Arch Capital Group Ltd. — Q1 2018 Form 10-Q
Business context and reporting period. Arch Capital is a Bermuda-based provider of insurance, reinsurance and mortgage insurance. This unaudited filing covers the three months ended March 31, 2018, with comparisons to Q1 2017 unless otherwise noted. PwC performed an interim review, not an audit, and reported no material modifications that should be made to the statements for GAAP conformity.
Financial performance and position
- Premiums and revenue: Net premiums written rose 10.7% to $1.413 billion; net premiums earned increased 10.6% to $1.235 billion. Total revenue declined 2.7% to $1.284 billion, principally reflecting a $111.0 million net realized investment loss, versus a $34.2 million gain a year earlier.
- Profit and per-share results: Net income was $166.4 million, down from $274.0 million. Net income available to Arch common shareholders was $137.3 million versus $241.9 million; reported diluted EPS was $0.99 versus $1.74. After-tax operating income, a non-GAAP measure, increased to $235.1 million from $198.0 million, and operating return on average common equity rose to 11.3% from 10.3%. Management’s through-cycle objective is an average operating return on average equity of at least 15%.
- Underwriting and margins: Consolidated underwriting income increased to $237.0 million from $212.1 million; the combined ratio was 81.3% versus 81.4%. Segment combined ratios were 98.6% for insurance, 80.7% for reinsurance and 38.8% for mortgage. The mortgage segment generated $174.9 million of underwriting income; insurance generated $7.9 million and reinsurance $54.8 million.
- Investment returns: Net investment income rose to $126.7 million from $117.9 million. Arch’s investment portfolio total return was negative 0.32% in Q1, compared with positive 1.70% in Q1 2017; the benchmark returns were negative 0.68% and positive 1.49%, respectively. Management attributed the current-quarter decline mainly to higher interest rates. Book value per share was $61.24, up from $60.91 at year-end, but below the quarter’s level before the effect of market movements is reflected in equity.
- Cash flow and liquidity: Consolidated operating cash flow was $400.2 million versus $183.7 million; this includes Watford Re. Excluding Watford Re, operating cash flow was $370.3 million versus $121.7 million. Consolidated investing cash flow was negative $57.9 million and financing cash flow negative $338.9 million. Cash was $680.9 million and cash plus restricted cash $732.3 million at quarter-end. Arch reported $19.79 billion of investable assets held by Arch, excluding $2.49 billion attributable to Watford Re, and said it expected liquidity needs for at least the next 12 months to be met through operating cash flows, investments and credit facilities.
- Debt and capital: Arch reported $11.26 billion of capital available to Arch, including $2.108 billion of debt, $780.0 million of preferred shares and $8.370 billion of common shareholders’ equity. Debt was 18.7% of total capital; debt and preferred shares together were 25.7%. The consolidated balance sheet reports $1.733 billion of senior notes and $755.3 million of revolving borrowings, including borrowings attributable to Watford Re.
- Reserves and equity: The balance-sheet reserve for losses and loss adjustment expenses was $11.496 billion, compared with $11.384 billion at year-end. Arch recorded $51.0 million of favorable prior-year reserve development, down from $83.2 million in Q1 2017. Shareholders’ equity available to Arch was $9.150 billion versus $9.197 billion at year-end.
Material changes versus Q1 2017
- Premium growth did not translate into higher reported net income: underwriting income improved, but the swing from investment gains to losses materially reduced revenue and profit.
- Net realized investment results moved from a $34.2 million gain to a $111.0 million loss. Investment-fund equity income also fell to $28.1 million from $48.1 million.
- Reinsurance net premiums written increased 23.3%, while its combined ratio worsened to 80.7% from 77.2%, partly reflecting less favorable prior-year reserve development and higher current-year loss ratio effects.
- Mortgage underwriting income rose 17.4% to $174.9 million, while net premiums earned grew 14.6%. U.S. mortgage new insurance written declined to $11.4 billion from $12.7 billion.
- Q1 2018 included a $2.7 million accounting loss on redemption of Series C preferred shares. The $92.6 million redemption reduced cash and preferred capital; the accounting loss itself had no effect on total equity or cash flows.
Outlook, risks and notable items
- Management described property-casualty markets as competitive, with slight rate deterioration in some areas, and said rate increases are needed in many lines to meet return requirements. It emphasized underwriting discipline, account selection and reinsurance to manage volatility.
- Management continues to write some catastrophe-exposed business. Its stated goal is to limit modeled 1-in-250-year net catastrophe loss in any geographic zone to approximately 25% of shareholders’ equity available to Arch. The April 1 modeled peak exposures included Northeastern U.S. windstorm at $477 million and Gulf of Mexico windstorm at $472 million. Management cautioned that modeled estimates are uncertain and are not maximum exposures.
- Mortgage conditions were described as favorable, with increased pricing pressure. The modeled severe-economic-event loss for U.S. mortgage insurance was less than 17% of tangible shareholders’ equity, against a stated limit of approximately 25%.
- Key risks include catastrophe and severe economic losses, reserve-estimation uncertainty, competition and pricing, investment and interest-rate movements, foreign exchange, reinsurance counterparty performance, regulatory and tax changes, and integration of acquired operations. Management noted that actual losses may differ materially from reserve and catastrophe-model estimates.
- No litigation or arbitration was identified as expected to have a material adverse effect on results, financial condition or liquidity. The filing reported no material change to the risk factors in the 2017 Form 10-K.
- Accounting changes effective in 2018 require fair-value changes on certain equity investments to be recognized in earnings; management said this may increase future earnings volatility. Adoption produced a $149.8 million transfer from accumulated other comprehensive income to retained earnings, with no material impact on total comprehensive income or financial position.
- Subsequent events included an April mortgage reinsurance agreement providing up to $374.5 million of aggregate excess-of-loss coverage, and approval of a three-for-one common share split expected to take effect in June 2018. Arch repurchased $110.5 million of shares from April 1 through May 9, leaving approximately $332.7 million available under the program at May 9.
Important facts for investors to verify
- Whether the improvement in underwriting and operating income persists, particularly given competitive pricing and the 15% through-cycle return objective.
- How investment performance, interest rates and adoption of fair-value accounting for equity securities affect earnings, comprehensive income and book value.
- Whether reserve estimates remain adequate; Q1 favorable development was lower than in the prior-year quarter and depends on reported and paid claims experience.
- Mortgage portfolio trends, including new insurance written, persistency, delinquencies, risk in force and the effect of changing pricing conditions.
- The composition of consolidated revolving borrowings and the distinction between Arch’s capital and liquidity measures and Watford Re’s separately managed assets and obligations.
- Execution and timing of the announced share split, post-quarter repurchases and the new mortgage reinsurance arrangements.