Arch Capital: Solid Underwriting Drives A Strong Q1

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Arch Capital reported solid Q1 results, with adjusted EPS beating expectations and net premiums written rising by 19.3%.The company's insurance unit saw growth in written premiums but a decrease in ...

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Monday after the bell, Arch reported solid Q1 results. Given its large reinsurance exposure, Q1 is typically relatively strong, but results should be supportive of shares in my view, I last covered Arch in November, rating shares a buy, and since then, shares have risen 7%. While a strong absolute return, this has lagged the market’s ~13.5% rally. I see ongoing upside in this well-run insurer and would remain a buyer. Seeking Alpha In the company’s first quarter, Arch earned $2.45 in adjusted EPS, beating consensus by $0.36. This was up from $1.73 last year. This growth in earnings was primarily due to ongoing business growth because its 20.7% return on equity was flat to last year’s performance. To be clear, a 20+% return on equity in the insurance industry is a strong result, due to both the favorable interest environment and strong underwriting. Net premiums written rose by 19.3% to $4.1 billion, and ACGL earned $736 million in underwriting income, up by 29%, given both higher premiums and lower loss ratios. In Q1, Arch’s headline combined ratio of 78.8% was down 1.8% from last year. As a reminder, an insurer’s combined ratio measures its cost to write policies and pay claims relative to premiums received. At 78.8%, ACGL made $21.20 on every $100 in policies in wrote. This performance included $58 million of catastrophe losses, which can be lumpy and volatile. I would note catastrophes tend to be the worst in Q3, which is peak US hurricane season with residual impact in Q4. Seasonally, Q1 should be among the stronger underwriting quarters in a given year. On top of this, insurers are constantly measuring reserves, comparing actual results to actuarial assumptions and making adjustments to reserves as needed. ACGL had favorable prior year developments of $126 million. In other words, past policies have been better and more profitable than expected, which is a good thing but not necessarily a recurring item. This was a $0.26 benefit to EPS, explaining much of the beat. Excluding cats and prior year developments, ACGL delivered an 80.8% combined ratio from 82.2% last year, a very strong underwriting result. I continue to view ACGL as a premier underwriter, and that was the case this quarter across units. Its insurance unit grew written premiums by 7% to $1.5 billion, but underwriting income fell by 25% to $86 million as its combined ratio rose to 94.1% from 90.9%. The primary headwinds was the Baltimore bridge collapse, which added 2.1%. ACGL is active in higher-margin, niche businesses like marine insurance, which are generally profitable but faced losses here. This bridge collapse is genuinely a one-time item, akin to a catastrophe, rather than a sign of deteriorating underwriting in my view. Even with this loss, ACGL’s insurance unit was profitable, speaking to the diversity of its business. One tailwind offsetting Baltimore is that Arch is charging higher premiums to cover the same risk, which makes claims relatively less expensive. This is the nature of insurance pricing. Most policies are written on a 6-12 month basis. That means when inflation spikes, it takes time for insurers to reset premium rates to reflect a higher priced environment. During the spike, insurers can face a profit squeeze as claims become more expensive, and then they regain margin as they rise prices and overall inflation normalizes. This is exactly what happened the past three years. As you can see below, inflation rose before insurance premiums, but premium inflation now exceeds overall inflation. This catch-up is helping to de-risk the business and support wider underwriting margins, a phenomenon that should persist into 2025. St. Louis Federal Reserve Next, reinsurance premiums rose 31% to $2.3 billion, and underwriting income was $379 million, up 78%. After Hurricane Ian in 2022, capital has left the sector. With fewer competitors, those who remain, like Arch, have had materially stronger pricing power. Of course, depending on hurricane season, results can be volatile. Still, Q1 was strong as its combined ratio fell by 6.9% to 77.4%. Management specifically called out the fact that higher rates are reducing the combined ratio. Cats were down 2.6% to 1.8%, but the Baltimore bridge added 3%. Given seasonal trends, Q1 should be strong in reinsurance, and it was. Finally, its smallest unit continues to drive great results. Its mortgage business grew by 6% to $305 million, with a combined ratio of 14.5% from 20%. This is entirely due to underwriting expenses, not actual losses. At the moment, this is essentially a zero-loss business because home prices are at record highs, which means even struggling homeowners can likely sell their house to pay off the mortgage. Arch only faces losses when a consumer defaults and when the house cannot be sold for its remaining mortgage value. Given the slow pace of sales, this unit has $75.2 billion risk in force, down $600 million from last year. 62% of borrowers have a FICO score above 740, and a further 33% are between 680 and 740. These are high-quality borrowers, and with unemployment 4%, I expect defaults to stay low. Additionally, 91% of the portfolio has at least a 5% equity cushion, and over 60% of the business was written in 2021 or earlier. Home prices are 12% above December 2021 levels, further enhancing equity coverage and making potential losses here quite small in my view. St. Louis Federal Reserve Beyond underwriting income, Arch also had strong investment income. It generated $327 million of net investment income from $311 million last quarter and $199 million last year. Its portfolio yields 4.14%, up 3bp sequentially and 111bp from a year ago. As it continues to invest into higher-yielding securities, net investment income should grow. Arch has $35.2 billion of investment securities, up $1.4 billion sequentially, as its continues to write new business. $25.8 billion is in fixed income and cash equivalents. This provides nearly 110% coverage of its $23.7 billion in insurance reserves. That allows the rest of the portfolio to be in return-seeking asset classes like equities and private securities. Still, fixed income is the core driver of investment income. Importantly, this is a high quality portfolio. 21% of its portfolio is US treasury or government agency with a further 18% AAA rated. Less than 6% of the portfolio is high yield. Given the risks around commercial real estate, I would note that its CMBS portfolio is just $1.2 billion or ~5% of the fixed income portfolio, a very small weighting that will make losses manageable. ACGL has $580 million of maturities this year, and $13.6 billion in years 1-5. As these securities roll off, they can be reinvested at higher yields, so long as the Fed does not significantly cut rates, which no longer appears likely. Between reinvestment and portfolio growth, I expect investment yields to rise modestly and likely peak around year-end, unless the Fed surprisingly raises rates further. Subsequent to quarter end on April 5th, Arch announced a deal to acquire Allianz’s middle market and entertainment insurance business for $450 million in cash. ACGL will also need to use $1.4 billion of capital to support the unit, which writes about $1.7 billion in policies per year. As such, I expect it to slow its organic premium growth modestly. The transaction is expected to close in the second half of the year and be funded with cash on hand. It will be modestly accretive to EPS and ROE next year and run a low-90% combined ratio. ACGL will receive $2 billion in insurance reserves as part of the transaction. All 2015 and prior liabilities remain with Allianz, reducing tail risk around losses. About 87% of this business is middle market. This purchase will grow its insurance business by about 20% and meaningfully increase segment diversity. I view this positively. Increased diversity reduces the importance of any one event or sector, which should make results even steadier over time. Additionally, this skews the business more toward insurance and away from reinsurance, reducing the impact of hurricanes on overall financial results. This should also reduce volatility and could over time help ACGL trade at a higher multiple, given lowered event risk. Arch Capital Back in November, I argue ACGL could earn $8.40, creating upside to $100. Now, hurricanes can move around full year results, but this quarter puts ACGL on path to meet or exceed my expectations. Excluding prior year adjustments, ACGL earned $2.19, or $8.76 annualized. Now assuming $200 million of hurricane-related losses and adding back Q1’s prior year again, ACGL is set to earn about $8.50, excluding any benefit from this acquisition as well as one-time integration expense.  While its business mix is diversifying, this is a slow process, and so I continue to expect some “hurricane fears” to limit multiple expansion and view ~12x at the right multiple or $102. This is just over 2x book value of $49.36, which I view as appropriate given a 20% ROE and my required rate of return of 10%. ACGL has a further 12% upside over the next year. I would continue to be a buyer and expect it to outperform the market over time with these results showing execution remains strong.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2432510786"}