Arch Capital Group Q3 Earnings: Growth Priced In, Hold (ACGL)

Arch Capital Group Ltd., (NASDAQ:ACGL) a company that provides insurance, reinsurance, and mortgage insurance products to the global marketplace, is coming off a decent earnings report, which beat on the top and bottom lines; not easy to do in the current economic and financial environment it has faced.

There are some mixed outlooks for insurance going forward, with Property & Casualty (P&C) facing some headwinds, as well as the investment side of the insurance business, which is underperforming, primarily because of the interest rate hikes that have put a lot of downward pressure on stocks, and also the bond market which has been getting hit hard at the same time.

In this article we’ll look at the various insurance units and how they are performing, uncertainty concerning the impact of Hurricane Ian, its latest earnings report, and the prospects for the company in the current economic climate.

Latest earnings report

The last quarter was good for the company, as it reported revenue of $2.72 billion, up 31.21 year-over-year, beating estimates by $272.93 million. EPS was $0.28, beating by $0.10, but down from the $0.74 in earnings last year in the same reporting period. Over the last year ACGL has surpassed earnings expectations in three out of the four quarters.

Net premiums earned $2.47 billion, up 28 percent over last year in the same quarter, beating estimates by $20 million. Net premiums written in the third quarter were up a solid 19 percent over the third quarter of 2021.

How the insurance units performed

The Mortgage insurance group performed surprisingly well in the quarter. It underwrote $299 million in income. While higher interest rates had an impact on new origination volume, CFO Francois Morin added that higher interest rates “also improve the persistency of our portfolio,” which he stated climbed to 75.4 percent in the quarter, a gain of 4 percent. That resulted in an increase in its U.S. primary mortgage insurance imports to close to $295 million.

Some of the positive factors in this segment of its insurance business include, 90 percent of homeowners having an equity of at least 15 percent in homes, which protects against claims. The quality of credit is also very high, with its average borrower having an excellent FICO score of 748. Last, he noted the unemployment rate remains at historical lows; although I would add a lot of that has to do with lower workforce participation than in the past.

Even though the numbers were good in mortgage insurance for ACGL, Morin did say in the near term its P&C business would probably generate better returns, suggesting to me the last quarter hadn’t experienced the rapidly increasing interest rates that the market is experiencing now.

The Reinsurance Segment generated gross premiums of $1.6 billion, up 30.9 percent year-over-year. Net premiums of $1.1 billion were up 73.6 percent from the third quarter of 2021; minus adjustments, it was 37.9 percent higher. Net premiums earned were $1 billion.

Concerning P&C, CEO Marc Grandisson said competition is strong in that segment, but remains rational. That suggests there isn’t a lot of lowball offers preferred in order to win new business. More than likely that is because of the floods in Europe and Hurricane Ian, which is providing more of a sober look at this segment of the insurance industry.

Grandisson did say that the opportunity in cyber insurance is increasing as businesses grasp the risk they have in this field. I have no doubt cyber insurance is going to be a high-growth part of the insurance business.

As for ACGL’s exposure to Hurricane Ian, management said it’s too early in the claim adjusting process to provide final numbers on what the company’s loss exposure will be; it’ll take “quite some time.”

But generally speaking, the company is looking at an overall industry loss in the range of $50 billion to $60 billion. Some of the variables there include “the unknown impacts of inflationary trends, potential supply and demand imbalances and labor and material costs.”

Another factor noted was the recently introduced Florida Property Insurance Reforms, which could result in insurers paying out for storm search claims and other related costs. That said, management believes its market share in Hurricane Ian will be similar to what it has paid out in similar events.

Unsurprisingly, its investment returns remained weak in the third quarter. Pre-tax net investment income was $129 million, with total return on investment resulting in a loss of 3.01 percent.

The company sees there being negative investment markdowns in the current interest rate environment, but added that as its fixed income securities mature over the next few years it expects to recover a significant amount of that.

Conclusion

With interest rates expected to continue to increase, at least over the next two to three months, the mortgage business of ACGL, while enjoying good numbers in the third quarter, will likely slowdown in growth until the market is convinced the Federal Reserve has made a pivot.

For that reason, I believe management is guiding for its P&C segment to be a more significant catalyst for growth in 2023. I think that’s an accurate assertion.

As mentioned earlier, the cybersecurity market is a growing one, and the concerns over current market conditions and global events is, in my opinion, causing companies to reassess their risks.

On the investment side, the use of the float isn’t going to be as effective as it has been because of the use of the DCF model in projecting future cash flows. In other words, the model takes into account the increase in interest rates which puts downward pressure on margins and earnings in relationship to stocks, which is the major reason for the market’s recent poor performance.

Again, until the Fed pivots, that’s going to remain in play.

Even though investors will have to wait until the impact from Hurricane Ian on the company, it also provides opportunities to raise premiums because of concerns over protection from those types of catastrophes.

Looking ahead, 2023 promises to be a challenging year for ACGL. If it’s able to once again surprise to the upside like it’s done in three of the last four quarters in relationship to earnings, its share price should get a nice boost.

On the other hand, if P&C growth isn’t enough to offset expected weaknesses in the company’s other segments, 2023 could be more of a down year for the company.

A concern I have is since May 2020, when the company was trading at about $21 per share, it has soared to its current price of a little over $56 per share as I write. Under current conditions, if the company does falter in the near term, it could get hammered like it did in early 2020 when it collapsed by over 50 percent.

That was obviously related to the pandemic, but the negative catalysts now at the macro level and out of the company’s control, could generate similar consequences. If that’s how it plays out they would be temporary, but potentially very deep.

So far the company has shown resilience, and if it can hold out for a couple of quarters, it could avert another steep collapse in its share price. If the recession we’re now in goes deep, it’s going to hit shareholders hard.

My conclusion is a lot of ACGL’s growth is already priced in, even with its recent promotion to the S&P 500, which will give it more exposure and liquidity. But that can work both ways as well.

ACGL should continue to do very well over the long term, but if it underperforms in the next couple of quarters, it will likely take a big hit to its share price. While it would be painful to shareholders, it would also provide a great entry point to enter or add to a position.