UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
Or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period to
Commission file number: 0-26456
ARCH CAPITAL GROUP LTD.
(Exact name of registrant as specified in its charter)
Bermuda
Not Applicable
(State or other jurisdiction of incorporation 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 ý No o
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
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 October 31, 2005
Common Shares, $0.01 par value
35,524,092
INDEX
PART I. Financial Information
Item 1 — Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
September 30, 2005 and December 31, 2004
Consolidated Statements of Income
For the three and nine month periods ended September 30, 2005 and 2004
Consolidated Statements of Changes in Shareholders’ Equity
For the nine month periods ended September 30, 2005 and 2004
Consolidated Statements of Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3 — Quantitative and Qualitative Disclosures About Market Risk
Item 4 — Controls and Procedures
PART II. Other Information
Item 1 — Legal Proceedings
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds
Item 5 — Other Information
Item 6 — Exhibits
1
To the Board of Directors and Shareholders ofArch Capital Group Ltd.:
We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries as of September 30, 2005, and the related consolidated statements of income for each of the three month and nine month periods ended September 30, 2005 and 2004, and the consolidated statements of changes in shareholders’ equity, comprehensive income and cash flows for the nine month periods ended September 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, changes in shareholders’ equity, comprehensive income and 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
November 7, 2005
2
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
(Unaudited)
September 30,2005
December 31,2004
Assets
Investments:
Fixed maturities available for sale, at fair value (amortized cost: 2005, $5,201,166; 2004, $5,506,193)
$
5,153,953
5,545,121
Short-term investments available for sale, at fair value (amortized cost: 2005, $485,571; 2004, $155,498)
485,157
155,771
Short-term investment of funds received under securities lending agreements, at fair value
954,684
—
Privately held securities, at fair value (cost: 2005, $5,371; 2004, $17,022)
12,945
21,571
Total investments
6,606,739
5,722,463
Cash
161,759
113,052
Accrued investment income
56,017
57,163
Fixed maturities pledged under securities lending agreements
918,882
Premiums receivable
678,335
520,781
Funds held by reinsureds
198,908
209,946
Unpaid losses and loss adjustment expenses recoverable
1,239,815
695,582
Paid losses and loss adjustment expenses recoverable
30,051
26,874
Prepaid reinsurance premiums
334,229
321,422
Deferred income tax assets, net
57,320
58,745
Deferred acquisition costs, net
313,942
278,184
Receivable for securities sold
68,247
5,285
Other assets
262,509
209,257
Total Assets
10,926,753
8,218,754
Liabilities
Reserve for losses and loss adjustment expenses
5,098,327
3,570,734
Unearned premiums
1,678,198
1,541,217
Reinsurance balances payable
196,728
169,502
Senior notes
300,000
Deposit accounting liabilities
49,782
44,023
Securities lending collateral
Payable for securities purchased
10,096
53,642
Other liabilities
287,407
297,730
Total Liabilities
8,575,222
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, 35,504,734; 2004, 34,902,923)
355
349
Additional paid-in capital
1,575,843
1,560,291
Deferred compensation under share award plan
(5,625
)
(9,879
Retained earnings
800,455
644,862
Accumulated other comprehensive income (loss), net of deferred income tax
(19,870
45,910
Total Shareholders’ Equity
2,351,531
2,241,906
Total Liabilities and Shareholders’ Equity
See Notes to Consolidated Financial Statements
3
CONSOLIDATED STATEMENTS OF INCOME
Three Months EndedSeptember 30,
Nine Months EndedSeptember 30,
2005
2004
Revenues
Net premiums written
787,304
743,229
2,310,833
2,304,463
Increase in unearned premiums
(39,529
(7,821
(126,098
(137,830
Net premiums earned
747,775
735,408
2,184,735
2,166,633
Net investment income
59,270
40,752
162,846
98,136
Net realized gains (losses)
(10,291
13,503
(7,725
20,083
Fee income
2,239
5,853
9,376
14,151
Other income (loss)
95
(3,248
Total revenues
798,993
795,611
2,349,232
2,295,755
Expenses
Losses and loss adjustment expenses
672,224
561,602
1,541,678
1,428,111
Acquisition expenses
142,803
137,480
417,474
427,225
Other operating expenses
71,960
70,331
219,593
195,579
Interest expense
5,632
6,334
16,897
12,350
Net foreign exchange (gains) losses
(7,334
1,787
(20,769
1,603
Non-cash compensation
641
2,330
2,168
7,724
Total expenses
885,926
779,864
2,177,041
2,072,592
Income (Loss) Before Income Taxes
(86,933
15,747
172,191
223,163
Income tax expense (benefit)
(642
(2,282
16,598
13,397
Net Income (Loss)
(86,291
18,029
155,593
209,766
Net Income (Loss) Per Share Data
Basic
(2.48
0.55
4.50
6.82
Diluted
0.25
2.09
2.91
Weighted Average Shares Outstanding
34,750,770
32,985,085
34,561,131
30,770,428
73,547,450
74,458,013
72,090,798
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
Preference Shares
Balance at beginning of year
388
Converted to common shares
(0
(15
Balance at end of period
Common Shares
282
Common shares issued
6
50
Converted from preference shares
0
15
347
Additional Paid-in Capital
1,361,267
2,893
189,542
Exercise of stock options
13,415
5,430
Common shares retired
(1,398
(3,019
Other
642
2,064
1,555,284
Deferred Compensation Under Share Award Plan
(15,004
Restricted common shares issued
(1,488
(7,395
Deferred compensation expense recognized
5,742
10,137
(12,262
Retained Earnings
327,963
Net income
537,729
Accumulated Other Comprehensive Income (Loss)
35,833
Change in unrealized appreciation (decline) in value of investments, net of deferred income tax
(64,571
12,735
Foreign currency translation adjustments, net of deferred income tax
(1,209
(1,585
46,983
2,128,454
5
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
(74,758
28,948
Reclassification of net realized (gains) losses, net of income taxes, included in net income
10,187
(16,213
Foreign currency translation adjustments
Other comprehensive income (loss)
(65,780
11,150
89,813
220,916
CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized (gains) losses
9,601
(19,570
Other (income) loss
3,248
6,486
11,719
Changes in:
Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable
983,360
1,063,950
Unearned premiums, net of prepaid reinsurance premiums
124,174
137,828
(157,554
(124,188
(35,758
(28,758
11,038
8,126
27,226
8,471
1,146
(19,390
(3,177
(1,682
6,649
(8,285
5,759
29,515
(9,026
68,202
Other items, net
(20,023
13,537
Net Cash Provided By Operating Activities
1,105,494
1,352,489
Investing Activities
Purchases of fixed maturity investments
(6,212,818
(5,260,351
Proceeds from sales of fixed maturity investments
5,178,452
3,412,623
Proceeds from redemptions and maturities of fixed maturity investments
282,552
154,094
Sales of equity securities
12,701
13,332
Net (purchases) sales of short-term investments
(317,043
99,062
Investment of securities lending collateral
(954,684
Purchases of furniture, equipment and other
(10,548
(13,809
Net Cash Used For Investing Activities
(2,021,388
(1,595,049
Financing Activities
Proceeds from common shares issued
11,415
183,775
Proceeds from issuance of senior notes
296,442
Repayment of revolving credit agreement borrowings
(200,000
Securities lending collateral received
Repurchase of common shares
(1,334
(1,525
Net Cash Provided By Financing Activities
964,765
278,692
Effects of exchange rate changes on foreign currency cash
(164
(268
Increase in cash
48,707
35,864
Cash beginning of year
56,899
Cash end of period
92,763
Income taxes paid, net
37,099
25,304
Interest paid
11,141
1,967
7
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 (loss).
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.
8
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 (loss) and earnings (loss) per share would have instead been reported as the pro forma amounts indicated below:
Net income (loss), as reported
Total stock-based employee compensation expense under fair value method, net of income taxes
(1,342
(2,349
(3,538
(3,286
Pro forma net income (loss)
(87,633
15,680
152,055
206,480
Earnings (loss) per share – basic:
As reported
Pro forma
(2.52
0.48
4.40
6.71
Earnings (loss) per share – diluted:
0.21
2.04
2.86
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 approach. 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 approach, 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 total 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. Intersegment 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 (loss), other expenses incurred by the Company, interest expense, net realized gains or losses, net foreign exchange gains or losses, non-cash compensation and income taxes. 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 (loss) by segment, together with a reconciliation of underwriting income (loss) to net income (loss):
Three Months EndedSeptember 30, 2005
Reinsurance
Insurance
Total
Gross premiums written (1)
445,628
617,499
1,048,042
Net premiums written (1)
409,768
377,536
Net premiums earned (1)
407,813
339,962
Policy-related fee income
833
Other underwriting-related fee income
74
1,332
1,406
(371,453
(300,771
(672,224
Acquisition expenses, net
(107,827
(34,976
(142,803
(12,397
(53,444
(65,841
Underwriting loss
(83,790
(47,064
(130,854
Net realized losses
Other expenses
(6,119
(5,632
Net foreign exchange gains
7,334
(641
Income (loss) before income taxes
Income tax benefit
Net income (loss)
Underwriting Ratios
Loss ratio
91.1
%
88.5
89.9
Acquisition expense ratio (2)
26.4
10.0
19.0
Other operating expense ratio
3.0
15.7
8.8
Combined ratio
120.5
114.2
117.7
(1) Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total. The reinsurance segment and insurance segment results include $14.3 million and $0.8 million, respectively, of gross and net premiums written and $12.4 million and $1.1 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 EndedSeptember 30, 2004
412,355
552,608
927,658
394,495
348,734
403,113
332,295
4,915
184
635
819
(329,451
(232,151
(561,602
(101,622
(35,858
(137,480
(11,562
(54,264
(65,826
Underwriting income (loss)
(39,338
15,572
(23,766
Net realized gains
Other fee income, net of related expenses
119
(4,505
(6,334
Net foreign exchange losses
(1,787
(2,330
Income before income taxes
2,282
81.7
69.9
76.4
25.2
9.3
18.0
2.9
16.3
9.0
109.8
95.5
103.4
(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 $36.3 million and $1.0 million, respectively, of gross and net premiums written and $37.5 million and $1.9 million, respectively, of net premiums earned assumed through intersegment transactions.
12
Nine Months EndedSeptember 30, 2005
1,311,226
1,701,663
2,969,487
1,237,517
1,073,316
1,169,651
1,015,084
2,482
4,719
2,175
6,894
(804,074
(737,604
(1,541,678
(320,722
(96,752
(417,474
(35,172
(167,631
(202,803
Underwriting income
14,402
17,754
32,156
(16,790
(16,897
20,769
(2,168
Income tax expense
(16,598
68.7
72.7
70.6
27.4
16.5
99.1
98.5
98.9
(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 $41.1 million and $2.3 million, respectively, of gross and net premiums written and $43.5 million and $3.5 million, respectively, of net premiums earned assumed through intersegment transactions.
13
Nine Months EndedSeptember 30, 2004
1,361,081
1,499,693
2,753,769
1,309,654
994,809
1,165,037
1,001,596
12,308
560
1,059
1,619
(767,747
(660,364
(1,428,111
(307,015
(120,210
(427,225
(31,213
(152,047
(183,260
59,622
82,342
141,964
224
(12,319
(12,350
(1,603
(7,724
(13,397
65.9
10.8
19.2
2.7
15.2
8.5
95.0
91.9
93.6
(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 $100.8 million and $6.2 million, respectively, of gross and net premiums written and $106.2 million and $5.4 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
Amount
% ofTotal
Casualty (2)
194,871
47.5
222,448
56.4
Property excluding property catastrophe
92,853
22.7
57,943
14.7
Other specialty
56,441
13.8
51,792
13.1
Marine and aviation
24,264
5.9
23,263
Property catastrophe
22,008
5.4
23,052
5.8
19,331
4.7
15,997
4.1
100.0
193,891
47.6
212,371
52.7
72,865
17.9
68,654
17.0
71,529
17.5
64,047
15.9
31,089
7.6
26,195
6.5
20,387
5.0
23,357
18,052
4.4
8,489
2.1
Pro rata
323,133
78.9
288,349
73.1
Excess of loss
86,635
21.1
106,146
26.9
304,425
74.6
298,309
74.0
103,388
25.4
104,804
26.0
Net premiums written by client location (1)
United States
245,755
60.0
245,538
62.2
Europe
95,241
23.2
75,898
38,507
9.4
35,706
9.1
Canada
17,549
4.3
22,423
5.7
Asia and Pacific
5,134
1.2
5,746
1.5
7,582
1.9
9,184
2.3
(1) Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $14.3 million and $12.4 million, respectively, for the 2005 third quarter and $36.3 million and $37.5 million, respectively, for the 2004 third quarter. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $0.8 million and $1.1 million, respectively, for the 2005 third quarter and $1.0 million and $1.9 million, respectively, for the 2004 third quarter.
(2) Includes professional liability business.
566,386
45.8
674,624
51.5
262,389
21.2
232,519
17.8
222,458
200,323
15.3
75,932
6.1
94,276
7.2
72,382
65,973
37,970
3.1
41,939
3.2
583,551
49.9
554,724
217,848
18.6
210,329
18.1
190,828
223,962
66,916
73,968
6.3
73,699
68,658
36,809
33,396
948,622
76.7
899,767
288,895
23.3
409,887
31.3
876,563
74.9
862,531
293,088
25.1
302,506
690,284
55.8
748,341
57.1
360,706
29.1
325,558
24.9
82,885
6.7
109,661
8.4
59,607
4.8
74,965
20,533
1.7
26,134
2.0
23,502
24,995
(1) Reinsurance segment results include premiums written and earned assumed through intersegment transactions of $41.1 million and $43.5 million, respectively, for the nine months ended September 30, 2005 and $100.8 million and $106.2 million, respectively, for the nine months ended September 30, 2004. Reinsurance segment results exclude premiums written and earned ceded through intersegment transactions of $2.3 million and $3.5 million, respectively, for the nine months ended September 30, 2005 and $6.2 million and $5.4 million, respectively, for the nine months ended September 30, 2004.
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The following tables provide summary information regarding net premiums written and earned by major line of business together with net premiums written by client location for the insurance segment:
INSURANCE SEGMENT
Casualty
70,924
18.8
67,250
19.3
Professional liability
66,257
52,252
15.0
Programs
56,335
14.9
62,327
Executive assurance
51,654
13.7
31,342
Construction and surety
50,401
13.3
45,799
Property, marine and aviation
46,407
12.3
48,886
14.0
Healthcare
19,507
5.2
18,036
16,051
22,842
76,200
22.4
57,687
17.4
54,993
16.2
51,894
15.6
54,392
16.0
72,239
21.7
40,693
12.0
29,873
46,812
45,264
13.6
32,484
9.5
39,446
11.9
18,099
5.3
14,676
16,289
21,216
6.4
324,525
86.0
327,697
94.0
22,680
6.0
6,627
30,331
8.0
14,410
(1) Insurance segment results include premiums written and earned assumed through intersegment transactions of $0.8 million and $1.1 million, respectively, for the 2005 third quarter and $1.0 million and $1.9 million, respectively, for the 2004 third quarter. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $14.3 million and $12.4 million, respectively, for the 2005 third quarter and $36.3 million and $37.5 million, respectively, for the 2004 third quarter.
17
207,225
183,509
18.4
174,492
145,134
14.6
168,126
244,304
24.6
156,589
114,409
11.5
142,995
111,787
11.2
125,815
11.7
89,357
48,569
4.5
41,830
4.2
49,505
4.6
64,479
219,153
21.6
170,028
156,665
15.4
137,140
162,857
262,806
26.2
131,567
13.0
107,800
136,501
13.4
136,436
105,064
10.4
92,284
9.2
51,438
5.1
38,342
3.8
51,839
56,760
934,181
87.0
959,983
96.5
78,981
7.4
12,886
1.3
60,154
5.6
21,940
2.2
(1) Insurance segment results include premiums written and earned assumed through intersegment transactions of $2.3 million and $3.5 million, respectively, for the nine months ended September 30, 2005 and $6.2 million and $5.4 million, respectively, for the nine months ended September 30, 2004. Insurance segment results exclude premiums written and earned ceded through intersegment transactions of $41.1 million and $43.5 million, respectively, for the nine months ended September 30, 2005 and $100.8 million and $106.2 million, respectively, for the nine months ended September 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 or retrocessionaires are unable to satisfy their obligations under the agreements, the Company 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
602,087
526,228
1,659,769
1,433,396
Assumed
445,955
401,430
1,309,718
1,320,373
Ceded
(260,738
(184,429
(658,654
(449,306
Net
Premiums Earned:
564,013
475,052
1,589,604
1,381,296
446,807
416,774
1,239,307
1,210,367
(263,045
(156,418
(644,176
(425,030
Losses and Loss Adjustment Expenses:
684,029
336,088
1,310,827
919,788
486,417
370,351
935,891
810,691
(498,222
(144,837
(705,040
(302,368
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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 $0.1 million and $0.2 million, respectively, for the 2005 third quarter and nine months ended September 30, 2005 compared to $0.2 million and $0.6 million, respectively, for the 2004 third quarter and nine months ended September 30, 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 $1.0 million and $4.8 million, respectively, for the 2005 third quarter and nine months ended September 30, 2005. The Company incurred losses on such contracts of $12.7 million and $10.2 million, respectively, for the 2004 third quarter and nine months ended September 30, 2004. On a notional basis, the amount of premiums from those contracts that contain an element of underwriting risk was $7.4 million and $17.0 million, respectively, for the 2005 third quarter and nine months ended September 30, 2005, compared to $20.1 million and $65.6 million, respectively, for the 2004 third quarter and nine months ended September 30, 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, fixed maturities pledged under securities lending agreements and equity securities:
September 30, 2005
EstimatedFair Valueand CarryingValue
GrossUnrealizedGains
GrossUnrealizedLosses
AmortizedCost
Fixed maturities and fixed maturities pledged under securities lending agreements:
U.S. government and government agencies
2,379,552
23,114
(22,217
2,378,655
Corporate bonds
1,310,230
1,491
(16,439
1,325,178
Asset backed securities
800,829
111
(9,485
810,203
Municipal bonds
628,126
4,934
(5,890
629,082
Non-U.S. government securities
403,685
4,964
(8,159
406,880
Commercial mortgage backed securities
311,321
466
(3,984
314,839
Mortgage backed securities
239,092
168
(1,708
240,632
6,072,835
35,248
(67,882
6,105,469
Equity securities:
Privately held
7,574
5,371
6,085,780
42,822
6,110,840
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December 31, 2004
Fixed maturities:
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
(937
157,543
81,009
1,096
(267
80,180
67,057
(28,129
5,506,193
4,549
17,022
5,566,692
71,606
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
177,711
105,319
Deposits with non-U.S. regulatory authorities
16,986
18,074
Assets used for collateral or guarantees
500,969
461,978
Trust funds
63,249
58,934
Total restricted assets
758,915
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 September 30, 2005 and December 31, 2004, such amounts approximated $2.55 billion and $2.25 billion, respectively.
Securities Lending Program
During the 2005 third quarter, the Company began a securities lending program under which certain of its fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. Such securities have been reclassified as ‘Fixed maturities pledged under securities lending agreements.’ The Company maintains control over the securities it lends, retains the earnings, cash flows and interest rate risk associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. Collateral received, primarily in the form of cash, is required at a rate of 102% of the market value of the loaned securities (or 105% of the market value of the loaned securities when the collateral and loaned securities are denominated in non-U.S. currencies) including accrued investment
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income and is monitored and maintained by the lending agent. Such collateral is reinvested and is reflected as ‘Short-term investment of funds received under securities lending agreements, at fair value.’ At September 30, 2005, the fair value and amortized cost of fixed maturities pledged under securities lending agreements were $918.9 million and $904.3 million, respectively. Collateral received at September 30, 2005 totaled $954.7 million at fair value and amortized cost.
8. Earnings (Loss) Per Share
Due to the net loss for the 2005 third quarter, diluted average shares outstanding for the 2005 third quarter do not include 40.0 million shares of otherwise dilutive securities since the inclusion of such securities would be anti-dilutive. Since the Company reported net income for the nine months ended September 30, 2005, the computation of diluted average shares outstanding includes dilutive securities for such year-to-date period. The following table sets forth the computation of basic and diluted earnings (loss) per share:
(U.S. dollars in thousands,
except share data)
Basic Earnings (Loss) Per Share:
Divided by:
Weighted average shares outstanding for the period
Basic earnings (loss) per share
Diluted Earnings (Loss) Per Share:
Effect of dilutive securities:
Preference shares
37,488,658
37,328,788
38,154,477
Warrants
71,885
54,011
75,371
Nonvested restricted shares
1,143,409
437,161
1,100,836
Stock options
1,858,413
2,076,922
1,989,686
Total diluted shares
Diluted earnings (loss) 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 nil and 75,397, respectively, for the 2005 third quarter and 2004 third quarter and 31,071 and 23,266, respectively, for the nine months ended September 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
22
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 9.6% for the nine months ended September 30, 2005, compared to 6.0% for the nine months ended September 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 September 30, 2005.
10. Transactions with Related Parties
Pursuant to an agreement, dated September 6, 2005 (the “Agreement”), ACGL and Robert Clements, former Chairman of the Board of Directors of ACGL, terminated all consulting and related payment obligations under a consulting agreement, dated as of March 17, 2005, between ACGL and Mr. Clements which had a term extending through December 31, 2009. Pursuant to the Agreement, ACGL made payments to, and on behalf of, Mr. Clements in the aggregate amount of $1.4 million and wrote off fixed assets of $0.5 million related to the Agreement in the 2005 third quarter.
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. One of the agreements was terminated in July 2005, and the other arrangement is variable based on usage. The Company made payments under such arrangements of approximately $0.3 million for the nine months ended September 30, 2005, compared to $0.3 million for the nine months ended September 30, 2004.
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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 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 September 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. 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
24
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 shareholders’ equity levels. At September 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 September 30, 2005. At such date, the Company had $396.5 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $447.0 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 2005, the Company has received payments on the agency loan which reduced the Guarantee to $5.1 million at September 30, 2005. In return for the issuance of the 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 $21.4 million under such agreement through September 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 their respective shares of stock in the agency, in the case of the principals, 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
25
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.
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 $16.6 million for the nine months ended September 30, 2005, compared to $9.2 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 September 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 was granted. The plaintiffs were allowed until October 28, 2005 to file their new pleading and they did so on such date. ACGL and the other defendants intend again to move to dismiss the complaint. Although no assurances can be made as to the resolution of the motion or of the plaintiffs’ claims, management does not believe that any of the claims are meritorious.
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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, FIN 46R did not have a material impact on the Company’s consolidated financial statements as of or for the nine months ended September 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 $2.6 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 2005, 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 addition, the catastrophic events that occurred in the 2005 third quarter may result in a substantial improvement in market conditions in property and certain marine lines of business. The actual
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impact of such events on premium rates and other market conditions should become more apparent over the next several months.
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 September 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 September 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 September 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
391,594
294,966
Additional case reserves
73,812
40,839
IBNR reserves
1,688,277
1,293,009
Total net reserves
2,153,683
1,628,814
Insurance:
324,311
231,215
1,380,518
1,015,123
1,704,829
1,246,338
Total:
715,905
526,181
3,068,795
2,308,132
3,858,512
2,875,152
At September 30, 2005 and December 31, 2004, the reinsurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
1,198,390
836,148
287,180
251,453
266,188
254,442
163,342
94,647
131,394
104,846
107,189
87,278
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At September 30, 2005 and December 31, 2004, the insurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
396,472
276,966
357,171
330,548
223,345
146,828
221,876
104,374
214,137
180,741
185,041
130,295
100,659
70,068
6,128
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 September 30, 2005 and December 31, 2004 was $17.5 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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Reinstatement premiums are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described above in “Reserves for Losses and Loss Adjustment Expenses.”
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 September 30, 2005 and December 31, 2004:
(U.S. dollars inthousands)
GrossAmount
AcquisitionExpenses
NetAmount
223,069
(64,961
158,108
199,046
(61,187
137,859
116,541
(34,718
81,823
71,956
(22,017
49,939
100,102
(25,999
74,103
101,237
(19,339
81,898
56,300
(15,662
40,638
49,033
(12,382
36,651
5,628
(1,435
4,193
5,457
(1,816
3,641
2,088
(147
1,941
3,355
(315
3,040
503,728
(142,922
360,806
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 September 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 anticipatedmargin, 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
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corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages, financial quota share coverages and multi-year retrospectively rated excess of loss coverages. If these contracts transfer risk, they are accounted for as reinsurance.
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 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 September 30, 2005 and December 31, 2004, our reserves for doubtful
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accounts were approximately $3.1 million and $2.2 million, respectively. At September 30, 2005, approximately 66.7% of premiums receivable of $678.3 million represented amounts not yet due, while amounts in excess of 90 days overdue were 2.0% 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 2.2% of the $30.1 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue at September 30, 2005, compared to 4.8% of the $26.9 million of paid losses and loss adjustment expenses recoverable at December 31, 2004.
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 and internal 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.
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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 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 during the 2005 fourth quarter 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 “—Investments.”
Stock Issued to Employees
We have adopted the provisions of Accounting Principles Board 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 approach. We are currently evaluating the
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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 total shareholders’ equity.
Recent Accounting Pronouncements
See note 3, “Accounting Pronouncements,” of the notes accompanying our consolidated financial statements.
Results of Operations—Three Months Ended September 30, 2005 and 2004
The following table sets forth net income (loss) and earnings (loss) per share data:
Diluted earnings (loss) per share (1)
Diluted weighted average shares outstanding (1)
(1) As a result of the significant catastrophic activity during the 2005 third quarter, we sustained a net loss for the 2005 third quarter. Accordingly, based on GAAP, diluted net loss per share and actual diluted weighted average shares outstanding do not include approximately 40.0 million shares of otherwise dilutive securities since the inclusion of such securities would be anti-dilutive. As such, the comparison of per share amounts and diluted weighted average shares outstanding for the 2005 and 2004 third quarters is not meaningful.
We incurred a net loss of $86.3 million for the 2005 third quarter, compared to net income of $18.0 million for the 2004 third quarter, with the loss primarily due to catastrophic activity during the period. We recorded an estimated $250.9 million of after-tax net losses in the 2005 third quarter, after reinsurance and net of reinstatement premiums, related to Hurricanes Dennis, Emily, Katrina and Rita and the European floods, compared to $144.6 million in the 2004 third quarter related to Hurricanes Charley, Frances, Ivan and Jeanne and Typhoon Songda. With respect to the 2005 events, the estimates were based on currently available information derived from modeling techniques, industry assessments of exposure, preliminary claims information obtained from our clients and brokers and a review of our in-force contracts. Due to the size and complexity of Hurricane Katrina, substantial uncertainty remains regarding total covered losses for the insurance industry and the assumptions underlying our estimates relating to the hurricane. In addition, actual losses from Hurricane Katrina may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or otherwise unavailable. Our actual losses from all of these events may vary materially from the estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the preliminary nature of the available information, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques, the contingent nature of business interruption exposures, the effects of any resultant demand surge on claims activity and, in the case of the hurricanes, attendant coverage issues. Basic earnings (loss) 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.
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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.
Reinsurance Segment
The following table sets forth our reinsurance segment’s underwriting results:
Gross premiums written
Acquisition expense ratio
Underwriting Income (Loss). The reinsurance segment incurred an underwriting loss of $83.8 million and a combined ratio of 120.5% for the 2005 third quarter, compared to an underwriting loss of $39.3 million and a combined ratio of 109.8% for the 2004 third quarter. In the 2005 third quarter, the reinsurance segment incurred estimated pre-tax net losses, after reinsurance and net of reinstatement premiums, related to Hurricanes Dennis, Emily, Katrina and Rita and the European Floods of $159.5 million. Before reinsurance, such estimated losses were $235.4 million. The components of the reinsurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for the reinsurance segment were $445.6 million for the 2005 third quarter, compared to $412.4 million for the 2004 third quarter. Net premiums written were $409.8 million for the 2005 third quarter, compared to $394.5 million for the 2004 third quarter. The increase in premium volume was primarily due to approximately $18.0 million of additional premiums written related to adjustments to premium estimates on treaties incepting in 2004 and prior periods. In addition, 2005 premium volume includes $18.2 million of reinstatement premiums written and earned related to the catastrophic events noted above while reinstatement premiums were not significant in 2004. Such items more than offset the reduction in U.S. casualty business as the reinsurance segment responded to changing market conditions.
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For the 2005 third quarter, 78.9% and 21.1% of net premiums written were generated from pro rata contracts and excess of loss treaties, respectively, compared to 73.1% and 26.9% for the 2004 third 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 36.3% of amounts included in the pro rata contracts written are related to excess of loss policies for the 2005 third quarter, compared to 35.7% for the 2004 third 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 $407.8 million for the 2005 third quarter, compared to $403.1 million for the 2004 third 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 third quarter, 74.6% and 25.4% of net premiums earned were generated from pro rata contracts and excess of loss treaties, respectively, compared to 74.0% and 26.0% for the 2004 third quarter.
Losses and Loss Adjustment Expenses. The loss ratio for the reinsurance segment was 91.1% for the 2005 third quarter, compared to 81.7% for the 2004 third quarter. The reinsurance segment’s incurred losses for the 2005 third quarter included $177.7 million related to the catastrophic activity noted above (before reinstatement premiums), compared to $109.9 million in losses related to catastrophic activity in the 2004 third quarter. The net increase in catastrophic activity in the 2005 third quarter resulted in a 16.6 point increase in the 2005 third quarter loss ratio. The loss ratio for the 2005 third quarter also reflected estimated net favorable development in prior year loss reserves of $28.2 million, compared to $13.1 million in the 2004 third quarter, with the net development in both periods primarily attributable to property and other short tail business. The net impact of the change in prior year development was a 3.7 point reduction in the 2005 third quarter loss ratio. In addition, the 2005 period included estimated net favorable development of approximately $6.6 million, or a 1.6 point reduction in the loss ratio, resulting from the commutation of a treaty. This effect was substantially offset by additional profit commissions payable that increased acquisition expenses by $4.5 million, or 1.1 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 third quarter was 26.4%, compared to 25.2% for the 2004 third quarter. The 2005 third quarter ratio included 1.1 points related to the commutation of a non-traditional treaty noted above. The other operating expense ratio was 3.0% for the 2005 third quarter, compared to 2.9% for the 2004 third quarter.
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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 (Loss). The insurance segment incurred an underwriting loss of $47.1 million and a combined ratio of 114.2% for the 2005 third quarter, compared to underwriting income of $15.6 million and a combined ratio of 95.5% for the 2004 third quarter. In the 2005 third quarter, the insurance segment incurred estimated pre-tax net losses, after reinsurance and net of reinstatement premiums, related to Hurricanes Dennis, Emily, Katrina and Rita and the European Floods of $96.5 million. Before reinsurance, such estimated losses were $408.4 million. The components of the insurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for the insurance segment were $617.5 million for the 2005 third quarter, compared to $552.6 million for the 2004 third quarter. The growth in gross premiums written in the 2005 third 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 property and executive assurance lines, was partially offset by a lower level of premiums written in 2005 resulting from the sale of the insurance segment’s non-standard auto insurance operations in late 2004.
Ceded premiums written were 38.9% of gross premiums written for the 2005 third quarter, compared to 36.9% for the 2004 third quarter. The insurance segment’s property business was a higher percentage of written premium in the 2005 third 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 third quarter. The 2005 third quarter included $20.0 million of ceded premiums written, or 3.2 points of gross premiums written, related to reinstating catastrophe covers following the catastrophic events noted above. In addition, the ceded ratio on property business increased in the 2005 period as the insurance segment built capacity in order to increase its penetration of global businesses, primarily through the use of reinsurance, as well as the cession of 30% of certain program business with effective dates subsequent to March 31, 2004.
40
Net premiums written for the insurance segment were $377.5 million for the 2005 third quarter, compared to $348.7 million for the 2004 third quarter, with the increase due to the reasons discussed above. 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 $340.0 million for the 2005 third quarter, compared to $332.3 million for the 2004 third quarter, and 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 $0.8 million for the 2005 third quarter, compared to $4.9 million for the 2004 third 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 2005 and 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. The loss ratio for the insurance segment was 88.5% for the 2005 third quarter, compared to 69.9% for the 2004 third quarter. The insurance segment’s incurred losses for the 2005 third quarter included $76.5 million related to the catastrophic activity noted above (before reinstatement premiums), compared to $40.2 million in losses related to catastrophic activity in the 2004 third quarter. The net increase in catastrophic activity in the 2005 third quarter resulted in a 10.7 point increase in the 2005 third quarter loss ratio. The loss ratio for the 2005 third quarter also reflected estimated net adverse development in prior year Loss Reserves of $3.8 million, primarily in the property, marine and lenders lines of business, compared to $7.8 million of favorable development in the 2004 third quarter. The net impact of the change in prior year development was a 3.4 point increase in the 2005 third quarter loss 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 acquisition expense ratio was 10.0% for the 2005 third quarter, compared to 9.3% for the 2004 third 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 increase in the acquisition expense ratio was primarily due to the increased contribution from the insurance segment’s European operations, which had a higher acquisition expense ratio than the insurance segment’s U.S. operations.
The insurance segment’s other operating expense ratio for the 2005 third quarter was 15.7%, compared to 16.3% for the 2004 third quarter. The decrease in the operating expense ratio was primarily due to the contribution from the insurance segment’s European operations.
Net Investment Income
Net investment income was $59.3 million for the 2005 third quarter, compared to $40.8 million for the 2004 third quarter. The higher level of net investment income in the 2005 third 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 3.6% for the 2005 third quarter, compared to 3.2% for the 2004 third quarter. The increase in the pre-tax investment income yield in the 2005 period was primarily related to higher rates available in the financial markets. 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):
Fixed maturities
(13,086
12,656
Privately held securities
2,463
1,284
332
(437
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 third quarter was (0.39%), compared to 2.62% for the 2004 third quarter.
During the 2005 third quarter and 2004 third quarter, we realized gross losses from the sale of fixed maturities of $30.9 million and $2.7 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
14,158
2,655
At least 6 months but less than 12 months
8,682
Over 12 months
8,098
30,938
The fair values of such securities sold at a loss during the 2005 third quarter and 2004 third quarter were $2.5 billion and $311 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 third 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.”
Net Foreign Exchange Gains or Losses
Net foreign exchange gains for the 2005 third quarter of $7.3 million consisted of net unrealized gains of $7.6 million and net realized losses of $0.3 million, compared to net foreign exchange losses for the 2004 third quarter of $1.8 million, which consisted of net unrealized losses of $1.4 million and net realized losses of $0.4 million. The net unrealized gains in the 2005 third quarter resulted from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at September 30, 2005. We hold investments in foreign currencies, which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities. However, changes in the value of such investments due to foreign currency rate movements
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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 third quarter were essentially offset by decreases in our investments held in foreign currencies, which declined due to the strengthening U.S. Dollar against the Euro and British Pound. 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 third quarter was $0.6 million, compared to $2.3 million for the 2004 third 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 third quarter was $1.1 million, compared to $8.9 million for the 2004 third quarter.
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.
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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.
Results of Operations—Nine Months Ended September 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 $155.6 million for the nine months ended September 30, 2005, compared to $209.8 million for the nine months ended September 30, 2004, with the decrease primarily due to the higher level of catastrophic activity in the 2005 third quarter over the 2004 third quarter, partially offset by growth in investment income. We recorded an estimated $250.9 million of after-tax net losses in the 2005 third quarter, after reinsurance and net of reinstatement premiums, related to Hurricanes Dennis, Emily, Katrina and Rita and the European floods, compared to $144.6 million in the 2004 third quarter related to Hurricanes Charley, Frances, Ivan and Jeanne and Typhoon Songda. Our net income for the nine months ended September 30, 2005 represented a 9.0% annualized return on average equity, compared to 14.6% for the nine months ended September 30, 2004.
The higher level of diluted average shares outstanding for the nine months ended September 30, 2005, compared to the 2004 period, was primarily due to the full weighting of 4,688,750 common shares issued in March 2004. The increase was also due to the exercise of stock options 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 increases as the market price of our common shares increases.
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Underwriting Income. The reinsurance segment reported underwriting income of $14.4 million and a combined ratio of 99.1% for the nine months ended September 30, 2005, compared to $59.6 million and 95.0% for the nine months ended September 30, 2004. In the 2005 third quarter, the reinsurance segment incurred estimated pre-tax net losses, after reinsurance and net of reinstatement premiums, related to Hurricanes Dennis, Emily, Katrina and Rita and the European Floods of $159.5 million. Before reinsurance, such estimated losses were $235.4 million. The components of the reinsurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for our reinsurance segment were $1.31 billion for the nine months ended September 30, 2005, compared to $1.36 billion for the nine months ended September 30, 2004. Net premiums written for our reinsurance segment were $1.24 billion for the nine months ended September 30, 2005, compared to $1.31 billion for the nine months ended September 30, 2004. The decrease in premium volume was primarily due to a reduction in U.S. casualty business and in response to softening market conditions. Partially offsetting such decline was $18.2 million of reinstatement premiums written and earned related to the catastrophic events noted above and approximately $18.0 million of additional premiums written related to adjustments to premium estimates on treaties incepting in 2004 and prior periods. In addition, 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 for the nine months ended September 30, 2005 by approximately $11.3 million.
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For the nine months ended September 30, 2005, 76.7% and 23.3% of net premiums written were generated from pro rata contracts and excess of loss treaties, respectively, compared to 68.7% and 31.3% for the nine months ended September 30, 2004. Approximately 28.7% of amounts included in the pro rata contracts written are related to excess of loss treaties for the nine months ended September 30, 2005, compared to 30.7% for the nine months ended September 30, 2004.
Net Premiums Earned. Net premiums earned for our reinsurance segment were $1.17 billion for the nine months ended September 30, 2005, compared to $1.17 billion for the nine months ended September 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 nine months ended September 30, 2005, 74.9% and 25.1% of net premiums earned were generated from pro rata contracts and excess of loss treaties, respectively, compared to 74.0% and 26.0% for the nine months ended September 30, 2004.
Losses and Loss Adjustment Expenses. The loss ratio for the reinsurance segment was 68.7% for the nine months ended September 30, 2005, compared to 65.9% for the 2004 period. The reinsurance segment’s incurred losses included $177.7 million related to the 2005 third quarter catastrophic activity noted above (before reinstatement premiums), compared to $109.9 million in losses related to 2004 third quarter catastrophic activity. The net increase in catastrophic activity for the nine months ended September 30, 2005 resulted in a 5.8 point increase in the 2005 loss ratio. The loss ratio for the nine months ended September 30, 2005 also reflected estimated net favorable development in prior year Loss Reserves of $63.0 million, compared to $36.4 million in the 2004 period, with the net development in both periods primarily attributable to property and other short tail business. The net impact of the change in prior year development was a 2.3 point reduction in the 2005 loss ratio. In addition, the 2005 period included estimated net favorable development of approximately $11.5 million resulting from the commutation of certain contracts, compared to $26.9 million of estimated net favorable development from commutations in the 2004 period. The net impact of the change in commutation activity was a 1.3 point increase in the 2005 loss ratio. This effect was substantially offset by additional profit commissions payable that increased acquisition expenses for the 2005 and 2004 periods by $7.5 million and $21.7 million, respectively. The net impact of the change in acquisition expenses was a 1.2 point increase in the 2005 acquisition expense ratio.
Underwriting Expenses. The acquisition expense ratio for the nine months ended September 30, 2005 was 27.4%, compared to 26.4% for the nine months ended September 30, 2004. The higher ratio in 2005 reflects the 1.2 point increase due to commutation activity discussed above and 1.0 point from the adjustments on certain treaties written in 2002 and 2003 discussed above. The balance of the change 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 nine months ended September 30, 2005, compared to 2.7% for the nine months ended September 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 reported underwriting income of $17.8 million and a combined ratio of 98.5% for the nine months ended September 30, 2005, compared to $82.3 million and 91.9% for the nine months ended September 30, 2004. In the 2005 third quarter, the insurance segment incurred estimated pre-tax net losses, after reinsurance and net of reinstatement premiums, related to Hurricanes Dennis, Emily, Katrina and Rita and the European Floods of $96.5 million. Before reinsurance, such estimated losses were $408.4 million. The components of the insurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for our insurance segment were $1.7 billion for the nine months ended September 30, 2005, compared to $1.5 billion for the nine months ended September 30, 2004. The growth in gross premiums written for the nine months ended September 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 construction and surety, professional liability and property 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 nine months ended September 30, 2005 primarily resulted from the non-renewal of certain programs in 2004.
Ceded premiums written were 36.9% of gross premiums written for the nine months ended September 30, 2005, compared to 33.7% for the nine months ended September 30, 2004. The growth in the ceded percentage for the nine months ended September 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 nine months ended September 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
47
increased in the 2005 period 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 $1.07 billion for the nine months ended September 30, 2005, compared to $994.8 million for the nine months ended September 30, 2004, with the increase due to the reasons discussed above.
Net Premiums Earned. Net premiums earned for our insurance segment were $1.02 billion for the nine months ended September 30, 2005, compared to $1.0 billion for the nine months ended September 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 $2.5 million for the nine months ended September 30, 2005, compared to $12.3 million for the nine months ended September 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 2005 and 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. The loss ratio for the insurance segment was 72.7% for the nine months ended September 30, 2005, compared to 65.9% for the 2004 period. The insurance segment’s incurred losses for the nine months ended September 30, 2005 included $76.5 million related to the 2005 third quarter catastrophic activity noted above (before reinstatement premiums), compared to $40.2 million in losses related to 2004 third quarter catastrophic activity. The net increase in catastrophic activity for the nine months ended September 30, 2005 period resulted in a 3.6 point increase in the 2005 loss ratio. The loss ratio for the nine months ended September 30, 2005 also reflected estimated net adverse development in prior year Loss Reserves of $11.2 million, compared to $9.6 million of estimated net favorable development in the 2004 period. The net adverse development in the 2005 period primarily resulted from the marine and lenders lines of business, partially offset by favorable development in executive assurance, healthcare, professional liability and construction and surety business. The net impact of the change in prior year development was a 2.0 point increase in the 2005 loss ratio.
Underwriting Expenses. The acquisition expense ratio was 9.3% for the nine months ended September 30, 2005, compared to 10.8% for the nine months ended September 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 nine months ended September 30, 2005 decreased compared to the nine months ended September 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 nine months ended September 30, 2005 was 16.5%, compared to 15.2% for the nine months ended September 30, 2004, reflecting additional expenses incurred in the 2005 period to the expansion of the insurance segment’s operating platform, including the addition of operations in Canada, and the leveling off of net premiums earned.
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Net investment income was $162.8 million for the nine months ended September 30, 2005, compared to $98.1 million for the nine months ended September 30, 2004. The higher level of net investment income for the nine months ended September 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 nine months ended September 30, 2005, compared to 2.9% for the nine months ended September 30, 2004. The increase in the pre-tax investment income yield in the 2005 period was primarily related to higher rates available in the financial markets.
(10,613
15,700
1,012
2,426
1,876
1,957
Total return on our portfolio under management for the nine months ended September 30, 2005 was 1.48%, compared to 2.82% for the nine months ended September 30, 2004. Realized gains for the nine months ended September 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 nine months ended September 30, 2005 and 2004, we realized gross losses from the sale of fixed maturities of $39.5 million and $10.6 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:
18,913
10,567
10,745
9,809
39,467
10,585
The fair values of such securities sold at a loss during the nine months ended September 30, 2005 and 2004 were $3.1 billion and $1.2 billion, respectively. We did not record an other-than-temporary impairment on securities that were purchased and subsequently sold at a loss during the nine months ended September 30, 2005.
Included in other income (loss) for the nine months ended September 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.
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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.
Interest Expense
Interest expense was $16.9 million for the nine months ended September 30, 2005, compared to $12.4 million for the nine months ended September 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 nine months ended September 30, 2005 of $20.8 million consisted of net unrealized gains of $21.1 million and net realized losses of $0.3 million, compared to net foreign exchange losses for the nine months ended September 30, 2004 of $1.6 million, which consisted of net unrealized losses of $1.0 million and net realized losses of $0.6 million.
Non-cash compensation expense was $2.2 million for the nine months ended September 30, 2005, compared to $7.7 million for the nine months ended September 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 nine months ended September 30, 2005 was $1.5 million, compared to $9.4 million in the 2004 period.
Net income, as reported
Pro forma net income
Earnings per share – basic:
Earnings per share – diluted:
The effective tax rate on income before income taxes was 9.6% for the nine months ended September 30, 2005, compared to 6.0% for the nine months ended September 30, 2004. The higher effective tax rate in the 2005 period resulted from a change in the relative mix of income reported by jurisdiction. 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.
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 investable assets, including cash and short-term investments, totaled $6.73 billion at September 30, 2005, compared to $5.84 billion at December 31, 2004. At September 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 3.6 years. ACGL’s readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled $16.1 million at September 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
51
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 September 30, 2005 and December 31, 2004, such amounts approximated $758.9 million and $644.3 million, respectively. In addition, Arch Re Bermuda maintains assets in trust accounts to support insurance and reinsurance transactions with affiliated U.S. companies. At September 30, 2005 and December 31, 2004, such amounts approximated $2.55 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 September 30, 2005, Arch Specialty was in compliance with the ratio required under the Stipulation following its receipt during 2005 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 was in compliance with this ratio at September 30, 2005.
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
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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 $1.11 billion for the nine months ended September 30, 2005, compared to $1.35 billion for the nine months ended September 30, 2004. The decrease in operating cash flows in the 2005 period was due, in part, to a higher level of paid losses as our insurance and reinsurance Loss Reserves have continued to mature. Cash flow from operating activities are provided by premiums collected, fee 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 are currently in the process of estimating our exposure to Hurricane Wilma, which struck Mexico and Florida in mid-October and will negatively impact our after-tax earnings for the 2005 fourth quarter. To date, we have received relatively few claims notices from clients and brokers.
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
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the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities.
In 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.
The catastrophic events that occurred in the 2005 third quarter may result in a substantial improvement in market conditions in property and certain marine lines of business. In order to take advantage of these opportunities, we may seek to increase our underwriting capacity, including through retrocession arrangements with non-traditional vehicles, such as a newly-formed reinsurance company funded by institutional investors, and/or raise additional capital through the issuance of perpetual preference shares or similar securities.
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 September 30, 2005, our capital of $2.65 billion consisted of senior notes of $300.0 million, representing 11.3% of the total, and shareholders’ equity of $2.35 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 nine months ended September 30, 2005 of $109.6 million was primarily attributable to net income, which more than offset declines in the market value of our investment portfolio primarily due to the effects of higher interest rates.
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.”
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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 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 September 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 nine months ended September 30, 2005, ceded premiums written represented approximately 22.2% of gross premiums written, compared to 16.3% for the nine months ended September 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.
During the 2005 third quarter, our reinsurance recoverables on paid and unpaid losses increased by 53%, primarily due to reinsurance and retrocessional protection we received on the catastrophic events which occurred in the 2005 third quarter. We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. At September 30, 2005, approximately 82.8% of our reinsurance recoverables on paid and unpaid losses of $1.27 billion (not including prepaid reinsurance
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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 5.3% of our total shareholders’ equity at September 30, 2005.
The following table details our reinsurance recoverables at September 30, 2005:
% of Total
A.M. BestCompanyRating (1)
Everest Reinsurance Company
9.6
A+
Alternative market recoverables (2)
8.3
NR
Allied World Assurance Company Ltd.
Max Re Ltd.
A-
Lloyd’s of London syndicates (3)
5.5
A
Employers Reinsurance Corporation
American Re-Insurance Company
Sentry Insurance a Mutual Company (4)
Swiss Reinsurance America Corporation
Odyssey America Reinsurance Corporation (5)
Federal Insurance Company
A++
Endurance Specialty Insurance Ltd.
ACE Property & Casualty Insurance Company
2.5
Liberty Mutual Insurance Company
Converium Reinsurance (NA) Inc.
B-
All other (6)
27.2
(1) The financial strength ratings are as of November 3, 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) The A.M. Best Company group rating of “A” (Excellent) has been applied to all Lloyd’s of London syndicates.
(4) 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.
(5) Approximately 84% of such amount is collateralized through a reinsurance trust.
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(6) The following table provides a breakdown of the “All other” category by A.M. Best Company rating:
Companies rated “A++”
0.8
Companies rated “A+”
6.6
Companies rated “A”
10.7
Companies rated “A-”
Companies rated “B++”
0.5
Companies rated “B+”
0.3
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.
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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.
In addition to the use of individual per risk and inuring reinsurance contracts to limit exposure, 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. With the occurrence of Hurricane Katrina in the 2005 third quarter, such coverage has begun to be utilized. As such, the coverage was automatically reinstated once and is available under the same terms as described immediately above for an additional event. Our reinsurance operations have purchased reinsurance which provides up to $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. Based on current estimates, we expect to recoup approximately $42 million, net of reinstatement premiums, related to catastrophic activity in the 2005 third quarter through such coverage with approximately $50 million in available coverage. 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
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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, 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
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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 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 Investor 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. 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
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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.
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 September 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 September 30, 2005. At such date, we had approximately $396.5 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $447.0 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.
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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 2005, we received payments on the agency loan which reduced the Guarantee to $5.1 million at September 30, 2005. In return for the issuance of the 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 $21.4 million under such agreement through September 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 their respective shares of stock in the agency, in the case of the principals, 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 internal and 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 September 30, 2005 and December 31, 2004:
Fixed maturities available for sale, at fair value
Fixed maturities pledged under securities lending agreements, at fair value
Total fixed maturities
Short-term investments available for sale, at fair value
Privately held securities, at fair value
6,732,696
5,835,515
At September 30, 2005 and December 31, 2004, our fixed income portfolio, which includes fixed maturities and short-term investments, had an average effective duration of 3.6 years and 3.7 years, respectively, an average Standard & Poor’s quality rating of “AA+” for both periods and an imbedded book yield of 3.8% and 3.5%, respectively. At September 30, 2005 and December 31, 2004, our invested assets did not include any
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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 2005 fourth quarter.
During the 2005 third quarter, we began a securities lending program under which certain of our fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. Such securities have been reclassified as ‘Fixed maturities pledged under securities lending agreements.’ We maintain control over the securities we lend, retain the earnings and cash flows associated with the loaned securities and receive a fee from the borrower for the temporary use of the securities. Collateral received, primarily in the form of cash, is required at a rate of 102% of the market value of the loaned securities (or 105% of the market value of the loaned securities when the collateral and loaned securities are denominated in non-U.S. currencies) including accrued investment income and is monitored and maintained by the lending agent. Such collateral is reinvested and is reflected as ‘Short-term investment of funds received under securities lending agreements, at fair value.’ At September 30, 2005, the fair value and amortized cost of fixed maturities pledged under securities lending agreements were $918.9 million and $904.3 million, respectively. Collateral received at September 30, 2005 totaled $954.7 million at fair value and amortized cost.
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 $67.9 million at September 30, 2005. At September 30, 2005, on a lot level basis, approximately 1,678 fixed maturity securities out of a total of approximately 2,177 securities were in an unrealized loss position and the largest single unrealized loss from one investment in our fixed maturity portfolio was $2.2 million. The information presented below for the gross unrealized losses on our fixed maturity securities at September 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 September 30, 2005 has been in a continual unrealized loss position:
Less than 12 Months
12 Months or Greater andLess Than 18 Months
EstimatedFair Value and Carrying Value
1,741,692
(16,806
113,199
(2,984
908,329
(11,436
160,641
(4,227
469,796
(5,091
227,578
(3,981
363,291
(3,897
38,839
(789
273,823
192,711
(7,694
20,136
(465
131,778
(1,030
20,538
(678
4,081,420
(49,938
580,931
(13,124
Equal or Greater Than18 Months
EstimatedFair Value andCarrying Value
49,447
(2,427
1,904,338
18,843
(776
1,087,813
17,904
(413
715,278
39,709
(1,204
441,839
212,847
152,316
125,903
(4,820
4,788,254
The following table presents the Standard & Poor’s credit quality distribution of our fixed maturities at September 30, 2005 and December 31, 2004:
AAA
4,818,041
79.3
4,162,703
75.1
AA
499,526
8.2
356,999
535,505
772,262
13.9
BBB
154,606
2.6
151,171
BB
21,221
0.4
13,488
B
43,259
0.7
83,690
Lower than B
677
0.0
4,808
0.1
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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 September 30, 2005, our investments in mortgage-backed securities, excluding commercial mortgage backed securities, amounted to approximately $239.1 million, or 3.6% 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 September 30, 2005 and December 31, 2004, we held three privately held securities totaling $12.9 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 September 30, 2005. In addition, 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. No investments in the mezzanine fund have been made through September 30, 2005. 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.
Book Value Per Share
The following book value per share calculations are based on shareholders’ equity of $2.35 billion and $2.24 billion at September 30, 2005 and December 31, 2004, respectively. The shares and per share numbers set forth below exclude the effects of 5,859,027 and 6,172,199 stock options, nil and 150,000 Class B warrants and 95,500 and 84,992 restricted stock units outstanding at September 30, 2005 and December 31, 2004, respectively. Our diluted book value per share increased by 4.1% to $32.29 at September 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, which more than offset declines in the market value of our investment portfolio primarily due to the effects of higher interest rates.
OutstandingShares
CumulativeBook ValuePer Share
Common shares (1)
35,504,734
44.15
34,902,923
41.76
Series A convertible preference shares
37,327,502
37,348,150
Total shares
72,832,236
32.29
72,251,073
31.03
(1) Book value per common share at September 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,
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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 September 30, 2005. (See section captioned “Management’s Discussion and Analysis 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 September 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 and General Portfolio Risk
Among many factors and risk considerations, we consider the effect of interest rate movements on the market value of our fixed maturities, short-term investments and fixed maturities pledged under securities lending agreements 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 September 30, 2005 (excluding any impact on our short-term investment of funds received under securities lending agreements). Based on historical observations, the assumption that all global yield curves would simultaneously shift in the same direction is uncertain 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
6,799.9
6,676.8
6,558.0
6,443.4
6,332.8
Market value change from base
3.69
1.81
(1.75
)%
(3.43
Change in unrealized value
241.9
118.8
(114.6
(225.2
Another method to view portfolio risk is Value-at-Risk (“VaR”). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio’s initial value. In other words, 95% of the time, the portfolio’s loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio’s initial value. As of September 30, 2005, our portfolio’s VaR was estimated to be 4.35%, compared to an estimated 4.20% at December 31, 2004 and an estimated 5.00% at September 30, 2004.
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 September 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 $8.7 million and would have decreased diluted book value per share by approximately $0.12 at September 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
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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;
• 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 September 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;
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• 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.
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 nine months ended September 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 third 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.
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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 September 30, 2005 that have materially affected, or are reasonably likely to materially affect, internal controls over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We, in common with the insurance industry in general, are subject to litigation and arbitration in the normal course of our business. As of September 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.
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 ACGL 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 ACGL. 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 was granted. The plaintiffs were allowed until October 28, 2005 to file their new pleading and they did so on such date. ACGL and the other defendants intend again to move to dismiss the complaint. Although no assurances can be made as to the resolution of the motion or of the plaintiffs’ claims, management does not believe that any of the claims are meritorious.
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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table summarizes ACGL’s purchases of its common shares for the 2005 third quarter:
Issuer Purchases of Equity Securities
Period
Total Numberof SharesPurchased (1)
Average PricePaid per Share
Total Number ofSharesPurchased asPart of PubliclyAnnouncedPlans orPrograms
MaximumNumber ofShares that MayYet bePurchasedUnder the Planor Programs
7/1/2005-7/31/2005
45.33
8/1/2005-8/31/2005
2,538
44.72
9/1/2005-9/30/2005
9,311
47.07
11,870
46.56
(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.
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 nine months ended September 30, 2005, the Audit Committee approved engagements of PricewaterhouseCoopers LLP for the following permitted non-audit services: tax services, tax consulting and tax compliance.
Exhibit No.
Description
10.1
Agreement, dated September 6, 2005, between ACGL and Robert Clements (incorporated herein by reference from the current report on Form 8-K filed with the SEC on September 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).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(REGISTRANT)
/s/ Constantine Iordanou
Date: November 9, 2005
Constantine Iordanou
President and Chief Executive Officer(Principal Executive Officer) and Director
/s/ John D. Vollaro
John D. Vollaro
Executive Vice President, Chief FinancialOfficer and Treasurer (Principal Financial andAccounting Officer)
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EXHIBIT INDEX
72