Arch Capital Group Ltd. — 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. This is a full-year filing, not a Q4-only report. Arch provides specialty property and casualty insurance and reinsurance, mortgage insurance and related risk-sharing products worldwide.
Financial performance and position
| Metric | 2016 | 2015 |
|---|---|---|
| Net premiums written | $4.031 billion | $3.818 billion |
| Net premiums earned | $3.885 billion | $3.734 billion |
| Total revenue | $4.464 billion | $3.937 billion |
| Net income | $824.2 million | $526.6 million |
| Net income available to Arch common shareholders | $664.7 million | $515.8 million |
| Diluted EPS | $5.33 | $4.09 |
| Underwriting income, consolidated | $454.7 million | $429.5 million |
| Combined ratio, consolidated | 89.9% | 89.5% |
| Net investment income | $366.7 million | $348.1 million |
| Total assets | $29.372 billion | $23.139 billion |
| Total shareholders’ equity | $9.106 billion | $6.905 billion |
| Book value per share | $55.19 | $47.64 |
Net premiums written rose about 5.6%, earned premiums about 4.0%, and common-shareholder income about 28.9%. Results included $137.6 million in net realized investment gains, versus $185.8 million in net realized losses in 2015. After-tax operating income, a non-GAAP measure, was $577.4 million, down from $565.2 million? The filing reports $577.4 million in 2016 and $565.2 million in 2015; operating return on average common equity was 9.4% versus 9.7%. Management’s long-term objective is an average operating return of at least 15% over the insurance cycle.
Consolidated cash from operations was $1.397 billion, investing cash outflow was $2.722 billion, and financing cash inflow was $1.636 billion. Cash ended the year at $842.9 million. Investing outflows included the UGC acquisition. Arch reported $18.64 billion of investable assets excluding Watford Re, or $20.49 billion including it; approximately 78% of Arch’s investable assets were fixed maturities. The fixed-income portfolio had an average credit quality of AA-/Aa3 and 95.1% of fixed maturities were investment grade.
At year-end, senior notes were $1.732 billion and revolving credit borrowings were $756.7 million; the latter includes $256.7 million at consolidated Watford Re. Arch’s total capital available was $10.49 billion. The parent company reported only $4.3 million of readily available cash, short-term investments and marketable securities outside regulated subsidiaries; access to subsidiary funds is subject to regulatory and other restrictions.
Business changes and segment performance
- UGC acquisition: Closed December 31, 2016 for approximately $3.26 billion: $2.16 billion cash and $1.10 billion in convertible non-voting common-equivalent preferred shares. The balance sheet includes UGC, but 2016 operating results do not include UGC’s business activity, apart from financing effects and transaction costs. Unaudited pro forma 2016 results assuming UGC had been acquired at the start of 2015 were revenue of $5.312 billion and common-shareholder income of $913.9 million; these are not reported actual results.
- Insurance: Net premiums written increased 1.3% to $2.072 billion. Underwriting income declined 43.5% to $56.7 million, and the combined ratio worsened to 97.3% from 95.1%, reflecting a higher current-year loss ratio and catastrophe activity.
- Reinsurance: Net premiums written increased 1.5% to $1.054 billion, while earned premiums fell 1.9%. Underwriting income was $261.1 million, down 2.6%; the combined ratio rose to 78.7% from 76.2%. Results included a loss portfolio transfer that contributed $52.1 million of gross written premiums and increased the current-year loss ratio.
- Mortgage: Net premiums written increased 46.3% to $391.5 million and underwriting income rose to $141.4 million from $64.8 million. The 56.6% combined ratio improved from 78.4%. These results exclude UGC’s operating activity; year-end mortgage exposures include the acquisition.
Outlook, risks and unusual items
- Management described property and casualty markets as competitive and soft, with slight rate deterioration in some insurance sectors and continued low investment yields. Arch reduced writings in selected lines and emphasized underwriting discipline. Management said mortgage market conditions remained favorable and identified U.S. mortgage expansion, international business and GSE risk-sharing as growth opportunities.
- UGC integration, anticipated synergies and savings are uncertain. The acquisition increased leverage and mortgage exposure. The GSEs imposed additional capital and integration requirements; eligible mortgage insurers met PMIERs financial requirements at year-end. Arch expected additional capital contributions may be needed as the mortgage portfolio grows.
- Following the acquisition, rating agencies took differing actions in January 2017: A.M. Best ratings remained under review; Fitch affirmed certain operating-company ratings but downgraded debt and preferred ratings and placed them on negative watch; Moody’s downgraded certain operating-company, debt and preferred ratings; S&P raised certain mortgage-insurer ratings but changed the outlook on certain Arch ratings to negative.
- Prior-year reserve development was $270.0 million favorable, compared with $285.1 million favorable in 2015. Loss reserves are inherently uncertain; reported net reserves at year-end were $8.117 billion, and gross reserves were $10.201 billion. Mortgage insurance reserves cover loans in default and are not an estimate of all future losses on insured loans.
- Catastrophe losses, reserve uncertainty, reinsurance counterparty performance, investment-market and interest-rate movements, foreign exchange, mortgage-market conditions, regulatory changes and Brexit-related disruption are material risks. Arch’s modeled peak-zone 1-in-250-year catastrophe loss was $492 million for a Northeastern U.S. windstorm; management cautioned that modeled estimates are not maximum exposures.
- 2016 included $41.7 million of UGC transaction costs and other items, including $32.3 million of transaction costs and a deferred-acquisition-cost accounting change. The change was applied retrospectively; the filing identifies a $9.4 million fourth-quarter out-of-period charge and a $6.6 million annual charge. The auditor issued an unqualified opinion and found internal control over financial reporting effective, while UGC was excluded from the year-end control assessment pending integration.
- No litigation or arbitration was identified as expected to have a material adverse effect. The filing provides no specific earnings guidance for 2017.
Important facts for investors to verify
- How UGC performs after closing, including integration costs, realized synergies, capital needs and the effect on ratings and leverage.
- Whether favorable reserve development continues, particularly in reinsurance, and how actual claims compare with reserve assumptions.
- Mortgage portfolio credit performance, delinquency and claim trends, PMIERs capital headroom, and the GSEs’ eligibility and risk-transfer policies.
- Underlying underwriting results excluding favorable prior-year reserve development and unusual transactions, alongside the reported segment combined ratios.
- Liquidity available at the holding company, regulated-subsidiary dividend capacity, debt and facility covenants, and the funding of investment commitments.
- Investment returns, credit quality and valuation of less-liquid or alternative assets, as well as catastrophe exposure and reinsurance recoverability.