ARCH CAPITAL GROUP LTD. quarterly report, Q1 FY2013

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Arch Capital Group Ltd. — Q1 2013 Form 10-Q

Reporting period: Three months ended March 31, 2013. Financial statements are unaudited and were reviewed, not audited, by PricewaterhouseCoopers LLP. Amounts below are U.S. dollars; figures are in millions unless stated otherwise.

Business context and financial performance

Arch writes specialty insurance and reinsurance worldwide through operations in Bermuda, the United States, Europe and Canada. Results improved year over year, with stronger underwriting and a $45.0 million favorable swing in foreign-exchange results contributing to higher reported earnings.

  • Revenue: $890.1, up 9.2% from $815.0. Net premiums written were $952.8, up 10.3%; net premiums earned were $752.8, up 10.7%.
  • Profit: Net income was $256.5 versus $164.3; net income available to common shareholders was $251.0 versus $157.8. Diluted EPS rose to $1.85 from $1.14. After-tax operating income available to common shareholders, a non-GAAP measure, was $158.7 versus $113.7; Operating ROAE was 12.9% versus 10.4%.
  • Underwriting: Underwriting income increased to $116.4 from $67.2. The combined ratio improved to 84.6% from 90.1% (lower is better): insurance was 96.7% versus 101.8%, and reinsurance was 67.1% versus 68.4%.
  • Investment results: Net investment income fell to $65.7 from $74.3, while net realized gains rose to $58.3 from $44.1. Equity-method investment fund income declined to $13.8 from $24.8. Portfolio pre-tax total return was 0.50% versus 1.87%; the benchmark returned 0.46% versus 1.56%.
  • Cash flow: Operating cash flow was $205.7 versus $144.8; investing activities used $210.4 versus provided $3.4; financing activities used $3.1 versus $81.3. Cash declined $14.3 to $356.8 during the quarter.
  • Balance sheet and capital: Total assets were $18.76 billion and shareholders’ equity $5.34 billion at March 31, compared with $17.82 billion and $5.17 billion at year-end. Book value per common share increased 4.1% in the quarter to $37.66. Total cash and investments were $13.33 billion; investable assets were $13.13 billion.
  • Debt and liquidity: Debt comprised $300 million of senior notes and $100 million drawn on the revolving facility; preferred shares totaled $325 million. Parent-company readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, were $4.0 million. Subsidiaries had $449.0 million of letters of credit outstanding, secured by investments worth $524.9 million. The company reported compliance with facility covenants.

Changes versus Q1 2012

  • Insurance net premiums written rose 2.8%; reinsurance net premiums written rose 20.2%, including growth in mortgage, casualty and specialty business and renewals of credit and surety business acquired from Ariel in 2012.
  • Underwriting improvement was partly supported by favorable prior-period reserve development: $54.4 million in Q1 2013 versus $53.3 million in Q1 2012. Q1 2013 development included $49.4 million in reinsurance and $5.0 million in insurance.
  • Catastrophe effects were lighter in Q1 2013: insurance had no current-quarter catastrophe impact versus 1.2 loss-ratio points a year earlier; reinsurance had 3.6 points versus 7.4.
  • Net foreign-exchange results shifted to a $24.3 million gain from a $20.7 million loss. Conversely, investment income and equity-method fund earnings decreased. Comprehensive income was $199.0 million versus $244.8 million, reflecting a $57.5 million other comprehensive loss, including currency translation effects.
  • Operating cash flow increased, while cash used in investing rose. Q1 2013 financing included $41.0 million of share repurchases; Q1 2012 included repayment of $70.0 million of TALF borrowings.

Outlook, risks and unusual items

  • Management described broad market conditions as improving. In insurance, weighted rate increases were about 3% above loss-cost trends in Q1, but management said longer-tail lines still needed significant rate improvement. Property and property-catastrophe reinsurance renewals were expected to decline 5%–10% in aggregate, with variation by account and impact from Superstorm Sandy.
  • Management’s objective is average Operating ROAE of 15% or greater over the insurance cycle. It emphasized underwriting discipline, smaller and medium-sized accounts, and greater focus on short-tail business, while noting catastrophe-exposed business remains significant and can increase results volatility.
  • Modeled peak-zone 1-in-250-year net probable maximum pre-tax loss at April 1 was $886 million for a Northeastern U.S. windstorm, followed by $798 million for the Gulf of Mexico and $582 million for Florida Tri-County. The estimates are model-dependent, are not maximum exposures, and exclude income taxes and excess-reinsurance reinstatement premiums. Management’s stated target is to limit such modeled peak-zone loss to about 25% of shareholders’ equity.
  • Arch agreed to acquire CMG Mortgage Insurance Company and PMI’s mortgage insurance operating platform for estimated aggregate consideration of about $300 million, with possible additional payments tied to portfolio results. The deal requires regulatory, Arizona receivership court and government-sponsored enterprise approvals; closing was not expected before late 2013. Related reinsurance and legacy-runoff service arrangements are also contemplated.
  • Key risks include uncertainty in loss reserves and reinsurance recoveries, catastrophe frequency and severity, reinsurer performance, investment-market and interest-rate movements, mortgage-security credit and prepayment risks, foreign-exchange exposure, and possible restrictions on subsidiary distributions. Unfunded investment commitments were about $807.2 million.
  • There were no litigation or arbitration matters management expected to have a material adverse effect. Disclosure controls were reported effective; no material change in internal control over financial reporting was reported.

Important facts for investors to verify

  • Whether favorable reserve development—particularly the reinsurance releases—and low catastrophe activity are repeatable, and how reserves develop in later periods.
  • Whether premium growth and achieved rate changes are sufficient to offset loss-cost trends, especially in longer-tail insurance and upcoming property reinsurance renewals.
  • Required approvals, final consideration, portfolio performance adjustments and risk allocation under the proposed CMG MI/PMI transactions.
  • Investment portfolio sensitivity to credit, interest rates, mortgage exposures and foreign exchange, including the increase in below-investment-grade fixed maturities to 8.0% from 6.9% at year-end.
  • Availability of parent-level liquidity and subsidiary dividend capacity, given restricted assets, outstanding letters of credit, $807.2 million in investment commitments and the planned acquisition.