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Good morning. My name is Leandra, and I will be your conference operator. At this time, I would like to welcome everyone to the Essent Group Limited Second Quarter 2018 Earnings Conference 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. [Operator Instructions] Thank you.
Chris Curran, Senior Vice President of Investor Relations, you may begin your conference.
Thank you, Leandra. 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 second 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 can 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.
Thanks Chris. Good morning everyone and thank you for joining us. I'm pleased to report that Essent generated another strong quarter of financial results. We earned $112 million or $1.14 per diluted share and generated a 22% annualized return on equity. This compares to $72 million or $0.70 per diluted share for the second quarter a year ago.
Our results for the quarter continue to be driven by growth in our high-quality and profitable mortgage insurance portfolio. During the quarter, we grew our insurance in force 28% to $123 billion compared to $95 billion as of the second quarter a year ago. This growth drove a 24% increase in net premiums earned to $157 million compared to $127 million for the second quarter of 2017.
Our outlook for Essent remains positive as the operating environment is strong. Favorable housing fundamentals and credit performance continue to fuel Essent's high quality earnings growth and strong returns. For a franchise like Essent, we believe that the macro housing and economic environments are very meaningful drivers of our long-term prospects.
Our industry remains competitive and during the second quarter, new rates previously announced by Essent and some of the other MIs went into effect. From Essent's perspective we continue to see further utilization of risk-based pricing and delivery through pricing engines. One of the benefits of this approach is it provides flexibility to increase or decrease rates, allowing us to shape our portfolio.
Looking forward as a franchise that invests in long-tail mortgage credit risk, we remain prudent in employing strategies that mitigate against future economic downturns. The combination a risk based pricing engine on the front-end and the utilization of reinsurance on the back-end create an important link that allows us to better manage risk. We believe that this evolution is positive for Essent and will ultimately make us a stronger company.
In Bermuda, Essent Re continues to provide us another platform to invest in the growing distribution of U.S. mortgage risk by the GSEs. To-date, Re has participated in 45 GSE risk-share deals, primarily through ACIS and CIRT. Also Essent Re has been growing it's 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 other reinsurers invest in GSE risk-share. Our participation in GSE risk share and managing an MGA demonstrates the optionality and flexibility of the Re platform.
Turning our attention to PMIERs 2.0, we expect them to be finalized during the third quarter and become effective at the end of the first quarter 2019. Based on what we believe will be the final requirements, we estimate that there would be minimal impact on our $380 million PMIERs excess at the end of the second quarter.
On the Washington front, we do not see any meaningful efforts to address GSE reform occurring in 2018. With regard to FHA, we believe that the administration recognizes the significant growth in the portfolio from a pre-financial crisis balance of $200 billion to $1.2 trillion as of year-end 2017. As a result, we also believe that actions to reduce FHA's footprint will be explored further, which is positive for the U.S. taxpayer.
Now, let me turn the call over to Larry.
Thanks Mark and good morning, everyone. I will now discuss our results for the quarter in more detail. For the second quarter, we reported net income of $112 million or $1.14 per diluted share. Net income for the first quarter of 2018 was $111 million or $1.13 per diluted share. Note that income tax expense for the first quarter was reduced by $9.5 million of excess tax benefits associated with divesting of employee restricted shares.
To compare the quarters, it is helpful to consider pre-tax income, which is up $11.3 million or 9% in the second quarter over the first quarter of 2018. Earned premium for the second quarter was $157 million, an increase of 3% over the first quarter of $153 million, and an increase of 24% from $127 million in the second quarter of 2017.
Note the premiums ceded to Radnor Re are reflected as a reduction of earned premium and were $3.6 million in the second quarter compared to $300,000 in the first quarter of 2018. The average net premium rate for the second quarter was 51 basis points, which was 1 basis point lower than the first quarter of 2018, due primarily to premium ceded to Radnor Re.
We expect our average net premium rate to be approximately 50 basis points for the balance of 2018. Note that this rate reflects on the primary 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 expense was $1.8 million in the second quarter of 2018 compared to $5.3 million in the first quarter of 2018, and $1.8 million in the second quarter a year ago. The default rate on the portfolio declined 22 basis points from March 31, 2018 to 54 basis points at June 30, 2018. This decrease was primarily the result of continued tour activity associated with hurricane defaults, partially offset by an increase of 44 non-hurricane defaults during the second quarter.
Other underwriting and operating expenses were $36.4 million for the second quarter and our expense ratio was 23.2% compared to $38.1 million and 25%, respectively, for the first quarter of 2018. The decrease in expenses from the first quarter is primarily due to payroll taxes associated divesting of shares and incentive payments which occur in our first quarter.
Income tax expense for the first six months of 2018 was calculated using an estimated annual effective tax rate of 16.2% and was further reduced by $9.6 million of excess tax benefits associated with divesting of shares issued to employees. We currently expect our effective tax rate to be 16.2% in the third and fourth quarters of 2018.
The consolidated balance of cash investments at June 30 was $2.6 billion. The cash investment balance of the holding company was $76 million at both June 30 and March 31, 2018. No capital contributions were made to Essent Re or Essent Guaranty during the second quarter.
As discussed in our call in May, we increasingly are now committed to our existing credit facility by $125 million to $500 million. Related to this transaction, Essent Guaranty paid a $40 million dividend to our U.S. holding company to pay down the outstanding balance of the revolver. As of June 30, we have $275 million of undrawn capacity under the revolving credit component of the facility and $225 million of term debt outstanding.
As of June 30, 2018, the combined U.S. mortgage insurance business statutory capital was $1.7 billion. With the risk to capital ratio of 14 to 1, compared to 13.6 to 1 as of March 31, 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 quarter Essent Re had GAAP equity of $717 million supporting $7.2 billion of net risk in force. As of June 30, 2018, based on PMIERs 1.0, we can see that Essent Guaranty's available assets exceed minimal required assets by approximately $380 million, primarily as a result of the insurance-linked note transaction.
In June, the Company received an updated draft of PMIERs 2.0. Based on our interpretation, if PMIERs 2.0 were to go into effect as of the end of the second quarter of 2018, the Company's excess available asset position will be substantially unchanged from the excess of $380 million computed under PMIERs 1.0. Accordingly, once these standards become effective, which we anticipate will be at the end of the first quarter 2019 we expect to be fully compliant.
Now, let me turn the call back over to Mark.
Thanks Larry. In closing Essent generated another strong quarter of financial results. As we continue to executing upon our goal of building a high credit quality and profitable mortgage insurance portfolio, our second quarter results reflect the strength of our franchise and we continue to benefit from a positive macro housing and economic environment.
Looking forward, as our industry continues to evolve, whether on the front-end with pricing or on the back-end with reinsurance, we believe Essent is well positioned to continue playing an integral and growing role in supporting a robust, well-functioning housing finance system.
Now, let's get to your question. Operator?
[Operator Instructions]. And your first question comes from the line of Mark DeVries with Barclays. Your line is open.
Thanks for the update on where you'd expect to be with PMIERs 2.0. With the pretty substantial cushion you already have that you don't expect to change materially, can you just remind us on kind of the post PMIERs 2.0 world, what size cushion you think is appropriate? And if you're still going to be over that, how you think about using some of that excess?
I don't think we come up with an exact percentage on the cushion. I would just say right now, at the end of the second quarter, when you factor in the PMIERs cushion along with HoldCo cash of approximately $75 million and untapped line of credit, you know that's in excess of over $700 million of kind of excess capital. So, one, caveat in terms of using the excess capital, we'll wait to see that PMIERs the ink is dry on 2.0 before we decide anything. And then it really comes down to reinvesting in the core business in the states, expanding opportunities with Essent Re, should they become available. And third, we would look for ways to redistribute it shareholders. And I think that's something we'll evaluate over the coming call it six to nine months.
Then you know previously you guys communicated, underwriting OpEx to be kind of in that $150 million to $155 million range for the year. But giving the meaningful improvement in expense ratio we saw in this quarter, can we expect to see expense potentially fall below that, and if so, kind of what's the right range to think about?
No, I think the $150 million to $155 million is still a good guide.
Your next question comes from the line of Bose George with KBW. Your line is open.
Just in your comment about PMIERs available assets being substantially unchanged, when it goes into effect. Does that reflect sort of earnings that you guys will generate up to that period as well?
Not at all Bose, it actually reflects. If 2.0 went into effect at the end of June, there wouldn't be any change in the excess.
Then, actually going back to the capital issue as well, you know giving your – the use of the ILN's going forward, can you just talk about that, I mean given your growth et cetera, you probably don't need it for capital, but how would it play into your sort of risk management, view on risk management?
Yeah, it's a good question. Again I think we – it obviously provides some capital – really significant capital at least on our first quarter deal. But the real strategy behind the ILN is to mitigate the credit risk. And as we said before, you know credit is one of the most, if not the most important risk we face in the company, and I think with the technology in the capital markets, as it continues to improve and in the reinsurance market also, we now have the ability to hedge out that risk. And I think that's important, because it will start to – as we execute upon this over the next few years, I think only 35% of insurance in force is hedged out, but as we do one next year that will continue to increase.
The ultimate goal really is to remove the volatility of the business model. And historically these businesses have been kind of buy-and-hold type businesses and really just finance themselves through debt and equity on the balance sheet. With these new tools, I think we are evolving into what we call buy, manage and distribute type model, which is a much different model. We think it's a better model going forward, not just for Essent and our shareholders, but also for our counterparties, whether it's our lender counterparties or the GSEs.
And I think eventually it will work its way in the ratings. So, I think the technology is good and it's available. We also look to further mitigate that risk by potentially going and looking for reinsurance above the detachment point that we had on our ILN, so that's something that we'll look to do one the 2017 book. We'll see if we can get it done, but it's something that we are really focused on the credit aspects. Although, credit has been very good, better than even expected, given the macro environment and the quality of our portfolio, we just think it's prudent to use the new technology to our advantage to improve the business model.
Okay. That's helps, Mark. Let me just go back to the PMIERs again to just make sure I understand. So under PMIERs 2.0 with the required assets for the company remain unchanged?
Yes. So I mean again to cut to the chase, there was a revised draft, and based on the revised draft is the reason we changed our guidance. If you remember, in the first quarter we thought there would be some reduction to that cushion, but now that we reviewed and of course we can't say anything because we are under the NDA. There has clearly been a change which was positive for Essent.
The next question comes from the line of Mackenzie Aron with Zelman & Associates. Your line is open.
Mark, I guess my first question is just around last quarter you had mentioned that the Company was piloting a more granular risk-based pricing engine. Just curious if that remains in pilot mode and any update you can provide there?
Sure. No, it remains firmly in pilot mode. We've expanded that to a few more lenders, but the focus for us in 2018, Mackenzie, is really kind of the operational deployment of the model. So we're very focused on ease of use with the lender. So, we are comfortable piloting it and taking our time. I wouldn't expect the full rollout to 2019. I mean we don't think there is any risk-based pricing. It's clearly got more granular with the new cards with DTI and with the borrower count. So, we feel like from our risk-based standpoint, the cards are actually doing a pretty good job, so there is no rush from our risk standpoint. So again, we're going to take our time with it and make sure we get it done right. That's kind of how we built the company early on and we'll systematically get it out there and roll it. So, it's a good kind of customer experience for our lenders.
Okay. That's great. And then just curious on the Fannie Mae Enterprise-Paid MI program, is there any involvement through the Bermuda reinsure?
Yes. We did participate in that transaction as part of our, kind of the 45 plus deals that we did, relatively small even compared to some of the other deals. But yeah we did participate and really just kind of stay involved with it. I think longer term we still question the viability of the program, both in terms of lender acceptance and real practical improvement in housing finance. I think when you have two GSEs that set our capital standards and also have the ability now to compete with us. We are not really sure it complies with the spirit of PMIERs. But we're still going to – again it's shows the flexibility of the Essent Re platform to participating, but longer term we are still a little wary of the program.
Your next question comes from the line of Douglas Harter with Credit Suisse. Your line is open.
Thanks. Mark, now that we are couple of quarters out from tax, the tax changes. Can you just tell us how you're thinking about the quarter share with Bermuda?
Sure, Doug. I think we are still in the 25% camp as we kind of manage through the BEAT. We feel like we're fine with the BEAT this year and we think will be fine with it next year. The big driver of the BEAT is more combined ratio in terms of taxes paid in the states. Quota share obviously is an influence on it, but you don't want to go too far on it, so I think kind of keeping at 25% will allow us to comply and be in good shape. So we have no intention of changing in at this point.
Your next question comes from the line of Jack Micenko with SIG. Your line is open.
Good morning guys. This is actually Soham for Jack this morning. My first question was on the investment yields, it was up nicely 8 basis points year-over-year. So do you see a similar trajectory in 2019 as you reinvest. And maybe could you just give us some color on the duration on the portfolio today?
Salman, it's Larry. I think we will be dependent on further increases in rates to have the portfolio move up. It has moved up nicely in line and in tandem with the increase in rates. In terms of the duration, the duration is substantially unchanged. We were 4.1 years at the end of March and we are right at 4 at the end of June.
Okay. And Mark, just to circle back on potential return of capital, is there a preference for buyback versus dividend for you guys at this point?
Right now, it's something we – we're still in the early stages of it. So again, we want to wait till PMIERs 2.0 is finalized and we'll evaluate. And just like we did when we were in the capital consumption mode, we'll look at all factors and judge market conditions and so forth so. And just circling back to the investment yield question that will continue to rise over the coming years as rates go up and as we both extend duration and probably take a little bit more risk in the portfolio. So remember, investment yield is a pretty decent driver around unit economics. It doesn't get a lot of play. In our model the combined ratio is been so low, but as that starts to rise with some of the premium consumption. You're going to see yield be important and it's an important driver both revenue growth and the unit economics, so definitely something for investors to keep their eye on.
The next question comes from the line Phil Stefano with Deutsche Bank. Your line is open.
Thanks. So the black box remains in a pilot mode, but it sounds like the rate cards are still doing a good job. Why do you need a black box then?
Excellent question, Phil. And I think it gets down to that granular and kind of electronic delivery of rate. So when you have a rate card, the ease of changing that rate cards through time becomes a lot more difficult right. You have to file new rates in 50 states. The way the black box works is you file either a short form, which is a list of factors or in certain states you file a long form which is really kind of the output. There are various outputs that could come out of different model inputs. So it gives the insurer more flexibility to change rates and that's both decreasing rates in some environments also allows the insurer to increase rates. And that's where it really becomes important, when you think about managing credit, kind of longer term.
So if a part of our view is the next recession will be more regional than national. It's going to give us and other insurers the ability to lighten up on an area. So, let's use the example of Texas a few years ago when folks were worried about. There is a potential there we can go in and raise price as a way to either get better returns given the heightened risk or potentially reduce volume. So, I know we are all in the more market share is better phase of the cycle. But there could be a point where the insurers don't want – they don't want to risk and it's another tool to avoid the risk.
So remember earlier this year and later last year, the MIs really pushed back on the higher DCIs, they're above 45, below 700. The only tool we had at the time given the rate cards was as simply not due to business. So one, excellent example by the way of the value of MIs in terms of the second set of eyes, but two, the flexibility to do that for pricing, I think it's a big benefit. So again, everyone is – when you think about risk-based pricing, everyone jump to, you know prices are going down, but also prices can go up to and it allows us to move in and there may be certain regions where different MIs have different views on the credit and that's fine. I think that's a good thing.
And I also think it points to fill some of the changes you're going to see in a business where you know the ability around credit selection and use of data is going to become much more important for MIs over the next kind of three to five years that it was over the previous three to five years when all things were good, we all kind of price for same because of the technology of the lenders. I think at Essent, even we price off a couple of factors and now it's more factors on the rate card. When we set losses in our economic capitals, we use many more factors in that. We just didn't have the ability to price for it because a lot of the lenders, especially the larger lenders had system restrictions. So the technology improves and you see most of the lenders, I believe is now 90% of our lenders price electronically either coming to our website or through Encompass or Black Knight.
Their ability to kind of bring on more factors and handle that type of granularity has increased substantially. So I think it's an underappreciated positive for the industry, and now when you link that in to the reinsurance on the backend, that's our second set of eyes. So, as we reinsurer risk whether it's capital markets and reinsurers and the pricing backs up or we have to raise our attachment points or you have conversations with your partners or maybe we can factor. Now we have the ability to factor that back into the frontend.
And again, I think at the end of the day it's going to make us a much more sustainable business model. So, it kind of gets back to what I said earlier, the buy, manage and distribute, it allow us to manage through the cycle and that's the key thing here. And again, we get caught up in a lot of the short term drivers or the alpha. As I'd like to say for certain investors, but when you take a step back and say what do we want to do? What are we here to do? We are here to do. We are here to take claims to our policyholders through the cycle and we are making improvements. And I see the other MIs making very similar improvements to strengthen the business model, which in turn again will make us – we think will make us stronger company for our shareholders, for our policyholders and even for our employees. I think that's important too, so good changes.
So as the build out of the black boxes is happening, I guess this is kind of two sub questions in my mind there. Have there been any lessons learned as you're going through the pilot program? Has there been anything that's surprised you? And then the second point to that would be, is there an expense headwind that we should think about as you build out the black box, it maybe goes away.
No. There is no real headwind. I mean we developed this last year in terms of the technology and in terms of our ability. And during the pilot stage, it's not just testing with lenders just to make sure you're also connected to all the key vendors and that's also underway and in process. I would say lessons learned. We are working with one large lender where it's in play now. And it's interesting to watch how the pricing kind of goes back and forth because of the ability to change it. So we are learning things. We are taking a lot of notes. Again we are not in a rush. So we are just trying to learn, and as I said earlier to Mackenzie, much more focused on the operational part of risk-based pricing right now than the pricing part. The pricing part again will continue to evolve over time. And as we improve and try to use more factors and that's under way, but that's a much more longer term development and that will continue to evolve. But I would say right now it's much more focused on the operational end of it.
Your next question comes from the line of Mihir Bhatia with Bank of America. Your line is open.
First question is, was there any contribution from single premium cancellations this quarter for the premium yield?
This is Larry. It's relatively unchanged. It's up about $1 million, $4.2 million last quarter to $5.2 million this quarter. So it's in range of a basis point – we have 2 basis points over the last two quarters.
Great. And then just I was wondering if you – just curious, if you could comment a little bit on the competitive environment, I recognize that it's very competitive industry. But certainly it seems like it was just relative to history little more competitive maybe earlier this year. Are things back to where it was like in 2017 or still remains elevated? Just curious on if you have any thoughts on that?
Mihir, I've been in this industry for 15 years and it's always been competitive. There is always something whether it's LPMI, singles, the quest to go after credit unions, changes in BPMI pricing, contract underwriting back in the day. There is always something, so I wouldn't – I wouldn't look at the first quarter as heightened price competition. I think the competition – we have very good competitors and we compete a lot at the local level whether it's to train and provide training. We provide non-delegated underwriting I think we look at least half of our business is non-delegated. We look at another 10% through QC, so the ability and speed and accuracy of non-delegated underwriting is a competitive factor.
So, again, from a capital market standpoint, and from an investor standpoint, the focus is on pricing, because that's what you see. You know through the rate cards and some of the announcements, but I would say it's always been competitive and we wouldn't expect much to change. So, I wouldn't look at it just as price across the board. And I think that's fine. I think six companies should compete. I think that helps lenders, as long as we continue as an industry to hold appropriate amount of capital through PMIERs, which again as we've always said are clear and transparent standards. So, our friends at the GSEs don't have to worry about us from a capital standpoint competing on the front end for various ways to grow the business is a good think for housing finance system.
Great. Just changing gears a little bit, just on the capital, was there any capital contributions this quarter? I know last quarter you'll had a $50 million I think contribution in Essent Guaranty. Is there anything this quarter?
Yeah. There were no contributions either this quarter or last quarter to either of the insurance companies.
Okay.
There was $15 million last quarter.
There was 15 last quarter early in the year and then we did the ILN transaction late in the quarter.
And just, I know you talked about capital returns earlier, just – well could you give just a little bit of comment on your ability to get capital out of the insurance companies. Do you have to go through a special process with the state regulators and get special dividends? Are you at the point where you can maybe apply for regular dividends or something?
Mihir, Larry again. Yeah, we do have some normal dividend capacity and in fact we mentioned during the quarter we used $40 million dividend from Essent Guaranty to our U.S. holding company to pay down the revolving credit facility. So, we do have some capacity. It's still relatively limited as we grow the business, but we do have that dividend capacity and that dividend capacity will continue to increase over time.
And we also have the ability to apply for special dividends. And don't forget we have capital at the wholesales and at Essent Re which is obviously a lot easier to get out.
Then just last question, just looking at the vintage data, 2016 and 2017 I guess stand out a little bit. Is that mostly just hurricane impact, because they are pretty young or is that more because of the (Canadian side) doing maybe more 95 plus LTVs and things like that going on .
No, I think right now and that was even – if you looked at this last quarter is even higher, so it's really – still a little bit of the impact from the hurricanes which obviously continue to clean up. It's not a superfast process, so it's really around that.
Your next question comes from the line of Chris Gamaitoni with Compass Point. Your line is open.
Most of my questions have been answered. I think you answered this on the call, but I missed it. Where does your hurricane reserve stand today?
This is Larry. We made no adjustment to the hurricane reserve that we recorded in the fourth quarter of last year which is $11 million. So, right now that continue to be our best estimate of the ultimate losses we'll pay associated with those defaults.
And what drove the additional reserve release this quarter?
Really kind of two factors, one is the claims that we paid this quarter had a lower severity than they did last quarter. So, last quarter, the severity and claims was 76% versus 64% in the second quarter. In addition, we had lower number of new defaults, net new defaults in the portfolio.
Your last question comes from the line of Geoffrey Dunn with Dowling & Partners. Your line is open.
Just a follow-up on the dividend question. So, Larry, can you confirm, it was an ordinary course dividend and you took this quarter and then I know you are evaluating capital plans et cetera, but is there an intention to mean change some level of ordinary dividends in future quarters including the back half, or is that also still to be determined?
Geoff, two different questions. On the first one, it wasn't ordinary dividend. In terms of sort of maintaining dividend capacity, that's going to be driven by our earnings each quarter. So, each quarter we'll continue to build that dividend capacity and then we'll eat into it as we declare normal dividends, but right now that will be really mechanic based on the amount of earnings that we record at the insurance company each quarter.
So, I think you were over $100 million unassigned surplus as of last quarter. So, I would assume as long as positive earnings are there, when you see, you do have the capacity to maintain that ordinary correct?
Correct.
Correct.
And we're right about 100 between Essent Guaranty and the sister insurance company Essent Guaranty FPA as of the end of – as of the end of June.
There are no further questions at this time. I will turn the call back over to Management for closing remarks.
Okay, thank you operator. Before ending our call, we'd like to thank everyone for participating in today's call and enjoy your weekend.
This concludes today's conference call. You may now disconnect.