ARCH CAPITAL GROUP LTD. quarterly report, Q2 FY2021

Business context and reporting period

Arch Capital Group Ltd. is a Bermuda-based global insurer, reinsurer and mortgage insurer. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2021; comparisons are with the corresponding 2020 periods unless stated otherwise. Amounts below are in U.S. dollars.

Financial performance and position

Underwriting improved across all three underwriting segments. Q2 combined ratios were 94.3% for insurance, 87.1% for reinsurance and 26.5% for mortgage; ratios below 100% indicate underwriting profit. Arch reported Q2 operating ROAE of 13.0%, versus 0.6% a year earlier. GAAP results also included investment gains and equity-method fund income; these can be volatile and are excluded from management’s non-GAAP operating-income measure.

For the six months, operating cash flow was $1.613bn, investing cash flow was $(1.094)bn and financing cash flow was $22.4m. Cash and restricted cash ended the period at $1.818bn, including $1.234bn of balance-sheet cash and $584.4m of restricted cash. Short-term investments were $2.249bn.

At June 30, total assets were $46.482bn, total liabilities $31.519bn and total shareholders’ equity $14.905bn. Consolidated senior notes were $2.862bn and revolving credit agreement borrowings $155.7m; Arch’s capital-structure presentation excluding Watford reported $2.724bn of senior notes and debt-to-total-capital of 16.3%. Arch available capital was $16.710bn. Book value per share was $32.02, up 4.8% from March 31 and 15.9% year over year. Arch issued $500m of Series G preferred shares at a 4.55% dividend rate and repurchased 13.1m common shares for $485.3m during the first half.

Material changes versus the prior period

• Premium growth and stronger underwriting drove the improved results: Q2 net premiums earned rose about 27%, and the combined ratio improved 19.8 percentage points. Lower catastrophe losses than in the 2020 comparison period, including COVID-related impacts in 2020, contributed to the loss-ratio improvement.
• Q2 net investment income fell about 15%, reflecting lower market yields; the annualized pre-tax investment-income yield was 1.47% versus 1.92%. Q2 realized gains were also lower than the unusually high prior-year quarter, while equity-method investment funds moved from a $65.1m loss to $122.2m of income.
• Arch acquired a 29.5% stake in Coface for approximately $546m. First-half income from operating affiliates included a $74.5m one-time acquisition gain; a further approximately $36m gain was deferred and is generally expected to be recognized over five years.
• Watford was consolidated through June 30 despite Arch owning about 10% of its common equity. Its acquisition by an Arch subsidiary and third-party investors closed July 1; Arch expects to stop consolidating Watford from that date and anticipates a third-quarter gain of approximately $65m.

Outlook, commentary and risks

Management’s 2021 priorities are to grow where pricing supports returns above the cost of capital, manage the mortgage portfolio through recovery, and optimize investments and capital. Arch reported a weighted property-casualty rate increase of about 10% in Q2, its sixth consecutive quarter of increases, and expects improved underwriting margins over the next several quarters as rate increases earn through. It expects to continue growing where pricing meets its return thresholds.

U.S. primary mortgage delinquencies were 3.11% at June 30, approximately 40% below the year-earlier level, but remained elevated in the context of recession effects and COVID-19 forbearance. U.S. primary mortgage insurance in force was about $278bn; total mortgage-segment insurance in force was $422bn. Management noted that refinancing had slowed and expected persistency to improve through the remainder of 2021. Arch’s estimated PMIER sufficiency ratio was 196%, versus 173% at year-end 2020. Bellemeade structures provided approximately $4.7bn of aggregate mortgage reinsurance coverage.

Key risks include catastrophe and severe economic losses, COVID-related mortgage claims, uncertainty in loss-reserve estimates, inflation and investment-market volatility, and counterparty or reinsurance recoverability risk. Management’s modeled peak catastrophe losses and mortgage stress estimates are not maximum exposures and actual losses could differ materially. Investment commitments were approximately $2.4bn at June 30. Arch said it expected its next 12 months’ liquidity needs to be met through underwriting and investment cash flows, cash and short-term investments, investment maturities or sales, and credit facilities. No litigation or arbitration was identified as expected to have a material adverse effect, and the filing reported no material change in previously disclosed risk factors.

Most important facts for investors to verify

• How much of the earnings and book-value improvement reflects recurring underwriting performance versus volatile investment results and the Coface one-time gain.
• Whether favorable prior-year reserve development continues and whether catastrophe losses, inflation or mortgage delinquencies create adverse reserve development.
• Watford’s post-July 1 accounting treatment, the expected approximately $65m gain, and the effect of removing its results and balances from future consolidated reporting.
• Mortgage portfolio performance as forbearance and refinancing trends change, including delinquency rates, persistency and capital sufficiency.
• Liquidity and capital deployment, including the preferred-share proceeds and intended Series E redemption, share repurchases, and funding of investment commitments.

PricewaterhouseCoopers reviewed the interim financial statements and reported that it was not aware of material modifications needed for GAAP conformity; this was a review, not an audit.