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ACGL > SEC Filings for ACGL > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for ARCH CAPITAL GROUP LTD.

Form 10-K for ARCH CAPITAL GROUP LTD.


3-Mar-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements and, therefore, undue reliance should not be placed on them. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the sections entitled "Cautionary Note Regarding Forward-Looking Statements," and "Risk Factors." This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto presented under Item 8. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
GENERAL
Overview
Arch Capital Group Ltd. ("ACGL" and, together with its subsidiaries, "we" or "us") is a Bermuda public limited liability company with approximately $6.55 billion in capital at December 31, 2013 and, through operations in Bermuda, the United States, Europe and Canada, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in the insurance and reinsurance markets.
The worldwide insurance and reinsurance industry is highly competitive and has traditionally been subject to an underwriting cycle in which a hard market (high premium rates, restrictive underwriting standards, as well as terms and conditions, and underwriting gains) is eventually followed by a soft market (low premium rates, relaxed underwriting standards, as well as broader terms and conditions, and underwriting losses). Insurance market conditions may affect, among other things, the demand for our products, our ability to increase premium rates, the terms and conditions of the insurance policies we write, changes in the products offered by us or changes in our business strategy.
The financial results of the insurance and reinsurance industry are influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence, among other things, the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market. Current Outlook
The broad market environment continues to be competitive with softening in terms and conditions in our reinsurance business, reflecting the increased capacity that has entered the market. In our insurance business, the best opportunities are in some sectors of the excess and surplus market and in the contract binding and program lines. In these areas, our insurance business is experiencing improved pricing and has increased exposure units. With the continued low interest rate environment, additional increases are needed in many lines in order for us to achieve our return requirements. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts and by focusing more on short-tail business. In addition, our reinsurance business entered into a number of large transactions during 2013 while our insurance operations continues to diversify into various lines of business such as contract binding and travel insurance.
On January 30, 2014, our U.S.-based subsidiaries completed the acquisition of CMG Mortgage Insurance Company and the mortgage insurance operating platform of PMI Mortgage Insurance Co. ("PMI"). CMG Mortgage Insurance Company has been renamed "Arch Mortgage Insurance Company" ("Arch MI U.S.") subject to receipt of applicable state approvals. As part of the transaction, Arch MI U.S. has obtained approval as an eligible mortgage insurer from Fannie Mae and Freddie Mac, subject to maintaining certain ongoing requirements. The completion of the transaction enables us to enter the U.S. mortgage insurance marketplace immediately and allows us to serve all lenders nationwide, including CMG Mortgage Insurance Company's existing credit union customers. The acquisition provides us with mortgage insurance


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licenses across the U.S. and a comprehensive mortgage insurance operating platform. Arch MI U.S. is rated "BBB+" with a stable outlook by S&P. In addition, we entered into a distribution agreement with CMFG Life Insurance Company (CUNA Mutual) and a reinsurance agreement with an affiliate of CUNA Mutual. In addition to traditional mortgage insurance, affiliates of ACGL provide various risk sharing products to mortgage lenders as well as Fannie Mae and Freddie Mac.
Our objective is to achieve an average operating return on average equity of 15% or greater over the insurance cycle, which we believe to be an attractive return to our common shareholders given the risks we assume. We continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline. We expect that catastrophe-exposed business will continue to represent a significant proportion of our overall book, which could increase the volatility of our operating results.
The current economic conditions could continue to have a material impact on the frequency and severity of claims and, therefore, could negatively impact our underwriting returns. In addition, volatility in the financial markets could continue to significantly affect our investment returns, reported results and shareholders' equity. We consider the potential impact of economic trends in the estimation process for establishing unpaid losses and loss adjustment expenses and in determining our investment strategies.
In addition, the impact of the continuing weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio. Natural Catastrophe Risk
We monitor our natural catastrophe risk globally for all perils and regions, in each case, where we believe there is significant exposure. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. Currently, we seek to limit our 1-in-250 year return period net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders' equity. We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of January 1, 2014, our modeled peak zone catastrophe exposure is a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $801 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum pre-tax losses of $670 million and $566 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, are less than the exposures arising from U.S. windstorms and hurricanes. As of January 1, 2014, our modeled peak zone earthquake exposure (New Madrid area earthquake) represented approximately 46% of our peak zone catastrophe exposure, and our modeled peak zone international exposure (Japan earthquake) is substantially less than both our peak zone windstorm and earthquake exposures. Net probable maximum pre-tax loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones.
The loss estimates shown above do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer a net loss greater than 25% of our total shareholders' equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event. In addition, actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See "Risk Factors-Risk Relating to Our Industry" and "Management's Discussion and Analysis of Financial Condition and Results of Operations-Natural and Man-Made Catastrophic Events."


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Financial Measures
Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for ACGL's common shareholders:
Book Value per Common Share
Book value per common share represents total common shareholders' equity divided by the number of common shares outstanding. Management uses growth in book value per common share as a key measure of the value generated for our common shareholders each period and believes that book value per common share is the key driver of ACGL's common share price over time. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per common share depending on the purchase price.
Book value per common share was $39.82 at December 31, 2013, a 10.0% increase from $36.19 at December 31, 2012. The growth in 2013 was primarily generated through underwriting returns.
After-Tax Operating Return on Average Common Equity After-tax operating return on average common equity ("Operating ROAE") represents after-tax operating income available to common shareholders divided by the average of beginning and ending common shareholders' equity during the period. After-tax operating income available to common shareholders, a "non-GAAP measure" as defined in the SEC rules, represents net income available to common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and loss on repurchase of preferred shares, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to common shareholders and has set an objective to achieve an average Operating ROAE of 15% or greater over the insurance cycle, which it believes to be an attractive return to common shareholders given the risks we assume. See "Comment on Non-GAAP Financial Measures."
Our Operating ROAE was 11.7% for 2013, compared to 7.7% for 2012 and 7.2% for 2011. The Operating ROAE for 2013 reflects a lower amount of losses from catastrophic events than the comparable periods, somewhat offset by the impact of lower interest yields on the investment portfolio. Total Return on Investments
Total return on investments includes net investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by our investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses and includes the effect of financial market conditions along with foreign currency fluctuations. Management uses total return on investments as a key measure of the return generated to common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against a benchmark return index.
The benchmark return index is a customized combination of indices intended to approximate a target portfolio by asset mix and average credit quality while also matching the approximate estimated duration and currency mix of our insurance and reinsurance liabilities. Although the estimated duration and average credit quality of this index will move as the duration and rating of its constituent securities change, generally we do not adjust the composition of the benchmark return index. The benchmark return index should not be interpreted as expressing a preference for or aversion to any particular sector or sector weight. The index is intended solely to provide, unlike many master indices that change based on the size of their constituent indices, a relatively stable basket of investable indices.


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At December 31, 2013, the benchmark return index had an average Moody's credit quality of "Aa1", an estimated duration of 3.66 years and included weightings to the following indices:

                                                                       Weighting
The Bank of America Merrill Lynch 1-10 Year AA U.S. Corporate &
Yankees Index                                                             21.250 %
The Bank of America Merrill Lynch 5-10 Year U.S. Treasury Index           12.500
The Bank of America Merrill Lynch U.S. Mortgage Backed Securities
Index                                                                     11.875
Barclays Capital CMBS, AAA Index                                          10.000
The Bank of America Merrill Lynch 1-5 Year U.S. Treasury Index             7.500
The Bank of America Merrill Lynch 1-10 Year U.S. Municipal
Securities Index                                                           7.125
The Bank of America Merrill Lynch US Bullet Agency Securities 1-10
Years Index                                                                5.000
MSCI World Free Index                                                      5.000
The Bank of America Merrill Lynch 0-3 Month U.S. Treasury Bill Index       5.000
The Bank of America Merrill Lynch 1-10 Year EMU Governments Index          4.000
The Bank of America Merrill Lynch U.S. High Yield Constrained Index        2.750
Barclays Capital U.S. High-Yield Corporate Loan Index                      2.750
The Bank of America Merrill Lynch 1-10 Year U.K. Gilt Index                2.750
The Bank of America Merrill Lynch 1-5 Year CAD Governments Index           2.500
Total                                                                    100.000 %

The following table summarizes the pre-tax total return (before investment expenses) of our investment portfolio compared to the benchmark return against which we measured our portfolio during the periods:

                                                         Arch Portfolio (1)     Benchmark Return
Pre-tax total return (before investment expenses):
Year Ended December 31, 2013                                       1.28 %               0.85 %
Year Ended December 31, 2012                                       5.88 %               4.90 %
Year Ended December 31, 2011                                       3.81 %               4.80 %

(1) Our investment expenses were approximately 0.26%, 0.22% and 0.22%, respectively, of average invested assets in 2013, 2012 and 2011.

Total return for our investment portfolio outperformed that of the benchmark return index in 2013 and reflected strong returns on high-yield corporate bonds and bank loan investments, which augmented the return on our investment grade fixed income portfolio. Excluding foreign exchange, total return was 1.13% for 2013, compared to 5.59% for 2012 and 4.10% for 2011. Comment on Non-GAAP Financial Measures
Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to common shareholders, which is defined as net income available to common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method net foreign exchange gains or losses and loss on repurchase of preferred shares, net of income taxes. The presentation of after-tax operating income available to common shareholders is a "non-GAAP financial measure" as defined in Regulation G. The reconciliation of such measure to net income available to common shareholders (the most directly comparable GAAP financial measure) in accordance with Regulation G is included under "Results of Operations" below.
We believe that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and loss on repurchase of preferred shares in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or


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losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the fair value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. The loss on repurchase of preferred shares related to the redemption of the Series A and B preferred shares in April 2012 and had no impact on total shareholders' equity or cash flows. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and loss on repurchase of preferred shares from the calculation of after-tax operating income available to common shareholders.
We believe that showing net income available to common shareholders exclusive of the items referred to above reflects the underlying fundamentals of our business since we evaluate the performance of and manage our underwriting to produce a profit. In addition to presenting net income available to common shareholders, we believe that this presentation enables investors and other users of our financial information to analyze our performance in a manner similar to how management analyzes performance. We also believe that this measure follows industry practice and, therefore, allows the users of financial information to compare our performance with our industry peer group. We believe that the equity analysts and certain rating agencies which follow us and the insurance industry as a whole generally exclude these items from their analyses for the same reasons.
RESULTS OF OPERATIONS
The following table summarizes, on an after-tax basis, our consolidated financial data, including a reconciliation of after-tax operating income available to common shareholders to net income available to common shareholders:

                                                         Year Ended December 31,
                                                    2013           2012           2011
After-tax operating income available to common
shareholders                                    $  595,715     $  350,640     $  303,382
Net realized gains, net of tax                      73,844        184,083        108,306
Net impairment losses recognized in earnings,
net of tax                                          (3,786 )      (11,388 )       (9,062 )
Equity in net income (loss) of investment funds
accounted for using the equity method, net of
tax                                                 35,738         73,510         (9,605 )
Net foreign exchange (losses) gains, net of tax    (13,718 )      (28,527 )       17,298
Loss on repurchase of preferred shares, net of
tax                                                      -        (10,612 )            -
Net income available to common shareholders     $  687,793     $  557,706     $  410,319

The higher level of after-tax operating income in 2013 than in 2012 and 2011 was primarily due to a lower amount of losses from catastrophic events and also reflected the impact of current insurance and reinsurance market conditions and the impact of lower interest yields on the investment portfolio. Segment Information
For the periods presented, we classified our businesses into two underwriting segments - insurance and reinsurance - and corporate and other (non-underwriting). Accounting guidance regarding disclosures about segments of an enterprise and related information requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. For a description of our underwriting segments, refer to Note 3, "Segment Information," of the notes accompanying our consolidated financial statements. Management measures segment performance based on underwriting income or loss.


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Insurance Segment
The following table sets forth our insurance segment's underwriting results:
                                   Year Ended December 31,                           Year Ended December 31,
                           2013            2012           % Change           2012            2011           % Change
Gross premiums written $ 2,712,509     $ 2,593,959               4.6     $ 2,593,959     $ 2,444,485               6.1
Net premiums written     1,948,796       1,825,334               6.8       1,825,334       1,721,279               6.0

Net premiums earned    $ 1,876,014     $ 1,800,343               4.2     $ 1,800,343     $ 1,679,047               7.2
Other underwriting
income                       2,122           2,335                             2,335           2,870
Losses and loss
adjustment expenses     (1,188,445 )    (1,283,841 )                      (1,283,841 )    (1,172,742 )
Acquisition expenses,
net                       (311,904 )      (298,983 )                        (298,983 )      (278,696 )
Other operating
expenses                  (315,387 )      (307,489 )                        (307,489 )      (307,797 )
Underwriting income
(loss)                 $    62,400     $   (87,635 )             n/m     $   (87,635 )   $   (77,318 )             n/m

Underwriting Ratios                                    % Point Change                                    % Point Change
Loss ratio                    63.3 %          71.3 %            (8.0 )          71.3 %          69.8 %             1.5
Acquisition expense
ratio (1)                     16.5 %          16.5 %               -            16.5 %          16.4 %             0.1
Other operating
expense ratio                 16.8 %          17.1 %            (0.3 )          17.1 %          18.3 %            (1.2 )
Combined ratio                96.6 %         104.9 %            (8.3 )         104.9 %         104.5 %             0.4

(1) The acquisition expense ratio is adjusted to include certain other underwriting income. The components of the insurance segment's underwriting results are discussed below. Premiums Written.
The following table sets forth our insurance segment's net premiums written by major line of business:

                                                Year Ended December 31,
                               2013                      2012                      2011
                         Amount          %         Amount          %         Amount          %
Programs              $   419,673          22   $   340,130          19   $   290,378          17
Property, energy,
marine and aviation       280,551          14       294,690          16       335,589          19
Professional
liability                 222,351          11       260,705          14       237,860          14
Executive assurance       213,727          11       250,904          14       231,405          13
Construction              161,877           8       130,201           7       120,405           7
Casualty                  112,094           6       112,307           6       114,235           7
National accounts         109,233           6        80,929           4        80,973           5
Lenders products          101,576           5        99,724           5        94,301           5
Surety                     64,911           3        53,271           3        42,475           2
Travel and accident        63,209           3        80,489           4        71,940           4
Healthcare                 40,115           2        36,814           2        35,652           2
Other (1)                 159,479           9        85,170           6        66,066           5
Total                 $ 1,948,796         100   $ 1,825,334         100   $ 1,721,279         100

(1) Includes alternative markets, contract binding, accident and health and . . .

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