2023-09-01 17:59:31 ET
Summary
- Arch Capital Group Ltd.'s recent price appreciation brings it closer to fair value.
- The company has seen significant growth in net income over the past five years, attributed to its ability to thrive in a rising rates environment.
- Arch Capital benefits from higher investment income, improved underwriting profit, favorable investment portfolio, enhanced reserves, and diversification. However, it faces various risks in the insurance industry.
Finding hidden gems in the market is my primary passion. I love reading through 10-k’s and government reports. I enjoy finding opportunities that others might ignore. This is a primary part of being a deep value investor.
Over the last two months, I have challenged myself to look at over 100 companies that I knew little about. Most of these companies turn out to be something that I would never buy, but sometimes you find the proverbial gold at the end of the rainbow.
Arch Capital Group Ltd. (ACGL) appears to be one of those great companies that has returned value to shareholders at an amazing rate. The max chart tells a compelling growth story. The recent price appreciation has brought Arch Capital into its fair value range and makes it a current hold. I would be interested in shares at prices under $45, but I do not expect that to happen in the near future.
Arch Capital Group Ltd. and its subsidiaries are global providers of insurance, reinsurance, and mortgage insurance products. The company's extensive offerings span various sectors, including primary and excess casualty insurance, directors' and officers' liability, property, energy, marine, and aviation insurance, as well as a range of specialty coverages such as travel insurance and commercial surety products. With a diverse portfolio of financial-related and liability insurance solutions, Arch Capital is a key player in the insurance industry, serving clients worldwide.
With a market cap of over $22 billion, it would be hard to call Arch Capital a hidden gem. However, with only five thousand followers on Seeking Alpha, I am confident that it is relatively unknown to retail investors.
Over the last five years, Arch Capital has seen net income triple from $758 million to over $2.2 billion dollars.
Part of these gains can likely be attributed to Arch Capital’s ability to thrive in a rising rates environment. Investments that the company can make with its current float are providing a higher return than in the past.
Since Powell and the Fed have seemingly committed to higher rates for longer and even hinted at possibly raising rates in the future as indicated here , this gives Arch Capital a major tailwind over the next few years.
Tailwinds
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Higher Investment Income: In a high-rate environment, the returns on fixed-income investments, such as bonds, tend to be more attractive. Insurance companies like Arch Capital often invest their premium income in bonds and other interest-bearing securities. When interest rates are higher, the yields on these investments increase, leading to higher investment income.
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Improved Underwriting Profit: Insurance companies generate profits not only from their investments but also from their core underwriting activities. In a high-rate environment, insurers can potentially charge higher premiums for policies, leading to increased underwriting profits. This is because they can earn more income from the premiums received before having to pay out claims.
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Favorable Investment Portfolio: Insurers may hold a significant portion of their investment portfolio in fixed-income assets. In a high-rate environment, the market value of existing bonds may temporarily decrease as newer bonds with higher yields become available. However, as these older bonds mature, insurers can reinvest in higher-yielding securities, potentially improving the overall yield on their investment portfolio over time.
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Enhanced Reserves: Insurance companies are required to set aside reserves to cover future claims and liabilities. In a high-rate environment, the returns on these reserves can be more substantial, helping insurers better manage their long-term obligations.
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Diversification: Arch Capital, being a global insurer and reinsurer, can benefit from geographic diversification. If interest rates rise in certain regions or markets, the company may allocate its investments to those areas, taking advantage of higher yields.
Risks
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Underwriting Risk: Arch Capital underwrites various insurance and reinsurance products, and there is inherent risk associated with these underwriting activities. This risk includes unexpected catastrophic events, adverse changes in claims experience, and exposure to large losses that could impact the company's profitability.
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Investment Risk: As an insurer, Arch Capital invests a substantial portion of its assets in fixed-income securities and other investments. Investment risk arises from factors such as credit risk (default by issuers), interest rate risk (fluctuations in bond prices due to changes in interest rates), and market risk (volatility in equity markets). A significant downturn in the investment portfolio could lead to investment losses.
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Catastrophic Events: Natural disasters, such as hurricanes, earthquakes, or major weather events, can result in a surge of insurance claims. Arch Capital is exposed to catastrophe risk, and a series of large catastrophic events could strain its financial resources and capital adequacy.
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Regulatory and Compliance Risk: Insurance and reinsurance companies operate in a highly regulated environment. Changes in regulations, compliance failures, or legal actions can impact the company's operations and financial performance.
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Market Competition: Arch Capital faces competition from other insurers and reinsurers. Competitive pressures may lead to lower premium rates and reduced underwriting profitability.
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Interest Rate Risk: Arch Capital holds investments in fixed-income securities, and fluctuations in interest rates can impact the valuation of its investment portfolio. Rising interest rates can lead to mark-to-market losses on bonds.
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Credit Risk: The company may face credit risk from its investment portfolio and counterparties. Defaults by bond issuers or counterparty defaults in derivative transactions can result in financial losses.
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Mortgage Insurance Risk: Arch Capital's mortgage insurance business is sensitive to the housing market. A downturn in the housing market can lead to increased mortgage insurance claims and losses.
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Reserve Adequacy: Insurance companies need to maintain adequate reserves to cover future claims. Inadequate reserving can lead to unexpected losses and financial instability.
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Currency Exchange Risk: Arch Capital operates internationally, which exposes it to currency exchange rate fluctuations. Adverse currency movements can impact reported earnings and financial results.
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Liquidity Risk: Liquidity risk arises when Arch Capital faces difficulty in meeting its short-term financial obligations. This risk can be exacerbated during periods of economic stress or market disruptions.
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Operational Risk: Operational risks include errors in underwriting, claims processing, and other core business functions. Cybersecurity threats also pose operational risks.
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Acquisition Integration Risk: Arch Capital has a history of acquisitions. Integrating acquired companies and portfolios can be challenging, and any integration issues could impact the expected benefits of acquisitions.
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Economic Downturn: A broader economic downturn can reduce demand for insurance products and impact investment returns, affecting Arch Capital's revenue and profitability.
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Pandemic Risk: While the impact of the COVID-19 pandemic has been managed reasonably well by the insurance industry, future pandemics or unexpected developments related to COVID-19 could pose risks to the company.
Many of these risks are just part of the insurance business. Throughout their history, Arch Capital has demonstrated that it can manage these risks and maintain profitability in most economic environments. Over the last ten years, Arch Capital has grown its assets from $19 billion to over $53 billion.
During the same period, book value has increased from $13 dollars a share to $37 dollars a share.
The company's diversification across various insurance lines allows it to spread risk, ensuring that if one segment faces difficulties, others can remain profitable. Robust risk management practices, including the use of advanced modeling tools and experienced underwriters, contribute to more accurate risk assessment and pricing. Arch Capital's role as a reinsurer enables it to transfer a portion of its risk to other reinsurers, reducing exposure to catastrophic events. With a strong financial foundation and a disciplined approach to underwriting, the company can weather losses from significant events while maintaining stability. Its global presence and commitment to geographic diversification further reduce the impact of localized issues.
Additionally, Arch Capital maintains a conservative investment strategy, prioritizing capital preservation over high investment returns. These factors, along with a history of compliance with regulatory standards and experienced management, collectively contribute to its ability to manage and mitigate risks effectively in the insurance and reinsurance industry.
Overall, there is a lot to like about how Arch Capital Group Ltd. conducts business. However, it currently trades near its historic average P/E of 12 and is currently fair valued. If the stock revisited its recent lows of $41, it would be a great deal. Although I currently would rate Arch Capital a hold, I think it is a great company that I will continue to follow and should be bought on dips. As always, please do your own due diligence before buying any positions and good luck investing. If you like this article, feel free to give me a like and follow. Thank you for reading.
For further details see:
Arch Capital: A Great Company At A Fair Price