Argo Group International Holdings Ltd (ARGO) 2010 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Third Quarter 2010 Argo Group Earnings Conference Call. My name is Francine, and I am your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question and answer session.

(Operator Instructions). I would now like to turn the presentation over to your host for today's call, Mr. Michael Russell, Director of Investor Relations. You may proceed, sir.

Thank you, Francine, and good morning. Welcome to Argo Group's Conference Call for the Third Quarter of 2010. On the call today is Mark Watson, Chief Executive Officer, 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. I would like to remind you this conference call is being recorded and following management's opening remarks, the operator had provide instructions on how you may queue in to ask questions.

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 introduced 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 Chief Financial Officer, Jay Bullock, will provide you with additional financial details for the quarter, and then we'll take your questions. But for now, I'd like to just make a few general remarks.

Argo Group reported positive results for the third quarter, despite a continuation of the challenging market environment and another major earthquake occurring during the three-month period. We generated diluted earnings per share of $0.77 and net after tax operating income per share of $0.69.

Results for the quarter ending September 30th produced record book value per share of $58.38, which was up 6.5% from June 30th and up 14.2% over the last 12 months. Items of note during the quarter included the earthquake in New Zealand, continuing a trend of significant though isolated 2010 events affecting financial results in each of the first three quarters. For the insurance marketplace, these events individually or taken in total have lacked the significance to produce a meaningful impact on industry capacity or pricing, but have been significant enough to measurably impact financial results. Or to say it differently, we keep having a number of events hit us during the course of the year. Unfortunately, because they seem to happen sequentially instead of all at the same time, none of them seem to be enough to move the market.

Our exposure to the New Zealand quake was both in our Reinsurance and International Specialty segments, resulting in total net losses of $11.3 million, or 3.9 points on our third quarter combined ratio of 101.3. During what can be a cat-prone third quarter, we experienced a benign hurricane season in both the Atlantic basin and Gulf of Mexico, with no major storms hitting the US coastline. Our Excess & Surplus Lines and Commercial Specialty businesses both generated sub-100 combined ratios, which in the current environment reflects the scrutiny of our underwriters have embraced in selecting business they believe will produce profitable margins. As was the case during the first half the year, the decline in written premiums in the third quarter was a logical reaction to intense competition writing business at what we view as unrealistic levels. Additionally, our lower top line reflects a planned reduction in certain classes within the International Specialty and Commercial Specialty segments.

As our top line has continued to decline, we've been squarely focused on the adequacy our capital position. In reaction, we continued to return capital to shareholders through share repurchases and payment of cash dividends. Year-to-date, we've repurchased $81.5 million, or approximately 2.6 million shares of our outstanding common stock, and in the first nine months of this year, our Board has approved total cash dividend payments of $0.36 per share.

Given our strong financial position, combined with the highly competitive market environment, our current business strategy revolves around three primary tenants.

First, we're streamlining our infrastructure by realigning some of our business units to better position how we go to market, interact with our distribution partners and be more responsive to customer needs, and I'll talk more about that in just a minute. This includes more effectively leveraging available technologies that reduce the cost of doing business and make our platform more efficient overall.

Second, as we pursue our top-line growth objectives, we're judiciously deploying available capital in new areas of the market, those for which we believe will produce the highest returns. This element of our strategy often means investing in new underwriting teams that understand the industries and risk profiles of business they pursue, can benefit from the breadth and resource of our international platform and have demonstrated a track record of success. And I would, again, just point out that over the last two years we have spent a fair amount of our time attracting new talented people to our Company in lieu of making acquisitions. It isn't that we haven't been looking for them, but we think with the platform we have today, we finally have an opportunity to grow organically, as well as we do through M&A.

And then, third, we're renewing our focus on growth in new initiatives. As we work to secure a profitable market position across our existing platform, we're directing our attention and resources on under-served market niches, those that hold the potential of producing near-term upside while expanding our business reach for the long-term. This includes expanding our geographic footprint, as well as introducing innovative products and programs that better meet the needs of our insurers.

Let me talk about each business segment in a little bit more detail. Again, I'll leave a lot of financial metrics to Jay in his part of the presentation. Overall, the performance of our US business segments improved in the third quarter compared to the same period a year ago. Although it's far too early to call a bottom, we've seen over the course of 2010 a moderation of rate declines in the US, with selected slight improvements in pricing quarter-over-quarter for certain product lines. It doesn't mean I'm optimistic, it just means that I think we're starting to see things moderate.

Having said that, the Excess & Surplus Lines marketplace continued to experience a highly competitive environment. Our E&S segment produced slightly improved operating results in the third quarter, but written premiums were down meaningfully. Much of this decline is a result of the market conditions I've mentioned on previous calls, including the state of the US economy, resulting in a lack of start-ups, as well as business closures in our typical customer base; standard lines carriers expanding their risk appetites and writing accounts in what have traditionally been E&S territory; retailers going direct whenever possible; new entrants emerging into the E&S marketplace still; and our discipline to turn away from unprofitable business. It really is the combination of all of these. Given these factors, we expect the competitive market for E&S to continue.

With that backdrop, we've made adjustments to remain competitive. We are furthering our penetration in the profitable business classes and geographies, while exiting under-performing classes. Of significance in the third quarter was our combination of Colony and Argonaut Specialty into Colony Specialty, the formation for which we announced in early October. So this, again, is what I was talking about earlier in terms of some of our reorganization of our business and streamlining it. This new entity allows us to maintain the respected Colony brand; it makes it easier for our wholesale distribution partners to access our more simplified line of products.

Internally, the realignment makes us more nimble so that we can quickly responds to customer needs and changes in the marketplace. It promotes efficiencies within our E&S operations and better leverages the strengths of the entire Argo Group platform. Finally, E&S President Lou Levinson has named a very strong and experienced team to lead E&S, which we also announced in October.

As regards our Specialty Commercial segment, with market conditions as they are, our admitted business performed well in the third quarter. Commercial Specialty's risk selection produced a combined ratio of 93.7% in Q3 with prior year losses developing favorably. Lower written premiums for both renewals and new business reflect intense marketplace competition and the impact the continued sluggish US economy is having on the small- to medium-sized businesses. National and regional carriers continue to lower pricing and loosen terms and conditions to keep renewals and acquire new business. However, we have reason for optimism in some Commercial Specialty niche markets. For instance, the outlook is positive in the coal mining and grocery store industries. Further, we haven't seen demand for public entity coverage changing, even though state and local governments have curtailed spending.

Internally, our Commercial Specialty segment has fostered a culture of innovation and creativity aimed at increasing written premiums, insuring that risk selections meet margin requirements and improve loss selections. We also have implemented IT solutions that streamline policy administration, claims and billing, and we will continue to do more of this in the fourth quarter and all of next year.

Let's move on to our Bermuda and London-based segments. The Reinsurance segment in Bermuda, which includes our Casualty and Professional Risks businesses, reported positive results in the third quarter. As I mentioned earlier on my remarks, the segment's results were impact by the New Zealand earthquake and sustained $5.8 million in net Cat losses. This segment produced $8.4 million in operating profit, including favorable prior year loss development of $2.6 million. The combined ratio for the third quarter was 72.2, which includes 23.4 percentage points due to Cat losses. In the Reinsurance market, competition for third quarter renewals intensified with new competition moving into the space. However, Argo's Re client retention remained high. The increase in the Reinsurance segments written and earned premiums over last year's third quarter was primarily due to business written by our Casualty and Professional Risks business.

Finally, in our International Specialty segment, I'm pleased that the work we have done over the last several quarters is starting to produce better underwriting results. The improvement in the third quarter, however, was overshadowed by the effects of the New Zealand earthquake, which produced $6.1 million in losses. Net effect of Cat losses on International Specialty's third quarter loss ratio was 7.4 percentage points, and a combined ratio of 106.9.

As we mentioned last quarter, International Specialty's reduction in written premium is due primarily to a planned reduction of the property book, both the binder book and the direct and facultative book. We reduced our volatility and have begun to add diversifying classes of business typical of the Lloyd's market. For 2011, we believe the segment's book is right-sized with an acceptable risk profile, and I remain optimistic about the potential of our Lloyd's operation for the coming years.

With that, I'll turn the call over to Jay.

Thanks, Mark. I'll take a few minutes to add some additional detail on the quarter, and after that we'll take your questions.

Consistent with our comments over the last several quarters, market conditions for both our underwriting and investment businesses remain quite challenging. We continue to focus on the intelligent use of our capital, responding accordingly to the market with reductions in our underwriting businesses, while investing in new underwriting teams, modest reallocation of our investment portfolio, and return of capital to shareholders. These actions are reflected in a period-over-period reduction in gross written premiums of approximately 20%, a sequential although modest increase in net investment income despite the continued decline in portfolio yield, the realization of approximately $9 million in gains from the investment portfolio in the quarter and almost $29 million for the year-to-date period, and in the return of just over $92 million in capital to shareholders during the year.

The resulting financial impact is a continued increase in our book value per share, which is compounded at an annual rate of 12.5% since 2002. We continue to view this as a compelling track record over a period of time, which included significant industry wide loss events and the most challenging economic environment in recent memory. Our performance highlights and our focus on risk management in generating long-term shareholder value.

Now, I'd like to add to Mark's comments regarding commentary on our operating performance by segment in the third quarter of 2010. In the Excess & Surplus Line segment, the decline in premium was driven by intense competition and by underwriting actions taken in our casualty division, and the repositioning of some of our property exposures in this book. We reported positive prior year development of $1.5 million for the quarter and have reported $9.3 million of positive development year-to-date. Our E&S segment was not impacted by any significant catastrophe activity in the quarter.

In Commercial Specialty, the decline in premium is largely a function of increased competition in our public entity business. The exit late last year of certain classes in Argo Select, mainly religious institutions and hotel/motel risks, offset by increases in our mining operation and our surety business. In this segment, we reported positive prior year development of $1.9 million, mainly from our mining operation, and have reported positive prior year development of $5.4 million for the year-to-date. Likewise, the segment did not experience any losses related to storm activity occurring during the quarter.

Consistent with our communications last quarter, the premium written in our International Specialty segment reflects the planned reduction in certain property classes and the significant competition in the direct and facultative market. Further distorting the decline in premium, however, is the fact that the 2009 period result included $40 million in additional gross written premium related to property binder business stemming from late reported premium from prior periods. Prior year development for the quarter was negligible at positive $800,000 offset by prior year negative premium development of $3.5 million. As Mark mentioned, the segment did experience a loss from the earthquake in New Zealand of approximately $6 million.

In the Reinsurance segment, we saw an increase in premium primarily related to the continued development of our excess casualty business, as well as an increase from a third-party relationship we have in the Middle East region. Prior year development was positive $2.6 million as the most recent accident year continues to develop favorably. So for the quarter, for the group in total, prior year reserve development was favorable at $3 million. Year-to-date, we stand at approximately $26 million of favorable prior year development. In addition to our quarterly review of prior accidents years, our reviews always incorporate a look at the current accident year as well, to make sure we are responding appropriately to changes in business, the external environment and market conditions. We continue to focus our attention on infrastructure and have several initiatives under way which we expect will have a meaningful impact on the expense ratio in the future. These initiatives, however, continue to require investment in system and process redesign in the near term.

Now let me comment on Argo's investment results. The global trend in yield decline continued in the quarter. Argo's investment income for the third quarter, however, increased slightly to $33.6 million from $33.2 million in the second quarter, and $31.9 million in the third quarter of 2009. This result was achieved by a modest reallocation of the portfolio in the first nine months of the year to credit and to a lesser extent on high yield credit.

Total return performance for our portfolio was 2.9% for the quarter and 5.4% year-to-date, supported in part by strong performance in our equity allocation. The book yield on our fixed income portfolio decreased slightly during the quarter from 4.1% to 3.9%. The duration of our portfolio has not changed significantly and is approximately three years, slightly shorter than our expected liability duration. Argo's investment portfolios remain conservatively positioned with a weighted average rating of double A and with 91% of our assets in total invested in investment-grade bonds.

Argo's unrealized gain for the third quarter increased $268 million, up from $180 million at the end the second quarter. This appreciation reflects the decline in real and absolute yields during the quarter. Our portfolio generated $9 million in net realized gains for the quarter coming from a number of our different strategies. We continue to believe our conservative investment strategy provides us flexibility to take advantage of investment opportunities as they arise. Other than the repurchase of common stock, which we have mentioned, there was no material change to our capital structure in the quarter, but we find the composition of our capital base provides us flexibility, and we believe that as a group we remain well-capitalized.

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

Yes, sir. (Operator Instructions). We have a question from the line of Amit Kumar of Macquarie.

Thanks and good morning. Just going back to the discussion on the market conditions, I get the sense that you're more pessimistic than a large specialty company. That company had, in fact, noted that audit premiums were turning positive and standard lines and new entrants had started reducing or exiting the movement from E&S. And what I'm hearing today from you is that it's as bad as it was in the past few quarters. Can you just expand on that a bit more? You know, is it a function on the specific segments or is there something else going on?

Well, actually I'm not sure that our comments are that inconsistent. I think you're now seeing signs of being at the bottom of the market as opposed to getting to the bottom of the market. I'm not any more pessimistic today than I was last quarter or the quarter before. I probably am slightly more optimistic, actually. I say that because we are seeing some of the same things, which is we're seeing rates flattening out, we are seeing some competitors exit the E&S marketplace, either completely or by line of business.

Having said that, we are still seeing new competition coming into the marketplace. I'm not sure that that's necessarily offsetting those that are exiting, but so far the companies that have exited the business are either very small or, if they're larger, they're exiting a particular line of business. I think that you're going to start hearing mixed commentary from a number of us over the next few quarters as we bump along the bottom of the cycle, but I think that we have kind of flattened out, but we've flattened out at the bottom, right? That doesn't means things are moving up. And so while things don't appear to be declining, I don't think that investors should think that means that all of a sudden the hard market is here and things are moving up. So I'm just erroring on the side of being cautious in my comments.

And these new entrants, who are these? Are these public companies or are these non-public companies?

Most of what I have seen come in, Amit, has been small non-public companies that have been quietly setting up for the last year or two, or new startups within existing public companies.

Okay. That's actually quite helpful. Secondly, in your opening comments, you mentioned that you were streamlining units. And I'm just wondering would there be any impact on expenses going forward from doing that?

I think the answer is yes. I mentioned in my remarks earlier today that we had streamlined a fair amount of our Excess & Surplus Lines operation. That led to a negligible expense as we continue looking at ways to consolidate many of our back office operations at a group level, so not just within E&S. I think that in the short run that will lead to additional expense. Obviously, we wouldn't do it if we didn't think there were long-term gains to be had. And I think that as we become a little bit closer to doing some of these things, we'll have more to say on our earnings call at the end of the fourth quarter.

Okay. That's actually quite helpful. Just moving on and then I will re-queue. In terms of sort of your overall premium picture, so what you're saying is that E&S would likely be down for 2011, Commercial Specialty would likely be down, Reinsurance could be flat from that excess casualty, and International Specialty will also be down. Is it fair to say that 2011 premiums might be down maybe mid single-digits and maybe also can you talk about that and maybe remind us regarding your stand capacity for

So I think it's possible that premium will be down next year, depending upon market conditions, because, again, we are still at the bottom of the market. I think we have to keep in context that while part of the decline this year is a function of the competitive marketplace, that a significant amount of the decline in premium was intentional, and I think we also need to keep perspective that during 2007, 2008, and 2009, when many of our competitors were holding flat and/or declining their premium base, ours grew rather dramatically.

And so, 2010 has been a year to reset the risks that we have on our portfolio given market conditions. And I think with that done, I think we look for 2011 to be probably flat from 2010. It's possible that any one of the segments could see a single-digit decline in premium. It's also equally possible that we could see an increase in premium.

It wouldn't surprise me if our London syndicate actually grew premium double-digits. Our stand capacity at Lloyd's is GBP350 million. We originally were planning to reduce that to GBP325 million, but given some of opportunities that we believe will -- that we'll be able to execute on in 2011, we're actually going to keep the stand capacity flat. So a lot of the initiatives that we've been working on the last couple years to grow, even in this market, are starting to take hold. And so I think it's just as likely that you would see us growing next year as declining, but, again, some of that is going to be dependent upon how competitive the marketplace is.

Okay. That's actually very helpful. That's all for now. Thanks so much.

(Operator Instructions). We have a question from the line of Scott Heleniak from Royal Bank of Canada Capital Markets.

Hi. Good morning. Just wondering, investment income was up for the quarter. I guess it was about the first time it was up in about five quarters, and I know you guys have been doing some repositioning there. You mentioned credit and higher credit. Just wondering, is that completed or should we expect that to continue over the next couple quarters? And do you think it will be enough to generate positive investment income growth for next year?

Well, I guess that there's countervailing winds blowing here. One is we're taking a modest part of our portfolio and, as an example, just how modest it is just to kind of size it for everybody. The portfolio is about $4 billion. We allocated $100 million out of that $4 billion to high yield, but that was taking something that was otherwise generating -- we actually -- and we took most of it out of our equity portfolio. So generating a 2% dividend yield to something generating 6% or 7% coupon has a pretty immediate and meaningful impact on investment income.

So there are a couple of other strategies that we're in the process of moving towards that would be more income oriented and have a slightly better yield than what we're getting on the core of our portfolio. But I don't think that you will see -- you certainly won't see a change in overall quality, and probably won't see much of a change away from the sort of 90% total investment grade bonds number that I mentioned. So that's one thing that we're doing to try to offset it. The countervailing wind is that quarter-over-quarter the portfolio yield continues to go down. Our duration is three years.

Yields are down -- new money yields are down around 3% right now. Roll the clock forward for everybody, and 18 months, if the world hasn't changed, we'll be -- our portfolio will have gone from 3.9 to 3, as the math would take you there. So we're doing what we think is prudent. We're paying a lot of attention to the capital that we allocate to the various strategies to the risk that -- to any sort of risk correlations that are there, and I think the things that we're doing are modest. We're seeing some benefit from that, but we've got this other pressure on the portfolio, and we'll see how long it takes for the markets to change and start to get a little bit of momentum.

Okay. But do you expect to do more of that in the fourth quarter, though, of reallocating some of the capital to the higher yielding investments?

The answer is yes. The answer is yes. But again, it's in $50 million increments, and in total if we had at the start of this year $250 million in our equity portfolio and the rest in investment grade bonds, at the end of this year we'll have in round numbers $400 million in equity and higher yielding fixed income. However, that might -- whatever form it might come in, and the rest in investment grade bonds. So, again, not a significant shift.

Okay.

Also, with the global capital market's dead-end equity moving around so much, I think there's going to be continued repositioning in the portfolio every quarter next year.

Okay. And then next question is just on the E&S segment. The premiums were down pretty significantly, and I know you guys mentioned in Commercial Specialty that there were two particular areas, religious institutions and hotel/motel business. Was there any specific areas in E&S that were similar where you may have really, really paired back or exited any particular class this year or last quarter, that drove that decline?

We pulled back substantially in our excess casualty book of business, particularly our transportation exposure, and I think you we'll continue to see that. Perhaps not the same magnitude, but we'll continue to see some of that in the fourth quarter of this year. I would not expect to see a lot of that in 2011.

Okay. The only other question I had was just International Specialty. Just wondering if you could give some quick detail on the reserve building there of $3 million -- any particular class or was it several different classes or just any more color on that?

Well, just to be clear, the positive development was $800,000, offset by a revision in premium estimates. We call it premium development, the local description is premium development. And so the $3.5 million that we, in effect, reduced on premium was related to the property binder book. And so it's, again, it's late reported business and so we are -- last year we reported $40 million of positive development, so good news is that the changes are getting much more modest. But there wasn't anything in the book in the quarter that was specifically negative related to any sort of reserve development.

Okay. Thanks.

(Operator Instructions). And there are no further questions in the queue. That concludes the Q&A portion of our presentation. I would like to turn the call over to Mr. Mark Watson for closing remarks.

Thank you, and thank you everyone for calling in today. I think what you've seen is that we have completed making a number of the changes that we've been working on over the last year and a half as respects underwriting. We're now shifting the focus of our attention to streamlining our operations and that will be the theme for the next couple of quarters. And we also have been very actively managing our capital base, and you should expect us to continue doing that in the foreseeable future, as well. Thank you again for your time, and we look forward to talking to you again at the end of the fourth quarter.

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