Good afternoon. I'm Tracy Bangige, Insurance Analyst at Barclays, and I'm pleased to moderate a fireside chat with François Morin, Chief Financial Officer of Arch. Unfortunately, Marc Grandisson isn't able to participate, welcome, François.
Thank you. Thanks for having me.
Excellent. Hopefully, we could get the polling, our audience response system, to work. I actually had to borrow my kid's iPad here. The first question that I'm laying out is my estimate for COVID-19 industry insured losses. The options, and this is on the left side of your screen, if you want to navigate it through, is either over $100 billion event, $70 billion event, $50 billion event, $30 billion, or luckier, picking lotto numbers. I think that's just going to warm everyone up. Far, it seems, there's a few responses coming in, $50 billion event, followed by $70 billion, and for the skeptics in the room, luckier picking lotto numbers. Maybe moving on to the next polling question. What inning are we in regarding recognition of COVID-19 insured losses? Either early innings, mid innings, late innings, or overtime.
Let's just give everyone a minute or so. I don't even see this one on the screen. As everyone's mulling this through, François, any kind of early reaction regarding potential size of COVID-19 insured losses and what inning we're in?
I think as you know, some people did put together some estimates early on, I'd say in April or May, and had a view on what it all meant. Recognizing that early on, I think event cancellation, for example, was one line of business that was probably easier to understand and have a view on what the ultimate or what the industry losses could be for that line of business. Since then, we at Arch think of it sometimes as indirect losses. You can think of first party, again, event cancellation, property, BI kind of coverages that are pretty clear, even though there's some lines of business, some coverages within that you might have disagreements on wordings and coverage.
That said, as you get into workers' compensation and liability coverages, D&O, Med Mal, there's other lines of business where it's a bit harder to truly have a good sense of where things are going to play out. The ranges early on were big and wide. I think the, I wouldn't call it consensus, but there are some views out there that seem to suggest that it might be a bit less than what people had feared, at least initially. May not get to $100 billion or plus, but again, it's very early and that leads us to part B, maybe, of your question, where I would say we're still very early innings. We're still learning more about what the damages are and what it means for industry losses.
I would say that certainly we think there's more to come, given that the pandemic's not over yet, right? We got a lot more to learn over the coming next two quarters and probably into 2021.
Great. Yeah, it seems like the results are coming in with the mid-innings and some sentiment with early innings, it seems to be in sync with your comments, though I think we're leaning more on the early innings side. Given that you actually have an actuarial background, François, do you think insurers are adequately putting up IBNR at this point, or are their hands tied due to difficulty estimating loss probability with any certainty? If you could also speak to your reserving practice.
Yeah, sure. I think it's worth commenting maybe separately for insurance versus reinsurance. I think insurance, at least at Arch, and I would think that at most companies, I'd say it's a bit easier to come up with a pretty robust analysis of what the exposure is. Again, with the uncertainties around wording and potential rulings on the legal implications on BI in particular, that would cause some companies to have different views on it. At a high level, we're pretty comfortable that the approaches we've taken have been consistent with, certainly they have to be consistent for us, at least with US GAAP. It means the event must be quantifiable and the IBNR is therefore incurred but not reported. It means that the losses has occurred, but we just don't have enough details to assign a case reserve to the particular insurer, the particular claim.
At a high level, I'd say from the insurance side, there's enough data, there's enough good knowledge and hands-on first knowledge to be able to come up with a good estimate of what the reserves, what people are booking. Reinsurance side, as usual, it's a bit more maybe different points of view on that, especially as sometimes getting the information from the scenes can be a bit difficult. There's different ways to think about property cat coverage, for example, where am I playing low excess? Where am I in the tower and what does that mean for me in terms of booking IBNR on a particular property cat treaty? There's some lines of business where on the reinsurance side, it's a bit harder. I think you will probably see differences in interpretation or practices across the industry.
Maybe moving on to pricing. Everyone's talking about a hard pricing cycle. I mentioned earlier in another session that it's almost sacrilegious to call a pricing cycle hard, but everyone seems to be moving in that direction. On the reinsurance side, I'm wondering about that bid-ask spread. As reinsurance pricing momentum predictions over the next 12 months, how optimistic are you? I'm going to one of the polling questions, over 30%, 30%-20%, 20%-10%, 10%-5%, or short-lived reversion to low single digits. It seems like the responses are gravitating towards 20%-10%, with second place 30%-20%. Does that sound about right to you, François, or do you have a different view?
Yeah. I think the issue there is probably around the differences across lines of business, even within the reinsurance segment. Property cat seems to have some, I think, good legs behind it in terms of getting the momentum going in terms of sustained rate increases. There's June and July ones were solid, not as good as we thought they could've been or should've been. That said, it gives us hope that the one ones in 2021 will be good. Again, with a sustained solid pricing environment. On the casualty front, maybe a bit more disparity there. It's not uniform what type of increases we're getting or seeing. We're seeing a lot of good rate increases on excess of loss type coverages.
As you know, we're benefiting from the pricing environment that the primary companies are seeing give to us or they get. It's hard to generalize, I want to say, but the 10-20 probably for across the sector or across the reinsurance universe is probably something that we've seen. We've seen better in some places and lower in others.
Got it. Probably just coming off the heels of a virtual Monte Carlo. I've read that Swiss Re mentioned that rate rises to date have been timid, and that a 7-12-point improvement in underwriting margins are needed to offset the impact of near zero interest rates. Without discussing Swiss Re, on your book, how would you characterize the rate need to overcome this low interest rate environment that we're in?
Well, that's by far one of our most important challenges in front of us. We had been in a low interest rate environment for quite a few years, didn't think it would even get lower or worse than that. Yet here we are with basically zero interest rates. That's something that we have to reflect in our pricing. It force you to recognize that in a long tail casualty line of business, we need to generate very solid underwriting income to make up for the lack of investment income that we're not getting, and we don't think we're going to get for some time. Yeah.
Just simple rule of thumb math in terms of lose 100 basis points on investment income, if not more, times the duration of 3-4 years, let's say on a typical line of business or an average more longer tail line of business, it makes a huge difference. To generate the type of returns that we expect and we think we need to deliver, basically, we have to make that up on the underwriting side, and it's a big difference. It's a big ask out of the pricing to get to that level.
When you look at pricing in a way that's too one-dimensional. On top of my mind, I've heard actually Marc mention an interesting comment in the past that terms and conditions more than double the rate effect. In your view, is the industry tightening terms and conditions enough?
It's never enough. The reality is We're here to pay claims. We're in the risk business. We're fully aware of the risks we're taking, and I think the important thing is to make sure that the risk that we're taking, we're getting paid for. Even in COVID, we unfortunately have realized in a few areas that we were exposed to losses that unfortunately we didn't appreciate or didn't think would ever be a reality, one, but also didn't think we were getting compensated for. That's really on us, on the whole industry to make sure that the terms and conditions are reflected in the price. Yeah. At one extreme, you could say, well, if I make the terms and conditions so tight, I don't really need a whole lot of rate increase. The flip of that is, well, what's the client actually buying?
They want to buy something, they want to get coverage. It's finding the right balance between the price and the terms and conditions. Our view is that no question, our results over time will reflect a bit more than just the rate and environment, because terms and conditions will make our results even better as we continue to tighten the terms and conditions.
Okay. The next polling question we have is, I guess the audience expectation for ROE in 2021, either 7%-9%, 9%-11%, 11%-13%, or above 13%. It seems like the favorite is 7%-9%. About evenly split between 9%-11%, 11%-13%. I guess my question on that is, maybe your reaction and if you could put into context ROE and meeting your cost of capital.
Yeah. Cost of capital certainly has come down over time. Then we can ask investors what type of returns they're looking for. Yes, lower than what it was. I think the days of producing a 15 ROE is probably, I think, maybe a bit ambitious. It's a difficult thing to do, especially when you're not earning a whole lot on an investment side. Yeah, in terms of the polling, I'd say, yes, it seems about right. We'll see how the renewals, how they play out, and there's still a lot to go to know for sure how 2021 is going to play out.
Certainly if there's another round of rate on rate, if there's a good momentum in 2021 and that gets earned and reflected in the premium base that we earn in 2021, yeah, I'd like to think that we can get close as an industry to double digits. Still I'd say a bit early to know for sure how that's going to play out. We still got a few months until we have visibility on the rate environment. So far, I think the view of the audience seems to me seems reasonable.
Okay, great. Maybe that's just a good lead in for capital management. Before getting into that, maybe just to address the elephant in the room. There's, I guess, some talk about Watford Re and a consortium of buyers that Arch has led for a $500 million buy. Can you share any comments if this is part of your plans?
No plans. Really no comment on this kind of story that popped up last week. As you know, Watford's, we have a relationship with them, and we have discussions with them on an ongoing basis. In terms of us acquiring them or any consortium is, I think is speculation a little bit at this point. We'll see what the future holds.
Got it. Fair enough. If I may, it would be helpful if you could share your perspective of the strategic value of being a major shareholder and reinsurance underwriting sponsor of a hedge fund re. Maybe you're fleshing this out, to what extent is Watford Re more than just a source of fee income?
Well, the whole Watford story to us has always been about being relevant to our clients. That was certainly a key reason of why we were involved in the formation of Watford Re. There's been a transition over time to be relevant, to be able to provide meaningful solutions to our clients. Having access effectively to a third-party capital base such as Watford was helpful, was very meaningful to us. We were able to enter into many transactions where we were just able to step up and provide a meaningful amount of capital to our partners. That's always been the story. Yes, there's an angle around a source of underwriting fees for the services we provide, but it's much more than that. It's very much around being in the marketplace and being able to serve many needs at the same time.
We still, yes, the hedge fund remodel may have some issues. Those have been made pretty public, I'd say, across many different forums and magazines and articles. Fundamentally, we still believe in the model very much in the way that it provides us access to another source of capital that we can deploy in the marketplace, and making Arch just a much more important brand, a much more meaningful source of capital to our partners. Again, things have changed, evolved over time, and you could debate the merits of having an aggressive investment strategy to go with an underwriting strategy. Still, that said, the source of capital for us remains very important.
Yeah. Got it. I get the sentiment that us offering a second balance sheet may help you win business. Maybe if you could remind me if you have a quota share arrangement between Arch and Watford, just to add to that kind of strategic relationship.
Yeah. It goes from day one. It was very important that we demonstrate that there was alignment of interest. They were absolutely every piece of business that we write, either directly on an Arch balance sheet that gets reinsured by Watford or vice versa. We participate both in some varying percentages, but we always have alignment of interest because we participate on everything that they write. There's reinsurers in place there.
Got it. All right. Maybe now on some more traditional capital management questions. Arch's capital base has been bolstered by your $1 billion of senior debt raise at the end of the second quarter. At the same time, at the start of the pandemic, Arch has paused its share repurchase activity through the remainder of 2020. Can you share what factors you're considering to make a better determination of share buyback resumption?
Well, that's an ongoing discussion, right? It's something we just wrapped up board meetings last week. It's something that we do constantly. It's part of our day-to-day conversations. At a high level, no question that back in March, like many others, and I think we were very uncertain around what the future held for us, so we felt that the prudent thing to do was to hold on to as much capital as we could, because we just didn't know how the pandemic would play out. That was really, I'd say, the first step in the process, holding on to a bit more capital as a defensive measure going into the pandemic. Then we realized, and we had some thoughts anyway before then that the second half of 2020 and 2021 we thought were going to be better markets for us to deploy capital.
We just decided to act on it late in the second quarter to access a bit more capital to deploy in the marketplace. Not knowing what the conditions would be like in terms of capital raising in the second or third or fourth quarter, we just thought the timing was appropriate for us to raise $1 billion. Happy we did it, and on pretty attractive terms. Here we are, we've already deployed some of it in the business, but the mission really for our guys is to look for opportunities to deploy more of that capital as we enter 2021. We think the market will be there for that. If it's not, we'll reevaluate everything we do around as part of our ongoing analysis of share buybacks.
If we can't deploy the capital in the business, then we'll be more than happy to return it to shareholders. At this time, not having all the details in front of us, but we'll have more visibility into that later on this year. We'll be active either way, whether we deploy in the business or return it to shareholders. That's our number one mission, is to be efficient capital allocators and I don't think that'll change going forward.
Got it. I guess one factor you did touch upon in your capital deployment is your MI experience, which looks like it's been faring better than expected. How much pause on your capital deployment is attributable to the MI book?
Well, certainly a lot of it. No question that early in the pandemic, we went into the pandemic and we didn't expect it was going to be a pandemic, but we had been very comfortable and confident that our underwriting and the business model we had for the mortgage group was as good as it turned out to be. When people started asking questions, "Are we back to another repeat of the crisis?" Right from the start, we knew that it was a totally different situation and we had a lot of confidence that it would not play out to be as bad as what it was 10, 12 years ago. That said, it was still new and government intervention, there's a lot of things that took place that minimized the losses to our industry.
Because of the uncertainties, that certainly forced us or made us think a bit harder about share buybacks, and that certainly contributed to the pause or the fact that we stopped buying back shares at the end of March. Since then, we've had a few quarters of positive signs. We're not over the hump yet. This is by no means a done deal, but we are certainly more optimistic that things will work out well or won't be, and we said it a few times, we think it'll be an earnings event and not a capital event for us, and we still believe in that very much so, and maybe even not much of an earnings event.
Again, time will tell, but if we keep getting more and more positive signs that the mortgage industry is going to perform well, even through the pandemic, then it'll give us more reassurance that we can be even more active around capital management decisions.
Got it. I think we touched on the buybacks, but I guess just given the optimism on pricing, to what extent would you be preserving capital versus deploying underwriting capacity in areas that meet your risk-adjusted return hurdles?
Well, not every line of business is at the level that we would like it to be, but it's getting more and more at that level for many of our lines. There's a few areas still that we need more rate to really deploy a ton of capital or be very aggressive in those lines. At a high level, I'd say that we have the capital we need now to be able to deploy, to be as active as our underwriters feel they want to be or can achieve the returns that we demand of them. We have the capital to do that for the foreseeable future. If it ends up being that 2021 gets to be even better or harder than we think it may be, then we'll see how much capital, if we need additional capital.
For the time being, we feel we're in a good position to go through the next few innings of the pandemic, and we think we've been relatively prudent in terms of reserving and what it means for us on the P&C side. Hopefully, the mortgage keeps performing well, as we enter, again, 2021, we'd like to think we got lots of room for us to deploy a lot more capital.
Got it. What's interesting is that for P&C insurers, they actually take more risks on the liability side than the asset side. If you look at your earnings track record, investment income eclipsed underwriting income, excluding CATs and PYD. I'm just wondering, given the unprecedented near- zero interest rates, do you think you'll get to the point where underwriting income becomes a more meaningful contributor to earnings?
It has to, no question. It's something that you could generate relatively reasonable returns in the last few years if you adjust for CATs and PYD with certainly. It's been a soft market, so not nearly as good as they need to be in the long term over the cycle, but still, I think people were able to produce reasonable returns basically on the heels of investment income because underwriting returns really haven't been there. Now that investment income is, we feel, is going to be depressed for the foreseeable future. No question that underwriting income has to step up or has to be the main source of income across the group, and we're not alone in that.
I think all companies and maybe some companies are. I think companies that have relied even more so on investment income may feel a bit more pressure to adjust their underwriting model to generate those kind of returns from the underwriting side. Yeah. No question that across the industry, underwriting income has to become a more meaningful part of the picture.
Okay. With that being said, how many points on the combined ratio would you need to get there to make up for that difference?
If you do a typical line of business and you say you write that 1 to 1 and maybe some lines you write at less than that, depending on the leverage you can employ. 1 to 1 and you're saying you're losing even if you're losing just 100 basis points of investment income, over a three-year duration, there's your math. It's at least three points of underwriting on the combined ratio that you have to find. Well, you have to find it in the combined ratio if you're just and yes, there's taxes and everything, but big picture, it's a material difference that has to be made up.
In some lines, we are making it, and that's why in others, we're saying, yes, the rate improvement is there, but we feel it has to be even more pronounced for us to really make up not only what's been lost in prior years in terms of underwriting profitability, but also make up for that loss of investment income we've seen in the last six months.
Got it. Just going to remind folks to submit questions, hopefully I'll be taking some questions, but I'll warm it up and continue asking from my prepared questions. Maybe just shifting from the earnings side, underwriting earnings side on low interest rates to your investment portfolio. How does low interest rates reshape your asset allocation posture?
Well, it's a difficult game, right? We at Arch have always said, listen, we're an underwriting shop first, and we like to enhance our ROEs. Our view is that we can enhance our ROEs by providing with the investment side and generate some additional income or returns from the underwriting side. We never really relied in a material way on the investment side to really produce superior ROEs. It's been an underwriting game for us, and that remains so. There's still a basic minimum of investment income that we need to generate. Now in the old days, we could easily generate that with a pretty vanilla investment strategy of treasuries and corporates, high quality investment grade, and you'd be there. Now that feels that it's even harder to do that with those types of basic investment instruments.
We're trying to, and we have to, and I'm sure others are as well, we're trying to be a bit more open to alternative types of investments. It doesn't have to be necessarily long-dated, PE-like investments. It could be there's some credit strategies out there that have a bit more structure where we can still generate a fair amount of investment income but generate a bit more yield as well without being locked in for an extremely long period and not having any kind of liquidity. It's a balance, I'd say. We're, again, more open, more on the lookout for those kinds of opportunities. Recognizing that bottom line and ultimately for us, underwriting has to drive it, and investments is there to help us out along the way.
Got it. Let's talk about alternate capital. I don't even like using that term. I like to call it third-party capital because it's really permanent, here to stay. There's a lot of talk now about that third-party capital being trapped, or like to call trapital. New capital is coming in. Do you think that it's going to reload the trapped capital, or is this new capital really going to be incremental to the overall mix?
That's a good question. I think the trapped capital, I think there's been movement, certainly. I think some of the investors in alternative capital ILS funds have been, maybe some of them have been disappointed in the performance of some markets in the last few years, and they're reassessing the value or the partnerships they have in place. I think there's certainly been a movement to better or high-quality houses to partner up with. That's something that I wouldn't say necessarily is people pulling out. It's maybe just a shift in where they're deploying their capital. In terms of the new capital, yes, there's a lot of speculation, I guess. There's a lot of people that are interested in entering the space at this time. It feels like it's an opportune time to deploy capital in the P&C insurance industry. We'll see how that plays.
We haven't lost a whole lot of capital, I don't think, as an industry. Yes, there's COVID and some of the bigger companies have taken on some material, pretty large losses. If we agree or if we assume that COVID's going to be $50 billion or whatever, and then there's still nat cats that it's been an active season so far, there's more losses to come on that front. At a high level, I think the industry is still, in terms of capital, is pretty healthy. It's not like there's tons of opportunities, I think, for new entrants to come in and deploy a lot of capital that has vanished. I think the capital base is still very strong.
As people think about new vehicles or new ways to deploy capital, I don't think it'll make a big difference in where we're at today, because most of the established players are still pretty active in the space.
Got it. Maybe moving on to MI. Arch's mortgage delinquency rates are trending near 5%, and it is lower than what you had expected in the first quarter. How much do you cautiously attribute this better than expected trend to the pent-up demand in housing versus government stimulus measures?
Well, it's hard, right, to know exactly why it's doing everything better. No question that, again, as I said earlier, we were comfortable that our book would perform well in an adverse or in a stress scenario. The reality is, on the early days, unemployment spiked up quite rapidly, which is something we look at and has an impact on the performance of the book. Although we realized relatively quickly that unemployment did not affect our book of insureds as bad as maybe the broader population. That's something that I'd say worked in our favor. I think we take some credit for that because that was considered in our underwriting.
For sure, the reality of a strong housing environment in terms of good demand and home prices going up had a reasonable, if not even maybe higher than what people expected or what I saw coming, works in our favor. That's always something we've said from the get-go is home prices are by far the most important variable in the performance of the book. If people have equity in the home, they find a way to either make their payments or at least there's, for them, an opportunity to sell the house without realizing a loss. That's something that we've known all along, and it's actually playing out very strongly in the last few months.
There's reasons to believe that the people that took up forbearance, signed up for forbearance plans will exit those plans without really being delinquent. We'll know more in the coming months. For the time being, I think we're pleased that it's been a somewhat stronger than expected housing environment across the U.S.
Got it. This conversation just flew by. We only have about a minute left, maybe I'll just put you on the spot, François, and ask any type of bold predictions for 2021, either for Arch or for the industry.
Well, we're bullish. I think across all three of our segments, we see the market coming to a realization that the business has been underpriced. I think the buyers, the sellers, everybody realized that there's more risk out there, ultimately that creates a bit of fear in the system, which we think will give us the ability to hopefully enjoy a solid, if not, we don't like to say hard market like you do. I would think it's a taboo word, but it's an improving marketplace, we'd like to think that it'll be there with us for 2021 and beyond. We like to think it's there for a solid-