Argo Group International Holdings Ltd (ARGO) 2013 Q4 法說會逐字稿

Good day, and welcome to the Argo Group 2013 fourth-quarter earnings call and webcast.

(Operator Instructions)

Please note this event is being recorded.

I would now like to turn the conference over to Ms. Susan Spivak, Senior Vice President of Investor Relations. Please go ahead.

Thank you, and good morning. Welcome to Argo Group's conference call for the fourth-quarter and calendar-2013 results. Last night we issued a press release on earnings, which is available in the investor section of our website at 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 and year, as well as provide you with management's perspective on the Business.

As the operator mentioned, this call is being recorded. Following management's opening remarks, you will receive instructions on how to queue in to ask for questions.

As a result of this conference call, Argo management may make comments that reflect their intentions, beliefs and expectations for the future. Such forward-looking statements are qualified by the inherent risks and uncertainties surrounding future expectations generally, and may materially differ from actual, future results involving any one or more of such statements.

Argo Group undertakes no obligation to publicly update forward-looking statements as a result of events or developments subsequent to this conference call. For a more detailed discussion of such risks and uncertainties, please see Argo Group's filings with the SEC.

With that, I'm pleased to turn the call over to Mark Watson, Chief Executive Officer of Argo Group. Mark?

Thank you, Susan.

Good morning, everyone, and welcome to Argo Group's fourth-quarter and year-end 2013 earnings conference call. I will briefly share my thoughts regarding the highlights from the quarter and the year, after which, Jay Bullock, our Chief Financial Officer, will add some color to the financial results. We look forward to responding to any questions you may have during the Q&A portion, following our remarks.

Overall, I am pleased that Argo reported a solid 2013. We delivered a better performance in most of our business lines, and showed continued year-over-year improved underwriting profits in every business. We ended the year with consolidated gross written premium of $1.9 billion, an increase of 8.2% over 2002 (sic - see press release, "2012").

Our excess and surplus lines, syndicate at Lloyd's, and international specialty businesses all experienced strong double-digit growth for the year. We posted a combined ratio of 97.5% for the year, and a 95.2% for the fourth quarter of 2013. For the Group as a whole, we ended the year with diluted book value per share of $58.96 per share, up 3% from $57.38 at September 30, 2013, and up 7.9% from $55.22 at the end of 2002 -- excuse me, 2012, including cash dividends.

Capital management remains a focus, as we maintained a measured pace of return to shareholders during the year. We continue to think of our Franchise as undervalued, and view share repurchases at a discount to book value as a great investment. In 2013, we repurchased approximately 1.1 million of our shares, or 4.4% of our 2012 year-end share base, at an average price of $41.04, for a total value of $45.1 million. In addition, cash dividends for the year totaled $15.8 million.

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 nearly 16% in both the quarter and the year, with most of that growth coming from our higher-margin businesses. Our core casualty business, where we are experiencing the strongest growth, is a segment of the market that we have been successfully underwriting at Colony for the last 20 years. This is but one example of the payoff from the hard work and focused marketing efforts of our E&S team in 2013.

In addition to finding ways to expand this business, we continue to refine our underwriting appetite, and that was reflected in selected reductions in lines such as our transportation business. These decisions, coupled with our growth initiatives, are reflected in our improved combined ratios. For the quarter, we posted a combined ratio of 83.2% compared with 92.6% in the 2012 fourth quarter; and for the year, a combined ratio of 88.1% compared with 91.9% for the 2012 year. Prior-year development continues to have a positive impact on our results in this segment, and Jay will go through the results by segment when discussing the financials in more detail.

As we look to 2014, we have several initiatives, including those mentioned, like transportation, above, which will continue the progress we made in 2013. Continued expansion in areas where we see the best profit potential, the introduction of new technology tools, and the addition of new underwriting talent in areas where we don't yet have critical mass, should contribute to the top- and bottom-line results.

Commercial specialty made significant progress in 2013 in returning to profitability, particularly in our Argo insurance business, which you will recall from prior discussions encompasses are admitted grocery, restaurant, and dry cleaning businesses. John Yediny, President of Rockwood, our mining business, worked diligently with the management team at Argo Insurance in 2013 to return to the focus of that business, to their core areas of expertise; and we are all pleased with the results we're seeing from those efforts.

We still have work to do in Trident, our public entity business, but I am really pleased with our results in commercial specialty for the year. As planned, premium for the segment declined for the quarter by 3.3%, and for the year by 4.1%, reflecting our continued re-underwriting of the portfolio.

We continued achieving rate increases where needed, and remain positive about the prospects for this segment in 2014. The segment's combined ratio improved to 97.1% in the fourth quarter from 122.9% in 2012's fourth quarter, and to 97.8% for the year compared to 115.1% for 2012.

On the heels of the significant improvement, our President of Commercial Specialty, Mike Arledge, retired at the end of the year, after having spent the past 13 years helping me build this Business. I want to thank Mike for all of his efforts, leadership, and his friendship over the years, and I am sure he is proud to have wrapped up the year on such a positive note. We all wish him the very best in retirement.

Talent management is an important element of our annual process at Argo. It has enabled us to identify internal candidates to lead our E&S segment, as mentioned in one of our previous conference calls, which Art Davis is now running. And in our international specialty segment, we also had some management changes, as we appointed Matthew Wilken as President of Argo Re. Matthew has served as Chief Underwriting Officer of Argo Re since 2008 -- took over the helm of that Business in the fourth quarter.

Overall, gross written premiums written in our international specialty segment declined 18.2% in the fourth quarter, primarily driven by lower reinsurance premiums. This was more a function of a modest shift in portfolio direction than a reflection of the dynamics in the reinsurance market. Premiums were also impacted by increased competition in our Bermuda professional lines business.

On an annual basis, our gross premiums written were up 11.7%. The combined ratio improved to 94% in the fourth quarter, and was 95.4% for the full year. Remember: 2012 results were impacted by Superstorm Sandy losses.

We are quite pleased with the results for the Syndicate for both the quarter and the year. This is especially rewarding to us looking back to where we were just a couple of years ago. Gross written premiums written were up 15% for the quarter, and 9.5% for the full year. Net premiums written were up even more as we retained more risk.

On an underwriting basis, the combined ratio improved to 88.7%, from 93.9%, in the fourth quarter of 2013, and 92.4% from 96.2% for the year. Here, the strategy of diversifying into lines which are historically good opportunities for those in the Lloyd's market, while at the same time a focused discipline on risk concentration and good underwriting decisions, is paying off. The progress which we have made in this segment in the last 24 months has increased our ability to focus management's attention on other areas of the Business.

Moving on to the investment side, our portfolio achieved a strong performance in the fourth quarter, where we had realized gains of $41.7 million for the full year, and we had realized gains of $71.3 million -- sorry, we had $41.7 million for the quarter, and for the full year, $71.3 million. Most of that was due to our decision to reduce our equity portfolio by approximately 50%; additionally, we reduced our non-investment-grade bond holdings by approximately $40 million.

Our decision to reallocate was made in view of several macro observations. The S&P 500 -- excuse me, the S&P was up 30% for 2013; the US Federal Reserve was close to reducing its QE program; and there was very low volatility in the financial markets, and near-record-low yields for corporate bonds of all ratings.

We remain committed to the strategy of a diversified portfolio across a spectrum of high-grade and value-focused asset classes, but thought the time was right to make permanent some of the gains we had achieved. This small shift is reflected in significant gains flowing through this quarter's and this year's P&L.

Specific for the fourth quarter, Argo's portfolio achieved a total return of over 1.6%. This performance is despite the fact that we continue to manage our bond portfolio, by far the majority of our holdings, defensively with respect to duration. Our bond portfolio duration declined to 2.8 at the end of the third quarter, compared to 3.0 at the end of the third quarter.

Next, investment income was $22.7 million for the fourth quarter, down $5.8 million quarter over quarter. Our book yield has continued to compress, but to a lesser degree, with a modest rebound in reinvestment rates in the fourth quarter. Our book continues to benefit, and our portfolio yield and net investment income continue to be impacted by an emphasis on total return over income. We believe this approach is most consistent with maximizing shareholder value in the long run, and the long run is our focus.

For example, our modest allocation to alternatives produced a return in excess of $17 million in 2013, against what otherwise would have been approximately $4 million of current income, had it remained in the bond portfolio. In other words, this return flows through as gains, instead of net investment income.

Overall, the observed rate of decline in investment income continues to decelerate. We continue to analyze and seek investment opportunities providing greater yield. And we expect to see an inflection point in book yield by mid-2014.

In summary, we reported a solid 2013, showing continued improvement in our results. The market is no doubt equally challenging today on the underwriting side as it was a year ago, and we continue to face strong headwinds from the investment environment. Having said that, I feel really good about where we are going today. Our focus and commitment to the specialty underwriting space is working, and, as it has for the last 13 years, this strategy will produce good, stable returns for our shareholders. And I am proud of the progress that we have made this year.

On the underwriting side, our E&S platform is producing a greater amount of profitable business, with roughly an equivalent level of resources. Commercial specialty is once again contributing to underwriting income. At the Syndicate, we have overcome our initial challenges, and are now a top-performing Lloyd's franchise against similarly diversified syndicates. Our international specialty operations include a mix of growing emerging-market business and lines, now fully matured, that will produce attractive returns to the Group in the coming years.

On the balance sheet side, we have demonstrated a disciplined approach to reserving, which has resulted in overall favorable development in each of the last eight years. Capital management has been a key part of our strategy, and we've returned over $300 million of capital to shareholders over the last six years. We will continue to invest in our stock, and return capital to shareholders, weighted carefully against the risk-adjusted returns of other capital uses. While we still have a long way to go, and we will continue to focus on driving efficiencies and improving performance through our platforms, I am optimistic about 2014 and our future.

And with that, I will turn the call over to our Chief Financial Officer, Jay Bullock.

Thanks, Mark, and good morning, everyone. I will take everyone quickly through some additional detail on the financials, and then open it up to Q&A.

I won't repeat the themes that Mark has just gone through, but clearly, we are pleased to see the results of much hard work over the past few years. Key for finding our underwriting selections: make the Organization more efficient, and effectively deploy our capital, were the execution initiatives for 2013, and will continue to be the initiatives for 2014.

With that in mind, let me comment on some of our results more specifically. The Group's accident year loss ratio improved by 2 points from 2012, as we continue to see the impact of rate in 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 our initiatives around risk selection.

Catastrophe losses were negligible in the quarter, and total cat losses for the year were $22.7 million, down from $69.8 million in 2012. However, as the press release notes, in our E&S segment we had several unrelated fire losses in the fourth quarter that impacted our current-year accident results in that segment. These losses increased the fourth-quarter combined ratio by approximately 4 points. In addition, our commercial specialty results include a very large individual loss of $2.5 million, representing $3.4 million on -- 3.4 points on the fourth-quarter combined ratio.

Away from the current accident year, we experienced overall favorable reserve development in the quarter, representing our 11th consecutive quarter of overall positive reserve development. Total prior-year development for the Group was $12.1 million in the quarter, and $33.6 million for 2013.

In excess and surplus lines, positive development for the quarter was $17.1 million, driven by accident years 2011 and prior. And Syndicate 1200 positive development totaled $2.1 million, driven by the liability lines. Commercial specialty and international specialty were both essentially flat, with small ups and downs by unit.

And finally, adverse development of $5.9 million in run-off was a result of modest adjustment to the assumed domestic A&E exposure, as well as a review and re-estimation of some reinsurance recoverables. The table in the press release provides a full-year breakdown.

While our expense ratio improved year over year, we did not report the degree of progress we want to see. That was, in part, due to the $22.8 million of increased equity compensation incurred as a result of the increase in our stock price during the year. This expense alone accounted for fully 170 basis points on the expense ratio. So, absent that, you can see real underlying improvement.

That said, our combined ratio improved by 7.1 percentage points. More importantly, we generated 2.5 points of underwriting profit for the year, towards our goal of generating a consistent 5 points of underwriting margin by 2015. While we continue to focus on how we organize and execute our Business, and will continue to focus on the efficient use of resources, at the end of the day, underwriting margin is what drives long-term shareholder value creation.

Briefly, on the fee income line, our results continue to be affected by the lack of scale in certain businesses in our Alteris unit, which are reported net of expenses; and certain expenses incurred by the managing agent of Syndicate 1200, which were higher than in prior periods, primarily as a result of the strong performance of the Syndicate in 2013. In both instances, adjustments are being made to these units to bring results more in line with expectations.

Foreign exchange gains in the P&L in 2013 were a modest $1.7 million, and roughly offset by a loss on the value of foreign-denominated assets running through the balance sheet of $2.8 million. Generally speaking, we manage foreign currency exposure through the natural hedge available through foreign-denominated assets against contracts denominated in like currencies.

For 2013, the effective tax rate for the Group was 20.3%, and compares to 21.6% in 2012. As we have discussed, our blended tax rate for the Organization should, over time, be approximately 20%.

Turning to investments, the overall size of the portfolio, including cash, decreased by approximately $60 million from 2012. This was the net result of positive cash flow in the Business, offset by approximately $60 million returned to shareholders in the form of share repurchases and dividends, and approximately $140 million of assets transferred as a result of the loss portfolio transfer on the Syndicate years 2009 and prior, which was effective at the beginning of the year.

Net investment income totaled $22.7 million during the fourth quarter, bringing full-year 2013 investment income to $100 million. The decline reflects primarily the continued reinvestment at market yields below the portfolio's book yield, a shift in strategy toward slightly lower -- shorter duration, and a movement of a portion of the portfolio out of traditional fixed-income investments.

We ended the quarter with a pre-tax unrealized gain position of $243 million, down from $253 million at September 30, and down from $305 million at year-end 2012. For the year 2013, we generated a 3.3% total return on the aggregate portfolio. This includes total return for the year of negative 0.5 for the core bond portfolio, and 15.8% positive return from strategies outside that portfolio.

Our equity position at December 31 was approximately $1.56 billion, and our total capital was approximately $2 billion. Both our financial and operating leverage remain modest, which provides us the flexibility to respond to market opportunities. We ended the year with book value of $58.96 per share, which represents a 10.4% annual compound growth rate including cumulative dividends since 2002.

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

We will now begin the question-and-answer session.

(Operator Instructions)

Ken Billingsley, Compass Point.

Good morning. I wanted to just follow up on some questions on the expense ratio going up, specifically, I may have missed it if you commented on this.

International Specialty, the expense ratio moved higher year over year, and then also in Syndicate 1200. Can you talk about that, especially if you are shrinking some aspect of that business?

In International Specialty, the change in expense ratio is primarily a function of change in portfolio mix. As we write more premium in Brazil, it runs at a higher expense ratio than the Business and Bermuda. That accounts for, probably, 80% of it, and the remainder would be writing a little less premium than planned, and the expense associated with that.

And the Syndicate, the fourth quarter reflected primarily compensation-related expenses, based on the strong performance of the Syndicate in the year. So it is slightly higher than it was last year. If you recall, last year, Q4 -- well, as everybody recalls, was Superstorm Sandy, so we probably would have scaled back compensation expectations in that quarter, and that would have knocked the ratio down just slightly.

I understand. And on the Run-off side, I believe you said that, asbestos and environmental was a large piece of the increase there. It seems like a number of firms have been having A&E charges, and it doesn't seem like anybody is really taking much note of it; but has there been any pathway for claims? Is there a reason that, maybe, go back and rethink, maybe, why some of the frequently or some of the severity may be increasing?

So we -- everyone has different exposure, in our case we have A&E exposure from the general liability policies that we issued in the [1950]s and [1960]s, mainly in California, as well as assumed reinsurance from business underwritten, I believe, in the [1970]]s; and then, to a lesser extent, some assumed business from London. The primary policies in London have pretty much played out.

Where we are seen some development, is coming from the assumed book, where we still haven't commuted with some of our insurance companies that we reinsured, again, back in the 1970s. The plaintiffs' bar has been working on new, novel theories of liability; but, I think, this is mainly just stuff coming through from older [bits.]

Jay, do you want to add something?

Yes. The only thing I would point out is that it was $3 million, it was a pretty small number. And because it is in the assume book, much of that is going to legal expense these days, we are not leading the effort on the claims, and so we are incurring some legal expense. But, it was a fairly small number, relative to what I have seen come out of some other companies.

So currently, no fundamental shift in maybe having to recategorize or reevaluate how the claims are coming to you?

No.

And the last question, and I apologize if I missed this. The line item on the income statement, the $5.4 million charge -- other income. Could you talk about that?

Yes, there is really two components to it. That reflects the net result in our Alteris unit, and we had -- we have started some new businesses in 2013, we haven't yet achieved scale in those businesses, so it is running at a slight loss.

And then, sort of an anomaly, there is the managing agent of the Syndicate is accounted for, because most of what comes out of the Syndicate managing agent is fee income on the third-party capital that we manage; but we also charge certain expenses there, and in the fourth quarter, those expenses were higher than they were in the prior year's quarter. They were mainly compensation-related expenses, again, from the very strong performance in the Syndicate.

And so, most of it was compensation-related from the syndicate. So on the Alteris unit, you said this is the net results from the Alteris unit. Is this something that, maybe, we need to anticipate, maybe, a little bit more in 2014 as they grow and develop?

Well, I think, we have strategies in place to generate -- to move that unit to profitability during 2014. And so, it could be that it takes a quarter or two to get there, but I think the strategies are in place, and being executed.

Okay so we should anticipate maybe there could be some bleed through into the first part of 2014?

Very small numbers.

Great thank you for taking my questions.

Bijan Moazami, Guggenheim.

Good morning everyone. A couple questions for Jay, just for clarification. First, the four points on the combined ratios from unrelated fire losses, is that on the overall Company combined ratio, or is just for Surplus Lines?

It's just for Excess and Surplus Lines, and it is just for the fourth quarter number.

Okay, perfect. And in terms of Corporate overhead, you mentioned that there was options and warrants issues, you went through your comments a little bit quickly; but, could you walk me through the impact of those items on the Corporate overhead in the fourth quarter?

Well it's not just Corporate overhead, it is throughout the Organization. For people that are compensated in part with equity compensation, stock price was up dramatically during the year. The total number, in the P&L, was about $22 million accounting for that.

It wasn't options issued in the year, it was options that have been issued, frankly, they would be over the last seven years, because generally our options have seven-year term. So, with outstanding options and the strong increase in the stock price that led to that impact through the P&L.

But for modeling --

There are no warrants issued in the Company that I am aware of.

No, it would be options and restricted stock.

So, just to clarify, when you have a big increase in the stock price, with the cost of that, the allocated to the subsidiary or is it carried at the Corporate overhead? And the reason I want to figure that out is, that, obviously, the Corporate overhead increased quite dramatically in the fourth quarter. Just want to see if we are going to go back to the historical trend, rather than the big increase that we had in the last three months of the year.

Yes, the largest component of that would be, it would be in the Corporate segment, if you will. As that is where -- a meaningful portion of that equity compensation resides.

Okay, perfect. Thank you.

(Operator Instructions)

Amit Kumar, Macquarie capital.

Thanks, thanks and good morning. Just a few follow-up questions.

The first question goes back, I guess, to the discussion we have had in the past, as well as, I guess, some of the prior questions alluded to it. How should we think about a normalized expense ratio going forward? I think we have spent some time talking about improvement, what sort of ranges are we thinking about on that?

I think the expectation is -- let me go back to what I said in my comments, alright? We are trying to figure out to get 5 points of margin through our P&L, and that is going to come from the loss ratio is going to come from expense ratio.

We had a good year on underwriting basis this year, we have some anomalies on the expense side. I think if you take out those anomalies, the expense ratio was running in mid- $38 million range, and we need to start to move it below $38 million this year.

But, what I think is most important, is the combination of those two things by 2015 is looking more like 95% than it is 97.5%. That said, 97.5% is a really nice improvement over where we were doing.

And keep in mind, for some of our businesses, they are going to run at a higher expense ratio, the Syndicate is a good example of that. It is always going to run in the mid- to high- $30 millions, with our mix of business, and given that most of the business comes from wholesalers. And as long as that is a significant part of the P&L, it is going to run a bit higher than you might see at other competitors'.

Got it, that is helpful. The other question I have, and maybe the answer is no, Q1 to-date and has seen sort of a wide variety of smaller losses all over the place, do you have a view of how that could impact your numbers?

I'm sorry, I don't think I understood the question?

The fourth quarter, we have seen some the storm losses, some floods, and it has been all over the place. Is there anything which could flow into your numbers and could impact the numbers, versus maybe what the Street has for you right now?

So we haven't seen anything -- I will start by saying, we haven't seen anything, but I will say yes, because there always seems to be something that flows through. We haven't seen any particular large loss, so it is likely to be something that hits one of our non-US businesses that has risk back here in the US; but I could not tell you exactly what that might be.

Got it, that is helpful. The only other question I have is; and you address some of these points.

In terms of the reserves, obviously, it looks like turn the corner -- things look pretty good now, I mean, is there anything that you are noticing in terms of loss cost trends, which makes you sort of sit back, or is everything on the reserving side, now, where you would have wanted it to be? I think, after all the noise we used to see in Heritage, et cetera?

Well, I don't -- so, I haven't -- we haven't seen a change in loss cost trends so far. With the economy, both in the US and globally, remaining somewhat stagnant, I don't see that changing in the near-term either.

When I look at where we have had loss emergence, mainly it has been positive. There are only two places where we have seen negative -- well, actually, we haven't been really seen anything negative out of the Syndicate in a couple of years now.

So, that was more a function of underwriting, than it was loss emergence, and the same was true within the Commercial Specialty segment a year and a half ago. It was in, I think, the first quarter of 2012, that we adjusted our lost reserves to take that into consideration. And you look at the difference between -- I think for the year, 2012, we had just over $20 million of negative development in Commercial Specialty, and this year it was only, I think, $1 million.

So, I am pretty comfortable with where our reserves are, certainly at a group level, I am very comfortable with where they are. And, I think, that our pricing actions that we have taken over the last few years, and we continue to take -- I mean we are still getting rate increase, right now, across the board.

The exception, of course, would be property cap reinsurance; but remember, that is less than 10% of our Business; and of course we are the beneficiary of that, as a net buyer of reinsurance. So, I am pretty positive with where I see pricing today, relative to loss cost trends.

Got it, that is helpful. That is all I have. Thanks for the answers and good luck for the future.

Thank you.

John Thomas, William Blair.

Hi. In Excess and Surplus Lines, where do you see -- seeing the most new business growths, where is the growth coming from?

Most of -- so, I will give you two different have answers. Most of the premium growth, I think I said in my remarks earlier, was in our Casualty business. But we are getting submission flow activity from really every part of our operation.

We just happen to think the margins are better in our Casualty business, more so than some of the other parts, which is why you are seeing more growth there. But the opportunity to grow is in just about every part of E&S that we do. And we have got over ten business segments within E&S.

Okay. And then, Commercial Specialty, looking out into 2014, I guess, what kind of growth do you think you are going to get there?

I don't see us growing Commercial Specialty in aggregate that much. And that is because, while, I think, we will see some growth outside of Argo Insurance, I think that Argo Insurance will probably still contract for the first couple of quarters during the year, as we continue to optimize that portfolio and remove some low-margin business.

All right, thanks.

(Operator Instructions)

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Watson, President and CEO, for any closing remarks.

Thank you. I would like to just end by giving a few remarks, really, to our employees.

Everyone has worked really hard over the course of 2013. They have put in, I think, a solid performance, and I think that we are in a very good place for 2014. I just want to express my appreciation to our employees for helping make Argo a better Company today than a year ago.

And operator, that concludes my remarks.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.