ACGL 10Q 6.30.14
Table of Contents

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 period ended June 30, 2014
 
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.)
 
Waterloo House, Ground Floor
100 Pitts Bay Road
Pembroke HM 08, 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 July 31, 2014 was 135,112,921.


Table of Contents

ARCH CAPITAL GROUP LTD.
 
INDEX
 
 
 
Page No.
PART I. Financial Information
 
 
 
 
 
Item 1 — Consolidated Financial Statements
 
 
 
 
 
 
 
 
 
 
 
June 30, 2014 (unaudited) and December 31, 2013
 
 
 
 
 
 
For the three and six month periods ended June 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
For the three and six month periods ended June 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
For the six month periods ended June 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
For the six month periods ended June 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

1

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 condensed consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of June 30, 2014, and the related condensed consolidated statements of income and comprehensive income for the three-month and six-month periods ended June 30, 2014 and June 30, 2013, and the condensed consolidated statements of changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2014 and June 30, 2013. 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 condensed 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, 2013, 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 March 3, 2014, 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, 2013, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
 
/s/ PricewaterhouseCoopers LLP
 
New York, NY
August 8, 2014

2

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
June 30,
2014
 
December 31,
2013
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $10,599,911 and $9,564,634)
$
10,714,532

 
$
9,571,776

Short-term investments available for sale, at fair value (amortized cost: $977,347 and $1,477,584)
977,058

 
1,478,367

Investment of funds received under securities lending, at fair value (amortized cost: $79,242 and $97,943)
82,603

 
100,584

Equity securities available for sale, at fair value (cost: $513,094 and $433,275)
608,820

 
496,824

Other investments available for sale, at fair value (cost: $428,958 and $488,687)
457,567

 
498,310

Investments accounted for using the fair value option
2,041,091

 
1,221,534

Investments accounted for using the equity method
281,464

 
244,339

Total investments
15,163,135

 
13,611,734

 
 
 
 
Cash
926,443

 
434,057

Accrued investment income
64,869

 
66,848

Investment in joint venture (cost: $100,000)
103,934

 
104,856

Fixed maturities and short-term investments pledged under securities lending, at fair value
87,031

 
105,081

Premiums receivable
1,098,692

 
753,924

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
1,796,403

 
1,804,330

Contractholder receivables
1,234,392

 
1,064,246

Prepaid reinsurance premiums
430,214

 
328,343

Deferred acquisition costs, net
399,385

 
342,314

Receivable for securities sold
261,669

 
50,555

Goodwill and intangible assets
118,721

 
27,319

Other assets
888,627

 
872,487

Total assets
$
22,573,515

 
$
19,566,094

 
 
 
 
Liabilities
 
 
 
Reserve for losses and loss adjustment expenses
$
9,018,989

 
$
8,824,696

Unearned premiums
2,299,692

 
1,896,365

Reinsurance balances payable
263,347

 
196,167

Contractholder payables
1,234,392

 
1,064,246

Deposit accounting liabilities
397,337

 
421,297

Senior notes
800,000

 
800,000

Revolving credit agreement borrowings
100,000

 
100,000

Securities lending payable
89,298

 
107,999

Payable for securities purchased
552,075

 
51,318

Other liabilities
577,320

 
456,510

Total liabilities
15,332,450

 
13,918,598

 
 
 
 
Commitments and Contingencies


 


Redeemable noncontrolling interests
219,326

 

 
 
 
 
Shareholders' Equity
 
 
 
Non-cumulative preferred shares
325,000

 
325,000

Common shares ($0.0033 par, shares issued: 171,096,771 and 169,560,591)
570

 
565

Additional paid-in capital
353,208

 
299,517

Retained earnings
6,421,701

 
6,042,154

Accumulated other comprehensive income, net of deferred income tax
233,883

 
74,964

Common shares held in treasury, at cost (shares: 36,065,885 and 35,885,707)
(1,104,963
)
 
(1,094,704
)
Total shareholders' equity available to Arch
6,229,399

 
5,647,496

Non-redeemable noncontrolling interests (1)
792,340

 

Total shareholders' equity
7,021,739

 
5,647,496

Total liabilities, noncontrolling interests and shareholders' equity
$
22,573,515

 
$
19,566,094


(1)     See Note 4.

See Notes to Consolidated Financial Statements

3

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
(Unaudited)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Revenues
 

 
 

 
 

 
 

Net premiums written
$
971,928

 
$
810,535

 
$
2,036,918

 
$
1,763,311

Change in unearned premiums
(64,776
)
 
(51,719
)
 
(269,986
)
 
(251,725
)
Net premiums earned
907,152

 
758,816

 
1,766,932

 
1,511,586

Net investment income
72,990

 
68,369

 
139,984

 
134,041

Net realized gains
54,144

 
12,652

 
73,841

 
70,992

Other-than-temporary impairment losses
(14,749
)
 
(724
)
 
(17,720
)
 
(2,972
)
Less investment impairments recognized in other comprehensive income, before taxes

 

 

 
2

Net impairment losses recognized in earnings
(14,749
)
 
(724
)
 
(17,720
)
 
(2,970
)
 
 
 
 
 
 
 
 
Other underwriting income
2,033

 
902

 
3,615

 
1,440

Equity in net income of investment funds accounted for using the equity method
9,240

 
10,941

 
12,493

 
24,764

Other income (loss)
4,850

 
834

 
2,746

 
2,078

Total revenues
1,035,660

 
851,790

 
1,981,891

 
1,741,931

 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
Losses and loss adjustment expenses
485,518

 
418,653

 
921,758

 
818,056

Acquisition expenses
158,158

 
131,677

 
318,500

 
259,269

Other operating expenses
156,350

 
127,408

 
302,149

 
247,591

Interest expense
14,334

 
5,852

 
28,738

 
11,750

Net foreign exchange losses (gains)
2,294

 
(13,811
)
 
8,857

 
(38,075
)
Total expenses
816,654

 
669,779

 
1,580,002

 
1,298,591

 
 
 
 
 
 
 
 
Income before income taxes
219,006

 
182,011

 
401,889

 
443,340

Income tax expense
(7,289
)
 
(5,071
)
 
(11,027
)
 
(9,924
)
Net income
$
211,717

 
$
176,940

 
$
390,862

 
$
433,416

Amounts attributable to noncontrolling interests (1)
(3,701
)
 

 
(346
)
 

Net income available to Arch
208,016

 
176,940

 
390,516

 
433,416

Preferred dividends
(5,485
)
 
(5,485
)
 
(10,969
)
 
(10,969
)
Net income available to common shareholders
$
202,531

 
$
171,455

 
$
379,547

 
$
422,447

 
 
 
 
 
 
 
 
Net income per common share
 

 
 

 
 

 
 

Basic
$
1.53

 
$
1.31

 
$
2.87

 
$
3.22

Diluted
$
1.48

 
$
1.26

 
$
2.78

 
$
3.11

 
 
 
 
 
 
 
 
Weighted average common shares and common share equivalents outstanding
 

 
 

 
 

 
 

Basic
132,650,634

 
131,377,274

 
132,256,462

 
131,143,885

Diluted
136,889,944

 
135,849,050

 
136,716,889

 
135,624,226


(1)     See Note 4.


See Notes to Consolidated Financial Statements

4

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)
 
(Unaudited)
 
(Unaudited)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Comprehensive Income (Loss)
 
 
 
 
 

 
 

Net income
$
211,717

 
$
176,940

 
$
390,862

 
$
433,416

Other comprehensive income (loss), net of deferred income tax
 
 
 
 
 
 
 
Unrealized appreciation (decline) in value of available-for-sale investments:
 
 
 
 
 
 
 
Unrealized holding gains (losses) arising during period
108,428

 
(259,562
)
 
179,781

 
(250,091
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax

 

 

 
(2
)
Reclassification of net realized gains, net of income taxes, included in net income
(8,285
)
 
(13,916
)
 
(29,534
)
 
(52,617
)
Foreign currency translation adjustments
10,021

 
(5,407
)
 
8,672

 
(33,629
)
Comprehensive income (loss)
321,881

 
(101,945
)
 
549,781

 
97,077

Amounts attributable to noncontrolling interests (1)
(3,701
)
 

 
(346
)
 

Comprehensive income (loss) available to Arch
$
318,180

 
$
(101,945
)
 
$
549,435

 
$
97,077


(1)     See Note 4.


See Notes to Consolidated Financial Statements

5

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
 
(Unaudited)
 
Six Months Ended
 
June 30,
 
2014
 
2013
Non-Cumulative Preferred Shares
 

 
 

Balance at beginning and end of period
$
325,000

 
$
325,000

 
 
 
 
Common Shares
 
 
 
Balance at beginning of year
565

 
561

Common shares issued, net
5

 
3

Balance at end of period
570

 
564

 
 
 
 
Additional Paid-in Capital
 

 
 

Balance at beginning of year
299,517

 
227,778

Common shares issued, net
6,360

 
5,362

Exercise of stock options
11,233

 
6,022

Amortization of share-based compensation
35,627

 
31,466

Other
471

 
2,327

Balance at end of period
353,208

 
272,955

 
 
 
 
Retained Earnings
 

 
 

Balance at beginning of year
6,042,154

 
5,354,361

Net income
390,862

 
433,416

Amounts attributable to noncontrolling interests (1)
(346
)
 

Preferred share dividends
(10,969
)
 
(10,969
)
Balance at end of period
6,421,701

 
5,776,808

 
 
 
 
Accumulated Other Comprehensive Income (Loss)
 
 
 
Balance at beginning of year
74,964

 
287,017

Unrealized appreciation in value of available-for-sale investments, net of deferred income tax:
 
 
 
Balance at beginning of year
80,692

 
289,956

Unrealized holding gains (losses) arising during period, net of reclassification adjustment
150,247

 
(302,708
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax

 
(2
)
Balance at end of period
230,939

 
(12,754
)
Foreign currency translation adjustments:
 
 
 
Balance at beginning of year
(5,728
)
 
(2,939
)
Foreign currency translation adjustments
8,672

 
(33,629
)
Balance at end of period
2,944

 
(36,568
)
Balance at end of period
233,883

 
(49,322
)
 
 
 
 
Common Shares Held in Treasury, at Cost
 
 
 
Balance at beginning of year
(1,094,704
)
 
(1,025,839
)
Shares repurchased for treasury
(10,259
)
 
(65,848
)
Balance at end of period
(1,104,963
)
 
(1,091,687
)
 
 
 
 
Total shareholders’ equity available to Arch
6,229,399

 
5,234,318

Non-redeemable noncontrolling interests (1)
792,340

 

Total shareholders’ equity
$
7,021,739

 
$
5,234,318


(1)     See Note 4.

 

See Notes to Consolidated Financial Statements

6

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
 
(Unaudited)
 
Six Months Ended
 
June 30,
 
2014
 
2013
Operating Activities
 

 
 

Net income
$
390,862

 
$
433,416

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Net realized gains
(87,520
)
 
(73,611
)
Net impairment losses recognized in earnings
17,720

 
2,970

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
(135
)
 
37,493

Share-based compensation
35,627

 
31,466

Changes in:
 
 
 
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
60,474

 
(33,163
)
Unearned premiums, net of prepaid reinsurance premiums
269,986

 
251,725

Premiums receivable
(325,953
)
 
(205,044
)
Deferred acquisition costs, net
(55,822
)
 
(51,971
)
Reinsurance balances payable
65,803

 
24,267

Other liabilities
43,133

 
(26,981
)
Other items
38,888

 
(2,213
)
Net Cash Provided By Operating Activities
453,063

 
388,354

 
 
 
 
Investing Activities
 

 
 

Purchases of:
 

 
 

Fixed maturity investments
(14,311,748
)
 
(8,599,697
)
Equity securities
(174,687
)
 
(272,323
)
Other investments
(1,022,987
)
 
(648,915
)
Proceeds from the sales of:
 
 
 
Fixed maturity investments
13,204,854

 
8,468,641

Equity securities
98,687

 
194,212

Other investments
618,707

 
506,434

Proceeds from redemptions and maturities of fixed maturity investments
432,040

 
424,953

Net sales (purchases) of short-term investments
430,304

 
(375,146
)
Change in investment of securities lending collateral
18,701

 
3,221

Purchase of business, net of cash acquired (1)
(235,578
)
 

Purchases of furniture, equipment and other assets
(10,360
)
 
(7,092
)
Net Cash Used For Investing Activities
(952,067
)
 
(305,712
)
 
 
 
 
Financing Activities
 

 
 

Purchases of common shares under share repurchase program

 
(56,463
)
Proceeds from common shares issued, net
2,521

 
(517
)
Change in securities lending collateral
(18,701
)
 
(3,221
)
Third party investment in non-redeemable noncontrolling interests (2)
796,903

 

Third party investment in redeemable noncontrolling interests (2)
219,233

 

Dividends paid to redeemable noncontrolling interests (2)
(4,816
)
 

Other
4,706

 
5,042

Preferred dividends paid
(10,969
)
 
(10,969
)
Net Cash Provided By (Used For) Financing Activities
988,877

 
(66,128
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash
2,513

 
(12,436
)
 
 
 
 
Increase in cash
492,386

 
4,078

Cash beginning of year
434,057

 
371,041

Cash end of period
$
926,443

 
$
375,119


(1)     See Note 2.
(2)     See Note 4.


See Notes to Consolidated Financial Statements

7

Table of Contents
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 subsidiaries (together with ACGL, the “Company”).

On January 30, 2014, the Company acquired CMG Mortgage Insurance Company and its affiliated mortgage insurance companies (together, “CMG Entities”) and the mortgage insurance platform and related assets from PMI Mortgage Insurance Co. (“PMI”) (see Note 2).

On March 20, 2014, the Company acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity for $100 million. Watford Holdings Ltd. is the parent of Watford Re Ltd., a newly-formed multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., “Watford”). Watford is considered a variable interest entity (“VIE”) and the Company concluded that it is the primary beneficiary of Watford. As such, the results of Watford are included in the Company’s consolidated financial statements (see Note 4).

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 the Company and Watford. 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, 2013 (“2013 Form 10-K”), 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, comprehensive income, shareholders’ equity or cash flows. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
 
2.    Business Acquired

On January 30, 2014, the Company’s U.S.-based subsidiaries completed the acquisition of the CMG Entities through a stock purchase agreement (“SPA”) from its previous owners, PMI, which has been in rehabilitation under the receivership of the Arizona Department of Insurance since 2011, and CMFG Life Insurance Company (“CUNA Mutual”). In addition, the Company entered into a distribution agreement with CUNA Mutual and a reinsurance agreement with an affiliate of CUNA Mutual. CMG Mortgage Insurance Company has been renamed “Arch Mortgage Insurance Company” (“Arch MI U.S.”). As part of the transaction, Arch MI U.S. obtained approval as an eligible mortgage insurer from Fannie Mae and Freddie Mac (each a government sponsored enterprise or “GSE”), subject to maintaining certain ongoing requirements.

In addition, through an asset purchase agreement (“APA”) with PMI, the Company acquired the mortgage insurance operating platform of PMI, 100% of the capital stock of PMI Mortgage Assurance Co., a mortgage insurance company licensed in all 50 states (renamed Arch Mortgage Guaranty Company), and entered into a quota share reinsurance agreement pursuant to which Arch Reinsurance Ltd. agreed to provide 100% quota share indemnity reinsurance to PMI for all certificates of insurance that were issued by PMI between and including January 1, 2009 and December 31, 2011 that were not in default as of an agreed upon effective date. Other than this quota share, no PMI legacy exposures were assumed in the transaction. As part of the transaction, the Company entered into a services agreement with PMI to provide certain necessary operational services to administer the run-off of PMI’s legacy business at the direction of PMI. Arch MI U.S. also entered into a quota share reinsurance agreement whereby it will cede 20% of all new primary flow mortgage insurance business post-closing (both credit union and non-credit union business) on the first $25 billion in original loan amounts to PMI, on a funds-withheld basis.

8




The completion of the SPA and APA transactions enabled the Company to enter the U.S. mortgage insurance marketplace and serve all lenders nationwide. The arrangements with CUNA Mutual also provided a seamless transition and enabled the Company to provide uninterrupted access and services to the credit union marketplace.

At closing, the Company paid aggregate consideration of $160.6 million (80% of the actual closing date book value of the CMG Entities) under the SPA and $84.6 million under the APA. Additionally, the SPA contains provisions for contingent consideration payments, subject to an overall maximum payment of 150% of closing book value of the pre-closing portfolio of the CMG Entities as re-calculated over an earn-out period and payable at the third, fifth and sixth anniversaries after closing (subject to a one time extension period of one to three years at the sellers’ discretion). The maximum amount of contingent consideration payments is $136.9 million. To the extent that the adjusted book value of the CMG Entities drops below the cumulative amount paid by the Company, no additional payments would be due. To determine the fair value of the contingent consideration liability, the Company estimated future payments using a weighted average cost of capital approach at a rate of return of 15% which reflects the industry-weighted average rate of return on debt and equity as required by market participants. The fair value of the contingent consideration liability was $41.8 million at closing. The contingent consideration liability, which is included in ‘other liabilities’ in the consolidated balance sheets, is remeasured at fair value at each balance sheet date ($53.1 million at June 30, 2014) until the contingency is resolved with changes in fair value recognized in ‘net realized gains (losses).’

The following table summarizes the fair value of net assets acquired and allocation of purchase price, measured as of the acquisition date:
 
 
Total
 
Useful Life
Purchase price
 
 
 
 
Cash paid
 
$
245,157

 
 
Contingent consideration liability
 
41,762

 
 
Total purchase price (a)
 
$
286,919

 
 
 
 
 
 
 
Assets acquired
 
 
 
 
Cash
 
$
9,579

 
 
Investments, at fair value
 
312,093

 
 
Intangible asset -- acquired insurance contracts
 
46,473

 
5 years
Intangible asset -- operating platform
 
29,900

 
5 years
Intangible asset -- favorable lease contract
 
1,056

 
5 years
Intangible asset -- insurance licenses
 
16,858

 
Indefinite
Other assets acquired
 
21,691

 
 
Total assets acquired
 
437,650

 
 
 
 
 
 
 
Liabilities acquired
 
 
 
 
Reserves for losses and loss adjustment expenses
 
$
121,572

 
 
Unearned premiums
 
26,261

 
 
Intangible liability -- unfavorable service contract
 
9,533

 
9 years
Other liabilities acquired
 
7,217

 
 
Total liabilities acquired
 
164,583

 
 
Net assets acquired (b)
 
$
273,067

 
 
Goodwill (a)-(b)
 
$
13,852

 
 

From the acquisition date to June 30, 2014, the Company recorded amortization expense of $9.3 million related to net intangible assets acquired. The Company recognized goodwill of $13.9 million that is primarily attributed to PMI’s assembled workforce, access to the mortgage insurance market and additional synergies to be realized in the future. Under U.S. tax principles, which differentiate between taxable and non-taxable business combinations, the Company estimates that $48.0 million of goodwill is expected to be deductible for tax purposes.

The Company includes the operations of Arch MI U.S. in its mortgage segment (see Note 6).


9



3.    Significant Accounting Policies

As discussed in Note 2, the Company completed its acquisition of the CMG Entities on January 30, 2014. As such, the Company has added relevant sections pertaining to mortgage insurance to its significant accounting policies as described in Note 2, “Significant Accounting Policies,” of its audited consolidated financial statements and related notes of the 2013 Form 10-K.

(b) Premium Revenues and Related Expenses

Insurance. Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in the Company’s programs, specialty lines, lenders products business and for participation in involuntary pools. Such premium estimates are derived from multiple sources which include the historical experience of the underlying business, similar business and available industry information. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of in-force insurance policies.

Reinsurance. Reinsurance premiums written include amounts reported by brokers and ceding companies, supplemented by the Company’s own estimates of premiums where reports have not been received. The determination of premium estimates requires a review of the Company’s experience with the ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management’s judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to the Company. On an ongoing basis, the Company’s underwriters review the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business, taking into account the Company’s historical experience with the brokers or ceding companies. In addition, reinsurance contracts under which the Company assumes business generally contain specific provisions which allow the Company to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined.

Reinsurance premiums written are recorded based on the type of contracts the Company writes. Premiums on the Company’s excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, premiums are recorded as written based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.

Reinstatement premiums for the Company’s insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment. Premium estimates are reviewed by management at least quarterly. Such review includes a comparison of actual reported premiums to expected ultimate premiums along with a review of the aging and collection of premium estimates. Based on management’s review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts.

Reinsurance premiums written, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a “losses occurring” basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a “risks attaching” basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period. Certain

10



of the Company’s reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses, are recorded based upon the projected experience under such contracts.

The Company also writes certain reinsurance business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, the Company assumes a measured amount of insurance risk in exchange for an anticipated margin, which is typically lower than on traditional reinsurance contracts. The terms and conditions of these contracts may include additional or return premiums based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages, financial quota share coverages and multi- year retrospectively rated excess of loss coverages. If these contracts are deemed to transfer risk, they are accounted for as reinsurance.

Mortgage. Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy. If single premium policies related to insured loans are canceled due to repayment by the borrower and the policy is a non-refundable product, the remaining unearned premium related to each canceled policy is recognized as earned premium upon notification of the cancellation.

Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. A portion of premium payments may be refundable if the insured cancels coverage, which generally occurs when the loan is repaid, the loan amortizes to a sufficiently low amount to trigger a lender permitted or legally required cancellation, or the value of the property has increased sufficiently in accordance with the terms of the contract. Premium refunds reduce premiums earned in the consolidated statements of operations.

Acquisition Costs. Acquisition expenses and other expenses related to the Company’s underwriting operations that vary with, and are directly related to, the successful acquisition or renewal of business are deferred and amortized based on the type of contract. For property and casualty insurance and reinsurance contracts, deferred acquisition costs are amortized over the period in which the related premiums are earned. Consistent with mortgage insurance industry accounting practice, amortization of acquisition costs related to the mortgage insurance contracts for each underwriting year’s book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are comprised of earned premiums and losses and loss adjustment expenses. For each underwriting year, the Company estimates the rate of amortization to reflect actual experience and any changes to persistency or loss development.

Acquisition expenses, net of ceding commissions received from reinsurers, consist principally of commissions and premium taxes paid to obtain the Company’s business. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Deferred acquisition costs are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income. A premium deficiency occurs if the sum of anticipated losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceed unearned premiums and anticipated investment income. A premium deficiency is recorded by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency.


11



(i) Reserves for Losses and Loss Adjustment Expenses

Insurance and Reinsurance. The reserve for losses and loss adjustment expenses consists of estimates of unpaid reported losses and loss adjustment expenses and estimates for losses incurred but not reported. The reserve for unpaid reported losses and loss adjustment expenses, established by management based on reports from ceding companies and claims from insureds, excludes estimates of amounts due from insureds related to losses under high deductible policies, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company. Such reserves are supplemented by management’s estimates of reserves for losses incurred for which reports or claims have not been received. The Company’s reserves are based on a combination of reserving methods, incorporating both Company and industry loss development patterns. The Company selects the initial expected loss and loss adjustment expense ratios based on information derived by its underwriters and actuaries during the initial pricing of the business, supplemented by industry data where appropriate. Such ratios consider, among other things, rate changes and changes in terms and conditions that have been observed in the market. These estimates are reviewed regularly and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments, if any, are reflected in income in the period in which they are determined. As actual loss information has been reported, the Company has developed its own loss experience and its reserving methods include other actuarial techniques. Over time, such techniques have been given further weight in its reserving process based on the continuing maturation of the Company’s reserves. Inherent in the estimates of ultimate losses and loss adjustment expenses are expected trends in claims severity and frequency and other factors which may vary significantly as claims are settled. Accordingly, ultimate losses and loss adjustment expenses may differ materially from the amounts recorded in the accompanying consolidated financial statements. Losses and loss adjustment expenses are recorded on an undiscounted basis, except for excess workers’ compensation and employers’ liability business written by the Company’s insurance operations.

Mortgage. The reserves for mortgage guaranty insurance losses and loss adjustment expenses are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. Consistent with industry accounting practice, the Company does not establish loss reserves for future claims on insured loans that are not currently in default (defined as two consecutive missed payments). The Company establishes loss reserves on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and average claim sizes for each report year, net of any salvage recoverable. The Company also reserves for defaults that have occurred but have not yet been reported to the Company prior to the close of an accounting period. To determine this reserve, the Company estimates the number of defaults not yet reported using historical information regarding late reported delinquencies and applies estimated claim rates and claim sizes for the estimated defaults not yet reported.

The establishment of reserves across the Company’s segments is an inherently uncertain process, are necessarily based on estimates, and the ultimate net cost may vary from such estimates. The methods for making such estimates and for establishing the resulting liability are reviewed and updated using the most current information available. Any resulting adjustments, which may be material, are reflected in current operations

(p) Recent Accounting Pronouncements

A new accounting standard issued in the 2014 second quarter will change the manner in which most companies recognize revenue. The standard requires that revenue reflect the transfer of goods or services to customers based on the consideration or payment the company expects to be entitled to in exchange for those goods or services; however, the standard does not change the accounting for insurance contracts or investment income. The new standard also requires enhanced disclosures about revenue. This accounting guidance is effective in the 2017 first quarter and may be applied on a full retrospective or modified retrospective approach. The Company is currently assessing the impact the implementation of this standard will have on its consolidated financial statements.

(q) Goodwill and Intangible Assets

Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired and is assigned to the applicable reporting unit at acquisition. Goodwill is not amortized and is evaluated for impairment on an annual basis. Impairment tests may be performed more frequently if the facts and circumstances indicate a possible impairment. In performing impairment tests, the Company may first assess qualitative factors to determine whether it is more likely than not (that is, more than a 50% probability) that the fair value of a reporting unit exceeds its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in the accounting guidance.


12



Indefinite-lived intangible assets, such as insurance licenses, are not amortized and are evaluated for impairment similar to goodwill. Finite-lived intangible assets and liabilities include the value of insurance and reinsurance contracts, which are estimated based on the present value of future expected cash flows and amortized in ‘acquisition expenses’ in proportion to the estimated profits expected to be realized. Other finite-lived intangible assets or liabilities, including favorable or unfavorable contracts, are amortized in ‘other operating expenses’ over their useful lives. Finite-lived intangible assets and liabilities are periodically reviewed for indicators of impairment. An impairment is recognized when the carrying amount is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and fair value.

If goodwill or intangible assets are impaired, such assets are written down to their realizable values with the related expense recorded in the Company’s results of operations.

4.     Variable Interest Entity and Noncontrolling Interests

Variable interest entity

A VIE refers to an entity that has characteristics such as (i) insufficient equity at risk to allow the entity to finance its activities without additional financial support or (ii) instances where the equity investors, as a group, do not have characteristics of a controlling financial interest. The primary beneficiary of a VIE is defined as the variable interest holder that is determined to have the controlling financial interest as a result of having both (i) the power to direct the activities of a VIE that most significantly impact the economic performance of the VIE and (ii) the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. If a company is determined to be the primary beneficiary, it is required to consolidate the VIE in its financial statements.

In March 2014, Watford raised approximately $1.1 billion of capital consisting of $907.3 million in common equity ($895.6 million net of issuance costs) and $226.6 million in preference equity ($219.2 million net of issuance costs and discount). The Company invested $100.0 million and acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity. Arch Underwriters Ltd. (“AUL”), a subsidiary of the Company, acts as Watford’s reinsurance manager, and Highbridge Principal Strategies, LLC (“Highbridge”), a subsidiary of JPMorgan Chase & Co., manages Watford’s investment assets, each under separate long term services agreements. John Rathgeber, previously Vice Chairman of Arch Worldwide Reinsurance Group, was named CEO of Watford. In addition, Marc Grandisson, Chairman and CEO of Arch Worldwide Reinsurance and Mortgage Groups, and Nicolas Papadopoulo, CEO Reinsurance Group, were appointed to the board of directors of Watford.

The Company concluded that Watford is a VIE due to both the reinsurance management services agreement with AUL and the investment management agreement with Highbridge. Both of these agreements provide for services for an extended period of time with limited termination rights by Watford. In addition, these agreements allow for both AUL and Highbridge to participate in the favorable results of Watford in the form of performance fees. To determine if the Company is the primary beneficiary of Watford, the Company concluded that the most significant activity of Watford pertains to the insurance activities arising from the reinsurance management services agreement, as these activities will ultimately generate the investable assets required by Highbridge to execute the investment strategy. In addition, the Company factored into its analysis qualitative aspects of the relationship with Watford that are indicative of power to direct the insurance activities. These aspects coupled with the Company’s board seats and a former executive of the Company serving as Watford’s CEO resulted in the Company concluding that it is the primary beneficiary of Watford. As such, the results of Watford are included in the Company’s consolidated financial statements.

The Company concluded that Watford represents a separate operating segment and provides the income statement and total investable assets, total assets and total liabilities of Watford within Note 6. Because Watford is an independent company, the assets of Watford can be used only to settle obligations of Watford and Watford is solely responsible for its own liabilities and commitments. The Company’s financial exposure to Watford is limited to its investment in Watford’s common shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions.


13



Non-redeemable noncontrolling interests

The Company accounts for the portion of Watford’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford’s common shares was approximately 89% at June 30, 2014. The portion of Watford’s income or loss attributable to third party investors is recorded in the consolidated statements of income in ‘amounts attributable to noncontrolling interests.’ The following table sets forth activity in the non-redeemable noncontrolling interests:
 
Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
Balance, beginning of period
$
793,496

 
$

Sale of shares to noncontrolling interests

 
796,903

Amounts attributable to noncontrolling interests
(1,156
)
 
(4,563
)
Balance, end of period
$
792,340

 
$
792,340


Redeemable noncontrolling interests

The Company accounts for redeemable noncontrolling interests in the mezzanine section of its consolidated balance sheets in accordance with applicable accounting guidance. Such redeemable noncontrolling interests represent the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in late March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. The Watford Preference Shares were issued at a discounted amount of $24.50 per share. Holders of the Watford Preference Shares will be entitled to receive, if declared by Watford’s board, quarterly cash dividends on the last day of March, June, September, and December. Dividends will accrue from the closing date to June 30, 2019 at a fixed rate of 8.5% per annum. From June 30, 2019 and subsequent, dividends will accrue based on a floating rate equal to the 3 month U.S. dollar LIBOR (with a 1% floor) plus a margin based on the difference between the fixed rate and the 5 year mid swap rate to the floating rate as set out on the IRSB18. The Watford Preference Shares may be redeemed by Watford on or after June 30, 2019 or at the option of the preferred shareholders at any time on or after June 30, 2034. Because the redemption features are not solely within the control of Watford, the Company accounts for the redeemable noncontrolling interests in the Watford Preference Shares in the mezzanine section of its consolidated balance sheets. Third party investors own 100% of the Watford Preference Shares at June 30, 2014. Preferred dividends, including the accretion of the discount and issuance costs, are included in ‘amounts attributable to noncontrolling interests’ in the Company’s consolidated statements of income.


14

Table of Contents
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
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
Numerator:
 

 
 

 
 

 
 

Net income
$
211,717

 
$
176,940

 
$
390,862

 
$
433,416

Amounts attributable to noncontrolling interests
(3,701
)
 

 
(346
)
 

Net income available to Arch
208,016

 
176,940

 
390,516

 
433,416

Preferred dividends
(5,485
)
 
(5,485
)
 
(10,969
)
 
(10,969
)
Net income available to Arch common shareholders
$
202,531

 
$
171,455

 
$
379,547

 
$
422,447

 
 
 
 
 
 
 
 
Denominator:
 

 
 

 
 

 
 

Weighted average common shares outstanding — basic
132,650,634

 
131,377,274

 
132,256,462

 
131,143,885

Effect of dilutive common share equivalents:
 
 
 
 
 
 
 
Nonvested restricted shares
1,144,621

 
1,088,030

 
1,236,408

 
1,181,947

Stock options (1)
3,094,689

 
3,383,746

 
3,224,019

 
3,298,394

Weighted average common shares and common share equivalents outstanding — diluted
136,889,944

 
135,849,050

 
136,716,889

 
135,624,226

 
 
 
 
 
 
 
 
Earnings per common share:
 

 
 

 
 

 
 

Basic
$
1.53

 
$
1.31

 
$
2.87

 
$
3.22

Diluted
$
1.48

 
$
1.26

 
$
2.78

 
$
3.11

_________________________________________________
(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 2014 second quarter and 2013 second quarter, the number of stock options excluded were 978,237 and 1,428,616, respectively. For the six months ended June 30, 2014 and 2013, the number of stock options excluded were 1,318,662 and 1,730,313, respectively.


15

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

6.    Segment Information
 
During the 2014 first quarter, to reflect activity during the period as described below, the Company changed its segment structure and added two new segments (mortgage and ‘other’). The Company now classifies its businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — ‘other’ and corporate (non-underwriting). The Company determined its reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. 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 Company’s insurance, reinsurance and mortgage segments each have 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 Chairman, 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. Management measures segment performance for its three underwriting segments based on underwriting income or loss. The Company does not manage its assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.

The corporate (non-underwriting) segment results include net investment income, other income (loss), other expenses incurred by the Company, interest expense, net realized gains or losses, net impairment losses included in earnings, equity in net income (loss) of investment funds accounted for using the equity method, net foreign exchange gains or losses, income taxes and items related to the Company’s non-cumulative preferred shares. Such amounts exclude the results of the ‘other’ segment.

The ‘other’ segment includes the results of Watford (see Note 4). Watford has its own management and board of directors that is responsible for the overall profitability of the ‘other’ segment. For the ‘other’ segment, performance is measured based on net income or loss.


16

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


The following tables summarize 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
 
June 30, 2014
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
852,231

 
$
349,841

 
$
55,476

 
$
1,256,934

 
$
54,562

 
$
1,271,761

Premiums ceded
(273,349
)
 
(58,994
)
 
(5,079
)
 
(336,808
)
 
(2,760
)
 
(299,833
)
Net premiums written
578,882

 
290,847

 
50,397

 
920,126

 
51,802

 
971,928

Change in unearned premiums
(71,170
)
 
44,780

 
436

 
(25,954
)
 
(38,822
)
 
(64,776
)
Net premiums earned
507,712

 
335,627

 
50,833

 
894,172

 
12,980

 
907,152

Other underwriting income
514

 
303

 
1,216

 
2,033

 

 
2,033

Losses and loss adjustment expenses
(311,526
)
 
(150,325
)
 
(15,473
)
 
(477,324
)
 
(8,194
)
 
(485,518
)
Acquisition expenses, net
(76,449
)
 
(66,035
)
 
(11,481
)
 
(153,965
)
 
(4,193
)
 
(158,158
)
Other operating expenses
(85,829
)
 
(37,666
)
 
(16,288
)
 
(139,783
)
 
(1,635
)
 
(141,418
)
Underwriting income (loss)
$
34,422

 
$
81,904

 
$
8,807

 
125,133

 
(1,042
)
 
124,091

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
72,458

 
532

 
72,990

Net realized gains
 
 
 
 
 
 
50,966

 
3,178

 
54,144

Net impairment losses recognized in earnings
 
 
 
 
 
 
(14,749
)
 

 
(14,749
)
Equity in net income of investment funds accounted for using the equity method
 
 
 
 
 
 
9,240

 

 
9,240

Other income (loss)
 
 
 
 
 
 
4,850

 

 
4,850

Other expenses
 
 
 
 
 
 
(15,279
)
 
347

 
(14,932
)
Interest expense
 
 
 
 
 
 
(14,334
)
 

 
(14,334
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
(2,764
)
 
470

 
(2,294
)
Income before income taxes
 
 
 
 
 
 
215,521

 
3,485

 
219,006

Income tax expense
 
 
 
 
 
 
(7,289
)
 

 
(7,289
)
Net income
 
 
 
 
 
 
208,232

 
3,485

 
211,717

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(4,857
)
 
(4,857
)
Amounts attributable to noncontrolling interests
 
 
 
 
 
 

 
1,156

 
1,156

Net income available to Arch
 
 
 
 
 
 
208,232

 
(216
)
 
208,016

Preferred dividends
 
 
 
 
 
 
(5,485
)
 

 
(5,485
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
202,747

 
$
(216
)
 
$
202,531

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
61.4
%
 
44.8
%
 
30.4
%
 
53.4
%
 
63.1
%
 
53.5
%
Acquisition expense ratio (2)
15.0
%
 
19.7
%
 
22.6
%
 
17.2
%
 
32.3
%
 
17.4
%
Other operating expense ratio
16.9
%
 
11.2
%
 
32.0
%
 
15.6
%
 
12.6
%
 
15.6
%
Combined ratio
93.3
%
 
75.7
%
 
85.0
%
 
86.2
%
 
108.0
%
 
86.5
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
24,498

 
$
4,942

 
$
89,281

 
$
118,721

 
$

 
$
118,721

 
 
 
 
 
 
 
 
 
 
 
 
Total investable assets
 
 
 
 
 
 
$
14,688,881

 
$
1,114,719

 
$
15,803,600

Total assets
 
 
 
 
 
 
21,210,197

 
1,363,318

 
22,573,515

Total liabilities
 
 
 
 
 
 
15,078,943

 
253,507

 
15,332,450

_________________________________________________
(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 certain other underwriting income.
 

17

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
Three Months Ended
 
June 30, 2013
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
703,904

 
$
318,898

 
$
18,744

 
$
1,040,738

 
$

 
$
1,040,738

Premiums ceded
(202,336
)
 
(28,675
)
 

 
(230,203
)
 

 
(230,203
)
Net premiums written
501,568

 
290,223

 
18,744

 
810,535

 

 
810,535

Change in unearned premiums
(42,912
)
 
(2,731
)
 
(6,076
)
 
(51,719
)
 

 
(51,719
)
Net premiums earned
458,656

 
287,492

 
12,668

 
758,816

 

 
758,816

Other underwriting income
529

 
373

 

 
902

 

 
902

Losses and loss adjustment expenses
(291,192
)
 
(125,283
)
 
(2,178
)
 
(418,653
)
 

 
(418,653
)
Acquisition expenses, net
(74,249
)
 
(53,291
)
 
(4,137
)
 
(131,677
)
 

 
(131,677
)
Other operating expenses
(80,167
)
 
(31,902
)
 
(1,290
)
 
(113,359
)
 

 
(113,359
)
Underwriting income
$
13,577

 
$
77,389

 
$
5,063

 
96,029

 

 
96,029

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
68,369

 

 
68,369

Net realized gains
 
 
 
 
 
 
12,652

 

 
12,652

Net impairment losses recognized in earnings
 
 
 
 
 
 
(724
)
 

 
(724
)
Equity in net income of investment funds accounted for using the equity method
 
 
 
 
 
 
10,941

 

 
10,941

Other income (loss)
 
 
 
 
 
 
834

 

 
834

Other expenses
 
 
 
 
 
 
(14,049
)
 

 
(14,049
)
Interest expense
 
 
 
 
 
 
(5,852
)
 

 
(5,852
)
Net foreign exchange gains
 
 
 
 
 
 
13,811

 

 
13,811

Income before income taxes
 
 
 
 
 
 
182,011

 

 
182,011

Income tax expense
 
 
 
 
 
 
(5,071
)
 

 
(5,071
)
Net income
 
 
 
 
 
 
176,940

 

 
176,940

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 

 

Amounts attributable to noncontrolling interests
 
 
 
 
 
 

 

 

Net income available to Arch
 
 
 
 
 
 
176,940

 

 
176,940

Preferred dividends
 
 
 
 
 
 
(5,485
)
 

 
(5,485
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
171,455

 
$

 
$
171,455

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
63.5
%
 
43.6
%
 
17.2
%
 
55.2
%
 
%
 
55.2
%
Acquisition expense ratio (2)
16.1
%
 
18.5
%
 
32.7
%
 
17.3
%
 
%
 
17.3
%
Other operating expense ratio
17.5
%
 
11.1
%
 
10.2
%
 
14.9
%
 
%
 
14.9
%
Combined ratio
97.1
%
 
73.2
%
 
60.1
%
 
87.4
%
 
%
 
87.4
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
20,888

 
$
10,072

 
$

 
$
30,960

 
$

 
$
30,960

 
 
 
 
 
 
 
 
 
 
 
 
Total investable assets
 
 
 
 
 
 
$
12,960,811

 
$

 
$
12,960,811

Total assets
 
 
 
 
 
 
18,917,683

 

 
18,917,683

Total liabilities
 
 
 
 
 
 
13,683,365

 

 
13,683,365

_________________________________________________
(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 certain other underwriting income.


18

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
Six Months Ended
 
June 30, 2014
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
1,582,877

 
$
866,894

 
$
103,383

 
$
2,552,070

 
$
86,756

 
$
2,566,897

Premiums ceded
(458,393
)
 
(132,121
)
 
(9,718
)
 
(599,148
)
 
(2,760
)
 
(529,979
)
Net premiums written
1,124,484

 
734,773

 
93,665

 
1,952,922

 
83,996

 
2,036,918

Change in unearned premiums
(139,271
)
 
(57,798
)
 
(4,067
)
 
(201,136
)
 
(68,850
)
 
(269,986
)
Net premiums earned
985,213

 
676,975

 
89,598

 
1,751,786

 
15,146

 
1,766,932

Other underwriting income
1,014

 
619

 
1,982

 
3,615

 

 
3,615

Losses and loss adjustment expenses
(598,296
)
 
(289,961
)
 
(23,951
)
 
(912,208
)
 
(9,550
)
 
(921,758
)
Acquisition expenses, net
(153,381
)
 
(139,468
)
 
(20,635
)
 
(313,484
)
 
(5,016
)
 
(318,500
)
Other operating expenses
(166,973
)
 
(73,861
)
 
(30,164
)
 
(270,998
)
 
(2,744
)
 
(273,742
)
Underwriting income (loss)
$
67,577

 
$
174,304

 
$
16,830

 
258,711

 
(2,164
)
 
256,547

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
139,451

 
533

 
139,984

Net realized gains
 
 
 
 
 
 
70,663

 
3,178

 
73,841

Net impairment losses recognized in earnings
 
 
 
 
 
 
(17,720
)
 

 
(17,720
)
Equity in net income of investment funds accounted for using the equity method
 
 
 
 
 
 
12,493

 

 
12,493

Other income (loss)
 
 
 
 
 
 
2,746

 

 
2,746

Other expenses
 
 
 
 
 
 
(26,078
)
 
(2,329
)
 
(28,407
)
Interest expense
 
 
 
 
 
 
(28,738
)
 

 
(28,738
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
(9,420
)
 
563

 
(8,857
)
Income before income taxes
 
 
 
 
 
 
402,108

 
(219
)
 
401,889

Income tax expense
 
 
 
 
 
 
(11,027
)
 

 
(11,027
)
Net income (loss)
 
 
 
 
 
 
391,081

 
(219
)
 
390,862

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(4,909
)
 
(4,909
)
Amounts attributable to noncontrolling interests
 
 
 
 
 
 

 
4,563

 
4,563

Net income available to Arch
 
 
 
 
 
 
391,081

 
(565
)
 
390,516

Preferred dividends
 
 
 
 
 
 
(10,969
)
 

 
(10,969
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
380,112

 
$
(565
)
 
$
379,547

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
 
 
 
 
 
 
 
Loss ratio
60.7
%
 
42.8
%
 
26.7
%
 
52.1
%
 
63.1
%
 
52.2
%
Acquisition expense ratio (2)
15.5
%
 
20.6
%
 
23.0
%
 
17.8
%
 
33.1
%
 
18.0
%
Other operating expense ratio
16.9
%
 
10.9
%
 
33.7
%
 
15.5
%
 
18.1
%
 
15.5
%
Combined ratio
93.1
%
 
74.3
%
 
83.4
%
 
85.4
%
 
114.3
%
 
85.7
%
_________________________________________________
(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 certain other underwriting income.
 

19

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
Six Months Ended
 
June 30, 2013
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
1,392,721

 
$
769,345

 
$
44,502

 
$
2,204,437

 
$

 
$
2,204,437

Premiums ceded
(386,603
)
 
(56,654
)
 

 
(441,126
)
 

 
(441,126
)
Net premiums written
1,006,118

 
712,691

 
44,502

 
1,763,311

 

 
1,763,311

Change in unearned premiums
(102,497
)
 
(129,046
)
 
(20,182
)
 
(251,725
)
 

 
(251,725
)
Net premiums earned
903,621

 
583,645

 
24,320

 
1,511,586

 

 
1,511,586

Other underwriting income
1,054

 
386

 

 
1,440

 

 
1,440

Losses and loss adjustment expenses
(574,659
)
 
(239,140
)
 
(4,257
)
 
(818,056
)
 

 
(818,056
)
Acquisition expenses, net
(145,007
)
 
(106,434
)
 
(7,828
)
 
(259,269
)
 

 
(259,269
)
Other operating expenses
(156,482
)
 
(64,099
)
 
(2,693
)
 
(223,274
)
 

 
(223,274
)
Underwriting income
$
28,527

 
$
174,358

 
$
9,542

 
212,427

 

 
212,427

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
134,041

 

 
134,041

Net realized gains
 
 
 
 
 
 
70,992

 

 
70,992

Net impairment losses recognized in earnings
 
 
 
 
 
 
(2,970
)
 

 
(2,970
)
Equity in net income of investment funds accounted for using the equity method
 
 
 
 
 
 
24,764

 

 
24,764

Other income (loss)
 
 
 
 
 
 
2,078

 

 
2,078

Other expenses
 
 
 
 
 
 
(24,317
)
 

 
(24,317
)
Interest expense
 
 
 
 
 
 
(11,750
)
 

 
(11,750
)
Net foreign exchange gains
 
 
 
 
 
 
38,075

 

 
38,075

Income before income taxes
 
 
 
 
 
 
443,340

 

 
443,340

Income tax expense
 
 
 
 
 
 
(9,924
)
 

 
(9,924
)
Net income
 
 
 
 
 
 
433,416

 

 
433,416

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 

 

Amounts attributable to noncontrolling interests
 
 
 
 
 
 

 

 

Net income available to Arch
 
 
 
 
 
 
433,416

 

 
433,416

Preferred dividends
 
 
 
 
 
 
(10,969
)
 

 
(10,969
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
422,447

 
$

 
$
422,447

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
 
 
 
 
 
 
 
Loss ratio
63.6
%
 
41.0
%
 
17.5
%
 
54.1
%
 
%
 
54.1
%
Acquisition expense ratio (2)
15.9
%
 
18.2
%
 
32.2
%
 
17.1
%
 
%
 
17.1
%
Other operating expense ratio
17.3
%
 
11.0
%
 
11.1
%
 
14.8
%
 
%
 
14.8
%
Combined ratio
96.8
%
 
70.2
%
 
60.8
%
 
86.0
%
 
%
 
86.0
%
_________________________________________________
(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(2)
The acquisition expense ratio is adjusted to include certain other underwriting income.


20

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

7.    Investment Information
 
At June 30, 2014, total investable assets of $15.80 billion included $14.69 billion managed by the Company and $1.11 billion attributable to Watford.

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:
 
Fair
Value
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Cost or
Amortized
Cost
 
OTTI
Unrealized
Losses (2)
June 30, 2014
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

Corporate bonds
$
2,906,484

 
$
48,736

 
$
(10,472
)
 
$
2,868,220

 
$
(16
)
Mortgage backed securities
1,138,385

 
25,925

 
(8,572
)
 
1,121,032

 
(3,602
)
Municipal bonds
1,413,131

 
33,549

 
(1,095
)
 
1,380,677

 

Commercial mortgage backed securities
1,119,401

 
18,238

 
(6,051
)
 
1,107,214

 

U.S. government and government agencies
1,435,974

 
5,137

 
(2,162
)
 
1,432,999

 
(19
)
Non-U.S. government securities
1,073,256

 
14,936

 
(5,399
)
 
1,063,719

 

Asset backed securities
1,710,631

 
8,988

 
(6,740
)
 
1,708,383

 
(47
)
Total
10,797,262

 
155,509

 
(40,491
)
 
10,682,244

 
(3,684
)
Equity securities
608,820

 
100,476

 
(4,750
)
 
513,094

 

Other investments
457,567

 
28,609

 

 
428,958

 

Short-term investments
981,359

 
902

 
(1,191
)
 
981,648

 

Total
$
12,845,008

 
$
285,496

 
$
(46,432
)
 
$
12,605,944

 
$
(3,684
)
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

Corporate bonds
$
2,267,263

 
$
35,289

 
$
(35,537
)
 
$
2,267,511

 
$
(16
)
Mortgage backed securities
1,133,095

 
16,270

 
(22,209
)
 
1,139,034

 
(9,269
)
Municipal bonds
1,481,738

 
29,378

 
(9,730
)
 
1,462,090

 
(17
)
Commercial mortgage backed securities
1,074,497

 
13,972

 
(15,224
)
 
1,075,749

 
(199
)
U.S. government and government agencies
1,301,809

 
3,779

 
(11,242
)
 
1,309,272

 
(19
)
Non-U.S. government securities
1,085,861

 
14,729

 
(19,363
)
 
1,090,495

 

Asset backed securities
1,332,594

 
20,033

 
(13,795
)
 
1,326,356

 
(3,422
)
Total
9,676,857

 
133,450

 
(127,100
)
 
9,670,507

 
(12,942
)
Equity securities
496,824

 
69,487

 
(5,938
)
 
433,275

 

Other investments
498,310

 
28,082

 
(18,459
)
 
488,687

 

Short-term investments
1,478,367

 
1,654

 
(871
)
 
1,477,584

 

Total
$
12,150,358

 
$
232,673

 
$
(152,368
)
 
$
12,070,053

 
$
(12,942
)
_________________________________________________
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged. See “—Securities Lending Agreements.”
(2)
Represents the total other-than-temporary impairments (“OTTI”) recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At June 30, 2014, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $2.0 million, compared to a net unrealized gain of $6.0 million at December 31, 2013.


21

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
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
June 30, 2014
 

 
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
546,004

 
$
(3,596
)
 
$
238,526

 
$
(6,876
)
 
$
784,530

 
$
(10,472
)
Mortgage backed securities
176,720

 
(1,893
)
 
142,523

 
(6,679
)
 
319,243

 
(8,572
)
Municipal bonds
99,417

 
(290
)
 
59,847

 
(805
)
 
159,264

 
(1,095
)
Commercial mortgage backed securities
163,092

 
(2,219
)
 
95,877

 
(3,832
)
 
258,969

 
(6,051
)
U.S. government and government agencies
338,288

 
(1,783
)
 
13,616

 
(379
)
 
351,904

 
(2,162
)
Non-U.S. government securities
361,383

 
(2,571
)
 
69,218

 
(2,828
)
 
430,601

 
(5,399
)
Asset backed securities
362,407

 
(2,135
)
 
215,752

 
(4,605
)
 
578,159

 
(6,740
)
Total
2,047,311

 
(14,487
)
 
835,359

 
(26,004
)
 
2,882,670

 
(40,491
)
Equity securities
81,731

 
(4,750
)
 

 

 
81,731

 
(4,750
)
Other investments

 

 

 

 

 

Short-term investments
95,699

 
(1,191
)
 

 

 
95,699

 
(1,191
)
Total
$
2,224,741

 
$
(20,428
)
 
$
835,359

 
$
(26,004
)
 
$
3,060,100

 
$
(46,432
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

 
 

 
 

Corporate bonds
$
1,183,625

 
$
(32,837
)
 
$
46,673

 
$
(2,700
)
 
$
1,230,298

 
$
(35,537
)
Mortgage backed securities
778,693

 
(20,253
)
 
43,634

 
(1,956
)
 
822,327

 
(22,209
)
Municipal bonds
589,009

 
(9,422
)
 
6,092

 
(308
)
 
595,101

 
(9,730
)
Commercial mortgage backed securities
677,617

 
(15,110
)
 
1,612

 
(114
)
 
679,229

 
(15,224
)
U.S. government and government agencies
1,144,809

 
(11,242
)
 

 

 
1,144,809

 
(11,242
)
Non-U.S. government securities
821,506

 
(15,776
)
 
24,334

 
(3,587
)
 
845,840

 
(19,363
)
Asset backed securities
692,362

 
(10,431
)
 
88,629

 
(3,364
)
 
780,991

 
(13,795
)
Total
5,887,621

 
(115,071
)
 
210,974

 
(12,029
)
 
6,098,595

 
(127,100
)
Equity securities
76,563

 
(5,938
)
 

 

 
76,563

 
(5,938
)
Other investments
165,891

 
(15,775
)
 
47,316

 
(2,684
)
 
213,207

 
(18,459
)
Short-term investments
28,170

 
(871
)
 

 

 
28,170

 
(871
)
Total
$
6,158,245

 
$
(137,655
)
 
$
258,290

 
$
(14,713
)
 
$
6,416,535

 
$
(152,368
)
_________________________________________________
(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.”

At June 30, 2014, on a lot level basis, approximately 1,070 security lots out of a total of approximately 4,450 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. At December 31, 2013, on a lot level basis, approximately 2,080 security lots out of a total of approximately 4,400 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 $3.5 million.
 

22

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The contractual maturities of the Company’s fixed maturities and fixed maturities pledged under securities lending agreements are shown in the following table. Expected maturities, which are management’s best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
June 30, 2014
 
December 31, 2013
Maturity
 
Fair Value
 
Amortized
Cost
 
Fair Value
 
Amortized
Cost
Due in one year or less
 
$
209,116

 
$
203,646

 
$
235,330

 
$
232,652

Due after one year through five years
 
4,408,427

 
4,369,079

 
3,738,500

 
3,718,920

Due after five years through 10 years
 
1,958,624

 
1,924,301

 
1,966,536

 
1,979,510

Due after 10 years
 
252,678

 
248,589

 
196,305

 
198,286

 
 
6,828,845

 
6,745,615

 
6,136,671

 
6,129,368

Mortgage backed securities
 
1,138,385

 
1,121,032

 
1,133,095

 
1,139,034

Commercial mortgage backed securities
 
1,119,401

 
1,107,214

 
1,074,497

 
1,075,749

Asset backed securities
 
1,710,631

 
1,708,383

 
1,332,594

 
1,326,356

Total
 
$
10,797,262

 
$
10,682,244

 
$
9,676,857

 
$
9,670,507

 
Securities Lending Agreements
 
The Company operates a securities lending program under which certain of its fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. The fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $87.0 million and $86.6 million, respectively, at June 30, 2014, compared to $105.1 million and $105.9 million, respectively, at December 31, 2013. The fair value of the portfolio of collateral backing the Company’s securities lending program was $82.6 million at June 30, 2014, compared to $100.6 million at December 31, 2013. Such amounts included approximately $6.2 million of sub-prime securities at June 30, 2014, compared to $6.3 million at December 31, 2013. The Company maintains legal control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. An indemnification agreement with the lending agent protects the Company in the event a borrower becomes insolvent or fails to return any of the securities on loan to the Company

Other Investments

The following table summarizes the Company’s other investments, including available for sale and fair value option components:
 
June 30,
2014
 
December 31,
2013
Available for sale:
 
 
 
Asian and emerging markets
$
292,772

 
$
331,984

Investment grade fixed income
164,795

 
159,115

Other

 
7,211

Total available for sale
457,567

 
498,310

Fair value option:
 
 
 
Term loan investments (par value: $909,538 and $494,502)
953,649

 
512,076

Asian and emerging markets
25,321

 
14,054

Investment grade fixed income
81,737

 
75,062

Other (1)
310,829

 
172,088

Total fair value option
1,371,536

 
773,280

Total
$
1,829,103

 
$
1,271,590

_________________________________________________
(1)
Includes fund investments with strategies in mortgage servicing rights, transportation and infrastructure assets and other.

Certain of the Company’s other investments are in investment funds for which the Company has the option to redeem at agreed upon values as described in each investment fund’s subscription agreement. Depending on the terms of the various subscription agreements, investments in investment funds may be redeemed daily, monthly, quarterly or on other terms. Two common redemption restrictions which may impact the Company’s ability to redeem these investment funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the investment fund’s net assets which may otherwise hinder the general partner or investment manager’s ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. If the investment funds are eligible to be redeemed, the time to redeem such fund can take weeks or months following the notification.

Fair Value Option
 
The following table summarizes the Company’s assets and liabilities which are accounted for using the fair value option:
 
June 30,
2014
 
December 31,
2013
Fixed maturities
$
438,048

 
$
448,254

Other investments
1,371,536

 
773,280

Short-term investments
231,507

 

Investments accounted for using the fair value option
$
2,041,091

 
$
1,221,534


Net Investment Income
 
The components of net investment income were derived from the following sources:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Fixed maturities
$
65,869

 
$
62,004

 
$
128,318

 
$
124,010

Term loan investments
6,908

 
6,026

 
12,577

 
10,243

Equity securities (dividends)
3,271

 
3,164

 
6,192

 
4,587

Short-term investments
107

 
364

 
512

 
756

Other (1)
9,099

 
4,734

 
13,819

 
11,033

Gross investment income
85,254

 
76,292

 
161,418

 
150,629

Investment expenses
(12,264
)
 
(7,923
)
 
(21,434
)
 
(16,588
)
Net investment income
$
72,990

 
$
68,369

 
$
139,984

 
$
134,041

_________________________________________________
(1)
Includes dividends on investment funds and other items.
 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Net Realized Gains (Losses)
 
Net realized gains (losses) were as follows, excluding other-than-temporary impairment provisions:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Available for sale securities:
 

 
 

 
 

 
 

Gross gains on investment sales
$
56,763

 
$
68,853

 
$
122,814

 
$
135,873

Gross losses on investment sales
(33,028
)
 
(54,783
)
 
(73,041
)
 
(79,839
)
Change in fair value of assets and liabilities accounted for using the fair value option:
 
 
 
 
 
 
 
Fixed maturities
10,984

 
(6,702
)
 
9,341

 
(1,644
)
Other investments
17,985

 
(9,502
)
 
28,761

 
449

Equity securities

 
5

 

 
704

Derivative instruments (1)
12,402

 
15,646

 
(366
)
 
15,268

Other (2)
(10,962
)
 
(865
)
 
(13,668
)
 
181

Net realized gains (losses)
$
54,144

 
$
12,652

 
$
73,841

 
$
70,992

_________________________________________________
(1)
See Note 9 for information on the Company’s derivative instruments.
(2)
Includes accretion of contingent consideration liability amounts related to the acquisition of the CMG Entities (see Note 2 for further details).
 
Other-Than-Temporary Impairments
 
The Company performs quarterly reviews of its available for sale investments in order to determine whether declines in fair value below the amortized cost basis were considered other-than-temporary in accordance with applicable guidance. The following table details the net impairment losses recognized in earnings by asset class:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Fixed maturities:
 

 
 

 
 

 
 

Mortgage backed securities
$

 
$

 
$

 
$
(15
)
Corporate bonds
(664
)
 

 
(664
)
 

Asset backed securities
(5
)
 

 
(11
)
 
(20
)
Total
(669
)
 

 
(675
)
 
(35
)
Equity securities
(278
)
 
(724
)
 
(278
)
 
(2,935
)
Other investments
(13,802
)
 

 
(16,767
)
 

Net impairment losses recognized in earnings
$
(14,749
)
 
$
(724
)
 
$
(17,720
)
 
$
(2,970
)
 
A description of the methodology and significant inputs used to measure the amount of net impairment losses recognized in earnings in the 2014 periods is as follows:

Other investments — the Company utilized information received from fund managers and positive and negative evidence on the fund investment, including the business prospects, recent events, industry and market data and other factors. Net impairment losses for the 2014 second quarter primarily related to one fund investment which was in an unrealized loss position and where the Company determined that it did not intend to hold such investment for a reasonable period of time by which the fair value of the fund would increase and the Company would recover its cost. The cost basis of such fund was adjusted down accordingly. The remainder of the net impairment losses for the 2014 periods related to a fund investment which, due to its convex investment strategy, operates at a loss in absence of certain market stress events. The Company determined that the fair value of the fund investment was unlikely to increase based on the underlying strategy and the cost basis was adjusted down accordingly;

Corporate bonds — the Company reviewed the business prospects, credit ratings, estimated loss given default factors and information received from asset managers and rating agencies for certain corporate bonds. The

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

amortized cost basis of the corporate bonds were adjusted down, if required, to the expected recovery value calculated in the OTTI review process;

Equity securities — the Company utilized information received from asset managers on common stocks, including the business prospects, recent events, industry and market data and other factors. For certain equities which were in an unrealized loss position and where the Company determined that it did not have the intent or ability to hold such securities for a reasonable period of time by which the fair value of the securities would increase and the Company would recover its cost, the cost basis of such securities was adjusted down accordingly.

The Company believes that the $3.7 million of OTTI included in accumulated other comprehensive income at June 30, 2014 on the securities which were considered by the Company to be impaired was due to market and sector-related factors (i.e., not credit losses). At June 30, 2014, the Company did not intend to sell these securities, or any other securities which were in an unrealized loss position, and determined that it is more likely than not that the Company will not be required to sell such securities before recovery of their cost basis.
 
The following table provides a roll forward of the amount related to credit losses recognized in earnings for which a portion of an OTTI was recognized in accumulated other comprehensive income:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Balance at start of period
$
47,256

 
$
61,956

 
$
60,062

 
$
62,001

Credit loss impairments recognized on securities not previously impaired

 

 

 
33

Credit loss impairments recognized on securities previously impaired
5

 

 
11

 
2

Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security

 

 

 

Reductions for securities sold during the period
(25,820
)
 
(507
)
 
(38,632
)
 
(587
)
Balance at end of period
$
21,441

 
$
61,449

 
$
21,441

 
$
61,449

 
Restricted Assets
 
The Company is required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support its insurance and reinsurance operations. The Company’s insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. See Note 10 for further details. The following table details the value of the Company’s restricted assets:
 
June 30,
2014
 
December 31,
2013
Assets used for collateral or guarantees:
 

 
 

Affiliated transactions
$
4,352,540

 
$
4,060,533

Third party agreements
943,551

 
856,890

Deposits with U.S. regulatory authorities
344,087

 
302,809

Deposits with non-U.S. regulatory authorities

 
6,546

Trust funds
81,942

 
75,264

Total restricted assets
$
5,722,120

 
$
5,302,042



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

8.    Fair Value
 
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).
 
The levels in the hierarchy are defined as follows:
 
Level 1:
Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets
 
Level 2:
Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument
 
Level 3:
Inputs to the valuation methodology are unobservable and significant to the fair value measurement
 
Following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy.
 
The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. To validate the techniques or models used by pricing sources, the Company’s review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value including a review of deep dive reports on selected securities which indicate the use of observable inputs in the pricing process; (iv) comparing the fair value estimates to its knowledge of the current market; (v) a comparison of the pricing services’ fair values to other pricing services’ fair values for the same investments; and (vi) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. For a majority of investments, the Company obtained multiple quotes. A price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value. The Company did not adjust any of the prices obtained from the pricing services at June 30, 2014.

The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the $14.94 billion of financial assets and liabilities measured at fair value at June 30, 2014, approximately $635.5 million, or 4.3%, were priced using non-binding broker-dealer quotes. Of the $13.37 billion of financial assets and liabilities measured at fair value at December 31, 2013, approximately $601.9 million, or 4.5%, were priced using non-binding broker-dealer quotes.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


The Company reviews its securities measured at fair value and discusses the proper classification of such investments with investment advisers and others. No transfers were made in the periods presented. A discussion of the general classification of the Company’s financial instruments follows:

Fixed maturities. The Company determined that all U.S. Treasuries would be classified as Level 1 securities due to observed levels of trading activity, the high number of strongly correlated pricing quotes received on U.S. Treasuries and other factors. Where the Company believes that quoted market prices are not available or that the market is not active, fair values are estimated by using quoted prices of securities with similar characteristics, pricing models or matrix pricing and are generally classified as Level 2 securities. The Company determined that Level 2 securities included corporate bonds, mortgage backed securities, municipal bonds, asset backed securities and non-U.S. government securities.

Equity securities. The Company determined that exchange-traded equity securities would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other equity securities are included in Level 2 of the valuation hierarchy.

Other investments. The fair values for certain of the Company’s other investments are determined using net asset values (“NAV”) as advised by external fund managers. The NAV is based on the fund manager’s valuation of the underlying holdings in accordance with the fund’s governing documents. Periodically, the Company performs a number of monitoring procedures in order to assess the quality of the NAVs, including regular review and discussion of each fund’s performance, regular evaluation of fund performance against applicable benchmarks and the backtesting of the NAVs against audited and interim financial statements. Other investments with liquidity terms allowing the Company to substantially redeem its holdings in a short time frame at the applicable NAV are reflected in Level 2. Other investments with redemption restrictions that prevent the Company from redeeming in the near term are classified in Level 3 of the valuation hierarchy. Other investments also include term loan investments for which fair values are estimated by using quoted prices of term loan investments with similar characteristics, pricing models or matrix pricing. Such investments are generally classified as Level 2 securities.

Short-term investments. The Company determined that certain of its short-term investments held in highly liquid money market-type funds would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other short-term investments are classified in Level 2 of the valuation hierarchy.

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 the following tables, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged under securities lending agreements, at fair value.

Contingent consideration liability. The contingent consideration liability (included in ‘other liabilities’ in the consolidated balance sheets) resulted from the acquisition of the CMG Entities and is remeasured at fair value at each balance sheet date. Changes in fair value are recognized in ‘net realized gains (losses).’ To determine the fair value of the contingent consideration liability, the Company estimates future payments using an income approach based on modeled inputs which include a weighted average cost of capital. The Company determined that the contingent consideration liability would be included in Level 3 of the valuation hierarchy.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the Company’s financial assets and liabilities measured at fair value by level at June 30, 2014:
 
 
 
Fair Value Measurement Using:
 
Fair
Value
 
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets measured at fair value:
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

Corporate bonds
$
2,906,484

 
$

 
$
2,906,484

 
$

Mortgage backed securities
1,138,385

 

 
1,138,385

 

Municipal bonds
1,413,131

 

 
1,413,131

 

Commercial mortgage backed securities
1,119,401

 

 
1,119,401

 

U.S. government and government agencies
1,435,974

 
1,435,974

 

 

Non-U.S. government securities
1,073,256

 

 
1,073,256

 

Asset backed securities
1,710,631

 

 
1,710,631

 

Total
10,797,262

 
1,435,974

 
9,361,288

 

 
 
 
 
 
 
 
 
Equity securities
608,820

 
608,820

 

 

Other investments
457,567

 

 
354,354

 
103,213

Short-term investments
981,359

 
948,468

 
32,891

 

 
 
 
 
 
 
 
 
Fair value option:
 
 
 
 
 
 
 
Corporate bonds
343,607

 

 
343,607

 

Non-U.S. government bonds
60,268

 

 
60,268

 

Mortgage backed securities
16,807

 

 
16,807

 

Asset backed securities
17,366

 

 
17,366

 

Other investments
1,371,536

 

 
920,500

 
451,036

Short-term investments
231,507

 
231,507

 

 

Total
2,041,091

 
231,507

 
1,358,548

 
451,036

Total assets measured at fair value
$
14,886,099

 
$
3,224,769

 
$
11,107,081

 
$
554,249

 
 
 
 
 
 
 
 
Liabilities measured at fair value:
 

 
 

 
 

 
 

Contingent consideration liability
$
53,099

 
$

 
$

 
$
53,099

Total liabilities measured at fair value
$
53,099

 
$

 
$

 
$
53,099

_________________________________________________
(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.
 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2013:
 
 
 
Fair Value Measurement Using:
 
Fair
Value
 
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets measured at fair value:
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities and fixed maturities pledged under securities lending agreements (1):
 

 
 

 
 

 
 

Corporate bonds
$
2,267,263

 
$

 
$
2,265,218

 
$
2,045

Mortgage backed securities
1,133,095

 

 
1,133,095

 

Municipal bonds
1,481,738

 

 
1,481,738

 

Commercial mortgage backed securities
1,074,497

 

 
1,074,497

 

U.S. government and government agencies
1,301,809

 
1,301,809

 

 

Non-U.S. government securities
1,085,861

 

 
1,085,861

 

Asset backed securities
1,332,594

 

 
1,332,594

 

Total
9,676,857

 
1,301,809

 
8,373,003

 
2,045

 
 
 
 
 
 
 
 
Equity securities
496,824

 
496,738

 
86

 

Other investments
498,310

 

 
327,890

 
170,420

Short-term investments
1,478,367

 
1,427,744

 
50,623

 

 
 
 
 
 
 
 
 
Fair value option:
 
 
 
 
 
 
 
Corporate bonds
334,065

 

 
334,065

 

Non-U.S. government bonds
73,156

 

 
73,156

 

Mortgage backed securities
41,033

 

 
41,033

 

Other investments
773,280

 

 
395,755

 
377,525

Total
1,221,534

 

 
844,009

 
377,525

Total assets measured at fair value
$
13,371,892

 
$
3,226,291

 
$
9,595,611

 
$
549,990

_________________________________________________
(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.
 

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

The following tables present a reconciliation of the beginning and ending balances for all financial assets and liabilities measured at fair value on a recurring basis using Level 3 inputs:
 
Fair Value Measurements Using:
Significant Unobservable Inputs (Level 3)
 
Assets
 
Liabilities
s
Available-For-Sale
 
Fair Value Option
 
 
 
 
 
Corporate
Bonds
 
Other
Investments
 
Other
Investments
 
Total
 
Contingent Consideration Liability
Three Months Ended June 30, 2014
 

 
 
 
 

 
 
 
 
Balance at beginning of period
$

 
$
104,335

 
$
419,146

 
$
523,481

 
$
43,156

Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)

 
(1,722
)
 
16,136

 
14,414

 
9,943

Included in other comprehensive income

 
600

 
932

 
1,532

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 

 
66,615

 
66,615

 

Issuances

 

 

 

 

Sales

 

 

 

 

Settlements

 

 
(51,793
)
 
(51,793
)
 

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$

 
$
103,213

 
$
451,036

 
$
554,249

 
$
53,099

 
 
 
 
 
 
 
 
 
 
Three Months Ended June 30, 2013
 

 
 
 
 

 
 

 
 
Balance at beginning of period
$
97,298

 
$
185,934

 
$
179,370

 
$
462,602

 
$

Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)
3,187

 

 
(2,075
)
 
1,112

 

Included in other comprehensive income
(1,363
)
 
3,959

 

 
2,596

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 

 
118,916

 
118,916

 

Issuances

 

 

 

 

Sales
(96,655
)
 

 

 
(96,655
)
 

Settlements
(107
)
 

 
(6,022
)
 
(6,129
)
 

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$
2,360

 
$
189,893

 
$
290,189

 
$
482,442

 
$

_________________________________________________
(1)
Gains or losses on corporate bonds were included in net realized gains (losses) while gains or losses on other investments were included in net realized gains (losses) or net investment income. Gains or losses on the contingent consideration liability were included in net realized gains (losses).


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 
Fair Value Measurements Using:
Significant Unobservable Inputs (Level 3)
 
Assets
 
Liabilities
s
Available-For-Sale
 
Fair Value Option
 
 
 
 
 
Corporate
Bonds
 
Other
Investments
 
Other
Investments
 
Total
 
Contingent Consideration Liability
Six Months Ended June 30, 2014
 
 
 
 
 

 
 
 
 
Balance at beginning of period
$
2,045

 
$
170,420

 
$
377,525

 
$
549,990

 
$

Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)

 
553

 
22,446

 
22,999

 
11,337

Included in other comprehensive income

 
(1,596
)
 
932

 
(664
)
 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 

 
106,725

 
106,725

 

Issuances

 

 

 

 
41,762

Sales
(2,045
)
 
(66,164
)
 

 
(68,209
)
 

Settlements

 

 
(56,592
)
 
(56,592
)
 

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$

 
$
103,213

 
$
451,036

 
$
554,249

 
$
53,099

 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2013
 
 
 
 
 

 
 

 
 
Balance at beginning of period
$
98,404

 
$
184,202

 
$
195,350

 
$
477,956

 
$

Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)
4,679

 
4,762

 
(1,702
)
 
7,739

 

Included in other comprehensive income
(3,051
)
 
5,871

 

 
2,820

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 
5,000

 
160,570

 
165,570

 

Issuances

 

 

 

 

Sales
(96,655
)
 

 

 
(96,655
)
 

Settlements
(1,017
)
 
(9,942
)
 
(64,029
)
 
(74,988
)
 

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$
2,360

 
$
189,893

 
$
290,189

 
$
482,442

 
$

_________________________________________________
(1)
Gains or losses on corporate bonds were included in net realized gains (losses) while gains or losses on other investments were included in net realized gains (losses) or net investment income. Gains or losses on the contingent consideration liability were included in net realized gains (losses).

The amount of total gains for the 2014 second quarter included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2014 was $14.4 million, while the amount of total gains for the six months ended June 30, 2014 included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2014 was $17.8 million. The amount of total losses for the 2013 second quarter included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2013 was $2.2 million, while the amount of total gains for the six months ended June 30, 2013 included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2013 was $4.4 million.
 
Financial Instruments Disclosed, But Not Carried, At Fair Value
 
The Company uses various financial instruments in the normal course of its business. The carrying values of cash, accrued investment income, receivable for securities sold, certain other assets, payable for securities purchased and certain other liabilities approximated their fair values at June 30, 2014, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.
 
At June 30, 2014, the senior notes of ACGL were carried at their cost of $300.0 million and had a fair value of $412.6 million while the senior notes of Arch-U.S. were carried at their cost of $500.0 million and had a fair value of $540.1 million. The fair values of the senior notes were obtained from a third party pricing service and are based on observable market inputs. As such, the fair value of the senior notes is classified within Level 2.
 

32

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

9.     Derivative Instruments
 
The Company’s investment strategy allows for the use of derivative securities. The Company’s derivative instruments are recorded on its consolidated balance sheets at fair value. The fair values of those derivatives are based on quoted market prices. All realized and unrealized contract gains and losses are reflected in the Company’s results of operations. The Company utilizes exchange traded U.S. Treasury note, Eurodollar and other futures contracts and commodity futures to manage portfolio duration or replicate investment positions in its portfolios. Certain of the Company’s corporate bonds are managed in a global bond portfolio which incorporates the use of foreign currency forward contracts which are intended to provide an economic hedge against foreign currency movements on the portfolio’s non-U.S. Dollar denominated holdings. The Company routinely utilizes other foreign currency forward contracts, currency options, index futures contracts and other derivatives as part of its total return objective.
 
In addition, the Company purchases to-be-announced mortgage backed securities (“TBAs”) as part of its investment strategy. TBAs represent commitments to purchase a future issuance of agency mortgage backed securities. For the period between purchase of a TBA and issuance of the underlying security, the Company’s position is accounted for as a derivative. The Company purchases TBAs in both long and short positions to enhance investment performance and as part of its overall investment strategy. The Company did not hold any derivatives which were designated as hedging instruments at June 30, 2014 or December 31, 2013.
 
The following table summarizes information on the fair values and notional values of the Company’s derivative instruments. The fair value of TBAs is included in ‘fixed maturities available for sale, at fair value.’
 
 
Asset
Derivatives
 
Liability Derivatives
 
Net
Derivatives
 
Fair Value
 
Fair Value
 
Fair Value
 
Notional Value (1)
June 30, 2014
 

 
 

 
 

 
 

Futures contracts
$
986

 
$
(198
)
 
$
788

 
$
783,914

Foreign currency forward contracts
856

 
(1,949
)
 
(1,093
)
 
279,559

TBAs
160,074

 
(149,782
)
 
10,292

 
296,380

Other
1,100

 
(722
)
 
378

 
504,709

Total
$
163,016

 
$
(152,651
)
 
$
10,365

 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

Futures contracts
$
461

 
$
(110
)
 
$
351

 
$
475,967

Foreign currency forward contracts
5,023

 
(3,090
)
 
1,933

 
330,746

TBAs
33,455

 
(21,731
)
 
11,724

 
56,160

Other
920

 
(1,541
)
 
(621
)
 
347,916

Total
$
39,859

 
$
(26,472
)
 
$
13,387

 
 
_________________________________________________
(1)
Represents the absolute notional value of all outstanding contracts, consisting of long and short positions.

The Company’s derivative instruments are generally traded under master netting agreements, which establish terms that apply to all derivative transactions with a counterparty. In the event of a bankruptcy or other stipulated event of default, such agreements provide that the non-defaulting party may elect to terminate all outstanding derivative transactions, in which case all individual derivative positions (loss or gain) with a counterparty are closed out and netted and replaced with a single amount, usually referred to as the termination amount, which is expressed in a single currency. The resulting single net amount, where positive, is payable to the party “in-the-money” regardless of whether or not it is the defaulting party, unless the parties have agreed that only the non-defaulting party is entitled to receive a termination payment where the net amount is positive and is in its favor. Effectively, contractual close-out netting reduces derivatives credit exposure from gross to net exposure. At June 30, 2014, asset derivatives and liability derivatives of $77.8 million and $36.5 million, respectively, were subject to a master netting agreement, compared to $28.0 million and $14.6 million, respectively, at December 31, 2013. The remaining derivatives included in the table above were not subject to a master netting agreement.

33

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


The following table summarizes net realized gains (losses) recorded on the Company’s derivative instruments in the consolidated statements of income:
 
 
Three Months Ended
 
Six Months Ended
Derivatives not designated as
 
June 30,
 
June 30,
hedging instruments
 
2014
 
2013
 
2014
 
2013
Futures contracts
 
$
15,185

 
$
10,623

 
$
5,323

 
$
9,794

Foreign currency forward contracts
 
(1,811
)
 
7,605

 
(4,068
)
 
6,880

TBAs
 
(270
)
 
(3,751
)
 
(307
)
 
(3,210
)
Other
 
(702
)
 
1,169

 
(1,314
)
 
1,804

Total
 
$
12,402

 
$
15,646

 
$
(366
)
 
$
15,268

 
10.           Commitments and Contingencies
 
Letter of Credit and Revolving Credit Facilities
 
As of June 30, 2014, 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 June 30, 2019. In addition, the Company had access to secured letter of credit facilities of approximately $194.8 million as of June 30, 2014, 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 June 30, 2014, the Company had $424.2 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $484.1 million, and had $100.0 million of borrowings outstanding under the Credit Agreement which are due on June 30, 2019. The Company was in compliance with all covenants contained in the LOC Facilities at June 30, 2014. As of June 30, 2014, Watford had a $200 million line of credit facility that expires on May 19, 2015. At June 30, 2014, Watford had $1.4 million in outstanding letters of credit under that credit facility. Watford was in compliance with all covenants contained in its credit facility at June 30, 2014.

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 $966.1 million at June 30, 2014.

11.                    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 2014. Since the inception of the share repurchase program, ACGL has repurchased approximately 109.9 million common shares for an aggregate purchase price of $2.79 billion. During the 2014 second quarter and six months ended June 30, 2014, ACGL did not repurchase any common shares. During the 2013 second quarter and six months ended June 30, 2013, ACGL repurchased 307,659 and 1,238,418 common shares, respectively, for an aggregate purchase price of $15.5 million and $56.5 million, respectively. At June 30, 2014, $712.1 million of share repurchases were available under the program. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations.

Share-Based Compensation

During the 2014 second quarter, the Company made a stock grant of 551,836 stock appreciation rights and stock options and 571,108 restricted shares and units to certain employees and directors with weighted average grant-date fair values of $15.23 and $57.25, respectively. During the 2013 second quarter, the Company made a stock grant of 516,859 stock appreciation rights and stock options and 544,075 restricted shares and units to certain employees and directors with weighted average grant-date fair values of $13.35 and $53.50, respectively. The stock appreciation rights and stock options were valued at the grant date using the Black-Scholes option pricing model. Such values are being amortized over the respective substantive vesting period. For awards granted to retirement-eligible employees where no service is required for the employee to retain the award, the grant date fair value is immediately recognized as compensation expense at the grant date because the employee is

34



able to retain the award without continuing to provide service. For employees near retirement eligibility, attribution of compensation cost is over the period from the grant date to the retirement eligibility date.
12.            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. The Company 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 31, 2035. 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 and its non-U.S. subsidiaries will be subject to U.S. federal income tax only to the extent that they derive 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 and its non-U.S. subsidiaries will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors (subject to reduction by any applicable income tax treaty). ACGL and its non-U.S. subsidiaries intend to conduct their operations in a manner that will not cause them to be treated as engaged in a trade or business in the United States and, therefore, will not be required to pay U.S. federal income taxes (other than U.S. excise taxes on insurance and reinsurance premium and withholding taxes on dividends and certain other U.S. source investment income). However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, 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 United States. 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 United States, United Kingdom, Ireland, Canada, Switzerland and Denmark.
 
The Company’s income tax provision on income before income taxes resulted in an expense of 2.7% for the six months ended June 30, 2014, compared to an expense of 2.2% for the 2013 period. These rates include the tax effect of unusual or infrequent items representing 0.1% and 0.3% of the Company’s effective tax rate for the six months ended June 30, 2014 and the 2013 period, respectively. 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 or loss reported by jurisdiction and the varying tax rates in each jurisdiction. The Company had a net deferred tax asset of $151.5 million at June 30, 2014, compared to $128.6 million at December 31, 2013. In addition, the Company paid $8.3 million in income taxes for the six months ended June 30, 2014, while the Company paid $4.8 million for the 2013 period.
 
13.            Other Comprehensive Income (Loss)
 
The following table presents details about amounts reclassified from accumulated other comprehensive income:
 
 
 
 
Amounts Reclassed from AOCI
 
 
Consolidated Statement of Income
 
Three Months Ended
 
Six Months Ended
Details About
 
Line Item That Includes
 
June 30,
 
June 30,
AOCI Components
 
Reclassification
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
 
 
 
Unrealized appreciation on available-for-sale investments
 
 
 
 
 
 
 
 
 
 
Net realized gains
 
$
23,735

 
$
14,634

 
$
49,773

 
$
59,001

 
 
Other-than-temporary impairment losses
 
(14,749
)
 
(724
)
 
(17,720
)
 
(2,972
)
 
 
Total before tax
 
8,986

 
13,910

 
32,053

 
56,029

 
 
Income tax (expense) benefit
 
(701
)
 
6

 
(2,519
)
 
(3,412
)
 
 
Net of tax
 
$
8,285

 
$
13,916

 
$
29,534

 
$
52,617



35

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the tax effects allocated to each component of other comprehensive income (loss):
 
Before Tax Amount
 
Tax Expense (Benefit)
 
Net of Tax Amount
Three Months Ended June 30, 2014
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
115,150

 
$
6,722

 
$
108,428

Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)

 

 

Less reclassification of net realized gains included in net income
8,986

 
701

 
8,285

Foreign currency translation adjustments
10,021

 

 
10,021

Other comprehensive income (loss)
$
116,185

 
$
6,021

 
$
110,164

 
 
 
 
 
 
Three Months Ended June 30, 2013
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
(281,388
)
 
$
(21,826
)
 
$
(259,562
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)

 

 

Less reclassification of net realized gains included in net income
13,910

 
(6
)
 
13,916

Foreign currency translation adjustments
(5,407
)
 

 
(5,407
)
Other comprehensive income (loss)
$
(300,705
)
 
$
(21,820
)
 
$
(278,885
)
 
 
 
 
 
 
Six Months Ended June 30, 2014
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
190,550

 
$
10,769

 
$
179,781

Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)

 

 

Less reclassification of net realized gains included in net income
32,053

 
2,519

 
29,534

Foreign currency translation adjustments
8,672

 

 
8,672

Other comprehensive income (loss)
$
167,169

 
$
8,250

 
$
158,919

 
 
 
 
 
 
Six Months Ended June 30, 2013
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
(271,041
)
 
$
(20,950
)
 
$
(250,091
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)
(2
)
 

 
(2
)
Less reclassification of net realized gains included in net income
56,029

 
3,412

 
52,617

Foreign currency translation adjustments
(33,629
)
 

 
(33,629
)
Other comprehensive income (loss)
$
(360,701
)
 
$
(24,362
)
 
$
(336,339
)




36



14.            Guarantor Financial Information

The following tables present condensed financial information for ACGL, Arch Capital Group (U.S.) Inc. (“Arch-U.S.”), a 100% owned subsidiary of ACGL, and ACGL’s other subsidiaries.
 
 
June 30, 2014
Condensed Consolidating Balance Sheet
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Assets
 
 
 
 
 
 
 
 
 
Total investments
$
2,561

 
$
78,702

 
$
15,081,872

 
$

 
$
15,163,135

Cash
4,715

 
7,746

 
913,982

 

 
926,443

Investments in subsidiaries
6,629,043

 
1,639,914

 

 
(8,268,957
)
 

Due from subsidiaries and affiliates
636

 

 
411,687

 
(412,323
)
 

Premiums receivable

 

 
1,477,354

 
(378,662
)
 
1,098,692

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

 
5,634,614

 
(3,838,211
)
 
1,796,403

Contractholder receivables

 

 
1,234,392

 

 
1,234,392

Prepaid reinsurance premiums

 

 
1,407,938

 
(977,724
)
 
430,214

Deferred acquisition costs, net

 

 
399,385

 

 
399,385

Other assets
8,025

 
64,629

 
2,022,687

 
(570,490
)
 
1,524,851

 
Total assets
$
6,644,980

 
$
1,790,991

 
$
28,583,911

 
$
(14,446,367
)
 
$
22,573,515

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Reserve for losses and loss adjustment expenses
$

 
$

 
$
12,848,119

 
$
(3,829,130
)
 
$
9,018,989

Unearned premiums

 

 
3,277,416

 
(977,724
)
 
2,299,692

Reinsurance balances payable

 

 
804,239

 
(540,892
)
 
263,347

Contractholder payables

 

 
1,234,392

 

 
1,234,392

Deposit accounting liabilities

 

 
715,369

 
(318,032
)
 
397,337

Senior notes
300,000

 
500,000

 

 

 
800,000

Revolving credit agreement borrowings
100,000

 

 

 

 
100,000

Due to subsidiaries and affiliates
4,954

 
1,189

 
406,180

 
(412,323
)
 

Other liabilities
10,627

 
45,057

 
1,262,318

 
(99,309
)
 
1,218,693

 
Total liabilities
415,581

 
546,246

 
20,548,033

 
(6,177,410
)
 
15,332,450

 
 
 
 
 
 
 
 
 
 
 
Redeemable noncontrolling interests (1)

 

 
219,326

 

 
219,326

 
 
 
 
 
 
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
 
 
 
 
 
Total shareholders’ equity available to Arch
6,229,399

 
1,244,745

 
7,024,212

 
(8,268,957
)
 
6,229,399

Non-redeemable noncontrolling interests (1)

 

 
792,340

 

 
792,340

 
Total shareholders’ equity
6,229,399

 
1,244,745

 
7,816,552

 
(8,268,957
)
 
7,021,739

 
 
 
 
 
 
 
 
 
 
 
Total liabilities, noncontrolling interests and shareholders’ equity
$
6,644,980

 
$
1,790,991

 
$
28,583,911

 
$
(14,446,367
)
 
$
22,573,515


(1)     See Note 4.



37




 
 
December 31, 2013
Condensed Consolidating Balance Sheet
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Assets
 
 
 
 
 
 
 
 
 
Total investments
$
2,530

 
$
408,957

 
$
13,200,247

 
$

 
$
13,611,734

Cash
3,223

 
509

 
430,325

 

 
434,057

Investments in subsidiaries
6,046,060

 
1,258,889

 

 
(7,304,949
)
 

Due from subsidiaries and affiliates
2,251

 

 
405,110

 
(407,361
)
 

Premiums receivable

 

 
1,085,369

 
(331,445
)
 
753,924

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

 
5,645,156

 
(3,840,826
)
 
1,804,330

Contractholder receivables

 

 
1,064,246

 

 
1,064,246

Prepaid reinsurance premiums

 

 
1,109,312

 
(780,969
)
 
328,343

Deferred acquisition costs, net

 

 
342,314

 

 
342,314

Other assets
6,598

 
60,342

 
1,714,651

 
(554,445
)
 
1,227,146

 
Total assets
$
6,060,662

 
$
1,728,697

 
$
24,996,730

 
$
(13,219,995
)
 
$
19,566,094

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Reserve for losses and loss adjustment expenses
$

 
$

 
$
12,625,766

 
$
(3,801,070
)
 
$
8,824,696

Unearned premiums

 

 
2,677,334

 
(780,969
)
 
1,896,365

Reinsurance balances payable

 

 
662,394

 
(466,227
)
 
196,167

Contractholder payables

 

 
1,064,246

 

 
1,064,246

Deposit accounting liabilities

 

 
758,490

 
(337,193
)
 
421,297

Senior notes
300,000

 
500,000

 

 

 
800,000

Revolving credit agreement borrowings
100,000

 

 

 

 
100,000

Due to subsidiaries and affiliates
18

 
10,250

 
397,093

 
(407,361
)
 

Other liabilities
13,148

 
33,206

 
691,699

 
(122,226
)
 
615,827

 
Total liabilities
413,166

 
543,456

 
18,877,022

 
(5,915,046
)
 
13,918,598

 
 
 
 
 
 
 
 
 
 
 
Redeemable noncontrolling interests

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
 
 
 
 
 
Total shareholders’ equity available to Arch
5,647,496

 
1,185,241

 
6,119,708

 
(7,304,949
)
 
5,647,496

Non-redeemable noncontrolling interests

 

 

 

 

 
Total shareholders’ equity
5,647,496

 
1,185,241

 
6,119,708

 
(7,304,949
)
 
5,647,496

 
 
 
 
 
 
 
 
 
 
 
Total liabilities, noncontrolling interests and shareholders’ equity
$
6,060,662

 
$
1,728,697

 
$
24,996,730

 
$
(13,219,995
)
 
$
19,566,094






38




 
 
Three Months Ended June 30, 2014
Condensed Consolidating Statement of Income and Comprehensive Income
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
907,152

 
$

 
$
907,152

Net investment income

 

 
80,380

 
(7,390
)
 
72,990

Net realized gains

 

 
54,144

 

 
54,144

Net impairment losses recognized in earnings

 

 
(14,749
)
 

 
(14,749
)
Other underwriting income

 

 
2,033

 

 
2,033

Equity in net income of investment funds accounted for using the equity method

 

 
9,240

 

 
9,240

Other income (loss)

 

 
4,850

 

 
4,850

 
Total revenues

 

 
1,043,050

 
(7,390
)
 
1,035,660

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
485,518

 

 
485,518

Acquisition expenses

 

 
158,158

 

 
158,158

Other operating expenses
15,250

 
494

 
140,606

 

 
156,350

Interest expense
5,854

 
6,448

 
9,422

 
(7,390
)
 
14,334

Net foreign exchange losses

 

 
1,054

 
1,240

 
2,294

 
Total expenses
21,104

 
6,942

 
794,758

 
(6,150
)
 
816,654

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(21,104
)
 
(6,942
)
 
248,292

 
(1,240
)
 
219,006

Income tax benefit (expense)

 
3,294

 
(10,583
)
 

 
(7,289
)
Income (loss) before equity in net income of subsidiaries
(21,104
)
 
(3,648
)
 
237,709

 
(1,240
)
 
211,717

Equity in net income of subsidiaries
229,120

 
9,334

 

 
(238,454
)
 

Net income
208,016

 
5,686

 
237,709

 
(239,694
)
 
211,717

Amounts attributable to noncontrolling interests (1)

 

 
(3,701
)
 

 
(3,701
)
Net income available to Arch
208,016

 
5,686

 
234,008

 
(239,694
)
 
208,016

Preferred dividends
(5,485
)
 

 

 

 
(5,485
)
Net income available to Arch common shareholders
$
202,531

 
$
5,686

 
$
234,008

 
$
(239,694
)
 
$
202,531

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
318,180

 
$
23,186

 
$
335,348

 
$
(358,534
)
 
$
318,180


(1)     See Note 4.


39




 
 
Three Months Ended June 30, 2013
Condensed Consolidating Statement of Income and Comprehensive Income
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
758,816

 
$

 
$
758,816

Net investment income

 

 
74,980

 
(6,611
)
 
68,369

Net realized gains

 

 
12,652

 

 
12,652

Net impairment losses recognized in earnings

 

 
(724
)
 

 
(724
)
Other underwriting income

 

 
902

 

 
902

Equity in net income of investment funds accounted for using the equity method

 

 
10,941

 

 
10,941

Other income

 

 
834

 

 
834

 
Total revenues

 

 
858,401

 
(6,611
)
 
851,790

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
418,653

 

 
418,653

Acquisition expenses

 

 
131,677

 

 
131,677

Other operating expenses
13,691

 
773

 
112,944

 

 
127,408

Interest expense
5,843

 
5

 
6,615

 
(6,611
)
 
5,852

Net foreign exchange (gains) losses

 

 
(15,882
)
 
2,071

 
(13,811
)
 
Total expenses
19,534

 
778

 
654,007

 
(4,540
)
 
669,779

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(19,534
)
 
(778
)
 
204,394

 
(2,071
)
 
182,011

Income tax benefit (expense)

 
2,750

 
(7,821
)
 

 
(5,071
)
Income (loss) before equity in net income of subsidiaries
(19,534
)
 
1,972

 
196,573

 
(2,071
)
 
176,940

Equity in net income of subsidiaries
196,474

 
10,703

 

 
(207,177
)
 

Net income
176,940

 
12,675

 
196,573

 
(209,248
)
 
176,940

Amounts attributable to noncontrolling interests

 

 

 

 

Net income available to Arch
176,940

 
12,675

 
196,573

 
(209,248
)
 
176,940

Preferred dividends
(5,485
)
 

 

 

 
(5,485
)
Net income available to Arch common shareholders
$
171,455

 
$
12,675

 
$
196,573

 
$
(209,248
)
 
$
171,455

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
(101,945
)
 
$
(28,981
)
 
$
(84,383
)
 
$
113,364

 
$
(101,945
)


40



 
 
Six Months Ended June 30, 2014
Condensed Consolidating Statement of Income and Comprehensive Income
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
1,766,932

 
$

 
$
1,766,932

Net investment income

 

 
157,381

 
(17,397
)
 
139,984

Net realized gains

 

 
73,841

 

 
73,841

Net impairment losses recognized in earnings

 

 
(17,720
)
 

 
(17,720
)
Other underwriting income

 

 
3,615

 

 
3,615

Equity in net income of investment funds accounted for using the equity method

 

 
12,493

 

 
12,493

Other income (loss)

 

 
2,746

 

 
2,746

 
Total revenues

 

 
1,999,288

 
(17,397
)
 
1,981,891

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
921,758

 

 
921,758

Acquisition expenses

 

 
318,500

 

 
318,500

Other operating expenses
25,557

 
1,471

 
275,121

 

 
302,149

Interest expense
11,707

 
12,962

 
21,466

 
(17,397
)
 
28,738

Net foreign exchange losses

 

 
6,795

 
2,062

 
8,857

 
Total expenses
37,264

 
14,433

 
1,543,640

 
(15,335
)
 
1,580,002

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(37,264
)
 
(14,433
)
 
455,648

 
(2,062
)
 
401,889

Income tax benefit (expense)

 
6,082

 
(17,109
)
 

 
(11,027
)
Income (loss) before equity in net income of subsidiaries
(37,264
)
 
(8,351
)
 
438,539

 
(2,062
)
 
390,862

Equity in net income of subsidiaries
427,780

 
31,486

 

 
(459,266
)
 

Net income
390,516

 
23,135

 
438,539

 
(461,328
)
 
390,862

Amounts attributable to noncontrolling interests (1)

 

 
(346
)
 

 
(346
)
Net income available to Arch
390,516

 
23,135

 
438,193

 
(461,328
)
 
390,516

Preferred dividends
(10,969
)
 

 

 

 
(10,969
)
Net income available to Arch common shareholders
$
379,547

 
$
23,135

 
$
438,193

 
$
(461,328
)
 
$
379,547

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
549,435

 
$
40,406

 
$
587,467

 
$
(627,873
)
 
$
549,435


(1)     See Note 4.


41




 
 
Six Months Ended June 30, 2013
Condensed Consolidating Statement of Income and Comprehensive Income
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
1,511,586

 
$

 
$
1,511,586

Net investment income

 

 
147,302

 
(13,261
)
 
134,041

Net realized gains

 

 
70,992

 

 
70,992

Net impairment losses recognized in earnings

 

 
(2,970
)
 

 
(2,970
)
Other underwriting income

 

 
1,440

 

 
1,440

Equity in net income of investment funds accounted for using the equity method

 

 
24,764

 

 
24,764

Other income

 

 
2,078

 

 
2,078

 
Total revenues

 

 
1,755,192

 
(13,261
)
 
1,741,931

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
818,056

 

 
818,056

Acquisition expenses

 

 
259,269

 

 
259,269

Other operating expenses
23,633

 
1,550

 
222,408

 

 
247,591

Interest expense
11,663

 
8

 
13,340

 
(13,261
)
 
11,750

Net foreign exchange (gains) losses

 

 
(28,654
)
 
(9,421
)
 
(38,075
)
 
Total expenses
35,296

 
1,558

 
1,284,419

 
(22,682
)
 
1,298,591

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(35,296
)
 
(1,558
)
 
470,773

 
9,421

 
443,340

Income tax benefit (expense)

 
2,985

 
(12,909
)
 

 
(9,924
)
Income (loss) before equity in net income of subsidiaries
(35,296
)
 
1,427

 
457,864

 
9,421

 
433,416

Equity in net income of subsidiaries
468,712

 
29,185

 

 
(497,897
)
 

Net income
433,416

 
30,612

 
457,864

 
(488,476
)
 
433,416

Amounts attributable to noncontrolling interests

 

 

 

 

Net income available to Arch
433,416

 
30,612

 
457,864

 
(488,476
)
 
433,416

Preferred dividends
(10,969
)
 

 

 

 
(10,969
)
Net income available to Arch common shareholders
$
422,447

 
$
30,612

 
$
457,864

 
$
(488,476
)
 
$
422,447

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
97,077

 
$
(22,829
)
 
$
130,946

 
$
(108,117
)
 
$
97,077





42




 
 
 
 
Six Months Ended June 30, 2014
Condensed Consolidating Statement
of Cash Flows
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Operating Activities
 
 
 
 
 
 
 
 
 
 
Net Cash Provided By Operating Activities
$
10,099

 
$
424

 
$
474,565

 
$
(32,025
)
 
$
453,063

Investing Activities
 
 
 
 
 
 
 
 
 
Purchases of fixed maturity investments

 
(78,509
)
 
(14,233,239
)
 

 
(14,311,748
)
Purchases of equity securities

 

 
(174,687
)
 

 
(174,687
)
Purchases of other investments

 

 
(1,022,987
)
 

 
(1,022,987
)
Proceeds from the sales of fixed maturity investments

 

 
13,204,854

 

 
13,204,854

Proceeds from the sales of equity securities

 

 
98,687

 

 
98,687

Proceeds from the sales of other investments

 

 
618,707

 

 
618,707

Proceeds from redemptions and maturities of fixed maturity investments

 

 
432,040

 

 
432,040

Net (purchases) sales of short-term investments
(31
)
 
408,779

 
21,556

 

 
430,304

Change in investment of securities lending collateral

 

 
18,701

 

 
18,701

Contributions to subsidiaries

 
(313,207
)
 
(100,000
)
 
413,207

 

Intercompany loans issued

 

 
10,250

 
(10,250
)
 

Purchase of business, net of cash acquired

 

 
(235,578
)
 

 
(235,578
)
Purchases of furniture, equipment and other assets
(128
)
 

 
(10,232
)
 

 
(10,360
)
 
Net Cash Provided By (Used For) Investing Activities
(159
)
 
17,063

 
(1,371,928
)
 
402,957

 
(952,067
)
Financing Activities
 
 
 
 
 
 
 
 
 
Purchases of common shares under share repurchase program

 

 

 

 

Proceeds from common shares issued, net
2,521

 

 
413,207

 
(413,207
)
 
2,521

Repayments of intercompany borrowings

 
(10,250
)
 

 
10,250

 

Change in securities lending collateral

 

 
(18,701
)
 

 
(18,701
)
Third party investment in non-redeemable noncontrolling interests (1)

 

 
796,903

 

 
796,903

Third party investment in redeemable noncontrolling interests (1)

 

 
219,233

 

 
219,233

Dividends paid to redeemable noncontrolling interests (1)

 

 
(4,816
)
 

 
(4,816
)
Dividends paid to parent

 

 
(32,025
)
 
32,025

 

Other

 

 
4,706

 

 
4,706

Preferred dividends paid
(10,969
)
 

 

 

 
(10,969
)
 
Net Cash Provided By (Used For) Financing Activities
(8,448
)
 
(10,250
)
 
1,378,507

 
(370,932
)
 
988,877

Effects of exchange rates changes on foreign currency cash

 

 
2,513

 

 
2,513

Increase in cash
1,492

 
7,237

 
483,657

 

 
492,386

Cash beginning of year
3,223

 
509

 
430,325

 

 
434,057

Cash end of period
$
4,715

 
$
7,746

 
$
913,982

 
$

 
$
926,443


(1)     See Note 4.


43




 
 
 
 
Six Months Ended June 30, 2013
Condensed Consolidating Statement
of Cash Flows
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Operating Activities
 
 
 
 
 
 
 
 
 
 
Net Cash Provided By (Used For) Operating Activities
$
69,021

 
$
(534
)
 
$
412,867

 
$
(93,000
)
 
$
388,354

Investing Activities
 
 
 
 
 
 
 
 
 
Purchases of fixed maturity investments

 

 
(8,599,697
)
 

 
(8,599,697
)
Purchases of equity securities

 

 
(272,323
)
 

 
(272,323
)
Purchases of other investments

 

 
(648,915
)
 

 
(648,915
)
Proceeds from the sales of fixed maturity investments

 

 
8,468,641

 

 
8,468,641

Proceeds from the sales of equity securities

 

 
194,212

 

 
194,212

Proceeds from the sales of other investments

 

 
506,434

 

 
506,434

Proceeds from redemptions and maturities of fixed maturity investments

 

 
424,953

 

 
424,953

Net (purchases) sales of short-term investments
(3,028
)
 
996

 
(373,114
)
 

 
(375,146
)
Change in investment of securities lending collateral

 

 
3,221

 

 
3,221

Contributions to subsidiaries

 
(10,250
)
 
(250
)
 
10,500

 

Intercompany loans issued

 

 
(10,250
)
 
10,250

 

Purchases of furniture, equipment and other assets
(131
)
 

 
(6,961
)
 

 
(7,092
)
 
Net Cash Provided By (Used For) Investing Activities
(3,159
)
 
(9,254
)
 
(314,049
)
 
20,750

 
(305,712
)
Financing Activities
 
 
 
 
 
 
 
 
 
Purchases of common shares under share repurchase program
(56,463
)
 

 

 

 
(56,463
)
Proceeds from common shares issued, net
(517
)
 

 
10,500

 
(10,500
)
 
(517
)
Proceeds from intercompany borrowings

 
10,250

 

 
(10,250
)
 

Change in securities lending collateral

 

 
(3,221
)
 

 
(3,221
)
Dividends paid to parent

 

 
(93,000
)
 
93,000

 

Other

 

 
5,042

 

 
5,042

Preferred dividends paid
(10,969
)
 

 

 

 
(10,969
)
 
Net Cash Provided By (Used For) Financing Activities
(67,949
)
 
10,250

 
(80,679
)
 
72,250

 
(66,128
)
Effects of exchange rates changes on foreign currency cash

 

 
(12,436
)
 

 
(12,436
)
Increase (decrease) in cash
(2,087
)
 
462

 
5,703

 

 
4,078

Cash beginning of year
6,417

 
612

 
364,012

 

 
371,041

Cash end of period
$
4,330

 
$
1,074

 
$
369,715

 
$

 
$
375,119


15.            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 June 30, 2014, the Company was not a party to any litigation or arbitration which is expected by management to have a material adverse effect on the Company’s results of operations and financial condition and liquidity.
 

44

Table of Contents

ITEM 2.            MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with our consolidated financial statements included in Item 1 of this report and also our 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, 2013 (“2013 Form 10-K”). In addition, readers should review “Risk Factors” set forth in Item 1A of Part I of our 2013 Form 10-K. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
 
Arch Capital Group Ltd. (“ACGL” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with approximately $7.13 billion in capital at June 30, 2014 and, through operations in Bermuda, the United States, Europe and Canada, writes specialty lines of property and casualty insurance and reinsurance, as well as mortgage insurance and reinsurance, on a worldwide basis.
 
Current Outlook
 
Our insurance group continued to obtain rate increases above loss cost trends in the primary insurance markets during the 2014 second quarter, although slightly below the levels observed in the 2014 first quarter. Our insurance group continues to see its best opportunities in some sectors of the excess and surplus market and in its binding authority and program businesses. In our reinsurance business, we see a continued softening of terms and conditions with property catastrophe business remaining under pressure due to the alternative capacity in the market. Also, cedents continue to request additional ceding commissions on quota share contracts and reinsurance buyers continue to shift business to excess of loss treaties. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts and focusing more on short-tail business.

On January 30, 2014, the Company acquired CMG Mortgage Insurance Company and its affiliated mortgage insurance companies (together, “CMG Entities”) and the mortgage insurance platform and related assets from PMI Mortgage Insurance Co. (“PMI”). CMG Mortgage Insurance Company (subsequently renamed Arch Mortgage Insurance Company), is the leading provider of mortgage insurance products and services to credit unions in the U.S. Prior to the acquisition, CMG Mortgage Insurance Company had been approved as an eligible mortgage insurer by Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (each a government sponsored enterprise or “GSE”) solely for credit union customers. As part of the transaction, Arch Mortgage Insurance Company (“Arch MI U.S.”) has been approved as an eligible mortgage insurer by the GSEs. Arch MI U.S. will continue to serve its existing credit union customers and, at the same time, has made substantial progress in building out its sales force to serve banks and other mortgage originators.

In late March 2014, Watford Re Ltd., a newly-formed multi-line Bermuda reinsurance company, was launched with over $1.1 billion of initial capital. We invested $100.0 million in Watford Holdings Ltd., Watford Re Ltd.’s parent (combined with Watford Re Ltd., “Watford”) to acquire approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity. Arch Underwriters Ltd., our subsidiary, acts as Watford’s reinsurance manager, and Highbridge Principal Strategies, LLC, a subsidiary of JPMorgan Chase & Co., manages Watford’s investment assets, each under a long term services agreement. John Rathgeber, previously Vice Chairman of Arch Worldwide Reinsurance Group, was named CEO of Watford. In addition, Marc Grandisson, Chairman and CEO of Arch Worldwide Reinsurance and Mortgage Groups, and Nicolas Papadopoulo, CEO Reinsurance Group, were appointed to the board of directors of Watford.

Our objective is to achieve an average operating return on average equity of 15% or greater over the insurance cycle, which we believe to be an attractive return to our common shareholders given the risks we assume. We continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline and continue to write a significant portion of our overall book in catastrophe-exposed business which has the potential to increase the volatility of our operating results.
 
The current economic conditions could continue to have a material impact on the frequency and severity of claims and, therefore, could negatively impact our underwriting returns. In addition, volatility in the financial markets could continue to significantly affect our investment returns, reported results and shareholders’ equity. We consider the potential impact of economic trends in the estimation process for establishing unpaid losses and loss adjustment expenses and in determining our investment strategies.
 
In addition, the impact of weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and

45

Table of Contents

could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value of securities in our investment portfolio.
 
Natural Catastrophe Risk
 
We monitor our natural catastrophe risk globally for all perils and regions, in each case, where we believe there is significant exposure. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. Currently, we seek to limit our 1-in-250 year return period net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders’ equity. We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of July 1, 2014, our modeled peak zone catastrophe exposure was a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $674 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum pre-tax losses of $623 million and $426 million, respectively. Based on in-force exposure estimated as of April 1, 2014, our modeled peak zone exposure was a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $705 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum pre-tax losses of $624 million and $488 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, was less than the exposures arising from U.S. windstorms and hurricanes in both periods. As of July 1, 2014, our modeled peak zone earthquake exposure (Los Angeles earthquake) represented approximately 50% of our peak zone catastrophe exposure, and our modeled peak zone international exposure (Japan earthquake) was substantially less than both our peak zone windstorm and earthquake exposures. Net probable maximum pre-tax loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones.
 
The loss estimates shown above do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer a net loss greater than 25% of our total shareholders’ equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders’ equity exposed to a single catastrophic event. Actual losses may also increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See “Risk Factors—Risk Relating to Our Industry” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Natural and Man-Made Catastrophic Events” in our 2013 Form 10-K.
 
Financial Measures
 
Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for ACGL’s common shareholders:
 
Book Value per Common Share
 
Book value per common share represents total common shareholders’ equity divided by the number of common shares outstanding. Management uses growth in book value per common share as a key measure of the value generated for our common shareholders each period and believes that book value per common share is the key driver of ACGL’s share price over time. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per common share depending on the purchase price. Book value per common share was $43.73 at June 30, 2014, compared to $41.52 at March 31, 2014 and $36.80 at June 30, 2013. The 5.3% increase in the 2014 second quarter and 18.8% increase for the trailing twelve months were driven by underwriting and investment returns.
 

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Table of Contents

Operating Return on Average Common Equity
 
Operating return on average common equity (“Operating ROAE”) represents annualized after-tax operating income available to Arch common shareholders divided by the average of beginning and ending common shareholders’ equity during the period. After-tax operating income available to Arch common shareholders, a “non-GAAP measure” as defined in the SEC rules, represents net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to common shareholders and has set an objective to achieve an average Operating ROAE of 15% or greater over the insurance cycle, which it believes to be an attractive return to common shareholders given the risks we assume. See “Comment on Non-GAAP Financial Measures.” Our Operating ROAE was 11.2% for the 2014 second quarter, compared to 10.9% for the 2013 second quarter, and 11.6% for the six months ended June 30, 2014, compared to 12.0% for the 2013 period. The higher level of Operating ROAE for the 2014 second quarter primarily resulted from a higher level of underwriting income, reflecting a lower level of catastrophic activity and improved margins in our insurance group. Operating ROAE for the 2014 periods also reflected a higher level of average common shareholders’ equity compared to the 2013 periods. Our Operating ROAE also reflects the impact of new initiatives, such as our U.S. mortgage business, which required an upfront capital commitment but will take time to contribute significantly to our returns.
 
Total Return on Investments
 
Total return on investments includes investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by Arch’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses, excluding amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. Management uses total return on investments as a key measure of the return generated to Arch common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods.
 
The benchmark return index is a customized combination of indices intended to approximate a target portfolio by asset mix and average credit quality while also matching the approximate estimated duration and currency mix of our insurance and reinsurance liabilities. Although the estimated duration and average credit quality of this index will move as the duration and rating of its constituent securities change, generally we do not adjust the composition of the benchmark return index except to incorporate the currency mix as noted above. The benchmark return index should not be interpreted as expressing a preference for or aversion to any particular sector or sector weight. The index is intended solely to provide, unlike many master indices that change based on the size of their constituent indices, a relatively stable basket of investable indices.

At June 30, 2014, the benchmark return index had an average credit quality of “Aa2” by Moody’s Investors Service (“Moody’s”), an estimated duration of 3.36 years and included weightings to the following indices:
 
 
Weighting
The Bank of America Merrill Lynch 1-10 Year AA U.S. Corporate & Yankees Index
21.250
%
The Bank of America Merrill Lynch 1-5 Year U.S. Treasury Index
13.000

The Bank of America Merrill Lynch U.S. Mortgage Backed Securities Index
11.875

Barclays Capital CMBS, AAA Index
10.000

The Bank of America Merrill Lynch 1-10 Year U.S. Municipal Securities Index
7.125

The Bank of America Merrill Lynch 1-10 Year Euro Government Bond Index
5.500

The Bank of America Merrill Lynch US Bullet Agency Securities 1-10 Years Index
5.000

The Bank of America Merrill Lynch 0-3 Month U.S. Treasury Bill Index
5.000

MSCI World Free Index
5.000

The Bank of America Merrill Lynch 5-10 Year U.S. Treasury Index
3.250

The Bank of America Merrill Lynch 1-10 Year U.K. Gilt Index
3.000

The Bank of America Merrill Lynch U.S. High Yield Constrained Index
2.750

Barclays Capital U.S. High-Yield Corporate Loan Index
2.750

The Bank of America Merrill Lynch 1-10 Year Australia Government Bond Index
2.500

The Bank of America Merrill Lynch 1-5 Year Canada Government Bond Index
2.000

Total
100.000
%

 

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The following table summarizes the pre-tax total return (before investment expenses) of investments managed by Arch compared to the benchmark return against which we measured our portfolio during the periods:
 
Arch
Portfolio
 
Benchmark
Return
Pre-tax total return (before investment expenses):
 

 
 

2014 second quarter
1.80
 %
 
1.73
 %
2013 second quarter
(1.59
)%
 
(1.43
)%
 
 
 
 
Six Months Ended June 30, 2014
2.84
 %
 
3.08
 %
Six Months Ended June 30, 2013
(1.11
)%
 
(0.97
)%
 
Total return for the 2014 periods primarily resulted from our fixed income portfolio, which makes up over three quarters of our portfolio, augmented by higher returns from our equity and alternative strategies. Excluding foreign exchange, total return was 1.63% for the 2014 second quarter, compared to (1.56)% for the 2013 second quarter, and 2.67% for the six months ended June 30, 2014, compared to (0.57)% for the 2013 period.
 
Comment on Non-GAAP Financial Measures
 
Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to Arch common shareholders, which is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. The presentation of after-tax operating income available to Arch common shareholders is a “non-GAAP financial measure” as defined in Regulation G. The reconciliation of such measure to net income available to Arch common shareholders (the most directly comparable GAAP financial measure) in accordance with Regulation G is included under “Results of Operations” below.
 
We believe that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses from the calculation of after-tax operating income available to Arch common shareholders.
 
We believe that showing net income available to Arch common shareholders exclusive of the items referred to above reflects the underlying fundamentals of our business since we evaluate the performance of and manage our business to produce an underwriting profit. In addition to presenting net income available to Arch common shareholders, we believe that this presentation enables investors and other users of our financial information to analyze our performance in a manner similar to how management analyzes performance. We also believe that this measure follows industry practice and, therefore, allows the users of financial information to compare our performance with our industry peer group. We believe that the equity analysts and certain rating agencies which follow us and the insurance industry as a whole generally exclude these items from their analyses for the same reasons.

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RESULTS OF OPERATIONS
 
The following table summarizes, on an after-tax basis, our consolidated financial data, including a reconciliation of after-tax operating income available to Arch common shareholders to net income available to Arch common shareholders:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
After-tax operating income available to Arch common shareholders
$
160,669

 
$
135,021

 
$
325,073

 
$
293,769

Net realized gains, net of tax
50,267

 
13,779

 
68,540

 
68,702

Net impairment losses recognized in earnings, net of tax
(14,749
)
 
(724
)
 
(17,720
)
 
(2,970
)
Equity in net income of investment funds accounted for using the equity method, net of tax
9,054

 
10,941

 
12,218

 
24,764

Net foreign exchange (losses) gains, net of tax
(2,710
)
 
12,438

 
(8,564
)
 
38,182

Net income available to Arch common shareholders
$
202,531

 
$
171,455

 
$
379,547

 
$
422,447


Segment Information
 
During the 2014 first quarter, to reflect activity during the period as described below, we changed our segment structure and added two new segments (mortgage and ‘other’). We now classify our businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — ‘other’ and corporate (non-underwriting). Our insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to our chief operating decision makers, the Chairman, 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. Management measures segment performance for our three underwriting segments based on underwriting income or loss. We do not manage our assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.

We determined our reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of our consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results. The corporate (non-underwriting) segment results include net investment income, other income (loss), other expenses incurred by us, interest expense, net realized gains or losses, net impairment losses included in earnings, equity in net income (loss) of investment funds accounted for using the equity method, net foreign exchange gains or losses, income taxes and items related to our non-cumulative preferred shares. Such amounts exclude the results of the ‘other’ segment.

The mortgage segment was formed in the 2014 first quarter and consists of our mortgage insurance and reinsurance business, including Arch MI U.S. The mortgage segment also provides reinsurance on both a proportional and non-proportional basis globally, direct mortgage insurance in Europe and various risk-sharing products to government sponsored entities and mortgage lenders.

The ‘other’ segment includes the results of Watford, which is a multi-line Bermuda reinsurance company launched in late March 2014. Watford has its own management and board of directors that is responsible for the overall profitability of its results. We are required to consolidate the results of Watford in our financial statements. The portion of Watford’s earnings attributable to third party investors is recorded in the consolidated statements of income as ‘amounts attributable to noncontrolling interests.’ For the ‘other’ segment, performance is measured based on net income or loss.


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Table of Contents

Insurance Segment
 
The following table sets forth our insurance segment’s underwriting results:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
% Change
 
2014
 
2013
 
% Change
Gross premiums written
$
852,231

 
$
703,904

 
21.1

 
$
1,582,877

 
$
1,392,721

 
13.7

Premiums ceded
(273,349
)
 
(202,336
)
 
 
 
(458,393
)
 
(386,603
)
 
 
Net premiums written
578,882

 
501,568

 
15.4

 
1,124,484

 
1,006,118

 
11.8

Change in unearned premiums
(71,170
)
 
(42,912
)
 
 
 
(139,271
)
 
(102,497
)
 
 
Net premiums earned
507,712

 
458,656

 
10.7

 
985,213

 
903,621

 
9.0

Other underwriting income
514

 
529

 
 

 
1,014

 
1,054

 
 
Losses and loss adjustment expenses
(311,526
)
 
(291,192
)
 
 

 
(598,296
)
 
(574,659
)
 
 
Acquisition expenses, net
(76,449
)
 
(74,249
)
 
 

 
(153,381
)
 
(145,007
)
 
 
Other operating expenses
(85,829
)
 
(80,167
)
 
 

 
(166,973
)
 
(156,482
)
 
 
Underwriting income
$
34,422

 
$
13,577

 
153.5

 
$
67,577

 
$
28,527

 
136.9

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
 
 
 
 
 
% Point
Change
Loss ratio
61.4
%
 
63.5
%
 
(2.1
)
 
60.7
%
 
63.6
%
 
(2.9
)
Acquisition expense ratio (1)
15.0
%
 
16.1
%
 
(1.1
)
 
15.5
%
 
15.9
%
 
(0.4
)
Other operating expense ratio
16.9
%
 
17.5
%
 
(0.6
)
 
16.9
%
 
17.3
%
 
(0.4
)
Combined ratio
93.3
%
 
97.1
%
 
(3.8
)
 
93.1
%
 
96.8
%
 
(3.7
)
_________________________________________________
(1)     The acquisition expense ratio is adjusted to include certain other underwriting income.

The insurance segment consists of our insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include:

Construction and national accounts: primary and excess casualty coverages to middle and large accounts in the construction industry and a wide range of products for middle and large national accounts, specializing in loss sensitive primary casualty insurance programs (including large deductible, self-insured retention and retrospectively rated programs).
Excess and surplus casualty: primary and excess casualty insurance coverages, including middle market energy business, and contract binding, which primarily provides casualty coverage through a network of appointed agents to small and medium risks.
Lenders products: collateral protection, debt cancellation and service contract reimbursement products to banks, credit unions, automotive dealerships and original equipment manufacturers and other specialty programs that pertain to automotive lending and leasing.
Professional lines: directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity and other financial related coverages for corporate, private equity, venture capital, real estate investment trust, limited partnership, financial institution and not-for-profit clients of all sizes and medical professional and general liability insurance coverages for the healthcare industry. The business is predominately written on a claims-made basis.
Programs: primarily package policies, underwriting workers’ compensation and umbrella liability business in support of desirable package programs, targeting program managers with unique expertise and niche products offering general liability, commercial automobile, inland marine and property business with minimal catastrophe exposure.
Property, energy, marine and aviation: primary and excess general property insurance coverages, including catastrophe-exposed property coverage, for commercial clients. Coverages for marine include hull, war, specie and liability. Aviation and stand alone terrorism are also offered.
Travel, accident and health: specialty travel and accident and related insurance products for individual, group travelers, travel agents and suppliers, as well as accident and health, which provides accident, disability and medical plan insurance coverages for employer groups, medical plan members, students and other participant groups.
Other: includes alternative market risks (including captive insurance programs), excess workers’ compensation and employer’s liability insurance coverages for qualified self-insured groups, associations and trusts, and contract and commercial surety coverages, including contract bonds (payment and performance bonds) primarily for medium and large contractors and commercial surety bonds for Fortune 1,000 companies and smaller transaction business programs.

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Premiums Written.
 
The following table sets forth our insurance segment’s net premiums written by major line of business:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
Programs
$
126,722

 
22

 
$
116,453

 
23

 
$
248,962

 
22

 
$
212,255

 
21

Professional lines
114,411

 
20

 
120,243

 
24

 
237,319

 
21

 
246,015

 
24

Construction and national accounts
79,171

 
14

 
69,060

 
14

 
174,668

 
16

 
156,388

 
16

Property, energy, marine and aviation
84,530

 
14

 
81,675

 
16

 
147,286

 
13

 
165,286

 
16

Excess and surplus casualty
58,789

 
10

 
32,467

 
7

 
102,729

 
9

 
56,262

 
6

Travel, accident and health
34,393

 
6

 
21,933

 
4

 
75,231

 
7

 
49,910

 
5

Lenders products
24,909

 
4

 
29,368

 
6

 
46,915

 
4

 
55,754

 
6

Other
55,957

 
10

 
30,369

 
6

 
91,374

 
8

 
64,248

 
6

Total
$
578,882

 
100

 
$
501,568

 
100

 
$
1,124,484

 
100

 
$
1,006,118

 
100

 
2014 Second Quarter versus 2013 Second Quarter. Gross premiums written by the insurance segment in the 2014 second quarter were 21.1% higher than in the 2013 second quarter, while net premiums written were 15.4% higher than in the 2013 second quarter. The differential in gross versus net premiums written primarily resulted from growth in alternative markets business which is subject to a high level of cessions, primarily to captives. The growth in net premiums written primarily resulted from increases in: alternative markets; excess and surplus casualty; travel, accident and health; and construction and national accounts. Such amounts were partially offset by a reduction in professional lines. The increase in alternative markets reflected new accounts written in the quarter resulting from a renewal rights agreement, while the growth in excess and surplus casualty primarily resulted from contract binding business along with rate increases. Growth in travel, accident and health primarily resulted from expansion in existing and new distribution channels while the increase in construction and national accounts primarily resulted from growth in existing accounts and rate increases. The decrease in professional lines was primarily due to a continued strategic reduction in exposure to international business.

Six Months Ended June 30, 2014 versus 2013. Gross premiums written by the insurance segment for the six months ended June 30, 2014 were 13.7% higher than in the 2013 period, while net premiums written were 11.8% higher than in the 2013 period. The differential in gross versus net premiums written primarily resulted from growth in alternative markets business which is subject to a high level of cessions, primarily to captives, and reflects increases in lines such as programs and contract binding (which was launched in early 2013), both of which are retained at a high level. The growth in net premiums written primarily resulted from increases in: excess and surplus casualty; programs; alternative markets; travel, accident and health; and construction and national accounts. Such amounts were partially offset by reductions in professional lines, property and marine lines. The growth in excess and surplus casualty primarily resulted from contract binding business along with rate increases. The increase in program business resulted from new business, underlying exposure growth and rate strengthening within existing programs while the increase in alternative markets reflected new accounts written in the quarter resulting from a renewal rights agreement. Growth in travel, accident and health primarily resulted from expansion in existing and new distribution channels while the increase in construction and national accounts primarily resulted from growth in existing accounts and rate increases. The decrease in professional lines was primarily due to a continued strategic reduction in exposure to international business while the reduction in property lines reflected reductions in U.S. property and marine business in response to current market conditions.


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Net Premiums Earned.
 
The following table sets forth our insurance segment’s net premiums earned by major line of business:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
Programs
$
114,043

 
22

 
$
95,472

 
21

 
$
223,224

 
23

 
$
181,552

 
20

Professional lines
116,031

 
23

 
124,379

 
27

 
228,775

 
23

 
250,197

 
28

Construction and national accounts
72,064

 
14

 
61,193

 
13

 
141,053

 
14

 
118,075

 
13

Property, energy, marine and aviation
66,221

 
13

 
71,978

 
16

 
127,810

 
13

 
149,983

 
17

Excess and surplus casualty
43,600

 
9

 
25,585

 
6

 
82,707

 
8

 
51,408

 
6

Travel, accident and health
30,645

 
6

 
25,850

 
6

 
58,710

 
6

 
46,085

 
5

Lenders products
22,763

 
5

 
25,104

 
5

 
46,595

 
5

 
49,904

 
5

Other
42,345

 
8

 
29,095

 
6

 
76,339

 
8

 
56,417

 
6

Total
$
507,712

 
100

 
$
458,656

 
100

 
$
985,213

 
100

 
$
903,621

 
100

 
Net premiums written are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Net premiums earned in the 2014 second quarter were 10.7% higher than in the 2013 second quarter and 9.0% higher for the six months ended June 30, 2014 than in the 2013 period. Net premiums earned reflect changes in net premiums written over the previous five quarters.
 
Losses and Loss Adjustment Expenses.
 
The table below shows the components of the insurance segment’s loss ratio:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Current year
65.2
 %
 
67.0
 %
 
64.2
 %
 
65.9
 %
Prior period reserve development
(3.8
)%
 
(3.5
)%
 
(3.5
)%
 
(2.3
)%
Loss ratio
61.4
 %
 
63.5
 %
 
60.7
 %
 
63.6
 %
 
Current Year Loss Ratio.
 
The insurance segment’s current year loss ratio in the 2014 second quarter was 1.8 points lower than in the 2013 second quarter and 1.7 points lower for the six months ended June 30, 2014 than in the 2013 period. The 2014 second quarter loss ratio reflected 0.7 points of current year catastrophic activity, compared to 1.5 points in the 2013 second quarter. The loss ratio for the six months ended June 30, 2014 reflected 0.6 points of current year catastrophic activity, compared to 0.7 points for the 2013 period. The loss ratios for the 2014 periods also reflected the impact of rate improvement on net premiums earned over the previous five quarters and changes in the mix of business.

Prior Period Reserve Development.
 
2014 Second Quarter: The insurance segment’s net favorable development of $19.4 million, or 3.8 points, consisted of $26.2 million of net favorable development in short-tailed lines and $6.8 million of net adverse development in medium-tailed and long-tailed lines. Favorable development in short-tailed lines primarily consisted of reductions in property (including special risk other than marine) reserves from the 2010 and 2013 accident years (i.e., the year in which a loss occurred), primarily due to varying levels of reported claims activity. Development on the 2005 to 2013 named catastrophic events was favorable by $4.4 million in the quarter. Net adverse development in medium-tailed and long-tailed lines reflected increases in construction reserves of $12.6 million, primarily resulting from higher reported losses in the 2011 to 2013 accident years, and net increases in professional lines of $2.6 million, reflecting adverse development in international professional liability from recent accident years and favorable development in healthcare business across most accident years. In addition, the insurance segment results reflected favorable development in marine business of $6.0 million and surety business of $2.0 million.

2013 Second Quarter: The insurance segment’s net favorable development of $16.0 million, or 3.5 points, consisted of $11.7 million of net favorable development in short-tailed lines and $4.3 million of net favorable development in medium-tailed and long-tailed lines. Favorable development in short-tailed lines primarily consisted of reductions in property (including special risk other than marine) reserves from the 2008 to 2011 accident years, primarily due to varying levels of reported claims

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activity. Development on the 2005 to 2012 named catastrophic events was favorable by $7.2 million in the quarter. Net favorable development in medium-tailed and long-tailed lines reflected a reduction of $8.2 million in marine reserves, $3.1 million of favorable development in healthcare reserves and $2.0 million in national accounts, all spread across various accident years. Such amounts were partially offset by a net increase of $4.1 million in reserves for professional lines, primarily from a small number of claims in the 2006 accident year, and $5.8 million in casualty reserves, primarily from the 2012 accident year on certain Canadian captive business which was non-renewed.

Six Months Ended June 30, 2014: The insurance segment’s net favorable development of $35.0 million, or 3.5 points, consisted of $40.6 million of net favorable development in short-tailed lines and $5.6 million of net adverse development in medium-tailed and long-tailed lines. Favorable development in short-tailed lines primarily consisted of reductions in property (including special risk other than marine) reserves from the 2008 and 2012 accident years, primarily due to varying levels of reported claims activity. Development on the 2005 to 2013 named catastrophic events was favorable by $6.2 million for the 2014 period. Net adverse development in medium-tailed and long-tailed lines reflected increases in construction reserves of $14.0 million and in program reserves of $13.7 million, both reflecting higher reported losses in the 2011 to 2013 accident years. In addition, the insurance segment results reflected favorable development in professional lines, reflecting favorable development in healthcare business across most accident years and other professional lines from earlier accident years, and in marine business.

Six Months Ended June 30, 2013: The insurance segment’s net favorable development of $21.0 million, or 2.3 points, consisted of $27.8 million of net favorable development in short-tailed lines, partially offset by $6.8 million of net adverse development in medium-tailed and long-tailed lines. Favorable development in short-tailed lines primarily consisted of reductions in property (including special risk other than marine) reserves from the 2009 to 2011 accident years, primarily due to varying levels of reported claims activity. Development on the 2005 to 2012 named catastrophic events was favorable by $8.6 million in the period. Net adverse development in medium-tailed and long-tailed lines included an increase of $10.4 million in casualty reserves, primarily related to claims from the two most recent accident years on certain Canadian accounts which have been non-renewed, a net increase of $7.9 million in reserves for professional lines, primarily from a small number of claims in the 2006 accident year. Such amounts were partially offset by favorable development of $7.5 million in healthcare reserves, $4.5 million in marine, and $4.2 million in national accounts, all spread across various accident years.

Underwriting Expenses.
 
2014 Second Quarter versus 2013 Second Quarter: The insurance segment’s underwriting expense ratio was 31.9% in the 2014 second quarter, compared to 33.6% in the 2013 second quarter. The acquisition expense ratio was 15.0% in the 2014 second quarter, compared to 16.1% in the 2013 second quarter. The comparison of the 2014 second quarter and 2013 second quarter acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commissions. The 2014 second quarter ratio was disproportionately impacted by ceding commissions on the alternative markets business noted above. In addition, the acquisition expense ratio was impacted by changes in development of prior year loss reserves which increased the 2014 second quarter ratio by 0.6 points, compared to 0.5 points in the 2013 second quarter. The other operating expense ratio was 16.9% for the 2014 second quarter, compared to 17.5% for the 2013 second quarter, with the improvement mainly due to the higher level of net premiums earned.
 
Six Months Ended June 30, 2014 versus 2013: The insurance segment’s underwriting expense ratio was 32.4% for the six months ended June 30, 2014, compared to 33.2% in the 2013 period. The acquisition expense ratio was 15.5% for the six months ended June 30, 2014, compared to 15.9% in the 2013 period. The acquisition expense ratio was impacted by ceding commissions on the alternative markets business noted above and from changes in development of prior year loss reserves which increased the ratio by 0.8 points for the six months ended June 30, 2014, compared to 0.2 points in the 2013 period. The other operating expense ratio was 16.9% for the six months ended June 30, 2014, compared to 17.3% for the 2013 period, with the improvement mainly due to the higher level of net premiums earned.



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Reinsurance Segment
 
The following table sets forth our reinsurance segment’s underwriting results:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
% Change
 
2014
 
2013
 
% Change
Gross premiums written
$
349,841

 
$
318,898

 
9.7

 
$
866,894

 
$
769,345

 
12.7

Premiums ceded
(58,994
)
 
(28,675
)
 
 
 
(132,121
)
 
(56,654
)
 
 
Net premiums written
290,847

 
290,223

 
0.2

 
734,773

 
712,691

 
3.1

Change in unearned premiums
44,780

 
(2,731
)
 
 
 
(57,798
)
 
(129,046
)
 
 
Net premiums earned
335,627

 
287,492

 
16.7

 
676,975

 
583,645

 
16.0

Other underwriting income
303

 
373

 
 

 
619

 
386

 
 

Losses and loss adjustment expenses
(150,325
)
 
(125,283
)
 
 

 
(289,961
)
 
(239,140
)
 
 

Acquisition expenses, net
(66,035
)
 
(53,291
)
 
 

 
(139,468
)
 
(106,434
)
 
 

Other operating expenses
(37,666
)
 
(31,902
)
 
 

 
(73,861
)
 
(64,099
)
 
 

Underwriting income
$
81,904

 
$
77,389

 
5.8

 
$
174,304

 
$
174,358

 

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
 
 
 
 
 
% Point
Change
Loss ratio
44.8
%
 
43.6
%
 
1.2

 
42.8
%
 
41.0
%
 
1.8

Acquisition expense ratio
19.7
%
 
18.5
%
 
1.2

 
20.6
%
 
18.2
%
 
2.4

Other operating expense ratio
11.2
%
 
11.1
%
 
0.1

 
10.9
%
 
11.0
%
 
(0.1
)
Combined ratio
75.7
%
 
73.2
%
 
2.5

 
74.3
%
 
70.2
%
 
4.1


The reinsurance segment consists of our reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include:

Casualty: provides coverage to ceding company clients on third party liability and workers’ compensation exposures from ceding company clients, primarily on a treaty basis. Exposures include, among others, executive assurance, professional liability, workers’ compensation, excess and umbrella liability, excess motor and healthcare business.
Marine and aviation: provides coverage for energy, hull, cargo, specie, liability and transit, and aviation business, including airline and general aviation risks. Business written may also include space business, which includes coverages for satellite assembly, launch and operation for commercial space programs.
Other specialty: provides coverage to ceding company clients for non-excess motor, including U.K. business primarily emanating from one client, and other lines including surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and political risk.
Property catastrophe: provides protection for most catastrophic losses that are covered in the underlying policies written by reinsureds, including hurricane, earthquake, flood, tornado, hail and fire, and coverage for other perils on a case-by-case basis. Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and loss adjustment expense from a single occurrence of a covered peril exceed the retention specified in the contract.
Property excluding property catastrophe: provides coverage for both personal lines and commercial property exposures and principally covers buildings, structures, equipment and contents. The primary perils in this business include fire, explosion, collapse, riot, vandalism, wind, tornado, flood and earthquake. Business is assumed on both a proportional and excess of loss basis. In addition, facultative business is written which focuses on commercial property risks on an excess of loss basis.
Other. includes life reinsurance business on both a proportional and non-proportional basis, casualty clash business and, in limited instances, non-traditional business which is intended to provide insurers with risk management solutions that complement traditional reinsurance.

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Table of Contents

Premiums Written.
 
The following table sets forth our reinsurance segment’s net premiums written by major line of business:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
Other specialty
$
105,721

 
36

 
$
61,480

 
21

 
$
253,330

 
34

 
$
192,817

 
27

Casualty
67,823

 
23

 
51,502

 
18

 
194,536

 
27

 
148,747

 
21

Property excluding property catastrophe
54,887

 
19

 
62,938

 
22

 
150,014

 
20

 
151,998

 
21

Property catastrophe
53,986

 
19

 
99,874

 
34

 
106,498

 
15

 
177,016

 
25

Marine and aviation
6,880

 
2

 
14,319

 
5

 
23,791

 
3

 
37,461

 
5

Other
1,550

 
1

 
110

 

 
6,604

 
1

 
4,652

 
1

Total
$
290,847

 
100

 
$
290,223

 
100

 
$
734,773

 
100

 
$
712,691

 
100

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Pro rata
$
123,663

 
43

 
$
96,361

 
33

 
$
297,860

 
41

 
$
258,454

 
36

Excess of loss
167,184

 
57

 
193,862

 
67

 
436,913

 
59

 
454,237

 
64

Total
$
290,847

 
100

 
$
290,223

 
100

 
$
734,773

 
100

 
$
712,691

 
100


2014 Second Quarter versus 2013 Second Quarter. Gross premiums written by the reinsurance segment in the 2014 second quarter were 9.7% higher than in the 2013 second quarter, while net premiums written were 0.2% higher than in the 2013 second quarter. The differential in gross versus net premiums written reflects the cession of premiums to the ‘other’ segment (Watford) in the 2014 second quarter and a higher level of other retrocessions than in the 2013 second quarter. The growth in net premiums written reflected increases in other specialty and casualty lines, partially offset by reductions in property catastrophe, property excluding property catastrophe and marine lines. Growth in other specialty premiums primarily reflected a higher level of accident and health business while the increase in casualty premiums reflected new international excess motor business as well as quota shares of U.S. professional liability business which were written after June 30, 2013. The reduction in property lines reflected market conditions, selected non-renewals and a higher usage of retrocessional coverage.

Six Months Ended June 30, 2014 versus 2013. Gross premiums written by the reinsurance segment for the six months ended June 30, 2014 were 12.7% higher than in the 2013 period, while net premiums written were 3.1% higher than in the 2013 period. The differential in gross versus net premiums written reflects the cession of premiums to the ‘other’ segment (Watford) for the six months ended June 30, 2014 and a higher amount of retrocessional usage than in the 2013 period. The growth in net premiums written reflected increases in other specialty and casualty lines, partially offset by reductions in property catastrophe and marine lines. Growth in other specialty premiums primarily reflected a higher level of accident and health business while the increase in casualty premiums reflected new international excess motor business as well as quota shares of U.S. professional liability business which were written after June 30, 2013. The reduction in property lines reflected market conditions, selected non-renewals and a higher usage of retrocessional coverage.
  
Net Premiums Earned.
 
The following table sets forth our reinsurance segment’s net premiums earned by major line of business:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
Other specialty
$
118,504

 
35

 
$
79,508

 
28

 
$
233,442

 
35

 
$
169,101

 
29

Casualty
90,176

 
27

 
54,922

 
19

 
168,922

 
25

 
109,927

 
19

Property excluding property catastrophe
69,172

 
21

 
66,980

 
23

 
144,546

 
21

 
131,882

 
22

Property catastrophe
39,870

 
12

 
63,332

 
22

 
89,664

 
13

 
127,565

 
22

Marine and aviation
15,259

 
4

 
20,392

 
7

 
34,154

 
5

 
40,496

 
7

Other
2,646

 
1

 
2,358

 
1

 
6,247

 
1

 
4,674

 
1

Total
$
335,627

 
100

 
$
287,492

 
100

 
$
676,975

 
100

 
$
583,645

 
100

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Pro rata
$
178,344

 
53

 
$
128,957

 
45

 
$
365,781

 
54

 
$
271,486

 
47

Excess of loss
157,283

 
47

 
158,535

 
55

 
311,194

 
46

 
312,159

 
53

Total
$
335,627

 
100

 
$
287,492

 
100

 
$
676,975

 
100

 
$
583,645

 
100

 

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Table of Contents

Net premiums written, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Net premiums earned for the 2014 second quarter were 16.7% higher than in the 2013 second quarter and 16.0% higher for the six months ended June 30, 2014 than in the 2013 period. Net premiums earned reflect changes in net premiums written over the previous five quarters.

Losses and Loss Adjustment Expenses.
 
The table below shows the components of the reinsurance segment’s loss ratio:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Current year
65.4
 %
 
62.2
 %
 
63.4
 %
 
58.6
 %
Prior period reserve development
(20.6
)%
 
(18.6
)%
 
(20.6
)%
 
(17.6
)%
Loss ratio
44.8
 %
 
43.6
 %
 
42.8
 %
 
41.0
 %
 
Current Year Loss Ratio.
 
The reinsurance segment’s current year loss ratio in the 2014 second quarter was 3.2 points higher than in the 2013 second quarter and 4.8 points higher for the six months ended June 30, 2014 than in the 2013 period. The 2014 second quarter loss ratio reflected 4.1 points of current year catastrophic activity, compared to 11.6 points in the 2013 second quarter. The loss ratio for the six months ended June 30, 2014 reflected 2.5 points of current year catastrophic activity, compared to 7.6 points for the 2013 period. The current year loss ratio for the 2014 second quarter and six months ended June 30, 2014 also reflects changes in the mix of business earned due, in part, to a lower contribution from property catastrophe business. The balance of the increase in the current year loss ratio for the 2014 second quarter and six months ended June 30, 2014 primarily resulted from changes in the mix of net premiums earned, including a lower contribution from property catastrophe business, and also reflected a higher level of non-catastrophic large loss activity.

Prior Period Reserve Development.
 
2014 Second Quarter: The reinsurance segment’s net favorable development of $69.1 million, or 20.6 points, consisted of $37.2 million from short-tailed lines and $31.9 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $29.4 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2012 and 2013 underwriting years (i.e., all premiums and losses attributable to contracts having an inception or renewal date within the given twelve-month period). Contained within this release was favorable development from the 2005 to 2013 named catastrophic events of $11.0 million. The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed lines reflected reductions in casualty reserves of $24.7 million, primarily from the 2003 to 2007 underwriting years based on varying levels of reported and paid claims activity, and a reduction of $4.3 million in marine and aviation reserves, across all underwriting years.
 
2013 Second Quarter: The reinsurance segment’s net favorable development of $53.5 million, or 18.6 points, consisted of $30.6 million from long-tailed and medium-tailed lines and $22.9 million from short-tailed lines. Favorable development in long-tailed lines reflected reductions in casualty reserves, primarily from the 2002 to 2006 underwriting years based on varying levels of reported and paid claims activity. Favorable development in short-tailed lines included $23.8 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2010 to 2012 underwriting years. Contained within this release was favorable development from the 2005 to 2012 named catastrophic events of $7.2 million. The net reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period.
 
Six Months Ended June 30, 2014: The reinsurance segment’s net favorable development of $139.5 million, or 20.6 points, consisted of $88.4 million from short-tailed lines and $51.1 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $67.9 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2011 to 2013 underwriting years. Contained within this release was favorable development from the 2005 to 2013 named catastrophic events of $9.4 million. The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed lines reflected reductions in casualty reserves of $40.1 million, primarily from the 2003 to 2007 underwriting years based on varying levels of reported and paid claims activity, and a reduction of $8.6 million in marine and aviation reserves, across all underwriting years.
 

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Six Months Ended June 30, 2013: The reinsurance segment’s net favorable development of $102.9 million, or 17.6 points, consisted of $58.0 million of net favorable development in short-tailed lines and $44.9 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $69.0 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2010 to 2012 underwriting years. Contained within this release was favorable development from the 2005 to 2012 named catastrophic events of $19.2 million. The net reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Such amounts were partially offset by an increase in estimates for U.S. crop hail losses of $10.1 million. Favorable development in long-tailed lines reflected reductions in casualty reserves, primarily from the 2002 to 2006 underwriting years based on varying levels of reported and paid claims activity, while favorable development in medium-tailed lines was across most underwriting years.

Underwriting Expenses.
 
2014 Second Quarter versus 2013 Second Quarter: The underwriting expense ratio for the reinsurance segment was 30.9% in the 2014 second quarter, compared to 29.6% in the 2013 second quarter. The acquisition expense ratio for the 2014 second quarter was 19.7%, compared to 18.5% for the 2013 second quarter. The acquisition expense ratio was impacted by changes in development of prior year loss reserves which increased the 2014 second quarter acquisition expense ratio by 0.4 points, compared to a 0.6 point reduction in the 2013 second quarter. In addition, the comparison of the acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commissions. The operating expense ratio for the 2014 second quarter was 11.2%, compared to 11.1% in the 2013 second quarter.

Six Months Ended June 30, 2014 versus 2013: The underwriting expense ratio for the reinsurance segment was 31.5% for the six months ended June 30, 2014, compared to 29.2% in the 2013 period. The acquisition expense ratio was 20.6% for the six months ended June 30, 2014, compared to 18.2% in the 2013 period. The 2014 ratio reflected a higher level of premiums earned on a pro rata basis, including two large contracts entered into in the second half of 2013, which resulted in a higher level of ceding commissions. The acquisition expense ratio was impacted by changes in development of prior year loss reserves which increased the acquisition expense ratio by 0.2 points, compared to a 0.1 point reduction in the 2013 period. The operating expense ratio for the six months ended June 30, 2014 was 10.9%, compared to 11.0% in the 2013 period.

Mortgage Segment
 
The following table sets forth our mortgage segment’s underwriting results:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
% Change
 
2014
 
2013
 
% Change
Gross premiums written
$
55,476

 
$
18,744

 
196.0

 
$
103,383

 
$
44,502

 
132.3

Premiums ceded
(5,079
)
 

 
 
 
(9,718
)
 

 
 
Net premiums written
50,397

 
18,744

 
168.9

 
93,665

 
44,502

 
110.5

Change in unearned premiums
436

 
(6,076
)
 
 
 
(4,067
)
 
(20,182
)
 
 
Net premiums earned
50,833

 
12,668

 
301.3

 
89,598

 
24,320

 
268.4

Other underwriting income
1,216

 

 
 

 
1,982

 

 
 

Losses and loss adjustment expenses
(15,473
)
 
(2,178
)
 
 

 
(23,951
)
 
(4,257
)
 
 

Acquisition expenses, net
(11,481
)
 
(4,137
)
 
 

 
(20,635
)
 
(7,828
)
 
 

Other operating expenses
(16,288
)
 
(1,290
)
 
 

 
(30,164
)
 
(2,693
)
 
 

Underwriting income
$
8,807

 
$
5,063

 
73.9

 
$
16,830

 
$
9,542

 
76.4

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
 
 
 
 
 
% Point
Change
Loss ratio
30.4
%
 
17.2
%
 
13.2

 
26.7
%
 
17.5
%
 
9.2

Acquisition expense ratio
22.6
%
 
32.7
%
 
(10.1
)
 
23.0
%
 
32.2
%
 
(9.2
)
Other operating expense ratio
32.0
%
 
10.2
%
 
21.8

 
33.7
%
 
11.1
%
 
22.6

Combined ratio
85.0
%
 
60.1
%
 
24.9

 
83.4
%
 
60.8
%
 
22.6


The mortgage segment includes the results of Arch MI U.S., a leading provider of mortgage insurance products and services to credit unions in the U.S. marketplace, which was acquired in January 2014, along with the Company’s other global mortgage insurance, reinsurance and risk-sharing products. Since the acquisition, Arch MI U.S. has made substantial progress in building out its sales force to serve banks and other mortgage originators.

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Table of Contents

Premiums Written.
 
The following table sets forth our mortgage segment’s net premiums written by client location and underwriting location (i.e., where the business is underwritten):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
Net premiums written by client location:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
United States
$
46,111

 
92

 
$
11,594

 
62

 
82,667

 
88

 
35,558

 
80

Other
4,286

 
8

 
7,150

 
38

 
10,998

 
12

 
8,944

 
20

Total
$
50,397

 
100

 
$
18,744

 
100

 
$
93,665

 
100

 
$
44,502

 
100

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net premiums written by underwriting location:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
United States
$
24,594

 
49

 
$

 

 
$
41,325

 
44

 
$

 

Other
25,803

 
51

 
18,744

 
100

 
52,340

 
56

 
44,502

 
100

Total
$
50,397

 
100

 
$
18,744

 
100

 
$
93,665

 
100

 
$
44,502

 
100


2014 Second Quarter versus 2013 Second Quarter. Net premiums written in the 2014 second quarter included $24.6 million of business underwritten by Arch MI U.S., substantially all of which was for credit union customers. In addition, net premiums written included $9.3 million from a 100% quota share indemnity reinsurance agreement with PMI for all certificates of insurance that were issued by PMI between and including January 1, 2009 and December 31, 2011 that were not in default as of an agreed upon effective date. The mortgage segment’s net premiums written also included other reinsurance treaties covering U.S. and international mortgages. The change on such business was minimal, with a decrease in U.S. premiums written offset by growth in international business. The persistency rate represents the percentage of mortgage insurance in force at the beginning of a 12-month period that remains in force at the end of such period. The persistency rate of the Arch MI U.S. portfolio of mortgage loans was 80.5% at June 30, 2014, compared to 79.1% at March 31, 2014.

Six Months Ended June 30, 2014 versus 2013. Net premiums written for the six months ended June 30, 2014 included $41.3 million of business underwritten by Arch MI U.S. (representing activity from February to June 2014), substantially all of which was for credit union customers. In addition, net premiums written included $16.0 million from the PMI quota share agreement noted above. The mortgage segment’s net premiums written also included other reinsurance treaties covering U.S. and international mortgages. The change on such business was minimal, with a decrease in U.S. premiums written offset by growth in international business.

Arch MI U.S. generated $941 million of new insurance written (“NIW”) during the 2014 second quarter and $1.58 billion of NIW for the six months ended June 30, 2014 (including activity for January 2014 for comparability purposes), substantially all of which was for credit union clients. NIW represents the original principal balance of all loans that received coverage during the period.


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Table of Contents

The following table provides details on the NIW generated by Arch MI U.S. for the 2014 periods:
(U.S. Dollars in millions)
 
Three Months Ended
 
Six Months Ended
 
 
June 30, 2014
 
March 31, 2014 (1)
 
June 30, 2014 (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
Total new insurance written (NIW)
 
$
941

 
 
 
$
639

 
 
 
$
1,580

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total NIW by credit quality (FICO score):
 
 
 
 
 
 
 
 
 
 
 
 
>=740
 
$
534

 
56.8
%
 
$
375

 
58.7
%
 
$
909

 
57.5
%
680-739
 
339

 
36.0
%
 
225

 
35.2
%
 
$
564

 
35.7
%
620-679
 
68

 
7.2
%
 
39

 
6.1
%
 
$
107

 
6.8
%
  Total
 
$
941

 
100.0
%
 
$
639

 
100.0
%
 
$
1,580

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Total NIW by LTV:
 
 
 
 
 
 
 
 
 
 
 
 
95.01% and above
 
$
70

 
7.4
%
 
$
45

 
7.0
%
 
$
115

 
7.3
%
90.01% to 95.00%
 
500

 
53.1
%
 
330

 
51.6
%
 
$
830

 
52.5
%
85.01% to 90.00%
 
265

 
28.2
%
 
186

 
29.1
%
 
$
451

 
28.5
%
85.01% and below
 
106

 
11.3
%
 
78

 
12.3
%
 
$
184

 
11.7
%
  Total
 
$
941

 
100.0
%
 
$
639

 
100.0
%
 
$
1,580

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Total NIW purchase vs. refinance:
 
 
 
 
 
 
 
 
 
 
 
 
Purchase
 
$
786

 
83.5
%
 
$
487

 
76.2
%
 
$
1,273

 
80.6
%
Refinance
 
155

 
16.5
%
 
152

 
23.8
%
 
$
307

 
19.4
%
  Total
 
$
941

 
100.0
%
 
$
639

 
100.0
%
 
$
1,580

 
100.0
%
_________________________________________________
(1)     Includes activity for January 2014 for comparability purposes (pre-acquisition date).

Net Premiums Earned.
 
Net premiums earned for the 2014 periods were substantially higher than in the 2013 periods, primarily due to the acquisition of Arch MI U.S. along with a higher earned contribution from the mortgage segment’s quota share reinsurance business.
 
Losses and Loss Adjustment Expenses.
 
The table below shows the components of the mortgage segment’s loss ratio:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Current year
30.2
%
 
17.2
%
 
27.9
 %
 
17.5
%
Prior period reserve development
0.2
%
 
%
 
(1.2
)%
 
%
Loss ratio
30.4
%
 
17.2
%
 
26.7
 %
 
17.5
%
 
Unlike property and casualty business for which we estimate ultimate losses on premiums earned, losses on mortgage insurance business are only recorded at the time a borrower is delinquent on their mortgage, in accordance with mortgage insurance industry practice. Because our mortgage insurance reserving process does not take into account the impact of future losses from loans that are not in default, mortgage insurance loss reserves are not an estimate of ultimate losses. In addition to establishing loss reserves for loans in default, under GAAP, we are required to establish a premium deficiency reserve for our mortgage insurance products if the amount of expected future losses for a particular product and maintenance costs for such product exceeds expected future premiums, existing reserves and the anticipated investment income for such product. We evaluate whether a premium deficiency exists quarterly. No such reserve was established for the six months ended June 30, 2014.

The mortgage segment’s current year loss ratio was 13.0 points higher in the 2014 second quarter compared to the 2013 second quarter. The current year loss ratio for the 2014 periods reflect changes in the mix of business earned, resulting in part from our acquisition of Arch MI U.S., when compared to the 2013 periods. The mortgage segment’s net favorable development for the six months ended June 30, 2014 of $1.0 million, or 1.2 points, was spread across a number of underwriting years.
 
Underwriting Expenses.
 
2014 Second Quarter versus 2013 Second Quarter. The underwriting expense ratio for the mortgage segment was 54.6% in the 2014 second quarter, compared to 42.9% in the 2013 second quarter. The acquisition expense ratio was 22.6% for the

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Table of Contents

2014 second quarter, compared to 32.7% for the 2013 second quarter. The operating expense ratio was 32.0% for the 2014 second quarter, compared to 10.2% in the 2013 second quarter. As the mortgage segment’s mix is expected to shift more towards U.S. mortgage insurance business, the underwriting expense ratio is expected to stay at an elevated rate until Arch MI U.S. reaches scale with respect to non-credit union clientele.

Six Months Ended June 30, 2014 versus 2013. The underwriting expense ratio for the mortgage segment was 56.7% for the six months ended June 30, 2014, compared to 43.3% for the 2013 period. The acquisition expense ratio was 23.0% for the six months ended June 30, 2014, compared to 32.2% for the 2013 period. The operating expense ratio was 33.7% for the six months ended June 30, 2014, compared to 11.1% in the 2013 period. As the mortgage segment’s mix is expected to shift more towards U.S. mortgage insurance business, the underwriting expense ratio is expected to stay at an elevated rate until Arch MI U.S. reaches scale with respect to non-credit union clientele.

Other Segment

The following table sets forth our ‘other’ segment’s results:
 
Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
Gross premiums written
$
54,562

 
$
86,756

Premiums ceded
(2,760
)
 
(2,760
)
Net premiums written
51,802

 
83,996

Change in unearned premiums
(38,822
)
 
(68,850
)
Net premiums earned
12,980

 
15,146

Losses and loss adjustment expenses
(8,194
)
 
(9,550
)
Acquisition expenses, net
(4,193
)
 
(5,016
)
Other operating expenses
(1,635
)
 
(2,744
)
Underwriting income (loss)
(1,042
)
 
(2,164
)
 
 
 
 
Net investment income
$
532

 
$
533

Other expenses
347

 
(2,329
)
Net realized gains
3,178

 
3,178

Net foreign exchange gains
470

 
563

Net income (loss)
3,485

 
(219
)
Dividends attributable to redeemable noncontrolling interests (1)
(4,857
)
 
(4,909
)
Net income (loss) attributable to common interests
(1,372
)
 
(5,128
)
Amounts attributable to nonredeemable noncontrolling interests (1)
1,156

 
4,563

Net income (loss) available to Arch
$
(216
)
 
$
(565
)
Underwriting Ratios
 

 
 
Loss ratio
63.1
%
 
63.1
%
Acquisition expense ratio
32.3
%
 
33.1
%
Other operating expense ratio
12.6
%
 
18.1
%
Combined ratio
108.0
%
 
114.3
%
 
 
 
 
Total investable assets
$
1,114,719

 
 
Total assets
1,363,318

 
 
Total liabilities
253,507

 
 
_________________________________________________
(1)     Recorded as ‘amounts attributable to noncontrolling interests’ in the consolidated statements of income.

As noted earlier, the ‘other’ segment includes the results of Watford. Watford has its own management and board of directors and is responsible for the overall profitability of its results. We act as Watford’s reinsurance manager and Highbridge Principal Strategies, a subsidiary of JPMorgan Chase & Co., manages Watford’s investment assets, each under a long term services agreement. We invested $100.0 million to acquire approximately 11% of Watford’s common equity and a warrant to purchase additional common equity. We performed an analysis of Watford and concluded that Watford is a variable interest entity (“VIE”) and concluded that we are the primary beneficiary of Watford. As such, 100% of the results of Watford are included in our consolidated financial statements. Management measures segment performance for the ‘other’ segment based on net income or loss. See note 4, “Variable Interest Entity and Noncontrolling Interests” of the notes accompanying our consolidated financial statements for additional information.

For the six months ended June 30, 2014, Watford’s net premiums written included $14.8 million of premiums written directly by Watford with the remainder ceded by Arch affiliates, primarily from our reinsurance segment. Watford’s net

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premiums written are primarily in longer-tail lines, including casualty and other specialty treaties. In addition, Watford’s operating expenses included $2.3 million of non-recurring initial costs (shown in the table above as ‘other expenses’).

Other Income or Expense Items (excluding amounts related to the ‘other’ segment)
 
Net Investment Income. The components of net investment income were derived from the following sources:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Fixed maturities
$
64,499

 
$
62,004

 
$
126,948

 
$
124,010

Term loan investments
5,233

 
6,026

 
10,902

 
10,243

Equity securities (dividends)
3,271

 
3,164

 
6,192

 
4,587

Short-term investments
103

 
364

 
508

 
756

Other (1)
9,067

 
4,734

 
13,785

 
11,033

Gross investment income
82,173

 
76,292

 
158,335

 
150,629

Investment expenses (2)
(9,715
)
 
(7,923
)
 
(18,884
)
 
(16,588
)
Net investment income
$
72,458

 
$
68,369

 
$
139,451

 
134,041

_________________________________________________
(1)
Amounts include dividends and interest distributions on investment funds and other items.
(2)
Investment expenses were approximately 0.29% of average invested assets for the 2014 second quarter, compared to 0.26% for the 2013 second quarter, and 0.29% for the six months ended June 30, 2014, compared to 0.28% for the 2013 period.

Investment income for the 2014 second quarter included a $4.1 million interest income distribution received on a fund investment. The pre-tax investment income yield, calculated based on amortized cost and on an annualized basis, was 2.05% for the 2014 second quarter, excluding the interest income distribution noted above, compared to 2.08% for the 2014 first quarter and 2.20% for the 2013 second quarter, and 2.07% for the six months ended June 30, 2014, compared to 2.20% for the 2013 period. Such yields reflect the effects of low prevailing interest rates available in the market and our investment strategy which puts an emphasis on total return. Yields on future investment income may vary based on financial market conditions, investment allocation decisions and other factors.
 
Other Income (Loss). We record income or loss from our investments in Gulf Reinsurance Limited (joint venture) and certain other investments using the equity method on a three month lag basis based on the availability of their financial statements. In addition, other income (loss) from time to time includes certain non-recurring items. We recorded other income of $4.9 million in the 2014 second quarter, compared to income of $0.8 million in the 2013 second quarter, and $2.7 million for the six months ended June 30, 2014, compared to $2.1 million for the 2013 period. The amount recorded for the 2014 second quarter was primarily due to a non-recurring income item while amounts for other periods were primarily related to Gulf Reinsurance Limited.
 
Equity in Net Income of Investment Funds Accounted for Using the Equity Method. We recorded $9.2 million of equity in net income related to investment funds accounted for using the equity method in the 2014 second quarter, compared to $10.9 million for the 2013 second quarter, and $12.5 million for the six months ended June 30, 2014, compared to $24.8 million for the 2013 period. We use the equity method on certain investments (which primarily invest in fixed maturity securities) due to the ownership structure of these investment funds, where we do not have a controlling interest and are not the primary beneficiary. In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). Such investments, which are typically structured as limited partnerships, are generally recorded on a one to three month lag based on the availability of reports from the investment funds. Certain of these funds employ leverage to achieve a higher rate of return on their assets under management. While leverage presents opportunities for increasing the total return of such investments, it may increase losses as well. Fluctuations in the carrying value of the investment funds accounted for using the equity method may increase the volatility of our reported results of operations. Investment funds accounted for using the equity method totaled $281.5 million at June 30, 2014, compared to $244.3 million at December 31, 2013.  

Net Realized Gains or Losses. We recorded net realized gains of $51.0 million for the 2014 second quarter, compared to net realized gains of $12.7 million for the 2013 second quarter, and $70.7 million for the six months ended June 30, 2014, compared to $71.0 million for the 2013 period. Currently, our portfolio is actively managed to maximize total return within certain guidelines. In assessing returns under this approach, we include net investment income, net realized gains and losses and the change in unrealized gains and losses generated by our investment portfolio. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. Net realized gains or losses from the sale of fixed maturities primarily resulted from our decisions to reduce credit exposure, to

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change duration targets, to rebalance our portfolios or due to relative value determinations. Net realized gains or losses also included changes in the fair value of assets and liabilities accounted for using the fair value option along with remeasurement of the contingent consideration liability related to our purchase of the CMG Entities. See note 2, “Business Acquired,” and note 7, “Investment Information—Net Realized Gains (Losses),” of the notes accompanying our consolidated financial statements for additional information.
 
Net Impairment Losses Recognized in Earnings. On a quarterly basis, we perform reviews of our available for sale investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of other-than-temporary impairments. The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include (i) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (ii) the time period in which there was a significant decline in value, (iii) the significance of the decline, and (iv) the analysis of specific credit events. We evaluate the unrealized losses of our equity securities by issuer and determine if we can forecast a reasonable period of time by which the fair value of the securities would increase and we would recover our cost. If we are unable to forecast a reasonable period of time in which to recover the cost of our equity securities, we record a net impairment loss in earnings equivalent to the entire unrealized loss. We recorded $14.7 million of credit related impairments in earnings for the 2014 second quarter, compared to $0.7 million for the 2013 second quarter, and $17.7 million for the six months ended June 30, 2014, compared to $3.0 million for the 2013 period. The OTTI recorded for the 2014 second quarter was primarily on one investment fund following a review of available positive and negative evidence. See note 7, “Investment Information—Other-Than-Temporary Impairments,” of the notes accompanying our consolidated financial statements for additional information.

Other Expenses. Other expenses, which are included in our other operating expenses and part of corporate and other (non-underwriting), were $15.3 million for the 2014 second quarter, compared to $14.0 million for the 2013 second quarter, and $26.1 million for the six months ended June 30, 2014, compared to $24.3 million for the 2013 period. Such amounts primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations, share based compensation expense and costs associated with operating as a publicly traded company. Other expenses for the 2014 periods reflected a higher level of compensation costs than in the 2013 periods.

Interest expense. Interest expense was $14.3 million for the 2014 second quarter, compared to $5.9 million for the 2013 second quarter, and $28.7 million for the six months ended June 30, 2014, compared to $11.8 million for the 2013 period. The higher level of interest expense primarily resulted from interest related to the $500.0 million of 5.144% senior notes issued by Arch Capital Group (U.S.) Inc. (“Arch-U.S.”) in December 2013. In addition, interest expense for the 2014 periods includes accretion on certain deposit accounting liabilities.
 
Net Foreign Exchange Gains or Losses. Net foreign exchange losses for the 2014 second quarter were $2.8 million (net unrealized losses of $2.1 million and net realized losses of $0.7 million), compared to net foreign exchange gains for the 2013 second quarter of $13.8 million (net unrealized gains of $21.6 million and net realized losses of $7.8 million). Net foreign exchange losses for the six months ended June 30, 2014 were $9.4 million (net unrealized losses of $8.7 million and net realized losses of $0.7 million), compared to net foreign exchange gains for the 2013 period of $38.1 million (net unrealized gains of $47.5 million and net realized losses of $9.4 million). Net unrealized foreign exchange gains or losses result from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date. Changes in the value of investments held in foreign currencies due to foreign currency rate movements are reflected as a direct increase or decrease to shareholders’ equity and are not included in the consolidated statements of income. We have not matched a portion of our projected liabilities in foreign currencies with investments in the same currencies and may not match such amounts in future periods, which could increase our exposure to foreign currency fluctuations and increase the volatility of our shareholders’ equity.

Income tax expense. Our income tax provision on income before income taxes resulted in an expense of 3.3% for the 2014 second quarter, compared to 2.8% for the 2013 second quarter, and 2.7% for the six months ended June 30, 2014, compared to 2.2% for the 2013 period. Our 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 or loss reported by jurisdiction and the varying tax rates in each jurisdiction.

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 2013 Form 10-K, updated where applicable in the notes accompanying our consolidated financial statements.
 

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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
 
Financial Condition
 
Investable Assets Managed by Arch
 
The finance and investment committee of our board of directors establishes our investment policies and sets the parameters for creating guidelines for our investment managers. The finance and investment committee reviews the implementation of the investment strategy on a regular basis. Our current approach stresses preservation of capital, market liquidity and diversification of risk. While maintaining our emphasis on preservation of capital and liquidity, we expect our portfolio to become more diversified and, as a result, we may expand into areas which are not currently part of our investment strategy. Our Chief Investment Officer administers the investment portfolio, oversees our investment managers, formulates investment strategy in conjunction with our finance and investment committee and directly manages certain portions of our fixed income and equity portfolios.

At June 30, 2014, total investable assets of $15.80 billion included $14.69 billion managed by Arch and $1.11 billion included in the ‘other’ segment (i.e., attributable to Watford). The following table summarizes total investable assets managed by Arch:
 
June 30, 2014
 
December 31, 2013
 
Amount
 
% of
Total
 
Amount
 
% of
Total
Investable assets (1) (2):
 
 
 
 
 
 
 
Fixed maturities available for sale, at fair value
$
10,714,532

 
72.9

 
$
9,571,776

 
68.1

Fixed maturities, at fair value (3)
372,746

 
2.5

 
448,254

 
3.2

Fixed maturities pledged under securities lending agreements, at fair value
82,730

 
0.6

 
105,081

 
0.8

Total fixed maturities
11,170,008

 
76.0

 
10,125,111

 
72.1

Short-term investments available for sale, at fair value
977,058

 
6.7

 
1,478,367

 
10.5

Short-term investments pledged under securities lending agreements, at fair value
4,301

 

 

 

Cash
471,721

 
3.2

 
434,057

 
3.1

Equity securities available for sale, at fair value
608,820

 
4.2

 
496,824

 
3.5

Other investments available for sale, at fair value
457,567

 
3.1

 
498,310

 
3.6

Other investments, at fair value (3)
848,864

 
5.8

 
773,280

 
5.5

Investments accounted for using the equity method (4)
281,464

 
1.9

 
244,339

 
1.7

Securities transactions entered into but not settled at the balance sheet date
(130,922
)
 
(0.9
)
 
(763
)
 

Total investable assets managed by Arch
$
14,688,881

 
100.0

 
$
14,049,525

 
100.0

_________________________________________________
(1)
The table above excludes investable assets attributable to the ‘other’ segment. Such amounts are summarized as follows:
(U.S. dollars in thousands)
June 30,
2014
 
 
Investable assets in ‘other’ segment:
 
Cash
$
454,722

Investments accounted for using the fair value option (3)
819,481

Securities transactions entered into but not settled at the balance sheet date
(159,484
)
Total investable assets included in ‘other’ segment
$
1,114,719


(2)
This table excludes the collateral received and reinvested and includes the fixed maturities and short-term investments pledged under securities lending agreements, at fair value.
(3)
Represents investments which are carried at fair value under the fair value option and reflected as “investments accounted for using the fair value option” on the Company’s balance sheet. Changes in the carrying value of such investments are recorded in net realized gains or losses.
(4)
Changes in the carrying value of investment funds accounted for using the equity method are recorded as “equity in net income (loss) of investment funds accounted for using the equity method” rather than as an unrealized gain or loss component of accumulated other comprehensive income.

At June 30, 2014, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had average credit quality ratings from Standard & Poor’s Rating Services (“S&P”)/Moody’s of “AA/Aa2” and an average yield to maturity (embedded book yield), before investment expenses, of 2.17%. At December 31, 2013, our fixed income portfolio had average credit quality ratings from S&P/Moody’s of “AA-/Aa2” and an average yield to maturity of 2.38%. Our investment portfolio had an average effective duration of 3.14 years at June 30, 2014, compared to 2.62 years at December 31, 2013. At

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June 30, 2014, approximately $9.85 billion, or 67%, of total investable assets managed by Arch were internally managed, compared to $9.07 billion, or 65%, at December 31, 2013.

The following table summarizes our fixed maturities and fixed maturities pledged under securities lending agreements (“Fixed Maturities”) by type:
 
Fair
Value
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Cost or
Amortized
Cost
June 30, 2014
 

 
 

 
 

 
 

Corporate bonds
$
3,202,155

 
$
48,736

 
$
(10,472
)
 
$
3,163,891

Mortgage backed securities
1,155,192

 
25,925

 
(8,572
)
 
1,137,839

Municipal bonds
1,413,131

 
33,549

 
(1,095
)
 
1,380,677

Commercial mortgage backed securities
1,119,401

 
18,238

 
(6,051
)
 
1,107,214

U.S. government and government agencies
1,435,974

 
5,137

 
(2,162
)
 
1,432,999

Non-U.S. government securities
1,133,524

 
14,936

 
(5,399
)
 
1,123,987

Asset backed securities
1,710,631

 
8,988

 
(6,740
)
 
1,708,383

Total
$
11,170,008

 
$
155,509

 
$
(40,491
)
 
$
11,054,990

 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

Corporate bonds
$
2,601,328

 
$
35,289

 
$
(35,537
)
 
$
2,601,576

Mortgage backed securities
1,174,128

 
16,270

 
(22,209
)
 
1,180,067

Municipal bonds
1,481,738

 
29,378

 
(9,730
)
 
1,462,090

Commercial mortgage backed securities
1,074,497

 
13,972

 
(15,224
)
 
1,075,749

U.S. government and government agencies
1,301,809

 
3,779

 
(11,242
)
 
1,309,272

Non-U.S. government securities
1,159,017

 
14,729

 
(19,363
)
 
1,163,651

Asset backed securities
1,332,594

 
20,033

 
(13,795
)
 
1,326,356

Total
$
10,125,111

 
$
133,450

 
$
(127,100
)
 
$
10,118,761


The following table provides the credit quality distribution of our Fixed Maturities:
 
 
June 30, 2014
 
December 31, 2013
Rating (1)
 
Fair Value
 
% of
Total
 
Fair Value
 
% of
Total
U.S. government and government agencies (2)
 
$
2,339,891

 
20.9

 
$
2,284,053

 
22.6

AAA
 
4,250,726

 
38.1

 
3,709,872

 
36.6

AA
 
2,072,825

 
18.6

 
1,720,605

 
17.0

A
 
1,462,471

 
13.1

 
1,359,193

 
13.4

BBB
 
330,207

 
3.0

 
304,543

 
3.0

BB
 
169,865

 
1.5

 
180,125

 
1.8

B
 
195,951

 
1.8

 
188,119

 
1.9

Lower than B
 
177,309

 
1.6

 
241,463

 
2.4

Not rated
 
170,763

 
1.4

 
137,138

 
1.3

Total
 
$
11,170,008

 
100.0

 
$
10,125,111

 
100.0

_________________________________________________
(1)
For individual fixed maturities, S&P ratings are used. In the absence of an S&P rating, ratings from Moody’s are used, followed by ratings from Fitch Ratings.
(2)
Includes U.S. government-sponsored agency mortgage backed securities and agency commercial mortgage backed securities.
 
At June 30, 2014, below-investment grade securities comprised approximately 6% of our Fixed Maturities, compared to 7% at December 31, 2013. In accordance with our investment strategy, we invest in high yield fixed income securities which are included in “Corporate bonds.” Upon issuance, these securities are typically rated below investment grade (i.e., rating assigned by the major rating agencies of “BB+” or less). At June 30, 2014, corporate bonds represented 41% of the total below investment grade securities at fair value, mortgage backed securities represented 44% of the total and 15% were in other classes. At December 31, 2013, corporate bonds represented 46% of the total below investment grade securities at fair value, mortgage backed securities represented 46% of the total and 8% were in other classes. Unrealized losses include the impact of foreign exchange movements on certain securities denominated in foreign currencies and, as such, the amount of securities in an unrealized loss position fluctuates due to foreign currency movements.
 

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The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for all Fixed Maturities which were in an unrealized loss position:
 
 
June 30, 2014
 
December 31, 2013
Severity of
Unrealized Loss
 
Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
0-10%
 
$
2,861,539

 
$
(37,116
)
 
91.6

 
$
6,006,316

 
$
(110,954
)
 
87.3

10-20%
 
21,076

 
(3,353
)
 
8.3

 
78,250

 
(11,465
)
 
9.0

20-30%
 
55

 
(22
)
 
0.1

 
13,955

 
(4,621
)
 
3.6

30-40%
 

 

 

 
74

 
(60
)
 
0.1

Total
 
$
2,882,670

 
$
(40,491
)
 
100.0

 
$
6,098,595

 
$
(127,100
)
 
100.0


The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for non-investment grade Fixed Maturities which were in an unrealized loss position:
 
 
June 30, 2014
 
December 31, 2013
Severity of
Unrealized Loss
 
Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
0-10%
 
$
56,646

 
$
(1,369
)
 
3.4

 
$
133,354

 
$
(3,882
)
 
3.1

10-20%
 
3,992

 
(594
)
 
1.5

 
444

 
(64
)
 
0.1

20-30%
 

 

 

 
1,292

 
(350
)
 
0.3

30-80%
 

 

 

 
28

 
(35
)
 

Total
 
$
60,638

 
$
(1,963
)
 
4.9

 
$
135,118

 
$
(4,331
)
 
3.5

 
We determine estimated recovery values for our Fixed Maturities following a review of the business prospects, credit ratings, estimated loss given default factors and information received from asset managers and rating agencies for each security. For structured securities, we utilize underlying data, where available, for each security provided by asset managers and additional information from credit agencies in order to determine an expected recovery value for each security. The analysis provided by the asset managers includes expected cash flow projections under base case and stress case scenarios which modify expected default expectations and loss severities and slow down prepayment assumptions.

The following table summarizes our top ten exposures to fixed income corporate issuers by fair value at June 30, 2014, excluding guaranteed amounts and covered bonds:
 
Fair Value
 
Credit
Rating (1)
General Electric Co.
$
104,833

 
AA+/A1
Toyota Motor Corporation
67,557

 
AA-/Aa3
Apple Inc.
66,109

 
AA+/Aa1
Porsche Automobil Holding SE
62,811

 
A-/A3
Westpac Banking Corp
59,323

 
AA-/Aa2
Exxon Mobil Corp.
56,311

 
AAA/Aaa
Daimler AG
53,288

 
A-/A3
Royal Bank of Canada
52,904

 
AA-/Aa3
Caterpillar Inc.
52,003

 
A/A2
Australia & New Zealand Banking Group Ltd.
50,324

 
AA-/Aa2
Total
$
625,463

 
 
_________________________________________________
(1) 
Ratings as assigned by S&P/Moody’s.
 
Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. At June 30, 2014, our investments in residential mortgage-backed securities (“MBS”) amounted to approximately $1.16 billion, or 7.9% of total investable assets managed by Arch, compared to $1.17 billion, or 8.4%, at December 31, 2013.  As with other fixed income investments, the fair value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to changes in the prepayment rate on these investments. In periods of declining interest rates, mortgage prepayments generally increase and MBS are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates. Conversely, in periods of rising rates, mortgage prepayments generally fall, preventing us from taking full advantage of the higher level of rates. However, economic conditions may curtail prepayment activity if refinancing becomes more difficult, thus limiting prepayments on MBS. Our portfolio also includes commercial mortgage backed securities (“CMBS”). At June 30, 2014, CMBS constituted approximately $1.12 billion,

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or 7.6% of total investable assets managed by Arch, compared to $1.07 billion, or 7.6%, at December 31, 2013. The commercial real estate market has experienced price deterioration, which could lead to increased delinquencies and defaults on commercial real estate mortgages. We do not have a significant exposure to insurance enhanced asset-backed or mortgage-backed securities. We do not have any significant investments in companies which guarantee securities at June 30, 2014.

Delinquencies and losses with respect to residential mortgage loans from certain vintage years have increased since 2007 and may continue to increase, particularly in the sub-prime sector. In addition, during this period, residential property values in many states have declined or remained stable, after extended periods during which those values appreciated. A continued decline or an extended flattening in those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to second homes and investment properties, and with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinated loans) are close to or greater than the related property values. These developments may have a significant adverse effect on the prices of loans and securities, including those in our investment portfolio. The situation continues to have wide ranging consequences, including downward pressure on economic growth and the potential for increased insurance and reinsurance exposures, which could have an adverse impact on our results of operations, financial condition, business and operations.

The following table provides information on our MBS and CMBS at June 30, 2014, excluding amounts guaranteed by the U.S. government:
 
 
 
 
 
 
 
Fair Value
 
Issuance
Year
 
Amortized
Cost
 
Average
Credit
Quality
 
Total
 
% of
Amortized
Cost
 
% of Investable
Assets Managed by Arch
Non-agency MBS:
2003-2008
 
$
138,608

 
CC+
 
$
149,433

 
107.8
%
 
1.0
%
 
2009
 
32,217

 
AAA
 
32,181

 
99.9
%
 
0.2
%
 
2010
 
39,002

 
AA+
 
39,132

 
100.3
%
 
0.3
%
 
2012
 
32,520

 
AAA
 
32,341

 
99.4
%
 
0.2
%
 
2013
 
102,950

 
AAA
 
103,692

 
100.7
%
 
0.7
%
 
2014
 
20,507

 
AAA
 
19,889

 
97.0
%
 
0.1
%
Total non-agency MBS
 
 
$
365,804

 
BBB
 
$
376,668

 
103.0
%
 
2.6
%
 
 
 
 
 
 
 
 
 
 
 
 
Non-agency CMBS:
2002-2008
 
67,683

 
A+
 
69,369

 
102.5
%
 
0.5
%
 
2009
 
372

 
BBB-
 
375

 
100.8
%
 
0.0
%
 
2010
 
74,558

 
AAA
 
76,990

 
103.3
%
 
0.5
%
 
2011
 
89,554

 
AAA
 
93,194

 
104.1
%
 
0.6
%
 
2012
 
107,750

 
AAA
 
108,817

 
101.0
%
 
0.7
%
 
2013
 
327,589

 
AAA
 
332,580

 
101.5
%
 
2.3
%
 
2014
 
311,518

 
AAA
 
312,683

 
100.4
%
 
2.1
%
Total non-agency CMBS
 
 
$
979,024

 
AA+
 
$
994,008

 
101.5
%
 
6.8
%
 
 
Non-Agency
 
Non-Agency
Additional Statistics:
 
MBS
 
CMBS (1)
Weighted average loan age (months)
 
79

 
23

Weighted average life (months) (2) 
 
57

 
52

Weighted average loan-to-value % (3) 
 
62.0
%
 
58.7
%
Total delinquencies (4) 
 
10.7
%
 
0.5
%
Current credit support % (5) 
 
17.1
%
 
34.2
%
_________________________________________________
(1)
Loans defeased with government/agency obligations were not material to the collateral underlying our CMBS holdings.
(2)
The weighted average life for MBS is based on the interest rates in effect at June 30, 2014. The weighted average life for CMBS reflects the average life of the collateral underlying our CMBS holdings.
(3)
The range of loan-to-values is 22% to 89% on MBS and 11% to 116% on CMBS.
(4)
Total delinquencies includes 60 days and over.
(5)
Current credit support % represents the % for a collateralized mortgage obligation (“CMO”) or CMBS class/tranche from other subordinate classes in the same CMO or CMBS deal.


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The following table provides information on our asset backed securities (“ABS”) at June 30, 2014:
 
 
 
 
 
 
 
Fair Value
 
Amortized
Cost
 
Average
Credit
Quality
 
Weighted Average Credit Support
 
Total
 
% of
Amortized
Cost
 
% of Investable
Assets Managed by Arch
Sector:
 

 
 
 
 
 
 

 
 

 
 

Credit cards
$
626,244

 
AAA
 
15
%
 
$
629,111

 
100.5
%
 
4.3
%
Loans
318,673

 
AA
 
20
%
 
317,080

 
99.5
%
 
2.2
%
Autos
303,161

 
AAA
 
28
%
 
303,386

 
100.1
%
 
2.1
%
Equipment
225,049

 
AA-
 
7
%
 
223,660

 
99.4
%
 
1.5
%
Other
235,256

 
AA+
 
11
%
 
237,394

 
100.9
%
 
1.6
%
Total ABS (1)
$
1,708,383

 
AA+
 
 
 
$
1,710,631

 
100.1
%
 
11.6
%
_________________________________________________
(1)
The effective duration of the total ABS was 1.8 years at June 30, 2014.
  
At June 30, 2014, our fixed income portfolio included $12.7 million par value in sub-prime securities with a fair value of $4.7 million and average credit quality ratings from S&P/Moody’s of “CCC/Caa1.” At December 31, 2013, our fixed income portfolio included $48.5 million par value in sub-prime securities with a fair value of $27.9 million and average credit quality ratings from S&P/Moody’s of “B/Caa1.” Such amounts were primarily in the home equity sector of our asset backed securities, with the balance in other ABS, MBS and CMBS sectors. We define sub-prime mortgage-backed securities as investments in which the underlying loans primarily exhibit one or more of the following characteristics: low FICO scores, above-prime interest rates, high loan-to-value ratios or high debt-to-income ratios. In addition, the portfolio of collateral backing our securities lending program contained $6.2 million fair value of sub-prime securities with average credit quality ratings from S&P/Moody’s of “CCC-/Ca” at June 30, 2014, compared to $6.3 million and “CCC/Caa3” at December 31, 2013.
 
The following table provides information on the fair value of our Eurozone investments at June 30, 2014:
 
Sovereign (2)
 
Financial
Corporates
 
Other
Corporates
 
Covered
Bonds (3)
 
Bank
Loans (4)
 
Equities and
Other
 
Total
Country (1)
 

 
 

 
 

 
 

 
 

 
 

 
 

Netherlands
$
164,507

 
$
2,763

 
$
64,214

 
$

 
$
19,976

 
$
9,851

 
$
261,311

Germany
180,284

 

 
3,452

 

 
14,274

 
9,974

 
207,984

Luxembourg

 

 
33,996

 

 
13,286

 

 
47,282

France

 
2,565

 
28,414

 

 
4,426

 
7,963

 
43,368

Finland
14,434

 

 

 
7,078

 

 

 
21,512

Supranational (5)
32,060

 

 

 

 

 

 
32,060

Italy

 

 
1,228

 

 
3,611

 

 
4,839

Ireland

 

 
511

 

 
1,607

 
881

 
2,999

Spain

 

 

 

 
1,609

 

 
1,609

Total
$
391,285

 
$
5,328

 
$
131,815

 
$
7,078

 
$
58,789

 
$
28,669

 
$
622,964

_________________________________________________
(1)
The country allocations set forth in the table are based on various assumptions made by us in assessing the country in which the underlying credit risk resides, including a review of the jurisdiction of organization, business operations and other factors. Based on such analysis, we do not believe that we have any Eurozone investments from Austria, Belgium, Estonia, Greece, Malta, Portugal, Slovakia or Slovenia at June 30, 2014.
(2)
Sovereign includes securities issued and/or guaranteed by Eurozone governments.
(3)
Securities issued by Eurozone banks where the security is backed by a separate group of loans.
(4)
Included in “investments accounted for using the fair value option.”
(5)
Includes World Bank, European Investment Bank, International Finance Corp. and European Bank for Reconstruction and Development.
 

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At June 30, 2014, our equity portfolio included $608.8 million of equity securities, compared to $496.8 million at December 31, 2013. Our equity portfolio primarily consists of publicly traded common stocks in the consumer staples, real estate and natural resources sectors. The following table provides information on the severity of the unrealized loss position as a percentage of cost for all equity securities classified as available for sale which were in an unrealized loss position:
 
 
June 30, 2014
 
December 31, 2013
Severity of
Unrealized Loss
 
Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
0-10%
 
$
69,129

 
$
(2,285
)
 
48.1

 
$
52,964

 
$
(1,924
)
 
32.4

10-20%
 
10,457

 
(1,761
)
 
37.1

 
20,312

 
(2,792
)
 
47.0

20-30%
 
1,863

 
(537
)
 
11.3

 
3,103

 
(1,140
)
 
19.2

30-40%
 
216

 
(121
)
 
2.5

 
184

 
(82
)
 
1.4

40-50%
 
66

 
(46
)
 
1.0

 

 

 

Total
 
$
81,731

 
$
(4,750
)
 
100.0

 
$
76,563

 
$
(5,938
)
 
100.0

 
On a quarterly basis, we evaluate the unrealized losses of our equity securities by issuer and forecast a reasonable period of time by which the fair value of the securities would increase and we would recover the cost basis. All of the unrealized losses on equity securities were on holdings which have been in a continual unrealized loss position for less than 12 months at June 30, 2014. We believe that a reasonable period of time exists to allow for recovery of the cost basis of our equity securities that are in an unrealized loss position at June 30, 2014.
 
The following table summarizes our other investments:
 
June 30,
2014
 
December 31,
2013
Available for sale:
 
 
 
Asian and emerging markets
$
292,772

 
$
331,984

Investment grade fixed income
164,795

 
159,115

Other

 
7,211

Total available for sale
457,567

 
498,310

Fair value option:
 
 
 
Term loan investments (par value: $389,383 and $494,502)
430,977

 
512,076

Asian and emerging markets
25,321

 
14,054

Investment grade fixed income
81,737

 
75,062

Other (1)
310,829

 
172,088

Total fair value option
848,864

 
773,280

Total
$
1,306,431

 
$
1,271,590

________________________________________________
(1)
Includes fund investments with strategies in mortgage servicing rights, transportation and infrastructure assets and other.

Certain of our other investments are in investment funds for which we have the option to redeem at agreed upon values as described in each investment fund’s subscription agreement. Depending on the terms of the various subscription agreements, investments in investment funds may be redeemed daily, monthly, quarterly or on other terms. Two common redemption restrictions which may impact our ability to redeem these investment funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the investment fund’s net assets which may otherwise hinder the general partner or investment manager’s ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. If our investment is eligible to be redeemed, the time to redeem such investment can take weeks or months following the notification.

Certain of our investment managers may use leverage to achieve a higher rate of return on their assets under management, primarily those included in “other investments available for sale, at fair value,” “investments accounted for using the fair value option” and “investments accounted for using the equity method” on our balance sheet. While leverage presents opportunities for increasing the total return of such investments, it may increase losses as well. Accordingly, any event that adversely affects the value of the underlying holdings would be magnified to the extent leverage is used and our potential losses would be magnified. In addition, the structures used to generate leverage may lead to such investments being required to meet covenants based on market valuations and asset coverage. Market valuation declines could force the sale of investments into a depressed

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market, which may result in significant additional losses. Alternatively, the levered investments may attempt to delever by raising additional equity or potentially changing the terms of the established financing arrangements. We may choose to participate in the additional funding of such investments.
 
Our investment strategy allows for the use of derivative instruments. We utilize various derivative instruments such as futures contracts to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. See note 9, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives.
 
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. See note 8, “Fair Value,” of the notes accompanying our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value at June 30, 2014 and December 31, 2013 segregated by level in the fair value hierarchy.

Investable Assets in the ‘Other’ Segment

Investable assets in the ‘other’ segment are managed by Watford. The board of directors of Watford establishes their investment policies and guidelines. Watford’s investments are accounted for using the fair value option with changes in the carrying value of such investments recorded in net realized gains or losses. At June 30, 2014, Watford’s investable assets consisted of the following:
 
June 30,
2014
 
 
Cash
$
454,722

Investments accounted for using the fair value option:
 
Term loan investments (par value: $520,155)
522,672

Fixed maturities
65,302

Short-term investments
231,507

Total investments accounted for using the fair value option
819,481

Securities transactions entered into but not settled at the balance sheet date
(159,484
)
Total investable assets included in ‘other’ segment
$
1,114,719


Premiums Receivable and Reinsurance Recoverables
 
At June 30, 2014, 82.6% of premiums receivable of $1.10 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 2.8% of the total. At December 31, 2013, 80.0% of premiums receivable of $753.9 million represented amounts not yet due, while amounts in excess of 90 days overdue were 3.3% of the total. Approximately 33.3% of the $49.6 million of paid losses and loss adjustment expenses recoverable at June 30, 2014 were more than 90 days overdue, while 27.6% of the $56.1 million of paid losses and loss adjustment expenses recoverable at December 31, 2013 were more than 90 days overdue. Our reserves for doubtful accounts were approximately $12.9 million at June 30, 2014, compared to $12.3 million at December 31, 2013.
 
At June 30, 2014, approximately 84.5% of reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.80 billion were due from carriers which had an A.M. Best rating of “A-” or better and the largest reinsurance recoverables from any one carrier was approximately 3.6% of our total shareholders’ equity. At December 31, 2013, approximately 86.5% of reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.80 billion were due from carriers which had an A.M. Best rating of “A-” or better and the largest reinsurance recoverables from any one carrier was approximately 4.2% of our total shareholders’ equity.
 

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The effects of reinsurance on written and earned premiums and losses and loss adjustment expenses with unaffiliated reinsurers were as follows:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
Premiums Written
 

 
 

 
 

 
 

Direct
$
875,133

 
$
716,724

 
$
1,621,122

 
$
1,431,776

Assumed
396,627

 
324,014

 
945,774

 
772,661

Ceded
(299,832
)
 
(230,203
)
 
(529,978
)
 
(441,126
)
Net
$
971,928

 
$
810,535

 
$
2,036,918

 
$
1,763,311

 
 
 
 
 
 
 
 
Premiums Earned
 

 
 

 
 
 
 
Direct
$
734,022

 
$
656,700

 
$
1,415,910

 
$
1,304,222

Assumed
396,158

 
299,415

 
778,456

 
606,339

Ceded
(223,028
)
 
(197,299
)
 
(427,434
)
 
(398,975
)
Net
$
907,152

 
$
758,816

 
$
1,766,932

 
$
1,511,586

 
 
 
 
 
 
 
 
Losses and Loss Adjustment Expenses
 

 
 

 
 
 
 
Direct
$
435,863

 
$
415,766

 
$
821,578

 
$
767,533

Assumed
165,614

 
114,534

 
309,635

 
223,531

Ceded
(115,959
)
 
(111,647
)
 
(209,455
)
 
(173,008
)
Net
$
485,518

 
$
418,653

 
$
921,758

 
$
818,056

 
Reserves for Losses and Loss Adjustment Expenses
 
We establish reserves for losses and loss adjustment expenses (“Loss Reserves”) which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of losses incurred. Estimating Loss Reserves is inherently difficult, which is exacerbated by the fact that we have relatively limited historical experience upon which to base such estimates. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of Loss Reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements.

At June 30, 2014 and December 31, 2013, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:
 
June 30,
2014
 
December 31,
2013
Insurance:
 

 
 

Case reserves
$
1,460,059

 
$
1,446,029

IBNR reserves
3,055,381

 
3,037,755

Total net reserves
4,515,440

 
4,483,784

Reinsurance:
 
 
 
Case reserves
722,278

 
749,830

Additional case reserves
113,805

 
113,331

IBNR reserves
1,788,400

 
1,722,214

Total net reserves
2,624,483

 
2,585,375

Mortgage:
 
 
 
Case reserves
102,787

 
1,419

IBNR reserves
19,876

 
5,868

Total net reserves
122,663

 
7,287

Other:
 
 
 
Case reserves
96

 

Additional case reserves

 

IBNR reserves
9,495

 

Total net reserves
9,591

 

Total:
 

 
 

Case reserves
2,285,220

 
2,197,278

Additional case reserves
113,805

 
113,331

IBNR reserves
4,873,152

 
4,765,837

Total net reserves
$
7,272,177

 
$
7,076,446

 

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Table of Contents

At June 30, 2014 and December 31, 2013, the insurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
 
June 30,
2014
 
December 31,
2013
Professional lines (1)
$
1,552,249

 
$
1,525,360

Construction and national accounts
742,917

 
694,721

Excess and surplus casualty (2)
676,027

 
678,893

Programs
649,311

 
644,689

Property, energy, marine and aviation
430,434

 
503,208

Travel, accident and health
55,434

 
49,934

Lenders products
36,018

 
31,076

Other (3)
373,050

 
355,903

Total net reserves
$
4,515,440

 
$
4,483,784

_________________________________________________
(1)
Includes professional liability, executive assurance and healthcare business.
(2)
Includes casualty and contract binding business.
(3)
Includes alternative markets, excess workers’ compensation and surety business.

At June 30, 2014 and December 31, 2013, the reinsurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
 
June 30,
2014
 
December 31,
2013
Casualty (1)
$
1,528,050

 
$
1,513,205

Other specialty (2)
453,215

 
397,776

Property excluding property catastrophe (3)
272,119

 
260,968

Property catastrophe
164,686

 
190,027

Marine and aviation
150,271

 
163,293

Other (4)
56,142

 
60,106

Total net reserves
$
2,624,483

 
$
2,585,375

 _________________________________________________
(1)
Includes professional liability, executive assurance, healthcare and excess motor business.
(2)
Includes non-excess motor, surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and political risk.
(3)
Includes facultative business.
(4)
Includes life, casualty clash and other.

Mortgage Segment Supplemental Information

At June 30, 2014 and December 31, 2013, the mortgage segment’s insurance in force (“IIF”), which represents the aggregate dollar amount of each insured mortgage loan’s original principal balance, and risk in force (“RIF”), which represents the aggregate dollar amount of each insured mortgage loan’s current principal balance multiplied by the insurance coverage percentage specified in the policy for insurance policies issued, were as follows:
(U.S. Dollars in millions)
 
June 30, 2014
 
March 31, 2014
Insurance In Force (IIF)
 
 
 
 
 
 
 
 
U.S. mortgage insurance
 
$
21,168

 
44.9
%
 
$
21,240

 
46.9
%
Mortgage reinsurance
 
21,405

 
45.4
%
 
21,161

 
46.7
%
Other (1)
 
4,586

 
9.7
%
 
2,869

 
6.4
%
Total
 
$
47,159

 
100.0
%
 
$
45,270

 
100.0
%
 
 
 
 
 
 
 
 
 
Risk In Force (RIF) (2)
 
 
 
 
 
 
 
 
U.S. mortgage insurance
 
$
5,273

 
52.7
%
 
$
5,275

 
52.6
%
Mortgage reinsurance
 
4,601

 
46.0
%
 
4,664

 
46.6
%
Other (1)
 
139

 
1.3
%
 
80

 
0.8
%
Total
 
$
10,013

 
100.0
%
 
$
10,019

 
100.0
%
 
 
 
 
 
 
 
 
 
Ending number of policies in force
 
126,347

 
 
 
127,019

 
 
_________________________________________________
(1)    Includes risk-sharing products offered to government sponsored enterprises and mortgage lenders and international insurance business.        
(2)
For international business and risk-sharing products, the RIF calculation is based on the maximum claim amount which we are exposed to on each insured mortgage loan. For certain of our mortgage reinsurance treaties, such amount incorporates loss ratio caps.
    

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The following table provides supplemental disclosures for our mortgage segment’s U.S. mortgage insurance operations related to RIF:
(U.S. Dollars in millions)
 
June 30, 2014
 
March 31, 2014
 
 
 
 
 
 
 
 
 
Total RIF by credit quality (FICO score):
 
 
 
 
 
 
 
 
>=740
 
$
2,687

 
51.0
%
 
$
2,671

 
50.6
%
680-739
 
1,724

 
32.7
%
 
1,713

 
32.5
%
620-679
 
709

 
13.4
%
 
731

 
13.9
%
<620
 
153

 
2.9
%
 
160

 
3.0
%
Total
 
$
5,273

 
100.0
%
 
$
5,275

 
100.0
%
Weighted average FICO score
 
731

 
 
 
730

 
 
 
 
 
 
 
 
 
 
 
Total RIF by Loan-To-Value (LTV):
 
 
 
 
 
 
 
 
95.01% and above
 
$
1,161

 
22.0
%
 
$
1,183

 
22.4
%
90.01% to 95.00%
 
2,389

 
45.3
%
 
2,337

 
44.3
%
85.01% to 90.00%
 
1,474

 
28.0
%
 
1,494

 
28.3
%
85.00% and below
 
249

 
4.7
%
 
261

 
5.0
%
Total
 
$
5,273

 
100.0
%
 
$
5,275

 
100.0
%
Weighted average LTV
 
93.4
%
 
 
 
93.4
%
 
 
 
 
 
 
 
 
 
 
 
Total RIF by State:
 
 
 
 
 
 
 
 
Wisconsin
 
$
517

 
9.8
%
 
$
510

 
9.7
%
California
 
454

 
8.6
%
 
460

 
8.7
%
Texas
 
283

 
5.4
%
 
285

 
5.4
%
Florida
 
264

 
5.0
%
 
268

 
5.1
%
Minnesota
 
258

 
4.9
%
 
255

 
4.8
%
Washington
 
228

 
4.3
%
 
230

 
4.4
%
Massachusetts
 
204

 
3.9
%
 
203

 
3.8
%
Alaska
 
202

 
3.8
%
 
201

 
3.8
%
Virginia
 
186

 
3.5
%
 
185

 
3.5
%
New York
 
184

 
3.5
%
 
186

 
3.5
%
Others
 
2,493

 
47.3
%
 
2,492

 
47.3
%
Total
 
$
5,273

 
100.0
%
 
$
5,275

 
100.0
%
 
 
 
 
 
 
 
 
 
Weighted average coverage (end of period RIF divided by IIF)
 
24.9
%
 
 
 
24.8
%
 
 
Analysts’ persistency (1)
 
80.5
%
 
 
 
79.1
%
 
 
Risk-to-capital ratio (2)
 
8.9:1

 
 
 
9.0:1

 
 
_________________________________________________
(1)
Represents the percentage of IIF at the beginning of a 12-month period that remained in force at the end of the period.        
(2)
Represents total current (non-delinquent) RIF, net of reinsurance, divided by total statutory capital. Ratio calculated for Arch Mortgage Insurance Company only (estimate for June 30, 2014).

The following table provides supplemental disclosures for our mortgage segment’s U.S. mortgage insurance operations related to insured loans and loss metrics:

(U.S. Dollars in thousands, except loan count)
 
Three Months Ended
 
Six Months Ended
 
 
June 30, 2014
 
March 31, 2014 (1)
 
June 30, 2014 (1)
 
 
 
 
 
 
 
Rollforward of insured loans in default:
 
 
 
 
 
 
Beginning delinquent number of loans
 
3,858

 
4,469

 
4,469

  Plus: new notices
 
1,377

 
1,458

 
2,835

  Less: cures
 
(1,202
)
 
(1,635
)
 
(2,837
)
  Less: paid claims
 
(383
)
 
(429
)
 
(812
)
  Less: delinquent rescissions and denials
 
(9
)
 
(5
)
 
(14
)
Ending delinquent number of loans
 
3,641

 
3,858

 
3,641

 
 
 
 
 
 
 
Losses:
 
 
 
 
 
 
Number of claims paid
 
383

 
429

 
812

Total paid claims
 
$
16,190

 
$
18,117

 
$
34,307

Average per claim
 
$
42.3

 
$
42.2

 
$
42.3

Severity (2)
 
93.0
%
 
97.4
%
 
95.9
%
 
 
 
 
 
 
 
Average reserve per default
 
$
28.1

 
$
27.5

 
 
_________________________________________________
(1)     Includes activity for January 2014 for comparability purposes (pre-acquisition date).
(2)    Represents total paid claims divided by RIF of loans for which claims were paid.


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Shareholders’ Equity and Book Value per Common Share
 
Total shareholders’ equity available to Arch was $6.23 billion at June 30, 2014, compared to $5.65 billion at December 31, 2013. The increase in 2014 was primarily attributable to net income, reflecting contributions from both underwriting and investing activities. There were no share repurchases during 2014.
 
The following table presents the calculation of book value per common share:
(U.S. dollars in thousands, except share data)
June 30,
2014
 
December 31,
2013
Calculation of book value per common share:
 

 
 

Total shareholders’ equity available to Arch
$
6,229,399

 
$
5,647,496

Less preferred shareholders’ equity
325,000

 
325,000

Common shareholders’ equity available to Arch
$
5,904,399

 
$
5,322,496

Common shares outstanding, net of treasury shares (1)
135,030,886

 
133,674,884

Book value per common share
$
43.73

 
$
39.82

_________________________________________________
(1)
Excludes the effects of 8,282,092 and 8,338,480 stock options and 460,217 and 443,710 restricted stock units outstanding at June 30, 2014 and December 31, 2013, respectively.
 
Liquidity and Capital Resources
 
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, ACGL depends on its available cash resources, liquid investments and dividends or other distributions from its subsidiaries to make payments, including the payment of debt service obligations and operating expenses it may incur and any dividends or liquidation amounts with respect to the non-cumulative preferred shares and common shares. ACGL’s readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled $7.3 million at June 30, 2014, compared to $5.8 million at December 31, 2013. During 2014, ACGL received dividends of $32.0 million from Arch Reinsurance Ltd. (“Arch Re Bermuda”), our Bermuda-based reinsurer and insurer.
 
The ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Arch Re Bermuda is required to maintain an enhanced capital requirement which must equal or exceed its minimum solvency margin (i.e., the amount by which the value of its general business assets must exceed its general business liabilities) equal to the greatest of (1) $100.0 million, (2) 50% of net premiums written (being gross premiums written less any premiums ceded by Arch Re Bermuda, but Arch Re Bermuda may not deduct more than 25% of gross premiums when computing net premiums written) and (3) 15% of net aggregated losses and loss expense provisions and other insurance reserves. Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with its enhanced capital requirement, minimum solvency margin or minimum liquidity ratio. In addition, Arch Re Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet) unless it files, at least seven days before payment of such dividends, with the Bermuda Monetary Authority (“BMA”) an affidavit stating that it will continue to meet the required margins. In addition, Arch Re Bermuda is prohibited, without prior approval of the BMA, from reducing by 15% or more its total statutory capital, as set out in its previous year’s statutory financial statements. As a Class 4 insurer, Arch Re Bermuda is required to maintain available statutory capital and surplus pertaining to its general business at a level equal to or in excess of its enhanced capital requirement (“ECR”) which is established by reference to either the BSCR model (“BSCR”) or an approved internal capital model. At December 31, 2013, as determined under Bermuda law, Arch Re Bermuda had statutory capital of $2.36 billion ($2.32 billion at December 31, 2012) and statutory capital and surplus of $5.42 billion ($5.01 billion at December 31, 2012), which amounts were in compliance with Arch Re Bermuda’s ECR at such date. Such amounts include ownership interests in U.S. insurance and reinsurance subsidiaries. Accordingly, Arch Re Bermuda can pay approximately $1.32 billion to ACGL during the remainder of 2014 without providing an affidavit to the BMA, as discussed above. Under BMA guidelines, the value of the assets of our insurance group (i.e., the group of companies that conducts exclusively, or mainly, insurance business) must exceed the amount of the group’s liabilities by the aggregate minimum margin of solvency of each qualifying member of the group (the “Group MSM”). A member is a qualifying member of the insurance group if it is subject to solvency requirements in the jurisdiction in which it is registered. We were in compliance with the Group MSM at December 31, 2013.

Our U.S. insurance and reinsurance subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate. The ability of our regulated insurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. These regulations include restrictions that limit the amount of dividends or other

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distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities. Dividends or distributions, if any, made by Arch Re U.S. would result in an increase in available capital at Arch Capital Group (U.S.) Inc. (“Arch-U.S.”), a wholly-owned subsidiary of ACGL. Arch Re U.S. can declare a maximum of approximately $101.3 million of dividends during 2014 subject to the authority of the Nebraska Director of Insurance to disapprove the payment of such dividend. Nebraska insurance laws also require that the statutory surplus of Arch Re U.S. following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate to its financial needs. In addition, Nebraska insurance laws require that each insurer give notice to the Nebraska Director of Insurance of all dividends and other distributions within five business days following declaration thereof and that any such dividend or other distribution may not be paid within ten business days of such notice, unless for good cause shown and the Nebraska Director of Insurance has approved such payment within the ten business days of such notice.

In addition to meeting applicable regulatory standards, the ability of our insurance and reinsurance subsidiaries to pay dividends to intermediate parent companies owned by Arch Re Bermuda is also constrained by our dependence on the financial strength ratings of our insurance and reinsurance subsidiaries from independent rating agencies. The ratings from these agencies depend to a large extent on the capitalization levels of our insurance and reinsurance subsidiaries. We believe that ACGL has sufficient cash resources and available dividend capacity to service its indebtedness and other current outstanding obligations.

Our insurance and reinsurance subsidiaries are required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support their operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. Our insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. At June 30, 2014 and December 31, 2013, such amounts approximated $5.72 billion and $5.30 billion, respectively.
 
Our non-U.S. operations account for a significant percentage of our net premiums written. In general, the business written by our non-U.S. operations, which is heavily weighted towards reinsurance business, has been more profitable than the business written in our U.S. operations, which is weighted more towards insurance business. In general, our reinsurance segment has operated at a higher margin than our insurance segment, which is due to prevailing market conditions and the mix and type of business written. Historically, the most profitable line of business has been catastrophe-exposed property reinsurance, which is written primarily in our non-U.S. operations. Additionally, a significant component of our pre-tax income is generated through our investment performance. We hold a substantial amount of our investable assets in our non-U.S. operations and, accordingly, a large portion of our investment income is produced in our non-U.S. operations. In addition, ACGL, through its subsidiaries, provides financial support to certain of its insurance subsidiaries and affiliates, through certain reinsurance arrangements beneficial to the ratings of such subsidiaries. Our U.S.-based insurance and reinsurance groups enter into separate reinsurance arrangements with Arch Re Bermuda covering individual lines of business. For the 2013 calendar year, the U.S. groups ceded business to Arch Re Bermuda at an aggregate net cession rate (i.e., net of third party reinsurance) of approximately 55% (compared to 46% for 2012). All of the above factors have resulted in the non-U.S. group providing a higher contribution to our overall pre-tax income in the current period than the percentage of net premiums written would indicate.
 
Except as described in the above paragraph, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of ACGL’s subsidiaries or affiliates is solely responsible for its own liabilities and commitments (and no other ACGL subsidiary or affiliate is so responsible). Any reinsurance arrangements, guarantees or other financial support contractual arrangements that are in place are solely for the benefit of the ACGL subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements.
 
The following table summarizes our consolidated cash flows from operating, investing and financing activities:
 
Six Months Ended
 
June 30,
 
2014
 
2013
Total cash provided by (used for):
 

 
 

Operating activities
$
453,063

 
$
388,354

Investing activities
(952,067
)
 
(305,712
)
Financing activities
988,877

 
(66,128
)
Effects of exchange rate changes on foreign currency cash
2,513

 
(12,436
)
Increase in cash
$
492,386

 
$
4,078

 

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Cash provided by operating activities for the six months ended June 30, 2014 was higher than in the 2013 period. The increase in operating cash flows reflected a higher level of premiums collected, partially offset by a lower level of distributions on certain fund investments and a higher level of operating expenses paid.

Cash used for investing activities for the six months ended June 30, 2014 was higher than in the 2013 period. Activity for the six months ended June 30, 2014 reflected the investment by Watford of some of its available cash into investments and our acquisition of Arch MI U.S. in the 2014 first quarter. In addition, gross purchases and sales of fixed maturity investments were higher than in the 2013 period.

Cash provided by financing activities for the six months ended June 30, 2014 was higher than in the 2013 period, primarily due to the consolidation of Watford in our results, and its capital raising in the 2014 first quarter. There were no repurchases under our share repurchase program in the six months ended June 30, 2014, compared to $56.5 million in the 2013 period.
 
Our insurance and reinsurance operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time losses are paid. The period of time from the occurrence of a claim through the settlement of the liability may extend many years into the future. Sources of liquidity include cash flows from operations, financing arrangements or routine sales of investments.
 
As part of Arch’s investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. However, due to the nature of our operations, cash flows are affected by claim payments that may comprise large payments on a limited number of claims and which can fluctuate from year to year. We believe that our liquid investments and cash flow will provide us with sufficient liquidity in order to meet our claim payment obligations. However, the timing and amounts of actual claim payments related to recorded Loss Reserves vary based on many factors, including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claim payments could differ materially from our estimated amounts. Certain lines of business written by us, such as excess casualty, have loss experience characterized as low frequency and high severity. The foregoing may result in significant variability in loss payment patterns. The impact of this variability can be exacerbated by the fact that the timing of the receipt of reinsurance recoverables owed to us may be slower than anticipated by us. Therefore, the irregular timing of claim payments can create significant variations in cash flows from operations between periods and may require us to utilize other sources of liquidity to make these payments, which may include the sale of investments or utilization of existing or new credit facilities or capital market transactions. If the source of liquidity is the sale of investments, we may be forced to sell such investments at a loss, which may be material.
 
Our investments in certain securities, including certain fixed income and structured securities, investments in funds accounted for using the equity method, other investments and our investments in Gulf Reinsurance Limited (joint venture) and Watford may be illiquid due to contractual provisions or investment market conditions. If we require significant amounts of cash on short notice in excess of anticipated cash requirements, then we may have difficulty selling these investments in a timely manner or may be forced to sell or terminate them at unfavorable values.
 
Total investable assets managed by Arch were $14.69 billion at June 30, 2014, compared to $14.05 billion at December 31, 2013. The primary goals of our asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including debt service obligations. Generally, the expected principal and interest payments produced by our fixed income portfolio adequately fund the estimated runoff of our insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the fair value of the fixed income portfolio exceeds the expected present value of the net insurance liabilities, as well as the positive cash flow from newly sold policies and the large amount of high quality liquid bonds, provide assurance of our ability to fund the payment of claims and to service our outstanding debt without having to sell securities at distressed prices or access credit facilities. Our unfunded investment commitments totaled approximately $966.1 million at June 30, 2014.
 
Various rating agencies have announced the possibility of future downgrades of the United States’ credit rating, depending on spending levels, interest rates, fiscal pressures that result in a higher general government debt trajectory and other factors. In addition, the impact of the continuing weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of

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operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio. Our investment portfolio as of June 30, 2014 included $1.44 billion of obligations of the U.S. government and government agencies at fair value and $1.41 billion of municipal bonds at fair value. Please refer to Item 1A “Risk Factors” of our 2013 Form 10-K for a discussion of other risks relating to our business and investment portfolio.
 
We expect that our liquidity needs, including our anticipated insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by funds generated from underwriting activities and investment income, as well as by our balance of cash, short-term investments, proceeds on the sale or maturity of our investments, and our credit facilities.

We monitor our capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by several ratings agencies, at a level considered necessary by management to enable our key operating subsidiaries to compete; (2) sufficient capital to enable our underwriting subsidiaries to meet the capital adequacy tests performed by statutory agencies in the U.S. and other key markets; and (3) letters of credit and other forms of collateral that are necessary for our non-U.S. operating companies because they are “non-admitted” under U.S. state insurance regulations.

New financial requirements for private mortgage insurers were released for public comment by the Federal Housing Finance Agency (“FHFA”) in July 2014, and Arch MI U.S. will be subject to these requirements once enacted. The draft Private Mortgage Insurer Eligibility Requirements (“PMIERs”) establish new standards that mortgage insurers must meet in order to insure loans sold to or guaranteed by Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (the GSEs). The PMIERs are subject to a sixty-day public comment period ending on September 8, 2014. The PMIERs’ financial requirements are based in part on a risk-based, required assets model and employ a grid approach based upon a number of factors, including vintage (origination year), original loan-to-value and original credit score of performing loans and the delinquency status of non-performing loans. The draft PMIERs propose up to a two year phase-in, beginning after publication of final PMIERs, for approved mortgage insurers to fully comply with the PMIER financial requirements. The available assets required to satisfy such final requirements at any point in time will be affected by many factors, including the content and timing of any final PMIERs, macro-economic conditions, and the size and composition of Arch MI U.S.’s mortgage insurance portfolio at the applicable point in time.  Based upon its mortgage insurance portfolio as of June 30, 2014, Arch MI U.S. currently satisfies the proposed financial requirements, although no assurance can be given as to what changes, if any, will be made to the final PMIERS.

In December 2013, Arch-U.S., a wholly-owned subsidiary of ACGL, completed a public offering of $500.0 million principal amount of 5.144% senior notes issued at par and due November 1, 2043 (“Arch-U.S. Senior Notes”), fully and unconditionally guaranteed by ACGL (the “Guarantee”). The Arch-U.S. Senior Notes and the Guarantee are unsecured and unsubordinated obligations of Arch-U.S. and ACGL, respectively, and rank equally and ratably with the other unsecured and unsubordinated indebtedness of Arch-U.S. and ACGL, respectively.

On January 30, 2014, we completed our acquisition of the CMG Entities. The Stock Purchase Agreement contains provisions for contingent consideration payments, subject to an overall maximum payment of 150% of closing book value of the pre-closing portfolio of the CMG Entities as re-calculated over an earn-out period and payable at the third, fifth and sixth anniversaries after closing (subject to a one time extension period of one to three years at the sellers’ discretion). The maximum amount of contingent consideration payments is $136.9 million over the earn-out period. To the extent that the adjusted book value of the CMG Entities drops below the cumulative amount paid by us, no additional payments would be due.

As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements and such other factors as our board of directors deems relevant.
 
The board of directors of ACGL has authorized the investment in ACGL’s common shares through a share repurchase program. Authorizations have consisted of a $1.0 billion authorization in February 2007, a $500.0 million authorization in May 2008, a $1.0 billion authorization in November 2009 and a $1.0 billion authorization in February 2011. Since the inception of the share repurchase program through June 30, 2014, ACGL has repurchased 109.9 million common shares for an aggregate purchase price of $2.79 billion. At June 30, 2014, $712.1 million of share repurchases were available under the program.

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Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through December 2014. 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. We will continue to monitor our share price and, depending upon results of operations, market conditions and the development of the economy, as well as other factors, we will consider share repurchases on an opportunistic basis.
 
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. We can provide no assurance that, if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all. Adverse developments in the financial markets, such as disruptions, uncertainty or volatility in the capital and credit markets, may result in realized and unrealized capital losses that could have a material adverse effect on our results of operations, financial position and our businesses, and may also limit our access to capital required to operate our business.
 
If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our operating subsidiaries, which could place those operating subsidiaries at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our operating subsidiaries are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of bank credit and letters of credit. In addition, under certain of the reinsurance agreements assumed by our reinsurance operations, upon the occurrence of a ratings downgrade or other specified triggering event with respect to our reinsurance operations, such as a reduction in surplus by specified amounts during specified periods, our ceding company clients may be provided with certain rights, including, among other things, the right to terminate the subject reinsurance agreement and/or to require that our reinsurance operations post additional collateral.
 
In addition to common share capital, we depend on external sources of finance to support our underwriting activities, which can be in the form (or any combination) of debt securities, preference shares, common equity and bank credit facilities providing loans and/or letters of credit. As noted above, equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities.
 
In June 2014, we entered into a five-year agreement for a $300 million unsecured revolving loan and letter of credit facility and a $500 million secured letter of credit facility. Under the terms of the agreement, Arch Reinsurance Company, our U.S.-based reinsurer, and Arch Re Bermuda are limited to issuing $100 million of unsecured letters of credit as part of the unsecured revolving loan. In addition, we have access to secured letter of credit facilities of approximately $194.8 million, which are available on a limited basis and for limited purposes. Refer to note 10, “Commitments and Contingencies—Letter of Credit and Revolving Credit Facilities,” of the notes accompanying our consolidated financial statements for a discussion of our available facilities, applicable covenants on such facilities and available capacity.
 
In March 2012, ACGL and Arch Capital Group (U.S.) Inc. filed a universal shelf registration statement with the SEC. This registration statement allows for the possible future offer and sale by us of various types of securities, including unsecured debt securities, preference shares, common shares, warrants, share purchase contracts and units and depositary shares. The shelf registration statement enables us to efficiently access the public debt and/or equity capital markets in order to meet our future capital needs. The shelf registration statement also allows selling shareholders to resell common shares that they own in one or more offerings from time to time. We will not receive any proceeds from any shares offered by the selling shareholders. This report is not an offer to sell or the solicitation of an offer to buy nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state.
 
At June 30, 2014, total capital available to Arch of $7.13 billion consisted of $800.0 million of senior notes, representing 11.2% of the total, $100.0 million of revolving credit agreement borrowings due in June 2019, representing 1.4% of the total, $325.0 million of preferred shares, representing 4.6% of the total, and common shareholders’ equity of $5.90 billion, representing 82.8% of the total. At December 31, 2013, total capital available to Arch of $6.55 billion consisted of $800.0 million of senior notes, representing 12.2% of the total, $100.0 million of revolving credit agreement borrowings due in August 2014, representing 1.5% of the total, $325.0 million of preferred shares, representing 5.0% of the total, and common shareholders’ equity of $5.32 billion, representing 81.3% of the total. The increase in capital during 2014 was primarily attributable to net income, reflecting contributions from both underwriting and investing activities.
 

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Off-Balance Sheet Arrangements
 
Off-balance sheet arrangements are discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our 2013 Form 10-K.
 
Market Sensitive Instruments and Risk Management
 
In accordance with the SEC’s Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as of June 30, 2014. Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. An analysis of material changes in market risk exposures at June 30, 2014 that affect the quantitative and qualitative disclosures presented in our 2013 Form 10-K (see section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Sensitive Instruments and Risk Management”) were as follows:
 
Investment Market Risk
 
Fixed Income Securities. We invest in interest rate sensitive securities, primarily debt securities. We consider the effect of interest rate movements on the fair value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments which invest in fixed income securities and the corresponding change in unrealized appreciation. As interest rates rise, the fair value of our interest rate sensitive securities falls, and the converse is also true. Based on historical observations, there is a low probability that all interest rate yield curves would shift in the same direction at the same time. Accordingly, the actual effect of interest rate movements may differ materially from the amounts set forth in the following tables.
 
The following table summarizes the effect that an immediate, parallel shift in the interest rate yield curve would have had on our fixed income securities (including amounts attributable to the ‘other’ segment):
 
Interest Rate Shift in Basis Points
(U.S. dollars in millions)
-100
 
-50
 
 
+50
 
+100
June 30, 2014
 

 
 

 
 

 
 

 
 

Total fair value
$
14,587.7

 
$
14,372.7

 
$
14,155.7

 
$
13,942.7

 
$
13,735.6

Change from base
3.05
%
 
1.53
%
 
 
 
(1.50
)%
 
(2.97
)%
Change in unrealized value
$
432.0

 
$
217.0

 
 
 
$
(213.0
)
 
$
(420.1
)
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 
 
 
 
 
 
 
 
 
Total fair value
$
13,338.9

 
$
13,178.2

 
$
13,009.5

 
$
12,839.6

 
$
12,671.3

Change from base
2.53
%
 
1.30
%
 
 
 
(1.31
)%
 
(2.60
)%
Change in unrealized value
$
329.4

 
$
168.7

 
 
 
$
(169.9
)
 
$
(338.2
)
 
In addition, we consider the effect of credit spread movements on the fair value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments and investment funds accounted for using the equity method which invest in fixed income securities and the corresponding change in unrealized appreciation. As credit spreads widen, the fair value of our fixed income securities falls, and the converse is also true.
 
The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on our fixed income securities (including amounts attributable to the ‘other’ segment):
 
Credit Spread Shift in Basis Points
(U.S. dollars in millions)
-100
 
-50
 
 
+50
 
+100
June 30, 2014
 

 
 

 
 

 
 

 
 

Total fair value
$
14,408.8

 
$
14,298.8

 
$
14,155.7

 
$
14,027.9

 
$
13,901.2

Change from base
1.79
%
 
1.01
%
 
 
 
(0.90
)%
 
(1.80
)%
Change in unrealized value
$
253.1

 
$
143.1

 
 
 
$
(127.8
)
 
$
(254.5
)
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 
 
 
 
 
 
 
 
 
Total fair value
$
13,228.3

 
$
13,137.9

 
$
13,009.5

 
$
12,896.3

 
$
12,783.0

Change from base
1.68
%
 
0.99
%
 
 
 
(0.87
)%
 
(1.74
)%
Change in unrealized value
$
218.8

 
$
128.4

 
 
 
$
(113.2
)
 
$
(226.5
)
 

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Another method that attempts to measure portfolio risk is Value-at-Risk (“VaR”). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio’s initial value. In other words, 95% of the time, should the risks taken into account in the VaR model perform per their historical tendencies, the portfolio’s loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio’s initial value. As of June 30, 2014, our portfolio’s VaR was estimated to be 3.04%, compared to an estimated 3.43% at December 31, 2013.
 
Certain Other Investments and Equity Securities. Our investment portfolio includes certain other investments which do not invest in fixed income securities along with equity holdings. At June 30, 2014 and December 31, 2013, the fair value of such investments totaled $721.4 million and $606.4 million, respectively. These investments are exposed to price risk, which is the potential loss arising from decreases in fair value. An immediate hypothetical 10% decline in the value of each position would reduce the fair value of such investments by approximately $72.1 million and $60.6 million at June 30, 2014 and December 31, 2013, respectively, and would have decreased book value per common share by approximately $0.53 and $0.45, respectively. An immediate hypothetical 10% increase in the value of each position would increase the fair value of such investments by approximately $72.1 million and $60.6 million at June 30, 2014 and December 31, 2013, respectively, and would have increased book value per common share by approximately $0.53 and $0.45, respectively.
 
Investment-Related Derivatives. Derivative instruments may be used to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. The fair values of those derivatives are based on quoted market prices. See note 9, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives. At June 30, 2014, the notional value of all derivative instruments (excluding to-be-announced mortgage backed securities which are included in the fixed income securities analysis above and foreign currency forward contracts which are included in the foreign currency exchange risk analysis below) was $1.29 billion, compared to $812.1 million at December 31, 2013. A 100 basis point depreciation of the underlying exposure to these derivative instruments at June 30, 2014 and December 31, 2013 would have resulted in a reduction in net income of approximately $12.9 million and $8.1 million, respectively, and would have decreased book value per common share by $0.10 and $0.06, respectively. A 100 basis point appreciation of the underlying exposure to these derivative instruments at June 30, 2014 and December 31, 2013 would have resulted in an increase in net income of approximately $12.9 million and $8.1 million, respectively, and would have increased book value per common share by $0.10 and $0.06, respectively.
 
For further discussion on investment activity, please refer to “—Financial Condition, Liquidity and Capital Resources—Financial Condition—Investable Assets.”
 
Foreign Currency Exchange Risk
 
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Through our subsidiaries and branches located in various foreign countries, we conduct our insurance and reinsurance operations in a variety of local currencies other than the U.S. Dollar. We generally hold investments in foreign currencies which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities. We may also utilize foreign currency forward contracts and currency options as part of our investment strategy. See Note 9, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional information.
 

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The following table provides a summary of our net foreign currency exchange exposures, as well as foreign currency derivatives in place to manage these exposures:
(U.S. dollars in thousands, except per share data)
June 30,
2014
 
December 31,
2013
Net assets (liabilities), denominated in foreign currencies, excluding shareholders’ equity and derivatives
$
3,052

 
$
168,352

Shareholders’ equity denominated in foreign currencies (1)
404,356

 
396,106

Net foreign currency forward contracts outstanding (2)
(89,036
)
 
(87,399
)
Net exposures denominated in foreign currencies
$
318,372

 
$
477,059

 
 
 
 
Pre-tax impact of a hypothetical 10% appreciation of the U.S. Dollar against foreign currencies:
 

 
 

Shareholders’ equity
$
(31,837
)
 
$
(47,706
)
Book value per common share
$
(0.24
)
 
$
(0.36
)
 
 
 
 
Pre-tax impact of a hypothetical 10% decline of the U.S. Dollar against foreign currencies:
 

 
 

Shareholders’ equity
$
31,837

 
$
47,706

Book value per common share
$
0.24

 
$
0.36

_________________________________________________
(1)
Represents capital contributions held in the foreign currencies of our operating units.
(2)
Notional value of the outstanding foreign currency forward contracts in U.S. Dollars.
 
As a result of the current financial and economic environment as well as the potential for additional investment returns, we may not match a portion of our projected liabilities in foreign currencies with investments in the same currencies, which would increase our exposure to foreign currency fluctuations and increase the volatility in our results of operations. Historical observations indicate a low probability that all foreign currency exchange rates would shift against the U.S. Dollar in the same direction and at the same time and, accordingly, the actual effect of foreign currency rate movements may differ materially from the amounts set forth above. For further discussion on foreign exchange activity, please refer to “—Results of Operations.”
 
Cautionary Note Regarding Forward-Looking Statements
 
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This release or any other written or oral statements made by or on behalf of us may include forward-looking statements, which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this release are forward-looking statements. Forward-looking statements, for purposes of the PSLRA or otherwise, can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe” or “continue” and similar statements of a future or forward-looking nature or their negative or variations or similar terminology.
 
Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and 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 below and elsewhere in this release and in our periodic reports filed with the Securities and Exchange Commission (the “SEC”), and include:
 
our ability to successfully implement its business strategy during “soft” as well as “hard” markets;
acceptance of our business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and our insureds and reinsureds; 
our ability to maintain or improve our ratings, which may be affected by our ability to raise additional equity or debt financings, by ratings agencies’ existing or new policies and practices, as well as other factors described herein;
general economic and market conditions (including inflation, interest rates, foreign currency exchange rates, prevailing credit terms and the depth and duration of a recession) and conditions specific to the reinsurance and insurance markets (including the length and magnitude of the current “soft” market) in which we operate;
competition, including increased competition, on the basis of pricing, capacity, coverage terms or other factors;
developments in the world’s financial and capital markets and our access to such markets;
our ability to successfully enhance, integrate and maintain operating procedures (including information technology) to effectively support our current and new business;
the loss of key personnel;

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the integration of businesses we have acquired or may acquire into our existing operations;
accuracy of those estimates and judgments utilized in the preparation of our financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation, and any determination to use the deposit method of accounting, which for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to us through June 30, 2014;
 greater than expected loss ratios on business written by us and adverse development on claim and/or claim expense liabilities related to business written by our insurance and reinsurance subsidiaries;
 severity and/or frequency of losses;
claims for natural or man-made catastrophic events in our insurance or reinsurance business could cause large losses and substantial volatility in our results of operations;
acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;
availability to us of reinsurance to manage our gross and net exposures and the cost of such reinsurance;
the failure of reinsurers, managing general agents, third party administrators or others to meet their obligations to us;
the timing of loss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us;
our investment performance, including legislative or regulatory developments that may adversely affect the fair value of our investments;
the impact of the continued weakness of the U.S., European countries or other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies, and the resulting effect on the value of securities in our investment portfolio as well as the uncertainty in the market generally;
losses relating to aviation business and business produced by a certain managing underwriting agency for which we may be liable to the purchaser of its prior reinsurance business or to others in connection with the May 5, 2000 asset sale described in our periodic reports filed with the SEC;
changes in accounting principles or policies or in our application of such accounting principles or policies;
changes in the political environment of certain countries in which we operates, underwrites business or invests;
statutory or regulatory developments, including as to tax policy matters and insurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers and/or changes in regulations or tax laws applicable to us, our subsidiaries, brokers or customers; and
the other matters set forth under Item 1A “Risk Factors”, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of our Annual Report on Form 10-K, as well as the other factors set forth in our other documents on file with the SEC, and management’s response to any of the aforementioned factors.
 
All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.
 
Other Financial Information
 
The consolidated financial statements as of June 30, 2014 and for the three month and six month periods ended June 30, 2014 and 2013 have been reviewed by PricewaterhouseCoopers LLP, an independent registered public accounting firm. Their report (dated August 8, 2014) is included on page 2. The report of PricewaterhouseCoopers LLP states that they did not audit and they do not express an opinion on that unaudited financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report

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on the unaudited financial information because that report is not a “report” or a “part” of the registration statement prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Securities Act of 1933.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Reference is made to the information appearing above under the subheading “Market Sensitive Instruments and Risk Management” under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which information is hereby incorporated by reference.
 
ITEM 4.  CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
In connection with the filing of this Form 10-Q, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of disclosure controls and procedures pursuant to applicable Exchange Act Rules as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of the end of and during the period covered by this report with respect to information being recorded, processed, summarized and reported within time periods specified in the SEC’s rules and forms and with respect to timely communication to them and other members of management responsible for preparing periodic reports of all material information required to be disclosed in this report as it relates to ACGL and its consolidated subsidiaries.
 
We continue to enhance our operating procedures and internal controls to effectively support our business and our regulatory and reporting requirements. Our management does not expect that our disclosure controls or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons or by collusion of two or more people. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. As a result of the inherent limitations in a cost-effective control system, misstatement due to error or fraud may occur and not be detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the disclosure controls and procedures are met.

Changes in Internal Controls Over Financial Reporting
 
There have been no changes in internal control over financial reporting that occurred during the fiscal quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

PART II.  OTHER INFORMATION
 
Item 1.  Legal Proceedings
 
We, in common with the insurance industry in general, are subject to litigation and arbitration in the normal course of our business. As of June 30, 2014, we were not a party to any litigation or arbitration which is expected by management to have a material adverse effect on our results of operations and financial condition and liquidity.
 

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Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
 
The following table summarizes our purchases of our common shares for the 2014 second quarter:
 
 
 
Issuer Purchases of Equity Securities
Period
 
Total Number of Shares
Purchased (1)
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of
Publicly Announced
Plans or Programs
 
Approximate Dollar
Value of Shares that
 May Yet be Purchased
Under the Plan or
Programs (2)
4/1/2014 - 4/30/2014
 
6,090

 
$
56.61

 

 
$
712,115

5/1/2014 - 5/31/2014
 
132,099

 
56.87

 

 
$
712,115

6/1/2014 - 6/30/2014
 
4,876

 
57.47

 

 
$
712,115

Total
 
143,065

 
$
56.88

 

 
$
712,115

_________________________________________________
(1)
Includes repurchases by ACGL of shares, from time to time, from employees in order to facilitate the payment of withholding taxes on restricted shares granted and the exercise of stock appreciation rights. We purchased these shares at their fair value, as determined by reference to the closing price of our common shares on the day the restricted shares vested or the stock appreciation rights were exercised.
(2)
Remaining amount available at June 30, 2014 under ACGL’s share repurchase authorization, under which repurchases may be effected from time to time in open market or privately negotiated transactions through December 2014.
 
Item 5.  Other Information
 
In accordance with Section 10a(i)(2) of the Securities Exchange Act of 1934, as amended, we are responsible for disclosing non-audit services to be provided by our independent auditor, PricewaterhouseCoopers LLP, which are approved by the Audit Committee of our board of directors. During the 2014 second quarter, the Audit Committee approved engagements of PricewaterhouseCoopers LLP for permitted non-audit services, which consisted of tax consulting services, tax compliance services and other accounting consulting services.


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Item 6.  Exhibits
 
Exhibit No.
 
Description
 
 
 
10.1
 
Restricted Share Agreement with Arch Capital Group Ltd. substantially in the form signed by the Non-Employee Directors of Arch Capital Group Ltd. for May 9, 2014 grants
10.2
 
Restricted Share Agreement with Arch Capital Group Ltd. substantially in the form signed by each of Constantine Iordanou, Mark D. Lyons, Marc Grandisson, W. Preston Hutchings and Louis T. Petrillo for May 13, 2014 grants
10.3
 
Share Appreciation Right Agreement with Arch Capital Group Ltd. substantially in the form signed by each of Constantine Iordanou, Mark D. Lyons, Marc Grandisson, W. Preston Hutchings, David McElroy and Louis T. Petrillo for May 13, 2014 grants
10.4
 
Restricted Share Unit Agreement, dated as of May 13, 2014, between Arch Capital Group Ltd. and David McElroy
10.5
 
Share Appreciation Right Agreement, dated as of February 28, 2014 between Arch Capital Group Ltd. and Mark D. Lyons
10.6
 
Share Appreciation Right Agreement, dated as of February 28, 2014 between Arch Capital Group Ltd. and Constantine Iordanou
10.7
 
Amended and Restated Credit Agreement, dated as of June 30, 2014, by and among Arch Capital Group Ltd. and its subsidiaries, Arch Capital Group (U.S.) Inc., Arch Reinsurance Ltd., Arch Reinsurance Company, Arch Reinsurance Europe Underwriting Limited, Arch Insurance Company, Arch Specialty Insurance Company and Arch Insurance Company (Europe) Limited, and Bank of America, N.A., as Administrative Agent, Fronting Bank and L/C Administrator, JPMorgan Chase Bank, N.A. and Wells Fargo Bank, National Association, as Co-Syndication Agents, U.S. Bank National Association and Lloyds Bank plc, as Co-Documentation Agents, Merrill Lynch, Pierce, Fenner & Smith Incorporated, J.P. Morgan Securities LLC and Wells Fargo Securities, LLC, as Joint Lead Arrangers and Joint Book Managers and the other lenders party thereto*
15
 
Accountants’ Awareness Letter (regarding unaudited interim financial information)
31.1
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
 
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
 
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101
 
The following financial information from Arch Capital Group Ltd.’s Quarterly Report for the quarter ended June 30, 2014 formatted in XBRL: (i) Consolidated Balance Sheets at June 30, 2014 and December 31, 2013; (ii) Consolidated Statements of Income for the three and six month periods ended June 30, 2014 and 2013; (iii) Consolidated Statements of Comprehensive Income for the three and six month periods ended June 30, 2014 and 2013; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six month periods ended June 30, 2014 and 2013; (v) Consolidated Statements of Cash Flows for the six month periods ended June 30, 2014 and 2013; and (vi) Notes to Consolidated Financial Statements.
 

* Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on July 1, and incorporated by reference.


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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
ARCH CAPITAL GROUP LTD.
 
 
(REGISTRANT)
 
 
 
 
 
/s/ Constantine Iordanou
Date: August 8, 2014
 
Constantine Iordanou
 
 
President and Chief Executive Officer
(Principal Executive Officer) and Chairman of the Board of Directors
 
 
 
 
 
/s/ Mark D. Lyons
Date: August 8, 2014
 
Mark D. Lyons
 
 
Executive Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

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EXHIBIT INDEX

Exhibit No.
 
Description
 
 
 
10.1
 
Restricted Share Agreement with Arch Capital Group Ltd. substantially in the form signed by the Non-Employee Directors of Arch Capital Group Ltd. for May 9, 2014 grants
10.2
 
Restricted Share Agreement with Arch Capital Group Ltd. substantially in the form signed by each of Constantine Iordanou, Mark D. Lyons, Marc Grandisson, W. Preston Hutchings and Louis T. Petrillo for May 13, 2014 grants
10.3
 
Share Appreciation Right Agreement with Arch Capital Group Ltd. substantially in the form signed by each of Constantine Iordanou, Mark D. Lyons, Marc Grandisson, W. Preston Hutchings, David McElroy and Louis T. Petrillo for May 13, 2014 grants
10.4
 
Restricted Share Unit Agreement, dated as of May 13, 2014, between Arch Capital Group Ltd. and David McElroy
10.5
 
Share Appreciation Right Agreement, dated as of February 28, 2014 between Arch Capital Group Ltd. and Mark D. Lyons
10.6
 
Share Appreciation Right Agreement, dated as of February 28, 2014 between Arch Capital Group Ltd. and Constantine Iordanou
10.7
 
Amended and Restated Credit Agreement, dated as of June 30, 2014, by and among Arch Capital Group Ltd. and its subsidiaries, Arch Capital Group (U.S.) Inc., Arch Reinsurance Ltd., Arch Reinsurance Company, Arch Reinsurance Europe Underwriting Limited, Arch Insurance Company, Arch Specialty Insurance Company and Arch Insurance Company (Europe) Limited, and Bank of America, N.A., as Administrative Agent, Fronting Bank and L/C Administrator, JPMorgan Chase Bank, N.A. and Wells Fargo Bank, National Association, as Co-Syndication Agents, U.S. Bank National Association and Lloyds Bank plc, as Co-Documentation Agents, Merrill Lynch, Pierce, Fenner & Smith Incorporated, J.P. Morgan Securities LLC and Wells Fargo Securities, LLC, as Joint Lead Arrangers and Joint Book Managers and the other lenders party thereto*
15
 
Accountants’ Awareness Letter (regarding unaudited interim financial information)
31.1
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
 
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
 
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101
 
The following financial information from Arch Capital Group Ltd.’s Quarterly Report for the quarter ended June 30, 2014 formatted in XBRL: (i) Consolidated Balance Sheets at June 30, 2014 and December 31, 2013; (ii) Consolidated Statements of Income for the three and six month periods ended June 30, 2014 and 2013; (iii) Consolidated Statements of Comprehensive Income for the three and six month periods ended June 30, 2014 and 2013; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six month periods ended June 30, 2014 and 2013; (v) Consolidated Statements of Cash Flows for the six month periods ended June 30, 2014 and 2013; and (vi) Notes to Consolidated Financial Statements.
 

* Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on July 1, and incorporated by reference.


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