Business context and reporting period
Arch Capital Group Ltd. (Bermuda) filed its Form 10-K for the fiscal year ended December 31, 2019; the filing also presents fourth-quarter results. The company writes specialty property and casualty insurance and reinsurance, and mortgage insurance and reinsurance worldwide. Results consolidate Watford, although Arch owned approximately 13% of its common equity; Watford is reported separately as the “other” segment. 2019 included the January acquisition of U.K. commercial-lines renewal rights from Ardonagh and the November acquisition of Barbican.
Financial performance and position
- Revenue and premiums: Total revenue was $6.93 billion, up 27% from $5.45 billion. Net premiums written rose 13% to $6.04 billion; net premiums earned rose 11% to $5.79 billion.
- Profit: Net income available to Arch common shareholders was $1.595 billion, or $3.87 diluted per share, versus $714 million, or $1.73, in 2018. After-tax operating income, a non-GAAP measure, was $1.163 billion ($2.82 diluted per share), up from $909 million ($2.20). After-tax ROAE was 16.5%; operating ROAE was 12.0%, versus 8.4% and 10.7%, respectively, in 2018.
- Underwriting and margins: Underwriting income was $1.036 billion versus $874 million. Combined ratios were 101.5% for insurance, 94.9% for reinsurance, and 24.9% for mortgage. The consolidated ratio was 82.5%, including Watford. Favorable prior-year reserve development was $163.6 million, down from $272.7 million.
- Cash flow and investments: Consolidated operating cash flow was $2.048 billion versus $1.559 billion; investing activities used $1.806 billion and financing activities used $81 million. Cash and restricted cash ended at $904 million. Arch-held investable assets, excluding Watford, were $22.29 billion. Net investment income was $627.7 million consolidated ($491.1 million excluding Watford). Arch’s pre-tax investment total return was 7.30%, approximately in line with the 7.39% benchmark.
- Capital, debt and liquidity: Total capital available to Arch was $13.23 billion; debt was 13.1% of total capital. Arch’s senior notes were $1.734 billion net of issuance costs, with no Arch revolving borrowings at year-end. Consolidated balance-sheet debt also includes Watford’s $484 million revolving borrowings and its notes. Book value per share increased 22.8% to $26.42. Arch MI U.S. reported a PMIER sufficiency ratio of 161%, versus 141% in 2018.
- Balance sheet: Total assets were $37.89 billion, total shareholders’ equity $12.26 billion, and net loss reserves $9.81 billion. Gross reserves were $13.89 billion; reinsurance recoverables on paid and unpaid losses were $4.35 billion.
- Fourth quarter: Net premiums earned were $1.516 billion, underwriting income $251 million, net income available to common shareholders $316 million, and diluted EPS $0.76.
Material changes versus 2018
- Net income more than doubled, reflecting a swing to $366 million in net realized investment gains from $405 million in net realized losses in 2018, alongside higher underwriting and investment income. The 2019 result therefore includes a substantial investment-market contribution.
- Net premiums written rose across insurance (+19%), reinsurance (+17%) and mortgage (+9%). Insurance growth included acquisitions and new initiatives as well as expansion in existing business and rate increases.
- Mortgage underwriting income rose 22% to $1.041 billion, while reinsurance underwriting income rose 17% to $81 million. Insurance underwriting remained loss-making at $35 million, with its expense ratio rising in part because of acquisitions.
- Catastrophe losses were lower than in 2018: current-year catastrophe activity contributed 1.4 points to the insurance loss ratio and 5.7 points to the reinsurance ratio. 2019 events included Hurricane Dorian and Japanese typhoons.
- Net favorable reserve development fell to $164 million from $273 million. The 2019 total included $125 million favorable development in mortgage, partly offset by adverse development in Watford and certain insurance and casualty lines.
- Book value growth reflected underwriting performance and investment returns. The investment portfolio’s unrealized position improved substantially, with accumulated other comprehensive income moving to $212 million from a $179 million loss.
Outlook, commentary and key risks
- Management targets an average operating ROAE of at least 15% over the insurance cycle, not as near-term earnings guidance. It described property and casualty markets as transitioning, with rate increases in many lines, and emphasized disciplined risk selection and capital allocation. Mortgage conditions were described as generally favorable, with strong borrower credit quality and economic conditions.
- Management highlighted catastrophe exposure, climate-related uncertainty, reserve estimation risk, competitive and cyclical pricing, investment-market volatility, foreign exchange, reinsurer collectability and mortgage-credit deterioration as material risks. The filing notes that actual losses may materially differ from modeled estimates. Mortgage insurance reserves cover delinquent loans and are not an estimate of all future losses on in-force policies.
- COVID-19 was identified as an emerging risk following the January 2020 global health emergency declaration; management said its effects were difficult to assess. The filing predates the pandemic’s later financial and claims impacts.
- Brexit’s effects remained uncertain. Arch moved EU insurance business previously written by its U.K. entity to its Irish-authorized platform from January 2020; future market access and regulatory arrangements depended on the transition-period outcome.
- Arch entered into an agreement to acquire a 29.5% stake in Coface for approximately €480 million, announced February 25, 2020. Closing remained subject to regulatory and antitrust approvals.
- Barbican transferred liability for 2018 and prior years of account to Premia effective July 1, 2019; reported year-end recoverables and funds-held liability were $177.7 million and $180.0 million, respectively. The auditor identified reserve valuation as a critical audit matter, reflecting significant estimation judgment; the audit opinion was unqualified and internal control over financial reporting was found effective.
- Management reported no litigation or arbitration expected to have a material adverse effect. The $1.0 billion common-share repurchase authorization runs through December 31, 2021; no common shares were repurchased under the public program in 2019, although employee-related share repurchases occurred. The company paid no common dividend.
Investor verification priorities
- Review the drivers and sustainability of the $1.595 billion common-share profit, especially realized gains, equity-method income and the non-GAAP operating-income reconciliation.
- Assess reserve adequacy and development by segment and line, particularly long-tail casualty, program and contract-binding exposures, and the implications of the auditor’s critical audit matter.
- Verify catastrophe aggregation and reinsurance protection, including counterparty collateral and the timing and collectability of recoverables.
- Track U.S. mortgage portfolio credit quality, delinquency trends, persistency, PMIER capital headroom and sensitivity to housing and employment conditions.
- Distinguish Arch’s own debt and liquidity from Watford’s consolidated balances, and monitor regulated-subsidiary dividend capacity, restricted assets and unfunded investment commitments.
- Confirm the closing, price, regulatory approvals and capital implications of the Coface transaction, as well as integration and performance of the 2019 acquisitions.