Good afternoon. I'm Tracy Benguigui, insurance analyst at Barclays. I'm pleased to host our Fireside Chat with Palomar. Our speakers are Mac Armstrong, Chairman and CEO, and Chris Uchida, CFO. We have a lot to cover. I'm going to kick it off to Mac for some opening remarks.
Terrific. Good afternoon, all, and thank you, Tracy and the Barclays team for hosting us today. We're thrilled to be here. I am Mac Armstrong, the Chairman, CEO of Palomar Holdings. We are a specialty insurer based in La Jolla, California, and I'm joined by our CFO, Chris Uchida, today, as Tracy pointed out. Palomar focuses on finding dislocated and orphaned segments of the insurance market, where we want to deliver and provide innovative insurance products that are built around analytics and analytics-informed underwriting, technology-enabled delivery, and thorough reinsurance. We offer our products on both an admitted and an E&S basis. Over the course of 2021, we have focused on four key initiatives that we believe will create value this year and more importantly, beyond. It started with continuing to drive very strong top-line growth, if not industry leading, certainly top decile.
I'm pleased to report that we have grown for the first half of the year over 50%, and including strong growth in nearly 30% for our bellwether earthquake business. Secondly, we have been very focused on building out our E&S company, Palomar Excess and Surplus Insurance Company. We launched that business around a year ago this time. It was in August of 2020. We have seen good traction. We are now on a $130 million run rate as you exited the second quarter, and that's a nice combination of property business as well as some new emerging categories that will diversify the book. Thirdly, we wanted to continue to enhance our underwriting efforts and our risk transfer efforts to ensure predictable and consistent earnings.
While these actions take time to manifest themselves, they do bear fruit, and they position us very well in the years to come. I think that's best typified by the fact that the combination of these efforts on both underwriting and reinsurance has allowed us to put an ROE for 2021 of 11%. We don't see a circumstance where the ROE this year is less than 11%, and obviously our goal is to exceed that considerably. Lastly, we continue to invest in systems, talent, and risk transfer, as well as new products to not only drive growth this year, but more importantly, sustain our growth for the indefinite future. That's really kind of Palomar, where we are today, where we're looking to go. With that, I'll hand over to you, Tracy.
Thank you so much. We're going to touch upon a lot of those themes. I did mention earlier our housekeeping comments. There is a question box you could hit, or you could send me an email, and we could entertain questions at the end of the session. We also have our audience response system. We're polling questions, and that's the survey button. I'll just read out loud those polling questions, and then we could revisit that later in the session as we get more responses. The first one, Palomar's gross premium growth was 54.4% in the second quarter of 2021. My gross written premium growth expectation for Palomar in the second half of the year is, one, above 50%, two, 30%-40%, three, 20%-30%, or four, below 20%. The second question is basically just an iteration of that.
It's the same options, just the growth expectation for full year 2022. We'll jump into the prepared questions. Again, towards the end of the session, we would love to take audience questions. The first question I have for you, speaking about your second quarter premium growth of 54.4%, how would you characterize the order of magnitude for each of the following premium contribution drivers? Was it really more rate increases, higher submission volume into existing business lines, greenfield operations, or underlying economic growth?
It's a very good question, Tracy. I think it was really a combination of those four categories. Obviously we grew very rapidly, 54%. Rate was a contributor to it, not as meaningful as it may have been for other operators. Rate increases for us on the commercial side of the business were in the mid-teens. Commercial earthquake was 14%. Our large layered and shared kind of builders risk business was around 21%. Most of the business is coming from exposure and new business. If you put it into a line like residential earthquake, we grew mid-20s. We only have a 5% inflation guard that kicks in year by year. It's really driving new sales, new distribution sources, as well as some new partnerships that are allowing us to grow in our largest line of business.
Our Hawaiian hurricane business, we doubled our policy count. That was a function of submissions as well as some rollover business that we acquired. Lastly, as we are the only A-minus or A.M. Best rated entity that's widing monoline hurricane Hawaii, we've kind of become the only preferred option or high-value option in that market. Greenfield is a contributor. A good example of that would probably be in some of the new partnerships we've done in the marine line of business or our real estate E&O. They're starting to make more meaningful contributions, those are still pretty nascent in terms of where they are in their development cycle. Underlying economic growth is probably the least impactful. That real estate E&O program is probably being a beneficiary of it's a $3 million run rate right now.
I think for us, it's really new distribution, new exposures, and rate are the primary drivers. It's the first three for us.
Got it. Yeah, you basically were saying a little bit of everything.
Yeah.
If we could also unpack higher submission volume into the non-admitted market, what is driving this ebb and flow at this point in the cycle?
Yeah, I think for us and where we are going, and the majority of where we are participating, in the E&S market right now is property driven. It's commercial earthquake, it's builder's risk and to a lesser degree, it's just commercial property or wind-exposed property. That tends to be more capacity pullback. I think for us, it's more capacity pullback from other E&S markets, maybe Lloyd's being one example. Another one would potentially be just a rotation out of the standard market by someone. I'll give you an example. In high-value residential earthquake, which we're writing on an E&S basis, AIG decided to pull back in high net worth homeowners in California in earthquake altogether. That's an opportunity for us to come in. Again, it's really more for us, capacity that's driving it.
Got it. What proportion of your policies do you write on inflation-sensitive exposure business? As inflation goes up, the premiums go up commensurately for that bulk of your policies.
At this point, not a lot of our business is written on a revenue basis. It tends to be more the structural value. The majority of what we're doing, call it 90% of the book, is property in nature. Only a handful would be tied to revenue or sales or head count. It's really a modest amount. What we are doing, and even in those lines, it tends to be more short-tail business. Even real estate E&O, and not to harp too much on a small line of business, but that tends to be even shorter tail business. It's not long tail like you might see for certain professional lines or workers' compensation. The short tail nature of our business really informs the inflation impact too.
Yeah, makes sense. Maybe just sticking on inflation, I mean, it also affects losses.
Yeah.
Did you have a view on whether inflation's sort of transitory or not?
Yeah. When you look at inflation for insurance products, it varies. There's COGS, your cost of goods. It could be medical inflation, it could be other, or it could be social inflation adjustments. Our inflation exposure tends to be more COGS oriented. For us, it's been scarcity of labor, and the cost of raw goods in particular like plywood. Because our, again, short tail property focus, that does somewhat limit our inflation exposure to purely just the COGS side. I think for us, it's probably a bit transitory, and not a long-term dynamic. It's certainly not one that over four or five years, the loss exposure could build because of the delay or the inflation associated with the indemnity.
It's very helpful. Let's get into your products and start with California Earthquake. As you mentioned, it's your bellwether product.
Yeah.
Are there any secular changes going on that may lead to more growth?
Yeah, Tracy, I think you and I have talked about this in the past, there are some considerable secular positive dynamics for us in earthquake right now. It starts with really the dislocation in the California homeowners market that's really being driven by wildfire losses. 2021 has remained a pretty active wildfire season. Fortunately, so far there's not been material structural damage, there has been some. I think what that is leading to is people continuing to want to pull out of the California homeowners market. When policies are non-renewed and there's an earthquake policy attached to us, we have been able to go after those policies and have done a good job of converting them.
Similarly, as member companies of the CEA non-renew their book, the California Earthquake Authority can only offer a companion earthquake policy to a member company or a member company insured. As the CEA companies participate in insurers non-renew their policies, they come back into the open market as well. That's been a nice beneficiary for us. That's led to strong partnerships, it's led to increase in distribution, and it's certainly led to new business sales. I think it's important to point out that that dislocation in the homeowners market is going to persist, certainly into 2022 and potentially beyond. The third thing that I would say is that I think the CEA is taking a hard look at its exposure and how much business it can take on.
It is the behemoth in the state, and I think their writings alone add up to the remaining nine members of the top 10 in the market. They have come out and stated they are exploring reducing their coverages and the amount of limit in their deductible options, and that's something that the APCIA has pointed out, and I think it's something that's up for discussion at the CEA's next board meeting. I think that's something that could be a good catalyst for us in the near term too, as they pull back their coverage or try to reduce their exposure.
That's very helpful. Could you walk us through the process of entering greenfield operations? I guess it started off on the catastrophe adjacencies, but now you're dovetailing out to casualty lines. Especially on the casualty side, these businesses are not commoditized. How do you feel about your underwriting bench strength, and how dependent are you on MGAs to underwrite your business?
Yeah. Let me start by saying we're very excited about the casualty initiatives that we have underway, we have made considerable investments, and particularly on the talent side, to help us execute those plans. Because you are right, there is a specialization in a line like professional liability or excess casualty. What we are trying to do is find underwriting talent that we can bring in-house, that we can bring operational expertise behind them. That might be systems, it might be reinsurance acumen, it might be distribution relationships. What we're going to want to do is allow these new leaders to develop their products, capitalize on market trends that are dislocations, where we have identified, and then again, bring those operating resources to bear behind them.
As it relates to the second part of your question on how we will use MGAs, I think we have developed a strategy that we have used in earthquake, we use in builders risk, where what we're going to try to do is develop an underwriting box. If we develop that box and we have these guidelines in place, we are somewhat agnostic on how we aggregate the business. We would work with an MGA, we'll work with direct retailers, we might work with other insurance carriers. That's what we have done in builders risk. A good example of that is builders risk is led by a gentleman named Robert Byerly. Robert writes that directly in-house through retailers and wholesalers. He's also partnered with other insurance companies like PURE to go out and target the high net worth builders risk market.
Similarly, he has developed an underwriting framework to put out layered and shared limits with Ryan Specialty and their technical risk underwriters facility. We'll work with MGAs in segments where we're also writing it in-house because it's the same underwriting framework, it's the same reinsurance program. It's just another distribution mechanism for us.
Got it. Could you describe the competitive landscape? What proportion of submissions are flowing in and out of large established carriers? Has startups and scale-ups been making any meaningful dent on your business prospects? How well capitalized do you think these structures are relative to your capacity?
Yeah. For us, what I would say is, as we talked about earlier, where we are going into markets, there is a capacities constraint. There are needs. Some of that might be informed by Lloyd's. I think Lloyd's is still saying they are in the period of exposure reductions and optimization of their book. Some of that might be a larger company just pulling out of certain guidelines, like I referenced in AIG, pulling out of residential quake. For us, it is really a capacity circumstance that we are capitalizing on. There are new entrants in some of those segments. We look at the insurtech market. They tend to be going after bigger market opportunities like homeowners or even private passenger auto. We'll partner with them, though. We can be a product specialist and these newer market entrants, we can be an earthquake offering.
We can be a flood offering. We can be a Hawaiian hurricane offering, which allows them to focus on their core competence and provide a broader product suite. Maybe generate a modest amount of fee income while we're taking on the risk for our bread and butter lines like hurricane in Hawaii, flood, and obviously earthquake.
Got it. I guess on most investors' minds are such a heavy catastrophe quarter, and I recognize a lot of the re-underwriting efforts you've made, particularly exiting homeowners in Louisiana and basically your all-risk nationwide cutbacks. How do you feel about those re-underwriting actions? Do you think that materially reduced some of the Hurricane Ida losses? If you could just speak more broadly on what you think about the storm.
Yeah. With Hurricane Ida, as you've touched upon, we did take a decision last year to pull out of Louisiana in the homeowners market, as well as on the admitted all risk side of the business. By the time Hurricane Ida hit, we had reduced our exposure in the commercial all risk segment by 80%. The homeowners book, we were less than a couple hundred policies. Overarchingly, Hurricane Ida, we will have losses there, but if it would have happened a month or even two months later, almost all of that business would have been run off. We think the actions that we took and the fact that it was premised around the cat payback, that decision was affirmed by Hurricane Ida for that matter. We could have sat back and said, "Well, geez, 2020 was an aberrant year.
Let's go deeper into this market and write more primary business or write more homeowners." We just weren't going to see a return, I think that has been validated. I wish we would have done it maybe two months earlier, because we would have been totally out of it. I think the decision that we've taken and the opportunities we see in other markets will continue to prove itself out in the fourth quarter and certainly into 2022, when all of that business will have been run off. I think the only other thing that I would add on that storm is it's another example of a storm taking a further swath of impact, not just in one state where it makes landfall, but obviously it's going into the Northeast.
For what we're doing in the Northeast, it tends to be what is really a flood exposure in the state of Pennsylvania. That's a fair bit of quota share, and it's short limit business. What our exposure really looked like was tended to be more either layered or shared or short limit business in the Northeast. It'll be a manageable event, although, again, there will be losses from the storm that, while disappointing, majority of which will be kind of non-recurring.
That's very helpful context. The modeling firms will keep updating their assumptions for industry losses. Do you think this event will be enough of a catalyst to increase reinsurance pricing? How do you thinking about that?
What I would say is, I think it'll probably, to me, it's going to look a lot like some of the storms last year, in that if you have losses in those loss impacted layers, you likely would see a rate increase, but the rest of the program will not be as impacted. For us, one thing that we look at, I guess the silver lining is, the losses that we will generate from Ida, the good majority of them won't be on the books in 2022. My hunch is that it will lead to sustained rate in the impacted areas and regions, and I think it will lead to rate increases on the reinsurance side and those layers that generate loss.
What about on the primary side?
Yeah, primary, in the State of Louisiana, I think there's going to be considerable capacity needs on the admitted and the E&S side. I think, how we participate in that, it certainly won't be on the admitted side, and it'll be pretty modest from a layer and share E&S standpoint.
Okay. Also, you've done a lot, speaking of reinsurance, to protect frequency risk, but it's been a very frequent quarter. Any comments just outside Ida, how you're thinking collectively on the frequency of losses?
Yeah. I guess we've got a couple weeks left and this has been an active wind season. I don't think it's going to look like last year. I think the other thing that we take comfort in is that we put in horizontal reinsurance protection. We put in the aggregate cover to insulate us from multiple events. Simply put, we have an aggregate that attaches of $30 million. So once we have $30 million of cat loss, and that could be from earthquakes or hurricanes or severe convective storms, once it tips above that level, the next $25 million goes into the reinsurance market. So it's basically the equivalent of two and a half retentions. After that, the next two and a half, so five retentions would go into Excuse me, the third, fourth, and fifth retentions would go into the reinsurance tower or the aggregate tower.
All in all, we've done a lot to preserve the downside and again, put this 11% ROE floor in place that gives us certainly more comfort on the sustainability of the earnings base.
Got it. I guess just on that topic, a year ago, when I was getting up to speed on Palomar, you mentioned at the time about 63% of your business does not provide attritional losses. How much of that has changed since then?
Yeah. Right now it's right around 53%-55%. It's come down some. It's still anchored, and we think that offers a fair bit of visibility, not just in the underlying profitability, but also the loss ratio and how that trends. Earthquake and Hawaiian hurricane are somewhat binary in their coverages, and those constitute around 53%-55% of the business.
Got it. As you expand your risk profile outside high severity, low frequency, like California Earthquake, even though that's your bellwether product,
How will your reinsurance needs change?
As we write more casualty business, the good thing about that is you won't need to support the growth with excess of loss. That will potentially allow us to retain a little bit more, or how we retain it will be more governed by quota share participation or some type of stop loss. As we diversify and do other lines of business, if the combined ratio is sub 100, it's going to be accretive to the ROE, and frankly, allow us to convert more of the earned premium to net earned premium because we won't need to have the excess of loss cover to support that growth. It should allow us to scale some, but it's still contingent upon us underwriting it well and making sure that the combined ratio is sub 100.
I think a good example of that is, our first casualty line, on the E&S side, was an excess casualty program and we will write a $5 million limit for that business, but we're only keeping 20% of that. Our limit's $1 million and we're using mostly quota share to reinsure that. That's a prime example of how that line of business will be more informed by quota share and potentially some stop loss.
Because you spoke about casualty lines, how will your investment posture change in light of you being able to hold onto assets to back liabilities a bit longer?
Yeah, that's a good question. Obviously, when we expand into these casualty lines, and we grow our overall capital base, we do have the ability to look at longer duration and higher yields for our investment portfolio. We will continue to evaluate it, but we will always maintain a conservative approach to how we look at our investment portfolio. We're just trying to optimize within that framework. We believe that our shareholders are much more focused on Palomar and our underwriting acumen versus our investment portfolio management.
Got it. Maybe I'll stick with you, Chris, and talk about premium leverage. Basically, one of your competitors mentioned they could operate at 1.2 to 1.25 times premium to surplus. On the earnings call, you reminded us you operate at 0.64 times, but I guess you think you could operate closer to 1.1 to 1.2 times. I guess I appreciate from my past life living and breathing risk-based capital models, which if you look at premium leverage, it's a terrible proxy. If you look at where your binding constraint is, which I'm guessing is the A.M. Best BCAR model, is there a certain minimum threshold under your A.M. Best BCAR model they hold you against? What is your excess position in either dollar or percentage-wise relative to that?
You described it well. From a premium leverage standpoint, we're at 0.64. We feel that we are very well-capitalized to grow, and that we do have adequate capital for that growth. Especially, some of the expansion into less catastrophe exposed lines of business. We do feel that that ratio could increase above the 1-to-1 ratio that we've described before. With that, we feel that we have plenty of capital to facilitate growth in the near and/or in the foreseeable future. You described it and thought about A.M. Best and as we think about the BCAR model. Even with that model, in looking at our numbers, we're very strong. I think we're probably as high as we can be in their mathematical formulas.
We are much more focused when we work with them on some of the subjective topics, because our BCAR is very strong and our net written premium to capital is very strong. With all those components, we're very focused, are very comfortable that our capital base will facilitate growth on either metric and gives us the ability to continue to grow, especially when you consider that we're profitably adding to that capital base on an annual basis. It's something we look at and focus on, but we feel very good about the capital facilitating our growth going forward.
Got it. It sounds like you have some strong metrics behind you. This may be a naive question. Why not continue to operate with more dry powder to grow with even greater force? I guess help us make sense of growing and buying back shares. It was not that too long ago, you basically raised capital in a secondary offering for the purpose of growing. Really, what has changed then to now?
Yeah, no, that's a great question. Obviously, we did do the buyback or used the buyback in the second quarter. Like I just said, we do feel that we do have adequate capital for growth in the foreseeable future. The buyback for us, we felt was good corporate management and good use of capital when we looked at our share price and the depressed values that we were seeing. For us, it was very strategic, and we just felt it was a good use of capital. Even with the capital raise that we did a year prior. It was just everything from a metric standpoint made sense, from a corporate governance standpoint.
Got it.
Chris, if I may. Chris described that very well. The one thing that I would add is that we opportunistically bought stock in the quarter, but the amount that we purchased was basically equivalent to the free cash flow generated. We actually still grew the book value in the quarter, while buying back the stock.
That's very helpful. Just thinking of other types of underwriting capacity. You've recently announced a fronting business, so if you could highlight what that's about and if I could dovetail the underwriting capacity in that question, like what is the appeal to cede the risk versus assuming or co-participating in those programs? You just spoke about having that capacity.
Yeah, I think for us, fronting allows us to be able to do several things. First off, we've done it in the past. When we went public, we were coming off the heels of our Texas homeowners program being a front. Our flood program initially started off as a front where we took 10% and ceded off 90% to the market. To me, first and foremost, it allows us to generate fee income. Therefore, it allows us to generate compelling risk-adjusted returns. It will give us the ability to enter and assess new markets while dipping our toe in the water, acting potentially as a participatory front where we take 5%-10%.
For a newer line, whether that's casualty or property, we could use the fronting to, again, get the underwriting right, learn more about the market, partner with good reinsurers, or operators that need access to our balance sheet, where we can generate fee income and get the proverbial sea legs. It gives us optionality. It really, for us, it comes down to extending our franchise in a market that we have experience, that will offer us predictable results, and then lastly, gives us optionality. That optionality is how we participate. We're pretty excited about it.
Great. I just want to remind folks again, they could submit their questions in the portal or email it to me directly. Maybe just going a little bit more into reinsurance. I think your property catastrophe reinsurance program is well understood, but I think it'll be helpful for the audience to better understand your catastrophe risk management process. Like basically how you run the vendor capital models, what your proprietary view is on top of those models that could give additional comfort that you own the risk.
Yeah, absolutely. I think this is the thing that if you ask me what keeps me up most at night is just understanding our exposure and making sure that we have a fundamental uniform and unequivocal sense of it. Our Chief Risk Officer, Jon Knutzen, and his team in the analytics side, really spends the lion's share of their time looking at our portfolio and managing to understand the exposure across peril by geography, by age of construction, by construction type, on a zonal, regional, and locational level basis. We do license all three of the models, and all three of those models are incorporated into how we price risk at a location level and manage it at the portfolio level.
Also what we try to do is when we're looking at our exposures, we want to blend the results so there's no bias from one model to the other. Then, like you said, overlay our proprietary analytics on top of that. Within those analytics, what that could be is biases to certain zones, it could be biases to certain types of construction, or biases away from them, one or the other. I think what we went through last year from 2020's wind season informed decisions to make material changes in how we underwrote, but also how we managed the book, because there were certain things from storms that weren't captured by the model. That's where, again, that proprietary analytics layer on top of it is really helpful.
For us, again, it really just comes down to making sure that the top of the program is as steadfast and as black swan-ish as it possibly can be. That's why you want to have a multi-model view. You want to have not just the model's vendor's view, but your own. Then you also want to overlay traditional underwriting, looking at concentration areas and damage factors, and making sure that just, okay, if there's an earthquake in West L.A. and there's a 10% damage factor to our exposure, where does that sit within our tower? Then say, "Okay, that's great. Then let's overlay the 1994 Northridge earthquake, and what does that look like?" It's a combination of all those things that really inform how we manage our portfolio and how we look to spread risk, accumulate risk, lay off risk, and things of that sort.
That's very helpful because a lot of startups just basically have their reinsurance broker running it on an infrequent basis. I appreciate.
Yeah
Providing that context.
Yeah.
We have a few more minutes. I just want to remind folks again to submit questions. I did weave in some questions from the audience that were actually on my list as well. Maybe just to talk about more growth opportunities. When you think about the white space on your board, what businesses do you feel like you have to get into, or ones you really have no appetite, which would be off-limits indefinitely?
I think we've kind of identified some that we want to make a big push in over the course of 2022 and beyond. In fronting, we just discussed. We've obviously brought on new talent to help us in the casualty side, but in particular in professional lines and excess liability. I think one area that we probably haven't discussed as much is really trying to go deeper into the flood market. Flood right now is approximately 2%-3% of our book. It certainly has the potential to grow at a much higher clip, and that's with the focus on inland flood. I should point that out. That tends to be more inland flood, so think rivers as opposed to storm surge.
I think that's a market that we want to go deeper in, and there's potentially some regulatory change that could prove fortuitous to that with some reform in the NFIP and the re-underwriting of the NFIP's book. That's another area. I think we also want to continue to go deep in earthquake. As I mentioned at the outset, there are some catalysts or potential catalysts for growth there and further disruption and dislocation in the residential earthquake market specifically. As it pertains to those that we probably would say would be off-limits, at least for the undefined future, workers' compensation is probably one. You've got to be very good at that. I think Florida homeowners is another one that there are people that are really good at that are still trying to get their hands around the regulatory environment there.
Those are two that I would say we certainly won't write on a primary basis.
Let me do some follow-up on flood because modeling is so important to you guys. How do you feel about modeling capabilities for flood, just given how outdated these flood maps are?
Yeah. We've never relied on the flood maps. We've come up with our own. When we launched our flood product, we did it in concert with AIR, and again, that was more inland flood. What we've been able to do and why we've been able to have our inception to date loss ratio is sub 20% on the flood, and that's writing in states that do take flood losses like a Pennsylvania or Illinois or California for that matter. What we've done is we've always come up with our own flood exposure, and we price flood and come up at the geocode level. We carve up a state like California or Washington or Pennsylvania into a 30 by 30-meter grid. The expected loss is at that grid level. It factors in elevation, it factors in distance to alluvial and fluvial flows.
It's our model. It's not doing a write your own where you're just pricing off the NFIP. We have our own exposure.
That's a very good context. I'm just wondering if either of you had some bold predictions going into 2022.
Well, it's week one of the NFL, so it's a little early to call the Super Bowl winner. I think for bold predictions for Palomar is that I think you'll start to see fee income grow. I think you'll also probably see sustained growth in earthquake. Certainly, those are operational objectives. Yeah, those are probably two. I think what you'll also continue to see is the ILS market in the insurance space provide more and more solutions, and an even more viable alternative to the traditional reinsurance market.
Okay. Chris, any for you?
I was going to stick to sports, I was going to go back to the ending baseball season and still give high hopes that the San Diego Padres are going to be able to pull off a World Series victory.
Yeah. That's bold.
Yeah. They've been struggling, they're still in the wildcard.
Yeah. That is bold.
That's my son's favorite team.
Oh, yeah.
I grew up in California, that's awesome. Okay, thank you so much for your time. I really enjoyed today's discussion. With that, this session concludes.
Thanks, Tracy. Appreciate it. Thanks for having us