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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
 
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the quarterly period ended June 30, 2017
 
Or
 
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number:  001-16209

 archnewlogo11a16.jpg
ARCH CAPITAL GROUP LTD.
(Exact name of registrant as specified in its charter)

Bermuda
Not applicable
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
Waterloo House, Ground Floor
 
100 Pitts Bay Road, Pembroke HM 08, Bermuda
(441) 278-9250
(Address of principal executive offices)
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ     No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated Filer þ Accelerated Filer o Non-accelerated Filer o Smaller reporting
company o Emerging growth company o
If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o  
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No þ
As of August 1, 2017, there were 130,740,860 common shares, $0.0033 par value per share, of the registrant outstanding.



Table of Contents

ARCH CAPITAL GROUP LTD.
 
INDEX TO FORM 10-Q
 
 
 
 
Page No.
 
PART I
 
 
 
 
 2
Item 1.
 
 4
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
 
PART II
 
 
 
 
73 
Item 1.
 
Item 1A.
 
73 
Item 2.
 
Item 5.
 
Item 6.
 
 
 

 
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PART I.  FINANCIAL INFORMATION
Cautionary Note Regarding Forward-Looking Statements 
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This release or any other written or oral statements made by or on behalf of us may include forward-looking statements, which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this release are forward-looking statements. Forward-looking statements, for purposes of the PSLRA or otherwise, can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe” or “continue” and similar statements of a future or forward-looking nature or their negative or variations or similar terminology.
Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this release and in our periodic reports filed with the Securities and Exchange Commission (the “SEC”), and include:
our ability to successfully implement our business strategy during “soft” as well as “hard” markets;
acceptance of our business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and our insureds and reinsureds;
the integration of United Guaranty and any other businesses we have acquired or may acquire into our existing operations;
our ability to maintain or improve our ratings, which may be affected by our ability to raise additional equity or debt financings, by ratings agencies’ existing or new policies and practices, as well as other factors described herein;
general economic and market conditions (including inflation, interest rates, foreign currency exchange rates, prevailing credit terms and the depth and duration of a recession) and conditions specific to the reinsurance and insurance markets (including the length and magnitude of the current “soft” market) in which we operate;
competition, including increased competition, on the basis of pricing, capacity (including alternative forms of capital), coverage terms or other factors;
developments in the world’s financial and capital markets and our access to such markets;
our ability to successfully enhance, integrate and maintain operating procedures (including information technology) to effectively support our current and new business;
the loss of key personnel;
accuracy of those estimates and judgments utilized in the preparation of our financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation, and any determination to use the deposit method of accounting, which for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to us through June 30, 2017;
greater than expected loss ratios on business written by us and adverse development on claim and/or claim expense liabilities related to business written by our insurance and reinsurance subsidiaries;
severity and/or frequency of losses;
claims for natural or man-made catastrophic events in our insurance or reinsurance business could cause large losses and substantial volatility in our results of operations;
acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;
availability to us of reinsurance to manage our gross and net exposures and the cost of such reinsurance;
the failure of reinsurers, managing general agents, third party administrators or others to meet their obligations to us;
the timing of loss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us;
our investment performance, including legislative or regulatory developments that may adversely affect the fair value of our investments;

 
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changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, which could affect our business, financial condition and results of operations;
the volatility of our shareholders’ equity from foreign currency fluctuations, which could increase due to us not matching portions of our projected liabilities in foreign currencies with investments in the same currencies;
losses relating to aviation business and business produced by a certain managing underwriting agency for which we may be liable to the purchaser of our prior reinsurance business or to others in connection with the May 5, 2000 asset sale described in our periodic reports filed with the SEC;
changes in accounting principles or policies or in our application of such accounting principles or policies;
changes in the political environment of certain countries in which we operate or underwrite business;
statutory or regulatory developments, including as to tax policy and matters and insurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers and/or changes in regulations or tax laws applicable to us, our subsidiaries, brokers or customers; and
the other matters set forth under Item 1A “Risk Factors”, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of our Annual Report on Form 10-K for the year ended December 31, 2016, as well as the other factors set forth in our other documents on file with the SEC, and management’s response to any of the aforementioned factors.
 
All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. 


 
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ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
 
 
Page No.
 
 
 
 
 
 
 
 
 
June 30, 2017 (unaudited) and December 31, 2016
 
 
 
 
 
 
For the three and six month periods ended June 30, 2017 and 2016 (unaudited)
 
 
 
 
 
 
For the three and six month periods ended June 30, 2017 and 2016 (unaudited)
 
 
 
 
 
 
For the six month periods ended June 30, 2017 and 2016 (unaudited)
 
 
 
 
 
 
For the six month periods ended June 30, 2017 and 2016 (unaudited)
 
 
 
 
Notes to Consolidated Financial Statements (unaudited)
 
 
 
11 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 
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Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Shareholders of Arch Capital Group Ltd.:
 
We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. and its subsidiaries (the “Company”) as of June 30, 2017, and the related consolidated statements of income and comprehensive income for the three-month and six-month periods ended June 30, 2017 and June 30, 2016, and the consolidated statements of changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2017 and June 30, 2016. These interim financial statements are the responsibility of the Company’s management.
 
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
 
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
 
We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2016, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein), and in our report dated March 1, 2017, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2016, is fairly stated, in all material respects in relation to the consolidated balance sheet from which it has been derived.
 
/s/ PricewaterhouseCoopers LLP
 
August 4, 2017

 
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
 
 
June 30,
2017
 
December 31,
2016
Assets
 

 
 

Investments:
 

 
 

Fixed maturities available for sale, at fair value (amortized cost: $13,626,639 and $13,522,671)
$
13,671,011

 
$
13,426,577

Short-term investments available for sale, at fair value (amortized cost: $914,032 and $611,878)
914,356

 
612,005

Collateral received under securities lending, at fair value (amortized cost: $627,852 and $762,554)
627,843

 
762,565

Equity securities available for sale, at fair value (cost: $389,745 and $475,085)
461,017

 
518,041

Other investments available for sale, at fair value (cost: $208,941 and $149,077)
248,661

 
167,970

Investments accounted for using the fair value option
3,827,408

 
3,421,220

Investments accounted for using the equity method
948,856

 
811,273

Total investments
20,699,152

 
19,719,651

 
 
 
 
Cash
740,320

 
842,942

Accrued investment income
108,562

 
124,483

Securities pledged under securities lending, at fair value (amortized cost: $610,355 and $746,409)
610,121

 
744,980

Premiums receivable
1,314,564

 
1,072,435

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses
2,155,107

 
2,114,138

Contractholder receivables
1,826,966

 
1,717,436

Ceded unearned premiums
961,330

 
859,567

Deferred acquisition costs
506,748

 
447,560

Receivable for securities sold
212,512

 
58,284

Goodwill and intangible assets
712,975

 
781,553

Other assets
1,014,282

 
889,080

Total assets
$
30,862,639

 
$
29,372,109

 
 
 
 
Liabilities
 
 
 
Reserve for losses and loss adjustment expenses
$
10,520,511

 
$
10,200,960

Unearned premiums
3,679,651

 
3,406,870

Reinsurance balances payable
361,000

 
300,407

Contractholder payables
1,826,966

 
1,717,436

Collateral held for insured obligations
338,737

 
301,406

Senior notes
1,732,570

 
1,732,258

Revolving credit agreement borrowings
686,452

 
756,650

Securities lending payable
627,852

 
762,554

Payable for securities purchased
458,722

 
76,183

Other liabilities
648,099

 
806,260

Total liabilities
20,880,560

 
20,060,984

 
 
 
 
Commitments and Contingencies


 


Redeemable noncontrolling interests
205,736

 
205,553

 
 
 
 
Shareholders' Equity
 
 
 
Non-cumulative preferred shares
772,555

 
772,555

Convertible non-voting common equivalent preferred shares
489,627

 
1,101,304

Common shares ($0.0033 par, shares issued: 182,714,362 and 174,644,101)
609

 
582

Additional paid-in capital
1,196,884

 
531,687

Retained earnings
8,412,114

 
7,996,701

Accumulated other comprehensive income (loss), net of deferred income tax
78,441

 
(114,541
)
Common shares held in treasury, at cost (shares: 52,034,403 and 51,856,584)
(2,051,343
)
 
(2,034,570
)
Total shareholders' equity available to Arch
8,898,887

 
8,253,718

Non-redeemable noncontrolling interests
877,456

 
851,854

Total shareholders' equity
9,776,343

 
9,105,572

Total liabilities, noncontrolling interests and shareholders' equity
$
30,862,639

 
$
29,372,109


See Notes to Consolidated Financial Statements

 
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except share data)
 
(Unaudited)
 
(Unaudited)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Revenues
 

 
 

 
 

 
 

Net premiums written
$
1,248,695

 
$
1,023,563

 
$
2,524,955

 
$
2,144,798

Change in unearned premiums
(7,821
)
 
(17,578
)
 
(167,064
)
 
(187,234
)
Net premiums earned
1,240,874

 
1,005,985

 
2,357,891

 
1,957,564

Net investment income
111,124

 
88,338

 
228,998

 
182,073

Net realized gains (losses)
21,735

 
68,218

 
55,888

 
105,542

 
 
 
 
 
 
 
 
Other-than-temporary impairment losses
(1,730
)
 
(5,395
)
 
(3,537
)
 
(13,132
)
Less investment impairments recognized in other comprehensive income, before taxes

 
52

 

 
150

Net impairment losses recognized in earnings
(1,730
)
 
(5,343
)
 
(3,537
)
 
(12,982
)
 
 
 
 
 
 
 
 
Other underwriting income
4,822

 
25,224

 
9,455

 
30,271

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

 
8,737

 
80,794

 
15,392

Other income (loss)
(1,994
)
 
(7
)
 
(2,776
)
 
(32
)
Total revenues
1,407,537

 
1,191,152

 
2,726,713

 
2,277,828

 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
Losses and loss adjustment expenses
689,860

 
584,592

 
1,242,430

 
1,107,541

Acquisition expenses
190,436

 
172,677

 
372,725

 
340,515

Other operating expenses
169,981

 
157,314

 
344,700

 
307,462

Corporate expenses
24,876

 
17,200

 
52,668

 
26,583

Amortization of intangible assets
30,824

 
4,880

 
62,118

 
9,628

Interest expense
28,749

 
15,663

 
57,425

 
31,770

Net foreign exchange losses (gains)
39,543

 
(24,662
)
 
58,947

 
(1,096
)
Total expenses
1,174,269

 
927,664

 
2,191,013

 
1,822,403

 
 
 
 
 
 
 
 
Income before income taxes
233,268

 
263,488

 
535,700

 
455,425

Income tax expense
(34,169
)
 
(14,131
)
 
(62,566
)
 
(30,441
)
Net income
$
199,099

 
$
249,357

 
$
473,134

 
$
424,984

Net (income) loss attributable to noncontrolling interests
(13,932
)
 
(38,302
)
 
(34,840
)
 
(59,131
)
Net income available to Arch
185,167

 
211,055

 
438,294

 
365,853

Preferred dividends
(11,349
)
 
(5,485
)
 
(22,567
)
 
(10,969
)
Net income available to Arch common shareholders
$
173,818

 
$
205,570

 
$
415,727

 
$
354,884

 
 
 
 
 
 
 
 
Net income per common share and common share equivalent
 

 
 

 
 

 
 

Basic
$
1.29

 
$
1.70

 
$
3.10

 
$
2.94

Diluted
$
1.25

 
$
1.65

 
$
2.99

 
$
2.85

 
 
 
 
 
 
 
 
Weighted average common shares and common share equivalents outstanding
 
 
 
 
 

 
 

Basic
134,486,664

 
120,599,060

 
134,262,043

 
120,513,620

Diluted
139,244,646

 
124,365,596

 
139,140,632

 
124,425,126





See Notes to Consolidated Financial Statements

 
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)
 
(Unaudited)
 
(Unaudited)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Comprehensive Income
 
 
 
 
 

 
 

Net income
$
199,099

 
$
249,357

 
$
473,134

 
$
424,984

Other comprehensive income (loss), net of deferred income tax
 
 
 
 
 
 
 
Unrealized appreciation (decline) in value of available-for-sale investments:
 
 
 
 
 
 
 
Unrealized holding gains (losses) arising during period
92,969

 
102,460

 
193,761

 
235,441

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax

 
(52
)
 

 
(150
)
Reclassification of net realized (gains) losses, net of income taxes, included in net income
(17,224
)
 
(22,094
)
 
(22,268
)
 
(54,317
)
Foreign currency translation adjustments
18,297

 
(18,151
)
 
21,421

 
(838
)
Comprehensive income
293,141

 
311,520

 
666,048

 
605,120

Net (income) loss attributable to noncontrolling interests
(13,932
)
 
(38,302
)
 
(34,840
)
 
(59,131
)
Foreign currency translation adjustments attributable to noncontrolling interests
76

 
42

 
68

 
200

Comprehensive income available to Arch
$
279,285

 
$
273,260

 
$
631,276

 
$
546,189





See Notes to Consolidated Financial Statements

 
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
 
(Unaudited)
 
Six Months Ended
 
June 30,
 
2017
 
2016
Non-cumulative preferred shares
 

 
 

Balance at beginning and end of period
$
772,555

 
$
325,000

 
 
 
 
Convertible non-voting common equivalent preferred shares
 
 
 
Balance at beginning of year
1,101,304

 

Series D preferred shares issued

 

Series D preferred shares converted to common shares
(611,677
)
 

Balance at end of period
489,627

 

 
 
 
 
Common shares
 
 
 
Balance at beginning of year
582

 
577

Common shares issued, net
27

 
4

Balance at end of period
609

 
581

 
 
 
 
Additional paid-in capital
 

 
 

Balance at beginning of year
531,687

 
467,339

Common shares issued, net
9,027

 
8,265

Series D preferred shares converted to common shares
611,653

 

Exercise of stock options
2,125

 
5,143

Amortization of share-based compensation
42,739

 
35,769

Other
(347
)
 
1,426

Balance at end of period
1,196,884

 
517,942

 
 
 
 
Retained earnings
 

 
 

Balance at beginning of year
7,996,701

 
7,332,032

Cumulative effect of an accounting change
(314
)
 

Balance at beginning of year, as adjusted
7,996,387

 
7,332,032

Net income
473,134

 
424,984

Net (income) loss attributable to noncontrolling interests
(34,840
)
 
(59,131
)
Preferred share dividends
(22,567
)
 
(10,969
)
Balance at end of period
8,412,114

 
7,686,916

 
 
 
 
Accumulated other comprehensive income (loss), net of deferred income tax
 
 
 
Balance at beginning of year
(114,541
)
 
(16,502
)
Unrealized appreciation (decline) in value of available-for-sale investments, net of deferred income tax:
 
 
 
Balance at beginning of year
(27,641
)
 
50,085

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

 
181,124

Portion of other-than-temporary impairment losses recognized in other comprehensive income, net of deferred income tax

 
(150
)
Balance at end of period
143,852

 
231,059

Foreign currency translation adjustments:
 
 
 
Balance at beginning of year
(86,900
)
 
(66,587
)
Foreign currency translation adjustments
21,421

 
(838
)
Foreign currency translation adjustments attributable to noncontrolling interests
68

 
200

Balance at end of period
(65,411
)
 
(67,225
)
Balance at end of period
78,441

 
163,834

 
 
 
 
Common shares held in treasury, at cost
 
 
 
Balance at beginning of year
(2,034,570
)
 
(1,941,904
)
Shares repurchased for treasury
(16,773
)
 
(86,786
)
Balance at end of period
(2,051,343
)
 
(2,028,690
)
 
 
 
 
Total shareholders’ equity available to Arch
8,898,887

 
6,665,583

Non-redeemable noncontrolling interests
877,456

 
788,589

Total shareholders’ equity
$
9,776,343

 
$
7,454,172



See Notes to Consolidated Financial Statements

 
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
 
(Unaudited)
 
Six Months Ended
 
June 30,
 
2017
 
2016
Operating Activities
 

 
 

Net income
$
473,134

 
$
424,984

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Net realized (gains) losses
(74,985
)
 
(126,337
)
Net impairment losses recognized in earnings
3,537

 
12,982

Equity in net income or loss of investment funds accounted for using the equity method and other income or loss
(47,529
)
 
11,161

Amortization of intangible assets
62,118

 
9,628

Share-based compensation
42,739

 
35,769

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

 
186,199

Unearned premiums, net of ceded unearned premiums
167,064

 
187,234

Premiums receivable
(222,498
)
 
(278,814
)
Deferred acquisition costs
(53,553
)
 
(33,450
)
Reinsurance balances payable
50,112

 
73,712

Other items, net
(26,414
)
 
38,156

Net Cash Provided By Operating Activities
554,067

 
541,224

Investing Activities
 

 
 

Purchases of fixed maturity investments
(19,899,326
)
 
(17,541,731
)
Purchases of equity securities
(400,155
)
 
(212,678
)
Purchases of other investments
(883,704
)
 
(650,613
)
Proceeds from sales of fixed maturity investments
19,611,680

 
16,978,549

Proceeds from sales of equity securities
473,064

 
337,619

Proceeds from sales, redemptions and maturities of other investments
614,494

 
636,535

Proceeds from redemptions and maturities of fixed maturity investments
447,941

 
370,980

Net settlements of derivative instruments
(5,984
)
 
45,174

Net (purchases) sales of short-term investments
(445,203
)
 
(304,460
)
Change in cash collateral related to securities lending
175,693

 
(18,715
)
Acquisitions, net of cash

 
(1,460
)
Purchases of fixed assets
(11,103
)
 
(8,284
)
Other
(13,792
)
 
13,416

Net Cash Provided By (Used For) Investing Activities
(336,395
)
 
(355,668
)
Financing Activities
 

 
 

Purchases of common shares under share repurchase program

 
(75,256
)
Proceeds from common shares issued, net
(6,838
)
 
(1,487
)
Proceeds from borrowings

 
46,000

Repayments of borrowings
(72,000
)
 
(179,171
)
Change in cash collateral related to securities lending
(175,693
)
 
18,715

Dividends paid to redeemable noncontrolling interests
(8,994
)
 
(8,994
)
Other
(41,698
)
 
(2,223
)
Preferred dividends paid
(22,567
)
 
(10,969
)
Net Cash Provided By (Used For) Financing Activities
(327,790
)
 
(213,385
)
 
 
 
 
Effects of exchange rate changes on foreign currency cash
7,496

 
(8,906
)
 
 
 
 
Increase (decrease) in cash
(102,622
)
 
(36,735
)
Cash beginning of year
842,942

 
553,326

Cash end of period
$
740,320

 
$
516,591

 
 
 
 
Income taxes paid
$
3,935

 
$
26,619

Interest paid
$
58,035

 
$
31,524


See Notes to Consolidated Financial Statements

 
ACGL 2017 SECOND QUARTER FORM 10-Q
10

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


1.    General

Arch Capital Group Ltd. (“ACGL”) is a Bermuda public limited liability company which provides insurance and reinsurance on a worldwide basis through its wholly-owned subsidiaries. As used herein, the “Company” means ACGL and its subsidiaries. The Company’s consolidated financial statements include the results of Watford Holdings Ltd. and its wholly owned subsidiaries. See Note 3.
On December 31, 2016, the Company completed the acquisition of United Guaranty Corporation, a North Carolina corporation (“UGC”) pursuant to a stock purchase agreement with American International Group, Inc. (“AIG”). The acquisition of UGC (“UGC acquisition”) expanded the scale of Arch’s existing mortgage insurance businesses 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, further diversifying the Company’s business profile and customer base.
The interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of results on an interim basis. The results of any interim period are not necessarily indicative of the results for a full year or any future periods.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; however, management believes that the disclosures are adequate to make the information presented not misleading. This report should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 (“2016 Form 10-K”), including the Company’s audited consolidated financial statements and related notes.
The Company has reclassified the presentation of certain prior year information to conform to the current presentation, including the presentation of ‘amortization of intangible assets’ on its consolidated statements of income to split out such item
 
(previously reflected in acquisition expenses and/or other operating expenses). Such reclassifications had no effect on the Company’s net income, comprehensive income, shareholders’ equity or cash flows. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
2.    Recent Accounting Pronouncements

Recently Issued Accounting Standards Adopted
The Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standard Update (“ASU”) 2016-09, “Compensation - Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment Accounting,” effective January 1, 2017. This ASU was issued in the 2016 first quarter to improve and simplify the accounting for employee share-based payment transactions. This ASU provides simplifications with respect to income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows for these types of transactions. With respect to the forfeiture accounting policy election, the Company has elected to account for forfeitures as they occur, which did not result in a material cumulative effect adjustment. With respect to the change in presentation in the statement of cash flows related to excess tax benefits, the Company has applied the guidance prospectively and prior periods have not been adjusted.
Recently Issued Accounting Standards Not Yet Adopted
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 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 core principle of this ASU is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under the current guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The ASU also requires enhanced disclosures about revenue. The ASU is effective in the 2018 first quarter and may be applied on a full retrospective or modified retrospective approach. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated

 
ACGL 2017 SECOND QUARTER FORM 10-Q
11

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

financial statements. The adoption of this ASU will not impact the Company's insurance premium revenues or revenues from its investment portfolio, which represent a substantial portion of consolidated revenues, but may have an impact on the Company's other revenues.

ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities,” was issued in the 2016 first quarter to enhance the reporting model for financial instruments and to provide improved financial information to readers of the financial statements. Among other provisions focused on improving the recognition and measurement of financial instruments, the ASU requires that equity investments be measured at fair value on the balance sheet with changes in fair value reported in the income statement and that an exit price notion be used when measuring the fair value of financial instruments for disclosure purposes. The ASU is effective in the 2018 first quarter and, aside from limited situations, cannot be early adopted. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements. The adoption of this ASU is not expected to have a material impact on the Company's financial position, cash flows, or total comprehensive income, but will have a material impact on the Company's results of operations as changes in fair value of equity instruments will be presented in net income rather than other comprehensive income.

ASU 2016-18, "Statement of Cash Flows (Topic 230) - Restricted Cash " was issued in the 2016 fourth quarter. The ASU requires that restricted cash and restricted cash equivalents be included with cash and cash equivalents in the reconciliation of beginning and ending cash on the statements of cash flows. As a result, transfers between cash and cash equivalents and restricted cash and restricted cash equivalents will no longer be presented on the statement of cash flows. The ASU is effective, with retrospective adoption, for interim and annual periods beginning after December 15, 2017, with early adoption permitted. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements. The adoption of this ASU is not expected to have a material effect on the Company’s results of operations, financial position, comprehensive income or net cash provided from operating activities.

ASU 2017-08, “Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities,” was issued in the 2017 first quarter. The ASU amends the amortization period for certain purchased callable debt securities held at a premium by shortening the amortization period for the premium to the earliest call date. The ASU will be effective for the Company on January 1, 2019 and is required to be applied using a modified retrospective approach through a cumulative-effect adjustment to retained
 
earnings as of the beginning of the first reporting period in which the guidance is effective. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements. The adoption of this ASU is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.

ASU 2017-09, “Compensation - Stock Compensation (Topic 718) - Scope of Modification Accounting” was issued in the 2017 second quarter. The ASU provides updated guidance to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The ASU is effective prospectively for all companies for annual periods beginning on or after December 15, 2017, with early adoption permitted. The adoption of this ASU is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.

3.
Variable Interest Entities and Noncontrolling Interests

A variable interest entity (“VIE”) refers to an entity that has characteristics such as (i) insufficient equity at risk to allow the entity to finance its activities without additional financial support or (ii) instances where the equity investors, as a group, do not have characteristics of a controlling financial interest. The primary beneficiary of a VIE is defined as the variable interest holder that is determined to have the controlling financial interest as a result of having both (i) the power to direct the activities of a VIE that most significantly impact the economic performance of the VIE and (ii) the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. If a company is determined to be the primary beneficiary, it is required to consolidate the VIE in its financial statements.
Watford Holdings Ltd.
In March 2014, the Company invested $100.0 million and acquired approximately 11% of Watford Holdings Ltd.’s common equity and a warrant to purchase additional common equity. Watford Holdings Ltd. is the parent of Watford Re Ltd., a multi-line Bermuda reinsurance company (together with Watford Holdings Ltd., “Watford Re”). Watford Re is considered a VIE and the Company concluded that it is the primary beneficiary of Watford Re. As such, the results of Watford Re are included in the Company’s consolidated financial statements.
The Company does not guarantee or provide credit support for Watford Re, and the Company’s financial exposure to Watford

 
ACGL 2017 SECOND QUARTER FORM 10-Q
12

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

Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.
The following table provides the carrying amount and balance sheet caption in which the assets and liabilities of Watford Re are reported:
 
June 30,
 
December 31,

 
2017
 
2016
Assets
 
 
 
Investments accounted for using the fair value option
$
2,129,436

 
$
1,857,623

Cash
63,929

 
74,893

Accrued investment income
13,229

 
17,017

Premiums receivable
193,769

 
189,911

Reinsurance recoverable on unpaid and paid losses and LAE
28,267

 
24,420

Ceded unearned premiums
20,455

 
12,145

Deferred acquisition costs
91,183

 
86,379

Receivable for securities sold
32,618

 
1,326

Goodwill and intangible assets
7,650

 
7,650

Other assets
132,068

 
111,386

Total assets of consolidated VIE
$
2,712,604

 
$
2,382,750

 
 
 
 
Liabilities
 
 
 
Reserves for losses and loss adjustment expenses
$
643,424

 
$
510,809

Unearned premiums
314,446

 
293,480

Reinsurance balances payable
17,623

 
12,289

Revolving credit agreement borrowings
186,452

 
256,650

Payable for securities purchased
224,152

 
42,922

Other liabilities
119,928

 
88,976

Total liabilities of consolidated VIE
$
1,506,025

 
$
1,205,126

 
 
 
 
Redeemable noncontrolling interests
$
220,436

 
$
220,253

For the six months ended June 30, 2017, Watford Re generated $134.4 million of cash provided by operating activities, $70.1 million of cash used for investing activities and $76.4 million of cash used for financing activities, compared to $131.6 million of cash provided by operating activities, $13.8 million of cash used for investing activities and $148.2 million of cash used for financing activities for the six months ended June 30, 2016.
Non-redeemable noncontrolling interests
The Company accounts for the portion of Watford Re’s common equity attributable to third party investors in the shareholders’ equity section of its consolidated balance sheets. The noncontrolling ownership in Watford Re’s common shares was approximately 89% at June 30, 2017. The portion of Watford Re’s income or loss attributable to third party investors is recorded in the consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests.’
 
The following table sets forth activity in the non-redeemable noncontrolling interests:
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Balance, beginning of period
$
868,186

 
$
754,915

Amounts attributable to noncontrolling interests
9,346

 
33,716

Foreign currency translation adjustments attributable to noncontrolling interests
(76
)
 
(42
)
Balance, end of period
$
877,456

 
$
788,589

 
 
 
 
Six Months Ended
 
 
 
Balance, beginning of year
$
851,854

 
$
738,831

Amounts attributable to noncontrolling interests
25,670

 
49,958

Foreign currency translation adjustments attributable to noncontrolling interests
(68
)
 
(200
)
Balance, end of period
$
877,456

 
$
788,589

Redeemable noncontrolling interests
The Company accounts for redeemable noncontrolling interests in the mezzanine section of its consolidated balance sheets in accordance with applicable accounting guidance. Such redeemable noncontrolling interests relate to the 9,065,200 cumulative redeemable preference shares (“Watford Preference Shares”) issued in March 2014 with a par value of $0.01 per share and a liquidation preference of $25.00 per share. Preferred dividends, including the accretion of the discount and issuance costs, are included in ‘net (income) loss attributable to noncontrolling interests’ in the Company’s consolidated statements of income.
The following table sets forth activity in the redeemable non-controlling interests:
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Balance, beginning of period
$
205,644

 
$
205,274

Accretion of preference share issuance costs
92

 
92

Balance, end of period
$
205,736

 
$
205,366

 
 
 
 
Six Months Ended
 
 
 
Balance, beginning of year
$
205,553

 
$
205,182

Accretion of preference share issuance costs
183

 
184

Balance, end of period
$
205,736

 
$
205,366


 
ACGL 2017 SECOND QUARTER FORM 10-Q
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Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The portion of Watford Re’s income or loss attributable to third party investors, recorded in the Company’s consolidated statements of income in ‘net (income) loss attributable to noncontrolling interests,’ are summarized in the table below:
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Amounts attributable to non-redeemable noncontrolling interests
$
(9,346
)
 
$
(33,716
)
Dividends attributable to redeemable noncontrolling interests
(4,586
)
 
(4,586
)
Net (income) loss attributable to noncontrolling interests
$
(13,932
)
 
$
(38,302
)
 
 
 
 
Six Months Ended
 
 
 
Amounts attributable to non-redeemable noncontrolling interests
$
(25,670
)
 
$
(49,958
)
Dividends attributable to redeemable noncontrolling interests
(9,170
)
 
(9,173
)
Net (income) loss attributable to noncontrolling interests
$
(34,840
)
 
$
(59,131
)
Bellemeade Re I and II
Upon closing of the UGC acquisition, the Company acquired the rights and obligations related to aggregate excess of loss reinsurance agreements with Bellemeade Re I Ltd. (“Bellemeade I”), entered into in July 2015, and with Bellemeade Re II Ltd. (“Bellemeade II”), entered into in May 2016 (the “Bellemeade Agreements”). Bellemeade I and Bellemeade II are special purpose reinsurance companies domiciled in Bermuda, each of which 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.
As a result of the evaluation of the Bellemeade Agreements, the Company concluded that both Bellemeade I and Bellemeade II are VIEs. However, given that the ceding insurers do not have the unilateral power to direct those activities that are significant to the economic performance of Bellemeade I and Bellemeade II, the Company does not consolidate Bellemeade I and Bellemeade II in its consolidated financial statements.
The following table presents total assets of Bellemeade I and Bellemeade II as well as the Company’s maximum exposure to loss associated with these VIEs:
 
 
 
Maximum Exposure to Loss
 
Total VIE Assets
 
On-Balance Sheet
 
Off-Balance Sheet
 
Total
Bellemeade I
$
129,475

 
$
489

 
$
1,165

 
$
1,654

Bellemeade II
238,310

 
58

 
929

 
987

Total
$
367,785

 
$
547

 
$
2,094

 
$
2,641

 
Irving Partners Limited Partnership
Upon closing of the UGC acquisition, the Company acquired a limited partnership interest in Irving Partners Limited Partnership (“Irving Partners”), which owns and operates an office building in Greensboro, North Carolina in which the Company is the main tenant. The Company concluded that Irving Partners is a VIE but that it is not the primary beneficiary. The Company’s maximum exposure to loss is approximately $13.9 million at June 30, 2017.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
14

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

4.    Earnings Per Common Share

The following table sets forth the computation of basic and diluted earnings per common share:
 
Three Months Ended

Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Numerator:
 
 
 
 
 
 
 
Net income
$
199,099

 
$
249,357

 
$
473,134

 
$
424,984

Amounts attributable to noncontrolling interests
(13,932
)
 
(38,302
)
 
(34,840
)
 
(59,131
)
Net income available to Arch
185,167

 
211,055

 
438,294

 
365,853

Preferred dividends
(11,349
)
 
(5,485
)
 
(22,567
)
 
(10,969
)
Net income available to Arch common shareholders
$
173,818

 
$
205,570

 
$
415,727

 
$
354,884

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding
123,009,234

 
120,599,060

 
122,145,469

 
120,513,620

Series D preferred shares (1)
11,477,430

 

 
12,116,574

 

Weighted average common shares and common share equivalents outstanding — basic
134,486,664

 
120,599,060

 
134,262,043

 
120,513,620

Effect of dilutive common share equivalents:
 
 
 
 
 
 
 
Nonvested restricted shares
1,482,963

 
1,295,342

 
1,556,963

 
1,374,272

Stock options (2)
3,275,019

 
2,471,194

 
3,321,626

 
2,537,234

Weighted average common shares and common share equivalents outstanding — diluted
139,244,646

 
124,365,596

 
139,140,632

 
124,425,126

 
 
 
 
 
 
 
 
Earnings per common share:
 
 
 
 
 
 
 
Basic
$
1.29

 
$
1.70

 
$
3.10

 
$
2.94

Diluted
$
1.25

 
$
1.65

 
$
2.99

 
$
2.85

(1)
Such shares are convertible non-voting common equivalent preferred shares issued in connection with the UGC acquisition.
(2)
Certain stock options were not included in the computation of diluted earnings per share where the exercise price of the stock options exceeded the average market price and would have been anti-dilutive or where, when applying the treasury stock method to in-the-money options, the sum of the proceeds, including unrecognized compensation, exceeded the average market price and would have been anti-dilutive. For the 2017 second quarter and 2016 second quarter, the number of stock options excluded were 499,999 and 575,931, respectively. For the six months ended June 30, 2017 and 2016, the number of stock options excluded were 764,076 and 1,027,784, respectively.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
15

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

5.    Segment Information

The Company classifies its businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — ‘other’ and corporate (non-underwriting). The Company determined its reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of the Company’s consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.
The Company’s insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to the Company’s chief operating decision makers, the Chairman and Chief Executive Officer, the President and Chief Operating Officer, and the Chief Financial Officer of ACGL. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. Management measures segment performance for its three underwriting segments based on underwriting income or loss. The Company does not manage its assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.
The insurance segment consists of the Company’s insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: construction and national accounts; excess and surplus casualty; lenders products; professional lines; programs; property, energy, marine and aviation; travel, accident and health; and other (consisting of alternative markets, excess workers' compensation and surety business).
The reinsurance segment consists of the Company’s reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include: casualty; marine and aviation; other specialty; property catastrophe; property excluding property catastrophe (losses on a single risk, both excess of loss and pro rata); and other (consisting of life reinsurance, casualty clash and other).
The mortgage segment includes the Company’s U.S. and international mortgage insurance and reinsurance operations as well as government sponsored enterprise (“GSE”) credit-risk sharing transactions. Arch Mortgage Insurance Company, United Guaranty Residential Insurance Company and United Guaranty Mortgage Indemnity Company (combined “Arch MI U.S.”) are approved as eligible mortgage insurers by Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), each a GSE.
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, UGC transaction costs and other, interest expense, dividends related to the Company’s non-cumulative preferred shares, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and income taxes. Such amounts exclude the results of the ‘other’ segment.
The ‘other’ segment includes the results of Watford Re (see Note 3). Watford Re has its own management and board of directors that is responsible for the overall profitability of the ‘other’ segment. For the ‘other’ segment, performance is measured based on net income or loss.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
16

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

The following tables summarize the Company’s underwriting income or loss by segment, together with a reconciliation of underwriting income or loss to net income available to common shareholders:
 
Three Months Ended
 
June 30, 2017
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
743,902

 
$
453,186

 
$
336,226

 
$
1,533,142

 
$
152,813

 
$
1,609,659

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

 
337,924

 
273,912

 
1,108,292

 
140,403

 
1,248,695

Change in unearned premiums
21,118

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

 
(7,821
)
Net premiums earned
517,574

 
314,702

 
257,844

 
1,090,120

 
150,754

 
1,240,874

Other underwriting income (loss)

 
(279
)
 
4,277

 
3,998

 
824

 
4,822

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

 
$
183,611

 
198,062

 
(2,643
)
 
195,419

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
92,520

 
18,604

 
111,124

Net realized gains (losses)
 
 
 
 
 
 
18,046

 
3,689

 
21,735

Net impairment losses recognized in earnings
 
 
 
 
 
 
(1,730
)
 

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

 

 
32,706

Other income (loss)
 
 
 
 
 
 
(1,994
)
 

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

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

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

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

 
15,091

 
233,268

Income tax expense
 
 
 
 
 
 
(34,169
)
 

 
(34,169
)
Net income (loss)
 
 
 
 
 
 
184,008

 
15,091

 
199,099

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

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

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

 
1,159

 
185,167

Preferred dividends
 
 
 
 
 
 
(11,349
)
 

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

 
$
1,159

 
$
173,818

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

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

 
$
609

 
$
680,236

 
$
705,325

 
$
7,650

 
$
712,975

(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(2)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’


 
ACGL 2017 SECOND QUARTER FORM 10-Q
17

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

 
Three Months Ended
 
June 30, 2016
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
762,043

 
$
412,053

 
$
118,434

 
$
1,292,199

 
$
109,285

 
$
1,329,936

Premiums ceded
(246,875
)
 
(119,951
)
 
(6,969
)
 
(373,464
)
 
(4,457
)
 
(306,373
)
Net premiums written
515,168

 
292,102

 
111,465

 
918,735

 
104,828

 
1,023,563

Change in unearned premiums
12,482

 
(846
)
 
(44,953
)
 
(33,317
)
 
15,739

 
(17,578
)
Net premiums earned
527,650

 
291,256

 
66,512

 
885,418

 
120,567

 
1,005,985

Other underwriting income (loss)

 
20,118

 
4,137

 
24,255

 
969

 
25,224

Losses and loss adjustment expenses
(354,633
)
 
(146,091
)
 
(366
)
 
(501,090
)
 
(83,502
)
 
(584,592
)
Acquisition expenses
(77,312
)
 
(55,756
)
 
(5,964
)
 
(139,032
)
 
(33,645
)
 
(172,677
)
Other operating expenses
(91,440
)
 
(36,914
)
 
(22,847
)
 
(151,201
)
 
(6,113
)
 
(157,314
)
Underwriting income (loss)
$
4,265

 
$
72,613

 
$
41,472

 
118,350

 
(1,724
)
 
116,626

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
70,397

 
17,941

 
88,338

Net realized gains (losses)
 
 
 
 
 
 
40,927

 
27,291

 
68,218

Net impairment losses recognized in earnings
 
 
 
 
 
 
(5,343
)
 

 
(5,343
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
8,737

 

 
8,737

Other income (loss)
 
 
 
 
 
 
(7
)
 

 
(7
)
Corporate expenses
 
 
 
 
 
 
(17,200
)
 

 
(17,200
)
Amortization of intangible assets
 
 
 
 
 
 
(4,880
)
 

 
(4,880
)
Interest expense
 
 
 
 
 
 
(12,432
)
 
(3,231
)
 
(15,663
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
22,461

 
2,201

 
24,662

Income (loss) before income taxes
 
 
 
 
 
 
221,010

 
42,478

 
263,488

Income tax expense
 
 
 
 
 
 
(14,131
)
 

 
(14,131
)
Net income (loss)
 
 
 
 
 
 
206,879

 
42,478

 
249,357

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

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

 
(33,716
)
 
(33,716
)
Net income (loss) available to Arch
 
 
 
 
 
 
206,879

 
4,176

 
211,055

Preferred dividends
 
 
 
 
 
 
(5,485
)
 

 
(5,485
)
Net income (loss) available to Arch common shareholders
 
 
 
 
 
 
$
201,394

 
$
4,176

 
$
205,570

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
 

 
 
 
 

 
 

Loss ratio
67.2
%
 
50.2
%
 
0.6
%
 
56.6
%
 
69.3
%
 
58.1
%
Acquisition expense ratio
14.7
%
 
19.1
%
 
9.0
%
 
15.7
%
 
27.9
%
 
17.2
%
Other operating expense ratio
17.3
%
 
12.7
%
 
34.4
%
 
17.1
%
 
5.1
%
 
15.6
%
Combined ratio
99.2
%
 
82.0
%
 
44.0
%
 
89.4
%
 
102.3
%
 
90.9
%
 
 
 
 
 
 
 
 
 
 
 
 
Goodwill and intangible assets
$
27,457

 
$
1,440

 
$
59,430

 
$
88,327

 
$

 
$
88,327


(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.


 
ACGL 2017 SECOND QUARTER FORM 10-Q
18

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

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

 
$
928,968

 
$
684,849

 
$
3,139,828

 
$
306,933

 
$
3,267,649

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

 
647,614

 
548,610

 
2,240,866

 
284,089

 
2,524,955

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

 
559,553

 
502,367

 
2,085,140

 
272,751

 
2,357,891

Other underwriting income (loss)

 
(585
)
 
8,400

 
7,815

 
1,640

 
9,455

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

 
$
74,366

 
$
332,556

 
412,429

 
(4,938
)
 
407,491

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
188,332

 
40,666

 
228,998

Net realized gains (losses)
 
 
 
 
 
 
46,558

 
9,330

 
55,888

Net impairment losses recognized in earnings
 
 
 
 
 
 
(3,537
)
 

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

 

 
80,794

Other income (loss)
 
 
 
 
 
 
(2,776
)
 

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

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

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

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

 
38,020

 
535,700

Income tax expense
 
 
 
 
 
 
(62,566
)
 

 
(62,566
)
Net income (loss)
 
 
 
 
 
 
435,114

 
38,020

 
473,134

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

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

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

 
3,180

 
438,294

Preferred dividends
 
 
 
 
 
 
(22,567
)
 

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

 
$
3,180

 
$
415,727

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

(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.
(2)
Certain expenses have been excluded from ‘corporate expenses’ and reflected in ‘UGC transaction costs and other.’


 
ACGL 2017 SECOND QUARTER FORM 10-Q
19

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

 
Six Months Ended
 
June 30, 2016
 
Insurance
 
Reinsurance
 
Mortgage
 
Sub-Total
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
Gross premiums written (1)
$
1,560,596

 
$
893,443

 
$
229,714

 
$
2,683,260

 
$
257,891

 
$
2,767,902

Premiums ceded
(495,664
)
 
(280,517
)
 
(11,736
)
 
(787,424
)
 
(8,929
)
 
(623,104
)
Net premiums written
1,064,932

 
612,926

 
217,978

 
1,895,836

 
248,962

 
2,144,798

Change in unearned premiums
(24,193
)
 
(60,462
)
 
(89,701
)
 
(174,356
)
 
(12,878
)
 
(187,234
)
Net premiums earned
1,040,739

 
552,464

 
128,277

 
1,721,480

 
236,084

 
1,957,564

Other underwriting income (loss)

 
20,443

 
7,930

 
28,373

 
1,898

 
30,271

Losses and loss adjustment expenses
(678,242
)
 
(257,689
)
 
(8,995
)
 
(944,926
)
 
(162,615
)
 
(1,107,541
)
Acquisition expenses
(151,660
)
 
(110,514
)
 
(11,757
)
 
(273,931
)
 
(66,584
)
 
(340,515
)
Other operating expenses
(176,498
)
 
(73,172
)
 
(46,341
)
 
(296,011
)
 
(11,451
)
 
(307,462
)
Underwriting income (loss)
$
34,339

 
$
131,532

 
$
69,114

 
234,985

 
(2,668
)
 
232,317

 
 
 
 
 
 
 
 
 
 
 
 
Net investment income
 
 
 
 
 
 
140,806

 
41,267

 
182,073

Net realized gains (losses)
 
 
 
 
 
 
72,789

 
32,753

 
105,542

Net impairment losses recognized in earnings
 
 
 
 
 
 
(12,982
)
 

 
(12,982
)
Equity in net income (loss) of investment funds accounted for using the equity method
 
 
 
 
 
 
15,392

 

 
15,392

Other income (loss)
 
 
 
 
 
 
(32
)
 

 
(32
)
Corporate expenses
 
 
 
 
 
 
(26,583
)
 

 
(26,583
)
Amortization of intangible assets
 
 
 
 
 
 
(9,628
)
 

 
(9,628
)
Interest expense
 
 
 
 
 
 
(25,059
)
 
(6,711
)
 
(31,770
)
Net foreign exchange gains (losses)
 
 
 
 
 
 
420

 
676

 
1,096

Income (loss) before income taxes
 
 
 
 
 
 
390,108

 
65,317

 
455,425

Income tax expense
 
 
 
 
 
 
(30,441
)
 

 
(30,441
)
Net income (loss)
 
 
 
 
 
 
359,667

 
65,317

 
424,984

Dividends attributable to redeemable noncontrolling interests
 
 
 
 
 
 

 
(9,173
)
 
(9,173
)
Amounts attributable to nonredeemable noncontrolling interests
 
 
 
 
 
 

 
(49,958
)
 
(49,958
)
Net income (loss) available to Arch
 
 
 
 
 
 
359,667

 
6,186

 
365,853

Preferred dividends
 
 
 
 
 
 
(10,969
)
 

 
(10,969
)
Net income (loss) available to Arch common shareholders
 
 
 
 
 
 
$
348,698

 
$
6,186

 
$
354,884

 
 
 
 
 
 
 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
 
 
 
 
 
 
 
Loss ratio
65.2
%
 
46.6
%
 
7.0
%
 
54.9
%
 
68.9
%
 
56.6
%
Acquisition expense ratio
14.6
%
 
20.0
%
 
9.2
%
 
15.9
%
 
28.2
%
 
17.4
%
Other operating expense ratio
17.0
%
 
13.2
%
 
36.1
%
 
17.2
%
 
4.9
%
 
15.7
%
Combined ratio
96.8
%
 
79.8
%
 
52.3
%
 
88.0
%
 
102.0
%
 
89.7
%

(1)
Certain amounts included in the gross premiums written of each segment are related to intersegment transactions. Accordingly, the sum of gross premiums written for each segment does not agree to the total gross premiums written as shown in the table above due to the elimination of intersegment transactions in the total.



 
ACGL 2017 SECOND QUARTER FORM 10-Q
20

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

6.    Reserve for Losses and Loss Adjustment Expenses

The following table represents an analysis of losses and loss adjustment expenses and a reconciliation of the beginning and ending reserve for losses and loss adjustment expenses:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Reserve for losses and loss adjustment expenses at beginning of period
$
10,296,821

 
$
9,378,987

 
$
10,200,960

 
$
9,125,250

Unpaid losses and loss adjustment expenses recoverable
2,095,130

 
1,937,724

 
2,083,575

 
1,828,837

Net reserve for losses and loss adjustment expenses at beginning of period
8,201,691

 
7,441,263

 
8,117,385

 
7,296,413

 
 
 
 
 
 
 
 
Net incurred losses and loss adjustment expenses relating to losses occurring in:
 
 
 
 
 
 
 
Current year
759,261

 
670,381

 
1,395,037

 
1,249,359

Prior years
(69,401
)
 
(85,789
)
 
(152,607
)
 
(141,818
)
Total net incurred losses and loss adjustment expenses
689,860

 
584,592

 
1,242,430

 
1,107,541

 
 
 
 
 
 
 
 
Net foreign exchange losses (gains)
75,295

 
(48,328
)
 
106,574

 
(14,733
)
 
 
 
 
 
 
 
 
Net paid losses and loss adjustment expenses relating to losses occurring in:
 
 
 
 
 
 
 
Current year
(80,499
)
 
(107,957
)
 
(115,502
)
 
(157,036
)
Prior years
(482,046
)
 
(401,691
)
 
(946,586
)
 
(764,306
)
Total net paid losses and loss adjustment expenses
(562,545
)
 
(509,648
)
 
(1,062,088
)
 
(921,342
)
 
 
 
 
 
 
 
 
Net reserve for losses and loss adjustment expenses at end of period
8,404,301

 
7,467,879

 
8,404,301

 
7,467,879

Unpaid losses and loss adjustment expenses recoverable
2,116,210

 
2,003,768

 
2,116,210

 
2,003,768

Reserve for losses and loss adjustment expenses at end of period
$
10,520,511

 
$
9,471,647

 
$
10,520,511

 
$
9,471,647

Development on Prior Year Loss Reserves

2017 Second Quarter

During the 2017 second quarter, the Company recorded net favorable development on prior year loss reserves of $69.4 million, which consisted of $39.5 million from the reinsurance segment, $2.0 million from the insurance segment, $29.8 million from the mortgage segment and adverse development of $1.9 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $39.5 million, or 12.6 points, for the 2017 second quarter consisted of $28.1 million from short-tailed lines and $11.4 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $16.9 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years (i.e., all premiums and losses attributable to contracts having an inception or renewal date within the given twelve-month period), reflecting lower levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed and medium-tailed lines reflected reductions in casualty reserves of $9.0 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2004 underwriting years, and favorable development in marine reserves of $2.4 million across most underwriting years.
 
The insurance segment’s net favorable development of $2.0 million, or 0.4 points, for the 2017 second quarter consisted of $5.3 million of net favorable development in short-tailed lines, partially offset by $3.3 million of net adverse development in long-tailed and medium-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2012 to 2016 accident years (i.e., the year in which a loss occurred). Net adverse development in medium-tailed and long-tailed lines reflected $12.2 million of adverse development on programs, primarily on a small number of programs in the 2014 and 2015 accident years, and $8.9 million on construction reserves across various accident years. Such amounts were partially offset by net favorable development of $17.8 million in other medium-tailed lines, primarily in professional liability with $12.1 million of favorable development across most accident years, and surety with $3.6 million of favorable development.
The mortgage segment’s net favorable development was $29.8 million, or 11.5 points, for the 2017 second quarter. The 2017 second quarter development was primarily driven by continued lower than expected claim emergence across most origination years and also reflected $4.9 million related to subrogation recoveries on second lien and other portfolios.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
21

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

2016 Second Quarter
During the 2016 second quarter, the Company recorded net favorable development on prior year loss reserves of $85.8 million, which consisted of $69.8 million from the reinsurance segment, $4.9 million from the insurance segment, $11.1 million from the mortgage segment and minimal activity from the ‘other’ segment.
The reinsurance segment’s net favorable development of $69.8 million, or 24.0 points, for the 2016 second quarter consisted of $48.9 million from short-tailed lines and $20.9 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $39.5 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years, reflecting lower levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed lines reflected reductions in casualty reserves of $22.8 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2009 underwriting years and 2012 to 2013 underwriting years.
The insurance segment’s net favorable development of $4.9 million, or 0.9 points, for the 2016 second quarter consisted of $8.1 million of net favorable development in long-tailed lines and $6.5 million of net favorable development in short-tailed lines, partially offset by $9.7 million of net adverse development in medium-tailed lines. Net favorable development in long-tailed lines reflected net reductions in executive assurance reserves from the 2008 to 2012 accident years (i.e., the year in which a loss occurred), and net reductions in casualty reserves from the 2004 to 2012 accident years, offset by a large energy casualty claim from the 2015 accident year. Net favorable development in short-tailed lines primarily resulted from reductions in property (including special risk other than marine) reserves from the 2012 to 2014 accident years and the 2008 accident year, primarily due to varying levels of reported claims activity. Such amount included $4.1 million of favorable development on the 2005 to 2015 named catastrophic events. Net adverse development in medium-tailed lines primarily resulted from an increase in programs of $16.4 million stemming in part from terminated programs, partially offset by favorable development of $6.7 million in other medium-tailed lines, primarily in professional liability and surety.
The mortgage segment’s net favorable development was $11.1 million, or 16.6 points, for the 2016 second quarter. The 2016 second quarter development was primarily driven by lower than expected claim rates across most origination years.
Six Months Ended June 30, 2017
During the six months ended June 30, 2017, the Company recorded net favorable development on prior year loss reserves
 
of $152.6 million, which consisted of $96.8 million from the reinsurance segment, $4.1 million from the insurance segment, $53.4 million from the mortgage segment and adverse development of $1.7 million from the ‘other’ segment.
The reinsurance segment’s net favorable development of $96.8 million, or 17.3 points, for the 2017 period consisted of $68.9 million from short-tailed lines and $27.9 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $51.0 million from property catastrophe and property other than property catastrophe reserves, across most underwriting years, reflecting lower levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during the period. Favorable development in long-tailed and medium-tailed lines reflected reductions in casualty reserves of $15.6 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2013 underwriting years, and favorable development in marine reserves of $12.3 million across most underwriting years.
The insurance segment’s net favorable development of $4.1 million, or 0.4 points, for the 2017 period consisted of $7.2 million of net favorable development in short-tailed lines and $6.6 million of net favorable development in long-tailed lines, partially offset by $9.7 million of net adverse development in medium-tailed lines. Net favorable development in short-tailed lines primarily resulted from property (including special risk other than marine) reserves from the 2011 to 2016 accident years. Net favorable development in long-tailed lines reflected net reductions in executive assurance reserves from the 2008 to 2014 accident years and reductions in healthcare reserves across various accident years, partially offset by $13.4 million on construction reserves across various accident years. Net adverse development in medium-tailed lines primarily resulted from an increase in programs of $26.4 million stemming in part from development on a small number of programs in the 2013 to 2015 accident years, partially offset by net favorable development of $16.7 million in other medium-tailed lines, primarily in professional liability and surety.
The mortgage segment’s net favorable development was $53.4 million, or 10.6 points, for the 2017 period. The development was primarily driven by continued lower than expected claim emergence across most origination years and also reflected $13.1 million related to subrogation recoveries on second lien and other portfolios.
Six Months Ended June 30, 2016
During the six months ended June 30, 2016, the Company recorded net favorable development on prior year loss reserves of $141.8 million, which consisted of $117.2 million from the reinsurance segment, $11.1 million from the insurance segment, $13.8 million from the mortgage segment and adverse development of $0.2 million from the ‘other’ segment.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
22

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

The reinsurance segment’s net favorable development of $117.2 million, or 21.2 points, for the 2016 period consisted of $85.4 million from short-tailed lines and $31.8 million from long-tailed and medium-tailed lines. Favorable development in short-tailed lines included $69.4 million from property catastrophe and property other than property catastrophe reserves, across most 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 the period. Favorable development in long-tailed lines reflected reductions in casualty reserves of $37.0 million based on varying levels of reported and paid claims activity, primarily from the 2002 to 2013 underwriting years. Such amounts were partially offset by net adverse development on marine reserves of $3.9 million, primarily from the 2002 and 2015 underwriting years, partially offset by favorable development from most other underwriting years.
The insurance segment’s net favorable development of $11.1 million, or 1.1 points, for the 2016 period consisted of $18.0 million of net favorable development in long-tailed lines and $10.2 million of net favorable development in short-tailed lines, partially offset by $17.1 million of net adverse development in medium-tailed lines. Net favorable development in long-tailed lines reflected net reductions in executive assurance reserves from the 2008 to 2012 accident years, and net reductions in casualty reserves from the 2004 to 2013 accident years, partially offset by a large energy casualty claim from the 2015 accident year. Net favorable development in short-tailed lines primarily resulted from reductions in property (including special risk other than marine) reserves from the 2012 to 2014 accident years, primarily due to varying levels of reported claims activity. Such amount included $7.3 million of favorable development on the 2005 to 2015 named catastrophic events. Net adverse development in medium-tailed lines primarily resulted from an increase in programs of $22.4 million stemming in part from terminated programs, partially offset by favorable development of $5.3 million in other medium-tailed lines, primarily in professional liability and surety.
The mortgage segment’s net favorable development was $13.8 million, or 10.8 points, for the 2016 period. The development was primarily driven by lower than expected claim rates across most origination years.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
23

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

7.    Investment Information


At June 30, 2017, total investable assets of $21.11 billion included $19.17 billion managed by the Company and $1.93 billion attributable to Watford Re.
Available For Sale Investments
The following table summarizes the fair value and cost or amortized cost of the Company’s investments classified as available for sale:
 
Estimated
Fair
Value
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Cost or
Amortized
Cost
 
OTTI
Unrealized
Losses (2)
June 30, 2017
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
Corporate bonds
$
4,262,411

 
$
42,142

 
$
(23,632
)
 
$
4,243,901

 
$
(468
)
Mortgage backed securities
331,082

 
4,650

 
(1,596
)
 
328,028

 
(3,102
)
Municipal bonds
2,618,827

 
29,728

 
(9,841
)
 
2,598,940

 

Commercial mortgage backed securities
521,272

 
3,448

 
(6,363
)
 
524,187

 

U.S. government and government agencies
3,425,196

 
4,673

 
(15,246
)
 
3,435,769

 

Non-U.S. government securities
1,375,796

 
30,114

 
(21,466
)
 
1,367,148

 

Asset backed securities
1,739,695

 
10,540

 
(4,494
)
 
1,733,649

 
(22
)
Total
14,274,279

 
125,295

 
(82,638
)
 
14,231,622

 
(3,592
)
Equity securities
467,870

 
79,953

 
(7,200
)
 
395,117

 

Other investments
248,661

 
39,748

 
(28
)
 
208,941

 

Short-term investments
914,356

 
446

 
(122
)
 
914,032

 

Total
$
15,905,166

 
$
245,442

 
$
(89,988
)
 
$
15,749,712

 
$
(3,592
)
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
Corporate bonds
$
4,392,373

 
$
27,606

 
$
(46,905
)
 
$
4,411,672

 
$
(2,285
)
Mortgage backed securities
490,093

 
4,794

 
(8,357
)
 
493,656

 
(3,323
)
Municipal bonds
3,713,434

 
8,554

 
(29,154
)
 
3,734,034

 
(201
)
Commercial mortgage backed securities
536,051

 
2,876

 
(6,508
)
 
539,683

 

U.S. government and government agencies
2,804,540

 
9,319

 
(24,437
)
 
2,819,658

 

Non-U.S. government securities
1,096,440

 
19,036

 
(56,872
)
 
1,134,276

 

Asset backed securities
1,123,987

 
6,897

 
(6,526
)
 
1,123,616

 
(22
)
Total
14,156,918

 
79,082

 
(178,759
)
 
14,256,595

 
(5,831
)
Equity securities
532,680

 
62,627

 
(17,517
)
 
487,570

 

Other investments
167,970

 
21,358

 
(2,465
)
 
149,077

 

Short-term investments
612,005

 
272

 
(145
)
 
611,878

 

Total
$
15,469,573

 
$
163,339

 
$
(198,886
)
 
$
15,505,120

 
$
(5,831
)
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the securities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See “—Securities Lending Agreements.”
(2)
Represents the total other-than-temporary impairments (“OTTI”) recognized in accumulated other comprehensive income (“AOCI”). It does not include the change in fair value subsequent to the impairment measurement date. At June 30, 2017, the net unrealized gain related to securities for which a non-credit OTTI was recognized in AOCI was $0.8 million, compared to a net unrealized gain of $2.8 million at December 31, 2016.


 
ACGL 2017 SECOND QUARTER FORM 10-Q
24

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

The following table summarizes, for all available for sale securities in an unrealized loss position, the fair value and gross unrealized loss by length of time the security has been in a continual unrealized loss position:
 
Less than 12 Months
 
12 Months or More
 
Total
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Losses
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
 
 
Corporate bonds
$
1,384,481

 
$
(22,572
)
 
$
15,198

 
$
(1,060
)
 
$
1,399,679

 
$
(23,632
)
Mortgage backed securities
189,816

 
(1,534
)
 
1,573

 
(62
)
 
191,389

 
(1,596
)
Municipal bonds
788,714

 
(9,329
)
 
39,912

 
(512
)
 
828,626

 
(9,841
)
Commercial mortgage backed securities
249,658

 
(6,232
)
 
3,383

 
(131
)
 
253,041

 
(6,363
)
U.S. government and government agencies
2,662,818

 
(15,246
)
 

 

 
2,662,818

 
(15,246
)
Non-U.S. government securities
1,017,781

 
(21,360
)
 
11,123

 
(106
)
 
1,028,904

 
(21,466
)
Asset backed securities
751,464

 
(4,220
)
 
12,282

 
(274
)
 
763,746

 
(4,494
)
Total
7,044,732

 
(80,493
)
 
83,471

 
(2,145
)
 
7,128,203

 
(82,638
)
Equity securities
167,176

 
(7,200
)
 

 

 
167,176

 
(7,200
)
Other investments
1,562

 
(28
)
 

 

 
1,562

 
(28
)
Short-term investments
22,941

 
(122
)
 

 

 
22,941

 
(122
)
Total
$
7,236,411

 
$
(87,843
)
 
$
83,471

 
$
(2,145
)
 
$
7,319,882

 
$
(89,988
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
Fixed maturities (1):
 
 
 
 
 
 
 
 
 
 
 
Corporate bonds
$
1,700,813

 
$
(43,011
)
 
$
46,902

 
$
(3,894
)
 
$
1,747,715

 
$
(46,905
)
Mortgage backed securities
402,699

 
(8,134
)
 
6,105

 
(223
)
 
408,804

 
(8,357
)
Municipal bonds
1,513,308

 
(28,504
)
 
29,636

 
(650
)
 
1,542,944

 
(29,154
)
Commercial mortgage backed securities
231,374

 
(6,331
)
 
5,635

 
(177
)
 
237,009

 
(6,508
)
U.S. government and government agencies
1,888,018

 
(24,437
)
 

 

 
1,888,018

 
(24,437
)
Non-U.S. government securities
807,598

 
(56,872
)
 

 

 
807,598

 
(56,872
)
Asset backed securities
627,557

 
(5,465
)
 
65,723

 
(1,061
)
 
693,280

 
(6,526
)
Total
7,171,367

 
(172,754
)
 
154,001

 
(6,005
)
 
7,325,368

 
(178,759
)
Equity securities
269,381

 
(17,517
)
 

 

 
269,381

 
(17,517
)
Other investments
39,299

 
(2,465
)
 

 

 
39,299

 
(2,465
)
Short-term investments
29,146

 
(145
)
 

 

 
29,146

 
(145
)
Total
$
7,509,193

 
$
(192,881
)
 
$
154,001

 
$
(6,005
)
 
$
7,663,194

 
$
(198,886
)
(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the securities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See “—Securities Lending Agreements.”

At June 30, 2017, on a lot level basis, approximately 3,150 security lots out of a total of approximately 7,610 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 $2.5 million. 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.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
25

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

The contractual maturities of the Company’s fixed maturities are shown in the following table. Expected maturities, which are management’s best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
June 30, 2017
 
December 31, 2016
Maturity
 
Estimated
Fair
Value
 
Amortized
Cost
 
Estimated
Fair
Value
 
Amortized
Cost
Due in one year or less
 
$
580,006

 
$
579,694

 
$
560,830

 
$
557,675

Due after one year through five years
 
7,240,600

 
7,222,772

 
6,158,148

 
6,211,099

Due after five years through 10 years
 
3,542,222

 
3,528,439

 
4,676,847

 
4,710,017

Due after 10 years
 
319,402

 
314,853

 
610,962

 
620,849

 
 
11,682,230

 
11,645,758

 
12,006,787

 
12,099,640

Mortgage backed securities
 
331,082

 
328,028

 
490,093

 
493,656

Commercial mortgage backed securities
 
521,272

 
524,187

 
536,051

 
539,683

Asset backed securities
 
1,739,695

 
1,733,649

 
1,123,987

 
1,123,616

Total (1)
 
$
14,274,279

 
$
14,231,622

 
$
14,156,918

 
$
14,256,595

(1)
In securities lending transactions, the Company receives collateral in excess of the fair value of the securities pledged. For purposes of this table, the Company has excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. See “—Securities Lending Agreements.”
 
Securities Lending Agreements
The Company enters into securities lending agreements with financial institutions to enhance investment income whereby it loans certain of its securities to third parties, primarily major brokerage firms, for short periods of time through a lending agent. The Company maintains legal control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the securities. An indemnification agreement with the lending agent protects the Company in the event a borrower becomes insolvent or fails to return any of the securities on loan from the Company.
The Company receives collateral in the form of cash or securities. At June 30, 2017, the fair value of the cash collateral received on securities lending was $36.7 million and the fair value of security collateral received was $591.1 million. At December 31, 2016, the fair value of the cash collateral received on securities lending was $212.5 million, and the fair value of security collateral received was $550.1 million. Cash collateral is reinvested in short-term investments.
The Company’s securities lending transactions were accounted for as secured borrowings with significant investment categories as follows:
 
 
Remaining Contractual Maturity of the Agreements
 
 
Overnight and Continuous
 
Less than 30 Days
 
30-90 Days
 
90 Days or More
 
Total
June 30, 2017
 
 
 
 
 
 
 
 
 
 
U.S. government and government agencies
 
$
406,753

 
$
10,175

 
$
133,449

 
$
29,984

 
$
580,361

Corporate bonds
 
40,488

 

 

 

 
40,488

Equity securities
 
7,003

 

 

 

 
7,003

Total
 
$
454,244

 
$
10,175

 
$
133,449

 
$
29,984

 
$
627,852

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

Amounts related to securities lending not included in offsetting disclosure in Note 9
 
$
627,852

 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
U.S. government and government agencies
 
$
556,015

 
$
31,244

 
$
126,093

 
$
5,140

 
$
718,492

Corporate bonds
 
29,078

 

 

 

 
29,078

Equity securities
 
14,984

 

 

 

 
14,984

Total
 
$
600,077

 
$
31,244

 
$
126,093

 
$
5,140

 
$
762,554

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

Amounts related to securities lending not included in offsetting disclosure in Note 9
 
$
762,554


 
ACGL 2017 SECOND QUARTER FORM 10-Q
26

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

Other Investments
The following table summarizes the Company’s other investments, including available for sale and fair value option components:
 
June 30,
2017
 
December 31,
2016
Available for sale:
 
 
 
Asian and emerging markets
$
114,594

 
$
84,778

Investment grade fixed income
52,266

 
33,923

Credit related funds
14,632

 
7,469

Other
67,169

 
41,800

Total available for sale
248,661

 
167,970

Fair value option:
 
 
 
Term loan investments (par value: $1,367,178 and $1,208,537)
1,334,590

 
1,190,799

Mezzanine debt funds
141,066

 
127,943

Credit related funds
197,144

 
218,298

Investment grade fixed income
86,389

 
75,468

Asian and emerging markets
245,866

 
178,568

Other (1)
138,710

 
129,717

Total fair value option
2,143,765

 
1,920,793

Total
$
2,392,426

 
$
2,088,763

(1)
Includes fund investments with strategies in mortgage servicing rights, transportation, infrastructure and other.

Certain of the Company’s other investments are in investment funds for which the Company has the option to redeem at agreed upon values as described in each investment fund’s subscription agreement. Depending on the terms of the various subscription agreements, investments in investment funds may be redeemed daily, monthly, quarterly or on other terms. Two common redemption restrictions which may impact the Company’s ability to redeem these investment funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the investment fund’s net assets which may otherwise hinder the general partner or investment manager’s ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. If the investment funds are eligible to be redeemed, the time to redeem such fund can take weeks or months following the notification.
 
Fair Value Option 
The following table summarizes the Company’s assets and liabilities which are accounted for using the fair value option:
 
June 30,
2017
 
December 31,
2016
Fixed maturities
$
1,074,961

 
$
1,099,116

Other investments
2,143,765

 
1,920,793

Short-term investments
527,384

 
373,669

Equity securities
81,298

 
27,642

Investments accounted for using the fair value option
$
3,827,408

 
$
3,421,220

Limited partnership interests
In the normal course of its activities, the Company invests in limited partnerships as part of its overall investment strategy. Such amounts are included in ‘investments accounted for using the equity method’ and ‘investments accounted for using the fair value option.’ The Company has determined that it is not required to consolidate these investments because it is not the primary beneficiary of the funds. The Company’s maximum exposure to loss with respect to these investments is limited to the investment carrying amounts reported in the Company’s consolidated balance sheet and any unfunded commitment.
The following table summarizes investments in limited partnership interests where the Company has a variable interest by balance sheet line item:
 
June 30,
2017
 
December 31,
2016
Investments accounted for using the equity method (1)
$
948,856

 
$
800,970

Investments accounted for using the fair value option (2)
86,888

 
90,804

Total
$
1,035,744

 
$
891,774

(1)
Aggregate unfunded commitments were $961.0 million at June 30, 2017, compared to $776.6 million at December 31, 2016.
(2)
Aggregate unfunded commitments were $67.7 million at June 30, 2017, compared to $16.7 million at December 31, 2016.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
27

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

Net Investment Income
The components of net investment income were derived from the following sources:
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Fixed maturities
$
94,270

 
$
77,994

Term loan investments
19,105

 
18,608

Equity securities (dividends)
3,654

 
3,663

Short-term investments
2,016

 
816

Other (1)
14,971

 
8,260

Gross investment income
134,016

 
109,341

Investment expenses
(22,892
)
 
(21,003
)
Net investment income
$
111,124

 
$
88,338

 
 
 
 
Six Months Ended
 
 
 
Fixed maturities
$
188,663

 
$
151,667

Term loan investments
40,275

 
38,620

Equity securities (dividends)
6,297

 
7,098

Short-term investments
3,775

 
1,312

Other (1)
33,381

 
22,003

Gross investment income
272,391

 
220,700

Investment expenses
(43,393
)
 
(38,627
)
Net investment income
$
228,998

 
$
182,073

(1)
Includes income distributions from investment funds and other items.
 
Net Realized Gains (Losses)
Net realized gains (losses) were as follows, excluding other than-temporary impairment provision.
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Available for sale securities:
 

 
 

Gross gains on investment sales
$
76,730

 
$
74,695

Gross losses on investment sales
(52,619
)
 
(43,293
)
Change in fair value of assets and liabilities accounted for using the fair value option:
 
 
 
Fixed maturities
9,656

 
18,632

Other investments
637

 
13,136

Equity securities
2,829

 
401

Short-term investments
3,328

 
(621
)
Derivative instruments (1)
(4,770
)
 
20,334

Other (2)
(14,056
)
 
(15,066
)
Net realized gains (losses)
$
21,735

 
$
68,218

 
 
 
 
Six Months Ended
 
 
 
Available for sale securities:
 
 
 
Gross gains on investment sales
$
145,905

 
$
182,514

Gross losses on investment sales
(113,981
)
 
(106,424
)
Change in fair value of assets and liabilities accounted for using the fair value option:
 
 
 
Fixed maturities
30,197

 
18,299

Other investments
17,885

 
(8,412
)
Equity securities
6,374

 
437

Short-term investments
3,332

 
(1,043
)
Derivative instruments (1)
(13,951
)
 
41,066

Other (2)
(19,873
)
 
(20,895
)
Net realized gains (losses)
$
55,888

 
$
105,542

(1)
See Note 9 for information on the Company’s derivative instruments.
(2)
Includes the re-measurement of contingent consideration liability amounts.

Equity in Net Income (Loss) of Investment Funds Accounted for Using the Equity Method
The Company recorded $32.7 million of equity in net income related to investment funds accounted for using the equity method in the 2017 second quarter, compared to $8.7 million for the 2016 second quarter, and $80.8 million for the six months ended June 30, 2017, compared to $15.4 million for the 2016 period. In applying the equity method, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). Such investments are generally recorded on a one to three month lag based on the availability of reports from the investment funds.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
28

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

Other-Than-Temporary Impairments
The Company performs quarterly reviews of its available for sale investments in order to determine whether declines in fair value below the amortized cost basis were considered other-than-temporary in accordance with applicable guidance.
The following table details the net impairment losses recognized in earnings by asset class:
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Fixed maturities:
 

 
 

Mortgage backed securities
$
(92
)
 
$
(82
)
Corporate bonds
(1,401
)
 
(775
)
Non-U.S. government securities

 
(51
)
Asset backed securities

 
(2,500
)
Municipal bonds
(173
)
 

Total
(1,666
)
 
(3,408
)
Equity securities

 
(1,935
)
Other investments
(64
)
 

Net impairment losses recognized in earnings
$
(1,730
)
 
$
(5,343
)
 
 
 
 
Six Months Ended
 
 
 
Fixed maturities:
 
 
 
Mortgage backed securities
$
(1,411
)
 
$
(555
)
Corporate bonds
(1,402
)
 
(5,655
)
Non-U.S. government securities
(198
)
 
(232
)
Asset backed securities

 
(2,506
)
Municipal bonds
(173
)
 

Total
(3,184
)
 
(8,948
)
Equity securities
(186
)
 
(3,037
)
Other investments
(167
)
 
(997
)
Net impairment losses recognized in earnings
$
(3,537
)
 
$
(12,982
)
 
Net impairment losses recognized in earnings in the 2017 second quarter were primarily related to foreign currency fluctuations on corporate bonds. For the six months ended June 30, 2017, net impairment losses recognized in earnings 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 believes that the $3.6 million of OTTI included in accumulated other comprehensive income at June 30, 2017 on the securities which were considered by the Company to be impaired was due to market and sector-related factors (i.e., not credit losses). At June 30, 2017, the Company did not intend to sell these securities, or any other securities which were in an unrealized loss position, and determined that it is more likely than not that the Company will not be required to sell such securities before recovery of their cost basis.
 
The following table provides a roll forward of the amount related to credit losses recognized in earnings for which a portion of an OTTI was recognized in accumulated other comprehensive income:
 
June 30,
 
2017
 
2016
Three Months Ended
 
 
 
Balance at start of period
$
12,537

 
$
18,291

Credit loss impairments recognized on securities not previously impaired
31

 
287

Credit loss impairments recognized on securities previously impaired
172

 

Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security

 

Reductions for securities sold during the period
(8,303
)
 
(3,731
)
Balance at end of period
$
4,437

 
$
14,847

 
 
 
 
Six Months Ended
 
 
 
Balance at start of year
$
13,138

 
$
26,875

Credit loss impairments recognized on securities not previously impaired
31

 
1,350

Credit loss impairments recognized on securities previously impaired
195

 
522

Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security

 

Reductions for securities sold during the period
(8,927
)
 
(13,900
)
Balance at end of period
$
4,437

 
$
14,847

Restricted Assets
The Company is required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support its insurance and reinsurance operations. The Company’s insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. See Note 10 for further details.
The following table details the value of the Company’s restricted assets:
 
June 30,
2017
 
December 31,
2016
Assets used for collateral or guarantees:
 

 
 

Affiliated transactions
$
4,003,009

 
$
3,871,971

Third party agreements
1,672,159

 
1,513,079

Deposits with U.S. regulatory authorities
618,448

 
472,890

Deposits with non-U.S. regulatory authorities
45,493

 
44,399

Total restricted assets
$
6,339,109

 
$
5,902,339


 
ACGL 2017 SECOND QUARTER FORM 10-Q
29

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

8.    Fair Value

Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).
The levels in the hierarchy are defined as follows:
Level 1:
Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets
Level 2:
Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument
Level 3:
Inputs to the valuation methodology are unobservable and significant to the fair value measurement
Following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy. The Company reviews its securities measured at fair value and discusses the proper classification of such investments with investment advisers and others.
The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. To validate the techniques or models used by pricing sources, the Company's review process includes, but is not limited to: (i) quantitative analysis (e.g.,
 
comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value; (iv) a comparison of the fair value estimates to the Company’s knowledge of the current market; (v) a comparison of the pricing services' fair values to other pricing services' fair values for the same investments; and (vi) periodic back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. A price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value. The Company did not adjust any of the prices obtained from the independent pricing sources at June 30, 2017.
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 $19.92 billion of financial assets and liabilities measured at fair value at June 30, 2017, approximately $140.9 million, or 0.7%, were priced using non-binding broker-dealer quotes. Of the $19.10 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.
Fixed maturities
The Company uses the market approach valuation technique to estimate the fair value of its fixed maturity securities, when possible. The market approach includes obtaining prices from independent pricing services, such as index providers and pricing vendors, as well as to a lesser extent quotes from broker-dealers. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
30

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

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

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

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

 
ACGL 2017 SECOND QUARTER FORM 10-Q
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Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the Company’s financial assets and liabilities measured at fair value by level at June 30, 2017:
 
 
 
Estimated Fair Value Measurements Using:
 
Estimated
Fair
Value
 
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets measured at fair value (1):
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities:
 

 
 

 
 

 
 

Corporate bonds
$
4,262,411

 
$

 
$
4,250,841

 
$
11,570

Mortgage backed securities
331,082

 

 
331,082

 

Municipal bonds
2,618,827

 

 
2,618,827

 

Commercial mortgage backed securities
521,272

 

 
521,272

 

U.S. government and government agencies
3,425,196

 
3,360,752

 
64,444

 

Non-U.S. government securities
1,375,796

 

 
1,375,796

 

Asset backed securities
1,739,695

 

 
1,739,695

 

Total
14,274,279

 
3,360,752

 
10,901,957

 
11,570

 
 
 
 
 
 
 
 
Equity securities
467,870

 
463,015

 
4,855

 

 
 
 
 
 
 
 
 
Short-term investments
914,356

 
906,191

 
8,165

 

 
 
 
 
 
 
 
 
Other investments
170,402

 
170,402

 

 

Other investments measured at net asset value (2)
78,259

 
 
 
 
 
 
Total other investments
248,661

 
170,402

 

 

 
 
 
 
 
 
 
 
Derivative instruments (4)
30,215

 

 
30,215

 

 
 
 
 
 
 
 
 
Fair value option:
 
 
 
 
 
 
 
Corporate bonds
749,399

 

 
749,399

 

Non-U.S. government bonds
75,084

 

 
75,084

 

Mortgage backed securities
19,812

 

 
19,812

 

Asset backed securities
16,291

 

 
16,291

 

U.S. government and government agencies
209,583

 
209,583

 

 

Short-term investments
527,384

 
524,167

 
3,217

 

Equity securities
76,915

 
57,523

 
19,392

 

Other investments
1,392,973

 
92,860

 
1,275,113

 
25,000

Other investments measured at net asset value (2)
750,792

 
 
 
 
 
 
Total
3,818,233

 
884,133

 
2,158,308

 
25,000

 
 
 
 
 
 
 
 
Total assets measured at fair value
$
19,753,614

 
$
5,784,493

 
$
13,103,500

 
$
36,570

 
 
 
 
 
 
 
 
Liabilities measured at fair value:
 

 
 

 
 

 
 

Contingent consideration liabilities
$
(57,246
)
 
$

 
$

 
$
(57,246
)
Securities sold but not yet purchased (3)
(69,273
)
 

 
(69,273
)
 

Derivative instruments (4)
(35,004
)
 

 
(35,004
)
 

Total liabilities measured at fair value
$
(161,523
)
 
$

 
$
(104,277
)
 
$
(57,246
)

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

 
ACGL 2017 SECOND QUARTER FORM 10-Q
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Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2016:
 
 
 
Estimated Fair Value Measurements Using:
 
Estimated
Fair
Value
 
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Assets measured at fair value (1):
 

 
 

 
 

 
 

Available for sale securities:
 

 
 

 
 

 
 

Fixed maturities:
 

 
 

 
 

 
 

Corporate bonds
$
4,392,373

 
$

 
$
4,374,029

 
$
18,344

Mortgage backed securities
490,093

 

 
490,093

 

Municipal bonds
3,713,434

 

 
3,713,434

 

Commercial mortgage backed securities
536,051

 

 
536,051

 

U.S. government and government agencies
2,804,540

 
2,691,575

 
112,965

 

Non-U.S. government securities
1,096,440

 

 
1,096,440

 

Asset backed securities
1,123,987

 

 
1,112,698

 
11,289

Total
14,156,918

 
2,691,575

 
11,435,710

 
29,633

 
 
 
 
 
 
 
 
Equity securities
532,680

 
529,695

 
2,985

 

 
 
 
 
 
 
 
 
Short-term investments
612,005

 
608,862

 
3,143

 

 
 
 
 
 
 
 
 
Other investments
112,313

 
112,313

 

 

Other investments measured at net asset value (2)
55,657

 
 
 
 
 
 
Total other investments
167,970

 
112,313

 

 

 
 
 
 
 
 
 
 
Derivative instruments (4)
28,410

 

 
28,410

 

 
 
 
 
 
 
 
 
Fair value option:
 
 
 
 
 
 
 
Corporate bonds
790,935

 

 
790,935

 

Non-U.S. government bonds
61,747

 

 
61,747

 

Mortgage backed securities
18,624

 

 
18,624

 

Asset backed securities
30,324

 

 
30,324

 

U.S. government and government agencies
197,486

 
197,486

 

 

Short-term investments
373,669

 
309,127

 
64,542

 

Equity securities
27,642

 
25,328

 
2,314

 

Other investments
1,226,242

 
80,706

 
1,120,536

 
25,000

Other investments measured at net asset value (2)
694,551

 
 
 
 
 
 
Total
3,421,220

 
612,647

 
2,089,022

 
25,000

 
 
 
 
 
 
 
 
Total assets measured at fair value
$
18,919,203

 
$
4,555,092

 
$
13,559,270

 
$
54,633

 
 
 
 
 
 
 
 
Liabilities measured at fair value:
 

 
 

 
 

 
 

Contingent consideration liabilities
$
(122,350
)
 
$

 
$

 
$
(122,350
)
Securities sold but not yet purchased (3)
(33,157
)
 

 
(33,157
)
 

Derivative instruments (4)
(26,049
)
 

 
(26,049
)
 

Total liabilities measured at fair value
$
(181,556
)
 
$

 
$
(59,206
)
 
$
(122,350
)

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


 
ACGL 2017 SECOND QUARTER FORM 10-Q
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Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The following table presents a reconciliation of the beginning and ending balances for all financial assets and liabilities measured at fair value on a recurring basis using Level 3 inputs:
 
Assets
 
Liabilities
s
Available For Sale
 
Fair Value Option
 
 
 
 
 
Asset Backed Securities
 
Corporate
Bonds
 
Other
Investments
 
Total
 
Contingent Consideration Liabilities
Three Months Ended June 30, 2017
 
 
 

 
 

 
 
 
 
Balance at beginning of period
$
10,637

 
$
18,601

 
$
25,000

 
$
54,238

 
$
(125,544
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)
3,072

 
636

 

 
3,708

 
(3,441
)
Included in other comprehensive income

 

 

 

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 
4,935

 

 
4,935

 

Issuances

 

 

 

 

Sales
(13,640
)
 
(12,602
)
 

 
(26,242
)
 

Settlements
(69
)
 

 

 
(69
)
 
71,739

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$

 
$
11,570

 
$
25,000

 
$
36,570

 
$
(57,246
)
 
 
 
 
 
 
 
 
 
 
Three Months Ended June 30, 2016
 
 
 

 
 

 
 

 
 
Balance at beginning of period
$
57,500

 
$
15,166

 
$

 
$
72,666

 
$
(100,710
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)
(2,500
)
 
1,363

 

 
(1,137
)
 
(10,923
)
Included in other comprehensive income

 

 

 

 
(37
)
Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 
776

 

 
776

 

Issuances

 

 

 

 

Sales

 

 

 

 

Settlements
(5,789
)
 

 

 
(5,789
)
 

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$
49,211

 
$
17,305

 
$

 
$
66,516

 
$
(111,670
)
 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2017
 
 
 

 
 

 
 
 
 
Balance at beginning of year
$
11,289

 
$
18,344

 
$
25,000

 
$
54,633

 
$
(122,350
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)
3,779

 
893

 

 
4,672

 
(7,087
)
Included in other comprehensive income

 

 

 

 

Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 
4,935

 

 
4,935

 

Issuances

 

 

 

 

Sales
(13,640
)
 
(12,602
)
 

 
(26,242
)
 

Settlements
(1,428
)
 

 

 
(1,428
)
 
72,191

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$

 
$
11,570

 
$
25,000

 
$
36,570

 
$
(57,246
)
 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2016
 
 
 

 
 

 
 

 
 
Balance at beginning of year
$
57,500

 
$
16,368

 
$

 
$
73,868

 
$
(96,048
)
Total gains or (losses) (realized/unrealized)
 
 
 
 
 
 
 
 
 
Included in earnings (1)
(2,500
)
 
161

 

 
(2,339
)
 
(16,121
)
Included in other comprehensive income

 

 

 

 
(37
)
Purchases, issuances, sales and settlements
 
 
 
 
 
 
 
 
 
Purchases

 
776

 

 
776

 

Issuances

 

 

 

 

Sales

 

 

 

 

Settlements
(5,789
)
 

 

 
(5,789
)
 
536

Transfers in and/or out of Level 3

 

 

 

 

Balance at end of period
$
49,211

 
$
17,305

 
$

 
$
66,516

 
$
(111,670
)

(1)
For the 2017 periods, gains or losses were included in net realized gains (losses). For the 2016 periods, losses on asset backed securities were included in net impairment losses recognized in earnings gains or losses while gains or losses on corporate bonds and contingent consideration liabilities were included in net realized gains (losses).


 
ACGL 2017 SECOND QUARTER FORM 10-Q
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Table of Contents
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Financial Instruments Disclosed, But Not Carried, At Fair Value
The Company uses various financial instruments in the normal course of its business. The carrying values of cash, accrued investment income, receivable for securities sold, certain other assets, payable for securities purchased and certain other liabilities approximated their fair values at June 30, 2017, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.
At June 30, 2017, the senior notes of ACGL were carried at their cost, net of debt issuance costs, of $297.0 million and had a fair value of $407.0 million, while the senior notes of Arch Capital Group (U.S.) Inc. (“Arch-U.S.”) were carried at their cost, net of debt issuance costs, of $494.6 million and had a fair value of $564.2 million. The senior notes of Arch Capital Finance LLC due in 2026 were carried at their cost, net of debt issuance costs, of $495.9 million and had a fair value of $518.2 million, while the senior notes due in 2046 were carried at their cost, net of debt issuance costs, of $445.1 million and had a fair value of $505.5 million. The fair values of the senior notes were obtained from a third party pricing service and are based on observable market inputs. As such, the fair values of the senior notes are classified within Level 2.
9.    Derivative Instruments

The Company’s investment strategy allows for the use of derivative instruments. The Company’s derivative instruments are recorded on its consolidated balance sheets at fair value. The Company utilizes exchange traded U.S. Treasury note, Eurodollar and other futures contracts and commodity futures to manage portfolio duration or replicate investment positions in its portfolios and the Company routinely utilizes foreign currency forward contracts, currency options, index futures contracts and other derivatives as part of its total return objective. In addition, certain of the Company’s investments are managed in portfolios which incorporate the use of foreign currency forward contracts which are intended to provide an economic hedge against foreign currency movements. 
In addition, the Company purchases to-be-announced mortgage backed securities (“TBAs”) as part of its investment strategy. TBAs represent commitments to purchase a future issuance of agency mortgage backed securities. For the period between purchase of a TBA and issuance of the underlying security, the Company’s position is accounted for as a derivative. The Company purchases TBAs in both long and short positions to enhance investment performance and as part of its overall investment strategy.
 
The following table summarizes information on the fair values and notional values of the Company’s derivative instruments:
 
Estimated Fair Value
 
 
 
Asset Derivatives
 
Liability Derivatives
 
Notional
Value (1)
June 30, 2017
 
 
 
 
 
Futures contracts (2)
$
4,490

 
$
(9,988
)
 
$
2,402,654

Foreign currency forward contracts (2)
13,854

 
(16,659
)
 
1,068,430

TBAs (3)
4,970

 

 
4,978

Other (2)
11,871

 
(8,357
)
 
1,747,025

Total
$
35,185

 
$
(35,004
)
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
Futures contracts (2)
$
360

 
$
(9,398
)
 
$
1,655,530

Foreign currency forward contracts (2)
9,354

 
(12,941
)
 
1,186,386

TBAs (3)

 

 

Other (2)
20,287

 
(3,710
)
 
1,014,863

Total
$
30,001

 
$
(26,049
)
 
 
(1)
Represents the absolute notional value of all outstanding contracts, consisting of long and short positions.
(2)
The fair value of asset derivatives are included in ‘other assets’ and the fair value of liability derivatives are included in ‘other liabilities.’
(3)
The fair value of TBAs are included in ‘fixed maturities available for sale, at fair value.’
The Company did not hold any derivatives which were designated as hedging instruments at June 30, 2017 or December 31, 2016.
The Company’s derivative instruments can be traded under master netting agreements, which establish terms that apply to all derivative transactions with a counterparty. In the event of a bankruptcy or other stipulated event of default, such agreements provide that the non-defaulting party may elect to terminate all outstanding derivative transactions, in which case all individual derivative positions (loss or gain) with a counterparty are closed out and netted and replaced with a single amount, usually referred to as the termination amount, which is expressed in a single currency. The resulting single net amount, where positive, is payable to the party “in-the-money” regardless of whether or not it is the defaulting party, unless the parties have agreed that only the non-defaulting party is entitled to receive a termination payment where the net amount is positive and is in its favor. Contractual close-out netting reduces derivatives credit exposure from gross to net exposure.
At June 30, 2017, asset derivatives and liability derivatives of $33.1 million and $34.5 million, respectively, were subject to a master netting agreement, compared to $28.4 million and $26.0 million, respectively, at December 31, 2016. The remaining derivatives included in the preceding table were not subject to a master netting agreement.
All realized and unrealized contract gains and losses on the Company’s derivative instruments are reflected in net realized

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

gains (losses) in the consolidated statements of income, as summarized in the following table:
Derivatives not designated as
 
June 30,
hedging instruments:
 
2017
 
2016
 
 
 
 
 
Three Months Ended
 
 
 
 
Net realized gains (losses):
 
 
 
 
Futures contracts
 
$
(5,310
)
 
$
34,871

Foreign currency forward contracts
 
(272
)
 
(13,782
)
TBAs
 
86

 
37

Other
 
726

 
(792
)
Total
 
$
(4,770
)
 
$
20,334

 
 
 
 
 
Six Months Ended
 
 
 
 
Net realized gains (losses):
 
 
 
 
Futures contracts
 
$
2,410

 
$
61,322

Foreign currency forward contracts
 
(12,038
)
 
(18,534
)
TBAs
 
21

 
334

Other
 
(4,344
)
 
(2,056
)
Total
 
$
(13,951
)
 
$
41,066


10.    Commitments and Contingencies

Investment Commitments
The Company’s investment commitments, which are primarily related to agreements entered into by the Company to invest in funds and separately managed accounts when called upon, were approximately $1.56 billion at June 30, 2017.

11.    Share Transactions

Share-Based Compensation
During the 2017 second quarter, the Company granted 492,466 stock options and 511,636 restricted shares and units to certain employees and directors with weighted average grant-date fair values of $24.66 and $96.28, respectively. During the 2016 second quarter, the Company granted 427,379 stock options and 456,217 restricted shares and units to certain employees and directors with weighted average grant-date fair values of $17.46 and $71.61, respectively. The stock options were valued at the grant date using the Black-Scholes option pricing model. Such values are being amortized over the respective substantive vesting period. For awards granted to retirement-eligible employees where no service is required for the employee to retain the award, the grant date fair value is immediately recognized as compensation expense at the grant date because the employee is able to retain the award without continuing to provide service. For employees near retirement eligibility, attribution of compensation cost is recognized over the period from the grant date to the retirement eligibility date.
 
Share Repurchases 
The board of directors of ACGL has authorized the investment in ACGL’s common shares through a share repurchase program. Since the inception of the share repurchase program, ACGL has repurchased approximately 125.2 million common shares for an aggregate purchase price of $3.68 billion. For the six months ended June 30, 2017, the Company did not repurchase any shares under the share repurchase program, compared to 1.1 million common shares repurchased for the six months ended June 30, 2016 with an aggregate purchase price of $75.3 million (no repurchases in the 2016 second quarter). At June 30, 2017, $446.5 million of share repurchases were available under the program, which may be effected from time to time in open market or privately negotiated transactions through December 31, 2019. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations.
Conversion of Convertible Non-Voting Common Equivalent Preferred Shares  
On June 8, 2017, ACGL 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 1,276,282 shares of ACGL’s convertible non-voting common-equivalent preference shares owned by AIG (the “Convertible Preferred Shares”). The Convertible Preferred Shares were issued to AIG as part of the consideration in UGC acquisition. Pursuant to the certificate of designations for the Convertible Preferred Shares and in accordance with the terms and conditions set forth therein, each Convertible Preferred Share is convertible into ten common shares of ACGL.
Pursuant to the Amendment, ACGL permitted AIG to transfer: (i) 638,141 Convertible Preferred Shares from and after June 8, 2017, and up to an additional 95,721 of the Convertible Preferred Shares to the extent that the several underwriters exercise the option to purchase additional securities expected to be granted pursuant to an underwritten secondary offering of AGCL common shares issuable upon conversion of the Convertible Preferred Shares by AIG and (ii) any and all of the Convertible Preferred Shares from and after January 15, 2018, subject to certain exceptions, and in each case subject to the terms and conditions of the Investor Rights Agreement. All other terms of the Investor Rights Agreement remain in effect.
In June 2017, ACGL completed an underwritten public secondary offering of 7,088,620 common shares by AIG following transfer of 708,862 Convertible Preferred Shares. Proceeds from the sale of common shares pursuant to the public offering were received by AIG. At June 30, 2017, 567,420 Convertible Preferred Shares were outstanding.

 
ACGL 2017 SECOND QUARTER FORM 10-Q
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

12.    Other Comprehensive Income (Loss)

The following tables present details about amounts reclassified from accumulated other comprehensive income and the tax effects allocated to each component of other comprehensive income (loss):
 
 
 
 
Amounts Reclassified from AOCI
 
 
Consolidated Statement of Income
 
Three Months Ended
 
Six Months Ended
Details About
 
Line Item That Includes
 
June 30,
 
June 30,
AOCI Components
 
Reclassification
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
 
 
 
Unrealized appreciation on available-for-sale investments
 
 
 
 
 
 
 
 
 
 
Net realized gains (losses)
 
$
24,111

 
$
31,404

 
$
31,924

 
$
76,091

 
 
Other-than-temporary impairment losses
 
(1,730
)
 
(5,395
)
 
(3,537
)
 
(13,132
)
 
 
Total before tax
 
22,381

 
26,009

 
28,387

 
62,959

 
 
Income tax (expense) benefit
 
(5,157
)
 
(3,915
)
 
(6,119
)
 
(8,642
)
 
 
Net of tax
 
$
17,224

 
$
22,094

 
$
22,268

 
$
54,317

 
Before Tax Amount
 
Tax Expense (Benefit)
 
Net of Tax Amount
Three Months Ended June 30, 2017
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
108,011

 
$
15,042

 
$
92,969

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

 

 

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

 
5,157

 
17,224

Foreign currency translation adjustments
18,509

 
212

 
18,297

Other comprehensive income (loss)
$
104,139

 
$
10,097

 
$
94,042

 
 
 
 
 
 
Three Months Ended June 30, 2016
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
117,904

 
$
15,444

 
$
102,460

Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)
(52
)
 

 
(52
)
Less reclassification of net realized gains (losses) included in net income
26,009

 
3,915

 
22,094

Foreign currency translation adjustments
(18,186
)
 
(35
)
 
(18,151
)
Other comprehensive income (loss)
$
73,657

 
$
11,494

 
$
62,163

 
 
 
 
 
 
Six Months Ended June 30, 2017
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
219,483

 
$
25,722

 
$
193,761

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

 

 

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

 
6,119

 
22,268

Foreign currency translation adjustments
21,674

 
253

 
21,421

Other comprehensive income (loss)
$
212,770

 
$
19,856

 
$
192,914

 
 
 
 
 
 
Six Months Ended June 30, 2016
 
 
 
 
 
Unrealized appreciation (decline) in value of investments:
 
 
 
 
 
Unrealized holding gains (losses) arising during period
$
270,078

 
$
34,637

 
$
235,441

Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss)
(150
)
 

 
(150
)
Less reclassification of net realized gains (losses) included in net income
62,959

 
8,642

 
54,317

Foreign currency translation adjustments
(326
)
 
512

 
(838
)
Other comprehensive income (loss)
$
206,643

 
$
26,507

 
$
180,136



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

13.     Guarantor Financial Information

The following tables present condensed financial information for ACGL, Arch-U.S., a 100% owned subsidiary of ACGL, and ACGL’s other subsidiaries.
 
 
June 30, 2017
Condensed Consolidating Balance Sheet
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Assets
 
 
 
 
 
 
 
 
 
Total investments
$
258

 
$
69,569

 
$
20,644,025

 
$
(14,700
)
 
$
20,699,152

Cash
2,742

 
46,002

 
691,576

 

 
740,320

Investments in subsidiaries
9,292,102

 
3,967,022

 

 
(13,259,124
)
 

Due from subsidiaries and affiliates
27

 
248

 
1,888,499

 
(1,888,774
)
 

Premiums receivable

 

 
1,948,630

 
(634,066
)
 
1,314,564

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

 
6,390,582

 
(4,235,475
)
 
2,155,107

Contractholder receivables

 

 
1,826,966

 

 
1,826,966

Ceded unearned premiums

 

 
2,218,529

 
(1,257,199
)
 
961,330

Deferred acquisition costs

 

 
651,295

 
(144,547
)
 
506,748

Goodwill and intangible assets

 

 
712,975

 

 
712,975

Other assets
14,101

 
65,626

 
2,042,421

 
(176,671
)
 
1,945,477

 
Total assets
$
9,309,230

 
$
4,148,467

 
$
39,015,498

 
$
(21,610,556
)
 
$
30,862,639

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Reserve for losses and loss adjustment expenses
$

 
$

 
$
14,728,976

 
$
(4,208,465
)
 
$
10,520,511

Unearned premiums

 

 
4,936,850

 
(1,257,199
)
 
3,679,651

Reinsurance balances payable

 

 
995,065

 
(634,065
)
 
361,000

Contractholder payables

 

 
1,826,966

 

 
1,826,966

Collateral held for insured obligations

 

 
338,737

 

 
338,737

Senior notes
297,007

 
494,572

 
940,991

 

 
1,732,570

Revolving credit agreement borrowings
100,000

 

 
586,452

 

 
686,452

Due to subsidiaries and affiliates
301

 
536,831

 
1,352,313

 
(1,889,445
)
 

Other liabilities
13,035

 
60,878

 
2,008,318

 
(347,558
)
 
1,734,673

 
Total liabilities
410,343

 
1,092,281

 
27,714,668

 
(8,336,732
)
 
20,880,560

 
 
 
 
 
 
 
 
 
 
 
Redeemable noncontrolling interests

 

 
220,436

 
(14,700
)
 
205,736

 
 
 
 
 
 
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
 
 
 
 
 
Total shareholders’ equity available to Arch
8,898,887

 
3,056,186

 
10,202,938

 
(13,259,124
)
 
8,898,887

Non-redeemable noncontrolling interests

 

 
877,456

 

 
877,456

 
Total shareholders’ equity
8,898,887

 
3,056,186

 
11,080,394

 
(13,259,124
)
 
9,776,343

 
 
 
 
 
 
 
 
 
 
 
Total liabilities, noncontrolling interests and shareholders’ equity
$
9,309,230

 
$
4,148,467

 
$
39,015,498

 
$
(21,610,556
)
 
$
30,862,639







 
ACGL 2017 SECOND QUARTER FORM 10-Q
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


 
 
December 31, 2016
Condensed Consolidating Balance Sheet
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Assets
 
 
 
 
 
 
 
 
 
Total investments
$
2,612

 
$
41,672

 
$
19,690,067

 
$
(14,700
)
 
$
19,719,651

Cash
1,687

 
71,955

 
769,300

 

 
842,942

Investments in subsidiaries
8,660,586

 
3,716,681

 

 
(12,377,267
)
 

Due from subsidiaries and affiliates
14,297

 
51,298

 
1,866,681

 
(1,932,276
)
 

Premiums receivable

 

 
1,579,865

 
(507,430
)
 
1,072,435

Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses

 

 
6,114,518

 
(4,000,380
)
 
2,114,138

Contractholder receivables

 

 
1,717,436

 

 
1,717,436

Ceded unearned premiums

 

 
1,985,311

 
(1,125,744
)
 
859,567

Deferred acquisition costs

 

 
577,461

 
(129,901
)
 
447,560

Goodwill and intangible assets

 

 
781,553

 

 
781,553

Other assets
15,725

 
49,244

 
1,901,786

 
(149,928
)
 
1,816,827

 
Total assets
$
8,694,907

 
$
3,930,850

 
$
36,983,978

 
$
(20,237,626
)
 
$
29,372,109

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Reserve for losses and loss adjustment expenses
$

 
$

 
$
14,164,191

 
$
(3,963,231
)
 
$
10,200,960

Unearned premiums

 

 
4,532,614

 
(1,125,744
)
 
3,406,870

Reinsurance balances payable

 

 
807,837

 
(507,430
)
 
300,407

Contractholder payables

 

 
1,717,436

 

 
1,717,436

Collateral held for insured obligations

 

 
301,406

 

 
301,406

Deposit accounting liabilities

 

 
22,150

 

 
22,150

Senior notes
296,957

 
494,525

 
940,776

 

 
1,732,258

Revolving credit agreement borrowings
100,000

 

 
656,650

 

 
756,650

Due to subsidiaries and affiliates
26,270

 
535,584

 
1,370,422

 
(1,932,276
)
 

Other liabilities
17,962

 
54,823

 
1,867,040

 
(316,978
)
 
1,622,847

 
Total liabilities
441,189

 
1,084,932

 
26,380,522

 
(7,845,659
)
 
20,060,984

 
 
 
 
 
 
 
 
 
 
 
Redeemable noncontrolling interests

 

 
220,253

 
(14,700
)
 
205,553

 
 
 
 
 
 
 
 
 
 
 
Shareholders’ Equity
 
 
 
 
 
 
 
 
 
Total shareholders’ equity available to Arch
8,253,718

 
2,845,918

 
9,531,349

 
(12,377,267
)
 
8,253,718

Non-redeemable noncontrolling interests

 

 
851,854

 

 
851,854

 
Total shareholders’ equity
8,253,718

 
2,845,918

 
10,383,203

 
(12,377,267
)
 
9,105,572

 
 
 
 
 
 
 
 
 
 
 
Total liabilities, noncontrolling interests and shareholders’ equity
$
8,694,907

 
$
3,930,850

 
$
36,983,978

 
$
(20,237,626
)
 
$
29,372,109



 
ACGL 2017 SECOND QUARTER FORM 10-Q
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


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

 
$

 
$
1,240,874

 
$

 
$
1,240,874

Net investment income
1

 
184

 
133,627

 
(22,688
)
 
111,124

Net realized gains (losses)

 

 
21,735

 

 
21,735

Net impairment losses recognized in earnings

 

 
(1,730
)
 

 
(1,730
)
Other underwriting income

 

 
4,822

 

 
4,822

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

 

 
32,706

 

 
32,706

Other income (loss)
(437
)
 

 
(1,557
)
 

 
(1,994
)
 
Total revenues
(436
)
 
184

 
1,430,477

 
(22,688
)
 
1,407,537

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
689,860

 

 
689,860

Acquisition expenses

 

 
190,436

 

 
190,436

Other operating expenses

 

 
169,981

 

 
169,981

Corporate expenses
21,816

 
1,309

 
1,751

 

 
24,876

Amortization of intangible assets

 

 
30,824

 

 
30,824

Interest expense
6,075

 
11,989

 
33,050

 
(22,365
)
 
28,749

Net foreign exchange (gains) losses

 

 
29,843

 
9,700

 
39,543

 
Total expenses
27,891

 
13,298

 
1,145,745

 
(12,665
)
 
1,174,269

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

 
(10,023
)
 
233,268

Income tax (expense) benefit

 
4,069

 
(38,238
)
 

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

 
(10,023
)
 
199,099

Equity in net income of subsidiaries
213,494

 
86,156

 

 
(299,650
)
 

Net income
185,167

 
77,111

 
246,494

 
(309,673
)
 
199,099

Net (income) loss attributable to noncontrolling interests

 

 
(14,254
)
 
322

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

 
77,111

 
232,240

 
(309,351
)
 
185,167

Preferred dividends
(11,349
)
 

 

 

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

 
$
77,111

 
$
232,240

 
$
(309,351
)
 
$
173,818

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income (loss) available to Arch
$
279,285

 
$
105,302

 
$
475,747

 
$
(581,049
)
 
$
279,285



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


 
 
Three Months Ended June 30, 2016
Condensed Consolidating Statement of Income and Comprehensive Income
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
1,005,985

 
$

 
$
1,005,985

Net investment income

 
775

 
94,097

 
(6,534
)
 
88,338

Net realized gains (losses)

 

 
68,218

 

 
68,218

Net impairment losses recognized in earnings

 

 
(5,343
)
 

 
(5,343
)
Other underwriting income

 

 
41,450

 
(16,226
)
 
25,224

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

 

 
8,737

 

 
8,737

Other income (loss)
(7
)
 

 

 

 
(7
)
 
Total revenues
(7
)
 
775

 
1,213,144

 
(22,760
)
 
1,191,152

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
584,592

 

 
584,592

Acquisition expenses

 

 
172,677

 

 
172,677

Other operating expenses

 

 
157,314

 

 
157,314

Corporate expenses
17,441

 
359

 
(600
)
 

 
17,200

Amortization of intangible assets

 

 
4,880

 

 
4,880

Interest expense
5,929

 
6,647

 
25,527

 
(22,440
)
 
15,663

Net foreign exchange (gains) losses

 

 
(14,125
)
 
(10,537
)
 
(24,662
)
 
Total expenses
23,370

 
7,006

 
930,265

 
(32,977
)
 
927,664

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(23,377
)
 
(6,231
)
 
282,879

 
10,217

 
263,488

Income tax (expense) benefit

 
2,086

 
(16,217
)
 

 
(14,131
)
Income (loss) before equity in net income of subsidiaries
(23,377
)
 
(4,145
)
 
266,662

 
10,217

 
249,357

Equity in net income of subsidiaries
234,432

 
19,873

 

 
(254,305
)
 

Net income
211,055

 
15,728

 
266,662

 
(244,088
)
 
249,357

Net (income) loss attributable to noncontrolling interests

 

 
(38,623
)
 
321

 
(38,302
)
Net income available to Arch
211,055

 
15,728

 
228,039

 
(243,767
)
 
211,055

Preferred dividends
(5,485
)
 

 

 

 
(5,485
)
Net income available to Arch common shareholders
$
205,570

 
$
15,728

 
$
228,039

 
$
(243,767
)
 
$
205,570

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income (loss) available to Arch
$
273,260

 
$
28,536

 
$
300,542

 
$
(329,078
)
 
$
273,260


 
ACGL 2017 SECOND QUARTER FORM 10-Q
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


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

 
$

 
$
2,357,891

 
$

 
$
2,357,891

Net investment income
6

 
1,000

 
271,608

 
(43,616
)
 
228,998

Net realized gains (losses)

 

 
55,888

 

 
55,888

Net impairment losses recognized in earnings

 

 
(3,537
)
 

 
(3,537
)
Other underwriting income

 

 
9,455

 

 
9,455

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

 

 
80,794

 

 
80,794

Other income (loss)
(266
)
 

 
(2,510
)
 

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

 
2,769,589

 
(43,616
)
 
2,726,713

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
1,242,430

 

 
1,242,430

Acquisition expenses

 

 
372,725

 

 
372,725

Other operating expenses

 

 
344,700

 

 
344,700

Corporate expenses
39,063

 
3,317

 
10,288

 

 
52,668

Amortization of intangible assets

 

 
62,118

 

 
62,118

Interest expense
12,090

 
23,919

 
64,386

 
(42,970
)
 
57,425

Net foreign exchange losses (gains)

 

 
45,191

 
13,756

 
58,947

 
Total expenses
51,153

 
27,236

 
2,141,838

 
(29,214
)
 
2,191,013

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

 
(14,402
)
 
535,700

Income tax (expense) benefit

 
8,942

 
(71,508
)
 

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

 
(14,402
)
 
473,134

Equity in net income of subsidiaries
489,707

 
163,529

 

 
(653,236
)
 

Net income
438,294

 
146,235

 
556,243

 
(667,638
)
 
473,134

Amounts attributable to noncontrolling interests

 

 
(35,485
)
 
645

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

 
146,235

 
520,758

 
(666,993
)
 
438,294

Preferred dividends
(22,567
)
 

 

 

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

 
$
146,235

 
$
520,758

 
$
(666,993
)
 
$
415,727

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income (loss) available to Arch
$
631,276

 
$
193,083

 
$
699,920

 
$
(893,003
)
 
$
631,276



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


 
 
Six Months Ended June 30, 2016
Condensed Consolidating Statement of Income and Comprehensive Income
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Revenues
 
 
 
 
 
 
 
 
 
Net premiums earned
$

 
$

 
$
1,957,564

 
$

 
$
1,957,564

Net investment income
1

 
1,548

 
194,358

 
(13,834
)
 
182,073

Net realized gains (losses)

 

 
105,542

 

 
105,542

Net impairment losses recognized in earnings

 

 
(12,982
)
 

 
(12,982
)
Other underwriting income

 

 
46,769

 
(16,498
)
 
30,271

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

 

 
15,392

 

 
15,392

Other income (loss)
199

 

 
(231
)
 

 
(32
)
 
Total revenues
200

 
1,548

 
2,306,412

 
(30,332
)
 
2,277,828

 
 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses

 

 
1,107,541

 

 
1,107,541

Acquisition expenses

 

 
340,515

 

 
340,515

Other operating expenses

 

 
307,462

 

 
307,462

Corporate expenses
26,796

 
941

 
(1,154
)
 

 
26,583

Amortization of intangible assets

 

 
9,628

 

 
9,628

Interest expense
11,863

 
13,319

 
36,279

 
(29,691
)
 
31,770

Net foreign exchange losses (gains)

 

 
2,370

 
(3,466
)
 
(1,096
)
 
Total expenses
38,659

 
14,260

 
1,802,641

 
(33,157
)
 
1,822,403

 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
(38,459
)
 
(12,712
)
 
503,771

 
2,825

 
455,425

Income tax (expense) benefit

 
4,330

 
(34,771
)
 

 
(30,441
)
Income (loss) before equity in net income of subsidiaries
(38,459
)
 
(8,382
)
 
469,000

 
2,825

 
424,984

Equity in net income of subsidiaries
404,312

 
42,739

 

 
(447,051
)
 

Net income
365,853

 
34,357

 
469,000

 
(444,226
)
 
424,984

Amounts attributable to noncontrolling interests

 

 
(59,773
)
 
642

 
(59,131
)
Net income available to Arch
365,853

 
34,357

 
409,227

 
(443,584
)
 
365,853

Preferred dividends
(10,969
)
 

 

 

 
(10,969
)
Net income available to Arch common shareholders
$
354,884

 
$
34,357

 
$
409,227

 
$
(443,584
)
 
$
354,884

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income (loss) available to Arch
$
546,189

 
$
87,185

 
$
592,793

 
$
(679,978
)
 
$
546,189




 
ACGL 2017 SECOND QUARTER FORM 10-Q
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ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


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

 
$
27,853

 
$
976,969

 
$
(458,238
)
 
$
554,067

Investing Activities
 
 
 
 
 
 
 
 
 
Purchases of fixed maturity investments

 

 
(19,899,326
)
 

 
(19,899,326
)
Purchases of equity securities

 

 
(400,155
)
 

 
(400,155
)
Purchases of other investments

 

 
(883,704
)
 

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

 

 
19,611,680

 

 
19,611,680

Proceeds from the sales of equity securities

 

 
473,064

 

 
473,064

Proceeds from the sales, redemptions and maturities of other investments

 

 
614,494

 

 
614,494

Proceeds from redemptions and maturities of fixed maturity investments

 

 
447,941

 

 
447,941

Net settlements of derivative instruments

 

 
(5,984
)
 

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

 
(27,896
)
 
(419,661
)
 

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

 

 
175,693

 

 
175,693

Contributions to subsidiaries
20,641

 
(72,900
)
 
(342,950
)
 
395,209

 

Issuance of intercompany loans

 

 
(47,000
)
 
47,000

 

Repayment of intercompany loans

 
47,000

 

 
(47,000
)
 

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

 
(11,103
)
Other

 

 
6,849

 
(20,641
)
 
(13,792
)
 
Net Cash Provided By (Used For) Investing Activities
22,977

 
(53,806
)
 
(680,134
)
 
374,568

 
(336,395
)
Financing Activities
 
 
 
 
 
 
 
 
 
Proceeds from common shares issued, net
(6,838
)
 

 
395,209

 
(395,209
)
 
(6,838
)
Proceeds from intercompany borrowings

 

 
47,000

 
(47,000
)
 

Repayments of intercompany borrowings

 

 
(47,000
)
 
47,000

 

Repayments of borrowings

 

 
(72,000
)
 

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

 

 
(175,693
)
 

 
(175,693
)
Dividends paid to redeemable noncontrolling interests

 

 
(9,632
)
 
638

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

 

 
(457,600
)
 
457,600

 

Other

 

 
(62,339
)
 
20,641

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

 

 

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

 
(382,055
)
 
83,670

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

 

 
7,496

 

 
7,496

Increase (decrease) in cash
1,055

 
(25,953
)
 
(77,724
)
 

 
(102,622
)
Cash beginning of year
1,687

 
71,955

 
769,300

 

 
842,942

Cash end of period
$
2,742

 
$
46,002

 
$
691,576

 
$

 
$
740,320


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


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


 
 
Six Months Ended June 30, 2016
Condensed Consolidating Statement
of Cash Flows
ACGL (Parent Guarantor)
 
Arch-U.S. (Subsidiary Issuer)
 
Other ACGL Subsidiaries
 
Consolidating Adjustments and Eliminations
 
ACGL Consolidated
Operating Activities
 
 
 
 
 
 
 
 
 
 
Net Cash Provided By (Used For) Operating Activities
$
89,499

 
$
10,732

 
$
588,067

 
$
(147,074
)
 
$
541,224

Investing Activities
 
 
 
 
 
 
 
 
 
Purchases of fixed maturity investments

 

 
(17,541,731
)
 

 
(17,541,731
)
Purchases of equity securities

 

 
(212,678
)
 

 
(212,678
)
Purchases of other investments

 

 
(650,613
)
 

 
(650,613
)
Proceeds from the sales of fixed maturity investments

 

 
16,978,549

 

 
16,978,549

Proceeds from the sales of equity securities

 

 
337,619

 

 
337,619

Proceeds from the sales, redemptions and maturities of other investments

 

 
636,535

 

 
636,535

Proceeds from redemptions and maturities of fixed maturity investments

 
41,500

 
329,480

 

 
370,980

Net settlements of derivative instruments

 

 
45,174

 

 
45,174

Net (purchases) sales of short-term investments
(76
)
 
(53,729
)
 
(250,655
)
 

 
(304,460
)
Change in cash collateral related to securities lending

 

 
(18,715
)
 

 
(18,715
)
Contributions to subsidiaries
(3,300
)
 

 
(2,779
)
 
6,079

 

Acquisitions, net of cash

 

 
(1,460
)
 

 
(1,460
)
Purchases of fixed assets
(8
)
 

 
(8,276
)
 

 
(8,284
)
Other
2,000

 

 
11,416

 

 
13,416

 
Net Cash Provided By (Used For) Investing Activities
(1,384
)
 
(12,229
)
 
(348,134
)
 
6,079

 
(355,668
)
Financing Activities
 
 
 
 
 
 
 
 
 
Purchases of common shares under share repurchase program
(75,256
)
 

 

 

 
(75,256
)
Proceeds from common shares issued, net
(1,487
)
 

 
6,079

 
(6,079
)
 
(1,487
)
Proceeds from borrowings

 

 
46,000

 

 
46,000

Repayments of borrowings

 

 
(179,171
)
 

 
(179,171
)
Change in cash collateral related to securities lending

 

 
18,715

 

 
18,715

Dividends paid to redeemable noncontrolling interests

 

 
(9,632
)
 
638

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

 

 
(146,436
)
 
146,436

 

Other

 
200

 
(2,423
)
 

 
(2,223
)
Preferred dividends paid
(10,969
)
 

 

 

 
(10,969
)
 
Net Cash Provided By (Used For) Financing Activities
(87,712
)
 
200

 
(266,868
)
 
140,995

 
(213,385
)
Effects of exchange rates changes on foreign currency cash

 

 
(8,906
)
 

 
(8,906
)
Increase (decrease) in cash
403

 
(1,297
)
 
(35,841
)
 

 
(36,735
)
Cash beginning of year
6,809

 
17,023

 
529,494

 

 
553,326

Cash end of period
$
7,212

 
$
15,726

 
$
493,653

 
$

 
$
516,591


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


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

14.    Income Taxes

The Company’s income tax provision on income before income taxes resulted in an expense of 11.7% for the six months ended June 30, 2017, compared to an expense of 6.7% for the 2016 period. The Company’s effective tax rate, which is based upon the expected annual effective tax rate, may fluctuate from period to period based on the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction. For interim reporting purposes, the Company has calculated its effective tax rate for the full year of 2017 by treating any excess tax benefits that arise from the accounting for stock based compensation as a discrete item. As such, this amount is not included when projecting the Company’s full year effective tax rate but rather is accounted for at the U.S. Federal statutory rate of 35% after applying the projected full year effective tax rate to actual six-month results before the discrete item. The impact of the discrete item resulted in a benefit of 1.2% for the six months ended June 30, 2017.
The Company had a net deferred tax asset of $221.1 million at June 30, 2017, compared to $221.2 million at December 31, 2016. In addition, the Company paid $3.9 million and $26.6 million of income taxes for the six months ended June 30, 2017 and 2016, respectively.
15.    Legal Proceedings

The Company, in common with the insurance industry in general, is subject to litigation and arbitration in the normal course of its business. As of June 30, 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. 
16.    Transactions with Related Parties

Kewsong Lee, a director of ACGL, is a Managing Director and Deputy Chief Investment Officer for Corporate Private Equity of The Carlyle Group (“Carlyle”). As part of its investment philosophy, the Company invests a portion of its investment portfolio in alternative investment funds. As of June 30, 2017, the total value of the Company’s investments in funds or other investments managed by Carlyle was approximately $228.5 million, and the Company had aggregate unfunded commitments to funds managed by Carlyle of $493.0 million. The Company may make additional commitments to funds managed by Carlyle from time to time. During the six months ended June 30, 2017 and 2016, the Company made aggregate capital contributions to funds managed by Carlyle of $57.2 million and $56.6 million, respectively, and received aggregate cash distributions from funds managed by Carlyle of $38.3 million and $13.8 million, respectively.
 
17.    Subsequent Event

On July 1, 2017, the Company completed its previously announced acquisition of AIG United Guaranty Insurance (Asia) Limited following the payment of $40.0 million to AIG. The Company plans to operate such operation as Arch MI Asia Limited. This acquisition adds to the Company’s existing private mortgage insurance businesses, which have operations in the United States, Europe and Australia.

 
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ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with our consolidated financial statements included in Item 1 of this report and also our Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2016 (“2016 Form 10-K”). In addition, readers should review “Risk Factors” set forth in Item 1A of Part I of our 2016 Form 10-K. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
Arch Capital Group Ltd. (“ACGL” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with approximately $11.13 billion in capital at June 30, 2017 and, through operations in Bermuda, the United States, Europe, Canada and Australia, writes insurance, reinsurance and mortgage insurance on a worldwide basis.
CURRENT OUTLOOK

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. As in the 2017 first quarter, this has led to flat or lower writings in certain property casualty lines in the 2017 second quarter. With the continued low interest rate environment, additional price increases are needed in many lines in order for us to achieve our return requirements. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts 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. We plan to operate such operation as 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-exposed business which has the potential to increase the volatility of our operating results.
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.
NATURAL CATASTROPHE RISK

We monitor our natural catastrophe risk globally for all perils and regions, in each case, where we believe there is significant exposure. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. Currently, we seek to limit our 1-in-250 year return period net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders’ equity available to Arch. We reserve the right to change this threshold at any time.
Based on in-force exposure estimated as of July 1, 2017, our modeled peak zone catastrophe exposure was a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $500 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County regions with net

 
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probable maximum pre-tax losses of $439 million and $370 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, were less than the exposures arising from U.S. windstorms and hurricanes. As of July 1, 2017, our modeled peak zone earthquake exposure (Los Angeles earthquake) represented approximately 59% of our peak zone catastrophe exposure, and our modeled peak zone international exposure (Japan earthquake) was substantially less than both our peak zone windstorm and earthquake exposures.
Net probable maximum pre-tax loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. The loss estimates shown above do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer a net loss greater than 25% of total shareholders’ equity available to Arch from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders’ equity exposed to a single catastrophic event. Actual losses may also increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See “Risk Factors—Risks Relating to Our Industry” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Natural and Man-Made Catastrophic Events” in our 2016 Form 10-K.
FINANCIAL MEASURES

Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for ACGL’s common shareholders:
Book Value per Common Share
Book value per common share represents total common shareholders’ equity available to Arch divided by the number of common shares outstanding. Management uses growth in book value per common share as a key measure of the value generated for our common shareholders each period and believes that book value per common share is the key driver of ACGL’s share price over time. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an
 
accretive or dilutive impact on book value per common share depending on the purchase price.
Book value per common share was $59.60 at June 30, 2017, compared to $57.69 at March 31, 2017 and $51.73 at June 30, 2016. The 3.3% increase in the 2017 second quarter and the 15.2% increase over the trailing twelve months reflected strong underwriting and investment returns.
Operating Return on Average Common Equity
Operating return on average common equity (“Operating ROAE”) represents annualized after-tax operating income available to Arch common shareholders divided by the average of beginning and ending common shareholders’ equity available to Arch during the period. After-tax operating income available to Arch common shareholders, a non-GAAP financial measure as defined in Regulation G, represents net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other and income taxes. Management uses Operating ROAE as a key measure of the return generated to common shareholders. See “Comment on Non-GAAP Financial Measures.”
Our Operating ROAE was 8.5% for the 2017 second quarter, compared to 9.1% for the 2016 second quarter, and 9.4% for the six months ended June 30, 2017, compared to 9.4% for the 2016 period, reflecting satisfactory underwriting returns and favorable investment returns.
Total Return on Investments
Total return on investments includes investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by Arch’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses, excludes amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. In addition, total return incorporates the timing of investment returns during the periods. The following table summarizes our total return compared to the benchmark return against which we measured our portfolio during the periods. See “Comment on Non-GAAP Financial Measures.”
 
Arch
Portfolio
 
Benchmark
Return
2017 Second Quarter
1.63
%
 
1.53
%
2016 Second Quarter
1.27
%
 
1.08
%
 
 
 
 
Six Months Ended June 30, 2017
3.37
%
 
3.05
%
Six Months Ended June 30, 2016
3.11
%
 
3.50
%

 
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Excluding the effects of foreign exchange, total return was 1.29% for the 2017 second quarter and 2.94% for the six months ended June 30, 2017, reflecting favorable returns on equity and fixed income strategies. Total return for the 2017 second quarter reflected the weakening of the U.S. Dollar against the Euro, British Pound Sterling and other major currencies on non-U.S. Dollar denominated investments.
The benchmark return index included weightings to the following indices, which are primarily from The Bank of America Merrill Lynch (“BoAML”):
 
%
BoAML 1-10 Year U.S. Corporate & All Yankees, A - AAA Rated Index
20.00
%
BoAML 1-5 Year U.S. Treasury Index
13.00

BoAML 1-10 Year U.S. Municipal Securities Index
17.00

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

BoAML 5-10 Year U.S. Treasury Index
5.00

Barclays CMBS Inv. Grade, AAA Rated Index
5.00

MSCI All Country World Gross Total Return Index
5.00

BoAML German Government Index
4.50

BoAML U.S. Mortgage Backed Securities Index
4.00

Hedge Fund Research HFRX Fixed Income Credit Index
2.50

Hedge Fund Research HFRX Equal Weighted Strategies
2.50

BoAML U.S. High Yield Constrained Index
2.50

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

BoAML 1-5 Year Australian Governments Index
2.50

S&P Leveraged Loan Index
2.50

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

BoAML 1-5 Year Canada Government Index
1.50

BoAML 20+ Year Canada Government Index
0.50

Total
100.00
%
The benchmark return index is a customized combination of indices intended to approximate a target portfolio by asset mix and average credit quality while also matching the approximate estimated duration and currency mix of our insurance and reinsurance liabilities. Although the estimated duration and average credit quality of this index will move as the duration and rating of its constituent securities change, generally we do not adjust the composition of the benchmark return index except to incorporate changes to the mix of liability currencies and durations noted above. The benchmark return index should not be interpreted as expressing a preference for or aversion to any particular sector or sector weight. The index is intended solely to provide, unlike many master indices that change based on the size of their constituent indices, a relatively stable basket of investable indices. At June 30, 2017, the benchmark return index had an average credit quality of “Aa2” by Moody’s Investors Service (“Moody’s”), and an estimated duration of 3.54 years.
 
COMMENT ON NON-GAAP FINANCIAL MEASURES

Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to Arch common shareholders, which is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other 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 believe that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which

 
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include changes in the market value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. UGC transaction costs and other include advisory, financing, legal, severance, incentive compensation and other transaction costs related to the UGC acquisition. The Company believes that UGC transaction costs and other, due to their non-recurring nature, are not indicative of the performance of, or trends in, the Company’s business performance. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other from the calculation of after-tax operating income available to Arch common shareholders. 
We believe that showing net income available to Arch common shareholders exclusive of the items referred to above reflects the underlying fundamentals of our business since we evaluate the performance of and manage our business to produce an underwriting profit. In addition to presenting net income available to Arch common shareholders, we believe that this presentation enables investors and other users of our financial information to analyze our performance in a manner similar to how management analyzes performance. We also believe that this measure follows industry practice and, therefore, allows the users of financial information to compare our performance with our industry peer group. We believe that the equity analysts and certain rating agencies which follow us and the insurance industry as a whole generally exclude these items from their analyses for the same reasons.
Our segment information includes the presentation of consolidated underwriting income or loss and a subtotal of underwriting income or loss before the contribution from the ‘other’ segment. Such measures represent the pre-tax profitability of our underwriting operations and include net premiums earned plus other underwriting income, less losses and loss adjustment expenses, acquisition expenses and other operating expenses. Other operating expenses include those operating expenses that are incremental and/or directly attributable to our individual underwriting operations. Underwriting income or loss does not incorporate items included in our corporate (non-underwriting) segment. While these measures are presented in Note 5, “Segment Information,” of the notes accompanying our consolidated financial statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis. The reconciliations of underwriting income or loss to income before income taxes (the most directly comparable GAAP financial measure) on a consolidated basis and a subtotal before the contribution from the ‘other’ segment, in accordance with
 
Regulation G, is shown in Note 5, “Segment Information” of the notes accompanying our consolidated financial statements.

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

Our presentation of segment information includes the use of a current year loss ratio which excludes favorable or adverse development in prior year loss reserves. This ratio is a non-GAAP financial measure as defined in Regulation G. The reconciliation of such measure to the loss ratio (the most directly comparable GAAP financial measure) in accordance with Regulation G is shown on the individual segment pages. Management utilizes the current year loss ratio in its analysis of the underwriting performance of each of our underwriting segments.
Total return on investments includes investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by Arch’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses, excludes amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. In addition, total return incorporates the timing of investment returns during the periods. There is no directly comparable GAAP financial measure for total return. Management uses total return on investments as a key measure of the return generated to Arch common shareholders on the capital held in the business, and

 
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compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods.
RESULTS OF OPERATIONS

The following table summarizes our consolidated financial data, including a reconciliation of net income available to Arch common shareholders to after-tax operating income available to Arch common shareholders. Each line item reflects the impact of our approximate 11% ownership of Watford Re’s common equity.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Net income available to Arch common shareholders
$
173,818

 
$
205,570

 
$
415,727

 
$
354,884

Net realized (gains) losses
(18,452
)
 
(43,935
)
 
(47,586
)
 
(76,399
)
Net impairment losses recognized in earnings
1,730

 
5,343

 
3,537

 
12,982

Equity in net (income) loss of investment funds accounted for using the equity method
(32,706
)
 
(8,737
)
 
(80,794
)
 
(15,392
)
Net foreign exchange (gains) losses
38,012

 
(22,703
)
 
57,808

 
(494
)
UGC transaction costs and other
2,675

 

 
18,259

 

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

 
5,036

 
(67
)
 
10,735

After-tax operating income available to Arch common shareholders
$
168,919

 
$
140,574

 
$
366,884

 
$
286,316

 
 
 
 
 
 
 
 
Beginning common shareholders’ equity
$
7,833,289

 
$
6,050,248

 
$
7,481,163

 
$
5,841,542

Ending common shareholders’ equity
8,126,332

 
6,340,583

 
8,126,332

 
6,340,583

Average common shareholders’ equity
$
7,979,811

 
$
6,195,416

 
$
7,803,748

 
$
6,091,063

 
 
 
 
 
 
 
 
Annualized return on average common equity %
8.7

 
13.3

 
10.7

 
11.7

Annualized operating return on average
common equity %
8.5

 
9.1

 
9.4

 
9.4

(1)
Income tax on net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other reflects the relative mix reported by jurisdiction and the varying tax rates in each jurisdiction.
 
Segment Information
We classify our businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — corporate (non-underwriting) and ‘other.’ Our insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to our chief operating decision makers, the Chairman and Chief Executive Officer, the President and Chief Operating Officer, and the Chief Financial Officer of ACGL. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. Management measures segment performance for our three underwriting segments based on underwriting income or loss. We do not manage our assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.
We determined our reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of our consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.
Insurance Segment
The following tables set forth our insurance segment’s underwriting results:
 
Three Months Ended June 30,
 
2017
 
2016
 
% Change
Gross premiums written
$
743,902

 
$
762,043

 
(2.4
)
Premiums ceded
(247,446
)
 
(246,875
)
 
 
Net premiums written
496,456

 
515,168

 
(3.6
)
Change in unearned premiums
21,118

 
12,482

 
 
Net premiums earned
517,574

 
527,650

 
(1.9
)
Other underwriting income

 

 
 

Losses and loss adjustment expenses
(350,939
)
 
(354,633
)
 
 

Acquisition expenses
(78,872
)
 
(77,312
)
 
 

Other operating expenses
(92,267
)
 
(91,440
)
 
 

Underwriting income
$
(4,504
)
 
$
4,265

 
(205.6
)
 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
Loss ratio
67.8
%
 
67.2
%
 
0.6

Acquisition expense ratio
15.2
%
 
14.7
%
 
0.5

Other operating expense ratio
17.8
%
 
17.3
%
 
0.5

Combined ratio
100.8
%
 
99.2
%
 
1.6


 
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Six Months Ended June 30,
 
2017
 
2016
 
% Change
Gross premiums written
$
1,526,183

 
$
1,560,596

 
(2.2
)
Premiums ceded
(481,541
)
 
(495,664
)
 
 
Net premiums written
1,044,642

 
1,064,932

 
(1.9
)
Change in unearned premiums
(21,422
)
 
(24,193
)
 
 
Net premiums earned
1,023,220

 
1,040,739

 
(1.7
)
Other underwriting income

 

 
 
Losses and loss adjustment expenses
(683,580
)
 
(678,242
)
 
 
Acquisition expenses
(153,740
)
 
(151,660
)
 
 
Other operating expenses
(180,393
)
 
(176,498
)
 
 
Underwriting income
$
5,507

 
$
34,339

 
(84.0
)
 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
% Point
Change
Loss ratio
66.8
%
 
65.2
%
 
1.6

Acquisition expense ratio
15.0
%
 
14.6
%
 
0.4

Other operating expense ratio
17.6
%
 
17.0
%
 
0.6

Combined ratio
99.4
%
 
96.8
%
 
2.6

The insurance segment consists of our insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include:
Construction and national accounts: primary and excess casualty coverages to middle and large accounts in the construction industry and a wide range of products for middle and large national accounts, specializing in loss sensitive primary casualty insurance programs (including large deductible, self-insured retention and retrospectively rated programs).
Excess and surplus casualty: primary and excess casualty insurance coverages, including middle market energy business, and contract binding, which primarily provides casualty coverage through a network of appointed agents to small and medium risks.
Lenders products: collateral protection, debt cancellation and service contract reimbursement products to banks, credit unions, automotive dealerships and original equipment manufacturers and other specialty programs that pertain to automotive lending and leasing.
Professional lines: directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity and other financial related coverages for corporate, private equity, venture capital, real estate investment trust, limited partnership, financial institution and not-for-profit clients of all sizes and medical professional and general liability insurance coverages for the healthcare industry. The business is predominately written on a claims-made basis.
Programs: primarily package policies, underwriting workers’ compensation and umbrella liability business in
 
support of desirable package programs, targeting program managers with unique expertise and niche products offering general liability, commercial automobile, inland marine and property business with minimal catastrophe exposure.
Property, energy, marine and aviation: primary and excess general property insurance coverages, including catastrophe-exposed property coverage, for commercial clients. Coverages for marine include hull, war, specie and liability. Aviation and stand alone terrorism are also offered.
Travel, accident and health: specialty travel and accident and related insurance products for individual, group travelers, travel agents and suppliers, as well as accident and health, which provides accident, disability and medical plan insurance coverages for employer groups, medical plan members, students and other participant groups.
Other: includes alternative market risks (including captive insurance programs), excess workers’ compensation and employer’s liability insurance coverages for qualified self-insured groups, associations and trusts, and contract and commercial surety coverages, including contract bonds (payment and performance bonds) primarily for medium and large contractors and commercial surety bonds for Fortune 1,000 companies and smaller transaction business programs.
Premiums Written.
The following table sets forth our insurance segment’s net premiums written by major line of business:
 
Three Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Professional lines
$
110,784

 
22.3

 
$
107,519

 
20.9

Programs
93,428

 
18.8

 
75,420

 
14.6

Construction and national accounts
73,474

 
14.8

 
85,260

 
16.5

Travel, accident and health
52,690

 
10.6

 
54,456

 
10.6

Property, energy, marine and aviation
46,031

 
9.3

 
50,194

 
9.7

Excess and surplus casualty
45,222

 
9.1

 
60,412

 
11.7

Lenders products
21,459

 
4.3

 
25,254

 
4.9

Other
53,368

 
10.7

 
56,653

 
11.0

Total
$
496,456

 
100.0

 
$
515,168

 
100.0

2017 Second Quarter versus 2016 Second Quarter. Gross premiums written by the insurance segment in the 2017 second quarter were 2.4% lower than in the 2016 second quarter, while net premiums written were 3.6% lower than in the 2016 second quarter. The decrease in net premiums written largely reflected our response to weaker market conditions, with reductions in construction, excess and surplus casualty and property lines, partially offset by growth in programs. The lower level of construction premiums reflected non-renewals as well as lower

 
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audit and project premium, while excess and surplus casualty reflected a targeted reduction in certain exposures, increased use of reinsurance and other factors. The reduction in property lines reflected continued weak market conditions while growth in program business primarily reflected the continued impact of two newer programs.
 
Six Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Professional lines
$
219,252

 
21.0

 
$
216,986

 
20.4

Programs
193,385

 
18.5

 
165,204

 
15.5

Construction and national accounts
173,451

 
16.6

 
189,734

 
17.8

Travel, accident and health
118,218

 
11.3

 
111,719

 
10.5

Property, energy, marine and aviation
86,135

 
8.2

 
100,169

 
9.4

Excess and surplus casualty
91,054

 
8.7

 
114,069

 
10.7

Lenders products
46,164

 
4.4

 
50,038

 
4.7

Other
116,983

 
11.2

 
117,013

 
11.0

Total
$
1,044,642

 
100.0

 
$
1,064,932

 
100.0

Six Months Ended June 30, 2017 versus 2016 period. Gross premiums written by the insurance segment for the six months ended June 30, 2017 were 2.2% lower than in the 2016 period, while net premiums written were 1.9% lower than in the 2016 period. The decrease in net premiums written largely reflected our response to weaker market conditions, with reductions in construction, excess and surplus casualty and property lines, partially offset by growth in programs and travel, accident and health. The lower level of construction premiums reflected non-renewals as well as lower audit and project premium, while excess and surplus casualty reflected a targeted reduction in certain exposures, increased use of reinsurance and other factors. The reduction in property lines reflected continued weak market conditions. Growth in program business primarily reflected the continued impact of two newer programs while the increase in travel, accident and health reflected continued expansion in existing travel accounts.

 
Net Premiums Earned.
The following tables set forth our insurance segment’s net premiums earned by major line of business:
 
Three Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Professional lines
$
108,375

 
20.9

 
$
108,556

 
20.6

Programs
87,582

 
16.9

 
90,595

 
17.2

Construction and national accounts
80,848

 
15.6

 
84,414

 
16.0

Travel, accident and health
63,436

 
12.3

 
59,821

 
11.3

Property, energy, marine and aviation
41,423

 
8.0

 
47,076

 
8.9

Excess and surplus casualty
48,850

 
9.4

 
57,155

 
10.8

Lenders products
24,562

 
4.7

 
23,007

 
4.4

Other
62,498

 
12.1

 
57,026

 
10.8

Total
$
517,574

 
100.0

 
$
527,650

 
100.0

 
Six Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Professional lines
$
217,013

 
21.2

 
$
213,500

 
20.5

Programs
172,762

 
16.9

 
189,096

 
18.2

Construction and national accounts
158,271

 
15.5

 
161,457

 
15.5

Travel, accident and health
121,917

 
11.9

 
107,366

 
10.3

Property, energy, marine and aviation
79,501

 
7.8

 
96,113

 
9.2

Excess and surplus casualty
99,857

 
9.8

 
112,120

 
10.8

Lenders products
48,661

 
4.8

 
47,409

 
4.6

Other
125,238

 
12.2

 
113,678

 
10.9

Total
$
1,023,220

 
100.0

 
$
1,040,739

 
100.0

Net premiums written are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Net premiums earned reflect changes in net premiums written over the previous five quarters. Net premiums earned in the 2017 second quarter were 1.9% lower than in the 2016 second quarter, and 1.7% lower for the six months ended June 30, 2017 than in the 2016 period.
Losses and Loss Adjustment Expenses.
The table below shows the components of the insurance segment’s loss ratio:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Current year
68.2
 %
 
68.1
 %
 
67.2
 %
 
66.3
 %
Prior period reserve development
(0.4
)%
 
(0.9
)%
 
(0.4
)%
 
(1.1
)%
Loss ratio
67.8
 %
 
67.2
 %
 
66.8
 %
 
65.2
 %

 
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Current Year Loss Ratio.
The insurance segment’s current year loss ratio in the 2017 second quarter was 0.1 points higher than in the 2016 second quarter and reflected 1.6 points of current year catastrophic activity, compared to 3.9 points in the 2016 second quarter. The insurance segment’s current year loss ratio for the six months ended June 30, 2017 was 0.9 points higher than in the 2016 period and reflected 1.1 points of current year catastrophic activity, compared to 2.0 points in the 2016 period. The current year loss ratios for the 2017 periods reflected changes in the mix of business and loss cost trends.
Prior Period Reserve Development.
The insurance segment’s net favorable development was $2.0 million, or 0.4 points, for the 2017 second quarter, compared to $4.9 million, or 0.9 points, for the 2016 second quarter, and $4.1 million, or 0.4 points, for the six months ended June 30, 2017, compared to $11.1 million, or 1.1 points, for the 2016 period. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” of the notes accompanying our consolidated financial statements for information about the insurance segment’s prior year reserve development.
Underwriting Expenses.
2017 Second Quarter versus 2016 Second Quarter: The insurance segment’s underwriting expense ratio was 33.0% in the 2017 second quarter, compared to 32.0% in the 2016 second quarter. The comparison of the underwriting expense ratios reflects changes in the level of reinsurance ceded on a quota share basis and changes in the mix of business.
Six Months Ended June 30, 2017 versus 2016 period: The insurance segment’s underwriting expense ratio was 32.6% for the six months ended June 30, 2017, compared to 31.6% for the 2016 period. The comparison of the underwriting expense ratios reflects changes in the level of reinsurance ceded on a quota share basis and changes in the mix of business.
 
Reinsurance Segment 
The following tables set forth our reinsurance segment’s underwriting results:
 
Three Months Ended June 30,
 
2017
 
2016
 
% Change
Gross premiums written
$
453,186

 
$
412,053

 
10.0

Premiums ceded
(115,262
)
 
(119,951
)
 
 
Net premiums written
337,924

 
292,102

 
15.7

Change in unearned premiums
(23,222
)
 
(846
)
 
 
Net premiums earned
314,702

 
291,256

 
8.0

Other underwriting income
(279
)
 
20,118

 
 

Losses and loss adjustment expenses
(207,606
)
 
(146,091
)
 
 

Acquisition expenses
(51,151
)
 
(55,756
)
 
 

Other operating expenses
(36,711
)
 
(36,914
)
 
 

Underwriting income
$
18,955

 
$
72,613

 
(73.9
)
 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
% Point
Change
Loss ratio
66.0
%
 
50.2
%
 
15.8

Acquisition expense ratio
16.3
%
 
19.1
%
 
(2.8
)
Other operating expense ratio
11.7
%
 
12.7
%
 
(1.0
)
Combined ratio
94.0
%
 
82.0
%
 
12.0

 
Six Months Ended June 30,
 
2017
 
2016
 
% Change
Gross premiums written
$
928,968

 
$
893,443

 
4.0

Premiums ceded
(281,354
)
 
(280,517
)
 
 
Net premiums written
647,614

 
612,926

 
5.7

Change in unearned premiums
(88,061
)
 
(60,462
)
 
 
Net premiums earned
559,553

 
552,464

 
1.3

Other underwriting income
(585
)
 
20,443

 
 

Losses and loss adjustment expenses
(313,060
)
 
(257,689
)
 
 

Acquisition expenses
(97,298
)
 
(110,514
)
 
 

Other operating expenses
(74,244
)
 
(73,172
)
 
 

Underwriting income
$
74,366

 
$
131,532

 
(43.5
)
 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
% Point
Change
Loss ratio
55.9
%
 
46.6
%
 
9.3

Acquisition expense ratio
17.4
%
 
20.0
%
 
(2.6
)
Other operating expense ratio
13.3
%
 
13.2
%
 
0.1

Combined ratio
86.6
%
 
79.8
%
 
6.8

The reinsurance segment consists of our reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include:
Casualty: provides coverage to ceding company clients on third party liability and workers’ compensation exposures from ceding company clients, primarily on a treaty basis. Exposures include, among others, executive assurance, professional liability, workers’ compensation, excess and umbrella liability, excess motor and healthcare business.

 
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Marine and aviation: provides coverage for energy, hull, cargo, specie, liability and transit, and aviation business, including airline and general aviation risks. Business written may also include space business, which includes coverages for satellite assembly, launch and operation for commercial space programs.
Other specialty: provides coverage to ceding company clients for proportional motor and other lines including surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and political risk.
Property catastrophe: provides protection for most catastrophic losses that are covered in the underlying policies written by reinsureds, including hurricane, earthquake, flood, tornado, hail and fire, and coverage for other perils on a case-by-case basis. Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and loss adjustment expense from a single occurrence of a covered peril exceed the retention specified in the contract.
Property excluding property catastrophe: provides coverage for both personal lines and commercial property exposures and principally covers buildings, structures, equipment and contents. The primary perils in this business include fire, explosion, collapse, riot, vandalism, wind, tornado, flood and earthquake. Business is assumed on both a proportional and excess of loss basis. In addition, facultative business is written which focuses on commercial property risks on an excess of loss basis.
Other. includes life reinsurance business on both a proportional and non-proportional basis, casualty clash business and, in limited instances, non-traditional business which is intended to provide insurers with risk management solutions that complement traditional reinsurance.
 
Premiums Written.
The following table sets forth our reinsurance segment’s net premiums written by major line of business:
 
Three Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Other specialty
$
155,328

 
46.0

 
$
113,943

 
39.0

Property excluding property catastrophe
69,115

 
20.5

 
69,831

 
23.9

Casualty
63,054

 
18.7

 
61,555

 
21.1

Property catastrophe
37,127

 
11.0

 
41,771

 
14.3

Marine and aviation
8,932

 
2.6

 
1,463

 
0.5

Other
4,368

 
1.3

 
3,539

 
1.2

Total
$
337,924

 
100.0

 
$
292,102

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
200,893

 
59.4

 
$
146,231

 
50.1

Excess of loss
137,031

 
40.6

 
145,871

 
49.9

Total
$
337,924

 
100.0

 
$
292,102

 
100.0

2017 Second Quarter versus 2016 Second Quarter. Gross premiums written by the reinsurance segment in the 2017 second quarter were 10.0% higher than in the 2016 second quarter, while net premiums written were 15.7% higher than in the 2016 second quarter. Gross and net premiums written in both periods reflected an increase in other specialty business related to certain retroactive reinsurance contracts. For the 2017 second quarter, net premiums written included $53.6 million related to such contracts, compared to $40.2 million in the 2016 second quarter. Such premiums, which were with the same cedent but covered different underwriting years, were substantially earned in each period and resulted in a corresponding increase to losses and loss adjustment expenses. In addition to the retroactive reinsurance contracts noted above, the increase in net premiums written in the 2017 second quarter reflected growth in other specialty, primarily new international motor quota share business, partially offset by a reduction in property catastrophe business.
 
Six Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Other specialty
$
269,746

 
41.7

 
$
214,763

 
35.0

Property excluding property catastrophe
144,502

 
22.3

 
143,554

 
23.4

Casualty
173,674

 
26.8

 
188,038

 
30.7

Property catastrophe
29,650

 
4.6

 
39,476

 
6.4

Marine and aviation
18,473

 
2.9

 
19,003

 
3.1

Other
11,569

 
1.8

 
8,092

 
1.3

Total
$
647,614

 
100.0

 
$
612,926

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
329,909

 
50.9

 
$
258,440

 
42.2

Excess of loss
317,705

 
49.1

 
354,486

 
57.8

Total
$
647,614

 
100.0

 
$
612,926

 
100.0

Six Months Ended June 30, 2017 versus 2016 period. Gross premiums written by the reinsurance segment for the six months

 
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ended June 30, 2017 were 4.0% higher than in the 2016 period, while net premiums written were 5.7% higher than in the 2016 period. Gross and net premiums written in both periods reflected an increase in other specialty business related to certain retroactive reinsurance contracts noted above. In addition to the retroactive reinsurance contracts noted above, the increase in net premiums written in the six months ended June 30, 2017 reflected growth in other specialty, primarily new international motor quota share business, partially offset by reductions in casualty and property catastrophe business.
Net Premiums Earned.
The following tables set forth our reinsurance segment’s net premiums earned by major line of business:
 
Three Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Other specialty
$
141,565

 
45.0

 
$
109,493

 
37.6

Property excluding property catastrophe
62,884

 
20.0

 
65,487

 
22.5

Casualty
79,903

 
25.4

 
80,157

 
27.5

Property catastrophe
15,759

 
5.0

 
19,823

 
6.8

Marine and aviation
9,986

 
3.2

 
12,559

 
4.3

Other
4,605

 
1.5

 
3,737

 
1.3

Total
$
314,702

 
100.0

 
$
291,256

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
181,988

 
57.8

 
$
153,933

 
52.9

Excess of loss
132,714

 
42.2

 
137,323

 
47.1

Total
$
314,702

 
100.0

 
$
291,256

 
100.0

 
Six Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Other specialty
$
211,530

 
37.8

 
$
183,742

 
33.3

Property excluding property catastrophe
132,736

 
23.7

 
137,440

 
24.9

Casualty
152,871

 
27.3

 
156,210

 
28.3

Property catastrophe
31,936

 
5.7

 
37,776

 
6.8

Marine and aviation
19,476

 
3.5

 
30,437

 
5.5

Other
11,004

 
2.0

 
6,859

 
1.2

Total
$
559,553

 
100.0

 
$
552,464

 
100.0

 
 
 
 
 
 
 
 
Pro rata
$
315,080

 
56.3

 
$
293,626

 
53.1

Excess of loss
244,473

 
43.7

 
258,838

 
46.9

Total
$
559,553

 
100.0

 
$
552,464

 
100.0

Net premiums written, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. For the 2017 second quarter, net premiums earned were 8.0% higher than in the 2016 second quarter, while net premiums earned for the six months ended June 30, 2017 were 1.3% higher than in the 2016 period. Net premiums earned reflects changes in net premiums written over the previous five quarters.
 
Other Underwriting Income (Loss).
Other underwriting income (loss) for the 2017 second quarter and six months ended June 30, 2017 was de minimis, compared to $20.1 million for the 2016 second quarter, and $20.4 million for the 2016 year-to-date period. The 2016 periods included $19.1 million related to a contract which was commuted during the 2016 second quarter. This contract had been reflected as a deposit accounting liability (i.e., a contract that, in accordance with GAAP, does not pass risk transfer) prior to the commutation.
Losses and Loss Adjustment Expenses.
The table below shows the components of the reinsurance segment’s loss ratio:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Current year
78.6
 %
 
74.2
 %
 
73.2
 %
 
67.8
 %
Prior period reserve development
(12.6
)%
 
(24.0
)%
 
(17.3
)%
 
(21.2
)%
Loss ratio
66.0
 %
 
50.2
 %
 
55.9
 %
 
46.6
 %
Current Year Loss Ratio.
The reinsurance segment’s current year loss ratio in the 2017 second quarter was 4.4 points higher than in the 2016 second quarter and reflected 5.4 points of current year catastrophic activity, compared to 6.1 points in the 2016 second quarter. The reinsurance segment’s current year loss ratio for the six months ended June 30, 2017 was 5.4 points higher than in the 2016 period and reflected 4.8 points of current year catastrophic activity, compared to 3.9 points in the 2016 second quarter. The balance of the change in the 2017 current year loss ratios resulted, in part, from a higher level of property facultative loss activity and changes in the mix of business.
Prior Period Reserve Development.
The reinsurance segment’s net favorable development was $39.5 million, or 12.6 points, for the 2017 second quarter, compared to $69.8 million, or 24.0 points, for the 2016 second quarter, and $96.8 million, or 17.3 points, for the six months ended June 30, 2017, compared to $117.2 million, or 21.2 points, for the 2016 period. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” of the notes accompanying our consolidated financial statements for information about the reinsurance segment’s prior year reserve development.
Underwriting Expenses.
2017 Second Quarter versus 2016 Second Quarter: The underwriting expense ratio for the reinsurance segment was 28.0% in the 2017 second quarter, compared to 31.8% in the 2016 second quarter. The retroactive reinsurance contracts noted above improved the reported 2017 second quarter

 
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underwriting expense ratio by 5.6 points, compared to 5.0 points in the 2016 second quarter. The comparison of the underwriting expense ratios primarily reflected changes in the mix and type of business and a higher level of net premiums earned in the 2017 second quarter.
Six Months Ended June 30, 2017 versus 2016 period: The underwriting expense ratio for the reinsurance segment was 30.7% for the six months ended June 30, 2017, compared to 33.2% for the 2016 period. The comparison of the underwriting expense ratios primarily reflected changes in the mix and type of business.
Mortgage Segment 
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 periods do not reflect UGC activity.
 
Three Months Ended June 30,
 
2017
 
2016
 
% Change
Gross premiums written
$
336,226

 
$
118,434

 
183.9

Premiums ceded
(62,314
)
 
(6,969
)
 
 
Net premiums written
273,912

 
111,465

 
145.7

Change in unearned premiums
(16,068
)
 
(44,953
)
 
 
Net premiums earned
257,844

 
66,512

 
287.7

Other underwriting income
4,277

 
4,137

 
 

Losses and loss adjustment expenses
(20,694
)
 
(366
)
 
 

Acquisition expenses
(25,666
)
 
(5,964
)
 
 

Other operating expenses
(32,150
)
 
(22,847
)
 
 

Underwriting income
$
183,611

 
$
41,472

 
342.7

 
 
 
 
 
 
Underwriting Ratios
 

 
 

 
% Point
Change
Loss ratio
8.0
%
 
0.6
%
 
7.4

Acquisition expense ratio
10.0
%
 
9.0
%
 
1.0

Other operating expense ratio
12.5
%
 
34.4
%
 
(21.9
)
Combined ratio
30.5
%
 
44.0
%
 
(13.5
)
 
 
Six Months Ended June 30,
 
2017
 
2016
 
% Change
Gross premiums written
$
684,849

 
$
229,714

 
198.1

Premiums ceded
(136,239
)
 
(11,736
)
 
 
Net premiums written
548,610

 
217,978

 
151.7

Change in unearned premiums
(46,243
)
 
(89,701
)
 
 
Net premiums earned
502,367

 
128,277

 
291.6

Other underwriting income
8,400

 
7,930

 
 

Losses and loss adjustment expenses
(49,759
)
 
(8,995
)
 
 

Acquisition expenses
(54,432
)
 
(11,757
)
 
 

Other operating expenses
(74,020
)
 
(46,341
)
 
 

Underwriting income
$
332,556

 
$
69,114

 
381.2

 
 
 
 
 
 
Underwriting Ratios
 
 
 
 
% Point
Change
Loss ratio
9.9
%
 
7.0
%
 
2.9

Acquisition expense ratio
10.8
%
 
9.2
%
 
1.6

Other operating expense ratio
14.7
%
 
36.1
%
 
(21.4
)
Combined ratio
35.4
%
 
52.3
%
 
(16.9
)
The mortgage segment includes the results of our U.S. primary mortgage insurance operations, including Arch Mortgage Insurance Company, United Guaranty Residential Insurance Company and United Guaranty Mortgage Indemnity Company (combined “Arch MI U.S.”), which are approved as eligible mortgage insurers by Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), each a GSE. Arch MI U.S. and Arch Mortgage Insurance Designated Activity Company are leading providers of mortgage insurance products and services to the U.S. and European markets, respectively. The mortgage segment also includes GSE credit risk-sharing transactions and mortgage reinsurance for the U.S. and Australian markets.

 
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Premiums Written.
The following tables set forth our mortgage segment’s net premiums written by client location and underwriting location (i.e., where the business is underwritten):
 
Three Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Client location:
 
 
 
 
 
 
 
United States
$
253,456

 
92.5

 
$
66,261

 
59.4

Other
20,456

 
7.5

 
45,204

 
40.6

Total
$
273,912

 
100.0

 
$
111,465

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
227,266

 
83.0

 
$
42,442

 
38.1

Other
46,646

 
17.0

 
69,023

 
61.9

Total
$
273,912

 
100.0

 
$
111,465

 
100.0

 
Six Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Client location:
 
 
 
 
 
 
 
United States
494,592

 
90.2

 
122,064

 
56.0

Other
54,018

 
9.8

 
95,914

 
44.0

Total
$
548,610

 
100.0

 
$
217,978

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
443,995

 
80.9

 
$
77,772

 
35.7

Other
104,615

 
19.1

 
140,206

 
64.3

Total
$
548,610

 
100.0

 
$
217,978

 
100.0

2017 Second Quarter versus 2016 Second Quarter. Gross premiums written by the mortgage segment in the 2017 second quarter were 183.9% higher than in the 2016 second quarter, primarily reflecting the growth in insurance in force due to the acquisition of UGC. The lower increase in net premiums written of 145.7% primarily reflected cessions to AIG under the 50% quota share reinsurance agreement, which covers 2014 to 2016 policy years of UGC business on a run-off basis.
Six Months Ended June 30, 2017 versus 2016 period. Gross premiums written by the mortgage segment were 198.1% higher than in the 2016 period, primarily reflecting the growth in insurance in force due to the acquisition of UGC. The lower increase in net premiums written of 151.7% reflected the 50% quota share agreement noted above.
The persistency rate, which represents the percentage of mortgage insurance in force at the beginning of a 12-month period that remains in force at the end of such period, of the Arch MI U.S. portfolio of mortgage loans was 78.1% at June 30, 2017, compared to 76.6% at March 31, 2017. The higher persistency rate at June 30, 2017 reflects changes in level of mortgage refinance activity and mortgage interest rates.
Arch MI U.S. generated $17.3 billion of new insurance written (“NIW”) in the 2017 second quarter, compared to $6.4 billion
 
in the 2016 second quarter. NIW represents the original principal balance of all loans that received coverage during the period. Our NIW for the 2017 second quarter reflected the combination of Arch and UGC, a higher percentage of monthly premium business and a lower level of refinance activity, as detailed in the following table.
The following tables provide details on the NIW generated by Arch MI U.S.:
(U.S. Dollars in millions)
Three Months Ended June 30,
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Total new insurance written (NIW) (1)
$
17,303

 
 
 
$
6,420

 
 
 
 
 
 
 
 
 
 
Credit quality (FICO):
 
 
 
 
 
 
 
>=740
$
9,814

 
56.7

 
$
3,950

 
61.5

680-739
6,274

 
36.3

 
2,162

 
33.7

620-679
1,215

 
7.0

 
307

 
4.8

<620

 

 
1

 

  Total
$
17,303

 
100.0

 
$
6,420

 
100.0

 
 
 
 
 
 
 
 
Loan-to-value (LTV):
 
 
 
 
 
 
 
95.01% and above
$
1,700

 
9.8

 
$
551

 
8.6

90.01% to 95.00%
8,372

 
48.4

 
2,983

 
46.5

85.01% to 90.00%
5,462

 
31.6

 
2,078

 
32.4

85.01% and below
1,769

 
10.2

 
808

 
12.6

  Total
$
17,303

 
100.0

 
$
6,420

 
100.0

 
 
 
 
 
 
 
 
Monthly vs. single:
 
 
 
 
 
 
 
Monthly
$
14,832

 
85.7

 
$
5,182

 
80.7

Single
2,471

 
14.3

 
1,238

 
19.3

  Total
$
17,303

 
100.0

 
$
6,420

 
100.0

 
 
 
 
 
 
 
 
Purchase vs. refinance:
 
 
 
 
 
 
 
Purchase
$
16,063

 
92.8

 
$
5,309

 
82.7

Refinance
1,240

 
7.2

 
1,111

 
17.3

  Total
$
17,303

 
100.0

 
$
6,420

 
100.0

(1)
Represents the original principal balance of all loans that received coverage during the period.



 
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(U.S. Dollars in millions)
Six Months Ended June 30,
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Total new insurance written (NIW) (1)
$
29,963

 
 
 
$
9,326

 
 
 
 
 
 
 
 
 
 
Credit quality (FICO):
 
 
 
 
 
 
 
>=740
$
16,998

 
56.7

 
$
5,758

 
61.7

680-739
10,889

 
36.3

 
3,121

 
33.5

620-679
2,076

 
6.9

 
446

 
4.8

<620

 

 
1

 

  Total
$
29,963

 
100.0

 
$
9,326

 
100.0

 
 
 
 
 
 
 
 
Loan-to-value (LTV):
 
 
 
 
 
 
 
95.01% and above
$
2,672

 
8.9

 
$
726

 
7.8

90.01% to 95.00%
14,357

 
47.9

 
4,216

 
45.2

85.01% to 90.00%
9,523

 
31.8

 
3,099

 
33.2

85.01% and below
3,411

 
11.4

 
1,285

 
13.8

  Total
$
29,963

 
100.0

 
$
9,326

 
100.0

 
 
 
 
 
 
 
 
Monthly vs. single:
 
 
 
 
 
 
 
Monthly
$
25,200

 
84.1

 
$
7,371

 
79.0

Single
4,763

 
15.9

 
1,955

 
21.0

  Total
$
29,963

 
100.0

 
$
9,326

 
100.0

 
 
 
 
 
 
 
 
Purchase vs. refinance:
 
 
 
 
 
 
 
Purchase
$
26,783

 
89.4

 
$
7,364

 
79.0

Refinance
3,180

 
10.6

 
1,962

 
21.0

  Total
$
29,963

 
100.0

 
$
9,326

 
100.0

(1)
Represents the original principal balance of all loans that received coverage during the period.
Net Premiums Earned.
The following tables set forth our mortgage segment’s net premiums earned by client location and underwriting location:
 
Three Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Client Location:
 
 
 
 
 
 
 
United States
$
246,656

 
95.7

 
$
61,046

 
91.8

Other
11,188

 
4.3

 
5,466

 
8.2

Total
$
257,844

 
100.0

 
$
66,512

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
219,084

 
85.0

 
$
34,124

 
51.3

Other
38,760

 
15.0

 
32,388

 
48.7

Total
$
257,844

 
100.0

 
$
66,512

 
100.0

 
Six Months Ended June 30,
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
Client Location:
 
 
 
 
 
 
 
United States
$
482,687

 
96.1

 
$
118,178

 
92.1

Other
19,680

 
3.9

 
10,099

 
7.9

Total
$
502,367

 
100.0

 
$
128,277

 
100.0

 
 
 
 
 
 
 
 
Underwriting location:
 
 
 
 
 
 
 
United States
$
427,783

 
85.2

 
$
66,644

 
52.0

Other
74,584

 
14.8

 
61,633

 
48.0

Total
$
502,367

 
100.0

 
$
128,277

 
100.0

 
Net premiums earned for the 2017 periods were higher than in the 2016 periods, primarily due to the UGC acquisition and growth in insurance in force for Arch MI U.S.
Other Underwriting Income.
Other underwriting income, which is primarily related to older GSE risk-sharing transactions receiving derivative accounting treatment, was $4.3 million for the 2017 second quarter, compared to $4.1 million for the 2016 second quarter, and $8.4 million for the six months ended June 30, 2017, compared to $7.9 million for the 2016 period.
Losses and Loss Adjustment Expenses.
The table below shows the components of the mortgage segment’s loss ratio:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Current year
19.5
 %
 
17.2
 %
 
20.5
 %
 
17.8
 %
Prior period reserve development
(11.5
)%
 
(16.6
)%
 
(10.6
)%
 
(10.8
)%
Loss ratio
8.0
 %
 
0.6
 %
 
9.9
 %
 
7.0
 %
Current Year Loss Ratio.
The mortgage segment’s current year loss ratio was 2.3 points higher in the 2017 second quarter than in the 2016 second quarter and 2.7 points higher for the six months ended June 30, 2017 than in the 2016 period. The current year loss ratio for the 2017 second quarter reflects the UGC acquisition and growth in insurance in force.
Prior Period Reserve Development.
The mortgage segment’s net favorable development was $29.8 million, or 11.5 points, for the 2017 second quarter, compared to $11.1 million, or 16.6 points, for the 2016 second quarter, and $53.4 million, or 10.6 points for the six months ended June 30, 2017, compared to $13.8 million, or 10.8 points, for the 2016 period. See note 6, “Reserve for Losses and Loss Adjustment Expenses,” of the notes accompanying our consolidated financial statements for information about the mortgage segment’s prior year reserve development.
Underwriting Expenses.
2017 Second Quarter versus 2016 Second Quarter. The underwriting expense ratio for the mortgage segment was 22.5% in the 2017 second quarter, compared to 43.4% in the 2016 second quarter. The improvement primarily resulted from a higher level of net premiums earned reflecting the UGC acquisition as Arch MI U.S. has increased its scale of operations.
Six Months Ended June 30, 2017 versus 2016 period. The underwriting expense ratio for the mortgage segment was

 
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25.5% for the six months ended June 30, 2017, compared to 45.3% for the 2016 period. The improvement primarily resulted from a higher level of net premiums earned reflecting the UGC acquisition as Arch MI U.S. has increased its scale of operations.
Corporate (Non-Underwriting) Segment
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, UGC transaction costs and other, amortization of intangible assets, interest expense, dividends on our non-cumulative preferred shares, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and income taxes. Such amounts exclude the results of the ‘other’ segment.
Net Investment Income.
The components of net investment income were derived from the following sources:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Fixed maturities
$
83,656

 
$
64,365

 
$
166,437

 
$
123,366

Term loan investments
3,881

 
5,669

 
6,995

 
10,527

Equity securities
3,976

 
3,984

 
6,942

 
7,740

Short-term investments
1,669

 
618

 
3,110

 
1,076

Other (1)
14,417

 
8,152

 
32,537

 
21,824

Gross investment income
107,599

 
82,788

 
216,021

 
164,533

Investment expenses (2)
(15,079
)
 
(12,391
)
 
(27,689
)
 
(23,727
)
Net investment income
$
92,520

 
$
70,397

 
$
188,332

 
140,806

(1)
Amounts include dividends and interest distributions on investment funds and other items.
(2)
Investment expenses were approximately 0.33% of average invested assets for the 2017 second quarter, compared to 0.36% for the 2016 second quarter, and 0.29% for the six months ended June 30, 2017, compared to 0.33% for the 2016 period.
Net investment income for the 2017 periods reflected income on the acquired UGC portfolio and higher returns on fund investments than in the 2016 periods. The pre-tax investment income yield, calculated based on amortized cost and on an annualized basis, was 2.04% for the 2017 second quarter, compared to 2.08% for the 2016 second quarter, and 2.10% for the six months ended June 30, 2017, compared to 2.12% for the 2016 period.
 
Corporate Expenses.
Corporate expenses were $22.2 million for the 2017 second quarter, compared to $17.2 million for the 2016 second quarter, and $34.4 million for the six months ended June 30, 2017, compared to $26.6 million for the 2016 period. The higher level of corporate expenses in the 2017 periods was primarily due to higher incentive compensation costs.
UGC Transaction Costs and Other.
UGC transaction costs and other were $2.7 million for the 2017 second quarter and $18.3 million for the six months ended June 30, 2017. UGC transaction costs and other include advisory, financing, legal and other transaction costs related to the UGC acquisition. Amounts for the 2017 second quarter primarily related to severance and severance related costs, while the total for the six months ended June 30, 2017 reflected $10.8 million of severance and severance related costs, with the remainder primarily due to incentive compensation paid in conjunction with the UGC acquisition.
Amortization of Intangible Assets.
Amortization of intangible assets for the 2017 second quarter was $30.8 million, compared to $4.9 million for the 2016 second quarter, and $62.1 million for the six months ended June 30, 2017, compared to $9.6 million for the 2016 period. During the 2017 first quarter, we reclassified our income statement presentation of amortization of intangible assets to reflect such item separately (previously reflected in acquisition and/or other operating expenses). The higher level of expense for the 2017 periods reflects the amortization of intangible assets included in the UGC acquisition, including intangible assets related to acquired insurance contracts and distribution relationships.
Interest Expense.
Interest expense was $25.9 million for the 2017 second quarter, compared to $12.4 million for the 2016 second quarter, and $51.7 million for the six months ended June 30, 2017, compared to $25.1 million for the 2016 period. The increase in the 2017 periods primarily reflects the impact of the issuance of the Company’s 2026 and 2046 senior notes in December 2016 and the higher level of borrowings outstanding under our revolving credit agreement. The proceeds from the debt offering and additional borrowings under the revolving credit agreement were used to close the UGC acquisition on December 31, 2016.
Net Realized Gains or Losses.
We recorded net realized gains of $18.0 million for the 2017 second quarter, compared to net realized gains of $40.9 million for the 2016 second quarter, and net realized gains of $46.6 million for the six months ended June 30, 2017, compared to net realized gains of $72.8 million for the 2016 period. Currently, our portfolio is actively managed to maximize total return within certain guidelines. The effect of financial market

 
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movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. Net realized gains or losses from the sale of fixed maturities primarily results from our decisions to reduce credit exposure, to change duration targets, to rebalance our portfolios or due to relative value determinations. Net realized gains or losses also includes realized and unrealized contract gains and losses on our derivative instruments, changes in the fair value of assets and liabilities accounted for using the fair value option along with re-measurement of contingent consideration liability amounts.
Net Impairment Losses Recognized in Earnings.
We recorded $1.7 million of impairment losses for the 2017 second quarter, compared to $5.3 million for the 2016 second quarter, and $3.5 million for the six months ended June 30, 2017, compared to $13.0 million for the 2016 period. See note 7, “Investment Information—Other-Than-Temporary Impairments,” of the notes accompanying our consolidated financial statements for additional information.
Equity in Net Income (Loss) of Investment Funds Accounted for Using the Equity Method.
We recorded $32.7 million of equity in net income related to investment funds accounted for using the equity method in the 2017 second quarter, compared to $8.7 million of income for the 2016 second quarter, and $80.8 million of income for the six months ended June 30, 2017, compared to $15.4 million of income for the 2016 period. Investment funds accounted for using the equity method totaled $948.9 million at June 30, 2017, compared to $811.3 million at December 31, 2016.
Net Foreign Exchange Gains or Losses.
Net foreign exchange losses for the 2017 second quarter were $37.8 million, compared to net foreign exchange gains for the 2016 second quarter of $22.5 million, and net foreign exchange losses of $57.7 million for the six months ended June 30, 2017, compared to net foreign exchange gains of $0.4 million for the 2016 period. Amounts in such periods were primarily unrealized and resulted from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date.
Income Tax Expense.
Our income tax provision on income before income taxes resulted in an expense of 15.7% for the 2017 second quarter, compared to an expense of 6.4% for the 2016 second quarter, and 12.6% for the six months ended June 30, 2017, compared to 7.8% for the 2016 period. The effective tax rates for the 2017 second quarter and six months ended June 30, 2017 included a discrete income tax benefit of $3.9 million and $6.4 million, respectively, arising from the change in accounting for stock based compensation. Our effective tax rate, which is based upon
 
the expected annual effective tax rate, may fluctuate from period to period based on the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction.
Other Segment 
The ‘other’ segment includes the results of Watford Re. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. See note 3, “Variable Interest Entities and Noncontrolling Interests” and note 5, “Segment Information,” of the notes accompanying our consolidated financial statements for additional information on Watford Re.
CRITICAL ACCOUNTING POLICIES,
ESTIMATES AND RECENT ACCOUNTING PRONOUNCEMENTS

Critical accounting policies, estimates and recent accounting pronouncements are discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our 2016 Form 10-K, updated where applicable in the notes accompanying our consolidated financial statements, including note 2, “Recent Accounting Pronouncements.”
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

Financial Condition
Investable Assets 
At June 30, 2017, total investable assets of $21.11 billion included $19.17 billion held by Arch and $1.93 billion included in the ‘other’ segment (i.e., attributable to Watford Re).

 
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Investable Assets Held by Arch 
The following table summarizes the fair value of the investable assets held by Arch:
Investable assets (1):
Estimated
Fair Value
 
% of
Total
June 30, 2017
 
 
 
Fixed maturities (2)
$
14,682,692

 
76.6

Short-term investments
966,775

 
5.0

Cash
676,391

 
3.5

Equity securities (2)
529,776

 
2.8

Other investments (2)
1,423,895

 
7.4

Investments accounted for using the equity method
948,856

 
4.9

Securities transactions entered into but not settled at the balance sheet date
(54,676
)
 
(0.3
)
Total investable assets held by Arch
$
19,173,709

 
100.0

 
 
 
 
December 31, 2016
 
 
 
Fixed maturities (2)
$
14,521,774

 
77.9

Short-term investments
676,547

 
3.6

Cash
768,049

 
4.1

Equity securities (2)
558,008

 
3.0

Other investments (2)
1,276,841

 
6.9

Investments accounted for using the equity method
811,273

 
4.4

Securities transactions entered into but not settled at the balance sheet date
23,697

 
0.1

Total investable assets held by Arch
$
18,636,189

 
100.0

(1)
In securities lending transactions, we receive collateral in excess of the fair value of the securities pledged. For purposes of this table, we have excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value.
(2)
Includes investments carried as available for sale, at fair value and at fair value under the fair value option.
At June 30, 2017, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had average credit quality ratings from Standard & Poor’s Rating Services (“S&P”)/Moody’s of “AA/Aa2” and an average yield to maturity (embedded book yield), before investment expenses, of 2.27%. 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 3.41 years at June 30, 2017, compared to 3.64 years at December 31, 2016. At June 30, 2017, approximately $13.37 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 fixed maturities and fixed maturities pledged under securities lending agreements (“Fixed Maturities”) by type:
 
Estimated
Fair Value
 
% of
Total
June 30, 2017
 

 
 
Corporate bonds
$
4,598,288

 
31.3

Mortgage backed securities
344,572

 
2.3

Municipal bonds
2,618,827

 
17.8

Commercial mortgage backed securities
521,272

 
3.6

U.S. government and government agencies
3,425,196

 
23.3

Non-U.S. government securities
1,434,842

 
9.8

Asset backed securities
1,739,695

 
11.8

Total
$
14,682,692

 
100.0

 
 
 
 
December 31, 2016
 

 
 
Corporate bonds
$
4,696,079

 
32.3

Mortgage backed securities
504,677

 
3.5

Municipal bonds
3,713,434

 
25.6

Commercial mortgage backed securities
536,051

 
3.7

U.S. government and government agencies
2,804,811

 
19.3

Non-U.S. government securities
1,142,735

 
7.9

Asset backed securities
1,123,987

 
7.7

Total
$
14,521,774

 
100.0

The following table provides the credit quality distribution of our Fixed Maturities. For individual fixed maturities, S&P ratings are used. In the absence of an S&P rating, ratings from Moody’s are used, followed by ratings from Fitch Ratings.
 
Estimated Fair Value
 
% of
Total
June 30, 2017
 
 
 
U.S. government and gov’t agencies (1)
$
3,710,779

 
25.3

AAA
4,659,940

 
31.7

AA
2,636,762

 
18.0

A
2,091,875

 
14.2

BBB
800,125

 
5.4

BB
285,952

 
1.9

B
175,908

 
1.2

Lower than B
81,493

 
0.6

Not rated
239,858

 
1.6

Total
$
14,682,692

 
100.0

 
 
 
 
December 31, 2016
 
 
 
U.S. government and gov’t agencies (1)
$
3,210,899

 
22.1

AAA
3,918,739

 
27.0

AA
3,148,226

 
21.7

A
2,338,834

 
16.1

BBB
1,203,942

 
8.3

BB
226,321

 
1.6

B
156,405

 
1.1

Lower than B
90,833

 
0.6

Not rated
227,574

 
1.6

Total
$
14,521,774

 
100.0

(1)
Includes U.S. government-sponsored agency residential mortgage-backed securities and agency commercial mortgage-backed securities.

 
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The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for all Fixed Maturities which were in an unrealized loss position:
Severity of gross unrealized losses:
Estimated Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
June 30, 2017
 
 
 
 
 
0-10%
$
7,031,570

 
$
(64,424
)
 
78.0

10-20%
94,549

 
(17,555
)
 
21.2

20-30%
1,835

 
(519
)
 
0.6

Greater than 30%
249

 
(140
)
 
0.2

Total
$
7,128,203

 
$
(82,638
)
 
100.0

 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
0-10%
$
7,078,582

 
$
(127,909
)
 
71.6

10-20%
155,403

 
(24,219
)
 
13.5

20-30%
89,887

 
(25,929
)
 
14.5

Greater than 30%
1,496

 
(702
)
 
0.4

Total
$
7,325,368

 
$
(178,759
)
 
100.0

The following table summarizes our top ten exposures to fixed income corporate issuers by fair value at June 30, 2017, excluding guaranteed amounts and covered bonds:
 
Estimated Fair Value
 
Credit
Rating (1)
Apple Inc.
$
141,619

 
AA+/Aa1
Microsoft Corporation
131,332

 
AAA/Aaa
JPMorgan Chase & Co.
118,359

 
A-/A3
The Bank of New York Mellon Corporation
94,126

 
A/A1
Wells Fargo & Company
86,082

 
A/A2
Massmutual Global Funding II C
82,409

 
AA+/Aa2
Citigroup Inc.
81,149

 
A-/A3
MetLife, Inc.
77,893

 
AA-/Aa3
New York Life Insurance Company
69,203

 
AA+/Aaa
Morgan Stanley
64,765

 
BBB+/A3
Total
$
946,937

 
 
(1)
Average credit ratings as assigned by S&P and Moody’s, respectively.
 
The following table provides information on our structured securities, which includes residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and asset-backed securities (“ABS”):
 
Agencies
 
Investment Grade
 
Below Investment Grade
 
Total
June 30, 2017
 
 
 
 
 
 
 
RMBS
$
281,187

 
$
20,705

 
$
42,680

 
$
344,572

CMBS
4,397

 
468,001

 
48,874

 
521,272

ABS

 
1,624,303

 
115,392

 
1,739,695

Total
$
285,584

 
$
2,113,009

 
$
206,946

 
$
2,605,539

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
RMBS
$
393,188

 
$
60,600

 
$
50,889

 
$
504,677

CMBS
12,900

 
513,266

 
9,885

 
536,051

ABS

 
1,077,614

 
46,373

 
1,123,987

Total
$
406,088

 
$
1,651,480

 
$
107,147

 
$
2,164,715

At June 30, 2017, our structured securities included $27.3 million par value in sub-prime securities with a fair value of $23.5 million and average credit quality ratings from S&P/Moody’s of “CCC-/Ca.” At December 31, 2016, our fixed income portfolio included $25.3 million par value in sub-prime securities with a fair value of $23.3 million and average credit quality ratings from S&P/Moody’s of “CCC/Caa3.”
At June 30, 2017, our equity portfolio included $529.8 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.
The following table provides information on the severity of the unrealized loss position as a percentage of cost for all equity securities classified as available for sale which were in an unrealized loss position:
Severity of gross unrealized losses:
Estimated Fair Value
 
Gross
Unrealized
Losses
 
% of
Total Gross
Unrealized
Losses
June 30, 2017
 
 
 
 
 
0-10%
$
151,242

 
$
(3,262
)
 
45.3

10-20%
11,309

 
(1,879
)
 
26.1

20-30%
3,388

 
(1,019
)
 
14.2

Greater than 30%
1,237

 
(1,040
)
 
14.4

Total
$
167,176

 
$
(7,200
)
 
100.0

 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
0-10%
$
214,364

 
$
(8,776
)
 
50.1

10-20%
52,034

 
(7,100
)
 
40.5

20-30%
1,983

 
(607
)
 
3.5

Greater than 30%
1,000

 
(1,034
)
 
5.9

Total
$
269,381

 
$
(17,517
)
 
100.0


 
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The following table provides information on the fair value of our Eurozone investments at June 30, 2017:
Country (1)
Sovereign
(2)
 
Corporate Bonds
 
Other
(3)
 
Total
Netherlands
$
100,046

 
$
108,724

 
$
3,492

 
$
212,262

Germany
113,430

 
49,448

 
43,334

 
206,212

Belgium
35,278

 
7,667

 

 
42,945

France
4,816

 
13,193

 
23,790

 
41,800

Luxembourg

 
13,559

 
11,827

 
25,386

Austria
16,525

 

 

 
16,525

Spain

 
1,668

 
12,899

 
14,567

Ireland

 
6,049

 
2,285

 
8,335

Supranational (4)
7,282

 

 

 
7,282

Italy

 

 
6,540

 
6,540

Finland

 

 
3,464

 
3,464

Greece

 
155

 
1,220

 
1,375

Portugal

 

 
562

 
562

Total
$
277,378

 
$
200,464

 
$
109,412

 
$
587,254

(1)
The country allocations set forth in the table are based on various assumptions made by us in assessing the country in which the underlying credit risk resides, including a review of the jurisdiction of organization, business operations and other factors. Based on such analysis, we do not believe that we have any other Eurozone investments at June 30, 2017.
(2)
Includes securities issued and/or guaranteed by Eurozone governments.
(3)
Includes bank loans, equities and other.
(4)
Includes World Bank, European Investment Bank, International Finance Corp. and European Bank for Reconstruction and Development.
The following table summarizes our other investments:
 
June 30,
2017
 
December 31,
2016
Available for sale:
 
 
 
Asian and emerging markets
$
114,594

 
$
84,778

Investment grade fixed income
52,266

 
33,923

Credit related funds
14,632

 
7,469

Other
67,169

 
41,800

Total available for sale
248,661

 
167,970

Fair value option:
 
 
 
Term loan investments
409,126

 
378,877

Mezzanine debt funds
141,066

 
127,943

Credit related funds
197,144

 
218,298

Investment grade fixed income
86,389

 
75,468

Asian and emerging markets
202,799

 
178,568

Other (1)
138,710

 
129,717

Total fair value option
1,175,234

 
1,108,871

Total
$
1,423,895

 
$
1,276,841

(1)
Includes fund investments with strategies in mortgage servicing rights, transportation and infrastructure assets and other.
Investable Assets in the ‘Other’ Segment
Investable assets in the ‘other’ segment are managed by Watford Re. The board of directors of Watford Re establishes their investment policies and guidelines. Watford Re’s investments are accounted for using the fair value option with changes in
 
the carrying value of such investments recorded in net realized gains or losses.
The following table summarizes investable assets in the ‘other’ segment:
 
June 30,
2017
 
December 31,
2016
Investments accounted for using the fair value option:
 
 
 
Other investments
$
968,531

 
$
811,922

Fixed maturities
666,548

 
734,260

Short-term investments
474,965

 
309,127

Equity securities
19,392

 
2,314

Total
2,129,436

 
1,857,623

Cash
63,929

 
74,893

Securities sold but not yet purchased
(69,273
)
 
(33,157
)
Securities transactions entered into but not settled at the balance sheet date
(191,534
)
 
(41,596
)
Total investable assets included in ‘other’ segment
$
1,932,558

 
$
1,857,763

Premiums Receivable and Reinsurance Recoverables
At June 30, 2017, 77.7% of premiums receivable of $1.31 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 3.8% of the total. At December 31, 2016, 81.0% of premiums receivable of $1.07 billion represented amounts not yet due, while amounts in excess of 90 days overdue were 5.2% of the total. Our reserves for doubtful accounts were approximately $23.2 million at June 30, 2017, compared to $21.0 million at December 31, 2016.
At June 30, 2017 and December 31, 2016, approximately 75.3% and 75.7% of reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.16 billion and $2.11 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better while 24.7% 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 June 30, 2017 and December 31, 2016. The largest reinsurance recoverables from any one carrier was approximately 2.1% and 2.4%, respectively, of total shareholders’ equity available to Arch at June 30, 2017 and December 31, 2016.
Approximately 4.1% of the $38.9 million of paid losses and loss adjustment expenses recoverable at June 30, 2017 were more than 90 days overdue, 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 June 30, 2017.

 
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The effects of reinsurance on written and earned premiums and losses and loss adjustment expenses (“LAE”) with unaffiliated reinsurers were as follows:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Premiums written:
 
 
 
 
 
 
 
Direct
$
1,093,558

 
$
839,844

 
$
2,190,313

 
$
1,697,954

Assumed
516,101

 
490,092

 
1,077,336

 
1,069,948

Ceded
(360,964
)
 
(306,373
)
 
(742,694
)
 
(623,104
)
Net
$
1,248,695

 
$
1,023,563

 
$
2,524,955

 
$
2,144,798

 
 
 
 
 
 
 
 
Premiums earned:
 
 
 
 
 
 
 
Direct
$
1,071,648

 
$
795,358

 
$
2,095,100

 
$
1,575,128

Assumed
513,814

 
473,331

 
930,159

 
894,389

Ceded
(344,588
)
 
(262,704
)
 
(667,368
)
 
(511,953
)
Net
$
1,240,874

 
$
1,005,985

 
$
2,357,891

 
$
1,957,564

 
 
 
 
 
 
 
 
Losses and LAE:
 
 
 
 
 
 
 
Direct
$
544,061

 
$
525,719

 
$
1,051,179

 
$
981,052

Assumed
303,582

 
265,321

 
490,538

 
457,781

Ceded
(157,783
)
 
(206,448
)
 
(299,287
)
 
(331,292
)
Net
$
689,860

 
$
584,592

 
$
1,242,430

 
$
1,107,541

Reserves for Losses and Loss Adjustment Expenses 
We establish reserves for losses and loss adjustment expenses (“Loss Reserves”) which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of losses incurred. Estimating Loss Reserves is inherently difficult, which is exacerbated by the fact that we have relatively limited historical experience upon which to base such estimates. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of Loss Reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements.
 
At June 30, 2017 and December 31, 2016, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:
 
June 30,
2017
 
December 31,
2016
Insurance segment:
 

 
 

Case reserves
$
1,494,732

 
$
1,414,603

IBNR reserves
3,218,063

 
3,187,451

Total net reserves
4,712,795

 
4,602,054

Reinsurance segment:
 
 
 
Case reserves
928,379

 
762,730

Additional case reserves
93,693

 
92,524

IBNR reserves
1,485,774

 
1,517,983

Total net reserves
2,507,846

 
2,373,237

Mortgage segment:
 
 
 
Case reserves
491,124

 
593,222

IBNR reserves
74,127

 
59,791

Total net reserves (1)
565,251

 
653,013

Other segment:
 
 
 
Case reserves
209,184

 
125,703

Additional case reserves
11,110

 
9,513

IBNR reserves
398,115

 
353,865

Total net reserves
618,409

 
489,081

Total:
 

 
 

Case reserves
3,123,419

 
2,896,258

Additional case reserves
104,803

 
102,037

IBNR reserves
5,176,079

 
5,119,090

Total net reserves
$
8,404,301

 
$
8,117,385

(1)
Includes $510.3 million of net reserves from U.S. primary mortgage insurance business, of which 74.1% represents policy years 2007 and prior, 12.2% from 2008 and the remainder from later policy years.
At June 30, 2017 and December 31, 2016, the insurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
 
June 30,
2017
 
December 31,
2016
Insurance segment:
 
 
 
Professional lines (1)
$
1,331,585

 
$
1,293,667

Construction and national accounts
1,044,929

 
976,109

Excess and surplus casualty (2)
688,583

 
687,305

Programs
662,774

 
667,677

Property, energy, marine and aviation
270,265

 
302,057

Travel, accident and health
75,512

 
72,726

Lenders products
45,213

 
42,147

Other (3)
593,934

 
560,366

Total net reserves
$
4,712,795

 
$
4,602,054

(1)
Includes professional liability, executive assurance and healthcare business.
(2)
Includes casualty and contract binding business.
(3)
Includes alternative markets, excess workers’ compensation and surety business.

 
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At June 30, 2017 and December 31, 2016, the reinsurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
 
June 30,
2017
 
December 31,
2016
Reinsurance segment:
 
 
 
Casualty (1)
$
1,416,618

 
$
1,355,362

Other specialty (2)
498,497

 
428,205

Property excluding property catastrophe (3)
315,683

 
297,200

Marine and aviation
139,608

 
147,700

Property catastrophe
77,834

 
86,026

Other (4)
59,606

 
58,744

Total net reserves
$
2,507,846

 
$
2,373,237

(1)
Includes executive assurance, professional liability, workers’ compensation, excess motor, healthcare and other.
(2)
Includes non-excess motor, surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and other.
(3)
Includes facultative business.
(4)
Includes life, casualty clash and other.
Mortgage Operations Supplemental Information
The mortgage segment’s insurance in force (“IIF”) and risk in force (“RIF”) were as follows at the end of the last two quarters:
(U.S. Dollars in millions)
June 30, 2017
 
March 31, 2017
Amount
 
%
 
Amount
 
%
Insurance In Force (IIF) (1):
 
 
 
 
 
 
 
U.S. primary mortgage insurance
$
244,235

 
73.4

 
$
237,769

 
73.1

Mortgage reinsurance
26,120

 
7.8

 
25,846

 
7.9

Other (2)
62,503

 
18.8

 
61,596

 
18.9

Total
$
332,858

 
100.0

 
$
325,211

 
100.0

 
 
 
 
 
 
 
 
Risk In Force (RIF) (3):
 
 
 
 
 
 
 
U.S. primary mortgage insurance
$
62,362

 
92.6

 
$
60,591

 
92.5

Mortgage reinsurance
2,453

 
3.6

 
2,494

 
3.8

Other (2)
2,517

 
3.7

 
2,409

 
3.7

Total
$
67,332

 
100.0

 
$
65,494

 
100.0

(1)
Represents the aggregate dollar amount of each insured mortgage loan’s current principal balance.
(2)
Includes GSE credit risk-sharing transactions and international insurance business.
(3)
Represents the aggregate dollar amount of each insured mortgage loan’s current principal balance multiplied by the insurance coverage percentage specified in the policy for insurance policies issued and after contract limits and/or loss ratio caps for credit risk-sharing or reinsurance transactions.
 
The insurance in force and risk in force for our U.S. primary mortgage insurance business by policy year were as follows at June 30, 2017:
(U.S. Dollars in millions)
IIF
 
RIF
 
Delinquency
Amount
 
%
 
Amount
 
%
 
Rate (1)
Policy year:
 
 
 
 
 
 
 
 
 
2007 and prior
$
22,865

 
9.4

 
$
5,222

 
8.4

 
10.12
%
2008
6,089

 
2.5

 
1,500

 
2.4

 
6.78
%
2009
1,369

 
0.6

 
323

 
0.5

 
2.41
%
2010
1,472

 
0.6

 
395

 
0.6

 
1.62
%
2011
4,423

 
1.8

 
1,208

 
1.9

 
1.07
%
2012
15,205

 
6.2

 
4,159

 
6.7

 
0.56
%
2013
24,871

 
10.2

 
6,764

 
10.8

 
0.69
%
2014
25,916

 
10.6

 
6,889

 
11.0

 
0.69
%
2015
46,682

 
19.1

 
11,941

 
19.1

 
0.39
%
2016
65,720

 
26.9

 
16,476

 
26.4

 
0.21
%
2017
29,623

 
12.1

 
7,485

 
12.0

 
0.03
%
Total
$
244,235

 
100.0

 
$
62,362

 
100.0

 
2.02
%
(1)
Represents the ending percentage of loans in default.
The following tables provide supplemental disclosures on risk in force for our U.S. primary mortgage insurance business at the end of the last two quarters:
(U.S. Dollars in millions)
June 30, 2017
 
March 31, 2017
Amount
 
%
 
Amount
 
%
Credit quality (FICO):
 
 
 
 
 
 
 
>=740
$
36,378

 
58.3

 
$
35,396

 
58.4

680-739
20,122

 
32.3

 
19,343

 
31.9

620-679
5,118

 
8.2

 
5,065

 
8.4

<620
744

 
1.2

 
787

 
1.3

Total
$
62,362

 
100.0

 
$
60,591

 
100.0

Weighted average FICO score
743

 
 
 
743

 
 
 
 
 
 
 
 
 
 
Loan-to-value (LTV):
 
 
 
 
 
 
 
95.01% and above
$
5,983

 
9.6

 
$
5,808

 
9.6

90.01% to 95.00%
34,718

 
55.7

 
33,617

 
55.5

85.01% to 90.00%
18,810

 
30.2

 
18,346

 
30.3

85.00% and below
2,851

 
4.6

 
2,820

 
4.7

Total
$
62,362

 
100.0

 
$
60,591

 
100.0

Weighted average LTV
92.8
%
 
 
 
92.9
%
 
 
 
 
 
 
 
 
 
 
Total RIF, net of external reinsurance
$
45,774

 
 
 
$
43,606

 
 



 
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(U.S. Dollars in millions)
June 30, 2017
 
March 31, 2017
Amount
 
%
 
Amount
 
%
Total RIF by State:
 
 
 
 
 
 
 
Texas
$
5,075

 
8.1

 
$
4,995

 
8.2

California
3,524

 
5.7

 
3,333

 
5.5

Virginia
2,691

 
4.3

 
2,625

 
4.3

Florida
2,622

 
4.2

 
2,467

 
4.1

North Carolina
2,346

 
3.8

 
2,278

 
3.8

Washington
2,311

 
3.7

 
2,313

 
3.8

Georgia
2,239

 
3.6

 
2,153

 
3.6

Maryland
2,160

 
3.5

 
2,107

 
3.5

Illinois
2,157

 
3.5

 
2,109

 
3.5

Minnesota
2,072

 
3.3

 
2,003

 
3.3

Others
35,165

 
56.4

 
34,208

 
56.5

Total
$
62,362

 
100.0

 
$
60,591

 
100.0

The following table provides supplemental disclosures for our U.S. primary mortgage insurance business related to insured loans and loss metrics:
(U.S. Dollars in thousands, except policy, loan and claim count)
 
Three Months Ended
 
June 30,
2017
 
March 31,
2017
Roll-forward of insured loans in default:
 
 
 
 
Beginning delinquent number of loans
 
26,234

 
29,691

New notices
 
8,858

 
9,863

Cures
 
(9,078
)
 
(11,707
)
Paid claims
 
(2,111
)
 
(1,613
)
Ending delinquent number of loans (1)
 
23,903

 
26,234

 
 
 
 
 
Ending number of policies in force (1)
 
1,183,659

 
1,164,929

 
 
 
 
 
Delinquency rate (1)
 
2.02
%
 
2.25
%
 
 
 
 
 
Losses:
 
 
 
 
Number of claims paid
 
2,111

 
1,613

Total paid claims
 
$
85,539

 
$
70,784

Average per claim
 
$
40.5

 
$
43.9

Severity (2)
 
104.4
%
 
102.0
%
Average reserve per default (in thousands) (1)
 
$
20.4

 
$
20.4

(1)
Includes first lien primary and pool policies.
(2)
Represents total paid claims divided by RIF of loans for which claims were paid.
The risk-to-capital ratio, which represents total current (non-delinquent) risk in force, net of reinsurance, divided by total statutory capital, for Arch MI U.S. was approximately 11.7 to 1 at June 30, 2017, compared to 12.0 to 1 at March 31, 2017.
Shareholders’ Equity and Book Value per Share
Total shareholders’ equity available to Arch was $8.90 billion at June 30, 2017, compared to $8.25 billion at December 31, 2016. The increase was primarily attributable to net income, reflecting contributions from both underwriting and investing activities.
 
The following table presents the calculation of book value per share:
(U.S. dollars in thousands, except 
share data)
June 30,
2017
 
December 31,
2016
Total shareholders’ equity available to Arch
$
8,898,887

 
$
8,253,718

Less preferred shareholders’ equity
772,555

 
772,555

Common shareholders’ equity available to Arch
$
8,126,332

 
$
7,481,163

Common shares and common share equivalents outstanding, net of treasury shares (1)
136,354,159

 
135,550,337

Book value per share
$
59.60

 
$
55.19

(1)
Excludes the effects of 6,972,369 and 6,872,494 stock options and 429,583 and 381,461 restricted stock units outstanding at June 30, 2017 and December 31, 2016, respectively.
Liquidity and Capital Resources 
Refer to the ‘Liquidity and Capital Resources’ section contained in Item 7 of our 2016 Form 10-K for a general discussion of our liquidity and capital resources. This section does not include information specific to Watford Re. We do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions with Watford Re.
The following table provided an analysis of our capital structure:
(U.S. dollars in thousands, except 
share data)
June 30,
2017
 
December 31,
2016
Debt:
 
 
 
ACGL senior notes, due May 2034
$
297,007

 
$
296,957

Arch-U.S. senior notes, due Nov 2043 (1)
494,572

 
494,525

ACF senior notes, due Dec 2026 (2)
495,868

 
495,689

ACF senior notes, due Dec 2046 (2)
445,123

 
445,087

Revolving credit agreement borrowings due Oct 2021
500,000

 
500,000

Total
$
2,232,570

 
$
2,232,258

 
 
 
 
Shareholders’ equity available to Arch:
 
 
 
Series C non-cumulative preferred shares
$
322,555

 
$
322,555

Series E non-cumulative preferred shares
450,000

 
450,000

Common shareholders’ equity
8,126,332

 
7,481,163

Total
$
8,898,887

 
$
8,253,718

 
 
 
 
Total capital available to Arch
$
11,131,457

 
$
10,485,976

 
 
 
 
Debt to total capital (%)
20.1

 
21.3

Debt and prefered to total capital (%)
27.0

 
28.7

(1)
Issued by Arch Capital Group (U.S.) Inc., a wholly owned subsidiary of ACGL, and fully and unconditionally guaranteed by ACGL.
(2)
Issued by Arch Capital Finance LLC (“ACF”), a wholly owned subsidiary of Arch U.S. MI Holdings Inc., and fully and unconditionally guaranteed by ACGL.

 
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For the six months ended June 30, 2017, ACGL received dividends of $56.0 million from Arch Reinsurance Ltd. (“Arch Re Bermuda”), our Bermuda-based reinsurer and insurer, which can pay approximately $1.91 billion to ACGL during the remainder of 2017 without providing an affidavit to the Bermuda Monetary Authority (“BMA”).
Our U.S. insurance and reinsurance subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate. The ability of our 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.
In addition, Arch MI U.S. is required to maintain compliance with the GSEs requirements, known as the Private Mortgage Insurer Eligibility Requirements or “PMIERs.” The financial requirements require an eligible mortgage insurer’s available assets, which generally include only the most liquid assets of an insurer, to meet or exceed “minimum required assets” as of each quarter end. Minimum required assets are calculated from PMIERs tables with several risk dimensions (including origination year, original loan-to-value and original credit score of performing loans, and the delinquency status of non-performing loans) and are subject to a minimum amount. Arch MI U.S. satisfied the PMIERs’ financial requirements as of June 30, 2017 with an estimated PMIER sufficiency ratio of 122%, compared to 122% at March 31, 2017.
For the six months ended June 30, 2017, Arch U.S. MI Holdings Inc., a subsidiary of Arch-U.S., received $319.0 million of dividends from subsidiaries of United Guaranty Corporation including United Guaranty Residential Insurance Company. Of such amount, $263.0 million was contributed to Arch Mortgage Insurance Company. No additional dividends are available to be paid to Arch U.S. MI Holdings Inc. for the remainder of 2017.
Pursuant to our 2014 acquisition of the CMG Entities, we made a contingent consideration payment of $71.7 million in April 2017. The maximum amount of remaining contingent consideration payments over the remaining earn-out period is $68.2 million.
 
The following table summarizes our cash flows from operating, investing and financing activities, excluding amounts related to the ‘other’ segment (i.e., Watford Re). See Note 3, “Variable Interest Entities,” for cash flows related to Watford Re.
 
Six Months Ended
 
June 30,
 
2017
 
2016
Total cash provided by (used for):
 

 
 

Operating activities
$
420,287

 
$
410,213

Investing activities
(266,273
)
 
(341,882
)
Financing activities
(252,009
)
 
(65,796
)
Effects of exchange rate changes on foreign currency cash
6,337

 
(5,246
)
Increase (decrease) in cash
$
(91,658
)
 
$
(2,711
)
Cash provided by operating activities for the six months ended June 30, 2017 was higher than in the 2016 period, primarily reflecting higher premiums collected, partially offset by a higher level of paid losses.
Cash used for investing activities for the six months ended June 30, 2017 was lower than in the 2016 period, reflecting changes in cash collateral related to securities lending. In addition, activity for the 2017 period reflected higher net purchases of investments than in the 2016 period, including re-balancing of the UGC portfolio.
Cash used for financing activities for the six months ended June 30, 2017 was higher than in the 2016 period, reflecting changes in cash collateral related to securities lending. Activity for the 2016 period reflected $75.3 million of repurchases under our share repurchase program.
At June 30, 2017, our investable assets were $19.17 billion (excluding the $1.93 billion of investable assets related to the ‘other’ segment). Our unfunded investment commitments totaled approximately $1.56 billion at June 30, 2017. Please refer to Item 1A “Risk Factors” of our 2016 Form 10-K for a discussion of other risks relating to our business and investment portfolio.
We expect that our liquidity needs, including our anticipated (re)insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by funds generated from underwriting activities and investment income, as well as by our balance of cash, short-term investments, proceeds on the sale or maturity of our investments, and our credit facilities.
Off-Balance Sheet Arrangements
Off-balance sheet arrangements are discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our 2016 Form 10-K.

 
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Market Sensitive Instruments and Risk Management
In accordance with the SEC’s Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as of June 30, 2017. Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. We have not included Watford Re in the following analyses as we do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions.
An analysis of material changes in market risk exposures at June 30, 2017 that affect the quantitative and qualitative disclosures presented in our 2016 Form 10-K (see section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Sensitive Instruments and Risk Management”) were as follows: 
Investment Market Risk
Fixed Income Securities. We invest in interest rate sensitive securities, primarily debt securities. We consider the effect of interest rate movements on the fair value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments which invest in fixed income securities and the corresponding change in unrealized appreciation. As interest rates rise, the fair value of our interest rate sensitive securities falls, and the converse is also true. Based on historical observations, there is a low probability that all interest rate yield curves would shift in the same direction at the same time. Accordingly, the actual effect of interest rate movements may differ materially from the amounts set forth in the following tables.
The following table summarizes the effect that an immediate, parallel shift in the interest rate yield curve would have had on our fixed income securities:
(U.S. dollars in 
billions)
Interest Rate Shift in Basis Points
-100
 
-50
 
 
+50
 
+100
Jun. 30, 2017
 

 
 

 
 

 
 

 
 

Total fair value
$
18.58

 
$
18.27

 
$
17.97

 
$
17.66

 
$
17.37

Change from base
3.40
%
 
1.70
%
 
 
 
(1.70
)%
 
(3.30
)%
Change in unrealized value
$
0.61

 
$
0.31

 
 
 
$
(0.31
)
 
$
(0.59
)
 
 
 
 
 
 
 
 
 
 
Dec. 31, 2016
 
 
 
 
 
 
 
 
 
Total fair value
$
17.95

 
$
17.62

 
$
17.31

 
$
17.00

 
$
16.70

Change from base
3.70
%
 
1.80
%
 
 
 
(1.80
)%
 
(3.50
)%
Change in unrealized value
$
0.64

 
$
0.31

 
 
 
$
(0.31
)
 
$
(0.61
)
 
In addition, we consider the effect of credit spread movements on the fair value of our fixed income securities and the corresponding change in unrealized appreciation. As credit spreads widen, the fair value of our fixed income securities falls, and the converse is also true.
The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on our fixed income securities:
(U.S. dollars in 
billions)
Credit Spread Shift in Percentage Points
-100
 
-50
 
 
+50
 
+100
Jun. 30, 2017
 

 
 

 
 

 
 

 
 

Total fair value
$
18.38

 
$
18.18

 
$
17.97

 
$
17.75

 
$
17.55

Change from base
2.30
%
 
1.20
%
 
 
 
(1.20
)%
 
(2.30
)%
Change in unrealized value
$
0.41

 
$
0.22

 
 
 
$
(0.22
)
 
$
(0.41
)
 
 
 
 
 
 
 
 
 
 
Dec. 31, 2016
 
 
 
 
 
 
 
 
 
Total fair value
$
17.79

 
$
17.55

 
$
17.31

 
$
17.07

 
$
16.83

Change from base
2.80
%
 
1.40
%
 
 
 
(1.40
)%
 
(2.80
)%
Change in unrealized value
$
0.48

 
$
0.24

 
 
 
$
(0.24
)
 
$
(0.48
)
Another method that attempts to measure portfolio risk is Value-at-Risk (“VaR”). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio’s initial value. In other words, 95% of the time, should the risks taken into account in the VaR model perform per their historical tendencies, the portfolio’s loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio’s initial value. As of June 30, 2017, our portfolio’s VaR was estimated to be 3.69% compared to an estimated 3.75% at December 31, 2016.
Equity Securities. At June 30, 2017 and December 31, 2016, the fair value of our investments in equity securities totaled $529.8 million and $558.0 million, respectively. These investments are exposed to price risk, which is the potential loss arising from decreases in fair value. An immediate hypothetical 10% decline in the value of each position would reduce the fair value of such investments by approximately $53.0 million and $55.8 million at June 30, 2017 and December 31, 2016, respectively, and would have decreased book value per common share by approximately $0.39 and $0.41, respectively. An immediate hypothetical 10% increase in the value of each position would increase the fair value of such investments by approximately $53.0 million and $55.8 million at June 30, 2017 and December 31, 2016, respectively, and would have increased book value per common share by approximately $0.39 and $0.41, respectively.

 
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Investment-Related Derivatives. At June 30, 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 $3.63 billion, compared to $2.12 billion at December 31, 2016. If the underlying exposure of each investment-related derivative held at June 30, 2017 depreciated by 100 basis points, it would have resulted in a reduction in net income of approximately $36.3 million, and a decrease in book value per common share of approximately $0.27 per share, compared to $21.2 million and $0.16 per share, respectively, on investment-related derivatives held at December 31, 2016. If the underlying exposure of each investment-related derivative held at June 30, 2017 appreciated by 100 basis points, it would have resulted in an increase in net income of approximately $36.3 million, and an increase in book value per common share of approximately $0.27 per share, compared to $21.2 million and $0.16 per share, respectively, on investment-related derivatives held at December 31, 2016. See note 9, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives.
Foreign Currency Exchange Risk
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Through our subsidiaries and branches located in various foreign countries, we conduct our insurance and reinsurance operations in a variety of local currencies other than the U.S. Dollar. We generally hold investments in foreign currencies which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities and also utilize foreign currency forward contracts and currency options as part of our investment strategy. From time to time, we may elect to over or underweight one or more currencies, which could increase our exposure to foreign currency fluctuations and increase the volatility of our shareholders’ equity.
For further discussion on foreign exchange activity, please refer to “—Results of Operations” and note 9, “Derivative Instruments,” of the notes accompanying our consolidated financial statements.
 
The following table provides a summary of our net foreign currency exchange exposures, as well as foreign currency derivatives in place to manage these exposures:
(U.S. dollars in thousands, except 
per share data)
June 30,
2017
 
December 31,
2016
Net assets (liabilities), denominated in foreign currencies, excluding shareholders’ equity and derivatives
$
(314,239
)
 
$
(63,077
)
Shareholders’ equity denominated in foreign currencies (1)
305,326

 
290,752

Net foreign currency forward contracts outstanding (2)
(194,170
)
 
(250,263
)
Net exposures denominated in foreign currencies
$
(203,083
)
 
$
(22,588
)
 
 
 
 
Pre-tax impact of a hypothetical 10% appreciation of the U.S. Dollar against foreign currencies:
 

 
 

Shareholders’ equity
$
20,308

 
$
2,259

Book value per common share
$
0.15

 
$
0.02

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

 
 

Shareholders’ equity
$
(20,308
)
 
$
(2,259
)
Book value per common share
$
(0.15
)
 
$
(0.02
)
(1)
Represents capital contributions held in the foreign currencies of our operating units.
(2)
Represents the net notional value of outstanding foreign currency forward contracts.
Historical observations indicate a low probability that all foreign currency exchange rates would shift against the U.S. Dollar in the same direction and at the same time and, accordingly, the actual effect of foreign currency rate movements may differ materially from the amounts set forth above.
Other Financial Information
The consolidated financial statements as of June 30, 2017 and for the three month and six month periods ended June 30, 2017 and 2016 have been reviewed by PricewaterhouseCoopers LLP, the registrant's independent public accountants, whose report is included as an exhibit to this filing. The report of PricewaterhouseCoopers LLP states that they did not audit and they do not express an opinion on that unaudited financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report on the unaudited financial information because that report is not a "report" or a "part" of the registration statement prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Securities Act of 1933.

 
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Reference is made to the information appearing above under the subheading “Market Sensitive Instruments and Risk Management” under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which information is hereby incorporated by reference. 

ITEM 4. CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
In connection with the filing of this Form 10-Q, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of disclosure controls and procedures pursuant to applicable Exchange Act Rules as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of the end of and during the period covered by this report with respect to information being recorded, processed, summarized and reported within time periods specified in the SEC’s rules and forms and with respect to timely communication to them and other members of management responsible for preparing periodic reports of all material information required to be disclosed in this report as it relates to ACGL and its consolidated subsidiaries.
We continue to enhance our operating procedures and internal controls to effectively support our business and our regulatory and reporting requirements. Our management does not expect that our disclosure controls or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons or by collusion of two or more people. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in
 
achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. As a result of the inherent limitations in a cost-effective control system, misstatement due to error or fraud may occur and not be detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the disclosure controls and procedures are met.
Changes in Internal Controls Over Financial Reporting
We acquired all of the issued and outstanding capital stock of UGC on December 31, 2016. As allowed under SEC guidance, management’s assessment of and conclusion regarding the design and effectiveness of internal control over financial reporting excluded the internal control over financial reporting of UGC, which is relevant to the Company’s consolidated financial statements as of and for the six months ended June 30, 2017. UGC represents 14% of total assets as of June 30, 2017 and 14% of our total revenues for the six months ended June 30, 2017. The financial reporting systems of UGC have not yet been fully integrated into our financial reporting systems and, as such, we did not have the practical ability to perform an assessment of UGC’s internal control over financial reporting in time for the current quarter-end. Management expects to complete the process of integrating UGC’s internal control over financial reporting during 2017. The UGC acquisition represents a material change in internal control over financial reporting as defined in Exchange Act Rule 13a-15(f) for the six months ended June 30, 2017.
There have been no changes in internal control over financial reporting that occurred during the quarter ended June 30, 2017 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting, other than the UGC acquisition as described in the preceding paragraph.

 
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PART II.  OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
We, in common with the insurance industry in general, are subject to litigation and arbitration in the normal course of our business. As of June 30, 2017, we were not a party to any litigation or arbitration which is expected by management to have a material adverse effect on our results of operations and financial condition and liquidity.

ITEM 1A. RISK FACTORS
There were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016.

 
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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table summarizes our purchases of our common shares for the 2017 second quarter:
 
 
Issuer Purchases of Equity Securities
Period
 
Total Number of Shares
Purchased (1)
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of
Publicly Announced
Plans or Programs
 
Approximate Dollar
Value of Shares that
 May Yet be Purchased
Under the Plan or
Programs (2)
4/1/2017 - 4/30/2017
 
10,403

 
$
95.44

 

 
$
446,501

5/1/2017 - 5/31/2017
 
114,538

 
95.22

 

 
$
446,501

6/1/2017 - 6/30/2017
 
1,844

 
94.20

 

 
$
446,501

Total
 
126,785

 
$
95.22

 

 
$
446,501

(1)
Represents repurchases by ACGL of shares, from time to time, from employees in order to facilitate the payment of withholding taxes on restricted shares granted and the exercise of stock appreciation rights. We purchased these shares at their fair value, as determined by reference to the closing price of our common shares on the day the restricted shares vested or the stock appreciation rights were exercised.
(2)
Remaining amount available at June 30, 2017 under ACGL’s share repurchase authorization, under which repurchases may be effected from time to time in open market or privately negotiated transactions through December 31, 2019.

ITEM 5. OTHER INFORMATION
In accordance with Section 10a(i)(2) of the Securities Exchange Act of 1934, as amended, we are responsible for disclosing non-audit services to be provided by our independent auditor, PricewaterhouseCoopers LLP, which are approved by the Audit Committee of our board of directors. During the 2017 second quarter, the Audit Committee approved engagements of PricewaterhouseCoopers LLP for permitted non-audit services, which consisted of tax consulting services, tax compliance services and other accounting consulting services.
Disclosure of Certain Activities Under Section 13(r) of the Securities Exchange Act of 1934

Section 13(r) of the Securities Exchange Act of 1934, as amended, requires an issuer to disclose in its annual or quarterly reports whether it or an affiliate knowingly engaged in certain activities described in that section, including certain activities related to Iran during the period covered by the report.
Effective January 16, 2016, the Office of Foreign Assets Control of the U.S. Department of the Treasury adopted General License H which authorizes non-U.S. entities that are owned or controlled by a U.S. person to engage in certain activities with Iran so long as they comply with certain specific requirements set forth therein.
Certain of our non-U.S. subsidiaries provide global marine policies that provide coverage for vessels navigating into and out of ports worldwide. In light of European Union and U.S. modifications to Iran sanctions this year, including the issuance of General License H, and consistent with General License H, we have been notified that certain of our policyholders have begun to, or will begin to, ship cargo to and from Iran, and that such cargo may include transporting crude oil from Iran to another country. Since these policies insure multiple voyages and fleets containing multiple ships, we are unable to attribute gross revenues and net profits from such marine policies to these activities involving Iran. We intend for our non-U.S. subsidiaries to continue to provide such coverage to the extent permitted by applicable law.

ITEM 6. EXHIBITS
 
See Exhibit Index for a list of exhibits filed as part of this report.
 



 
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
ARCH CAPITAL GROUP LTD.
 
 
(REGISTRANT)
 
 
 
 
 
/s/ Constantine Iordanou
Date: August 4, 2017
 
Constantine Iordanou
 
 
Chief Executive Officer (Principal Executive Officer) and Chairman of the Board of Directors
 
 
 
 
 
/s/ Mark D. Lyons
Date: August 4, 2017
 
Mark D. Lyons
 
 
Executive Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

 
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EXHIBIT INDEX

Exhibit No.
 
Description
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101
 
The following financial information from Arch Capital Group Ltd.’s Quarterly Report for the quarter ended June 30, 2017 formatted in XBRL: (i) Consolidated Balance Sheets at June 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income for the three and six month periods ended June 30, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income for the three and six month periods ended June 30, 2017 and 2016; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the six month periods ended June 30, 2017 and 2016; (v) Consolidated Statements of Cash Flows for the six month periods ended June 30, 2017 and 2016; and (vi) Notes to Consolidated Financial Statements.
 
 
 
 
Management contract or compensatory plan or arrangement.






 
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