ARCH CAPITAL GROUP LTD. quarterly report, Q3 FY2013

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Arch Capital Group Ltd. — Form 10-Q Summary

Business context and reporting period

Arch Capital Group Ltd. is a Bermuda-based global insurer and reinsurer focused on specialty property and casualty business. This unaudited quarterly report covers the three and nine months ended September 30, 2013; comparisons are with the corresponding 2012 periods unless stated otherwise. PwC performed an interim review, not an audit.

Financial performance and position

  • Third-quarter results: Net premiums earned were $795.0 million, up 6.2%; total revenue was $861.1 million, down 4.8%. Net income was $114.8 million versus $189.7 million, and net income available to common shareholders was $109.3 million versus $184.2 million. Diluted EPS was $0.80 versus $1.33.
  • Nine-month results: Net premiums earned were $2.307 billion, up 7.0%; total revenue was $2.603 billion, up 1.6%. Net income was $548.2 million versus $574.2 million; income available to common shareholders was $531.8 million versus $544.0 million. Diluted EPS was $3.92 versus $3.93.
  • Underwriting: Third-quarter underwriting income rose to $111.0 million from $73.5 million; the combined ratio improved to 86.0% from 90.2%. Nine-month underwriting income was $323.4 million versus $234.4 million, and the combined ratio improved to 86.0% from 89.2%. The reinsurance segment was the larger underwriting contributor.
  • Operating returns: Management’s non-GAAP operating ROAE was 11.9% for both the quarter and nine-month period, compared with 9.9% and 10.8%, respectively, in 2012. The company’s stated objective is an average operating ROAE of at least 15% over the insurance cycle.
  • Investment performance: Net investment income was $66.1 million for the quarter and $200.1 million for nine months, both below the prior-year periods. Net realized investment results were a $6.0 million loss for the quarter and a $65.0 million gain year to date, versus gains of $60.4 million and $139.4 million. Portfolio pre-tax total return was 1.43% for the quarter (benchmark 1.36%) and 0.31% year to date (benchmark 0.38%).
  • Cash flow: Nine-month operating cash flow was $627.0 million versus $732.0 million; investing cash outflow was $485.7 million versus $493.1 million; financing cash outflow was $71.5 million versus $173.5 million. Cash increased $65.1 million to $436.1 million. Management attributed lower operating cash flow primarily to higher paid losses, partly offset by increased premium receipts.
  • Balance sheet and capital: At September 30, total assets were $18.931 billion, liabilities $13.488 billion and shareholders’ equity $5.443 billion. Book value per common share was $38.34, versus $36.80 at June 30 and $36.79 a year earlier. Capital included $300 million of senior notes, $100 million of revolving borrowings and $325 million of preferred shares; the revolving facility was due in August 2014.
  • Liquidity and commitments: Consolidated cash and investments were $13.514 billion. The company had $408.4 million of letters of credit outstanding, secured by investments worth $480.4 million, and $815.3 million of unfunded investment commitments. Parent-company readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, were only $1.9 million; the parent received $94.0 million in subsidiary dividends during the nine months.

Material changes versus prior periods

  • Lower reported quarterly earnings reflected sharply weaker realized investment results and a $40.6 million foreign-exchange loss, compared with a $17.0 million loss in Q3 2012. Net realized investment results shifted from a $60.4 million gain to a $6.0 million loss.
  • Underwriting improved in both segments. Insurance’s combined ratio improved to 96.8% for the quarter and 96.9% year to date; reinsurance’s improved to 69.6% and 69.9%, respectively. Favorable prior-period reserve development contributed $17.5 million in insurance and $51.4 million in reinsurance during Q3.
  • Written premiums grew, but mix varied: insurance net premiums written rose 3.9% in Q3, while reinsurance rose 24.0%. Reinsurance growth included a $55.2 million multi-line quota-share transaction, including a $39.7 million unearned-premium transfer, which management said was not expected to recur in 2014.
  • Investment-related accumulated other comprehensive income fell substantially, from $287.0 million at year-end 2012 to $42.0 million at September 30, 2013, mainly reflecting unrealized investment declines. Total shareholders’ equity nevertheless increased from $5.169 billion, primarily due to underwriting returns.

Outlook, commentary and risks

  • Management described market conditions as improving, but said rate increases moderated. U.S. insurance weighted rate increases produced 1.7% expected margin improvement in Q3; management said much longer-tail casualty business still needed rate improvement. In reinsurance, alternative capacity pressured property-catastrophe rates, and cedents sought higher commissions and more excess-of-loss coverage. The company emphasized underwriting discipline and smaller and medium-sized accounts.
  • Management expects liquidity needs for at least the next 12 months to be met through underwriting cash flows, investment income, cash and liquid investments, investment maturities or sales, and credit facilities. This is an outlook statement, not earnings guidance.
  • A proposed mortgage-insurance acquisition of CMG MI and certain PMI operating assets was expected to require approximately $300 million, with possible additional amounts. Court approval had been obtained, but regulatory and other approvals remained; closing was expected in Q4 2013 or early 2014.
  • Catastrophe losses, reserve-estimation uncertainty, delayed or impaired reinsurance recoveries, softening rates, investment-market volatility, interest-rate and credit-spread movements, foreign exchange, and restricted or illiquid investments could adversely affect results and liquidity. The modeled October 1 peak-zone catastrophe estimate was an $868 million net probable maximum pre-tax loss for a Northeast U.S. windstorm; management cautioned that modeled losses are not maximum exposures and actual losses may differ materially.
  • The company reported no litigation or arbitration expected by management to have a material adverse effect. Disclosure controls were assessed as effective, and no material change in internal control over financial reporting was reported.

Important facts for investors to verify

  • How much of underwriting improvement depends on favorable reserve development, and whether that development persists—particularly in reinsurance and short-tailed lines.
  • The sustainability and underlying profitability of premium growth, excluding the nonrecurring reinsurance quota-share transaction and considering rate adequacy and business mix.
  • The drivers and potential volatility of investment income, realized gains or losses, foreign-exchange results, unrealized portfolio losses and the rising estimated portfolio VaR.
  • The mortgage-insurance transaction’s final approvals, required financial commitments, closing timing and total cost.
  • Parent-level liquidity and subsidiary dividend capacity, the August 2014 revolving-facility maturity, outstanding letters of credit and unfunded investment commitments.
  • Catastrophe exposure, reinsurance counterparty strength, reserve adequacy and the sensitivity of results to economic and financial-market conditions.