Argo Group International Holdings Ltd (ARGO) 2014 Q2 法說會逐字稿

Good morning and welcome to the Argo Group International Holdings second quarter 2014 earnings conference call.

All participants will be in listen-only mode. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions.

Please note this event is being recorded.

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

Thank you and good morning. Let me add my welcome to Argo Group's conference call for the second quarter and six months 2014 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 the call today is Mark Watson, Chief Executive Officer, and Jay Bullock, Chief Financial Officer. We're pleased to review the Company's results for the quarter and six months, as well as provide you with management's perspective on the business.

As the operator mentioned, this conference call is being recorded.

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 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'll turn the call over to Mark Watson, Chief Executive Officer of Argo Group.

Thank you, Susan. Good morning, everyone, and welcome to our second quarter call.

Argo posted solid second quarter 2014 results, with net income up over 22% from the prior year. At June 30th, the book value was -- book value per share was $62.80, up 4.2% from March of this year, and up over 13% for the last 12 months, and tangible book value per share was up even more, with 15% growth.

I mention this first to remind everyone that growth in book value is the most important measure of how we are doing, but even on a more -- even on more narrow measures we are showing improvement in our returns. Our annualized net income return on average equity was approximately 10%, and on an operating basis, almost 8%. On second quarter 2014, operating earnings were $0.89 per share compared to $0.75 in the comparable 2013 quarter, or an increase of 19%.

For the first half of 2014, operating earnings grew to $1.83 per share from $1.45 in the same period of 2013, or an increase of 26%. Net income for the first half of the year was up 28% on a per share basis from last year.

So, however you want to look at the results, I think we're seeing tangible improvement. For example, for the six months ended June 30th of this year, our underwriting income was $28.7 million, up from $7.4 million in the same period of last year.

And, despite the decline in investment income and its impact on operating earnings, we continue to see good results in the investment portfolio. I'll comment more on this in a moment.

For the quarter, we produced consolidated gross written premiums of $520 million, which was down 4% from the second quarter of last year.

For the six months, our consolidated gross written premiums were $983.2 million compared to $980.4 million for the first half of last year.

The decline in our top line is somewhat misleading, as underlying growth in parts of our -- underlying parts of our business is being offset by planned reductions in areas that are not meeting our profit objectives. As we have said in the past, margin improvement takes precedence over growth. In that vein, we posted an improvement in the combined ratio to 95.8 for the quarter, compared to 98.3 in the second quarter of last year.

We achieved these results even after incurring several large non-catastrophic losses totaling approximately $12 million in the quarter, or 3.6 points on the combined ratio. This is a trend we've seen across the industry for the quarter.

And for the six month period, our combined ratio improved to 95.7 from 98.8 for the same period a year ago.

During the quarter, we repurchased over 500,000 shares of stock at an average price of $46.84 for a total value of $23.9 million. We still think our franchise is undervalued and view share repurchases at a discount to book value as a great investment.

Capital management has been the key part of our strategy over the last six years. We've returned more than $345 million of capital to shareholders, and we'll continue investing in our stock at these prices, while also staying focused on ways to build the Argo franchise, which remains our main priority.

Turning to market conditions, as you've heard others say, so I'm not going to elaborate too much, we're not lacking competition, and that competition has accelerated in the first half of 2014. We're working harder to find opportunities to grow intelligently.

In our book of business, rates are still up overall, but the pace of increase has slowed, and, like everyone else, we are experiencing declines in most property-related accounts. On a positive note, there are several parts of our business where we continue achieving needed rate improvement. Perhaps as important, our retention rates in our better performing books of business remain stable, as well as those we are -- where we are actively working on improving risk selection. We believe our focus on smaller accounts and only writing specialty business gives us more of an 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.

In our Excess and Surplus Lines business, premium on a reported basis was flat at $175.8 million. Underlying growth in higher-margin businesses is being offset by two things.

First, the planned reduction in our transportation portfolio as we continue to run off the commercial auto book. This is mainly within our E&S segment.

And second, there's a fundamental shift occurring in the large-risk property market where several companies have materially increased their limits appetite and many of these risks are originated through retail brokers outside the traditional wholesale market. Again, this is impacting our E&S business.

Excluding transportation and property, growth in our E&S company would have been up 12.5% in the second quarter and 14.8% for the first six months of the year, driven (technical difficulty) core businesses within E&S.

Overall, rate increases across the segment were up modestly, with larger increases focused on certain classes. For the quarter, we posted an improvement in the combined ratio to 83.4 from 93.2 in the same period last year.

Prior year development continues to have a positive impact in our results in E&S, and Jay will go into that in more detail in his discussion.

Commercial Specialty overall premium was down a modest 2.3% in the quarter. The decline in premium continues to reflect underwriting actions taken at Argo Insurance and Trident.

Overall rate increases for the quarter across the segment were 3.2%, with higher increases in those lines that needed it the most. For example, at Argo Insurance rate increases averaged 8.3% across the segment, representing the 10th consecutive period that the quarterly rate change exceeded 6%.

We remain pleased with the strong renewal retention ratios, and are working hard to identify new business opportunities. The segment's combined ratio was 103.4% in the second quarter of 2014, compared to 103.8 in the same period in 2013, and was impacted by storm losses and a modest amount of prior-year development in the quarter.

You may recall in my remarks last quarter that I thought there could be a few million dollars of development. I also mentioned that July 1 was a big day for public entity -- that's the Trident operation -- and that we should hit bottom in the third quarter, and I still think that's true. While gross written premium was down year over year at Trident, we exceeded our plans for July 1, and we're very happy.

So, all in, I would actually say Commercial Specialty performed about where we thought it would for the quarter and the first half of the year.

Overall, gross written premiums in our International Specialty segment were up 1.3% in the second quarter and 3.6% for the first six months, driven by our Brazilian business, Argo Seguros, partially offset by a decline in our short-tail reinsurance business.

In our emerging markets business, rates in general remained under pressure, with slight declines in Brazil and professional liability, offset by slight rate improvements in excess casualty.

At Argo Re, rates are down about 10% to 15% for many of our US property exposures, and, as I try to remind everyone each quarter, we buy far more reinsurance than we sell, so whatever margin we're losing at Argo Re, we're more than making up in the other part of our operations by reinsurance savings.

So, the segment's combined ratio improved to an 88.9 in the second quarter compared to 94.3 in 2013.

Switching to London, Lloyd's right now is, perhaps, the most challenging broad market environment. Having said that, we improved our margins for the quarter. Finding profitable top-line growth opportunities, however, is increasingly challenging as the market softens across the majority of classes of risks in London.

On a reported basis, gross written premiums declined 11.6% to $163.5 million in this year's second quarter compared to a year ago. This includes the impact of a large discontinued property binder account. Otherwise, premiums would have been pretty flat.

On an underwriting basis, the combined ratio improved slightly to 93.2 from 93.4 a year ago. The loss ratio improved 5.3 points to 51.1 in 2014 compared to the second quarter of 2013, despite the impact of an above-average level of large losses, including some of the property losses I referred to earlier, as well as yet another couple of satellites failing to get into orbit.

Turning to our investment portfolio, the performance through the first six months of the year, considering the environment, continues to be strong. Argo's portfolio achieved a total return of 1.8% in the second quarter, bringing year to date performance to 2.8%. Our year-to-date financial return of $115 million compares favorably to the flat result generated through the first six months of last year.

The duration of our core bond portfolio was 2.4 years at June 30th, with the 10-year US Treasury yield falling 20 basis points during the quarter, and credit spreads at historical levels, meaning tight. We remain defensive toward both credit and duration right now, and cash and short-term investments remain relatively high at 11% of the portfolio.

Net investment income declined by $4.7 million to $20.8 million in this year's second quarter versus a year ago. This was driven, in part, by book yield compression, as reinvestment rates on market yields remain below the portfolio book yield, and we think that this will probably hit bottom in the next two quarters, as spreads between book yield and new money yields in the portfolio continue to narrow as we fund new investment strategies.

We continue to focus largely on a total return approach, and the expecting positive impact on growth in book value per share. In addition to the cash component of our return reported as net investment income, we realized investment gains of $7.5 million from our alternatives portfolio that otherwise would have been considered investment in core or investment income, which is up from $3.3 million in the second quarter of 2013.

Since the beginning of 2013, we estimate that gains from our hedge funds alone or hedge fund investments were more than 2 times the investment income foregone by those investments.

In closing, the results for the first six months of this year demonstrate overall improving performance in our platform, and while work remains to make sure all of our businesses are contributing to the bottom line, we are in a much better position today that 18 to 24 months ago, when we began our re-underwriting efforts, and we continue to focus on reporting consistent results that will generate stable returns for our shareholders.

And with that, I'll turn the call over to our CFO, Jay Bullock.

Thanks, Mark, and good morning, everyone. In the first half of 2014, we continued to see validation of our efforts to increase underwriting income and grow our most profitable business lines. Mark talked about the underlying growth trends, and mentioned the improvement in underwriting income, for the first half of 2014, a fourfold increase on the 2013 underwriting income result.

This improvement is the result of better risk selection, a more effective reinsurance purchase, and continued contribution from prior-year accident results. I'm optimistic the trends in underwriting income will continue.

One further item to note. In the most recent iteration of our Loma Re reinsurance transactions, we altered the terms such that the current transaction is accounted for as traditional reinsurance, rather than a specific expense line. When taking this into account, growth in earned premium was 4% over the prior 3-month period and 6% over the 6-month period.

On the loss side, away from the current accident year, we experienced overall favorable reserve development in the quarter of $14.4 million, representing our 13th consecutive quarter of overall positive reserve development.

And within our businesses, E&S development overall has been favorable in each consecutive quarter since 2009. Syndicate 1200 development has been favorable for the last 10 quarters.

The largest quarter's of this quarter's release were continued strong results out of prior years in our E&S business, mainly from contract and casualty lines, and positive development out of several lines in Syndicate 1200, including reductions in prior-year loss estimates for the Japanese earthquake and the Thailand floods.

These were partially offset by an increase of reserves in Commercial Specialty and the run-off segments. The table in the press release provides a full breakdown for the quarter and first six months of the year.

We posted a 2.5% improvement in the current accident year non-catastrophe loss ratio to 58.1, despite having approximately $12 million in greater-than-expected large losses, as Mark mentioned, in the quarter that added 3.6 points to the loss ratio.

In E&S there was a $4 million net loss in the special property book, and in Syndicate 1200 we had $8 million due to two large energy losses and two satellite losses in our aerospace book.

Catastrophe losses for the quarter were, again, relatively modest, $4.2 million for US and European storms, less than the $9.7 million incurred in the second quarter of 2013.

The expense ratio was, once again, impacted in the quarter by the increase in the stock price, driving equity compensation approximately $5 million higher than would have been experienced from an expected stock price increase. Adjusting for this, and other, smaller, one-time items normalizes the expense ratio to approximately 39% in the quarter. As we've said before, not as much progress as we'd like, but trending in the right direction.

In the quarter, we reported $18.5 million of net realized gains. The largest contributors to the net gain were the contribution from our alternative investment, as Mark mentioned, in addition to the equity portfolio and gains from certain private equity and strategic investments.

For the second quarter of 2014 the effective tax rate for the Group was 13.6%. The lower-than-expected tax rate was largely a function of a greater proportion of income related to our Bermuda entities.

Turning to the balance sheet, the sum of investments and cash decreased by approximately $52 million since year end 2013. For the six months ended June 30th, total return on the investment portfolio was approximately $115 million. Offsetting the increase was a settlement for a reinsurance to close transaction at the Syndicate, funding of the share repurchase program, dividends paid, and other, smaller, items.

Paid claims for the six months were flat with a year. As a result, we expect cash flow to be positive in the second half of the year.

And we ended the quarter with a pretax realized gain position of $285 million, up from $251 million at the end of the first quarter of 2014.

Finally, while the reported capital structure was essentially unchanged at June 30th, subsequent to quarter end we were able to repurchase a single tranche of one of our older trust-preferred securities for a discount of $0.10 on the dollar. The face amount of the securities was approximately $20 million, and, as a result, we will report a $2 million gain on this trade in the third quarter.

In addition to the share repurchase activity Mark mentioned, we think that this is an additional value-added use of our capital that will be earnings accretive in subsequent periods.

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

Thank you. We will now begin the question-and-answer session. (Operator Instructions). Our first question comes from Dan Farrell with Sterne, Agee.

Hi. Good morning. Just a question on the $12 million of larger losses. I just want to clarify. Is that $12 million larger than the normalized assumption, or $12 million versus the year ago? I just am trying to relate to what you would expect for a normal level.

Yes, I didn't mean it as $12 million more than we would have expected, but there were just a few things that when you added them up, you're like, wow, that's a fair amount of money.

Sure.

So, what would we have normally have expected? Probably half as many.

Okay. And then, so, even if we assume half, that would imply some solid underlying improvement in the loss ratio. I guess my question for you is how much do you think has been driven by rate, and how much by mix changes? And, as we look forward in an environment where pricing is moderating, do you still see levers for improvement in the loss ratio from further mix changes and underwriting changes?

Yes. Now let me think of where to begin. That's a pretty open-ended question.

So, you got to kind of break it down. I think that we'll continue to -- so, let me say that if look at our loss ratio today versus a year ago, or our loss picks today versus a year ago, so meaning accident -- current accident-year loss ratio, they have improved year over year notwithstanding how much large-loss activity we've had.

I think that we will continue to see some improvement in our loss picks prospectively, because in places where we need to get rate increases we still are. And we continue to change our portfolio mix and move away from classes of business that aren't as profitable.

So, we talked about commercial -- we've been talking about commercial auto for the last few quarters. A couple of years ago, we were talking about getting out of some of our food merchant business within Argo Insurance. If property rates come down a little bit more, I could see us just writing less property.

But we have -- we've always got some investment going on that allows us to bring on more new business. It's a bit -- it can be a bit lumpy, as we saw in this quarter, and the top line is down at the Syndicate because we canceled a contract within our property group. But you know what? It was the right thing to do, and I applaud the guys for making that decision, because it does make the top line look bad, but it's the right long-term thing to do.

So, we're going to keep investing in new opportunities, and that doesn't always mean hiring people and making acquisitions, it also means building new products from within, which we've been rolling out over the last few quarters within E&S. And I think that that will allow us to continue improving underwriting margin, both in terms of loss ratio and expense ratio.

Okay. Thank you very much.

Our next question comes from Brett Shirreffs from KBW.

Hi. Good morning. Thanks for taking my question.

Mark, you highlighted that you're a significant buyer of reinsurance. I was wondering if you could maybe expand on how you're benefiting or taking advantage of the increasing level of competition in the reinsurance market right now?

Sure. So, for the last couple of years, you've heard us talk about trying to increase the amount of net written premium and stop ceding off underwriting profit, and we've done, I think, a pretty good job of that over the last 18 months. Now we're looking at a place where reinsurance pricing is coming down to a point where, actually, we might think about buying a little bit more.

As respects contracts that we have in place today, we are getting a better ceding commission on our pro rata contracts today than we were a year ago. So, that's going straight to the bottom line right now.

And second, on our excessive loss covers, we're getting a little bit more exposure for the same price, or we're getting a slightly lower price for the same exposure. And it'll begin impacting the bottom line in a positive way towards the end of this year and the beginning of next year. Remember, there is a lag between written and earned, and some of the contracts we've only just renewed in the second quarter.

So, I'm -- right now, that's all inuring straight to our bottom line. We're not seeing insurance pricing come down. As I said earlier, for the most part, we're still seeing rate increases for property, and I think that will continue to inure to our benefit next year for sure.

Okay, thank you. And then, just touching on the expense ratio, I realize there were a few one-time items in there, maybe, this quarter, but are you okay with it at the 39% level, or a little bit elevated, given that you're -- you are seeing some significant improvement on the loss ratio side?

Well, the answer is yes and no. Sure, we want it to come down, and we're working on it, and I'll talk about that in a second. But I'm focused on underwriting margin, not just the expense ratio, and Jay and I have been pretty adamant about us being able to get to a 95 combined ratio, and we think it takes both parts to get there.

As respects the expense ratio, if you look at our -- if I just look at controllable expenses, so, let's take payroll, as the biggest number, that hasn't really moved very much. We've been able to do more with the same amount of people.

With the change in mix of business, our commission expense is up slightly. We've changed some of our broker relationships, and we're paying them more to originate what we believe is better risk. So, I may pay a little bit more, but I ought to have a lower corresponding loss ratio, but, of course, that takes time.

So, there are a lot of moving parts on the expense ratio. It isn't just overhead. Overhead's actually been pretty flat, and I think as -- I'm pretty happy with how we're executing our strategy. As long as we can continue to execute and move ahead, then I think it continues to take care of itself, over time.

Great. Thank you.

Our next question comes from Amit Kumar with Macquarie.

Thanks and good morning, and congrats on the quarter. Just a few quick follow-ups.

The first is going back to Brett's question on the reinsurance purchase and usage. Can you remind us, when is the biggest piece of your, I guess, various reinsurance renewed?

Amit, there's not really any one period. I guess if I look at it, if I break it down, January the 1st is the largest time, but we also buy a fair amount of reinsurance that renews in May, as well.

Yes, of course, what I was trying to get at is, if you do choose to exercise -- and many companies have been talking about utilizing cheaper reinsurance at the bottom of the cycle. And I was trying to figure out, if you do intend to expand on that, how should we be thinking about, I guess, the premium numbers going forward? That's where --

Yes, right. So, first of all, we have to see what's presented to us. The next -- I don't think we have anything renewing in any material way between now and the 1st of January. So, we'll see what happens in the fall.

But I do think that there's a possibility that we will reverse the trend of the last few quarters and consider buying more reinsurance. But in terms of premium -- ceded premium relative to gross written premium, I think in the aggregate it would be unlikely to change more than 100 to 200 basis points.

That's very helpful, Mark.

The only other -- I guess the one other question I have is on the capital management. Do you intend to step back during the hurricane season? And how do you think about utilizing repurchases versus how the stock has performed over 2014?

So, Jay and I always have a debate this time of year of how much we should buy back during the hurricane season, which is always a debate about how much capital we really have that's excess.

I think we will -- I think I will prevail, and I think we will buy back some stock during the hurricane season this year. As I said in my remarks earlier, I'm -- if I'm just thinking about, do I want to buy Argo stock or sell Argo stock at this price, I think I want to buy Argo stock, and I remain very bullish on our Company.

But that is only one way that we repatriate capital to shareholders. We also pay a dividend, which we increased earlier this year, and we are, also, looking for additional ways to reinvest our capital, over time, and I think we've had a nice balance of doing all three of those things over the last couple of years.

All right. That's very helpful.

I guess the last question would be why is Jay not on the same page in terms of buying back stock here?

Well, I'm going to answer for Jay and then we'll see what he says. He's always more conservative than I am, and he's always trying to keep -- well, you know how CFOs are. They want to keep all the capital they can.

I'll leave it at that.

That's all I have. Thanks for the answers and good luck for the future.

Thank you.

Our next question comes from Adam Klauber with William Blair.

Thanks. Good morning, everyone. You continue to a lot in the Commercial Specialty segment. Results seemed to have flattened out. Do you think that's an area we'll see continue to see improvement over the longer term?

Yes, I do, Adam. Our loss pick -- and Jay will correct me if I'm wrong -- but our loss pick for Argo Insurance this year is in the mid-50s. So, if you think about where it was a few years ago, I think we've improved it about 10 points over the last couple of years.

So, we had a little bit of adverse development in the quarter, which masks that a little bit, but I actually think that our commercial specialty business is looking pretty good right now. I don't think we'll see it -- I don't think we're really going to see it in the financial results for another three or four quarters, but I'm pretty happy with where it is.

And the only thing I'd add, it's not too early to be optimistic, but it's too early to be certain. But the 2013 and 2014 loss picks, the very sort of early indications that we're getting is that those numbers are holding up pretty well.

Yes.

Thanks. And then with the industry clearly under more pressure today than it was a year ago, growth is more challenging, and that doesn't look to turn around any time in the near or -- near term, at least. Do acquisitions come back on the table, even though they're small, mid-size?

Well, I would -- so, the answer is yes. But I hesitate when I answer that question, because we're always looking at small things. We just haven't found deals that we thought were priced adequately. That may actually drive price up more, and make it more difficult to get a deal done, because people start chasing growth through acquisition.

So, I don't think we're going to look any harder than we have been looking, and I'm not sure that we'll get any more deals done than we have recently, which is not very many, and they've been much smaller, so, we haven't talked about them very much.

I don't think we changed the way we -- I don't think we, Argo, changed the way we do things, but we certainly -- we certainly are looking more now than we were a couple of years ago, and we just -- we haven't found something that we thought was adequately priced to acquire.

Thanks.

Our next question comes from Bijan Moazami from Guggenheim.

Good morning, everyone. I guess my first question is a follow-up to Adam's question on Commercial Specialty. You have a lot of very good businesses mixed up with not-so-good businesses in that segment. Could you be a little bit more specific in terms of what are the stuff that works in that particular segment and what are the stuff that doesn't work?

And I know that in Argo Insurance you mentioned that your loss pick is going to be in the mid-50s. Could you expand on what is contributing to that?

Well, I'll start with the end. I think what's contributing is the re-underwriting that we talked about two years ago, or we started working on it two years ago, and it took about five quarters. So, you're now seeing that coming through.

If you look at the amount of premium, net premium, from both Argo Insurance and Trident, that's more than 80% of the premium on a net basis. It might even be as much as 90%. So, those are the two -- sorry, John Yediny, the President of Rockwood, will hurt me for that one. Sorry, if I add up Argo Insurance, Trident, and Rockwood, our mining business, that's about 90% of the premium.

So, Rockwood has done very well for the last several years, and I think we've -- we are getting Argo Insurance on track. I think we're getting Trident on track.

So, in the aggregate, I think we've got 90% of it going the right way, and Jay just reminded me that we also have our surety business within Commercial Specialty, and it's doing very well.

So, I actually kind of think Commercial Specialty is almost back to making a pretty good contribution to the bottom line.

Their loss reserve, where did it come from? Was it a particular product? Is it workers' comp? Is it commercial auto? What is it in that line?

You want to take that, Jay?

Yes, sorry, Bijan, you're talking about specifically in Commercial Specialty?

Correct.

Yes, it was a little bit of GL in Argo Insurance. That's sort of one of the main products there, and a smaller amount of workers' comp in Trident, but-- And let me just think what else.

That's a pretty small portfolio.

It is.

It's pretty much run off now.

Yes, and I think that the -- and, as I said, it's -- the 2013 and 2014 years in both of those businesses, across the various products lines in those businesses, are looking pretty good.

I think the Argo Insurance development came from 2010 and 2011.

That's right.

Yes.

Perfect. And one last question, if I may. Your International Specialty, a big jump in the expense ratio, is that related to your expansion in Brazil? Or is that something else that has been driving that up?

That's exactly what it is. I mean, one of the things that you'll note in that line of business, Bijan, is that it's got a fairly -- it's got a fairly small amount of earned premium relative to the others. So, it doesn't take much to move the needle, and we've allocated some additional expense into the Brazil operation as we continue to support the buildout of the operation down there.

Great. Thank you.

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

I'd like to thank everyone for joining us on the call today. We look forward to talking to you again at the end of the third quarter in November, and thank you, again, for your time.

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