Argo Group International Holdings Ltd (ARGO) 2012 Q3 法說會逐字稿

Welcome to the Argo Group 2012 third-quarter earnings call. My name is Lorraine and I will be your operator for today's call. (Operator Instructions). Please note that this conference is being recorded.

I will now turn the call over to Mr. Matthew Coyle. Mr. Coyle, you may begin.

Thank you, Lorraine, and good morning, everyone. Welcome to Argo Group's third-quarter 2012 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 up the call for your questions.

I'd 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 risks and uncertainties surrounding future expectations 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.

Now, ladies and gentlemen, it's my pleasure to turn the call over to Mark Watson.

Thank you, Matt, and good morning to everyone. We appreciate you taking the time to join us today.

Let me take a few moments to share with you my thoughts on the quarter, after which Jay Bullock, our Chief Financial Officer, will provide you with additional detail about this quarter's financial results, and then we'll take your questions.

I obviously can't begin my comments on last quarter without addressing the events of last week. Everyone at Argo is very focused on the millions of people impacted by Hurricane Sandy. Our offices in New York City were closed all of last week, and many of our employees were displaced or without power.

At times like this, it's important that we as an industry demonstrate the value we provide to customers and businesses alike. We have our property claims team on the ground helping policyholders already. Later in my remarks, I will share with you my thoughts on our potential exposure to Hurricane Sandy.

Turning to the quarter, for the group we reported $17.7 million of pretax income in the quarter versus a pretax loss of $4 million for the same period last year. In three of our four operating segments, we saw strong topline growth and solid underwriting profits as initiatives to expand businesses and to raise rates continue to be evidenced in the results.

I am encouraged by the positive developments we're seeing from most of our businesses this past quarter. Perhaps most significant in the quarter was our continued growth in book value per share. We completed the quarter at $61.41 per share, an all-time high, which represents a 10.4% increase in book value per share from the beginning of the year.

Regarding market conditions, we continue to see what I would call an improving market, as we are seeing rate increases in each of our segments for most products. While far from the expectations of a traditional hard market, this positive momentum can only be credited to some level of overall market discipline, recognizing the need for higher rates as a result of historically low interest rates. For the foreseeable future, our success as measured by us achieving our return on equity targets will be a function of underwriting profits, not investment returns, something you've heard me talk about in previous quarters.

To that end, the focus of our team is on rate improvement, risk selection, and improved efficiency in our cost structure. We are building our plans for 2013 and beyond on the view that while certain events may have a temporary impact on the underwriting or investment environment, it's the execution of our strategies to deliver underwriting profits in the current environment that will be critical to our success.

As a group, we achieved topline growth for the fifth consecutive quarter, which I believe largely reflects the collective efforts of all the hard work in each of our businesses. I expect this trend to continue in subsequent quarters.

On the business development front, our fee-based distribution-focused unit Alteris enhanced its product and service capabilities with small bolt-on acquisitions. Just after the quarter closed, we acquired the stock of John Sutak Insurance Brokers, a leader in providing specialty programs for the wine industry. This complements a program that we already had in place and now makes us one of the larger insurers of independent wineries in the US -- or, I should say, insurance provider of independent wineries in the US.

We also acquired the operating assets and business rights of Mattei Insurance Services, a Seattle-based specialty program manager with a focus on agricultural and transportation risk. While modest contributors to our 2013 result, they represent important additions to the strategy of controlling specialty premium to better serve the needs of our clients.

Before I comment on each of our businesses specifically, I'd like to mention a couple of capital management items contemplated in the quarter. We continued to return capital to our shareholders, repurchasing $10.2 million of stock at an average price of $30.34. In conjunction with our strong operating results and investment appreciation, our decision to repurchase shares contributed to the growth in book value per share.

In addition, we issued 6.5% senior unsecured fixed-rate notes in the quarter. The notes have a 30-year final maturity, and the proceeds will be used to retire more expensive, shorter-dated securities in our capital structure. That should be completed in the next few weeks, and Jay will talk more about that in his remarks.

Now let me briefly recap how each of our business segments performed in the quarter before I turn the call over to Jay.

Our excess and surplus lines segment continues to perform very well, with gross written premiums up 12.6% in the quarter, due primarily to strong growth in our casualty, contract, and environmental businesses. Most notable, though, is the fact that our net earned premiums showed positive growth for the first time since the third quarter of 2009. We've been reporting topline growth for the past several quarters, but, as you know, it takes time for growth to be evidenced in earned premium.

In the quarter, submission activity was up 26% year over year versus 17% last quarter, and I think this is a really important metric to think about because we're seeing more business flowing back into the marketplace and we're also getting, I think, a bigger share of business to look at, and that's helping drive our topline.

Our renewal retention ratio also improved from a year ago, and rate activity for the segment was positive for the sixth consecutive quarter, most notably in those businesses where rate is needed the most, transportation being an example.

Moreover, we reported an underwriting profit for the fifth consecutive quarter, even with the losses from Hurricane Isaac contributing 7.8 loss ratio points to our margin.

Our reserving practices continued to lead to positive development for this segment, and in the quarter, we posted $11.8 million in favorable development.

The progress we've made in this segment over the last several quarters has been very rewarding. We spend a lot of time, as you know, shrinking our business and trying to drive margin, and I think you're now beginning to see it in the results and I'm very pleased with the platform that we have. I really do believe that it's one of the best E&S platforms in the business and I look forward to talking about that more in future quarters.

In our commercial specialty segment, gross written premiums were down about 4.7% in the quarter as compared to the same period a year ago. As we discussed with you last quarter, we've been taking a hard look at the business inside our Argo insurance unit. Recall, this is our retail book focused on grocers, restaurants, and other retail establishments, such as dry cleaners.

While this process continues, I would expect our topline at Argo insurance to decline for the remainder of this year and probably a good part of next year.

While the overall prior-year development for this segment was modestly negative at just under $1 million, we incurred several large property losses beyond what we would normally expect, mainly related to fire in the quarter, which led to negative underwriting result. And I think those losses were about $5 million, but Jay will talk more about that as well.

Away from Argo insurance, Rockwood, our mining business, continued to produce strong results in the quarter. And our surety business is experiencing strong topline growth as well.

Just to go back to Rockwood for a minute, I should also note that if President Obama is re-elected, I suspect the coal industry will continue coming under pressure and I think that that's likely to affect Rockwood's top line slightly next year.

Turning to our International Specialty segment, gross written premiums were up approximately 36% in the quarter as compared to the same period a year ago. The increase reflects approximately $14 million of new premium from our startup operations, primarily in Brazil. We experienced growth at Argo Re as a result of rate increases and new business opportunities, mainly in our property cat reinsurance portfolio.

In our excess casualty and professional liability units, which also are a part of International Specialty, we saw good topline growth as these businesses continued to modestly expand their footprints. Of the combined ratio for the whole segment, for the quarter it came in at an 85.4%, which reflected relatively benign cats for the quarter, offset by losses from a few smaller, isolated events, as well as some losses from our crop reinsurance book.

In Syndicate 1200, our Lloyd's segment, gross written premiums were up 9.6% in the quarter, and the segment produced a combined ratio of 90.7%. And you'll recall that our gross written premium grew quite substantially in the third quarter of last year.

Growth came at each of our casualty, specialty, and aerospace divisions, offset by the planned decline in our property division. It was worth noting that through nine months, the pretax result for this segment stands at $18 million, in stark contrast to the $45 million loss through nine months of 2011. And while much of the hard work in reshaping the syndicate was done in 2011, a more normal loss environment, at least up until last week, provided -- I think provides a better opportunity to see the effort that's really being contributed to the bottom line.

In addition, we can now see the effects reflected in the balance sheet for this segment, starting with approximately $2 million of favorable development that we reported in the quarter. This quarter's results reflect a second consecutive quarter the syndicate has generated an underwriting profit. This is, I believe, continued evidence that our initiatives are taking shape.

As respects Hurricane Sandy, it's really too early to tell what's going to happen. We have risk in all parts of the group. We insure small businesses directly through Argo insurance, particularly laundry and dry cleaners. We also insure public entities through our commercial -- through Trident in our commercial specialty segment.

As respects to the syndicate, we have some risk to homeowners through our binder book and some large petrochemical companies through our DNF book. You may recall, over the last couple of years Jay and I have talked about derisking the portfolio, particularly at the syndicate, and I believe that our risk in the Northeast is down about 75% today versus a couple of years ago in the syndicate.

And then, as respects Argo Re, while the majority of our risk is in Florida, we do have risk in the Northeast, and I think that if we're going to see claims, we'll see them both from our cat programs and from our per-risk covers. It's likely that somewhere there will be one, two, or a handful of large properties that we reinsure on a per-risk basis that may have a specific amount of damage.

I would also say, remember that for business interruption to be triggered, there has to have been property damage in order for a policyholder to file a claim.

And with that, I'll turn it over to Jay and I'm sure that you'll have more questions in Q&A about Hurricane Sandy.

Thanks, Mark, and good morning, everyone.

As Mark mentioned, there are many positives to take away from the quarter just reported. We're excited about our progress and can see the evidence of all the hard work the team has put into the business over the past couple of years. Let me highlight and further discuss a few things about our financial results, and then we'll open up the call for your questions.

As outlined in our press release, we reported after-tax income of $13.4 million for the third quarter, compared to a net loss of $10.8 million for the same period a year ago. That translates into earnings per share -- earnings per diluted share of $0.52 versus a loss of $0.39 per share in the prior-year period.

Current-period results include $8.3 million of realized investment gains and $9.7 million of losses from movements in foreign currencies. After-tax net operating income per share was $0.59, versus a loss of $0.31 per share in the prior-year period.

As Mark discussed, our topline gross and net written premiums, as well as earned premiums, all were up significantly in the quarter and through nine months. Through nine months, the gross and net written premiums were up 12.7% and 17.5%, respectively, as compared to the same period -- same nine-month period a year ago.

Earned premiums in the first nine months were up 8.4% over the first nine months of last year. The disparity in growth rates is a function of the timing of the recording of certain reinsurance contracts.

During the quarter, we incurred catastrophe losses of $13.9 million versus $26.7 million for the same period a year ago. The majority of those losses were incurred from Hurricane Isaac, which totaled $11.9 million. Catastrophe losses in the quarter were -- the majority of the Hurricane Isaac losses were incurred in our Excess and Surplus Lines unit.

Overall prior-year loss development was favorable in the quarter. We recorded $10.4 million of favorable development versus $2 million of favorable development for the same period a year ago.

By segment, the development was as follows. Excess and Surplus Lines, $11.8 million favorable, coming from accident years 2009 and prior. Syndicate 1200, $2.1 million favorable, largely from property classes. International Specialty, $900,000 favorable, coming from movement in prior-year catastrophe events -- small movements in prior-year catastrophe events.

Commercial Specialty $600,000 unfavorable, the combination of small negative prior-year movements in Argo Insurance and Trident offset by positive movements in Rockwood, our mining business. And as Mark said, the current-year period had approximately $5 million of losses that were fire related in the current period.

And finally, in run-off adverse development of $3.8 million, the net effect of approximately $5.5 million of prior-year strengthening for asbestos liabilities, due primarily to an increase in defense costs. This was offset, to some degree, by positive development in our risk management reserves.

The loss ratio in the quarter, inclusive of catastrophes and prior-year development, was 62.6% versus 74.5% for the same period a year ago.

The expense ratio was up slightly in the quarter and for the nine-month period, primarily due to our investment in new initiatives, which include both our new underwriting operations and changes to our support systems. As these new ventures generate premium and projects come online, we expect to see sequential improvements in our expense ratio.

Foreign currency losses for three and nine months reflect significant -- sorry, foreign currency losses for the three months reflect significant third-quarter strengthening of the US dollar against the pound sterling and the euro and the resulting decline in the value of contracts denominated in those currencies. As is our practice of managing this exposure by investing in assets denominated in currencies of like amount to the liabilities, we saw a corresponding increase in the value of those investments, which is reflected in our equity account.

Our third-quarter tax provision of $4.3 million reflects a blend of various tax rates in countries where operating profits were produced in the quarter, primarily in our US segments and two Syndicate 1200 based in the UK. The provision is also affected in the current period by foreign currency adjustments in non-dollar-denominated jurisdictions.

Turning to investments, the overall size of the portfolio, including cash, increased in the quarter, due primarily to the receipt of $139 million of cash proceeds from our recent debt offering and an increase in the unrealized gain position of $45 million, as compared to the second quarter.

Given the continued lower yield environment, our net investment income was down $1.1 million as compared to the same quarter a year ago and as compared to the second quarter of 2012.

The book yield on the fixed-income portfolio declined to 3.5% from a yield of 3.6% in the prior quarter.

In the quarter, we achieved net realized gains of $8.3 million, consisting of fixed maturity gains, net of other than temporary write-offs of just over $1 million, and gains related to foreign exchange movements which favorably impacted the funds we hold at Lloyd's and our FX edges on certain catastrophe exposures. Also impacting realized gains in this quarter was an increase in the market value of certain strategic investments.

The fixed-income portfolio, which represents approximately 84% of our invested assets, has an average rating of AA-minus and an effective duration of 3.2 years.

At the end of the quarter, pretaxed unrealized gains in the portfolio were approximately $333 million, up $101 million from year-end.

Elsewhere on the balance sheet, our receivables declined, reflecting our increased percentage participation on Syndicate 1200. Loss reserves were down, reflecting the continued payout of last year's higher level of catastrophe losses, and unearned premium was up as a result of increased production.

Our total capital position ended the quarter at approximately $2.1 billion. That amount includes $144 million of the 30-year senior notes that Mark mentioned, which were issued in September through our wholly-owned subsidiary, Argo Group US, at a coupon of 6.5%. The majority of the proceeds will be used to redeem our 8.85% PXRE Capital Trust securities and 9.75% PXRE Capital Trust junior subordinated debt securities, which we expect to be completed in the next couple of weeks.

We were very pleased with the execution of this transaction, and I want to thank everyone that was involved in getting this done.

Our book value per share increased 10.4% to $61.41 in the quarter against $55.60 at December 31, 2011. In the quarter, we repurchased 336,000 shares at $10.2 million and returned $3 million to shareholders in the form of common dividends. Year to date, we've repurchased $37.6 million, or approximately 1 million shares, and returned $9.3 million in dividends.

We will continue to balance the decision on return of capital against the opportunities we see in front of us in the market and a compelling valuation of the stock.

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

(Operator Instructions). Amit Kumar, Macquarie.

Thanks and good morning. Maybe just going back to the comment you made regarding BI. Can you sort of expand on BI and CBI issues, as well as commercial flood coverage, as it relates to you? Maybe just talk about how should we think about the exposure and the policies and the supplements.

Amit, we've got so many different businesses and so many different policy forms, we could spend two hours going through each of them. And so, I'm not going to do that.

I think what you should focus on is that most of the commercial insurance policies that we have do insure for property damage. A lot of it does include flooding, some excludes it. It depends on which program within the group we're talking about, and in most cases, there is business interruption coverage.

As respects contingent business interruption coverage, think more about supply chain, and for most of the properties -- or most of the businesses that we insure that have property, I'm not sure that's as much of an issue here as perhaps it might have been for the Thai floods a year ago. Jay, you may have something else.

I guess what I would say, Amit, to amplify that is there was a lot of concern after the Japanese loss and after the Thai loss, and we were obviously very focused on it, our exposure to those -- to that risk, and it turned out for us to not be a material exposure coming out of those events.

As Mark was pointing out, for contingent business interruption, think more about supply chain. That was very relevant for areas like Thailand. It seems to me to be less relevant for an area like the northeast United States.

Okay, I mean, at this stage, that seems to be the biggest variable. And listening to your answer, it seems that you are less concerned about it as of now.

The answer is we just don't know. The event happened less than a week ago, and to try and -- I mean, we have some -- obviously, we know where all of the businesses are that we insure and we know where all the physical properties are located, some of which we still don't have access to because of restriction to the area.

But like any event that happens, it takes at least a couple of weeks to really get a feel for where the claims are likely to come from. I think, you know, is it a larger event than Irene? Yes. Will we likely have more loss than we did in Irene? Yes. But it's just too early to tell you precisely where it's going to come from.

Can you talk about your reinsurance protection as it relates to different segments, as this loss continues to climb?

I think we've disclosed that in our SEC filings, but we have a reinsurance -- we have three different programs. We have one for the US insurance business, we have one for the property business at the syndicate, and then we have a retro program for Argo Re.

And at this point, I don't see us hitting our attachment points in our reinsurance programs. I guess if the loss continues to grow, that's certainly a possibility, but right now I think that the losses that we may incur are probably just going to be net to us and not hit our reinsurance programs.

Got it.

But that's just me speculating because, again, we just don't know yet.

Yes, and I understand and appreciate that. Final question, do you think this event -- let me rephrase that. What sort of pricing impact do you anticipate from Hurricane Sandy, both on the commercial front as well as the reinsurance front, going forward? Thanks.

Those could be two different answers, so if you go back to the answer of the question you just asked, if the loss continues to stay in our net retention and other insurance companies' net retention, which I think -- I think we'll all kind of start hitting our reinsurance at roughly the same place in terms of industry loss, but of course we all have different risk and we have different programs.

But if the insurance industry keeps the risk net and it doesn't go into the reinsurance programs, then I don't think it will have much impact on reinsurance pricing.

I do think it will have an impact on insurance pricing either way, and so I'm going to say the obvious now, which is the larger the loss, the more impact it will have, and it's happened at a point in time where we will all be taking that into consideration for business that's renewing towards the end of this year and certainly on 1 January.

And just a quick follow-up, you said all of us would likely hit the retention at the same place. What would be the industry loss at that place?

Yes, sorry, I was saying more or less. I'm not sure where that is because I don't know how it develops, but it's probably somewhere north of $20 billion to $25 billion.

Got it. Thanks for all the answers.

Adam Klauber, William Blair.

A couple different questions. On E&S, clearly you had good growth. I think, following on Amit's question, I think there's probably a better chance of even more rate and property as we go towards the year-end and into next year. Were you seeing more flow of business, more risk come into the market? And I know this is forward-looking, but is it logical after this type of storm you'll see even more property come into the E&S market, particularly in the Northeast?

Yes, I think that is a logical conclusion to make, Adam. The quantum of that, I can't tell you.

But keep in mind that a lot of the business that was coming into the market -- to the E&S market was being driven by the new version of RMS, which is version 11, and so I think this will just accelerate a change that was already happening. But I think the quantum is -- it's hard to pin down just yet.

Right, yes, it's still very early.

On the commercial specialty, I think you talked about trying to improve profitability rates and backing off from some business. Can we -- do you think we'll see a better accident year in 2013 or do you think that's more 2014?

No, I think that some of the changes that we've been working on throughout the course of 2012, we would expect to have an improved loss pick for those classes of business in 2013. You can pin me down next quarter a little more on what I think that is, but I do think that we'll have an improvement as soon as 2013.

Okay, great. And then, also, when we look at the progression of your margin over the last two, three years, you've been putting a lot of work into the London business. That's beginning to show up. The E&S business is holding up, so the margins are clearly improving. The expense ratio remains higher. Are there a way that that can start moving down in 2013?

The answer is yes, but let's go back and talk about what we've focused on.

Clearly, we've been focused on margin for the last couple of years as we've cut the top line, but margin improvement begins with getting the right loss ratio. If you look at our loss ratios across the board, not only have you seen them improve, but I think you'll see that they're in line with some of our -- with many of our specialty competitors. The challenge for us has been the expense ratio because, of course, as we've cut premium to get the right loss ratio, that we haven't been able to cut expense -- non-acquisition expense quite as fast as we cut premium.

So, we believe that we'll continue growing in 2013.

If you take that into consideration with some of the investments we're making in technology and outsourcing today that Jay mentioned earlier in the call, and the expense benefits of that, plus actually being able to cut some expense in 2013 relative to 2012, I believe all of those together should improve -- should begin improving our expense ratio. We're not going to get all of that done in 2013. I think you'll continue to see improvement in the expense ratio over the next couple of years, for sure, as we finish those investment initiatives and as we continue growing the top line.

I should also add that while our operation in Brazil has been a bit of an expense drag this year because premium hasn't caught up with payroll, that will be less of an issue going forward next year as well.

So on the investment spend, as we think about next year, is it more level, up, or down?

No, I think we will spend less -- we will have less negative impact on the P&L next year relative to this year.

Okay, thank you. And just one follow-up on the hurricane, and again, obviously it's very early so there's a lot of unknowns out here, but in your retro book, do you need the event to go 2025? Does that start impacting your retro book or is the sensitivity higher on the retro book than it is for -- is it higher than the 2025, I guess I'd ask?

We don't -- Adam, we don't really -- while we buy retro for the reinsurance book, we don't really write retro. I mean, we happen to have one quota share -- one account, but we don't really write retro.

Okay, okay, great. Thank you very much.

(Operator Instructions). Amit Kumar, Macquarie.

Thanks. Just a few cleanup questions here. In the opening remarks, you were talking about submission activity. I'm curious, do you have sort of a new business contribution number available as a percentage of topline?

I don't have it right in front of me, Amit, but our -- so you're talking about our E&S business, and our E&S -- so our E&S renewal rate for the quarter was about 62%. So our (multiple speakers)

Right, of that GWP, 38% would be new business.

So that's 38% of, I'm just rounding here, $130 million.

And then, do you have those numbers as of Q2, the numbers you just gave?

I don't have the Q2 premium number in front of me, but the renewal rate for Q2 was, I believe, about 58%. It was just under 60%.

That's helpful. And the only other, I guess, two questions I had, you mentioned, I think, in Lloyd's, exposure was down 75% or -- I couldn't write that down quickly enough. What were you referring to?

(Multiple speakers). What I was saying was that over the last couple of years, we have been derisking the property portfolio at the syndicate, which I've mentioned on previous calls, and the result of that derisking, of course, has been a substantial decline in premium, but we reduced our property exposure at the syndicate in the northeastern United States by approximately 75%.

Got it. Okay, that's helpful. And finally, on capital management, based on where your stock is trading at and obviously with Hurricane Sandy and I guess the coastal storm coming in tomorrow or the day after, I mean, do you sit out or can you buy back -- just remind me, you know, how do you think about capital management from this point onwards as we head into [one one]?

I don't think that Hurricane Sandy changes our view of our capital management, so I think that we will still be on track to continue buying back stock during the remainder of the fourth quarter.

Got it. Okay, that's all I have. Thanks for the answers.

Thank you, and I'm showing no further questions at this time.

All right. Thank you.

Let me just say a couple of words before we adjourn. It's really tough to focus on what happened in the third quarter, given the potential or likely impact of Hurricane Sandy on the industry and on our Company. Right now, we're focused on helping out the businesses that we insure and getting their claims managed as quickly as we can.

But I do want to say that as respects the third quarter, I really feel pretty good about the direction that the Company is heading in. We've had a number of consecutive quarters now of positive momentum, both in terms of rate and topline. That's about five quarters, and I like the trends that we're seeing in terms of growth for our Company and what's happening at an industry level.

I think we've put some very good people in place to add to an already good team over the last year, and I think that the financial results that you saw in the third quarter are a reflection of much of the work that we were doing in 2011, which was hard to see because of the cat activity in 2011 and also back in 2010.

So I look forward to talking to you all at the end of the fourth quarter where we can talk about the year's results and 2013 as -- our expectations for 2013. So with that, Operator, I'll conclude the call.

Thank you, and thank you, ladies and gentlemen. This concludes today's teleconference. Thank you for participating. You may now disconnect.