ARCH CAPITAL GROUP LTD. quarterly report, Q3 FY2014

Abrir documento

Arch Capital Group Ltd. — Q3 2014 Form 10-Q

Business context and reporting period

Arch is a Bermuda-based global insurance and reinsurance group. This unaudited quarterly report covers the three and nine months ended September 30, 2014; balance-sheet comparisons are with December 31, 2013. The interim statements were reviewed by PwC, not audited.

During 2014, Arch added a mortgage segment following its acquisition of the CMG mortgage insurance entities and platform on January 30, and consolidated Watford, a newly launched reinsurance company, as a variable interest entity. Reported results therefore include acquired mortgage operations and Watford activity not present in the comparable 2013 periods.

Financial performance and condition

  • Q3 revenue and earnings: Total revenues were $992.5 million, versus $861.1 million a year earlier. Net income was $223.3 million; net income available to common shareholders was $223.2 million, or $1.69 basic and $1.64 diluted per share. After-tax operating income available to common shareholders, a non-GAAP measure, was $142.1 million, versus $149.2 million.
  • Nine-month results: Total revenues were $2.974 billion, versus $2.603 billion. Net income was $614.1 million; common-shareholder income was $602.7 million, or $4.56 basic and $4.42 diluted per share. After-tax operating income was $467.1 million, versus $443.0 million.
  • Underwriting and margins: Q3 underwriting income was $101.1 million, compared with $111.0 million; the total combined ratio was 89.0%, versus 86.1%. Nine-month underwriting income was $357.6 million, compared with $323.4 million; the combined ratio was 86.9%, versus 86.1%. Q3 segment combined ratios were 96.8% for insurance, 74.3% for reinsurance and 86.6% for mortgage. Operating ROAE was 9.7% for Q3 and 11.2% for the nine months, below management’s 15% or greater through-the-cycle objective.
  • Investment results: Net investment income was $80.1 million in Q3 and $220.1 million for nine months. Net realized gains were $18.5 million and $92.4 million, respectively; net impairment losses recognized in earnings were $8.6 million and $26.3 million. Q3 included $57.6 million of net foreign-exchange gains, primarily unrealized, materially affecting reported earnings.
  • Cash flow: For the nine months, operating cash flow was $799.7 million, investing cash outflow was $1.311 billion and financing cash inflow was $750.7 million. Cash increased by $229.7 million to $663.7 million. Investing outflows included the mortgage acquisition and investment activity; financing inflows included third-party Watford capital.
  • Balance sheet and capital: Total assets were $22.611 billion and total liabilities $15.528 billion at September 30. Total shareholders’ equity was $6.863 billion, including $6.081 billion attributable to Arch; book value per common share was $44.04, versus $39.82 at year-end 2013 and $43.73 at June 30, 2014. Total investable assets, including Watford, were $15.71 billion.
  • Debt and liquidity: Senior notes totaled $800 million and revolving-credit borrowings were $100 million. Arch reported $663.7 million of consolidated cash and expected its next-12-month liquidity needs to be met by operating and investment cash flows, liquid assets, investment maturities or sales, and credit facilities. Parent-company readily available cash, short-term investments and marketable securities excluding regulated subsidiaries were only $6.1 million; holding-company liquidity depends in part on subsidiary distributions, which are subject to regulatory limits.
  • Other commitments: Unfunded investment commitments were approximately $941.9 million. The company had $421.4 million of outstanding letters of credit, secured by investments with a fair value of $480.9 million. It reported compliance with facility covenants.

Material changes versus comparable periods

  • Premium growth, acquisitions and new segment reporting contributed to higher revenues. Net premiums earned rose to $903.7 million in Q3 from $795.0 million and to $2.671 billion for nine months from $2.307 billion.
  • Q3 insurance underwriting income increased to $16.7 million from $15.2 million, while reinsurance underwriting income declined to $76.4 million from $90.8 million. Mortgage underwriting income was $8.1 million, with the comparison affected by the 2014 acquisition and business mix.
  • Reinsurance net premiums written fell 16.1% in Q3 and 2.8% for nine months, despite higher gross premiums, in part because of increased cessions to Watford and softer market conditions. Property catastrophe business remained under pressure.
  • Favorable prior-period reserve development supported results: $11.4 million in insurance and $61.0 million in reinsurance during Q3; for nine months, $46.4 million and $200.5 million, respectively. The company cautions that reserve estimates are inherently uncertain.
  • Q3 GAAP earnings benefited from the foreign-exchange gain and improved realized gains, while operating income was lower year over year. Nine-month operating income increased, but investment-fund income declined to $17.5 million from $30.4 million.
  • Arch repurchased 4.6 million common shares for $251.9 million in the first nine months, versus $57.8 million in the prior-year period. Total shareholders’ equity available to Arch rose from $5.647 billion at year-end despite repurchases.

Outlook, commentary and risks

  • Management said insurance rate increases continued to exceed loss-cost trends in Q3, but were slightly below Q2 levels. Competitive conditions pressured primary property rates and premium volume. Reinsurance terms continued to soften, especially in property catastrophe, amid alternative capacity and higher ceding-commission requests. Management described a disciplined approach favoring smaller and medium-sized accounts.
  • Management’s stated objective is average operating ROAE of at least 15% over the insurance cycle; this is an objective, not near-term earnings guidance. It expects mortgage underwriting expense ratios to remain elevated until Arch MI U.S. achieves greater scale among non-credit-union customers.
  • As of October 1, modeled peak-zone catastrophe exposure was a Northeastern U.S. windstorm, with a net probable maximum pre-tax loss of $658 million; Gulf of Mexico and Florida Tri-County windstorm estimates were $608 million and $451 million. Management targets limiting a modeled 1-in-250-year event in any zone to approximately 25% of equity available to Arch, but states actual losses could differ materially and estimates do not represent maximum exposure.
  • Key risks include catastrophe severity and frequency, reserve estimation uncertainty, reinsurance recoverability and timing, soft pricing, investment-market volatility, foreign-exchange exposure, illiquid or leveraged investments, and possible adverse economic or sovereign-credit developments. Mortgage insurance is also subject to proposed FHFA eligibility and capital requirements; management believed Arch MI U.S. met the proposed financial requirements based on its September portfolio, but final requirements were not yet known.
  • Arch recorded $8.6 million of Q3 investment impairment, primarily related to a fund investment it decided to redeem in early October. It also expected a $4–$6 million loss on its Gulf Re investment in Q4 based on Gulf Re’s Q3 results. No litigation was identified as expected to have a material adverse effect.
  • After quarter-end, Arch repurchased 1.6 million shares for $89.2 million through October 29. On November 6, the board raised the repurchase authorization to $1.0 billion, with repurchases permitted through December 31, 2016.

Important facts for investors to verify

  • How much of reported earnings and book-value movement reflects recurring underwriting and investment performance versus unrealized FX gains, realized gains and impairment charges.
  • Whether favorable reserve development continues, particularly in reinsurance, and how adverse development in insurance construction and program reserves evolves.
  • Progress and capital requirements for Arch MI U.S., including final PMIERs, portfolio quality, persistency, claims and the path to operating scale.
  • Effects of soft pricing, alternative reinsurance capacity, catastrophe exposure and increased cessions to Watford on future net premiums and margins.
  • Availability of parent-company liquidity and regulatory capacity to upstream dividends, alongside share repurchases, investment commitments and debt obligations.
  • Exposure to illiquid and leveraged investments, foreign-currency movements, and actual outcomes relative to catastrophe models and reserve estimates.