ARCH CAPITAL GROUP LTD. quarterly report, Q3 FY2017

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Arch Capital Group Ltd. — Q3 2017 Form 10-Q

Business context and period: Bermuda-based global insurer, reinsurer and mortgage insurer. This unaudited quarterly report covers the three and nine months ended September 30, 2017; comparisons are with the corresponding 2016 periods unless stated otherwise. United Guaranty Corporation (UGC), acquired on December 31, 2016, materially expanded the mortgage segment, so 2017 mortgage growth is not directly comparable with 2016.

Financial performance

  • Third quarter: Total revenue was $1.480 billion, up 23.5%. Net loss was $45.2 million versus net income of $303.6 million; loss available to common shareholders was $52.8 million, or $0.39 per diluted share, versus income of $247.4 million, or $1.98 per diluted share.
  • First nine months: Revenue was $4.206 billion, up 21.0%. Net income was $427.9 million versus $728.6 million; income available to common shareholders was $363.0 million versus $602.3 million, or $2.61 diluted EPS versus $4.84.
  • Underwriting: Consolidated Q3 combined ratio rose to 111.8% from 87.5%; underwriting loss was $142.2 million versus income of $127.6 million. For nine months, the combined ratio was 93.1% versus 89.0%, with underwriting income of $265.3 million versus $360.0 million. Insurance and reinsurance Q3 combined ratios were 138.7% and 127.4%; mortgage was 33.4%.
  • Catastrophe and reserves: Q3 estimated net catastrophe losses were $347.8 million in insurance and reinsurance, plus $19.8 million in the “other” segment, primarily from Hurricanes Harvey, Irma and Maria, Mexican earthquakes and other events. Prior-year reserve development was favorable by $45.2 million in Q3 and $197.8 million year to date.
  • Investments: Net investment income rose to $116.5 million from $93.6 million for Q3 and to $345.5 million from $275.7 million year to date. Net realized gains declined to $66.3 million from $125.1 million for Q3 and to $122.2 million from $230.6 million year to date. Equity-method investment fund income was $111.9 million year to date, versus $32.1 million.
  • Cash flow: Consolidated operating cash flow was $1.081 billion for nine months, versus $1.037 billion; investing cash use was $880.6 million versus $1.255 billion, and financing cash use was $194.9 million versus cash provided of $253.8 million. Cash ended the period at $862.4 million.
  • Balance sheet and capital: Total assets were $32.625 billion and total shareholders’ equity $9.772 billion at September 30. Equity available to Arch was $8.911 billion; book value per share was $59.61, compared with $55.19 at year-end 2016. Arch’s stated capital structure showed $2.133 billion of debt and $11.044 billion of total capital; debt-to-total-capital was 19.3%. The consolidated balance sheet separately reports $1.733 billion of senior notes and $826.2 million of revolving borrowings, including Watford Re.
  • Liquidity: Arch reported $19.70 billion of investable assets, excluding $2.30 billion attributable to Watford Re, and expected next-12-month needs to be met by operating cash generation, investment income, cash and short-term investments, investment maturities or sales, and credit facilities. Unfunded investment commitments were approximately $1.58 billion.

Material changes and management commentary

  • UGC acquisition drove the mortgage segment’s expansion: Q3 net premiums written increased 260.1% to $290.1 million, and mortgage underwriting income increased to $186.4 million from $41.2 million. U.S. mortgage new insurance written was $17.7 billion in Q3 versus $8.8 billion.
  • Management described property-casualty markets as competitive, with slight rate deterioration in some areas and flat or lower writings in certain lines. It said catastrophe activity could improve pricing and create growth opportunities, while emphasizing underwriting discipline and reinsurance use.
  • Management’s objective is an average operating return on average equity of 15% or more over the insurance cycle—not a near-term earnings forecast. Operating ROAE was negative 5.3% for Q3 and 4.4% year to date, versus 9.3% and 9.4% in 2016.
  • Management said mortgage delinquencies may rise in areas affected by hurricanes and wildfires, principally in Q4; the filing did not reserve for future notices not yet reported and stated management did not expect related mortgage losses to be material.
  • After quarter-end, Arch estimated California wildfire losses at $30 million to $55 million pre-tax, net of reinsurance and reinstatement premiums. The estimate was preliminary and subject to significant uncertainty.
  • Arch completed a $230 million offering of 5.45% Series F preferred shares and redeemed $230 million of 6.75% Series C preferred shares. A $6.7 million accounting loss on redemption reduced common earnings but did not affect total equity or cash flow.

Risks, contingencies and other items

  • Key risks include catastrophe severity and frequency, reserve-estimation uncertainty, competitive pricing, market and investment volatility, foreign-exchange movements, reinsurer counterparty performance, and successful integration of acquired businesses.
  • Arch’s modeled October 1 peak-zone catastrophe losses were $493 million for a Northeastern U.S. windstorm, $442 million for Gulf of Mexico windstorm and $383 million for Florida Tri-County windstorm. Management cautioned that modeled estimates are not maximum exposures and actual losses may differ materially.
  • Management reported no litigation or arbitration expected to have a material adverse effect and no material changes to previously disclosed risk factors. The interim statements received an accountant review, not an audit.
  • Disclosure controls were assessed as effective. UGC’s internal controls were excluded from management’s assessment because its reporting systems were not yet fully integrated; management expected integration during Q4 2017.
  • Adoption of the financial-instruments accounting standard in 2018 was expected to materially affect where changes in equity-security fair values are reported, moving them into net income; management did not expect a material effect on financial position, cash flows or total comprehensive income.

Most important facts for investors to verify

  1. How much of the Q3 underwriting deterioration reflects catastrophe losses, and how estimates develop as claims from the 2017 events mature.
  2. Whether favorable prior-year reserve releases—especially in reinsurance and mortgage—continue, and how sensitive reserves are to updated claims experience.
  3. UGC integration progress, the sustainable profitability and capital requirements of the enlarged mortgage business, and the quality of new business written.
  4. Debt and liquidity on a consistent basis, distinguishing Arch’s capital structure from consolidated amounts that include Watford Re, and the implications of $1.58 billion in unfunded investment commitments.
  5. The outcome of the California wildfire loss estimate, subsequent mortgage delinquencies, and any changes to catastrophe pricing or exposure after quarter-end.