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ACGL > SEC Filings for ACGL > Form 10-Q on 8-Nov-2013All Recent SEC Filings

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Form 10-Q for ARCH CAPITAL GROUP LTD.


8-Nov-2013

Quarterly Report


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, 2012 ("2012 Form 10-K"). In addition, readers should review "Risk Factors" set forth in Item 1A of Part I of our 2012 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 $5.84 billion in capital at September 30, 2013 and, through operations in Bermuda, the United States, Europe and Canada, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in the insurance and reinsurance markets.

Current Outlook

The broad market environment continued to show improvement in the 2013 third quarter, although rate increases moderated somewhat relative to earlier in 2013. In our U.S. insurance business, weighted rate increases provided 1.7% of expected margin improvement (i.e., rates in excess of loss cost trends) in the 2013 third quarter. We expanded our insurance underwriting platform in the excess and surplus lines market in March 2013 by starting a binding authority insurance facility that caters to smaller accounts through the wholesale distribution channel. This group immediately began contributing to our premiums and continues to gain traction across Arch's distribution platform. On an absolute basis, we believe that most longer-tail casualty business still requires rate improvement to meet our return objectives but some segments are approaching rate adequacy. In our reinsurance business, we see pressure on terms and conditions in property catastrophe business, where alternative capacity is putting pressure on rates. In addition, cedents have pressed for additional ceding commissions (generally one to two points) and are moving to excess of loss instead of pro rata coverage. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts and focusing more on short-tail business.

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 significant portion of our overall book in catastrophe-exposed business which has the potential to increase the volatility of our operating results.

The current economic conditions could continue to 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, the impact of the continuing 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 possible additional 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 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. We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of October 1, 2013, our modeled peak zone catastrophe exposure was a windstorm affecting the


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Northeastern U.S., with a net probable maximum pre-tax loss of $868 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum pre-tax losses of $736 million and $615 million, respectively. Based on in-force exposure estimated as of July 1, 2013, our modeled peak zone exposure was a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $858 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum pre-tax losses of $746 million and $606 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, was less than the exposures arising from U.S. windstorms and hurricanes in both periods. As of October 1, 2013, our modeled peak zone earthquake exposure (New Madrid earthquake) represented less than 45% 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 our total shareholders' equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques 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-Risk 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 2012 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 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 $38.34 at September 30, 2013, compared to $36.80 at June 30, 2013 and $36.79 at September 30, 2012. The 4.2% increase in the 2013 third quarter and trailing twelve months was primarily driven by strong underwriting results.

Operating Return on Average Common Equity

Operating return on average common equity ("Operating ROAE") represents annualized after-tax operating income available to common shareholders divided by the average of beginning and ending common shareholders' equity during the period. After-tax operating income available to common shareholders, a "non-GAAP measure" as defined in the SEC rules, represents net income available to 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 loss on repurchase of preferred shares, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to common shareholders and has set an objective to achieve an average Operating ROAE of 15% or greater over the insurance cycle, which it believes to be an attractive return to common shareholders given the risks we assume. See "Comment on Non-GAAP Financial Measures." Our Operating ROAE was 11.9% for the 2013 third quarter, compared to 9.9% for the 2012 third quarter, and 11.9% for the nine months ended September 30, 2013, compared to 10.8% for the 2012 period. The higher level of Operating ROAE for the 2013 periods primarily resulted from better underwriting results in our reinsurance and insurance segments.


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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 our investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses and includes the effect of financial market conditions along with foreign currency fluctuations. Management uses total return on investments as a key measure of the return generated to common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods. The benchmark return is a weighted average of the benchmarks assigned to each of our investment managers and vary based on the nature of the portfolios under management.

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. 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 September 30, 2013, the benchmark return index had an average credit quality of "Aa2" by Moody's Investors Service ("Moody's"), an estimated duration of 3.56 years and included weightings to the following indices:

                                                                       Weighting
The Bank of America Merrill Lynch 1-10 Year U.S. Treasury & Agency
Index                                                                    30.875 %
The Bank of America Merrill Lynch 1-10 Year AA U.S. Corporate &
Yankees Index                                                            20.875 %
The Bank of America Merrill Lynch U.S. Mortgage Backed Securities
Index                                                                    11.875 %
Barclays Capital CMBS, AAA Index                                         10.000 %
The Bank of America Merrill Lynch 1-10 Year U.S. Municipal Securities
Index                                                                     7.125 %
MSCI World Free Index                                                     5.000 %
The Bank of America Merrill Lynch 0-3 Month U.S. Treasury Bill Index      4.750 %
The Bank of America Merrill Lynch U.S. High Yield Constrained Index       2.375 %
Barclays Capital U.S. High-Yield Corporate Loan Index                     2.375 %
The Bank of America Merrill Lynch 1-10 Year U.K. Gilt Index               2.375 %
The Bank of America Merrill Lynch 1-10 Year Euro Government Index         2.375 %
Total                                                                   100.000 %

The following table summarizes the pre-tax total return (before investment expenses) of our investment portfolio compared to the benchmark return against which we measured our portfolio during the periods:

                                                      Arch      Benchmark
                                                   Portfolio      Return
Pre-tax total return (before investment expenses):
2013 third quarter                                     1.43 %       1.36 %
2012 third quarter                                     2.45 %       1.86 %

Nine Months Ended September 30, 2013                   0.31 %       0.38 %
Nine Months Ended September 30, 2012                   5.04 %       4.34 %

Total return for the 2013 periods reflected positive returns of our equity and alternatives portfolios, partially offset by the impact of both higher interest rates and wider credit spreads compared to the 2012 periods. Excluding foreign exchange, total return was 0.84% for the 2013 third quarter, compared to 2.17% for the 2012 third quarter, and 0.27% for the nine months ended September 30, 2013, compared to 4.89% for the 2012 period.


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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 common shareholders, which is defined as net income available to 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 loss on repurchase of preferred shares, net of income taxes. The presentation of after-tax operating income available to common shareholders is a "non-GAAP financial measure" as defined in Regulation G. The reconciliation of such measure to net income available to common shareholders (the most directly comparable GAAP financial measure) 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 loss on repurchase of preferred shares in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. The loss on repurchase of preferred shares related to the redemption of the Series A and B preferred shares in April 2012 and had no impact on total shareholders' equity or cash flows. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and loss on repurchase of preferred shares from the calculation of after-tax operating income available to common shareholders.

We believe that showing net income available to 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 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.


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RESULTS OF OPERATIONS

The following table summarizes, on an after-tax basis, our consolidated
financial data, including a reconciliation of after-tax operating income
available to common shareholders to net income available to common shareholders:

                                             Three Months Ended           Nine Months Ended
                                                September 30,               September 30,
                                             2013          2012          2013          2012
After-tax operating income available to
common shareholders                       $ 149,205     $ 120,247     $ 442,974     $ 375,307
Net realized gains (losses), net of tax      (3,442 )      58,904        65,260       133,052
Net impairment losses recognized in
earnings, net of tax                           (728 )      (2,379 )      (3,698 )      (5,353 )
Equity in net income of investment funds
accounted for using the equity method,
net of tax                                    5,665        24,330        30,429        56,943
Net foreign exchange losses, net of tax     (41,359 )     (16,930 )      (3,177 )      (5,363 )
Loss on repurchase of preferred shares,
net of tax                                        -             -             -       (10,612 )
Net income available to common
shareholders                              $ 109,341     $ 184,172     $ 531,788     $ 543,974

Segment Information

We classify our businesses into two underwriting segments - insurance and reinsurance - and corporate and other (non-underwriting). Management measures segment performance based on underwriting income or loss. We do not manage our assets by segment and, accordingly, investment income is not allocated to each underwriting segment. In addition, other revenue and expense items are not evaluated by segment.

Insurance Segment

The following table sets forth our insurance segment's underwriting results:

                                   Three Months Ended September 30,                Nine Months Ended September 30,
                                  2013               2012        % Change         2013             2012        % Change
Gross premiums written       $    682,839       $    658,599         3.7     $   2,075,560     $ 2,022,802         2.6
Net premiums written              501,971            483,356         3.9         1,508,089       1,438,620         4.8

Net premiums earned          $    479,129       $    456,341         5.0     $   1,382,750     $ 1,344,675         2.8
Fee income                            545                645                         1,599           1,803
Losses and loss adjustment
expenses                         (305,921 )         (307,155 )                    (880,580 )      (900,735 )
Acquisition expenses, net         (82,799 )          (73,663 )                    (227,806 )      (223,591 )
Other operating expenses          (75,734 )          (75,379 )                    (232,216 )      (225,366 )
Underwriting income (loss)   $     15,220       $        789         n/m     $      43,747     $    (3,214 )       n/m

                                                                  % Point                                       % Point
Underwriting Ratios                                               Change                                        Change
Loss ratio                           63.8 %             67.3 %      (3.5 )            63.7 %          67.0 %      (3.3 )
Acquisition expense ratio
(1)                                  17.2 %             16.0 %       1.2              16.4 %          16.5 %      (0.1 )
Other operating expense
ratio                                15.8 %             16.5 %      (0.7 )            16.8 %          16.8 %         -
Combined ratio                       96.8 %             99.8 %      (3.0 )            96.9 %         100.3 %      (3.4 )


_________________________________________________


(1) The acquisition expense ratio is adjusted to include certain fee income.


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Premiums Written.

The following table sets forth our insurance segment's net premiums written by
major line of business:

                         Three Months Ended September 30,                     Nine Months Ended September 30,
                           2013                     2012                      2013                       2012
                     Amount          %        Amount         %          Amount           %         Amount          %
Programs         $    116,399        23     $  98,052        20     $     339,895        23     $   272,666        19
Property,
energy, marine
and aviation           77,201        15        92,266        19           242,487        16         258,475        18
Professional
liability              57,367        11        68,923        14           179,289        12         204,682        14
Executive
assurance              56,410        11        63,059        13           160,483        11         191,642        13
Construction           29,927         6        23,481         5           127,557         8         106,918         7
Casualty               29,311         6        23,662         5            79,343         5          81,273         6
National
accounts               18,618         4        22,483         5            77,376         5          62,882         4
Lenders products       16,848         3        20,257         4            61,361         4          63,149         4
Surety                 17,324         3        14,958         3            50,081         3          39,815         3
Travel and
accident               14,068         3        22,017         5            47,283         3          65,147         5
Healthcare             10,227         2         8,722         2            30,247         2          27,316         2
Other (1)              58,271        13        25,476         5           112,687         8          64,655         5
Total            $    501,971       100     $ 483,356       100     $   1,508,089       100     $ 1,438,620       100


_________________________________________________


(1) Includes alternative markets, contract binding, accident and health and excess workers' compensation business.

2013 third quarter versus 2012. Net premiums written were 3.9% higher than in the 2012 third quarter with increases in programs, contract binding (launched in March 2013), excess workers' compensation, construction and accident and health lines, partially offset by a reduction in property lines, professional liability, executive assurance and travel premiums. The increase in program business resulted from a mix of new business, underlying exposure growth within existing programs and rate increases. Growth in excess workers' compensation and accident and health primarily resulted from new business while the higher level of construction business resulted from expanded product lines, new business and rate increases. The decrease in property lines reflected reductions in offshore and onshore energy, property and marine business in response to current market conditions while the lower level of professional liability and executive assurance business resulted from a continued strategic reduction in exposure to international business. The decline in travel premiums was due in part to a change in distribution strategy at the end of 2012.

Nine Months Ended September 30, 2013 versus 2012. Net premiums written were 4.8% higher than in the 2012 period with increases in programs, contract binding, construction and accident and health lines, partially offset by reduction in executive assurance, professional liability, travel and property premiums. The increase in program business resulted from a mix of new business, underlying exposure growth within existing programs and rate increases. The increase in . . .

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