Argo Group International Holdings Ltd (ARGO) 2013 Q3 法說會逐字稿

Welcome to the Argo Group 2013 third quarter earnings conference call. My name is Cliff and I will be your operator today. (Operator Instructions). Later we'll conduct a question and answer session. Please note that this conference is being recorded.

I would now like to turn the call over to Ms. Susan Spivak Bernstein, Senior Vice President, Investor Relations. Susan, you may begin.

Thank you, Cliff, and good morning. Welcome to Argo Group's conference call for the third quarter 2013. Last night, we issued a press release on third quarter earnings, which is available on the investor section of our website www.argolimited.com. With me on today's call 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 you with management's perspective on the business.

As the operator mentioned, this call is being recorded and following management's opening remarks you will receive instructions on how to queue in to ask questions. As a result of this conference call, Argo Group management may make comments that reflect our 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'm pleased to turn the call over to Mark Watson, Chief Executive Officer, of Argo Group

Thank you, Susan and good morning, everyone. Welcome to Argo Group's third quarter earnings conference call. I'll briefly share my thoughts regarding the quarter's highlights after which Jay Bullock will add some color to the quarter's financial results and then we look forward to taking any questions that you might have during the Q and A portion following our remarks. We're pleased to report our results for the third quarter having generated $31 million or $1.12 per diluted share of net income, which is up from $13.4 million or $0.47 per diluted share in the third quarter of 2002.

Our third quarter 2013 operating -- earnings were $0.80 per share compared to $0.54 per share in the comparable 2002 quarter, an increase of 48%. We produced consolidated gross written premiums of $495.1 million, an increase of 2% from the third quarter of last year. And for the nine months our consolidated gross written premium was up almost 9% over the prior year. This growth is despite the fact that we continue to implement planned reductions in select lines that are not meeting our profitability objectives as margin improvements remain -- remains more important than growth.

In that vein, we saw improvement in our underwriting results posting a combined ratio of 97.5% for the quarter. This is an improvement from the 102.4% in the third quarter of 2012. For the nine months, our combined ratio improved to 98.3% from 102.7% for the same period in 2012. Of particular note is the improvement in our commercial specialty segment where our efforts to return to our core areas of expertise at Argo Insurance have had a positive impact on our financial results.

The underwriting margin improved despite a few nonrecurring items in our runoff unit that totaled approximately $9 million. For the group as a whole, we ended the quarter with diluted book value per share of $57.38, up 3% from $55.73 at June 30 and up 4% for the first nine months of the year. Growth for the first nine months of the year has, obviously, been impacted by the improvements in the value of our -- excuse me -- impacted by movements in the value of our investment portfolio. While our bond portfolio recovered modestly our cap portfolio did very well, and we'll talk more about that in a little bit.

Turning to market conditions, [as] you heard others say, we're not lacking competition, notwithstanding a meaningful amount of dislocation over the past 12 months. While it's too early to determine the effect of this dislocation, we believe opportunities will exist to continue to grow intelligently. In our book, rates are up overall in the low single digit range and, significantly more than that, often mid double digits, in several lines where we needed to see rate improvement. Perhaps as important, we're achieving the expected retention rates in both our well performing books of business and those where we are actively working on improving [risk] selection. We believe our focus on smaller accounts and writing only specialty business gives us the opportunity to influence the discussion on price. Let me briefly comment on each of our operating segments before turning the call over to Jay to discuss our financials in more detail.

Our excess and surplus lines business grew premium by 5.8% in the third quarter. While we continue to focus on growing our higher margin businesses, as alluded to earlier, this quarter's growth was offset by a planned reduction of premium in our transportation portfolio. We've stated in the past that we will not seek to -- we will not seek growth at the expense of profitability and our actions in the transportation line we believe demonstrate this discipline.

E and S posted an improvement in the combined ratio of 82.2% from 95% in the 2012 third quarter. In particular this segment benefited from the relatively benign loss environment of the past several years, as evidenced by significant favorable reserve development. I do want to take the opportunity to congratulate Art Davis, who was promoted during the quarter to the head of this segment. Art's been with Argo since our acquisition of Colony in 2001 and he most recently led our E and S contract division, which has been one of our more profitable business lines.

We're excited about Art's vision and leadership for this segment and, at the same time, I also want to congratulate Mike Fleischer, formerly our Chief Underwriting Officer for E and S, who's now been promoted to the Chief Underwriting Officer of all of our U.S. operations. Mike's success in improving underwriting margin in this unit over the past several years made the decision to elevate his role a logical one and we look forward to Mike's influence across all business lines of our U.S. operations.

As I mentioned earlier, I'm very pleased with the results in our commercial specialty segment in the third quarter. We've worked hard over the last 12 months to improve the results in two business units and we are beginning to see the impact of our actions. The segments combined ratio improved to a profitable 91.4% the year from 113.1% in the 2012 third quarter. As expected, we saw a decline in gross written program, which is a direct result of removing under performing accounts in both of our books of business. This decline was partially offset by modest growth in other business units.

We continued achieving rate increases where needed and remain positive about the prospects for this segment in 2012. Our international specialty segment achieved an increase of 14.3% in gross written premium, primarily driven by continued growth in our Brazil business. As our excess casualty and professional lines businesses mature, they will -- they will present more modest opportunities for future growth given the competitive environment. The results in our property catastrophe business reflect the impact of alternative capital filling the space, however, we still see attractive opportunities in the space in which we compete.

Look for us to increase the size of our sidecar in 2014. While catastrophic events were less frequent and severe than expected in the third quarter, it was not a loss-free period. Results for the quarter reflect $9.3 million in cap losses stemming from floods in Canada and hail storms in Germany. Rounding out our segment discussion is Syndicate 1200. While gross written premiums were flat, net written premiums were up 6% as we take more risk net this unit delivered another quarter of solid underwriting results. You can imagine this is particularly rewarding given the challenges of a few years ago.

With an eye on increased competition, we expect to see modest growth in this unit over the coming 12 months and we continue evaluating new initiatives, and I am encouraged by the direction which this unit is heading. We're pleased with the performance of Argo's investment portfolio in the third quarter and I'd like to come back to that. As most investors know, the macro environment for fixed income has been challenged with interest rate uncertainty driven by economic indicators, U.S. federal reserve action, or inaction, and the turmoil in Washington. And I'm not sure that's over.

This quarter, these factors made for a rally in treasuries and corporate bonds, positive momentum in equities and a drop in the U.S. dollar relative to major currencies. With that backdrop, Argo's portfolio recovered most of the decline experienced in the second quarter. We continue to manage our bond portfolio defensively with respect to duration and, in fact, the duration declined to three years at the end of the third quarter compared to three and a half years at the end of the previous quarter. Net investment income was $24.1 million in the third quarter down $4.8 million quarter over quarter.

Our book yield has continued to compress with falling rates over the past two and a half years. During the third quarter, our book yield was also impacted by our emphasis on total return objectives, which are most consistent with maximizing shareholder value. That said, the observed rate of decline in investment income has decelerated over the trailing four quarters. As rates continue to rise, we will have the opportunity to reinvest at greater yields. We expect to reach an inflection point in book yield by mid 2014, but, of course, that depends on what actually happens with interest rates.

From a capital perspective, we maintain a measured pace of return of capital to shareholders in the quarter. While our stock prices moved up quite a bit this year we continue to think our franchise is undervalued and still view share repurchases as a great investment. In the first nine months of this year we repurchased approximately 948 -- 998 shares of investment, which is about 4% of the 2012 year-end share base at an average price of $40.80 for a total value of $38.7 million. In the third quarter, we purchased $8.6 million or about 195,000 shares for an average price of $44.23.

As discussed previously, we slowed our repurchase activity during the peak of hurricane season. We expect activity to return to recent levels through the balance of the year, always judged against other alternatives to deploy our capital. And, in fact, today we reauthorized a new $150 million share repurchase plan. In summary, we've had a solid first -- a solid first nine months for 2013. We continue to focus on intelligent growth and margin improvement. This should produce consistent profitability across our business units.

At the same time, we continue to invest in our stock and return capital to our shareholders. With the investments would've made in our people, systems, and processes, 2013 results continue to show sequential improvement. We still have a lot of work to do but I think we've really set the stage now for 2014 and 2015. With that, I'll turn the call over to our CFO, Jay Bullock.

Thanks, Mark, and good morning everyone. I'll take everyone quickly through some additional detail on the financials and then open it up to Q and A. As Mark has already been through the growth by segment, I'll highlight some of our improving trends. All elements of our current action [at year] showed improvement in margin while we continued to benefit from positive developments from prior action [at years]. (Inaudible) from current period cap losses in prior year development our action at year loss ratio improved by over 3% from the first nine months of 2012as we continue to see the impact of rate and underwriting initiatives.

This was most pronounced in our commercial specialty segment as we continue to achieve, and in some cases exceed, rate targets and benefit from initiatives around risk selection. In addition, our expense ratio showed just less than 1% improvement over the same nine month period of 2012, even including the effect of the increased equity compensation expense incurred as a result of the increase in our stock price during the first nine months of the year. Rate increases, better risk selection and a continued focus on efficiencies are producing the desired effect on our operating margins. At the same time, the growth we generated in the first nine months of the year is putting our capital base to more effective use. These are all part of the team's focus on generating improving returns on capital.

Away from the current action at year we experienced overall favorable reserve development on the quarter representing our tenth consecutive quarter of favorable -- of overall positive reserve development. Total prior year development for the group was [$4.2 million] in the quarter and E and S positive development was [$12.4 million] and was primarily from action at years 2009 and prior. In commercial specialty modest adverse development of [300,000] was the result of positive results in Rockwood offset by Argo Insurance and Trident.

In international specialty the result of positive [$1.2 million] was the net effect of favorable short tail and Bermuda long tail casualty, partially offset by a small adverse movement in our Brazilian operation. In Syndicate 1200, the positive result of $600,000 was the net of small positive movements in property offset by some minor movements in our liability segment. In run off the [$9.7 million] of unfavorable development was comprised of [$5.7 million] in our asbestos one off driven by an increase in defense costs for claims from general liability policies written on a direct basis,[$2 million] of unfavorable development related to legacy medical mall practice claims and the exhaustion of a few structured settlement defacements and [$2 million] in unfavorable development due to the settlement of late reported Hurricane Katrina claim.

As Mark mentioned, our catastrophe losses were largely from outside the U.S. as we posted losses from the Canadian floods and German hailstorms. In total cat losses through the nine months were just slightly less than experienced in the first nine months of 2012. Finishing up any thoughts on the income statement, the effective tax rate for the quarter was 6%, which reflects the increase in income out of our Bermuda domicile, the impact of a tax benefit in the UK as a result of the currency translation of that business into local currency, offset by our U.S. based income.

Year-to-date our effective tax rate was 16% which is closer to our current long term expectation of 20%. Turning to investments, the overall size of the investment portfolio, including cash, decreased by approximately $105 million through the first nine months of the year. This is the net effect of the lost portfolio transfer we entered into at the end of last year, a decline in the value of the bond portfolio as interest rates have risen, share repurchases and dividends, offset by income, and the positive cash flow in the business as we continue to find ways to grow at a reasonable pace.

The impact of the lower investment yields, reallocation of the portfolio to certain strategies targeted towards total return, rather than income, and modest shifts in portfolio duration resulted in a continued decline in a net investment income this quarter, down approximately $1 million from the prior quarter. The book yield on the fixed income portfolio was 3.1% this quarter compared to 3.2% in the second quarter this year. We recognize pre tax realized gains of $9.1 million. Included in those gains was approximately $7 million from our equity strategies as we took the opportunity to reduce some positions slightly in the strong market conditions we saw in the quarter.

Also included in our realized gains of $29.7 million for the first nine months of the year is approximately $9 million from strategies we've invested in over the past 24 months that would otherwise have been accounted for as investment income. We ended the quarter with an unrealized -- with a pre tax unrealized gain position of $252 million, up from $225 million at June 30 but down from $305 million at the end of the year. Our equity position at September 30th was approximately [$1.5 billion] and our total capital was approximately [$1.9 billion].

Both our financial and operating leverage remain modest, which provides the flexibility to respond to market opportunities. We returned $12.6 million to shareholders in the form of common dividends and share repurchases in the quarter, as Mark had mentioned. As always, we evaluate all alternatives to deploy our capital and continue to buy back shares as warranted by the availability of competing investments relative to the compelling valuation of our stock. Operator, that concludes our prepared remarks and we'll now take questions.

Thank you. We will now begin the question and answer session. (Operator Instructions). Our first question comes from Ken Billingsley from Compass Point. You may go ahead.

Good morning. Congratulations on the quarter.

Thank you.

I wanted to -- I just want to ask a couple questions about -- From a pricing standpoint,I believe you mentioned risk selection is what may be driving it. Can you just talk about how you're adopting to what's going on from a competitive standpoint and for top line growth and where you think you will be looking for that next stage or opportunities to grow premiums, given the fact that you are shedding some lines?

Yes. So, Ken, we've been doing this now for a few years, depending on the portfolio. For the -- for the business that we want to keep -- we want to keep on the books, just about everything continues to grow. And, depending upon the line of business, that may mean 5%,it could mean 15%. We're getting -- we're getting rate increases across the board for accounts that are already well priced. The rate increases are modest, single digits.

For portfolios where we needed to take some underwriting action where we've talked about, the rate increases have been -- they could be as much as 20% plus. But for every -- the only place we're seeing -- the only place that we're not seeing rate improvement right now would be on some of the professional lines where there's still a substantial margin and, or in the property cat business, which is starting to see the additional capacity coming into the marketplace. So that's been flat to down 10% for the last few months and our top line, as a result, has been pretty flat there as compared to prior years. So--

Also, keep in mind that, for the most part, we're focused on small account business. That's certainly true in the U.S. And we've seen less price volatility for the small account business than we have for the larger account business. It's much more expensive for brokers to move the business around and the acquisition costs were -- the all-in acquisition cost is much more expensive so it's tough to be too competitive in that marketplace.

And on retentions, and I know you mentioned this in prepared comments, is the expectation that higher retentions going forward at these levels or maybe even at higher levels to help reduce the expense ratio?

Well, I -- look, I don't think we want to see -- our retention levels are pretty good already. And I think I mentioned in my remarks earlier that, notwithstanding, some of the rating action that we've taken we've seen our retention levels stay fairly flat. I -- there's always some business that you look at every year and you go, hmmm, maybe that doesn't really fit our risk parameters. So I don't think we ever want to see 100% retention rate but for our best performing books of business the retention rate is still 90%.

I think that's about as good as we want it to be. Obviously for some of our more traditional E and S business the retention ratios are between 50% and 60% but that's by design. That's what you would expect there to be.

So this is about where you guys expect it head -- to remain?

Yes. We actually have, across the board, our retention rates, I think, are higher today than they've ever been in the Company. And that's been true now for the last few quarters so I'm really pretty happy with where the retention rates are.

And if you're not taking them higher -- And I did see, obviously, there was improvement in the expense ratio. I believe that's been in a place where you guys have continue to work on. How do you get that expense ratio down even another 100 basis points or so at this level, at this point?

Yes. So if you go back to and think about my comments for the last couple of years, certainly two years ago, we were much more focused on making sure that we had the loss ratio correct and getting that in line. And if you look at -- if you look at our loss ratio today on a traditional basis, or even all-in, I think we're doing pretty well. The challenge for us now is the expense ratio.

And that -- there's two things that solve that, and I think I've talked about them a little bit in the last couple of calls. The first is continuing to complete our technology initiative that we think will give us a bit the more scale. It will reduce some expense but, mainly, it allows for more scale without adding expense. And the second thing is our ability to keep prudently growing our business. And we think that we'll continue growing the revenue stream faster than non acquisition expenses and that will lead to a lower expense ratio.

And it is coming down. Remember, and I think Jay said this in his remarks, but a lot of what's driving the expense ratio, certainly for the first nine months of -- for the first six months of the year was equity compensation expense because of variable accounting issues. But keep in mind that that's a non cash charge and it's probably a good problem to have had our share price move up so much in the first half of the year.

Sure. And then the -- from a growth perspective, given that you talked about the rate increases that you did see across most of your lines of businesses,it appears that maybe you were letting some more business go than what you were getting from a rate increase standpoint. Can you talk about any of those lines a little bit more, about what's -- ?

Yes. So that's particularly true in commercial specialty where the top line was down from -- I think this quarter a year ago it was about $145 million and this time it was about $139 million or $140 million. So it wasn't a huge decline. But if you look at it on the policy count basis it was probably down not quite 10% but close. But because of the rate increases that we were getting, the actual top line didn't drop as much. In E and S, we saw policy count go up and we saw rate go up. But, again, that was masked by the decline in transportation business that we wrote for the quarter.

And probably we'll see that again in the fourth quarter. So the core business that we want to keep is growing nicely both because of policy count and rate. But we would rather continue focusing on underwriting margin right now and I appreciate that if we -- if we kept our renewal rates up on all the books of business, our top line would be more robust and that would help the expense ratio. But I'm still much more focused on the loss ratio than the expense ratio. As long as we can keep focusing on that, I really do believe the expense ratio will take care of itself.

If you go back and look at our portfolio ten years ago, we had the same challenges. And it took us a couple of years to work out of the expense ratio challenge but we got there. And it's -- I think the best way to get there is to do it methodically instead of quickly and we've seen recently what's happened with some of our competitors that tried to get there quickly. And I'd rather take our time and do it right

Very good. Just last quick question for Jay here and then I'll requeue. I missed this on the duration. Did you say that your duration is down to three years from three and a half years last quarter?

Yes, that's right.

And what did you do to drive it down that quickly in one quarter?

It was really -- it was really more about -- It's kind of what I said last quarter. We've compressed the duration somewhat, right, so if you look at the distribution of bonds, you're going to get an average duration. So that means that if -- that some of that spread is what was driving the longer duration. We've simply taken some of the longer bonds out. It's not that more -- it's really not much more complicated than that.

Yes. So when the market rallied in the third quarter we took a hard look at anything that had a duration over ten years and liquidated a substantial amount of it.

Okay. Great. Thank you.

Our next question comes from Amit Kumar from Macquarie. You may go ahead.

Thanks and good morning. Just a few quick, I guess, follow-up questions. Going back to the discussion on, I guess, capital management versus pricing, does the pace of capital management change at all or does it remain opportunistic at current price to book levels?

Well, I think the biggest -- there have been two things that have -- that have regulated the pace at which we buy back stock. The seasonality of our business. So I think we all tend to slow down a bit during the cat season and also our flow. We have more flow today than we did a year ago or I should say volume -- trading volume. So we're having -- we're able to buy -- I think that, going forward, we'll be able to buy back a little bit more stock if we'd like to. Certainly, that's our intention.

But as you -- as you point out, we tend to be pretty opportunistic about buying our stock, and I think it's still, as I said in my remarks, a good value. And that's where we've been putting a lot of our excess capital. But I also -- As I think I've said the last couple calls, we do want to make sure that we've got enough capital to support the balance sheet and the organic growth in the company today and then, perhaps, some other short term opportunities. So I think we've done a good job of balancing all of those competing interests and that's why we reloaded the stock buy back plan today with another $150 million.

Yes. The other question I had is there have been some losses in Q4, including the [Christian] and then you had the Spanish surety losses. Can you possibly --talk about your exposure to those or maybe it's too early?

Well, our -- let me deal with them in reverse order. Our -- our surety business is largely a U.S. surety business. Now, we do have -- we do have support for our clients outside of the U.S. But, generally speaking, they're U.S. clients. And so you've learned that -- you learn never say never but we don't think we have any exposure to the recent ruling in the Spanish surety situation.

It is kind of -- it is kind of early on the storm and I expect that we'll see -- we'll see some small losses out of that. But I don't think -- you know, if you look at it on the scale of the German hailstorm, for example, where we had roundabout [$4 million], [$5 million], that kind of gives you a sense as to how that -- how that might scale. And if you go back to [zenthea], which, I guess, is a couple years ago now, our exposure to that was pretty modest.

Got it. That's helpful. And, I guess, the final question, and you address this had partly in the previous discussion,just going back to, I guess, the aspirational goal for a double digit ROE by 2015, when you look at the trends in Q3, do you get the sense that perhaps you could get there sooner or -- or is it too early?

I think, given the macro environment, I, it's -- I think it would be challenging to get there sooner. We have more competition today than we did a year ago or two years ago. Hard to believe. The interest rate environment remains very low. We would have thought by now interest rates would have begun moving back up.

And, as you've seen, we've repositioned our portfolio, and that -- frankly, we have a much better investment portfolio today than we did before. But the majority of it is still in fixed income. And there's just not a lot of yield to be had at the moment. And if you look at the growth and book value per share, which is what we focus on, most of the -- most of the growth in book value per share has come from the investment portfolio.

Yes.

And I think that's going to continue to create a head wind for us with interest rates where they are. Not just us, for everyone. So I don't think our challenge -- To some extent, getting there is macro with more competition and interest rates. But, look, we keep plugging ahead and we're doing better today than a year ago and much better than two years ago, and I'm much more optimistic today than I was a year ago.

Absolutely. But your expectation hasn't changed. Is that fair? That you will still hit the -- ?

Well, here -- here's what I'd say on -- My expectation probably has moderated slightly because there is more competition today and interest rates have stayed lower than I thought they would be a year ago at this time.

Okay.

So if, all of a sudden, interest rates move up, then yes. But if they stay lower for an extended period of time, I think it makes it difficult for any of us to get there.

Yes. Yes. That's -- that clarification is very helpful. That's all I have for now. Thanks for all the answers.

Thank you.

Our next question comes from Bijan Moazami from Guggenheim. You may go ahead.

Good morning, everyone. A question for Mark and a follow-up for Jay. Mark, could you comment on the transportation book? How big is it? Why is there a problem there? Is it a pricing issue? Is it a loss cost trend? And for Jay, if you can talk about the run off business, how much reserve is left in there? How fast is running off? And why we have so many different charges coming up from that segment? Thank you.

So there's not a problem in the transportation business. We just don't think it's -- it's just not meeting our underwriting returns. So we're peeling off -- I forgot what the exact number is but the whole portfolio somewhere between $50 million or $60 million and maybe we'll run off $5 million or $10 million. It's -- there's nothing more to it than that. We're always pairing something. It's just good portfolio management.

And probably most of that is coming out of New York and New Jersey only because we don't have a lot of California exposure, or perhaps we'd be talking about that as well. So I'm just explaining why we're not growing quite as quickly as we otherwise would be in the quarter. I don't see a problem with it at all. It's just not meeting our underwriting returns. Jay --

On the runoff side, Bijan, I would look at the result in the quarter and look at two of them as aberrations. So in total, we're down to less than $60 million on A and E and we're under $200 million on the comp runoff. And, as you know, the comp runoff has been running very steady for a long time. The last time we made a negative adjustment to the comp book was 2003. So that one is really just a very slow and steady payout. You know, the A and E goes up a little bit and maybe gets -- we see some slightly better trends here or slightly worse trends there. That was about $5.5 million. The other two were --

Well, and I'll, just to jump in -- If you look at some of our competitors that have similar exposures on their balance sheet, they've make some adjustments too but --

Substantially larger adjustments in the quarter,yes.

So I don't view this as a trend to continue. It's a one off charge that we took and, frankly, they don't happen very often

Yes. I think the Katrina claim is unfortunate. They happen, you know? It had been in litigation for several years and just -- it went against the climate. And then the other one was an issue that we knew could develop. It was $2 million. Not something that we spent a lot of time on but it had to -- had to do with some structured settlements from a company that was no longer viable. And it's behind us and it's not like there's another bucket of those out there that we'll have to be dealing with.

Great. Thank you.

And, sir, we have no further questions at this time.

I would like it thank everybody for joining us on our call today. As I said earlier in my remarks, I think we've had a pretty good quarter, certainly compared to a year ago and two years ago. We still have a lot of work to do and I think we're just now setting the stage to hopefully improve again in 2014 and 2015, and I look forward to talking to you all at the end of the next quarter. Thank you and that concludes our remarks.

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