Arch Capital Group Ltd. — Q3 2016 Form 10-Q
Business context and reporting period. Bermuda-based insurer and reinsurer writing specialty property and casualty, reinsurance, and mortgage insurance business worldwide. This unaudited filing covers the three and nine months ended September 30, 2016; the interim statements were reviewed, not audited, by PwC. Consolidated results include Watford Re, a variable-interest entity in which Arch owns approximately 11% of common equity.
Financial results and position
- Q3 revenue and earnings: Total revenues were $1.198 billion, versus $932.6 million a year earlier. Net income was $303.6 million; net income available to Arch common shareholders was $247.4 million, or $1.98 per diluted share, versus $74.5 million, or $0.60, in Q3 2015. The comparison benefited substantially from investment results: net realized gains were $125.1 million, versus losses of $89.7 million.
- Nine-month results: Net premiums earned were $2.916 billion, up 4.5% from $2.790 billion. Total revenues were $3.475 billion, versus $3.035 billion. Net income available to common shareholders was $602.3 million, or $4.84 per diluted share, versus $462.7 million, or $3.66.
- Underwriting and margins: Consolidated underwriting income was $122.8 million in Q3 and $345.5 million for nine months. The total combined ratio was 88.0% for Q3 (90.7% in Q3 2015) and 89.5% for nine months (89.7%). Q3 segment combined ratios were insurance 95.9%, reinsurance 76.0%, mortgage 57.5%, and Watford/“other” 99.7%. Nine-month ratios were 96.5%, 78.8%, 57.9%, and 101.2%, respectively.
- Operating measure: After-tax operating income available to common shareholders, a non-GAAP measure, was $142.5 million in Q3 versus $125.8 million; nine-month income was $428.8 million versus $421.6 million. Operating ROAE was 8.8% for Q3 (8.6% prior year) and 9.2% for nine months (9.7%). Management’s objective is average operating ROAE of 15% or greater over the insurance cycle, not a period-specific forecast.
- Cash flow and liquidity: Consolidated operating cash flow was $1.037 billion for nine months, versus $807.6 million; investing used $1.255 billion and financing provided $253.8 million. Cash was $578.8 million at September 30. Excluding Watford Re, operating cash flow was $831.1 million and cash increased $67.0 million. Arch-managed investable assets were $16.04 billion; total investable assets including Watford were $17.88 billion.
- Debt and capital: Consolidated senior notes were $791.4 million and revolving borrowings were $398.1 million, of which $298.1 million related to Watford Re. Arch’s capital presentation excluded Watford and included $791.4 million senior notes, $100.0 million revolving borrowings, $775.0 million preferred shares, and $6.58 billion common equity. Total shareholders’ equity was $8.19 billion; equity available to Arch was $7.35 billion. Book value per common share was $53.62 at quarter-end, up from $47.95 at year-end 2015.
Material changes and management commentary
- Q3 net premiums written rose 4.4% to $1.014 billion. Mortgage underwriting expanded strongly: nine-month mortgage net premiums written increased 65.5% to $298.5 million, while insurance was nearly flat and reinsurance increased 1.1%.
- Management described property-casualty markets as competitive, with slight rate deterioration in some insurance lines and continued low interest rates. Arch reduced writings in certain lines, emphasizing disciplined underwriting, smaller and medium-sized accounts, and reinsurance to limit volatility. Management reported more favorable conditions in mortgage insurance and growth in U.S. mortgage insurance market share.
- Reserve releases materially supported underwriting: nine-month favorable prior-period development was $24.8 million in insurance, $176.7 million in reinsurance, and $16.3 million in mortgage. Reinsurance’s nine-month current-year loss ratio was also affected by a loss portfolio transfer, which added 2.8 points; its associated premium was substantially earned in the period.
- Investment results were volatile. Nine-month net realized gains were $230.6 million versus losses of $42.1 million; investment income increased to $275.7 million from $252.2 million. The investment portfolio’s nine-month total return was 4.03%, below its 4.43% benchmark. Fixed-income portfolio yield was 1.95% for nine months, compared with 2.06% in 2015.
Outlook, acquisition, and risks
- Arch agreed to acquire United Guaranty from AIG for estimated consideration of approximately $3.43 billion, including about $2.20 billion cash and approximately $983.1 million of convertible preferred shares, with additional consideration subject to specified adjustments. Closing was targeted for late Q4 2016 and remained subject to regulatory and other conditions. Failure to obtain required approvals by the applicable deadline could trigger a $150 million termination fee in specified circumstances.
- Arch issued $450 million of Series E preferred shares in September, receiving $434.9 million net. It had a bridge facility commitment of $938.5 million at quarter-end after reductions related to the offering. Management expected to fund the acquisition with investment sales, preferred proceeds, revolving credit and potentially additional capital; it cautioned that funding could require use of the bridge facility. The October 26 amended credit agreement provides $500 million unsecured revolving capacity and a $350 million secured letter-of-credit facility.
- Acquisition risks include regulatory delay or failure to close, integration costs, employee or customer disruption, unknown liabilities, and failure to realize anticipated benefits. The filing notes that costs and savings from integration were not yet fully identified.
- Catastrophe exposure remains a source of earnings volatility. As of October 1, modeled peak-zone net probable maximum pre-tax losses were $488 million for a Northeastern U.S. windstorm, $418 million for Gulf of Mexico windstorm, and $405 million for Florida Tri-County windstorm. These are model estimates, not maximum-loss limits or guarantees.
- Other risks include reserve-estimation uncertainty, reinsurer credit and collection timing, soft-market pricing, low investment yields, market and foreign-exchange volatility, and liquidity constraints on alternative investments. Unfunded investment commitments were approximately $1.34 billion. Management reported no litigation expected to have a material adverse effect and stated disclosure controls were effective.
Important facts for investors to verify
- Whether United Guaranty closed, its final purchase consideration and funding mix, and any subsequent integration charges, realized synergies, or termination exposure.
- How much reported earnings and book-value growth depended on investment gains, Watford’s consolidated results, and favorable reserve development; compare these with operating income and current-year underwriting performance.
- Whether reserve releases persist and whether the reinsurance loss portfolio transfer materially affects comparisons beyond the reported period.
- Mortgage portfolio growth, credit quality, persistency, delinquency and claims trends, and Arch MI U.S.’s compliance with PMIERs as its “newly-approved insurer” restrictions change.
- Available parent-company liquidity and borrowing capacity after acquisition funding, alongside debt covenants, regulatory dividend limits, and the $1.34 billion of unfunded investment commitments.