-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RACGY9CFbSRklfZGME6kyOEowOZPBPghdPpSZi5wcg6lVENIi5efuwqPPToHPIlz mPIbjS/X6Y9J6kbqjHac3w== 0000912057-00-024860.txt : 20000516 0000912057-00-024860.hdr.sgml : 20000516 ACCESSION NUMBER: 0000912057-00-024860 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20000331 FILED AS OF DATE: 20000515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ARCH CAPITAL GROUP LTD CENTRAL INDEX KEY: 0000947484 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 061424716 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-26456 FILM NUMBER: 635755 BUSINESS ADDRESS: STREET 1: 20 HORSENECK LANE CITY: GREENWICH STATE: CT ZIP: 06830 BUSINESS PHONE: 2038624300 MAIL ADDRESS: STREET 1: 20 HORSENECK LANE CITY: GREENWICH STATE: CT ZIP: 06830 FORMER COMPANY: FORMER CONFORMED NAME: RISK CAPITAL HOLDINGS INC DATE OF NAME CHANGE: 19950816 FORMER COMPANY: FORMER CONFORMED NAME: RISK CAPITAL RE INC DATE OF NAME CHANGE: 19950703 10-Q 1 FORM 10-Q ================================================================================ 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, 2000 Or [ ] 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) Delaware 06-1424716 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 20 Horseneck Lane Greenwich, Connecticut 06830 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (203) 862-4300 RISK CAPITAL HOLDINGS, INC. -------------------------------------------------------- (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 ______ ------- Indicate the number of shares outstanding of each of the issuer's classes of common stock. CLASS OUTSTANDING AT MARCH 31, 2000 ----- ----------------------------- Common Stock, $.01 par value 12,329,398 ================================================================================ ARCH CAPITAL GROUP LTD. INDEX
PAGE NO. ------------- PART I. FINANCIAL INFORMATION ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS Review Report of Independent Accountants 1 Consolidated Balance Sheet March 31, 2000 and December 31, 1999 2 Consolidated Statement of Income and Comprehensive Income For the three month periods ended March 31, 2000 and 1999 3 Consolidated Statement of Changes in Stockholders' Equity For the three month periods ended March 31, 2000 and 1999 4 Consolidated Statement of Cash Flows For the three month periods ended March 31, 2000 and 1999 5 Notes to Consolidated Financial Statements 6 Unaudited Pro-Forma Condensed Consolidated Financial Data As of March 31, 2000 and for the three month period ended March 31, 2000 and for the year ended December 31, 1999 17 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 24 ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 32 PART II. OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS 33 ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K 33
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Arch Capital Group Ltd. We have reviewed the accompanying interim consolidated balance sheet of Arch Capital Group Ltd. (formerly known as Risk Capital Holdings, Inc.) and its subsidiaries as of March 31, 2000 and the related consolidated statement of income and comprehensive income, changes in stockholders' equity and of cash flows for the three-month period ended March 31, 2000. This financial information is the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, 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 information for it to be in conformity with generally accepted accounting principles. We previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet as of December 31, 1999, and the related consolidated statements of income and comprehensive income, of changes in stockholders' equity, and of cash flows for the year then ended (not presented herein), and in our report dated February 1, 2000, except as to Note 14, which is as of March 2, 2000, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 1999, 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 2, 2000 1 ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS)
(UNAUDITED) MARCH 31, DECEMBER 31, 2000 1999 --------- ---------- ASSETS Investments: Fixed maturities (amortized cost: 2000, $214,608; 1999, $270,345) $ 206,302 $ 261,067 Publicly traded equity securities (cost: 2000, $49,971; 1999, $105,747) 42,887 158,631 Privately held securities (cost: 2000 $59,583; 1999, $85,748) 58,231 83,969 Short-term investments 140,766 72,785 --------- --------- Total investments 448,186 576,452 --------- --------- Cash 11,447 9,457 Accrued investment income 3,737 4,527 Premiums receivable 115,371 119,320 Reinsurance recoverable 77,590 73,122 Deferred policy acquisition costs 22,285 23,585 Investment accounts receivable 36,628 Federal income tax recoverable 8,150 8,758 Deferred income tax asset 10,103 7,834 Other insurance assets 36,281 36,975 Other assets 4,472 4,329 --------- --------- TOTAL ASSETS $ 774,250 $ 864,359 ========= ========= LIABILITIES Claims and claims expenses $ 378,297 $ 364,554 Unearned premiums 103,469 108,743 Reinsurance balances payable 16,043 14,666 Investment accounts payable 398 Federal income tax payable Deferred income tax liability Other insurance liabilities 22,344 24,541 Other liabilities 4,446 5,341 --------- --------- TOTAL LIABILITIES 524,997 517,845 --------- --------- STOCKHOLDERS' EQUITY Preferred stock, $.01 par value: 20,000,000 shares authorized (none issued) Common stock, $.01 par value: 80,000,000 shares authorized (issued: 2000, 17,106,936; 1999, 17,109,736) 171 171 Additional paid-in capital 342,012 342,034 Deferred compensation under stock award plan (224) (317) Retained earnings (deficit) (16,367) (22,175) Less treasury stock, at cost (2000, 4,777,538; 1999, 21,766 shares) (59,597) (387) Accumulated other comprehensive income (loss) consisting of unrealized (depreciation) appreciation of investments, net of income tax (16,742) 27,188 --------- --------- TOTAL STOCKHOLDERS' EQUITY 249,253 346,514 --------- --------- Total Liabilities & Stockholders' Equity $ 774,250 $ 864,359 ========= =========
See Notes to Consolidated Financial Statements. 2 ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME (IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED) THREE MONTHS ENDED MARCH 31, 2000 1999 ------------ ------------ PREMIUMS AND OTHER REVENUES Net premiums written $ 52,889 $ 64,437 (Increase) decrease in unearned premiums 5,273 (1,515) ------------ ------------ Net premiums earned 58,162 62,922 Net investment income 5,290 4,483 Net investment gains (losses) 29,300 (1,152) ------------ ------------ TOTAL REVENUES 92,752 66,253 EXPENSES Claims and claims expenses 53,875 80,732 Commissions and brokerage 16,753 19,538 Other operating expenses 2,568 3,661 Foreign exchange loss 1,159 388 ------------ ------------ TOTAL EXPENSES 74,355 104,319 INCOME (LOSS) BEFORE INCOME TAXES, EQUITY IN NET INCOME (LOSS) OF INVESTEES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE 18,397 (38,066) Federal income taxes: Current 264 (6,000) Deferred 12,355 (7,621) ------------ ------------ Income tax expense (benefit) 12,619 (13,621) ------------ ------------ INCOME (LOSS) BEFORE EQUITY IN NET INCOME (LOSS) OF INVESTEES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE 5,778 (24,445) Equity in net income (loss) of investees 30 (163) ------------ ------------ INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 5,808 (24,608) Cumulative effect of accounting change (383) ------------ ------------ NET INCOME (LOSS) 5,808 (24,991) ------------ ------------ OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX Change in net unrealized depreciation of investments, net of tax (43,930) (10,500) ------------ ------------ COMPREHENSIVE INCOME (LOSS) ($ 38,122) ($ 35,491) ============ ============ AVERAGE SHARES OUTSTANDING Basic 15,517,163 17,086,601 Diluted 15,518,341 17,102,353 PER SHARE DATA Net Income (Loss) - Basic $ 0.37 ($ 1.46) - Diluted $ 0.37 ($ 1.46) Comprehensive Income (Loss) - Basic ($ 2.46) ($ 2.08) - Diluted ($ 2.46) ($ 2.08)
See Notes to Consolidated Financial Statements. 3 ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
UNAUDITED THREE MONTHS ENDED, MARCH 31, 2000 1999 --------- --------- COMMON STOCK Balance at beginning of year $ 171 $ 171 Common stock issued (cancelled) --------- --------- Balance at end of period 171 171 --------- --------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of year 342,034 341,878 Common stock issued (cancelled) (22) --------- --------- Balance at end of period 342,012 341,878 --------- --------- DEFERRED COMPENSATION UNDER STOCK AWARD PLAN Balance at beginning of year (317) (1,062) Restricted common stock (issued) cancelled 22 Compensation expense recognized 71 231 --------- --------- Balance at end of period (224) (831) --------- --------- RETAINED EARNINGS (DEFICIT) Balance at beginning of year (22,175) 10,261 Net income (loss) 5,808 (24,991) --------- --------- Balance at end of period (16,367) (14,730) --------- --------- TREASURY STOCK, AT COST Balance at beginning of year (387) (284) Purchase of treasury stock (59,210) (25) --------- --------- Balance at end of period (59,597) (309) --------- --------- ACCUMULATED OTHER COMPREHENSIVE INCOME CONSISTING OF UNREALIZED (DEPRECIATION) APPRECIATION OF INVESTMENTS, NET OF INCOME TAX Balance at beginning of year 27,188 47,038 Change in unrealized depreciation (43,930) (10,500) --------- --------- Balance at end of period (16,742) 36,538 --------- --------- TOTAL STOCKHOLDERS' EQUITY Balance at beginning of year 346,514 398,002 Issuance of common stock (22) Change in deferred compensation 93 231 Net income (loss) 5,808 (24,991) Purchase of treasury stock (59,210) (25) Change in unrealized depreciation of investments, net of income tax (43,930) (10,500) ========= ========= Balance at end of period $ 249,253 $ 362,717 ========= =========
See Notes to Consolidated Financial Statements. 4 ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS)
UNAUDITED THREE MONTHS ENDED, MARCH 31, 2000 1999 --------- ---------- OPERATING ACTIVITIES Net income (loss) $ 5,808 ($ 24,991) Adjustments to reconcile net income to net cash provided by operating activities: Liability for claims and claims expenses 13,743 65,357 Unearned premiums (5,274) 12,124 Premiums receivable 3,949 (15,212) Accrued investment income 790 (779) Reinsurance recoverable (6,645) (14,594) Reinsurance balances payable 1,377 13,716 Deferred policy acquisition costs 1,300 (1,836) Net investment (gains)/losses (29,300) 1,152 Deferred income tax asset 12,371 (7,728) Other liabilities (3,092) (6,612) Other items, net 2,279 (6,543) --------- --------- NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES (2,694) 14,054 --------- --------- INVESTING ACTIVITIES Purchases of fixed maturity investments (83,092) (63,727) Sales of fixed maturity investments 136,903 52,165 Net (purchases)/sales of short-term investments (66,982) (2,711) Purchases of equity securities (12,119) (16,321) Sales of equity securities 89,178 8,714 (Purchases) disposal of furniture and equipment 6 (161) --------- --------- NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 63,894 (22,041) --------- --------- FINANCING ACTIVITIES Common stock issued (22) Purchase of treasury stock (59,210) (25) Deferred compensation on restricted stock 22 --------- --------- NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES (59,210) (25) --------- --------- Increase (decrease) in cash 1,990 (8,012) Cash beginning of year 9,457 12,037 --------- --------- Cash end of period $ 11,447 $ 4,025 ========= =========
See Notes to Consolidated Financial Statements. 5 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Arch Capital Group Ltd. (the "Company"), formerly known as Risk Capital Holdings, Inc., is a holding company that was incorporated in March 1995 under the laws of the State of Delaware and commenced operations in September 1995 upon completion of an initial public offering. In September 1995, through its initial public offering, related exercise of the underwriters' over-allotment option and direct sales of 16,750,625 shares of the Company's common stock, par value $.01 per share (the "Common Stock"), at $20 per share, and the issuance of warrants, the Company was capitalized with net proceeds of approximately $335.0 million, of which $328.0 million was contributed to the statutory capital of Risk Capital Reinsurance Company (which name is being changed to Arch Reinsurance Company and is referred to herein as "Arch Re"). In July 1998, Arch Re capitalized its wholly owned subsidiary, Cross River Insurance Company ("Cross River"), with $20 million. Cross River received its Nebraska license in October 1998, and is currently authorized to write insurance on an excess and surplus lines basis in 22 other states. Class A warrants to purchase an aggregate of 2,531,079 shares of Common Stock and Class B warrants to purchase an aggregate of 1,920,601 shares of Common Stock were issued in connection with the direct sales of Common Stock in the Company's initial public offering. Class A warrants are immediately exercisable at $20 per share and expire September 19, 2002. Class B warrants are exercisable at $20 per share during the seven year period commencing September 19, 1998, provided that the Common Stock has traded at or above $30 per share for 20 out of 30 consecutive trading days. To date, the Class B warrants have not become exercisable. 2. GENERAL The accompanying interim consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP") and in the opinion of management, reflect all adjustments necessary (consisting of normal recurring accruals) for a fair presentation of results for such periods. These consolidated financial statements should be read in conjunction with the 1999 consolidated financial statements and related notes contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1999. 3. COMPREHENSIVE INCOME In presenting its financial statements, the Company has adopted the reporting of comprehensive income in a one financial statement approach, consistent with Statement of Financial Accounting Standards No. 130 of the Financial Accounting Standards Board ("FASB"). Comprehensive income is comprised of net income and other comprehensive income, which for the Company consists of the change in net unrealized appreciation or depreciation of investments, net of income tax, as follows: 6 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. COMPREHENSIVE INCOME (CONT'D)
(IN THOUSANDS) THREE MONTHS ENDED MARCH 31, 2000 1999 -------- --------- Net income (loss) $ 5,808 ($24,991) Other comprehensive income, net of tax: Unrealized appreciation (depreciation) of investments: Unrealized holdings gains (losses) arising during period (1) (24,885) (11,249) Less, reclassification adjustment for net realized (gains) losses included in net income (19,045) 749 -------- -------- Other comprehensive income (loss) (43,930) (10,500) ======== ======== Comprehensive income (loss) ($38,122) ($35,491) ======== ========
(1) Includes deferred tax valuation allowance of $5.8 million at March 31, 2000. See Note 6. 4. EARNINGS PER SHARE DATA Earnings per share are computed in accordance with FASB Statement No. 128 "Earnings Per Share." Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of shares of Common Stock outstanding for the periods. Diluted earnings per share reflect the potential dilution that could occur if Class A and B warrants and employee stock options were exercised or converted into Common Stock. Diluted per share amounts are computed using basic average shares outstanding when a loss occurs since the inclusion of dilutive securities in dilutive earnings per share would be anti-dilutive. The following table sets forth the computation of basic and diluted earnings per share:
(IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED MARCH 31, 2000 1999 ------------ ------------ NET INCOME BASIC EARNINGS PER SHARE: Net income (loss) $ 5,808 ($ 24,991) Divided by: Weighted average shares outstanding for the period 15,517,163 17,086,601 Basic earnings (loss) per share $ 0.37 ($ 1.46) DILUTED EARNINGS PER SHARE: Net income (loss) $ 5,808 ($ 24,991) Divided by: Weighted average shares outstanding for the period 15,517,163 17,086,601 Effect of dilutive securities: Warrants Employee stock options 1,178 15,752 ------------ ------------ Total shares 15,518,341 17,102,353 ============ ============ Diluted earnings (loss) per share $ 0.37 ($ 1.46)
7 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. EARNINGS PER SHARE DATA (CONT'D)
(IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED MARCH 31, 2000 1999 ----------- ----------- COMPREHENSIVE INCOME BASIC EARNINGS PER SHARE: Comprehensive income (loss) ($ 38,122) ($ 35,491) Divided by: Weighted average shares outstanding for the period 15,517,163 17,086,601 Basic earnings (loss) per share ($ 2.46) ($ 2.08) DILUTED EARNINGS PER SHARE: Comprehensive income (loss) ($ 38,122) ($ 35,491) Divided by: Weighted average shares outstanding for the period 15,517,163 17,086,601 Effect of dilutive securities: Warrants Employee stock options 1,178 15,752 ------------ ------------ Total shares 15,518,341 17,102,353 ============ ============ Diluted earnings (loss) per share ($ 2.46) ($ 2.08)
5. INVESTMENT INFORMATION The Company classifies all of its publicly traded fixed maturity and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturity securities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. Short-term investments, which have a maturity of one year or less at the date of acquisition, are carried at cost, which approximates fair value. All of the Company's publicly traded equity securities and privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance industry. At March 31, 2000, the publicly traded equity portfolio consisted of the following: 8 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. INVESTMENT INFORMATION (CONT'D)
MARCH 31, 2000 ------------------------------ ESTIMATED FAIR VALUE AND NET CARRYING UNREALIZED VALUE GAINS (LOSSES) COST ------- ------ ------- COMMON STOCK: ACE Limited $ 7,398 ($ 744) $ 8,142 XL Capital Ltd. 14,397 5,522 8,875 E.W. Blanch Holdings, Inc. 7,140 (181) 7,321 Farm Family Holdings, Inc. 1,844 (98) 1,942 IPC Holdings, Ltd. 6,444 (8,549) 14,993 Limit PLC 1,450 (1,361) 2,811 Meadowbrook Insurance Group 915 (2,167) 3,082 Renaissance Re 2,044 334 1,710 PREFERRED STOCK: St. Paul Companies, 6% Convertible Preferred 1,255 160 1,095 OTHER Markel Corp (62,239 Contingent Value Rights) -- -- -- ------- ------- ------- Total $42,887 ($7,084) $49,971 ======= ======= =======
Investments in privately held securities, issued by privately and publicly held companies, may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities). Privately held securities are subject to trading restrictions or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in the Company's inability to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security which the Company seeks to sell. Such investments are classified as "available for sale" and carried at estimated fair value, except for investments in which the Company believes it has the ability to exercise significant influence (generally defined as investments in which the Company owns 20% or more of the outstanding voting common stock of the issuer), which are carried under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss for such investments in results of operations. 9 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. INVESTMENT INFORMATION (CONT'D) Goodwill for privately held equity securities carried under the equity method of accounting was $8.3 million at March 31, 2000, compared to $8.9 million at December 31, 1999. The estimated fair value of investments in privately held securities, other than those carried under the equity method or those with quoted market values, is initially equal to the cost of such investments until the investments are revalued based principally on substantive events or other factors which could indicate a diminution or appreciation in value, such as an arm's-length third party transaction justifying an increased valuation or adverse development of a significant nature requiring a write-down. The Company periodically reviews the valuation of investments in privately held securities with Marsh & McLennan Capital, Inc., its equity investment advisor, with respect to certain of the Company's privately held securities. Privately held securities consisted of the following:
(IN THOUSANDS) MARCH 31, DECEMBER 31, 2000 1999 ------- ------- CARRIED UNDER THE EQUITY METHOD: The ARC Group, LLC $ 7,858 $ 8,687 Arx Holding Corp. 2,680 2,654 Island Heritage Insurance Company, Ltd. 4,123 4,356 LARC Holdings, Ltd. -- 24,039 New Europe Insurance Ventures 770 819 Sunshine State Holding Corporation 1,854 1,885 ------- ------- Sub-total 17,285 42,440 ------- ------- CARRIED AT FAIR VALUE: Altus Holdings, Ltd. 16,000 19,173 American Independent Insurance Holding Company 7,350 4,250 GuideStar Health Systems, Inc. 500 500 Sorrento Holdings, Inc. 908 1,517 Stockton Holdings Limited 10,000 10,000 Trident II, L.P. 6,188 6,089 ------- ------- Sub-total 40,946 41,529 ------- ------- Total $58,231 $83,969 ======= =======
10 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. INVESTMENT INFORMATION (CONT'D) During the 2000 first quarter, the Company received a distribution from The ARC Group, LLC totaling $1,080,000. The Company also received $618,000 from Sorrento Holdings, Inc. ("Sorrento") for the redemption of 609 shares of preferred stock of Sorrento, which redemption amount included a payment of $1,000 per share and interest income at 6%. At March 31, 2000, the Company had investment commitments relating to its privately held securities totaling approximately $23.1 million. The outstanding commitments at March 31, 2000 included $18.9 million committed to Trident II, L.P., an investment fund formed in 1999 dedicated to making private equity and equity related investments in the global insurance, reinsurance and related industries. Set forth below is certain information relating to the Company's private investment activity for the 2000 first quarter: ALTUS HOLDINGS, LTD. In March 2000, the Company reduced the carrying value of Altus Holdings, Ltd. by $3.2 million, realizing an after-tax loss of $2.1 million. AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY On March 6, 2000, the Company provided an additional loan in an aggregate principal amount of $3.5 million to American Independent Insurance Holding Company ("AIHC"). The loan is secured by a second priority pledge of the capital stock of AIHC and assets of AIHC, and matures on September 6, 2001 (which date may be extended to March 6, 2002 upon the occurrence of certain events). The net proceeds of the loan were contributed to the surplus of AIHC's subsidiary, American Independent Insurance Company. In connection with the loan, the Company was issued warrants (in addition to the warrants issued to the Company in connection with a prior loan to AIHC) granting the Company the right to acquire equity in AIHC. As of March 31, 2000, based on a comparison of the AIHC notes to bonds with similar characteristics, the Company recorded a $1.1 million pre-tax unrealized loss to adjust the aggregate carrying value of the aggregate of $8.5 million in loans made to AIHC ($5 million in February 1999 and $3.5 million in March 2000). LARC HOLDINGS, LTD. As of March 2, 2000, the Company transferred to XL Capital Ltd. the Company's interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company), valued at $25 million, in connection with the Company's repurchase from XL Capital of the Common Stock it previously held. See Note 8. 6. INCOME TAXES The Company, Arch Re and Cross River file a consolidated federal income tax return and have a tax sharing agreement (the "Tax Sharing Agreement"), allocating the consolidated income tax liability on a separate return basis. Pursuant to the Tax Sharing Agreement, Arch Re and Cross River make tax sharing payments to the Company based on such allocation. 11 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. INCOME TAXES (CONT'D) The provision for federal income taxes has been determined on the basis of a consolidated tax return consisting of the Company, Arch Re and Cross River. An analysis of the Company's effective tax rate for the three months ended March 31, 2000 and 1999 follows:
(IN THOUSANDS) THREE MONTHS ENDED MARCH 31, 2000 1999 -------- --------- Income taxes (benefit) computed on pre-tax income (loss) $ 6,439 ($13,323) Addition (reduction) in income taxes resulting from: Valuation allowance 6,285 Tax-exempt investment income (162) (165) Dividend received deduction (127) (237) Other 184 104 -------- -------- Income tax expense (benefit) on pre-tax income (loss) $ 12,619 ($13,621) ======== ========
The Company's current federal tax expense (benefit) for the three months ended March 31, 2000 and 1999 was based on regular taxable income. The net deferred income tax asset reflects temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes, net of a valuation allowance for any portion of the deferred tax asset that management believes will not be realized. Significant components of the Company's deferred income tax assets and liabilities as of March 31, 2000 and December 31, 1999 were as follows:
(IN THOUSANDS) MARCH 31, DECEMBER 31, 2000 1999 -------- -------- Deferred income tax assets: Net claim reserve discount $ 15,628 $ 15,639 Net operating loss -- 7,334 Net unearned premium reserve 6,171 6,573 Net unrealized depreciation of investments 5,859 -- Loss on investees, net 2,040 7 Compensation liabilities 223 372 Other, net 126 165 -------- -------- Total deferred tax assets 30,047 30,090 -------- -------- Deferred income tax liabilities: Deferred policy acquisition cost (7,800) (8,255) Net unrealized appreciation of investments (14,001) -------- -------- Total deferred tax liabilities (7,800) (22,256) -------- -------- Valuation allowance (12,144) -- -------- -------- Net deferred income tax asset $ 10,103 $ 7,834 ======== ========
During the 2000 first quarter, the Company recorded a deferred tax asset valuation allowance of $12.1 million, of which $6.3 million is included in income tax expense reflected in net income and $5.8 million is included in the change in net unrealized depreciation of investments contained in other comprehensive loss. A valuation allowance has been established due to the future uncertainty of realizing a portion of deferred tax assets at March 31, 2000. 12 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. INCOME TAXES (CONT'D) The repurchase of Common Stock held by XL Capital resulted in a 27.8% change in ownership by 5% stockholders. If, in the ensuing three years, there is more than a 22.2% additional change in ownership by 5% stockholders, an "ownership change" will have taken place for federal income tax purposes. If such ownership change occurs, the amount of loss carryforwards that can be used in any subsequent year may be severely limited and could be eliminated in certain circumstances. 7. ACCOUNTING PRONOUNCEMENTS START-UP COSTS Effective January 1, 1999, the Company changed its method of accounting for start-up costs in accordance with the Accounting Standards Executive Committee's Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." The change in accounting principle resulted in the write-off of the start-up costs capitalized as of January 1, 1999 for the Company and its investee companies carried under the equity method of accounting. The cumulative effect of the write-off, which totals $383,000, after-tax, or $0.02 per share, has been expensed and is included in the 1999 first quarter net loss. The effect of the change on the net loss in the first quarter of 1999 was not material. MARKET RISK SENSITIVE INSTRUMENTS The Securities and Exchange Commission ("SEC") issued Financial Reporting Release ("FRR") No. 48 which included amended rules requiring domestic and foreign issuers to clarify and expand existing disclosure for derivative financial instruments, other financial instruments and derivative commodity instruments (collectively, "market risk sensitive instruments"). The amendments require enhanced disclosure of accounting policies for derivative financial instruments and derivative commodity instruments (collectively, "derivatives"). In addition, the amendments expand existing disclosure requirements to include quantitative and qualitative information about market risk inherent in market risk sensitive instruments, which disclosure will be subject to safe harbor protection under the new SEC rule (see "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Form 10-Q). These amendments are designed to provide additional information about market risk sensitive instruments which investors can use to better understand and evaluate market risk exposures of registrants, including the Company. There have been no material changes in market risk exposures that affect the quantitative and qualitative disclosures presented as of the year ended December 31, 1999. 13 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. XL TRANSACTION On March 2, 2000, the Company repurchased from XL Capital, then the Company's single largest stockholder, all of the 4,755,000 shares of Common Stock held by it for a purchase price of $12.45 per share of Common Stock, or a total of $59.2 million. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of Common Stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. The Company paid XL Capital the consideration for the repurchase with (i) the Company's interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million, and (ii) all of the Company's interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate. XL Capital paid the Company in cash the difference (equal to $3.6 million) between the repurchase price and the value of the Company's interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of the Company's shares. The value of the warrants was determined using a Black Scholes methodology. The cost of the stock repurchase of $59.2 million was recorded as a reduction to stockholders' equity reflected as treasury stock. Arch Re's statutory surplus was reduced by $62.8 million due to the distribution to the Company of the stock and warrants in both LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd. based on statutory carrying values. 9. FOLKSAMERICA TRANSACTION On May 5, 2000 the Company sold the reinsurance operations of Arch Re pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica"). Folksamerica Reinsurance Company assumed Arch Re's liabilities under the reinsurance agreements transferred in the asset sale and Arch Re transferred to Folksamerica Reinsurance Company assets in an aggregate amount equal, in book value (as set forth on the Company's estimated closing date balance sheet), to the book value (as set forth on the Company's estimated closing date balance sheet) of the liabilities assumed. In consideration for the transfer of Arch Re's book of business, Folksamerica paid $20.084 million (net of a credit equal to $251,000 for certain tax costs) in cash at the closing, subject to possible post closing adjustments based on an independent actuarial report of the claim liabilities transferred and independent audit of the net assets sold. The actuarial report and audit and related adjustments, which could be material, could be completed as early as the second quarter of 2000, subject to a dispute resolution mechanism (if necessary). Under the terms of the agreement, $20 million has been placed in escrow for a period of five years. These funds will be primarily used to reimburse Folksamerica to the extent that the loss reserves (which were $35.1 million at March 31, 2000) relating to business produced on behalf of Arch Re by a certain managing underwriting agency are deficient as measured at the end of such five year period. To the extent that such loss reserves are redundant, all of the escrowed funds will be returned to the Company and Folksamerica will pay the Company an amount equal to such redundancy. An additional amount of up to $5 million may be placed in escrow for a period of five years to the extent that Arch Re's reserves at closing are less by at least a specified amount than those estimated by its independent actuaries. In connection with either escrow arrangement, the Company will record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five year period. 14 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. FOLKSAMERICA TRANSACTION (CONT'D) Under the terms of the agreement, the Company has also purchased reinsurance protection covering the Company's aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed $5.4 million, the Company has agreed to reimburse Folksamerica for a net financial loss it may incur that is in excess of $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. The GAAP book value of the assets and liabilities transferred to Folksamerica recorded in the accompanying financial statements at March 31, 2000 are as follows:
(IN MILLIONS) Fixed maturities and short-term investments $ 254.5 Premiums receivable 115.4 Reinsurance recoverable 77.6 Deferred policy acquisition costs 22.3 Deferred income tax asset 14.0 Other insurance assets 36.3 -------- Total Assets $ 520.1 -------- Reserve for claims and claims expenses $ 378.3 Net unearned premium reserve 103.5 Reinsurance premiums payable 16.0 Other insurance liabilities 22.3 -------- Total Liabilities $ 520.1 -------- Net book value of assets and liabilities to be transferred -- ========
The actual GAAP book value of the assets and liabilities transferred to Folksamerica was updated for estimated underwriting results and estimated cash flow activity through May 5, 2000 and was not materially different from the amounts set forth above at March 31, 2000. At the closing of the asset sale, Arch Re and Folksamerica entered into a transfer and assumption agreement, under which Folksamerica assumed Arch Re's rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements that are in-force will be notified that Folksamerica has assumed Arch Re's obligations and, unless the reinsureds object to the assumption, Arch Re will be released from its obligations to those reinsureds. Assuming that none of the reinsureds object to the assumption, the gross liabilities for such business will be removed from the accounts of Arch Re for statutory and GAAP accounting purposes. Arch Re will continue to record gross liabilities in its accounts for reinsureds that object to the release of Arch Re from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica would be recorded as an asset equal to such gross liabilities. This would also result in a portion of any pre-tax gain on the asset sale being deferred and amortized into income as gross liabilities are extinguished. 15 ARCH CAPITAL GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. ARCH RE DISTRIBUTION Upon payment of a contemplated distribution from Arch Re to the Company that is currently anticipated to occur in the second quarter, the Company's assets would consist of fixed maturity and short term investments (including amounts placed in escrow for five years as described above), publicly traded equity securities and privately held securities. The Company will also continue to own all of the outstanding capital stock of Arch Re and Cross River, each with statutory surplus of up to approximately $20 million (or any greater amount the Nebraska Insurance Department requires Arch Re to retain in the event there are any objections from reinsureds to the release of Arch Re from further liability under the reinsurance agreements transferred pursuant to the transfer and assumption agreement). The Company's remaining $18.9 million investment commitment to Trident II, L.P. would also remain in place. 16 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA The following unaudited pro forma balance sheet as of March 31, 2000 reflects our historical accounts as of that date, adjusted to give pro forma effect to the sale of our reinsurance business to Folksamerica Reinsurance Company ("Folksamerica"), which closed on May 5, 2000, as if the transaction had occurred on March 31, 2000. The following unaudited pro forma statement of income and comprehensive income for the quarter ended March 31, 2000 and for the year ended December 31, 1999 reflects our historical accounts for that period, adjusted to give pro forma effect to the asset sale as if the transactions had occurred on January 1, 1999. The pro forma financial data and accompanying notes should be read in conjunction with the description of the asset sale contained in this report and the unaudited consolidated financial statements and related notes for the quarter ended March 31, 2000 also included in this report as well as our audited consolidated financial statements and related notes and the description of the asset sale included in our special meeting proxy statement. We believe that the assumptions used in the following statements, which are set forth in the accompanying notes, provide a reasonable basis on which to present the pro forma financial data. The pro forma financial data is provided for informational purposes only and should not be construed to be indicative of our financial condition or results of operations had the asset sale been consummated on the dates assumed and are not intended to project our financial condition on any future date or results of operations for any future period. 17 ARCH CAPITAL GROUP LTD. PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET MARCH 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
FOLKSAMERICA HISTORICAL TRANSACTION(1) PRO FORMA ---------- -------------- ---------- ASSETS Investments: Fixed maturities and short-term investments $347,068 ($252,972)(2) $94,096(7) Publicly traded equity securities 42,887 42,887 Privately held securities 58,231 58,231 ---------- --------- -------- Total investments 448,186 (252,972) 195,214 Cash 11,447 (1,616)(5) 9,831 Accrued investment income 3,737 (1,779)(2) 1,958 Investment accounts receivable 36,628 36,628 Premiums receivable 115,371 (115,371)(2) - Reinsurance recoverable 77,590 (77,590)(2) - Deferred policy acquisition costs 22,285 (22,285)(3) - Deferred income tax asset 10,103 (5,235)(4) 4,868 Other assets 48,903 (36,281)(2) 12,622 ---------- --------- -------- TOTAL ASSETS $774,250 ($513,129) $261,121 ---------- --------- -------- ---------- --------- -------- LIABILITIES Claims and claims expenses $378,297 ($378,297)(2) - Unearned premiums 103,469 (103,469)(2) - Reinsurance balances payable 16,043 (16,043)(2) - Other liabilities 27,188 (22,344)(2) $4,844 ---------- --------- -------- TOTAL LIABILITIES 524,997 (520,153) 4,844 ---------- --------- -------- STOCKHOLDERS' EQUITY Common stock, $.01 par value: 171 171 Additional paid-in capital 342,012 342,012 Deferred compensation under stock award plan (224) (224) Retained earnings (deficit) (16,367) 3,167(6) (13,200) Less treasury stock, at cost (59,597) (59,597) Accumulated other comprehensive income (loss) consisting of unrealized depreciation of investments, net of income tax (16,742) 3,857(6) (12,885) ---------- --------- -------- TOTAL STOCKHOLDERS' EQUITY 249,253 7,024(6) 256,277 ---------- --------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $774,250 ($513,129) $261,121 ---------- --------- -------- ---------- --------- -------- SHARES OUTSTANDING - BASIC 12,329,398 12,329,398 BASIC BOOK VALUE PER SHARE $20.22 $20.79
18 NOTES TO PRO FORMA BALANCE SHEET 1. Reflects the asset sale, pursuant to which Folksamerica Reinsurance Company has assumed Arch Re's liabilities under the reinsurance agreements transferred to it and Arch Re transferred to Folksamerica Reinsurance Company assets in an aggregate amount equal, in GAAP book value (as set forth on our estimated closing date balance sheet), to the GAAP book value (as set forth on our estimated closing date balance sheet) of the liabilities assumed. In consideration for the transfer of Arch Re's book of business, Folksamerica paid $20.084 million (net of a credit equal to $251,000 for certain tax costs) in cash at the closing, subject to possible post closing adjustments based on an independent actuarial report of the claim liabilities transferred and an independent audit of the net assets sold. The report and audit and related adjustments, which could be material, could be completed as early as the second quarter of 2000, subject to a dispute resolution mechanism (if necessary). 2. Represents securities and insurance assets and insurance liabilities transferred to Folksamerica based on March 31, 2000 financial statement amounts. The actual GAAP book value of the assets and liabilities transferred to Folksamerica was updated for estimated underwriting results and estimated cash flow activity through May 5, 2000 and was not materially different from the amounts set forth herein at March 31, 2000. At the closing of the asset sale, Arch Re and Folksamerica Reinsurance Company entered into a transfer and assumption agreement, under which Folksamerica Reinsurance Company assumed Arch Re's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following the closing of the asset sale, Folksamerica Reinsurance Company will notify the reinsureds under such agreements that are in-force that it has assumed Arch Re's obligations and, unless the reinsureds object to such assumption, Arch Re will be released from its obligations to those reinsureds. The pro forma accounting for this transaction assumes that none of Arch Re's reinsureds will object to such assumption and, accordingly, the gross liabilities for its reinsurance business will be removed from the accounts of Arch Re for statutory and GAAP accounting purposes. Arch Re will continue to record gross liabilities in its accounts for reinsureds that object to the release of Arch Re from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica Reinsurance Company would be recorded as an asset equal to such gross liabilities. 3. Elimination of deferred policy acquisition costs related to the liability for unearned premiums transferred to Folksamerica. 4. Net reduction in deferred income tax asset as follows (in thousands): Reduction in net deferred tax asset for elimination of temporary differences between financial statements and income tax return amounts resulting from the Folksamerica transaction $13,875 Less, estimated tax benefit resulting from the transaction (8,640) ------- Net reduction in deferred tax asset $ 5,235 ------- -------
The net reduction in deferred tax asset includes a valuation allowance of approximately $1 million. 5. Represents cash payment received from Folksamerica at the closing of the asset sale of $20.084 million less estimated related transaction costs of $21.7 million, which include investment banking, legal and accounting fees, severance costs, and costs for the purchase of additional insurance and reinsurance protection in connection with the transaction, as well as certain write-offs of furniture, equipment and leasehold improvements and lease obligations. 19 6. The pro forma book value gain resulting from the Folksamerica transaction based on financial statement amounts at March 31, 2000 is calculated as follows (in thousands): Consideration received, consisting of the following: Total liabilities transferred $520,153 Cash premium received 20,084 -------- 540,237 -------- Assets transferred 483,993 Amortization of deferred policy acquisition costs 22,285 Transaction costs 21,700 -------- 527,978 -------- Pre-tax gain 12,259 Tax expense 5,235 -------- Net transaction gain 7,024 Realized loss, net of tax for securities transferred at market value (3,857) -------- Net income 3,167 Change in net unrealized depreciation of investments, net of tax 3,857 -------- Comprehensive income and net book gain $7,024 -------- --------
The pro forma accounting for this transaction assumes that none of Arch Re's reinsureds will object to the release of Arch Re under the transfer and assumption agreement and, accordingly, the gross liabilities for such business are removed from the accounts of Arch Re for statutory and GAAP accounting purposes (see note 2 above). Arch Re will continue to record gross liabilities in its accounts for reinsureds that object to the release of Arch Re from its obligations to such reinsureds. This would result in a portion of the pre-tax gain on the transaction being deferred and amortized into income as the gross liabilities are extinguished. 7. Includes $20 million of fixed income securities deposited in an escrow account for a five year period primarily to reimburse Folksamerica for claims and claim expenses exceeding reserves recorded by Arch Re as of the closing date resulting from business produced on behalf of Arch Re by a certain managing underwriting agency. At March 31, 2000, such reserves approximated $35.1 million, which were recorded based on Arch Re's best estimate for such business based on its actuarial practices. The Company could record a loss at any time during the five year period to the extent that such reserves are deficient. Amounts in escrow may also be released to Folksamerica to satisfy its indemnification claims against the Company relating to undisclosed liabilities, Arch Re's reinsurance agreements and the managing underwriting agency referred to above. Under the asset purchase agreement, the Company may be required to deposit an additional amount of up to $5 million into a supplemental escrow account based on an actuarial report to be completed shortly after the closing of the asset sale. The above unaudited pro forma condensed consolidated balance sheet has been prepared assuming that such supplemental escrow account will not be required. 20 ARCH CAPITAL GROUP LTD. PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED MARCH 31, 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
FOLKSAMERICA HISTORICAL TRANSACTION(1) PRO FORMA ---------------- -------------------- ----------------- REVENUES Net premiums written $52,889 ($52,889) - (Increase) decrease in unearned premiums 5,273 (5,273) - ---------------- -------------------- ----------------- Net premiums earned 58,162 (58,162) - Net investment income 5,290 (3,515) $1,775 Net realized investment gains (losses) 29,300 1,748 31,048 ---------------- -------------------- ----------------- Total revenues 92,752 (59,929) 32,823 OPERATING COSTS AND EXPENSES Claims and claims expenses 53,875 (53,875) Commissions and brokerage 16,753 (16,753) Other operating expenses 2,568 (868) 1,700 Foreign exchange (gain) loss 1,159 (1,159) ---------------- -------------------- ----------------- Total operating costs and expenses 74,355 (72,655) 1,700 INCOME (LOSS) Income (loss) before income taxes and equity in net income of investees 18,397 12,726 31,123 Federal income taxes expense (benefit) 12,619 (1,160) 11,459 ---------------- -------------------- ----------------- Income (loss) before equity in net income of investees 5,778 13,886 19,664 Equity in net income of investees 30 30 ---------------- -------------------- ----------------- Net income (loss) 5,808 13,886 19,694 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX Change in net unrealized depreciation of investments, net of tax (43,930) (708) (44,638) ---------------- -------------------- ----------------- COMPREHENSIVE INCOME (LOSS) ($38,122) $13,178 ($24,944) ---------------- -------------------- ----------------- ---------------- -------------------- ----------------- AVERAGE SHARES OUTSTANDING Basic 15,517,163 15,517,163 Diluted 15,518,341 15,518,341 PER SHARE DATA Net Income (Loss) - Basic $0.37 $1.23 - Diluted $0.37 $1.23 Comprehensive Income (Loss) - Basic $2.46 ($1.61) - Diluted $2.46 ($1.61)
21 ARCH CAPITAL GROUP LTD. PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME FOR THE YEAR ENDED DECEMBER 31, 1999 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
FOLKSAMERICA HISTORICAL TRANSACTION(1) PRO FORMA ---------------- -------------------- ----------------- REVENUES Net premiums written $306,726 ($306,726) - (Increase) decrease in unearned premiums 4,642 (4,642) - ---------------- -------------------- ----------------- Net premiums earned 311,368 (311,368) - Net investment income 20,173 (10,253) $9,920 Net realized investment gains (losses) 17,227 1,192 18,419 ---------------- -------------------- ----------------- Total revenues 348,768 (320,429) 28,339 OPERATING COSTS AND EXPENSES Claims and claims expenses 305,841 (305,841) Commissions and brokerage 80,540 (80,540) Other operating expenses 14,816 (10,666) 4,150 Foreign exchange (gain) loss (198) 198 ---------------- -------------------- ----------------- Total operating costs and expenses 400,999 (396,849) 4,150 INCOME (LOSS) Income (loss) before income taxes, equity in net income of investees and cumulative effect of accounting change (52,231) 76,420 24,189 Federal income taxes expense (benefit) (19,557) 27,171 7,614 ---------------- -------------------- ----------------- Income (loss) before equity in net income of investees and cumulative effect of accounting change (32,674) 49,249 16,575 Equity in net income of investees 621 621 ---------------- -------------------- ----------------- Income (loss) before cumulative effect of accounting change (32,053) 49,249 17,196 Cumulative effect of accounting change (383) (383) ---------------- -------------------- ----------------- Net income (loss) (32,436) 49,249 16,813 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX Change in net unrealized depreciation of investments, net of tax (19,850) 4,553 (15,297) ---------------- -------------------- ----------------- COMPREHENSIVE INCOME (LOSS) ($52,286) $53,802 $1,516 ---------------- -------------------- ----------------- ---------------- -------------------- ----------------- AVERAGE SHARES OUTSTANDING Basic 17,086,732 17,086,732 Diluted 17,086,808 17,086,806 PER SHARE DATA Net Income (Loss) - Basic ($1.90) $0.98 - Diluted ($1.90) $0.98 Comprehensive Income (Loss) - Basic ($3.06) $0.09 - Diluted ($3.06) $0.09
22 NOTES TO PRO FORMA STATEMENT OF INCOME AND COMPREHENSIVE INCOME 1. Represents all revenue and expense and other comprehensive income items recorded during the quarter ended March 31, 2000 and the year ended December 31, 1999 related to our reinsurance business sold to Folksamerica Reinsurance Company. Net investment income, net realized investment gains (losses) and unrealized appreciation (depreciation) of investments have been allocated based on the proportion of the average amount of fixed maturities and short term investments related to the business transferred to the average total fixed maturities and short term investments in the quarter ended March 31, 2000 and the year ended December 31, 1999. All other revenue and expense items were allocated based on specific identification. 23 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL THE COMPANY Arch Capital Group Ltd. (formerly known as Risk Capital Holdings, Inc.) is a holding company that was incorporated in March 1995 and commenced operations in September 1995 upon completion of our initial public offering. We received aggregate net proceeds from the offering of approximately $335 million, of which $328 million was contributed to the capital of our wholly owned subsidiary Risk Capital Reinsurance Company (which name is being changed to Arch Reinsurance Company and is referred to herein as "Arch Re"). On November 6, 1995, Arch Re was licensed under the insurance laws of the State of Nebraska and is currently licensed or accredited as a reinsurer in 44 states. As of March 31, 2000, the statutory surplus of Arch Re was approximately $191.5 million. In July 1998, Arch Re capitalized its wholly owned subsidiary, Cross River Insurance Company ("Cross River"), with $20 million. Cross River received its Nebraska insurance license in October 1998, and is currently authorized to write insurance on an excess and surplus lines basis in 22 other states. FOLKSAMERICA TRANSACTION On May 5, 2000, we sold the reinsurance operations of Arch Re pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica"). Folksamerica Reinsurance Company assumed Arch Re's liabilities under the reinsurance agreements transferred in the asset sale and Arch Re transferred to Folksamerica Reinsurance Company assets in an aggregate amount equal, in book value (as set forth on our estimated closing date balance sheet), to the book value (as set forth on our estimated closing date balance sheet) of the liabilities assumed. In consideration for the transfer of Arch Re's book of business, Folksamerica paid $20.084 million (net of a credit equal to $251,000 for certain tax costs) in cash at the closing, subject to possible post closing adjustments based on an independent actuarial report of the claim liabilities transferred and independent audit of the net assets sold. The actuarial report and audit and related adjustments, which could be material, could be completed as early as the second quarter of 2000, subject to a dispute resolution mechanism (if necessary). Under the terms of the agreement, $20 million has been placed in escrow for a period of five years. These funds will be primarily used to reimburse Folksamerica to the extent that the loss reserves (which were $35.1 million at March 31, 2000) relating to business produced on behalf of Arch Re by a certain managing underwriting agency are deficient as measured at the end of such five year period. To the extent that such loss reserves are redundant, all of the escrowed funds will be returned to us and Folksamerica will pay us an amount equal to such redundancy. An additional amount of up to $5 million may be placed in escrow for a period of five years to the extent that Arch Re's reserves at closing are less by at least a specified amount than those estimated by its independent actuaries. In connection with either escrow arrangement, we will record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five year period. Under the terms of the agreement, we have also purchased reinsurance protection covering our aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although we believe that any such net financial loss will not exceed $5.4 million, we have agreed to reimburse Folksamerica for a net financial loss it may incur that is in excess of $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. 24 The GAAP book value of the assets and liabilities transferred to Folksamerica recorded in the accompanying financial statements at March 31, 2000 are as follows:
(IN MILLIONS) Fixed maturities and short-term investments $254.5 Premiums receivable 115.4 Reinsurance recoverable 77.6 Deferred policy acquisition costs 22.3 Deferred income tax asset 14.0 Other insurance assets 36.3 ------ Total Assets $520.1 ------ Reserve for claims and claims expenses $378.3 Net unearned premium reserve 103.5 Reinsurance premiums payable 16.0 Other insurance liabilities 22.3 ------ Total Liabilities $520.1 ------ Net book value of assets and liabilities to be transferred -- ------ ------
The actual GAAP book value of the assets and liabilities transferred to Folksamerica was updated for estimated underwriting results and estimated cash flow activity through May 5, 2000 and was not materially different from the amounts set forth above at March 31, 2000. At the closing of the asset sale, Arch Re and Folksamerica entered into a transfer and assumption agreement, under which Folksamerica assumed Arch Re's rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements that are in-force will be notified that Folksamerica has assumed Arch Re's obligations and, unless the reinsureds object to the assumption, Arch Re will be released from its obligations to those reinsureds. Assuming that none of the reinsureds object to the assumption, the gross liabilities for such business will be removed from the accounts of Arch Re for statutory and GAAP accounting purposes. Arch Re will continue to record gross liabilities in its accounts for reinsureds that object to the release of Arch Re from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica would be recorded as an asset equal to such gross liabilities. This would also result in a portion of any pre-tax gain on the asset sale being deferred and amortized into income as gross liabilities are extinguished. XL TRANSACTION On March 2, 2000, we repurchased from XL Capital, then our single largest stockholder, all of the 4,755,000 shares of our common stock held by it for a purchase price of $12.45 per share of our common stock, or a total of $59.2 million. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the consideration for the repurchase with (i) our interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million (which was carried by us at $24 million at December 31, 1999); and (ii) all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate. XL Capital paid us in cash the difference (equal to $3.6 million) between our repurchase price and the value of our interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of our shares. The value of the warrants was determined using a Black Scholes methodology. 25 The cost of the stock repurchase of $59.2 million was recorded as a reduction to stockholder's equity reflected as treasury stock. Arch Re's statutory surplus was reduced by $62.8 million due to the distribution to us of the stock and warrants in both LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd. based on statutory carrying values. ARCH RE DISTRIBUTION Upon payment of a contemplated distribution from Arch Re to us that is currently anticipated to occur in the second quarter, our assets would consist of fixed maturity and short term investments, publicly traded equity securities and privately held securities. We will also continue to own all of the outstanding capital stock of Arch Re and Cross River, each with statutory surplus of up to approximately $20 million (or any greater amount the Nebraska Insurance Department requires Arch Re to retain in the event there are any objections from reinsureds to the release of Arch Re from further liability under the reinsurance agreements transferred pursuant to the transfer and assumption agreement). Our remaining $19 million investment commitment to Trident II, L.P. would also remain in place. See "Liquidity and Capital Resources" below for a discussion of the regulatory issues relating to distributions by Arch Re. FUTURE OPERATIONS Subsequent to the sale of our reinsurance business to Folksamerica, our present strategy is to pursue business combinations and ventures with operating businesses. Our success will depend to a large extent on the operations, financial condition and management of the companies with which we may merge or which we may acquire in whole or in part. We have not yet identified specific business opportunities that we intend to pursue. Accordingly, the financial and operational risks that we may encounter in the future cannot be specified. RESULTS OF OPERATIONS We had consolidated comprehensive loss for the three months ended March 31, 2000 of $38.1 million, which was composed of net income of $5.8 million and other comprehensive loss of $43.9 million, consisting of the change in after-tax unrealized depreciation of investments. Net income for the three months ended March 31, 2000 included after-tax realized investment gains of $19 million and equity in net income of investees of approximately $30,000. These amounts compare with comprehensive loss for the three months ended March 31, 1999 of $35.5 million, which was composed of net loss of $25 million and the change in after-tax unrealized appreciation of investments of $10.5 million. Net loss for the three months ended March 31, 1999 included after-tax realized investment losses of $749,000, equity in net loss of investees of $163,000 and a loss of $383,000 from the cumulative effect of an accounting change. Following is a table of per share data for the three months ended March 31, 2000 and 1999 on an after-tax basis:
THREE MONTHS ENDED MARCH 31, 2000 1999 ------- ------ BASIC AND DILUTED EARNINGS PER SHARE: Underwriting loss ($1.10) ($1.58) Net investment income .24 .19 Net realized investment gains (losses) 1.23 (.04) Equity in net income (loss) of investees - (.01) Cumulative effect of accounting change - (.02) ------- ------ Net income (loss) .37 (1.46) Change in net unrealized appreciation (depreciation) of investments (2.83) (0.62) ------- ------ Comprehensive income (loss) ($2.46) ($2.08) ------- ------ ------- ------ Average shares outstanding (000's) Basic 15,517 17,087 Diluted 15,518 17,102
26 At March 31, 2000, consolidated stockholders' equity totaled $249.3 million, compared with $346.5 million at December 31, 1999. On a basic and diluted basis, book value per share was $20.22 based on 12,329,398 shares outstanding at March 31, 2000, compared with $20.28 based on 17,087,970 shares outstanding at December 31, 1999. Book value and per share amounts at March 31, 2000 reflect the repurchase on March 2, 2000 from XL Capital Ltd of all of the 4,755,000 shares of our common stock it held for $59.2 million, or $12.45 per share, recorded as treasury stock. IN-FORCE BUSINESS With respect to our divested reinsurance operations, Arch Re had approximately 340 renewable in-force reinsurance treaties on April 1, 2000 (such renewal is subject to negotiation and evaluation during the renewal period), with approximately $234 million of estimated annualized net premiums written, compared to $249 million at January 1, 2000. Such in-force premiums at April 1, 2000 represent estimated annualized premiums from treaties entered into during 1999 and the year 2000 renewal periods that were expected to generate net premiums written during 2000. The 6% decline in in-force business at April 1, 2000 compared to January 1, 2000 is due to several factors which included (i) the previously announced asset sale; (ii) discontinuing aviation and space business in 1999; and (iii) non-renewals in other classes of business, due to (a) our adherence to underwriting standards in competitive market conditions and (b) the effect on cedents of our poor underwriting performance, coupled with a decline in Arch Re's A.M. Best rating from A to A- during 1999. Such decline was partially offset by increased in-force premiums in Accident & Health business where significant underwriting capacity has exited the market since 1998, and we believe reinsurance pricing improvements have occurred in 1999 and 2000. NET PREMIUMS WRITTEN Net premiums written for the three months ended March 31, 2000 and 1999 were as follows:
(IN THOUSANDS) THREE MONTHS ENDED MARCH 31, ------------------------------------- CORE BUSINESS 2000 1999 ------- ------- Property $2,680 $12,245 Casualty 12,129 19,850 Multi-line 11,965 17,455 Other 4,307 (4,592) ------- ------- Sub-total Core Business 31,081 44,958 ------- ------- SPECIALTY BUSINESS Accident & Health 19,422 8,068 Aviation & Space (294) 5,642 Marine 2,197 3,965 Surety & Fidelity 483 1,804 ------- ------- Sub-total Specialty Business 21,808 19,479 ------- ------- Total $52,889 $64,437 ------- ------- ------- -------
Net premiums written for the 2000 first quarter were $52.9 million, representing a 22% decrease from the $64.4 million of net premiums written for the 1999 first quarter. See "In-Force Business" above for a discussion of the decline in in-force business that also relates to the decline in net premiums written in the 2000 first quarter. 27 Net premiums written for the 1999 first quarter for other business was reduced by $10.6 million for the retrocession of a treaty which covered multiple future rocket launches. The reduction of net premiums written resulting from this retrocession increased the commission and operating expense ratio components of the statutory composite ratio by 4.7 points, but had no impact on operating results. Set forth below are our statutory combined ratios for the three months ended March 31, 2000 and 1999:
THREE MONTHS ENDED MARCH 31, ---------------------------- 2000 1999 ------ ------ Claims and claims expenses 92.6% 128.3% Commissions and brokerage 29.2 33.2 Other operating expenses 4.6 5.5 ------ ------ Statutory combined ratio 126.4% 167.0% ------ ------ ------ ------
The statutory combined ratio for the 2000 first quarter was adversely affected by a pre-tax underwriting loss of $11 million (excluding operating expenses) from aviation business, which added 19.6 points to the statutory composite ratio. The statutory combined ratio for the 1999 first quarter was adversely affected by pre-tax underwriting losses of $38.8 million (excluding operating expenses) from the following sources: aviation business ($5.8 million), satellite business ($6.8 million), business produced by a managing underwriting agency ($23.7 million) and property business ($2.5 million). Such underwriting losses added 59.1 points to the 1999 first quarter statutory combined ratio. FOREIGN EXCHANGE Pre-tax foreign exchange gains and losses are recorded separately from statutory underwriting results and are therefore excluded from the statutory combined ratio. Unhedged monetary assets and liabilities are translated at the exchange rate in effect at the balance sheet date, with the resulting foreign exchange gains or losses recognized in income. We do not have any remaining assets or liabilities denominated in foreign currency as a result of the asset sale to Folksamerica Reinsurance Company. NET INVESTMENT INCOME Invested assets, including accrued investment income, net of investment accounts receivable and payable, consisted of the following at March 31, 2000 compared to December 31, 1999:
MILLIONS MARCH 31, DECEMBER 31, 2000 1999 --------- ------------ Fixed maturities Taxable - Investment Grade $151.0 $171.2 - High Yield 35.9 37.6 Tax Exempt - Investment Grade 19.4 52.3 ------ ------ 206.3 261.1 Publicly traded equity securities 42.9 158.8 Privately held securities 58.2 83.9 Cash, short-term investments and accrued interest 192.2 86.7 ------ ------ Total $499.6 $590.5 ------ ------ ------ ------
Approximately 90% of the fixed maturity and short-term investments were rated investment grade by Moody's and Standard & Poor's and had an average quality rating of AA and average duration of 2.3 years. 28 During the 2000 first quarter, we liquidated a substantial portion of the public equity portfolio and reduced our investment in tax-exempt securities for tax planning purposes. All funds were reinvested in short-term securities in anticipation of the delivery of a substantial portion of the investment portfolio to Folksamerica Reinsurance Company in connection with the asset sale and had the effect of reducing the average duration of the fixed maturity and short-term investments by approximately 1.4 years compared to December 31, 1999. All fixed maturity and short-term investments transferred on May 5, 2000 to Folksamerica and the securities placed in the escrow account are rated investment grade. At March 31, 2000, our private equity portfolio consisted of 11 investments having an aggregate carrying value of $58.2 million, with additional investment portfolio commitments in the aggregate amount of approximately $23 million. During the 2000 first quarter, we provided an additional loan in an aggregate principal amount of $3.5 million to American Independent Insurance Holding Company, one of our investee companies, and increased our investment in Trident II, L.P. by approximately $100,000. See Note 5 under the caption "Investment Information" of the accompanying notes to our unaudited consolidated financial statements for the 2000 first quarter for certain information regarding our publicly traded and privately held securities and their carrying values. Net investment income for the 2000 first quarter was $5.3 million, compared to $4.5 million for the 1999 first quarter, which reflects higher pre-tax and net of tax yields of 4.2% and 3.0%, respectively, in 2000, compared to 3.4% and 2.5% in 1999. Our yields have moderately increased as proceeds from the sales of public equity securities have been allocated into fixed maturity and short-term investments over the last several quarterly periods. Our sources of net realized investment gain (losses) for the 2000 first quarter were as follows (in thousands): Fixed maturities ($2,399) Publicly traded equity securities 35,359 Privately held securities (3,660) ------- Total $29,300 ------- -------
During the 2000 first quarter, we disposed of, or reduced our position in, several publicly traded equity security investments, including our investment in Annuity and Life Re (Holdings), Ltd. for a net gain of $17.3 million. The realized loss on privately held securities includes a net loss of $487,000 resulting from the disposition of our investment in LARC Holdings, Ltd. and a write-down of $3.2 million in the carrying value of our investment in Altus Holdings, Ltd. The change in after-tax net unrealized depreciation of investments of $43.9 million for the 2000 first quarter reflects the following (in thousands): Net unrealized losses on investments held during the period $29.3 Reclassification for net realized gains recorded in net income 29.3 ----- Pre-tax net unrealized depreciation of investments 58.6 Less: Deferred tax asset 20.5 Valuation allowance (5.8) ----- Deferred tax benefit 14.7 ----- Change in net unrealized depreciation of investments, net of tax $43.9 ----- -----
The $29.3 million in net unrealized losses on investments held during the period was principally due to declines in the market values of publicly traded equity securities. 29 INCOME TAXES During the 2000 first quarter, we recorded a deferred tax asset valuation allowance of $12.1 million, of which $6.3 million is included in income tax expense reflected in net income and $5.8 million is included in the change in net unrealized depreciation of investments contained in other comprehensive loss. A valuation allowance has been established due to the future uncertainty of realizing a portion of deferred tax assets at March 31, 2000. RATINGS Effective with the sale of the reinsurance business to Folksamerica, A.M. Best has withdrawn it's A- rating of Arch Re and has assigned the classification of NR-3 (Rating Procedure Inapplicable), which applies to companies in run-off with no active business writings or that are effectively dormant. LIQUIDITY AND CAPITAL RESOURCES We are a holding company and currently have no significant operations or assets other than our ownership of the capital stock of Arch Re. We rely on cash dividends and distributions from Arch Re to make payments, including for any operating expenses that we may incur and for any dividends or stock repurchases as our board of directors may determine. Our board currently does not intend to declare dividends or make any other distributions. However, our board intends to make a determination regarding stock repurchases. Arch Re's ability to pay dividends or make distributions to us is dependent upon its ability to meet regulatory standards of the State of Nebraska, as described below. There are presently no contractual restrictions on Arch Re's payment of dividends or the making of distributions to us. We intend to cause Arch Re to make an extraordinary distribution to us. See "-- General -- Arch Re Distribution." Nebraska insurance laws provide that, without prior approval of the Nebraska Director of Insurance (the "Nebraska Director"), Arch Re cannot pay a dividend or make a distribution (together with other dividends or distributions paid during the preceding 12 months) that exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31 or (ii) statutory net income from operations from the preceding calendar year not including realized capital gains. Net income (exclusive of realized capital gains) not previously distributed or paid as dividends from the preceding two calendar years may be carried forward for dividends and distribution purposes. Any proposed dividend or distribution in excess of such amount is called an "extraordinary" dividend or distribution and may not be paid until either it has been approved, or a 30-day waiting period has passed during which it has not been disapproved, by the Nebraska Director. Notwithstanding the foregoing, Nebraska insurance laws provide that any distribution that is a dividend may be paid by Arch Re only out of earned surplus arising from its business, which is defined as unassigned funds (surplus) as reported in the statutory financial statement filed by Arch Re with the Nebraska Insurance Department for the most recent year, including any surplus arising from unrealized capital gains or revaluations of assets. Any distribution that is a dividend and that is in excess of Arch Re's unassigned funds, exclusive of any surplus arising from unrealized capital gains or revaluation of assets, will be deemed an "extraordinary" dividend subject to the foregoing requirements. Due to the distribution that was required to be made in connection with the XL Capital stock repurchase, we may not declare any other distribution for twelve months from the closing date of the stock repurchase unless such subsequent distribution is approved by the Nebraska Director. Net cash flow provided by (used for) operating activities for the 2000 first quarter and 1999 first quarter was approximately ($2.7) million and $14.1 million, respectively, consisting principally of premiums received, investment income (excluding net realized investment gains), offset by operating costs and expenses. The primary sources of liquidity of the Company subsequent to the asset sale will be from short-term and fixed maturity investments presently owned directly by the Company ($11.8 million at March 31, 2000) and the invested assets to be distributed to the Company by Arch Re as an extraordinary distribution, which could occur during the second quarter of 2000, provided applicable regulatory approval is obtained. Such invested assets would include $58.2 million of privately held securities at March 31, 2000, which are generally restricted as to resale, do not have readily ascertainable market values or are otherwise illiquid. 30 The fixed maturity investments contemplated to be restricted or unavailable for liquidity purposes subsequent to the asset sale will include $20 to $25 million to be held in escrow for a period of five years under the terms of the asset sale and our investments in Arch Re and Cross River, each contemplated to have up to approximately $20 million in statutory surplus (or any greater amount the Nebraska Insurance Department requires Arch Re to retain in the event there are any objections from reinsureds to the release of Arch Re from further liability under reinsurance agreements transferred pursuant to the transfer and assumption agreement). We do not currently have any material commitments for any capital expenditures over the next 12 months. We expect that our financing and operational needs for the foreseeable future will be met by our balance of cash and short-term investments, as well as by funds generated from operations. Following the sale of the reinsurance operations to Folksamerica, our objective is to pursue business combinations and ventures with operating businesses. We have not yet identified any specific business opportunities that we intend to pursue. Accordingly, we may need to secure additional financing to carry out our business plan. We cannot assure you that we will be successful in obtaining any such financing or in the implementation of our future business strategy. MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT In accordance with the SEC's Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as of December 31, 1999. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 1999 Annual Report on Form 10-K.) Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. At March 31, 2000, there have been no material changes in market risk exposures that affect the quantitative and qualitative disclosures presented as of December 31, 1999. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. This report or any other written or oral statements made by or on behalf of the Company may include forward-looking statements which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in this report are forward-looking statements. Forward-looking statements can generally be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" or their negative or variations or similar terminology. Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this report and include: -- the availability of investments on attractive terms; -- competition, including increased competition; -- changes in the performance of the insurance sector of the public equity markets or market professionals' views as to such sector; -- general economic conditions; -- regulatory changes and conditions; -- claims development, including as to the frequency or severity of claims and the timing of payments; -- our future business operations and strategy; and -- loss of key personnel. 31 In addition, the sale of our reinsurance operations to Folksamerica Reinsurance Company referred to in this report is subject to various risks and uncertainties including the risks that the costs (including tax costs) of the transaction and purchase price and reserve adjustments will be greater than currently expected with resulting effects on our income statement and book value. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Reference is made to the information appearing above under the subheading "Market Sensitive Instruments and Risk Management" under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," which information is hereby incorporated by reference. 32 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is subject to litigation and arbitration in the ordinary course of business. PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. Exhibit No. Description ----------- ----------- 10 Amendment to Sub-Sublease Agreement, between Arch Reinsurance Company and Marsh & McLennan Capital, Inc. 15 Accountants' Awareness Letter and Limitation of Liability (regarding unaudited interim financial information) 27 Financial Data Schedule (b) Reports on Form 8-K. The Company filed reports on Form 8-K during the three month period ended March 31, 2000 on: (1) January 18, 2000 (reporting the sale of the Company's reinsurance operations to Folksamerica Reinsurance Company and the XL Capital stock repurchase) and (2) March 2, 2000 (reporting the closing of the XL Capital stock repurchase). Omitted from this Part II are items which are inapplicable or to which the answer is negative for the period covered. 33 SIGNATURES =============================================================================== Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. RISK CAPITAL HOLDINGS, INC. ---------------------------------------- (REGISTRANT) /s/ Peter A. Appel ---------------------------------------- DATE: MAY 15, 2000 PETER A. APPEL PRESIDENT AND CHIEF EXECUTIVE OFFICER /s/ Paul J. Malvasio ---------------------------------------- DATE: MAY 15, 2000 PAUL J. MALVASIO CHIEF FINANCIAL OFFICER 34 EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 10 Amendment to Sub-Sublease Agreement, between Arch Reinsurance Company and Marsh & McLennan Capital, Inc. 15 Accountants' Awareness Letter and Limitation of Liability (regarding unaudited interim financial information) 27 Financial Data Schedule 35 EX-10 2 EXHIBIT 10 EXHIBIT 10 AMENDMENT OF SUB-SUBLEASE Amendment of Sub-Sublease ("Amendment") dated as of the 1st day of April, 2000, by and between RISK CAPITAL REINSURANCE COMPANY ("Sub-Sublandlord") having an office at 20 Horseneck Lane, Greenwich, Connecticut 06830 and MARSH & McLENNAN CAPITAL INC. (formerly known as Marsh & McClennan Risk Capital Corp.) ("Sub-Subtenant") having an office at 20 Horseneck Lane, Greenwich, Connecticut 06830. W I T N E S S E T H : WHEREAS, by Sub-Sublease Agreement dated as of March 18, 1996 entered into between Sub-Sublandlord and Sub-Subtenant (the "Sub-Sublease"), Sub-Sublandlord sub-subleased to Sub-Subtenant approximately 11,514 square feet of rentable area on the first floor of the building (the "Building") located at and known as 20 Horseneck Lane, Greenwich, Connecticut. (The portion of the Building so sub-subleased to Sub-Subtenant is herein referred to as the "M&M Space"). WHEREAS, Sub-Sublandlord and Sub-Subtenant agree that approximately 6,431 rentable square feet on the first floor of the Building (the "BOI Space"), occupied by Bank of Ireland Asset Management (US) Limited ("BOI") pursuant to a Sub-Sublease Agreement dated as of April 30, 1997 by and between Sub-Sublandlord and BOI ('the "BOI Sublease") will be vacated by BOI on or prior to March 31, 2000 pursuant to the Sub-Sublandlord Termination Agreement by and between BOI and Sub-Sublandlord dated as of November 8, 1999. WHEREAS, Section 14 of the Sub-Sublease provides that upon the termination of the BOI Sublease, the Sub-Subtenant's Pro Rata Share of BOI Space would be added to the M&M Space and the Sub-Sublandlord Expansion Space would be retained by the Sub-Sublandlord, unless Sublandlord elected not to retain the Sub-Sublandlord Expansion Space and make it available to Sub-Subtenant. WHEREAS, Sub-Sublandlord does not desire to retain the Sub-Sublandlord Expansion Space and the Sub-Subtenant desires to (a) add the M&M Expansion Space and the Sub-Sublandlord Expansion Space to the M&M Space; and (b) to amend the Sub-Sublease in the manner hereinafter set forth. NOW THEREFORE, in consideration of the mutual covenants herein contained and other good and valuable consideration the receipt and sufficiency of which are hereby acknowledged, the parties hereto agrees as follows: 1. All capitalized terms used herein, and not otherwise defined herein, shall have the meanings ascribed to them in the Sub-Sublease. 2. A. The entire BOI Space, marked as the "Additional Space" on EXHIBIT A annexed hereto and made a part hereof (the "Additional Space") is, from and after the Additional Space Commencement Date (as hereinafter defined) added to and shall form a part of the M&M Space with the same force and effect as if originally demised under the Sub-Sublease and, from and after the Additional Space Commencement Date, the term "M&M Space", as used in the Sub- Sublease, shall include the Additional Space. Notwithstanding any contrary or inconsistent provision contained herein or in the Sub-Sublease, Sub-Sublandlord, at all times during the term of the Sub-Sublease shall have unrestricted access to those areas of the Additional Space utilized for the common services and facilities of the Building, such as mechanical rooms and stairways. B. Sub-Subtenant accepts the Additional Space in its "as is" condition. C. Sub-Subtenant, at Sub-Subtenant's sole cost and expense, shall take all actions required to design and construct all improvements necessary or desirable to permit Sub-Subtenant's use and occupancy of the Additional Space (the "Additional Space Fit-Up") in accordance with all Plans (the "Plans") to be approved by the parties hereto. Sub-Subtenant shall be responsible for the costs of all design services of such architects and engineers who have prepared the Plans. All additional property assessments and real estate taxes incurred by Sub-Sublandlord as a result of the Additional Space Fit-Up shall be billed to, and paid by, Sub-Subtenant as additional rent. D. The "Additional Space Commencement Date" shall be April 1, 2000. E. This Amendment shall not be effective until such time as a counterpart or reproduced copy of this Amendment shall have first been delivered to the Coca-Cola Bottling Company of New York, Inc. ("Coke") in accordance with the Sublease Agreement by and between Sub-Sublandlord and Coke dated as of March 18, 1996. 3. Effective upon the Additional Space Commencement Date, provided the condition set forth in Paragraph 3E has been satisfied, the Sub-Sublease is hereby amended in the following respects: A. Section 3 of the Sub-Sublease is amended to provide that Sub-Subtenant's Pro-Rata Share shall be 47.3%. B. Section 4 of the Sub-Sublease is modified and amended to provide that Sub-Subtenant's Security Deposit shall be increased from $37,082.51 to $46,733.412 and such amount shall for all purposes under the Sub-Sublease be "Sub-Subtenant's Security Deposit". C. Sub-Sublandlord and Sub-Subtenant agree that, for purposes of Section 13 of the Sub-Sublease, Sub-Subtenant's Pro-Rata Share of the indoor parking spaces shall be twenty-seven (27) spaces. D. Sub-Sublandlord waives and releases its right to retain the Sub-Sublandlord Expansion Space as set forth in Section 14 of the Sub-Sublease. 4. Sub-Sublandlord and Sub-Subtenant each represent to the other that they have dealt with no broker or brokers in connection with this Amendment. Sub-Sublandlord and Sub-Subtenant each hereby agree to indemnify and hold the other harmless from any and all loss, cost, claim, damage or expense (including, without limitation, reasonable attorneys' fees and 2 disbursements) incurred by the other and arising out of any inaccuracy or alleged inaccuracy of the above representation made by the indemnifying party. 5. Except as expressly amended herein, the Sub-Sublease is in all respects, confirmed, ratified and approved and is on the date of this Amendment, subject to the terms thereof, in full force and effect and, to the best knowledge of each of Sub-Sublandlord and Sub-Subtenant on the date hereof, there are defaults by either party under the Sub-Sublease. IN WITNESS WHEREOF, Sub-Sublandlord and Sub-Subtenant have duly executed this Amendment of Sub-Sublease as of the day and year first above written. RISK CAPITAL REINSURANCE COMPANY By: /s/ LOUIS T. PETRILLO -------------------------------- Vice President MARSH & McLENNAN CAPITAL, INC. By: /s/ RICHARD GOLDMAN -------------------------------- Principle and Financial Director 3 STATE OF CONNECTICUT ) ) ss. GREENWICH COUNTY OF FAIRFIELD ) On this 7th day of March, 2000, personally appeared, RISK CAPITAL REINSURANCE COMPANY, by Louis T. Petrillo, its Vice President hereunto duly authorized, who acknowledged that he/she signed, sealed and delivered the above and foregoing instrument as his/her free act and deed, and the free act and deed of said corporation, for the purposes therein stated, before me. /s/ LISA M. MORRISSEY ----------------------------------- Notary Public Commissioner of the Superior Court My Commission Expires: May 31, 2003 ------------ STATE OF CONNECTICUT ) ) ss. GREENWICH COUNTY OF FAIRFIELD ) On this 13th day of April, 2000, personally appeared, MARSH & McLENNAN CAPITAL INC., by Richard A. Goldman, its Principle and Financial Director hereunto duly authorized, who acknowledged that he/she signed, sealed and delivered the above and foregoing instrument as his/her free act and deed, and the free act and deed of said corporation, for the purposes therein stated, before me. /s/ SANDRA A. SANDLOCK ---------------------------------------- Notary Public Commissioner of the Superior Court My Commission Expires: February 28, 2004 ----------------- 4 EX-15 3 EXHIBIT 15 EXHIBIT 15 ACCOUNTANTS' AWARENESS LETTER AND LIMITATION OF LIABILITY We are aware of the incorporation by reference in the Registration Statement on Form S-3 (Registration No. 33-34499) and in the Registration Statements on Form S-8 (Registration No. 33-99974 and Registration No. 333-86145) of Arch Capital Group Ltd. of our report dated May 2, 2000 (issued pursuant to the provisions of Statement on Auditing Standards No. 71) appearing in this Form 10-Q. We are also aware of our responsibilities under the Securities Act of 1933. We are not subject to the liability provisions of section 11 of the Securities Act of 1933 for our report dated May 2, 2000 (issued pursuant to the provisions of Statement on Auditing Standards No. 71) on the unaudited interim consolidated financial information of Arch Capital Group Ltd. because our report is not a "report" or a "part" of the Registration Statement on Form S-3 (Registration No. 33-34499) or of the Registration Statement on Form S-8 (Registration No. 33-99974 and Registration No. 333-86145) prepared or certified by us within the meaning of sections 7 and 11 of the Securities Act of 1933. /s/ PricewaterhouseCoopers LLP New York, New York May 15, 2000 EX-27 4 EXHIBIT 27
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET OF ARCH CAPITAL GROUP LTD AND ITS SUBSIDIARY AT MARCH 31, 2000 AND THE RELATED STATEMENT OF INCOME, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 3-MOS DEC-31-2000 JAN-01-2000 MAR-31-2000 206,302 0 0 101,118 0 0 448,186 11,447 77,590 22,285 774,250 378,297 103,469 0 0 0 0 0 171 249,082 774,250 58,162 5,290 29,300 0 53,875 16,753 3,727 18,397 12,619 5,808 0 0 0 5,808 0.37 0.37 308,628 48,703 5,172 3,715 41,753 317,035 5,172 Includes equity in net income of investees of $30. Net income excludes Other Comprehensive income (loss) which the Company adopted 1st Qtr 1998 in a one financial statement approach. Comprehensive loss was $38,122 or $2.08 per share Basic and Diluted. Loss reserves net of reinsurance.
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