Arch Capital Group Ltd. — Q3 2012 Form 10-Q
Business context and period: Bermuda-based global insurance and reinsurance group. This filing covers the quarter and nine months ended September 30, 2012; interim statements are unaudited and were reviewed, not audited, by PwC. Financial figures below are U.S. dollars; amounts are in millions unless stated otherwise.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Net premiums written | $755.2 | $691.4 | $2,439.1 | $2,162.2 |
| Net premiums earned | $748.7 | $682.0 | $2,155.7 | $1,958.6 |
| Total revenues | $904.8 | $765.0 | $2,562.3 | $2,315.6 |
| Net income | $189.7 | $168.8 | $574.2 | $290.8 |
| Net income available to common shareholders | $184.2 | $162.3 | $554.6 | $271.4 |
| Diluted EPS | $1.33 | $1.18 | $4.01 | $1.96 |
| Net investment income | $73.2 | $82.8 | $221.1 | $257.7 |
| Net realized gains | $60.4 | $30.2 | $139.4 | $96.1 |
- Underwriting: Combined ratio was 90.2% for Q3 (94.4% prior year) and 89.2% for nine months (101.3% prior year). Underwriting income was $73.5 million for Q3 and $234.4 million year to date, versus $38.6 million and an underwriting loss of $25.5 million, respectively.
- Segments: Q3 insurance underwriting income was $0.8 million, with a 99.8% combined ratio; reinsurance earned $72.7 million, with a 75.3% ratio. Nine-month reinsurance underwriting income rose to $237.6 million from $40.9 million; insurance remained slightly loss-making at $3.2 million.
- Cash flow: Nine-month operating cash flow was $732.0 million versus $756.5 million. Investing used $493.1 million and financing used $173.5 million; cash increased $70.7 million to $422.4 million.
- Financial position at September 30: Total assets were $18.89 billion, liabilities $13.54 billion and shareholders’ equity $5.35 billion, up from $17.11 billion, $12.51 billion and $4.59 billion at year-end 2011. Book value per common share was $36.79, up from $31.76 at year-end.
- Debt and liquidity: Senior notes were $300 million, revolving credit borrowings $100 million, and TALF borrowings $185.2 million. The company had $422.4 million cash and $12.91 billion investments. It reported $444.8 million outstanding letters of credit, secured by investments, and $528 million of investment commitments. The $300 million revolving/LOC facility expires in August 2014; the company reported covenant compliance.
Material changes and unusual items
- Year-to-date earnings improved substantially, primarily reflecting lower catastrophe losses and stronger underwriting. Net catastrophe losses, net of reinsurance and reinstatement premiums, were $27.7 million in Q3 versus $59.6 million and $57.9 million for nine months versus $333.3 million.
- Favorable prior-period reserve development contributed $50.5 million in Q3 ($10.3 million insurance; $40.2 million reinsurance) and $167.6 million year to date. The filing notes adverse development in certain longer-tail insurance lines alongside favorable development elsewhere.
- Investment income fell despite larger investable assets; management cited lower market yields and investment mix. Pre-tax investment income yield was 2.45% in Q3 and 2.51% year to date, compared with 2.83% and 2.98% in 2011. Total investment return was 2.45% for Q3 and 5.04% year to date.
- In April, Arch issued $325 million of 6.75% Series C non-cumulative preferred shares and redeemed $325 million of Series A and B shares bearing 8.0% and 7.875% rates. No common shares were repurchased under the program during the period; $942 million remained authorized through December 2012.
- Arch acquired Ariel Re’s credit and surety reinsurance operations in April. Acquired unearned premiums contributed about $18 million to Q3 and $35 million year to date earned premiums.
- Effective January 1, 2012, the company retrospectively adopted revised accounting for insurance acquisition and renewal costs. The filing reports a $0.27 reduction in December 2011 book value per common share from the adoption.
- Subsequent to quarter-end, Arch sold its remaining TALF investments and extinguished the related financing. Hurricane Sandy made landfall on October 29; management said it was too early to estimate losses.
Outlook, commentary and risks
- Management described market rates as generally improving or holding steady. Insurance rates increased about 3.5% on a weighted basis in Q3; property catastrophe reinsurance pricing had improved significantly. Management cautioned that longer-tail insurance lines still needed substantial rate improvement and that additional reinsurance capacity could pressure renewal pricing, with Sandy potentially altering that outlook.
- The company targets average operating return on average common equity of at least 15% over the insurance cycle. Reported operating ROAE was 9.9% in Q3 and 10.8% year to date; management attributed the year-to-date improvement to better underwriting and fewer catastrophe losses.
- Arch expects catastrophe-exposed business to remain a significant part of its portfolio, adding earnings volatility. Its modeled peak-zone 1-in-250-year net probable maximum pre-tax losses as of October 1 were $880 million for Gulf of Mexico windstorm, $857 million for Northeastern U.S. windstorm and $653 million for Florida Tri-County windstorm. Management cautioned modeled losses are not maximum exposures and actual losses could differ materially.
- Key risks include reserve-estimation uncertainty, catastrophe frequency and severity, reinsurer collectability, investment and interest-rate volatility, credit and foreign-exchange risks, and economic weakness or sovereign-credit downgrades. Management also warned that irregular claim payments or delayed recoveries could require investment sales, potentially at a loss. It expects next-12-month liquidity needs to be met by operations, investment income, cash and investments, maturities/sales and credit facilities.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It did not identify litigation expected to have a material adverse effect.
Important facts for investors to verify
- Whether favorable reserve development persists, particularly in reinsurance, and whether adverse trends in longer-tail insurance reserves develop further.
- The ultimate insured and reinsured losses from Hurricane Sandy and the impact on catastrophe exposure and future pricing.
- Investment portfolio sensitivity: fixed-income credit quality, mortgage-backed and commercial mortgage-backed exposure, valuation inputs, and lower reinvestment yields.
- Liquidity and capital availability after considering restricted assets, outstanding letters of credit, investment commitments, subsidiary dividend restrictions and potential claim-payment volatility.
- Whether the improved underwriting results and the 15% cycle-average operating ROAE objective are achievable across market and catastrophe cycles.