Arch Capital Group Ltd. (NASDAQ:ACGL) Q3 2023 Earnings Call Transcript

Arch Capital Group Ltd. (NASDAQ:ACGL) Q3 2023 Earnings Call Transcript October 31, 2023

Operator: Good day, ladies and gentlemen, and welcome to the Q3 2023 Arch Capital Earnings Conference 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 this 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 states 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 filled by 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 the call to be subject to the safe harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website and on the SEC's website.

A woman signing papers with her banker for her first home mortgage.

I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs, you may begin.

Marc Grandisson: Thank you, Gigi. Good morning, and thank you for joining our third quarter earnings call. I hope everybody is safe and well. Yesterday, we reported another excellent quarter, highlighted by strong performances from each of our three operating segments that resulted in an annualized operating return of 25% and a 4% increase in book value per share. Overall, our teams capitalized on good underwriting conditions and relatively light catastrophe losses to produce an outstanding $721 million of underwriting income in the quarter. Our property and casualty teams continued to lean into favorable market conditions to drive $3 billion of net premium, up 26% from one year ago. Mortgage insurance once again delivered impressive high-quality underwriting earnings that we redeployed into our P&C segments where opportunities abound.

Broadly, we continue to achieve rate increases above loss trend in most sectors of the P&C market. Although rate increases are slowing in some lines, they are reaccelerating, which is a good reminder that there is not a single insurance cycle with May. As always, Arch is well positioned to navigate across these many cycles by reallocating capital to the segment with the best risk-adjusted returns. One of our core differentiating principle is that our underwriters are aligned with our shareholders through our unique compensation structure. Our underwriting teams are always seeking to maximize opportunities as long as they need our shareholders' targets. As we near the end of 2023 and look ahead to 2024, I believe that although the dynamics may shift, this hard market will continue to support profitable growth.

Let's take a moment to recap the current state of the market and where we are likely headed. I see it as a play in three acts. The first act, the current hard market started in primary liability insurance in 2019 and then has a unique circumstance of a two-year pause in claims activity due to a global pandemic. The second act introduced Hurricane Ian as a main character where property reinsurers had to adjust both their pricing and risk appetite. In addition, capital got more expensive and the industry has to respond to meet new expectations from investors. While property has been the most recent driver of this market as we move into act three. We are faced with increasing evidence at casualty rates widely underpriced and oversold during the last submarket need to increase.

We expect this third act of the extended hard market already one of the longest in memory to persist until the industry's reserving issues are resolved and until capital rates generate positive results. Arch is well positioned to capitalize on this operating environment. As new hard market underwriting opportunities arise, our incredibly nimble reinsurance group allows us to grow more quickly and significantly than in our insurance group and is therefore where we are most likely to deploy capital first. Today, market trends point to a reinsurance-driven GL hard market, and we stand ready to act. The third act has very started, but things are very promising for Arch. Now some color on our operating segments. Our reinsurance group has once again driven our growth with third quarter net premium written of $1.6 billion, up 45% from the same quarter in 2022 and 60% over the last 12 months.

Underwriting performance in the reinsurance group was excellent with a combined ratio of 80% for the quarter. Our expectation is that we will continue to see hard property market conditions to next year's renewal cycle as uncertainty and loss activity remains elevated. As noted above, we expect increased opportunities in liability as well. Our insurance group also remains in growth mode in both our North American and international units, while net premium written in the Insurance segment, up 16% over the last -- over the past 12 months, are more modest than in reinsurance, they are more broad-based because of our focus on small- and medium-sized specialty accounts. Underwriting income continues to build with increased earned premium and a strong combined ratio of 90.9%.

Today, there are still plenty of opportunities to grow profitably in insurance. Property and short-dated lines pricing in terms and conditions remained very strong with rate increases in excess of 15%. The then casualty pricing is increasing in response to overall casualty trends in the market and our programs unit continues to achieve rate increases above trend. Professional liability rates softened in the quarter, with net premiums written down 9% in the third quarter of '22. We share the marketplace sentiment about the D&O segment where both IPO and M&A activity decreased, at the same time as rig pressures from competition and security class action activity increased. However, returns in that segment are still strong. In the same vein, we maintained a positive outlook on cyber pricing on an absolute basis despite rate decreases in the 15% range.

Our outstanding mortgage group continues to deliver quality earnings for our shareholders anda higher persistency of our in-force portfolio helped offset the slight decrease in NIW which has been affected by lower mortgage originations. Although we tend to focus our comments on the U.S. primary MI market, it is worth noting that nearly 40% of our mortgage segment underwriting profit this quarter came from non-U.S. operations compared to just over 10% in 2017. International business represents a significant growth opportunity for the mortgage group at Arch and our strategic decision to diversify our mortgage operations is yielding positive results that further differentiate Arch from our competitors. We are currently in a positive cycle on the investment side of our business, where increasing cash flows from growth are being invested into today's higher yield environment.

New money rates are well in excess of our book yield which should continue to boost our investment income over time and provide us with an additional ongoing tailwind. In late October, which for baseball fans, mean it's fine for the world series, baseball is somewhat unique in that it's one of the few team sports that isn't limited to a specific length of time. You can score as many runs as possible until the other team gets three outs. To me, the current hard market feels like a baseball game. We know there's only nine innings to be placed, but we have no idea how long those innings will take. We've got a great lineup, we're happy to keep paying our singles, doubles and occasional home runs until the beginning is over. At Arch, we remain committed to being good stewards that are capital entrusted to us.

We do that by following a tried and true data-driven approach that maximizes the capability of our diversified platform, diligently adheres to a cycle management philosophy and is centered around superior risk selection and prudent reserving. All the while, our underwriters are fully aligned with our shareholders. This principles are foundational to our playbook and underscore our long-term commitment to superior value creation. As we close out 2023, we have significant momentum in all three of our businesses and a reliable and high-quality earnings engine in our mortgage group that are helping fuel our growing investment base. All the pieces are fitting together nicely, and we're well positioned for the future. Now I'll call François up on an on-deck circle, and we'll return to answer your questions shortly.

François?

François Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. To add to the baseball team, I would also emphasize that while this long winning streak has certainly been fueled by a timely and dynamic offense, we're also very much aware that team defense has played an important role in our success. We've been working hard not to waste any offensive production with careless errors and by executing well actively and on the field. We produced exceptional third quarter results from high-quality earnings across all our lines. The highlights of this team effort are numerous and include after-tax operating income of $2.31 per share for an annualized operating return on average common equity of 24.8% and a book value per share of $38.62 as of September 30, up 4.3% in the quarter and 18.4% on a year-to-date basis.

Similar to the quarterly results, our reinsurance segment grew net written premium by 45% over the same quarter last year, led by the property other than catastrophe line which was 73% higher than the same quarter one year ago. As for our property catastrophe business, it's worth mentioning that the net written premium in the third quarter one year ago included approximately $34 million of reinstatement premiums, mostly as a result of Hurricane Ian. If we adjust for the impact of reinstatement premiums, our growth in net written premium for this line would have been approximately 64% year-over-year. The quarterly bottom line for the segment was excellent with a combined ratio of 80%, 73.5% on an accident year ex cat basis, producing an underwriting profit of $310 million.

The Insurance segment had another very strong quarter, with third quarter net premium roving growth of 11% over the same quarter one year ago. Similar to last quarter's results, we experienced good growth in most lines of business with the main exception being professional lines where the market remains competitive, particularly in public directors and officers liability. If we exclude professional lines, net written premium would have been 20% higher this quarter compared to the same quarter one year ago. Overall, market conditions for our insurance and reinsurance segment remained attractive and we expect the returns on the business underwritten this year to exceed our long-term targets by a solid margin for some business units. Profitable growth during periods of favorable market conditions is one of the hallmarks of our cycle management strategy and the current hard market is definitely giving us the opportunity to deploy meaningful capital in many areas.

Our Mortgage segment's banning average has consistently been a league leader, and this quarter was no different with a 4.7% combined ratio. Net premiums earned were in line with the past few quarters across each of our lines of business. Included in our results was approximately $98 million of favorable prior year reserve development in the quarter, net of acquisition expenses with over 75% of that amount coming from U.S. MI and the rest from other underwriting units. Our delinquency rate at U.S. MI remains low based on historical averages and close to 85% of our net reserves at U.S. MI are from post-COVID accident periods at the end of the quarter. Across our three segments, our underwriting income reflected $152 million of favorable prior year development on a pretax basis or 4.7 points on the combined ratio was observed across all three segments, driven by short cat lines.

Current accident year catastrophe losses across the group were $180 million, approximately half of which are related to U.S. severe convective storms with the rest coming from the Lahaina wildfire, Hurricane Idaliaand other global events. Pretax net investment income was $0.71 per share, up 11% from last quarter as our pretax investment income yield was up by approximately 18 basis points since last quarter. Total return for our investment portfolio was a negative 40 bps on a U.S. dollar basis for the quarter as our fixed income portfolio was impacted by the increase in interest rates during the quarter and most other asset classes and negative returns in line with broader financial market indices, such as the S&P 500, which was approximately 3.7% in the quarter.

Net cash flow from operating activities has been very strong so far this year in excess of $4 billion, which has helped grow our invested asset base by approximately 20% in the last 12 months with new money rates in our fixed income portfolio comfortably above 5%, we should see continued meaningful tailwinds in our net investment income. Turning to risk management. As of October 1, on a net basis, our peak zone natural cat PML for a single event 1- to 250-year return level remain basically unchanged on a dollar basis from July 1 and now stands at 10.1% of tangible shareholders' equity well below our internal earnings. Our capital base grew and got stronger during the quarter and now stands at $18 billion. Our leverage ratio represented as debt plus preferred shares to total capital is currently under 20%, which provides us with significant flexibility as we look to deploy capital as opportunities arise.

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

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