we've been like -- we have a pretty sizable ILS franchise on the property reinsurance side. So we have third-party capital supporting our underwriting. We have side cars. We have a couple of the vehicles that have worked well over the years, and that has grown certainly in the last 5-plus years, I want to say. We have our own more -- I mean, it's a multiline effectively side car called Somers Re. So that's been a vehicle for us that is -- that's how we can bring in third-party investors with a slightly longer kind of view of the investment in having kind of a more permanent capital base. So that is a best rated. So it's a more permanent vehicle that we think works well for us. Yes, I mean, third-party capital is an important part of the business for the industry in general. I think the issue is always around having third-party capital that is, I'd say, has similar, if not identical, kind of expectations about returns. I think some of the issues we had in the past was ILS capital being kind of offering or wanting to participate on risk without we think at the right level of return. So that creates some inefficiencies or arbitrage in the system. But as long as these providers are see risk in a similar way as we do, there's a role for them. But ultimately, we still think going with -- for us, leading with the Arch brand is better than -- and we use them really to -- we think we can provide solutions to our partners. That's our goal, right? We want to be the place they come to us to solve some of their issues, some of their challenges. For us to have third-party capital supporting the offering, that's great. We want to leverage that. But ultimately, we want to be the front of the discussion or the decision to kind of support these decisions.

Got it. Let's talk M&A. So there's been a lot of M&A in the industry within the broader P&C market. Like could Arch be a participant in that M&A? Are there any product gaps potentially that you'd be looking to fill through that mechanism?

Yes. We're all -- I mean we look at a lot of things. I mean, we have certainly an appetite to get better and get -- to be more relevant. I mean -- so no question that when we look at M&A for us, it's the mindset like what is there out there that we could -- if they were part of Arch, would make Arch better. And in the past, we've made a couple of balance sheet kind of larger acquisitions, United Guaranty on the mortgage side was certainly transformative. But as you get bigger, it's harder to find like somethings that were -- you minimize the overlap and you got to think about culture. And so all these things matter. Ultimately, the MCE acquisition, we think, is a model that we think worked well in the sense that it certainly was a market segment that we weren't in that we were able to get our -- to get some business -- extract a business unit from an established carrier. Can we do more of that? Absolutely. So at this point, we're -- we like what we do. We got a lot of offerings, a lot of franchises, a lot of distribution, both in North America and in Europe. So I think we touch a lot of things. I think for us, it's going to be more, I'd say, on the margin trying to -- and if there's a line of business that if we're like #5 in the space, could be #2 if we did this kind of this acquisition, those are the types of questions that we ask ourselves. But given our size, as you know, it's -- there's a lot of things that we do already. So we're always ultra careful with a kind of -- we're just not going to make an acquisition just to make an acquisition. It's got to make us better.

Great. I think we're coming up on time, so we'll end it there. Thank you very much for joining us this afternoon, and thank you, Francois, for spending time with us.

Thanks for being here.