Lancashire Holdings' (LCSHF) CEO Alex Maloney on Q1 2018 Results - Earnings Call Transcript

Lancashire Holdings Ltd. (OTCPK:LCSHF) Q1 2018 Earnings Conference Call May 3, 2018 8:00 AM ET

Executives

Alex Maloney - Group, CEO

Paul Gregory - Group Chief Underwriting Officer and CEO

Elaine Whelan - Group CFO and CEO, Lancashire Insurance Company Limited

Analysts

Thomas Seidl - Bernstein

Kamran Hossain - RBC

Jonny Urwin - UBS

Ben Cohen - Investec

Darius Satkauskas - KBW

Thomas Fossard - HSBC

Alex Maloney

Okay. Thank you, everyone. Thank you for calling in for our Q1 call. I'm delighted with our first quarter results. Our underwriting portfolio has seen little loss activity in the quarter coupled with strong reserve releases mainly from the 2016 accident year. We have top line growth driven by the improved underwriting environment. And lastly, our hedging strategies has mitigated are mark-to-market investment loss as interest rates increase. We are, therefore, satisfied that strategic decisions we took coming into this year were the correct ones and insurance markets and investment markets are where we thought they would be. It's pleasing to see top line growth, which is partly driven positive rate movements and partly driven by new business across the majority of our portfolio. Even where rates are not positive such as terrorism, we have seen more rating discipline in the terrorism market than we have seen in many years.

We have commented before that we hope to achieve more rates across our underwriting portfolio, but as others have also commented, the underwriting environment is not currently there to push for more rates. But our portfolio is definitely more profitable than the market average so any positive change is accretive and margins are improving.

We see daily evidence of carriers taking corrective to improve the profitability of their underwriting portfolios. Not a day goes by where a headline doesn't pop up with another carrier closing another product line. These are small signs of the change in underwriting environment. We are yet to witness material rate improvements from this action, but this is another clear indicator to us that we are finally off the bottom of the market. This very much feels like the year 2000 all over again.

We will continue to demonstrate the underwriting and capital discipline that we have always demonstrated. We are witnessing for the first time in years pretty much everything pulling in the right direction. We will adjust quickly if the current direction of travel accelerates, which we believe could happen if we see further loss activity or loss creep from the 2017 events. It's a finely balanced market that just has to improve. It simply has to.

So, in summary, we're in excellent shape as a business, probably the best we have been in years. We have maintained our underwriting discipline during a prolonged soft market. We have no need to review any product lines, and we have the flexibility of our three underwriting platforms to navigate through the next stage of the cycle. We have a supportive long-term shareholder base, which we thank for their patience, and one which we believe we will be able to provide the risk-adjusted return they require.

I will now pass over to Paul.

Paul Gregory

Thanks, Alex. Following the loss frequency and severity of two quarters, the first quarter 2018 has been very benign. Those losses that have occurred during the quarter, such as U.S. and European winter storms, are relatively minor in nature and, as such, have a limited impact on our underwriting results. Given this loss environment, the group has been able to generate a respectable combined ratio of 65.2% for the quarter.

As we highlighted last quarter, we anticipated the majority of the group's portfolio to be exposed to positive rate movement, and this has transpired. Rate movements were in line with our previously communicated expectations. Catastrophe-exposed lines, such as retro, property cat and property D&F, also rates moving positively. In addition to this, the energy market has also seen rate rises, and other lines, such as terrorism, has flattened.

The group's overall portfolio saw a rate improvement of approximately 5% year-on-year. Rate improvements is certainly a positive for us as a group, especially given that they are focused in the areas in which we specialize. In addition to this, there are other areas of optimism.

In the property catastrophe classes, there were some small pockets of opportunity to write some new business with both existing and new clients. Some of this is post-loss opportunities, and others were opportunities to expand relationships at slightly improved rates.

The energy market is also showing the first green shoots of recovery. With a more robust oil price, our clients are cautiously optimistic about the future, and we should start to see demand slowly coming back into the energy market should the oil price remain close to its current level.

As a group, we're well placed to capture any increased premium flow to this market and have plenty of room to expand if conditions become favorable. Our 2017 premium income was approximately 50% of its all-time high. On new accounts, our energy costs made a good start for 2018, securing new business for the group, and our new power team will commence underwriting during the latter part of the second quarter. Once these product lines are fully established in 2019 and beyond, we'd expect them to generate approximately $20 million to $25 million of gross written premium combined, assuming, of course, stable market conditions.

Kineses grew limits deployed at 1st of January by approximately 28% and premiums written by approximately 33.5%, managing to grow with both existing and new clients, the first time in many years the overall trajectory is upwards. Rates have improved, and there's been some small opportunities for new business. As a result, our gross premium has grown modestly year-on-year. Gross premiums grew by 9.8%, and total premium under management grew by 15.3%, reflecting the modestly improved environment.

As we previously explained, any growth will be driven by the underwriting opportunity. If the risk-return metrics makes sense, then we're happy to deploy capital. Whilst the rating environment is positive, we are coming from a base that is historically low given years of rate reductions. As such, our growth is broadly in line with the rate improvement plus the small amount of new business.

The group's risk levels did not materially increase, producing a portfolio with a better risk-adjusted return year-on-year. From an underwriting perspective, the first quarter is positive: the rating environment for our portfolio has improved, combined ratios are very respectable, premiums have grown modestly, and risk levels have been managed appropriately.

As the group progresses through 2018, the underwriting philosophy will remain constant. We underwrite our portfolio based upon risk and reward and have the discipline to hold our nerves should the risk-reward metrics not transpire due to market dynamics. But also, when viable opportunities do manifest, we have the capital, platforms and people to maximize these.

I'll now pass it over to Elaine.

Elaine Whelan

Thanks, Paul. While we hedge our interest rate risk with yields at the front end of the curve rising by 30 to 40 basis points in the quarter, our investing portfolio had a loss of 14 basis points. Our underwriting results were strong, and we had releases on our prior accident years. That resulted in a loss ratio of just 12% for the quarter and a ROE of 2.9%. This is the first quarter in many years we have shown growth in our top line. Further, that's the combination of the rate increases we expect just following last year's cat events, plus the new business will also lessen the impact this quarter from the timing of last-year contracts.

As Paul has said, pricing has improved across most of our portfolio, just not as much as we would have hoped for following last year's events. But as we said before, we're well-positioned to take advantage of the increases that are there and any other opportunities that may arise.

We also saw the impact of rate increases in our reinsurance program. But there are a few moving parts to both largely the same program. Our overall spend for the year will be a little bit higher than last year though because of the rate increases and a couple of new quota share deals we added this year. Our acquisition cost ratio looks a little higher this quarter driven mostly by some adjustments in the energy construction book. As we expect, the ratio should normalize over the year toward the 27% level we've been running at. On losses, we've had very few losses reported this quarter. Our attritional ratio is, therefore, comfortably in the mid-30s. We also had a 2016 accident year energy claim develop in our favor, a little bit of favorable development on last year's cat events, plus some general IBNR releases due to lack of reported claims coming through. Overall, we had net favorable development for the quarter at $25.2 million, helping us produce that low loss ratio of 12%.

As I mentioned, investments produced a 14-basis point loss for the quarter driven primarily by the mark-to-market impact of yields increasing. Our interest rate hedge and our risk assets that further mentioned to, I mean, just the downside impact of the increase in yields. While we expect volatility to continue and further rate increases this year, we remain well positioned for both of those. We will also have the benefit of reinvesting at higher rates in the future, and we will gradually increase our duration and, thus also, take advantage of those higher rates. There's a reduction in other income this quarter due to reduced profit commissions from Kinesis. As I said last quarter, with the loss events for 2017, there's traps collateral at Kinesis and no PCS under 1/1/17 cycle. As Paul has said, we wrote about 28% limit in Kinesis for the 1/1/18 cycle. If there are no losses on that cycle, profit commissions could be about $9 million, but the earliest we would receive that would be Q1 2019.

There's a very small uptick in our G&A this quarter as largely driven by the increase in sterling in the quarter. We do hedge our currency exposures. We took advantage of lower sterling rates last year given our sterling costs for our UK operations, and we're slightly low on sterling just now. You can see the impact of that in our FX line in income statement. While there are reduced vesting expectations in employee stock compensation awards, which reduces the expense we acquired on those, the Q1 2017 charge was significantly impacted by last year's departures of some of Cathedral employees. We have small gain this quarter on the mark-to-market of our interest rate swaps but also a slight increase in our unhedged sub debt cost given rising rates. We also have more LOC costs coming through as we continue to fund some of final Cathedral biannual fee. Ignoring this LOC, mark-to-market and any one-off costs, our financing costs are now running at around $4.5 million to $5 million a quarter. Lastly, on capital, we continue to be comfortable that our current level of capital will more than adequately support the bit we hope to write this year. As ever, we will monitor underwriting opportunities and adjust our capital accordingly.

With that, I'll now hand over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We will now take our first question from Thomas Seidl from Bernstein. Please go ahead.

Thomas Seidl

First question on pricing. There seems to be a healthy debate right now whether we have seen the peak of pricing already internally or whether there's another peak to be expected about midyear. I wonder what you see in the market in terms of supply-demand dynamics and how those shapes up to H1 and probably, also, beyond. Secondly, capital, Elaine, you just mentioned, you have enough capital for 10% growth. Can you give us some color how much capital do you have in terms of further growth? Let's say, if you go to 15%, 20% growth, is the capital base still then comfortable? And thirdly, on nat cat, you started to release, I think, $8 million of reserves. And lastly, you mentioned the big uncertainty about those reserves, and I just wonder how so far loss emergence has been coming in versus assumptions you did back then.

Alex Maloney

Thomas, thank you for your questions. I think, on rate, there is a debate. Our view into our book, I don't think rate gets stronger from here unless there's any loss activity or if anything changes, but equally, I don't think it goes backwards. Florida probably the cat market is not a huge market for us. So, you're probably better off listening to the run rates of the world. But our portfolio, we don't see rates going backwards. Equally, we don't see big changes in rates hardening from here. And if you think about our portfolio, most people's portfolio, you've got the run-in now to the winter season, and most people would have written their income by the 1st of July. So, we don't expect any real changes. So, we're quite comfortable with where we're at on that basis.

Elaine Whelan

Thomas, on the capital buffer, we're pretty happy with where we are. We think we got plenty to handle growth. When you look at capital, we normally work at what we need, rather strict on that, and then put a buffer on top of that so that there's more than adequate capital there to handle the -- our growth expectations. And on the nat cat, we did have a small release this quarter. We're not really expecting to see an awful lot of movement on those written reserves until later in the year. Now it's still relatively early days. Most of the release so far has come from Harvey, which you may expect. By memory, you're going to take a bit more adjusting.

Thomas Seidl

On Harvey, I mean, this was a -- there's in-line flat stuff and commercial line stuff, so how is the actual losses coming in versus the expectations there?

Elaine Whelan

I think it's lower than we would normally expect for these kinds of events.

Thomas Seidl

Okay, but you still feel comfortable and, hence, you started releasing reserves.

Elaine Whelan

Yes, I know. Put in context, it's a pretty small release.

Operator

We will now take our next question from Kamran Hossain from RBC.

Kamran Hossain

First question is just on, I guess, pricing and kind of what it's done to your book. So, looking at your RPI, you've talked about 5% up in the call and, actually 6% up at Cathedral. Obviously, there's renewal business -- sorry, new business as well which doesn't get increased in that calculation. Could you get -- maybe give an indication whether kind of the new business on an implied basis kind of has either higher pricing than the renewal bit. That's the first question. And second question, just on the, I guess, increasing energy demand. Is this construction or kind of -- which part of the energy market do you see picking up very strongly?

Alex Maloney

Paul, do you want to start on that question?

Paul Gregory

Yes, so on new business, Kamran, I'd almost split it into two parts. There's been some new business where we've grown with existing clients, and that's going to be broadly in line with the RPIs you're seeing in our statements. And then there's another pocket, which is what I call your post-loss opportunities, which -- there's been some of it, not lots but there's been some of it, not lots but there's been some. And that, by nature, is likely to be paying RPIs that are in excess of those RPIs that we're seeing here but, obviously, probably starting from a slightly smaller base. So that -- hopefully, that answers that question. And then on the energy piece -- sorry, Kamran, was your question around where we expect to see the demand come from?

Kamran Hossain

Yes, is it neutral, and is it kind of existing assets where you see the new demand coming from?

Paul Gregory

Yes, so it will be from a number of areas. First of all, as oil price kind of stabilizes, you'll see insurance values themselves start to edge up. You will then see some of our clients starting to basically conduct more activity. So, energy contractors will be employed more and start going through [a wealth] people, and operators will start employing those contracted to drill wells, and that just brings premium back into the market. And then there is the construction side of the portfolio. That's probably -- we got a bit more of a time lag on it. People won't start putting big construction projects out here until they really are comfortable that oil prices are stable, but we have just started to see new projects come to market. None of this will -- you're not going to see all of this in '18. It is going to be a slow burn, but we are starting to see the first green shoots of all those things starting to happen. And if you want to put in context, the kind of 2017 upstream energy premium was about half of its peak of four to five years ago. So, the energy market has room to grow if oil prices are stable and...

Kamran Hossain

It sounds like...

Paul Gregory

Yes, for us, we are uniquely placed in that market, so that is positive, but oil prices do move around, obviously. But where they are at the moment, that gives us some room for optimism.

Alex Maloney

Yes, on that, Kamran, just to give you a bit more flavor. If you think about some of our property D&F book at the Syndicate, you can see a renewal found in the U.S. that's paying a rate increase, but you kind of sit on it and think that the rate increases you would hope for would be more, and then you'll see something the Caribbean where you can charge an awful lot of money that, quite frankly, you just haven't written for two or three years. So, our property D&F guys are writing some business that they haven't seen for five years or even longer because it's been completely underpriced. And again, this is why the market's so patchy, and you have to just -- you have to have the right underwriters to sort of -- to work your way through the market. You can see some U.S. business where you think that's quite a business that should be paying. It's in Florida. It should be paying a sensible rate increase, and when the rate increase comes, then you're disappointed. And then you something in the Caribbean that you haven't seen for five years, and you can charge double the price. So, it's just patchy, so you just need to make sure you got the right people to sort of sift through an evolving story to be all over the place, quite frankly.

Operator

We will now take our next question from Jonny Urwin from UBS.

Jonathan Urwin

Just two please. So firstly, on the energy book again. You mentioned that the current premium levels are approximately 50% below peak. So, at the current oil price, could you see yourself taking the book back over like $200 million, or does the oil price need to go higher from here for that to happen? That's the first question. And secondly, the comments around trapped capital in Kinesis. Can you give us an idea of how long you expect that to be trapped, for how much capital is trapped and just whether that your experience is indicative of the broader market? That will be very interesting.

Alex Maloney

Paul, do you want to start on energy?

Paul Gregory

Yes. Jonny, so I think Brent this morning was around $53. And our premium in energy was obviously significantly below 200 million last year. So, my honest opinion is that $73-ish oil and rates increasing at the level that they're currently increasing in, which is just kind of like mid-single digit, it would be a stretch to get to 200 million. That said, if only the oil price remains stable for a period of time at these kind of levels, demand will come back in. So, you can certainly start adding premium to that portfolio quite quickly. I think, when we were north of 200 million, you were sort of looking at sort of a world of $100 oil. So, we've got way to go to get there, but all the signs are encouraging, and if stays around the $75 mark for a period of time, you'll definitely see demand coming back into the system.

Alex Maloney

Yes, and on that, Jonny, as well, we also got a bit of a broader footprint as well, so we do have an on-shore energy book as well now, and we will have a power book. So, it all starts moving in the right direction. We do have a sort of a broader energy footprint than we had in the past. But as Paul said, $100 oil, there was a lot of business, but it definitely feels like our energy customers have turned the corner. And when they're in London and meeting our underwriters, it's much more positive. As Paul said, construction works are coming back on track, but that is a '19 story for us as opposed to an '18 story. But again, weirdly similar to the insurance and reinsurance market, those guys are sort of dragging themselves off the bottom, and everything is looking more positive. So that's a good story for us.

Darren Redhead

Jonny, regarding the question on trapped funds. Quickly, I mean, Kinesis has approximately 30% trapped. Regarding when we'd expect that to be released, I wouldn't expect to see any of that until about after the third or fourth quarter this year, more likely the fourth quarter. Just as a general comment on the market overall, you have but loss tables that would dictate when that's released. I would imagine, on average, a higher-risk fund would have larger amounts trapped in that, but it depends what they've told their investors. The losses are -- but we don't count trapped funds as actively something to manage, and I know some others do.

Operator

We will now take our next question from Ben Cohen from Investec. Please go ahead.

Ben Cohen

I wanted to ask two things. Firstly, just stepping back. I think at the full year you were indicating in broad terms that, because of some of the headwind from multiyear contracts in prior periods, that you would expect roughly top line to be flattish to maybe slightly up this year. After the growth that you had in the first quarter, does that make you more bullish for the full year, or there some other seasonality effects that we need to be aware of in terms of timings? And then just on the investment portfolio. You said, Elaine, that you were going to maybe take out the duration at some stage. I just wonder, what is the rate that you're investing in it at the moment, and what sort of instrument are most of interest to you with what sort of field?

Elaine Whelan

Ben, I'm going to let Denise answer your second question. On the first one, we did mention the multiyear impact on the Q4 earnings call, and we said it was about $65 billion last year and expected to see this year. We didn't get quarterly guidance on that. It's very difficult to do that given contracts can extend or cancel the place. So, although with that growth in this quarter, there was a bit more of a multiyear impact in Q1 2017, and so -- and less an impact in this quarter, so you can still expect to see a multiyear impact on other quarters going out this year. It's not a linear thing.

Denise O’Donoghue

Yes, right now, we're obviously very short at 1.7 years. So, we're looking at sort of 8% to 9% highs over the next 2.5 years. We're probably sort of midway thinking about increasing duration by taking our hedge off at least to buffer further attack in that sort of the next 12 to 18 months. And then we'll slowly try to increase it a little bit more to take advantage of the higher rate. So, sort of thinking halfway through the hike cycle. That's what we're anticipating.

Ben Cohen

And the -- sorry, the investment yield on new investments at the moment?

Denise O’Donoghue

Right now, it's 2.5%. So yes, after that, the last couple of quarters.

Operator

We will now take our next question from Darius Satkauskas from KBW. Please go ahead.

Darius Satkauskas

Just one. Have you released [indiscernible] for HIM in California wildfires, like $8 million? How much of that is in that $25.2 million prior year development you reported?

Alex Maloney

I think that question was how much of this $25 million of HIM related is our releases.

Elaine Whelan

So, within our press release this year, if you have a look at the loss reserves section there, you'll see the movement in there's about just under $8 million. That's the release on those reserves there. But you can into the factor that into the property book in prior year movement.

Operator

[Operator Instructions] We will now take our next question from Thomas Fossard from HSBC.

Thomas Fossard

Two questions on my side. First one is related to the GWP growth in the large segments, so plus 18% in Q1. Could you give us a bit more granularity on what is driving this growth? You're pointing to property in aviation and new business. But I mean, I can't understand where the growth is coming from on the property side. Aviation, I'm struggling a bit more to understand where you're finding what you say were right opportunities at the present time. And the second question, related to your cap protection program. So actually, you mentioned slightly increase in the money spent. And I think that you've made some small changes on the side. Just to make it clear, can you tell us if we had a return of HIM this year? I mean, how much of the net loss incurred, which end? Would that be completely stable? Or should we expect some slight improvement?

Alex Maloney

Thomas, on the cat reinsurance program, we made a point on the last call saying that we decided, when came into this year, to buy exactly the same cat reinsurance program that we had for last year. So, we didn't feel the need to take any more net exposure. We've got exactly the same program. But if we -- we did buy a slightly enhanced program, and we did buy a bit of a retro quota share, so there may be some; slightly -- if you had exactly the same as HIM, which is unlikely, but if you had exactly the same pattern, we definitely wouldn't have more risk. We'll probably have a slightly reduced exposure to what we had in '17, but obviously, these things are impossible to predict. But as a business, or as a shareholder, we'll get more rate in the front door for no more additional net risk. And that was the point we were trying to make at the last call, and we think that's the right way to the position the underwriting portfolio for the '18 year. And one thing we've always said is, if rates get a lot more -- if rates harden, for whatever reason, a lot more, we'll look at that position again, and we're more than happy to deploy capital if we think we're getting substantially more rate. As we've seen this year where rates have gone, we're happy with the position that we took to buy the same reinsurance program.

Paul Gregory

On the increase in the Lloyd portfolio, Thomas, as you said, there's some increase in the property insurance lines, which predominantly rate driven. In direct and fac property, again, there's some good growth there that is both rate and new business, and Alex alluded to where we're seeing some of that new business earlier on in the call. On aviation, which you mentioned, there's three things there. There is a little bit of rate improvement. Not huge, there is a little bit of new business, but there's also some timing around certain contracts, and also, that's coming from a reasonably -- percentage increases are big, but it's coming from a reasonably low base. And then on the other lines, marine and energy, you're also seeing some growth there. Again, that is small amount of rate but also some increased demand, new business in those lines, albeit the dollar amounts are relatively small.

Operator

There are no further questions from the telephone. We have a next question, a follow-up from Ben Cohen from Investec.

Ben Cohen

Sorry, I just wanted to ask two things. On the Lloyd's business, it looks like there's quite an improvement in margin there if you look year-on-year. Presumably, that's driven by the price. I was just wondering if you could say a bit more about how much you're looking to grow the business through the year and the impact that you think the price increase should have on the margins that you want? And the second thing, more generally, the price increases that you're getting through at the moment, do you think they should start have a meaningful impact on your attritional loss ratio, if we look into 2019?

Alex Maloney

On that, Ben, we would grow the business as much as we can according to where we think the rates are. So, we have seen some good opportunities in Cathedral. We have cleaned up some of the book. So, one of the first years when we really decided to sort re-underwrite the portfolio for that, hopefully, should improve the ratios over time. Obviously, only time will tell. But we have cleaned up the book. Again, they're taking now more risks. So, the margin improvement is obvious, and we will grow as hard as the opportunity allows us. But as I said, we think the growth put on is sensible to the opportunity. And as I said, we have re-underwritten some of that book and taken out, hopefully, some of the more attritional accounts. And it's one of the -- I mean, '17 was a year where, because of the cat activities, it was very difficult to sort of re-underwrite the book. But the start of '18, as I said in my comments, as a business, we've probably never been in such good shape. Cathedral was in brilliant shape. Their new underwriting team has been there a long enough period now to really kind of change that business overtime.

And as the market opportunity improves, we will continue to grow Cathedral accordingly. And I just think -- another I mentioned earlier, about the small things that we see, the market cannot go backwards from here, and everything we see, particularly Lloyd's, with people shutting down product lines and all the necessary behavior that we are finally seeing, leads us to believe that this market has changed. It's getting there slowly, and that's frustrating for everyone including ourselves. But I think you seeing now the sins of the past all coming back to haunt people. For my point of view, that's good. And we don't really have to do much to clean up by book, really. So hopefully, it's one-way traffic from here. But as usual, we will stay disciplined, and we will only match our underwriting to the opportunity, and quite frankly, that's why these companies had the results it's had for such a long period of time. So, it is an evolving story. We will grow as much as we need to or as much as we can. But I do think I just can't see how the market goes backwards from here.

Elaine Whelan

Ben, on the attritional guidance. I mean, we're still pretty happy with where we're guiding. And it's obviously getting too early change that. There is going to be a lag off of lower-rate businesses to this year. But you're right, [areas] of new business and businesses renewing at higher rates will [err] more into 2019. If you feel like price is adjusting the attritional loss ratio, feel free, but it wouldn't really at move it that many points at this stage because we're looking at kind of 5%-ish rate changes.

Operator

There are no further questions from the telephone.

Alex Maloney

Okay, thank you for your questions, and we'll talk to you next quarter.