Business context and reporting period
Arch Capital Group Ltd. is a Bermuda-based global specialty property and casualty insurer and reinsurer, with mortgage insurance operations. This unaudited Form 10-Q covers the three and six months ended June 30, 2016; comparisons are with the same 2015 periods unless noted. PwC performed an interim review, not an audit. Results include Watford Re, which Arch consolidates as a variable interest entity despite owning approximately 11% of its common equity.
Financial performance and position
Unless otherwise stated, dollar amounts below are in millions.
| Metric | Q2 2016 | Q2 2015 | First half 2016 | First half 2015 |
|---|---|---|---|---|
| Net premiums earned | $1,006 | $943 | $1,958 | $1,854 |
| Total revenues | $1,191 | $1,020 | $2,278 | $2,102 |
| Net income | $249 | $126 | $425 | $435 |
| Net income available to Arch common shareholders | $206 | $110 | $355 | $388 |
| Diluted EPS | $1.65 | $0.88 | $2.85 | $3.05 |
| Consolidated combined ratio | 91.4% | 89.7% | 90.2% | 89.2% |
Q2 revenue and common-shareholder income rose substantially, aided by investment gains and foreign-exchange gains; first-half common income declined despite higher revenue. Q2 underwriting income was $111.7 million versus $105.1 million. The company’s non-GAAP operating return on average common equity was 9.0% for Q2 and 9.3% for the first half, below its stated through-cycle objective of 15% or greater.
Segment combined ratios for Q2 were 99.4% in insurance, 82.1% in reinsurance and 49.5% in mortgage. Insurance underwriting income fell to $3.3 million from $23.6 million; reinsurance income was $72.4 million versus $68.1 million; and mortgage income increased to $37.8 million from $16.6 million. The first-half consolidated combined ratio also worsened year over year.
Six-month operating cash flow was $541 million, compared with $385 million; investing activities used $356 million and financing activities used $213 million. Cash at June 30 was $517 million. Total assets were $24.4 billion, investments $16.7 billion, and total shareholders’ equity $7.5 billion, including $6.7 billion available to Arch. Book value per common share was $52.04, up from $47.95 at December 31, 2015.
Consolidated liabilities included $791 million of senior notes and $398 million of revolving borrowings; the latter included $298 million attributable to Watford Re. Arch’s own revolving borrowings were $100 million. Arch reported total capital available of approximately $7.6 billion, including $6.38 billion of common equity and $325 million of preferred shares. Restricted assets totaled $6.0 billion. Investment commitments were approximately $1.35 billion, including unfunded commitments.
Material changes and unusual items
- Net premiums written increased 8.4% to $2.145 billion in the first half. Mortgage premiums written rose 92%, while growth in reinsurance premiums was modest excluding a specific transaction. Insurance growth was partly offset by reduced program and property writings.
- Investment results were a significant year-over-year earnings factor: Q2 net realized gains were $68.2 million, compared with losses of $35.7 million; first-half gains were $105.5 million versus $47.6 million. Net investment income increased to $182.1 million for the first half from $166.0 million.
- Q2 reinsurance premiums included a loss portfolio transfer ($52.1 million gross and $40.2 million net written premium), substantially earned during the quarter and accompanied by corresponding losses. The transaction increased the Q2 current-year reinsurance loss ratio by 7.7 points. A separate contract commutation contributed $19.1 million to reinsurance other underwriting income.
- Prior-period reserve development was favorable in all three underwriting segments, including $69.8 million in reinsurance and $4.9 million in insurance for Q2. Reinsurance’s large favorable development materially affected reported loss ratios; meanwhile, Q2 catastrophe activity raised current-year loss ratios in insurance and reinsurance.
- Arch repurchased $75.3 million of common shares in the first half, versus $361.9 million in the prior-year period. No shares were repurchased under the public program in Q2; the program had $446.5 million remaining at June 30.
- Adoption of consolidation guidance led Arch to stop consolidating Alternative Re Ltd. from January 1, 2016; the filing says this had no effect on net income or shareholders’ equity.
Outlook, commentary and risks
- Management described property and casualty markets as competitive, with slight rate deterioration in some insurance sectors. It reduced writings in certain lines, emphasized underwriting discipline and said further price increases are needed in many lines given low interest rates. Mortgage market conditions were described as favorable, with U.S. market-share growth and opportunities in international and credit risk-sharing business.
- Management’s objective is average operating ROAE of at least 15% over the insurance cycle; this is an objective, not period-specific earnings guidance. It expects elevated mortgage underwriting expense ratios until Arch MI U.S. reaches scale.
- For catastrophe exposure, management’s modeled peak-zone net probable maximum pre-tax losses as of July 1 were $495 million for a Northeastern U.S. windstorm, $434 million for the Gulf of Mexico and $392 million for Florida’s Tri-County region. These estimates are not maximum exposures and may differ materially from actual losses.
- Risks include catastrophe severity and frequency, reserve-estimation uncertainty, reinsurer recoverability and payment timing, soft-market pricing, investment and interest-rate volatility, foreign exchange exposure, and potentially illiquid or leveraged alternative investments. Management also highlighted uncertainty following the U.K. Brexit vote. It expects liquidity needs over at least the next 12 months to be met from operations, investment income, cash and investments, maturities or sales, and credit facilities; claim timing or forced asset sales could affect liquidity.
- Management reported no litigation or arbitration expected to have a material adverse effect and stated disclosure controls were effective. Arch reported that Arch MI U.S. met PMIERs financial requirements at June 30, 2016. The filing notes the potential for regulatory limits on subsidiary dividends and capital availability.
Important facts for investors to verify
- How much of earnings and underwriting performance is supported by recurring operations versus realized investment/FX gains, the loss portfolio transfer and favorable reserve releases.
- Reserve adequacy and subsequent development, especially given substantial favorable reinsurance development and the increase in current-year catastrophe losses.
- Whether premium growth and pricing can sustain underwriting returns in competitive insurance and reinsurance markets, and whether mortgage growth maintains acceptable credit quality and capital requirements.
- Liquidity available at the parent and regulated subsidiaries after restricted assets, unfunded investment commitments, potential claims, and dividend and collateral requirements.
- Watford Re’s results, leverage and obligations, and the distinction between its consolidated balances and Arch’s stated limited financial exposure.