Arch Capital Group Ltd. — Q1 2017 Form 10-Q
Business context and period. Bermuda-based global specialty insurer and reinsurer, with mortgage insurance operations. This filing covers the three months ended March 31, 2017; the interim financial statements were reviewed, not audited. Results include United Guaranty Corporation (UGC), acquired December 31, 2016, so mortgage-segment comparisons with Q1 2016 are not like-for-like.
Key financial metrics
| Metric | Q1 2017 | Q1 2016 / prior date |
|---|---|---|
| Total revenue | $1.319 billion | $1.087 billion |
| Net premiums earned | $1.117 billion | $951.6 million |
| Net income | $274.0 million | $175.6 million |
| Net income available to Arch common shareholders | $241.9 million | $149.3 million |
| Diluted earnings per common share | $1.74 | $1.20 |
| Net investment income | $117.9 million | $93.7 million |
| Operating cash flow | $208.1 million | $322.5 million |
| Cash | $703.8 million | $842.9 million at Dec. 31, 2016 |
| Total assets | $30.092 billion | $29.372 billion at Dec. 31, 2016 |
| Total shareholders’ equity | $9.474 billion | $9.106 billion at Dec. 31, 2016 |
| Debt in Arch capital structure | $2.232 billion | $2.232 billion at Dec. 31, 2016 |
Consolidated underwriting income was $212.1 million, versus $115.7 million. The consolidated combined ratio improved to 81.4% from 88.4% (lower is better). Segment combined ratios were 98.0% for insurance, 77.2% for reinsurance, and 40.8% for mortgage. Favorable prior-year reserve development was $83.2 million, compared with $56.0 million.
Book value per common share rose 4.5% during the quarter to $57.69. Management reported annualized operating return on average common equity of 10.3%, versus 9.8%, and total investment return of 1.70%, versus 1.82%; the Q1 2017 benchmark return was 1.49%.
Liquidity and capital: Arch reported $18.83 billion in investable assets, excluding $1.90 billion attributable to Watford Re. Debt-to-total-capital was 20.6%, down from 21.3%. Arch MI U.S. reported estimated PMIERs sufficiency of 122%, versus 116% at year-end. Unfunded investment commitments were approximately $1.45 billion. The company said it expects liquidity needs for at least the next 12 months to be met by operating and investment cash flows, cash and short-term investments, investment maturities or sales, and credit facilities.
Material changes versus the prior comparable period
- Revenue increased about 21% and common-share net income about 62%; diluted EPS increased from $1.20 to $1.74. Revenue and earnings comparisons reflect UGC, acquired at year-end, as well as investment and underwriting results.
- Mortgage net premiums earned increased to $244.5 million from $61.8 million, and mortgage underwriting income to $148.9 million from $27.6 million; the acquired UGC business is a major driver, so this growth is not directly comparable.
- Insurance underwriting income declined to $10.0 million from $30.1 million; its combined ratio worsened to 98.0% from 94.2%, reflecting a higher current-year loss ratio and weaker market conditions.
- Reinsurance underwriting income decreased to $55.4 million from $58.9 million. Its combined ratio was broadly stable at 77.2% versus 77.6%; current-year catastrophe activity and large losses raised the current-year loss ratio, partly offset by reserve releases.
- Equity-method investment fund income was $48.1 million, versus $6.7 million in the prior-year quarter. Amortization of intangibles rose to $31.3 million from $4.7 million, mainly reflecting UGC-acquired intangibles; interest expense rose to $28.7 million from $16.1 million, primarily following debt issuance and higher revolver borrowings.
- Operating cash flow fell to $208.1 million from $322.5 million. Management attributed lower Arch-only operating cash flow in part to lower premiums collected and higher retrocessional activity. The decline in reported cash also reflects investing and financing cash uses.
Outlook, commentary, risks and unusual items
- Management described property-casualty markets as competitive, with slight rate deterioration in some sectors and flat or lower writings in certain lines. Low interest rates mean additional pricing increases are needed in many lines to meet return requirements. Mortgage market conditions were described as favorable.
- Management targets an average operating return on average equity of 15% or greater over the insurance cycle. It emphasized underwriting discipline, a focus on small and medium accounts, and using reinsurance to reduce volatility on large, high-capacity business; this is an objective, not quarterly guidance.
- Management’s modeled peak catastrophe exposure as of April 1, 2017 was a Northeastern U.S. windstorm with a $473 million net probable maximum pre-tax loss; Florida Tri-County and Gulf of Mexico windstorm estimates were $386 million and $383 million. Estimates are model-based, net of expected reinsurance and not maximum exposures; actual losses could differ materially. The stated risk threshold is to limit a modeled 1-in-250-year net loss in a zone to approximately 25% of Arch shareholders’ equity, subject to change.
- Risks include competitive pricing and alternative capital, catastrophe frequency and severity, reserve-estimation uncertainty, reinsurer and counterparty performance, market and interest-rate movements, foreign exchange, and regulatory or tax changes. No material changes to previously disclosed risk factors were reported.
- Q1 included $15.6 million of UGC transaction costs and other, including $8.2 million of severance-related costs. The company recorded $1.8 million of investment impairment losses, primarily on mortgage-backed securities it decided to liquidate in April 2017. Favorable reserve development and investment-fund gains materially contributed to results.
- Management reported no litigation or arbitration expected to have a material adverse effect. Disclosure controls were deemed effective, but the assessment of internal control over financial reporting excluded UGC; integration was expected to be completed during 2017. The filing also disclosed that certain non-U.S. marine policies may cover voyages involving Iran, but the company could not attribute revenues or profits to those activities.
Important facts for investors to verify
- How much of the earnings and premium growth reflects the UGC acquisition versus underlying organic performance, and how UGC integration and acquired intangible amortization progress.
- Whether reserve releases—$83.2 million overall, including $23.6 million in mortgage—are sustainable, and how current-year claims and catastrophe losses develop.
- Whether investment returns, particularly the $48.1 million of equity-method fund income, persist; review portfolio credit, valuation, liquidity, and interest-rate sensitivity.
- Liquidity and capital needs, including the $1.45 billion of unfunded investment commitments, debt and revolver usage, and mortgage-insurer PMIERs compliance.
- Catastrophe-model assumptions and reinsurance recoverability, noting the filing warns modeled loss estimates are uncertain and may understate actual outcomes.