UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

(Mark One)

ý

 

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

 

 

 

 

 

For the quarterly period ended March 31, 2005

 

 

 

 

 

Or

 

 

 

o

 

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

 

 

 

 

 

For the transition period                               to                               

 

Commission file number:  0-26456

 

ARCH CAPITAL GROUP LTD.

(Exact name of registrant as specified in its charter)

 

Bermuda

 

Not Applicable

(State or other jurisdiction of incorporation or
organization)

 

(I.R.S. Employer Identification No.)

 

 

 

Wessex House, 45 Reid Street
Hamilton HM 12, Bermuda

 

 

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code:  (441) 278-9250

 

 

(Former name, former address and former fiscal year, if changed since last report)

 

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   ý     No   o   

 

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes   ý     No   o   

 

Indicate the number of shares outstanding of each of the issuer’s classes of common shares as of the latest practicable date.

 

Class

 

Outstanding at April 29, 2005

Common Shares, $0.01 par value

 

35,113,126

 

 



 

ARCH CAPITAL GROUP LTD.

 

INDEX

 

 

 

Page No.

PART I. Financial Information

 

 

 

 

 

Item 1 — Consolidated Financial Statements

 

 

 

 

 

Report of Independent Registered Public Accounting Firm

 

2

 

 

 

Consolidated Balance Sheets
  March 31, 2005 and December 31, 2004

 

3

 

 

 

Consolidated Statements of Income
  For the three month periods ended March 31, 2005 and 2004

 

4

 

 

 

 

 

 

Consolidated Statements of Changes in Shareholders’ Equity
  For the three month periods ended March 31, 2005 and 2004

 

5

 

 

 

Consolidated Statements of Comprehensive Income
  For the three month periods ended March 31, 2005 and 2004

 

6

 

 

 

Consolidated Statements of Cash Flows
  For the three month periods ended March 31, 2005 and 2004

 

7

 

 

 

Notes to Consolidated Financial Statements

 

8

 

 

 

Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

23

 

 

 

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

 

56

 

 

 

Item 4 — Controls and Procedures

 

56

 

 

 

PART II. Other Information

 

 

 

 

 

Item 1 — Legal Proceedings

 

57

 

 

 

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds

 

57

 

 

 

Item 5 — Other Information

 

58

 

 

 

Item 6 — Exhibits

 

58

 

1



 

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 as of March 31, 2005, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and statement of cash flows for each of the three month periods ended March 31, 2005 and 2004. 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, 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, 2004, and the related consolidated statements of income, comprehensive income, and changes in shareholders’ equity and of cash flows for the year then ended (not presented herein), and in our report dated March 14, 2005, 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, 2004, 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, New York

May 5, 2005

 

2



 

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

 

 

 

(Unaudited)
March 31,
2005

 

December 31,
2004

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed maturities available for sale, at fair value (amortized cost: 2005, $5,777,249; 2004, $5,506,193)

 

$

5,732,566

 

$

5,545,121

 

Short-term investments available for sale, at fair value (amortized cost: 2005, $205,115; 2004, $155,498)

 

205,217

 

155,771

 

Privately held securities (cost: 2005, $15,124; 2004, $17,022)

 

22,692

 

21,571

 

Total investments

 

5,960,475

 

5,722,463

 

Cash

 

86,723

 

113,052

 

Accrued investment income

 

56,978

 

57,163

 

Premiums receivable

 

642,877

 

520,781

 

Funds held by reinsureds

 

190,019

 

209,946

 

Unpaid losses and loss adjustment expenses recoverable

 

740,465

 

695,582

 

Paid losses and loss adjustment expenses recoverable

 

31,253

 

26,874

 

Prepaid reinsurance premiums

 

318,026

 

321,422

 

Goodwill and intangible assets

 

16,666

 

16,666

 

Deferred income tax assets, net

 

61,121

 

58,745

 

Deferred acquisition costs, net

 

297,613

 

278,184

 

Other assets

 

213,461

 

197,876

 

Total Assets

 

$

8,615,677

 

$

8,218,754

 

Liabilities

 

 

 

 

 

Reserve for losses and loss adjustment expenses

 

$

3,865,940

 

$

3,570,734

 

Unearned premiums

 

1,640,892

 

1,541,217

 

Reinsurance balances payable

 

149,470

 

169,502

 

Senior notes

 

300,000

 

300,000

 

Deposit accounting liabilities

 

48,203

 

44,023

 

Payable for securities purchased

 

24,009

 

53,642

 

Other liabilities

 

298,299

 

297,730

 

Total Liabilities

 

6,326,813

 

5,976,848

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

Preference shares ($0.01 par value, 50,000,000 shares authorized, issued: 2005, 37,327,502; 2004, 37,348,150)

 

373

 

373

 

Common shares ($0.01 par value, 200,000,000 shares authorized, issued: 2005, 35,098,258; 2004, 34,902,923)

 

351

 

349

 

Additional paid-in capital

 

1,564,488

 

1,560,291

 

Deferred compensation under share award plan

 

(7,894

)

(9,879

)

Retained earnings

 

760,754

 

644,862

 

Accumulated other comprehensive income (loss), net of deferred income tax

 

(29,208

)

45,910

 

Total Shareholders’ Equity

 

2,288,864

 

2,241,906

 

Total Liabilities and Shareholders’ Equity

 

$

8,615,677

 

$

8,218,754

 

 

See Notes to Consolidated Financial Statements

 

3



 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except share data)

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

 

 

2005

 

2004

 

Revenues

 

 

 

 

 

Net premiums written

 

$

799,801

 

$

883,588

 

Increase in unearned premiums

 

(102,733

)

(175,762

)

Net premiums earned

 

697,068

 

707,826

 

Net investment income

 

49,916

 

24,573

 

Net realized gains

 

461

 

8,901

 

Fee income

 

6,112

 

3,994

 

Other income

 

 

1,042

 

Total revenues

 

753,557

 

746,336

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

Losses and loss adjustment expenses

 

425,536

 

429,614

 

Acquisition expenses

 

126,133

 

152,856

 

Other operating expenses

 

73,401

 

56,093

 

Interest expense

 

5,636

 

1,374

 

Net foreign exchange (gains) losses

 

(3,237

)

5,319

 

Non-cash compensation

 

774

 

2,638

 

Total expenses

 

628,243

 

647,894

 

 

 

 

 

 

 

Income Before Income Taxes

 

125,314

 

98,442

 

 

 

 

 

 

 

Income tax expense

 

9,422

 

10,987

 

 

 

 

 

 

 

Net Income

 

$

115,892

 

$

87,455

 

 

 

 

 

 

 

Net Income Per Share Data

 

 

 

 

 

Basic

 

$

3.37

 

$

3.21

 

Diluted

 

$

1.57

 

$

1.26

 

 

 

 

 

 

 

Weighted Average Shares Outstanding

 

 

 

 

 

Basic

 

34,364,818

 

27,277,998

 

Diluted

 

74,013,546

 

69,145,060

 

 

See Notes to Consolidated Financial Statements

 

4



 

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

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

 

 

2005

 

2004

 

Preference Shares

 

 

 

 

 

Balance at beginning of year

 

$

373

 

$

388

 

Converted to common shares

 

(0

)

(4

)

Balance at end of period

 

373

 

384

 

 

 

 

 

 

 

Common Shares

 

 

 

 

 

Balance at beginning of year

 

349

 

282

 

Common shares issued

 

2

 

50

 

Converted from preference shares

 

0

 

4

 

Balance at end of period

 

351

 

336

 

 

 

 

 

 

 

Additional Paid-in Capital

 

 

 

 

 

Balance at beginning of year

 

1,560,291

 

1,361,267

 

Common shares issued

 

1,127

 

184,483

 

Exercise of stock options

 

3,710

 

2,080

 

Common shares retired

 

(838

)

(551

)

Other

 

198

 

128

 

Balance at end of period

 

1,564,488

 

1,547,407

 

 

 

 

 

 

 

Deferred Compensation Under Share Award Plan

 

 

 

 

 

Balance at beginning of year

 

(9,879

)

(15,004

)

Restricted common shares issued

 

 

(3,950

)

Deferred compensation expense recognized

 

1,985

 

3,159

 

Balance at end of period

 

(7,894

)

(15,795

)

 

 

 

 

 

 

Retained Earnings

 

 

 

 

 

Balance at beginning of year

 

644,862

 

327,963

 

Net income

 

115,892

 

87,455

 

Balance at end of period

 

760,754

 

415,418

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income (Loss)

 

 

 

 

 

Balance at beginning of year

 

45,910

 

35,833

 

Change in unrealized appreciation (decline) in value of investments, net of deferred income tax

 

(74,772

)

26,614

 

Foreign currency translation adjustments, net of deferred income tax

 

(346

)

 

Balance at end of period

 

(29,208

)

62,447

 

Total Shareholders’ Equity

 

$

2,288,864

 

$

2,010,197

 

 

See Notes to Consolidated Financial Statements

 

5



 

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

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

 

 

2005

 

2004

 

Comprehensive Income

 

 

 

 

 

Net income

 

$

115,892

 

$

87,455

 

Other comprehensive income (loss), net of deferred income tax Unrealized appreciation (decline) in value of investments:

 

 

 

 

 

Unrealized holding gains (losses) arising during period

 

(75,341

)

33,686

 

Reclassification of net realized (gains) losses, net of income taxes, included in net income

 

569

 

(7,072

)

Foreign currency translation adjustments, net of deferred income tax

 

(346

)

 

Other comprehensive income (loss)

 

(75,118

)

26,614

 

Comprehensive Income

 

$

40,774

 

$

114,069

 

 

See Notes to Consolidated Financial Statements

 

6



 

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

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

 

 

2005

 

2004

 

Operating Activities

 

 

 

 

 

Net income

 

$

115,892

 

$

87,455

 

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

 

 

 

 

 

Net realized (gains) losses

 

426

 

(8,275

)

Other income

 

 

(1,042

)

Non-cash compensation

 

2,095

 

2,638

 

Changes in:

 

 

 

 

 

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

 

250,323

 

349,756

 

Unearned premiums, net of prepaid reinsurance premiums

 

103,071

 

176,905

 

Premiums receivable

 

(122,096

)

(154,592

)

Deferred acquisition costs, net

 

(19,429

)

(28,681

)

Funds held by reinsureds

 

19,927

 

(18,176

)

Reinsurance balances payable

 

(20,032

)

(6,921

)

Accrued investment income

 

185

 

(888

)

Paid losses and loss adjustment expenses recoverable

 

(4,379

)

(6,713

)

Deferred income tax assets, net

 

3,646

 

551

 

Deposit accounting liabilities

 

4,180

 

4,308

 

Other liabilities

 

2,238

 

8,667

 

Other items, net

 

(8,207

)

(5,358

)

Net Cash Provided By Operating Activities

 

327,840

 

399,634

 

 

 

 

 

 

 

Investing Activities

 

 

 

 

 

Purchases of fixed maturity investments

 

(938,227

)

(1,388,771

)

Proceeds from sales of fixed maturity investments

 

548,030

 

865,492

 

Proceeds from redemptions and maturities of fixed maturity investments

 

74,943

 

50,063

 

Sales of privately held securities

 

1,786

 

7,557

 

Net purchases of short-term investments

 

(39,102

)

(87,199

)

Purchases of furniture, equipment and other

 

(3,020

)

(6,114

)

Net Cash Used For Investing Activities

 

(355,590

)

(558,972

)

 

 

 

 

 

 

Financing Activities

 

 

 

 

 

Proceeds from common shares issued

 

2,898

 

181,548

 

Repurchase of common shares

 

(773

)

(551

)

Net Cash Provided By Financing Activities

 

2,125

 

180,997

 

Effects of exchange rate changes on foreign currency cash

 

(704

)

 

Increase (decrease) in cash

 

(26,329

)

21,659

 

Cash beginning of year

 

113,052

 

56,899

 

Cash end of period

 

$

86,723

 

$

78,558

 

Income taxes paid, net

 

$

15,796

 

$

73

 

Interest paid

 

$

58

 

$

2,516

 

 

See Notes to Consolidated Financial Statements

 

7



 

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

 

1.      General

 

Arch Capital Group Ltd. (“ACGL”) is a Bermuda public limited liability company which provides insurance and reinsurance on a worldwide basis through its wholly owned subsidiaries.

 

The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of ACGL and its wholly owned subsidiaries (together with ACGL, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of results on an interim basis. The results of any interim period are not necessarily indicative of the results for a full year or any future periods.

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, including the Company’s audited consolidated financial statements and related notes and the section entitled “Business—Risk Factors.”

 

To facilitate period-to-period comparisons, certain amounts in the 2004 consolidated financial statements have been reclassified to conform to the 2005 presentation. Such reclassifications had no effect on the Company’s consolidated net income.

 

2.      Stock Options

 

The Company has adopted the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations in accounting for its employee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized by the Company to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date. As provided under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” the Company has elected to continue to account for stock-based compensation in accordance with APB No. 25 and has provided the required additional pro forma disclosures.

 

8



 

If compensation expense for stock-based employee compensation plans had been determined using the fair value recognition provisions of SFAS No. 123, the Company’s net income and earnings per share would have instead been reported as the pro forma amounts indicated below:

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

(U.S. dollars in thousands, except share data)

 

2005

 

2004

 

 

 

 

 

 

 

Net income, as reported

 

$

115,892

 

$

87,455

 

Total stock-based employee compensation expense under fair value method, net of income taxes

 

(1,077

)

(510

)

Pro forma net income

 

$

114,815

 

$

86,945

 

 

 

 

 

 

 

Earnings per share – basic:

 

 

 

 

 

As reported

 

$

3.37

 

$

3.21

 

Pro forma

 

$

3.34

 

$

3.19

 

Earnings per share – diluted:

 

 

 

 

 

As reported

 

$

1.57

 

$

1.26

 

Pro forma

 

$

1.55

 

$

1.26

 

 

3.      Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB No. 25 and requires that the estimated expense resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) eliminates the alternative to disclose, on a pro forma basis, the effects of the fair value based method. Pursuant to a Securities and Exchange Commission ruling released on April 14, 2005, which deferred the effective date of SFAS No. 123(R) for calendar year companies from July 1, 2005 to January 1, 2006, the Company will adopt the fair value recognition provisions of accounting for employee stock option awards as defined in SFAS No. 123(R) on January 1, 2006 under the modified prospective application. Under the fair value method of accounting, compensation expense is estimated based on the fair value of the award at the grant date and recognized over the requisite service period. Under the modified prospective application, the fair value based method described in SFAS No. 123(R) is applied to new awards granted after January 1, 2006. Additionally, the unrecognized expense related to the unvested portions of option awards that were outstanding as of the effective date will be recognized as compensation expense as the requisite service is rendered. The Company is currently evaluating the impact of adopting SFAS No. 123(R) on the results of its operations. However, the impact of adopting SFAS No. 123(R) will have no effect on the Company’s cash flows or shareholders’ equity.

 

9



 

4.      Segment Information

 

The Company classifies its businesses into two underwriting segments – reinsurance and insurance – and a corporate and other segment (non-underwriting). The Company’s reinsurance and insurance operating segments each have segment 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 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. The Company determined its reportable operating segments using the management approach described in SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information.”

 

Management measures segment performance based on underwriting income or loss. The Company does not manage its assets by segment and, accordingly, investment income is not allocated to each underwriting segment. In addition, other revenue and expense items are not evaluated by segment. The accounting policies of the segments are the same as those used for the preparation of the Company’s consolidated financial statements. Inter-segment insurance business is allocated to the segment accountable for the underwriting results.

 

The reinsurance segment consists of the Company’s reinsurance underwriting subsidiaries. The reinsurance segment generally seeks to write significant lines on specialty property and casualty reinsurance treaties. Classes of business 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 non-traditional and casualty clash business).

 

The insurance segment consists of the Company’s insurance underwriting subsidiaries which primarily write on both an admitted and non-admitted basis. The insurance segment consists of eight product lines: casualty; construction and surety; executive assurance; healthcare; professional liability; programs; property, marine and aviation; and other (primarily non-standard auto prior to the sale of such operations in December 2004, collateralized protection business and certain programs).

 

The corporate and other segment (non-underwriting) includes net investment income, other fee income, net of related expenses, other income, other expenses incurred by the Company, interest expense, net realized gains or losses, net foreign exchange gains or losses and non-cash compensation. The corporate and other segment also includes the results of the Company’s merchant banking operations prior to the sale of such operations in October 2004.

 

10



 

The following table sets forth an analysis of the Company’s underwriting income by segment, together with a reconciliation of underwriting income to net income:

 

 

 

(Unaudited)
Three Months Ended
March 31, 2005

 

(U.S. dollars in thousands)

 

Reinsurance

 

Insurance

 

Total

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$

488,795

 

$

506,744

 

$

980,692

 

Net premiums written (1)

 

477,693

 

322,108

 

799,801

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

$

376,032

 

$

321,036

 

$

697,068

 

Policy-related fee income

 

 

917

 

917

 

Other underwriting-related fee income

 

4,623

 

572

 

5,195

 

Losses and loss adjustment expenses

 

(218,674

)

(206,862

)

(425,536

)

Acquisition expenses, net

 

(99,452

)

(26,681

)

(126,133

)

Other operating expenses

 

(10,893

)

(56,955

)

(67,848

)

Underwriting income

 

$

51,636

 

$

32,027

 

83,663

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

49,916

 

Net realized gains

 

 

 

 

 

461

 

Other expenses

 

 

 

 

 

(5,553

)

Interest expense

 

 

 

 

 

(5,636

)

Net foreign exchange gains

 

 

 

 

 

3,237

 

Non-cash compensation

 

 

 

 

 

(774

)

Income before income taxes

 

 

 

 

 

125,314

 

Income tax expense

 

 

 

 

 

(9,422

)

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

$

115,892

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

Loss ratio

 

58.2

%

64.4

%

61.0

%

Acquisition expense ratio (2)

 

26.4

%

8.0

%

18.0

%

Other operating expense ratio

 

2.9

%

17.7

%

9.7

%

Combined ratio

 

87.5

%

90.1

%

88.7

%

 


(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. The reinsurance segment and insurance segment results include $14.0 million and $0.8 million, respectively, of gross and net premiums written and $16.4 million and $1.2 million, respectively, of net premiums earned assumed through intersegment transactions.

(2)   The acquisition expense ratio is adjusted to include policy-related fee income.

 

11



 

The following table sets forth an analysis of the Company’s underwriting income by segment, together with a reconciliation of underwriting income to net income:

 

 

 

(Unaudited)
Three Months Ended
March 31, 2004

 

(U.S. dollars in thousands)

 

Reinsurance

 

Insurance

 

Total

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$

565,739

 

$

481,569

 

$

1,009,788

 

Net premiums written (1)

 

550,888

 

332,700

 

883,588

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

$

383,050

 

$

324,776

 

$

707,826

 

Policy-related fee income

 

 

3,785

 

3,785

 

Other underwriting-related fee income

 

320

 

128

 

448

 

Losses and loss adjustment expenses

 

(219,817

)

(209,797

)

(429,614

)

Acquisition expenses, net

 

(107,128

)

(45,728

)

(152,856

)

Other operating expenses

 

(9,271

)

(43,259

)

(52,530

)

Underwriting income

 

$

47,154

 

$

29,905

 

77,059

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

24,573

 

Net realized gains

 

 

 

 

 

8,901

 

Other fee income, net of related expenses

 

 

 

 

 

(239

)

Other income

 

 

 

 

 

1,042

 

Other expenses

 

 

 

 

 

(3,563

)

Interest expense

 

 

 

 

 

(1,374

)

Net foreign exchange losses

 

 

 

 

 

(5,319

)

Non-cash compensation

 

 

 

 

 

(2,638

)

Income before income taxes

 

 

 

 

 

98,442

 

Income tax expense

 

 

 

 

 

(10,987

)

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

$

87,455

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

Loss ratio

 

57.4

%

64.6

%

60.7

%

Acquisition expense ratio (2)

 

28.0

%

12.9

%

21.1

%

Other operating expense ratio

 

2.4

%

13.3

%

7.4

%

Combined ratio

 

87.8

%

90.8

%

89.2

%

 


(1)   Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total. The reinsurance segment and insurance segment results include $34.7 million and $2.8 million, respectively, of gross and net premiums written and $34.0 million and $1.6 million, respectively, of net premiums earned assumed through intersegment transactions.

(2)   The acquisition expense ratio is adjusted to include policy-related fee income.

 

12



 

Set forth below is summary information regarding net premiums written and earned by major line of business and type of business, together with net premiums written by client location for the reinsurance segment:

 

 

 

Three Months Ended
March 31,

 

 

 

2005

 

2004

 

REINSURANCE SEGMENT
(U.S. dollars in thousands)

 

Amount

 

% of
Total

 

Amount

 

% of
Total

 

 

 

 

 

 

 

 

 

 

 

Net premiums written

 

 

 

 

 

 

 

 

 

Casualty

 

$

210,869

 

44.1

%

$

228,550

 

41.5

%

Other specialty

 

91,029

 

19.1

%

106,297

 

19.3

%

Property excluding property catastrophe

 

88,195

 

18.5

%

108,590

 

19.7

%

Property catastrophe

 

44,563

 

9.3

%

58,204

 

10.6

%

Marine and aviation

 

30,029

 

6.3

%

30,643

 

5.6

%

Other

 

13,008

 

2.7

%

18,604

 

3.3

%

Total

 

$

477,693

 

100.0

%

$

550,888

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

 

 

 

 

 

 

 

 

Casualty

 

$

213,260

 

56.7

%

$

152,576

 

39.8

%

Other specialty

 

50,754

 

13.5

%

86,115

 

22.5

%

Property excluding property catastrophe

 

57,495

 

15.3

%

84,797

 

22.2

%

Property catastrophe

 

24,761

 

6.6

%

27,214

 

7.1

%

Marine and aviation

 

21,991

 

5.8

%

20,782

 

5.4

%

Other

 

7,771

 

2.1

%

11,566

 

3.0

%

Total

 

$

376,032

 

100.0

%

$

383,050

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Net premiums written

 

 

 

 

 

 

 

 

 

Pro rata

 

$

319,647

 

66.9

%

$

324,106

 

58.8

%

Excess of loss

 

158,046

 

33.1

%

226,782

 

41.2

%

Total

 

$

477,693

 

100.0

%

$

550,888

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

 

 

 

 

 

 

 

 

Pro rata

 

$

277,612

 

73.8

%

$

284,282

 

74.2

%

Excess of loss

 

98,420

 

26.2

%

98,768

 

25.8

%

Total

 

$

376,032

 

100.0

%

$

383,050

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Net premiums written by client location

 

 

 

 

 

 

 

 

 

United States and Canada

 

$

280,750

 

58.8

%

$

340,898

 

61.9

%

Europe

 

155,495

 

32.5

%

158,602

 

28.8

%

Bermuda

 

27,064

 

5.7

%

37,125

 

6.7

%

Asia and Pacific

 

5,570

 

1.2

%

5,452

 

1.0

%

Other

 

8,814

 

1.8

%

8,811

 

1.6

%

Total

 

$

477,693

 

100.0

%

$

550,888

 

100.0

%

 


(1)   Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $14.0 million and $16.4 million, respectively, for the 2005 first quarter and $34.7 million and $34.0 million, respectively, for the 2004 first quarter. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $0.8 million and $1.2 million, respectively, for the 2005 first quarter and $2.8 million and $1.6 million, respectively, for the 2004 first quarter.

 

13



 

Set forth below is summary information regarding net premiums written and earned by major line of business and net premiums written by client location for the insurance segment:

 

 

 

Three Months Ended
March 31,

 

 

 

2005

 

2004

 

INSURANCE SEGMENT
(U.S. dollars in thousands)

 

Amount

 

% of
Total

 

Amount

 

% of
Total

 

 

 

 

 

 

 

 

 

 

 

Net premiums written

 

 

 

 

 

 

 

 

 

Casualty

 

$

63,799

 

19.8

%

$

63,546

 

19.1

%

Programs

 

53,267

 

16.5

%

89,780

 

27.0

%

Construction and surety

 

52,042

 

16.1

%

38,243

 

11.5

%

Professional liability

 

50,440

 

15.7

%

44,144

 

13.3

%

Property, marine and aviation

 

42,092

 

13.1

%

29,731

 

8.9

%

Executive assurance

 

26,029

 

8.1

%

27,483

 

8.3

%

Healthcare

 

16,436

 

5.1

%

13,426

 

4.0

%

Other

 

18,003

 

5.6

%

26,347

 

7.9

%

Total

 

$

322,108

 

100.0

%

$

332,700

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

 

 

 

 

 

 

 

 

Casualty

 

$

69,267

 

21.6

%

$

54,780

 

16.9

%

Programs

 

55,311

 

17.2

%

88,071

 

27.1

%

Construction and surety

 

42,779

 

13.3

%

49,912

 

15.4

%

Professional liability

 

48,750

 

15.2

%

40,628

 

12.5

%

Property, marine and aviation

 

43,549

 

13.6

%

34,712

 

10.7

%

Executive assurance

 

27,222

 

8.5

%

31,039

 

9.6

%

Healthcare

 

17,000

 

5.3

%

11,517

 

3.5

%

Other

 

17,158

 

5.3

%

14,117

 

4.3

%

Total

 

$

321,036

 

100.0

%

$

324,776

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Net premiums written by client location

 

 

 

 

 

 

 

 

 

United States and Canada

 

$

286,542

 

89.0

%

$

324,835

 

97.6

%

Europe

 

27,106

 

8.4

%

995

 

0.3

%

Other

 

8,460

 

2.6

%

6,870

 

2.1

%

Total

 

$

322,108

 

100.0

%

$

332,700

 

100.0

%

 


(1)   Insurance segment results include premiums written and earned assumed through intersegment transactions of $0.8 million and $1.2 million, respectively, for the 2005 first quarter and $2.8 million and $1.6 million, respectively, for the 2004 first quarter. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $14.0 million and $16.4 million, respectively, for the 2005 first quarter and $34.7 million and $34.0 million, respectively, for the 2004 first quarter.

 

14



 

5.      Reinsurance

 

In the normal course of business, the Company’s insurance subsidiaries cede a substantial portion of their premium through pro rata, excess of loss and facultative reinsurance agreements. The Company’s reinsurance subsidiaries purchase a limited amount of retrocessional coverage as part of their aggregate risk management program. In addition, the Company’s reinsurance subsidiaries participate in “common account” retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as the Company’s reinsurance subsidiaries, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, the Company’s insurance subsidiaries would be liable for such defaulted amounts.

 

The following table sets forth the effects of reinsurance with unaffiliated reinsurers on the Company’s reinsurance and insurance subsidiaries:

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

(U.S. dollars in thousands)

 

2005

 

2004

 

 

 

 

 

 

 

Premiums Written:

 

 

 

 

 

Direct

 

$

498,325

 

$

461,030

 

Assumed

 

482,367

 

548,758

 

Ceded

 

(180,891

)

(126,200

)

Net

 

$

799,801

 

$

883,588

 

 

 

 

 

 

 

Premiums Earned:

 

 

 

 

 

Direct

 

$

489,811

 

$

431,828

 

Assumed

 

391,391

 

405,337

 

Ceded

 

(184,134

)

(129,339

)

Net

 

$

697,068

 

$

707,826

 

 

 

 

 

 

 

Losses and Loss Adjustment Expenses Incurred:

 

 

 

 

 

Direct

 

$

300,714

 

$

278,798

 

Assumed

 

221,362

 

230,790

 

Ceded

 

(96,540

)

(79,974

)

Net

 

$

425,536

 

$

429,614

 

 

6.      Deposit Accounting

 

Certain assumed reinsurance contracts are deemed, under current financial accounting standards, not to transfer insurance risk, and are accounted for using the deposit method of accounting. However, it is possible that the Company could incur financial losses on such contracts. For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in the Company’s underwriting results. When the estimated profit margin is explicit, the margin is reflected as fee income and any adverse financial results on such contracts are reflected as incurred losses. For the 2005 first quarter and 2004 first quarter, the Company recorded $0.1 million and $0.3 million, respectively, of fee income on such contracts. When the estimated profit margin is implicit, the margin is reflected as an offset to paid losses and any adverse financial results on such contracts are reflected as incurred losses. For the 2005 first quarter and 2004 first quarter, the Company recorded $1.7 million and $2.2 million,

 

15



 

respectively, as an offset to paid losses on such contracts. On a notional basis, the amount of premiums from those contracts that contain an element of underwriting risk was $6.1 million and $18.0 million, respectively, for the 2005 first quarter and 2004 first quarter.

 

In making any determination to account for a contract using the deposit method of accounting, the Company is required to make many estimates and judgments under the current financial accounting standards. Such standards are currently under review by the FASB.

 

7.      Investment Information

 

The following tables summarize the Company’s fixed maturities and equity securities:

 

 

 

(Unaudited)
March 31, 2005

 

(U.S. dollars in thousands)

 

Estimated
Fair Value
and Carrying
Value

 

Gross
Unrealized
Gains

 

Gross
Unrealized
(Losses)

 

Amortized
Cost

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

U.S. government and government agencies

 

$

2,290,040

 

$

16,390

 

$

(35,548

)

$

2,309,198

 

Corporate bonds

 

1,468,751

 

4,262

 

(23,216

)

1,487,705

 

Asset backed securities

 

760,801

 

122

 

(12,039

)

772,718

 

Municipal bonds

 

608,278

 

2,163

 

(8,060

)

614,175

 

Non-U.S. government securities

 

363,473

 

14,059

 

(1,129

)

350,543

 

Commercial mortgage-backed securities

 

120,846

 

681

 

(1,649

)

121,814

 

Mortgage backed securities

 

120,377

 

559

 

(1,278

)

121,096

 

 

 

5,732,566

 

38,236

 

(82,919

)

5,777,249

 

Equity securities:

 

 

 

 

 

 

 

 

 

Privately held

 

22,692

 

7,568

 

 

15,124

 

Total

 

$

5,755,258

 

$

45,804

 

$

(82,919

)

$

5,792,373

 

 

 

 

December 31, 2004

 

(U.S. dollars in thousands)

 

Estimated
Fair Value
and Carrying
Value

 

Gross
Unrealized
Gains

 

Gross
Unrealized
(Losses)

 

Amortized
Cost

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

U.S. government and government agencies

 

$

2,266,411

 

21,317

 

(11,176

)

$

2,256,270

 

Corporate bonds

 

1,419,911

 

12,436

 

(7,810

)

1,415,285

 

Asset backed securities

 

766,651

 

276

 

(6,367

)

772,742

 

Municipal bonds

 

536,742

 

6,733

 

(1,117

)

531,126

 

Non-U.S. government securities

 

316,311

 

23,719

 

(455

)

293,047

 

Mortgage backed securities

 

158,086

 

1,480

 

(937

)

157,543

 

Commercial mortgage-backed securities

 

81,009

 

1,096

 

(267

)

80,180

 

 

 

5,545,121

 

67,057

 

(28,129

)

5,506,193

 

Equity securities:

 

 

 

 

 

 

 

 

 

Privately held

 

21,571

 

4,549

 

 

17,022

 

Total

 

$

5,566,692

 

$

71,606

 

$

(28,129

)

$

5,523,215

 

 

16



 

Restricted Assets

 

The Company is required to maintain assets on deposit with various regulatory authorities to support its insurance and reinsurance operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. The Company also has investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties.

 

The following table details the value of restricted assets at March 31, 2005 and December 31, 2004:

 

(U.S. dollars in thousands)

 

(Unaudited)
March 31,
2005

 

December 31,
2004

 

 

 

 

 

 

 

Deposits with U.S. regulatory authorities

 

$

106,174

 

$

105,319

 

Deposits with non-U.S. regulatory authorities

 

17,387

 

18,074

 

Assets used for collateral or guarantees

 

465,040

 

461,978

 

Trust funds

 

89,335

 

58,934

 

Total restricted assets

 

$

677,936

 

$

644,305

 

 

In addition, the Company’s Bermuda-based reinsurance and insurance subsidiary maintains assets in trust accounts to support insurance and reinsurance transactions with affiliated U.S. companies. At March 31, 2005 and December 31, 2004, such amounts approximated $2.38 billion and $2.25 billion, respectively.

 

8.      Earnings Per Share

 

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

 

 

 

(Unaudited)
Three Months Ended
March 31,

 

(U.S. dollars in thousands, except share data)

 

2005

 

2004

 

 

 

 

 

 

 

Basic Earnings Per Share:

 

 

 

 

 

Net income

 

$

115,892

 

$

87,455

 

Divided by:

 

 

 

 

 

Weighted average shares outstanding for the period

 

34,364,818

 

27,277,998

 

Basic earnings per share

 

$

3.37

 

$

3.21

 

 

 

 

 

 

 

Diluted Earnings Per Share:

 

 

 

 

 

Net income

 

$

115,892

 

$

87,455

 

Divided by:

 

 

 

 

 

Weighted average shares outstanding for the period

 

34,364,818

 

27,277,998

 

Effect of dilutive securities:

 

 

 

 

 

Preference shares

 

37,331,402

 

38,617,118

 

Warrants

 

48,327

 

79,165

 

Nonvested restricted shares

 

400,266

 

1,038,305

 

Stock options

 

1,868,733

 

2,132,474

 

Total diluted shares

 

74,013,546

 

69,145,060

 

Diluted earnings per share

 

$

1.57

 

$

1.26

 

 

17



 

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. The number of excluded stock options were 36,611 and nil, respectively, for the 2005 first quarter and 2004 first quarter.

 

9.      Income Taxes

 

ACGL is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act of 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to ACGL or any of its operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda.

 

ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. taxpayers. ACGL does not consider itself (or its non-U.S. subsidiaries) to be engaged in a trade or business within the U.S. and, consequently, does not expect it or such non-U.S. subsidiaries to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL’s shareholders’ equity and earnings could be materially adversely affected. ACGL’s U.S. subsidiaries are subject to U.S. income taxes on their worldwide income. ACGL’s U.K. subsidiaries are subject to U.K. corporation tax on their worldwide income.

 

ACGL changed its legal domicile from the United States to Bermuda in November 2000. Some U.S. insurance companies have been lobbying Congress to pass legislation intended to eliminate certain perceived tax advantages of U.S. insurance companies with Bermuda affiliates resulting principally from reinsurance between or among U.S. insurance companies and their Bermuda affiliates. This legislation, if passed, and other changes in U.S. tax laws, regulations and interpretations thereof to address these issues could materially adversely affect the Company.

 

The Company’s income tax provision resulted in an effective tax rate on income before income taxes of 7.5% for the 2005 first quarter, compared to 11.2% for the 2004 first quarter. The Company’s effective tax rate, which is based upon the expected annual effective tax rate, may fluctuate from period to period based on the relative mix of income reported by jurisdiction due primarily to the varying tax rates in each jurisdiction. The Company’s remaining valuation allowance related to its deferred income tax assets is $1.4 million at March 31, 2005.

 

10.    Transactions with Related Parties

 

Paul Ingrey, formerly Vice Chairman of ACGL, succeeded Robert Clements as Chairman of ACGL’s board of directors on April 1, 2005. Under a Consulting Agreement, dated as of March 17, 2005, between Mr. Clements and the Company, Mr. Clements will make himself available to provide consulting services to the Company for up to 25 days per year (for 2005, a prorated portion thereof) from April 1, 2005 through December 31, 2009 (the “Consulting Term”). During the Consulting Term, Mr. Clements will receive $100,000 per year for such services (for 2005, a prorated portion thereof), and the Company will continue to pay for rent and utilities for office space occupied by Mr. Clements and related administrative support.

 

18



 

In connection with the Company’s information technology initiative in 2002, the Company entered into arrangements with two software companies, which provide document management systems and information and research tools to insurance underwriters, in which Mr. Clements and John Pasquesi, Vice Chairman of ACGL’s board of directors, each hold minority ownership interests. The Company will pay approximately $50,000 in fees under one arrangement for the period of July 2004 to July 2005 while the other arrangement is variable based on usage. The Company made payments under such arrangements of approximately $0.1 million in each of the 2005 and 2004 first quarters.

 

11.    Contingencies Relating to the Sale of Prior Reinsurance Operations

 

On May 5, 2000, the Company sold the prior reinsurance operations of Arch Reinsurance Company (“Arch Re U.S.”) pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, “Folksamerica”). Folksamerica Reinsurance Company assumed Arch Re U.S.’s liabilities under the reinsurance agreements transferred in the asset sale and Arch Re U.S. transferred to Folksamerica Reinsurance Company assets estimated in an aggregate amount equal in book value to the book value of the liabilities assumed. The Folksamerica transaction was structured as a transfer and assumption agreement (and not reinsurance) and, accordingly, the loss reserves (and any related reinsurance recoverables) relating to the transferred business are not included as assets or liabilities on the Company’s balance sheet. Folksamerica assumed Arch Re U.S.’s rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements were notified that Folksamerica had assumed Arch Re U.S.’s obligations and that, unless the reinsureds object to the assumption, Arch Re U.S. would be released from its obligations to those reinsured. None of such reinsureds objected to the assumption. However, Arch Re U.S. will continue to be liable under those reinsurance agreements if the notice is found not to be an effective release by the reinsureds. Folksamerica has agreed to indemnify the Company for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale.
However, in the event that Folksamerica refuses or is unable to perform its obligations to the Company, Arch Re U.S. may incur losses relating to the reinsurance agreements transferred in the asset sale. Folksamerica’s A.M. Best rating was “A” (Excellent) at March 31, 2005.

 

Under the terms of the agreement, in 2000, the Company had also purchased reinsurance protection covering the Company’s transferred aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed $5.4 million, the Company has agreed to reimburse Folksamerica if a loss is incurred that exceeds $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. The Company also made representations and warranties to Folksamerica about the Company and the business transferred to Folksamerica for which the Company retains exposure for certain periods, and made certain other agreements. In addition, the Company retained its tax and employee benefit liabilities and other liabilities not assumed by Folksamerica, including all liabilities not arising under reinsurance agreements transferred to Folksamerica in the asset sale and all liabilities (other than liabilities arising under reinsurance agreements) arising out of or relating to a certain managing underwriting agency. Although Folksamerica has not asserted that any amount is currently due under any of the indemnities provided by the Company under the asset purchase agreement, Folksamerica has indicated a potential indemnity claim under the agreement in the event of the occurrence of certain future events. Based on all available information, the Company has denied the validity of any such potential claim.

 

19



 

12.    Commitments and Contingencies

 

Letter of Credit and Revolving Credit Facilities

 

On September 16, 2004, the Company entered into a three-year agreement (“Credit Agreement”) for a $300 million unsecured revolving loan and letter of credit facility and a $400 million secured letter of credit facility. Letters of credit were issued under the Credit Agreement on September 17, 2004. Borrowings of revolving loans may be made by ACGL at a variable rate based on LIBOR or an alternative base rate at the option of the Company. The $300 million unsecured revolving loan is also available for the issuance of unsecured letters of credit up to $100 million for Arch Reinsurance Ltd., Arch Re U.S. Secured letters of credit are available for issuance on behalf of Arch Reinsurance Ltd., Arch Re U.S., Arch Insurance Company, Arch Specialty Insurance Company, Arch Excess & Surplus Insurance Company and Western Diversified Casualty Insurance Company. The Credit Agreement replaced the Company’s former credit agreement, dated as of September 12, 2003 and amended as of September 10, 2004, which provided for unsecured borrowings of up to $300 million. The Company used $200 million of the net proceeds from the offering of senior notes in May 2004 (see Note 13) to repay all amounts outstanding on the former credit agreement. Simultaneously with the execution of the Credit Agreement, the former credit agreement expired.

 

Issuance of letters of credit and borrowings under the Credit Agreement are subject to the Company’s compliance with certain covenants and conditions, including absence of a material adverse effect. These covenants require, among other things, that the Company maintain a debt to shareholders’ equity ratio of not greater than 0.35 to 1 and shareholders’ equity in excess of $1.4 billion plus 40% of future aggregate net income beginning after September 30, 2004 (not including any future net losses) and 40% of future aggregate proceeds from the issuance of common or preferred equity, that the Company maintain minimum unencumbered cash and investment grade securities in the amount of $400 million and that the Company’s principal insurance and reinsurance subsidiaries maintain at least a “B++” rating from A.M. Best. In addition, certain of the Company’s subsidiaries that are parties to the Credit Agreement are required to maintain minimum shareholders’ equity levels. At March 31, 2005, the Company was in compliance with all covenants contained in the Credit Agreement. The Credit Agreement expires in September 2007.

 

Including the secured letter of credit portion of the Credit Agreement and another letter of credit facility (together, the “LOC Facilities”), the Company has access to secured letter of credit facilities for up to a total of $575 million. The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which it has entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from the Company’s reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of the Company’s business and the loss experience of such business. When issued, such letters of credit are secured by a portion of the Company’s investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which the Company was in compliance with at March 31, 2005. At such date, the Company had $413.3 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $465.0 million. The other letter of credit facility expires in December 2005. It is anticipated that the LOC facilities will be renewed (or replaced) on expiry, but such renewal (or replacement) will be subject to the availability of credit from banks which the Company utilizes or may utilize.

 

In addition to letters of credit, the Company has and may establish insurance trust accounts in the U.S. and Canada to secure its reinsurance amounts payable as required (see Note 7).

 

20



 

Guarantee and Other

 

In the 2005 first quarter, the Company agreed to provide a guarantee, through the issuance of a standby letter of credit in the amount of $6.0 million (the “Guarantee”) for the benefit of a commercial bank, to assist the principals of an agency to obtain a loan to purchase the agency from its prior owner. The agency loan is payable over a seven year term, and the Guarantee will be outstanding until such time as the loan is repaid in full. In return for the issuance of Guarantee, the agency entered into an exclusive agency relationship with the Company with respect to certain property and casualty insurance. Pursuant to such exclusive arrangement, the Company will pay the agency commissions based on an agreed percentage of written premium and, under certain circumstances, other remuneration based upon performance. The Company recorded net premiums written of $2.7 million under such agreement through March 31, 2005. The agency and each of the principals have signed pledge and security agreements that, among other things, provide the Company with collateral, in the case of the agency, and in the case of the principals, their respective shares of stock in the agency, as long as the Guarantee is in place. Such agreements also require the agency to use all excess cash flow beyond a reasonable reserve to accelerate reduction of the principal loan amount. Based on an analysis of the expected results of the agency and the likelihood of a default on the loan, the Company has determined that the fair value of the Guarantee is $0.3 million at March 31, 2005, and has recorded such amount as an expense and related liability.

 

In addition, the Company has agreed to extend a $10.0 million letter of credit through July 1, 2006 (“Extension”) for the benefit of a Lloyd’s of London syndicate (“Syndicate”) which was originally issued in connection with a reinsurance treaty covering the 2002 year of account. The Company received $0.5 million of fees in December 2004 and will receive $0.2 million in December 2005 in compensation for the Extension. To the extent that Lloyd’s of London draws down on the letter of credit on behalf of the Syndicate for any reason not related to the Company’s obligations under the 2002 year of account, the Syndicate will reimburse the Company for the amount drawn down plus interest at 6.0% per annum.

 

13.          Senior Notes

 

On May 4, 2004, ACGL completed a public offering of $300 million principal amount of 7.35% senior notes (“Senior Notes”) due May 1, 2034 and received net proceeds of $296.4 million. ACGL used $200 million of the net proceeds to repay all amounts outstanding under a revolving credit agreement (see Note 12). ACGL will pay interest on the Senior Notes on May 1 and November 1 of each year. The first such payment was made on November 1, 2004. ACGL may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The Senior Notes are ACGL’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. The effective interest rate related to the Senior Notes, based on the net proceeds received, is approximately 7.46%. For the 2005 first quarter, interest expense on the Senior Notes was $5.5 million.

 

14.          Legal Proceedings

 

The Company, in common with the insurance industry in general, is subject to litigation and arbitration in the normal course of its business. As of March 31, 2005, the Company was not a party to any material litigation or arbitration other than as a part of the ordinary course of business in relation to claims activity, none of which is expected by management to have a significant adverse effect on the Company’s results of operations and financial condition and liquidity.

 

In 2003, the former owners of American Independent Insurance Holding Company (“American Independent”) commenced an action against ACGL, American Independent and certain of American Independent’s directors and officers and others seeking unspecified damages relating to the reorganization agreement pursuant to which the Company acquired American Independent in 2001. The reorganization agreement provided that, as part of the consideration for the stock of American Independent, the former owners would have the right to receive a limited, contingent payment from the proceeds, if any, from certain pre-

 

21



 

existing lawsuits that American Independent had brought as plaintiff prior to its acquisition by the Company. The former owners alleged, among other things, that the defendants entered into the agreement without intending to honor their commitments under the agreement and are liable for securities and common law fraud, breach of contract and intentional infliction of emotional distress. ACGL and the other defendants strongly denied the validity of these allegations, and filed a motion to dismiss all claims. That motion was granted on March 23, 2005. In accordance with the opinion and order granting the motion, the plaintiffs were given until April 15, 2005 to file an amended complaint. Although they did attempt to amend the complaint, on April 26, 2005 the Court entered a judgment dismissing the complaint in its entirety and dismissing the action with prejudice.

 

15.  Variable Interest Entities

 

The Company concluded that, under FASB Interpretation No. 46R (“FIN 46R”), “Consolidation of Variable Interest Entities,” it is required to consolidate the assets, liabilities and results of operations (if any) of a certain managing general agency in which one of the Company’s subsidiaries has an investment. Such agency ceased producing business in 1999 and is currently running-off its operations. Based on current information, there are no assets or liabilities of such agency required to be reflected on the face of the Company’s consolidated financial statements that are not, or have not been previously, otherwise reflected therein. Therefore, the adoption of FIN 46R did not have a material impact on the Company’s consolidated financial statements as of or for the three months ended March 31, 2005 and 2004.

 

22



 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

 

The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual 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 in this report, including the section entitled “Cautionary Note Regarding Forward Looking Statements,” and in our periodic reports filed with the Securities and Exchange Commission (“SEC”).

 

General

 

Overview

 

Arch Capital Group Ltd. (“ACGL” and, together with its subsidiaries, “we,” or “us”) is a Bermuda public limited liability company with over $2.5 billion in capital and, through operations in Bermuda, the United States, Europe and Canada, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in an attractive insurance and reinsurance marketplace.

 

The worldwide insurance and reinsurance industry is highly competitive and has traditionally been subject to an underwriting cycle in which a hard market (high premium rates, restrictive underwriting standards, as well as terms and conditions, and underwriting gains) is eventually followed by a soft market (low premium rates, relaxed underwriting standards, as well as terms and conditions, and underwriting losses). Insurance market conditions may affect, among other things, the demand for our products, our ability to increase premium rates, the terms and conditions of the insurance policies we write, changes in the products offered by us or changes in our business strategy.

 

The financial results of the insurance and reinsurance industry are influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence, among other things, the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market. During 2001, market conditions had been improving primarily as a result of declining insurance capacity.

 

In general, market conditions improved during 2002 and 2003 in the insurance and reinsurance marketplace. This reflected improvement in pricing, terms and conditions following significant industry losses arising from the events of September 11th, as well as the recognition that intense competition in the late 1990s led to inadequate pricing and overly broad terms, conditions and coverages. Such industry developments resulted in poor financial results and erosion of the industry’s capital base. Consequently, many established insurers and reinsurers reduced their participation in, or exited from, certain markets and, as a result, premium rates escalated in many lines of business. These developments provided relatively new insurers and reinsurers, like us, with an opportunity to provide needed underwriting capacity. Beginning in late 2003 and continuing through the 2005 first quarter, additional capacity emerged in many classes of business and, consequently, premium rate increases have decelerated and, in many classes of business, premium rates have decreased. However, we believe that we are still able to write insurance and reinsurance business at what we believe to be attractive rates. In response to these market conditions, we maintained underwriting discipline during the 2005 first quarter and, as a result, gross premiums written for the quarter declined compared to the 2004 first quarter.

 

23



 

Absent changes in market conditions, our premium volume in 2005 may continue to decline from comparable periods in 2004, despite our expansion into the European and Canadian markets, as we respond to more challenging market conditions.

 

As previously reported, we have received various formal and informal information requests from insurance regulatory authorities as to relationships with, and payments to, brokers and other agents. In addition, we received a subpoena from the New York State Attorney General requesting certain information concerning our underwriting activities with respect to insurance coverages to lawyers and law firms for acts of professional malpractice. We are cooperating with these requests.

 

In view of the ongoing industry investigation, we retained Cahill Gordon & Reindel LLP to conduct an internal review relating to certain business practices in the insurance industry currently being investigated by the Attorney General of New York and others. They informed us in February 2005 that their review is complete and that they have found no evidence that we have engaged in illegal bid-rigging or price fixing such as alleged in the New York Attorney General’s October 14, 2004 complaint against Marsh & McLennan Companies, Inc., and have found no evidence that we have engaged in any illegal tying of insurance and reinsurance services. For additional information regarding the ongoing industry investigations, see the sections entitled “Business—Regulation” and “Risk Factors—Risks Relating to Our Industry” included in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Critical Accounting Policies, Estimates and Recent Accounting Pronouncements

 

The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, allowance for doubtful accounts, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments 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 limited historical information has been reported to us through March 31, 2005. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies require our more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Reserves for Losses and Loss Adjustment Expenses

 

We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses that arise from the business we underwrite. These reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured claims which have occurred at or before the balance sheet date. Due to the lack of historical loss data for our reinsurance and insurance operations, and the resulting inability to use a historical loss development methodology, there is a possibility that significant changes in the reserve estimates in future periods could occur.

 

Insurance and reinsurance loss reserves are inherently subject to uncertainty. The period of time from the occurrence of a loss through the settlement of the liability may extend many years into the future. During this period, additional facts and trends will become known and, as these factors become apparent, reserves will be adjusted in the period in which the new information becomes known. While reserves are established based upon available information, certain factors, such as those inherent in the political, judicial and legal systems,

 

24



 

including judicial and litigation trends and legislation changes, could impact the ultimate liability. Changes to our prior year loss reserves can impact our current underwriting results by (1) reducing our reported results if the prior year reserves prove to be deficient or (2) improving our reported results if the prior year reserves prove to be redundant. The reserves for losses and loss adjustment expenses represent estimates involving actuarial and statistical projections at a given point in time of our expectations of the ultimate settlement and administration costs of losses incurred, and it is likely that the ultimate liability will differ from such estimates. We utilize actuarial models as well as available historical insurance and reinsurance industry loss ratio experience and loss development patterns to assist in the establishment of loss reserves. Even actuarially sound methods can lead to subsequent adjustments to loss reserves that are both significant and irregular due to the nature of the risks written, potentially by a material amount.

 

For our reinsurance operations, we establish case reserves based on reports of claims notices received from ceding companies. Case reserves usually are based upon the amount of reserves recommended by the ceding company. Reported case reserves on known events may be supplemented by additional case reserves. Additional case reserves are often estimated by our claims function ahead of official notification from the ceding company, or when our judgment regarding the size or severity of the known event differs from the ceding company. In certain instances, we may establish additional case reserves even when the ceding company does not report any liability on a known event.

 

For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made.

 

We also maintain incurred but not reported (“IBNR”) reserves. Such reserves are established to provide for incurred claims which have not yet been reported to an insurer or reinsurer at the financial statement date as well as to adjust for any projected variance in case reserving.

 

Even though most insurance policies have policy limits, the nature of property and casualty insurance and reinsurance is such that losses can exceed policy limits for a variety of reasons and also could very significantly exceed the premiums received on the underlying policies. We attempt to limit our risk of loss through reinsurance and may also use retrocessional arrangements. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control.

 

In establishing the reserves for losses and loss adjustment expenses, we have made various assumptions relating to the pricing of our reinsurance contracts and insurance policies and have also considered available historical industry experience and current industry conditions. Our reserving method to date has primarily been the expected loss method, which is commonly applied when limited loss experience exists. We select the initial expected loss and loss adjustment expense ratios based on information derived by our underwriters and actuaries during the initial pricing of the business, supplemented by industry data where appropriate. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that limited historical information has been reported to us through March 31, 2005. Reinsurance operations by their nature add further complexity to the reserving process in that there is an inherent additional lag in the timing and reporting of a loss event to a reinsurer from an insured or ceding company through a broker. As actual loss information is reported to us and we develop our own loss experience,

 

25



 

our reserving methods will also include other actuarial techniques. It is possible that claims in respect of events that have occurred could exceed our reserves and have a material adverse effect on our results of operations in a future period or our financial condition in general.

 

We are only permitted to establish loss and loss adjustment expense reserves for losses that have occurred on or before the applicable financial statement date. Reserves for losses and loss adjustment expenses do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.

 

At March 31, 2005 and December 31, 2004, our reserves for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2005

 

2004

 

 

 

 

 

 

 

Reinsurance:

 

 

 

 

 

Case reserves

 

$

308,634

 

$

294,966

 

Additional case reserves

 

68,701

 

40,839

 

IBNR reserves

 

1,411,466

 

1,293,009

 

Total net reserves

 

$

1,788,801

 

$

1,628,814

 

 

 

 

 

 

 

Insurance:

 

 

 

 

 

Case reserves

 

$

255,131

 

$

231,215

 

IBNR reserves

 

1,081,543

 

1,015,123

 

Total net reserves

 

$

1,336,674

 

$

1,246,338

 

 

 

 

 

 

 

Total:

 

 

 

 

 

Case reserves

 

$

563,765

 

$

526,181

 

Additional case reserves

 

68,701

 

40,839

 

IBNR reserves

 

2,493,009

 

2,308,132

 

Total net reserves

 

$

3,125,475

 

$

2,875,152

 

 

At March 31, 2005 and December 31, 2004, reserves for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable, for the reinsurance segment by major line of business were as follows:

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2005

 

2004

 

 

 

 

 

 

 

Casualty

 

$

992,121

 

$

836,148

 

Other specialty

 

254,446

 

254,442

 

Property excluding property catastrophe

 

241,446

 

251,453

 

Property catastrophe

 

109,927

 

104,846

 

Marine and aviation

 

101,093

 

94,647

 

Other

 

89,768

 

87,278

 

Total net reserves

 

$

1,788,801

 

$

1,628,814

 

 

26



 

At March 31, 2005 and December 31, 2004, reserves for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable, for the insurance segment by major line of business were as follows:

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2005

 

2004

 

 

 

 

 

 

 

Programs

 

$

332,505

 

$

330,548

 

Casualty

 

310,114

 

276,966

 

Professional liability

 

176,100

 

146,828

 

Executive assurance

 

168,092

 

180,741

 

Construction and surety

 

145,923

 

130,295

 

Property, marine and aviation

 

116,783

 

104,374

 

Healthcare

 

79,269

 

70,068

 

Other

 

7,888

 

6,518

 

Total net reserves

 

$

1,336,674

 

$

1,246,338

 

 

We do not have significant exposure to pre-2002 liabilities, such as asbestos-related illnesses and other long-tail liabilities and, to date, we have experienced a relatively low level of reported claims activity in most of our business, particularly in our longer tail exposures, such as casualty, executive assurance and professional liability, which have longer time periods during which claims are reported and paid. Our limited history does not provide any meaningful trend information. See “—Results of Operations—Segment Information” for a discussion of prior year development of loss reserves.

 

Premium Revenues and Related Expenses

 

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 twelve months. Premiums written include estimates in our program, aviation, construction and surety and collateralized protection business and for participation in involuntary pools. The amount of such insurance premium estimates included in premiums receivable and other assets at March 31, 2005 and December 31, 2004 was $13.3 million and $34.6 million, respectively. 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 premiums written include amounts reported by brokers and ceding companies, supplemented by our own estimates of premiums where reports have not been received or in cases where the amounts reported by brokers and ceding companies is adjusted to reflect management’s best judgments and expectations. Premium estimates are derived from multiple sources which include our underwriters, the historical experience of the underlying business, similar business and available industry information. Premiums written are recorded based on the type of contracts we write. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the inception date of the treaty. 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.

 

27



 

The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by type of business were as follows at March 31, 2005 and December 31, 2004:

 

 

 

(Unaudited)

 

 

 

 

 

 

 

 

 

March 31, 2005

 

December 31, 2004

 

(U.S. dollars in
thousands)

 

Gross
Amount

 

Acquisition
Expenses

 

Net
Amount

 

Gross
Amount

 

Acquisition
Expenses

 

Net
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Casualty

 

$

218,635

 

$

(65,835

)

$

152,800

 

$

199,046

 

$

(61,187

)

$

137,859

 

Other specialty

 

118,695

 

(26,720

)

91,975

 

101,237

 

(19,339

)

81,898

 

Property excluding property catastrophe

 

92,131

 

(21,945

)

70,186

 

71,956

 

(22,017

)

49,939

 

Marine and aviation

 

48,752

 

(12,963

)

35,789

 

49,033

 

(12,382

)

36,651

 

Property catastrophe

 

5,671

 

(2,035

)

3,636

 

5,457

 

(1,816

)

3,641

 

Other

 

1,331

 

(213

)

1,118

 

3,355

 

(315

)

3,040

 

Total

 

$

485,215

 

$

(129,711

)

$

355,504

 

$

430,084

 

$

(117,056

)

$

313,028

 

 

Premium estimates are reviewed at least quarterly, based on management’s detailed review, comparing 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. Based on currently available information, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates at March 31, 2005.

 

Reinsurance premiums assumed, 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 our 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.

 

We also write certain business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, we assume a measured amount of insurance risk in 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 and financial quota share coverages.

 

Certain assumed reinsurance contracts, which pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” issued by the Financial Accounting Standards Board (“FASB”), are deemed not to transfer insurance

 

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risk, are accounted for using the deposit method of accounting as prescribed in Statement of Position (“SOP”) 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk.” However, it is possible that we could incur financial losses on such contracts. Management exercises significant judgment in the assumptions used in determining whether assumed contracts should be accounted for as reinsurance contracts under SFAS No. 113 or deposit insurance contracts under SOP 98-7. Under SOP 98-7, for those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in our underwriting results. When the estimated profit margin is explicit, the margin is reflected as fee income and any adverse financial results on such contracts are reflected as incurred losses. When the estimated profit margin is implicit, the margin is reflected as an offset to paid losses and any adverse financial results on such contracts are reflected as incurred losses. For those contracts that do not transfer an element of underwriting risk, the projected profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income. Additional judgments are required when applying the accounting guidance set forth in SOP 98-7 with respect to the revenue recognition criteria for contracts deemed not to transfer insurance risk.

 

Retroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered by the underlying policies reinsured. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and, accordingly, we bifurcate the prospective and retrospective elements of these reinsurance contracts and account for each element separately. Underwriting income generated in connection with retroactive reinsurance contracts is deferred and amortized into income over the settlement period while losses are charged to income immediately. Subsequent changes in estimated or actual cash flows under such retroactive reinsurance contracts are accounted for by adjusting the previously deferred amount to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction, with a corresponding charge or credit to income.

 

Acquisition expenses and other expenses that vary with, and are directly related to, the acquisition of business in our underwriting operations are deferred and amortized over the period in which the related premiums are earned. Acquisition expenses, net of ceding commissions received from unaffiliated reinsurers, consist primarily of commissions, brokerage and taxes paid to obtain our business. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Deferred acquisition costs, which are based on the related unearned premiums, 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.

 

Collection of Insurance-Related Balances

 

We are subject to credit risk with respect to our reinsurance ceded because the ceding of risk to reinsurers or retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. We are also subject to risks based upon the possibility that loss payments could occur earlier than the receipt of related reinsurance recoverables. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We evaluate the credit worthiness of all the reinsurers to which we cede business. If our analysis indicates that there is significant uncertainty regarding the collectibility of amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. At March 31, 2005 and December 31, 2004, our reserve for doubtful accounts were approximately $2.9 million and $2.2 million, respectively. At March 31, 2005, approximately 77.1% of premiums receivable of $642.9 million represented amounts not yet due, while amounts in excess of 90 days overdue were 1.0% of the total. At December 31, 2004, approximately 71.0% of premiums receivable of $520.8 million represented amounts not yet due, while amounts in excess of 90 days overdue were 3.2% of the total. Approximately 3.7% of the $31.3 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue at March 31, 2005, compared to 4.8% of the $26.9 million of paid losses and loss adjustment expenses recoverable at December 31, 2004.

 

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We are also subject to credit risk from our alternative market products, such as rent-a-captive risk-sharing programs, which allow a client to retain a significant portion of its loss exposure without the administrative costs and capital commitment required to establish and operate its own captive. In certain of these programs, we participate in the operating results by providing excess reinsurance coverage and earn commissions and management fees. In addition, we write program business on a risk-sharing basis with m