Kestrel Group, Ltd. (KG) Q1 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Maiden Holdings First Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call may be recorded. I would now like to turn the conference over to Noah Fields, Vice President, Investor Relations. Sir, you may begin.

Good morning, and thank you for joining us today for Maiden's First Quarter 2012 Earnings Conference Call. Presenting on the call today, we have Art Raschbaum, Maiden's Chief Executive Officer; along with John Marshaleck, our Chief Financial Officer. Also in attendance is Pat Haveron, Executive Vice President. Before we begin, I'd like to note that any forward-looking statements on this call are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and these forward-looking statements are based on company's current expectations and beliefs concerning future developments and their potential effects on the company. There can be no assurance that the actual developments will be those anticipated by the company. Our actual results may differ materially from those projected as a result of significant risks and uncertainties, including nonreceipt of expected payments; changes in interest rates; the effect of the performance of the financial markets on investment income and fair value of investments; the impact of competition and pricing; changes in demand for the company's products; the effect of general economic conditions and unusual weather-related activity; adverse state and federal legislation, regulations and the regulatory investigations into industry practices; developments relating to existing agreements; heightened competition; changes in pricing environment; and changes in asset valuations. Of course, the company undertakes no obligation to publicly update any forward-looking statements except as may be required by law. Some of our discussions about the company's performance today will include reference to both non-GAAP financial measures and information that reconciles those measures to GAAP, as well as certain operating metrics that may be found in our filings with the SEC and in our news release located on Maiden's Investor Relations website. And with that, I'll turn it over to Art.

Thank you, Noah. Good morning, and thank you for joining us for the Maiden Holdings First Quarter 2012 Earnings Call. Overall, we're very pleased with our performance and our results. Importantly, we continue to enjoy profitable underwriting results, strong year-on-year growth in each of our major business segments, a solid increase in invested assets, continued strong operating cash flow and significant growth in shareholders' equity and book value. Book value per share increased 5.5% from year-end 2011, reflecting both the impact of earnings and unrealized gains in our invested asset portfolio, while our annualized return on equity and annualized return on operating equity were 10.4% and 9.9% respectively. We were also successful in completing a $100 million senior note issuance, which provides us with enhanced capital flexibility. In the context of a first quarter with significant U.S. tornado activity, continued weak fixed income yields and a competitive operating environment, we're encouraged by these results and the continued efforts of the Maiden team. With Maiden's focus as a specialist reinsurer serving the unique noncatastrophe reinsurance needs of our regional and specialty insurer clients, we continue to enjoy relatively stable underwriting and operating performance in contrast to more catastrophe-oriented reinsurers. In the quarter, we continued to see the positive effects of the 2011 business development activity as premium writings continue to reflect the impact of both new account development and expansion of existing client relationships last year with strong written premium. We're up 31.4% versus the first quarter of 2011 with increases in all 3 of our business segments. And when viewing the quarter, it's important to note that first quarter typically includes some level of seasonality in several of our business segments. Typically, premium levels moderate in subsequent quarters. The most significant growth was realized in the AmTrust Quota Share segment as the largest client continued its profitable expansion. It's important to note that the bulk of the 78% AmTrust growth versus first quarter 2011 was significantly the result of the addition of the European Hospital Liability business, which incepted in the second quarter of 2011 as well as their acquisition activity throughout last year. In the Diversified Reinsurance segment, net premiums increased by 11.4%. The majority of diversified segment premium growth was in our U.S. subsidiary Maiden Re, where net premiums written grew by 20%. This increase reflects the impact of the expansion of accounts in 2011, as written premiums on both quota share and working layer accounts are recognized throughout the year. Despite a slight reduction in our 1/1/2012 renewal volume, which we mentioned in the year-end call, overall written premium reflects a productive 2011 underwriting year. Today, we continue to actively evaluate a number of new opportunities across the diversified business platform. We believe that weather-related loss activity, capital pressures and a weak investment environment will drive increased demand for reinsurance in our core regional and specialty insurer target market. Year-on-year written premium for the balance of the diversified segment was essentially flat, reflecting a stable environment for our international business. For 2012, the International Insurance Services team is working on a number of new initiatives to increase future fee income opportunities as well as underwriting income. And lastly, the ACAC, our personal auto quota share segment, grew 19.6% from the first quarter of 2011. And notwithstanding the year-on-year written premium growth throughout Maiden, the profitability of business remains our top priority. Underwriting results remained profitable for the quarter, but we did experience some loss ratio variability across segments. Maiden's combined ratio of 97.9% reflected strong results from our 2 largest clients. Our AmTrust Quota Share segment reflects a combined ratio of 95.5%. Compared with a year ago, that's an improvement of 1.9 percentage points. Now looking at the components of the combined ratio, the first quarter 2012 loss ratio was 67.2% compared to 64.2% in 2011, while the expense ratio in 2012 is 28.3% versus 33.2% in 2011. These differences in both loss and expense ratio reflect a change in business mix, in particular, the impact of the Hospital Liability segment, which incepted in the second quarter of 2011. The ACAC Quota Share produced a 96.4% combined ratio. And as we discussed last quarter, the ACAC contract has a variable commission feature. And while our fourth quarter performance exceeded the upper end of that variable commission swing rate, in the first quarter, the combined ratio moderated downward a bit, reflecting more typical first quarter seasonality and loss costs. In the Diversified Reinsurance segment, the comparison between the first quarter of 2011 and the first quarter of 2012 is a bit complicated by the fact that in the first quarter of 2011, we reflected favorable impacts primarily associated with the GMAC International Insurance Services acquisition. In 2012, that impact is much smaller and we expect combined ratios for this segment to normalize to targeted levels. In the quarter, the diversified segment combined ratio was also impacted by the implementation of a change in accounting rules for deferred acquisition costs, which John Marshaleck will discuss in a moment, as well as some quarterly variability in reported results to our Bermuda underwriting portfolio and our U.S. excess property business. But importantly, we don't view these results as normal levels of performance. But as we've stated in the past, we do see some variability in quarter -- or quarter combined ratios by segment. Overall, we continue to focus on improving our overall combined ratios across Maiden and it remains a high priority. As we've commented in the past, at our current level of capital efficiency, a 1 point decrease in combined ratio can improve return on equity by more than 1.5 percentage points. We're confident that both the impact of efforts by insurers to strengthen rate levels in the U.S. and the Maiden underwriting team's continued focus on strengthening operating performance should benefit future results. The first quarter of 2012 saw a very high incidence of tornado activity in the U.S. Despite an elevated frequency, we were very pleased to see that our risk management has been effective as our catastrophe losses remained within our normalized provision for expected losses in the quarter. Towards the end of the first quarter, Maiden's capital position was enhanced by the issuance of $100 million 30-year 8% coupon senior note. Unlike our June 2011 debt issue and subsequent repurchase of a portion of the company's 14% coupon trust deferred securities, the economics of repurchasing more of the trust deferred securities are not currently viable. The most recent debt issuance was a great opportunity, given the market conditions and deal flow at the time. And we're very pleased to have locked in a lower cost of capital and attractive rate, given the potential uncertainty of the financial markets in the feature. The proceeds for the offering enhance our flexibility to take advantage of continued rate improvements in the insurance market or for use to eventually pay back a significant portion of the remaining balance of our trust deferred securities. Now in that regard, I'd like to mention one housekeeping item. While we have no immediate plans to raise additional capital with 2 debt issues having been completed in the last 12 months totaling in excess of $200 million, we will shortly be replenishing our shelf registration to provide us with continued flexibility should circumstances arise in the future. Overall, we're very encouraged by the continuing development of the business. Our client retention levels remain strong and each of our business segments are well positioned to benefit from increased demand and strengthening rate levels. I'll now turn over the call to John Marshaleck, our Chief Financial Officer, to review the first quarter financial results in a bit more detail. John?

Thank you, and good morning. Last night, Maiden reported net income of $20.4 million or $0.28 per diluted share, compared with $19.3 million or $0.27 per diluted share in the first quarter of 2011. Net operating earnings for the first quarter of 2012 were $19.4 million or $0.27 per diluted share, compared with $19.8 million or $0.27 per diluted share in the comparative quarter of 2011. Net premiums earned of $438.5 million increased 26.5% or $92 million compared to the first quarter of 2011. Earned premiums increased across all business lines with Diversified Reinsurance up 17.3%, AmTrust Quota Share Reinsurance up 46.7% and ACAC Quota Share up 14.4%. Net investment income of $18.4 million increased 7% compared to the fourth quarter of 2011. Total investments increased $179 million to $2.2 billion or 8.9% versus December 31, 2011. The book yield on the fixed income portfolio, excluding cash, is 3.86% with an average duration of 3.22 years. Net investment income benefited from the growth of investable assets. Net loss and loss adjustment expenses of $287.9 million were up $66.7 million. The loss ratio increased 2 percentage points to 65% versus the first quarter of 2011. Commission and other acquisition expenses, together with general and administrative expenses, of $146.1 million increased $26.7 million from the year-ago quarter and reflected a total expense ratio of 32.9% compared with 34%. General and administrative expenses for the quarter totaled $13.8 million compared with $12.3 million in the first quarter of 2011. The general and administrative expense ratio is 3.1% compared to 3.5% in the first quarter of 2011. The combined ratio for the first quarter totaled 97.9%, compared with 97% in the quarter -- comparative quarter in 2011. In prior years, we were able to capitalize certain costs associated with acquiring new and renewal business. Under the new accounting standards adopted in 2012, some of these costs are no longer permitted to be capitalized but must be expensed when incurred. The impact of adopting this new standard perspectively increased expenses by approximately $1.2 million or $0.02 per diluted share. The impact on our combined ratio was an increase of approximately 0.3%. Total assets increased 9.4% to $3.7 billion compared to $3.4 billion at the end of 2011. Shareholders' equity was $810.4 million, an increase of 5.4% compared to December 31, 2011. Book value per share was $11.22 at the end of the first quarter of 2012 or 5.5% higher than the end of 2011. In addition to book value growth, we are pleased that Maiden's total capital has grown by 14% since December 31. We were engaged in significant levels of investing activity during the first quarter of 2012, making $358.5 million in new investments during the quarter. We continue to believe that in the current investment environment, significantly increasing duration of securities does not provide enough return in relation to the risk. These new bond purchases were at a weighted average yield of 3.17% and a duration of 4.7 years in total. Specifically, we invested $225.8 million in new U.S. agency mortgage-backed securities at a yield of 2.37% and a duration of 3.2 years. We also invested $125.6 million in new investment-grade corporate bond purchases at an average yield of 4.46% and a duration of 7.19 years. While we are reducing the amount of cash we are carrying on our balance sheet, we continue to have significant amounts of operating cash flow, $71.2 million in the first quarter alone, $77 million in mortgage-backed security repayments during the quarter and as mentioned, at the very end of the quarter, the proceeds from the senior note offering. As we continue to work proactively to invest these funds, we expect to continue to reduce the amount of cash in our balance sheet and increase our investment income run rate. I will now turn it back over to Art for some additional comments.

Thank you, John. We continue to see evidence of rate improvements in the primary market in the U.S, although not in every line and geography. The lines most impacted are property, workers' compensation and personal lines. But depending on the client and the region of the country, we're seeing similar efforts in other lines, such as commercial auto, commercial multiperil and general liability. From a reinsurance perspective, we've been generally able to adjust reinsurance pricing, either adding margin or protective features as needed based on our clients' account experience. And we're seeing similar rate strengthening evidenced at our AmTrust and ACAC clients. Internationally, our autofocus [ph] reinsurance portfolio is a bit less vulnerable to reinsurance competition, given the long-term nature and specialized nature of our reinsurance contracts there. However, in the primary insurance markets with a few exceptions, where rates are just certain specialty lines, markets generally remained competitive. From a Maiden perspective, we remain focused on strengthening underwriting performance across the segments. In summary, the first quarter was an excellent start to 2012 for Maiden, as we increased invested assets, grew net written premium, generated profitable underwriting results and strengthened our capital base with the $100 million debt offering. Book value and assets continue to grow at an encouraging pace. And importantly, we're focused on continuing to deliver exceptional value to our existing clients while maintaining focused and disciplined underwriting. I'm confident that we're well positioned to continue the profitable development and expansion of Maiden's unique, highly differentiated specialty reinsurance business model. That concludes our prepared remarks. Operator, could you please open the lines for Q&A?

[Operator Instructions] Our first question comes from Randy Binner with FBR.

Just a couple of clarification questions. I guess, starting with the expense ratio, I'm not sure if I heard this in the commentary. But the higher expense ratio in the quarter, I guess, was the result of a bigger top line driving kind of higher commissions before you can earn against the premium. And then also the 0.3% was in the commission ratio, I just want to clarify, are those the 2 items that kind of drove us higher with the expense ratio this quarter?

Randy, this is John. The expense ratio for the quarter was actually down from last year at this time, but the loss ratio was up. So there is a -- as we talked about in prior quarters, there is a direct relationship between the 2, the business mix and we do get fluctuations in the expense ratio along with the loss ratio. So I don't -- there's nothing specific to point out other than the business mix change.

I think in terms of the overall expense, if our business mix shifts more to pro rata than excess, we tend to get an increase in the local expense ratio. And so that does occur quarter-to-quarter and create -- we've always kind of commented that because of our business mix, it's really more relevant to look at the total sort of combined ratio movement. The area that we focus on a lot and we talk about is our G&A expense, so our controllable expense relative to earned revenue. I believe that's the 3.1% that you alluded to. And because of the growth in the business, we've seen an improvement in that G&A ratio quarter-to-quarter and year-on-year.

Okay, fair enough. And just to clarify, the 0.3% is in the commission ratio or in the G&A ratio?

That is in the acquisition cost. That would be in the commission ratio.

Okay. And then on -- do you have a consolidated surplus number you can share?

Well, we look at statutory surplus certainly as well as the GAAP surplus. And we talk about total capital as well. And our statutory capital is -- the capital on the 2, our U.S. subsidiary and our subsidiary in Bermuda here. And total GAAP capital is over $1 billion. I think we showed it in our news release, where we have a total GAAP capital of $1.144 billion. So that is up significantly from year end and mainly due to the new debt offering as well as the earnings.

Okay. So that puts your premium and the surplus at something like 1.65? And I guess, just -- I mean, that's more comfortable than you would have been otherwise. And so I think -- do you continue to think the ceiling is something like 1.8 there from an operating leverage perspective?

Yes. We sort of always kind of commented that it's not -- not all premium is created equal. And if you look at most of our growth in the quarter, again it's kind of following in the U.S., a lot of growth in auto. That's a line we can more efficiently allocate capital to. The other important point, Randy, is that when you do a year-to-year comparison, a lot of the growth in 2011 really occurred in the second quarter and beyond. So the growth is quite significant in this first quarter. We expect it to moderate through the balance of the year. Equally important, we'll continue to strengthen the balance sheet through strengthening earnings throughout the year. So we feel comfortable with our capital position today. And I think the $100 million certainly helps us, and I think it gives us some breathing room. But as it stands today and given the risk profile of the business, we're pretty comfortable.

Our next question comes from Ryan Byrnes with Macquarie Holdings.

I just had a -- just a quick question. Obviously, you've mentioned that you guys may file a mixed shelf in the near term. Just wanted to get your thought process as to which ways or I guess, how you would look at potentially raising capital, which would be your best options going forward?

Well, first of all, I mean, we don't contemplate raising any capital in the near future here. I think that as I've mentioned in my prepared remarks, it's really more of a housekeeping item. We would have taken the shelf down to about $50 million now. So we just wanted to make sure it was at a reasonable level. I think that we talked about probably the next area we need to focus on will be when the trust preferred securities sort of call premium ends, which is beginning of 2014. And as we look at that marketplace -- as we look at that period of time, we'll look at what our current capital position is. If we have the ability to sort of pay it out of our own capital structure, that will certainly be a viable option, but we'll also probably need some incremental capital. So it depends on a great deal of things and what the capital markets will look like in early 2014 in terms of which direction. But we're always guided, and I think we've demonstrated a view that we really want to find the most shareholder-friendly solution, the least dilutive solution. And that will be our guidance for anything we do as we approach the end of the TRUPs call premium.

Okay. And then quickly just on the ACAC growth in the quarter, it's one of the larger growth quarters for you guys in ACAC. But I wanted to see, is that from going into new regions? Or is that just from the expanding footprint, just more penetration? Just wanted to see where the growth is coming from.

They've had some rate increase activity in the quarter and some of that is in response to what we saw in the fourth quarter of 2011. And it also does reflect some expansion of geography, not dramatically so. I think that it's really the reflection of, I think, effective marketing efforts in their core business.

Okay. And do you guys know -- how do you -- like obviously, when you go into newer geographies, how do you, I guess, do the loss ticks for those new areas, I guess, the untested areas? I just wanted to get the thought process there.

Well, like most companies that look and expand their personal lines, they certainly look at available loss cost data that is promulgated by a number of different firms that measure loss cost. But they also look at their own experience, and then adjust it for what they view as the exposure differences in different geographies, different coverage brands, et cetera. So they're thoughtful about it. But as we talked about last quarter, some of that growth did elevate their overall loss cost. And they reacted pretty swiftly by strengthening rate and actually pulling back in a few areas as well. So entering a new market can be a bit more challenging obviously than just growing in an existing market that you know much better.

Our next question comes from Kenneth Billingsley with BGB Securities.

I had a couple of questions just on, one, kind of housekeeping. On the $100 million note that just came out, was there an over-allotment filled on that as well?

There was not.

There was not. Okay. And then you talked about the decline in 1/1 renewals and you talked about it on the prior quarter, just kind of a two-part question here. Could you kind of talk about what it was that caused the nonrenewals? But then obviously, you had some growth there as well. So what is it that caused the new win for you? Was it price versus product diversification? Could you just kind of talk about that a little?

I guess, I'll look at it and kind of divide it in 2 sections. There's the January 1 renewal business, which we commented a bit at the end of 2011. And what we saw there were a couple of situations where retentions were reduced. We did, as we do in every quarter, reunderwrite some accounts and some fell off. But in addition, we've had some business growth but at smaller percentages than we typically see. Now that gives us the ability to position ourselves to expand our relationship with those clients. So we see that as a good sort of driver of future expansion. And a lot of our growth comes from kind of core and existing relationships. The growth piece of it is really a reflection of how the business that was written in 2011 is coming on the books in 2012. And a lot of that growth came in the latter part of the year, certainly after the first quarter of 2011. If there are quota share or low excess contracts, working layer contracts, we book those on a quarter-to-quarter basis. And so we're still seeing some of that quarter-to-quarter booking coming through, and we'll probably see that in the next quarter or so. So it really reflects the 2011 underwriting year being recognized in the 2012 calendar year.

Okay. And then just talking about just kind of pricing, and you guys alluded to some of the pricing here in a little bit commentary for international. Could you talk about maybe what the loss experience is at least in the books of business that you compete on internationally versus maybe domestically and then how that obviously fits into the pricing, maybe pricing differential that is occurring both overseas and here?

Sure. That's a pretty broad question. And I think it's a kind account-specific. But I'll try to sort of give you a broad answer to it. I mean, in -- let's start with international. And again most of those contracts are kind of in place and operating. And sort of the pricing and underwriting and risk selection is sort of predefined and flows. I think it's fair to say that there are some elements of the European markets where loss cost trends have been a bit higher than they've historically been. And we're reacting to that with our partners by raising rate. I think Germany is one market where we've seen that activity. But on balance, we sort of attacked those kind of market-to-market and client-to-client. In the U.S., we are seeing, I think, in the auto line in specific, I think the first quarter is probably a reasonably good quarter as we saw it at ACAC but with a bit of reduction in frequencies. I think some of that could have been weather-driven in the first quarter. Some of that is just seasonality in the quarter. And then in sort of the broader commercial lines, I think sort of account-by-account, we are seeing some rate firming. And I think that rate firming is resulting from increased severity in a variety of casualty lines. And I think that's what our clients are trying to respond to. When we look at our business, Ken, we take a realistic look at changes in exposure as well as changes in loss cost and both severity and frequency and we factor those into our forward pricing. So we try to look at that on an account-by-account basis as we write or renew.

Last question here is just on the policies, and I know it's not so much on the ACAC business but on maybe the diversified segment as well as AmTrust. Are you seeing a push for people trying to ask for multiyears on that? Are you writing multiyear policies on renewal? Or are you shying away from that, based on where you think price is going?

We generally do not write multiyear contracts other than our strategic relationships. I mean, on occasion, we might write a multiyear if we feel comfortable about the underlying business and the local market where the company is operating. But today, I don't think that -- we're not getting a lot of pressure to write multiyear nor are we offering multiyear.

[Operator Instructions] Our next question comes from Bob Farnam with KBW.

I think I heard in your commentary that you are working on some initiatives this year to help drive some fee income. Could you maybe add some color to that?

Yes. I think particularly in Europe, one of our fee income sources in Europe is an agency that we hold in Germany that develops a lot of the auto business. And that's a relationship that we had with an auto manufacturer for many years that actually predates the acquisition of the platform. We're looking to actually extend that model to other parts of Europe. And if we can do that successfully with not just our current partner, with other potential OEM partners, we think that can help drive incremental revenue. I don't think that it will have a huge P&L impact in 2012. But our hope is to kind of prove the concept and then continue to build it out in subsequent years. So we're really kind of investing for the future there.

So it's mostly a European thing then.

Yes, it is.

Okay. And the European Hospital Liability book, how has that been performing relative to your expectations?

I mean, we took a pretty conservative posture in terms of way we looked at that business and it's really performing extremely well. I mean, we're in there probably -- well, certainly once a quarter, we've done claim reviews. We've done technical underwriting reviews as well. We think pricing is holding. It's probably not increasing dramatically at this point. But we think that there's still pricing power there. And as far as competition, you see competition here, it's here and there but nothing that dramatically suggests that we're going to see a wholesale change in the pricing environment. Obviously, we're going to be cautious with that. But on balance, our general view is exceeding our expectation for performance.

Thank you. I'm showing no further questions at this time. I'm sorry. We have a question from Peter Okin with Stifel, Nicolaus.

I just have a quick question. As far as the book value being -- just as far as shareholder value, the stock has been weak. And not just to look at it on a short-term basis, but you have a book value of $11 and change, the stock trades at $8. Would there be consideration to a stock buyback or any use of the funds available now to try to do something like that? Would that make sense? Because it's just -- although you're doing great, you're making money, you have a great story. But it just doesn't seem that there's a lot of interest. Can you talk to that?

Yes. I mean, our focus is on making the business stronger, improving the earnings, improving returns. And I think that will ultimately translate to increased shareholder value. As far as stock buybacks and so on, I think some of the questions from earlier callers have kind of, I think, clearly identifies it. We're using capital very efficiently today. We do not have what I believe is a significant amount of excess capital to buy back stock. We're just as disappointed with sort of the slow growth in the share price. But on the other hand, if you look kind of historically, we definitely had periods of time where I think we've had good recognition of the value of the business. I think to some extent, the entire reinsurance sector has been discounted for a while now. We do believe that our business model is quite a bit different than many. And we think that if we can continue to generate stable returns, continue to build the business, that the stock price will reflect it. And we'll do our best in terms of managing the business to ensure that we are delivering value to shareholders. I think the other point I would make is that all of your points being accepted, the shares do generate a fairly healthy dividend for our investors. And our board continues to look at the dividend to ensure that we are, to the extent that our earnings rates grow, that we are sharing our successes with investors as we move along. So I sympathize with the point, Peter, but I honestly believe that the best thing we can do to strengthen share price is to deliver.

Thank you. I'm showing no further questions at this time. I would now like to turn the conference back over for closing remarks.

We'd like to thank everyone for joining us today. We know it's a busy day for calls. So have a great day, thank you.

Ladies and gentlemen, this concludes today's conference. Thanks for your participation, and have a wonderful day.