Arch Capital Group Ltd. 2015 Annual Report
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Arch Capital Group Ltd. 2015 Annual Report ARCH CAPITAL GROUP LTD . 2015 ANNUAL REPORT Amounts in millions, except percentages and per share amounts 2015 2014 Change Book value per common share at year-end $ 47.95 $ 45.58 5.2% After-tax operating income* $ 565.2 $ 617.3 (8.4)% Per share $ 4.48 $ 4.58 (2.2)% Operating return on average common equity 9.7% 11.1% Net income available to common shareholders $ 515.8 $ 812.4 (36.5)% Per share $ 4.09 $ 6.02 (32.1)% Net income return on average common equity 8.8% 14.6% Combined ratio 88.0% 86.8% Gross premiums written $4,656.7 $4,760.4 (2.2)% Net premiums written $3,351.6 $3,617.5 (7.4)% Net investment income $ 271.7 $ 284.3 (4.5)% Per share $ 2.16 $ 2.11 2.4% Weighted average common shares and common share equivalents outstanding 126.0 134.9 (6.6)% Table excludes amounts related to the “other” segment. All per share amounts are on a diluted basis. To Our Shareholders: Arch navigated a complex market environment in which each of our three business segments encountered its own distinct conditions in 2015. Our reinsurance segment faced the strong headwinds of industry overcapacity and weak pricing. By contrast, our mortgage segment enjoyed strong tailwinds as we continued to build this relatively new division of the Company. Market conditions for insurance, our third and largest segment, were in between: the prevailing winds were mostly calm, although some product lines came under pricing pressure in the second half of the year. Overall, the year was challenging, not only because of price softness in some areas of our risk taking activities, but also due to investment market volatility and a low yield environment, which affected our investment results. As shown in the table above, operating income, net income and return on equity all declined in 2015. Arch was built with a deep commitment to underwriting discipline in all phases of the insurance and reinsurance cycle. We focus on generating adequate risk-adjusted returns on capital, not on maximizing premiums written. This discipline served us well in 2015 as we wrote less business in some segments rather than chase after risks that were inadequately priced. Net premiums written were $3.35 billion in 2015, down 7.4% from 2014. We also benefited from our diversification across three market segments, as well as within each segment, which gave us the flexibility to increase our writings in those areas offering the best potential returns and reduce our writings where pricing was weaker. Among our three segments, insurance accounted for 61% of net premiums written in 2015, up from 59% in 2014; reinsurance accounted for 31%, down from 35% in 2014; and mortgage insurance and reinsurance accounted for 8%, up from 6%. * After-tax operating income, which is a non-GAAP measure of financial performance, is defined as net income available to common shareholders, excluding net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. The reconciliation to net income available to Arch common shareholders and definition of after-tax operating income can be found in the Company’s Annual Report on Form 10-K, filed with the SEC on February 26, 2016, under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” A copy of the Form 10-K is available on the Company’s web site and accompanies this letter. Equally important, we ceded more of our business to reinsurers, in part due to opportunities to purchase reinsurance economically in the current market environment. Companywide, we ceded 28% of gross premiums written in 2015 compared with 24% in 2014 and 20% in 2013. We evaluate the Company’s performance by several yardsticks, including book value per share, as growth in this metric creates long-term value for shareholders. We had a satisfactory year in that regard. Book value per share gained 5.2% in 2015 to $47.95 at year-end and has now grown at an average annual rate of 15.6% over the past decade. We also emphasize return on equity (ROE), a key driver of book value growth. Operating ROE was 9.7% in 2015, down from 11.1% in 2014, reflecting the impact of more difficult market conditions. Our operating ROE has averaged 14.4% per year over the past decade, certainly a strong performance. Operating ROE measures the Company’s returns after excluding non-operating items such as investment gains and losses and foreign exchange gains and losses. Our ROE based on net income, which includes realized gains and losses and foreign exchange gains and losses, was 8.8% in 2015, down from 14.6% in 2014, and has averaged 15.9% over the past decade. Although operating ROE generally reflects a more stable stream of earnings in the short term, we believe net income ROE contributes more directly to value creation over time. We maintain a longer-term ROE target of 15% over the insurance and reinsurance cycle. Our reported ROE does not reflect the full extent of the profitability of the mortgage business we have written to date, due to the accounting model which requires us to record revenues and profits for mortgage insurance policies over the period of coverage. We believe that the mortgage business written in 2015 will exceed our 15% ROE target as the embedded value in that business is recognized over time. All financial results in this letter exclude amounts related to the “other” segment,i.e., Watford Re, in which the Company owns an approximately 11% equity interest. In accordance with U.S. generally accepted accounting principles (GAAP), the results of Watford are included in the Company’s consolidated financial statements. The results for the “other” segment can be found on page 97 of the Company’s Form 10-K for 2015. Underwriting and Investment Results After-tax operating income available to common shareholders—which consists principally of reported underwriting income and net investment income—was $565.2 million, or $4.48 per share, in 2015, decreasing 2.2% from 2014 on a per-share basis. Net income available to common shareholders was $515.8 million, or $4.09 per share, in 2015, down 32.1% per share. The larger decline in net income was due primarily to the inclusion of net realized gains and losses as well as foreign exchange gains and losses. Our reported underwriting profits remained strong, aided by good risk selection, a low level of catastrophe losses and favorable reserve development. Underwriting income was $433.2 million in 2015, down 8.6% from 2014. Our GAAP combined ratio, a measure of underwriting profitability, was 88.0% in 2015, compared to 86.8% in 2014. A lower ratio indicates higher underwriting margins. Our underwriting margins were excellent in relation to the industry; the average combined ratio for property/casualty companies was about 98% in 2015, according to A.M. Best Company. Our combined ratio consisted of a loss ratio of 53.2% in 2015, compared to 53.0% in 2014, and an underwriting expense ratio of 34.8% in 2015, compared to 33.8% in 2014. The upturn in the expense ratio was driven by the growth in earned premiums of our U.S. mortgage operation, which is operating at a higher expense ratio until business hits a steady state, as well as the impact of spreading expenses over smaller premium volumes in 2015. The expense ratio for the U.S. mortgage operations is not representative of the normalized run rate since we expect the ratio to decrease over time as those operations develop. Our total net losses from catastrophic events were $55.2 million in 2015, the lowest since 2009. This compared with $56.1 million in 2014, another year of low cat losses. Net favorable reserve development was $272.3 million in 2015 and $306.6 million in 2014, as earlier-year reserves proved more than adequate, allowing the release of a portion of these reserves to 2015 and 2014 earnings. We have now had favorable reserve development for 13 consecutive years, reflecting 2 our prudent reserving policies as well as better-than-expected claims trends experienced across the industry over the past decade. There is no guarantee, however, that favorable reserve development will continue into the future. On the investment side, our portfolio generated $271.7 million of net investment income, or $2.16 per share, in 2015, a 2.4% increase from 2014 on a per-share basis. The portfolio’s pre-tax investment income yield was 2.06% in 2015 and 2.08% in 2014, reflecting the low yields available in today’s fixed income market. We continue to own a high quality, liquid portfolio aimed at preserving capital and minimizing investment risk. Cash flow from operations was $705.1 million in 2015, down 29.3% from 2014. The sharp decrease was caused by several factors, including reduced premium inflows due to lower underwriting volumes and the timing and the payment of increased reinsurance cessions, including premiums paid to Watford Re. Emphasis on Total Investment Return Total investable assets managed by the Company were $14.64 billion at the end of 2015, compared to a similar level of $14.60 billion a year earlier, reflecting share buyback activity and changes in market values. The year was a difficult one for investors due to market volatility and a lack of meaningful returns in any of four major asset classes: stocks, bonds, commodities and cash equivalents.