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Baron Funds Comments on Arch Capital Group

August 24, 2012 | About:
Holly LaFon

Holly LaFon

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From Baron Funds' second quarter commentary:

Shares of Arch Capital Group Ltd. (ACGL) rose 6.6% during the second quarter versus a 2.8% decline for the S&P 500 Index. The outperformance was driven by improving pricing expectations. During the second quarter, overall pricing rose 4%, up one percentage point from the first quarter. Most of this increase came from shorter-tail lines. Pricing continues to grow slightly faster than loss cost which implies improving margin. Most meaningful to Arch, specialty pricing rose 6%. This indicates that the admitted insurers are pulling out of the specialty lines because there is now enough business to be written in the standard lines. This reduces competition and helps pricing go up. Perversely, pricing also continues to improve because interest rates are so low. Arch and its peers are unable to re-invest maturing securities at the same yield and thus they need to rely on better underwriting margins to buoy overall earnings. This leads to better pricing discipline across the industry, and Arch, which is known for its patience and discipline in underwriting, benefits greatly. Going forward, pricing should continue to improve slowly, but unless we see more sizeable losses it is unlikely that pricing will become "hard." We are at a major inflection point in P&C insurance pricing. What happens to capital (assuming rates stay low) will dictate the direction overall pricing goes from here. Arch is writing new business around a 10% ROE.We believe the industry is writing business a point or two below this, and just slightly below its cost of equity.We expect an improving market to push ROEs above cost of equity and drive multiples up beyond 1 times book value. (Rob Susman)

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