Arch Capital Group Ltd. — Q1 2020 Form 10-Q
Business context and period. Arch Capital is a Bermuda-based global insurance, reinsurance and mortgage insurance group. This unaudited report covers the three months ended March 31, 2020; the prior-period comparison is Q1 2019 unless otherwise stated. PwC performed an interim review, not an audit.
Financial results and condition
| Metric | Q1 2020 / March 31, 2020 | Comparable period / prior year-end |
|---|---|---|
| Net premiums written | $2.137 billion | $1.525 billion; up 40.1% |
| Net premiums earned | $1.744 billion | $1.369 billion; up 27.4% |
| Total revenue | $1.534 billion | $1.723 billion |
| Net realized investment losses | $367.0 million | $140.3 million gains |
| Net income (loss), consolidated | $(88.7) million | $495.5 million |
| Net income available to Arch common shareholders | $133.7 million; diluted EPS $0.32 | $438.1 million; diluted EPS $1.07 |
| After-tax operating income available to Arch common shareholders (non-GAAP) | $189.8 million; operating ROAE 7.1% | $275.9 million; operating ROAE 12.3% |
| Operating cash flow | $610.5 million consolidated; $586.0 million excluding Watford | $235.4 million consolidated; $165.4 million excluding Watford |
| Cash and restricted cash | $1.070 billion | $903.7 million at December 31, 2019 |
| Total assets / total liabilities | $38.416 billion / $26.501 billion | $37.885 billion / $25.570 billion at year-end |
| Shareholders’ equity available to Arch | $11.367 billion; book value per share $26.10 | $11.497 billion; $26.42 at year-end |
| Capital and debt | $13.102 billion total capital available to Arch; debt-to-total-capital 13.2% | $13.232 billion; 13.1% at year-end |
The difference between consolidated net loss and positive income attributable to Arch reflects the large loss attributed to noncontrolling interests, principally Watford. Consolidated senior notes were $1.872 billion and revolving-credit borrowings were $500.6 million; Arch’s capital-structure debt figure excludes Watford and reports senior notes of $1.734 billion. Management said liquidity and capital resources were not materially affected by COVID-19 in the quarter and expects the next 12 months’ needs to be met from operating and investment cash flows, liquid assets and credit facilities.
Consolidated underwriting income was $154.1 million, versus $260.1 million in Q1 2019. The total combined ratio was 91.5%, compared with 81.7%; the combined ratio excluding the “other” segment was 90.5%, compared with 79.0%.
- Insurance: underwriting loss of $28.2 million versus income of $0.6 million; combined ratio 103.9% versus 99.9%. Net premiums written rose 33.4%.
- Reinsurance: underwriting loss of $9.4 million versus income of $20.9 million; combined ratio 102.0% versus 95.2%. Net premiums written rose 76.6%, including an $88 million loss portfolio transfer contract written and fully earned during the quarter.
- Mortgage: underwriting income of $197.6 million versus $244.1 million; combined ratio 44.1% versus 25.6%. Net premiums written rose 5.7%.
Net investment income fell to $145.2 million from $156.9 million. Arch’s investment portfolio returned negative 0.86% before investment expenses, outperforming its benchmark’s negative 4.55%. Book value per share fell 1.2% during the quarter, which management attributed to negative investment returns and COVID-19-related losses. Operating cash flow improved year over year; investing and financing activities used $278.5 million and $134.5 million, respectively, on a consolidated basis.
Material changes, outlook and risks
- COVID-19 losses and uncertainty: Arch recorded approximately $87 million of pandemic losses in insurance and reinsurance, allocated 41% and 59%, respectively. Mortgage’s Q1 combined ratio included 12.0 points of COVID-related losses. The company said exposure estimates remain highly uncertain and it could not predict the pandemic’s effects on results, financial condition or liquidity.
- Mortgage outlook: Management expects U.S. delinquencies to rise as borrowers seek CARES Act forbearance, with incurred losses likely to increase in coming quarters. It expects the mortgage segment to produce minimal pretax underwriting income for the remainder of 2020, with quarter-to-quarter variability. Management characterized the pandemic as an earnings event, not a capital event, based on its then-current analysis.
- Investment volatility: Market disruption drove realized losses and increased unrealized losses on available-for-sale investments: gross unrealized losses were $350.8 million at March 31, versus $55.0 million at year-end. Management warned that further market disruption, credit deterioration, defaults and lower reinvestment yields could adversely affect results. Equity-method fund reporting lags by one to three months; Arch warned Q1 results did not yet reflect the full market impact and said Q2 equity-method income could be significantly negative.
- Underwriting and reserve risks: Current-year catastrophe activity increased in insurance and reinsurance, including pandemic exposure. Prior-year reserves developed favorably by $19.0 million, less than the $39.4 million favorable development in Q1 2019. Actual claims may differ materially from reserve estimates.
- Mortgage capital and regulatory risks: Arch MI U.S. reported a 165% estimated PMIERs sufficiency ratio at quarter-end, up from 161% at year-end. Management cautioned that rising delinquencies, evolving forbearance treatment and potential changes in PMIERs requirements could affect capital requirements.
- Other risks and contingencies: Potential retroactive business-interruption coverage mandates, expanded workers’ compensation coverage, premium refunds, rating downgrades, cyber threats from remote work, and catastrophe losses are identified risks. Modeled 1-in-250-year peak-zone catastrophe losses were $680 million for Florida Tri-County windstorm, $583 million for the Northeastern U.S. and $568 million for the Gulf of Mexico; management cautioned these models are not maximum exposures. No litigation or arbitration was identified as expected to have a material adverse effect.
- Share repurchases: Arch repurchased 2.6 million shares for $75.5 million in Q1; approximately $924.5 million remained authorized through December 31, 2021. Management said future repurchases would depend on results, markets and other factors.
Most important facts for investors to verify
- How COVID-19 claims develop, including coverage disputes, business-interruption exposure and the adequacy of the $87 million P&C estimate.
- Mortgage delinquency, forbearance, cure and claim trends, and the impact on mortgage reserves, PMIERs capital sufficiency and the remainder-of-2020 outlook.
- Whether investment losses, credit deterioration and delayed equity-method fund reporting produce further earnings or book-value declines.
- Reserve development and loss trends by insurance and reinsurance line, especially catastrophe, casualty and contract-binding exposures.
- Liquidity and capital availability, including the distinction between Arch and consolidated Watford balances, debt and noncontrolling interests.
- Changes in regulatory or legislative treatment of pandemic-related insurance claims, mortgage relief and insurer capital requirements.