Document
Table of Contents


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
 
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the quarterly period ended June 30, 2018
 
Or
 
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number:  001-16209

 archlogorgbsolida27.jpg
ARCH CAPITAL GROUP LTD.
(Exact name of registrant as specified in its charter)

Bermuda
Not applicable
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
Waterloo House, Ground Floor
 
100 Pitts Bay Road, Pembroke HM 08, Bermuda
(441) 278-9250
(Address of principal executive offices)
(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 þ     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 þ     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,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated Filer þ Accelerated Filer o Non-accelerated Filer o Smaller reporting
company o Emerging growth company o
If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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 þ
As of August 3, 2018, there were 405,299,490 common shares, $0.0011 par value per share, of the registrant outstanding.



Table of Contents

ARCH CAPITAL GROUP LTD.
 
INDEX TO FORM 10-Q
 
 
 
 
Page No.
 
PART I
 
 
 
 
 2
Item 1.
 
 4
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
 
PART II
 
 
 
 
74 
Item 1.
 
Item 1A.
 
74 
Item 2.
 
Item 5.
 
Item 6.
 
 
 

ARCH CAPITAL
 1
2018 SECOND QUARTER FORM 10-Q

Table of Contents

PART I.  FINANCIAL INFORMATION
Cautionary Note Regarding Forward-Looking Statements 
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This report 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 report 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 report and in our periodic reports filed with the Securities and Exchange Commission (the “SEC”), and include:
our ability to successfully implement our 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;
the integration of any businesses we have acquired or may acquire into our existing operations;
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, unemployment, housing prices, 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 (including alternative sources of capital), 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;
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, 2018;
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 or severe economic events in our insurance, reinsurance and mortgage businesses 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;

ARCH CAPITAL
 2
2018 SECOND QUARTER FORM 10-Q

Table of Contents

changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, which could affect our business, financial condition and results of operations;
the volatility of our shareholders’ equity from foreign currency fluctuations, which could increase due to us not matching portions of our projected liabilities in foreign currencies with investments in the same currencies;
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 operate or underwrite business;
a disruption caused by cyber-attacks or other technology breaches or failures on us or our business partners and service providers, which could negatively impact our business and/or expose us to litigation;
statutory or regulatory developments, including as to tax 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, including the Tax Cuts and Jobs Act of 2017; 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 for the year ended December 31, 2017, 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. 


ARCH CAPITAL
 3
2018 SECOND QUARTER FORM 10-Q

Table of Contents


ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
 
 
Page No.
 
 
 
 
 
 
 
 
 
June 30, 2018 (unaudited) and December 31, 2017
 
 
 
 
 
 
For the three and six month periods ended June 30, 2018 and 2017 (unaudited)
 
 
 
 
 
 
For the three and six month periods ended June 30, 2018 and 2017 (unaudited)
 
 
 
 
 
 
For the six month periods ended June 30, 2018 and 2017 (unaudited)
 
 
 
 
 
 
For the six month periods ended June 30, 2018 and 2017 (unaudited)
 
 
 
 
Notes to Consolidated Financial Statements (unaudited)
 
 
 
11 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


ARCH CAPITAL
 4
2018 SECOND QUARTER FORM 10-Q

Table of Contents


Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Shareholders of Arch Capital Group Ltd.:

Results of Review of Financial Statements

We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries as of June 30, 2018, and the related consolidated statements of income and of comprehensive income for the three-month and six-month periods ended June 30, 2018 and June 30, 2017, and the consolidated statements of changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2018 and June 30, 2017 including the related notes (collectively referred to as the “interim financial statements”). Based on our reviews, we are not aware of any material modifications that should be made to the accompanying interim financial statements for them to be conformity with accounting principles generally accepted in the United States of America.
 
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2017, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and of cash flows for the year then ended (not presented herein), and in our report dated February 28, 2018, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2017, is fairly stated, in all material respects in relation to the consolidated balance sheet from which it has been derived.

Basis for Review Results

These interim financial statements are the responsibility of the Company’s management. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our review in accordance with the standards of the PCAOB. 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 PCAOB, 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.


/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP
New York, NY
August 8, 2018

ARCH CAPITAL
 5
2018 SECOND QUARTER FORM 10-Q

Table of Contents

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
June 30,
2018
 
December 31,
2017
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $14,293,121 and $13,869,460)
$
14,128,989

 
$
13,876,003

Short-term investments available for sale, at fair value (amortized cost: $1,096,532 and $1,468,955)
1,096,798

 
1,469,042

Collateral received under securities lending, at fair value (amortized cost: $236,948 and $476,605)
236,956

 
476,615

Equity securities, at fair value
534,482

 
495,804

Other investments available for sale, at fair value (cost: $0 and $198,163)

 
264,989

Investments accounted for using the fair value option
4,111,611

 
4,216,237

Investments accounted for using the equity method
1,428,582

 
1,041,322

Total investments
21,537,418

 
21,840,012

 
 
 
 
Cash
526,628

 
606,199

Accrued investment income
114,307

 
113,133

Securities pledged under securities lending, at fair value (amortized cost: $229,857 and $463,181)
230,064

 
464,917

Premiums receivable
1,351,310

 
1,135,249

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
2,727,303

 
2,540,143

Contractholder receivables
2,044,322

 
1,978,414

Ceded unearned premiums
1,014,663

 
926,611

Deferred acquisition costs net
569,817

 
535,824

Receivable for securities sold
143,809

 
205,536

Goodwill and intangible assets
593,008

 
652,611

Other assets
1,000,471

 
1,053,009

Total assets
$
31,853,120

 
$
32,051,658

 
 
 
 
Liabilities
 
 
 
Reserve for losses and loss adjustment expenses
$
11,424,337

 
$
11,383,792

Unearned premiums
3,833,540

 
3,622,314

Reinsurance balances payable
411,082

 
323,496

Contractholder payables
2,044,322

 
1,978,414

Collateral held for insured obligations
257,396

 
240,183

Senior notes
1,733,211

 
1,732,884

Revolving credit agreement borrowings
572,289

 
816,132

Securities lending payable
236,948

 
476,605

Payable for securities purchased
356,583

 
449,186

Other liabilities
752,399

 
782,717

Total liabilities
21,622,107

 
21,805,723

 
 
 
 
Commitments and Contingencies


 


Redeemable noncontrolling interests
206,105

 
205,922

 
 
 
 
Shareholders' Equity
 
 
 
Non-cumulative preferred shares
780,000

 
872,555

Convertible non-voting common equivalent preferred shares

 
489,627

Common shares ($0.0011 par, shares issued: 569,458,341 and 549,872,226)
633

 
611

Additional paid-in capital
1,760,606

 
1,230,617

Retained earnings
9,083,202

 
8,562,889

Accumulated other comprehensive income (loss), net of deferred income tax
(194,157
)
 
118,044

Common shares held in treasury, at cost (shares: 164,021,704 and 156,938,409)
(2,266,529
)
 
(2,077,741
)
Total shareholders' equity available to Arch
9,163,755

 
9,196,602

Non-redeemable noncontrolling interests
861,153

 
843,411

Total shareholders' equity
10,024,908

 
10,040,013

Total liabilities, noncontrolling interests and shareholders' equity
$
31,853,120

 
$
32,051,658


See Notes to Consolidated Financial Statements

ARCH CAPITAL
6
2018 SECOND QUARTER FORM 10-Q

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,
 
2018
 
2017
 
2018
 
2017
Revenues
 

 
 

 
 

 
 

Net premiums written
$
1,298,896

 
$
1,248,695

 
$
2,711,440

 
$
2,524,955

Change in unearned premiums
37,867

 
(7,821
)
 
(139,778
)
 
(167,064
)
Net premiums earned
1,336,763

 
1,240,874

 
2,571,662

 
2,357,891

Net investment income
135,668

 
111,124

 
262,392

 
228,998

Net realized gains (losses)
(76,611
)
 
21,735

 
(187,609
)
 
55,888

Other-than-temporary impairment losses
(470
)
 
(1,730
)
 
(632
)
 
(3,537
)
Less investment impairments recognized in other comprehensive income, before taxes

 

 

 

Net impairment losses recognized in earnings
(470
)
 
(1,730
)
 
(632
)
 
(3,537
)
 
 
 
 
 
 
 
 
Other underwriting income
3,874

 
4,822

 
9,223

 
9,455

Equity in net income (loss) of investment funds accounted for using the equity method
8,472

 
32,706

 
36,541

 
80,794

Other income (loss)
3,113

 
(1,994
)
 
3,187

 
(2,776
)
Total revenues
1,410,809

 
1,407,537

 
2,694,764

 
2,726,713

 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
Losses and loss adjustment expenses
726,153

 
689,860

 
1,363,013

 
1,242,430

Acquisition expenses
202,838

 
190,436

 
394,214

 
372,725

Other operating expenses
176,181

 
169,981

 
351,196

 
344,700

Corporate expenses
22,512

 
24,876

 
37,824

 
52,668

Amortization of intangible assets
26,472

 
30,824

 
53,208

 
62,118

Interest expense
30,344

 
28,749

 
60,980

 
57,425

Net foreign exchange (gains) losses
(53,706
)
 
39,543

 
(33,985
)
 
58,947

Total expenses
1,130,794

 
1,174,269

 
2,226,450

 
2,191,013

 
 
 
 
 
 
 
 
Income before income taxes
280,015

 
233,268

 
468,314

 
535,700

Income tax expense
(23,668
)
 
(34,169
)
 
(45,583
)
 
(62,566
)
Net income
$
256,347

 
$
199,099

 
$
422,731

 
$
473,134

Net (income) loss attributable to noncontrolling interests
(12,701
)
 
(13,932
)
 
(28,662
)
 
(34,840
)
Net income available to Arch
243,646

 
185,167

 
394,069

 
438,294

Preferred dividends
(10,403
)
 
(11,349
)
 
(20,840
)
 
(22,567
)
Loss on redemption of preferred shares

 

 
(2,710
)
 

Net income available to Arch common shareholders
$
233,243

 
$
173,818

 
$
370,519

 
$
415,727

 
 
 
 
 
 
 
 
Net income per common share and common share equivalent
 

 
 

 
 

 
 

Basic
$
0.58

 
$
0.43

 
$
0.91

 
$
1.03

Diluted
$
0.56

 
$
0.42

 
$
0.89

 
$
1.00

 
 
 
 
 
 
 
 
Weighted average common shares and common share equivalents outstanding
 
 
 
 
 

 
 

Basic
404,800,421

 
403,459,992

 
406,162,508

 
402,786,129

Diluted
413,111,205

 
417,733,938

 
415,460,756

 
417,421,896





See Notes to Consolidated Financial Statements

ARCH CAPITAL
7
2018 SECOND QUARTER FORM 10-Q

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,
 
2018
 
2017
 
2018
 
2017
Comprehensive Income
 
 
 
 
 

 
 

Net income
$
256,347

 
$
199,099

 
$
422,731

 
$
473,134

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
(85,271
)
 
92,969

 
(251,948
)
 
193,761

Reclassification of net realized (gains) losses, net of income taxes, included in net income
36,643

 
(17,224
)
 
99,104

 
(22,268
)
Foreign currency translation adjustments
(12,595
)
 
18,297

 
(11,313
)
 
21,421

Comprehensive income
195,124

 
293,141

 
258,574

 
666,048

Net (income) loss attributable to noncontrolling interests
(12,701
)
 
(13,932
)
 
(28,662
)
 
(34,840
)
Other comprehensive (income) loss attributable to noncontrolling interests
1,077

 
76

 
1,750

 
68

Comprehensive income available to Arch
$
183,500

 
$
279,285

 
$
231,662

 
$
631,276





See Notes to Consolidated Financial Statements

ARCH CAPITAL
8
2018 SECOND QUARTER FORM 10-Q

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,
 
2018
 
2017
Non-cumulative preferred shares
 

 
 

Balance at beginning of year
$
872,555

 
$
772,555

Preferred shares redeemed
(92,555
)
 

Balance at end of period
780,000

 
772,555

 
 
 
 
Convertible non-voting common equivalent preferred shares
 
 
 
Balance at beginning of year
489,627

 
1,101,304

Preferred shares converted to common shares
(489,627
)
 
(611,677
)
Balance at end of period

 
489,627

 
 
 
 
Common shares
 
 
 
Balance at beginning of year
611

 
582

Common shares issued, net
22

 
27

Balance at end of period
633

 
609

 
 
 
 
Additional paid-in capital
 

 
 

Balance at beginning of year
1,230,617

 
531,687

Preferred shares converted to common shares
489,608

 
611,653

Reversal of issue costs on preferred shares redeemed
2,710

 

All other
37,671

 
53,544

Balance at end of period
1,760,606

 
1,196,884

 
 
 
 
Retained earnings
 

 
 

Balance at beginning of year
8,562,889

 
7,996,701

Cumulative effect of an accounting change (see Note 2)
149,794

 
(314
)
Balance at beginning of year, as adjusted
8,712,683

 
7,996,387

Net income
422,731

 
473,134

Net (income) loss attributable to noncontrolling interests
(28,662
)
 
(34,840
)
Preferred share dividends
(20,840
)
 
(22,567
)
Loss on redemption of preferred shares
(2,710
)
 

Balance at end of period
9,083,202

 
8,412,114

 
 
 
 
Accumulated other comprehensive income (loss), net of deferred income tax
 
 
 
Balance at beginning of year
118,044

 
(114,541
)
Unrealized appreciation (decline) in value of available-for-sale investments, net of deferred income tax:
 
 
 
Balance at beginning of year
157,400

 
(27,641
)
Cumulative effect of an accounting change (see Note 2)
(149,794
)
 

Balance at beginning of year, as adjusted
7,606

 
(27,641
)
Unrealized holding gains (losses) arising during period, net of reclassification adjustment
(152,844
)
 
171,493

Unrealized holding gains (losses) arising during period attributable to noncontrolling interests
1,885

 

Balance at end of period
(143,353
)
 
143,852

Foreign currency translation adjustments, net of deferred income tax:
 
 
 
Balance at beginning of year
(39,356
)
 
(86,900
)
Foreign currency translation adjustments
(11,313
)
 
21,421

Foreign currency translation adjustments attributable to noncontrolling interests
(135
)
 
68

Balance at end of period
(50,804
)
 
(65,411
)
Balance at end of period
(194,157
)
 
78,441

 
 
 
 
Common shares held in treasury, at cost
 
 
 
Balance at beginning of year
(2,077,741
)
 
(2,034,570
)
Shares repurchased for treasury
(188,788
)
 
(16,773
)
Balance at end of period
(2,266,529
)
 
(2,051,343
)
 
 
 
 
Total shareholders’ equity available to Arch
9,163,755

 
8,898,887

Non-redeemable noncontrolling interests
861,153

 
877,456

Total shareholders’ equity
$
10,024,908

 
$
9,776,343



See Notes to Consolidated Financial Statements

ARCH CAPITAL
9
2018 SECOND QUARTER FORM 10-Q

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,
 
2018
 
2017
Operating Activities
 

 
 

Net income
$
422,731

 
$
473,134

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Net realized (gains) losses
177,442

 
(74,985
)
Net impairment losses recognized in earnings
632

 
3,537

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
(13,543
)
 
(47,529
)
Amortization of intangible assets
53,208

 
62,118

Share-based compensation
35,419

 
42,739

Changes in:
 
 
 
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
(77,891
)
 
180,342

Unearned premiums, net of ceded unearned premiums
139,778

 
167,064

Premiums receivable
(236,950
)
 
(222,498
)
Deferred acquisition costs
(35,111
)
 
(53,553
)
Reinsurance balances payable
88,961

 
50,112

Other items, net
(57,790
)
 
(46,946
)
Net cash provided by operating activities
496,886

 
533,535

Investing Activities
 

 
 

Purchases of fixed maturity investments
(16,867,570
)
 
(19,899,326
)
Purchases of equity securities
(679,663
)
 
(400,155
)
Purchases of other investments
(1,017,147
)
 
(883,704
)
Proceeds from sales of fixed maturity investments
16,090,543

 
19,611,680

Proceeds from sales of equity securities
622,068

 
473,064

Proceeds from sales, redemptions and maturities of other investments
773,298

 
614,494

Proceeds from redemptions and maturities of fixed maturity investments
511,448

 
447,941

Net settlements of derivative instruments
4,498

 
(5,984
)
Net sales (purchases) of short-term investments
451,901

 
(445,203
)
Change in cash collateral related to securities lending
176,304

 
175,693

Purchases of fixed assets
(13,242
)
 
(11,103
)
Other
49,961

 
33,488

Net cash provided by (used for) investing activities
102,399

 
(289,115
)
Financing Activities
 

 
 

Redemption of preferred shares
(92,555
)
 

Purchases of common shares under share repurchase program
(173,575
)
 

Proceeds from common shares issued, net
(13,851
)
 
(6,838
)
Proceeds from borrowings
130,579

 

Repayments of borrowings
(373,000
)
 
(72,000
)
Change in cash collateral related to securities lending
(176,304
)
 
(175,693
)
Dividends paid to redeemable noncontrolling interests
(8,994
)
 
(8,994
)
Other
(4,489
)
 
(41,698
)
Preferred dividends paid
(20,840
)
 
(22,567
)
Net cash provided by (used for) financing activities
(733,029
)
 
(327,790
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash and restricted cash
(10,431
)
 
9,616

 
 
 
 
Increase (decrease) in cash and restricted cash
(144,175
)
 
(73,754
)
Cash and restricted cash, beginning of year
727,284

 
969,569

Cash and restricted cash, end of period
$
583,109

 
$
895,815

Reconciliation of cash and restricted cash within the Consolidated Balance Sheets:
June 30,
2018
 
December 31,
2017
Cash
$
526,628

 
$
606,199

Restricted cash (included in ‘other assets’)
$
56,481

 
$
121,085

Cash and restricted cash
$
583,109

 
$
727,284



See Notes to Consolidated Financial Statements

ARCH CAPITAL
10
2018 SECOND QUARTER FORM 10-Q

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

 
1.    General

Arch Capital Group Ltd. (“Arch Capital”) is a Bermuda public limited liability company which provides insurance, reinsurance and mortgage insurance on a worldwide basis through its wholly-owned subsidiaries. As used herein, the “Company” means Arch Capital and its subsidiaries. The Company’s consolidated financial statements include the results of Watford Holdings Ltd. and its wholly owned subsidiaries. See Note 11.
The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). 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 materially 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, 2017 (“2017 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.    Recent Accounting Pronouncements

Recently Issued Accounting Standards Adopted
The Company adopted ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities,” which enhances the
 
reporting model for financial instruments and provides improved financial information to readers of the financial statements. Among other provisions focused on improving the recognition and measurement of financial instruments, the ASU significantly changes the income statement impact of equity instruments and the recognition of changes in fair value of financial liabilities attributable to an entity's own credit risk when the fair value option is elected. The ASU requires equity instruments that do not result in consolidation and are not accounted for under the equity method to be measured at fair value with any changes in fair value recognized in net income rather than other comprehensive income. Upon adoption of this ASU, the Company recorded a cumulative effect adjustment of $149.8 million in retained earnings and an offsetting decrease in accumulated other comprehensive income. The adoption of this ASU did not have a material impact on the Company's financial position, cash flows, or total comprehensive income, but may increase volatility in the Company's results of operations in future periods.
The Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standard Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606),” which creates a new comprehensive revenue recognition standard that serves as a single source of revenue guidance for all companies in all industries. The guidance applies to all companies that either enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of non-financial assets, unless those contracts are within the scope of other standards, such as insurance contracts or financial instruments. The ASU also requires enhanced disclosures about revenue. The Company adopted the ASU using the modified retrospective method, whereby the cumulative effect of adoption was recognized as an adjustment to retained earnings at the date of initial application. The impact of the adoption of this ASU was not material, mostly because the accounting for insurance contracts is outside of the scope of ASU 2014-09.
The Company adopted ASU 2016-18, “Statement of Cash Flows (Topic 230) - Restricted Cash,” which requires that restricted cash and restricted cash equivalents be included with cash and cash equivalents in the reconciliation of beginning and ending cash on the statements of cash flows. As a result, transfers between cash and cash equivalents and restricted cash and restricted cash equivalents will no longer be presented on the statement of cash flows. The revised presentation required in this ASU is reflected in the Company’s consolidated statements of cash flows for both periods presented. The adoption of this ASU did not have any effect on the Company’s results of operations, financial position or comprehensive income.
Recently Issued Accounting Standards Not Yet Adopted
For information regarding accounting standards that the Company has not yet adopted, see note 3(q), “Significant

ARCH CAPITAL
 11
2018 SECOND QUARTER FORM 10-Q

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

Accounting Policies—Recent Accounting Pronouncements,” of the notes to consolidated financial statements in the Company’s 2017 Form 10-K.

3.    Share Transactions

Three-For-One Common Share Split
In May 2018, shareholders approved a proposal to amend the memorandum of association by sub-dividing the authorized common shares of Arch Capital to effect a three-for-one split of Arch Capital’s common shares. The share split changed the Company’s authorized common shares to 1.8 billion common shares (600 million previously), with a par value of $.0011 per share ($.0033 previously). Information pertaining to the composition of the Company’s shareholders’ equity accounts, shares and earnings per share has been retroactively restated in the accompanying financial statements and notes to the consolidated financial statements to reflect the share split.
Share-Based Compensation
During the 2018 second quarter, the Company granted 2,199,656 stock options, 1,264,931 restricted shares and units and 705,345 performance shares and units to certain employees and directors with weighted average grant-date fair values of $7.43, $26.56 and $24.65, respectively. During the 2017 second quarter, the Company granted 1,477,398 stock options and 1,534,908 restricted shares and units to certain employees and directors with weighted average grant-date fair values of $8.22 and $32.09, respectively. The 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 able to retain the award without continuing to provide service. For employees near retirement eligibility, attribution of compensation cost is recognized over the period from the grant date to the retirement eligibility date.
 
Share Repurchases 
The board of directors of Arch Capital has authorized the investment in Arch Capital’s common shares through a share repurchase program. Since the inception of the share repurchase program, Arch Capital has repurchased 382.2 million common shares for an aggregate purchase price of $3.86 billion. For the six months ended June 30, 2018, Arch Capital repurchased 6,522,645 shares under the share repurchase program with an aggregate purchase price of $173.6 million. Arch Capital did not repurchase any shares under the share repurchase program during the six months ended June 30, 2017. At June 30, 2018, $272.9 million of share repurchases were available under the program, which may be effected from time to time in open market or privately negotiated transactions through December 31, 2019. 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.
Conversion of Convertible Non-Voting Common Equivalent Preferred Shares  
In March 2018, Arch Capital completed an underwritten public secondary offering of 17,022,600 common shares (split adjusted) by American International Group, Inc. (“AIG”) following transfer of 567,420 Series D convertible non-voting common equivalent preferred shares (“Series D Preferred Shares”). Proceeds from the sale of common shares pursuant to the public offering were received by AIG. At June 30, 2018, no Series D Preferred Shares were outstanding.
Series C Preferred Shares
On January 2, 2018, Arch Capital redeemed all outstanding 6.75% Series C non-cumulative preferred shares. The preferred shares were redeemed at a redemption price equal to $25 per share, plus all declared and unpaid dividends to (but excluding) the redemption date. In accordance with GAAP, following the redemption, original issuance costs related to such shares have been removed from additional paid-in capital and recorded as a “loss on redemption of preferred shares.” Such adjustment had no impact on total shareholders’ equity or cash flows.

ARCH CAPITAL
 12
2018 SECOND QUARTER FORM 10-Q

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

4.    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,
 
2018
 
2017
 
2018
 
2017
Numerator:
 
 
 
 
 
 
 
Net income
$
256,347

 
$
199,099

 
$
422,731

 
$
473,134

Amounts attributable to noncontrolling interests
(12,701
)
 
(13,932
)
 
(28,662
)
 
(34,840
)
Net income available to Arch
243,646

 
185,167

 
394,069

 
438,294

Preferred dividends
(10,403
)
 
(11,349
)
 
(20,840
)
 
(22,567
)
Loss on redemption of preferred shares

 

 
(2,710
)
 

Net income available to Arch common shareholders
$
233,243

 
$
173,818

 
$
370,519

 
$
415,727

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding
404,800,421

 
369,027,702

 
399,485,135

 
366,436,407

Series D preferred shares (1)

 
34,432,290

 
6,677,373

 
36,349,722

Weighted average common shares and common share equivalents outstanding — basic
404,800,421

 
403,459,992

 
406,162,508

 
402,786,129

Effect of dilutive common share equivalents:
 
 
 
 
 
 
 
Nonvested restricted shares
1,575,749

 
4,448,889

 
1,837,356

 
4,670,889

Stock options (2)
6,735,035

 
9,825,057

 
7,460,892

 
9,964,878

Weighted average common shares and common share equivalents outstanding — diluted
413,111,205

 
417,733,938

 
415,460,756

 
417,421,896

 
 
 
 
 
 
 
 
Earnings per common share:
 
 
 
 
 
 
 
Basic
$
0.58

 
$
0.43

 
$
0.91

 
$
1.03

Diluted
$
0.56

 
$
0.42

 
$
0.89

 
$
1.00

(1)
Such shares are convertible non-voting common equivalent preferred shares issued in connection with the UGC acquisition. See Note 3.
(2)
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 2018 second quarter and 2017 second quarter, the number of stock options excluded were 5,350,733 and 1,499,997, respectively. For the six months ended June 30, 2018 and 2017, the number of stock options excluded were 5,372,789 and 2,292,228, respectively.

ARCH CAPITAL
 13
2018 SECOND QUARTER FORM 10-Q

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

5.    Segment Information

The Company 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 President and Chief Executive Officer of Arch Capital, and the Chief Financial Officer of Arch Capital. 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 insurance segment consists of the Company’s insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: construction and national accounts; excess and surplus casualty; lenders products; professional lines; programs; property, energy, marine and aviation; travel, accident and health; and other (consisting of alternative markets, excess workers' compensation and surety business).
The reinsurance segment consists of the Company’s reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: casualty; marine and aviation; other specialty; property catastrophe; property excluding property catastrophe (losses on a single risk, both excess of loss and pro rata); and other (consisting of life reinsurance, casualty clash and other).
The mortgage segment includes the Company’s U.S. and international mortgage insurance and reinsurance operations as well as government sponsored enterprise (“GSE”) credit-risk sharing transactions. Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (combined “Arch MI U.S.”) are approved as eligible mortgage insurers by Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), each a GSE.
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, UGC transaction costs and other, interest expense, items related to the Company’s non-cumulative preferred shares, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and income taxes. Such amounts exclude the results of the ‘other’ segment.
The ‘other’ segment includes the results of Watford Re (see Note 11). Watford Re 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.

ARCH CAPITAL
 14
2018 SECOND QUARTER FORM 10-Q

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 Arch common shareholders:
 
Three Months Ended
 
June 30, 2018
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
769,372

 
$
490,327

 
$
330,990

 
$
1,591,202

 
$
175,175

 
$
1,696,544

Premiums ceded
(245,265
)
 
(136,247
)
 
(50,867
)
 
(432,892
)
 
(34,589
)
 
(397,648
)
Net premiums written
524,107

 
354,080

 
280,123

 
1,158,310

 
140,586

 
1,298,896

Change in unearned premiums
22,342

 
(13,762
)
 
10,355

 
18,935

 
18,932

 
37,867

Net premiums earned
546,449

 
340,318

 
290,478

 
1,177,245

 
159,518

 
1,336,763

Other underwriting income (loss)

 
(129
)
 
3,315

 
3,186

 
688

 
3,874

Losses and loss adjustment expenses
(357,465
)
 
(229,956
)
 
(21,591
)
 
(609,012
)
 
(117,141
)
 
(726,153
)
Acquisition expenses
(90,670
)
 
(50,142
)
 
(27,737
)
 
(168,549
)
 
(34,289
)
 
(202,838
)
Other operating expenses
(92,680
)
 
(35,678
)
 
(38,729
)
 
(167,087
)
 
(9,094
)
 
(176,181
)
Underwriting income (loss)
$
5,634

 
$
24,413

 
$
205,736

 
235,783

 
(318
)
 
235,465

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
107,761

 
27,907

 
135,668

Net realized gains (losses)
 
 
 
 
 
 
(59,545
)
 
(17,066
)
 
(76,611
)
Net impairment losses recognized in earnings
 
 
 
 
 
 
(470
)
 

 
(470
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
8,472

 

 
8,472

Other income (loss)
 
 
 
 
 
 
3,113

 

 
3,113

Corporate expenses (2)
 
 
 
 
 
 
(15,604
)
 

 
(15,604
)
UGC transaction costs and other (2)
 
 
 
 
 
 
(6,908
)
 

 
(6,908
)
Amortization of intangible assets
 
 
 
 
 
 
(26,472
)
 

 
(26,472
)
Interest expense
 
 
 
 
 
 
(26,058
)
 
(4,286
)
 
(30,344
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
46,211

 
7,495

 
53,706

Income before income taxes
 
 
 
 
 
 
266,283

 
13,732

 
280,015

Income tax expense
 
 
 
 
 
 
(23,644
)
 
(24
)
 
(23,668
)
Net income
 
 
 
 
 
 
242,639

 
13,708

 
256,347

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(4,585
)
 
(4,585
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 

 
(8,116
)
 
(8,116
)
Net income available to Arch
 
 
 
 
 
 
242,639

 
1,007

 
243,646

Preferred dividends
 
 
 
 
 
 
(10,403
)
 

 
(10,403
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
232,236

 
$
1,007

 
$
233,243

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
65.4
%
 
67.6
%
 
7.4
%
 
51.7
%
 
73.4
%
 
54.3
%
Acquisition expense ratio
16.6
%
 
14.7
%
 
9.5
%
 
14.3
%
 
21.5
%
 
15.2
%
Other operating expense ratio
17.0
%
 
10.5
%
 
13.3
%
 
14.2
%
 
5.7
%
 
13.2
%
Combined ratio
99.0
%
 
92.8
%
 
30.2
%
 
80.2
%
 
100.6
%
 
82.7
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
20,724

 
$

 
$
564,634

 
$
585,358

 
$
7,650

 
$
593,008

(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)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’


ARCH CAPITAL
 15
2018 SECOND QUARTER FORM 10-Q

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

 
Three Months Ended
 
June 30, 2017
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
743,902

 
$
453,186

 
$
336,226

 
$
1,533,142

 
$
152,813

 
$
1,609,659

Premiums ceded
(247,446
)
 
(115,262
)
 
(62,314
)
 
(424,850
)
 
(12,410
)
 
(360,964
)
Net premiums written
496,456

 
337,924

 
273,912

 
1,108,292

 
140,403

 
1,248,695

Change in unearned premiums
21,118

 
(23,222
)
 
(16,068
)
 
(18,172
)
 
10,351

 
(7,821
)
Net premiums earned
517,574

 
314,702

 
257,844

 
1,090,120

 
150,754

 
1,240,874

Other underwriting income (loss)

 
(279
)
 
4,277

 
3,998

 
824

 
4,822

Losses and loss adjustment expenses
(350,939
)
 
(207,606
)
 
(20,694
)
 
(579,239
)
 
(110,621
)
 
(689,860
)
Acquisition expenses
(78,872
)
 
(51,151
)
 
(25,666
)
 
(155,689
)
 
(34,747
)
 
(190,436
)
Other operating expenses
(92,267
)
 
(36,711
)
 
(32,150
)
 
(161,128
)
 
(8,853
)
 
(169,981
)
Underwriting income (loss)
$
(4,504
)
 
$
18,955

 
$
183,611

 
198,062

 
(2,643
)
 
195,419

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
92,520

 
18,604

 
111,124

Net realized gains (losses)
 
 
 
 
 
 
18,046

 
3,689

 
21,735

Net impairment losses recognized in earnings
 
 
 
 
 
 
(1,730
)
 

 
(1,730
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
32,706

 

 
32,706

Other income (loss)
 
 
 
 
 
 
(1,994
)
 

 
(1,994
)
Corporate expenses (2)
 
 
 
 
 
 
(22,201
)
 

 
(22,201
)
UGC transaction costs and other (2)
 
 
 
 
 
 
(2,675
)
 

 
(2,675
)
Amortization of intangible assets
 
 
 
 
 
 
(30,824
)
 

 
(30,824
)
Interest expense
 
 
 
 
 
 
(25,912
)
 
(2,837
)
 
(28,749
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
(37,821
)
 
(1,722
)
 
(39,543
)
Income before income taxes
 
 
 
 
 
 
218,177

 
15,091

 
233,268

Income tax expense
 
 
 
 
 
 
(34,169
)
 

 
(34,169
)
Net income
 
 
 
 
 
 
184,008

 
15,091

 
199,099

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(4,586
)
 
(4,586
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 

 
(9,346
)
 
(9,346
)
Net income available to Arch
 
 
 
 
 
 
184,008

 
1,159

 
185,167

Preferred dividends
 
 
 
 
 
 
(11,349
)
 

 
(11,349
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
172,659

 
$
1,159

 
$
173,818

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
67.8
%
 
66.0
%
 
8.0
%
 
53.1
%
 
73.4
%
 
55.6
%
Acquisition expense ratio
15.2
%
 
16.3
%
 
10.0
%
 
14.3
%
 
23.0
%
 
15.3
%
Other operating expense ratio
17.8
%
 
11.7
%
 
12.5
%
 
14.8
%
 
5.9
%
 
13.7
%
Combined ratio
100.8
%
 
94.0
%
 
30.5
%
 
82.2
%
 
102.3
%
 
84.6
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
24,480

 
$
609

 
$
680,236

 
$
705,325

 
$
7,650

 
$
712,975


(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)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’


ARCH CAPITAL
 16
2018 SECOND QUARTER FORM 10-Q

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

 
Six Months Ended
 
June 30, 2018
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
1,592,750

 
$
1,067,810

 
$
652,168

 
$
3,312,807

 
$
389,045

 
$
3,534,758

Premiums ceded
(492,445
)
 
(331,977
)
 
(97,004
)
 
(921,505
)
 
(68,907
)
 
(823,318
)
Net premiums written
1,100,305

 
735,833

 
555,164

 
2,391,302

 
320,138

 
2,711,440

Change in unearned premiums
(15,119
)
 
(116,343
)
 
15,556

 
(115,906
)
 
(23,872
)
 
(139,778
)
Net premiums earned
1,085,186

 
619,490

 
570,720

 
2,275,396

 
296,266

 
2,571,662

Other underwriting income (loss)

 
1,103

 
6,731

 
7,834

 
1,389

 
9,223

Losses and loss adjustment expenses
(711,195
)
 
(371,631
)
 
(65,057
)
 
(1,147,883
)
 
(215,130
)
 
(1,363,013
)
Acquisition expenses
(175,839
)
 
(98,461
)
 
(54,304
)
 
(328,604
)
 
(65,610
)
 
(394,214
)
Other operating expenses
(184,654
)
 
(71,249
)
 
(77,500
)
 
(333,403
)
 
(17,793
)
 
(351,196
)
Underwriting income (loss)
$
13,498

 
$
79,252

 
$
380,590

 
473,340

 
(878
)
 
472,462

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
208,004

 
54,388

 
262,392

Net realized gains (losses)
 
 
 
 
 
 
(171,404
)
 
(16,205
)
 
(187,609
)
Net impairment losses recognized in earnings
 
 
 
 
 
 
(632
)
 

 
(632
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
36,541

 

 
36,541

Other income (loss)
 
 
 
 
 
 
3,187

 

 
3,187

Corporate expenses (2)
 
 
 
 
 
 
(30,086
)
 

 
(30,086
)
UGC transaction costs and other (2)
 
 
 
 
 
 
(7,738
)
 

 
(7,738
)
Amortization of intangible assets
 
 
 
 
 
 
(53,208
)
 

 
(53,208
)
Interest expense
 
 
 
 
 
 
(51,965
)
 
(9,015
)
 
(60,980
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
31,172

 
2,813

 
33,985

Income before income taxes
 
 
 
 
 
 
437,211

 
31,103

 
468,314

Income tax expense
 
 
 
 
 
 
(45,556
)
 
(27
)
 
(45,583
)
Net income
 
 
 
 
 
 
391,655

 
31,076

 
422,731

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(9,170
)
 
(9,170
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 

 
(19,492
)
 
(19,492
)
Net income available to Arch
 
 
 
 
 
 
391,655

 
2,414

 
394,069

Preferred dividends
 
 
 
 
 
 
(20,840
)
 

 
(20,840
)
Loss on redemption of preferred shares
 
 
 
 
 
 
(2,710
)
 

 
(2,710
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
368,105

 
$
2,414

 
$
370,519

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
65.5
%
 
60.0
%
 
11.4
%
 
50.4
%
 
72.6
%
 
53.0
%
Acquisition expense ratio
16.2
%
 
15.9
%
 
9.5
%
 
14.4
%
 
22.1
%
 
15.3
%
Other operating expense ratio
17.0
%
 
11.5
%
 
13.6
%
 
14.7
%
 
6.0
%
 
13.7
%
Combined ratio
98.7
%
 
87.4
%
 
34.5
%
 
79.5
%
 
100.7
%
 
82.0
%
(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)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’

ARCH CAPITAL
 17
2018 SECOND QUARTER FORM 10-Q

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

 
Six Months Ended
 
June 30, 2017
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
1,526,183

 
$
928,968

 
$
684,849

 
$
3,139,828

 
$
306,933

 
$
3,267,649

Premiums ceded
(481,541
)
 
(281,354
)
 
(136,239
)
 
(898,962
)
 
(22,844
)
 
(742,694
)
Net premiums written
1,044,642

 
647,614

 
548,610

 
2,240,866

 
284,089

 
2,524,955

Change in unearned premiums
(21,422
)
 
(88,061
)
 
(46,243
)
 
(155,726
)
 
(11,338
)
 
(167,064
)
Net premiums earned
1,023,220

 
559,553

 
502,367

 
2,085,140

 
272,751

 
2,357,891

Other underwriting income (loss)

 
(585
)
 
8,400

 
7,815

 
1,640

 
9,455

Losses and loss adjustment expenses
(683,580
)
 
(313,060
)
 
(49,759
)
 
(1,046,399
)
 
(196,031
)
 
(1,242,430
)
Acquisition expenses
(153,740
)
 
(97,298
)
 
(54,432
)
 
(305,470
)
 
(67,255
)
 
(372,725
)
Other operating expenses
(180,393
)
 
(74,244
)
 
(74,020
)
 
(328,657
)
 
(16,043
)
 
(344,700
)
Underwriting income (loss)
$
5,507

 
$
74,366

 
$
332,556

 
412,429

 
(4,938
)
 
407,491

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
188,332

 
40,666

 
228,998

Net realized gains (losses)
 
 
 
 
 
 
46,558

 
9,330

 
55,888

Net impairment losses recognized in earnings
 
 
 
 
 
 
(3,537
)
 

 
(3,537
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
80,794

 

 
80,794

Other income (loss)
 
 
 
 
 
 
(2,776
)
 

 
(2,776
)
Corporate expenses (2)
 
 
 
 
 
 
(34,409
)
 

 
(34,409
)
UGC transaction costs and other (2)
 
 
 
 
 
 
(18,259
)
 

 
(18,259
)
Amortization of intangible assets
 
 
 
 
 
 
(62,118
)
 

 
(62,118
)
Interest expense
 
 
 
 
 
 
(51,668
)
 
(5,757
)
 
(57,425
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
(57,666
)
 
(1,281
)
 
(58,947
)
Income before income taxes
 
 
 
 
 
 
497,680

 
38,020

 
535,700

Income tax expense
 
 
 
 
 
 
(62,566
)
 

 
(62,566
)
Net income
 
 
 
 
 
 
435,114

 
38,020

 
473,134

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(9,170
)
 
(9,170
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 

 
(25,670
)
 
(25,670
)
Net income available to Arch
 
 
 
 
 
 
435,114

 
3,180

 
438,294

Preferred dividends
 
 
 
 
 
 
(22,567
)
 

 
(22,567
)
Net income available to Arch common shareholders
 
 
 
 
 
 
$
412,547

 
$
3,180

 
$
415,727

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
66.8
%
 
55.9
%
 
9.9
%
 
50.2
%
 
71.9
%
 
52.7
%
Acquisition expense ratio
15.0
%
 
17.4
%
 
10.8
%
 
14.6
%
 
24.7
%
 
15.8
%
Other operating expense ratio
17.6
%
 
13.3
%
 
14.7
%
 
15.8
%
 
5.9
%
 
14.6
%
Combined ratio
99.4
%
 
86.6
%
 
35.4
%
 
80.6
%
 
102.5
%
 
83.1
%

(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)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’


ARCH CAPITAL
 18
2018 SECOND QUARTER FORM 10-Q

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

6.    Reserve for Losses and Loss Adjustment Expenses

The following table represents an analysis of losses and loss adjustment expenses and a reconciliation of the beginning and ending reserve for losses and loss adjustment expenses:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2018
 
2017
 
2018
 
2017
Reserve for losses and loss adjustment expenses at beginning of period
$
11,496,205

 
$
10,296,821

 
$
11,383,792

 
$
10,200,960

Unpaid losses and loss adjustment expenses recoverable
2,446,990

 
2,095,130

 
2,464,910

 
2,083,575

Net reserve for losses and loss adjustment expenses at beginning of period
9,049,215

 
8,201,691

 
8,918,882

 
8,117,385

 
 
 
 
 
 
 
 
Net incurred losses and loss adjustment expenses relating to losses occurring in:
 
 
 
 
 
 
 
Current year
790,742

 
759,261

 
1,478,627

 
1,395,037

Prior years
(64,589
)
 
(69,401
)
 
(115,614
)
 
(152,607
)
Total net incurred losses and loss adjustment expenses
726,153

 
689,860

 
1,363,013

 
1,242,430

 
 
 
 
 
 
 
 
Retroactive reinsurance transaction (1)
(420,404
)
 

 
(420,404
)
 

 
 
 
 
 
 
 
 
Net foreign exchange (gains) losses
(118,542
)
 
75,295

 
(74,528
)
 
106,574

 
 
 
 
 
 
 
 
Net paid losses and loss adjustment expenses relating to losses occurring in:
 
 
 
 
 
 
 
Current year
(59,022
)
 
(80,499
)
 
(95,022
)
 
(115,502
)
Prior years
(404,812
)
 
(482,046
)
 
(919,353
)
 
(946,586
)
Total net paid losses and loss adjustment expenses
(463,834
)
 
(562,545
)
 
(1,014,375
)
 
(1,062,088
)
 
 
 
 
 
 
 
 
Net reserve for losses and loss adjustment expenses at end of period
8,772,588

 
8,404,301

 
8,772,588

 
8,404,301

Unpaid losses and loss adjustment expenses recoverable
2,651,749

 
2,116,210

 
2,651,749

 
2,116,210

Reserve for losses and loss adjustment expenses at end of period
$
11,424,337

 
$
10,520,511

 
$
11,424,337

 
$
10,520,511

(1)
During the 2018 second quarter, a subsidiary of the Company entered into a retroactive reinsurance transaction with a third party reinsurer to reinsure run-off liabilities associated with certain discontinued U.S. specialty casualty and program exposures.

Development on Prior Year Loss Reserves

2018 Second Quarter

During the 2018 second quarter, the Company recorded net favorable development on prior year loss reserves of $64.6 million, which consisted of $33.0 million from the reinsurance segment, $6.1 million from the insurance segment, $23.3 million from the mortgage segment and $2.2 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $33.0 million, or 9.7 loss ratio points, for the 2018 second quarter consisted of $22.2 million from short-tailed lines and $10.8 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $19.3 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years (i.e., all premiums and losses attributable to contracts having an inception or renewal date within the given twelve-month period), reflecting lower 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 and medium-tailed lines reflected
 
reductions in marine reserves of $3.8 million, across most accident years, and in casualty reserves of $6.9 million based on varying levels of reported and paid claims activity, primarily from the 2003 to 2010 underwriting years.
The insurance segment’s net favorable development of $6.1 million, or 1.1 loss ratio points, for the 2018 second quarter consisted of $13.9 million of net favorable development in short-tailed lines and $14.3 million of net favorable development in long-tailed lines, partially offset by $22.1 million of net adverse development in medium-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2010 to 2017 accident years (i.e., the year in which a loss occurred) while net favorable development in long-tailed lines primarily resulted from reductions in executive assurance reserves of $6.9 million, primarily from the 2007 to 2011 accident years, and in healthcare reserves of $4.9 million, primarily from the 2003 accident year. Net adverse development in medium-tailed lines reflected $11.6 million of adverse development in program business, primarily driven by a few inactive programs that were non-renewed in 2015 and early in 2016 and $18.0 million of adverse development on

ARCH CAPITAL
 19
2018 SECOND QUARTER FORM 10-Q

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

contract binding business, primarily from the 2014 to 2016 accident years. Such amounts were partially offset by $7.6 million of net favorable development in other medium-tailed lines, including professional liability and surety business, across most accident years.
The mortgage segment’s net favorable development was $23.3 million, or 8.0 loss ratio points, for the 2018 second quarter. The 2018 second quarter development was primarily driven by continued lower than expected claim rates on first lien business and subrogation recoveries on second lien business at Arch MI U.S.
2017 Second Quarter
During the 2017 second quarter, the Company recorded net favorable development on prior year loss reserves of $69.4 million, which consisted of $39.5 million from the reinsurance segment, $2.0 million from the insurance segment, $29.8 million from the mortgage segment and adverse development of $1.9 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $39.5 million, or 12.6 loss ratio points, for the 2017 second quarter consisted of $28.1 million from short-tailed lines and $11.4 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $16.9 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years, reflecting lower 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 and medium-tailed lines reflected reductions in casualty reserves of $9.0 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2004 underwriting years, and favorable development in marine reserves of $2.4 million across most underwriting years.
The insurance segment’s net favorable development of $2.0 million, or 0.4 loss ratio points, for the 2017 second quarter consisted of $5.3 million of net favorable development in short-tailed lines, partially offset by $3.3 million of net adverse development in medium-tailed and long-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2012 to 2016 accident years. Net adverse development in medium-tailed and long-tailed lines reflected $12.2 million of adverse development on programs, primarily on a small number of programs in the 2014 and 2015 accident years, and $8.9 million on construction reserves across various accident years. Such amounts were partially offset by net favorable development of $17.8 million in other medium-tailed lines, primarily in professional liability with $12.1 million of favorable development across most accident years, and surety with $3.6 million of favorable development.
 
The mortgage segment’s net favorable development was $29.8 million, or 11.5 loss ratio points, for the 2017 second quarter. The 2017 second quarter development was primarily driven by continued lower than expected claim rates on first lien business and subrogation recoveries on second lien business at Arch MI U.S.
Six Months Ended June 30, 2018
During the six months ended June 30, 2018, the Company recorded net favorable development on prior year loss reserves of $115.6 million, which consisted of $69.6 million from the reinsurance segment, $8.2 million from the insurance segment, $36.3 million from the mortgage segment and $1.6 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $69.6 million, or 11.2 loss ratio points, for the 2018 period consisted of $51.1 million from short-tailed lines and $18.5 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $40.4 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years, reflecting lower 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 and medium-tailed lines reflected reductions in casualty reserves of $8.1 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2010 underwriting years, and favorable development in marine reserves of $10.0 million across most underwriting years.
The insurance segment’s net favorable development of $8.2 million, or 0.8 loss ratio points, for the 2018 period consisted of $22.7 million of net favorable development in short-tailed lines and $17.2 million of net favorable development in long-tailed lines, partially offset by $31.7 million of net adverse development in medium-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2010 and 2017 accident years. Net favorable development in long-tailed lines reflected net reductions in executive assurance reserves of $7.5 million, primarily from the 2008 to 2015 accident years, and in healthcare reserves of $7.0 million, primarily from the 2003 accident year. Net adverse development in medium-tailed lines reflected $21.9 million of adverse development in program business, primarily driven by a few inactive programs that were non-renewed in 2015 and early in 2016 and $25.6 million of adverse development on contract binding business, primarily from the 2014 to 2016 accident years. Such amounts were partially offset by $15.8 million of net favorable development in other medium-tailed lines, including professional liability and surety business, across most accident years.
The mortgage segment’s net favorable development was $36.3 million, or 6.4 loss ratio points, for the 2018 period. The 2018

ARCH CAPITAL
 20
2018 SECOND QUARTER FORM 10-Q

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

development was primarily driven by continued lower than expected claim rates on first lien business and subrogation recoveries on second lien business at Arch MI U.S.
Six Months Ended June 30, 2017
During the six months ended June 30, 2017, the Company recorded net favorable development on prior year loss reserves of $152.6 million, which consisted of $96.8 million from the reinsurance segment, $4.1 million from the insurance segment, $53.4 million from the mortgage segment and adverse development of $1.7 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $96.8 million, or 17.3 loss ratio points, for the 2017 period consisted of $68.9 million from short-tailed lines and $27.9 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $51.0 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years, reflecting lower 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 and medium-tailed lines reflected reductions in casualty reserves of $15.6 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2013 underwriting years, and favorable development in marine reserves of $12.3 million across most underwriting years.
The insurance segment’s net favorable development of $4.1 million, or 0.4 loss ratio points, for the 2017 period consisted of $7.2 million of net favorable development in short-tailed lines and $6.6 million of net favorable development in long-tailed lines, partially offset by $9.7 million of net adverse development in medium-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2011 to 2016 accident years. Net favorable development in long-tailed lines reflected net reductions in executive assurance reserves from the 2008 to 2014 accident years and reductions in healthcare reserves across various accident years, partially offset by $13.4 million of net adverse development on construction reserves across various accident years. Net adverse development in medium-tailed lines primarily resulted from an increase in programs of $26.4 million stemming in part from development on a small number of programs in the 2013 to 2015 accident years, partially offset by net favorable development of $16.7 million in other medium-tailed lines, primarily in professional liability and surety.
The mortgage segment’s net favorable development was $53.4 million, or 10.6 loss ratio points, for the 2017 period. The 2017 development was primarily driven by continued lower than expected claim rates on first lien business and subrogation recoveries on second lien business at Arch MI U.S.

ARCH CAPITAL
 21
2018 SECOND QUARTER FORM 10-Q

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

7.    Investment Information


At June 30, 2018, total investable assets of $21.82 billion included $19.17 billion held by the Company and $2.65 billion attributable to Watford Re.
Available For Sale Investments
The following table summarizes the fair value and cost or amortized cost of the Company’s securities classified as available for sale:
 
Estimated
Fair
Value
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Cost or
Amortized
Cost
 
OTTI
Unrealized
Losses (2)
June 30, 2018
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
Corporate bonds
$
5,535,763

 
$
7,199

 
$
(103,978
)
 
$
5,632,542

 
$
(69
)
Mortgage backed securities
488,699

 
1,699

 
(4,742
)
 
491,742

 
(15
)
Municipal bonds
1,431,256

 
7,371

 
(22,047
)
 
1,445,932

 

Commercial mortgage backed securities
590,198

 
776

 
(13,222
)
 
602,644

 

U.S. government and government agencies
2,788,272

 
6,216

 
(19,577
)
 
2,801,633

 

Non-U.S. government securities
1,692,783

 
17,124

 
(27,480
)
 
1,703,139

 

Asset backed securities
1,820,489

 
3,310

 
(16,574
)
 
1,833,753

 

Total
14,347,460

 
43,695

 
(207,620
)
 
14,511,385

 
(84
)
Equity securities (3)
 
 
 
 
 
 
 
 
 
Other investments

 

 

 

 

Short-term investments
1,096,798

 
338

 
(72
)
 
1,096,532

 

Total
$
15,444,258

 
$
44,033

 
$
(207,692
)
 
$
15,607,917

 
$
(84
)
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
Corporate bonds
$
4,434,439

 
$
30,943

 
$
(32,340
)
 
$
4,435,836

 
$
(73
)
Mortgage backed securities
316,141

 
1,640

 
(2,561
)
 
317,062

 
(15
)
Municipal bonds
2,158,840

 
20,285

 
(12,308
)
 
2,150,863

 

Commercial mortgage backed securities
545,817

 
2,131

 
(4,268
)
 
547,954

 

U.S. government and government agencies
3,484,257

 
2,188

 
(28,769
)
 
3,510,838

 

Non-U.S. government securities
1,612,754

 
48,764

 
(17,321
)
 
1,581,311

 

Asset backed securities
1,780,143

 
5,147

 
(8,614
)
 
1,783,610

 

Total
14,332,391

 
111,098

 
(106,181
)
 
14,327,474

 
(88
)
Equity securities
504,333

 
88,739

 
(5,583
)
 
421,177

 

Other investments
264,989

 
66,946

 
(120
)
 
198,163

 

Short-term investments
1,469,042

 
650

 
(563
)
 
1,468,955

 

Total
$
16,570,755

 
$
267,433

 
$
(112,447
)
 
$
16,415,769

 
$
(88
)
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. 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, 2018, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $0.2 million, compared to a net unrealized gain of $0.3 million at December 31, 2017.
(3)
Effective January 1, 2018, the Company adopted new accounting guidance for financial instruments (see Note 2). As a result, equity securities are no longer accounted for as available for sale and are excluded from this table.


ARCH CAPITAL
 22
2018 SECOND QUARTER FORM 10-Q

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

The following table summarizes, for all available for sale securities in an unrealized loss position, the fair value and gross unrealized loss by length of time the security has been in a continual unrealized loss position:
 
Less than 12 Months
 
12 Months or More
 
Total
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
 
 
Corporate bonds
$
4,541,077

 
$
(94,563
)
 
$
236,332

 
$
(9,415
)
 
$
4,777,409

 
$
(103,978
)
Mortgage backed securities
296,876

 
(4,618
)
 
708

 
(124
)
 
297,584

 
(4,742
)
Municipal bonds
814,694

 
(16,888
)
 
109,913

 
(5,159
)
 
924,607

 
(22,047
)
Commercial mortgage backed securities
351,013

 
(9,067
)
 
56,382

 
(4,155
)
 
407,395

 
(13,222
)
U.S. government and government agencies
1,957,338

 
(18,470
)
 
41,069

 
(1,107
)
 
1,998,407

 
(19,577
)
Non-U.S. government securities
1,243,055

 
(24,034
)
 
160,434

 
(3,446
)
 
1,403,489

 
(27,480
)
Asset backed securities
1,377,269

 
(14,096
)
 
110,507

 
(2,478
)
 
1,487,776

 
(16,574
)
Total
10,581,322

 
(181,736
)
 
715,345

 
(25,884
)
 
11,296,667

 
(207,620
)
Equity securities (2)
 
 
 
 
 
 
 
 
 
 
 
Other investments

 

 

 

 

 

Short-term investments
53,937

 
(72
)
 

 

 
53,937

 
(72
)
Total
$
10,635,259

 
$
(181,808
)
 
$
715,345

 
$
(25,884
)
 
$
11,350,604

 
$
(207,692
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
 
 
Corporate bonds
$
2,320,716

 
$
(25,411
)
 
$
279,082

 
$
(6,929
)
 
$
2,599,798

 
$
(32,340
)
Mortgage backed securities
221,113

 
(1,715
)
 
28,380

 
(846
)
 
249,493

 
(2,561
)
Municipal bonds
1,030,389

 
(8,438
)
 
132,469

 
(3,870
)
 
1,162,858

 
(12,308
)
Commercial mortgage backed securities
225,164

 
(1,899
)
 
57,291

 
(2,369
)
 
282,455

 
(4,268
)
U.S. government and government agencies
2,646,415

 
(26,501
)
 
111,879

 
(2,268
)
 
2,758,294

 
(28,769
)
Non-U.S. government securities
1,218,514

 
(15,546
)
 
93,530

 
(1,775
)
 
1,312,044

 
(17,321
)
Asset backed securities
1,111,246

 
(5,915
)
 
209,207

 
(2,699
)
 
1,320,453

 
(8,614
)
Total
8,773,557

 
(85,425
)
 
911,838

 
(20,756
)
 
9,685,395

 
(106,181
)
Equity securities
166,562

 
(5,583
)
 

 

 
166,562

 
(5,583
)
Other investments
15,025

 
(120
)
 

 

 
15,025

 
(120
)
Short-term investments
109,528

 
(563
)
 

 

 
109,528

 
(563
)
Total
$
9,064,672

 
$
(91,691
)
 
$
911,838

 
$
(20,756
)
 
$
9,976,510

 
$
(112,447
)
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See “—Securities Lending Agreements.”
(2)
Effective January 1, 2018, the Company adopted new accounting guidance for financial instruments (see Note 2). As a result, equity securities are no longer accounted for as available for sale and are excluded from this table.

At June 30, 2018, on a lot level basis, approximately 5,440 security lots out of a total of approximately 7,450 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 $1.7 million. At December 31, 2017, on a lot level basis, approximately 3,830 security lots out of a total of approximately 7,450 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 $1.3 million.

ARCH CAPITAL
 23
2018 SECOND QUARTER FORM 10-Q

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

The contractual maturities of the Company’s fixed maturities 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, 2018
 
December 31, 2017
Maturity
 
Estimated
Fair
Value
 
Amortized
Cost
 
Estimated
Fair
Value
 
Amortized
Cost
Due in one year or less
 
$
344,007

 
$
343,938

 
$
550,711

 
$
548,771

Due after one year through five years
 
8,154,773

 
8,235,481

 
7,436,153

 
7,434,801

Due after five years through 10 years
 
2,703,341

 
2,756,097

 
3,369,635

 
3,369,750

Due after 10 years
 
245,953

 
247,730

 
333,791

 
325,526

 
 
11,448,074

 
11,583,246

 
11,690,290

 
11,678,848

Mortgage backed securities
 
488,699

 
491,742

 
316,141

 
317,062

Commercial mortgage backed securities
 
590,198

 
602,644

 
545,817

 
547,954

Asset backed securities
 
1,820,489

 
1,833,753

 
1,780,143

 
1,783,610

Total (1)
 
$
14,347,460

 
$
14,511,385

 
$
14,332,391

 
$
14,327,474

(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the securities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See “—Securities Lending Agreements.”
 
Securities Lending Agreements
The Company enters into securities lending agreements with financial institutions to enhance investment income whereby it loans certain of its securities to third parties, primarily major brokerage firms, for short periods of time through a lending agent. The Company maintains legal control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. 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 from the Company.
The Company receives collateral in the form of cash or securities. Cash collateral primarily consists of short term investments. At June 30, 2018, the fair value of the cash collateral received on securities lending was $28.0 million and the fair value of security collateral received was $209.0 million. At December 31, 2017, the fair value of the cash collateral received on securities lending was $199.9 million, and the fair value of security collateral received was $276.7 million.
The Company’s securities lending transactions were accounted for as secured borrowings with significant investment categories as follows:
 
 
Remaining Contractual Maturity of the Agreements
 
 
Overnight and Continuous
 
Less than 30 Days
 
30-90 Days
 
90 Days or More
 
Total
June 30, 2018
 
 
 
 
 
 
 
 
 
 
U.S. government and government agencies
 
$
147,509

 
$

 
$
48,268

 
$

 
$
195,777

Corporate bonds
 
29,265

 

 

 

 
29,265

Equity securities
 
11,906

 

 

 

 
11,906

Total
 
$
188,680

 
$

 
$
48,268

 
$

 
$
236,948

Gross amount of recognized liabilities for securities lending in offsetting disclosure in Note 9
 
$

Amounts related to securities lending not included in offsetting disclosure in Note 9
 
$
236,948

 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
U.S. government and government agencies
 
$
343,425

 
$
20,309

 
$
76,086

 
$

 
$
439,820

Corporate bonds
 
28,003

 

 

 

 
28,003

Equity securities
 
8,782

 

 

 

 
8,782

Total
 
$
380,210

 
$
20,309

 
$
76,086

 
$

 
$
476,605

Gross amount of recognized liabilities for securities lending in offsetting disclosure in Note 9
 
$

Amounts related to securities lending not included in offsetting disclosure in Note 9
 
$
476,605


ARCH CAPITAL
 24
2018 SECOND QUARTER FORM 10-Q

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

Other Investments
The following table summarizes the Company’s other investments, including available for sale and fair value option components:
 
June 30,
2018
 
December 31,
2017
Available for sale securities:
 
 
 
Asian and emerging markets
$

 
$
135,140

Investment grade fixed income

 
53,878

Credit related funds

 
18,365

Other

 
57,606

Total available for sale (1)

 
264,989

Fair value option:
 
 
 
Term loan investments (par value: $1,321,154 and $1,223,453)
$
1,286,305

 
$
1,200,882

Mezzanine debt funds
257,750

 
252,160

Credit related funds
199,437

 
175,422

Investment grade fixed income
98,240

 
102,347

Asian and emerging markets
350,308

 
258,541

Other (2)
136,864

 
147,029

Total fair value option
2,328,904

 
2,136,381

Total
$
2,328,904

 
$
2,401,370

(1)
The Company reviewed the accounting treatment for three limited partnership investments which were accounted for as available for sale at December 31, 2017 during the 2018 first quarter and determined, based on reconsideration during the period of the Company’s percentage ownership, that the equity method of accounting was appropriate for such investments.
(2)
Includes fund investments with strategies in mortgage servicing rights, transportation, 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 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,
2018
 
December 31,
2017
Fixed maturities
$
1,428,503

 
$
1,642,855

Other investments
2,328,904

 
2,136,381

Short-term investments
217,066

 
297,426

Equity securities
137,138

 
139,575

Investments accounted for using the fair value option
$
4,111,611

 
$
4,216,237

Limited Partnership Interests
In the normal course of its activities, the Company invests in limited partnerships as part of its overall investment strategy. Such amounts are included in ‘investments accounted for using the equity method’ and ‘investments accounted for using the fair value option.’ The Company has determined that it is not required to consolidate these investments because it is not the primary beneficiary of the funds. The Company’s maximum exposure to loss with respect to these investments is limited to the investment carrying amounts reported in the Company’s consolidated balance sheet and any unfunded commitment.
The following table summarizes investments in limited partnership interests where the Company has a variable interest by balance sheet line item:
 
June 30,
2018
 
December 31,
2017
Investments accounted for using the equity method (1)
$
1,292,573

 
$
1,041,321

Investments accounted for using the fair value option (2)
130,471

 
130,471

Total
$
1,423,044

 
$
1,171,792

(1)
Aggregate unfunded commitments were $994.7 million at June 30, 2018, compared to $1.02 billion at December 31, 2017.
(2)
Aggregate unfunded commitments were $91.0 million at June 30, 2018, compared to $100.4 million at December 31, 2017.

ARCH CAPITAL
 25
2018 SECOND QUARTER FORM 10-Q

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

Net Investment Income
The components of net investment income were derived from the following sources:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Fixed maturities
$
115,110

 
$
94,270

Equity securities
4,777

 
3,654

Short-term investments
4,392

 
2,016

Other (1)
38,168

 
34,076

Gross investment income
162,447

 
134,016

Investment expenses
(26,779
)
 
(22,892
)
Net investment income
$
135,668

 
$
111,124

 
 
 
 
Six Months Ended
 
 
 
Fixed maturities
$
222,997

 
$
188,663

Equity securities
7,345

 
6,297

Short-term investments
9,252

 
3,775

Other (1)
75,542

 
73,656

Gross investment income
315,136

 
272,391

Investment expenses
(52,744
)
 
(43,393
)
Net investment income
$
262,392

 
$
228,998

(1)
Includes income distributions from investment funds, term loan investments and other items.
Equity in Net Income (Loss) of Investment Funds Accounted for Using the Equity Method
The Company recorded $8.5 million of equity in net income related to investment funds accounted for using the equity method in the 2018 second quarter, compared to $32.7 million for the 2017 second quarter, and $36.5 million for the six months ended June 30, 2018, compared to $80.8 million for the 2017 period. In applying the equity method, investments are initially recorded at cost and are subsequently adjusted based on the Company’s 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 are generally recorded on a one to three month lag based on the availability of reports from the investment funds.

 
Net Realized Gains (Losses)
Net realized gains (losses) were as follows, excluding net impairment losses recognized in earnings:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Available for sale securities:
 

 
 

Gross gains on investment sales
$
18,777

 
$
76,730

Gross losses on investment sales
(57,711
)
 
(52,619
)
Change in fair value of assets and liabilities accounted for using the fair value option:
 
 
 
Fixed maturities
(22,927
)
 
9,656

Other investments
(254
)
 
637

Equity securities
1,230

 
2,829

Short-term investments
(136
)
 
3,328

Equity securities, at fair value (1):
 
 
 
Net realized gains (losses) on sales during the period
(5,918
)
 

Net unrealized gains (losses) on equity securities still held at reporting date
(7,278
)
 

Derivative instruments (2)
(2,146
)
 
(4,770
)
Other (3)
(248
)
 
(14,056
)
Net realized gains (losses)
$
(76,611
)
 
$
21,735

 
 
 
 
Six Months Ended
 
 
 
Available for sale securities:
 
 
 
Gross gains on investment sales
$
33,742

 
$
145,905

Gross losses on investment sales
(140,262
)
 
(113,981
)
Change in fair value of assets and liabilities accounted for using the fair value option:
 
 
 
Fixed maturities
(40,478
)
 
30,197

Other investments
(6,628
)
 
17,885

Equity securities
7,898

 
6,374

Short-term investments
(287
)
 
3,332

Equity securities, at fair value (1):
 
 
 
Net realized gains (losses) on sales during the period
(11,286
)
 

Net unrealized gains (losses) on equity securities still held at reporting date
(14,861
)
 

Derivative instruments (2)
(6,109
)
 
(13,951
)
Other (3)
(9,338
)
 
(19,873
)
Net realized gains (losses)
$
(187,609
)
 
$
55,888

(1)
Pursuant to new accounting guidance (see Note 2), changes in fair value on equity securities are recorded through net income effective January 1, 2018.
(2)
See Note 9 for information on the Company’s derivative instruments.
(3)
Includes the re-measurement of contingent consideration liability amounts.



ARCH CAPITAL
 26
2018 SECOND QUARTER FORM 10-Q

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

Net Impairment Losses Recognized in Earnings
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:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Fixed maturities:
 

 
 

Mortgage backed securities
$
(81
)
 
$
(92
)
Corporate bonds
(241
)
 
(1,401
)
Asset backed securities
(148
)
 

Municipal bonds

 
(173
)
Total
(470
)
 
(1,666
)
Other investments

 
(64
)
Net impairment losses recognized in earnings
$
(470
)
 
$
(1,730
)
 
 
 
 
Six Months Ended
 
 
 
Fixed maturities:
 
 
 
Mortgage backed securities
$
(123
)
 
$
(1,411
)
Corporate bonds
(361
)
 
(1,402
)
Non-U.S. government securities

 
(198
)
Asset backed securities
(148
)
 

Municipal bonds

 
(173
)
Total
(632
)
 
(3,184
)
Equity securities

 
(186
)
Other investments

 
(167
)
Net impairment losses recognized in earnings
$
(632
)
 
$
(3,537
)
 
Net impairment losses recognized in earnings in the 2018 periods were primarily related to foreign currency fluctuations on corporate bonds and asset backed securities.
The Company believes that the $0.1 million of OTTI included in accumulated other comprehensive income at June 30, 2018 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, 2018, 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:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Balance at start of period
$
767

 
$
12,537

Credit loss impairments recognized on securities not previously impaired

 
31

Credit loss impairments recognized on securities previously impaired

 
172

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
(69
)
 
(8,303
)
Balance at end of period
$
698

 
$
4,437

 
 
 
 
Six Months Ended
 
 
 
Balance at start of year
$
767

 
$
13,138

Credit loss impairments recognized on securities not previously impaired

 
31

Credit loss impairments recognized on securities previously impaired

 
195

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
(69
)
 
(8,927
)
Balance at end of period
$
698

 
$
4,437

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 16, “Commitments and Contingencies,” of the notes to consolidated financial statements in the Company’s 2017 Form 10-K.
The following table details the value of the Company’s restricted assets:
 
June 30,
2018
 
December 31,
2017
Assets used for collateral or guarantees:
 

 
 

Affiliated transactions
$
4,549,122

 
$
4,323,726

Third party agreements
1,537,336

 
1,674,304

Deposits with U.S. regulatory authorities
701,026

 
616,987

Deposits with non-U.S. regulatory authorities
58,371

 
55,895

Total restricted assets
$
6,845,855

 
$
6,670,912


ARCH CAPITAL
 27
2018 SECOND QUARTER FORM 10-Q

Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
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 reviews its securities measured at fair value and discusses the proper classification of such investments with investment advisers and others.
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; (iv) a comparison of the fair value estimates to the Company’s 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) periodic back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. 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 independent pricing sources at June 30, 2018.
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 $20.24 billion of financial assets and liabilities measured at fair value at June 30, 2018, approximately $276.8 million, or 1.4%, were priced using non-binding broker-dealer quotes. Of the $20.92 billion of financial assets and liabilities measured at fair value at December 31, 2017, approximately $181.5 million, or 0.9%, were priced using non-binding broker-dealer quotes.
Fixed maturities
The Company uses the market approach valuation technique to estimate the fair value of its fixed maturity securities, when possible. The market approach includes obtaining prices from independent pricing services, such as index providers and pricing vendors, as well as to a lesser extent quotes from broker-dealers. 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.

ARCH CAPITAL
 28
2018 SECOND QUARTER FORM 10-Q

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

The following describes the significant inputs generally used to determine the fair value of the Company’s fixed maturity securities by asset class:
U.S. government and government agencies — valuations provided by independent pricing services, with all prices provided through index providers and pricing vendors. 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. The fair values of U.S. government agency securities are generally determined using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.
Corporate bonds — valuations provided by independent pricing services, substantially all through index providers and pricing vendors with a small amount through broker-dealers. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. As the significant inputs used in the pricing process for corporate bonds are observable market inputs, the fair value of these securities are classified within Level 2. A small number of securities are included in Level 3 due to a low level of transparency on the inputs used in the pricing process.
Mortgage-backed securities — valuations provided by independent pricing services, substantially all through pricing vendors and index providers with a small amount through broker-dealers. The fair values of these securities are generally determined through the use of pricing models (including Option Adjusted Spread) which use spreads to determine the expected average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for mortgage-backed securities are observable market inputs, the fair value of these securities are classified within Level 2. A small number of securities are included in Level 3 due to a low level of transparency on the inputs used in the pricing process.
Municipal bonds — valuations provided by independent pricing services, with all prices provided through index providers and pricing vendors. The fair values of these securities are generally determined using spreads obtained from broker-dealers who trade in the relevant security market, trade prices and the new issue market. As the significant inputs used in the pricing process for municipal bonds are observable market inputs, the fair value of these securities are classified within Level 2.
 
Commercial mortgage-backed securities — valuations provided by independent pricing services, substantially all through index providers and pricing vendors with a small amount through broker-dealers. The fair values of these securities are generally determined through the use of pricing models which use spreads to determine the appropriate average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for commercial mortgage-backed securities are observable market inputs, the fair value of these securities are classified within Level 2. A small number of securities are included in Level 3 due to a low level of transparency on the inputs used in the pricing process.
Non-U.S. government securities — valuations provided by independent pricing services, with all prices provided through index providers and pricing vendors. The fair values of these securities are generally based on international indices or valuation models which include daily observed yield curves, cross-currency basis index spreads and country credit spreads. As the significant inputs used in the pricing process for non-U.S. government securities are observable market inputs, the fair value of these securities are classified within Level 2.
Asset-backed securities — valuations provided by independent pricing services, substantially all through index providers and pricing vendors with a small amount through broker-dealers. The fair values of these securities are generally determined through the use of pricing models (including Option Adjusted Spread) which use spreads to determine the appropriate average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for asset-backed securities are observable market inputs, the fair value of these securities are classified within Level 2. A small number of securities are included in Level 3 due to a low level of transparency on the inputs used in the pricing process.
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 Company determined that exchange-traded investments in mutual funds would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other investments also include term loan investments for which fair values are estimated by using quoted prices of term loan

ARCH CAPITAL
 29
2018 SECOND QUARTER FORM 10-Q

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

investments with similar characteristics, pricing models or matrix pricing. Such investments are generally classified within Level 2. The fair values for certain of the Company’s other investments are determined using net asset values as advised by external fund managers. The net asset value is based on the fund manager’s valuation of the underlying holdings in accordance with the fund’s governing documents. In accordance with applicable accounting guidance, certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy. A small number of securities are included in Level 3 due to the lack of an available independent price source for such securities.
Derivative instruments
The Company’s futures contracts, foreign currency forward contracts, interest rate swaps and other derivatives trade in the over-the-counter derivative market. The Company uses the market approach valuation technique to estimate the fair value for these derivatives based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. As the significant inputs used in the pricing process for these derivative instruments are observable market inputs, the fair value of these securities are classified within Level 2.
 
Short-term investments
The Company determined that certain of its short-term investments held in highly liquid money market-type funds, Treasury bills and commercial paper would be included in Level 1 as their fair values are based on quoted market prices in active markets. The fair values of other short-term investments are generally determined using the spread above the risk-free yield curve and are classified within Level 2.
Contingent consideration liabilities
Contingent consideration liabilities (included in ‘other liabilities’ in the consolidated balance sheets) include amounts related to the acquisition of CMG Mortgage Insurance Company and its affiliated mortgage insurance companies and other acquisitions. Such amounts are remeasured at fair value at each balance sheet date with changes in fair value recognized in ‘net realized gains (losses).’ To determine the fair value of contingent consideration liabilities, 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 contingent consideration liabilities would be included within Level 3.

ARCH CAPITAL
 30
2018 SECOND QUARTER FORM 10-Q

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

The following table presents the Company’s financial assets and liabilities measured at fair value by level at June 30, 2018:
 
 
 
Estimated Fair Value Measurements Using:
 
Estimated
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 (1):
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities:
 

 
 

 
 

 
 

Corporate bonds
$
5,535,763

 
$

 
$
5,526,990

 
$
8,773

Mortgage backed securities
488,699

 

 
488,352

 
347

Municipal bonds
1,431,256

 

 
1,431,256

 

Commercial mortgage backed securities
590,198

 

 
590,169

 
29

U.S. government and government agencies
2,788,272

 
2,660,621

 
127,651

 

Non-U.S. government securities
1,692,783

 

 
1,692,783

 

Asset backed securities
1,820,489

 

 
1,820,489

 

Total
14,347,460

 
2,660,621

 
11,677,690

 
9,149

 
 
 
 
 
 
 
 
Short-term investments
1,096,798

 
1,053,661

 
43,137

 

 
 
 
 
 
 
 
 
Equity securities, at fair value
546,075

 
493,975

 
52,100

 

 
 
 
 
 
 
 
 
Derivative instruments (4)
31,623

 

 
31,623

 

 
 
 
 
 
 
 
 
Fair value option:
 
 
 
 
 
 
 
Corporate bonds
936,840

 

 
925,505

 
11,335

Non-U.S. government bonds
132,162

 

 
132,162

 

Mortgage backed securities
16,410

 

 
16,410

 

Municipal bonds
7,082

 

 
7,082

 

Commercial mortgage backed securities
1,306

 

 
1,306

 

Asset backed securities
214,718

 

 
214,718

 

U.S. government and government agencies
119,985

 
119,875

 
110

 

Short-term investments
217,066

 
19,869

 
197,197

 

Equity securities
137,138

 
65,400

 
71,738

 

Other investments
1,260,645

 
65,665

 
1,136,766

 
58,214

Other investments measured at net asset value (2)
1,068,259

 
 
 
 
 
 
Total
4,111,611

 
270,809

 
2,702,994

 
69,549

 
 
 
 
 
 
 
 
Total assets measured at fair value
$
20,133,567

 
$
4,479,066

 
$
14,507,544

 
$
78,698

 
 
 
 
 
 
 
 
Liabilities measured at fair value:
 

 
 

 
 

 
 

Contingent consideration liabilities
$
(63,930
)
 
$

 
$

 
$
(63,930
)
Securities sold but not yet purchased (3)
(24,529
)
 

 
(24,529
)
 

Derivative instruments (4)
(22,398
)
 

 
(22,398
)
 

Total liabilities measured at fair value
$
(110,857
)
 
$

 
$
(46,927
)
 
$
(63,930
)

(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the securities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See Note 7, “Investment Information—Securities Lending Agreements.”
(2)
In accordance with applicable accounting guidance, certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets.
(3)
Represents the Company’s obligations to deliver securities that it did not own at the time of sale. Such amounts are included in “other liabilities” on the Company’s consolidated balance sheets.
(4)
See Note 9, “Derivative Instruments.”

ARCH CAPITAL
 31
2018 SECOND QUARTER FORM 10-Q

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

The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2017:
 
 
 
Estimated Fair Value Measurements Using:
 
Estimated
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 (1):
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities:
 

 
 

 
 

 
 

Corporate bonds
$
4,434,439

 
$

 
$
4,424,979

 
$
9,460

Mortgage backed securities
316,141

 

 
315,754

 
387

Municipal bonds
2,158,840

 

 
2,158,840

 

Commercial mortgage backed securities
545,817

 

 
545,277

 
540

U.S. government and government agencies
3,484,257

 
3,408,902

 
75,355

 

Non-U.S. government securities
1,612,754

 

 
1,612,754

 

Asset backed securities
1,780,143

 

 
1,775,143

 
5,000

Total
14,332,391

 
3,408,902

 
10,908,102

 
15,387

 
 
 
 
 
 
 
 
Equity securities
504,333

 
498,182

 
6,151

 

 
 
 
 
 
 
 
 
Short-term investments
1,469,042

 
1,420,732

 
48,310

 

 
 
 
 
 
 
 
 
Other investments
76,427

 
74,611

 
1,816

 

Other investments measured at net asset value (2)
188,562

 
 
 
 
 
 
Total other investments
264,989

 
74,611

 
1,816

 

 
 
 
 
 
 
 
 
Derivative instruments (4)
15,747

 

 
15,747

 

 
 
 
 
 
 
 
 
Fair value option:
 
 
 
 
 
 
 
Corporate bonds
1,068,725

 

 
1,056,508

 
12,217

Non-U.S. government bonds
195,788

 

 
195,788

 

Mortgage backed securities
20,491

 

 
20,491

 

Municipal bonds
15,210

 

 
15,210

 

Commercial mortgage backed securities
11,997

 

 
11,997

 

Asset backed securities
99,354

 

 
99,354

 

U.S. government and government agencies
231,290

 
231,019

 
271

 

Short-term investments
297,426

 
40,166

 
257,260

 

Equity securities
139,575

 
67,440

 
72,135

 

Other investments
1,128,094

 
82,291

 
986,636

 
59,167

Other investments measured at net asset value (2)
1,008,287

 
 
 
 
 
 
Total
4,216,237

 
420,916

 
2,715,650

 
71,384

 
 
 
 
 
 
 
 
Total assets measured at fair value
$
20,802,739

 
$
5,823,343

 
$
13,695,776

 
$
86,771

 
 
 
 
 
 
 
 
Liabilities measured at fair value:
 

 
 

 
 

 
 

Contingent consideration liabilities
$
(60,996
)
 
$

 
$

 
$
(60,996
)
Securities sold but not yet purchased (3)
(34,375
)
 

 
(34,375
)
 

Derivative instruments (4)
(20,464
)
 

 
(20,464
)
 

Total liabilities measured at fair value
$
(115,835
)
 
$

 
$
(54,839
)
 
$
(60,996
)

(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the securities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See Note 7, “Investment Information—Securities Lending Agreements.”
(2)
In accordance with applicable accounting guidance, certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets.
(3)
Represents the Company’s obligations to deliver securities that it did not own at the time of sale. Such amounts are included in “other liabilities” on the Company’s consolidated balance sheets.
(4)
See Note 9, “Derivative Instruments.”


ARCH CAPITAL
 32
2018 SECOND QUARTER FORM 10-Q

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

The following table presents 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:
 
Assets
 
Liabilities
s
Available For Sale
 
Fair Value Option
 
 
 
 
 
Structured Securities (1)
 
Corporate
Bonds
 
Corporate
Bonds
 
Other
Investments
 
Total
 
Contingent Consideration Liabilities
Three Months Ended June 30, 2018
 
 
 

 
 
 
 

 
 
 
 
Balance at beginning of period
$
5,413

 
$
9,152

 
$
11,872

 
$
58,452

 
$
84,889

 
$
(62,449
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
 
 
Included in earnings (2)
3

 

 
(537
)
 
336

 
(198
)
 
(1,481
)
Included in other comprehensive income
(4
)
 
(316
)
 

 

 
(320
)
 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
 
 
Purchases

 
393

 

 

 
393

 

Issuances

 

 

 

 

 

Sales
(5,003
)
 

 

 
(74
)
 
(5,077
)
 

Settlements
(33
)
 
(456
)
 

 
(500
)
 
(989
)
 

Transfers in and/or out of Level 3

 

 

 

 

 

Balance at end of period
$
376

 
$
8,773

 
$
11,335

 
$
58,214

 
$
78,698

 
$
(63,930
)
 
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended June 30, 2017
 
 
 

 
 
 
 

 
 

 
 
Balance at beginning of period
$
10,637

 
$
18,601

 
$

 
$
25,000

 
$
54,238

 
$
(125,544
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
 
 
Included in earnings (2)
3,072

 
636

 

 

 
3,708

 
(3,441
)
Included in other comprehensive income

 

 

 

 

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
 
 
Purchases

 
4,935

 

 

 
4,935

 

Issuances

 

 

 

 

 

Sales
(13,640
)
 
(12,602
)
 

 

 
(26,242
)
 

Settlements
(69
)
 

 

 

 
(69
)
 
71,739

Transfers in and/or out of Level 3

 

 

 

 

 

Balance at end of period
$

 
$
11,570

 
$

 
$
25,000

 
$
36,570

 
$
(57,246
)
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2018
 
 
 

 
 
 
 

 
 
 
 
Balance at beginning of year
$
5,927

 
$
9,460

 
$
12,217

 
$
59,167

 
$
86,771

 
$
(60,996
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
 
 
Included in earnings (2)
4

 

 
(612
)
 
(379
)
 
(987
)
 
(2,934
)
Included in other comprehensive income
(8
)
 
(168
)
 

 

 
(176
)
 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
 
 
Purchases

 
393

 

 

 
393

 

Issuances

 

 

 

 

 

Sales
(5,003
)
 

 

 
(74
)
 
(5,077
)
 

Settlements
(544
)
 
(912
)
 
(270
)
 
(500
)
 
(2,226
)
 

Transfers in and/or out of Level 3

 

 

 

 

 

Balance at end of period
$
376

 
$
8,773

 
$
11,335

 
$
58,214

 
$
78,698

 
$
(63,930
)
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2017
 
 
 

 
 
 
 

 
 

 
 
Balance at beginning of year
$
11,289

 
$
18,344

 
$

 
$
25,000

 
$
54,633

 
$
(122,350
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
 
 
Included in earnings (2)
3,779

 
893

 

 

 
4,672

 
(7,087
)
Included in other comprehensive income

 

 

 

 

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
 
 
Purchases

 
4,935

 

 

 
4,935

 

Issuances

 

 

 

 

 

Sales
(13,640
)
 
(12,602
)
 

 

 
(26,242
)
 

Settlements
(1,428
)
 

 

 

 
(1,428
)
 
72,191

Transfers in and/or out of Level 3

 

 

 

 

 

Balance at end of period
$

 
$
11,570

 
$

 
$
25,000

 
$
36,570

 
$
(57,246
)

(1)
Includes asset backed securities, mortgage backed securities and commercial mortgage backed securities.
(2)
Gains or losses were included in net realized gains (losses).

ARCH CAPITAL
 33
2018 SECOND QUARTER FORM 10-Q

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


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, 2018, 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, 2018, the Company’s senior notes were carried at their cost, net of debt issuance costs, of $1.73 billion and had a fair value of $1.89 billion. At December 31, 2017, Company’s senior notes were carried at their cost, net of debt issuance costs, of $1.73 billion and had a fair value of $2.04 billion. 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 values of the senior notes are classified within Level 2.
9.    Derivative Instruments

The Company’s investment strategy allows for the use of derivative instruments. The Company’s derivative instruments are recorded on its consolidated balance sheets at fair value. 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 and the Company routinely utilizes foreign currency forward contracts, currency options, index futures contracts and other derivatives as part of its total return objective. In addition, certain of the Company’s investments are managed in portfolios which incorporate the use of foreign currency forward contracts which are intended to provide an economic hedge against foreign currency movements. 
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 following table summarizes information on the fair values and notional values of the Company’s derivative instruments:
 
Estimated Fair Value
 
 
 
Asset Derivatives
 
Liability Derivatives
 
Notional
Value (1)
June 30, 2018
 
 
 
 
 
Futures contracts (2)
$
556

 
$
(3,425
)
 
$
1,276,189

Foreign currency forward contracts (2)
18,183

 
(7,732
)
 
1,072,743

TBAs (3)
14,761

 

 
14,480

Other (2)
12,884

 
(11,241
)
 
1,924,299

Total
$
46,384

 
$
(22,398
)
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
Futures contracts (2)
$
3,371

 
$
(1,542
)
 
$
1,452,497

Foreign currency forward contracts (2)
4,478

 
(4,381
)
 
686,941

TBAs (3)
27,184

 

 
27,066

Other (2)
7,898

 
(14,541
)
 
1,457,345

Total
$
42,931

 
$
(20,464
)
 
 
(1)
Represents the absolute notional value of all outstanding contracts, consisting of long and short positions.
(2)
The fair value of asset derivatives are included in ‘other assets’ and the fair value of liability derivatives are included in ‘other liabilities.’
(3)
The fair value of TBAs are included in ‘fixed maturities available for sale, at fair value.’
The Company did not hold any derivatives which were designated as hedging instruments at June 30, 2018 or December 31, 2017.
The Company’s derivative instruments can be 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. Contractual close-out netting reduces derivatives credit exposure from gross to net exposure. The remaining derivatives included in the table above were not subject to a master netting agreement.
At June 30, 2018, asset derivatives and liability derivatives of $44.0 million and $20.1 million, respectively, were subject to a master netting agreement, compared to $40.6 million and $19.6 million, respectively, at December 31, 2017. The

ARCH CAPITAL
 34
2018 SECOND QUARTER FORM 10-Q

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

remaining derivatives included in the preceding table were not subject to a master netting agreement.
Realized and unrealized contract gains and losses on the Company’s derivative instruments are reflected in ‘net realized gains (losses)’ in the consolidated statements of income, as summarized in the following table:
Derivatives not designated as
 
June 30,
hedging instruments:
 
2018
 
2017
 
 
 
 
 
Three Months Ended
 
 
 
 
Net realized gains (losses):
 
 
 
 
Futures contracts
 
$
(240
)
 
$
(5,310
)
Foreign currency forward contracts
 
(1,692
)
 
(272
)
TBAs
 

 
86

Other
 
(214
)
 
726

Total
 
$
(2,146
)
 
$
(4,770
)
 
 
 
 
 
Six Months Ended
 
 
 
 
Net realized gains (losses):
 
 
 
 
Futures contracts
 
$
4,790

 
$
2,410

Foreign currency forward contracts
 
(7,616
)
 
(12,038
)
TBAs
 
(97
)
 
21

Other
 
(3,186
)
 
(4,344
)
Total
 
$
(6,109
)
 
$
(13,951
)

10.    Commitments and Contingencies

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 $1.63 billion at June 30, 2018, compared to $1.70 billion at December 31, 2017.
Interest Paid
Interest paid on the Company’s senior notes and other borrowings were $60.9 million for the six months ended June 30, 2018, compared to $58.0 million for the 2017 period.
 
11.
Variable Interest Entities and Noncontrolling Interests

A variable interest entity (“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.
Watford Holdings Ltd.
In March 2014, 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. Watford Holdings Ltd. is the parent of Watford Re Ltd., a multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., “Watford Re”). Watford Re is considered a VIE and the Company concluded that it is the primary beneficiary of Watford Re. As such, the results of Watford Re are included in the Company’s consolidated financial statements.
The Company does not guarantee or provide credit support for Watford Re, and the Company’s financial exposure to Watford Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.

ARCH CAPITAL
 35
2018 SECOND QUARTER FORM 10-Q

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

The following table provides the carrying amount and balance sheet caption in which the assets and liabilities of Watford Re are reported:
 
June 30,
 
December 31,

 
2018
 
2017
Assets
 
 
 
Investments accounted for using the fair value option
$
2,385,316

 
$
2,426,066

Fixed maturities available for sale, at fair value
279,177

 

Equity securities, at fair value
63,010

 

Cash
45,644

 
54,503

Accrued investment income
18,108

 
18,261

Premiums receivable
232,842

 
177,492

Reinsurance recoverable on unpaid and paid losses and LAE
54,299

 
42,777

Ceded unearned premiums
55,853

 
24,762

Deferred acquisition costs
88,752

 
85,961

Receivable for securities sold
31,387

 
36,374

Goodwill and intangible assets
7,650

 
7,650

Other assets
75,478

 
140,808

Total assets of consolidated VIE
$
3,337,516

 
$
3,014,654

 
 
 
 
Liabilities
 
 
 
Reserves for losses and loss adjustment expenses
$
899,395

 
$
798,262

Unearned premiums
384,537

 
330,644

Reinsurance balances payable
41,185

 
18,424

Revolving credit agreement borrowings
447,289

 
441,132

Payable for securities purchased
132,164

 
42,501

Other liabilities
244,320

 
215,186

Total liabilities of consolidated VIE
$
2,148,890

 
$
1,846,149

 
 
 
 
Redeemable noncontrolling interests
$
220,805

 
$
220,622

For the six months ended June 30, 2018, Watford Re generated $92.4 million of cash provided by operating activities, $168.0 million of cash used for investing activities and $2.1 million of cash used for financing activities, compared to $134.4 million of cash provided by operating activities, $63.5 million of cash used for investing activities and $76.4 million of cash used for financing activities for the six months ended June 30, 2017.
Non-redeemable noncontrolling interests
The Company accounts for the portion of Watford Re’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford Re’s common shares was approximately 89% at June 30, 2018. The portion of Watford Re’s income or loss attributable to third party investors is recorded in the consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests.’
 
The following table sets forth activity in the non-redeemable noncontrolling interests:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Balance, beginning of period
$
854,112

 
$
868,186

Amounts attributable to noncontrolling interests
8,116

 
9,346

Other comprehensive income attributable to noncontrolling interests
(1,075
)
 
(76
)
Balance, end of period
$
861,153

 
$
877,456

 
 
 
 
Six Months Ended
 
 
 
Balance, beginning of year
$
843,411

 
$
851,854

Amounts attributable to noncontrolling interests
19,492

 
25,670

Other comprehensive income attributable to noncontrolling interests
(1,750
)
 
(68
)
Balance, end of period
$
861,153

 
$
877,456

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 relate to the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. Preferred dividends, including the accretion of the discount and issuance costs, are included in ‘net (income) loss attributable to noncontrolling interests’ in the Company’s consolidated statements of income.
The following table sets forth activity in the redeemable non-controlling interests:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Balance, beginning of period
$
206,013

 
$
205,644

Accretion of preference share issuance costs
92

 
92

Balance, end of period
$
206,105

 
$
205,736

 
 
 
 
Six Months Ended
 
 
 
Balance, beginning of year
$
205,922

 
$
205,553

Accretion of preference share issuance costs
183

 
183

Balance, end of period
$
206,105

 
$
205,736


ARCH CAPITAL
 36
2018 SECOND QUARTER FORM 10-Q

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

The portion of Watford Re’s income or loss attributable to third party investors, recorded in the Company’s consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests,’ are summarized in the table below:
 
June 30,
 
2018
 
2017
Three Months Ended
 
 
 
Amounts attributable to non-redeemable noncontrolling interests
$
(8,116
)
 
$
(9,346
)
Dividends attributable to redeemable noncontrolling interests
(4,585
)
 
(4,586
)
Net (income) loss attributable to noncontrolling interests
$
(12,701
)
 
$
(13,932
)
 
 
 
 
Six Months Ended
 
 
 
Amounts attributable to non-redeemable noncontrolling interests
$
(19,492
)
 
$
(25,670
)
Dividends attributable to redeemable noncontrolling interests
(9,170
)
 
(9,170
)
Net (income) loss attributable to noncontrolling interests
$
(28,662
)
 
$
(34,840
)
Bellemeade Re
The Company has entered into various aggregate excess of loss reinsurance agreements with Bellemeade Re I Ltd. (July 2015), with Bellemeade Re II Ltd. (May 2016), with Bellemeade 2017-1 Ltd. (October 2017) and with Bellemeade 2018-1 Ltd. (April 2018) (the “Bellemeade Agreements”), special purpose reinsurance companies domiciled in Bermuda. At the time the Bellemeade Agreements were entered into, the applicability of the accounting guidance that addresses VIEs was evaluated. As a result of the evaluation of the Bellemeade Agreements, the Company concluded that Bellemeade Re I Ltd., Bellemeade Re II Ltd., Bellemeade 2017-1 Ltd. and Bellemeade 2018-1 Ltd. are VIEs. However, given that the ceding insurers do not have the unilateral power to direct those activities that are significant to the economic performance of Bellemeade Re I Ltd., Bellemeade Re II Ltd., Bellemeade 2017-1 Ltd. and Bellemeade 2018-1 Ltd., the Company does not consolidate such companies in its consolidated financial statements.
 
The following table presents total assets of the Bellemeade entities, as well as the Company’s maximum exposure to loss associated with these VIEs as of June 30, 2018 and December 31, 2017:
 
 
 
Maximum Exposure to Loss
 
Total VIE Assets
 
On-Balance Sheet
 
Off-Balance Sheet
 
Total
June 30, 2018
 
 
 
 
 
 
 
Bellemeade Re I Ltd.
$
69,079

 
$
263

 
$
469

 
$
732

Bellemeade Re II Ltd.
55,388

 
14

 
110

 
124

Bellemeade 2017-1 Ltd.
329,030

 
815

 
1,759

 
2,574

Bellemeade 2018-1 Ltd.
374,460

 
1,242

 
2,050

 
3,292

Total
$
827,957

 
$
2,334

 
$
4,388

 
$
6,722

December 31, 2017
 
 
 
 
 
 
 
Bellemeade Re I Ltd.
$
92,390

 
$
471

 
$
832

 
$
1,303

Bellemeade Re II Ltd.
135,201

 
20

 
527

 
547

Bellemeade 2017-1 Ltd.
347,139

 
391

 
1,867

 
2,258

Total
$
574,730

 
$
882

 
$
3,226

 
$
4,108



ARCH CAPITAL
 37
2018 SECOND QUARTER FORM 10-Q

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

12.    Other Comprehensive Income (Loss)

The following tables present details about amounts reclassified from accumulated other comprehensive income and the tax effects allocated to each component of other comprehensive income (loss):
 
 
 
 
Amounts Reclassified 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
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
Unrealized appreciation on available-for-sale investments
 
 
 
 
 
 
 
 
 
 
Net realized gains (losses)
 
$
(38,935
)
 
$
24,111

 
$
(106,521
)
 
$
31,924

 
 
Other-than-temporary impairment losses
 
(470
)
 
(1,730
)
 
(632
)
 
(3,537
)
 
 
Total before tax
 
(39,405
)
 
22,381

 
(107,153
)
 
28,387

 
 
Income tax (expense) benefit
 
2,762

 
(5,157
)
 
8,049

 
(6,119
)
 
 
Net of tax
 
$
(36,643
)
 
$
17,224

 
$
(99,104
)
 
$
22,268

 
Before Tax Amount
 
Tax Expense (Benefit)
 
Net of Tax Amount
Three Months Ended June 30, 2018
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
(88,034
)
 
$
(2,763
)
 
$
(85,271
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)

 

 

Less reclassification of net realized gains (losses) included in net income
(39,405
)
 
(2,762
)
 
(36,643
)
Foreign currency translation adjustments
(12,701
)
 
(106
)
 
(12,595
)
Other comprehensive income (loss)
$
(61,330
)
 
$
(107
)
 
$
(61,223
)
 
 
 
 
 
 
Three Months Ended June 30, 2017
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
108,011

 
$
15,042

 
$
92,969

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

 

 

Less reclassification of net realized gains (losses) included in net income
22,381

 
5,157

 
17,224

Foreign currency translation adjustments
18,509

 
212

 
18,297

Other comprehensive income (loss)
$
104,139

 
$
10,097

 
$
94,042

 
 
 
 
 
 
Six Months Ended June 30, 2018
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
(277,977
)
 
$
(26,029
)
 
$
(251,948
)
Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)

 

 

Less reclassification of net realized gains (losses) included in net income
(107,153
)
 
(8,049
)
 
(99,104
)
Foreign currency translation adjustments
(11,269
)
 
44

 
(11,313
)
Other comprehensive income (loss)
$
(182,093
)
 
$
(17,936
)
 
$
(164,157
)
 
 
 
 
 
 
Six Months Ended June 30, 2017
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
219,483

 
$
25,722

 
$
193,761

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

 

 

Less reclassification of net realized gains (losses) included in net income
28,387

 
6,119

 
22,268

Foreign currency translation adjustments
21,674

 
253

 
21,421

Other comprehensive income (loss)
$
212,770

 
$
19,856

 
$
192,914



ARCH CAPITAL
 38
2018 SECOND QUARTER FORM 10-Q

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

13.     Guarantor Financial Information

The following tables present condensed financial information for Arch Capital, Arch-U.S., a 100% owned subsidiary of Arch Capital, and Arch Capital’s other subsidiaries.
 

June 30, 2018
Condensed Consolidating Balance Sheet
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Assets
 
 
 
 
 
 
 
 
 
Total investments
$
134

 
$
198,122

 
$
21,353,862

 
$
(14,700
)
 
$
21,537,418

Cash
7,033

 
27,513

 
492,082

 

 
526,628

Investments in subsidiaries
9,455,746

 
4,033,568

 

 
(13,489,314
)
 

Due from subsidiaries and affiliates

 
2

 
1,849,468

 
(1,849,470
)
 

Premiums receivable

 

 
1,897,517

 
(546,207
)
 
1,351,310

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

 
8,441,528

 
(5,714,225
)
 
2,727,303

Contractholder receivables

 

 
2,044,322

 

 
2,044,322

Ceded unearned premiums

 

 
1,821,539

 
(806,876
)
 
1,014,663

Deferred acquisition costs

 

 
633,454

 
(63,637
)
 
569,817

Goodwill and intangible assets

 

 
593,008

 

 
593,008

Other assets
12,978

 
56,042

 
1,555,017

 
(135,386
)
 
1,488,651

 
Total assets
$
9,475,891

 
$
4,315,247

 
$
40,681,797

 
$
(22,619,815
)
 
$
31,853,120

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Reserve for losses and loss adjustment expenses
$

 
$

 
$
16,855,050

 
$
(5,430,713
)
 
$
11,424,337

Unearned premiums

 

 
4,640,416

 
(806,876
)
 
3,833,540

Reinsurance balances payable

 

 
957,289

 
(546,207
)
 
411,082

Contractholder payables

 

 
2,044,322

 

 
2,044,322

Collateral held for insured obligations

 

 
257,396

 

 
257,396

Senior notes
297,101

 
494,672

 
941,438

 

 
1,733,211

Revolving credit agreement borrowings

 

 
572,289

 

 
572,289

Due to subsidiaries and affiliates
1,824

 
536,747

 
1,310,899

 
(1,849,470
)
 

Other liabilities
13,211

 
29,304

 
1,785,950

 
(482,535
)
 
1,345,930

 
Total liabilities
312,136

 
1,060,723

 
29,365,049

 
(9,115,801
)
 
21,622,107

 
 
 
 
 
 
 
 
 
 
 
Redeemable noncontrolling interests

 

 
220,805

 
(14,700
)
 
206,105

 
 
 
 
 
 
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
 
 
 
 
 
Total shareholders’ equity available to Arch
9,163,755

 
3,254,524

 
10,234,790

 
(13,489,314
)
 
9,163,755

Non-redeemable noncontrolling interests

 

 
861,153

 

 
861,153

 
Total shareholders’ equity
9,163,755

 
3,254,524

 
11,095,943

 
(13,489,314
)
 
10,024,908

 
 
 
 
 
 
 
 
 
 
 
Total liabilities, noncontrolling interests and shareholders’ equity
$
9,475,891

 
$
4,315,247

 
$
40,681,797

 
$
(22,619,815
)
 
$
31,853,120







ARCH CAPITAL
 39
2018 SECOND QUARTER FORM 10-Q

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


 
 
December 31, 2017
Condensed Consolidating Balance Sheet
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Assets
 
 
 
 
 
 
 
 
 
Total investments
$
96,540

 
$
46,281

 
$
21,711,891

 
$
(14,700
)
 
$
21,840,012

Cash
9,997

 
30,380

 
565,822

 

 
606,199

Investments in subsidiaries
9,396,621

 
4,097,765

 

 
(13,494,386
)
 

Due from subsidiaries and affiliates
394

 

 
1,828,864

 
(1,829,258
)
 

Premiums receivable

 

 
2,967,701

 
(1,832,452
)
 
1,135,249

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

 
8,442,192

 
(5,902,049
)
 
2,540,143

Contractholder receivables

 

 
1,978,414

 

 
1,978,414

Ceded unearned premiums

 

 
2,165,789

 
(1,239,178
)
 
926,611

Deferred acquisition costs

 

 
693,053

 
(157,229
)
 
535,824

Goodwill and intangible assets

 

 
652,611

 

 
652,611

Other assets
13,176

 
49,585

 
1,860,505

 
(86,671
)
 
1,836,595

 
Total assets
$
9,516,728

 
$
4,224,011

 
$
42,866,842

 
$
(24,555,923
)
 
$
32,051,658

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Reserve for losses and loss adjustment expenses
$

 
$

 
$
17,236,401

 
$
(5,852,609
)
 
$
11,383,792

Unearned premiums

 

 
4,861,491

 
(1,239,177
)
 
3,622,314

Reinsurance balances payable

 

 
2,155,947

 
(1,832,451
)
 
323,496

Contractholder payables

 

 
1,978,414

 

 
1,978,414

Collateral held for insured obligations

 

 
240,183

 

 
240,183

Senior notes
297,053

 
494,621

 
941,210

 

 
1,732,884

Revolving credit agreement borrowings

 

 
816,132

 

 
816,132

Due to subsidiaries and affiliates
235

 
536,919

 
1,292,104

 
(1,829,258
)
 

Other liabilities
22,838

 
29,317

 
1,949,696

 
(293,343
)
 
1,708,508

 
Total liabilities
320,126

 
1,060,857

 
31,471,578

 
(11,046,838
)
 
21,805,723

 
 
 
 
 
 
 
 
 
 
 
Redeemable noncontrolling interests

 

 
220,622

 
(14,700
)
 
205,922

 
 
 
 
 
 
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
 
 
 
 
 
Total shareholders’ equity available to Arch
9,196,602

 
3,163,154

 
10,331,231

 
(13,494,385
)
 
9,196,602

Non-redeemable noncontrolling interests

 

 
843,411

 

 
843,411

 
Total shareholders’ equity
9,196,602

 
3,163,154

 
11,174,642

 
(13,494,385
)
 
10,040,013

 
 
 
 
 
 
 
 
 
 
 
Total liabilities, noncontrolling interests and shareholders’ equity
$
9,516,728

 
$
4,224,011

 
$
42,866,842

 
$
(24,555,923
)
 
$
32,051,658



ARCH CAPITAL
 40
2018 SECOND QUARTER FORM 10-Q

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


 
 
Three Months Ended June 30, 2018
Condensed Consolidating Statement of Income and Comprehensive Income
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
1,336,763

 
$

 
$
1,336,763

Net investment income
15

 
560

 
157,532

 
(22,439
)
 
135,668

Net realized gains (losses)

 

 
(76,611
)
 

 
(76,611
)
Net impairment losses recognized in earnings

 

 
(470
)
 

 
(470
)
Other underwriting income

 

 
3,874

 

 
3,874

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

 

 
8,472

 

 
8,472

Other income (loss)
2,339

 

 
774

 

 
3,113

 
Total revenues
2,354

 
560

 
1,430,334

 
(22,439
)
 
1,410,809

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
726,153

 

 
726,153

Acquisition expenses

 

 
202,838

 

 
202,838

Other operating expenses

 

 
176,181

 

 
176,181

Corporate expenses
16,642

 
470

 
5,400

 

 
22,512

Amortization of intangible assets

 

 
26,472

 

 
26,472

Interest expense
5,537

 
12,013

 
34,911

 
(22,117
)
 
30,344

Net foreign exchange (gains) losses

 

 
(43,357
)
 
(10,349
)
 
(53,706
)
 
Total expenses
22,179

 
12,483

 
1,128,598

 
(32,466
)
 
1,130,794

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(19,825
)
 
(11,923
)
 
301,736

 
10,027

 
280,015

Income tax (expense) benefit

 
2,477

 
(26,145
)
 

 
(23,668
)
Income (loss) before equity in net income of subsidiaries
(19,825
)
 
(9,446
)
 
275,591

 
10,027

 
256,347

Equity in net income of subsidiaries
263,471

 
86,727

 

 
(350,198
)
 

Net income
243,646

 
77,281

 
275,591

 
(340,171
)
 
256,347

Net (income) loss attributable to noncontrolling interests

 

 
(13,023
)
 
322

 
(12,701
)
Net income available to Arch
243,646

 
77,281

 
262,568

 
(339,849
)
 
243,646

Preferred dividends
(10,403
)
 

 

 

 
(10,403
)
Net income available to Arch common shareholders
$
233,243

 
$
77,281

 
$
262,568

 
$
(339,849
)
 
$
233,243

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
183,500

 
$
70,066

 
$
212,802

 
$
(282,868
)
 
$
183,500



ARCH CAPITAL
 41
2018 SECOND QUARTER FORM 10-Q

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


 
 
Three Months Ended June 30, 2017
Condensed Consolidating Statement of Income and Comprehensive Income
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
1,240,874

 
$

 
$
1,240,874

Net investment income
1

 
184

 
133,627

 
(22,688
)
 
111,124

Net realized gains (losses)

 

 
21,735

 

 
21,735

Net impairment losses recognized in earnings

 

 
(1,730
)
 

 
(1,730
)
Other underwriting income

 

 
4,822

 

 
4,822

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

 

 
32,706

 

 
32,706

Other income (loss)
(437
)
 

 
(1,557
)
 

 
(1,994
)
 
Total revenues
(436
)
 
184

 
1,430,477

 
(22,688
)
 
1,407,537

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
689,860

 

 
689,860

Acquisition expenses

 

 
190,436

 

 
190,436

Other operating expenses

 

 
169,981

 

 
169,981

Corporate expenses
21,816

 
1,309

 
1,751

 

 
24,876

Amortization of intangible assets

 

 
30,824

 

 
30,824

Interest expense
6,075

 
11,989

 
33,050

 
(22,365
)
 
28,749

Net foreign exchange (gains) losses

 

 
29,843

 
9,700

 
39,543

 
Total expenses
27,891

 
13,298

 
1,145,745

 
(12,665
)
 
1,174,269

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(28,327
)
 
(13,114
)
 
284,732

 
(10,023
)
 
233,268

Income tax (expense) benefit

 
4,069

 
(38,238
)
 

 
(34,169
)
Income (loss) before equity in net income of subsidiaries
(28,327
)
 
(9,045
)
 
246,494

 
(10,023
)
 
199,099

Equity in net income of subsidiaries
213,494

 
86,156

 

 
(299,650
)
 

Net income
185,167

 
77,111

 
246,494

 
(309,673
)
 
199,099

Net (income) loss attributable to noncontrolling interests

 

 
(14,254
)
 
322

 
(13,932
)
Net income available to Arch
185,167

 
77,111

 
232,240

 
(309,351
)
 
185,167

Preferred dividends
(11,349
)
 

 

 

 
(11,349
)
Net income available to Arch common shareholders
$
173,818

 
$
77,111

 
$
232,240

 
$
(309,351
)
 
$
173,818

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
279,285

 
$
105,302

 
$
475,747

 
$
(581,049
)
 
$
279,285


ARCH CAPITAL
 42
2018 SECOND QUARTER FORM 10-Q

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


 
 
Six Months Ended June 30, 2018
Condensed Consolidating Statement of Income and Comprehensive Income
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
2,571,662

 
$

 
$
2,571,662

Net investment income
35

 
818

 
306,299

 
(44,760
)
 
262,392

Net realized gains (losses)
29

 
(7
)
 
(187,631
)
 

 
(187,609
)
Net impairment losses recognized in earnings

 

 
(632
)
 

 
(632
)
Other underwriting income

 

 
9,223

 

 
9,223

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

 

 
36,541

 

 
36,541

Other income (loss)
2,261

 

 
926

 

 
3,187

 
Total revenues
2,325

 
811

 
2,736,388

 
(44,760
)
 
2,694,764

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
1,363,013

 

 
1,363,013

Acquisition expenses

 

 
394,214

 

 
394,214

Other operating expenses

 

 
351,196

 

 
351,196

Corporate expenses
32,811

 
759

 
4,254

 

 
37,824

Amortization of intangible assets

 

 
53,208

 

 
53,208

Interest expense
11,073

 
23,939

 
70,083

 
(44,115
)
 
60,980

Net foreign exchange (gains) losses
29

 

 
(26,921
)
 
(7,093
)
 
(33,985
)
 
Total expenses
43,913

 
24,698

 
2,209,047

 
(51,208
)
 
2,226,450

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(41,588
)
 
(23,887
)
 
527,341

 
6,448

 
468,314

Income tax (expense) benefit

 
5,428

 
(51,011
)
 

 
(45,583
)
Income (loss) before equity in net income of subsidiaries
(41,588
)
 
(18,459
)
 
476,330

 
6,448

 
422,731

Equity in net income of subsidiaries
435,657

 
173,147

 

 
(608,804
)
 

Net income
394,069

 
154,688

 
476,330

 
(602,356
)
 
422,731

Net (income) loss attributable to noncontrolling interests

 

 
(29,307
)
 
645

 
(28,662
)
Net income available to Arch
394,069

 
154,688

 
447,023

 
(601,711
)
 
394,069

Preferred dividends
(20,840
)
 

 

 

 
(20,840
)
Loss on redemption of preferred shares
(2,710
)
 

 

 

 
(2,710
)
Net income available to Arch common shareholders
$
370,519

 
$
154,688

 
$
447,023

 
$
(601,711
)
 
$
370,519

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
231,662

 
$
76,603

 
$
291,883

 
$
(368,486
)
 
$
231,662



ARCH CAPITAL
 43
2018 SECOND QUARTER FORM 10-Q

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


 
 
Six Months Ended June 30, 2017
Condensed Consolidating Statement of Income and Comprehensive Income
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
2,357,891

 
$

 
$
2,357,891

Net investment income
6

 
1,000

 
271,608

 
(43,616
)
 
228,998

Net realized gains (losses)

 

 
55,888

 

 
55,888

Net impairment losses recognized in earnings

 

 
(3,537
)
 

 
(3,537
)
Other underwriting income

 

 
9,455

 

 
9,455

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

 

 
80,794

 

 
80,794

Other income (loss)
(266
)
 

 
(2,510
)
 

 
(2,776
)
 
Total revenues
(260
)
 
1,000

 
2,769,589

 
(43,616
)
 
2,726,713

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
1,242,430

 

 
1,242,430

Acquisition expenses

 

 
372,725

 

 
372,725

Other operating expenses

 

 
344,700

 

 
344,700

Corporate expenses
39,063

 
3,317

 
10,288

 

 
52,668

Amortization of intangible assets

 

 
62,118

 

 
62,118

Interest expense
12,090

 
23,919

 
64,386

 
(42,970
)
 
57,425

Net foreign exchange (gains) losses

 

 
45,191

 
13,756

 
58,947

 
Total expenses
51,153

 
27,236

 
2,141,838

 
(29,214
)
 
2,191,013

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(51,413
)
 
(26,236
)
 
627,751

 
(14,402
)
 
535,700

Income tax (expense) benefit

 
8,942

 
(71,508
)
 

 
(62,566
)
Income (loss) before equity in net income of subsidiaries
(51,413
)
 
(17,294
)
 
556,243

 
(14,402
)
 
473,134

Equity in net income of subsidiaries
489,707

 
163,529

 

 
(653,236
)
 

Net income
438,294

 
146,235

 
556,243

 
(667,638
)
 
473,134

Net (income) loss attributable to noncontrolling interests

 

 
(35,485
)
 
645

 
(34,840
)
Net income available to Arch
438,294

 
146,235

 
520,758

 
(666,993
)
 
438,294

Preferred dividends
(22,567
)
 

 

 

 
(22,567
)
Net income available to Arch common shareholders
$
415,727

 
$
146,235

 
$
520,758

 
$
(666,993
)
 
$
415,727

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income available to Arch
$
631,276

 
$
193,083

 
$
699,920

 
$
(893,003
)
 
$
631,276



ARCH CAPITAL
 44
2018 SECOND QUARTER FORM 10-Q

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

 
 
Six Months Ended June 30, 2018
Condensed Consolidating Statement
of Cash Flows
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Operating Activities
 
 
 
 
 
 
 
 
 
 
Net Cash Provided By (Used For) Operating Activities
$
201,487

 
$
149,576

 
$
1,010,703

 
$
(864,880
)
 
$
496,886

Investing Activities
 
 
 
 
 
 
 
 
 
Purchases of fixed maturity investments

 
(125,440
)
 
(17,347,846
)
 
605,716

 
(16,867,570
)
Purchases of equity securities

 

 
(679,663
)
 

 
(679,663
)
Purchases of other investments

 

 
(1,017,147
)
 

 
(1,017,147
)
Proceeds from the sales of fixed maturity investments

 
33,793

 
16,662,466

 
(605,716
)
 
16,090,543

Proceeds from the sales of equity securities

 

 
622,068

 

 
622,068

Proceeds from the sales, redemptions and maturities of other investments

 

 
773,298

 

 
773,298

Proceeds from redemptions and maturities of fixed maturity investments

 

 
511,448

 

 
511,448

Net settlements of derivative instruments

 

 
4,498

 

 
4,498

Net (purchases) sales of short-term investments
96,446

 
(59,798
)
 
415,253

 

 
451,901

Change in cash collateral related to securities lending

 

 
176,304

 

 
176,304

Contributions to subsidiaries

 
(1,000
)
 
(22,595
)
 
23,595

 

Purchases of fixed assets
(71
)
 

 
(13,171
)
 

 
(13,242
)
Other
(4
)
 

 
49,965

 

 
49,961

 
Net Cash Provided By (Used For) Investing Activities
96,371

 
(152,445
)
 
134,878

 
23,595

 
102,399

Financing Activities
 
 
 
 
 
 
 
 
 
Redemption of preferred shares
(92,555
)
 

 

 

 
(92,555
)
Purchases of common shares under share repurchase program
(173,575
)
 

 

 

 
(173,575
)
Proceeds from common shares issued, net
(13,851
)
 

 
23,595

 
(23,595
)
 
(13,851
)
Proceeds from borrowings

 

 
130,579

 

 
130,579

Repayments of borrowings

 

 
(373,000
)
 

 
(373,000
)
Change in cash collateral related to securities lending

 

 
(176,304
)
 

 
(176,304
)
Dividends paid to redeemable noncontrolling interests

 

 
(9,632
)
 
638

 
(8,994
)
Dividends paid to parent (1)

 

 
(864,242
)
 
864,242

 

Other

 

 
(4,489
)
 

 
(4,489
)
Preferred dividends paid
(20,840
)
 

 

 

 
(20,840
)
 
Net Cash Provided By (Used For) Financing Activities
(300,821
)
 

 
(1,273,493
)
 
841,285

 
(733,029
)
Effects of exchange rates changes on foreign currency cash and restricted cash

 

 
(10,431
)
 

 
(10,431
)
Increase (decrease) in cash and restricted cash
(2,963
)
 
(2,869
)
 
(138,343
)
 

 
(144,175
)
Cash and restricted cash, beginning of year
10,048

 
30,380

 
686,856

 

 
727,284

Cash and restricted cash, end of period
$
7,085

 
$
27,511

 
$
548,513

 
$

 
$
583,109


(1)     Dividends received by parent are included in net cash provided by (used for) operating activities.


ARCH CAPITAL
 45
2018 SECOND QUARTER FORM 10-Q

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


 
 
Six Months Ended June 30, 2017
Condensed Consolidating Statement
of Cash Flows
Arch Capital (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other Arch Capital Subsidiaries
 
Consolidating Adjustments and Eliminations
 
Arch Capital Consolidated
Operating Activities
 
 
 
 
 
 
 
 
 
 
Net Cash Provided By (Used For) Operating Activities
$
7,483

 
$
27,853

 
$
956,437

 
$
(458,238
)
 
$
533,535

Investing Activities
 
 
 
 
 
 
 
 
 
Purchases of fixed maturity investments

 

 
(19,899,326
)
 

 
(19,899,326
)
Purchases of equity securities

 

 
(400,155
)
 

 
(400,155
)
Purchases of other investments

 

 
(883,704
)
 

 
(883,704
)
Proceeds from the sales of fixed maturity investments

 

 
19,611,680

 

 
19,611,680

Proceeds from the sales of equity securities

 

 
473,064

 

 
473,064

Proceeds from the sales, redemptions and maturities of other investments

 

 
614,494

 

 
614,494

Proceeds from redemptions and maturities of fixed maturity investments

 

 
447,941

 

 
447,941

Net settlements of derivative instruments

 

 
(5,984
)
 

 
(5,984
)
Net (purchases) sales of short-term investments
2,354

 
(27,896
)
 
(419,661
)
 

 
(445,203
)
Change in cash collateral related to securities lending

 

 
175,693

 

 
175,693

Contributions to subsidiaries
20,641

 
(72,900
)
 
(342,950
)
 
395,209

 

Issuance of intercompany loans

 

 
(47,000
)
 
47,000

 

Repayment of intercompany loans

 
47,000

 

 
(47,000
)
 

Purchases of fixed assets
(18
)
 
(10
)
 
(11,075
)
 

 
(11,103
)
Other

 

 
54,129

 
(20,641
)
 
33,488

 
Net Cash Provided By (Used For) Investing Activities
22,977

 
(53,806
)
 
(632,854
)
 
374,568

 
(289,115
)
Financing Activities
 
 
 
 
 
 
 
 
 
Proceeds from common shares issued, net
(6,838
)
 

 
395,209

 
(395,209
)
 
(6,838
)
Repayments of borrowings

 

 
(72,000
)
 

 
(72,000
)
Change in cash collateral related to securities lending

 

 
(175,693
)
 

 
(175,693
)
Dividends paid to redeemable noncontrolling interests

 

 
(9,632
)
 
638

 
(8,994
)
Dividends paid to parent (1)

 

 
(457,600
)
 
457,600

 

Other

 

 
(62,339
)
 
20,641

 
(41,698
)
Preferred dividends paid
(22,567
)
 

 

 

 
(22,567
)
 
Net Cash Provided By (Used For) Financing Activities
(29,405
)
 

 
(382,055
)
 
83,670

 
(327,790
)
Effects of exchange rates changes on foreign currency cash and restricted cash

 

 
9,616

 

 
9,616

Increase (decrease) in cash and restricted cash
1,055

 
(25,953
)
 
(48,856
)
 

 
(73,754
)
Cash and restricted cash, beginning of year
1,738

 
71,955

 
895,876

 

 
969,569

Cash and restricted cash, end of period
$
2,793

 
$
46,002

 
$
847,020

 
$

 
$
895,815


(1)     Dividends received by parent are included in net cash provided by (used for) operating activities.




ARCH CAPITAL
 46
2018 SECOND QUARTER FORM 10-Q

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

14.    Income Taxes

The Company’s income tax provision on income before income taxes resulted in an expense of 9.7% for the six months ended June 30, 2018, compared to an expense of 11.7% for the 2017 period. 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. For interim reporting purposes, the Company has calculated its effective tax rate for the full year of 2018 by treating any excess tax benefits that arise from the accounting for stock based compensation as a discrete item. As such, this amount is not included when projecting the Company’s full year effective tax rate but rather is accounted for at the U.S. Federal statutory rate of 21% after applying the projected full year effective tax rate to actual results before the discrete item. The impact of the discrete item resulted in a benefit of 0.6% for the six months ended June 30, 2018.
On December 22, 2017, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of GAAP in situations when a registrant does not have the necessary information available, prepared or analyzed in reasonable detail to complete the accounting for certain income tax effects of the Tax Cuts and Jobs Act of 2017 (“Tax Cuts Act”). Pursuant to the guidance within SAB 118, the Company’s remeasurement of its deferred taxes at December 31, 2017 included certain provisional effects associated with enactment of the Tax Cuts Act for which measurement could be reasonably estimated. Provisional amounts may be adjusted in 2018 during the measurement period in accordance with SAB 118 when additional information is obtained. Additional information that may affect the provisional amounts would include, completion of the Company’s U.S. subsidiaries’ 2017 tax return filings, and potential future guidance from the IRS with respect to the transitional adjustment pertaining to loss reserve discounting as well as the utilization of alternative minimum tax credits. The Company’s income tax provision six months ended June 30, 2018 does not include any adjustments to the provisional effects recorded at December 31, 2017.

The Company had a net deferred tax asset of $9.7 million at June 30, 2018, compared to $39.6 million at December 31, 2017. In addition, the Company recovered $46.5 million and paid $3.9 million of income taxes for the six months ended June 30, 2018 and 2017, respectively.
 
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, 2018, 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. 

ARCH CAPITAL
 47
2018 SECOND QUARTER FORM 10-Q

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, 2017 (“2017 Form 10-K”). In addition, readers should review “Risk Factors” set forth in Item 1A of Part I of our 2017 Form 10-K. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
Arch Capital Group Ltd. (“Arch Capital” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with approximately $11.02 billion in capital at June 30, 2018 and, through operations in Bermuda, the United States, Europe, Canada and Australia, writes insurance, reinsurance and mortgage insurance on a worldwide basis.
CURRENT OUTLOOK

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 portion of our overall book in catastrophe-exposed business which has the potential to increase the volatility of our operating results.
The broad property casualty insurance market environment continues to be competitive, with market conditions improving modestly in the 2018 second quarter. In most of our insurance lines of business, rate increases appear to be in excess of loss cost trends. However, with the continued low interest rate environment, additional price increases are needed in many lines in order for us to achieve our return requirements. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts, shrinking premiums in more commoditized lines such as general liability and directors and officers, and by utilizing reinsurance purchases to reduce volatility on large account, high capacity business. Writings in property catastrophe exposed business were down in the 2018 second quarter as most rate levels were below our risk-adjusted return requirements.
Our mortgage segment continues to experience generally favorable market conditions, albeit with pressure on pricing,
 
and our results reflect our success in making superior credit underwriting risk decisions and in expanding our distribution and producer relationships.
Arch remains committed to providing solutions across many offerings as the marketplace evolves, including new mortgage credit risk transfer programs initiated by government sponsored enterprises, or “GSEs,” in 2018. Such programs are in their infancy and did not contribute in any significant fashion to our results in the 2018 second quarter. In addition, in April 2018, we announced that we entered into a multi-year agreement with Munich Re to provide mortgage credit assessment and underwriting advisory services related to Munich Re’s involvement in credit risk transfer programs offered by Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), each a GSE.
FINANCIAL MEASURES

Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for Arch Capital’s common shareholders:
Book Value per Share
Book value per share represents total common shareholders’ equity available to Arch divided by the number of common shares outstanding. Management uses growth in book value per share as a key measure of the value generated for our common shareholders each period and believes that book value per share is the key driver of Arch Capital’s share price over time. Book value per 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 share depending on the purchase price.
Book value per share was $20.68 at June 30, 2018, compared to $20.41 at March 31, 2018 and $19.87 at June 30, 2017. The 1.3% increase for the 2018 second quarter reflected strong underwriting results, partially offset by the impact of an increase in interest rates on our fixed income securities in the period, while the 4.1% increase over the trailing twelve months reflected strong investment and underwriting results.
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

ARCH CAPITAL
 48
2018 SECOND QUARTER FORM 10-Q

Table of Contents

of beginning and ending common shareholders’ equity available to Arch during the period. After-tax operating income available to Arch common shareholders, a non-GAAP financial measure as defined in Regulation G, 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, net foreign exchange gains or losses, UGC transaction costs and other, loss on redemption of preferred shares and income taxes. Management uses Operating ROAE as a key measure of the return generated to common shareholders. See “Comment on Non-GAAP Financial Measures.”
Our Operating ROAE was 11.6% for the 2018 second quarter, compared to 8.5% for the 2017 second quarter, and 11.4% for the six months ended June 30, 2018, compared to 9.4% for the 2017 period. The 2018 returns reflected strong mortgage insurance underwriting performance and a low level of catastrophic activity.
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, excludes amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. In addition, total return incorporates the timing of investment returns during the periods. The following table summarizes our total return compared to the benchmark return against which we measured our portfolio during the periods. See “Comment on Non-GAAP Financial Measures.”
 
Arch
Portfolio
 
Benchmark
Return
2018 Second Quarter
(0.19
)%
 
(0.21
)%
2017 Second Quarter
1.63
 %
 
1.53
 %
 
 
 
 
Six Months Ended June 30, 2018
(0.51
)%
 
(0.89
)%
Six Months Ended June 30, 2017
3.37
 %
 
3.05
 %
Excluding the effects of foreign exchange, total return was 0.33% for the 2018 second quarter and (0.08)% for the six months ended June 30, 2018, reflecting an increase in interest rates in the 2018 periods. Total return for the 2018 periods reflected the strengthening of the U.S. Dollar against the Euro and British Pound Sterling on non-U.S. Dollar denominated investments.
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 changes to the mix of liability currencies and durations 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, 2018, the benchmark return index had an average credit quality of “Aa2” by Moody’s Investors Service (“Moody’s”), and an estimated duration of 3.25 years.
The benchmark return index included weightings to the following indices, which are primarily from The Bank of America Merrill Lynch (“BoAML”):
 
%
BoAML 1-10 Year U.S. Corporate & All Yankees, A - AAA Rated Index
20.00
%
BoAML 1-5 Year U.S. Treasury Index
15.00

BoAML 1-10 Year U.S. Municipal Securities Index
14.50

BoAML 3-5 Year Fixed Rate Asset Backed Securities Index
7.00

Barclays CMBS Inv. Grade, AAA Rated Index
5.00

MSCI All Country World Gross Total Return Index
5.00

BoAML German Government 1-10 Year Index
5.00

BoAML U.S. Mortgage Backed Securities Index
4.00

Hedge Fund Research HFRX Fixed Income Credit Index
3.50

Hedge Fund Research HFRX Equal Weighted Strategies
3.50

BoAML 5-10 Year U.S. Treasury Index
3.00

BoAML 1-5 Year U.K. Gilt Index
3.00

BoAML U.S. High Yield Constrained Index
2.50

BoAML 1-5 Year Australian Governments Index
2.50

S&P Leveraged Loan Index
2.50

BoAML 0-3 Month U.S. Treasury Bill Index
2.00

BoAML 1-5 Year Canada Government Index
1.50

BoAML 20+ Year Canada Government Index
0.50

Total
100.00
%
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, net foreign exchange gains or losses, UGC transaction costs and other, loss on redemption of preferred shares and income taxes, and the use of annualized operating return on average common equity. The

ARCH CAPITAL
 49
2018 SECOND QUARTER FORM 10-Q

Table of Contents

presentation of after-tax operating income available to Arch common shareholders and annualized operating return on average common equity are non-GAAP financial measures as defined in Regulation G. The reconciliation of such measures to net income available to Arch common shareholders and annualized return on average common equity (the most directly comparable GAAP financial measures) 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, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares 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. UGC transaction costs and other include advisory, financing, legal, severance, incentive compensation and other transaction costs related to the acquisition of United Guaranty Corporation, a North Carolina corporation (“UGC”) which closed at the end of 2016. We believe that UGC transaction costs and other, due to their non-recurring nature, are not indicative of the performance of, or trends in, our business performance. The loss on redemption of preferred shares related to the redemption of our Series C preferred shares
 
in January 2018 and had no impact on shareholders' equity or cash flows. 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, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares 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.
Our segment information includes the presentation of consolidated underwriting income or loss and a subtotal of underwriting income or loss before the contribution from the ‘other’ segment. Such measures represent the pre-tax profitability of our underwriting operations and include net premiums earned plus other underwriting income, less losses and loss adjustment expenses, acquisition expenses and other operating expenses. Other operating expenses include those operating expenses that are incremental and/or directly attributable to our individual underwriting operations. Underwriting income or loss does not incorporate items included in our corporate (non-underwriting) segment. While these measures are presented in Note 5, “Segment Information,” of the notes accompanying our consolidated financial statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis. The reconciliations of underwriting income or loss to income before income taxes (the most directly comparable GAAP financial measure) on a consolidated basis and a subtotal before the contribution from the ‘other’ segment, in accordance with Regulation G, is shown in Note 5, “Segment Information” to our consolidated financial statements.

We measure 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 intangibles and, accordingly, investment income and other non-underwriting related items are not allocated to each underwriting segment. For the ‘other’ segment, performance is measured based on net income or loss.


ARCH CAPITAL
 50
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Along with consolidated underwriting income, we provide a subtotal of underwriting income or loss before the contribution from the ‘other’ segment. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. Watford Re has its own management and board of directors that is responsible for its overall profitability. In addition, we do not guarantee or provide credit support for Watford Re. Since Watford Re is an independent company, the assets of Watford Re can be used only to settle obligations of Watford Re and Watford Re is solely responsible for its own liabilities and commitments. Our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions. We believe that presenting certain information excluding the ‘other’ segment enables investors and other users of our financial information to analyze our performance in a manner similar to how our management analyzes performance.

Our presentation of segment information includes the use of a current year loss ratio which excludes favorable or adverse development in prior year loss reserves. This ratio is a non-GAAP financial measure as defined in Regulation G. The reconciliation of such measure to the loss ratio (the most directly comparable GAAP financial measure) in accordance with Regulation G is shown on the individual segment pages. Management utilizes the current year loss ratio in its analysis of the underwriting performance of each of our underwriting segments.
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, excludes amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. In addition, total return incorporates the timing of investment returns during the periods. There is no directly comparable GAAP financial measure for total return. 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.
 
RESULTS OF OPERATIONS

The following table summarizes our consolidated financial data, including a reconciliation of net income available to Arch common shareholders to after-tax operating income available to Arch common shareholders. Each line item reflects the impact of our approximate 11% ownership of Watford Re’s common equity.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2018
 
2017
 
2018
 
2017
Net income available to Arch common shareholders
$
233,243

 
$
173,818

 
$
370,519

 
$
415,727

Net realized (gains) losses
61,426

 
(18,452
)
 
173,190

 
(47,586
)
Net impairment losses recognized in earnings
470

 
1,730

 
632

 
3,537

Equity in net (income) loss of investment funds accounted for using the equity method
(8,472
)
 
(32,706
)
 
(36,541
)
 
(80,794
)
Net foreign exchange (gains) losses
(47,038
)
 
38,012

 
(31,482
)
 
57,808

UGC transaction costs and other
6,908

 
2,675

 
7,738

 
18,259

Loss on redemption of preferred shares

 

 
2,710

 

Income tax expense (benefit) (1)
(3,941
)
 
3,842

 
(9,027
)
 
(67
)
After-tax operating income available to Arch common shareholders
$
242,596

 
$
168,919

 
$
477,739

 
$
366,884

 
 
 
 
 
 
 
 
Beginning common shareholders’ equity
$
8,370,372

 
$
7,833,289

 
$
8,324,047

 
$
7,481,163

Ending common shareholders’ equity
8,383,755

 
8,126,332

 
8,383,755

 
8,126,332

Average common shareholders’ equity
$
8,377,064

 
$
7,979,811

 
$
8,353,901

 
$
7,803,748

 
 
 
 
 
 
 
 
Annualized return on average common equity %
11.1

 
8.7

 
8.9

 
10.7

Annualized operating return on average
common equity %
11.6

 
8.5

 
11.4

 
9.4

(1)
Income tax on 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, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares reflects the relative mix reported by jurisdiction and the varying tax rates in each jurisdiction.

ARCH CAPITAL
 51
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Segment Information
We classify our businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — corporate (non-underwriting) and ‘other.’ 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 President and Chief Executive Officer of Arch Capital and the Chief Financial Officer of Arch Capital. 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.
Insurance Segment
The following tables set forth our insurance segment’s underwriting results:
 
Three Months Ended June 30,
 
2018
 
2017
 
% Change
Gross premiums written
$
769,372

 
$
743,902

 
3.4

Premiums ceded
(245,265
)
 
(247,446
)
 
 
Net premiums written
524,107

 
496,456

 
5.6

Change in unearned premiums
22,342

 
21,118

 
 
Net premiums earned
546,449

 
517,574

 
5.6

Losses and loss adjustment expenses
(357,465
)
 
(350,939
)
 
 

Acquisition expenses
(90,670
)
 
(78,872
)
 
 

Other operating expenses
(92,680
)
 
(92,267
)
 
 

Underwriting income (loss)
$
5,634

 
$
(4,504
)
 
 n/m

 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
Loss ratio
65.4
%
 
67.8
%
 
(2.4
)
Acquisition expense ratio
16.6
%
 
15.2
%
 
1.4

Other operating expense ratio
17.0
%
 
17.8
%
 
(0.8
)
Combined ratio
99.0
%
 
100.8
%
 
(1.8
)
 
 
Six Months Ended June 30,
 
2018
 
2017
 
% Change
Gross premiums written
$
1,592,750

 
$
1,526,183

 
4.4

Premiums ceded
(492,445
)
 
(481,541
)
 
 
Net premiums written
1,100,305

 
1,044,642

 
5.3

Change in unearned premiums
(15,119
)
 
(21,422
)
 
 
Net premiums earned
1,085,186

 
1,023,220

 
6.1

Losses and loss adjustment expenses
(711,195
)
 
(683,580
)
 
 

Acquisition expenses
(175,839
)
 
(153,740
)
 
 

Other operating expenses
(184,654
)
 
(180,393
)
 
 

Underwriting income
$
13,498

 
$
5,507

 
145.1

 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
Loss ratio
65.5
%
 
66.8
%
 
(1.3
)
Acquisition expense ratio
16.2
%
 
15.0
%
 
1.2

Other operating expense ratio
17.0
%
 
17.6
%
 
(0.6
)
Combined ratio
98.7
%
 
99.4
%
 
(0.7
)
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

ARCH CAPITAL
 52
2018 SECOND QUARTER FORM 10-Q

Table of Contents

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.
Premiums Written.
The following tables set forth our insurance segment’s net premiums written by major line of business:
 
Three Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Professional lines
$
108,298

 
20.7

 
$
110,784

 
22.3

Programs
100,178

 
19.1

 
93,428

 
18.8

Construction and national accounts
66,384

 
12.7

 
73,474

 
14.8

Travel, accident and health
63,222

 
12.1

 
52,690

 
10.6

Property, energy, marine and aviation
62,121

 
11.9

 
46,031

 
9.3

Excess and surplus casualty
40,042

 
7.6

 
45,222

 
9.1

Lenders products
22,290

 
4.3

 
21,459

 
4.3

Other
61,572

 
11.7

 
53,368

 
10.7

Total
$
524,107

 
100.0

 
$
496,456

 
100.0

2018 Second Quarter versus 2017 Second Quarter. Gross premiums written by the insurance segment in the 2018 second quarter were 3.4% higher than in the 2017 second quarter, while net premiums written were 5.6% higher than in the 2017 second quarter. Changes in foreign currency rates resulted in an increase in net premiums written in the 2018 second quarter of $2.0 million, or 0.4%, compared to the 2017 second quarter. The increase in net premiums written reflected growth in property, primarily due to new business and rate increases, in travel, due to both new business and growth in existing
 
accounts, and in programs, reflecting rate increases and growth in recently added programs.
 
Six Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Professional lines
$
228,087

 
20.7

 
$
219,252

 
21.0

Programs
196,734

 
17.9

 
193,385

 
18.5

Construction and national accounts
164,812

 
15.0

 
173,451

 
16.6

Travel, accident and health
143,746

 
13.1

 
118,218

 
11.3

Property, energy, marine and aviation
114,248

 
10.4

 
86,135

 
8.2

Excess and surplus casualty
81,964

 
7.4

 
91,054

 
8.7

Lenders products
44,274

 
4.0

 
46,164

 
4.4

Other
126,440

 
11.5

 
116,983

 
11.2

Total
$
1,100,305

 
100.0

 
$
1,044,642

 
100.0

Six Months Ended June 30, 2018 versus 2017 period. Gross premiums written by the insurance segment for the six months ended June 30, 2018 were 4.4% higher than in the 2017 period, while net premiums written were 5.3% higher than in the 2017 period. The increase in net premiums written reflected growth in travel, due to both new business and growth in existing accounts, in property, primarily due to new business and rate increases, and in professional lines, reflecting increases in small and medium sized accounts.

ARCH CAPITAL
 53
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Net Premiums Earned.
The following tables set forth our insurance segment’s net premiums earned by major line of business:
 
Three Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Professional lines
$
112,226

 
20.5

 
$
108,375

 
20.9

Programs
97,333

 
17.8

 
87,582

 
16.9

Construction and national accounts
81,784

 
15.0

 
80,848

 
15.6

Travel, accident and health
74,754

 
13.7

 
63,436

 
12.3

Property, energy, marine and aviation
50,840

 
9.3

 
41,423

 
8.0

Excess and surplus casualty
40,049

 
7.3

 
48,850

 
9.4

Lenders products
23,161

 
4.2

 
24,562

 
4.7

Other
66,302

 
12.1

 
62,498

 
12.1

Total
$
546,449

 
100.0

 
$
517,574

 
100.0

 
Six Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Professional lines
$
228,244

 
21.0

 
$
217,013

 
21.2

Programs
192,344

 
17.7

 
172,762

 
16.9

Construction and national accounts
158,996

 
14.7

 
158,271

 
15.5

Travel, accident and health
141,589

 
13.0

 
121,917

 
11.9

Property, energy, marine and aviation
99,443

 
9.2

 
79,501

 
7.8

Excess and surplus casualty
86,593

 
8.0

 
99,857

 
9.8

Lenders products
45,977

 
4.2

 
48,661

 
4.8

Other
132,000

 
12.2

 
125,238

 
12.2

Total
$
1,085,186

 
100.0

 
$
1,023,220

 
100.0

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 reflect changes in net premiums written over the previous five quarters. Net premiums earned in the 2018 second quarter were 5.6% higher than in the 2017 second quarter. Net premiums earned for the six months ended June 30, 2018 were 6.1% higher than in the 2017 period.
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,
 
2018
 
2017
 
2018
 
2017
Current year
66.5
 %
 
68.2
 %
 
66.3
 %
 
67.2
 %
Prior period reserve development
(1.1
)%
 
(0.4
)%
 
(0.8
)%
 
(0.4
)%
Loss ratio
65.4
 %
 
67.8
 %
 
65.5
 %
 
66.8
 %
 
Current Year Loss Ratio.
The insurance segment’s current year loss ratio in the 2018 second quarter was 1.7 points lower than in the 2017 second quarter and reflected 1.4 points of current year catastrophic activity, compared to 1.6 points in the 2017 second quarter. The insurance segment’s current year loss ratio for the six months ended June 30, 2018 was 0.9 points lower than in the 2017 period and reflected 0.8 points of current year catastrophic activity, compared to 1.1 points in the 2017 period. The balance of the change in the 2018 loss ratios resulted, in part, from changes in mix of business.
Prior Period Reserve Development.
The insurance segment’s net favorable development was $6.1 million, or 1.1 points, for the 2018 second quarter, compared to $2.0 million, or 0.4 points, for the 2017 second quarter, and $8.2 million, or 0.8 points, for the six months ended June 30, 2018, compared to $4.1 million, or 0.4 points, for the 2017 period. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements for information about the insurance segment’s prior year reserve development.
Underwriting Expenses.
2018 Second Quarter versus 2017 Second Quarter. The insurance segment’s underwriting expense ratio was 33.6% in the 2018 second quarter, compared to 33.0% in the 2017 second quarter. The comparison of the underwriting expense ratios reflects changes in the level of reinsurance ceded on a quota share basis and changes in the mix of business.
Six Months Ended June 30, 2018 versus 2017 period. The insurance segment’s underwriting expense ratio was 33.2% for the six months ended June 30, 2018, compared to 32.6% for the 2017 period. The comparison of the underwriting expense ratios reflects changes in the level of reinsurance ceded on a quota share basis and changes in the mix of business.

ARCH CAPITAL
 54
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Reinsurance Segment 
The following tables set forth our reinsurance segment’s underwriting results:
 
Three Months Ended June 30,
 
2018
 
2017
 
% Change
Gross premiums written
$
490,327

 
$
453,186

 
8.2

Premiums ceded
(136,247
)
 
(115,262
)
 
 
Net premiums written
354,080

 
337,924

 
4.8

Change in unearned premiums
(13,762
)
 
(23,222
)
 
 
Net premiums earned
340,318

 
314,702

 
8.1

Other underwriting income
(129
)
 
(279
)
 
 

Losses and loss adjustment expenses
(229,956
)
 
(207,606
)
 
 

Acquisition expenses
(50,142
)
 
(51,151
)
 
 

Other operating expenses
(35,678
)
 
(36,711
)
 
 

Underwriting income
$
24,413

 
$
18,955

 
28.8

 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
% Point
Change
Loss ratio
67.6
%
 
66.0
%
 
1.6

Acquisition expense ratio
14.7
%
 
16.3
%
 
(1.6
)
Other operating expense ratio
10.5
%
 
11.7
%
 
(1.2
)
Combined ratio
92.8
%
 
94.0
%
 
(1.2
)
 
Six Months Ended June 30,
 
2018
 
2017
 
% Change
Gross premiums written
$
1,067,810

 
$
928,968

 
14.9

Premiums ceded
(331,977
)
 
(281,354
)
 
 
Net premiums written
735,833

 
647,614

 
13.6

Change in unearned premiums
(116,343
)
 
(88,061
)
 
 
Net premiums earned
619,490

 
559,553

 
10.7

Other underwriting income
1,103

 
(585
)
 
 

Losses and loss adjustment expenses
(371,631
)
 
(313,060
)
 
 

Acquisition expenses
(98,461
)
 
(97,298
)
 
 

Other operating expenses
(71,249
)
 
(74,244
)
 
 

Underwriting income
$
79,252

 
$
74,366

 
6.6

 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
% Point
Change
Loss ratio
60.0
%
 
55.9
%
 
4.1

Acquisition expense ratio
15.9
%
 
17.4
%
 
(1.5
)
Other operating expense ratio
11.5
%
 
13.3
%
 
(1.8
)
Combined ratio
87.4
%
 
86.6
%
 
0.8

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 proportional motor 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 or aggregation of losses from 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 individual 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.

ARCH CAPITAL
 55
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Premiums Written.
The following tables set forth our reinsurance segment’s net premiums written by major line of business:
 
Three Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Other specialty
$
155,081

 
43.8

 
$
155,328

 
46.0

Casualty
68,113

 
19.2

 
63,054

 
18.7

Property excluding property catastrophe
77,876

 
22.0

 
69,115

 
20.5

Property catastrophe
35,045

 
9.9

 
37,127

 
11.0

Marine and aviation
10,061

 
2.8

 
8,932

 
2.6

Other
7,904

 
2.2

 
4,368

 
1.3

Total
$
354,080

 
100.0

 
$
337,924

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
212,858

 
60.1

 
$
200,893

 
59.4

Excess of loss
141,222

 
39.9

 
137,031

 
40.6

Total
$
354,080

 
100.0

 
$
337,924

 
100.0

2018 Second Quarter versus 2017 Second Quarter. Gross premiums written by the reinsurance segment in the 2018 second quarter were 8.2% higher than in the 2017 second quarter, while net premiums written were 4.8% higher than in the 2017 second quarter. Changes in foreign currency rates resulted in an increase in net premiums written in the 2018 second quarter of $6.9 million, or 2.0%, compared to the 2017 second quarter. The increase in net premiums written reflected growth in property excluding property catastrophe business, primarily due to new accounts and rate increases.
 
Six Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Other specialty
$
294,073

 
40.0

 
$
269,746

 
41.7

Casualty
198,289

 
26.9

 
173,674

 
26.8

Property excluding property catastrophe
163,046

 
22.2

 
144,502

 
22.3

Property catastrophe
42,677

 
5.8

 
29,650

 
4.6

Marine and aviation
20,073

 
2.7

 
18,473

 
2.9

Other
17,675

 
2.4

 
11,569

 
1.8

Total
$
735,833

 
100.0

 
$
647,614

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
365,023

 
49.6

 
$
329,909

 
50.9

Excess of loss
370,810

 
50.4

 
317,705

 
49.1

Total
$
735,833

 
100.0

 
$
647,614

 
100.0

Six Months Ended June 30, 2018 versus 2017 period. Gross premiums written by the reinsurance segment for the six months ended June 30, 2018 were 14.9% higher than in the 2017 period, while net premiums written were 13.6% higher than in the 2017 period. The increase in net premiums written reflected growth in property lines, primarily due to new business and rate increases, and in other specialty, primarily due to new international motor contracts.
 
Net Premiums Earned.
The following tables set forth our reinsurance segment’s net premiums earned by major line of business:
 
Three Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Other specialty
$
149,648

 
44.0

 
$
141,565

 
45.0

Casualty
85,009

 
25.0

 
79,903

 
25.4

Property excluding property catastrophe
70,849

 
20.8

 
62,884

 
20.0

Marine and aviation
10,089

 
3.0

 
9,986

 
3.2

Property catastrophe
15,716

 
4.6

 
15,759

 
5.0

Other
9,007

 
2.6

 
4,605

 
1.5

Total
$
340,318

 
100.0

 
$
314,702

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
203,632

 
59.8

 
$
181,988

 
57.8

Excess of loss
136,686

 
40.2

 
132,714

 
42.2

Total
$
340,318

 
100.0

 
$
314,702

 
100.0

 
Six Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Other specialty
$
253,365

 
40.9

 
$
211,530

 
37.8

Casualty
154,381

 
24.9

 
152,871

 
27.3

Property excluding property catastrophe
139,603

 
22.5

 
132,736

 
23.7

Marine and aviation
19,478

 
3.1

 
19,476

 
3.5

Property catastrophe
34,103

 
5.5

 
31,936

 
5.7

Other
18,560

 
3.0

 
11,004

 
2.0

Total
$
619,490

 
100.0

 
$
559,553

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
367,628

 
59.3

 
$
315,080

 
56.3

Excess of loss
251,862

 
40.7

 
244,473

 
43.7

Total
$
619,490

 
100.0

 
$
559,553

 
100.0

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. For the 2018 second quarter, net premiums earned were 8.1% higher than in the 2017 second quarter, and reflect changes in net premiums written over the previous five quarters. For the six months ended June 30, 2018, net premiums earned were 10.7% higher than in the 2017 period.
Other Underwriting Income (Loss).
Other underwriting income (loss) for the 2018 second quarter was $(0.1) million, compared to $(0.3) million for the 2017 second quarter, and $1.1 million for the six months ended June 30, 2018, compared to $(0.6) million for the 2017 period.

ARCH CAPITAL
 56
2018 SECOND QUARTER FORM 10-Q

Table of Contents

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,
 
2018
 
2017
 
2018
 
2017
Current year
77.3
 %
 
78.6
 %
 
71.2
 %
 
73.2
 %
Prior period reserve development
(9.7
)%
 
(12.6
)%
 
(11.2
)%
 
(17.3
)%
Loss ratio
67.6
 %
 
66.0
 %
 
60.0
 %
 
55.9
 %
Current Year Loss Ratio.
The reinsurance segment’s current year loss ratio in the 2018 second quarter was 1.3 points lower than in the 2017 second quarter and reflected 2.2 points of current year catastrophic activity, compared to 5.4 points in the 2017 second quarter. The 2018 second quarter loss ratio contained 9.9 points, or $33.7 million, of property facultative loss activity, compared to 11.1 points, or $34.8 million, in the 2017 second quarter. The balance of the change in the 2018 second quarter current year loss ratio resulted, in part, from a higher level of large attritional loss activity than in the 2017 second quarter.
The reinsurance segment’s current year loss ratio for the six months ended June 30, 2018 was 2.0 points lower than in the 2017 period and reflected 1.4 points of current year catastrophic activity, compared to 4.8 points in the 2017 period. The loss ratio for the six months ended June 30, 2018 contained 7.0 points, or $43.4 million, of property facultative loss activity, compared to 5.9 points, or $33.1 million, in the 2017 period.
Prior Period Reserve Development.
The reinsurance segment’s net favorable development was $33.0 million, or 9.7 points, for the 2018 second quarter, compared to $39.5 million, or 12.6 points, for the 2017 second quarter, and $69.6 million, or 11.2 points, for the six months ended June 30, 2018, compared to $96.8 million, or 17.3 points, for the 2017 period. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements for information about the reinsurance segment’s prior year reserve development.
Underwriting Expenses.
2018 Second Quarter versus 2017 Second Quarter. The underwriting expense ratio for the reinsurance segment was 25.2% in the 2018 second quarter, compared to 28.0% in the 2017 second quarter. The comparison of the underwriting expense ratios also reflected changes in the mix and type of business and a higher level of net premiums earned in the 2018 second quarter. The underwriting expense ratio benefited from a reduction in federal excise taxes incurred of $2.6 million, or 0.8 points, as the reinsurance agreements between the Company’s U.S.-based property casualty insurance and
 
reinsurance subsidiaries and Arch Reinsurance Ltd. (“Arch Re Bermuda”) were canceled on a cutoff basis as of January 1, 2018.
Six Months Ended June 30, 2018 versus 2017 period. The underwriting expense ratio for the reinsurance segment was 27.4% for the six months ended June 30, 2018, compared to 30.7% for the 2017 period. The comparison of the underwriting expense ratios also reflected changes in the mix and type of business and a higher level of net premiums earned for the 2018 period. The underwriting expense ratio benefited from a reduction in federal excise taxes incurred of $5.1 million, or 0.8 points, as discussed above.
Mortgage Segment 
Our mortgage operations include U.S. and international mortgage insurance and reinsurance operations as well as GSE credit risk sharing transactions. Our mortgage group includes direct mortgage insurance in the U.S. primarily provided by Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (together, “Arch MI U.S.”), as well as through Arch Mortgage Guaranty Company; mortgage reinsurance by Arch Re Bermuda to mortgage insurers on both a proportional and non-proportional basis globally; direct mortgage insurance in Europe provided by Arch MI Europe and in Hong Kong by Arch MI Asia; and various GSE credit risk sharing products provided primarily by Arch Re Bermuda.
The following tables set forth our mortgage segment’s underwriting results.
 
Three Months Ended June 30,
 
2018
 
2017
 
% Change
Gross premiums written
$
330,990

 
$
336,226

 
(1.6
)
Premiums ceded
(50,867
)
 
(62,314
)
 
 
Net premiums written
280,123

 
273,912

 
2.3

Change in unearned premiums
10,355

 
(16,068
)
 
 
Net premiums earned
290,478

 
257,844

 
12.7

Other underwriting income
3,315

 
4,277

 
 

Losses and loss adjustment expenses
(21,591
)
 
(20,694
)
 
 

Acquisition expenses
(27,737
)
 
(25,666
)
 
 

Other operating expenses
(38,729
)
 
(32,150
)
 
 

Underwriting income
$
205,736

 
$
183,611

 
12.0

 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
Loss ratio
7.4
%
 
8.0
%
 
(0.6
)
Acquisition expense ratio
9.5
%
 
10.0
%
 
(0.5
)
Other operating expense ratio
13.3
%
 
12.5
%
 
0.8

Combined ratio
30.2
%
 
30.5
%
 
(0.3
)

ARCH CAPITAL
 57
2018 SECOND QUARTER FORM 10-Q

Table of Contents

 
Six Months Ended June 30,
 
2018
 
2017
 
% Change
Gross premiums written
$
652,168

 
$
684,849

 
(4.8
)
Premiums ceded
(97,004
)
 
(136,239
)
 
 
Net premiums written
555,164

 
548,610

 
1.2

Change in unearned premiums
15,556

 
(46,243
)
 
 
Net premiums earned
570,720

 
502,367

 
13.6

Other underwriting income
6,731

 
8,400

 
 

Losses and loss adjustment expenses
(65,057
)
 
(49,759
)
 
 

Acquisition expenses
(54,304
)
 
(54,432
)
 
 

Other operating expenses
(77,500
)
 
(74,020
)
 
 

Underwriting income
$
380,590

 
$
332,556

 
14.4

 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
Loss ratio
11.4
%
 
9.9
%
 
1.5

Acquisition expense ratio
9.5
%
 
10.8
%
 
(1.3
)
Other operating expense ratio
13.6
%
 
14.7
%
 
(1.1
)
Combined ratio
34.5
%
 
35.4
%
 
(0.9
)
Premiums Written.
The following tables set 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,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Client location:
 
 
 
 
 
 
 
United States
$
254,966

 
91.0

 
$
253,456

 
92.5

Other
25,157

 
9.0

 
20,456

 
7.5

Total
$
280,123

 
100.0

 
$
273,912

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
229,715

 
82.0

 
$
227,266

 
83.0

Other
50,408

 
18.0

 
46,646

 
17.0

Total
$
280,123

 
100.0

 
$
273,912

 
100.0

2018 Second Quarter versus 2017 Second Quarter. Gross premiums written by the mortgage segment in the 2018 second quarter were 1.6% lower than in the 2017 second quarter. The reduction in gross premiums written primarily reflected a lower level of Australian mortgage reinsurance business and a lower level of U.S. single premium business. Net premiums written for the 2018 second quarter were 2.3% higher than in the 2017 second quarter and reflected a declining cession to AIG on the 50% quota share reinsurance agreement covering 2014 to 2016 policy years of UGC business on a run-off basis, while the 2017 second quarter also reflected higher retrocessions of Australian mortgage reinsurance business.
 
 
Six Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Client location:
 
 
 
 
 
 
 
United States
$
501,514

 
90.3

 
$
494,592

 
90.2

Other
53,650

 
9.7

 
54,018

 
9.8

Total
$
555,164

 
100.0

 
$
548,610

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
450,892

 
81.2

 
$
443,995

 
80.9

Other
104,272

 
18.8

 
104,615

 
19.1

Total
$
555,164

 
100.0

 
$
548,610

 
100.0

Six Months Ended June 30, 2018 versus 2017 period. Gross premiums written by the mortgage segment for the six months ended June 30, 2018 were 4.8% lower than in the 2017 period. The reduction in gross premiums written primarily reflected a lower level of Australian mortgage reinsurance business and a lower level of U.S. single premium business. Net premiums written for the six months ended June 30, 2018 were 1.2% higher than in the 2017 period and reflected a declining cession to AIG on the 50% quota share reinsurance agreement covering 2014 to 2016 policy years of UGC business on a run-off basis, while the 2017 period also reflected higher retrocessions of Australian mortgage reinsurance business.
The persistency rate, which 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, of the Arch MI U.S. portfolio of mortgage loans was 81.7% at June 30, 2018, compared to 81.8% at December 31, 2017.
Arch MI U.S. generated $19.9 billion of new insurance written (“NIW”) in the 2018 second quarter, compared to $17.3 billion in the 2017 second quarter, with a decrease in the origination market and a decline in single premium and other business with high risk attributes. NIW represents the original principal balance of all loans that received coverage during the period. Monthly premium policies contributed 94.3% of NIW in the 2018 second quarter, compared to 85.7% for the 2017 second quarter.

ARCH CAPITAL
 58
2018 SECOND QUARTER FORM 10-Q

Table of Contents

The following tables provide details on the NIW generated by Arch MI U.S.:
(U.S. Dollars in millions)
Three Months Ended June 30,
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Total new insurance written (NIW) (1)
$
19,944

 
 
 
$
17,303

 
 
 
 
 
 
 
 
 
 
Credit quality (FICO):
 
 
 
 
 
 
 
>=740
$
11,308

 
56.7

 
$
9,814

 
56.7

680-739
7,182

 
36.0

 
6,274

 
36.3

620-679
1,454

 
7.3

 
1,215

 
7.0

  Total
$
19,944

 
100.0

 
$
17,303

 
100.0

 
 
 
 
 
 
 
 
Loan-to-value (LTV):
 
 
 
 
 
 
 
95.01% and above
$
2,835

 
14.2

 
$
1,700

 
9.8

90.01% to 95.00%
9,205

 
46.2

 
8,372

 
48.4

85.01% to 90.00%
5,910

 
29.6

 
5,462

 
31.6

85.01% and below
1,994

 
10.0

 
1,769

 
10.2

  Total
$
19,944

 
100.0

 
$
17,303

 
100.0

 
 
 
 
 
 
 
 
Monthly vs. single:
 
 
 
 
 
 
 
Monthly
$
18,814

 
94.3

 
$
14,832

 
85.7

Single
1,130

 
5.7

 
2,471

 
14.3

  Total
$
19,944

 
100.0

 
$
17,303

 
100.0

 
 
 
 
 
 
 
 
Purchase vs. refinance:
 
 
 
 
 
 
 
Purchase
$
18,871

 
94.6

 
$
16,063

 
92.8

Refinance
1,073

 
5.4

 
1,240

 
7.2

  Total
$
19,944

 
100.0

 
$
17,303

 
100.0

(1)
Represents the original principal balance of all loans that received coverage during the period.
(U.S. Dollars in millions)
Six Months Ended June 30,
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Total new insurance written (NIW) (1)
$
31,317

 
 
 
$
29,963

 
 
 
 
 
 
 
 
 
 
Credit quality (FICO):
 
 
 
 
 
 
 
>=740
$
17,920

 
57.2

 
$
16,998

 
56.7

680-739
11,224

 
35.8

 
10,889

 
36.3

620-679
2,173

 
6.9

 
2,076

 
6.9

  Total
$
31,317

 
100.0

 
$
29,963

 
100.0

 
 
 
 
 
 
 
 
Loan-to-value (LTV):
 
 
 
 
 
 
 
95.01% and above
$
4,097

 
13.1

 
$
2,672

 
8.9

90.01% to 95.00%
14,341

 
45.8

 
14,357

 
47.9

85.01% to 90.00%
9,553

 
30.5

 
9,523

 
31.8

85.01% and below
3,326

 
10.6

 
3,411

 
11.4

  Total
$
31,317

 
100.0

 
$
29,963

 
100.0

 
 
 
 
 
 
 
 
Monthly vs. single:
 
 
 
 
 
 
 
Monthly
$
29,204

 
93.3

 
$
25,200

 
84.1

Single
2,113

 
6.7

 
4,763

 
15.9

  Total
$
31,317

 
100.0

 
$
29,963

 
100.0

 
 
 
 
 
 
 
 
Purchase vs. refinance:
 
 
 
 
 
 
 
Purchase
$
29,159

 
93.1

 
$
26,783

 
89.4

Refinance
2,158

 
6.9

 
3,180

 
10.6

  Total
$
31,317

 
100.0

 
$
29,963

 
100.0

(1)
Represents the original principal balance of all loans that received coverage during the period.
 
Net Premiums Earned.
The following tables set forth our mortgage segment’s net premiums earned by client location and underwriting location (i.e., where the business is underwritten):
 
Three Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Client Location:
 
 
 
 
 
 
 
United States
$
274,921

 
94.6

 
$
246,656

 
95.7

Other
15,557

 
5.4

 
11,188

 
4.3

Total
$
290,478

 
100.0

 
$
257,844

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
247,897

 
85.3

 
$
219,084

 
85.0

Other
42,581

 
14.7

 
38,760

 
15.0

Total
$
290,478

 
100.0

 
$
257,844

 
100.0

 
Six Months Ended June 30,
 
2018
 
2017
 
Amount
 
%
 
Amount
 
%
Client Location:
 
 
 
 
 
 
 
United States
$
540,606

 
94.7

 
$
482,687

 
96.1

Other
30,114

 
5.3

 
19,680

 
3.9

Total
$
570,720

 
100.0

 
$
502,367

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
486,038

 
85.2

 
$
427,783

 
85.2

Other
84,682

 
14.8

 
74,584

 
14.8

Total
$
570,720

 
100.0

 
$
502,367

 
100.0

Net premiums earned for the 2018 second quarter were 12.7% higher than in the 2017 second quarter. For the six months ended June 30, 2018, net premiums earned were 13.6% higher than in the 2017 period. The increases were primarily due to growth in insurance in force for Arch MI U.S.
Other Underwriting Income.
Other underwriting income, which is primarily related to older GSE credit risk-sharing transactions receiving derivative accounting treatment, was $3.3 million for the 2018 second quarter, compared to $4.3 million for the 2017 second quarter, and $6.7 million for the six months ended June 30, 2018, compared to $8.4 million for the 2017 period.
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,
 
2018
 
2017
 
2018
 
2017
Current year
15.4
 %
 
19.5
 %
 
17.8
 %
 
20.5
 %
Prior period reserve development
(8.0
)%
 
(11.5
)%
 
(6.4
)%
 
(10.6
)%
Loss ratio
7.4
 %
 
8.0
 %
 
11.4
 %
 
9.9
 %

ARCH CAPITAL
 59
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Current Year Loss Ratio.
The mortgage segment’s current year loss ratio was 4.1 points lower in the 2018 second quarter than in the 2017 second quarter. The mortgage segment’s current year loss ratio was 2.7 points lower for the six months ended June 30, 2018 than for the 2017 period. The lower current year loss ratio for the 2018 periods reflect the current favorable macroeconomic environment.
Prior Period Reserve Development.
The mortgage segment’s net favorable development was $23.3 million, or 8.0 points, for the 2018 second quarter, compared to $29.8 million, or 11.5 points, for the 2017 second quarter, and $36.3 million, or 6.4 points, for the six months ended June 30, 2018, compared to $53.4 million, or 10.6 points, for the 2017 period. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements for information about the mortgage segment’s prior year reserve development.
Underwriting Expenses.
2018 Second Quarter versus 2017 Second Quarter. The underwriting expense ratio for the mortgage segment was 22.8% in the 2018 second quarter, compared to 22.5% in the 2017 second quarter. The higher underwriting expense ratio in the 2018 second quarter reflected a higher level of incentive compensation costs.
Six Months Ended June 30, 2018 versus 2017 period. The underwriting expense ratio for the mortgage segment was 23.1% for the six months ended June 30, 2018, compared to 25.5% for the 2017 period. The lower underwriting expense ratio in the 2018 period reflected a higher level of net premiums earned and expense savings from integration efforts following the acquisition of UGC.
Corporate (Non-Underwriting) Segment
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, UGC transaction costs and other, amortization of intangible assets, interest expense, items related to our non-cumulative preferred shares, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and income taxes. Such amounts exclude the results of 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,
 
2018
 
2017
 
2018
 
2017
Fixed maturities
$
98,968

 
$
83,656

 
$
191,406

 
$
166,437

Equity securities
4,232

 
3,976

 
6,982

 
6,942

Short-term investments
4,225

 
1,669

 
8,174

 
3,110

Other (1)
19,242

 
18,298

 
38,471

 
39,532

Gross investment income
126,667

 
107,599

 
245,033

 
216,021

Investment expenses (2)
(18,906
)
 
(15,079
)
 
(37,029
)
 
(27,689
)
Net investment income
$
107,761

 
$
92,520

 
$
208,004

 
188,332

(1)
Amounts include dividends and other distributions on investment funds, term loan investments, funds held balances, cash balances and other items.
(2)
Investment expenses were approximately 0.40% of average invested assets for the 2018 second quarter, compared to 0.33% for the 2017 second quarter, and 0.37% for the six months ended June 30, 2018, compared to 0.29% for the 2017 period.
The higher level of net investment income for the 2018 second quarter reflected an increase in the embedded book yield on fixed income securities, partially offset by a higher level of expenses. The pre-tax investment income yield, calculated based on amortized cost and on an annualized basis, was 2.32% for the 2018 second quarter, compare to 2.04% for the 2017 second quarter, and 2.23% for the six months ended June 30, 2018, compared to 2.10% for the 2017 period.
Corporate Expenses.
Corporate expenses were $15.6 million for the 2018 second quarter, compared to $22.2 million for the 2017 second quarter, and $30.1 million for the six months ended June 30, 2018, compared to $34.4 million for the 2017 period. The lower level of corporate expenses in the 2018 periods was primarily due to lower incentive compensation costs.
UGC Transaction Costs and Other.
UGC transaction costs and other were $6.9 million for the 2018 second quarter, compared to $2.7 million for the 2017 second quarter, and $7.7 million for the six months ended June 30, 2018, compared to $18.3 million for the 2017 period. Amounts for the 2018 second quarter were primarily attributable to the write off of intangible assets related to insurance licenses for a subsidiary of UGC which is being merged with another subsidiary. Amounts for the 2017 periods primarily related to severance and related costs along with incentive compensation paid in conjunction with the UGC acquisition.

ARCH CAPITAL
 60
2018 SECOND QUARTER FORM 10-Q

Table of Contents

Amortization of Intangible Assets.
Amortization of intangible assets for the 2018 second quarter was $26.5 million, compared to $30.8 million for the 2017 second quarter, and $53.2 million for the six months ended June 30, 2018, compared to $62.1 million for the 2017 period, with amounts in all periods primarily related to intangible assets related to the UGC acquisition.
Interest Expense.
Interest expense was $26.1 million for the 2018 second quarter, compared to the $25.9 million for the 2017 second quarter, and $52.0 million for the six months ended June 30, 2018, compared to $51.7 million for the 2017 period.
Loss on Redemption of Preferred Shares.
In January 2018, we redeemed all remaining 6.75% Series C preferred shares and, in accordance with GAAP, recorded a loss of $2.7 million to remove original issuance costs related to the redeemed shares from additional paid-in capital. Such adjustment had no impact on total shareholders’ equity or cash flows.
Net Realized Gains or Losses.
We recorded net realized losses of $59.5 million for the 2018 second quarter, compared to net realized gains of $18.0 million for the 2017 second quarter, and net realized losses of $171.4 million for the six months ended June 30, 2018, compared to net realized gains of $46.6 million for the 2017 period. Currently, our portfolio is actively managed to maximize total return within certain guidelines. 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 results from our decisions to reduce credit exposure, to change duration targets, to rebalance our portfolios or due to relative value determinations. Net realized gains or losses also include realized and unrealized contract gains and losses on our derivative instruments, changes in the fair value of assets and liabilities accounted for using the fair value option and in the fair value of equities pursuant to new accounting guidance effective in the 2018 first quarter, along with re-measurement of contingent consideration liability amounts. See note 7, “Investment Information—Net Realized Gains (Losses),” to our consolidated financial statements for additional information.
Net Impairment Losses Recognized in Earnings.
We recorded $0.5 million of impairment losses for the 2018 second quarter, compared to $1.7 million for the 2017 second quarter, and $0.6 million for the six months ended June 30, 2018, compared to $3.5 million for the 2017 period. See note 7, “Investment Information—Other-Than-Temporary
 
Impairments,” to our consolidated financial statements for additional information.
Equity in Net Income (Loss) of Investment Funds Accounted for Using the Equity Method.
We recorded $8.5 million of equity in net income related to investment funds accounted for using the equity method in the 2018 second quarter, compared to $32.7 million of income for the 2017 second quarter, and $36.5 million of income for the six months ended June 30, 2018, compared to $80.8 million for the 2017 period. Investment funds accounted for using the equity method totaled $1.43 billion at June 30, 2018, compared to $1.04 billion at December 31, 2017.
Net Foreign Exchange Gains or Losses.
Net foreign exchange gains for the 2018 second quarter were $46.2 million, compared to net foreign exchange losses for the 2017 second quarter of $37.8 million. Net foreign exchange gains for the six months ended June 30, 2018 were $31.2 million, compared to net foreign exchange losses for the 2017 period of $57.7 million. Amounts in such periods were primarily unrealized and resulted from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date.
Income Tax Expense.
Our income tax provision on income (loss) before income taxes resulted in an expense of 8.9% for the 2018 second quarter, compared to an expense of 15.7% for the 2017 second quarter, and 10.4% for the six months ended June 30, 2018, compared to 12.6% for the 2017 period. The effective tax rates for the 2018 second quarter and six months ended June 30, 2018 included a discrete income tax benefit of $1.6 million and $3.0 million, respectively, related to share-based compensation. 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. The change in the U.S. federal corporate tax rate from 35% to 21% commencing on January 1, 2018 contributed to a lower effective tax rate for the 2018 periods as compared to the 2017 periods.
Other Segment 
The ‘other’ segment includes the results of Watford Re. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. See note 11, “Variable Interest Entities and Noncontrolling Interests” and note 5, “Segment Information,” to our consolidated financial statements for additional information on Watford Re.

ARCH CAPITAL
 61
2018 SECOND QUARTER FORM 10-Q



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 2017 Form 10-K, updated where applicable in the notes accompanying our consolidated financial statements, including note 2, “Recent Accounting Pronouncements.”
FINANCIAL CONDITION

Investable Assets 
At June 30, 2018, total investable assets held by Arch were $19.17 billion, excluding the $2.65 billion included in the ‘other’ segment (i.e., attributable to Watford Re).
Investable Assets Held by Arch 
The following table summarizes the fair value of the investable assets held by Arch:
Investable assets (1):
Estimated
Fair Value
 
% of
Total
June 30, 2018
 
 
 
Fixed maturities (2)
$
14,442,991

 
75.3

Short-term investments (2)
1,119,977

 
5.8

Cash
480,984

 
2.5

Equity securities (2)
545,146

 
2.8

Other investments (2)
1,266,327

 
6.6

Investments accounted for using the equity method
1,428,582

 
7.5

Securities transactions entered into but not settled at the balance sheet date
(111,997
)
 
(0.6
)
Total investable assets held by Arch
$
19,172,010

 
100.0

 
 
 
 
December 31, 2017
 
 
 
Fixed maturities (2)
$
14,798,213

 
75.1

Short-term investments (2)
1,509,713

 
7.7

Cash
551,696

 
2.8

Equity securities (2)
576,040

 
2.9

Other investments (2)
1,476,960

 
7.5

Investments accounted for using the equity method
1,041,322

 
5.3

Securities transactions entered into but not settled at the balance sheet date
(237,523
)
 
(1.2
)
Total investable assets held by Arch
$
19,716,421

 
100.0

(1)
In securities lending transactions, we receive collateral in excess of the fair value of the securities pledged. For purposes of this table, we have excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value.
(2)
Includes investments carried at fair value under the fair value option.
At June 30, 2018, 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 2.64%. At December 31, 2017, our fixed income portfolio had average credit quality ratings from S&P/Moody’s of “AA-/Aa2” and an average yield to maturity of 2.32%. Our investment portfolio had an average effective duration of 2.89 years at June 30, 2018, compared to 2.83 years at December 31, 2017. At June 30, 2018, approximately $13.54 billion, or 71%, of total investable assets held by Arch were internally managed, compared to $13.73 billion, or 70%, at December 31, 2017.
The following table summarizes our fixed maturities and fixed maturities pledged under securities lending agreements (“Fixed Maturities”) by type:
 
Estimated
Fair Value
 
% of
Total
June 30, 2018
 

 
 
Corporate bonds
$
5,847,160

 
39.7

Mortgage backed securities
498,759

 
3.4

Municipal bonds
1,431,256

 
9.7

Commercial mortgage backed securities
590,198

 
4.0

U.S. government and government agencies
2,788,272

 
18.9

Non-U.S. government securities
1,735,495

 
11.8

Asset backed securities
1,831,028

 
12.4

Total
$
14,722,168

 
100.0

 
 
 
 
December 31, 2017
 

 
 
Corporate bonds
$
4,787,272

 
32.4

Mortgage backed securities
328,924

 
2.2

Municipal bonds
2,158,840

 
14.6

Commercial mortgage backed securities
545,817

 
3.7

U.S. government and government agencies
3,484,257

 
23.5

Non-U.S. government securities
1,704,337

 
11.5

Asset backed securities
1,788,766

 
12.1

Total
$
14,798,213

 
100.0


ARCH CAPITAL
 62
2018 SECOND QUARTER FORM 10-Q

Table of Contents

The following table provides the credit quality distribution of our Fixed Maturities. 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.
 
Estimated Fair Value
 
% of
Total
June 30, 2018
 
 
 
U.S. government and gov’t agencies (1)
$
3,196,856

 
22.1

AAA
3,897,441

 
27.0

AA
2,139,794

 
14.8

A
3,114,115

 
21.6

BBB
1,373,644

 
9.5

BB
240,114

 
1.7

B
185,066

 
1.3

Lower than B
64,858

 
0.4

Not rated
231,103

 
1.6

Total
$
14,442,991

 
100.0

 
 
 
 
December 31, 2017
 
 
 
U.S. government and gov’t agencies (1)
$
3,771,835

 
25.5

AAA
4,080,808

 
27.6

AA
2,440,864

 
16.5

A
2,470,936

 
16.7

BBB
1,157,136

 
7.8

BB
313,286

 
2.1

B
254,011

 
1.7

Lower than B
77,543

 
0.5

Not rated
231,794

 
1.6

Total
$
14,798,213

 
100.0

(1)
Includes U.S. government-sponsored agency residential mortgage-backed securities and agency commercial mortgage-backed securities.
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:
Severity of gross unrealized losses:
Estimated Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
June 30, 2018
 
 
 
 
 
0-10%
$
11,248,303

 
$
(200,606
)
 
96.6

10-20%
45,886

 
(6,215
)
 
3.0

20-30%
2,105

 
(591
)
 
0.3

Greater than 30%
373

 
(208
)
 
0.1

Total
$
11,296,667

 
$
(207,620
)
 
100.0

 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
0-10%
$
9,598,768

 
$
(93,057
)
 
87.6

10-20%
82,638

 
(11,269
)
 
10.6

20-30%
2,108

 
(671
)
 
0.6

Greater than 30%
1,881

 
(1,184
)
 
1.1

Total
$
9,685,395

 
$
(106,181
)
 
100.0

 
The following table summarizes our top ten exposures to fixed income corporate issuers by fair value at June 30, 2018, excluding guaranteed amounts and covered bonds:
 
Estimated Fair Value
 
Credit
Rating (1)
Citigroup Inc.
$
190,925

 
A/A2
JPMorgan Chase & Co.
180,960

 
A-/A2
Bank of America Corporation
178,797

 
A-/A3
Apple Inc.
170,852

 
AA+/Aa1
Wells Fargo & Company
136,738

 
A/A1
Daimler AG
100,541

 
A/A2
Philip Morris International Inc.
99,728

 
A/A2
The Bank of New York Mellon Corporation
96,728

 
A/A1
Toyota Motor Corporation
96,200

 
AA-/Aa3
U.S. Bancorp
90,850

 
AA-/A1
Total
$
1,342,319

 
 
(1)
Average credit ratings as assigned by S&P and Moody’s, respectively.
The following table provides information on our structured securities, which includes residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and asset-backed securities (“ABS”):
 
Agencies
 
Investment Grade
 
Below Investment Grade
 
Total
June 30, 2018
 
 
 
 
 
 
 
RMBS
$
460,617

 
$
14,362

 
$
23,780

 
$
498,759

CMBS
46,205

 
523,535

 
20,458

 
590,198

ABS

 
1,747,850

 
73,898

 
1,821,748

Total
$
506,822

 
$
2,285,747

 
$
118,136

 
$
2,910,705

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
RMBS
$
284,466

 
$
14,581

 
$
29,877

 
$
328,924

CMBS
3,112

 
465,980

 
76,725

 
545,817

ABS

 
1,691,232

 
97,534

 
1,788,766

Total
$
287,578

 
$
2,171,793

 
$
204,136

 
$
2,663,507

At June 30, 2018, our structured securities included $40.3 million par value in sub-prime securities with a fair value of $32.7 million and average credit quality ratings from S&P/Moody’s of “CCC-/Caa3,” compared to $42.3 million par value with a fair value of $35.4 million and average credit quality ratings of “CCC/Caa3” at December 31, 2017.

ARCH CAPITAL
 63
2018 SECOND QUARTER FORM 10-Q

Table of Contents

The following table provides information on the fair value of our Eurozone investments at June 30, 2018:
Country (1)
Sovereign
(2)
 
Corporate Bonds
 
Other
(3)
 
Total
Germany
$
256,053

 
$
3,404

 
$
45,854

 
$
305,311

Netherlands
110,568

 
117,589

 
18,360

 
246,517

France
20,275

 
45,582

 
34,912

 
100,769

Luxembourg

 
11,338

 
8,952

 
20,290

Ireland

 
7,811

 
5,302

 
13,113

Spain

 
2,415

 
9,157

 
11,572

Greece
1,968

 

 
3,091

 
5,059

Austria
3,976

 

 

 
3,976

Italy

 
685

 
2,309

 
2,994

Belgium

 
181

 
1,166

 
1,347

Portugal

 

 
1,236

 
1,236

Total
$
392,840

 
$
189,005

 
$
130,339

 
$
712,184

(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 other Eurozone investments at June 30, 2018.
(2)
Includes securities issued and/or guaranteed by Eurozone governments.
(3)
Includes bank loans, equities and other.
At June 30, 2018, our investment portfolio included $545.1 million of equity securities, compared to $576.0 million at December 31, 2017. Our equity portfolio includes publicly traded common stocks in the natural resources, energy, consumer staples and other sectors.
The following table summarizes our other investments:
 
June 30,
2018
 
December 31,
2017
Asian and emerging markets
$
300,050

 
$
344,068

Term loan investments
273,986

 
326,085

Mezzanine debt funds
257,750

 
252,160

Credit related funds
199,437

 
193,787

Investment grade fixed income
98,240

 
156,225

Other (1)
136,864

 
204,635

Total
$
1,266,327

 
$
1,476,960

(1)
Includes fund investments with strategies in mortgage servicing rights, transportation and infrastructure assets and other.
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,” to our consolidated financial statements for additional disclosures related to 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,” to our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value, segregated by level in the fair value hierarchy.
Investable Assets in the ‘Other’ Segment
Investable assets in the ‘other’ segment are managed by Watford Re. The board of directors of Watford Re establishes their investment policies and guidelines. Watford Re’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.
The following table summarizes investable assets in the ‘other’ segment:
 
June 30,
2018
 
December 31,
2017
Investments accounted for using the fair value option:
 
 
 
Other investments
$
1,062,577

 
$
924,410

Fixed maturities
1,053,795

 
1,177,033

Short-term investments
193,887

 
256,755

Equity securities
75,058

 
67,868

Total
2,385,317

 
2,426,066

Fixed maturities available for sale, at fair value
279,177

 

Equity securities, at fair value
63,009

 

Cash
45,644

 
54,503

Securities sold but not yet purchased
(24,529
)
 
(34,375
)
Securities transactions entered into but not settled at the balance sheet date
(100,777
)
 
(6,127
)
Total investable assets included in ‘other’ segment
$
2,647,841

 
$
2,440,067

Premiums Receivable and Reinsurance Recoverables
At June 30, 2018, 79.7% of premiums receivable of $1.35 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 3.7% of the total. At December 31, 2017, 78.2% of premiums receivable of $1.14 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 4.0% of the total. Our reserves for doubtful accounts were approximately $26.6 million at June 30, 2018, compared to $25.3 million at December 31, 2017.
At June 30, 2018 and December 31, 2017, approximately 63.5% and 69.9% of reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.73 billion and $2.54 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better while 36.5% and 30.1%, respectively, were from companies not rated. For items not rated, over 90% of such amount was collateralized through reinsurance trusts or letters of credit at June 30, 2018 and December 31, 2017. The largest reinsurance recoverables from any one carrier was approximately 3.1% and 2.2%,

ARCH CAPITAL
 64
2018 SECOND QUARTER FORM 10-Q

Table of Contents

respectively, of total shareholders’ equity available to Arch at June 30, 2018 and December 31, 2017. Growth in items not rated is due to recoverables from a third party reinsurer related to a retroactive reinsurance transaction to reinsure run-off liabilities associated with certain discontinued U.S. specialty casualty and program exposures. Such amounts are fully collateralized. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements for additional information.
Approximately 5.1% of the $67.7 million of paid losses and loss adjustment expenses recoverable at June 30, 2018 were more than 90 days overdue, compared to 3.0% of the $75.2 million of paid losses and loss adjustment expenses recoverable at December 31, 2017. No collection issues were indicated on the amount in excess of 90 days overdue at June 30, 2018.
The effects of reinsurance on written and earned premiums and losses and loss adjustment expenses (“LAE”) with unaffiliated reinsurers were as follows:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2018
 
2017
 
2018
 
2017
Premiums written:
 
 
 
 
 
 
 
Direct
$
1,158,772

 
$
1,093,558

 
$
2,359,134

 
$
2,190,313

Assumed
537,772

 
516,101

 
1,175,624

 
1,077,336

Ceded
(397,648
)
 
(360,964
)
 
(823,318
)
 
(742,694
)
Net
$
1,298,896

 
$
1,248,695

 
$
2,711,440

 
$
2,524,955

 
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Direct
$
1,174,372

 
$
1,071,648

 
$
2,322,048

 
$
2,095,100

Assumed
534,485

 
513,814

 
980,454

 
930,159

Ceded
(372,094
)
 
(344,588
)
 
(730,840
)
 
(667,368
)
Net
$
1,336,763

 
$
1,240,874

 
$
2,571,662

 
$
2,357,891

 
 
 
 
 
 
 
 
Losses and LAE:
 
 
 
 
 
 
 
Direct
$
520,473

 
$
544,061

 
$
1,088,939

 
$
1,051,179

Assumed
340,969

 
303,582

 
561,279

 
490,538

Ceded
(135,289
)
 
(157,783
)
 
(287,205
)
 
(299,287
)
Net
$
726,153

 
$
689,860

 
$
1,363,013

 
$
1,242,430

 
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, 2018 and December 31, 2017, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:
 
June 30,
2018
 
December 31,
2017
Insurance segment:
 

 
 

Case reserves
$
1,449,505

 
$
1,648,910

IBNR reserves
3,190,253

 
3,272,351

Total net reserves
4,639,758

 
4,921,261

Reinsurance segment:
 
 
 
Case reserves
1,111,716

 
1,033,413

Additional case reserves
128,272

 
158,377

IBNR reserves
1,509,580

 
1,499,962

Total net reserves
2,749,568

 
2,691,752

Mortgage segment:
 
 
 
Case reserves
403,464

 
443,069

IBNR reserves
129,848

 
104,169

Total net reserves (1)
533,312

 
547,238

Other segment:
 
 
 
Case reserves
327,170

 
260,876

Additional case reserves
18,200

 
32,587

IBNR reserves
504,580

 
465,168

Total net reserves
849,950

 
758,631

Total:
 

 
 

Case reserves
3,291,855

 
3,386,268

Additional case reserves
146,472

 
190,964

IBNR reserves
5,334,261

 
5,341,650

Total net reserves
$
8,772,588

 
$
8,918,882

(1)
At June 30, 2018, total net reserves include $451.2 million from U.S. primary mortgage insurance business, of which 76.7% represents policy years 2008 and prior and the remainder from later policy years. At December 31, 2017, total net reserves include $477.1 million from U.S. primary mortgage insurance business, of which 79.8% represents policy years 2008 and prior and the remainder from later policy years.

ARCH CAPITAL
 65
2018 SECOND QUARTER FORM 10-Q

Table of Contents

At June 30, 2018 and December 31, 2017, 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,
2018
 
December 31,
2017
Insurance segment:
 
 
 
Professional lines (1)
$
1,275,011

 
$
1,308,261

Construction and national accounts
1,133,342

 
1,094,300

Excess and surplus casualty (2)
605,675

 
672,903

Programs
444,959

 
644,340

Property, energy, marine and aviation
380,149

 
437,518

Travel, accident and health
83,251

 
86,122

Lenders products
47,387

 
53,912

Other (3)
669,984

 
623,905

Total net reserves
$
4,639,758

 
$
4,921,261

(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, 2018 and December 31, 2017, 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,
2018
 
December 31,
2017
Reinsurance segment:
 
 
 
Casualty (1)
$
1,492,791

 
$
1,489,933

Other specialty (2)
589,117

 
523,321

Property excluding property catastrophe (3)
385,442

 
376,020

Marine and aviation
130,262

 
135,484

Property catastrophe
83,712

 
98,622

Other (4)
68,244

 
68,372

Total net reserves
$
2,749,568

 
$
2,691,752

(1)
Includes executive assurance, professional liability, workers’ compensation, excess motor, healthcare and other.
(2)
Includes non-excess motor, surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and other.
(3)
Includes facultative business.
(4)
Includes life, casualty clash and other.
 
Mortgage Operations Supplemental Information
The mortgage segment’s insurance in force (“IIF”) and risk in force (“RIF”) were as follows at June 30, 2018 and December 31, 2017:
(U.S. Dollars in millions)
June 30, 2018
 
December 31, 2017
Amount
 
%
 
Amount
 
%
Insurance In Force (IIF) (1):
 
 
 
 
 
 
 
U.S. primary mortgage insurance
$
262,889

 
73.1

 
$
253,914

 
72.2

Mortgage reinsurance
26,302

 
7.3

 
28,017

 
8.0

Other (2)
70,677

 
19.6

 
69,905

 
19.9

Total
$
359,868

 
100.0

 
$
351,836

 
100.0

 
 
 
 
 
 
 
 
Risk In Force (RIF) (3):
 
 
 
 
 
 
 
U.S. primary mortgage insurance
$
67,271

 
92.4

 
$
64,904

 
92.3

Mortgage reinsurance
2,282

 
3.1

 
2,473

 
3.5

Other (2)
3,237

 
4.4

 
2,921

 
4.2

Total
$
72,790

 
100.0

 
$
70,298

 
100.0

(1)
Represents the aggregate dollar amount of each insured mortgage loan’s current principal balance.
(2)
Includes GSE credit risk-sharing transactions and international insurance business.
(3)
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 and after contract limits and/or loss ratio caps for credit risk-sharing or reinsurance transactions.
The insurance in force and risk in force for our U.S. primary mortgage insurance business by policy year were as follows at June 30, 2018:
(U.S. Dollars in millions)
IIF
 
RIF
 
Delinquency
Amount
 
%
 
Amount
 
%
 
Rate (1)
Policy year:
 
 
 
 
 
 
 
 
 
2008 and prior
$
23,538

 
9.0

 
$
5,335

 
7.9

 
8.76
%
2009
889

 
0.3

 
207

 
0.3

 
2.73
%
2010
806

 
0.3

 
220

 
0.3

 
2.22
%
2011
3,201

 
1.2

 
879

 
1.3

 
1.29
%
2012
11,398

 
4.3

 
3,135

 
4.7

 
0.71
%
2013
19,175

 
7.3

 
5,300

 
7.9

 
0.83
%
2014
20,352

 
7.7

 
5,473

 
8.1

 
0.92
%
2015
37,664

 
14.3

 
9,792

 
14.6

 
0.60
%
2016
57,643

 
21.9

 
14,645

 
21.8

 
0.65
%
2017
57,325

 
21.8

 
14,502

 
21.6

 
0.34
%
2018
30,898

 
11.8

 
7,783

 
11.6

 
0.03
%
Total
$
262,889

 
100.0

 
$
67,271

 
100.0

 
1.70
%
(1)
Represents the ending percentage of loans in default.

ARCH CAPITAL
 66
2018 SECOND QUARTER FORM 10-Q

Table of Contents

The insurance in force and risk in force for our U.S. primary mortgage insurance business by policy year were as follows at December 31, 2017:
(U.S. Dollars in millions)
IIF
 
RIF
 
Delinquency
Amount
 
%
 
Amount
 
%
 
Rate (1)
Policy year:
 
 
 
 
 
 
 
 
 
2008 and prior
$
26,140

 
10.3

 
$
6,003

 
9.2

 
10.24
%
2009
1,072

 
0.4

 
253

 
0.4

 
2.94
%
2010
1,089

 
0.4

 
295

 
0.5

 
2.31
%
2011
3,828

 
1.5

 
1,046

 
1.6

 
1.37
%
2012
13,247

 
5.2

 
3,629

 
5.6

 
0.75
%
2013
21,840

 
8.6

 
5,996

 
9.2

 
0.95
%
2014
22,884

 
9.0

 
6,112

 
9.4

 
1.10
%
2015
41,991

 
16.5

 
10,828

 
16.7

 
0.77
%
2016
62,020

 
24.4

 
15,643

 
24.1

 
0.80
%
2017
59,803

 
23.6

 
15,099

 
23.3

 
0.35
%
Total
$
253,914

 
100.0

 
$
64,904

 
100.0

 
2.23
%
(1)
Represents the ending percentage of loans in default.
The following tables provide supplemental disclosures on risk in force for our U.S. primary mortgage insurance business at June 30, 2018 and December 31, 2017:
(U.S. Dollars in millions)
June 30, 2018
 
December 31, 2017
Amount
 
%
 
Amount
 
%
Credit quality (FICO):
 
 
 
 
 
 
 
>=740
$
39,038

 
58.0

 
$
37,794

 
58.2

680-739
22,325

 
33.2

 
21,213

 
32.7

620-679
5,235

 
7.8

 
5,159

 
7.9

<620
673

 
1.0

 
738

 
1.1

Total
$
67,271

 
100.0

 
$
64,904

 
100.0

Weighted average FICO score
743

 
 
 
743

 
 
 
 
 
 
 
 
 
 
Loan-to-value (LTV):
 
 
 
 
 
 
 
95.01% and above
$
6,915

 
10.3

 
$
6,337

 
9.8

90.01% to 95.00%
37,488

 
55.7

 
36,174

 
55.7

85.01% to 90.00%
19,904

 
29.6

 
19,482

 
30.0

85.00% and below
2,964

 
4.4

 
2,911

 
4.5

Total
$
67,271

 
100.0

 
$
64,904

 
100.0

Weighted average LTV
92.9
%
 
 
 
92.9
%
 
 
 
 
 
 
 
 
 
 
Total RIF, net of external reinsurance
$
52,167

 
 
 
$
49,100

 
 
 
(U.S. Dollars in millions)
June 30, 2018
 
December 31, 2017
Amount
 
%
 
Amount
 
%
Total RIF by State:
 
 
 
 
 
 
 
Texas
$
5,260

 
7.8

 
$
5,151

 
7.9

California
4,066

 
6.0

 
3,803

 
5.9

Florida
3,186

 
4.7

 
2,881

 
4.4

Virginia
2,844

 
4.2

 
2,773

 
4.3

North Carolina
2,456

 
3.7

 
2,410

 
3.7

Georgia
2,453

 
3.6

 
2,331

 
3.6

Illinois
2,351

 
3.5

 
2,229

 
3.4

Maryland
2,298

 
3.4

 
2,234

 
3.4

Washington
2,297

 
3.4

 
2,294

 
3.5

Minnesota
2,268

 
3.4

 
2,165

 
3.3

Others
37,792

 
56.2

 
36,633

 
56.4

Total
$
67,271

 
100.0

 
$
64,904

 
100.0

The following table provides supplemental disclosures for our U.S. primary mortgage insurance business related to insured loans and loss metrics:
(U.S. Dollars in thousands, except policy, loan and claim count)
Six Months Ended
June 30,
2018
 
2017
Roll-forward of insured loans in default:
 
 
 
Beginning delinquent number of loans
27,068

 
29,691

New notices (1)
17,792

 
18,721

Cures
(21,865
)
 
(20,785
)
Paid claims
(1,958
)
 
(3,724
)
Ending delinquent number of loans (1)(2)
21,037

 
23,903

 
 
 
 
Ending number of policies in force (2)
1,239,565

 
1,183,659

 
 
 
 
Delinquency rate (1)(2)
1.70
%
 
2.02
%
 
 
 
 
Losses:
 
 
 
Number of claims paid
1,958

 
3,724

Total paid claims
$
83,534

 
$
156,323

Average per claim
$
42.7

 
$
42.0

Severity (3)
101.6
%
 
103.1
%
Average reserve per default (in thousands)
$
19.3

 
$
20.4

(1)
There were no incremental new notices for the six months ended June 30, 2018 and 1,300 ending delinquent loans at June 30, 2018 from areas attributable to the 2017 third quarter hurricanes.
(2)
Includes first lien primary and pool policies.
(3)
Represents total paid claims divided by RIF of loans for which claims were paid.
The risk-to-capital ratio, which represents total current (non-delinquent) risk in force, net of reinsurance, divided by total statutory capital, for Arch MI U.S. was approximately 11.6 to 1 at June 30, 2018, compared to 10.8 to 1 at December 31, 2017.
Shareholders’ Equity and Book Value per Share
Total shareholders’ equity available to Arch was $9.16 billion at June 30, 2018, compared to $9.20 billion at December 31, 2017. The decrease reflected share buybacks and negative investment returns resulting from the increase in interest rates during the period, partially offset by strong underwriting results.

ARCH CAPITAL
 67
2018 SECOND QUARTER FORM 10-Q

Table of Contents

The following table presents the calculation of book value per share:
(U.S. dollars in thousands, except 
share data)
June 30,
2018
 
December 31,
2017
Total shareholders’ equity available to Arch
$
9,163,755

 
$
9,196,602

Less preferred shareholders’ equity
780,000

 
872,555

Common shareholders’ equity available to Arch
$
8,383,755

 
$
8,324,047

Common shares and common share equivalents outstanding, net of treasury shares (1)
405,436,637

 
409,956,417

Book value per share
$
20.68

 
$
20.30

(1)
Excludes the effects of 20,843,879 and 19,770,174 stock options and 1,400,051 and 913,488 restricted stock units outstanding at June 30, 2018 and December 31, 2017, respectively.
LIQUIDITY

This section does not include information specific to Watford Re. We do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions with Watford Re.
Liquidity is a measure of our ability to access sufficient cash flows to meet the short-term and long-term cash requirements of our business operations.

Arch Capital is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, Arch Capital 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 our preferred and common shares.
For the six months ended June 30, 2018, Arch Capital received dividends of $239.6 million from Arch Re Bermuda, our Bermuda-based reinsurer and insurer, which can pay approximately $1.93 billion to Arch Capital during the remainder of 2018 without providing an affidavit to the Bermuda Monetary Authority (“BMA”).
For the six months ended June 30, 2018, Arch Capital Group (U.S.) Inc. (“Arch-U.S.”) received $25.0 million of dividends from Arch Reinsurance Company (“Arch Re U.S.”), our U.S.-licensed reinsurer. Arch Re U.S. can pay approximately $103.8 million to Arch-U.S. during the remainder of 2018, subject to the approval of the Commissioner of the Delaware Department of Insurance.
For the six months ended June 30, 2018, Arch-U.S. received
 
$150.0 million of dividends from Arch U.S. MI Holdings Inc., a subsidiary of Arch-U.S., which received $400.0 million of dividends from United Guaranty Residential Insurance Company (“UGRIC”) and other UGC companies. Arch U.S. MI Holdings Inc. used $250.0 million of such proceeds to pay down its revolving credit agreement borrowings. UGRIC has no remaining ordinary dividend capacity for the remainder of 2018.
We expect that our liquidity needs, including our anticipated (re)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.
Cash Flows
The following table summarizes our cash flows from operating, investing and financing activities, excluding amounts related to the ‘other’ segment (i.e., Watford Re). See note 11, “Variable Interest Entities and Noncontrolling Interests,” for cash flows related to Watford Re.
 
Six Months Ended
 
June 30,
 
2018
 
2017
Total cash provided by (used for):
 

 
 

Operating activities
$
404,451

 
$
399,755

Investing activities
270,381

 
(225,626
)
Financing activities
(731,613
)
 
(252,009
)
Effects of exchange rate changes on foreign currency cash
(9,024
)
 
8,457

Increase (decrease) in cash and restricted cash
$
(65,805
)
 
$
(69,423
)
Cash provided by operating activities for the six months ended June 30, 2018 reflected a higher level of premiums collected than in the 2017 period and an income tax refund, partially offset by a retroactive reinsurance transaction with a third party reinsurer, while the 2017 period reflected higher purchases of tax and loss bonds and outflows related to the UGC acquisition.
Cash provided by investing activities for the six months ended June 30, 2018 was higher than the cash used in the 2017 period, primarily reflecting the sale of short term investments to fund the financing activities noted below. In addition, activity for the 2018 period reflected higher net purchases of fixed maturity investments than in the 2017 period.
Cash used for financing activities for the six months ended June 30, 2018 was higher than in the 2017 period, and reflected $250.0 million of paydowns on our revolving credit agreement borrowings, $173.6 million of repurchases under our share repurchase program and $92.6 million related to redemption of our Series C preferred shares in January 2018.

ARCH CAPITAL
 68
2018 SECOND QUARTER FORM 10-Q

Table of Contents

CAPITAL RESOURCES

This section does not include information specific to Watford Re. We do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions with Watford Re.
The following table provides an analysis of our capital structure:
(U.S. dollars in thousands, except 
share data)
Jun 30,
2018
 
Dec 31,
2017
Debt:
 
 
 
Senior notes, due May 2034
$
297,101

 
$
297,053

Arch-U.S. senior notes, due Nov 2043 (1)
494,671

 
494,621

Arch Finance senior notes, due Dec 2026 (1)
496,229

 
496,043

Arch Finance senior notes, due Dec 2046 (1)
445,210

 
445,167

Revolving credit agreement borrowings due Oct 2021 (2)
125,000

 
375,000

Total
$
1,858,211

 
$
2,107,884

 
 
 
 
Shareholders’ equity available to Arch:
 
 
 
Series C non-cumulative preferred shares (3)
$

 
$
92,555

Series E non-cumulative preferred shares
450,000

 
450,000

Series F non-cumulative preferred shares
330,000

 
330,000

Common shareholders’ equity
8,383,755

 
8,324,047

Total
$
9,163,755

 
$
9,196,602

 
 
 
 
Total capital available to Arch
$
11,021,966

 
$
11,304,486

 
 
 
 
Senior notes to total capital (%)
15.7

 
15.3

Revolving credit agreement borrowings to total capital (%)
1.1

 
3.3

Debt to total capital (%)
16.9

 
18.6

Preferred to total capital (%)
7.1

 
7.7

Debt and preferred to total capital (%)
23.9

 
26.4

(1)
Fully and unconditionally guaranteed by Arch Capital.
(2)
$500 million unsecured facility for revolving loans and letters of credit.
(3)
Redeemed on January 2, 2018.
Arch Capital and Arch-U.S. are each holding companies and, accordingly, they conduct substantially all of their operations through their operating subsidiaries. Arch Capital Finance LLC (“Arch Finance”) is a wholly owned subsidiary of Arch U.S. MI Holdings Inc. As a result, Arch Capital, Arch-U.S. and Arch Finance's cash flows and their ability to service their debt depends upon the earnings of their operating subsidiaries, or affiliates in the case of Arch Finance, and on their ability to distribute the earnings, loans or other payments from such subsidiaries or affiliates to Arch Capital, Arch-U.S. and Arch Finance, respectively.
In addition, Arch MI U.S. is required to maintain compliance with the GSEs requirements, known as the Private Mortgage Insurer Eligibility Requirements or “PMIERs.” The financial requirements require an eligible mortgage insurer’s available assets, which generally include only the most liquid assets of
 
an insurer, to meet or exceed “minimum required assets” as of each quarter end. Minimum required assets are calculated from PMIERs tables with several risk dimensions (including origination year, original loan-to-value and original credit score of performing loans, and the delinquency status of non-performing loans) and are subject to a minimum amount. Arch MI U.S. satisfied the PMIERs’ financial requirements as of June 30, 2018 with an estimated PMIER sufficiency ratio of 134%, compared to 129% at December 31, 2017.
Arch Capital, 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. Historically, our insurance, reinsurance and mortgage insurance subsidiaries have entered into separate reinsurance arrangements with Arch Re Bermuda covering individual lines of business. The reinsurance agreements between our U.S.-based property casualty insurance and reinsurance subsidiaries and Arch Re Bermuda were canceled on a cutoff basis as of January 1, 2018. As a result, the level of subject business ceded to Arch Re Bermuda was substantially lower for the six months ended June 30, 2018 than in prior periods.
SHARE REPURCHASE PROGRAM

The board of directors of Arch Capital has authorized the investment in Arch Capital’s common shares through a share repurchase program. For the six months ended June 30, 2018, Arch Capital repurchased 6,522,645 shares under the share repurchase program with an aggregate purchase price of $173.6 million. Since the inception of the share repurchase program through June 30, 2018, Arch Capital has repurchased 382.2 million common shares for an aggregate purchase price of $3.86 billion. At June 30, 2018, approximately $272.9 million of share repurchases were available under the program, which may be effected from time to time in open market or privately negotiated transactions through December 31, 2019.
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.
CATASTROPHIC EVENTS AND SEVERE ECONOMIC EVENTS

We have large aggregate exposures to natural and man-made catastrophic events and severe economic events. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, tornadoes, explosions, severe winter weather, fires, droughts and other natural disasters. Catastrophes can also cause losses in non-property

ARCH CAPITAL
 69
2018 SECOND QUARTER FORM 10-Q

Table of Contents

business such as mortgage insurance, workers’ compensation or general liability. In addition to the nature of property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration, tend to generally increase the size of losses from catastrophic events over time.
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. We seek to limit the probable maximum pre-tax loss to a specific level for severe catastrophic events. Currently, we seek to limit our 1-in-250 year return period net probable maximum loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders’ equity available to Arch. We reserve the right to change this threshold at any time.
Based on in-force exposure estimated as of July 1, 2018, our modeled peak zone catastrophe exposure was a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $404 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County regions with net probable maximum pre-tax losses of $390 million and $346 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, were less than the exposures arising from U.S. windstorms and hurricanes. As of July 1, 2018, our modeled peak zone earthquake exposure (Los Angeles earthquake) represented approximately 57% 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.
Effective July 1, 2018, our insurance operations had in effect a reinsurance program which provided coverage for certain property-catastrophe related losses equal to $275 million in excess of a $75 million retention per occurrence. Such amounts compare to $200 million in excess of a $150 million retention per occurrence prior to July 1, 2018.
We also have significant exposure to losses due to mortgage defaults resulting from severe economic events in the future. For our U.S. mortgage insurance business, we have developed a proprietary risk model (“Realistic Disaster Scenario” or “RDS”) that simulates the maximum loss resulting from a severe economic downturn impacting the housing market. The RDS models the collective impact of adverse conditions for key economic indicators, the most significant of which is a decline in home prices. The RDS model projects paths of future home prices, unemployment rates, income levels and interest rates and assumes correlation across states and geographic regions.  The resulting future performance of our in-force portfolio is then estimated under the economic stress scenario, reflecting
 
loan and borrower information. 
Currently, we seek to limit our modeled RDS loss from a severe economic event to approximately 25% of total tangible shareholders’ equity available to Arch (total shareholders’ equity available to Arch less goodwill and intangible assets). We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of July 1, 2018, our modeled RDS loss was less than 15% of tangible shareholders’ equity available to Arch.
Net probable maximum loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. RDS loss estimates are net of expected reinsurance recoveries and after income tax. Catastrophe 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 catastrophe loss estimates include clash estimates from other zones. Our catastrophe loss estimates and RDS loss estimates 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 pre-tax losses greater than 25% of our total shareholders' equity or tangible shareholders’ equity from one or more catastrophic events or severe economic 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 or severe economic event. In addition, actual losses may 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—Risks Relating to Our Industry” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Catastrophic Events and Severe Economic Events” in our 2017 Form 10-K.
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 2017 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, 2018. Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of

ARCH CAPITAL
 70
2018 SECOND QUARTER FORM 10-Q

Table of Contents

several components, including liquidity, basis and price risks. We have not included Watford Re in the following analyses as we do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.
An analysis of material changes in market risk exposures at June 30, 2018 that affect the quantitative and qualitative disclosures presented in our 2017 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. Furthermore, at times interest rate movements in certain credit sectors exhibit a much lower correlation to changes in U.S. Treasury yields. 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:
(U.S. dollars in 
billions)
Interest Rate Shift in Basis Points
-100
 
-50
 
 
+50
 
+100
Jun 30, 2018
 

 
 

 
 

 
 

 
 

Total fair value
$
18.67

 
$
18.40

 
$
18.15

 
$
17.89

 
$
17.64

Change from base
2.9
%
 
1.4
%
 
 
 
(1.4
)%
 
(2.8
)%
Change in unrealized value
$
0.53

 
$
0.25

 
 
 
$
(0.25
)
 
$
(0.51
)
 
 
 
 
 
 
 
 
 
 
Dec 31, 2017
 
 
 
 
 
 
 
 
 
Total fair value
$
19.11

 
$
18.85

 
$
18.59

 
$
18.33

 
$
18.09

Change from base
2.8
%
 
1.4
%
 
 
 
(1.4
)%
 
(2.7
)%
Change in unrealized value
$
0.52

 
$
0.26

 
 
 
$
(0.26
)
 
$
(0.50
)
In addition, we consider the effect of credit spread movements on the market 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:
(U.S. dollars in 
billions)
Credit Spread Shift in Percentage Points
-100
 
-50
 
 
+50
 
+100
Jun 30, 2018
 

 
 

 
 

 
 

 
 

Total fair value
$
18.51

 
$
18.33

 
$
18.15

 
$
17.96

 
$
17.78

Change from base
2.0
%
 
1.0
%
 
 
 
(1.0
)%
 
(2.0
)%
Change in unrealized value
$
0.36

 
$
0.18

 
 
 
$
(0.18
)
 
$
(0.36
)
 
 
 
 
 
 
 
 
 
 
Dec 31, 2017
 
 
 
 
 
 
 
 
 
Total fair value
$
18.96

 
$
18.77

 
$
18.59

 
$
18.40

 
$
18.22

Change from base
2.0
%
 
1.0
%
 
 
 
(1.0
)%
 
(2.0
)%
Change in unrealized value
$
0.37

 
$
0.19

 
 
 
$
(0.19
)
 
$
(0.37
)
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, 2018, our portfolio’s VaR was estimated to be 3.15% compared to an estimated 3.10% at December 31, 2017.
Equity Securities. At June 30, 2018 and December 31, 2017, the fair value of our investments in equity securities totaled $545.1 million and $576.0 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 $54.5 million and $57.6 million at June 30, 2018 and December 31, 2017, respectively, and would have decreased book value per share by approximately $0.13 and $0.14, respectively. An immediate hypothetical 10% increase in the value of each position would increase the fair value of such investments by approximately $54.5 million and $57.6 million at June 30, 2018 and December 31, 2017, respectively, and would have increased book value per share by approximately $0.13 and $0.14, respectively.
Investment-Related Derivatives. At June 30, 2018, the notional value of all derivative instruments (excluding to-be-announced

ARCH CAPITAL
 71
2018 SECOND QUARTER FORM 10-Q

Table of Contents

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 $3.20 billion, compared to $2.44 billion at December 31, 2017. If the underlying exposure of each investment-related derivative held at June 30, 2018 depreciated by 100 basis points, it would have resulted in a reduction in net income of approximately $32.0 million, and a decrease in book value per share of approximately $0.08 per share, compared to $24.4 million and $0.06 per share, respectively, on investment-related derivatives held at December 31, 2017. If the underlying exposure of each investment-related derivative held at June 30, 2018 appreciated by 100 basis points, it would have resulted in an increase in net income of approximately $32.0 million, and an increase in book value per share of approximately $0.08 per share, compared to $24.4 million and $0.06 per share, respectively, on investment-related derivatives held at December 31, 2017. See note 9, “Derivative Instruments,” to our consolidated financial statements for additional disclosures concerning derivatives.
For further discussion on investment activity, please refer to “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,” to our
 
consolidated financial statements for additional information.
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,
2018
 
December 31,
2017
Net assets (liabilities), denominated in foreign currencies, excluding shareholders’ equity and derivatives
$
(67,954
)
 
$
401,966

Shareholders’ equity denominated in foreign currencies (1)
336,778

 
345,743

Net foreign currency forward contracts outstanding (2)
138,494

 
(123,732
)
Net exposures denominated in foreign currencies
$
407,318

 
$
623,977

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

 
 

Shareholders’ equity
$
(40,732
)
 
$
(62,398
)
Book value per share
$
(0.10
)
 
$
(0.15
)
 
 
 
 
Pre-tax impact of a hypothetical 10% decline of the U.S. Dollar against foreign currencies:
 

 
 

Shareholders’ equity
$
40,732

 
$
62,398

Book value per share
$
0.10

 
$
0.15

(1)
Represents capital contributions held in the foreign currencies of our operating units.
(2)
Represents the net notional value of outstanding foreign currency forward contracts.
Although the Company generally attempts to match the currency of its projected liabilities with investments in the same currencies, from time to time the Company may elect to over or underweight one or more currencies, which could increase the Company’s exposure to foreign currency fluctuations and increase the volatility of the Company’s shareholders’ equity. 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.”
Effects of Inflation
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect our reserves for losses and loss adjustment expenses and interest rates. The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The anticipated effects of inflation on us are considered in our catastrophe loss models. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled.


ARCH CAPITAL
 72
2018 SECOND QUARTER FORM 10-Q

Table of Contents

OTHER FINANCIAL INFORMATION

The consolidated financial statements as of June 30, 2018 and for the three month and six month periods ended June 30, 2018 and 2017 have been reviewed by PricewaterhouseCoopers LLP, the registrant's independent public accountants, whose report is included as an exhibit to this filing. 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 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 Arch Capital 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 quarter ended June 30, 2018 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

ARCH CAPITAL
 73
2018 SECOND QUARTER FORM 10-Q

Table of Contents

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, 2018, 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.

ITEM 1A. RISK FACTORS
There were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table summarizes our purchases of common shares for the 2018 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)
4/1/2018 - 4/30/2018
 
2,754,393

 
$
26.90

 
2,727,816

 
$
369,861

5/1/2018 - 5/31/2018
 
3,215,118

 
26.38

 
2,872,941

 
$
294,159

6/1/2018 - 6/30/2018
 
888,757

 
26.43

 
803,673

 
$
272,926

Total
 
6,858,268

 
$
26.60

 
6,404,430

 
 
(1)
Represents repurchases by Arch Capital 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, 2018 under Arch Capital’s share repurchase authorization, under which repurchases may be effected from time to time in open market or privately negotiated transactions through December 31, 2019.


ARCH CAPITAL
 74
2018 SECOND QUARTER FORM 10-Q

Table of Contents


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 2018 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.
Disclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934

Section 13(r) of the Securities Exchange Act of 1934, as amended, requires an issuer to disclose in its annual or quarterly reports whether it or an affiliate knowingly engaged in certain activities described in that section, including certain activities related to Iran during the period covered by the report.
On January 16, 2016, the Office of Foreign Assets Control of the U.S. Department of the Treasury (“OFAC”) adopted General License H which authorized non-U.S. entities that are owned or controlled by a U.S. person to engage in certain activities with Iran so long as they complied with certain specific requirements set forth therein.
Certain of our non-U.S. subsidiaries provide global marine policies that provide coverage for vessels navigating into and out of ports worldwide. In light of European Union and U.S. modifications to Iran sanctions in 2016, including the issuance of General License H, and consistent with General License H, we have been notified that certain of our policyholders shipped cargo to and from Iran, and that such cargo may include transporting crude oil from Iran to another country. Since these policies insure multiple voyages and fleets containing multiple ships, we are unable to attribute gross revenues and net profits from such marine policies to these activities involving Iran. On May 8, 2018, the President announced that the U.S. will cease participation in the Joint Comprehensive Plan of Action and will begin reimposing the U.S. nuclear-related sanctions. On June 27, 2018, OFAC revoked General License H and added Section 560.537 to the Iranian Transactions and Sanctions Regulations, which authorizes all transactions and activities that are ordinarily incident and necessary to the winding down of activities previously approved under General License H through November 4, 2018. Our non-U.S. affiliates expect to wind down activities in Iran by November 4, 2018 in accordance with all applicable laws and regulations. Since May 8, 2018, our non-U.S. subsidiaries have not entered into any new transactions that had previously been permitted under General License H.

ARCH CAPITAL
 75
2018 SECOND QUARTER FORM 10-Q

Table of Contents


ITEM 6. EXHIBITS
 
Exhibit No.
 
Description
10.1
 
10.2
 
10.3
 
10.4
 
10.5
 
10.6
 
10.7
 
10.8
 
15
 
31.1
 
31.2
 
32.1
 
32.2
 
101
 
The following financial information from Arch Capital Group Ltd.’s Quarterly Report for the quarter ended June 30, 2018 formatted in XBRL: (i) Consolidated Balance Sheets at June 30, 2018 and December 31, 2017; (ii) Consolidated Statements of Income for the three and six month periods ended June 30, 2018 and 2017; (iii) Consolidated Statements of Comprehensive Income for the three and six month periods ended June 30, 2018 and 2017; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six month periods ended June 30, 2018 and 2017; (v) Consolidated Statements of Cash Flows for the six month periods ended June 30, 2018 and 2017; and (vi) Notes to Consolidated Financial Statements.
 
 
 
 
Management contract or compensatory plan or arrangement

ARCH CAPITAL
 76
2018 SECOND QUARTER FORM 10-Q

Table of Contents

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/ Marc Grandisson
Date: August 8, 2018
 
Marc Grandisson
 
 
President and Chief Executive Officer (Principal Executive Officer)
 
 
 
 
 
/s/ François Morin
Date: August 8, 2018
 
François Morin
 
 
Executive Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

ARCH CAPITAL
 77
2018 SECOND QUARTER FORM 10-Q