Arch Capital Group Ltd. — 2017 Form 10-K
Business context and reporting period. Bermuda-based Arch provides property and casualty insurance, reinsurance, and mortgage insurance worldwide. This annual report covers the year ended December 31, 2017; comparisons are primarily with 2016. Results include Watford Re, which Arch consolidates despite owning approximately 11% of its common equity. Arch completed its UGC acquisition on December 31, 2016, so 2017 includes a full year of UGC operations; Arch MI Asia was acquired July 1, 2017.
Key financial metrics
| Metric | 2017 | 2016 | Change / context |
|---|---|---|---|
| Net premiums written | $4.961 billion | $4.031 billion | Up 23.1% |
| Net premiums earned | $4.845 billion | $3.885 billion | Up 24.7% |
| Total revenue | $5.627 billion | $4.464 billion | Up 26.1% |
| Net income | $629.7 million | $824.2 million | Down 23.6% |
| Net income available to common shareholders | $566.5 million | $664.7 million | Down 14.8% |
| Diluted earnings per common share | $4.07 | $5.33 | Down from $5.33 |
| Book value per share | $60.91 | $55.19 | Up 10.4% |
| Operating return on average common equity | 5.7% | 9.4% | Lower; management cites catastrophe losses |
| Consolidated underwriting income | $447.4 million | $474.1 million | Combined ratio 91.4%, versus 89.3% |
| Net investment income | $470.9 million | $366.7 million | Up; investment assets and yields contributed |
Segment underwriting results: Insurance recorded a $192.6 million underwriting loss and a 109.1% combined ratio, compared with $60.3 million of income and a 97.1% ratio in 2016. Reinsurance earned $12.1 million, with a 99.9% combined ratio, versus $262.0 million and 78.6%. Mortgage earned $691.3 million, with a 36.0% combined ratio, versus $156.3 million and 51.4%; the comparison is substantially affected by the UGC acquisition and the enlarged 2017 business base.
Cash flow and liquidity: Consolidated operating cash flow was $1.113 billion, investing cash flow was negative $1.360 billion, and financing cash flow was negative $3.4 million. Cash declined $236.7 million to $606.2 million. The MD&A also presents operating cash flow of $827.3 million excluding Watford Re; these figures have different scopes. Arch-held investable assets, excluding Watford, were $19.72 billion, including $14.80 billion of fixed maturities; average fixed-income credit quality was AA-/Aa2 and portfolio duration was 2.83 years. Restricted assets totaled approximately $6.67 billion. Arch reported $11.30 billion of capital available to Arch, including $2.11 billion of debt and $8.32 billion of common equity. Its mortgage insurers met PMIERs requirements, with a 129% sufficiency ratio.
Loss reserves and debt: Gross reserves for losses and loss adjustment expenses were $11.38 billion, or $8.92 billion net of recoverables, versus $10.20 billion gross and $8.12 billion net in 2016. Arch recorded $238.0 million of net favorable prior-year reserve development. At year-end, Arch’s capital presentation included $1.73 billion of senior notes and $375 million of revolving borrowings; consolidated balance-sheet revolving borrowings were $816.1 million, including Watford Re. The debt figures therefore differ by scope.
Material changes versus 2016
- Premium growth was substantial, driven in large part by the UGC mortgage acquisition; mortgage net premiums written rose to $1.111 billion from $391.5 million.
- Catastrophe activity sharply worsened property and reinsurance underwriting. The insurance current-year loss ratio included 10.3 points of catastrophe losses, versus 2.2 points in 2016; reinsurance included 16.0 points, versus 4.1 points. Events included Hurricanes Harvey, Irma and Maria and California wildfires.
- Favorable prior-year reserve development continued but declined to $238.0 million from $270.0 million, with a large contribution from reinsurance and acquired mortgage reserves.
- Investment returns strengthened: Arch’s 2017 pre-tax total return was 5.87%, above its 4.74% benchmark, compared with 2.07% versus 2.13% in 2016. Equity-method investment fund income rose to $142.3 million from $48.5 million.
- Net foreign-exchange results shifted to a $113.3 million loss from a $31.4 million gain. Interest expense rose to $117.4 million from $66.3 million, reflecting acquisition-related financing and borrowings.
- The U.S. corporate tax rate reduction under the Tax Cuts and Jobs Act resulted in a provisional remeasurement of deferred taxes; management identified an $8.1 million net charge, with a $21.5 million tax expense excluded from its non-GAAP operating measure.
Outlook, management commentary and risks
- Management described property and casualty markets as competitive, with slight rate deterioration in some areas and additional pricing needed to meet return requirements. Catastrophe activity could support rate improvement and growth opportunities. Mortgage market conditions were described as favorable.
- 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 a specific 2018 earnings forecast. The filing provides no numerical near-term earnings guidance.
- Reinsurance agreements between U.S.-based insurance and reinsurance subsidiaries and Arch Re Bermuda were not renewed effective January 1, 2018; the level of subject business ceded to Bermuda is expected to be substantially lower than in prior periods.
- Key risks include catastrophe severity and frequency, reserve estimation uncertainty, mortgage defaults tied to employment and home prices, reinsurance recoverability and counterparty credit, competitive pricing, investment-market and foreign-exchange volatility, and regulatory or rating changes. The company’s mortgage insurance reserves cover delinquent loans and are not an estimate of all future losses on loans not yet delinquent.
- Arch expected revised PMIERs requirements no earlier than the fourth quarter of 2018 and said it expected to meet them without capital changes, while noting uncertainty about final requirements. Brexit could disrupt U.K. and EU market access and passporting rights.
- The company reported no litigation or arbitration expected by management to have a material adverse effect. The auditor gave an unqualified opinion on the financial statements and concluded internal control over financial reporting was effective as of year-end.
Most important facts for investors to verify
- How much of premium growth and mortgage underwriting income is attributable to the full-year consolidation of UGC, and whether integration savings are being achieved.
- Whether catastrophe-related claims develop as estimated, particularly for 2017 events, and whether favorable prior-year reserve development persists.
- The effect of the non-renewed intercompany reinsurance agreements on 2018 underwriting, capital allocation, taxes and segment results.
- Arch MI U.S.’s PMIERs capital sufficiency, mortgage portfolio credit quality and delinquency trends, including the ultimate claims from hurricane-affected areas.
- Liquidity and capital availability after considering restricted assets, $1.70 billion of unfunded investment commitments, subsidiary dividend constraints, and the differing Arch versus consolidated debt figures.
- The final tax impact of the Tax Cuts and Jobs Act and the realized performance and liquidity of investment funds and other alternative investments.