ARCH CAPITAL GROUP LTD. quarterly report, Q2 FY2018

Arch Capital Group Ltd. — 2018 Second-Quarter Form 10-Q

Reporting period: Three and six months ended June 30, 2018. Arch provides global insurance, reinsurance and mortgage insurance. Financial statements are unaudited and were reviewed by PwC; the review is not an audit.

Financial results

Amounts below are in U.S. dollars; figures are rounded to millions except per-share data and ratios.

MetricQ2 2018Q2 2017Six months 2018Six months 2017
Net premiums earned$1,337$1,241$2,572$2,358
Total revenues$1,411$1,408$2,695$2,727
Net income$256$199$423$473
Net income available to common shareholders$233$174$371$416
Diluted EPS$0.56$0.42$0.89$1.00
Combined ratio82.7%84.6%82.0%83.1%
Operating ROAE (non-GAAP)11.6%8.5%11.4%9.4%
  • Underwriting: Consolidated underwriting income was $235 million in Q2 and $472 million for the first half. Mortgage contributed $206 million of Q2 underwriting income; insurance $6 million; reinsurance $24 million. Q2 combined ratios improved in insurance (99.0% vs. 100.8%) and reinsurance (92.8% vs. 94.0%); mortgage was 30.2% vs. 30.5%.
  • Investment results: Net investment income rose to $136 million in Q2 from $111 million; first-half income increased to $262 million from $229 million. However, net realized losses were $77 million in Q2 and $188 million for the first half, versus gains of $22 million and $56 million in the comparable periods. Equity-method fund income also declined to $8 million in Q2 and $37 million year to date, from $33 million and $81 million.
  • Cash flow: Consolidated operating cash flow was $497 million for the first half, versus $534 million. Investing activities provided $102 million, versus $289 million used in 2017; financing activities used $733 million, versus $328 million. Cash and restricted cash ended at $583 million, down from $727 million at year-end.
  • Balance sheet and capital: Total assets were $31.85 billion and total shareholders’ equity $10.02 billion at June 30. Equity available to Arch was $9.16 billion, versus $9.20 billion at year-end; book value per share was $20.68, versus $20.30 at year-end. Arch reported $11.02 billion of capital available to Arch, with debt-to-total-capital of 16.9% (18.6% at year-end). Consolidated senior notes were $1.73 billion and revolving-credit borrowings $572 million; the latter includes Watford Re borrowings. Arch’s separate capital-structure presentation excludes Watford Re and reports debt of $1.86 billion.
  • Liquidity: Management expects requirements for 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. Arch received $240 million of dividends from Arch Re Bermuda in the first half; further distributions are subject to regulatory and subsidiary constraints.

Changes versus prior periods

  • Q2 net income available to common shareholders rose about 34%, while first-half common income fell about 11%. Q2 revenue was nearly flat; first-half revenue declined about 1%.
  • Q2 investment and foreign-exchange items materially affected reported earnings: Arch recorded $46 million of net FX gains, compared with $38 million of losses in Q2 2017. First-half FX gains were $31 million versus losses of $58 million.
  • Investment performance was negative: total portfolio return was -0.19% in Q2 and -0.51% for the first half, compared with +1.63% and +3.37% in 2017. Management attributed 2018 performance principally to rising interest rates and currency effects; excluding foreign exchange, returns were 0.33% in Q2 and -0.08% year to date.
  • Net premiums written grew 4% in Q2 and 7% in the first half. Mortgage underwriting income rose 12% in Q2 and 14% year to date; reinsurance premiums grew, while its first-half combined ratio weakened to 87.4% from 86.6%.
  • Arch repurchased 6.5 million shares for $174 million in the first half and redeemed $93 million of Series C preferred shares. It also completed conversion of outstanding Series D preferred shares to common shares. A three-for-one common share split was approved in May and reflected retroactively in reported share and EPS data.

Outlook, commentary and risks

  • Management’s stated objective is an average operating return on average equity of 15% or greater over the insurance cycle; this is an objective, not quarterly guidance.
  • Management described the property-casualty market as competitive, with modest improvement in Q2. Rate increases in many lines were said to exceed loss-cost trends, though low investment yields mean further pricing is needed to meet return goals. The company emphasized underwriting discipline, smaller and mid-sized accounts, and reduced writings in catastrophe-exposed property where pricing did not meet return requirements.
  • Mortgage conditions were described as generally favorable but with pricing pressure. Arch MI U.S. new insurance written was $19.9 billion in Q2, up from $17.3 billion; its delinquency rate was 1.70%, down from 2.02% at year-end. Management cited favorable claim experience, but mortgage results remain exposed to housing and economic downturns.
  • Prior-year reserve development was favorable by $65 million in Q2 and $116 million for the first half, below the respective 2017 amounts of $69 million and $153 million. Insurance medium-tailed program and contract-binding lines had adverse development, partly offset by favorable developments elsewhere and in mortgage.
  • A subsidiary entered a retroactive reinsurance transaction covering certain discontinued U.S. specialty casualty and program liabilities. The reserve roll-forward records a $420 million transaction adjustment; related recoverables from the third-party reinsurer were reported as fully collateralized.
  • Effective July 1, 2018, insurance property-catastrophe reinsurance coverage changed to $275 million excess of a $75 million retention, versus $200 million excess of $150 million. Management’s modeled peak catastrophe exposure was a $404 million Northeastern U.S. windstorm loss. Such models are estimates, not maximum-loss limits, and actual losses could differ materially.
  • Risks include catastrophe and severe economic losses, reserve-estimation uncertainty, reinsurance counterparty performance, investment-market and interest-rate volatility, competition, foreign-currency movements, regulatory and tax changes, and cyber or operational disruption. Management reported no litigation expected to have a material adverse effect and no material change to previously disclosed risk factors.
  • New financial-instrument accounting requires fair-value changes on certain equity securities to run through net income. Adoption shifted $150 million between retained earnings and accumulated other comprehensive income and may increase earnings volatility. The first-half decline in accumulated other comprehensive income also reflected investment and currency movements.

Most important facts for investors to verify

  • How much reported earnings and the improvement in Q2 depended on FX gains, reserve releases, and other items excluded from management’s operating measure.
  • Whether favorable reserve development remains sustainable, particularly given adverse development in certain insurance programs and the limits of the company’s loss-history data.
  • The quality, collectibility, and collateral arrangements for the $420 million retroactive-reinsurance transaction and other reinsurance recoverables.
  • Mortgage portfolio credit quality, delinquency trends, capital requirements, and sensitivity to home-price or employment deterioration; verify the 134% estimated PMIER sufficiency ratio and 11.6-to-1 risk-to-capital ratio.
  • Investment portfolio exposure to rising rates, widening credit spreads, unrealized losses, less-liquid funds, and fair-value estimates; also assess the impact of the new equity-security accounting on earnings volatility.
  • Liquidity and capital allocation, including subsidiary dividend restrictions, remaining repurchase authorization of about $273 million, and the distinction between consolidated debt and Arch capital-structure figures that exclude Watford Re.