Why are ACGL's 2002 results difficult to compare with prior years?

The company was effectively restarted in October 2001 when it launched a new underwriting initiative, recruited new management, and raised $763.2 million of new capital. It also sold its prior reinsurance book to Folksamerica in May 2000 and redomesticated to Bermuda in November 2000. Management states that comparisons with 2001 and 2000 are not meaningful, since the reinsurance operation only began writing new business from the January 1, 2002 renewal season.

What is the main dilution risk for common shareholders?

The preference shares issued in November 2001 convert into common shares on a one-for-one basis, and 38.8 million were outstanding at year-end 2002. Purchase price adjustments could require issuing more preference shares if the adjustment basket falls below zero, with a calculation due around November 2003 and a further one tied to the fourth anniversary. Shareholders also face potential dilution from future capital raises and from the 5.5 million shares issuable under options, warrants and convertibles.

How strong are ACGL's reserves and how much uncertainty is there?

Reserves are net $381 million and gross $592 million at year-end 2002. Management relies heavily on expected loss ratios because limited historical claims data exists, and 67% of net loss reserves are IBNR. A 5% change in IBNR would move net reserves by about $12.8 million, roughly 24% of 2002 net income. The 2001 reserves developed adversely by about $4 million on a net basis, mainly from program accounts and non-standard auto.

What are the main risks from catastrophe exposure and reinsurance counterparties?

The company targets a probable maximum pre-tax loss of about 25% of shareholders' equity for a 1-in-250-year severe catastrophe event, but acknowledges it could exceed this. For 2003, a catastrophe treaty covers 95% of the first $70 million in excess of a $50 million retention. About 81% of $225.6 million in reinsurance recoverables are rated A- or better by A.M. Best, and the top recoverable counterparty is Sentry Insurance at 16.7%.

Is ACGL paying dividends, and what limits its ability to return capital?

ACGL does not plan to declare dividends or repurchase common shares. A shareholders agreement bars dividends and buybacks until $250 million of preference shares are repurchased pro rata from investors. Regulatory limits also apply: Arch Re Bermuda may pay dividends only within Bermuda solvency constraints, and U.S. subsidiaries cannot pay significant dividends in 2003 without regulatory approval. ACGL held only about $8 million of readily available holding-company cash outside its regulated subsidiaries.

ACGL 10-K FY2002 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 31, 2003. Cited figures are marked; the original filing is the authoritative source.

Arch Capital Group Ltd. (ACGL) reported its 2002 10-K as a Bermuda-domiciled property and casualty reinsurer and insurer that is still in the early stages of a start-up-style underwriting initiative launched in October 2001.

The company ended 2002 with shareholders' equity of approximately $1.41 billion^a (up from $1.02 billion), total assets of $2.99 billion, and gross premiums written of $1.49 billion, of which 61% came from reinsurance and 39% from insurance. Net income was $59.0 million, or $0.99 per diluted share, and the GAAP combined ratio was 90.9%, which reflects an underwriting profit of $59.2 million. Results were helped by $3.9 million of extraordinary gain from the PSIC acquisition and hurt by $49.5 million of non-cash compensation, largely from the accelerated vesting of restricted shares for Chairman Robert Clements.

The filing shows a company whose results are not yet comparable to prior years because the business was fundamentally reshaped. The capital base was rebuilt through a $763.2 million^b preference share infusion in November 2001 led by Warburg Pincus and Hellman & Friedman, plus a $179.2 million common offering in April 2002 and $74.3 million from class A warrant exercises. Those investors now control a majority of voting power and board nominations, and purchase-price adjustments could issue additional preference shares, creating dilution risk.

Reserves are young and largely IBNR (67% of net loss reserves), so estimates carry substantial uncertainty; the company also recorded a $58 million^c gross deficiency on 2001 program business and a $10 million gross deficiency in non-standard auto. Management signals strong growth ahead, with significant premium growth expected in 2003 and a new construction and surety unit being added. Key risks include reserve adequacy, catastrophe exposure (with a target of limiting probable maximum loss to about 25% of equity for a 1-in-250-year event), counterparty and broker concentration (Marsh & McLennan at 20.2% of gross premiums), reliance on brokers and managing general agents, ratings pressure (A- from A.M.

Best), and Bermuda tax and regulatory changes. ACGL itself holds only about $8 million^d of readily available cash at the holding company, and dividends are not planned.

02—Key points

Key Highlights

Net income of $59.0 million ($0.99 diluted EPS) in 2002, versus $22.0 million in 2001, with a GAAP combined ratio of 90.9%
Gross premiums written of $1.49 billion and net premiums written of $1.26 billion, with reinsurance at 70% of net premiums and insurance at 30%
Shareholders' equity grew to $1.41 billion from $1.02 billion, supported by the April 2002 common offering and class A warrant exercises
Cash and invested assets of about $2.0 billion, with a fixed income portfolio averaging AA- quality and a duration of about 2.1 years
Heavy dependence on a few shareholders: Warburg Pincus and Hellman & Friedman funds hold about 56% of voting shares and can influence board composition and major transactions
Possible further dilution from purchase price adjustments tied to the November 2001 capital infusion, with a calculation due around November 2003
Significant reserve uncertainty: 67% of net loss reserves are IBNR, and the company recorded a $68 million gross deficiency on 2001 program and non-standard auto reserves

03—Questions

Frequently Asked Questions

Why are ACGL's 2002 results difficult to compare with prior years?
The company was effectively restarted in October 2001 when it launched a new underwriting initiative, recruited new management, and raised $763.2 million of new capital. It also sold its prior reinsurance book to Folksamerica in May 2000 and redomesticated to Bermuda in November 2000. Management states that comparisons with 2001 and 2000 are not meaningful, since the reinsurance operation only began writing new business from the January 1, 2002 renewal season.
What is the main dilution risk for common shareholders?
The preference shares issued in November 2001 convert into common shares on a one-for-one basis, and 38.8 million were outstanding at year-end 2002. Purchase price adjustments could require issuing more preference shares if the adjustment basket falls below zero, with a calculation due around November 2003 and a further one tied to the fourth anniversary. Shareholders also face potential dilution from future capital raises and from the 5.5 million shares issuable under options, warrants and convertibles.
How strong are ACGL's reserves and how much uncertainty is there?
Reserves are net $381 million and gross $592 million at year-end 2002. Management relies heavily on expected loss ratios because limited historical claims data exists, and 67% of net loss reserves are IBNR. A 5% change in IBNR would move net reserves by about $12.8 million, roughly 24% of 2002 net income. The 2001 reserves developed adversely by about $4 million on a net basis, mainly from program accounts and non-standard auto.
What are the main risks from catastrophe exposure and reinsurance counterparties?
The company targets a probable maximum pre-tax loss of about 25% of shareholders' equity for a 1-in-250-year severe catastrophe event, but acknowledges it could exceed this. For 2003, a catastrophe treaty covers 95% of the first $70 million in excess of a $50 million retention. About 81% of $225.6 million in reinsurance recoverables are rated A- or better by A.M. Best, and the top recoverable counterparty is Sentry Insurance at 16.7%.
Is ACGL paying dividends, and what limits its ability to return capital?
ACGL does not plan to declare dividends or repurchase common shares. A shareholders agreement bars dividends and buybacks until $250 million of preference shares are repurchased pro rata from investors. Regulatory limits also apply: Arch Re Bermuda may pay dividends only within Bermuda solvency constraints, and U.S. subsidiaries cannot pay significant dividends in 2003 without regulatory approval. ACGL held only about $8 million of readily available holding-company cash outside its regulated subsidiaries.

04—Continue

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