Definity Financial Corporation (DFY) Earnings Call Transcript & Summary

Good morning, everyone. Thank you for joining us today. We've got Rowan Saunders, the CEO of Definity. Definity just reported a pretty solid even kind of surprising Q4 result, surprising in the context of one of the results from one of your peers earlier in reporting season. Rowan, thank you for being here. Do you want to get started with just some opening comments, maybe focusing on the quarter, any other topics I think you're interesting before I get into it. And one thing I want to remind everybody, as soon as Rowan is done, feel free to submit your questions through the portal. I have my own list of questions. But I'll be looking over my left shoulder once in a while for questions. But Rowan, why don't you get us started?

Well, good morning, and thanks for all for joining, and thanks, Mario, for hosting this. Yes, I mean we just announced our Q4 and we're really pleased with not just the Q4 results and on their own but also how we completed our first full year as a public company. I think if I reflect back over the last year or so, we've largely delivered as we had expected and as we had promised investors to do. I think we feel good that we've advanced the strategy of the business, but also delivered some pretty solid financial performance. Just thinking about the top line, what we were trying to do was to grow at a rate faster than the industry. We've been successful in doing that. And we also said we'd be shifting the mix of business. And so if you think about the composition of our portfolios, we've been growing commercial lines faster and personal property faster than the automobile. And through the course of 2022, what we saw was our commercial business exceeded $1 billion. So that's a $1 billion business now. And then in the fourth quarter, our personal property exceeded $1 billion of revenue. So that's now another $1 billion. And on a strategic perspective, when we acquired McDougall Partway through the world in the fourth quarter, we're probably now partway to another $1 billion business. So definitely, on strategy in terms of changing the mix of our business. As far as the combined ratio, we delivered a little under a 92 combined ratio, very pleased with that. I was pleased all three lines of business contributed towards that. And that's been fairly consistent through the year. Stepping back, the operating environment has got more complicated. It's got a bit more challenging as the year has gone on. But I also am very proud of what the team has done. We have lent in early. We were kind of early to pick up on inflation. And I think handled the market way back to middle of 2021 started addressing and leaning into that. And that Mario has actually been one of the big drivers of helping us mitigate some of the trends that we're seeing in the market. So we still see lots of opportunities. We're getting great support from our brokers. We're not firing on all cylinders yet. There's still more to come, but I think we feel like we've made good progress in the last year.

Sure. So thanks for that. And as a reminder, everyone is welcome to submit questions to the portal, I'll check once in a while for questions. Let me get started first with this quarter, the company's retention, cap retention is up or the amount of reinsurance is down somewhat. Sort of tying that in, we had Hurricane Fiona. How do you think the company is done in dealing with Hurricane Fiona? Like how would you grade your claims department? And just overall how the company doubled it?

Yes. I think we've done a good job there. I think when we step back, one of the things we definitely realize is that natural disasters, the frequency and the intensity is increasing. And we see that both in Canada, but also, quite frankly, around the world. So we've been thinking about that. And if you look at 2022, it was an active year from Nat Cats in Canada. I think it was the third highest Nat Cat year that we've seen in recent history, and about $3 billion of claims. So Fiona itself pretty significant, it was a top 10 event at about $800 million. We had about 3,000 claims. That was roughly $50 million in losses for ourselves. And we've closed over half of those. So the team's done a very good job of dealing with that. When we get NPS scores, they're about 70%. So I'm quite satisfied with that. And it's a bit of an awkward timing because in a way, you can get and deal with all your quick and emergency claims, but there are some significant losses, some rebuilds. And those are only really done after the winter. So you're talking about spring and summer. So the claim still continues on for us. But I think our -- the feedback from brokers and customers has been pretty good. I mean, we've anticipated more Nat Cat events, and we've taken steps, not just underwriting, but on claims capabilities to be able to address these.

So on a related note, there was some confusion for me the night, the company reported on the recovery, the Cat premium recovery. It was difficult for me to decide whether I wanted to treat that as sort of part of your ongoing operating earnings or really treated as unusual. Without maybe getting into too much of the detail because I suspect that there's some complexity here. Could you just sort of make an argument one way or the other? How does that feel? Does that feel like normal, a normal part of your earnings? Or is that really quite unusual, the recovery?

The way I think about it is part of your reinsurance program, you set out an underwriting appetite. You think about your lines of business and the exposure you have, you anticipate Nat Cat events and weather events and you have different types of insurance. And so for example, we've got access a lot Cat insurance for big events that cap and ad retention. But also, a couple of years ago, we thought about this trend of increasing weather. We thought about the fact we were consciously shifting our portfolio by growing personal property and commercial lines. And so wanted to buy some protection in case you had exactly what we saw this year, very active year. I think it's part of how we manage the business as part of our earnings. We consciously buy the coverage. We pay for the coverage and sometimes you get recoveries. But the years you get a recovery is when it's been a particularly active year with a number of events, and that's what we saw in the fourth quarter. And so it wasn't unexpected that coverage like this would -- if it's going to pay out, it's going to pay out later in the year as opposed to earlier in the year, given the nature of claims. What I do think the teams pretty made a smart trade on this. This was something we've done a couple of years ago. We were proactive in the marketplace. Not everybody has a coverage like this. And actually, with the reinsurance markets changing and have got much more into a difficult or, let's call it, a hard market cycle, this is a 3-year program. We're already 1 year into it. So we also have this protection locked in for the next couple of years as well.

So it is entirely conceivable that Q4 '23, if we have an unfortunate Cat year, it's possible the recovery could play out again. And as you say, it would only -- it's only really likely would happen in the Q4. If it happened before in Q4, it would have to mean a really bad CAT year. Is that fair?

Yes, that's exactly right. That's how I would characterize it.

Okay. And you're right. Obviously, everybody is talking about how it's pretty firm market in reinsurance. What do you do to ensure that profitability is not compromised having -- given that you're paying more for reinsurance?

Yes. I think, Mario, when you think about Nat Cats and that environment, there's a number of things that you do from the front of the business working all the way backwards. And so as we think about how do we manage this. And I think this is something that you've got to be best-in-class in doing and certainly relevant relative to the marketplace. We started with thinking about our underwriting and our accumulation. So how good are we in understanding the accumulation of flood mapping, trying to understand that we're not getting anti-selected. We can write better quality business at not just a certain distance from a flood or from a water but also elevation. So it's that level of sophistication. Then we get into underwriting terms and conditions, policy wordings, sublimits, deductibles, things like that, and then you put that into your pricing and sophistication. Claims is a big piece. So that's why we build these Cat teams. So you can get there really -- get a preferential position in the supply chain issue, but then it's reinsurance at the end of that. And I think that -- this is something that is a core part of a primary underwriter and you've just got to be able to put this into your pricing models and pass them along. And so this is something we've been doing for, obviously, for a long time. The market has changed. And already, we've captured that into our pricing models and feel that we're able to pass on the additional costs that we will be incurring in 2023. And I think there are two things there, a couple of things have happened. One is you've got prices that have gone up, but also net retentions have gone up for the industry and we did that ourselves. It made sense for us after really keeping a fairly low net retention for the last decade. Now we're a public company. Now we're bigger and a stronger balance sheet, taking some of that net retention. But you've got to get paid for that, and that's put into your underlying pricing models.

Okay. Now the next question that came up is one that I was going to get through later, but I'm going to ask it now because I have a feeling this is the big one that a lot of investors are interested in. So I was pleased that I saw it come through early. And the question is what explains the underlying personal auto loss ratio outperformance in Q4 for Definity versus your largest peer? And I don't mind just saying what everybody was thinking. When we saw the largest company in the industry, and we saw their Q4 results, and you can clean it up as best you can. There was a very significant increase in that company's claims ratio in personal auto. And the immediate question that I saw rolling in was isn't this far more relevant to Definity given that auto is a bigger part of the overall business for Definity. Now I don't really -- I'm not expecting you to opine on what happened at that competitor. But maybe talk about what happened at Definity. Why would we not have seen a more material increase? And I want to be clear, I'm cleaning that up for the inflation reserve that we saw last year. So excluding the inflation reserve, the increase in your claims ratio just was rather modest in personal auto, given what the street was looking for?

Yes. A couple of things that have been there. So we just kind of deconstruct that a little bit. Firstly, I think it's fair to say that we still see elevated claims inflation, but we actually have seen it normalizing for a couple of quarters or really being kind of flat quarter-on-quarter, and we've seen that now for a couple of successful quarters. I think the other thing is you've got to look at the type of your portfolio. And different companies, so I can't comment on other specifics or even in the market as a whole. But roughly 50% of our portfolio is physical damage and the other 50% is injury. And so on that mix, we're seeing different levels of loss cost trend. So we are definitely seeing let's call it, the high teens on the automobile physical damage. But on the injury, which is half our portfolio, we're really not seeing too much as 4-ish type percent. So that kind of gets us on a year-on-year basis to about 10.5% auto inflation but it's been flattening for some quarters. And we all know the reasons for that, that's the capacity issues in the supply chain and extra thefts and part delays and things like that. But from our -- so that's driven a fairly steep increase in terms of loss cost. Now I talked a couple of minutes ago, but what we did is we were pretty early in terms of looking at inflation. In the middle of 2021, we actually took a provision for personal property. And at the end of '21, we took a provision on order. So when you do that, immediately, your teams are focused on a number of things, trying to get pricing through the portfolio, initiating quality of business, change of mix of business initiatives, tightening your underwrite capacity. If you think about things like thefts, thefts have gone up dramatically. Well, we changed our underwriting appetite, we used risk-sharing pool for some of -- laying off some of that exposure, tightened eligibly quite. So a number of underwriting and claims initiatives that have now had a number of quarters to kind of roll through. So I think that helped. What still hasn't actually really worked for us is the pricing because we were giving some COVID relief until there's recent as middle of 2022. That earned impact that is still trickling through the portfolio. So by the end of Q4 2022, we had about 7 points of written rate. Most of that is still to come ahead. So I can't really compare about the pace of deterioration versus other players, but it certainly deteriorated for us, not as much as perhaps you've indicated. And I think a good part of that is because we're lending so heavily to the 2021 year and took a number of actions. The other point I would just drop into that. When we talk about our auto, obviously, we're talking about both the broker business and the Sonnet business. And that is material because our Sonnet business, as we've indicated, is still scaling up, it's still maturing, and it's still on its path to profitability. And so in 2021, Q4, it would have been more profitable than it would have been in the prior period a year ago. So that's something that, again, influences the trajectory of the overall auto loss ratio.

Sorry, if Sonnet was more profitable, you'd say, in Q4 '22 than Q4 '21?

Yes.

Right. Okay, got it. So let me just ask a couple of questions around that. You've made the point that inflation is moderating. That you've got some earned premium increases to come throughout the year, both of which are positive. But the company has also been clear that you expect the claims ratio or the combined ratio in personal auto to move up a little bit from current levels. Help us understand how those two statements come together because you would expect with pricing higher inflation moderating, maybe would look a little better?

So a couple of things in that there. A lot has got to do with the earning pattern of the rates. So I think if you think more -- as we changed the quarter, we're now in Q1 2023, we're still at elevated inflation levels. And the economy is more open this Q1 than it was the Q1 in the prior period. We're still a bit of a lockdown. So I think what's going against us, if you will, is still elevated inflation, albeit it is starting to flat line or normal. A gradual movement up in mobility and therefore, claims patterns, we've been positively surprised by the claims frequencies are still pre-pandemic levels, but they have been kind of moving up. And then offsetting that will become increasingly impacted by the earned rate increase which grows through the year. We still have now a favorable net earned increase expected in the first quarter, but that will get bigger as we get it in the back half of 2023. On top of that, there's seasonality. So if we think about our auto portfolio, the worst quarter for us is Q1, and the best quarter for us is Q2 and then we move from there. So it's going to get a little worse before it flattens and then gets better. And so that's kind of our view. And I think that generally, our philosophy around auto and cycle management is we are slowing the growth. We're looking to protect the margin because we know they were in for a couple of tougher quarters. And then as the quality of business goes in as Sonnet's path to profitability keeps its trajectory and as those rates are in the back half of the year, we feel we'll be covering the cost of inflation, and that's why we think it will kind of peak in the near term and then start improving as we get into 2024.

Yes, that's an important distinction to make then. Let me just go to the whole topic of pricing. We know Alberta has a cap in place or freeze, I guess. And is it a freeze?

It's a freeze.

The freeze is in place. Ontario, not so much. First of all, how would you characterize pricing as a whole right now in personal auto throughout Canada -- in the provinces that matter to Definity?

Yes. So the big portfolio for us is Ontario. That's our major portfolio. But after that, we go to next wait is Alberta and then Quebec and so if you think about those areas in aggregate, I think we're in a pretty good spot. We've actually had rate flowing through the system in all of those areas. We have as recently as a couple of weeks ago, had rate filings approved. So we are finding that generally, the regulators are being very constructive. They're responding to data and the data shows inflation and it shows increased mobility and frequency. So I think we've moved out of the rate reduction areas of COVID, and now into a rate increase. And I'm expecting that that's going to stay fairly healthy for us and for the industry in the next -- for the several next quarters. I think Alberta that you talked about, it is a freeze. And it is -- I think, quite frankly, we're disappointed in that. I think we disappointed the government froze prices in a period of obvious inflation periods. We know that rate freezers do not work. They didn't work when they tried this before. This is going to create some dysfunctionality in the marketplace. There's going to be capacity issues, we think in the next kind of few quarters. But it also affects different companies from a different perspective. And I think from our own perspective, we have about $220 million of auto business in the province. That's about 6% of Definity's total business. 2/3 of that is in our broker business, Vyne and 1/3 in Sonnet. The 2/3 that's in Vyne, we're actually pretty comfortable with, as we said, because it's a mature book. We're very carefully selected that the quality of that portfolio. It's had price increases as recently as a few months ago. And so we can withstand the test for us some time on that type of portfolio. It's really the Sonnet portfolio that it's more impactful to us. And that's effectively 2% of Definity's portfolio. So if you just put that into context, it's not that bigger deal for us. And what we will clearly do is look to try to make that up in other restrictions. Already, we turned down marketing significantly, and we're reallocating marketing and capital to other more profitable jurisdictions. So I think there is a way to trade through that. But nonetheless, that is a bit of an outlier province in terms of our regulatory intervention, and we do think it's very politically motivated as opposed to driven by the regulators.

Now one quick question. When you talk about capacity constraints from a practical perspective, how does that -- what does that look like? Does that look like players really leaving the business, like leaving their province or how does that really manifest and how does that affect the province?

So a couple of things happen there is that companies are going to look to kind of not market. They're not going to deploy as much. They're not going to be as competitive. They're not going to provide incentives to grow. In the broker world, the last time this went around, there were some brokers that lost their contracts, and they didn't have a contract with their insurance company. So what they then have to do is take that block of business and remarket it to the rest of the insurance companies, which often went at a higher price. And so you don't really achieve the true rate freeze in that perspective.

So there are real implications to a freeze. These inefficiencies essentially is what it sounds like to me. Let me go to a very specific question about Ontario. The question is, is the 3.5% rate filing in Ontario is sufficient to offset claims inflation? If not, what does it need to be until the regulator approves higher rate filing?

I think one of the things you got to also remember when we talk about these increases, they're kind of rolling rates. So an example, if you take our Ontario portfolio, when we entered the COVID relief, that was effectively a 5% rate increase. Subsequent to that, we've got another 3.5% rate increase. That rate increase will have completed through the cycle as we get into the middle of this year. And so in order to keep mid- to upper single-digit rate increases, we will need to replace that with another increase. And so that's kind of a rolling perspective of keeping your earned rate ahead of your loss cost trend. I think the view would be that we feel that we've got a good portfolio in Ontario, and we would largely be rate adequate based on our expectations of inflation. And so will there be more increases as inflation continues? Yes, there will be. If inflation shifts, it starts to go into deflation, then of course, we don't need the rate that otherwise we would anticipate getting. So I think we think about a number of things. You've got to think about what inflation does, you've got to think about what frequency does. But then you also got to add all your mix of business changes, quality of underwriting. So there's a number of elements that kind of dictate what your rate adequacy levels is. I think if we look forward to deliver the results we've said we've got the rates we need. In order to improve on those, we'll need to rate ahead of loss cost inflation, which we think we'll be able to justify.

Okay. Here's another sort of, I think, interesting question. And the person is asking about how your competitors are doing in personal auto, and they were very clear in saying outside of Intact. So we're not really talking about Intact now. And I think I know where this person is going with the question. They're just asking, how do you feel like the industry is doing in personal auto, personal property, commercial, again, outside of your largest competitor?

I think everyone is seeing a very similar trend. We do know the ability is back. We know people are having for accidents and frequency is up. And quite frankly, even if you are very good at managing our supply chain, the cost of a new Tesla or the cost of a new Ford -- is the cost of Ford. So that is affecting everybody. Different companies, I think, recognize things differently. What has been really difficult to do through the pandemic is get your reserving right. And there's a big range of capability there or, let's say, our capability, but some judgment. And you could be a bit more aggressive or you could be a bit more prudent. And I think those companies that have been more prudent, you will see continue to run with higher-than-normal levels of favorable development. And that's kind of the stance we've taken through this process. So we're not looking at the world with rose-colored glasses. And I think that serves us kind of well. Not every company is going to have the exact same level of prudence, which therefore changes their short-term level of profitability. But our view is that this kind of upper single-digit rate increase is going to be needed across the industry. And I think if that is the case, we're still very comfortable with our levels of cost competitiveness. And able to kind of roll the business at the pace that we would like. I also would just once more reiterate I think we see different levels of profitability based on the Sonnet scaling business, which we're not happy with this profitability. It's expected where we plan -- what we thought it would be but it's not at its run rate level, but we're pretty comfortable with our broker business. It's a super quality portfolio we have there.

Now let me ask it, this might be tricky to ask. If I could -- if we could snap our fingers in Sonnet, it reaches scale tomorrow. Is there any way you could help us think of what would that mean from a marginal ROE perspective? Would it -- how much would that improve the overall ROE of the business?

There's quite a strong correlation for us in terms of combined ratio points and operating ROE with our current structure the way it is. But it's meaningful. I mean, it's in a couple of points range. So we're like -- we will notice it.

Yes, that's what I figured. And we're still thinking -- did you extend that period out 1 year for Sonnet?

We did. We did, yes. We had originally talked about through the road show period as we were into -- or back in 2021, around 2023 number. And I think we now feel prudently the right thing to do is to be disciplined, not chase business that we knew we were underpriced on dealing with this inflationary environment. And so that has slowed a little bit, so we can mature the portfolio so we can get our rate adequate in the areas we want to grow, and that will move it into 2024.

Now that brings me to -- like to me, one of the biggest questions I think when you sit back at your desk and you really got to think about what direction this company is going. To me, one of the biggest questions I would imagine was would be on your mind is balancing two big demands, the need to grow to be -- to grow Definity. This has got to be -- it's got a growthy feel to it, particularly in financial services, when you think about how banks are growing and life insurance companies are growing and the industry as a whole is growing, you clearly want to grow this institution. But at the same time, investors do want to see that ROE improve over time. Help me think about how you balance those two. Is there a level of growth you must have you would sacrifice some ROE? Is there a level of ROE you must have in which case you'll sacrifice some growth? I know it's not that simple. So maybe walk me through how -- when you sit back on your own and you and Phil discuss it, how do you think about?

It's something we do spend a lot of time thinking about. It's something we kind of agree with the Board on what the priorities of the business are. But I think that very simply put, we see more value creation of a strong bottom line than a strong top line. And so when push comes to shove, as you get detailed into the business and you say, what it really comes to manifest is what would an underwriter do at the front of the business. And if they have to make a decision between writing business that's unprofitable or passing on revenue, they go for the bottom line. So I think that's more of a fundamental approach to us, even if it does slow the top line. And I think a great example of that is Sonnet. I mean like Sonnet is a great model. I mean we could continue to scale this but it would push out the level of profitability. And so when we think about this, why would we grow taking share when we know we rate an adequate. Alberta is a great example. We're definitely tapping the brakes in Alberta. There is no point when you know you're going to write business at a loss to pilot to it, even if the market is giving it to you on a plate. So I think that's just a fundamental principle of ourselves.

But presumably, a business has to be more than just profitable. It has to sort of meet -- my assumption is there's a hurdle ROE or hurdle return you have in mind? But are you right in call that sort of high single digits right now or maybe 10%? Is that the hurdle?

I think that's where we go. And I think we feel comfortable that we can really do both. And I mean, so the -- it's about degrees on that. And that's where I think you see us shifting our growth a little bit. It's very slowly -- very modestly shifted from about 10% on average to upper single digit to 10%. And that's because we want to make sure that path gets into the double-digit ROE path going forward. But we're not here about trying to get the last dollar of profit out of the business. We've made a big investment on these digital platforms and on these growth engines, we know these growth engines can run quite nicely. And so we actually think we can do both. We do believe that we can grow at about double the price -- the rate of industry, still while maintaining that 95, mid-90s combined ratio. So that's really what the underwriters are trying to do. We're not trying to deliver a 92, we probably could if we really focused much more on mix and on slowing the growth to kind of single-digit growth. But that isn't the fact. We think if we can grow around 10-ish on average over a period of time at that mid-90s combined ratio, that's a very powerful compounding impact, and we'll be using that excess capital that we've got. And that's the organic story before we get into a M&A story. So I think the way we look at it is that the growth engines are very strong and we can continue to grow ahead of the marketplace without sacrificing profitability.

I'm going to get into the M&A story for sure. It's an important -- like every analyst when we wrote about your company to mutualization, I think we all went to great pains to understand what this company could look like on a deal. But before we get there, another important lever of this growth in operating earnings and the improvement in ROE is the impact of interest rates. So the question is, please comment on the impact of interest rate changes on your investment portfolio and how you're positioned to further impact -- you're positioned for further impact of inflation interest rate increases. So we discussed inflation already. So let's leave that part out. Let's focus more on the move in interest rates. And let me just supplement this question a little bit. There was no doubt on the call that there was some -- there were a lot of questions there, but why the guidance on net investment income seemed light relative to your book yield and market yield and Phil tried to address that? I know you did find job a bit. But you can tell that this is still a question lingering with investors. And just -- I think we all need to understand why you wouldn't be a little bit more optimistic on your investment income.

Well, a couple of things there. Firstly, I think if you think about our investment income, our net investment income, if you go back the last couple of years, it's really been about $100 million, and we're guiding to $150 million. So that is quite a substantial change already baked in. We know that the new money rates are above the book yield rates, but a significant part of that, we closed the gap through 2022. Then there's maybe 100 basis points still to go between new money market rates and book value rates. So with a reasonably short duration, yes, we will roll over and get the benefit of some of that pickup. I think one question we do get is why don't you just take Q4 and times by 4, isn't that kind of proxy for what your investment income would be. One of the differences is that we had a significant amount of cash in Q4. And as you know, cash is actually giving a fairly good return. There is some seasonality to our cash. And in Q1, we actually or a bit more cash consumptive in terms of -- this is when we pay for our reinsurance. This is when we pay the brokers the contingent profit commissions we pay taxes, et cetera. So that excess cash typically gets deployed and put to work later quarters of the year. So that probably explains a little bit of that. And then as you saw, we are a deployment story. We have this excess capital, we're acquisitive and we're trying to build out a number of portfolios, one of being -- one of which being the broker distribution platform. You saw us put to work almost $0.25 billion in the fourth quarter for that. And so it's possible, given potential pipelines we see, we could be deploying more capital. Now ultimately, what that does is it moves around geography because if you use that to invest in a broker distribution platform, i.e., make an acquisition, you have less funds in your net investment portfolio, but you're replacing that with a better yielding investment. So it's -- that's all taken into consideration as we're going to share the $150 million guidance.