Arch Capital Group Ltd. — Q2 2015 Form 10-Q
Business context and reporting period. Arch is a Bermuda-based insurer and reinsurer writing specialty property and casualty and mortgage business worldwide. This unaudited quarterly report covers the three and six months ended June 30, 2015; the balance sheet is compared with December 31, 2014. PwC performed an interim review, not an audit, and reported no material modifications needed for GAAP conformity.
Financial performance and position
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Net premiums written | $943.6 million | $971.9 million | $2,010.6 million | $2,036.9 million |
| Net premiums earned | $943.4 million | $907.2 million | $1,853.7 million | $1,766.9 million |
| Total revenues | $1,019.7 million | $1,035.7 million | $2,102.0 million | $1,981.9 million |
| Net income | $125.8 million | $211.7 million | $434.6 million | $390.9 million |
| Net income available to common shareholders | $110.3 million | $202.5 million | $388.2 million | $379.5 million |
| Diluted earnings per share | $0.88 | $1.48 | $3.05 | $2.78 |
| After-tax operating income available to common shareholders (non-GAAP) | $146.0 million | $160.7 million | $295.8 million | $325.1 million |
In Q2, the consolidated combined ratio was 89.7%, versus 86.5% a year earlier. Underwriting income was $105.1 million, versus $124.1 million. For the first half, combined ratio was 89.2%, versus 85.7%, and underwriting income was $221.6 million, versus $256.5 million. Lower premiums and weaker underwriting results were partly offset by investment income growth.
At June 30, total assets were $23.08 billion, total investments $15.35 billion, cash $525.1 million, and shareholders’ equity $6.93 billion. Equity available to Arch was $6.14 billion; common book value per share was $47.49, compared with $45.58 at year-end. Total capital available to Arch was approximately $7.03 billion.
Debt comprised $791.2 million of senior notes and $100.0 million of revolving credit borrowings. The company had $456.3 million of outstanding letters of credit secured by investments valued at $521.9 million. It reported compliance with facility covenants. Six-month operating cash flow was $385.2 million, compared with $453.1 million; investing cash use was $39.2 million, versus $952.1 million; financing cash use was $306.6 million, versus $988.9 million of financing inflows. Cash increased by $39.4 million.
Material changes versus comparable periods
- Q2 net income available to common shareholders fell to $110.3 million from $202.5 million. The swing included $35.7 million in consolidated net realized investment losses, versus $54.1 million in gains a year earlier, and $19.6 million in foreign-exchange losses, versus $2.3 million. Six-month net income increased, aided by $46.9 million in foreign-exchange gains versus $8.9 million in losses in 2014; realized gains were lower.
- Q2 net premiums written declined 2.9% overall. Insurance net premiums written fell 12.1% and reinsurance fell 13.1%, while mortgage grew 22.4%. For the first half, total net premiums written fell 1.3%; reinsurance declined 18.2%, while mortgage increased 21.2%.
- Q2 insurance underwriting income fell 31.3% to $23.6 million, and its combined ratio worsened to 95.4% from 93.4%. Reinsurance underwriting income fell 16.9% to $68.1 million, though its combined ratio was nearly stable at 76.1%. Mortgage underwriting income rose 88.8% to $16.6 million, with a 75.3% combined ratio versus 85.0%.
- Favorable prior-period reserve development supported results: $18.6 million in insurance and $57.8 million in reinsurance during Q2; first-half favorable development was $27.3 million and $115.8 million, respectively. The reinsurance release was lower than the prior-year comparable period.
- Q2 net investment income rose to $87.0 million from $73.0 million, while the managed portfolio’s Q2 pre-tax total return was negative 0.04%, compared with positive 1.80% a year earlier. First-half portfolio return was 1.07%, versus 2.84%.
Outlook, management commentary, risks and unusual items
- Management described insurance and reinsurance markets as competitive, with softening prices and pressure on terms. Rates increased in some longer-tailed insurance lines but remained below management’s view of loss-cost trends; short-tailed rates declined. Arch reduced writings in selected reinsurance lines and emphasized disciplined underwriting. It cited a long-term objective of average operating return on average common equity of at least 15% over the insurance cycle; reported Operating ROAE was 9.9% for Q2 and 10.2% for the first half.
- Arch completed its acquisition of full ownership and effective control of Gulf Re on May 14, 2015. Gulf Re distributed $130.6 million to Arch and its partner; Arch acquired the partner’s remaining investment for $25.6 million in fixed-maturity investments. The partner retains equal participation in Gulf Re’s financial results and an option to purchase shares over seven years.
- Watford Re is consolidated as a variable interest entity, although third parties own approximately 89% of its common equity. Its assets are available only to satisfy its own obligations; Arch’s exposure is limited to its investment and collateral-mitigated counterparty risk.
- Management estimated Q2 catastrophe exposure, based on July 1 in-force exposures, at net pre-tax probable maximum losses of $541 million for a Northeast U.S. windstorm, $522 million for the Gulf of Mexico, and $445 million for Florida Tri-County. These modeled zone estimates are not maximum possible losses; actual losses can differ materially. Arch’s stated 1-in-250-year zone loss threshold is approximately 25% of equity available to Arch.
- Key exposures include catastrophe severity and frequency, reserve-estimation uncertainty, reinsurer collectability and timing, market and interest-rate movements, currency fluctuations, and the liquidity of certain investments. Investment commitments were approximately $1.12 billion, compared with $968.9 million at year-end; some funds may have gates or lockups. Regulatory and rating requirements can restrict subsidiary dividends and capital availability.
- Revised GSE mortgage-insurer eligibility requirements take effect December 31, 2015. Based on its interpretation and June 30 portfolio and balance sheet, management believed Arch MI U.S. then met the financial requirements. The filing notes that available-asset needs depend on portfolio composition, economic conditions, and allowable ceded-risk credit.
- Arch repurchased 5.9 million shares for $361.9 million in the first half, including 3.2 million shares for $199.0 million in Q2. Approximately $525.3 million remained authorized at June 30. Q2 book value per share declined 0.6% from March 31, which management attributed primarily to the dilutive effect of repurchases.
- A reassessment of an assumed deposit-accounting liability reduced Q2 interest expense by $8.4 million, because paid losses were expected to be lower than previously estimated. No material litigation expected to adversely affect results, financial condition, or liquidity was disclosed.
Most important facts for investors to verify
- Whether underwriting margins and premium trends stabilize in the persistently soft insurance and reinsurance market, particularly in property catastrophe and other reduced-writing lines.
- The sustainability and quality of favorable reserve development, especially the material reinsurance reserve releases, and how actual claims compare with estimates.
- How much reported earnings depend on volatile realized investment results and foreign-exchange movements; compare GAAP earnings with the company’s non-GAAP operating income.
- Arch MI U.S.’s progress toward the revised PMIERs requirements, its risk-to-capital ratio, mortgage persistency, and growth in new insurance written.
- Liquidity and capital flexibility after share repurchases, including subsidiary dividend capacity, $1.12 billion of investment commitments, collateral requirements, and the availability of credit and letter-of-credit facilities.