Why did ACGL's earnings decline so sharply in 2008?

Earnings fell from $832.1 million to $265.1 million due to three main factors: about $287 million in after-tax losses from Hurricanes Gustav and Ike, $185 million in net realized investment losses (mainly credit-related impairments), and a $179 million loss from equity-method bank loan funds during the fall 2008 credit market turmoil. These were partially offset by $310 million of favorable prior-year reserve development and $96.6 million of net foreign exchange gains.

How large is ACGL's exposure to catastrophe losses, and how does it manage it?

The company seeks to limit its probable maximum pre-tax loss from a 1-in-250-year event in any geographic zone to about 25% of shareholders' equity. As of January 1, 2009, this was approximately $763 million. Management manages exposure through excess-of-loss reinsurance, geographic zone limits, and per-client program limits. The 2009 property catastrophe program covers 80% of the first $275 million above a $75 million retention. Management notes that modeled estimates may prove materially inaccurate.

Is ACGL's reserving adequate, and how reliable are its reserve estimates?

Net loss reserves were $5.94 billion at year-end 2008, with about 70% being IBNR. The company has developed favorably for three consecutive years, with $310 million of net favorable development in 2008. However, the company is relatively new, and the filing states that limited historical information makes estimates inherently uncertain. A simulation suggests a 90th-percentile reserve of $7.1 billion, which would imply a pre-tax charge of about $1.16 billion, so reserve risk is material.

What are the main risks to ACGL's business and ratings?

Key risks include ratings downgrades (A.M. Best 'A', Moody's 'A2', S&P 'A'), which could reduce new business and trigger collateral or termination rights under some reinsurance contracts; concentration in a few brokers (Marsh & McLennan 17.0% and Aon 15.3% of gross premiums); cyclical pricing and rising industry capacity; Bermuda tax exposure after March 28, 2016; and possible U.S. tax changes affecting Bermuda reinsurance. The Warburg Pincus funds also hold about 6.6% of voting shares and have board nomination rights.

What is ACGL's capital position and capacity for shareholder returns?

ACGL had $3.83 billion of total capital at year-end 2008, comprising $300 million of 7.35% senior notes, $100 million of revolver borrowings, $325 million of preferred shares, and $3.11 billion of common equity. Arch Re Bermuda can pay about $834 million in dividends to ACGL in 2009 without regulatory affidavit requirements. Management stated it will likely not repurchase shares in the first half of 2009 and that it may need to raise capital if conditions warrant, but acknowledged that financing may not be available on acceptable terms.

ACGL 10-K FY2008 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 2, 2009. Cited figures are marked; the original filing is the authoritative source.

Arch Capital Group Ltd. (ACGL) reported a sharply weaker 2008 as a Bermuda-domiciled specialty insurer and reinsurer.

Net income available to common shareholders fell to $265.1 million^a (diluted EPS $4.09) from $832.1 million in 2007, and return on average common equity dropped to 7.8% from 23.9%. Net premiums written declined 3.3% to $2.81 billion, and diluted book value per share fell to $51.36 from $55.12 after $513 million of buybacks and a roughly $602 million decline in shareholders' equity driven by unrealized investment losses. The decline was driven by three factors: Hurricanes Gustav and Ike (about $287 million after-tax net losses, or $4.44 per share), a $310 million favorable prior-year reserve development that partly offset the decline, and investment losses.

Net realized losses were $185 million^b, including $181 million of other-than-temporary impairments, and the equity-method bank loan funds lost $179 million. The insurance segment swung to an underwriting loss with a 101.7% combined ratio, while the reinsurance segment remained profitable at an 85.3% combined ratio.

For investors, the key positives are a conservative, high-quality portfolio (about 97% investment grade, average rating AA+), a low effective tax rate (4.4%), and a capital base that still supports a $1.5 billion^c buyback authorization, though management said it would likely not repurchase shares in the first half of 2009. The key concerns are reliance on a limited number of brokers (Marsh and Aon accounted for about 17% and 15% of gross premiums), ratings sensitivity, the cyclical nature of pricing, and the relatively short operating history that makes reserve estimates inherently uncertain.

02—Key points

Key Highlights

Net income available to common shareholders fell 68% to $265.1 million ($4.09 diluted EPS) from $832.1 million in 2007; return on average common equity was 7.8% versus 23.9%.
Hurricanes Gustav and Ike produced estimated after-tax net losses of $287.4 million ($4.44 per share), with the insurance segment's combined ratio rising to 101.7% from 91.2%.
Net realized investment losses of $185.1 million included $181.2 million of other-than-temporary impairments, and equity-method bank loan funds posted a $178.6 million loss.
Favorable prior-year reserve development of $310.2 million net ($317.7 million gross) helped offset catastrophe and investment losses; the reinsurance segment's combined ratio was 85.3%.
Diluted book value per share declined to $51.36 from $55.12, and shareholders' equity fell to $3.43 billion from $4.04 billion, reflecting buybacks and a $375 million after-tax decline in unrealized investment value.
The investment portfolio totaled $9.99 billion, with about 97% rated investment grade and an average credit rating of AA+; the 2008 pre-tax total return was negative 2.84%.
Repurchased about 7.5 million shares for $513 million in 2008 under a $1.5 billion program, with $449.8 million remaining, though management indicated no repurchases were likely in the first half of 2009.

03—One dollar

04—Financials

Financial Highlights

10-KFY2008filed March 2, 2009

Revenue$2.97B Net Income$290.97M9.8% Net Margin EPS (Diluted)$0.45 Cash & Equivalents$251.74M Free Cash Flow$1.14B

Financial Statements

Revenue	$2.97B
Interest Expense	$23.84M
Net Income	$290.97M
EPS (Basic)	$0.47
EPS (Diluted)	$0.45
Shares Outstanding (Basic)	558.91M
Shares Outstanding (Diluted)	583.10M

05—Questions

Frequently Asked Questions

Why did ACGL's earnings decline so sharply in 2008?
Earnings fell from $832.1 million to $265.1 million due to three main factors: about $287 million in after-tax losses from Hurricanes Gustav and Ike, $185 million in net realized investment losses (mainly credit-related impairments), and a $179 million loss from equity-method bank loan funds during the fall 2008 credit market turmoil. These were partially offset by $310 million of favorable prior-year reserve development and $96.6 million of net foreign exchange gains.
How large is ACGL's exposure to catastrophe losses, and how does it manage it?
The company seeks to limit its probable maximum pre-tax loss from a 1-in-250-year event in any geographic zone to about 25% of shareholders' equity. As of January 1, 2009, this was approximately $763 million. Management manages exposure through excess-of-loss reinsurance, geographic zone limits, and per-client program limits. The 2009 property catastrophe program covers 80% of the first $275 million above a $75 million retention. Management notes that modeled estimates may prove materially inaccurate.
Is ACGL's reserving adequate, and how reliable are its reserve estimates?
Net loss reserves were $5.94 billion at year-end 2008, with about 70% being IBNR. The company has developed favorably for three consecutive years, with $310 million of net favorable development in 2008. However, the company is relatively new, and the filing states that limited historical information makes estimates inherently uncertain. A simulation suggests a 90th-percentile reserve of $7.1 billion, which would imply a pre-tax charge of about $1.16 billion, so reserve risk is material.
What are the main risks to ACGL's business and ratings?
Key risks include ratings downgrades (A.M. Best 'A', Moody's 'A2', S&P 'A'), which could reduce new business and trigger collateral or termination rights under some reinsurance contracts; concentration in a few brokers (Marsh & McLennan 17.0% and Aon 15.3% of gross premiums); cyclical pricing and rising industry capacity; Bermuda tax exposure after March 28, 2016; and possible U.S. tax changes affecting Bermuda reinsurance. The Warburg Pincus funds also hold about 6.6% of voting shares and have board nomination rights.
What is ACGL's capital position and capacity for shareholder returns?
ACGL had $3.83 billion of total capital at year-end 2008, comprising $300 million of 7.35% senior notes, $100 million of revolver borrowings, $325 million of preferred shares, and $3.11 billion of common equity. Arch Re Bermuda can pay about $834 million in dividends to ACGL in 2009 without regulatory affidavit requirements. Management stated it will likely not repurchase shares in the first half of 2009 and that it may need to raise capital if conditions warrant, but acknowledged that financing may not be available on acceptable terms.

06—Continue

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