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Greetings, and welcome to the Third Point Reinsurance Fourth Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris Coleman, CFO. Please go ahead, sir.
Thank you, operator. Welcome to the Third Point Reinsurance Ltd. earnings call for the fourth quarter of 2017. Last night, we issued an earnings press release and a financial supplement, which is available on our website, www.thirdpointre.bm. Leading today's call will be Rob Bredahl, President and CEO, but before we begin, I would like to remind you that many of the remarks today will contain forward-looking statements based on current expectations. Actual results may differ materially from those projected as a result of certain risks and uncertainties. Please refer to the fourth quarter 2017 earnings press release; and the company's other public filings, including the risk factors in the company's 10-K, where you will find factors that could cause actual results to differ materially from these forward-looking statements. Forward-looking statements speak only as of the date they are made. And the company assumes no obligation to update or revise them in light of new information, future events or otherwise. In addition, management will refer to certain non-GAAP measures, which management believes allow for a more complete understanding of the company's financial results. A reconciliation of these measures to the most comparable GAAP measure is presented in the company's earnings press release. At this time, I will turn the call over to Rob Bredahl. Rob?
Thank you, Chris. Well, we had a strong fourth quarter and a terrific full year. In the fourth quarter, we generated net income of $44 million for a return on equity of 2.8%. And for the full year, we generated net income of $278 million and return on equity of 20.1%. The strong results were particularly gratifying given that they allowed us to highlight the strengths or at least the uniqueness of our total return business model. In a year with record cat losses and poor industry results, we had stable underwriting results; and a 20% return on equity, among the very highest in the industry. Chris will go through the details of our results in just a minute. From our inception 6 years ago, we have focused on generating stable long-term float and minimizing underwriting risk by focusing on closure contracts of less-volatile lines of business. Now that we have stable long-term float, have increased surplus by $1.1 billion over 6 years and are fully connected with producers, we plan to increase our expected underwriting returns by incrementally, and I stress incrementally, increasing the risk profile of our reinsurance portfolio. We plan to increase our writings of specialty lines, rate lower-layer excess covers in addition to quota share and raise some shorter-tail event-type covers. We are off to a strong start in 2018 having already written more than $325 million of premium and at improved pricing levels to the transactions we booked early last year. We believe that, in the years leading up to 2017, when there was much less cat activity than the modeled expected activity, reinsurers earned outside profits, which masked the poor pricing in noncat lines. Recent cat events have shone a light on this poor pricing. And we've seen 300 to 400 basis point improvement in the composite ratios of the quota share contracts we renewed at 1/1 through a combination of improved underlying insurance pricing and reinsurance terms and conditions. Now I would like to take a few minutes and talk about the potential impact of U.S. tax legislation passed at the end of 2017. To start and to be very clear: We do not believe that the new tax legislation will have a material impact on our financial results. The tax legislation is enormously complicated, and there are really 2 pieces of the Tax Act that can impact us. The first is the Base Erosion Anti-Abuse Tax or BEAT. This is a tax on certain payments from U.S. taxpayers to their foreign affiliates. For many reinsurance companies, there will be phased-in 10% tax on gross premium ceded under intercompany quota share agreements. This has caused many offshore reinsurance companies to eliminate or restructure these agreements and to increase the capitalization level of their U.S. affiliates. For Third Point Re, there will be no change to our intercompany quota share arrangement. And we will not be subject to any BEAT tax. The tax applies to entities where the gross receipts of their U.S. tax-paying subsidiary exceeds $500 million. Our U.S. tax-paying subsidiary is under this threshold. And we expect that it will be so for the foreseeable future, and therefore the BEAT tax should not apply to us. The other part of the tax bill that will impact us, at least indirectly, is the test for determining a passive foreign investment company or PFIC. If we were deemed a PFIC, our U.S. tax-paying investors would be required to pay taxes on the current taxable income of the company. To be clear: Our financial results are not impacted by the PFIC rule, just our investors' after-tax returns. But of course, any negative impact to our investors is a concern to us, especially since it will affect our share price and our access to capital, so we will be taking certain steps to ensure we are not a PFIC. The Tax Act modifies the active insurance exception to PFIC status by adding a requirement that reserves must generally constitute more than 25% of a company's total assets for the relevant year. However, the tax law uses an odd definition of reserves. Only loss and loss adjustment expense reserves are used in the formula and not UEP reserves. Our loss and loss adjustment reserves are currently less than 25% of our total assets, as they are, by the way, for almost half the U.S. P&C market. One factor working against us is the structure of our investment account. Instead of investing through a traditional limited partnership arrangement where only the net asset value of our portfolio managed by Third Point LLC would be presented in our balance sheet, our investments are managed through a separate account, with the gross assets and the gross liabilities related to our investment activities reflected on our balance sheet. Under our current investment account structure, our gross assets exceed the net asset value of our investment portfolio by more than $1 billion. We plan to restructure our investment account so that we will present only its net asset value on our balance sheet and thereby reduce our total balance sheet assets by the $1 billion while preserving similar economic exposure to Third Point investment strategy. Once we've completed the investment account restructuring, we are confident that we will clear the 25% threshold by year-end. I will now hand the call over to Daniel Loeb, who will discuss our investment results in greater detail. Daniel?
Thanks, Rob. And good morning. The Third Point Reinsurance investment portfolio managed by Third Point LLC returned 2.7% in the fourth quarter of 2017, net of fees and expenses. The account returned 17.7% in 2017, net of fees and expenses, versus returns for the S&P and CS event-driven indices of 21.8% and 6.3%, respectively, for the year. The Third Point Reinsurance account represents approximately 15% of assets managed by Third Point LLC. In 2017, many factors combined to create a favorable environment for our opportunistic equity investment style. 93% of returns came from the equity portfolio. And these were driven by strong stock selection in event-driven situations, several constructivist investments, strength in the tech sector, successful short-selling efforts and maintaining a well-balanced portfolio across sectors with equal exposures to cyclical and defensive stocks. Our equity book generated a return of nearly 30% on invested assets for the year. While the portfolio was mostly U.S. focused, we had more ex U.S. exposure than in recent years. And international investments generated 25% of 2017 returns. In Q4, equities continued to drive profits, with industrials, consumer and financials as the top-performing sectors. Energy, TMT and health care were flat for the quarter. The total equity portfolio returned 5.2% on average exposure during the quarter. Credit exposure remains modest in an environment, with tight spreads and many participants chasing the same opportunities. We continue to monitor the impact of a rising rate regime and will adjust exposures accordingly. Corporate, structured and sovereign credit debt returned 3.2%, 1.4% and 60 basis points, respectively, for the quarter. Our portfolio remains concentrated in equities and balanced across sectors, with a focus on U.S. investment opportunities. We will continue to monitor economic data closely and adjust our portfolio exposures to changing market conditions. Now I'd like to turn this call over to Chris to discuss our financial results.
Thanks, Daniel. As Rob noted, 2017 was an excellent year for Third Point Re with a market-leading return on equity exceeding 20%. Our diluted book value per share ended the year at $15.65, which was an increase of 2.8% for the fourth quarter and 19% for the full year. The key driver of our results was the excellent investment returns that Daniel just discussed in detail. For the fourth quarter, we generated net investment income of $67 million, bringing the full year to $392 million. Related to our underwriting results. We continued to reshape the portfolio. And based on these changes as well as some improvement in overall market conditions that Rob discussed earlier, we expect continued improvement in our underwriting results over the next 12 to 24 months. Related to movements in gross written premium, just a reminder that, given our focus on large contracts that in some cases may not renew or may renew in noncomparable periods, we will not overly react to premium movements in any given quarter. Having said that, our gross premiums written increased by $83 million or 103% to $164 million from $81 million in the prior year's quarter. Gross written premium increased by $24 million or 4% to $642 million from $617 million in 2016. The increase during the fourth quarter was primarily due to the renewal of 2 contracts, l of it -- l of which was a 2-year contract written in 2015 which renewed this year. And the second was a contract previously written for 1 year in 2016 where we renewed for a 2-year period in 2017. As Rob mentioned earlier, these were 2 examples of contracts where improvements in pricing, terms and conditions resulted in us writing contracts that we would not have expected to renew earlier in the year. The modest increase in premium for the full year reflects several moving parts but includes $286 million of new premium written during 2017, partially offset by nonrenewals and other timing differences. Movements in net premiums earned between periods reflect the timing of earnings in our in-force portfolio but was also impacted for the full year of 2017 by $109 million of new retroactive reinsurance contracts written in the second quarter which are fully earned when written. We did not write any retroactive reinsurance contracts in 2016.
We generated a $9.2 million net underwriting loss for the 3 months ended December 31, 2017, compared to an underwriting loss of $9.5 million in the prior year period. And our combined ratio was 107.1% compared to 105.0%. For the 12-month period, we generated a $43 million net underwriting loss compared to an underwriting loss of $50 million in the prior year period, and our combined ratio was 107.7% compared to 108.5%. We did not record any catastrophe losses in the fourth quarter, and we maintained our $5 million estimate of cat losses for the full year of 2017. The cat losses in 2017 accounted for 1 point on the full year combined ratio. During the fourth quarter, we recognized net prior year's favorable reserve development of $2.5 million. As we did not have any net reserve development in the prior quarters, this was also the amount impacting our full year's results. As a reminder: Our reference to the net impact of reserve development reflects the impact of changes in loss reserve estimates as well as any offsetting impact of acquisition costs. Federal and administrative expenses for the fourth quarter of 2017 were $14 million compared to $5 million for the prior year period. General and administrative expenses in 2017 were $53 million compared to $39 million for 2016. The increase was primarily due to an increase in our annual incentive plan compensation accruals, reflecting the performance of the company year-to-date. In the fourth quarter of 2016, we reversed our bonus accruals based on performance, which lowered the expense in that period. The increase in income tax expense for the 12 months ended December 31, 2017, compared to the 12 months ended December 31, 2016, was primarily due to higher taxable income generated by our U.S. subsidiaries. As a result of the change in tax rate, we reduced our net deferred tax liability during the fourth quarter, which resulted in a gain of approximately $800,000. We do not expect any material impact to our effective tax rate as a result of the changes from recent tax legislation, which Rob discussed earlier. Finally, as noted in our earnings press release, we have increased the authorization on our share repurchase plan to $200 million. We intend to buy back shares when our share price is 95% of diluted book value per share or lower, subject to market conditions, rating agency capital considerations and other factors. I will now hand the call back over to Rob.
Thanks, Chris. We had a great year in 2017 with market-leading returns, and were able to showcase the strengths of our total return business model. After building up stable long-term float by focusing on less-volatile, cash-rich quota share contracts and reserve covers, we plan to incrementally shift to more risk taking to improve our underwriting results. Recent cat events have contributed to some improvement in pricing, and we're off to a strong start in 2018. I will now hand the call back over to the operator, who will open the call up for questions. Thank you.
[Operator Instructions] Our first question today is coming from Kai Pan from Morgan Stanley.
First, a few questions for Dan. Dan, in your letter in January you identified that inflation as a key issue you closely watch. Since then, the market has experienced a period of heightened volatility. Do you think that will continue? And how do you position the portfolio?
Yes, I think obviously inflation goes hand-in-hand with interest rates. And that's been a -- and that's obviously been something that we, along with everyone else, have been focused on. I think we also need to just look at growth expectations. And I'm not saying that growth is a problem, but it's definitely an issue that we're looking at and, I think, getting past sort of the concerns about interest rates and inflation. And I think that maybe a more pressing issue is going to be whether the rosy assumptions that everybody has about earnings growth this year and next year will be met. I'm not saying they won't be met, but it's definitely something, given some of the recent economic data which tends to be noisy, we need to keep an eye on. As far as positioning the portfolio, we've been in a process of reducing both gross and net to be more nimble in what we think will be more of a range-bound market this year, still one with a lot of great opportunities but probably won't have the same tailwinds that we had last year in terms of a low volatility and a steady up and to the right market that ended up over 20% for the year.
My -- and then my second question, on the tax reform, if you step back and think about it, is that does it take away or blunt it -- blunt one of the key competitive advantage for the Third Point Re business model?
I'll let Rob answer that one.
I mean I guess -- yes, we can -- I can -- this is Chris here. I'll start that. And certainly Rob can chime in. So I mean, I guess, to your question, Kai, we don't intend to be a PFIC at the end of the year. Clearly, if we were deemed a PFIC, that would blunt the advantage of investing in Third Point Re in terms of the tax considerations of investing in a corporation. As -- Rob laid out in his initial remarks our plans to address the PFIC, and there's really 2 parts to how we intend to ensure we're not a PFIC entity at the end of the year. As Rob mentioned, due to the structure of our investment portfolio as a separate account rather than an LP investment, our balance sheet is grossed up by the underlying investment assets and liabilities. We plan to restructure our investment account to more of an LP-type structure in a manner that achieves the balance sheet presentation that helps on the PFIC ratio while preserving the same investment exposure and expected investment returns to our shareholders as they would have under the existing structure. And based on the information you would see in the earnings release and the financial supplement, by doing that, it would bring our ratio for purposes of the PFIC test from 15% to 21%. And so that would leave us about $200 million of loss reserves, under the required 25% ratio. We expect to be able to close that gap in the normal course of business, including writing additional reserve covers, which as you know is already a core part of our underwriting strategy.
And also, Kai, although we don't like the measurement, there's now a bright line test. So everybody knows what they have to achieve to be considered not a PFIC. And I -- there's always been a cloud over Bermuda reinsurers with respect to PFIC, and so I view that as a positive.
Okay, that's great. And back to Dan: You talk about the -- your data science team in the letter. Could you give us more detail about how is the team helping the investment process?
Yes. I mean it's early days in terms of data science, but -- they've already had a very strong influence on us in terms of using machine learning and artificial intelligence and applying that to the data that we get, both from our developing some quantitative screens that we use, especially on the short side, and also on helping to supplement the fundamental work that our various industry teams do in terms of better understanding consumer behavior or what's going on in sales channels and other things. So it's a very exciting thing. We spend a lot of time and energy on it, but look, this is something that is going to be -- is going to require a lot of time and resources as this is a multiyear project. It's basically embedded in our organization at this point and will be there, and we're just starting to see the first fruits of that effort. But I don't think you can be in any business today that's reliant on information and requires people to make decisions based on data without having a sophisticated approach to accessing and analyzing that data, whether you're a hedge fund or an operating business. And we're certainly making the commitment and the investment in that area so that we stay up to date.
Great. Last one for you, Dan. What's your take on the media report of a potential investment by SoftBank in Swiss Re?
I have no real opinion about it. I mean they've made some unusual investments in the financial services area. And I don't know. I don't really have an opinion on this one -- unusual in that they're unexpected for a tech company, both the Fortress investment and this investment. But you'll have to ask Masa Son that question.
Okay, great. And then switch to Rob and to Chris. I had a couple for you. Number one, Rob, you mentioned that you're gradually increasing the risk profile of the underwriting. Is that will help the combined ratio profile to lower? And -- but at the same time, will that increase volatility of the underwriting results? Will the rating agency be comfortable with that?
Well, the combined ratio is going to improve our core book of business. We're just seeing improved pricing. We already write some specialty business through quota share contracts, and so Kai, it's really an extension or maybe a slight acceleration of what we've been doing. And we've retained a lot of earnings recently, so from a rating agency standpoint, I think we're just fine.
Okay. Last one, on buyback. You increased your authorization. And also, it seems like, sounds like to me, if I remember correctly, you have threshold of 90% before. And now it's 95%. Is that the change?
Yes. I mean, yes, you're right. I mean previously we had announced a threshold of 90%, and now we've just announced a threshold of 95%. And it's a little bit of an increase. Clearly, as we said in the past, buying back our shares below book is immediately accretive to shareholders on future earnings. And given the -- as Rob just pointed out, the additional earnings that we've retained over the course of the year and a strengthening of our capital position, we made the decision to move that dial out slightly.
Kai, our gross premium really hasn't changed much in 3 or 4 years. And now we're up to $1.7 billion in surplus, which is $500 million or so more than we were a few years ago. So we have room to take a little bit more risk and buy back shares.
[Operator Instructions] Our next question today is coming from Meyer Shields from KBW.
Rob, again touching on the incremental increase in underwriting risk. I guess, 2 questions. Should we expect some measure of capacity risk? And will the reserve duration on this enhanced risky portfolio be longer than the current liability duration?
I guess, first, on property cat, we're unlikely to write any meaningful amount of property cat this year. We're looking at how the market is shaping up, pricing; very interested in what goes on at [ 6 1 ]. And then we're going to look at cat activity during the year. And so that's something that's under consideration. And the second question is are we going to stretch out the tail, that -- was it your -- the second part of your question, Meyer? More, just sort of expectations on liability duration as result of shaping the -- reshaping the portfolio.
Yes, yes.
I think it comes in a little bit. Just the more event-driven-type risk that we're looking at, we're bringing in slightly. You're probably not going to notice any meaningful change this year.
Yes, that's right.
Okay, that's very helpful. And then this is just an ignorant question, but does the restructuring of the investment accounts into an LP require any external approvals?
No.
No, it didn't require any external approvals. Of course, any time you're making changes like this, we'll be working closely with our regulators and with the rating agencies to ensure they fully understand what we're doing, but as I said before, the intention is to restructure things in a manner that results in a different balance sheet presentation but retains very similar, if not the same, investment exposure and expected investment return.
Yes. And, Meyer, we currently have a separate account. Maybe a more traditional way for reinsurers to invest in hedge funds is through an LP structure, but both approaches are widely used.
Okay, yes. Just to know if there was any restriction on that but I completely understand what you're doing.
Thank you. We have reached the end of our question-and-answer session, and I'll just turn the floor back over to management for any further or closing comments.
Well, thanks, everybody, for joining us. We look forward to talking to you next quarter. If there is any questions in the interim, please give us a call.
Thank you. That does conclude today's teleconference. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.