How profitable has ACGL been, and what drove the improvement in 2004?

Net income rose to $316.9 million in 2004 from $280.6 million in 2003, and return on average equity was 16.0%. The increase came mainly from higher investment income, which grew to $143.7 million from $81.0 million as invested assets expanded through operating cash flow and capital raising. Underwriting income in both segments was slightly higher than in 2003, despite significant catastrophe losses in the third quarter of 2004.

How exposed is ACGL to catastrophe losses and reserve uncertainty?

The company has large aggregate exposures to natural and man-made catastrophes and states it aims to limit probable maximum pre-tax loss to about 25% of shareholders' equity for a 1-in-250-year event in any zone. Reserves of $2.88 billion (net) are largely IBNR and rely on expected loss methods because the company has limited historical data. The filing notes that prior-year development has been favorable so far, with a 2004 net redundancy of $98.7 million, but says future development could be adverse.

What are the main concentration and credit risks for investors?

Marsh & McLennan (21.4%) and Aon (16.0%) together accounted for about 37% of 2004 gross premiums written, and the company bears credit risk on premiums and claims passing through brokers. Reinsurance recoverables of $722.5 million are 81.1% from carriers rated A- or better, and Sentry is the largest single recoverable at 11.3%. The Warburg Pincus and Hellman & Friedman funds hold a majority of voting power and have governance rights that could limit minority shareholder influence.

What capital actions has ACGL taken, and what might come next?

In 2004 ACGL completed a common share offering (net proceeds $179.3 million) and issued $300 million of 7.35% senior notes due 2034 (net proceeds $296.4 million), using $200 million to repay its credit facility. Management said that in 2005 it is more likely to return capital to shareholders than to raise new capital, although any such action depends on board discretion, rating agency requirements, and regulatory constraints. The company's dividend capacity depends largely on subsidiary dividends, with about $235 million available from Arch Re Bermuda in 2005 without prior approval.

What regulatory and legal risks should investors monitor?

Key items include the New York Attorney General's investigation of broker practices and contingent commissions, a subpoena to a U.S. subsidiary about lawyers' malpractice underwriting, and a lawsuit by former American Independent owners, which management does not believe has merit. Arch Specialty's Wisconsin stipulation requires a 275% risk-based capital ratio versus a current level above 200%, and talks with regulators are ongoing. The TRIA terrorism backstop is scheduled to expire on December 31, 2005, which could change the company's terrorism exposure.

ACGL 10-K FY2004 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 15, 2005. Cited figures are marked; the original filing is the authoritative source.

Arch Capital Group Ltd. (ACGL), a Bermuda-domiciled specialty insurer and reinsurer, reported a strong 2004, its third full year after launching its underwriting initiative in October 2001.

Net premiums written reached $2.98 billion^a (up from $2.74 billion), net income rose to $316.9 million (from $280.6 million), return on average equity was 16.0%, and diluted book value per share grew 21.6% to $31.03. Growth was driven by reinsurance casualty lines and insurance specialty lines, while catastrophe losses from four Florida hurricanes and Typhoon Songda (about $125 million net to reinsurance and $42 million net to insurance) pressured combined ratios, which were 92.4% for reinsurance and 91.6% for insurance. The balance sheet expanded materially.

Total assets grew to $8.2 billion^b, net loss reserves reached $2.88 billion, and shareholders' equity rose to $2.24 billion. Funding came from a March 2004 common equity offering (net proceeds $179.3 million) and a $300 million 7.35% senior notes issuance due 2034. Management also disclosed that a further capital return to shareholders, rather than new capital raising, is more likely in 2005.

Credit-related risks flagged in the filing include a BBB- S&P counterparty rating, reliance on a few large brokers (Marsh 21.4%, Aon 16.0% of gross premiums), and a pending New York Attorney General investigation of broker practices. Investors should weigh the company's rapid growth and favorable reserve development (about $99 million^c net redundancy in 2004) against a short operating history, reserves that are largely IBNR and based on limited data, and concentration in a few brokers and the Warburg Pincus and Hellman & Friedman shareholder groups, which together hold a majority of voting power. Regulatory items to watch include the Arch Specialty Stipulation with Wisconsin regulators, which requires a 275% risk-based capital ratio, and the expiration of TRIA at year-end 2005.

02—Key points

Key Highlights

Net premiums written rose 9% to $2.98 billion in 2004, with the reinsurance segment at $1.59 billion and the insurance segment at $1.39 billion.
Net income increased to $316.9 million from $280.6 million, and diluted EPS was $4.37 versus $4.14 in 2003.
Return on average equity was 16.0% in 2004, compared with 18.0% in 2003.
Diluted book value per share increased 21.6% to $31.03, supported by earnings and a March 2004 equity offering netting $179.3 million.
Estimated net pre-tax catastrophe losses of about $167 million from Hurricanes Charley, Frances, Ivan and Jeanne and Typhoon Songda weighed on the combined ratios, which were 92.4% in reinsurance and 91.6% in insurance.
Net favorable prior-year reserve development of $98.7 million supported 2004 results, and total cash and invested assets reached $5.81 billion.
S&P rates ACGL BBB- and A.M. Best rates the operating subsidiaries A- (Excellent), and the filing notes the Arch Specialty statutory capital issue with Wisconsin regulators.

03—Questions

Frequently Asked Questions

How profitable has ACGL been, and what drove the improvement in 2004?
Net income rose to $316.9 million in 2004 from $280.6 million in 2003, and return on average equity was 16.0%. The increase came mainly from higher investment income, which grew to $143.7 million from $81.0 million as invested assets expanded through operating cash flow and capital raising. Underwriting income in both segments was slightly higher than in 2003, despite significant catastrophe losses in the third quarter of 2004.
How exposed is ACGL to catastrophe losses and reserve uncertainty?
The company has large aggregate exposures to natural and man-made catastrophes and states it aims to limit probable maximum pre-tax loss to about 25% of shareholders' equity for a 1-in-250-year event in any zone. Reserves of $2.88 billion (net) are largely IBNR and rely on expected loss methods because the company has limited historical data. The filing notes that prior-year development has been favorable so far, with a 2004 net redundancy of $98.7 million, but says future development could be adverse.
What are the main concentration and credit risks for investors?
Marsh & McLennan (21.4%) and Aon (16.0%) together accounted for about 37% of 2004 gross premiums written, and the company bears credit risk on premiums and claims passing through brokers. Reinsurance recoverables of $722.5 million are 81.1% from carriers rated A- or better, and Sentry is the largest single recoverable at 11.3%. The Warburg Pincus and Hellman & Friedman funds hold a majority of voting power and have governance rights that could limit minority shareholder influence.
What capital actions has ACGL taken, and what might come next?
In 2004 ACGL completed a common share offering (net proceeds $179.3 million) and issued $300 million of 7.35% senior notes due 2034 (net proceeds $296.4 million), using $200 million to repay its credit facility. Management said that in 2005 it is more likely to return capital to shareholders than to raise new capital, although any such action depends on board discretion, rating agency requirements, and regulatory constraints. The company's dividend capacity depends largely on subsidiary dividends, with about $235 million available from Arch Re Bermuda in 2005 without prior approval.
What regulatory and legal risks should investors monitor?
Key items include the New York Attorney General's investigation of broker practices and contingent commissions, a subpoena to a U.S. subsidiary about lawyers' malpractice underwriting, and a lawsuit by former American Independent owners, which management does not believe has merit. Arch Specialty's Wisconsin stipulation requires a 275% risk-based capital ratio versus a current level above 200%, and talks with regulators are ongoing. The TRIA terrorism backstop is scheduled to expire on December 31, 2005, which could change the company's terrorism exposure.

04—Continue

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