10-Q 1 a11-25791_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 September 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 November 1, 2011 was 134,188,052.

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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
September 30, 2011 (unaudited) and December 31, 2010	3

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

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

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

Consolidated Statements of Cash Flows
For the nine month periods ended September 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	68

Item 4 — Controls and Procedures	68

*PART II. Other Information*

Item 1 — Legal Proceedings	69

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds	69

Item 5 — Other Information	69

Item 6 — Exhibits	70

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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 September 30, 2011, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2011 and September 30, 2010, and the consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the nine-month periods ended September 30, 2011 and September 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

November 8, 2011

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

	(Unaudited)
	September 30,			December 31,
	2011			2010
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: $9,304,357 and $8,771,988)	$	9,529,834		$	8,957,859
Short-term investments available for sale, at fair value (amortized cost: $807,872 and $913,488)	799,662			915,841
Investment of funds received under securities lending, at fair value (amortized cost: $44,695 and $69,682)	44,553			69,660
Equity securities available for sale, at fair value (cost: $300,335 and $292,958)	273,213			310,194
Other investments available for sale, at fair value (cost: $226,089 and $252,590)	229,974			275,538
Investments accounted for using the fair value option	319,381			219,173
TALF investments, at fair value (amortized cost: $376,889 and $389,200)	392,455			402,449
Investments accounted for using the equity method	383,543			508,334
Total investments	11,972,615			11,659,048

Cash	369,895			362,740
Accrued investment income	71,264			74,837
Investment in joint venture (cost: $100,000)	107,642			105,698
Fixed maturities and short-term investments pledged under securities lending, at fair value	72,399			75,575
Securities purchased under agreements to resell using funds received under securities lending	20,032			—
Premiums receivable	606,963			503,434
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	1,840,191			1,763,985
Prepaid reinsurance premiums	267,846			263,448
Deferred acquisition costs, net	306,810			277,861
Receivable for securities sold	1,067,188			56,145
Other assets	727,183			669,164
Total Assets	$	17,430,028		$	15,811,935

Liabilities
Reserve for losses and loss adjustment expenses	$	8,523,522		$	8,098,454
Unearned premiums	1,578,419			1,370,075
Reinsurance balances payable	123,815			132,452
Senior notes	300,000			300,000
Revolving credit agreement borrowings	100,000			100,000
TALF borrowings, at fair value (par: $314,371 and $326,219)	314,137			325,770
Securities lending payable	74,696			78,021
Payable for securities purchased	1,161,591			200,192
Other liabilities	779,477			693,968
Total Liabilities	12,955,657			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: 163,267,317 and 160,073,616)	544			534
Additional paid-in capital	150,882			110,325
Retained earnings	4,696,256			4,422,553
Accumulated other comprehensive income, net of deferred income tax	146,576			204,503
Common shares held in treasury, at cost (shares: 30,261,852 and 20,441,391)	(844,887		)	(549,912		)
Total Shareholders’ Equity	4,474,371			4,513,003
Total Liabilities and Shareholders’ Equity	$	17,430,028		$	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						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
Revenues
Net premiums written	$	691,381		$	636,117		$	2,162,202		$	2,028,129
Change in unearned premiums	(9,332		)	(8,708		)	(203,579		)	(107,792		)
Net premiums earned	682,049			627,409			1,958,623			1,920,337
Net investment income	82,753			90,768			257,731			274,277
Net realized gains	30,199			68,828			96,104			178,724

Other-than-temporary impairment losses	(5,180		)	(2,679		)	(10,406		)	(9,732		)
Less investment impairments recognized in other comprehensive income, before taxes	2,441			604			3,303			1,641
Net impairment losses recognized in earnings	(2,739		)	(2,075		)	(7,103		)	(8,091		)

Fee income	848			874			2,447			2,551
Equity in net income (loss) of investment funds accounted for using the equity method	(30,549		)	9,708			5,097			38,410
Other income	2,432			1,840			2,734			12,346
Total revenues	764,993			797,352			2,315,633			2,418,554

Expenses
Losses and loss adjustment expenses	423,984			359,193			1,349,486			1,150,389
Acquisition expenses	120,205			111,279			339,598			336,378
Other operating expenses	105,998			103,121			318,981			311,460
Interest expense	8,125			7,371			23,604			22,547
Net foreign exchange losses (gains)	(60,040		)	65,157			(4,753		)	(22,069		)
Total expenses	598,272			646,121			2,026,916			1,798,705

Income before income taxes	166,721			151,231			288,717			619,849

Income tax (benefit) expense	(2,267		)	3,200			(4,369		)	11,373

Net income	168,988			148,031			293,086			608,476

Preferred dividends	6,461			6,461			19,383			19,383

Net income available to common shareholders	$	162,527		$	141,570		$	273,703		$	589,093

Net income per common share
Basic	$	1.24		$	0.96		$	2.07		$	3.85
Diluted	$	1.19		$	0.92		$	1.98		$	3.68

Weighted average common shares and common share equivalents outstanding
Basic	131,560,851			146,993,373			132,090,354			152,979,948
Diluted	137,140,929			153,546,027			138,542,558			159,951,594

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)
	Nine Months Ended
	September 30,
	2011			2010
Comprehensive Income
Net income	$	293,086		$	608,476
Other comprehensive income, net of deferred income tax
Unrealized appreciation in value of investments:
Unrealized holding gains arising during period	53,371			378,543
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(3,303		)	(1,641		)
Reclassification of net realized gains, net of income taxes, included in net income	(98,565		)	(126,517		)
Foreign currency translation adjustments	(9,430		)	(541		)
Other comprehensive income (loss)	(57,927		)	249,844
Comprehensive Income	$	235,159		$	858,320

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)
	Nine Months Ended
	September 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	10			13
Purchases of common shares under share repurchase program	—			(30		)
Balance at end of period	544			531

Additional Paid-in Capital
Balance at beginning of year	110,325			253,466
Common shares issued	3,910			3,572
Exercise of stock options	9,379			35,150
Common shares retired	—			(217,562		)
Amortization of share-based compensation	25,286			25,450
Other	1,982			564
Balance at end of period	150,882			100,640

Retained Earnings
Balance at beginning of year	4,422,553			3,605,809
Dividends declared on preferred shares	(19,383		)	(19,383		)
Net income	293,086			608,476
Balance at end of period	4,696,256			4,194,902

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	(45,194		)	252,026
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(3,303		)	(1,641		)
Foreign currency translation adjustments, net of deferred income tax	(9,430		)	(541		)
Balance at end of period	146,576			388,370

Common Shares Held in Treasury, at Cost
Balance at beginning of year	(549,912		)	—
Shares repurchased for treasury	(294,975		)	(291,533		)
Balance at end of period	(844,887		)	(291,533		)

Total Shareholders’ Equity	$	4,474,371		$	4,717,910

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)
	Nine Months Ended
	September 30,
	2011			2010
Operating Activities
Net income	$	293,086		$	608,476
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized gains	(100,982		)	(184,423		)
Net impairment losses recognized in earnings	7,103			8,091
Equity in net income of investment funds accounted for using the equity method and other income	50,324			(29,925		)
Share-based compensation	25,286			25,450
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable	334,620			212,024
Unearned premiums, net of prepaid reinsurance premiums	204,042			105,905
Premiums receivable	(114,044		)	(73,654		)
Deferred acquisition costs, net	(29,146		)	(17,570		)
Reinsurance balances payable	(3,381		)	(22,255		)
Other liabilities	12,678			8,143
Other items, net	76,885			17,299
Net Cash Provided By Operating Activities	756,471			657,561

Investing Activities
Purchases of:
Fixed maturity investments	(10,116,781		)	(14,501,938		)
Equity securities	(343,062		)	(139,165		)
Other investments	(373,814		)	(376,405		)
Proceeds from the sales of:
Fixed maturity investments	8,855,624			13,984,442
Equity securities	311,117			55,919
Other investments	396,514			245,889
Proceeds from redemptions and maturities of fixed maturity investments	738,081			683,826
Net (purchases) sales of short-term investments	112,465			(212,093		)
Change in investment of securities lending collateral	3,325			9,705
Purchases of furniture, equipment and other assets	(15,526		)	(10,111		)
Net Cash Used By Investing Activities	(432,057		)	(259,931		)

Financing Activities
Purchases of common shares under share repurchase program	(287,558		)	(503,724		)
Proceeds from common shares issued, net	3,087			22,956
Proceeds from borrowings	—			264,526
Repayments of borrowings	(11,839		)	(125,985		)
Change in securities lending collateral	(3,325		)	(9,705		)
Other	3,999			8,950
Preferred dividends paid	(19,383		)	(19,383		)
Net Cash Used For Financing Activities	(315,019		)	(362,365		)

Effects of exchange rate changes on foreign currency cash	(2,240		)	(3,839		)

Increase in cash	7,155			31,426
Cash beginning of year	362,740			334,571
Cash end of period	$	369,895		$	365,997

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 with earlier adoption permitted. Retrospective application to all prior periods presented upon the date of adoption is also permitted but is not required. The Company plans to adopt this ASU on January 1, 2012 using a retrospective application and, based on a preliminary analysis, does not expect the adoption of the ASU to have a material impact on its consolidated financial statements. In applying the retrospective application, deferred policy acquisition costs and related deferred taxes will be reduced as of the beginning of the earliest period presented in the financial statements with a corresponding reduction to shareholders’ equity.

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

permitted. The Company is evaluating the impact the new guidance will have on its consolidated financial statements.

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 does not believe that the adoption of this ASU will impact the presentation of 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 104.8 million common shares for an aggregate purchase price of $2.56 billion. During the 2011 third quarter, ACGL repurchased 0.7 million common shares for an aggregate purchase price of $20.8 million, compared to 2.0 million common shares for an aggregate purchase price of $53.4 million during the 2010 third quarter. For the nine months ended September 30, 2011, ACGL repurchased 9.6 million common shares for an aggregate purchase price of $287.6 million, compared to 20.6 million common shares for an aggregate purchase price of $503.7 million for the 2010 period.

At September 30, 2011, $942.0 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.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

4. Commitments and Contingencies

Letter of Credit and Revolving Credit Facilities

As of September 30, 2011, the Company had a $300 million unsecured revolving loan and letter of credit facility and a $500 million secured letter of credit facility (the “Credit Agreement”). The Company was in compliance with all covenants contained in the Credit Agreement at September 30, 2011. The Credit Agreement expires on August 18, 2014. In addition, the Company had access to secured letter of credit facilities of approximately $180 million as of September 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 September 30, 2011. At September 30, 2011, the Company had $621.5 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $644.2 million, and had $100.0 million of borrowings outstanding under the Credit Agreement.

Dividends for Preferred Shares

On September 8, 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 November 15, 2011 to holders of record of the Preferred Shares as of November 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 September 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 and other investments, were approximately $229.6 million at September 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 third quarter and 2010 third quarter:

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

Gross premiums written (1)	$	634,280		$	227,837		$	860,289		$	624,490		$	208,770		$	831,788
Net premiums written	472,986			218,395			691,381			431,361			204,756			636,117
Net premiums earned	$	437,970		$	244,079		$	682,049		$	411,881		$	215,528		$	627,409
Fee income	661			187			848			864			10			874
Losses and loss adjustment expenses	(290,608		)	(133,376		)	(423,984		)	(265,411		)	(93,782		)	(359,193		)
Acquisition expenses, net	(76,763		)	(43,442		)	(120,205		)	(67,309		)	(43,970		)	(111,279		)
Other operating expenses	(77,078		)	(22,740		)	(99,818		)	(77,078		)	(20,247		)	(97,325		)
Underwriting income (loss)	$	(5,818	)	$	44,708		38,890			$	2,947		$	57,539		60,486

Net investment income							82,753									90,768
Net realized gains							30,199									68,828
Net impairment losses recognized in earnings							(2,739		)							(2,075		)
Equity in net income (loss) of investment funds accounted for using the equity method							(30,549		)							9,708
Other income							2,432									1,840
Other expenses							(6,180		)							(5,796		)
Interest expense							(8,125		)							(7,371		)
Net foreign exchange gains (losses)							60,040									(65,157		)
Income before income taxes							166,721									151,231
Income tax benefit (expense)							2,267									(3,200		)

Net income							168,988									148,031
Preferred dividends							(6,461		)							(6,461		)
Net income available to common shareholders							$	162,527								$	141,570

Underwriting Ratios
Loss ratio	66.4		%	54.6		%	62.2		%	64.4		%	43.5		%	57.3		%
Acquisition expense ratio (2)	17.4		%	17.8		%	17.5		%	16.1		%	20.4		%	17.6		%
Other operating expense ratio	17.6		%	9.3		%	14.6		%	18.7		%	9.4		%	15.5		%
Combined ratio	101.4		%	81.7		%	94.3		%	99.2		%	73.3		%	90.4		%

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

	Nine Months Ended									Nine Months Ended
	September 30, 2011									September 30, 2010
	Insurance			Reinsurance			Total			Insurance			Reinsurance			Total

Gross premiums written (1)	$	1,903,868		$	836,616		$	2,736,794		$	1,874,419		$	735,942		$	2,602,575
Net premiums written	1,360,540			801,662			2,162,202			1,307,122			721,007			2,028,129
Net premiums earned	$	1,256,380		$	702,243		$	1,958,623		$	1,246,831		$	673,506		$	1,920,337
Fee income	2,141			306			2,447			2,491			60			2,551
Losses and loss adjustment expenses	(889,973		)	(459,513		)	(1,349,486		)	(852,716		)	(297,673		)	(1,150,389		)
Acquisition expenses, net	(204,721		)	(134,877		)	(339,598		)	(200,099		)	(136,279		)	(336,378		)
Other operating expenses	(228,580		)	(65,798		)	(294,378		)	(229,525		)	(59,948		)	(289,473		)
Underwriting income (loss)	$	(64,753	)	$	42,361		(22,392		)	$	(33,018	)	$	179,666		146,648

Net investment income							257,731									274,277
Net realized gains							96,104									178,724
Net impairment losses recognized in earnings							(7,103		)							(8,091		)
Equity in net income of investment funds accounted for using the equity method							5,097									38,410
Other income							2,734									12,346
Other expenses							(24,603		)							(21,987		)
Interest expense							(23,604		)							(22,547		)
Net foreign exchange gains							4,753									22,069
Income before income taxes							288,717									619,849
Income tax benefit (expense)							4,369									(11,373		)

Net income							293,086									608,476
Preferred dividends							(19,383		)							(19,383		)
Net income available to common shareholders							$	273,703								$	589,093

Underwriting Ratios
Loss ratio	70.8		%	65.4		%	68.9		%	68.4		%	44.2		%	59.9		%
Acquisition expense ratio (2)	16.1		%	19.2		%	17.2		%	15.8		%	20.2		%	17.4		%
Other operating expense ratio	18.2		%	9.4		%	15.0		%	18.4		%	8.9		%	15.1		%
Combined ratio	105.1		%	94.0		%	101.1		%	102.6		%	73.3		%	92.4		%

(1)	Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(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 September 30, 2011
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,766,651	$	93,418	$	(42,230	)	$	2,715,463	$	(17,607	)
Mortgage backed securities	1,545,321		32,503		(21,110		)	1,533,928		(20,676		)
Municipal bonds	1,422,943		66,880		(2,322		)	1,358,385		(105		)
Commercial mortgage backed securities	1,118,905		26,981		(4,230		)	1,096,154		(3,259		)
U.S. government and government agencies	1,263,665		39,866		(536		)	1,224,335		(207		)
Non-U.S. government securities	837,043		42,570		(15,610		)	810,083		—
Asset backed securities	647,705		19,529		(8,572		)	636,748		(3,876		)
Total	9,602,233		321,747		(94,610		)	9,375,096		(45,730		)

Equity securities	273,213		9,049		(36,171		)	300,335		—
Other investments	229,974		10,530		(6,645		)	226,089		—
Short-term investments	799,662		58		(8,268		)	807,872		—
Total	$	10,905,082	$	341,384	$	(145,694	)	$	10,709,392	$	(45,730	)

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 September 30, 2011, the net unrealized loss related to securities for which a non-credit OTTI was recognized in AOCI was $13.8 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 September 30, 2011
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	946,958	$	(38,638	)	$	39,640	$	(3,592	)	$	986,598	$	(42,230	)
Mortgage backed securities	377,312		(11,221		)	41,759		(9,889		)	419,071		(21,110		)
Municipal bonds	243,629		(2,197		)	3,174		(125		)	246,803		(2,322		)
Commercial mortgage backed securities	193,318		(3,453		)	8,408		(777		)	201,726		(4,230		)
U.S. government and government agencies	149,684		(536		)	—		—			149,684		(536		)
Non-U.S. government securities	351,494		(14,840		)	11,890		(770		)	363,384		(15,610		)
Asset backed securities	200,706		(5,922		)	10,716		(2,650		)	211,422		(8,572		)
Total	2,463,101		(76,807		)	115,587		(17,803		)	2,578,688		(94,610		)
Equity securities	193,356		(36,171		)	—		—			193,356		(36,171		)
Other investments	103,167		(6,229		)	2,906		(416		)	106,073		(6,645		)
Short-term investments	150,061		(8,268		)	—		—			150,061		(8,268		)
Total	$	2,909,685	$	(127,475	)	$	118,493	$	(18,219	)	$	3,028,178	$	(145,694	)

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 September 30, 2011, on a lot level basis, approximately 1,830 security lots out of a total of approximately 4,800 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 $5.3 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.

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

Due in one year or less	$	424,945	$	413,387	$	414,390	$	398,795
Due after one year through five years	2,950,545		2,869,718		2,924,879		2,833,955
Due after five years through 10 years	2,446,160		2,376,760		1,719,446		1,671,306
Due after 10 years	468,652		448,401		442,575		442,626
	6,290,302		6,108,266		5,501,290		5,346,682
Mortgage backed securities	1,545,321		1,533,928		1,806,813		1,814,905
Commercial mortgage backed securities	1,118,905		1,096,154		1,167,299		1,141,584
Asset backed securities	647,705		636,748		558,032		541,350
Total	$	9,602,233	$	9,375,096	$	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 September 30, 2011, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $72.4 million and $70.7 million, respectively, compared to $75.6 million and $72.5 million at December 31, 2010, respectively. At September 30, 2011, the portfolio of collateral backing the Company’s securities lending program included approximately $8.5 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:

	September 30,			December 31,
	2011			2010

Fixed maturities	$	122,866		$	124,969
Equity securities	100,719			94,204
Other investments (par: $100,250 and $0)	95,796			—
Investments accounted for using the fair value option	319,381			219,173
Securities sold but not yet purchased (1)	(46,526		)	(41,143		)
TALF investments	392,455			402,449
TALF borrowings	(314,137		)	(325,770		)
Net assets accounted for using the fair value option	$	351,173		$	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						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010

Fixed maturities	$	82,686		$	94,209		$	252,250		$	286,051
Equity securities	1,796			120			5,187			410
Short-term investments	430			473			1,613			958
Other (1)	4,264			1,174			17,625			2,296
Gross investment income	89,176			95,976			276,675			289,715
Investment expenses	(6,423		)	(5,208		)	(18,944		)	(15,438		)
Net investment income	$	82,753		$	90,768		$	257,731		$	274,277

(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						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010

Available for sale securities:
Gross gains on investment sales	$	61,008		$	87,358		$	204,303		$	207,368
Gross losses on investment sales	(21,503		)	(29,819		)	(85,170		)	(71,282		)
Change in fair value of assets and liabilities accounted for using the fair value option:
Fixed maturities	(4,366		)	6,240			(12,759		)	(2,457		)
Equity securities	(28,993		)	5,660			(32,043		)	369
Other investments	(3,755		)	—			(3,432		)	—
TALF investments	(2,130		)	6,534			2,317			14,431
TALF borrowings	79			(1,231		)	(206		)	(691		)
Derivative instruments (1)	36,179			(7,030		)	28,035			28,522
Other	(6,320		)	1,116			(4,941		)	2,464
Net realized gains	$	30,199		$	68,828		$	96,104		$	178,724

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Other-Than-Temporary Impairments

The Company performs quarterly reviews of its available for sale investments in order to determine whether declines in fair value b