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Axis Q4: ROE expansion thesis remains a work in progress

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Axis Capital reported an operating loss of $0.20/share, modestly better than the consensus loss of $0.29/share. Axis had pre-announced certain data items on January 19 so the focus was on longer-term trends. The key topics for those watching the franchise include tracking its progress on underlying loss ratio improvement, work to manage its catastrophe exposure and success in rationalizing its expense ratio.

Below are the main takeaways:

Underlying loss ratio improves but will this last? 

For the year, Axis’ underlying loss ratio improved 2.9pts to 57.7%. By segment, the insurance business improved 1.9pts to 55.1%, and reinsurance saw a 3.4pt improvement to 60.6%. Below, we highlight the quarterly shift in the underlying loss ratio. Additionally, Axis has continued to pivot away from the more volatile classes in reinsurance over the past several years. In theory, this should continue to reduce the variation seen below.

However, recent industry commentary has focused on returning to a more normalized loss environment as and when the economy reopens. It remains to be seen the degree to which Axis is recognizing one-time benefits and the degree to which it is reflecting rate in excess of underlying trend.

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Business mix shift reflects less reliance on property catastrophe

One of the challenges of Axis’ smaller franchise is the extreme volatility seen in results when writing attractive return classes in the reinsurance segment. Axis historically faced a similar volatility in its results, which resulted in a valuation overhang. Over the past year or so, Axis has reduced its property-catastrophe writings and pivoted towards insurance, which should reduce the volatility albeit earning a lower return. It also continued to shrink its reinsurance book in the aggregate, with Q4 writings down 19% at $244mn and its full-year top-line down 13% at $2.8bn.

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Exposure management continues to stabilize probable maximum losses

To reduce Axis’ exposure to prop-cat events, it continues to pivot away from catastrophe exposed lines and increase its exposure to professional lines, liability, and motor in the reinsurance segment. Consequently, its PMLs stand at half of what they were a decade ago. Although the data below reflects a slight uptick for 2020, this reflects the expiration of certain corporate-wide covers at year-end. It is likely that mid-year PML’s will continue to decline vs. 2020.

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Expense ratio improvement to continue over 2021

Over the years, Axis has embarked on expense rationalization exercises to align with its peer group. In 2019, it was targeting $100mn of savings as of year-end 2020. $70 million of this was achieved in 2019 with the remainder in 2020. For 2020, its expense ratio was 34.5% vs. 36.2% for 2019. We anticipate that Axis will continue to work on reducing its expense ratio by an additional 1-2% over 2021.

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Valuation at a relative discount

Axis has continued to trade at a relative discount to RenaissanceRe and Everest Re in a shrinking cohort of publicly-traded (re)insurers. This discount reflects its single-digit ROE as well as its historically volatile results in recent years. The last time Axis achieved a double-digit ROE was in 2014. Its target to achieve a double-digit ROE going forward also faces headwinds from a reduction in new money reinvestment rates. Axis’ premium to common equity leverage is at 0.9x and invested assets leverage is at 3x. 

This implies that to offset a reinvestment rate decline by 100 basis points based on the current investment climate would entail an additional 270-basis point improvement in its combined ratio for 2021. With 100-200 basis points coming from the expense ratio, this would imply a target to reduce loss ratios by another 200 or so basis points on the lower end for 2021.

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Pricing commentary should be mixed

Axis provides pricing commentary on its conference call, although this could turn into a balancing act based on comments RenaissanceRe made yesterday on its earnings call.

RenRe noted that: “Heading into the renewal, we expected retro and U.S. property cat markets to provide us with the greatest opportunities. While this was the case up until mid-December, ultimately, the market dynamics in retro and property cat reinsurance were not as strong as the market initially expected."

However, it added that casualty and specialty lines "continued to experience extremely favorable pricing dynamics" in excess of its expectations.

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