Argo Group International Holdings Ltd (ARGO) 2011 Q3 法說會逐字稿

Hello, ladies and gentlemen, and welcome to the third quarter 2011 Argo Group International Holdings conference call. My name is Francine, and I am your coordinator for today. (Operator Instructions). I would now like to turn the presentation over to your host for today, Mr. Matt Coyle, VP of Investor Relations. Sir?

Thank you, Operator, and good morning, everyone. Welcome to Argo Group's third quarter 2011 earnings conference call. Joining me today is Mark Watson, Chief Executive Officer; and Jay Bullock, Chief Financial Officer. On today's call, Mark and Jay will review the Company's financial results for the quarter, and afterwards, we will open the call for questions. I would like to remind everyone that this conference call is being recorded and that 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 risk and uncertainties surrounding future expectations, generally and may materially differ from actual future results involving any one or more such statements. Argo Group undertakes no obligation to publicly update forward-looking statements as a result of the 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. Now, ladies and gentlemen, it's my pleasure to turn the call over to Mark Watson, CEO of Argo Group.

Thank you, Matt, and good day to everyone. We appreciate you taking the time to join us today. After my remarks, Jay Bullock, our CFO, will provide you with additional detail about this quarter's financial results, and then we will be happy to take your questions. It goes without saying this has been a challenging quarter for us in a year that has presented the industry with significant catastrophe activity. For the quarter, we incurred a modest pre-tax loss of $6.1 million. It is always disappointing to have to report a loss. However, I would like to say the overall financial condition of the Company remains strong.

Moreover, the platform that we have built and the strategic actions we have taken to date position us well for achieving sustained profitable growth as market pricing and economic conditions improve. In terms of market conditions, I am sure many of you have already listened to the earnings reports of our peers and competitors this quarter. It is good to hear certain carriers are pushing hard for rate increases as are we. However, market pricing is still very competitive especially for new business opportunities which is why, as an example, premium in our E&S segment continues to shrink.

While we continue to push for rate increases, there is significant capacity that continues to underwrite business at what we believe are unsupportable rate levels. But, I assure you, we are not willing to grow premiums at the expense of underwriting discipline. That said, we did grow this quarter as gross written premiums were up 12.6% versus the same period in 2010 primarily due to new product initiatives we launched in our Lloyd's platform, Syndicate 1200, earlier this year. I will discuss the details in a few minutes. In our excess and surplus line segment, gross written premiums were down 12.2% in the quarter as compared to the same period a year ago. The decrease primarily reflects targeted reductions in certain specialty casualty and property programs as margins on those classes of business were inconsistent with expectations. Further complicating matters was a lack of new business opportunities due to competition in a weak economy. The economy has really put a damper on small business startups, Something you have heard me talk about before as it's a key source of growth for our part of the property casualty industry. That said, we like the business we have retained and actually recorded a combined ratio of 91.8 for this quarter.

Equally note-worthy was the positive rate change in our E&S segment this quarter. Although modest it is the first rate increase we've observed in seven quarters. In our commercial specialties segment, gross written premiums up 3.8% as compared to the same period a year ago. The increase primarily reflects higher payrolls in the coal mining industry which generated increased premiums. New business opportunities in our commercial assurety business and low single-digit rate increases also added for the second quarter. I should say the second consecutive quarter.

During the quarter, we continued to invest in this segment of the business as evidenced by our strategic investment in SureTec and our acquisition of S.N. Potter Insurance Agency. We believe our investment in SureTec, the 20th largest surety writer in the US, will offer us an attractive investment return as well as an opportunity to partner with a top-notch organization and grow our presence in the U.S. surety market. Our other acquisition, S.N. Potter Insurance is a boutique program manager of wineries that will complement our suite of fee-based specialty businesses in our all terrace division. In our international specialty segment, it is the quietest quarter in terms of new business generated.

The change in gross written premiums during the quarter primarily reflected a timing difference with respect to when accounts were renewed this quarter versus last quarter. The pricing in this segment is still very mixed. Rates are high in some cases and significantly higher across all energy classes and for loss-affected areas. Remember, this is where we have our excess casualty business as well as property cat reassurance operation. And the market for professional lines and management liability, however, which is also in this segment, remains disappointingly competitive. Pricing for renewal business is generally lower as there is an abundance of capacity willing to write business at lower margins. Separately but related, we continue to leverage opportunity to expand in key markets abroad.

During the quarter, we opened our office in Dubai, the world's fastest growing financial center, to better serve existing and future customers on a more local basis. And hopefully we'll have more to talk about our operation in Brazil in the next quarter's call. In our Lloyd segment, Syndicate 1200, gross written premiums were up significantly in the quarter versus the prior year and 9.2% higher than the second quarter of this year. The increase was primarily due to new business growth from our aerospace and specialty divisions, which we launched earlier this year, and strong growth from our casualty and property divisions. That said, pricing remains mixed and our premium volumes remain well below 2009 levels. Rates in our casualty division were effectively flat as compared to a year ago, and our marine specialty and aviation divisions reported rate increases in the mid single digits. Absent continued catastrophic activity, we feel we have positioned Syndicate 1200 to perform in line with our expectations.

In summary, I feel good about the actions we have taken to position the Company for long-term profitable growth. I don't want to dismiss the volatility from our international property cat portfolio, which has been quite disappointing for the year. But I must say that I am confident the platform we've built will service well when the market fully turns. Until such time, we remain vigilant on writing only those risks where we can earn an acceptable return on our investment. I will turn the call over to Jay Bullock, our CFO.

Thanks, Mark. Good morning, everyone. I will take a few minutes toreview the results and then open up the call for your questions. As Mark mentioned, it was a challenging quarter. While there is discussion about improving conditions, with investment yields as low as they are, the amount needed to achieve acceptable returns is significant. We are doing our part on rates and at the same time we continue to walk away from business that's under priced. That said, our new initiatives are gaining traction and our portfolio repositioning is largely done, as we saw quarter-over-quarter growth in premiums written for the first time since 2009. As outlined in our press release, we reported a modest pre-tax loss of $6.1 million for the quarter. This compares to pre-tax income of $31.4 million for the same period a year ago.

The loss for this quarter was driven primarily by continued catastrophe activity and to a lesser extent by events in prior periods which I will speak to in a moment. It's worth noting that despite the incurrence of an operating loss, we generated sufficient income in our U.S. operations to incur a tax provision which pushed our net results to a $12.1 million loss. While gross premium was up in the quarter, net written premium was relatively flat. This is a function of an outwards reinsurance transaction in the quarter which required us to account for the full premium in the quarter. The decline in net earned simply reflects the timing differences between written and earned.

During the quarter, we've incurred storm and catastrophe losses net of reinstatement premiums of $26.7 million versus $12.8 million for the same period a year ago. Losses in the quarter primarily reflect catastrophe activity related to hurricane Irene, the Danish floods, and an increase in loss estimates on events that occurred in the first half of 2011. The quarterwas also impacted by approximately $10 million of loss from aggregate reinsurance coverage relating to exposures in the Midwestern United States. By segment, the losses were as follows. Excess and surplus line; $2.2 million. Commercial specialty; $7.3 million. International specialty; $14.7 million from specific events and $10 million from the aggregate excess of loss coverage. And Syndicate 1200; $2.5 million. Year-to-date storm and catastrophe losses net of estimated reinstatement premium were $171.6 million and $56.6 million for 2011 and 2010 respectively.

Prior year reserve development was favorable in the quarter. For the quarter, we reported $4.6 million of favorable prior year reserve development net of premiums and losses. Versus $3 million for the same period a year ago. The positive development in the quarter was most pronounced in our excess and surplus lines segment, where we saw net development of approximately $15 million. Driven primarily by general and products liability. We experienced unfavorable development in our runoff business resulting from our annual asbestos and environmental review. Specifically, $6.2 million for asbestos driven by increased severities and higher defense cost and $3.5 million in our environmental segment driven by one significant environmental loss. We also had approximately $4 million of unfavorable development in commercial specialty. Year-to-date for the group, we reported $1 million of favorable prior-year reserve development net of premiums and losses.

In addition to our quarterly review of prior accident years, our reviews always incorporate a look at the current action year as well to make sure that we are responding appropriately to changes in our business, the external environment, and market conditions. This was most pronounced in Syndicate 1200 this quarter to reflect the larger incurrence of property losses related to weather activity but not specifically identified in the catastrophe the numbers I cited a moment ago. Our expense ratio improved slightly in the quarter. This is reflection of continued efficiency improvements offset by investment and new initiatives designed both to drive the top line and further stream line the infrastructure of the organization.

Turning now to investments, the prolonged decline in interest rates and the eventual reinvestment at those lower rates was most pronounced in the quarter, as investment income declined to $30 million from $32.9 million in the prior quarter. Majority of this decline was in the U.S. portion of our fixed income portfolio. The quality of the fixed income portfolio, which represents approximately 86% invested assets was unchanged with an average rating of AA and a duration of 3 years. Net realized gains in the quarter were $3.9 million versus $9.1 million a year ago.

As you know, the period ending September 30 was close to the bottom of the market for risk assets. As a result, we saw a decline of $69 million on a pre-tax basis in the value of our portfolio in the quarter to $186 million above book from $255 million in the second quarter of 2011. This decline accounted for the majority of the decline in our book value per share in the quarter. As you also know, the market rallied globally in October. By the end of the month of October, the portfolio had regained all of the value lost in the prior period. In terms of capitalization, we ended the quarter with $1.85 billion of capital comprised of $1.5 billion of book equity and $378 million of debt. Book value per share inclusive of common dividends at the end of the quarter was $54.85 versus $56.65 at June 30th .

As just mentioned, most of the decline in book value was recovered in the month of October. In the quarter, we repurchased approximately 600,000 shares for $17 million. Through nine months, we have repurchased $37 million of our stock and returned $10 million to shareholders in the form of common dividends. During the month of October, we repurchased an additional $1.3 million of our shares. Operator, that concludes our prepared remarks. At this time, we are happy to take

(Operator Instructions). First question from Amit Kumar with Macquarie.

Thanks and good morning. Just going back to the opening comments and this is a question for Mark. You sound a bit more skeptical compared to some of the other companies. That is fine. I am wondering if you can expand on the difference between renewal and new business pricing and maybe also talk about what your expectation is of margin improvement going into 2012?

I think that I probably do sound a bit more skeptical. I am no more skeptical today than I was a quarter ago. Actually, I am probably more optimistic today than I was a quarter ago. If you listen to what a lot of our competitors are saying. Yes, they are getting rate improvements. They will also, I think, at least the ones that I have talked to also recognize that given where interest rates are and given the expected loss cost inflation, the rate improvement that we are seeing isn't sufficient to cover either one of those prospectively, let alone both of them.

Seeing rates going up 3%, 5%. That is great compared to a quarter ago and a year ago where we still saw declines where the market flattening. It is good news that it appears that the market has stopped declining and has bottomed out and is now moving up slightly. But until we start to see more substantial rate increases, it is hard to imagine us as an industry covering our cost of capital with interest rates at record lows and, therefore, yields on our portfolios at half of what they were just a few years ago as we continue to reinvest pre-cash at lower and lower interest rates. So I don't mean to be too skeptical. We are in a good spot. I think rates need to keep moving more and more. That is particularly true for international property risks. Certainly property cat reassurance portfolios.

When you look at the losses that have come in this year, Amit, it wouldn't surprise me if the industry loss radio for international property cat risks was 300%. And that comes on top of a year that wasn't very good last year, and we are looking at programs that are coming up for renewal on the 1st of January where market terms are becoming a bit more solidified, and there are accounts that may renew not at just a 10% increase, but maybe even flat in Europe. So I am scratching my head thinking it is just not mathematically possible. So if that is the case,we will probably pull back some of our premium writing for international property cat this year because rates, particularly loss exposed programs, ought to be going up 100% plus and I just don't see it happening. It defies logic.

That makes sense. I guess related to that is the capital question. How do you view capital going forward? I know that you have talked about $100 million or $150 million backing the runoff. How do you view capital management? The way you are talking, it sounds that it might be still attractive versus some of the new opportunities. Maybe just expand on what are your thoughts on capital, capital management, and capital backing the runoff entity and maybe its future disposition?

Starting in the first quarter of 2011, we began more aggressively repatriating capital both through share buybacks and dividends. We just thought that with our share price where it was that was the best use of any excess capital we might have. We continued that through the first quarter of this year and then, of course, we have had like everyone else in the industry, had a number of losses from all of the natural catastrophes that occurred. That slowed down our share buy back in the second quarter of the year. As Jay just announced, we became a bit more aggressive in the third quarter buying back stock and we have been buying it back through the fourth quarter as well. I think that as of about now, meaning the beginning of November, we have repatriated about $50 million worth of capital from share repurchases and dividends so far this year. I don't think we will get to $100 million this year because we had stopped for the time being. We have a use for our capital going forward.

We are making investments in the future. We have made small acquisitions. We have not made large acquisitions. We would rather use any excess cash right now to repatriate capital. I don't see us accelerating the rate. I think the market is changing enough for us to deploy our capital and of course as we do continue under writing business, the loss reserves on our balance sheet continue to grow. Which is a positive thing, not a negative thing, but we do need the capital to support them.

As I said in previous calls, our first priority for capital is to support our current business. Our second priority for capital is to support the organic growth which is core to our business. The third use is to look for other strategic opportunities that further our strategic business plan. And to the extent that we have excess capital, we will repatriate it. I haven't changed my mind about that nor have my colleagues on board . As we look -- it's a tradeoff as to what is going to be most accretive or best for our shareholders in the short term and the long run, and we are always balancing that. But I think that right now with our share price where it is we will continue repatriating some capital to our

Got it. Final question and I'll re-queue. In terms of the development from the first half losses, what sort of outcomes can we expect going forward in terms of can your number move or how should we think about that?

I am not sure what you mean by can our number move.

In terms of the industry loss. Loss keeps on increasing from the first half. Does your number -- is it booked? I guess it is not booked to the limits. Maybe just talk about the correlation?

That is the right question. Many of our programs are booked at limits. Having said that, there are a couple programs where depending upon what is reported, we could see some loss emergence, but I would be surprised if that loss emergence was more than at this point a few million dollars.

Okay. Thank you for your answers.

Our next question comes from the line of Doug McWhirter of RBC Capital Markets.

Good morning. I just had two quick questions. The first, on the reserve movements in the quarter, I just wanted to make sure I understood the numbers correctly. You reported the net positive result for your business and reported the asbestos and environmental charge. Is the $4 million of net positive is that inclusive of the asbestos charge or is the asbestos charge on top of that $4 million favorable?

The number I mentioned was $4.6 million inclusive of premium and losses, and that was inclusive. That included any charges in our runoff segment.

Thanks. That clears it up. Second question on the investment side. So, Jay, there was no, I guess, major movements within your portfolio that sent the yield down so much? What is your book yield now and what is your new money yield? Is it dropping that quickly?

Yeah. It was significant in the quarter, I've got to tell you. The new money yield -- the book yield is about 3.7%. The effective yield, the portfolio yield is about 2.2%. You know, we are just seeing the effect. We had a bit more cash in the quarter.

We have some money set aside for our investment in Brazil. It was just a few things on the margin that pushed it down. When you get into it, when you look at the numbers, the decline in income just out of the fixed income portfolio that is allocated to the U.S. was $1.8 million. That is nothing more than a reflection of the decline in yields in that portfolio and the reinvestment of money into that portfolio.

For the last three years, we have been investing the majority of our cash at the short end of the yield curve. All of that stuff is rolling off at even lower yields unfortunately.

Thank you for the answers. That is all my questions.

And our next question comes from Howard Frankner from Argo Group.

Hello everybody. I have a comment and question. It took 13 minutes to connect to your conference call. They might hire another person or do something other than Morris code. I didn't hear the part, I am sure you mentioned something about rates at the beginning of the call. Could you please repeat what you said?

I was saying that rates across-the-board for our company are moving up slightly, but that is very mixed. For loss exposed accounts, we are seeing double-digit rate increases, particularly our energy portfolio for our professional liability business. We are still seeing a fair amount of competition and rates are still declining. For our international property cat portfolio, we are seeing pricing indications from the first of January that would suggest that accounts will be renewing at 10% to 15% instead of perhaps 50% to 100% and, in some cases, they may be renewing flat, which I find absolutely shocking.

People love to lose a lot of money. It happened before. They will catch on.

I also suggested that if indeed that did happen that we would not be providing as much capacity in 2012 as we did in 2011.

That is the discipline that will make you more money in the long run Thanks for repeating that. I just wasn't able to connect.

I don't know why. We have never had that happen, but we will certainly look into it.

As the time went, I kept looking at the clock on the PC -- I am telling you, 13 minutes.

We'll look into it Howard. Thank you very much for giving us a heads up.

That reminds me from trying to get an airline ticket on any one of the airlines.

And we have a follow-up question from the line of Amit Kumar from Macquarie.

Hey. Just two quick follow-ups. I know you briefly touched upon the binder book. Can you expand on that comment? You mentioned the growth came from specialty, and I couldn't write down the other unit that you might have mentioned. May we just talk about that and the margins you might be getting on this business?

I am not sure what I said that sounded like the binder book because we didn't actually talk about it.

So let's talk.

So you know, the binder book is still actually declining a little bit. Most of the growth is coming from kind of retooling our casualty operation in the Syndicate and getting it going again. As I mentioned in my remarks in the beginning, Amit, while we have seen a fair amount of growth in the Syndicate, it is still well below where we were in 2009. I don't envision getting back to that level for a couple of years because I don't think the pricing is there, so the growth we see is mainly policy count, not rate. Having said that, we think the margins will lead to an acceptable return. I will define that as 10% plus percent of underwriting margin.

Got it. And the only other follow-up is just going back to the asbestos and environmental reserve charge. You mentioned that briefly, but can you just expand on that a bit more?

Let me say a couple of things, then I will let Jay get back to the numbers. To remind everyone, every year in the third quarter we do a review of our asbestos and environmental reserves. We have been doing this since I became CEO 11 years ago. It was much more of issue then than it is now. Having said that, there was a bit of movement this year. Part of that was, in effect, we haven't really moved our loss reserves that much for the last eight years. On a gross basis, what we have seen is changes on a net basis primarily due to credit issues from reinsurance recoverables which are pretty much taken care of at this point.

We continue to see the claims count come down although I am still amazed that here we are 10, 20, 30 years later and in some cases more than that from when the policies were in force that we still have thousands of new claims a year. Of course, we close more than we open. We are down to a few thousand open claims. There are still claims coming in. There are a few that were a bit larger than we thought, and as a result, we thought it made sense to true up our gross reserves a bit in this quarter. Jay, do you want to go back through the numbers?

Yeah. The net number for the quarter was $6.3 million. It is worth noting there was some ups and some downs. We had the $6.2 million for asbestos which I mentioned which was all about severity and defense cost. Environmental was $3.5 million that was related to one large loss that was elevated in the quarter. We had a few miscellaneous things that are in the runoff that about $2.3 million. That was offset by $5.7 million of favorable development in our risk management business.

You remember, we sold the renewal rights to the risk management back in 2005. The significant reserve changes to that business were made back in 2000. They haven't moved significantly since then. We have been fortunate in the last couple of years they have proven slightly redundant. The net number for the runoff segment for the quarter was $6.3 million. It is worth noting that the net number for runoff for the year is about $3 million.

One of the challenges that we also have is that the reserve balance is so small now that when you have any one significant claim come in, it moves the gross number around because the reserves are getting so small.

Got it. Thank you for all of the answers.

We have a question from the line of Randy Binner from FBR Capital.

Thank you. You know, I know that the RBC analyst asked this and I just wanted to sure we are 100% clear. The $9.7 million A&E prior year development charge is included in the overall $4.6 millionfavorable number?Is that the case?

That is the case.

Okay. Thank you. Then on, I guess, going to the combined ratio and particularly on expenses, can you review for us what expenses might have been one time in the quarter? Because there is an upward trend there yet the commentary is more towards improvement. So just trying to think about how we run our expense ratio going forward? How much unusual was there in the quarter that we might not expect going forward?

One of the challenges -- overall expenses, Randy, are declining, but right now premium -- earned premium declined as well from earlier this year from the decline in written premium this year and the end of last year which will start moving back the other direction, which will help reduce the expense ratio. The expense ratio has actually been coming down a little bit. We will start to see it improve more as expenses remain relatively flat and earned premiums start to improve in prospective quarters. Having said that, there are a few one-time expenses. Jay, I don't know if you have got a schedule in front of you.

We have got a few IT initiatives going on right now that will last for the next 24 months in terms of cash outlay, but they will be amortized over a larger period of time. Right now, we are in the process of bringing all of our underwriting systems and claims systems and other technology platforms together into one or two platforms both in the U.S. and outside the U.S.,and that spend is going to probably affect the expense ratio by about 100 basis points for the next couple of years.

Yeah. I'd say that there was some one-off items for the nine months. There weren't that many one-off items for the three months. But just to give you a couple numbers. General expense away from the commissions and premium taxes was $51 million in the quarter. That is against approximately $56 million in last year's quarter.

So having said that, you know, as I mentioned in my comments, we are investing in new initiatives. Those new initiatives will start to pay dividends in terms of top line generation. A lot of the savings we've made recently are being put into new initiatives both to drive the top line and to streamline our operations. As Mark is alluding to, we are embarking on a project or have embarked on a project on the systems side that will keep our spend on IT relatively flat for the next two years, but we think it will reduce it significantly from a scale standpoint in 2013 and beyond. I don't actually anticipate until we start to see some of the top line growth that we saw this quarter. Flowing through the numbers, I don't actually expect to see the expense ratio decline significantly primarily and that's primarily because of the costs we are incurring in some of our new operations.

That is great. Fully understood on the premium aspect of it. The bottom there is the underlying combined ratio probably would stay a little bit above 100 on a go-forward basis. Is that a fair conclusion?

The underlying combined ratio is just above 100. Last year it was just below 100. When you take out prior accident year and you take out the cats and everything else, you've got that about right. Some of what you see, I mean, the other comment that I made in my prepared comments was that we have seen some top line growth as we have launched new initiatives and dealt with what I called the repositioning of the portfolio.

We have been talking about that for a while. That would be things like the binder book in London as an example or some of our what was formerly Argonaut Specialty excess casualty book there. The point that I'm making is that I really do think there is reason to think with some of the actions we have taken in the portfolio in a couple of areas that really did cause some issues that would have added a point here or there to the combined ratio, I think we've dealt with some of those. So absent continued unusual catastrophe activity, I actually think that we could see improvement in the combined ratio.

Just one other on investment income or investment yield. You know, how actively do you consider the prevailing investment when you kind of set the parameters for your underwriters?How much do you perceive that your competitors do? Are you trying to price today's business on a 200 basis point treasury?

The answer is yes. The problem is that doesn't necessarily mean all of our competitors are. And even if all of our competitors say they are publicly, that doesn't mean their line underwriters are, nor does that mean ours necessarily are either. Sometimes the larger the organization, the more easy it is for the message to get lost. For so much of what we underwrite, we are in a very competitive marketplace, and I hate it when my subordinates say this, but the reality is the market price is the market price.

That is why I was saying earlier when Amit said, look, you don't sound so positive compared to your competitors. The answer is, yeah, that's great market pricing has gone up. But to your point, if the yield is 2% and a few years ago, it was 5.5%, Then, you know, for every 100 basis-point decline in yield, we need to improve underwriting margin by almost 300 basis points. That hasn't happened yet. That hasn't happened in our company and it's happening at an industry level yet either. So yes, I think about that a lot and so does our entire management team. And that is the challenge we have, and that is why you have seen our top line decline in part for the last couple of years. Because the margin we need to generate the return is just not there.

I think I share your cynicism there. Thank you for the comments.

And as we have no further questions in the queue, I would like to turn the call over to Mr. Watson for closing remarks.

I would like to thank everyone for joining us today. And Howard, if you're still on, I am sorry you had trouble getting in. It has been a challenging quarter knowing where we are in the market cycle. But I see more positive than negatives. We continue to, I believe, reposition our portfolio in a more positive way.

We are starting to see signs of that in the margins in some of our business and in the top line overall. I look forward to your questions and talking to you again at the end of the fourth quarter in February. Thank you again for joining us.

Ladies and gentlemen, that concludes today's conference. We thank you for your participation. You may now disconnect.