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Watford Holdings Ltd (WTRE)
Q3Â 2019 Earnings Call
Oct 30, 2019, 1:00 p.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good day, ladies and gentlemen, and welcome to the Watford Holdings Third Quarter Earnings Conference Call. [Operator Instructions]. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions].
Before the company gets started with its update, management wants to first remind everyone that certain statements discussed on this call may constitute forward-looking statements under the Federal Securities Law. These statements are based upon management's current assessments and assumptions that are subject to a number of risks and uncertainties.
Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports and other filings that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby.
Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP, the definitions of underwriting income/loss, adjusted underwriting income/loss and adjusted combined ratio and the descriptions of the non-investment grade portfolio and investment-grade portfolio components of the company's investment returns can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website.
I would now like to introduce your host for today's conference, Mr. John Rathgeber, CEO of Watford Holdings. Sir you may begin.
John Rathgeber -- Chief Executive Officer and Director
Thank you Tuwanda [Phonetic]. Good day, everyone and thank you for joining the Watford Holdings third-quarter earnings call. Joining me on the call today are Rob Hawley, CFO and Jon Levy, President and Chief Risk Officer. I'll provide some high-level commentary on our third quarter underwriting and investment results, briefly discuss insurance market conditions and then give an update on the status of our share repurchase program.
Rob will then provide a more detailed recap of the third quarter financial results. Following that, we'll be pleased to take your questions. Net income for the 2019 third quarter was essentially break-even at $150,000. However, our results were stronger than you might first surmise once you understand the individual components contributing to the final result. To begin with, due to the refinancing of a sizable portion of our preferred shares, this quarter's results were impacted by charges totaling $5.5 million for accelerated amortization of the initial discount and other one-time expenses related to the redemption. Going forward, we will recognize substantial savings from the refinancing, which Rob will detail in his remarks.
The third quarter results were also impacted by approximately $15 million of net unrealized investment losses, which was largely in line with the slight spread widening experienced by the high yield and leveraged loan markets overall.Those two items combined to produce a $20 million swing in our results and mask the real underlying economic result. Importantly, net interest income was strong at $29.5 million. For the quarter, the net interest income yield on the non-investment grade assets under HPS management was 1.7% and the net interest income yield on our investment grade portfolio was 0.6%.
Through nine months, the net interest income return on the HPS portfolio is 5.2% or 6.9% on an annualized basis. Exclusive of realized and unrealized gains and losses, this translates to an annualized 6.2% net interest income return after performance fees. The combined ratio for the quarter was 104% on $125.8 million of net premiums earned resulting in a gap underwriting loss of $5 million. The combined ratio when adjusted for certain corporate and non-recurring expenses and other underwriting income was 101.8% .
As a reminder, what most other companies report as their combined ratio is generally more comparable to what Watford reports as its adjusted combined ratio. The unadjusted combined ratio that we report is a more conservative presentation of our underwriting results compared with our peers. Given our mix of business and the sizable industry catastrophe events during the quarter, most notably Hurricane Dorian and Typhoon Faxai, we are pleased with the third quarter underwriting results, while Dorian and Faxai were major industry events, our losses were quite modest. Our total losses for the third quarter catastrophe events are estimated at less than $3 million adding roughly 2 points to the combined ratio for the quarter.
Our loss reserves for prior accident years continued to hold up well with slight net favorable development in the quarter. I'll talk more about our loss reserves when I discuss market conditions and the [Indecipherable] inflation that many market participants have observed and are commenting about. Net premiums written for the quarter were 2.7% higher than a year ago, while net premiums earned were 7.2% lower The reduction in net premiums earned is a result of lower net written premiums in prior periods. The increase in net premiums written this quarter is primarily due to one large casualty reinsurance excess of loss contract. It is a three-year contract, and the entire three-year net premium of $28 million was recognized in the quarter. After annualizing the premium, net premiums written were lower by approximately 10% from the year-ago third quarter. This contract also had a sizable impact on our gross and ceded written premiums which Rob will cover.
Including other comprehensive income, the growth in book value was slightly down quarter-over-quarter. Through nine months, our book value has grown 8% and book value per diluted share has grown 7.2% and we remain confident about continued strong long-term book value growth. As mentioned on our last call, one reason for optimism is that insurance and reinsurance market conditions are noticeably improving in most lines of business. We talked last time about increased rates in most lines of insurance with workers compensation being the most notable outlier, those positive rate trends continued in the third quarter and are providing a welcome tailwind.
Recently, however, there has been considerable talking concerned about elevated loss costs due to higher than anticipated social inflation. To the extent, this is a real phenomenon, this could have a negative impact on Watford's results. As a large casualty writer, we are certainly exposed to the effects of social inflation. Concerning this issue, we believe that our historical reserving philosophy of reacting quickly to higher than anticipated loss activity will serve us well by reducing the chances of more sizable reserve corrections in future years.
We are also in a better position than many of our competitors, because we are relatively new entrant with fewer accident years exposed to potential shortfall and loss reserve adequacy, due to higher social inflation.Thus, on the whole, we view the situation as a net positive for Watford as the negative impacts are likely to be more strongly felt by our competitors while Watford should benefit from any further rate strengthening that occurs as a result.
Turning now to the status of our share repurchase program, as you may already know the Board has authorized share repurchases of up to $75 million. I am pleased to report that we began implementation of our share repurchase program on September 30 via a 10b5-1 program. The share repurchases are subject to daily volume constraints. In order to remain within the Safe Harbor, our daily purchases cannot exceed 25% of the last four weeks' average daily trading volume. As the program incepted at the end of the third quarter and there is a short settlement lag, the reduction in shares outstanding will not be reflected in our financial results until the end of the fourth quarter.
Given where our stock is currently trading such purchases are obviously very accretive to book value per share. We will continuously reevaluate the best uses for our capital and certainly give strong consideration to additional share repurchase authorizations, if we have
The excess capital to do so. With those introductory comments. I'll now turn it over to Rob to go through our financial results in more detail. Thank you, John, and good afternoon everyone. I'd like to provide you with some commentary and observations on our financial results for the third quarter 2019. Net income after tax and payment of preferred dividends and accelerated amortization of costs related to the redemption of preference shares for the quarter was $152,000. As John mentioned earlier, this quarter's results were impacted by $5.5 million of one-time costs relating to the refinancing of our preference shares. The one-time impact on our results this quarter will be outweighed by the significant savings to be realized going forward.
The projected annual savings will be approximately $3.8 million per year. The year-to-date diluted EPS remains at $2.71 and book value per diluted share dropped $0.02 this quarter to $42.05, 7.2% increase from year-end 2018.
Moving to our underwriting results for the quarter. Our gross premiums written for the third quarter were $249.9 million, an increase of 35% or $64.9 million versus the same quarter last year, premium growth in casualty and insurance programs and coinsurance were offset in part by a reduction in other specialty. Our casualty reinsurance gross premiums were up, primarily due to the binding of a three-year, $81 million casualty excess of loss contract. A significant portion of this contract is ceded to Arch further aligning our interest and netting our exposure to match our risk tolerances. The full amount of the contract is recorded this quarter as written and will be earned over a three-year period.
The growth in premium written was offset in part by the continued impact of the Q1, 2019 non-renewal of one multi-line quota share contract as well as reduced participation on certain professional liability contracts which we've discussed on prior earnings calls. Other specialty gross premiums were down primarily due to the reduction in the season's original exposure for one large renewal with the remaining reduction attributable to the non-renewal of one motor quota share contract.
Insurance programs and coinsurance growth was due to the continued expansion of our US and European businesses. Ceded premiums written grew a 182% year-over-year. Premium ceded to Arch increased significantly primarily due to the casualty excess of loss contract just mentioned. In addition, as our Insurance gross premiums written have grown in our WICE, WSIC and WIC companies the outward ceded premiums to Arch have grown in proportion.
The Q3, 2019 combined ratio was 104% and 3.3 points higher than the same quarter last year. After removing corporate expenses, our adjusted combined ratio for the quarter was 101.8% or 2.3 points higher than the same quarter last year. Overall, the prior year development for the quarter was essentially flat, made up of slightly favorable development in our property catastrophe and other specialty business, partially offset by slight adverse development in casualty and insurance programs and coinsurance lines.
The Q3, 2019 loss ratio was 76.5%, 5 points higher than a year ago. The increase in the loss ratio partly reflects changes in the mix and type of business, which also resulted in a 3-point lower acquisition expense ratio. In addition, the year-ago third quarter results benefited from 1.7 points of net favorable loss reserve development, while loss reserve development this quarter was essentially flat.
The general and administrative expense ratio was 5.6% in the 2019 third quarter compared to 4.3% in the third quarter of 2018. The 1.3 point increase this quarter versus the third quarter of 2018 reflects ongoing public company corporate expenses. Removing these corporate expenses, our adjusted general and administrative expenses were flat compared to the third quarter of 2018 and slightly lower compared to the 2019 second quarter.
Now moving to our investment results. The third [Phonetic] quarter net investment return benefited from continued strong net interest income of $29.5 million, an 8% increase versus the third quarter, 2018. The increase in net interest income, essentially mirrors the growth in our average net assets. The quarterly investment return for the entire portfolio was 0.6% on average net invested assets of $2.2 billion. Net realized and unrealized losses totaled $14.6 million, reducing the overall return by 70 basis points. Net realized gains were $600,000 and net unrealized losses were $15.3 million this quarter.
Focusing on our non-investment grade portfolio, net interest income was $27.2 million versus $26.3 million a year ago. The net interest income yield of 1.7% was consistent with the third quarter of 2018 while average net invested assets were up approximately 5.6%. As noted in prior calls, interest income is a long-term driver of our investment performance and our year-to-date net interest income yield of 5.2% is in line with the 5.1% year-to-date yield in 2018.
The non-investment grade portfolio unrealized loss of $15.7 million reported was roughly in line with the slight credit spread widening this quarter. Turning to our investment grade portfolio. The net interest income yield was 0.6% in the quarter compared to 0.5% in the third quarter of 2018. Year-to-date net interest income yield was 1.8% compared to the prior year-to-date yield of 1.4% reflecting reinvestments at higher yields in 2019, as well as a slight shift in our portfolio composition.
As of the end of September, the ending balance sheet, net unrealized loss position for the combined investment portfolios was $94.8 million.
Lastly, I'll touch on capital and collateral management. During the quarter, Watford closed on a new $100 million, 364 day unsecured bilateral letter of credit facility. This new facility will add additional collateral and financial flexibility to our business strategy.
Our total financial leverage ratio defined as debt plus preferred to total capital remains at 19% at the end of September.
With that, I'll hand it back to John.
Thanks, Rob. Before we open the call up to questions, I would just like to remind our shareholders to please register your votes for the proxy, you should have received in connection with our upcoming Annual Meeting on November 6. The items being voted on are fairly routine in nature, but it is important that we receive your votes in order to achieve a quorum if you did not receive a proxy, you can contact Rob Hawley whose contact details are shown at the end of the earnings release. And with that, we will now be pleased to take your questions.
Questions and Answers:
Operator
[Operator Instructions] Our first question comes from the line of Pablo Singzon with JP Morgan. Your line is open.
Pablo Singzon -- JP Morgan -- Analyst
Hi, good afternoon. John, so based on your comments P&C pricing continues to improve broadly, but probably more and even if you look at, look at it by specific business line or geographies or even insurance versus reinsurance. So if we sort of accept that premise and consider your own business mix, how should I guess industry trend be reflected in your prospective premium growth and margin. So if you focus on growth here for a second. Right, more specifically, are there enough opportunities out there to turn it on the negative trend in premium growth you did book a large case this quarter, but there were several non-renewal too early this year and I have couple more follow-ups.
John Rathgeber -- Chief Executive Officer and Director
Yeah. Well following Arch's underwriting philosophy and again, I used to work at Arch, and so I'm very familiar with how they approach underwriting is that you really don't forecast how much premium you're going to write in future periods. It's all a matter of seizing on the best opportunity -- opportunities as they present themselves. So I can't predict, even though we know that market conditions are improving, what exactly will happen because switch [Phonetic] the reinsurance side, it's very lumpy as we just saw where we found [Phonetic] a $80 million contract with stroke of a pen. So the large contracts will come and go and it's just really hard to predict. I mean I would say I think we're still continuing to see a lot of good submissions on the insurance side and program basis and we'd expect that to certainly continue to grow but on the reinsurance, especially casualty reinsurance it's just really hard to predict.
We have written some more commercial auto liability recently and some general liability both insurance and reinsurance side. So there are opportunities out there, but what the net impact is going to be over the next couple of quarters. I just can't tell you.
Pablo Singzon -- JP Morgan -- Analyst
Okay and then just switching to margins here for a bit. So assuming no adverse impact on reserves from ongoing social inflation and recognizing the benefit from higher pricing. Should the benefit there be reflected immediately in your -- in the lower accident year loss ratios maybe via changing your loss picks or if you sort of I guess maintain your approach right now will the earnings recognition be more back-ended via reserve releases?
John Rathgeber -- Chief Executive Officer and Director
Well, I mean certainly it's going to take a while for rate increases to flow-through because it's got to come through the earned premium, which will take time to be recognized. And then along the way, I mean, we're going to certainly take a very cautious approach to reserving as again, that's always been Arch's philosophy and that's kind of the starting point, they provide initial reserve recommendations, which then as a management, we do our own analysis and make the final determinations. But given the environment. And just the inherent nature of casualty business to begin with [Indecipherable] very cautious and we're not going to rush to take down reserves, we'll make very optimistic loss picks. And it's always been our philosophy.
Pablo Singzon -- JP Morgan -- Analyst
Okay. And the last question for [Indecipherable]. John can you just give us an update on where the PFIC issue stands, I think the public comment period has passed. I was wondering if you are -- the broader industry has received any feedback from the regulators. Thanks.
John Rathgeber -- Chief Executive Officer and Director
Yeah, so as we've mentioned, the industry has provided a number of comments and by a large, they're all very similar in nature in terms of recommendations and there were also meetings with Treasury and the IRS. A couple of those group meetings were with some of the trade associations and other companies, we attended as well. So we've had personal interactions with some of the folks of at Treasury and IRS, and what I would say is that I think by and large the recommendations and advice that's been given by the industry is being well received -- has been well received by Treasury and at this point, they haven't made any decisions of what to do with that. But every indication we have is that they've heard what we've been telling them. And in terms of the one specific issue that's of most relevance to Watford which is whether they would be adding an active conduct percentage tests based on the expenses of employees versus outsourcing, they seem to clearly get the message that that would not be a valid way of discriminating between insurance company or an investment company.
And I feel very good that they are ultimately going to decide that not to adopt that approach and to have some other way of thinking about active conduct. So I feel very good about where we are, where this is going. Although they said it probably will be at the earliest the spring of next year when they will finalize the guidelines. So this is going to remain unresolved for a few more months at least. But once enacted, any rules that come into play would not take effect until the following year, so there will be quite a bit of lead time if in worst case something came out that was adverse for situation [Phonetic], but the way I see it now, I feel very good about where we are. And you have to remember also the bright-line test that they introduced in 2017 with the Tax Reform Act, the 25% bright-line test of loss reserves to total assets, which is an extremely stringent test, which really does discriminate between investment companies and insurance companies. I mean it definitely gets to the core of that issue. We very comfortably pass that test. So, right there is a very strong presumption that we should not be considered to be a PFIC. So overall, we think we're in very good shape.
Pablo Singzon -- JP Morgan -- Analyst
Got it. Thank you.
John Rathgeber -- Chief Executive Officer and Director
Yeah.
Operator
Thank you. Our next question comes from the line of Christopher Campbell with KBW. Your line is open.
Christopher Campbell -- KBW. -- Analyst
Yeah, hi, good afternoon and congrats on the quarter.
John Rathgeber -- Chief Executive Officer and Director
Thanks, Chris.
Christopher Campbell -- KBW. -- Analyst
I guess, kind of the first question is, -- looks like the share repurchases program went in at last quarter and so how many shares have you guys bought quarter-to-date?
John Rathgeber -- Chief Executive Officer and Director
Well, just to answer slightly differently. I'd say as of today it's roughly $30 million of the authorization reviews [Phonetic]. So, there's roughly $45 million still to be used for the remainder of the remainder of the year. So that's where things stand today.
Christopher Campbell -- KBW. -- Analyst
Okay. So originally it was the $175 million was the authorization and you guys have used $30 million so far?
John Rathgeber -- Chief Executive Officer and Director
Approximately, yes.
Christopher Campbell -- KBW. -- Analyst
Okay, got it. And are there any, I mean, are there any like certain like price [Phonetic] book levels or opportunity cost in terms of just reinvesting in the underlying business or you would slow buyback activity?
John Rathgeber -- Chief Executive Officer and Director
I think our general approach, because we feel very good about our prospects in terms of underwriting the business and investing it and the ROEs we can generate on the allocated capital of the business that we're writing to the extent that we can use the capital to support the growth of the business. I think we're going to want to do that. So it's really when we feel we're in an excess capital position, is when we will certainly strongly consider purchases especially at the levels like -- or what we see today, but I mean, having said that, obviously, we just take all factors into consideration, what are the opportunities ahead of us. Where can we use on the underwriting side, the capital, where do we sit relative to risk-based capital requirements of the rating agencies and regulators and we'll just make the best holistic decision that we can at each point in time.
Christopher Campbell -- KBW. -- Analyst
Got it. And so, like how should we think about like a targeted underwriting leverage ratio. So if I look at your balance sheet, you have about $960 million of shareholders' equity and we're only forecasting about $540 million of net written premiums for 2019. And then obviously a little bit more for 2020, obviously that's a pretty low underwriting leverage ratio, which probably makes sense given you're operating at an underwriting loss, but I guess like, how does the pricing environment, how does that improving and then, like how should we think about that underwriting leverage target if we wanted to back into our own estimate of what we thought the excess capital, would be?
John Rathgeber -- Chief Executive Officer and Director
Well, I think there is certainly is room for us to write more premium, especially in an increasing rate environment. But it's just a matter of, do we actually find those opportunities, do we find the opportunities that we feel unexpected basis ROE basis that meets our return requirements. So I think definitely there's room there. But what I can't say is whether we're actually going to find those opportunities and it'll meet our standards.
Christopher Campbell -- KBW. -- Analyst
Okay, that's helpful. And then how should we think about the combined ratios going forward, given the improving pricing environment. So, I mean the combined ratios were elevated year-over-year, but obviously some of these higher ratio should start earning in 2020, when should we start to see like a pick up or improvement in the underwriting ratios for the better pricing.
John Rathgeber -- Chief Executive Officer and Director
Yeah. Again, I wish I could forecast the future for you, but I just -- all I can say is that we price the business -- it's very actuarial, quantitative analysis that's done, we try to achieve the highest pricing we can, get the best terms we can, but obviously we've got to be very careful about what assumptions are made about future loss costs and those are hard to quantify if you are making substantial estimates. So some companies might going forward project lower loss ratios sooner than we might, but if we feel [Indecipherable] it up and given the rate changes -- we'll just give our best estimate of what we think what it is, and if it turns out, it was 65 last year and we think it's priced at the 63 this year, we'll book at 63 but until actually see the deals and price them up, I can't tell you what that's going to turn out to be, but I know Arch being these good underwriters they are and the cautiousness and the conservativeness -- conservatism that they approach the business. I wouldn't expect to see dramatic reductions in the near future.
Christopher Campbell -- KBW. -- Analyst
Okay, great and then one last one, I was noticing like in one of the investment tables that the non-investment grade borrowing ratio was only about 11.7% which is down significantly quarter-over-quarter and year-over-year. So I guess. Yes, with lower interest rates and kind of spreads little bit widening on the lower investment grades, why aren't you guys leveraging more debt to kind of increase in net interest income. Even more?
Jon Levy -- President and Chief Risk Officer
Hey, Chris, this is Jon Levy. We think -- in a kind of similar vein too kind of what Arch approaches its business. Think we can say the same thing about HPS I think given, given kind of where the various economic forecasts are right now. I think we're relatively comfortable with the exposure we have on the investment and non-investment grade market. As you know, we're taking most of our risk on the leveraged loan bases which has more collateral behind it and more covenants. But I think right now I think HPS' view is, is with the amount of leverage they're employing right now they're kind of comfortable with that. If there's better opportunities with the spread widening. I think we can expect that to be deployed, but given where spreads are right now, I don't expect us to jump in with [Indecipherable] until maybe there's a little bit more movement.
Christopher Campbell -- KBW. -- Analyst
Okay, got it. And I mean with the [Indecipherable] there is probably more concerns about default risk in the levered loans and then that's why you wouldn't ramp up the leverage right now, is that like kind of the way we should be thinking about it?
John Rathgeber -- Chief Executive Officer and Director
I think if you believe some of the economic forecasts. And I think people are forecasting a probably recession elevated to where it was maybe six months ago that would make you cautious across the entire credit market.
Jon Levy -- President and Chief Risk Officer
I think kind of our -- position more on the levered loan space is taking a bit kind of a defensive position within that market. But yeah, absolutely with the backdrop of the weakening economic forecast, I think you'll see us act defensively for a while.
Christopher Campbell -- KBW. -- Analyst
Okay, got it. And then what should -- what trigger should would we look at for where you would go from a defense to offense, like what things should we be looking at in the macro environment where, OK, this is like this would be a positive catalyst for Watford to add the -- to add more low investment grade exposure and then boost the NII?
Jon Levy -- President and Chief Risk Officer
I mean I won't be able to give you any specifics if credit spreads widen out significantly. I think you've seen that in our past, you'll see us do it again. I think we still have leverage, we've got some dry powder to be able to do it, but I don't think we can guide you to kind of exactly what the point is exactly where the spreads, need to be, it will become individual opportunities that we'll slowly could work our way into.
Christopher Campbell -- KBW. -- Analyst
Okay. Great well, thanks. Best of luck in the fourth quarter.
John Rathgeber -- Chief Executive Officer and Director
Thanks, Chris.
Operator
Thank you. I'm not showing any further questions. I would now like to turn the call over to John for closing remarks.
John Rathgeber -- Chief Executive Officer and Director
Okay. Well, thanks everyone for your time and attention and enjoy the rest of your day. Thank you.
Operator
[Operator Closing Remarks]
Duration: 31 minutes
Call participants:
John Rathgeber -- Chief Executive Officer and Director
Jon Levy -- President and Chief Risk Officer
Pablo Singzon -- JP Morgan -- Analyst
Christopher Campbell -- KBW. -- Analyst
