10-Q 1 a11-14025_110q.htm 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 June 30, 2011

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

Commission file number: 001-26456

ARCH CAPITAL GROUP LTD.

(Exact name of registrant as specified in its charter)

Bermuda

(State or other jurisdiction of incorporation or organization)

Not Applicable

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

Wessex House, 45 Reid Street

Hamilton HM 12, Bermuda

(Address of principal executive offices)

(441) 278-9250

(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer x		Accelerated filer o

Non-accelerated filer o		Smaller reporting company o

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

The number of the registrant’s common shares (par value, $0.0033 per share) outstanding as of August 1, 2011 was 133,244,445.

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ARCH CAPITAL GROUP LTD.

INDEX

	Page No.
*PART I. Financial Information*

Item 1 — Consolidated Financial Statements

Report of Independent Registered Public Accounting Firm	2

Consolidated Balance Sheets June 30, 2011 (unaudited) and December 31, 2010	3

Consolidated Statements of Income For the three and six month periods ended June 30, 2011 and 2010 (unaudited)	4

Consolidated Statements of Comprehensive Income For the six month periods ended June 30, 2011 and 2010 (unaudited)	5

Consolidated Statements of Changes in Shareholders’ Equity For the six month periods ended June 30, 2011 and 2010 (unaudited)	6

Consolidated Statements of Cash Flows For the six month periods ended June 30, 2011 and 2010 (unaudited)	7

Notes to Consolidated Financial Statements (unaudited)	8

Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations	29

Item 3 — Quantitative and Qualitative Disclosures About Market Risk	65

Item 4 — Controls and Procedures	65

*PART II. Other Information*

Item 1 — Legal Proceedings	66

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds	66

Item 5 — Other Information	67

Item 6 — Exhibits	67

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of
Arch Capital Group Ltd.:

We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of June 30, 2011, and the related consolidated statements of income for the three-month and six-month periods ended June 30, 2011 and June 30, 2010, and the consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2011 and June 30, 2010. These interim financial statements are the responsibility of the Company’s management.

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

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

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2010, 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, 2011, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of December 31, 2010, 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, NY

August 5, 2011

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

	(Unaudited)
	June 30,			December 31,
	2011			2010
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: $9,002,395 and $8,771,988)	$	9,247,002		$	8,957,859
Short-term investments available for sale, at fair value (amortized cost: $702,595 and $913,488)	704,495			915,841
Investment of funds received under securities lending, at fair value (amortized cost: $145,496 and $69,682)	145,224			69,660
Equity securities available for sale, at fair value (cost: $303,743 and $292,958)	320,434			310,194
Other investments available for sale, at fair value (cost: $270,342 and $252,590)	299,845			275,538
Investments accounted for using the fair value option	321,790			219,173
TALF investments, at fair value (amortized cost: $381,644 and $389,200)	399,341			402,449
Investments accounted for using the equity method	399,968			508,334
Total investments	11,838,099			11,659,048

Cash	411,001			362,740
Accrued investment income	71,083			74,837
Investment in joint venture (cost: $100,000)	105,982			105,698
Fixed maturities and short-term investments pledged under securities lending, at fair value	150,501			75,575
Premiums receivable	712,397			503,434
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	1,855,342			1,763,985
Prepaid reinsurance premiums	278,587			263,448
Deferred acquisition costs, net	310,616			277,861
Receivable for securities sold	733,931			56,145
Other assets	746,267			669,164
Total Assets	$	17,213,806		$	15,811,935

Liabilities
Reserve for losses and loss adjustment expenses	$	8,564,908		$	8,098,454
Unearned premiums	1,589,497			1,370,075
Reinsurance balances payable	154,860			132,452
Senior notes	300,000			300,000
Revolving credit agreement borrowings	100,000			100,000
TALF borrowings, at fair value (par: $318,596 and $326,219)	318,441			325,770
Securities lending payable	155,072			78,021
Payable for securities purchased	838,787			200,192
Other liabilities	750,972			693,968
Total Liabilities	12,772,537			11,298,932

Commitments and Contingencies

Shareholders’ Equity
Non-cumulative preferred shares - Series A and B	325,000			325,000
Common shares ($0.0033 par, shares issued: 162,363,488 and 160,073,616)	541			534
Additional paid-in capital	142,001			110,325
Retained earnings	4,533,729			4,422,553
Accumulated other comprehensive income, net of deferred income tax	263,584			204,503
Common shares held in treasury, at cost (shares: 29,591,964 and 20,441,391)	(823,586		)	(549,912		)
Total Shareholders’ Equity	4,441,269			4,513,003
Total Liabilities and Shareholders’ Equity	$	17,213,806		15,811,935

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

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

	(Unaudited)						(Unaudited)
	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
Revenues
Net premiums written	$	706,543		$	624,258		$	1,470,821		$	1,392,012
Change in unearned premiums	(63,664		)	(1,247		)	(194,247		)	(99,084		)
Net premiums earned	642,879			623,011			1,276,574			1,292,928
Net investment income	86,671			90,537			174,978			183,509
Net realized gains	45,210			62,114			65,905			109,896

Other-than-temporary impairment losses	(1,969		)	(4,718		)	(5,227		)	(7,054		)
Less investment impairments recognized in other comprehensive income, before taxes	285			308			863			1,038
Net impairment losses recognized in earnings	(1,684		)	(4,410		)	(4,364		)	(6,016		)

Fee income	784			883			1,599			1,677
Equity in net income (loss) of investment funds accounted for using the equity method	5,973			(348		)	35,646			28,702
Other income (loss)	(4,265		)	4,528			302			10,506
Total revenues	775,568			776,315			1,550,640			1,621,202

Expenses
Losses and loss adjustment expenses	431,622			363,145			925,502			791,196
Acquisition expenses	110,639			107,475			219,393			225,099
Other operating expenses	110,563			101,533			212,983			208,339
Interest expense	7,758			7,916			15,479			15,176
Net foreign exchange losses (gains)	18,375			(48,625		)	55,287			(87,226		)
Total expenses	678,957			531,444			1,428,644			1,152,584

Income before income taxes	96,611			244,871			121,996			468,618

Income tax (benefit) expense	(1,731		)	1,420			(2,102		)	8,173

Net income	98,342			243,451			124,098			460,445

Preferred dividends	6,461			6,461			12,922			12,922

Net income available to common shareholders	$	91,881		$	236,990		$	111,176		$	447,523

Net income per common share
Basic	$	0.70		$	1.55		$	0.84		$	2.87
Diluted	$	0.67		$	1.48		$	0.80		$	2.74

Weighted average common shares and common share equivalents outstanding
Basic	131,232,269			152,962,620			132,359,493			156,022,848
Diluted	137,975,599			159,795,909			139,234,931			163,160,070

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(U.S. dollars in thousands)

	(Unaudited)
	Six Months Ended
	June 30,
	2011			2010
Comprehensive Income
Net income	$	124,098		$	460,445
Other comprehensive income, net of deferred income tax
Unrealized appreciation in value of investments:
Unrealized holding gains arising during period	125,232			113,934
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(863		)	(1,038		)
Reclassification of net realized gains, net of income taxes, included in net income	(67,858		)	(70,218		)
Foreign currency translation adjustments	2,570			(7,973		)
Other comprehensive income	59,081			34,705
Comprehensive Income	$	183,179		$	495,150

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(U.S. dollars in thousands)

	(Unaudited)
	Six Months Ended
	June 30,
	2011			2010
Non-Cumulative Preferred Shares
Balance at beginning and end of period	$	325,000		$	325,000

Common Shares
Balance at beginning of year	534			548
Common shares issued, net	7			11
Purchases of common shares under share repurchase program	—			(30		)
Balance at end of period	541			529

Additional Paid-in Capital
Balance at beginning of year	110,325			253,466
Common shares issued	3,912			3,289
Exercise of stock options	6,372			24,664
Common shares retired	—			(217,562		)
Amortization of share-based compensation	19,505			19,376
Other	1,887			595
Balance at end of period	142,001			83,828

Retained Earnings
Balance at beginning of year	4,422,553			3,605,809
Dividends declared on preferred shares	(12,922		)	(12,922		)
Net income	124,098			460,445
Balance at end of period	4,533,729			4,053,332

Accumulated Other Comprehensive Income

Balance at beginning of year	204,503			138,526
Change in unrealized appreciation in value of investments, net of deferred income tax	57,374			43,716
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(863		)	(1,038		)
Foreign currency translation adjustments, net of deferred income tax	2,570			(7,973		)
Balance at end of period	263,584			173,231

Common Shares Held in Treasury, at Cost
Balance at beginning of year	(549,912		)	—
Shares repurchased for treasury	(273,674		)	(237,917		)
Balance at end of period	(823,586		)	(237,917		)

Total Shareholders’ Equity	$	4,441,269		$	4,398,003

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(U.S. dollars in thousands)

	(Unaudited)
	Six Months Ended
	June 30,
	2011			2010
Operating Activities
Net income	$	124,098		$	460,445
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized gains	(71,367		)	(111,889		)
Net impairment losses recognized in earnings	4,364			6,016
Equity in net income of investment funds accounted for using the equity method and other income	18,590			(18,380		)
Share-based compensation	19,505			19,376
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable	286,223			162,604
Unearned premiums, net of prepaid reinsurance premiums	194,123			96,881
Premiums receivable	(196,244		)	(136,851		)
Deferred acquisition costs, net	(30,261		)	(17,617		)
Reinsurance balances payable	15,987			(17,402		)
Other liabilities	6,753			(15,771		)
Other items, net	74,776			(37,275		)
Net Cash Provided By Operating Activities	446,547			390,137

Investing Activities
Purchases of:
Fixed maturity investments	(7,669,992		)	(9,483,319		)
Equity securities	(248,947		)	(74,010		)
Other investments	(207,365		)	(283,450		)
Proceeds from the sales of:
Fixed maturity investments	7,622,120			9,111,774
Equity securities	199,650			36,768
Other investments	201,680			177,046
Proceeds from redemptions and maturities of fixed maturity investments	537,410			456,937
Net purchases of short-term investments	(544,295		)	(6,682		)
Change in investment of securities lending collateral	(77,051		)	(680		)
Purchases of furniture, equipment and other assets	(12,348		)	(7,860		)
Net Cash Used By Investing Activities	(199,138		)	(73,476		)

Financing Activities
Purchases of common shares under share repurchase program	(266,725		)	(450,326		)
Proceeds from common shares issued, net	1,478			14,370
Proceeds from borrowings	—			264,526
Repayments of borrowings	(7,614		)	(120,339		)
Change in securities lending collateral	77,051			680
Other	3,181			7,357
Preferred dividends paid	(12,922		)	(12,922		)
Net Cash Used For Financing Activities	(205,551		)	(296,654		)

Effects of exchange rate changes on foreign currency cash	6,403			(13,109		)

Increase in cash	48,261			6,898
Cash beginning of year	362,740			334,571
Cash end of period	$	411,001		$	341,469

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. General

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

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

Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, including the Company’s audited consolidated financial statements and related notes.

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

2. Recent Accounting Pronouncements

In October 2010, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standards Update (“ASU”) that modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new or renewal insurance contracts. The amended guidance specifies that certain costs incurred in the successful acquisition of new and renewal insurance contracts should be capitalized. Those costs include incremental direct costs of contract acquisition that result directly from and are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. All other acquisition-related costs, such as costs incurred for soliciting business, administration, and unsuccessful acquisition or renewal efforts should be charged to expense as incurred. Administrative costs, including rent, depreciation, occupancy, equipment, and all other general overhead costs are considered indirect costs and should also be charged to expense as incurred. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. Earlier adoption is permitted. Retrospective application to all prior periods presented upon the date of adoption is also permitted but is not required. The Company is evaluating the impact this new guidance will have on its consolidated statement of financial position and results of operations.

In May 2011, the FASB issued an ASU that provides clarification or changes to existing fair value measurement and disclosure requirements, including, for example, additional disclosure for fair value measurements categorized within Level 3 of the fair value hierarchy. This ASU is effective for interim and annual periods beginning after December 15, 2011 and is to be applied prospectively. Early application is not permitted. The Company is evaluating the impact the new guidance will have on its consolidated financial statements.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

In June 2011, the FASB issued an ASU that is intended to increase the prominence of other comprehensive income in the financial statements by allowing only two options for reporting comprehensive income: (1) A single statement that presents the components of net income and total net income, the components of other comprehensive income and total other comprehensive income, and a total for comprehensive income or (2) in a two-statement approach that presents the components of net income and total net income in the first statement. That statement must be immediately followed by a financial statement that presents the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. This ASU is effective for interim and annual periods beginning after December 15, 2011 and should be applied retrospectively. Early adoption is permitted. The Company is evaluating the impact the new guidance will have on its consolidated financial statements.

3. Share Transactions

Three-for-One Share Split

In May 2011, shareholders approved a proposal to amend the memorandum of association by sub-dividing the authorized common shares of ACGL to effect a three-for-one split of ACGL’s common shares. The share split changed the Company’s authorized common shares to 600 million common shares (200 million previously) with a par value of $0.0033 per share ($0.01 previously). Information pertaining to the composition of the Company’s shareholders’ equity accounts, shares and earnings per share has been retroactively adjusted in the accompanying financial statements and notes to the consolidated financial statements to reflect the share split.

Share Repurchases

The board of directors of ACGL has authorized the investment in ACGL’s common shares through a share repurchase program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through December 2012. Since the inception of the share repurchase program, ACGL has repurchased approximately 104.1 million common shares for an aggregate purchase price of $2.54 billion. During the 2011 second quarter, ACGL repurchased 0.9 million common shares for an aggregate purchase price of $29.6 million, compared to 10.9 million common shares for an aggregate purchase price of $269.1 million during the 2010 second quarter. For the six months ended June 30, 2011, ACGL repurchased 8.9 million common shares for an aggregate purchase price of $266.7 million, compared to 18.5 million common shares for an aggregate purchase price of $450.3 million for the 2010 period.

At June 30, 2011, $962.8 million of share repurchases were available under the program. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations.

Share-Based Compensation

During the 2011 second quarter, the Company made a stock grant of 697,632 stock appreciation rights and stock options and 727,641 restricted shares and units to certain employees and directors. The weighted average grant-date fair value of the stock appreciation rights and options and restricted shares and units granted during the 2011 second quarter were approximately $9.75 and $33.91 per share, respectively. During the 2010 second quarter, the Company made a stock grant of 865,257 stock appreciation rights and stock options and 895,965 restricted shares and units to certain employees. The weighted average grant-date fair value of the stock appreciation rights and options and restricted shares and units granted during the 2010 second quarter were approximately $7.66 and $25.01 per share, respectively. The stock appreciation rights and stock options were valued at the grant date using the Black-Scholes option pricing model. Such values are being amortized over the respective substantive vesting period. For awards granted to retirement-eligible employees where no service is required for the employee to retain the award, the grant date fair value is immediately recognized as

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

compensation expense at the grant date because the employee is able to retain the award without continuing to provide service. For employees near retirement eligibility, attribution of compensation cost is over the period from the grant date to the retirement eligibility date.

4. Commitments and Contingencies

Letter of Credit and Revolving Credit Facilities

As of June 30, 2011, the Company had a $300 million unsecured revolving loan and letter of credit facility and a $1.0 billion secured letter of credit facility (the “Credit Agreement”). The Company was in compliance with all covenants contained in the Credit Agreement at June 30, 2011. The Credit Agreement expires on August 30, 2011. In addition, the Company had access to secured letter of credit facilities of approximately $180 million as of June 30, 2011, which were primarily used to support the Company’s syndicate at Lloyd’s of London, and to other secured letter of credit facilities, some of which are available on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the “LOC Facilities”). The Company was in compliance with all covenants contained in the LOC Facilities at June 30, 2011. At June 30, 2011, the Company had $629.0 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $714.6 million, and had $100.0 million of borrowings outstanding under the Credit Agreement.

Dividends for Preferred Shares

On May 6, 2011, the Company’s board of directors declared dividends with respect to the $200.0 million principal amount of 8.0% series A non-cumulative preferred shares outstanding and $125.0 million principal amount of 7.875% series B non-cumulative preferred shares outstanding (together, “Preferred Shares”). All such dividends will be payable out of lawfully available funds for the payment of dividends under Bermuda law on August 15, 2011 to holders of record of the Preferred Shares as of August 1, 2011, unless determined otherwise by the board of directors or the executive committee of the board of directors on or prior to the applicable effective date. At June 30, 2011, the Company had declared an aggregate of $3.3 million of dividends to be paid to the holders of the Preferred Shares.

Investment Commitments

The Company’s investment commitments, which are primarily related to investment funds accounted for using the equity method, were approximately $158.2 million at June 30, 2011.

5. Segment Information

The Company classifies its businesses into two underwriting segments — insurance and reinsurance — and corporate and other (non-underwriting). Management measures segment performance based on underwriting income or loss. The Company does not manage its assets by segment and, accordingly, investment income is not allocated to each underwriting segment. In addition, other revenue and expense items are not evaluated by segment.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table summarizes the Company’s underwriting income or loss by segment, together with a reconciliation of underwriting income or loss to net income available to common shareholders, for the 2011 second quarter and 2010 second quarter:

	Three Months Ended									Three Months Ended
	June 30, 2011									June 30, 2010
	Insurance			Reinsurance			Total			Insurance			Reinsurance			Total

Gross premiums written (1)	$	635,005		$	277,766		$	911,939		$	616,353		$	203,695		$	817,100
Net premiums written	438,263			268,280			706,543			422,837			201,421			624,258

Net premiums earned	$	410,819		$	232,060		$	642,879		$	405,473		$	217,538		$	623,011
Fee income	702			82			784			874			9			883
Losses and loss adjustment expenses	(301,642		)	(129,980		)	(431,622		)	(275,294		)	(87,851		)	(363,145		)
Acquisition expenses, net	(66,543		)	(44,096		)	(110,639		)	(65,359		)	(42,116		)	(107,475		)
Other operating expenses	(76,765		)	(22,401		)	(99,166		)	(71,727		)	(19,303		)	(91,030		)
Underwriting income (loss)	$	(33,429	)	$	35,665		2,236			$	(6,033	)	$	68,277		62,244

Net investment income							86,671									90,537
Net realized gains							45,210									62,114
Net impairment losses recognized in earnings							(1,684		)							(4,410		)
Equity in net income (loss) of investment funds accounted for using the equity method							5,973									(348		)
Other income (loss)							(4,265		)							4,528
Other expenses							(11,397		)							(10,503		)
Interest expense							(7,758		)							(7,916		)
Net foreign exchange gains (losses)							(18,375		)							48,625
Income before income taxes							96,611									244,871
Income tax benefit (expense)							1,731									(1,420		)

Net income							98,342									243,451
Preferred dividends							(6,461		)							(6,461		)
Net income available to common shareholders							$	91,881								$	236,990

Underwriting Ratios
Loss ratio	73.4		%	56.0		%	67.1		%	67.9		%	40.4		%	58.3		%
Acquisition expense ratio (2)	16.0		%	19.0		%	17.1		%	15.9		%	19.4		%	17.1		%
Other operating expense ratio	18.7		%	9.7		%	15.4		%	17.7		%	8.9		%	14.6		%
Combined ratio	108.1		%	84.7		%	99.6		%	101.5		%	68.7		%	90.0		%

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

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

	Six Months Ended									Six Months Ended
	June 30, 2011									June 30, 2010
	Insurance			Reinsurance			Total			Insurance			Reinsurance			Total

Gross premiums written (1)	$	1,269,588		$	608,779		$	1,876,505		$	1,249,929		$	527,172		$	1,770,787
Net premiums written	887,554			583,267			1,470,821			875,761			516,251			1,392,012

Net premiums earned	$	818,410		$	458,164		$	1,276,574		$	834,950		$	457,978		$	1,292,928
Fee income	1,480			119			1,599			1,627			50			1,677
Losses and loss adjustment expenses	(599,365		)	(326,137		)	(925,502		)	(587,305		)	(203,891		)	(791,196		)
Acquisition expenses, net	(127,958		)	(91,435		)	(219,393		)	(132,790		)	(92,309		)	(225,099		)
Other operating expenses	(151,502		)	(43,058		)	(194,560		)	(152,447		)	(39,701		)	(192,148		)
Underwriting income (loss)	$	(58,935	)	$	(2,347	)	(61,282		)	$	(35,965	)	$	122,127		86,162

Net investment income							174,978									183,509
Net realized gains							65,905									109,896
Net impairment losses recognized in earnings							(4,364		)							(6,016		)
Equity in net income of investment funds accounted for using the equity method							35,646									28,702
Other income							302									10,506
Other expenses							(18,423		)							(16,191		)
Interest expense							(15,479		)							(15,176		)
Net foreign exchange gains (losses)							(55,287		)							87,226
Income before income taxes							121,996									468,618
Income tax benefit (expense)							2,102									(8,173		)

Net income							124,098									460,445
Preferred dividends							(12,922		)							(12,922		)
Net income available to common shareholders							$	111,176								$	447,523

Underwriting Ratios
Loss ratio	73.2		%	71.2		%	72.5		%	70.3		%	44.5		%	61.2		%
Acquisition expense ratio (2)	15.5		%	20.0		%	17.1		%	15.7		%	20.2		%	17.3		%
Other operating expense ratio	18.5		%	9.4		%	15.2		%	18.3		%	8.7		%	14.9		%
Combined ratio	107.2		%	100.6		%	104.8		%	104.3		%	73.4		%	93.4		%

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6. Investment Information

Available For Sale Securities

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

	Estimated		Gross		Gross			Cost or		OTTI
	Fair		Unrealized		Unrealized			Amortized		Unrealized
	Value		Gains		Losses			Cost		Losses (2)

At June 30, 2011
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,847,018	$	107,792	$	(8,879	)	$	2,748,105	$	(17,680	)
Mortgage backed securities	1,540,523		19,167		(18,015		)	1,539,371		(19,204		)
Municipal bonds	1,141,706		51,558		(1,757		)	1,091,905		(125		)
Commercial mortgage backed securities	1,190,058		27,321		(3,421		)	1,166,158		(3,453		)
U.S. government and government agencies	1,166,222		16,925		(6,033		)	1,155,330		(207		)
Non-U.S. government securities	775,380		45,346		(6,742		)	736,776		(72		)
Asset backed securities	736,596		26,023		(2,457		)	713,030		(3,927		)
Total	9,397,503		294,132		(47,304		)	9,150,675		(44,668		)

Equity securities	320,434		25,387		(8,696		)	303,743		—
Other investments	299,845		30,415		(912		)	270,342		—
Short-term investments	704,495		2,251		(351		)	702,595		—
Total	$	10,722,277	$	352,185	$	(57,263	)	$	10,427,355	$	(44,668	)

At December 31, 2010
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,714,375	$	97,400	$	(18,343	)	$	2,635,318	$	(18,047	)
Mortgage backed securities	1,806,813		18,801		(26,893		)	1,814,905		(21,147		)
Municipal bonds	1,182,100		40,410		(6,958		)	1,148,648		(125		)
Commercial mortgage backed securities	1,167,299		31,743		(6,028		)	1,141,584		(3,481		)
U.S. government and government agencies	872,149		20,150		(5,696		)	857,695		(207		)
Non-U.S. government securities	732,666		39,539		(11,894		)	705,021		(72		)
Asset backed securities	558,032		20,672		(3,990		)	541,350		(3,954		)
Total	9,033,434		268,715		(79,802		)	8,844,521		(47,033		)

Equity securities	310,194		20,660		(3,424		)	292,958		—
Other investments	275,538		24,280		(1,332		)	252,590		—
Short-term investments	915,841		2,845		(492		)	913,488		—
Total	$	10,535,007	$	316,500	$	(85,050	)	$	10,303,557	$	(47,033	)

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

(2) Represents the total other-than-temporary impairments (“OTTI”) recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At June 30, 2011, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $0.5 million, compared to a net unrealized loss of $7.1 million at December 31, 2010.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

	Less than 12 Months					12 Months or More					Total
	Estimated		Gross			Estimated		Gross			Estimated		Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses

At June 30, 2011
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	502,806	$	(7,537	)	$	27,144	$	(1,342	)	$	529,950	$	(8,879	)
Mortgage backed securities	429,033		(10,002		)	45,886		(8,013		)	474,919		(18,015		)
Municipal bonds	176,280		(1,695		)	1,065		(62		)	177,345		(1,757		)
Commercial mortgage backed securities	284,888		(2,818		)	9,123		(603		)	294,011		(3,421		)
U.S. government and government agencies	661,493		(6,033		)	—		—			661,493		(6,033		)
Non-U.S. government securities	251,687		(6,000		)	22,373		(742		)	274,060		(6,742		)
Asset backed securities	117,233		(863		)	11,055		(1,594		)	128,288		(2,457		)
Total	2,423,420		(34,948		)	116,646		(12,356		)	2,540,066		(47,304		)
Equity securities	120,546		(8,696		)	—		—			120,546		(8,696		)
Other investments	45,802		(912		)	—		—			45,802		(912		)
Short-term investments	30,046		(351		)	—		—			30,046		(351		)
Total	$	2,619,814	$	(44,907	)	$	116,646	$	(12,356	)	$	2,736,460	$	(57,263	)

At December 31, 2010
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	530,956	$	(16,580	)	$	20,351	$	(1,763	)	$	551,307	$	(18,343	)
Mortgage backed securities	913,138		(20,331		)	57,895		(6,562		)	971,033		(26,893		)
Municipal bonds	294,978		(6,440		)	8,465		(518		)	303,443		(6,958		)
Commercial mortgage backed securities	311,703		(5,273		)	22,030		(755		)	333,733		(6,028		)
U.S. government and government agencies	190,497		(5,696		)	—		—			190,497		(5,696		)
Non-U.S. government securities	271,446		(7,418		)	45,884		(4,476		)	317,330		(11,894		)
Asset backed securities	75,655		(827		)	8,126		(3,163		)	83,781		(3,990		)
Total	2,588,373		(62,565		)	162,751		(17,237		)	2,751,124		(79,802		)
Equity securities	68,629		(3,424		)	—		—			68,629		(3,424		)
Other investments	46,750		(916		)	2,850		(416		)	49,600		(1,332		)
Short-term investments	42,030		(492		)	—		—			42,030		(492		)
Total	$	2,745,782	$	(67,397	)	$	165,601	$	(17,653	)	$	2,911,383	$	(85,050	)

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

At June 30, 2011, on a lot level basis, approximately 1,230 security lots out of a total of approximately 4,490 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $1.4 million. At December 31, 2010, on a lot level basis, approximately 1,130 security lots out of a total of approximately 4,360 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $2.6 million.

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

	June 30, 2011				December 31, 2010
	Estimated		Amortized		Estimated		Amortized
Maturity	Fair Value		Cost		Fair Value		Cost

Due in one year or less	$	435,294	$	412,582	$	414,390	$	398,795
Due after one year through five years	3,135,468		3,023,360		2,924,879		2,833,955
Due after five years through 10 years	2,058,035		2,002,934		1,719,446		1,671,306
Due after 10 years	301,529		293,240		442,575		442,626
	5,930,326		5,732,116		5,501,290		5,346,682
Mortgage backed securities	1,540,523		1,539,371		1,806,813		1,814,905
Commercial mortgage backed securities	1,190,058		1,166,158		1,167,299		1,141,584
Asset backed securities	736,596		713,030		558,032		541,350
Total	$	9,397,503	$	9,150,675	$	9,033,434	$	8,844,521

Securities Lending Agreements

The Company operates a securities lending program under which certain of its fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. The Company maintains legal control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. At June 30, 2011, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $150.5 million and $148.3 million, respectively, compared to $75.6 million and $72.5 million at December 31, 2010, respectively. At June 30, 2011, the portfolio of collateral backing the Company’s securities lending program included approximately $9.5 million fair value of sub-prime securities with an average credit quality of “CCC” from Standard & Poor’s and “Caa3” from Moody’s, compared to $13.2 million with an average credit quality of “B-” from Standard & Poor’s and “Caa2” from Moody’s at December 31, 2010.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Fair Value Option

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

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

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

	June 30,			December 31,
	2011			2010

Fixed maturities	$	102,897		$	124,969
Equity securities	152,844			94,204
Other investments (par: $66,480 and $0)	66,049			—
Investments accounted for using the fair value option	321,790			219,173
Securities sold but not yet purchased (1)	(51,626		)	(41,143		)
TALF investments	399,341			402,449
TALF borrowings	(318,441		)	(325,770		)
Net assets accounted for using the fair value option	$	351,064		$	254,709

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Net Investment Income

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

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010

Fixed maturities	$	84,420		$	94,181		$	169,564		$	191,842
Equity securities	1,844			80			3,391			290
Short-term investments	505			256			1,183			485
Other (1)	6,307			846			13,361			1,122
Gross investment income	93,076			95,363			187,499			193,739
Investment expenses	(6,405		)	(4,826		)	(12,521		)	(10,230		)
Net investment income	$	86,671		$	90,537		$	174,978		$	183,509

(1) Includes interest on term loan investments (included in “investments accounted for using the fair value option”), dividends on investment funds and other items.

Net Realized Gains (Losses)

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

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010

Available for sale securities:
Gross gains on investment sales	$	71,578		$	63,619		$	143,295		$	120,010
Gross losses on investment sales	(15,917		)	(21,169		)	(63,667		)	(41,463		)
Change in fair value of assets and liabilities accounted for using the fair value option:
Fixed maturities	(8,483		)	(7,420		)	(8,393		)	(8,697		)
Equity securities	(6,484		)	(4,630		)	(3,050		)	(5,291		)
Other investments	196			—			323			—
TALF investments	2,795			4,320			4,447			7,897
TALF borrowings	(138		)	1,512			(285		)	540
Derivative instruments (1)	3,176			28,135			(8,144		)	35,552
Other	(1,513		)	(2,253		)	1,379			1,348
Net realized gains	$	45,210		$	62,114		$