Arch Capital Group Ltd. — 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018. This is an annual filing; the filing also provides unaudited fourth-quarter results. Arch is a Bermuda-based global insurer, reinsurer and mortgage insurer. Figures are U.S. dollars unless noted; financial amounts are rounded.
Key financial results and condition
| Metric | 2018 | 2017 | Change or context |
|---|---|---|---|
| Net premiums written | $5.35 billion | $4.96 billion | Up 7.8% |
| Net premiums earned | $5.23 billion | $4.84 billion | Up 8.0% |
| Total revenues | $5.45 billion | $5.63 billion | Down 3.1%, largely reflecting investment losses |
| Income before taxes | $841.8 million | $757.3 million | Up 11.2% |
| Net income available to Arch common shareholders | $713.6 million | $566.5 million | Up 26.0%; diluted EPS was $1.73 versus $1.36 |
| After-tax operating income available to common shareholders (non-GAAP) | $909.2 million | $447.2 million | Diluted operating EPS was $2.20 versus $1.07 |
| Operating return on average common equity (non-GAAP) | 10.7% | 5.7% | Company objective is an average 15% or greater over the insurance cycle |
| Book value per share | $21.52 | $20.30 | Up 6.0% |
| Net investment income | $563.6 million | $470.9 million | Up 19.7% |
| Net realized investment gains (losses) | $(405.3) million | $149.1 million | Material drag on GAAP revenue and earnings |
| Net cash provided by operating activities (consolidated) | $1.56 billion | $1.09 billion | Higher premiums collected and lower net losses paid contributed |
| Arch capital available | $11.17 billion | $11.30 billion | Debt was 15.5% of capital; debt plus preferred shares was 22.5% |
Underwriting: Insurance, reinsurance and mortgage underwriting income totaled $897.1 million, compared with $510.8 million in 2017. Their combined ratio was 81.0% versus 88.8%. The insurance segment remained slightly unprofitable, with a 101.3% combined ratio; reinsurance was 94.5% and mortgage 28.9%. These ratios reflect favorable prior-year reserve development.
Liquidity and investments: Arch-held investable assets, excluding Watford Re, were $19.57 billion at year-end, including $583 million cash, $996 million short-term investments and $14.88 billion fixed maturities. The portfolio’s average effective duration was 3.38 years and embedded book yield 2.89%. The filing says expected operating cash flows, liquid investments and credit facilities are expected to meet foreseeable obligations; it does not provide a clear consolidated current-ratio measure. Arch’s revolving borrowings were repaid to zero; the $455.7 million revolving borrowing reported on the consolidated balance sheet was Watford Re debt, which Arch says it does not guarantee. Arch senior notes, net of issuance costs, were $1.73 billion.
Material changes and fourth-quarter results
- Mortgage underwriting income increased 24% to $857.0 million; net earned premiums rose 12.2%, and the segment loss ratio improved to 6.9% from 12.7%.
- Reinsurance underwriting income increased to $69.0 million from $12.1 million, as earned premiums grew and catastrophe activity was lower than in 2017.
- Insurance underwriting loss narrowed to $28.9 million from $192.6 million, but the combined ratio remained above 100%.
- Favorable prior-year reserve development was $272.7 million, versus $238.0 million in 2017. A 2018 retroactive reinsurance transaction reduced net reserves by $420.4 million and transferred specified runoff liabilities.
- Net realized investment results swung to a $405.3 million loss from a $149.1 million gain. Equity-method investment income also fell to $45.6 million from $142.3 million. Rising rates, wider credit spreads and negative equity returns weighed on returns, partly offset by alternative-investment performance. Pre-tax portfolio total return was 0.33%, versus 5.87% in 2017; the benchmark returned negative 0.60%.
- Fourth quarter 2018 net premiums earned were $1.37 billion, underwriting income was $167.0 million, and net income available to common shareholders was $126.1 million (diluted EPS $0.31). In fourth quarter 2017, the comparable figures were $1.22 billion, $182.1 million and $203.5 million (diluted EPS $0.49). The 2018 quarter included $166.0 million of net realized investment losses.
- Arch acquired specialized program administrator McNeil in December 2018. The U.K. Ardonagh commercial-lines renewal-rights transaction and authorization to write Australian lenders’ mortgage insurance occurred in January 2019.
Outlook, commentary and risks
- Management described property-casualty markets as competitive, with limited specialty areas offering returns that meet its risk-adjusted requirements. It emphasized underwriting discipline, reducing exposure in some commoditized lines, and limiting catastrophe exposure; property-catastrophe writings remained low.
- Management reported generally favorable mortgage conditions and U.S. mortgage pricing stabilization in the third quarter. Arch MI U.S. new insurance written grew to $69.5 billion from $62.0 billion, and first-lien delinquency declined to 1.60% from 2.23%. The mortgage business remains exposed to housing, employment, interest-rate and borrower-credit conditions.
- The company stated a long-term objective of average operating ROAE of at least 15% over the insurance cycle; this is an objective, not specific near-term earnings guidance. No numerical 2019 earnings or revenue guidance is provided.
- Key risks include catastrophic and climate-related losses, reserve-estimation uncertainty and adverse development, competitive pricing and capacity, reinsurer and broker credit risk, investment-market volatility, foreign-exchange exposure, cyber incidents, regulatory and tax changes, and Brexit-related disruption to U.K./EU insurance permissions.
- Net loss reserves were $9.04 billion, net of recoverables, and gross reserves were $11.85 billion at year-end. Management stresses that reserves are estimates and actual claims may differ materially. Mortgage reserves generally cover delinquent loans, not all potential future losses on loans currently performing.
- Arch-held reinsurance recoverables were $2.92 billion; 63.0% were due from carriers rated A- or better, while more than 90% of unrated recoverables were collateralized. The company also reported $1.77 billion of unfunded investment commitments, callable by managers.
- There were no litigation or arbitration matters management expected to have a material adverse effect. The financial statements received an unqualified audit opinion, and the auditor and management concluded internal control over financial reporting was effective.
Most important facts for investors to verify
- Whether reported earnings quality is sustained without the $272.7 million favorable prior-year reserve development and the 2018 retroactive reinsurance benefit.
- How the $405.3 million investment loss, market-sensitive fair values and equity-method investment returns develop, and how they affect book value.
- Whether mortgage underwriting remains strong as housing, unemployment, interest rates, persistency and GSE eligibility requirements change; review the $71.0 billion U.S. primary mortgage risk in force and 13.0-to-1 risk-to-capital ratio.
- Whether insurance segment performance improves from its 101.3% combined ratio and catastrophe losses remain within management’s modeled risk limits.
- Availability and collectability of reinsurance recoverables, funding of investment commitments, subsidiary dividend capacity, and the distinction between Arch debt and consolidated Watford Re obligations.
- Effects of acquisitions, integration, regulatory changes and Brexit on capital, operating costs and access to insurance markets.