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Maximilian Thompson

ACGL AT A GLANCE

P/E ► 19.1 AVG EV/EBITDA ► 17.0 AVG ROA ► 1.2% AVG ROE ► 4.4% AVG Debt to Equity ► 3.13 AVG Current Ratio ► 0   Interest Coverage Ratio ► 10.2 AVG

 

 

 

 

 

 

Arch Capital Group Ltd. (NASDAQ GS:ACGL) writes major insurance policies for businesses and sells reinsurance to other insurance companies. The company targets insurance policies that have an anticipated minimum return (ROE) of 15%,^[1] which is problematic in economic downturns as companies become more price sensitive. This ROE litmus test means that Arch first evaluates a projected combined ratio for a potential policy, and from that ratio Arch attaches a projected net income to the policy. If this is below what is needed to generate a 15% ROE, then Arch does not write the policy.

ACGL's revenue growth was flat from 2006 to 2007, and the company saw a slight decrease in sales (less than a 1% change).^[2]

Like other insurance companies, Arch invests the premiums it collects to earn income. Its portfolio consists solely of fixed income securities rated in the range of AAA to AA, with virtually no investment in hedge funds or private equity, and as a result earned a AA+ credit rating from Standard & Poor’s as of year end 2007.^[3] Importantly, as of 2007 its portfolio of investments held no collateralized debt obligations (CDOs) or loan obligations (CLOs). This conservative investment strategy stands in stark contrast to the investments of many other insurance companies, most notably AIG, whose well-publicized write-offs were centered on collateralized debt obligations (CDOs). ^[4]

Corporate Overview

Financial Metrics

Arch has increased both revenues and net income consistently over the past three years. From 2005 to 2007, revenue increased from $3.16 billion to $3.45 billion and net income increased from $256 million to $857 million.^[5]

Source: ^[6]

From 2006 to 2007, the operating return on equity decreased slightly from 25.6% to 24.3%, indicating a very slightly less efficient use of capital in operations. During the same period, however, the company had double-digit growth in after-tax operating income (+15%) and net income (+20%). ^[7]

Return on equity is a useful metric in insurance companies, because dollar amounts can be misleading. ^[8] For example, imagine two insurance companies: A and B. A has an average net worth of $20 million while B has a net worth of $10 million. Both companies generate $1 million dollars profit. Return on equity (measured as net income / total equity) indicates that company B is the more profitable business, because it earned the same amount with half as much capital.

Cash flow decreased from $1.61 billion in 2006 to $1.44 billion in 2007, due to an increase in predicted losses on older policies and a decrease in new sales. ^[9]

Combined Ratio

The metric for profitability in the insurance industry is the combined loss ratio, a ratio that reflects the percentage of each dollar sold of insurance policies that must actually be paid out as a claim or expense over the lives of the policies. A low combined ratio for a company indicates the insurance policies it has sold are profitable, because for every 1 dollar sold, a lower amount of money is paid out. For example, if the combined ratio is .6, this means that for every dollar of insurance sold, 60 cents are paid out and 40 cents are kept as earnings. A lower amount of money being paid out, the lower the combined ratio, indicates high earnings for the insurance company by definition.

Arch's combined ratio improved to 84.1% in 2007 from 85.4% in 2006. The company attributes this to low catastrophe losses and five consecutive years of reserve increases;^[10] money set aside for predicted losses on policies has consistently been greater than the actual amount of money required to settle claims over 5 years, resulting in the difference between predicted losses and actual losses to be moved from reserves into earnings.

^[11]

Revenue Sources

By Product

Arch has grown revenues from almost all of its product segments, with the exceptions of the casualty and healthcare segments. Revenues from casualty insurance have decreased by 33.12% between 2005 and 2007 (90mm), while healthcare revenues have decreased by 10.11% (7mm) during the same period.^[12]

Source: ^[13]

By Geography

The share of premiums written for companies in the US has decline by 11.8% from 2005 to 2007, while the share of premiums written for European companies has more than doubled in these three years. This indicates that the company's growth has largely been dependent on expansion in European and other non-US markets.^[14]

Source: ^[15]

Premiums Written

Source:^[16]

Premiums written is more useful in breaking down Arch's insurance business policy instead of revenue and net income. Premiums written are the new policies issued in a year. The profit that the company makes on the policy is determined by the price the insurance company sells the policy for AND on the long-term amount of money that must be paid out under the policy. Although Arch has access to historical data, and does use this data to help understand its profitability on a policy as the policy matures, this is merely projection.

Revenue and net income are problematic measures for an insurance company, because they involve dollars from the core business of issuing insurance and reinsurance, as well as dollars from investing. Pulling apart revenue between these two income streams is further complicated by the relationship between the type of investments made with premiums set aside from the different insurance products. For an example, say X type of insurance has small margins, but the premiums are rarely paid out. An insurance company can more aggressively invest those premiums, which indicates that the total revenues X type insurance accounts for will be understated in a break down of overall revenues by segment, which will look at revenue from investing and revenue from premiums written as separate categories.

Trends and Forces

Slow Down in American Economy Leads to Weaker Revenue in a Highly Cyclical Industry

The insurance industry is particularly cyclical, in part because home, auto, commercial property and workers compensation lines of business collectively account for more than 70% of the total premiums written in the industry. ^[17]The longer firms experience a declining number of customers who are looking to purchase policies, the more likely they are to lower margins and compete aggressively for remaining customers. This trend is revealed in declining returns on equity during economic downturns. ^[18]

Despite a slowing economy, Arch has been able to increase revenue in part by increasing returns on investments. From 2005 to 2007, the share of revenue from investment income has nearly doubled. ^[19]

Arch has secured against declines in revenue in part by increasing returns on its portfolio and generating more investment income; from 2006 to 2007, net investment income increased by 22%, while gross premiums written (sales of new policies) decreased by 3%. ^[20] Although Arch's substantial holdings in fixed income securities and bonds should strengthen in a weak economy, its ability to continue to offset declines in issuing new policies to the extent it has been able to in the past two years in a longer-term, weak economy could become an obstacle.

Emerging Markets Have Potential for Growth

Global insurance premiums have been increasing with a growth rate (CAGR) of 9.1% since 2001 to a 2006 level of $3.723 trillion dollars annually; drivers of this trend include tax incentives and regulatory changes in many developing countries. ^[21] The demand for both basic insurance in emerging markets and the demand for increasingly complex insurance policies in industrialized markets are projected to increase. ^[22]

^[23]

In terms of market penetration, emerging markets had an insurance penetration rate of 2.6% compared to 9.18% for industrialized markets; the countries with the lowest penetration rates were Saudi Arabia (.5%) and Algeria (.5%). Countries with a lower penetration rate are by definition less saturated and smaller than N. America.^[24] Insurance penetration is defined as Insurance Premiums as a Percentage of GDP.

Arch has been able to expand dramatically in the global marketplace, doubling its European business from 2005 to 2008 and expanding its Global (excluding US and Europe) business by 79% percent during the same period. ^[25]

In January 2008, Arch announced a 50-50 joint venture with the Gulf Investment Corp. (GIC) to form a reinsurance company, Gulf Re, based in Dubai. ^[26]GIC is wholly owned by the governments of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. By partnering with an institution that has strong knowledge and access to the Middle Eastern market, Arch has the stated assumption that it will gain access and market share in a fast growing geographic region.

Shifting Away from Reinsurance, Unforeseen Risk Possible

Arch's activity with reinsurance indicates substantial exposure to policies in which Arch's underwriters were one step removed from the customer.

Reinsurance is a transaction that involves an insurance company that has written a policy for a customer (determined premiums, coverage, and risk) then selling part or all of the future premiums to be paid by the customer and the risk associated with that client over the remaining life of the policy.

Arch's role as a reinsurer means that it takes on the risks and recieves some portion of the premiums that were structured by another insurer, who actually wrote the policy with the company that is now essentially being covered by Arch. This opens up the possibility of unforeseen risks, because another insurance company was responsible for conducting due diligence on customers before then seeking reinsurance with Arch for the customer's policy. Arch must trust the evaluation made by the issuing insurance company. It remains to be seen though whether previously issued reinsurance agreements represent greater risks than predicted by Arch, due to the accuracy of information provided by the initial issuing insurance company.

Arch has shifted its mix of new business from 45% reinsurance and 55% insurance in 2006, to 59% insurance and 41% reinsurance in 2007^[27]

Failing insurance companies

Fallout among insurance companies from insurance of poor and risky investments will create an opportunity for growth for the firms that remain solvent and poised to react quicker to new opportunities.

AIG, one of the world's largest insurance agencies, was subject to a US Federal Reserve rescue deal, as it approached the edge of bankruptcy, because of its insurance of financial products including mortgage backed securities. ^[28] Standard & Poor's analyst Rodney Clark indicated that the three-level downgrade of AIG's S&P credit rating was due to credit default swaps CDOs, that were causing most of the strain, as well as holdings of residential Mortgage-Backed Securities (MBS). ^[29]

Although Arch did not insure similar financial transactions, the damage done to insurers who did and subsequently lost capital and public trust will benefit insurers who compete against them across all sectors of insurance.

The link between the businesses performance in the future and the current Standard and Poor's rating is the Percentage of Defaults measurement. The higher the categorical risk of default is for an insurer, the less stable the company appears to both customers for insurance and investors. For example, a company with a rating that indicates a higher default rate may not be able to settle a claim it is obligated to pay on a policy a customer has paid premiums on for 20 years, if it is having liquidity issues. It is also less likely to be able to successfully raise capital in such a situation.

With an S&P rating of AA+, Standard and Poor's has evaluated and grouped Arch Capital in a collection of companies that has traditionally had a low chance of default. A top rated, low chance of default generally means that a firm can withstand further turmoil in the markets and capitalize on the failure of other firms by absorbing their customers.

Competition

Competitors are insurance subsidiaries of global conglomerates or independent companies. As defined by Arch Capital Group, its competitors in insurance are: ^[30]

• Ace (ACE)
• Allied World Assurance Company Holdings (AWH)
• American International Group (AIG)
• Axis Capital Holdings (AXS)
• Berkshire Hathaway (BRK)
• Chubb (CB)
• Endurance Specialty Holdings (ENH)
• Hartford Financial Services Group (HIG)
• HCC Insurance Holdings (HCC)
• Lloyds Tsb Group (LYG)
• ST PAUL TRAVELERS (STA)
• W.R. Berkley (BER)
• XL CAPITAL LIMITED (XL)
• Zurich Insurance Group.

In response to price competition from larger insurers and subsidiary companies, Arch is aggressively shifting its strategy toward opening smaller insurance policies with businesses in a diverse set of specialty markets, where it can offer a higher level of expertise than many of its larger competitors. ^[31]

The company also faces competition from emerging alternatives to insurance, such as catastrophe bonds and alternatives to traditional reinsurance such as finite reinsurance products.

Market Share

Arch has captured 1.32% of domestic P&C insurance premiums, ranking as the 15th largest insurance company by market share.^[32]

References

1. ↑ ACGL. ACGL Annual Report 2007, To Our Shareholders Letter, Pg 1.
2. ↑ ACGL. 10-K, Balance Sheet.
3. ↑ ACGL. Annual Report 2007, Cash Flow, Investable Assets and Investment Income, Pg 2.
4. ↑ WSJ. AIG reports $5.36 billion quarterly net loss.
5. ↑ ACGL. 10-K, Balance Sheet.
6. ↑ ACGL. 10-K, Balance Sheet.
7. ↑ ACGL. Annual Report, Pg 1.
8. ↑ Insurance Information Institute. Financial Reporting in the P/C Insurance Industry, Measuring Profitability: Dollars vs. Return on Equity (or Return on Surplus).
9. ↑ ACGL. Annual Report, Pg 3.
10. ↑ ACGL. Annual Report, Pg 2.
11. ↑ Wikinvest. Property and Casualty Insurance Wikinvest Article.
12. ↑ ACGL. 10-K,Income Statement.
13. ↑ ACGL. 10-K, Balance Sheet.
14. ↑ ACGL. 10-K,Income Statement.
15. ↑ ACGL. 10-K, Income Statement.
16. ↑ ACGL. 10-K, Balance Sheet.
17. ↑ Friedman, Fliescher, Lowe, LLC. The Insurance Industry's Ability to Attract Capital Given Historically Low ROE.
18. ↑ Friedman, Fliescher, Lowe, LLC. The Insurance Industry's Ability to Attract Capital Given Historically Low ROE.
19. ↑ ACGL. 10-K, Income Statement.
20. ↑ ACGL. Annual Report, Pg 1.
21. ↑ ABCI. Insurance Sector Report Sept 2007, Section 2.0 Insurance Across the Globe, 2.1 Global Market Characteristics, Pg 6.
22. ↑ ABCI. Insurance Sector Report Sept 2007, Section 2.0 Insurance Across the Globe, 2.1 Global Market Characteristics, Pg 6.
23. ↑ ABCI. Insurance Sector Report Sept 2007, Section 2.0 Insurance Across the Globe, 2.1 Global Market Characteristics, Pg 6.
24. ↑ ABCI. Insurance Sector Report Sept 2007, Section 2.0 Insurance Across the Globe, 2.1 Global Market Characteristics, Pg 8.
25. ↑ ACGL. 10-K,Income Statement.
26. ↑ ACGL. ACGL Annual Report 2007, Pg 5.
27. ↑ ACGL. ACGL Annual Report 2007, Pg 4.
28. ↑ Associated Press. AIG clients await news of business sales.
29. ↑ Mark Pittman, Bloomberg. Goldman, Merrill Collect Billions After Fed's AIG Bailout Loans.
30. ↑ ACGL. Annual Report 2007, Pg 23.
31. ↑ ACGL. Annual Report 2007, Market Positions and Strategic Principles, Pg 2.
32. ↑ National Association of Insurance Commissioners. Annual Report 2008.