ACGL 10Q 9.30.13
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 September 30, 2013
 
Or
 
 
o
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.)
 
Waterloo House, Ground Floor
100 Pitts Bay Road
Pembroke HM 08, 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 o
 
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 o
 
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 o
 
 
 
Non-accelerated filer o
 
Smaller reporting company o
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o   No x
 
The number of the registrant’s common shares (par value, $0.0033 per share) outstanding as of October 31, 2013 was 133,543,538.

Table of Contents

ARCH CAPITAL GROUP LTD.
 
INDEX
 
 
 
Page No.
PART I. Financial Information
 
 
 
 
 
Item 1 — Consolidated Financial Statements
 
 
 
 
 
 
 
 
 
 
 
September 30, 2013 (unaudited) and December 31, 2012
 
 
 
 
 
 
For the three and nine month periods ended September 30, 2013 and 2012 (unaudited)
 
 
 
 
 
 
For the three and nine month periods ended September 30, 2013 and 2012 (unaudited)
 
 
 
 
 
 
For the nine month periods ended September 30, 2013 and 2012 (unaudited)
 
 
 
 
 
 
For the nine month periods ended September 30, 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 September 30, 2013, and the related consolidated statements of income and comprehensive income for the three-month and nine-month periods ended September 30, 2013 and September 30, 2012, and the consolidated statements of changes in shareholders’ equity and cash flows for the nine-month periods ended September 30, 2013 and September 30, 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
November 8, 2013

2
Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
September 30,
2013
 
December 31,
2012
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $9,671,665 and $9,567,290)
$
9,688,345

 
$
9,839,988

Short-term investments available for sale, at fair value (amortized cost: $992,644 and $719,848)
993,375

 
722,121

Investment of funds received under securities lending, at fair value (amortized cost: $39,793 and $42,302)
42,135

 
42,531

Equity securities available for sale, at fair value (cost: $418,319 and $298,414)
452,195

 
312,749

Other investments available for sale, at fair value (cost: $527,435 and $519,955)
528,938

 
549,280

Investments accounted for using the fair value option
1,139,725

 
917,466

Investments accounted for using the equity method
226,644

 
307,105

Total investments
13,071,357

 
12,691,240

 
 
 
 
Cash
436,141

 
371,041

Accrued investment income
64,428

 
71,748

Investment in joint venture (cost: $100,000)
106,982

 
107,284

Fixed maturities and short-term investments pledged under securities lending, at fair value
48,361

 
50,848

Premiums receivable
850,386

 
688,873

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
1,795,888

 
1,870,037

Contractholder receivables
1,028,772

 
865,728

Prepaid reinsurance premiums
330,980

 
298,484

Deferred acquisition costs, net
338,671

 
262,822

Receivable for securities sold
288,080

 
19,248

Other assets
570,777

 
519,409

Total Assets
$
18,930,823

 
$
17,816,762

 
 
 
 
Liabilities
 

 
 

Reserve for losses and loss adjustment expenses
$
8,819,419

 
$
8,933,292

Unearned premiums
1,983,408

 
1,647,978

Reinsurance balances payable
190,721

 
188,546

Contractholder payables
1,028,772

 
865,728

Senior notes
300,000

 
300,000

Revolving credit agreement borrowings
100,000

 
100,000

Securities lending payable
49,849

 
52,356

Payable for securities purchased
519,244

 
37,788

Other liabilities
496,125

 
522,196

Total Liabilities
13,487,538

 
12,647,884

 
 
 
 
Commitments and Contingencies


 


 
 
 
 
Shareholders’ Equity
 

 
 

Non-cumulative preferred shares
325,000

 
325,000

Common shares ($0.0033 par, shares issued: 169,350,789 and 168,255,572)
565

 
561

Additional paid-in capital
283,449

 
227,778

Retained earnings
5,886,149

 
5,354,361

Accumulated other comprehensive income, net of deferred income tax
41,955

 
287,017

Common shares held in treasury, at cost (shares: 35,870,466 and 34,412,959)
(1,093,833
)
 
(1,025,839
)
Total Shareholders' Equity
5,443,285

 
5,168,878

Total Liabilities and Shareholders' Equity
$
18,930,823

 
$
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)
 
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Revenues
 

 
 

 
 

 
 

Net premiums written
$
839,135

 
$
755,249

 
$
2,602,446

 
$
2,439,093

Change in unearned premiums
(44,135
)
 
(6,558
)
 
(295,860
)
 
(283,434
)
Net premiums earned
795,000

 
748,691

 
2,306,586

 
2,155,659

Net investment income
66,083

 
73,221

 
200,124

 
221,126

Net realized gains (losses)
(6,022
)
 
60,391

 
64,970

 
139,379

 
 
 
 
 
 
 
 
Other-than-temporary impairment losses
(901
)
 
(2,644
)
 
(3,873
)
 
(6,129
)
Less investment impairments recognized in other comprehensive income, before taxes
173

 
265

 
175

 
776

Net impairment losses recognized in earnings
(728
)
 
(2,379
)
 
(3,698
)
 
(5,353
)
 
 
 
 
 
 
 
 
Fee income
526

 
1,077

 
1,966

 
2,426

Equity in net income of investment funds accounted for using the equity method
5,665

 
24,330

 
30,429

 
56,943

Other income (loss)
624

 
(532
)
 
2,702

 
(7,905
)
Total revenues
861,148

 
904,799

 
2,603,079

 
2,562,275

 
 
 
 
 
 
 
 
Expenses
 

 
 

 
 

 
 

Losses and loss adjustment expenses
427,045

 
443,871

 
1,245,101

 
1,238,771

Acquisition expenses
147,313

 
128,065

 
406,582

 
375,316

Other operating expenses
118,070

 
113,429

 
365,661

 
337,602

Interest expense
5,937

 
7,378

 
17,687

 
22,338

Net foreign exchange losses
40,562

 
16,959

 
2,487

 
5,958

Total expenses
738,927

 
709,702

 
2,037,518

 
1,979,985

 
 
 
 
 
 
 
 
Income before income taxes
122,221

 
195,097

 
565,561

 
582,290

 
 
 
 
 
 
 
 
Income tax expense
7,396

 
5,441

 
17,320

 
8,110

 
 
 
 
 
 
 
 
Net income
114,825

 
189,656

 
548,241

 
574,180

 
 
 
 
 
 
 
 
Preferred dividends
5,484

 
5,484

 
16,453

 
19,594

Loss on repurchase of preferred shares
—

 
—

 
—

 
10,612

 
 
 
 
 
 
 
 
Net income available to common shareholders
$
109,341

 
$
184,172

 
$
531,788

 
$
543,974

 
 
 
 
 
 
 
 
Net income per common share
 

 
 

 
 

 
 

Basic
$
0.83

 
$
1.36

 
$
4.05

 
$
4.04

Diluted
$
0.80

 
$
1.33

 
$
3.92

 
$
3.93

 
 
 
 
 
 
 
 
Weighted average common shares and common share equivalents outstanding
 

 
 

 
 

 
 

Basic
131,495,296

 
135,067,360

 
131,262,309

 
134,519,046

Diluted
136,034,413

 
138,696,934

 
135,680,829

 
138,235,995

 


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)
 
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Comprehensive Income (Loss)
 
 
 
 
 

 
 

Net income
$
114,825

 
$
189,656

 
$
548,241

 
$
574,180

Other comprehensive income, net of deferred income tax
 

 
 

 
 
 
 
Unrealized appreciation (decline) in value of investments:
 

 
 

 
 
 
 
Unrealized holding gains (losses) arising during period
41,226

 
164,733

 
(208,865
)
 
277,656

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax
(173
)
 
(265
)
 
(175
)
 
(776
)
Reclassification of net realized gains, net of income taxes, included in net income
20,701

 
(47,411
)
 
(31,916
)
 
(118,714
)
Foreign currency translation adjustments, net of deferred income tax
29,523

 
13,978

 
(4,106
)
 
12,043

Other comprehensive income (loss)
91,277

 
131,035

 
(245,062
)
 
170,209

Comprehensive Income
$
206,102

 
$
320,691

 
$
303,179

 
$
744,389

 

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)
 
Nine Months Ended
 
September 30,
 
2013
 
2012
Non-Cumulative Preferred Shares
 

 
 

Balance at beginning of year
$
325,000

 
$
325,000

Shares issued - Series C
—

 
325,000

Shares repurchased - Series A and B
—

 
(325,000
)
Balance at end of period
325,000

 
325,000

 
 
 
 
Common Shares
 

 
 

Balance at beginning of year
561

 
549

Common shares issued, net
4

 
7

Balance at end of period
565

 
556

 
 
 
 
Additional Paid-in Capital
 

 
 

Balance at beginning of year
227,778

 
161,419

Common shares issued, net
5,583

 
4,561

Issue costs on Series C preferred shares
—

 
(9,398
)
Reversal of issue costs on repurchase of preferred shares
—

 
10,612

Exercise of stock options
7,438

 
7,619

Amortization of share-based compensation
40,305

 
34,659

Other
2,345

 
1,747

Balance at end of period
283,449

 
211,219

 
 
 
 
Retained Earnings
 

 
 

Balance at beginning of year
5,354,361

 
4,796,655

Net income
548,241

 
574,180

Dividends declared on preferred shares
(16,453
)
 
(19,594
)
Loss on repurchase of preferred shares
—

 
(10,612
)
Balance at end of period
5,886,149

 
5,340,629

 
 
 
 
Accumulated Other Comprehensive Income
 

 
 

Balance at beginning of year
287,017

 
153,923

Change in unrealized appreciation (decline) in value of investments, net of deferred income tax
(240,781
)
 
158,942

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax
(175
)
 
(776
)
Foreign currency translation adjustments, net of deferred income tax
(4,106
)
 
12,043

Balance at end of period
41,955

 
324,132

 
 
 
 
Common Shares Held in Treasury, at Cost
 

 
 

Balance at beginning of year
(1,025,839
)
 
(845,472
)
Shares repurchased for treasury
(67,994
)
 
(7,270
)
Balance at end of period
(1,093,833
)
 
(852,742
)
 
 
 
 
Total Shareholders’ Equity
$
5,443,285

 
$
5,348,794

 

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)
 
Nine Months Ended
 
September 30,
 
2013
 
2012
Operating Activities
 

 
 

Net income
$
548,241

 
$
574,180

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

 
 

Net realized losses
(66,957
)
 
(142,703
)
Net impairment losses recognized in earnings
3,698

 
5,353

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
35,634

 
(37,318
)
Share-based compensation
40,305

 
34,659

Changes in:
 

 
 

Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
(24,305
)
 
180,016

Unearned premiums, net of prepaid reinsurance premiums
295,860

 
283,433

Premiums receivable
(160,091
)
 
(204,854
)
Deferred acquisition costs, net
(73,793
)
 
(51,222
)
Reinsurance balances payable
2,573

 
19,171

Other liabilities
(15,893
)
 
21,664

Other items, net
41,776

 
49,572

Net Cash Provided By Operating Activities
627,048

 
731,951

 
 
 
 
Investing Activities
 

 
 

Purchases of:
 

 
 

Fixed maturity investments
(12,436,587
)
 
(12,670,073
)
Equity securities
(438,255
)
 
(215,921
)
Other investments
(992,935
)
 
(700,308
)
Proceeds from the sales of:
 

 
 

Fixed maturity investments
11,877,419

 
11,522,538

Equity securities
373,000

 
264,417

Other investments
813,596

 
329,093

Proceeds from redemptions and maturities of fixed maturity investments
595,503

 
867,080

Net purchases of short-term investments
(268,968
)
 
72,139

Change in investment of securities lending collateral
2,508

 
22,840

Purchase of business, net of cash acquired
—

 
28,948

Purchases of furniture, equipment and other assets
(10,953
)
 
(13,894
)
Net Cash Used For Investing Activities
(485,672
)
 
(493,141
)
 
 
 
 
Financing Activities
 

 
 

Proceeds from issuance of Series C preferred shares, net
—

 
315,763

Repurchase of Series A and B preferred shares
—

 
(325,000
)
Purchases of common shares under share repurchase program
(57,796
)
 
—

Proceeds from common shares issued, net
(425
)
 
1,604

Repayments of borrowings
—

 
(124,577
)
Change in securities lending collateral
(2,508
)
 
(22,840
)
Other
5,679

 
4,479

Preferred dividends paid
(16,453
)
 
(22,897
)
Net Cash Used For Financing Activities
(71,503
)
 
(173,468
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash
(4,773
)
 
5,399

 
 
 
 
Increase in cash
65,100

 
70,741

Cash beginning of year
371,041

 
351,699

Cash end of period
$
436,141

 
$
422,440

 

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, comprehensive 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 109.9 million common shares for an aggregate purchase price of $2.79 billion. During the 2013 third quarter and nine months ended September 30, 2013, ACGL repurchased 26,300 and 1.3 million common shares, respectively, for an aggregate purchase price of $1.3 million and $57.8 million, respectively. No share repurchases were made in the comparable 2012 periods. At September 30, 2013, $712.1 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.

Loss on Repurchase of Preferred Shares

The Company issued $325.0 million of 6.75% Series C preferred shares in April 2012 and subsequently redeemed all of its $200.0 million of 8.0% Series A preferred shares and $125.0 million of 7.875% Series B preferred shares at a redemption price equal to $25.00 per share in May 2012. In accordance with GAAP, upon issuance of the Series A and B preferred shares in 2006, costs of $10.6 million were recognized as a reduction of additional paid-in capital in shareholders' equity. Following the redemption of such shares, such issue costs were recorded as a “loss on repurchase of preferred shares” to remove the costs from additional paid-in capital in the second quarter of 2012, as revised and as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 (see Note 16 and Note 21).

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."

8


 
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."

4.                   Commitments and Contingencies
 
Letter of Credit and Revolving Credit Facilities
 
As of September 30, 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 $113.8 million as of September 30, 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 September 30, 2013, the Company had $408.4 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $480.4 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 September 30, 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 $815.3 million at September 30, 2013.

Acquisition of CMG Mortgage Insurance Company and Mortgage Insurance Operating Platform of PMI

In February 2013, certain of the Company's U.S.-based subsidiaries (collectively “Arch U.S. MI”) entered into a definitive agreement to acquire (1) CMG Mortgage Insurance Company (“CMG MI”) from its current owners, PMI Mortgage Insurance Co. in rehabilitation (“PMI”), which has been under the receivership of the Arizona Department of Insurance since 2011, and CMFG Life Insurance Company, and (2) PMI's mortgage insurance operating platform and certain related assets from PMI. 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. At closing, it is currently estimated that the Company's U.S.-based subsidiaries will pay aggregate consideration of approximately $300 million under all transaction documents. Additional amounts may be paid based on the actual results of CMG MI's pre-closing portfolio over an agreed upon period. 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.

On June 20, 2013, the Arizona receivership court provided the required approval of the acquisition. The transaction is also subject to approvals of the applicable regulators and approvals by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation of Arch U.S. MI as an eligible insurance carrier in the U.S. mortgage insurance marketplace, as well as the satisfaction of customary closing conditions. In connection with obtaining such consents of regulatory authorities and government-sponsored entities, it is anticipated that Arch U.S. MI or its affiliates will be required to make certain financial commitments to CMG MI, the form and amount of which will be determined based upon discussions with such authorities and entities. Arch U.S. MI's obligation to the sellers to accept financial requirements imposed by regulatory authorities and government-sponsored entities will be determined on the basis of, among other things, the appropriateness of such requirements in light of Arch U.S. MI's business plan and the consistency of such requirements with those imposed on other active participants in the U.S. mortgage insurance industry, as described in the purchase agreements. If these approvals are obtained, it is expected the transaction will close during the 2013 fourth quarter or early 2014.
 

9
Table of Contents
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
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
 
 
Numerator:
 

 
 

 
 

 
 

Net income
$
114,825

 
$
189,656

 
$
548,241

 
$
574,180

Preferred dividends
(5,484
)
 
(5,484
)
 
(16,453
)
 
(19,594
)
Loss on repurchase of preferred shares
—

 
—

 
—

 
(10,612
)
Net income available to common shareholders
$
109,341

 
$
184,172

 
$
531,788

 
$
543,974

 
 
 
 
 
 
 
 
Denominator:
 

 
 

 
 

 
 

Weighted average common shares outstanding — basic
131,495,296

 
135,067,360

 
131,262,309

 
134,519,046

Effect of dilutive common share equivalents:
 

 
 

 
 

 
 

Nonvested restricted shares
1,124,644

 
723,538

 
1,094,327

 
847,959

Stock options (1)
3,414,473

 
2,906,036

 
3,324,193

 
2,868,990

Weighted average common shares and common share equivalents outstanding — diluted
136,034,413

 
138,696,934

 
135,680,829

 
138,235,995

 
 
 
 
 
 
 
 
Earnings per common share:
 

 
 

 
 

 
 

Basic
$
0.83

 
$
1.36

 
$
4.05

 
$
4.04

Diluted
$
0.80

 
$
1.33

 
$
3.92

 
$
3.93

_________________________________________________
(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 third quarter and 2012 third quarter, the number of stock options excluded were 387,249 and 621,556, respectively. For the nine months ended September 30, 2013 and 2012, the number of stock options excluded were 1,735,995 and 860,088, respectively.


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

6.                   Segment Information
 
The following tables summarize 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
 
September 30, 2013
 
September 30, 2012
 
Insurance
 
Reinsurance
 
Total
 
Insurance
 
Reinsurance
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
682,839

 
$
355,091

 
$
1,036,987

 
$
658,599

 
$
279,751

 
$
936,764

Net premiums written
501,971

 
337,164

 
839,135

 
483,356

 
271,893

 
755,249

 
 
 
 
 
 
 
 
 
 
 
 
Net premiums earned
$
479,129

 
$
315,871

 
$
795,000

 
$
456,341

 
$
292,350

 
$
748,691

Fee income
545

 
(19
)
 
526

 
645

 
432

 
1,077

Losses and loss adjustment expenses
(305,921
)
 
(121,124
)
 
(427,045
)
 
(307,155
)
 
(136,716
)
 
(443,871
)
Acquisition expenses, net
(82,799
)
 
(64,514
)
 
(147,313
)
 
(73,663
)
 
(54,402
)
 
(128,065
)
Other operating expenses
(75,734
)
 
(34,442
)
 
(110,176
)
 
(75,379
)
 
(29,001
)
 
(104,380
)
Underwriting income
$
15,220

 
$
95,772

 
110,992

 
$
789

 
$
72,663

 
73,452

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 

 
 

 
66,083

 
 

 
 

 
73,221

Net realized gains (losses)
 

 
 

 
(6,022
)
 
 

 
 

 
60,391

Net impairment losses recognized in earnings
 

 
 

 
(728
)
 
 

 
 

 
(2,379
)
Equity in net income of investment funds accounted for using the equity method
 

 
 

 
5,665

 
 

 
 

 
24,330

Other income (loss)
 

 
 

 
624

 
 

 
 

 
(532
)
Other expenses
 

 
 

 
(7,894
)
 
 

 
 

 
(9,049
)
Interest expense
 

 
 

 
(5,937
)
 
 

 
 

 
(7,378
)
Net foreign exchange losses
 

 
 

 
(40,562
)
 
 

 
 

 
(16,959
)
Income before income taxes
 

 
 

 
122,221

 
 

 
 

 
195,097

Income tax expense
 

 
 

 
(7,396
)
 
 

 
 

 
(5,441
)
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 
 

 
114,825

 
 

 
 

 
189,656

Preferred dividends
 

 
 

 
(5,484
)
 
 

 
 

 
(5,484
)
Net income available to common shareholders
 

 
 

 
$
109,341

 
 

 
 

 
$
184,172

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 

 
 

 
 

Loss ratio
63.8
%
 
38.3
%
 
53.7
%
 
67.3
%
 
46.8
%
 
59.3
%
Acquisition expense ratio (2)
17.2
%
 
20.4
%
 
18.5
%
 
16.0
%
 
18.6
%
 
17.0
%
Other operating expense ratio
15.8
%
 
10.9
%
 
13.8
%
 
16.5
%
 
9.9
%
 
13.9
%
Combined ratio
96.8
%
 
69.6
%
 
86.0
%
 
99.8
%
 
75.3
%
 
90.2
%
_________________________________________________
(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)


 
Nine Months Ended
 
Nine Months Ended
 
September 30, 2013
 
September 30, 2012
 
Insurance
 
Reinsurance
 
Total
 
Insurance
 
Reinsurance
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
2,075,560

 
$
1,168,938

 
$
3,241,424

 
$
2,022,802

 
$
1,036,708

 
$
3,055,233

Net premiums written
1,508,089

 
1,094,357

 
2,602,446

 
1,438,620

 
1,000,473

 
2,439,093

 
 
 
 
 
 
 
 
 
 
 
 
Net premiums earned
$
1,382,750

 
$
923,836

 
$
2,306,586

 
$
1,344,675

 
$
810,984

 
$
2,155,659

Fee income
1,599

 
367

 
1,966

 
1,803

 
623

 
2,426

Losses and loss adjustment expenses
(880,580
)
 
(364,521
)
 
(1,245,101
)
 
(900,735
)
 
(338,036
)
 
(1,238,771
)
Acquisition expenses, net
(227,806
)
 
(178,776
)
 
(406,582
)
 
(223,591
)
 
(151,725
)
 
(375,316
)
Other operating expenses
(232,216
)
 
(101,234
)
 
(333,450
)
 
(225,366
)
 
(84,264
)
 
(309,630
)
Underwriting income (loss)
$
43,747

 
$
279,672

 
323,419

 
$
(3,214
)
 
$
237,582

 
234,368

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 

 
 

 
200,124

 
 

 
 

 
221,126

Net realized gains
 

 
 

 
64,970

 
 

 
 

 
139,379

Net impairment losses recognized in earnings
 

 
 

 
(3,698
)
 
 

 
 

 
(5,353
)
Equity in net income of investment funds accounted for using the equity method
 

 
 

 
30,429

 
 

 
 

 
56,943

Other income (loss)
 

 
 

 
2,702

 
 

 
 

 
(7,905
)
Other expenses
 

 
 

 
(32,211
)
 
 

 
 

 
(27,972
)
Interest expense
 

 
 

 
(17,687
)
 
 

 
 

 
(22,338
)
Net foreign exchange losses
 

 
 

 
(2,487
)
 
 

 
 

 
(5,958
)
Income before income taxes
 

 
 

 
565,561

 
 

 
 

 
582,290

Income tax expense
 

 
 

 
(17,320
)
 
 

 
 

 
(8,110
)
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 
 

 
548,241

 
 

 
 

 
574,180

Preferred dividends
 

 
 

 
(16,453
)
 
 

 
 

 
(19,594
)
Loss on repurchase of preferred shares
 
 
 
 
—

 
 
 
 
 
(10,612
)
Net income available to common shareholders
 

 
 

 
$
531,788

 
 

 
 

 
$
543,974

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 

 
 

 
 

Loss ratio
63.7
%
 
39.5
%
 
54.0
%
 
67.0
%
 
41.7
%
 
57.5
%
Acquisition expense ratio (2)
16.4
%
 
19.4
%
 
17.5
%
 
16.5
%
 
18.7
%
 
17.3
%
Other operating expense ratio
16.8
%
 
11.0
%
 
14.5
%
 
16.8
%
 
10.4
%
 
14.4
%
Combined ratio
96.9
%
 
69.9
%
 
86.0
%
 
100.3
%
 
70.8
%
 
89.2
%
_________________________________________________
(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.
 


12
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)
September 30, 2013
 

 
 

 
 

 
 

 
 

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

 
 

 
 

 
 

 
 

Corporate bonds
$
2,428,219

 
$
37,646

 
$
(46,263
)
 
$
2,436,836

 
$
(21
)
Mortgage backed securities
1,499,403

 
17,831

 
(36,567
)
 
1,518,139

 
(9,335
)
Municipal bonds
1,531,324

 
36,907

 
(9,079
)
 
1,503,496

 
(17
)
Commercial mortgage backed securities
783,718

 
13,690

 
(11,322
)
 
781,350

 
(199
)
U.S. government and government agencies
1,121,898

 
11,336

 
(4,299
)
 
1,114,861

 
(19
)
Non-U.S. government securities
1,172,057

 
16,401

 
(15,789
)
 
1,171,445

 
—

Asset backed securities
1,199,241

 
19,442

 
(12,221
)
 
1,192,020

 
(3,494
)
Total
9,735,860

 
153,253

 
(135,540
)
 
9,718,147

 
(13,085
)
 
 
 
 
 
 
 
 
 
 
Equity securities
452,195

 
41,295

 
(7,419
)
 
418,319

 
—

Other investments
528,938

 
26,860

 
(25,357
)
 
527,435

 
—

Short-term investments
994,221

 
1,172

 
(449
)
 
993,498

 
—

Total
$
11,711,214

 
$
222,580

 
$
(168,765
)
 
$
11,657,399

 
$
(13,085
)
 
 
 
 
 
 
 
 
 
 
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 September 30, 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.


13
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
September 30, 2013
 

 
 

 
 

 
 

 
 

 
 

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

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
1,351,619

 
$
(44,843
)
 
$
18,507

 
$
(1,420
)
 
$
1,370,126

 
$
(46,263
)
Mortgage backed securities
750,898

 
(32,059
)
 
51,227

 
(4,508
)
 
802,125

 
(36,567
)
Municipal bonds
444,603

 
(8,886
)
 
3,817

 
(193
)
 
448,420

 
(9,079
)
Commercial mortgage backed securities
381,215

 
(11,157
)
 
1,660

 
(165
)
 
382,875

 
(11,322
)
U.S. government and government agencies
266,379

 
(4,299
)
 
—

 
—

 
266,379

 
(4,299
)
Non-U.S. government securities
615,731

 
(13,890
)
 
10,138

 
(1,899
)
 
625,869

 
(15,789
)
Asset backed securities
588,492

 
(9,962
)
 
38,279

 
(2,259
)
 
626,771

 
(12,221
)
Total
4,398,937

 
(125,096
)
 
123,628

 
(10,444
)
 
4,522,565

 
(135,540
)
Equity securities
151,580

 
(7,419
)
 
—

 
—

 
151,580

 
(7,419
)
Other investments
183,501

 
(20,934
)
 
46,988

 
(4,423
)
 
230,489

 
(25,357
)
Short-term investments
9,500

 
(449
)
 
—

 
—

 
9,500

 
(449
)
Total
$
4,743,518

 
$
(153,898
)
 
$
170,616

 
$
(14,867
)
 
$
4,914,134

 
$
(168,765
)
 
 
 
 
 
 
 
 
 
 
 
 
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.”


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

At September 30, 2013, on a lot level basis, approximately 1,840 security lots out of a total of approximately 4,560 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 $3.0 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.
 
 
 
September 30, 2013
 
December 31, 2012
Maturity
 
Fair Value
 
Amortized
Cost
 
Fair Value
 
Amortized
Cost
Due in one year or less
 
$
247,663

 
$
243,987

 
$
446,402

 
$
436,376

Due after one year through five years
 
3,743,302

 
3,703,446

 
3,876,062

 
3,769,426

Due after five years through 10 years
 
2,009,579

 
2,023,258

 
1,949,297

 
1,869,698

Due after 10 years
 
252,954

 
255,947

 
179,927

 
172,275

 
 
6,253,498

 
6,226,638

 
6,451,688

 
6,247,775

Mortgage backed securities
 
1,499,403

 
1,518,139

 
1,532,736

 
1,515,411

Commercial mortgage backed securities
 
783,718

 
781,350

 
824,165

 
791,119

Asset backed securities
 
1,199,241

 
1,192,020

 
1,073,999

 
1,054,309

Total
 
$
9,735,860

 
$
9,718,147

 
$
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 $48.4 million and $47.3 million, respectively, at September 30, 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 $42.1 million at September 30, 2013, compared to $42.5 million at December 31, 2012. Such amounts included approximately $6.4 million of sub-prime securities at September 30, 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. 


15
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:

 
September 30,
2013
 
December 31,
2012
Available for sale:
 
 
 
Asian and emerging markets
$
357,069

 
$
316,860

Investment grade fixed income
164,768

 
220,410

Other
7,101

 
12,010

Total available for sale
528,938

 
549,280

Fair value option:
 
 
 
Term loan investments (par value: $487,083 and $307,016)
496,477

 
308,596

Asian and emerging markets
19,705