No. of Recommendations: 5
This is the 4th part of a 5 segment piece on Arch Capital Group Holding Ltd. (ACGL), this time focusing on growth and risk.

Updated values and quick summary:

Framework structure:

1) Valuation

2) Operational Reality

3) Company History/Background

4) Operational Growth/Risk

5) Establishing Price Target and/or exit conditions

1) Valuation

Trailing P/E = 7.59
Trailing FCF/EV = 1.69

Analysts Growth Est. (5yr) = 20%
Past Growth (5yr) = 8.9%
Industry predicted growth (5yr) = 12.4%

Pondered growth average (20+8.9+10.95)/3 = 13.77% <- This one is the one I'll be using

We will try and justify how reasonable this growth is in section 4 - Operational growth and risk

FCF/EV/G = 0.12

2) Operational Reality

I will subdivide this section into:

(1)- Industry
(2)- Company operations
(2.1)- Small description
(2.2)- Management
(2.3)- Operational metrics
(2.4)- Company's equity makeup and balance sheet

This section's content can be found on a previous post:

3) Company History/Background

This section's content can be found on a previous post:

4) Operational Growth/Risk

This section focuses on the various risks and growth opportunities for both ACGL's business and the stockholders opportunity by itself. The risk section has a specific substructure:

(1)- Sector risks
(2)- Industry risks
(3)- Company operational risks:
(4)- Other risks

The structure is self-explanatory.

Moving on:

ACGL's growth perspectives are closely intertwined with its risks. The company presents a diversified array of adversities that may, in the future, significantly impact earnings and cash flow.


Sector risks:
-Interest rates.

Industry risks:
-Cyclicity associated with the "soft" and "hard" markets of the insurance business.

Company operational risks:
-Natural catastrophes that offset the obtained balance between received premiums and claim payments.

Other risks:
-Abuse of voting and decision making privileges by the preferred shares stockholders.
-Abusive options issuing in favor of the preferred shares stockholders.

There are other "negligible" risks, described in detail in the company's 10-K. But those are associated more with lost of key operational personnel or increase in the combined ratio due to the lack of underwriting efficiency. I will ignore those because, in the big picture, they aren't particularly relevant.

So lets focus on the risks listed above:

Interest rates: Since part of the (re)insurance business is investing the "insurance float" in bond market, equity market, currency market or any other investment vehicle, the increase in interest rates affects the return potential of those same investments. But since management as already stated that it is comfortable in investing in low risk/high income markets (like bonds), and since the investment activity is only a small part of ACGL's activity, this risk seems contained.

Cyclical nature: The insurance industry is characterized by having "soft" and "hard" cycles. Those cycles define the competitiveness of the market and subsequential average operating margins (or, in this case, combined ratios). There is no defined period for an insurance market cycle, it might last 2 years, it might last a full decade. Historically those cycles have been characterized as being of either an extreme degree of competition (where insurers would support underwriting losses to guarantee increase in "insurance float") or by a great deal of underwriting sobriety (refusing to underwrite policies that aren't profitable). We are currently in that last state, defined has a "hard" market. The main question is: when is it going to fade and give place to a more competitive "soft" market? The risk associated with the cyclical nature of the insurance industry is linked with the predictability of the operational efficiency (in this case the difference between forecasted combined ratio and real combined ratio). ACGL has continually stressed that it might have difficulties in retaining the same operational efficiency in a "soft" market.

Company operational risks: The biggest operational risk that a small/mid sized insurance company like ACGL (which operates in the catastrophe segment) faces, is the probability that a sequence of large catastrophes in successive events might result in claim payments that exceed it's reserves. This is a very real risk, but with a very good upside to it: a high succession of cat events, if survived by the insurance company, justify a large increase in the value of premiums industry wide, there by contributing to the continuity or emergence of a "hard" cycle. <- More on this at the end of this post

Other risks: Unfortunately, by far the biggest risks associated with ACGL have nothing to do with the company itself, but with the specificities of the common shareholders position.
With 53% of the shares outstanding being preferred and owned by insiders, the common stockholders have no guarantees that the board won't act against their interests - namely buying back those preferred shares at exorbitant prices.


Growth wise ACGL clearly presents a lot of opportunities. With an estimated growth rate of 20% for the next 5 years, ACGL is clearly ahead of the rest of both its industry and segment ,who average a 12.33% estimated growth.

There are good reasons for this estimate. First, every single growth metric is accelerating. Cash flow, return on equity, combined ratio, underwritten premiums, all these have in the past 3 years grown at continuously increasing speeds. So, although I find the 20% annual growth rate a bit excessive, I believe that at least a 15% growth rate for the next 5 years is viable.

As way to "smooth" that number I chose to average it with past 5 years growth, industry predicted growth and forecasted growth, there by arriving to the 13.77% number used in valuation and DCF calculations.

That's it for now. But before I end this post I would like to discuss ACGL's recent share price fluctuations (also observed in other reinsurers) and relate it with the industries perspectives regarding the "soft" and "hard" cycles.

Just as I said before, we are currently in a "hard" market, where underwriting is done with a great efficiency. The advent of hurricane Charlie and a forecasted loss of $40M for ACGL, contributed to some downwards adjustment of ACGL's price (aprox 3%). But, the imminent arrival of hurricane Frances resulted in a drastic gain in share prices industry wide (about 8% in 3 days in ACGL's case).

This means that, with the first hurricane, the market interpreted it as objective losses to the company's bottom line. But, with a second hurricane in such a small amount of time and of even bigger damage potential, the industry will have arguments to prolong the "hard" market cycle, readjust risk calculations upward, maintaining underwriting discipline and there by increasing operational margins with clear repercussions to the bottom line.


Print the post  


What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Community Home
Speak Your Mind, Start Your Blog, Rate Your Stocks

Community Team Fools - who are those TMF's?
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.