Arch Capital Group Ltd. — Q3 2010 Form 10-Q
Reporting period: Three and nine months ended September 30, 2010. Arch is a Bermuda-based global insurer and reinsurer focused on specialty property and casualty business. Financial statements are unaudited; PwC performed a review, not an audit, and reported no material modifications were required.
Financial performance
Amounts below are U.S. dollars in millions, except per-share data and ratios.
| Metric | Q3 2010 | Q3 2009 | 9M 2010 | 9M 2009 |
|---|---|---|---|---|
| Net premiums written | 636.1 | 727.3 | 2,028.1 | 2,244.0 |
| Net premiums earned | 627.4 | 734.4 | 1,920.3 | 2,134.2 |
| Total revenues | 797.4 | 976.2 | 2,418.6 | 2,575.4 |
| Income before tax | 151.2 | 283.1 | 619.8 | 606.3 |
| Net income | 148.0 | 280.9 | 608.5 | 585.8 |
| Net income available to common shareholders | 141.6 | 274.4 | 589.1 | 566.4 |
| Diluted EPS | $2.77 | $4.39 | $11.05 | $9.05 |
| Operating income available to common shareholders, after tax (non-GAAP) | 130.7 | 160.3 | 361.6 | 492.4 |
| Combined ratio | 90.4% | 90.0% | 92.4% | 88.0% |
- Underwriting by segment: Q3 insurance underwriting income was $2.9 million (99.2% combined ratio); reinsurance income was $57.5 million (73.3%). For the first nine months, insurance recorded a $33.0 million underwriting loss (102.6% combined ratio), while reinsurance earned $179.7 million (73.3%).
- Investment results: Net investment income was $90.8 million in Q3 and $274.3 million year to date, down from $100.2 million and $296.6 million. Pre-tax investment yield was 3.33% in Q3 and 3.41% for nine months, reflecting lower market interest rates. Equity-method investment income fell to $9.7 million in Q3 and $38.4 million year to date, from $69.1 million and $135.4 million.
- Other earnings drivers: Net realized gains were $68.8 million in Q3 and $178.7 million year to date. Q3 included $65.2 million of foreign-exchange losses, largely unrealized; nine-month results included $22.1 million of FX gains. Impairment losses recognized in earnings were $2.1 million in Q3 and $8.1 million year to date, versus $4.6 million and $61.6 million in 2009.
- Cash flow and liquidity: Operating cash flow was $657.6 million for nine months, down from $808.7 million, primarily due to lower premium collections. Cash at September 30 was $366.0 million. Total assets were $17.70 billion, liabilities $12.98 billion, and shareholders’ equity $4.72 billion. Book value per common share was $89.24, up 22.2% from year-end 2009.
- Debt and capital: The balance sheet included $300 million of senior notes, $125 million drawn on the revolving facility, and $331.8 million of TALF borrowings, alongside $325 million of preferred shares. The company reported compliance with credit-facility covenants. It had $703.2 million of letters of credit outstanding, secured by investments valued at $785.4 million. Its $300 million revolving/LOC facility expires in August 2011.
Changes, outlook and risks
- Compared with Q3 2009, Q3 2010 common net income declined substantially, while nine-month common net income increased modestly. Lower premiums, investment income, and equity-method income weighed on results; realized gains helped, while Q3 FX losses were a significant offset.
- Management said 2010 rates were generally slightly lower, with increased competition in executive assurance and some property lines. It identified U.S. catastrophe-exposed business as the most attractive pricing area, while noting that it may remain a significant and more volatile part of the portfolio. No specific earnings or revenue guidance was provided.
- Catastrophe activity included the Chilean earthquake, European windstorm Xynthia, Australian hailstorms and floods, and New Zealand earthquake. As of October 1, modeled peak-zone 1-in-250-year net probable maximum pre-tax loss was $809 million for a Florida Tri-County windstorm, compared with $750 million at January 1. Management cautioned modeled losses are not maximum exposures and actual losses could vary materially.
- Management attributed lower operating returns to higher catastrophe activity, market conditions, and lower interest yields. Operating ROAE was 12.3% for Q3 and 11.5% for nine months, below the stated long-term objective of at least 15% over the insurance cycle.
- Key risks include reserve-estimation uncertainty and adverse development, catastrophe severity, softening prices and competition, investment-market and interest-rate volatility, mortgage and structured-security exposures, foreign exchange, and reinsurer nonperformance. Reinsurance recoverables were $1.72 billion; 91.7% were due from carriers rated A- or better.
- Management expected liquidity needs over at least the next 12 months to be met through underwriting and investment cash flows, cash and short-term investments, investment maturities or sales, and credit facilities. It cautioned that claims timing, delayed recoveries, illiquid investments, and constrained access to financing could pressure liquidity. The company had repurchased $503.7 million of shares in the first nine months; approximately $487.7 million remained authorized.
- Management reported no litigation or arbitration expected to have a material adverse effect. Disclosure controls were considered effective, and no material changes in internal control over financial reporting were reported.
Most important facts for investors to verify
- Whether the sharp year-over-year Q3 earnings decline and large FX loss reverse, and how much reported earnings depend on realized gains and investment-fund income.
- Reserve adequacy and the sustainability of favorable prior-period development, particularly given the insurance segment’s year-to-date underwriting loss.
- Catastrophe exposure relative to capital, including the assumptions and uncertainty in the Florida modeled loss estimate.
- Investment portfolio valuation, credit quality, liquidity and mortgage-related exposures; verify the effect of lower yields and unrealized losses.
- Liquidity and refinancing capacity ahead of the August 2011 facility expiration, as well as regulatory limits on subsidiary dividends and the continued pace of share repurchases.