Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

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

 

For the quarterly period ended March 31, 2012

 

Or

 

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

 

Commission file number:  001-26456

 

ARCH CAPITAL GROUP LTD.

(Exact name of registrant as specified in its charter)

 

Bermuda

(State or other jurisdiction of incorporation or organization)

 

Not Applicable

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

 

Wessex House, 5th Floor, 45 Reid Street

Hamilton HM 12, Bermuda 

(Address of principal executive offices)

 

(441) 278-9250

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

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

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

 

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

 

The number of the registrant’s common shares (par value, $0.0033 per share) outstanding as of May 1, 2012 was 135,451,630.

 

 

 



Table of Contents

 

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, 2012 (unaudited) and December 31, 2011

3

 

 

Consolidated Statements of Income
For the three month periods ended March 31, 2012 and 2011 (unaudited)

4

 

 

Consolidated Statements of Comprehensive Income
For the three month periods ended March 31, 2012 and 2011 (unaudited)

5

 

 

Consolidated Statements of Changes in Shareholders’ Equity
For the three month periods ended March 31, 2012 and 2011 (unaudited)

6

 

 

Consolidated Statements of Cash Flows
For the three month periods ended March 31, 2012 and 2011 (unaudited)

7

 

 

Notes to Consolidated Financial Statements (unaudited)

8

 

 

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

26

 

 

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

63

 

 

Item 4 — Controls and Procedures

63

 

 

PART II. Other Information

 

 

 

Item 1 — Legal Proceedings

64

 

 

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

64

 

 

Item 5 — Other Information

64

 

 

Item 6 — Exhibits

65

 

1



Table of Contents

 

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Shareholders of

Arch Capital Group Ltd.:

 

We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of March 31, 2012, and the related consolidated statements of income for the three-month periods ended March 31, 2012 and March 31, 2011, and the consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the three-month periods ended March 31, 2012 and March 31, 2011. 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, 2011, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein), and in our report dated February 29, 2012, we expressed an unqualified opinion on those consolidated financial statements.  As discussed in Note 2 to the accompanying consolidated financial statements, the Company changed its method of accounting for costs associated with acquiring or renewing insurance contracts. The accompanying December 31, 2011 consolidated balance sheet reflects this change.

 

 

/s/ PricewaterhouseCoopers LLP

 

New York, NY

May 10, 2012

 

2



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

 

 

 

(Unaudited)

 

 

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed maturities available for sale, at fair value (amortized cost: $8,989,350 and $9,165,438)

 

$

9,221,145

 

$

9,375,604

 

Short-term investments available for sale, at fair value (amortized cost: $1,110,944 and $909,121)

 

1,112,249

 

904,219

 

Investment of funds received under securities lending, at fair value (amortized cost: $42,174 and $48,577)

 

41,867

 

48,419

 

Equity securities available for sale, at fair value (cost: $295,242 and $299,058)

 

318,181

 

299,584

 

Other investments available for sale, at fair value (cost: $342,234 and $235,381)

 

357,992

 

238,111

 

Investments accounted for using the fair value option

 

500,283

 

366,903

 

TALF investments, at fair value (amortized cost: $297,301 and $373,040)

 

313,187

 

387,702

 

Investments accounted for using the equity method

 

347,273

 

380,507

 

Total investments

 

12,212,177

 

12,001,049

 

 

 

 

 

 

 

Cash

 

422,806

 

351,699

 

Accrued investment income

 

65,643

 

70,739

 

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

 

107,866

 

107,576

 

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

 

50,813

 

56,393

 

Premiums receivable

 

700,137

 

501,563

 

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

1,849,603

 

1,851,584

 

Contractholder receivables

 

762,031

 

748,231

 

Prepaid reinsurance premiums

 

261,619

 

265,696

 

Deferred acquisition costs, net

 

261,467

 

227,884

 

Receivable for securities sold

 

621,560

 

462,891

 

Other assets

 

497,061

 

460,052

 

Total Assets

 

$

17,812,783

 

$

17,105,357

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

Reserve for losses and loss adjustment expenses

 

$

8,511,323

 

$

8,456,210

 

Unearned premiums

 

1,595,712

 

1,411,872

 

Reinsurance balances payable

 

137,791

 

133,866

 

Contractholder payables

 

762,031

 

748,231

 

Senior notes

 

300,000

 

300,000

 

Revolving credit agreement borrowings

 

100,000

 

100,000

 

TALF borrowings, at fair value (par: $241,005 and $310,868)

 

239,551

 

310,486

 

Securities lending payable

 

52,224

 

58,546

 

Payable for securities purchased

 

742,995

 

480,230

 

Other liabilities

 

531,700

 

513,842

 

Total Liabilities

 

12,973,327

 

12,513,283

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

Non-cumulative preferred shares

 

325,000

 

325,000

 

Common shares ($0.0033 par, shares issued: 165,725,990 and 164,636,338)

 

552

 

549

 

Additional paid-in capital

 

170,694

 

161,419

 

Retained earnings

 

4,954,450

 

4,796,655

 

Accumulated other comprehensive income, net of deferred income tax

 

234,468

 

153,923

 

Common shares held in treasury, at cost (shares: 30,284,303 and 30,277,993)

 

(845,708

)

(845,472

)

Total Shareholders’ Equity

 

4,839,456

 

4,592,074

 

Total Liabilities and Shareholders’ Equity

 

$

17,812,783

 

$

17,105,357

 

 

See Notes to Consolidated Financial Statements

 

3



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

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

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Revenues

 

 

 

 

 

Net premiums written

 

$

863,611

 

$

764,278

 

Change in unearned premiums

 

(183,299

)

(130,583

)

Net premiums earned

 

680,312

 

633,695

 

Net investment income

 

74,297

 

88,307

 

Net realized gains

 

44,121

 

20,695

 

 

 

 

 

 

 

Other-than-temporary impairment losses

 

(1,031

)

(3,258

)

Less investment impairments recognized in other comprehensive income, before taxes

 

8

 

578

 

Net impairment losses recognized in earnings

 

(1,023

)

(2,680

)

 

 

 

 

 

 

Fee income

 

543

 

815

 

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

 

24,826

 

29,673

 

Other income (loss)

 

(8,068

)

4,567

 

Total revenues

 

815,008

 

775,072

 

 

 

 

 

 

 

Expenses

 

 

 

 

 

Losses and loss adjustment expenses

 

395,207

 

493,880

 

Acquisition expenses

 

118,962

 

108,754

 

Other operating expenses

 

106,472

 

102,882

 

Interest expense

 

7,521

 

7,721

 

Net foreign exchange losses

 

20,688

 

36,912

 

Total expenses

 

648,850

 

750,149

 

 

 

 

 

 

 

Income before income taxes

 

166,158

 

24,923

 

 

 

 

 

 

 

Income tax expense (benefit)

 

1,902

 

(550

)

 

 

 

 

 

 

Net income

 

164,256

 

25,473

 

 

 

 

 

 

 

Preferred dividends

 

6,461

 

6,461

 

 

 

 

 

 

 

Net income available to common shareholders

 

$

157,795

 

$

19,012

 

 

 

 

 

 

 

Net income per common share

 

 

 

 

 

Basic

 

$

1.18

 

$

0.14

 

Diluted

 

$

1.14

 

$

0.14

 

 

 

 

 

 

 

Weighted average common shares and common share equivalents outstanding

 

 

 

 

 

Basic

 

133,954,623

 

133,499,241

 

Diluted

 

137,814,906

 

140,460,516

 

 

See Notes to Consolidated Financial Statements

 

4



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(U.S. dollars in thousands)

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Comprehensive Income

 

 

 

 

 

Net income

 

$

164,256

 

$

25,473

 

Other comprehensive income, net of deferred income tax

 

 

 

 

 

Unrealized appreciation in value of investments:

 

 

 

 

 

Unrealized holding gains arising during period

 

94,863

 

40,370

 

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

 

(8

)

(578

)

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

 

(27,511

)

(20,176

)

Foreign currency translation adjustments, net of deferred income tax

 

13,201

 

1,286

 

Other comprehensive income

 

80,545

 

20,902

 

Comprehensive Income

 

$

244,801

 

$

46,375

 

 

See Notes to Consolidated Financial Statements

 

5



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(U.S. dollars in thousands)

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Non-Cumulative Preferred Shares

 

 

 

 

 

Balance at beginning and end of period

 

$

325,000

 

$

325,000

 

 

 

 

 

 

 

Common Shares

 

 

 

 

 

Balance at beginning of year

 

549

 

534

 

Common shares issued, net

 

3

 

1

 

Balance at end of period

 

552

 

535

 

 

 

 

 

 

 

Additional Paid-in Capital

 

 

 

 

 

Balance at beginning of year

 

161,419

 

110,325

 

Common shares issued, net

 

(3

)

8

 

Exercise of stock options

 

1,851

 

4,127

 

Amortization of share-based compensation

 

7,411

 

5,628

 

Other

 

16

 

21

 

Balance at end of period

 

170,694

 

120,109

 

 

 

 

 

 

 

Retained Earnings

 

 

 

 

 

Balance at beginning of year

 

4,796,655

 

4,422,553

 

Cumulative effect of adjustment resulting from adoption of new accounting guidance (1)

 

 

(36,217

)

Balance at beginning of year, as adjusted

 

4,796,655

 

4,386,336

 

Dividends declared on preferred shares

 

(6,461

)

(6,461

)

Net income

 

164,256

 

25,473

 

Balance at end of period

 

4,954,450

 

4,405,348

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income

 

 

 

 

 

Balance at beginning of year

 

153,923

 

204,503

 

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

 

67,352

 

20,194

 

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

 

(8

)

(578

)

Foreign currency translation adjustments, net of deferred income tax

 

13,201

 

1,286

 

Balance at end of period

 

234,468

 

225,405

 

 

 

 

 

 

 

Common Shares Held in Treasury, at Cost

 

 

 

 

 

Balance at beginning of year

 

(845,472

)

(549,912

)

Shares repurchased for treasury

 

(236

)

(237,450

)

Balance at end of period

 

(845,708

)

(787,362

)

 

 

 

 

 

 

Total Shareholders’ Equity

 

$

4,839,456

 

$

4,289,035

 

 


(1) Adoption of accounting guidance regarding costs incurred that can be capitalized by insurance entities.

 

See Notes to Consolidated Financial Statements

 

6



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(U.S. dollars in thousands)

 

 

 

(Unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Operating Activities

 

 

 

 

 

Net income

 

$

164,256

 

$

25,473

 

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

 

 

 

 

 

Net realized gains

 

(44,072

)

(22,481

)

Net impairment losses recognized in earnings

 

1,023

 

2,680

 

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

 

(12,030

)

(355

)

Share-based compensation

 

7,411

 

5,628

 

Changes in:

 

 

 

 

 

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

 

39,343

 

155,477

 

Unearned premiums, net of prepaid reinsurance premiums

 

181,735

 

130,136

 

Premiums receivable

 

(190,102

)

(118,688

)

Deferred acquisition costs, net

 

(32,269

)

(22,056

)

Reinsurance balances payable

 

(3,181

)

(7,122

)

Other liabilities

 

10,134

 

33,366

 

Other items, net

 

22,573

 

42,522

 

Net Cash Provided By Operating Activities

 

144,821

 

224,580

 

 

 

 

 

 

 

Investing Activities

 

 

 

 

 

Purchases of:

 

 

 

 

 

Fixed maturity investments

 

(3,593,630

)

(3,151,767

)

Equity securities

 

(33,803

)

(89,790

)

Other investments

 

(239,167

)

(92,777

)

Proceeds from the sales of:

 

 

 

 

 

Fixed maturity investments

 

3,628,932

 

3,232,541

 

Equity securities

 

75,860

 

52,316

 

Other investments

 

111,149

 

84,967

 

Proceeds from redemptions and maturities of fixed maturity investments

 

261,660

 

253,898

 

Net purchases of short-term investments

 

(207,444

)

(223,415

)

Change in investment of securities lending collateral

 

6,322

 

(125,904

)

Purchases of furniture, equipment and other assets

 

(6,498

)

(8,082

)

Net Cash Provided By (Used For) Investing Activities

 

3,381

 

(68,013

)

 

 

 

 

 

 

Financing Activities

 

 

 

 

 

Purchases of common shares under share repurchase program

 

 

(237,173

)

Proceeds from common shares issued, net

 

780

 

2,875

 

Repayments of borrowings

 

(69,863

)

(3,695

)

Change in securities lending collateral

 

(6,322

)

125,904

 

Other

 

588

 

714

 

Preferred dividends paid

 

(6,461

)

(6,461

)

Net Cash Used For Financing Activities

 

(81,278

)

(117,836

)

 

 

 

 

 

 

Effects of exchange rate changes on foreign currency cash

 

4,183

 

5,406

 

 

 

 

 

 

 

Increase in cash

 

71,107

 

44,137

 

Cash beginning of year

 

351,699

 

362,740

 

Cash end of period

 

$

422,806

 

$

406,877

 

 

See Notes to Consolidated Financial Statements

 

7



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.      General

 

Arch Capital Group Ltd. (“ACGL”) is a Bermuda public limited liability company which provides insurance and reinsurance on a worldwide basis through its 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, 2011, including the Company’s audited consolidated financial statements and related notes.

 

The Company has reclassified the presentation of certain prior year information to conform to the current presentation. Such reclassifications had no effect on the Company’s net income, shareholders’ equity or cash flows. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.

 

2.      Recent Accounting Pronouncements

 

Effective January 1, 2012, the Company adopted an Accounting Standards Update (“ASU”) issued by the Financial Accounting Standards Board (“FASB”) concerning the accounting for costs associated with acquiring or renewing insurance contracts. This guidance was adopted retrospectively and has been applied to all prior period financial information contained in these consolidated financial statements. The impact of the adoption of the new guidance on the consolidated financial statements was as follows:

 

 

 

As Previously

 

Effect of

 

As Currently

 

 

 

Reported

 

Change

 

Reported

 

 

 

 

 

 

 

 

 

December 31, 2010

 

 

 

 

 

 

 

Deferred acquisition costs, net

 

$

277,861

 

$

(50,583

)

$

227,278

 

Other assets (1)

 

475,911

 

14,366

 

490,277

 

Retained earnings

 

4,422,553

 

(36,217

)

4,386,336

 

 

 

 

 

 

 

 

 

Three Months Ended March 31, 2011

 

 

 

 

 

 

 

Other operating expenses

 

$

102,420

 

$

462

 

$

102,882

 

Income tax benefit

 

(371

)

(179

)

(550

)

Net income

 

25,756

 

(283

)

25,473

 

 

 

 

 

 

 

 

 

Net income per common share - basic

 

$

0.14

 

$

 

$

0.14

 

Net income per common share - diluted

 

$

0.14

 

$

 

$

0.14

 

 


(1) Effect of change equals tax benefit included in “other assets” on the Company’s balance sheet.

 

8



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

3.      Commitments and Contingencies

 

Letter of Credit and Revolving Credit Facilities

 

As of March 31, 2012, the Company had a $300 million unsecured revolving loan and letter of credit facility and a $500 million secured letter of credit facility (the “Credit Agreement”). The Credit Agreement expires on August 18, 2014. In addition, the Company had access to secured letter of credit facilities of approximately $80 million as of March 31, 2012, which are available on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the “LOC Facilities”). At March 31, 2012, the Company had $473.1 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $555.8 million, and had $100.0 million of borrowings outstanding under the Credit Agreement. The Company was in compliance with all covenants contained in the LOC Facilities at March 31, 2012.

 

Investment Commitments

 

The Company’s investment commitments, which are primarily related to investment funds accounted for using the equity method, were approximately $275.0 million at March 31, 2012.

 

4.      Earnings Per Common Share

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

Net income

 

$

164,256

 

$

25,473

 

Preferred dividends

 

(6,461

)

(6,461

)

Net income available to common shareholders

 

$

157,795

 

$

19,012

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

Weighted average common shares outstanding — basic

 

133,954,623

 

133,499,241

 

Effect of dilutive common share equivalents:

 

 

 

 

 

Nonvested restricted shares

 

1,012,303

 

1,141,668

 

Stock options (1)

 

2,847,980

 

5,819,607

 

Weighted average common shares and common share equivalents outstanding — diluted

 

137,814,906

 

140,460,516

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

Basic

 

$

1.18

 

$

0.14

 

Diluted

 

$

1.14

 

$

0.14

 

 


(1)              Certain stock options were not included in the computation of diluted earnings per share where the exercise price of the stock options exceeded the average market price and would have been anti-dilutive or where, when applying the treasury stock method to in-the-money options, the sum of the proceeds, including unrecognized compensation, exceeded the average market price and would have been anti-dilutive. For the 2012 first quarter and 2011 first quarter, the number of stock options excluded were 451,877 and 202,074, respectively.

 

9



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

5.      Segment Information

 

The following table summarizes the Company’s underwriting income or loss by segment, together with a reconciliation of underwriting income or loss to net income available to common shareholders:

 

 

 

Three Months Ended

 

Three Months Ended

 

 

 

March 31, 2012

 

March 31, 2011

 

 

 

Insurance

 

Reinsurance

 

Total

 

Insurance

 

Reinsurance

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$

688,113

 

$

379,976

 

$

1,066,656

 

$

634,583

 

$

331,013

 

$

964,566

 

Net premiums written

 

490,680

 

372,931

 

863,611

 

449,291

 

314,987

 

764,278

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

441,740

 

$

238,572

 

$

680,312

 

$

407,591

 

$

226,104

 

$

633,695

 

Fee income

 

530

 

13

 

543

 

778

 

37

 

815

 

Losses and loss adjustment expenses

 

(303,164

)

(92,043

)

(395,207

)

(297,723

)

(196,157

)

(493,880

)

Acquisition expenses, net

 

(73,870

)

(45,092

)

(118,962

)

(61,415

)

(47,339

)

(108,754

)

Other operating expenses

 

(73,370

)

(26,123

)

(99,493

)

(74,629

)

(21,227

)

(95,856

)

Underwriting income (loss)

 

$

(8,134

)

$

75,327

 

67,193

 

$

(25,398

)

$

(38,582

)

(63,980

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income

 

 

 

 

 

74,297

 

 

 

 

 

88,307

 

Net realized gains

 

 

 

 

 

44,121

 

 

 

 

 

20,695

 

Net impairment losses recognized in earnings

 

 

 

 

 

(1,023

)

 

 

 

 

(2,680

)

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

 

 

 

 

 

24,826

 

 

 

 

 

29,673

 

Other income (loss)

 

 

 

 

 

(8,068

)

 

 

 

 

4,567

 

Other expenses

 

 

 

 

 

(6,979

)

 

 

 

 

(7,026

)

Interest expense

 

 

 

 

 

(7,521

)

 

 

 

 

(7,721

)

Net foreign exchange losses

 

 

 

 

 

(20,688

)

 

 

 

 

(36,912

)

Income before income taxes

 

 

 

 

 

166,158

 

 

 

 

 

24,923

 

Income tax (expense) benefit

 

 

 

 

 

(1,902

)

 

 

 

 

550

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

164,256

 

 

 

 

 

25,473

 

Preferred dividends

 

 

 

 

 

(6,461

)

 

 

 

 

(6,461

)

Net income available to common shareholders

 

 

 

 

 

$

157,795

 

 

 

 

 

$

19,012

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Underwriting Ratios

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss ratio

 

68.6

%

38.6

%

58.1

%

73.0

%

86.8

%

77.9

%

Acquisition expense ratio (2)

 

16.6

%

18.9

%

17.4

%

14.9

%

20.9

%

17.0

%

Other operating expense ratio

 

16.6

%

10.9

%

14.6

%

18.3

%

9.4

%

15.1

%

Combined ratio

 

101.8

%

68.4

%

90.1

%

106.2

%

117.1

%

110.0

%

 


(1)         Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.

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

 

10



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

6.      Investment Information

 

Available For Sale Securities

 

The following table summarizes the fair value and cost or amortized cost of the Company’s securities classified as available for sale:

 

 

 

Estimated

 

Gross

 

Gross

 

Cost or

 

OTTI

 

 

 

Fair

 

Unrealized

 

Unrealized

 

Amortized

 

Unrealized

 

 

 

Value

 

Gains

 

Losses

 

Cost

 

Losses (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

At March 31, 2012

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$

2,616,226

 

$

90,793

 

$

(11,263

)

$

2,536,696

 

$

(488

)

Mortgage backed securities

 

1,494,968

 

26,747

 

(14,777

)

1,482,998

 

(15,444

)

Municipal bonds

 

1,301,255

 

64,044

 

(1,381

)

1,238,592

 

(105

)

Commercial mortgage backed securities

 

1,124,667

 

35,721

 

(2,651

)

1,091,597

 

(3,259

)

U.S. government and government agencies

 

1,254,434

 

19,500

 

(4,295

)

1,239,229

 

(207

)

Non-U.S. government securities

 

856,535

 

30,517

 

(9,552

)

835,570

 

 

Asset backed securities

 

623,873

 

16,033

 

(6,132

)

613,972

 

(3,876

)

Total

 

9,271,958

 

283,355

 

(50,051

)

9,038,654

 

(23,379

)

 

 

 

 

 

 

 

 

 

 

 

 

Equity securities

 

318,181

 

37,649

 

(14,710

)

295,242

 

 

Other investments

 

357,992

 

17,119

 

(1,361

)

342,234

 

 

Short-term investments

 

1,112,249

 

3,570

 

(2,265

)

1,110,944

 

 

Total

 

$

11,060,380

 

$

341,693

 

$

(68,387

)

$

10,787,074

 

$

(23,379

)

 

 

 

 

 

 

 

 

 

 

 

 

At December 31, 2011

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$

2,596,118

 

$

79,407

 

$

(29,922

)

$

2,546,633

 

$

(1,138

)

Mortgage backed securities

 

1,592,762

 

27,633

 

(23,226

)

1,588,355

 

(20,466

)

Municipal bonds

 

1,430,565

 

77,977

 

(886

)

1,353,474

 

(105

)

Commercial mortgage backed securities

 

1,046,326

 

28,780

 

(2,904

)

1,020,450

 

(3,259

)

U.S. government and government agencies

 

1,451,993

 

34,811

 

(3

)

1,417,185

 

(207

)

Non-U.S. government securities

 

737,477

 

33,486

 

(17,684

)

721,675

 

 

Asset backed securities

 

576,757

 

14,649

 

(10,078

)

572,186

 

(3,876

)

Total

 

9,431,998

 

296,743

 

(84,703

)

9,219,958

 

(29,051

)

 

 

 

 

 

 

 

 

 

 

 

 

Equity securities

 

299,584

 

22,870

 

(22,344

)

299,058

 

 

Other investments

 

238,111

 

8,340

 

(5,610

)

235,381

 

 

Short-term investments

 

904,219

 

390

 

(5,292

)

909,121

 

 

Total

 

$

10,873,912

 

$

328,343

 

$

(117,949

)

$

10,663,518

 

$

(29,051

)

 


(1)         In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged. See “—Securities Lending Agreements.”

(2)         Represents the total other-than-temporary impairments (“OTTI”) recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At March 31, 2012, the net unrealized loss related to securities for which a non-credit OTTI was recognized in AOCI was $9.4 million, compared to a net unrealized loss of $18.0 million at December 31, 2011.

 

11



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The following table summarizes, for all available for sale securities in an unrealized loss position, the fair value and gross unrealized loss by length of time the security has been in a continual unrealized loss position:

 

 

 

Less than 12 Months

 

12 Months or More

 

Total

 

 

 

Estimated

 

Gross

 

Estimated

 

Gross

 

Estimated

 

Gross

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

Losses

 

Value

 

Losses

 

Value

 

Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At March 31, 2012

 

 

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$

446,225

 

$

(7,774

)

$

49,733

 

$

(3,489

)

$

495,958

 

$

(11,263

)

Mortgage backed securities

 

293,374

 

(5,324

)

49,160

 

(9,453

)

342,534

 

(14,777

)

Municipal bonds

 

114,896

 

(935

)

14,834

 

(446

)

129,730

 

(1,381

)

Commercial mortgage backed securities

 

88,471

 

(1,349

)

14,495

 

(1,302

)

102,966

 

(2,651

)

U.S. government and government agencies

 

818,965

 

(4,295

)

 

 

818,965

 

(4,295

)

Non-U.S. government securities

 

353,794

 

(9,370

)

4,267

 

(182

)

358,061

 

(9,552

)

Asset backed securities

 

208,215

 

(5,834

)

4,248

 

(298

)

212,463

 

(6,132

)

Total

 

2,323,940

 

(34,881

)

136,737

 

(15,170

)

2,460,677

 

(50,051

)

Equity securities

 

99,686

 

(14,241

)

4,547

 

(469

)

104,233

 

(14,710

)

Other investments

 

36,620

 

(295

)

23,934

 

(1,066

)

60,554

 

(1,361

)

Short-term investments

 

134,299

 

(2,265

)

 

 

134,299

 

(2,265

)

Total

 

$

2,594,545

 

$

(51,682

)

$

165,218

 

$

(16,705

)

$

2,759,763

 

$

(68,387

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At December 31, 2011

 

 

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$

781,635

 

$

(24,977

)

$

47,687

 

$

(4,945

)

$

829,322

 

$

(29,922

)

Mortgage backed securities

 

255,101

 

(11,988

)

44,606

 

(11,238

)

299,707

 

(23,226

)

Municipal bonds

 

39,156

 

(537

)

14,988

 

(349

)

54,144

 

(886

)

Commercial mortgage backed securities

 

87,796

 

(1,676

)

14,582

 

(1,228

)

102,378

 

(2,904

)

U.S. government and government agencies

 

7,059

 

(3

)

 

 

7,059

 

(3

)

Non-U.S. government securities

 

310,182

 

(16,139

)

20,482

 

(1,545

)

330,664

 

(17,684

)

Asset backed securities

 

260,647

 

(8,197

)

7,317

 

(1,881

)

267,964

 

(10,078

)

Total

 

1,741,576

 

(63,517

)

149,662

 

(21,186

)

1,891,238

 

(84,703

)

Equity securities

 

130,045

 

(22,039

)

1,923

 

(305

)

131,968

 

(22,344

)

Other investments

 

98,605

 

(3,053

)

22,443

 

(2,557

)

121,048

 

(5,610

)

Short-term investments

 

189,100

 

(5,292

)

 

 

189,100

 

(5,292

)

Total

 

$

2,159,326

 

$

(93,901

)

$

174,028

 

$

(24,048

)

$

2,333,354

 

$

(117,949

)

 


(1)         In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged. See “—Securities Lending Agreements.”

 

12



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

At March 31, 2012, on a lot level basis, approximately 920 security lots out of a total of approximately 4,340 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $2.2 million. At December 31, 2011, on a lot level basis, approximately 1,150 security lots out of a total of approximately 4,520 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $3.0 million.

 

The contractual maturities of the Company’s fixed maturities and fixed maturities pledged under securities lending agreements are shown in the following table. Expected maturities, which are management’s best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

 

March 31, 2012

 

December 31, 2011

 

 

 

Estimated

 

Amortized

 

Estimated

 

Amortized

 

Maturity

 

Fair Value

 

Cost

 

Fair Value

 

Cost

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Due in one year or less

 

$

470,608

 

$

457,213

 

$

486,986

 

$

476,734

 

Due after one year through five years

 

3,128,343

 

3,047,581

 

2,850,578

 

2,793,982

 

Due after five years through 10 years

 

2,210,672

 

2,138,648

 

2,532,834

 

2,441,800

 

Due after 10 years

 

218,827

 

206,645

 

345,755

 

326,451

 

 

 

6,028,450

 

5,850,087

 

6,216,153

 

6,038,967

 

Mortgage backed securities

 

1,494,968

 

1,482,998

 

1,592,762

 

1,588,355

 

Commercial mortgage backed securities

 

1,124,667

 

1,091,597

 

1,046,326

 

1,020,450

 

Asset backed securities

 

623,873

 

613,972

 

576,757

 

572,186

 

Total

 

$

9,271,958

 

$

9,038,654

 

$

9,431,998

 

$

9,219,958

 

 

Securities Lending Agreements

 

The Company operates 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. The Company maintains legal 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. At March 31, 2012, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $50.8 million and $49.3 million, respectively, compared to $56.4 million and $54.5 million at December 31, 2011, respectively. At March 31, 2012, the portfolio of collateral backing the Company’s securities lending program included approximately $6.2 million fair value of sub-prime securities, compared to $7.3 million at December 31, 2011.

 

13



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Fair Value Option

 

The Company elected to carry certain fixed maturity securities, equity securities and other investments (primarily term loans) at fair value under the fair value option afforded by accounting guidance regarding the fair value option for financial assets and liabilities. Changes in fair value of investments accounted for using the fair value option are included in “Net realized gains (losses).” The primary reasons for electing the fair value option were to reflect economic events in earnings on a timely basis and address simplification and cost-benefit considerations.

 

The Company also elected to carry the securities and related borrowings under the Federal Reserve Bank of New York’s (“FRBNY”) Term Asset-Backed Securities Loan Facility (“TALF”) at fair value under the fair value option. The primary reason for electing the fair value option on the TALF investments and TALF borrowings was to mitigate volatility in equity from using different measurement attributes (i.e., TALF investments carried at fair value whereas the related TALF borrowings would be recorded on an accrual basis absent electing the fair value option). Changes in fair value for both the securities and borrowings are included in “Net realized gains (losses)” while interest income on the TALF investments is reflected in net investment income and interest expense on the TALF borrowings is reflected in interest expense.

 

The following table summarizes the Company’s assets and liabilities which are accounted for using the fair value option:

 

 

 

March 31,

 

December 31,

 

 

 

2012 

 

2011

 

 

 

 

 

 

 

Fixed maturities

 

$

250,805

 

$

147,779

 

Equity securities

 

52,766

 

87,403

 

Other investments (par: $201,216 and $138,062)

 

196,712

 

131,721

 

Investments accounted for using the fair value option

 

500,283

 

366,903

 

Securities sold but not yet purchased (1)

 

(18,831

)

(27,178

)

TALF investments

 

313,187

 

387,702

 

TALF borrowings

 

(239,551

)

(310,486

)

Net assets accounted for using the fair value option

 

$

555,088

 

$

416,941

 

 


(1)              Represents the Company’s obligation to deliver equity securities that it did not own at the time of sale. Such amounts are included in “other liabilities” on the Company’s consolidated balance sheets.

 

14



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Net Investment Income

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Fixed maturities

 

$

73,450

 

$

85,144

 

Term loan investments (1)

 

2,299

 

151

 

Equity securities

 

1,664

 

1,547

 

Short-term investments

 

372

 

678

 

Other (2)

 

3,193

 

6,903

 

Gross investment income

 

80,978

 

94,423

 

Investment expenses

 

(6,681

)

(6,116

)

Net investment income

 

$

74,297

 

$

88,307

 

 


(1)              Included in “investments accounted for using the fair value option” on the Company’s consolidated balance sheets.

(2)              Amounts include dividends on investment funds and other items.

 

Net Realized Gains (Losses)

 

Net realized gains (losses) were as follows, excluding the other-than-temporary impairment provisions discussed above:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012 

 

2011

 

 

 

 

 

 

 

Available for sale securities:

 

 

 

 

 

Gross gains on investment sales

 

$

48,012

 

$

71,717

 

Gross losses on investment sales

 

(17,936

)

(47,750

)

Change in fair value of assets and liabilities accounted for using the fair value option:

 

 

 

 

 

Fixed maturities

 

8,217

 

90

 

Equity securities

 

3,387

 

3,434

 

Other investments

 

3,753

 

127

 

TALF investments

 

1,224

 

1,652

 

TALF borrowings

 

1,071

 

(147

)

Derivative instruments (1)

 

(4,669

)

(11,320

)

Other

 

1,062

 

2,892

 

Net realized gains

 

$

44,121

 

$

20,695

 

 


(1)              See Note 8 for information on the Company’s derivative instruments.

 

15



Table of Contents

 

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Other-Than-Temporary Impairments

 

The Company performs quarterly reviews of its available for sale investments in order to determine whether declines in fair value below the amortized cost basis were considered other-than-temporary in accordance with applicable guidance. The following table details the OTTI recognized in earnings by asset class:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012 

 

2011

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

Mortgage backed securities

 

$

746

 

$

1,118

 

Asset backed securities

 

 

10

 

Corporate bonds

 

196

 

359

 

Total

 

942

 

1,487

 

 

 

 

 

 

 

Investment of funds received under securities lending agreements

 

81

 

856

 

 

 

 

 

 

 

Equity securities

 

 

337

 

Total OTTI recognized in earnings

 

$

1,023

 

$

2,680

 

 

A description of the methodology and significant inputs used to measure the amount of OTTI in the 2012 first quarter is as follows:

 

·             Mortgage backed securities — the Company utilized underlying data provided by asset managers, cash flow projections and additional information from credit agencies in order to determine an expected recovery value for each security. The analysis includes expected cash flow projections under base case and stress case scenarios which modify the expected default expectations and loss severities and slow down prepayment assumptions. The significant inputs in the models include the expected default rates, delinquency rates and foreclosure costs. The expected recovery values were reduced on a number of mortgage backed securities, primarily as a result of increases in expected default expectations and foreclosure costs. The amortized cost basis of the mortgage backed securities were adjusted down, if required, to the expected recovery value calculated in the OTTI review process;

 

·                  Investment of funds received under securities lending agreements — the Company utilized analysis from its securities lending program manager in order to determine an expected recovery value for certain collateral backing the Company’s securities lending program which was invested in sub-prime securities. The analysis provided expected cash flow projections for the securities using similar criteria as described in the mortgage backed securities section above. The amortized cost basis of the investment of funds received under securities lending agreements was adjusted down, if required, to the expected recovery value calculated in the OTTI review process;

 

·                  Corporate bonds — the Company reviewed the business prospects, credit ratings, estimated loss given default factors, foreign currency impacts and information received from asset managers and rating agencies for certain corporate bonds. The amortized cost basis of the corporate bonds were adjusted down, if required, to the expected recovery value calculated in the OTTI review process.

 

The Company believes that the $23.4 million of OTTI included in accumulated other comprehensive income at March 31, 2012 on the securities which were considered by the Company to be impaired was due to market and sector-related factors (i.e., not credit losses). At March 31, 2012, the Company did not intend to sell

 

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

these securities, or any other securities which were in an unrealized loss position, and determined that it is more likely than not that the Company will not be required to sell such securities before recovery of their cost basis.

 

The following table provides a roll forward of the amount related to credit losses recognized in earnings for which a portion of an OTTI was recognized in accumulated other comprehensive income:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Balance at start of period

 

$

66,545

 

$

86,040

 

Credit loss impairments recognized on securities not previously impaired

 

212

 

2,006

 

Credit loss impairments recognized on securities previously impaired

 

811

 

674

 

Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security

 

 

 

Reductions for securities sold during the period

 

(482

)

(3,862

)

Balance at end of period

 

$

67,086

 

$

84,858

 

 

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 Company’s insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. See Note 3, “Commitments and Contingencies—Letter of Credit and Revolving Credit Facilities,” for further details. The following table details the value of the Company’s restricted assets:

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Assets used for collateral or guarantees:

 

 

 

 

 

Affiliated transactions

 

$

4,521,655

 

$

4,321,535

 

Third party agreements

 

693,371

 

757,669

 

Deposits with U.S. regulatory authorities

 

279,537

 

288,458

 

Deposits with non-U.S. regulatory authorities

 

221,179

 

169,733

 

Trust funds

 

64,398

 

60,558

 

Total restricted assets

 

$

5,780,140

 

$

5,597,953

 

 

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

7.      Fair Value

 

Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).

 

The levels in the hierarchy are defined as follows:

 

Level 1:                            Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets

 

Level 2:                            Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument

 

Level 3:                            Inputs to the valuation methodology are unobservable and significant to the fair value measurement

 

Following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy.

 

The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. To validate the techniques or models used by pricing sources, the Company’s review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value including a review of deep dive reports on selected securities which indicated the use of observable inputs in the pricing process; (iv) comparing the fair value estimates to its knowledge of the current market; (v) a comparison of the pricing services’ fair values to other pricing services’ fair values for the same investments; and (vi) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. At March 31, 2012, the Company obtained an average of 2.8 quotes per investment, compared to 2.8 quotes at December 31, 2011. Where multiple quotes or prices were obtained, a price source hierarchy was maintained in order to determine which price source provided the fair value (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value. At March 31, 2012 and December 31, 2011, the Company adjusted certain prices (primarily on structured securities) obtained from the pricing services and substituted alternate prices (primarily broker-dealer quotes) for such securities. Such adjustments did not have a material impact on the overall fair value of the Company’s investment portfolio.

 

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the $12.13 billion of financial assets and liabilities measured at fair value at March 31, 2012, approximately $927.3 million, or 7.6%, were priced using non-binding broker-dealer quotes. Of the $11.97 billion of financial assets and liabilities measured at fair value at December 31, 2011, approximately $1.19 billion, or 9.9%, were priced using non-binding broker-dealer quotes.

 

The Company reviews its securities measured at fair value and discusses the proper classification of such investments with investment advisors and others. The Company determined that Level 1 securities would include highly liquid, recent issue U.S. Treasuries and certain of its short-term investments held in highly liquid money market-type funds where it believes that quoted prices are available in an active market. In addition, the Company determined that exchange-traded equity securities would be included in Level 1.

 

Where the Company believes that quoted market prices are not available or that the market is not active, fair values are estimated by using quoted prices of securities with similar characteristics, pricing models or matrix pricing and are generally classified as Level 2 securities. The Company determined that Level 2 securities would include corporate bonds, mortgage backed securities, municipal bonds, asset backed securities, non-U.S. government securities, TALF investments and TALF borrowings, certain equities, certain short-term investments and certain other investments.

 

The Company determined that a Euro-denominated corporate bond which consists of an underlying portfolio of fixed income securities for which there is a low level of transparency around inputs to the valuation process should be classified within Level 3 of the valuation hierarchy along with certain other corporate bonds. In addition, the Company determined that certain other investments would be classified within Level 3 of the valuation hierarchy. The Company reviews the classification of its investments each quarter.

 

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 and reinvested and included the fixed maturities and short-term investments pledged under securities lending agreements, at fair value.

 

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

The following table presents the Company’s financial assets and liabilities measured at fair value by level at March 31, 2012:

 

 

 

 

 

Fair Value Measurement Using:

 

 

 

Estimated
Fair

 

Quoted Prices in
Active Markets
for Identical
Assets

 

Significant
Other
Observable
Inputs

 

Significant
Unobservable
Inputs

 

 

 

Value

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Assets measured at fair value:

 

 

 

 

 

 

 

 

 

Available for sale securities:

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$

2,616,226

 

$

 

$

2,519,571

 

$

96,655

 

Mortgage backed securities

 

1,494,968

 

 

1,494,968

 

 

Municipal bonds

 

1,301,255

 

 

1,301,255

 

 

Commercial mortgage backed securities

 

1,124,667

 

 

1,124,667

 

 

U.S. government and government agencies

 

1,254,434

 

1,254,434

 

 

 

Non-U.S. government securities

 

856,535

 

 

856,535

 

 

Asset backed securities

 

623,873

 

 

623,873

 

 

Total

 

9,271,958

 

1,254,434

 

7,920,869

 

96,655

 

 

 

 

 

 

 

 

 

 

 

Equity securities

 

318,181

 

316,977

 

1,204

 

 

Other investments

 

357,992

 

 

351,777

 

6,215

 

Short-term investments

 

1,112,249

 

976,446

 

135,803

 

 

 

 

 

 

 

 

 

 

 

 

Fair value option:

 

 

 

 

 

 

 

 

 

Investments accounted for using the fair value option:

 

 

 

 

 

 

 

 

 

Corporate bonds

 

195,320

 

 

195,320

 

 

Non-U.S. government bonds

 

55,485