ACGL 10Q 3.31.13
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the period ended March 31, 2013
 
Or
 
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission file number:  001-26456
 
ARCH CAPITAL GROUP LTD.
(Exact name of registrant as specified in its charter)
 
Bermuda
(State or other jurisdiction of incorporation or organization)
 
Not Applicable
(I.R.S. Employer Identification No.)
 
Wessex House, 5th Floor, 45 Reid Street
Hamilton HM 12, Bermuda
(Address of principal executive offices)
 
(441) 278-9250
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x     No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x     No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
 
Accelerated filer ¨
 
 
 
Non-accelerated filer ¨
 
Smaller reporting company ¨
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨   No x
 
The number of the registrant’s common shares (par value, $0.0033 per share) outstanding as of May 2, 2013 was 133,078,576.

Table of Contents

ARCH CAPITAL GROUP LTD.
 
INDEX
 
 
 
Page No.
PART I. Financial Information
 
 
 
 
 
Item 1 — Consolidated Financial Statements
 
 
 
 
 
 
 
 
 
 
 
March 31, 2013 (unaudited) and December 31, 2012
 
 
 
 
 
 
For the three month periods ended March 31, 2013 and 2012 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2013 and 2012 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2013 and 2012 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2013 and 2012 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

1
Table of Contents

Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Shareholders of
Arch Capital Group Ltd.:
 
We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of March 31, 2013, and the related consolidated statements of income for the three-month periods ended March 31, 2013 and March 31, 2012, and the consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the three-month periods ended March 31, 2013 and March 31, 2012. These interim financial statements are the responsibility of the Company’s management.
 
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.
 
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
 
We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2012, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein), and in our report dated March 1, 2013, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2012, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
 
/s/ PricewaterhouseCoopers LLP
 
New York, NY
May 10, 2013

2
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
March 31,
2013
 
December 31,
2012
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $9,682,653 and $9,567,290)
$
9,890,425

 
$
9,839,988

Short-term investments available for sale, at fair value (amortized cost: $944,691 and $719,848)
943,414

 
722,121

Investment of funds received under securities lending, at fair value (amortized cost: $83,319 and $42,302)
84,315

 
42,531

Equity securities available for sale, at fair value (cost: $300,890 and $298,414)
342,091

 
312,749

Other investments available for sale, at fair value (cost: $551,797 and $519,955)
585,277

 
549,280

Investments accounted for using the fair value option
902,230

 
917,466

Investments accounted for using the equity method
219,674

 
307,105

Total investments
12,967,426

 
12,691,240

 
 
 
 
Cash
356,767

 
371,041

Accrued investment income
65,023

 
71,748

Investment in joint venture (cost: $100,000)
108,038

 
107,284

Fixed maturities and short-term investments pledged under securities lending, at fair value
90,801

 
50,848

Premiums receivable
870,575

 
688,873

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
1,846,064

 
1,870,037

Contractholder receivables
908,034

 
865,728

Prepaid reinsurance premiums
301,736

 
298,484

Deferred acquisition costs, net
306,505

 
262,822

Receivable for securities sold
395,958

 
19,248

Other assets
540,134

 
519,409

Total Assets
$
18,757,061

 
$
17,816,762

 
 
 
 
Liabilities
 

 
 

Reserve for losses and loss adjustment expenses
$
8,835,710

 
$
8,933,292

Unearned premiums
1,841,870

 
1,647,978

Reinsurance balances payable
204,233

 
188,546

Contractholder payables
908,034

 
865,728

Senior notes
300,000

 
300,000

Revolving credit agreement borrowings
100,000

 
100,000

Securities lending payable
93,375

 
52,356

Payable for securities purchased
594,521

 
37,788

Other liabilities
543,788

 
522,196

Total Liabilities
13,421,531

 
12,647,884

 
 
 
 
Commitments and Contingencies


 


 
 
 
 
Shareholders’ Equity
 

 
 

Non-cumulative preferred shares
325,000

 
325,000

Common shares ($0.0033 par, shares issued: 168,419,936 and 168,255,572)
561

 
561

Additional paid-in capital
242,492

 
227,778

Retained earnings
5,605,353

 
5,354,361

Accumulated other comprehensive income, net of deferred income tax
229,563

 
287,017

Common shares held in treasury, at cost (shares: 35,356,711 and 34,412,959)
(1,067,439
)
 
(1,025,839
)
Total Shareholders' Equity
5,335,530

 
5,168,878

Total Liabilities and Shareholders' Equity
$
18,757,061

 
$
17,816,762



See Notes to Consolidated Financial Statements

3
Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2013
 
2012
Revenues
 

 
 

Net premiums written
$
952,776

 
$
863,611

Change in unearned premiums
(200,006
)
 
(183,299
)
Net premiums earned
752,770

 
680,312

Net investment income
65,672

 
74,297

Net realized gains
58,340

 
44,121

 
 
 
 
Other-than-temporary impairment losses
(2,248
)
 
(1,031
)
Less investment impairments recognized in other comprehensive income, before taxes
2

 
8

Net impairment losses recognized in earnings
(2,246
)
 
(1,023
)
 
 
 
 
Fee income
538

 
543

Equity in net income of investment funds accounted for using the equity method
13,823

 
24,826

Other income (loss)
1,244

 
(8,068
)
Total revenues
890,141

 
815,008

 
 
 
 
Expenses
 

 
 

Losses and loss adjustment expenses
399,403

 
395,207

Acquisition expenses
127,592

 
118,962

Other operating expenses
120,183

 
106,472

Interest expense
5,898

 
7,521

Net foreign exchange (gains) losses
(24,264
)
 
20,688

Total expenses
628,812

 
648,850

 
 
 
 
Income before income taxes
261,329

 
166,158

 
 
 
 
Income tax expense
4,853

 
1,902

 
 
 
 
Net income
256,476

 
164,256

 
 
 
 
Preferred dividends
5,484

 
6,461

 
 
 
 
Net income available to common shareholders
$
250,992

 
$
157,795

 
 
 
 
Net income per common share
 

 
 

Basic
$
1.92

 
$
1.18

Diluted
$
1.85

 
$
1.14

 
 
 
 
Weighted average common shares and common share equivalents outstanding
 

 
 

Basic
130,907,902

 
133,954,623

Diluted
135,409,288

 
137,814,906

 


See Notes to Consolidated Financial Statements

4
Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2013
 
2012
Comprehensive Income
 

 
 

Net income
$
256,476

 
$
164,256

Other comprehensive income, net of deferred income tax
 

 
 

Unrealized appreciation (decline) in value of investments:
 

 
 

Unrealized holding gains arising during period
9,471

 
94,863

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax
(2
)
 
(8
)
Reclassification of net realized gains, net of income taxes, included in net income
(38,701
)
 
(27,511
)
Foreign currency translation adjustments, net of deferred income tax
(28,222
)
 
13,201

Other comprehensive income (loss)
(57,454
)
 
80,545

Comprehensive Income
$
199,022

 
$
244,801

 

See Notes to Consolidated Financial Statements

5
Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2013
 
2012
Non-Cumulative Preferred Shares
 

 
 

Balance at beginning and end of period
$
325,000

 
$
325,000

 
 
 
 
Common Shares
 

 
 

Balance at beginning of year
561

 
549

Common shares issued, net
—

 
3

Balance at end of period
561

 
552

 
 
 
 
Additional Paid-in Capital
 

 
 

Balance at beginning of year
227,778

 
161,419

Common shares issued, net
—

 
(3
)
Exercise of stock options
3,093

 
1,851

Amortization of share-based compensation
11,543

 
7,411

Other
78

 
16

Balance at end of period
242,492

 
170,694

 
 
 
 
Retained Earnings
 

 
 

Balance at beginning of year
5,354,361

 
4,796,655

Net income
256,476

 
164,256

Dividends declared on preferred shares
(5,484
)
 
(6,461
)
Balance at end of period
5,605,353

 
4,954,450

 
 
 
 
Accumulated Other Comprehensive Income
 

 
 

Balance at beginning of year
287,017

 
153,923

Change in unrealized appreciation in value of investments, net of deferred income tax
(29,230
)
 
67,352

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax
(2
)
 
(8
)
Foreign currency translation adjustments, net of deferred income tax
(28,222
)
 
13,201

Balance at end of period
229,563

 
234,468

 
 
 
 
Common Shares Held in Treasury, at Cost
 

 
 

Balance at beginning of year
(1,025,839
)
 
(845,472
)
Shares repurchased for treasury
(41,600
)
 
(236
)
Balance at end of period
(1,067,439
)
 
(845,708
)
 
 
 
 
Total Shareholders’ Equity
$
5,335,530

 
$
4,839,456

 

See Notes to Consolidated Financial Statements

6
Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2013
 
2012
Operating Activities
 

 
 

Net income
$
256,476

 
$
164,256

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Net realized gains
(59,504
)
 
(44,072
)
Net impairment losses recognized in earnings
2,246

 
1,023

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
23,052

 
(12,030
)
Share-based compensation
11,543

 
7,411

Changes in:
 

 
 

Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
(22,182
)
 
39,343

Unearned premiums, net of prepaid reinsurance premiums
200,004

 
181,735

Premiums receivable
(198,814
)
 
(190,102
)
Deferred acquisition costs, net
(45,159
)
 
(32,269
)
Reinsurance balances payable
17,365

 
(3,181
)
Other liabilities
23,811

 
10,134

Other items, net
(3,179
)
 
22,573

Net Cash Provided By Operating Activities
205,659

 
144,821

 
 
 
 
Investing Activities
 

 
 

Purchases of:
 

 
 

Fixed maturity investments
(3,970,320
)
 
(3,593,630
)
Equity securities
(63,353
)
 
(33,803
)
Other investments
(250,442
)
 
(239,167
)
Proceeds from the sales of:
 

 
 

Fixed maturity investments
3,796,638

 
3,628,932

Equity securities
81,513

 
75,860

Other investments
280,010

 
111,149

Proceeds from redemptions and maturities of fixed maturity investments
181,727

 
261,660

Net purchases of short-term investments
(221,444
)
 
(207,444
)
Change in investment of securities lending collateral
(41,019
)
 
6,322

Purchases of furniture, equipment and other assets
(3,742
)
 
(6,498
)
Net Cash (Used For) Provided By Investing Activities
(210,432
)
 
3,381

 
 
 
 
Financing Activities
 

 
 

Purchases of common shares under share repurchase program
(40,964
)
 
—

Proceeds from common shares issued, net
1,280

 
780

Repayments of borrowings
—

 
(69,863
)
Change in securities lending collateral
41,019

 
(6,322
)
Other
1,084

 
588

Preferred dividends paid
(5,484
)
 
(6,461
)
Net Cash Used For Financing Activities
(3,065
)
 
(81,278
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash
(6,436
)
 
4,183

 
 
 
 
(Decrease) increase in cash
(14,274
)
 
71,107

Cash beginning of year
371,041

 
351,699

Cash end of period
$
356,767

 
$
422,806

 

See Notes to Consolidated Financial Statements

7
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


1.                   General
 
Arch Capital Group Ltd. (“ACGL”) is a Bermuda public limited liability company which provides insurance and reinsurance on a worldwide basis through its wholly owned subsidiaries.
 
The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of ACGL and its wholly owned subsidiaries (together with ACGL, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of results on an interim basis. The results of any interim period are not necessarily indicative of the results for a full year or any future periods.
 
Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, including the Company’s audited consolidated financial statements and related notes.
 
The Company has reclassified the presentation of certain prior year information to conform to the current presentation. Such reclassifications had no effect on the Company’s net income, shareholders’ equity or cash flows. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
 
2.                    Share Transactions
 
Share Repurchases
 
The board of directors of ACGL has authorized the investment in ACGL’s common shares through a share repurchase program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through December 2014. Since the inception of the share repurchase program, ACGL has repurchased approximately 109.6 million common shares for an aggregate purchase price of $2.77 billion. During the 2013 first quarter, ACGL repurchased 0.9 million common shares for an aggregate purchase price of $41.0 million. At March 31, 2013, $728.9 million of share repurchases were available under the program. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations.

3.                   Recent Accounting Pronouncements
 
Effective January 1, 2013, the Company adopted Financial Accounting Standards Board ("FASB") guidance requiring additional disclosures about reclassification adjustments from accumulated other comprehensive income. As this guidance is disclosure-related only, the adoption of this guidance did not impact the Company’s results of operations, financial condition or liquidity. The additional disclosures are provided in Note 11, "Other Comprehensive Income."
 
Effective January 1, 2013, the Company adopted FASB guidance requiring additional disclosures about financial instruments and derivative instruments that are either: (1) offset for balance sheet presentation purposes or (2) subject to an enforceable master netting arrangement or similar arrangement, regardless of whether they are offset for balance sheet presentation purposes. The disclosure requirements of this guidance are limited to derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing/lending transactions. As this guidance is disclosure-related only and did not amend existing balance sheet offsetting guidance, adoption did not impact the Company’s results of operations, financial condition or liquidity. The additional disclosures are provided in Note 7, "Investment Information," and Note 9, "Derivative Instruments."

8
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

4.                   Commitments and Contingencies
 
Letter of Credit and Revolving Credit Facilities
 
As of March 31, 2013, the Company had a $300 million unsecured revolving loan and letter of credit facility and a $500 million secured letter of credit facility (the “Credit Agreement”). The Credit Agreement expires on August 18, 2014. In addition, the Company had access to secured letter of credit facilities of approximately $86.7 million as of March 31, 2013, which are available on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the “LOC Facilities”). At March 31, 2013, the Company had $449.0 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $524.9 million, and had $100.0 million of borrowings outstanding under the Credit Agreement. The Company was in compliance with all covenants contained in the LOC Facilities at March 31, 2013.
 
Investment Commitments
 
The Company’s investment commitments, which are primarily related to agreements entered into by the Company to invest in funds and separately managed accounts when called upon, were approximately $807.2 million at March 31, 2013.

Acquisition of CMG Mortgage Insurance Company and Mortgage Platform of PMI

In February 2013, the Company's U.S.-based subsidiaries entered into a definitive agreement to acquire CMG Mortgage Insurance Company (“CMG MI”) from its current owners, PMI Mortgage Insurance Co. (“PMI”), which has been in rehabilitation under the receivership of the Arizona Department of Insurance since 2011, and CMFG Life Insurance Company. The Company also agreed to acquire PMI's mortgage insurance operating platform and related assets from PMI. At closing, it is currently estimated that the Company's U.S.-based subsidiaries will pay aggregate consideration of approximately $300 million. Additional amounts may be paid based on the actual results of CMG MI's pre-closing portfolio over an agreed upon period. In connection with the closing of the transactions, PMI and an affiliate of the Company's U.S.-based subsidiaries will enter into a quota share reinsurance agreement pursuant to which such affiliate, as the reinsurer, will agree to provide 100% quota share indemnity reinsurance to PMI for all certificates of insurance that were issued by PMI between and including January 1, 2009 and December 31, 2011 that are not in default as of an agreed upon effective date. Such affiliate also will provide quota share reinsurance to CMG MI through a reinsurance agreement that will become effective prior to the closing. In addition, the Company will enter into a services agreement with PMI to provide for necessary services to administer the run-off of PMI's legacy business at the direction of PMI. The Company is in the process of attempting to obtain the required approvals from various regulators, the Arizona receivership court and the government sponsored enterprises. If the approvals are obtained and the customary closing conditions are satisfied, the Company would not expect the transaction to close until late 2013 at the earliest.
 

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

5.                   Earnings Per Common Share
 
The following table sets forth the computation of basic and diluted earnings per common share:
 
 
Three Months Ended
 
 
March 31,
 
 
2013
 
2012
 
 
 
 
 
 
Numerator:
 

 
 

 
Net income
$
256,476

 
$
164,256

 
Preferred dividends
(5,484
)
 
(6,461
)
 
Net income available to common shareholders
$
250,992

 
$
157,795

 
 
 
 
 
 
Denominator:
 

 
 

 
Weighted average common shares outstanding — basic
130,907,902

 
133,954,623

 
Effect of dilutive common share equivalents:
 

 
 

 
Nonvested restricted shares
1,290,161

 
1,012,303

 
Stock options (1)
3,211,225

 
2,847,980

 
Weighted average common shares and common share equivalents outstanding — diluted
135,409,288

 
137,814,906

 
 
 
 
 
 
Earnings per common share:
 

 
 

 
Basic
$
1.92

 
$
1.18

 
Diluted
$
1.85

 
$
1.14

 
_________________________________________________
(1)
Certain stock options were not included in the computation of diluted earnings per share where the exercise price of the stock options exceeded the average market price and would have been anti-dilutive or where, when applying the treasury stock method to in-the-money options, the sum of the proceeds, including unrecognized compensation, exceeded the average market price and would have been anti-dilutive. For the 2013 first quarter and 2012 first quarter, the number of stock options excluded were 1,016,043 and 451,877, respectively.


10
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6.                   Segment Information
 
The following table summarizes the Company’s underwriting income or loss by segment, together with a reconciliation of underwriting income or loss to net income available to common shareholders:
 
 
Three Months Ended
 
Three Months Ended
 
March 31, 2013
 
March 31, 2012
 
Insurance
 
Reinsurance
 
Total
 
Insurance
 
Reinsurance
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
688,817

 
$
476,205

 
$
1,163,699

 
$
688,113

 
$
379,976

 
$
1,066,656

Net premiums written
504,550

 
448,226

 
952,776

 
490,680

 
372,931

 
863,611

 
 
 
 
 
 
 
 
 
 
 
 
Net premiums earned
$
444,965

 
$
307,805

 
$
752,770

 
$
441,740

 
$
238,572

 
$
680,312

Fee income
525

 
13

 
538

 
530

 
13

 
543

Losses and loss adjustment expenses
(283,467
)
 
(115,936
)
 
(399,403
)
 
(303,164
)
 
(92,043
)
 
(395,207
)
Acquisition expenses, net
(70,758
)
 
(56,834
)
 
(127,592
)
 
(73,870
)
 
(45,092
)
 
(118,962
)
Other operating expenses
(76,315
)
 
(33,600
)
 
(109,915
)
 
(73,370
)
 
(26,123
)
 
(99,493
)
Underwriting income (loss)
$
14,950

 
$
101,448

 
116,398

 
$
(8,134
)
 
$
75,327

 
67,193

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 

 
 

 
65,672

 
 

 
 

 
74,297

Net realized gains
 

 
 

 
58,340

 
 

 
 

 
44,121

Net impairment losses recognized in earnings
 

 
 

 
(2,246
)
 
 

 
 

 
(1,023
)
Equity in net income of investment funds accounted for using the equity method
 

 
 

 
13,823

 
 

 
 

 
24,826

Other income (loss)
 

 
 

 
1,244

 
 

 
 

 
(8,068
)
Other expenses
 

 
 

 
(10,268
)
 
 

 
 

 
(6,979
)
Interest expense
 

 
 

 
(5,898
)
 
 

 
 

 
(7,521
)
Net foreign exchange gains (losses)
 

 
 

 
24,264

 
 

 
 

 
(20,688
)
Income before income taxes
 

 
 

 
261,329

 
 

 
 

 
166,158

Income tax expense
 

 
 

 
(4,853
)
 
 

 
 

 
(1,902
)
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 
 

 
256,476

 
 

 
 

 
164,256

Preferred dividends
 

 
 

 
(5,484
)
 
 

 
 

 
(6,461
)
Net income available to common shareholders
 

 
 

 
$
250,992

 
 

 
 

 
$
157,795

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 

 
 

 
 

Loss ratio
63.7
%
 
37.7
%
 
53.1
%
 
68.6
%
 
38.6
%
 
58.1
%
Acquisition expense ratio (2)
15.8
%
 
18.5
%
 
16.9
%
 
16.6
%
 
18.9
%
 
17.4
%
Other operating expense ratio
17.2
%
 
10.9
%
 
14.6
%
 
16.6
%
 
10.9
%
 
14.6
%
Combined ratio
96.7
%
 
67.1
%
 
84.6
%
 
101.8
%
 
68.4
%
 
90.1
%
_________________________________________________
(1)     Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(2)     The acquisition expense ratio is adjusted to include policy-related fee income.
 


11
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

7.                   Investment Information
 
Available For Sale Investments
 
The following table summarizes the fair value and cost or amortized cost of the Company’s investments classified as available for sale:
 
 
Fair
Value
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Cost or
Amortized
Cost
 
OTTI
Unrealized
Losses (2)
March 31, 2013
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

Corporate bonds
$
2,592,744

 
$
77,404

 
$
(6,854
)
 
$
2,522,194

 
$
(56
)
Mortgage backed securities
1,704,813

 
23,249

 
(9,395
)
 
1,690,959

 
(9,330
)
Municipal bonds
1,442,116

 
54,533

 
(1,732
)
 
1,389,315

 
(17
)
Commercial mortgage backed securities
867,856

 
27,757

 
(2,717
)
 
842,816

 
(231
)
U.S. government and government agencies
1,151,429

 
21,512

 
(463
)
 
1,130,380

 
(19
)
Non-U.S. government securities
1,074,797

 
24,745

 
(12,817
)
 
1,062,869

 
—

Asset backed securities
1,146,611

 
24,706

 
(9,760
)
 
1,131,665

 
(3,348
)
Total
9,980,366

 
253,906

 
(43,738
)
 
9,770,198

 
(13,001
)
 
 
 
 
 
 
 
 
 
 
Equity securities
342,091

 
51,325

 
(10,124
)
 
300,890

 
—

Other investments
585,277

 
36,425

 
(2,945
)
 
551,797

 
—

Short-term investments
944,274

 
2,962

 
(4,227
)
 
945,539

 
—

Total
$
11,852,008

 
$
344,618

 
$
(61,034
)
 
$
11,568,424

 
$
(13,001
)
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

Corporate bonds
$
2,857,513

 
$
105,798

 
$
(6,710
)
 
$
2,758,425

 
$
(62
)
Mortgage backed securities
1,532,736

 
24,809

 
(7,484
)
 
1,515,411

 
(9,329
)
Municipal bonds
1,463,586

 
62,322

 
(1,421
)
 
1,402,685

 
(17
)
Commercial mortgage backed securities
824,165

 
37,514

 
(4,468
)
 
791,119

 
(270
)
U.S. government and government agencies
1,131,688

 
20,178

 
(1,095
)
 
1,112,605

 
(19
)
Non-U.S. government securities
998,901

 
33,701

 
(8,860
)
 
974,060

 
—

Asset backed securities
1,073,999

 
25,528

 
(5,838
)
 
1,054,309

 
(3,346
)
Total
9,882,588

 
309,850

 
(35,876
)
 
9,608,614

 
(13,043
)
 
 
 
 
 
 
 
 
 
 
Equity securities
312,749

 
26,625

 
(12,290
)
 
298,414

 
—

Other investments
549,280

 
32,582

 
(3,257
)
 
519,955

 
—

Short-term investments
730,369

 
3,521

 
(1,248
)
 
728,096

 
—

Total
$
11,474,986

 
$
372,578

 
$
(52,671
)
 
$
11,155,079

 
$
(13,043
)
_________________________________________________
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged. See “—Securities Lending Agreements.”
(2)
Represents the total other-than-temporary impairments (“OTTI”) recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At March 31, 2013, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $5.1 million, compared to a net unrealized gain of $2.0 million at December 31, 2012.


12
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarizes, for all available for sale securities in an unrealized loss position, the fair value and gross unrealized loss by length of time the security has been in a continual unrealized loss position:
 
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
March 31, 2013
 

 
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
533,561

 
$
(4,593
)
 
$
35,835

 
$
(2,261
)
 
$
569,396

 
$
(6,854
)
Mortgage backed securities
728,792

 
(8,613
)
 
24,055

 
(782
)
 
752,847

 
(9,395
)
Municipal bonds
188,494

 
(1,292
)
 
10,513

 
(440
)
 
199,007

 
(1,732
)
Commercial mortgage backed securities
216,698

 
(2,665
)
 
710

 
(52
)
 
217,408

 
(2,717
)
U.S. government and government agencies
44,237

 
(463
)
 
—

 
—

 
44,237

 
(463
)
Non-U.S. government securities
384,535

 
(7,178
)
 
76,346

 
(5,639
)
 
460,881

 
(12,817
)
Asset backed securities
190,944

 
(4,425
)
 
54,700

 
(5,335
)
 
245,644

 
(9,760
)
Total
2,287,261

 
(29,229
)
 
202,159

 
(14,509
)
 
2,489,420

 
(43,738
)
Equity securities
114,184

 
(8,210
)
 
20,725

 
(1,914
)
 
134,909

 
(10,124
)
Other investments
62,020

 
(2,043
)
 
33,759

 
(902
)
 
95,779

 
(2,945
)
Short-term investments
108,123

 
(4,227
)
 
—

 
—

 
108,123

 
(4,227
)
Total
$
2,571,588

 
$
(43,709
)
 
$
256,643

 
$
(17,325
)
 
$
2,828,231

 
$
(61,034
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 

 
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
490,784

 
$
(3,692
)
 
$
52,334

 
$
(3,018
)
 
$
543,118

 
$
(6,710
)
Mortgage backed securities
537,883

 
(4,290
)
 
60,574

 
(3,194
)
 
598,457

 
(7,484
)
Municipal bonds
147,766

 
(1,120
)
 
7,052

 
(301
)
 
154,818

 
(1,421
)
Commercial mortgage backed securities
36,649

 
(2,261
)
 
8,878

 
(2,207
)
 
45,527

 
(4,468
)
U.S. government and government agencies
146,526

 
(1,095
)
 
—

 
—

 
146,526

 
(1,095
)
Non-U.S. government securities
244,827

 
(1,070
)
 
135,564

 
(7,790
)
 
380,391

 
(8,860
)
Asset backed securities
234,584

 
(1,508
)
 
57,371

 
(4,330
)
 
291,955

 
(5,838
)
Total
1,839,019

 
(15,036
)
 
321,773

 
(20,840
)
 
2,160,792

 
(35,876
)
Equity securities
130,385

 
(10,200
)
 
16,469

 
(2,090
)
 
146,854

 
(12,290
)
Other investments
23,849

 
(2,474
)
 
35,083

 
(783
)
 
58,932

 
(3,257
)
Short-term investments
57,415

 
(1,248
)
 
—

 
—

 
57,415

 
(1,248
)
Total
$
2,050,668

 
$
(28,958
)
 
$
373,325

 
$
(23,713
)
 
$
2,423,993

 
$
(52,671
)
_________________________________________________
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged. See “—Securities Lending Agreements.”


13
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

At March 31, 2013, on a lot level basis, approximately 860 security lots out of a total of approximately 4,340 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $3.2 million. At December 31, 2012, on a lot level basis, approximately 910 security lots out of a total of approximately 4,580 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $2.5 million.
 
The contractual maturities of the Company’s fixed maturities and fixed maturities pledged under securities lending agreements are shown in the following table. Expected maturities, which are management’s best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
 
March 31, 2013
 
December 31, 2012
Maturity
 
Fair Value
 
Amortized
Cost
 
Fair Value
 
Amortized
Cost
Due in one year or less
 
$
414,808

 
$
405,063

 
$
446,402

 
$
436,376

Due after one year through five years
 
3,692,725

 
3,617,078

 
3,876,062

 
3,769,426

Due after five years through 10 years
 
1,852,459

 
1,789,372

 
1,949,297

 
1,869,698

Due after 10 years
 
301,094

 
293,245

 
179,927

 
172,275

 
 
6,261,086

 
6,104,758

 
6,451,688

 
6,247,775

Mortgage backed securities
 
1,704,813

 
1,690,959

 
1,532,736

 
1,515,411

Commercial mortgage backed securities
 
867,856

 
842,816

 
824,165

 
791,119

Asset backed securities
 
1,146,611

 
1,131,665

 
1,073,999

 
1,054,309

Total
 
$
9,980,366

 
$
9,770,198

 
$
9,882,588

 
$
9,608,614

 
Securities Lending Agreements
 
The Company operates a securities lending program under which certain of its fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. The fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $90.8 million and $88.4 million, respectively, at March 31, 2013, compared to $50.8 million and $49.6 million, respectively, at December 31, 2012. The fair value of the portfolio of collateral backing the Company's securities lending program was $84.3 million at March 31, 2013, compared to $42.5 million at December 31, 2012. Such amounts included approximately $5.4 million fair value of sub-prime securities at March 31, 2013, compared to $5.4 million at December 31, 2012. The Company maintains legal control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. An indemnification agreement with the lending agent protects the Company in the event a borrower becomes insolvent or fails to return any of the securities on loan to the Company. 


14
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Other Investments

The following table summarizes the Company's other investments, including available for sale and fair value option components:

 
March 31,
2013
 
December 31,
2012
Available for sale:
 
 
 
Asian and emerging markets
$
328,652

 
$
316,860

Investment grade fixed income
249,345

 
220,410

Other
7,280

 
12,010

Total available for sale
585,277

 
549,280

Fair value option:
 
 
 
Term loan investments (par value: $323,833 and $307,016)
328,254

 
308,596

Asian and emerging markets
30,796

 
24,035

Investment grade fixed income
81,583

 
67,624

Non-investment grade fixed income
11,107

 
11,093

Other
86,105

 
116,623

Total fair value option
$
537,845

 
$
527,971

Total
$
1,123,122

 
$
1,077,251


Certain of the Company's other investments are in investment funds for which the Company has the option to redeem at agreed upon values as described in each investment fund's subscription agreement. Depending on the terms of the various subscription agreements, investments in investment funds may be redeemed daily, monthly, quarterly or on other terms. Two common redemption restrictions which may impact the Company's ability to redeem these investment funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the investment fund's net assets which may otherwise hinder the general partner or investment manager's ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. If the investment funds are eligible to be redeemed, the time to redeem such fund can take weeks or months following the notification.

Fair Value Option
 
The Company elected to carry certain fixed maturity securities, equity securities and other investments (primarily term loans) at fair value under the fair value option afforded by accounting guidance regarding the fair value option for financial assets and liabilities. Changes in fair value of investments accounted for using the fair value option are included in net realized gains or losses while interest income, dividends received and distributions from fund investments which are not a return of capital are reflected in net investment income. The primary reasons for electing the fair value option were to reflect economic events in earnings on a timely basis and to address practicality and cost-benefit considerations.
 

15
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarizes the Company’s assets and liabilities which are accounted for using the fair value option:
 
 
March 31,
2013
 
December 31,
2012
Fixed maturities
$
364,385

 
$
363,541

Other investments
537,845

 
527,971

Equity securities
—

 
25,954

Investments accounted for using the fair value option
902,230

 
917,466

Securities sold but not yet purchased (1)
—

 
(6,924
)
Net assets accounted for using the fair value option
$
902,230

 
$
910,542

_________________________________________________
(1)
Represents the Company’s obligation to deliver equity securities that it did not own at the time of sale. Such amounts are included in “other liabilities” on the Company’s consolidated balance sheets.

Net Investment Income
 
The components of net investment income were derived from the following sources:
 
 
Three Months Ended
 
 
March 31,
 
 
2013
 
2012
 
Fixed maturities
$
62,006

 
$
73,450

 
Term loan investments (1)
4,217

 
2,299

 
Equity securities
1,423

 
1,664

 
Short-term investments
392

 
372

 
Other (2)
6,299

 
3,193

 
Gross investment income
74,337

 
80,978

 
Investment expenses
(8,665
)
 
(6,681
)
 
Net investment income
$
65,672

 
$
74,297

 
_________________________________________________
(1)
Included in “investments accounted for using the fair value option” on the Company’s consolidated balance sheets.
(2)
Amounts include dividends on investment funds and other items.
 
Net Realized Gains (Losses)
 
Net realized gains (losses) were as follows, excluding other-than-temporary impairment provisions:

 
 
Three Months Ended
 
 
March 31,
 
 
2013
 
2012
 
Available for sale securities:
 

 
 

 
Gross gains on investment sales
$
67,020

 
$
48,012

 
Gross losses on investment sales
(25,056
)
 
(17,936
)
 
Change in fair value of assets and liabilities accounted for using the fair value option:
 

 
 

 
Fixed maturities
5,058

 
8,217

 
Equity securities
699

 
3,387

 
Other investments
9,951

 
3,753

 
TALF investments
—

 
1,224

 
TALF borrowings
—

 
1,071

 
Derivative instruments (1)
(378
)
 
(4,669
)
 
Other
1,046

 
1,062

 
Net realized gains
$
58,340

 
$
44,121

 
_________________________________________________
(1)
See Note 9 for information on the Company’s derivative instruments.
 

16
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Other-Than-Temporary Impairments
 
The Company performs quarterly reviews of its available for sale investments in order to determine whether declines in fair value below the amortized cost basis were considered other-than-temporary in accordance with applicable guidance. The following table details the net impairment losses recognized in earnings by asset class:
 
 
Three Months Ended
 
 
March 31,
 
 
2013
 
2012
 
Fixed maturities:
 

 
 

 
Mortgage backed securities
$
(15
)
 
$
(746
)
 
Corporate bonds
—

 
(196
)
 
Asset backed securities
(20
)
 
—

 
Total
(35
)
 
(942
)
 
Investment of funds received under securities lending agreements
—

 
(81
)
 
Equity securities
(2,211
)
 
—

 
Net impairment losses recognized in earnings
$
(2,246
)
 
$
(1,023
)
 
 
A description of the methodology and significant inputs used to measure the amount of net impairment losses recognized in earnings in the 2013 first quarter is as follows:

•
Equity securities — the Company utilized information received from asset managers on common stocks, including the business prospects, recent events, industry and market data and other factors. For certain equities which were in an unrealized loss position and where the Company determined that it did not have the intent or ability to hold such securities for a reasonable period of time by which the fair value of the securities would increase and the Company would recover its cost, the cost basis of such securities was adjusted down accordingly;

•
Mortgage backed and asset backed securities — the Company utilized underlying data provided by asset managers, cash flow projections and additional information from credit agencies in order to determine an expected recovery value for each security. The analysis includes expected cash flow projections under base case and stress case scenarios which modify the expected default expectations and loss severities and slow down prepayment assumptions. The significant inputs in the models include the expected default rates, delinquency rates and foreclosure costs. The expected recovery values were reduced on a small number of securities, primarily as a result of increases in expected default expectations and foreclosure costs. The amortized cost basis of the securities were adjusted down, if required, to the expected recovery value calculated in the OTTI review process.

The Company believes that the $13.0 million of OTTI included in accumulated other comprehensive income at March 31, 2013 on the securities which were considered by the Company to be impaired was due to market and sector-related factors (i.e., not credit losses). At March 31, 2013, the Company did not intend to sell these securities, or any other securities which were in an unrealized loss position, and determined that it is more likely than not that the Company will not be required to sell such securities before recovery of their cost basis.
 

17
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table provides a roll forward of the amount related to credit losses recognized in earnings for which a portion of an OTTI was recognized in accumulated other comprehensive income:
 
 
Three Months Ended
 
 
March 31,
 
 
2013
 
2012
 
Balance at start of period
$
62,001

 
$
66,545

 
Credit loss impairments recognized on securities not previously impaired
33

 
212

 
Credit loss impairments recognized on securities previously impaired
2

 
811

 
Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security
—

 
—

 
Reductions for securities sold during the period
(80
)
 
(482
)
 
Balance at end of period
$
61,956

 
$
67,086

 
 
Restricted Assets
 
The Company is required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support its insurance and reinsurance operations. The Company’s insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. See Note 4, “Commitments and Contingencies—Letter of Credit and Revolving Credit Facilities,” for further details. The following table details the value of the Company’s restricted assets:
 
 
March 31,
2013
 
December 31,
2012
Assets used for collateral or guarantees:
 

 
 

Affiliated transactions
$
4,104,426

 
$
4,062,097

Third party agreements
791,160

 
771,631

Deposits with U.S. regulatory authorities
308,110

 
290,441

Deposits with non-U.S. regulatory authorities
6,843

 
247,321

Trust funds
110,266

 
96,342

Total restricted assets
$
5,320,805

 
$
5,467,832



18
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

8.                   Fair Value
 
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).
 
The levels in the hierarchy are defined as follows:
 
Level 1:
Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets
 
Level 2:
Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument
 
Level 3:
Inputs to the valuation methodology are unobservable and significant to the fair value measurement
 
Following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy.
 
The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. To validate the techniques or models used by pricing sources, the Company's review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value including a review of deep dive reports on selected securities which indicated the use of observable inputs in the pricing process; (iv) comparing the fair value estimates to its knowledge of the current market; (v) a comparison of the pricing services' fair values to other pricing services' fair values for the same investments; and (vi) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. For a majority of investments, the Company obtained multiple quotes. A price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value. At March 31, 2013, the Company adjusted certain prices (primarily on structured securities) obtained from the pricing services and substituted alternate prices (primarily broker-dealer quotes) for such securities. Such adjustments did not have a material impact on the overall fair value of the Company's investment portfolio at March 31, 2013.

The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the $12.75 billion of financial assets and liabilities measured at fair value at March 31, 2013, approximately $1.10 billion, or 8.6%, were priced using non-binding broker-dealer quotes. Of the $12.40 billion of financial

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

assets and liabilities measured at fair value at December 31, 2012, approximately $927.9 million, or 7.5%, were priced using non-binding broker-dealer quotes.

The Company reviews its securities measured at fair value and discusses the proper classification of such investments with investment advisors and others. A discussion of the general classification of the Company's financial instruments follows:

Fixed maturities. The Company determined that all U.S. Treasuries would be classified as Level 1 securities due to observed levels of trading activity, the high number of strongly correlated pricing quotes received on U.S. Treasuries and other factors. Where the Company believes that quoted market prices are not available or that the market is not active, fair values are estimated by using quoted prices of securities with similar characteristics, pricing models or matrix pricing and are generally classified as Level 2 securities. The Company determined that Level 2 securities included corporate bonds, mortgage backed securities, municipal bonds, asset backed securities and non-U.S. government securities. The Company determined that certain Euro-denominated corporate bonds which invest in underlying portfolios of fixed income securities for which there is a low level of transparency around inputs to the valuation process should be classified within Level 3 of the valuation hierarchy and certain other corporate bonds.

Equity securities. The Company determined that exchange-traded equity securities would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other equity securities are included in Level 2 of the valuation hierarchy.

Other investments. The fair values for certain of the Company's other investments are determined using net asset values (“NAV”) as advised by external fund managers. The NAV is based on the fund manager's valuation of the underlying holdings in accordance with the fund's governing documents. Periodically, the Company performs a number of monitoring procedures in order to assess the quality of the NAVs, including regular review and discussion of each fund's performance, regular evaluation of fund performance against applicable benchmarks and the backtesting of the NAVs against audited and interim financial statements. Other investments with liquidity terms allowing the Company to substantially redeem its holdings in a short time frame at the applicable NAV are reflected in Level 2. Other investments with redemption restrictions that prevent the Company from redeeming in the near term are classified in Level 3 of the valuation hierarchy.

Short-term investments. The Company determined that certain of its short-term investments held in highly liquid money market-type funds would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other short-term investments are classified in Level 2 of the valuation hierarchy.

The Company reviews the classification of its investments each quarter. No transfers were made in the periods presented. In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of the following tables, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged under securities lending agreements, at fair value.



 

20
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the Company’s financial assets and liabilities measured at fair value by level at March 31, 2013:
 
 
 
 
Fair Value Measurement Using:
 
Fair
Value
 
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets measured at fair value:
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

Corporate bonds
$
2,592,744

 
$
—

 
$
2,495,446

 
$
97,298

Mortgage backed securities
1,704,813

 
—

 
1,704,813

 
—

Municipal bonds
1,442,116

 
—

 
1,442,116

 
—

Commercial mortgage backed securities
867,856

 
—

 
867,856

 
—

U.S. government and government agencies
1,151,429

 
1,151,429

 
—

 
—

Non-U.S. government securities
1,074,797

 
—

 
1,074,797

 
—

Asset backed securities
1,146,611

 
—

 
1,146,611

 
—

Total
9,980,366

 
1,151,429

 
8,731,639

 
97,298

 
 
 
 
 
 
 
 
Equity securities
342,091

 
340,798

 
1,293

 
—

Other investments
585,277

 
—

 
399,342

 
185,935

Short-term investments
944,274

 
896,774

 
47,500

 
—

 
 
 
 
 
 
 
 
Fair value option:
 

 
 

 
 

 
 

Investments accounted for using the fair value option:
 

 
 

 
 

 
 

Corporate bonds
291,922

 
—

 
291,922

 
—

Non-U.S. government bonds
72,463

 
—

 
72,463

 
—

Other investments
537,845

 
—

 
358,475

 
179,370

Equity securities
—

 
—

 
—

 
—

Total
902,230

 
—

 
722,860

 
179,370

 
 
 
 
 
 
 
 
Total assets measured at fair value
$
12,754,238

 
$
2,389,001

 
$
9,902,634

 
$
462,603

 
 
 
 
 
 
 
 
Liabilities measured at fair value:
 

 
 

 
 

 
 

Fair value option:
 

 
 

 
 

 
 

Securities sold but not yet purchased (2) 
$
—

 
$
—

 
$
—

 
$
—

Total liabilities measured at fair value
$
—

 
$
—

 
$
—

 
$
—

_________________________________________________
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged.
(2)
Represents the Company’s obligation to deliver securities that it did not own at the time of sale. Such amounts are included in “other liabilities” on the Company’s consolidated balance sheets.

 

21
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2012:
 
 
 
 
Fair Value Measurement Using:
 
Fair
Value
 
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets measured at fair value:
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

Corporate bonds
$
2,857,513

 
$
—

 
$
2,759,109

 
$
98,404

Mortgage backed securities
1,532,736

 
—</