Years of superior performance have established quite a reputation for the management of Arch Capital (Nasdaq:ACGL). In good times and bad, this seems to be one of the best-run Bermuda-based insurance companies. The question investors have to ask, though, is whether there is enough leeway in the present valuation to really make this one of the best-performing stocks out there over the coming year or two.

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Fourth Quarter Results
Arch Capital reported that gross written premiums rose more than 5% for the fourth quarter, with particular strength (up 17%) in reinsurance. Net written premium growth was a little stronger, coming in at nearly 6%, while net investment income was down 11%.

Arch Capital's expense ratio fell slightly from the prior year, but the real star was the loss ratio. The company made one of the largest reserve releases in years, and that helped drive an overall operating ratio (90.2) that was not only better than last year but considerably better than sell-side expectations.

Underlying Results More Mixed
Although Arch Capital carries a great reputation as a capital allocator and disciplined pricer, there are underlying details in recent quarters that concern me a bit.

For starters, Arch Capital is not all that efficient when it comes to its operations - rivals like Axis (NYSE:AXS) and Endurance (NYSE:ENH) run a tighter ship when it comes to expenses. Although Arch recoups some of this through underwriting and has a pretty good core margin relative to the likes of Ace (NYSE:ACE) or Everest Re (NYSE:RE), it's still a concern.

I'm also concerned about the core underwriting profitability of the company. Reserve releases are difficult to rely on, particularly as the tough recent pricing environment should theoretically be narrowing this pipeline over the coming years. Consequently, Arch Capital may find it harder to deliver the sort of outperformance that it has trained the market to expect, particularly when investment returns are compromised by the low-rate environment. (For related reading, see The History Of Insurance.)

On the Other Hand...
That said, Arch Capital has managed itself well through a tough market, and it looks as though conditions are getting better. Serious disasters (including the flooding in Thailand) have strengthened the hand of insurers and it appears as though higher property and casualty rates are going through.

Arch Capital also continues to maintain a flexibility that most of its competitors cannot match. The company moves around its underwriting capital to support whenever markets offer the most satisfactory returns or returns on capital when there really aren't good options. In my mind, then, the fact that the company did not repurchase any shares this quarter is a sign that management is finding worthwhile business to write instead.

The Bottom Line
I wish Arch Capital were trading at a discount, but it simply isn't. Unless investors are willing to assume long-term sustainable returns on equity of above 12% (which is demanding, albeit not impossible), the shares are trading more or less where they should. While I would certainly prefer to own a well-run company at fair value in lieu of a poorly-run company that's cheap, investors should at the very least run the numbers on alternatives like Ace before committing to Arch Capital today.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

Tickers in this Article: ACGL, ACE, AXS, ENH

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