Arch Capital Group Ltd. — Q1 2015 Form 10-Q
Period and business: Three months ended March 31, 2015; Bermuda-based global specialty insurer and reinsurer, including mortgage insurance and reinsurance. Financial statements are unaudited and were reviewed by PwC, which expressed no audit opinion.
Financial performance
Amounts below are U.S. dollars in millions, except per-share data and ratios.
| Metric | Q1 2015 | Q1 2014 |
|---|---|---|
| Total revenues | $1,082.3 | $946.2 |
| Net premiums written | $1,067.0 | $1,065.0 |
| Net premiums earned | $910.3 | $859.8 |
| Net income | $308.8 | $179.1 |
| Net income available to Arch common shareholders | $277.9 | $177.0 |
| Diluted EPS | $2.16 | $1.30 |
| Operating cash flow | $85.5 | $198.2 |
- Net income rose 72%, while common-shareholder income rose 57%. Results included $83.3 million of net realized gains and $66.5 million of net foreign-exchange gains; after-tax operating income available to common shareholders, a non-GAAP measure, fell to $149.8 million from $164.4 million.
- Consolidated combined ratio was 88.4%, versus 84.7%; underwriting income was $116.5 million, versus $132.5 million. Insurance and mortgage combined ratios were 94.7% and 88.5%; reinsurance was 74.0%.
- Net investment income was $79.0 million, up from $67.0 million. Pre-tax investment return was 1.11%, compared with 0.29% for the benchmark in Q1 2015.
- At March 31, total assets were $22.85 billion, total liabilities $15.55 billion, and total shareholders’ equity $7.08 billion. Equity available to Arch was $6.29 billion. Book value per common share was $47.80, up 4.9% during the quarter.
- Cash was $471.0 million; short-term investments available for sale were $855.0 million. Debt comprised $800 million of senior notes and $100 million of revolving-credit borrowings. The company also had $415.9 million of letters of credit outstanding against its LOC facilities, secured by investments valued at $488.4 million.
- Operating cash flow fell to $85.5 million, primarily reflecting higher claim-related outflows, lower premium collections and increased outflows to reinsurers. Share repurchases were $162.9 million in the quarter.
Changes versus the prior comparable period
- Revenue increased 14%, driven by higher earned premiums, investment income and realized gains. Written premiums were essentially flat overall.
- Insurance earned premiums increased 6%, but underwriting income declined 18% and its combined ratio worsened 1.5 percentage points. Reinsurance earned premiums declined 18% and underwriting income declined 20%, as the company reduced writings amid softening prices and terms. Mortgage earned premiums increased 30% and underwriting income increased 68%, partly reflecting the acquired U.S. mortgage insurance business.
- Favorable prior-period reserve development remained significant: $8.8 million in insurance and $58.0 million in reinsurance, compared with $15.6 million and $70.4 million, respectively, a year earlier.
- Operating ROAE was 10.2%, down from 12.1% and below management’s objective of an average 15% or greater over the insurance cycle.
- Cash at quarter-end was substantially below the year-earlier $1.57 billion; the 2014 comparison included capital raised for Watford Re. Q1 2015 financing cash flow was a $138.3 million outflow, versus $978.4 million inflow in Q1 2014.
Outlook, risks and unusual items
- Management described reinsurance markets as competitive, with softening prices and pressure on terms; it reduced reinsurance writings. Primary insurance generally continued to obtain rate increases, though competition in property weighed on rates and premium volume. Management emphasized underwriting discipline and smaller and medium-sized accounts.
- Management’s stated objective is average operating ROAE of at least 15% over the insurance cycle. No specific quarterly or full-year earnings guidance was provided.
- Management estimated its largest modeled catastrophe exposure at April 1, 2015 as a Northeastern U.S. windstorm, with $550 million net probable maximum pre-tax loss; it cautioned actual losses could differ materially and exceed modeled thresholds.
- Material risks include catastrophe losses, uncertain reserve estimates and adverse development, reinsurance-counterparty failure or delayed recoveries, investment-market and interest-rate volatility, foreign-exchange movements, and restricted liquidity in certain investments. Unfunded investment commitments were approximately $1.22 billion.
- Arch reported a $66.5 million foreign-exchange gain, primarily unrealized, from revaluing foreign-currency insurance liabilities. Q1 net realized gains also included derivative gains; these items materially affected reported earnings.
- The filing notes an immaterial revision to the prior earnings-release presentation: total assets and liabilities had been understated by $147.0 million, and investing and financing cash flows were each misclassified by $60.2 million. There was no effect on net income, comprehensive income or equity.
- Arch said it believed Arch MI U.S. met the revised GSE mortgage-insurer eligibility financial requirements based on its March 31 portfolio and balance sheet. The requirements take effect December 31, 2015.
- No litigation or arbitration was identified as expected by management to have a material adverse effect. The agreement to acquire full ownership of Gulf Re received regulatory approval in April 2015.
Key facts for investors to verify
- How much of reported earnings growth came from realized investment gains and foreign-exchange gains, versus recurring underwriting and investment operations?
- Whether reserve development remains favorable, particularly in reinsurance, and how changes in accident-year loss experience affect combined ratios.
- Whether soft reinsurance pricing and pressure on terms continue, and how disciplined reductions in writings affect future premium and underwriting income.
- Arch MI U.S.’s compliance with revised PMIERs, capital needs, persistency and mortgage-credit performance as the portfolio grows.
- Liquidity available after restricted assets, investment commitments and letters of credit; and the effect of claim-payment timing and reinsurance recoveries on operating cash flow.
- Catastrophe exposure, investment valuation and liquidity risks, foreign-currency exposure, and the accuracy of the modeled loss and reserve estimates.