Arch Capital Group Ltd. (NASDAQ:ACGL) Q4 2023 Earnings Call Transcript

Arch Capital Group Ltd. (NASDAQ:ACGL) Q4 2023 Earnings Call Transcript February 15, 2024

Arch Capital Group Ltd. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, ladies and gentlemen, and welcome to the Q4 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 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 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 will also 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 at www.archgroup.com and on the SEC’s website at www.sec.gov.

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 earnings call. Our fourth quarter results conclude another record year as we continued to lean into broadly favorable underwriting conditions in the property and casualty sectors. Our full year financial performance was excellent with an annual operating return on average common equity of 21.6% and an exceptional 43.9% increase in book value per share, which remains an impressive 34.2% if we exclude the one-time benefit from the deferred tax asset we booked in the fourth quarter. The $3.2 billion of operating income reported in 2023 made it Arch’s most profitable year-to-date. Growth was strong all year as we allocated capital to our property and casualty teams, we short over $17 billion of gross premium and over $12.4 billion of net premium.

And while most current growth opportunities are in the P&C sector, it’s important to recognize the steady quality underwriting performance of our mortgage group. Although, mortgage market conditions meant fewer opportunities for top-line MI growth, the business unit continued to generate significant profits totaling nearly $1.1 billion of underwriting income for the year. As we have mentioned on previous calls, those earnings have helped fund growth opportunities in the segments with the best risk adjusted returns, demonstrating that the disciplined underwriting approach and active capital allocation are essential throughout the cycle. Our ability to deploy capital early in the hard market cycle is paying dividends as we own the renewals, a phrase I learned from Paul Ingrey, a personal mentor and foundational leader of Arch.

What Paul meant was quite simple. When markets turn hard, you should aggressively write business early in the cycle. This puts your underwriters in a strong position to fully capitalize on the market opportunity. By making decisive early moves, you won become an [indiscernible] then want to do more business with you. In some ways, the growth becomes self-sustaining, which explains part of our success throughout this hard market. At Arch, our primary focus has always been on rate adequacy, regardless of market conditions. Our underwriting culture dictates that we include a meaningful margin of safety in our pricing, especially in softer conditions. And we also take a longer view of inflation and rates. For these reasons, Arch was underweight in casualty premium from 2016 to 2019, when cumulative rates were cut by as much as 50%.

I thought I’d borrow a soccer analogy to help explain the current casualty market. In soccer, players who commit a deliberate foul are often given a yellow card. Two yellow cards mean the player is ejected from the remainder of the match and their team continues with a one player disadvantage. Today’s casualty market feels as though some market participants took to the field with a yellow card from a prior game. They’re playing in match but cautiously, not wanting to make an error that will put their entire team at a disadvantage. So whilst Arch sometimes plays aggressively, we’ve remained disciplined and avoided drawing a yellow card. At a high level, we must remember that casualty lines take longer to remediate than property. So if insurers are being cautious and adding to their margin of safety, we could experience profitable underwriting opportunities in an improving casualty market for the next several years.

Now, I’ll provide some additional color about the performance of our operating units, starting with reinsurance. The performance of our reinsurance segment last year was nothing short of stellar. For the year, reinsurance net premium written were $6.6 billion, an increase of over $1.6 billion from 2022. Underwriting income of nearly $1.1 billion is a record for this segment and a significant improvement from the cat heavy 2022. Reinsurance underwriting results remain excellent as we ended the year with an 81.4% combined ratio overall in a 77.4% combined ratio ex-cat and prior year development both significant improvements over 2022. Turning now to our insurance segment, which continued its growth trajectory by writing nearly $5.9 billion of net premium in 2023, a 17% increase from the prior year.

While the business model for primary insurance means that shifts may not appear as dramatic as our reinsurance groups, a look at where we’ve allocated capital year-over-year provides meaningful insight into our view of the market opportunities. In 2023, the most notable gains came in from property, marine, construction, and national accounts. The $450 million of underwriting income generated by the insurance segment in 2023 doubled our 2022 output as we continue to earn in premium from our deliberate growth during the early years of this hard market. Underwriting results remained solid on the year as the insurance segment delivered a combined ratio of 91.7% and a healthy 89.6% excluding cat and prior year development. Now on to mortgage, our industry-leading mortgage segment continued to deliver profitable results, despite a significant industry-wide reduction in mortgage originations last year.

The high persistency of our insurance in-force portfolio, which carries its own unique version of owning the renewals, enables a segment to consistently serve as an earnings engine for our shareholders. The credit profile of our U.S. primary MI portfolio remains excellent and the overall MI market continues to be disciplined and returned focus. These conditions should help to ensure that our mortgage segment remains a valuable source of earnings diversification for Arch. Onto investments, net investment income grew to over $1 billion for the year due to rising interest rates that enhanced earnings from the float generated by our increasing cash flows from underwriting. The significant increases to our asset base provide a tailwind for our creative investment group to further increase its contributions to Arch’s earnings.

Over the past several years, Arch has leaned into both the hard market and our role as a market leader in the specialty insurance space. We have successfully deployed capital into our diversified operating segments to fuel growth, while also making substantial operational enhancements to our platform, including entering new lines, expanding into new geographies and making investments into new underwriting teams, technology and data analytics. Finally, as we bid adieu to 2023, I want to take a moment to thank our more than 6,500 employees around the world who help deliver so much value to our customers and shareholders. Our people are our competitive advantage and without their creativity, dedication and integrity, none of this would be possible.

So thank you to team Arch. François?

François Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. As Marc mentioned, we closed the year on a high note with after-tax operating income of $2.49 per share for the quarter for an annualized operating return on average common equity of 23.7%. Book value per share was $46.94 as of December 31, up 21.5% for the quarter and 43.9% for the year aided by the establishment of a net deferred tax asset related to the recently introduced Bermuda Corporate Income Tax, which I will expand on in a moment. Our excellent performance resulted from an outstanding quarter across our three business segments highlighted by $715 million in underwriting income. We delivered strong net premium written growth across our insurance and reinsurance segments, a 22% increase over the fourth quarter of 2022 after adjusting for large non-recurring reinsurance transactions we discussed last year, and an excellent combined ratio of 78.9% for the Group.

Our underwriting income reflected $135 million of favorable prior year development on a pretax basis or 4.1 points on the combined ratio across our three segments. We observed favorable development across many units, but primarily in short day lines in our property and casualty segments and in mortgage due to strong cure activity. While there were no major catastrophe industry events this quarter, a series of smaller events that occurred across the globe throughout the year resulted in current accident year catastrophe losses of $137 million for the Group in the quarter. Overall, the catastrophe losses we recognize were below our expected catastrophe load. As of January 1, our peak zone natural cat PML for a single event, one in 250-year return level on a net basis increased 11% from October 1 but has declined relative to our capital and now stands at 9.2% of tangible shareholders equity, well below our internal limits.

On the investment front, we earned $415 million combined from net investment income and income from funds accounted using the equity method, up 27% from last quarter. This amount represents $1.09 per share. With an investable asset base approaching $35 billion, supported by a record $5.7 billion of cash flow from operating activities in 2023 and new money rates near 5%, we should see continued positive momentum in our investment returns. Our capital base grew to $21.1 billion with a low leverage ratio of 16.9%, represented as debt plus preferred shares to total capital. Overall, our balance sheet remains extremely strong and we retain significant financial flexibility to pursue any opportunities that arise. Moving to the recently introduced corporate — Bermuda Corporate Income Tax.

As mentioned in our earnings release and in connection with the law change, we recognized a net deferred tax asset of $1.18 billion this quarter, which we have excluded from operating income due to its non-recurring nature. This asset will amortize mostly over a 10-year period in our financials, reducing our cash tax payments in those years. All things equal, we expect our effective tax rate to be in the 9% to 11% range for 2024, with a higher expected rate starting in 2025. As regards our income from operating affiliates, it’s worth mentioning that approximately 40% of this quarter’s income is attributable to non-recurring items such as Coface adoption of IFRS 17 and the establishment of a deferred tax asset at summers in connection with the Bermuda Corporate Income Tax.

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

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo.

Elyse Greenspan: Thanks. Marc, my first question, I wanted to expand on some of your introductory comments just on the casualty side, right? We’ve started to see some reserve additions this quarter, and I think you alluded to that last quarter as being what was going to drive the market turn. So how do you see it playing out from here? I know you said it should play out over the next several years. Could you just give us a little bit of a roadmap in how you think about this opportunity emerging for Arch?

Marc Grandisson: Yes. Great question. I think that we’re observing our own book of business. We also look at all the information around; I think from an actuaries perspective both François and I have maybe dusting off our actuarial diplomas. You rely on data that’s historically stable, or at least has some kind of predictability. I think what we’ve seen over the last two, three years, as a result of the pandemic, largely in the courts being closed and everything else in between all the uncertainty and then the bout of inflation, there’s a lot of data that’s really hard to pin down and get comfortable with to make your prediction for what you should be pricing the business. As we all know, reserving leads to the pricing, right, by virtue of reserving and having the right number for the reserving, you then feed that into your pricing.

So we’re in a situation where people have lesser visibility or about what the reserving will ultimately develop to. So I can totally understand our clients and our competitors having to adjust on the fly, or having to adjust a little bit progressively and cumulatively. The issue with casualty, at least as you know, is even if you have that information and you make some correction of corrective actions, it still takes a while to evaluate whether what you did was enough or whether what you needed to do. So I think right now, we have — we already had a couple of rate increases in casualty starting in 2020. But I think that now we’re realizing that maybe it’s a little bit worse collectively as an industry than we thought. And there’s a lot more uncertainty, a lot more inflation, certainly, as we all know, is a big factor.

So what I would expect right now is people will start refining their book of business. They will try to re-underwrite away from the social inflation impact lines. They’ll probably push for rates. Some of them might kick some business to E&S until such time as we have more stability in the reserving now the loss emerges as it relates to what your initial pricing assumptions was. And in casualty, that’s why it takes several years and its history is any indication. If you look back at the — even the [indiscernible] market and then the yo tutors the 90s — 1999 or 2000 to 2003, it took three to four years from the start of that, even in the middle of it, to really get clarity. And the market got much harder, in fact, in 2004 or 2005 than it was in 2002.

Just because you have to do the action and see what the actions did, what you thought. And I think that’s what we’re going to collectively as an industry are going through and we’re seeing it with our clients and that’s really what’s happening.

Elyse Greenspan: Thanks. And then, my second question, second quarter in a row, right, we’ve seen the underlying loss ratio within your reinsurance business come in sub-50, and you guys are obviously earning in like cat business written at strong rates last year. How should we think about the sustainability of a sub-50 underlying loss ratio within your reinsurance book?

François Morin: Well, sustainability is a great question. I think you’re absolutely right that we have more property premium that is more short tail and should have a lower loss ratio ex cat than not, right, compared to other lines. It’s a good market. So obviously profitability embedded in the business should be strong. But we send you back to kind of quarterly volatility, where you are — sometimes we have a better than, call it normal quarter, even as a function of the book and sometimes not. There’s going to volatility. We said it before; we said again the 12-month kind of rolling average is to us a better way to look at it and that’s how we see it. But certainly we like the profitability in the book and it should be — it should remain strong.

One thing I will tell you Elyse, by heard on the other calls is that the markets — reinsurance market is continuing to improve somewhat into the one, one renewal. So it is still a very good marketplace. So what it means for the loss ratio, I don’t know. But certainly, we’re seeing improvement.

Elyse Greenspan: And then, just one last one on capital, right? I believe on there was some pushes and pulls from the S&P capital changes on your capital but should be positive relative to your mortgage business. Can you just help us think through your capital position and relative to just organic growth opportunities you see at hand over the next year.

François Morin: Well, certainly, I mean S&P is one thing that we look at. We look at many different way — I mean, we have different looks at capital adequacy. We have our own internal view which drives really how we make our decisions. Rating agencies are an important factor but I think more importantly is how we think about it. But you’re right. I mean no question that from the S&P point of view, I mean the change of their model was a net benefit and that’s reduced kind, you know give us, I say a bit more excess capital. But we — and we look at it very carefully. We want to make sure that we’re able to seize the opportunities that will be in front of us and we see plenty for 2024. So right now our very — our main focus is growing the business and kind of deploying that capital into what’s in front of us and then we’ll see how the rest of the year plays out.

Operator: Thank you. One moment for our next question. Our next question comes from the line of Andrew Kligerman from TD Cowen.

Andrew Kligerman: First question — good morning. First question would be around M&A, we’ve seen a lot in the media about other specialty players that could be acquired. Arch has been mentioned along with other companies. And I know you can’t comment on specific transactions and that you’ve talked a lot about 15% return on capital over time. But when you do transactions, could you give us a little color on what the parameters might be, what’s really important to Arch when you do deals?

Marc Grandisson: Yes. On the M&A front, we’re very prudent and careful when we do — if we do anything. And I think historically, our historical track record is probably the best way to look at this. We’ll look for something where our opportunities to earn a return is with a proper margin of safety is fairly healthy. We’re not — there’s no desire to grow for growth sake in this company. It really has to do with the return on capital. And as François mentioned, the fact that we have opportunities to above 15% opportunities in this marketplace certainly makes it a little more harder. Having said all this, we might make not exceptions, but there might be some other considerations as it relates to maybe a strategic, maybe a different kind of product, maybe a geography, or maybe — and we prefer that, maybe a new team that can really bring the expertise on an underwriting basis.

So it’s a very, very disciplined approach to M&A that we take. And we have the luxury because we have plenty of organic growth available to us. So something has to be very compelling for us to engage in those and also other risks, as you all know, that we don’t want to take on necessarily the number one is the culture. Now we’re very, very adamant about keeping top culture the way it is, and that’s really something. And that quite oftentimes the thing that makes the most, and then — probably the one that makes the most difference in whether or not we’ll entertain an M&A or not.

Andrew Kligerman: That makes a lot of sense. You mentioned on the favorable developments that short tail property was a big driver. So looking at insurance at $21 million favorable, reinsurance at seven favorable. Just trying to understand, were there any large casualty offsets that might have played in and if so, what would they be?

François Morin: Yes, well, there’s no, I’d say offsets. I mean, we look at each line on its own. There’s always going to be pluses and minuses on that every single quarter. We look at the data, we react to the data. I think, as you can imagine, or I mean, very much a function of the type of business that we’ve written the last few years we — in reinsurance in particular, we’ve grown a lot in property. We’ve taken our usual — used our same methodology, same approach to reserve, and that generated a little bit of redundancies or releases this quarter on the short tail side. There’s always a little bit of noise on any line of business. Yes. Did we have a couple of sublines or kind of sales in casualty where we had a little bit of adverse? Absolutely, but it’s not — I wouldn’t call it an offset. I mean, we booked every single line on its own. We reacted to data, and then when numbers come up is what we end up with.