Arch Capital Group Ltd. (NASDAQ:ACGL) Q4 2022 Earnings Call Transcript

Arch Capital Group Ltd. (NASDAQ:ACGL) Q4 2022 Earnings Call Transcript February 14, 2023

Operator: Good day, ladies and gentlemen. And welcome to Arch Capital Group Fourth Quarter 2022 Earnings Call. At this time, all participants are in a listen only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today’s press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management’s current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied.

For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed in the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in this call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company’s current report or Form 8-K furnished to the SEC yesterday, which contains the company’s earnings press release and is available on the company’s Web site.

I would now like to introduce your host for today’s conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin.

Marc Grandisson: Thank you, Towanda. Good morning, and welcome to the fourth quarter earnings call for Arch Capital Group. Happy Valentine’s Day to all. I’m pleased to share that for the fourth quarter of 2022, each of our three underwriting segments produced exceptional results. Our quarter’s results were buoyed by a lower than average cat loss experience, a significant favorable development in mortgage reserves and a higher level of profitable earned premiums from our recent growth. This quarter demonstrates the power of our strategy, namely our management of the underwriting cycle across the diversified specialty portfolio with a prudent reserving and underwriting stance. Our P&C insurance underwriting teams continued to lean into hard market conditions and our mortgage team delivered record underwriting income, which is again a direct result of our years as the established market leader there.

For the full year of 2022, Arch generated over $1.8 billion of operating income with an operating return on equity of 14.8%. 2022 was our third consecutive year of sustained premium and revenue growth, supporting stronger and more stable earnings power for the near term. The net premium written growth from our P&C unit was exceptional. Reinsurance segment NPW grew 51% for 2022 as the team seized on market dislocations, while our insurance segment grew a robust 21% on the year. We continue to see a broad array of opportunities to allocate capital where rates and terms and conditions allow for growth and attractive returns. Taking stock of where we are in the current market cycle, it’s important to note that we have recorded premium growth significantly above the long term industry average.

Over the last four years, we’ve grown property and casualty net premium written threefold to nearly $10 billion from less than $3.6 billion in 2018, while overall rates increased cumulatively by over 40%. As we have stated previously, our cycle management strategy dictates that we maximize premium volume when rates are rising, which is precisely what we’ve done. While we expect to continue to allocate more capital to the P&C segments for the next several years, I wish to remind our shareholders that we capitalize on the attractive return opportunities in our MI segment to the tune of $5.4 billion of underwriting income since 2017. These profits allowed us to redeploy capital into more accretive uses, including $2 billion worth of share repurchases since 2018 and the substantial growth in profitable P&C premium.

MI has been vital to our ability to propel our P&C underwriting growth. Underwriting cycle management is core to our culture, and I want to take a brief detour into how we think about the underwriting cycle here at Arch. Here within simplification of falling grade insurance clock split into four stages. Stage one, at the onset of the hard market, we see rates increase dramatically and capacity withdrawn. Results on the previous soft market results only begin to show up in claims activity. Stage two. This is the beginning of the restoration phase, which is indicated by second and sometimes third round of rate increases along with some improvements for the insurers in the terms and conditions as the industry adjusts its appetite and underwriting policies.

Much of the focus during this stage is also geared to filling guests in and replenishing reserve shortfalls from the soft years while showing rapid improvements. Stage 3. That next period is where rates gradually decrease often as a result of overreaction in Stage 2. Underwriting profits from the hard market years gradually show up in the results. This period can be lengthy and it usually allows for still profitable growth, especially for the disciplined underwriters. And finally, Stage 4. Famous Stage 4 is where the industry foresakes underwriting discipline and overly focuses on topline growth even as rate decreases accelerate. This is where Arch’s culture of underwriting discipline is most apparent as we cut exposure and prepare for the return of Stage 1.

Right now, we are at Stage two in most lines. Some, for instance property, are back to Stage one since the fourth quarter. Understanding where you are at each point of the cycle for every product line and the nuances within each stage is critical to the timely allocation of capital to the areas of greatest opportunity. One of Arch’s key sustainable advantages is the breadth of its capabilities across many specialty insurance lines, enhancing greatly our cycle management capabilities. A core strategic tenant of Arch is that underwriting acumen and discipline through the cycle drive superior risk adjusted returns. Now I’d like to share some highlights from our underwriting units. We’ll kick it off with reinsurance. For the fourth quarter, net premium written in the reinsurance segment was $1.5 billion, that’s more than double the same quarter one year ago.

Francois will cover the details. But much of this growth is because we were well positioned to capitalize on broad market opportunities as well as several one off opportunities resulting from market dislocations emerging in the fourth quarter. It is worth noting that the fourth quarter growth does not include the January 1 property and property cat renewals, which will be reflected in our next quarter’s results. As you’ve heard, pricing for the January 1 renewals were strong. Cat pricing and terms both improved, leading to effective rate changes in the plus 30% to plus 50% range. We anticipate these trends will continue as the midyear property cat renewal and should translate to strong property cat premium growth in 2023 for Arch. Moving now to our Insurance segment.

where we continue to reap the benefits of the investments we’ve made in enhancing our specialty businesses in the UK and in the US. On the year, we wrote over $5 billion of NPW, net premium written, compared to $4.1 billion in ’21, with growth coming from a diverse mix of business. Underwriting performance continues to be excellent with an ex-cat accident year commodity ratio of 89.6%. Rate increases with a few exceptions remain above loss cost trend and we expect this strong momentum to continue for 2023. The insurance market remains rational and disciplined. We expect also continued opportunities due to the ongoing global uncertainties and remain optimistic that this disciplined behavior that we saw in the P&C industry for the last three years will persist as we move through Stage two of the cycles.

Next, our mortgage team, again, had an acceptable quarter, capping off an excellent year. As we benefited from earnings from our embedded book as well as from favorable reserve development as cures on delinquencies exceeded our expectations. The mortgage segment delivered $374 million of underwriting income in the quarter and $1.3 billion for the year, an excellent contribution in a year where higher mortgage interest rates slowed new originations. Our insurance in force, the earnings foundation of the mortgage segment, grew to $513 billion at year end ’22 as persistency increased due to higher mortgage rates. As expected, higher mortgage rates led to reduced as mortgage rates touched 7%, the highest rates in 20 years. Looking broadly at the MI industry’s health, we have borrower credit quality which is outstanding and excess housing demand above supply, the US unemployment rate is near historic lows and the borrowers’ equity in their homes remain at very healthy levels.

One thing worthy of mention is that the MI industry is acting in a disciplined and responsible manner. In the face of these economic uncertainties, premium rates are increasing while underwriting quality remains strong. Finally, the interest rate increases we’ve seen in the last 12 plus months should help fuel our net investment income through 2023. We are poised to benefit from higher reinvestment rates coupled with the growth in invested assets. I’ve got auto racing on my mind lately, and when I look at our industry, I can’t help but think that Arch is one of the best cars on the track. We know that winning the raise comes down to more than having a great driver or the fastest car. There is much preparation, analysis and looking at the conditions on the track as well as monitoring the other drivers.

By recognizing the soft market conditions in ’17 and ’18, we avoided the mistakes others made early in the race when they might have burned tires or overheated their engines. The pricing began to improve in 2019, we’re able to take advantage of some of our competition basket stuff and engine problems, and we took the opportunity to take more of a lead on the track by increasing substantially our writings. And then once we saw some clear track ahead of us, we were able to accelerate even faster. Today, we’re firing on all cylinders and I know we’ve got the right crew to bring in home. Let’s hand the wheel over to Francois before coming back to and answer your questions. Francois?

Francois Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. I’m very pleased to share that once again, Arch had an excellent quarter on virtually every front. The year concluded with fourth quarter aftertax operating income of $2.14 per share for an annualized operating return on average common equity of 28%. Book value per share was up 9.9% in the quarter to $32.62 and down only 2.8% on the year, a great result considering the impact raising interest rates had on our fixed income portfolio with a difficult year in equity markets and the elevated catastrophe activity we experienced this year. Turning to the operating segments. Net premium written by our reinsurance segment grew by an exceptional 118% over same quarter last year.

Although this quarter, we had a few large one off transactions that impacted our results and contributed $407 million to our net written premium. Adjusting for these transactions, our net premium written growth was still elevated at 61% for the quarter. These transactions are yet another example of the dislocated state of the uninsurance market where our strong balance sheet provides a significant advantage as we look to deploy meaningful capital to support ceding companies at terms that meet our target return expectations. More importantly, the underlying performance of the segment this quarter was very good with an ex-cat accident year combined ratio of 82.9% and a de minimis impact from current accident year capacity losses. Reflecting ongoing hard market conditions, the insurance segment also closed the year on a very good note with fourth quarter net premium written growth of 17.4% over the same quarter one year ago in an accident quarter combined ratio, excluding caps of 89.6%.

Most of our lines of business still benefit from excellent market conditions, both in the US and internationally, and our expectations for the coming year remain very positive. Our mortgage segment continued its run of quarters with results better than long term averages as claim activity for the business remain low. While production volumes were down due to the lower level of originations in the market, we remain positive on the return prospects for this business. Net premiums earned were up slightly on a sequential basis as the persistency of our in-force insurance at 79.5% at the end of the quarter continued to increase. The combined ratio, excluding prior year development, was 45% for the quarter and reflects our prudent approach to loss reserving, one of our key operating principles.

Our underwriting income reflected $270 million of favorable prior year development on a pretax basis across all segments this quarter, which represents approximately $0.66 per share after tax. While most of this favorable prior year development, $211 million, came from the mortgage segment, mostly on claim reserves set up for COVID related delinquencies in the 2020 and 2021 accident years at US MI, it is worth pointing out that our P&C reserves also contributed to the overall results. Of note, both our insurance and reinsurance segments had another quarter of favorable reserve development, and the 2022 calendar year phase two incurred ratio for our P&C operations was 58.7%, its lowest level in more than five years. Both these metrics provide some insight into the adequacy of our loss reserves, which constitute an important element in the quality of our balance sheet.

Quarterly income from operating affiliates stood at $36 million and was generated from good results in summers. Pretax net investment income was $0.48 per share, up 41% from the third quarter of 2022. Cash flow from operations, over $3.8 billion for the year, was strong and when combined with the proceeds from maturities and sales of securities in a rapidly rising yield environment, and hence, the underlying contribution from our investment portfolio. Going forward, with new money rates in our fixed income portfolio in the 4.5% to 5% range and a growing base of invested assets, we are well positioned to deliver an increasing level of investment income to help fuel our bottom line. Total return for our investment portfolio was 2.6% on a US dollar basis for the quarter with all of our strategies delivering positive returns.

The contribution to the overall result was primarily led by our fixed income portfolio, which benefited from relatively stable interest rates and tightening credit spreads. The overall position of our investment portfolio remains relatively unchanged as we remain cautious relative to duration, credit and equity risk. Turning to risk management. Our natural cat PML on a net basis stood at $970 million as of January 1 or 8% of tangible shareholders’ equity. Again, well below our internal limits at the single event one in 250 year return level. Our peak zone PML remains at Florida Tri-County region. And as Marc mentioned, the PMLs we report represent a point in time estimate of the exposure from our in-force portfolio and the premium associated with the January 1 renewals will get reported in our financials starting next quarter.

On the capital front, we did not repurchase any shares this quarter as our assessment of the market opportunity in 2023 remains very positive, one where we should be able to deploy meaningful capital into our business at attractive returns for the benefit of our shareholders. Finally, as Marc mentioned in his remarks, the results we enjoyed this year across our operations were achieved through a thoughtful and deliberate execution of our cycle management strategy and a strong culture of allocating capital to the most profitable markets and opportunities. These results, which were an important contributor to us joining the S&P 500, were only made possible by the ongoing hard work and dedication of our over 5,000 employees across the globe. They deserve a tremendous amount of credit for making us who we are today, an industry leader with a stellar 20 plus year track record that is ready for the opportunities and challenges ahead of us.

With these introductory comments, we are now prepared to take your questions.

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Q&A Session

Operator: Our first question comes from the line of Tracy Benguigui with Barclays.

Tracy Benguigui: Your one in 250 PML to tangible equity of 8% as of 1/1 wasn’t too dissimilar to your 7.7% as of September 30th. So I’m wondering what made you pause to incrementally take more exposure? Did that have anything to do with less retro capacity or your view of ROEs based on pricing for that incremental cat exposure?

Marc Grandisson: I think this number — interesting, this number is one region, one area, one sub zone. What is not seen in the numbers, and we’ll have a more thorough discussion at the Q1 call is that we’ve increased cat exposure across a wider range of sub zones, and that doesn’t really come across through that Tri-County. And I remind you, Tracy that the Tri-County renewal is going to be more important and more apparent at the June 1 renewal. So it’s also one first step into it. So we have grown a European exposure because the race course look pretty good there. Significantly, it would not show up into that one single number, right? This is sort of a — it relies sort of the true increase in allocated capital to catastrophe. If you look at the aggregate number, which is a better reflection there is increase, that will be commensurate, it actually would — you’ll see the premium increase and the cap allocation increase are — it will make sense to you.

Tracy Benguigui: So as you look through the year, even though 25% is your maximum threshold, where do you think you could realistically land based on your risk appetite?

Marc Grandisson: Tracy, our typical answer is, you tell me what the rate levels are like, and we’ll tell you what we think we can do. We have a plan based on certain various levels of rate changes in terms of condition changes by zone by region. And our team, as you can appreciate, is willing and able to operate on that basis. If you take a step back, I think the overall capital position of the company is, we have plenty of opportunities to deploy, it’s hard for us right now to see going all the way to ’25. But certainly, we have room to grow and we have the capital and the relationships to do so.

Tracy Benguigui: And also really quickly on the reinsurance side, in recent times, you focused more on quota share over XOL. So with hard pricing, where do you see the best opportunities? I’m thinking about lower ceding commissions on quota shares and the higher rate online on the XOL side?

Marc Grandisson: So I think it’s across the board. You just mentioned that we have improved economics both on the quota share in excess of loss. I think that the numbers you see in Q4, a lot of it has to do with our recent growth in the quota share that we’ve written. I think by virtue of the cat XL, as we just talked about a few months ago, increasing, I think that we would be in a position to increase our excess of loss contribution to the bottom line. But when the hard market is around, which we still see on the reinsurance side and the insurance and the P&C side, we have a tendency to migrate towards a quota share. There’s a few reasons for that. Number one, one of the big reasons that we like to talk about is, you inherit some diversification within that portfolio that you otherwise would not necessarily get from a net excess of loss perspective.

And we really, really like this and we like to be closer to the rate change, right? When you’re on a quota share basis, you’re side by side with a client as opposed to in excess of loss, you need to be relying on your sole pricing to make it work. So over time when the market gets harder, I think you will expect us and as part of the cycle management to underwrite more quota share versus excess of loss. This year, they’re both pretty good.