Arch Downgraded Following Acquisition Of UGC
Moody’s Investors Service has downgraded the senior unsecured debt rating of Arch Capital Group Ltd. to Baa1 from A3 and the insurance financial strength [IFS] ratings of Arch Capital’s principal P&C [re]insurance operating subsidiaries to A2 from A1.
A statement from the ratings agency said, “The outlook for these ratings is stable. In the same rating action, Moody’s downgraded the IFS rating of Arch Mortgage Guaranty Company [AMG] to Baa1 from A3. The outlook for AMG is positive. These rating actions conclude reviews for downgrade that were initiated on 17 August 2016.
“Moody’s also affirmed the Baa1 IFS rating of Arch Mortgage Insurance Company [AMI] with the outlook changed to positive from stable. Moody’s also took various rating actions on other Arch Capital subsidiaries, as listed below.
“These rating actions follow the completion of Arch Capital’s previously announced acquisition of United Guaranty Corporation [UGC -- not rated], a holding company for a leading US mortgage insurance group, from American International Group, Inc. [AIG -- senior Baa1/stable]. Arch Capital purchased UGC for approximately $3.3 billion in cash and stock.
Ratings Rationale — Arch Capital and its P&C Insurance and Reinsurance Subsidiaries
“The downgrade of Arch Capital’s ratings reflects Moody’s view that the acquisition of UGC increases the group’s credit risk profile due to the substantial expansion of Arch Capital’s mortgage insurance operations and a significant increase in the holding company’s financial leverage following the issuance of debt and preferred shares to finance a portion of the UGC acquisition. On a pro forma basis giving effect to the acquisition, Arch Capital’s mortgage operations represent approximately 24% of the group’s gross premiums written, up from around 8%. Moody’s currently views the stand-alone credit profiles of leading US mortgage insurers to be in the Baa range due to the sector’s historical deep cyclicality, its undifferentiated, commoditized product, and industry conditions that are largely tied to some of its main stakeholders [lenders and GSEs], public policy decisions, the performance of the housing sector, and other uncontrollable variables, including competition from the FHA.
“Given the large amount of debt and preferred stock issued by Arch Capital in recent months to help finance the UGC acquisition, the firm’s pro forma adjusted financial leverage has risen to around 25%, up from 19% at year-end 2015. While Moody’s expects Arch Capital to gradually reduce its financial leverage through debt repayments and organic capital growth, the firm’s leverage metrics are likely to remain elevated for several years.
“Moody’s notes that the combination of UGC and Arch’s existing mortgage insurance operations will create the market share leader in the US private mortgage insurance market. The acquisition also provides some diversification benefit to Arch Capital as its traditional P&C reinsurance business faces challenging competitive dynamics. Current mortgage insurance conditions are, by contrast, quite sound, with strong mortgage insurance profitability, supported by high quality mortgage loan origination and benign housing market conditions. We expect Arch Capital’s profitability to be positively impacted by its mortgage insurance operations over the near to medium term.
Ratings Rationale — Arch Mortgage Insurance Company
“Moody’s affirmation of AMI’s Baa1 IFS rating, with the outlook changed to positive from stable, reflects the improvement in its stand-alone credit profile following the UGC acquisition. UGC brings a well-established US mortgage insurance franchise with strong profitability to the Arch Capital group. Moody’s has aligned the ratings of AMI and United Guaranty Residential Insurance Company [UGRIC -- IFS rating Baa1/positive] based on our expectation that these GSE eligible subsidiaries will comprise the core operations of Arch Capital’s mortgage insurance business going forward.
“Arch Capital’s acquisition of UGC accelerates its efforts to achieve scale in the US mortgage insurance market. For the first nine months of 2016, UGC and Arch Capital had private MI market shares of about 18% and 9%, respectively. The combination of the two companies will result in a market leading mortgage insurance platform, with strong core earnings power and better financial flexibility than its peers. However, we expect the combined platform will lose some market share due to customer overlap with credit unions, community banks, and other lenders.
“The positive outlook reflects Moody’s expectation that the combination of UGC and AMI will improve the stand-alone credit profile of the new Arch mortgage insurance platform due to its leading market position, strong core earnings power and its robust underwriting and risk management capabilities.
“AMI also benefits from implicit and explicit support from Arch Capital and Arch Reinsurance Ltd. [Arch Re Bermuda -- IFS rating A2/stable]. Arch Re Bermuda provides reinsurance to AMI through a 50% quota-share reinsurance arrangement.
Ratings Rationale — Arch Mortgage Guaranty Company,
“The downgrade of AMG’s IFS rating to Baa1 from A3 [with a positive outlook] reflects Moody’s view that following the acquisition, Arch’s mortgage insurance operations should be viewed as a singular analytic unit. As such, AMG’s rating was aligned with the ratings of AMI and UGRIC. While AMG benefits from extensive reinsurance support from Arch Re Bermuda and Arch Reinsurance Company [IFS rating A2/stable], the company has modest stand-alone capital resources, and, as a non-GSE focused mortgage insurer, narrower business prospects relative to its US mortgage insurance affiliates. The positive outlook reflects the alignment of AMG’s rating with the ratings on AMI and UGRIC.
Rating Drivers
“Rating Drivers – Arch Capital and its P&C Insurance and Reinsurance Subsidiaries Given today’s downgrade of Arch Capital’s ratings, there is little possibility of an upgrade in the near term. However, reduced financial leverage and the maintenance of the firm’s current modest catastrophe risk posture would positively influence the ratings. Conversely, the following factors could lead to a downgrade of Arch Capital’s ratings: 1] returns on capital below the mid-single digits across multiple years; 2] consolidated adjusted financial leverage above 30%; 3] gross underwriting leverage in excess of 3x; or 4] a decline in shareholders’ equity [including share repurchases] by more than 10% over a rolling twelve month period.
Rating Drivers — Arch Mortgage Insurance Company
“Continued improvement of AMI’s stand-alone credit profile as evidenced by increased market share at attractive pricing levels, continued strong earnings and strong capital adequacy could result in an upgrade of AMI’s rating. Conversely, the following factors could lead to a stabilization of the outlook or a downgrade of the rating: 1] downgrade of Arch Re Bermuda; 2] significant weakening of underwriting standards or pricing; 3] public policy decisions that significantly diminish the role of private mortgage insurance in the housing finance market; and 4] non-compliance with the GSE’s capital standards [PMIERs]. AMI’s rating is expected to remain aligned with UGRIC’s rating going forward.
Rating Drivers — Arch Mortgage Guaranty Company
“AMG’s IFS rating is expected to remain closely linked to that of AMI going forward. Consequently, an upgrade or downgrade of AMI is likely to result in an upgrade or downgrade of AMG.
