ARCH CAPITAL GROUP LTD. quarterly report, Q2 FY2014

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Arch Capital Group Ltd. — Q2 2014 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2014. Financial statements are unaudited and were reviewed, not audited, by PricewaterhouseCoopers LLP. Unless stated otherwise, dollar amounts below are U.S. dollars.

Business context and reporting period

Arch provides property and casualty insurance and reinsurance, mortgage insurance and related products worldwide. In 2014, it acquired the CMG mortgage insurance businesses and platform, expanding into U.S. mortgage insurance. It also consolidated Watford, a newly launched reinsurance company, after determining Arch was its primary beneficiary; Watford’s assets are available only to meet Watford’s obligations.

The company reorganized reporting into insurance, reinsurance, mortgage, “other” (Watford) and corporate segments. Comparisons with 2013 therefore reflect the newly acquired mortgage business and Watford’s inclusion in 2014.

Financial performance and position

  • Q2 revenue and earnings: Total revenue was $1.036 billion, up 21.6% from $851.8 million. Net premiums earned were $907.2 million, up 19.5%; net premiums written were $971.9 million, up 19.9%. Net income available to common shareholders was $202.5 million, versus $171.5 million; diluted EPS was $1.48, versus $1.26.
  • Six-month results: Total revenue was $1.982 billion, up 13.8%, while net income available to common shareholders declined to $379.5 million from $422.4 million. Diluted EPS was $2.78 versus $3.11. Management’s non-GAAP after-tax operating income available to common shareholders was $325.1 million, up from $293.8 million.
  • Underwriting: Q2 underwriting income was $124.1 million versus $96.0 million; the combined ratio improved to 86.5% from 87.4%. For the first six months, underwriting income was $256.5 million versus $212.4 million and the combined ratio was 85.7% versus 86.0%. Lower catastrophe activity and improved insurance margins helped; favorable prior-period reserve development also contributed materially.
  • Segments: Q2 underwriting income was $34.4 million in insurance, $81.9 million in reinsurance and $8.8 million in mortgage. Q2 combined ratios were 93.3%, 75.7% and 85.0%, respectively. Reinsurance’s combined ratio worsened from 73.2% a year earlier, while mortgage’s increased from 60.1%, partly reflecting the acquired U.S. business and elevated start-up expenses.
  • Investments and margins: Q2 net investment income was $73.0 million, up from $68.4 million. Net realized gains were $54.1 million versus $12.7 million; net impairment losses were $14.7 million versus $0.7 million. Six-month net realized gains were broadly flat at $73.8 million, while impairment losses rose to $17.7 million from $3.0 million. Q2 pre-tax portfolio return before investment expenses was 1.80%, compared with a 1.73% benchmark; the six-month return was 2.84% versus 3.08% for the benchmark.
  • Cash flow: First-half operating cash flow was $453.1 million, compared with $388.4 million. Investing activities used $952.1 million, including $235.6 million for the business acquisition; financing provided $988.9 million, largely reflecting Watford’s third-party capital raises. Cash increased by $492.4 million to $926.4 million.
  • Balance sheet and liquidity: Total assets were $22.57 billion, versus $19.57 billion at year-end 2013. Total shareholders’ equity was $7.02 billion, including noncontrolling interests; equity available to Arch was $6.23 billion. Book value per common share was $43.73, up from $39.82 at year-end. Consolidated investments totaled $15.16 billion. Arch reported $800 million of senior notes and $100 million of revolving borrowings; total capital available to Arch was $7.13 billion. The holding company’s readily available cash, short-term investments and marketable securities, excluding regulated subsidiaries, were $7.3 million. Restricted assets were $5.72 billion, and unfunded investment commitments were approximately $966 million.

Material changes versus the prior comparable period

  • Insurance net premiums written rose 15.4% in Q2 and 11.8% for the six-month period; insurance underwriting income more than doubled in both comparisons, with the combined ratio improving.
  • Reinsurance Q2 net premiums written were nearly flat, despite higher gross premiums, amid increased cessions and retrocessional protection. Its six-month combined ratio increased to 74.3% from 70.2%, and favorable reserve development remained significant.
  • Mortgage net premiums written rose to $50.4 million in Q2 and $93.7 million for six months, largely reflecting the acquisition. Mortgage underwriting expenses and loss ratios were higher than in the prior-year periods; management expected the expense ratio to remain elevated until the U.S. business achieved greater scale.
  • Interest expense increased to $14.3 million in Q2 and $28.7 million for six months, primarily due to the $500 million of 5.144% senior notes issued by Arch-U.S. in December 2013 and accretion on deposit accounting liabilities.
  • First-half GAAP net income fell despite higher underwriting income; among the key differences were substantially smaller foreign-exchange gains and lower equity-method investment income. The 2013 six-month period included $38.1 million of foreign-exchange gains, versus $9.4 million of losses in 2014.

Outlook, management commentary, risks and unusual items

  • Management’s objective is an average operating return on average common equity of at least 15% over the insurance cycle. Operating ROAE was 11.2% in Q2 2014 and 11.6% for the first half, versus 10.9% and 12.0%, respectively, in 2013.
  • Management reported insurance rate increases above loss-cost trends, though slightly below Q1 levels. It described reinsurance terms as softening, with property catastrophe pricing under pressure from alternative capacity and increased ceding-commission demands. Underwriting strategy emphasized discipline, smaller and medium-sized accounts, and short-tail business.
  • Management expects liquidity needs for at least the next 12 months to be met by underwriting and investment cash flows, cash and short-term investments, investment maturities or sales, and credit facilities. This is a management expectation, not a guarantee.
  • Catastrophe exposure remains a significant source of volatility. The modeled peak-zone 1-in-250-year net probable maximum pre-tax loss as of July 1, 2014 was $674 million for a Northeastern U.S. windstorm; estimates are model-based, not maximum-loss limits, and actual losses may differ materially. Management’s stated target is to limit such modeled peak-zone loss to approximately 25% of shareholders’ equity.
  • Other risks include adverse reserve development and uncertainty in loss estimates; soft insurance and reinsurance markets; mortgage credit and housing-market conditions; interest-rate, credit-spread, foreign-exchange and investment-market movements; illiquid or leveraged investments; counterparty and reinsurance recoverability; and regulatory, rating-agency and capital requirements.
  • The proposed FHFA private mortgage insurer eligibility requirements were under public comment. Arch MI U.S. then met the proposed financial requirements based on its June 30 portfolio, but final requirements could change. Mortgage reserves do not cover future claims on loans not yet in default; no mortgage premium-deficiency reserve was recorded for the first half.
  • Unusual items include $14.7 million of Q2 investment impairment, primarily related to one fund investment, and $2.3 million of Watford non-recurring start-up costs for the first half. The acquired CMG entities generated a contingent consideration liability valued at $53.1 million at June 30, up from $41.8 million at acquisition.
  • Management reported no litigation or arbitration expected to have a material adverse effect. Disclosure controls were assessed as effective, and no material change in internal control over financial reporting was reported.

Most important facts for investors to verify

  1. How much of underwriting income and reported earnings depends on favorable prior-period reserve development, and whether that development persists.
  2. Whether mortgage insurance production grows beyond the credit-union base and reaches scale without materially worsening credit performance or capital needs.
  3. How the softening reinsurance market, premium cessions and catastrophe exposures affect future pricing, combined ratios and volatility.
  4. Whether the substantial first-half cash increase is repeatable, given Watford’s capital raising and the acquisition-related investing outflow.
  5. Arch’s capacity to meet regulatory, rating-agency and proposed mortgage-insurer capital requirements while maintaining liquidity and shareholder returns.
  6. The valuation, liquidity and impairment exposure in alternative, fund and fair-value-option investments, and the sensitivity of reported results to market and foreign-exchange movements.