Why is the 2001 financial information difficult to compare with prior years?

The company sold its prior reinsurance book to Folksamerica in May 2000, redomesticated to Bermuda in November 2000, acquired American Independent and ART Services in 2001, and received the $763.2 million capital infusion in November 2001. Management explicitly states that 2001 and 2000 results are not comparable, so the historical figures do not indicate future performance.

How much dilution could common shareholders face from the capital infusion?

The 35.7 million preference shares are convertible into common shares one-for-one, subject to adjustment. Fully diluted, the Warburg Pincus and Hellman & Friedman funds own about 33.8% and 18.8% of common shares, respectively. The company also estimates about 875,765 additional preference shares from the audit adjustment in Q1 2002 and up to 2,831,174 more if the $30 share price trigger or a change of control occurs before September 2005.

Who controls ACGL after the capital infusion?

The Warburg Pincus and Hellman & Friedman funds together control a majority of fully diluted voting power and can nominate a majority of the board once regulatory approvals are received, with the board expanding to up to 17 members. Their shareholder agreement also requires approval by their designated directors for many actions outside the ordinary course, including acquisitions, debt, dividends, and changes to the auditor or key officers, so their interests may diverge from those of other common shareholders.

What are the main risks to the new underwriting strategy?

The management team was recently assembled and the strategy is newly formulated. The reinsurance market has attracted more than $10 billion of new capital since September 11, 2001, which may pressure pricing. Catastrophe and reserving uncertainty, reliance on a limited number of brokers, dependence on A.M. Best ratings (A- for the main reinsurance subsidiaries), and reinsurance counterparty risk could all materially affect results.

Is the company paying dividends or returning capital to shareholders?

No. The board does not intend to declare dividends in the near term, and the shareholders agreement prohibits any common dividend or share repurchase until preference shares with an aggregate value of $250 million have been repurchased from the investors. Dividends from insurance subsidiaries also require regulatory approval during 2002.

ACGL 10-K FY2001 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 18, 2002. Cited figures are marked; the original filing is the authoritative source.

Arch Capital Group Ltd. (ACGL) reported its 2001 results in its 10-K filed March 18, 2002, a year defined by a strategic pivot rather than comparable operating history.

In October 2001 the company launched a new specialty insurance and reinsurance underwriting initiative and, on November 20, 2001, closed a $763.2 million^a capital infusion led by the Warburg Pincus and Hellman & Friedman funds, which left shareholders' equity at about $1.02 billion at year-end, up from $272.3 million in 2000. Management states that 2001 and 2000 results are not meaningfully comparable because of the May 2000 sale of the prior reinsurance book to Folksamerica, the November 2000 redomestication to Bermuda, 2001 acquisitions (American Independent and ART Services), and the capital infusion. Reported 2001 net income was $22.0 million, or $1.29 diluted EPS, on total revenues of $76.5 million, with a 9% effective tax rate, and the company generated negative operating cash flow of $5.6 million.

For investors, the filing is primarily a picture of a company in transition. Premium volume was minimal in 2001 (net premiums written of $36.2 million^b), with management guiding to very substantial growth in 2002, citing about $500 million of expected gross written reinsurance premiums from roughly 800 treaties written since January 1, 2002. The balance sheet is now dominated by about $1.0 billion of cash and invested assets, with a conservative fixed-income portfolio (average S&P rating AA-, duration about 1.9 years), but the equity base carries a substantial overhang: the preference shares issued in the capital infusion convert into 35.7 million common shares, and purchase price adjustments could issue roughly 3.7 million more.

Investors should weigh governance concentration, since Warburg Pincus and Hellman & Friedman hold a majority of fully diluted voting power and have approval rights over many corporate actions, and the company has no near-term dividend plans. Key risks include the unproven new management team and strategy, intense competition from newly raised industry capital after September 11, 2001, catastrophe and reserving uncertainty, dependence on a small number of brokers, ratings sensitivity (the reinsurance subsidiaries are rated A- by A.M.

Best), and contingent exposure to the Folksamerica sale. Regulatory approvals for the capital infusion were still pending in Pennsylvania and Florida at filing, and a Florida failure to approve before May 20, 2002 could trigger exchange rights for the preferred holders.

02—Key points

Key Highlights

Shareholders' equity rose to $1.02 billion at December 31, 2001, from $272.3 million a year earlier, driven by the $763.2 million capital infusion closed November 20, 2001.
2001 net income of $22.0 million ($1.29 diluted EPS) versus a net loss of $8.0 million in 2000, though management says prior-period comparisons are not meaningful due to the business changes.
Net premiums written were only $36.2 million in 2001, with management guiding to very substantial 2002 growth, citing about 800 treaties and roughly $500 million of expected gross written reinsurance premiums.
Cash and invested assets of about $1.0 billion are high quality and short duration: average S&P rating AA-, average duration about 1.9 years, and 100% investment grade fixed maturities.
Warburg Pincus and Hellman & Friedman together hold a majority of fully diluted voting power and have board designation rights and approval rights over many major corporate actions.
Potential additional preference share issuance from purchase price adjustments (about 875,765 shares estimated in Q1 2002, plus up to 2.83 million if the $30 trading trigger is met) could further dilute common shareholders.
No dividends are planned, and the shareholders agreement bars common dividends or buybacks until $250 million of preference shares are repurchased.

03—Questions

Frequently Asked Questions

Why is the 2001 financial information difficult to compare with prior years?
The company sold its prior reinsurance book to Folksamerica in May 2000, redomesticated to Bermuda in November 2000, acquired American Independent and ART Services in 2001, and received the $763.2 million capital infusion in November 2001. Management explicitly states that 2001 and 2000 results are not comparable, so the historical figures do not indicate future performance.
How much dilution could common shareholders face from the capital infusion?
The 35.7 million preference shares are convertible into common shares one-for-one, subject to adjustment. Fully diluted, the Warburg Pincus and Hellman & Friedman funds own about 33.8% and 18.8% of common shares, respectively. The company also estimates about 875,765 additional preference shares from the audit adjustment in Q1 2002 and up to 2,831,174 more if the $30 share price trigger or a change of control occurs before September 2005.
Who controls ACGL after the capital infusion?
The Warburg Pincus and Hellman & Friedman funds together control a majority of fully diluted voting power and can nominate a majority of the board once regulatory approvals are received, with the board expanding to up to 17 members. Their shareholder agreement also requires approval by their designated directors for many actions outside the ordinary course, including acquisitions, debt, dividends, and changes to the auditor or key officers, so their interests may diverge from those of other common shareholders.
What are the main risks to the new underwriting strategy?
The management team was recently assembled and the strategy is newly formulated. The reinsurance market has attracted more than $10 billion of new capital since September 11, 2001, which may pressure pricing. Catastrophe and reserving uncertainty, reliance on a limited number of brokers, dependence on A.M. Best ratings (A- for the main reinsurance subsidiaries), and reinsurance counterparty risk could all materially affect results.
Is the company paying dividends or returning capital to shareholders?
No. The board does not intend to declare dividends in the near term, and the shareholders agreement prohibits any common dividend or share repurchase until preference shares with an aggregate value of $250 million have been repurchased from the investors. Dividends from insurance subsidiaries also require regulatory approval during 2002.

04—Continue

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