Essent Group Ltd. (ESNT) Q3 2018 Earnings Conference Call Transcript

Essent Group, Ltd. (ESNT 0.35%)
Q3 2018 Earnings Conference Call
Nov. 9, 2018, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. My name is Adam, and I will be your conference operator today. At this time, I would like to welcome everyone to the Essent Group Limited Third Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question telephone at that time, simply press * then the number 1 on your telephone keypad. And if you do want to remove yourself from the question queue, just press the # key. Thank you.

Chris Curran, Senior Vice President of Investor Relations, you may begin.

Christopher Curran -- Senior Vice President of Investor Relations

Thank you, Adam. Good morning, everyone, and welcome to our call. Joining me today are Mark Casale, Chairman and CEO; and Larry McAlee, Chief Financial Officer. Our press release, which contains Essent's financial results for the third quarter of 2018 was issued earlier today and is available on our website at essentgroup.com in the Investors section.

Our press release also includes non-GAAP financial measures that may be discussed during today's call. The complete description of these measures and the reconciliation to GAAP may be found in Exhibit L of our press release.

Prior to getting started, I would like to remind participants that today's discussions are being recorded and will include the use of forward-looking statements. These statements are based on current expectations, estimates, projections, and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially.

For a discussion of these risks and uncertainties, please review the cautionary language regarding forward-looking statements in today's press release; the risk factors included in our Form 10-K filed with the SEC on February 20, 2018; and any other reports and registration statements filed with the SEC, which are also available on our website.

Now, let me turn the call over to Mark.

Mark Casale -- Chairman, Chief Executive Officer & President

Thanks, Chris. Good morning everyone and thank you for joining us today. I am pleased to report that Essent generated another strong quarter of financial results as we continued growing our high credit quality and profitable mortgage insurance portfolio. For the quarter, we earned $116 million or $1.18 per diluted share, compared to $78 million or $0.82 per diluted share for the third quarter of 2017, while also generating a 21% annualized return on equity.

Our results for the quarter were primarily driven by a 26% increase in our insurance in force to $131 billion, compared to $104 billion as of the third quarter a year ago. This growth drove a 21% increase in net premiums earned to $167 million, compared to $138 million for the third quarter of 2017. Strong credit performance also contributed to our results as our loss ratio for the quarter was 3.3%.

On the industry front, we continue to see further utilization of risk-based pricing engines, an engine provides the capability to price more attributes at the loan level, unlike the current rate card structure which is generally based on broad FICO and LTV ranges. One of the primary benefits of an engine is that it provides flexibility to increase or decrease rates, allowing us to better shape our portfolio, especially in times of stress.

While we do not see the entire lender space converting to more sophisticated pricing engines overnight, we do expect the trend to continue. Much of the progress today is being driven by the market, as many lenders are enhancing their front end and best execution technologies in a very competitive originations environment. During the quarter, we continued to pilot our engine and anticipate a broad rollout in 2019 as we evolve our risk-based pricing strategy to best serve our customers.

From Essent's beginning, we have taken a long-term approach to assuring and managing mortgage credit risk. We believe that the combination of risk-based pricing on the front end and reinsurance on the back end makes us a stronger company by reducing franchise volatility during down cycles.

In Bermuda, Essent Re continues to provide us another platform to invest in GSE risk share and has now participated in over 40 deals, primarily through the ACIS and CIRT transactions. Essent Re has also been growing its advisory business, referred to as a managing general agent or MGA. This business generates fee-based income and enables us to leverage our expertise to help reinsurers invest in GSE risk share. Our participation in GSE risk share and managing our MGA demonstrates the optionality and flexibility of the Re platform.

Turning our attention to PMIERs 2.0, we are pleased that they have been finalized. We remain supportive of the PMIERs framework and believe that strong and transparent capital standards are a long-term positive for our industry. When applying PMIERs 2.0 to our financial position as of September 30, 2018, our PMIERs excess of $360 million would be substantially unchanged.

On the Washington front, we continue to monitor the landscape following the results of this week's elections. Given the changes in both the House and Senate, we do not believe there will be any meaningful to address housing finance reform at the start of 2019. Looking forward, we will continue to support USMI and engage with policy makers in promoting the benefits of private mortgage insurance in a well-functioning and robust housing finance system.

Now, let me turn the call over to Larry.

Lawrence McAlee -- Senior Vice President & Chief Financial Officer

Thanks Mark, and good morning everyone. I will now discuss our results for the quarter in more detail. For the third quarter, we reported net income of $116 million or $1.18 per diluted share, compared to $112 or $1.14 per diluted share for the second quarter and $78 million or $0.82 per diluted share for the third quarter a year ago. Note that the 48% increase in net income compared to the third quarter of 2017 was driven primarily by a 21% increase in net premiums earned, as well as the decrease in our effective tax rate as a result of the passage of Federal Tax Reform in December of last year.

Earned premium for the third quarter was $167 million, an increase of 6% over the second quarter of $157 million, and an increase of 21% from $138 million in the third quarter of 2017.

Note the premiums ceded to Radnor Re on our ILN transaction are reflected as a reduction of earned premium and were $3.2 million in the third quarter, compared to $3.6 in the second quarter of 2018. The average net premium rate for the third quarter was 50 basis points, which was 1 basis point lower than the second quarter of 2018, due a lower level of single premium policy cancellation income.

We expect our average net premium rate to be approximately 49 basis points for the balance of 2018. Note that this rate reflects only the primary MI business and does not include premiums earned by Essent Re on its GSE risk-share business.

We remain pleased with the credit performance of our insured portfolio. Our provision for losses and loss adjustment expenses was $5.5 million in the third quarter of 2018, compared to $1.8 million in the second quarter of 2018 and $4.3 million in the third quarter a year ago. The default rate on the portfolio declined 3 basis points from June 30, 2018, to 61 basis points at September 30th. This decrease was primarily a result of continued cure activity on defaults associated with hurricanes Harvey and Irma, offset by an increase of 519 non-hurricane defaults during the third quarter.

Our defaults at September 30th so not reflect any impacts of hurricanes Florence or Michael. While we are closely monitoring default activity and damage assessments in these regions, given that only 1.5% of our insured portfolio is located in the impacted areas, we do not believe that these hurricanes will have a material impact on our portfolio.

Other underwriting and operating expenses were $36.9 million for the third quarter and our expense ratio was 22.1%, compared to $36.4 million and 23.2%, respectively, for the second quarter of 2018.

Income tax expense for the third quarter of 2018 was calculated using an estimated annual effective tax rate of 16.2%, plus $1.5 million of additional tax expense associated with the completion of our 2017 federal income tax return. We currently expect our effective tax rate to be 16.2% in the fourth quarter of 2018.

The consolidated balance of cash and investments at September 30, 2018, was $2.7 billion. The cash and investment balance at the holding company was $77 million at September 30th. No capital contributions nor dividends between the holding company and operating businesses were completed during the third quarter. As of September 30th, we have $275 million of undrawn capacity under the revolving credit component of our credit facility and $225 million of term debt outstanding.

As of 2018, the combined U.S. mortgage insurance business statutory capital was $1.8 billion, with a risk-to-capital ratio of 14.1 to 1, compared to 14 to 1 as of June 30, 2018. The risk-to-capital ratio at both dates reflects a reduction in risk in force of $424 million for the reinsurance coverage obtained from our insurance-linked note transaction.

At the end of the third quarter, Essent Re had GAAP equity of $749 million, supporting $7.8 billion of net risk in force.

Now, let me turn the call back over to Mark.

Mark Casale -- Chairman, Chief Executive Officer & President

Thanks, Larry. In closing, Essent generated another strong quarter of financial results as we continued build a high credit quality and profitable mortgage insurance portfolio. The operating environment during the quarter was favorable, and we remain pleased with credit performance and our market presence.

Looking forward, our outlook on our business remains positive, and we believe that increased utilization of risk-based pricing and reinsurance will make Essent a stronger company.

Now, let's get to your questions. Operator?

Questions and Answers:

Operator

Our first question comes from Mark DeVries of Barclays. Mark, your line is open.

Mark DeVries -- Barclays -- Analyst

Thanks. I had a question about market share. Mark, I know you don't manage to market share and that it does tend to be a little bit volatile from quarter to quarter, but we estimate it at 16.7% market share this quarter, and I think it's been almost two years since you were inside of your range of 13% to 15% long-term guidance. Curious kind of what's driving the strength there and how should we think about market share longer term?

Mark Casale -- Chairman, Chief Executive Officer & President

That's a good question, Mark. Again, we don't -- like I said, it's really -- for us it's about insurance in force growth. I think given how big the market is, market share is really not as important a metric as maybe it once was in a smaller market. So, we're one of six. So, if we're at the higher end of that range, which it seems like we've been and a little bit over, and still think that's a good long-term outlook.

I mean, it could shift quarter to quarter as you get into -- as the market share gets a little bit more volatile with some of the pricing as the engines roll out. You could see some with less transparency. You could see some more volatility, and I think we have, in the past few quarters, with certain MIs and certain lenders.

But again, really the focus longer term is insurance in force. We grew it 26% year over year. And again, given that we're one of six, we feel very comfortable with our market presence and our ability to continue to grow the portfolio.

Mark DeVries -- Barclays -- Analyst

Okay. And then it also seems like the private mortgage insurance industry is growing faster here than the broader mortgage market. Are you seeing signs that you are continuing to gain share on the margin from the FHA?

Mark Casale -- Chairman, Chief Executive Officer & President

Yeah, I would -- I mean, a little bit on the FHA, especially as you think about the higher DTIs and some of the higher LTVs. We're seeing in some of the share -- we have seen, really over the past year or year and a half, the share shift from FHA to conventional.

I think the other thing driving is just the demand around the first-time homebuyer. And even when you look at the builders, some of the larger builders now -- I think the number two builder in fact, 35% to 40% of their closings are in their first-time -- really their starter home unit. That average size, I believe, of that builder is $240,000 to $250,000. Our average loan size is 230.

So, across all homebuilders, the demand is not equal among the different price points, but with the starters, it's clear that the demand is there, and a lot of those consumers will use MI. So, I think it's more secular than just kind of a shift from FHA to conventional.

Mark DeVries -- Barclays -- Analyst

Okay, great. Thank you.

Operator

Your next question comes from Douglas Harter of Credit Suisse. Douglas, your line is open.

Sam Choe -- Credit Suisse -- Analyst

Hi, this is actually Sam Choe filling in for Doug. On the credit side, current losses have been coming lower as -- I mean claims rates have also trended down. Could you give us a sense on your updated view as to how low claim rates can go in this environment?

Mark Casale -- Chairman, Chief Executive Officer & President

Hey, Sam. It's Mark. I think we're gonna -- we'll still to our guidance. I still think when we run the models, we would assume kind of 2% to 3% claim rates, and that's really not that many. You're talking about two to three borrowers out of 100 going into claim. It's obviously been better in the environment given the full employment, where interest rates are, and just generally the economy has been strong. But these things can turn. So, we still think 2% to 3% is really the range that you guys should be thinking about going forward.

Sam Choe -- Credit Suisse -- Analyst

Got it. And you guys had pretty good improvement on persistency. How do you see that improving going forward?

Mark Casale -- Chairman, Chief Executive Officer & President

We don't see it improving. We think longer-term guidance is probably closer to the 80% range, Sam. It's been higher, and it could tend to stay at this level a little bit if interest rates continue to climb up. But remember, persistency, especially if rates climb a litter faster and then they come down, the consumer is so trained on the ability to refinance that you could see volatility. So, we're kind of in the -- we're in the high altitudes now in terms of persistency. So, I wouldn't look to -- as you guys build your models, I wouldn't look to the mid 80s. I think it's closer to the 80s, so probably a more conservative measure going forward.

Sam Choe -- Credit Suisse -- Analyst

Got it, all right. Thank you so much.

Mark Casale -- Chairman, Chief Executive Officer & President

You're welcome.

Operator

Your next question comes from Bose George of KBW. Your line is now open.

Bose George -- KBW -- Analyst

Hey, guys. Good morning. Actually, my first question is just on operating expenses. Just given the growth on the revenue side that was sort of implied by your insurance in force growth, should the expense ratio continue to trend down from the 22% you did this quarter?

Mark Casale -- Chairman, Chief Executive Officer & President

It's tough to tell, Bose. I think we focus more on the nominal dollars, and I think we still feel comfortable kind of this year in that 150 to 155 range, probably a little bit on the lower side of that. But going forward, we would still see some increase in expenses -- nothing that jumps out. Premium taxes clearly rise as revenues rise. We'll continue to invest in parts of the business. And then the expense ratio really just becomes a calculation. And don't forget with the premium compression that you're seeing in the market, that the revenues may not grow as fast as you may think.

So, longer term, we tend to give more combined ratio guidance. We still think kind of that 35 to 40 in the longer-term range over the intermediate to longer term is still a pretty good guide.

Bose George -- KBW -- Analyst

Okay, that's helpful. Thanks. And then, just switching to excess capital, can you give us an update on that? And just when we think about excess capital, should we also keep in mind the untapped line of credit as we think about excess capital and potential capital return?

Mark Casale -- Chairman, Chief Executive Officer & President

I mean, we look at capital this way -- I think we feel very comfortable with our capital position at the end of the third quarter, given the PMIERs excess 75-plus million at the holdco, another 275 kind of in terms of dry powder at the line of credit. So, we're very comfortable from a capital position, feel like we'll be able to reinvest some of that in the core business and within Essent Re.

I think when you think about excess capital, though, it's a little bit more nuanced. Don't forget that a lot of the PMIERs excess, Bose, is driven by the ILN deal that we did. We've only done one of those. So, it only covers 30% of the book.

I think in terms of capital distribution, we certainly wouldn't want to execute another insurance-linked note deal next year, and that's kind of our plan is to take the 2018 book in early 2019. Once we get that under our belts, I think we'll have a better -- we'll be able to give you a little bit more guidance around capital distribution.

But right now, you're talking about a company that just equity 15 months ago. We're still growing in insurance in force and at returns of 20% return on equity in a business that's very pro-cyclical. Capital is king. So, we're not -- it's something we're going to be really careful about. But right now, we're going to enjoy our capital position and the strength of it.

And remember, capital begets opportunities, too. So, we're running these businesses for the long term, and one ILN deal doesn't necessarily make -- turn us into a capital distribution story.

Bose George -- KBW -- Analyst

Okay, great. Thanks. And actually, one more related question on capital. Are there any tax consequences that make it difficult for you to dividend up capital from the USMI to the Bermuda holdco?

Lawrence McAlee -- Senior Vice President & Chief Financial Officer

Hey, Bose. It's Larry. I'll respond to that question. Yeah, there is a withholding tax between the US and the Bermuda hold company. The way that we're structured, that would be a 5% withholding tax on any distributions from the US through our intermediate holding company up to Bermuda.

Bose George -- KBW -- Analyst

Okay, great. Thank you.

Mark Casale -- Chairman, Chief Executive Officer & President

And also don't forget, Bose, that with the 25% affiliate reinsurance deal, that's another way to get capital from guaranty to the holdco.

Lawrence McAlee -- Senior Vice President & Chief Financial Officer

Correct.

Bose George -- KBW -- Analyst

Okay, great. Thank you.

Operator

Your next question comes from Mackenzie Aron from Zelman & Associates. Mackenzie, your line is open.

Mackenzie Aron -- Zelman & Associates -- Analyst

Thanks. Just one from me. Mark, on the -- can you give us an update on the pilot programs from Frannie, Freddie, EPMI, and IMAGIN? Are you seeing any change once we get into -- as lenders get more comfortable with those programs now that they've been out on the market for the last several months?

Mark Casale -- Chairman, Chief Executive Officer & President

Yeah, I can give you a little bit of an update. I've been out a lot this past quarter meeting with lenders, and we haven't seen a lot of impact. I would -- from what I can is there's not more than a handful of lenders contributing to either one of the programs. And again, it's early for the programs. And I think one of the GSE's announced that they're gonna go after the smaller lenders where there's clearly not a ton of volume. And also don't forget, the environment's really not well suited for LPMI, especially in a rising rate environment. So, again, it's early, but I would say the traction's -- the traction has been really limited.

Mackenzie Aron -- Zelman & Associates -- Analyst

Okay, that's helpful. Thank you. And then, as we kind of get into the end of year and hopefully get some announcements from the White House on the direction of FHFA, is there anything that you're watching on the policy? Whether it's FHA or with the GSEs?

Mark Casale -- Chairman, Chief Executive Officer & President

I think with HFA, it's pretty clear. I think they're on a path to -- from what we can tell, is to shrink their footprint over time. And that's something we continue to wait and see.

I think on GSE reform, again like I said in our prepared remarks, we don't see anything coming early in 2019. I think we will look to see who the new head of FHFA is -- if there's an interim or a confirmed head of FHFA. It's tough to tell. It's still pretty early. I mean, the election just happened the last couple days. So, I think we're in wait and see mode, and it's too hard to really guess at this point.

Mackenzie Aron -- Zelman & Associates -- Analyst

Okay, thanks. And good luck for the rest of the year.

Mark Casale -- Chairman, Chief Executive Officer & President

Thanks.

Operator

Your next question comes from Jack Micenko from SIG. Jack, your line is open.

Jack Micenko -- SIG -- Analyst

Good morning. Mark, looking at the mix of the portfolio, 95-plus, it looks like risk in-force now about 10.5%, but the NIW number was closer to 18, so the portfolio is migrating in that direction. I guess the question -- is that strategic? I know you talked to an earlier question about the FHA picking up some share there, but I'm wondering if you're doing something that's more pronounced there? Obviously, you're getting paid more for that risk, but just curious.

Mark Casale -- Chairman, Chief Executive Officer & President

No, nothing -- nothing in particular that we're doing. I think we've seen a rise, especially around the LTVs across the lender base. So, it's not any one particular lender at all. I think it's above the base. We feel like the credit is still pretty strong, Jack. The FICOs are elevated at that level, and obviously the pricing is pretty good. So, again, I think that's just where some of the market is trending, and we feel pretty comfortable with it, at this point, given where we are in the economy.

Jack Micenko -- SIG -- Analyst

Is it possible it's a function of rising home prices? I mean, are the loan balances larger there?

Mark Casale -- Chairman, Chief Executive Officer & President

No, not particularly. No, we haven't seen any real difference in home prices.

Jack Micenko -- SIG -- Analyst

Okay. And then, on the loss incurred number, was there maybe more of a mechanical change this quarter? I mean, defaults came down a little bit quarter on quarter, but the number came in a bit higher, your severity is lower. Just curious. I know you talked about the 2% to 3% claim rate assumption, but was there any shift to this quarter specifically in the way you're modeling the reserve?

Lawrence McAlee -- Senior Vice President & Chief Financial Officer

Hey, Jack. It's Larry. No. No change at all relative to that. One thing we would want to point out is that we have not made an adjustment to the hurricane reserves that we booked in the fourth quarter of last year. So, again, you saw the impact of the cure activity in the count, but you did not see any impact in terms of the dollar.

So, we continue to the cure activity. We'll do that through the fourth quarter and any claim activity. And then we'll look at considering whether or not we would make an adjustment to the hurricane reserve sometime in the fourth quarter.

Jack Micenko -- SIG -- Analyst

All right. Thank you.

Operator

Your next question comes from Mihir Bhatia from Bank of America. Your line is open.

Mihir Bhatia -- Bank of America Merrill Lynch -- Analyst

Thank you for taking my question. Just staying with the claims. Just a quick question on -- you talked about claim frequency, but what about claim severity? That's come down nicely this year. I think it's down like 10% year over year, just through the year so far. And I was just wondering, is there something driving that or is it just home price appreciation or something else? How do you see that trending?

Mark Casale -- Chairman, Chief Executive Officer & President

Yeah, I mean we always -- we would be very conservative on that. I think some of it is the lull of small numbers driving some of that, and clearly the home price appreciation helps somewhat. But I wouldn't -- I wouldn't forecast kind of continued improvement in severity at all.

Mihir Bhatia -- Bank of America Merrill Lynch -- Analyst

Okay. And then just one other question on going back to the risk-based pricing engine that you mentioned -- I think in the prepared remarks -- a just curious on where are we as you think about the industry as you all roll that out and the pilot program gains and as your learning from it -- where are we in terms of just actually moving toward that type of a pricing structure as a whole? Are we talking three years? Are we talking one year? Or 10 years?

Mark Casale -- Chairman, Chief Executive Officer & President

Well, I mean, yeah. I mean, it's out in the market now. I mean, two MIs are doing it every day. We're in pilot phase. We'll roll it out.

Certain lenders will take it -- it's going to take certain lenders time just because of the technology. So, a lot of smaller lenders are using it today. We know one large bank that's using it today. So, yeah, I think it will take a couple years. I think this is more evolutionary versus revolutionary where it's all going to shift day one. I mean, there's too many lenders, the technology is too complicated. You have get to get integrated with all the different vendors. Lenders have to become comfortable with it from a compliance standpoint. This just doesn't happen overnight because they MIs roll out their pricing engines. I mean, we don't drive the market; our lenders do.

So, I think we have to be very patient with that. That's why we say it's going to evolve. And that's why we're careful to roll it out and make sure it works from an operational standpoint.

The major point is just, again, longer term. As once these are in place, I do think it shifts some of the pricing power from the lenders to the MIs. And when you just have a rate card that has two factors and now we're up to a whopping four factors -- with one lender, it's one-size-fits-all. And I think I mentioned in the last quarter. That's fine when the market's strong. It's really bad when the market starts to soften. And I think now, once they're in place -- and I would expect all the MIs to have them in place at some point, and you have five or six MIs basically pricing differently every day on every loan, that's an advantage.

So, in a softening market, there may be one MI that likes that risk and another MI that doesn't. The lender wins, because they'll get the best price for them. But the MIs get a chance to shape their portfolio. And I just think when you combine that pricing power, so to speak, with the hedging that we're doing on the back end, what you're left with now is an entity that has a lot less volatility to it and a lot more control.

You think about the last downturn, the MIs went into the downturn with an uncapped liability on their balance sheet. That's a tough -- that's a tough thing to enter into any type of market. And I think as the insurance-linked note market continues to mature and the reinsurance market continues to mature and you combine that with kind of the granularity of pricing on the front end -- like I said in our prepared remarks, from an Essent standpoint, we feel it's going to be a much stronger company and much better able to withstand cycles.

And cycles are what -- the down cycles are what has really hurt the MI business. And being able to kind of reduce that volatility makes us a better counter party for our lenders. Certainly from a GSE perspective when you think about housing finance, just from a taxpayer standpoint, our ability to stand in front of the GSEs now and have that type of volatility, I just think makes for a stronger housing finance system.

So, there's a bigger -- there's a bigger picture here. And it's not measured in quarters in terms of how many lenders we've rolled the engine out to. I think there's much -- there's a broader message here that I'm trying to get across.

Mihir Bhatia -- Bank of America Merrill Lynch -- Analyst

Great. I think that makes sense. Okay, great. I'll just stop there. Thank you.

Mark Casale -- Chairman, Chief Executive Officer & President

You're welcome.

Operator

And we've reached the end of our Q&A session for today, so I'll turn the call back over to Mark Casale for closing remarks.

Mark Casale -- Chairman, Chief Executive Officer & President

Thank you, Operator. Before ending our call, I'd like to thank everyone for participating today and have a great weekend.

Operator

This does conclude today's conference call. You may now disconnect.

Duration: 29 minutes

Call participants:

Christopher Curran -- Senior Vice President of Investor Relations

Mark Casale -- Chairman, Chief Executive Officer & President

Lawrence McAlee -- Senior Vice President & Chief Financial Officer

Mark DeVries -- Barclays -- Analyst

Sam Choe -- Credit Suisse -- Analyst

Bose George -- KBW -- Analyst

Mackenzie Aron -- Zelman & Associates -- Analyst

Jack Micenko -- SIG -- Analyst

Mihir Bhatia -- Bank of America Merrill Lynch -- Analyst

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