Arch Capital Group Ltd. — Q1 2019 Form 10-Q
Reporting period: Three months ended March 31, 2019; balance-sheet comparisons are to December 31, 2018. Amounts are U.S. dollars. Arch provides insurance, reinsurance and mortgage insurance globally. Interim statements are unaudited and were reviewed, not audited, by PwC.
Financial performance and condition
| Metric | Q1 2019 | Q1 2018 / prior date |
|---|---|---|
| Net premiums written | $1.525 billion | $1.413 billion |
| Net premiums earned | $1.369 billion | $1.235 billion |
| Total revenues | $1.723 billion | $1.284 billion |
| Net income available to Arch common shareholders | $438.1 million; diluted EPS $1.07 | $137.3 million; diluted EPS $0.33 |
| After-tax operating income available to common shareholders | $275.9 million; annualized operating ROAE 12.3% | $235.1 million; 11.3% |
| Operating cash flow, consolidated | $235.4 million | $400.2 million |
| Cash and restricted cash, consolidated | $710.2 million | $724.6 million at year-end |
| Total assets | $33.98 billion | $32.22 billion at year-end |
| Total shareholders’ equity | $10.95 billion | $10.23 billion at year-end |
| Book value per share | $23.12 | $21.52 at year-end |
Revenue and reported earnings benefited substantially from investment results: net realized gains were $141.6 million versus a $111.0 million loss a year earlier, net investment income rose to $156.9 million from $126.7 million, and equity-method investment fund income rose to $46.9 million from $28.1 million. The reported earnings increase therefore was not solely underwriting-driven. The overall combined ratio was 81.7%, versus 81.3%; the consolidated loss ratio was 52.5%, versus 51.6%.
Underwriting income was $260.1 million, compared with $237.0 million. By segment, insurance earned $0.6 million (combined ratio 99.9%, versus 98.6%); reinsurance earned $20.9 million (95.2%, versus 80.7%); and mortgage earned $244.1 million (25.6%, versus 38.8%).
Consolidated operating cash flow declined year over year. Excluding Watford Re, Arch reported operating cash flow of $165.4 million versus $370.3 million. Management attributed the decrease principally to the effect of a retroactive reinsurance transaction. Investing activities used $294.8 million and financing activities provided $41.5 million on a consolidated basis.
At March 31, total investments were $22.33 billion and reserves for losses and loss adjustment expenses were $12.01 billion. Consolidated liabilities included $1.734 billion of senior notes and $488.6 million of revolving-credit borrowings; the latter is reported in Watford Re’s consolidated balances. For Arch’s capital structure excluding Watford Re, debt was $1.734 billion and debt represented 14.6% of total capital, down from 15.5% at year-end. Arch reported $11.85 billion of capital available to it. Arch MI U.S. met PMIERs requirements with an estimated sufficiency ratio of 146%, versus 141% at year-end.
Material changes and notable items
- Common shareholders’ equity rose to $9.33 billion from $8.66 billion; book value per share increased 7.4% during the quarter, reflecting underwriting and investment returns.
- Net premiums written increased about 8% overall. Insurance growth included acquired renewal rights to a U.K. commercial-lines book effective January 1, 2019; reinsurance growth reflected selected casualty and non-catastrophe property opportunities; mortgage growth reflected increased U.S. insurance in force.
- Prior-year reserve development was $39.4 million favorable, versus $51.0 million favorable in Q1 2018. Mortgage contributed $36.6 million favorable; reinsurance had $1.7 million adverse development, including a $16.0 million increase for Typhoon Jebi.
- A subsidiary entered a retroactive reinsurance transaction covering certain U.S. insurance liabilities. The reserve reconciliation records a $225.5 million reduction associated with the transaction; related recoverables are reported as fully collateralized.
- Arch adopted the new lease standard on January 1, 2019, recognizing an initial right-of-use asset of $147.9 million and lease liability of $163.6 million; adoption had no material effect on results or liquidity.
- In April, after quarter-end, U.S. mortgage subsidiaries entered a Bellemeade agreement providing up to $621 million of aggregate excess-of-loss reinsurance coverage for a portfolio of in-force policies.
Outlook, management commentary and risks
Management’s stated objective is an average operating return on average equity of 15% or more over the insurance cycle; this is a long-term objective, not quarterly earnings guidance. Management described property-casualty markets as competitive, with modest rate improvement in property and select casualty lines. It emphasized underwriting discipline, a preference for small and midsize accounts, reduced exposure in some commoditized lines, and reinsurance to manage volatility. Property-catastrophe writings remained low in Q1. Mortgage conditions were described as generally favorable, supported by borrower credit quality and economic conditions, though U.S. pricing remained competitive.
Key risks include catastrophe and severe economic losses, reserve-estimation uncertainty, competition and pricing, investment and interest-rate volatility, foreign exchange movements, reinsurer counterparty performance, and changes in economic, regulatory or tax conditions. Management seeks to limit modeled 1-in-250-year catastrophe loss in a zone to approximately 25% of Arch’s equity; modeled peak-zone loss as of April 1 was $371 million for a Northeastern U.S. windstorm. The company cautioned that modeled losses are uncertain and actual losses can materially differ. Mortgage exposure also remains sensitive to housing and borrower-credit conditions.
Management reported no litigation or arbitration expected to have a material adverse effect and no material changes to previously disclosed risk factors. Disclosure controls were considered effective; no material change in internal control over financial reporting was reported. Management also cautioned that interim results are not necessarily indicative of full-year results.
Important facts for investors to verify
- How much of the earnings increase reflects repeatable underwriting and investment income versus realized investment gains and market-driven valuation changes.
- Whether the reinsurance segment’s higher current-year loss ratio and Typhoon Jebi reserve increase develop further, and whether mortgage favorable reserve development persists.
- The adequacy of loss reserves and the recoverability, collateral terms and cash-flow effects of the retroactive reinsurance transaction.
- Mortgage portfolio credit quality, delinquency trends, housing-market sensitivity, Bellemeade protection and PMIERs capital sufficiency.
- Watford Re’s effect on consolidated figures: Arch owns approximately 11% of its common equity but consolidates it; third-party noncontrolling interests absorb a significant portion of its results.
- Investment portfolio sensitivity to interest rates, credit spreads, equity prices and less-liquid fund commitments; investment commitments were approximately $1.83 billion.