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Edited Transcript of WTRE.OQ earnings conference call or presentation 12-Feb-20 6:00pm GMT

Q4 2019 Watford Holdings Ltd Earnings Call

Feb 14, 2020 (Thomson StreetEvents) -- Edited Transcript of Watford Holdings Ltd earnings conference call or presentation Wednesday, February 12, 2020 at 6:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John F. Rathgeber

Watford Holdings Ltd. - CEO & Director

* Jonathan D. Levy

Watford Holdings Ltd. - President

* Robert L. Hawley

Watford Holdings Ltd. - CFO

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Conference Call Participants

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* Pablo Singzon

JP Morgan Chase & Co, Research Division - Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Watford Holdings Fourth Quarter Earnings Conference Call. 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 discussed on this call may constitute forward-looking statements under the federal securities law. These statements are based upon management's current assessments and assumptions that 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 factors that may affect future performance, investors should review periodic reports and other filings that are filed 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 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, the definition of underwriting income, adjusted underwriting income and adjusted combined ratio and descriptions of noninvestment-grade portfolio and investment-grade portfolio components of the company's investment returns 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.

I would now like to introduce your host for today's conference, Mr. John Rathgeber, CEO of Watford Holdings. You may now begin.

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [2]

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Thank you, Sheri. Good day, everyone, and thank you for joining the Watford Holdings' Fourth Quarter Earnings Call. Joining me on the call today are Rob Hawley, CFO; and Jon Levy, President.

I'll provide some high-level commentary on our fourth quarter and full year underwriting and investment results, touch on insurance and reinsurance market conditions and briefly discuss our previously-announced pending acquisition of Axeria Insurance. Rob will then provide a more detailed recap of the fourth quarter and full year financial results. Following that, we'll be pleased to answer questions from the analysts. If there are individual investors with questions that aren't addressed today, we'll be happy to arrange one-on-one follow-up calls with you.

For the fourth quarter of 2019, Watford reported a net loss available to common shareholders of $16.9 million or negative $0.79 per diluted common share. Book value per share increased 3.4% to $43.49 per diluted share, which is an increase of 10.9% from the 2018 ending book value per share of $39.22.

The 2019 fourth quarter was an eventful one with a full spectrum of positive and negative news to report.

I'll start with the action we took with regard to our loss reserves. The decision to strengthen our prior period loss reserves resulted in an underwriting loss, which in turn was largely responsible for our reported net loss. Our reserving approach is to react to negative information when it is received, while being cautious about taking down reserves too quickly in periods when reported loss activity is lighter than expected. In line with that philosophy, we took a conservative response to the higher level of reported losses we saw this quarter.

In total, we increased prior accident year loss reserves by $24 million and 2019 accident year reserves by approximately $4 million. The increase primarily relates to 2 large casualty reinsurance programs that we've been closely monitoring. In both cases, we've taken action over the past several years to reduce our exposure to business that has underperformed our expectations. The reserve adjustments were driven by the loss activity on a handful of contracts with limited ongoing exposure, and as such, we believe the action taken is not indicative of more broad-based issues with our portfolio. We believe that the reserve strengthening was the prudent course of action in light of the higher frequency and severity of claims in certain casualty lines that the entire industry has experienced.

On the positive side, there is much to talk about. Our investment performance was strong, we had meaningful growth in book value per share and insurance and reinsurance market conditions continue to improve. Rising loss costs and the threat of social inflation are driving rate increases in many insurance lines, enabling Watford to deploy capital into this side of our business.

Insurance net premiums written were up 42% from the year ago quarter and were up 26% for the year. This growth on the insurance side, while simultaneously paring back our reinsurance writings, should have a beneficial impact on both our combined ratio and our overall return going forward due to lower acquisition expenses, increasing rates and less posting of collateral.

In addition, we recently announced an agreement to purchase the French primary insurer, Axeria, which will further expand our insurance platforms. I'll have more to say about that transaction in a minute.

Our investment performance was solid, both for the quarter and the full year. For the quarter, net interest income was approximately $30 million. The quarterly net interest income yield on the noninvestment-grade assets under HPS management was 1.7% and the net interest income yield on our investment-grade portfolio was 0.6%.

After including realized and unrealized gains and losses and performance fees, our total net investment income for the quarter was $32 million, representing a 1.5% return on net invested assets. For the full year, the net interest income yield on net assets was 5.4% and the net investment return on net assets was 6%.

The current ratio of net invested assets to equity is 2.5:1. So if the annual net investment return for 2020 is between 5% and 6%, that would translate to a 12.5 to 15% return on equity contribution from investments.

In the quarter, we fully utilized our $75 million share repurchase authorization, which had a very beneficial impact on book value per share. Despite the fourth quarter reserve charge, we were able to deliver 3.4% growth in book value per diluted common share for the quarter. And as mentioned, we grew 10.9% for the year. As announced in our earnings release, the Board has just authorized a new share repurchase program under which the company may repurchase up to $50 million of its outstanding common shares.

Turning back to market conditions. The insurance market continues to improve with meaningful rate increases in many lines of business. Our U.S. insurance business is currently weighted toward commercial auto and general liability. We are achieving rate increases of approximately 10% in commercial auto and mid- to high single-digit increases for general liability.

After a period of slight declines, rates on primary U.K. Motor insurance have leveled off. We believe the business is still generating attractive expected returns. And on many reinsurance contracts and insurance programs, we are largely protected from loss ratio deterioration by sliding scale commission adjustments.

Largely in response to the revised Ogden discount rate, the rates on U.K. Motor excess-of-loss business were up 10% to 15% on an absolute basis and up mid-single digits after adjusting for changes in exposure.

While we don't write a lot of property catastrophe risk, reinsurance pricing has improved in response to 3 consecutive years of sizable industry losses, and we have modestly increased our PML exposure as a result. Our current 1-in-250 year per occurrence PML for our peak zone is approximately $40 million.

Aggregate excess-of-loss mortgage pricing is stable at what we believe are attractive levels, given the current strength of the U.S. economy and housing market.

We are optimistic that we will continue to find growth opportunities in the U.S. and international insurance space, while our casualty reinsurance book may continue to be paired back, the magnitude of which will depend on the level of rate increases and other improvements in terms and conditions we are able to achieve.

Turning now to the Axeria acquisition. We are extremely pleased to have negotiated the purchase of Axeria. Axeria is primarily a writer of small-to-medium commercial property and casualty business in France. Axeria's in-force gross written premiums are approximately EUR 140 million and net premiums are roughly EUR 50 million. Axeria is an attractive acquisition for us because it furthers our strategic initiative to expand our insurance platforms into attractive new regions. Axeria gives us an immediate presence in France as well as licenses in other European countries, which should provide additional avenues for potential future growth.

We have submitted our applications to purchase Axeria to the appropriate regulators and anticipate closing to occur in the second quarter upon successful conclusion of the regulatory reviews. We will disclose the terms of the transaction after closing, but can say that it will be financed 100% with cash on hand, and that, based on the current equity position of Axeria and the value projected at closing, we anticipate that the transaction will be immediately accretive to book value per share.

Concurrent with the closing, we intend to have Arch provide certain services to Axeria under a long-term services agreement that would be tailored to Axeria's platform, similiar to the arrangements our other insurance subsidiaries have with Arch.

And with those introductory comments, I'll now turn it over to Rob to go through our financial results in more detail.

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Robert L. Hawley, Watford Holdings Ltd. - CFO [3]

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Thank you, John, and good afternoon, everyone. I'd like to provide you with some commentary and observations on our financial results for the fourth quarter of 2019.

Net loss after tax and payment of preferred dividends for the quarter was $16.9 million or $0.79 per diluted common share. The net loss reflects an underwriting loss of $37 million, debt plus preferred expenses of $4 million, net foreign exchange losses of $7.5 million, all offset in part by net investment income of $32 million.

It's important to note that within the statement of comprehensive income resides an unrealized net foreign exchange gain for the 2019 fourth quarter of $7.5 million relating to the available-for-sale investment portfolio. Adjusting for this in the primary income statement would result in a slight net foreign exchange gain and reduce our net loss by $7.5 million.

For the 12 months ended December 31, 2019, net income available to common shareholders was $44.7 million or $2.00 per diluted common share. The return on average equity for the year was 4.8%.

Growth in book value per diluted share was strong for the quarter and year-to-date. Book value per diluted share grew 3.4% in the quarter to $43.49, which represents a 10.9% increase from year-end 2018.

During the quarter, the company repurchased approximately 2.8 million shares at an average price of $26.89 per share, fully utilizing the company's previously-announced share repurchase program of $75 million. The fourth quarter share repurchases contributed approximately 5% to growth in book value per diluted share.

As John mentioned earlier, the Board has authorized a new $50 million share repurchase program for 2020. The exact timing and amount of further share repurchases is dependent on a number of factors, but will likely be deployed at a slower pace than our prior program in order to pursue opportunities in an improving insurance market. As a reminder, we initiated our share repurchases on September 30, 2019, and fully exhausted the previous program by year-end.

Moving to our underwriting results for the quarter. Our gross premiums written for the fourth quarter were $156.3 million, a decrease of 2.9% or $4.7 million versus the same quarter last year. Premium growth in insurance programs and co-insurance was offset by reductions in casualty and other specialty lines. Due to the continued impact of the Q1 '19 nonrenewal of one multi-line quota share contract as well as reduced participations on certain professional liability contracts, our casualty reinsurance gross premiums were down 49% over the prior year quarter.

Other Specialty gross premiums were down 23% over the prior year quarter, primarily due to a reduction in the cedent's original exposure for one large renewal, with the remaining reduction attributable to the nonrenewal of one motor quota share contract. Partially offsetting these decreases was growth in our international motor business with premium increases both from existing relationships as well as new treaties bound in 2019.

Insurance programs and co-insurance growth of 51% was due to the continued expansion of our U.S. and European business.

Ceded written premiums grew $15.3 million to $43.9 million, a 54% year-over-year increase. As our insurance gross premiums written have grown in our WICE, WSIC and WIC companies, the outward ceded premiums have grown in proportion.

The Q4 '19 combined ratio was 128.3%, 12.9 points higher than the same quarter last year. The increase in the combined ratio can be primarily attributed to a loss ratio increase of 13 points over the prior year quarter. The Q4 2019 loss ratio increase reflects prior year loss reserve strengthening of $24 million and current accident year loss reserve strengthening of approximately $4 million. In addition, current quarter catastrophe losses impacted the company's underwriting results by approximately $5 million.

The acquisition expense ratio decreased 1.1 percentage point to 22.3%, in comparison to the prior year quarter, due to changes in mix and type of business, while the [general] (corrected by the company after the call) and administrative expense ratio increased 1 percentage point to 5.1%, reflecting ongoing public company expenses.

Moving to our investment results for the quarter. The fourth quarter net investment return benefited from consistent net interest income of $29.8 million and realized and unrealized gains of $6.1 million. The quarterly net investment return for the entire portfolio was 1.5% on average net invested assets of $2.2 billion. As noted on prior calls, interest income is the long-term driver of our investment performance, and our year-to-date interest income yield of 5.4% is in line with the 5.4% yield achieved in 2018.

Focusing on our noninvestment-grade portfolio. Net interest income in the quarter was $27.2 million versus $28.7 million a year ago. The net interest income yield of 1.7% was down slightly versus the fourth quarter of 2018. The decrease in yield was driven by a decrease in LIBOR rates and its impact on our floating rate assets, as well as less leverage having been deployed in 2019. In the noninvestment-grade portfolio, the net realized and unrealized gain of $3.7 million was roughly in line with slight credit spread tightening this quarter.

Turning to our investment-grade portfolio. The net interest income yield was 0.6% in the quarter compared to 0.5% in the fourth quarter of 2018. Year-to-date, the net interest income yield was 2.5% compared to the prior year year-to-date yield of 1.9%, reflecting reinvestments at higher yields in 2019 as well as a slight shift in our portfolio composition. As of the end of December, the ending balance sheet net unrealized loss position for the combined investment portfolios was $63.2 million.

Lastly, I'll touch on capital and leverage management. Our debt to total capital ratio was 15.7% at December 31, 2019, and the debt plus preferred to total capital ratio was 20.4%. The debt plus preferred ratio increase of 50 basis points versus the year-end 2018 ratio was driven by share repurchases in the fourth quarter.

In conclusion, we are pleased with the strength of our balance sheet and believe we are well positioned for 2020 and beyond. This year's refinancing of roughly three-quarters of our preferred shares outstanding has significantly lowered our cost of capital.

Our fixed income portfolios provide a steady interest income stream, and we maintain appropriate levels of liquidity to meet our short-term goals. We continue to benefit from excellent financial strength ratings from A.M. Best and Kroll Bond Rating Agency.

And finally, we will continue to carefully manage our capital to ensure we are in the position to take advantage of market opportunities and execute strategic decisions, such as our continued expansion into the insurance marketplace.

With that, I'll hand it back to John.

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [4]

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Thanks, Rob. We'd now be very pleased to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We have a question from Pablo Singzon with JPMorgan.

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Pablo Singzon, JP Morgan Chase & Co, Research Division - Analyst [2]

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Rob, just to follow-up on your share buyback commentary. It seems like we should expect the utilization of the $50 million to be more even this year. But I was wondering if your buyback plan had any sensitivity to where Watford stock is trading? And I guess, related to that, were you in the market buying back shares either before or after your fourth quarter pre-announcement?

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [3]

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So we exhausted -- it was toward the end of December, which was when we exhausted it. So we haven't been active since then. So the new plan has not come into effect yet. It's just been authorized. And in terms of how it will be used going forward, we just want to level-set expectations. We really were in a position with the original $75 million that was true excess, excess capital. Obviously, the share price was extremely attractive to purchase as quickly as we could, given the restrictions that are placed on how much the company can buy in any one day. But we basically used it up as quickly as we could.

Now going forward, having reduced our excess, excess capital and having a quarter where you have a slight net loss, obviously, we don't have as much excess, excess capital as we sit here today, but obviously, we're very cognizant of the accretive nature of these purchases, and we'll certainly do it when and where we can. And it will be obviously a function of our earnings that we deliver going forward and just general market conditions and opportunities in the insurance side.

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Pablo Singzon, JP Morgan Chase & Co, Research Division - Analyst [4]

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Okay. And John, should I take more (inaudible) to mean -- part of that to mean where the stock is trading, right? So there is some -- should we assume some embedded sensitivity in Watford stock price?

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [5]

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Yes, absolutely. So it's a calibrated plan where the [amount] (corrected by the company after the call) that we purchase is dependent on where the stock is trading at the level.

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Pablo Singzon, JP Morgan Chase & Co, Research Division - Analyst [6]

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Okay. And then just broadly, I guess, can you quantify or maybe just sort of how you think about Watford's excess capital position and how much capital you generate every year, right, maybe on a normalized basis, net of any potential new business needs?

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Jonathan D. Levy, Watford Holdings Ltd. - President [7]

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Pablo, this is Jon Levy. I think when we look at our capital position, we first look at kind of the underlying risk metrics and the other kind of risk concentrations that we have. On top of that, we thought we obviously get very sensitive to our regulatory and rating agency constraints. I think when we look at everything holistically, we first look at our -- what we need, we look at kind of what's required from rating agencies and then we look kind of externally as to what are kind of market opportunities, be it on the investment side or on the underwriting side.

I think sitting here today, we think that the underwriting market out there has certainly significantly improved over what has been over the last couple of years. But I don't think we'll quantify on this call kind of what we think our kind of excess, excess capital position is other than to say that the $50 million share authorization is something that, I think, we and the Board feels is kind of a comfortable amount to authorize and we'll deploy it if and when kind of the opportunities are available and balance that against the underwriting opportunities that are there.

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Pablo Singzon, JP Morgan Chase & Co, Research Division - Analyst [8]

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Got it. And then just switching to the business side here. John, it seems like you're continuing to pare back your reinsurance exposure, even if some of your reinsurance peers have seen pretty good growth this quarter actually. So what do you think is driving that? Is it the business mix issue, just given where you're focused? Or maybe your view of risk is a bit different from what other companies are seeing?

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [9]

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I think a lot of it is mix more than that. I think there's -- you're seeing really extremely healthy increases on property side and shorter tail lines that -- it's not to say that there aren't increases on the casualty side as well. But I think a lot of the growth, some of the companies have seen is more on the shorter tail lines of business, which we're not as active in. But in the end, it really comes down to negotiating each deal. And we're just going to only write those deals that we think produce attractive ROEs.

And the thing about reinsurance is that they can be very sizable transactions, and you can not write anything for several months, but then all of a sudden, you hit on a $50 million or $100 million transaction. So it's very lumpy, and it's hard to predict going forward exactly how much business you're going to write.

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Pablo Singzon, JP Morgan Chase & Co, Research Division - Analyst [10]

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Right. Okay. And then last question before I re-queue. I guess for you, John, again, what gives you confidence that the issues you uncovered in the 2 problematic contracts you identified, I guess, do not affect your assessment of risk exposures in your other reinsurance agreements, particularly when you think about IBNRs, right? It seems like you think that the charge was specific to certain product lines, geographies or clients that may not have a direct read-through to your other exposures. But maybe if you could speak about that a little bit more.

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [11]

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So I think I'd point back again to our conservative philosophy of how we just approach things in general where we react to negative information. But when reported loss activity is actually lighter than expected, we don't necessarily reduce our loss reserves immediately. We were very cautious, and this quarter's example why we did that is that it takes time for business to really know where things stand. I mean I have to say we have a very sizable amount of IBNR. And it's a judgment call when you face a situation like this. We could have reduced our IBNR dollar-for-dollar to offset the increase in reported loss activity that we saw in the quarter. Many people might have taken that route and it's justifiable, and we'd still be within the very reasonable range of actuarial reasonable estimates.

But again, going back to our philosophy, we saw the issue. We wanted -- given the general environment where people are talking about social inflation and seeing an uptick of frequency and severity in certain lines-- we wanted to take a cautious approach, and hope we prevent further increases and more dramatic increases a few years from now.

So that's the fundamental reason. And then the fact that it's really isolated to contracts, primarily the couple of very sizable contracts, but they're ones we've been following for a number of years. We actually took action over several years quite a while ago, realizing that the business in hindsight was probably underpriced, and it was coming in with loss activity higher than we expected. So it's really the whole history of how we've been monitoring and watching things and -- our just general conservative nature in how we approach reserving.

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Jonathan D. Levy, Watford Holdings Ltd. - President [12]

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I'll add some little more color to that, if I can. These deals really made up the vast majority of our U.S. casualty reinsurance play. Most of the loss reserves we have -- as you know, we have a fairly significant international exposure. So most of the losses at this point really aren't quite as exposed to U.S. tort trends. I think a lot of people are having a lot of commentary about that over the last couple of earnings seasons.

So I think when you look at our loss reserves, we did take decisive action on these 2 deals. But if you look at kind of the rest of our portfolio, it's not to say the rest of our portfolio won't have different risks, but they won't be -- have the same type of kind of U.S. tort trend exposure that these 2 deals did.

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Pablo Singzon, JP Morgan Chase & Co, Research Division - Analyst [13]

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Got it. And on the premium basis, John, what's the share of these 2 contracts in your overall mix, if you could provide that?

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [14]

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So I mean, if you go back 3, 4 years ago, each of those contracts was roughly $100 million on an annual basis. And as I mentioned, over succeeding renewal periods, we've gradually been reducing our participations in those contracts. On one of them, we got non-renewed as of 1/1/19. On the other one, we have what people would describe as a watching line at this point. It's not a material size of participation.

So you do have to factor in, when you look at the size of this increase, it really goes all the way back, covers exposures back to 2014. We earned premium on those contracts for over a 6-year period. So in that respect, it's really not a tremendously huge increase in the reserves relative to the magnitude of the size of those contracts. But today, we're much more diversified portfolio. As Jon mentioned, we're in a lot of areas other than the U.S. casualty reinsurance market, which on an ongoing basis, represent, I think, a lot safer proposition in terms of if you want to talk about social inflation.

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Operator [15]

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Thank you. Speakers, I'm showing no further questions at this time. I would now like to turn the call back over to you for any closing remarks.

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John F. Rathgeber, Watford Holdings Ltd. - CEO & Director [16]

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Okay. Thanks, Sheri. So I'd just like to conclude by saying that we're very optimistic about our prospects for 2020, and I think we have a lot of levers to pull that can lead to another year of solid book value growth. We'd like to thank everyone for dialing in. Enjoy the rest of your day. Thank you.

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Robert L. Hawley, Watford Holdings Ltd. - CFO [17]

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Thank you.

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Operator [18]

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Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.