We lease office space in Bermuda where our principal offices are located. Our reinsurance group leases space for offices in the U.S., Bermuda, Europe, Canada and Dubai. Our insurance group leases space for offices in the U.S., Canada, Bermuda, Europe, South Africa and Australia. Our mortgage group leases space for offices in the U.S., Hong Kong and Australia. We believe that the above described office space is adequate for our
needs. However, as we continue to develop our business, we may open additional office locations in 2018.
This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto presented under Item 8. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
Arch Capital Group Ltd. (“Arch Capital” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with approximately $11.30 billion in capital at December 31, 2017 and, through operations in Bermuda, the United States, Europe and Canada, writes specialty lines of property and casualty insurance and reinsurance, as well as mortgage insurance and reinsurance, on a worldwide basis. It is our belief that our underwriting platform, our experienced management team and our strong capital base have enabled us to establish a strong presence in the insurance and reinsurance markets.
The broad property casualty insurance market environment continues to be competitive in our business, consistent with our view in prior quarters, reflecting slight deterioration in rates across certain sectors. This has led to flat or lower writings in certain property casualty lines in the 2017 quarters. With the continued low interest rate environment, additional price increases are needed in many lines in order for us to achieve our return requirements. Recent catastrophic loss activity, including Hurricanes Harvey, Irma and Maria and the California wildfires, may result in improvements in rates and provide opportunities for growth. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts and by utilizing reinsurance purchases to reduce volatility on large account, high capacity business.
Our mortgage segment continues to experience favorable market conditions. The mortgage segment includes our U.S. primary mortgage insurance operations, international mortgage insurance and reinsurance operations as well as government sponsored enterprise (GSE) credit-risk sharing transactions. On December 31, 2016, we completed the acquisition of United Guaranty Corporation, a North Carolina corporation (UGC) from American International Group, Inc. (AIG). The acquisition of UGC expanded our U.S. primary mortgage insurance operations by combining UGC’s position as the market leader in the U.S. private mortgage insurance industry with Arch’s financial strength and history of innovation. On July 1, 2017, we completed our previously announced acquisition of AIG United Guaranty Insurance (Asia) Limited from AIG (renamed Arch MI Asia Limited).
Our objective is to achieve an average operating return on average equity of 15% or greater over the insurance cycle, which we believe to be an attractive return to our common shareholders given the risks we assume. We continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline and continue to write a portion of our overall book in catastrophe-
Changing economic conditions could have a material impact on the frequency and severity of claims and, therefore, could negatively impact our underwriting returns. In addition, volatility in the financial markets could continue to significantly affect our investment returns, reported results and shareholders’ equity. We consider the potential impact of economic trends in the estimation process for establishing unpaid losses and loss adjustment expenses and in determining our investment strategies. In addition, weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with potential downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio.
Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for Arch Capital’s common shareholders:
Total return for our investment portfolio outperformed that of the benchmark return index in 2017 and primarily reflected strong investment returns on our investment grade fixed income portfolio, which represents the majority of our investment portfolio, and in equities and alternatives. Total return was impacted by weakening of the U.S. Dollar against the Euro, British Pound Sterling and other major currencies which increased total return on non-U.S. Dollar denominated
The benchmark return index is a customized combination of indices intended to approximate a target portfolio by asset mix and average credit quality while also matching the approximate estimated duration and currency mix of our insurance and reinsurance liabilities. Although the estimated duration and average credit quality of this index will move as the duration and rating of its constituent securities change, generally we do not adjust the composition of the benchmark return index except to incorporate changes to the mix of liability currencies and durations noted above. The benchmark return index should not be interpreted as expressing a preference for or aversion to any particular sector or sector weight. The index is intended solely to provide, unlike many master indices that change based on the size of their constituent indices, a relatively stable basket of investable indices. At December 31, 2017, the benchmark return index had an average credit quality of “Aa2” by Moody’s, an estimated duration of 3.53 years.
Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to Arch common shareholders, which is defined as
net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other, loss on redemption of preferred shares and income taxes, and the use of annualized operating return on average common equity. The presentation of after-tax operating income available to Arch common shareholders and annualized operating return on average common equity are non-GAAP financial measures as defined in Regulation G. The reconciliation of such measures to net income available to Arch common shareholders and annualized return on average common equity (the most directly comparable GAAP financial measures) in accordance with Regulation G is included under “Results of Operations” below.
We determined our reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of our consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.
• Property, energy, marine and aviation: primary and excess general property insurance coverages, including catastrophe-exposed property coverage, for commercial clients. Coverages for marine include hull, war, specie and liability. Aviation and stand-alone terrorism are also offered.
2016 versus 2015: Net premiums written by the insurance segment were 1.3% higher in 2016 than in 2015. The increase in net premiums written reflected growth in travel, accident and health, construction and national accounts and alternative markets business, partially offset by a reduction in programs and property lines. The growth in travel, accident and health reflected both new travel business and continued expansion in existing travel accounts. The increase in construction and national accounts primarily reflected new business and audit premiums while the increase in alternative markets resulted from new accounts, exposure growth and audit premiums. The reduction in program business primarily reflected the continued impact of the non-renewal of a large program in the latter part of 2015 while the lower level of net premiums written in property lines reflected continued weak market conditions.
Net premiums earned by the insurance segment were 1.9% higher in 2017 than in 2016, reflecting changes in net premiums written over the previous five quarters. Net premiums earned by the insurance segment were 1.4% higher in 2016 than in 2015.
2016 versus 2015: The insurance segment’s current year loss ratio was 1.6 points higher in 2016 than in 2015. The 2016 loss ratio included 2.2 points of current year catastrophic event activity, compared to 1.0 points in 2015. The 2016 loss ratio also reflected changes in the mix of business.
The insurance segment’s net favorable development was $8.6 million, or 0.4 points, for 2017, compared to $33.1 million, or 1.6 points, for 2016, and $47.2 million, of 2.3 points, for 2015. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements in Item 8
•Other: includes life reinsurance business on both a proportional and non-proportional basis, casualty clash business and, in limited instances, non-traditional business which is intended to provide insurers with risk management solutions that complement traditional reinsurance.
Net premiums earned in 2017 were 8.2% higher than in 2016, reflecting changes in net premiums written over the previous five quarters, including the mix and type of business written and a higher level of retrocessions. Net premiums earned in 2016 were 1.9% lower than in 2015.
2016 versus 2015: The underwriting expense ratio for the reinsurance segment was 33.6% in 2016, compared to 35.2% in 2015. The 2016 ratio reflected approximately 1.3 points of benefit from the loss portfolio transfer noted above (net premiums earned with no related expenses).
Our mortgage operations include U.S. and international mortgage insurance and reinsurance operations as well as GSE credit risk sharing transactions. Our mortgage group includes direct mortgage insurance in the U.S. primarily provided by Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (together, “Arch MI U.S.”), as well as through Arch Mortgage Guaranty Company; mortgage reinsurance by Arch Re Bermuda to mortgage insurers on both a proportional and non-proportional basis globally; direct mortgage insurance in Europe provided by Arch MI Europe and in Hong Kong by Arch MI Asia; and various GSE credit risk-sharing products provided primarily by Arch Re Bermuda.
The following tables set forth our mortgage segment’s underwriting results. On December 31, 2016, we completed the acquisition of UGC. As such, the 2017 results reflect the combination of Arch and UGC while the 2016 and 2015 periods do not reflect UGC activity.
2016 versus 2015: Gross premiums written by the mortgage segment in 2016 were 69.1% higher than in 2015, reflecting growth in Australian mortgage reinsurance, in U.S. primary business and from GSE credit risk-sharing transactions receiving insurance accounting treatment. The lower increase in net premiums written of 46.3% reflected retrocessions on Australian mortgage reinsurance business covering exposures written since May 2015, including a substantial portion representing catch up premiums.
Arch MI U.S. generated $62.0 billion of new insurance written (“NIW”) during 2017. NIW represents the original principal balance of all loans that received coverage during the period.
Other underwriting income, which is primarily related to GSE risk-sharing transactions receiving derivative accounting treatment, was $15.7 million for 2017, compared to $17.0 million for 2016 and $18.4 million for 2015.
2015. The decrease in the underwriting expense ratio reflects the expansion of the mortgage segment’s insurance in force in 2016.
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, interest expense, 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, income taxes and items related to our non-cumulative preferred shares. Such amounts exclude the results of the ‘other’ segment.
Interest expense was $103.6 million for 2017, compared to $53.5 million for 2016 and $41.5 million for 2015. Interest expense reflects amounts related to our outstanding senior notes, revolving credit agreement borrowings and other. We issued $950.0 million of senior notes in December 2016 in connection with the UGC acquisition and borrowed $400.0 million on our revolving credit agreement. During 2017, we repaid $125 million of such borrowings. As such, our borrowing costs were higher for 2017 than in the 2016 and 2015 periods.
In September 2017, we redeemed $230 million of 6.75% Series C preferred shares and, in accordance with GAAP, recorded a loss of $6.7 million to remove original issuance costs related to the redeemed shares from additional paid-in capital. Such adjustment had no impact on total shareholders’ equity or cash flows.
For 2017, we recorded $7.1 million of credit related impairments in earnings, compared to $30.4 million in 2016 and $20.1 million in 2015. The impairment losses recorded in 2017 were primarily related to foreign currency and the liquidation of one portfolio, while the 2016 period included reductions on two asset backed securities based on information received from external investment managers and a review of cash flow projections in order to determine expected recovery values. See note 9, “Investment Information-Other-Than-Temporary Impairments,” to our consolidated financial statements in Item 8 for additional information.
We recorded $142.3 million of equity in net income related to investment funds accounted for using the equity method for 2017, compared to $48.5 million for 2016 and $25.5 million for 2015. The increase reflected strong returns on funds invested in global equities and other strategies. Investment funds accounted for using the equity method totaled $1.04 billion at December 31, 2017, compared to $811.3 million at December 31, 2016. See note 9, “Investments-Equity in Net Income (Loss) of Investment Funds Accounted For Using the Equity Method,” to our consolidated financial statements in Item 8 for additional information.
Our income tax provision on income before income taxes resulted in an expense of 17.1% for 2017, compared to an expense of 4.3% for 2016 and an expense of 7.0% for 2015. Our effective tax rate fluctuates from year to year consistent with the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction. Income tax expense for 2017 included a net $8.1 million charge due to the revaluation of our net U.S. deferred tax asset resulting from the reduction in the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. We recorded a $21.5 million income tax expense outside of after-tax operating income available to Arch common shareholders, a non-GAAP measure, for the pure impact of the U.S. corporate tax rate reduction and a partially offsetting income tax benefit as part of after-tax operating income available to Arch common shareholders for actions taken by management, resulting in the net $8.1 million charge due to the revaluation of our net U.S. deferred tax asset resulting from the reduction in the U.S. corporate income tax rate. See “General-Comment on Non-GAAP Financial Measures.”
See note 14, “Income Taxes,” to our consolidated financial statements in Item 8 for a reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average statutory tax rate for 2017, 2016 and 2015.
The ‘other’ segment includes the results of Watford Re. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. See note 4, “Variable Interest Entity and Noncontrolling Interests,” and note 5, “Segment Information,” to our consolidated financial statements in Item 8 for additional information.
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses, or Loss Reserves, that arise from the business we underwrite. Loss Reserves for our insurance and reinsurance operations are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured events which have occurred
at or before the balance sheet date. Loss Reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
At December 31, 2017, total net reserves include $477.1 million from U.S. primary mortgage insurance business, of which 68.3% represents policy years 2007 and prior, 11.5% from 2008 and the remainder from later policy years. At December 31, 2016, total net reserves include $606.9 million from U.S. primary mortgage insurance business, of which 76.6% represents policy years 2007 and prior, 12.3% from 2008 and the remainder from later policy years.
At December 31, 2017 and 2016, the insurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
It is not necessarily appropriate to sum the total impact for a specific factor or the total impact for a specific business category as the business categories are not perfectly correlated. In addition, the potential variability shown in the tables above are reasonably likely scenarios of changes in our key assumptions at December 31, 2017 and are not meant to be a “best case” or “worst case” series of outcomes and, therefore, it is possible that future variations may be more or less than the amounts set forth above.
At December 31, 2017, our recorded Loss Reserves by underwriting segment, net of unpaid losses and loss adjustment expenses recoverable, and the results of the simulation were as follows:
For informational purposes, based on the total simulation results, a change in our Loss Reserves to the amount indicated at the 90th percentile would result in a decrease in income before income taxes of approximately $1.41 billion, or $10.13 per diluted share, while a change in our Loss Reserves to the amount indicated at the 10th percentile would result in an increase in income before income taxes of approximately $1.28 billion, or $9.23 per diluted share. The simulation results noted above are informational only, and no assurance can be given that our ultimate losses will not be significantly different than the simulation results shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined. We do not have significant exposure to pre-2002 liabilities, such as asbestos-related illnesses and other long-tail liabilities. It is difficult to provide meaningful trend information for certain liability/casualty coverages for which the claim-tail may be especially long, as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to us through December 31, 2017.
Represents the aggregate dollar amount of each insured mortgage loan’s current principal balance.
The insurance in force and risk in force for our U.S. primary mortgage segment’s business were as follows at December 31, 2017:
In the normal course of business, our insurance and mortgage insurance operations cede a portion of their premium on a quota
share or excess of loss basis through treaty or facultative reinsurance agreements. Our reinsurance operations also obtain reinsurance whereby another reinsurer contractually agrees to indemnify it for all or a portion of the reinsurance risks underwritten by our reinsurance operations. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as “retrocessional reinsurance” arrangements. In addition, our reinsurance subsidiaries participate in “common account” retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as our reinsurance operations, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, our insurance or reinsurance operations would be liable for such defaulted amounts.
The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Although we believe that our insurance and reinsurance operations have been successful in obtaining adequate reinsurance and retrocessional protection, it is not certain that they will be able to continue to obtain adequate protection at cost effective levels. As a result of such market conditions and other factors, our insurance, reinsurance and mortgage operations may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements and may lead to increased volatility in our results of operations in future periods. See “Risk Factors-Risks Relating to Our Industry-The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or results of operations.”
Our insurance operations had in effect during 2017 a reinsurance program which provided coverage for certain property-catastrophe related losses equal to $200 million in excess of a $150 million retention per occurrence, consistent with the program in place for 2016. In the 2018 first quarter, our insurance operations renewed its reinsurance program with the same limits.
For purposes of managing risk, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. On a consolidated basis, ceded premiums written represented 22.1% of gross premiums written for 2017, compared to 22.5% for 2016 and 20.4% for 2015. We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as
The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by type of business were as follows at December 31, 2017:
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Based on currently available information, management believes that the premium estimates included in
We determine the existence of an active market based on our judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. We use quoted values and other data provided by nationally recognized independent pricing sources as inputs into our process for determining fair values of our fixed maturity investments. To validate the techniques or models used by pricing sources, our review process includes, but is not limited to: quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to their target benchmark, with significant differences identified and investigated); a review of the average number of prices obtained in the pricing process and the range of resulting fair values; initial and ongoing evaluation of methodologies used by outside parties to calculate fair value; comparing the fair value estimates to our knowledge of the current market; a
comparison of the pricing services’ fair values to other pricing services’ fair values for the same investments; and back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. Where multiple quotes or prices were obtained, a price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used from a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, we will challenge any prices for a security or portfolio which are considered not to be representative of fair value.
For 2017, we recorded $7.1 million of credit related impairments in earnings, compared to $30.4 million in 2016 and $20.1 million in 2015. See note 9, “Investment Information-Other-Than-Temporary Impairments,” to our consolidated financial statements in Item 8 for additional information.
See note 3(q), “Significant Accounting Policies-Recent Accounting Pronouncements,” to our consolidated financial statements in Item 8 for disclosures concerning recent accounting pronouncements.
The following table summarizes the fair value of investable assets held by Arch (i.e., excluding the ‘other’ segment):
At December 31, 2017, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had average credit quality ratings from S&P/Moody’s of “AA-/Aa2” and an average yield to maturity (embedded book yield), before investment expenses, of 2.32%. At December 31, 2016, our fixed income portfolio had average credit quality ratings from S&P/Moody’s of “AA-/Aa3” and an average yield to maturity of 2.03%. Our investment portfolio had an average effective duration of 2.83 years at December 31, 2017, compared to 3.64 years at December 31, 2016. At December 31, 2017, approximately $13.73 billion, or 70%, of total investable assets held by Arch were internally managed, compared to $13.90 billion, or 75%, at December 31, 2016.
The following table summarizes our top ten exposures to fixed income corporate issuers by fair value at December 31, 2017, excluding guaranteed amounts and covered bonds:
At December 31, 2017, our investment portfolio included $576.0 million of equity securities, compared to $558.0 million at December 31, 2016. Our equity portfolio includes publicly traded common stocks in the natural resources, energy, consumer staples and other sectors.
At December 31, 2017 and 2016, approximately 69.9% and 75.7% of reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.54 billion and $2.11 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better while 30.1% and 24.3%, respectively, were from companies not rated. For items not rated, over 90% of such amount was collateralized through reinsurance trusts or letters of credit at December 31, 2017 and 2016. The largest reinsurance recoverables from any one carrier was approximately 2.2% and 2.4%, respectively, of total shareholders’ equity available to Arch at December 31, 2017 and 2016.
Approximately 3.0% of the $75.2 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue at December 31, 2017, compared to 6.7% of the $30.6 million of paid losses and loss adjustment expenses recoverable at December 31, 2016. No collection issues were indicated on the amount in excess of 90 days overdue at December 31, 2017.
The following table details our reinsurance recoverables at December 31, 2017:
The financial strength ratings are as of February 12, 2018 and were assigned by A.M. Best based on its opinion of the insurer’s financial strength as of such date. An explanation of the ratings listed in the table follows: the rating of “A+” is designated “Superior”; and the “A” rating is designated “Excellent.”
Total shareholders’ equity available to Arch was $9.20 billion at December 31, 2017, compared to $8.25 billion at December 31, 2016. The increase in 2017 was primarily attributable to underwriting and investment returns.
Liquidity is a measure of our ability to access sufficient cash flows to meet the short-term and long-term cash requirements of our business operations.
the third, fifth and sixth anniversaries after closing (subject to a one time extension period of one to three years at the sellers’ discretion). The maximum amount of remaining contingent consideration payments is $68.2 million over the earn-out period. We currently expect that the maximum amount will be paid 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 us, no additional payments would be due.
Arch Capital has no material restrictions on its ability to make distributions to shareholders, however the ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is limited by the applicable local laws and relevant regulations of the various countries and states in which we operate. See note 23, “Statutory Information,” to our consolidated financial statements in Item 8 for additional information on dividend restrictions.
parties. Our insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. At December 31, 2017 and 2016, such amounts approximated $6.01 billion and $5.48 billion, respectively, excluding amounts related to the ‘other’ segment.
Our investments in certain securities, including certain fixed income and structured securities, investments in funds accounted for using the equity method, other alternative investments and investments in ventures such as Watford Re and others may be illiquid due to contractual provisions or investment market conditions. If we require significant amounts of cash on short notice in excess of anticipated cash requirements, then we may have difficulty selling these investments in a timely manner or may be forced to sell or terminate them at unfavorable values. Our unfunded investment commitments totaled approximately $1.70 billion at December 31, 2017 and are callable by our investment managers. The timing of the funding of investment commitments is uncertain and may require us to access cash on short notice.
•Cash used for investing activities for 2017 was lower than in 2016, reflecting changes in cash collateral related to securities lending. Activity for 2016 reflected our acquisition of UGC, which closed on December 31, 2016.
•Cash used for financing activities for 2017 was higher than the cash provided in 2016, reflecting changes in cash collateral
related to securities lending and a $125 million repayment of borrowing on our revolving credit agreement. Activity for 2016 reflected various capital raising activity, such as the issuance of $950.0 million of senior notes, $400.0 million of borrowings under our revolving loan facility and $450.0 million of preferred shares in order to fund the cash consideration portion of the UGC acquisition. Activity for 2016 also reflected $75.3 million of repurchases under our share repurchase program, compared to $365.4 million for 2015.
Changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio. Our investment portfolio as of December 31, 2017 included $346.8 million of securities issued and/or guaranteed by Eurozone governments at fair value, $3.48 billion of obligations of the U.S. government and government agencies at fair value and $2.16 billion of municipal bonds at fair value. Please refer to Item 1A “Risk Factors” for a discussion of other risks relating to our business and investment portfolio.
At December 31, 2017, total capital available to Arch of $11.30 billion consisted of $1.73 billion of senior notes, representing 15.3% of the total, $375.0 million of revolving credit agreement borrowings due in October 2021, representing 3.3% of the total, $872.6 million of preferred shares, representing 7.7% of the total, and common shareholders’ equity of $8.32 billion, representing 73.6% of the total. At December 31, 2016, total capital available to Arch of $10.49 billion consisted of $1.73 billion of senior notes, representing 16.5% of the total, $500.0 million of revolving credit agreement borrowings, representing 4.8% of the total, $772.6 million of preferred shares, representing 7.4% of the total, and common shareholders’ equity of $7.48 billion, representing 71.3% of the total.
In addition, Arch MI U.S. is required to maintain compliance with the GSEs requirements, known as the Private Mortgage Insurer Eligibility Requirements or “PMIERs.” The financial
As such, the level of subject business ceded to Arch Re Bermuda will be substantially lower in 2018 than in prior periods.
In addition, certain of Arch Capital’s subsidiaries had outstanding letters of credit of $160.1 million, which were issued on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the “LOC Facilities”). The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from our reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, these letters of credit are secured by a portion of our investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which we were in compliance with at December 31, 2017. At such date, we had approximately $324.4 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $388.0 million, and had $375.0 million of borrowings outstanding under the Credit Agreement. Under the $350.0 million secured letter of credit facility, we had $164.3 million of letters of credit outstanding and remaining capacity of $185.7 million at December 31, 2017.
The ratings issued on our companies by these agencies are announced publicly and are available directly from the agencies. Our Internet site (www.ir.archcapgroup.com, under Credit Ratings) contains information about our ratings, but such information on our website is not incorporated by reference into this report.
The sensitivity analysis performed as of December 31, 2017 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which were held by us on December 31, 2017 and are sensitive to changes in interest rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses.
The following table summarizes the effect that an immediate, parallel shift in the interest rate yield curve would have had on our investment portfolio at December 31, 2017 and 2016:
Investment-Related Derivatives. At December 31, 2017, the notional value of all derivative instruments (excluding to-be-announced mortgage backed securities which are included in the fixed income securities analysis above and foreign currency forward contracts which are included in the foreign currency exchange risk analysis below) was $2.44 billion, compared to
$2.12 billion at December 31, 2016. If the underlying exposure of each investment-related derivative held at December 31, 2017 depreciated by 100 basis points, it would have resulted in a reduction in net income of approximately $24.4 million, and a decrease in book value per share of $0.18, compared to $21.2 million and $0.16, respectively, on investment-related derivatives held at December 31, 2016. If the underlying exposure of each investment-related derivative held at December 31, 2017 appreciated by 100 basis points, it would have resulted in an increase in net income of approximately $24.4 million, and an increase in book value per share of $0.18, compared to $21.2 million and $0.16, respectively, on investment-related derivatives held at December 31, 2016. See note 11, “Derivative Instruments,” to our consolidated financial statements in Item 8 for additional disclosures concerning derivatives.
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Through our subsidiaries and branches located in various foreign countries, we conduct our insurance and reinsurance operations in a variety of local currencies other than the U.S. Dollar. We generally hold investments in foreign currencies which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities. We may also utilize foreign currency forward contracts and currency options as part of our investment strategy. See note 11, “Derivative Instruments,” to our consolidated financial statements in Item 8 for additional information.
To the Board of Directors and Shareholders of Arch Capital Group Ltd.:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and December 31, 2016, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2017 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.
Prior to our acquisition, UGC, which is based in Greensboro, North Carolina, operated its U.S. business through its primary operating subsidiaries: United Guaranty Residential Insurance Company, which is licensed and operates in all 50 states, the District of Columbia and Puerto Rico; and United Guaranty Mortgage Indemnity Company (“UGMIC”), which is licensed in 48 states and the District of Columbia.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Arch Capital and its subsidiaries, including Arch Reinsurance Ltd. (“Arch Re Bermuda”), Arch Reinsurance Company (“Arch Re U.S.”), Arch-U.S., Arch Insurance Company, Arch Specialty Insurance Company, Arch Excess & Surplus Insurance Company, Arch Indemnity Insurance Company, Arch Insurance Canada Ltd. (“Arch Insurance Canada”), Arch Reinsurance Europe Underwriting Designated Activity Company (“Arch Re Europe”), Arch Mortgage Insurance Company, Arch Mortgage Guaranty Company, United Guaranty Residential Insurance Company, Arch Mortgage Insurance Designated Activity Company (“Arch MI Europe”), Arch Insurance Company (Europe) Limited (“Arch Insurance Company Europe”), Lloyd’s of London syndicate 2012 and related companies (“Arch Syndicate 2012”), Gulf Reinsurance Limited and Watford Re. All significant intercompany transactions and balances have been eliminated in consolidation.
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.
an estimate of losses and loss adjustment expenses, which reflects management’s judgment.
and maintenance costs exceed unearned premiums (including expected future premiums) and anticipated investment income. A premium deficiency reserve (“PDR”) is recorded by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency.
The Company invests in limited partner interests and shares of limited liability companies. Such amounts are included in investments accounted for using the equity method, other investments available for sale and investments accounted for using the fair value option. These investments can often have characteristics of a variable interest entity (“VIE”). A VIE refers to entities that have characteristics such as (i) insufficient equity at risk to allow the entity to finance its activities without additional financial support or (ii) instances where the equity investors, as a group, do not have the characteristic of a controlling financial interest. If the Company is determined to be the primary beneficiary, it is required to consolidate the VIE. The primary beneficiary is defined as the variable interest holder that is determined to have the controlling financial interest as a result of having both (i) the power to direct the activities of a VIE that most significantly impact the economic performance of the VIE and (ii) the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. At inception of the VIE as well as on an ongoing basis, the Company determines whether it is the primary beneficiary based on an analysis of the Company’s level of involvement in the VIE, the contractual terms, and the overall structure of the VIE. The Company's maximum exposure to loss with respect to these investments is limited to the investment carrying amounts reported in the Company's consolidated balance sheet and any unfunded commitment.
When there are credit-related losses associated with debt securities for which the Company does not have an intent to sell and it is more likely than not that it will not be required to sell the security before recovery of its cost basis, the amount of the OTTI related to a credit loss is recognized in earnings and the amount of the OTTI related to other factors (e.g., interest rates, market conditions, etc.) is recorded as a component of other comprehensive income (loss). The amount of the credit loss of an impaired debt security is the difference between the amortized cost and the greater of (i) the present value of expected future cash flows and (ii) the fair value of the security. In instances where no credit loss exists but it is more likely than not that the Company will have to sell the debt security prior to the anticipated recovery, the decline in fair value below amortized cost is recognized as an OTTI in earnings. In periods after the recognition of an OTTI on debt securities, the Company accounts for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For debt securities for which OTTI were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted or amortized into net investment income. See Note 9 for additional information.
income and recorded as a separate component of accumulated other comprehensive income, net of applicable deferred income tax.
(j) Contractholder Receivables and Payables and Collateral Held for Insured Obligations
and circumstances indicate a possible impairment. In performing impairment tests, the Company may first assess qualitative factors to determine whether it is more likely than not (that is, more than a 50% probability) that the fair value of a reporting unit exceeds its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in the accounting guidance.
The Company adopted ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment,” prospectively effective October 1, 2017. The ASU provides updated guidance that eliminates the requirement to calculate the implied fair value of goodwill (i.e., step 2 of the current goodwill impairment test) to measure a
goodwill impairment charge. Instead, entities will record an impairment charge by comparing a reporting unit's fair value with its carrying amount and recognizing an impairment charge for the excess of the carrying amount over estimated fair value (i.e., step 1 of the current goodwill impairment test). The adoption of this ASU did not have a material effect on the Company's results of operations, financial position or liquidity.
ASU 2014-09, “Revenue from Contracts with Customers (Topic 606),” was issued in the 2014 second quarter and updated through various ASUs in 2016. This ASU (and as updated in 2016) creates a new comprehensive revenue recognition standard that will serve as a single source of revenue guidance for all companies in all industries. The guidance applies to all companies that either enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of non-financial assets, unless those contracts are within the scope of other standards, such as insurance contracts or financial instruments. The ASU also requires enhanced disclosures about revenue. The ASU is effective in the 2018 first quarter and the Company intends on adopting the ASU using the modified retrospective method, whereby the cumulative effect of adoption will be recognized as an adjustment to retained earnings at the date of initial application. The Company does not expect that the cumulative effect adjustment as a result of the adoption of this ASU will be material, mostly because the accounting for insurance contracts is outside of the scope of ASU 2014-09.
ASU 2016-16, “Income Taxes - Intra-Entity Transfers of Assets Other than Inventory (Topic 740),” was issued in the 2016 fourth quarter. This ASU requires entities to recognize current and deferred income tax resulting from an intra-entity asset transfer when the transfer occurs. Previously, recognition of income tax consequences under GAAP was not allowed until the asset had been sold to a third party. The ASU is effective in the 2018 first quarter. The Company does not expect that the cumulative effect adjustment as a result of the adoption of this ASU will be material.
ASU 2016-02, “Leases,” was issued in the 2016 first quarter pertaining to the accounting for leases by a lessee. The ASU requires that the lessee recognize an asset and a liability for leases with a lease term greater than 12 months regardless of whether the lease is classified as operating or financing. Under current accounting, operating leases are not reflected in the balance sheet. The ASU is effective for the 2019 first quarter, though early application is permitted, and should be applied on a modified retrospective basis. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements. The Company's lease obligations under various non-cancelable operating lease agreements amounted to $169.0 million at December 31, 2017.
ASU 2016-15, “Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments (Topic 230),” was issued in the 2016 third quarter. The ASU addresses several clarifications on the presentation and classification of certain cash receipts and cash payments in the statement of cash flows. Among several other cash flow issues, the ASU specifically addresses the classification of debt prepayment or debt issuance costs, contingent consideration payments made after a business combination and distributions received from equity method investees. The ASU also provides a broader principle on identifying the type of activity of the cash flow item by focusing on the cash flow item’s nature and the predominant source or use of that item. The ASU is effective in the 2018 first quarter and should be applied retrospectively. Early adoption is permitted. The Company is assessing the impact the
In March 2014, Watford Re raised approximately $1.1 billion of capital consisting of $907.3 million in common equity ($895.6 million net of issuance costs) and $226.6 million in preference equity ($219.2 million net of issuance costs and discount). The Company invested $100.0 million and acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity. Subsidiaries of the Company act as Watford Re’s reinsurance and insurance underwriting managers. HPS Investment Partners, LLC (formerly Highbridge Principal Strategies, LLC) (“HPS”) manages Watford Re’s non-investment grade credit portfolios, and the Company manages Watford Re’s investment grade portfolios, each under separate long term services agreements. In connection with the capital raise at Watford Re, warrants to purchase a total of 1.7 million common shares were issued to the Company and HPS. The warrants are only exercisable if Watford Re has consummated an initial public offering of its common shares or otherwise effected a listing of its common shares on a U.S. national securities exchange and certain targeted returns are achieved for existing common shareholders. The warrants expire on March 25, 2020. John Rathgeber, previously Vice Chairman of Arch Worldwide Reinsurance Group, is CEO of Watford Re. In addition, Marc Grandisson and Nicolas Papadopoulo, both officers of the Company, serve on the board of directors of Watford Re.
The Company concluded that Watford Re is a VIE due to both the reinsurance underwriting management services agreements with the Company and the investment management agreements with HPS and the Company. These agreements provide for services for an extended period of time with limited termination rights by Watford Re. In addition, these agreements allow for both the Company and HPS to participate in the favorable
results of Watford Re in the form of performance fees. To determine if the Company is the primary beneficiary of Watford Re, the Company concluded that the most significant activity of Watford Re pertains to the insurance activities arising from the reinsurance underwriting management services agreement. As such, the Company concluded that it is the primary beneficiary of Watford Re and includes the results of Watford Re in its consolidated financial statements.
The following table summarizes Watford Re’s cash flow from operating, investing and financing activities.
The following table sets forth activity in the non-redeemable noncontrolling interests:
The Company accounts for redeemable noncontrolling interests in the mezzanine section of its consolidated balance sheet. Such redeemable noncontrolling interests relate to the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in late March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. The Watford Preference Shares were issued at a discounted amount of $24.50 per share. Holders of the Watford Preference Shares will be entitled to receive, if declared by Watford Re’s board, quarterly cash dividends on the last day of March, June, September, and December. Dividends will accrue from the closing date to June 30, 2019 at a fixed rate of 8.5% per annum. From June 30, 2019 and subsequent, dividends will accrue based on a floating rate equal to the 3 month U.S. dollar LIBOR (with a 1% floor) plus a margin based on the difference between the fixed rate and the 5 year mid swap rate to the floating rate as set out on the Bloomberg Screen IRSB 18. The Watford Preference Shares may be redeemed by Watford Re on or after June 30, 2019 or at the option of the preferred shareholders at any time on or after June 30, 2034. Because the redemption features are not solely within the control of Watford Re, the
(1) During the 2015 second quarter, the Company acquired Gulf Re, which owns 600,000 Watford Preference Shares. Such shares, net of a discount, along with related dividends and accretion of the discount, are eliminated in consolidation.
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’ as summarized in the table below:
UGC entered into an aggregate excess of loss reinsurance agreement with Bellemeade Re I Ltd. in July 2015, with Bellemeade Re II Ltd. in May 2016 and the Company entered into an aggregate excess of loss reinsurance agreement with Bellemeade 2017-1 Ltd. in October 2017 (the “Bellemeade Agreements”), special purpose reinsurance companies domiciled in Bermuda. Bellemeade Re I Ltd. and Bellemeade Re II Ltd. each provided for up to approximately $300 million of aggregate excess of loss reinsurance coverage at inception for new delinquencies on portfolios of in-force policies issued while Bellemeade 2017-1 Ltd. provided for up to approximately $368.1 million of aggregate excess of loss reinsurance coverage at inception for new delinquencies on portfolios of in-force policies issued between January 1, 2017 and June 30, 2017. See Note 8 for further details. At the time the Bellemeade Agreements were entered into, the applicability of the
Property excluding property catastrophe: provides coverage for both personal lines and commercial property exposures and principally covers buildings, structures,
During 2017, the Company recorded estimated net favorable development on prior year loss reserves of $238.0 million, which consisted of $165.4 million from the reinsurance segment, $8.6 million from the insurance segment and $95.0 million from the mortgage segment, less adverse development of $31.0 million from the ‘other’ segment.
favorable development in professional liability business, primarily from the 2010 to 2016 accident years.
The reinsurance segment’s net favorable development of $218.8 million, or 20.7 points of net earned premium, consisted of $133.8 million from short-tailed lines and $85.0 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines included $113.6 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2009 to 2015 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 2016. Net favorable development of $85.0 million in medium-tailed and long-tailed lines included reductions in casualty reserves of $86.1 million, primarily from the 2002 to 2013 underwriting years.
The insurance segment’s net favorable development of $47.2 million, or 2.3 points of net earned premium, consisted of $27.3 million of net favorable development from short-tailed lines and $19.9 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines predominantly consisted of $32.4 million of net favorable development in property lines, primarily from the 2011 to 2014 accident years. Net favorable development in medium-tailed and long-tailed lines of $19.9 million included $29.7 million of net favorable development on professional lines, primarily from the 2005 to 2010 accident years, partially offset by $15.0 million of net adverse development in program business, primarily from the 2013 and 2014 accident years.
The Company determined the following to be insignificant for disclosure purposes: (i) amounts included in the ‘other’ segment (i.e., Watford Re) as described in Note 4; (ii) certain mortgage business, including non-U.S. primary business, second lien and student loan exposures, global mortgage reinsurance and various GSE credit risk-sharing products; and (iii) certain reinsurance business, including casualty clash and non-traditional lines. Such amounts are included as reconciling items.
The Company is required to establish reserves for losses and loss adjustment expenses (“Loss Reserves”) that arise from the business the Company underwrites. Loss Reserves for the
Ultimate losses and loss adjustment expenses are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate losses and loss adjustment expenses with respect to any line of business, past experience with respect to that line of business is the primary resource, developed through both industry and company experience, but cannot be relied upon in isolation. Uncertainties in estimating ultimate losses and loss adjustment expenses are magnified by the length of the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the “claim-tail.” During this period additional facts regarding coverages written in prior accident years, as well as about actual claims and trends, may
become known and, as a result, may lead to adjustments of the related Loss Reserves. If the Company determines that an adjustment is appropriate, the adjustment is recorded in the accounting period in which such determination is made. Accordingly, should Loss Reserves need to be increased or decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted respectively. The Company authorizes managing general agents, general agents and other producers to write program business on the Company’s behalf within prescribed underwriting authorities. This delegated authority process introduces additional complexity to the actuarial determination of unpaid future losses and loss adjustment expenses. In order to monitor adherence to the underwriting guidelines given to such parties, the Company periodically performs underwriting and claims due diligence reviews.
Although Loss Reserves are initially determined based on underwriting and pricing analyses, the Company’s insurance segment applies several generally accepted actuarial methods, as discussed below, on a quarterly basis to evaluate the Loss Reserves, in addition to the expected loss method, in particular for Loss Reserves from more mature accident years (the year in which a loss occurred). Each quarter, as part of the reserving process, the segments’ actuaries reaffirm that the assumptions used in the reserving process continue to form a sound basis for the projection of liabilities. If actual loss activity differs substantially from expectations based on historical information, an adjustment to Loss Reserves may be supported. The Company places more or less reliance on a particular actuarial
Historical paid loss development methods - these methods, like historical incurred loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant. These methods use historical loss payments over discrete periods of time to estimate future losses and necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use incurred losses to estimate ultimate losses, they may be more reliable than the other methods that use incurred losses in situations where there are significant changes in how incurred losses are established by a company’s claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes
Additional analyses - other methodologies are often used in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, which are typically used in the estimation of Loss Reserves at the early stage of known catastrophic events before information has been reported to an insurer or reinsurer.
individual catastrophic events and management judgment. The development of losses on short-tail business can be unstable, especially for policies characterized by high severity, low frequency losses. As time passes, for a given accident year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. The Company makes a number of key assumptions in their reserving process, including that historical paid and reported development patterns are stable, catastrophe models provide useful information about our exposure to catastrophic events that have occurred and underwriters’ judgment as to potential loss exposures can be relied on. The expected loss ratios used in the initial reserving process for short-tail business have varied over time due to changes in pricing, reinsurance structure, estimates of catastrophe losses, policy changes (such as attachment points, class and limits) and geographical distribution. As losses in short-tail lines are reported relatively quickly, expected loss ratios are selected for the current accident year based upon actual attritional loss ratios for earlier accident years, adjusted for rate changes, inflation, changes in reinsurance programs and expected attritional losses based on modeling. Furthermore, ultimate losses for short-tail business are known in a reasonably short period of time.
The estimation of Loss Reserves for the reinsurance segment is subject to the same risk factors as the estimation of Loss Reserves for the insurance segment. In addition, the inherent uncertainties of estimating such reserves are even greater for reinsurers, due primarily to the following factors: (1) the claim-tail for reinsurers is generally longer because claims are first reported to the ceding company and then to the reinsurer through one or more intermediaries, (2) the reliance on premium estimates, where reports have not been received from the ceding company, in the reserving process, (3) the potential for writing a number of reinsurance contracts with different ceding companies with the same exposure to a single loss event, (4) the diversity of loss development patterns among different types of reinsurance contracts, (5) the necessary reliance on the
For direct mortgage insurance business, the Company establishes case reserves for loans that have been reported as delinquent by loan servicers as well as those that are delinquent but not reported (IBNR reserves). The Company’s U.S. mortgage insurance operations also reserve for the expenses of adjusting claims related to these delinquencies. The trigger that creates a case reserve estimate is that an insured loan is reported to us as being two payments in arrears. The actuarial reviews and documentation created in the reserving process are completed in accordance with generally accepted actuarial
Claim size estimates are determined by examining the risk sizes on the delinquent loans and estimating the portion of risk that will be paid, as well as any expenses. This is done based on a review of historical development patterns, an assessment of economic conditions and the level of equity the borrowers may have in their homes, as well as considering economic conditions and loss mitigation opportunities. Mortgage insurance is generally not subject to large claim sizes, as with some other
lines of insurance. A claim size over $250,000 is rare, and this helps reduce the volatility of claim size estimates. The claim rate and claim size assumptions generate case reserves for the population of reported delinquencies. The reserve for unreported delinquencies (included in IBNR reserves) is estimated by looking at historical patterns of reporting. Claim rates and claim sizes can then be assigned to estimated unreported delinquencies using assumptions made in the establishment of case reserves.
Mortgage insurance Loss Reserves are short-tail, in the sense that the vast majority of delinquencies are resolved within two years of being reported. While reserves are initially analyzed by reserve cohort, as described above, they are also rolled up by underwriting year to ensure that reserve assumptions are consistent with the performance of the underwriting year. The accuracy of prior reserve assumptions is also checked in hindsight to determine if adjustments are needed.
The tables below include the acquired business of UGC across all periods presented. Due to the length of time for which claims incurred typically remain outstanding prior to payment and the Company’s formation of the mortgage segment in 2014, the Company determined that six accident years was sufficient for its current disclosures. The following table presents information on the mortgage segment’s short-duration insurance contracts:
The following table presents the average annual percentage payout of incurred losses and allocated loss adjustment expenses by age, net of reinsurance, as of December 31, 2017:
Loss Reserves for the ‘other’ segment (i.e., Watford Re) are comprised of case reserves, ACRs and IBNR reserves. For all business assumed by Watford Re, the Company acts as reinsurance underwriting manager, provides actuarial and risk management services and recommends a level of Loss Reserves to Watford Re. The Company does not guarantee or provide credit support for Watford Re, and the Company’s financial exposure to Watford Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions. The estimation of Loss Reserves for Watford Re is subject to the same risk factors as the estimation of Loss Reserves for the Company’s insurance, reinsurance and mortgage segments as described earlier. Watford Re performs its own reserve reviews and sets its reserves independently. As noted previously, the Company determined that amounts in the ‘other’ segment are insignificant for the purposes of these footnote disclosures.
For the year ended December 31, 2017, the Company did not make any significant changes in its methodologies or assumptions as described above (a) to determine the presented amounts of IBNR reserves, (b) for expected development on case reserves.
For the year ended December 31, 2017, the Company did not make any significant changes in its methodologies or assumptions as described above to calculate the cumulative claim frequency.
The Company monitors the financial condition of its reinsurers and attempts to place coverages only with substantial, financially sound carriers. At December 31, 2017, approximately 69.9% of the Company’s reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.54 billion were due from carriers which had an A.M. Best rating of “A-” or better while 30.1% 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 2.2% of the Company’s total shareholders’ equity at December 31, 2017. At December 31, 2016,
On May 9, 2016, UGC 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 in 2008 and prior years through a mortgage insurance-linked notes offering by Bellemeade Re II Ltd.
For the respective coverage periods, the ceding insurers will retain the first layer of the respective aggregate losses and the special purpose reinsurance companies will provide second layer coverage up to the outstanding coverage amount. The ceding insurers will then retain losses in excess of the outstanding coverage limit. The aggregate excess of loss reinsurance coverage decreases over a ten-year period as the underlying covered mortgages amortize.
At December 31, 2017, total investable assets of $22.16 billion included $19.72 billion held by the Company and $2.44 billion attributable to Watford Re.
At December 31, 2017, on a lot level basis, approximately 3,830 security lots out of a total of approximately 7,450 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $1.3 million. The Company believes that such securities were temporarily impaired at December 31, 2017. At December 31, 2016, on a lot level basis, approximately 3,540 security lots out of a total of approximately 7,240 security lots were in an unrealized loss position and the largest single unrealized loss from a single lot in the Company’s fixed maturity portfolio was $4.6 million.
The Company receives collateral in the form of cash or securities. Cash collateral primarily consists of short-term investments. At December 31, 2017, the fair value of the cash collateral received on securities lending was $199.9 million and the fair value of security collateral received was $276.7 million. At December 31, 2016, the fair value of the cash collateral received on securities lending was $212.4 million and the fair value of security collateral received was $550.1 million.
Aggregate unfunded commitments were $1,020.1 million at December 31, 2017, compared to $776.6 million at December 31, 2016.
Aggregate unfunded commitments were $100.4 million at December 31, 2017, compared to $16.7 million at December 31, 2016.
The Company recorded equity in net income related to investment funds accounted for using the equity method of $142.3 million for 2017, compared to $48.5 million for 2016 and $25.5 million for 2015. In applying the equity method, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of the net income or loss of the funds (which include changes in the fair value of the underlying securities in the funds). Such
A summary of financial information for the Company’s investments accounted for using the equity method is as follows:
Mortgage backed securities - the Company utilized underlying data provided by asset managers, cash flow projections and additional information from credit agencies in order to determine an expected recovery value for each security. Impairment losses primarily reflected the Company’s decision to liquidate a portfolio of mortgage backed securities in April 2017. The Company recorded impairment losses on securities in such portfolio that were in an unrealized loss position at March 31, 2017;
The Company’s insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. See Note 16 for further details.
The following table details the value of the Company’s restricted assets:
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).
The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. To validate the techniques or models used by pricing sources, the Company's review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (ii) a review of the prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value; (iv) a comparison of the fair value estimates to the Company’s knowledge of the current market; (v) a comparison of the pricing services' fair values to other pricing services' fair values for the same investments; and (vi) periodic back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. A price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value.
In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the $20.9 billion of financial assets and liabilities measured at fair value at December 31, 2017, approximately $181.5 million, or 0.9%, were priced using non-binding broker-dealer quotes. Of the $19.1 billion of financial assets and liabilities measured at fair value at December 31, 2016, approximately $234.0 million, or 1.2%, were priced using non-binding broker-dealer quotes.
possible. The market approach includes obtaining prices from independent pricing services, such as index providers and pricing vendors, as well as to a lesser extent quotes from broker-dealers. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. The following describes the significant inputs generally used to determine the fair value of the Company’s fixed maturity securities by asset class:
During 2017, the Company transferred $17.6 million of fixed maturities from Level 2 to Level 3 based on a review of the pricing of such securities, as described above.
The Company determined that certain of its short-term investments held in highly liquid money market-type funds, Treasury bills and commercial paper would be included in Level 1 as their fair values are based on quoted market prices in active markets. The fair values of other short-term investments are generally determined using the spread above the risk-free yield curve and are classified within Level 2.
(losses).’ To determine the fair value of contingent consideration liabilities, the Company estimates future payments using an income approach based on modeled inputs
which include a weighted average cost of capital. The Company determined that contingent consideration liabilities would be included within Level 3.
The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2017:
The following table presents a reconciliation of the beginning and ending balances for all financial assets and liabilities measured at fair value on a recurring basis using Level 3 inputs for 2017 and 2016:
The Company uses various financial instruments in the normal course of its business. The carrying values of cash, accrued investment income, receivable for securities sold, certain other assets, payable for securities purchased and certain other liabilities approximated their fair values at December 31, 2017, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.
The Company’s derivative instruments can be traded under master netting agreements, which establish terms that apply to all derivative transactions with a counterparty. In the event of a bankruptcy or other stipulated event of default, such agreements provide that the non-defaulting party may elect to terminate all outstanding derivative transactions, in which case all individual derivative positions (loss or gain) with a counterparty are closed out and netted and replaced with a single amount, usually referred to as the termination amount, which is expressed in a single currency. The resulting single net amount, where positive, is payable to the party “in-the-money” regardless of whether or not it is the defaulting party, unless the parties have agreed that only the non-defaulting party is entitled to receive a termination payment where the net amount is positive and is in its favor. Effectively, contractual close-out netting reduces the derivatives credit exposure from a gross to a net exposure. At December 31, 2017, $40.6 million and $19.6 million, respectively, of asset derivatives and liability derivatives were subject to a master netting agreement compared to $28.4 million and $26.0 million, respectively, at December 31, 2016. The remaining derivatives
source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. Arch Capital and its non-U.S. subsidiaries will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors (subject to reduction by any applicable income tax treaty). Arch Capital and its non-U.S. subsidiaries intend to conduct their operations in a manner that will not cause them to be treated as engaged in a trade or business in the United States and, therefore, will not be required to pay U.S. federal income taxes (other than U.S. excise taxes on insurance and reinsurance premium and withholding taxes on dividends and certain other U.S. source investment income). However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that Arch Capital or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If Arch Capital or any of its non-U.S. subsidiaries
The effect of a change in tax laws or rates on deferred taxes assets and liabilities is recognized in income in the period in which such change is enacted. On December 22, 2017, the Tax Cuts Act was signed into law by the President of the United States which significantly changes the U.S. tax law in many way including a reduction of the U.S. federal income tax rate from 35% to 21% effective January 1, 2018. As a result of the Tax Cuts Act, the Company remeasured certain of its U.S. net deferred tax assets and liabilities.
The Company provides a valuation allowance to reduce certain deferred tax assets to an amount which management expects to more likely than not be realized. As of December 31, 2017, the Company’s valuation allowance was $30.6 million, compared to $17.0 million at December 31, 2016. The valuation allowance in both periods was primarily attributable to: (1) a full valuation allowance on the Company’s Canadian and Australian operations; (2) unutilized foreign tax credits; and (3) certain other deferred tax assets relating to loss carryforwards that have a limited use.
At December 31, 2017, the Company has net operating loss carryforwards in its U.K. operating subsidiaries of approximately $46.4 million. Additionally, the Company’s U.K. operations have a foreign tax credit carryforward of $6.3 million at December 31, 2017. These operating losses and foreign tax credits can be carried forward without expiration.
At December 31, 2017, net operating loss carryforwards in Hong Kong were approximately $9.5 million. Although these losses may be carried forward indefinitely the associated net deferred tax asset is offset by a valuation allowance of $1.5 million.
At December 31, 2017, net operating loss carryforwards in the U.S. were approximately $76.9 million. This includes $4.6 million net operating loss carryforwards from Watford Re. Watford Re’s $1.0 million deferred tax asset is fully offset by a valuation allowance. The Company’s net operating loss carryforwards are currently available to offset future taxable income of the Company’s U.S. subsidiaries. Under applicable law, the U.S. net operating loss carryforwards expire between 2029-2037.
On January 30, 2014, the Company’s U.S. mortgage operations underwent an ownership change for U.S. federal income tax purposes as a result of the Company’s acquisition of the CMG Entities. As a result of this ownership change, a limitation has been imposed upon the utilization of approximately $10.8 million of the Company’s existing U.S. net operating loss carryforwards. Utilization is limited to approximately $0.6 million per year in accordance with Section 382 of the Internal Revenue Code of 1986 as amended (“the Code”). Additionally, the Company has an AMT credit carryforward in the amount of $12.3 million which, beginning in 2018, and pursuant to the Tax Cuts Act, will either be available to offset the Company’s regular tax liability or refundable.
The Company’s U.S. mortgage operations are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Code for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is
allowed only to the extent that the Company purchases non-interest bearing U.S. Mortgage Guaranty Tax and Loss Bonds (“T&L Bonds”) issued by the U.S. Treasury Department in an amount equal to the tax benefit derived from deducting any portion of the statutory contingency reserves. T&L Bonds are reflected in ‘other assets’ on the Company’s balance sheet and totaled approximately $177.2 million at December 31, 2017, compared to $16.2 million at December 31, 2016.
The Company or its subsidiaries or branches files income tax returns in the U.S. federal jurisdiction and various state, local and foreign jurisdictions. The Company’s examination by the tax authorities in the U.S. for the 2009 through 2011 tax years closed with no change. The following table details open tax years that are potentially subject to examination by local tax
As of December 31, 2017, the Company’s current income tax recoverable (included in “Other assets”) was $104.8 million.
Kewsong Lee, a director of Arch Capital until November 2, 2017, resigned from Arch Capital’s Board of Directors because of the expansion of his duties at The Carlyle Group (“Carlyle”) following his promotion to co-CEO effective January 1, 2018. As part of its investment philosophy, the Company invests a portion of its investment portfolio in alternative investment funds. As of December 31, 2017, the total value of the Company’s investments in funds or other investments managed by Carlyle was approximately $293.0 million, and the Company had aggregate unfunded commitments to funds managed by Carlyle of $468.8 million. The Company may make additional commitments to funds managed by Carlyle from time to time. During 2017, 2016 and 2015, the Company made aggregate capital contributions to funds managed by Carlyle of $131.8 million, $62.1 million and $116.5 million, respectively. During 2017, 2016 and 2015, the Company received aggregate cash distributions from funds managed by Carlyle of $55.6 million, $21.5 million and $44.6 million, respectively.
The areas where significant concentrations of credit risk may exist include unpaid losses and loss adjustment expenses recoverable, contractholder receivables, ceded unearned
In addition, the Company underwrites a significant amount of its business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances owed to the Company. The following table summarizes the percentage of the Company’s gross premiums written generated from or placed by the largest brokers:
The Company’s available for sale investment portfolio is managed in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification, which limit the allowable holdings of any single issue. There were no investments in any entity in excess of 10% of the Company’s shareholders’ equity at December 31, 2017 other than investments issued or guaranteed by the United States government or its agencies.
The Company’s investment commitments, which are primarily related to agreements entered into by the Company to invest in funds and separately managed accounts when called upon, were approximately $1.70 billion and $1.29 billion at December 31, 2017 and 2016, respectively.
As of December 31, 2017, Arch Capital and certain of its subsidiaries had a $350.0 million secured facility for letters of credit and $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.
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.
In addition, certain of Arch Capital’s subsidiaries had outstanding letters of credit of $160.1 million, which were issued on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the “LOC Facilities”). The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which certain of Arch Capital’s subsidiaries has entered into reinsurance arrangements. This is required to ensure that such counterparties are permitted to take credit for reinsurance obtained in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of business and the loss experience of such business. When issued, these letters of credit are secured by a portion of the investment portfolio. Arch Capital and its’ subsidiaries which are party to the LOC Facilities were in compliance with all covenants contained in the LOC Facilities at December 31, 2017. At such date, approximately $324.4 million of letters of credit under the LOC Facilities were outstanding, which were secured by investments with a fair value of $388.0 million, and $375.0 million of borrowings were outstanding under the Credit Agreement. Under the $350.0 million secured letter of credit facility, Arch Capital’s subsidiaries had $164.3 million of letters of credit outstanding and remaining capacity of $185.7 million at December 31, 2017.
Watford Re has access to a $100 million letter of credit facility expiring on May 19, 2018 and an $800 million secured credit facility expiring on June 4, 2018, that provides for borrowings and the issuance of letters of credit not to exceed $400 million. Borrowings of revolving loans may be made by Watford Re at a variable rate based on LIBOR or an alternative base rate at the option of Watford Re. At December 31, 2017, Watford Re had $109.5 million in outstanding letters of credit under the two facilities and $441.1 million of borrowings outstanding under the secured credit facility, backed by Watford Re’s investment portfolio. Watford Re was in compliance with all covenants contained in both of its credit facilities at December 31, 2017. The Company does not guarantee or provide credit support for Watford Re, and the Company’s financial exposure to Watford
Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions.
At December 31, 2017, the future minimum rental commitments, exclusive of escalation clauses and maintenance costs and net of rental income, for all of the Company’s operating leases are as follows:
At December 31, 2017, the Company has entered into capital lease agreements. The future lease payments for the Company’s capital leases are expected to be $9.7 million, $5.6 million and $0.2 million for 2018, 2019 and 2020, respectively.
The Company has also entered into certain agreements which commit the Company to purchase goods or services, primarily related to software and computerized systems. Such purchase obligations were approximately $29.7 million and $24.8 million at December 31, 2017 and 2016, respectively.
(2) Senior notes of Arch-U.S., a wholly-owned subsidiary of Arch Capital, issued on December 13, 2013 and due November 1, 2043 (“2043 notes”), fully and unconditionally guaranteed by Arch Capital. The 2043 notes are unsecured and unsubordinated obligations of Arch-U.S. and Arch Capital, respectively, and rank equally and ratably with the other unsecured and unsubordinated indebtedness of Arch-U.S. and Arch Capital, respectively. Interest payments on the 2043 notes are due on May 1st and November 1st of each year. Arch-U.S. may redeem the 2043 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price.
(3) Senior notes of Arch Capital Finance LLC (“Arch Finance”), a wholly-owned finance subsidiary of Arch Capital, issued on December 8, 2016 and due December 15, 2026 (“2026 notes”), fully and unconditionally guaranteed by Arch Capital. The 2026 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 2026 notes are due on June 15th and December 15th of each year. Arch Finance may redeem the 2026 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price.
The estimated remaining useful lives of these assets range from one to nineteen years at December 31, 2017.
The authorized share capital of Arch Capital consists of 600 million Common Shares, par value of $0.0033 per share, and 50 million Preferred Shares, par value of $0.01 per share.
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.
On June 8, 2017, Arch Capital and AIG entered into Amendment No. 1 (the “Amendment”) to the Investor Rights Agreement (the “Investor Rights Agreement”) dated as of December 31, 2016 to amend the restrictions on transfers of the Series D Preferred Shares owned by AIG. Pursuant to the Amendment, Arch Capital permitted AIG to transfer: (i) 638,141 Series D Preferred Shares from and after June 8, 2017, and up to an additional 95,721 of the Series D Preferred Shares
In June 2017, Arch Capital completed an underwritten public secondary offering of 7,088,620 common shares by AIG following transfer of 708,862 Series D Preferred Shares. Proceeds from the sale of common shares pursuant to the public offering were received by AIG. At December 31, 2017, 567,420 Series D Preferred Shares were outstanding, representing 5,674,200 common share equivalents.
In August 2017 and November 2017, Arch Capital completed combined $330 million of underwritten public offerings ($230 million in August 2017 and $100 million in November 2017) of 13.2 million depositary shares (the “Series F Depositary Shares”), each of which represents a 1/1,000th interest in a share of its 5.45% Non-Cumulative Preferred Shares, Series F, have a $0.01 par value and $25,000 liquidation preference per share (equivalent to $25 liquidation preference per Series F Depositary Share) (the “Series F Preferred Shares”). Each Series F 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 F Preferred Shares represented thereby (including any dividend, liquidation, redemption and voting rights).
redeemed if and to the extent the related Series F Preferred Shares are redeemed by the Company. Neither the Series F Depositary Shares nor the Series F Preferred Shares have a stated maturity, nor will they be subject to any sinking fund or mandatory redemption. The Series F Preferred Shares are not convertible into any other securities. The Series F Preferred Shares will not have voting rights, except under limited circumstances. The net proceeds from the Series F Preferred Share offerings were used to redeem the Company’s outstanding 6.75% Series C Non-Cumulative Preferred Shares, as described below.
Except in specified circumstances relating to certain tax or corporate events, the Series E Preferred Shares are not redeemable prior to September 29, 2021 (the fifth anniversary of the issue date). On and after that date, the Series E 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 E Preferred Shares (equivalent to $25 per Series E Depositary Share), plus any declared and unpaid dividends, without accumulation of any undeclared dividends to, but excluding, the redemption date. The Series E Depositary Shares will be redeemed if and to the extent the related Series E Preferred Shares are redeemed by the Company. Neither the Series E Depositary Shares nor the Series E Preferred Shares have a stated maturity, nor will they be subject to any sinking fund or mandatory redemption. The Series E Preferred Shares are not convertible into any other securities. The Series E
On April 2, 2012, Arch Capital completed the underwritten public offering of $325.0 million of its 6.75% Series C non-cumulative preferred shares (“Series C Preferred Shares”). In the 2016 fourth quarter, Arch Capital repurchased 97,807 Series C preferred shares at a weighted average price of $25.48 per share ($2.5 million aggregate cost). In September 2017, the Company used the net proceeds from the August 2017 Series F Preferred Shares offering to redeem 9.2 million Series C Preferred Shares at $25 per share ($230 million aggregate cost). The preferred shares were redeemed at a redemption price equal to $25 per share, plus all declared and unpaid dividends to (but excluding) the redemption date. In accordance with GAAP, following the redemption, original issuance costs related to such shares have been removed from additional paid-in capital and recorded as a “loss on redemption of preferred shares.” Such adjustment had no impact on total shareholders’ equity or cash flows. On January 2, 2018, the net proceeds from the November 2017 Series F Preferred Shares offering were used to redeem the Company’s remaining outstanding Series C Preferred Shares.
The 2015 Long Term Incentive and Share Award Plan (the (“2015 Plan”) became effective as of May 7, 2015 following approval by shareholders of the Company. Officers, other employees and directors of Arch Capital and its subsidiaries will be eligible for grants of awards under the 2015 Plan. The 2015 Plan will terminate as to future awards on February 26, 2025.
The number of common shares reserved for grants of awards under the 2012 Plan, subject to anti-dilution adjustments in the event of certain changes in the Company’s capital structure is 7,433,924 which is the sum of (i) 4,280,000 and (ii) 3,153,924 shares remaining available for grants under the 2007 Plan. 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, 475,546 shares are available for grant under the 2012 Plan.
Upon shareholder approval on May 6, 2016, the Amended and Restated Arch Capital Group Ltd. 2007 Employee Share Purchase Plan (the “ESPP”) became effective. After the amendment and restatement, a total of 1,563,259 common shares were reserved for issuance. The purpose of the ESPP is to give employees of Arch Capital and its subsidiaries an opportunity to purchase common shares through payroll deductions, thereby encouraging employees to share in the economic growth and success of Arch Capital and its subsidiaries. The ESPP is designed to qualify as an “employee share purchase plan” under Section 423 of the Code. At December 31, 2017, approximately 1,209,876 shares remain available for issuance.
For purposes of determining estimated fair value, the Company has computed the estimated fair values of share-based compensation related to stock options and SARs using the Black-Scholes option valuation model and has applied the assumptions set forth in the following table. As described above, stock options and SARs generally vest over a three year period with one-third vesting on the first, second and third anniversaries of the grant date. The expected life assumption (i.e., the estimated period of time between the date an option or SAR is granted and the date the option or SAR is exercised) was based on an expected term analysis which incorporated the Company’s historical exercise experience. The Company based its estimate of expected volatility for stock options and SARs granted during 2017 on daily historical trading data of its common shares from September 20, 2002, the date marking the completion of the Company’s transition as a worldwide insurance and reinsurance company. For stock options and SARs granted during 2016 and 2015, the Company based its volatility estimate under the same method used for 2017, using the period from September 20, 2002 through the last day of the applicable period.
The Black-Scholes option pricing model requires the input of highly subjective assumptions. Because the Company’s employee stock options and SARs have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models may not provide a reliable single measure of the fair value of its employee stock options and SARs. In addition, management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation. Circumstances may change and additional data may become available over time, which could result in changes to these assumptions and methodologies, and
A summary of restricted share and restricted unit activity under the Company’s Long Term Incentive and Share Award Plans for 2017 is presented below:
The Company, in common with the insurance industry in general, is subject to litigation and arbitration in the normal course of its business. As of December 31, 2017, the Company was not a party to any litigation or arbitration which is expected by management to have a material adverse effect on the Company’s results of operations and financial condition and liquidity.
The actual and required statutory capital and surplus for the Company’s principal operating subsidiaries at December 31, 2017 and 2016:
The Company has two Bermuda based subsidiaries: Arch Re Bermuda, a Class 4 insurer and long-term insurer, and Watford Re, a Class 4 insurer. Under the Bermuda Insurance Act 1978 (the “Insurance Act”), these subsidiaries are required to maintain minimum statutory capital and surplus equal to the greater of a minimum solvency margin and the enhanced capital requirement as determined by the Bermuda Monetary Authority (“BMA”). The enhanced capital requirement is calculated based on the Bermuda Solvency Capital Requirement model, a risk-based model that takes into account the risk characteristics of different aspects of the company’s business. At December 31, 2017 and 2016, all such requirements were met.
The Company’s U.S. insurance and reinsurance subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate. The ability of the Company’s regulated insurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. These regulations include restrictions that limit the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities.
Dividends or distributions, if any, made by Arch Re U.S. would result in an increase in available capital at Arch-U.S., the Company’s U.S. holding company. Arch Re U.S. can declare a maximum of approximately $128.8 million of dividends during 2018 subject to the approval of the Commissioner of the Delaware Department of Insurance.
regulators, the Wisconsin Office of the Commissioner of Insurance (“Wisconsin OCI”) for Arch Mortgage Insurance Company and Arch Mortgage Guaranty Company, the North Carolina Department of Insurance (“NC DOI”) for United Guaranty Residential Insurance Company, and by state insurance departments in each state in which they are licensed. As mandated by state insurance laws, mortgage insurers are generally mono-line companies restricted to writing a single type of insurance business, such as mortgage insurance business. Each company is subject to either Wisconsin or North Carolina statutory requirements as to payment of dividends. Generally, both Wisconsin and North Carolina law precludes any dividend before giving at least 30 days’ notice to the Wisconsin OCI or NC DOI, as applicable, and prohibits paying any dividend unless it is fair and reasonable to do so. In addition, the state regulators and the GSEs limit or restrict our eligible mortgage insurers’ ability to pay stockholder dividends or otherwise return capital to shareholders. Under North Carolina law, United Guaranty Residential Insurance Company can declare a maximum of approximately $302.7 million of dividends during 2018 subject to the approval of the NC DOI. In certain instances, approval by the GSEs would be required for dividends or other forms of return of capital to shareholders due to the requirements under PMIERs, including the minimum required assets imposed on our eligible mortgage insurers by the GSEs. Such dividend would result in an increase in available capital at Arch U.S. MI Holdings Inc., a subsidiary of Arch-U.S.
licensed to carry-on reinsurance business by OSFI and in the provinces of Ontario and Quebec.
The following table summarizes the 2017 and 2016 unaudited condensed quarterly financial information:
The following tables present condensed consolidating balance sheets at December 31, 2017 and 2016 and condensed consolidating statements of income, comprehensive income and cash flows for 2017, 2016 and 2015 for Arch Capital, Arch-U.S., a 100% owned subsidiary of Arch Capital, and Arch Capital's other subsidiaries.