Business context and reporting period
Arch Capital Group Ltd. is a Bermuda-based global insurer and reinsurer focused on specialty property and casualty lines. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2012; the interim financial statements were reviewed, not audited, by PwC.
Financial performance
Amounts below are U.S. dollars; financial amounts are in millions except per-share data and ratios.
| Metric | Q2 2012 | Q2 2011 | First half 2012 | First half 2011 |
|---|---|---|---|---|
| Net premiums written | $820.2 | $706.5 | $1,683.8 | $1,470.8 |
| Net premiums earned | $726.7 | $642.9 | $1,407.0 | $1,276.6 |
| Total revenue | $842.5 | $775.6 | $1,657.5 | $1,550.6 |
| Net income | $220.3 | $96.6 | $384.5 | $122.1 |
| Net income available to common shareholders | $212.6 | $90.1 | $370.4 | $109.2 |
| Diluted EPS | $1.54 | $0.65 | $2.68 | $0.78 |
| Net investment income | $73.6 | $86.7 | $147.9 | $175.0 |
| Operating cash flow | Not separately presented by quarter | $397.3 | $446.5 |
Combined ratio was 87.2% in Q2 and 88.6% for the first half, compared with 100.0% and 105.1%, respectively, in 2011. Reinsurance underwriting income was $89.6 million for Q2 and $164.9 million for the half; insurance underwriting income was $4.1 million in Q2, while the first-half segment recorded a $4.0 million underwriting loss. After-tax operating income available to common shareholders, a non-GAAP measure, was $141.4 million in Q2 and $255.1 million for the first half.
At June 30, total assets were $18.50 billion, total investments $12.49 billion, cash $355.4 million, and shareholders’ equity $5.02 billion. Book value per common share was $34.45, up from $31.76 at year-end 2011. Balance-sheet debt included $300 million of senior notes, $100 million drawn on the revolving facility, and $235.8 million of TALF borrowings. The senior notes’ fair value was $374.1 million versus $300 million carrying value.
Material changes versus prior comparable periods
- Net income and EPS rose substantially, primarily alongside improved underwriting and much lower catastrophe losses; current-year catastrophe losses net of reinsurance and reinstatement premiums were $7.2 million in Q2 versus $95.0 million in Q2 2011, and $30.2 million for the half versus $273.7 million.
- Premium growth was broad: Q2 net premiums written rose 16.1%; reinsurance grew 32.6% and insurance 6.0%. Reinsurance growth reflected property catastrophe, other specialty and mortgage business.
- Favorable prior-period reserve development remained significant: $63.8 million in Q2 and $117.1 million for the first half across the two segments. The filing describes adverse development in some longer-tail insurance lines, including executive assurance and construction.
- Investment income fell 15.1% in Q2 and 15.5% for the half, reflecting lower yields. Total portfolio return was 0.63% for Q2, below the 0.86% benchmark; first-half return of 2.53% exceeded the 2.43% benchmark.
- Operating cash flow declined year over year, despite higher premium receipts, reflecting higher paid losses, lower interest and dividend receipts, and timing of operating expenses.
Outlook, management commentary, risks and unusual items
- Management reported broadly improving rates in Q2: insurance rates increased about 4% on a weighted basis; property and catastrophe reinsurance rates improved significantly on a risk-adjusted basis. Healthcare and surety were exceptions, with moderate rate declines. Management said longer-tail lines still needed substantial rate improvement.
- Management’s stated objective is average operating ROAE of at least 15% over the insurance cycle; reported operating ROAE was 12.3% for Q2 and 11.4% for the first half. No specific earnings or revenue guidance was provided.
- Catastrophe exposure is material. July 1 modeled peak-zone net probable maximum pre-tax losses were $878 million for Gulf of Mexico windstorm, $846 million for Northeastern U.S. windstorm and $645 million for Florida Tri-County windstorm. Management cautioned actual losses may differ materially and can exceed modeled estimates.
- Investment and economic risks include low interest rates, market volatility, credit-spread and foreign-exchange movements, mortgage-related exposures and potential U.S. or European sovereign credit deterioration. The portfolio’s average fixed-income credit quality was AA/Aa2; below-investment-grade securities were 5.6% of fixed maturities.
- Liquidity resources included $12.74 billion of investable assets and access to revolving and letter-of-credit facilities. The company had $445.4 million of outstanding letters of credit secured by investments and $537 million of unfunded investment commitments. Parent-company readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, were only $5.1 million; parent liquidity depends in part on permitted subsidiary distributions.
- In April, the company issued $325 million of 6.75% Series C preferred shares and used proceeds plus other funds to redeem $325 million of Series A and B preferred shares bearing higher coupon rates. Common-share repurchases under the public program were not made during the period; approximately $942 million remained authorized through December 2012.
- Other notable items: the April acquisition of Ariel Re’s credit and surety reinsurance operations brought $83.1 million of unearned premiums, including $17.3 million earned in Q2. Q2 net foreign-exchange gains were $31.7 million, versus losses of $18.4 million a year earlier. The 2012 second-quarter impairment charge included securities management intended to liquidate in Q3.
- Management reported no litigation or arbitration expected to have a material adverse effect. Adoption of revised insurance acquisition-cost accounting was retrospective and reduced reported 2011 comparative net income; comparisons in this filing reflect the revised accounting.
Important facts for investors to verify
- How much of the earnings improvement is sustainable underwriting performance versus lower catastrophe activity, favorable reserve releases, foreign-exchange gains and investment-related items.
- Reserve adequacy, especially in longer-tail insurance lines, and the persistence of favorable development in prior accident or underwriting years.
- Actual catastrophe exposure and the adequacy and collectability of reinsurance protections relative to modeled loss estimates.
- Investment portfolio sensitivity to rates, credit spreads, mortgage and structured securities, liquidity conditions, and foreign currency movements.
- Availability of regulated-subsidiary dividends and parent-company liquidity, including capacity under credit and letter-of-credit facilities and the use of capital for buybacks or other purposes.