Arch Capital Group Ltd. — Q2 2019 Form 10-Q
Business and period: Bermuda-based global insurer, reinsurer and mortgage insurer. This unaudited quarterly report covers the three and six months ended June 30, 2019; comparisons are to the corresponding 2018 periods unless noted. PwC performed an interim review, not an audit. Results include Watford Re, which Arch consolidates despite owning approximately 11% of its common equity.
Financial results and key metrics
- Q2 revenue and earnings: Total revenue was $1.779 billion, up from $1.411 billion. Net premiums earned rose 9.5% to $1.464 billion. Net income was $485.8 million versus $256.3 million; net income available to Arch common shareholders was $458.6 million versus $233.2 million. Diluted EPS was $1.12 versus $0.56.
- First half: Total revenue was $3.502 billion versus $2.695 billion; net premiums earned were $2.833 billion versus $2.572 billion. Net income available to common shareholders was $896.7 million versus $370.5 million, and diluted EPS was $2.19 versus $0.89.
- Underwriting: Q2 consolidated underwriting income was $293.1 million, compared with $235.5 million; the combined ratio improved to 80.4% from 82.7%. Segment combined ratios were 99.6% for insurance (99.0% prior year), 90.3% for reinsurance (92.8%), and 28.0% for mortgage (30.2%). Mortgage underwriting income increased 25.6% to $258.4 million; insurance underwriting income was $2.7 million and reinsurance income was $36.7 million.
- Investments and unusual earnings drivers: Q2 net investment income increased to $155.0 million from $135.7 million. Net realized investment gains were $120.8 million, compared with losses of $76.6 million; these included derivative and fair-value movements. Equity-method investment fund income increased to $32.5 million from $8.5 million. First-half net realized gains were $262.4 million versus losses of $187.6 million. These market-sensitive items materially contributed to reported earnings.
- Operating returns and book value: Annualized operating ROAE, a non-GAAP measure, was 13.1% in Q2 versus 11.6%, and 12.7% for the first half versus 11.4%. Book value per share was $24.64 at June 30, up from $23.12 at March 31 and $20.68 at June 30, 2018.
- Cash flow and liquidity: Consolidated first-half operating cash flow was $712.5 million, investing cash outflow $746.9 million and financing cash outflow $9.1 million. Cash and restricted cash ended at $683.1 million. Excluding Watford, operating cash flow was $597.3 million and cash and restricted cash decreased $47.0 million. Management said anticipated liquidity needs for at least the next 12 months are expected to be met through operations, investment income, liquid assets, investment maturities or sales, and credit facilities.
- Balance sheet and capital: Total assets were $34.852 billion and total shareholders’ equity was $11.613 billion at June 30. Arch-available equity was $10.757 billion; total capital available to Arch was $12.491 billion. Arch’s senior notes, net of issuance costs, were $1.734 billion; its revolving facility had no borrowings. Debt was 13.9% of Arch total capital, and debt plus preferred shares was 20.1%. The consolidated balance sheet also includes $491.0 million of Watford revolving borrowings.
- Reserves and reinsurance: Loss and LAE reserves were $12.230 billion, including $9.206 billion net of recoverables. First-half favorable prior-year reserve development was $77.6 million, down from $115.6 million in the 2018 period. Reinsurance recoverables were $3.171 billion; 58.7% was due from carriers rated A- or better, and the filing says most amounts due from unrated carriers were collateralized.
Changes, outlook and risks
- Premium growth reflected expansion across underwriting segments, including U.K. commercial-lines renewal rights acquired in January 2019. Management described property-casualty market conditions as improving, with upward rate movement in property and selected casualty lines; Arch selectively increased writings while emphasizing underwriting discipline. Net property-catastrophe writings remained low.
- Management’s objective is average operating ROAE of 15% or greater over the insurance cycle; this is a long-term objective, not specific quarterly guidance. Mortgage conditions were described as generally favorable, with strong borrower credit quality and economy, though U.S. pricing remained competitive. Mortgage favorable reserve development and lower-than-expected claims helped results.
- Q2 catastrophe activity was modest in the reported segment ratios. The filing highlights modeled exposures, not maximum-loss guarantees: the July 1, 2019 peak-zone net probable maximum loss was $398 million for a Northeastern U.S. windstorm. Management’s target is to limit a 1-in-250-year event in any zone to approximately 25% of Arch-available equity. The modeled U.S. mortgage severe-economic-event loss was approximately 10% of tangible Arch-available equity.
- Key risks include catastrophe severity and frequency, mortgage defaults in a severe downturn, reserve-estimation uncertainty, changing market rates and competition, investment and interest-rate volatility, foreign exchange movements, and reinsurer performance or recoverability timing. A hypothetical 100-basis-point rise in rates was estimated to reduce fixed-income fair value by $690 million; actual effects may differ. Management reported no litigation expected to have a material adverse effect and no material change to previously disclosed risk factors.
- Subsequent events: Arch entered into a July agreement for up to $700.9 million of mortgage reinsurance coverage through Bellemeade 2019-3. Watford issued $175 million of 6.5% senior notes in July and redeemed most of its preference shares in August; Arch purchased $35 million of the notes. Arch announced an agreement to acquire Barbican Group on July 30, subject to regulatory approval, with closing expected in late Q3 or early Q4 2019.
Important facts for investors to verify
- Separate underlying underwriting performance from investment gains, derivative fair-value changes and equity-method fund income; these materially affected reported year-over-year earnings.
- Assess reserve adequacy and the sustainability of favorable development, particularly mortgage reserve releases and reinsurance loss trends; favorable development was lower than the prior-year comparable period overall.
- Track insurance-segment profitability: premium growth was strong, but the Q2 combined ratio rose and underwriting income declined from the prior year.
- Review Arch’s own liquidity and debt separately from Watford’s consolidated balances, and consider that some investments and commitments may not be immediately redeemable. Investment commitments were approximately $1.92 billion.
- Monitor mortgage portfolio credit quality, delinquencies, new business mix, reinsurance protection and the Barbican acquisition’s approval, closing and integration. Arch MI U.S. reported a 163% estimated PMIER sufficiency ratio at June 30.