Arch Capital Group Ltd. — Q2 2011 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2011. Arch is a Bermuda-based global insurer and reinsurer focused on specialty property and casualty lines. Financial amounts below are in U.S. dollars; millions are used unless noted. Interim statements are unaudited and were reviewed, not audited, by PricewaterhouseCoopers.
Financial performance
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Net premiums written | $706.5m | $624.3m | $1,470.8m | $1,392.0m |
| Net premiums earned | $642.9m | $623.0m | $1,276.6m | $1,292.9m |
| Total revenues | $775.6m | $776.3m | $1,550.6m | $1,621.2m |
| Net income | $98.3m | $243.5m | $124.1m | $460.4m |
| Net income available to common shareholders | $91.9m | $237.0m | $111.2m | $447.5m |
| Diluted EPS | $0.67 | $1.48 | $0.80 | $2.74 |
Six-month after-tax operating income available to common shareholders, a non-GAAP measure, was $69.3m versus $230.9m; Q2 was $61.5m versus $132.2m. Operating ROAE was 6.1% in Q2 and 3.3% year to date, below management’s through-cycle objective of 15% or more. The filing attributes weaker results mainly to catastrophe losses, market conditions and lower reinvestment yields.
- Underwriting: Q2 underwriting income was $2.2m, down from $62.2m; the combined ratio was 99.6% versus 90.0%. Insurance recorded a $33.4m underwriting loss and a 108.1% combined ratio; reinsurance earned $35.7m with an 84.7% ratio.
- Year-to-date underwriting: Underwriting loss was $61.3m versus income of $86.2m; combined ratio was 104.8% versus 93.4%. Insurance’s ratio was 107.2%, and reinsurance’s was 100.6%.
- Current-year catastrophe losses, net of reinsurance and reinstatement premiums, were $95.0m in Q2 and $273.7m for the first half, compared with $7.0m and $65.1m in the respective 2010 periods. Favorable prior-period reserve development partly offset current losses: $58.3m in Q2 and $117.0m for the first half.
- Net investment income declined to $86.7m in Q2 and $175.0m in the first half, from $90.5m and $183.5m. Net realized gains were $45.2m and $65.9m, respectively, also below prior-year periods. First-half net foreign-exchange losses were $55.3m, compared with gains of $87.2m in 2010.
- Pre-tax total investment return was 1.65% in Q2 and 3.17% for the first half; the portfolio underperformed its benchmark by 28 basis points in Q2 but exceeded it year to date by about 30 basis points.
Financial position, cash flow and liquidity
- At June 30, total assets were $17.21bn, total liabilities $12.77bn and shareholders’ equity $4.44bn, compared with $15.81bn, $11.30bn and $4.51bn at December 31, 2010. Book value per common share increased to $31.00 from $29.99.
- Cash was $411.0m; total investments were $11.84bn. Net cash from operating activities for the first half was $446.5m, versus $390.1m. Investing activities used $199.1m and financing activities used $205.6m. Cash increased $48.3m.
- Debt and financing included $300m of senior notes, $100m drawn on the revolving facility and $318.4m of TALF borrowings. The $300m senior notes had a reported fair value of $321.9m. The revolving borrowing was due in August 2011.
- The revolving loan/letter-of-credit and secured letter-of-credit agreement expired August 30, 2011. The company reported covenant compliance at June 30 and said renewal or replacement was anticipated, but could not be assured on satisfactory terms. It had $629m of letters of credit outstanding, secured by investments valued at $714.6m.
- Holding-company readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, were only $9.9m. Management expected next-12-month liquidity needs to be met through underwriting and investment cash flows, cash and investments, and credit facilities. Subsidiary dividends are subject to regulatory and rating-related constraints.
- Repurchases used $266.7m of cash in the first half. At June 30, $962.8m remained authorized under the buyback program, which could continue through December 2012. Repurchases were a principal reason shareholders’ equity declined despite positive net income.
Changes, outlook and risks
- Net premiums written rose 13% year to date, led by reinsurance growth; earned premiums fell about 1%. Reinsurance catastrophe and other specialty premiums increased, while some casualty and non-catastrophe property writings declined.
- Management described insurance-market conditions as competitive, with slight price declines in many long-tail lines. Property catastrophe pricing improved: Q2 average rate increases were 8% in U.S. and 28% in international reinsurance business, with larger increases on loss-impacted business. Executive assurance and healthcare remained under pricing pressure.
- Management’s stated objective is average operating ROAE of at least 15% over the insurance cycle, not a near-term earnings forecast. Catastrophe-exposed business is expected to remain a significant part of the portfolio and may increase results volatility.
- Modeled July 1 peak-zone catastrophe losses were $740m for Florida Tri-County windstorm and $724m for Northeastern U.S. windstorm. These are model estimates, not maximum exposures; actual losses can materially differ and may exceed management’s stated goal of limiting a 1-in-250-year peak-zone net loss to about 25% of equity.
- Key risks include catastrophe severity and frequency, reserve-estimation uncertainty, reinsurance recoverability, investment-market and interest-rate volatility, foreign exchange, mortgage and structured-security exposures, and possible effects of U.S. economic weakness or a U.S. sovereign-rating downgrade. Management also warned that failure to renew or replace credit facilities could adversely affect liquidity.
- Investment commitments were approximately $158.2m. No litigation or arbitration was identified as expected to have a material adverse effect. Management reported effective disclosure controls and no material quarterly change in internal control over financial reporting.
Most important facts for investors to verify
- Renewal or replacement terms and availability of the credit and letter-of-credit facilities expiring August 30, 2011.
- Catastrophe loss development, including claims from 2011 events, and the sustainability of favorable prior-period reserve releases.
- Reserve adequacy and reinsurance recoverability, given the growth in loss reserves and the inherent uncertainty management describes.
- How buybacks, regulated-subsidiary dividend capacity and holding-company liquidity affect capital flexibility.
- Investment portfolio sensitivity to market declines, currency movements, mortgage-related credit deterioration and lower reinvestment yields.