S&P Lowers Outlook on Arch Capital Group Ltd (ACGL) to Negative Amid United Guaranty Deal
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S&P Global Ratings said it affirmed its 'A-' long-term counterparty credit rating on Arch Capital Group Ltd. (Nasdaq: ACGL) as well as its counterparty credit and financial strength ratings on its operating subsidiaries. At the same time S&P Global Ratings revised its outlook to negative from stable on all ratings on ACGL and its subsidiaries except for Arch Mortgage Insurance Co. (Arch MI), which continues to carry a positive outlook.
S&P Global Ratings also placed its 'BBB+' long-term counterparty credit and financial strength ratings on United Guaranty Corporation's U.S.-domiciled operating subsidiaries on CreditWatch with positive implications. The ratings on AIG United Guaranty Insurance (Asia) Ltd. (UGC Asia) remain on CreditWatch with negative implications, where they had been placed Jan. 27, 2016.
"The outlook revision on ACGL reflects execution risks inherent in the proposed acquisition," said S&P Global Ratings credit analyst Hardeep Manku. The acquisition of UGC accelerates ACGL's push into the U.S. primary mortgage insurance (MI) sector, complementing its own initiative started in 2014 through Arch MI. The combined UGC and Arch MI business will constitute one of the largest players in the sector, providing increased presence and scale benefits to ACGL. On a pro forma basis, MI would be the largest single business line both from a premium and capital perspective. While ACGL's strong competitive position will continue to be supported by a diversified re/insurance platform, in our view, the significant change in the business mix pursuant to the acquisition raises concentration risk. Such a large exposure, in our view, has implications and could hamper ACGL's ability to manage its business mix, ability to integrate the acquired business within its risk management framework, and execute on its opportunistic approach to cycle management. In addition, we believe there is pressure on capital adequacy as the capital requirements will increase significantly due to the capital-intensive nature of the MI business. Total consideration for the transaction is about $3.4 billion, financed through a combination of internal cash, debt, preferred stock, and equity as well as a possible pre-close dividend from UGC. The financing plan and the resultant capital structure would result in increased leverage over the next two years, but we would view them as neutral to the ratings.
We have placed our ratings on UGC's U.S. domiciled insurance operating entities on CreditWatch with positive implications based on our expectation that the ratings can benefit from additional support that would likely come through from the new group given the importance of the mortgage operations in ACGL's strategy. While the exact structure of the combined UGC and Arch MI operations is yet unclear, we believe UGC would be an important component of the group's strategy. In our view, UGC's capitalization is likely to stay at least at a moderately strong level, which along with our view of the company's adequate competitive position, should support the stand-alone profile. The ratings on UGC Asia remain on CreditWatch with negative implications, following American International Group Inc.'s announcement on Jan 27, 2016 that it is planning an IPO of 19.9% of UGC. We will look to resolve the CreditWatch following an assessment of the role of this entity and the level of group support under new ownership.
The negative outlook reflects elevated execution risk that is embedded in the transaction, as ACGL would need to incorporate risk controls around pricing, concentration, and tolerances in the newly acquired book. A large proportion of mortgage re/insurance business could also hamper its ability to strategically manage its business mix through effective risk-reward analysis taking into account market conditions and in line with its risk appetite. Furthermore, capitalization might weaken from our current expectation, pressuring the ratings.
The positive outlook on Arch MI reflects our expectation that there is potential for us to revise its group status to strategically important if there is further clarity around its relative importance within the combined operations.
The positive CreditWatch placement on rated U.S. domiciled entities of UGC reflects the potential for additional group support under the new ownership. UGC would likely become an important component in executing ACGL's strategy of enhanced presence in the U.S. primary MI market, which would positively influence our view of UGC's group status under ACGL.
We could lower the ratings over the next two years if:
- Our opinion of the company's ERM deteriorates due to ACGL being unable to enhance its risk controls and risk-reward framework to account for significant mortgage re/insurance business that may constrain its ability to effectively manage business mix to optimize risk-adjusted returns;
- ACGL's business mix is constituted mainly of mortgage re/insurance business, which could constrain our view of its competitive position;
- Capitalization weakens to below a very strong stress level; or
- Financial flexibility declines to less than adequate in case financial leverage increases to beyond 40% or fixed charge coverage drops to less than 4x, none of which is our base case.
We could affirm the ratings on Arch MI and revise the outlook to stable over the next 12-24 months if we lower the ratings on ACGL's core companies.
We could affirm our ratings on UGC and revise the outlook to stable over the next six-12 months if the company's role is reduced relative to Arch MI in the post-acquisition hierarchy, which would limit our view of its prospective group status, and if we lower its stand-alone capitalization assessment to upper adequate. We could lower the ratings on UGC Asia based on the relative importance of these operations to the rest of the group's mortgage insurance activities and level of group support, which may not support the current level of ratings.
Ratings on entities that are we do not assess as core are generally capped at one notch below the ratings on core subsidiaries.
We could affirm the ratings and revise the outlook to stable over the next two years if ACGL is successful in managing the related execution risks, including demonstration of a strong risk management framework that enables the company to maintain its strong competitive position, highlighting its continued ability to opportunistically manage its business mix, and maintains capitalization at very strong levels.
We could revise Arch MI's group status to strategically important and raise the ratings over the next 12-24 months based on increased clarity on its role within the group's larger combined U.S. MI operations, assuming the acquisition has been executed successfully.
We could raise the ratings on UGC by at least one notch over the next six-12 months if the transaction closes successfully and we view its group status to be moderately strategic or better. The ratings on UGC Asia will be limited by the group credit profile of ACGL, so we do not see any scope for higher ratings.
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