Edgar Filing: ARCH CAPITAL GROUP LTD.

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 March 31, 2007

Or

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

	For the transition period to

Commission file number: 0-26456

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

Bermuda		Not Applicable
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

Wessex House, 45 Reid Street Hamilton HM 12, Bermuda (Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (441) 278-9250

(Former name, former address and former fiscal year, if changed since last report)

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer x

Accelerated Filer o

Non-Accelerated Filer 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

Indicate the number of shares outstanding of each of the issuer’s classes of common shares as of the latest practicable date.

Class		Outstanding at April 27, 2007
Common Shares, $0.01 par value		73,641,614

ARCH CAPITAL GROUP LTD.

INDEX


*PART I. Financial Information*

Item 1 — Consolidated Financial Statements

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets
March 31, 2007 (unaudited) and December 31, 2006

Consolidated Statements of Income
For the three month periods ended March 31, 2007 and 2006 (unaudited)

Consolidated Statements of Changes in Shareholders’ Equity
For the three month periods ended March 31, 2007 and 2006 (unaudited)

Consolidated Statements of Comprehensive Income
For the three month periods ended March 31, 2007 and 2006 (unaudited)

Consolidated Statements of Cash Flows
For the three month periods ended March 31, 2007 and 2006 (unaudited)

Notes to Consolidated Financial Statements (unaudited)

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

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

Item 4 — Controls and Procedures

*PART II. Other Information*

Item 1 — Legal Proceedings

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

Item 5 — Other Information

Item 6 — Exhibits

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 March 31, 2007, and the related consolidated statements of income, changes in shareholders’ equity, comprehensive income and cash flows for each of the three-month periods ended March 31, 2007 and 2006. 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, 2006, and the related consolidated statements of income, changes in shareholders’ equity, comprehensive income, and cash flows for the year then ended (not presented herein), and in our report dated February 28, 2007 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, 2006, 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, New York
May 10, 2007

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)

	(Unaudited)
	March 31,		December 31,
	2007		2006
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: 2007, $6,933,803; 2006, $6,858,970)	$	6,963,359	$	6,876,548
Short-term investments available for sale, at fair value (amortized cost: 2007, $794,726; 2006, $956,926)	796,682		957,698
Short-term investment of funds received under securities lending agreements, at fair value	1,160,098		891,376
Other investments (cost: 2007, $394,604; 2006, $282,923)	422,387		307,082
Total investments	9,342,526		9,032,704

Cash	225,249		317,017
Accrued investment income	68,012		68,440
Fixed maturities and short-term investments pledged under securities lending agreements, at fair value	1,120,957		860,803
Premiums receivable	954,168		749,961
Funds held by reinsureds	60,783		82,385
Unpaid losses and loss adjustment expenses recoverable	1,537,176		1,552,157
Paid losses and loss adjustment expenses recoverable	120,883		122,149
Prepaid reinsurance premiums	501,287		470,138
Deferred income tax assets, net	64,271		63,606
Deferred acquisition costs, net	314,686		290,999
Receivable for securities sold	164,124		190,168
Other assets	487,749		511,940
Total Assets	$	14,961,871	$	14,312,467

Liabilities
Reserve for losses and loss adjustment expenses	$	6,595,820	$	6,463,041
Unearned premiums	1,950,264		1,791,922
Reinsurance balances payable	393,658		301,679
Senior notes	300,000		300,000
Deposit accounting liabilities	43,284		45,107
Securities lending collateral	1,160,098		891,376
Payable for securities purchased	216,381		418,109
Other liabilities	519,018		510,614
Total Liabilities	11,178,523		10,721,848

Commitments and Contingencies

Shareholders’ Equity
Non-cumulative preferred shares ($0.01 par value, 50,000,000 shares authorized)
— Series A (issued: 2007 and 2006, 8,000,000)	80		80
— Series B (issued: 2007 and 2006, 5,000,000)	50		50
Common shares ($0.01 par value, 200,000,000 shares authorized, issued: 2007, 73,746,726; 2006, 74,270,466)	737		743
Additional paid-in capital	1,910,125		1,944,304
Retained earnings	1,794,569		1,596,018
Accumulated other comprehensive income (loss), net of deferred income tax	77,787		49,424
Total Shareholders’ Equity	3,783,348		3,590,619
Total Liabilities and Shareholders’ Equity	$	14,961,871	$	14,312,467

See Notes to Consolidated Financial Statements

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except share data)

	(Unaudited)
	Three Months Ended March 31,
	2007			2006
Revenues
Net premiums written	$	871,745		$	873,719
Increase in unearned premiums	(126,252		)	(112,118		)
Net premiums earned	745,493			761,601
Net investment income	112,689			80,326
Net realized losses	(981		)	(3,383		)
Fee income	1,969			1,805
Other income	604			—
Total revenues	859,774			840,349

Expenses
Losses and loss adjustment expenses	420,061			468,178
Acquisition expenses	120,128			129,672
Other operating expenses	90,813			82,977
Interest expense	5,523			5,555
Net foreign exchange losses	9,742			10,253
Total expenses	646,267			696,635

Income before income taxes	213,507			143,714

Income tax expense	8,495			11,424

Net income	205,012			132,290

Preferred dividends	6,461			2,667

Net income available to common shareholders	$	198,551		$	129,623

Net income per common share
Basic	$	2.69		$	1.78
Diluted	$	2.59		$	1.71

Weighted average common shares and common share equivalents outstanding
Basic	73,931,996			72,899,249
Diluted	76,640,686			75,855,309

See Notes to Consolidated Financial Statements

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)

	(Unaudited)
	Three Months Ended
	March 31,
	2007			2006
Non-Cumulative Preferred Shares
Balance at beginning of period	$	130		$	—
Preferred shares issued	—			80
Balance at end of period	130			80

Common Shares
Balance at beginning of year	743			733
Common shares issued, net	1			5
Purchases of common shares under share repurchase program	(7		)	—
Balance at end of period	737			738

Additional Paid-in Capital
Balance at beginning of year	1,944,304			1,595,440
Cumulative effect of change in accounting for unearned stock grant compensation	—			(9,646		)
Series A non-cumulative preferred shares issued	—			193,378
Common shares issued	109			160
Exercise of stock options	6,997			12,152
Common shares retired	(46,291		)	(647		)
Amortization of share-based compensation	4,306			3,299
Other	700			274
Balance at end of period	1,910,125			1,794,410

Deferred Compensation Under Share Award Plan
Balance at beginning of year	—			(9,646		)
Cumulative effect of change in accounting for unearned stock grant compensation	—			9,646
Balance at end of period	—			—

Retained Earnings
Balance at beginning of year	1,593,907			901,348
Adjustment to adopt SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140”	2,111			—
Balance at beginning of year, as adjusted	1,596,018			901,348
Dividends declared on preferred shares	(6,461		)	(2,667		)
Net income	205,012			132,290
Balance at end of period	1,794,569			1,030,971

Accumulated Other Comprehensive Income (Loss)
Balance at beginning of year	51,535			(7,348		)
Adjustment to adopt SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140”	(2,111		)	—
Balance at beginning of year, as adjusted	49,424			(7,348		)
Change in unrealized appreciation (decline) in value of investments, net of deferred income tax	20,587			(67,032		)
Foreign currency translation adjustments, net of deferred income tax	7,776			(2,265		)
Balance at end of period	77,787			(76,645		)

Total Shareholders’ Equity	$	3,783,348		$	2,749,554

See Notes to Consolidated Financial Statements

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)

	(Unaudited)
	Three Months Ended
	March 31,
	2007			2006
Comprehensive Income
Net income	$	205,012		$	132,290
Other comprehensive income (loss), net of deferred income tax
Unrealized decline in value of investments:
Unrealized holding gains (losses) arising during period	22,014			(67,987		)
Reclassification of net realized (gains) losses, net of income taxes, included in net income	(1,427		)	955
Foreign currency translation adjustments	7,776			(2,265		)
Other comprehensive income (loss)	28,363			(69,297		)
Comprehensive Income	$	233,375		$	62,993

See Notes to Consolidated Financial Statements

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)

	(Unaudited)
	Three Months Ended
	March 31,
	2007			2006
Operating Activities
Net income	$	205,012		$	132,290
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized losses	1,097			783
Other income	(604		)	—
Share-based compensation	4,306			3,299
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable	147,462			256,469
Unearned premiums, net of prepaid reinsurance premiums	127,107			113,179
Premiums receivable	(203,707		)	(200,073		)
Deferred acquisition costs, net	(23,700		)	(10,134		)
Funds held by reinsureds	21,602			35,771
Reinsurance balances payable	91,498			76,441
Deferred income tax assets, net	(2,972		)	(7,352		)
Other liabilities	1,296			46,147
Other items, net	34,734			(23,642		)
Net Cash Provided By Operating Activities	403,131			423,178

Investing Activities
Purchases of fixed maturity investments	(5,047,868		)	(4,330,266		)
Proceeds from sales of fixed maturity investments	4,326,607			4,121,591
Proceeds from redemptions and maturities of fixed maturity investments	183,984			83,394
Purchases of other investments	(151,978		)	(32,596		)
Proceeds from sales of other investments	54,754			5,359
Net sales (purchases) of short-term investments	188,663			(444,527		)
Change in securities lending collateral	(268,722		)	10,429
Purchases of furniture, equipment and other	(4,138		)	(4,602		)
Net Cash Used For Investing Activities	(718,698		)	(591,218		)

Financing Activities
Purchases of common shares under share repurchase program	(44,475		)	—
Proceeds from common shares issued, net	3,145			8,690
Proceeds from preferred shares issued, net of issuance costs	—			193,527
Change in securities lending collateral	268,722			(10,429		)
Excess tax benefits from share-based compensation	2,355			2,450
Preferred dividends paid	(6,461		)	—
Net Cash Provided By Financing Activities	223,286			194,238

Effects of exchange rate changes on foreign currency cash	513			(769		)

Increase (decrease) in cash	(91,768		)	25,429
Cash beginning of year	317,017			222,477
Cash end of period	$	225,249		$	247,906

Income taxes paid, net	$	596		$	9,591
Interest paid	—			$	42

See Notes to Consolidated Financial Statements

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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, 2006, including the Company’s audited consolidated financial statements and related notes and the section entitled “Risk Factors.”

To facilitate period-to-period comparisons, certain amounts in the 2006 consolidated financial statements have been reclassified to conform to the 2007 presentation. Such reclassifications had no effect on the Company’s consolidated net income.

2. Share Transactions

Share Repurchase Program

On February 28, 2007, ACGL’s board of directors authorized the investment of up to $1 billion 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 February 2009. During the 2007 first quarter, ACGL repurchased approximately 683,000 common shares for an aggregate purchase price of $44.5 million. 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. In connection with the repurchase program, the Warburg Pincus funds and Hellman & Friedman funds waived their rights relating to share repurchases under the shareholders agreement for all repurchases of common shares by ACGL under the repurchase program in open market transactions and certain privately negotiated transactions.

Non-Cumulative Preferred Shares

During 2006, ACGL completed two public offerings of non-cumulative preferred shares (“Preferred Shares”). On February 1, 2006, $200.0 million principal amount of 8.0% series A non-cumulative preferred shares (“Series A Preferred Shares”) were issued with net proceeds of $193.5 million and, on May 24, 2006, $125.0 million principal amount of 7.875% series B non-cumulative preferred shares (“Series B Preferred Shares”) were issued with net proceeds of $120.9 million. The net proceeds of the offerings were used to support the underwriting activities of ACGL’s insurance and reinsurance subsidiaries. ACGL has the right to redeem all or a portion of each series of Preferred Shares at a redemption price of $25.00 per share on or after (1) February 1, 2011 for the Series A Preferred Shares and (2) May 15, 2011 for the Series B Preferred Shares. Dividends on the Preferred Shares are non-cumulative. Consequently, in the event dividends are not declared on

the Preferred Shares for any dividend period, holders of Preferred Shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accrue and will not be payable. Holders of Preferred Shares will be entitled to receive dividend payments only when, as and if declared by ACGL’s board of directors or a duly authorized committee of the board of directors. Any such dividends will be payable from the date of original issue on a non-cumulative basis, quarterly in arrears. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 8.0% of the $25.00 liquidation preference per annum for the Series A Preferred Shares and 7.875% of the $25.00 liquidation preference per annum for the Series B Preferred Shares. At March 31, 2007, the Company had declared an aggregate of $3.3 million of dividends to be paid to holders of the Preferred Shares.

Share-Based Compensation

As required by the provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), we recorded after-tax share-based compensation expense related to stock options in the 2007 first quarter of $1.6 million, or $0.02 per diluted share, compared to $1.1 million, or $0.01 per diluted share, in the 2006 first quarter.

3. Debt and Financing Arrangements

Senior Notes

On May 4, 2004, ACGL completed a public offering of $300 million principal amount of 7.35% senior notes (“Senior Notes”) due May 1, 2034 and received net proceeds of $296.4 million. ACGL used $200 million of the net proceeds to repay all amounts outstanding under a revolving credit agreement. The Senior Notes are ACGL’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. Interest payments on the Senior Notes are due on May 1st and November 1st of each year. ACGL may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. For the 2007 and 2006 first quarters, interest expense on the Senior Notes was approximately $5.5 million. The market value of the Senior Notes at March 31, 2007 and December 31, 2006 was $323.7 million and $332.0 million, respectively.

Letter of Credit and Revolving Credit Facilities

As of March 31, 2007, the Company had a $300 million unsecured revolving loan and letter of credit facility and a $1.0 billion secured letter of credit facility. The $300 million unsecured revolving loan is also available for the issuance of unsecured letters of credit up to $100 million for Arch Reinsurance Company (“Arch Re U.S.”). Borrowings of revolving loans may be made by ACGL and Arch Re U.S. at a variable rate based on LIBOR or an alternative base rate at the option of the Company. Secured letters of credit are available for issuance on behalf of the Company’s insurance and reinsurance subsidiaries. Issuance of letters of credit and borrowings under the Credit Agreement are subject to the Company’s compliance with certain covenants and conditions, including absence of a material adverse change. These covenants require, among other things, that the Company maintain a debt to shareholders’ equity ratio of not greater than 0.35 to 1 and shareholders’ equity in excess of $1.95 billion plus 25% of future aggregate net income for each quarterly period (not including any future net losses) beginning after June 30, 2006 and 25% of future aggregate proceeds from the issuance of common or preferred equity and that the Company’s principal insurance and reinsurance subsidiaries maintain at least a “B++” rating from A.M. Best. In addition, certain of the Company’s subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders’ equity levels. The Company was in compliance with all covenants contained in the Credit Agreement at March 31, 2007. The Credit Agreement expires on August 30, 2011.

Including the secured letter of credit portion of the Credit Agreement and another letter of credit facility (together, the “LOC Facilities”), the Company has access to letter of credit facilities for up to a total of $1.45 billion. The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which the Company has entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from the Company’s reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of the Company’s business and the loss experience of such business. When issued, certain letters of credit are secured by a portion of the Company’s investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which the Company was in compliance with at March 31, 2007. At such date, the Company had approximately $618.6 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $646.6 million. The other letter of credit facility was amended and restated in December 2006. It is anticipated that the LOC Facilities will be renewed (or replaced) on expiry, but such renewal (or replacement) will be subject to the availability of credit from banks which the Company utilizes. In addition to letters of credit, the Company has and may establish insurance trust accounts in the U.S. and Canada to secure its reinsurance amounts payable as required.

4. Segment Information

The Company classifies its businesses into two underwriting segments — insurance and reinsurance — and a corporate and other segment (non-underwriting). The Company’s insurance and reinsurance operating segments each have segment managers who are responsible for the overall profitability of their respective segments and who are directly accountable to the Company’s chief operating decision makers, the President and Chief Executive Officer of ACGL and the Chief Financial Officer of ACGL. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. The Company determined its reportable operating segments using the management approach described in SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.”

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. The accounting policies of the segments are the same as those used for the preparation of the Company’s consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.

The insurance segment consists of the Company’s insurance underwriting subsidiaries which primarily write on both an admitted and non-admitted basis. The insurance segment consists of eight product lines: casualty; construction, surety and national accounts; executive assurance; healthcare; professional liability; programs; property, marine and aviation; and other (consisting of collateral protection business).

The reinsurance segment consists of the Company’s reinsurance underwriting subsidiaries. The reinsurance segment generally seeks to write significant lines on specialty property and casualty reinsurance treaties. Classes of business include: casualty; marine and aviation; other specialty; property catastrophe; property excluding property catastrophe (losses on a single risk, both excess of loss and pro rata); and other (consisting of non-traditional and casualty clash business).

The corporate and other segment (non-underwriting) includes net investment income, other fee income, net of related expenses, other income (loss), other expenses incurred by the Company, interest expense, net realized gains or losses, net foreign exchange gains or losses and income taxes. In addition, results for the corporate and other segment include dividends on the Company’s non-cumulative preferred shares.

The following tables set forth an analysis of the Company’s underwriting income by segment, together with a reconciliation of underwriting income to net income available to common shareholders:

	(Unaudited)
	Three Months Ended
	March 31, 2007
(U.S. dollars in thousands)	Insurance			Reinsurance			Total

Gross premiums written (1)	$	661,210		$	558,654		$	1,210,614
Net premiums written (1)	428,344			443,401			871,745

Net premiums earned (1)	$	413,847		$	331,646		$	745,493
Fee income	1,425			544			1,969
Losses and loss adjustment expenses	(259,322		)	(160,739		)	(420,061		)
Acquisition expenses, net	(46,695		)	(73,433		)	(120,128		)
Other operating expenses	(68,894		)	(13,781		)	(82,675		)
Underwriting income	$	40,361		$	84,237		124,598

Net investment income							112,689
Net realized losses							(981		)
Other income							604
Other expenses							(8,138		)
Interest expense							(5,523		)
Net foreign exchange losses							(9,742		)
Income before income taxes							213,507
Income tax expense							(8,495		)

Net income							205,012
Preferred dividends							(6,461		)
Net income available to common shareholders							$	198,551

Underwriting Ratios
Loss ratio	62.7		%	48.5		%	56.3		%
Acquisition expense ratio (2)	11.1		%	22.1		%	16.0		%
Other operating expense ratio	16.6		%	4.2		%	11.1		%
Combined ratio	90.4		%	74.8		%	83.4		%

(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. The insurance segment and reinsurance segment results include $0.5 million and $8.7 million, respectively, of gross and net premiums written and $0.5 million and $10.6 million, respectively, of net premiums earned assumed through intersegment transactions.

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

	(Unaudited)
	Three Months Ended
	March 31, 2006
(U.S. dollars in thousands)	Insurance			Reinsurance			Total

Gross premiums written (1)	$	615,484		$	564,668		$	1,167,814
Net premiums written (1)	397,254			476,465			873,719

Net premiums earned (1)	$	380,254		$	381,347		$	761,601
Fee income	1,404			401			1,805
Losses and loss adjustment expenses	(248,002		)	(220,176		)	(468,178		)
Acquisition expenses, net	(37,885		)	(91,787		)	(129,672		)
Other operating expenses	(62,076		)	(13,252		)	(75,328		)
Underwriting income	$	33,695		$	56,533		90,228

Net investment income							80,326
Net realized losses							(3,383		)
Other income							—
Other expenses							(7,649		)
Interest expense							(5,555		)
Net foreign exchange losses							(10,253		)
Income before income taxes							143,714
Income tax expense							(11,424		)

Net income							132,290
Preferred dividends							(2,667		)
Net income available to common shareholders							$	129,623

Underwriting Ratios
Loss ratio	65.2		%	57.7		%	61.5		%
Acquisition expense ratio (2)	9.7		%	24.1		%	16.9		%
Other operating expense ratio	16.3		%	3.5		%	9.9		%
Combined ratio	91.2		%	85.3		%	88.3		%

(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. The insurance segment and reinsurance segment results include $0.8 million and $11.5 million, respectively, of gross and net premiums written and $0.9 million and $12.8 million, respectively, of net premiums earned assumed through intersegment transactions.

(2) The acquisition expense ratio is adjusted to include certain fee income.

Set forth below is summary information regarding net premiums written and earned by major line of business and net premiums written by client location for the insurance segment:

	(Unaudited)
	Three Months Ended
	March 31,
	2007				2006
INSURANCE SEGMENT (U.S. dollars in thousands)	Amount			% of Total	Amount		% of Total

Net premiums written (1)
Property, marine and aviation	$	84,863		19.8	$	68,646	17.3
Construction, surety and national accounts	79,230			18.5	80,629		20.3
Professional liability	70,403			16.4	62,454		15.7
Programs	58,323			13.6	60,534		15.2
Executive assurance	44,091			10.3	45,591		11.5
Casualty	43,091			10.1	50,750		12.8
Healthcare	21,530			5.0	18,115		4.6
Other	26,813		(2)	6.3	10,535		2.6
Total	$	428,344		100.0	$	397,254	100.0

Net premiums earned (1)
Property, marine and aviation	$	81,804		19.8	$	62,968	16.6
Construction, surety and national accounts	67,104			16.2	66,703		17.5
Professional liability	77,130			18.6	54,045		14.2
Programs	56,209			13.6	57,389		15.1
Executive assurance	45,378			11.0	50,076		13.2
Casualty	51,542			12.4	62,808		16.5
Healthcare	19,844			4.8	16,677		4.4
Other	14,836		(2)	3.6	9,588		2.5
Total	$	413,847		100.0	$	380,254	100.0

Net premiums written by client location (1)
United States	$	320,005		74.7	$	324,465	81.7
Europe	74,935			17.5	47,580		12.0
Other	33,404			7.8	25,209		6.3
Total	$	428,344		100.0	$	397,254	100.0

(1) Insurance segment results include premiums written and earned assumed through intersegment transactions of $0.5 million and $0.5 million, respectively, for the 2007 first quarter and $0.8 million and $0.9 million, respectively, for the 2006 first quarter. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $8.7 million and $10.6 million, respectively, for the 2007 first quarter and $11.5 million and $12.8 million, respectively, for the 2006 first quarter.

(2) Includes excess workers’ compensation and employers’ liability business.

The following table sets forth the reinsurance segment’s net premiums written and earned by major line of business and type of business, together with net premiums written by client location:

	(Unaudited)
	Three Months Ended
	March 31,
	2007			2006
REINSURANCE SEGMENT (U.S. dollars in thousands)	Amount		% of Total	Amount			% of Total

Net premiums written (1)
Casualty (2)	$	144,476	32.6	$	162,988		34.2
Property excluding property catastrophe	94,944		21.4	106,782			22.4
Property catastrophe	80,659		18.2	70,336			14.7
Other specialty	73,996		16.7	93,264			19.6
Marine and aviation	43,715		9.8	41,352			8.7
Other	5,611		1.3	1,743			0.4
Total	$	443,401	100.0	$	476,465		100.0

Net premiums earned (1)
Casualty (2)	$	140,444	42.4	$	171,197		44.9
Property excluding property catastrophe	73,039		22.0	79,620			20.9
Property catastrophe	34,691		10.5	49,106			12.8
Other specialty	52,042		15.7	57,919			15.2
Marine and aviation	26,622		8.0	23,650			6.2
Other	4,808		1.4	(145		)	(0.0	)
Total	$	331,646	100.0	$	381,347		100.0

Net premiums written (1)
Pro rata	$	263,815	59.5	$	272,534		57.2
Excess of loss	179,586		40.5	203,931			42.8
Total	$	443,401	100.0	$	476,465		100.0

Net premiums earned (1)
Pro rata	$	242,439	73.1	$	295,288		77.4
Excess of loss	89,207		26.9	86,059			22.6
Total	$	331,646	100.0	$	381,347		100.0

Net premiums written by client location (1)
United States	$	253,991	57.3	$	277,315		58.2
Europe	124,338		28.0	127,263			26.7
Bermuda	50,841		11.5	43,839			9.2
Other	14,231		3.2	28,048			5.9
Total	$	443,401	100.0	$	476,465		100.0

(1) Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $8.7 million and $10.6 million, respectively, for the 2007 first quarter and $11.5 million and $12.8 million, respectively, for the 2006 first quarter. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $0.5 million and $0.5 million, respectively, for the 2007 first quarter and $0.8 million and $0.9 million, respectively, for the 2006 first quarter.

(2) Includes professional liability and executive assurance business.

5. Reinsurance

In the normal course of business, the Company’s insurance subsidiaries cede a substantial portion of their premium through pro rata, excess of loss and facultative reinsurance agreements. The Company’s reinsurance subsidiaries purchase retrocessional coverage as part of their risk management program. In addition, the Company’s reinsurance subsidiaries participate in “common account” retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as the Company’s reinsurance subsidiaries, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, the Company’s insurance or reinsurance subsidiaries would be liable for such defaulted amounts.

The effects of reinsurance on the Company’s written and earned premiums and losses and loss adjustment expenses with unaffiliated reinsurers were as follows:

	(Unaudited)
	Three Months Ended
	March 31,
(U.S. dollars in thousands)	2007			2006

Premiums Written
Direct	$	649,880		$	601,699
Assumed	560,734			566,115
Ceded	(338,869		)	(294,095		)
Net	$	871,745		$	873,719

Premiums Earned
Direct	$	637,008		$	575,418
Assumed	416,132			419,277
Ceded	(307,647		)	(233,094		)
Net	$	745,493		$	761,601

Losses and Loss Adjustment Expenses
Direct	$	359,476		$	382,105
Assumed	195,271			246,609
Ceded	(134,686		)	(160,536		)
Net	$	420,061		$	468,178

The Company monitors the financial condition of its reinsurers and attempts to place coverages only with substantial, financially sound carriers. At March 31, 2007 and December 31, 2006, approximately 91.3% and 92.3%, respectively, of the Company’s reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.66 billion and $1.67 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better. At March 31, 2007 and December 31, 2006, the largest reinsurance recoverables from any one carrier were less than 5.0% and 5.1%, respectively, of the Company’s total shareholders’ equity.

On December 29, 2005, Arch Reinsurance Ltd. (“Arch Re Bermuda”) entered into a quota share reinsurance treaty with Flatiron Re Ltd., a newly-formed Bermuda reinsurance company, pursuant to which Flatiron Re Ltd. is assuming a 45% quota share (the “Treaty”) of certain lines of property and marine business underwritten by Arch Re Bermuda for unaffiliated third parties for the 2006 and 2007 underwriting years (January 1, 2006 to December 31, 2007). The quota share is subject to decrease by Arch Re Bermuda under certain circumstances. In addition, in certain circumstances, Flatiron Re Ltd. may extend at its option the coverage provided by the Treaty to Arch Re Bermuda’s 2008 underwriting year. Effective June 28, 2006, the

parties amended the Treaty to increase the percentage ceded to Flatiron Re Ltd. from 45% to 70% of all covered business bound by Arch Re Bermuda from (and including) June 28, 2006 until (and including) August 15, 2006 provided such business did not incept beyond September 30, 2006. The ceding percentage for all business bound outside of this period will continue to be 45%, subject to adjustment as provided under the Treaty.

Flatiron Re Ltd. is required to contribute funds into a trust for the benefit of Arch Re Bermuda (the “Trust”). Effective June 28, 2006, the parties amended the Treaty to provide that, for the period ending on December 31 of the final underwriting year covered by the Treaty, the amount required to be on deposit in the Trust, together with certain other amounts, will be an amount equal to the greater of (1) $800 million and (2) a calculated amount estimated to cover ceded losses arising from in excess of two 1-in-250 year events for the applicable forward twelve-month period (the “Requisite Funded Amount”). For the period after the end of the final underwriting year covered by the Treaty through the earning of all written premium, the Requisite Funded Amount will be the calculated amount described in clause “(2)” above. If the actual amounts on deposit in the Trust, together with certain other amounts (the “Funded Amount”), do not at least equal the Requisite Funded Amount, Arch Re Bermuda will, among other things, reduce the percentage of business ceded on a prospective basis and, at Arch Re Bermuda’s option under certain circumstances, recapture unearned premium reserves and reassume losses that would have been ceded in respect of such unearned premiums. No assurances can be given that actual losses will not exceed the Requisite Funded Amount or that Flatiron Re Ltd. will make, or will have the ability to make, the required contributions into the Trust. Arch Re Bermuda will have the right to terminate its obligations to cede business to Flatiron Re Ltd. if, among other things, the assets held in the Trust do not meet certain conditions, if ceded unpaid loss reserves equal or exceed the Funded Amount or if the direct or indirect ownership of Flatiron Re Ltd. changes in certain respects.

Arch Re Bermuda pays to Flatiron Re Ltd. a reinsurance premium in the amount of the ceded percentage of the original gross written premium on the business reinsured with Flatiron Re Ltd. less a ceding commission, which includes a reimbursement of direct acquisition expenses as well as a commission to Arch Re Bermuda for generating the business. The Treaty also provides for a profit commission to Arch Re Bermuda based on the underwriting results for the 2006 and 2007 underwriting years on a cumulative basis. For the 2007 first quarter, $108.9 million of premiums written, $66.0 million of premiums earned and $25.4 million of losses and loss adjustment expenses were ceded to Flatiron Re Ltd. by Arch Re Bermuda, compared to $82.4 million of premiums written, $18.3 million of premiums earned and $6.7 million of losses and loss adjustment expenses for the 2006 first quarter.

6. Deposit Accounting

Certain assumed reinsurance contracts are deemed, under current financial accounting standards, not to transfer insurance risk, and are accounted for using the deposit method of accounting. However, it is possible that the Company could incur financial losses on such contracts. For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in the Company’s underwriting results. When the estimated profit margin is explicit, the margin is reflected as fee income and any adverse financial results on such contracts are reflected as incurred losses. For the 2007 and 2006 first quarters, the Company recorded $0.5 million and $0.3 million, respectively, of fee income on such contracts. When the estimated profit margin is implicit, the margin is reflected as an offset to paid losses and any adverse financial results on such contracts are reflected as incurred losses. For the 2007 and 2006 first quarters, the Company recorded $0.1 million and $0.6 million, respectively, as an offset to paid losses on such contracts. On a notional basis, the amount of premiums from those contracts that contain an element of underwriting risk was $0.3 million and $6.0 million, respectively, for the 2007 and 2006 first quarters.

In making any determination to account for a contract using the deposit method of accounting, the Company is required to make many estimates and judgments under the current financial accounting standards.

7. Investment Information

The following table summarizes the Company’s invested assets:

	(Unaudited)
	March 31,			December 31,
(U.S. dollars in thousands)	2007			2006

Fixed maturities available for sale, at fair value	$	6,963,359		$	6,876,548
Fixed maturities pledged under securities lending agreements, at fair value (1)	1,120,530			860,803
Total fixed maturities	8,083,889			7,737,351
Short-term investments available for sale, at fair value	796,682			957,698
Short-term investments pledged under securities lending agreements, at fair value (1)	427			—
Other investments	422,387			307,082
Total investments (1)	9,303,385			9,002,131
Securities transactions entered into but not settled at the balance sheet date	(52,257		)	(227,941		)
Total investments, net of securities transactions	$	9,251,128		$	8,774,190

(1) In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of this table, the Company has excluded the collateral received at March 31, 2007 and December 31, 2006 of $1.16 billion and $891.4 million, respectively, which is reflected as “short-term investment of funds received under securities lending agreements, at fair value” and included the $1.12 billion and $860.8 million, respectively, of “fixed maturities and short-term investments pledged under securities lending agreements, at fair value.”

Fixed Maturities and Fixed Maturities Pledged Under Securities Lending Agreements

The following table summarizes the Company’s fixed maturities and fixed maturities pledged under securities lending agreements:

(U.S. dollars in thousands)	Estimated Fair Value		Gross Unrealized Gains		Gross Unrealized Losses			Amortized Cost

March 31, 2007 (Unaudited):
U.S. government and government agencies	$	2,468,478	$	16,506	$	(4,362	)	$	2,456,334
Corporate bonds	1,429,575		7,864		(2,584		)	1,424,295
Mortgage backed securities	1,218,401		7,266		(1,259		)	1,212,394
Commercial mortgage backed securities	874,857		7,583		(449		)	867,723
Asset backed securities	854,525		1,451		(782		)	853,856
Municipal bonds	754,118		1,213		(2,560		)	755,465
Non-U.S. government securities	483,935		12,612		(3,285		)	474,608
Total	$	8,083,889	$	54,495	$	(15,281	)	$	8,044,675
December 31, 2006:
U.S. government and government agencies	$	1,922,511	$	12,835	$	(10,806	)	$	1,920,482
Corporate bonds	1,504,989		9,196		(5,634		)	1,501,427
Mortgage backed securities	1,183,805		7,866		(1,678		)	1,177,617
Commercial mortgage backed securities	868,586		4,953		(1,098		)	864,731
Asset backed securities	907,829		923		(1,457		)	908,363
Municipal bonds	815,204		1,323		(3,885		)	817,766
Non-U.S. government securities	534,427		15,776		(4,718		)	523,369
Total	$	7,737,351	$	52,872	$	(29,276	)	$	7,713,755

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140” (“SFAS No. 155”). Upon adopting SFAS No. 155 on January 1, 2007, the Company applied the “fair value option” to certain hybrid securities which are included in the Company’s fixed maturities. The fair market values of such securities at March 31, 2007 were approximately $53.0 million. The change in market value of such securities is reflected as realized gains or losses. The adoption of SFAS No. 155 did not have a material impact on the Company’ results of operations.

The credit quality distribution of the Company’s fixed maturities and fixed maturities pledged under securities lending agreements are shown below:

	(Unaudited)
(U.S. dollars in thousands)	March 31, 2007			December 31, 2006
Rating (1)	Estimated Fair Value		% of Total	Estimated Fair Value		% of Total

AAA	$	6,782,485	83.9	$	6,366,059	82.3
AA	590,062		7.3	605,427		7.8
A	353,284		4.4	430,103		5.6
BBB	232,668		2.9	194,408		2.5
BB	26,912		0.3	32,572		0.4
B	50,632		0.6	64,636		0.8
Lower than B	11,296		0.1	11,149		0.2
Not rated	36,550		0.5	32,997		0.4
Total	$	8,083,889	100.0	$	7,737,351	100.0

(1) Ratings as assigned by Standard & Poor’s.

Securities Lending Agreements

The Company participates in 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. Such securities have been reclassified as “Fixed maturities and short-term investments pledged under securities lending agreements, at fair value.” The Company maintains 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. Collateral received, primarily in the form of cash, is required at a rate of 102% of the market value of the loaned securities (or 104% of the market value of the loaned securities when the collateral and loaned securities are denominated in non-U.S. currencies) including accrued investment income and is monitored and maintained by the lending agent. Such collateral is reinvested and is reflected as “Short-term investment of funds received under securities lending agreements, at fair value.” At March 31, 2007, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $1.12 billion and $1.11 billion, respectively, while collateral received totaled $1.16 billion at fair value and amortized cost. At December 31, 2006, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $860.8 million and $854.8 million, respectively, while collateral received totaled $891.4 million at fair value and amortized cost.

Investment-Related Derivatives

The Company’s investment strategy allows for the use of derivative securities. Derivative instruments may be used to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under the Company’s investment guidelines if implemented in other ways. The fair values of those derivatives are based on quoted market prices. At March 31, 2007 and December 31, 2006, the notional value of the net long position for equity futures was $89.5 million and $78.6 million, respectively, and the notional value of the net short position for Treasury note futures was $34.6 million and $35.2 million, respectively. For the 2007 first quarter, the Company recorded net realized losses of $0.9 million

related to changes in the fair value of all futures contracts, compared to net realized gains of $0.6 million for the 2006 first quarter. At March 31, 2007, the carrying value and fair value of all futures contracts was de minimis, compared to $0.3 million at December 31, 2006.

Other Investments

The following table details the Company’s other investments:

	(Unaudited)
	March 31, 2007				December 31, 2006
(U.S. dollars in thousands)	Estimated Fair Value		Cost		Estimated Fair Value		Cost

Alternative investment funds	$	269,453	$	269,462	$	167,497	$	167,703
Equity securities	88,483		70,607		75,496		60,619
Privately held securities	64,451		54,535		64,089		54,601
Total	$	422,387	$	394,604	$	307,082	$	282,923

Alternative investment funds primarily include funds that invest in investment grade and non-investment grade fixed income securities and funds that invest in senior floating rate loans; equity securities include certain investments in mutual funds and other preferred stocks; and privately held securities include the Company’s investment in Aeolus LP (see Note 10). The Company’s investment commitments relating to its other investments totaled approximately $85.7 million at March 31, 2007.

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 assets on deposit are available to settle insurance and reinsurance liabilities to third parties. The Company also has investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. The following table details the value of restricted assets:

	(Unaudited)
	March 31,		December 31,
(U.S. dollars in thousands)	2007		2006

Assets used for collateral or guarantees	$	715,513	$	798,437
Deposits with U.S. regulatory authorities	244,982		221,864
Trust funds	117,407		104,408
Deposits with non-U.S. regulatory authorities	38,565		34,112
Total restricted assets	$	1,116,467	$	1,158,821

In addition, certain of the Company’s operating subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies. At March 31, 2007 and December 31, 2006, such amounts approximated $3.53 billion and $3.61 billion, respectively.

Net Investment Income

The components of net investment income were as follows:

	(Unaudited)
	Three Months Ended
	March 31,
(U.S. dollars in thousands)	2007			2006

Fixed maturities	$	98,099		$	69,424
Short-term investments	9,734			9,787
Other (1)	8,661			3,884
Gross investment income	116,494			83,095
Investment expenses	(3,805		)	(2,769		)
Net investment income	$	112,689		$	80,326

(1) Primarily consists of interest income on operating cash accounts, other investments and securities lending transactions.

Net Realized Gains (Losses)

The components of net realized losses were as follows:

	(Unaudited)
	Three Months Ended
	March 31,
(U.S. dollars in thousands)	2007		2006

Fixed maturities	($1,144	)	($4,153	)
Other investments	1,139		2,728
Other	(976	)	(1,958	)
Net realized losses	($981	)	($3,383	)

Currently, the Company’s portfolio is actively managed on a total return basis within certain guidelines. The effect of financial market movements will influence the recognition of net realized gains and losses as the portfolio is adjusted and rebalanced. For the 2007 and 2006 first quarters, net realized losses on the Company’s fixed maturities of $1.1 million and $4.2 million, respectively, included provisions for declines in the market value of investments held in the Company’s available for sale portfolio which were considered to be other-than-temporary of $7.2 million and $5.3 million, respectively, based on reviews performed in each period. The declines in market value on such securities were primarily due to the current interest rate environment. For the 2007 and 2006 first quarters, the balance of $6.1 million and $1.1 million, respectively, in net realized gains on the Company’s fixed maturities resulted from the sale of securities. In the 2007 and 2006 first quarters, net realized gains or losses from the sale of fixed maturities resulted from the Company’s decisions to reduce credit exposure, changes in duration targets and sales related to rebalancing the portfolio.

8. Earnings Per Common Share

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

	(Unaudited)
	Three Months Ended
	March 31,
(U.S. dollars in thousands, except share data)	2007			2006

Basic earnings per common share:
Net income	$	205,012		$	132,290
Preferred dividends	(6,461		)	(2,667		)
Net income available to common shareholders	$	198,551		$	129,623
Divided by:
Weighted average common shares outstanding	73,931,996			72,899,249

Basic earnings per common share	$	2.69		$	1.78

Diluted earnings per common share:
Net income	$	205,012		$	132,290
Preferred dividends	(6,461		)	(2,667		)
Net income available to common shareholders	$	198,551		$	129,623
Divided by:
Weighted average common shares outstanding	73,931,996			72,899,249
Effect of dilutive securities:
Nonvested restricted shares	165,006			438,200
Stock options (1)	2,543,684			2,517,860
Weighted average common shares and common share equivalents outstanding — diluted	76,640,686			75,855,309

Diluted earnings per common share	$	2.59		$	1.71

(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 2007 and 2006 first quarters, the number of stock options excluded were 268,250 and 504,495, respectively.

9. Income Taxes

ACGL is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. ACGL has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to ACGL or any of its operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda.

ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors. ACGL does not consider itself to be engaged in a trade or business within the U.S. and, consequently, does not expect to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the U.S., there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or

business in the U.S. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL’s shareholders’ equity and earnings could be materially adversely affected.

ACGL has subsidiaries and branches that operate in various jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which ACGL’s subsidiaries and branches are subject to tax are the U.S., U.K., Canada and Switzerland.

The Company’s income tax provision resulted in an effective tax rate on income before income taxes of 4.0% for the 2007 first quarter, compared to 7.9% for the 2006 first quarter. The Company’s effective tax rate, which is based upon the expected annual effective tax rate, may fluctuate from period to period based on the relative mix of income reported by jurisdiction due primarily to the varying tax rates in each jurisdiction.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” an interpretation of SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a “more likely than not” threshold for the financial statement recognition of a tax position taken or expected to be taken in a tax return, assuming the relevant tax authority has full knowledge of all relevant information. The amount recognized represents the largest amount of tax benefit that is greater than 50% likely of being ultimately realized. A liability is recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalty (if applicable) on the excess.

The Company adopted the provisions of FIN 48 on January 1, 2007. As prescribed, the cumulative effect of applying FIN 48 is reported as an adjustment to the opening balance of retained earnings. As a result of the adoption on January 1, 2007, the Company’s retained earnings remained unchanged. As of January 1, 2007 and March 31, 2007, the Company’s total unrecognized tax benefits were zero.

The Company recognizes interest and penalties relating to unrecognized tax benefits in the provision for income taxes. As there were no unrecognized tax benefits included in its balance sheet, the Company did not record any interest or penalties in the 2007 first quarter.

The Company or its subsidiaries or branches files income tax returns in the U.S. federal jurisdiction and various state, local and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations for years before 2003. During 2006, the U.S. Internal Revenue Service commenced an examination of the Company’s U.S. income tax returns for the 2004 tax year that is anticipated to be completed within the next twelve months. The Company is not aware of any tax positions for which it is reasonable possible that the total amount of unrecognized tax benefits will significantly change in the next twelve months.

In addition to unrecognized tax benefits, the Company has provided a valuation allowance to reduce certain deferred tax assets to an amount which management expect to more likely than not be realized. At March 31, 2007 and December 31, 2006, the Company had a valuation allowance of $0.5 million and $1.4 million, respectively. The reduction in the valuation allowance in the 2007 first quarter resulted from the ability of one of the Company’s U.S. subsidiaries to utilize a net operating loss.

10. Transactions with Related Parties

In connection with the Company’s information technology initiative in 2002, the Company entered into arrangements with two software companies, which provide document management systems and information and research tools to insurance underwriters, in which John Pasquesi, Vice Chairman of ACGL’s board of directors, holds a minority ownership interest. One of the agreements was terminated in July 2005, and the other arrangement is variable based on usage. The Company made payments under such arrangement of approximately $0.1 million in the 2007 and 2006 first quarters.

The Company made an investment of $50.0 million in Aeolus LP (“Aeolus”) in 2006. Aeolus operates as an unrated reinsurance platform that provides property catastrophe protection to insurers and reinsurers on both an ultimate net loss and industry loss warranty basis. In return for its investment, included in “Other investments” on the Company’s balance sheet, the Company received an approximately 4.9% preferred interest in Aeolus and a pro rata share of certain founders’ interests. The Company made its investment in Aeolus on the same economic terms as a fund affiliated with Warburg Pincus, which has invested $350 million in Aeolus. Funds affiliated with Warburg Pincus owned 25.4% of the Company’s outstanding voting shares as of December 31, 2006. In addition, one of the founders of Aeolus is Peter Appel, former President and CEO and a former director of the Company.

On January 1, 2007, Arch Re Bermuda entered into four reinsurance treaties with PARIS RE Holdings Limited (“PARIS RE”), a reinsurance group in which the Hellman & Friedman funds acquired a 19% ownership interest in December 2006. Arch Re Bermuda recorded $12.9 million of business in the 2007 first quarter and expects to record approximately $33.1 million of ultimate assumed premiums written under such treaties. Prior to the acquisition by the Hellman & Friedman funds of its ownership interest in PARIS RE, Arch Re Bermuda recorded during 2006 (i) assumed premiums written of $21.9 million and (ii) ceded premiums written of $1.1 million under transactions with the predecessor of PARIS RE’s reinsurance business.

11. Contingencies Relating to the Sale of Prior Reinsurance Operations

On May 5, 2000, the Company sold the prior reinsurance operations of Arch Re U.S. pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, “Folksamerica”). Folksamerica Reinsurance Company assumed Arch Re U.S.’s liabilities under the reinsurance agreements transferred in the asset sale and Arch Re U.S. transferred to Folksamerica Reinsurance Company assets estimated in an aggregate amount equal in book value to the book value of the liabilities assumed. The Folksamerica transaction was structured as a transfer and assumption agreement (and not reinsurance) and, accordingly, the loss reserves (and any related reinsurance recoverables) relating to the transferred business are not included as assets or liabilities on the Company’s balance sheet. Folksamerica assumed Arch Re U.S.’s rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements were notified that Folksamerica had assumed Arch Re U.S.’s obligations and that, unless the reinsureds object to the assumption, Arch Re U.S. will be released from its obligations to those reinsured. None of such reinsureds objected to the assumption. However, Arch Re U.S. will continue to be liable under those reinsurance agreements if the notice is found not to be an effective release by the reinsureds. Folksamerica has agreed to indemnify the Company for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale. However, in the event that Folksamerica refuses or is unable to perform its obligations to the Company, Arch Re U.S. may incur losses relating to the reinsurance agreements transferred in the asset sale. Folksamerica’s A.M. Best rating was “A-” (Excellent) at March 31, 2007.

Under the terms of the agreement, in 2000, the Company had also purchased reinsurance protection covering the Company’s transferred aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed $5.4 million, the Company has agreed to reimburse

Folksamerica if a loss is incurred that exceeds $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. The Company also made representations and warranties to Folksamerica about the Company and the business transferred to Folksamerica for which the Company retains exposure for certain periods, and made certain other agreements. In addition, the Company retained its tax and employee benefit liabilities and other liabilities not assumed by Folksamerica, including all liabilities not arising under reinsurance agreements transferred to Folksamerica in the asset sale and all liabilities (other than liabilities arising under reinsurance agreements) arising out of or relating to a certain managing underwriting agency. Although Folksamerica has not asserted that any amount is currently due under any of the indemnities provided by the Company under the asset purchase agreement, Folksamerica has previously indicated a potential indemnity claim under the agreement in the event of the occurrence of certain future events. Based on all available information, the Company has denied the validity of any such potential claim.

12. Commitments and Contingencies

Variable Interest Entities

The Company concluded that, under FASB Interpretation No. 46R (“FIN 46R”), “Consolidation of Variable Interest Entities,” that it is required to consolidate the assets, liabilities and results of operations (if any) of a certain managing general agency in which one of its subsidiaries has an investment. Such agency ceased producing business in 1999 and is currently running-off its operations. Based on current information, there are no assets or liabilities of such agency required to be reflected on the face of the Company’s consolidated financial statements that are not, or have not been previously, otherwise reflected therein.

On December 29, 2005, Arch Re Bermuda entered into a quota share reinsurance treaty with Flatiron Re Ltd., a newly-formed Bermuda reinsurance company, pursuant to which Flatiron Re Ltd. is assuming a 45% quota share (the “Treaty”) of certain lines of property and marine business underwritten by Arch Re Bermuda for unaffiliated third parties for the 2006 and 2007 underwriting years (January 1, 2006 to December 31, 2007). As a result of the terms of the Treaty, the Company has determined that Flatiron Re Ltd. is a variable interest entity. However, Arch Re Bermuda is not the primary beneficiary of Flatiron Re Ltd. and, as such, the Company is not required to consolidate the assets, liabilities and results of operations of Flatiron Re Ltd. per FIN 46R. See Note 5, “Reinsurance” for information on the Treaty with Flatiron Re Ltd.

13. Legal Proceedings

The Company, in common with the insurance industry in general, is subject to litigation and arbitration in the normal course of its business. As of March 31, 2007, the Company was not a party to any material litigation or arbitration other than as a part of the ordinary course of business in relation to claims and reinsurance recoverable matters, none of which is expected by management to have a significant adverse effect on the Company’s results of operations and financial condition and liquidity.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the section entitled “Cautionary Note Regarding Forward Looking Statements,” and in our periodic reports filed with the Securities and Exchange Commission (“SEC”). For additional information regarding our business and operations, please also refer to our Annual Report on Form 10-K for the year ended December 31, 2006, including our audited consolidated financial statements and related notes and the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

GENERAL

Overview

Arch Capital Group Ltd. (“ACGL” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with over $4.0 billion in capital at March 31, 2007 and, through operations in Bermuda, the United States, Europe and Canada, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in the insurance and reinsurance markets.

The worldwide insurance and reinsurance industry is highly competitive and has traditionally been subject to an underwriting cycle in which a hard market (high premium rates, restrictive underwriting standards, as well as terms and conditions, and underwriting gains) is eventually followed by a soft market (low premium rates, relaxed underwriting standards, as well as broader terms and conditions, and underwriting losses). Insurance market conditions may affect, among other things, the demand for our products, our ability to increase premium rates, the terms and conditions of the insurance policies we write, changes in the products offered by us or changes in our business strategy.

The financial results of the insurance and reinsurance industry are influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence, among other things, the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market.

Current Outlook

The weather-related catastrophic events that occurred in the second half of 2005 caused significant industry losses and led to a strengthening of rating agency capital requirements for catastrophe-exposed business. The 2005 events also resulted in substantial improvements in market conditions in property and certain marine lines of business. We increased our writings in property and certain marine lines of business in 2006 in order to take advantage of the improved market conditions and these lines represented a larger proportion of our overall book of business in 2006 and 2007 than in prior periods. We expect that our writings in these lines of business will represent a larger proportion of our overall book of business in future periods, which may increase the volatility in our results of operations. Although we saw price erosion in many of our lines in 2006, current pricing remains attractive in many areas, even in lines for which rates have fallen. The most attractive area from a pricing point

of view remains catastrophe-related property business. We are still able to write insurance and reinsurance business at what we believe to be attractive rates.

In December 2005, we entered into a quota-share reinsurance treaty with Flatiron Re Ltd., a dedicated reinsurance vehicle, which has allowed us to increase our participation in property and marine lines without significantly increasing our probable maximum loss. The treaty with Flatiron Re Ltd. provides for commission income (in excess of the reimbursement of direct acquisition expenses) which includes a profit commission based on the reported underwriting results on a cumulative basis. We record the profit commission portion of income from Flatiron Re Ltd. based on underwriting experience recorded each quarter. The profit commission arrangement with Flatiron Re Ltd. may increase the volatility of our reported results of operations on both a quarterly and annual basis.

In January 2007, we entered into a new line of business when we agreed to write excess workers’ compensation and employers’ liability insurance produced by a managing general agent, Wexford Underwriting Managers, Inc. (“Wexford”). Wexford, which produced $74 million of business in 2006 for its predecessor carrier and $9.8 million of gross premiums written for us in the 2007 first quarter, primarily serves not-for-profit clients. We also entered into an asset purchase agreement to acquire the operations of Wexford, including the renewal rights of the subject business, as of January 1, 2008.

In April 2007, we launched a new property facultative reinsurance operation headed by a very experienced and well respected industry veteran. This unit will be based in Farmington, Connecticut with branch offices across the United States and in Toronto, Canada. We view this business as a long-term opportunity that expands our specialty underwriting platform and will further diversify our book of business.

On May 2, 2007, Standard & Poor’s Rating Services (“S&P”) announced that it has upgraded the financial strength ratings of our principal operating subsidiaries from “A-” (Strong) to “A” (Strong). S&P also upgraded the counterparty credit and senior debt ratings on ACGL to “BBB+” from “BBB”. The outlook on all of the ratings is stable.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RECENT ACCOUNTING PRONOUNCEMENTS

Critical accounting policies, estimates and recent accounting pronouncements are discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2006, updated where applicable in the notes accompanying our consolidated financial statements.

RESULTS OF OPERATIONS

Three Months Ended March 31, 2007 and 2006

The following table sets forth net income available to common shareholders and earnings per common share data:

	Three Months Ended
	March 31,
(U.S. dollars in thousands, except share data)	2007	2006