UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

(Mark One)

x

 

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

 

 

For the quarterly period ended March 31, 2008

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 x     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x   Accelerated filer  o   Non-accelerated filer   o       Smaller reporting company  o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No x

 

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 30, 2008

Common Shares, $0.01 par value

 

64,086,081

 

 


 

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, 2008 (unaudited) and December 31, 2007

 

3

 

 

 

Consolidated Statements of Income
For the three month periods ended March 31, 2008 and 2007 (unaudited)

 

4

 

 

 

Consolidated Statements of Changes in Shareholders’ Equity
For the three month periods ended March 31, 2008 and 2007 (unaudited)

 

5

 

 

 

Consolidated Statements of Comprehensive Income
For the three month periods ended March 31, 2008 and 2007 (unaudited)

 

6

 

 

 

Consolidated Statements of Cash Flows
For the three month periods ended March 31, 2008 and 2007 (unaudited)

 

7

 

 

 

Notes to Consolidated Financial Statements (unaudited)

 

8

 

 

 

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

 

27

 

 

 

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

 

47

 

 

 

Item 4 — Controls and Procedures

 

47

 

 

 

PART II. Other Information

 

 

 

 

 

Item 1 — Legal Proceedings

 

48

 

 

 

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

 

49

 

 

 

Item 5 — Other Information

 

49

 

 

 

Item 6 — Exhibits

 

50

 

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 sheets of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of March 31, 2008, and the related consolidated statements of income, changes in shareholders’ equity, comprehensive income and cash flows for each of the three-month periods ended March 31, 2008 and March 31, 2007. These interim financial statements are the responsibility of the Company’s management.

 

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

 

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2007, and the related consolidated statements of income, changes in shareholders’ equity, comprehensive income, and of cash flows for the year then ended (not presented herein), and in our report dated February 28, 2008, 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, 2007, 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, 2008

 

2


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

 

 

2008

 

2007

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed maturities available for sale, at fair value (amortized cost: 2008, $7,511,224; 2007, $7,037,272)

 

$7,591,695

 

$7,137,998

 

Short-term investments available for sale, at fair value (amortized cost: 2008, $629,249; 2007, $700,262)

 

631,285

 

699,036

 

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

 

1,228,868

 

1,503,723

 

Other investments (cost: 2008, $308,075; 2007, $323,950)

 

316,252

 

353,694

 

Investment funds accounted for using the equity method

 

294,379

 

235,975

 

Total investments

 

10,062,479

 

9,930,426

 

 

 

 

 

 

 

Cash

 

258,680

 

239,915

 

Accrued investment income

 

73,686

 

73,862

 

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

 

1,190,086

 

1,463,045

 

Premiums receivable

 

880,946

 

729,628

 

Funds held by reinsureds

 

72,844

 

74,752

 

Unpaid losses and loss adjustment expenses recoverable

 

1,652,117

 

1,609,619

 

Paid losses and loss adjustment expenses recoverable

 

110,962

 

132,289

 

Prepaid reinsurance premiums

 

419,046

 

480,462

 

Deferred income tax assets, net

 

55,645

 

57,051

 

Deferred acquisition costs, net

 

311,364

 

290,059

 

Receivable for securities sold

 

671,354

 

17,359

 

Other assets

 

595,266

 

525,800

 

Total Assets

 

$16,354,475

 

$15,624,267

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

Reserve for losses and loss adjustment expenses

 

$7,319,141

 

$7,092,452

 

Unearned premiums

 

1,810,324

 

1,765,881

 

Reinsurance balances payable

 

322,280

 

301,309

 

Senior notes

 

300,000

 

300,000

 

Securities lending collateral

 

1,228,868

 

1,503,723

 

Payable for securities purchased

 

710,994

 

23,155

 

Other liabilities

 

658,324

 

601,936

 

Total Liabilities

 

12,349,931

 

11,588,456

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

Non-cumulative preferred shares ($0.01 par value, 50,000,000 shares authorized)

 

 

 

 

 

- Series A (issued: 2008 and 2007, 8,000,000)

 

80

 

80

 

- Series B (issued: 2008 and 2007, 5,000,000)

 

50

 

50

 

Common shares ($0.01 par value, 200,000,000 shares authorized, issued: 2008, 64,649,618; 2007, 67,318,466)

 

646

 

673

 

Additional paid-in capital

 

1,269,821

 

1,451,667

 

Retained earnings

 

2,617,539

 

2,428,117

 

Accumulated other comprehensive income, net of deferred income tax

 

116,408

 

155,224

 

Total Shareholders’ Equity

 

4,004,544

 

4,035,811

 

Total Liabilities and Shareholders’ Equity

 

$16,354,475

 

$15,624,267

 

 

 

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,

 

 

 

2008

 

2007

 

Revenues

 

 

 

 

 

Net premiums written

 

$811,342

 

 

$871,745

 

 

Increase in unearned premiums

 

(103,108

)

 

(126,252

)

 

Net premiums earned

 

708,234

 

 

745,493

 

 

Net investment income

 

122,193

 

 

110,047

 

 

Net realized gains (losses)

 

35,975

 

 

(981

)

 

Fee income

 

1,068

 

 

1,969

 

 

Equity in net income (loss) of investment funds accounted for using the equity method

 

(22,313

)

 

2,642

 

 

Other income

 

4,036

 

 

604

 

 

Total revenues

 

849,193

 

 

859,774

 

 

 

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

 

 

Losses and loss adjustment expenses

 

404,417

 

 

420,061

 

 

Acquisition expenses

 

114,639

 

 

120,128

 

 

Other operating expenses

 

97,187

 

 

90,813

 

 

Interest expense

 

5,524

 

 

5,523

 

 

Net foreign exchange losses

 

23,587

 

 

9,742

 

 

Total expenses

 

645,354

 

 

646,267

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

203,839

 

 

213,507

 

 

 

 

 

 

 

 

 

 

Income tax expense

 

7,956

 

 

8,495

 

 

 

 

 

 

 

 

 

 

Net income

 

195,883

 

 

205,012

 

 

 

 

 

 

 

 

 

 

Preferred dividends

 

6,461

 

 

6,461

 

 

 

 

 

 

 

 

 

 

Net income available to common shareholders

 

$189,422

 

 

$198,551

 

 

 

 

 

 

 

 

 

 

Net income per common share

 

 

 

 

 

 

 

Basic

 

$2.90

 

 

$2.69

 

 

Diluted

 

$2.78

 

 

$2.59

 

 

 

 

 

 

 

 

 

 

Weighted average common shares and common share
equivalents outstanding

 

 

 

 

 

 

 

Basic

 

65,295,516

 

 

73,931,996

 

 

Diluted

 

68,019,413

 

 

76,640,686

 

 

 

 

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,

 

 

 

2008

 

2007

 

Non-Cumulative Preferred Shares

 

 

 

 

 

Balance at beginning and end of period

 

$130

 

 

$130

 

 

 

 

 

 

 

 

 

 

Common Shares

 

 

 

 

 

 

 

Balance at beginning of year

 

673

 

 

743

 

 

Common shares issued, net

 

0

 

 

1

 

 

Purchases of common shares under share repurchase program

 

(27

)

 

(7

)

 

Balance at end of period

 

646

 

 

737

 

 

 

 

 

 

 

 

 

 

Additional Paid-in Capital

 

 

 

 

 

 

 

Balance at beginning of year

 

1,451,667

 

 

1,944,304

 

 

Common shares issued

 

0

 

 

109

 

 

Exercise of stock options

 

3,749

 

 

6,997

 

 

Common shares retired

 

(190,278

)

 

(46,291

)

 

Amortization of share-based compensation

 

4,600

 

 

4,306

 

 

Other

 

83

 

 

700

 

 

Balance at end of period

 

1,269,821

 

 

1,910,125

 

 

 

 

 

 

 

 

 

 

Retained Earnings

 

 

 

 

 

 

 

Balance at beginning of year

 

2,428,117

 

 

1,593,907

 

 

Adjustment to adopt SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140”

 

 

 

2,111

 

 

Balance at beginning of year, as adjusted

 

2,428,117

 

 

1,596,018

 

 

Dividends declared on preferred shares

 

(6,461

)

 

(6,461

)

 

Net income

 

195,883

 

 

205,012

 

 

Balance at end of period

 

2,617,539

 

 

1,794,569

 

 

 

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income

 

 

 

 

 

 

 

Balance at beginning of year

 

155,224

 

 

51,535

 

 

Adjustment to adopt SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140”

 

 

 

(2,111

)

 

Balance at beginning of year, as adjusted

 

155,224

 

 

49,424

 

 

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

 

(37,577

)

 

20,587

 

 

Foreign currency translation adjustments, net of deferred income tax

 

(1,239

)

 

7,776

 

 

Balance at end of period

 

116,408

 

 

77,787

 

 

 

 

 

 

 

 

 

 

Total Shareholders’ Equity

 

$4,004,544

 

 

$3,783,348

 

 

 

 

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,

 

 

 

2008

 

2007

 

Comprehensive Income

 

 

 

 

 

Net income

 

$195,883

 

 

$205,012

 

 

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

 

 

 

 

 

 

 

Unrealized decline in value of investments:

 

 

 

 

 

 

 

Unrealized holding gains arising during period

 

12,707

 

 

22,014

 

 

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

 

(50,284

)

 

(1,427

)

 

Foreign currency translation adjustments

 

(1,239

)

 

7,776

 

 

Other comprehensive (loss) income

 

(38,816

)

 

28,363

 

 

Comprehensive Income

 

$157,067

 

 

$233,375

 

 

 

 

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,

 

 

 

2008

 

2007

 

Operating Activities

 

 

 

 

 

Net income

 

$195,883

 

 

$205,012

 

 

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

 

 

 

 

 

 

 

Net realized (gains) losses

 

(33,791

)

 

1,097

 

 

Equity in net (income) loss of investment funds accounted for using the equity method and other income

 

18,277

 

 

(3,246

)

 

Share-based compensation

 

4,600

 

 

4,306

 

 

Changes in:

 

 

 

 

 

 

 

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

 

182,498

 

 

147,462

 

 

Unearned premiums, net of prepaid reinsurance premiums

 

105,497

 

 

127,107

 

 

Premiums receivable

 

(148,197

)

 

(203,707

)

 

Deferred acquisition costs, net

 

(21,319

)

 

(23,700

)

 

Funds held by reinsureds

 

1,908

 

 

21,602

 

 

Reinsurance balances payable

 

19,677

 

 

91,498

 

 

Other liabilities

 

40,490

 

 

1,296

 

 

Other items, net

 

(30,978

)

 

34,404

 

 

Net Cash Provided By Operating Activities

 

334,545

 

 

403,131

 

 

 

 

 

 

 

 

 

 

Investing Activities

 

 

 

 

 

 

 

Purchases of fixed maturity investments

 

(3,772,652

)

 

(5,047,868

)

 

Proceeds from sales of fixed maturity investments

 

3,523,338

 

 

4,326,607

 

 

Proceeds from redemptions and maturities of fixed maturity investments

 

136,932

 

 

183,984

 

 

Purchases of other investments

 

(146,815

)

 

(151,978

)

 

Proceeds from sales of other investments

 

65,226

 

 

54,754

 

 

Net sales of short-term investments

 

74,201

 

 

188,663

 

 

Change in securities lending collateral

 

274,855

 

 

(268,722

)

 

Purchases of furniture, equipment and other

 

(3,045

)

 

(4,138

)

 

Net Cash Provided By (Used For) Investing Activities

 

152,040

 

 

(718,698

)

 

 

 

 

 

 

 

 

 

Financing Activities

 

 

 

 

 

 

 

Purchases of common shares under share repurchase program

 

(189,843

)

 

(44,475

)

 

Proceeds from common shares issued, net

 

2,540

 

 

3,145

 

 

Change in securities lending collateral

 

(274,855

)

 

268,722

 

 

Excess tax benefits from share-based compensation

 

660

 

 

2,355

 

 

Preferred dividends paid

 

(6,461

)

 

(6,461

)

 

Net Cash (Used For) Provided By Financing Activities

 

(467,959

)

 

223,286

 

 

 

 

 

 

 

 

 

 

Effects of exchange rate changes on foreign currency cash

 

139

 

 

513

 

 

 

 

 

 

 

 

 

 

Increase (decrease) in cash

 

18,765

 

 

(91,768

)

 

Cash beginning of year

 

239,915

 

 

317,017

 

 

Cash end of period

 

$258,680

 

 

$225,249

 

 

 

 

 

 

 

 

 

 

Income taxes paid, net

 

$2,510

 

 

$596

 

 

Interest paid

 

 

 

 

 

 

 

See Notes to Consolidated Financial Statements

 

7


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.      General

 

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

 

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

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, 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 2007 consolidated financial statements have been reclassified to conform to the 2008 presentation. Such reclassifications had no effect on the Company’s consolidated net income.

 

2.      Share Transactions

 

Share Repurchase Program

 

On February 28, 2007, ACGL’s board of directors authorized the investment of up to $1 billion in ACGL’s common shares through a share repurchase program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through February 2009. During the 2008 first quarter, ACGL repurchased approximately 2.7 million common shares under the share repurchase program for an aggregate purchase price of $189.8 million. Since the inception of the share repurchase program, ACGL has repurchased approximately 10.5 million common shares for an aggregate purchase price of $726.9 million. As a result of the share repurchase transactions, book value per common share was reduced by $1.70 per share at March 31, 2008 and weighted average shares outstanding for the 2008 first quarter were reduced by 9.4 million shares. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations. In connection with the repurchase program, the Warburg Pincus funds waived their rights relating to share repurchases under its shareholders agreement with ACGL for all repurchases of common shares by ACGL under the repurchase program in open market transactions and certain privately negotiated transactions.

 

Non-Cumulative Preferred Shares

 

During 2006, ACGL completed two public offerings of non-cumulative preferred shares (“Preferred Shares”). On February 1, 2006, $200.0 million principal amount of 8.0% series A non-cumulative preferred shares (“Series A Preferred Shares”) were issued with net proceeds of $193.5 million and, on May 24, 2006, $125.0 million principal amount of 7.875% series B non-cumulative preferred shares (“Series B Preferred Shares”) were issued with net proceeds of $120.9 million. The net proceeds of the offerings were used to

 

8


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

support the underwriting activities of ACGL’s insurance and reinsurance subsidiaries. ACGL has the right to redeem all or a portion of each series of Preferred Shares at a redemption price of $25.00 per share on or after (1) February 1, 2011 for the Series A Preferred Shares and (2) May 15, 2011 for the Series B Preferred Shares. Dividends on the Preferred Shares are non-cumulative. Consequently, in the event dividends are not declared on the Preferred Shares for any dividend period, holders of 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 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. 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 $25.00 liquidation preference per annum for the Series A Preferred Shares and 7.875% of the $25.00 liquidation preference per annum for the Series B Preferred Shares. At March 31, 2008, the Company had declared an aggregate of $3.3 million of dividends to be paid to holders of the Preferred Shares.

 

Share-Based Compensation

 

As required by the provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), the Company recorded after-tax share-based compensation expense related to stock options in the 2008 first quarter of $1.1 million, or $0.02 per diluted share, compared to $1.6 million, or $0.02 per diluted share, in the 2007 first quarter.

 

3.      Debt and Financing Arrangements

 

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. The Senior Notes are ACGL’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. Interest payments on the Senior Notes are due on May 1st and November 1st of each year. 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. For the 2008 and 2007 first quarters, interest expense on the Senior Notes was approximately $5.5 million. The fair value of the Senior Notes at March 31, 2008 and December 31, 2007 was $285.2 million and $325.4 million, respectively.

 

Letter of Credit and Revolving Credit Facilities

 

As of March 31, 2008, the Company had a $300 million unsecured revolving loan and letter of credit facility and a $1.0 billion secured letter of credit facility (the “Credit Agreement”). The $300 million unsecured revolving loan is also available for the issuance of unsecured letters of credit up to $100 million for Arch Reinsurance Company (“Arch Re U.S.”). Borrowings of revolving loans may be made by ACGL and Arch Re U.S. at a variable rate based on LIBOR or an alternative base rate at the option of the Company. Secured letters of credit are available for issuance on behalf of the Company’s insurance and reinsurance subsidiaries. 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 change. 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 $1.95 billion plus 25% of future aggregate net income for each quarterly period (not including any future net losses) beginning after June 30, 2006 and 25% of future aggregate proceeds from the issuance of common or preferred equity 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 which are party to the Credit Agreement are required to maintain minimum shareholders’ equity levels. The

 

9


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Company was in compliance with all covenants contained in the Credit Agreement at December 31, 2007. The Credit Agreement expires on August 30, 2011.

 

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 letter of credit facilities for up to a total of $1.45 billion. 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 the Company 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, certain 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, 2008. At such date, the Company had approximately $579.9 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $612.2 million. 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. 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.

 

4.      Segment Information

 

The Company classifies its businesses into two underwriting segments — insurance and reinsurance — and corporate and other (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. Intersegment 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 nine product lines: casualty; construction and national accounts; executive assurance; healthcare; professional liability; programs; property, marine and aviation; surety; and other (consisting of collateral protection, excess workers’ compensation and employers’ liability business and travel and accident 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).

 

10


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Corporate and other (non-underwriting) includes net investment income, other fee income, net of related expenses, other income (loss), other expenses incurred by the Company, interest expense, net realized gains or losses, equity in net income (loss) of investment funds accounted for using the equity method, net foreign exchange gains or losses and income taxes. In addition, corporate and other results include dividends on the Company’s non-cumulative preferred shares. 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:

 

 

 

Three Months Ended

 

 

 

March 31, 2008

 

(U.S. dollars in thousands)

 

Insurance

 

Reinsurance

 

Total

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$626,348

 

 

$433,827

 

 

$1,053,152

 

 

Net premiums written (1)

 

402,764

 

 

408,578

 

 

811,342

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

$419,100

 

 

$289,134

 

 

$708,234

 

 

Fee income

 

882

 

 

186

 

 

1,068

 

 

Losses and loss adjustment expenses

 

(287,303

)

 

(117,114

)

 

(404,417

)

 

Acquisition expenses, net

 

(51,889

)

 

(62,750

)

 

(114,639

)

 

Other operating expenses

 

(73,637

)

 

(18,238

)

 

(91,875

)

 

Underwriting income

 

$7,153

 

 

$91,218

 

 

98,371

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

 

 

122,193

 

 

Net realized gains

 

 

 

 

 

 

 

35,975

 

 

Equity in net income (loss) of investment funds accounted for using the equity method

 

 

 

 

 

 

 

(22,313

)

 

Other income

 

 

 

 

 

 

 

4,036

 

 

Other expenses

 

 

 

 

 

 

 

(5,312

)

 

Interest expense

 

 

 

 

 

 

 

(5,524

)

 

Net foreign exchange losses

 

 

 

 

 

 

 

(23,587

)

 

Income before income taxes

 

 

 

 

 

 

 

203,839

 

 

Income tax expense

 

 

 

 

 

 

 

(7,956

)

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

195,883

 

 

Preferred dividends

 

 

 

 

 

 

 

(6,461

)

 

Net income available to common shareholders

 

 

 

 

 

 

 

$189,422

 

 

 

 

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

 

 

 

Loss ratio

 

68.6

%

 

40.5

%

 

57.1

%

 

Acquisition expense ratio (2)

 

12.2

%

 

21.7

%

 

16.1

%

 

Other operating expense ratio

 

17.6

%

 

6.3

%

 

13.0

%

 

Combined ratio

 

98.4

%

 

68.5

%

 

86.2

%

 

 

(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 insurance segment results include $7.0 million of gross and net premiums written and $8.7 million of net premiums earned assumed through intersegment transactions. The reinsurance segment results include $0.1 million of net premiums earned assumed through intersegment transactions.

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

 

11


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

 

 

Three Months Ended

 

 

 

March 31, 2007

 

(U.S. dollars in thousands)

 

Insurance

 

Reinsurance

 

Total

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$661,210

 

 

$558,654

 

 

$1,210,614

 

 

Net premiums written (1)

 

428,344

 

 

443,401

 

 

871,745

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

$413,847

 

 

$331,646

 

 

$745,493

 

 

Fee income

 

1,425

 

 

544

 

 

1,969

 

 

Losses and loss adjustment expenses

 

(259,322

)

 

(160,739

)

 

(420,061

)

 

Acquisition expenses, net

 

(46,695

)

 

(73,433

)

 

(120,128

)

 

Other operating expenses

 

(68,894

)

 

(13,781

)

 

(82,675

)

 

Underwriting income

 

$40,361

 

 

$84,237

 

 

124,598

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

 

 

110,047

 

 

Net realized losses

 

 

 

 

 

 

 

(981

)

 

Equity in net income (loss) of investment funds accounted for using the equity method

 

 

 

 

 

 

 

2,642

 

 

Other income

 

 

 

 

 

 

 

604

 

 

Other expenses

 

 

 

 

 

 

 

(8,138

)

 

Interest expense

 

 

 

 

 

 

 

(5,523

)

 

Net foreign exchange losses

 

 

 

 

 

 

 

(9,742

)

 

Income before income taxes

 

 

 

 

 

 

 

213,507

 

 

Income tax expense

 

 

 

 

 

 

 

(8,495

)

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

205,012

 

 

Preferred dividends

 

 

 

 

 

 

 

(6,461

)

 

Net income available to common shareholders

 

 

 

 

 

 

 

$198,551

 

 

 

 

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

 

 

 

Loss ratio

 

62.7

%

 

48.5

%

 

56.3

%

 

Acquisition expense ratio (2)

 

11.1

%

 

22.1

%

 

16.0

%

 

Other operating expense ratio

 

16.6

%

 

4.2

%

 

11.1

%

 

Combined ratio

 

90.4

%

 

74.8

%

 

83.4

%

 

 

(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 $0.5 million and $8.7 million, respectively, of gross and net premiums written and $0.5 million and $10.6 million, respectively, of net premiums earned assumed through intersegment transactions.

(2)          The acquisition expense ratio is adjusted to include certain fee income.

 

12


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

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,

 

 

 

2008

 

2007

 

INSURANCE SEGMENT
(U.S. dollars in thousands)

 

Amount

 

% of
Total

 

Amount

 

% of
Total

 

 

 

 

 

 

 

 

 

 

 

Net premiums written (1)

 

 

 

 

 

 

 

 

 

Property, marine and aviation

 

$98,162

 

 

24.4

 

 

$84,863

 

 

19.8

 

 

Construction and national accounts

 

61,211

 

 

15.2

 

 

60,483

 

 

14.1

 

 

Programs

 

54,583

 

 

13.5

 

 

58,323

 

 

13.6

 

 

Professional liability

 

54,081

 

 

13.4

 

 

58,355

 

 

13.6

 

 

Executive assurance

 

42,169

 

 

10.5

 

 

44,091

 

 

10.3

 

 

Casualty

 

27,618

 

 

6.9

 

 

43,091

 

 

10.1

 

 

Healthcare

 

10,997

 

 

2.7

 

 

21,530

 

 

5.0

 

 

Surety

 

10,867

 

 

2.7

 

 

18,747

 

 

4.4

 

 

Other (2)

 

43,076

 

 

10.7

 

 

38,861

 

 

9.1

 

 

Total

 

$402,764

 

 

100.0

 

 

$428,344

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Property, marine and aviation

 

$84,992

 

 

20.3

 

 

$81,804

 

 

19.8

 

 

Construction and national accounts

 

57,115

 

 

13.6

 

 

47,975

 

 

11.6

 

 

Programs

 

56,987

 

 

13.6

 

 

56,209

 

 

13.6

 

 

Professional liability

 

68,810

 

 

16.4

 

 

67,884

 

 

16.4

 

 

Executive assurance

 

44,408

 

 

10.6

 

 

45,378

 

 

11.0

 

 

Casualty

 

41,772

 

 

10.0

 

 

51,542

 

 

12.4

 

 

Healthcare

 

13,445

 

 

3.2

 

 

19,844

 

 

4.8

 

 

Surety

 

13,499

 

 

3.2

 

 

19,129

 

 

4.6

 

 

Other (2)

 

38,072

 

 

9.1

 

 

24,082

 

 

5.8

 

 

Total

 

$419,100

 

 

100.0

 

 

$413,847

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums written by client location (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$279,255

 

 

69.3

 

 

$320,005

 

 

74.7

 

 

Europe

 

86,300

 

 

21.4

 

 

74,935

 

 

17.5

 

 

Other

 

37,209

 

 

9.3

 

 

33,404

 

 

7.8

 

 

Total

 

$402,764

 

 

100.0

 

 

$428,344

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums written by underwriting location (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$287,207

 

 

71.3

 

 

$331,557

 

 

77.4

 

 

Europe

 

102,011

 

 

25.3

 

 

82,016

 

 

19.1

 

 

Other

 

13,546

 

 

3.4

 

 

14,771

 

 

3.5

 

 

Total

 

$402,764

 

 

100.0

 

 

$428,344

 

 

100.0

 

 

 

(1)          Insurance segment results include premiums earned assumed through intersegment transactions of $0.1 million for the 2008 first quarter and premiums written and earned assumed of $0.5 million and $0.5 million, respectively, for the 2007 first quarter. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $7.0 million and $8.7 million, respectively, for the 2008 first quarter and $8.7 million and $10.6 million, respectively, for the 2007 first quarter.

(2)          Includes excess workers’ compensation and employers’ liability business and travel and accident business.

 

13


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

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:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2008

 

2007

 

REINSURANCE SEGMENT
(U.S. dollars in thousands)

 

Amount

 

% of
Total

 

Amount

 

% of
Total

 

 

 

 

 

 

 

 

 

 

 

Net premiums written (1)

 

 

 

 

 

 

 

 

 

Property catastrophe

 

$106,224

 

 

26.0

 

 

$80,659

 

 

18.2

 

 

Casualty (2)

 

105,987

 

 

26.0

 

 

144,476

 

 

32.6

 

 

Property excluding property catastrophe (3)

 

95,922

 

 

23.5

 

 

94,944

 

 

21.4

 

 

Other specialty

 

75,680

 

 

18.5

 

 

73,996

 

 

16.7

 

 

Marine and aviation

 

22,164

 

 

5.4

 

 

43,715

 

 

9.8

 

 

Other

 

2,601

 

 

0.6

 

 

5,611

 

 

1.3

 

 

Total

 

$408,578

 

 

100.0

 

 

$443,401

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Property catastrophe

 

$50,281

 

 

17.4

 

 

$34,691

 

 

10.5

 

 

Casualty (2)

 

107,648

 

 

37.2

 

 

140,444

 

 

42.4

 

 

Property excluding property catastrophe (3)

 

63,341

 

 

21.9

 

 

73,039

 

 

22.0

 

 

Other specialty

 

38,484

 

 

13.3

 

 

52,042

 

 

15.7

 

 

Marine and aviation

 

27,431

 

 

9.5

 

 

26,622

 

 

8.0

 

 

Other

 

1,949

 

 

0.7

 

 

4,808

 

 

1.4

 

 

Total

 

$289,134

 

 

100.0

 

 

$331,646

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums written (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro rata

 

$215,419

 

 

52.7

 

 

$263,815

 

 

59.5

 

 

Excess of loss

 

193,159

 

 

47.3

 

 

179,586

 

 

40.5

 

 

Total

 

$408,578

 

 

100.0

 

 

$443,401

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro rata

 

$192,076

 

 

66.4

 

 

$242,439

 

 

73.1

 

 

Excess of loss

 

97,058

 

 

33.6

 

 

89,207

 

 

26.9

 

 

Total

 

$289,134

 

 

100.0

 

 

$331,646

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums written by client location (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$217,179

 

 

53.2

 

 

$253,991

 

 

57.3

 

 

Europe

 

143,920

 

 

35.2

 

 

124,338

 

 

28.0

 

 

Bermuda

 

34,060

 

 

8.3

 

 

50,841

 

 

11.5

 

 

Other

 

13,419

 

 

3.3

 

 

14,231

 

 

3.2

 

 

Total

 

$408,578

 

 

100.0

 

 

$443,401

 

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums written by underwriting location (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Bermuda

 

$220,669

 

 

54.0

 

 

$252,028

 

 

56.8

 

 

United States

 

154,480

 

 

37.8

 

 

180,362

 

 

40.7

 

 

Other

 

33,429

 

 

8.2

 

 

11,011

 

 

2.5

 

 

Total

 

$408,578

 

 

100.0

 

 

$443,401

 

 

100.0

 

 

 

(1)          Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $7.0 million and $8.7 million, respectively, for the 2008 first quarter and $8.7 million and $10.6 million, respectively, for the 2007 first quarter. Reinsurance segment results exclude premiums earned ceded through intersegment transactions of $0.1 million for the 2008 first quarter and premiums written and earned ceded of $0.5 million and $0.5 million, respectively, for the 2007 first quarter.

(2)          Includes professional liability, executive assurance and healthcare business.

(3)          Includes facultative business.

 

14


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

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 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. In addition, the Company’s reinsurance subsidiaries may purchase retrocessional coverage as part of their risk management program. 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:

 

 

 

Three Months Ended

 

 

 

March 31,

 

(U.S. dollars in thousands)

 

2008

 

2007

 

 

 

 

 

 

 

Premiums Written

 

 

 

 

 

Direct

 

$619,486

 

 

$649,880

 

 

Assumed

 

433,666

 

 

560,734

 

 

Ceded

 

(241,810

)

 

(338,869

)

 

Net

 

$811,342

 

 

$871,745

 

 

 

 

 

 

 

 

 

 

Premiums Earned

 

 

 

 

 

 

 

Direct

 

$630,814

 

 

$637,008

 

 

Assumed

 

365,364

 

 

416,132

 

 

Ceded

 

(287,944

)

 

(307,647

)

 

Net

 

$708,234

 

 

$745,493

 

 

 

 

 

 

 

 

 

 

Losses and Loss Adjustment Expenses

 

 

 

 

 

 

 

Direct

 

$420,971

 

 

$359,476

 

 

Assumed

 

141,249

 

 

195,271

 

 

Ceded

 

(157,803

)

 

(134,686

)

 

Net

 

$404,417

 

 

$420,061

 

 

 

The Company monitors the financial condition of its reinsurers and attempts to place coverages only with substantial, financially sound carriers. At March 31, 2008 and December 31, 2007, approximately 87.9% and 88.5%, respectively, of the Company’s reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.76 billion and $1.74 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better. At March 31, 2008 and December 31, 2007, the largest reinsurance recoverables from any one carrier were less than 5.7% and 5.2%, respectively, of the Company’s total shareholders’ equity.

 

On December 29, 2005, Arch Re Bermuda entered into a quota share reinsurance treaty with Flatiron Re Ltd., a Bermuda reinsurance company, pursuant to which Flatiron Re Ltd. assumed a 45% quota share (the “Treaty”) of certain lines of property and marine business underwritten by Arch Re Bermuda for unaffiliated third parties for the 2006 and 2007 underwriting years (January 1, 2006 to December 31, 2007). Effective June 28, 2006, the parties amended the Treaty to increase the percentage ceded to Flatiron Re Ltd. from 45% to 70% of all covered business bound by Arch Re Bermuda from (and including) June 28, 2006 until (and including) August 15, 2006 provided such business did not incept beyond September 30, 2006. The ceding percentage for all business bound outside of this period continued to be 45%. On December 31, 2007, the Treaty expired by its terms.

 

15


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Flatiron Re Ltd. is required to contribute funds into a trust for the benefit of Arch Re Bermuda (the “Trust”). Effective June 28, 2006, the parties amended the Treaty to provide that, through the earning of all written premium, the amount required to be on deposit in the Trust, together with certain other amounts, will be an amount equal to a calculated amount estimated to cover ceded losses arising from in excess of two 1-in-250 year events for the applicable forward twelve-month period (the “Requisite Funded Amount”). If the actual amounts on deposit in the Trust, together with certain other amounts (the “Funded Amount”), do not at least equal the Requisite Funded Amount, Arch Re Bermuda will, among other things, recapture unearned premium reserves and reassume losses that would have been ceded in respect of such unearned premiums. No assurances can be given that actual losses will not exceed the Requisite Funded Amount or that Flatiron Re Ltd. will make, or will have the ability to make, the required contributions into the Trust.

 

Arch Re Bermuda pays to Flatiron Re Ltd. a reinsurance premium in the amount of the ceded percentage of the original gross written premium on the business reinsured less a ceding commission, which includes a reimbursement of direct acquisition expenses as well as a commission to Arch Re Bermuda for generating the business. The Treaty also provides for a profit commission to Arch Re Bermuda based on the underwriting results for the 2006 and 2007 underwriting years on a cumulative basis. For the 2008 first quarter, $18.4 million of premiums written, $58.9 million of premiums earned and $11.8 million of losses and loss adjustment expenses were ceded to Flatiron Re Ltd. by Arch Re Bermuda, compared to $108.9 million of premiums written, $66.0 million of premiums earned and $25.4 million of losses and loss adjustment expenses for the 2007 first quarter. At March 31, 2008, $104.5 million of premiums ceded to Flatiron Re Ltd. were unearned. Reinsurance recoverables from Flatiron Re Ltd., which is not rated by A.M. Best, were $167.1 million at March 31, 2008, compared to $152.6 million at December 31, 2007. As noted above, Flatiron Re Ltd. is required to contribute funds into a trust for the benefit of Arch Re Bermuda. The recoverable from Flatiron Re Ltd. was fully collateralized through such trust at March 31, 2008 and December 31, 2007.

 

6.      Investment Information

 

The following table summarizes the Company’s invested assets:

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2008

 

2007

 

 

 

 

 

 

 

Fixed maturities available for sale, at fair value

 

$7,591,695

 

 

$7,137,998

 

 

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

 

1,189,050

 

 

1,462,826

 

 

Total fixed maturities

 

8,780,745

 

 

8,600,824

 

 

Short-term investments available for sale, at fair value

 

631,285

 

 

699,036

 

 

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

 

1,036

 

 

219

 

 

Other investments

 

316,252

 

 

353,694

 

 

Investment funds accounted for using the equity method

 

294,379

 

 

235,975

 

 

Total investments (1)

 

10,023,697

 

 

9,889,748

 

 

Securities transactions entered into but not settled at the balance sheet date

 

(39,640

)

 

(5,796

)

 

Total investments, net of securities transactions

 

$9,984,057

 

 

$9,883,952

 

 

 

(1)          In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of this table, the Company has excluded the collateral received at March 31, 2008 and December 31, 2007 of $1.23 billion and $1.5 billion, respectively, which is reflected as “short-term investment of funds received under securities lending agreements, at fair value” and included the $1.19 billion and $1.46 billion, respectively, of “fixed maturities and short-term investments pledged under securities lending agreements, at fair value.”

 

16


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

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, 2008:

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$2,380,756

 

 

$63,605

 

 

($32,568

)

 

$2,349,719

 

 

Commercial mortgage backed securities

 

1,334,521

 

 

17,326

 

 

(6,536

)

 

1,323,731

 

 

Mortgage backed securities

 

1,333,473

 

 

19,605

 

 

(41,664

)

 

1,355,532

 

 

Municipal bonds

 

1,184,123

 

 

17,156

 

 

(3,156

)

 

1,170,123

 

 

Asset backed securities

 

1,082,196

 

 

15,956

 

 

(7,020

)

 

1,073,260

 

 

U.S. government and government agencies

 

1,028,256

 

 

29,468

 

 

(735

)

 

999,523

 

 

Non-U.S. government securities

 

437,420

 

 

34,497

 

 

(2,259

)

 

405,182

 

 

Total

 

$8,780,745

 

 

$197,613

 

 

($93,938

)

 

$8,677,070

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2007:

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$2,452,527

 

 

$40,296

 

 

($10,994

)

 

$2,423,225

 

 

Commercial mortgage backed securities

 

1,315,680

 

 

17,339

 

 

(558

)

 

1,298,899

 

 

Mortgage backed securities

 

1,234,596

 

 

14,211

 

 

(4,087

)

 

1,224,472

 

 

Municipal bonds

 

990,325

 

 

13,213

 

 

(195

)

 

977,307

 

 

Asset backed securities

 

1,008,030

 

 

9,508

 

 

(4,030

)

 

1,002,552

 

 

U.S. government and government agencies

 

1,165,423

 

 

21,598

 

 

(447

)

 

1,144,272

 

 

Non-U.S. government securities

 

434,243

 

 

28,032

 

 

(3,056

)

 

409,267

 

 

Total

 

$8,600,824

 

 

$144,197

 

 

($23,367

)

 

$8,479,994

 

 

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140” (“SFAS No. 155”). Upon adopting SFAS No. 155 on January 1, 2007, the Company applied the “fair value option” to certain hybrid securities which are included in the Company’s fixed maturities and records changes in market value of such securities as realized gains or losses. The fair market values of such securities at March 31, 2008 were approximately $62.9 million and the Company recorded a realized loss of $2.4 million on such securities in the 2008 first quarter.

 

17


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The Company’s investment portfolio, which includes fixed maturity securities, short-term investments and other investments, had a “AA+” average credit quality rating at March 31, 2008 and December 31, 2007. The credit quality distribution of the Company’s fixed maturities and fixed maturities pledged under securities lending agreements are shown below:

 

(U.S. dollars in thousands)

 

March 31, 2008

 

December 31, 2007

 

Rating (1)

 

Estimated
Fair Value

 

% of Total

 

Estimated
Fair Value

 

% of Total

 

 

 

 

 

 

 

 

 

 

 

AAA

 

$6,676,227

 

 

76.0

 

 

$6,600,258

 

 

76.7

 

 

AA

 

950,671

 

 

10.8

 

 

882,262

 

 

10.3

 

 

A

 

730,523

 

 

8.3

 

 

677,047

 

 

7.9

 

 

BBB

 

209,874

 

 

2.4

 

 

243,610

 

 

2.8

 

 

BB

 

34,072

 

 

0.4

 

 

25,390

 

 

0.3

 

 

B

 

113,912

 

 

1.3

 

 

128,459

 

 

1.5

 

 

Lower than B

 

9,785

 

 

0.1

 

 

11,321

 

 

0.1

 

 

Not rated

 

55,681

 

 

0.7

 

 

32,477

 

 

0.4

 

 

Total

 

$8,780,745

 

 

100.0

 

 

$8,600,824

 

 

100.0

 

 

(1) Ratings as assigned by the major rating agencies.

 

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, at fair value.” 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, 2008, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $1.19 billion and $1.17 billion, respectively, while collateral received totaled $1.23 billion at fair value and amortized cost. At December 31, 2007, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $1.46 billion and $1.44 billion, respectively, while collateral received totaled $1.5 billion 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, replicate investment positions or manage market exposures and duration risk that would be allowed under the Company’s investment guidelines if implemented in other ways. The fair values of those derivatives are based on quoted market prices. At March 31, 2008, the notional value of the net short position for equity futures was $66.2 million, compared to a net long position for equity futures of $91.2 million at December 31, 2007. At March 31, 2008 and December 31, 2007, the notional value of the net long position for Treasury note futures was $444.4 million and $61.7 million, respectively. For the 2008 first quarter, the Company recorded $5.8 million of net realized losses related to changes in the fair value of all futures contracts, compared to $0.9 million of net realized losses for the 2007 first quarter.

 

18


 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Other Investments

 

The following table details the Company’s other investments:

 

 

 

March 31, 2008

 

December 31, 2007

 

(U.S. dollars in thousands)

 

Estimated
Fair Value

 

Cost

 

Estimated
Fair Value

 

Cost

 

 

 

 

 

 

 

 

 

 

 

Mutual funds

 

$253,947

 

 

$255,624

 

 

$286,147

 

 

$266,515

 

 

Privately held securities and other

 

62,305

 

 

52,451

 

 

67,547

 

 

57,435

 

 

Total

 

$316,252

 

 

$308,075

 

 

$353,694

 

 

$323,950

 

 

 

Other investments include: (i) mutual funds which invest in fixed maturity securities and international equity index funds; and (ii) privately held securities and other which include the Company’s investment in Aeolus LP (see Note 9). The Company’s investment commitments relating to its other investments and investment funds accounted for using the equity method totaled approximately $91.5 million at March 31, 2008.

 

Investment Funds Accounted for Using the Equity Method

 

The Company’s investment portfolio includes certain funds that invest in fixed maturity securities which, due to their ownership structure, are accounted for by the Company using the equity method. In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). Changes in the carrying value of such investments are recorded in net income as ‘Equity in net income (loss) of investment funds accounted for using the equity method.’ Changes in the carrying value of the Company’s other fixed income investments are recorded as an unrealized gain or loss component of accumulated other comprehensive income in shareholders’ equity. Investment funds accounted for using the equity method totaled $294.4 million at March 31, 2008, compared to $236.0 million at December 31, 2007. The Company recorded $22.3 million of equity in net loss of investment funds accounted for using the equity method in the 2008 first quarter, compared to equity in net income of $2.6 million in the 2007 first quarter.

 

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:

 

 

 

March 31,

 

December 31,

 

(U.S. dollars in thousands)

 

2008

 

2007

 

 

 

 

 

 

 

Assets used for collateral or guarantees

 

$714,871

 

 

$736,938

 

 

Deposits with U.S. regulatory authorities

 

248,399

 

 

251,586

 

 

Trust funds

 

139,005

 

 

133,238

 

 

Deposits with non-U.S. regulatory authorities

 

57,130

 

 

46,789