Arch Capital Group Ltd. — 2010 Form 10-K Summary
Business context and reporting period
Arch Capital Group Ltd. is a Bermuda-based global property and casualty insurer and reinsurer focused on specialty lines. This filing covers the fiscal year ended December 31, 2010, with comparisons to 2009 and 2008. Unless stated otherwise, amounts are U.S. dollars.
Financial performance and condition
- Premiums and revenue: Net premiums written were $2.51 billion, down 9.1% from $2.76 billion; net premiums earned were $2.55 billion, down 10.2%. Total revenue was $3.24 billion, down 7.4%.
- Earnings: Net income was $842.6 million, versus $876.9 million. Net income available to common shareholders was $816.7 million, down from $851.1 million. Diluted EPS rose to $15.55 from $13.74, reflecting materially fewer weighted-average shares following repurchases.
- Operating results: After-tax operating income, a non-GAAP measure, declined to $491.1 million from $651.8 million; operating return on average common equity fell to 12.0% from 18.3%. Management attributed the decline mainly to higher catastrophe losses, difficult underwriting conditions and lower investment yields.
- Underwriting: The insurance segment recorded a $38.8 million underwriting loss and a 102.3% combined ratio, versus $32.9 million income and 98.1% in 2009. Reinsurance underwriting income was $233.8 million, down from $303.2 million; its combined ratio was 74.3%, compared with 73.7%. Favorable prior-year reserve development was $146.7 million overall, below $189.2 million in 2009.
- Investments: Net investment income was $364.9 million, down from $390.1 million; investment income yield declined to 3.34% from 3.74%. Net realized gains increased to $252.8 million from $143.6 million, while impairment losses recognized in earnings decreased to $11.3 million from $66.1 million. Portfolio pre-tax total return was 7.00%, exceeding the 6.38% benchmark.
- Cash flow and liquidity: Operating cash flow was $802.1 million, down from $992.6 million, primarily reflecting lower premium collections. Cash and invested assets totaled $11.84 billion at year-end. Parent-company readily available cash, short-term investments and marketable securities outside regulated subsidiaries were $14.4 million. Management expected liquidity needs for at least the next 12 months to be met through operations, investment income, liquid assets and credit facilities.
- Capital, debt and reserves: Total shareholders’ equity was $4.51 billion; common book value per share rose 23.2% to $89.98. Debt comprised $300 million of senior notes and $100 million of revolving borrowings, excluding $325.8 million of TALF financing. Net loss reserves were $6.40 billion; gross reserves were $8.10 billion. About 67% of net reserves were incurred but not reported.
Material changes versus 2009
- Net premiums written contracted, with the largest decline in reinsurance: reinsurance net premiums written fell 19.5%, while insurance declined 2.7%. Management cited non-renewals, reduced participation and soft-market pricing.
- Insurance underwriting performance weakened to a loss as acquisition and operating expense ratios increased; catastrophe claims and adverse developments in some casualty, program and executive assurance years also affected results.
- Reinsurance underwriting income declined despite a similar combined ratio, primarily because earned premiums fell. Its 2010 current-year loss ratio included 9.9 points of catastrophe activity, compared with 2.0 points in 2009.
- Reported GAAP net income held relatively close to 2009, but included higher realized investment gains and positive investment-fund income. The more conservative operating-income measure declined substantially.
- Common book value per share increased while common shareholders’ equity rose more modestly, reflecting earnings and the accretive effect of repurchases. The company repurchased $761.9 million of shares in 2010.
Outlook, risks and unusual items
- Management expected 2011 to remain challenging for underwriting amid excess capacity, declining rates and inadequate pricing in some lines. Its stated objective was average operating ROAE of at least 15% over the insurance cycle; this is an objective, not near-term earnings guidance.
- Management considered U.S. catastrophe-exposed business the most attractive pricing opportunity, while noting that catastrophe exposure could increase results volatility. The modeled peak-zone net probable maximum pre-tax loss as of January 1, 2011 was $733 million for a Northeastern U.S. windstorm; management cautioned that models are uncertain and losses could exceed estimates.
- Subsequent events: Australian floods and Cyclone Yasi were estimated to produce first-quarter 2011 net losses of $30–$60 million, including reinstatement premiums. The February 2011 New Zealand earthquake was expected to adversely affect first-quarter results, but the company could not yet estimate the loss and did not expect a material adverse effect on financial condition.
- The $300 million unsecured revolving loan and $1.0 billion secured letter-of-credit facility were due to expire August 30, 2011. Renewal or replacement was expected but not assured; higher costs or failure to renew could affect liquidity and results. Outstanding letters of credit were $743.1 million, secured by $831.6 million of investments.
- Other significant risks include catastrophe severity and frequency, reserve estimation uncertainty, reinsurance recoverable and counterparty credit risk, broker concentration, investment and interest-rate volatility, soft-market competition, rating downgrades and regulatory or tax changes. Aon and Marsh & McLennan generated or placed 18.8% and 15.1% of 2010 gross premiums, respectively.
- The company reported no litigation or arbitration expected by management to materially adversely affect results, financial condition or liquidity. Its auditor gave an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective.
- In February 2011, the board authorized up to an additional $1.0 billion in common-share repurchases through December 31, 2012. Total remaining authorization was approximately $1.08 billion as of February 24, 2011.
Most important facts for investors to verify
- Whether reserve adequacy and favorable prior-year development persist, particularly given the company’s limited history in some lines and substantial IBNR reserves.
- How catastrophe losses develop, including the 2011 Australia and New Zealand events, and whether recoveries are collectible and modeled exposure limits remain appropriate.
- Whether underwriting pricing, premium volumes and combined ratios improve, especially in insurance, where the 2010 combined ratio exceeded 100%.
- How much earnings depend on realized investment gains and equity-method fund results versus recurring underwriting and investment income.
- Whether the 2011 credit and letter-of-credit facilities are renewed on acceptable terms and regulated-subsidiary dividend capacity remains available to the holding company.
- Whether repurchases at prevailing prices support per-share value without compromising capital strength, ratings or underwriting capacity.