Arch Capital Group Ltd (ACGL) Ratings Affirms by S&P

Moody's Investors Service, has affirmed the insurance financial strength ratings of Arch Capital Group Ltd.'s (Nasdaq: ACGL) principal operating subsidiaries at A1. In the same rating action, Moody's affirmed the ratings on Arch's senior unsecured debt at A3 and preferred stock at Baa2 (hyb). The outlook for the ratings is stable.

RATINGS RATIONALE

According to Moody's, Arch's ratings reflect its established operating platform and good spread of risk in specialty insurance and reinsurance, its strong equity capitalization and balance sheet unencumbered by legacy exposures, its strong profitability, its moderate financial leverage and strong liquidity at the holding company. These strengths are tempered by underwriting volatility and pricing uncertainty inherent in many of the company's chosen lines of business, which include catastrophe-exposed property risks and high excess layer casualty exposures. Additionally, two substantial initiatives of the group, the expansion of its mortgage insurance operations and its participation in Watford Re Ltd. (Watford Re), a reinsurer with a non-traditional, more aggressive investment mandate, are still in early stages of development.

In Moody's opinion, Arch's strong performance across a variety of financial metrics, including its longer-term profitability outperformance (with lower volatility) relative to most of its peers, continues to be supportive of the company's ratings. However, we note that Arch's initiatives in mortgage insurance and involvement with Watford Re, while still small relative to Arch's more prominent specialty insurance and reinsurance businesses, could alter Arch's business and financial profile longer term in ways that could be positive or negative from a credit perspective.

Arch's recent entry into the primary U.S. mortgage insurance market enhances its business diversification profile and provides an attractive market to deploy capital given the tighter, more conservative mortgage loan underwriting standards since the financial crisis and the current expected profitability on new business. However, Moody's also notes that this initiative carries some risks. In the near term, we believe that Arch's current lack of scale will adversely impact profitability, and the evolving competitive conditions and GSE capital requirements in the sector could result in lower long-term returns on this business than was originally anticipated. Additionally, the tail risk associated with mortgage insurance adds some additional complexity to the firm's enterprise risk management efforts.

Arch's other recent initiative involves the establishment of Watford Re Ltd., a Bermuda-based reinsurer capitalized primarily with third-party capital (Arch provided $100 million of equity for an 11% stake) and for which Arch serves as underwriting manager, demonstrates Arch's embrace of the rapidly evolving alternative reinsurance market. This could help the company differentiate itself from some of its competitors and leverages its underwriting infrastructure to gain fee income and the potential for profit-based incentive payments. However, we believe there could be reputational risk to Arch if the venture fails to execute on its business plan, which include certain operational aspects outside of Arch's direct control, including a more aggressive fixed income investment strategy managed by Highbridge Capital Management.

Going forward, Moody's noted that while there is unlikely to be positive rating pressure at Arch over the medium term, the following factors could enhance the firm's credit profile: 1) continued development of the core franchise; 2) reduced catastrophe exposures; 3) maintenance of adjusted financial leverage at levels below 15%; and 4) maintenance of gross underwriting leverage below 2.5x.

Conversely, the following factors could lead to negative ratings pressure: 1) returns on capital significantly below 10% across multiple years; 2) a decline in shareholders' equity (including share repurchases) by more than 10% over a rolling twelve month period; 3) adjusted financial leverage greater than 20%; and 4) gross underwriting leverage above 3x.

The following ratings have been affirmed with a stable outlook:

Arch Capital Group Ltd. -- senior unsecured debt at A3, preferred stock at Baa2(hyb), provisional senior unsecured shelf at (P)A3, provisional subordinated shelf at (P)Baa1 and provisional preferred shelf at (P)Baa2;

Arch Capital Group (U.S.) Inc. -- guaranteed senior unsecured notes at A3; guaranteed provisional senior unsecured shelf at (P)A3, guaranteed provisional subordinated shelf at (P)Baa1 and guaranteed provisional preferred shelf at (P)Baa2;

Arch Reinsurance Ltd. -- insurance financial strength at A1;

Arch Insurance Company (Europe) Ltd. -- insurance financial strength at A1;

Arch Reinsurance Company -- insurance financial strength at A1;

Arch Insurance Company -- insurance financial strength at A1;

Arch Specialty Insurance Company -- insurance financial strength at A1;

Arch Excess and Surplus Insurance Company -- insurance financial strength at A1.

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