Arch Capital: Still The Best And Still Undervalued

Aug. 13, 2021 8:25 AM ETArch Capital Group Ltd. (ACGL)3 Comments11 Likes
Stephen Simpson profile picture
Stephen Simpson
17.53K Followers

Summary

  • Arch Capital had a great second quarter, with strong underwriting results across the board and strong premium growth.
  • Management is exploiting this hard market to expand underwriting in attractive opportunities across primary insurance and reinsurance, writing business well ahead of expected losses.
  • While the hard market won't last, Arch has shown it can make money in all kinds of markets, and the shares are undervalued today.

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In a still-hot insurance market, a "hard market" in industry-speak, I continue to believe that Arch Capital (NASDAQ:ACGL) is not only the best-run company out there, but still undervalued. While I don't typically cite share buybacks as proof of anything, given Arch's excellent historical track record with allocating capital, the fact that the company has been buying back shares at around 1.2x book when they're also underwriting seemingly all the business they can is a strong argument to me.

This hard market won't last, but Arch has always found ways to make money and do right by its shareholders, though it's not a year-in, year-out winner in the stock market. With the shares trading below my mid-$40's near-term fair value, I do think this is a name still worth considering at this level.

A Strong Quarter All Around

There was a pretty wide spread of estimates for certain line-items on the earnings statement (like underwriting income), but all in all this was a strong quarter for Arch. At the bottom lines, after-tax operating income was well ahead of last year's level, up about 40% sequentially, and about 20% higher than the average sell-side target. In EPS terms, that meant an $0.18/share beat.

Net premiums earned rose more than 4% this quarter, with growth in Insurance (up 26%) and Reinsurance (up 9%) offsetting weakness in Mortgage Insurance (down 9%). Investment income was down 12%, but still ahead of expectations. Helped by lower attritional losses in Insurance and Mortgage Insurance, underwriting income reversed a year-ago loss to $387M and beat expectations by a wide margin, led by Insurance and Mortgage Insurance, with positive results and sequential improvement in every business.

Book value per share rose 16% year over year and 5% sequentially to $32.02.

Taking Full Advantage Of A Hard Market

With insurance rates up another 10% and superior underwriting capabilities, Arch Capital is basically a kid in a candy store right now, and management is growing the business significantly.

Gross premiums rose 26% this quarter, with 19% growth in Insurance, 44% growth in Reinsurance, and 3% growth in Mortgage Insurance. Net written premiums rose 44% (or 42% on a core basis), with Insurance up 43%, Reinsurance up 64%, and Mortgage Insurance up 3%.

As the numbers may suggest, part of Arch's growth is coming from higher retention (net premiums growing faster than gross premiums). And clearly some is coming from the price increases. But I find it very significant that more than half (55%) is coming from new business or expanded business with existing customers.

As I said, management is seeing roughly 10% higher rates on average across its Insurance business, but claims inflation is more on the order of 3% to 5%, with a spread between general liability on the higher end (8% to 12%), and worker's comp on the other end (zero to slightly negative). Arch continues to see good opportunities in excess and surplus, while also significantly increasing its exposure to casualty and specialty reinsurance (while shrinking prop-cat).

Loss trends remain attractive. While Arch had some unusually large losses in the first quarter tied to the winter storms in Texas, that was largely due to the unusual nature of the storms (more personal lines losses). In Mortgage Insurance, default rates are still well above pre-pandemic levels (3.1% versus around 1.4% to 1.5%), but quite a bit of this is due to accounting rules (having to reserve on the basis of reported delinquencies) and borrowers choosing forbearance, and a lot of these defaults are expected to cure with no losses to Arch.

The Outlook

This hard market will fade at some point (though underwriters like W. R. Berkley (WRB) think it could last longer than the Street thinks), and Arch won't have the same attractive opportunities as they do now, but the benefits of this hard market should help results for years.

By the same token, however the market changes in a couple of years, Arch has shown they can adapt. Not only has Arch established strong models to inform their underwriting, but the corporate culture is built around making good decisions.

There are frequent, regular underwriting meetings, and these are almost "all hands on deck" affairs, with executive management, employees from the marketing department, and even interns joining the underwriting team for discussions of market conditions, where and what to write, loss attachment points and so on. On top of that underwriters are compensated through bonuses that include long-term clawback provisions, so there's no incentive to write bad business.

I'm modeling a couple of years of double-digit core earnings growth from Arch, followed by a slow-down towards mid-single-digit core earnings growth. If and when underwriting opportunities look less appealing, I would expect some accelerated returns of capital to shareholders - sharing the good times on a "tape delay" basis.

The Bottom Line

Between long-term discounted core earnings and near-term ROE-driven P/BV, I believe Arch shares should trade around $45 today, with longer-term annual return potential still in the double-digits. I suppose that doesn't make Arch a screaming bargain, but it's a decent entry price for what I believe to be the best-run insurance company out there and maybe one of the best-run companies in general.

This article was written by

Stephen Simpson profile picture
17.53K Followers
Stephen Simpson is a freelance financial writer and investor. Spent close to 15 years on the Street (sell-side, buy-side, equities, bonds); now a semi-retired raccoon rancher. That last part isn't entirely true. Probably.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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