Description

Almost exactly 5 years ago, Gary9 recommended Arch Capital, the Bermudian insurance company.  For anyone interested in this idea I would recommend reading his thoughtful analysis before going on.  In the ensuing period, the stock has been a decent performer—up over 40% (and much more only last fall) in a down market.  But the performance of the company has been much stronger than the stock.   Two figures of merit:  Book value/share has almost doubled to $54.61 at 3/31. More strikingly, investments (netting out debt and preferred) have grown from $58/share to $157/share, or a CAGR of 22%/year. Qualitatively, Arch has successfully navigated through a soft underwriting cycle that now appears to be hardening, continued to demonstrate its conservative reserving philosophy and avoided major investment losses. 

Arch is an excellent company at a bargain price.  Management has practiced underwriting discipline—shrinking important lines of business where they believed a 15% ROE was unattainable and, hence, produced an average corporate ROE of 18% since inception in 2002.  As CEO Dinos Iordanou said at the AIFA Conference in March, “ We want to grow the business significantly when we [can] produce an adequate return.  And we want to shrink the business when the market gets extremely competitive.” This is easy to say but hard to do when most analysts and investors are preoccupied with top-line growth.

Investment Portfolio:

It’s worth spending a little more time scrutinizing the investment portfolio given the recent travails of many other insurance companies. As of March 31, Arch had $10.24 billion in total investments.  As noted above, for every dollar you invest today you get $2.80 in invested assets.  The entire portfolio is held at market value.  There are no public equities, no hedge funds and no private equity funds. Duration is 3 years (down a little from recent quarters), the average credit rating is AA+ and the embedded book yield is 4.17%.  Arch does have $1.2 billion in CMBS (62% non-agency), $1.7 billion in RMBS (24% non-agency) and $331 million in bank loans (held at 64% of par.  See http://www.archcapgroup.com/docs/ACGL-1Q-2009-Financial-Supplement.pdf for more detail.

Could there be more impairment in the portfolio?  Of course, but I wouldn’t think that the magnitude would be great in the scheme of things.  Furthermore, given the reinvestment of income and continued powerful cash flow from underwriting, it is highly likely that the portfolio will grow over time.

Reserves:

Buffett famously described insurance reserves as a self-graded exam.   Particularly in long-tailed companies like Arch, reserve deficiencies have been crippling to countless investors over the years.  So why am I confident that reserves are unlikely to become an issue here?  First, a word on the origins of Arch:  it was a corporate shell reorganized in the wake of September 11 to take advantage of reinsurance opportunities.  Accordingly, the company has no meaningful pre-2002 liabilities (asbestos).  Second, in recent years Arch has demonstrated a history of favorable reserve development:

2006:  $77MM

2007:  $185MM

2008:  $310MM

Q109:  $51MM

Third, 70% of Arch’s reserves fall into the Incurred but Not Reported category, suggesting that over time further favorable reserve development is likely (and current book value is understated).

Hard vs. Soft Market:

Anecdotal evidence suggests that insurance pricing is firming.  Here is CEO Iordanou in February, “We have seen significant deterioration of the [industry] balance sheet because of the financial crisis.  And at the same time we saw prospects of the insurance cycle turning.  And for that reason we suspended our share repurchases, preserving our excess capital because we truly believe that over ’09,  ’10 and beyond we will be able to deploy that capital in the business of underwriting.” 

In discussing Q1 results in April he noted that the “environment for reinsurance is actually better than we had anticipated” and that the “pricing environment continues to improve in the reinsurance sector and become more stable in the insurance sector.” This is the ultimate supply/demand business.  While demand is somewhat muted because of the worldwide recession, supply is down more for a variety of factors—most importantly balance sheet destruction at a number of prominent companies.

Continued demonstration of pricing power in upcoming quarters should result in strong price performance.  In both its early days in 2002-03 and again in the wake of Hurricane Katrina, Arch traded between 1.2-1.5X book. Sell-side analysts will get excited and momentum buyers will renew their interest.  But what if this is a head fake and the market remains soft?  I think management will remain disciplined—using both the excess capital they currently have and the significant capital which Arch can generate in an environment of flattish premiums to shrink the balance sheet.  In 2007 and 2008 Arch bought back over 15MM shares of stock at roughly $69/share.  Note that the two key metrics determining executive comp are ROE and growth in book value/share.  This management understands the power of capital management.

Catalyst

1.  Firming market and continued evidence of price increases.

2.  Underlying value.