Arch Capital Group Reports Comparable 4Q 2011 Results [Professional Services Close – Up]

Arch Capital Group said that net income available to common shareholders for the 2011 fourth quarter was $136.8 million, or $1.00 per share, compared to $227.7 million, or $1.51 per share, for the 2010 fourth quarter, and $410.5 million, or $2.97 per share for 2011, compared to $816.7 million, or $5.18 per share, for 2010.

In a release on February 14, the Company noted that after-tax operating income available to common shareholders of $126.8 million, or $0.92 per share, for the 2011 fourth quarter, compared to $129.5 million, or $0.86 per share, for the 2010 fourth quarter, and $303.6 million, or $2.20 per share, for 2011, compared to $491.1 million, or $3.12 per share, for 2010. All earnings per share amounts discussed in this release are on a diluted basis. All information in this release has been adjusted to reflect the three-for-one share split effected in May 2011.

The Company's book value per common share was $32.03 at Dec. 31, 2011, a 2.7 percent increase from $31.20 per share at September 30, 2011 and a 6.8 percent increase from $29.99 per share at Dec. 31, 2010. The Company's after-tax operating income available to common shareholders represented a 12.0 percent annualized return on average common equity for the 2011 fourth quarter, compared to 12.1 percent for the 2010 fourth quarter, and 7.2 percent for 2011, compared to 12.0 percent for 2010. After-tax operating income available to common shareholders, a non-GAAP measure, is defined as net income available to 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 and net foreign exchange gains or losses, net of income taxes. See page 7 for a further discussion of after-tax operating income available to common shareholders and Regulation G.

The Company's 2011 fourth quarter results included losses for current year catastrophic events of $70.8 million, net of reinsurance and reinstatement premiums. Such amount included $60.6 million from the severe flooding in Thailand and $5.4 million from an Australian hailstorm in the 2011 fourth quarter, with the remainder due to net increases in loss estimates from other catastrophic events. The Company's estimates for these events are 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 severe flooding in Thailand spanned several months between July and December 2011 and has had a significant impact on the Thai economy. Due to the size, duration and complexity of the event, substantial uncertainty remains regarding total covered losses for the insurance industry and the assumptions underlying the Company's estimates. Actual losses will depend to a great extent on claims from contingent business interruption coverage. The Company's actual losses from catastrophic events 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.

In establishing the reserves for losses and loss adjustment expenses, the Company has made various assumptions relating to the pricing of its reinsurance contracts and insurance policies and also has considered available historical industry experience and current industry conditions. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to the Company through Dec. 31, 2011. As actual loss information is reported to the Company and it develops its own loss experience, the Company will give more emphasis to other actuarial techniques. For a discussion of underwriting activities and a review of the Company's results by operating segment, see Segment Information in the Supplemental Financial Information section of this release.

The Company's investment portfolio continues to be comprised primarily of high quality fixed income securities with an average credit quality of AA/Aa1. The average effective duration of the investment portfolio was 2.99 years at Dec. 31, 2011, compared to 3.17 years at September 30, 2011 and 2.83 years at Dec. 31, 2010. Including the effects of foreign exchange, total return on the Company's investment portfolio was approximately 0.82 percent for the 2011 fourth quarter, compared to (0.07) percent for the 2010 fourth quarter. Excluding the effects of foreign exchange, total return was 0.95 percent for the 2011 fourth quarter, compared to (0.04) percent for the 2010 fourth quarter. Total return in the 2011 fourth quarter reflected a recovery in U.S. equity markets and relatively stable U.S. Treasury yields, partially offset by negative returns on certain investments funds discussed below.

Net investment income for the 2011 fourth quarter was $80.5 million, or $0.59 per share, compared to $90.6 million, or $0.60 per share, for the 2010 fourth quarter. The comparability of net investment income between the periods was influenced by the Company's share repurchase program. The pre-tax investment income yield was 2.72 percent for the 2011 fourth quarter, compared to 3.24 percent for the 2010 fourth quarter, reflecting the effects of lower prevailing interest rates available in the market.

The Company recorded $14.7 million of equity in net losses related to investment funds accounted for using the equity method in the 2011 fourth quarter, compared to $23.0 million of equity in net income for the 2010 fourth quarter. The Company's losses on its investment funds accounted for using the equity method in the 2011 fourth quarter resulted, in part, from the effect of weakness in global economic conditions (both in the U.S. and Europe) and general risk aversion in certain asset types. The Company uses the equity method on certain investments due to the ownership structure of these investment funds (e.g., limited partnership), where it does not have a controlling interest and is not the primary beneficiary. 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 market value of the underlying securities in the funds). Such investments are generally recorded on a one month lag with some investments recorded on a three month lag based on the availability of reports from the investment funds.

Consolidated cash flow provided by operating activities for the 2011 fourth quarter was $109.6 million, compared to $144.5 million for the 2010 fourth quarter. The decline in operating cash flows in the 2011 fourth quarter primarily resulted from the collection of profit commissions in the 2010 fourth quarter from Flatiron Re Ltd., a Bermuda reinsurance company that assumed certain lines of property and marine business underwritten by the Company in the 2006 and 2007 underwriting years.

During 2006, the Company invested $50 million in Aeolus LP, which operates as an unrated reinsurance platform that provides collateralized property catastrophe protection to insurers and reinsurers on both an ultimate net loss and industry loss warranty basis. This investment is accounted for using the equity method on a three month lag (based on the availability of their financial statements) with changes in the carrying value recorded in other income (loss). As of Dec. 31, 2011, the carrying value of this investment, after taking into account the $67 million in cash distributions received through Dec. 31, 2011, was approximately $35 million, with no unfunded capital commitments. The Company recorded a loss of $5.7 million on its investment in Aeolus in the 2011 fourth quarter. Based upon information currently available to the Company as to the 2011 fourth quarter results of Aeolus, the Company estimates that it will record in its 2012 first quarter results a loss in the range of $8 million to $10 million with respect to this investment. However, actual losses may vary materially from the estimates due to the inherent uncertainties in making estimates for catastrophic events, as discussed earlier.

In addition, the Company's 2012 first quarter results will be impacted by the January 2012 Costa Concordia marine event. Although it is early in the estimation process, the Company's preliminary estimate of losses for the event is in the range of $18 million to $35 million, net of reinsurance and reinstatement premiums. The Company's estimates for the Costa Concordia event is based, in part, on preliminary estimates of industry insured losses ranging from $850 million to $2.0 billion. The Company's actual losses from this event may vary materially from the estimates due to the inherent uncertainties in making such determinations.

For 2011, the Company's effective tax rates on income before income taxes and pre-tax operating income were a benefit of 2.2 percent and 3.7 percent, respectively, compared to an expense of 0.9 percent and 0.5 percent, respectively, for 2010. The Company's effective tax rates may fluctuate from period to period based on the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction. The Company's quarterly tax provision is adjusted to reflect changes in its expected annual effective tax rate, if any. In addition, the Company's Bermuda- based reinsurer incurs federal excise taxes for premiums assumed on U.S. risks. The Company incurred $9.3 million of federal excise taxes for 2011, compared to $11.5 million for 2010. Such amounts are reflected as acquisition expenses in the Company's consolidated statements of income.

Net unrealized foreign exchange gains or losses result from the effects of revaluing the Company's net insurance liabilities required to be settled in foreign currencies at each balance sheet date. Historically, the Company has held investments in foreign currencies which are intended to mitigate its exposure to foreign currency fluctuations in its net insurance liabilities. However, changes in the value of such investments 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. As a result of the current financial and economic environment as well as the potential for additional investment returns, the Company may not match a portion of its projected liabilities in foreign currencies with investments in the same currencies, which could increase the Company's exposure to foreign currency fluctuations and increase the volatility of the Company's shareholders' equity.

Net foreign exchange gains for the 2011 fourth quarter were $12.6 million (net unrealized gains of $16.4 million and net realized losses of $3.8 million), compared to net foreign exchange gains for the 2010 fourth quarter of $6.0 million (net unrealized gains of $8.5 million and net realized losses of $2.5 million). Net foreign exchange gains for 2011 were $17.4 million (net unrealized gains of $23.5 million and net realized losses of $6.1 million), compared to net foreign exchange gains for 2010 of $28.1 million (net unrealized gains of $29.5 million and net realized losses of $1.4 million). The 2011 fourth quarter net foreign exchange gains primarily resulted from the strengthening of the U.S. Dollar against the Euro during the period.

At Dec. 31, 2011, the Company's capital of $5.03 billion consisted of $300.0 million of senior notes, representing 6.0 percent of the total, $100.0 million of revolving credit agreement borrowings due in August 2014, representing 2.0 percent of the total, $325.0 million of preferred shares, representing 6.5 percent of the total, and common shareholders' equity of $4.30 billion, representing the balance. At Dec. 31, 2010, the Company's capital of $4.91 billion consisted of $300.0 million of senior notes, representing 6.1 percent of the total, $100.0 million of revolving credit agreement borrowings, representing 2.0 percent of the total, $325.0 million of preferred shares, representing 6.6 percent of the total, and common shareholders' equity of $4.19 billion, representing the balance.

Arch Capital Group provides insurance and reinsurance.

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