Hello everyone, good afternoon, and welcome to the next presentation with Arch Capital. We are pleased today to be joined by Marc Grandisson, CEO, François Morin, CFO, Don Watson, EVP Financial Services and Head of Investor Relations. I want to thank the three of them for taking the time out today to be with us. The format today is going to be a fireside chat with Q&A. If anyone is listening online and would like to ask a question, please send that to me. It is Elyse, E-L-Y-S-E dot Greenspan, G-R-E-E-N-S-P-A-N @wellsfargo.com. I will kick things off. I think very topical these days for investors is just the impact of COVID-19 on the industry, and obviously that impacts many different businesses throughout Arch. Maybe if we start on the property casualty insurance side of things. We have been hearing about this being the largest loss ever for the industry.
I would be interested to get your views on this topic. Do you guys have some thoughts, recognizing it is still a fluid situation, given your presence on the primary and the reinsurance side, how we could see this loss transpire into both primary as well as certain percentage of losses that might hit the reinsurance market?
Okay. Elyse, this is Marc. Good to hear your voice. Hopefully we get to see each other at some point in 2020, and thanks for everyone dialing in and listening to us. I will start, I am sure François will complete some stuff I may be missing. This is truly, as everybody knows, a significant loss. Pretty hard to pin down what the size of loss is for the industry, because I do not think that we have a really clear, obviously, picture as to what and what lines of business it will impact and how widespread it will be. Finally, and not insignificantly, how long it is going to last. The longer it lasts, obviously the deeper the impact will be. It is hard for us to see what the size of loss is.
I think there is a couple of more immediate or the early stages of loss indication were easier to identify. One of it is the contingency market, obviously, that people talk $15 billion-$20 billion, I think sizable loss. Obviously, it is a small market in the grand scheme of things, but concentrated with really exposed to those kinds of events. It is a little bit, quote unquote, easier to identify. The rest of it is finding its way through the market. From our perspective at Arch, which is probably the best way for me to start talking to it because we have a little bit more visibility on this one ourselves. The initial numbers that we came up with for the first quarter had to do with I will run through at a high level, not the numbers, but the areas.
Some BI exposure from a very small portfolio in the U.K., which did not have a virus exclusion. Some Canadian program that had some kind of cancellation related coverages, some trade credit exposure. There was also some surety initial loss, but nothing really to speak of that was solid and concrete. A lot of it had to do with sort of built on expectations that the results for the remainder of the year will be a little bit more and a higher loss ratio as we go forward. On the reinsurance side, this is where trade credit came in. On the property cat side, I think it was too early. It is still quite early to see how the losses will accumulate, and if they do, whether they'll be recovered from the cat XL or the excess of loss protection treaties that were in place.
It's a little bit clearer on the quota share basis. If you're a reinsurance company and provide quota share protection to insurance companies, these transactions tend to follow the fortune of the client, and we tend to have a dollar, a pari passu, sort of equivalent recovery. In terms of our U.S. exposure on the property side, which is probably a bit more interesting because of all the legislative pressure or shall I say headlines in the papers. We have said on the call, and we want to emphasize it again, that 98% of our policies have a physical damage specific, direct physical damage coverage, and 94% plus of our policies have a virus exclusion. It also reflects the kind of business that we write. I think that the larger risk around the world, the larger cedents around the world probably have wider, broader coverage.
On the insurance side, we tend to focus on a smaller side of the risk, the policies are probably more standardized. A lot of them will have an ISO or an equivalent standardized language with some virus exclusion or indirect physical damage. For the rest of the portfolio that could be impacted in the U.S., workers' comp, for instance, is a good place to look at. Also including some other property business that we have written that did not necessarily have virus exclusion, we would be excess of the business interruption sub-limit in large parts on the property side, and workers' comp were also excess. From our vantage point. It's really as a result of our defensive posture for the last five or six years.
We will have losses, obviously, like everyone else, but we believe that our portfolio is a little bit less representative of the broader marketplace. This is just by the design of the portfolio. There's no foresight as to what COVID or COVID type of event could create into our portfolio, which leads me now to say, well, on the front, in terms of industry, my belief is that this loss feels more like Sandy than it does feel like Katrina, because in the sense that it's a large loss, and it will probably affect companies disproportionately. Not everyone will have an equivalent market share that you would ascribe to it under regular cat circumstances, which makes it a lot harder for all you guys to evaluate.
Certainly for us as a provider of reinsurance, some clients will have more exposure than others, and it will create a lot more uncertainties on the numbers that we'll be generating. In terms of the split between insurance and reinsurance, I would say that my expectation is that the insurance industry in the U.S. will take a larger share, and it's really as a result of the last 20 years. The insurance companies in the U.S. have had higher and higher retention. They're a lot less reliant on reinsurance, much to the chagrin to a lot of our reinsurance underwriting teams in the U.S. I would tend to think it's 60/60 on much more exposure on the insurance side than on the reinsurance side. I think internationally it's the opposite. I think that international companies have been historically buying more reinsurance at probably a lower level of attachment.
I would expect overall maybe a 50/50. This is, again, Elyse, really early, really high level with, granted, based on the portfolio we have, not as well-informed as perhaps the other big participant in the marketplace would see. On that note, I'll turn to François if he has more comment to add. I guess not.
Nothing to add, Marc.
As far as I know.
That's very thorough. Thank you.
Sure.
Maybe shifting gears and sticking with COVID from a different angle to your mortgage insurance business. That's obviously been a very profitable business for Arch through the years, and we're obviously heading into some uncertain times. You guys did lay out at least an initial outlook for the impact that the economic slowdown could have on that business on your last earnings call by effectively saying that there would be minimal underwriting income for the balance of the year. Just a few questions, I think, just to get some clarity surrounding the assumptions there by just realizing, obviously, that everything is fluid. If you could just maybe give a sense of the delinquencies versus actual claims that you guys are assuming within that projection.
Could you give a sense of the severity associated with the losses that you're thinking right now, recognizing that obviously it's an ongoing situation?
Yeah, let me start. I think what we're trying to tell people effectively is for 2020, we just expect a spike in delinquencies. I think it's just with the forbearance program that's in place and just the severity of the unemployment rate or how quickly that's transpired and what we think it means for the economy in the short term, at least. The reality is we do expect a fair amount of delinquencies to be reported to us starting in Q2, most likely there'll be more in Q3 and Q4. Just based on the accounting rules, we'll have to set up case reserves for those. Now, many of these delinquencies will be under forbearance programs, which means that they're effectively protected for a year. We can't pay a claim on those for a year. They can't be evicted. They can't be foreclosed on, et cetera.
What we're just seeing happen in pretty much for the remainder of the year is effectively just a surge in delinquencies. I'd say not much else at this point because we won't be paying claims. That will take time. That will probably be into 2021 and 2022. To answer your question, Elyse, around what's the scenario is, what we're thinking, delinquency rates could, at this point, could be in the 15% range. That's really what's at a high level underlying our projection of no underwriting income for the remainder of 2020 for the mortgage group. So far, it's very early, but the indications, and there's weekly statistics that get published, it looks like we're not at that level yet. That's at least somewhat encouraging, we're not, again, very early, not sure.
We're not ready to change that forecast, certainly not until the end of the second quarter. That's how we think about it. If the economy, depending on how the economy recovers, whether there's any recovery in the fourth quarter, or if it only really gets going in a meaningful way in 2021 and what it means for people getting their jobs back and whether they can actually exit the forbearance program our plan and with income and just being able to become current on their mortgage loans. We'll see how that plays out in 2021. At this time, we've done some modeling, we're pretty comfortable that it's not going to be, we said it on the call, it's really just going to be an earnings event for us and not a capital event.
I'll stop here and maybe Marc wants to chime in or Don.
The only other thing I would add to this is, in the call, we're not trying to ascribe any accuracy per se, because it's so early. Even three weeks ago feels like a lifetime at this point in time as we look back. We're trying to get a gauge or an evaluation, a rough idea as to what could happen and what it could look like. We had independently looked at some of our modeling and looked outside for third-party modeling that Moody's had put together, we felt that one was roughly in the same areas as the one that we would expect, generally to be, at that point in time, a nice expectation.
Based on that one, we said, "Listen, based on that one, this could be some volatility from quarter to quarter." Ultimately, when everything is said and done, because as you know, Elyse, mortgage insurance takes a long time to develop, both on paid claims and getting premium, that we felt, yeah, this was an S-3 that we call about. This was a level of pressure on the system that we felt was indicative and a good place to start from the prudent perspective. Even on that basis, we think, based on the modeling we made, there are always scenarios where it could be deviating from it. We felt that it was a good place to tell you that, well, don't expect much earnings or income from this year from the book of business.
Yeah, sort of puts a nice little ring fencing around what, at that point in time, we thought the losses could develop like. Since then, I will echo what François said. The forbearance. You saw the MBA had a survey, came out last week. We had Black Knight, I believe, late last week. It's a 6%-7% range of forbearance ratio. I want to put in perspective the 15% that François just mentioned. At this point in time, it looks like it's a little bit less. We're ramping up a bit less rapidly than we expected. Remains to be seen if it holds back, if it holds there.
The one thing I would also tell you, which is of interest to us, obviously, is that the 6% or 6.5% that is now at a forbearance rate, a third of those folks are still paying their mortgage. It's not technically delinquent, even though we receive them as forbearance, they are not technically delinquent because they're still current. The true, quote-unquote, forbearance number is close to 4%, 4.5%. It makes us feel a bit better, but it's still early, like I said. Really, the S-3 on the call was an attempt to put some kind of rough range around as to how bad it could get.
That's helpful. Maybe just one quick follow-up just to try to kind of ring-fence the outlook. You guys on the call also pointed to the fact that as furloughed workers go back to work, we could see a good percentage of these loans that become delinquent actually cure. When you came to your outlook for the next three quarters, are you assuming any significant cure rate? Or if it does play out, that a good portion of these notices actually cure, that would more come into your results in 2021?
I'll let François add a little bit. Just quickly, Elyse, the problem with the modeling is beyond the fact that there's a lot of uncertainties and not even including the government intervention and all the various ways they want the servicer to remediate all these forbearance as they come out, possibly, hopefully out of forbearance, is that the forbearance could stay there. People could choose to be on a forbearance for six to eight months. At that point, we won't be able to take it down until such time as they come out of forbearance and become current again, which could take a little while. We'll have a little bit of an in-between period where we have to let the forbearance come through.
Maybe some become delinquent, some stay forbearance as a forbearance claim, then it'll take a while before we see it evolving and ultimately resolving itself, either way, being cure or becoming a true delinquency the way we understand it, eventually makes its way, even itself, possibly carrying down the road or also becoming a claim ultimately. François, you want to say some few words?
No, exactly what I was going to say. I think it's a bit of an unknown here because forbearance programs are, for some people, maybe a bit of a free pass. It's hard to know how people are going to exactly behave. You read articles. I read an article this morning where people, I guess, were put into forbearance programs without their knowledge, that prevented them from buying a new truck, and they didn't like it. There's a lot of secondary kind of implications that will have to get resolved over the coming months, we just don't know. I think it's hard to be overly precise with forecasts of when the cures are going to show up by quarter is becoming a bit early. It's a bit too precise, or we don't have the precision at this point.
Okay, that's helpful. Shifting gears a little bit because obviously, there seems to be an emerging Hard market in many areas, the property casualty sector. Maybe if we first want to just touch, come back to your insurance business, just touching on that from a couple of angles. Just the pricing opportunities you see emerging and not to make it a two-part question, but at Arch you guys are really focused on getting that business to a mid-90s underlying margin. You guys got pretty close in the first quarter, I would imagine with some good pricing momentum, that could probably help put you at that target.
Yeah, I think it's a very fair statement, Elyse, we've been working hard at improving things for ourselves operationally, underwriting-wise, and all the things in between. The market is also very important, right? The market has accelerated the momentum in price increase. You've heard it everywhere, and we've seen it ourselves, and we continue to see it on the insurance, now it's catching on in a little bit bigger way on the reinsurance side. I think you're right. I mean, for the same amount of risk that you write, forgetting COVID for one second, because that will create a bit more top-line volatility in terms of premium earnings and written for the next probably year.
Everything else being equal, which never is, I know, everything else being equal, if you're at 100 combined ratio and you're getting a 10% increase, your combined ratio will go down significantly as a result of that. The one thing I will be cautioning everyone, though, is combined ratio is one dimension on the return on equity basis, which you know, Elyse, we're very keen on. At the same time, the pricing is going up, the interest rates are going down, that also put a little bit of a dampening on our return. In a 95 combined, which it would be a nice place for us to be, but it would have been a nicer place to be when interest rates were 2.5% to 3% for the five-year as it is right now, less than 1%.
The 95 ain't what it used to be, as some people say all the time. I just want to make sure we I guess the point to us, it's always about seeking and getting to the place where the returns are where we want them to be, or we would want them to be to right a bit more. As a result of some price increase on insurance and reinsurance, you saw our increase in written premium. I think that tells the story more than anything else I could tell you on this call. The fact that we're growing our top line is a great indication at Arch Capital Group that we are seeing returns improving to a large extent. François, anything else you want to add?
Nope.
I guess maybe to put in a little bit different perspective, just sticking still with reinsurance for a second. Does this feel like we're approaching one of the better reinsurance markets since Arch has been around, or is there another time period that you could compare this market to, just so we could get a full sense of the opportunity you see out there on the insurance side?
Yeah, I think some folks out there have seen it, I feel the same way. If you ask our underwriting team, I think that it feels a little bit like after 9/11. I mean, two terrible events, COVID and 9/11, obviously, creating a lot of uncertainties and the heightened risk perception, which is really what moves markets, right? Losses can move markets, oftentimes they don't. We've had a couple of cats over the last 10 years that did not move the needle either way on the pricing. I think that this one is different because it's, again, another non-modeled loss. We've had so many of those, it's sort of another one that you add onto the pile, it creates more uncertainty. What it creates is risk uncertainty on model losses.
You don't know, you heard me say earlier, we don't really know how it's going to develop and which line of business it will impact. In this case, it looks like World Trade Center, that it will impact way more than we could imagine, it's much broader, much deeper in terms of what lines of business it's impacting, which creates a little bit more anxiety, if you will, if you're an underwriting or a provider of capital or a board of director. It feels a little bit like 9/11. We also had a little bit of momentum building as we had in 2001. An event occurs that really pushes the, not things over the edge, because it's not a great analogy, but really pushes things a step further, maybe a bridge too far. People say, well, at that point, let's take a breather.
Let's take a step back. Let's reevaluate what we have. Let's rethink the way we price and provide risk to the marketplace. That was very similar to 9/11. Very much like 9/11, I was there counting all losses when I was at my prior job, it was very difficult to evaluate. It was very difficult to understand. We didn't have clarity or visibility. It took two, three months. 9/11 was done in a day, right? The losses occurred in one day, we started counting it. This one is ongoing. We don't know when it's going to end, we don't know the intensity. I would even argue it's World Trade Center, like a slow developing World Trade Center. It feels like this, which to me indicates a few things.
Unfortunately, some of our competitors may have booked a business that are overly exposed or not properly protected or not enough protected, which will make losses become capital events and will create probably more extreme or more striking reactions from their underwriting. It will take a while to develop. Again, I'm sure, Elyse, I'll sit here, and François will sit here with you in a year from now, and I'm sure we'll have discovered some other thing that has happened as a result of COVID-19 that we did not foresee. Everything else indicates that we're going to have to severe reprice of the capital. No more people are going to be accepting 6% or 7% return. I think there's a recognition that we need to price better. We need to provide the coverage better.
We need to know and be a bit more careful in the way we provide capital to the marketplace.
That's helpful. Maybe shifting gears a little bit, getting more into reinsurance. We've heard, seems like there is some pretty good pricing momentum within the Florida market. We're obviously a few days away from the 6/1 renewals. I've also heard that there could be a good amount of trapped capital related to COVID, which could have an impact on reinsurance, I would think, heading into 2021 and the January renewal. Just have kind of a short-term June 1 pricing view, and then how you think reinsurance market can play out heading into 2021.
We're not a big cat player, as you know, Elyse, it's one of the lines we do. It's a very profitable line for us, and I think right now we're seeing rates getting even better than I thought last week. This is a really fluid marketplace, Elyse. It's moving almost daily. We're for the first time hearing with one anecdote I shared with some of your clients earlier today that a blue-chip company buying a cat cover, has done it for years and years, was overplaced, no issue placing it for the first time in years, had to do a shortfall because it was missing capacity to fill the gap. That's a strong indicator of distress or stress on the part of the traditional reinsurance marketplace.
That's a good sign in terms of this market is not as reliant as it was once late 1990s, early 2000s on the retrocession market, but certainly the alternative capital being satisfied or being comfortable with its 6% or 7% return had helped. I would argue temper, or at least put the rates down and somewhat tempered them down for a while. I think that's going to go away, and that capital is one for one. There's not much diversification to that capital. That trapped capital not being there to support the overall cat market or being there at a much higher increase will push through the supply chain of capital, further increase as you go down the supply chain of capital. We heard that 50% of capital will be trapped as a result of that event. We'll see how that shakes out.
There's still capital available out there, though. There's still people wanting to get into the business. I think that there's still some need to assess, evaluate what's happening before we have a significant amount of capital coming in from the alternative side I'm talking about now. Because they've been burned once, if not twice before. There's a healthy level of skepticism and pragmatism from their perspective. Everything is indicating an ongoing hard market and very tightening of terms and conditions. I would even argue that clients tell us on the reinsurance side, Elyse, that they're going to probably buy more because they also have more risk. They feel more risk. They feel a bit more exposed. Shrinking of supply of capital with increased demand, you've done microeconomics, Elyse, that means price should go up.
That's helpful. I think we have time for one last question, maybe to, in a way, tie it all together. You guys started off by saying COVID is an earnings event and not a capital event for Arch. You guys did pause your buybacks with a whole host of other insurance carriers with earnings. It seems like that's more to help you guys play offense on the property casualty side. Is that kind of thought process be paying attention to when considering potential return to buying back the shares?
I mean, yeah. The share buyback pause, I'd say, we wanted to make sure we were able to assess everything that was in front of us. I think it's important for us to know all the exposures that we have, and even like Marc said three weeks ago, the world was a bit different. We weren't in a position to know everything that was in front of us. Thought it was prudent to just take a little bit of a break there. What's transpired in the last three weeks is improving P&C conditions. We want to have all the tools and toolbox available to us, and having a strong capital base is certainly one of those.
As we move into 6/1s and 7/1s and beyond, we want to be able to play offense as needed, and where we think the returns will be attractive to us, and that starts with having a strong capital base. We'll be looking to put that capital to work.
We have approached the end of the time period. Before we end things, do appreciate the mortgage update that things do seem to be better, what you guys had said on your conference call. Is there anything else you just want to make sure investors walk away with? Any kind of concluding comments, either Marc or François?
Not much other than we're pretty bullish on the P&C market. We think that our mortgage insurance perspective is still also a very important market. I mean, for the reasons that are obvious. We think we have a really good, solid credit base. The borrower base is pretty strong and it being w ell- diversified again, we still have a lot of reinsurance. I think the model that we rebuilt, and we're very happy. It's a resilient model that works out well for the MI, which allows us to seize the opportunity on P&C. We're pretty happy where we are right now.
Well, on that note, I want to take this time in saying to Marc and François and Don from Arch Capital, if anyone has any follow-up questions please reach out to Donald Watson within Investor Relations. You can also reach out to me if I can be of any help to you. I also just want to thank Arch Capital for participating today. Thank you. This does conclude today's webcast.
Thanks, Elyse. Thank you.