Greetings to everybody out on the line. This is Mark Dwelle, head of insurance research for RBC Capital Markets. I'm pleased to welcome everybody to the RBC Virtual Financials Conference. Let me start by thanking all the participants, both managements and investors, for their patience and support as we put this together. Big props to our conference team and sales for making everything happen in such a short period of time. We did some of these yesterday, and we had pretty good feedback, so hopefully today will be just as good. Given the number of businesses that are asking people to work from home and take other measures, probably there's somebody out there on the line who's sitting in their bathrobe listening to this right now. A coffee mug toast to those of you who are managing to pull that off.
Some quick rules of the road before we get into the main discussion. Online participants, please note that you can ask questions using the question box on the left side of the webcast browser. Yesterday, I noticed that there was a little bit of a lag on these showing up in my dialogue box, so don't be shy about getting those questions in there early. That way, they'll pop up on my screen so that I can get them asked straight away. Definitely want to try to make this as interactive as we possibly can. I'm going to lead off with a couple topics of general interest, and then we'll go to questions from the line or back to my question list as time allows. We'll call time at about 10:30. Joining me today, we have François Morin, who's been Arch's CFO for just about 2 years now.
He's been with Arch for 9 years in total. Before that, he was in the actuarial division at Tillinghast, which back then was part of Towers, and then it was part of Willis, and then it's soon going to be part of Aon. If you have any questions about the Bornhueter-Ferguson method or any other actuarial questions you've been burning to ask, maybe today is your chance. With that, let me get into the regular part of our show. Obviously, the question that's been on markets' minds for the last 2 weeks at least is the coronavirus, the impact that that's had on equity markets, impact on interest rates. Can you just talk for a minute about how these factors might impact Arch? Any direct exposures, lines of business that might be subject to claim, any indirect exposures, just how you're thinking about it at this point.
Yeah. Thanks, Mark, and thanks for having me today. I think everybody's trying to understand a bit more what's going on, and certainly it changes daily. Yes, for sure, that's something that we've been looking at, and actually had a board meeting last week and where we went through all those topics with our board. I will say from an industry point of view, I would argue it's still very early to know how things are going to play out, so it's hard for any one of us to come up with a definitive answer. Certainly, the one line of business that I think most people are in agreement on is around event cancellation, which certainly is a direct exposure that the participants in that market will probably be more exposed to early on. We're not a big player in that space.
That's generally more of a Lloyd's, London type of exposure, and we're definitely not a leader in that sector, shouldn't be a big issue for us at this point. We get into A&H travel. There's other lines of business that we could argue or know for a fact are directly linked to this pandemic or this issue. The one thing that is a bit of an unknown is whether there's edicts that come into play from governments and what that means to the contract wording, ability to travel. If you're not allowed to travel, do some of the travel policies get into play? I think there's a wide range out there of what it could be or what the losses or the exposure might be down the road for us.
I think we're certainly aware of it, but it'll take some time for everything to play out. Down the road from there, the indirect exposure could be maybe even more problematic for some companies. Again, very early. An example that we go back to is the healthcare industry. If there's misdiagnosis or bad treatment in some medical facilities, does that create liability exposure, et cetera? That definitely would take quite a bit of time to resolve itself. Early days still. As we all know, there's news that show up on our Bloomberg and et cetera every minute, every day, so it's a fluid situation. Quickly on the investment side, I think most companies, including us, would not be overly exposed to this issue.
Certainly, I think there's potential credit issues on the fixed income side, which with the reduction in the treasuries may offset a little bit of each other. We'll reassess that at the end of the quarter. We don't really have a huge equity portfolio. Yes, we'll take some hits there, but I don't think it's going to be a huge issue, at least at this point for the insurance industry, at least on the P&C side.
Yeah. That's helpful. I know at least in my conversations, and I think, yes, insurance companies have fixed income portfolios, and we'll expect to see some yield erosion over time as portfolios roll and so forth. The other side of the coin is that you all have big bond portfolios that are going to make substantial gains with interest rates as low as they are. Book values are going to go up and provide some additional capital cushion to the extent realized ultimately. There's a little bit of a natural shock absorber in just how all this unfolds. I feel like investors are focusing more on the downside of the future earnings than on the upside of the present book value benefits.
Right. That's fair. On that one, I think we will certainly be thinking about if we're not making the investment return, we should be making the underwriting income. Ultimately, as long as we make our returns in one shape or another, I think that's what we need to do. It will put some pressure and maybe make it for a more sustained improving pricing environment, which if not to say that. We all know that it's not always a perfect correlation, but as insurers reflect the reality of the lower interest rates and what that effectively takes away in terms of float and the ability to earn on that float, we should be looking to make those returns on the underwriting side.
Well, that's actually a good segue to probably my next major question that investors have is really just the pricing environment began to turn positive during the course of the second half of 2019. Several areas that Arch is involved in are doing pretty well. Some areas are still lagging a bit. What are you seeing right now? How are things continuing to evolve in the pricing environment? Are we still in the fairly early innings of the game? Maybe some updated thoughts in that area.
Yeah, we think so. Agree with your comments. We saw the same, certainly second half of third quarter, we saw good production, good rate improvement, good rate environment, which did accelerate in the fourth quarter. So far through the first quarter, we're seeing similar types of improvements. We're bullish on that front. I think it looks like it's going to be a good start to 2020. I think with what's been happening in the last week or so, I think that'll just provide even more juice or more impetus to sustain this positive environment. I think that's all good. We would have thought it would have been there with us for all of 2020. Whether it's sustainable for a longer period, time will tell.
This latest event, I think, will just be another reminder that there's bad stuff out there that can happen, and we need to remain disciplined in how we price the product. Some lines, even though property, for example, will be directly impacted by this event, I think collectively, we would argue that all of this pricing across the board needs to improve. Some more than others, I think there's hope that this will be with us for a bit longer.
There was a comment that came up on our discussion yesterday with one of your competitors, they had observed, insurance is a way that companies manage risk. When times are uncertain, that doesn't cause people to usually cut their coverages, certainly if related to an event that many people view as reasonably short-term in nature. If anything, it makes people look more carefully at what exposures they have and look for ways to do their own risk management. Who knows that we won't see actually some improvement in demand. Certainly nothing that would erode it in a major way.
Right. That's fair.
Okay.
The one thing that I would say, it's more on the supplier on, I think we've touched on it at other conferences and on our last earnings call. The one thing that gives us a bit of pause on how much improvement is needed in this based on what companies reported at Q4 and the general sentiment that things are improving, it's still related to insurance companies in general reporting fairly favorable results. There doesn't seem to be tremendous pain in the system quite yet, or at least on a published basis. That's the one thing that we still are trying to resolve or trying to connect the dots where some companies are reporting pretty, again, good, solid results, low 90s in terms of combined ratio. Yet they are saying that they're pushing for more rate.
That's the one thing that there seems to be a little disconnect, at least on a reported basis. Maybe they feel there's more pain that is yet to flow through the numbers, at this point, that's the one thing that we would caution everyone to think or say, well, how sustainable is this improvement? How truly is it sustainable given that we're not, at least in aggregate, the industry isn't short of capital.
Right
isn't really having seen a lot of adverse prior year adverse development. Yes, there have been CATs, we haven't had the really big, I'd say, capital event. We've had lots of earnings events. We put it all together, and that's the one thing that I think time will tell throughout as we go into 2020 how things are going to play out there.
I think that's an important difference relative to, say, the hard market of 2002 through 2005. There you had balance sheets that generally had sizable below the water holes in them, and it took several years to unwind that. While clearly some companies have had pockets of reserving issues, in general, the information systems are better. Companies have kept up closer along the way, have taken intermediate actions to not necessarily without pain, but I don't have the sense that anybody is particularly one bad CAT away from being capital stressed. It's really a matter of getting back to ROEs that are solid double-digit ROEs and acceptable to investors and return cost to capital. I think that's a very good point. Maybe turning over, I've got a question on the line which kind of aligned with one of the questions I was going to ask anyway.
You guys obviously, mortgage insurance is a big part of the overall portfolio. I guess, where are we in the mortgage insurance cycle? I would suppose interest rates going down as they have, that could actually be a little bit of a boost in the short run, at least for demand. Although, I guess there's credit and other pieces of the puzzle. What can you share there?
I think there's a lot of things working in our favor with lower interest rates. The one maybe goes a little bit against us is an elevated refinance activity, which we saw in the second half of. We'll see how that plays out. Certainly, in a lower interest rate environment, affordability is up. The credit characteristics, and again, considering that the unemployment rate stays really low as it is right now, I think we've got a lot of good demographics, again, working in our favor. People have jobs. They make their payments. I think work in our favor. One of the issues, though, that we want to keep an eye on for us is the supply of homes. As you know, entry-level homes is really our bread and butter. The first-time buyer that needs the product to afford his or her first home.
We're well behind the level of supply that we need to put everybody in homes. Just got to watch out a little bit for price wars or people coming up with a bit of elevating the price of the homes. We'll keep an eye on that, and we're fairly confident that things are behaving rationally in this environment. At this point, yeah, we're very bullish on how the housing market is looking and how it's performing.
No, it's definitely I don't know. I spent a lot of yesterday with the RBC Financials Conference, obviously the banks and things are presenting. Obviously, they have different issues because they have to worry about their net interest margins and all of that type of stuff. All of them are definitely expressing that there's demand for loans that people want to buy, view this as a good time to buy or refinance. As mortgage insurers, as long as the credit quality holds up, that's historically the big risk, not whether the volume is a little better or a little worse. Are the loan standards being maintained? I would think anyway, with interest rates at such low levels, banks have to keep diligent. They're not making much money in the first place on the loans.
They certainly can't afford a lot of credit loss when you let a mortgage go at 3%.
Absolutely. The other thing I'll add to that is the GSEs are very much behaving like they said they would. If in this potential evolution of their structure or their ownership or if they're serious about trying to go back to being public entities, they have to demonstrate that they're serious about credit and not taking on more than they're able to or want to price for. That also works in our favor. There's no pressure to expand or limited pressure, I'd say, to expand the credit box. There's always some areas where we're reevaluating things as we go, and I'd say that's just good business. To us, it's always been around the product, and if the product remains as it's been for the last 10-plus years without Alt-A and subprimes and all these types of bad loans, without income verification, et cetera.
If we remain solid at the front end with the underwriting, again, we think there's a lot of room for us to participate and then enjoy the robust housing market.
Yeah. No, I'm going to thank you, too. It was an unrehearsed segue. We've got Mark Calabria, head of the FHFA, is speaking on our conference at midday today. Anybody on the line, including yourself, that wants to listen in to his remarks, I'm certainly looking forward to it. That's another vector that could be potentially a positive for the sector. May I just throw out a quick reminder to those on the line, if you have any questions that you'd like me to ask, certainly pop them through using that question box in the left corner of your screen. Until I see my screen repopulate, I'll ask another one from my list. You recently did a deal to acquire Barbican Holdings.
We've seen a couple other smaller deals in recent years, the Aspen Re and the Binding and Insurance Specialty, the deal recently for the, I'm drawing a blank on the name, the political risk business. Maybe just take a minute and talk about. That's it. Yeah.
Yeah.
Talk about how you're thinking about M&A, what you're seeing, what kind of the strategy and thinking is with these deals.
I think we built out the three-legged stool approach a few years ago with the introduction of the mortgage segment. We've always felt that we were pretty much in most, if not all, of the segments that we felt we wanted to play in, and recognized that there's some areas we could do better. Ultimately, we were just always contemplating or looking for places that we could improve, either get scale or efficiencies, and improve our distribution. Certainly around Barbican, that was very much the play there, I would say. Two things that came to mind with that acquisition. One was around Lloyd's, as we all know, has had its struggles the last, let's say, 5 years or so, maybe a bit longer. An elevated expense ratio problem for most, if not all, participants in that market.
Maybe not enough sound or good underwriting at the front end, but in a soft market environment for sure. The 2 things that we liked about Barbican, one was it gave us a bit more scale, and they're bigger, and combining it with our existing syndicate just gave us a bit more scale, gave more relevance to the brokers, will give us the ability to lead on some programs. There's also some consortium business that we're leading, so that'll provide some fees. The other thing that I think is maybe just as important, if not more important, is the fact that they'd evolved their platform and their structure to really draw third-party capital and bring them in to support their operations or their syndicates. We were curious about that.
We feel that that's an area that we want to grow a little bit, leverage our underwriting expertise while relying on third-party, supporting or using third-party capital to support the growth and the business we're in. The fact that they'd done it in a good way, I think was intriguing to us. That was, I'd say, the second part of the proposition that we liked, and were able to reach terms with the seller, and here we are today. We're extremely happy with this acquisition. It was very much a strategic acquisition. It's still a bit early, but 6 months in since we announced the transaction in July, I want to say that maybe the improving marketplace is something that we hadn't fully baked into our projections. I think we may have some additional tailwinds that work in our favor on this one.
Thanks, François. That's a helpful update. Certainly, we'll see as time goes on. Between the fee income, the presence at Lloyd's, I think all of those are good extensions that could pay dividends over time.
Yeah.
I've got a question here from the line. This is kind of jumping back to the P&C pricing environment. The question is basically, are you seeing much activity from competitors exiting or curtailing certain lines of business? Is that creating dislocation that's an opportunity for you? Are you seeing any notable increases in just overall submission flow, particularly in some of your more specialty-oriented lines?
Yeah, I think people pulling out, I think there's been a lot at Lloyd's for sure, but I would say those have been typically smaller teams, and without the scale, without the presence to really drive the market. Not surprising. May have had a couple of bad years in a row of poor underwriting performance, then at some point, management teams decide to cut the cord and shut down some of those units. I think that happens throughout the cycle, now people that are seeing what kind of results some of those teams have generated, I think there's not a whole lot of options in front of them. Shutting them down is definitely one that we've seen a lot of over the last few months.
Going back, AIG and Lloyd's both really retracting or pulling capacity out of the market, which started sometime in 2019, second half of 2019 for sure, has been very helpful for us and everybody. I think it just helped us achieve a certain level of business being transacted at risk-adjusted rates.
From the line. This is a pretty interesting idea. Just some of the banks, and we've seen this in Italy, have talked about allowing homeowners a moratorium or a suspension of mortgage payments for a period of time related to coronavirus, of course. How would that work with MI? I guess you would grant that same forbearance, and it would just roll over, resume whenever the payment cycle resumed. Maybe it's too soon to ask. I don't know. Any thoughts?
It's happened with hurricanes. Maybe it becomes a national thing, but certainly in hurricane-hit areas, as recently as 2 years ago, the banks and the government or FHFA, et cetera, agree that they provide forbearance to the homeowners for 60 days, 90 days, depending on how long this thing lasts. I think it's early, as we all know, because maybe people are working from home, but they'll still get a paycheck. Production industries where people definitely need to be in the office or in the shop to produce a product, maybe the trade slows down. There's less production, maybe people get laid off for months. Who knows? We'll see how that plays out.
That's been done in the past, so not for us to decide who and when these things or programs may become declared, but it wouldn't be a total shock that they get it down the road.
Right. Okay. Well, that's helpful. I see from the clock that we're getting to the top of the hour, or the half of the bottom of the hour, I guess. This isn't the PNC clock. It starts at the bottom, not at the top. With that, I'm going to take the opportunity to thank you for participating. Everybody will give virtual applause at this point, wherever they all are sitting. We look forward to catching up with you again at first quarter earnings, if not before. Thanks very much.
Thanks, Mark.
Thank you.
Thanks for having me.
Indeed. Thank you for your participation. This does conclude today's program. You may disconnect at any time.