Arch Capital Group Ltd. — 2014 Form 10-K
Reporting period: Fiscal year ended December 31, 2014. The filing is an annual report, not a standalone fourth-quarter filing; it also provides selected fourth-quarter data. Arch writes specialty insurance, reinsurance and mortgage insurance globally. Results include the newly acquired U.S. mortgage insurance business and, from 2014, consolidated Watford Re.
Financial performance
| Metric | 2014 | 2013 | Change / context |
|---|---|---|---|
| Net premiums written | $3.892 billion | $3.351 billion | Up 16.1% |
| Net premiums earned | $3.594 billion | $3.146 billion | Up 14.2% |
| Total revenues | $3.989 billion | $3.526 billion | Up 13.1% |
| Net income | $821.3 million | $709.7 million | Up 15.7% |
| Net income available to common shareholders | $812.4 million | $687.8 million | Diluted EPS $6.02 vs. $5.07 |
| After-tax operating income available to common shareholders | $617.3 million | $595.7 million | Non-GAAP measure; diluted operating EPS $4.58 vs. $4.39 |
| Operating return on average common equity | 11.1% | 11.7% | Below management’s 15%+ through-cycle objective |
| Operating cash flow | $1.037 billion | $850.9 million | Investing cash outflow was $1.505 billion; financing cash inflow was $539.9 million |
Insurance, reinsurance and mortgage underwriting generated $474.2 million of income, with an 86.8% combined ratio. The separately reported Watford “other” segment had a $3.1 million underwriting loss and a 103.0% combined ratio. By underwriting segment, insurance income was $107.1 million (94.8% combined ratio), reinsurance income $340.6 million (73.6%), and mortgage income $26.4 million (88.9%).
Net favorable prior-year reserve development was $326.9 million, including $267.3 million in reinsurance and $58.7 million in insurance. This materially supported underwriting results. Net losses and loss adjustment expenses were $1.919 billion. The ending net loss reserve was $7.258 billion; gross reserves were $9.036 billion.
Balance sheet, investment results and capital
- Total assets were $22.010 billion and total liabilities were $14.891 billion at year-end. Total shareholders’ equity was $6.899 billion, including $6.130 billion attributable to Arch; book value per common share rose 14.5% to $45.58.
- Total investable assets were $15.773 billion, including $14.610 billion managed by Arch and $1.163 billion attributable to Watford Re. Cash was $485.7 million. Fixed maturities were 76.5% of Arch-managed investable assets; 94.4% of fixed maturities and securities pledged under securities lending were investment grade.
- Net investment income increased to $302.6 million from $267.2 million, while the pre-tax investment income yield declined to 2.08% from 2.12%. Arch’s pre-tax total investment return was 3.21%, outperforming its 2.58% benchmark. Net realized gains were $102.9 million; impairment losses recognized in earnings were $30.2 million.
- Net foreign-exchange gains were $83.7 million, compared with a $12.3 million loss in 2013. Net income therefore included material market-related items in addition to underwriting and investment income.
- Debt comprised $800 million of senior notes and $100 million of revolving-credit borrowings. The filing reported $900 million of total consolidated long-term debt. Debt to total capital was subject to a 0.35-to-1 credit-agreement limit; the company reported covenant compliance at year-end.
- Arch repurchased $454.1 million of common shares in 2014; $887.1 million remained authorized at year-end. No common-share dividends were paid. Preferred dividends were $21.9 million.
Material changes and fourth-quarter information
- Arch acquired CMG Mortgage Insurance Company and related assets in January 2014, entering the U.S. mortgage insurance market. Mortgage-segment net premiums written rose to $204.8 million from $89.6 million; the segment’s comparison is affected by the acquisition and is not like-for-like.
- Arch invested $100 million for about 11% of Watford Re and consolidated it as a variable interest entity. Watford raised about $1.1 billion from investors; its assets and results are included in Arch’s consolidated statements, with third-party interests separately presented.
- In the fourth quarter, net premiums written were $895.5 million, versus $748.9 million in fourth-quarter 2013; underwriting income was $113.5 million versus $128.3 million. Net income was $207.1 million versus $161.5 million, and diluted EPS was $1.60 versus $1.14.
- Book value growth and earnings benefited from underwriting and investment returns, but buybacks reduced the share count. The company also entered a 90% whole-account quota-share retrocession and transferred Gulf Re’s existing business effective October 1, 2014; a proposed acquisition of full ownership of Gulf Re remained subject to regulatory approval.
Outlook, risks and contingencies
- Management described reinsurance markets as competitive, with softening prices and pressure on terms and conditions. Insurance obtained rate increases in most lines, but increases slowed in the second half of 2014; management said further increases were needed in many lines given low investment yields.
- Management’s stated objective is an average operating return on average equity of at least 15% over the insurance cycle. No specific financial guidance for 2015 was provided in the supplied filing text.
- Management expects catastrophe-exposed business to remain significant and noted it can increase results volatility. Its modeled peak-zone net probable maximum losses as of January 1, 2015 were $544 million for a Northeastern U.S. windstorm, $527 million for Gulf of Mexico windstorm and $419 million for Florida Tri-County windstorm. These are estimates, not maximum possible losses.
- Mortgage insurer eligibility and capital rules were in flux. Draft GSE PMIERs were expected to be finalized in 2015; Arch estimated Arch MI U.S. met the draft financial requirements at year-end, but expected to contribute additional capital as the business grew. Arch MI U.S. was subject to GSE capital, risk-to-capital and dividend restrictions.
- Key risks include catastrophe severity and model uncertainty; reserve estimation and adverse development; reinsurance recoverability; soft-market pricing and competition; mortgage credit, home prices and unemployment; GSE, FHA and regulatory changes; interest-rate, credit-spread and currency movements; and liquidity constraints from restricted or illiquid investments. About 66% of gross loss reserves were incurred but not reported.
- Arch reported no litigation or arbitration expected by management to have a material adverse effect. The independent auditor opined that the financial statements were fairly presented under U.S. GAAP and that internal control over financial reporting was effective.
Most important facts for investors to verify
- How much of 2014 underwriting profitability depended on the $326.9 million favorable reserve development, particularly the large reinsurance releases, and how subsequent reserve development compares.
- Whether the final PMIERs and GSE treatment of affiliated quota-share reinsurance require more capital at Arch MI U.S. than management anticipated, and whether the subsidiary sustains GSE eligibility.
- How underwriting margins and pricing evolve in the softening insurance and reinsurance markets, relative to the company’s 15% through-cycle operating-return objective.
- Watford Re’s underwriting and investment performance, including the consequences of consolidating a business in which Arch held about 11% of common equity and third parties funded most of the capital.
- The quality and liquidity of investment assets, the effect of interest-rate and currency changes, and parent-company cash and dividend capacity. Although consolidated cash was $485.7 million, ACGL’s own readily available cash, short-term investments and marketable securities outside regulated subsidiaries were only $3.3 million.