Argo Group International Holdings, Ltd.
Q2 2010 Earnings Call Transcript

Published: 3 Aug 2010

[Operator:]

Good day, ladies and gentlemen, and welcome to the second quarter 2010 Argo Group International Holdings Ltd. earnings conference call. (Operator instructions) I would now like to turn the call over to your host for today, Mr. Michael Russell, Director of Investor Relations.

[Michael Russell:]

Welcome to Argo Group's conference call for the second quarter of 2010. On the 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 management's perspective on the business. Before we begin, I'd like to mention we will be participating in the KBW Insurance Conference on September 7. So should you be attending, we invite you to sign up for one-on-one meetings with Argo Group management. I would like to remind you this conference call is being recorded. Following management's opening remarks, the operator will provide instructions on how you may 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'd like to introduce Mark Watson, CEO of Argo Group.

[Mark Watson:]

Thank you, Mike, and hello everyone. We appreciate you taking the time to join us today. In a moment, our CFO, Jay Bullock, will provide you with some financial details on the second quarter, and then we'll take your questions. Let me just make a few remarks first. The challenging operating environment we saw in the first quarter of this year continued into the second, with a highly competitive marketplace, coupled with an above-the-average amount of large loss activity. Despite this, Argo Group generated earnings per share of $0.86 and operating earnings per share for the second quarter of $0.49. Results for the quarter resulted in book value per share at June 30 of $53.76, an all-time high and up 4.6% since the end of 2009. Over the preceding four quarters, our book value per share has risen 15.3%. Let me run through the items that had the most impact on our operating results for the second quarter. As previously reported, we experienced above-the-average losses from large events during the second quarter. Our U.S. segments, primarily Commercial Specialty and to a lesser extent Excess and Surplus Lines, sustained losses from severe spring storms. Unfortunately, 2010 looked more like 2008 than it did last year. Additionally, our Reinsurance segment received notices of increased loss estimates from cedents related to the Chilean earthquake that occurred in the first quarter. We've seen a number of industry numbers going up over the last few months as it relates to the Chilean earthquake. Finally, while information and facts surrounding the event remain quite unclear, we recorded the bulk estimates for potential losses related to the Deepwater Horizon incident and reaction to notices of potential claims in our excess liability book of business. Although the first half of the year has produced higher level of loss activity as anticipated, it's important to note that this activity has not had a material effect on pricing thus far, other than a few opportunistic areas of the industry, and we expect the impact on pricing unfortunately to still be negligible. Across our segments, the top-line, written premium reflects our reaction to the current environment in this point in the underwriting cycle. We are pulling back from business where we don't see sufficient returns, returns which are further under stress as a result of the investment environment and the generally poor level of economic activity. We continue to explore ways to intelligently grow, but expect the size of the business to decline modestly in reported expense certainly during the rest of this year, which has been our plan. The investment we are making today in people and new lines of business is designed to position the platform to federate better operating environment, which we hope is going to come in the future. We don't expect that environment to develop anytime soon, though. As a result, we continue to reserve the current and recent accident years at the level we think is prudent, while we, like much of the industry, continue to have favorable development on older accident years. We believe it is unlikely there will be any change to the pricing environment as long as older years continue to develop favorably, which bring me to our capital position. Argo Group remains very soundly capitalized. Our continued positive financial results and conservative management of our $4.3 billion investment portfolio has served to further strengthen our balance sheet, we believe. As mentioned, we have intentionally reduced our exposure in certain product classes in response to the challenge to attain acceptable risk-adjusted returns, and those reductions have exceeded our total capital deployed in new and existing areas of the business. In response, we've chosen to return capital to our shareholders during the first six months of this year. During the second quarter, we repurchased an additional 241,000 shares of Argo Group stock, and year-to-date, that brings our repurchases to about 1.2 million. Additionally, in the first six months of 2010, our Board has approved total payments of $0.24 per share in cash dividends. We consistently monitor our capital position, as you've hear me talk about in previous calls, as a part of our capital strategy. And we continue looking at how we can repatriate excess capital to our shareholders in the future. Let me talk about each segment in just a little bit detail, and then Jay can go through the numbers in more detail. We'll talk about the Excess and Surplus Lines segment first. As I mentioned earlier, the market there continues to be challenged, but we are pleased that we did generate an underwriting profit for the quarter, particularly as E&S maneuvers were helped as this business maneuvered through an environment of intense competition from traditional E&S competitors and new market entrants as well as from standard line carriers that are displaying rather risk appetite, often writing what has historically been written in the E&S marketplace; the classic sign of the bottom of the market cycle. This competition, coupled with the weak economic activity in the U.S., continues to dramatically reduce net new underwriting opportunities, but we're not seeing that many new things to look at. So submission rates for E&S in the second quarter were down substantially. Our hit rates haven't really changed. We're just not seeing that much new business at the moment. Anyone looking for profitable margins must achieve it therefore primarily through keeping up one's renewal book as opposed to counting on new business. So gross written premiums were down substantially in the second quarter when compared to last year's second quarter for all of those reasons. The E&S segment does have some exposure to spring storms in the U.S. And as a result, we reported about $2.3 million in property losses during the second quarter. On the positive side, our E&S segment continued to experience favorable prior-year loss development, which totaled about $6.4 million in the second quarter. And our non-acquisition expense reduction initiatives are starting to actually achieve some positive results. We'd like to see those expenses come down more, and we're now moving in the right direction. And that's happening with our new President of E&S, Lou Levinson, who I introduced on our last quarter's call. He has been strengthening his team since coming on Board and implementing some of the initiatives that I just referenced and also a few new growth opportunities. Now let's talk about Commercial Specialty. As I mentioned at the open, our Commercial Specialty segment bore the brunt of the U.S. spring storm losses during the second quarter, reporting losses of about $10.3 million net of reinsurance. The segment produced a second quarter operating loss of $2.1 million, which included favorable prior year loss development of $2.2 million, again for the quarter. The specialty admitted marketplace is facing of the same issues as our E&S segment, that of being impacted by a sluggish economy and rate declines due to this competition. In addition, we have exited certain lines of business, we're achieving scale, and that's predictable acceptable loss experience we thought was unattainable over a market cycle, not just where we are today. Let me next talk about our Reinsurance segment. In the second quarter, it generated a 76.6 combined ratio, making a meaningful contribution to operating results despite events in the quarter. Gross written premiums were $70 million or up approximately 15% from the second quarter of last year. Growth in this segment was generated primarily by the full year's operation of our excess casualty unit in Bermuda. That said, the returns in our reinsurance business represent one of the few market opportunities with an attractive risk-adjusted return. However, Argo Re remains very selective in their risks at reinsurance, and as a group we remain very cognizant of aggregate exposures across our underwriting platform. As I mentioned earlier during the quarter, the Reinsurance segment received notices of increased loss estimates from cedents related to last quarter's earthquake in Chile, and therefore recorded additional losses of $4.4 million in that event in the second quarter. Prior year losses for reinsurance did continue to develop favorably, notwithstanding that. Regarding the reinsurance market environment, competition intensified for July renewals, and although the cedents are retaining more risk and purchasing less reinsurance, client retention remained high for our Argo Re. In our Casualty and Professional Risks unit within the Reinsurance segment, not much has changed since our last report. Competition remains high, despite events such as the credit crisis and the Deepwater Horizon Event. Reaction to these events has had a limited impact on some specific classes of business in a positive way, but by no means has it impacted the broader casualty marketplace yet. Let me talk about our fourth segment, International Specialty. This is mainly our Lloyd's platform. And while the results for the quarter don't suggest it, I'm actually becoming more enthusiastic about the prospects in this business. We've made significant progress regarding the changing complexion and quality of the book of business and we're in the process of adding diversifying classes of business that naturally come to the Lloyd's marketplace. The core reduction in the top-line reflects our continued and planned reduction of Argo International's property book, both the binder business as well as the direct and facultative books of business. And this is more now about competition than it is risk mitigation. And there are other one-time events year-over-year that affected the top-line and have a distorting impact on production, but Jay is going to talk through those in more detail in just a minute. The disappointment in the business this quarter is really related to the liability book, where we saw a deterioration in the medical malpractice book of business, specifically Italian hospitals which has been a market wide event. Both of these books today look significantly different than when we acquired the business. These provisions led to the combined ratio for the second quarter that was 105.3. The second was not materially affected by catastrophes during the quarter, but reported unfavorable prior loss development of $5.5 million, again mainly because of the liability book of business. Let me just summarize. We've experienced unusually large loss activity in the first half of 2010. And while the level of activity, which suggests our exposures have increased whether you select any PML or aggregate exposure number, the reality is we've actually through I think methodical and disciplined risk management reduced our aggregate exposures by approximately 25% to 30% in the past two years. And while competition is high in all of our business lines, we remain disciplined, strengthening our infrastructure and personnel, while expanding our product offerings and evaluating new opportunities. Argo Group's balance sheet is strong; we continue to generate profitable positive results in a difficult part of the cycle, and the company is positioned well to take advantage of the market when it improves. With that, I'll turn the call over to Jay.

[Jay Bullock:]

Thanks, Mark. Let me add some additional detail on the quarter, and after that we'll take your questions. As mentioned over the last several quarters, market conditions for both our underwriting and investment businesses remain challenging. As Mark noted, we continue to react appropriately with reductions in our underwriting business, investment in new teams and opportunities and modest reallocation in our investment portfolio, all of which is designed to improve returns while protecting our capital base. We're pleased to report that we continued our book value per share growth through the quarter, increasing 2% from March while achieving a compound annual growth rate on our book value per share of 12% since 2002. Current environment aside, this is a compelling track record over a period of time and which includes significant industry wide loss events and the most challenging economic environment in recent years. Mark has already gone through the significant large loss activity for the quarter. So while we comment on unusual items by segment beyond this. First let me note again, that in 2010 we have began allocating interest expense, an item which was not allocated in 2009. In our Excess and Surplus Lines segment, the reduction in operating profit was driven in large part by the reduction in gross written premiums and the corresponding reduction in earned premium. The margin on this reduced volume coupled with the sprig storm losses and other property losses, the group wide reduction in investment income and increased expense ratio account for the decline in operating profit year-over-year. A decline in operating profit for Commercial Specialty is largely related to the increase in spring storm activity as Mark has mentioned. Likewise, the reduction in our Reinsurance segment is a function of the increase in our Chilean loss coupled with the provision for potential losses from the Deepwater Horizon event, partially offset by positive development from recent years' loss provisions. In our International Specialty, of particular note is the significant decrease in the quarter-over-quarter gross premium written. The second quarter of 2009 was impacted by the recognition of approximately $40 million of additional premium written, largely related to our property binder business. Quarter-over-quarter another $40 million of the reduction in gross written premium is a function of the planned reduction in certain lines of business. The balance of the decline is largely accounted for by the impact of exchange rates on our non-dollar premium, as the dollar strengthens significantly against sterling and the euro. The other factors impacting the net results include prior year development in two of our liability classes and the recognition in the current accident year of rate pressure on our current book. Across the platform, we continue to make progress on operating efficiencies, not only our non-acquisition expenses declined 6% year-over-year, continuing on pace with the progress we made in the first quarter. Despite the decrease we continue to target operating expenses and improve deficiencies across all segments. Let me spend some time on Argo's investment results. The levels of investment income in 2010 have been challenged, given the continued decline in interest rates in most global markets. Argo's investment income for the second quarter of 2010 decreased slightly to $33.1 million from $33.8 million in the first quarter of 2010' and from $41.9 million in the second quarter of 2009. Recall again, the prior year's quarter included a one-time gain on a settlement and collection of interest on a disputed receivable. Absent this, the year-over-year decline of $3.7 million is accounted for by the reduced rate environment. Total return on the portfolio is 1.6% for the second quarter and at end was 3.2% year-to-date. We continue to keep the duration of our portfolio relatively short with an overall duration of three years, which is slightly shorter than our expected liability to ratio. Argo's investment portfolio continues to be positioned conservatively with an overall rating of AA. In response to the investment environment and in recognition of the broad diversification we've maintained in the portfolio, we've selectively began allocating a small portion of the portfolio to higher yielding income oriented investments. The first such allocation was the lower-rated investment grade and higher-rated non-investment grade corporate bonds. We expect to see the positive impacts of this strategy on investment income in coming quarter. We also took advantage of bond market liquidity to dispose of some underperforming structure holdings. The immediate effect of these strategies during the second quarter was an increase in book yields to 4.1% from 3.9% in the first quarter on our fixed income investments. Again this quarter we continued an hold no sovereign exposure to any of the distressed Euro-zone countries. The quarter's bond market rally in contrast to the equity market decline increased Argo's unrealized gain position to $180 million at the end of the second quarter as compared to $176 million at the end of the first quarter and $60 million at June 30, 2009. Our portfolio's net realized gains of $5 million in the second quarter from execution of our strategies. This was in sharp contrast to last year's quarter where we experienced $9.2 million of realized losses as we took advantage of an improving market to increase our portfolio diversification. A final note on the income statement; we recorded an $8.5 million foreign currency gain in the quarter as the dollar strengthened against sterling and the euro. The gain represents the revaluation of our non-dollar liabilities. This was matched by a roughly equivalent decline in the value of our non-dollar denominated assets, which was accounted for in other comprehensive income. Commenting on our capital structure, Argo group ended the quarter with approximately $2 billion of capital, split between $1.6 billion of book equity and $386 million of debt comprised of $311 million of trust preferred securities, $60 million of senior debt and a balance of $15 million drawn on our revolver. We remain well capitalized. And as Mark noted, thus far this year have returned almost $44 million in capital to our shareholders. And that concludes our prepared remarks and we're ready to take questions.

[Operator:]

(Operator Instructions) Your first question comes from the line Amit Kumar of Macquarie Group.

[Amit Kumar:]

Just going back to the discussion on the Italian med mal, can you just expand on that a bit more? I know that one of your peers had adverse development, but that was in Q1, and that adverse development for them had come from the public hospital book. Maybe just comment on where did you see these issues in the Italian med mal market.

[Mark Watson:]

Amit, it was in a similar line of business. We got a significant amount of new notices in the second quarter. And so while we did react on a smaller scale in the first quarter, additional information came in, in the second quarter and we felt it was prudent to react.

[Amit Kumar:]

And are you still riding this or have you seized underwriting this book?

[Mark Watson:]

Well, I think the point we were making earlier, there were really two classes of business. There was a general liability class related to some Australian business and there is medical malpractice business. Both of those look significantly different today. We're not riding that Italian medical malpractice. And those were both books of businesses that were written prior to our acquisition of the company.

[Amit Kumar:]

So your sense is that you have sort of ring-fenced issues in Italian med mal?

[Mark Watson:]

I think we've taken very appropriate actions in this quarter, and I'm hopeful that we don't see additional issues anytime in the near future.

[Jay Bullock:]

Based upon what we know today, the answer is yes.

[Amit Kumar:]

And just staying on the International Specialty segment, going back to the binders book, maybe kind of as refresh, what exactly this book include? My sense is that that this was a North American and Australian sort of non-cat property exposure. Is that correct? Maybe just revisit this briefly and tell us how close you are to sort of putting this issue to bed.

[Mark Watson:]

A lot of the business that was on the book had cat exposure, but it was cat exposure to events that don't happen very often. So let's take as an example earthquake exposure in British Columbia. It's been a long time since there was a big earthquake. But as we went back and we looked at the amount of capital that we ought to be allocating to events that have significant kill risk, even though they don't happen very often, we decided to pull back some of that premium volume. And so that's freed up a fair amount of capital in doing so. We finished going through the program as of July 1 of this year. So while we may still be changing a few programs here and there, the work that we started over a year ago is now complete, which is why I made the comment earlier in my remarks that when I look at our aggregate exposure today versus a couple of years ago, pick any metric you want and we think it's about 25% to 30% less. And so when you think back to the losses that we had in 2008, which relative to our capital and others in the industry, I think we're pretty manageable. We would expect to have a better result today than we did then. And so it's a bit frustrating to look at losses that have come in at first half of this year, because we don't believe that they are reflective of the exposure we have on the books today. But there has been more frequency than we would have expected.

[Amit Kumar:]

And just finally going back to the discussion on capital management, obviously you bought back a small amount. If I were to ask you to sort of rank an open market purchase in ASR, a tender offer or a special dividend, how would you rank those options?

[Mark Watson:]

2-1-3-4. So I think that in the first half of this year, we found that during an accelerated share repurchase, it was a little easier to accomplish open market purchases, because it allows for the acquisition of shares even when we're in a quiet period. I don't know what my Board start is about a special dividend or a tender offer. We have our meeting next week for the quarter, and I'm sure that we'll be spending some time talking about it.

[Operator:]

Your next question comes from the line of Mark Dwelle of RBC Capital Markets.

[Mark Dwelle:]

A couple of questions. First, I'd like to just take a second and focus on the expense ratio. In this quarter, you'd managed to hold it pretty well in line with past run rates despite a pretty sharp drop in overall premiums. I just wanted to get your sense, as I heard you discuss the various lines of business, it sounded like there were a lot of crosscurrents between talking about adding teams and expanding product lines, which usually has the tendency to increase the expense ratio, as compared to you mentioned some cost cutting efforts in the E&S line. And I know you've been successful in cutting costs in the past. I'm just trying to get a sense really of kind of directionally where you see the expense ratio heading, particularly in the light of pretty sharply contracting book of business?

[Jay Bullock:]

Well, therein lies the challenge; how do you invest in the future and cut expense for the present? And I think some quarters, to be honest, Mark, we've done a better job of that than others. I think we do have the expense of focus going in the right direction at the company, not only at a group level, but also in the individual businesses. And one of the things that I think has allowed us to be successful over the last 10 years that I've been running the company is our ability to balance between managing expense and investing in the future. And there have been quarters where we've looked at the expense ratio and thought, that's a little high, but we saw the benefit of investing, and where we were going to get to by doing it. And that's one or two points of expense, not eight to 10. But it still affects margin, but it's not a material effect on margin. I think the biggest challenge for us isn't managing how much money we spend investing in the future; I think that's pretty moderate. I think the biggest challenge for us is, as we contract in certain markets, are we contracting the expenses associated with supporting that business as quickly as the contraction. And that's one of the internal pressure points we have right now. You can expect to see those expenses come down, but it's very difficult to get them to come down dollar-for-dollar with revenue for a couple of reasons; one, you still got to support what's on the books, and second, in our case, we have huge investments related to technology that once we finish, will allow us to bring down the expense number more. But until we finish deploying that technology, we've got another quarter or two where we're going to have more expense than we'd like.

[Mark Dwelle:]

The second question I had related to the reinsurance book. Can you remind me at what point that business sort of started to aggressively ramp up? What I'm getting at is, at what point do we kind of start lapping over, where we've got a book that is going to be more, I'll say, renewal-driven as compared to just simply new business growth driven?

[Jay Bullock:]

The answer is now. For the property cat reinsurance portion of the segment, which is the majority, that's been the case for two years on a written basis and for a year on an earned basis. As respects the liability components, so excess causality and excess professional liability, that was true on a written basis in the second quarter. So on the quarter we've just reported and on an earned basis, that will be true in the third and fourth quarters of this year.

[Mark Dwelle:]

On other question, Jay, you had mentioned related to changing some of the portfolio allocations. What I understood from your comments was that it was a modest increase in duration, and likewise a little bit of a modification in terms of targeted risk profile. Is that something that you see continuing over coming quarters with more portfolio have gone that way or is just kind of take it in very small baby steps or just to say, we've kind of done a little bit, now you'll seal that place out and then wait a while before doing some more?

[Jay Bullock:]

Well, I think one of the things that we, to the positive, realized over the last couple of years is that we have really benefited from a pretty well diversified portfolio. And as we started looking at the capital that we allocated to the investment portfolio and our ability to marginally improve returns by what I'll call fairly modest allocation. So for example, I mentioned a low investment grade, high yield mandate; that's about $100 million in the quarter, but it has a real impact on investment income, in part because some of it's coming from the equity portfolio. We've reduced our equity portfolio slightly and allocated some to the high yield mandate. I think you would expect to see us do more of that, but you won't see the portfolio statistics, i.e. the weighted average credit quality, or frankly for that matter the duration change all that dramatically. If we went from AA flat to AA minus in credit quality, I couldn't imagine it's going any further than that. But if you sit down and work through the math, it does have a material impact on income.

[Mark Dwelle:]

Maybe hearing that a little differently, it would seem to me, all else being equal, which I appreciate is a pretty big caveat around it, it would seem that those steps would begin to start kind of arresting the two year decline in average portfolio yield.

[Jay Bullock:]

That's the game plan.

[Operator:]

There are no further questions in the queue at this time. I would now like to turn the call over to Mr. Mark Watson for closing remarks.

[Mark Watson:]

I would like to thank everyone for being on the call this quarter. It's been a pretty lumpy quarter, and a lot of the initiatives that we alluded to, we will be working on for the remainder of this year, particularly on the expense side and capital repatriation. So I'd like to thank everyone, and I look forward to talking to you again in the third quarter. Have a good day.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.