Arch Capital Group Ltd. — Third Quarter 2019 Form 10-Q
Business context and reporting period
Arch is a Bermuda-based global insurer, reinsurer and mortgage insurer. This unaudited quarterly report covers the three and nine months ended September 30, 2019, compared with the corresponding 2018 periods. PwC reviewed the interim statements but did not audit them. The consolidated results include Watford, although Arch owns approximately 11% of its common equity; Watford is responsible for its own operations and liabilities.
Financial results and key metrics
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net premiums earned | $1.438B | $1.291B | $4.271B | $3.863B |
| Total revenues | $1.683B | $1.404B | $5.185B | $4.099B |
| Net income available to Arch common shareholders | $382.1M | $217.0M | $1.279B | $587.5M |
| Diluted earnings per common share | $0.92 | $0.53 | $3.11 | $1.42 |
| After-tax operating income available to common shareholders | $261.0M | $242.3M | $854.3M | $720.0M |
| Operating return on average common equity | 10.3% | 11.4% | 12.0% | 11.4% |
| Net investment income | $161.5M | $144.0M | $473.5M | $406.4M |
| Net realized investment gains (losses) | $62.5M | ($51.7M) | $324.9M | ($239.3M) |
- Premium growth: Net premiums written increased 21.0% to $1.613B in Q3 and 13.3% to $4.584B for the nine-month period. Management attributed growth to business expansion, rate increases, the U.K. renewal-rights acquisition, and mortgage insurance in-force growth.
- Underwriting: The consolidated combined ratio was 84.2% in Q3, versus 82.3% a year earlier; for nine months it was 82.1% in both periods. Q3 segment combined ratios were 104.0% for insurance, 100.3% for reinsurance and 24.6% for mortgage. Insurance and reinsurance therefore recorded underwriting losses in Q3; mortgage generated $262.5M of underwriting income.
- Investment returns and margins: Pre-tax total investment return before expenses was 1.00% for Q3 and 6.20% for nine months, compared with 0.31% and (0.19%) in 2018. The large swing in realized gains was a major contributor to GAAP earnings growth; operating income, which excludes specified investment and other items, grew more moderately. Nine-month income tax expense was $128.5M, an 8.5% effective rate versus 10.5% in 2018.
- Cash flow: Consolidated operating cash flow was $1.543B for nine months, compared with $1.121B; investing activities used $1.250B and financing activities used $46.5M. Excluding Watford, management reported operating cash flow of $1.367B versus $947.7M and an increase in cash and restricted cash of $221.0M.
- Balance sheet and capital: At September 30, total assets were $35.573B, total liabilities $23.511B, and shareholders’ equity $12.013B. Equity available to Arch was $11.158B. Book value per share was $25.61, up from $24.64 at June 30 and $21.15 a year earlier. Total investable assets were $24.30B, including $21.57B held by Arch and $2.73B attributable to Watford.
- Debt and liquidity: Senior notes were $1.871B and revolving credit borrowings were $490.7M on the consolidated balance sheet; the latter were attributable to Watford. Arch’s capital-structure table reported $1.734B of debt, 13.5% debt to total capital and 19.5% debt plus preferred equity to total capital. Arch reported $962.5M of consolidated cash and restricted cash. Management expects the next 12 months’ liquidity needs to be met by operating and investment cash flows, cash, short-term investments, investment maturities or sales, and credit facilities. Arch MI U.S. met PMIERs requirements with estimated sufficiency of 154%, up from 141% at year-end 2018.
Material changes, outlook and risks
- Common-shareholder net income rose sharply versus 2018, in part because realized investment results changed from losses to gains and investment returns improved. Operating ROAE was lower in Q3 but higher for the nine-month period.
- Reserve releases were favorable but smaller than in the comparable periods: $52.9M in Q3 2019 versus $79.6M, and $130.5M for nine months versus $195.2M. Mortgage contributed most of the 2019 nine-month favorable development ($92.5M); insurance and reinsurance also reported adverse development in certain longer-tailed lines.
- Management’s through-cycle objective is an average operating return on average equity of 15% or greater; this is a long-term objective, not specific quarterly earnings guidance. Management described modest renewal-rate increases in insurance, selected improving reinsurance markets, and generally favorable mortgage conditions, while noting continued pricing competition in U.S. mortgage insurance.
- Management emphasized underwriting discipline, including focusing on small and medium-sized accounts, reducing exposure in more commoditized lines, and using reinsurance to manage volatility. It noted that catastrophe-exposed business can increase earnings volatility.
- Catastrophe losses affected the quarter: insurance’s current-year catastrophe activity was 4.3 loss-ratio points, while reinsurance’s was 12.2 points, including Hurricane Dorian and Typhoon Faxai. The filing said Typhoon Hagibis, California wildfires and other fourth-quarter events could affect results, but estimates were not yet reasonably determinable.
- As of October 1, modeled peak-zone catastrophe losses included $414M for a Northeastern U.S. windstorm, $398M for Florida Tri-County and $357M for the Gulf of Mexico. The modeled mortgage severe-economic-event loss was approximately 9% of tangible equity. Management cautioned these models are uncertain and actual losses could differ materially.
- Other notable items: Arch acquired renewal rights to a U.K. commercial-lines book effective January 1, 2019; Watford issued $175M of 6.5% senior notes and redeemed a portion of preference shares; and the board increased Arch’s share repurchase authorization to $1.0B through December 31, 2021 after the quarter. No litigation was identified as expected to have a material adverse effect, and the filing reported no material changes to previously disclosed risk factors.
Important facts for investors to verify
- How much of earnings and book-value growth is repeatable underwriting and operating performance versus investment gains, unrealized investment marks and foreign-exchange effects.
- Whether insurance and reinsurance underwriting margins improve, particularly given Q3 combined ratios above 100% and reduced favorable reserve development.
- The durability of mortgage profitability and favorable claims experience, including the effects of housing and economic conditions, refinancing, persistency and reserve assumptions.
- Fourth-quarter catastrophe claims and the adequacy, availability and counterparty quality of reinsurance recoveries and other risk-transfer protection.
- Liquidity and capital availability across regulated subsidiaries, Watford’s separately borne obligations, investment commitments, and the execution and economics of the expanded repurchase authorization.