Edgar Filing: ARCH CAPITAL GROUP LTD.

Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q



x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

June 30, 2016

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

(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 þ 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 þ 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 þ 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 þ

As of July 28, 2016, there were 122,572,026 common shares, $0.0033 par value per share, of the registrant outstanding.

Table of Contents

ARCH CAPITAL GROUP LTD.

INDEX TO FORM 10-Q



		Page No.
	PART I.
	Financial Information	2
Item 1.	Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	44
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	74
Item 4.	Controls and Procedures	74

	PART II.
	Other Information	76
Item 1.	Legal Proceedings	76
Item 1A.	Risk Factors	76
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	76
Item 5.	Other Information	76
Item 6.	Exhibits	77
	Signatures	78



		1

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PART I. FINANCIAL INFORMATION

Cautionary Note Regarding Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This release or any other written or oral statements made by or on behalf of us may include forward-looking statements, which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this release are forward-looking statements. Forward-looking statements, for purposes of the PSLRA or otherwise, can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe” or “continue” and similar statements of a future or forward-looking nature or their negative or variations or similar terminology.

Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this release and in our periodic reports filed with the Securities and Exchange Commission (the “SEC”), and include:


•	our ability to successfully implement our business strategy during “soft” as well as “hard” markets;


•	acceptance of our business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and our insureds and reinsureds;


•	our ability to maintain or improve our ratings, which may be affected by our ability to raise additional equity or debt financings, by ratings agencies’ existing or new policies and practices, as well as other factors described herein;


•	general economic and market conditions (including inflation, interest rates, foreign currency exchange rates, prevailing credit terms and the depth and duration of a recession) and conditions specific to the reinsurance and insurance markets (including the length and magnitude of the current “soft” market) in which we operate;


•	competition, including increased competition, on the basis of pricing, capacity (including alternative forms of capital), coverage terms or other factors;


•	developments in the world’s financial and capital markets and our access to such markets;


•	our ability to successfully enhance, integrate and maintain operating procedures (including information technology) to effectively support our current and new business;


•	the loss of key personnel;


•	the integration of businesses we have acquired or may acquire into our existing operations;

•

accuracy of those estimates and judgments utilized in the preparation of our financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation, and any determination to use the deposit method of accounting, which for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to us through June 30, 2016;


•	greater than expected loss ratios on business written by us and adverse development on claim and/or claim expense liabilities related to business written by our insurance and reinsurance subsidiaries;


•	severity and/or frequency of losses;


•	claims for natural or man-made catastrophic events in our insurance or reinsurance business could cause large losses and substantial volatility in our results of operations;


•	acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;


•	availability to us of reinsurance to manage our gross and net exposures and the cost of such reinsurance;


•	the failure of reinsurers, managing general agents, third party administrators or others to meet their obligations to us;


•	the timing of loss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us;


•	our investment performance, including legislative or regulatory developments that may adversely affect the fair value of our investments;



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•	changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, which could affect our business, financial condition and results of operations;


•	the volatility of our shareholders’ equity from foreign currency fluctuations, which could increase due to us not matching portions of our projected liabilities in foreign currencies with investments in the same currencies;


•	losses relating to aviation business and business produced by a certain managing underwriting agency for which we may be liable to the purchaser of our prior reinsurance business or to others in connection with the May 5, 2000 asset sale described in our periodic reports filed with the SEC;


•	changes in accounting principles or policies or in our application of such accounting principles or policies;


•	changes in the political environment of certain countries in which we operate or underwrite business;


•	statutory or regulatory developments, including as to tax policy and matters and insurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers and/or changes in regulations or tax laws applicable to us, our subsidiaries, brokers or customers; and


•	the other matters set forth under Item 1A “Risk Factors”, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of our Annual Report on Form 10-K, as well as the other factors set forth in our other documents on file with the SEC, and management’s response to any of the aforementioned factors.

All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.



		3

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ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS



		Page No.

Report of Independent Registered Public Accounting Firm		5

Consolidated Balance Sheets
June 30, 2016 (unaudited) and December 31, 2015		6

Consolidated Statements of Income
For the three and six month periods ended June 30, 2016 and 2015 (unaudited)		7

Consolidated Statements of Comprehensive Income
For the six month periods ended June 30, 2016 and 2015 (unaudited)		8

Consolidated Statements of Changes in Shareholders’ Equity
For the six month periods ended June 30, 2016 and 2015 (unaudited)		9

Consolidated Statements of Cash Flows
For the six month periods ended June 30, 2016 and 2015 (unaudited)		10

Notes to Consolidated Financial Statements (unaudited)		11
Note 1 - General		11
Note 2 - Recent Accounting Pronouncements		11
Note 3 - VIE and Noncontrolling Interests		12
Note 4 - Earnings Per Common Share		14
Note 5 - Segment Information		15
Note 6 - Investment Information		20
Note 7 - Fair Value		26
Note 8 - Derivative Instruments		32
Note 9 - Commitments and Contingencies		33
Note 10 - Share Transactions		33
Note 11 - Other Comprehensive Income (Loss)		34
Note 12 - Guarantor Financial Information		35
Note 13 - Income Taxes		43
Note 14 - Legal Proceedings		43
Note 15 - Transactions With Related Parties		43



		4

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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 June 30, 2016, and the related consolidated statements of income and comprehensive income for the three-month and six-month periods ended June 30, 2016 and June 30, 2015, and the consolidated statements of changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2016 and June 30, 2015. 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, 2015, 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 February 26, 2016, 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, 2015, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

/s/ PricewaterhouseCoopers LLP

August 5, 2016



		5

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (U.S. dollars in thousands, except share data)

	(Unaudited)
	June 30, 2016			December 31, 2015
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: $10,879,863 and $10,515,440)	$	11,050,464		$	10,459,353
Short-term investments available for sale, at fair value (amortized cost: $855,764 and $591,141)	853,531			587,904
Collateral received under securities lending, at fair value (amortized cost: $338,318 and $385,984)	338,326			389,336
Equity securities available for sale, at fair value (cost: $414,537 and $543,767)	490,815			618,405
Other investments available for sale, at fair value (cost: $167,914 and $261,343)	182,957			300,476
Investments accounted for using the fair value option	3,066,029			2,894,494
Investments accounted for using the equity method	685,766			592,973
Total investments	16,667,888			15,842,941

Cash	516,591			553,326
Accrued investment income	85,317			87,206
Securities pledged under securities lending, at fair value (amortized cost: $328,274 and $386,411)	330,773			384,081
Premiums receivable	1,260,607			983,443
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	2,034,970			1,867,373
Contractholder receivables	1,600,426			1,486,296
Prepaid reinsurance premiums	540,954			427,609
Deferred acquisition costs, net	462,906			433,477
Receivable for securities sold	142,315			45,505
Goodwill and intangible assets	88,327			97,531
Other assets	680,843			968,482
Total assets	$	24,411,917		$	23,177,270

Liabilities
Reserve for losses and loss adjustment expenses	$	9,471,647		$	9,125,250
Unearned premiums	2,618,359			2,333,932
Reinsurance balances payable	295,987			224,120
Contractholder payables	1,600,426			1,486,296
Collateral held for insured obligations	261,228			248,982
Deposit accounting liabilities	22,325			260,364
Senior notes	791,392			791,306
Revolving credit agreement borrowings	397,830			530,434
Securities lending payable	338,318			393,844
Payable for securities purchased	382,834			64,996
Other liabilities	533,694			568,852
Total liabilities	16,714,040			16,028,376

Commitments and Contingencies
Redeemable noncontrolling interests	205,366			205,182

Shareholders' Equity
Non-cumulative preferred shares	325,000			325,000
Common shares ($0.0033 par, shares issued: 174,355,513 and 173,107,849)	581			577
Additional paid-in capital	517,942			467,339
Retained earnings	7,725,255			7,370,371
Accumulated other comprehensive income (loss), net of deferred income tax	163,834			(16,502		)
Common shares held in treasury, at cost (shares: 51,783,253 and 50,480,066)	(2,028,690		)	(1,941,904		)
Total shareholders' equity available to Arch	6,703,922			6,204,881
Non-redeemable noncontrolling interests	788,589			738,831
Total shareholders' equity	7,492,511			6,943,712
Total liabilities, noncontrolling interests and shareholders' equity	$	24,411,917		$	23,177,270



See Notes to Consolidated Financial Statements		6

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						Six Months Ended
	June 30,						June 30,
	2016			2015			2016			2015
Revenues
Net premiums written	$	1,023,563		$	943,580		$	2,144,798		$	2,010,575
Change in unearned premiums	(17,578		)	(142		)	(187,234		)	(156,873		)
Net premiums earned	1,005,985			943,438			1,957,564			1,853,702
Net investment income	88,338			86,963			182,073			165,957
Net realized gains (losses)	68,218			(35,725		)	105,542			47,623

Other-than-temporary impairment losses	(5,395		)	(1,126		)	(13,132		)	(8,373		)
Less investment impairments recognized in other comprehensive income, before taxes	52			13			150			1,461
Net impairment losses recognized in earnings	(5,343		)	(1,113		)	(12,982		)	(6,912		)

Other underwriting income	25,224			7,717			30,271			19,253
Equity in net income (loss) of investment funds accounted for using the equity method	8,737			16,167			15,392			22,056
Other income (loss)	(7		)	2,205			(32		)	317
Total revenues	1,191,152			1,019,652			2,277,828			2,101,996

Expenses
Losses and loss adjustment expenses	584,592			519,426			1,107,541			1,013,142
Acquisition expenses	175,281			175,425			345,746			338,501
Other operating expenses	159,590			151,190			311,859			299,727
Corporate expenses	17,200			17,418			26,583			26,763
Interest expense	15,663			4,011			31,770			16,747
Net foreign exchange (gains) losses	(24,662		)	19,583			(1,096		)	(46,918		)
Total expenses	927,664			887,053			1,822,403			1,647,962

Income before income taxes	263,488			132,599			455,425			454,034
Income tax expense	(14,131		)	(6,780		)	(30,441		)	(19,458		)
Net income	$	249,357		$	125,819		$	424,984		$	434,576
Net (income) loss attributable to noncontrolling interests	(38,302		)	(10,029		)	(59,131		)	(35,450		)
Net income available to Arch	211,055			115,790			365,853			399,126
Preferred dividends	(5,485		)	(5,485		)	(10,969		)	(10,969		)
Net income available to Arch common shareholders	$	205,570		$	110,305		$	354,884		$	388,157

Net income per common share
Basic	$	1.70		$	0.91		$	2.94		$	3.16
Diluted	$	1.65		$	0.88		$	2.85		$	3.05

Weighted average common shares and common share equivalents outstanding
Basic	120,599,060			121,719,214			120,513,620			122,957,384
Diluted	124,365,596			125,885,420			124,425,126			127,156,713



See Notes to Consolidated Financial Statements		7

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (U.S. dollars in thousands)

	(Unaudited)						(Unaudited)
	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2016			2015			2016			2015
Comprehensive Income
Net income	$	249,357		$	125,819		$	424,984		$	434,576
Other comprehensive income (loss), net of deferred income tax
Unrealized appreciation (decline) in value of available-for-sale investments:
Unrealized holding gains (losses) arising during period	102,460			(81,935		)	235,441			2,369
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(52		)	(13		)	(150		)	(1,461		)
Reclassification of net realized (gains) losses, net of income taxes, included in net income	(22,094		)	(21,214		)	(54,317		)	(52,146		)
Foreign currency translation adjustments	(18,151		)	11,580			(838		)	(11,177		)
Comprehensive income	311,520			34,237			605,120			372,161
Net (income) loss attributable to noncontrolling interests	(38,302		)	(10,029		)	(59,131		)	(35,450		)
Foreign currency translation adjustments attributable to noncontrolling interests	42			—			200			—
Comprehensive income available to Arch	$	273,260		$	24,208		$	546,189		$	336,711



See Notes to Consolidated Financial Statements		8

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (U.S. dollars in thousands)

	(Unaudited)
	Six Months Ended
	June 30,
	2016			2015
Non-cumulative preferred shares
Balance at beginning and end of period	$	325,000		$	325,000

Common shares
Balance at beginning of year	577			572
Common shares issued, net	4			4
Balance at end of period	581			576

Additional paid-in capital
Balance at beginning of year	467,339			383,073
Common shares issued, net	8,265			7,378
Exercise of stock options	5,143			9,624
Amortization of share-based compensation	35,769			36,044
Other	1,426			1,414
Balance at end of period	517,942			437,533

Retained earnings
Balance at beginning of year	7,370,371			6,854,571
Net income	424,984			434,576
Net (income) loss attributable to noncontrolling interests	(59,131		)	(35,450		)
Preferred share dividends	(10,969		)	(10,969		)
Balance at end of period	7,725,255			7,242,728

Accumulated other comprehensive income (loss), net of deferred income tax
Balance at beginning of year	(16,502		)	128,856
Unrealized appreciation (decline) in value of available-for-sale investments, net of deferred income tax:
Balance at beginning of year	50,085			161,598
Unrealized holding gains (losses) arising during period, net of reclassification adjustment	181,124			(49,777		)
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(150		)	(1,461		)
Balance at end of period	231,059			110,360
Foreign currency translation adjustments:
Balance at beginning of year	(66,587		)	(32,742		)
Foreign currency translation adjustments	(838		)	(11,177		)
Foreign currency translation adjustments attributable to noncontrolling interests	200			—
Balance at end of period	(67,225		)	(43,919		)
Balance at end of period	163,834			66,441

Common shares held in treasury, at cost
Balance at beginning of year	(1,941,904		)	(1,562,019		)
Shares repurchased for treasury	(86,786		)	(372,744		)
Balance at end of period	(2,028,690		)	(1,934,763		)

Total shareholders’ equity available to Arch	6,703,922			6,137,515
Non-redeemable noncontrolling interests	788,589			794,880
Total shareholders’ equity	$	7,492,511		$	6,932,395



See Notes to Consolidated Financial Statements		9

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (U.S. dollars in thousands)

	(Unaudited)
	Six Months Ended
	June 30,
	2016			2015
Operating Activities
Net income	$	424,984		$	434,576
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized (gains) losses	(126,337		)	(60,818		)
Net impairment losses recognized in earnings	12,982			6,912
Equity in net income or loss of investment funds accounted for using the equity method and other income or loss	11,161			(10,349		)
Share-based compensation	35,769			36,044
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable	186,199			91,616
Unearned premiums, net of prepaid reinsurance premiums	187,234			156,873
Premiums receivable	(278,814		)	(206,642		)
Deferred acquisition costs, net	(33,450		)	(39,009		)
Reinsurance balances payable	73,712			19,657
Other liabilities	56,314			(94,841		)
Other items	(8,530		)	51,180
Net Cash Provided By Operating Activities	541,224			385,199
Investing Activities
Purchases of fixed maturity investments	(17,541,731		)	(14,641,391		)
Purchases of equity securities	(212,678		)	(288,535		)
Purchases of other investments	(650,613		)	(779,678		)
Proceeds from sales of fixed maturity investments	16,978,549			14,333,436
Proceeds from sales of equity securities	337,619			272,343
Proceeds from sales, redemptions and maturities of other investments	636,535			587,650
Proceeds from redemptions and maturities of fixed maturity investments	370,980			474,984
Net settlements of derivative instruments	45,174			19,006
Proceeds from investment in joint venture	—			40,000
Net (purchases) sales of short-term investments	(304,460		)	3,707
Change in cash collateral related to securities lending	(18,715		)	(18,329		)
Purchase of business, net of cash acquired	(1,460		)	818
Purchases of fixed assets	(8,284		)	(6,396		)
Change in other assets	13,416			(36,769		)
Net Cash Provided By (Used For) Investing Activities	(355,668		)	(39,154		)
Financing Activities
Purchases of common shares under share repurchase program	(75,256		)	(361,877		)
Proceeds from common shares issued, net	(1,487		)	2,178
Proceeds from borrowings	46,000			—
Repayments of borrowings	(179,171		)	—
Change in cash collateral related to securities lending	18,715			18,329
Dividends paid to redeemable noncontrolling interests	(8,994		)	(9,313		)
Other	(2,223		)	55,018
Preferred dividends paid	(10,969		)	(10,969		)
Net Cash Provided By (Used For) Financing Activities	(213,385		)	(306,634		)

Effects of exchange rate changes on foreign currency cash	(8,906		)	(39		)

Increase (decrease) in cash	(36,735		)	39,372
Cash beginning of year	553,326			485,702
Cash end of period	$	516,591		$	525,074

Income taxes paid	$	26,619		$	25,992
Interest paid	$	31,524		$	25,076



See Notes to Consolidated Financial Statements		10

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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. As used herein, the “Company” means ACGL and its subsidiaries. The Company’s consolidated financial statements include the results of Watford Holdings Ltd. and its wholly owned subsidiaries (“Watford Re”). See Note 3.

The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). 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, 2015 (“2015 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. Recent Accounting Pronouncements

Recently Issued Accounting Standards Adopted

The Company adopted a new accounting standard in the 2016 first quarter that provided targeted improvements to consolidation guidance for limited partnerships and other similarly structured entities. The adoption of this standard resulted in the Company concluding that it no longer had a

variable interest in Alternative Re Ltd. and, as a result, no longer is required to consolidate Alternative Re Ltd. in its financial statements. Alternative Re Ltd. is a Bermuda-domiciled company that provides collateralized segregated accounts to its clients. The Company applied this new standard on a modified retrospective basis as of January 1, 2016. Such adoption did not impact the Company’s shareholders’ equity or net income.

The adoption of the new standard also resulted in a review of certain funds within the Company’s investment portfolio where the Company has a limited partnership interest. See Note 6 for disclosures on limited partnership interests.

The Company also adopted new accounting guidance pertaining to hybrid instruments. The new guidance clarified the evaluation of whether the nature of a host contract within a hybrid instrument issued in the form of a share is more akin to debt or equity. The Company has adopted this new guidance on a modified retrospective basis as of January 1, 2016. Based on a review of hybrid instruments issued in the form of a share (both held in its investment portfolio and issued as part of capital raising), the Company determined the new accounting guidance had no impact on the classification or accounting for its existing hybrid instruments.

Recently Issued Accounting Standards Not Yet Adopted

An accounting standard was issued in the 2015 second quarter requiring new disclosures about the reserve for losses and loss adjustment expenses for short-duration insurance contracts. These disclosures will provide additional insight into an insurance entity’s ability to underwrite and anticipate costs associated with claims. This accounting guidance is effective for the 2016 annual reporting period and interim periods thereafter and should be applied retrospectively. The Company is assessing the impact the implementation of this standard will have on the disclosures included in its consolidated financial statements.

A new accounting standard was issued in the 2016 first quarter to improve and simplify the accounting for employee share-based payment transactions. The new standard provides simplifications with respect to income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows for these types of transactions. The standard is effective in the 2017 first quarter and early adoption is permitted. The application of the new standard is dependent on the specific area that is amended. The Company is assessing the impact the implementation of this standard will have on its consolidated financial statements.

In the 2016 first quarter, new accounting guidance was issued pertaining to the accounting for leases by a lessee. The new accounting guidance requires that the lessee recognize an



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asset and a liability for leases with a lease term greater than 12 months regardless of whether the lease is classified as operating or financing. Under current accounting, operating leases are not reflected in the balance sheet. This accounting guidance is effective for the 2019 first quarter, though early application is permitted, and should be applied on a modified retrospective basis. The Company is assessing the impact the implementation of this standard will have on its consolidated financial statements.

A new accounting standard was issued in the 2016 second quarter that changes how entities will measure credit losses for most financial assets and certain other instruments that aren’t measured at fair value through net income. The standard requires an entity to estimate its lifetime “expected credit loss” and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. This accounting guidance is effective for the 2020 first quarter, though early application is permitted in the 2019 first quarter, and should be applied on a modified retrospective basis for the majority of the provisions. The Company is assessing the impact the implementation of this standard will have on its consolidated financial statements.


3.	Variable Interest Entities and Noncontrolling Interests

A variable interest entity (“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.

Watford Holdings Ltd.

In March 2014, 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. Watford Holdings Ltd. is the parent of Watford Re Ltd., a multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., “Watford Re”). Watford Re is considered a VIE and the Company concluded that it is the primary beneficiary of Watford Re. As such, the results of Watford Re are included in the Company’s consolidated financial statements.

The Company does not guarantee or provide credit support for Watford Re, and the Company’s financial exposure to Watford Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.

The following table provides the carrying amount and balance sheet caption in which the assets and liabilities of Watford Re are reported:



	June 30,		December 31,
	2016		2015
Assets
Investments accounted for using the fair value option	$	1,677,836	$	1,617,107
Cash	74,525		108,550
Accrued investment income	16,329		19,249
Premiums receivable	197,062		162,263
Reinsurance recoverable on unpaid and paid losses	16,675		14,135
Prepaid reinsurance premiums	10,602		11,129
Deferred acquisition costs, net	80,304		75,443
Receivable for securities sold	40,467		34,095
Other assets	92,935		80,361
Total assets of consolidated VIE	$	2,206,735	$	2,122,332

Liabilities
Reserves for losses and loss adjustment expenses	$	404,653	$	290,997
Unearned premiums	260,721		249,980
Reinsurance balances payable	12,872		14,005
Revolving credit agreement borrowings	297,830		430,434
Payable for securities purchased	34,729		33,062
Other liabilities	89,593		53,624
Total liabilities of consolidated VIE	$	1,100,398	$	1,072,102

Redeemable noncontrolling interests	$	220,066	$	219,882

For the six months ended June 30, 2016, Watford Re generated $131.0 million of cash provided by operating activities, $13.8 million of cash used for investing activities and $148.2 million of cash used for financing activities, compared to $137.8 million of cash provided by operating activities, $134.9 million of cash used for investing activities and $40.3 million of cash provided by financing activities for the six months ended June 30, 2015.

Non-redeemable noncontrolling interests

The Company accounts for the portion of Watford Re’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford Re’s common shares was approximately 89% at June 30, 2016. The portion of Watford Re’s income or loss attributable to third party investors is recorded in the consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests.’

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The following table sets forth activity in the non-redeemable noncontrolling interests:



	June 30,
	2016			2015
Three Months Ended
Balance, beginning of period	$	754,915		$	789,594
Amounts attributable to noncontrolling interests	33,716			5,286
Foreign currency translation adjustments attributable to noncontrolling interests	(42		)	—
Balance, end of period	$	788,589		$	794,880

Six Months Ended
Balance, beginning of year	$	738,831		$	769,081
Amounts attributable to noncontrolling interests	49,958			25,799
Foreign currency translation adjustments attributable to noncontrolling interests	(200		)	—
Balance, end of period	$	788,589		$	794,880

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 relate to the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. Preferred dividends, including the accretion of the discount and issuance costs, are included in ‘net (income) loss attributable to noncontrolling interests’ in the Company’s consolidated statements of income.

The following table sets forth activity in the redeemable non-controlling interests:



	June 30,
	2016		2015
Three Months Ended
Balance, beginning of period	$	205,274	$	219,604
Shares acquired by the Company	—		(14,700		)
Accretion of preference share issuance costs	92		92
Balance, end of period	$	205,366	$	204,996

Six Months Ended
Balance, beginning of year	$	205,182	$	219,512
Shares acquired by the Company	—		(14,700		)
Accretion of preference share issuance costs	184		184
Balance, end of period	$	205,366	$	204,996

The portion of Watford Re’s income or loss attributable to third party investors, recorded in the Company’s consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests,’ are summarized in the table below:



	June 30,
	2016			2015
Three Months Ended
Amounts attributable to non-redeemable noncontrolling interests	$	(33,716	)	$	(5,286	)
Dividends attributable to redeemable noncontrolling interests	(4,586		)	(4,743		)
Net (income) loss attributable to noncontrolling interests	$	(38,302	)	$	(10,029	)

Six Months Ended
Amounts attributable to non-redeemable noncontrolling interests	$	(49,958	)	$	(25,799	)
Dividends attributable to redeemable noncontrolling interests	(9,173		)	(9,651		)
Net (income) loss attributable to noncontrolling interests	$	(59,131	)	$	(35,450	)



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4. Earnings Per Common Share

The following table sets forth the computation of basic and diluted earnings per common share:



	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2016			2015			2016			2015
Numerator:
Net income	$	249,357		$	125,819		$	424,984		$	434,576
Net (income) loss attributable to noncontrolling interests	(38,302		)	(10,029		)	(59,131		)	(35,450		)
Net income available to Arch	211,055			115,790			365,853			399,126
Preferred dividends	(5,485		)	(5,485		)	(10,969		)	(10,969		)
Net income available to Arch common shareholders	$	205,570		$	110,305		$	354,884		$	388,157

Denominator:
Weighted average common shares outstanding — basic	120,599,060			121,719,214			120,513,620			122,957,384
Effect of dilutive common share equivalents:
Nonvested restricted shares	1,295,342			1,258,741			1,374,272			1,334,633
Stock options (1)	2,471,194			2,907,465			2,537,234			2,864,696
Weighted average common shares and common share equivalents outstanding — diluted	124,365,596			125,885,420			124,425,126			127,156,713

Earnings per common share:
Basic	$	1.70		$	0.91		$	2.94		$	3.16
Diluted	$	1.65		$	0.88		$	2.85		$	3.05

(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 2016 second quarter and 2015 second quarter, the number of stock options excluded were 575,931 and 1,009,113, respectively. For the six months ended June 30, 2016 and 2015, the number of stock options excluded were 1,027,784 and 1,187,162, respectively.



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5. Segment Information

The Company 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 and Chief Executive Officer, the President and Chief Operating Officer, 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, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.

The insurance segment consists of the Company’s insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: construction and national accounts; excess and surplus casualty; lenders products; professional lines; programs; property, energy, marine and aviation; travel, accident and health; and other (consisting of alternative markets, excess workers' compensation and surety business).

The reinsurance segment consists of the Company’s reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: casualty; marine and aviation; other specialty; property catastrophe; property excluding property catastrophe (losses on a single risk, both excess of loss and pro rata); and other (consisting of life reinsurance, casualty clash and other).

The mortgage segment includes the results of Arch Mortgage Insurance Company (“Arch MI U.S.”) and Arch Mortgage Insurance Designated Activity Company, leading providers of mortgage insurance products and services to the U.S. and European markets, respectively. Arch MI U.S. is approved as an eligible mortgage insurer by Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), each a government sponsored enterprise, or “GSE.” The mortgage segment also includes GSE credit risk-sharing transactions and mortgage reinsurance for the U.S. and Australian markets.

The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, interest expense, net realized gains or losses, net impairment losses included in earnings, equity in net income or 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 Re (see Note 3). Watford Re 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.



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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
	June 30, 2016
	Insurance			Reinsurance			Mortgage			Sub-Total			Other			Total

Gross premiums written (1)	$	762,043		$	412,053		$	118,434		$	1,292,199		$	109,285		$	1,329,936
Premiums ceded	(246,875		)	(119,951		)	(6,969		)	(373,464		)	(4,457		)	(306,373		)
Net premiums written	515,168			292,102			111,465			918,735			104,828			1,023,563
Change in unearned premiums	12,482			(846		)	(44,953		)	(33,317		)	15,739			(17,578		)
Net premiums earned	527,650			291,256			66,512			885,418			120,567			1,005,985
Other underwriting income	—			20,118			4,137			24,255			969			25,224
Losses and loss adjustment expenses	(354,633		)	(146,091		)	(366		)	(501,090		)	(83,502		)	(584,592		)
Acquisition expenses, net	(77,317		)	(55,796		)	(8,523		)	(141,636		)	(33,645		)	(175,281		)
Other operating expenses	(92,371		)	(37,115		)	(23,991		)	(153,477		)	(6,113		)	(159,590		)
Underwriting income (loss)	$	3,329		$	72,372		$	37,769		113,470			(1,724		)	111,746

Net investment income										70,397			17,941			88,338
Net realized gains (losses)										40,927			27,291			68,218
Net impairment losses recognized in earnings										(5,343		)	—			(5,343		)
Equity in net income (loss) of investment funds accounted for using the equity method										8,737			—			8,737
Other income (loss)										(7		)	—			(7		)
Corporate expenses										(17,200		)	—			(17,200		)
Interest expense										(12,432		)	(3,231		)	(15,663		)
Net foreign exchange gains (losses)										22,461			2,201			24,662
Income (loss) before income taxes										221,010			42,478			263,488
Income tax expense										(14,131		)	—			(14,131		)
Net income (loss)										206,879			42,478			249,357
Dividends attributable to redeemable noncontrolling interests										—			(4,586		)	(4,586		)
Amounts attributable to noncontrolling interests										—			(33,716		)	(33,716		)
Net income (loss) available to Arch										206,879			4,176			211,055
Preferred dividends										(5,485		)	—			(5,485		)
Net income (loss) available to Arch common shareholders										$	201,394		$	4,176		$	205,570

Underwriting Ratios
Loss ratio	67.2		%	50.2		%	0.6		%	56.6		%	69.3		%	58.1		%
Acquisition expense ratio	14.7		%	19.2		%	12.8		%	16.0		%	27.9		%	17.4		%
Other operating expense ratio	17.5		%	12.7		%	36.1		%	17.3		%	5.1		%	15.9		%
Combined ratio	99.4		%	82.1		%	49.5		%	89.9		%	102.3		%	91.4		%

Goodwill and intangible assets	$	27,457		$	1,440		$	59,430		$	88,327		$	—		$	88,327


(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.



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	Three Months Ended
	June 30, 2015
	Insurance			Reinsurance			Mortgage			Sub-Total			Other			Total

Gross premiums written (1)	$	744,810		$	342,101		$	68,572		$	1,155,253		$	127,954		$	1,199,209
Premiums ceded	(235,743		)	(89,446		)	(6,902		)	(331,861		)	(7,766		)	(255,629		)
Net premiums written	509,067			252,655			61,670			823,392			120,188			943,580
Change in unearned premiums	758			21,310			(9,211		)	12,857			(12,999		)	(142		)
Net premiums earned	509,825			273,965			52,459			836,249			107,189			943,438
Other underwriting income	521			2,658			3,686			6,865			852			7,717
Losses and loss adjustment expenses	(320,926		)	(111,183		)	(9,639		)	(441,748		)	(77,678		)	(519,426		)
Acquisition expenses, net	(76,723		)	(58,360		)	(10,200		)	(145,283		)	(30,142		)	(175,425		)
Other operating expenses	(89,054		)	(39,007		)	(19,679		)	(147,740		)	(3,450		)	(151,190		)
Underwriting income (loss)	$	23,643		$	68,073		$	16,627		108,343			(3,229		)	105,114

Net investment income										67,171			19,792			86,963
Net realized gains (losses)										(26,860		)	(8,865		)	(35,725		)
Net impairment losses recognized in earnings										(1,113		)	—			(1,113		)
Equity in net income (loss) of investment funds accounted for using the equity method										16,167			—			16,167
Other income (loss)										2,205			—			2,205
Corporate expenses										(17,418		)	—			(17,418		)
Interest expense										(4,011		)	—			(4,011		)
Net foreign exchange gains (losses)										(22,571		)	2,988			(19,583		)
Income (loss) before income taxes										121,913			10,686			132,599
Income tax expense										(6,780		)	—			(6,780		)
Net income (loss)										115,133			10,686			125,819
Dividends attributable to redeemable noncontrolling interests										—			(4,743		)	(4,743		)
Amounts attributable to noncontrolling interests										—			(5,286		)	(5,286		)
Net income (loss) available to Arch										115,133			657			115,790
Preferred dividends										(5,485		)	—			(5,485		)
Net income (loss) available to Arch common shareholders										$	109,648		$	657		$	110,305

Underwriting Ratios
Loss ratio	62.9		%	40.6		%	18.4		%	52.8		%	72.5		%	55.1		%
Acquisition expense ratio	15.0		%	21.3		%	19.4		%	17.4		%	28.1		%	18.6		%
Other operating expense ratio	17.5		%	14.2		%	37.5		%	17.7		%	3.2		%	16.0		%
Combined ratio	95.4		%	76.1		%	75.3		%	87.9		%	103.8		%	89.7		%

Goodwill and intangible assets	$	30,968		$	2,420		$	69,130		$	102,518		$	—		$	102,518


(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.



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	Six Months Ended
	June 30, 2016
	Insurance			Reinsurance			Mortgage			Sub-Total			Other			Total

Gross premiums written (1)	$	1,560,596		$	893,443		$	229,714		$	2,683,260		$	257,891		$	2,767,902
Premiums ceded	(495,664		)	(280,517		)	(11,736		)	(787,424		)	(8,929		)	(623,104		)
Net premiums written	1,064,932			612,926			217,978			1,895,836			248,962			2,144,798
Change in unearned premiums	(24,193		)	(60,462		)	(89,701		)	(174,356		)	(12,878		)	(187,234		)
Net premiums earned	1,040,739			552,464			128,277			1,721,480			236,084			1,957,564
Other underwriting income	—			20,443			7,930			28,373			1,898			30,271
Losses and loss adjustment expenses	(678,242		)	(257,689		)	(8,995		)	(944,926		)	(162,615		)	(1,107,541		)
Acquisition expenses, net	(151,671		)	(110,583		)	(16,908		)	(279,162		)	(66,584		)	(345,746		)
Other operating expenses	(178,232		)	(73,570		)	(48,606		)	(300,408		)	(11,451		)	(311,859		)
Underwriting income (loss)	$	32,594		$	131,065		$	61,698		225,357			(2,668		)	222,689

Net investment income										140,806			41,267			182,073
Net realized gains (losses)										72,789			32,753			105,542
Net impairment losses recognized in earnings										(12,982		)	—			(12,982		)
Equity in net income (loss) of investment funds accounted for using the equity method										15,392			—			15,392
Other income (loss)										(32		)	—			(32		)
Corporate expenses										(26,583		)	—			(26,583		)
Interest expense										(25,059		)	(6,711		)	(31,770		)
Net foreign exchange gains (losses)										420			676			1,096
Income (loss) before income taxes										390,108			65,317			455,425
Income tax expense										(30,441		)	—			(30,441		)
Net income (loss)										359,667			65,317			424,984
Dividends attributable to redeemable noncontrolling interests										—			(9,173		)	(9,173		)
Amounts attributable to noncontrolling interests										—			(49,958		)	(49,958		)
Net income (loss) available to Arch										359,667			6,186			365,853
Preferred dividends										(10,969		)	—			(10,969		)
Net income (loss) available to Arch common shareholders										$	348,698		$	6,186		$	354,884

Underwriting Ratios