Arch Capital Group Ltd. Reports 2018 Third Quarter Results

Arch Capital Group Ltd. ACGL announces its 2018 third quarter results. The results included:

• Net income available to Arch common shareholders of $217.0 million, or $0.53 per share, a 10.2% annualized return on average common equity, compared to a net loss of $52.8 million, or $0.13 per share, for the 2017 third quarter;
• After-tax operating income available to Arch common shareholders, a non-GAAP measure, of $242.3 million, or $0.59 per share, an 11.4% annualized return on average common equity, compared to a net loss of $107.1 million, or $0.26 per share, for the 2017 third quarter;
• Pre-tax current accident year catastrophic losses, net of reinsurance and reinstatement premiums⁽¹⁾, of $58.2 million, primarily related to Hurricane Florence and Typhoon Jebi;
• Favorable development in prior year loss reserves, net of related adjustments⁽¹⁾, of $77.6 million;
• Combined ratio excluding catastrophic activity and prior year development⁽¹⁾ of 81.8%;
• Book value per common share of $21.15 at September 30, 2018, a 2.3% increase in the 2018 third quarter and a 6.4% increase for the trailing twelve months;
• Share repurchases of $11.0 million.

All earnings per share amounts discussed in this release are on a diluted basis. The following table summarizes the Company's underwriting results, both (i) on a consolidated basis and (ii) on a consolidated basis excluding the ‘other' segment (i.e., results of Watford Re, as defined below):

Pursuant to GAAP, the Company consolidates the results of Watford Holdings Ltd. in its financial statements, although it only owns approximately 11% of Watford Holdings Ltd.'s common equity. Watford Holdings Ltd. is the parent of Watford Re Ltd., a multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., "Watford Re"). See ‘Comments on Regulation G' for further details.

In addition, the Company estimates that its 2018 fourth quarter results will be negatively impacted by Hurricane Michael, which occurred in October 2018, in the range of $40 million to $60 million, net of reinsurance and reinstatement premiums. This pre-tax preliminary loss estimate is based on industry insured losses ranging from $7 billion to $10 billion. The Company's preliminary estimate for Hurricane Michael is based on currently available information derived from modeling techniques, industry assessments of exposure, preliminary claims information obtained from the Company's clients and brokers to date and a review of in-force contracts. The Company's actual losses from this event may vary materially from the estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the preliminary nature of available information, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques, the contingent nature of business interruption exposures, the effects of any resultant demand surge on claims activity and attendant coverage issues. In addition, actual losses may increase if the Company's reinsurers fail to meet their obligations to the Company or the reinsurance protections purchased by the Company are exhausted or are otherwise unavailable.

The following table summarizes the Company's consolidated financial data, including a reconciliation of net income or loss available to Arch common shareholders to after-tax operating income or loss available to Arch common shareholders and related diluted per share results:

Each line item in the table above reflects the impact of the Company's approximate 11% ownership of Watford Re's common equity. See ‘Comments on Regulation G' for a discussion of non-GAAP financial measures.

Segment Information

The following section provides analysis on the Company's 2018 third quarter performance by operating segment. For additional details regarding the Company's operating segments, please refer to the Company's Financial Supplement dated September 30, 2018. The Company's segment information includes the use of underwriting income (loss) and a combined ratio excluding catastrophic activity (if applicable for the segment) and prior year development. Such items are non-GAAP financial measures (see ‘Comments on Regulation G' for further details).

Gross premiums written by the insurance segment in the 2018 third quarter were 6.3% higher than in the 2017 third quarter while net premiums written were 2.1% higher than in the 2017 third quarter. The increase in net premiums written reflected growth in travel insurance, due to both new business and growth in existing accounts, and in property, primarily due to new business and rate increases. Net premiums earned by the insurance segment in the 2018 third quarter were 4.8% higher than in the 2017 third quarter, and reflect changes in net premiums written over the previous five quarters.

The 2018 third quarter loss ratio reflected 5.8 points for current year catastrophic activity, primarily related to Hurricane Florence, compared to 40.1 points in the 2017 third quarter, primarily related to Hurricanes Harvey, Irma and Maria. Estimated net favorable development in prior year loss reserves, before related adjustments, reduced the loss ratio by 1.1 points in the 2018 third quarter, compared to 0.6 points in the 2017 third quarter. The balance of the change in the 2018 third quarter loss ratio resulted, in part, from a higher level of large attritional losses.

The underwriting expense ratio was 31.8% in the 2018 third quarter, compared to 32.4% in the 2017 third quarter, reflecting changes in the mix and type of business.

Gross premiums written by the reinsurance segment in the 2018 third quarter were 3.2% higher than in the 2017 third quarter, while net premiums written were 1.6% lower than in the 2017 third quarter. The lower change in net premiums written primarily reflects an increase in retrocessions on other specialty and casualty lines. Net premiums written for the 2018 third quarter reflected declines in property catastrophe and casualty lines, partially offset by growth in property excluding property catastrophe business, primarily due to new accounts. The reduction in property catastrophe net premiums written primarily related to a lower level of reinstatement premiums, as the 2017 third quarter included $15.8 million related to Hurricanes Harvey, Irma and Maria. The decline in casualty net premiums written was mostly due to the one-time impact of a retroactive reinsurance contract of $45.4 million recorded in the 2017 third quarter, which was substantially earned in that period with a corresponding increase in losses and loss adjustment expenses. A portion of the premium reduction in this line was offset by new business opportunities in the 2018 third quarter. Net premiums earned reflect the retroactive reinsurance contract and reinstatement premium impacts discussed above, as well as changes in net premiums written over the previous five quarters.

The 2018 third quarter loss ratio included 9.5 points of current year catastrophic activity, primarily related to Hurricane Florence and Typhoon Jebi, compared to 46.3 points of catastrophic activity in the 2017 third quarter, primarily related to Hurricanes Harvey, Irma and Maria. Estimated net favorable development in prior year loss reserves, before related adjustments, reduced the loss ratio by 11.7 points in the 2018 third quarter, compared to 11.3 points in the 2017 third quarter. The estimated net favorable development in the 2018 third quarter primarily resulted from better than expected claims emergence in short-tail business from more recent underwriting years and in longer-tail business across earlier underwriting years.

The underwriting expense ratio was 27.4% in the 2018 third quarter, compared to 28.9% in the 2017 third quarter, reflecting the non-renewal of certain reinsurance agreements between the Company's U.S.-based insurance and reinsurance subsidiaries and Arch Reinsurance Ltd. as of January 1, 2018, which reduced federal excise taxes incurred by $2.3 million, or 0.8 points, and changes in the mix and type of business.

Gross premiums written by the mortgage segment in the 2018 third quarter were 0.7% higher than in the 2017 third quarter, while net premiums written were 1.1% higher than in the 2017 third quarter. The growth in gross premiums written primarily reflected an increase in U.S. monthly premium business and government sponsored enterprise ("GSE") credit-risk sharing transactions, partially offset by a lower level of U.S. single premium business and a decrease in Australian mortgage reinsurance business. Net premiums written for the 2018 third quarter reflected a higher level of ceded premiums related to the new Bellemeade transaction in the 2018 third quarter, while the 2017 third quarter reflected higher retrocessions of Australian mortgage reinsurance business. The increase in net premiums earned for the 2018 third quarter primarily reflected the growth in insurance in force in the U.S. over the last twelve months. Insurance in force increased to $372.8 billion at September 30, 2018, compared to $346.2 billion at September 30, 2017.

Arch MI U.S. generated $21.4 billion of new insurance written ("NIW") in the 2018 third quarter, compared to $17.7 billion in the 2017 third quarter, as a higher level of purchase market activity more than offset a reduction in single premium business. Monthly premium policies contributed 92.6% of NIW in the 2018 third quarter, compared to 87.0% in the 2017 third quarter.

The loss ratio for the 2018 third quarter reflected 2.8 points of favorable current year development on delinquencies from the first half of 2018 which cured in the period, and estimated net favorable development in prior year loss reserves, before related adjustments, of 12.8 points, compared to 7.8 points in the 2017 third quarter. The estimated net favorable development in the 2018 third quarter was primarily driven by lower than expected claim rates on first lien business and subrogation activity on second lien business. The percentage of loans in default on first lien business decreased to 1.60% at September 30, 2018, from 1.70% at June 30, 2018.

The mortgage segment's underwriting expense ratio was 21.4% in the 2018 third quarter, compared to 20.6% in the 2017 third quarter, reflecting a higher level of acquisition expenses due to higher NIW and a lower level of other operating expenses.

At September 30, 2018, the mortgage segment's risk-in-force (before reinsurance) of $75.5 billion consisted of $69.8 billion from Arch MI U.S. with the remainder from reinsurance and credit-risk sharing operations. For additional information on the mortgage segment, please refer to the Company's Financial Supplement dated September 30, 2018.

Corporate and Non-Underwriting

Corporate and non-underwriting results include net investment income, other income (loss), corporate expenses, transaction costs and other, amortization of intangible assets, interest expense, items related to the Company's non-cumulative preferred shares, 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, net foreign exchange gains or losses and income taxes. Such amounts exclude the results of the ‘other' segment.

Pre-tax net investment income for the 2018 third quarter was $0.28 per share, or $114.3 million, compared to $0.23 per share, or $94.1 million, for the 2017 third quarter. The 2018 third quarter net investment income reflected the reinvestment of fixed income securities at higher available yields and a shift from municipal bonds to corporates. The annualized pre-tax investment income yield was 2.45% for the 2018 third quarter, compared to 2.00% for the 2017 third quarter.

Amortization of intangible assets for the 2018 third quarter was $26.3 million, compared to $31.8 million for the 2017 third quarter. Amounts in both periods primarily related to amortization of finite-lived intangible assets related to the UGC acquisition, as disclosed in the Company's Form 10-K.

Interest expense for the 2018 third quarter was $24.7 million, compared to $26.3 million for the 2017 third quarter, reflecting the lower revolving credit agreement borrowings outstanding partially offset by higher borrowing costs. Preferred dividends for the 2018 third quarter were $10.4 million, compared to $12.4 million for the 2017 third quarter.

On a pre-tax basis, net foreign exchange gains for the 2018 third quarter were $7.1 million, compared to net foreign exchange losses for the 2017 third quarter of $27.8 million. For both periods, such amounts were primarily unrealized and resulted from the effects of revaluing the Company's net insurance liabilities required to be settled in foreign currencies at each balance sheet date. Changes in the value of available-for-sale investments held in foreign currencies due to foreign currency rate movements are reflected as a direct increase or decrease to shareholders' equity and are not included in the consolidated statements of income. Although the Company generally attempts to match the currency of its projected liabilities with investments in the same currencies, the Company may elect to over or underweight one or more currencies from time to time, which could increase the Company's exposure to foreign currency fluctuations and increase the volatility of the Company's shareholders' equity.

The Company's effective tax rate on income before income taxes (based on the Company's annual effective tax rate) was 12.8% for the 2018 third quarter, while the effective tax rate on pre-tax operating income available to Arch common shareholders was 11.8% for the 2018 third quarter. The effective tax rates for the 2018 third quarter included a discrete income tax expense of $5.6 million which had the effect of increasing the 2018 third quarter effective tax rate on operating income available to Arch common shareholders by 1.9%. The discrete tax item in the 2018 third quarter primarily relates to the Company's change in judgment regarding the realizability of certain deferred tax assets, partially offset by tax benefits associated with share-based compensation. The Company's effective tax rate fluctuates from period to period based upon the relative mix of income or loss reported by jurisdiction, the level of catastrophic loss activity incurred, and the varying tax rates in each jurisdiction. The Company currently expects that its annual effective tax rate on pre-tax operating income available to Arch common shareholders for the year ended December 31, 2018 will be in the range of 9% to 12%.

Conference Call

The Company will hold a conference call for investors and analysts at 11:00 a.m. Eastern Time on October 31, 2018. A live webcast of this call will be available via the Investors section of the Company's website at http://www.archcapgroup.com. A telephone replay of the conference call also will be available beginning on October 31, 2018 at 2:00 p.m. Eastern Time until November 7, 2018 at midnight Eastern Time. To access the replay, domestic callers should dial 855-859-2056, and international callers should dial 404-537-3406 (passcode 4079781 for all callers).

Please refer to the Company's Financial Supplement dated September 30, 2018, which is available via the Investors section of the Company's website at http://www.archcapgroup.com. The Financial Supplement provides additional detail regarding the financial performance of the Company. From time to time, the Company posts additional financial information and presentations to its website, including information with respect to its subsidiaries. Investors and other recipients of this information are encouraged to check the Company's website regularly for additional information regarding the Company.

Arch Capital Group Ltd., a Bermuda-based company with approximately $11.21 billion in capital at September 30, 2018, provides insurance, reinsurance and mortgage insurance on a worldwide basis through its wholly owned subsidiaries.

Comments on Regulation G

Throughout this release, the Company presents its operations in the way it believes will be the most meaningful and useful to investors, analysts, rating agencies and others who use the Company's financial information in evaluating the performance of the Company and that investors and such other persons benefit from having a consistent basis for comparison between quarters and for comparison with other companies within the industry. These measures may not, however, be comparable to similarly titled measures used by companies outside of the insurance industry. Investors are cautioned not to place undue reliance on these non-GAAP financial measures in assessing the Company's overall financial performance.

This presentation includes the use of "after-tax operating income or loss available to Arch common shareholders," which is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, transaction costs and other and loss on redemption of preferred shares, net of income taxes, and the use of annualized operating return on average common equity. The presentation of after-tax operating income available to Arch common shareholders and annualized operating return on average common equity are non-GAAP financial measures as defined in Regulation G. The reconciliation of such measures to net income available to Arch common shareholders and annualized return on average common equity (the most directly comparable GAAP financial measures) in accordance with Regulation G is included on the following page of this release.

The Company believes that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, transaction costs and other and loss on redemption of preferred shares in any particular period are not indicative of the performance of, or trends in, the Company's business performance. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of the Company's operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of the Company's financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on the Company's investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of the Company's investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on the Company's proportionate share of the net income or loss of the funds (which include changes in the fair value of the underlying securities in the funds). This method of accounting is different from the way the Company accounts for its other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. transaction costs and other include advisory, financing, legal, severance, incentive compensation and other costs related to acquisitions. The Company believes that transaction costs and other, due to their non-recurring nature, are not indicative of the performance of, or trends in, the Company's business performance. The loss on redemption of preferred shares related to the redemption of the Company's Series C preferred shares in January 2018 and had no impact on shareholders' equity or cash flows. Due to these reasons, the Company excludes net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, transaction costs and other and loss on redemption of preferred shares from the calculation of after-tax operating income or loss available to Arch common shareholders.

The Company believes that showing net income available to Arch common shareholders exclusive of the items referred to above reflects the underlying fundamentals of the Company's business since the Company evaluates the performance of and manages its business to produce an underwriting profit. In addition to presenting net income available to Arch common shareholders, the Company believes that this presentation enables investors and other users of the Company's financial information to analyze the Company's performance in a manner similar to how the Company's management analyzes performance. The Company also believes that this measure follows industry practice and, therefore, allows the users of the Company's financial information to compare the Company's performance with its industry peer group. The Company believes that the equity analysts and certain rating agencies which follow the Company and the insurance industry as a whole generally exclude these items from their analyses for the same reasons.

The Company's segment information includes the presentation of consolidated underwriting income or loss and a subtotal of underwriting income or loss before the contribution from the ‘other' segment. Such measures represent the pre-tax profitability of its underwriting operations and include net premiums earned plus other underwriting income, less losses and loss adjustment expenses, acquisition expenses and other operating expenses. Other operating expenses include those operating expenses that are incremental and/or directly attributable to the Company's individual underwriting operations. Underwriting income or loss does not incorporate items included in the Company's corporate (non-underwriting) segment. While these measures are presented in the Segment Information footnote to the Company's Consolidated Financial Statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis. The reconciliations of underwriting income or loss to income before income taxes (the most directly comparable GAAP financial measure) on a consolidated basis and a subtotal before the contribution from the ‘other' segment, in accordance with Regulation G, is shown on the following pages.

Management measures segment performance for its three underwriting segments based on underwriting income or loss. The Company does not manage its assets by underwriting segment and, accordingly, investment income and other non-underwriting related items are not allocated to each underwriting segment. As noted earlier, the ‘other' segment includes the results of Watford Re. Watford Re has its own management and board of directors that is responsible for the overall profitability of the ‘other' segment. For the ‘other' segment, performance is measured based on net income or loss. The Company does not guarantee or provide credit support for Watford Re, and the Company's financial exposure to Watford Re is limited to its investment in Watford Re's common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.

Along with consolidated underwriting income, the Company provides a subtotal of underwriting income or loss before the contribution from the ‘other' segment and believes that this presentation enables investors and other users of the Company's financial information to analyze the Company's underwriting performance in a manner similar to how the Company's management analyzes performance.

In addition, the Company's segment information includes the use of a combined ratio excluding catastrophic activity (if applicable for the segment) and prior year development. These ratios are non-GAAP financial measures as defined in Regulation G. The reconciliation of such measures to the combined ratio (the most directly comparable GAAP financial measure) in accordance with Regulation G are shown on the individual segment pages. The Company's management utilizes the adjusted combined ratio excluding current accident year catastrophic events and favorable or adverse development in prior year loss reserves in its analysis of the underwriting performance of each of its underwriting segments.

The following tables summarize the Company's results by segment for the 2018 third quarter and 2017 third quarter and a reconciliation of underwriting income or loss to income or loss before income taxes and net income or loss available to Arch common shareholders:

Cautionary Note Regarding Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 ("PSLRA") provides a "safe harbor" for forward-looking statements. This release or any other written or oral statements made by or on behalf of the Company may include forward-looking statements, which reflect the Company's current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this release are forward-looking statements. Forward-looking statements, for purposes of the PSLRA or otherwise, can generally be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" and similar statements of a future or forward-looking nature or their negative or variations or similar terminology.

Forward-looking statements involve the Company's current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this release and in the Company's periodic reports filed with the Securities and Exchange Commission (the "SEC"), and include:

• the Company's ability to successfully implement its business strategy during "soft" as well as "hard" markets;
• acceptance of the Company's business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and its insureds and reinsureds;
• the integration of any businesses the Company has acquired or may acquire into its existing operations;
• the Company's ability to maintain or improve its ratings, which may be affected by its ability to raise additional equity or debt financings, by ratings agencies' existing or new policies and practices, as well as other factors described herein;
• general economic and market conditions (including inflation, interest rates, foreign currency exchange rates, prevailing credit terms and the depth and duration of a recession) and conditions specific to the reinsurance and insurance markets (including the length and magnitude of the current "soft" market) in which the Company operates;
• competition, including increased competition, on the basis of pricing, capacity (including alternative sources of capital), coverage terms or other factors;
• developments in the world's financial and capital markets and the Company's access to such markets;
• the Company's ability to successfully enhance, integrate and maintain operating procedures (including information technology) to effectively support its current and new business;
• the loss of key personnel;
• accuracy of those estimates and judgments utilized in the preparation of the Company's financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation, and any determination to use the deposit method of accounting, which for a relatively new insurance and reinsurance company, like the Company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to the Company through September 30, 2018;
• greater than expected loss ratios on business written by the Company and adverse development on claim and/or claim expense liabilities related to business written by its insurance and reinsurance subsidiaries;
• severity and/or frequency of losses;
• claims resulting from natural or man-made catastrophic events in the Company's insurance, reinsurance and mortgage businesses could cause large losses and substantial volatility in our results of operations;
• acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;
• availability to the Company of reinsurance to manage its gross and net exposures and the cost of such reinsurance;
• the failure of reinsurers, managing general agents, third party administrators or others to meet their obligations to the Company;
• the timing of loss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by the Company;
• the Company's investment performance, including legislative or regulatory developments that may adversely affect the fair value of the Company's investments;
• changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, which could affect the Company's business, financial condition and results of operations;
• the volatility of the Company's shareholders' equity from foreign currency fluctuations, which could increase due to us not matching portions of the Company's projected liabilities in foreign currencies with investments in the same currencies;
• changes in accounting principles or policies or in the Company's application of such accounting principles or policies;
• changes in the political environment of certain countries in which the Company operates, underwrites business or invests;
• statutory or regulatory developments, including as to tax policy matters and insurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers and/or changes in regulations or tax laws applicable to the Company, its subsidiaries, brokers or customers, including the Tax Cuts and Jobs Act of 2017; and
• the other matters set forth under Item 1A "Risk Factors", Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other sections of the Company's Annual Report on Form 10-K, as well as the other factors set forth in the Company's other documents on file with the SEC, and management's response to any of the aforementioned factors.

All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

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