Argo Group International Holdings Ltd (ARGO) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2010 Argo Group International Holdings, Ltd. earnings conference call. My name is Kaitlyn, and I will be your operator for today. At this time all participates are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). This conference is recorded for replay purposes. I would now like to turn the call over to your host for today, Mr. Michael Russell, Director of Investor Relations. Please proceed.

Thank you, Kaitlyn, and good morning. Welcome to Argo Group's conference call for the second quarter 2010. On the call is Mark Watson, Chief Executive Officers, and Jay Bullock, Chief Financial Officer. We are pleased to review the Company's results for the quarter as well as provide management's perspective on the business. Before we begin, I would like to mention we'll be participating in the KBW Insurance Conference September 7, so should you be attending, we invite you to sign up for one-on-one meetings with Argo Group management.

I would like to remind you this conference call is being recorded. Following management's opening remarks, the operator will provide instructions on how you may queue and ask questions. As a result of this conference call, Argo Group management may make comments that reflect intentions, beliefs and expectations for the future. Such forward-looking statements are qualified by 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 results events or developments subsequent to this call. For a more detailed discussion of such risks and uncertainties, see Argo Group's filings with the SEC. With that, I would like to introduce Mark Watson, CEO of Argo Group. Mark?

Thank you, Mike, and hello, everyone. We appreciate you taking the time to join us today. In a moment our CFO Jay Bullock will provide you with financials on the first quarter, and then we will take your questions. Let me make a few remarks first.

The challenging operating environment we saw in the first quarter this year continued into the second, with a highly competitive marketplace coupled with an above average amount of large loss activity. Despite this, Argo Group generated earnings per share of $0.86 and operating earnings per share for the second quarter of $0.49. Results for the quarter resulted in book value per share at June 30 of $53.76, an all-time high and up 4.6% since the end of 2009. Over the preceding four quarters, our book value per share has risen 15.3%.

Let me run through the items that had the most impact on our operating results for the second quarter. As previously reported, we experienced above average losses from large events during the second quarter. Our US segments, primarily Commercial Specialty and to a lesser extent Excess & Surplus Lines, sustained losses from severe spring storms. Unfortunately 2010 looked more like 2008 than it did last year. Additionally, our Reinsurance segment received notices of increased loss estimates from cedents related to the Chilean earthquake that occurred in the first quarter. We've seen a number of industry numbers going up over the last few months resulting from the Chilean earthquake.

Finally, while information and facts surrounding the event remain quite unclear, we reported bulk estimate for potential losses related to the Deepwater Horizon incident and reaction to notices of potential claims in our excess liability book of business. Although the first half of the year produced higher levels of loss activity than anticipated, it is important to note this activity has not had a material effect on pricing thus far. Other than in a few opportunistic areas of the industry, we expect the impact on pricing unfortunately to still be negligible.

Across our segments, the top line, written premium, reflects our reaction to the current environment in this point in the underwriting cycle. We are pulling back from business where we don't see sufficient returns, returns under stress as a result of the investment environment and the generally poor level of economic activity. We continue to explore ways to intelligently grow but expect the size of the business to decline modestly before it expands, certainly during the rest of this year, which has been our plan.

The investment we are making today in people and new lines of business is designed to position our platform for a better operating environment, which we hope is going to come in the future. We don't expect that environment to develop any time soon, though. As a result, we continue to reserve the current and recent accident years at the level we think is prudent, while we, like much of the industry, continue to have favorable development on older accident years. We believe it is unlikely there will be any change to the pricing environment as long as older years continue to develop favorably.

Which brings me to our capital position. Argo Group remains soundly capitalized. Our continued financial results and conservative management of our $4.3 billion investment portfolio have served to further strengthen our balance sheet, we believe. As mentioned, we have intentionally reduced our exposure in certain product classes in response to the challenge to attain acceptable risk-adjusted returns, and those reductions have exceeded our total capital deployed in new and existing areas of the business. In response, we've chosen to return capital to our shareholders during the first six months of this year.

During the second quarter we repurchased an additional 241,000 shares of Argo Group stock, and year to-date that brings our repurchases to 1.2 million. Additionally in the first six months of 2010, our Board has approved total payments of $0.24 per share in cash dividends. We consistently monitor our capital position, as you've heard me talk about in previous calls, as a part of our strategy, and we continue looking at how we can repatriation excess capital to our shareholders in the future.

Let me talk about each segment in just a little bit of detail, and then Jay can go through the numbers in more detail. We'll talk about the Excess & Surplus Lines segment first. And as I mentioned earlier, the market there continues to be challenged. We are pleased that we did generate an underwriting profit for the quarter, particularly as E&S maneuvers -- or as this business maneuvers -- through an environment of intense competition from traditional E&S competitors and new market entrants, as well as from standard line carriers that are displaying broader risk appetites, often writing what has historically been written in the E&S marketplace, the classic sign of the bottom of the market cycle.

This competition coupled with the weak economic activity in the US continues to dramatically reduce net new underwriting opportunities. We're not seeing that many new things to look at. So submission rates for E&S in the second quarter were down substantially. Our hit rates haven't changed, we're just not seeing that much new business at the moment. Anyone looking for profitable margins must achieve it, therefore, primarily through keeping up one's renewal book as opposed to counting on new business. So gross written premiums were down substantially in the second quarter when compared to last year's second quarter for all of those reasons. The E&S segment does have some exposure to spring storms in the US, and as a result we reported about $2.3 million in property losses during the second quarter.

On the positive side our E&S segment continued to experience favorable prior year loss development, which totaled $6.4 million in the second quarter, and non-acquisition expense reduction initiatives are starting to achieve positive results. We'd like to see those expenses come down more, but are now moving in the right direction. And that's happening with our new President of E&S, Lou Leavenson, who I introduced on our last quarter's call. He's been strengthening his team since coming on board and implementing some of the initiatives that I just referenced, and also a few new growth opportunities.

Let's talk about Commercial Specialty. As I mentioned at the open, our Commercial Specialty segment bore the brunt of US spring storm losses during the second quarter, reporting losses of about $10.3 million net of reinsurance. The segment produced second quarter operating losses of $2.1 million, which included favorable prior year loss development of $2.2 million, again, for the quarter. The specialty admitted marketplace is facing many of the same issues as our E&S segment, that of being impacted by the sluggish economy and rate declines due to stiff competition. In addition, we've exited certain lines of business where achieving scale and thus predictable and acceptable loss experience we thought was attainable over a market cycle is just not where we are today.

Let me next talk about our Reinsurance segment. In the second quarter, it generated a 76.6 combined ratio, making a meaningful combination to operating results despite events in the quarter. Gross written premiums were $70 million, or up approximately 15% from the second quarter of last year. Growth in this segment was generated primarily by the first full year operation of our excess casualty unit in Bermuda. That said, the returns in our Reinsurance business represent one of the few opportunities with an attractive risk-adjusted return. However, Argo Re remains selective in the risks it reinsures and as a group we remain very cognizant of aggregate exposures across our underwriting platform.

As I mentioned earlier during the quarter, the Reinsurance segment received notices of increased loss estimates for cedents related to last quarter's earthquake in Chile, and therefore recorded additional losses of $4.4 million from that event in the second quarter. Prior year losses for reinsurance did continue to develop favorably notwithstanding that. Regarding the reinsurance market environment, competition intensified for July renewals, and although cedents are retaining more risk and purchasing less reinsurance, client retention remained high for Argo Re.

In our Casualty and Professional Risks unit within the segment, not much has changed since our last report. Competition remains high despite events such as the credit crisis and the Deepwater Horizon event. Reaction to these events has had limited impact on specific classes of business in a positive way, but by no means has it impacted the broader marketplace yet.

Let me talk about our fourth segment, international Specialty. This is mainly our Lloyd's platform. And while the results for the quarter don't suggest it, I'm actually becoming more enthusiastic about the prospects in this business. We have made significant progress regarding the changing complexion and quality of the book of business, and we are in the process of adding diversifying classes of business that naturally comes to the Lloyd's marketplace. The core reduction in the top line reflects our continued and planned reduction of Argo International's property book, both the binder business as well as the direct and facultative books of business. And this is more now about competition than it is risk mitigation. And there were other one-time events, year over year, that affected the top line and have a distorting impact on production, but Jay will talk through those in more detail in just a minute.

The disappointment in the business this quarter is related to the liability book, where we saw adeterioration in the medical malpractice book of business, specifically Italian hospitals, which has been a market-wide event. Both of these books today look significantly different than when we acquired the business. These provisions led to a combined ratio for the second quarter that was 105.3 percent. The second was not materially affected by catastrophes during the quarter, but reported unfavorable prior year loss development of $5.5 million, again mainly because of the liability book of business.

Let me just summarize. We've experienced unusually large loss activity in the first half of 2010. And while the level of activity would suggest our exposures have increased, whether you select any PML or aggregate exposure number, the reality is we, through I think methodical and disciplined risk management, reduced our aggregate exposures by approximately 25% to 30% in the past two years. And while competition is high in all of our business lines, we remain disciplined, strengthening our infrastructure and personnel while expanding our product offerings and evaluating new opportunities.

Argo Group's balance sheet is strong, we continue to generate profitable and positive results in a difficult part of the cycle, and the Company is positioned well to take advantage of the market when it improves. With that I'll turn the call over to Jay.

Thanks, Mark. Let me add some additional detail on the quarter, and after that we'll take your questions. As mentioned over the last several quarters, market conditions for both our underwriting and investment businesses remain challenging. As Mark noted, we continued to react appropriately with reductions in our underwriting business, investments in new teams and opportunities, and a modest reallocation in our investment portfolio, all of which is designed to improve returns while protecting our capital base.

We are pleased to report we continued our book value per share growth through the quarter, increasing 2% from March, while achieving a compound annual growth rate on our book value per share of 12% since 2002. Current environment aside, this is a compelling track record over a period of time which includes industry wide loss events and challenging economic investment in recent years.

Mark has already gone through the significant large loss activity for the quarter, so I will comment on usual items by segment beyond this. First let me note again that in 2010 we have begun allocating interest expense, an item which was not allocated in 2009.

In our Excess & Surplus Lines segment, the reduction in operating profit was driven in large part by the reduction in gross written premiums and the corresponding reduction in earned premium. The margin on this reduced volume coupled with spring storm losses and other property losses, the group-wide reduction in investment income, and increased expense ratio account for the decline in operating profit year over year.

The decline in operating profit for Commercial Specialty is largely related to the increase in spring storm activity Mark just mentioned. Likewise the Reinsurance segment is a function of the increase of Chilean losses, coupled with a provision from the loss from the Deepwater Horizon event, partially offset by positive development from the recent years' lost provisions. In our International Specialty segment of particular note is the significant decrease in the quarter over quarter gross premium written. The second quarter of 2009 was impacted by the recognition of approximately $40 million of additional premium written largely related to our property binder business.

Quarter over quarter, another $40 million of the reduction in gross written premium is a function of the planned reduction of certain lines of business. The balance of the decline is largely accounted for by the impact of exchange rates on our non-dollar premium, as the dollar strengthened significantly against sterling and the euro. The other factors impacting the net results include prior year development in two of our liability classes and the recognition in the current accident year of rate pressure on our current book.

Across the platform we continue to make progress in operating efficiencies. Nominally our non-acquisition expenses declined 6% year over year, continuing on pace with the progress in the first quarter. Despite the decrease we continue to target operating expenses and improved efficiencies across all segments.

Let me spend time on Argo's investment results. The levels of investment income in 2010 have been challenged, given a continued decline in interest rates in most global markets. Argo's investment income for the second quarter of 2010 decreased slightly to $33.1 million from $33.8 million in the first quarter of 2010 and from $41.9 million in the second quarter of 2009. Recall again prior year's quarter included a one-time gain on the settlement and collection of interest on disputed receivable. Absence this, year over year decline of $3.7 million is accounted for by the reduced rate environment. Total return was 1.6% for the second quarter and 3.2% year to date.

We continue to keep the duration of our portfolio relatively short, with an overall duration of three years, which is slightly shorter than our expected liability duration. Argo's investment portfolio continues to be positioned conservatively with an overall rating of AA. In response to the investment environment and in recognition of the broad diversification we've maintained in the portfolio, we've selectively begun allocating a small portion of the portfolio to higher-yielding income-oriented investments. The first such allocation was to lower rated investment-grade and higher rated non-investment-grade corporate bonds. We expect to see the positive impacts of this strategy on investment income in coming quarters.

We also took advantage of bond market liquidity to dispose of some underperforming structure holdings. The effect of these strategies during the second quarter was increase in book yield to 4.1% from 3.9% in first quarter fixed income investments. Again this quarter we continued to hold no sovereign exposure to any of the distressed euro-zone countries. The quarter's bond market rally, in contrast to the equity market decline, increased Argo's unrealized gain position to $180 million at the end of the second quarter as compared to $176 million at the end of the first quarter and $60 million at June 30, 2009. Our portfolio's net realized gains of $5 million in the second quarter are from the execution of our strategies. This is in sharp contrast to last year's quarter $9.2 million of realized losses as we took advantage of an improving market to increase our portfolio diversification.

A final note on the income statement. We recorded an $8.5 million foreign currency gain in the quarter as the dollar strengthened against sterling and the euro. The gain represents the revaluation of our non-dollar liabilities. This was matched by a roughly equivalent decline in the value of our non-dollar denominated assets, which was accounted for in other comprehensive income.

Commenting on our capital structure, Argo Group ended the quarter with approximately $2 billion of capital, split between $1.6 billion book equity, and $386 million debt comprised of $311 million in trust preferred securities, $60 million of senior debt, and a balance of $15 million drawn on our revolver. We remain well capitalized, and as Mark noted, thus far this year returned almost $44 million in capital to our shareholders. Kaitlyn, that concludes our prepared remarks and we are ready to take questions.

(Operator Instructions). Your first question from the line of Amit Humar of Macquarie Group.

Good morning, and thanks. Just going back to the discussion on the Italian med mal, can you just expand on that a bit more? I know that one of your peers had adverse development, but in Q1, and that adverse development for them had come from a public hospital book. Maybe just comment on where did you see these issues in the Italian market?

It was -- Amit, it was in a similar line of business, and we got a significant amount of new notices in the second quarter. And so while we did react on a smaller scale in the first quarter, additional information came in during the second quarter, and we felt it prudent to react.

And are you still writing this? Or have you ceased underwriting the book?

Well, I think the point we were making earlier, there were really two classes of business. There was a general reliability class related to some Australian business, and this medical malpractice business. Both of those look significantly different today. We are not writing that Italian medical malpractice, and those were both books of business that were written prior to our acquisition of the company.

So you're [saying] that you have kind of ring-fenced the issues in Italian med mal?

I think we've taken an appropriate -- very appropriate action in this quarter, and I'm hopeful we don't see additional issues any time in the near future.

Based upon what we know today, the answer is yes.

Okay. That's helpful. And just staying on the International Specialty segment, going back to the binder book, maybe you can refresh what exactly does this book include? My sense is this was North American and Australian non-cat property exposure. Is that correct? Maybe just briefly tell us how close you are to putting this issue to bed?

So actually a lot of the business does have -- a lot of business that was on the book had cat exposure. But it was cat exposure to events that don't happen very often. So let's take as an example earthquake exposure in British Columbia. It has been a long time since there was a big earthquake there, but as we went back and looked at the amount of capital that we ought to be allocating to events that have significant tail risk, even though they don't happen very often, we decided to pull back some of that premium volume. And so that's freed up a fair amount of capital in doing so. We finished going through the program as of July 1 of this year.

So while we may still be changing a few programs here and there, the work that we started over a year ago is now compete, which is why I made the comment earlier in my remarks, Amit, that when I look at our exposure today versus a couple years ago, we think -- pick any metric you want and we think it's about 25% to 30% less. And so when you think back to the losses we had in 2008 --which relative to our capital and others in the industry, I think we're pretty manageable -- we would expect to have a better result today than we did then. So it's a bit frustrating to look at losses that came in the first half of this year, because we don't believe they are reflective to the exposure we have on the books today. There's been more frequency than we would have expected.

Okay, that's helpful. And just finally, going back to the discussion on capital management. Obviously you bought back a small amount. If I were to ask you to rank an open mark purchase, an ASR, a tender offer or a special dividend, how will you rank those options?

Two, one, three, four. So I think that in the first half of this year, we found that doing an accelerating share repurchase was a little easier to accomplish than open market purchases, because it allows us to -- it allows for the acquisition of shares even when we're in a quiet period. And I'm not really sure that we're -- I don't know what my Board's thought is about a special dividend or tender offer. We have our meeting next week for the quarter, and I'm sure we'll be spending some time talking about it.

Okay. That's all for now. Thanks so much.

Your next question comes from the line of Mark Dwelle from RBC Capital Markets. Please proceed.

Yes, good morning. A couple of questions. First I'd like to take a second and focus on the expense ratio. You managed to -- in this quarter you managed to hold it in pretty well in line with past run rates despite a pretty sharp drop in overall premiums. I just wanted to get your sense, as I heard you discuss the lines of business, it sounded like a lot of cross currents between talking about adding teams and expanding product lines, which usually has a tendency to increase the expense ratio, as compared to you mentioned cost-cutting efforts in the E&S line, and I know you've been successful in cutting costs in the past. I'm just trying to get a sense really of kind of directionally where you see the expense ratio heading, particularly in the light of contracting book of business?

Well, therein lies the challenge. How do you invest in the future and cut expense in the present? I think some quarters, to be honest, Mark, we've done a better job of that than others. I think we do have the expense focus going in the right direction at the Company, not only at a group level, but also in the individual businesses. And one of the things I think has allowed us to be successful over the last 10 years I've been running the Company is our ability to balance between managing expense and investing in the future. And there have been quarters where we looked at the expense ratio and thought that's a little high, but we saw the benefit of investing and where we were going to get to by doing it. And that's one or two points of experience, not eight to 10. It still affects margin but not a material effect on margin.

I think the biggest challenge for us isn't managing how much money we spend investing in the future. I think that's pretty moderate. I think the biggest challenge for us is, as we contract in certain markets, are we contracting the expenses associated with supporting that business as quickly as the contraction? And that's one of the internal pressure points we have right now. You can expect to see the expenses come down, but it's very difficult to get them to come down dollar for dollar with revenue for a couple of reasons. One, you've still got to support what's on the books. And second, in our case, we have a few investments related to technology that once we finish will allow us to bring down the expense number more, but until we finish deploying that technology, we've got another quarter or two where we're going to have more expense than we like.

Okay, that's a helpful discussion. The same question I had related to the reinsurance book. And really it's just more, can you remind me at what point that business started to aggressively ramp up, which -- What I'm getting at is, at what point do we kind of start lapping over where we've got a book that is going to be more, I'll say, renewal driven as compared to new business growth driven?

The answer is now for the property cat reinsurance portion of the segment, which is the majority. That's been the case for two years on a written basis, and for a year on an earned basis, as respects the liability component. So, excess casualty and excess professional liability, that was true on a written basis in the second quarter -- so on the quarter that we just reported, and on an earned basis that will be true in the third and fourth quarters of this year.

Okay. Just what I was looking for. Thanks very much.

There are no further questions in the queue at this time. (Operator Instructions) You have an additional question from the line of Mark Dwelle from RBC Capital Markets. Please proceed.

Sure, if no one else is going to ask, I'll keep going. One other question, Jay, you mentioned related to changing some of the portfolio allocations. It sounded like it was -- what I understood from your comments was that it was a modest increase in duration and likewise a little bit of a modification in terms of targeted risk profile. Is that something that you see continuing over coming quarters with more portfolio going that way, or this kind of take it in small baby steps, which to say we could have done a little bit now, you'll kind of see how that plays out, and then wait a while before we do more.

Well, I think one of the things that we, to the positive, realized over the past couple of years is we had really benefited from a pretty well diversified portfolio. And as we started looking at the capital that we allocate to the investment portfolio and our ability to marginally improve returns by what I would call fairly modest allocation. So for example I mentioned a low investment grade high-yield mandate. That's $100 million in the quarter, but it has a real impact on investment income in part because some of it is coming from the equity portfolio.

We reduced our equity portfolio slightly and allocated some to the high-yield mandate. I think you would expect to see us do more of that, but I don't think you see anything -- you won't see the portfolio statistics, i.e. the weighted average credit quality, or frankly the duration, change all that dramatically. If we went from a AA flat to a AA minus in credit quality, I couldn't imagine us going further than that. If you sit down and work through the math, it does have a material impact on income.

Maybe hearing that a little differently, it would seem to me all else being equal, which I appreciate is a pretty big caveat around it, it would seem the steps start arresting the two-year decline in average portfolio yield.

That's the game plan.

Okay. I will stop there then. Thanks.

There are no further questions in the queue at this time. I would now like to turn the call over to Mark Watson for closing remarks.

Thank you, Kaitlyn. I'd like to thank everyone for being on the call this quarter. It's been a pretty lumpy quarter and a lot of the initiatives we eluded to we'll be working on for the remainder of this year, particularly on the expense side and capital repatriation. So I'd like to thank everyone, and I look forward to talking to you at the end of the third quarter. Have a good day.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.