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Good morning. My name is Adam, and I will be your conference operator today. At this time, I would like to welcome everyone to the Essent Group Limited Third Quarter Earnings Call. [Operator Instructions] Thank you.
Chris Curran, Senior Vice President of Investor Relations, you may begin.
Thank you, Adam. Good morning, everyone, and welcome to our call. Joining me today are Mark Casale, Chairman and CEO; and Larry McAlee, Chief Financial Officer. Our press release, which contains Essent's financial results for the third quarter of 2018 was issued earlier today and is available on our website at essentgroup.com in the Investors section.
Our press release also includes non-GAAP financial measures that may be discussed during today's call. The complete description of these measures and the reconciliation to GAAP may be found in Exhibit L of our press release.
Prior to getting started, I would like to remind participants that today's discussions are being recorded and will include the use of forward-looking statements. These statements are based on current expectations, estimates, projections and assumptions that are subject to risks and uncertainties, which may cause actual results to differ materially.
For a discussion of these risks and uncertainties, please review the cautionary language regarding forward-looking statements in today's press release, the risk factors included in our Form 10-K filed with the SEC on February 20, 2018, and any other reports and registration statements filed with the SEC, which are also available on our website.
Now let me turn the call over to Mark.
Thanks Chris. Good morning everyone and thank you for joining us today.
I'm pleased to report that Essent generated another strong quarter of financial results as we continue growing our high credit quality and profitable mortgage insurance portfolio. For the quarter, we earned $116 million or $1.18 per diluted share compared to $78 million or $0.82 per diluted share for the third quarter of 2017, while also generating a 21% annualized return on equity.
Our results for the quarter were primarily driven by 26% increase in our insurance in force to $131 billion compared to $104 billion as of the third quarter a year ago. This growth drove a 21% increase in net premiums earned to $167 million compared to $138 million for the third quarter of 2017. Strong credit performance also contributed to our results as our loss ratio for the quarter was 3.3%.
On the industry front, we continued to see further utilization of risk-based pricing engines, and engine provides the capability to price more attributes at the loan level unlike the current rate part structure which is generally based on broad FICO and LTV ranges. One of the primary benefits of an engine is that it provides flexibility to increase or decrease rates allowing us to better shape our portfolio especially in times of stress.
While we do not see the entire lender space converting to more sophisticated pricing engines overnight, we do expect the trend to continue. Much of the progress today is being driven by the market as many lenders are enhancing the front-end and best execution technologies in a very competitive originations environment. During the quarter, we continue to pilot our engine and anticipate a broad rollout in 2019, as we have evolved our risk based pricing strategy to best serve our customers.
From Essent beginning, we have taken a long-term approach to ensuring and managing mortgage credit risk. We believe that the combination of risk based pricing on the front-end and reinsurance on the back-end makes us a stronger company by reducing franchise volatility during down cycles.
In Bermuda, Essent Re continues to provide us another platform to invest in GSE risk share and is now participated in over 50 deals primarily through the ACIS and CIRT transactions. Essent Re is also been growing its advisory business referred to as a managing general agent or MGA. This business generates fee-based income and enables us to leverage our expertise to help reinsurers invest in GSE risk share. Our participation in GSE risk share and managing our MGA demonstrates the optionality and flexibility of the replatform.
Turning our attention to PMIERs 2.0, we are pleased that they have been finalized. We remain supportive of the PMIER's framework and believe that strong and transparent capital standards are a long-term positive for our industry. When applying PMIER's 2.0 to our financial position as of September 30, 2018, our PMIER's excess of $360 million would be substantially unchanged.
On the Washington front, we continue to monitor the landscape following the results of this week’s elections. Given the changes in both the House and Senate we do not believe there will be any meaningful efforts to address housing finance reform at the start of 2019.
Looking forward, we will continue to support U.S. MI and engage with policymakers in promoting the benefits of private mortgage insurance in a well-functioning and robust housing finance system.
Now let me turn the call over to Larry.
Thanks Mark, and good morning everyone. I will now discuss our results for the quarter in more detail.
For the third quarter, we reported net income of $116 million or $1.18 per diluted share compared to $112 million or $1.14 per diluted share for the second quarter and $78 million or $0.82 per diluted share for the third quarter a year ago.
Note that the 48% increase in net income compared to the third quarter of 2017 was driven primarily by a 21% increase in net premiums earned, as well as the decrease in our effective tax rate as a result of the passage of federal tax reform in December of last year.
Earned premium for the third quarter was $167 million, an increase of 6% over the second quarter of $157 million and an increase of 21% from $138 million in the third quarter of 2017. Note the premiums ceded to Radnor Re on our ILN transaction are reflected as a reduction of earned premium and were $3.2 million in the third quarter compared to $3.6 million in the second quarter of 2018.
The average net premium rate for the third quarter was 50 basis points which was one basis point lower than the second quarter of 2018 due to a lower level of single premium policy cancellation income. We expect our average net premium rate to be approximately 49 basis points for the balance of 2018. Note that this rate reflects only the primary MI business and does not include premiums earned by Essent Re on its GSE risk share business.
We remain pleased with the credit performance of our insured portfolio. Our provision for losses and loss adjustment expenses was $5.5 million in the third quarter of 2018, compared to $1.8 million in the second quarter of 2018, and $4.3 million in the third quarter a year ago.
The default rate on the portfolio declined 3 basis points from June 30, 2018, to 61 basis points at September 30. This decrease was primarily a result of continued tour activity on defaults associated with hurricanes Harvey and Irma, offset by an increase of 519 non-hurricane defaults during the third quarter.
Our defaults at September 30, do not reflect any impacts of hurricanes Florence or Michael. While we're closely monitoring default activity and damage assessments in these regions given that only 1.5% of our insured portfolio is located in the impacted areas, we do not believe that these hurricanes will have a material impact on our portfolio.
Other underwriting and operating expenses were $36.9 million for the third quarter and our expense ratio was 22.1%, compared to $36.4 million and 23.2% respectively for the second quarter of 2018.
Income tax expense for the third quarter of 2018 with calculated use and an estimated annual effective tax rate of 16.2% plus $1.5 million of additional tax expense associated with the completion of our 2017 federal income tax return. We currently expect our effective tax rate to be 16.2% in the fourth quarter of 2018.
The consolidated balance of cash and investments at September 30, 2018, was $2.7 million. The cash and investment balance at the holding company was $77 million at September 30. New capital contributions or dividends between the holding company and operating businesses were completed during the third quarter.
As of September 30, we have $275 million of undrawn capacity under the revolving credit component of our credit facility and $225 million of term debt outstanding. As of September 30, 2018, the combined U.S. mortgage insurance business statutory capital was $1.8 billion with the risk-to-capital ratio of 14.1:1, compared to 14:1 as of June 30, 2018.
The risk-to-capital ratio at both dates reflects a reduction in risk in force of $424 million for the reinsurance coverage obtained from our insurance-linked note transaction. At the end of the third quarter, Essent Re had GAAP equity of $749 million, supporting $7.8 billion of net risk in force.
Now, let me turn the call back over to Mark.
Thanks Larry.
In closing, Essent generated another strong quarter of financial results as we continue building a high credit quality and profitable mortgage insurance portfolio. The operating environment during the quarter was favorable and we remain pleased with credit performance and our market presence.
Looking forward, our outlook on our business remains positive and we believe that increased utilization of risk based pricing and reinsurance will make Essent a stronger Company.
Now, let's get to your questions. Operator?
And your first question comes from Mark DeVries of Barclays. Mark, your line is open.
I had a question about market share. Mark, I know you don't manage the market share and that it does tend to be a little bit volatile from quarter-to-quarter but we estimated like 16.7% market share this quarter, and I think it's been almost two years since you were inside of your range of 13% to 15% long-term guidance. Curious kind of what's driving the strength there and how should we think about market share longer-term?
It's good question Mark. Again, we don't, like I said, it's really for us it's about insurance in force growth. I think given how big the market is, market share is really not as important metric as maybe it once was in a smaller market. So we're 1/6 so for the higher end of that range which seems like we've been and little bit over, I still think that's a good long-term outlook.
I mean, it could shift quarter-to-quarter as we get into - as the market share gets a little bit more volatile with some of the pricing as the engines roll out, you could see some with less transparency, you could see some more volatility. And I think we have in the past few quarters with certain MIs and certain lenders.
But again, really the focus longer-term is insurance in force. We grew it 26% year-over-year and again given that we're 1/6 we feel very comfortable with our market presence and our ability to continue to grow the portfolio.
And it also seems like the private mortgage insurance industry is growing faster here in the broader mortgage market. Are you seeing signs that you're continuing to gain share on the margin from the FHA?
Yes, I mean a little bit on the FHA especially as you think about the higher DTIs and some of the higher LTVs we’re seeing some of the share. We have seen really over the past year, year-and-a-half the share shift from FHA to a conventional. I think the other thing driving is just the demand around the first-time homebuyer and when you look at the builders some are larger builders now.
I mean the number two builder in fact 35% to 40% of their closings are in the first time really they’re the starter home unit and that average size I believe with that builder is $240 to $50,000 our average loan size is 230. So across all homebuilders, the demand is not equal among the different price points, but with the starters it’s clearly as demand is there and a lot of those consumers will use MI. So I think it's more secular than just kind of a shift from FHA to conventional.
Your next question comes from Douglas Harter of Credit Suisse. Douglas your line is open.
Hi, this is actually Sam Choe filling in Doug. On the credit side current losses have been coming in lower, I mean claim rates have also trended down. Could you give us a sense on your updated view as to how low claim rates can go in this environment?
Sam, it’s Mark. I think we’ll stick to our guidance I mean I still think when we run the models we would assume kind of 2% to 3% claim rates and it’s really not many you’re talking about two to three bars out of 100 going and the claim is obviously been better in the environment given the full employment where interest rates are and just generally the economy has been strong. But these things can turn. So we still think 2% to 3% is really the range that you guys should be thinking about going forward.
And you guys had pretty good improvement on persistency, how do you see that improving going forward?
We don't see it improving that. We think longer-term guidance is probably and closer to the 80% range Sam, it’s been higher and it could tend to stay at this level a little bit as interest rates continue to climb up. But remember persistency especially if rates climb a little faster and then they come down again, I know the consumer so trained on the ability to refinance we could see volatility.
So we’re kind of in the - we’re in the high-altitude now in terms of persistency so I wouldn't look to as you guys build your models I would look to the mid-80s I think it's closer to the 80s or probably more conservative measure going forward.
And your next question comes from Bose George of KBW. Your line is now open.
Actually first question is just on operating expenses. Just given the growth in your - on the revenue side that were sort of implied by your insurance enforce growth. Should the expense ratio continue to trend down from the 22% you did this quarter?
It’s tough to tell Bose, I think we focus more on the nominal dollars and I think we still feel comfortable kind of this year in that 150 to 155 range probably a little bit on the lower side of that. But going forward we would still see some increase in expenses nothing that jumps our premium taxes clearly arise as revenues rise. We will continue to invest in parts of the business and then the expense ratio really just becomes a calculation.
And don't forget with the premium compression that you're seeing in the market that the revenues may not grow as fast as you may think. So longer term we tend to give more combined ratio guidance and we still think kind of that 35 to 40 in the longer term range - intermediate to longer term is still pretty good guide.
And then just switching to excess capital, can you give us an update on that and just when you think about excess capital should we also keep in mind the untapped line of credit when we think about excess capital and potential capital return?
We look at capital this way, I think we feel very comfortable with our capital position at the end of the third quarter given the PMIERs excess 75 plus million of the Holdco another 275 kind of in terms of dry powder at the line of credit.
So very comfortable from a capital position feel like we'll be able to reinvest some of that in the core business and within Essent Re. I think when you think about excess capital - it’s a little bit more nuanced don't forget that a lot of the PMIERs excess those is driven by the land deal that we did. We’ve only done one of those.
So it only covers 30% of the book. I think in terms of capital distribution we certainly wouldn’t want to execute another insurance linked note deal next year and that's kind of our plan is to take the 2018 book in early 2019.
Once we get that under our belts, I think we’ll have better we’ll able to give you a little bit more guidance around capital distribution, but right now you talking about a company that just raised equity 15 months ago, we still grown insurance in force and at returns of 20% return on equity in a business that's very pro-cyclical capitals came.
So we're not - sometime we’re going to be really careful about but right now we’re going to enjoy our capital position and the strength of it and remember capital begets opportunities to so we’re running these businesses for the long-term, and one island deal doesn't necessarily make turn this into a capital distribution story.
And actually one more related question on capital, are there any tax consequences that make it difficult for you to dividend up capital from the U.S. MI to the Bermuda Holdco?
Bose, it’s Larry, I’ll respond to that question. Yes, there is a withholding tax between the U.S. and the Bermuda Hold company. The way that we’re structure that would be a 5% withholding tax on any distributions from the U.S. through our intermediate holding company up to Bermuda.
Okay, good. Thank you.
And also don't forget Bose the 25% affiliate reinsurance deal that’s another way to get capital from guarantee to the Holdco.
Your next question comes from Mackenzie Aron from Zelman & Associates. McKenzie your line is open.
Just one from me Mark on the - can you give us an update on the pilot programs from Fannie/Freddie LPMI and IMAGIN, are you seeing any change to get in group as lenders get more comfortable with this program now they have been out in the market for the last several months?
Yes, I mean I can give you a little bit of an update, I have been out a lot this past quarter meeting with lenders and we haven’t seen a lot of impact I would - from what I can tell is there not more than a handful of lenders contributing to either one of the programs and again its early for the programs.
And I think one of the GSEs announced that they're going to go after the smaller lenders but there's clearly not a ton of volume. And also don't forget the environment really not well suited for LPMI especially in a rising rate environment. So again it's early, but I would say the traction has been really limited.
And then as we kind of get into the end of the year and hopefully get some announcements from the White House from the direction of FHFA, is there anything that you're watching on the policy whether it’s FHA or with the GSEs?
No, I think with FHA it's pretty clear I think they are on a path to where we can tell is to shrink their footprint over time and that's something that continue to wait and see. I think on GSE reform again like I said on our prepared remarks, we don’t see anything coming early in 2019 and I think we will look to see here the new head of FHA is if there's an interim or confirmed head of FHA. It’s stuff to tell it’s still pretty early I mean the election just happened in the last couple days so I think we’re wait-and-see mode and it's too hard to really guess at this point.
Your next question comes from Jack Micenko from SIG. Jack your line is open.
Mark looking at the mix of the portfolio 95 plus like risk in force now about 10.5% but the NIW number was closer to 18. So the portfolio is migrating in that direction I guess question is that strategic, I know you talked into an earlier question about the FHA picking up some share there. I am wondering if you're doing something that's more pronounced there obviously you’re getting paid more for that risk but just curious?
No, nothing in particular that we’re doing I think we seen arise especially around the LTVs across the lender base. So it's not any one particular lender at all I think it's above the base. We feel like the credit still pretty strong Jack the FICO's were elevated at that level and obviously the pricing is pretty good. So again I think that just where some of the market is trending and we feel pretty comfortable with it at this point given where we are in the economy.
Is it possible to function rising home prices, I mean is loan balances larger there?
No, not particularly. No, we haven't seen any real difference in home prices.
And then on loss incurred number - maybe more of a mechanical change this quarter. I mean, default came down a little bit quarter-on-quarter but the number came in a bit higher, your severities lower. Just curious, I know you talked about the 2% to 3% claim rate assumption. But was there any shift in this quarter specifically in the way you're modeling the reserve?
No, change at all relative to that. One thing we would want to point out is that we have not made an adjustment to the hurricane reserves that we booked in the fourth quarter of last year. And again, you saw the impact of the cure activity in the count but you did not see any impact in terms of the dollar.
So we continue to monitor the cure activity. We'll do that through the fourth quarter and any claim activity, and then we'll look at considering whether or not we would make an adjustment to the hurricane reserves sometime in the fourth quarter.
And you next question comes from Mihir Bhatia from Bank of America. Your line is open.
Staying with claims, just quick question on - you talked about claim frequency but what about claim severity? That's come down nicely this year, I think it's on like 10% year-over-year just through the year so far. And I was just wondering, is there something driving that or is it just from price appreciation something else, how do you see that trending?
Yes, I mean we always - we would be very conservative on that. I think some of it is the low small numbers driving some of that and clearly the home price appreciation helps somewhat but I wouldn't - yes, I wouldn't forecast kind of continuing improvement severity at all.
And then just one other question on the - just going back to the risk based pricing engine that you mentioned I think in your prepared remarks. Just curious on where are we just like as you think about as the industry and as you-all roll that out and the pilot program gains - as your learning's from it, where are we in terms of just actually moving towards that type of a pricing structure as a whole? Is it - are we talking three years, are we talking two - one year or 10 years?
Well, I mean yes, I mean it's out in the market now. I mean two MIs are doing it every day and we're in pilot phase, we'll roll it out. Certain lenders will take it - and it's going to take certain lenders time just because of the technology. So a lot of smaller lenders are using it today. We know one large bank that's using it today. So yes, I think it will take a couple of years.
I think this is more evolutionary and I think that versus revolutionary where it's all going to shift day one. I mean it's just - there's too many lenders, the technology is too complicated. You have to get integrated with all the different vendors. Lenders have to become comfortable with it from a compliance standpoint. This just doesn't happen overnight because the MIs roll out their pricing engine. I mean we don't drive the market, our lenders do.
So, I think you have to be very patient with that. That's what we say, it's going to evolve. And that's why we're careful to roll it out and make sure it works from an operational standpoint. The major point is this - again, longer- term, as once these are in place, I do think it shifts some of the pricing power from the lenders to the MIs.
And when you just have a rate card that has two factors and now we're up to a whopping four factors, with one lender it's one-size fits all. And I think I mentioned this in the last quarter, that's fine when the market strong it's really bad when the market starts to soften.
And I think now once they're in place and I'll expect all the MIs to have them in place at some point. And you have five or six MIs basically pricing differently every day on every loan, that's an advantage.
And so on a softening market there may be one MI that likes that risk and then other MI that doesn't. The lender wins because they'll get kind of the best price for them but the MIs get a chance to shape their portfolio and I just think when you combine that pricing power so to speak with the hedging that we're doing on the backend, we're left with [indiscernible] that has a lot less volatility into it and lot more control.
Think about the last downturn, the MIs went into the downturn with an uncap liability on their balance sheet. It's tough thing to entering to any type of market and I think as the insurance-linked note market continues to mature and the reinsurance market continues to mature and you combine that with kind of the granularity of pricing on the front-end, like I said in our prepared remarks from an Essent standpoint we feel it's going to be a much stronger company and much better able to withstand cycles.
And the cycles are what - the down cycles are what's really hurt the MI business and you know being able to kind of reduce that volatility makes us a better counterparty for our lenders. Certainly from a GSE perspective, when you think about housing finance, just from a tax payer standpoint our ability to stand in front of the GSEs now and not have that type of volatility, I just think makes for a stronger housing finance system.
So there's a bigger picture here and it's not measured in quarters in terms of how many lenders we've rolled the engine out to. I think there's much - there's a broader message here that I'm trying to get across.
And we've reached the end of our Q&A session for today. So I'll turn the call back over to Mark Casale, for closing remarks.
Thank you, Operator. Before ending our call, I'd like to thank everyone for participating today, and have a great weekend.
And this does conclude today's conference call. You may now disconnect.