Arch Capital Group Ltd Earnings Call Insights: Long-Term ROEs and USMI Business

Arch Capital Group Ltd (NASDAQ:ACGL) recently reported its fourth quarter earnings and discussed the following topics in its earnings conference call.

Long-Term ROES

Vinay Misquith – Evercore Partners: First from the mortgage insurance perspective, what are the long-term ROEs that you’re looking in this? Is it 15% or is it higher than that?

Constantine Iordanou – Chairman, President and CEO: Well, it’s – I would say is 15% and it can be better than that, but let’s keep it at 15%; we’re happy with that.

Vinay Misquith – Evercore Partners: And you’re saying that the accretion will only happen in maybe 2015 if this transaction goes through?

Constantine Iordanou – Chairman, President and CEO: The accretion will not happen until actually 2016. We estimate this to close at by probably third, fourth quarter this year. There is a process we have to go through. So, the first full year of operation will be ’13; second year will be ’14. So, those two years we don’t expect any accretion and then after that we expect to be accretive in ’16. Mark, you want to add anything to that?

Mark D. Lyons – EVP, CFO and Treasurer: No, I agree. Just a clarification, that the first full – two full years are 2014 and 2015.

Constantine Iordanou – Chairman, President and CEO: Right.

Vinay Misquith – Evercore Partners: Okay, so ’14, ’15, no income, and ’16 will be okay. And also looking at the amount of capital that you plan to invest, you’ve planned to spend about $300 million. Do you think that you can upsize that based on the opportunities out there or is it too early right now?

Constantine Iordanou – Chairman, President and CEO: Well, it will depend on the opportunities. Traditionally, as a company, we always want to operate all the way with a strong capital position. That’s a commitment we make to customers. That’s a commitment we make to the rating agencies. That’s a commitment we make to customers, as a commitment we make to the rating agencies, as a commitments we make to our employees. So, depending on how well that business and how good our penetration is in the market, we will make sure that we have adequate capital supporting that business.

Vinay Misquith – Evercore Partners: Second question is on growth. Your top line growth in the primary insurance segment was lower than some of your peers’ has been. I’m just curious as to your perspective as to where pricing is right now and where you would like it to be so that it could significantly ramp up the top line.

Constantine Iordanou – Chairman, President and CEO: I think where we differ with some of our competitors is on the very long-tail lines when you factor in new money yield through the duration of their liabilities and you do those calculations. Even though some of these lines are getting actually the bigger rate increases, we still don’t see them meeting our returns. And for that reason we’re holding back our units in writing more. To be more specific is, some of the primary casualty line, some of the excess and umbrella lines, we’ve been very cautious about it. Any excess worker’ comp – the workers’ comp line, we’re being more cautious about these lines because of where interest rates are. Mark, you want to add to it or…?

Mark D. Lyons – EVP, CFO and Treasurer: Yeah, Dinos. I would say – just echoing what Dinos said, the specialty casualty line over the last couple of quarters has gotten 12% to 14% to 15% increases. But the way we look at it though and as we stated before, it’s what’s the absolute return those increases give us, not just the fact that they are increases. We still think that has a long way to go. Just to give you a little insight, our specialty casualty unit in the month that just went by as you look forward, we wrote a couple of hundred thousand dollars of new business. Why? Because we don’t (indiscernible) those kinds of increases, but the absolute margin isn’t there yet. So, we could make the same comment on excess work comp, we could make the same comment on other longer-tailed lines of business.

Constantine Iordanou – Chairman, President and CEO: But I don’t want to mislead you. I think the market is improving, so we’ll not disagree with some of our competitors’ comments. It’s just maybe it’s our view on the absolute profitability of certain classes that differs. We’ve been always a patient company on premium revenue, because to tell you the truth, we love to grow high percentages if the market allows us, but we will not hesitate to shrink if we don’t think we’re getting the right rate. So, it’s a mixed bag right now. We got segments where we’re bullish and we’re letting the units grow. And then we have segments we are not bullish and we’re actually shrinking .The combination of that though is giving us a growth which is not – I’m not disappointed. I think 7% on the net and about 5% on a gross on the Insurance Group is – in this market environment is not a bad result. And from the first quarter, I can talk about January 1. I think our growth in January 1 business was even a little higher than that, but one month doesn’t make a quarter or a year. So, in essence, the momentum is going in the right direction as far as we’re concerned.

Vinay Misquith – Evercore Partners: So just one follow-up on that. Just curious as to what do you think the trade-off is by being more conservative now versus some of your peers saying, we’ll write the business now and on the next renewal we’ll just take pricing up.

Constantine Iordanou – Chairman, President and CEO: Well, I mean, that’s a strategy that sometimes it works and sometimes it doesn’t. If you like to be a prophet to see what’s going to happen, sometimes bad things happen to you because you might be reading the obituary pages and you find your name on it. So, I don’t like to predict the future. What we see we instruct you on it. This is the market that you’re operating. What you see today you take actions today, and if that changes tomorrow, you have the right to change your approach. And that’s why we’re a company; we’ll pay very little attention to premium budgets. Our units; they get capital allocation on a quarterly basis, we reevaluate that based on market conditions, and we expect that agility from our operating units to be able to adjust and reflect what’s happening in the market. So, that formula has worked for us for 10 years and I’m not going to change it.

Mark D. Lyons – EVP, CFO and Treasurer: And that strategy that you just talked about, it isn’t just a forward look in the insurance market, it’s a forward look in the economy. So, the idea that the company would have recovered enough, that customers would be willing and able to make a – pay a big rate increase the year ahead. It is also a bet we don’t quite believe in yet.

USMI Business

Amit Kumar – Macquarie Group: Just a couple of follow-ups on the prior discussion on the USMI business. If you factor in the earn-out what would the deal equate on a price to book basis?

Constantine Iordanou – Chairman, President and CEO: We want to pay a true book value. So, the earn-out will give a fair price based on how the book evolves over the next two three years and that’s what we negotiated.

Mark D. Lyons – EVP, CFO and Treasurer: And that has to – the proof is in the pudding on that. As the in-force business is tracked over that period of time, it will indicate an additional payment or note…

Constantine Iordanou – Chairman, President and CEO: It could be a lot more. It could be a lot less, but we’ll let the book evolve and if it’s more, we don’t mind paying it. At the end of the day, we’re getting the value out of it.

Amit Kumar – Macquarie Group: I guess that leads to the related question. Does that tell us something about the state of the market with so many companies trading below book in the insurance land if you’re willing to look at other segments? I mean, is this sort of overreaching what the state of the cycle is or…

Constantine Iordanou – Chairman, President and CEO: No, it has nothing to do with the cycle. We’ve been in this phase now since ’09. Andrew Ripper which is the subject matter most senior expert in our operations was hired over three plus years ago. Originally, it was for us to see if we have reinsurance opportunities and later on to evolve into insurance opportunities both here in the United States and also in other parts around the world; European Union, Australia and other parts of the world. So, this is – this was a strategic move by us, but in our way, we try to do it as we acquire talent and as we find opportunities to acquire additional talent, licenses, et cetera. So, it goes in that continuum and it has nothing – we view this a long-term play. Mortgage insurance has been around for a long time, and with the exception of four, five years that unfortunately bad underwriting decisions were made by most in the space in – if you examine the history of the product, it’s been a profitable line as long as you remain disciplined in underwriting.

Amit Kumar – Macquarie Group: Final question and this goes back to your remarks regarding capital. How do you think about the capital needs for this business? I guess what I’m trying to ask is the deal is done and then you sort of ramp up. At that point of time, how much capital – sort of range of capital would you need and how would that play against capital management, let’s say, for ’14 and ’15 and I’m trying to sort of think of some sort of a relative proposition.

Mark D. Lyons – EVP, CFO and Treasurer: Well, I think, fundamentally, you have to think about capital a little differently. Well, first off, any final capital decision is going to be a function of two things really. It’s the implied business plan and our growth and the opportunities we see, and also discussions we have with GSEs and perhaps other regulators. But it’s not really a premium to surplus ratio or reserve to surplus ratio. It’s a view of, let’s call it, really risk in force to capital. And the industry has generally been operating around 20 to 1 ratio. There’s variations on that for different kinds of businesses and so forth, but 20 to 25 is what – it’s the one is what’s going on right now. A lot of the key competitors in that space are 23 to 25 to 1. And that’s the ratio amid to the risk to the capital. So, 20 to 1; it would be 5%; 25 to 1, it would be 4%, but again, that’s going to be a build-up over time directly as a function of our business plan.

Amit Kumar – Macquarie Group: So, if I simply add up the risk in-force number, it’s like – can easily come off the capital number?

Mark D. Lyons – EVP, CFO and Treasurer: That’s correct.

A Closer LookArch Capital Earnings Cheat Sheet>>