Morningstar DBRS Assigns First-Time Financial Strength Ratings to Arch U.S. MI Holdings Inc.'s Operating Subsidiaries at AA (low), Stable Trend

DBRS, Inc. (Morningstar DBRS) assigned first-time Financial Strength Ratings of AA (low) to the following operating subsidiaries of Arch U.S. MI Holdings, Inc. (Arch U.S. MI): Arch Mortgage Assurance Company, Arch Mortgage Guaranty Company, Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (together Arch U.S. MI's subsidiaries). The trend on all credit ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Financial Strength Ratings and Stable trends reflect the entrenched market position and solid franchise strength of Arch U.S. MI as well as being a core business in the larger, more diversified Arch Capital Group, Ltd. (Arch Capital or the Group). Indeed, the Group is one of the largest global insurance and reinsurance groups with a relatively moderate risk appetite, ample liquidity, strong capitalization, and resilient earnings ability. The credit ratings also reflect the loss volatility of the U.S. mortgage insurance business, which is subject to spikes in times of macroeconomic stress.

CREDIT RATING DRIVERS
The credit ratings are well placed in their current credit rating category. However, over the longer term, the credit ratings would be upgraded if Arch Capital materially expands its global franchise while maintaining its strong profitability, robust capitalization, and prudent risk management.

Conversely, the credit ratings would be downgraded if there is a material deterioration in Arch Capital's market position or a sustained deterioration in earnings that causes a significant reduction in the Group's capitalization. A weakening in the implicit support of Arch Capital to Arch U.S. MI's subsidiaries would also be negative for the credit ratings.

CREDIT RATING RATIONALE
Franchise Strength Building Block Assessment: Strong/Good
Arch U.S. MI is the U.S.-based private mortgage insurance arm of Arch Capital, with one of the largest market shares in terms of insurance in force among U.S. private mortgage insurers while maintaining a competitive position in new insurance written. Mortgage insurance products are distributed in the U.S. through a sales force targeting a broad group of lenders, including mortgage bankers, mortgage brokers, commercial banks, saving institutions, credit unions and community banks.

Arch Capital is a Bermuda-based global property and casualty insurer and reinsurer. Although Arch Capital is a relatively young company, formed in 2000, the Group is among the ten largest reinsurance conglomerates globally. Its insurance operations remain relatively niche and with certain concentrations in the U.S., but the Group has made steady progress increasing its international diversification with an upward trajectory in terms of gross premiums in the past five years. Arch Capital has almost tripled its gross premiums written in the past five years while maintaining strong profitability and underwriting discipline. Arch Capital has expanded rapidly through acquisitions, growing by both product line in its chosen markets. The Group's suite of products is strong and spread across three major operating segments: Reinsurance (52% of LTM GPW), Insurance (41% of LTM GPW), and Mortgage Insurance (7% of LTM GPW). Arch Capital focuses on specialty lines of businesses and ones where disciplined underwriting has the potential to meaningfully impact profitability. A focus on underwriting is a key strategic tool for Arch Capital's operating insurance and reinsurance subsidiaries.

Earnings Ability Building Block Assessment: Very Strong/Strong
Arch U.S. MI's subsidiaries have demonstrated consistently aggregated strong financial performance over the years, including low combined ratios and a high return on equity. Arch Capital's overall combined ratio for its mortgage insurance business has considerably improved following the COVID-19 pandemic, decreasing to 11.0% in H1 2024 (9.3% in FY 2023). However, underwriting results in the mortgage insurance business are inherently cyclical, particularly during economic downturns. Future premium revenue is likely to be impacted by increasing unaffordability in certain markets and elevated although decreasing interest rates. Offsetting factors to these headwinds include a strong labor market with relatively low unemployment, sound borrower balance sheets and sustained demand by first-time homebuyers. In the U.S. private mortgage insurance market, there is also limited pricing power due to the steep competition between the different providers.

At the Group level, revenues are well diversified by product and geography, with a limited reliance on any one sector. Arch Capital's above-average profitability benefits from diversification, as higher combined ratios in the insurance segment are mitigated by lower ones in the reinsurance and insurance business lines. The diversity of business lines and the low correlation between them also allows for overall stability in claims losses. The Group experienced very strong gross premiums growth in 2023, particularly in the reinsurance business, that more than offset a slight decrease in the mortgage insurance business. This trend continued in H1 2024, with gross premiums and net income rising 17.6% and 72.4% compared with H1 2023, respectively. The Group's gross premiums written reached $20.1 billion for the 12 months ending in June 2024, placing Arch Capital among the largest insurance and reinsurance groups globally. Arch Capital's three-year weighted average ROE of 21.7% at YE2023 underpins Morningstar DBRS' view of the Group's very strong profitability, which continued improving in the first half of 2024. The Group's profitability is mostly driven by a robust three-year weighted combined ratio of 81.2% at YE2023, supported by excellent investment results.

Risk Profile Building Block Assessment: Strong/Good
Product risk in the mortgage insurance business line comes from the lack of repricing flexibility for the product due to the multiyear nature of the contracts. However, Morningstar DBRS notes that Arch U.S. MI's successfully implemented price increases immediately after the COVID-19 pandemic for new policies. Like other U.S. private mortgage insurers, insurance in force originated during the years 2005-2008 continues to present an outsized risk in terms of claims although the amount has greatly reduced over the past few years. Notably, the delinquency rate for Arch U.S. MI's mortgage business has remained relatively stable between 1.61% and 1.82% since mid-2022. However, delinquency rates can quickly spike in times of stress as evidenced by Arch's peak 5.14% delinquency rate during the COVID-19 pandemic. Product offerings in Arch Capital's insurance and reinsurance lines typically do not have embedded guarantees and are mostly short-term contracts with annual repricing as is typical in the P&C space. The Group is exposed to catastrophe claims, which can make a product more difficult to price due to the unpredictable nature of claims. However, Arch Capital has been able to generate underwriting profits through the years.

Arch Capital has a conservative investment strategy mostly comprised of cash and investment grade fixed income securities. There is a relatively sizeable amount of "BBB"rated bonds at 23.5% of the fixed income portfolio as of the end of Q2 2024, presenting some risk in the event of a market downturn. However, the average credit rating of Arch Capital's investment portfolio is AA-. The global nature of the business and extensive growing operations can lend itself to some operational risk although the majority of the operations are primarily in well-developed, mature markets. There is some operational risk arising from the delegation of underwriting authority to third parties, including producers and agents. Morningstar DBRS has not identified any major lapses in operational risk in the last five years. For the mortgage insurance business, operational risk is well managed and has improved in recent years in part due to the GSEs mandating quality control procedures that ensure loans are underwritten to a high quality. Both Fannie Mae and Freddie Mac conduct operational reviews of Arch U.S. MI's quality control processes.

The Group has a comprehensive risk management framework in place, with a strong focus on underwriting. The mortgage insurance business is subject to extensive risk management processes. The PMIERs also impose limitations on the type of risk insured, the forms and insurance policies issued, standards for the geographic and customer diversification of risk, procedures for claims handling, acceptable underwriting practices, standards for certain reinsurance cessions and financial requirements, among others. Arch U.S. MI has also developed a proprietary risk model that simulates the maximum loss resulting from a severe economic downturn impacting the housing market and includes factors such as future house prices, unemployment rates, income levels and interest rates.

Liquidity Building Block Assessment: Strong/Good
The mortgage insurance business can present unique liquidity risks if claims rise rapidly. While the ongoing flow of premiums provide an additional source of liquidity, risks arise in a stressed macroeconomic environment, where lower-rated bonds may not be as easily marketable, and claims come due for payment as the number of loans in forbearance can increase quickly. Arch U.S. MI's extensive use of quota share and excess loss reinsurance, together with its mortgage insurance linked notes program, helps mitigate a significant portion of the risk surrounding immediate liquidity needs during a stressed market environment. Moreover, The Group maintains a large liquid and highly rated portfolio of fixed-income assets to meet its liability cash flow needs. As of the end of Q2 2024, Arch Capital also benefits from approximately $1.0 billion in cash and $2.3 billion in short-term investments. Arch U.S. MI's subsidiaries have access to Arch Capital's $500 million committed credit line, as well as to the Federal Home Loan Bank credit facility. More importantly, Arch Capital's and Arch U.S. MI's liquidity needs are well below available liquid assets under all their current realistic disaster scenarios.

Capitalization Building Block Assessment: Strong
Capital levels for the mortgage insurance business are managed in accordance with the private mortgage insurer eligibility requirements (PMIERs), as well as according to state regulatory standards. Arch U.S. MI maintained a solid PMIERs sufficiency ratio of 196% at the end of Q2 2024, which was the highest among peers. Arch U.S. MI's estimated net realistic disaster scenario loss (after external reinsurance) for a significant downturn in home prices and rise in unemployment is well within its available capital absorption capacity, supporting Morningstar DBRS's view of capitalization levels in line with the financial strength ratings of AA (low) assigned to the operating subsidiaries.

As of July 1, 2024, Arch Capital's estimated PML for a 1-in-250-year catastrophic event, such as windstorm or earthquake was $1,567 million, which represented 7.9% of its tangible shareholders' equity, which is very conservative. The Group has taken measures to reduce its capital requirements by using credit risk transfer techniques such as excess of loss reinsurance and mortgage insurance linked notes. By transferring balance sheet risk to highly rated reinsurance counterparties or to investors through collateralized transactions, the Group is aiming to minimize claims volatility and extreme losses, as well as to reduce its regulatory capital requirements. Arch Capital benefits from approximately $20 billion in tangible shareholders' equity as of the end of Q2 2024. The assessment of the Group's capitalization is also supported by a low financial leverage of 17.0% at the end of Q2 2024 (as calculated by Morningstar DBRS) and a very strong fixed charge coverage ratio of 16.2x on a three-year weighted average basis. Arch Capital's proven access to capital markets and excellent capital generation are also a positive for the credit ratings.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a relevant effect on the credit analysis.

Environmental (E) Factors
The following Environmental factor had a relevant effect on the credit analysis:

Environmental concerns regarding Climate and Weather Risks are relevant to the credit ratings of the subsidiaries of Arch U.S. MI Holdings, Inc (Arch U.S. MI), as part of Arch Capital Group, Ltd. (the Group.). Through its insurance and reinsurance businesses, the Group is exposed to catastrophic weather events, including severe storms, wildfires, flooding, and other extreme weather. These events can lead to underwriting losses, as well as earnings and capital volatility. Morningstar DBRS considered this ESG factor as part of the Group's product risk; income stability; claims predictability, frequency and severity; and capital cushion and the ability to deal with stress scenarios. The Group seeks to limit the net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone at the 1-in-250-year return period to approximately 25% of its tangible shareholders' equity. As of July 1, 2024, the modeled pre-tax catastrophe exposure (net of reinsurance) represented 7.9% on the Group's tangible shareholders' equity. The Group's largest catastrophe exposure is to windstorms in Florida, the Northeast U.S., and the Gulf of Mexico.

There were no Social or Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Insurance Companies and Insurance Organizations (10 September 2024) https://dbrs.morningstar.com/research/439195. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include Morningstar, Inc. and company documents, Arch Capital Group's consolidated annual reports 2019-2023, consolidated interim reports Q1 and Q2 2024, Financial Condition Reports 2019-2023, Arch Sustainability Report 2023, Q2 2024 Investor Presentation, and 2024 Arch Capital Group Overview. Morningstar DBRS considers the information available to it for the purposes of providing this credit rating to be of satisfactory quality.

The primary sources of information used for this credit rating include Morningstar, Inc. and company documents, Arch Capital Group's consolidated annual reports 2019-2023, consolidated interim reports Q1 and Q2 2024, Financial Condition Reports 2019-2023, Arch Sustainability Report 2023, Q2 2024 Investor Presentation, and 2024 Arch Capital Group Overview. Morningstar DBRS considers the information available to it for the purposes of providing this credit rating was of satisfactory quality.

The credit ratings were initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit https://dbrs.morningstar.com.

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