Palomar Holdings, Inc. (PLMR) Earnings Call Transcript & Summary

Okay. I'm going to kick things off. Everyone, I'm Tracy Benguigui, insurance analyst at Barclays. And I'm pleased to host fireside chat with Palomar. My steamed panelists are Mac Armstrong, Chairman, CEO; Chris Uchida, CFO. I thought the best place to start, Mac, if you could just give some high-level overview of what you're seeing in the market.

Yes, terrific. Thank you, Tracy, for having us. It's great to be here. I think overarchingly what we're seeing in the market is, for Palomar, simply put opportunity. We write 40% of our book is earthquake -- in the earthquake market. We are seeing dislocation on both the residential and the commercial side, in the teeth of a hard reinsurance market and a challenging overall property insurance segment, which is a great opportunity for us. And then additionally, as we look at across our 4 other product categories, property in the marine as well as casualty fronting and crop again, opportunities abound. I think what's important for us is to be mindful of risk-adjusted returns, managing volatility in the earnings base and making the requisite investments in growth. And so fortunately, first part of the year, we've been able to do that and execute on the plan and over the course of the year, raise our guidance twice.

Awesome. Okay. You obviously are a growing company. And I'm wondering if you could just unpack for us the key contributors of premium growth, whether it'd be rate increases, higher submission volume, greenfield operations or underlying economic growth.

Yes. Tracy, it's a great question. And I think it's important for us to look at that again kind of within those 5 product segments that I just touched upon. Within earthquake, it's driven as much by rate increase as it is by exposure. The commercial earthquake, more of the growth to date, has been from rate, where it's been in excess of 20-plus percent. But at [ 61 ], we did secure incremental reinsurance limit that's going to allow us to grow our exposure in addition. So that's leading to submissions as well as rate increase to drive the growth. When you look at the inland marine segment of our book, that's driven combination stable rate, call it, 10% increases there, but a lot of more greenfield as we brought on underwriters to help us expand our geographic footprint, so geographic expansion there. And then there is a healthy economy. Even with the low down the housing market, there are still a new house and start new projects for us to underwrite. So that's a little bit of a different one. And then casualty, that's really greenfield. We're new to that market. We're growing rapidly in that market. We have added additional talent to come on to the team. So we're seeing good submission flow, but it's really where we are planting a flag in a segment like real estate agency, adding underwriters within that segment. Last week, we announced the hiring of a leader in environmental team. So it's rebuild operation. Crop would fall in that same segment, new market opportunity for us, large market. We're one of 13 improvement insurance providers there. It's going to be more of a greenfield. And then fronting, that's probably now where we have a handful of clients. It's submission activity. We're seeing good submission growth. So some segments, some are front and carriers are seeing rate. Others, it's more flat. So it's really more submission activity.

It sounds very well rounded your sources of growth. But if I'm just thinking about a pricing cycle, it's almost like the mini cycle, being property right now. How long do you think this hard market will play out and when we do see a turn do you think would be more moderated?

Yes. So that's the -- I guess it's the multimillion dollar question. So for us, what I would say is we expect the property market on the primary side to persist through '24 into '25. I think the expectation right now is we view it on the reinsurance market, is that rates will be flat to up -- mid-single digits next year, which means that you kind of roll forward another 12 months off of like June '24, renewal into '25. You're going to [indiscernible] loss costs. I think reinsurers feel that they are at a point now where they feel good about their attachment. It's not in a 5-year or 3 years at a 10-year. They're feeling good about their risk-adjusted returns. They may try to optimize that incrementally. We have the opportunity to recoup that on the primary side. So my best sense is that property market remain at this level, if not increasing through '24 and into '25 on the primary side. I do think, I'd add though, that within property reinsurance, there is greater appetite for single payroll exposure that it is multi-payroll or all payroll exposure and so as our book has really transformed back to more of a single payroll book, whether it be earthquake or Hawaiian hurricane. I think that gives us a little more confidence that we will have rate stability in our reinsurance renewal down the line, some relief to come.

Great. We get into the products. You have your bellwether product, California Earthquake. Let's start with the residential side. You guys actually had a really successful reinsurance placement, the CEA, a little bit less successful. And I think you were talking about at one point and maybe you could see the spillover of some business as a consequence. Did that happen?

Yes. So the CEA has gone through -- is still going through a host of changes. And I think we've been a beneficiary of those. You alluded to it there did not procure as much clients as they had to renewal. And in the process, we saw several reinsurers migrate over onto our program, which again helped us drive incremental limit that we bought at [ 61 ] to be, call it, $500 million. They've also been reducing their coverage for any structure over $1 billion of limit. They are requiring a 50% deductible. Our average deductible is 12%, so call it either 10 or 15. They're reducing coverage. They've also been downgraded by the rating agencies. That means certain security committees will approve them for a new business or potential renewals. We have not had a circumstance where there's been -- you're absolutely right like there has been a step change where participator has left the CEA and come over to Palomar. But we have been able to sustain high teens, 20% growth in residential quite because of their pullback and their appetite. And we've been able to secure incremental reinsurance limit to support our growth in both residential and commercial because of the changes at the CEA.

Great. And how successful have you been migrating residential California quake to the E&S market, better price the risk.

Yes, Tracy, you and I have discussed this in the prior calls as well as just one off meetings that we want to see an increasing amount of our residential earthquake on our E&S company. Right now, it's just about 10%. It's doubled from where it was a year ago, but our goal -- intermediate goal to see that closer to 20%. In doing so, it accomplishes a few things. One, it does exactly what you just mentioned. We can charge more. We're not bound by a rate filing there so we can charge more than what we can on the admitted side. Two, it helps us manage the book from a risk adjusted perspective and from exposure management perspective in areas where we are -- have higher concentrations, so I think, West Los Angeles. And then thirdly, it provides a bit of a stop gap in relief from the California Department of Insurance lack of responsiveness, if there is a major event. We want to have the ability to move business on the E&S company, charge the requisite premium, if there was a major event that we would not be able to do because we'd be waiting for rate approval from CDI.

Great. You recently launched a crop fronting business, characterize it as a $20 billion TAM. So a couple of questions there. Realistically, how much market share do you think you could grab because it's fronting business, I'm wondering who your reinsurance counterparties are? I mean there have been some divestments within crop business. And scale has been cited. So I was curious if you feel like you have the scale in that business to get sufficient terms and conditions with your reinsurance?

Yes, sure. So first off, thanks for being up, we are very excited about crop. We think we have the opportunity to build a meaningful franchise. While we are fronting this year for that line of business, our expectation in 2024 is that we will take a modest risk participation, call it, 5% and then in '25 and beyond, it will increase. And so we'd like to see us be -- that's going to be a risk-bearing line of ours, say, over time. But like we've done historically we want to walk before we run, get the underwriting correct, get the reinsurance in place, leverage our in-house expertise. Both our President and our Chief Risk Officer have extensive histories in the crop market. So ultimately, we have a very strong reinsurance payment. We have a multiyear deal where we locked in reinsurance to both to '23 crop year as well as the '24 crop year. It's 5 reinsurers supporting us there including the [indiscernible] stuff. And what we do think we can accomplish is building to a several hundred million dollar product for us with specific targeted geographies, to get specific targeted crops and products as well. We're excited about PRF. We are excited about regional livestock in addition to wheat and soybeans and corn and the like. Fortunately, we have made a strategic investment in Advanced AgPro, who is a distribution expert and expert in the crop market that we're now on the board of that company. They're helping us on the distribution side where we can manage the insurance and underwriting. While scale is certainly important and some people said they've divested an asset because of the scale concerns. I think Palomar versus AIG in terms of how they define scale might be a little bit different. So for us getting to a several hundred million dollars. That makes dollars for us. It may not be for them.

Okay. Got it. You touched a little bit earlier about greenfield operations. I'll just note that when you started doing this, it was catastrophe adjacencies and now you're dovetailing into casualty lines. How do you feel about your underwriting bench strength? And how dependent are you on MGA to underwrite the business?

Yes. So we now, I guess, in 2 years into our casualty strategy and [indiscernible] how it's going. I think what we're most pleased with is the talent that we brought on to execute it for us. We have brought on best-in-class underwriters from household name insurers to build out a practice in new segments within casualty. So the professional liability, excess liability, general casualty but really focus within contractors and most recently now environmental. And so when each of these experts join us, what they are bringing is long-standing underwriting expertise. Distribution relationships that we are bringing to them are reinsurance actuarial and analytics and then technology. And so we think it's a nice combination to allow these underwriters to do what they're great at, and that is build a book of business that's profitable. And then it affords us the ability to leverage in-house talent and infrastructure. Where we stand right now, it's going deep in niche segments like real estate agents, collection agency, environmental, you're talking about environmental contractors providing either a combination of pollution liability or S&A pollution solution liability or combination of general liability and pollution liability and then it's excess liability or contractors. So these are areas where we think we can build out a nice franchise, again, be patient how we go about doing it. So heavy use of quota share, retaining 20%, maybe 50%, but no more than a max line of $1.5 million on a net basis. So it allows us to be deliberate and not -- our way. To your question on MGAs. If we have a subject matter expert, we're not opposed to working with an MGA that can help us access a segment of the business that we currently don't. And so that might be in the circumstance of excess liability, some larger account business where we can put a $5 million gross line, $1 million net line, part of a $20 million participation. Something that we might not -- directly submitted to us. So it's a complement and we will use MGAs to complement an existing strategy when we have a subject matter expert to underwriting.

Given the inflationary environment, we've seen more on the property side and casualty side so far, but -- does that give you pause at all casualty?

Yes. I mean social inflation is something -- fortunately, we're not weighed down by legacy experience there, but it's something that we're mindful of. But I think it really does start from having a conservative approach to exposure management and underwriting. And so for this casualty strategy, the first thing that we are going to be doing is mindful of in line, as I talked about, our net limit in $1 million to $1.5 million. Secondly, even when we're writing an E&S business, we're going to be using either ISO or AIS forms to court tested forms for these markets that will avoid the potential exposure that you might get on the manuscripted policy. And then thirdly, it does come down to really being mindful of what you are riding within those segments. So trying to avoid not only injury and physical damage, where you've seen the larger nuclear verdicts in the court. So it's a similar strategy. We've done the property side of exposure management being mindful of our net line exposed and being pretty focused on the classes of business that we write -- that we're employing, but it -- yes, we have to watch social inflation, litigation and those new, I guess, real time scenarios that we're all wrestling with now.

Chris, as casualty will grow, you could theoretically hold your assets a little bit longer to match those liabilities. How do you think your investment posture may change?

Yes, that's a great question. When you think about it, obviously, at the beginning, we were very focused on being liquid and having the capacity to pay claims in a large catastrophic event like an earthquake. The current market and the current mix of business and the changes [indiscernible] looking at alternative investments a little bit. Mac has talked about on the crop side. We can still looking at things like that. We've been able to get yield right now the overall marketplace, but we do see the ability to change the rate and look at some alternative [indiscernible]. More importantly, we view ourselves as underwriting company first, though investments nice to have, but our key focus is delivering returns to investors on our underwriting results.

I think the good thing is, to Chris' point, we have those options, but we haven't had -- like our duration [indiscernible] 4 years and we've seen a nice lift on our yields. And then lastly, our investment leverage is 1.5x. So we can just let the book grow organically and not have to change too much and that will give the lift to complement that underwriting place a premium.

Great. We touched on fronting business a little bit in your opening remarks as well as crop business. But holistically, can you just walk us through what type of businesses fall into the fronting business category and those businesses you may want to get into?

Yes. So we've taken a strategy with our fronting business to be more kind of rifle shot than others. We have less than 2 handful of clients. When you include the crop, it's around 8 partners. We're going deep with subject matter experts -- give our subject matter experts in targeted lines of business. So it's cyber, it's workers' compensation. There are a couple of property programs, and then there is a cross-border transportation programs. Those are examples of our fronting arrangements. All of them, we are actively involved in the orchestration of the reinsurance, certainly managing the collateral, how claims are handled, compliance and underwriting. We view them, even if we're not on risk, we're on risk with about a 5% average participation in 3 of the deals. But even if we are not on risk, we view them as programs and there's lines of business that we would manage as if we're taking 20% or 25%. So as a result, I think it's afforded us the ability to have a keen understanding of the exposure, it's afforded us the ability to avoid surprises. And I think it's a line that will continue to grow as we add new partners selectively. But it's -- the other thing I would add is the luxury of our funding strategy is it's a line of business. It's not the totality of what we do. Let's call it 10% to 12% of our adjusted net income. So we don't have to try to boil the ocean and find every deal because it's all that we do. It's -- just, again, it's like a builder's risk or in the marine line. It's a nice contributor to the marine line, but it's not the sole driver of profitability.

Sticking to fronting business, you have plenty of underwriting capacity. I think you like to manage below 1.1x and you're well below that. Why is it appealing to see the risk versus numerical participate in these programs?

I think for us, it's -- we are viewing -- these programs right now as newer lines of business that we can do R&D on and learn more about them. So we have the opportunity to participate over time, as we see the underwriting results come to fruition and to become more seasoned. We develop more in-house expertise on those lines of business. It does afford us the opportunity to take on risk and potentially convert them to products. That being said, and Chris talked about it, when we introduced Palomar 2x like if you just look at the existing lines of business that we underwrite in house and control the claims in-house, we -- how much better serve potentially taking risk participations on those lines of business like we've done with -- we went from 10% to 50% or we are dealing with professional lines and general casualty where we've gone from 20% to 30%. We think there's a greater driver of incremental income and capital utility with those lines than fronting per se.

Chris, given your dependence on the insurance, do you feel like a maximum reinsurers recoverable to capital metric in mind particularly as you're scaling up fronting business?

We don't necessarily have a specific number that we trying to manage to. We do know that when you look at some of the competitors or pure-play front-end companies, we are significantly below where they are. As Mac talked about a little bit earlier, our key goal when we're looking [indiscernible] so we evaluate that closely. We collect collateral and above regulatory requirements to make sure that we are protected. So our main goal is collateral managing the counterparty risk. But also, as Mac talked about, thinking about the fact that this is the line of -- this is something that is nice to have. It's a most diversifying line for us. It is not the totality of what we do so we do not necessarily have to be specifically looking at other pure-play front-end companies.

Then when just thinking about how large fronting business could be, it was just [ under 30% ] of your premiums -- gross premiums in the second quarter. What percentage of your gross premium you target in the near to longer term fronting business?

I don't think we've put a target on it, but what I would say is it's grown faster obviously, over the last 2 years. And it continues to have nice growth behind it. It's not 1 though where it's going to be our largest line of business and certainly on a -- from a net income contributor perspective. So I would expect fronting premium still growth to remain strong. It will slow and probably sort of index the overall growth rate of the company, especially as lines like crop and casualty accelerate their growth.

All right. On the second quarter earnings call, you mentioned you're being approached by dislocated MGAs, as a result, collateral crisis for fronting peers, has that interest actually translated into any client adds?

We've got a pipeline of them, but there's a lot that we just kind of categorically kill because of the line of business. So with the best to shake out, there was a lot of wheels business that was looking for a home, both commercial and private passenger and you said that's not a class that you want to write. So there are a few that we are in various stages of diligence -- normal due diligence to determine if we want to take on those clients and the partners. I think the other thing, Tracy, though, that is fundamental to that exercise is, right now, they're probably potentially looking to backfill a 10% to 15% reinsurance or risk participation. So that elevates this group. So Chris was just saying, if a normal front comes out, we were going to look at their underwriting and the performance of the book from a sustainability standpoint from a reinsurance execution standpoint. But we're more focused typically on counterparty risk and the collateral. In this circumstance where it's a 15% risk participation that needs to be assessed, it's a longer diligence. And so therefore, it's not like an overnight, if we're going to convert these and bring these on. But we do have 3 or 4 that are in various stages, and we'll see where they shake out.

I'm wondering if you'd be willing to offer any color on [ Hawaii ] fires in terms of potential losses. I mean think about your outline for like just under 10% market share.

Yes. So it's interesting. What's categorized as allied lines in Hawaii is broad. And so we write in the state of Hawaii a Hawaii hurricane policy. And so the way that policy works is you have to have an attached homeowners policy. And then this policy will cover you for damages caused by a hurricane [indiscernible]. So wildfire is not covered. And in fact, it's underlying coverage is in place for us to even be on risk for hurricane. So from a -- you look at our 10% share, 98% of that was going to be from these Hawaiian hurricane policies that were not on risk. As it relates to the residual business that we write there, there'll be right flood, and we have a handful of commercial business there, builders risk and some all risk, those were impacted.

You said like the hurricane fire will be excluded. I'm thinking about fire following. Like earthquake has fire following...

Well, earthquake -- fire following -- earthquake is excluded from an earthquake policy. So it's the same thing here. And then also though -- even though there was a strong wind, since there was no hurricane watch or warning on Maui, we're not on risk. And so it's no different than if there's like strong trade winds or a tropical storm that comes through there, we're not on risk. So it's very specific in the coverage that it provides.

Hilary, what's the right -- flood in California.

Yes. Hilary was a great weather channel and certainly had our phones in Southern California ringing from friends that want to understand what was going to happen when this massive storm was striking San Diego, where we all live. But what happened was it was a people on the East Coast kind [indiscernible]. It was a strong storm that came through, but there was flooding in certain areas. And we'll still have some flood losses but not aberrant from what we would see in the rainy part of the year in California. It's important to point out that like our flood program there typical limits $250,000, just kind of satisfy the mandatory requirement for flood policy that a mortgage would require, and it's also 50% quota here. So we've had dozen-and-a-half claims, very manageable.

Great. You've had a successful reinsurance renewal. Chris, my understanding just looking at the reinsurance schematic, it's almost like the quota share is linked to the XoL where you have to exhaust the quota share before you could get recovery on the XoL. Can you walk through that dynamic? And I don't really have a sense of if you could quantify the risk restriction within the quota share?

We have quantified all the sessions we have kind of given out color. But overall, it really depends on the type of risk depending on whether or not it will participate with excess of loss. The excess of loss tower is really designed for property risk. So some of our newer lines improve shares to casualty. It is going to have a several quota share with them, but not participate on the excess of loss. But a lot of our quota shares do are uncapped. We don't have any loss caps associated with them. Some of them do have loss caps associated with them, but they are significantly above the projected loss risk. Good example is on [indiscernible] depending on the partner, very protected from a quota share standpoint. And it's also important to note that we quota shares where we are taking the minority share, especially in a program where we're getting traction, we're limiting on the program. We're getting scale in that. So it's not something that we'll take a majority of the losses [indiscernible].

And there's a couple with the property quota shares where essentially if we -- commercial like we see now 20% to reinsurers have an occurrence limit that's related to the amount of premium ratio. If there was a circumstance where exceeding that PML to premium ratio, which, by the way, is above our existing PML to premium ratio. It comes back then on to our -- the benefit of our cat tower. So our cat tower we kick it. So let's just say if it was the amount of premium ratio equated to $100 million, if there was a -- once it's above $100 million, then it would come on to our excess of loss tower.

Just to be clear, you managed to [ $150 million ] that the PML to the premium threshold you're talking about...

Our PML to premium threshold is -- we keep it above the $250 million a year. The occurrence cap on the commercial earthquake quota share is actually above that. But if it does go above that within that quota share, then it comes on to our PML.

What about other perils that you're going to quantify?

They're uncapped. So like builders risk in the Marine, that are uncapped.

Okay. And how do you envision your ceded re strategy may be evolving over time?

Yes. We wrote -- we have historically written ceded re. We wrote some at the beginning of this year. And some of that was strategic to partner with existing reinsurers, say, "We will support you in the uncorrelated exposure, you continue to increase your support with us on the size." I do see a scenario where we will build out more of a ceded re franchise where we can write low frequency, high severity, both property and uncorrelated property and casualty business or specialty business. But it would be akin to a small line of business like we're trying to do within Casualty or within Inland Marine and other property. Frankly, we thought we'd write more at the beginning of this year. We are kind of taking the approach if you can't beat and join them on the reinsurance side. But -- and I think that opportunity will still persist, but it's not going to turn into a 20% line of business.

Okay. Let me take a pause and just see if anyone has questions in the room. Maybe [indiscernible] congrats on your positive outlook from AM Best. I'm wondering if there are positives that came out of that, whether it be better reinsurance terms, more traction with your agents? And specifically, maybe, Chris, you could say how your capital management strategy may evolve as a result?

Yes. We were pleased to get the positive outlook. I think we're pretty focused on trying to get the actual full upgrade Q&A. And if that does transpire, that will help us in selected lines of business where certain buyers are more rating sensitive. It won't change much on the property side, but I do think it will be helpful on the casualty side and particularly in professional lines as well as some of the excess liability. It would result in the reinsurance, but it hasn't. But I do think it will open up distribution for us and afford us the ability to access certain classes of business that [indiscernible].

Yes. On capital side, we're very well capitalized. I think when you look at it from an AMS standpoint, our capital ratio on new products are at the highest level. So we don't necessarily need to make any changes. We still feel we have very ample room for growth in our portfolio. We strategically review buybacks opportunistically, but overall, we feel very well capital position to grow the business organically.

Okay. So this is a little bit off topic, as you don't write residential homeowners, but you're in California and you seem to be very plugged in on that state. So I'm just wondering to hear your perspective on some of the proposals like changes to Prop 103.

Yes. Well, it sounds like they officially get an impasse last night with the changes that were being explored in particular around the utility of models and reinsurance customer models in particular wildfires especially. And so what I saw was that as soon as we were trying to go to this week, which would have, again, incorporated models in exchange for forcing insurers to take more in calculated regions that has fallen flat. And so my expectation is it will probably be revisited in January at the next legislature session. Without so you are going to continue to see a pullback from standard market carriers. I've heard a stat that is that of new business in the state right now -- 80% of new business in the state is either go to E&S market or the FAIR Plan. So I just don't know how that is sustainable when you have department that's either unresponsive or is scared of the consumer watch dogs coming in and intervening on judgment. So there has to be some change. In the interim, we continue to see a ton of wildfire focused submissions and plans or high-value homeowners plans that want a partner, but I think for us, we're better focused on being an earthquake and flood specialist in the state that can partner with those that want to take on to the homeowners risk, whether they're admitted or E&S, but there has to be some change. Otherwise, you're just being -- it's going to be -- I think the crisis will be exacerbated.

Do you think wildfire catastrophe models are robust enough?

I think they're getting better. I think the only thing that is that -- is it -- it probably works well from a risk selection standpoint, from a portfolio standpoint. It can help you with better risk, but I don't know if the science is as sound [indiscernible].

A year ago, you mentioned about 47% of your business does not provide additional losses. How much of that has changed since then?

Yes. So if you look at -- that was more for just the, call the, earthquake in Hawaii, the binary business that has decreased a little bit, that is now 43%. If you include fronting in that number, it's about 72% of our book has, let's call it, minimal attritional loss as opposed to it. And then the other 28%, as we talked about a little earlier is kind of exposed or attritional losses. . Still a heavy amount of quota share, where we're seeing the majority of that risk to reinsure. So it's part of the reason our loss ratio has been able to stay low, right, call it, around 20% for a significant period of time. So it's something we like about our book or something like that. Eventually, will change as we talked about [indiscernible]

Any questions? Okay. I think we're out of time. So let's give a round of applause and thank Mac and Chris.

Thank you, appreciate it.

Thank you.