Arch Capital Group Ltd. — 2013 Form 10-K
Reporting period: Fiscal year ended December 31, 2013. The filing also reports unaudited fourth-quarter results. Amounts are U.S. dollars.
Business context
Arch is a Bermuda-based global property and casualty insurer and reinsurer focused on specialty lines. In 2013, it wrote $3.35 billion of net premiums and reported $687.8 million of net income available to common shareholders. U.S. mortgage insurance acquisition activity occurred after year-end and is discussed below.
Key financial metrics
| Metric | 2013 | 2012 |
|---|---|---|
| Net premiums written | $3.351 billion | $3.052 billion |
| Net premiums earned | $3.146 billion | $2.935 billion |
| Total revenues | $3.526 billion | $3.482 billion |
| Income before income taxes | $742.5 million | $589.4 million |
| Net income | $709.7 million | $593.4 million |
| Net income available to common shareholders | $687.8 million | $557.7 million |
| Diluted earnings per share | $5.07 | $4.03 |
| After-tax operating income available to common shareholders | $595.7 million | $350.6 million |
| Operating return on average common equity | 11.7% | 7.7% |
| Cash provided by operating activities | $850.9 million | $921.6 million |
| Total shareholders’ equity | $5.647 billion | $5.169 billion |
| Book value per common share | $39.82 | $36.19 |
The 2013 consolidated combined ratio was 85.9%, compared with 95.4% in 2012. Insurance’s combined ratio was 96.6% (104.9% in 2012); reinsurance’s was 69.9% (80.2%). Ratios below 100% indicate underwriting profit.
Cash and invested assets totaled $14.05 billion at year-end, including $434.1 million of cash. Total debt was $900 million: $800 million of senior notes and $100 million drawn under a revolving credit agreement. The parent company reported only $5.8 million of readily available cash, short-term investments and marketable securities excluding regulated subsidiaries; access to subsidiary dividends is subject to regulatory and other restrictions.
Changes versus prior period and fourth quarter
- Net premiums written increased 9.8%; net premiums earned increased 7.2%. Reinsurance written premiums rose 14.3%, and insurance written premiums rose 6.8%.
- Underwriting income increased to $451.7 million from $143.0 million. Lower catastrophe losses and favorable prior-year reserve development supported results.
- Prior-year reserve development was favorable by $264.0 million, versus $221.5 million in 2012. The 2013 release included $218.9 million in reinsurance and $45.1 million in insurance.
- Net investment income declined to $267.2 million from $294.9 million; the investment-income yield fell to 2.12% from 2.51%. Net realized gains also fell, to $74.0 million from $194.2 million.
- Operating cash flow decreased to $850.9 million, which management attributed primarily to higher paid losses, partly offset by increased premium receipts. Investing cash outflow was $1.308 billion; financing cash inflow was $524.0 million, including proceeds from the new senior notes.
- Fourth-quarter 2013 net income was $161.5 million and diluted EPS was $1.14, versus $19.2 million and $0.10 in fourth-quarter 2012. Fourth-quarter underwriting income was $128.3 million, versus an underwriting loss of $91.3 million. Fourth-quarter net premiums written were $748.9 million and earned premiums were $839.4 million.
Outlook, risks and unusual items
- Management described reinsurance market conditions as competitive, with softening terms and conditions as capacity increased. It cited improved pricing and exposure growth in selected insurance areas, including excess and surplus, contract binding and program lines.
- Management’s objective is average operating ROAE of at least 15% over the insurance cycle; the 2013 result was 11.7%. Management said low interest rates mean increases are needed in many lines to meet return requirements, and emphasized underwriting discipline.
- Catastrophe risk remains material. The company seeks to limit modeled 1-in-250-year net probable maximum loss from a severe event in any geographic zone to approximately 25% of shareholders’ equity. January 1, 2014 modeled peak-zone losses included $801 million for a Northeastern U.S. windstorm, $670 million for Gulf of Mexico windstorm and $566 million for Florida Tri-County windstorm. Management cautioned actual losses could differ materially.
- Loss reserves are estimates subject to uncertainty and limited company-specific historical experience. Favorable reserve development materially benefited 2013 results; further development may differ. Reinsurance recoverables expose the company to counterparty risk.
- On December 13, 2013, Arch-U.S. issued $500 million of 5.144% senior notes due 2043, guaranteed by ACGL. The $300 million of 7.35% notes due 2034 remained outstanding. The $100 million revolving credit borrowing was due in August 2014; the credit agreement also expired then. The company reported compliance with its covenants at year-end.
- On January 30, 2014, subsidiaries acquired CMG Mortgage Insurance Company and PMI’s mortgage insurance platform for $253 million. Further consideration may be payable based on results of CMG’s pre-closing portfolio. Arch MI U.S. received Fannie Mae and Freddie Mac eligibility subject to ongoing requirements; integration, capital, customer acquisition and legacy-portfolio performance are stated risks. The transaction was subsequent to the 2013 reporting period.
- No litigation or arbitration was identified as expected by management to have a material adverse effect. The independent auditor reported that the financial statements were fairly presented under U.S. GAAP and internal control over financial reporting was effective.
Most important facts for investors to verify
- How sustainable underwriting profitability is after the benefit of $264.0 million in favorable prior-year reserve development and relatively lower catastrophe losses.
- Whether the mortgage insurance acquisition meets GSE capital and eligibility conditions, attracts lender customers, and performs as expected; also track integration costs and potential contingent consideration.
- How the company refinances or replaces the revolving credit agreement due in August 2014, and the impact of the additional long-dated debt on interest expense and capital flexibility.
- Whether investment income and returns can support management’s 15% operating ROAE objective amid low yields and market-value sensitivity.
- Whether catastrophe exposures, reinsurance recoverables, and the timing of claims payments remain consistent with liquidity and risk limits.