ACGL 10Q 3.31.14
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, 2014
 
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 May 1, 2014 was 134,099,536.

Table of Contents

ARCH CAPITAL GROUP LTD.
 
INDEX
 
 
 
Page No.
PART I. Financial Information
 
 
 
 
 
Item 1 — Consolidated Financial Statements
 
 
 
 
 
 
 
 
 
 
 
March 31, 2014 (unaudited) and December 31, 2013
 
 
 
 
 
 
For the three month periods ended March 31, 2014 and 2013 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2014 and 2013 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2014 and 2013 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2014 and 2013 (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 condensed consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of March 31, 2014, and the related condensed consolidated statements of income for the three-month periods ended March 31, 2014 and March 31, 2013, and the condensed consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the three-month periods ended March 31, 2014 and March 31, 2013. 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 condensed 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, 2013, 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 3, 2014, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of December 31, 2013, 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 12, 2014

2
Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
March 31,
2014
 
December 31,
2013
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $9,722,364 and $9,564,634)
$
9,775,730

 
$
9,571,776

Short-term investments available for sale, at fair value (amortized cost: $1,485,378 and $1,477,584)
1,484,280

 
1,478,367

Investment of funds received under securities lending, at fair value (amortized cost: $93,274 and $97,943)
96,264

 
100,584

Equity securities available for sale, at fair value (cost: $475,868 and $433,275)
548,168

 
496,824

Other investments available for sale, at fair value (cost: $417,762 and $488,687)
426,917

 
498,310

Investments accounted for using the fair value option
1,256,650

 
1,221,534

Investments accounted for using the equity method
255,488

 
244,339

Total investments
13,843,497

 
13,611,734

Cash
1,569,605

 
434,057

Accrued investment income
59,701

 
66,848

Investment in joint venture (cost: $100,000)
102,803

 
104,856

Fixed maturities and short-term investments pledged under securities lending, at fair value
100,590

 
105,081

Premiums receivable
1,008,375

 
753,924

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
1,790,025

 
1,804,330

Contractholder receivables
1,118,991

 
1,064,246

Prepaid reinsurance premiums
349,077

 
328,343

Deferred acquisition costs, net
384,294

 
342,314

Receivable for securities sold
426,431

 
50,555

Goodwill and intangible assets
120,875

 
27,319

Other assets
926,094

 
872,487

Total assets
$
21,800,358

 
$
19,566,094

 
 
 
 
Liabilities
 

 
 

Reserve for losses and loss adjustment expenses
$
8,938,958

 
$
8,824,696

Unearned premiums
2,148,475

 
1,896,365

Reinsurance balances payable
201,794

 
196,167

Contractholder payables
1,118,991

 
1,064,246

Deposit accounting liabilities
409,080

 
421,297

Senior notes
800,000

 
800,000

Revolving credit agreement borrowings
100,000

 
100,000

Securities lending payable
103,330

 
107,999

Payable for securities purchased
499,473

 
51,318

Other liabilities
575,394

 
456,510

Total liabilities
14,895,495

 
13,918,598

 
 
 
 
Commitments and Contingencies


 


Redeemable noncontrolling interests (1)
219,234

 
—

 
 
 
 
Shareholders’ Equity
 

 
 

Non-cumulative preferred shares
325,000

 
325,000

Common shares ($0.0033 par, shares issued: 170,006,958 and 169,560,591)
567

 
565

Additional paid-in capital
320,503

 
299,517

Retained earnings
6,219,170

 
6,042,154

Accumulated other comprehensive income, net of deferred income tax
123,719

 
74,964

Common shares held in treasury, at cost (shares: 35,922,820 and 35,885,707)
(1,096,826
)
 
(1,094,704
)
Total shareholders' equity available to Arch
5,892,133

 
5,647,496

Non-redeemable noncontrolling interests (1)
793,496

 
—

Total shareholders’ equity
6,685,629

 
5,647,496

Total liabilities, noncontrolling interests and shareholders’ equity
$
21,800,358

 
$
19,566,094


(1)     See Note 4.

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,
 
2014
 
2013
Revenues
 

 
 

Net premiums written
$
1,064,990

 
$
952,776

Change in unearned premiums
(205,210
)
 
(200,006
)
Net premiums earned
859,780

 
752,770

Net investment income
66,994

 
65,672

Net realized gains
19,697

 
58,340

Other-than-temporary impairment losses
(2,971
)
 
(2,248
)
Less investment impairments recognized in other comprehensive income, before taxes
—

 
2

Net impairment losses recognized in earnings
(2,971
)
 
(2,246
)
 
 
 
 
Other underwriting income
1,582

 
538

Equity in net income of investment funds accounted for using the equity method
3,253

 
13,823

Other income (loss)
(2,104
)
 
1,244

Total revenues
946,231

 
890,141

 
 
 
 
Expenses
 

 
 

Losses and loss adjustment expenses
436,240

 
399,403

Acquisition expenses
160,342

 
127,592

Other operating expenses
145,799

 
120,183

Interest expense
14,404

 
5,898

Net foreign exchange losses (gains)
6,563

 
(24,264
)
Total expenses
763,348

 
628,812

 
 
 
 
Income before income taxes
182,883

 
261,329

Income tax expense
3,738

 
4,853

Net income
$
179,145

 
$
256,476

Net (income) loss attributable to noncontrolling interests (1)
3,355

 
—

Net income available to Arch
182,500

 
256,476

Preferred dividends
5,484

 
5,484

Net income available to common shareholders
$
177,016

 
$
250,992

 
 
 
 
Net income per common share
 

 
 

Basic
$
1.34

 
$
1.92

Diluted
$
1.30

 
$
1.85

 
 
 
 
Weighted average common shares and common share equivalents outstanding
 

 
 

Basic
131,857,910

 
130,907,902

Diluted
136,562,717

 
135,409,288


(1)     See Note 4.


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,
 
2014
 
2013
Comprehensive Income
 
 
 
Net income
$
179,145

 
$
256,476

Other comprehensive income, net of deferred income tax
 
 
 
Unrealized appreciation in value of available-for-sale investments:
 
 
 
Unrealized holding gains arising during period
71,353

 
9,471

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax
—

 
(2
)
Reclassification of net realized gains, net of income taxes, included in net income
(21,249
)
 
(38,701
)
Foreign currency translation adjustments
(1,349
)
 
(28,222
)
Comprehensive income
227,900

 
199,022

 
 
 
 
Net (income) loss attributable to noncontrolling interests (1)
3,355

 
—

Other comprehensive (income) loss attributable to noncontrolling interests
—

 
—

Comprehensive (income) loss attributable to noncontrolling interests
3,355

 
—

 
 
 
 
Comprehensive income available to Arch
$
231,255

 
$
199,022


(1)     See Note 4.


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,
 
2014
 
2013
Non-Cumulative Preferred Shares
 

 
 

Balance at beginning and end of period
$
325,000

 
$
325,000

 
 
 
 
Common Shares
 

 
 

Balance at beginning of year
565

 
561

Common shares issued, net
2

 
—

Balance at end of period
567

 
561

 
 
 
 
Additional Paid-in Capital
 

 
 

Balance at beginning of year
299,517

 
227,778

Exercise of stock options
8,054

 
3,093

Amortization of share-based compensation
14,175

 
11,543

Other
(1,243
)
 
78

Balance at end of period
320,503

 
242,492

 
 
 
 
Retained Earnings
 

 
 

Balance at beginning of year
6,042,154

 
5,354,361

Net income
179,145

 
256,476

Net (income) loss attributable to noncontrolling interests (1)
3,355

 
—

Preferred share dividends
(5,484
)
 
(5,484
)
Balance at end of period
6,219,170

 
5,605,353

 
 
 
 
Accumulated Other Comprehensive Income
 

 
 

Balance at beginning of year
74,964

 
287,017

Unrealized appreciation in value of available-for-sale investments, net of deferred income tax:
 
 
 
Balance at beginning of year
80,692

 
289,956

Unrealized holding gains (losses) arising during period, net of reclassification adjustment
50,104

 
(29,230
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax
—

 
(2
)
Balance at end of period
130,796

 
260,724

Foreign currency translation adjustments:
 
 
 
Balance at beginning of year
(5,728
)
 
(2,939
)
Foreign currency translation adjustments
(1,349
)
 
(28,222
)
Balance at end of period
(7,077
)
 
(31,161
)
Balance at end of period
123,719

 
229,563

 
 
 
 
Common Shares Held in Treasury, at Cost
 

 
 

Balance at beginning of year
(1,094,704
)
 
(1,025,839
)
Shares repurchased for treasury
(2,122
)
 
(41,600
)
Balance at end of period
(1,096,826
)
 
(1,067,439
)
 
 
 
 
Total shareholders’ equity available to Arch
5,892,133

 
5,335,530

Noncontrolling interests (1)
793,496

 
—

Total shareholders’ equity
$
6,685,629

 
$
5,335,530


(1)     See Note 4.

 

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,
 
2014
 
2013
Operating Activities
 

 
 

Net income
$
179,145

 
$
256,476

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

 
 

Net realized gains
(22,367
)
 
(59,504
)
Net impairment losses recognized in earnings
2,971

 
2,246

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
9,559

 
23,052

Share-based compensation
14,175

 
11,543

Changes in:
 

 
 

Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
10,326

 
(22,182
)
Unearned premiums, net of prepaid reinsurance premiums
205,210

 
200,006

Premiums receivable
(242,616
)
 
(198,814
)
Deferred acquisition costs, net
(41,988
)
 
(45,159
)
Reinsurance balances payable
5,428

 
17,365

Other liabilities
59,285

 
23,811

Other items
19,041

 
(3,181
)
Net Cash Provided By Operating Activities
198,169

 
205,659

 
 
 
 
Investing Activities
 

 
 

Purchases of:
 

 
 

Fixed maturity investments
(7,131,071
)
 
(3,970,320
)
Equity securities
(89,227
)
 
(63,353
)
Other investments
(304,454
)
 
(250,442
)
Proceeds from the sales of:
 

 
 

Fixed maturity investments
7,014,281

 
3,796,638

Equity securities
49,614

 
81,513

Other investments
331,176

 
280,010

Proceeds from redemptions and maturities of fixed maturity investments
168,484

 
181,727

Net (purchases) sales of short-term investments
156,262

 
(221,444
)
Change in investment of securities lending collateral
4,669

 
(41,019
)
Purchase of business, net of cash acquired (1)
(235,578
)
 
—

Purchases of furniture, equipment and other assets
(5,382
)
 
(3,742
)
Net Cash Used For Investing Activities
(41,226
)
 
(210,432
)
 
 
 
 
Financing Activities
 

 
 

Purchases of common shares under share repurchase program
—

 
(40,964
)
Proceeds from common shares issued, net
3,021

 
1,280

Change in securities lending collateral
(4,669
)
 
41,019

Third party investment in non-redeemable noncontrolling interests (2)
796,903

 
—

Third party investment in redeemable noncontrolling interests (2)
186,893

 
—

Other
1,700

 
1,084

Preferred dividends paid
(5,484
)
 
(5,484
)
Net Cash Provided By (Used For) Financing Activities
978,364

 
(3,065
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash
241

 
(6,436
)
 
 
 
 
Increase (decrease) in cash
1,135,548

 
(14,274
)
Cash beginning of year
434,057

 
371,041

Cash end of period
$
1,569,605

 
$
356,767


(1)     See Note 2.
(2)     See Note 4.


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 subsidiaries (together with ACGL, the “Company”).

On January 30, 2014, the Company acquired CMG Mortgage Insurance Company and its affiliated mortgage insurance companies (together, “CMG Entities”) and the mortgage insurance platform and related assets from PMI Mortgage Insurance Co. (“PMI”) (see Note 2).

On March 20, 2014, the Company acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity for $100 million. Watford Holdings Ltd. is the parent of Watford Re Ltd., a newly-formed multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., “Watford”). Watford is considered a variable interest entity (“VIE”) and the Company concluded that it is the primary beneficiary of Watford. As such, the results of Watford are included in the Company’s consolidated financial statements (see Note 4).

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 the Company and Watford. 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, 2013 (“2013 Form 10-K”), 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.    Business Acquired

On January 30, 2014, the Company’s U.S.-based subsidiaries completed the acquisition of the CMG Entities through a stock purchase agreement (“SPA”) from its previous owners, PMI, which has been in rehabilitation under the receivership of the Arizona Department of Insurance since 2011, and CMFG Life Insurance Company (“CUNA Mutual”). In addition, the Company entered into a distribution agreement with CUNA Mutual and a reinsurance agreement with an affiliate of CUNA Mutual. CMG Mortgage Insurance Company has been renamed “Arch Mortgage Insurance Company” (“Arch MI U.S.”). As part of the transaction, Arch MI U.S. obtained approval as an eligible mortgage insurer from Fannie Mae and Freddie Mac (each a government sponsored enterprise or “GSE”), subject to maintaining certain ongoing requirements.

In addition, through an asset purchase agreement (“APA”) with PMI, the Company acquired the mortgage insurance operating platform of PMI, 100% of the capital stock of PMI Mortgage Assurance Co., a mortgage insurance company licensed in all 50 states (renamed Arch Mortgage Guaranty Company), and entered into a quota share reinsurance agreement pursuant to which Arch Reinsurance Ltd. agreed 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 were not in default as of an agreed upon effective date. Other than this quota share, no PMI legacy exposures were assumed in the transaction. As part of the transaction, the Company entered into a services agreement with PMI to provide certain necessary operational services to administer the run-off of PMI’s legacy business at the direction of PMI. Arch MI U.S. also entered into a quota share reinsurance agreement whereby it will cede 20% of all new primary flow mortgage insurance business post-closing (both credit union and non-credit union business) on the first $25 billion in original loan amounts to PMI, on a funds-withheld basis.

8



The completion of the SPA and APA transactions enabled the Company to enter the U.S. mortgage insurance marketplace and serve all lenders nationwide. The arrangements with CUNA Mutual also provided a seamless transition and enabled the Company to provide uninterrupted access and services to the credit union marketplace.

At closing, the Company paid aggregate consideration of $160.6 million (80% of the actual closing date book value of the CMG Entities) under the SPA and $84.6 million under the APA. Additionally, the SPA contains provisions for additional contingent consideration payments, subject to an overall maximum payment of 150% of closing book value of the pre-closing portfolio of the CMG Entities as re-calculated over an earn-out period and payable at the third, fifth and sixth anniversaries after closing (subject to a one time extension period of one to three years at the sellers’ discretion). The maximum amount of contingent consideration payments is $136.3 million. To the extent that the adjusted book value of the CMG Entities drops below the cumulative amount paid by the Company, no additional payments would be due. To determine the fair value of the contingent consideration liability, the Company estimated future payments using a weighted average cost of capital approach at a rate of return of 15% which reflects the industry-weighted average rate of return on debt and equity as required by market participants. The fair value of the contingent consideration liability was $41.8 million at closing. The contingent consideration liability, which is included in ‘other liabilities’ in the consolidated balance sheets, is remeasured at fair value at each balance sheet date ($43.2 million at March 31, 2014) until the contingency is resolved with changes in fair value recognized in ‘net realized gains (losses).’

The following table summarizes the fair value of net assets acquired and allocation of purchase price:
 
 
Total
 
Useful Life
Purchase price
 
 
 
 
Cash paid
 
$
245,157

 
 
Contingent consideration liability
 
41,762

 
 
Total purchase price (a)
 
$
286,919

 
 
 
 
 
 
 
Assets acquired
 
 
 
 
Cash
 
$
9,579

 
 
Investments, at fair value
 
312,093

 
 
Intangible asset -- acquired insurance contracts
 
46,473

 
5 years
Intangible asset -- operating platform
 
29,900

 
5 years
Intangible asset -- favorable lease contract
 
1,056

 
5 years
Intangible asset -- insurance licenses
 
16,858

 
Indefinite
Other assets acquired
 
21,691

 
 
Total assets acquired
 
437,650

 
 
 
 
 
 
 
Liabilities acquired
 
 
 
 
Reserves for losses and loss adjustment expenses
 
$
121,572

 
 
Unearned premiums
 
26,261

 
 
Intangible liability -- unfavorable service contract
 
9,533

 
9 years
Other liabilities acquired
 
7,217

 
 
Total liabilities acquired
 
164,583

 
 
Net assets acquired (b)
 
$
273,067

 
 
Goodwill (a)-(b)
 
$
13,852

 
 

The Company recognized goodwill of $13.9 million that is primarily attributed to PMI’s assembled workforce, access to the mortgage insurance market through an existing operating platform, and additional synergies to be realized in the future. Under U.S. tax principles, which differentiate between taxable and non-taxable business combinations, the Company estimates that $48.0 million of goodwill is expected to be deductible for tax purposes.

The Company includes the operations of Arch MI U.S. in its mortgage segment (see Note 6).

3.    Significant Accounting Policies

As discussed in Note 2, the Company completed its acquisition of the CMG Entities on January 30, 2014. As such, the Company has added relevant sections pertaining to mortgage insurance to its significant accounting policies as described in Note 2, “Significant Accounting Policies,” of its audited consolidated financial statements and related notes of the 2013 Form 10-K.

9



(b) Premium Revenues and Related Expenses

Insurance. Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in the Company’s programs, specialty lines, lenders products business and for participation in involuntary pools. Such premium estimates are derived from multiple sources which include the historical experience of the underlying business, similar business and available industry information. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of in-force insurance policies.

Reinsurance. Reinsurance premiums written include amounts reported by brokers and ceding companies, supplemented by the Company’s own estimates of premiums where reports have not been received. The determination of premium estimates requires a review of the Company’s experience with the ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management’s judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to the Company. On an ongoing basis, the Company’s underwriters review the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business, taking into account the Company’s historical experience with the brokers or ceding companies. In addition, reinsurance contracts under which the Company assumes business generally contain specific provisions which allow the Company to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined.

Reinsurance premiums written are recorded based on the type of contracts the Company writes. Premiums on the Company’s excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, premiums are recorded as written based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.

Reinstatement premiums for the Company’s insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment. Premium estimates are reviewed by management at least quarterly. Such review includes a comparison of actual reported premiums to expected ultimate premiums along with a review of the aging and collection of premium estimates. Based on management’s review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts.

Reinsurance premiums written, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a “losses occurring” basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a “risks attaching” basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period. Certain of the Company’s reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses, are recorded based upon the projected experience under such contracts.

The Company also writes certain reinsurance business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, the Company assumes a measured amount of insurance risk in

10


exchange for an anticipated margin, which is typically lower than on traditional reinsurance contracts. The terms and conditions of these contracts may include additional or return premiums based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages, financial quota share coverages and multi- year retrospectively rated excess of loss coverages. If these contracts are deemed to transfer risk, they are accounted for as reinsurance.

Mortgage. Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy. If single premium policies related to insured loans are canceled due to repayment by the borrower, and the premium is non-refundable, the remaining unearned premium related to each canceled policy is recognized as earned premium upon notification of the cancellation.

Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. A portion of premium payments may be refundable if the insured cancels coverage, which generally occurs when the loan is repaid, the loan amortizes to a sufficiently low amount to trigger a lender permitted or legally required cancellation, or the value of the property has increased sufficiently in accordance with the terms of the contract. Premium refunds reduce premiums earned in the consolidated statements of operations.

Acquisition Costs. Acquisition expenses and other expenses related to the Company’s underwriting operations that vary with, and are directly related to, the successful acquisition or renewal of business are deferred and amortized based on the type of contract. For property and casualty insurance and reinsurance contracts, deferred acquisition costs are amortized over the period in which the related premiums are earned. Consistent with mortgage insurance industry accounting practice, amortization of acquisition costs related to the mortgage insurance contracts for each underwriting year’s book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are comprised of earned premiums, interest income, losses and loss adjustment expenses. For each underwriting year, the Company estimates the rate of amortization to reflect actual experience and any changes to persistency or loss development.

Acquisition expenses, net of ceding commissions received from reinsurers, consist principally of commissions and premium taxes paid to obtain the Company’s business. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Deferred acquisition costs are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income. A premium deficiency occurs if the sum of anticipated losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceed unearned premiums and anticipated investment income. A premium deficiency is recorded by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency.


11


(i) Reserves for Losses and Loss Adjustment Expenses

Insurance and Reinsurance. The reserve for losses and loss adjustment expenses consists of estimates of unpaid reported losses and loss adjustment expenses and estimates for losses incurred but not reported. The reserve for unpaid reported losses and loss adjustment expenses, established by management based on reports from ceding companies and claims from insureds, excludes estimates of amounts due from insureds related to losses under high deductible policies, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company. Such reserves are supplemented by management’s estimates of reserves for losses incurred for which reports or claims have not been received. The Company’s reserves are based on a combination of reserving methods, incorporating both Company and industry loss development patterns. The Company selects the initial expected loss and loss adjustment expense ratios based on information derived by its underwriters and actuaries during the initial pricing of the business, supplemented by industry data where appropriate. Such ratios consider, among other things, rate changes and changes in terms and conditions that have been observed in the market. These estimates are reviewed regularly and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments, if any, are reflected in income in the period in which they are determined. As actual loss information has been reported, the Company has developed its own loss experience and its reserving methods include other actuarial techniques. Over time, such techniques have been given further weight in its reserving process based on the continuing maturation of the Company’s reserves. Inherent in the estimates of ultimate losses and loss adjustment expenses are expected trends in claims severity and frequency and other factors which may vary significantly as claims are settled. Accordingly, ultimate losses and loss adjustment expenses may differ materially from the amounts recorded in the accompanying consolidated financial statements. Losses and loss adjustment expenses are recorded on an undiscounted basis, except for excess workers’ compensation and employers’ liability business written by the Company’s insurance operations.

Mortgage. The reserves for mortgage guaranty insurance losses and loss adjustment expenses are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. Consistent with industry accounting practice, the Company does not establish loss reserves for future claims on insured loans that are not currently in default (defined as two consecutive missed payments). The Company establishes loss reserves on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and average claim sizes for each report year, net of any salvage recoverable. The Company also reserves for defaults that have occurred but have not yet been reported to the Company prior to the close of an accounting period. To determine this reserve, the Company estimates the number of defaults not yet reported using historical information regarding late reported delinquencies and applies estimated claim rates and claim sizes for the estimated defaults not yet reported.

The establishment of reserves across the Company’s segments is an inherently uncertain process, are necessarily based on estimates, and the ultimate net cost may vary from such estimates. The methods for making such estimates and for establishing the resulting liability are reviewed and updated using the most current information available. Any resulting adjustments, which may be material, are reflected in current operations

(q) Goodwill and Intangible Assets

Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired and is assigned to the applicable reporting unit at acquisition. Goodwill is not amortized and is evaluated for impairment on an annual basis. Impairment tests may be performed more frequently if the facts and circumstances indicate a possible impairment. In performing impairment tests, the Company may first assess qualitative factors to determine whether it is more likely than not (that is, more than a 50% probability) that the fair value of a reporting unit exceeds its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in the accounting guidance.

Indefinite-lived intangible assets, such as insurance licenses, are not amortized and are evaluated for impairment similar to goodwill. Finite-lived intangible assets and liabilities include the value of insurance and reinsurance contracts, which are estimated based on the present value of future expected cash flows and amortized in ‘acquisition expenses’ in proportion to the estimated profits expected to be realized. Other finite-lived intangible assets or liabilities, including favorable or unfavorable contracts, are amortized in ‘other operating expenses’ over their useful lives. Finite-lived intangible assets and liabilities are periodically reviewed for indicators of impairment. An impairment is recognized when the carrying amount is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and fair value.

If goodwill or intangible assets are impaired, such assets are written down to their realizable values with the related expense recorded in the Company’s results of operations.


12


4.     Variable Interest Entity and Noncontrolling Interests

Variable interest entity

A VIE refers to an entity that has characteristics such as (i) insufficient equity at risk to allow the entity to finance its activities without additional financial support or (ii) instances where the equity investors, as a group, do not have characteristics of a controlling financial interest. The primary beneficiary of a VIE is defined as the variable interest holder that is determined to have the controlling financial interest as a result of having both (i) the power to direct the activities of a VIE that most significantly impact the economic performance of the VIE and (ii) the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. If a company is determined to be the primary beneficiary, it is required to consolidate the VIE in its financial statements.

In March 2014, Watford raised approximately $1.1 billion of capital consisting of $907.3 million in common equity ($895.6 million net of issuance costs) and $226.6 million in preference equity ($219.2 million net of issuance costs and discount). The Company invested $100.0 million and acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity. Arch Underwriters Ltd. (“AUL”), a subsidiary of the Company, acts as Watford’s reinsurance manager, and Highbridge Principal Strategies, LLC (“Highbridge”), a subsidiary of JPMorgan Chase & Co., manages Watford’s investment assets, each under separate long term services agreements. John Rathgeber, previously Vice Chairman of Arch Worldwide Reinsurance Group, was named CEO of Watford. In addition, Marc Grandisson, Chairman and CEO of Arch Worldwide Reinsurance and Mortgage Groups, and Nicolas Papadopoulo, Chairman and CEO of Arch Reinsurance Ltd., were appointed to the board of directors of Watford.

The Company concluded that Watford is a VIE due to both the reinsurance management services agreement with AUL and the investment management agreement with Highbridge. Both of these agreements provide for services for an extended period of time with limited termination rights by Watford. In addition, these agreements allow for both AUL and Highbridge to participate in the favorable results of Watford in the form of performance fees. To determine if the Company is the primary beneficiary of Watford, the Company concluded that the most significant activity of Watford pertains to the insurance activities arising from the reinsurance management services agreement, as these activities will ultimately generate the investable assets required by Highbridge to execute the investment strategy. In addition, the Company factored into its analysis qualitative aspects of the relationship with Watford that are indicative of power to direct the insurance activities. These aspects coupled with the Company’s board seats and a former executive of the Company serving as Watford’s CEO resulted in the Company concluding that it is the primary beneficiary of Watford. As such, the results of Watford are included in the Company’s consolidated financial statements.

The Company concluded that Watford represents a separate operating segment and provides the income statement and total investable assets, total assets and total liabilities of Watford within Note 6. Because Watford is an independent company, the assets of Watford can be used only to settle obligations of Watford and Watford is solely responsible for its own liabilities and commitments. The Company’s financial exposure to Watford is limited to its investment in Watford’s common shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions.

Non-redeemable noncontrolling interests

The Company accounts for the portion of Watford’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford’s common shares was approximately 89% at March 31, 2014. The portion of Watford’s income or loss attributable to third party investors is recorded in the consolidated statements of income as ‘net (income) loss attributable to noncontrolling interests.’ The following table sets forth activity in the non-redeemable noncontrolling interests:
 
Three Months Ended March 31, 2014
Balance, beginning of year
$
—

Sale of shares to noncontrolling interests
796,903

Net (loss) income attributable to noncontrolling interests
(3,407
)
Balance, end of period
$
793,496



13


Redeemable noncontrolling interests

The Company accounts for redeemable noncontrolling interests in the mezzanine section of its consolidated balance sheets in accordance with applicable accounting guidance. Such redeemable noncontrolling interests represent the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in late March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. The Watford Preference Shares were issued at a discounted amount of $24.50 per share. Due to the timing of the issuance, not all amounts subscribed were collected by Watford by March 31, 2014. Holders of the Watford Preference Shares will be entitled to receive, if declared by Watford’s board, quarterly cash dividends on the last day of March, June, September, and December commencing June 30, 2014. Dividends will accrue from the closing date to June 30, 2019 at a fixed rate of 8.5% per annum. From June 30, 2019 and subsequent, dividends will accrue based on a floating rate equal to the 3 month U.S. dollar LIBOR (with a 1% floor) plus a margin based on the difference between the fixed rate and the 5 year mid swap rate to the floating rate as set out on the IRSB18. The Watford Preference Shares may be redeemed by Watford on or after June 30, 2019 or at the option of the preferred shareholders at any time on or after June 30, 2034. Because the redemption features are not solely within the control of Watford, the Company accounts for the redeemable noncontrolling interests in the Watford Preference Shares in the mezzanine section of its consolidated balance sheets. Third party investors own 100% of the Watford Preference Shares at March 31, 2014. Preferred dividends, including the accretion of the discount and issuance costs, are included as ‘net (income) loss attributable to noncontrolling interests’ in the Company’s consolidated statements of income.

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,
 
2014
 
2013
 
 
 
 
Numerator:
 

 
 

Net income
$
179,145

 
$
256,476

Net (income) loss attributable to noncontrolling interests
3,355

 
—

Net income available to Arch
182,500

 
256,476

Preferred dividends
(5,484
)
 
(5,484
)
Net income available to Arch common shareholders
$
177,016

 
$
250,992

 
 
 
 
Denominator:
 

 
 

Weighted average common shares outstanding — basic
131,857,910

 
130,907,902

Effect of dilutive common share equivalents:
 

 
 

Nonvested restricted shares
1,346,401

 
1,290,161

Stock options (1)
3,358,406

 
3,211,225

Weighted average common shares and common share equivalents outstanding — diluted
136,562,717

 
135,409,288

 
 
 
 
Earnings per common share:
 

 
 

Basic
$
1.34

 
$
1.92

Diluted
$
1.30

 
$
1.85

_________________________________________________
(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 2014 first quarter and 2013 first quarter, the number of stock options excluded were 759,172 and 1,016,043, respectively.


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

6.    Segment Information
 
During the 2014 first quarter, to reflect activity during the period as described below, the Company changed its segment structure and added two new segments (mortgage and ‘other’). The Company now classifies its businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — ‘other’ and corporate (non-underwriting). The Company determined its reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of the Company’s consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.

The Company’s insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to the Company’s chief operating decision makers, the Chairman, President and Chief Executive Officer of ACGL and the Chief Financial Officer of ACGL. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. Management measures segment performance for its three underwriting segments based on underwriting income or loss. The Company does not manage its assets by underwriting segment and, accordingly, investment income is not allocated to each underwriting segment.

The corporate (non-underwriting) segment results include net investment income, other income (loss), other expenses incurred by the Company, interest expense, net realized gains or losses, net impairment losses included in earnings, equity in net income (loss) of investment funds accounted for using the equity method, net foreign exchange gains or losses, income taxes and items related to the Company’s non-cumulative preferred shares. Such amounts exclude the results of the ‘other’ segment.

The ‘other’ segment includes the results of Watford (see Note 4). Watford has its own management and board of directors that is responsible for the overall profitability of the ‘other’ segment. For the ‘other’ segment, performance is measured based on net income or loss.


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


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
 
March 31, 2014
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
730,646

 
$
517,053

 
$
47,907

 
$
1,295,136

 
$
32,194

 
$
1,295,136

Premiums ceded
(185,044
)
 
(73,127
)
 
(4,639
)
 
(262,340
)
 
—

 
(230,146
)
Net premiums written
545,602

 
443,926

 
43,268

 
1,032,796

 
32,194

 
1,064,990

Change in unearned premiums
(68,101
)
 
(102,578
)
 
(4,503
)
 
(175,182
)
 
(30,028
)
 
(205,210
)
Net premiums earned
477,501

 
341,348

 
38,765

 
857,614

 
2,166

 
859,780

Other underwriting income
500

 
316

 
766

 
1,582

 
—

 
1,582

Losses and loss adjustment expenses
(286,770
)
 
(139,636
)
 
(8,478
)
 
(434,884
)
 
(1,356
)
 
(436,240
)
Acquisition expenses, net
(76,932
)
 
(73,433
)
 
(9,154
)
 
(159,519
)
 
(823
)
 
(160,342
)
Other operating expenses
(81,144
)
 
(36,195
)
 
(13,876
)
 
(131,215
)
 
(1,109
)
 
(132,324
)
Underwriting income (loss)
$
33,155

 
$
92,400

 
$
8,023

 
133,578

 
(1,122
)
 
132,456

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 

 
 

 
 
 
66,993

 
1

 
66,994

Net realized gains
 

 
 

 
 
 
19,697

 
—

 
19,697

Net impairment losses recognized in earnings
 

 
 

 
 
 
(2,971
)
 
—

 
(2,971
)
Equity in net income of investment funds accounted for using the equity method
 

 
 

 
 
 
3,253

 
—

 
3,253

Other income (loss)
 

 
 

 
 
 
(2,104
)
 
—

 
(2,104
)
Other expenses
 

 
 

 
 
 
(10,799
)
 
(2,676
)
 
(13,475
)
Interest expense
 

 
 

 
 
 
(14,404
)
 
—

 
(14,404
)
Net foreign exchange gains (losses)
 

 
 

 
 
 
(6,656
)
 
93

 
(6,563
)
Income before income taxes
 

 
 

 
 
 
186,587

 
(3,704
)
 
182,883

Income tax expense
 

 
 

 
 
 
(3,738
)
 
—

 
(3,738
)
Net income (loss)
 

 
 

 
 
 
182,849

 
(3,704
)
 
179,145

Net (income) loss attributable to noncontrolling interests
 
 
 
 
 
 
—

 
3,355

 
3,355

Net income available to Arch
 
 
 
 
 
 
182,849

 
(349
)
 
182,500

Preferred dividends
 

 
 

 
 
 
(5,484
)
 
—

 
(5,484
)
Net income available to Arch common shareholders
 

 
 

 
 
 
$
177,365

 
$
(349
)
 
$
177,016

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
60.1
%
 
40.9
%
 
21.9
%
 
50.7
%
 
62.6
%
 
50.7
%
Acquisition expense ratio (2)
16.0
%
 
21.5
%
 
23.6
%
 
18.5
%
 
38.0
%
 
18.6
%
Other operating expense ratio
17.0
%
 
10.6
%
 
35.8
%
 
15.3
%
 
51.2
%
 
15.4
%
Combined ratio
93.1
%
 
73.0
%
 
81.3
%
 
84.5
%
 
151.8
%
 
84.7
%
 
 
 
 
 
 
 
 
 
 
 
 
Total investable assets
 
 
 
 
 
 
$
14,261,106

 
$
1,083,280

 
$
15,344,386

Total assets
 
 
 
 
 
 
20,653,897

 
1,146,461

 
21,800,358

Total liabilities
 
 
 
 
 
 
14,860,124

 
35,371

 
14,895,495

_________________________________________________
(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 certain other underwriting income.
 

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

 
Three Months Ended
 
March 31, 2013
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
688,817

 
$
450,447

 
$
25,758

 
$
1,163,699

 
$
—

 
$
1,163,699

Premiums ceded
(184,267
)
 
(27,979
)
 
—

 
(210,923
)
 
—

 
(210,923
)
Net premiums written
504,550

 
422,468

 
25,758

 
952,776

 
—

 
952,776

Change in unearned premiums
(59,585
)
 
(126,315
)
 
(14,106
)
 
(200,006
)
 
—

 
(200,006
)
Net premiums earned
444,965

 
296,153

 
11,652

 
752,770

 
—

 
752,770

Other underwriting income
525

 
13

 
—

 
538

 
—

 
538

Losses and loss adjustment expenses
(283,467
)
 
(113,857
)
 
(2,079
)
 
(399,403
)
 
—

 
(399,403
)
Acquisition expenses, net
(70,758
)
 
(53,143
)
 
(3,691
)
 
(127,592
)
 
—

 
(127,592
)
Other operating expenses
(76,315
)
 
(32,197
)
 
(1,403
)
 
(109,915
)
 
—

 
(109,915
)
Underwriting income
$
14,950

 
$
96,969

 
$
4,479

 
116,398

 
—

 
116,398

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 

 
 

 
 
 
65,672

 
—

 
65,672

Net realized gains
 

 
 

 
 
 
58,340

 
—

 
58,340

Net impairment losses recognized in earnings
 

 
 

 
 
 
(2,246
)
 
—

 
(2,246
)
Equity in net income of investment funds accounted for using the equity method
 

 
 

 
 
 
13,823

 
—

 
13,823

Other income (loss)
 

 
 

 
 
 
1,244

 
—

 
1,244

Other expenses
 

 
 

 
 
 
(10,268
)
 
—

 
(10,268
)
Interest expense
 

 
 

 
 
 
(5,898
)
 
—

 
(5,898
)
Net foreign exchange gains
 

 
 

 
 
 
24,264

 
—

 
24,264

Income before income taxes
 

 
 

 
 
 
261,329

 
—

 
261,329

Income tax expense
 

 
 

 
 
 
(4,853
)
 
—

 
(4,853
)
Net income
 

 
 

 
 
 
256,476

 
—

 
256,476

Net (income) loss attributable to noncontrolling interests
 
 
 
 
 
 
—

 
—

 
—

Net income available to Arch
 
 
 
 
 
 
256,476

 
—

 
256,476

Preferred dividends
 

 
 

 
 
 
(5,484
)
 
—

 
(5,484
)
Net income available to Arch common shareholders
 

 
 

 
 
 
$
250,992

 
$
—

 
$
250,992

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
63.7
%
 
38.4
%
 
17.8
%
 
53.1
%
 
—
%
 
53.1
%
Acquisition expense ratio (2)
15.8
%
 
17.9
%
 
31.7
%
 
16.9
%
 
—
%
 
16.9
%
Other operating expense ratio
17.2
%
 
10.9
%
 
12.0
%
 
14.6
%
 
—
%
 
14.6
%
Combined ratio
96.7
%
 
67.2
%
 
61.5
%
 
84.6
%
 
—
%
 
84.6
%
 
 
 
 
 
 
 
 
 
 
 
 
Total investable assets
 
 
 
 
 
 
$
13,132,116

 
$
—

 
$
13,132,116

Total assets
 
 
 
 
 
 
18,757,061

 
—

 
18,757,061

Total liabilities
 
 
 
 
 
 
13,421,531

 
—

 
13,421,531

_________________________________________________
(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 other underwriting income.


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

7.    Investment Information
 
At March 31, 2014, total investable assets of $15.34 billion included $14.26 billion managed by the Company and $1.08 billion attributable to Watford. Due to the timing of Watford’s launch, the cash proceeds received from Watford’s capital raising activities was not invested at March 31, 2014 and, as such, Watford’s investable assets were included in the Company’s cash balance at such date. As such, the tables in this footnote do not reflect any Watford balances except for the net investment income table. See Note 4 for further details on Watford.

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, 2014
 

 
 

 
 

 
 

 
 

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

 
 

 
 

 
 

 
 

Corporate bonds
$
2,514,129

 
$
39,704

 
$
(20,047
)
 
$
2,494,472

 
$
(16
)
Mortgage backed securities
1,087,840

 
21,700

 
(14,253
)
 
1,080,393

 
(8,217
)
Municipal bonds
1,410,043

 
28,494

 
(3,742
)
 
1,385,291

 
(17
)
Commercial mortgage backed securities
1,023,055

 
11,769

 
(9,031
)
 
1,020,317

 
—

U.S. government and government agencies
1,153,120

 
4,048

 
(5,932
)
 
1,155,004

 
(19
)
Non-U.S. government securities
1,114,382

 
14,538

 
(12,978
)
 
1,112,822

 
—

Asset backed securities
1,573,751

 
11,143

 
(12,385
)
 
1,574,993

 
(2,902
)
Total
9,876,320

 
131,396

 
(78,368
)
 
9,823,292

 
(11,171
)
 
 
 
 
 
 
 
 
 
 
Equity securities
548,168

 
78,896

 
(6,596
)
 
475,868

 
—

Other investments
426,917

 
24,398

 
(15,243
)
 
417,762

 
—

Short-term investments
1,484,280

 
955

 
(2,053
)
 
1,485,378

 
—

Total
$
12,335,685

 
$
235,645

 
$
(102,260
)
 
$
12,202,300

 
$
(11,171
)
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

 
 

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

 
 

 
 

 
 

 
 

Corporate bonds
$
2,267,263

 
$
35,289

 
$
(35,537
)
 
$
2,267,511

 
$
(16
)
Mortgage backed securities
1,133,095

 
16,270

 
(22,209
)
 
1,139,034

 
(9,269
)
Municipal bonds
1,481,738

 
29,378

 
(9,730
)
 
1,462,090

 
(17
)
Commercial mortgage backed securities
1,074,497

 
13,972

 
(15,224
)
 
1,075,749

 
(199
)
U.S. government and government agencies
1,301,809

 
3,779

 
(11,242
)
 
1,309,272

 
(19
)
Non-U.S. government securities
1,085,861

 
14,729

 
(19,363
)
 
1,090,495

 
—

Asset backed securities
1,332,594

 
20,033

 
(13,795
)
 
1,326,356

 
(3,422
)
Total
9,676,857

 
133,450

 
(127,100
)
 
9,670,507

 
(12,942
)
 
 
 
 
 
 
 
 
 
 
Equity securities
496,824

 
69,487

 
(5,938
)
 
433,275

 
—

Other investments
498,310

 
28,082

 
(18,459
)
 
488,687

 
—

Short-term investments
1,478,367

 
1,654

 
(871
)
 
1,477,584

 
—

Total
$
12,150,358

 
$
232,673

 
$
(152,368
)
 
$
12,070,053

 
$
(12,942
)
_________________________________________________
(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, 2014, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $4.8 million, compared to a net unrealized gain of $6.0 million at December 31, 2013.


18
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, 2014
 

 
 

 
 

 
 

 
 

 
 

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

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
1,012,076

 
$
(17,780
)
 
$
40,352

 
$
(2,267
)
 
$
1,052,428

 
$
(20,047
)
Mortgage backed securities
434,286

 
(11,841
)
 
23,033

 
(2,412
)
 
457,319

 
(14,253
)
Municipal bonds
340,349

 
(3,484
)
 
3,741

 
(258
)
 
344,090

 
(3,742
)
Commercial mortgage backed securities
398,428

 
(8,977
)
 
581

 
(54
)
 
399,009

 
(9,031
)
U.S. government and government agencies
764,802

 
(5,932
)
 
—

 
—

 
764,802

 
(5,932
)
Non-U.S. government securities
541,534

 
(10,940
)
 
36,298

 
(2,038
)
 
577,832

 
(12,978
)
Asset backed securities
904,539

 
(8,424
)
 
99,179

 
(3,961
)
 
1,003,718

 
(12,385
)
Total
4,396,014

 
(67,378
)
 
203,184

 
(10,990
)
 
4,599,198

 
(78,368
)
Equity securities
102,589

 
(6,596
)
 
—

 
—

 
102,589

 
(6,596
)
Other investments
156,468

 
(15,243
)
 
—

 
—

 
156,468

 
(15,243
)
Short-term investments
180,233

 
(2,053
)
 
—

 
—

 
180,233

 
(2,053
)
Total
$
4,835,304

 
$
(91,270
)
 
$
203,184

 
$
(10,990
)
 
$
5,038,488

 
$
(102,260
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

 
 

 
 

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

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
1,183,625

 
$
(32,837
)
 
$
46,673

 
$
(2,700
)
 
$
1,230,298

 
$
(35,537
)
Mortgage backed securities
778,693

 
(20,253
)
 
43,634

 
(1,956
)
 
822,327

 
(22,209
)
Municipal bonds
589,009

 
(9,422
)
 
6,092

 
(308
)
 
595,101

 
(9,730
)
Commercial mortgage backed securities
677,617

 
(15,110
)
 
1,612

 
(114
)
 
679,229

 
(15,224
)
U.S. government and government agencies
1,144,809

 
(11,242
)
 
—

 
—

 
1,144,809

 
(11,242
)
Non-U.S. government securities
821,506

 
(15,776
)
 
24,334

 
(3,587
)
 
845,840

 
(19,363
)
Asset backed securities
692,362

 
(10,431
)
 
88,629

 
(3,364
)
 
780,991

 
(13,795
)
Total
5,887,621

 
(115,071
)
 
210,974

 
(12,029
)
 
6,098,595

 
(127,100
)
Equity securities
76,563

 
(5,938
)
 
—

 
—

 
76,563

 
(5,938
)
Other investments
165,891

 
(15,775
)
 
47,316

 
(2,684
)
 
213,207

 
(18,459
)
Short-term investments
28,170

 
(871
)
 
—

 
—

 
28,170

 
(871
)
Total
$
6,158,245

 
$
(137,655
)
 
$
258,290

 
$
(14,713
)
 
$
6,416,535

 
$
(152,368
)
_________________________________________________
(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.”

At March 31, 2014, on a lot level basis, approximately 1,580 security lots out of a total of approximately 4,310 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 $3.6 million. At December 31, 2013, on a lot level basis, approximately 2,080 security lots out of a total of approximately 4,400 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 $3.5 million.
 

19
Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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, 2014
 
December 31, 2013
Maturity
 
Fair Value
 
Amortized
Cost
 
Fair Value
 
Amortized
Cost
Due in one year or less
 
$
286,950

 
$
282,281

 
$
235,330

 
$
232,652

Due after one year through five years
 
3,757,966

 
3,731,777

 
3,738,500

 
3,718,920

Due after five years through 10 years
 
1,883,374

 
1,872,047

 
1,966,536

 
1,979,510

Due after 10 years
 
263,384

 
261,484

 
196,305

 
198,286

 
 
6,191,674

 
6,147,589

 
6,136,671

 
6,129,368

Mortgage backed securities
 
1,087,840

 
1,080,393

 
1,133,095

 
1,139,034

Commercial mortgage backed securities
 
1,023,055

 
1,020,317

 
1,074,497

 
1,075,749

Asset backed securities
 
1,573,751

 
1,574,993

 
1,332,594

 
1,326,356

Total
 
$
9,876,320

 
$
9,823,292

 
$
9,676,857