Fitch Puts Ratings of Arch Capital Group (ACGL) on Watch Negative Amid United Guaranty Deal (AIG)
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Fitch Ratings has placed the following ratings of Arch Capital Group Ltd. (Nasdaq: ACGL) on Rating Watch Negative:
--Issuer Default Rating (IDR) at 'A';
--Senior unsecured notes at 'A-';
--Series C preferred shares at 'BBB+'.
Additionally, Fitch has affirmed the Insurer Financial Strength (IFS) ratings of ACGL's various subsidiaries at 'A+'. The Rating Outlook is Stable. A complete list of ratings is provided at the end of this release.
KEY RATING DRIVERS
Fitch's affirmation of ACGL's IFS ratings follows yesterday's announcement that it entered into an agreement to acquire United Guaranty Corporation (UGC) from American International Group, Inc. (AIG) for total consideration of $3.4 billion (approximately 64% cash and 36% stock). ACGL subsidiaries will also ultimately assume future UGC mortgage insurance business that is currently ceded to AIG under a quota share treaty. The close is expected in either late fourth quarter 2016 or early first quarter 2017, subject to regulatory and government-sponsored enterprise (GSE) approval.
The Negative Watch on ACGL's holding company ratings reflects increased financial leverage to finance the deal. Fitch's action also reflects an anticipated change for ACGL to a 'ring-fencing' environment classification from a 'group solvency' approach following the purchase of UGC, as the acquisition is likely to increase the amount of capital outside of the Bermuda group solvency environment. Under Fitch's rating criteria, a ring-fencing approach is applied to global groups that have more than 30% of capital or earnings from foreign subsidiaries. At year-end 2015, ACGL had 34% and 17% of capital and earnings, respectively, from foreign subsidiaries.
Fitch views the transaction as a slight credit negative to ACGL in the near term given the execution and integration risk inherent in an acquisition, as well as the increased financial leverage post-merger. Successful execution of this acquisition could provide longer term positive credit benefits related to the increased size/scale of the mortgage insurance business and the diversification of earnings and business profile.
Fitch believes that the most significant risks of the acquisition are the possible complications arising during the process of integrating the operations and risk management practices of UGC. This is particularly the case given UGC's relatively large size and ACGL's more limited acquisition experience. Fitch expects that ACGL will prudently manage UGC to the company's conservative underwriting and risk-management standards.
Favorably, the acquisition gives ACGL a leadership position in the currently profitable U.S. mortgage insurance sector, as UGC is the top mortgage insurance company by sales (22% market share). UGC adds $1 billion of annual premium written to ACGL's current $0.4 billion of mortgage premiums. This significantly increased size and scale should help the company to more profitably manage its mortgage business, providing overall expense savings. Also positive, UGC adds an extensive bank channel distribution to ACGL's dominant credit union distribution position.
The acquisition also increases ACGL's business diversification with a pro forma gross premiums written (GPW) business mix (excluding Watford Re) of 24% mortgage, 51% insurance and 25% reinsurance. This compares to 8%, 61% and 31%, respectively, for ACGL currently.
Financial leverage increases sizably from 11.9% at June 30, 2016 to approximately 20%-25% pro forma (depending on final Fitch equity credit). The increase is due to an expected $1.125 billion of debt issued to partially finance the cash consideration for the acquisition. The consideration will also include perpetual non-cumulative preferred shares (100% equity credit) to be issued by ACGL. In addition, ACGL expects to issue $975 million of convertible non-voting perpetual preferred stock (either 100% or 50% equity credit depending on final terms) to AIG as stock consideration for the acquisition.
Fitch would expect to downgrade the holding company ratings by one notch following the increase in financial leverage or upon the closing of the UGC acquisition.
Key rating triggers that could result in a downgrade of both the IFS and holding company ratings include difficulties experienced in the mortgage insurance operations, including failure to successfully integrate UGC, or sizable adverse prior-year reserve development. In addition, increases in underwriting leverage above 1.0x net premiums written-to-equity ratio or a financial leverage ratio above 25% could generate negative rating pressure.
ACGL's hybrid securities ratings could be lowered by one notch to reflect non-performance risk should Fitch view Bermuda's regulatory environment as becoming more controlling in its supervision of (re)insurers.
Key rating triggers that could result in an upgrade include continued improvement in ACGL's competitive market position while demonstrating favorable run-rate earnings and low volatility in the challenging (re)insurance environment, with a combined ratio in the low 90s; and successfully managing the expansion of its mortgage operations with the planned acquisition of UGC. In addition, continued growth in equity while maintaining a net premiums written-to-equity ratio of 0.8x or lower, a financial leverage ratio at or below 20%, and fixed charge coverage of at least 10x could generate positive rating pressure.
FULL LIST OF RATING ACTIONS
Fitch places the following ratings on Rating Watch Negative:
Arch Capital Group, Ltd.
--IDR at 'A';
--$300 million 7.35% senior unsecured notes due 2034 at 'A-';
--$325 million 6.75% series C non-cumulative preferred shares at 'BBB+'.
Arch Capital Group (U.S.) Inc.
--$500 million 5.144% senior notes due 2043 at 'A-'.
Fitch affirms the following ratings with a Stable Outlook:
Arch Reinsurance Ltd.
Arch Reinsurance Company
Arch Reinsurance Europe Underwriting Designated Activity Company
Arch Insurance Company
Arch Excess and Surplus Insurance Company
Arch Specialty Insurance Company
Arch Indemnity Insurance Company
Arch Insurance Company (Europe) Limited
--IFS at 'A+'.
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