Arch Capital Group Ltd. — 2010 Second-Quarter Form 10-Q
Business context and period. Arch is a Bermuda-based global insurer and reinsurer focused on specialty property and casualty business. This unaudited report covers the quarter and six months ended June 30, 2010, compared with the same 2009 periods. PwC performed an interim review, not an audit, and reported no material modifications it believed were needed.
Financial performance
Amounts below are U.S. dollars in millions except per-share data and ratios.
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Total revenues | $776.3 | $848.7 | $1,621.2 | $1,599.2 |
| Net premiums written | $624.3 | $693.9 | $1,392.0 | $1,516.7 |
| Net premiums earned | $623.0 | $699.3 | $1,292.9 | $1,399.8 |
| Net income | $243.5 | $158.6 | $460.4 | $304.9 |
| Net income available to common shareholders | $237.0 | $152.1 | $447.5 | $292.0 |
| Diluted EPS | $4.45 | $2.43 | $8.23 | $4.67 |
| Operating income available to common shareholders, after tax (non-GAAP) | $132.2 | $163.0 | $230.9 | $332.0 |
- Underwriting: The consolidated combined ratio was 90.0% in Q2 versus 87.2% a year earlier, and 93.4% for the first half versus 87.0%. Insurance segment ratios were 101.5% and 104.3%, respectively, indicating underwriting losses; reinsurance ratios were 68.7% and 73.4%.
- Cash flow: Operating cash flow was $390.1 million for the first half, down from $518.5 million. Management attributed the decline mainly to lower premium collections, partly offset by lower paid losses. Cash increased to $341.5 million from $334.6 million at year-end.
- Investments and returns: Net investment income was $90.5 million in Q2 and $183.5 million for the first half, both below 2009. Pre-tax investment income yield was 3.48% for Q2 and 3.46% for the half-year, versus 3.91% and 3.87%. Pre-tax total portfolio return was 1.74% for Q2 and 3.35% for the half-year, ahead of the benchmark’s 1.19% and 3.17%.
- Balance sheet and capital: Total assets were $16.78 billion and shareholders’ equity $4.40 billion at June 30, compared with $15.38 billion and $4.32 billion at December 31, 2009. Book value per common share was $82.07, up 12.4% from year-end. Cash plus short-term investments totaled about $895.8 million; some assets are restricted or held in regulated subsidiaries.
- Debt and liquidity: The company reported $300 million of senior notes, $125 million of revolving-credit borrowings, and $336.2 million of TALF borrowings. It had $721.2 million of letters of credit outstanding, secured by investments valued at $840.1 million, and reported compliance with credit-agreement covenants. The parent company’s readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, were $23.9 million.
Material changes versus prior periods
- Q2 revenue declined 8.5%, while first-half revenue increased 1.4%. Net premiums written fell 10.0% in Q2 and 8.2% for the first half, primarily reflecting lower reinsurance writings.
- Net income rose substantially, but operating income declined. The difference reflected volatile non-underwriting items: realized investment gains replaced prior-year losses, foreign-exchange results swung to gains, and impairment losses were lower. These effects are not necessarily indicative of ongoing underwriting performance.
- Reinsurance net premiums written fell 26.6% in Q2 and 21.3% year to date, including reduced shares and non-renewals in property and casualty business. Insurance net premiums written rose modestly, though its combined ratios worsened.
- Arch repurchased 6.2 million common shares for $450.3 million in the first half. Approximately $541.1 million remained authorized under the program at June 30. Repurchases reduced capital but contributed to per-share book value growth, according to management.
Outlook, commentary and risks
- Management said 2010 rates were generally slightly lower, with more competition in executive assurance and certain property lines. It considered U.S. catastrophe-exposed business the most attractive area by pricing and expected it to remain a significant part of the portfolio, with increased results volatility. No specific earnings or revenue guidance was provided.
- Management cited higher catastrophe activity, softer market conditions and lower interest yields as reasons for lower operating returns. First-half catastrophe activity added 3.3 points to the insurance loss ratio and 8.3 points to reinsurance’s current-year loss ratio.
- The modeled peak catastrophe exposure was a Florida Tri-County windstorm, with a net probable maximum pre-tax loss of $797 million based on July 1, 2010 exposures. The filing cautions that modeled losses are not maximum exposures and actual losses could differ materially; the estimate is net of expected reinsurance recoveries and before reinstatement premiums.
- Net favorable prior-period reserve development supported results: $4.1 million for insurance and $65.6 million for reinsurance in the first half. Reserve estimates remain uncertain; adverse development, claim severity, catastrophe losses, or delayed/failed reinsurance recoveries could affect results and liquidity.
- Investment risks include low interest rates, mortgage and commercial-real-estate credit deterioration, valuation uncertainty, leveraged investment funds, and market volatility. The company recorded $6.0 million of net impairment losses in earnings for the first half; it also reported $68.6 million of non-credit OTTI losses in accumulated other comprehensive income.
- Standard & Poor’s raised subsidiary financial-strength ratings to A+ and ACGL’s issuer rating to A- on July 29, 2010, both with stable outlooks. Management stated that expected liquidity needs for at least the next 12 months should be met by operating and investment cash flows, existing liquid assets, investment maturities/sales and credit facilities. The $300 million revolving/LOC facility expires in August 2011; renewal terms are uncertain.
- Management reported no litigation expected to have a material adverse effect and stated disclosure controls were effective; there were no material changes in internal control over financial reporting during the quarter.
Important facts for investors to verify
- How much of the increase in reported net income came from realized gains and foreign-exchange gains, and how operating income and underwriting results trend in subsequent quarters.
- Whether favorable reserve development is sustainable, and the sensitivity of reserves to adverse development—especially given the insurance segment’s combined ratio above 100%.
- Catastrophe exposure, reinsurance protection and recoverables, including counterparty credit quality and the potential for losses above modeled estimates.
- Investment portfolio credit quality, mortgage-related exposures, fair-value assumptions and potential liquidity constraints; confirm the effect of lower yields on investment income.
- Available parent-company liquidity, regulatory limits on subsidiary dividends, credit-facility renewal, and the capital impact and pace of further share repurchases.