arch capital group ltd. (acgl) april 20, 2015tippie.biz.uiowa.edu/henry/reports15/acgl_sp15.pdf ·...

Important disclosures appear on the last page of this report.

The Henry Fund

Henry B. Tippie School of Management

Stuart Hemesath [[email protected]]

Arch Capital Group Ltd. (ACGL) April 20, 2015

Financial Services – P&C Insurance Stock Rating No Action

Investment Thesis Target Price $60 - $72 Arch Capital has had a solid start to the year, up 6.5% year-to-date and outperforming analyst EPS expectations for four consecutive quarters by an average of 12.7%. This recent performance, however, has placed a premium value on its stock price leading to a stock that we believe is fairly valued. Drivers of Thesis

A rising interest rate environment beginning in late 2015/early 2016 will provide an overdue growth catalyst for investment income revenues within the insurance industry

Arch Capital has recently expanded its mortgage insurance operations into the US through acquisitions which will grow its mortgage insurance operations by 10.5% and 8.5%, respectively, over the next two years.

The company has several layers of diversification through its business units, niche product offerings within those business units, and geographic diversification through its global presence minimizing operational risk.

Risks to Thesis

With its recent performance history, the company trades at premium multiples compared to its peers. With a forward P/E of 15.34 and a price-to-book ratio of 1.35 (peer averages 11.52 and 0.97, respectively), the company could be overvalued.

Rates rising to a forecasted 3.3% over the next two years will devalue the company’s fixed income portfolio by 10% in 2016, hampering short-term investment income performance

As an insurer, Arch Capital faces catastrophe risks which have risen in recent years as well as economic risks tied to compressed interest rates.

The market cycle is shifting toward a soft market, pressuring future growth rates on renewed premiums and loosening underwriting standards.

Henry Fund DCF $71.60 Henry Fund DDM $65.37 Relative Multiple $45.67 Price Data Current Price $62.04 52wk Range $52.51 – 63.01 Consensus 1yr Target $64.00 Key Statistics Market Cap (B) $7.78 Shares Outstanding (M) 125.40 Institutional Ownership 81.80% Five Year Beta .485 Dividend Yield N/A Est. 5yr Growth 2.02% Price/Earnings (TTM) 10.26 Price/Earnings (FY1) 15.34 Price/Sales (TTM) 1.95 Price/Book (mrq) 1.34 Profitability Operating Margin 20.13% Profit Margin 20.94% Return on Assets (TTM) 2.41% Return on Equity (TTM) 12.87%

Data Sources: Yahoo Finance & FactSet2,3

Earnings Estimates Year 2012 2013 2014 2015E 2016E 2017E

EPS $4.17 $5.15 $6.38 $4.10 $3.91 $3.58

growth 36.38% 23.48% 23.97% -35.68% -4.76% -8.27%

12 Month Performance Company Description

Arch Capital is a Bermuda based insurance company providing property and casualty, reinsurance, and mortgage insurance services. The company targets niche specialty markets in its property and casualty and reinsurance business units and recently expanded its mortgage insurance operations within the US. Arch Capital holds a global presence operating in the US, Europe and Asia.

10.3

12.9

8.7

11.8

9.3 9.6

15.2

9.1

16.0

0

5

10

15

20

P/E ROE EV/EBITDA

ACGL Industry Sector

-10%

-5%

0%

5%

10%

15%

A M J J A S O N D J F M

ACGL S&P 500

Data Source: Yahoo Finance

EXECUTIVE SUMMARY

Our recommendation for Arch Capital Group is to take no action. While the company has shown strength through its recent performance, outperforming analyst’s earnings per share expectations by an average of 12.5% over the past four quarterly earnings announcement, we believe its current trading price is fairly valued. This continued financial strength and outperformance has led to its stock trading at premiums in both its forward P/E and price-to-book multiples in comparison to its peers and is also just below its 52 week high.

Our valuation models price the company as high as $71.60, 13.8% above its trading price, and as low as $45.67 using a blend of relative P/E and price-to-book multiples. We do believe the company has strong growth catalysts and would reconsider the investment decision if the price were to provide an expected level of return above our safety margin of 15%.

COMPANY DESCRIPTION

Arch Capital Group Ltd., a multi-segmented insurance company founded in 1995 in Pembroke, Bermuda, operates its business through three major insurance segments: specialty property and casualty insurance, reinsurance, and private mortgage insurance. As an insurance company, it also receives a significant portion of its revenues through investment income, 8.69% in 2014.

Data Source: Arch Capital Group Ltd. 2014 10-K1

As a financial institution, Arch Capital was able to weather the 2008 financial crisis without reporting an annual loss and significantly outperformed both the financial sector and the broader market, primarily due to its lack of exposure to the US mortgage insurance market at that time. The company has relied on its core specialty property and casualty insurance and reinsurance businesses until recently when it more than doubled its mortgage insurance business through a series of acquisitions. While reinsurance accounted for 44% of the company’s net income in 2014, it must be noted that reinsurance industry goes through profitability cycles. A reinsurer must have a series of profitable years to offset a year of significant losses following a major catastrophe.

Gross Income

by Source

Net Income

by Source

Insurance 2,146.7 54.19% 107.1 13.79%

Reinsurance 1,266.0 31.96% 340.6 43.85%

Mortgage Insurance 204.8 5.17% 26.4 3.40%

Investment Income 344.2 8.69% 302.6 38.95%

Totals 3,961.7 100.00% 776.8 100.00%


Insurance

Property & Casualty

Property and casualty (P&C) insurance policies cover an array of consumer and commercial product needs from home and auto on the consumer side to workers’ compensation, business liability coverage, and a wide range of other demands on the commercial side. Recently, stricter underwriting standards and higher premiums have driven capital growth. Growth rates on premium rates have steadily risen since 2011 which could be described as a hard cycle in the insurance markets. Hard cycles often arise following a major catastrophe loss. As insurers go through a period of increased profitability, the market begins to adjust with increased competition leading back into a soft market cycle. It could alternatively be viewed as an improving pricing environment as the cost and frequency of events have risen so the premium growth is simply to cover loss expenses. Either way, it appears more likely that we will be seeing a softening of the cycle in the near future before we see signs of additional hardening.

Looking at commercial lines, data suggests that we have been slowly easing into a softening cycle which peaked in 2013.

Commercial Lines Rate Movements (Industry)

Source: Market Realist

Specialty Property & Casualty

Arch Capital finds its competitive advantage within the specialty P&C space which accounted for 55.4% of its premiums in 2014.1 Areas of coverage within the specialty group include energy risks, construction, several categories within marine and aviation, travel, and collateralized lending products, among others. This business requires a significant amount of industry experience within each sector to truly understand the underlying risks associated with each product. Along with that experience, the company feels they are able to capitalize on more profitable underwriting opportunities in the specialty P&C subdivision.

Segment Overview

With many P&C insurers, we have seen significant improvements in profit margins within the industry as companies focus on expenses and cost structures in a time when investment income margins are thin. With that in place, growth will need to come from the top line, premiums and investment income revenues. Rates on consumer lines within the industry rose 2% in February 2015, year-over-year, following a roughly 1% increase in January of this year.8 Arch Capital saw premium revenue growth rates of 6.8% and 10.1% in 2013 and 2014, respectively. This accounted for the bulk of their total revenues, 54.2% in 2014, but only netted 13.8% of its net

income due to the competitiveness and tight margins within the industry. Given the risks of a softening market, we conservatively forecasted a growth rate of 3% through 2018 before easing to a continuous rate of 2.5% beyond 2018.

Reinsurance

Reinsurance is the insurance coverage that insurance companies obtain as a measure of risk management. In some cases these policies can be used to smooth losses year to year or, in other cases, used to avoid or mitigate severe, potentially company ending, catastrophe losses. An increasing frequency of natural disasters and volatile financial markets have posed a threat to the risk management practices within the industry within recent years. This has caused reinsurers to maintain stronger underwriting principals and increase capital levels, which is reliant on strong investment income to cover losses.

As an industry, revenues, including both premiums and investment income, have risen 4.5% over the past five years going into 2014. Early industry growth estimates in 2014 were as high as 12.6%, driven by higher demand from primary insurance markets and a rise in interest rates, but the latter driver did not see to fruition as the 10-year treasury note fell an additional 27.3% from its early January peak.5 Arch Capital’s reinsurance premium growth fell 3.5% over the year. In the insurance cycle, markets last hardened in 2011, allowing premiums to increase, but we could be seeing markets soften again in 2015.8

Reinsurance policies came widely from property and casualty and life and health insurers in 2014, accounting for nearly 75% of the demand.5

Source: IBISWorld5

Arch Capital’s reinsurance group accounted for 32% of its revenues and 43.9% of its net revenue in 2014 making reinsurance its most profitable business unit.1 As mentioned earlier, this business unit faces significant volatility year to year based on the frequency of catastrophic events. Reserves must be built in years without catastrophic events to cover the losses of years that do. Like its specialty property and casualty business, Arch Capital specializes in niche reinsurance opportunities outside of what it deems “commoditized classes of coverage” in standard property and casualty reinsurances that it finds more profitable. While it still reinsurers P&C policies, one specialized area includes, among other areas, marine and aviation in an array of capacities. Revenues are expected to grow at a rate of 3% over the next five years within the industry but a rate increase in 2015 or 2016 would be a significant driver within those years. We see growth rates remaining relatively low in 2015 at 3% for Arch Capital before increasing to 8% in 2016, seeing a late but needed rise in interest rates, before returning to normal levels and an eventual continuous rate of 2.5%. Better underwriting disciplines and higher returns on investment income will also bolster profit margins in this space.

Mortgage Insurance

The mortgage insurance industry, which offers private mortgage insurance, or PMI, on consumer mortgages faced substantially difficult times for several years following the beginning of the housing crisis in late 2008. In the aftermath, insurers still offering PMI were difficult to come across leading to many of the major players filing bankruptcy. Mortgage insurance is required on mortgages originations and refinances when the homeowner has less than 20% equity in the home’s value.

The Federal Housing Administration (FHA) was forced to play a larger role in this market and, as a result, FHA program volumes surged 355% from 2007 to 2009 despite significant increases in upfront fees and rates. The PMI rates and fees for an FHA loan have nearly doubled since 2008. Fees associated with FHA loans have increased from $9210 to $17,398 in 2014 in the first five years on an average home value of $212,000. Using PMI, home owners without 20% equity are able to save $2,000 to $12,000 in the first five years of the loan based on the same average home value. Additionally, FHA fees are continuously charged throughout the remainder of the loan whereas PMI is removed by the lender once the loan-to-value (LTV)

reaches 78%. While these increased fees have improved profits for private insurers, we believe the risks previously associated with mortgage insurance were underestimated in retrospect.

Source: National Mortage News7

Arch Capital made significant moves in 2014 to grow its PMI business through inorganic or acquisition growth, specifically to enter the domestic markets, which we will expand on later. Premium revenues grew from $89.6 million in 2013 to $204.8 million, more than doubling revenues year-over-year. Two of the largest surviving players before the housing crisis, AIG and Genworth Financial, still have yet to fully recover from their insurance losses. AIG, which no longer offers mortgage insurance, was facing certain bankruptcy before it received its $182 billion government bailout in 2008. Arch Capital provided 2.3% of the PMI policies in the first quarter of 2014. This data was immediately following its acquisitions. With these recent domestic additions, we believe this business unit provides the largest area of growth and have its revenues growing an additional 10.5% and 8.5% in 2015 and 2016, respectively, as it begins to compete within the industry before tapering off to more modest rates and a continuous level of 3.5%.

Investment Income

The investment portfolio of Arch Capital, like all major insurers, is dominated by fixed maturity securities. At year-end 2014, the company’s fixed maturities, accounting for 76.5% for total investable assets, had an average credit rating of AA (S&P) with 94.4% of its securities above investment grade, a slight increase from 92.6% in 2013, and a duration of 3.34 years, up from 2.62 a year prior in 2013. An increased duration has been a trend within the

industry as we see asset managers within insurance companies stretch their durations in search of higher yields on fixed income products. This trend will have a negative impact on insurers in a rising interest rate environment as the longer duration increases the asset’s sensitivity to devaluation.

The next largest source of assets within its investment portfolio, categorized as “other investments”, consists of joint venture managed assets, primarily from its 11% stake in Watford Re, a Bermuda based reinsurance company. While Arch Capital is well diversified across the insurance universe, it holds a heavy weight toward P&C and P&C derivative products. This reliance on P&C products gives the company an advantage over annuity and life insurance companies in a volatile rate environment as they are more easily able to align their duration and liability driven investment policy with P&C policies expiring every six to twelve months. This also benefits them in the short-term in a rising rate environment as their shorter duration portfolio will have less exposure to security devaluation as yields improve, which we expect in late 2015 or early 2016.

Investable Assets by Type

Corporate Bonds 3,379.1 23.13%

Mortgage Backed Securities 965.5 6.61%

Municipal Bonds 1,494.1 10.23%

Commercial Mrtg Backed Sec. 1,114.5 7.63%

U.S. Gov. & GSE's 1,448.0 9.91%

Non-U.S. Gov. Securities 1,099.4 7.52%

Asset Backed Securities 1,677.9 11.48%

Total Fixed Maturities 11,178.6 76.51%

Short-Term Investments 797.2 5.46%

Cash 474.2 3.25%

Equity Securities 658.2 4.51%

Other Investments 1,501.7 10.28%

Total Investable Assets 14,610.0 100.00%


Arch Capital’s rate of return on fixed maturities has remained fairly stable in recent years ranging from 2.35% to 2.61% and we expect future rates of return to stay within this range throughout our forecast horizon. We forecast investment assets to grow 4% in 2015, driven by premium growth and investment income, before falling 10% in 2016 as the Fed’s actions finally allow rates to

adjust to a non-artificial level. After 2016, we see steady growth return leading to a continuous growth rate of 3.5%.

RECENT DEVELOPMENTS

4th Quarter Earnings and Recent Performance

Earnings estimates have been growing for Arch Capital as it outperformed estimates for the past four consecutive quarters by an average of 12.7%. Much of its performance was driven by improved underwriting results within the insurance segment. While reinsurance premiums were down, the P&C and mortgages insurance business units drove total net premiums to increase by 7.5%. Net interest income also grew by 8.2% year-over-year.10

In the past 12 months Arch Capital has underperformed the S&P 500 by 4.43% increasing 11.34% compared to the S&P’s 15.77% return. Year to date, the company has been on the move, up 6.48% compared to the S&P’s year to date return of 2.10% driven by recent earnings trends.

Mortgage Insurance Acquisitions

In 2014, Arch Capital finalized its acquisitions of two major US mortgage insurers, CMG Mortgage Insurance Company and PMI Group. Arch Capital paid $253 million for the pair. PMI Group previously held a 50% ownership stake in CMG. Prior to these acquisitions, Arch Capital’s mortgage insurance unit only operated in Europe. Both acquisitions provided strategic entrances into the US PMI market. CMG was previously the PMI arm of CUNA Mutual and provided significant access to the domestic credit union industry. PMI Group, which went into bankruptcy in 2011 following mounting losses after the housing crisis, was a leading provider of mortgage insurance for commercial banks and an approved insurer by government sponsored Fannie Mae and Freddie Mac. The acquisitions did not require the company to take on the portion of the portfolios of PMI Group and CMG that was previously in default, which brought the companies to their demise.

Following the acquisitions, Arch Capital, under its subsidiary Arch U.S. MI, received its approval as an eligible mortgage insurer from Fannie Mae and Freddie Mac. The company is now able to leverage its acquired client base to access a broad set of institutions, from credit unions to the big banks. These acquisitions create growth opportunities for Arch Capital as a pivotal entry into the US mortgage insurance market.

INDUSTRY TRENDS

Reinsurance Trends

Recent globalization has stagnated domestic growth reinsurers. Foreign reinsurers, including Arch Capital, captured 61.8% of the domestic reinsurance demand in 2014. This has also improved the industry’s ability to handle major catastrophes as losses are now spread globally across larger, more diverse capital bases.5 The industry is also expected to see continued M&A or acquisitions of smaller operators by larger players to meet the high capital needs of the business. Given Arch Capital’s large acquisitions in 2014, we do not foresee much M&A activity in 2015 or 2016. The company does, however, hold an 11% stake in Watford Re, a privately held reinsurer also located in Bermuda. The company has a hedge fund style approach to reinsurance and holds a higher percentage of non-investment grade fixed maturities than the industry average. Arch Capital currently oversees a portion of Watford Re’s reinsurance operations. If Arch Capital were to expand its reinsurance operations, Watford Re could be an attractive takeover target.

Mortgage Insurance Rates

Rates are assessed based on different loan-to-value (LTV) and credit score tiers with higher rates on higher LTV’s and lower credit scores. Rates for each tier are very close, if not identical, across peers within the industry. Within the past year, rates have decreased for lower risk home owners. For example, rates charged for a homeowner with a credit score of at least 760 and a LTV of at least 90% have decreased 11.36%. Conversely, rates charged for a higher risk customer over the same period have risen. Rates charged for a homeowner with a credit score under 620 have risen 2.98% across all LTV options. It is within this higher risk tier group where we start to see the industry’s rates beginning to differ.

Impending Insurance Regulation

While Dodd-Frank financial reform in the finance industry has generally focused on big banks over the past several years, there has recently been discussions on overlays within the insurance industry. Two issues impacting insurers are increased capital reserve requirements for its investment holdings and the risk of being labeled a systemically important financial institution (SIFI) or, more simply put, too big to fail. Specific details imposed by these

issues remain unclear. While Arch Capital will not face being categorized as a SIFI, both due to size and non-domestic location, it remains to be seen how this increased attention on insurers will impact the industry long-term.9

There are also two unresolved matters in congress impacting P&C insurers, the National Flood Insurance Program (NFIP) and the Terrorism Risk Insurance Act (TRIA). Both issues include increased policy risks. In regards to NFIP, insurers have removed flood and wind damage from high impact areas requiring NFIP coverage requirements and, similarly with TRIA, insurers have removed damages caused by acts of terrorism from their policies. Resolution on both acts has been extended by Congress, inevitably taking on these risks will play a significant role in future catastrophe reserves.9 This legislation could be undesirable to Arch Capital as terrorism policies are currently being written within their specialty P&C business unit. If legislation requires major insurers to cover terrorism in standard policies, the company could lose that line of extended coverage, albeit a small portion of its specialty P&C market.

MARKETS AND COMPETITION

The insurance industry is a highly competitive, mature industry. As mentioned earlier, the P&C insurance industry transitions from soft to hard market cycles where, in a hard market, insurers are able to operate with higher premiums and strict underwriting standards which yields higher profitability, and vice versa in a soft market. We generally see hard markets following a catastrophe. This creates excess underwriting over time which increases competition, relaxes underwriting standards, and begins to drive premium rates lower, restarting the cycle. In the PMI industry, profitability, in comparison to peers, is driven by operating efficiencies as rates assessed to mortgage insurance policies is widely driven by market rates which have minimal deviation from one another. Reinsurance, of the three major business units Arch Capital operates in, may show the most opportunity to deviate from industry peers as the investment opportunities widely differ from company to company looking at geography, niche markets, and risk management practices.

Geographic Regions of Operation

Geographic diversification separates Arch Capital from many of its domestic peers in P&C and mortgage insurance. Peers in the reinsurance space, on the other hand, have been a mix or domestic and international players beyond the past decade. Arch Capital’s total premium income consisted of 69% domestic and 31% international revenues. We believe this diversification minimizes the company’s risk in comparison to domestic peers. Insurers often align their investment portfolios with the regions they operate in. In the case of a rising rate environment in the US, a portion of the company’s international holdings will not feel the impact of price devaluation which benefits the company in the short term.


Peer Comparisons

Combined Ratio

The combined ratio, the most widely used metric in the insurance industry, is a profitability measure derived by comparing a company’s losses and expenses to its earned premiums for the year. Generally, a ratio under 1.0 means the company is operating at a loss, excluding investment or other supplemental income. This ratio is indicative of an insurance company’s underwriting profit and policy quality. The average among the selected peer group, removing RenaissanceRe as an outlier with historically volatile results, was 90.8% at year-end 2014.

This average among reinsurers is well below the total insurance industry average, which is currently in the mid to upper 90% range, due to the reinsurance exposure these firms have. Reinsurance businesses generally operate at very low combined ratios until a major catastrophe event occurs in which the firm could have a combined ratio well in excess of 150% for that year. Arch Capital, operating at 88.1% at year-end, has maintained this level at or below 90% in recent years which has driven profit margins for the company. To properly account for a future catastrophe event, but not knowing which year the event will occur, we have forecasted Arch Capital at an increased combined ratio than their historical average to price in the loss of future catastrophe events that will inevitably occur. From 2015 through our forecast horizon, we have Arch Capital operating with a combined ratio from 97% to 99%. This smoothing evens the volatility that reinsurers experience over a more prolonged period.

Price-to-Book Ratio

The price to book ratio (P/Book) holds significant importance in valuating insurance and other financial services companies. The book value, often equal to the shareholders’ equity, is the value of the company if liquidated. Since the assets on an insurer’s balance sheet are predominately securities which can easily be marked to market, this ratio is a solid measure for determining the value of the current trading price. Generally, a price to book ratio under 1.0 is considered underpriced and a ratio over 2.0 is overpriced, ignoring other factors. A low price-to-book ratio could also be a sign of distress if a company’s price is driven down for adverse reasons. Arch Capital currently trades with a price-to-book ratio of 1.35 compared to the peer average of 1.01 suggesting that the company may be overvalued at the current price level. The company’s book value, as well as stock price, has

Company

P/E

‘15 P/Book P/TBV

Combined

Ratio

Profit

Margin

Arch Capital 15.3 1.35 1.43 88.1% 20.3%

AXIS Capital 11.5 1.00 1.03 91.6% 19.7%

Endurance Specialty 10.4 0.90 0.95 86.0% 17.0%

XL Group 11.8 0.94 0.90 90.6% 2.4%

PartnerRe 12.1 0.77 0.88 86.2% 17.4%

RenaissanceRe 11.7 1.12 1.12 50.2% 47.8%

EMC Insurance Group 11.2 0.85 0.88 101.9% 5.4%

ACE Limited 11.9 1.24 1.56 87.8% 18.1%

Allianz SE 11.5 0.97 1.30 94.3% 5.1%

Average 11.9 1.01 1.12 90.8% 17.0%

Data Source: FactSet2

continued to increase since the financial crisis of 2008, increasing 14.5% in 2014.

Book Value per Common Share

Source: Arch Capital – Investor Information12

Price-to-Earnings (P/E) Ratio

The price-to-earnings ratio, or P/E, is a multiple of the company’s current trading price over a company’s earnings per share, in this case estimated earnings for 2015. Arch Capital’s forward P/E again suggests that it may be overvalued at its current pricing level. Its P/E of 15.3 is a significant premium over the peer group average of 11.9.

Delinquency Rates

A measure significant in the mortgage insurance industry is the delinquency rate among home owners within your policy portfolio. High delinquency rates following the housing crash in 2008 crippled the industry, putting many out of business. This rate also impacts a company’s combined ratio as high delinquencies drive losses, increasing the ratio measure and decreasing profitability.

Data Source: Arch Capital – Investor Information12

In comparison to the four major players in the domestic PMI industry, Arch MI significantly outperforms its peers with a delinquency rate of 2.7% in 2014, compared to a peer average of 5.38% including Arch MI (6.1% removing Arch MI).12 This is partly due to the portfolio Arch Capital acquired from its recent acquisitions, which did not include loans in default. This measure is indicative of credit underwriting quality and risk exposure and will aid in minimize losses for Arch Capital over the next few years.

ECONOMIC OUTLOOK

Unemployment and Consumer Spending

Employment growth has a positive correlation to revenue growth within the insurance industry. Strong employment data often drives higher wages and an increase in spending as consumer confidence rises. In the P&C business, these economic drivers impact home and auto sales which bring in higher premium revenues. Home mortgage originations, for example, are expected to increase 7% in 2015, driving both P&C and PMI markets.12 Increases in P&C activity, as well as growth in the life insurance industry, drive the reinsurance industry, which again would benefit businesses in this space. Employment also plays a significant role in the mortgage insurance industry as high unemployment rates are a catalyst for spikes in delinquency rates which can cause mounting losses for PMI policy holders.

Impacts of Employment Growth on Reinsurers

Source: IBISWorld5

2.70%

4.40%5.20%

6.30%

8.30%

5.38%

Arch MI UnitedGuaranty

Radian Genworth MGIC Average

Primary Delinquency Rates

The unemployment rate, which excludes individuals who have not looked for a job within the past four weeks, has remained fairly steady, slightly declining over the past 12 months ending at 5.5% at the end of the first quarter of 2015.13 The participation rate, however, continues to fall as well which suggests that the declining unemployment rate may be driven by discouraged workers who have given up on finding a job. Regardless, the fund’s consensus is that the employment environment will remain relatively steady as the annual GDP growth outlook remains low at 2.2% over the next two years, hampering near-term growth rates.

Interest Rates

Interest rates are the most significant economic driver impacting the insurance industry. Rates, both short and long-term, have remained artificially low for a number of years as a result of the Federal Reserve’s monetary policy and quantitative easing measures. Because of this, the net interest margins for insurers remain compressed, hampering the profitability of their fixed income driven portfolios. Despite the US’s up trending economic outlook and indicators, the Fed remains hesitant to allow rates to increase. This is presumably a result of the poor outlook globally with several countries in the Eurozone concurrently decreasing central bank rates, some with negative short term yields, as well as recent, unfavorable domestic employment data. The fund consensus foresees the 10 year treasury rate to finally rise in late 2015 to 2.35% and continue to rise to 3.3% over the two year horizon. This will drive long-term optimism within the industry which will have a direct impact on the earnings of insurance companies.

10 Year US Treasury Yield

Source: CNBC – US 10 Year Treasury11

CATALYSTS FOR GROWTH

Positive macro-economic factors play a large role in driving growth within the insurance industry. Continuing with interest rates, a rise in yields in necessary for long-term growth. Investment income plays a significant role on insurers income statements. For Arch Capital, investment income accounted for 8.7% of total revenue and 39.0% of net income. While we are forecasting steady increases beginning in early 2016, earlier increases or more rapid increases to reach historically normal levels would play as major growth drivers for the industry.

The market cycle also plays as a catalyst for the industry. As mentioned earlier, we believe we are nearing the end of a hard market cycle with improved pricing and stricter underwriting standards. A prolonged extension of this cycle would also be a growth catalyst for insurers. Conversely, if we do enter a softening cycle, the rate at which the industry adjusts, adding momentum to the cycle change, will ultimately determine the impact over our investment horizon.

INVESTMENT POSITIVES

Diversification, both in insurance product exposure and geographic operations, minimizes the risks that Arch Capital provides to an investor.

A rising interest rate environment and low duration on fixed maturities will allow for steady increases in investment income sources while also decreasing the devaluation impacts that rising yields have on bond prices.

Arch Capital’s recent entrance into the domestic mortgage insurance market provides growth opportunities to expand this business unit as they build upon the footprint of the companies acquired in 2014.

The company’s niche in specialty markets separates itself from the operations, and limitations in some cases, that many of its peers operate in. This adds to additional diversity within each business unit’s policy portfolio in the event a catastrophe loss occurs.

Arch Capital’s earning announcements have outperformed analyst expectations in all of the past four quarters. While it is not indicative of future performance, it has shown continued financial strength within the industry.

INVESTMENT NEGATIVES

Arch Capital currently trades at a price-to-book ratio of 1.35 and a forward P/E of 15.3. Both measures suggest that the company is potentially overvalued, trading at a premium to their peers.

Recent earnings announcements have remained positive, exceeding expectations and driving increases in the share price. This recent outperformance dampens the margin of safety on expected investment returns in relation to our valuations.

As with any insurer, the threat of a major catastrophe loss always looms, particularly in recent years where we have seen an increase in catastrophe loss events. Arch Capital has exposure to both the P&C and reinsurance sides of operation.

VALUATION

Assumptions

Many segment specific growth assumptions have been outlined in their respective business unit coverage. Overall, we see the most growth coming from the company’s mortgage insurance operations given its recent expansion efforts. We have premiums in that space growing 10.5% this year, continuing strong at 8.5% in 2016, and easing to a continuous 2.5% growth rate beyond 2018. We see this growth coming from policy increases as Arch Capital uses its recent acquisitions to expand into the US market.

Reinsurance shows the next largest area for growth. We foresee premiums within the reinsurance business unit growing as high as 8.5% in 2016 before easing to 3.0% continuous growth rate. The company’s P&C premiums remain more steady, growing at 3.0% before tapering off to 2.5% as a continuous growth rate. Income from investment operations are largely derived from asset growth as its return on those assets, mostly fixed maturities, have remained consistent over recent years.

We foresee asset growth of 4% in 2015 but falling 10% based on the portfolio’s duration in 2016 as rising rates devalue the portfolio’s fixed security holdings. This will have an adverse impact to investment income in 2016.

The company’s expenses also required significant assumptions to be made. Given the nature of the insurance industry, particularly in the reinsurance space, companies must operate with a combined ratio below 100% to remain profitable from underwriting operations. Companies must operate profitably most years in order to handle catastrophe events which may drive a company’s combined ratio well above 150 or even 200% in extreme cases. Because of this, we forecasted Arch Capital’s expenses to put pressure on the company’s combined ratio which, for modeling purposes, prices in a future catastrophe event to some degree. Recently the company has operated at a combine ratio near 90%. In order to price in future loss events, we forecasted the expenses to increase the combined ratio at a level near 98% over our five year forecast period.

Lastly, Arch Capital began its share repurchase program in 2010 with common share repurchases of $550 million. They have continued to grow their treasury stock by an average of 23.6% per year. At year-end 2014, the company had a treasury stock balance of $1,562 million and an authorized outstanding repurchase balance of $887 million which will continue to bolster the stock’s share price in the coming years and return money to shareholders in lieu of dividend payments, which the company has not issued in its history. Given the large available balance to repurchase stock, we foresee Arch Capital continuing their consistent share repurchasing, growing their treasury stock by an additional 15% in 2015 and 13% in 2016.

Relative Valuation

Arch Capital currently trades at a premium in regards to its peers in key metrics used for relative valuations within the insurance industry, P/E and price-to-book. Using the modeled income statement, the company’s future P/E’s are 15.3 and 16.1 for FY 2015 and 2016, respectively. This compares to peer averages of 11.5 and 11.3 over the same periods. Because of this, the relative valuations using forward P/E multiples are $47.24 and $44.16.

Similarly for price-to-book, Arch Capital currently trades at a price-to-book ratio of 1.35 which is well above the peer

group average of .97. Price-to-tangible-book value for the company is 1.43 compared to the peer group average of 1.08. These multiples price Arch Capital at $43.71 (P/B) and $47.62 (P/TB).

The overall relative valuation model put an emphasis on the P/B and P/TB values as they are the most effective at determining value in an insurance companies. Those two metrics received a two thirds weighting while the P/E valuations received a one third weighting. This derived a relative valuation price of $45.67.

Equity Discounted Cash Flow (DCF)

The equity DCF valuation arrived at a price of $71.60 with the terminal value accounting for 65.9% of the total value. This presents a potential upside of 13.8%, which is below our margin of safety resulting in a “no action” decision. Drivers of this value have growth in business units over the next few years but relatively low growth measures within the continuous values as the company competes in a very mature, competitive market. Low GDP growth expectations also taper our continuous growth measures.

The second sensitivity analysis in the appendix compares the impacts from adjusting cost of equity and continuous growth rates against the DCF valuation. The analysis shows a fair amount of sensitivity around these factors. With the widest ranges providing a price of $67.91 (no growth, 7% cost of equity) and $78.72 (3% continuous growth, 4% cost of equity).

Dividend Discount Model (DDM)

The dividend discount model derived a price of $65.37 with an intrinsic terminal value accounting for 100% of the total value since the company does not pay dividends on its common shares. Because of this, the dividend discount model may not be the most reliable model for valuation of Arch Capital. This valuation did however fairly value the stock as it is within 4% of its current trading price.

The third sensitivity analysis from the appendix comparing cost of equity and continuous growth rates against the DDM value show that these variable play significant roles in deriving the valuation metric. Prices ranged from $50 to $95 adjusting each measure by a few percentage points.

KEYS TO MONITOR

Earnings announcements, both Arch Capital’s and industry peers, will provide additional clarity on market expectations throughout the year, potentially adjusting key driver metrics used in our valuations which could change the investment recommendation. One key item to monitor during earning

We will also need to monitor broader economic indicators which will impact the interest rate environment. While the Fed has remained patient on allowing rate increases, strengthening employment data could expedite policy changes, impacting our short-term performance expectations. The 10 year treasury rate has remained under 2% for the majority of 2015 and have only briefly touched 3% since 2011.3 Our investment thesis will need to be reviewed if rates begin to approach the 3% or if rates do not exceed 2.5% by year-end.

REFERENCES

1. Arch Capital Group Ltd., Annual 10-K, 2014 2. FactSet 3. Yahoo Finance 4. 2014 Mortgage Insurance Report, Wallet Hub,

http://wallethub.com/edu/mortgage-insurance-report/8645/

5. IBISWorld iExpert Industry Summary 52413, Reinsurance Carriers in the US, December 2014, http://clients1.ibisworld.com/reports/us/iexpert/default.aspx?entid=1329

6. Arch Capital Closes Acquisition of CMG Mortgage Insurance, PMI Operating Platform, Insurance Journal, January 31, 2014, http://www.insurancejournal.com/news/international/2014/01/31/319008.htm

7. Competition Intensifies (Sorta) in Mortgage Insurance, National Mortgage News, Origination News, June 20, 2014, http://www.nationalmortgagenews.com/news/origination/competition-intensifies-sorta-in-mortgage-insurance-1042007-1.html

8. The Underwriting Profits of a Property and Casualty Insurer, Market Realist, March 12, 2015, http://marketrealist.com/2015/03/underwriting-profits-property-casualty-insurer/

9. Insurance: Property-Casualty, Industry Profile, S&P Capital IQ, September 2014

10. Is Arch Capital Worth Adding to Your Portfolio?, Zachs Equity Research, March 23, 2015 http://finance.yahoo.com/news/arch-capital-acgl-worth-adding-222210166.html

11. US 10 Year Treasury, CNBC, March 10, 2014, http://data.cnbc.com/quotes/US10Y/tab/2

12. Investor Information, Arch Capital, http://ir.archcapgroup.com/corporateprofile.aspx?iid=103577

13. Bureau of Labor Statistics, April 12, 2015, http://data.bls.gov/timeseries/LNS14000000

IMPORTANT DISCLAIMER

Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa’s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.



http://clients1.ibisworld.com/reports/us/iexpert/default.aspx?entid=1329

http://clients1.ibisworld.com/reports/us/iexpert/default.aspx?entid=1329

http://www.insurancejournal.com/news/international/2014/01/31/319008.htm

http://www.insurancejournal.com/news/international/2014/01/31/319008.htm

http://www.nationalmortgagenews.com/news/origination/competition-intensifies-sorta-in-mortgage-insurance-1042007-1.html



http://marketrealist.com/2015/03/underwriting-profits-property-casualty-insurer/

http://marketrealist.com/2015/03/underwriting-profits-property-casualty-insurer/

http://finance.yahoo.com/news/arch-capital-acgl-worth-adding-222210166.html

http://finance.yahoo.com/news/arch-capital-acgl-worth-adding-222210166.html

http://data.cnbc.com/quotes/US10Y/tab/2

http://ir.archcapgroup.com/corporateprofile.aspx?iid=103577

http://ir.archcapgroup.com/corporateprofile.aspx?iid=103577

http://data.bls.gov/timeseries/LNS14000000

Arch Capital Group Ltd.

Revenue Decomposition (in millions)

Fiscal Years Ending Dec. 31 2012 2013 2014 2015E 2016E 2017E 2018E 2019E

Insurance segment

Net premiums written

Programs 340.1 419.7 480.6 495.0 509.8 525.1 540.9 554.4

Professional lines 548.4 476.2 476.6 490.9 505.6 520.8 536.4 549.8

Construction and national accounts 211.1 271.1 287.0 295.6 304.5 313.6 323.0 331.1

Property, energy, marine and aviation 294.7 280.6 244.6 252.0 259.5 267.3 275.3 282.2

Excess and surplus casualty 112.3 149.3 212.5 218.9 225.5 232.2 239.2 245.2

Travel, accident and health 106.9 104.9 145.7 150.1 154.6 159.2 164.0 168.1

Lenders products 99.7 101.6 100.4 103.4 106.5 109.7 113.0 115.8

Other 112.1 145.5 199.2 205.2 211.3 217.6 224.2 229.8

Total 1,825.3 1,948.8 2,146.7 2,211.1 2,277.4 2,345.7 2,416.1 2,476.5

Reinsurance segment


Other specialty 308.1 417.9 405.1 406.2 407.2 408.3 409.3 410.4

Property excl. property catastrophe 265.8 292.5 343.0 344.1 345.2 346.2 347.2 348.3

Casualty 205.9 306.3 318.0 319.0 320.1 321.2 322.2 323.2

Property catastrophe 283.7 220.7 137.5 138.5 139.6 140.6 141.7 142.7

Marine and aviation 84.6 64.4 50.4 51.5 52.6 53.6 54.6 55.7

Other 10.7 11.2 11.9 12.9 14.0 15.1 16.1 17.1

Total 1,158.8 1,313.0 1,266.0 1,272.2 1,278.7 1,285.0 1,291.2 1,297.4

Mortgage segment


Domestic mortgage insurance 61.6 63.7 184.3 203.7 221.0 229.8 236.7 242.7

International mortgage insurance 6.5 25.9 20.5 22.7 24.6 25.6 26.3 27.0

Total 68.1 89.6 204.8 226.3 245.6 255.4 263.1 269.6

Total net premiums written 3,052.2 3,351.4 3,617.5 3,709.6 3,801.6 3,886.1 3,970.3 4,043.5

Net investment income by source

Fixed maturities 281.1 249.8 265.2 278.5 253.3 268.6 269.5 280.7

Return on fixed maturities 2.61% 2.35% 2.45% 2.47% 2.50% 2.54% 2.48% 2.51%

Equity securities (dividends) 8.0 8.9 13.0 14.0 11.9 12.7 13.1 13.4

Return on equity securities 2.35% 1.80% 1.98% 2.04% 1.94% 1.98% 1.99% 1.97%

Consolidated short-term & other 30.7 40.1 66.0 69.4 57.5 63.0 64.5 65.6

Return on loans and other inv. 2.34% 1.47% 1.87% 1.89% 1.74% 1.83% 1.82% 1.80%

Gross investment income 319.8 298.8 344.2 361.8 322.8 344.3 347.0 359.6

Investment expenses -25.7 -33.1 -46.3 -48.2 -49.6 -51.1 -52.7 -54.2

Net investment income 294.1 265.7 297.9 313.6 273.2 293.2 294.4 305.4

Key Growth Rates

Insurance segment 6.76% 10.15% 3.00% 3.00% 3.00% 3.00% 2.50%

Reinsurance segment 13.31% -3.58% 0.49% 0.51% 0.49% 0.49% 0.48%

Mortgage segment 31.51% 128.69% 10.50% 8.50% 4.00% 3.00% 2.50%

Total net premiums written 9.80% 7.94% 2.55% 2.48% 2.22% 2.17% 1.84%

Net investment income -9.65% 12.11% 5.29% -12.90% 7.33% 0.41% 3.74%


Income Statement (in millions)


Income Statement

Premiums Earned 2,935.1 3,146.0 3,593.7 3,709.6 3,801.6 3,886.1 3,970.3 4,043.5

Investment Income 294.1 265.7 297.9 313.6 273.2 293.2 294.4 305.4

Realized Gains (Losses) 175.6 36.3 102.2 135.5 112.1 112.3 99.7 112.4

Other Operating Income 8.1 7.6 10.1 10.5 10.9 11.2 11.5 11.9

Sales 3,412.9 3,455.7 4,004.0 4,169.3 4,197.7 4,302.8 4,375.9 4,473.1

Losses, Claims & Reserves 1,861.3 1,679.4 1,919.3 2,341.5 2,482.0 2,630.9 2,683.5 2,737.2

Selling, General & Admin. & Other 966.9 1,026.2 1,248.3 1,298.2 1,210.4 1,218.7 1,257.8 1,293.9

Operating Income Before Int. Expense 584.7 750.0 836.5 529.6 505.3 453.2 434.6 442.0

Interest Expense, Net of Int. Capitalized 28.5 27.1 45.6 31.2 32.4 32.7 32.9 33.7

Operating Income After Int. Expense 556.2 722.9 790.9 498.4 473.0 420.5 401.7 408.4

Non-operating Income (Expense) 44.6 23.4 103.6 53.8 46.6 54.4 56.4 62.9

Unusual Expense 11.4 3.8 50.2 17.2 18.3 20.2 21.9 25.6

Pretax Income 589.4 742.5 844.2 535.0 501.2 454.7 436.1 445.8

Income Taxes -4.0 32.8 23.0 11.8 10.4 10.8 14.1 17.1

Other After Tax Adjustments -10.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Consolidated Net Income 582.8 709.7 821.3 523.1 490.9 443.9 422.0 428.6

Minority Interest 0.0 0.0 -13.1 -13.5 -13.9 -14.3 -14.7 -15.2

Net Income 582.8 709.7 834.4 536.6 504.8 458.2 436.7 443.8

Preferred Dividends 25.1 21.9 21.9 21.9 21.9 21.9 21.9 21.9

Net Income available to Common 557.7 687.8 812.4 514.7 482.9 436.3 414.8 421.9

EPS 4.17 5.15 6.38 4.10 3.91 3.58 3.46 3.57

Diluted Shares Outstanding 138.3 135.8 134.9 115.5 113.6 111.7 109.9 108.1

Total Shares Outstanding 133.8 133.7 127.4 125.5 123.6 121.7 119.9 118.1


Balance Sheet (in millions)


Balance Sheet

Assets

Total Fixed Income Securities Inv. 10,783.3 10,611.7 10,845.9 11,279.7 10,151.7 10,557.8 10,874.5 11,200.8

Total Equity Securities Investment 338.7 496.8 658.2 684.5 616.1 640.7 659.9 679.7

Other Investments 1,313.0 2,734.4 3,529.0 3,670.1 3,303.1 3,435.3 3,538.3 3,644.5

Total Investments 12,435.0 13,843.0 15,033.0 15,634.4 14,070.9 14,633.8 15,072.8 15,525.0

Cash 371.0 434.1 485.7 285.9 618.6 416.2 212.9 223.3

Premium Balance Receivables 3,424.6 3,622.5 2,761.5 2,899.6 2,957.6 3,075.9 3,183.6 3,295.0

Contractholder receivables 865.7 1,064.2 1,309.2 1,440.1 1,555.3 1,664.2 1,780.7 1,869.7

Investment in Unconsolidated Subs. 414.4 349.2 439.4 426.3 443.3 434.4 451.8 460.9

Other Assets 306.0 253.1 1,980.6 2,079.7 1,996.5 2,076.3 2,138.6 2,202.8

Total Assets 17,816.8 19,566.1 22,009.5 22,765.9 21,642.3 22,300.9 22,840.4 23,576.6

Liabilities 0.184 0.215 0.247 0.256 0.256 0.261 0.267 0.269

Reserve for losses and adjustments 8,933.3 8,824.7 9,036.4 9,397.9 9,585.9 9,873.4 10,169.6 10,474.7

Unearned Premiums 1,648.0 1,896.4 2,231.6 2,410.1 2,458.3 2,581.2 2,710.3 2,818.7

Reinsurance balances payable 188.5 196.2 219.3 236.9 253.4 271.2 287.4 298.9

Contractholder payables 865.7 1,064.2 1,309.2 1,440.1 1,555.3 1,664.2 1,780.7 1,869.7

ST Debt & Curr. Portion LT Debt 0.0 100.0 150.5 100.0 100.0 150.0 150.0 200.0

Long-Term Debt 400.0 800.0 800.0 850.0 850.0 900.0 900.0 950.0

Other Liabilities 612.3 1,037.1 1,143.8 1,196.5 1,251.5 1,309.1 1,369.3 1,432.3

Total Liabilities 12,647.9 13,918.6 14,890.9 15,631.4 16,054.4 16,749.1 17,367.3 18,044.4

Shareholders' Equity

Preferred Stock (Carrying Value) 325.0 325.0 325.0 325.0 325.0 325.0 325.0 325.0

Common Stock 227.8 299.5 383.1 440.5 497.8 552.6 602.3 644.5

Retained Earnings 5,354.4 6,042.2 6,854.6 6,991.7 5,596.8 5,714.6 5,766.5 5,954.4

Other Appropriated Reserves 287.6 75.5 129.4 165.2 169.5 163.6 165.1 144.7

Treasury Stock 1,025.8 1,094.7 1,562.0 1,796.3 2,029.8 2,253.1 2,455.9 2,627.8

Common Equity 4,843.9 5,322.5 5,805.1 5,801.1 4,234.3 4,177.7 4,078.0 4,115.8

Total Shareholders' Equity 5,168.9 5,647.5 6,130.1 6,126.1 4,559.3 4,502.7 4,403.0 4,440.8

Accumulated Minority Interest 0.0 0.0 988.6 1,008.4 1,028.5 1,049.1 1,070.1 1,091.5

Total Equity 5,168.9 5,647.5 7,118.6 7,134.5 5,587.9 5,551.8 5,473.1 5,532.3

Total Liabilities & Shareholders' Eq. 17,816.8 19,566.1 22,009.5 22,765.9 21,642.3 22,300.9 22,840.4 23,576.6


Cash Flow Statement (in millions)

Fiscal Years Ending Dec. 31 2012 2013 2014

Operating Activities

Funds from Operations 403.9 737.5 792.0

Changes in Working Capital 517.7 113.4 245.1

Net Operating Cash Flow 921.6 850.9 1,037.1

Investing Activities

Capital Expenditures -18.5 -17.5 -19.9

Net Assets from Acquisitions 0.0 0.0 -237.1

Sale of Fixed Assets & Businesses 28.9 0.0 0.0

Purchase/Sale of Investments -406.4 -1,290.0 -1,248.4

Other Funds 0.0 0.0 0.0

Net Investing Cash Flow -396.0 -1,307.5 -1,505.4

Financing Activities

Repurchase of Common & Preferred Stk. -497.06 -57.80 -454.14

Sale of Common & Preferred Stock 322.80 3.05 1,022.96

Change in Capital Stock -174.26 -54.75 568.83

Cash Dividends Paid -28.38 -21.94 -21.94

Issuance/Reduction of Debt, Net -310.87 494.23 0.00

Other Funds 0.47 106.47 -6.95

Net Financing Cash Flow -513.04 524.02 539.94

Exchange Rate Effect 6.74 -4.36 -20.01

Net Change in Cash 19.34 63.02 51.64

Free Cash Flow 903.07 833.37 1,017.25

Free Cash Flow per Share 6.53 6.14 7.54

Free Cash Flow Yield (%) 14.84 10.28 12.76


Cash Flow Statement (in millions)

Fiscal Years Ending Dec. 31 2015E 2016E 2017E 2018E 2019E

Cash Flows from Operating Activities

Net income (loss) 536.6 504.8 458.2 436.7 443.8

Increase (decrease) in premiums receivable -138.1 -58.0 -118.3 -107.7 -111.4

Increase (decrease) in contractholder receivables -130.9 -115.2 -108.9 -116.5 -89.0

Increase (decrease) in contractholder payables 130.9 115.2 108.9 116.5 89.0

Increase (decrease) in reinsurance balances payable 17.5 16.6 17.7 16.3 11.5

Increase (decrease) in reserves for losses & adjustments -361.5 -188.0 -287.6 -296.2 -305.1

Increase (decrease) in unearned premiums 178.5 48.2 122.9 129.1 108.4

Net cash provided by operating activities 233.2 323.6 193.0 178.2 147.2

Cash Flows from Investing Activities

(Increase) decrease in total investment assets -300.7 781.7 -281.4 -219.5 -226.1

(Increase) decrease in short-term investments 50.5 0.0 -50.0 0.0 -50.0

(Increase) decrease in unconsolidated subsidiary inv. 13.2 -17.1 8.9 -17.4 -9.0

(Increase) decrease in other assets/liabilities -46.4 138.2 -22.3 -2.1 -1.2

Net cash used for investing activities -283.4 902.9 -344.8 -239.0 -286.3

Cash Flows from Financing Activities

Proceeds from issuing long-term debt 50.0 0.0 50.0 0.0 50.0

Payment of dividends -21.9 -21.9 -21.9 -21.9 -21.9

Repurchase of common stock -457.6 -367.5 -285.4 -319.0 -274.2

Net cash provided by financing activities -429.6 -389.4 -257.3 -341.0 -246.2

Exchange Rate Effect -20.0 -4.4 6.7 -1.6 -4.4

Net increase (decrease) in cash -199.8 332.7 -202.4 -203.3 10.4

Cash, beginning of year 485.7 285.9 618.6 416.2 212.9

Cash, end of year 285.9 618.6 416.2 212.9 223.3


Common Size Income Statement (as a percentage of assets)


Income Statement

Premiums Earned 16.47% 16.08% 16.33% 16.30% 17.58% 17.44% 17.40% 17.17%

Investment Income 1.65% 1.36% 1.35% 1.38% 1.26% 1.32% 1.29% 1.30%

Realized Gains (Losses) 0.99% 0.19% 0.46% 0.60% 0.52% 0.50% 0.44% 0.48%

Other Operating Income 0.05% 0.04% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05%

Sales 19.16% 17.66% 18.19% 18.32% 19.41% 19.31% 19.18% 18.99%

Losses, Claims & Reserves 10.45% 8.58% 8.72% 10.29% 11.47% 11.81% 11.76% 11.62%

Selling, General & Admin. & Other 5.43% 5.25% 5.67% 5.70% 5.60% 5.47% 5.51% 5.49%

Operating Income Before Int. Expense 3.28% 3.83% 3.80% 2.33% 2.34% 2.03% 1.90% 1.88%

Interest Expense, Net of Int. Capitalized 0.16% 0.14% 0.21% 0.14% 0.15% 0.15% 0.14% 0.14%

Operating Income After Int. Expense 3.12% 3.69% 3.59% 2.19% 2.19% 1.89% 1.76% 1.73%

Non-operating Income (Expense) 0.25% 0.12% 0.47% 0.24% 0.22% 0.24% 0.25% 0.27%

Unusual Expense 0.06% 0.02% 0.23% 0.08% 0.08% 0.09% 0.10% 0.11%

Pretax Income 3.31% 3.79% 3.84% 2.35% 2.32% 2.04% 1.91% 1.89%

Income Taxes -0.02% 0.17% 0.10% 0.05% 0.05% 0.05% 0.06% 0.07%

Other After Tax Adjustments -0.06% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Consolidated Net Income 3.27% 3.63% 3.73% 2.30% 2.27% 1.99% 1.85% 1.82%

Minority Interest 0.00% 0.00% -0.06% -0.06% -0.06% -0.06% -0.06% -0.06%

Net Income 3.27% 3.63% 3.79% 2.36% 2.33% 2.06% 1.91% 1.88%

Preferred Dividends 0.14% 0.11% 0.10% 0.10% 0.10% 0.10% 0.10% 0.09%

Net Income available to Common 3.13% 3.52% 3.69% 2.26% 2.23% 1.96% 1.82% 1.79%


Common Size Balance Sheet (as a percentage of assets)


Balance Sheet

Assets

Total Fixed Income Securities Inv. 60.52% 54.24% 49.28% 49.56% 46.93% 47.38% 47.65% 47.56%

Total Equity Securities Investment 1.90% 2.54% 2.99% 3.01% 2.85% 2.88% 2.89% 2.89%

Mortgage, Policy & Other Loans 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Other Investments 7.37% 13.98% 16.03% 16.13% 15.27% 15.42% 15.51% 15.47%

Total Investments 69.79% 70.75% 68.30% 68.69% 65.05% 65.67% 66.05% 65.92%

Cash 2.08% 2.22% 2.21% 1.23% 2.81% 1.80% 0.84% 0.84%

Premium Balance Receivables 19.22% 18.51% 12.55% 12.74% 13.67% 13.80% 13.95% 13.99%

Contractholder receivables 4.86% 5.44% 5.95% 6.33% 7.19% 7.47% 7.80% 7.94%

Investment in Unconsolidated Subs. 2.33% 1.78% 2.00% 1.87% 2.05% 1.95% 1.98% 1.96%

Deferred Tax Assets 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Other Assets 1.72% 1.29% 9.00% 9.14% 9.23% 9.32% 9.37% 9.35%

Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Liabilities

Reserve for losses and adjustments 50.14% 45.10% 41.06% 41.29% 44.32% 44.31% 44.56% 44.47%

Unearned Premiums 9.25% 9.69% 10.14% 10.59% 11.37% 11.58% 11.88% 11.97%

Reinsurance balances payable 1.06% 1.00% 1.00% 1.04% 1.17% 1.22% 1.26% 1.27%

Contractholder payables 4.86% 5.44% 5.95% 6.33% 7.19% 7.47% 7.80% 7.94%

ST Debt & Curr. Portion LT Debt 0.00% 0.51% 0.68% 0.44% 0.46% 0.67% 0.66% 0.85%

Long-Term Debt 2.25% 4.09% 3.63% 3.73% 3.93% 4.04% 3.94% 4.03%

Deferred Tax Liabilities 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Other Liabilities 3.44% 5.30% 5.20% 5.26% 5.79% 5.87% 6.00% 6.08%

Total Liabilities 70.99% 71.14% 67.66% 68.68% 74.22% 75.16% 76.11% 76.61%

Shareholders' Equity

Preferred Stock (Carrying Value) 1.82% 1.66% 1.48% 1.43% 1.50% 1.46% 1.42% 1.38%

Additional Paid-In Capital/Cap. Surplus 1.28% 1.53% 1.74% 1.94% 2.30% 2.48% 2.64% 2.74%

Retained Earnings 30.05% 30.88% 31.14% 30.69% 25.82% 25.57% 25.18% 25.18%

Other Appropriated Reserves 1.61% 0.39% 0.59% 0.73% 0.78% 0.73% 0.72% 0.61%

Treasury Stock -5.76% -5.59% -7.10% -7.89% -9.38% -10.11% -10.76% -11.16%

Common Equity 27.19% 27.20% 26.38% 25.46% 19.52% 18.68% 17.78% 17.37%

Total Shareholders' Equity 29.01% 28.86% 27.85% 26.89% 21.02% 20.13% 19.20% 18.75%

Accumulated Minority Interest 0.00% 0.00% 4.49% 4.43% 4.76% 4.71% 4.69% 4.63%

Total Equity 29.01% 28.86% 32.34% 31.32% 25.78% 24.84% 23.89% 23.39%

Total Liabilities & Shareholders' Eq. 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%


Value Driver Estimation


Net Income 582.8 709.7 834.4 536.6 504.8 458.2 436.7 443.8

Total Shareholder's Equity 5,168.9 5,647.5 7,118.6 7,134.5 5,587.9 5,551.8 5,473.1 5,532.3

Return on Equity (ROE) 12.59% 13.73% 14.77% 7.54% 7.08% 8.20% 7.87% 8.11%

Equity Economic Profit (EEP) 334.6 432.6 531.5 154.9 122.2 158.6 139.0 150.3

Free Cash Flow to Equity (FCFE) - Easy

Net income 582.8 709.7 834.4 536.6 504.8 458.2 436.7 443.8

Change in total assets 675.0 1,749.3 2,443.4 756.4 -1,123.7 658.6 539.5 736.2

Change in total liabilities 134.6 1,270.7 972.3 740.5 423.0 694.7 618.2 677.0

Free Cash Flow to Equity 42.4 231.1 -636.8 520.8 2,051.4 494.3 515.4 384.6

Free Cash Flow to Equity (FCFE) - Formal

Cash from operations

Net income 582.8 709.7 834.4 536.6 504.8 458.2 436.7 443.8

- Preferred dividends -25.1 -21.9 -21.9 -21.9 -21.9 -21.9 -21.9 -21.9

- Minority interest 0.0 0.0 13.1 13.5 13.9 14.3 14.7 15.2

Cash from operations 607.9 731.7 843.2 545.1 512.8 465.9 443.9 450.6

Sources of Cash

Increase in accounts payable 172.2 206.1 268.1 148.5 131.8 126.6 132.8 100.5

+ Increase in reserves 477.1 -108.6 211.8 361.5 188.0 287.6 296.2 305.1

+ Increase in debt -310.5 500.0 50.5 -0.5 0.0 100.0 0.0 100.0

+ Increase in unearned premiums 236.1 248.4 335.2 178.5 48.2 122.9 129.1 108.4

+ Increase in deferred tax liabilities 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

+ Increase in other liabilities -440.3 424.8 106.7 52.6 55.0 57.6 60.2 63.0

Sources of Cash 134.6 1,270.7 972.3 740.5 423.0 694.7 618.2 677.0

Uses of Cash

Increase in investments and cash 777.4 1,471.0 1,241.7 401.6 -1,230.7 360.4 235.7 462.6

+ Increase in accts receivable/recoverable 440.8 396.4 -616.0 269.0 173.2 227.2 224.2 200.5

+ Increase in unconsolidated subsidiaries -73.7 -65.2 90.2 -13.2 17.1 -8.9 17.4 9.0

+ Increase deferred tax assets 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

+ Increase in other assets -469.5 -52.9 1,727.5 99.0 -83.2 79.9 62.3 64.2

Uses of cash 675.0 1,749.3 2,443.4 756.4 -1,123.7 658.6 539.5 736.2

Free Cash Flow to Equity 67.5 253.0 -627.9 529.2 2,059.5 501.9 522.6 391.4


Discounted Cash Flow (DCF) and Economic Profit (EP) Valuation Models

Key Inputs:

CV Growth 1.50%

CV ROE 8.11%

Cost of Equity 5.36%

Beta 0.547

Risk Free 2.71%

Equity Risk Premium 4.85%


12/31/2015 12/31/2016 12/31/2017 12/31/2018 12/31/2019

Equity DCF Model

Free Cash Flow to Equity 529.2 2059.5 501.9 522.6 391.4

Terminal Value 7,758.4

Discount Factor 1.04 1.11 1.18 1.25 1.25

Discounted FCFE 506.8 1857.5 426.4 418.3

Discounted Terminal Value 6,208.8

Present Value of Equity DCF 9,417.8

- ESOP 298.8

Net Value 9,119.0

Shares Outstanding 127.4

Value per Share 71.60

Equity EP Model

Equity Economic Profit 154.9 122.2 158.6 139.0 150.3

Terminal Value 2,995.8

Discount Factor 1.04 1.11 1.18 1.25 1.25

Discounted EEP 148.4 110.2 134.7 111.3

Discounted Terminal Value 2,397.5

Present Value of Equity EP 2,902.1

Beg. Total Stockholders' Equity 7,118.6

Equity Value 10,020.7

- ESOP 298.8

Net Value 9,721.9

Shares Outstanding 127.4

Value per Share 76.33


Dividend Discount Model (DDM) or Fundamental P/E Valuation Model

Key Assumptions

CV growth 1.50%

CV ROE 8.11%

Cost of Equity 6.16%

Beta 0.547

Risk Free 2.71%

Equity Risk Premium 4.85%


Dividend Discount Model

Earnings per Share 4.10 3.91 3.58 3.46 3.57

Dividend 0.0 0.0 0.0 0.0 0.0

Intrinsic Value 81.7

Discount Factor 1.04 1.11 1.18 1.25 1.25

Discounted Values 65.37

PV Dividend Discount Model 65.37


Relative Valuation Models

EPS EPS

Ticker Company Price 2015E 2016E P/E 15 P/E 16 P/Book P/TBV

AXS AXIS Capital $51.61 $4.50 $4.71 11.5 11.0 1.00 1.03

ENH Endurance Specialty $64.30 $6.16 $6.20 10.4 10.4 0.90 0.95

XL XL Group $37.33 $3.16 $3.57 11.8 10.5 0.94 0.90

PRE PartnerRe $114.96 $9.50 $9.25 12.1 12.4 0.77 0.88

RNR RenaissanceRe $100.93 $8.66 $9.25 11.7 10.9 1.12 1.12

EMCI EMC Insurance Group $32.59 $2.90 $2.62 11.2 12.4 0.85 0.88

ACE ACE Limited $112.21 $9.39 $9.67 11.9 11.6 1.24 1.56

AZSEY Allianz SE $17.65 $1.54 $1.57 11.5 11.2 0.97 1.30

Average 11.5 11.3 0.97 1.08

ACGL Arch Capital Group Ltd. $62.93 $4.10 $3.91 15.3 16.1 1.35 1.43

Implied Value:

Relative P/E (EPS15) $ 47.24

Relative P/E (EPS16) $ 44.16

Relative Price/Book $ 43.71

Relative Price/Tangible Book $ 47.62

Relative Value* $ 45.67

*Relative Value used 2/3 weight from Price/Book and Price/Tangible Book, 1/3 weight from 2015 and 2016 Price/Earnings.


Key Management Ratios


Liquidity Ratios

Current Assets 4,661.4 5,120.8 4,556.4 4,625.7 5,131.6 5,156.3 5,177.2 5,388.0

Current Liabilities 11,635.5 12,081.5 12,947.1 13,585.0 13,952.9 14,540.0 15,098.1 15,662.1

Current Ratio 40.1% 42.4% 35.2% 34.0% 36.8% 35.5% 34.3% 34.4%

Cash & Cash Equivalents 371.0 434.1 485.7 285.9 618.6 416.2 212.9 223.3

Current Liabilities 2,702.3 3,256.8 3,910.6 4,187.1 4,367.1 4,666.6 4,928.4 5,187.4

Cash Ratio 13.7% 13.3% 12.4% 6.8% 14.2% 8.9% 4.3% 4.3%

Activity or Asset-Management Ratios

Expenses 966.9 1,026.2 1,248.3 1,298.2 1,210.4 1,218.7 1,257.8 1,293.9

Earned Premiums 2,935.1 3,146.0 3,593.7 3,709.6 3,801.6 3,886.1 3,970.3 4,043.5

Expense Ratio 32.9% 32.6% 34.7% 35.0% 31.8% 31.4% 31.7% 32.0%

Net Investment Income 294.1 265.7 297.9 313.6 273.2 293.2 294.4 305.4

Total Investments 12,435.0 13,843.0 15,033.0 15,634.4 14,070.9 14,633.8 15,072.8 15,525.0

Return on Investments 2.4% 1.9% 2.0% 2.0% 1.9% 2.0% 2.0% 2.0%

Net Income 557.7 687.8 812.4 514.7 482.9 436.3 414.8 421.9

Average Total Assets 17,479.3 18,691.4 20,787.8 22,387.7 22,204.1 21,971.6 22,570.6 23,208.5

Return on Assets 3.2% 3.7% 3.9% 2.3% 2.2% 2.0% 1.8% 1.8%

Net Income 133.8 133.7 127.4 125.5 123.6 121.7 119.9 118.1

Average Shareholders’ Equity 4,898.7 5,408.2 5,888.8 6,128.1 5,342.7 4,531.0 4,452.8 4,421.9

Return on Equity 2.7% 2.5% 2.2% 2.0% 2.3% 2.7% 2.7% 2.7%

Financial Leverage Ratios

Total Debt 400.0 900.0 950.5 950.0 950.0 1,050.0 1,050.0 1,150.0

Total Assets 17,816.8 19,566.1 22,009.5 22,765.9 21,642.3 22,300.9 22,840.4 23,576.6

Debt Ratio 2.2% 4.6% 4.3% 4.2% 4.4% 4.7% 4.6% 4.9%

Total Liabilities 12,647.9 13,918.6 14,890.9 15,631.4 16,054.4 16,749.1 17,367.3 18,044.4

Shareholders' Equity 5,168.9 5,647.5 6,130.1 6,126.1 4,559.3 4,502.7 4,403.0 4,440.8

Debt-to-Equity Ratio 2.4 2.5 2.4 2.6 3.5 3.7 3.9 4.1

Long-Term Debt 400.0 800.0 800.0 850.0 850.0 900.0 900.0 950.0

Long-Term Debt & TSE 5,568.9 6,447.5 6,930.1 6,976.1 5,409.3 5,402.7 5,303.0 5,390.8

Capitalization Ratio 7.2% 12.4% 11.5% 12.2% 15.7% 16.7% 17.0% 17.6%

Profitability Ratios

Incurred Losses and Expenses 2,828.2 2,705.7 3,167.5 3,639.7 3,692.4 3,849.6 3,941.3 4,031.1

Earned Premiums 2,935.1 3,146.0 3,593.7 3,709.6 3,801.6 3,886.1 3,970.3 4,043.5

Combined Ratio 96.4% 86.0% 88.1% 98.1% 97.1% 99.1% 99.3% 99.7%

Net Income 557.7 687.8 812.4 514.7 482.9 436.3 414.8 421.9

Revenue 3,412.9 3,455.7 4,004.0 4,169.3 4,197.7 4,302.8 4,375.9 4,473.1

Return on Revenue 16.3% 19.9% 20.3% 12.3% 11.5% 10.1% 9.5% 9.4%

Net Income 582.8 709.7 834.4 536.6 504.8 458.2 436.7 443.8

Beginning TSE 4,628.5 5,168.9 5,647.5 7,118.6 7,134.5 5,587.9 5,551.8 5,473.1

Return on Equity 12.6% 13.7% 14.8% 7.5% 7.1% 8.2% 7.9% 8.1%

Sensitivity Analysis

Equity Risk Premium

Impact on DCF Value $ 71.60 3.5% 4.0% 4.5% 4.9% 5.5% 6.0% 6.5%

0.400 93.32 88.86 84.86 84.86 77.98 75.00 72.27

0.450 89.39 84.86 80.83 80.83 73.95 70.99 68.29

0.500 85.82 81.25 77.21 77.21 70.37 67.45 64.80

Beta 0.547 82.76 78.18 74.15 74.15 67.36 64.49 61.88

0.600 79.58 75.00 70.99 70.99 64.30 61.47 58.92

0.650 76.83 72.27 68.29 68.29 61.70 58.92 56.43

0.700 74.29 69.76 65.83 65.83 59.33 56.61 54.17

Cost of Equity

Impact on DCF Value $ 71.60 4.0% 4.5% 5.0% 5.4% 6.0% 6.5% 7.0%

0.00% 68.26 68.20 68.14 68.10 68.03 67.97 67.91

0.50% 69.24 69.17 69.11 69.06 68.98 68.92 68.86

1.00% 70.40 70.33 70.26 70.21 70.12 70.05 69.98

Continuous Growth Rate 1.50% 71.81 71.73 71.65 71.60 71.50 71.42 71.35

2.00% 73.56 73.47 73.38 73.32 73.21 73.13 73.05

2.50% 75.79 75.69 75.59 75.52 75.39 75.30 75.21

3.00% 78.72 78.60 78.49 78.41 78.26 78.16 78.05

Cost of Equity

Impact on DDM Value $ 65.37 4.0% 4.5% 5.0% 5.4% 6.0% 6.5% 7.0%

0.00% 50.17 50.16 50.16 50.15 50.15 50.14 50.13

0.50% 54.35 54.34 54.33 54.33 54.32 54.31 54.31

1.00% 59.34 59.33 59.32 59.31 59.31 59.30 59.29

Continuous Growth Rate 1.50% 65.39 65.38 65.38 65.37 65.36 65.35 65.34

2.00% 72.90 72.90 72.89 72.88 72.87 72.86 72.85

2.50% 82.47 82.46 82.45 82.44 82.43 82.42 82.41

3.00% 95.06 95.04 95.03 95.02 95.01 95.00 94.98

Investment Asset Devaluation (loss) in 2016

Impact on DCF Value $ 71.60 -20.0% -16.0% -13.0% -10.0% -7.0% -4.0% 0.0%

-3.00% 61.37 60.40 59.67 58.94 58.21 57.48 56.51

-1.00% 65.59 64.62 63.89 63.16 62.43 61.70 60.73

1.00% 69.81 68.84 68.11 67.38 66.65 65.92 64.95

Insurance Premiums 3.00% 74.03 73.06 72.33 71.60 70.87 70.14 69.16

Growth in 2016 5.00% 78.25 77.27 76.54 75.81 75.08 74.35 73.38

7.00% 82.46 81.49 80.76 80.03 79.30 78.57 77.60

9.00% 86.68 85.71 84.98 84.25 83.52 82.79 81.82

arch capital group ltd. (acgl) april 20, 2015tippie.biz.uiowa.edu/henry/reports15/acgl_sp15.pdf ·...

Documents