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Watford Holdings Ltd (WTRE)
Q2 2019 Earnings Call
Jul 30, 2019, 1:00 p.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good day ladies and gentlemen and welcome to the Watford Holdings Second Quarter Earnings Conference Call. [Operator Instructions] Before the company gets started with its update management wants to first remind everyone that certain statements discussed on this call may constitute forward-looking statements under the Federal Securities Law. These statements are based upon management's current assessments and assumptions that are subject to a number of risks and uncertainties. Consequently actual results may differ materially from those expressed or implied.
For more information on the risks and other factors that may affect future performance investors should review periodic reports and other filings that are filed by the company with the SEC from time to time. Additionally certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in this call to be subject to the Safe Harbor created thereby.
Management also will make references of non-GAAP measures of financial performance. The reconciliation to GAAP the definition of underwriting income adjusted underwriting income and adjusted combined ratio and descriptions of non-investment grade portfolio and investment grade portfolio components of the company's investment returns can be found in the company's current report on Form 8-K furnished with the SEC yesterday which contains the company's earnings press release and is available on the company's website.
I would now like to introduce your host for today's conference Mr. John Rathgeber CEO of Watford Holdings. You may begin.
John Fredrick Rathgeber -- Chief Executive Officer and Director
Thank you Jamie. Good day everyone and thank you for joining Watford Re's Second Quarter Earnings Call. Joining me on the call today are Rob Hawley CFO; John Healey President and Chief Risk Officer; and Jake Blair from HPS the Investment Manager for a high-yield fixed income portfolio. I'll provide some high-level commentary on our second quarter underwriting and investment results insurance market conditions and other notable events during the quarter then turn it over to Rob for more detailed recap of the second quarter financial results.
Following that I'll provide some comments regarding the recently proposed PFIC regulations and then we'll take your questions. We're pleased to report net income after dividends of $13.8 million for the 2019 second quarter. It was a relatively quiet quarter both from an underwriting standpoint and from an investment perspective. There were no major insured catastrophe events impacting our results. And our loss reserves for prior accident periods continued to hold steady.
On the investment side in addition to strong net interest income realized and unrealized gains were essentially flat versus a $34 million realized and unrealized gain recorded in the prior period. The combined ratio for the quarter was 103.5% on $151 million of premiums earned resulting in an underwriting loss of $5.3 million. A higher-than-normal general and expense ratio of 6.5% was impacted by approximately $2 million of mostly onetime expense for long-term compensation equity grants.
The adjusted combined ratio which excludes corporate expenses and includes other underwriting income was 99.9%. In our view what we report is our adjusted combined ratio is more directly comparable to what most other reinsurers report as their combined ratio. Our net premiums written and earned for the quarter were are 15% and 5% lower respectively than a year ago which is reflective of the continued planned reduction in casualty reinsurance and growth on the insurance side.
Through six months insurance net premiums written are up 26% and casualty reinsurance net premiums written are down 24%. On a net basis loss reserves on prior accident years including reserves for prior period catastrophe events remained essentially unchanged. The recently announced change in the Ogden rate from negative 0.75% to negative 0.25% while a disappointing outcome was consistent with the assumptions embedded in our carried reserves for U.K. Motor excess-of-loss reinsurance.
We will of course continuously evaluate our reserve position for U.K. Motor based on actual reported loss activity as the ceding companies recalibrate their case reserves now that the new discount rate is in place. Turning back again to our investments we recorded $26.4 million of net interest income and we're factoring in performance fees on realized and unrealized gains and losses registered net investment income of $23.8 million. For assets under HPS management the net interest income yield was 1.6% for the quarter and the net investment income return was 1.2%.
While there were some movement in credit spreads for high-yield bonds and leverage loans during the quarter the beginning and ending spreads were fairly close which resulted in little movement in unrealized gains or losses impacting the indices. Our non-investment grade portfolio on the other hand which has a long market value of approximately $1.9 billion had net unrealized losses in the quarter of $4.5 million reducing the return on total invested assets by roughly 20 basis points.
As our portfolio is actively managed it will generally track the benchmark indices but not always match or exceed the indices in every quarter. Including other comprehensive income the growth in book value was 2% quarter-over-quarter and through six months our book value has grown 8%. We continue to be optimistic about continued strong book value growth for the remainder of the year. One reason for that confidence is that insurance and reinsurance market conditions are noticeably improving in most lines of business.
There's a growing consensus that we've entered if not a hard market but sellers market. Primary rates in most casualty lines with the exception of worker's compensation appear to be firming to a larger extent than previous quarters. Whether this trend will continue and if so for how long is a subject of much debate and I don't pretend to know the answer however the near-term forward outlook is promising.
In particular we continue to see good growth opportunities in insurance space as new program submission activity is strong. In addition property catastrophe rates were up meaningfully for the June quarter renewals. We have a 7.5% quota share of Arch's worldwide property catastrophe excess-of-loss writings. Our premium and exposure from this contract have increased in proportion to Arch's increase in its exposure this renewal season. Our 1-in-250 year U.S. wins from PML grew approximately 10 million.
In relation to our capital and overall portfolio however property catastrophe still represents a much smaller exposure than net carried by most of the reinsurers. More important perhaps than the financial results for the quarter were the positive outcomes achieved in several areas that are significant to our competitive positioning and future results. First the company's financial strength ratings were reaffirmed by both A.M. Best and Kroll. Watford carries an A- rating from A.M. Best and an A rating from Kroll.
The reaffirmation of our ratings with the stable outlook is an important prerequisite for continuing to track quality business. So while not unexpected this was very positive news. The company also completed a $175 million senior note offering with a 6.5% coupon which was done as a private placement. The net proceeds will be used to redeem approximately 75% of our preference shares which initially had an 8.5% coupon and recently converted to a higher floating rate.
This will result in substantial savings going forward which Rob will cover in his remarks. We're particularly pleased that Arch participated for $35 million which further demonstrates Arch's commitment to Watford success and strengthens the alignment of interest. Lastly Watford was added to the Russell 3000 Index in June. This is further evidence of the long-term value creation that we're building. A little over five years ago Watford was only a concept on paper. Today Watford is among the 3000 largest companies actively traded on the major U.S. stock exchange. With those introductory comments
I'll turn now it over to Rob to go through our financial results in more detail.
Robert Hawley -- Chief Financial Officer
Thank you John and good afternoon everyone. I'd like to give you some commentary and observations on our financial results for the second quarter 2019. Net income after tax and payment of preferred dividends for the quarter was $13.8 million which translates to an annualized 5.8% return on average common equity and earnings per diluted common share of $0.61. Diluted book value per share grew to $42.07 million at June 30 2019 a 7.3% increase from year-end 2018.
As John mentioned on July 2 the company completed a 6.5% 10-year $175 million senior notes offering. The net proceeds from the offering will be used to redeem 173 million or 76% of the company's preferred shares on August 1. Calling a substantial portion of the preference shares on August one will result in the third quarter preferred dividend payment of approximately $2.6 million versus the prior quarterly payment of $4.9 million. In subsequent quarters the preferred dividend payment will be approximately $1.2 million for the remaining outstanding shares.
In addition in the third quarter we will recognize an accelerated preferred dividend expense relating to the unamortized original issue discount and underwriting fees of approximately $4.2 million. Overall the refinancing lowers our debt plus preferred capital servicing cost significantly from the preferred floating rate coupon 9.1% to a weighted average debt plus preferred cost of 7.1%. This will result in pro forma annual projected net savings of approximately $4.3 million.
Moving to our underwriting results for the quarter. Our gross premiums written for the second quarter were $162 million a decrease of 7.5% or $13 million versus the same quarter last year. Premium reductions and other specialty and casualty reinsurance were offset in part by premium growth of $20 million in our insurance programs and coinsurance line of business. Other specialty gross premiums were down primarily due to a reduction in one large clients underwriting underlying exposure ceded at this year's renewal.
The remaining decrease is largely attributable to a Q1 2019 nonrenewal of one Motor quota share contract as mentioned on last quarter's call. Our casualty gross premiums were down primarily due to the Q1 2019 nonrenewal of one multi-line quota share contract as well as the continued impact of gradually reduced participations over time on one-cedant professional liability contracts. Insurance programs and coinsurance premium growth was due to the continued expansion of our U.S. and European business.
Our ceded premiums grew 23% year-over-year primarily as the result of the restructured insurance program. We previously participated on a coinsurance basis and now write the entire program on our paper and see the portion of the risk in order to maintain a similar net position. Additionally premium ceded to Arch increased primarily relating to their risk sharing participation on our WICE WSIC and WIC outward quota share retrocession agreements reflecting the gross premium written growth in these platforms.
The Q2 2019 combined ratio was 103.5% 2.9 points higher than the same quarter last year. After removing nonoperating and onetime expenses our adjusted combined ratio for the quarter was 99.9% compared to 99.6% for the same quarter last year. Overall the prior year loss reserve development for the quarter was essentially flat this made up of slightly favorable development in our casualty reinsurance business partially offset by slight adverse development in insurance and other specialty lines.
The general and administrative expense ratio was 6.5% in the 2019 second quarter compared to 4.9% in the 2019 first quarter and 3.4% in the second quarter of 2018. The 1.6 point increase this quarter versus the first quarter of 2019 reflects the timing of certain long-term incentive compensation expenses including a onetime accelerated expense equating to approximately 1% of earned premium. Removing certain corporate nonoperating and nonrecurring expenses our adjusted G&A expense ratio was slightly lower than first quarter of 2019.
Moving to our investment results for the quarter the second quarter net investment return benefited from continued strong net interest income of $26.4 million in line with the second quarter 2018. Realized and unrealized losses totaled $0.9 million or approximately five basis points on average total invested assets. The quarterly investment return for the entire portfolio was 1.1% on average net invested assets of $2.1 billion.
Focusing on our non-investment grade portfolio's results net interest income of $24.5 million or 1.6% of net assets remained steady relative to the second quarter of 2018. As noted in our prior call interest income is the long-term driver of our investment performance and our year-to-date yield of 3.5% is in line with the 3.3% year-to-date yield in 2018. Credit spreads were relatively flat this quarter and our actively managed portfolio recognized a handful of idiosyncratic mark-to-market movements.
Our non-investment grade portfolio recognized net realized and unrealized losses of $4.7 million impacting our return on net assets by 30 basis points. These results compared favorably to our second quarter 2018 realized and unrealized loss of $8.6 million. The non-investment grade borrowing ratio decreased to 15% from 21% in the prior quarter. As credit spreads tightened through the first half of 2019 we reduced our exposure to high yield to the high-yield market through sales of certain bond issuers whose debt prices had appreciated.
Turning to our investment grade portfolio. Net interest income yields are slightly higher than the second quarter of 2018 reflecting higher interest rates in 2019. We recognized $3.8 million of net realized and unrealized gains in the quarter as compared to a loss of $1.9 million in the second quarter of 2018. The unrealized gains and losses largely relate to interest rate movements in the respective quarters within the fair value option portion of our investment grade portfolio.
In addition the investment grade available-for-sale portfolio recognized approximately $3 million of net unrealized gains which is reflected in other comprehensive income. As of the end of June the ending balance sheet net unrealized loss position for the combined investment portfolio was a $79 million. Our total financial leverage ratio defined as debt plus preferred to total capital is 19% at June 30 2019. After the preference share call the pro forma total financial leverage is expected to remain consistent with Q2 2019.
With that I'll now hand it back to John.
John Fredrick Rathgeber -- Chief Executive Officer and Director
Thanks Rob. And now I'd like to take a moment to mention the newly proposed regulations relating to the Passive Foreign Investment Company or PFIC status of insurance companies issued by treasury about three weeks ago. These proposed guidelines replaced earlier guidelines that came out in 2015 but were never finalized.
The regulations elaborate on the changes to the PFIC provisions relating to insurance companies containing contained in 2017 Tax Reform Act and introduced some new proposals for determining whether a non-U. S. insurance company's business is considered to be "activity conducted". It is important to note that the regulations would apply prospectively more specifically the regulations would not be effective until the year after they are finalized which means there will be advance notice of the final rules before they take affect.
In addition treasury has requested comments on a number of the proposals and the nature of the questions indicates the treasury has uncertainty about some of the regulations and appears open to modifying them if reasonable considerations are presented. We expect that there will be significant comments on the regulations from numerous companies and the trade associations. And we therefore view these proposals as preliminary and likely to further evolve.
Naturally we're studying these developments with our counsel and are working closely with the relevant trade associations as they develop response letters. And we'll continue to closely monitor the issue. The bottom line is that we believe our business is in fact actively conducted and we would expect to satisfy any reasonable test that may be adopted in the future for determining act of conduct.
And with that we now be pleased to take your questions.
Questions and Answers:
Operator
[Operator Instructions] Our first question comes from Pablo Singzon with JPMorgan. Your line is now open
Pablo Singzon -- JPMorgan Chase & Co. -- Analyst
Thank you, So gross interest income in the below investment grade portfolio declined about 13% sequentially while gross invested assets were down only low to mid-single digits even if you adjust for unrealized losses. Can you help us think about the moving pieces behind that divergence? And how should we think about interest income going forward whether in asset dollar terms or as a yield?
Jon Levy -- President and Chief Risk Officer
This is Jon Levy. I think some of the things you've already pointed out are some of the things we will point to. I mean the first thing is obviously there was a decrease in leverage in the portfolio through the quarter. And as obviously as we decreased leverage the return the interest income on net assets can be expected to decrease. The other thing just to point out is that the mix in the portfolio I think you can see that we've reduced our exposure to certain bonds and you can kind of you can expect kind of our portfolio to continue to have small minor movements quarter-to-quarter for interest income just as we either reposition our portfolio or as we kind of or as we take down leverage or increase leverage.
So well I think what you'd see is our net interest income for the quarter is relatively consistent with where it has been in prior quarters. And even it's concretely our year-to-date net interest income is higher than it was about a year ago. So I wouldn't make too much of this. And I think it's just kind of normal fluctuation that you can expect to see which shouldn't change all that dramatically quarter-over-quarter.
Pablo Singzon -- JPMorgan Chase & Co. -- Analyst
Okay. And just as a follow-up to that Jon. So I think about half of your investment portfolio is in floating rate assets. How much has it declined in short-term rates this year impact the year results and could there be additional impacts in future periods?
Jon Levy -- President and Chief Risk Officer
A good portion you're correct. A good portion of our portfolio is in floating rate assets. And if there is decreases on LIBOR you can expect to see the coupon interest as similarly decrease. The one thing that I would note as a partial offset to this is as we apply investment leverage a lot of that investment leverage is borrowed at a LIBOR rate also. So you can also see a corresponding decrease on our borrowing cost. So net-net it's probably negative. But I think there's some embedded natural hedges embedded in our in the way we do our investment leverage.
Pablo Singzon -- JPMorgan Chase & Co. -- Analyst
Okay. Thank you.
Operator
[Operator Instructions] The next question comes from Christopher Campbell with KBW. Your line is now open.
Christopher Campbell -- KBW -- Analyst
Yes I do. Good afternoon gentlemen.
John Fredrick Rathgeber -- Chief Executive Officer and Director
Hi Chris.
Christopher Campbell -- KBW -- Analyst
I guess first question is just the trading range and everything. So I know you guys now are like below 50% of book and I know you guys have the $75 million share repurchase authorization. So I guess why didn't Watford buyback any shares in Q2? And how should we think about modeling this going forward?
John Fredrick Rathgeber -- Chief Executive Officer and Director
So we definitely intend to implement a share repurchase program hopefully by the end of the year. And really the only reason why we haven't is that we're regulated by the SEC. And as they consider our listing to an effect have been an offering now we're subject to the same restrictions as any other company that would have done even a traditional IPO. And obviously they don't want us in their eyes to be manipulating stock price in anyway. And we don't have anything in writing from them.
We've discussed with them and have verbal indications that they would like us to wait on the order of say six months or so from the end of the effective period of the offering. So obviously we have to respect their sentiments. And that's really the issue. We just need to let some time go by when we know the SEC will have no issues whatsoever with us implementing the program.
Christopher Campbell -- KBW -- Analyst
Got it. So it's basically you just have like 180-day lockup from when the IPO finish right? I mean the direct lifting sorry.
John Fredrick Rathgeber -- Chief Executive Officer and Director
Yes I mean it's not as formal as the legal lockup but that's kind of what the SEC has indicated to us that would be make them comfortable.
Christopher Campbell -- KBW -- Analyst
Okay got it. And then about when would that lockup period end?
John Fredrick Rathgeber -- Chief Executive Officer and Director
So six months from the end of the effective period. So it's really like seven months from moment when you lift it. So I think you're talking like the end of October would be that's when conceivably if this could start to kick in. But obviously we need to go back and reconfirm that because again that was based on earlier discussions that we had several months ago with the SEC. And we obviously want to reconfirm before we actually do it.
Christopher Campbell -- KBW -- Analyst
Got it. But then you'll be like in like the 3Q earnings like blackout period. So would you guys think about putting in a trading plan?
Robert Hawley -- Chief Financial Officer
Chris. We're exploring open market and it can be 5-1 plant
Christopher Campbell -- KBW -- Analyst
Awesome thanks for that extra color. Quick question and then just moving on to the unrealized gains and manner of the net operating income but it does effect like the book value. So how should we think about forecasting the unrealized and realized gains giving kind of all the moving pieces that you guys have like the leverage portfolio shift. What's a good way for us on the outside to like think about modeling there?
John Fredrick Rathgeber -- Chief Executive Officer and Director
Chris this is John again. It's I mean I think the first thing we would probably point you to is just the indices and maybe kind of whatever your firm's expectations are for how those things will move. I think and that we know that our portfolio will track the indices but won't match the indices exactly because we do have an actively managed portfolio and we will have certain positions that go up and down that won't exactly track where the indices are. I think we're sympathetic to anyone trying to model this out as quarter advance. I think it's probably not easy but I think what we probably point to is a good guide but just be tracking the indices and trying to make adjustments from there.
Christopher Campbell -- KBW -- Analyst
Got it awesome. And then just one last one on property cap growth. I guess how much you have as doubled? Like so how much of that was rates versus exposure? So like what was the rate increase all else equal on your portfolio?
John Fredrick Rathgeber -- Chief Executive Officer and Director
So it was roughly in the magnitude of 15% to 20% on a risk exposure basis adjusted basis. So that's in respect to the forward renewals.
Christopher Campbell -- KBW -- Analyst
Okay got it. And then basically we could back that out it in the rest as exposure and then that's contributing to the $10 million pickup in the P&L?
John Fredrick Rathgeber -- Chief Executive Officer and Director
That's correct.
Christopher Campbell -- KBW -- Analyst
Well thanks for the answers. That's the end. Thank you.
John Fredrick Rathgeber -- Chief Executive Officer and Director
All right. Thanks Chris.
Operator
And I'm showing no further questions in the queue at this time. I'd like to turn the call back to John Rathgeber for any closing remarks.
John Fredrick Rathgeber -- Chief Executive Officer and Director
Okay thanks everyone for your time today. I look forward to speaking with you again next quarter. Enjoy the rest of your day.
Operator
[Operator Closing Remarks]
Duration: 25 minutes
Call participants:
John Fredrick Rathgeber -- Chief Executive Officer and Director
Robert Hawley -- Chief Financial Officer
Jon Levy -- President and Chief Risk Officer
Pablo Singzon -- JPMorgan Chase & Co. -- Analyst
Christopher Campbell -- KBW -- Analyst
