Arch Capital Group Ltd. — FY 2015 Form 10-K
Business context and reporting period. This is an annual report for the fiscal year ended December 31, 2015, not a standalone fourth-quarter filing. Arch is a Bermuda-based global specialty insurer and reinsurer, with insurance, reinsurance, mortgage and other operations. Results include Watford Re, which Arch consolidates as a variable interest entity despite owning about 11% of its common equity. Arch obtained full ownership and effective control of Gulf Re in May 2015.
Financial performance and condition
| Metric | FY 2015 | FY 2014 |
|---|---|---|
| Net premiums written | $3.82 billion | $3.89 billion |
| Net premiums earned | $3.73 billion | $3.59 billion |
| Total revenues | $3.94 billion | $3.99 billion |
| Net income available to Arch common shareholders | $515.8 million | $812.4 million |
| Diluted earnings per common share | $4.09 | $6.02 |
| After-tax operating income available to common shareholders (non-GAAP) | $565.2 million | $617.3 million |
| Operating return on average common equity | 9.7% | 11.1% |
| Book value per common share, year-end | $47.95 | $45.58 |
| Net cash provided by operating activities, consolidated | $997.9 million | $1.04 billion |
- Underwriting: Underwriting income was $429.5 million, down from $471.1 million; the consolidated combined ratio was 89.5%, versus 87.2%. Insurance, reinsurance and mortgage segment combined ratios were 95.1%, 76.2% and 78.4%, respectively. Favorable prior-year reserve development totaled $285.1 million.
- Cash flow: Consolidated investing activities used $913.9 million and financing activities used $4.7 million. Cash increased by $67.6 million to $553.3 million. Management also presents cash-flow figures excluding Watford Re; those differ from the consolidated amounts.
- Investments: Total investable assets were $16.34 billion, including $1.70 billion attributable to Watford Re. Arch-managed assets excluding Watford Re were $14.64 billion. Fixed maturities were 76.5% of Arch-managed assets; 94.7% of fixed maturities were investment grade. Pre-tax portfolio total return was 0.41%, compared with a -0.38% benchmark return.
- Reserves: Year-end gross loss and loss-adjustment expense reserves were $9.13 billion, or $7.30 billion net of recoverables. Reinsurance recoverables were $1.87 billion. The filing emphasizes that reserve estimates are uncertain and sensitive to assumptions.
- Capital and debt: Capital available to Arch was approximately $7.10 billion, including $5.88 billion of common equity, $325 million of preferred shares, $791.3 million of senior notes and $100 million of Arch-level revolving borrowings. The consolidated balance sheet also includes $430.4 million of Watford Re borrowings; Arch states it does not guarantee or provide credit support for Watford Re. Common shareholders’ equity available to Arch was $5.88 billion.
- Liquidity: Arch reported $6.9 million of readily available cash, short-term investments and marketable securities at the parent level, excluding regulated subsidiaries. Arch received $459.8 million in dividends from Arch Re Bermuda during 2015. The filing says expected liquidity needs for at least the next 12 months are expected to be met by underwriting cash flows, investment income, available cash and investments, and credit facilities. Regulatory and contractual restrictions limit subsidiary distributions.
Material changes versus the prior comparable period
- Net premiums written fell 1.9%, while earned premiums rose 3.9%. Reinsurance net premiums written declined 18.0%, reflecting reduced writings in soft markets and increased cessions, including to Watford Re. Insurance net premiums written fell 4.7%; mortgage net premiums written increased 30.6%.
- Common-shareholder net income declined 36.5%. Net realized investment losses were $185.8 million in 2015, versus gains of $102.9 million in 2014; investment impairment losses recognized in earnings were $20.1 million, versus $30.2 million.
- After-tax operating income declined 8.4%, and operating ROAE fell 1.4 percentage points. Favorable reserve development was $285.1 million, compared with $326.9 million in 2014.
- Book value per common share rose 5.2%. Arch repurchased $365.4 million of common shares during 2015, compared with $454.1 million in 2014.
- Arch MI U.S. expanded its lender base and generated $10.27 billion of new insurance written. It satisfied the GSE’s PMIER financial requirements at year-end, but management expected additional capital contributions as the mortgage portfolio grows.
Outlook, commentary and risks
- Management described insurance and reinsurance markets as competitive, with continued pricing softening and broader pressure on terms. Arch reduced writings in selected lines and emphasized underwriting discipline. Its stated objective is an average operating ROAE of at least 15% over the insurance cycle; this is a long-term objective, not specific earnings guidance.
- Arch’s modeled peak catastrophe exposures as of January 1, 2016 included net probable maximum pre-tax losses of $489 million for a Northeastern U.S. windstorm, $444 million for the Gulf of Mexico and $362 million for Florida Tri-County. Management cautions that model estimates are not maximum exposures and actual losses could differ materially.
- Principal risks include catastrophic losses, reserve uncertainty and adverse development, competition and alternative capital, reinsurer and broker credit risk, investment and interest-rate volatility, foreign-exchange movements, mortgage-market conditions, and regulatory or tax changes. Arch’s 1-in-250-year catastrophe-loss target is approximately 25% of shareholders’ equity, but is not a cap on potential losses.
- Mortgage operations face competition from the FHA, other insurers and risk-transfer markets. PMIER requirements and GSE eligibility, housing-market performance, mortgage originations and loss experience could affect business, capital needs and profitability.
- Management reported no litigation or arbitration expected to have a material adverse effect on results, financial condition or liquidity. The independent auditor opined that the financial statements were fairly presented and internal control over financial reporting was effective.
Most important facts for investors to verify
- How much of reported earnings and underwriting profitability depends on favorable prior-year reserve releases, particularly the $224.8 million reinsurance-segment release.
- Whether investment losses, including the $185.8 million net realized loss, reflect temporary market movements or more persistent deterioration in portfolio values.
- Arch MI U.S.’s ongoing PMIER compliance, capital needs, GSE eligibility, portfolio growth and mortgage delinquency and claim trends.
- Liquidity available at the parent and regulated-subsidiary levels, dividend restrictions, outstanding credit facilities and the distinction between Arch’s borrowings and Watford Re’s debt.
- Whether soft-market pricing and terms continue to pressure premium volumes, underwriting margins and management’s long-term 15% operating-return objective.