Arch Capital Group Ltd. — 2013 Second-Quarter Form 10-Q
Business and period: Bermuda-based global insurer and reinsurer focused on specialty property and casualty business. This unaudited filing covers the quarter and six months ended June 30, 2013; comparisons are with the corresponding 2012 periods unless noted. PwC conducted an interim review, not an audit.
Financial performance
Amounts below are U.S. dollars in millions, except per-share data and ratios.
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Net premiums written | 810.5 | 820.2 | 1,763.3 | 1,683.8 |
| Net premiums earned | 758.8 | 726.7 | 1,511.6 | 1,407.0 |
| Total revenues | 851.8 | 842.5 | 1,741.9 | 1,657.5 |
| Net income | 176.9 | 220.3 | 433.4 | 384.5 |
| Net income available to common shareholders | 171.5 | 202.0 | 422.4 | 359.8 |
| Diluted earnings per common share | $1.26 | $1.46 | $3.11 | $2.61 |
| Underwriting income | 96.0 | 93.7 | 212.4 | 160.9 |
| Combined ratio | 87.4% | 87.2% | 86.0% | 88.6% |
| After-tax operating income available to common shareholders (non-GAAP) | 135.0 | 141.4 | 293.8 | 255.1 |
Q2 underwriting income improved modestly despite a higher reinsurance loss ratio. The six-month improvement reflected stronger underwriting income in both segments. Favorable prior-period reserve development was $69.5 million in Q2 and $123.9 million in the first half, including $53.5 million and $102.9 million, respectively, in reinsurance.
- Insurance: Q2 net premiums written rose 8.0%; underwriting income was $13.6 million versus $4.1 million, and the combined ratio improved to 97.1% from 99.1%. First-half underwriting income was $28.5 million versus a $4.0 million loss.
- Reinsurance: Q2 net premiums written fell 13.1%, mainly from reduced property catastrophe business; underwriting income was $82.5 million versus $89.6 million, and the combined ratio increased to 72.7% from 68.0%. First-half underwriting income rose to $183.9 million from $164.9 million.
Financial position, cash flow and capital
- Total assets were $18.92 billion at June 30, 2013, versus $17.82 billion at year-end 2012. Shareholders’ equity was $5.23 billion versus $5.17 billion.
- Book value per common share was $36.80, down from $37.66 at March 31, but up from $36.19 at December 31, 2012. Management attributed the quarterly decline primarily to rising interest rates and wider credit spreads.
- Cash was $375.1 million and short-term investments were $1.09 billion. Total investments were $12.98 billion. The filing reports $5.43 billion of restricted assets, principally supporting affiliated transactions, regulatory deposits and collateral arrangements.
- Six-month operating cash flow was $388.4 million versus $397.3 million. Investing activities used $305.7 million and financing activities used $66.1 million; cash increased by $4.1 million to $375.1 million. Management cited higher paid losses, including catastrophe claims, as a reason operating cash flow declined.
- Debt comprised $300 million of senior notes and $100 million drawn under a revolving credit facility, both unchanged from year-end. The revolver and letter-of-credit agreement expires August 2014. The company reported covenant compliance; $412.7 million of letters of credit were outstanding under facilities.
- Common-share repurchases were $56.5 million in the first half; $713.4 million remained authorized under the program, which runs through December 2014. The company reported approximately $751 million of unfunded investment commitments.
Material changes, outlook and risks
- Investments and comprehensive income: Q2 net investment income declined to $68.4 million from $73.6 million, and realized gains fell to $12.7 million from $34.9 million. The portfolio’s pretax total return was negative 1.59% for Q2 and negative 1.11% for the first half. Higher rates and wider spreads drove a $278.9 million Q2 other comprehensive loss and a $336.3 million first-half loss; accumulated other comprehensive income moved from positive $287.0 million at year-end to negative $49.3 million at June 30. Management stated the unrealized declines were largely market-related and that it did not intend, and was not likely required, to sell the affected securities before recovery.
- Management outlook: Management said market rates continued to improve in Q2, but longer-tail insurance lines still required significant rate increases to meet return objectives. Reinsurance terms and conditions were relatively stable. The company emphasized underwriting discipline and reduced property catastrophe deployment amid rate reductions. Its objective is an average operating return on average common equity of at least 15% over the insurance cycle; Q2 Operating ROAE was 10.9%, versus 12.3% a year earlier.
- Catastrophe exposure: Q2 losses included U.S. tornado and hail activity and European and Canadian flooding. As of July 1, modeled peak-zone net probable maximum pre-tax losses were $858 million for a Northeastern U.S. windstorm, $746 million for the Gulf of Mexico, and $606 million for Florida Tri-County. Management targets approximately 25% of shareholders’ equity for a 1-in-250-year event in any zone, but cautioned estimates are uncertain and actual losses may materially exceed modeled amounts.
- Acquisition: Arch U.S. MI agreed to acquire CMG Mortgage Insurance Company and PMI’s mortgage insurance platform. Estimated consideration was approximately $300 million, potentially subject to additional payments and financial commitments. Arizona receivership court approval was obtained; regulatory and Fannie Mae/Freddie Mac approvals and other closing conditions remained. Closing was expected in the latter part of 2013.
- Other risks and contingencies: Management highlighted reserve-estimation uncertainty, catastrophe severity and frequency, investment-market volatility, interest-rate and credit-spread risk, foreign currency exposure, potential reinsurer nonperformance, and possible liquidity constraints if claims or recoverables timing differs from expectations. The company reported no litigation expected to have a material adverse effect. Management said disclosure controls were effective and reported no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether reserve releases—particularly reinsurance releases—and catastrophe-related loss estimates remain favorable as claims develop.
- How investment portfolio values and book value respond to interest rates, credit spreads, realized sales, and the shift to unrealized losses in accumulated other comprehensive income.
- Whether lower property catastrophe premiums and improving market rates support underwriting returns without weakening risk selection.
- Final acquisition cost, required regulatory or government-sponsored entity capital commitments, approvals, and closing outcome for the mortgage insurance transaction.
- Liquidity and capital capacity after claims payments, restricted assets, unfunded investment commitments, share repurchases, and the August 2014 revolving facility maturity.