Arch Capital Group Ltd. — 2011 Form 10-K
Business context and reporting period. Arch Capital is a Bermuda-based global property-and-casualty insurer and reinsurer focused on specialty lines. This annual report covers the year ended December 31, 2011; financial figures are U.S. dollars. The company reports insurance and reinsurance underwriting segments.
Key financial metrics
| Metric | 2011 | 2010 |
|---|---|---|
| Net premiums written | $2.673 billion | $2.511 billion |
| Net premiums earned | $2.632 billion | $2.552 billion |
| Total revenues | $3.063 billion | $3.244 billion |
| Net income | $436.4 million | $842.6 million |
| Net income available to common shareholders | $410.5 million | $816.7 million |
| Diluted EPS | $2.97 | $5.18 |
| After-tax operating income available to common shareholders | $303.6 million | $491.1 million |
| Operating ROAE | 7.2% | 12.0% |
| Net cash provided by operating activities | $866.1 million | $802.1 million |
- Underwriting: Combined ratio was 98.3% overall, 104.5% for insurance and 87.3% for reinsurance. Insurance underwriting recorded a $76.3 million loss; reinsurance underwriting income was $121.0 million.
- Investment results: Net investment income was $338.2 million, down from $364.9 million. Net realized gains were $110.6 million, versus $252.8 million; equity-method investment funds recorded a $9.6 million loss versus $61.4 million income.
- Capital and balance sheet: Total shareholders’ equity was $4.63 billion, including $4.30 billion common equity. Book value per common share rose 6.8% to $32.03. Cash and invested assets were $12.32 billion.
- Debt and liquidity: Long-term debt was $400 million: $300 million of senior notes and $100 million of revolving-credit borrowings. TALF borrowings added $310.5 million, secured by TALF investments. The company reported $866.1 million of operating cash flow. Parent-company readily available cash, short-term investments and marketable securities outside regulated subsidiaries totaled $8.0 million; management cited subsidiary dividend capacity and other liquidity sources as supporting obligations.
- Reserves: Gross loss and LAE reserves were $8.46 billion and net reserves were $6.64 billion. Reinsurance recoverables on paid and unpaid losses were approximately $1.85 billion.
Material changes versus comparable periods
- Net premiums written increased 6.5%; net premiums earned increased 3.1%. Reinsurance net premiums written rose 11.7%, while insurance net premiums written rose 3.8%.
- Common-shareholder net income and diluted EPS fell by about half. Management attributed lower operating income principally to higher catastrophe losses, competitive market conditions and lower investment yields. Lower realized gains and weaker equity-method fund results also reduced reported earnings.
- 2011 catastrophe activity materially affected underwriting: current-year catastrophe losses represented 6.5 points of the insurance loss ratio and 31.0 points of the reinsurance loss ratio. Events included the Japan earthquake and tsunami, Thailand floods, New Zealand earthquakes and U.S. wind and rain events.
- Prior-year reserve development was favorable by $285.0 million, compared with $146.7 million in 2010. Favorable releases were partly offset by adverse development in certain insurance casualty and program lines.
- Operating cash flow increased from $802.1 million. Share repurchases were $288.0 million in 2011, down from $761.9 million in 2010; approximately $942 million remained authorized at year-end.
Fourth-quarter information, outlook and risks
- Fourth quarter: Net income available to common shareholders was $136.8 million and diluted EPS was $1.00. Net premiums earned were $673.2 million. The quarter included $12.6 million of net foreign-exchange gains and $14.5 million of net realized gains.
- Management outlook: Management said market conditions remained competitive, though rates turned positive in many lines during the second half of 2011; further increases were needed in many lines for adequate returns. It viewed catastrophe-exposed business as the most attractive pricing area and expected it to remain a significant part of the portfolio. Its stated objective is average operating ROAE of at least 15% over the insurance cycle; this is a long-term objective, not specific 2012 earnings guidance.
- Catastrophe exposure: The company seeks to limit modeled 1-in-250-year net probable maximum loss in any geographic zone to approximately 25% of shareholders’ equity. January 1, 2012 modeled peak-zone losses were $881 million for Gulf of Mexico windstorm, $842 million for Northeastern U.S. windstorm and $638 million for Florida Tri-County windstorm. Management cautioned that modeled estimates are uncertain and are not maximum exposures.
- Subsequent events: Management estimated a $18–$35 million net loss from the January 2012 Costa Concordia marine event. It also estimated an $8–$10 million first-quarter 2012 loss on the Aeolus investment based on preliminary information. Both estimates could differ materially from actual results.
- Other risks and contingencies: Key exposures include catastrophe severity and frequency, reserve uncertainty, reinsurance counterparty performance, investment-market and interest-rate risk, broker concentration, competition, regulatory change and foreign-exchange movements. Aon and Marsh accounted for 19.4% and 14.2% of 2011 gross premiums written, respectively. Management said no litigation or arbitration was expected to have a material adverse effect at year-end.
- Capital access and regulation: A ratings downgrade could impair sales, trigger collateral requirements or contract termination rights, and affect credit facilities. Bermuda dividend and capital rules constrain upstream payments; Arch Re Bermuda could pay approximately $1.14 billion to ACGL during 2012 without filing a dividend affidavit. The company reported compliance with credit-facility covenants at year-end.
Most important facts for investors to verify
- Whether catastrophe losses and 2011’s unusually large favorable prior-year reserve releases are reflected appropriately in normalized underwriting expectations.
- Reserve adequacy, especially for long-tail casualty lines, and the sensitivity of estimates to loss ratios and reporting patterns.
- Reinsurance recoverable quality, collectability and counterparty concentration, given approximately $1.85 billion of paid and unpaid loss recoverables.
- Investment portfolio valuation, liquidity and exposure to mortgage-backed, structured, lower-rated and leveraged investments; investment returns trailed the benchmark in 2011.
- Parent-company liquidity and the practical availability of subsidiary dividends, credit facilities and letters of credit under regulatory, rating and covenant constraints.
- Actual development of the Costa Concordia and Aeolus estimates, and whether market-rate improvements support the company’s long-term return objective.
Audit and controls: PricewaterhouseCoopers issued an unqualified opinion on the consolidated financial statements and internal control over financial reporting; management also concluded that disclosure controls were effective.