Why did ACGL's net income decline in 2005 despite premium growth?

Net income fell to $256.5 million from $316.9 million mainly because of higher catastrophe losses in 2005, including Hurricanes Katrina, Rita, Wilma and Dennis, and the European floods. Net premiums earned rose modestly, but the loss ratio increased to 67.2% from 64.4%, and net realized investment losses of $53.5 million, including $25.7 million of other-than-temporary impairments, further reduced earnings.

How strong is ACGL's balance sheet and capital position?

Shareholders' equity was $2.48 billion at year-end 2005, up from $2.24 billion, and total capital including $300 million of senior notes was about $2.78 billion. The company's U.S. and Bermuda subsidiaries reported capital above regulatory thresholds, and ratings were A- from A.M. Best and BBB/Baa1 at the holding company level. Management also noted reserves for losses were net of $1.39 billion of reinsurance recoverables, of which about 92.6% were due from carriers rated A- or better.

What are the main risks to investors according to the filing?

Key risks include catastrophe exposure, reserve adequacy given limited historical loss data for a company founded in 2001, dependence on brokers (Marsh and Aon together produced about 32.5% of gross premiums), and credit risk from reinsurers. The Warburg Pincus and Hellman & Friedman funds hold about 43.9% of voting shares and have significant governance influence. Reinsurance costs are expected to rise significantly in 2006, and the company may retain more risk as a result.

Can ACGL pay dividends or repurchase shares?

ACGL has not paid cash dividends. Under a shareholders agreement, it may not declare common dividends or repurchase common shares until it has bought back $250 million of shares from the Warburg Pincus and Hellman & Friedman funds, a restriction that runs until 2011. Any preferred dividends are non-cumulative and discretionary. Bermuda law limits Arch Re Bermuda's dividends to about $249 million in 2006 without regulatory approval, and the holding company relies on subsidiary dividends for debt service.

What changed in the company's structure and capital raising in 2005–2006?

In the fourth quarter of 2005, all 37.3 million series A convertible preference shares converted to common shares, so the company no longer has preference shares outstanding. In February 2006, ACGL issued $200 million of 8.00% non-cumulative preferred shares. The Flatiron Re quota share reinsurance treaty, effective for the 2006 and 2007 underwriting years, transfers 45% of certain property and marine business from Arch Re Bermuda to a third-party reinsurer, which is expected to reduce net exposure while increasing writings in those lines.

ACGL 10-K FY2005 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 13, 2006. Cited figures are marked; the original filing is the authoritative source.

Arch Capital Group Ltd. (ACGL) closed fiscal 2005 with net income of $256.5 million^a, down from $316.9 million in 2004, and diluted EPS of $3.43 versus $4.37.

The decline was driven mainly by a heavy 2005 catastrophe year, with Hurricanes Katrina, Rita, Wilma and Dennis, Emily and the European floods producing estimated pre-tax net losses of roughly $192 million^b in reinsurance and $140 million in insurance after reinsurance recoveries. Return on average equity fell to 10.9% from 16.0%, while diluted book value per share rose 9.0% to $33.82. The company wrote $3.14 billion of net premiums and reported total capital of about $2.8 billion, with $300 million of 7.35% senior notes as its only long-term debt.

The balance sheet grew substantially, with total assets of $11.5 billion^c, net loss reserves of $4.06 billion, and cash and invested assets of $7.12 billion. Management highlighted that favorable prior-year reserve development of $119 million helped results, and that the company expects reinsurance costs to rise sharply in 2006. Post-year-end, ACGL issued $200 million of 8.00% series A non-cumulative preferred shares in February 2006, and it launched a 45% quota share arrangement with Flatiron Re Ltd. for its Bermuda reinsurer's 2006 and 2007 property and marine business.

Investors should weigh several items: the company is a relatively young underwriter (it launched its underwriting initiative in October 2001), so reserves rest on limited historical data. Its Warburg Pincus and Hellman & Friedman shareholders control about 43.9% of voting shares and have board nomination rights, and the company is restricted from paying common dividends or repurchasing shares until it buys back $250 million^d of shares from those funds. A 2006 Arch Specialty capital shortfall under a Wisconsin stipulation was cured with a $57 million capital contribution.

02—Key points

Key Highlights

Net income fell 19% to $256.5 million in 2005 (diluted EPS $3.43 vs. $4.37), reflecting heavy catastrophe losses from Hurricanes Katrina, Rita and Wilma.
Return on average equity declined to 10.9% from 16.0%, while diluted book value per share grew 9.0% to $33.82.
Net premiums written rose 5.3% to $3.14 billion, with the insurance segment at $1.48 billion and the reinsurance segment at $1.66 billion.
Reinsurance combined ratio worsened to 97.5% (from 92.4%) and insurance combined ratio to 93.8% (from 91.6%), largely due to catastrophe losses.
Favorable prior-year reserve development of $119 million supported 2005 results, but gross reserves reached $5.45 billion, and 75% of net reserves are IBNR.
Investment income rose 62% to $232.9 million on a 3.7% pre-tax yield, with a portfolio rated AA+ and 96% investment grade.
Issued $200 million of 8.00% series A preferred shares in February 2006 and entered a 45% quota share with Flatiron Re Ltd. for 2006–2007 property and marine business.

03—Questions

Frequently Asked Questions

Why did ACGL's net income decline in 2005 despite premium growth?
Net income fell to $256.5 million from $316.9 million mainly because of higher catastrophe losses in 2005, including Hurricanes Katrina, Rita, Wilma and Dennis, and the European floods. Net premiums earned rose modestly, but the loss ratio increased to 67.2% from 64.4%, and net realized investment losses of $53.5 million, including $25.7 million of other-than-temporary impairments, further reduced earnings.
How strong is ACGL's balance sheet and capital position?
Shareholders' equity was $2.48 billion at year-end 2005, up from $2.24 billion, and total capital including $300 million of senior notes was about $2.78 billion. The company's U.S. and Bermuda subsidiaries reported capital above regulatory thresholds, and ratings were A- from A.M. Best and BBB/Baa1 at the holding company level. Management also noted reserves for losses were net of $1.39 billion of reinsurance recoverables, of which about 92.6% were due from carriers rated A- or better.
What are the main risks to investors according to the filing?
Key risks include catastrophe exposure, reserve adequacy given limited historical loss data for a company founded in 2001, dependence on brokers (Marsh and Aon together produced about 32.5% of gross premiums), and credit risk from reinsurers. The Warburg Pincus and Hellman & Friedman funds hold about 43.9% of voting shares and have significant governance influence. Reinsurance costs are expected to rise significantly in 2006, and the company may retain more risk as a result.
Can ACGL pay dividends or repurchase shares?
ACGL has not paid cash dividends. Under a shareholders agreement, it may not declare common dividends or repurchase common shares until it has bought back $250 million of shares from the Warburg Pincus and Hellman & Friedman funds, a restriction that runs until 2011. Any preferred dividends are non-cumulative and discretionary. Bermuda law limits Arch Re Bermuda's dividends to about $249 million in 2006 without regulatory approval, and the holding company relies on subsidiary dividends for debt service.
What changed in the company's structure and capital raising in 2005–2006?
In the fourth quarter of 2005, all 37.3 million series A convertible preference shares converted to common shares, so the company no longer has preference shares outstanding. In February 2006, ACGL issued $200 million of 8.00% non-cumulative preferred shares. The Flatiron Re quota share reinsurance treaty, effective for the 2006 and 2007 underwriting years, transfers 45% of certain property and marine business from Arch Re Bermuda to a third-party reinsurer, which is expected to reduce net exposure while increasing writings in those lines.

04—Continue

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