10-Q 1 a12-20028_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, 2012

Or

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, 5th Floor, 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, 2012 was 136,550,744.

Table of Contents

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, 2012 (unaudited) and December 31, 2011		3

Consolidated Statements of Income
For the three and nine month periods ended September 30, 2012 and 2011 (unaudited)		4

Consolidated Statements of Comprehensive Income
For the nine months ended ended September 30, 2012 and 2011 (unaudited)		5

Consolidated Statements of Changes in Shareholders’ Equity
For the nine months ended ended September 30, 2012 and 2011 (unaudited)		6

Consolidated Statements of Cash Flows
For the nine months ended ended September 30, 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		31

Item 3 — Quantitative and Qualitative Disclosures About Market Risk		70

Item 4 — Controls and Procedures		70

*PART II. Other Information*

Item 1 — Legal Proceedings		71

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds		71

Item 5 — Other Information		71

Item 6 — Exhibits		72

Table of Contents

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, 2012, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2012 and September 30, 2011, and the consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the nine-month periods ended September 30, 2012 and September 30, 2011. 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, 2011, 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 29, 2012, we expressed an unqualified opinion on those consolidated financial statements. As discussed in Note 3 to the accompanying consolidated financial statements, the Company changed its method of accounting for costs associated with acquiring or renewing insurance contracts. The accompanying December 31, 2011 consolidated balance sheet reflects this change.

/s/ PricewaterhouseCoopers LLP

New York, NY

November 9, 2012

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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,
	2012			2011
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: $9,616,883 and $9,165,438)	$	9,944,186		$	9,375,604
Short-term investments available for sale, at fair value (amortized cost: $840,457 and $909,121)	845,158			904,219
Investment of funds received under securities lending, at fair value (amortized cost: $25,651 and $48,577)	26,279			48,419
Equity securities available for sale, at fair value (cost: $297,506 and $299,058)	312,371			299,584
Other investments available for sale, at fair value (cost: $455,149 and $235,381)	477,857			238,111
Investments accounted for using the fair value option	698,068			366,903
TALF investments, at fair value (amortized cost: $255,615 and $373,040)	270,206			387,702
Investments accounted for using the equity method	339,587			380,507
Total investments	12,913,712			12,001,049

Cash	422,440			351,699
Accrued investment income	68,069			70,739
Investment in joint venture (cost: $100,000)	109,363			107,576
Fixed maturities and short-term investments pledged under securities lending, at fair value	34,769			56,393
Premiums receivable	773,172			501,563
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	1,733,830			1,851,584
Contractholder receivables	849,352			748,231
Prepaid reinsurance premiums	302,513			265,696
Deferred acquisition costs, net	279,171			227,884
Receivable for securities sold	894,318			462,891
Other assets	509,048			460,052
Total Assets	$	18,889,757		$	17,105,357

Liabilities
Reserve for losses and loss adjustment expenses	$	8,562,328		$	8,456,210
Unearned premiums	1,815,524			1,411,872
Reinsurance balances payable	172,016			133,866
Contractholder payables	849,352			748,231
Senior notes	300,000			300,000
Revolving credit agreement borrowings	100,000			100,000
TALF borrowings, at fair value (par: $186,291 and $310,868)	185,223			310,486
Securities lending payable	35,707			58,546
Payable for securities purchased	1,012,060			480,230
Other liabilities	508,753			513,842
Total Liabilities	13,540,963			12,513,283

Commitments and Contingencies

Shareholders’ Equity
Non-cumulative preferred shares	325,000			325,000
Common shares ($0.0033 par, shares issued: 167,004,690 and 164,636,338)	556			549
Additional paid-in capital	200,607			161,419
Retained earnings	5,351,241			4,796,655
Accumulated other comprehensive income, net of deferred income tax	324,132			153,923
Common shares held in treasury, at cost (shares: 30,464,512 and 30,277,993)	(852,742		)	(845,472		)
Total Shareholders’ Equity	5,348,794			4,592,074
Total Liabilities and Shareholders’ Equity	$	18,889,757		$	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)						(Unaudited)
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
Revenues
Net premiums written	$	755,249		$	691,381		$	2,439,093		$	2,162,202
Change in unearned premiums	(6,558		)	(9,332		)	(283,434		)	(203,579		)
Net premiums earned	748,691			682,049			2,155,659			1,958,623
Net investment income	73,221			82,753			221,126			257,731
Net realized gains	60,391			30,199			139,379			96,104

Other-than-temporary impairment losses	(2,644		)	(5,180		)	(6,129		)	(10,407		)
Less investment impairments recognized in other comprehensive income, before taxes	265			2,441			776			3,304
Net impairment losses recognized in earnings	(2,379		)	(2,739		)	(5,353		)	(7,103		)

Fee income	1,077			848			2,426			2,447
Equity in net income (loss) of investment funds accounted for using the equity method	24,330			(30,549		)	56,943			5,097
Other income (loss)	(532		)	2,432			(7,905		)	2,734
Total revenues	904,799			764,993			2,562,275			2,315,633

Expenses
Losses and loss adjustment expenses	443,871			423,984			1,238,771			1,349,486
Acquisition expenses	128,065			120,205			375,316			339,598
Other operating expenses	113,429			106,321			337,602			322,045
Interest expense	7,378			8,125			22,338			23,604
Net foreign exchange losses (gains)	16,959			(60,040		)	5,958			(4,753		)
Total expenses	709,702			598,595			1,979,985			2,029,980

Income before income taxes	195,097			166,398			582,290			285,653

Income tax expense (benefit)	5,441			(2,357		)	8,110			(5,178		)

Net income	189,656			168,755			574,180			290,831

Preferred dividends	5,484			6,461			19,594			19,383

Net income available to common shareholders	$	184,172		$	162,294		$	554,586		$	271,448

Net income per common share
Basic	$	1.36		$	1.23		$	4.12		$	2.06
Diluted	$	1.33		$	1.18		$	4.01		$	1.96

Weighted average common shares and common share equivalents outstanding
Basic	135,067,360			131,560,851			134,519,046			132,090,354
Diluted	138,696,934			137,140,929			138,235,995			138,542,558

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,
	2012			2011
Comprehensive Income
Net income	$	574,180		$	290,831
Other comprehensive income, net of deferred income tax
Unrealized appreciation in value of investments:
Unrealized holding gains arising during period	277,656			53,371
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(776		)	(3,303		)
Reclassification of net realized gains, net of income taxes, included in net income	(118,714		)	(98,565		)
Foreign currency translation adjustments, net of deferred income tax	12,043			(9,430		)
Other comprehensive income	170,209			(57,927		)
Comprehensive Income	$	744,389		$	232,904

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,
	2012			2011
Non-Cumulative Preferred Shares
Balance at beginning of year	$	325,000		$	325,000
Shares issued - Series C	325,000			—
Shares repurchased - Series A and B	(325,000		)	—
Balance at end of period	325,000			325,000

Common Shares
Balance at beginning of year	549			534
Common shares issued, net	7			10
Balance at end of period	556			544

Additional Paid-in Capital
Balance at beginning of year	161,419			110,325
Common shares issued, net	4,561			3,910
Issue costs on Series C preferred shares	(9,398		)	—
Exercise of stock options	7,619			9,379
Amortization of share-based compensation	34,659			25,286
Other	1,747			1,982
Balance at end of period	200,607			150,882

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	(19,594		)	(19,383		)
Net income	574,180			290,831
Balance at end of period	5,351,241			4,657,784

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	158,942			(45,194		)
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax	(776		)	(3,303		)
Foreign currency translation adjustments, net of deferred income tax	12,043			(9,430		)
Balance at end of period	324,132			146,576

Common Shares Held in Treasury, at Cost
Balance at beginning of year	(845,472		)	(549,912		)
Shares repurchased for treasury	(7,270		)	(294,975		)
Balance at end of period	(852,742		)	(844,887		)

Total Shareholders’ Equity	$	5,348,794		$	4,435,899

(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)
	Nine Months Ended
	September 30,
	2012			2011
Operating Activities
Net income	$	574,180		$	290,831
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized gains	(142,703		)	(100,982		)
Net impairment losses recognized in earnings	5,353			7,103
Equity in net income or loss of investment funds accounted for using the equity method and other income or loss	(37,318		)	50,324
Share-based compensation	34,659			25,286
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable	180,016			334,620
Unearned premiums, net of prepaid reinsurance premiums	283,433			204,042
Premiums receivable	(204,854		)	(114,044		)
Deferred acquisition costs, net	(51,222		)	(26,082		)
Reinsurance balances payable	19,171			(3,381		)
Other liabilities	21,664			12,678
Other items, net	49,572			76,076
Net Cash Provided By Operating Activities	731,951			756,471

Investing Activities
Purchases of:
Fixed maturity investments	(12,670,073		)	(10,116,781		)
Equity securities	(215,921		)	(343,062		)
Other investments	(700,308		)	(373,814		)
Proceeds from the sales of:
Fixed maturity investments	11,522,538			8,855,624
Equity securities	264,417			311,117
Other investments	329,093			396,514
Proceeds from redemptions and maturities of fixed maturity investments	867,080			738,081
Net sales of short-term investments	72,139			112,465
Change in investment of securities lending collateral	22,840			3,325
Purchase of business, net of cash acquired	28,948			—
Purchases of furniture, equipment and other assets	(13,894		)	(15,526		)
Net Cash Used For Investing Activities	(493,141		)	(432,057		)

Financing Activities
Proceeds from issuance of Series C preferred shares, net	315,763			—
Repurchase of Series A and B preferred shares	(325,000		)	—
Purchases of common shares under share repurchase program	—			(287,558		)
Proceeds from common shares issued, net	1,604			3,087
Repayments of borrowings	(124,577		)	(11,839		)
Change in securities lending collateral	(22,840		)	(3,325		)
Other	4,479			3,999
Preferred dividends paid	(22,897		)	(19,383		)
Net Cash Used For Financing Activities	(173,468		)	(315,019		)

Effects of exchange rate changes on foreign currency cash	5,399			(2,240		)

Increase in cash	70,741			7,155
Cash beginning of year	351,699			362,740
Cash end of period	$	422,440		$	369,895

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. Share Transactions

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 2012 periods, ACGL did not repurchase any common shares, compared to 0.7 million common shares for an aggregate purchase price of $20.8 million during the 2011 third quarter and 9.6 million common shares for an aggregate purchase price of $287.6 during the nine months ended September 30, 2011. At September 30, 2012, $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.

Preferred Share Offering

On April 2, 2012, the Company completed the underwritten public offering of $325 million of its 6.75% Series C non-cumulative preferred shares. Except in specified circumstances relating to certain tax or corporate events, the Series C non-cumulative preferred shares are not redeemable prior to April 2, 2017. The net proceeds from the offering of approximately $316 million and other available funds were used to redeem all of the Company’s $200 million of 8.0% Series A preferred shares and $125 million of 7.875% Series B preferred shares on May 2, 2012. The preferred shares were redeemed at a redemption price equal to $25.00 per share, plus all declared and unpaid dividends to (but excluding) the redemption date.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

3. 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 September 30, 2011
Other operating expenses	$	105,998		$	323		$	106,321
Income tax benefit	(2,267		)	(90		)	(2,357		)
Net income	168,988			(233		)	168,755

Net income per common share - basic	$	1.24		$	(0.01	)	$	1.23
Net income per common share - diluted	$	1.19		$	(0.01	)	$	1.18

Nine Months Ended September 30, 2011
Other operating expenses	$	318,981		$	3,064		$	322,045
Income tax benefit	(4,369		)	(809		)	(5,178		)
Net income	293,086			(2,255		)	290,831

Net income per common share - basic	$	2.07		$	(0.01	)	$	2.06
Net income per common share - diluted	$	1.98		$	(0.02	)	$	1.96

(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)

Effective January 1, 2012, the Company prospectively adopted 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. See Note 8, “Fair Value,” for the Company’s disclosures on fair value.

Effective January 1, 2012, the Company adopted 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. The adoption of this ASU did not impact the presentation of the Company’s consolidated financial statements.

In December 2011, the FASB issued an ASU that expands the required disclosures about financial instruments and derivative instruments that are either offset for balance sheet presentation purposes or subject to an enforceable master netting arrangement or similar arrangement, regardless of whether they are offset for balance sheet presentation purposes. This ASU is effective for periods beginning on or after January 1, 2013. This new guidance is disclosure-related only and does not amend existing guidance on offsetting on the balance sheet. As such, the Company does not believe that the adoption of this ASU will impact the presentation of its consolidated financial statements.

4. Commitments and Contingencies

Letter of Credit and Revolving Credit Facilities

As of September 30, 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 $81 million as of September 30, 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 September 30, 2012, the Company had $444.8 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $518.7 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 September 30, 2012.

Investment Commitments

The Company’s investment commitments, which are primarily related to agreements entered into by the Company to invest in funds and separately managed accounts when called upon, were approximately $528.0 million at September 30, 2012.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

5. Earnings Per Common Share

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

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011

Numerator:
Net income	$	189,656		$	168,755		$	574,180		$	290,831
Preferred dividends	(5,484		)	(6,461		)	(19,594		)	(19,383		)
Net income available to common shareholders	$	184,172		$	162,294		$	554,586		$	271,448

Denominator:
Weighted average common shares outstanding — basic	135,067,360			131,560,851			134,519,046			132,090,354
Effect of dilutive common share equivalents:
Nonvested restricted shares	723,538			750,289			847,959			952,898
Stock options (1)	2,906,036			4,829,789			2,868,990			5,499,306
Weighted average common shares and common share equivalents outstanding — diluted	138,696,934			137,140,929			138,235,995			138,542,558

Earnings per common share:
Basic	$	1.36		$	1.23		$	4.12		$	2.06
Diluted	$	1.33		$	1.18		$	4.01		$	1.96

(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 third quarter and 2011 third quarter, the number of stock options excluded were 621,556 and 698,912, respectively. For the nine months ended September 30, 2012 and 2011, the number of stock options excluded were 860,088 and 385,444, respectively.

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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6. 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
	September 30, 2012									September 30, 2011
	Insurance			Reinsurance			Total			Insurance			Reinsurance			Total
Gross premiums written (1)	$	658,599		$	279,751		$	936,764		$	634,280		$	227,837		$	860,289
Net premiums written	483,356			271,893			755,249			472,986			218,395			691,381

Net premiums earned	$	456,341		$	292,350		$	748,691		$	437,970		$	244,079		$	682,049
Fee income	645			432			1,077			661			187			848
Losses and loss adjustment expenses	(307,155		)	(136,716		)	(443,871		)	(290,608		)	(133,376		)	(423,984		)
Acquisition expenses, net	(73,663		)	(54,402		)	(128,065		)	(76,763		)	(43,442		)	(120,205		)
Other operating expenses	(75,379		)	(29,001		)	(104,380		)	(77,801		)	(22,340		)	(100,141		)
Underwriting income (loss)	$	789		$	72,663		73,452			$	(6,541	)	$	45,108		38,567

Net investment income							73,221									82,753
Net realized gains							60,391									30,199
Net impairment losses recognized in earnings							(2,379		)							(2,739		)
Equity in net income (loss) of investment funds accounted for using the equity method							24,330									(30,549		)
Other income (loss)							(532		)							2,432
Other expenses							(9,049		)							(6,180		)
Interest expense							(7,378		)							(8,125		)
Net foreign exchange gains (losses)							(16,959		)							60,040
Income before income taxes							195,097									166,398
Income tax (expense) benefit							(5,441		)							2,357

Net income							189,656									168,755
Preferred dividends							(5,484		)							(6,461		)
Net income available to common shareholders							$	184,172								$	162,294

Underwriting Ratios
Loss ratio	67.3		%	46.8		%	59.3		%	66.4		%	54.6		%	62.2		%
Acquisition expense ratio (2)	16.0		%	18.6		%	17.0		%	17.4		%	17.8		%	17.5		%
Other operating expense ratio	16.5		%	9.9		%	13.9		%	17.8		%	9.2		%	14.7		%
Combined ratio	99.8		%	75.3		%	90.2		%	101.6		%	81.6		%	94.4		%

(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)

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 nine months ended September 30, 2012 and 2011:

	Nine Months Ended									Nine Months Ended
	September 30, 2012									September 30, 2011
	Insurance			Reinsurance			Total			Insurance			Reinsurance			Total
Gross premiums written (1)	$	2,022,802		$	1,036,708		$	3,055,233		$	1,903,868		$	836,616		$	2,736,794
Net premiums written	1,438,620			1,000,473			2,439,093			1,360,540			801,662			2,162,202

Net premiums earned	$	1,344,675		$	810,984		$	2,155,659		$	1,256,380		$	702,243		$	1,958,623
Fee income	1,803			623			2,426			2,141			306			2,447
Losses and loss adjustment expenses	(900,735		)	(338,036		)	(1,238,771		)	(889,973		)	(459,513		)	(1,349,486		)
Acquisition expenses, net	(223,591		)	(151,725		)	(375,316		)	(204,721		)	(134,877		)	(339,598		)
Other operating expenses	(225,366		)	(84,264		)	(309,630		)	(230,204		)	(67,238		)	(297,442		)
Underwriting income (loss)	$	(3,214	)	$	237,582		234,368			$	(66,377	)	$	40,921		(25,456		)

Net investment income							221,126									257,731
Net realized gains							139,379									96,104
Net impairment losses recognized in earnings							(5,353		)							(7,103		)
Equity in net income of investment funds accounted for using the equity method							56,943									5,097
Other income (loss)							(7,905		)							2,734
Other expenses							(27,972		)							(24,603		)
Interest expense							(22,338		)							(23,604		)
Net foreign exchange gains (losses)							(5,958		)							4,753
Income before income taxes							582,290									285,653
Income tax (expense) benefit							(8,110		)							5,178

Net income							574,180									290,831
Preferred dividends							(19,594		)							(19,383		)
Net income available to common shareholders							$	554,586								$	271,448

Underwriting Ratios
Loss ratio	67.0		%	41.7		%	57.5		%	70.8		%	65.4		%	68.9		%
Acquisition expense ratio (2)	16.5		%	18.7		%	17.3		%	16.1		%	19.2		%	17.2		%
Other operating expense ratio	16.8		%	10.4		%	14.4		%	18.3		%	9.6		%	15.2		%
Combined ratio	100.3		%	70.8		%	89.2		%	105.2		%	94.2		%	101.3		%

(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)

7. Investment Information

Available For Sale Investments

The following table summarizes the fair value and cost or amortized cost of the Company’s investments 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, 2012
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,707,999	$	113,295	$	(7,039	)	$	2,601,743	$	(113	)
Mortgage backed securities	1,873,874		42,374		(7,439		)	1,838,939		(9,342		)
Municipal bonds	1,579,872		74,558		(730		)	1,506,044		(17		)
Commercial mortgage backed securities	824,162		42,745		(1,838		)	783,255		(3,498		)
U.S. government and government agencies	1,131,358		28,015		(1,520		)	1,104,863		(19		)
Non-U.S. government securities	1,026,432		37,927		(11,193		)	999,698		—
Asset backed securities	835,258		25,400		(6,093		)	815,951		(3,459		)
Total	9,978,955		364,314		(35,852		)	9,650,493		(16,448		)

Equity securities	312,371		29,744		(14,879		)	297,506		—
Other investments	477,857		24,737		(2,029		)	455,149		—
Short-term investments	845,158		5,439		(738		)	840,457		—
Total	$	11,614,341	$	424,234	$	(53,498	)	$	11,243,605	$	(16,448	)

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 September 30, 2012, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $1.1 million, compared to a net unrealized loss of $18.0 million at December 31, 2011.

Table of Contents

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, 2012
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	199,075	$	(2,673	)	$	67,200	$	(4,366	)	$	266,275	$	(7,039	)
Mortgage backed securities	280,362		(5,268		)	42,033		(2,171		)	322,395		(7,439		)
Municipal bonds	46,307		(248		)	9,802		(482		)	56,109		(730		)
Commercial mortgage backed securities	9,901		(451		)	14,632		(1,387		)	24,533		(1,838		)
U.S. government and government agencies	123,700		(1,520		)	—		—			123,700		(1,520		)
Non-U.S. government securities	153,052		(1,103		)	126,123		(10,090		)	279,175		(11,193		)
Asset backed securities	27,932		(71		)	90,149		(6,022		)	118,081		(6,093		)
Total	840,329		(11,334		)	349,939		(24,518		)	1,190,268		(35,852		)
Equity securities	60,326		(5,985		)	43,562		(8,894		)	103,888		(14,879		)
Other investments	56,778		(1,027		)	27,539		(1,002		)	84,317		(2,029		)
Short-term investments	80,420		(738		)	—		—			80,420		(738		)
Total	$	1,037,853	$	(19,084	)	$	421,040	$	(34,414	)	$	1,458,893	$	(53,498	)

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	)

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

At September 30, 2012, on a lot level basis, approximately 590 security lots out of a total of approximately 4,440 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 $3.1 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.

	September 30, 2012				December 31, 2011
	Estimated		Amortized		Estimated		Amortized
Maturity	Fair Value		Cost		Fair Value		Cost
Due in one year or less	$	471,678	$	462,425	$	486,986	$	476,734
Due after one year through five years	3,664,256		3,556,156		2,850,578		2,793,982
Due after five years through 10 years	2,083,013		1,978,601		2,532,834		2,441,800
Due after 10 years	226,714