Argo Group International Holdings Ltd (ARGO) 2007 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third quarter 2007 Argo Group earnings conference call. At this time, all participants are on a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (OPERATOR INSTRUCTIONS).

I would now like to turn the call over to Mr. Mike Russell, Investor Relations. Please proceed, sir.

Thank you and good morning. Welcome to Argo Group's conference call for the third quarter of 2007. With me today is Mark Watson, President and Chief Executive Officer; and Mark Haushill, Senior Vice President and Interim Chief Financial Officer. We are pleased to have the opportunity to review the Company's results for the third quarter as well as management's perspective on the business. No earnings guidance will be provided in this call.

I would like to remind you that this conference call is being recorded and currently participants are in listen-only mode. Following management's opening remarks, the Operator will provide instructions on how you may queue in to ask questions.

Let me remind everyone that as a result of this conference call, Argo Group management may make comments that reflect their intentions, beliefs and expectations for the future. Such forward-looking statements are qualified by the inherent risks and uncertainties surrounding future expectations generally and may materially differ from actual future results involving any one or more of such statements. Argo Group undertakes no obligation to publicly update forward-looking statements as a result of events or developments subsequent to this conference call. For a more detailed discussion of such risks and uncertainties, please see Argo Group's filings with the SEC.

With that, I would like to introduce Argo Group's President and CEO, Mark Watson. Mark?

Thank you, Mike, and good morning, everyone. We are pleased you could join us today for a review of Argo Group's third quarter financial results as well as an update on some of the initiatives we've undertaken since we announced the completion of the Argonaut Group-PXRE merger.

Our focus has been on three things -- strengthening our balance sheet by reviewing legacy issues, evaluating our capital management strategy and, most importantly, growing our core business.

Let me begin my remarks by providing a summary of third quarter highlights. While we are competing in a challenging marketplace, our earnings reflect the strength of our business model, specifically targeting smaller accounts. Top line growth continued with gross written premiums increasing more than 8% over last year for the same quarter. Margins in our largest business segments, Excess & Surplus Lines and Select Markets, remained strong with combined ratios just above 90% for each of those segments. Book value per share increased to $43.81 per share. Our International Specialty segment is performing in line with our expectations as Peleus is just getting started. And finally, our post-merger operating plan is on track and, as you may have seen last week, we announced new executive appointments at both our U.S. and international operations.

Since the completion of the merger some 90 days ago, we've been hard at work enhancing the Company's infrastructure and planning for the successful future of Argo Group. I'm very pleased with our progress thus far. We have started to execute our strategy at Peleus, our Bermuda-based underwriting company, including our other international business, the International Specialty segment, which generated $20 million in gross written premium for the third quarter, resulting in a slight operating profit.

You may remember last quarter we announced that Andrew Carrier will become President of Peleus. Last week we also announced the hiring of a Chief Underwriting Officer and an Underwriter for Peleus, which will round out that team. Matthew Wilken and Mike Cornish, respectively, are former colleagues of Andrew and both have extensive experience in the reinsurance industry. We continue to believe the property reinsurance market presents Peleus with opportunities to build its portfolio in 2008. We intend to be disciplined in our underwriting approach so as to protect our capital. In fact, we continue to expect International Specialty to represent no more than 15% of our gross written premiums.

Last week we also announced the appointment of Dale Pilkington as President of Argo Group's U.S. operations. Dale is an industry veteran with nearly three decades of experience. For the last five years, Dale has led our E&S segment through a remarkable growth phase and I'm confident he is the right executive to lead our entire U.S. operation through its next stage of maturity.

We also appointed Bill Meisen to head up our operations at both Grocers and Great Central. With 20 years of insurance industry experience, Bill's newest responsibilities reflect the confidence I have in his ability to deliver on Argo Group's superior service and innovative products to our retail business clients.

Moving on to our underwriting operations in the U.S., we continue to focus on profitable margins rather than growing in our Specialty E&S and Select Markets platforms. Having said that, we did manage to grow Select Markets in a judicious manner for the quarter. Gross written premiums in our E&S segment were down approximately 5% compared to the year-ago quarter, reflecting the increasing appetite by the standard market. In the face of current market conditions, we are pleased with the margins in E&S.

Select Markets produced an improving third quarter with gross written premiums up nearly 20% over the same period last year. We are beginning to see results from various niche programs that we have targeted, which are generating a positive impact to the segment's top-line momentum. These programs are just beginning to develop and I am encouraged by the pipeline of additional opportunities that we have in front of us.

As respects the marketplace, rates are down between 3% to 4% overall for our account. We're not seeing the same declines as some of our competitors due to our focus on small accounts, but certain classes as seeing more pressure than others. It's not uncommon for us to see our renewal business come under pricing pressure with competitors frequently offering 15% to 20% rate cuts or even higher. We're defending our renewal book as appropriate by meeting competitor pricing on the better price risks and letting go of the business when it falls below our target price point.

With respect to new business, we're faced with the mirror image situation of our renewal business challenge. We're playing that game selectively and prudently, and as a result, our new business writings are slowing in some areas.

Let me now talk about the balance sheet. First, let me say that over the past eight years, our Company has maintained a strong balance sheet and we continue that commitment today. Our recent action highlights that focus. Our balance sheet was further strengthened by our sale of PXRE Reinsurance Company, which we expect to close in the first quarter of 2008 after regulatory approvals are obtained. There are several long-term benefits in completing this transaction. First, it eliminates the uncertainty and risk with the legacy PXRE business. Second, rating agencies should consider this a positive move. And third, it increases our flexibility in deploying capital.

We remain comfortable with the reserves contained in PXRE's Bermuda-based reinsurance company, which is unaffected by this transaction. So, at September 30, our balance sheet reflects the merger with PXRE and the sale eliminates the most significant risk component in the merger. The net effect of these transactions was a $67 million gain reflected in our income statement, or $2.44 per share.

As noted in the earnings release, during the third quarter we completed our annual actuarial review of asbestos and environmental loss reserves. This year's review concluded that our run-off reserves should be increased by approximately $26 million. Our ultimate loss estimates can vary when paid losses differ from expected. This was a case in point where our paids increased significantly this year from a few settlements. To the extent that payouts exceed our expectations, we will maintain our conservative reserving philosophy and record our actuarial best estimates.

Let me talk about capital management for a minute. Now that we've had a chance to really look over the balance sheet and address items there we thought were prudent to do so in the third quarter, we're now focused on looking at the organizational structure from a both capital management and legal perspective. And Mark and I will be spending the remainder of the year changing some of the structure, both in the U.S. and Bermuda, to streamline those operations. I will have more to talk about on our year-end conference call about that.

As always, Argo Group's Board will focus on capital utilization. When our directors convene next week in Bermuda, we will be spending a fair amount of time talking about that.

So to summarize, I would like to just reiterate some key points. Argo Group's core business remains strong, achieving top line growth and profitable margins during the third quarter in a competitive marketplace. Our International Specialty segment is almost fully staffed with a very strong and experienced team and is gearing up for the 2008 season. And, our post-merger integration process is proceeding according to plan.

Now I would like to ask Mark Haushill to review our third quarter financial results in more detail. Mark?

Thank you, Mark, and good morning. We expect to file the 10-Q in the next few days and it will provide some more detail on the quarter's financial results. Today I will provide some data on the key aspects of our earnings release.

Operating earnings for the quarter include the asbestos charge of $26 million pretax, $17.6 million after tax, or $0.64 a share. Merger related expenses of $3.9 million after tax or $0.14 a share and the after tax extraordinary gain of $67.3 million or $2.44 a share. So absent those items, you get about $1.04 a share in earnings. Recall that the $67.3 million extraordinary gain resulted from the negative goodwill generated in the merger and has been recognized in the P&L.

Prior year loss development for the quarter was $21.2 million unfavorable. That is comprised of unfavorable development on A&E of $26 million offset by $3.1 million favorable development in Med-Mal; $2.1 million favorable development in E&S; and some other minor adjustments. Med-Mal is included in the runoff segment.

Favorable development for the same quarter of last year totaled about $7 million, comprised of $4.3 million in E&S and $3 million in Select Markets. For the nine months ended 2007, loss development was $5 million unfavorable with the previously mentioned A&E development partially offset by $16.6 million of favorable development in E&S; $1.4 million in Select Markets; and a favorable Med-Mal development of $3.1 million.

For the nine months ended 2006, favorable loss development was $16.3 million. The composition was E&S of $5.6 million; Select Markets of $7.4 million; and run-off of $3.3 million, that related primarily to Workers' Compensation. And all those amounts are favorable.

As Mark said, we have executed an agreement to sell PXRE Insurance Company, which is wholly owned by PXRE Corporation. PXRE Reinsurance Company is a Connecticut domicile reinsurance company. We expect this transaction to close in early 2008, once required regulatory approvals are obtained.

As of September 30, 2007, the surplus of PXRE Insurance Company is approximately $140 million. Gross loss reserves approximate $120 million and invested assets approximate $240 million. The impact of the transaction is reflected in the extraordinary gain that resulted from the merger of Argonaut Group and PXRE. The transaction, once closed, removes Argo Group from any significant exposure to business written before 2002, including the long-tail reserves held by PXRE Group.

Lastly, we are working with the lawyers and expect to find a solution with the trust preferred holders of PXRE Corporation. We are satisfied with the asset base underlying the trust preferreds and we will continue to service them at existing terms.

We discussed with you last quarter that we had swapped nearly all the costs and potential benefits of the KRW II catastrophe bond for the last six months of 2007 through a third party. We continually evaluate the benefits of this protection and will update you next quarter. Should we utilize this cat bond in 2008, the expense associated with it is approximately $8.7 million.

Property reserves for KRW are developing in line with our expectations and reserves did not move. As of September 30, 2007, we have paid $693.9 million in net claims for KRW, which represents 81% of our ultimate losses for these events. We have $162.3 million of net loss reserves held for KRW as of September 30, 2007.

Looking at our loss selections for accident year 2007 as compared to 2006, the rate decreases are in line with our expectations, with certain classes being more challenged than others. But in the aggregate, we remain comfortable with our selections, which are slightly higher than 2006. Argonaut's longer-tailed casualty business written primarily from 2003 through 2006 are developing favorably compared to our expectations. Our actuarial review in the fourth quarter will provide more analytics and we will update you on that work in February.

The share count for the quarter earnings per share reflects three months of Argonaut Group shares adjusted for the reverse split, and approximately two months of PXRE shares adjusted for the reverse split. On a going forward basis, the share count for purposes of earnings per share should be approximately $30.5 million.

The investment portfolio was $3.7 billion as of September 30, 2007 and had a pretax unrealized gain of about $98 million. The current fixed-income portfolio duration is about 3.1 years and has decreased due to the addition of the PXRE portfolio. Recall the duration of the PXRE portfolio is approximately one year and is matched with the expected duration of the liabilities. We have not changed our philosophy with respect to the investment portfolio and are in the process of evaluating our strategy for the combined company.

Our leverage ratio was 21% consisting of trust preferred securities of $311.6 million and $58 million we borrowed under our revolving line of credit to fund the special dividend. We're comfortable in this range and believe we have additional debt capacity.

Operator, that concludes our prepared remarks and we're ready for questions.

(OPERATOR INSTRUCTIONS). David Lewis.

Mark, you had very great success in the Select Markets area. You produced 20% gross written premiums. Can you give us a sense of where that business is coming from and give us some confidence that you're prudent in those writings? And whether those products you have some underwriting history?

I don't think -- sure. We're just adding to the business that we're doing today. So, we haven't gone off and started a new business separate and apart from what we're already doing. Some of that growth came on the Public Entity side. Some of it came within Great Central. And some of it came within the State Funds program that we've already got up and going. So, there's nothing new coming on the books. It's just coming from different production sources.

All right, that's helpful. And back to the PXRE reinsurance transaction. Are there any guarantees going with that sale? And I assume most of the casualty liabilities go with that transaction? Is that correct?

Correct. There are no guarantees with the transaction at all. And I believe that those are all of the casualty reserves of PXRE Group.

Okay. And lastly, are you going to consider a repurchase program with excess capital and what you think your access capital levels might be after this transaction?

Without sounding coy, that's what I meant by saying that my Board and I always review our capital management and we'll be getting together next week.

And any range of maybe excess capital from your view? I know the rating agencies have their own views, but your thoughts?

Well, I think that it's still premature to talk about how much excess capital we think we may have until we can finish reorganizing the structure of the Group, both in the U.S. and in Bermuda. As we continue that process and also as we continue from a capital management perspective to have Peleus reinsure portions of the U.S., that will change our capital requirements in the U.S. And we'll be sorting through that over the next couple of months. But now we're down to the next couple of months, not next couple of quarters.

Very good. Thank you.

Bijan Moazami.

I just want to follow up on the last question. So, let's say you complete this transaction by the first quarter of '08. How much capital will you have at the parent company, including the dividend that you can pay up to the parent?

Well, the proceeds from the sale of that entity will remain in one of the U.S. subsidiaries. So we will then figure out what to do with that capital. The likely outcome will be to dividend that capital to the parent company and then figure out what to do with it once it's at the parent company. My guess is that will happen some time in January. And we'll be meeting -- the Board will be meeting again in early February, so right about the same time.

Just to make sure I understand that well, is there going to be any regulatory issues with pushing that capital back up to the parent?

I think in that case, no. There are other dividends that we are contemplating and we are discussing them with the various regulatory bodies, both in Bermuda and in the U.S. So we're looking at moving capital on both sides of the Caribbean.

Wonderful. You've been growing very rapidly in Select Markets. If you can be a little bit more specific in terms of what's growing and what's not growing in the Select Markets segment and how sustainable it would be?

Well, the growth has been fairly consistent in Select Markets. It is 10% to 20% on an annualized basis and has been for the last several years. It is really coming from the things that I mentioned earlier. I would say that the only part that's not growing right now is our Food Merchant program within Grocers. Having said that, the Retail Furniture Store program that Grocers started has been growing pretty quickly over the last couple of years. So it's really kind of across the board. The business is either flat or moving up. I don't think there's anything within Select Markets that is actually moving down at this point.

With regard to A&E and run-off liabilities, I know that you've considered in the past what to do with some of these liabilities including a loss portfolio transfer. Have you had any change of those views in terms of what to do with these liabilities? Keeping them, doing a loss portfolio transfer or any other form of transaction that can help you in freeing up the capital?

Yes, we looked at -- I think I alluded to this on our last call -- we looked at a lot of different alternatives as respects not only our A&E reserves but other reserves on our balance sheet. What we concluded was that selling -- the best way to eliminate the casualty reserves at PXRE was to sell PXRE Reinsurance Company -- and as respects our A&E reserves, because the only way to remove them from the balance sheet is through a reinsurance transaction. We concluded that the financial benefit to that really wasn't significant relative to what the price might be and that the best thing to do was continue our conservative approach as respects A&E.

You'll note this is actually the first time we have increased our loss reserves for development since 1996. The change in reserves you have seen in prior years has been related to either primarily credit or a change in reserving philosophy. When Mark and I first joined the Company, our A&E reserves were picked at the low end of our actuary's range. For the last several years they've been at the midpoint and that led to a change in 2002.

And again, this has more to do with payout patterns, we believe, than necessarily where we're going to end up. But we thought that now is the time to be conservative; not that we aren't and haven't been in the past, but now is a good time to be conservative. And I don't expect to spend any more time focused on moving our A&E reserves off our balance sheet. I'm comfortable with where they are and I think we've got other things -- other levers to pull in terms of capital management. But that won't be one of them.

Wonderful. Thank you very much.

Mark Lane.

I don't know if I missed it but on the sale of the PXRE subsidiary, what are the expected proceeds from that?

The proceeds may change depending on when we close and if we declare a dividend. So we didn't say what the expected proceeds will be because we don't know.

Okay. What's the maximum expected proceeds?

Again, Mark, that kind of depends on if we're allowed to pay a dividend and that would reduce the expected proceeds effectively dollar for dollar.

Okay. So when you go through this capital management process and discussion, what are the priorities you're trying to achieve? And how do you expect to communicate that to the market?

Well, I don't expect to communicate it any differently than we have done. Our first priority is to have capital to support our balance sheet, particularly the loss reserves on our balance sheet. Our second priority is to support our ongoing business, particularly growth in our core operations. And third, to then figure out what to do with any excess capital.

As we continue to reorganize the Group and determine how we use the capital -- in other words, to the extent that we can more efficiently utilize capital, that will free up more capital to use strategically, or to figure out how to best repatriate that capital. And that is where we are moving towards.

As I have been saying for several months now, it's a multi-step process. The first step was to go through the balance sheet and make sure that we're comfortable with both the asset side and the liability side of the balance sheet. The second thing to do is to reorganize the operations. Then the third thing is to assess any excess capital that we may have. We are quickly getting to that point.

So do you expect then by the fourth-quarter conference call to be able to quantify what you think your excess capital is? Or what sort of alternatives that there will be for that, including potentially share repurchase programs?

I would expect that we will be working on all of those things between now and the fourth quarter conference call.

Okay. The asbestos and environmental reserve, I mean, you always talk about conservative reserve setting, et cetera. I don't understand the justification for increasing reserves. I mean, no one else is talking about increasing reserves in asbestos. You talk about payout patterns, but I don't -- what exactly are you looking at that causes you to increase reserves by $26 million?

Well, when you have as few reserves as we do now, and when you settle a few large claims or arbitrations during the year on an actuarial basis, your paid method will move dramatically relative to your incurred method. And that's what happened in this case.

Does this -- what about the paid recoverable with Lloyd's? Does this have anything to do with that?

No, it does not.

Okay. On the International Specialty, the business was written in the quarter. That is all international property? Or what exactly is that business?

The majority of that is international property.

So Europe, basically?

Some Europe, the majority of it is in the U.S., but there is some Europe in there.

(OPERATOR INSTRUCTIONS). Amit Kumar.

I guess just starting with the PXT-related costs of $3.9 million, do you have any sense what that number might be for Q4 '07?

Zero.

Okay. Moving on, in terms of the recent management changes, could you perhaps just update as to where we stand in terms of the search for the new CFO?

I am flying to New York this afternoon and will be there the remainder of the week interviewing candidates.

Got it. I guess just talking about some of the competition; I know you briefly touched upon that. Could you give some more color as to where you seeing the usual players being a bit more aggressive? Or is it regional, sort of stepping into that space? Or where do you see the pressures coming from?

Well, I'm not sure how much more I can say, but maybe I can say it differently. On the E&S side, we are losing far more business to admitted markets coming in -- so it's not that we are losing it to competition. It just goes away. That is the nature of E&S.

For our traditional competitors, they are seeing the same things. Their results look very similar to ours. You still have some of the smaller competitors who are still trying to grow quickly coming in and pricing aggressively.

I guess the most extraordinary thing I have seen is -- or I should say, I have been told by my colleagues at our company is in our allied medical program in the E&S book, which we have been doing for years. That book continues to come under pressure. And we are seeing accounts leaving us at 40% to 50% of our renewal pricing, or of our expiring pricing. And I find that somewhat extraordinary. So maybe somebody is smarter than we are, but I sure can't figure that out.

And I guess just moving on to A&E, if I am doing the math right, I guess we get to a survivor ratio of, I guess close to 10? Is that a fair number?

That's correct.

Okay. And what you said was that this was mostly due to some settlements which you saw in '07, right? Was it numerous small settlements, or were there a few unusually large settlements?

A few unusually large settlements. And we don't have that many of those left, so that really skewed the numbers.

Got it. Okay, that's all for now. Thanks so much.

[Jay Winsing].

I got sort of lost in the description of the surviving capital trust notes. I believe there's a reference to some legal negotiation. Is it somewhat complicated? I imagine the structure as to who is responsible and the payment flows. Could you clarify that in somewhat layman's terms as to how that works going forward? Where those bonds are and who is responsible for them?

I'm sorry I wasn't clear when I said it earlier.

It was too legal for my simple brain, I'm afraid.

That's good because he is an accountant.

The short story is we would expect to keep the trust preferred outstanding and service that debt within one of our U.S. companies. Does that make sense?

That I follow, right. So they don't go with the transaction in other words, they stay with you.

They do not. They stay with us. So that's the intention.

Okay. The second question, assuming the transaction closes, essentially are you just sort of -- what are you sort of left with from the merger other than the new corporate name, et cetera, et cetera? Just essentially the tax loss carryforwards?

Actually you lose the tax loss carryforward in the U.S. What you're left with is the legacy Bermuda company balance sheet and the operating infrastructure. In fact, as a part of the sale of the U.S. company, we've capped the infrastructure and the people with us to service our operation prospectively. We're going to provide services to the buyer of the U.S. subsidiary. But we're actually keeping the infrastructure.

Okay. All right, so you actually did buy a business as opposed to just sort of a financial transaction. I would have had that backwards. I would have thought you -- I thought you were going to keep the tax loss carryforwards.

It's too hard to keep.

All right. Okay, that sort of clarifies my question. Thank you very much.

There are no further questions at this time.

All right. Well, I'd like to thank you all for being on the call today. If you look at the history of Argonaut over the last few years, we have grown substantially. We have changed substantially. It has all been methodical and incremental. And while I know that the last few months have been somewhat challenging in terms of getting clarity for where we're heading, I think that our actions in the third quarter and the early part of the fourth quarter that we've talked about today should give more clarity to what we've done on the balance sheet, the strength of the balance sheet. And we are now changing our focus to streamlining how we are organized, and most importantly, continuing our commitment to grow our core business.

I'd really like to thank our employees who have been working a lot of overtime over the last few months, both on the product marketing side and in the financial department. Thank you all very much. And I look forward to talking to everyone at year-end.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.