Hello, everyone. Tracy Benguigui, insurance analyst at Barclays, and I'm pleased to host a fireside chat with Palomar. To my right, I have Mac Armstrong, Chairman and CEO, and Chris Uchida, CFO. Did I pronounce that right?
Close enough.
Okay. I know I'm from pronounce [Benguigui]. Welcome, everyone. I thought maybe, Mac, you could start off with some high-level thoughts.
Yeah, happy to, and thanks, Tracy, for the opportunity to be here today. Palomar as you're aware, is a specialty insurer that focuses on niche lines in the property and casualty space. The history of the business dates back to 2014 when we launched our initial offering in the earthquake market. Earthquake now constitutes 40% of the book of business, as we have diversified into a host of other specialty lines. As we looked to 2022, we really were focusing on four key initiatives this year. One was sustained strong top and bottom line growth, monetizing new investments in areas like fronting casualty and non-cat excess property, continuing to reduce the volatility in the earnings base, then making investments in the scale of the business. Fortunately, we're off to a good start this year and have been executing all four of those items.
In addition to that, we've also introduced our new strategic initiative of Palomar 2X, which we're excited to talk about today, too.
Great. We've seen a business transformation since Palomar's IPO back in 2019. I mean, earthquake is still a huge growth play. We'll definitely touch upon that in today's session, but you've also entered into other business lines over the years. I guess in hindsight, what has been the greatest lesson learned in the diversification process?
Yeah. We have indeed learned some lessons along the way, I think one of the key tenets is really just trying to solve for risk-adjusted return. As the book has evolved, we, outside of earthquake and wind hurricane, have really tried to pull back our cat exposure, and in particular in areas that wasn't going to generate the requisite risk-adjusted return. We were riding all risk business on a primary basis and an admitted and E&S basis that just wasn't getting the requisite cat payback on the heels of an active 2020 and 2021 wind season. Similar logic was applied to some residential wind exposed homeowners business.
I think ultimately, as the book has evolved, our focus on what we call our binary cat lines is where we're going to keep the predominance of our catastrophe exposure, and then new lines of business will have a different volatility profile and won't be faced with the high beta of a catastrophe line.
In my conversations with investors, I'm hearing mixed merits expressed of being earthquake-only insurer versus a diversified insurer. This may be a naive question, but should I take your entry into other business lines as a sign that there's limited growth upside within binary business? Or is the motivation more on balance sheet protection?
Yeah. I'd definitely say it's the latter circumstance. If you look at the second quarter, our earthquake premium grew 40-plus %. We continue to see very strong secular trends in the earthquake arena, whether that be dislocation in the homeowners market in California and now the Pacific Northwest, be changes to the California Earthquake Authority or capacity pullback in commercial quake. We feel very good about the growth prospects in the quake market. Our entrée into other lines of business is really premised around certainly having the balance sheet to do so, but also the expertise to do so.
We've got what we call our Palomar approach, which is premised around identification of niche and dislocated markets, leveraging existing or attracting new talent to attack those markets, buttressing the approach with a comprehensive and sound risk transfer plan, and a conservative one at that, hopefully leveraging existing infrastructure, technology, and distribution.
When I think about the white space on your board, what business lines do you feel like you have to get into, and which ones do you not have any appetite that would be off-limits?
Yeah. Last year we launched really four new product lines. Those are the ones we definitely need to get into and monetize the investment made, in particular, the excess liability and general casualty strategy led by Ty Robben, our professional liability strategy, non-cat excess property, and then the fronting. Those are the four that I'd say we have to. We've made investments from a talent perspective. We're doing a lot from a system development perspective and have the reinsurance in place to support a conservative entry into those markets. I think segments that we're probably you're not going to hear us going into, private passenger auto is a very specialized market despite the large size of it, and certainly requires a sophistication and scale that we don't have. I think that's one that I would say you won't be hearing us entering.
Great. Maybe a question for Chris.
You okay? Hopefully it's not a tough question.
Sorry.
No problem.
Palomar 2X. Palomar introduced this concept at your Investor Day. I was struck on the focus on doubling underwriting profitability. While that's good, it kind of left a lesser feel on the top-line growth. This may be your opportunity to clarify that standpoint.
Yeah, no. Obviously, Palomar 2X, the most important piece of that was doubling underwriting income. For the illustrative example that we put together, we did that without operating expenses put in there, just to kind of show where we're going from an underwriting standpoint. When we think about it in totality, the adjusted underwriting income, we do expect it to double that, including operating expenses. We wanted to pick a conservative framework to show how the book may evolve and how the overall portfolio may look after we do that, and that if we can get any scale on the other underwriting expenses, we should be able to accelerate that timeframe or do it faster than any expectation from the conservative standpoint. With that framework, there is the expectation that we still are able to grow the top line.
I would say, aggressively with strong results, we've been able to do that. I think we were showing strong growth in Q2. We showed strong growth in Q1 of this year, we do expect that to continue. I think when we look at Palomar 2X, we feel very good about where we're at. I think compared to where we were at Investor Day, we feel like we are ahead of plan, right? I think we are continuing to accelerate that. The one thing I want to point out, or maybe clarify for the group, as you pointed out, is that Palomar 2X is more of an operating philosophy. It's not tied to hitting a certain target. It's tied to growing or doubling Palomar continually.
By the end of 2022, we'll be looking at our portfolio again as looking at the different items or portfolio that we have and book of business and see what else do we need to do to add, to change, to continue to grow our book, to double off of where we're off of 2022. It's not a target or a finish line. It's more of a starting line, right? It's something that we're always doing, always looking at, and making sure that the investor community understands that we're aligned with them as we're always trying to grow and improve and double Palomar.
That's helpful. I guess other feedback is the intermediate term leaves us a lot to imagine. I think investors are taking your illustrative example upon a 2- to 3-year timeline and coming up with some lower growth prospects. What do you think about that?
Yeah, I think as Chris pointed out, we certainly, based on the second quarter results, pushed the timeframe up some. The top line grew nearly 70%. We also upped the guidance on the fronting premium that we were providing. Initially, it was $80 million-$100 million. We've now taken it up to $120 million-$160 million. That was a nice component to the illustrative example that Chris gave. I would say that we feel that the top-line momentum still remains rather strong for all facets of the business. Therefore, whether it's 2 to 3 years or somewhere in between, it's pushed ahead of plan.
Great, that's an excellent segue to our audience response system. If we could put the first question up. Palomar's growth, premium growth was 69% in the second quarter of 2022. My gross written premium growth expectation for Palomar in the second half of the year is greater than 50%, 30%-40%, 20%-30%, or less than 20%. 50/50, either greater than 50% or between 30% and 40%. Could we go to the next question? My gross written premium growth expectation for Palomar in full year 2023 is? Same choice of answers. It shifted a little bit. I would say between 20% and 40%. I'm just wondering your reaction.
We've got our marching orders. I think there's multiple growth vectors for the business. We feel great about the prospects within those bands, we got our marching orders. We'll be all right.
Okay. Palomar, your growth has really accelerated over the last number of quarters, and I'm wondering if you could characterize the order of magnitude in each of the following premium contribution drivers, rate increases, higher submission volume into existing business lines, greenfield operations, or underlying economic growth?
Yeah, Tracy, it's a good question. It's thoughtful. What I would say is the largest really is
New submissions in existing lines. It's product specific, but it's new submissions in existing lines. Rate is probably most pronounced in commercial property right now. I think in the second quarter, we talked about our commercial all risks, which we're not growing the exposure, so not pushing into new greenfield. We are seeing submission activities, but that's rate driven. Earthquake, it's really increased submissions, some new greenfield. Underlying exposure increase or excuse me, types of payrolls and things of that sort, that's probably the fourth biggest contributor or the least contributor. It's really just us executing, broadening distribution footprint, entering new geographies, and capturing the opportunities that we've established for some of our newer lines.
Since you've mentioned the submission volume, can we talk about what you're seeing the ebb and flow into the non-admitted market?
Yeah. Again, I think it's product specific, but we are seeing on the commercial business, almost the entirety of our flows coming in through the E&S market and the non-admitted market. I think that's going to persist, especially as it relates to the property arena. I think it's a multitude of reasons. It starts with the current market environment, and particularly the property remains a hard market and will persist into 2023. Certainly on the heels of what looks like a 1/1 reinsurance renewal, that's going to look a lot like 6/1/22. You're going to want to have the ability to take rate well beyond what you can do on the admitted side. I think also just the flexibility in forms and coverages is going to persist and create a dynamic that E&S remains robust.
I think a third factor that's going to be specific to potentially Palomar and geographically specific is just insurance departments and the challenges that you have as a commercial writer or an admitted writer, frankly, dealing with certain insurance departments, which is going to make you more predisposed to maintaining your products in the E&S market, just because you don't get the response or the engagement or the permissibility that you're seeking from an insurance department. California, we've had a filing that was a me-too filing, a simple me-too filing that we've been waiting on for 8 months. It's not a rate filing. It was just a me-too filing. We are probably the world's smallest violin when it comes to complaining about the California Insurance Department. It's just illustrative.
I think people are going to want to continue to work in the E&S market because of the challenges with insurance departments.
That's interesting. It has come up in other discussions. I've heard you speak about the inflation guard piece in premiums. How much of that would you characterize acts like rate?
I would say prior to 2021, we thought it was kind of 100% rate. Now it truly is an inflation guard. We are using multiple tools to attack inflation. One, it starts with just getting the TIV, right? Second is insurance to value and making sure that you have the most up-to-date sense of replacement cost and labor. We're using third-party tools, our own work that we do through our builder's risk auditable policies. The inflation guard is kind of the third component, which can be viewed as rate. We've been able to increase those. Our average inflation guard on residential quake was 5%. It's now 8%. Our average commercial earthquake increase is 9%-10%. We kind of view those somewhat contemporarily. Right now, it's really keeping up with loss cost, those inflation guards.
How do you ensure you're getting the right insured value? Do you have risk engineers on site? How frequent do you update those exposures?
Yeah. On the ITV side, it's constantly updated. The luxury we have is that our builder's risk business, about two-thirds of those policies are auditable, which means at the end of the risk period, you go back and look at what was the ultimate cost of construction for the project and then apply that from a per square foot basis. Using that really is a great tool to inform insurance to value in as real time of a basis as possible. The good thing is it's not informed just by your loss experience. It's actually informed by your underwriting. It's not quite as painful of a lesson to learn, and it's an easy one to update and put into your rate-making mechanics.
Okay. You mentioned some of your products, like builder's risk. We could touch on California earthquake. That's your bellwether product.
Yeah.
I've heard you express optimism about the spillover of less CEA reinsurance cover and that some insurers that are part of that CEA may look for other solutions, but I don't think that's actually happened yet.
Yeah.
Can you share any updated view about prospects?
The CEA has gone on record saying that they are going to be buying less reinsurance. They are going to, I think, the equivalent of $1 billion to $1.2 billion of lower reinsurance limit. You're right, it has not transpired yet. I think it will transpire as their program renews is my current understanding. I think some of the other changes around reduced coverages or potential shedding of policies, that's also yet to transpire. I think the good thing is, though, all of those actions create a marketing catalyst for us, whether it's talking to existing distribution sources that use the CEA, it's talking to existing insurance carrier partners that are CEA member companies, or potential other existing CEA member companies that we do not do business with that are looking for private market solutions.
The rose-tinted glasses view says this is a great catalyst for us that's in 2023 and beyond, and it really hasn't impacted the strong new business growth that we've seen to date. I think it just hopefully is a really strong secular trend that carries us for the next year or so.
This may be a naive question, but what would stop some of those insurers from fronting the business?
In terms of the CEA member companies finding fronts?
Yeah.
Well, ultimately, there are still some restrictions on what they can and can't do in terms of finding private market alternatives. The good thing is we have a very healthy working relationship with the CEA that's kind of made us a preferred party. I think going and finding fronting, the hard part is fronting for earthquake is the capital intensity of it, right? A fronting company would need to get considerable collateral that these member companies already are putting up into the CEA, or they'd have to buy considerable reinsurance that would need to get a rating agency comfortable with it. I think the capital intensity of earthquake makes it a harder line to front for.
Got it. Can you walk us through the process of entering greenfield operations? You start off with these catastrophe adjacencies, and now you're dovetailing into casualty lines.
Yeah.
Especially on the casualty side, where that business is not commoditized, how do you feel about your underwriting bench strength, and how dependent are you on MGAs to underwrite the business?
Yeah. The good thing is what we are building out is going to be underwritten in-house. We work with MGAs, especially for large national property accounts, and it's a great channel in that regard. We will potentially emulate that strategy for certain selected casualty lines. What we're looking to do is we have attracted some terrific talent to join us on both the professional line side and the casualty and excess liability side. We think that we have great bench strength there. We are bringing to them reinsurance sophistication and acumen that they may not have had in prior seats. We are bringing supplemental distribution, and ultimately, we're bringing technology that's kind of built customized around how they want to service and underwrite the business.
I think you'll see us continue to attract more talent to build that out, and it will be in-house with maybe some supplementation from program managers and MGAs.
Okay. We discussed the concept of fronting business earlier. What kind of business lines are you getting into on the fronting side?
Yeah. We've actually gotten into a range of lines. We've fronted an earthquake solution where I think we're uniquely qualified to do so because of A, are familiar with the line, but also because of the reinsurance program that we can leverage. Cyber is a segment. We are partnering with the company Cowbell, who has a terrific panel of world-class reinsurers supporting them, where we're fronting. We actually announced a partnership with the company Omaha National in the workers' comp arena. There's a couple smaller ones that are in commercial transportation and commercial GL. We've got a good pipeline. The good thing ultimately is there's great secular trends in the fronting market right now. We don't have to chase every deal, though. We can be pretty selective in what we do because it's a nice leg of the stool. It's not the stool, so to speak.
It's a nice complement to what we're doing on a direct underwritten basis in casualty lines and certainly what we're doing on the binary business with quake and Hawaiian hurricane.
Maybe just a follow-up. I think you're actually ceding 100% of the risk, or at least that's how you're envisioning the fronting business.
Yeah.
How are you able to do that for workers' comp?
For workers' comp and cyber, we've taken a small amount of risk. We're taking 4% on workers' comp and then 5% on the cyber. The cyber was our first deal that we've done, so we've had a year and a half to see the underwriting and see the market dynamics and get comfortable with the approach that we're taking. The workers' comp, I think that was helpful for us to round out a very strong slate of reinsurers. I think you have certain big reinsurers that on the fronting side want to see some eating of your own cooking, so to speak. I think we're willing to take a modicum of risk to help round out a stronger slate of reinsurance, reinsurers, excuse me, and also potentially allow the scale of the program to increase some.
Is that the California workers' comp market?
That's the California workers' comp market, yeah.
Okay. Got it. A year ago, you mentioned about 53%-55% of your business does not provide attritional losses. How much has that changed since then?
Yeah, there's a couple ways to look at it. Right now, if you factor in the earthquake and the Hawaiian hurricane, that's around what? 46%-47%?
47%, yeah.
Of the book versus that 53%. When you add in now the fronting, and fronting last quarter was just under, it was like 18%. You could actually say that you add those up, it's closer to 65% doesn't have a traditional loss. The binary lines are now 47%, but when you factor in the fronting, it's closer to low 60s.
Got it. The other thing I'd also add to that is that we didn't talk about it yet, but the specialty homeowners book that we do have. Call it two components of our specialty homeowners book. We have a Texas book and then some other Southeast exposure. The Texas is the majority of that or the larger portion of that, and that is actually moving into a full front as well. That will actually be increasing the portion that has no attritional loss associated with it.
Right. You've made a number of underwriting changes. How has that expanded your risk profile outside the high severity, low frequency risk? How would that change your reinsurance needs?
I think you basically have kind of two different reinsurance approaches then. We have, obviously, the need for excess of loss reinsurance coverage, and that's most pertinent to those binary lines and the commercial property segment. You have quota share reinsurance. Quota share reinsurance is the predominant reinsurance strategy for those lines of business with attritional loss. What we're doing there in many instances is we're retaining 20%-30% of the risk and ceding off 70% to quota share reinsurers. What that does, it accomplishes a couple things. First, it allows us to manage our net line versus our gross line, which insulates us from a shock loss, especially for a younger program. Additionally, it affords us a bit of fee income, because you're getting an override on top of your cost of acquisition and overhead.
We think it's a nice approach for those newer segments that we want to, as I said before to you, Tracy, kind of walk before we run.
Can we touch on your reinsurance panel for quota share and XOL?
Yeah.
I was struck that bigger guys like Swiss Re, Munich Re are on your quota share program, but not XOL.
Yeah. There's a couple good things to it. One is both Munich and Swiss are now on the excess of loss.
Okay.
They're not very consequential. Our largest reinsurers are Ren and then Tokio Marine HCC. I think the encouraging thing is that there's room for growth with the Swiss and Munich. They certainly have big balance sheets to put to use, and I think they both have appetite for quake, which is the predominance and will be an increasing predominance of the excess of loss tower. I think it's a good opportunity for us to continue to grow with them because they are, as you point out, meaningful contributors on the quota share side.
Okay. As you get more into casualty lines, how will your investment posture change? Might you be able to hold on assets to back liabilities a bit longer?
Chris, you want to-
Yeah. No, I can handle that one. Obviously, the first and foremost, we think of ourselves as an underwriting company, right? I think investors are investing in Palomar for our underwriting acumen, the underwriting returns that we have. Like you mentioned, we do have some changes in our portfolio. Obviously, we've grown. The balance sheet will grow and mature. The lines of business that we have, especially on the casualty line, do have a longer tail associated with them. We do have the opportunity to increase our duration. I would say that we aren't going to be overly aggressive in any of that. We will still take a very conservative approach, but we do see opportunities out there where we can improve our margin.
I think right now we haven't seen a need to accelerate or to increase our duration too much right now because of just the market opportunities that are there naturally that's going on in the marketplace right now. We do think that over the long term or what's called in the near term, we can improve our margins and start tweaking our portfolio a little bit to increase the yield on our investments.
Any particular asset class?
What was that?
Any particular asset class?
Nothing aggressive. Nothing stands out, but I think typical conservative plays that other people are doing as well.
Yeah. I think right now 94% fixed income, 6% equity, there's really no alternatives. There might be a path down the line as duration can extend, there may be alternatives as it comes to class. But like Chris said, I think all of our investors view us as an underwriter, not an investor, and I think that's going to be the predominance of the ROE, if not the entirety.
Okay. I noticed in your Palomar 2X plan, it appears that you're assuming higher ceding commission than your own policy acquisition cost. As you enter more business lines, do you feel like those offerings are proprietary enough to justify a higher ceding commission? Like I could see why on earthquake that might be attractive to reinsure.
Yeah. I think ultimately, if they have to maintain a stance in the business, I think it's going to come down to underwriting performance. If we're not hitting our loss targets, and hitting the requisite margins, those ceding commissions will compress. Fortunately, they have not. In fact, the quota shares that we've had in place for multiple years, actually, we improved the economics of them over the course of this year. Earthquake was one, another was in real estate E&O, and then the builder's risk being the third. The market will speak for itself. If we're not, those commissions would get compressed, but I think we feel good about the underwriting results to date and the sustainability of them.
Even with a shorter operating history?
Yeah.
Maybe this is a good question for Chris. On the premium leverage side, you're running at, I think you said the last quarter call, 0.85 times, and you could operate at like 1.1 times.
This may be a naive question, but why not continue to operate with more dry powder to grow with even greater force? Can you help us make a sense of growing and buying back shares? I think it was not that long ago that you actually raised capital in a secondary offering for the purpose of growing. I guess what has changed from then to now?
Yeah. When we look at our leverage ratio, we said that for our cat lines, we were comfortable riding at close to a 1-to-1. As the mix of our business has changed and evolved, we felt that we can go higher, right? Especially on those lines like casualty that do have a longer tail. We felt that we could go 1.2, 1.5, and there's even certain lines of business that are a lot more stable that you could probably even get up to two times leverage. As our book evolves and as we change and do more things to protect it with reinsurance, we definitely feel we have the ability to increase our leverage.
If we were at, I think, 0.85, 0.9 in Q2, we do think that we could go up to 1.1.2 and still have adequate capital to facilitate all the growth we're seeing, and definitely in the 2X model. The use of the buybacks has been very opportunistic. There's no strategic need that we have to get $X of shares out of the marketplace. It's really been more of a function of this is where our stock price is. We did feel, in certain situations, it was undervalued, and this was the right move for our investors and ourselves to start buying back. It was never at the detriment of growth. We always had adequate capital to continue to grow and continue to grow for the foreseeable future without needing to access the capital markets again.
Going back to your fronting business, since you have plenty of underwriting capacity, why is it appealing to cede the risk versus a surplus quote participating in these programs?
I think right now, when we go into lines of business where we don't have a long history or we've brought in the underwriting talent, we want to make this more fee generative. Your point is a good one in that we like optionality. One of the key points that Chris made at Palomar 2X was for our existing lines of business where we are taking a measure of risk, whether it's 20%, 25%, 30%, the optionality of taking more on could have resulted in an incremental $60 million of net income. We like having that flexibility. For fronting right now, we think with the key tenet of our operating strategy being reducing earnings volatility or minimal earnings volatility, we think this is a great way to contribute, I don't want to say risk-free income, but less risky income.
Maybe it's a good opportunity to pause and see if there are any questions from the audience. Okay, I see one here.
Yeah. Just a quick one.
If you don't mind, the mic is coming.
Hi, thanks. I was just curious, I know you mentioned about 4% in workers' comp you retain and 5% in Cyber in the fronting business. If you look at overall fronting premium, what would you say from a portfolio level is your average retention?
It'd probably be about half that number. It'd be like 2%.
I think you've seen like a lot of these newer fronting carriers popping up in the last couple of years. Just curious more on the competitive dynamics that you're seeing, especially in Cyber. We've seen some big programs move, like At-Bay had a pretty big one in the last, I guess it was a month ago now.
Yeah.
I'm just curious what the competitive landscape is.
I think there certainly are a decent amount of fronting carriers out there. I think the good thing is that there's an increasing amount of insurance company talent that is leaving the composite insurers and going to more of a distribution storefront, so to speak. That means that those underwriters that leave to go to an MGA or a retail broker, they don't have carrier relationships, they have reinsurer relationships. That you do need a viable front for that. I think the secular trend is strong in that regard. As it relates to us, it gets back to what we were just speaking to with Tracy. Fronting is a very good line of business for us.
It's not the totality of what we do, if you look at the examples that Chris gave in Palomar 2X, you can see that the strong majority of our income comes from the underwriting side, and particularly the binary side. What that really means is that we can be selective in the deals that we do on the fronting side. It also means that we can structure good terms and conditions. On the cyber deal, we have a multi-year arrangement. Similarly, doing that on the workers' comp side. I think it affords us a visibility that we won't be competing every year for the renewal on some of these larger programs.
Any other questions? Okay. Last one for me. I recognize that in California, homeowners and auto are not your areas of focus, but since you're based there, it would be great to hear your perspective about the state developments on the repricing side and the ability for insurers to reduce their in-force.
We obviously operate in California, we do write a fair amount of earthquake on an admitted basis there. We are very attuned to what's going on in the Insurance Department. Candidly, even though it hasn't been a material impact to us, we have seen just the gridlock that's in the Department. My expectation is that post the election, there should be some freeing up of capacity or improved responsiveness from the Department. There's rumblings of potential lawsuits against the Insurance Commissioner for dereliction of duty. I think that probably also may contribute to some action. The state has to do something because it's potentially dealing with an existential crisis in its two largest lines of insurance in auto and homeowners.
I think if they don't do something, even though it's very consumer-focused, you're going to see people doing the bare maximum, so to speak, and non-renewing 10% a year. It's just all left with is a non-standard market.
Very good. Definitely learned a lot. Appreciate the discussion. If everyone could give a round of applause.
Thank you.
Thank you.
Thanks, Tracy.