Arch Capital Group Ltd. — Q1 2014 Form 10-Q
Period: Three months ended March 31, 2014. Unaudited interim financial statements were reviewed, not audited, by PricewaterhouseCoopers LLP. Unless stated otherwise, amounts below are U.S. dollars.
Business context and material developments
Arch writes specialty property and casualty insurance and reinsurance, and mortgage insurance and reinsurance worldwide. In Q1, it completed its acquisition of the CMG mortgage insurance entities and PMI’s mortgage insurance platform, expanding into the U.S. mortgage insurance market. It also invested $100 million for approximately 11% of Watford Holdings and a warrant. Arch consolidated Watford as a variable interest entity, despite owning a minority of its common equity; Watford’s assets are available only to meet Watford’s obligations.
Financial performance
| Metric | Q1 2014 | Q1 2013 |
|---|---|---|
| Total revenue | $946.2 million | $890.1 million |
| Net premiums written | $1,065.0 million | $952.8 million |
| Net premiums earned | $859.8 million | $752.8 million |
| Underwriting income | $132.5 million | $116.4 million |
| Net income | $179.1 million | $256.5 million |
| Net income available to common shareholders | $177.0 million | $251.0 million |
| Diluted earnings per common share | $1.30 | $1.85 |
| Operating ROAE | 12.1% | 12.9% |
- Premiums earned rose 14%; underwriting income increased about 14%. The consolidated combined ratio was 84.7%, versus 84.6% (lower is better). The underwriting segments’ combined ratio was 84.5%, versus 84.6%.
- Net income fell about 30%, primarily reflecting lower realized investment gains, foreign-exchange results shifting to a loss, and lower equity-method investment fund income. Realized gains were $19.7 million versus $58.3 million; foreign-exchange losses were $6.6 million versus gains of $24.3 million; equity in investment fund income was $3.3 million versus $13.8 million. Net investment income was broadly stable at $67.0 million versus $65.7 million.
- Segment underwriting income: insurance $33.2 million (up from $15.0 million); reinsurance $92.4 million (down from $97.0 million); mortgage $8.0 million (up from $4.5 million). Mortgage results include the acquired U.S. business only from its January 30 closing.
- Insurance combined ratio improved to 93.1% from 96.7%; reinsurance increased to 73.0% from 67.2%; mortgage increased to 81.3% from 61.5%. Favorable prior-period reserve development contributed $15.6 million in insurance and $70.4 million in reinsurance, compared with $5.0 million and $49.4 million, respectively, in Q1 2013.
- Book value per common share was $41.52, up 4.3% from year-end 2013. Comprehensive income was $227.9 million, compared with $199.0 million.
Financial position, cash flow and liquidity
- At March 31, total assets were $21.80 billion, total liabilities $14.90 billion, equity available to Arch $5.89 billion and total shareholders’ equity, including noncontrolling interests, $6.69 billion. Investable assets were $15.34 billion, including $1.08 billion attributable to Watford.
- Cash was $1.57 billion, up from $434.1 million at year-end, largely reflecting Watford’s capital raise. Cash from operating activities was $198.2 million (versus $205.7 million); investing activities used $41.2 million (versus $210.4 million); financing activities provided $978.4 million, principally from third-party investments in Watford.
- Debt included $800 million of senior notes and $100 million outstanding under the revolving credit agreement. The $300 million unsecured revolving loan/letter-of-credit and $500 million secured letter-of-credit facility expire August 18, 2014. Arch reported covenant compliance; $430 million of letters of credit were outstanding and secured by investments valued at $493.1 million.
- Parent-company readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries’ assets, totaled only $14.9 million. The company said expected operating cash flow, investment income, liquid assets and credit facilities should meet liquidity needs for at least the next 12 months, subject to regulatory limits on subsidiary distributions.
- Unfunded investment commitments were approximately $966.1 million. Restricted assets totaled $5.74 billion. No common shares were repurchased under the repurchase program during the quarter; $712.1 million remained authorized through December 2014.
Outlook, risks and unusual items
- Management’s objective is an average operating return on average common equity of 15% or greater over the insurance cycle; Q1 operating ROAE was 12.1%. This is a long-term objective, not quarter-specific earnings guidance.
- Management reported U.S. insurance rate increases generating 120 basis points of expected margin improvement in Q1. Reinsurance conditions softened: gross property catastrophe rates fell approximately 15%, cedents sought higher quota-share commissions, and buyers shifted toward excess-of-loss treaties. Arch said it was emphasizing disciplined underwriting and smaller and medium-sized accounts.
- Arch’s modeled peak-zone catastrophe loss was $705 million for a Northeastern U.S. windstorm, based on April 1 exposures. Management targets a 1-in-250-year net probable maximum pre-tax loss in any zone of approximately 25% of total shareholders’ equity, but cautioned actual losses can differ materially and exceed modeled estimates.
- Risk factors include catastrophic and other severe claims, reserve-estimation uncertainty, reinsurer nonperformance or delayed recoveries, soft pricing, investment-market and interest-rate volatility, foreign-exchange exposure, illiquid or leveraged investments, regulatory limits on capital distributions, and the ability to maintain financial strength ratings. The investment portfolio’s effective duration rose to 3.24 years from 2.62 years at year-end.
- Watford reported a $3.7 million net loss, including $2.7 million of nonrecurring start-up expenses; third-party interests reduced Arch’s attributable loss to $0.3 million. Watford’s capital proceeds remained in cash at quarter-end rather than invested. The CMG acquisition also created contingent consideration valued at $43.2 million at March 31, with a maximum potential payment of $136.3 million.
- Management reported no litigation or arbitration expected to have a material adverse effect and stated disclosure controls were effective. The filing identifies no formal quarterly earnings guidance.
Important facts for investors to verify
- How much of reported underwriting income and book-value growth depends on favorable prior-period reserve releases, particularly in reinsurance?
- Whether mortgage insurance growth, profitability and expense ratios develop as the acquired U.S. platform expands beyond credit-union customers; review risk-in-force, new business and persistency.
- Whether reinsurance pricing and terms continue to soften, and how premium growth and underwriting margins respond.
- Whether modeled catastrophe exposures, actual loss experience and purchased reinsurance remain consistent with management’s risk limits.
- Watford’s subsequent investment of raised capital, underwriting results, start-up costs and effects of consolidation; distinguish Arch’s economic ownership from consolidated balances.
- Liquidity and refinancing plans ahead of the August 2014 credit-facility expiry, alongside regulated-subsidiary dividend capacity and the $966.1 million of investment commitments.
- Investment portfolio valuation, interest-rate and credit-spread sensitivity, and liquidity restrictions; assess the effect of lower realized gains and foreign-exchange volatility on reported earnings.