ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

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

	(Unaudited)
	March 31,			December 31,
	2012			2011
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: $8,989,350 and $9,165,438)	$	9,221,145		$	9,375,604
Short-term investments available for sale, at fair value (amortized cost: $1,110,944 and $909,121)	1,112,249			904,219
Investment of funds received under securities lending, at fair value (amortized cost: $42,174 and $48,577)	41,867			48,419
Equity securities available for sale, at fair value (cost: $295,242 and $299,058)	318,181			299,584
Other investments available for sale, at fair value (cost: $342,234 and $235,381)	357,992			238,111
Investments accounted for using the fair value option	500,283			366,903
TALF investments, at fair value (amortized cost: $297,301 and $373,040)	313,187			387,702
Investments accounted for using the equity method	347,273			380,507
Total investments	12,212,177			12,001,049

Cash	422,806			351,699
Accrued investment income	65,643			70,739
Investment in joint venture (cost: $100,000)	107,866			107,576
Fixed maturities and short-term investments pledged under securities lending, at fair value	50,813			56,393
Premiums receivable	700,137			501,563
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	1,849,603			1,851,584
Contractholder receivables	762,031			748,231
Prepaid reinsurance premiums	261,619			265,696
Deferred acquisition costs, net	261,467			227,884
Receivable for securities sold	621,560			462,891
Other assets	497,061			460,052
Total Assets	$	17,812,783		$	17,105,357

Liabilities
Reserve for losses and loss adjustment expenses	$	8,511,323		$	8,456,210
Unearned premiums	1,595,712			1,411,872
Reinsurance balances payable	137,791			133,866
Contractholder payables	762,031			748,231
Senior notes	300,000			300,000
Revolving credit agreement borrowings	100,000			100,000
TALF borrowings, at fair value (par: $241,005 and $310,868)	239,551			310,486
Securities lending payable	52,224			58,546
Payable for securities purchased	742,995			480,230
Other liabilities	531,700			513,842
Total Liabilities	12,973,327			12,513,283

Commitments and Contingencies

Shareholders’ Equity
Non-cumulative preferred shares	325,000			325,000
Common shares ($0.0033 par, shares issued: 165,725,990 and 164,636,338)	552			549
Additional paid-in capital	170,694			161,419
Retained earnings	4,954,450			4,796,655
Accumulated other comprehensive income, net of deferred income tax	234,468			153,923
Common shares held in treasury, at cost (shares: 30,284,303 and 30,277,993)	(845,708		)	(845,472		)
Total Shareholders’ Equity	4,839,456			4,592,074
Total Liabilities and Shareholders’ Equity	$	17,812,783		$	17,105,357

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

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

	(Unaudited)
	Three Months Ended
	March 31,
	2012			2011
Revenues
Net premiums written	$	863,611		$	764,278
Change in unearned premiums	(183,299		)	(130,583		)
Net premiums earned	680,312			633,695
Net investment income	74,297			88,307
Net realized gains	44,121			20,695

Other-than-temporary impairment losses	(1,031		)	(3,258		)
Less investment impairments recognized in other comprehensive income, before taxes	8			578
Net impairment losses recognized in earnings	(1,023		)	(2,680		)

Fee income	543			815
Equity in net income of investment funds accounted for using the equity method	24,826			29,673
Other income (loss)	(8,068		)	4,567
Total revenues	815,008			775,072

Expenses
Losses and loss adjustment expenses	395,207			493,880
Acquisition expenses	118,962			108,754
Other operating expenses	106,472			102,882
Interest expense	7,521			7,721
Net foreign exchange losses	20,688			36,912
Total expenses	648,850			750,149

Income before income taxes	166,158			24,923

Income tax expense (benefit)	1,902			(550		)

Net income	164,256			25,473

Preferred dividends	6,461			6,461

Net income available to common shareholders	$	157,795		$	19,012

Net income per common share
Basic	$	1.18		$	0.14
Diluted	$	1.14		$	0.14

Weighted average common shares and common share equivalents outstanding
Basic	133,954,623			133,499,241
Diluted	137,814,906			140,460,516

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(U.S. dollars in thousands)

	(Unaudited)
	Three Months Ended
	March 31,
	2012			2011
Non-Cumulative Preferred Shares
Balance at beginning and end of period	$	325,000		$	325,000

Common Shares
Balance at beginning of year	549			534
Common shares issued, net	3			1
Balance at end of period	552			535

Additional Paid-in Capital
Balance at beginning of year	161,419			110,325
Common shares issued, net	(3		)	8
Exercise of stock options	1,851			4,127
Amortization of share-based compensation	7,411			5,628
Other	16			21
Balance at end of period	170,694			120,109

Retained Earnings
Balance at beginning of year	4,796,655			4,422,553
Cumulative effect of adjustment resulting from adoption of new accounting guidance (1)	—			(36,217		)
Balance at beginning of year, as adjusted	4,796,655			4,386,336
Dividends declared on preferred shares	(6,461		)	(6,461		)
Net income	164,256			25,473
Balance at end of period	4,954,450			4,405,348

Accumulated Other Comprehensive Income
Balance at beginning of year	153,923			204,503
Change in unrealized appreciation in value of investments, net of deferred income tax	67,352			20,194
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(8		)	(578		)
Foreign currency translation adjustments, net of deferred income tax	13,201			1,286
Balance at end of period	234,468			225,405

Common Shares Held in Treasury, at Cost
Balance at beginning of year	(845,472		)	(549,912		)
Shares repurchased for treasury	(236		)	(237,450		)
Balance at end of period	(845,708		)	(787,362		)

Total Shareholders’ Equity	$	4,839,456		$	4,289,035

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

See Notes to Consolidated Financial Statements

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(U.S. dollars in thousands)

	(Unaudited)
	Three Months Ended
	March 31,
	2012			2011
Operating Activities
Net income	$	164,256		$	25,473
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized gains	(44,072		)	(22,481		)
Net impairment losses recognized in earnings	1,023			2,680
Equity in net income of investment funds accounted for using the equity method and other income	(12,030		)	(355		)
Share-based compensation	7,411			5,628
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable	39,343			155,477
Unearned premiums, net of prepaid reinsurance premiums	181,735			130,136
Premiums receivable	(190,102		)	(118,688		)
Deferred acquisition costs, net	(32,269		)	(22,056		)
Reinsurance balances payable	(3,181		)	(7,122		)
Other liabilities	10,134			33,366
Other items, net	22,573			42,522
Net Cash Provided By Operating Activities	144,821			224,580

Investing Activities
Purchases of:
Fixed maturity investments	(3,593,630		)	(3,151,767		)
Equity securities	(33,803		)	(89,790		)
Other investments	(239,167		)	(92,777		)
Proceeds from the sales of:
Fixed maturity investments	3,628,932			3,232,541
Equity securities	75,860			52,316
Other investments	111,149			84,967
Proceeds from redemptions and maturities of fixed maturity investments	261,660			253,898
Net purchases of short-term investments	(207,444		)	(223,415		)
Change in investment of securities lending collateral	6,322			(125,904		)
Purchases of furniture, equipment and other assets	(6,498		)	(8,082		)
Net Cash Provided By (Used For) Investing Activities	3,381			(68,013		)

Financing Activities
Purchases of common shares under share repurchase program	—			(237,173		)
Proceeds from common shares issued, net	780			2,875
Repayments of borrowings	(69,863		)	(3,695		)
Change in securities lending collateral	(6,322		)	125,904
Other	588			714
Preferred dividends paid	(6,461		)	(6,461		)
Net Cash Used For Financing Activities	(81,278		)	(117,836		)

Effects of exchange rate changes on foreign currency cash	4,183			5,406

Increase in cash	71,107			44,137
Cash beginning of year	351,699			362,740
Cash end of period	$	422,806		$	406,877

See Notes to Consolidated Financial Statements

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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, 2011, including the Company’s audited consolidated financial statements and related notes.

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

2. Recent Accounting Pronouncements

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

	As Previously			Effect of			As Currently
	Reported			Change			Reported

December 31, 2010
Deferred acquisition costs, net	$	277,861		$	(50,583	)	$	227,278
Other assets (1)	475,911			14,366			490,277
Retained earnings	4,422,553			(36,217		)	4,386,336

Three Months Ended March 31, 2011
Other operating expenses	$	102,420		$	462		$	102,882
Income tax benefit	(371		)	(179		)	(550		)
Net income	25,756			(283		)	25,473

Net income per common share - basic	$	0.14		$	—		$	0.14
Net income per common share - diluted	$	0.14		$	—		$	0.14

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

3. Commitments and Contingencies

Letter of Credit and Revolving Credit Facilities

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

Investment Commitments

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

4. Earnings Per Common Share

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

	Three Months Ended
	March 31,
	2012			2011

Numerator:
Net income	$	164,256		$	25,473
Preferred dividends	(6,461		)	(6,461		)
Net income available to common shareholders	$	157,795		$	19,012

Denominator:
Weighted average common shares outstanding — basic	133,954,623			133,499,241
Effect of dilutive common share equivalents:
Nonvested restricted shares	1,012,303			1,141,668
Stock options (1)	2,847,980			5,819,607
Weighted average common shares and common share equivalents outstanding — diluted	137,814,906			140,460,516

Earnings per common share:
Basic	$	1.18		$	0.14
Diluted	$	1.14		$	0.14

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

5. Segment Information

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

	Three Months Ended									Three Months Ended
	March 31, 2012									March 31, 2011
	Insurance			Reinsurance			Total			Insurance			Reinsurance			Total

Gross premiums written (1)	$	688,113		$	379,976		$	1,066,656		$	634,583		$	331,013		$	964,566
Net premiums written	490,680			372,931			863,611			449,291			314,987			764,278

Net premiums earned	$	441,740		$	238,572		$	680,312		$	407,591		$	226,104		$	633,695
Fee income	530			13			543			778			37			815
Losses and loss adjustment expenses	(303,164		)	(92,043		)	(395,207		)	(297,723		)	(196,157		)	(493,880		)
Acquisition expenses, net	(73,870		)	(45,092		)	(118,962		)	(61,415		)	(47,339		)	(108,754		)
Other operating expenses	(73,370		)	(26,123		)	(99,493		)	(74,629		)	(21,227		)	(95,856		)
Underwriting income (loss)	$	(8,134	)	$	75,327		67,193			$	(25,398	)	$	(38,582	)	(63,980		)

Net investment income							74,297									88,307
Net realized gains							44,121									20,695
Net impairment losses recognized in earnings							(1,023		)							(2,680		)
Equity in net income of investment funds accounted for using the equity method							24,826									29,673
Other income (loss)							(8,068		)							4,567
Other expenses							(6,979		)							(7,026		)
Interest expense							(7,521		)							(7,721		)
Net foreign exchange losses							(20,688		)							(36,912		)
Income before income taxes							166,158									24,923
Income tax (expense) benefit							(1,902		)							550

Net income							164,256									25,473
Preferred dividends							(6,461		)							(6,461		)
Net income available to common shareholders							$	157,795								$	19,012

Underwriting Ratios
Loss ratio	68.6		%	38.6		%	58.1		%	73.0		%	86.8		%	77.9		%
Acquisition expense ratio (2)	16.6		%	18.9		%	17.4		%	14.9		%	20.9		%	17.0		%
Other operating expense ratio	16.6		%	10.9		%	14.6		%	18.3		%	9.4		%	15.1		%
Combined ratio	101.8		%	68.4		%	90.1		%	106.2		%	117.1		%	110.0		%

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

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

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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 March 31, 2012
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,616,226	$	90,793	$	(11,263	)	$	2,536,696	$	(488	)
Mortgage backed securities	1,494,968		26,747		(14,777		)	1,482,998		(15,444		)
Municipal bonds	1,301,255		64,044		(1,381		)	1,238,592		(105		)
Commercial mortgage backed securities	1,124,667		35,721		(2,651		)	1,091,597		(3,259		)
U.S. government and government agencies	1,254,434		19,500		(4,295		)	1,239,229		(207		)
Non-U.S. government securities	856,535		30,517		(9,552		)	835,570		—
Asset backed securities	623,873		16,033		(6,132		)	613,972		(3,876		)
Total	9,271,958		283,355		(50,051		)	9,038,654		(23,379		)

Equity securities	318,181		37,649		(14,710		)	295,242		—
Other investments	357,992		17,119		(1,361		)	342,234		—
Short-term investments	1,112,249		3,570		(2,265		)	1,110,944		—
Total	$	11,060,380	$	341,693	$	(68,387	)	$	10,787,074	$	(23,379	)

At December 31, 2011
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,596,118	$	79,407	$	(29,922	)	$	2,546,633	$	(1,138	)
Mortgage backed securities	1,592,762		27,633		(23,226		)	1,588,355		(20,466		)
Municipal bonds	1,430,565		77,977		(886		)	1,353,474		(105		)
Commercial mortgage backed securities	1,046,326		28,780		(2,904		)	1,020,450		(3,259		)
U.S. government and government agencies	1,451,993		34,811		(3		)	1,417,185		(207		)
Non-U.S. government securities	737,477		33,486		(17,684		)	721,675		—
Asset backed securities	576,757		14,649		(10,078		)	572,186		(3,876		)
Total	9,431,998		296,743		(84,703		)	9,219,958		(29,051		)

Equity securities	299,584		22,870		(22,344		)	299,058		—
Other investments	238,111		8,340		(5,610		)	235,381		—
Short-term investments	904,219		390		(5,292		)	909,121		—
Total	$	10,873,912	$	328,343	$	(117,949	)	$	10,663,518	$	(29,051	)

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

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

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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 March 31, 2012
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	446,225	$	(7,774	)	$	49,733	$	(3,489	)	$	495,958	$	(11,263	)
Mortgage backed securities	293,374		(5,324		)	49,160		(9,453		)	342,534		(14,777		)
Municipal bonds	114,896		(935		)	14,834		(446		)	129,730		(1,381		)
Commercial mortgage backed securities	88,471		(1,349		)	14,495		(1,302		)	102,966		(2,651		)
U.S. government and government agencies	818,965		(4,295		)	—		—			818,965		(4,295		)
Non-U.S. government securities	353,794		(9,370		)	4,267		(182		)	358,061		(9,552		)
Asset backed securities	208,215		(5,834		)	4,248		(298		)	212,463		(6,132		)
Total	2,323,940		(34,881		)	136,737		(15,170		)	2,460,677		(50,051		)
Equity securities	99,686		(14,241		)	4,547		(469		)	104,233		(14,710		)
Other investments	36,620		(295		)	23,934		(1,066		)	60,554		(1,361		)
Short-term investments	134,299		(2,265		)	—		—			134,299		(2,265		)
Total	$	2,594,545	$	(51,682	)	$	165,218	$	(16,705	)	$	2,759,763	$	(68,387	)

At December 31, 2011
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	781,635	$	(24,977	)	$	47,687	$	(4,945	)	$	829,322	$	(29,922	)
Mortgage backed securities	255,101		(11,988		)	44,606		(11,238		)	299,707		(23,226		)
Municipal bonds	39,156		(537		)	14,988		(349		)	54,144		(886		)
Commercial mortgage backed securities	87,796		(1,676		)	14,582		(1,228		)	102,378		(2,904		)
U.S. government and government agencies	7,059		(3		)	—		—			7,059		(3		)
Non-U.S. government securities	310,182		(16,139		)	20,482		(1,545		)	330,664		(17,684		)
Asset backed securities	260,647		(8,197		)	7,317		(1,881		)	267,964		(10,078		)
Total	1,741,576		(63,517		)	149,662		(21,186		)	1,891,238		(84,703		)
Equity securities	130,045		(22,039		)	1,923		(305		)	131,968		(22,344		)
Other investments	98,605		(3,053		)	22,443		(2,557		)	121,048		(5,610		)
Short-term investments	189,100		(5,292		)	—		—			189,100		(5,292		)
Total	$	2,159,326	$	(93,901	)	$	174,028	$	(24,048	)	$	2,333,354	$	(117,949	)

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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

	March 31, 2012				December 31, 2011
	Estimated		Amortized		Estimated		Amortized
Maturity	Fair Value		Cost		Fair Value		Cost

Due in one year or less	$	470,608	$	457,213	$	486,986	$	476,734
Due after one year through five years	3,128,343		3,047,581		2,850,578		2,793,982
Due after five years through 10 years	2,210,672		2,138,648		2,532,834		2,441,800
Due after 10 years	218,827		206,645		345,755		326,451
	6,028,450		5,850,087		6,216,153		6,038,967
Mortgage backed securities	1,494,968		1,482,998		1,592,762		1,588,355
Commercial mortgage backed securities	1,124,667		1,091,597		1,046,326		1,020,450
Asset backed securities	623,873		613,972		576,757		572,186
Total	$	9,271,958	$	9,038,654	$	9,431,998	$	9,219,958

Securities Lending Agreements

The Company operates a securities lending program under which certain of its fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. The Company maintains legal control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. At March 31, 2012, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $50.8 million and $49.3 million, respectively, compared to $56.4 million and $54.5 million at December 31, 2011, respectively. At March 31, 2012, the portfolio of collateral backing the Company’s securities lending program included approximately $6.2 million fair value of sub-prime securities, compared to $7.3 million at December 31, 2011.

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

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

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

	March 31,			December 31,
	2012			2011

Fixed maturities	$	250,805		$	147,779
Equity securities	52,766			87,403
Other investments (par: $201,216 and $138,062)	196,712			131,721
Investments accounted for using the fair value option	500,283			366,903
Securities sold but not yet purchased (1)	(18,831		)	(27,178		)
TALF investments	313,187			387,702
TALF borrowings	(239,551		)	(310,486		)
Net assets accounted for using the fair value option	$	555,088		$	416,941

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

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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
	March 31,
	2012			2011

Fixed maturities	$	73,450		$	85,144
Term loan investments (1)	2,299			151
Equity securities	1,664			1,547
Short-term investments	372			678
Other (2)	3,193			6,903
Gross investment income	80,978			94,423
Investment expenses	(6,681		)	(6,116		)
Net investment income	$	74,297		$	88,307

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

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

Net Realized Gains (Losses)

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

	Three Months Ended
	March 31,
	2012			2011

Available for sale securities:
Gross gains on investment sales	$	48,012		$	71,717
Gross losses on investment sales	(17,936		)	(47,750		)
Change in fair value of assets and liabilities accounted for using the fair value option:
Fixed maturities	8,217			90
Equity securities	3,387			3,434
Other investments	3,753			127
TALF investments	1,224			1,652
TALF borrowings	1,071			(147		)
Derivative instruments (1)	(4,669		)	(11,320		)
Other	1,062			2,892
Net realized gains	$	44,121		$	20,695

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

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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 below the amortized cost basis were considered other-than-temporary in accordance with applicable guidance. The following table details the OTTI recognized in earnings by asset class:

	Three Months Ended
	March 31,
	2012		2011

Fixed maturities:
Mortgage backed securities	$	746	$	1,118
Asset backed securities	—		10
Corporate bonds	196		359
Total	942		1,487

Investment of funds received under securities lending agreements	81		856

Equity securities	—		337
Total OTTI recognized in earnings	$	1,023	$	2,680

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

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

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

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

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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

	Three Months Ended
	March 31,
	2012			2011

Balance at start of period	$	66,545		$	86,040
Credit loss impairments recognized on securities not previously impaired	212			2,006
Credit loss impairments recognized on securities previously impaired	811			674
Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security	—			—
Reductions for securities sold during the period	(482		)	(3,862		)
Balance at end of period	$	67,086		$	84,858

Restricted Assets

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

	March 31,		December 31,
	2012		2011

Assets used for collateral or guarantees:
Affiliated transactions	$	4,521,655	$	4,321,535
Third party agreements	693,371		757,669
Deposits with U.S. regulatory authorities	279,537		288,458
Deposits with non-U.S. regulatory authorities	221,179		169,733
Trust funds	64,398		60,558
Total restricted assets	$	5,780,140	$	5,597,953

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

7. Fair Value

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

The levels in the hierarchy are defined as follows:

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

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

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

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

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

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

			Fair Value Measurement Using:
	Estimated Fair		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Value		(Level 1)		(Level 2)		(Level 3)
Assets measured at fair value:
Available for sale securities:
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,616,226	$	—	$	2,519,571	$	96,655
Mortgage backed securities	1,494,968		—		1,494,968		—
Municipal bonds	1,301,255		—		1,301,255		—
Commercial mortgage backed securities	1,124,667		—		1,124,667		—
U.S. government and government agencies	1,254,434		1,254,434		—		—
Non-U.S. government securities	856,535		—		856,535		—
Asset backed securities	623,873		—		623,873		—
Total	9,271,958		1,254,434		7,920,869		96,655

Equity securities	318,181		316,977		1,204		—
Other investments	357,992		—		351,777		6,215
Short-term investments	1,112,249		976,446		135,803		—

Fair value option:
Investments accounted for using the fair value option:
Corporate bonds	195,320		—		195,320		—
Non-U.S. government bonds	55,485		—		55,485		—
Equity securities	52,766

Large accelerated filer x		Accelerated filer o

Non-accelerated filer o		Smaller reporting company o

	Page No.
*PART I. Financial Information*

Item 1 — Consolidated Financial Statements

Report of Independent Registered Public Accounting Firm	2

Consolidated Balance Sheets March 31, 2012 (unaudited) and December 31, 2011	3

Consolidated Statements of Income For the three month periods ended March 31, 2012 and 2011 (unaudited)	4

Consolidated Statements of Comprehensive Income For the three month periods ended March 31, 2012 and 2011 (unaudited)	5

Consolidated Statements of Changes in Shareholders’ Equity For the three month periods ended March 31, 2012 and 2011 (unaudited)	6

Consolidated Statements of Cash Flows For the three month periods ended March 31, 2012 and 2011 (unaudited)	7

Notes to Consolidated Financial Statements (unaudited)	8

Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations	26

Item 3 — Quantitative and Qualitative Disclosures About Market Risk	63

Item 4 — Controls and Procedures	63

*PART II. Other Information*

Item 1 — Legal Proceedings	64

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds	64

Item 5 — Other Information	64

Item 6 — Exhibits	65