Business context and reporting period
Arch Capital Group Ltd. is a Bermuda-based global insurer and reinsurer with insurance, reinsurance, and mortgage businesses. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2017; comparative periods are 2016. The December 31, 2016 acquisition of United Guaranty Corporation (UGC) materially expanded mortgage insurance, so 2017 mortgage results are not directly comparable with 2016. PwC performed an interim review, not an audit.
Financial results and key metrics
Amounts are U.S. dollars; financial statement amounts below are in millions unless stated otherwise.
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net premiums written | $1,248.7 | $1,023.6 | $2,525.0 | $2,144.8 |
| Net premiums earned | $1,240.9 | $1,006.0 | $2,357.9 | $1,957.6 |
| Total revenues | $1,407.5 | $1,191.2 | $2,726.7 | $2,277.8 |
| Net income | $199.1 | $249.4 | $473.1 | $425.0 |
| Net income available to common shareholders | $173.8 | $205.6 | $415.7 | $354.9 |
| Diluted EPS | $1.25 | $1.65 | $2.99 | $2.85 |
| Net cash from operating activities | Not presented quarterly | $554.1 | $541.2 |
- Q2 revenue increased about 18%, while net income fell about 20% and diluted EPS fell about 24%. Six-month common earnings increased about 17% and diluted EPS about 5%.
- Q2 underwriting income was $195.4 million versus $116.6 million; the consolidated combined ratio improved to 84.6% from 90.9%. The result includes the expanded mortgage business, whose combined ratio was 30.5%; insurance was 100.8% and reinsurance 94.0%.
- Net investment income was $111.1 million in Q2 and $229.0 million for six months, up from $88.3 million and $182.1 million, respectively. Realized gains were lower year over year: $21.7 million in Q2 and $55.9 million year to date.
- Book value per common share was $59.60 at June 30, versus $55.19 at year-end 2016. Total shareholders’ equity was $9.78 billion; equity available to Arch was $8.90 billion.
- Cash was $740.3 million and total investments $20.70 billion at June 30. Reported capital-structure debt was $2.23 billion, with debt-to-total-capital of 20.1%; balance-sheet senior notes were $1.73 billion and revolving borrowings $686.5 million. The filing’s capital-structure measure and consolidated balance-sheet debt differ in scope.
- Operating cash flow was $554.1 million for the first half, compared with $541.2 million; cash declined $102.6 million to $740.3 million. Management said liquidity needs for at least the next 12 months are expected to be met through underwriting and investment cash flows, cash and short-term investments, investment maturities or sales, and credit facilities.
Material changes versus the prior period
- UGC drove much of the mortgage segment’s growth: Q2 net premiums written increased 146% and earned premiums 288% year over year. The comparison excludes UGC in 2016. Management reported mortgage underwriting income of $183.6 million in Q2.
- Insurance premiums written declined modestly amid weaker pricing and market conditions; insurance underwriting income turned to a $4.5 million loss in Q2 from $4.3 million income, with a 100.8% combined ratio.
- Reinsurance Q2 net premiums written grew 16%, but underwriting income decreased to $19.0 million from $72.6 million. Its current-year loss ratio increased, while favorable prior-year reserve development was lower.
- Q2 net favorable prior-year reserve development was $69.4 million, compared with $85.8 million a year earlier. Six-month favorable development was $152.6 million versus $141.8 million.
- Higher UGC-related intangible amortization and acquisition costs, increased interest expense from debt issued to fund the acquisition, and net foreign-exchange losses weighed on reported earnings. Q2 intangible amortization was $30.8 million; interest expense was $28.7 million; and foreign-exchange losses were $39.5 million.
- Common shareholders’ equity grew during the half-year, while preferred dividends increased to $22.6 million from $11.0 million. No shares were repurchased under the company’s public repurchase program during the first half.
Outlook, risks and unusual items
- Management described property-casualty markets as competitive, with slight rate deterioration in certain sectors, and said low interest rates require additional pricing increases to achieve return targets. It cited disciplined underwriting, emphasis on small and medium-sized accounts, and reinsurance to limit volatility.
- The stated objective is an average operating return on average equity of 15% or greater over the insurance cycle. Operating ROAE was 8.5% in Q2 and 9.4% for the first half; these are non-GAAP measures, not formal period-specific guidance.
- Management’s modeled peak catastrophe exposure was a Northeastern U.S. windstorm, with a $500 million net probable maximum pre-tax loss as of July 1, 2017; Gulf of Mexico and Florida Tri-County estimates were $439 million and $370 million. The company targets a 1-in-250-year net loss in any zone of approximately 25% of Arch-available equity, but actual losses could materially exceed modeled estimates.
- Key risks include catastrophe severity and frequency, reserve-estimation uncertainty, competition and pricing, investment-market and interest-rate volatility, foreign-exchange movements, reinsurance counterparty performance, and integration of acquired businesses. Management noted limited historical loss experience makes reserve estimates especially difficult.
- On July 1, 2017, Arch completed the $40 million acquisition of AIG United Guaranty Insurance (Asia) Limited. The filing reports no litigation or arbitration expected by management to have a material adverse effect and no material change to previously disclosed risk factors.
- Management concluded disclosure controls were effective. Its assessment of internal control over financial reporting excluded UGC, which represented 14% of assets and 14% of first-half revenue; UGC’s reporting systems were not yet fully integrated, with integration expected during 2017.
Important facts for investors to verify
- How much of premium growth and earnings reflects UGC and other acquisition effects, and how sustainable are the acquired mortgage results?
- Whether prior-year reserve releases continue, particularly in reinsurance and mortgage, and how loss emergence compares with current reserve assumptions.
- Whether pricing and underwriting conditions support target returns amid competitive property-casualty markets and low investment yields.
- Catastrophe exposures, reinsurance protection and recoverability, mortgage-insurer PMIERs sufficiency (reported at 122%), and mortgage credit quality and delinquency trends.
- Debt, liquidity, investment commitments of $1.56 billion, and the scope difference between capital-structure debt and consolidated balance-sheet borrowings.
- UGC integration progress and completion of its internal-control integration; also monitor subsequent acquisition costs and amortization.