Arch Capital Group Ltd. — Q3 2015 Form 10-Q
Reporting period: Three and nine months ended September 30, 2015, compared with the same periods in 2014. Amounts are U.S. dollars; financial statements are unaudited and were reviewed, but not audited, by PwC. Arch writes specialty insurance and reinsurance and mortgage insurance globally.
Financial performance and condition
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Net premiums written | $972.0m | $959.5m | $2,982.5m | $2,996.5m |
| Net premiums earned | $936.7m | $903.7m | $2,790.4m | $2,670.6m |
| Total revenues | $932.6m | $992.5m | $3,034.6m | $2,974.4m |
| Net income available to Arch common shareholders | $74.5m | $223.2m | $462.7m | $602.7m |
| Diluted EPS | $0.60 | $1.64 | $3.66 | $4.42 |
| After-tax operating income available to common shareholders (non-GAAP) | $125.8m | $142.1m | $421.6m | $467.1m |
| Combined ratio | 90.7% | 89.0% | 89.7% | 86.9% |
| Net investment income | $86.2m | $80.1m | $252.2m | $220.1m |
Underwriting: Q3 underwriting income was $94.8m versus $101.1m; nine-month underwriting income was $316.4m versus $357.6m. Q3 segment combined ratios were 96.0% insurance, 80.1% reinsurance, and 75.2% mortgage. Nine-month ratios were 95.4%, 76.6%, and 79.5%, respectively. Favorable prior-period reserve development contributed materially, particularly in reinsurance: $49.9m in Q3 and $165.8m year to date.
Cash flow and liquidity: Consolidated operating cash flow was $807.6m for the nine months, versus $799.7m; investing activities used $500.8m and financing activities used $134.1m. Cash increased $164.1m to $649.8m. Excluding Watford, operating cash flow was $606.6m versus $770.9m, reflecting higher claim-related outflows and lower premium collections. Total investable assets were $16.33bn, including $14.73bn managed by Arch and $1.59bn attributable to Watford.
Capital and debt: Total shareholders’ equity was $6.94bn; equity available to Arch was $6.16bn, including $5.84bn common equity. Book value per common share was $47.68 at September 30, versus $45.58 at year-end 2014 (and $47.49 at June 30). Senior notes were $791.3m and revolving borrowings $339.1m, of which $239.1m related to Watford; Arch itself had $100m outstanding under its revolving facility. Total capital available to Arch was approximately $7.05bn. Arch repurchased $365.4m of common shares in the first nine months; $521.8m remained authorized.
Material changes and notable items
- Common-shareholder earnings fell sharply year over year, principally as investment results swung: Q3 net realized losses were $89.7m versus $18.5m gains; nine-month losses were $42.1m versus $92.4m gains. Investment fair-value movements, including losses on investments carried under the fair value option, were a major factor.
- Premiums earned rose, but the combined ratio worsened. Nine-month net premiums written were nearly flat overall, with mortgage growth offset by lower insurance and reinsurance writings. Reinsurance net premiums written declined 15.9% year over year as the company reduced business in competitive markets and increased cessions to Watford.
- Mortgage underwriting income increased to $17.1m in Q3 and $47.2m year to date. Arch MI U.S. generated $3.18bn of new insurance written in Q3; portfolio persistency declined to 76.0% from 80.9% at year-end, attributed to refinancing and low interest rates.
- Arch acquired full ownership and effective control of Gulf Re on May 14, 2015, purchasing GIC’s remaining interest for $25.6m in fixed-maturity investments. GIC retains participation rights in financial results and an option to purchase shares over seven years.
- Other-than-temporary impairment losses were $5.9m in Q3 and $12.8m year to date. Q3 corporate-bond impairments included energy-sector non-investment-grade holdings and foreign-currency effects.
Outlook, risks, and contingencies
- Management described insurance and reinsurance markets as competitive, with softening prices and broader pressure on terms. It said it reduced writings in selected lines and emphasized underwriting discipline and smaller and mid-sized accounts. The stated objective is average operating ROAE of 15% or more over the insurance cycle; reported Operating ROAE was 8.6% for Q3 and 9.7% year to date.
- Management expects liquidity needs for at least the next 12 months to be met through underwriting and investment cash flows, cash and short-term investments, investment sales or maturities, and credit facilities. No specific earnings or premium guidance was provided.
- Catastrophe exposures are material. Management’s modeled October 1 peak-zone net probable maximum pre-tax losses were $509m for a Northeastern U.S. windstorm, $473m for Gulf of Mexico windstorm, and $414m for Florida Tri-County windstorm. The stated target is to limit a modeled 1-in-250-year event in any zone to about 25% of equity available to Arch; management cautioned actual losses may differ materially and exceed modeled estimates.
- Other risks include reserve-estimation uncertainty, catastrophe frequency and severity, reinsurer collectability and timing of recoveries, competitive pricing, low interest rates, investment-market volatility, foreign-exchange movements, and potential illiquidity or redemption restrictions in certain investments. About $1.23bn of investment commitments were outstanding.
- Arch MI U.S. believed it met the revised GSE mortgage-insurer eligibility financial requirements as of September 30, 2015. The new requirements were scheduled to supersede existing conditions on December 31, 2015, with later certification and remediation deadlines.
- Credit facilities were within covenants. Outstanding letters of credit under Arch facilities were $451.8m, secured by investments valued at $517.4m. Management reported no litigation expected to have a material adverse effect on results, financial condition, or liquidity.
Important facts for investors to verify
- Whether the investment losses and fair-value volatility persist, and how much reported earnings depend on realized investment results, foreign exchange, and reserve releases.
- The durability of favorable reserve development—especially reinsurance—and the adequacy of loss reserves given management’s stated estimation uncertainty.
- Whether competitive pricing and reduced writings continue to weigh on premiums and underwriting returns, and whether the 15% cycle-average Operating ROAE objective remains attainable.
- Arch MI U.S.’s compliance with GSE eligibility requirements, its capital and risk-to-capital position, and the implications of declining persistency and mortgage-market conditions.
- Liquidity and capital availability after share repurchases, restricted assets, investment commitments, and the distinction between Arch borrowings and Watford’s non-guaranteed borrowings.
- Potential exposure to catastrophe losses above modeled estimates, as well as investment credit, market, currency, and fund-redemption risks.