After-tax operating income available to Arch common shareholders is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares, net of income taxes. The presentation of after-tax operating income available to Arch common shareholders is a “non-GAAP financial measure” as defined in Regulation G. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-General-Comment on Non-GAAP Financial Measures” for further details.
Reflects the impact of outstanding convertible non-voting common equivalent preferred shares which were issued on December 31, 2016 as part of the UGC acquisition.
exposed business which has the potential to increase the volatility of our operating results.
Book value per share represents total common shareholders’ equity available to Arch divided by the number of common shares and common share equivalents outstanding. Management uses growth in book value per share as a key measure of the value generated for our common shareholders each period and believes that book value per share is the key driver of Arch Capital’s share price over time. Book value per share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per share depending on the purchase price. Book value per share was $60.91 at December 31, 2017, a 10.4% increase from $55.19 at December 31, 2016. The growth in 2017 was primarily generated through underwriting and investment returns.
shareholders, a “non-GAAP measure” as defined in the SEC rules, represents net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to Arch common shareholders. See “Comment on Non-GAAP Financial Measures.” Our Operating ROAE was 5.7% for 2017, compared to 9.4% for 2016 and 9.7% for 2015. The lower Operating ROAE for 2017 primarily reflected a higher level of catastrophic loss activity, partially offset by strong mortgage insurance underwriting performance and favorable investment returns.
Total return on investments includes investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by Arch’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses excluding amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. Management uses total return on investments as a key measure of the return generated to Arch common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods.
The following table summarizes the pre-tax total return (before investment expenses) of investment held by Arch compared to the benchmark return (both based in U.S. Dollars) against which we measured our portfolio during the periods:
Our investment expenses were approximately 0.30%, 0.34% and 0.35%, respectively, of average invested assets in 2017, 2016 and 2015.
We believe that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. UGC transaction costs and other include advisory, financing, legal, severance, incentive compensation
and other transaction costs related to the UGC acquisition. During the 2016 fourth quarter, UGC transaction costs and other included non-recurring expenses related to a change in the our approach on the deferral of certain internal underwriting costs which are no longer being deferred. We believe that UGC transaction costs and other, due to their non-recurring nature, are not indicative of the performance of, or trends in, our business performance. The loss on redemption of preferred shares related to the redemption of our Series C preferred shares in September 2017 and had no impact on shareholders' equity or cash flows. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares from the calculation of after-tax operating income available to Arch common shareholders. In addition, income tax expense for 2017 included a $21.5 million charge due to the revaluation of the Company’s net deferred tax asset resulting from the reduction in the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Due to the non-recurring nature of this item, we excluded it from after-tax operating income available to Arch common shareholders.
underwriting income or loss to income before income taxes (the most directly comparable GAAP financial measure) on a consolidated basis and a subtotal before the contribution from the ‘other’ segment, in accordance with Regulation G, is shown in note 5, “Segment Information,” to our consolidated financial statements in Item 8.
Along with consolidated underwriting income, we provide a subtotal of underwriting income or loss before the contribution from the ‘other’ segment. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. Watford Re has its own management and board of directors that is responsible for its overall profitability. In addition, we do not guarantee or provide credit support for Watford Re. Since Watford Re is an independent company, the assets of Watford Re can be used only to settle obligations of Watford Re and Watford Re is solely responsible for its own liabilities and commitments. Our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions. We believe that presenting certain information excluding the ‘other’ segment enables investors and other users of our financial information to analyze our performance in a manner similar to how our management analyzes performance.
along with foreign currency fluctuations. In addition, total return incorporates the timing of investment returns during the periods. There is no directly comparable GAAP financial measure for total return. Management uses total return on investments as a key measure of the return generated to Arch common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods.
Income tax on net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other and loss on redemption of preferred shares reflects the relative mix reported by jurisdiction and the varying tax rates in each jurisdiction.
• Excess and surplus casualty: primary and excess casualty insurance coverages, including middle market energy business, and contract binding, which primarily provides casualty coverage through a network of appointed agents to small and medium risks.
general liability, commercial automobile, inland marine and property business with minimal catastrophe exposure.
2017 versus 2016: Net premiums written by the insurance segment were 2.4% higher in 2017 than in 2016. The increase in net premiums written reflected growth in programs, due to the continued effects of two newer programs, in travel, accident and health, reflecting both new travel business and continued expansion in existing travel accounts, and in professional lines, reflecting increases in small and medium sized accounts. Such amounts were partially offset by a reduction in excess and surplus casualty in response to current market conditions.
2017 versus 2016: The insurance segment’s underwriting expense ratio was 32.3% in 2017, compared to 31.6% in 2016. The comparison of the underwriting expense ratios reflects changes in the level of reinsurance ceded on a quota share basis and changes in the mix of business.
2016 versus 2015: The insurance segment’s underwriting expense ratio was 31.6% in 2016, compared to 31.8% in 2015. The underwriting expense ratios were generally flat in 2016 when compared to 2015.
•Property excluding property catastrophe: provides coverage for both personal lines and commercial property exposures and principally covers buildings, structures, equipment and contents. The primary perils in this business include fire, explosion, collapse, riot, vandalism, wind, tornado,
2017 versus 2016: Gross premiums written by the reinsurance segment in 2017 were 9.8% higher than in 2016, while net premiums written were 11.4% higher than in 2016. Premiums written reflected growth in other specialty business, primarily in international motor quota share contracts, and in casualty business, primarily due to a $45.4 million retroactive reinsurance contract which was substantially earned in the period and resulted in a corresponding increase to losses and loss adjustment expenses. Such amounts were partially offset by a reduction in property excluding property catastrophe business, primarily related to a targeted reduction in onshore energy writings.
Other underwriting income in 2017 was $11.3 million, compared to $36.4 million in 2016 and $10.6 million in 2015. The 2016 period included $19.1 million related to a contract which was commuted during the 2016 second quarter. This contract had been reflected as a deposit accounting liability (i.e., a contract that, in accordance with GAAP, does not pass risk transfer) prior to the commutation.
2016 versus 2015: The reinsurance segment’s current year loss ratio was 3.9 points higher in 2016 than in 2015. The 2016 loss ratio included 4.1 points for current year catastrophic event activity, compared to 3.5 points in 2015. The 2016 current year loss ratio reflected a significantly lower contribution from property lines than in 2015. In addition, the loss ratio for 2016 reflects the impact of a loss portfolio transfer (net premiums earned at a high loss ratio), which increased the current year loss ratio by 2.1 points.
The reinsurance segment’s net favorable development was $165.4 million, or 14.5 points, for 2017, compared to $218.8 million, or 20.7 points, for 2016, and $224.8 million, of 20.9 points, for 2015. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements in Item 8 for information about the reinsurance segment’s prior year reserve development.
2017 versus 2016: The underwriting expense ratio for the reinsurance segment was 32.2% in 2017, compared to 33.6% in 2016. Due to intercompany loss portfolio transfers effective on December 31, 2017 that transferred $1.36 billion of net retained reserves for losses and allocated loss adjustment expenses between subsidiaries, the reinsurance segment’s 2017 acquisition expense ratio reflected 1.2 points of federal excise taxes in connection with such activity. The comparison of the underwriting expense ratios primarily reflected changes in the mix and type of business.
2017 versus 2016: Gross premiums written by the mortgage segment in 2017 were 173.8% higher than in 2016, primarily reflecting growth in insurance in force due to the acquisition of UGC, while net premiums written increased 183.9%. The persistency rate of the primary portfolio of mortgage loans of Arch MI U.S. was 81.8% at December 31, 2017. The persistency rate represents the percentage of mortgage insurance in force at the beginning of a 12-month period that remains in force at the end of such period.
Net premiums earned for 2017 was substantially higher than in 2016, primarily due to the acquisition of UGC. Growth from 2015 to 2016 primarily reflected growth of U.S. primary business along with a higher earned contribution from the mortgage segment’s quota share reinsurance business.
Unlike property and casualty business for which we estimate ultimate losses on premiums earned, losses on mortgage insurance business are only recorded at the time a borrower is delinquent on their mortgage, in accordance with primary mortgage insurance industry practice. Because our primary mortgage insurance reserving process does not take into account the impact of future losses from loans that are not delinquent, mortgage insurance loss reserves are not an estimate of ultimate losses. In addition to establishing loss reserves for delinquent loans, under GAAP, we are required to establish a premium deficiency reserve for our mortgage insurance products if the amount of expected future losses and
maintenance costs exceeds expected future premiums, existing reserves and the anticipated investment income for such product. We evaluate whether a premium deficiency exists quarterly. No such reserve was established during 2017.
We insure mortgages for homes in areas that have been impacted by catastrophic events, such as Hurricanes Harvey and Irma. We experienced an increase in delinquency notices on insured loans impacted by such events in the 2017 fourth quarter. Generally, mortgage insurance losses occur only when a credit event occurs and, following a physical damage event, when the home is restored to pre-storm condition. Our ultimate claims exposure will depend on the number of delinquency notices received and the ultimate claim rate related to such notices. In the event of natural disasters, cure rates are influenced by the adequacy of homeowners and flood insurance carried on a related property, and a borrower's access to aid from government entities and private organizations, in addition to other factors which generally impact cure rates in unaffected areas. Management anticipates that subsequent quarters may experience some loss activity from the impacted areas, but does not expect this to be material.
The mortgage segment’s net favorable development was $95.0 million, or 9.0 points, for 2017, compared to $21.2 million, or 7.4 points, for 2016, and $12.3 million, or 5.7 points, for 2015. The 2017 increase in net favorable development was primarily on the acquired UGC reserves. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements in Item 8 for information about the mortgage segment’s prior year reserve development.
2017 versus 2016: The underwriting expense ratio for the mortgage segment was 23.3% for 2017, compared to 41.3% for 2016. The decrease in the underwriting expense ratio reflects the higher level of net premiums earned and expense savings from integration efforts following the acquisition of UGC.
2016 versus 2015: The underwriting expense ratio for the mortgage segment was 41.3% for 2016, compared to 50.9% for
Investment expenses were approximately 0.30% of average invested assets for 2017, compared to 0.34% for 2016 and 0.35% for 2015.
The pre-tax investment income yield was 2.06% for 2017, compared to 1.92% for 2016 and 2.06% for 2015. The comparability of net investment income between the periods was influenced by the increase in investable assets resulting from the UGC acquisition, repurchase activity under our share repurchase program, as well as changes in the pre-tax investment income yield, reflecting changes in investment allocations and the impact of prevailing interest rates. The pre-tax investment income 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.
Corporate expenses were $61.6 million for 2017, compared to $49.4 million for 2016 and $49.7 million for 2015. Such amounts primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly traded company.
We recorded net realized gains of $148.8 million for 2017, compared to net realized gains of $69.6 million for 2016 and net realized losses of $99.1 million for 2015. Currently, our portfolio is actively managed to maximize total return within certain guidelines. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. Net realized gains or losses from the sale of fixed maturities primarily results from our decisions to reduce credit exposure, to change duration targets, to rebalance our portfolios or due to relative value determinations. Net realized gains or losses also includes realized and unrealized contract gains and losses on our derivative instruments, changes in the fair value of assets and liabilities accounted for using the fair value option along with re-measurement of contingent consideration liability amounts.
Net foreign exchange losses for 2017 were $113.3 million, compared to net foreign exchange gains for 2016 of $31.4 million and net foreign exchange gains for 2015 of $62.6 million. Amounts in such periods were primarily unrealized and resulted from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date.
UGC transaction costs and other were $22.2 million for 2017, compared to $41.7 million for 2016. For 2017, UGC transaction costs and other primarily related to severance and severance related costs related to the UGC acquisition. For 2016, UGC transaction costs and other included $32.3 million of non-recurring costs such as advisory, financing and legal.
The preparation of consolidated financial statements in accordance with 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, goodwill and 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 relatively limited historical information has been reported to us through December 31, 2017. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies affect significant estimates used in the preparation of our consolidated financial statements.
See note 7, “Short Duration Contracts,” to our consolidated financial statements in Item 8 for additional information on our reserving process.
At December 31, 2017 and 2016, the reinsurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
The tables below summarize the effect of reasonably likely scenarios on the key actuarial assumptions used to estimate our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, at December 31, 2017 by underwriting segment (excluding the ‘other’ segment). The scenarios shown in the tables summarize the effect of (i) changes to the expected loss ratio selections used at December 31, 2017, which represent loss ratio point increases or decreases to the expected loss ratios used, and (ii) changes to the loss development patterns used in our reserving process at December 31, 2017, which represent claims reporting that is either slower or faster than the reporting patterns used. We believe that the illustrated sensitivities are indicative of the potential variability inherent in the estimation process of those parameters. The results show the impact of varying each key actuarial assumption using the chosen sensitivity on our IBNR reserves, on a net basis and across all accident years.
For our mortgage segment, we considered the sensitivity of loss reserve estimates at December 31, 2017 by assessing the potential changes resulting from a parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in primary claim severity (which we estimate to be 27% of the unpaid principal balance at December 31, 2017), we estimated that our loss reserves would change by approximately $20.8 million at December 31, 2017. For every one percentage point change in our primary net default to claim rate (which we estimate to be approximately 35% at December 31, 2017), we estimated a $16.0 million change in our loss reserves at December 31, 2017.
The insurance in force and risk in force for our U.S. primary mortgage segment’s business were as follows at December 31, 2016:
The following tables provide supplemental disclosures on risk in force for our U.S. primary mortgage insurance business risk in force at December 31, 2017 and 2016:
The following table provides supplemental disclosures for our U.S. mortgage insurance operations related to insured loans and loss metrics for the years ended December 31, 2017 and 2016:
2017 year includes approximately 3,700 new notices and 3,200 ending delinquent loans from areas impacted by the 2017 third quarter hurricanes.
The risk-to-capital ratio, which represents total current (non-delinquent) risk in force, net of reinsurance, divided by total statutory capital, for Arch MI U.S. was approximately 10.8 to 1 at December 31, 2017, compared to 12.4 to 1 at December 31, 2016.
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 our ability to collect amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. See “Risk Factors-Risks Relating to Our Company-We are exposed to credit risk in certain of our business operations” and “Financial Condition, Liquidity and Capital Resources-Financial Condition-Premiums Receivable and Reinsurance Recoverables” for further details.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in our insurance operations’ programs, specialty lines, collateral protection business and for participation in involuntary pools. The amount of such insurance premium estimates, included in premiums receivable and other assets, was $71.1 million at December 31, 2017, compared to $67.1 million at December 31, 2016. 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.
premiums are recorded as written based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks 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.
premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates at December 31, 2017.
product, the remaining unearned premium related to each canceled policy is recognized as earned premium upon notification of the cancellation.
No premium deficiency charges were recorded by us during 2017, 2016 and 2015.
We review our securities measured at fair value and discuss the proper classification of such investments with investment advisors and others. See note 10, “Fair Value,” to our consolidated financial statements in Item 8 for a summary of our financial assets and liabilities measured at fair value at December 31, 2017 by valuation hierarchy.
At December 31, 2017, total investable assets held by Arch were $19.72 billion, excluding the $2.44 billion included in the ‘other’ segment (i.e., attributable to Watford Re).
The following table provides information on our structured securities, which include residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and asset backed securities (“ABS”):
At December 31, 2017, our structured securities included $42.3 million par value in sub-prime securities with a fair value of $35.4 million and average credit quality ratings from S&P/Moody’s of “CCC/Caa3.” At December 31, 2016, our fixed income portfolio included $25.3 million par value in sub-prime securities with a fair value of $23.3 million and average credit quality ratings from S&P/Moody’s of “CCC/Caa3.”
The country allocations set forth in the table are based on various assumptions made by us in assessing the country in which the underlying credit risk resides, including a review of the jurisdiction of organization, business operations and other factors. Based on such analysis, we do not believe that we have any other Eurozone investments at December 31, 2017.
Our investment strategy allows for the use of derivative instruments. We utilize various derivative instruments such as futures contracts to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. See note 11, “Derivative Instruments,” to our consolidated financial statements in Item 8 for additional disclosures concerning derivatives.
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. See note 10, “Fair Value,” to our consolidated financial statements in Item 8 for a summary of our financial assets and liabilities measured at fair value at December 31, 2017 and December 31, 2016 segregated by level in the fair value hierarchy.
At December 31, 2017, 78.2% of premiums receivable of $1.14 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 4.0% of the total. At December 31, 2016, 81.0% of premiums receivable of $1.07 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 5.2% of the total. At December 31, 2017 and 2016, our reserves for doubtful accounts were approximately $25.3 million and $21.0 million, respectively.
The A.M. Best group rating of “A” (Excellent) has been applied to all Lloyd’s syndicates.
Excludes the effects of 6,590,058 and 6,872,494 stock options and 304,496 and 381,461 restricted stock units outstanding at December 31, 2017 and December 31, 2016, respectively.
Pursuant to our 2014 acquisition of the CMG Entities, we made a contingent consideration payment of $71.7 million in April 2017. The contingent consideration payments are based on the closing book value of the pre-closing portfolio of the CMG Entities as re-calculated over an earn-out period and payable at
We expect that our liquidity needs, including our anticipated insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by funds generated from underwriting activities and investment income, as well as by our balance of cash, short-term investments, proceeds on the sale or maturity of our investments, and our credit facilities.
We also have insurance subsidiaries that are the parent company for other insurance subsidiaries, which means that dividends and other distributions will be subject to multiple layers of regulations in order for our insurance subsidiaries to be able to dividend funds to Arch Capital. The inability of the subsidiaries of Arch Capital to pay dividends and other permitted distributions could have a material adverse effect on Arch Capital’s cash requirements and our ability to make principal, interest and dividend payments on the senior notes, preferred shares and common shares.
At December 31, 2017, our investable assets were $19.72 billion, excluding the $2.44 billion of investable assets related to the ‘other’ segment. The primary goals of our asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including debt service obligations. Generally, the expected principal and interest payments produced by our fixed income portfolio adequately fund the estimated runoff of our insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the fair value of the fixed income portfolio exceeds the expected present value of the net insurance liabilities, as well as the positive cash flow from newly sold policies and the large amount of high quality liquid bonds, provide assurance of our ability to fund the payment of claims and to service our outstanding debt without having to sell securities at distressed prices or access credit facilities.
Arch Capital and Arch-U.S. are each holding companies and, accordingly, they conduct substantially all of their operations through their operating subsidiaries. Arch Capital Finance LLC (“Arch Finance”) is a wholly owned subsidiary of Arch U.S. MI Holdings Inc., a U.S. holding company. As a result, Arch Capital, Arch-U.S. and Arch Finance's cash flows and their ability to service their debt depends upon the earnings of their
operating subsidiaries and on their ability to distribute the earnings, loans or other payments from such subsidiaries to Arch Capital, Arch-U.S. and Arch Finance, respectively.
See note 17, “Senior Notes,” to our consolidated financial statements in Item 8 for additional disclosures concerning our senior notes and note 16, “Commitments and Contingencies-Letters of Credit and Revolving Credit Facilities,” to our consolidated financial statements in Item 8 for information on our revolving credit agreement borrowings. For additional information on our preferred shares, see note 19, “Shareholders’ Equity,” to our consolidated financial statements in Item 8.
During 2017, 2016 and 2015, we made interest payments of $103.7 million, $50.4 million and $49.6 million, respectively, related to our senior notes and other financing arrangements.
requirements require an eligible mortgage insurer’s available assets, which generally include only the most liquid assets of an insurer, to meet or exceed “minimum required assets” as of each quarter end. Minimum required assets are calculated from PMIERs tables with several risk dimensions (including origination year, original loan-to-value and original credit score of performing loans, and the delinquency status of non-performing loans) and are subject to a minimum amount. Arch MI U.S. satisfied the PMIERs’ financial requirements as of December 31, 2017 with a PMIER sufficiency ratio of 129%, compared to 116% at December 31, 2016.
The board of directors of Arch Capital has authorized the investment in Arch Capital’s common shares through a share repurchase program. Since the inception of the share repurchase program through December 31, 2017, Arch Capital has repurchased approximately 125.2 million common shares for an aggregate purchase price of $3.68 billion. At December 31, 2017, approximately $446.5 million of share repurchases were available under the program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through December 31, 2019. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations. We will continue to monitor our share price and, depending upon results of operations, market conditions and the development of the economy, as well as other factors, we will consider share repurchases on an opportunistic basis.
The following table provides an analysis of our contractual commitments at December 31, 2017:
The estimated expected contractual commitments related to the reserves for losses and loss adjustment expenses are presented on a gross basis (i.e., not reflecting any corresponding reinsurance recoverable amounts that would be due to us). It should be noted that until a claim has been presented to us, determined to be valid, quantified and settled, there is no known obligation on an individual transaction basis, and while estimable in the aggregate, the timing and amount contain significant uncertainty. Approximately 62% of our reserves for losses and loss adjustment expenses were incurred but not reported at December 31, 2017.
As of December 31, 2017, Arch Capital and certain of its subsidiaries had a $350.0 million secured facility for letters of credit and a $500.0 million unsecured facility for revolving loans and letters of credit (the “Credit Agreement”). Obligations of each borrower under the secured facility for letters of credit are secured by cash and eligible securities of such borrower held in collateral accounts. Subject to the receipt of commitments, the secured facility may be increased by up to an aggregate of $350.0 million, and the unsecured facility may be increased to an amount not to exceed $750.0 million. Arch Capital has a one-time option to convert any or all outstanding revolving loans of Arch Capital and/or Arch-U.S. to term loans with the same terms as the revolving loans except that any prepayments may not be reborrowed. Arch-U.S. guarantees the obligations of Arch Capital, and Arch Capital guarantees the obligations of Arch-U.S. Borrowings of revolving loans may be made at a variable rate based on LIBOR or an alternative base rate at the option of Arch Capital. Secured letters of credit are available for issuance on behalf of Arch Capital insurance and reinsurance subsidiaries. The Credit Agreement and related documents are structured such that each party that requests a letter of credit or borrowing does so only for itself and for only its own obligations.
The Credit Agreement contains customary representations, conditions to issuance of letters of credit and borrowings which include, among other things: (i) the maintenance of a debt to total capital ratio of not greater than 0.35 to 1; (ii) consolidated tangible net worth in excess of $5.63 billion plus 25% of future aggregate net income (not including any future net losses) for each quarterly period ending after December 31, 2016 plus 25% of future aggregate net cash proceeds from the issuance of common or preferred equity (other than the proceeds of which are used to fund the repurchase or redemption of our preferred securities (“Refinanced Preferred Securities”)), minus 70% of up to $750.0 million of the aggregate book value of any preferred securities of Arch Capital which are repurchased or redeemed by Arch Capital or its subsidiaries (other than Refinanced Preferred Securities); and (iii) that Arch Capital’s principal insurance and reinsurance subsidiaries that are borrowers under the Credit Agreement maintain a financial strength rating of at least a “B++” from A.M. Best or “BBB+” from S&P. In addition, certain of Arch Capital’s subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders’ equity levels. Commitments under the Amended Credit Agreement will expire on October 26, 2021, and all loans then outstanding under the Amended Credit Agreement must be repaid. Letters of credit issued under the Amended Credit Agreement will not have an expiration date later than October 26, 2022. Arch Capital and its subsidiaries which are party to the Credit Agreement were in compliance with all covenants contained in the Credit Agreement at December 31, 2017.
We have large aggregate exposures to natural and man-made catastrophic events and severe economic events. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, tornadoes, explosions, severe winter weather, fires, droughts and other natural disasters. Catastrophes can also cause losses in non-property business such as mortgage insurance, workers’ compensation or general liability. In addition to the nature of property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration, tend to generally increase the size of losses from catastrophic events over time.
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 our loss exposure by 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.
Based on in-force exposure estimated as of January 1, 2018, our modeled peak zone catastrophe exposure is a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $496 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum pre-tax losses of $478 million and $406 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, were less than the exposures arising from U.S. windstorms and hurricanes in both periods. As of January 1, 2018, our modeled peak zone earthquake exposure (San Francisco area earthquake) represented approximately 67% of our peak zone catastrophe exposure, and our modeled peak zone international exposure (Japan earthquake) was substantially less than both our peak zone windstorm and earthquake exposures.
We also have significant exposure to losses due to mortgage defaults resulting from severe economic events in the future. For our U.S. mortgage insurance business, we have developed a proprietary risk model (“Realistic Disaster Scenario” or “RDS”) that simulates the maximum loss resulting from a severe economic downturn impacting the housing market. The RDS models the collective impact of adverse conditions for key
economic indicators, the most significant of which is a decline in home prices. The RDS model projects paths of future home prices, unemployment rates, income levels and interest rates and assumes correlation across states and geographic regions. The resulting future performance of our in-force portfolio is then estimated under the economic stress scenario, reflecting loan and borrower information.
Currently, we seek to limit our modeled RDS loss from a severe economic event to approximately 25% of total tangible shareholders’ equity available to Arch (total shareholders’ equity available to Arch less goodwill and intangible assets). We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of January 1, 2018, our modeled RDS loss was less than 17% of tangible shareholders’ equity available to Arch.
Net probable maximum loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. RDS loss estimates are net of expected reinsurance recoveries and after income tax. Catastrophe loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our catastrophe loss estimates include clash estimates from other zones. Our catastrophe loss estimates and RDS loss estimates do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer pre-tax losses greater than 25% of our total shareholders' equity or tangible shareholders’ equity from one or more catastrophic events or severe economic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event or severe economic event. In addition, actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See “Risk Factors-Risk Relating to Our Industry.” Depending on business opportunities and the mix of business that may comprise our insurance, reinsurance and mortgage portfolios, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business and mortgage default exposed business. See “-Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Ceded Reinsurance” for a discussion of our catastrophe reinsurance programs.
Bellemeade Re I Ltd., Bellemeade Re II Ltd. and Bellemeade 2017-1 Ltd. are special purpose variable interest entities that are not consolidated in our financial results because we do not have the unilateral power to direct those activities that are significant to its economic performance. As of December 31, 2017, our estimated off-balance sheet maximum exposure to loss from such entities was $3.2 million. See note 4, “Variable Interest Entities-Bellemeade Re,” to our consolidated financial statements in Item 8 for additional information.
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 December 31, 2017. Market risk represents the risk of changes in the fair value of a financial instrument and consists of several components, including liquidity, basis and price risks.
We have not included Watford Re in the following analyses as we do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions.
analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments. The financial instruments included in the following sensitivity analysis consist of all of our investments and cash.
The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on the portfolio at December 31, 2017 and 2016:
Equity Securities, Privately Held Securities and Other Investments. Our investment portfolio includes an allocation to equity securities, privately held securities and certain other investments. At December 31, 2017 and 2016, the fair value of our investments in equity securities, privately held securities and certain other investments totaled $576.0 million and $558.0 million, respectively. These securities are exposed to price risk, which is the potential loss arising from decreases in fair value. An immediate hypothetical 10% depreciation in the value of each position would reduce the fair value of such investments by approximately $57.6 million and $55.8 million at December 31, 2017 and 2016, respectively, and would have decreased book value per share by approximately $0.42 and $0.41, respectively.
Represents the net notional value of outstanding foreign currency forward contracts.
We have audited the accompanying consolidated balance sheets of Arch Capital Group Ltd. (The Company) and its subsidiaries as of December 31, 2017 and December 31, 2016, and the related consolidated statements of income, statements of comprehensive income, statements of changes in shareholders’ equity, and statements of cash flows for each of the three years in the period ended December 31, 2017, including the related notes and financial statement schedules listed in the index appearing under Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying: Management's Annual Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
As used herein, the “Company” means Arch Capital and its subsidiaries. Similarly, “Common Shares” means the common shares of Arch Capital. The Company’s consolidated financial statements include the results of Watford Holdings Ltd., and its wholly owned subsidiaries (“Watford Re”). See Note 4.
On July 1, 2017, the Company completed its previously announced acquisition of AIG United Guaranty Insurance (Asia) Limited (renamed “Arch MI Asia Limited”) following the payment of $40.0 million to AIG. Arch MI Asia Limited compliments the Company’s existing private mortgage insurance businesses, which have operations in the United States, Europe and Australia.
The purchase price was allocated to the acquired assets and liabilities of Arch MI Asia Limited based on estimated fair values on the acquisition date. The Company recognized other intangible assets of $2.3 million and goodwill of $0.8 million. The goodwill balance is primarily attributed to Arch MI Asia Limited’s assembled workforce and access to the mortgage insurance market. None of the goodwill recognized is expected to be deductible for income tax purposes.
On December 31, 2016, the Company’s U.S.-based subsidiaries completed the acquisition of all of the issued and outstanding shares of capital stock of United Guaranty Corporation, a North Carolina corporation (“UGC”) pursuant to the Stock Purchase Agreement with American International Group, Inc. (“AIG”) entered into on August 15, 2016 (“Stock Purchase Agreement”). The acquisition under the Stock Purchase Agreement is referred to herein as the “UGC acquisition.”
The UGC acquisition expanded the scale of the Company’s existing mortgage insurance business by combining UGC’s position as the market leader in the U.S. private mortgage
insurance industry with the Company’s financial strength and history of innovation.
The aggregate purchase price paid by the Company was $3.26 billion, consisting of cash consideration of $2.16 billion and convertible non-voting common equivalent preferred shares of Arch Capital with a fair value of $1.1 billion. In connection with the UGC acquisition, the 50% quota share reinsurance agreement between United Guaranty Residential Insurance Company and three subsidiaries of AIG relating to policy years 2014, 2015 and 2016 was amended to terminate on a run-off basis as of 12:01 a.m. on January 1, 2017.
(1) Based upon a formula set forth in the Stock Purchase Agreement, AIG received 1,276,282 of Arch Capital’s convertible non-voting common equivalent preferred shares, each of which is convertible into 10 shares of Arch Capital fully paid non-assessable common stock. The Company has determined that, based on a review of the terms, features and rights of the Company’s non-voting common equivalent preferred shares compared to the rights of the Company’s common shareholders, the underlying 12,762,820 common shares that the convertible securities converted to were common share equivalents at the time of their issuance. See Note 19 for further details.
Insurance. Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in the Company’s programs, specialty lines, lenders products business and for participation in involuntary pools. Such premium estimates are derived from multiple sources which include the historical
Reinstatement premiums for the Company’s insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on
Mortgage. Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premiums on a monthly, annual or single basis. Upon renewal, the Company
No premium deficiency charges were recorded by the Company during 2017, 2016 or 2015.
Certain assumed reinsurance contracts that are deemed not to transfer insurance risk, are accounted for using the deposit method of accounting. However, it is possible that the Company 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 or deposit contracts. For those contracts that contain only significant 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 other underwriting 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. Additional judgments are required when applying the accounting guidance with respect to the revenue recognition criteria for contracts deemed to transfer only significant underwriting risk. For those contracts that contain only significant timing risk, an accretion rate is established at inception of the contract based on actuarial estimates whereby the deposit accounting liability is increased to the estimated amount payable over the contract term. The accretion on the deposit is based on the expected rate of return required to fund the expected future payment obligations. Periodically the Company reassesses the estimated ultimate liability and the related expected rate of return. The accretion of the deposit accounting liability as well as changes to the estimated ultimate liability and the accretion rate would be reflected as part of
interest expense in the Company’s results of operations. Any negative accretion in a deposit accounting liability is shown in other underwriting income in the Company’s results of operations.
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, the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately where practical. 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 amount or timing of 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.
The Company performs quarterly reviews of its investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of OTTI. The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include (i) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (ii) the time period in which
there was a significant decline in value, (iii) the significance of the decline and (iv) the analysis of specific credit events. The Company evaluates the unrealized losses of its equity securities by issuer and forecasts a reasonable period of time by which the fair value of the securities would increase and the Company would recover its cost. If the Company is unable to forecast a reasonable period of time in which to recover the cost of its equity securities, a net impairment loss in earnings equivalent to the entire unrealized loss is recognized.
Investment gains or losses realized on the sale of investments, except for certain fund investments, are determined on a first-in, first-out basis and are reflected in net income. Investment gains or losses realized on the sale of certain fund investments are determined on an average cost basis. Unrealized appreciation or decline in the value of available for sale securities, which are carried at fair value, is excluded from net
policyholder to mitigate the Company’s credit risk. In the instances where the Company receives collateral in the form of cash, the Company reflects it in “Collateral held for insured obligations.”
Assets and liabilities of foreign operations whose functional currency is not the U.S. Dollar are translated at the prevailing exchange rates at each balance sheet date. Revenues and expenses of such foreign operations are translated at average exchange rates during the year. The net effect of the translation adjustments for foreign operations is included in accumulated other comprehensive income, net of applicable deferred income tax. Monetary assets and liabilities, such as premiums receivable and the reserve for losses and loss adjustment expenses, denominated in foreign currencies are revalued at the exchange rate in effect at the balance sheet date with the resulting foreign exchange gains and losses included in net income. Accounts that are classified as non-monetary, such as deferred acquisition costs and the unearned premium reserves, are not revalued. In the case of foreign currency denominated fixed maturity securities which are classified as “available for sale,” the change in exchange rates between the local currency in which the investments are denominated and the Company’s functional currency at each balance sheet date is included in unrealized appreciation or decline in value of securities, a component of accumulated other comprehensive income, net of applicable deferred income tax.
Deferred income taxes reflect the expected future tax consequences 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 tax asset may not be realized. The Company considers future taxable income and feasible tax planning strategies in assessing the need for a valuation allowance. In the event the Company determines that it will not be able to realize all or part of its 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 the Company subsequently assesses that the valuation allowance is no longer needed, a benefit would be recorded to income in the period in which such determination is made. See Note 14 for additional information.
The Company recognizes a tax benefit where it concludes that it is more likely than not that the tax benefit will be sustained on audit by the taxing authority based solely on the technical merits of the associated tax position. If the recognition threshold is met, the Company recognizes a tax benefit measured at the largest amount of the tax benefit that, in the Company’s judgment, is greater than 50% likely to be realized. The
Company records interest and penalties related to unrecognized tax benefits in the provision for income taxes.
Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired and is assigned to the applicable reporting unit at acquisition. Goodwill is evaluated for impairment on an annual basis. Impairment tests may be performed more frequently if the facts
ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities,” was issued in the 2016 first quarter to enhance the reporting model for financial instruments and to provide improved financial information to readers of the financial statements. Among other provisions focused on improving the recognition and measurement of financial instruments, the ASU significantly changes the income statement impact of equity instruments and the recognition of changes in fair value of financial liabilities attributable to an entity's own credit risk when the fair value option is elected. The ASU requires equity instruments that do not result in consolidation and are not accounted for under the equity method to be measured at fair value with any changes in fair value recognized in net income rather than other comprehensive income. The ASU is effective in the 2018 first quarter. Upon adoption of this ASU, the Company expects to record a cumulative effect adjustment of $149.8 million in retained earnings and an offsetting decrease in accumulated other comprehensive income. The adoption of this ASU is not expected to have a material impact on the Company's financial position, cash flows, or total comprehensive income, but will increase volatility in the Company's results of operations.
implementation of this ASU will have on the classification and presentation of its statements of cash flows.
ASU 2016-18, "Statement of Cash Flows (Topic 230) - Restricted Cash" requires that restricted cash and restricted cash equivalents be included with cash and cash equivalents in the reconciliation of beginning and ending cash on the statements of cash flows. As a result, transfers between cash and cash equivalents and restricted cash and restricted cash equivalents will no longer be presented on the statement of cash flows. The ASU is effective, with retrospective adoption, for interim and annual periods beginning after December 15, 2017, with early adoption permitted. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements. The adoption of this ASU is not expected to have a material effect on the Company’s results of operations, financial position, comprehensive income or net cash provided from operating activities.
ASU 2018-02 “Income Statement-Reporting Comprehensive Income (Topic 220) - Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income,” was issued in February 2018 to allow the reclassification of the stranded tax effects in accumulated other comprehensive income (“AOCI”) resulting from the Tax Cuts and Jobs Act of 2017 (“Tax Cuts Act”). Current guidance requires the effect of a change in tax laws or rates on deferred tax balances to be reported in income from continuing operations in the accounting period that includes the period of enactment, even if the related income tax effects were originally charged or credited directly to AOCI. The amount of the reclassification would include the effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts and related valuation allowances, if any, at the date of the enactment of the Tax Cuts Act related to items in AOCI. The updated guidance is effective for reporting periods beginning after December 15, 2018 and is to be applied retrospectively to each period in which the effect of the Tax Cuts Act related to items remaining in AOCI are recognized or at the beginning of the period of adoption. Early adoption is permitted. The adoption of this ASU is not expected to have a material effect on the Company’s results of operations, financial position or liquidity.
The Company accounts for the portion of Watford Re’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford Re’s common shares was approximately 89% at December 31, 2017. The portion of Watford Re’s income or loss attributable to third party investors is recorded in the consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests.’
Company accounts for the redeemable noncontrolling interests in the Watford Preference Shares in the mezzanine section of its consolidated balance sheets. Preferred dividends on the Watford Preference Shares, including the accretion of the discount and issuance costs, was $19.6 million for 2017, 2016 and 2015. Preferred dividends, including the accretion of the discount and issuance costs, are included in ‘amounts attributable to noncontrolling interests’ in the Company’s consolidated statements of income.
The following table sets forth activity in the redeemable non-controlling interests:
accounting guidance was that addresses VIEs was evaluated. As a result of the evaluation of the Bellemeade Agreements, we concluded that Bellemeade Re I Ltd., Bellemeade Re II Ltd. and Bellemeade 2017-1 Ltd. are VIEs. However, given that the ceding insurers do not have the unilateral power to direct those activities that are significant to the economic performance of Bellemeade Re I Ltd., Bellemeade Re II Ltd. and Bellemeade 2017-1 Ltd., the Company does not consolidate such companies in its consolidated financial statements.
The Company’s insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to the Company’s chief operating decision makers, the Chairman and Chief Executive Officer of Arch Capital, the President and Chief Operating Officer of Arch Capital and the Chief Financial Officer of Arch Capital. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. Management measures segment performance for its three underwriting segments based on underwriting income or loss. The Company does not manage its assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.
Construction and national accounts: primary and excess casualty coverages to middle and large accounts in the construction industry and a wide range of products for middle and large national accounts, specializing in loss sensitive primary casualty insurance programs (including large deductible, self-insured retention and retrospectively rated programs).
Professional lines: directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity and other financial related coverages for corporate, private equity, venture capital, real estate investment trust, limited partnership, financial institution and not-for-profit clients of all sizes and medical professional and general liability insurance coverages for the healthcare industry. The business is predominately written on a claims-made basis.
Other: includes alternative market risks (including captive insurance programs), excess workers’
compensation and employer’s liability insurance coverages for qualified self-insured groups, associations and trusts, and contract and commercial surety coverages, including contract bonds (payment and performance bonds) primarily for medium and large contractors and commercial surety bonds for Fortune 1000 companies and smaller transaction business programs.
equipment and contents. The primary perils in this business include fire, explosion, collapse, riot, vandalism, wind, tornado, flood and earthquake. Business is assumed on both a proportional and excess of loss basis. In addition, facultative business is written which focuses on commercial property risks on an excess of loss basis.
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’ See ‘Comments on Regulation G’ for a further discussion of the presentation of such items.
Certain expenses have been excluded from ‘corporate expenses’ and ‘other operating expenses’ and reflected in ‘UGC transaction costs and other.’ See ‘Comments on Regulation G’ for a further discussion of the presentation of such items.
The reinsurance segment’s net favorable development of $165.4 million, or 14.5 points of net earned premium, consisted of $101.0 million from short-tailed lines and $64.4 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines included $82.6 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2009 to 2016 underwriting years (i.e., losses attributable to contracts having an inception or renewal date within the given twelve-month period). The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2017. Net favorable development of $64.4 million in medium-tailed and long-tailed lines included reductions in casualty reserves of $43.7 million, primarily from the 2002 to
2013 underwriting years, and in marine and aviation reserves of $19.6 million, spread across most underwriting years.
The insurance segment’s net favorable development of $8.6 million, or 4.0 points of net earned premium, consisted of $14.9 million of net favorable development from short-tailed lines and $11.8 million of net favorable development from long-tailed lines, partially offset by $18.1 million of net adverse development from medium-tailed lines. Favorable development in short-tailed lines predominantly consisted of $22.8 million of net favorable development in property lines, primarily from the 2011 to 2016 accident years (i.e., the year in which a loss occurred), partially offset by $11.8 million of adverse development on travel, accident and health business from the 2014 to 2016 accident years. Net favorable development in long-tailed lines of $11.8 million included $10.0 million of net favorable development on executive assurance business, primarily from the 2013 accident year, and $8.3 million of net favorable development in casualty business, primarily from the 2007 to 2013 accident years. Net adverse development in medium-tailed lines of $18.1 million included $56.3 million of net adverse development in program business, primarily from the 2013 to 2015 accident years and primarily driven by a few inactive programs that were non-renewed in 2015 and early in 2016, partially offset by $36.2 million of net
The insurance segment’s net favorable development of $33.1 million, or 1.6 points of net earned premium, consisted of $8.7 million of net favorable development from short-tailed lines and $24.4 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines predominantly consisted of $17.2 million of net favorable development in property lines, primarily from the 2008 to 2014 accident years, partially offset by $11.1 million of adverse development on travel, accident and health business from the 2012 to 2015 accident years. Net favorable development in medium-tailed and long-tailed lines of $24.4 million included $53.8 million of net favorable development on professional lines, primarily from the 2008 to 2012 accident years, partially offset by $33.1 million of net adverse development in program business, primarily from the 2013 to 2015 accident years. The adverse development in program business was primarily driven by a few inactive programs that were non-renewed in 2015 and early in 2016.
The mortgage segment’s net favorable development of $21.2 million, or 7.4 points of net earned premium, for 2016, included $18.5 million of favorable development on U.S. primary mortgage business, reflecting a decrease in the number of delinquent loans and a lower claim rate on such loans. Such development was primarily from the 2004 to 2008 and 2014 origination years. The mortgage segment also experienced net favorable development of $2.7 million on U.S. mortgage reinsurance business.
The reinsurance segment’s net favorable development of $224.8 million, or 20.9 points of net earned premium, consisted of $107.6 million from short-tailed lines and $117.2 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines included $80.9 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2011 to 2014 underwriting years. The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2015. Net favorable development of $117.2 million in medium-tailed and long-tailed lines included reductions in casualty reserves of $99.7 million, primarily from the 2003 to 2006 underwriting years and the 2008 and 2009 underwriting years, and marine and aviation reserves of $11.7 million, primarily from the 2008 to 2012 underwriting years. The balance of net favorable development was spread across various lines and underwriting years.
The mortgage segment’s net favorable development of $12.3 million, or 5.7 points of net earned premium, included $11.1 million of favorable development on U.S. primary mortgage
Loss Reserves for the insurance segment are comprised of (1) estimated amounts for (1) reported losses (“case reserves”) and (2) incurred but not reported losses (“IBNR reserves”). 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. The Company also contracts 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 loss adjustment expenses and represent 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 case reserves may be made as additional information is reported or payments are made. IBNR reserves are established to provide for incurred claims which have not yet been reported at the balance sheet date as well as to adjust for any projected variance in case reserving. Actuaries estimate ultimate losses and loss adjustment expenses using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain.
In determining ultimate losses and loss adjustment expenses, the cost to indemnify claimants, provide needed legal defense and other services for insureds and administer the investigation and adjustment of claims are considered. These claim costs are influenced by many factors that change over time, such as expanded coverage definitions as a result of new court decisions, inflation in costs to repair or replace damaged property, inflation in the cost of medical services and legislated changes in statutory benefits, as well as by the particular, unique facts that pertain to each claim. As a result, the rate at which claims arose in the past and the costs to settle them may not always be representative of what will occur in the future. The factors influencing changes in claim costs are often difficult to isolate or quantify and developments in paid and incurred losses from historical trends are frequently subject to multiple and conflicting interpretations. Changes in coverage terms or claims handling practices may also cause future experience and/or development patterns to vary from the past. A key objective of actuaries in developing estimates of ultimate losses and loss adjustment expenses, and resulting IBNR reserves, is to identify aberrations and systemic changes occurring within historical experience and adjust for them so that the future can be projected more reliably. Because of the factors previously discussed, this process requires the substantial use of informed judgment and is inherently uncertain.
method based on the facts and circumstances at the time the estimates of Loss Reserves are made.
Bornhuetter-Ferguson (“B-F”) paid and incurred loss methods - these methods utilize actual paid and incurred losses and expected patterns of paid and incurred losses, taking the initial expected ultimate losses into account to determine an estimate of expected ultimate losses. The B-F paid and incurred loss methods are useful when there are few reported claims and a relatively less stable pattern of reported losses.
In the initial reserving process for short-tail insurance lines (consisting of property, energy, marine and aviation and other exposures including travel, accident and health and lenders products), the Company relies on a combination of the reserving methods discussed above. For catastrophe-exposed business, the reserving process also includes the usage of catastrophe models for known events and a heavy reliance on analysis of
Loss Reserves for the Company’s reinsurance segment are comprised of (1) case reserves, (2) additional case reserves (“ACRs”) and (3) IBNR reserves. The Company receives reports of claims notices from ceding companies and records case reserves based upon the amount of reserves recommended by the ceding company. Case reserves may be supplemented by ACRs, which are often estimated by the Company’s claims personnel ahead of official notification from the ceding company, or when judgment regarding the size or severity of the known event differs from the ceding company. In certain instances, the Company establishes ACRs even when the ceding company does not report any liability on a known event. In addition, specific claim information reported by ceding companies or obtained through claim audits can alert the Company to emerging trends such as changing legal interpretations of coverage and liability, claims from unexpected sources or classes of business, and significant changes in the frequency or severity of individual claims. Such information is often used in the process of estimating IBNR reserves. IBNR reserves are established to provide for incurred claims which have not yet been reported at the balance sheet date as well as to adjust for any projected variance in case reserving. Actuaries estimate ultimate losses and loss adjustment expenses using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating Loss Reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain.
ceding companies for information regarding reported claims and (6) the differing reserving practices among ceding companies.
As mentioned above, there can be a considerable time lag from the time a claim is reported to a ceding company to the time it is reported to the reinsurer. The lag can be several years in some cases and may be attributed to a number of reasons, including the time it takes to investigate a claim, delays associated with the litigation process, the deterioration in a claimant’s physical condition many years after an accident occurs, the case reserving approach of the ceding company, etc. In the reserving process, the Company assumes that such lags are predictable, on average, over time and therefore the lags are contemplated in the loss reporting patterns used in their actuarial methods. This means that the reinsurance segment must rely on estimates for a longer period of time than does an insurance company. Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2017 there were no significant backlogs related to the processing of assumed reinsurance information at our reinsurance operations.
standards. The selected assumptions reflect the actuary’s judgment based on historical data and experience combined with information concerning current underwriting, economic, judicial, regulatory and other influences on ultimate claim settlements.
Loss Reserves for the Company’s mortgage reinsurance business and GSE credit-risk sharing transactions are comprised of case reserves and IBNR reserves. The Company’s mortgage reinsurance operations receive reports of delinquent loans and claims notices from ceding companies and record case reserves based upon the amount of reserves recommended by the ceding company. In addition, specific claim and delinquency information reported by ceding companies is used in the process of estimating IBNR reserves.
The following table represents a reconciliation of the disclosures of net incurred and paid loss development tables to the reserve for losses and loss adjustment expenses at December 31, 2017:
approximately 75.7% of the Company’s reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.11 billion were due from carriers which had an A.M. Best rating of “A-” or better while 24.2% were from companies not rated, a substantial portion of which was collateralized through reinsurance trusts or letters of credit. The largest reinsurance recoverables from any one carrier was approximately 2.4% of the Company’s total shareholders’ equity at December 31, 2016. Although the Company has not experienced any material credit losses to date, an inability of its reinsurers or retrocessionaires to meet their obligations to it over the relevant exposure periods for any reason could have a material adverse effect on its financial condition and results of operations.
On July 29, 2015, UGC entered into an aggregate excess of loss reinsurance agreement with Bellemeade Re, a special purpose reinsurance company domiciled in Bermuda, at inception for new delinquencies on a portfolio of in-force policies issued between January 1, 2009 and March 31, 2013 through a mortgage insurance-linked notes offering by Bellemeade Re I Ltd.
On October 25, 2017, the Company entered into an aggregate excess of loss reinsurance agreement with Bellemeade Re at inception for new delinquencies on a portfolio of in-force policies issued between January 1, 2017 and June 30, 2017 through a mortgage insurance-linked notes offering by Bellemeade 2017-1 Ltd.
The following table summarizes the respective coverages and retentions at December 31, 2017:
Represents the total OTTI recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At December 31, 2017, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $0.3 million, compared to a net unrealized loss of $2.8 million at December 31, 2016.
Includes fund investments with strategies in mortgage servicing rights, transportation and infrastructure assets and other.
Includes dividends and other distributions from investment funds, term loan investments, funds held balances, cash balances and other.
investments are generally recorded on a one to three month lag based on the availability of reports from the investment funds.
A description of the methodology and significant inputs used to measure the amount of net impairment losses recognized in earnings in 2017 is as follows:
Corporate bonds - the Company reviewed the business prospects, credit ratings, estimated loss given default factors, foreign currency impacts and information received from asset managers and rating agencies for certain
The Company believes that the OTTI included in accumulated other comprehensive income at December 31, 2017 on the securities which were considered by the Company to be impaired was due to market and sector-related factors (i.e., not credit losses). At December 31, 2017, the Company did not intend to sell these securities, or any other securities which were in an unrealized loss position, and determined that it is more likely than not that the Company will not be required to sell such securities before recovery of their cost basis.
The Company is required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support its insurance and reinsurance operations.
The Company uses the market approach valuation technique to estimate the fair value of its fixed maturity securities, when
• Municipal bonds - valuations provided by independent pricing services, with all prices provided through index providers and pricing vendors. The fair values of these securities are generally determined using spreads obtained from broker-dealers who trade in the relevant security market, trade prices and the new issue market. As the significant inputs used in the pricing process for municipal bonds are observable market inputs, the fair value of these securities are classified within Level 2.
based on quoted market prices in active markets. Other equity securities are included in Level 2 of the valuation hierarchy.
Contingent consideration liabilities (included in ‘other liabilities’ in the consolidated balance sheets) include amounts related to the Company’s 2014 acquisition of CMG Mortgage Insurance Company and its affiliated mortgage insurance companies (the “CMG Entities”) and other acquisitions. Such amounts are remeasured at fair value at each balance sheet date with changes in fair value recognized in ‘net realized gains
The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2016:
Gains or losses on asset backed securities were included in net impairment losses recognized in earnings while gains or losses on corporate bonds and contingent consideration liabilities were included in net realized gains (losses).
At December 31, 2017, the Company’s senior notes were carried at their cost, net of debt issuance costs, of $1.73 billion and had a fair value of $2.04 billion. At December 31, 2016, the Company’s senior notes were carried at their cost, net of debt issuance costs, of $1.73 billion and had a fair value of $1.90 billion. The fair values of the senior notes were obtained from a third party pricing service and are based on observable market inputs. As such, the fair value of the senior notes is classified within Level 2.
Long-Lived Assets. The Company tests its long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of a long-lived asset may not be recoverable.
In addition, the Company purchases to-be-announced mortgage backed securities (“TBAs”) as part of its investment strategy. TBAs represent commitments to purchase a future issuance of agency mortgage backed securities. For the period between purchase of a TBA and issuance of the underlying security, the Company’s position is accounted for as a derivative. The Company purchases TBAs in both long and short positions to enhance investment performance and as part of its overall investment strategy.
The Company did not hold any derivatives which were designated as hedging instruments at December 31, 2017 or 2016.
The following tables present details about amounts reclassified from accumulated other comprehensive income and the tax effects allocated to each component of other comprehensive income (loss):
Certain stock options were not included in the computation of diluted earnings per share where the exercise price of the stock options exceeded the average market price and would have been anti-dilutive or where, when applying the treasury stock method to in-the-money options, the sum of the proceeds, including unrecognized compensation, exceeded the average market price and would have been anti-dilutive. For 2017, 2016 and 2015, the number of stock options excluded were 867,817, 722,729 and 799,535, respectively.
The expected tax provision computed on pre-tax income or loss at the weighted average tax rate has been calculated as the sum of the pre-tax income in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The statutory tax rates by jurisdiction were as follows: Bermuda (0.0%), United States (35.0%), United Kingdom (19.25%), Ireland (12.5%), Denmark (22.0%), Canada (26.5%), Gibraltar (10.0%), Australia (30.0%), Hong Kong (16.5%) and the Netherlands (20.0%).
potential future guidance from the IRS with respect to the transitional adjustment pertaining to loss reserve discounting as well as the utilization of alternative minimum tax (“AMT”) credits.
Due to uncertainty surrounding their future utilization, a valuation allowance of $14.8 million is in place. Beginning in 2017, the U.K. losses are subject to usage restrictions that will limit the amount of carried forward losses which may be utilized in a given year. Such restrictions are not expected to limit the utilization of the Company’s existing U.K. loss carryforwards that have been recognized in the financial statements.
At December 31, 2017, net operating loss carryforwards in Ireland were approximately $15.3 million. Although these losses may be carried forward indefinitely, an offsetting valuation allowance of $1.2 million exists given management’s expectation that certain losses, which are specific to an individual Irish entity, will not be utilized in the future.
At December 31, 2017, net operating loss carryforwards in Australia were approximately $19.6 million. Although these losses may be carried forward indefinitely, subject to certain business and ownership continuity requirements, the associated net deferred tax asset of $5.9 million is fully offset by a valuation allowance of $5.9 million.
premiums, paid losses and loss adjustment expenses recoverable net of reinsurance balances payable, investments and cash and cash equivalent balances. A credit exposure exists with respect to reinsurance recoverables as they may become uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound and, if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis. In addition, certain insurance policies written by the Company’s insurance operations feature large deductibles, primarily in its construction and national accounts lines of business. Under such contracts, the Company is obligated to pay the claimant for the full amount of the claim. The Company is subsequently reimbursed by the policyholder for the deductible amount. These amounts are included on a gross basis in the consolidated balance sheet in contractholder payables and contractholder receivables, respectively. In the event that the Company is unable to collect from the policyholder, the Company would be liable for such defaulted amounts. Collateral, primarily in the form of letters of credit, cash and trusts, is obtained from the policyholder to mitigate the Company’s credit risk. In the instances where the company receives collateral in the form of cash, the Company records a related liability in “Collateral held for insured obligations.”
No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written for 2017, 2016 and 2015.
The Credit Agreement contains customary representations, conditions to issuance of letters of credit and borrowings which include, among other things: (i) the maintenance of a debt to total capital ratio of not greater than 0.35 to 1; (ii) consolidated tangible net worth in excess of and consolidated tangible net worth in excess of $5.63 billion plus 25% of future aggregate net income (not including any future net losses) for each quarterly period ending after December 31, 2016 plus 25% of future aggregate net cash proceeds from the issuance of common or preferred equity (other than the proceeds of which are used to fund the repurchase or redemption of our preferred securities (“Refinanced Preferred Securities”)), minus 70% of up to $750.0 million of the aggregate book value of any preferred securities of Arch Capital which are repurchased or redeemed by Arch Capital or its subsidiaries (other than Refinanced Preferred Securities); and (iii) that Arch Capital’s principal insurance and reinsurance subsidiaries that are borrowers under the Credit Agreement maintain a financial strength rating of at least a “B++” from A.M. Best or “BBB+” from S&P. In addition, certain of Arch Capital’s subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders’ equity levels. Commitments under the
Pursuant to the Company’s 2014 acquisition of the CMG Entities, the Company made a contingent consideration payment of $71.7 million in April 2017. The maximum remaining amount of contingent consideration payments is $68.2 million over the remaining earn-out period. To the extent that the adjusted book value of the CMG Entities drops below the cumulative amount paid by the Company, no additional payments would be due.
All of these leases are for the rental of office space, with expiration terms that range from 2018 to 2026. Rental expense, net of income from subleases, was approximately $31.1 million, $24.2 million and $23.8 million for 2017, 2016 and 2015, respectively.
At December 31, 2017, the Company has entered into employment agreements with certain of its executive officers. Such employment arrangements provide for compensation in the form of base salary, annual bonus, share-based awards, participation in the Company’s employee benefit programs and the reimbursements of expenses.
The Company’s senior notes payable at December 31, 2017 and 2016 were as follows:
(1) Senior notes of Arch Capital issued on May 4, 2004 and due May 1, 2034 (“2034 notes”). The 2034 notes are Arch Capital’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. Interest payments on the 2034 notes are due on May 1st and November 1st of each year. Arch Capital may redeem the 2034 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price.
(4) Senior notes of Arch Finance issued on December 8, 2016 and due December 15, 2046 (“2046 notes”), fully and unconditionally guaranteed by Arch Capital. The 2046 notes are unsecured and unsubordinated obligations of Arch Finance and Arch Capital, respectively, and rank equally and ratably with the other unsecured and unsubordinated indebtedness of Arch Finance and Arch Capital, respectively. Interest payments on the 2046 notes are due on June 15th and December 15th of each year. Arch Finance may redeem the 2046 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price.
The following table shows an analysis of goodwill and intangible assets:
The following table presents the components of goodwill and intangible assets:
The Company’s impairment reviews for goodwill and intangible assets did not result in the recognition of impairment losses for 2017, 2016 and 2015.
Such shares represent common shares that were issued upon conversion of the non-voting common equivalent preference shares issued in connection with the AIG acquisition.
The board of directors of Arch Capital has authorized the investment in Arch Capital’s common shares through a share repurchase program. At December 31, 2017, approximately $446.5 million of share repurchases were available under the program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through December 31, 2019. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations.
In May 2010, Arch Capital’s shareholders approved amendments to the bye-laws to permit Arch Capital to hold its own acquired shares as treasury shares in lieu of cancellation, as determined by Arch Capital’s board of directors. From May 5, 2010 to December 31, 2017, all repurchases of Arch Capital’s common shares in connection with the share repurchase plan noted above and other share-based transactions were held in the treasury under the cost method, and the cost of the common shares acquired is included in ‘Common shares held in treasury, at cost.’ At December 31, 2017, Arch Capital held 52.3 million shares for an aggregate cost of $2.08 billion in treasury, at cost.
Except in specified circumstances relating to certain tax or corporate events, the Series F Preferred Shares are not redeemable prior to August 17, 2022 (the fifth anniversary of the issue date). On and after that date, the Series F Preferred Shares will be redeemable at the Company’s option, in whole or in part, at a redemption price of $25,000 per share of the Series F Preferred Shares (equivalent to $25 per depositary share), plus any declared and unpaid dividends, without accumulation of any undeclared dividends to, but excluding, the redemption date. The Series F Depositary Shares will be
On September 29, 2016, Arch Capital completed a $450 million underwritten public offering of 18.0 million depositary shares (the “Series E Depositary Shares”), each of which represents a 1/1,000th interest in a share of its 5.25% Non-Cumulative Preferred Shares, Series E, have a $0.01 par value and $25,000 liquidation preference per share (equivalent to $25 liquidation preference per Series E Depositary Share) (the “Series E Preferred Shares”). Each Series E Depositary Share, evidenced by a depositary receipt, entitles the holder, through the depositary, to a proportional fractional interest in all rights and preferences of the Series E Preferred Shares represented thereby (including any dividend, liquidation, redemption and voting rights).
Preferred Shares will not have voting rights, except under limited circumstances.
The number of common shares reserved for grants of awards under the 2015 Plan, subject to anti-dilution adjustments in the event of certain changes in the Company’s capital structure is 4,300,000. In addition, no more than 50% of such common shares may be issued in connection with full value awards (i.e., awards other than stock options or SARs) and no more than 2,000,000 common shares may be issued as incentive stock options under Section 422 of the Code. At December 31, 2017, 1,312,899 shares are available for future issuance.
The ESPP provides for consecutive six-month offering periods (or other periods of not more than 27 months as determined by the compensation committee) under which participating employees can elect to have up to 20% of their total compensation withheld and applied to the purchase of common shares of the Company at the end of the period. Unless otherwise determined by the compensation committee before an offering period commences, (1) the purchase price will be 85% of the fair market value of the common shares at the beginning of the offering period; and (2) the maximum number of common shares that may be purchased by an employee in any offering period is 3,000 shares. In addition, applicable Code limitations specify, in general, that a participant’s right to purchase stock under the ESPP cannot accumulate at a rate in excess of $25,000 (based on the value at the beginning of the applicable offering periods) per calendar year.
The Company generally issues stock options and SARs to eligible employees, with exercise prices equal to the fair market values of the Company’s Common Shares on the grant dates. Such grants generally vest over a three year period with one-third vesting on the first, second and third anniversaries of the grant date. In addition, in November 2012 the Company issued off-cycle stock options and SARs to certain employees, which vested on the fifth anniversary of the grant date. Option awards and SARs have a 10 year contractual life. Refer to Note 3(m) for details related to the Company’s accounting for stock options and SARs.
The aggregate intrinsic value of stock options and SARs exercised represents the difference between the exercise price of the stock options and SARs and the closing market price of the Company’s common shares on the exercise dates. During 2017, the Company received proceeds of $4.4 million from the exercise of stock options and recognized a tax benefit of $7.6 million from the exercise of stock options and SARs.
The Company also issues restricted share and unit awards to eligible employees and directors, for which the fair value is equal to the fair market values of the Company’s Common Shares on the grant dates. Restricted share and unit awards generally vest over a three year period with one-third vesting on the first, second and third anniversaries of the grant date. In addition, in November 2012 the Company issued off-cycle restricted share and unit awards to certain employees, which vested on the fifth anniversary of the grant date. Refer to Note 3(m) for details related to the Company’s accounting for restricted share and unit awards.
The aggregate intrinsic value of restricted units outstanding at December 31, 2017 was $27.6 million, and the aggregate intrinsic value of restricted units vested and deferred was $13.8 million.
For purposes of providing employees with retirement benefits, the Company maintains defined contribution retirement plans. Contributions are based on the participants’ eligible compensation. For 2017, 2016 and 2015, the Company expensed $40.7 million, $30.6 million and $29.7 million, respectively, related to these retirement plans.
Such amounts include ownership interests in affiliated insurance and reinsurance subsidiaries.
The statutory net income (loss) for the Company’s principal operating subsidiaries for 2017, 2016 and 2015 was as follows:
The ability of these subsidiaries to pay dividends is limited under Bermuda law and regulations. Under the Insurance Act, Arch Re Bermuda is restricted with respect to the payment of dividends. 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 following the declaration of those dividends. Accordingly, Arch Re Bermuda can pay approximately $2.17 billion to Arch Capital during 2018 without providing an affidavit to the BMA.
required to maintain a minimum level of capital. At December 31, 2017 and 2016, these requirements were met.
The amount of assets required to satisfy the revised financial requirements of the PMIERs at any point in time will be affected by many factors, including macro-economic conditions, the size and composition of our eligible mortgage insurers’ mortgage insurance portfolio at the point in time, and the amount of risk ceded to reinsurers that may be deducted in our calculation of “minimum required assets.” The Company’s eligible mortgage insurers satisfied the PMIERs’ financial requirements as of December 31, 2017.
The Company’s U.S. mortgage insurance subsidiaries are subject to detailed regulation by their domiciliary and primary
The Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”) regulate insurance and reinsurance companies and the FCA regulates firms carrying on insurance mediation activities operating in the U.K., both under the Financial Services and Markets Act 2000. The Company’s European insurance operations are conducted on two platforms: Arch Insurance Company Europe and Arch Syndicate 2012. Arch Syndicate 2012 has one member, Arch Syndicate Investments Ltd. (“ASIL”) and is managed by Arch Underwriting at Lloyd’s Ltd (“AUAL”). All U.K. companies are also subject to a range of statutory provisions, including the laws and regulations of the Companies Acts 2006 (as amended) (the “U.K. Companies Acts”).
Arch Insurance Company Europe and AUAL (on behalf of itself, Arch Syndicate 2012 and ASIL) must maintain a margin of solvency at all times under the Solvency II Directive from the European Insurance and Occupational Pensions Authority. The regulations stipulate that insurers are required to maintain the minimum capital requirement and solvency capital requirement at all times. The capital requirements are calculated by reference to standard formulae defined in Solvency II. At December 31, 2017 and 2016, our subsidiaries were in compliance with these requirements.
Under U.K. law, all U.K. companies are restricted from declaring a dividend to their shareholders unless they have “profits available for distribution.” The calculation as to whether a company has sufficient profits is based on its accumulated realized profits minus its accumulated realized losses. U.K. insurance regulatory laws do not prohibit the payment of dividends, but the PRA or FCA, as applicable, requires that insurance companies and insurance intermediaries maintain certain solvency margins and may restrict the payment of a dividend by Arch Insurance Company Europe, AUAL and ASIL.
Arch Insurance Canada and the Canadian branch of Arch Re U.S. (“Arch Re Canada”) are subject to federal, as well as provincial and territorial, regulation in Canada. The Office of the Superintendent of Financial Institutions (“OSFI”) is the federal regulatory body that, under the Insurance Companies Act (Canada), regulates federal Canadian and non-Canadian insurance companies operating in Canada. Arch Insurance Canada and Arch Re Canada are subject to regulation in the provinces and territories in which they underwrite insurance/reinsurance, and the primary goal of insurance/reinsurance regulation at the provincial and territorial levels is to govern the market conduct of insurance/reinsurance companies. Arch Insurance Canada is licensed to carry on insurance business by OSFI and in each province and territory. Arch Re Canada is
On January 2, 2018, the Company redeemed all remaining outstanding Series C Preferred Shares at $25 per share ($92.6 million aggregate cost), plus all declared and unpaid dividends to (but excluding) the redemption date. In accordance with GAAP, following the redemption, original issuance costs related to such shares will be removed from additional paid-in capital and the Company will record a $2.7 million loss on redemption of preferred shares. Such adjustment will have no impact on total shareholders’ equity or cash flows.