ARCH CAPITAL GROUP LTD. quarterly report, Q1 FY2012

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Arch Capital Group Ltd. — Q1 2012 Form 10-Q

Business context and reporting period. Arch Capital is a Bermuda-based global insurer and reinsurer focused on specialty property and casualty lines. This unaudited report covers the three months ended March 31, 2012, compared with the three months ended March 31, 2011, and the balance sheet date is March 31, 2012. Figures below are in U.S. dollars; financial statement amounts are in millions unless otherwise stated. The interim statements were reviewed by PwC, not audited.

Financial performance and condition

  • Revenue and earnings: Total revenues were $815.0 million, up from $775.1 million. Net premiums written rose to $863.6 million from $764.3 million; net premiums earned were $680.3 million versus $633.7 million. Net income was $164.3 million, compared with $25.5 million; net income available to common shareholders was $157.8 million, or $1.18 basic and $1.14 diluted per share, versus $19.0 million, or $0.14 per share.
  • Underwriting and margins: Consolidated underwriting income was $67.2 million versus a $64.0 million loss. The combined ratio improved to 90.1% from 110.0%. Insurance reported an $8.1 million underwriting loss and a 101.8% combined ratio, improving from a $25.4 million loss and 106.2%. Reinsurance earned $75.3 million, compared with a $38.6 million loss; its combined ratio improved to 68.4% from 117.1%.
  • Drivers of results: Current-quarter catastrophe losses were $23.0 million net of reinsurance and reinstatement premiums, compared with $178.7 million in Q1 2011. Favorable prior-period reserve development was $53.3 million in total ($0.5 million insurance and $52.8 million reinsurance), versus $58.8 million in Q1 2011. Net investment income declined to $74.3 million from $88.3 million, while realized gains increased to $44.1 million from $20.7 million. Net foreign exchange losses were $20.7 million, down from $36.9 million.
  • Cash flow: Operating cash flow was $144.8 million, down from $224.6 million. Investing activities provided $3.4 million, versus $68.0 million used in the prior-year quarter. Financing activities used $81.3 million, compared with $117.8 million. Cash increased by $71.1 million to $422.8 million. Management attributed lower operating cash flow mainly to higher paid losses, lower investment receipts, and the timing of operating expenses, partly offset by higher premium receipts.
  • Balance sheet and capital: Total assets were $17.81 billion and total liabilities were $12.97 billion. Shareholders’ equity was $4.84 billion, up from $4.59 billion at year-end 2011; book value per common share rose to $33.33 from $31.76. Total cash and investments were $12.64 billion, and total investable assets were $12.50 billion. Loss reserves were $8.51 billion gross on the balance sheet; net reserves were $6.71 billion.
  • Debt and liquidity: At quarter-end the company had $300 million of senior notes, $100 million drawn on its revolving credit agreement, and $239.6 million of TALF borrowings. It also had $473.1 million of letters of credit outstanding, secured by investments valued at $555.8 million, and reported compliance with facility covenants. The parent holding company’s readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, totaled $10.4 million. Investment commitments were approximately $275 million; restricted assets totaled $5.78 billion.
  • Investment portfolio: The fixed-income portfolio’s average credit quality was AA/Aa2 and its average effective duration was 2.75 years. The pre-tax investment yield based on amortized cost was 2.52%, down from 3.06% in Q1 2011. The portfolio’s pre-tax total return was 1.87%, compared with 1.50% in Q1 2011, and exceeded its benchmark by 31 basis points.

Material changes versus the prior comparable period

  • Profitability improved markedly, principally reflecting much lower catastrophe losses and stronger underwriting, especially in reinsurance. Prior-period reserve development remained favorable but was slightly lower in total than in Q1 2011.
  • Written and earned premiums increased; net premiums written grew in both insurance and reinsurance. Reinsurance growth included property catastrophe and other specialty business.
  • Net investment income fell, reflecting lower yields and investment mix, while realized gains rose. Equity-method investment fund income decreased to $24.8 million from $29.7 million.
  • Operating cash flow declined despite higher net income. The company made no share repurchases under its repurchase program during the quarter, compared with $237.2 million of program repurchases in Q1 2011; small employee-related share withholding purchases did occur.
  • The company adopted new insurance acquisition-cost accounting guidance retrospectively from January 1, 2012. It reduced December 31, 2011 book value per common share by $0.27 and reduced Q1 2011 net income by $0.3 million; reported Q1 2011 EPS was unchanged.

Outlook, management commentary, risks and unusual items

  • Management reported improving market pricing in Q1 2012: insurance rates were up approximately 2% on a weighted basis, and property catastrophe reinsurance rates improved significantly on a risk-adjusted basis. Management said further increases remained necessary in many lines to achieve adequate returns in the low-interest-rate environment.
  • Management’s objective is average operating return on average common equity of 15% or greater over the insurance cycle. Q1 2012 operating ROAE was 10.4%, compared with 0.7% in Q1 2011; this is a non-GAAP measure, and management linked the improvement mainly to better underwriting and fewer catastrophe losses. This is an objective, not quarterly earnings guidance.
  • Management expects catastrophe-exposed business to remain a significant part of the portfolio and warned that this can increase results volatility. Its modeled April 1, 2012 peak-zone 1-in-250-year net probable maximum pre-tax losses were $860 million for Gulf of Mexico windstorm, $826 million for Northeastern U.S. windstorm and $608 million for Florida Tri-County windstorm. Management cautioned these estimates are not maximum exposures and actual losses may differ materially.
  • Key risks include adverse reserve development and estimation uncertainty; catastrophe severity and frequency; reinsurer default, delayed recoveries or exhausted protection; low interest rates and market volatility; credit, mortgage and sovereign exposures; foreign-exchange movements; and possible limits on liquidity or capital access. Management noted that sale of illiquid investments under pressure could result in material losses.
  • At March 31, 2012, Arch reported $710.2 million of Eurozone investments. It also reported $1.49 billion of mortgage-backed securities, $1.12 billion of commercial mortgage-backed securities, and $44 million par value of sub-prime securities with $20.7 million fair value. These exposures are subject to credit, valuation, prepayment and market risks.
  • Subsequent events: Arch completed a $325 million offering of 6.75% Series C non-cumulative preferred shares on April 2, 2012, then used proceeds and other funds to redeem its $200 million Series A and $125 million Series B preferred shares on May 2. On April 10, it acquired Ariel Re’s credit and surety reinsurance operations; those results are expected to be included beginning in Q2 2012. Arch also signed a mortgage reinsurance quota-share contract in Q2.
  • Management reported no litigation or arbitration expected to have a material adverse effect and concluded disclosure controls were effective; it reported no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

  • Whether the sharp improvement in catastrophe losses and reinsurance underwriting is sustainable, and how future events affect results.
  • The assumptions supporting reserve estimates and favorable prior-period development, particularly in reinsurance casualty and insurance specialty casualty and executive assurance.
  • The quality, valuation and liquidity of investment exposures, including mortgage-related, sub-prime, Eurozone and leveraged fund investments.
  • Whether investment yields and underwriting pricing can support management’s 15% through-the-cycle operating ROAE objective.
  • Cash generation, holding-company liquidity, restricted assets, investment commitments, and the availability of subsidiary dividends and credit facilities.
  • The financial and underwriting effects of the preferred-share refinancing and Ariel Re acquisition, including integration and future-period results.