10-Q 1 acgl10q33118.htm 10-Q 3.31.18 Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
 
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the quarterly period ended March 31, 2018
 
Or
 
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number:  001-16209

 archlogorgbsolida24.jpg
ARCH CAPITAL GROUP LTD.
(Exact name of registrant as specified in its charter)

Bermuda
Not applicable
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
Waterloo House, Ground Floor
 
100 Pitts Bay Road, Pembroke HM 08, Bermuda
(441) 278-9250
(Address of principal executive offices)
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ     No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated Filer þ Accelerated Filer o Non-accelerated Filer o Smaller reporting
company o Emerging growth company o
If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o  
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No þ
As of May 4, 2018, there were 135,775,651 common shares, $0.0033 par value per share, of the registrant outstanding.


ARCH CAPITAL GROUP LTD.
 
INDEX TO FORM 10-Q
 

ARCH CAPITAL
 1
2018 FIRST QUARTER FORM 10-Q

PART I.  FINANCIAL INFORMATION
Cautionary Note Regarding Forward-Looking Statements 
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This report or any other written or oral statements made by or on behalf of us 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 or incorporated by reference in this report are forward-looking statements. Forward-looking statements, for purposes of the PSLRA or otherwise, can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe” or “continue” and similar statements of a future or forward-looking nature 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 in our periodic reports filed with the Securities and Exchange Commission (the “SEC”), and include:
•
our ability to successfully implement our business strategy during “soft” as well as “hard” markets;
•
acceptance of our business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and our insureds and reinsureds;
•
the integration of United Guaranty Corporation and any other businesses we have acquired or may acquire into our existing operations;
•
our ability to maintain or improve our ratings, which may be affected by our ability to raise additional equity or debt financings, by ratings agencies’ existing or new policies and practices, as well as other factors described herein;
•
general economic and market conditions (including inflation, interest rates, unemployment, housing prices, foreign currency exchange rates, prevailing credit terms and the depth and duration of a recession) and conditions specific to the reinsurance and insurance markets (including the length and magnitude of the current “soft” market) in which we operate;
•
competition, including increased competition, on the basis of pricing, capacity (including alternative sources of capital), coverage terms, or other factors;
•
developments in the world’s financial and capital markets and our access to such markets;
•
our ability to successfully enhance, integrate and maintain operating procedures (including information technology) to effectively support our current and new business;
•
the loss of key personnel;
•
accuracy of those estimates and judgments utilized in the preparation of our financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation, and any determination to use the deposit method of accounting, which for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to us through March 31, 2018;
•
greater than expected loss ratios on business written by us and adverse development on claim and/or claim expense liabilities related to business written by our insurance and reinsurance subsidiaries;
•
severity and/or frequency of losses;
•
claims for natural or man-made catastrophic events or severe economic events in our insurance, reinsurance and mortgage businesses could cause large losses and substantial volatility in our results of operations;
•
acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;
•
availability to us of reinsurance to manage our gross and net exposures and the cost of such reinsurance;
•
the failure of reinsurers, managing general agents, third party administrators or others to meet their obligations to us;
•
the timing of loss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us;

ARCH CAPITAL
 2
2018 FIRST QUARTER FORM 10-Q

•
our investment performance, including legislative or regulatory developments that may adversely affect the fair value of our investments;
•
changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, which could affect our business, financial condition and results of operations;
•
the volatility of our shareholders’ equity from foreign currency fluctuations, which could increase due to us not matching portions of our projected liabilities in foreign currencies with investments in the same currencies;
•
losses relating to aviation business and business produced by a certain managing underwriting agency for which we may be liable to the purchaser of our prior reinsurance business or to others in connection with the May 5, 2000 asset sale described in our periodic reports filed with the SEC;
•
changes in accounting principles or policies or in our application of such accounting principles or policies;
•
changes in the political environment of certain countries in which we operate or underwrite business;
•
statutory or regulatory developments, including as to tax policy and matters and insurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers and/or changes in regulations or tax laws applicable to us, our subsidiaries, brokers or customers, including the Tax Cuts and Jobs Act of 2017; and
•
the other matters set forth under Item 1A “Risk Factors”, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of our Annual Report on Form 10-K for the year ended December 31, 2017, as well as the other factors set forth in our other documents on file with the SEC, and management’s response to any of the aforementioned factors.
 
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. 


ARCH CAPITAL
 3
2018 FIRST QUARTER FORM 10-Q

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
 
 
Page No.
 
 
 
 
 
 
 
 
 
March 31, 2018 (unaudited) and December 31, 2017
 
 
 
 
 
 
For the three month periods ended March 31, 2018 and 2017 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2018 and 2017 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2018 and 2017 (unaudited)
 
 
 
 
 
 
For the three month periods ended March 31, 2018 and 2017 (unaudited)
 
 
 
 
Notes to Consolidated Financial Statements (unaudited)
 
 
 
11 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


ARCH CAPITAL
 4
2018 FIRST QUARTER FORM 10-Q


Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Shareholders of Arch Capital Group Ltd.:

Results of Review of Financial Statements

We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries as of March 31, 2018, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for the three-month periods ended March 31, 2018 and March 31, 2017 including the related notes (collectively referred to as the “interim financial statements”). Based on our reviews, we are not aware of any material modifications that should be made to the accompanying interim financial statements for them to be conformity with accounting principles generally accepted in the United States of America.
 
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2017, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein), and in our report dated February 28, 2018, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2017, is fairly stated, in all material respects in relation to the consolidated balance sheet from which it has been derived.

Basis for Review Results

These interim financial statements are the responsibility of the Company’s management. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our review in accordance with the standards of the PCAOB. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the PCAOB, 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.


/s/ PricewaterhouseCoopers LLP
New York, NY
May 9, 2018

ARCH CAPITAL
 5
2018 FIRST QUARTER FORM 10-Q

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
March 31,
2018
 
December 31,
2017
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $14,469,013 and $13,869,460)
$
14,348,941

 
$
13,876,003

Short-term investments available for sale, at fair value (amortized cost: $966,722 and $1,468,955)
967,389

 
1,469,042

Collateral received under securities lending, at fair value (amortized cost: $367,034 and $476,605)
367,043

 
476,615

Equity securities, at fair value
543,650

 
495,804

Other investments available for sale, at fair value (cost: $0 and $198,163)
—

 
264,989

Investments accounted for using the fair value option
4,119,139

 
4,216,237

Investments accounted for using the equity method
1,394,548

 
1,041,322

Total investments
21,740,710

 
21,840,012

 
 
 
 
Cash
680,891

 
606,199

Accrued investment income
106,114

 
113,133

Securities pledged under securities lending, at fair value (amortized cost: $356,518 and $463,181)
358,152

 
464,917

Premiums receivable
1,375,080

 
1,135,249

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
2,510,119

 
2,540,143

Contractholder receivables
2,002,469

 
1,978,414

Ceded unearned premiums
996,772

 
926,611

Deferred acquisition costs
596,264

 
535,824

Receivable for securities sold
217,224

 
205,536

Goodwill and intangible assets
626,004

 
652,611

Other assets
922,156

 
1,053,009

Total assets
$
32,131,955

 
$
32,051,658

 
 
 
 
Liabilities
 
 
 
Reserve for losses and loss adjustment expenses
$
11,496,205

 
$
11,383,792

Unearned premiums
3,885,297

 
3,622,314

Reinsurance balances payable
379,728

 
323,496

Contractholder payables
2,002,469

 
1,978,414

Collateral held for insured obligations
253,709

 
240,183

Senior notes
1,733,043

 
1,732,884

Revolving credit agreement borrowings
755,294

 
816,132

Securities lending payable
367,034

 
476,605

Payable for securities purchased
282,731

 
449,186

Other liabilities
765,948

 
782,717

Total liabilities
21,921,458

 
21,805,723

 
 
 
 
Commitments and Contingencies


 


Redeemable noncontrolling interests
206,013

 
205,922

 
 
 
 
Shareholders' Equity
 
 
 
Non-cumulative preferred shares
780,000

 
872,555

Convertible non-voting common equivalent preferred shares
—

 
489,627

Common shares ($0.0033 par, shares issued: 189,070,234 and 183,290,742)
630

 
611

Additional paid-in capital
1,737,978

 
1,230,617

Retained earnings
8,849,959

 
8,562,889

Accumulated other comprehensive income (loss), net of deferred income tax
(134,009
)
 
118,044

Common shares held in treasury, at cost (shares: 52,387,812 and 52,312,803)
(2,084,186
)
 
(2,077,741
)
Total shareholders' equity available to Arch
9,150,372

 
9,196,602

Non-redeemable noncontrolling interests
854,112

 
843,411

Total shareholders' equity
10,004,484

 
10,040,013

Total liabilities, noncontrolling interests and shareholders' equity
$
32,131,955

 
$
32,051,658


See Notes to Consolidated Financial Statements

ARCH CAPITAL
6
2018 FIRST QUARTER FORM 10-Q

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Revenues
 

 
 

Net premiums written
$
1,412,544

 
$
1,276,260

Change in unearned premiums
(177,645
)
 
(159,243
)
Net premiums earned
1,234,899

 
1,117,017

Net investment income
126,724

 
117,874

Net realized gains (losses)
(110,998
)
 
34,153

Other-than-temporary impairment losses
(162
)
 
(1,807
)
Less investment impairments recognized in other comprehensive income, before taxes
—

 
—

Net impairment losses recognized in earnings
(162
)
 
(1,807
)
 
 
 
 
Other underwriting income
5,349

 
4,633

Equity in net income (loss) of investment funds accounted for using the equity method
28,069

 
48,088

Other income (loss)
74

 
(782
)
Total revenues
1,283,955

 
1,319,176

 
 
 
 
Expenses
 
 
 
Losses and loss adjustment expenses
636,860

 
552,570

Acquisition expenses
191,376

 
182,289

Other operating expenses
175,015

 
174,719

Corporate expenses
15,312

 
27,792

Amortization of intangible assets
26,736

 
31,294

Interest expense
30,636

 
28,676

Net foreign exchange losses (gains)
19,721

 
19,404

Total expenses
1,095,656

 
1,016,744

 
 
 
 
Income before income taxes
188,299

 
302,432

Income tax expense
(21,915
)
 
(28,397
)
Net income
$
166,384

 
$
274,035

Net (income) loss attributable to noncontrolling interests
(15,961
)
 
(20,908
)
Net income available to Arch
150,423

 
253,127

Preferred dividends
(10,437
)
 
(11,218
)
Loss on redemption of preferred shares
(2,710
)
 
—

Net income available to Arch common shareholders
$
137,276

 
$
241,909

 
 
 
 
Net income per common share and common share equivalent
 

 
 

Basic
$
1.01

 
$
1.80

Diluted
$
0.99

 
$
1.74

 
 
 
 
Weighted average common shares and common share equivalents outstanding
 
 
 
Basic
135,846,576

 
134,034,927

Diluted
139,297,934

 
139,047,672





See Notes to Consolidated Financial Statements

ARCH CAPITAL
7
2018 FIRST QUARTER FORM 10-Q

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Comprehensive Income
 
 
 
Net income
$
166,384

 
$
274,035

Other comprehensive income (loss), net of deferred income tax
 
 
 
Unrealized appreciation (decline) in value of available-for-sale investments:
 
 
 
Unrealized holding gains (losses) arising during period
(166,677
)
 
100,792

Reclassification of net realized (gains) losses, net of income taxes, included in net income
62,461

 
(5,044
)
Foreign currency translation adjustments
1,282

 
3,124

Comprehensive income
63,450

 
372,907

Net (income) loss attributable to noncontrolling interests
(15,961
)
 
(20,908
)
Foreign currency translation adjustments attributable to noncontrolling interests
673

 
(8
)
Comprehensive income available to Arch
$
48,162

 
$
351,991





See Notes to Consolidated Financial Statements

ARCH CAPITAL
8
2018 FIRST QUARTER FORM 10-Q

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Non-cumulative preferred shares
 

 
 

Balance at beginning of year
$
872,555

 
$
772,555

Preferred shares redeemed
(92,555
)
 
—

Balance at end of period
780,000

 
772,555

 
 
 
 
Convertible non-voting common equivalent preferred shares
 
 
 
Balance at beginning of year
489,627

 
1,101,304

Preferred shares converted to common shares
(489,627
)
 
—

Balance at end of period
—

 
1,101,304

 
 
 
 
Common shares
 
 
 
Balance at beginning of year
611

 
582

Common shares issued, net
19

 
1

Balance at end of period
630

 
583

 
 
 
 
Additional paid-in capital
 

 
 

Balance at beginning of year
1,230,617

 
531,687

Preferred shares converted to common shares
489,608

 
—

Reversal of issue costs on preferred shares redeemed
2,710

 
—

All other
15,043

 
16,366

Balance at end of period
1,737,978

 
548,053

 
 
 
 
Retained earnings
 

 
 

Balance at beginning of year
8,562,889

 
7,996,701

Cumulative effect of an accounting change (see Note 2)
149,794

 
(314
)
Balance at beginning of year, as adjusted
8,712,683

 
7,996,387

Net income
166,384

 
274,035

Net (income) loss attributable to noncontrolling interests
(15,961
)
 
(20,908
)
Preferred share dividends
(10,437
)
 
(11,218
)
Loss on redemption of preferred shares
(2,710
)
 
—

Balance at end of period
8,849,959

 
8,238,296

 
 
 
 
Accumulated other comprehensive income (loss), net of deferred income tax
 
 
 
Balance at beginning of year
118,044

 
(114,541
)
Unrealized appreciation (decline) in value of available-for-sale investments, net of deferred income tax:
 
 
 
Balance at beginning of year
157,400

 
(27,641
)
Cumulative effect of an accounting change (see Note 2)
(149,794
)
 
—

Balance at beginning of year, as adjusted
7,606

 
(27,641
)
Unrealized holding gains (losses) arising during period, net of reclassification adjustment
(104,216
)
 
95,748

Unrealized holding gains (losses) arising during period attributable to noncontrolling interests
372

 
—

Balance at end of period
(96,238
)
 
68,107

Foreign currency translation adjustments, net of deferred income tax:
 
 
 
Balance at beginning of year
(39,356
)
 
(86,900
)
Foreign currency translation adjustments
1,282

 
3,124

Foreign currency translation adjustments attributable to noncontrolling interests
303

 
(8
)
Balance at end of period
(37,771
)
 
(83,784
)
Balance at end of period
(134,009
)
 
(15,677
)
 
 
 
 
Common shares held in treasury, at cost
 
 
 
Balance at beginning of year
(2,077,741
)
 
(2,034,570
)
Shares repurchased for treasury
(6,445
)
 
(4,700
)
Balance at end of period
(2,084,186
)
 
(2,039,270
)
 
 
 
 
Total shareholders’ equity available to Arch
9,150,372

 
8,605,844

Non-redeemable noncontrolling interests
854,112

 
868,186

Total shareholders’ equity
$
10,004,484

 
$
9,474,030



See Notes to Consolidated Financial Statements

ARCH CAPITAL
9
2018 FIRST QUARTER FORM 10-Q

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
 
(Unaudited)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Operating Activities
 

 
 

Net income
$
166,384

 
$
274,035

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Net realized (gains) losses
101,995

 
(40,855
)
Net impairment losses recognized in earnings
162

 
1,807

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
(19,383
)
 
(36,141
)
Amortization of intangible assets
26,736

 
31,294

Share-based compensation
14,664

 
15,657

Changes in:
 
 
 
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
86,319

 
53,027

Unearned premiums, net of ceded unearned premiums
177,645

 
159,243

Premiums receivable
(233,772
)
 
(176,350
)
Deferred acquisition costs
(30,347
)
 
(41,728
)
Reinsurance balances payable
53,634

 
20,114

Other items, net
56,143

 
(76,445
)
Net cash provided by operating activities
400,180

 
183,658

Investing Activities
 

 
 

Purchases of fixed maturity investments
(9,681,267
)
 
(10,476,918
)
Purchases of equity securities
(377,000
)
 
(143,833
)
Purchases of other investments
(522,454
)
 
(427,039
)
Proceeds from sales of fixed maturity investments
8,679,147

 
10,386,746

Proceeds from sales of equity securities
291,311

 
253,347

Proceeds from sales, redemptions and maturities of other investments
436,566

 
317,518

Proceeds from redemptions and maturities of fixed maturity investments
287,031

 
174,718

Net settlements of derivative instruments
36,070

 
(3,921
)
Net (purchases) sales of short-term investments
595,318

 
(397,851
)
Change in cash collateral related to securities lending
161,567

 
180,946

Purchases of fixed assets
(4,240
)
 
(5,194
)
Other
40,037

 
23,068

Net cash provided by (used for) investing activities
(57,914
)
 
(118,413
)
Financing Activities
 

 
 

Redemption of preferred shares
(92,555
)
 
—

Purchases of common shares under share repurchase program
(3,299
)
 
—

Proceeds from common shares issued, net
(2,779
)
 
(3,990
)
Proceeds from borrowings
39,585

 
—

Repayments of borrowings
(101,000
)
 
(22,000
)
Change in cash collateral related to securities lending
(161,567
)
 
(180,946
)
Dividends paid to redeemable noncontrolling interests
(4,497
)
 
(4,497
)
Other
(2,356
)
 
(5,018
)
Preferred dividends paid
(10,437
)
 
(11,218
)
Net cash provided by (used for) financing activities
(338,905
)
 
(227,669
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash and restricted cash
1,611

 
2,618

 
 
 
 
Increase (decrease) in cash and restricted cash
4,972

 
(159,806
)
Cash and restricted cash, beginning of year
727,284

 
969,569

Cash and restricted cash, end of period
$
732,256

 
$
809,763

 
 
 
 
Reconciliation of cash and restricted cash within the Consolidated Balance Sheets:
March 31,
2018
 
December 31,
2017
Cash
$
680,891

 
$
606,199

Restricted cash (included in ‘other assets’)
$
51,365

 
$
121,085

Cash and restricted cash
$
732,256

 
$
727,284


See Notes to Consolidated Financial Statements

ARCH CAPITAL
10
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
1.    General
Arch Capital Group Ltd. (“Arch Capital”) is a Bermuda public limited liability company which provides insurance, reinsurance and mortgage insurance on a worldwide basis through its wholly-owned subsidiaries. As used herein, the “Company” means Arch Capital and its subsidiaries. The Company’s consolidated financial statements include the results of Watford Holdings Ltd. and its wholly owned subsidiaries. See Note 3.
The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of results on an interim basis. The results of any interim period are not necessarily indicative of the results for a full year or any future periods.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 (“2017 Form 10-K”), including the Company’s audited consolidated financial statements and related notes.
The Company has reclassified the presentation of certain prior year information to conform to the current presentation. Such reclassifications had no effect on the Company’s net income, comprehensive income, shareholders’ equity or cash flows. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
2.    Recent Accounting Pronouncements
Recently Issued Accounting Standards Adopted
The Company adopted ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities,” which enhances the
 
reporting model for financial instruments and provides improved financial information to readers of the financial statements. Among other provisions focused on improving the recognition and measurement of financial instruments, the ASU significantly changes the income statement impact of equity instruments and the recognition of changes in fair value of financial liabilities attributable to an entity's own credit risk when the fair value option is elected. The ASU requires equity instruments that do not result in consolidation and are not accounted for under the equity method to be measured at fair value with any changes in fair value recognized in net income rather than other comprehensive income. Upon adoption of this ASU, the Company recorded a cumulative effect adjustment of $149.8 million in retained earnings and an offsetting decrease in accumulated other comprehensive income. The adoption of this ASU did not have a material impact on the Company's financial position, cash flows, or total comprehensive income, but may increase volatility in the Company's results of operations in future periods.
The Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standard Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606),” which creates a new comprehensive revenue recognition standard that serves as a single source of revenue guidance for all companies in all industries. The guidance applies to all companies that either enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of non-financial assets, unless those contracts are within the scope of other standards, such as insurance contracts or financial instruments. The ASU also requires enhanced disclosures about revenue. The Company adopted the ASU using the modified retrospective method, whereby the cumulative effect of adoption was recognized as an adjustment to retained earnings at the date of initial application. The impact of the adoption of this ASU was not material, mostly because the accounting for insurance contracts is outside of the scope of ASU 2014-09.
The Company adopted ASU 2016-18, “Statement of Cash Flows (Topic 230) - Restricted Cash,” which requires that restricted cash and restricted cash equivalents be included with cash and cash equivalents in the reconciliation of beginning and ending cash on the statements of cash flows. As a result, transfers between cash and cash equivalents and restricted cash and restricted cash equivalents will no longer be presented on the statement of cash flows. The revised presentation required in this ASU is reflected in the Company’s consolidated statements of cash flows for both periods presented. The adoption of this ASU did not have any effect on the Company’s results of operations, financial position or comprehensive income.
Recently Issued Accounting Standards Not Yet Adopted
For information regarding accounting standards that the Company has not yet adopted, see note 3(q), “Significant

ARCH CAPITAL
 11
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Accounting Policies—Recent Accounting Pronouncements,” of the notes to consolidated financial statements in the Company’s 2017 Form 10-K.

3.
Variable Interest Entities and Noncontrolling Interests
A variable interest entity (“VIE”) refers to an entity that has characteristics such as (i) insufficient equity at risk to allow the entity to finance its activities without additional financial support or (ii) instances where the equity investors, as a group, do not have characteristics of a controlling financial interest. The primary beneficiary of a VIE is defined as the variable interest holder that is determined to have the controlling financial interest as a result of having both (i) the power to direct the activities of a VIE that most significantly impact the economic performance of the VIE and (ii) the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. If a company is determined to be the primary beneficiary, it is required to consolidate the VIE in its financial statements.
Watford Holdings Ltd.
In March 2014, the Company invested $100.0 million and acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity. Watford Holdings Ltd. is the parent of Watford Re Ltd., a multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., “Watford Re”). Watford Re is considered a VIE and the Company concluded that it is the primary beneficiary of Watford Re. As such, the results of Watford Re are included in the Company’s consolidated financial statements.
The Company does not guarantee or provide credit support for Watford Re, and the Company’s financial exposure to Watford Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.
 
The following table provides the carrying amount and balance sheet caption in which the assets and liabilities of Watford Re are reported:
 
March 31,
 
December 31,

 
2018
 
2017
Assets
 
 
 
Investments accounted for using the fair value option
$
2,331,393

 
$
2,426,066

Fixed maturities available for sale, at fair value
203,176

 
—

Cash
54,053

 
54,503

Accrued investment income
16,831

 
18,261

Premiums receivable
242,116

 
177,492

Reinsurance recoverable on unpaid and paid losses and LAE
47,289

 
42,777

Ceded unearned premiums
45,111

 
24,762

Deferred acquisition costs
92,699

 
85,961

Receivable for securities sold
47,568

 
36,374

Goodwill and intangible assets
7,650

 
7,650

Other assets
63,143

 
140,808

Total assets of consolidated VIE
$
3,151,029

 
$
3,014,654

 
 
 
 
Liabilities
 
 
 
Reserves for losses and loss adjustment expenses
$
852,828

 
$
798,262

Unearned premiums
395,605

 
330,644

Reinsurance balances payable
26,340

 
18,424

Revolving credit agreement borrowings
380,294

 
441,132

Payable for securities purchased
79,786

 
42,501

Other liabilities
235,554

 
215,186

Total liabilities of consolidated VIE
$
1,970,407

 
$
1,846,149

 
 
 
 
Redeemable noncontrolling interests
$
220,713

 
$
220,622

For the three months ended March 31, 2018, Watford Re generated $30.2 million of cash provided by operating activities, $35.4 million of cash used for investing activities and $66.2 million of cash used for financing activities, compared to $62.2 million of cash provided by operating activities, $58.8 million of cash used for investing activities and $29.0 million of cash used for financing activities for the three months ended March 31, 2017.
Non-redeemable noncontrolling interests
The Company accounts for the portion of Watford Re’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford Re’s common shares was approximately 89% at March 31, 2018. The portion of Watford Re’s income or loss attributable to third party investors is recorded in the consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests.’

ARCH CAPITAL
 12
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table sets forth activity in the non-redeemable noncontrolling interests:
 
March 31,
 
2018
 
2017
Three Months Ended
 
 
 
Balance, beginning of period
$
843,411

 
$
851,854

Amounts attributable to noncontrolling interests
11,376

 
16,324

Foreign currency translation adjustments
(675
)
 
8

Balance, end of period
$
854,112

 
$
868,186

Redeemable noncontrolling interests
The Company accounts for redeemable noncontrolling interests in the mezzanine section of its consolidated balance sheets in accordance with applicable accounting guidance. Such redeemable noncontrolling interests relate to the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. Preferred dividends, including the accretion of the discount and issuance costs, are included in ‘net (income) loss attributable to noncontrolling interests’ in the Company’s consolidated statements of income.
The following table sets forth activity in the redeemable non-controlling interests:
 
March 31,
 
2018
 
2017
Three Months Ended
 
 
 
Balance, beginning of period
$
205,922

 
$
205,553

Accretion of preference share issuance costs
91

 
91

Balance, end of period
$
206,013

 
$
205,644

The portion of Watford Re’s income or loss attributable to third party investors, recorded in the Company’s consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests,’ are summarized in the table below:
 
March 31,
 
2018
 
2017
Three Months Ended
 
 
 
Amounts attributable to non-redeemable noncontrolling interests
$
(11,376
)
 
$
(16,324
)
Dividends attributable to redeemable noncontrolling interests
(4,585
)
 
(4,584
)
Net (income) loss attributable to noncontrolling interests
$
(15,961
)
 
$
(20,908
)
Bellemeade Re
The Company has entered into various aggregate excess of loss reinsurance agreements with Bellemeade Re I Ltd. (July 2015), with Bellemeade Re II Ltd. (May 2016) and with Bellemeade 2017-1 Ltd. (October 2017) (the “Bellemeade Agreements”),
 
special purpose reinsurance companies domiciled in Bermuda. At the time the Bellemeade Agreements were entered into, the applicability of the accounting guidance that addresses VIEs was evaluated. As a result of the evaluation of the Bellemeade Agreements, the Company concluded that Bellemeade Re I Ltd., Bellemeade Re II Ltd. and Bellemeade 2017-1 Ltd. are VIEs. However, given that the ceding insurers do not have the unilateral power to direct those activities that are significant to the economic performance of Bellemeade Re I Ltd., Bellemeade Re II Ltd. and Bellemeade 2017-1 Ltd., the Company does not consolidate such companies in its consolidated financial statements.
The following table presents total assets of Bellemeade Re I Ltd., Bellemeade Re II Ltd. and Bellemeade 2017-1 Ltd., as well as the Company’s maximum exposure to loss associated with these VIEs as of March 31, 2018 and December 31, 2017:
 
 
 
Maximum Exposure to Loss
 
Total VIE Assets
 
On-Balance Sheet
 
Off-Balance Sheet
 
Total
March 31, 2018
 
 
 
 
 
 
 
Bellemeade Re I Ltd.
$
79,372

 
$
360

 
$
610

 
$
970

Bellemeade Re II Ltd.
100,871

 
72

 
278

 
350

Bellemeade 2017-1 Ltd.
336,343

 
519

 
1,979

 
2,498

Total
$
516,586

 
$
951

 
$
2,867

 
$
3,818

December 31, 2017
 
 
 
 
 
 
 
Bellemeade Re I Ltd.
$
92,390

 
$
471

 
$
832

 
$
1,303

Bellemeade Re II Ltd.
135,201

 
20

 
527

 
547

Bellemeade 2017-1 Ltd.
347,139

 
391

 
1,867

 
2,258

Total
$
574,730

 
$
882

 
$
3,226

 
$
4,108

See note 16, “Subsequent Events.”

ARCH CAPITAL
 13
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

4.    Earnings Per Common Share
The following table sets forth the computation of basic and diluted earnings per common share:
 
Three Months Ended
 
March 31,
 
2018
 
2017
Numerator:
 
 
 
Net income
$
166,384

 
$
274,035

Amounts attributable to noncontrolling interests
(15,961
)
 
(20,908
)
Net income available to Arch
150,423

 
253,127

Preferred dividends
(10,437
)
 
(11,218
)
Loss on redemption of preferred shares
(2,710
)
 
—

Net income available to Arch common shareholders
$
137,276

 
$
241,909

 
 
 
 
Denominator:
 
 
 
Weighted average common shares outstanding
131,370,263

 
121,272,107

Series D preferred shares (1)
4,476,313

 
12,762,820

Weighted average common shares and common share equivalents outstanding — basic
135,846,576

 
134,034,927

Effect of dilutive common share equivalents:
 
 
 
Nonvested restricted shares
719,859

 
1,646,555

Stock options (2)
2,731,499

 
3,366,190

Weighted average common shares and common share equivalents outstanding — diluted
139,297,934

 
139,047,672

 
 
 
 
Earnings per common share:
 
 
 
Basic
$
1.01

 
$
1.80

Diluted
$
0.99

 
$
1.74

(1)
Such shares are convertible non-voting common equivalent preferred shares issued in connection with the UGC acquisition. See Note 11.
(2)
Certain stock options were not included in the computation of diluted earnings per share where the exercise price of the stock options exceeded the average market price and would have been anti-dilutive or where, when applying the treasury stock method to in-the-money options, the sum of the proceeds, including unrecognized compensation, exceeded the average market price and would have been anti-dilutive. For the 2018 first quarter and 2017 first quarter, the number of stock options excluded were 1,056,262 and 263,475, respectively.

ARCH CAPITAL
 14
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

5.    Segment Information
The Company classifies its businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — ‘other’ and corporate (non-underwriting). The Company determined its reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of the Company’s consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.
The Company’s insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to the Company’s chief operating decision makers, the President and Chief Executive Officer of Arch Capital, and the Chief Financial Officer of Arch Capital. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. Management measures segment performance for its three underwriting segments based on underwriting income or loss. The Company does not manage its assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.
The insurance segment consists of the Company’s insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: construction and national accounts; excess and surplus casualty; lenders products; professional lines; programs; property, energy, marine and aviation; travel, accident and health; and other (consisting of alternative markets, excess workers' compensation and surety business).
The reinsurance segment consists of the Company’s reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: casualty; marine and aviation; other specialty; property catastrophe; property excluding property catastrophe (losses on a single risk, both excess of loss and pro rata); and other (consisting of life reinsurance, casualty clash and other).
The mortgage segment includes the Company’s U.S. and international mortgage insurance and reinsurance operations as well as government sponsored enterprise (“GSE”) credit-risk sharing transactions. Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (combined “Arch MI U.S.”) are approved as eligible mortgage insurers by Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), each a GSE.
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, UGC transaction costs and other, interest expense, items related to the Company’s non-cumulative preferred shares, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and income taxes. Such amounts exclude the results of the ‘other’ segment.
The ‘other’ segment includes the results of Watford Re (see Note 3). Watford Re has its own management and board of directors that is responsible for the overall profitability of the ‘other’ segment. For the ‘other’ segment, performance is measured based on net income or loss.

ARCH CAPITAL
 15
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following tables summarize the Company’s underwriting income or loss by segment, together with a reconciliation of underwriting income or loss to net income available to Arch common shareholders:
 
Three Months Ended
 
March 31, 2018
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
823,378

 
$
577,483

 
$
321,178

 
$
1,721,605

 
$
213,870

 
$
1,838,214

Premiums ceded
(247,180
)
 
(195,730
)
 
(46,137
)
 
(488,613
)
 
(34,318
)
 
(425,670
)
Net premiums written
576,198

 
381,753

 
275,041

 
1,232,992

 
179,552

 
1,412,544

Change in unearned premiums
(37,461
)
 
(102,581
)
 
5,201

 
(134,841
)
 
(42,804
)
 
(177,645
)
Net premiums earned
538,737

 
279,172

 
280,242

 
1,098,151

 
136,748

 
1,234,899

Other underwriting income (loss)
—

 
1,232

 
3,416

 
4,648

 
701

 
5,349

Losses and loss adjustment expenses
(353,730
)
 
(141,675
)
 
(43,466
)
 
(538,871
)
 
(97,989
)
 
(636,860
)
Acquisition expenses
(85,169
)
 
(48,319
)
 
(26,567
)
 
(160,055
)
 
(31,321
)
 
(191,376
)
Other operating expenses
(91,974
)
 
(35,571
)
 
(38,771
)
 
(166,316
)
 
(8,699
)
 
(175,015
)
Underwriting income (loss)
$
7,864

 
$
54,839

 
$
174,854

 
237,557

 
(560
)
 
236,997

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
100,243

 
26,481

 
126,724

Net realized gains (losses)
 
 
 
 
 
 
(111,859
)
 
861

 
(110,998
)
Net impairment losses recognized in earnings
 
 
 
 
 
 
(162
)
 
—

 
(162
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
28,069

 
—

 
28,069

Other income (loss)
 
 
 
 
 
 
74

 
—

 
74

Corporate expenses (2)
 
 
 
 
 
 
(14,482
)
 
—

 
(14,482
)
UGC transaction costs and other (2)
 
 
 
 
 
 
(830
)
 
—

 
(830
)
Amortization of intangible assets
 
 
 
 
 
 
(26,736
)
 
—

 
(26,736
)
Interest expense
 
 
 
 
 
 
(25,907
)
 
(4,729
)
 
(30,636
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
(15,039
)
 
(4,682
)
 
(19,721
)
Income before income taxes
 
 
 
 
 
 
170,928

 
17,371

 
188,299

Income tax expense
 
 
 
 
 
 
(21,912
)
 
(3
)
 
(21,915
)
Net income
 
 
 
 
 
 
149,016

 
17,368

 
166,384

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 
—

 
(4,585
)
 
(4,585
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 
—

 
(11,376
)
 
(11,376
)
Net income available to Arch
 
 
 
 
 
 
149,016

 
1,407

 
150,423

Preferred dividends
 
 
 
 
 
 
(10,437
)
 
—

 
(10,437
)
Loss on redemption of preferred shares
 
 
 
 
 
 
(2,710
)
 
—

 
(2,710
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
135,869

 
$
1,407

 
$
137,276

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
65.7
%
 
50.7
%
 
15.5
%
 
49.1
%
 
71.7
%
 
51.6
%
Acquisition expense ratio
15.8
%
 
17.3
%
 
9.5
%
 
14.6
%
 
22.9
%
 
15.5
%
Other operating expense ratio
17.1
%
 
12.7
%
 
13.8
%
 
15.1
%
 
6.4
%
 
14.2
%
Combined ratio
98.6
%
 
80.7
%
 
38.8
%
 
78.8
%
 
101.0
%
 
81.3
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
21,664

 
$
—

 
$
596,690

 
$
618,354

 
$
7,650

 
$
626,004

(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(2)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’ See ‘Comments on Regulation G’ for a further discussion of the presentation of such items.


ARCH CAPITAL
 16
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
Three Months Ended
 
March 31, 2017
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
782,281

 
$
475,782

 
$
348,623

 
$
1,606,686

 
$
154,120

 
$
1,657,990

Premiums ceded
(234,095
)
 
(166,092
)
 
(73,925
)
 
(474,112
)
 
(10,434
)
 
(381,730
)
Net premiums written
548,186

 
309,690

 
274,698

 
1,132,574

 
143,686

 
1,276,260

Change in unearned premiums
(42,540
)
 
(64,839
)
 
(30,175
)
 
(137,554
)
 
(21,689
)
 
(159,243
)
Net premiums earned
505,646

 
244,851

 
244,523

 
995,020

 
121,997

 
1,117,017

Other underwriting income (loss)
—

 
(306
)
 
4,123

 
3,817

 
816

 
4,633

Losses and loss adjustment expenses
(332,641
)
 
(105,454
)
 
(29,065
)
 
(467,160
)
 
(85,410
)
 
(552,570
)
Acquisition expenses
(74,868
)
 
(46,147
)
 
(28,766
)
 
(149,781
)
 
(32,508
)
 
(182,289
)
Other operating expenses
(88,126
)
 
(37,533
)
 
(41,870
)
 
(167,529
)
 
(7,190
)
 
(174,719
)
Underwriting income (loss)
$
10,011

 
$
55,411

 
$
148,945

 
214,367

 
(2,295
)
 
212,072

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
95,812

 
22,062

 
117,874

Net realized gains (losses)
 
 
 
 
 
 
28,512

 
5,641

 
34,153

Net impairment losses recognized in earnings
 
 
 
 
 
 
(1,807
)
 
—

 
(1,807
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
48,088

 
—

 
48,088

Other income (loss)
 
 
 
 
 
 
(782
)
 
—

 
(782
)
Corporate expenses (2)
 
 
 
 
 
 
(12,208
)
 
—

 
(12,208
)
UGC transaction costs and other (2)
 
 
 
 
 
 
(15,584
)
 
—

 
(15,584
)
Amortization of intangible assets
 
 
 
 
 
 
(31,294
)
 
—

 
(31,294
)
Interest expense
 
 
 
 
 
 
(25,756
)
 
(2,920
)
 
(28,676
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
(19,845
)
 
441

 
(19,404
)
Income before income taxes
 
 
 
 
 
 
279,503

 
22,929

 
302,432

Income tax (expense) benefit
 
 
 
 
 
 
(28,397
)
 
—

 
(28,397
)
Net income
 
 
 
 
 
 
251,106

 
22,929

 
274,035

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 
—

 
(4,584
)
 
(4,584
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 
—

 
(16,324
)
 
(16,324
)
Net income available to Arch
 
 
 
 
 
 
251,106

 
2,021

 
253,127

Preferred dividends
 
 
 
 
 
 
(11,218
)
 
—

 
(11,218
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
239,888

 
$
2,021

 
$
241,909

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
65.8
%
 
43.1
%
 
11.9
%
 
46.9
%
 
70.0
%
 
49.5
%
Acquisition expense ratio
14.8
%
 
18.8
%
 
11.8
%
 
15.1
%
 
26.6
%
 
16.3
%
Other operating expense ratio
17.4
%
 
15.3
%
 
17.1
%
 
16.8
%
 
5.9
%
 
15.6
%
Combined ratio
98.0
%
 
77.2
%
 
40.8
%
 
78.8
%
 
102.5
%
 
81.4
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
24,371

 
$
773

 
$
717,521

 
$
742,665

 
$
7,650

 
$
750,315


(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(2)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’ See ‘Comments on Regulation G’ for a further discussion of the presentation of such items.



ARCH CAPITAL
 17
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6.    Reserve for Losses and Loss Adjustment Expenses
The following table represents an analysis of losses and loss adjustment expenses and a reconciliation of the beginning and ending reserve for losses and loss adjustment expenses:
 
Three Months Ended
 
March 31,
 
2018
 
2017
Reserve for losses and loss adjustment expenses at beginning of year
$
11,383,792

 
$
10,200,960

Unpaid losses and loss adjustment expenses recoverable
2,464,910

 
2,083,575

Net reserve for losses and loss adjustment expenses at beginning of year
8,918,882

 
8,117,385

 
 
 
 
Net incurred losses and loss adjustment expenses relating to losses occurring in:
 
 
 
Current year
687,885

 
635,776

Prior years
(51,025
)
 
(83,206
)
Total net incurred losses and loss adjustment expenses
636,860

 
552,570

 
 
 
 
Net foreign exchange losses
44,014

 
31,279

 
 
 
 
Net paid losses and loss adjustment expenses relating to losses occurring in:
 
 
 
Current year
(36,000
)
 
(35,003
)
Prior years
(514,541
)
 
(464,540
)
Total net paid losses and loss adjustment expenses
(550,541
)
 
(499,543
)
 
 
 
 
Net reserve for losses and loss adjustment expenses at end of period
9,049,215

 
8,201,691

Unpaid losses and loss adjustment expenses recoverable
2,446,990

 
2,095,130

Reserve for losses and loss adjustment expenses at end of period
$
11,496,205

 
$
10,296,821

Development on Prior Year Loss Reserves

2018 First Quarter

During the 2018 first quarter, the Company recorded net favorable development on prior year loss reserves of $51.0 million, which consisted of $36.5 million from the reinsurance segment, $2.1 million from the insurance segment, $13.0 million from the mortgage segment and adverse development of $0.6 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $36.5 million, or 13.1 points, for the 2018 first quarter consisted of $28.9 million from short-tailed lines and $7.6 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $21.1 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years (i.e., all premiums and losses attributable to contracts having an inception or renewal date within the given twelve-month period), reflecting lower levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed and medium-tailed lines reflected reductions in marine reserves of $6.2 million, primarily from the 2011 accident year, and in casualty reserves of $1.1 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2009 underwriting years.
 
The insurance segment’s net favorable development of $2.1 million, or 0.4 points, for the 2018 first quarter consisted of $8.7 million of net favorable development in short-tailed lines and $3.0 million of net favorable development in long-tailed lines, partially offset by $9.6 million of net adverse development in medium-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2017 accident year (i.e., the year in which a loss occurred) while net favorable development in long-tailed lines primarily resulted from reductions in casualty reserves of $3.9 million, primarily from the 2012 to 2014 accident years. Net adverse development in medium-tailed lines reflected $10.2 million of adverse development in program business, primarily driven by a few inactive programs that were non-renewed in 2015 and early in 2016.
The mortgage segment’s net favorable development was $13.0 million, or 4.6 points, for the 2018 first quarter. The 2018 first quarter development was primarily driven by continued lower than expected claim rates on first lien business and subrogation recoveries on second lien business.

ARCH CAPITAL
 18
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

2017 First Quarter
During the 2017 first quarter, the Company recorded net favorable development on prior year loss reserves of $83.2 million, which consisted of $57.2 million from the reinsurance segment, $2.1 million from the insurance segment, $23.6 million from the mortgage segment and $0.3 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $57.2 million, or 23.4 points, for the 2017 first quarter consisted of $40.8 million from short-tailed lines and $16.4 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $34.0 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years, reflecting lower levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed and medium-tailed lines reflected reductions in casualty reserves of $5.5 million based on varying levels of reported and paid claims activity, primarily from the 2003 to 2013 underwriting years, and favorable development in marine reserves of $9.9 million across most underwriting years.
The insurance segment’s net favorable development of $2.1 million, or 0.4 points, for the 2017 first quarter consisted of $7.0 million of net favorable development in long-tailed lines and $1.9 million of net favorable development in short-tailed lines, partially offset by $6.8 million of net adverse development in medium-tailed lines. Net favorable development in long-tailed lines reflected net reductions in executive assurance reserves from the 2008 to 2014 accident years. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2011 to 2016 accident years. Net adverse development in medium-tailed lines primarily resulted from an increase in programs, partially offset by favorable development of $7.5 million in other medium-tailed lines, primarily in professional liability and surety.
The mortgage segment’s net favorable development was $23.6 million, or 9.6 points, for the 2017 first quarter. The 2017 first quarter development was primarily driven by lower than expected claim rates on first lien business and subrogation recoveries on second lien business.


ARCH CAPITAL
 19
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

7.    Investment Information

At March 31, 2018, total investable assets of $22.28 billion included $19.79 billion held by the Company and $2.49 billion attributable to Watford Re.
Available For Sale Investments
The following table summarizes the fair value and cost or amortized cost of the Company’s securities classified as available for sale:
 
Estimated
Fair
Value
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Cost or
Amortized
Cost
 
OTTI
Unrealized
Losses (2)
March 31, 2018
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
Corporate bonds
$
5,405,695

 
$
12,379

 
$
(95,220
)
 
$
5,488,536

 
$
(73
)
Mortgage backed securities
339,662

 
1,751

 
(5,054
)
 
342,965

 
(15
)
Municipal bonds
1,553,616

 
7,906

 
(24,106
)
 
1,569,816

 
—

Commercial mortgage backed securities
561,543

 
1,106

 
(11,078
)
 
571,515

 
—

U.S. government and government agencies
3,060,805

 
5,622

 
(20,734
)
 
3,075,917

 
—

Non-U.S. government securities
1,656,859

 
44,821

 
(21,910
)
 
1,633,948

 
—

Asset backed securities
2,121,126

 
3,891

 
(17,812
)
 
2,135,047

 
—

Total
14,699,306

 
77,476

 
(195,914
)
 
14,817,744

 
(88
)
Equity securities (3)
 
 
 
 
 
 
 
 
 
Other investments
—

 
—

 
—

 
—

 
—

Short-term investments
967,389

 
1,851

 
(1,184
)
 
966,722

 
—

Total
$
15,666,695

 
$
79,327

 
$
(197,098
)
 
$
15,784,466

 
$
(88
)
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
Corporate bonds
$
4,434,439

 
$
30,943

 
$
(32,340
)
 
$
4,435,836

 
$
(73
)
Mortgage backed securities
316,141

 
1,640

 
(2,561
)
 
317,062

 
(15
)
Municipal bonds
2,158,840

 
20,285

 
(12,308
)
 
2,150,863

 
—

Commercial mortgage backed securities
545,817

 
2,131

 
(4,268
)
 
547,954

 
—

U.S. government and government agencies
3,484,257

 
2,188

 
(28,769
)
 
3,510,838

 
—

Non-U.S. government securities
1,612,754

 
48,764

 
(17,321
)
 
1,581,311

 
—

Asset backed securities
1,780,143

 
5,147

 
(8,614
)
 
1,783,610

 
—

Total
14,332,391

 
111,098

 
(106,181
)
 
14,327,474

 
(88
)
Equity securities
504,333

 
88,739

 
(5,583
)
 
421,177

 
—

Other investments
264,989

 
66,946

 
(120
)
 
198,163

 
—

Short-term investments
1,469,042

 
650

 
(563
)
 
1,468,955

 
—

Total
$
16,570,755

 
$
267,433

 
$
(112,447
)
 
$
16,415,769

 
$
(88
)
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See “—Securities Lending Agreements.”
(2)
Represents the total other-than-temporary impairments (“OTTI”) recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At March 31, 2018, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $0.3 million, compared to a net unrealized gain of $0.3 million at December 31, 2017.
(3)
Effective January 1, 2018, the Company adopted new accounting guidance for financial instruments (see Note 2). As a result, equity securities are no longer accounted for as available for sale and are excluded from this table.


ARCH CAPITAL
 20
2018 FIRST QUARTER FORM 10-Q
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarizes, for all available for sale securities in an unrealized loss position, the fair value and gross unrealized loss by length of time the security has been in a continual unrealized loss position:
 
Less than 12 Months
 
12 Months or More
 
Total
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
March 31, 2018