Arch Capital Group Ltd. — FY 2012 Form 10-K
Business context and period. Bermuda-based global property-and-casualty insurer and reinsurer focused on specialty lines. This annual filing covers the year ended December 31, 2012; amounts are U.S. dollars. Fourth-quarter figures are noted separately where relevant.
Financial performance and position
- Premiums and revenue: Net premiums written rose 14.2% to $3.05 billion; net premiums earned increased 11.5% to $2.94 billion. Total revenue was $3.48 billion, up 13.7%.
- Profit: Net income was $593.4 million, versus $436.2 million in 2011; net income available to common shareholders was $557.7 million ($4.03 diluted EPS), up from $410.3 million ($2.97). After-tax operating income, a non-GAAP measure, was $350.6 million, or $2.54 per diluted share; operating ROAE was 7.7% versus 7.2%.
- Underwriting and margins: Combined ratio improved to 95.4% from 98.3%. Reinsurance delivered $230.7 million of underwriting income and an 80.2% combined ratio. Insurance recorded an $87.6 million underwriting loss and a 104.9% combined ratio. Fourth-quarter consolidated underwriting loss was $91.3 million; Superstorm Sandy was among the quarter’s catastrophe losses.
- Investment results: Net investment income fell to $294.9 million from $338.2 million as yields declined; investment income yield was 2.51% versus 2.89%. Net realized gains increased to $194.2 million, and equity-method investment income was $73.5 million, compared with a $9.6 million loss in 2011. Portfolio pre-tax total return was 5.88%, above the 4.90% benchmark.
- Cash flow: Operating cash flow was $921.6 million, compared with $866.1 million. Investing activities used $396.0 million and financing activities used $513.0 million; cash increased $19.3 million to $371.0 million.
- Capital, debt and liquidity: Total shareholders’ equity was $5.17 billion; common book value per share increased 13.9% to $36.19. Investable assets were $13.05 billion. Debt comprised $300 million of senior notes and $100 million of revolver borrowings. The company reported compliance with credit-facility covenants and Bermuda capital requirements. Parent-company readily available cash, short-term investments and marketable securities outside regulated subsidiaries totaled $14.7 million; subsidiary dividend capacity is subject to regulatory constraints.
- Reserves: Gross loss reserves were $8.93 billion and net reserves were $7.10 billion, up from $8.46 billion and $6.64 billion, respectively. Prior-year net favorable reserve development was $221.5 million, down from $285.0 million in 2011.
Material changes versus 2011
- Reinsurance net premiums written grew 28.9%, including growth in specialty, mortgage and U.K. motor business and the April 2012 acquisition of Ariel Re’s credit and surety reinsurance operations. Insurance net premiums written rose 6.0%.
- Reinsurance underwriting income increased to $230.7 million from $121.3 million, aided by lower catastrophe losses and favorable prior-year development. Insurance underwriting loss widened to $87.6 million from $77.3 million; its combined ratio increased to 104.9% from 104.5%.
- Common book value per share rose from $31.76 to $36.19. Share repurchases were $172.1 million, compared with $287.6 million in 2011.
- In April 2012, the company issued $325 million of 6.75% Series C preferred shares and redeemed $325 million of Series A and B preferred shares. The associated $10.6 million accounting loss did not affect total equity or cash flows.
- The company sold its remaining TALF investments and extinguished the related financing in fourth-quarter 2012.
Outlook, commentary and risks
- Management described the market as competitive, with modest rate improvement across most lines, but said further increases were needed in many lines to meet return objectives given low investment yields. It targets average operating ROAE of at least 15% over the insurance cycle; 2012’s result was 7.7%.
- Management emphasized underwriting discipline, smaller and medium-sized accounts and short-tail business, while noting catastrophe-exposed business remains significant and may increase earnings volatility.
- Catastrophe exposure is a central risk. The company’s modeled peak zones as of January 1, 2013 included Northeastern U.S. windstorm ($867 million net probable maximum pre-tax loss), Gulf of Mexico windstorm ($838 million) and Florida Tri-County windstorm ($603 million). These modeled estimates are not maximum-loss limits or guarantees.
- Reserves depend on actuarial estimates and limited company-specific historical experience; actual claims may differ materially. Reinsurance recoverables, broker concentration, investment-market and interest-rate risks, foreign exchange, regulation, ratings and access to capital are also material risks.
- Subsequent event: in February 2013, subsidiaries agreed to acquire CMG Mortgage Insurance and related PMI assets for estimated consideration of about $300 million, subject to court, regulatory and GSE approvals and other conditions. Additional consideration may depend on portfolio results.
- No litigation or arbitration was identified as expected to have a material adverse effect. The independent auditor issued an unqualified opinion and concluded internal control over financial reporting was effective.
Important facts for investors to verify
- Whether reinsurance growth and favorable reserve development are repeatable, and how the reserve sensitivity and subsequent claims experience affect adequacy.
- The drivers of the fourth-quarter underwriting loss, including Sandy’s ultimate net cost and recoveries.
- Underlying underwriting profitability by segment, excluding catastrophe effects and prior-year reserve releases.
- Investment income and portfolio sensitivity to low yields, rising rates, credit-spread changes and less-liquid or leveraged investments.
- CMG/PMI transaction approvals, final consideration, reinsurance terms, legacy runoff obligations and capital requirements.
- Holding-company liquidity and subsidiary dividend capacity, including debt maturities, credit-facility availability and collateral needs.