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, 2006

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer   ý         Accelerated Filer   o         Non-Accelerated Filer   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   ý

 

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 May 1, 2006

Common Shares, $0.01 par value

 

73,880,077

 

 



 

ARCH CAPITAL GROUP LTD.

 

INDEX

 

PART I. Financial Information

 

 

 

Item 1 — Consolidated Financial Statements

 

 

 

Report of Independent Registered Public Accounting Firm

 

 

 

Consolidated Balance Sheets
March 31, 2006 and December 31, 2005

 

 

 

Consolidated Statements of Income
For the three month periods ended March 31, 2006 and 2005

 

 

 

Consolidated Statements of Changes in Shareholders’ Equity
For the three month periods ended March 31, 2006 and 2005

 

 

 

Consolidated Statements of Comprehensive Income
For the three month periods ended March 31, 2006 and 2005

 

 

 

Consolidated Statements of Cash Flows
For the three month periods ended March 31, 2006 and 2005

 

 

 

Notes to Consolidated Financial Statements

 

 

 

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

 

 

 

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

 

 

 

Item 4 — Controls and Procedures

 

 

 

PART II. Other Information

 

 

 

Item 1 — Legal Proceedings

 

 

 

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

 

 

 

Item 5 — Other Information

 

 

 

Item 6 — Exhibits

 

 

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 (the “Company”) as of March 31, 2006, the related consolidated statements of income, changes in shareholders’ equity, comprehensive income and cash flows for the three-month periods ended March 31, 2006 and 2005. 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 have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2005, and the related consolidated statements of income, changes in shareholders’ equity, comprehensive income, and cash flows for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005; and in our report dated March 7, 2006, we expressed unqualified opinions thereon. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2005, 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 8, 2006

 

2



 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

 

 

2006

 

2005

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed maturities available for sale, at fair value (amortized cost: 2006, $5,488,075;
2005, $5,310,712)

 

$

5,414,156

 

$

5,280,987

 

Short-term investments available for sale, at fair value (amortized cost: 2006, $1,052,669;
2005, $679,530)

 

1,052,753

 

681,887

 

Short-term investment of funds received under securities lending agreements, at fair value

 

882,950

 

893,379

 

Other investments, at fair value (cost: 2006, $89,100; 2005, $59,839)

 

102,351

 

70,233

 

Total investments

 

7,452,210

 

6,926,486

 

 

 

 

 

 

 

Cash

 

247,906

 

222,477

 

Accrued investment income

 

59,936

 

62,196

 

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

 

858,283

 

863,866

 

Premiums receivable

 

872,975

 

672,902

 

Funds held by reinsureds

 

131,968

 

167,739

 

Unpaid losses and loss adjustment expenses recoverable

 

1,441,412

 

1,389,768

 

Paid losses and loss adjustment expenses recoverable

 

63,803

 

80,948

 

Prepaid reinsurance premiums

 

376,815

 

322,435

 

Deferred income tax assets, net

 

83,595

 

71,139

 

Deferred acquisition costs, net

 

327,491

 

317,357

 

Other assets

 

444,746

 

391,123

 

Total Assets

 

$

12,361,140

 

$

11,488,436

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

Reserve for losses and loss adjustment expenses

 

$

5,760,939

 

$

5,452,826

 

Unearned premiums

 

1,867,250

 

1,699,691

 

Reinsurance balances payable

 

226,892

 

150,451

 

Senior notes

 

300,000

 

300,000

 

Deposit accounting liabilities

 

49,646

 

43,104

 

Securities lending collateral

 

882,950

 

893,379

 

Payable for securities purchased

 

35,690

 

12,020

 

Other liabilities

 

488,219

 

456,438

 

Total Liabilities

 

9,611,586

 

9,007,909

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

Series A non-cumulative preferred shares ($0.01 par value, 50,000,000 shares authorized,
issued: 2006, 8,000,000)

 

80

 

 

Common shares ($0.01 par value, 200,000,000 shares authorized, issued: 2006, 73,827,467;
2005, 73,334,870)

 

738

 

733

 

Additional paid-in capital

 

1,794,410

 

1,595,440

 

Deferred compensation under share award plan

 

 

(9,646

)

Retained earnings

 

1,030,971

 

901,348

 

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

 

(76,645

)

(7,348

)

Total Shareholders’ Equity

 

2,749,554

 

2,480,527

 

Total Liabilities and Shareholders’ Equity

 

$

12,361,140

 

$

11,488,436

 

 

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,

 

 

 

2006

 

2005

 

Revenues

 

 

 

 

 

Net premiums written

 

$

873,719

 

$

799,801

 

Increase in unearned premiums

 

(112,118

)

(102,733

)

Net premiums earned

 

761,601

 

697,068

 

Net investment income

 

80,326

 

49,916

 

Net realized gains (losses)

 

(3,383

)

461

 

Fee income

 

1,805

 

6,112

 

Total revenues

 

840,349

 

753,557

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

Losses and loss adjustment expenses

 

468,178

 

425,536

 

Acquisition expenses

 

129,672

 

126,133

 

Other operating expenses

 

82,977

 

74,175

 

Interest expense

 

5,555

 

5,636

 

Net foreign exchange (gains) losses

 

10,253

 

(3,237

)

Total expenses

 

696,635

 

628,243

 

 

 

 

 

 

 

Income before income taxes

 

143,714

 

125,314

 

 

 

 

 

 

 

Income tax expense

 

11,424

 

9,422

 

 

 

 

 

 

 

Net income

 

132,290

 

115,892

 

 

 

 

 

 

 

Preferred dividends

 

2,667

 

 

 

 

 

 

 

 

Net income available to common shareholders

 

$

129,623

 

$

115,892

 

 

 

 

 

 

 

Net income per common share

 

 

 

 

 

Basic

 

$

1.78

 

$

3.37

 

Diluted

 

$

1.71

 

$

1.57

 

 

 

 

 

 

 

Weighted average common shares and common share equivalents outstanding

 

 

 

 

 

Basic (1)

 

72,899,249

 

34,364,818

 

Diluted (1)

 

75,855,309

 

74,013,546

 

 


(1)

 

For the 2005 period, basic weighted average common shares and common share equivalents outstanding excluded 37,331,402 series A convertible preference shares. Such shares were included in the diluted weighted average common shares and common share equivalents outstanding. During the 2005 fourth quarter, all remaining series A convertible preference shares were converted into an equal number of common shares.

 

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,

 

 

 

2006

 

2005

 

Series A Convertible Preference Shares

 

 

 

 

 

Balance at beginning of year

 

$

 

$

373

 

Converted to common shares

 

 

(0

)

Balance at end of period

 

 

373

 

 

 

 

 

 

 

Series A Non-Cumulative Preferred Shares

 

 

 

 

 

Balance at beginning of year

 

 

 

Preferred shares issued

 

80

 

 

Balance at end of period

 

80

 

 

 

 

 

 

 

 

Common Shares

 

 

 

 

 

Balance at beginning of year

 

733

 

349

 

Common shares issued, net

 

5

 

2

 

Balance at end of period

 

738

 

351

 

 

 

 

 

 

 

Additional Paid-in Capital

 

 

 

 

 

Balance at beginning of year

 

1,595,440

 

1,560,291

 

Cumulative effect of change in accounting for unearned stock grant compensation

 

(9,646

)

 

Series A non-cumulative preferred shares issued

 

193,378

 

 

Common shares issued

 

160

 

1,127

 

Exercise of stock options

 

12,152

 

3,710

 

Common shares retired

 

(647

)

(838

)

Amortization of share-based compensation

 

3,299

 

 

Other

 

274

 

198

 

Balance at end of period

 

1,794,410

 

1,564,488

 

 

 

 

 

 

 

Deferred Compensation Under Share Award Plan

 

 

 

 

 

Balance at beginning of year

 

(9,646

)

(9,879

)

Cumulative effect of change in accounting for unearned stock grant compensation

 

9,646

 

 

Restricted common shares issued

 

 

 

Deferred compensation expense recognized

 

 

1,985

 

Balance at end of period

 

 

(7,894

)

 

 

 

 

 

 

Retained Earnings

 

 

 

 

 

Balance at beginning of year

 

901,348

 

644,862

 

Dividends declared on preferred shares

 

(2,667

)

 

Net income

 

132,290

 

115,892

 

Balance at end of period

 

1,030,971

 

760,754

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income (Loss)

 

 

 

 

 

Balance at beginning of year

 

(7,348

)

45,910

 

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

 

(67,032

)

(74,772

)

Foreign currency translation adjustments, net of deferred income tax

 

(2,265

)

(346

)

Balance at end of period

 

(76,645

)

(29,208

)

Total Shareholders’ Equity

 

$

2,749,554

 

$

2,288,864

 

 

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,

 

 

 

2006

 

2005

 

Comprehensive Income

 

 

 

 

 

Net income

 

$

132,290

 

$

115,892

 

Other comprehensive income (loss), net of deferred income tax

 

 

 

 

 

Unrealized decline in value of investments:

 

 

 

 

 

Unrealized holding losses arising during period

 

(67,987

)

(75,341

)

Reclassification of net realized losses, net of income taxes, included in net income

 

955

 

569

 

Foreign currency translation adjustments

 

(2,265

)

(346

)

Other comprehensive loss

 

(69,297

)

(75,118

)

Comprehensive Income

 

$

62,993

 

$

40,774

 

 

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,

 

 

 

2006

 

2005

 

Operating Activities

 

 

 

 

 

Net income

 

$

132,290

 

$

115,892

 

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

 

 

 

 

 

Net realized losses

 

783

 

426

 

Share-based compensation

 

3,299

 

2,095

 

Changes in:

 

 

 

 

 

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

 

256,469

 

250,323

 

Unearned premiums, net of prepaid reinsurance premiums

 

113,179

 

103,071

 

Premiums receivable

 

(200,073

)

(122,096

)

Deferred acquisition costs, net

 

(10,134

)

(19,429

)

Funds held by reinsureds

 

35,771

 

19,927

 

Reinsurance balances payable

 

76,441

 

(20,032

)

Paid losses and loss adjustment expenses recoverable

 

17,145

 

(2,861

)

Deferred income tax assets, net

 

(7,352

)

3,646

 

Deposit accounting liabilities

 

6,542

 

4,180

 

Other liabilities

 

22,460

 

7,155

 

Other items, net

 

(23,642

)

(14,457

)

Net Cash Provided By Operating Activities

 

423,178

 

327,840

 

 

 

 

 

 

 

Investing Activities

 

 

 

 

 

Purchases of fixed maturity investments

 

(4,330,266

)

(938,227

)

Proceeds from sales of fixed maturity investments

 

4,121,591

 

548,030

 

Proceeds from redemptions and maturities of fixed maturity investments

 

83,394

 

74,943

 

Purchases of other investments

 

(32,596

)

 

Proceeds from sales of other investments

 

5,359

 

1,786

 

Net purchases of short-term investments

 

(444,527

)

(39,102

)

Change in securities lending collateral

 

10,429

 

 

Purchases of furniture, equipment and other

 

(4,602

)

(3,020

)

Net Cash Used For Investing Activities

 

(591,218

)

(355,590

)

 

 

 

 

 

 

Financing Activities

 

 

 

 

 

Proceeds from common shares issued, net of repurchases

 

8,690

 

2,125

 

Net proceeds from preferred shares issued

 

193,527

 

 

Change in securities lending collateral

 

(10,429

)

 

Excess tax benefits from share-based compensation

 

2,450

 

 

Net Cash Provided By Financing Activities

 

194,238

 

2,125

 

Effects of exchange rate changes on foreign currency cash

 

(769

)

(704

)

Increase (decrease) in cash

 

25,429

 

(26,329

)

Cash beginning of year

 

222,477

 

113,052

 

Cash end of period

 

$

247,906

 

$

86,723

 

Income taxes paid, net

 

$

9,591

 

$

15,796

 

Interest paid

 

$

42

 

$

58

 

Declaration of preferred dividends to be paid

 

$

2,667

 

 

 

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, 2005, including the Company’s audited consolidated financial statements and related notes and the section entitled “Risk Factors.”

 

To facilitate period-to-period comparisons, certain amounts in the 2005 consolidated financial statements have been reclassified to conform to the 2006 presentation. Such reclassifications had no effect on the Company’s consolidated net income.

 

2.      Share-Based Compensation

 

Stock Options

 

Effective January 1, 2006, the Company adopted the fair value method of accounting for share-based compensation arrangements in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), using the modified prospective method of transition. Under the fair value method of accounting, compensation expense is estimated based on the fair value of the award at the grant date and is recognized in net income over the requisite service period. Such compensation cost is reduced by assumed forfeitures and adjusted based on actual forfeitures until vesting. Under the modified prospective approach, the fair value based method described in SFAS No. 123(R) is applied to new awards granted after January 1, 2006. Additionally, compensation expense for unvested stock options that are outstanding as of January 1, 2006 will be recognized in net income as the requisite service is rendered based on the grant date fair value of those options as previously calculated under pro forma disclosures under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” Therefore, under the modified prospective method, compensation expense is recognized beginning with the effective date of adoption of SFAS No.123(R) for all stock option awards (i) granted after the effective date of adoption and (ii) granted prior to the effective date of adoption and that remain unvested on the date of adoption.

 

Prior to January 1, 2006, the Company accounted for its share-based compensation related to stock option awards using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and its related interpretations permitted by SFAS No. 123, which did not require the recognition of compensation expense related to the issuance of

 

8



 

stock options so long as the quoted market price of the Company’s stock at the date of grant was less than or equal to the amount an employee must pay to acquire the stock.

 

As required by the provisions of SFAS No. 123(R), the Company recorded $1.1 million of after-tax share-based compensation expense, or $0.01 per basic and diluted share, related to stock option awards for the 2006 first quarter. Such amount was net of a tax benefit of $0.2 million. The share-based compensation expense associated with stock options that have graded vesting features and vest based on service conditions only (i) granted after the effective date of adoption is calculated on a straight-line basis over the requisite service periods of the related options and (ii) granted prior to the effective date of adoption and that remain unvested as of the date of adoption is calculated on a graded-vesting basis as prescribed under FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans—an interpretation of APB Opinions No. 15 and 25,” over the remaining requisite service periods of the related options. These charges had no impact on the Company’s cash flows or total shareholders’ equity.

 

Under the modified prospective method of transition under SFAS No.123(R), the Company is not required to restate its prior period financial statements to reflect expensing of share-based compensation under SFAS No. 123(R). Therefore, the results for the 2006 first quarter are not comparable to the 2005 first quarter. As required by SFAS No.123(R), the Company has presented pro forma disclosures of its net income and earnings per share for the 2005 first quarter assuming the estimated fair value of the options granted prior to January 1, 2006 is amortized to expense over the requisite service period, as indicated below:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

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

 

March 31, 2005

 

 

 

 

 

Net income, as reported

 

$

115,892

 

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

 

(1,077

)

Pro forma net income

 

$

114,815

 

 

 

 

 

Earnings per share – basic:

 

 

 

As reported

 

$

3.37

 

Pro forma

 

$

3.34

 

Earnings per share – diluted:

 

 

 

As reported

 

$

1.57

 

Pro forma

 

$

1.55

 

 

For purposes of disclosure in the foregoing table and for purposes of determining estimated fair value under SFAS No. 123(R), the Company has computed the estimated fair values of share-based compensation related to stock options using the Black-Scholes option valuation model and has applied the assumptions set forth in the following table. In September 2005, the Company’s board of directors approved a longer vesting period for future awards to vest over a three year period as follows: one third on the anniversary of the grant date and one-third each year thereafter. Prior to September 2005, awards generally vested over a two year period: one third on the grant date and one-third each year thereafter. The Company increased the expected life assumption for stock options granted beginning in September 2005 to six years after considering the increase in the vesting period, the ten year contractual term of the option awards, the historical share option exercise experience, peer data and guidance from the Securities and Exchange Commission as contained in Staff Accounting Bulletin No. 107 permitting the initial application of a “simplified” method, which is based on the average of the vesting term and the contractual term of the option. Previously, the Company calculated the estimated life based on the expectation that options would be exercised within five years on average after consideration of the vesting and contractual terms, historical share option exercise experience and peer data. The Company based its estimate of expected volatility for options granted in the

 

9



 

2005 first quarter, the Company based its volatility estimate under the same method as the 2006 first quarter, using the period from September 20, 2002 through the last day of the applicable period.

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Dividend yield

 

0.0

%

0.0

%

Expected volatility

 

21.4

%

21.1

%

Risk free interest rate

 

4.56

%

4.26

%

Expected option life

 

6.0 years

 

5.0 years

 

 

The Black-Scholes option pricing model requires the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models may not provide a reliable single measure of the fair value of its employee stock options. In addition, management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation. Circumstances may change and additional data may become available over time, which result in changes to these assumptions and methodologies, and which could materially impact the Company’s fair value determination.

 

A summary of option activity under the Company’s Long term Incentive and Share Award Plans during the 2006 first quarter is presented below:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31, 2006

 

 

 

Number of
Options

 

Weighted Average
Exercise Price

 

Outstanding, beginning of year

 

5,637,108

 

$

26.30

 

Granted

 

843,500

 

$

56.25

 

Exercised

 

(393,069

)

$

23.75

 

Forfeited or expired

 

(14,499

)

$

44.95

 

Outstanding, end of period

 

6,073,040

 

$

30.58

 

Exercisable, end of period

 

4,713,519

 

$

24.47

 

 

The weighted average remaining contractual life of the Company’s outstanding and exercisable stock options at March 31, 2006 was 6.6 years and 5.7 years, respectively. The aggregate intrinsic value of the Company’s outstanding and exercisable stock options at March 31, 2006 was $165.0 million and $156.8 million, respectively. The Company received proceeds of approximately $9.3 million from the exercise of stock options during the 2006 first quarter.

 

The weighted average grant-date fair value of options during the 2006 first quarter was $18.13 per option based on the Black-Scholes option pricing model. The aggregate intrinsic value of options exercised during the 2006 first quarter was approximately $12.1 million and represents the difference between the exercise price of the option and the closing market price of the Company’s common shares on the exercise dates. As of March 31, 2006, there was approximately $18.2 million of unrecognized compensation cost related to nonvested stock options. Such cost is expected to be recognized over a weighted average period of 1.63 years.

 

At March 31, 2006, approximately 1,600,000 and 7,000 shares are available for grant under the 2005 and 2002 share award plans, respectively. The Company issues new shares upon exercise of stock options and when granting restricted shares. For a description of the Company’s share award plans and the number of shares

 

10



 

authorized for awards of options or other equity instruments, refer to Note 13, “Share Capital–Long Term Incentive and Share Award Plans,” of the notes accompanying the Company’s consolidated financial statements for the year ended December 31, 2005, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Restricted Common Shares and Restricted Units

 

As discussed above, effective January 1, 2006, the Company adopted the fair value method of accounting for share-based compensation arrangements in accordance with SFAS No.123(R), which governs the accounting for all share-based compensation. Under the fair value method of accounting pursuant to SFAS No. 123(R), the fair value for restricted shares and units is measured by the grant-date price of the Company’s shares. No value is attributed to awards that employees forfeit because they fail to satisfy vesting conditions. As such, the number of shares granted is reduced by assumed forfeitures and adjusted based on actual forfeitures until vesting. Such expense is amortized over the requisite service period of the related awards. Restricted share and unit awards granted prior to September 2005 generally vest over a two year period: one-third on the grant date and one-third each year thereafter. Restricted share and unit awards granted subsequent to September 2005 generally vest over a three year period: one third on the first anniversary of the grant date and one-third each year thereafter.

 

Prior to January 1, 2006, the Company accounted for its share-based compensation related to restricted share and unit awards using the intrinsic value method of accounting in accordance with APB No. 25 and its related interpretations. Compensation expense equal to the market value of the restricted share awards at the measurement date was amortized and recorded in net income over the vesting period. The Company’s unearned compensation balance of $9.6 million as of December 31, 2005, which was accounted for under APB No. 25, was reclassified into additional paid-in capital upon adoption of SFAS No.123(R).

 

The Company recorded $1.7 million of share-based compensation expense, net of a tax benefit of $0.3 million, related to restricted share and unit awards for the 2006 first quarter as required by the provisions of SFAS No.123(R), compared to $1.7 million, net of a tax benefit of $0.4 million, for the 2005 first quarter. The share-based compensation expense associated with restricted share and unit awards that have graded vesting features and vest based on service conditions only (i) granted after the effective date of adoption is calculated on a straight-line basis over the requisite service periods of the related awards and (ii) granted prior to the effective date of adoption and that remain unvested as of the date of adoption is calculated on a graded-vesting basis over the remaining requisite service periods of the related awards. These charges had no impact on the Company’s cash flows or total shareholders’ equity.

 

A summary of restricted share activity under the Company’s Long Term Incentive and Share Award Plans during the 2006 first quarter is presented below:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31, 2006

 

 

 

Nonvested
Shares

 

Weighted Average
Grant Date
Fair Value

 

Unvested balance, beginning of year

 

666,504

 

$

33.14

 

Granted

 

106,143

 

$

56.27

 

Vested

 

(52,045

)

$

36.98

 

Forfeited

 

(1,476

)

$

46.64

 

Unvested balance, end of period

 

719,126

 

$

36.25

 

 

11



 

As of March 31, 2006, 95,870 restricted units were outstanding with an aggregate intrinsic value of $5.5 million. The aggregate intrinsic value of 6,375 restricted units converted during the 2006 first quarter was $0.3 million. As of March 31, 2006, there were $13.7 million and $0.7 million, respectively, of unrecognized compensation costs related to unvested restricted share and unit awards granted under the Company’s Long Term Incentive and Share Award Plans. The unrecognized compensation costs related to unvested restricted share and unit awards are expected to be recognized over a weighted-average period of 1.25 years and 1.16 years, respectively. The total weighted average fair value of restricted shares that vested during the 2006 first quarter was $2.9 million, or $56.33 per share.

 

3.      Share Transactions

 

On February 1, 2006, ACGL completed a public offering of $200.0 million principal amount of 8.0% series A non-cumulative preferred shares (“Series A Preferred Shares”) with a liquidation preference of $25.00 per share and received net proceeds of $193.5 million. The net proceeds were used to support the underwriting activities of ACGL’s insurance and reinsurance subsidiaries. ACGL has the right to redeem all or a portion of the Series A Preferred Shares at a redemption price of $25.00 per share on or after February 1, 2011. Dividends on the Series A Preferred Shares are non-cumulative. Consequently, in the event dividends are not declared on the Series A Preferred Shares for any dividend period, holders of Series A Preferred Shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accrue and will not be payable. Holders of Series A Preferred Shares will be entitled to receive dividend payments only when, as and if declared by ACGL’s board of directors or a duly authorized committee of the board of directors. Any such dividends will be payable from the date of original issue on a non-cumulative basis, quarterly in arrears on the 15th day of February, May, August and November of each year, commencing on May 15, 2006. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 8.0% of the liquidation preference per annum.

 

On February 23, 2006 and May 3, 2006, ACGL’s board of directors declared dividends with respect to the Series A Preferred Shares for the dividend period from February 1, 2006 through May 14, 2006, in an aggregate amount of $4.6 million, to be payable out of lawfully available funds for the payment of dividends under Bermuda law on May 15, 2006 to holders of record as of May 1, 2006. In addition, effective June 30, 2006 and August 14, 2006, respectively, ACGL’s board of directors declared additional partial dividends with respect to the outstanding Series A Preferred Shares for the partial dividend periods from May 15, 2006 through June 30, 2006 and July 1, 2006 through August 14, 2006, in aggregate amounts of $2.0 million and $2.0 million, respectively, in each case, to be payable out of lawfully available funds for the payment of dividends under Bermuda law on August 15, 2006 to holders of record as of August 1, 2006, unless determined otherwise by the Board or the Executive Committee of the Board on or prior to the applicable effective date.

 

12



 

4.      Segment Information

 

The Company classifies its businesses into two underwriting segments –insurance and reinsurance – and a corporate and other segment (non-underwriting). The Company’s insurance and reinsurance 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 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 specialty product lines: casualty; construction and surety; executive assurance; healthcare; professional liability; programs; property, marine and aviation; and other (consisting of collateralized protection business).

 

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 corporate and other segment (non-underwriting) includes net investment income, other fee income, net of related expenses, other expenses incurred by the Company, interest expense, net realized gains or losses, net foreign exchange gains or losses and income taxes. In addition, results for the corporate and other segment include dividends on the Company’s Series A Preferred Shares (see Note 3, “Share Transactions”).

 

13



 

The following tables set forth an analysis of the Company’s underwriting income by segment, together with a reconciliation of underwriting income to net income available to common shareholders:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31, 2006

 

(U.S. dollars in thousands)

 

Insurance

 

Reinsurance

 

Total

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$

615,484

 

$

564,668

 

$

1,167,814

 

Net premiums written

 

397,254

 

476,465

 

873,719

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

380,254

 

$

381,347

 

$

761,601

 

Policy-related fee income

 

937

 

 

937

 

Other underwriting-related fee income

 

467

 

401

 

868

 

Losses and loss adjustment expenses

 

(248,002

)

(220,176

)

(468,178

)

Acquisition expenses, net

 

(37,885

)

(91,787

)

(129,672

)

Other operating expenses

 

(62,076

)

(13,252

)

(75,328

)

Underwriting income

 

$

33,695

 

$

56,533

 

90,228

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

80,326

 

Net realized losses

 

 

 

 

 

(3,383

)

Other expenses

 

 

 

 

 

(7,649

)

Interest expense

 

 

 

 

 

(5,555

)

Net foreign exchange losses

 

 

 

 

 

(10,253

)

Income before income taxes

 

 

 

 

 

143,714

 

Income tax expense

 

 

 

 

 

(11,424

)

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

132,290

 

Preferred dividends

 

 

 

 

 

(2,667

)

Net income available to common shareholders

 

 

 

 

 

$

129,623

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

Loss ratio

 

65.2

%

57.7

%

61.5

%

Acquisition expense ratio (2)

 

9.7

%

24.1

%

16.9

%

Other operating expense ratio

 

16.3

%

3.5

%

9.9

%

Combined ratio

 

91.2

%

85.3

%

88.3

%

 


(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 insurance segment and reinsurance segment results include $0.8 million and $11.5 million, respectively, of gross and net premiums written and $0.9 million and $12.8 million, respectively, of net premiums earned assumed through intersegment transactions.

(2)

 

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

 

14



 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31, 2005

 

(U.S. dollars in thousands)

 

Insurance

 

Reinsurance

 

Total

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$

506,744

 

$

488,795

 

$

980,692

 

Net premiums written

 

322,108

 

477,693

 

799,801

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

321,036

 

$

376,032

 

$

697,068

 

Policy-related fee income

 

917

 

 

917

 

Other underwriting-related fee income

 

572

 

4,623

 

5,195

 

Losses and loss adjustment expenses

 

(206,862

)

(218,674

)

(425,536

)

Acquisition expenses, net

 

(26,681

)

(99,452

)

(126,133

)

Other operating expenses

 

(57,287

)

(10,916

)

(68,203

)

Underwriting income

 

$

31,695

 

$

51,613

 

83,308

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

49,916

 

Net realized gains

 

 

 

 

 

461

 

Other expenses

 

 

 

 

 

(5,972

)

Interest expense

 

 

 

 

 

(5,636

)

Net foreign exchange gains

 

 

 

 

 

3,237

 

Income before income taxes

 

 

 

 

 

125,314

 

Income tax expense

 

 

 

 

 

(9,422

)

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

115,892

 

Preferred dividends

 

 

 

 

 

 

Net income available to common shareholders

 

 

 

 

 

$

115,892

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

Loss ratio

 

64.4

%

58.2

%

61.0

%

Acquisition expense ratio (2)

 

8.0

%

26.4

%

18.0

%

Other operating expense ratio

 

17.8

%

2.9

%

9.8

%

Combined ratio

 

90.2

%

87.5

%

88.8

%

 


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

(2)

 

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

 

15



 

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:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2006

 

2005

 

INSURANCE SEGMENT
(U.S. dollars in thousands)

 

Amount

 

% of
Total

 

Amount

 

% of
Total

 

 

 

 

 

 

 

 

 

 

 

Net premiums written (1)

 

 

 

 

 

 

 

 

 

Construction and surety

 

$

80,629

 

20.3

 

$

62,440

 

19.4

 

Property, marine and aviation

 

68,646

 

17.3

 

42,092

 

13.1

 

Professional liability

 

62,454

 

15.7

 

46,901

 

14.6

 

Programs

 

60,534

 

15.2

 

53,267

 

16.5

 

Casualty

 

50,750

 

12.8

 

63,799

 

19.8

 

Executive assurance

 

45,591

 

11.5

 

24,017

 

7.4

 

Healthcare

 

18,115

 

4.6

 

16,436

 

5.1

 

Other

 

10,535

 

2.6

 

13,156

 

4.1

 

Total

 

$

397,254

 

100.0

 

$

322,108

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

 

 

 

 

 

 

 

 

Construction and surety

 

$

66,703

 

17.5

 

$

50,664

 

15.8

 

Property, marine and aviation

 

62,968

 

16.6

 

43,549

 

13.6

 

Professional liability

 

54,045

 

14.2

 

46,802

 

14.5

 

Programs

 

57,389

 

15.1

 

55,311

 

17.2

 

Casualty

 

62,808

 

16.5

 

69,266

 

21.6

 

Executive assurance

 

50,076

 

13.2

 

24,635

 

7.7

 

Healthcare

 

16,677

 

4.4

 

17,000

 

5.3

 

Other

 

9,588

 

2.5

 

13,809

 

4.3

 

Total

 

$

380,254

 

100.0

 

$

321,036

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Net premiums written by client location (1)

 

 

 

 

 

 

 

 

 

United States

 

$

324,465

 

81.7

 

$

285,924

 

88.8

 

Europe

 

47,580

 

12.0

 

27,106

 

8.4

 

Other

 

25,209

 

6.3

 

9,078

 

2.8

 

Total

 

$

397,254

 

100.0

 

$

322,108

 

100.0

 

 


(1)

 

Insurance segment results include premiums written and earned assumed through intersegment transactions of $0.8 million and $0.9 million, respectively, for the 2006 first quarter and $0.8 million and $1.2 million, respectively, for the 2005 first quarter. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $11.5 million and $12.8 million, respectively, for the 2006 first quarter and $14.0 million and $16.4 million, respectively, for the 2005 first quarter.

 

16



 

The following table sets forth the reinsurance segment’s net premiums written and earned by major line of business and type of business, together with net premiums written by client location:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2006

 

2005

 

REINSURANCE SEGMENT
(U.S. dollars in thousands)

 

Amount

 

% of
Total

 

Amount

 

% of
Total

 

 

 

 

 

 

 

 

 

 

 

Net premiums written (1)

 

 

 

 

 

 

 

 

 

Casualty

 

$

162,988

 

34.2

 

$

210,869

 

44.1

 

Property excluding property catastrophe

 

106,782

 

22.4

 

88,195

 

18.5

 

Other specialty

 

93,264

 

19.6

 

91,029

 

19.1

 

Property catastrophe

 

70,336

 

14.7

 

44,563

 

9.3

 

Marine and aviation

 

41,352

 

8.7

 

30,029

 

6.3

 

Other

 

1,743

 

0.4

 

13,008

 

2.7

 

Total

 

$

476,465

 

100.0

 

$

477,693

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

 

 

 

 

 

 

 

 

Casualty

 

$

171,197

 

44.9

 

$

213,260

 

56.7

 

Property excluding property catastrophe

 

79,620

 

20.9

 

57,495

 

15.3

 

Other specialty

 

57,919

 

15.2

 

50,754

 

13.5

 

Property catastrophe

 

49,106

 

12.8

 

24,761

 

6.6

 

Marine and aviation

 

23,650

 

6.2

 

21,991

 

5.8

 

Other

 

(145

)

(0.0

)

7,771

 

2.1

 

Total

 

$

381,347

 

100.0

 

$

376,032

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Net premiums written (1)

 

 

 

 

 

 

 

 

 

Pro rata

 

$

272,534

 

57.2

 

$

319,647

 

66.9

 

Excess of loss

 

203,931

 

42.8

 

158,046

 

33.1

 

Total

 

$

476,465

 

100.0

 

$

477,693

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

 

 

 

 

 

 

 

 

Pro rata

 

$

295,288

 

77.4

 

$

277,612

 

73.8

 

Excess of loss

 

86,059

 

22.6

 

98,420

 

26.2

 

Total

 

$

381,347

 

100.0

 

$

376,032

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Net premiums written by client location (1)

 

 

 

 

 

 

 

 

 

United States

 

$

277,315

 

58.2

 

$

259,414

 

54.3

 

Europe

 

127,263

 

26.7

 

155,495

 

32.5

 

Bermuda

 

43,839

 

9.2

 

27,064

 

5.7

 

Canada

 

9,556

 

2.0

 

21,336

 

4.5

 

Asia and Pacific

 

6,389

 

1.4

 

5,570

 

1.2

 

Other

 

12,103

 

2.5

 

8,814

 

1.8

 

Total

 

$

476,465

 

100.0

 

$

477,693

 

100.0

 

 


(1)

 

Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $11.5 million and $12.8 million, respectively, for the 2006 first quarter and $14.0 million and $16.4 million, respectively, for the 2005 first quarter. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $0.8 million and $0.9 million, respectively, for the 2006 first quarter and $0.8 million and $1.2 million, respectively, for the 2005 first quarter.

 

17



 

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 retrocessional coverage as part of their 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 or reinsurance subsidiaries would be liable for such defaulted amounts.

 

The effects of reinsurance on the Company’s written and earned premiums and losses and loss adjustment expenses with unaffiliated reinsurers were as follows:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

(U.S. dollars in thousands)

 

2006

 

2005

 

 

 

 

 

 

 

Premiums Written

 

 

 

 

 

Direct

 

$

601,699

 

$

498,325

 

Assumed

 

566,115

 

482,367

 

Ceded

 

(294,095

)

(180,891

)

Net

 

$

873,719

 

$

799,801

 

 

 

 

 

 

 

Premiums Earned

 

 

 

 

 

Direct

 

$

575,418

 

$

489,811

 

Assumed

 

419,277

 

391,391

 

Ceded

 

(233,094

)

(184,134

)

Net

 

$

761,601

 

$

697,068

 

 

 

 

 

 

 

Losses and Loss Adjustment Expenses

 

 

 

 

 

Direct

 

$

382,105

 

$

300,714

 

Assumed

 

246,609

 

221,362

 

Ceded

 

(160,536

)

(96,540

)

Net

 

$

468,178

 

$

425,536

 

 

The Company monitors the financial condition of its reinsurers and attempts to place coverages only with substantial, financially sound carriers. At March 31, 2006 and December 31, 2005, approximately 94.0% and 92.6%, respectively, of the Company’s reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.51 billion and $1.47 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better. At March 31, 2006 and December 31, 2005, the largest reinsurance recoverables from any one carrier were less than 5.6% of the Company’s total shareholders’ equity.

 

18



 

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 2006 and 2005 first quarters, the Company recorded $0.3 million and $0.1 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 2006 and 2005 first quarters, the Company recorded $0.6 million and $1.7 million, 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 $6.0 million and $6.1 million, respectively, for the 2006 and 2005 first quarters.

 

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 table summarizes the Company’s invested assets:

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2006

 

2005

 

 

 

 

 

 

 

Fixed maturities available for sale, at fair value

 

$

5,414,156

 

$

5,280,987

 

Fixed maturities pledged under securities lending agreements, at fair value (1)

 

794,583

 

862,766

 

Total fixed maturities

 

6,208,739

 

6,143,753

 

Short-term investments available for sale, at fair value

 

1,052,753

 

681,887

 

Short-term investments pledged under securities lending agreements, at fair value (1)

 

63,700

 

1,100

 

Other investments, at fair value

 

102,351

 

70,233

 

Total invested assets (1)

 

$

7,427,543

 

$

6,896,973

 

 


(1) In securities lending transactions, the Company receives collateral in excess of the market value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of this table, the Company has excluded $883.0 million and $893.4 million, respectively, of collateral received which is reflected as “short-term investment of funds received under securities lending agreements, at fair value” and included $858.3 million and $863.9 million, respectively, of “fixed maturities and short-term investments pledged under securities lending agreements, at fair value” at March 31, 2006 and December 31, 2005.

 

19



 

Fixed Maturities and Fixed Maturities Pledged Under Securities Lending Agreements

 

The following table summarizes the Company’s fixed maturities and fixed maturities pledged under securities lending agreements:

 

(U.S. dollars in thousands)

 

Estimated
Fair Value

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Amortized
Cost

 

 

 

 

 

 

 

 

 

 

 

March 31, 2006 (Unaudited):

 

 

 

 

 

 

 

 

 

U.S. government and government agencies

 

$

1,922,970

 

$

849

 

$

(43,909

)

$

1,966,030

 

Corporate bonds

 

1,563,809

 

3,232

 

(21,356

)

1,581,933

 

Asset backed securities

 

721,420

 

240

 

(4,836

)

726,016

 

Municipal bonds

 

698,711

 

3,280

 

(8,229

)

703,660

 

Commercial mortgage backed securities

 

526,752

 

67

 

(10,816

)

537,501

 

Mortgage backed securities

 

428,918

 

6,897

 

(20,527

)

442,548

 

Non-U.S. government securities

 

346,159

 

104

 

(2,398

)

348,453

 

Total

 

$

6,208,739

 

$

14,669

 

$

(112,071

)

$

6,306,141

 

 

 

 

 

 

 

 

 

 

 

December 31, 2005:

 

 

 

 

 

 

 

 

 

U.S. government and government agencies

 

$

2,106,866

 

$

18,152

 

$

(10,001

)

$

2,098,715

 

Corporate bonds

 

1,595,559

 

2,663

 

(10,345

)

1,603,241

 

Municipal bonds

 

623,822

 

5,039

 

(4,006

)

622,789

 

Asset backed securities

 

591,401

 

194

 

(3,348

)

594,555

 

Commercial mortgage backed securities

 

469,984

 

292

 

(5,292

)

474,984

 

Non-U.S. government securities

 

379,328

 

3,756

 

(20,483

)

396,055

 

Mortgage backed securities

 

376,793

 

653

 

(1,576

)

377,716

 

Total

 

$

6,143,753

 

$

30,749

 

$

(55,051

)

$

6,168,055

 

 

The credit quality distribution of the Company’s fixed maturities and fixed maturities pledged under securities lending agreements are shown below:

 

 

 

(Unaudited)

 

 

 

 

 

 

 

March 31, 2006

 

December 31, 2005

 

(U.S. dollars in thousands)
Rating (1)

 

Estimated
Fair Value

 

% of Total

 

Estimated
Fair Value

 

% of Total

 

 

 

 

 

 

 

 

 

 

 

AAA

 

$

4,721,987

 

76.1

 

$

4,692,579

 

76.4

 

AA

 

744,938

 

12.0

 

654,129

 

10.6

 

A

 

530,967

 

8.6

 

538,570

 

8.8

 

BBB

 

93,924

 

1.5

 

146,325

 

2.4

 

BB

 

21,655

 

0.3

 

24,472

 

0.4

 

B

 

56,686

 

0.9

 

53,178

 

0.9

 

Lower than B

 

6,571

 

0.1

 

7,388

 

0.1

 

Not rated

 

32,011

 

0.5

 

27,112

 

0.4

 

Total

 

$

6,208,739

 

100.0

 

$

6,143,753

 

100.0

 

 


(1) Ratings as assigned by Standard & Poor’s.

 

20



 

Securities Lending Agreements

 

The Company participates in a securities lending program under which certain of its fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. Such securities have been reclassified as “Fixed maturities and short-term investments pledged under securities lending agreements.” The Company maintains control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. Collateral received, primarily in the form of cash, is required at a rate of 102% of the market value of the loaned securities (or 105% of the market value of the loaned securities when the collateral and loaned securities are denominated in non-U.S. currencies) including accrued investment income and is monitored and maintained by the lending agent. Such collateral is reinvested and is reflected as “Short-term investment of funds received under securities lending agreements, at fair value.” At March 31, 2006, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $858.3 million and $881.8 million, respectively, while collateral received totaled $883.0 million at fair value and amortized cost. At December 31, 2005, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $863.9 million and $858.4 million, respectively, while collateral received totaled $893.4 million at fair value and amortized cost.

 

Investment-Related Derivatives

 

The Company’s investment strategy allows for the use of derivative securities. Derivative instruments may be used to enhance investment performance, to replicate investment positions or to manage market exposures and duration risk that would be allowed under the Company’s investment guidelines if implemented in other ways. In the 2006 first quarter, the Company began using exchange traded Treasury note futures as part of the management of its stock index fund discussed below. The notional value of the net short position for Treasury note futures was $12.5 million at March 31, 2006. The Company also began using equity futures to replicate equity investment positions in the 2006 first quarter. The fair values of those derivatives are based on quoted market prices. The notional value of the net long position for equity futures was $55.8 million at March 31, 2006. The Company recorded net realized gains of $0.6 million in the 2006 first quarter related to changes in the fair value of all futures contracts. At March 31, 2006, the carrying value and fair value of all futures contracts was a liability of $0.2 million.

 

Other Investments

 

The following table details the Company’s other investments:

 

 

 

(Unaudited)

 

 

 

 

 

 

 

March 31, 2006

 

December 31, 2005

 

(U.S. dollars in thousands)

 

Estimated
Fair Value

 

Cost

 

Estimated
Fair Value

 

Cost

 

 

 

 

 

 

 

 

 

 

 

Equity securities

 

$

51,831

 

$

46,231

 

$

27,900

 

$

25,899

 

Investment funds

 

38,691

 

38,651

 

28,719

 

28,746

 

Privately held securities

 

11,829

 

4,218

 

13,614

 

5,194

 

Total

 

$

102,351

 

$

89,100

 

$

70,233

 

$

59,839

 

 

Other investments include (i) equity securities consisting of the Company’s investments in certain stock index funds and other preferred stocks; (ii) investment funds consisting of senior secured floating rate loans and a mezzanine fund that invests in mezzanine debt and equity investments and in second lien and senior secured bank loans; and (iii) privately held securities. The Company’s investment commitments related to its other investments totaled approximately $7.5 million and $8.4 million, respectively, at March 31, 2006 and December 31, 2005.

 

21



 

Restricted Assets

 

The Company is required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support its insurance and reinsurance operations. The 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:

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2006

 

2005

 

Deposits with U.S. regulatory authorities

 

$

162,680

 

$

173,313

 

Deposits with non-U.S. regulatory authorities

 

16,913

 

17,029

 

Assets used for collateral or guarantees

 

731,621

 

745,084

 

Trust funds

 

73,148

 

69,468

 

Total restricted assets

 

$

984,362

 

$

1,004,894

 

 

In addition, Arch Reinsurance Ltd. (“Arch Re Bermuda”) maintains assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies. At March 31, 2006 and December 31, 2005, such amounts approximated $2.83 billion and $2.77 billion, respectively.

 

Net Investment Income

 

The components of net investment income were derived from the following sources:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

(U.S. dollars in thousands)

 

2006

 

2005

 

Fixed maturities

 

$

69,424

 

$

50,936

 

Short-term investments

 

9,787

 

597

 

Other

 

3,884

 

361

 

Gross investment income

 

83,095

 

51,894

 

Investment expenses

 

(2,769

)

(1,978

)

Net investment income

 

$

80,326

 

$

49,916

 

 

Net Realized Gains (Losses)

 

Net realized gains (losses) were as follows:

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

(U.S. dollars in thousands)

 

2006

 

2005

 

Fixed maturities

 

$

(4,153

)

$

(280

)

Other investments

 

2,728

 

(146

)

Other

 

(1,958

)

887

 

Net realized gains (losses)

 

$

(3,383

)

$

461

 

 

22



 

Currently, the Company’s portfolio is actively managed on a total return basis within certain guidelines. The effect of financial market movements will influence the recognition of net realized gains and losses as the portfolio is adjusted and rebalanced. For the 2006 first quarter, net realized losses on the Company’s fixed maturities of $4.2 million included a provision of $5.3 million for declines in the market value of investments held in the Company’s available for sale portfolio which were considered to be other-than-temporary based on a review performed during the 2006 first quarter. The declines in market value on such securities were primarily due to the current interest rate environment. For the 2005 first quarter, the Company did not consider any declines in the market value of investments to be other-than-temporary. The balance of $1.1 million in net realized gains on the Company’s fixed maturities in the 2006 first quarter resulted from the sale of securities, compared to net realized losses from the sale of fixed maturities of $0.3 million in the 2005 first quarter. In the 2006 and 2005 first quarters, net realized gains or losses from the sale of fixed maturities resulted from the Company’s decisions to reduce credit exposure, changes in duration targets and sales related to rebalancing the portfolio.

 

8.      Earnings Per Common Share

 

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

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

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

 

2006

 

2005

 

 

 

 

 

 

 

Basic earnings per common share:

 

 

 

 

 

Net income

 

$

132,290

 

$

115,892

 

Preferred dividends

 

(2,667

)

 

Net income available to common shareholders

 

$

129,623

 

$

115,892

 

Divided by:

 

 

 

 

 

Weighted average common shares outstanding (1)

 

72,899,249

 

34,364,818

 

Basic earnings per common share

 

$

1.78

 

$

3.37

 

 

 

 

 

 

 

Diluted earnings per common share:

 

 

 

 

 

Net income

 

$

132,290

 

$

115,892

 

Preferred dividends

 

(2,667

)

 

Net income available to common shareholders

 

$

129,623

 

$

115,892

 

Divided by:

 

 

 

 

 

Weighted average common shares outstanding (1)

 

72,899,249

 

34,364,818

 

Effect of dilutive securities:

 

 

 

 

 

Series A convertible preference shares

 

 

37,331,402

 

Warrants

 

 

48,327

 

Nonvested restricted shares

 

438,200

 

400,266

 

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