UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2005
Or
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period __________________ to __________________
Commission file number: 0-26456
ARCH CAPITAL GROUP LTD.
(Exact name of registrant as specified in its charter)
Bermuda
Not Applicable
(State or other jurisdiction of incorporation ororganization)
(I.R.S. Employer Identification No.)
Wessex House, 45 Reid Street
Hamilton HM 12, Bermuda
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: (441) 278-9250
___________________________________________________________________
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes X No ______
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common shares as of the latest practicable date.
Class
Outstanding at July 28, 2005
Common Shares, $0.01 par value
35,274,505
INDEX
Page No.
PART I. Financial Information
Item 1 — Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
2
Consolidated Balance SheetsJune 30, 2005 and December 31, 2004
3
Consolidated Statements of IncomeFor the three and six month periods ended June 30, 2005 and 2004
4
Consolidated Statements of Changes in Shareholders’ EquityFor the six month periods ended June 30, 2005 and 2004
5
Consolidated Statements of Comprehensive IncomeFor the six month periods ended June 30, 2005 and 2004
6
Consolidated Statements of Cash Flows For the six month periods ended June 30, 2005 and 2004
7
Notes to Consolidated Financial Statements
8
Item 2 — Management’s Discussion and Analysis of Financial Conditionand Results of Operations
27
Item 3 — Quantitative and Qualitative Disclosures About Market Risk
67
Item 4 — Controls and Procedures
PART II. Other Information
Item 1 — Legal Proceedings
68
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
Item 4 – Submission of Matters to a Vote of Security Holders
69
Item 5 — Other Information
71
Item 6 — Exhibits
1
To the Board of Directors and Shareholders of
Arch Capital Group Ltd.:
We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries as of June 30, 2005, and the related consolidated statements of income for each of the three-month and six-month periods ended June 30, 2005 and 2004, and the consolidated statements of comprehensive income, changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2005 and 2004. These interim financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2004, and the related consolidated statements of income, comprehensive income, and changes in shareholders’ equity and of cash flows for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 and the effectiveness of the Company’s internal control over financial reporting as of December 31,2004; and in our report dated March 14, 2005, we expressed unqualified opinions thereon. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2004, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
/s/ PricewaterhouseCoopers LLP
New York, New York
August 2, 2005
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
(Unaudited)
June 30,
December 31,
2005
2004
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: 2005, $6,079,549; 2004, $5,506,193)
$6,124,248
$5,545,121
Short-term investments available for sale, at fair value (amortized cost: 2005, $177,156; 2004, $155,498)
176,268
155,771
Privately held securities, at fair value (cost: 2005, $13,619; 2004, $17,022)
22,251
21,571
Total investments
6,322,767
5,722,463
Cash
162,017
113,052
Accrued investment income
63,210
57,163
Premiums receivable
622,664
520,781
Funds held by reinsureds
199,283
209,946
Unpaid losses and loss adjustment expenses recoverable
798,752
695,582
Paid losses and loss adjustment expenses recoverable
31,611
26,874
Prepaid reinsurance premiums
336,721
321,422
Goodwill and intangible assets
16,666
Deferred income tax assets, net
54,101
58,745
Deferred acquisition costs, net
303,969
278,184
Other assets
216,883
197,876
Total Assets
$9,128,644
$8,218,754
Liabilities
Reserve for losses and loss adjustment expenses
$4,175,403
$3,570,734
Unearned premiums
1,641,659
1,541,217
Reinsurance balances payable
143,838
169,502
Senior notes
300,000
Deposit accounting liabilities
50,337
44,023
Payable for securities purchased
20,152
53,642
Other liabilities
293,863
297,730
Total Liabilities
6,625,252
5,976,848
Commitments and Contingencies
Shareholders’ Equity
Preference shares ($0.01 par value, 50,000,000 shares authorized, issued: 2005, 37,327,502; 2004, 37,348,150)
373
Common shares ($0.01 par value, 200,000,000 shares authorized, issued: 2005, 35,262,005; 2004, 34,902,923)
353
349
Additional paid-in capital
1,568,955
1,560,291
Deferred compensation under share award plan
(6,389)
(9,879)
Retained earnings
886,746
644,862
Accumulated other comprehensive income, net of deferred income tax
53,354
45,910
Total Shareholders’ Equity
2,503,392
2,241,906
Total Liabilities and Shareholders’ Equity
See Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended
Six Months Ended
Revenues
Net premiums written
$723,728
$677,646
$1,523,529
$1,561,234
(Increase) decrease in unearned premiums
16,164
45,753
(86,569)
(130,009)
Net premiums earned
739,892
723,399
1,436,960
1,431,225
Net investment income
53,660
32,811
103,576
57,384
Net realized gains (losses)
2,105
(2,321)
2,566
6,580
Fee income
1,025
4,304
7,137
8,298
Other income (loss)
—
(4,385)
(3,343)
Total revenues
796,682
753,808
1,550,239
1,500,144
Expenses
Losses and loss adjustment expenses
443,918
436,895
869,454
866,509
Acquisition expenses
148,538
136,889
274,671
289,745
Other operating expenses
74,232
69,155
147,633
125,248
Interest expense
5,629
4,642
11,265
6,016
Net foreign exchange gains
(10,198)
(5,503)
(13,435)
(184)
Non-cash compensation
753
2,756
1,527
5,394
Total expenses
662,872
644,834
1,291,115
1,292,728
Income Before Income Taxes
133,810
108,974
259,124
207,416
Income tax expense
7,818
4,692
17,240
15,679
Net Income
$125,992
$104,282
$241,884
$191,737
Net Income Per Share Data
Basic
$3.65
$3.26
$7.02
$6.47
Diluted
$1.69
$1.42
$2.69
Weighted Average Shares Outstanding
34,563,565
32,023,865
34,464,740
29,650,932
74,412,553
73,500,041
74,249,728
71,336,798
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
Six Months EndedJune 30,
Preference Shares
Balance at beginning of year
$373
$388
Converted to common shares
(0)
(4)
Balance at end of period
384
Common Shares
282
Common shares issued
49
Converted from preference shares
0
335
Additional Paid-in Capital
1,361,267
1,698
184,437
Exercise of stock options
7,430
3,592
Common shares retired
(846)
(2,708)
Other
382
1,854
1,548,442
Deferred Compensation Under Share Award Plan
(15,004)
Restricted common shares issued
(291)
(2,142)
Deferred compensation expense recognized
3,781
5,354
(11,792)
Retained Earnings
327,963
Net income
241,884
191,737
519,700
Accumulated Other Comprehensive Income
35,833
Change in unrealized appreciation (decline) in value of investments, net of deferred income tax
8,514
(53,958)
Foreign currency translation adjustments, net of deferred income tax
(1,070)
(1,440)
(19,565)
$2,503,392
$2,037,504
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Comprehensive Income
Other comprehensive income (loss), net of deferred income tax
Unrealized appreciation (decline) in value of investments:
Unrealized holding gains (losses) arising during period
9,239
(50,987)
Reclassification of net realized gains, net of income taxes, included in net income
(725)
(2,971)
Foreign currency translation adjustments
Other comprehensive income (loss)
7,444
(55,398)
$249,328
$136,339
CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized gains
(1,022)
(5,630)
Other (income) loss
3,343
4,073
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
501,499
653,127
Unearned premiums, net of prepaid reinsurance premiums
85,143
130,009
(101,883)
(125,830)
(25,785)
(26,373)
10,663
5,148
(25,664)
(13,534)
(6,047)
(11,903)
(4,737)
(4,634)
5,142
(13,213)
6,314
15,733
(1,395)
24,360
Other items, net
(2,592)
15,671
Net Cash Provided By Operating Activities
685,593
843,405
Investing Activities
Purchases of fixed maturity investments
(1,985,427)
(3,413,832)
Proceeds from sales of fixed maturity investments
1,194,890
2,152,504
Proceeds from redemptions and maturities of fixed maturity investments
163,973
124,585
Sales of equity securities
1,986
11,043
Net (purchases) sales of short-term investments
(9,528)
148,182
Purchases of furniture, equipment and other
(7,588)
(10,878)
Net Cash Used For Investing Activities
(641,694)
(988,396)
Financing Activities
Proceeds from common shares issued
6,348
182,090
Proceeds from issuance of senior notes
296,442
Repayment of revolving credit agreement borrowings
(200,000)
Repurchase of common shares
(780)
(879)
Net Cash Provided By Financing Activities
5,568
277,653
Effects of exchange rate changes on foreign currency cash
(502)
Increase in cash
48,965
131,222
Cash beginning of year
56,899
Cash end of period
$162,017
$188,121
Income taxes paid, net
$34,958
$22,663
Interest paid
$11,141
$1,861
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. General
Arch Capital Group Ltd. (“ACGL”) is a Bermuda public limited liability company which provides insurance and reinsurance on a worldwide basis through its wholly owned subsidiaries.
The unaudited interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of ACGL and its wholly owned subsidiaries (together with ACGL, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of results on an interim basis. The results of any interim period are not necessarily indicative of the results for a full year or any future periods.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, including the Company’s audited consolidated financial statements and related notes and the section entitled “Business—Risk Factors.”
To facilitate period-to-period comparisons, certain amounts in the 2004 consolidated financial statements have been reclassified to conform to the 2005 presentation. Such reclassifications had no effect on the Company’s consolidated net income.
2. Stock Options
The Company has adopted the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations in accounting for its employee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized by the Company to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date. As provided under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” the Company has elected to continue to account for stock-based compensation in accordance with APB No. 25 and has provided the required additional pro forma disclosures.
If compensation expense for stock-based employee compensation plans had been determined using the fair value recognition provisions of SFAS No. 123, the Company’s net income and earnings per share would have instead been reported as the pro forma amounts indicated below:
Three Months EndedJune 30,
Net income, as reported
Total stock-based employee compensation expense underfair value method, net of income taxes
(1,119)
(427)
(2,196)
(937)
Pro forma net income
$124,873
$103,855
$239,688
$190,800
Earnings per share – basic:
As reported
Pro forma
$3.61
$3.24
$6.95
$6.43
Earnings per share – diluted:
$1.68
$1.41
$3.22
$2.67
3. Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB No. 25 and requires that the estimated expense resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) eliminates the alternative to disclose, on a pro forma basis, the effects of the fair value based method. Pursuant to a Securities and Exchange Commission ruling released on April 14, 2005, which deferred the effective date of SFAS No. 123(R) for calendar year companies from July 1, 2005 to January 1, 2006, the Company will adopt the fair value recognition provisions of accounting for employee stock option awards as defined in SFAS No. 123(R) on January 1, 2006 under the modified prospective application. Under the fair value method of accounting, compensation expense is estimated based on the fair value of the award at the grant date and recognized over the requisite service period. Under the modified prospective application, the fair value based method described in SFAS No. 123(R) is applied to new awards granted after January 1, 2006. Additionally, the unrecognized expense related to the unvested portions of option awards that were outstanding as of the effective date will be recognized as compensation expense as the requisite service is rendered. The Company is currently evaluating the impact of adopting SFAS No. 123(R) on the results of its operations. However, the impact of adopting SFAS No. 123(R) will have no effect on the Company’s cash flows or shareholders’ equity.
9
4. Segment Information
The Company classifies its businesses into two underwriting segments – reinsurance and insurance – and a corporate and other segment (non-underwriting). The Company’s reinsurance and insurance operating segments each have segment managers who are responsible for the overall profitability of their respective segments and who are directly accountable to the Company’s chief operating decision makers, the President and Chief Executive Officer of ACGL and the Chief Financial Officer of ACGL. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. The Company determined its reportable operating segments using the management approach described in SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information.”
Management measures segment performance based on underwriting income or loss. The Company does not manage its assets by segment and, accordingly, investment income is not allocated to each underwriting segment. In addition, other revenue and expense items are not evaluated by segment. The accounting policies of the segments are the same as those used for the preparation of the Company’s consolidated financial statements. Inter-segment insurance business is allocated to the segment accountable for the underwriting results.
The reinsurance segment consists of the Company’s reinsurance underwriting subsidiaries. The reinsurance segment generally seeks to write significant lines on specialty property and casualty reinsurance treaties. Classes of business include: casualty; marine and aviation; other specialty; property catastrophe; property excluding property catastrophe (losses on a single risk, both excess of loss and pro rata); and other (consisting of non-traditional and casualty clash business).
The insurance segment consists of the Company’s insurance underwriting subsidiaries which primarily write on both an admitted and non-admitted basis. The insurance segment consists of eight product lines: casualty; construction and surety; executive assurance; healthcare; professional liability; programs; property, marine and aviation; and other (primarily non-standard auto prior to the sale of such operations in December 2004, collateralized protection business and certain programs).
The corporate and other segment (non-underwriting) includes net investment income, other fee income, net of related expenses, other income, other expenses incurred by the Company, interest expense, net realized gains or losses, net foreign exchange gains or losses and non-cash compensation. The corporate and other segment also includes the results of the Company’s merchant banking operations prior to the sale of such operations in October 2004.
10
The following tables set forth an analysis of the Company’s underwriting income by segment, together with a reconciliation of underwriting income to net income:
Three Months EndedJune 30, 2005
Reinsurance
Insurance
Total
Gross premiums written (1)
$376,803
$577,420
$940,753
Net premiums written (1)
350,056
373,672
723,728
Net premiums earned (1)
$385,806
$354,086
$739,892
Policy-related fee income
732
Other underwriting-related fee income
22
271
293
(213,947)
(229,971)
(443,918)
Acquisition expenses, net
(113,443)
(35,095)
(148,538)
(11,882)
(57,232)
(69,114)
Underwriting income
$46,556
$32,791
79,347
Other expenses
(5,118)
(5,629)
10,198
(753)
Income before income taxes
(7,818)
Underwriting Ratios
Loss ratio
55.5%
64.9%
60.0%
Acquisition expense ratio (2)
29.4%
9.7%
20.0%
Other operating expense ratio
3.1%
16.2%
9.3%
Combined ratio
88.0%
90.8%
89.3%
(1) Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total. The reinsurance segment and insurance segment results include $12.8 million and $0.7 million, respectively, of gross and net premiums written and $14.7 million and $1.2 million, respectively, of net premiums earned assumed through intersegment transactions.
(2) The acquisition expense ratio is adjusted to include policy-related fee income.
11
Three Months EndedJune 30, 2004
$382,987
$465,516
$816,323
364,271
313,375
677,646
$378,874
$344,525
$723,399
3,608
56
296
352
(218,479)
(218,416)
(436,895)
(98,265)
(38,624)
(136,889)
(10,380)
(54,524)
(64,904)
$51,806
$36,865
88,671
Net realized losses
Other fee income, net of related expenses
344
(4,251)
(4,642)
5,503
(2,756)
(4,692)
57.7%
63.4%
60.4%
25.9%
10.2%
18.4%
2.7%
15.8%
9.0%
86.3%
89.4%
87.8%
(1) Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total. The reinsurance segment and insurance segment results include $29.8 million and $2.4 million, respectively, of gross and net premiums written and $34.7 million and $1.9 million, respectively, of net premiums earned assumed through intersegment transactions.
12
Six Months EndedJune 30, 2005
$865,598
$1,084,164
$1,921,445
827,749
695,780
1,523,529
$761,838
$675,122
$1,436,960
1,649
4,645
843
5,488
(432,621)
(436,833)
(869,454)
(212,895)
(61,776)
(274,671)
(22,775)
(114,187)
(136,962)
$98,192
$64,818
163,010
(10,671)
(11,265)
13,435
(1,527)
(17,240)
56.8%
64.7%
60.5%
27.9%
8.9%
19.0%
3.0%
16.9%
9.5%
87.7%
90.5%
89.0%
(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. The reinsurance segment and insurance segment results include $26.8 million and $1.5 million, respectively, of gross and net premiums written and $31.1 million and $2.4 million, respectively, of net premiums earned assumed through intersegment transactions.
13
Six Months EndedJune 30, 2004
$948,726
$947,085
$1,826,111
915,159
646,075
1,561,234
$761,924
$669,301
$1,431,225
7,393
376
424
800
(438,296)
(428,213)
(866,509)
(205,393)
(84,352)
(289,745)
(19,651)
(97,783)
(117,434)
$98,960
$66,770
165,730
105
(7,814)
(6,016)
184
(5,394)
(15,679)
57.5%
64.0%
27.0%
11.5%
19.7%
2.6%
14.6%
8.2%
87.1%
90.1%
88.4%
(1) Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total. The reinsurance segment and insurance segment results include $64.5 million and $5.2 million, respectively, of gross and net premiums written and $68.7 million and $3.5 million, respectively, of net premiums earned assumed through intersegment transactions.
14
The following tables provide summary information regarding net premiums written and earned by major line of business and type of business, together with net premiums written by client location for the reinsurance segment:
REINSURANCE SEGMENT(U.S. dollars in thousands)
Amount
% ofTotal
Casualty
$160,646
45.9%
$223,626
61.4%
Property excluding property catastrophe
81,341
23.2%
65,987
18.1%
Other specialty
74,988
21.4%
42,234
11.6%
Marine and aviation
18,089
5.2%
12,067
3.3%
Property catastrophe
9,362
13,019
3.6%
5,630
1.6%
7,338
2.0%
$350,056
100.0%
$364,271
$176,399
45.7%
$189,777
50.1%
87,488
22.7%
56,878
15.0%
68,545
17.8%
73,800
19.5%
20,619
5.3%
21,682
5.7%
21,768
5.6%
23,397
6.2%
10,987
2.9%
13,340
3.5%
Pro rata
$305,842
87.4%
$287,312
78.9%
Excess of loss
44,214
12.6%
76,959
21.1%
$294,526
76.3%
$279,940
73.9%
91,280
23.7%
98,934
26.1%
Net premiums written by client location (1)
United States and Canada
$205,837
58.8%
$239,841
65.9%
Europe
109,970
31.4%
78,079
17,314
5.0%
26,282
7.2%
Asia and Pacific
9,829
2.8%
12,419
3.4%
7,106
7,650
2.1%
(1) Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $12.8 million and $14.7 million, respectively, for the 2005 second quarter and $29.8 million and $34.7 million, respectively, for the 2004 second quarter. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $0.7 million and $1.2 million, respectively, for the 2005 second quarter and $2.4 million and $1.9 million, respectively, for the 2004 second quarter.
15
$371,515
44.9%
$452,177
49.4%
169,536
20.5%
174,576
19.1%
166,017
20.1%
148,531
53,924
6.5%
71,223
7.8%
48,118
5.8%
42,710
4.7%
18,639
2.2%
25,942
$827,749
$915,159
$389,660
51.1%
$342,353
144,983
141,675
18.6%
119,299
15.7%
159,915
21.0%
46,529
6.1%
50,610
6.6%
42,610
42,464
18,757
2.5%
24,907
$625,489
75.6%
$611,418
66.8%
202,260
24.4%
303,741
33.2%
$572,138
75.1%
$564,222
74.1%
189,700
24.9%
197,702
$486,587
$580,739
63.5%
265,465
32.1%
236,681
44,378
5.4%
63,407
6.9%
15,399
1.8%
17,871
1.9%
15,920
16,461
(1) Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $26.8 million and $31.1 million, respectively, for the six months ended June 30, 2005 and $64.5 million and $68.7 million, respectively, for the six months ended June 30, 2004. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $1.5 million and $2.4 million, respectively, for the 2005 second quarter and $5.2 million and $3.5 million, respectively, for the 2004 second quarter.
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The following tables provide summary information regarding net premiums written and earned by major line of business and type of business, together with net premiums written by client location for the insurance segment:
INSURANCE SEGMENT(U.S. dollars in thousands)
$72,503
19.4%
$52,712
16.8%
Property, marine and aviation
68,090
18.2%
35,792
11.4%
Programs
58,524
92,197
Professional liability
57,795
15.5%
41,318
13.2%
Executive assurance
48,131
12.9%
30,533
Construction and surety
40,552
10.8%
27,745
Healthcare
12,626
10,367
15,451
4.1%
22,711
7.3%
$373,672
$313,375
$73,686
20.8%
$57,560
16.7%
55,534
33,643
9.8%
53,154
102,496
29.7%
52,922
44,619
13.0%
37,149
10.5%
31,373
9.1%
46,910
41,260
12.0%
16,339
4.6%
12,149
18,392
21,425
$327,754
$303,075
96.7%
29,195
5,890
16,723
4.5%
4,410
1.4%
(1) Insurance segment results include premiums written and earned assumed through intersegment transactions of $0.7 million and $1.2 million, respectively, for the 2005 second quarter and $2.4 million and $1.9 million, respectively, for the 2004 second quarter. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $12.8 million and $14.7 million, respectively, for the 2005 second quarter and $29.8 million and $34.7 million, respectively, for the 2004 second quarter.
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$136,301
19.6%
$116,259
18.0%
111,791
16.1%
181,977
28.2%
110,182
65,523
10.1%
108,235
15.6%
92,882
14.4%
92,594
65,988
74,161
10.7%
58,016
29,062
4.2%
23,793
3.7%
33,454
4.8%
41,637
6.4%
$695,780
$646,075
$142,953
21.2%
$112,340
108,465
190,567
28.5%
99,083
14.7%
68,355
101,672
85,246
12.8%
89,689
13.3%
91,172
13.6%
64,371
62,411
33,339
4.9%
23,666
35,550
35,544
$614,296
88.3%
$627,910
97.2%
56,301
8.1%
6,885
1.1%
25,183
11,280
1.7%
(1) Insurance segment results include premiums written and earned assumed through intersegment transactions of $1.5 million and $2.4 million, respectively, for the six months ended June 30, 2005 and $5.2 million and $3.5 million, respectively, for the six months ended June 30, 2004. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $26.8 million and $31.1 million, respectively, for the six months ended June 30, 2005 and $64.5 million and $68.7 million, respectively, for the six months ended June 30, 2004.
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5. Reinsurance
In the normal course of business, the Company’s insurance subsidiaries cede a substantial portion of their premium through pro rata, excess of loss and facultative reinsurance agreements. The Company’s reinsurance subsidiaries purchase a limited amount of retrocessional coverage as part of their aggregate risk management program. In addition, the Company’s reinsurance subsidiaries participate in “common account” retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as the Company’s reinsurance subsidiaries, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, the Company’s insurance subsidiaries would be liable for such defaulted amounts.
The following table sets forth the effects of reinsurance with unaffiliated reinsurers on the Company’s reinsurance and insurance subsidiaries:
Premiums Written:
Direct
$559,357
$446,137
$1,057,682
$907,168
Assumed
381,396
370,186
863,763
918,943
Ceded
(217,025)
(138,677)
(397,916)
(264,877)
Net
Premiums Earned:
$535,780
$474,416
$1,025,591
$906,244
401,109
388,256
792,500
793,593
(196,997)
(139,273)
(381,131)
(268,612)
Losses and Loss Adjustment Expenses Incurred:
$326,084
$304,902
$626,798
$583,700
228,112
209,551
449,474
440,340
(110,278)
(77,558)
(206,818)
(157,531)
$443,918
$436,895
$869,454
$866,509
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6. Deposit Accounting
Certain assumed reinsurance contracts are deemed, under current financial accounting standards, not to transfer insurance risk, and are accounted for using the deposit method of accounting. However, it is possible that the Company could incur financial losses on such contracts. For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in the Company’s underwriting results. When the estimated profit margin is explicit, the margin is reflected as fee income and any adverse financial results on such contracts are reflected as incurred losses. The Company recorded fee income on such contracts of nil and $0.1 million, respectively, for the 2005 second quarter and 2004 second quarter, and $0.1 million and $0.4 million, respectively, for the six months ended June 30, 2005 and 2004. When the estimated profit margin is implicit, the margin is reflected as an offset to paid losses and any adverse financial results on such contracts are reflected as incurred losses. The Company recorded an offset to paid losses on such contracts of $2.1 million and $0.3 million, respectively, for the 2005 second quarter and 2004 second quarter, and $3.8 million and $2.5 million, respectively, for the six months ended June 30, 2005 and 2004. On a notional basis, the amount of premiums from those contracts that contain an element of underwriting risk was $3.5 million and $27.5 million, respectively, for the 2005 second quarter and 2004 second quarter, and $9.6 million and $45.5 million, respectively, for the six months ended June 30, 2005 and 2004.
In making any determination to account for a contract using the deposit method of accounting, the Company is required to make many estimates and judgments under the current financial accounting standards. Such standards are currently under review by the FASB.
7. Investment Information
The following tables summarize the Company’s fixed maturities and equity securities:
June 30, 2005
EstimatedFair Valueand CarryingValue
GrossUnrealizedGains
GrossUnrealized(Losses)
AmortizedCost
Fixed maturities:
U.S. government and government agencies
$2,380,513
$59,768
($12,638)
$2,333,383
Corporate bonds
1,506,420
8,974
(13,105)
1,510,551
Asset backed securities
835,871
666
(8,205)
843,410
Municipal bonds
611,914
9,555
(2,722)
605,081
Non-U.S. government securities
389,436
796
(546)
389,186
Commercial mortgage-backed securities
226,730
2,504
(426)
224,652
Mortgage backed securities
173,364
795
(717)
173,286
6,124,248
83,058
(38,359)
6,079,549
Equity securities:
Privately held
8,632
13,619
$6,146,499
$91,690
($38,359)
$6,093,168
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December 31, 2004
$2,266,411
21,317
(11,176)
$2,256,270
1,419,911
12,436
(7,810)
1,415,285
766,651
276
(6,367)
772,742
536,742
6,733
(1,117)
531,126
316,311
23,719
(455)
293,047
158,086
1,480
157,543
81,009
1,096
(267)
80,180
5,545,121
67,057
(28,129)
5,506,193
4,549
17,022
$5,566,692
$71,606
($28,129)
$5,523,215
Restricted Assets
The Company is required to maintain assets on deposit with various regulatory authorities to support its insurance and reinsurance operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. The Company also has investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. The following table details the market value of restricted assets:
Deposits with U.S. regulatory authorities
$172,871
$105,319
Deposits with non-U.S. regulatory authorities
16,247
18,074
Assets used for collateral or guarantees
537,774
461,978
Trust funds
54,130
58,934
Total restricted assets
$781,022
$644,305
In addition, the Company’s Bermuda-based reinsurance and insurance subsidiary maintains assets in trust accounts to support insurance and reinsurance transactions with affiliated U.S. companies. At June 30, 2005 and December 31, 2004, such amounts approximated $2.56 billion and $2.25 billion, respectively.
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8. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
(U.S. dollars in thousands,
except share data)
Basic Earnings Per Share:
Divided by:
Weighted average shares outstanding for the period
Basic earnings per share
Diluted Earnings Per Share:
Effect of dilutive securities:
Preference shares
37,327,502
38,364,972
37,329,441
38,491,045
Warrants
51,530
74,806
50,020
77,052
Nonvested restricted shares
413,040
1,065,605
421,222
1,064,325
Stock options
2,056,916
1,970,793
1,984,305
2,053,444
Total diluted shares
Diluted earnings per share
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. The number of excluded stock options were 9,368 and 9,011, respectively, for the 2005 second quarter and 2004 second quarter and 19,765 and 4,588, respectively, for the six months ended June 30, 2005 and 2004.
9. Income Taxes
ACGL is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act of 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to ACGL or any of its operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda.
ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. taxpayers. ACGL does not consider itself (or its non-U.S. subsidiaries) to be engaged in a trade or business within the U.S. and, consequently, does not expect it or such non-U.S. subsidiaries to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business
within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL’s shareholders’ equity and earnings could be materially adversely affected. ACGL’s U.S. subsidiaries are subject to U.S. income taxes on their worldwide income. ACGL’s U.K. subsidiaries are subject to U.K. corporation tax on their worldwide income.
ACGL changed its legal domicile from the United States to Bermuda in November 2000. Some U.S. insurance companies have been lobbying Congress to pass legislation intended to eliminate certain perceived tax advantages of U.S. insurance companies with Bermuda affiliates resulting principally from reinsurance between or among U.S. insurance companies and their Bermuda affiliates. This legislation, if passed, and other changes in U.S. tax laws, regulations and interpretations thereof to address these issues could materially adversely affect the Company.
The Company’s income tax provision resulted in an effective tax rate on income before income taxes of 5.8% for the 2005 second quarter, compared to 4.3% for the 2004 second quarter, and 6.7% for the six months ended June 30, 2005, compared to 7.6% for the six months ended June 30, 2004. The Company’s effective tax rates may fluctuate from period to period based on the relative mix of income reported by jurisdiction primarily due to the varying tax rates in each jurisdiction. The Company’s quarterly tax provision is adjusted to reflect changes in its expected annual effective tax rates, if any. The Company’s valuation allowance related to its deferred income tax assets is $1.4 million at June 30, 2005.
10. Transactions with Related Parties
Paul Ingrey, formerly Vice Chairman of ACGL, succeeded Robert Clements as Chairman of ACGL’s board of directors on April 1, 2005. Under a Consulting Agreement, dated as of March 17, 2005, between Mr. Clements and the Company, Mr. Clements will make himself available to provide consulting services to the Company for up to 25 days per year (for 2005, a prorated portion thereof) from April 1, 2005 through December 31, 2009 (the “Consulting Term”). During the Consulting Term, Mr. Clements will receive $100,000 per year for such services (for 2005, a prorated portion thereof), and the Company will continue to pay for rent and utilities for office space occupied by Mr. Clements and related administrative support.
In connection with the Company’s information technology initiative in 2002, the Company entered into arrangements with two software companies, which provide document management systems and information and research tools to insurance underwriters, in which Mr. Clements and John Pasquesi, Vice Chairman of ACGL’s board of directors, each hold minority ownership interests. The Company will pay approximately $50,000 in fees under one arrangement for the period of July 2004 to July 2005 while the other arrangement is variable based on usage. The Company made payments under such arrangements of approximately $0.2 million for the six months ended June 30, 2005, compared to $0.3 million for the six months ended June 30, 2004.
11. Contingencies Relating to the Sale of Prior Reinsurance Operations
On May 5, 2000, the Company sold the prior reinsurance operations of Arch Reinsurance Company (“Arch Re U.S.”) pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, “Folksamerica”). Folksamerica Reinsurance Company assumed Arch Re U.S.’s liabilities under the reinsurance agreements transferred in the asset sale and Arch Re U.S. transferred to Folksamerica Reinsurance Company assets estimated in an aggregate amount equal in book value to the book value of the liabilities assumed. The Folksamerica transaction was structured as a transfer and assumption agreement (and not reinsurance) and, accordingly, the loss reserves (and any related reinsurance recoverables) relating to the transferred business are not included as assets or liabilities on the Company’s balance sheet. Folksamerica assumed Arch Re U.S.’s rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements were notified that Folksamerica
23
had assumed Arch Re U.S.’s obligations and that, unless the reinsureds object to the assumption, Arch Re U.S. would be released from its obligations to those reinsured. None of such reinsureds objected to the assumption. However, Arch Re U.S. will continue to be liable under those reinsurance agreements if the notice is found not to be an effective release by the reinsureds. Folksamerica has agreed to indemnify the Company for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale. However, in the event that Folksamerica refuses or is unable to perform its obligations to the Company, Arch Re U.S. may incur losses relating to the reinsurance agreements transferred in the asset sale. Folksamerica’s A.M. Best Company rating was “A” (Excellent) at June 30, 2005.
Under the terms of the agreement, in 2000, the Company had also purchased reinsurance protection covering the Company’s transferred aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed $5.4 million, the Company has agreed to reimburse Folksamerica if a loss is incurred that exceeds $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. The Company also made representations and warranties to Folksamerica about the Company and the business transferred to Folksamerica for which the Company retains exposure for certain periods, and made certain other agreements. In addition, the Company retained its tax and employee benefit liabilities and other liabilities not assumed by Folksamerica, including all liabilities not arising under reinsurance agreements transferred to Folksamerica in the asset sale and all liabilities (other than liabilities arising under reinsurance agreements) arising out of or relating to a certain managing underwriting agency. Although Folksamerica has not asserted that any amount is currently due under any of the indemnities provided by the Company under the asset purchase agreement, Folksamerica has indicated a potential indemnity claim under the agreement in the event of the occurrence of certain future events. Based on all available information, the Company has denied the validity of any such potential claim.
12. Commitments and Contingencies
Letter of Credit and Revolving Credit Facilities
On September 16, 2004, the Company entered into a three-year agreement (“Credit Agreement”) for a $300 million unsecured revolving loan and letter of credit facility and a $400 million secured letter of credit facility. Letters of credit were issued under the Credit Agreement on September 17, 2004. Borrowings of revolving loans may be made by ACGL at a variable rate based on LIBOR or an alternative base rate at the option of the Company. The $300 million unsecured revolving loan is also available for the issuance of unsecured letters of credit up to $100 million for Arch Re U.S. Secured letters of credit are available for issuance on behalf of Arch Reinsurance Ltd., Arch Re U.S., Arch Insurance Company, Arch Specialty Insurance Company, Arch Excess & Surplus Insurance Company and Western Diversified Casualty Insurance Company. The Credit Agreement replaced the Company’s former credit agreement, dated as of September 12, 2003 and amended as of September 10, 2004, which provided for unsecured borrowings of up to $300 million. The Company used $200 million of the net proceeds from the offering of senior notes in May 2004 (see Note 13) to repay all amounts outstanding on the former credit agreement. Simultaneously with the execution of the Credit Agreement, the former credit agreement expired.
Issuance of letters of credit and borrowings under the Credit Agreement are subject to the Company’s compliance with certain covenants and conditions, including absence of a material adverse effect. These covenants require, among other things, that the Company maintain a debt to shareholders’ equity ratio of not greater than 0.35 to 1 and shareholders’ equity in excess of $1.4 billion plus 40% of future aggregate net income beginning after September 30, 2004 (not including any future net losses) and 40% of future aggregate proceeds from the issuance of common or preferred equity, that the Company maintain minimum unencumbered cash and investment grade securities in the amount of $400 million and that the Company’s principal insurance and reinsurance subsidiaries maintain at least a “B++” rating from A.M. Best Company. In addition, certain of the Company’s subsidiaries that are parties to the Credit Agreement are required to maintain minimum
24
shareholders’ equity levels. At June 30, 2005, the Company was in compliance with all covenants contained in the Credit Agreement. The Credit Agreement expires in September 2007.
Including the secured letter of credit portion of the Credit Agreement and another letter of credit facility (together, the “LOC Facilities”), the Company has access to secured letter of credit facilities for up to a total of $575 million. The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which it has entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from the Company’s reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of the Company’s business and the loss experience of such business. When issued, such letters of credit are secured by a portion of the Company’s investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which the Company was in compliance with at June 30, 2005. At such date, the Company had $411.6 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $465.7 million. The other letter of credit facility expires in December 2005. It is anticipated that the LOC Facilities will be renewed (or replaced) on expiry, but such renewal (or replacement) will be subject to the availability of credit from banks which the Company utilizes or may utilize.
In addition to letters of credit, the Company has and may establish insurance trust accounts in the U.S. and Canada to secure its reinsurance amounts payable as required (see Note 7).
Guarantee and Other
In the 2005 first quarter, the Company agreed to provide a guarantee, through the issuance of a standby letter of credit in the amount of $6.0 million (the “Guarantee”) for the benefit of a commercial bank, to assist the principals of an agency to obtain a loan to purchase the agency from its prior owner. The agency loan is payable over a seven year term, and the Guarantee will be outstanding until such time as the loan is repaid in full. During the 2005 second quarter, the Guarantee was reduced to $5.5 million due to a payment made on the agency loan. In return for the issuance of Guarantee, the agency entered into an exclusive agency relationship with the Company with respect to certain property and casualty insurance. Pursuant to such exclusive arrangement, the Company will pay the agency commissions based on an agreed percentage of written premium and, under certain circumstances, other remuneration based upon performance. The Company recorded net premiums written of $10.6 million under such agreement through June 30, 2005. The agency and each of the principals have signed pledge and security agreements that, among other things, provide the Company with collateral, in the case of the agency, and in the case of the principals, their respective shares of stock in the agency, as long as the Guarantee is in place. Such agreements also require the agency to use all excess cash flow beyond a reasonable reserve to accelerate reduction of the principal loan amount. Based on an analysis in the 2005 first quarter of the expected results of the agency and the likelihood of a default on the loan, the Company determined that the fair value of the Guarantee was $0.3 million, and recorded such amount as an expense and related liability.
In addition, the Company has agreed to extend a $10.0 million letter of credit through July 1, 2006 (“Extension”) for the benefit of a Lloyd’s of London syndicate (“Syndicate”) which was originally issued in connection with a reinsurance treaty covering the 2002 year of account. The Company received $0.5 million of fees in December 2004 and will receive $0.2 million in December 2005 in compensation for the Extension. To the extent that Lloyd’s of London draws down on the letter of credit on behalf of the Syndicate for any reason not related to the Company’s obligations under the 2002 year of account, the Syndicate will reimburse the Company for the amount drawn down plus interest at 6.0% per annum.
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13. Senior Notes
On May 4, 2004, ACGL completed a public offering of $300 million principal amount of 7.35% senior notes (“Senior Notes”) due May 1, 2034 and received net proceeds of $296.4 million. ACGL used $200 million of the net proceeds to repay all amounts outstanding under a revolving credit agreement (see Note 12). Interest payments on the Senior Notes are due on May 1 and November 1 of each year. ACGL may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The Senior Notes are ACGL’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. The effective interest rate related to the Senior Notes, based on the net proceeds received, is approximately 7.46%. Interest expense on the Senior Notes was $11.0 million for the six months ended June 30, 2005, compared to $3.7 million for the 2004 period.
14. 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, 2005, the Company was not a party to any material litigation or arbitration other than as a part of the ordinary course of business in relation to claims activity, none of which is expected by management to have a significant adverse effect on the Company’s results of operations and financial condition and liquidity.
In 2003, the former owners of American Independent Insurance Holding Company (“American Independent”) commenced an action against ACGL, American Independent and certain of American Independent’s directors and officers and others seeking unspecified damages relating to the reorganization agreement pursuant to which the Company acquired American Independent in 2001. The reorganization agreement provided that, as part of the consideration for the stock of American Independent, the former owners would have the right to receive a limited, contingent payment from the proceeds, if any, from certain pre-existing lawsuits that American Independent had brought as plaintiff prior to its acquisition by the Company. The former owners alleged, among other things, that the defendants entered into the agreement without intending to honor their commitments under the agreement and are liable for securities and common law fraud, breach of contract and intentional infliction of emotional distress. ACGL and the other defendants strongly denied the validity of these allegations, and filed a motion to dismiss all claims. That motion was granted on March 23, 2005, and the plaintiffs were allowed until April 15, 2005 to amend their complaint. Although they did attempt to amend the complaint, they did not timely and properly do so, and, on April 26, 2005, judgment was entered dismissing the action with prejudice. The plaintiffs thereafter moved to vacate the judgment and to allow retroactively the filing of their second amended complaint; that motion is now before the court. Although no assurances can be made as to the resolution of the motion or of the plaintiffs’ claims, should they be permitted to assert them, management does not believe that any of the claims are meritorious.
15. Variable Interest Entities
The Company concluded that, under FASB Interpretation No. 46R (“FIN 46R”), “Consolidation of Variable Interest Entities,” it is required to consolidate the assets, liabilities and results of operations (if any) of a certain managing general agency in which one of the Company’s subsidiaries has an investment. Such agency ceased producing business in 1999 and is currently running-off its operations. Based on current information, there are no assets or liabilities of such agency required to be reflected on the face of the Company’s consolidated financial statements that are not, or have not been previously, otherwise reflected therein. Therefore, the adoption of FIN 46R did not have a material impact on the Company’s consolidated financial statements as of or for the six months ended June 30, 2005 and 2004.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS
The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the section entitled “Cautionary Note Regarding Forward Looking Statements,” and in our periodic reports filed with the Securities and Exchange Commission (“SEC”).
General
Overview
Arch Capital Group Ltd. (“ACGL” and, together with its subsidiaries, “we,” or “us”) is a Bermuda public limited liability company with over $2.8 billion in capital and, through operations in Bermuda, the United States, Europe and Canada, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in an attractive insurance and reinsurance marketplace.
The worldwide insurance and reinsurance industry is highly competitive and has traditionally been subject to an underwriting cycle in which a hard market (high premium rates, restrictive underwriting standards, as well as terms and conditions, and underwriting gains) is eventually followed by a soft market (low premium rates, relaxed underwriting standards, as well as terms and conditions, and underwriting losses). Insurance market conditions may affect, among other things, the demand for our products, our ability to increase premium rates, the terms and conditions of the insurance policies we write, changes in the products offered by us or changes in our business strategy.
The financial results of the insurance and reinsurance industry are influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence, among other things, the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market. During 2001, market conditions had been improving primarily as a result of declining insurance capacity.
In general, market conditions improved during 2002 and 2003 in the insurance and reinsurance marketplace. This reflected improvement in pricing, terms and conditions following significant industry losses arising from the events of September 11th, as well as the recognition that intense competition in the late 1990s led to inadequate pricing and overly broad terms, conditions and coverages. Such industry developments resulted in poor financial results and erosion of the industry’s capital base. Consequently, many established insurers and reinsurers reduced their participation in, or exited from, certain markets and, as a result, premium rates escalated in many lines of business. These developments provided relatively new insurers and reinsurers, like us, with an opportunity to provide needed underwriting capacity. Beginning in late 2003 and continuing through the 2005 second quarter, additional capacity emerged in many classes of business and, consequently, premium rate increases have decelerated significantly and, in many classes of business, premium rates have decreased. However, we believe that we are still able to write insurance and reinsurance business at what we believe to be attractive rates. In response to these market conditions, we maintained underwriting discipline during 2005 and, as a result, net premiums written for the six months ended June 30, 2005 declined, compared
to the six months ended June 30, 2004, despite our expansion into the European and Canadian markets. Such trend may continue as we respond to more challenging market conditions.
Critical Accounting Policies, Estimates and Recent Accounting Pronouncements
The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, allowance for doubtful accounts, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments 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 limited historical information has been reported to us through June 30, 2005. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies require our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Reserves for Losses and Loss Adjustment Expenses
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses (“Loss Reserves”) that arise from the business we underwrite. Loss Reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured claims which have occurred at or before the balance sheet date. Due to many factors, including the lack of historical loss data for our reinsurance and insurance operations, and the resulting inability to use a historical loss development methodology, there is a possibility that significant changes in our Loss Reserves in future periods could occur.
Loss Reserves for our insurance and reinsurance operations are inherently subject to uncertainty. The period of time from the occurrence of a loss through the settlement of the liability may extend many years into the future. During this period, additional facts and trends will become known and, as these factors become apparent, Loss Reserves will be adjusted in the period in which the new information becomes known. While Loss Reserves are established based upon available information, certain factors, such as those inherent in the political, judicial and legal systems, including judicial and litigation trends and legislation changes, could impact the ultimate liability. Changes to our prior year Loss Reserves can impact our current underwriting results by (1) reducing our reported results if the prior year Loss Reserves prove to be deficient or (2) improving our reported results if the prior year Loss Reserves prove to be redundant. Loss Reserves 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, and it is likely that the ultimate liability will differ from such estimates. We utilize actuarial models as well as available historical insurance and reinsurance industry loss ratio experience and loss development patterns to assist in the establishment of Loss Reserves. Even actuarially sound methods can lead to subsequent adjustments to Loss Reserves that are both significant and irregular due to the nature of the risks written, potentially by a material amount.
For our reinsurance operations, we establish case reserves based on reports of claims notices received from ceding companies. Case reserves usually are based upon the amount of reserves recommended by the ceding company. Reported case reserves on known events may be supplemented by additional case reserves. Additional case reserves are often estimated by our claims function ahead of official notification from the ceding company, or when our judgment regarding the size or severity of the known event differs from the ceding company. In
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certain instances, we may establish additional case reserves even when the ceding company does not report any liability on a known event.
For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Loss Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made.
We also maintain incurred but not reported (“IBNR”) reserves. Such reserves are established to provide for incurred claims which have not yet been reported to an insurer or reinsurer at the financial statement date as well as to adjust for any projected variance in case reserving.
Even though most insurance policies have policy limits, the nature of property and casualty insurance and reinsurance is such that losses can exceed policy limits for a variety of reasons and also could very significantly exceed the premiums received on the underlying policies. We attempt to limit our risk of loss through reinsurance and may also use retrocessional arrangements. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control.
In establishing Loss Reserves, we have made various assumptions relating to the pricing of our reinsurance contracts and insurance policies and have also considered available historical industry experience and current industry conditions. Our reserving method to date has been, to a large extent, the expected loss method, which is commonly applied when limited loss experience exists. We select the initial expected loss and loss adjustment expense ratios based on information derived by our underwriters and actuaries during the initial pricing of the business, supplemented by industry data where appropriate. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that limited historical information has been reported to us through June 30, 2005. Reinsurance operations by their nature add further complexity to the reserving process in that there is an inherent additional lag in the timing and reporting of a loss event to a reinsurer from an insured or ceding company through a broker. As actual loss information has been reported to us, we have developed our own loss experience and our reserving methods include other actuarial techniques. Over time, such techniques will be given more weight in our reserving process based on the continuing maturation of our Loss Reserves. It is possible that claims in respect of events that have occurred could exceed our Loss Reserves and have a material adverse effect on our results of operations in a future period or our financial condition in general.
We are only permitted to establish Loss Reserves for losses that have occurred on or before the applicable financial statement date. Loss Reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
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At June 30, 2005 and December 31, 2004, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:
Reinsurance:
Case reserves
$351,874
$294,966
Additional case reserves
69,864
40,839
IBNR reserves
1,469,540
1,293,009
Total net reserves
$1,891,278
$1,628,814
Insurance:
$279,788
$231,215
1,205,585
1,015,123
$1,485,373
$1,246,338
Total:
$631,662
$526,181
2,675,125
2,308,132
$3,376,651
$2,875,152
At June 30, 2005 and December 31, 2004, Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, for the reinsurance segment by major line of business were as follows:
$1,093,951
$836,148
260,649
254,442
241,802
251,453
109,895
94,647
103,047
87,278
81,934
104,846
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At June 30, 2005 and December 31, 2004, Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, for the insurance segment by major line of business were as follows:
$351,740
$276,966
344,403
330,548
198,601
146,828
188,619
180,741
165,383
130,295
139,659
104,374
89,194
70,068
7,774
6,518
We do not have significant exposure to pre-2002 liabilities, such as asbestos-related illnesses and other long-tail liabilities and, to date, we have experienced a relatively low level of reported claims activity in most of our business, particularly in our longer tail exposures, such as casualty, executive assurance and professional liability, which have longer time periods during which claims are reported and paid. Our limited history does not provide any meaningful trend information. See “—Results of Operations—Segment Information” for a discussion of prior year development of Loss Reserves.
Premium Revenues and Related Expenses
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually twelve months. Premiums written include estimates in our program, aviation, construction and surety and collateralized protection business and for participation in involuntary pools. The amount of such insurance premium estimates included in premiums receivable and other assets at June 30, 2005 and December 31, 2004 was $28.4 million and $34.6 million, respectively. Such premium estimates are derived from multiple sources which include the historical experience of the underlying business, similar business and available industry information. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of in-force insurance policies.
Reinsurance premiums written include amounts reported by brokers and ceding companies, supplemented by our own estimates of premiums where reports have not been received or in cases where the amounts reported by brokers and ceding companies is adjusted to reflect management’s best judgments and expectations. Premium estimates are derived from multiple sources which include our underwriters, the historical experience of the underlying business, similar business and available industry information. Premiums written are recorded based on the type of contracts we write. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the inception date of the treaty. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
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The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by type of business were as follows at June 30, 2005 and December 31, 2004:
(U.S. dollars inthousands)
GrossAmount
AcquisitionExpenses
NetAmount
$237,337
($71,662)
$165,675
$199,046
($61,187)
$137,859
108,611
(28,127)
80,484
101,237
(19,339)
81,898
89,188
(26,951)
62,237
71,956
(22,017)
49,939
56,315
(15,525)
40,790
49,033
(12,382)
36,651
6,134
(1,878)
4,256
5,457
(1,816)
3,641
2,579
(446)
2,133
3,355
(315)
3,040
$500,164
($144,589)
$355,575
$430,084
($117,056)
$313,028
Premium estimates are reviewed by management at least quarterly. Such review includes a comparison of actual reported premiums to expected ultimate premiums along with a review of the aging and collection of premium estimates. Based on management’s review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned.
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Based on currently available information, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates at June 30, 2005.
Reinsurance premiums assumed, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a “losses occurring” basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a “risks attaching” basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period.
Certain of our reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses, are recorded based upon the projected experience under such contracts.
We also write certain business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, we assume a measured amount of insurance risk in exchange for an anticipated margin, which is typically lower than on traditional reinsurance contracts. The terms and conditions of these contracts may include additional or return premiums based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages and financial quota share coverages.
Certain assumed reinsurance contracts, which pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” issued by the Financial Accounting Standards Board (“FASB”), are deemed not to transfer insurance
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risk, are accounted for using the deposit method of accounting as prescribed in Statement of Position (“SOP”) 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk.” However, it is possible that we could incur financial losses on such contracts. Management exercises significant judgment in the assumptions used in determining whether assumed contracts should be accounted for as reinsurance contracts under SFAS No. 113 or deposit insurance contracts under SOP 98-7. Under SOP 98-7, for those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in our underwriting results. When the estimated profit margin is explicit, the margin is reflected as fee income and any adverse financial results on such contracts are reflected as incurred losses. When the estimated profit margin is implicit, the margin is reflected as an offset to paid losses and any adverse financial results on such contracts are reflected as incurred losses. For those contracts that do not transfer an element of underwriting risk, the projected profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income. Additional judgments are required when applying the accounting guidance set forth in SOP 98-7 with respect to the revenue recognition criteria for contracts deemed not to transfer insurance risk.
Retroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered by the underlying policies reinsured. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and, accordingly, we bifurcate the prospective and retrospective elements of these reinsurance contracts and account for each element separately. Underwriting income generated in connection with retroactive reinsurance contracts is deferred and amortized into income over the settlement period while losses are charged to income immediately. Subsequent changes in estimated or actual cash flows under such retroactive reinsurance contracts are accounted for by adjusting the previously deferred amount to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction, with a corresponding charge or credit to income.
Acquisition expenses and other expenses that vary with, and are directly related to, the acquisition of business in our underwriting operations are deferred and amortized over the period in which the related premiums are earned. Acquisition expenses, net of ceding commissions received from unaffiliated reinsurers, consist primarily of commissions, brokerage and taxes paid to obtain our business. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Deferred acquisition costs, which are based on the related unearned premiums, are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income.
Collection of Insurance-Related Balances
We are subject to credit risk with respect to our reinsurance ceded because the ceding of risk to reinsurers or retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. We are also subject to risks based upon the possibility that loss payments could occur earlier than the receipt of related reinsurance recoverables. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We evaluate the credit worthiness of all the reinsurers to which we cede business. If our analysis indicates that there is significant uncertainty regarding the collectibility of amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. At June 30, 2005 and December 31, 2004, our reserves for doubtful accounts were approximately $2.9 million and $2.2 million, respectively. At June 30, 2005, approximately 76.1% of premiums receivable of $622.7 million represented amounts not yet due, while amounts in excess of 90 days overdue were 1.3% of the total. At December 31, 2004, approximately 71.0% of premiums receivable of $520.8 million represented amounts not yet due, while amounts in excess of 90 days overdue were 3.2% of the total. Approximately 1.8% of the $31.6 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue at June 30, 2005, compared to 4.8% of the $26.9 million of paid losses and loss adjustment expenses recoverable at December 31, 2004.
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We are also subject to credit risk from our alternative market products, such as rent-a-captive risk-sharing programs, which allow a client to retain a significant portion of its loss exposure without the administrative costs and capital commitment required to establish and operate its own captive. In certain of these programs, we participate in the operating results by providing excess reinsurance coverage and earn commissions and management fees. In addition, we write program business on a risk-sharing basis with managing general agents or brokers, which may be structured with commissions which are contingent on the underwriting results of the program. While we attempt to obtain collateral from such parties in an amount sufficient to guarantee their projected financial obligations to us, there is no guarantee that such collateral will be sufficient to secure their actual ultimate obligations.
Income Taxes
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. A valuation allowance is recorded if it is more likely than not that some or all of a deferred income tax asset may not be realized. We consider future taxable income and feasible tax planning strategies in assessing the need for a valuation allowance. In the event we determine that we will not be able to realize all or part of our deferred income tax assets in the future, an adjustment to the deferred income tax assets would be charged to income in the period in which such determination is made. In addition, if we subsequently assess that the valuation allowance is no longer needed, a benefit would be recorded to income in the period in which such determination is made.
Investments
We currently classify all of our fixed maturity investments, short-term investments and publicly traded equity securities as “available for sale” and, accordingly, they are carried at estimated fair value. The fair value of fixed maturity securities is determined from quotations received from a nationally recognized pricing service. Short-term investments comprise securities due to mature within one year of the date of issue. Short-term investments include certain cash equivalents which are part of our investment portfolios under the management of external investment managers. Investments included in our private portfolio include securities issued by privately held companies. Our investments in privately held equity securities are carried at estimated fair value. Fair value is initially considered to be equal to the cost of such investment until the investment is revalued based on substantive events or other factors which could indicate a diminution or appreciation in value.
In accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and Emerging Issues Task Force (“EITF”) No. 03-1, “The Meaning of Other-than-Temporary Impairment and its Application to Certain Investments,” we periodically review our investments to determine whether a decline in fair value below the amortized cost basis is other than temporary. Our process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include (i) the time period in which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline and (iv) our intent and ability to hold the investment for a sufficient period of time for the value to recover. Where our analysis of the above factors results in the conclusion that declines in fair values are other than temporary, the cost of the securities is written down to fair value and is reflected as a realized loss.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. As mentioned above, we consider our intent and ability to hold a security until the value recovers in the process of evaluating whether a security with an unrealized loss represents an other than temporary decline. However, this factor, on its own, is not determinative as to whether we will recognize an impairment charge. We believe our ability to hold such securities is supported by our positive cash flow from operations where we can generate sufficient
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liquidity in order to meet our claims payment obligations arising from our underwriting operations without selling such investments. However, subsequent decisions to sell a security are made within the context of overall risk management, new information and the assessment of such security’s value relative to comparable securities. While our external investment managers may, at a given point in time, believe the preferred course of action is to hold securities until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision by us to sell the security and realize the loss, based upon a change in market and other factors discussed above. We believe these subsequent decisions are consistent with the classification of our investment portfolio as “available for sale.”
In March 2004, the EITF reached a consensus regarding EITF 03-1. The consensus provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective beginning with the 2004 third quarter. In October 2004, the FASB issued a final FASB Staff Position that delayed the effective date of the application guidance on impairment of securities that is included in paragraphs 10 through 20 of EITF 03-1. In June 2005, the FASB decided to nullify the guidance in paragraphs 10-18 of EITF 03-1. The Board decided not to provide any additional guidance on the meaning of other-than temporary impairment, but will issue a FASB Staff Position that will require companies to recognize other-than-temporary impairments by applying existing relevant guidance included in SFAS No. 115 or other current accounting standards, including current guidance for cost-method and equity-method investments. See note 7, “Investment Information,” of the notes accompanying our consolidated financial statements.
Stock Issued to Employees
We have adopted the provisions of APB Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” and related interpretations in accounting for employee stock options because the alternative fair value accounting provided for under SFAS No. 123, “Accounting for Stock-Based Compensation,” requires the use of option valuation models that we believe were not developed for use in valuing employee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized only to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date.
For restricted shares granted, we record deferred compensation equal to the market value of the shares at the measurement date, which is amortized and primarily charged to income as non-cash compensation over the vesting period. These restricted shares are recorded as outstanding upon issuance (regardless of any vesting period). See “—Results of Operations” for a discussion of non-cash compensation. We repurchase shares, from time to time, from employees in order to facilitate the payment of withholding taxes on restricted shares granted.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB No. 25 and requires that the estimated expense resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) eliminates the alternative to disclose, on a pro forma basis, the effects of the fair value based method. Pursuant to a Securities and Exchange Commission ruling released on April 14, 2005, which deferred the effective date of SFAS No. 123(R) for calendar year companies from July 1, 2005 to January 1, 2006, we will adopt the fair value recognition provisions of accounting for employee stock option awards as defined in SFAS No. 123(R) on January 1, 2006 under the modified prospective application. We are currently evaluating the impact of adopting SFAS No. 123(R) on the results of our operations. However, the impact of adopting SFAS No. 123(R) will have no effect on our cash flows or shareholders’ equity.
Recent Accounting Pronouncements
See note 3, “Accounting Pronouncements,” of the notes accompanying our consolidated financial statements.
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Results of Operations—Three Months Ended June 30, 2005 and 2004
The following table sets forth net income and earnings per share data:
Diluted net income per share
Diluted weighted average shares outstanding
Net income was $126.0 million for the 2005 second quarter, compared to $104.3 million for the 2004 second quarter, with the increase primarily due to growth in investment income. Our net income for the 2005 second quarter represented a 21.0% annualized return on average equity, compared to 20.6% for the 2004 second quarter. For purposes of computing return on average equity, average equity has been calculated as the average of shareholders’ equity outstanding at the beginning and ending of each period. Basic earnings per share data has not been presented or discussed herein as it does not include the significant number of preference shares outstanding in the periods. Diluted weighted average shares outstanding, which is used in the calculation of net income per share, was 0.9 million shares higher for the 2005 second quarter than for the 2004 second quarter with the increase primarily due to the exercise of stock options in 2004 and 2005 and increases in the dilutive effects of stock options and nonvested restricted stock calculated using the treasury stock method. Under such method, the dilutive impact of options and nonvested stock on diluted weighted average shares outstanding fluctuates as the market price of our common shares changes.
Segment Information
We classify our businesses into two underwriting segments — reinsurance and insurance — and a corporate and other segment (non-underwriting). SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. For a description of our underwriting segments, refer to note 4, “Segment Information,” of the notes accompanying our consolidated financial statements. Management measures segment performance based on underwriting income or loss.
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Reinsurance Segment
The following table sets forth our reinsurance segment’s underwriting results:
Gross premiums written
Acquisition expense ratio
Underwriting Income. The reinsurance segment’s underwriting income was $46.6 million for the 2005 second quarter, compared to $51.8 million for the 2004 second quarter. The combined ratio for the reinsurance segment was 88.0% for the 2005 second quarter, compared to 86.3% for the 2004 second quarter. The components of the reinsurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for the reinsurance segment were $376.8 million for the 2005 second quarter, compared to $383.0 million for the 2004 second quarter. Net premiums written were $350.1 million for the 2005 second quarter, compared to $364.3 million for the 2004 second quarter. During the 2005 second quarter, based on additional information provided by certain ceding companies, the reinsurance segment recorded adjustments on certain treaties written in 2002 and 2003. These adjustments, which had no impact on cash flow or underwriting income, had the effect of increasing gross and net premiums written, premiums earned and acquisition expenses by approximately $11.3 million. The decrease in premium volume, adjusted for such item, was primarily due to a reduction in U.S. casualty business and in response to softening market conditions.
For the 2005 second quarter, 87.4% and 12.6% of net premiums written were generated from pro rata contracts and excess of loss treaties, respectively, compared to 78.9% and 21.1% for the 2004 second quarter. Pro rata contracts are typically written at a lower loss ratio and higher expense ratio than excess of loss business. In certain cases, the reinsurance segment writes pro rata contracts where the underlying business consists of excess of loss policies. Approximately 22.2% of amounts included in the pro rata contracts written are related to excess of loss policies for the 2005 second quarter, compared to 35.3% for the 2004 second quarter. For information regarding net premiums written produced by type of business and geographic location, refer to note 4, “Segment Information,” of the notes accompanying our consolidated financial statements.
Net Premiums Earned. Net premiums earned for our reinsurance segment were $385.8 million for the 2005 second quarter, compared to $378.9 million for the 2004 second quarter, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written. For the 2005
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second quarter, 76.3% and 23.7% of net premiums earned were generated from pro rata contracts and excess of loss treaties, respectively, compared to 73.9% and 26.1% for the 2004 second quarter.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for our reinsurance segment in the 2005 second quarter were $213.9 million, or 55.5% of net premiums earned, compared to $218.5 million, or 57.7%, for the 2004 second quarter. The loss ratio for the 2005 second quarter benefited from estimated net favorable development in prior year Loss Reserves, net of related adjustments, of $15.1 million, primarily attributable to property and other short tail lines. The net impact of such development was a 3.9 point reduction in the 2005 second quarter combined ratio.
For the 2004 second quarter, underwriting income benefited from estimated net favorable development on prior year Loss Reserves of $26.4 million, or a 7.0 point reduction in the loss ratio, primarily in property and other short-tail business. Such amount included estimated net favorable development on non-traditional business of approximately $9.5 million, or a 2.5 point reduction in the loss ratio, which was substantially offset by additional profit commissions payable as a result of commutations during the period that increased acquisition expenses by $7.8 million, or 2.0 points of the acquisition expense ratio. For a discussion of Loss Reserves, please refer to the section above entitled “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses.”
Underwriting Expenses. The reinsurance segment’s acquisition expense ratio for the 2005 second quarter was 29.4%, compared to 25.9% for the 2004 second quarter. The 2005 second quarter ratio included 2.9 points from the adjustments on certain treaties written in 2002 and 2003 discussed above, and a 0.4 point increase under a sliding scale arrangement on a certain treaty which resulted from a decrease in the loss ratio of the same percentage. In addition, a higher percentage of net premiums earned in the 2005 second quarter were from pro rata business than in the 2004 second quarter. As pro rata contracts are typically written at a higher acquisition expense ratio and lower loss ratio than excess of loss business, this resulted in an increase in the acquisition expense ratio in the 2005 period. The balance of the increase in the acquisition expense ratio was due to changes in the reinsurance segment’s mix of business. The other operating expense ratio increased to 3.1% for the 2005 second quarter, compared to 2.7% for the 2004 second quarter. The higher ratio in the 2005 second quarter reflected additional expenses incurred in the 2005 second quarter as a result of the continued development of the reinsurance segment’s operating platform and the leveling off of net premiums earned.
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Insurance Segment
The following table sets forth our insurance segment’s underwriting results:
Acquisition expense ratio (1)
(1) The acquisition expense ratio is adjusted to include policy-related fee income.
Underwriting Income. The insurance segment’s underwriting income was $32.8 million for the 2005 second quarter, compared to $36.9 million for the 2004 second quarter. The combined ratio for the insurance segment was 90.8% for the 2005 second quarter, compared to 89.4% for the 2004 second quarter. The components of the insurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for the insurance segment were $577.4 million for the 2005 second quarter, compared to $465.5 million for the 2004 second quarter. The growth in gross premiums written in the 2005 second quarter primarily resulted from contributions in the property, executive assurance and professional liability lines from the insurance segment’s European operations, which became fully operational in the 2004 third quarter. In addition, growth in certain U.S. specialty lines, mainly in the primary casualty, property and professional liability lines, was partially offset by reductions in program business and from the sale of the insurance segment’s non-standard auto insurance operations in late 2004. The reduction in program business in the 2005 second quarter primarily resulted from the non-renewal of certain programs in 2004.
Ceded premiums written were 35.3% of gross premiums written for the 2005 second quarter, compared to 32.7% for the 2004 second quarter. The growth in the 2005 ceded percentage was due, in part, to the cession of 30% of certain program business with effective dates subsequent to March 31, 2004. In addition, the insurance segment’s property business was a higher percentage of written premium in the 2005 second quarter than in the 2004 period. As a higher percentage of property business is ceded to third parties than most other lines, this had the effect of increasing the ceded ratio in the 2005 second quarter. In addition, the ceded ratio on property business increased in the 2005 period as the insurance segment built capacity in order to increase the penetration of its global businesses, primarily through the use of reinsurance.
Net premiums written for the insurance segment were $373.7 million for the 2005 second quarter, compared to $313.4 million for the 2004 second quarter, with the increase due to the reasons discussed above.
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For information regarding net premiums written produced by type of business and geographic location, refer to note 4, “Segment Information,” of the notes accompanying our consolidated financial statements.
Net Premiums Earned. Net premiums earned for the insurance segment were $354.1 million for the 2005 second quarter, compared to $344.5 million for the 2004 second quarter, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written.
Policy-Related Fee Income. Policy-related fee income for our insurance segment was $0.7 million for the 2005 second quarter, compared to $3.6 million for the 2004 second quarter. The decrease in policy-related fee income resulted from the sale of our non-standard auto insurance operations in late 2004, which primarily generated such fee income. Policy-related fee income in future periods will be dependent on the insurance segment’s alternative markets and other lines of business and is likely to be substantially lower than the 2004 amounts.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for our insurance segment in the 2005 second quarter were $230.0 million, or 64.9% of net premiums earned, compared to $218.4 million, or 63.4%, for the 2004 second quarter. The loss ratio for the 2005 second quarter was impacted by estimated net adverse development in prior year Loss Reserves of $8.0 million, or a 2.3 point increase in the loss ratio, compared to minimal estimated net favorable development in the 2004 second quarter. The estimated net adverse development in the 2005 second quarter included $6.0 million of additional losses incurred related to the 2004 third quarter hurricane activity as well as adverse development on the insurance segment’s marine business. For a discussion of Loss Reserves, please refer to the section above entitled “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses.”
Underwriting Expenses. The acquisition expense ratio was 9.7% for the 2005 second quarter, compared to 10.2% for the 2004 second quarter. The acquisition expense ratio for the insurance segment is calculated net of policy-related fee income and is influenced by, among other things, (1) the amount of ceding commissions received from unaffiliated reinsurers and (2) the amount of business written on a surplus lines (non-admitted) basis. The acquisition expense ratio for the insurance segment in the 2005 second quarter decreased from the 2004 second quarter as the percentage of ceded business was higher in the 2005 period and the contribution of program business (which operates at a higher acquisition expense ratio) to net premiums earned was lower in the 2005 period.
The insurance segment’s other operating expense ratio for the 2005 second quarter was 16.2%, compared to 15.8% for the 2004 second quarter, reflecting additional expenses incurred in the 2005 second quarter as the insurance segment has expanded its operating platform, including the addition of operations in Canada, and the leveling off of net premiums earned.
Net Investment Income
Net investment income was $53.7 million for the 2005 second quarter, compared to $32.8 million for the 2004 second quarter. The higher level of net investment income in the 2005 second quarter resulted from a higher level of average invested assets in the 2005 period and an increase in the pre-tax investment income yield to 3.4% for the 2005 second quarter, compared to 2.9% for the 2004 second quarter. These yields were calculated based on amortized cost. Yields on future investment income may vary based on financial market conditions, investment allocation decisions and other factors.
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Net Realized Gains or Losses
Following is a summary of net realized gains (losses):
(Unaudited)Three Months EndedJune 30,
Fixed maturities
$2,753
($5,493)
Privately held securities
(1,305)
1,404
657
1,768
$2,105
($2,321)
Our investment portfolio is classified as available for sale. Currently, our portfolio is actively managed to maximize total return within certain guidelines. In assessing returns under this approach, we include net investment income, net realized gains and losses and the change in unrealized gains and losses generated by our investment portfolio. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. Total return on our portfolio under management, as reported to us by our investment advisors and as calculated on a weighted average basis, for the 2005 second quarter was 2.45%, compared to (1.38%) for the 2004 second quarter.
During the 2005 second quarter and 2004 second quarter, we realized gross losses from the sale of fixed maturities of $3.8 million and $7.9 million, respectively. With respect to those securities that were sold at a loss, the following is an analysis of the gross realized losses based on the period of time those securities had been in an unrealized loss position:
Less than 6 months
$1,635
$7,842
At least 6 months but less than 12 months
1,124
Over 12 months
1,011
$3,770
$7,860
The fair values of such securities sold at a loss during the 2005 second quarter and 2004 second quarter were $237 million and $893 million, respectively. We did not record an other than temporary impairment on securities that were purchased and subsequently sold at a loss during the 2005 second quarter. For a discussion of our accounting for investments, please refer to the section above entitled “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Investments.”
Included in other income (loss) for the 2004 second quarter is a charge of $4.5 million resulting from a write down of the carrying value of a subsidiary which was sold in the 2004 fourth quarter. Other income (loss) also includes income generated by certain of our privately held securities for which we used the equity method of accounting. In the 2004 third quarter, we sold the one remaining privately held security for which we used the equity method of accounting. Other expenses primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company.
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Interest Expense
Interest expense was $5.6 million for the 2005 second quarter, compared to $4.6 million for the 2004 second quarter. The higher level of interest expense in the 2005 period is primarily due to the full impact of the May 2004 issuance by ACGL of $300 million in 7.35% senior notes.
Net Foreign Exchange Gains or Losses
Net foreign exchange gains for the 2005 second quarter of $10.2 million consisted of net unrealized gains of $10.7 million and net realized losses of $0.5 million, compared to net foreign exchange gains for the 2004 second quarter of $5.5 million, which consisted of net unrealized gains of $6.0 million and net realized losses of $0.5 million. The net unrealized gains in the 2005 second quarter resulted from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at June 30, 2005. We hold investments in foreign currencies, which are intended to mitigate its exposure to foreign currency fluctuations in its net insurance liabilities. However, changes in the value of such investments due to foreign currency rate movements are reflected as a direct increase or decrease to shareholders’ equity and are not included in the statement of income. The net foreign exchange gains recorded by us in the 2005 second quarter were offset by decreases in our investments held in foreign currencies, which declined due to the strengthening U.S. Dollar. Foreign exchange gains and losses vary with fluctuations in currency rates and result from the remeasurement of foreign denominated monetary assets and liabilities. These gains and losses could add significant volatility to our net income in future periods.
Non-Cash Compensation
Restricted Stock
Non-cash compensation expense for the 2005 second quarter was $0.8 million, compared to $2.8 million for the 2004 second quarter. These amounts primarily relate to our capital raising activities during 2001 and the new underwriting initiative started in 2001. In addition, other non-cash compensation expenses that primarily relate to incentive compensation have been included in other operating expenses.
Stock Options
As discussed above under the caption “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Stock Issued to Employees,” we have elected to continue to account for stock-based compensation in accordance with APB No. 25 and have provided the required additional pro forma disclosures. Such pro forma information has been determined as if we had accounted for our employee stock options under the fair value method of SFAS No. 123. The fair value of employee stock options has been estimated at the date of grant using the Black-Scholes option valuation model. See note 2, “Stock Options,” of the notes accompanying our consolidated financial statements.
For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options’ vesting period. The weighted average fair value of options granted during the 2005 and 2004 second quarters was approximately $0.3 million.
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Had we accounted for our employee stock options under the fair value method, our net income per share would have been adjusted to the pro forma amounts indicated below; however, the expensing of stock options would have had no impact on our shareholders’ equity.
Total stock-based employee compensation expense under fair value method, net of income taxes
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models, such as the Black-Scholes model, require the input of highly subjective assumptions, including expected stock price volatility. As our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, we believe that the existing option valuation models, such as the Black-Scholes model, may not necessarily provide a reliable single measure of the fair value of employee stock options. The effects of applying SFAS No. 123 as shown in the pro forma disclosures may not be representative of the effects on reported net income for future periods. See note 3, “Accounting Pronouncements,” of the notes accompanying our consolidated financial statements.
The effective tax rate on income before income taxes was 5.8% for the 2005 second quarter, compared to 4.3% for the 2004 second quarter. Differences in the effective tax rates in the 2005 and 2004 periods resulted from a change in the relative mix of income reported by jurisdiction. Our effective tax rates may fluctuate from period to period based on the relative mix of income reported by jurisdiction primarily due to the varying tax rates in each jurisdiction. Our quarterly tax provision is adjusted to reflect changes in our expected annual effective tax rates, if any.
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Results of Operations—Six Months Ended June 30, 2005 and 2004
(Unaudited)Six Months EndedJune 30,
Net income was $241.9 million for the six months ended June 30, 2005, compared to $191.7 million for the six months ended June 30, 2004, with the increase primarily due to growth in investment income. Our net income for the six months ended June 30, 2005 represented a 20.4% annualized return on average equity, compared to 20.5% for the six months ended June 30, 2004. The higher level of diluted average shares outstanding for the six months ended June 30, 2005, compared to the 2004 period, was primarily due to the full weighting of 4,688,750 common shares issued in March 2004.
Underwriting Income. The reinsurance segment’s underwriting income was $98.2 million for the six months ended June 30, 2005, compared to $99.0 million for the six months ended June 30, 2004. The combined ratio for the reinsurance segment was 87.7% for the six months ended June 30, 2005, compared to 87.1% for the six months ended June 30, 2004. The components of the reinsurance segment’s underwriting income are discussed below.
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Premiums Written. Gross premiums written for our reinsurance segment were $865.6 million for the six months ended June 30, 2005, compared to $948.7 million for the six months ended June 30, 2004. Net premiums written for our reinsurance segment were $827.7 million for the six months ended June 30, 2005, compared to $915.2 million for the six months ended June 30, 2004. As discussed above, based on additional information provided by certain ceding companies, the reinsurance segment recorded adjustments during the 2005 second quarter on certain treaties written in 2002 and 2003. These adjustments, which had no impact on cash flow or underwriting income, had the effect of increasing gross and net premiums written, premiums earned and acquisition expenses by approximately $11.3 million. The decrease in premium volume, adjusted for such item, was primarily due to a reduction in U.S. casualty business and in response to softening market conditions.
For the six months ended June 30, 2005, 75.6% and 24.4% of net premiums written were generated from pro rata contracts and excess of loss treaties, respectively, compared to 66.8% and 33.2% for the six months ended June 30, 2004. Approximately 24.8% of amounts included in the pro rata contracts written are related to excess of loss treaties for the six months ended June 30, 2005, compared to 30.4% for the six months ended June 30, 2004.
Net Premiums Earned. Net premiums earned for our reinsurance segment were $761.8 million for the six months ended June 30, 2005, compared to $761.9 million for the six months ended June 30, 2004, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written. For the six months ended June 30, 2005, 75.1% and 24.9% of net premiums earned were generated from pro rata contracts and excess of loss treaties, respectively, compared to 74.1% and 25.9% for the six months ended June 30, 2004.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for our reinsurance segment in the six months ended June 30, 2005 were $432.6 million, or 56.8% of net premiums earned, compared to $438.3 million, or 57.5%, for the six months ended June 30, 2004. The loss ratio for the six months ended June 30, 2005 benefited from estimated net favorable development in prior year Loss Reserves, net of related adjustments, of $39.7 million, primarily attributable to property and other short-tail lines. The net impact of such development was a 5.2 point reduction in the loss ratio. The 2005 amount included estimated net favorable development of $4.9 million, or a 0.6 point reduction in the loss ratio, on two contracts which were commuted during the period. Such amount was substantially offset by additional profit commissions payable as a result of the commutations that increased acquisition expenses by $3.0 million, or 0.4 points of the acquisition expense ratio.
For the six months ended June 30, 2004, underwriting income benefited from estimated net favorable development on prior year Loss Reserves of $50.2 million, or a 6.6 point reduction in the loss ratio, primarily in property and other short-tail business. Such amount included favorable development on non-traditional business of approximately $28.2 million, or a 3.7 point reduction in the loss ratio, which was substantially offset by additional profit commissions payable as a result of the commutations that increased acquisition expenses by $21.7 million, or 2.8 points of the acquisition expense ratio.
Underwriting Expenses. The acquisition expense ratio for the six months ended June 30, 2005 was 27.9%, compared to 27.0% for the six months ended June 30, 2004. The 2005 ratio included 1.5 points from the adjustments on certain treaties written in 2002 and 2003 discussed above, and a 0.2 point increase under a sliding scale arrangement on a certain treaty which resulted from a decrease in the loss ratio of the same percentage. The balance of the increase in the acquisition expense ratio was due, in part, to changes in the reinsurance segment’s mix and type of business. The other operating expense ratio increased to 3.0% for the six months ended June 30, 2005, compared to 2.6% for the six months ended June 30, 2004. The higher ratio in the 2005 period reflected additional expenses incurred in 2005 as a result of the continued development of the reinsurance segment’s operating platform and the leveling off of net premiums earned.
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Underwriting Income. The insurance segment’s underwriting income was $64.8 million for the six months ended June 30, 2005, compared to $66.8 million for the six months ended June 30, 2004. The combined ratio for the insurance segment was 90.5% for the six months ended June 30, 2005, compared to 90.1% for the six months ended June 30, 2004. The components of the insurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for our insurance segment were $1.08 billion for the six months ended June 30, 2005, compared to $947.1 million for the six months ended June 30, 2004. The growth in gross premiums written for the six months ended June 30, 2005 primarily resulted from contributions in the property, executive assurance and professional liability lines from the insurance segment’s European operations, which became fully operational in the 2004 third quarter. In addition, growth in certain U.S. specialty lines, mainly in the primary casualty, construction and surety and professional liability lines, was partially offset by reductions in program business and from the sale of the insurance segment’s non-standard auto insurance operations in late 2004. The reduction in program business for the six months ended June 30, 2005 primarily resulted from the non-renewal of certain programs in 2004.
Ceded premiums written were 35.8% of gross premiums written for the six months ended June 30, 2005, compared to 31.8% for the six months ended June 30, 2004. The growth in the ceded percentage for the six months ended June 30, 2005 was due, in part, to the cession of 30% of certain program business with effective dates subsequent to March 31, 2004. In addition, the insurance segment’s property business was a higher percentage of written premium for the six months ended June 30, 2005 than in the 2004 period. As a higher percentage of property business is ceded to third parties than most other lines, this had the effect of increasing the ceded ratio in the 2005 period. In addition, the ceded ratio on property business increased in the 2005 period
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as the insurance segment built capacity in order to increase its penetration of global businesses, primarily through the use of reinsurance.
Net premiums written for our insurance segment were $695.8 million for the six months ended June 30, 2005, compared to $646.1 million for the six months ended June 30, 2004, with the increase due to the reasons discussed above.
Net Premiums Earned. Net premiums earned for our insurance segment were $675.1 million for the six months ended June 30, 2005, compared to $669.3 million for the six months ended June 30, 2004, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written.
Policy-Related Fee Income. Policy-related fee income for our insurance segment was $1.6 million for the six months ended June 30, 2005, compared to $7.4 million for the six months ended June 30, 2004. The decrease in policy-related fee income resulted from the sale of our non-standard auto insurance operations in late 2004, which primarily generated such fee income. Policy-related fee income in future periods will be dependent on the insurance segment’s alternative markets and other lines of business and is likely to be substantially lower than the 2004 amounts.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for our insurance segment in the six months ended June 30, 2005 were $436.8 million, or 64.7% of net premiums earned, compared to $428.2 million, or 64.0%, for the six months ended June 30, 2004. The loss ratio for the six months ended June 30, 2005 was impacted by estimated net adverse development in prior year Loss Reserves of $7.4 million, or a 1.1 point increase in the loss ratio, compared to $1.8 million of estimated net favorable development, or a 0.3 point decrease in the loss ratio, in the 2004 period. The estimated net adverse development in the 2005 period included $6.6 million of additional losses incurred related to the 2004 third quarter hurricane activity as well as adverse development on the insurance segment’s marine business.
Underwriting Expenses. The acquisition expense ratio was 8.9% for the six months ended June 30, 2005, compared to 11.5% for the six months ended June 30, 2004. The acquisition expense ratio for our insurance segment is calculated net of policy-related fee income and is influenced by, among other things, (1) the amount of ceding commissions received from unaffiliated reinsurers and (2) the amount of business written on a surplus lines (non-admitted) basis. The acquisition expense ratio for the six months ended June 30, 2005 decreased compared to the six months ended June 30, 2004 because the percentage of ceded business was higher in the 2005 period, increasing the amount of ceding commissions received, and the contribution of program business (which operates at a higher acquisition expense ratio) was lower in the 2005 period.
The insurance segment’s other operating expense ratio for the six months ended June 30, 2005 was 16.9%, compared to 14.6% for the six months ended June 30, 2004, as the insurance segment has expanded its operating platform, including the addition of operations in Canada, and the leveling off of net premiums earned.
Net investment income was $103.6 million for the six months ended June 30, 2005, compared to $57.4 million for the six months ended June 30, 2004. The higher level of net investment income for the six months ended June 30, 2005 resulted from a higher level of average invested assets in the 2005 period and an increase in the pre-tax investment income yield to 3.4% for the six months ended June 30, 2005, compared to 2.7% for the six months ended June 30, 2004.
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$2,473
$3,044
(1,451)
1,142
1,544
2,394
$2,566
$6,580
Total return on our portfolio under management for the six months ended June 30, 2005 was 0.99%, compared to 0.01% for the six months ended June 30, 2004. Realized gains for the six months ended June 30, 2004 included a $1.4 million gain in connection with a forward swap hedge, a derivative investment, which is included in “Other” in the table above.
During the six months ended June 30, 2005 and 2004, we realized gross losses from the sale of fixed maturities of $8.5 million and $7.9 million, respectively. With respect to those securities that were sold at a loss, the following is an analysis of the gross realized losses based on the period of time those securities had been in an unrealized loss position:
$4,755
$7,912
2,063
1,711
$8,529
$7,930
The fair values of such securities sold at a loss during the six months ended June 30, 2005 and 2004 were $663 million and $1.04 billion, respectively. We did not record an other than temporary impairment on securities that were purchased and subsequently sold at a loss during the six months ended June 30, 2005.
Included in other income (loss) for the six months ended June 30, 2004 is a charge of $4.5 million resulting from a write down of the carrying value of a subsidiary which was sold in the 2004 fourth quarter. Other income (loss) also includes income generated by certain of our investments in privately held securities for which we used the equity method of accounting. In the 2004 third quarter, we sold the one remaining privately held security for which we used the equity method of accounting. Other expenses primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company.
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Interest expense was $11.3 million for the six months ended June 30, 2005, compared to $6.0 million for the six months ended June 30, 2004. The higher level of interest expense in the 2005 period is primarily due to the full impact of the May 2004 issuance by ACGL of $300 million in 7.35% senior notes.
Net foreign exchange gains for the six months ended June 30, 2005 of $13.4 million consisted of net unrealized gains of $13.4 million and minimal net realized gains, compared to net foreign exchange gains for the six months ended June 30, 2004 of $0.2 million, which consisted of net unrealized gains of $0.5 million and net realized losses of $0.3 million.
Non-cash compensation expense was $1.5 million for the six months ended June 30, 2005, compared to $5.4 million for the six months ended June 30, 2004.
For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options’ vesting period. The weighted average fair value of options granted during the six months ended June 30, 2005 and 2004 was $0.4 million and $0.5 million, respectively.
The effective tax rate on income before income taxes was 6.7% for the six months ended June 30, 2005, compared to 7.6% for the six months ended June 30, 2004. The lower effective tax rate in the 2005 period resulted from a change in the relative mix of income reported by jurisdiction.
Liquidity and Capital Resources
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, we depend on our available cash resources, liquid investments and dividends or other distributions from our subsidiaries to make payments, including the payment of operating expenses we may incur, interest expense on our senior notes and for any dividends our board of directors may determine.
Pursuant to a shareholders agreement that we entered into in connection with the November 2001 capital infusion, we have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from funds affiliated with Warburg Pincus LLC (“Warburg Pincus funds”) and funds affiliated with Hellman & Friedman LLC (“Hellman & Friedman funds”), pro rata, on the basis of the amount of each of these shareholders’ investment in us at the time of such repurchase, preference shares having an aggregate value of $250 million, at a per share price acceptable to these shareholders.
On a consolidated basis, our aggregate invested assets, including cash and short-term investments, totaled $6.48 billion at June 30, 2005, compared to $5.84 billion at December 31, 2004. At June 30, 2005, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had an average Standard & Poor’s quality rating of “AA+” and an average effective duration of 3.9 years. ACGL’s readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled $9.3 million at June 30, 2005, compared to $6.1 million at December 31, 2004.
The ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Arch Reinsurance Ltd. (“Arch Re Bermuda”) is required to maintain a minimum solvency margin (i.e., the amount by which the value of its general business assets must exceed its general business liabilities) equal to the greatest of (1) $100 million, (2) 50% of net premiums written (being gross premiums written by us less any premiums ceded by us, but we may not deduct more than 25% of gross premiums when computing net premiums written) and (3) 15% of loss and other insurance reserves. Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with its minimum solvency margin. In addition, Arch Re Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet) unless it files, at least seven days before payment of such dividends, with the Bermuda Monetary Authority an affidavit stating that it will continue to meet the required margins. In addition, Arch Re Bermuda is prohibited, without prior approval of the Bermuda Monetary Authority, from reducing by 15% or more its total statutory capital, as set out in its previous year’s statutory financial statements. At December 31, 2004, as determined under Bermuda law, Arch Re Bermuda had statutory capital of $1.57 billion and statutory capital and surplus of $1.94 billion. Such amounts include ownership interests in U.S. insurance and reinsurance subsidiaries. Accordingly, approximately $235 million is available for dividends or distributions during 2005 without prior approval under Bermuda law, as discussed above. Our U.S. insurance and reinsurance subsidiaries can pay $29.8 million in dividends or distributions to Arch Re Bermuda during 2005 without prior regulatory approval, but such dividends or distributions may be subject to applicable withholding or other taxes. In addition, the ability of our insurance and reinsurance subsidiaries to pay dividends is also constrained by our dependence on financial strength ratings from independent rating agencies. Our ratings from these agencies depend to a large extent on the capitalization levels of our insurance and reinsurance subsidiaries.
Our insurance and reinsurance subsidiaries are required to maintain assets on deposit with various regulatory authorities to support their operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. Our insurance and reinsurance subsidiaries also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. At June 30, 2005 and December 31, 2004, such amounts approximated $781.0 million and $644.3 million, respectively.
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In addition, Arch Re Bermuda maintains assets in trust accounts to support insurance and reinsurance transactions with affiliated U.S. companies. At June 30, 2005 and December 31, 2004, such amounts approximated $2.56 billion and $2.25 billion, respectively.
ACGL, through its subsidiaries, provides financial support to certain of its insurance subsidiaries and affiliates, through certain reinsurance arrangements essential to the ratings of such subsidiaries. Except as described in the preceding sentence, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of ACGL’s subsidiaries or affiliates is solely responsible for its own liabilities and commitments (and no other ACGL subsidiary or affiliate is so responsible). Any reinsurance arrangements, guarantees or other financial support contractual arrangements that are in place are solely for the benefit of the ACGL subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements.
Arch Specialty Insurance Company (“Arch Specialty”) entered into a Stipulation and Order (“Stipulation”) with the Wisconsin Office of the Commissioner of Insurance (“OCI”) in connection with ACGL’s acquisition of Arch Specialty in 2002. While the ratio of Arch Specialty’s total adjusted capital to authorized control level risk-based capital exceeded 200% at December 31, 2004, and thus was above the risk-based capital threshold that would require company action (the lowest level of corrective action), it was below the 275% ratio that the Stipulation requires Arch Specialty to maintain. As of June 30, 2005, Arch Specialty was in compliance with the ratio required under the Stipulation following its receipt of a capital contribution in the amount of $45 million provided by Arch Re Bermuda. Western Diversified Casualty Insurance Company, which, like Arch Specialty, is domiciled in Wisconsin, also entered into a Stipulation with the OCI in 2003 whereby it must maintain a ratio of total adjusted capital to authorized control level risk-based capital of not less than 275%, and is currently in compliance with this ratio.
Our insurance and reinsurance operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time losses are paid. The period of time from the occurrence of a claim through the settlement of the liability may extend many years into the future. Sources of liquidity include cash flows from operations, financing arrangements or routine sales of investments.
As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. However, due to the nature of our operations, cash flows are affected by claim payments that may comprise large payments on a limited number of claims and which can fluctuate from year to year. We believe that our liquid investments and cash flow will provide us with sufficient liquidity in order to meet our claim payment obligations. However, the timing and amounts of actual claim payments related to recorded Loss Reserves vary based on many factors including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claim payments could differ materially from our estimated amounts. Certain lines of business written by us, such as excess casualty, have loss experience characterized as low frequency and high severity. The foregoing may result in significant variability in loss payment patterns. The impact of this variability can be exacerbated by the fact that the timing of the receipt of reinsurance recoverables owed to us may be slower than anticipated by us. Therefore, the irregular timing of claim payments can create significant variations in cash flows from operations between periods and may require us to utilize other sources of liquidity to make these payments, which may include the sale of investments or utilization of existing or new credit facilities or capital market transactions. If the source of liquidity is the sale of investments, we may be forced to sell such investments at a loss, which may be material.
Consolidated cash provided by operating activities was $685.6 million for the six months ended June 30, 2005, compared to $843.4 million for the six months ended June 30, 2004, with the decrease primarily attributable to a higher level of paid losses due, in part, to the continuing maturation of the Company’s insurance and reinsurance Loss Reserves. Cash flow from operating activities are provided by premiums collected, fee
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income, investment income and collected reinsurance recoverables, offset by losses and loss adjustment expense payments, reinsurance premiums paid, operating costs and current taxes paid.
We expect that our operational needs, including our anticipated insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by our balance of cash, short-term investments and our credit facilities, as well as by funds generated from underwriting activities and investment income and proceeds on the sale or maturity of our investments.
We previously announced that we currently expect to incur net losses of between $15 million and $25 million in the 2005 third quarter resulting from Hurricanes Dennis and Emily. The estimates relating to these events are based on currently available information derived from modeling techniques, industry assessments of exposure and claims information obtained from our clients and brokers. To date, we have received relatively few claims advices from clients and brokers. Our actual losses from these events may vary materially from the estimated net losses due to the inherent uncertainties in making such determinations resulting from several factors, including the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques, as well as the frequency of recent catastrophic events and the effects of any resultant demand surge on claims activity.
We monitor our capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by several ratings agencies, at a level considered necessary by management to enable our key operating subsidiaries to compete; (2) sufficient capital to enable our underwriting subsidiaries to meet the capital adequacy tests performed by statutory agencies in the U.S. and other key markets; and (3) letters of credit and other forms of collateral that are required by our non-U.S. operating companies that are “non-admitted” under U.S. state insurance regulations.
As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements and such other factors as our board of directors deems relevant.
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our operating subsidiaries, which could place those operating subsidiaries at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our operating subsidiaries are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of bank credit and letters of credit.
In addition to common share capital, we depend on external sources of finance to support our underwriting activities, which can be in the form (or any combination) of debt securities, preference shares, common equity and bank credit. Any equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities.
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In July 2004, we filed a universal shelf registration statement with the Securities and Exchange Commission. This registration statement allows for the possible future offer and sale by us of up to $650 million of various types of securities, including unsecured debt securities, preference shares, common shares, warrants, share purchase contracts and units and depositary shares. The shelf registration statement enables us to cost effectively and efficiently access public debt and/or equity capital markets in order to meet our future capital needs. In addition, our shelf registration statement allows selling shareholders to resell up to an aggregate of 9,892,594 common shares that they own (or may acquire upon the conversion of outstanding preference shares or warrants) in one or more offerings from time to time. We will not receive any proceeds from the shares offered by the selling shareholders. This report is not an offer to sell or the solicitation of an offer to buy, nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state.
In September 2004, we entered into a three-year agreement for a $300 million unsecured revolving loan and letter of credit facility and a $400 million secured letter of credit facility. The $300 million unsecured revolving loan is also available for the issuance of unsecured letters of credit up to $100 million for our U.S.-based reinsurance operation. Simultaneously with the execution of the credit agreement, our former credit agreement expired. See “—Contractual Obligations and Commercial Commitments—Letter of Credit and Revolving Credit Facilities” for a description of the credit agreement.
At June 30, 2005, our capital of $2.8 billion consisted of senior notes of $300.0 million, representing 10.7% of the total, and shareholders’ equity of $2.5 billion, representing the balance. At December 31, 2004, our capital of $2.54 billion consisted of senior notes of $300 million, representing 11.8% of the total, and shareholders’ equity of $2.24 billion, representing 88.2% of the total. The increase in our capital during the 2005 second quarter of $261.5 million was primarily attributable to net income.
Certain Matters Which May Materially Affect Our Results of Operations and/or Financial Condition
We establish 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 are a relatively new company with 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. See the section above entitled “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses.”
Premium Estimates
Our premiums written and premiums receivable include estimates for our insurance and reinsurance operations. Insurance premiums written include estimates for program, aviation, construction and surety and collateralized protection business and for participation in involuntary pools. Reinsurance premiums written include amounts reported by the ceding companies, supplemented by our own estimates of premiums for which ceding company reports have not been received. The basis for the amount of premiums written recognized varies based on the types of contracts we write. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the inception date of the treaty. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, only the initial annual
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installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
Premium estimates are reviewed by management at least quarterly. Such review includes a comparison of actual reported premiums to expected ultimate premiums together with a review of the aging and collection of premium estimates. Based on management’s review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to original premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the subject premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, is not currently due based on the terms of the underlying contracts. Based on the above process, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates at June 30, 2005.
Reinsurance Protection and Recoverables
For purposes of limiting our risk of loss, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. For the six months ended June 30, 2005, ceded premiums written represented approximately 20.7% of gross premiums written, compared to 14.5% for the six months ended June 30, 2004.
The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Although we believe that our insurance subsidiaries have been successful in obtaining adequate reinsurance protection since the commencement of our underwriting initiative in October 2001, it is not certain that we will be able to continue obtaining adequate protection at cost effective levels. As a result of such market conditions and other factors, we may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements. Further, we are subject to credit risk with respect to our reinsurers and retrocessionaires because the ceding of risk to reinsurers and retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our existing reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect our financial condition and results of operations.
We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. At June 30, 2005, approximately 81.8% of our reinsurance recoverables on paid and unpaid losses of $830.4 million (not including prepaid reinsurance premiums) were due from carriers which had an A.M. Best Company rating of “A-” or better. No reinsurance recoverables from any one carrier exceeded 3.6% of our total shareholders’ equity at June 30, 2005.
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The following table details our reinsurance recoverables at June 30, 2005:
% of Total
A.M. BestCompanyRating (1)
Everest Reinsurance Company
A+
Alternative market recoverables (2)
NR
Sentry Insurance a Mutual Company (3)
Allied World Assurance Company Ltd.
Swiss Reinsurance America Corporation
Employers Reinsurance Corporation
A
Federal Insurance Company
A++
Odyssey America Reinsurance Corporation
3.9%
American Re-Insurance Company
Converium Reinsurance (NA) Inc.
B-
ACE Property & Casualty Insurance Company
Lloyd’s of London syndicates (4)
Berkley Insurance Company
3.2%
PMA Capital Insurance Company
0.4%
B+
Lumbermens Mutual Casualty Company
All other (5)
(1) The financial strength ratings are as of July 14, 2005 and were assigned by A.M. Best Company based on its opinion of the insurer’s financial strength as of such date. An explanation of the ratings listed in the table follows: the ratings of “A++” and “A+” are designated “Superior”; the “A” and “A-” ratings are designated “Excellent”; ratings of “B++” and “B+” are designated “Very Good”; and the rating of “B-” is designated “Fair.” Additionally, A.M. Best Company has five classifications within the “Not Rated” or “NR” category. Reasons for an “NR” rating being assigned by A.M. Best Company include insufficient data, size or operating experience, companies which are in run-off with no active business writings or are dormant, companies which disagree with their rating and request that a rating not be published or insurers that request not to be formally evaluated for the purposes of assigning a rating opinion.
(2) Includes amounts recoverable from separate cell accounts in our alternative markets unit. Substantially all of such amounts are collateralized with reinsurance trusts, letters of credit or deposit funds.
(3) In connection with our acquisition of Arch Specialty in February 2002, the seller, Sentry, agreed to reinsure and guarantee all liabilities arising out of Arch Specialty’s business prior to the closing of the acquisition. In addition to the guarantee provided by Sentry, substantially all of therecoverable from Sentry is still subject to the original reinsurance agreements inuring to Arch Specialty and, to the extent Sentry fails to comply with its payment obligations to us, we may seek reimbursement from the third party reinsurers under such agreements.
(4) The A.M. Best Company group rating of “A” (Excellent) has been applied to all Lloyd’s of London syndicates.
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(5) The following table provides a breakdown of the “All other” category by A.M. Best Company rating:
Companies rated “A++”
1.3%
Companies rated “A+”
6.8%
Companies rated “A”
12.4%
Companies rated “A-”
Companies rated “B++”
0.3%
Companies rated “B+”
0.1%
Companies not rated
Natural and Man-Made Catastrophic Events
We have large aggregate exposures to natural and man-made catastrophic events. Catastrophes can be caused by various events, including, but not limited to, hurricanes, floods, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Catastrophes can also cause losses in non-property business such as 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.
We have substantial exposure to unexpected, large losses resulting from future man-made catastrophic events, such as acts of war, acts of terrorism and political instability. These risks are inherently unpredictable and recent events may lead to increased frequency and severity of losses. It is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. It is not possible to eliminate completely our exposure to unforecasted or unpredictable events and, to the extent that losses from such risks occur, our financial condition and results of operations could be materially adversely affected. Therefore, claims for natural and man-made catastrophic events could expose us to large losses and cause substantial volatility in our results of operations, which could cause the value of our common shares to fluctuate widely. In certain instances, we specifically insure and reinsure risks resulting from terrorism. Even in cases where we attempt to exclude losses from terrorism and certain other similar risks from some coverages written by us, we may not be successful in doing so. Moreover, irrespective of the clarity and inclusiveness of policy language, there can be no assurance that a court or arbitration panel will limit enforceability of policy language or otherwise issue a ruling adverse to us.
We seek to limit our loss exposure by writing a number of our reinsurance contracts on an excess of loss basis, adhering to maximum limitations on reinsurance written in defined geographical zones, limiting program size for each client and prudent underwriting of each program written. In the case of proportional treaties, we may seek per occurrence limitations or loss ratio caps to limit the impact of losses from any one or series of events. In our insurance operations, we seek to limit our exposure through the purchase of reinsurance. We cannot be certain that any of these loss limitation methods will be effective. We also seek to limit the loss exposure for our reinsurance and insurance operations through geographic diversification. Geographic zone limitations involve significant underwriting judgments, including the determination of the area of the zones and the inclusion of a particular policy within a particular zone’s limits. There can be no assurance that various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, will be enforceable in the manner we intend. Disputes relating to coverage and choice of legal forum may also arise. Underwriting is inherently a matter of judgment, involving important assumptions about matters that are inherently unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance. One or more catastrophic or other events could result in claims that substantially exceed our expectations, which could have a material adverse effect on our financial condition or our results of operations, possibly to the extent of eliminating our shareholders’ equity.
For our natural catastrophe exposed business, we seek to limit the amount of exposure we will assume from any one insured or reinsured and the amount of the exposure to catastrophe losses in any geographic zone. We monitor our exposure to catastrophic events, including earthquake and wind, and periodically reevaluate the estimated probable maximum pre-tax loss for such exposures. Our estimated probable maximum pre-tax loss is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. We seek to limit the probable maximum pre-tax loss to a specific level for severe catastrophic events. Currently, we generally seek to limit the probable maximum pre-tax loss to approximately 25% of consolidated shareholders’ equity for a severe catastrophic event in any geographic zone that could be expected to occur once in every 250 years. There can be no assurances that we will not suffer pre-tax losses greater than 25% of total shareholders’ equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques. In addition, depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business.
ACGL has purchased a reinsurance program for its insurance operations which provides coverage for certain property catastrophe-related losses equal to a maximum of 95% of the first $200 million in excess of a $50 million retention per occurrence of such losses commencing in June 2005. As coverage under this reinsurance program is utilized, it is automatically reinstated once and is available under the same terms as described immediately above. Our reinsurance operations have purchased reinsurance which primarily provides between $15 million and $55 million of coverage in excess of certain deductibles for any one occurrence and $110 million in the aggregate annually, for certain catastrophe-related losses worldwide for 2005 through April 2006. In the future, we may seek to purchase additional catastrophe or other reinsurance protection. The availability and cost of such reinsurance protection is subject to market conditions, which are beyond our control. As a result of market conditions and other factors, we may not be successful in obtaining such protection. See “—Reinsurance Protection and Recoverables” above.
Foreign Currency Exchange Rate Fluctuation
We write business on a worldwide basis, and our net income may be affected by fluctuations in foreign currency exchange rates as changes in foreign currency exchange rates can reduce our revenues and increase our liabilities and costs. In order to reduce our exposure to these exchange rate risks, we have invested and expect to continue to invest in securities denominated in currencies other than the U.S. Dollar. Our reinsurance segment invests certain funds in British Pounds Sterling and Euros in order to mitigate the economic effects of foreign currency exchange risk on projected liabilities in such currencies. We have chosen not to hedge the currency risk on the capital contributed to Arch Insurance Company (Europe) Limited (“Arch-Europe”) in May 2004, which is held in British Pounds Sterling. However, we intend to match Arch-Europe’s projected liabilities in foreign currencies with investments in the same currencies. We may suffer losses solely as a result of exchange rate fluctuations.
Management and Operations
As a relatively new insurance and reinsurance company, our success will also be dependent upon our ability to establish and maintain operating procedures and internal controls (including the timely and successful implementation of our information technology initiatives, which include the implementation of improved computerized systems and programs to replace and support manual systems) to effectively support our business and our regulatory and reporting requirements. We may not be successful in such efforts. We have enhanced and will continue to enhance our procedures and controls, including our controls over financial reporting. 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,
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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.
Shareholders Agreement
The Warburg Pincus funds and the Hellman & Friedman funds together control a majority of our voting power on a fully-diluted basis and have the right to nominate a majority of directors to our board under the shareholders agreement entered into in connection with the November 2001 capital infusion. The shareholders agreement also provides that we cannot engage in certain transactions (prior to November 20, 2005) outside the ordinary course of our business, including mergers and acquisitions and transactions in excess of certain amounts, without the consent of a designee of the Warburg Pincus funds and a designee of the Hellman & Friedman funds. These provisions could have an effect on the operation of our business and, to the extent these provisions discourage takeover attempts, they could deprive our shareholders of opportunities to realize takeover premiums for their shares or could depress the market price of our common shares. By reason of their ownership and the shareholders agreement, the Warburg Pincus funds and the Hellman & Friedman funds are able to strongly influence or effectively control actions to be taken by us. The interests of these shareholders may differ materially from the interests of the holders of our common shares, and these shareholders could take actions that are not in the interests of the holders of our common shares.
Contingencies Relating to the Sale of Prior Reinsurance Operations
See note 11, “Contingencies Relating to the Sale of Prior Reinsurance Operations,” of the notes accompanying our consolidated financial statements.
Industry and Ratings
We operate in a highly competitive environment, and since the September 11, 2001 events, new capital has entered the market. These factors may mitigate the benefits that the financial markets may perceive for the property and casualty insurance industry, and we cannot offer any assurances that we will be able to compete successfully in our industry or that the intensity of competition in our industry will not erode profitability and result in less favorable terms and conditions for insurance and reinsurance companies generally, including us. In addition, we can offer no assurances that we will participate at all or to the same extent as more established or other companies in any price increases or increased profitability in our industry. If we do not share in such price increases or increased profitability, our financial condition and results of operations could be materially adversely affected.
Financial strength and claims paying ratings from third party rating agencies are instrumental in establishing the competitive positions of companies in our industry. Periodically, rating agencies evaluate us to confirm that we continue to meet their criteria for the ratings assigned to us by them. A.M. Best Company maintains a letter scale rating system ranging from “A++” (Superior) to “F” (In Liquidation). Moody’s Investors Service maintains a letter scale rating from “Aaa” (Exceptional) to “NP” (Not Prime). Standard & Poor’s
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maintains a letter scale rating system ranging from “AAA” (Extremely Strong) to “R” (Under Regulatory Supervision). Our reinsurance subsidiaries, Arch Reinsurance Company (“Arch Re U.S.”) and Arch Re Bermuda, and our principal insurance subsidiaries, Arch Insurance Company (“Arch Insurance”), Arch Excess & Surplus Insurance Company (“Arch E&S”), Arch Specialty and Arch-Europe, currently have financial strength ratings of “A-” (Excellent) from A.M. Best Company and “A2” (Good) from Moody’s Investors Service. The “A-” rating is the fourth highest out of fifteen ratings assigned by A.M. Best Company, and the “A2” rating is the sixth highest out of 21 ratings assigned by Moody’s Investor Service. A.M. Best Company has assigned a financial strength rating of “NR-3” (Rating Procedure Inapplicable) to Western Diversified Casualty Insurance Company (“Western Diversified”), and Moody’s did not rate Western Diversified. In addition, our $300 million of senior notes were assigned a senior unsecured debt rating of “Baa1” (Stable) by Moody’s Investors Service and “BBB-” (Stable) by Standard & Poor’s. These ratings are statements of opinion, not statements of fact and not recommendations to buy, hold or sell any securities.
Rating agencies have been coming under increasing pressure as a result of high-profile corporate bankruptcies and may, as a result, increase their scrutiny of rated companies, revise their rating policies or take other action. We can offer no assurances that our ratings will remain at their current levels, or that our security will be accepted by brokers and our insureds and reinsureds. A ratings downgrade or the potential for such a downgrade, or failure to obtain a necessary rating, could adversely affect both our relationships with agents, brokers, wholesalers and other distributors of our existing products and services and new sales of our products and services. In addition, under certain of the reinsurance agreements assumed by our reinsurance operations, upon the occurrence of a ratings downgrade or other specified triggering event with respect to our reinsurance operations, such as a reduction in surplus by specified amounts during specified periods, our ceding company clients may be provided with certain rights, including, among other things, the right to terminate the subject reinsurance agreement and/or to require that our reinsurance operations post additional collateral. In the event of a ratings downgrade or other triggering event, the exercise of such contract rights by our clients could have a material adverse effect on our financial condition and results of operations, as well as our ongoing business and operations.
Industry Investigations
The New York Attorney General, various state insurance regulatory authorities and others are investigating contingent commission payments to brokers (and the disclosures relating to such payments), alleged “bid-rigging,” “steering” and other practices in the insurance industry involving brokers and agents, as well as finite insurance and/or reinsurance products. We cannot predict the effect that these investigations, and any changes in industry practice, including future legislation or regulations that may become applicable to us, will have on the insurance industry, the regulatory framework or our business.
Contractual Obligations and Commercial Commitments
On September 16, 2004, we entered into a three-year agreement (“Credit Agreement”) for a $300 million unsecured revolving loan and letter of credit facility and a $400 million secured letter of credit facility. Letters of credit were issued under the Credit Agreement on September 17, 2004. Borrowings of revolving loans may be made by ACGL at a variable rate based on LIBOR or an alternative base rate at our option. The $300 million unsecured revolving loan is also available for the issuance of unsecured letters of credit up to $100 million for Arch Re U.S. Secured letters of credit are available for issuance on behalf of Arch Re Bermuda, Arch Re U.S., Arch Insurance, Arch Specialty, Arch E&S and Western Diversified. The Credit Agreement replaced our former credit agreement, dated as of September 12, 2003 and amended as of September 10, 2004, which provided for unsecured borrowings of up to $300 million. We used $200 million of the net proceeds from the offering of senior notes in May 2004 (see “—Senior Notes” below) to repay all amounts outstanding on the former credit agreement. Simultaneously with the execution of the Credit Agreement, the former credit agreement expired.
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Issuance of letters of credit and borrowings under the Credit Agreement are subject to our compliance with certain covenants and conditions, including absence of a material adverse effect. These covenants require, among other things, that we maintain a debt to shareholders’ equity ratio of not greater than 0.35 to 1 and shareholders’ equity in excess of $1.4 billion plus 40% of future aggregate net income beginning after September 30, 2004 (not including any future net losses) and 40% of future aggregate proceeds from the issuance of common or preferred equity, that we maintain minimum unencumbered cash and investment grade securities in the amount of $400 million and that our principal insurance and reinsurance subsidiaries maintain at least a “B++” rating from A.M. Best Company. In addition, certain of our subsidiaries that are parties to the Credit Agreement are required to maintain minimum shareholders’ equity levels. We were in compliance with all covenants contained in the Credit Agreement at June 30, 2005. The Credit Agreement expires in September 2007.
Including the secured letter of credit portion of the Credit Agreement and another letter of credit facility (together, the “LOC Facilities”), we have access to secured letter of credit facilities for up to a total of $575 million. The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from our reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, such letters of credit are secured by a portion of our investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which we were in compliance with at June 30, 2005. At such date, we had approximately $411.6 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $465.7 million. The other letter of credit facility expires in December 2005. It is anticipated that the LOC Facilities will be renewed (or replaced) on expiry, but such renewal (or replacement) will be subject to the availability of credit from banks which we utilize or may utilize.
In addition to letters of credit, we have and may establish insurance trust accounts in the U.S. and Canada to secure its reinsurance amounts payable as required. See note 7, “Investment Information,” of the notes accompanying our consolidated financial statements.
Senior Notes
In May 2004, ACGL completed a public offering of $300 million principal amount of 7.35% senior notes (“Senior Notes”) due May 1, 2034 and received net proceeds of $296.4 million. Interest payments on the Senior Notes are due on May 1 and November 1 of each year. ACGL may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The Senior Notes are ACGL’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. The effective interest rate related to the Senior Notes, based on the net proceeds received, is approximately 7.46%. ACGL used $200 million of the net proceeds from the offering to repay all amounts outstanding under a revolving credit agreement and the remaining proceeds were used to support the underwriting activities of its insurance and reinsurance subsidiaries and for other general corporate purposes.
In the 2005 first quarter, we agreed to provide a guarantee, through the issuance of a standby letter of credit in the amount of $6.0 million (the “Guarantee”) for the benefit of a commercial bank, to assist the principals of an agency to obtain a loan to purchase the agency from its prior owner. The agency loan is payable over a seven year term, and the Guarantee will be outstanding until such time as the loan is repaid in full. During the 2005
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second quarter, the Guarantee was reduced to $5.5 million due to a payment made on the agency loan. In return for the issuance of Guarantee, the agency entered into an exclusive agency relationship with us with respect to certain property and casualty insurance. Pursuant to such exclusive arrangement, we will pay the agency commissions based on an agreed percentage of written premium and, under certain circumstances, other remuneration based upon performance. We recorded net premiums written of $10.6 million under such agreement through June 30, 2005. The agency and each of the principals have signed pledge and security agreements that, among other things, provide us with collateral, in the case of the agency, and in the case of the principals, their respective shares of stock in the agency, as long as the Guarantee is in place. Such agreements also require the agency to use all excess cash flow beyond a reasonable reserve to accelerate reduction of the principal loan amount. Based on an analysis in the 2005 first quarter of the expected results of the agency and the likelihood of a default on the loan, we determined that the fair value of the Guarantee was $0.3 million, and recorded such amount as an expense and related liability.
In addition, we agreed to extend a $10.0 million letter of credit through July 1, 2006 (“Extension”) for the benefit of a Lloyd’s of London syndicate (“Syndicate”) which was originally issued in connection with a reinsurance treaty covering the 2002 year of account. We received $0.5 million of fees in December 2004 and will receive $0.2 million in December 2005 in compensation for the Extension. To the extent that Lloyd’s of London draws down on the letter of credit on behalf of the Syndicate for any reason not related to our obligations under the 2002 year of account, the Syndicate will reimburse us for the amount drawn down plus interest at 6.0% per annum.
The finance and investment committee of our board of directors establishes our investment policies and creates guidelines for our external investment managers. The finance and investment committee reviews the implementation of the investment strategy on a regular basis. Our current approach stresses preservation of capital, market liquidity and diversification of risk. Our consolidated cash and invested assets were as follows at June 30, 2005 and December 31, 2004:
Fixed maturities available for sale, at fair value
Short-term investments available for sale, at fair value
Privately held securities, at fair value
$6,484,784
$5,835,515
At June 30, 2005 and December 31, 2004, our fixed income portfolio, which includes fixed maturities and short-term investments, had an average effective duration of 3.9 years and 3.7 years, respectively, an average Standard & Poor’s quality rating of “AA+” for both periods and an average yield to maturity at market value of 3.7% and 3.5%, respectively. At June 30, 2005 and December 31, 2004, our invested assets did not include any publicly traded equity securities. However, primarily for portfolio diversification purposes, we expect to begin allocating a small portion of our portfolio to equity securities during the second half of 2005.
In June 2005, we made a $10 million commitment to a mezzanine fund to invest primarily in mezzanine debt and equity investments and, to a lesser extent, in second lien and senior secured bank loans. It is the mezzanine fund’s objective to build a diversified portfolio composed primarily of mezzanine debt and equity investments and, to a lesser extent, second lien and senior secured bank loans, with individual investments typically ranging from $20 million to $75 million in size. We may invest in other investment vehicles in the future to diversify our portfolio and to potentially enhance our investment returns.
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In addition, we are planning on entering into a securities lending program in the 2005 third quarter. Under such program, certain of our fixed income portfolio securities will be loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. We will maintain control over the securities we lend, will retain the earnings and cash flows associated with the loaned securities and will receive a fee from the borrower for the temporary use of the securities. Collateral in the form of cash, government securities and letters of credit will be required in excess of the market value of the loaned securities and will be monitored and maintained by the lending agent.
Each quarter, we review our investments to determine whether a decline in fair value below the amortized cost basis is other than temporary. Our process for identifying if declines in the fair value of investments are other than temporary involves consideration of several factors. These factors include (i) the time period in which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline and (iv) our intent and ability to hold the investment for a sufficient period of time for the value to recover. Where our analysis of the above factors results in the conclusion that declines in fair values are other than temporary, the cost of the securities is written down to fair value and is reflected as a realized loss. In March 2004, the EITF reached a consensus regarding EITF 03-1, which provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective beginning with the 2004 third quarter. In October 2004, the FASB issued a final FASB Staff Position that delayed the effective date of the application guidance on impairment of securities that is included in paragraphs 10 through 20 of EITF 03-1. In June 2005, the FASB decided to nullify the guidance in paragraphs 10-18 of EITF 03-1. The Board decided not to provide any additional guidance on the meaning of other-than temporary impairment, but will issue a FASB Staff Position that will require companies to recognize other-than-temporary impairments by applying existing relevant guidance included in SFAS No. 115 or other current accounting standards, including current guidance for cost-method and equity-method investments.
Gross unrealized losses on our fixed maturity securities were $38.4 million at June 30, 2005. At June 30, 2005, on a lot level basis, approximately 1,314 fixed maturity securities out of a total of approximately 2,270 securities were in an unrealized loss position and the largest single unrealized loss from one investment in our fixed maturity portfolio was $1.6 million. The information presented below for the gross unrealized losses on our fixed maturity securities at June 30, 2005 indicates the potential effect upon future earnings and financial position in the event management later concludes that some of the current declines in the fair value of such securities are other than temporary.
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The following table provides an analysis of the length of time each of those fixed maturities with an unrealized loss at June 30, 2005 has been in a continual unrealized loss position:
Less than 12 Months
12 Months or Greater and Less Than 18 Months
EstimatedFair Value andCarryingValue
$862,185
($5,482)
$430,386
($7,156)
606,659
(6,473)
274,652
(5,683)
390,304
(3,806)
271,439
(3,733)
220,578
(1,342)
79,596
(1,380)
47,631
10,409
(82)
28,679
(635)
22,867
(264)
14,005
(282)
$2,160,633
($17,875)
$1,098,757
($18,869)
Equal or Greater Than18 Months
$—
$1,292,571
39,226
(949)
920,537
30,698
(666)
692,441
300,174
39,088
36,872
$69,924
($1,615)
$3,329,314
The following table presents the Standard & Poor’s credit quality distribution of our fixed maturities at June 30, 2005 and December 31, 2004:
(Unaudited)June 30, 2005
EstimatedFair Value andCarrying Value
Fixed Maturities:
AAA
$4,662,634
76.1%
$4,162,703
AA
430,022
7.0%
356,999
739,226
12.1%
772,262
13.9%
BBB
191,344
151,171
BB
23,135
13,488
B
76,121
83,690
1.5%
Lower than B
1,766
0.0%
4,808
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As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. We currently do not utilize derivative financial instruments such as futures, forward contracts, swaps or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments, other than a forward starting swap which was entered into in connection with the issuance of ACGL’s Senior Notes. Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. At June 30, 2005, our investments in mortgage-backed securities, excluding commercial mortgage-backed securities, amounted to approximately $173.4 million, or 2.7% of cash and invested assets, compared to $158.1 million, or 2.7% of cash and invested assets, at December 31, 2004. Such amounts are classified as “available for sale” and are not held for trading purposes.
At June 30, 2005 and December 31, 2004, we held three privately held securities totaling $22.3 million and $21.6 million, respectively, which were carried at fair value. Our investment commitments relating to privately held securities totaled approximately $0.4 million at June 30, 2005.
Book Value Per Share
The following book value per share calculations are based on shareholders’ equity of $2.50 billion and $2.24 billion at June 30, 2005 and December 31, 2004, respectively. The shares and per share numbers set forth below exclude the effects of 5,915,645 and 6,172,199 stock options, 98,125 and 150,000 Class B warrants and 96,651 and 84,992 restricted stock units outstanding at June 30, 2005 and December 31, 2004, respectively. Diluted per share book value increased to $34.49 at June 30, 2005 from $31.03 at December 31, 2004. The increase in shareholders’ equity and diluted per share book value was primarily attributable to net income.
OutstandingShares
CumulativeBook ValuePer Share
Common shares (1)
35,262,005
$48.76
34,902,923
$41.76
Series A convertible preference shares
37,348,150
Total shares
72,589,507
$34.49
72,251,073
$31.03
(1) Book value per common share at June 30, 2005 and December 31, 2004 was determined by dividing (i) the difference between total shareholders’ equity and the aggregate liquidation preference of the Series A convertible preference shares of $783.9 million and $784.3 million, respectively, by (ii) the number of common shares outstanding. Restricted common shares are included in the number of common shares outstanding as if such shares were issued on the date of grant.
Pursuant to the subscription agreement entered into in connection with the November 2001 capital infusion (the “Subscription Agreement”), in November 2005, there will be a calculation of a final adjustment basket based on (1) liabilities owed to Folksamerica (if any) under the Asset Purchase Agreement, dated as of January 10, 2000, between us and Folksamerica, and (2) specified tax and ERISA matters under the Subscription Agreement.
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, 2005. (See section captioned “Management’s Discussion and Analysis
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of Financial Condition and Results of Operations—Market Sensitive Instruments and Risk Management” included in our 2004 Annual Report on Form 10-K.) Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. At June 30, 2005, material changes in market risk exposures that affect the quantitative and qualitative disclosures presented as of December 31, 2004 are as follows:
Interest Rate Risk
We consider the effect of interest rate movements on the market value of our fixed maturities and short-term investments and the corresponding change in unrealized appreciation (depreciation). The following table summarizes the estimated effect that an immediate, parallel shift in the U.S. interest rate yield curve would have at June 30, 2005. Based on historical observations, it is unlikely that all global yield curves would shift in the same direction and at the same time and, accordingly, the actual effect of interest rate movements may differ materially from the amounts indicated in the table set forth below.
Interest Rate Shift in Basis Points
(U.S. dollars in millions)
-100
-50
100
Total market value
$6,558.2
$6,426.7
$6,300.5
$6,179.3
$6,062.8
Market value change from base
4.09%
2.00%
(1.92%)
(3.77%)
Change in unrealized value
$257.6
$126.2
($121.2)
($237.7)
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. A 10% appreciation of the U.S. Dollar against other currencies under our outstanding contracts at June 30, 2005, net of unrealized appreciation on our securities denominated in currencies other than the U.S. Dollar, would have resulted in unrealized losses of approximately $9.3 million and would have decreased diluted book value per share by approximately $0.13 at June 30, 2005. Based on historical observations, it is unlikely that all foreign currency exchange rates would shift against the U.S. Dollar in the same direction and at the same time and, accordingly, the actual effect of foreign currency rate movements may differ materially from the amounts set forth above. For further discussion on foreign exchange activity, please refer to “—Results of Operations.”
Cautionary Note Regarding Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 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 can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe” or “continue” 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, elsewhere in this report and in our periodic reports filed with the SEC, and include:
• our ability to successfully implement our business strategy during “soft” as well as “hard” markets;
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• acceptance of our business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and our insureds and reinsureds;
• our ability to maintain or improve our ratings, which may be affected by our ability to raise additional equity or debt financings, as well as other factors described herein;
• general economic and market conditions (including inflation, interest rates and foreign currency exchange rates) and conditions specific to the reinsurance and insurance markets in which we operate;
• competition, including increased competition, on the basis of pricing, capacity, coverage terms or other factors;
• our ability to successfully establish and maintain operating procedures (including the implementation of improved computerized systems and programs to replace and support manual systems) to effectively support our underwriting initiatives and to develop accurate actuarial data, especially in the light of the rapid growth of our business;
• the loss of key personnel;
• the integration of businesses we have acquired or may acquire into our existing operations;
• accuracy of those estimates and judgments utilized in the preparation of our financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies, 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 limited historical information has been reported to us through June 30, 2005;
• greater than expected loss ratios on business written by us and adverse development on claim and/or claim expense liabilities related to business written by our insurance and reinsurance subsidiaries;
• severity and/or frequency of losses;
• claims for natural or man-made catastrophic events in our insurance or reinsurance business could cause large losses and substantial volatility in our results of operations;
• acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;
• losses relating to aviation business and business produced by a certain managing underwriting agency for which we may be liable to the purchaser of our prior reinsurance business or to others in connection with the May 5, 2000 asset sale described in our periodic reports filed with the SEC;
• 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 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;
• changes in accounting principles or the application of such principles by accounting firms or regulators;
• statutory or regulatory developments, including as to tax policy and 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
• rating agency policies and practices.
In addition, other general factors could affect our results, including: (a) developments in the world’s financial and capital markets and our access to such markets; (b) changes in regulations or tax laws applicable to us, our subsidiaries, brokers or customers, including, without limitation, any such changes resulting from the recent investigations and inquiries by the New York Attorney General and others relating to the insurance industry and any attendant litigation; and (c) the effects of business disruption or economic contraction due to terrorism or other hostilities.
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All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.
OTHER FINANCIAL INFORMATION
The interim financial information included in this Quarterly Report on Form 10-Q as of and for the three and six months ended June 30, 2005 has not been audited by PricewaterhouseCoopers LLP. In reviewing such information, PricewaterhouseCoopers LLP has applied limited procedures in accordance with professional standards for reviews of interim financial information. However, their separate report included in this Quarterly Report on Form 10-Q for the 2005 second quarter states that they did not audit and they do not express an opinion on that interim financial information. Accordingly, you should restrict your reliance on their reports on such information. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their reports on the interim financial information because such reports do not constitute “reports” or “parts” of the registration statements prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Securities Act of 1933.
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.
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 are effective to provide reasonable assurance that all material information required to be filed in this report has been made known to them in a timely fashion.
Changes in Internal Controls Over Financial Reporting
There have been no changes in internal controls over financial reporting that occurred during the fiscal quarter ended June 30, 2005 that have materially affected, or are reasonably likely to materially affect, internal controls over financial reporting.
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, 2005, we were not a party to any material litigation or arbitration other than as a part of the ordinary course of business in relation to claims activity, none of which is expected by management to have a significant adverse effect on our results of operations and financial condition and liquidity.
The following table summarizes ACGL’s purchases of its common shares for the 2005 second quarter:
Issuer Purchases of Equity Securities
Period
Total Numberof SharesPurchased (1)
Average PricePaid per Share
Total Number ofSharesPurchased asPart of PubliclyAnnouncedPlans orPrograms
MaximumNumber of Shares that MayYet bePurchasedUnder the Planor Programs
4/1/2005-4/30/2005
5/1/2005-5/31/2005
186
$41.71
6/1/2005-6/30/2005
(1) ACGL repurchases shares, from time to time, from employees in order to facilitate the payment of withholding taxes on restricted shares granted. We purchased these shares at their fair market value, as determined by reference to the closing price of our common shares on the day the restricted shares vested.
(a) The annual meeting of shareholders (the “Annual Meeting”) of ACGL was held on April 28, 2005.
(b) Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under the Securities Exchange Act of 1934. There was no solicitation in opposition to management’s nominees as listed in ACGL’s proxy statement, dated March 31, 2005 (the “Proxy Statement”).
(c) The shareholders of ACGL (1) elected Class I Directors to hold office until the 2008 annual meeting of shareholders or until their successors are elected or qualified, (2) approved the ACGL 2005 Long Term Incentive and Share Award Plan, (3) elected certain individuals as Designated Company Directors of certain of ACGL’s non-U.S. subsidiaries and (4) ratified the selection of PricewaterhouseCoopers LLP as independent registered public accounting firm for the fiscal year ending December 31, 2005. Set forth below are the voting results for these proposals:
Election of Class I Directors of ACGL
FOR
WITHHOLD
Paul B. Ingrey
68,653,741
414,035
Kewsong Lee
66,528,257
2,539,519
David R. Tunnell
68,746,919
320,857
Robert F. Works
66,737,527
2,330,249
Approval of the ACGL 2005 Long Term Incentive and Share Award Plan
AGAINST
ABSTAIN
61,072,567
2,621,438
15,075
Election of Designated Directors of Non-U.S. Subsidiaries
James J. Ansaldi
68,792,879
274,897
Graham B. Collis
67,454,949
1,612,827
Dwight R. Evans
Marc Grandisson
Ralph E. Jones, III
68,789,629
278,147
Thomas G. Kaiser
68,789,879
277,897
Martin J. Nilsen
Nicolas Papadopoulo
Michael Quinn
Robert Van Gieson
John D. Vollaro
67,454,749
1,613,027
Graham Ward
Ratification of Selection of PricewaterhouseCoopers LLP as Independent Registered Public Accounting Firm
68,951,741
105,263
10,772
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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 six months ended June 30, 2005, the Audit Committee approved engagements of PricewaterhouseCoopers LLP for the following permitted non-audit services: tax services, tax consulting and tax compliance.
(a) Exhibits.
Exhibit No.
Description
10.1
Employment Agreement, dated as of May 29, 2005, between ACGL and W. Preston Hutchings (incorporated herein by reference from the current report on Form 8-K filed with the SEC on June 9, 2005).
Accountants’ Awareness Letter (regarding unaudited interim financial information) (filed herewith).
31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.1
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.2
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
(b) Reports on Form 8-K.
ACGL submitted reports on Form 8-K during the 2005 second quarter on April 28, 2005 to furnish the 2005 first quarter earnings release issued by ACGL, and on each of May 3, 2005 and June 9, 2005 to announce the entry into a material definitive agreement. ACGL also submitted a report on Form 8-K on July 28, 2005 to furnish the 2005 second quarter earnings release issued by ACGL. Since the reports submitted on April 28, 2005 and July 28, 2005 contain information that was furnished, they are not incorporated by reference herein.
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.
(REGISTRANT)
/s/ Constantine Iordanou
Date: August 3, 2005
Constantine Iordanou
President and Chief Executive Officer
(Principal Executive Officer) and Director
/s/ John D. Vollaro
Executive Vice President, Chief Financial
Officer and Treasurer (Principal Financial and
Accounting Officer)
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EXHIBIT INDEX