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QuickLinks-- Click here to rapidly navigate through this documentUNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON,
Washington, D.C. 20549--------------------------FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NO.
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2002
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from toCommission File No. 0-26456
ARCH CAPITAL GROUP LTD.
(Exact
(Exact name of Registrant as specified in its charter)
BERMUDA NOT APPLICABLE (StateBermuda
(State or other jurisdiction of(I.R.S. Employer
incorporation or organization)Identification) WESSEX HOUSENot applicable
(I.R.S. Employer Identification No.)
Wessex House, 45REID STREET HAMILTONReid Street
Hamilton HM 12BERMUDA (AddressBermuda
(Address of principal executive offices)(Zip
(Zip Code)
Registrant's telephone number, including area code:(441) 278-9250
Securities registered pursuant to Section 12(b) of the Act:Registrant's telephone number, including area code: (441) 296-8240 Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE TITLE OF EACH CLASS ON WHICH REGISTERED ------------------- ---------------------
Title of Each Class
Name of each Exchange
on which RegisteredNone None Securities registered pursuant to Section 12(g) of the Act: COMMON SHARES, PAR VALUE $0.01 PER SHARE
Securities registered pursuant to Section 12(g) of the Act:Common Shares, par value $0.01 per share 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
/X/ý No/ /oIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
/X/oIndicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ý No o
The aggregate market value of the voting and non-voting common
sharesequity held by non-affiliates,of the Registrant as of March 8, 2002 was approximately $341,147,288 based oncomputed by reference to the closing priceonas reported by theNasdaqNASDAQ National Marketon that date.as of the last business day of the Registrant's most recently completed second fiscal quarter, was approximately $586.0 million.As of March
8, 2002,25, 2003, there were15,765,33227,991,254 of the Registrant's common shares outstanding.- -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
DOCUMENTS INCORPORATED BY REFERENCEPortions of Part III and Part IV incorporate by reference our definitive proxy statement for the 2003 annual meeting of shareholders to be filed with the Securities and Exchange Commission before April 30, 2003.
ARCH CAPITAL GROUP LTD.
TABLE OF CONTENTS
ITEM PAGE - ---- --------
Item
PagePART I
ITEM 1.BUSINESS....................................................
BUSINESS
1ITEM 2. PROPERTIES.................................................. 46PROPERTIES 39 ITEM 3. LEGAL PROCEEDINGS........................................... 46PROCEEDINGS39 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......... 46HOLDERS39
PART II
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDERMATTERS....................................... 47MATTERS
40ITEM 6. SELECTED FINANCIAL DATA..................................... 48DATA41 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS................................. 51OPERATIONS.44 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...................................................... 63RISK75 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................. 63DATA75 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.................................. 63DISCLOSURE75
PART III
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT.......... 64REGISTRANT
76ITEM 11. EXECUTIVE COMPENSATION...................................... 66COMPENSATION76 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................................................MANAGEMENT76 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.............. 84TRANSACTIONS.76 ITEM 14. CONTROLS AND PROCEDURES 76
PART IV
ITEM14.15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM8-K....................................................... 858-K.
77ITEM 16. PRINCIPAL ACCOUNTANT FEES AND SERVICES. 77 i
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTSThe Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. This report includes forward-looking statements which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this report are forward-looking statements. Forward-looking statements can generally be identified by the use of forward-looking terminology such as
"may," "will," "expect," "intend," "estimate," "anticipate,""may", "will", "expect", "intend", "estimate", "anticipate", "believe" or "continue" or their negative or variations or similar terminology.Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this report, including, without limitation, the section entitled "Risk Factors," and include:
-
- •
- our management's ability to successfully implement its business strategy, as described herein;
-- •
- acceptance of our products and services and security by brokers and insureds;
-- •
- acceptance of our business strategy, security and financial condition by rating agencies and regulators;
-- •
- general economic and market conditions (including
as toinflation, interest rates and foreign currency exchange rates) and conditions specific to the reinsurance and insurance markets in which we operate;-- •
- competition, including increased competition, on the basis of pricing, capacity, coverage terms or other factors;
-- •
- our ability to successfully integrate new management and operating personnel and to establish and maintain operating procedures to effectively support our new underwriting initiatives and to develop accurate actuarial data and develop and implement actuarial models and procedures;
- •
- the loss of key personnel;
- •
- the integration of businesses we have acquired or may acquire into our existing operations;
-- •
- 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
us; -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;
-- •
- 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;
-- •
- availability to us of reinsurance to manage our gross and net
exposures; -exposures and the cost of such reinsurance;- •
- the failure of reinsurers, managing general agents or others to meet their obligations to us;
-ii
- •
- the timing of
claimsloss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by us;- changes in the financial environment, including interest rates; -- •
- changes in accounting principles or the application of such principles by accounting firms or regulators;
-- •
- statutory or regulatory developments, including as to tax policy and matters and insurance and other regulatory matters
and government provision(such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/orback-stopping of insurance (including for acts of terrorism)Bermuda-based insurers or reinsurers); and-- •
- rating agency policies and practices.
iiIn addition to the risks discussed in "Risk Factors," other general factors could affect our results, including: (a) developments in the world's financial and capital markets and our access to such markets; (b) changes in regulations or tax laws applicable to us, our subsidiaries, brokers or customers; and (c) the effects of business disruption or economic contraction due to terrorism or other hostilities.
All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.
iii
ITEM 1. BUSINESS
In this report, unlessWe refer you to the
context requires otherwise: (a) "ACGL" referssection below entitled "Risk Factors" for a discussion of certain risks relating to our business.General
Arch Capital Group Ltd.
, (b) "we," "us"("ACGL" and,"our" refer to ACGL andtogether with its subsidiaries,(c) "Arch Re (Bermuda)" refers only to our wholly owned Bermuda reinsurance subsidiary, Arch Reinsurance Ltd.the "Company",and (d) "Arch Re (US)" refers only to our wholly owned U.S. reinsurance subsidiary, Arch Reinsurance Company. The term "Arch US operations" refers to the insurance and reinsurance operations conducted in the United States principally by our subsidiaries First American Insurance Company, Arch Reinsurance Company, Cross River Insurance Company and Rock River Insurance Company. The term "Arch worldwide operations" refers to those operations conducted outside the United States principally by our subsidiaries Arch Re (Bermuda) and Arch Risk Transfer Services Ltd. We sometimes refer to these businesses collectively as our "core businesses." The term "other businesses" refers principally to the insurance advisory and other businesses conducted principally by our subsidiaries Hales & Company, Inc. and American Independent Insurance Holding Company. The terms the "Warburg Pincus funds" and the "Hellman & Friedman funds" refer to the Warburg Pincus LLC private equity funds and the Hellman & Friedman LLC private equity funds. OUR COMPANY We are"we" or "us") is a Bermuda public limited liability company with$1.0over $1.4 billion in equity capital and, through operations in Bermuda and the United States,are positioned to writewrites 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 are focusing on writing specialty lines of insurance andreinsurance profitably and earning a superior return on equity asreinsurance.In October 2001, we
establish an enduring underwriting franchise. Recent events have provided a significant market opportunity for well capitalized insurance companies that are not burdened by the uncertainties resulting from prior years' underwriting losses and material reinsurance recoverable balances. As a result, we recentlylaunched an underwriting initiative to meet current and future demand in the global insurance and reinsurance markets that included the recruitment of new insurance and reinsurance management teams and an equity capital infusion of $763.2 million. It is our belief that our existingBermudaBermuda- and U.S.-based underwriting platform, ourstrongexperienced management team and our$1.0 billion instrong capital base that is unencumbered by significant exposure to pre-2002 risks have enabled usbothto establish an immediate presence in anincreasinglyattractive insurancemarketplaceandto actively participate inreinsurance marketplace. For theJanuary 1, 2002 reinsurance renewal season. Since January 1,year ended December 31, 2002, wehavehad net premiums written of $1.26 billion. Of such amount, our reinsurance operations contributed net premiums of $882.7 million, or 70%, and our insurance operations, which commenced writing business in its new areas of focus during the 2002 second quarter, contributed $378.9 million, or 30%.The capital infusion, which closed in November 2001, was led by funds affiliated with Warburg Pincus LLC ("Warburg Pincus funds") and funds affiliated with Hellman & Friedman LLC ("Hellman & Friedman funds"), and also included investments by certain members of our management (or entities affiliated with them). For more information about the capital infusion and certain material terms of the shareholders agreement and management subscription agreement we entered into
approximately 800 reinsurance treatiesin connection therewith, see "Risk Factors—Risks Relating to our Company" and note 11, "Share Capital," of the notes accompanying our consolidated financial statements. In April 2002, we completed an offering of 7,475,000 of our common shares and received net proceeds of $179.2 million and, in September 2002, we received proceeds of $74.3 million from the exercise of class A warrants by our principal shareholders and certain otherreinsurance arrangements whichinvestors.Our registered office is located at Clarendon House, 2 Church Street, Hamilton HM 11 Bermuda (telephone number: (441) 295-1422), and our principal executive offices are
expectedlocated at Wessex House, 45 Reid Street, Hamilton HM 12 Bermuda (telephone number: (441) 278-9250). We make available free of charge through our website, located atwww.archcapgroup.bm, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments toprovide approximately $500 million of gross written reinsurance premiums during 2002. OUR HISTORYthose reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission ("SEC").Our History
We commenced operations in September 1995 following the completion of the initial public offering of our predecessor, Risk Capital Holdings, Inc. From that time until May 2000, we provided reinsurance and other forms of capital to insurance companies. On May 5, 2000, we sold our prior reinsurance book of business to Folksamerica Reinsurance Company in an asset sale, but retained our surplus and our U.S.-licensed reinsurance platform. On November 8, 2000, following shareholder
1
approval, we changed our legal domicile to Bermuda in order to benefit from Bermuda's favorable business, regulatory, tax and financing environment.
During the period from May 2000 through the announcement of our underwriting initiative in October 2001, we built and acquired insurance businesses that enable us to generate both fee-based revenue
(e.g.(e.g., commissions and advisory and management fees) and risk-based revenue(i.e.(i.e., insurance premium). As part of this strategy, we built an underwriting platform that is intended to enable us to1maximize risk-based revenue during periods in the underwriting cycle when we believe it is more favorable to assume underwriting risk. Recent events have led us to concludeIn October 2001, we concluded that underwriting conditionsfavorfavored dedicating our attention exclusively to building our insurance and reinsurance business.PRINCIPAL EXECUTIVE OFFICES Our registered office is located at Clarendon House, 2 Church Street, Hamilton HM 11 Bermuda (telephone number: (441) 295-1422),Operations
We classify our businesses into two underwriting segments, reinsurance and insurance. We also conduct insurance advisory and other businesses through our
principal executive offices are located at Wessex House, 45 Reid Street, Hamilton HM 12 Bermuda (telephone number: (441) 296-8240). RECENT DEVELOPMENTS THE CAPITAL INFUSION On November 20, 2001, investors led by the Warburg Pincus funds and the Hellman & Friedman funds purchased from us, for $750.0 million in cash, 35,072,795 series A convertible preference shares and 3,710,959 class A warrants. At the same time, we also entered into a management subscription agreement whereby certain memberssubsidiaries. For an analysis of ourmanagement (or entities affiliated with them) agreed to purchase, for an aggregate of $13.2 million, 614,940 preference shares and 65,066 class A warrants. The purpose of this capital infusion was to provide a significant infusion of capital to launch our newunderwritinginitiative to meet current and future demand in the global insurance and reinsurance markets. On March 7, 2002, certain matters relating to the capital infusion required to be approvedresults byour shareholders were approved. Regulatory approvals required in connection with the capital infusion have been obtained in Nebraska, Missouri and Wisconsin, and required regulatory approvals are pending in Pennsylvania and Florida. Prior to the closing on November 20, 2001, the Warburg Pincus funds and the Hellman & Friedman funds assigned portions of their commitments to third parties. At closing, we issued the following numbers of preference shares and class A warrants for the aggregate dollar amounts specified:
AGGREGATE PREFERENCE SHARES CLASS A WARRANTS DOLLAR AMOUNT ----------------- ---------------- -------------Warburg Pincus funds............................ 18,939,311 2,003,918 $405,000,000 Hellman & Friedman funds........................ 10,521,839 1,113,289 225,000,000 Trident II, L.P. and co-investment funds(1)..... 1,636,729 173,178 35,000,000 Farallon Capital investors...................... 1,169,093 123,698 25,000,000 Insurance Private Equity Investors, L.L.C. (affiliated with GE Asset Management)......... 2,338,186 247,397 50,000,000 Orbital Holdings, Ltd. (affiliated with GE Capital)...................................... 467,637 49,479 10,000,000 Management investors............................ 614,940 65,066 13,150,000 ---------- --------- ------------ Total....................................... 35,687,735 3,776,025 $763,150,000 ========== ========= ============- ------------------------ (1) In a related transaction, upon closingsegment, see note 3, "Segment Information," of thecapital infusion, 905,397 previously existing class A warrants held by Marsh & McLennan Risk Capital Holdings, Ltd. were canceled in exchange for 140,380 newly issued common shares, and 1,770,601 class B warrants held by Marsh & McLennan Risk Capital Holdings were canceled in exchange for a cash payment by us of $7.50 per class B warrant (approximately $13.3 million in the aggregate). See note (2) under "Security Ownership of Certain Beneficial Owners and Management" for a description of the terms of the class B warrants. Marsh & McLennan Risk Capital Holdings' pre-existing right to have an observer attend meetings of our board of directors was terminated, and The Trident Partnership, L.P.'s pre-existing right to designate a director for election to our board of directors was terminated. We were 2released from our remaining $11.0 million capital commitment to Trident II, L.P. for new investments. SUBSCRIPTION AGREEMENT Set forth below is a summary of the material terms of the subscription agreement entered into with the investors (other than the management investors) in connection with the capital infusion. You should read this summary in conjunction with the agreement, which is incorporated herein by reference. A conformed copy of the subscription agreement is filed herewith as an exhibit. PURCHASE PRICE. The purchase price for the preference shares and class A warrants paid at closing was based on the book value of our common shares as of June 30, 2001. The number of preference shares issued to each investor was equal to the total dollar amount of that investor's investment divided by the estimated per share price as determined under the subscription agreement (approximately $21.384), which was based on an estimate of the book value of our assets at June 30, 2001. The number of warrants issued to each investor was equal to the Adjusted Warrant Amount times the number of common shares issuable upon exercise of all outstanding class A warrants (2,531,079) divided by the number of common shares outstanding as of June 30, 2001 (12,863,079). The "Adjusted Warrant Amount" was equal to one-half of the quotient of the total dollar amount of that investor's investment divided by the difference of the estimated per share price minus $1.50. There would have been an adjustment to the purchase price if any of the transactions contemplated by the subscription agreement or the options granted to management concurrently therewith had triggered an anti-dilution adjustment under our existing class A warrants or class B warrants, but all holders of those warrants waived any rights to any anti-dilution adjustment with respect to the issuance under the subscription agreements or the grants to management contemplated thereby. For the ten trading days ended October 23, 2001, the last trading day prior to the announcement of the signing of the subscription agreements for the capital infusion and our new underwriting initiative, the average closing price of our common shares on the Nasdaq National Market was $16.86 per share. PURCHASE PRICE ADJUSTMENTS. The subscription agreement provides that the estimated per share price may be adjusted as described below. All determinations to be made by the investors in connection with the purchase price adjustments will be made by the Warburg Pincus funds and the Hellman & Friedman funds. These adjustments are the sole remedy for any breach of representations and warranties of the company under the subscription agreement. AUDIT ADJUSTMENT. We agreed to engage PricewaterhouseCoopers as independent accountants to auditnotes accompanying our consolidatedbalance sheet as of June 30, 2001, an independent actuary (to be selected by usfinancial statements andthe Warburg Pincus funds and the Hellman & Friedman funds) to review the reserves for claims and claims expenses on our balance sheet, and an independent pricing service selected by us and the Warburg Pincus funds and the Hellman & Friedman funds to determine the estimated fair value of our investments in marketable securities as of the third business day prior to closing. The independent pricing service, the public accountants and the independent actuary are referred to below as the independent advisors. If the audited per share price is greater than the estimated per share price at closing, each investor will either pay the difference to us in cash or return the equivalent amount in preference shares. If the estimated per share price at closing is greater than the audited per share price, we will issue an amount of preference shares to the investors representing the difference. We currently estimate that we will issue an additional 875,765 preference shares during the first quarter of 2002 in connection with the audit of the book value of our assets at June 30, 2001 discussed above. ADJUSTMENT FOR TRADING PRICE OR CHANGE OF CONTROL. In the event that on or prior to September 19, 2005, (1) the closing price of our common shares is at least $30.00 per share for at least 20 out of 30 consecutive trading days or (2) a change of control occurs (either case, a "Triggering Event"), we 3agreed to issue and deliver to each investor additional preference shares such that the audited per share price is adjusted downward by $1.50 per preference share. For this purpose "change of control" means the acquisition by any person or group (within the meaning of section 13(d)(3) of the Exchange Act) of beneficial ownership of 40% or more by either the voting power of our then outstanding common shares or the combined voting power of our then outstanding voting securities entitled to vote generally in the election of directors; provided that if such acquisition results in whole or in part from a transfer of common shares or other voting securities by Marsh & McLennan Companies, Inc. or any of its subsidiaries, such acquisition will not constitute a change of control unless such transfer is effected pursuant to an offer by such acquiror to purchase all of our outstanding common shares. FINAL ADJUSTMENTS. We agreed to make another adjustment at the second anniversary of closing (or such earlier date as the Warburg Pincus funds and the Hellman & Friedman funds request and the Transaction Committee (described below under "--Transaction Committee") agrees) based on an adjustment basket described below. The adjustment basket will be equal to: - the difference between value realized upon sale and the book value at closing (as adjusted based on a pre-determined growth rate) of the agreed upon non-core businesses; plus - the difference between the GAAP net book value of all of our insurance balances with respect to any policy or contract written or having an effective date prior to November 20, 2001 (I.E., premiums receivable, unpaid claims and claims expenses recoverable, prepaid reinsurance premiums, reinsurance balances receivable, deferred policy acquisition costs, claims and claims expenses, unearned premiums, reinsurance balances payable, and any other insurance balance attributable to our "core insurance operations," as defined below) at the time of determination of the final adjustment and those balances at the closing; minus - reductions in book value arising from (without duplication of any expenses included in the calculation of value realized upon sale of the non-core businesses or any expense otherwise reflected in the determination of the per share price) costs and expenses relating to the investments and transactions provided for under the subscription agreement, actual losses arising out of breach of representations under the subscription agreement and certain other costs and expenses. Our "core insurance operations" include: - Arch Re (Bermuda); - Arch Capital Group (U.S.) Inc.; - Arch Re (US); - Cross River (including funding for Rock River); - ART Services (including First American Financial Corporation); - capital held at ACGL, gross of capital to be invested in unfunded private equity commitments; and - $2.5 million in segregated assets and liabilities in "cell" accounts formed by Alternative Insurance Company Limited and Alternative Re, Ltd. Non-core businesses are currently defined as American Independent Insurance Holding Company, Hales & Company Inc., escrow assets under the Folksamerica disposition agreement, all nonpublic securities held by ACGL, Arch Capital Group (U.S.) Inc. and Arch Re (US) and all commitments to Trident II, L.P., Distribution Partners and Innovative Coverage Concepts LLC, as and when funded. 4The adjustment basket will be calculated by our independent auditors as soon as practicable after the second anniversary of the closing or such earlier date as the Warburg Pincus funds and the Hellman & Friedman funds request and ACGL agrees. ACGL and the Warburg Pincus funds and the Hellman & Friedman funds have the right to make a full review of the adjustment basket determination. We agreed to cause our subsidiaries to maintain the components necessary to calculate the adjustment basket under separate ledgers. If the adjustment basket is less than zero, we agreed to issue additional preference shares to the investors based on the decrease in the value of the components of the adjustment basket. If the adjustment basket is greater than zero, the subscription agreement allows us to use cash in an amount based on the increase in value of the components of the adjustment basket to repurchase common shares (other than any common shares issued upon conversion of the preference shares or exercise of the class A warrants). In addition, if the adjustment basket is less than zero and in the event that a Triggering Event occurs, we agreed to issue additional preference shares to the investors as a further adjustment. Finally, on the fourth anniversary of the closing, there will be a calculation of a further adjustment basket based on (1) liabilities in excess of the Folksamerica escrow assets owed to Folksamerica under the Asset Purchase Agreement, dated as of January 10, 2000, between ACGL, Arch Re (US), Folksamerica Holding Company, Inc. and Folksamerica Reinsurance Company and (2) specified tax and ERISA matters under the subscription agreement. As described under the heading"Management's Discussion and Analysis of Financial Condition and Results ofOperation--General--May 2000 Sale ofOperations."
Our
PriorReinsurance Operations" in February 2002, we reachedOur reinsurance operations are conducted on a
definitive settlement agreement with Folksamerica pursuant to which we will satisfy all ofworldwide basis through ourobligations under the escrow agreement for an amount equal to approximately $17.0 million of the escrowed assets, plus accrued interest on such amount. RESTRICTIONS ON TRANSFER OF SECURITIES. The investors agreed not to transfer, in one transaction, orprincipal reinsurance subsidiaries, Arch Reinsurance Ltd., aseries of transactions, to a single person or group, common shares or securities convertible into common shares representing in excess of either 51% of the votes then entitled to be cast in the election of directors, or 51% of the then outstanding common shares (taking into account common shares issuable upon conversion of the preference shares) without giving all shareholders the right to participate in such transaction on the same or substantially the same terms as the investors. The shareholders agreement between us and the holders of preference shares also contains restrictions on the transfer of preference shares, which terminates upon consumation of any registered public offering of our common shares generating net proceeds to us in excess of $25.0 million. DISPOSITIONS; PENDING ACQUISITION. We agreed to sell, prior to the time of the audit adjustment described above, the portion of our investment portfolio specified in a schedule to the agreement, consisting of specified publicly traded noninvestment grade debt securities and certain equity securities. INFORMATION. The investors agreed to give us information regarding their ownership of ourBermuda companyownership information concerning each of them and other related information in connection with preparing disclosure in filings under the United States Securities Act of 1933 (the "Securities Act") or the Exchange Act on issues arising under the Internal Revenue Code, including the rules applicable to "controlled foreign corporations." INDEMNIFICATION; INSURANCE. We and the investors agreed to maintain all rights to indemnification in favor of our directors, officers, employees and agents or any of our subsidiaries with respect to their activities prior to the closing (except that with respect to the Transaction Committee this covenant will cover activities after the closing) (as provided for in our organizational documents in effect on October 24, 2001) in full force and effect for a period of not less than six years from the closing. The investors agreed not to cause us to take any action inconsistent with this agreement. 5We and the investors also agreed that we will indemnify each of our present and former directors or officers against liabilities arising before the closing (including the transactions contemplated by the subscription agreement) and, with respect to the Transaction Committee, also after the closing. We and the investors agreed that we will maintain our current level of directors' and officers' liability insurance coverage for a period of at least six years after the closing. CERTAIN TAX MATTERS. With respect to each taxable year during which any of the Warburg Pincus funds or the Hellman & Friedman funds owns our shares, we agreed to use reasonable best efforts to cause us and each of our subsidiaries: - not to constitute a "passive foreign investment company" within the meaning of Section 1297 of the Code; - not to satisfy the gross income requirement set forth in Section 542(a) of the Code; - not to satisfy the gross income requirement set forth in Section 552(a) of the Code; and - not to have any related person insurance income within the meaning of Section 953(c)(2) of the Code. In the event that we or any of our subsidiaries constitute a personal holding company, a foreign personal holding company, a controlled foreign corporation, a foreign investment company or a passive foreign investment company for U.S. federal income tax purposes with respect to any taxable year, we agreed to provide each of the Warburg Pincus funds or the Hellman & Friedman funds with any information it requests to satisfy its legitimate tax, accounting or other reporting requirements. RIGHT TO EXCHANGE INTO SUBSIDIARY SHARES. We agreed to form a new, wholly owned subsidiary to hold("Arch Re(Bermuda) as well as all of the "core insurance operations" other thanBermuda"), and Arch Reinsurance Company, a Nebraska corporation ("Arch Re(US). In the event that: - we fail to obtain the regulatory approvals required in connection with the investment before May 20, 2002 or - the adjustments described above under "--Purchase Price Adjustments--Final Adjustment" are less than zero and their absolute value exceeds $250.0 million, the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of our preference shares will have the option to exchange their preference shares and class A warrants, in whole or in part (but not for less than $150.0 million liquidation preference of preference shares), for preference shares and warrants of our newly formed subsidiary bearing identical rights and privileges, including the right to convert into, or be exercised for, common shares of our newly formed subsidiary, but not including voting limitations to the extent such limitations are not required pending the remaining regulatory approvals required in connection with the capital infusion. INVESTORS' COSTS AND EXPENSES. We agreed to reimburse the Warburg Pincus funds and the Hellman & Friedman funds for their costs and expenses, and the GE investors for up to $50,000 of their costs and expenses, in connection with the investment and the related transactions. TRANSACTION COMMITTEE. Until the date of the final determination of the adjustment basket at the fourth anniversary of closing, approval of the following actions by the Transaction Committee (as defined below) is deemed to be approval by the entire board of directors: - an amendment, modification or waiver of rights by ACGL under the subscription agreement, the certificate of designation for the preference shares, the class A warrants or the shareholders agreement; - the enforcement of obligations of the investors under the above agreements; or 6- approval of actions relating to the disposition of non-core assets. "Transaction Committee" means a committee of the board of directors consisting of persons who either (a) were members of our board of directors on October 22, 2001 and/or (b) were designated as members of the Transaction Committee by a person who was a member of our board of directors on October 22, 2001. The Transaction Committee currently consists of Robert Clements, Peter A. Appel, James J. Meenaghan and Robert F. Works. SHAREHOLDERS AGREEMENT On November 20, 2001 upon consummation of the capital infusion, we entered into a shareholders agreement with the investors. Set forth below is a summary of the material terms of the shareholders agreement. You should read this summary in conjunction with the agreement. A conformed copy of the shareholders agreement is filed herewith as an exhibit. BOARD REPRESENTATION. Following the closing, the Warburg Pincus funds exercised their right to designate one director to our board and the Hellman & Friedman funds exercised their right to designate one director to our board. Kewsong Lee is serving as the designee for the Warburg Pincus funds and John L. Bunce, Jr. is serving as the designee for the Hellman & Friedman funds. Once the remaining regulatory approvals required in connection with the capital infusion have been obtained, we will increase the size of our board to up to 17 members and the Warburg Pincus funds will have the right to designate or nominate five additional directors and the Hellman & Friedman funds will have the right to designate or nominate two additional directors. Continued representation on our board of directors by these shareholders is based on the respective retained percentages of their equity securities in according to the following schedules:
WARBURG PINCUS FUNDS HELLMAN & FRIEDMAN FUNDS - ------------------------------------------------- ------------------------------------------------- PERCENTAGE MINIMUM NUMBER OF PERCENTAGE MINIMUM NUMBER OF OF ORIGINAL DIRECTORS TO BE OF ORIGINAL DIRECTORS TO BE INVESTMENT HELD NOMINATED INVESTMENT HELD NOMINATED - ----------------------------- ----------------- ----------------------------- -----------------greater than or equal to 75% 6 greater than or equal to 60% 3 60% greater than or equal to X< 75% 5 35% less than or equal to X < 60% 2 45% less than or equal to X < 60% 4 20% less than or equal to X < 35% 1 30% less than or equal to X < 45% 3 20% less than or equal to X < 30% 2 10% less than or equal to X < 20% 1COMMITTEES OF THE BOARD. As long as at least one representative of the Warburg Pincus funds is on the board, each board committee will include at least one representative of the Warburg Pincus funds, and as long as at least one representative of the Hellman & Friedman funds is on the board, each board committee will include at least one representative of the Hellman & Friedman funds. The foregoing is subject to any Nasdaq Stock Market or SEC restrictions applicable to the audit committee. INVESTOR PROTECTION MATTERS. Prior to the receipt of the remaining regulatory approvals in connection with the capital infusion certain matters require approval by at least one director representing the Warburg Pincus funds (if the Warburg Pincus funds hold at least 25% of their original investment in ACGL) and one director representing the Hellman & Friedman funds (if the Hellman & Friedman funds hold at least 50% of their original investment in us). Such matters include, among other things, subject to exceptions set forth in the subscription agreements: - any amendment to our organizational documents or the subscription agreement; - any change to our capital structure or the terms of our outstanding securities; - the declaration of any dividend or other distribution on, or repurchase of, our securities; 7- the issuance of any securities or the grant of any preemptive or anti-dilutive rights to any holder of our securities, or the grant of registration rights with respect to any of our securities; - any amendment to any grants made under our Long Term Incentive Plan for New Employees; - the incurrence of any material indebtedness; - our entering into any interested party transactions; - the acquisition of any material assets; - the acquisition of equity interests in any other person; - any change in our independent auditors or any material change in any method of financial accounting or accounting practice (other than changes required underU.S.generally accepted accounting principles); - any sale of material assets; - significant changes in compensation arrangements with any officer or key employee; - our liquidation or dissolution, or certain mergers or consolidations, sale of all or substantially all of our assets, or similar business combination; - entering into any transaction involving in excess of $1,000,000 or, if such transaction is in the ordinary course of business consistent with past practice, $5,000,000; - the approval of our annual plan, annual capital expenditure budget or the five-year plan of our company; or - the removal or appointment of a new chief executive officer or chairman. Notwithstanding the required approvals described above, the shareholders agreement does not grant these shareholders any right or consent to the extent that such right would result in such party being deemed to "control" any of our insurance subsidiaries that are domiciled in any state in the United States, where the exercise of such control would otherwise require the prior approval of such state. The rights of these shareholders described above terminate upon the mandatory conversion of the preference shares or the earlier conversion of all preference shares in accordance with their terms. SPECIAL BOARD MEETINGS. We agreed to use best efforts (1) to cause a special meeting of the board to be called upon the request of at least three directors and (2) to cause to be submitted, at the 2002 annual general meeting of our shareholders, a proposal to amend our bye-laws so that a special meeting of the board may be called by three directors or a majority of the total number of directors (whichever is fewer), in addition to the chairman of the board and the president of ACGL. VOTING. The signatories to the shareholders agreement agreed to vote all of their voting shares in favor of the proposal to approve a grant of restricted shares to Mr. Clements and an option grant to Mr. Pasquesi to be submitted for approval at our next annual general meeting. CHAIRMAN. The Warburg Pincus funds and the Hellman & Friedman funds agreed to take all actions necessary to cause Robert Clements to be duly elected as chairman of our board of directors for so long as he is willing and able to serve. CERTAIN TRANSACTIONS. The Warburg Pincus funds and the Hellman & Friedman funds agreed that, for a period of two years after the closing, they will not, directly or indirectly, without the prior 8approval of a majority of directors who are not affiliated with either the Warburg Pincus funds or the Hellman & Friedman funds: - acquire securities or assets from us or any of our subsidiaries, except as specifically contemplated by the subscription agreements, the preference shares and the class A warrants; - engage in any "Rule 13e-3 transaction" (as such term is defined in Rule 13e-3(a)(3) under the Exchange Act) involving us; or - engage in any other transaction that would result in the compulsory acquisition of our common shares. We and the Warburg Pincus funds and the Hellman & Friedman funds have agreed to endeavor to include at all times two directors on our board who are not affiliated with either the Warburg Pincus funds or the Hellman & Friedman funds. The prior approval of a majority of such independent directors is required prior to any change to or elimination of these provisions. REGISTRATION RIGHTS. The shareholders agreement also grants the investors registration rights described below. DEMAND REGISTRATION RIGHTS. The Warburg Pincus funds and the Hellman & Friedman funds have the right to request registration of their shares under the Securities Act, at any time and on not more than five separate occasions, so long as the request covers common shares with a market value on the date of the request of at least $25.0 million. PIGGY-BACK REGISTRATION RIGHTS. If at any time we propose to register any common shares under the Securities Act on our own behalf or on behalf of any of our shareholders (including pursuant to a demand registration as discussed above), we are required to give reasonably prompt written notice to each investor of our intention to do so and, upon request of any investor, but subject to limitations in some cases, include the investor's shares for registration. REGISTRATION EXPENSES. We agreed to bear all registration, filing and related fees (excluding underwriters' discounts or commissions) in connection with any registration and listing of any common shares pursuant the registration provisions described above. INDEMNIFICATION; CONTRIBUTION. We agreed to indemnify each investor and its officers, directors, employees and controlling persons, and each underwriter, its partners, officers, directors, employees and controlling persons, in any offering or sale of common shares, against certain liabilities in connection with these registered offerings. Each investor agreed to indemnify us and our officers, directors, employees and controlling persons, against certain liabilities in connection with these registered offerings. In the event that the indemnification provisions are unavailable, we and the investors agreed to contribute such amounts as are appropriate to reflect the relative fault of the parties. TAG-ALONG/DRAG-ALONG RIGHTS. In the event that a Warburg Pincus fund, a Hellman & Friedman fund or a GE investor proposes to transfer preference shares, class A warrants or common shares issued upon conversion or exercise of such securities to a third party, and the net proceeds of such sale are reasonably expected to exceed $50.0 million, other investors may have rights under the shareholders agreement to "tag along" in such sale. The following tag-along rights are provided for in the shareholders agreement: - The GE investors have tag-along rights only if (1) a Warburg Pincus fund is the seller or (2) a Hellman & Friedman fund is the seller and the Warburg Pincus funds also exercise their rights to tag along in the sale. 9- Farallon has tag-along rights only if (1) a Hellman & Friedman fund is the seller or (2) a Warburg Pincus fund is the seller and the Hellman & Friedman funds also exercise their rights to tag along in the sale. - Trident II has tag-along rights in the event that a Warburg Pincus fund or a Hellman & Friedman fund is the seller. Any sale effected in the public markets (including by means of a "block trade" effected through any registered broker-dealer) or any distribution to partners of any partnership in which a Warburg Pincus fund or a Hellman & Friedman fund, or any of their respective affiliates, is the general partner will not give rise to any tag-along rights. In the event that a Warburg Pincus fund and/or a Hellman & Friedman fund proposes to transfer preference shares, class A warrants or common shares issued upon conversion or exercise of such securities representing either 51% of the votes then entitled to be cast in the election of directors, or 51% of our then outstanding common shares (taking into account common shares issuable upon conversion of preference shares) in a transaction, or in a series of related transactions, to a single person or group, the Warburg Pincus funds and the Hellman & Friedman funds have the right to require that Trident II participate in such transaction on a ratable basis. RESTRICTIONS ON TRANSFER. Each investor has agreed not to sell more than one-third of the shares purchased in its original investment until the earliest to occur of - November 20, 2002; - any event that would cause our outstanding class B warrants to become exercisable; or - our completion of a registered public offering of common shares the net proceeds of which to us exceed $25.0 million. RESTRICTIONS ON CONVERSION/EXERCISE. Prior to receipt of the regulatory approvals required in connection with the investment, the investors agreed not to convert any preference shares or exercise class A warrants issued under the subscription agreements unless all necessary approvals for the ownership of common shares issued upon such conversion or exercise have been obtained. RESTRICTIONS ON DIVIDENDS AND SHARE REPURCHASES. We agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from the Warburg Pincus funds, the Hellman & Friedman funds, and the other holders of our preference shares, pro rata, on the basis of the amount of each of these shareholders' retained investment in the company at the time of such repurchase, preference shares having an aggregate value of $250.0 million, at a per share price acceptable to these shareholders (subject to the exception described under "--Subscription Agreement--Purchase Price Adjustments--Final Adjustments"").TERMINATION. The shareholders agreement terminates upon the earlier to occur of: - November 20, 2011; or - mutual written agreement of us and the Warburg Pincus funds and the Hellman & Friedman funds. MANAGEMENT SUBSCRIPTION In connection with the capital infusion, we entered into a management subscription agreement, pursuant to which certain members of management (or entities affiliated with them) agreed to purchase preference shares and class A warrants on the same economic terms as the Warburg Pincus funds and the Hellman & Friedman funds. The management subscription agreement is filed as an exhibit to this report. 10On November 20, 2001, each of the persons or entities listed purchased preference shares and class A warrants for the amount opposite his or its names set forth in the table below:
NAME AMOUNT - ---- ------SoundView Partners LP (an entity affiliated with Robert Clements)............................................ $ 2,000,000 Otter Capital LLC (an entity affiliated with John M. Pasquesi)............................................ 7,500,000 Peter A. Appel......................................... 1,000,000 Paul B. Ingrey......................................... 2,000,000 Dwight R. Evans........................................ 400,000 Marc Grandisson........................................ 250,000 ----------- Total................................................ $13,150,000 ===========CERTIFICATE OF DESIGNATIONS Set forth below is a summary of the material terms of the certificate of designations for our series A convertible preference shares. You should read this summary in conjunction with the certificate, which is filed herewith as an exhibit. DIVIDENDS. The holders of preference shares are entitled to receive dividends along with holders of our common shares, on an as-converted basis. Dividends are payable on each outstanding preference share on an as-converted basis. No dividends may be paid or declared on or with respect to our common shares prior to the declaration and payment of a dividend on or with respect to the preference shares. Dividends on the preference shares are noncumulative. RANKING. The preference shares rank, with respect to dividends and upon liquidation, winding up or dissolution: - on a parity with those shares which, by the terms of our bye-laws or by such rights, preferences or limitations as fixed by the board of directors, are specifically entitled to share ratably with the preference shares, and - senior to each other class or series of our shares. The shareholders agreement between us and the holders of our preference shares includes a limitation on dividends on, and repurchases of, our common shares. CONVERSION GENERAL. Each preference share is convertible at any time and from time to time at the option of the holder, initially, into one fully paid and nonassessable common share, subject to adjustment for certain events as described below under "--Adjustments." In connection with the conversion of any preference shares, no fractional shares will be issued. Instead, we will pay a cash amount for such fractional interest based on the current market price of the common shares. As discussed above, the shareholders agreement between us and the holders of our preference shares contains a limitation on conversion of the preference shares until the receipt of certain shareholder and regulatory approvals. MANDATORY CONVERSION. The preference shares will automatically convert into common shares following the later of: (a) the receipt of the regulatory approvals required in connection with the November 20 capital infusion and (b) 90 days following the consummation of the purchase price 11adjustment to be performed at the fourth anniversary of closing (described above under "The Capital Infusion--Purchase Price Adjustments"). ADJUSTMENTS. The number of common shares into which each preference share is convertible is subject to adjustment from time to time in the event of: - share splits or combinations of our common shares; - the declaration and payment of dividends on the common shares in additional common shares; - the distribution of indebtedness, securities or assets to holders of our common shares; - transactions in which our common shares are exchanged (either for different securities of our company or securities of a different company); or - offerings of our common shares, or securities convertible into or exercisable for common shares, at a price below the market value for our common shares at the time of issuance, subject to exceptions. LIQUIDATION PREFERENCE. In the event of our voluntary or involuntary liquidation, dissolution or winding-up, or a reduction or decrease in our share capital resulting in a distribution of assets to the holders of any class or series of our shares, each holder of preference shares is entitled to payment out of our assets available for distribution of an amount equal to the liquidation preference of $21.00 per preference share held by such holder, plus all accumulated and unpaid dividends, before any distribution is made on any common shares. If, in the event of our voluntary or involuntary liquidation, dissolution or winding up or a reduction or decrease in our share capital, the amounts payable with respect to preference shares and parity shares are not paid in full, the holders of preference shares and the parity shares share equally and ratably in any distribution of share assets in proportion to the full liquidation preference and all accumulated and unpaid dividends to which each such holder is entitled. VOTING RIGHTS. Each holder of preference shares is entitled to the number of votes equal to the number of whole common shares into which all of such holder's preference shares are convertible, with respect to all matters submitted for shareholder approval. Except as required by applicable Bermuda law or by the express terms of the preference shares, holders will vote together with holders of the common shares as a single class. The affirmative vote of the holders of at least a majority of the outstanding preference shares, voting with holders of shares of all other series of preference shares affected in the same way as a single class, is required to amend, repeal or change any provisions of the certificate of designations in any manner which would adversely affect, alter or change the powers, preferences or special rights of the preference shares and any such securities affected in the same way. However, the creation, authorization or issuance of any other class or series of shares or the increase or decrease in the amount of authorized shares of any such class or series or of the preference shares, or any increase, decrease or change in the par value of any class or series of shares (including the preference shares) do not require the consent of the holders of the preference shares and are not deemed to affect adversely, alter or change the powers, preferences and special rights of the preference shares. With respect to any matter on which the holders are entitled to vote as a separate class, each preference share is entitled to one vote. Notwithstanding the foregoing, prior to the receipt of the regulatory approvals required in connection with the capital infusion by the Warburg Pincus funds and the Hellman & Friedman funds, if the votes conferred by common shares and preference shares beneficially owned by a given person would otherwise represent more than 9.9% of the voting power of all shares of the company entitled to vote generally at an election of directors, the vote of each preference share held by that person will be 12reduced by whatever amount is necessary so that after any reduction, the votes conferred by the common shares and preference shares beneficially owned by that person constitute 9.9% of the total voting power of all shares of the company entitled to vote generally at any election of directors. CLASS A WARRANTS Set forth below is a summary of the material terms of the class A warrants. You should read this summary in conjunction with the certificate for the class A warrants, the form of which is filed as an exhibit herewith. GENERAL. Each class A warrant entitles the holder to purchase one common share for $20.00. The exercise price is subject to adjustments as discussed in greater detail below under "--Anti-Dilution and Other Adjustments." The class A warrants will expire on September 19, 2002. EXERCISE OF THE CLASS A WARRANTS. Holders of the class A warrants may exercise their purchase rights under the class A warrants by making payment of the purchase price in cash or through a cashless exercise. Holders may effect a cashless exercise by (a) delivering common shares equivalent in value to the exercise price or (b) accepting a reduction in the number of common shares deliverable upon exercise of the class A warrant by an amount which would be equivalent in value to the exercise price. See "--Shareholders Agreement--Restrictions on Conversion/Exercise" for a description of the limitation on exercise of the class A warrants under the shareholders agreement. ANTI-DILUTION AND OTHER ADJUSTMENTS. The exercise price will be adjusted from time to time in order to prevent dilution. In addition, certain other adjustments will be made to the terms of the class A warrants upon extraordinary corporate events. Such anti-dilution and other adjustments include: - offerings of our common shares at a price below the market value of our common shares at the time of issuance will result in an adjustment to the exercise price under the class A warrants; - share splits or combinations of our common shares will result in an adjustment to the exercise price under the class A warrants; - a reorganization, reclassification, consolidation, merger or sale of assets may result in the substitution of other securities, cash or property upon exercise of the class A warrants; and - issuance of assets or debt securities or rights or warrants to purchase assets or securities by the company to its shareholders may result in an adjustment to the exercise price under the class A warrants. In addition, our board of directors may make such additional adjustments to the exercise price or other terms of the class A warrants in order to protect the rights of the holders of the class A warrants. OPERATIONS OUR REINSURANCE OPERATIONSOurReinsurance Group is worldwide, with U.S. and Bermuda-based operations. Itreinsurance group has two principal offices, one located in Hamilton, Bermuda and the other in Morristown, New Jersey. As of March14, 2002,25, 2003, the group has36 employees consisting of 20 underwriters, seven other professionals and nine non-professionals. We expect that our Reinsurance Group will haveapproximately55 total employees once fully staffed. 13STRATEGY.60 employees.Strategy. Our
Reinsurance Group'sreinsurance group's strategy is to capitalize on our financial capacity, experienced management and operational flexibility to offer multiple products through our Bermuda- and U.S.-based operations. The group's operating principles are:- ACTIVELY SELECT AND MANAGE RISKS.
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- Actively Select and Manage Risks. We will not underwrite business that does not meet our profitability criteria, and we will emphasize disciplined underwriting over premium growth. To this end, we will maintain centralized control over reinsurance underwriting guidelines and authorities.
- MAINTAIN FLEXIBILITY AND RESPOND TO CHANGING MARKET CONDITIONS.- •
- Maintain Flexibility and Respond to Changing Market Conditions. Our organizational structure and philosophy allow us to take advantage of increases or changes in demand or favorable pricing trends. We believe that our existing Bermuda and U.S.-based platform, broad underwriting expertise, and substantial capital will facilitate adjustments to our mix of business geographically and by line and type of coverage. We believe that this flexibility
will allowallows us to participate in those market opportunities that provide the greatest potential for underwriting profitability.- MAINTAIN A LOW COST STRUCTURE.- •
- Maintain a Low Cost Structure. We believe that maintaining tight control over our staffing and operating as a broker market reinsurer will permit us to maintain low operating costs relative to our capital and premiums.
LINES OF BUSINESS.Lines of Business. We
are seekingwrite our business on both a proportional and non-proportional basis. In a proportional reinsurance arrangement (also known as pro rata reinsurance, quota share reinsurance or participating reinsurance), the reinsurer shares a proportional part of the original premiums and losses of the reinsured. The reinsurer pays the cedent a commission which is generally based on the cedent's cost of acquiring the business being reinsured (including commissions, premium taxes, assessments and miscellaneous administrative expenses) and may also include a profit factor. Non-proportional (or excess of loss) reinsurance indemnifies the reinsured against all or a specified portion of losses on underlying insurance policies in excess of a specified amount, which is called a "retention."2
Non-proportional business is written in layers and a reinsurer or group of reinsurers accepts a band of coverage up to a specified amount. The total coverage purchased by the cedent is referred to as a "program." Any liability exceeding the upper limit of the program reverts to the cedent.
We generally seek to write
"large lines" (I.E.,significantportions)lines ona select number ofspecialty property and casualty reinsurance treaties. With respect to certain classes, such as property catastrophe and casualty clash, we participate in a relatively large number of treaties and assume smaller lines where we believe that we can underwrite and process the business efficiently.Our
Reinsurance Groupreinsurance group focuses on thefollowinglines ofbusiness: - PROPERTY CATASTROPHE REINSURANCE.business outlined below:
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- Casualty. We reinsure third party liability and workers compensation exposures from ceding company clients primarily on a treaty basis. The exposures that we reinsure include, among others, directors' and officers' liability, professional liability, automobile liability, workers compensation and excess and umbrella liability. We write this business on a proportional and non-proportional basis. On our proportional and non-proportional "working casualty business," which is treated separately from our casualty clash business, we write treaties where there is a meaningful amount of actuarial data and loss activity is more predictable.
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- Other Specialty. We write other specialty lines, including non-standard automobile business, multi-line contracts, surety business, trade credit and political risk.
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- Property Excluding Property Catastrophe. We reinsure individual property risks of ceding company clients on a treaty basis. Our property per risk treaty and pro rata reinsurance contracts cover claims from individual insurance policies issued by our reinsureds and include both personal lines and commercial property exposures (principally covering buildings, structures, equipment and contents). The primary perils in this line of business include fire, explosion, collapse, riot, vandalism, wind, tornado, flood and earthquake.
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- Property Catastrophe. Our property catastrophe reinsurance business reinsures catastrophic perils for our reinsureds on a treaty basis. Our treaties in this line of business provide protection for most catastrophic losses that are covered in the underlying policies written by our reinsureds. The primary perils in our portfolio include hurricane, earthquake, flood, tornado, hail and fire. We may also provide 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 covered peril exceed the
attachment pointretention specified in thepolicy. Somecontract. The multiple claimant nature ofourproperty catastrophecontracts limit coveragereinsurance requires careful monitoring and control of cumulative aggregate exposure.- •
- Marine, Aviation and Space. Our marine business relates to
one occurrence in a policy year, but most contracts generally provide for at least one reinstatement of the limit covered, which could result in two or more exposureshull, cargo, transit and offshore oil and gas operations, and our aviation business relates toa given risk. - PROPERTY RISK EXCESS OF LOSS.airline and general aviation risks. We also write space business, which includes coverages for satellite assembly, launch and operation for commercial space programs.- •
- Non-Traditional. We also write non-traditional business that is intended to provide insurers with creative risk
excess of loss propertymanagement solutions that complement traditional reinsurance.Risk excess of loss reinsurance responds to a loss of the reinsured on a single "risk" of the type reinsured rather than to aggregate losses for all covered risks as does catastrophe reinsurance. The risk excess of loss property protects the reinsured from losses in excess of its retention level on a single risk. A "risk" in this context might mean the insurance coverage on one building or a group of buildings or the insurance coverage under a single policy, which the reinsured treats as a single risk. Risk excessUnder these contracts,are generally "all risk" in nature, similar to property catastrophe reinsurance. - PROPERTY PRO RATA. In pro rata reinsurance,we assume a measured amount of insurance risk in exchange for a specifiedportionmargin. The terms and conditions ofthe risk on the specified coverage and receive an equal proportion of the premium. The ceding insurer receives a commission based upon thethese contracts may include additional or return premiumsceded to the reinsurer and may also be entitled to receive a profit commissionbased onthe ratioloss experience, loss corridors, sublimits and caps. Examples oflosses, loss adjustment expensesuch non-traditional business include aggregate stop-loss coverages andthe reinsurer's expenses to premiums ceded. A pro rata reinsurer is dependent upon the ceding insurer's underwriting, pricing and claims administration to yield an underwriting profit. In some instances we may be entitled to the benefit of other reinsurance, known as common account reinsurance, purchased by the ceding company on an account reinsured by us on a pro rata basis. - CASUALTY. We also write the following lines of business on both a pro rata and excess of loss basis: general liability (including excess general liability), workers' compensation, commercial transportation, non-standard auto liability, surety, aviation & aerospace, marine, medical 14malpractice, directors and officers, errors and omissions and energy. We may write other lines, including trade credit and political risk. Although we will seek to exclude terrorism from the property reinsurance which we write, we may specifically reinsure risks resulting from terrorism on an excess of loss basis, or, based on market factors, we may determine to include terrorism risk.financial quota share coverages.- •
- Casualty Clash. Our reinsurance business
mayalsoincludeincludes clash covers, which are excess of loss agreements where the underlying amount to be retained by the ceding insurer is at an amount which is higher than the limit on any one reinsured policy. Such agreements provide payment of loss when the unusual circumstances occur where two or more casualty policies (or, with respect3
to workers compensation coverages, multiple employees) experience the same occurrence of loss and the total amount of the payment of losses for the multiple policies exceeds the clash cover retention amount.
We also write non-traditional business that is intended to provide insurers with creative risk management solutions that complement traditional reinsurance. Under these covers, we would assume a measured amount of insurance risk in exchange for a specified margin. Coverages may include a combination of sublimits and caps. Examples of such non-traditional business include aggregate stop-loss coverages and financial quota share coverages. UNDERWRITING PHILOSOPHY.Underwriting Philosophy. We employ a disciplined, analytical approach to underwriting reinsurance risks that is designed to specify an adequate premium for a given exposure commensurate with the amount of capital we anticipate placing at risk.
ManyA number of our underwriters are also actuaries. We believe that employing actuaries on the front-end of the underwriting process gives us an advantage in evaluating risks and constructing a high quality book of business.As part of our underwriting process, we typically assess a variety of factors, including:
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- the reputation of the proposed cedent and the likelihood of establishing a long-term relationship with the cedent, the geographic area in which the cedent does business, together with its catastrophe exposures, and our market share in that area;
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- historical loss data for the cedent and, where available, for the industry as a whole in the relevant regions, in order to compare the cedent's historical loss experience to industry averages;
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- projections of future loss frequency and severity; and
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- the perceived financial strength of the cedent.
ForPremiums Written and Geographic Distribution. Set forth below is summary information regarding net premiums written by major line of business and by client location for our
catastrophe exposedreinsurancebusiness, we have developed underwriting guidelines under which we generally limit the amountsegment:
Year Ended
December 31, 2002Net Premiums
Written% Of Total (in thousands) Reinsurance Segment Major Line of Business(1): Casualty $ 245,236 27.8 % Other specialty 173,087 19.6 % Property excluding property catastrophe 166,344 18.8 % Property catastrophe 110,989 12.6 % Marine, aviation and space 60,383 6.8 % Non-traditional 109,978 12.5 % Casualty clash 16,683 1.9 % Total $ 882,700 100.0 % Client Location(1): United States $ 469,585 53.2 % United Kingdom 163,838 18.6 % Bermuda 51,562 5.8 % Canada 45,749 5.2 % Germany 42,899 4.9 % France 26,751 3.0 % Japan 11,920 1.4 % Switzerland 11,806 1.3 % Other 58,590 6.6 % Total $ 882,700 100.0 %
- (1)
- Includes $86.1 million of
exposure we will assumenet premiums written assumed fromany one reinsured and the amount of the aggregate exposure to catastrophe losses in any geographic zone. MARKETING.our insurance segment.4
Marketing. We market our reinsurance products through brokers. Brokers generally do not have the authority to bind us with respect to reinsurance agreements, nor do we commit in advance to accept any portion of the business that brokers submit to us. Reinsurance business from any ceding company, whether new or renewal, is subject to acceptance by us.
CLAIMS MANAGEMENT.We generally pay brokerage fees to brokers based on negotiated percentages of the premiums written by us through such brokers. For information on our major brokers, see note 10, "Commitments and Contingencies—Concentrations of Credit Risk," of the notes accompanying our consolidated financial statements.Risk Management and Retrocession. Our reinsurance group is currently retaining substantially all of their assumed reinsurance premiums written. They participate in "common account" retrocessional arrangements for certain treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating in such treaties, including the reinsurers, such as our reinsurance subsidiaries, and the ceding company. Our reinsurance subsidiaries will continue to evaluate their retrocessional requirements. See note 4, "Reinsurance," of the notes accompanying our consolidated financial statements.
For our catastrophe exposed reinsurance business, we seek to limit the amount of exposure we assume from any one reinsured and the amount of the aggregate exposure to catastrophe losses in any one geographic zone. For a discussion of our risk management policies, see "Management's Discussion and Analysis of Financial Condition and Results of Operations—Certain Matters Which May Materially Affect Our Results of Operations and/or Financial Condition—Natural and Man-Made Catastrophic Events."
Claims Management. Claims management includes the receipt of initial loss reports, creation of claim files, determination of whether further investigation is required, establishment and adjustment of case reserves and payment of claims. Additionally, audits will be conducted for both specific claims and overall claims procedures at the offices of selected ceding companies. We may make use of outside consultants for claims work.
15OUR INSURANCE OPERATIONS
Our Insurance
Group will haveOperationsOur insurance operations are conducted in the U.S. and Bermuda. In the U.S., our principal insurance subsidiaries are Arch Insurance Company (formerly known as First American Insurance Company) ("Arch Insurance"), Arch Excess & Surplus Insurance Company (formerly known as Cross River Insurance Company) ("Arch E&S") and Arch Specialty Insurance Company (formerly known as Rock River Insurance Company) ("Arch Specialty"). The principal office in the U.S. is located in New York City, with offices also located in Atlanta, Georgia, Chicago, Illinois, Kansas City, Missouri, Morristown, New Jersey, San Francisco, California, St. Paul, Minnesota and Stamford, Connecticut. We also have a contact office in London which sources underwriting opportunities for our U.S. insurance subsidiaries. Our insurance operations in Bermuda are conducted through Arch Insurance (Bermuda), a division of Arch Re Bermuda, which has an office in Hamilton, Bermuda. We also underwrite non-standard automobile liability and physical damage lines of insurance through our subsidiaries, American Independent Insurance Company ("American Independent") and Personal Service Insurance Company ("PSIC"), based in Conshohocken, Pennsylvania and Columbus, Ohio, respectively. As of March
14, 2002, our Insurance Group has 37 employees consisting of 17 underwriters, 16 other professionals and 4 non-professionals. We expect that the number of employees in our Insurance Group will increase significantly as we expand25, 2003, our insuranceoperations. STRATEGY.group has approximately 530 employees.Strategy. Our
Insurance Groupinsurance group strategy is to write business profitably (on both a gross and net basis) across all of our product lines. OurGroup'sinsurance group's operating principles are:- CAPITALIZE ON PROFITABLE UNDERWRITING OPPORTUNITIES.
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- Capitalize on Profitable Underwriting Opportunities. We believe that our experienced management and underwriting
team will be ableteams are positioned to locate and identify lines of business with attractive risk/reward characteristics. As profitable underwriting opportunities are identified, we will continue to seek to make additions to our product portfolio in order to take advantage of5
market trends. This could include adding underwriting and other professionals with specific expertise in specialty lines of business.
- CENTRALIZE RESPONSIBILITY WITHIN EACH LINE OF BUSINESS.
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- Centralize Responsibility Within Each Line of Business. Our
Insurance Group will consistinsurance group consists of "profit centers" consisting of individual lines of business. Within each profit center, profit center managerswilloversee the underwriting and other functions within each business region, and regional executiveswill beare responsible for overall profitability within each business line. We believe that this organizational structurewill allowallows close control of our profitability, andcreatecreates clear accountability, within each line of business and each region.- MAINTAIN A DISCIPLINED UNDERWRITING PHILOSOPHY.- •
- Maintain a Disciplined Underwriting Philosophy. Our underwriting philosophy is to generate an underwriting profit through prudent risk selection and proper pricing. We believe that the key to this approach is strict adherence to uniform underwriting standards across all lines of business. Our insurance senior management
intends to provideprovides close control of the underwriting process.- FOCUS ON PROVIDING SUPERIOR CLAIMS MANAGEMENT.- •
- Focus on Providing Superior Claims Management. We believe that claims handling is an integral component of credibility in the market for insurance products. Therefore, we believe that our ability to handle claims expeditiously and satisfactorily will be a key to our success. We
intend touse experienced internal claims professionals, as well as nationally recognized external claims managers.- UTILIZE AN OPEN BROKERAGE DISTRIBUTION SYSTEM.- •
- Utilize an Open Brokerage Distribution System. We believe that by avoiding reliance on contractual relationships with brokers or other agents, we can efficiently access a broad customer base while maintaining underwriting control. We
willcompensate our distribution sources on a risk-by-riskbasis and we do not intend to offer additional incentives based on volume or profitability. LINES OF BUSINESS.basis.Lines of Business. Our
Insurance Group will initially compriseinsurance group consists of sixlines of business or "profit centers":profit centers, including casualty, programs, property,casualty (including excess and umbrella),executive assurance,(including, but not limitedhealthcare and professional liability. We write business on both an admitted and non-admitted basis.
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- Casualty. Our casualty profit center writes casualty business on both a primary and excess basis for commercial clients.
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- Programs. Our programs profit center is comprised of the following three business units: (1) property and casualty programs unit, which targets general liability, commercial automobile, inland marine, personal watercraft, non-catastrophe-exposed and catastrophe-exposed property business, workers' compensation and umbrella liability coverages; (2) accident and health programs unit; and (3) alternative markets unit, which provides alternative risk transfer services. The alternative markets unit supports our program business by providing alternative market structures for general agents or other clients who wish to participate in the underwriting results of their business.
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- Property. Our property profit center provides property, energy and marine insurance coverages for commercial clients.
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- Executive Assurance. Our executive assurance profit center focuses on directors' and officers' liability insurance coverages for corporate and financial
and commercialinstitutiondirectors and officers liability andclients. We also write financial institution errors and omissionscoverage), medical malpractice,coverages, and also may provide employment practices liability insurance, pension trust errors and omissions insurance and fidelity bonds.- •
- Healthcare. Our healthcare profit center has three principal areas of focus: (1) lead umbrella coverages over self-insured retentions for large healthcare accounts, such as hospitals, physician group practices and multi-state outpatient facility operations; (2) excess coverages for hospitals and other healthcare facilities; and (3) primary professional and general liability coverages for healthcare facilities that provide outpatient care and/or services.
6
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- Professional Liability. Our professional liability
insurance (including, but not limited to, architectsprofit center has three principal areas of focus: (1) large law andengineers, small to mediumaccounting firms andlawyersprofessionalliability)programs; (2) environmental and design professionals, including practice policies for architectural and engineering firms and construction projects; and (3) miscellaneous professional liability, including coverages for consultants, systems integrations, wholesalers and managing general agents.Prior to 2002, we ceded a substantial portion of our program business
(including alternative risk). Once these unitsto unaffiliated reinsurers. Commencing in 2002, we made a strategic decision to retain more risk on our program business and reduce substantially the amount of premiums ceded to unaffiliated reinsurers.In addition, through American Independent and PSIC, we underwrite non-standard personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania and Ohio, as well as in Maryland and Delaware. We are
operational,also managing a portfolio of lenders products underwritten by Arch Insurance prior to the commencement of our new underwriting initiatives in 2001.During 2003, we added a construction and surety profit center, which will seek to provide primary and excess casualty, contract surety and property coverages. In support of this new initiative, in February 2003, we reached an agreement in principle with the Kemper Insurance Companies to acquire the renewal rights to Kemper's contract and specialty surety products written through the Kemper Surety division, including Lou Jones & Associates. As part of this transaction, Arch Insurance has hired Kemper's surety management team and members of its staff. Under the terms of the transaction, which is subject to definitive documentation, we will
explore other opportunitiesnot assume any run-off liabilities of the Kemper Surety division, and Kemper will provide services innew areas which may include: marine, environmental liability, construction riskreturn for fees during a transitional period while we file our rates andsurety. 16UNDERWRITING PHILOSOPHY.forms for contract and specialty products.Underwriting Philosophy. Our
Insurance Group'sinsurance group's underwriting philosophy is to generate an underwriting profit (on both a gross and net basis) through prudent risk selection and proper pricing across all lines of business. One key to this philosophywill beis the strict adherence to uniform underwriting standards across each profit center thatwill focusfocuses on the following:-
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- risk selection;
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- desired attachment point;
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- limits and retention management;
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- due diligence, including as to financial condition, claims history, management, and product, class and territorial exposure;
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- underwriting authority and appropriate approvals; and
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- collaborative decision-making.
MARKETING.7
Premiums Written and Geographic Distribution. Set forth below is summary information regarding net premiums written by major line of business and by client location for our insurance segment:
Year Ended
December 31, 2002Net Premiums
Written% Of Total (in thousands) Insurance Segment Major Line of Business(1): Casualty $ 95,419 25.2 % Programs 93,868 24.8 % Property 50,772 13.4 % Executive assurance 49,479 13.0 % Healthcare 23,624 6.2 % Professional liability 20,436 5.4 % Other 45,329 12.0 % Total $ 378,927 100.0 % Client Location(1): United States $ 375,725 99.2 % United Kingdom 1,179 0.3 % Bermuda 777 0.2 % Canada 555 0.1 % Switzerland 307 0.1 % Other 384 0.1 % Total $ 378,927 100.0 %
- (1)
- Reflects the cession of $86.1 million of net premiums written to our reinsurance segment.
Marketing. Our
Insurance Group'sinsurance group's productswill beare marketed principally through licensed independent brokers and wholesalers. Weanticipatereceive business from brokers who are paid a brokerage commission usually equal to a percentage of gross premiums. In general, we are not committed to accept business from any particular broker, and brokers do not have the authority to bind the company except with respect to program business. In our program business, following our underwriting, financial, claims and information technology due diligence reviews, we authorize managing general agents, general agents and other producers to write business on our behalf within underwriting authorities prescribed by us. See "Risk Factors—Risks Relating to Our Company—We could be materially adversely affected to the extent that managing general agents, general agents and other producers in our program business exceed their underwriting authorities or otherwise breach obligations owed to us." For information on our major brokers, see note 10, "Commitments and Contingencies—Concentrations of Credit Risk," of the notes accompanying our consolidated financial statements.Risk Management and Reinsurance. In the normal course of business, the insurance group may cede a
majorityportion of its premium through quota share, surplus share, excess of loss and facultative reinsurance agreements. Reinsurance arrangements do not relieve us from our obligations to our insureds. Reinsurance recoverables are recorded as assets, predicated on the reinsurers' ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, our insurance subsidiaries would be liable for such defaulted amounts. Our insurance subsidiaries will continue to evaluate their reinsurance requirements. For information regarding the effects of reinsurance on our company, see note 4, "Reinsurance," of the notes accompanying our consolidated financial statements.8
For our catastrophe exposed insurance business, we monitor and limit the amount of our
volume may emanate from the top three insurance brokers. CLAIMS MANAGEMENT.exposure to catastrophic losses through a combination of aggregate exposure limits, underwriting guidelines and reinsurance. For a discussion of our risk management policies, see "Management's Discussion and Analysis of Financial Condition and Results of Operations—Certain Matters Which May Materially Affect Our Results of Operations and/or Financial Condition—Natural and Man-Made Catastrophic Events."Claims Management. Our claims department
will provideprovides underwriting and loss service support to all of our branches. In addition, claims personnelwillfully participate in the creation of insurance products. Members of our claims departmentwillwork with our underwriting professionals as functional teams in order to develop products and services that our customers desire and may use independent national claims firms for investigations and field adjustments.RESERVES
Employees
At March 25, 2003, we employed a total of approximately 650 full-time employees.
Reserves
We believe we have applied, and will continue to so apply, a conservative reserving philosophy for both our insurance and reinsurance operations.
We utilize regular actuarial reviews.Reserve estimates are derived after extensive consultation with individual underwriters, actuarial analysis of the loss reserve development and comparison with market benchmarks. We are building our actuarial staff and will utilize both internal and external actuaries. Generally, reserves are established without regard to whether we may subsequently contest the claim. We do not currently expect to discount our loss reserves.Loss reserves represent estimates of what the insurer or reinsurer ultimately expects to pay on claims at a given time, based on facts and circumstances then known, and it is
possibleprobable that the ultimate liability may exceed or be less than such estimates. Even actuarially sound methods can lead to subsequent adjustments to reserves that are both significant and irregular due to the nature of the risks written. Insurance loss reserves are inherently subject to uncertainty. In establishing the reserves for losses and loss adjustment expenses, we have made various assumptions relating to the pricing of our reinsurance contracts and insurance policies and have also considered available historical industry experience and current industry conditions. Our reserving process reflects that there is a possibility that the assumptions made could prove to be inaccurate due to several factors, including the fact that very limited historical information has been reported to us through December 31, 2002 due to our start-up nature. See "Management's Discussion and Analysis of Financial Condition and Results ofOperations--CriticalOperations—Critical Accounting Policies, Estimates and Recent AccountingPronouncements--LossesPronouncements—Reserves for Losses and Loss Adjustment Expenses."The following table represents the development of generally accepted accounting principles ("GAAP")
balance sheetreserves as determined under GAAP for19971996 through December 31,2001.2002. This table does not present accident or policy year development data. Results for the period 1996 to December 31, 2000 relate to our prior reinsurance operations, whichwaswere sold on May 5, 2000 to Folksamerica Reinsurance Company. The top line of the table shows the reserves, net of reinsurance recoverables, at the balance sheet date for each of the indicated years. This represents the estimated amounts of netclaimslosses and17claimsloss adjustment expenses arising in all prior years that are unpaid at the balance sheet date, including incurred but not reported ("IBNR") reserves. The table also shows the reestimated amount of the previously recordedreservereserves based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The "cumulative redundancy (deficiency)" represents the aggregate change in the estimates over all prior years. The table also shows the cumulative amounts paid as of successive years with respect to that reserve liability. In addition, the table reflects the claim development of the gross balance sheet reserves for 1996 through December 31,2001.2002.9
With respect to the information in the table below, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For additional information on our reserves
including a reconciliation of claims and claims expense reservesfor the years ended December 31, 2002, 20012000and1999,2000, please refer toNotenote 5, "Reserve for Losses and Loss Adjustment Expenses," of the notes accompanying our consolidated financial statements.DEVELOPMENT OF
Development of GAAPRESERVES CUMULATIVE REDUNDANCY (DEFICIENCY)
YEARS ENDED DECEMBER 31, --------------------------------------------------------------------- 1996 1997 1998 1999 2000 2001 -------- -------- -------- -------- -------- -------- (IN MILLIONS)Reserves for unpaid claims and claims adjustment expenses, net of reinsurance recoverables...... $ 20 $ 71 $ 186 $ 309 $ -- $ 23 Paid (cumulative) as of: One year later................................. 9 19 88 311 -- -- Two years later................................ 10 33 216 311 -- -- Three years later.............................. 12 64 216 -- -- -- Four years later............................... 18 64 -- -- -- -- Five years later............................... 18 -- -- -- -- -- Reserve reestimated as of: One year later................................. 20 68 216 -- -- -- Two years later................................ 19 65 216 -- -- -- Three years later.............................. 18 64 216 -- -- -- Four years later............................... 18 64 -- -- -- -- Five years later............................... 18 -- -- -- -- -- Cumulative redundancy (deficiency)............... $ 2 $ 7 $ (30) $ (2) -- -- ===== ==== ====== ===== ==== ==== Cumulative redundancy (deficiency) as a percentage of net reserves..................... 10.0% 8.5% (16.1)% (1.0)% -- -- Gross reserve for claims and claims expenses..... $ 20 $ 71 $ 216 $ 365 -- $113 Reinsurance recoverable.......................... -- -- (30) (56) -- (90) ----- ---- ------ ----- ---- ---- Net reserve for claims and claims expenses....... $ 20 $ 71 $ 186 $ 309 $ -- $ 23 ----- ---- ------ ----- ---- ---- Gross reestimated reserve........................ $ 18 $ 64 $ 246 $ 367 $ -- $113 Reestimated reinsurance recoverable.............. -- -- (30) (56) -- (90) ----- ---- ------ ----- ---- ---- Net reestimated reserve.......................... $ 18 $ 64 $ 216 $ 311 $ -- $ 23 Gross reestimated redundancy (deficiency)........ $ 2 $ 7 $ (30) $ (2) -- -- ===== ==== ====== ===== ==== ====INVESTMENTS At December 31,Reserves
Cumulative Redundancy (Deficiency)
Years Ended December 31, 1996 1997 1998 1999 2000 2001 2002 (in millions) Reserves for unpaid losses and loss adjustment expenses, net of reinsurance recoverables $ 20 $ 71 $ 186 $ 309 — $ 21 $ 381 Paid (cumulative) as of: One year later 9 19 88 311 — 15 Two years later 10 33 216 311 — Three years later 12 64 216 311 Four years later 18 64 216 Five years later 18 64 Six years later 18 Reserve reestimated as of: One year later 20 68 216 — — 25 Two years later 19 65 216 — — Three years later 18 64 216 — Four years later 18 64 216 Five years later 18 64 Six years later 18 Cumulative redundancy (deficiency) $ 2 $ 7 $ (30 ) $ (2 ) — $ (4 ) — Cumulative redundancy (deficiency) as a percentage of net reserves 10.0 % 8.5 % (16.1 )% (1.0 )% — (18.8 )% — Gross reserve for losses and loss adjustment expenses $ 20 $ 71 $ 216 $ 365 — $ 111 $ 592 Reinsurance recoverable — — (30 ) (56 ) — (90 ) (211 ) Net reserve for losses and loss adjustment expenses 20 71 186 309 — 21 381 Gross reestimated reserve 18 64 246 367 — 179 592 Reestimated reinsurance recoverable — — (30 ) (56 ) — (154 ) (211 ) Net reestimated reserve 18 64 216 311 — 25 381 Gross reestimated redundancy (deficiency) $ 2 $ 7 $ (30 ) $ (2 ) — $ (68 ) — During 2002, we experienced a deficiency on both a gross and net basis in our 2001
consolidated cashreported reserves. A significant portion of this deterioration, approximately $58 million andinvested assets totaled approximately $1.0 billion, consisting of $486.8$2 million ofcashdeficiency on a gross andshort-term investments, $468.3net basis, respectively, occurred in a small number of program accounts in which, during 2001, we attempted to minimize our risk through the extensive use of reinsurance. The balance of the deficiency, approximately $10 million and $2 million on a gross and net basis, respectively, occurred in our non-standard automobile business as a result ofpublicly traded fixed 18maturity investments, $22.2 millionan actuarial review performed in 2002.We are subject to credit risk with respect to our reinsurance and retrocessions because the ceding of
fixed maturities heldrisk to reinsurers and retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our existing reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect our financial condition and results of operations. Although we monitor the financial condition of our reinsurers and attempt to place coverages only with10
substantial, financially sound carriers, we may not be successful in
escrow, $41.6 million of privately held securities and $0.2 million of publicly traded equity securities. Our strategy is to maximize our underwriting profitability and fully deploy our capital through our underwriting activities. Consequently, we have established an investment policy, which we consider to be conservative.doing so. See "Management's Discussion and Analysis of Financial Condition and Results ofOperations--Investments.Operations—Liquidity and Capital Resources—Certain Matters Which May Affect Our Results of Operations and/or Financial Condition—Reinsurance Protection and Recoverables."Investments
At December 31, 2002, consolidated cash and invested assets totaled approximately $2.0 billion, consisting of $572.3 million of cash and short-term investments, $1.4 billion of publicly traded fixed maturity investments and $31.5 million of privately held securities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Investments."
Our current investment guidelines stress preservation of capital, market liquidity, and diversification of risk. To achieve this objective, our current fixed income investment guidelines call for an average credit quality of "Aa3" and "AA-" as measured by Moody's and Standard & Poor's, respectively. Notwithstanding the foregoing, our investments are subject to market-wide risks and fluctuations, as well as to risks inherent in particular securities.
At December 31,
2001, almost2002, all of our fixed maturity and short-term investments were rated investment grade byMoody's orStandard & Poor's and had an average Standard & Poor's quality rating of "AA-" and an average duration of approximately1.92.1 years.The following table summarizes the fair value of our investments and cash and short-term investments at the dates indicated.
DECEMBER 31, --------------------------------------------------------------------------- 2001 2000 1999 --------------------- --------------------- --------------------- ESTIMATED % OF ESTIMATED % OF ESTIMATED % OF FAIR VALUE TOTAL FAIR VALUE TOTAL FAIR VALUE TOTAL ---------- -------- ---------- -------- ---------- -------- (DOLLARS IN THOUSANDS)Cash and short-term investments.... $ 486,790 48% $108,868 39% $ 82,242 14% Short-term investments held in escrow........................... 22,156 2 -- -- -- -- ---------- ---- -------- ---- -------- ---- Sub-total...................... 508,946 50 108,868 39 82,242 14 ---------- ---- -------- ---- -------- ---- Fixed maturities: U.S. government and government agencies....................... 137,861 14 27,122 10 41,095 7 Municipal bonds.................. -- -- -- -- 52,245 9 Corporate bonds.................. 239,261 23 5,835 2 136,838 24 Mortgage and asset-backed securities..................... 91,147 9 5,518 2 27,298 5 Foreign governments.............. -- -- -- -- 3,591 1 ---------- ---- -------- ---- -------- ---- Sub-total.................... 468,269 46 38,475 14 261,067 46 ---------- ---- -------- ---- -------- ---- Fixed maturities held in escrow.... -- -- 20,970 8 -- -- ---------- ---- -------- ---- -------- ---- Equity securities: Publicly traded.................. 235 -- 51,322 19 158,631 27 Privately held................... 41,608 4 56,418 20 77,934 13 ---------- ---- -------- ---- -------- ---- Sub-total.................... 41,843 4 107,740 39 236,565 40 ---------- ---- -------- ---- -------- ---- Total...................... $1,019,058 100% $276,053 100% $579,874 100% ========== ==== ======== ==== ======== ====19
December 31, 2002 2001 Estimated
Fair Value% of
TotalEstimated
Fair Value% of
Total(in thousands) Cash and short-term investments $ 572,258 29 % $ 486,790 48 % Short-term investments held in escrow — — 22,156 2 Sub-total 572,258 29 508,946 50 Fixed maturities: U.S. government and government agencies 179,322 9 137,861 14 Municipal bonds — — — — Corporate bonds 949,003 48 239,261 23 Mortgage and asset-backed securities 253,779 13 91,147 9 Foreign governments — — — — Sub-total 1,382,104 70 468,269 46 Fixed maturities held in escrow — — — — Equity securities: Publicly traded — — 235 — Privately held 31,536 1 41,608 4 Sub-total 31,536 1 41,843 4 Total $ 1,985,898 100 % $ 1,019,058 100 % 11
Primarily because of the potential for large claims payments, our investment portfolio is structured to provide a high level of liquidity. The table below shows the contractual maturities of our fixed maturities at December 31,
2001:
DECEMBER 31, 2001 -------------------------- ESTIMATED AMORTIZED FAIR VALUE COST ---------- --------- (IN THOUSANDS)Available for sale: Due in one year or less............................ $ 9,351 $ 10,438 Due after one year through five years.............. 322,923 321,315 Due after five years through ten years............. 34,751 31,445 Due after 10 years................................. 10,097 12,804 -------- -------- Sub-total........................................ 377,122 376,002 -------- -------- Mortgage and asset-backed securities............... 91,147 91,152 -------- -------- Total.......................................... $468,269 $467,154 ======== ========The table below presents the credit quality (according to Standard & Poor's) distribution of our fixed maturities at December 31, 2001:
DECEMBER 31, 2001 ------------------------- ESTIMATED % OF FAIR VALUE TOTAL ---------- -------- (IN THOUSANDS)AAA............................................... $199,416 42.6% AA................................................ 31,847 6.8% A................................................. 147,679 31.5% BBB............................................... 87,378 18.7% B................................................. 1,949 0.4% -------- ------ Total....................................... $468,269 100.0% ======== ======RATINGS2002:
Estimated Fair
ValueAmortized Cost (in thousands) Available for sale: Due in one year or less $ 19,671 $ 20,149 Due after one year through five years 1,058,158 1,023,151 Due after five years through ten years 21,966 24,100 Due after 10 years 28,530 23,090 Sub-total 1,128,325 1,090,490 Mortgage and asset-backed securities 253,779 244,147 Total $ 1,382,104 $ 1,334,637 Ratings
Our reinsurance subsidiaries, Arch Re
(US),U.S. and Arch Re(Bermuda) and First American Insurance Company,Bermuda, each currentlyhavehas financial strength ratings of "A-" (Excellent) from A.M.BestBest. Our principal insurance subsidiaries, Arch Insurance Company, Arch E&S and Arch Specialty, each has a financial strength rating of "A-" (Excellent) from A.M. Best. With respect to our non-standard automobile insurers, American IndependentInsurance Companyhas a financial strength rating of "C++" (Marginal) from A.M. Best, and PSIC has a financial strength rating of "A-" (Excellent) from A.M. Best. We do not believe thatAmerican Independent'sour non-standard automobile business is particularlyratings sensitiveratings-sensitive because its insureds purchase insurance primarily to satisfy state and local insurance and financial reporting requirements.Rock River has a financial strength ratingInsurance ratings are used by insurance and reinsurance intermediaries as an important means of
"A+u" (Superior--under review) from A.M. Best and Cross River has a financial strength rating of "NR-2" (Insufficient Size and/or Operating Experience) from A.M. Best. We are currently seeking to improveassessing the financial strengthfor Rock RiverandCross River,quality of insurers andwereinsurers. A.M. Best is generally considered to be a significant rating agency with respect to insurance and reinsurance companies. A.M. Best's ratings reflect that agency's independent opinion of the financial strength and ability of an insurer to meet ongoing obligations to policyholders, and arealso seeking ratings for our other principal U.S. insurance subsidiaries.not a warranty of an insurer's current or future ability to meet its obligations to policyholders. Recently, rating agencies have been coming under increasing pressure as a result of high-profile corporate bankruptcies and may, as a result, increase their scrutiny of rated companies, revise their rating policies or take other action. We can offer no assurances that our ratings will remain at their current levels.COMPETITIONCompetition
The world-wide reinsurance and insurance businesses are highly competitive. We compete, and will continue to compete, with major U.S. and non-U.S. insurers and reinsurers,
and others,some of which20have greater financial, marketing and management resources than us and have had longer-term relationships with insureds and brokers than us. We compete with other insurers and reinsurers primarily on the basis of overall financial strength, ratings assigned by independent rating agencies, geographic scope of business, strength of client relationships, premiums charged, contract terms and conditions, products and services offered, speed of claims payment, reputation, employee experience, and qualifications and local presence. OTHER OPERATIONS During the period following the sale of our prior reinsurance operations in May 2000 through the announcement of our underwriting initiative in October 2001, we built and acquired insurance businesses that enable us to generate both fee-based revenue (E.G., commissions and advisory and management fees) and risk-based revenue (I.E., insurance premium). As part of this strategy, we acquired certain businesses, including Hales & Company Inc. (an insurance advisory firm) and American IndependentRegulation
U.S. Insurance
Holding Company (which principally writes non-standard automobile coverages), which are considered "non-core businesses" for purposes of the capital infusion. See "The Capital Infusion." REGULATION U.S. INSURANCE REGULATION GENERAL.RegulationGeneral. In common with other insurers, our U.S.-based insurance subsidiaries are subject to extensive governmental regulation and supervision in the various states and jurisdictions in which they
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are domiciled and licensed to conduct business. The laws and regulations of the state of domicile have the most significant impact on operations. This regulation and supervision is designed to protect policyholders rather than investors. Generally, regulatory authorities have broad
supervisoryregulatory powers over such matters as licenses, standards of solvency, premium rates, policy forms, marketing practices, investments, security deposits, methods of accounting, form and content of financial statements, reserves and provisions for unearned premiums, unpaid losses and loss adjustment expenses, reinsurance, minimum capital and surplus requirements, dividends and other distributions to shareholders, periodic examinations and annual and other report filings. Certain insurance regulatory requirements are highlighted below. In addition, regulatory authorities conduct periodic financial and market conduct examinations.CREDIT FOR REINSURANCE.Credit for Reinsurance. Arch Re
(US)U.S. is subject to insurance regulation and supervision that is similar to the regulation of licensed primary insurers. However, the terms and conditions of reinsurance agreements generally are not subject to regulation by any governmental authority with respect to rates or policy terms. This contrasts with primary insurance policies and agreements, the rates and terms of which generally are regulated by state insurance regulators. As a practical matter, however, the rates charged by primary insurers do have an effect on the rates that can be charged by reinsurers.A primary insurer ordinarily will enter into a reinsurance agreement only if it can obtain credit for the reinsurance ceded on its statutory financial statements. In general, credit for reinsurance is allowed in the following circumstances:
-
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- if the reinsurer is licensed in the state in which the primary insurer is domiciled or, in some instances, in certain states in which the primary insurer is licensed;
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- if the reinsurer is an "accredited" or otherwise approved reinsurer in the state in which the primary insurer is domiciled or, in some instances, in certain states in which the primary insurer is licensed;
21-- •
- in some instances, if the reinsurer (a) is domiciled in a state that is deemed to have substantially similar credit for reinsurance standards as the state in which the primary insurer is domiciled and (b) meets certain financial requirements; or
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- if none of the above apply, to the extent that the reinsurance obligations of the reinsurer are collateralized appropriately, typically through the posting of a letter of credit for the benefit of the primary insurer or the deposit of assets into a trust fund established for the benefit of the primary insurer.
As a result of the requirements relating to the provision of credit for reinsurance, Arch Re
(US)U.S. and Arch Re(Bermuda)Bermuda are indirectly subject to certain regulatory requirements imposed by jurisdictions in which ceding companies are licensed.As of March
8, 2002,25, 2003, Arch Re(US)U.S. is licensed or is an accredited or otherwise approved reinsurer in4347 states and the District of Columbia,First AmericanArch Insurance is licensedor otherwise approvedas an insurer in4950 states and the District of Columbia,Cross RiverArch E&S is licensed or otherwise approved as an excess and surplus lines insurer in2324 states and the District of ColumbiaRock Riverand Arch Specialty is licensed or otherwise approved as an excess and surplus lines insurer in 47 states and the District ofColumbia andColumbia. American IndependentInsurance Companyis licensed as an insurer in three states, and PSIC is licensed as an insurer in two states. Arch Re(Bermuda)Bermuda is not, and does not expect to becomesolicensed orapproved. HOLDING COMPANY ACTS.approved in any U.S. jurisdiction.Holding Company Acts. State insurance holding company system statutes and related regulations provide a regulatory apparatus which is designed to protect the financial condition of domestic insurers operating within a holding company system. All insurance holding company statutes require disclosure and, in some instances, prior approval of material transactions between the domestic insurer and an affiliate. Such transactions typically include sales, purchases, exchanges, loans and extensions of credit, reinsurance agreements, service agreements, guarantees and investments between an insurance company
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and its affiliates, involving in the aggregate certain percentages of an insurance company's admitted assets or policyholders surplus, or dividends that exceed certain percentages of an insurance company's surplus or income.
Typically, the holding company statutes also require each of the insurance subsidiaries periodically to file information with state insurance regulatory authorities, including information concerning capital structure, ownership, financial condition and general business operations. Under the terms of applicable state statutes, any person or entity desiring to acquire control of a domestic insurer is required first to obtain approval of the applicable state insurance regulator.
REGULATION OF DIVIDENDS AND OTHER PAYMENTS FROM INSURANCE SUBSIDIARIES.Regulation of Dividends and Other Payments from Insurance Subsidiaries. The ability of an insurer to pay dividends or make other distributions is subject to insurance regulatory limitations of the insurance company's state of domicile. Generally, such laws limit the payment of dividends or other distributions above a specified level. Dividends or other distributions in excess of such thresholds are "extraordinary" and are subject to regulatory approval. Generally, during
2002,2003, all significant dividends or other distributions from Arch Re(US)U.S.,First AmericanArch Insurance and our other U.S. insurance subsidiaries will be subject to regulatory approval. See "Management's Discussion and Analysis of Financial Condition and Results ofOperations--LiquidityOperations—Liquidity and Capital Resources" andNote 12,note 11, "Share Capital," of the notes accompanying our financial statements.INSURANCE REGULATORY INFORMATION SYSTEM RATIOS.Insurance Regulatory Information System Ratios. The National Association of Insurance Commissioners ("NAIC") Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is intended primarily to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies
1112 industry ratios and specifies "usual values" for each ratio. Departure from the usual values of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer's business.Insurers that report four or 22more unusual values are generally targeted for regulatory review.For the year ended December 31,2001,2002, certain of our U.S.-basedinsurance operationssubsidiaries generated ratios that werewithinoutside of thenormal rangeusual values due, in part, to our new underwriting initiative and the resulting growth in net premiums written and surplus levels. To date, none ofresults except for American Independent, whichthese subsidiaries hasnotreceived any notice of regulatory review.ACCREDITATION.Accreditation. The NAIC has instituted its Financial Regulatory Accreditation Standards Program ("FRASP") in response to federal initiatives to regulate the business of insurance. FRASP provides a set of standards designed to establish effective state regulation of the financial condition of insurance companies. Under FRASP, a state must adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce such items in order to become an "accredited" state. If a state is not accredited, accredited states are not able to accept certain financial examination reports of insurers prepared solely by the regulatory agency in such unaccredited state.
RISK-BASED CAPITAL REQUIREMENTS.The respective states in which Arch Re U.S., Arch Insurance, Arch Specialty, Arch E&S, American Independent and PSIC are domiciled are accredited states.Risk-Based Capital Requirements. In order to enhance the regulation of insurer solvency, the NAIC adopted in December 1993 a formula and model law to implement risk-based capital requirements for property and casualty insurance companies. These risk-based capital requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The risk-based capital model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers:
-
- •
- underwriting, which encompasses the risk of adverse loss developments and inadequate pricing;
-- •
- declines in asset values arising from credit risk; and
-- •
- declines in asset values arising from investment risks.
14
Insurers having less statutory surplus than required by the risk-based capital calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy. Equity investments in common stock typically are valued at 85% of their market value under the risk-based capital guidelines. For equity investments in an insurance company affiliate, the risk-based capital requirement for the equity securities of such affiliate would generally be our U.S. insurance subsidiaries' proportionate share of the affiliate's risk-based capital requirement.
Under the approved formula, an insurer's statutory surplus is compared to its risk-based capital requirement. If this ratio is above a minimum threshold, no company or regulatory action is necessary. Below this threshold are four distinct action levels at which a regulator can intervene with increasing degrees of authority over an insurer as the ratio of surplus to risk-based capital requirement decreases. The four action levels include:
-
- •
- insurer is required to submit a plan for corrective action,
-- •
- insurer is subject to examination, analysis and specific corrective action,
-- •
- regulators may place insurer under regulatory control, and
-- •
- regulators are required to place insurer under regulatory control.
Each of our U.S. insurance subsidiaries' surplus (as calculated for statutory
annual statements purposes) is above the risk-based capital thresholds that would require either company or regulatory action.GUARANTY FUNDS AND ASSIGNED RISK PLANS.Guaranty Funds and Assigned Risk Plans. Most states require all admitted insurance companies to participate in their respective guaranty funds which cover certain claims against insolvent insurers. Solvent insurers licensed in these states are required to cover the losses paid on behalf of insolvent insurers by the guaranty funds and are generally subject to annual assessments in the state by its guaranty fund to cover these losses. Some states also require licensed insurance companies to participate in assigned risk plans which provide coverage for automobile insurance and other lines for insureds which, for various reasons, cannot otherwise obtain insurance in the open market. This
23participation may take the form of reinsuring a portion of a pool of policies or the direct issuance of policies to insureds. The calculation of an insurer's participation in these plans is usually based on the amount of premium for that type of coverage that was written by the insurer on a voluntary basis in a prior year. Assigned risk pools tend to produce losses which result in assessments to insurers writing the same lines on a voluntary basis. FEDERAL REGULATION.Federal Regulation. Although state regulation is the dominant form of regulation for insurance and reinsurance business, the federal government has shown increasing concern over the adequacy of state regulation. It is not possible to predict the future impact of any potential federal regulations or other possible laws or regulations on
Arch Re (US)'sour U.S. subsidiaries' capital and operations, and such laws or regulations could materially adversely affect its business.THE GRAMM-LEACH-BLILEY ACT.Terrorism Risk Insurance Act of 2002. On November 26, 2002, President Bush signed into law the Terrorism Risk Insurance Act of 2002 ("TRIA"). TRIA established a federal backstop for insurance-related losses resulting from any act of terrorism carried out by foreign powers on U.S. soil or against U.S. air carriers, vessels or foreign missions. Under TRIA, all U.S.-based property and casualty insurers are required to make terrorism insurance coverage available in specified commercial property and casualty insurance lines. In return, TRIA provides that the federal government will pay 90% of covered losses after an insurer's losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion pursuant to TRIA. If an act (or acts) of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses. The deductible for each year is based on the insurer's direct earned premiums for property and casualty
15
insurance for the prior calendar year multiplied by a specified percentage. The specified percentages are 7% for 2003, 10% for 2004 and 15% for 2005, respectively.
Our U.S.-based property and casualty insurers, Arch Insurance, Arch Specialty and Arch E&S, are subject to TRIA. TRIA specifically excludes reinsurance and personal lines business and, accordingly, currently does not apply to our non-standard automobile business or our reinsurance operations. Based on 2002 direct commercial earned premiums, our U.S. insurance group's deductible for 2003 would be $13.7 million (i.e., 7% of such earned premiums). The amount of our deductible for 2004 and 2005 could increase substantially, depending upon the amount of direct earned premiums we write in 2003 and 2004, and in light of the fact that the deductible percentage increases in such years. Currently, there is uncertainty as to what effect TRIA will have on the insurance industry.
The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act of 1999 ("GLBA"), which implements fundamental changes in the regulation of the financial services industry in the United States, was enacted on November 12, 1999. The GLBA permits the transformation of the already converging banking, insurance and securities industries by permitting mergers that combine commercial banks, insurers and securities firms under one holding company, a "financial holding company." Bank holding companies and other entities that qualify and elect to be treated as financial holding companies may engage in activities, and acquire companies engaged in activities, that are "financial" in nature or "incidental" or "complementary" to such financial activities. Such financial activities include acting as principal, agent or broker in the underwriting and sale of life, property, casualty and other forms of insurance and annuities.
Until the passage of the GLBA, the Glass-Steagall Act of 1933 had limited the ability of banks to engage in securities-related businesses, and the Bank Holding Company Act of 1956 had restricted banks from being affiliated with insurers. With the passage of the GLBA, among other things, bank holding companies may acquire insurers, and insurance holding companies may acquire banks. The ability of banks to affiliate with insurers may affect our U.S. subsidiaries' product lines by substantially increasing the number, size and financial strength of potential competitors.
LEGISLATIVE AND REGULATORY PROPOSALS.Legislative and Regulatory Proposals. From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers. In addition, there are a variety of proposals being considered by various state legislatures (some of which proposals have been enacted). We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition.
BERMUDA INSURANCE REGULATION THE INSURANCE ACT
Bermuda Insurance Regulation
The Insurance Act 1978,
AS AMENDED, AND RELATED REGULATIONS OF BERMUDA (THE "INSURANCE ACT"as Amended, and Related Regulations of Bermuda (the "Insurance Act"). As a holding company, ACGL is not subject to Bermuda insurance regulations. The Insurance Act, whichwill regulateregulates the insurance business of Arch Re(Bermuda),Bermuda, provides that no person shall carry on any insurance business in or from within Bermuda unless registered as an insurer under the Insurance Act by the BermudaSupervisor of InsuranceMonetary Authority (the"Supervisor""BMA"),whowhich is responsible for the day-to-day supervision of insurers. Under the Insurance Act, insurance business includes reinsurance business. TheSupervisor, in deciding whether to grantregistrationhas broad discretion to act as the Supervisor thinks fit in the public interest. The Supervisor is required by the Insurance Act to determine whether the applicant is a fit and proper body to be engaged in the insurance business and, in particular, whether it has, or has available to it, adequate knowledge and expertise. The registration 24of an applicant as an insurer is subject to its complying with the terms of its registration and such other conditions as the SupervisorBMA may impose from time to time.An Insurance Advisory Committee appointed by the Bermuda Minister of Finance advises the Supervisor on matters connected with the discharge of the Supervisor's functions and sub-committees thereof supervise and review the law and practice of insurance in Bermuda, including reviews of accounting and administrative procedures.The Insurance Act imposes solvency and liquidity standards and auditing and reporting requirements on Bermuda insurance companies and grants to the
SupervisorBMA powers to supervise, investigate and intervene in the affairs of insurance companies. Certain significant aspects of the Bermuda insurance regulatory framework are set forth below.CLASSIFICATION OF INSURERS.16
Classification of Insurers. The Insurance Act distinguishes between insurers carrying on long-term business and insurers carrying on general business. There are four classifications of insurers carrying on general business, with Class 4 insurers subject to the strictest regulation. Arch Re
(Bermuda)Bermuda is registered as both a long-term insurer and a Class 4 insurer in Bermuda, which we refer to in thisprospectus supplementannual report as a composite insurer, and is regulated as such under the Insurance Act.CANCELLATION OF INSURER'S REGISTRATION.Cancellation of Insurer's Registration. An insurer's registration may be canceled by the
SupervisorBMA on certain grounds specified in the Insurance Act, including failure of the insurer to comply with its obligations under the Insurance Act or if, in the opinion of theSupervisorBMA after consultation with the Insurance Advisory Committee, the insurer has not been carrying on business in accordance with sound insurance principles.PRINCIPAL REPRESENTATIVE.Principal Representative. An insurer is required to maintain a principal office in Bermuda and to appoint and maintain a principal representative in Bermuda.
For the purpose of the Insurance Act, the principal representative of Arch Re (Bermuda) is Marsh Management Services (Bermuda) Ltd. and the principal office of Arch Re (Bermuda) is at the offices of the principal representative at Victoria Hall, 11 Victoria Street, Hamilton HM 11, Bermuda. Without a reason acceptable to the Supervisor, an insurer may not terminate the appointment of its principal representative, and the principal representative may not cease to act as such, unless 30 days' notice in writing to the Supervisor is given of the intention to do so.It is the duty of the principal representative, within 30 days of reaching the view that there is a likelihood of the insurer for which the principal representative acts becoming insolvent or that a reportable "event" has, to the principal representative's knowledge, occurred or is believed to have occurred, to make a report in writing to theSupervisorBMA setting out all the particulars of the case that are available to the principal representative.Examples of such a reportable "event" include failure by the insurer to comply substantially with a condition imposed upon the insurer by the Supervisor relating to a solvency margin or a liquidity or other ratio. INDEPENDENT APPROVAL AUDITOR.Approved Independent Auditor. Every registered insurer must appoint an independent auditor who
willannuallyauditaudits andreportreports on the statutory financial statements and the statutory financial return of the insurer, both of which, in the case of Arch Re(Bermuda),Bermuda, are required to be filed annually with theSupervisor. The independent auditor of the insurer must be approved by the Supervisor and may be the same person or firm which audits the insurer's financial statements and reports for presentation to its shareholders. Our independent auditor is PricewaterhouseCoopers (Bermuda). APPROVED ACTUARY.BMA.Approved Actuary. Arch Re
(Bermuda),Bermuda, as a registered long-term insurer, is required to submit an annual actuary's certificate when filing its statutory financial returns. The actuary, whowillis normallybea qualified life actuary, must be approved by theSupervisor. Our approval actuary is John B. Kleiman of PricewaterhouseCoopers. LOSS RESERVE SPECIALIST.BMA.Loss Reserve Specialist. As a registered Class 4 insurer, Arch Re
(Bermuda)Bermuda is required to submit an opinion of itsapprovalapproved loss reserve specialist with its statutory financial return in respect of its loss25and loss expense provisions. The loss reserve specialist, who will normally be a qualified casualty actuary, must be approved by the Supervisor. Our approved loss reserve specialist is Simon Lambert of PricewaterhouseCoopers. STATUTORY FINANCIAL STATEMENTS.BMAStatutory Financial Statements. An insurer must prepare annual statutory financial statements. The Insurance Act prescribes rules for the preparation and substance of such statutory financial statements (which include, in statutory form, a balance sheet, an income statement, a statement of capital and surplus and notes thereto). The insurer is required to give detailed information and analyses regarding premiums, claims, reinsurance and investments. The statutory financial statements are not prepared in accordance with U.S. generally accepted accounting principles and are distinct from the financial statements prepared for presentation to the insurer's shareholders under the Companies Act 1981 of Bermuda (the "Companies Act"), which financial statements
will beare prepared in accordance with U.S. generally accepted accounting principles. Arch Re(Bermuda),Bermuda, as a general business insurer, is required to submit the annual statutory financial statements as part of the annual statutory financial return.The statutory financial statements and the statutory financial return do not form part of the public records maintained by the Supervisor. ANNUAL STATUTORY FINANCIAL RETURN.Annual Statutory Financial Return. Arch Re
(Bermuda)Bermuda is required to file with theSupervisorBMA in Bermuda a statutory financial return no later than four months after its financial year end (unless specificallyextended)extended upon application to the BMA). The statutory financial return for a Class 4 insurer includes, among other matters, a report of the approved independent auditor on the statutory financial statements of such insurer, solvency certificates, the statutory financial statements themselves, the opinion of the loss reserve specialist and a schedule of reinsurance ceded.The solvency certificates must be signed by the principal representativeMinimum Solvency Margin and
at least two directors of the insurer who are required to certify, among other matters, whether the minimum solvency margin has been metRestrictions on Dividends andwhether the insurer complied with the conditions attached to its certificate of registration. The independent approved auditor is required to state whether in its opinion it was reasonable for the directors to so certify. Where an insurer's accounts have been audited for any purpose other than compliance with the Insurance Act, a statement to that effect must be filed with the statutory financial return. MINIMUM SOLVENCY MARGIN AND RESTRICTIONS ON DIVIDENDS AND DISTRIBUTIONS.Distributions. Under the Insurance Act, Arch Re(Bermuda)Bermuda must ensure that the value of its long-term business assets exceed the amount of its long-term business liabilities by at least $250,000. The Insurance Act also provides that the value17
of the general business assets of Arch Re
(Bermuda),Bermuda, as a Class 4 insurer, must exceed the amount of its general business liabilities by an amount greater than the prescribed minimum solvency margin. Arch Re(Bermuda): -Bermuda:
- •
- is required, with respect to its general business, to maintain a minimum solvency margin (the prescribed amount by which the value of its general business assets must exceed its general business liabilities) equal to the greatest of:
- (A)
$100,000,000,- $100,000,000,
- (B)
- 50% of net premiums written (being gross premiums written less any premiums ceded by
the CompanyArch Re Bermuda butthe CompanyArch Re Bermuda may not deduct more than 25% of gross premiums when computing net premiums written), and- (C)
- 15% of loss and other insurance reserves;
-
- •
- is prohibited from declaring or paying any dividends during any financial year if it is in breach of its minimum solvency margin or minimum liquidity ratio or if the declaration or payment of such dividends would cause it to fail to meet such margin or ratio (if it has failed to meet its minimum solvency margin or minimum liquidity ratio on the last day of any financial year, Arch
26Re (Bermuda)Bermuda will be prohibited, without the approval of theSupervisor,BMA, from declaring or paying any dividends during the next financial year);-- •
- is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year's statutory balance sheet) unless it files (at least 7 days before payment of such dividends) with the
SupervisorBMA an affidavit stating that it will continue to meet the required margins;-- •
- is prohibited, without the approval of the
Supervisor,BMA, from reducing by 15% or more its total statutory capital as set out in its previous year's financial statements and any application for such approval must include an affidavit stating that it will continue to meet the required margins;-- •
- is required, at any time
ifit fails to meet its solvency margin, within 30 days (45 days where total statutory capital and surplus falls to $75 million or less) after becoming aware of that failure or having reason to believe that such failure has occurred, to file with theSupervisorBMA a written report containing certain information;-- •
- is required to establish and maintain a long-term business fund; and
-- •
- is required to obtain a certain certification from its approved actuary prior to declaring or paying any dividends and such certificate will not be given unless the value of its long-term business assets exceeds its long-term business liabilities, as certified by its
approvalapproved actuary, by the amount of the dividend and at least $250,000. The amount of any such dividend shall not exceed the aggregate of the excess referenced in the preceding sentence and other funds properly available for the payment of dividends, being funds arising out of its business, other than its long-term business.MINIMUM LIQUIDITY RATIO.Minimum Liquidity Ratio. The Insurance Act provides a minimum liquidity ratio for general business
insurers.insurers such as Arch Re Bermuda. An insurer engaged in general business is required to maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquotedbonesbonds and debentures, first liens on real estate, investment income due and accrued,accountaccounts and premiums receivable and reinsurance balances receivable.There are certain categories of assets which, unless specifically permitted by the Supervisor, do not automatically qualify as relevant assets, such as unquoted equity securities, investments in and advances to affiliates and real estate and collateral loans.The relevant liabilities are total general business insurance reserves and total other liabilities less deferred income tax and sundry liabilities (by interpretation, those not specifically defined).LONG-TERM BUSINESS FUND.18
Long-Term Business Fund. An insurer carrying on long-term business is required to keep its accounts in respect of its long-term business separate from any accounts kept in respect of any other business and all receipts of its long-term business form part of its long-term business fund. No payment may be made directly or indirectly from an insurer's long-term business fund for any purpose other than a purpose related to the insurer's long-term business, unless such payment can be made out of any surplus certified by the insurer's approved actuary to be available for distribution otherwise than to policyholders. Arch Re
(Bermuda)Bermuda may not declare or pay a dividend to any person other than a policyholder unless the value of the assets in its long-term business fund, as certified by its approved actuary, exceeds the liabilities of the insurer's long-term business (as certified by the insurer's approved actuary) by the amount of the dividend and at least the $250,000 minimum solvency margin prescribed by the Insurance Act, and the amount of any such dividend may not exceed the aggregate of that excess (excluding the said $250,000) and any other funds properly available for payment of dividends, such as funds arising out of business of the insurer other than long-term business.27RESTRICTIONS ON TRANSFER OF BUSINESS AND WINDING-UP.Restrictions on Transfer of Business and Winding-Up. Arch Re
(Bermuda),Bermuda, as a long-term insurer, is subject to the following provisions of the Insurance Act:-
- •
- all or any part of the long-term business, other than long-term business that is reinsurance business, may be transferred only with and in accordance with the sanction of the applicable Bermuda court; and
-- •
- an insurer or reinsurer carrying on long-term business may only be wound-up or liquidated by order of the applicable Bermuda court, and this may increase the length of time and costs incurred in the winding-up of Arch Re
(Bermuda)Bermuda when compared with a voluntary winding-up or liquidation.SUPERVISION, INVESTIGATION AND INTERVENTION.Supervision, Investigation and Intervention. The
SupervisorBMA may appoint an inspector with extensive powers to investigate the affairs of an insurer if theSupervisorBMA believes that an investigation is required in the interest of the insurer's policyholders or persons who may become policyholders. In order to verify or supplement information otherwise provided to theSupervisor,BMA, theSupervisorBMA may direct aninsureinsurer to produce documents or information relating to matters connected with the insurer's business.If it appears to the
SupervisorBMA that there is a risk of the insurer becoming insolvent, or that it is in breach of the Insurance Act or any conditions imposed upon its registration, theSupervisorBMA may, among other things, direct the insurer (1) not to take on any new insurance business, (2) not to vary any insurance contract if the effect would be to increase the insurer's liabilities, (3) not to make certain investments, (4) to realize certain investments, (5) to maintain in, or transfer to the custody of, a specified bank, certain assets, (6) not to declare or pay any dividends or other distributions or to restrict the making of such payments and/or (7) to limit its premium income.DISCLOSURE OF INFORMATION. In addition to powers under the Insurance Act to investigate the affairs of an insurer, the Supervisor may require certain information from an insurer (or certain other persons) to be produced to him. Further, the Supervisor has been given powers to assist other regulatory authorities, including foreign insurance regulatory authorities with their investigations involving insurance and reinsurance companies in
Certain Bermuda
but subject to restrictions. For example, the Supervisor must be satisfied that the assistance being requested is in connection with the discharge of regulatory responsibilities of the foreign regulatory authority. Further, the Supervisor must consider whether to co-operate is in the public interest. The grounds for disclosure are limited and the Insurance Act provides sanctions for breach of the statutory duty of confidentiality. CERTAIN BERMUDA LAW CONSIDERATIONSLaw ConsiderationsACGL and Arch Re
(Bermuda)Bermuda have been designated as non-resident for exchange control purposes by theBermuda Monetary AuthorityBMA and are required to obtain the permission of theBermuda Monetary AuthorityBMA for the issue and transfer of all of their shares. TheBermuda Monetary AuthorityBMA has given its consent for:-
- •
- The issue and
subsequenttransfer of ACGL's shares, up to the amount of its authorized capital from time to time, to and among personsnon residentthat are non-residents of Bermuda for exchange control purposes;-- •
- The issue and transfer of up to 20% of ACGL's shares in issue from time to time to and among persons resident in Bermuda for exchange control purposes.
Transfers and issues of ACGL's common shares to any resident in Bermuda for exchange control purposes may require specific prior approval under the Exchange Control Act 1972. Arch Re
(Bermuda)'s19
Bermuda's common shares cannot be issued or transferred without the consent of the
Bermuda Monetary Authority.BMA. Because we are designated as non-resident for Bermuda exchange control28purposes, we are allowed to engage in transactions, and to pay dividends to Bermuda non-residents who are holders of our common shares, in currencies other than the Bermuda Dollar. In accordance with Bermuda law, share certificates are issued only in the names of corporations or individuals. In the case of an applicant acting in a special capacity (for example, as an executor or trustee), certificates may, at the request of the applicant, record the capacity in which the applicant is acting. Notwithstanding the recording of any such special capacity, we are not bound to investigate or incur any responsibility in respect of the proper administration of any such estate or trust. We will take no notice of any trust applicable to any of our common shares whether or not we have notice of such trust.
ACGL and Arch Re
(Bermuda)Bermuda are incorporated in Bermuda as "exempted companies." As a result, they are exempt from Bermuda laws restricting the percentage of share capital that may be held by non-Bermudians, but they may not participate in certain business transactions, including (1) the acquisition or holding of land in Bermuda (except that required for their business and held by way of lease or tenancy for terms of not more than 50 years) without the express authorization of the Bermuda legislature, (2) the taking of mortgages on land in Bermuda to secure an amount in excess of $50,000 without the consent of the Minister of Finance, (3) the acquisition of any bonds or debentures secured by any land in Bermuda, other than certain types of Bermuda government securities or (4) the carrying on of business of any kind in Bermuda, except in furtherance of their business carried on outside Bermuda or under license granted by the Minister of Finance. While an insurer is permitted to reinsure risks undertaken by any company incorporated in Bermuda and permitted to engage in the insurance and reinsurance business, generally it is not permitted without a special license granted by the Minister of Finance to insure Bermuda domestic risks or risks of persons of, in or based in Bermuda.ACGL and Arch Re
(Bermuda)Bermuda also need to comply with the provisions of the Companies Act regulating the payment of dividends and making distributions from contributed surplus. A company shall not declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that: (a) the company is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of the company's assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts.Under the Companies Act, where a Bermuda company issues shares at a premium (that is for a price above the par value), whether for cash or otherwise, a sum equal to the aggregate amount or value of the premium on those shares must be transferred to an account, called "the share premium account." The provisions of the Companies Act relating to the reduction of the share capital of a company apply as if the share premium account were paid-up share capital of that company, except for certain matters such as premium arising on a particular class of shares may be used in paying up unissued shares of the same class to be issued to shareholders as fully paid bonus shares. The paid-up share capital may not be reduced if on the date the reduction is to be effected there are reasonable grounds for believing that the company is, or after the reduction would be, unable to pay its liabilities as they become due. Exempted companies, such as ACGL and Arch Re (Bermuda), must comply with Bermuda resident representation provisions under the Companies Act. We do not believe that such compliance will result in any material expense to us. The Proceeds of Crime Act 1997 and the Proceeds of Crime (Money Laundering) Regulations 1998 are anti-money laundering legislation, which apply to regulated institutions. The legislation is aimed at identifying offenses that give rise to proceeds of crime, including, in particular, money laundering. In addition to creating certain specific money laundering offenses, the legislation confers expansive information gathering powers upon the Bermuda policy relating to investigations to identify proceeds of crime. The Bermuda court has been empowered to make confiscation orders. 29Regulated institutions have a duty of vigilance which require that they: - verify their customers' bona fides; - monitor, recognize and report to the policy suspicious transactions; - maintain certain records for the time period prescribed; and - train employees and staff so as to recognize possible unlawful activities. Regulated institutions include a company or society registered under the Insurance Act to the extent that it is carrying out long-term insurance (but not reinsurance) business within the meaning of the Insurance Act, other than life insurance or disability insurance. While life insurance and disability insurance are not defined in the proceeds of crime legislation nor in the Insurance Act, such terms may be interpreted (as a guide) by using the meanings of similar terms defined in the June 2001 by the government authority established under the proceeds of crime legislation. While the Guidance Notes are not mandatory, they are represented as good practice procedures to be followed in order to discharge the duty of vigilance and can provide a statutory defense. In the Guidance Notes, reference is made to "life assurance, pensions or other risk management business . . . where the transaction at its simplest . . . may involve placing cash in the purchase of a single premium product from an insurer followed by early cancellation and reinvestment." The implication is that a long-term insurer that conducts variable life insurance or annuity business, and this may include Arch Re (Bermuda) in the event of carrying on such business, may be a regulated institution.Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. Our success may depend in part upon the continued services of key employees in Bermuda. Certain key employees may neither be a Bermudian nor a spouse of a Bermudian. Accordingly, any such key employee will require specific approval to work for us in Bermuda. A work permit may be granted or extended upon showing that, after proper public advertisement, no Bermudian (or spouse of a Bermudian) is available who meets the minimum standards reasonably required by the employer. The Bermuda government recently announced a new policy that places a
six yearsix-year term limit on individuals with work permits, subject to certain exemptions for key employees.3020
RISK FACTORSRISKS RELATING TO OUR INDUSTRY WE OPERATE IN A HIGHLY COMPETITIVE ENVIRONMENT, AND SINCE THE SEPTEMBERSet forth below are certain of the risks relating to our business. You should also refer to the other information provided in this report, including our "Management's Discussion and Analysis of Financial Condition and Results of Operation" and our accompanying consolidated financial statements.
Risks Relating to Our Industry
We operate in a highly competitive environment, and since the September 11, 2001
EVENTS, NEW CAPITAL HAS ENTERED THE MARKET; THESE FACTORS MAY MITIGATE THE BENEFITS THAT THE FINANCIAL MARKETS MAY PERCEIVE FOR THE PROPERTY AND CASUALTY INSURANCE INDUSTRY, AND WE CANNOT OFFER ANY ASSURANCES THAT WE WILL BE ABLE TO COMPETE SUCCESSFULLY IN OUR INDUSTRY.events, new capital has entered the market; these factors may mitigate the benefits that the financial markets may perceive for the property and casualty insurance and reinsurance industry, and we may not be able to compete successfully in our industry.The insurance and reinsurance industry is highly competitive. Trends toward consolidation in the insurance industry could also lead to pricing pressure and lower margins for insurers and reinsurers. In addition, since the events of September 11, 2001,
events,several newly formed offshore entities haveannounced their intentionentered the market to address the capacity issues in the insurance and reinsurance industry. Several publicly traded insurance and reinsurance companies have also raised additional capital to meet perceived demand in the current environment. Since September 11, 2001, newly formed and existing insurance industry companies have reportedly raisedin excess of $10.0 billion inadditional capital, and some industries (in particular, the airline industry) have announced that they may form industry consortia to provide insurance coverage for their members, thereby taking those lines out of the commercial insurance and reinsurance markets in which we operate.In addition, financialFinancial institutions and other capital markets participants also offer alternative products and services similar to our own or alternative products that compete with insurance and reinsurance products. In addition, we may not be aware of other companies that may be planning to enter the segments of the insurance and reinsurance market in which we operate or of existing companies that may be planning to raise additional capital.We
can offer no assurances that we willmay not be successful in competing with others in our industry,or thatand the intensity of competition in our industrywill notmay erode profitability for insurance and reinsurance companies generally, including us. In addition, wecan offer no assurances that we willmay not be able to participate at all or to the same extent as more established or other companies in any price increases or increased profitability in our industry. If we do not share in such price increases or increased profitability, our financial condition and results of operations could be materially adversely affected.THE INSURANCE INDUSTRY IS HIGHLY CYCLICAL AND THE VALUE OF OUR COMMON SHARES MAY BE ADVERSELY AFFECTED BY THIS CYCLICALITY.The insurance industry is highly cyclical, and the value of our common shares may be adversely affected by this cyclicality.
Historically, insurers and reinsurers have experienced significant fluctuations in operating results due to competition, frequency of occurrence or severity of catastrophic events, levels of capacity, general economic conditions, changes in legislation, case law and prevailing concepts of liability and other factors. In particular, demand for reinsurance is influenced significantly by the underwriting results of primary insurers and prevailing general economic conditions. The supply of reinsurance is related to prevailing prices and levels of surplus capacity that, in turn, may fluctuate in response to changes in rates of return being realized in the reinsurance industry. We can offer no assurances as to the magnitude or duration of any price increases or increased profitability in our industry or that factors that previously have resulted in excess capacity and pricing pressures in our industry will not recur.
WE COULD FACE UNANTICIPATED LOSSES FROM WAR, TERRORISM AND POLITICAL UNREST, AND THESE OR OTHER UNANTICIPATED LOSSES COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.We could face unanticipated losses from war, terrorism and political unrest, and these or other unanticipated losses could have a material adverse effect on our financial condition and results of operations.
We may have substantial exposure to unexpected, large losses resulting from future man-made catastrophic events, such as acts of war, acts of terrorism and political instability.
AlthoughThese risks are inherently unpredictable, although recent events may lead to increased frequency and severity of losses.21
It is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. In certain instances, we
mayspecifically insure and reinsure risks resulting from terrorism. Even in cases where we attempt to exclude losses from terrorism and certain other similar risks from some coverages written by us, we may not be successful in doing so.These risks are inherently unpredictable, although recent eventsMoreover, irrespective of the clarity and inclusiveness of policy language, a result-oriented court or arbitration panel favoring the insured or ceding company mayleadnot enforce the language as written; such a tribunal may adopt a strained interpretation of the policy language, invoke public policy toincreased frequency and severitylimit enforceability oflosses. It is difficultpolicy language, ignore policy language, make factual findings unwarranted by the evidence or otherwise seek topredict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate.justify a ruling adverse to us. Accordingly, we can offer no assurance that our reserves will be adequate to cover losses when they materialize. It is not possible to eliminate completely our exposure to unforecasted or unpredictable31events, and to the extent that losses from such risks occur, our financial condition and results of operations could be materially adversely affected. CLAIMS FOR CATASTROPHIC EVENTS COULD CAUSE LARGE LOSSES AND SUBSTANTIAL VOLATILITY IN OUR RESULTS OF OPERATIONS, AND, AS A RESULT, THE VALUE OF OUR COMMON SHARES MAY FLUCTUATE WIDELY.See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Certain Matters Which May Materially Affect Our Results of Operations and/or Financial Condition—Natural and Man-Made Catastrophic Events."Claims for catastrophic events could cause large losses and substantial volatility in our results of operations, and, as a result, the value of our common shares may fluctuate widely.
We
intend to underwrite property catastrophe reinsurance and willhave large aggregateexposureexposures to natural disasters. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, explosions, severe winter weather andfires, and we may have exposures to losses resulting from acts of war or acts of terrorism (to the extent not excluded from policy coverage) and political instability.fires. Catastrophes can also cause losses in non-property lines of business such as workers' compensation or general liability. In addition to the nature of the propertycatastrophebusiness, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration tend to generally increase the size of losses from catastrophic events over time. Therefore, claims for catastrophic events could expose us to large losses and cause substantial volatility in our results of operations, which could cause the value of our common shares to fluctuate widely.UNDERWRITING CLAIMS AND RESERVING FOR LOSSES ARE BASED ON PROBABILITIES AND RELATED MODELING, WHICH ARE SUBJECT TO INHERENT UNCERTAINTIES.See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Certain Matters Which May Materially Affect Our Results of Operations and/or Financial Condition—Natural and Man-Made Catastrophic Events."Underwriting claims and reserving for losses are based on probabilities and related modeling, which are subject to inherent uncertainties.
Our success is dependent upon our ability to assess accurately the risks associated with the businesses that we insure and reinsure.
ClaimWe establish reserves for losses and loss adjustment expenses which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs ofclaimslosses incurred. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of appropriateclaimloss reserves. Actualclaimslosses andclaimloss adjustment expenses paidmaywill deviate, perhaps substantially, from the reserve estimates reflected in our financial statements.Like other reinsurers, we do not separately evaluate each of the individual risks assumed under reinsurance treaties. Therefore, we will be largely dependent on the original underwriting decisions made by ceding companies. We are subject to the risk that the ceding companies may not have adequately evaluated the risks to be reinsured and that the premiums ceded may not adequately compensate us for the risks we assume.If our
claimloss reserves are determined to be inadequate, we will be required to increaseclaimloss reserves at the time of such determination with a corresponding reduction in our net income in the period in which the deficiencyis rectified.becomes known. It is possible that claims in respect of events that have occurred could exceed our claim reserves and have a material adverse effect on our results of operations, in a particular period, or our financial condition in general. As a compounding factor, although most insurance contracts have policy limits, the nature of property and casualty insurance and reinsurance is such that losses can exceed policy limits for a variety of reasons and could significantly exceed the premiums received on the underlying policies, thereby further adversely affecting our financial condition.WHILE REINSURANCE AND RETROCESSIONAL COVERAGE WILL BE USED TO LIMIT OUR EXPOSURE TO RISKS, THE AVAILABILITY OF SUCH ARRANGEMENTS MAY BE LIMITED, AND COUNTERPARTY CREDIT AND OTHER RISKS ASSOCIATED WITH OUR REINSURANCE ARRANGEMENTS MAY RESULT IN LOSSES WHICH COULD ADVERSELY AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.See "Management's Discussion and Analysis of Financial Condition and Results of22
Operations—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses."
The risk associated with reinsurance underwriting could adversely affect us.
Like other reinsurers, we do not separately evaluate each of the individual risks assumed under reinsurance treaties. Therefore, we are largely dependent on the original underwriting decisions made by ceding companies. We are subject to the risk that the ceding companies may not have adequately evaluated the risks to be reinsured and that the premiums ceded may not adequately compensate us for the risks we assume.
While reinsurance and retrocessional coverage will be used to limit our exposure to risks, the availability of such arrangements may be limited, and counterparty credit and other risks associated with our reinsurance arrangements may result in losses which could adversely affect our financial condition and results of operations.
For the purposes of limiting our risk of loss, we
willuse reinsurance and also may use retrocessional arrangements. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Currently, the market for these arrangements is experiencing high demand for various products and it is not certain that we will be able to obtain adequate protection at cost effective levels.32As a result of such market conditions and other factors, we may not be able successfully to alleviatemitigate risk through reinsurance and retrocessional arrangements. Further, we are subject to credit risk with respect to our reinsurance and retrocessions because the ceding of risk to reinsurers and retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our existing reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect our financial condition and results of operations.AS A RESULT OF RECENT EVENTS AND INSTABILITY IN THE MARKETPLACE FOR INSURANCE PRODUCTS, THERE IS THE POTENTIAL FOR GOVERNMENT INTERVENTION IN OUR INDUSTRY WHICH COULD HINDER OUR FLEXIBILITY AND NEGATIVELY AFFECT THE BUSINESS OPPORTUNITIES WE PERCEIVE ARE AVAILABLE TO US IN THE MARKET.Our reliance on brokers subjects us to their credit risk.
In accordance with industry practice, we generally pay amounts owed on claims under our insurance and reinsurance contracts to brokers, and these brokers, in turn, pay these amounts to the clients that have purchased insurance or reinsurance from us. In some jurisdictions, if a broker fails to make such payment, we may remain liable to the insured or ceding insurer for the deficiency. Likewise, in certain jurisdictions, when the insured or ceding company pays premium for these contracts to brokers for payment to us, these premiums are considered to have been paid and the insured or ceding company will no longer be liable to us for those amounts, whether or not we have actually received the premiums from the broker. Consequently, we assume a degree of credit risk associated with our brokers. To date, we have not experienced any losses related to this credit risk.
As a result of recent events and instability in the marketplace for insurance products, there is the potential for government intervention in our industry which could hinder our flexibility and negatively affect the business opportunities we perceive are available to us in the market.
In response to the current tightening of supply in certain insurance markets, as well as the impact of the September 11, 2001 events, it is possible that the United States and other governments worldwide may intervene in the insurance and reinsurance markets. Government regulators are generally concerned with the protection of policyholders to the exclusion of other constituencies, including shareholders. While we cannot predict the type of government intervention that may occur or its timing, such intervention could materially adversely affect us by:
-
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- disproportionately benefiting one country's companies over companies in other countries;
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- providing insurance and reinsurance capacity in the markets and to the customers that we target;
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- regulating the terms of insurance and reinsurance policies; or
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- mandating participation in guaranty associations or other industry pools.
For example, on November 26, 2002, President Bush signed into law TRIA, which established a federal backstop for insurance-related losses resulting from any act of terrorism carried out by foreign powers on U.S. soil or against U.S. air carriers, vessels or foreign missions. Under TRIA, all U.S.-based property and casualty insurers are required to make terrorism insurance coverage available in specified commercial property and casualty insurance lines. In return, TRIA provides that the federal government will pay 90% of covered losses after an insurer's losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act (or acts) of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses. The deductible for each year is based on the insurer's direct earned premiums for property and casualty insurance for the prior calendar year multiplied by a specified percentage. The specified percentages are 7% for 2003, 10% for 2004 and 15% for 2005, respectively.
Our U.S.-based property and casualty insurers, Arch Insurance, Arch Specialty and Arch E&S, are subject to TRIA. TRIA specifically excludes reinsurance and personal lines business and, accordingly, currently does not apply to our non-standard automobile business or our reinsurance operations. Based on 2002 direct commercial earned premiums, our U.S. insurance group's deductible for 2003 would be $13.7 million (i.e., 7% of such earned premiums). The amount of our deductible for 2004 and 2005 could increase substantially, depending upon the amount of direct earned premiums we write in 2003 and 2004, and in light of the fact that the deductible percentage increases in such years. Currently, there is uncertainty as to what effect the new act will have on the insurance industry.
The insurance industry is also affected by political, judicial and legal developments which have in the past resulted in new or expanded theories of liability. These or other changes could impose new financial obligations on us by extending coverage beyond our underwriting intent or otherwise, require us to make unplanned modifications to the products and services that we provide, or cause the delay or cancellation of products and services that we provide.
SubstantialIn some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued. The effects of unforeseen developments or substantial government intervention could adversely impact our ability to achieve our goals.In addition, we engage in intercompany reinsurance arrangements between our U.S. operations and our Bermuda reinsurance operations. Some U.S. insurance companies have been lobbying Congress to pass legislation intended to eliminate certain perceived tax advantages of U.S. insurance companies with Bermuda affiliates, which result principally from reinsurance arrangements between or among U.S. insurance companies and their Bermuda affiliates.
RISKS RELATING TO OUR COMPANY THE WARBURG PINCUS FUNDS AND THE HELLMAN & FRIEDMAN FUNDS TOGETHER CONTROL A MAJORITY OF OUR VOTING POWER ON A FULLY DILUTED BASIS AND THESE SHAREHOLDERS HAVE THE RIGHT TO HAVE DIRECTORS ON OUR BOARD AND THE RIGHT TO APPROVE MOST TRANSACTIONS OUTSIDE OF THE ORDINARY COURSE OF OUR BUSINESS; THEIR INTERESTS MAY MATERIALLY DIFFER FROM THE INTERESTS OF THE HOLDERS OF OUR COMMON SHARES. OnRisks Relating to Our Company
Our management team was assembled and our business strategy was formulated pursuant to our new underwriting initiative commenced in October 2001.
We assembled a
fully diluted basisnew management team andafter giving effectother personnel in connection with our new underwriting initiative in October 2001 to meet current and future demand in theexerciseglobal insurance and reinsurance marketplaces. Our future success depends on the successful integration ofall outstanding optionsour new management team andwarrantsother personnel and their ability to implement our business strategy. The success of the members of our management team in their past endeavors is not necessarily predictive of future results. We cannot assure you that this new management team will have success with our new24
underwriting initiative. In addition, the pool of talent from which we actively recruit is limited. The inability to attract and retain qualified personnel when available and the
conversionloss ofall preference issues,services of key personnel could have a material adverse effect on our financial condition and results of operations.Our success will depend on our ability to establish and maintain effective operating procedures and internal controls.
As a relatively new insurance and reinsurance company, our success will also be dependent upon our ability to establish and maintain operating procedures and internal controls (including the timely and successful implementation of our information technology initiatives) to effectively support our business and our regulatory and reporting requirements. We may not be successful in such efforts.
The Warburg Pincus funds and the Hellman & Friedman funds together own a majority of our voting shares, and these shareholders have the right to have directors on our board and the right to approve most transactions outside of the ordinary course of our business; their interests may materially differ from the interests of the holders of our common shares.
The Warburg Pincus funds and the Hellman & Friedman funds own
33.8%34.3% and18.8%21.5% of ourcommonoutstanding voting shares,respectively.respectively, as of March 25, 2003. These shareholders are non-U.S. persons (as defined in the Internal Revenue Code) and, as such, they are not subject to the voting limitation contained in our bye-laws. In addition, our shareholders agreement prevents us from taking many actions outside the ordinary course of our business without the approval of adirector designated bydesignee of the Warburg Pincus funds and adirector designated bydesignee of the Hellman & Friedman funds. We have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of preference shares, pro rata, on the basis of the amount of these shareholders' investments in us at the time of such repurchase, preference shares33having an aggregate value of $250.0 million, at a per share price acceptable to these shareholders. By reason of their ownership and the shareholders agreement between us and the holders of preference shares, the Warburg Pincus funds and the Hellman & Friedman funds, individually or together, are able to strongly influence or effectively control actions to be taken by us, or our shareholders. In addition, the Warburg Pincus funds and the Hellman & Friedman funds are entitled to nominate a prescribed number of directors based on the respective retained percentages of their equity securities purchased in November 2001. Currently, our board consists of
ninetwelve members, which includesone directorthree directors nominated by the Warburg Pincus funds andone directortwo directors nominated by the Hellman & Friedman funds.Once we have received the regulatory approvals required in connection with the capital infusion, the size of our board will be increased to up to 17 members.As long as the Warburg Pincus funds retain at least 75% of their original investment and the Hellman & Friedman funds retain at least 60% of their original investment, these shareholders will be entitled to nominate six and three directors, respectively. Together theywillhave the right to nominate a majority of directors to our board. The interests of these shareholders may differ materially from the interests of the holders of our common shares, and these shareholders could take actions or make decisions that are not in the interests of the holders of our commonshares. WE MAY BE REQUIRED TO ISSUE ADDITIONAL PREFERENCE SHARES TO THE INVESTORS IN THE CAPITAL INFUSION AS A RESULT OF VARIOUS PURCHASE PRICE ADJUSTMENTS AGREED TO IN CONNECTION WITH IT, AND THE VALUE OF OUR COMMON SHARES MAY, THEREFORE, BE FURTHER DILUTED.shares generally.We may be required to issue additional preference shares to the investors in the November 2001 capital infusion as a result of various purchase price adjustments agreed to in connection with it, and the value of our common shares may, therefore, be further diluted.
The purchase price paid for the securities purchased in the capital infusion was based on the estimated, unaudited U.S. GAAP book value of our common shares as of June 30, 2001 (before giving effect to certain agreed transaction costs incurred in connection with the capital infusion that had not yet been determined), subject to certain adjustments. We are required to
re-calculate,recalculate, on designated dates in the future, our June 30, 2001 book value on such dates (after giving effect to the agreed transaction costs) and, if that re-calculated amount is less than the amount used to calculate the25
purchase price for the preference shares and warrants, we will be required to issue additional securities, convertible into our common shares, to those investors.
In particular, we agreed to adjust the purchase price paid for the preference
shares: - based upon an audit of the book value of our assets at June 30, 2001 (after giving effect to the agreed transaction costs); - if, on or prior to September 19, 2005, the closing price of our commonsharesis at least $30.00 per share for at least 20 out of 30 consecutive trading days or a change of control occurs (in which event, the purchase price paid per preference share by the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of our preference shares would be adjusted downward by $1.50); - onas described below:
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- Second Anniversary Adjustment. As soon as practicable after the second anniversary of the closing (or such earlier date
based uponas the Warburg Pincus funds and the Hellman & Friedman funds request and we agree), our independent auditors will calculate the adjustment basketdescribedas set forth below. ACGL and the Warburg Pincus funds and the Hellman & Friedman funds have the right to make a full review of the adjustment basket determination. We agreed to cause our subsidiaries to maintain the components necessary to calculate the adjustment basket under separate ledgers. If the adjustment basket is less than zero, we agreed to issue additional preference shares to the investors based on the decrease in the value of the components of the adjustment basket. If the adjustment basket is greater than zero, the subscription agreement we entered into with the investors (other than members of our management who were part of the November 2001 capital infusion) in connection with the capital infusion ("Subscription Agreement") allows us to use cash in an amount based on the increase in value of the components of the adjustment basket to repurchase common shares (other than any common shares issued upon conversion of the preference shares or exercise of the class A warrants). The adjustment basket will be equal to:
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- the difference between value realized upon sale and the book value at closing (as adjusted based on a pre-determined growth rate) of the agreed upon non-core businesses; plus
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- the difference between the GAAP net book value of all of our insurance balances with respect to any policy or contract written or having an effective date prior to November 20, 2001 (i.e., premiums receivable, unpaid losses and loss adjustment expenses recoverable, prepaid reinsurance premiums, reinsurance balances receivable, deferred policy acquisition costs, losses and loss adjustment expenses, unearned premiums, reinsurance balances payable, and any other insurance balance attributable to our "core insurance operations," as defined below) at the time of determination of the final adjustment and those balances at the closing; minus
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- reductions in book value arising from (without duplication of any expenses included in the calculation of value realized upon sale of the non-core businesses or any expense otherwise reflected in the determination of the per share price) costs and expenses relating to the investments and transactions provided for under the
heading "TheSubscription Agreement, actual losses arising out of breach of representations under the Subscription Agreement and certain other costs and expenses.- •
- Our "core insurance operations" include: (i) Arch Re Bermuda; (ii) Arch Capital
Infusion--Subscription Agreement--Purchase Price Adjustments--Final Adjustments" relatedGroup (U.S.) Inc.; (iii) Arch Re U.S.; (iv) Arch E&S (including funding for Arch Specialty); (v) Arch Risk Transfer Services Ltd.; (vi) Arch Insurance Group Inc., formerly known as First American Financial Corporation; (vii) capital held at ACGL, gross of capital to be invested in unfunded private equity commitments; and (viii) $2.5 million in segregated assets and liabilities in "cell" accounts formed by Alternative Insurance Company Limited and Alternative Re, Ltd.- •
- Our "non-core businesses" are currently defined as American Independent Insurance Holding Company, the
valuationdirect parent ofour coreAmerican Independent, Hales & Company Inc., PSIC, all nonpublic securities held by ACGL, Arch Capital Group (U.S.) Inc. andnon-core businesses;Arch Re U.S. and- onall commitments to Distribution Partners, as and when funded.
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- Fourth Anniversary Adjustment. On the fourth anniversary of the closing,
date based upon anthere will be a calculation of a further adjustment basketrelated to specifiedbased on (1) liabilitiesconnected to our asset saleowed to Folksamerica, if any, under the Asset Purchase Agreement, dated as of January 10, 2000, between ACGL, Arch Re U.S., Folksamerica Holding Company, Inc. and Folksamerica Reinsurance Company, and (2) specified tax and ERISAmatters. See "--Recent Developments--The Capital Infusion--Subscription Agreement--Purchase Price Adjustments--Final Adjustments."matters under the Subscription Agreement.26
We
currently estimate that, principally becausealso agreed to form a new, wholly owned subsidiary to hold Arch Re Bermuda as well as all of thededuction of the agreed transaction costs, we will issue an additional 875,765 preference shares during the first quarter of 2002 in connection with the adjustments discussed in the first bullet point above, and we currently estimate that we may be required to issue an additional 2,831,174 preference shares in connection with the trading price adjustment described in the second bullet point above. 34OUR FAILURE TO OBTAIN REGULATORY APPROVAL FOR THE CAPITAL INFUSION WOULD HAVE A MATERIAL ADVERSE IMPACT ON THE VALUE OF OUR COMMON SHARES."core insurance operations" other than Arch Re U.S. In the eventthat: - we fail to obtainthat theapproval of the Florida insurance department with respect to the capital infusion before May 20, 2002; or - the purchase price adjustment to be made on the secondadjustments described in this risk factor above are less than zero andfourth anniversaries of the closing results in a downward adjustment to the purchase price of the preference shares aggregating more thantheir absolute value exceeds $250.0 million, the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of our preference shares will have therightoption to exchange theirequity securitiespreference shares, in whole or in part (but not forequity securities of a corporate entity which would hold our insurance and reinsurance operating subsidiaries, other than Arch Re (US). See "--Recent Developments--The Capital Infusion--Subscription Agreement--Right to Exchange into Subsidiary Shares." In this event, we would ownless thana majority$150.0 million liquidation preference ofthose subsidiaries. This situation would have a material adverse impact onpreference shares), for preference shares of our newly formed subsidiary bearing identical rights and privileges, including thevalueright to convert into, or be exercised for, common shares of our newly formed subsidiary.Future sales of our common
shares. OUR MANAGEMENT TEAM HAS ONLY RECENTLY BEEN ASSEMBLED AND OUR BUSINESS STRATEGY IS NEWLY FORMULATED; THEREFORE, THERE CAN BE NO ASSURANCE THAT WE WILL BE SUCCESSFUL IN ACCOMPLISHING OUR GOALS. We have recently assembled a new management team and other personnel in connection withshares, whether by us or ournew underwriting initiative to meet current and future demand in the global insurance and reinsurance marketplaces. Our future success depends on the successful integration of our new management team and other personnel. The success of our management team inshareholders, could adversely affect theirpast endeavors is not necessarily predictive of future results. In addition, we cannot assure you that we will be successful in integrating such executives and personnel into our existing operations or that this new management team will have success with our new underwriting initiative. In addition, the pool of talent from which we actively recruit is limited. The inability to attract and retain qualified personnel when available and the loss of services of key personnel could have a material adverse effect on our financial condition and results of operations. FUTURE SALES OF OUR COMMON SHARES, WHETHER BY US OR OUR SHAREHOLDERS, COULD ADVERSELY AFFECT THEIR MARKET PRICE.market priceGenerally, our board of directors has the power to issue new equity (to the extent of authorized shares) without shareholder approval, except that shareholder approval may be required under applicable law or
NasdaqNASDAQ National Market rules for certain transactions. We may issue new equity to raise additional capital to support our insurance and reinsurance operations or for other purposes. Any additional issuance by us would have the effect of diluting the percentage ownership of our shareholders and could have the effect of diluting our earnings and our book value per share.In addition, the market price of our common shares could fall substantially if our existing shareholders sell large amounts of common shares in the public
market following this offering.market. The availability of a large number of shares for sale could result in the need for sellers to accept a lower price in order to complete a sale.After this offering,On March 25, 2003 therewill be 22,265,332are 27,991,254 common shares outstanding,assuming no exercise of the underwriters' over-allotment option. Thereand there are up to45,973,2535,513,911 common shares issuable upon exercise of options or warrants or conversion of convertiblesecurities or exercise of outstanding class A warrants.securities.We have granted the Warburg Pincus funds and Hellman & Friedman funds demand registration rights and all of the investors in the November 2001 capital infusion certain "piggy-back" registration rights with respect to the common shares issuable to them upon conversion of the preference shares or exercise of the class A warrants. Certain other investors who purchased or acquired shares in unregistered transactions also have demand and piggy-back registration rights. They can exercise these rights at any time.
35OUR BUSINESS WILL BE DEPENDENT UPON INSURANCE AND REINSURANCE BROKERS, AND THE FAILURE TO DEVELOP OR THE LOSS OF IMPORTANT BROKER RELATIONSHIPS COULD MATERIALLY ADVERSELY AFFECT OUR ABILITY TO MARKET OUR PRODUCTS AND SERVICES.Our business is dependent upon insurance and reinsurance brokers, and the failure to develop or the loss of important broker relationships could materially adversely affect our ability to market our products and services.
We
intend tomarket our insurance and reinsurance products primarily through brokers. Weexpect that we willderive a significant portion of our business from a limited number of brokers. See note 10, "Commitments and Contingencies—Concentrations of Credit Risk," of the notes accompanying our consolidated financial statements. Some of our competitors have had longer term relationships with the brokerswhichwe use than we have. Loss of all or a substantial portion of the business provided by these brokers could have a material adverse effect on us.We could be materially adversely affected to the extent that managing general agents, general agents and other producers in our program business exceed their underwriting authorities or otherwise breach obligations owed to us.
In the program business conducted by our insurance group, following our underwriting, financial, claims and information technology due diligence reviews, we authorize managing general agents, general agents and other producers to write business on our behalf within underwriting authorities prescribed by us. Once a program incepts, we must rely on the underwriting controls of these agents to write business within the underwriting authorities provided by us. Although we monitor our programs on an ongoing basis, our monitoring efforts may not be adequate or our agents may exceed their
27
underwriting authorities or otherwise breach obligations owed to us. To the extent that our agents exceed their authorities or otherwise breach obligations owed to us, our financial condition and results of operations could be materially adversely affected.
A
DOWNGRADE IN OUR RATINGS OR OUR INABILITY TO OBTAIN A RATING FOR OUR OPERATING INSURANCE SUBSIDIARIES MAY ADVERSELY AFFECT OUR RELATIONSHIPS WITH CLIENTS AND BROKERS AND NEGATIVELY IMPACT SALES OF OUR PRODUCTS.downgrade in our ratings or our inability to obtain a rating for our operating insurance and reinsurance subsidiaries may adversely affect our relationships with clients and brokers and negatively impact sales of our products.Financial strength and claims paying ratings from third party rating agencies are instrumental in establishing the competitive positions of companies in our industry. Periodically, rating agencies evaluate us to confirm that we continue to meet their criteria for the ratings assigned to us by them. Recently, rating agencies have been coming under increasing pressure as a result of high-profile corporate bankruptcies and may, as a result, increase their scrutiny of rated companies, revise their rating policies or take other action. We can offer no assurances that our ratings will remain at their current levels. A ratings downgrade, or the potential for such a downgrade, could adversely affect both our relationships with agents, brokers, wholesalers and other distributors of our existing products and services and new sales of our products and services.
In addition, we are seeking ratings for our principal U.S. insurance subsidiaries. Due to the perceived importance of financial strength ratings in our industry, our failure to obtain adequate ratings for our unrated insurance subsidiaries could cause our operations to be removed from the approved lists of some brokers or clients.Any ratings downgrade or failure to obtain a necessary rating could adversely affect our ability to compete in our markets and have a material adverse impact on our financial condition and results of operations. See"Business--Ratings."Our Company—Ratings."WE SOLD OUR PRIOR REINSURANCE OPERATIONS IN MAYOur investment performance may affect our financial results and ability to conduct business.
Our operating results depend in part on the performance of our investment portfolio. A significant portion of our investment portfolio consists of fixed income securities. Although our current investment guidelines stress preservation of capital, market liquidity and diversification of risk, our investments are subject to market-wide risks and fluctuations, as well as risks inherent in particular securities. We may not be able to realize our investment objectives, which could reduce our net income significantly. In the event that we are unsuccessful in correlating our investment portfolio with our expected insurance and reinsurance liabilities, we may be forced to liquidate our investments at times and prices that are not optimal, which could have a material adverse effect on our financial results and ability to conduct our business.
We may require additional capital in the future which may not be available or only available on unfavorable terms.
We expect that our expanded underwriting initiative will initially be supported by our existing capital. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. To the extent that our existing capital is insufficient to fund our future operating requirements and/or cover claim losses, we may need to raise additional funds through financings or limit our growth. Any equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result (see "—Future sales of our common shares, whether by us or our shareholders, could adversely affect their market price"), and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected.
We sold our prior reinsurance operations in May 2000
AND MAY HAVE LIABILITY TO THE PURCHASER AND CONTINUING LIABILITY FROM THOSE REINSURANCE OPERATIONS IF THE PURCHASER SHOULD FAIL TO MAKE PAYMENTS ON THE REINSURANCE LIABILITIES IT ASSUMED.and may have liability to the purchaser and continuing liability from those reinsurance operations if the purchaser should fail to make payments on the reinsurance liabilities it assumed.On May 5, 2000, we sold our prior reinsurance operations to Folksamerica Reinsurance Company. The Folksamerica transaction was structured as a transfer and assumption agreement (and not
28
reinsurance), and, accordingly, the loss reserves (and any related reinsurance recoverables) relating to the transferred business are not included as assets or liabilities on our balance sheet. In addition, in connection with that sale, we made extensive representations and warranties about us and our reinsurance operations, some of which survived the closing of the asset sale. Breach of these representations and warranties could result in liability to us. We also retained our tax and employee benefit liabilities and other liabilities not assumed by Folksamerica, including all liabilities not arising under our reinsurance subsidiary's reinsurance agreements transferred to
Folksamerica.Folksamerica in the asset sale, and all liabilities (other than liabilities arising under reinsurance agreements) arising out of or relating to a certain managing underwriting agency. In the event that Folksamerica refuses or is unable to make payment for reserved losses transferred to it by us in the May 2000 sale and the notice given to reinsureds is found not to be an effective release by such reinsureds, we would be liable for such claims.In addition, if amounts related toSee note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of thetransferred liabilities turn out to be more than forecasted, wenotes accompanying our consolidated financial statements and "—We may be required to issue additional preference shares to theholdersinvestors in the November 2001 capital infusion as a result of various purchase price adjustments agreed to in connection with it, and the value of ourpreference shares. SOME OF THE PROVISIONS OF OUR BYE-LAWS AND OUR SHAREHOLDERS AGREEMENT MAY HAVE THE EFFECT OF HINDERING, DELAYING OR PREVENTING THIRD PARTY TAKEOVERS, WHICH MAY PREVENT OUR SHAREHOLDERS FROM RECEIVING PREMIUM PRICES FOR THEIR SHARES IN AN UNSOLICITED TAKEOVER.common shares may, therefore, be further diluted."Some of the provisions of our bye-laws and our shareholders agreement may have the effect of hindering, delaying or preventing third party takeovers, which may prevent our shareholders from receiving premium prices for their shares in an unsolicited takeover.
Some provisions of our bye-laws could have the effect of discouraging unsolicited takeover bids from third parties or the removal of incumbent management. These provisions may encourage
36companies interested in acquiring the company to negotiate in advance with our board of directors, since the board has the authority to overrule the operation of several of the limitations. In addition, pursuant to the shareholders agreement which we entered into in connection with the November 2001 capital infusion, we cannot engage in transactions outside the ordinary course of our business, including mergers and acquisitions, without the consent of a
director designated bydesignee of the Warburg Pincus funds and adirector designated bydesignee of the Hellman & Friedman funds. To the extent these provisions discourage takeover attempts, they could deprive our shareholders of opportunities to realize takeover premiums for their shares or could depress the market price of our common shares.OUR OPERATING INSURANCE AND REINSURANCE SUBSIDIARIES ARE SUBJECT TO REGULATION IN VARIOUS JURISDICTIONS, AND MATERIAL CHANGES IN THE REGULATION OF THEIR OPERATIONS COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.Our operating insurance and reinsurance subsidiaries are subject to regulation in various jurisdictions, and material changes in the regulation of their operations could adversely affect our results of operations.
Our Bermuda insurance and reinsurance subsidiary, Arch Re
(Bermuda),Bermuda, conducts its business from itsexecutiveoffices in Bermuda and is not licensed or admitted to do business in any jurisdiction except Bermuda. We do not believe that Arch Re(Bermuda)Bermuda is subject to the insurance laws of any state in the United States; however, recent scrutiny of the insurance and reinsurance industry in the U.S. and other countries could subject Arch Re(Bermuda)Bermuda to additional regulation.In addition, our U.S. reinsurance subsidiary, Arch Re
(US)U.S., and our U.S. insurance subsidiaries,First AmericanArch Insurance,Company, Rock River Insurance Company, Cross River Insurance Company andArch Specialty, Arch E&S, American IndependentInsurance Company,and PSIC, write reinsurance and insurance in the United States. These subsidiaries are subject to extensive regulation under state statutes which delegate regulatory, supervisory and administrative powers to state insurance commissioners. Such regulation generally is designed to protect policyholders rather than investors. See "Our Company—Regulation."We periodically review our corporate structure in the United States so that we can optimally deploy our capital. Changes in that structure require regulatory
approval, and we are in the process of seeking regulatory approval to maximize our U.S. regulatory capital that will support our U.S. insurance operations.approval. Delays or failure in obtaining any of these approvals could limit the amount of insurance that we can write in the United States.29
If ACGL or any of our subsidiaries were to become subject to the laws of a new jurisdiction
where that subsidiaryin which such entity is not presently admitted,itACGL or such subsidiary may not be in compliance with the laws of the new jurisdiction. Any failure to comply with applicable laws could result in the imposition of significant restrictions on our ability to do business, and could also result in fines and other sanctions, any or all of which could adversely affect our financial condition and results of operations.IF OUR BERMUDA REINSURANCE SUBSIDIARY IS UNABLE TO PROVIDE COLLATERAL TO CEDING COMPANIES, ITS ABILITY TO CONDUCT BUSINESS COULD BE SIGNIFICANTLY AND NEGATIVELY AFFECTED.ACGL is a holding company and is dependent on dividends and other payments from its operating subsidiaries, which are subject to dividend restrictions.
We are a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, we depend on our available cash resources, liquid investments and dividends or other distributions from our subsidiaries to make payments, including the payment of operating expenses we may incur. The ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources."
If our Bermuda reinsurance subsidiary is unable to provide collateral to ceding companies, its ability to conduct business could be significantly and negatively affected.
Arch Re
(Bermuda)Bermuda is a registered Bermuda insurance company and is not licensed or admitted as an insurer in any jurisdiction in the United States. Because insurance regulations in the United States do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless security is posted, Arch Re(Bermuda)'sBermuda's contracts generally require it to post a letter of credit or provide other security after a reinsured reports a claim. If we are unable to post security in the form of letters of credit or trust funds when required, the operations of Arch Re(Bermuda)Bermuda could be significantly and negatively affected.WE ARE SUBJECT TO CHANGES IN BERMUDA LAW OR POLITICAL CIRCUMSTANCES.We are subject to changes in Bermuda law or political circumstances.
Under current Bermuda law, we are not subject to tax on income or capital gains. Furthermore, we have obtained from the Minister of Finance of Bermuda under the Exempted Undertakings Tax Protection Act, 1966, an undertaking that, in the event that Bermuda enacts legislation imposing tax computed on profits, income, any capital asset, gain or appreciation, or any tax in the nature of estate
37duty or inheritance tax, then the imposition of the tax will not be applicable to us or our operations until March 28, 2016. We could be subject to taxes in Bermuda after that date. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda. Bermuda's political structure is based upon a parliamentary system with two major parties, the United Bermuda Party and the Progressive Labour Party. In the most recent election, the Progressive Labour Party gained control of the legislative branch for the first time over the incumbent United Bermuda Party. To date, the government's financial and regulatory policies have not been changed in ways that we believe would materially affect us or our shareholders.
FOREIGN CURRENCY EXCHANGE RATE FLUCTUATION MAY ADVERSELY AFFECT OUR FINANCIAL RESULTS.Foreign currency exchange rate fluctuation may adversely affect our financial results.
We
willwrite business on a worldwide basis, and our results of operations may be affected by fluctuations in the value of currencies other than the U.S. dollar. Changes in foreign currency exchange rates can reduce our revenues and increase our liabilities and costs, as measured in the dollar as our functional currency. We have not attempted and currently do not expect to attempt to reduce our exposure to these exchange rate risks by using hedgingtransactions.transactions or by investing in securities30
denominated in local (foreign) currencies. We may therefore suffer losses solely as a result of exchange rate fluctuations.
EMPLOYEES OF OUR BERMUDA OPERATIONS ARE REQUIRED TO OBTAIN WORK PERMITS BEFORE ENGAGING IN A GAINFUL OCCUPATION IN BERMUDA, AND WE CAN OFFER NO ASSURANCE THAT REQUIRED WORK PERMITS WILL BE GRANTED OR REMAIN IN EFFECT.Employees of our Bermuda operations are required to obtain work permits before engaging in a gainful occupation in Bermuda. Required work permits may not be granted or may not remain in effect.
Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. Our success may depend in part on the continued services of key employees in Bermuda. A work permit may be granted or renewed upon showing that, after proper public advertisement, no Bermudian (or spouse of a Bermudian) is available who meets the minimum standards reasonably required by the employer. The Bermuda government recently announced a new policy that places a
six yearsix-year term limit on individuals with work permits, subject to certain exemptions for key employees. A work permit is issued with an expiry date (up to five years) and no assurances can be given that any work permit will be issued or, if issued, renewed upon the expiration of the relevant term.THE ENFORCEMENT OF CIVIL LIABILITIES AGAINST US MAY BE DIFFICULT.The enforcement of civil liabilities against us may be difficult.
We are a Bermuda company and in the future some of our officers and directors may be residents of various jurisdictions outside the United States. All or a substantial portion of our assets and of those persons may be located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon those persons or to enforce in United States courts judgments obtained against those persons.
We have appointed National Registered Agents, Inc., New York, New York, as our agent for service of process with respect to actions based on offers and sales of securities made in the United States. We have been advised by our Bermuda counsel, Conyers Dill & Pearman, that the United States and Bermuda do not currently have a treaty providing for reciprocal recognition and enforcement of judgments of U.S. courts in civil and commercial matters and that a final judgment for the payment of money rendered by a court in the United States based on civil liability, whether or not predicated solely upon the U.S. federal securities laws, would, therefore, not be automatically enforceable in Bermuda. We also have been advised by Conyers Dill & Pearman that a final and conclusive judgment obtained in a court in the United States under which a sum of money is payable as compensatory damages
(i.e.(i.e., not being a sum claimed by a revenue authority for taxes or other charges of a similar nature by a governmental authority, or in respect of a fine or penalty or multiple or punitive damages) may be the subject of an action on a debt in the Supreme Court of Bermuda under the common law38doctrine of obligation. Such an action should be successful upon proof that the sum of money is due and payable, and without having to prove the facts supporting the underlying judgment, as long as: -
- •
- the court which gave the judgment had proper jurisdiction over the parties to such judgment;
-- •
- such court did not contravene the rules of natural justice of Bermuda;
-- •
- such judgment was not obtained by fraud;
-- •
- the enforcement of the judgment would not be contrary to the public policy of Bermuda;
-- •
- no new admissible evidence relevant to the action is submitted prior to the rendering of the judgment by the courts of Bermuda; and
-- •
- there is due compliance with the correct procedures under Bermuda law.
A Bermuda court may impose civil liability on us or our directors or officers in a suit brought in the Supreme Court of Bermuda against us or such persons with respect to a violation of U.S. federal securities laws, provided that the facts surrounding such violation would constitute or give rise to a cause of action under Bermuda law.
RISKS RELATING TO TAXATION WE AND OUR NON-U.S. SUBSIDIARIES MAY BECOME SUBJECT TO31
Risks Relating to Taxation
We and our non-U.S. subsidiaries may become subject to U.S.
FEDERAL INCOME TAXATION.federal income taxation.ACGL and its non-U.S. subsidiaries intend to operate their business in a manner that will not cause them to be treated as engaged in a trade or business in the United States and, thus, will not be required to pay U.S. federal income taxes (other than withholding taxes on certain U.S. source investment income) on their income. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business in the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, our shareholders' equity and earnings could be adversely affected.
We may be aCertain of our U.S. subsidiaries were personal holdingcompanycompanies in respect of 2002, butdodid notcurrently expect tohave "undistributed personal holding company income." See"--Tax Matters--Taxation"Tax Matters—Taxation ofACGL--United States--PersonalACGL—United States—Personal Holding Company Rules."We changed our legal domicile from the United States to Bermuda in November 2000. Legislation has recently been introduced which (if enacted) could eliminate the tax benefits available to companies, like us, that changed their legal domiciles to Bermuda. In addition, some U.S. insurance companies have been lobbying Congress to pass legislation intended to eliminate certain perceived tax advantages of U.S. insurance companies with Bermuda affiliates resulting principally from reinsurance between or among U.S. insurance companies and their Bermuda affiliates. Legislation, if passed, and other changes in U.S. tax laws, regulations and interpretations thereof to address these issues could adversely affect us.
U.S.
PERSONS WHO HOLD OUR COMMON SHARES MAY BE SUBJECT TOpersons who hold our common shares may be subject to U.S.INCOME TAXATION AT ORDINARY INCOME RATES ON OUR UNDISTRIBUTED EARNINGS AND PROFITS. IN ADDITION, THE HEIRS OR ESTATE OF ANY INDIVIDUAL HOLDER MAY NOT BE ENTITLED TO A "STEP-UP" IN BASIS OF OUR COMMON SHARES WHICH MIGHT OTHERWISE BE AVAILABLE UPON SUCH HOLDER'S DEATH.income taxation at ordinary income rates on our undistributed earnings and profits. In addition, the heirs or estate of any individual holder may not be entitled to a "step-up" in basis of our common shares which might otherwise be available upon such holder's death.We believe that we and our foreign subsidiaries currently are controlled foreign corporations ("CFCs"), although our bye-laws are designed to preclude any U.S. person from adverse tax consequences as a result of our CFC status.
WeACGL and certain of its non-U.S. subsidiaries were alsobelieve that we are likely to be aforeign personal holdingcompanycompanies in respect of 2002, butdodid notcurrently expect tohave undistributed foreign personal holding company income. We do not believe that we are a passive foreign investment company. Since these determinations and beliefs are based upon legal and factual conclusions, some of which are described under"--Tax"Tax Matters," no assurances can be given that the IRS or a court would concur with our conclusions. If they were not to so concur, U.S. persons who hold our common shares may suffer adverse tax consequences. See"--Tax"Tax Matters."39The following summary of the taxation of ACGL and the taxation of our shareholders is based upon current law and is for general information only. Legislative, judicial or administrative changes may be forthcoming that could affect this summary.
The following legal discussion (including and subject to the matters and qualifications set forth in such summary) of certain tax considerations (a) under
"--Taxation"—Taxation ofACGL--Bermuda"ACGL—Bermuda" and"--Taxation"—Taxation ofShareholders--BermudaShareholders—Bermuda Taxation" is based upon the advice of Conyers Dill & Pearman, Hamilton, Bermuda and (b) under"--Taxation"—Taxation ofACGL--UnitedACGL—United States,""--Taxation"—Taxation ofShareholders--UnitedShareholders—United States Taxation,""--Taxation"—Taxation of Our U.S. Shareholders" and"--United"—United States Taxation of Non-U.S. Shareholders" is based upon the advice of Cahill Gordon & Reindel, New York, New York (the advice of such firms does not include accounting matters, determinations or conclusions relating to the business or activities of ACGL). The summary is based upon current law and is for32
general information only. The tax treatment of a holder of our common shares, or of a person treated as a holder of our common shares for U.S. federal income, state, local or non-U.S. tax purposes, may vary depending on the holder's particular tax situation. Legislative, judicial or administrative changes or interpretations may be forthcoming that could be retroactive and could affect the tax consequences to us or to holders of our common shares.
TAXATION OFTaxation of ACGL
BERMUDA
Bermuda
Under current Bermuda law, we are not subject to tax on income or capital gains. We have obtained from the Minister of Finance under the Exempted Undertakings Tax Protection Act 1966 an assurance that, in the event that Bermuda enacts legislation imposing tax computed on profits, income, any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance, the imposition of any such tax shall not be applicable to us or to any of our operations or our shares, debentures or other obligations until March 28, 2016. We could be subject to taxes in Bermuda after that date. This assurance will be subject to the proviso that it is not to be construed so as to prevent the application of any tax or duty to such persons as are ordinarily resident in Bermuda (we are not so currently affected) or to prevent the application of any tax payable in accordance with the provisions of the Land Tax Act 1967 or otherwise payable in relation to any property leased to us or our insurance subsidiary. We pay annual Bermuda government fees, and our Bermuda insurance and reinsurance subsidiary pays annual insurance license fees. In addition, all entities employing individuals in Bermuda are required to pay a payroll tax and
there areother sundry other taxes payable, directly or indirectly, to the Bermuda government.UNITED STATES
United States
ACGL and its non-U.S. subsidiaries intend to conduct their operations
suchin a manner thattheywill not cause them to be treated as engaged in a trade or business in the United States and, therefore, will not be required to pay U.S. federal income taxes (other than withholding taxes on dividends and certain other U.S. source investment income). However, because definitive identification of activities which constitute being engaged in a trade or business in the United States is not provided by the Internal Revenue Code of 1986, as amended (the "Code"), or regulations or court decisions, there can be no assurance that the Internal Revenue Service ("IRS") will not contend successfully that ACGL or its non-U.S. subsidiarieswill beare or have been engaged in a trade or business in the United States. A foreign corporation deemed to be so engaged would be subject to U.S. income tax, as well as the branch profits tax, on its income, which is treated as effectively connected with the conduct of that trade or business unless the corporation is entitled to relief under the permanent establishment provisions of a tax treaty. Such income tax, if imposed, would be based on effectively connected income computed in a manner generally analogous40to that applied to the income of a domestic corporation, except that deductions and credits generally are not permitted unless the foreign corporation has timely filed a U.S. federal income tax return in accordance with applicable regulations. Penalties may be assessed for failure to file tax returns. The 30% branch profits tax is imposed on net income after subtracting the regular corporate tax and making certain other adjustments. Under the income tax treaty between Bermuda and the United States (the "Treaty"), ACGL's Bermuda insurance subsidiaries will be subject to U.S. income tax on any insurance premium income found to be effectively connected with a U.S. trade or business only if that trade or business is conducted through a permanent establishment in the United States. No regulations interpreting the Treaty have been issued. While there can be no assurances, ACGL does not believe that any of its Bermuda insurance subsidiaries
havehas a permanent establishment in the United States. Such subsidiaries would not be entitled to the benefits of the Treaty if (i) less than 50% of ACGL'sstockshares were beneficially owned, directly or indirectly, by Bermuda residents or U.S. citizens or residents, or (ii) any33
such subsidiary's income were used in substantial part to make disproportionate distributions to, or to meet certain liabilities to, persons who are not Bermuda residents or U.S. citizens or residents. While there can be no assurances, ACGL believes that its Bermuda insurance subsidiaries
will beare eligible for Treatybenefits after the sale of shares offered hereby.benefits.Foreign corporations not engaged in a trade or business in the United States are nonetheless subject to U.S. income tax on certain "fixed or determinable annual or periodic gains, profits and income" derived from sources within the United States as enumerated in Section 881(a) of the Code (such as dividends and certain interest on investments).
PERSONAL HOLDING COMPANY RULES.Personal Holding Company Rules. A corporation will not be classified as a personal holding company (a "PHC") in a given taxable year unless both (i) at some time during the last half of such taxable year, five or fewer individuals (without regard to their citizenship or residency) own or are deemed to own (pursuant to certain constructive ownership rules) more than 50% of the corporation's shares by value, and (ii) at least 60% of the adjusted ordinary gross income of the corporation for such taxable year consists of PHC income (as defined in Section 543 of the Code). For purposes of the 50% share ownership test, all of our common shares owned by an investment partnership will be attributed to each of its partners, if any, who are individuals. As a result of this attribution rule, we believe that currently five or fewer individuals are treated as owning more than 50% of the value of our common shares. Consequently, we or one or more of our subsidiaries could be or become PHCs, depending on whether we or any of our subsidiaries satisfy the PHC gross income test.
We will use reasonable best efforts to cause ACGL and each of its subsidiaries not to satisfy the gross income requirement set forth in Section 542(a) of the Code. If, however, we or any of our subsidiaries is or were to become a PHC in a given taxable year, such company would be subject to PHC tax (at the highest marginal rate on ordinary income applicable to individuals) on its "undistributed PHC income" (which, in our case and the case of our foreign subsidiaries, would include only PHC income that is from U.S. sources and foreign source income to the extent that such income is effectively connected with the conduct of a trade or business in the U.S.). PHC income generally would not include underwriting income or, in our case and the case of our foreign subsidiaries, investment income derived from non-U.S. sources or dividends received from non-U.S. subsidiaries. If we or any of our subsidiaries is or becomes a PHC, there can be no assurance that the amount of PHC income would be immaterial.
Certain of our U.S. subsidiaries were PHCs in respect of 2002 and may be PHCs in respect of 2003. Such subsidiaries did not have "undistributed personal holding company income" in 2002 and, currently, do not expect to have "undistributed personal holding company income" in 2003.
There can be no assurance that we and each of our subsidiaries are not or will not become a PHC
immediately following this offering orin the future because of factors including factual uncertainties regarding the application of the PHC rules, the makeup of our shareholder base and other circumstances that affect the application of the PHC rules to us and our subsidiaries.41TAXATION OF SHAREHOLDERSTaxation of Shareholders
The following summary sets forth certain United States federal income tax considerations related to the purchase, ownership and disposition of our common shares. Unless otherwise stated, this summary deals only with shareholders ("U.S. Holders") that are United States Persons (as defined below) who hold their common shares as capital assets. The following discussion is only a general summary of the United States federal income tax matters described herein and does not purport to address all of the United States federal income tax consequences that may be relevant to a particular shareholder in light of such shareholder's specific circumstances. In addition, the following summary does not describe the United States federal income tax consequences that may be relevant to certain types of shareholders, such as banks, insurance companies, regulated investment companies, real estate
34
investment trusts, financial asset securitization investment trusts, dealers in securities or traders that adopt a mark-to-market method of tax accounting, tax exempt organizations, expatriates or persons who hold the common shares as part of a hedging or conversion transaction or as part of a straddle, who may be subject to special rules or treatment under the Code. This
discussionsdiscussion is based upon the Code, the Treasury regulations promulgated thereunder and any relevant administrative rulings or pronouncements or judicial decisions, all as in effect on the datehereofof this annual report and as currently interpreted, and does not take into account possible changes in such tax laws or interpretations thereof, which may apply retroactively. This discussion does not include any description of the tax laws of any state or local governments within the United States, or of any foreign government, that may be applicable to the common shares or the shareholders. Persons considering making an investment in the common shares should consult their own tax advisors concerning the application of the United States federal tax laws to their particular situations as well as any tax consequences arising under the laws of any state, local or foreign taxing jurisdiction prior to making such investment.If a partnership holds our common shares, the tax treatment of a partner will generally depend upon the status of the partner and the activities of the partnership. If you are a partner of a partnership holding common shares, you should consult your tax advisor.
For purposes of this discussion, the term "United States Person" means:
-
- •
- a citizen or resident of the United States,
-- •
- a corporation or entity treated as a corporation created or organized in or under the laws of the United States, or any political subdivision thereof,
-- •
- an estate the income of which is subject to United States federal income taxation regardless of its source,
-- •
- a trust if either (x) a court within the United States is able to exercise primary supervision over the administration of such trust and one or more United States Persons have the authority to control all substantial decisions of such trust or (y) the trust has a valid election in effect to be treated as a United States Person for U.S. federal income tax purposes or
-- •
- any other person or entity that is treated for U.S. federal income tax purposes as if it were one of the foregoing.
BERMUDA TAXATIONBermuda Taxation
Currently, there is no Bermuda withholding tax on dividends paid by us.
UNITED STATES TAXATION TAXATION OF DIVIDENDS.
United States Taxation
Taxation of Dividends. Subject to the discussions below relating to the potential application of the CFC and PFIC rules, cash distributions, if any, made with respect to our common shares will constitute dividends for U.S. federal income tax purposes to the extent paid out of our current or accumulated
42earnings and profits (as computed using U.S. tax principles). To the extent such distributions exceed our earnings and profits, they will be treated first as a return of the U.S. Holder's basis in our common shares to the extent thereof, and then as gain from the sale of a capital asset. SALE, EXCHANGE OR OTHER DISPOSITION.Sale, Exchange or Other Disposition. Subject to the discussions below relating to the potential application of the CFC, PFIC and foreign personal holding company ("FPHC") rules, holders of common shares generally will recognize capital gain or loss for U.S. federal income tax purposes on the sale, exchange or disposition of common shares.
TAXATION OF OUR35
Taxation of Our U.S.
SHAREHOLDERS CONTROLLED FOREIGN CORPORATION RULESShareholders
Controlled Foreign Corporation Rules
Under our bye-laws, the 9.9% voting restriction applicable to the Controlled Shares of a U.S. Person (as defined in our bye-laws) generally does not apply to certain of our investors. As a result of certain attribution rules, we believe, therefore, that we and our foreign subsidiaries are controlled foreign corporations ("CFCs"). That status as a CFC does not cause us or any of our subsidiaries to be subject to U.S. federal income tax. Such status also has no adverse U.S. federal income tax consequences for any U.S. Holder that is considered to own less than 10% of the total combined voting power of our common shares or those of our foreign subsidiaries. Only U.S. Holders that are considered to own 10% or more of the total combined voting power of our common shares or those of our foreign subsidiaries (taking into account common shares actually owned by such U.S. Holder as well as common shares attributed to such U.S. Holder under the Code or the regulations thereunder) (a "10% U.S. Voting Shareholder") is affected by our status as a CFC. Our bye-laws are intended to prevent any U.S. Holder from being considered a 10% U.S. Voting Shareholder by limiting the votes conferred by the Controlled Shares (as defined in our bye-laws) of any U.S. Person to 9.9% of the total voting power of all our shares entitled to vote. However, because under our bye-laws certain funds associated with Warburg Pincus and Hellman & Friedman generally are entitled to vote their directly owned common shares in full, a U.S. Holder that is attributed (under the Code or the regulations thereunder) common shares owned by such funds may be considered a 10% U.S. Voting Shareholder. If you are a direct or indirect investor in a fund associated with Warburg Pincus or Hellman & Friedman additional common shares could be attributed to you for purposes of determining whether you are considered to be a 10% U.S. Voting Shareholder. As long as we are a CFC, a U.S. Holder that is considered a 10% U.S. Voting Shareholder will be subject to current U.S. federal income taxation (at ordinary income tax rates) to the extent of all or a portion of the undistributed earnings and profits of ACGL and our subsidiaries attributable to "subpart F income" (including certain insurance premium income and investment income) and may be taxable at ordinary income tax rates on any gain realized on a sale or other disposition (including by way of repurchase or liquidation) of our common shares to the extent of the current and accumulated earnings and profits attributable to such shares.
While our bye-laws are intended to prevent any member from being considered a 10% U.S. Voting Shareholder (except as described above), there can be no assurance that a U.S. Holder will not be treated as a 10% U.S. Voting Shareholder, by attribution or otherwise, under the Code or any applicable regulations thereunder. See "Risk
Factors--RisksFactors—Risks Relating toTaxation--U.S.Taxation—U.S. persons who hold our common shares may be subject to U.S. income taxation at ordinary income rates on our undistributed earnings and profits."RELATED PERSON INSURANCE INCOME RULES We
Related Person Insurance Income Rules
Generally, we do not expect the gross "related person insurance income" ("RPII") of any of our non-U.S. subsidiaries to equal or exceed 20% of its gross insurance income in any taxable year for the foreseeable future and do not expect the direct or indirect insureds (and related persons) of any such subsidiary to directly or indirectly own 20% or more of either the voting power or value of our
43common stock. Consequently, we do not expect any U.S. person owning common shares to be required to include in gross income for U.S. federal income tax purposes RPII income, but there can be no assurance that this will be the case. Section 953(c)(7) of the Code generally provides that Section 1248 of the Code (which generally would require a U.S. Holder to treat certain gains attributable to the sale, exchange or disposition of common shares as a dividend) will apply to the sale or exchange by a U.S. shareholder of shares in a foreign corporation that is characterized as a CFC under the RPII rules if the foreign corporation would be taxed as an insurance company if it were a domestic corporation, regardless of whether the
36
U.S. shareholder is a 10% U.S. Voting Shareholder or whether the corporation qualifies for either the RPII 20% ownership exception or the RPII 20% gross income exception. Although existing Treasury Department regulations do not address the question, proposed Treasury regulations issued in April 1991 create some ambiguity as to whether Section 1248 and the requirement to file Form 5471 would apply when the foreign corporation has a foreign insurance subsidiary that is a CFC for RPII purposes and that would be taxed as an insurance company if it were a domestic corporation. We believe that Section 1248 and the requirement to file Form 5471 will not apply to a less than 10% U.S. Shareholder because ACGL is not directly engaged in the insurance business. There can be no assurance, however, that the IRS will interpret the proposed regulations in this manner or that the Treasury Department will not take the position that Section 1248 and the requirement to file Form 5471 will apply to dispositions of our common shares.
If the IRS or U.S. Treasury Department were to make Section 1248 and the Form 5471 filing requirement applicable to the sale of our common shares, we would notify shareholders that Section 1248 of the Code and the requirement to file Form 5471 will apply to dispositions of our common shares. Thereafter, we would send a notice after the end of each calendar year to all persons who were shareholders during the year notifying them that Section 1248 and the requirement to file Form 5471 apply to dispositions of our common shares by U.S. Holders. We would attach to this notice a copy of Form 5471 completed with all our information and instructions for completing the shareholder information.
FOREIGN PERSONAL HOLDING COMPANY RULES
Foreign Personal Holding Company Rules
A foreign company will not be classified as an FPHC unless both (i) at some time during the taxable year at issue, five or fewer individuals who are U.S. citizens or residents own or are deemed to own (pursuant to certain constructive ownership rules) more than 50% of all classes of its shares measured by voting power or value and (ii) at least 60% (or in general 50% for any year after the first year that a corporation is an FPHC) of its gross income is FPHC income (as defined in Section 553 of the Code) (generally including passive income such as dividends, interest and gains from the sale of stocks and securities). For purposes of the share ownership test, all of our common shares owned by an investment partnership will be attributed to each of its partners, if any, who are individuals. As a result of this attribution rule, we believe that currently five or fewer individuals are treated as owning more than 50% of the value of our common shares. Consequently, we or one or more of our foreign subsidiaries could be or become FPHCs, depending on whether we or any of our foreign subsidiaries satisfy the FPHC gross income test.
We will use reasonable best efforts to cause us and each of our subsidiaries not to satisfy the gross income requirement set forth in Section 552 of the Code. If, however, we or any of our subsidiaries are or were to become an FPHC, a portion of such company's "undistributed foreign personal holding company income" (as defined in the Code) would be imputed to all of our U.S. Holders. Such income would be taxable as a dividend, even if no cash dividend were actually paid. In such event, subsequent cash distributions would first be treated as a tax-free return of any previously taxed and undistributed amounts. In addition, if we or any of our subsidiaries are or become an FPHC in any year, the heirs or estate of any individual U.S. Holder who dies in the immediately following year (whether or not we or
44any of our subsidiaries are an FPHC in such year) would not be entitled to a "step-up" in the basis of the common shares which might otherwise be available under U.S. income tax laws. We and certain of our non-U.S. subsidiaries were FPHCs in respect of 2002 and may be FPHCs in respect of 2003. We and such subsidiaries did not have "undistributed foreign personal holding company income" in 2002 and, currently, do not expect to have "undistributed foreign personal holding company income" in 2003.
37
There can be no assurance that we and each of our subsidiaries are not or will not become an FPHC because of factors including factual uncertainties regarding the application of the FPHC rules, the makeup of our shareholder base and other circumstances that could affect the application of the FPHC rules to us and our subsidiaries. If we or any of our subsidiaries are or were to become an FPHC, such company would not be subject to the PHC rules described above.
PASSIVE FOREIGN INVESTMENT COMPANIES
Passive Foreign Investment Companies
Sections 1291 through 1298 of the Code contain special rules applicable with respect to foreign corporations that are "passive foreign investment companies" ("PFICs"). In general, a foreign corporation will be a PFIC if 75% or more of its income constitutes "passive income" or 50% or more of its assets produce passive income. If we were to be characterized as a PFIC, U.S. Holders would be subject to a penalty tax at the time of their sale of (or receipt of an "excess distribution" with respect to) their common shares. In general, a shareholder receives an "excess distribution" if the amount of the distribution is more than 125% of the average distribution with respect to the shares during the three preceding taxable years (or shorter period during which the taxpayer held the stock). In general, the penalty tax is equivalent to an interest charge on taxes that are deemed due during the period the shareholder owned the shares, computed by assuming that the excess distribution or gain (in the case of a sale) with respect to the shares was taxable in equal portions throughout the holder's period of ownership. The interest charge is equal to the applicable rate imposed on underpayments of U.S. federal income tax for such period. A U.S. shareholder may avoid some of the adverse tax consequences of owning shares in a PFIC by making a qualified electing fund ("QEF") election. A QEF election is revocable only with the consent of the Internal Revenue Service and has the following consequences to a shareholder:
-
- •
- For any year in which ACGL is not a PFIC, no income tax consequences would result.
-- •
- For any year in which the ACGL is a PFIC, the shareholder would include in its taxable income a proportionate share of the net ordinary income and net capital gains of ACGL and certain of its non-U.S. subsidiaries.
The PFIC statutory provisions contain an express exception for income "derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business...." This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent such income is attributable to financial reserves in excess of the reasonable needs of the insurance business. The PFIC statutory provisions contain a look-through rule that states that, for purposes of determining whether a foreign corporation is a PFIC, such foreign corporation shall be treated as if it "received directly its proportionate share of the income" and as if it "held its proportionate share of the assets" of any other corporation in which it owns at least 25% of the stock. We will use reasonable best efforts to cause us and each of our subsidiaries not to constitute a PFIC within the meaning of Section 1297 of the Code.
No regulations interpreting the substantive PFIC provisions have yet been issued. Each U.S. Holder should consult his tax advisor as to the effects of these rules.
UNITED STATES TAXATION OF NON-U.S. SHAREHOLDERS TAXATION OF DIVIDENDSUnited States Taxation of Non-U.S. Shareholders
Taxation of Dividends
Cash distributions, if any, made with respect to common shares held by shareholders who are not United States Persons ("Non-U.S. holders") generally will not be subject to United States withholding tax.
45SALE, EXCHANGE OR OTHER DISPOSITION38
Sale, Exchange or Other Disposition
Non-U.S. holders of common shares generally will not be subject to U.S. federal income tax with respect to gain realized upon the sale, exchange or other disposition of common shares unless such gain is effectively connected with a U.S. trade or business of the Non-U.S. holder in the United States or such person is present in the United States for 183 days or more in the taxable year the gain is realized and certain other requirements are satisfied.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Information Reporting and Backup Withholding
Non-U.S. holders of common shares will not be subject to U.S. information reporting or backup withholding with respect to dispositions of common shares effected through a non-U.S. office of a broker, unless the broker has certain connections to the United States or is a United States person. No U.S. backup withholding will apply to payments of dividends, if any, on our common shares.
OTHER TAX LAWS
Other Tax Laws
Shareholders should consult their own tax advisors with respect to the applicability to them of the tax laws of other jurisdictions.
Our reinsurance group leases a total of approximately 7,300 square feet in Bermuda under a lease expiring in 2007, and
its subsidiaries rent spaceapproximately 15,800 square feet in Morristown, New Jersey under a lease expiring in 2006.We lease approximately 63,100 square feet in our New York City location under a lease and a sub-sublease expiring in 2012 and 2009, respectively. The principal U.S. office of our insurance group is located at One Liberty Plaza, New York, New York. Our insurance group also leases a total of approximately 109,000 square feet for
theirour other offices in Atlanta, Georgia, Chicago, Illinois, Columbus, Ohio, Conshohocken, Pennsylvania, Kansas City, Missouri, Morristown, New Jersey, San Francisco, California, St. Paul, Minnesota and Stamford, Connecticut. We lease approximately 4,500 square feet in Hamilton, Bermuda for our Bermuda insurance operations.For the years ended December 31, 2002, 2001 and
the United States under leases which expire at various times up to 2006.2000, our rental expense (income) was approximately $3.2 million, ($132,000) and $190,000, respectively. Our future minimum rental charges for the remaining terms of our existing leases, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately$5,081,000. For the years ended December 31, 2001, 2000 and 1999, our rental expense (income), including sublease income, was approximately $(132,000), $190,000 and $576,000, respectively.$46.9 million. We believe that the above described office space is adequate for our needs. However, as we continue to develop our business, weexpect that we willmay open additional office locations during2002.2003.We, in common with the insurance industry in general, are subject to litigation and arbitration in the normal course of our business. As of December 31,
2001,2002, we were not a party to any material litigation or arbitration other than as a part of the ordinary course of business in relation to claims activity, none of which is expected by management to have a significant adverse effect on our results of operation and financial condition and liquidity.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.HOLDERSNone.
4639
PART IIITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common shares are traded on the
NasdaqNASDAQ National Market under the symbol "ACGL." For the periods presented below, the high and low sales prices and closing prices for our common shares as reported on theNasdaqNASDAQ National Market were as follows:
THREE MONTHS ENDED ------------------------------------------------------------------------------ DECEMBER 31, 2001 SEPTEMBER 30, 2001 JUNE 30, 2001 MARCH 31, 2001(1) ------------------ ------------------- -------------- ------------------High................................ $28.34 $19.20 $17.06 $18.06 Low................................. 16.40 15.45 14.81 14.38 Close............................... 25.75 16.75 15.75 15.88
THREE MONTHS ENDED --------------------------------------------------------------------------- DECEMBER 31, 2000 SEPTEMBER 30, 2000 JUNE 30, 2000 MARCH 31, 2000 ------------------ ------------------- -------------- ---------------High................................ $15.88 $15.88 $16.63 $16.75 Low................................. 13.88 14.63 14.56 11.38 Close............................... 15.00 15.75 14.94 16.38- -------------------------- (1) For the ten trading days ended October 23, 2001, the last trading day prior to the announcement of the signing of the subscription agreements for the capital infusion and our new underwriting initiative, the average closing price of our common shares on the Nasdaq Stock Market was $16.86 per share.
Three Months Ended December 31, 2002 September 30, 2002 June 30, 2002 March 31, 2002 High $ 34.50 $ 28.93 $ 31.10 $ 27.94 Low 26.00 22.85 25.35 25.00 Close 31.17 27.90 28.15 25.81
Three Months Ended December 31, 2001 September 30, 2001 June 30, 2001 March 31, 2001 High $ 28.34 $ 19.20 $ 17.06 $ 18.06 Low 16.40 15.45 14.81 14.38 Close 25.75 16.75 15.75 15.88 On March
8, 2002,25, 2003, the high and low sales prices and the closing price for our common shares as reported on theNasdaqNASDAQ National Market were$27.14, $26.70$33.20, $32.77 and$26.70,$33.14, respectively.As of March
8, 2002,25, 2003, there were approximately53168 holders of record of our common shares,andapproximately1,6635,000 beneficial holders of our common shares,and 2328 holders of record and beneficial holders of our preference shares.Any determination to pay dividends will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition and other factors deemed relevant by our board of directors. As a holding company, we will depend on future dividends and other permitted payments from our subsidiaries to pay dividends to our shareholders. Our subsidiaries' ability to pay dividends, as well as our ability to pay dividends, is, and is expected to be, subject to regulatory, contractual, rating agency and other constraints. Our board of directors currently does not intend to declare dividends or make any other distributions.
In addition, pursuant to our shareholders agreement, we have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of our preference shares, pro rata, on the basis of the amount of those shareholders' investments in us at the time of such repurchase, preference shares having an aggregate value of $250.0 million, at a per share price acceptable to those shareholders.
RECENT SALES OF UNREGISTERED
SECURITIESOn November 20,AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANSOur shareholders approved the 2002 Long Term Incentive and Share Award Plan ("2002 Plan") on June 27, 2002. The 2002 Plan provides for grants of stock options, stock appreciation rights, restricted shares, restricted units payable in common shares or cash, share awards in lieu of cash awards, dividend
40
equivalents and other share-based awards common shares to our new employees, existing employees and members of our board of directors. We also adopted, and our shareholders approved, the 1995 Long Term Incentive and Share Award Plan ("1995 Plan") and the 1999 Long Term Incentive and Share Award Plan ("1999 Plan") in 1996 and 1999, respectively. In addition, our shareholders approved the 1995 Employee Stock Purchase Plan in 1996, but this plan was suspended in December 2002. All of the shares reserved for issuance under the 1995 Plan and the 1999 Plan have been issued.
In October 2001, we
issuedadopted the Long Term Incentive Plan for New Employees ("New Employee Plan") to provide incentives to attract and motivate new hires in connection with the launch of our new underwriting initiative. A total of 3,295,170 of such share awards were granted under the New Employee Plan. As eligibility under the New Employee Plan was restricted to new hires, none of the shares under the New Employee Plan were available for grants to directors or existing employees. As a result, in order to be in aprivate placementposition to provide long-term incentive compensation for our employees and directors, in June 2002, following shareholder approval, we adopted thesecurities described under "Business--Recent Developments--The2002 Plan, and the New Employee Plan was terminated. For information about our equity compensation plans, see note 11, "Share Capital,Infusion."The sales of these securities were exempt 47from registration under the provisions of Section 4(2)of theSecurities Act. For a description of the purchasers, consideration for and terms of conversion and exercise of the securities, please refer to the information appearing above under the subheading "The Capital Infusion" included as part of "Business," whichnotes accompanying our consolidated financial statements.The following information is
incorporated by reference.as of December 31, 2002:
Plan category Number of
securities to be
issued upon
exercise of
outstanding
options(1),
warrants and
rights
(a)Weighted-
average exercise
price of
outstanding
options(1),
warrants and
rights
(b)Number of
securities
remaining available
for future issuance
under equity
compensation plans
(excluding
securities reflected
in column (a))
(c)Equity compensation plans approved by security holders 3,104,031 $ 20.54 2,770,986 Equity compensation plans not approved by security holders 2,495,380 $ 23.48 0 Total 5,599,411 $ 21.85 2,770,986
- (1)
- Includes all vested and unvested options.
ITEM 6. SELECTED FINANCIAL DATAThe following table sets forth summary historical consolidated financial and operating data for the five-year period ended December 31,
2001.2002. Such data for the three-year period ended December 31,20012002 should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our financial statements and the related notes.Comparisons of our 2001 and 2000 results of operationsDue to
each other and to prior year periods are not relevant due tothe significant changes in our business during the years 2002, 2001 and 2000,and 2001, includingwe believe that the comparisons of our results of operations in such periods are not relevant. These changes included (1) the sale of our prior reinsurance operations in May 2000, (2) our change of legal domicile41
and reorganization completed in November 2000, (3) our
recentacquisition activity and (4) our new underwriting initiative and(5)the related capitalinfusion.
YEAR ENDED DECEMBER 31, ------------------------------------------------------------------- 2001 2000 1999 1998 1997 ----------- ----------- ----------- ----------- ----------- (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)STATEMENT OF OPERATIONS DATA: Revenues: Net premiums written........ $ 36,216 $ (10,604)(1) $ 306,726 $ 234,735 $ 144,834 Net premiums earned......... 30,918 87,530 311,368 206,194 107,372 Net investment income....... 12,120 15,923 20,173 15,687 14,360 Net realized investment gains (losses)............ 18,382 20,045 17,227 25,252 (760) Total revenues.......... 76,454 127,634 344,800 247,133 120,972 Income (loss) before income taxes....................... 24,144 503 (56,199) 2,347 1,598 Net income (loss)............. 22,016 (8,012) (35,636) 2,852 2,039 Average common shares outstanding: Basic....................... 12,855,668 13,198,075 17,086,732 17,065,165 17,032,601 Diluted..................... 17,002,231(2) 13,198,075 17,086,732 17,718,223 17,085,788 Net income (loss) per common share: Basic....................... $ 1.71 $ (0.61) $ (2.09) $ 0.17 $ 0.12 Diluted..................... $ 1.29 $ (0.61) $ (2.09) $ 0.16 $ 0.12 Cash dividends per share...... -- -- -- -- --48
DECEMBER 31, ------------------------------------------------------------------- 2001 2000 1999 1998 1997 ----------- ----------- ----------- ----------- ----------- (IN THOUSANDS)BALANCE SHEET DATA: Cash and invested assets...... $ 1,019,058 $ 276,053 $ 579,874 $ 586,788 $ 505,728 Unpaid losses and loss adjustment expenses recoverable................. 90,442 -- 55,925 30,468 -- Total assets.................. 1,313,701 295,907 860,175 757,463 581,247 Reserves for losses and loss adjustment expenses: Before reinsurance recoverable............... 113,507 -- 364,554 216,657 70,768 Net of reinsurance recoverable............... 23,065 -- 308,629 186,189 70,768 Shareholders' equity.......... 1,020,369 272,299 342,330 397,763 401,031
DECEMBER 31, ------------------------------------------------------------------- 2001 2000 1999 1998 1997 ----------- ----------- ----------- ----------- -----------Book value: Per common share.......... $ 20.05(3) $ 21.43 $ 20.03 $ 23.28 $ 23.51 Diluted................... $ 19.59 $ 21.43 $ 20.03 $ 22.80 $ 22.90 Common shares outstanding: Actual.................... 13,513,538 12,708,818 17,087,970 17,087,438 17,058,462 Diluted................... 52,097,108(4) 12,708,818 17,087,970 17,445,619 17,508,632- ------------------------infusions.
Year Ended December 31, 2002 2001 2000 1999 1998 (in thousands except share and per share data) Statement of Operations Data: Revenues: Net premiums written(1) $ 1,261,627 $ 36,216 $ (10,604 ) $ 306,726 $ 234,735 Net premiums earned 654,976 30,918 87,530 311,368 206,194 Net investment income 51,249 12,120 15,923 20,173 15,687 Net realized investment gains (losses) (839 ) 18,382 20,045 17,227 25,252 Total revenues 721,769 76,454 127,634 344,800 247,133 Income (loss) before income taxes and extraordinary item 54,540 24,144 503 (56,199 ) 2,347 Income (loss) before extraordinary item 55,096 22,016 (8,012 ) (35,636 ) 2,852 Extraordinary gain—excess of fair value of acquired net assets over cost (net of $0 tax)(2) 3,886 — — — — Net income (loss) $ 58,982 $ 22,016 $ (8,012 ) $ (35,636 ) $ 2,852 Average shares outstanding: Basic(3) 20,095,698 12,855,668 13,198,075 17,086,732 17,065,165 Diluted(3) 59,662,178 17,002,231 13,198,075 17,086,732 17,718,223 Net income (loss) per share data: Basic(3): Income (loss) before extraordinary item $ 2.74 $ 1.71 $ (0.61 ) $ (2.09 ) $ 0.17 Extraordinary gain(2) $ 0.19 — — — — Net income (loss) $ 2.93 $ 1.71 $ (0.61 ) $ (2.09 ) $ 0.17 Diluted(3): Income (loss) before extraordinary item $ 0.92 $ 1.29 $ (0.61 ) $ (2.09 ) $ 0.16 Extraordinary gain(2) $ 0.07 — — — — Net income (loss) $ 0.99 $ 1.29 $ (0.61 ) $ (2.09 ) $ 0.16 Cash dividends per share — — — — — 42
December 31, 2002 2001 2000 1999 1998 (in thousands) Balance Sheet Data: Cash and invested assets $ 1,985,898 $ 1,019,058 $ 276,053 $ 579,874 $ 586,788 Unpaid losses and loss adjustment expenses recoverable 211,100 90,442 — 55,925 30,468 Total assets 2,991,328 1,313,701 295,907 860,175 757,463 Reserves for losses and loss adjustment expenses: Before reinsurance recoverable 592,432 111,494 — 364,554 216,657 Net of reinsurance recoverable 381,332 21,052 — 308,629 186,189 Shareholders' equity 1,411,244 1,020,369 272,299 342,330 397,763
December 31, 2002 2001 2000 1999 1998 Book value: Per common share(4) $ 21.48 $ 20.05 $ 21.43 $ 20.03 $ 23.28 Diluted(5) $ 21.20 $ 18.28 $ 21.43 $ 20.03 $ 22.80 Shares outstanding: Basic 27,725,334 13,513,538 12,708,818 17,087,970 17,087,438 Diluted(5) 66,569,999 55,804,038 12,708,818 17,087,970 17,445,619
- (1)
- Net premiums written for the year ended December 31, 2000 includes the reversal of $92.9 million of premiums recorded in prior periods in connection with the sale of our prior reinsurance operations in May 2000.
- (2)
For- On November 30, 2002, we acquired PSIC and recorded an extraordinary gain of $3.9 million for the
purposesyear ended December 31, 2002. The extraordinary gain represents the excess ofcalculating "Netthe fair value of acquired net assets of $6.4 million over the purchase price of $2.5 million.- (3)
- Net income
(loss)per share is based on the basic and diluted weighted average number of common shares and common share equivalents outstanding. Net loss per share is based on the basic weighted average number of common shares outstanding.- (4)
- Book value per common share
" "Averageat December 31, 2002 and December 31, 2001 was determined by dividing (i) the difference between total shareholders' equity and the aggregate liquidation preference of the preference shares of $815.7 million and $749.4 million, respectively, by (ii) the number of common sharesoutstanding, Diluted" gives effect tooutstanding.- (5)
- Book value per share excludes the
issuanceeffects ofthe following Dilutive Shares,stock options and class B warrants. Diluted book value per share as of December 31, 2001 is adjusted on aweighted averagepro forma basiscalculated usingto reflect thetreasury stock method, where applicable, and does not give effect to theissuanceof the following Contingently Issuable Shares.
Dilutive shares (the "Dilutive Shares"): Common shares issuable upon conversion of outstanding preference shares......................... 35,687,735 Common shares issuable upon exercise of outstanding class A warrants.......................... 1,206,206(a) ---------- Subtotal............................................ 36,893,941 Common shares issuable upon conversion or exercise of contingently issuable (the "Contingently Issuable Shares"): Preference shares(b).................................... 875,765 Preference shares(c).................................... 2,831,174 Class B warrants(d)..................................... 33,495 ---------- Subtotal............................................ 3,740,434 ---------- Total............................................. 40,634,375 ==========(a) Calculated using the treasury stock method. Class A warrants to purchase an aggregate of 5,401,707 common shares were outstanding as of March 8, 2002. The class A warrants are currently exercisable at $20.00 per share and expire on September 19, 2002. 49(b) Represents our current estimate of the numberof additional preference shares thatwill bewere issuedduring the first quarter ofby us on June 28, 2002 and December 16, 2002 pursuant toapost-closing purchase price adjustment mechanisms under thesubscription agreement entered intoSubscription Agreement.43
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in
connectionthese statements and, therefore, undue reliance should not be placed on them. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the sections entitled "Cautionary Note Regarding Forward Looking Statements," and "Our Company—Risk Factors."This discussion and analysis should be read in conjunction with
the capital infusion. (c) Represents an estimate of the number of additional preference shares that would be issuedour audited consolidated financial statements and notes thereto presented underthe subscription agreement entered into in connection with the capital infusion in the event that, on or prior to September 19, 2005, the closing price of our common shares is at least $30.00 per share for at least 20 out of 30 consecutive trading days or a change of control occurs. (d) Calculated using the treasury stock method. Class B warrants to purchase an aggregate of 150,000 common shares were outstanding as of December 31, 2001 and expire on September 19, 2005. Class B warrants become exercisable at $20.00 per share if the closing price of our common shares is at least $30.00 per share for at least 20 out of 30 consecutive trading days or a change of control occurs. (3) For the purposes of calculating "Book value, Historical, Per common share" shareholders' equity at December 31, 2001 excludes the aggregate liquidation preference of $749.4 million for the preference shares issued in the capital infusion. (4) "Diluted" information gives effect to the Dilutive Shares and the issuance of 1,689,629 restricted shares issued as part of the capital infusion but does not include the issuance of any Contingently Issuable Shares. Such information excludes the effects of our outstanding stock options (4,068,311) at December 31, 2001. 50ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERALItem 8.General
The Company
We are a Bermuda public limited liability company with
$1.0over $1.4 billion in equity capital and, through operations in Bermuda and the United States,are positioned towe write 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 are focusing on writing specialty lines of insurance andreinsurance profitably and earning a superior return on equity asreinsurance.In October 2001, we
establish an enduring underwriting franchise. Recent events have provided a significant market opportunity for well capitalized insurance companies that are not burdened by the uncertainties resulting from prior years' underwriting losses and material reinsurance recoverable balances. As a result, we recentlylaunched an underwriting initiative to meet current and future demand in the global insurance and reinsurance markets that included the recruitment of new insurance and reinsurance management teams and an equity capital infusion of $763.2 million. It is our belief that our existingBermudaBermuda- and U.S.-based underwriting platform, ourstrongexperienced management team and our$1.0 billion instrong capital base that is unencumbered by significant exposure to pre-2002 risks have enabled usbothto establish an immediate presence in anincreasinglyattractiveinsurance marketplace and to actively participate in the January 1, 2002 reinsurance renewal season. Since January 1, 2002, we have entered into approximately 800 reinsurance treaties and other reinsurance arrangements which are expected to provide approximately $500 million of gross written reinsurance premiums during 2002. NEW UNDERWRITING INITIATIVE AND NOVEMBER 20, 2001 CAPITAL INFUSION On October 24, 2001, we announced the launch of a new underwriting initiative to meet current and future demand in the globalinsurance and reinsurancemarkets. Simultaneously with the launch of this new underwriting initiative, we entered into agreements with the Warburg Pincus funds and the Hellman & Friedman funds and certain members of management to purchase from us in a private placement, for $763.2 million in cash, 35,687,735 series A convertible preference shares and 3,776,025 class A warrants. This capital infusion was consummated on November 20, 2001. The proceeds of the capital infusion were primarily contributed to our Bermuda and U.S. subsidiaries to support the new underwriting initiative. EVENTS PRIOR TO THE NEW UNDERWRITING INITIATIVE 2001 ACQUISITIONS. On February 28, 2001, we acquired one of our investee companies, American Independent Insurance Company ("American Independent"). American Independent underwrites private passenger automobile liability and physical damage insurance primarily in the Commonwealth of Pennsylvania. During 2001, 70% of American Independent's written premiums were ceded to third-party reinsurers. Duringmarketplace. In April 2002,we expect that approximately 20% of American Independent's written premiums will be ceded to third-party reinsurers. On June 22, 2001, we acquired all of the remaining ownership interests in Arch Risk Transfer Services Ltd. ("ART Services"), which provides insurance and alternative risk transfer services through rent-a-captive and other facilities. First American Insurance Company, a subsidiary of ART Services, is an admitted insurer in 49 states with an A.M. Best rating of "A-" (Excellent). During 2001, approximately 71% of ART Services' written premiums were ceded to third-party reinsurers. During 2002, we expect that less than half of ART Services' written premiums will be ceded to third-party reinsurers. The results of operations of American Independent and ART Services are included in our financial statements from the respective dates of acquisition. Prior to the date of acquisition of ART Services, we accounted for our 27% initial ownership interest in ART Services under the equity method. 51We entered into a definitive agreement on September 24, 2001 to acquire Rock River Insurance Company, an approved excess and surplus lines insurer in 45 states and the District of Columbia and an admitted insurer in two other states, for $19.3 million. We consummated this acquisition on February 1, 2002. Under the terms of the acquisition agreement, the existing policies and other liabilities of Rock River reinsured or otherwise assumed by the seller, Sentry Insurance, a mutual company, which has an A.M. Best rating of "A+" (Superior). At February 1, 2002, Rock River had net assets of approximately $17.0 million. FORMATION OF BERMUDA-BASED REINSURANCE SUBSIDIARY On May 21, 2001, we formed our wholly owned Bermuda-based reinsurance subsidiary, Arch Re (Bermuda). Under the Insurance Act of 1978, Arch Re (Bermuda) is registered as a Class 4 and long-term insurer and reinsurer and, in December 2001, Arch Re (Bermuda) and Arch Re (US), our wholly owned U.S.-based reinsurance subsidiary, were assigned ratings of "A-" (Excellent) by A.M. Best. CHANGE OF LEGAL DOMICILE TO BERMUDA On November 8, 2000,we completed aninternal reorganization that resultedoffering of 7,475,000 of our common shares and received net proceeds of $179.2 million and, in September 2002, we received proceeds of $74.3 million from the exercise of class A warrants by ourchangingprincipal shareholders and certain other investors.
History
We commenced operations in September 1995 following the completion of the initial public offering of our
legal domicile to Bermuda. In that transaction, the shareholders ofpredecessor, Arch Capital(US) (formerly RiskGroup (U.S.) Inc. ("Arch-U.S."). Arch-U.S. is a Delaware company formed in March 1995 under the original name of "Risk Capital Holdings, Inc.) became the shareholders" From that time until May 2000, we provided reinsurance and other forms ofACGL. Priorcapital tothe reorganization, ACGL had no significant assets or capitalization and had not engaged in any business or prior activities other than in connection with the reorganization. MAY 2000 SALE OF OUR PRIOR REINSURANCE OPERATIONSinsurance companies. On May 5, 2000, we sold our prior reinsurance book of business to Folksamerica Reinsurance Company in an asset sale, but retained our surplus and our U.S.-licensed reinsurance platform. On November 8, 2000, following shareholder approval, we changed our legal domicile to Bermuda in order to benefit from Bermuda's favorable business, regulatory, tax and financing environment.During the period from May 2000 through the announcement of our underwriting initiative in October 2001, we built and acquired insurance businesses that enable us to generate both fee-based revenue (e.g., commissions and advisory and management fees) and risk-based revenue (i.e., insurance premium). As part of this strategy, we built an underwriting platform that is intended to enable us to maximize risk-based revenue during periods in the underwriting cycle when we believe it is more favorable to assume underwriting risk. In October 2001, we concluded that underwriting conditions favored dedicating our attention exclusively to building our insurance and reinsurance business.
Due to the significant changes in our business during the years 2002, 2001 and 2000, we believe the comparisons of our results of operations in such periods are not relevant.
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Revenues
We derive our revenues primarily from our issuance of insurance policies and reinsurance contracts. Insurance and reinsurance premiums are driven by the volume and classes of business of the policies and contracts that we write and prevailing market prices. The premium we charge for the risks assumed is priced based on many assumptions. We price these risks well before our ultimate costs are known, which may extend many years into the future. In addition, our revenues include fee income and income we generate from our investment portfolio. Our investment portfolio is comprised primarily of fixed income investments that are held as available for sale. Under our basis of accounting, which is GAAP, these investments are carried at fair market value and unrealized gains and losses on the investments are not included in our statement of operations. Rather, these unrealized gains and losses are included on our balance sheet in accumulated other comprehensive gain or loss as a separate component of shareholders' equity.
Costs and Expenses
Our costs and expenses primarily consist of losses and loss adjustment expenses, acquisition costs, other operating expenses and non-cash compensation. Losses and loss adjustment expenses include management's best estimate of the ultimate cost of claims incurred during a reporting period. Such costs consist of three components: paid losses, changes in estimated amounts for known losses ("case reserves"), and changes in reserves for incurred but not reported ("IBNR") losses. See "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses" for further discussion. Acquisition expenses consist primarily of commissions, brokerage and taxes paid to obtain our business. A significant portion of such costs is paid based on a percentage of the premium written and will vary for each class or line of business that we underwrite. Other operating expenses, a significant portion of which are general and administrative expenses, consist primarily of compensation-related expenses. Non-cash compensation relates to certain grants (primarily of restricted common shares) under our stock incentive plans and other arrangements. The issuance of restricted common shares and the related recognition of non-cash compensation expense has no impact on our shareholders' equity.
Recent Industry Performance
The insurance and reinsurance industry is influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market. During 2001, market conditions had been improving primarily as a result of declining insurance capacity. The events of September 11th and deteriorating underwriting results of the industry accelerated these already improving conditions.
In general, operating conditions continued to improve during 2002 in the insurance and reinsurance marketplace. This improvement reflects losses arising from the events of September 11th, as well as recognition that intense competition in the late 1990s led to inadequate pricing and overly broad terms, conditions and coverages. Such industry developments resulted in impaired financial results and erosion of the industry capital base. Additionally, many established insurers and reinsurers have exited key markets. These developments have provided relatively new insurers and reinsurers, like us, with an opportunity to provide needed underwriting capacity at what we believe to be attractive rates in conjunction with improved terms and conditions.
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Critical Accounting Policies, Estimates and Recent Accounting Pronouncements
The preparation of consolidated financial statements requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since very limited historical information has been reported to us through December 31, 2002. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies require our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Reserves for Losses and Loss Adjustment Expenses
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses that arise from the business we underwrite. These reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured claims which have occurred at or before the balance sheet date.
Insurance loss reserves are inherently subject to uncertainty. The period of time from the occurrence of a loss through the settlement of the liability may extend many years into the future. During this period, additional facts and trends will become known and, as these factors become apparent, reserves will be adjusted in the period in which the new information becomes known. While reserves are established based upon available information, certain factors, such as those inherent in the political, judicial and legal system, including judicial and litigation trends and legislation changes, could impact the ultimate liability. Changes to our prior year loss reserves can impact our current underwriting results by (1) reducing our reported results if the prior year reserves prove to be deficient or (2) improving our reported results if the prior year reserves prove to be redundant. The reserves for losses and loss adjustment expenses represent estimates involving actuarial and statistical projections at a given point in time of our expectations of the ultimate settlement and administration costs of losses incurred, and it is likely that the ultimate liability may exceed or be less than such estimates. We utilize actuarial models as well as available historical insurance and reinsurance industry loss ratio experience and loss development patterns to assist in the establishment of appropriate loss reserves. Even actuarially sound methods can lead to subsequent adjustments to loss reserves that are both significant and irregular due to the nature of the risks written, potentially by a material amount.
For reinsurance assumed, case reserves are based on reports received from ceding companies, supplemented by our estimates of reserves for which ceding company reports have not been received. For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices and the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments
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to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. In accordance with industry practice, we also maintain IBNR reserves. Such reserves are established to provide for incurred claims which have not yet been reported to an insurer or reinsurer as well as to actuarially adjust for any projected variance in case reserving.
Even though most insurance policies have policy limits, the nature of property and casualty insurance and reinsurance is such that losses can exceed policy limits for a variety of reasons and could very significantly exceed the premiums received on the underlying policies. We attempt to limit our risk of loss through reinsurance and may also use retrocessional arrangements. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. See note 2, "Significant Accounting Policies—Reinsurance Ceded," of the notes accompanying our consolidated financial statements.
In establishing the reserves for losses and loss adjustment expenses, we have made various assumptions relating to the pricing of our reinsurance contracts and insurance policies and have also considered available historical industry experience and current industry conditions. Our reserving method for 2002 was primarily the expected loss method, which is commonly applied when limited loss experience exists. We select the initial expected loss and loss adjustment expense ratios based on information derived by our underwriters and actuaries during the initial pricing of the business. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Our reserving process reflects that there is a possibility that the assumptions made could prove to be inaccurate due to several factors, including the fact that very limited historical information has been reported to us through December 31, 2002 due to our start-up nature. As of December 31, 2002, 67% of our total net loss reserves, or $255.5 million, were IBNR reserves. A 5% change in the IBNR reserves would result in an approximately $12.8 million change in our total net loss reserves. Such change would represent approximately 24% of our 2002 net income, or approximately $0.20 per diluted share, and 0.9% of our December 31, 2002 shareholders' equity. As actual loss information is reported to us and we develop our own loss experience, our reserving methods will also include other actuarial techniques. It is possible that claims in respect of events that have occurred could exceed our reserves and have a material adverse effect on our results of operations in a particular period or our financial condition in general.
Under GAAP, we are only permitted to establish loss and loss adjustment expense reserves for losses that have occurred on or before the financial statement date. Case reserves and IBNR reserves contemplate these obligations. No contingency reserve allowances are established to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
Premium Revenues and Related Expenses
Insurance premiums written are recorded at the policy inception and are earned ratably in accordance with the terms of the policies. Unearned premium reserves represent the portion of such premiums written that relates to the unexpired terms of insurance policies in-force.
Reinsurance premiums written include amounts reported by the ceding companies, supplemented by our own estimates of premiums for which ceding company reports have not been received. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the date of the treaty. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to
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commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
As actual premiums are reported by the ceding companies, management evaluates the appropriateness of the premium estimates, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to original premium estimates could be material and such adjustments could directly and significantly impact earnings in the period they are determined because the subject premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, is not currently due based on the terms of the underlying contracts.
Reinsurance premiums assumed are earned generally on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a losses occurring basis cover losses which occur during the term of the contract or policy, which typically extends 12 months. Accordingly, the premium is reflected as earned evenly over the term. Pro rata contracts, which are written on a risks attaching basis, cover losses which attach to the underlying insurance policies written during the terms of such pro rata contracts. Premiums earned on a risks attaching basis usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period.
Certain of our reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses under those contracts, are recorded based upon the projected experience under these contracts.
We also write certain business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, we assume a measured amount of insurance risk in exchange for a specified margin. The terms and conditions of these contracts may include additional or return premiums based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages and financial quota share coverages.
Certain reinsurance contracts included in our non-traditional business, which pursuant to Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," issued by the Financial Accounting Standards Board ("FASB"), are deemed, for financial reporting purposes, not to transfer insurance risk, are accounted for using the deposit method of accounting as prescribed in Statement of Position 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in our underwriting results. For those contracts that do not transfer an element of underwriting risk, the estimated profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income.
Under GAAP, acquisition expenses and other expenses that vary with, and are directly related to, the acquisition of business in our underwriting operations are deferred and amortized over the period in which the related premiums are earned. Under statutory accounting principles, underwriting expenses are recognized immediately as premiums are written.
Acquisition expenses consist principally of commissions and brokerage expenses. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Acquisition expenses are reflected net of ceding commissions received from unaffiliated reinsurers. Deferred acquisition costs are carried at their estimated realizable value based on the related unearned premiums and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income.
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Collection of Insurance-Related Balances
We are subject to credit risk with respect to our reinsurance ceded because the ceding of risk to reinsurers does not relieve us of our liability to the clients or companies we insure. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We are also subject to credit risk from our alternative market products, such as rent-a-captive risk-sharing programs, which allow a client to retain a significant portion of its loss exposure without the administrative costs and capital commitment required to establish and operate its own captive. In certain of these programs, we participate in the operating results by providing excess reinsurance coverage and earn commissions and management fees. In addition, we write program business on a risk-sharing basis with managing general agents or brokers, which may be structured with commissions which are contingent on the underwriting results of the program. While we attempt to obtain collateral from such parties in an amount sufficient to guarantee their projected financial obligations to us, there is no guarantee that such collateral will be sufficient to secure their actual ultimate obligations. We provide for probable losses resulting from our inability to collect amounts due from managing general agents, brokers and other clients.
Reinsurance recoverables on paid and unpaid losses were $225.6 million at December 31, 2002. If 5% of such recoverable balances were deemed uncollectible, such charge would have reduced our 2002 net income by approximately $11.3 million, pre-tax, or $7.7 million, after-tax, which represents approximately 13% of 2002 net income, or $0.13 per diluted share.
Valuation Allowance
We record a valuation allowance to reduce certain of our deferred tax assets to the amount that is more likely than not to be realized. Our deferred income tax asset of $16.5 million at December 31, 2002 is reflected net of a valuation allowance of $2.1 million. We have considered future taxable income and feasible tax planning strategies in assessing the need for a valuation allowance. In the event we determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. In addition, if we subsequently assessed that the valuation allowance was no longer needed, a benefit would be recorded to income in the period in which such determination was made.
Investments
We currently classify all of our publicly traded fixed maturity investments, short-term investments and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturity securities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. Short-term investments comprise securities due to mature within one year of the date of issue. Short-term investments include certain cash equivalents which are part of our investment portfolios under the management of external investment managers. Investments included in our private portfolio include securities issued by privately held companies. Our investments in privately held equity securities, other than those carried under the equity method of accounting, are carried at estimated fair value. Fair value is initially considered to be equal to the cost of such investment until the investment is revalued based on substantive events or other factors which could indicate a diminution or appreciation in value. We apply Accounting Principles Board ("APB") Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock," for privately held equity investments accounted for under the equity method, and we record our percentage share of the investee company's net income or loss. See note 2, "Significant Accounting Policies—Investments," of the notes accompanying our consolidated financial statements.
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In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," we periodically review our investments to determine whether a decline in fair value below the amortized cost basis is other than temporary. If such decline in fair value is judged to be other than temporary, we would write down the investment to fair value as a new cost basis and the amount of the write-down would be charged to income as a realized loss. The new cost basis would not be changed for subsequent recoveries in fair value.
Stock Issued to Employees
We have adopted the provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for employee stock options because the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation," requires the use of option valuation models that we believe were not developed for use in valuing employee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized only to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date. In addition, under APB No. 25, we do not recognize compensation expense for stock issued to employees under our stock purchase plan. We suspended the operation of our stock purchase plan in December 2002.
For restricted shares granted, we record deferred compensation equal to the market value of the shares at the measurement date, which is amortized and charged to income as non-cash compensation over the vesting period. These restricted shares are recorded as outstanding upon issuance (regardless of any vesting period). See "—Results of Operations—Non-Cash Compensation."
Recent Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 will be applied prospectively to exit or disposal activities initiated after December 31, 2002, and requires companies to recognize costs associated with exit activities when they are incurred, rather than at the date of a commitment to an exit or disposal plan. We are currently evaluating this standard.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for financial statements for fiscal years and interim periods ending after December 15, 2002. We have adopted the disclosure provisions of SFAS No. 148.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities—an interpretation of ARB No. 51," ("FIN 46") which requires the consolidation of certain entities considered to be variable interest entities ("VIEs"). An entity is considered to be a VIE when it has equity investors which lack the characteristics of a controlling financial interest or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE's expected losses or residual returns if they occur. FIN 46 provides certain exceptions to these rules, including qualifying special purpose entities subject to the requirements of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." VIEs created after January 31, 2003 must be consolidated immediately, while VIEs that existed prior to February 1, 2003 must be consolidated as of July 1, 2003. Certain ceding companies may meet the definition of a VIE due to the protection provided to the ceding company's equity investors from the absorption of expected losses. We are currently evaluating this standard.
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Comparisons of our results of operations for the three years ended December 31, 2002, 2001 and 2000 are not relevant due to the significant changes in our business during this period, including (1) our new insurance and reinsurance underwriting initiatives, (2) the significant amount of capital raised by us from November 2001 through September 2002 and (3) our 2001 acquisition activity. In 2000, we also sold our prior reinsurance operations to Folksamerica Reinsurance
Company. The Folksamerica transaction was structured as a transfer and assumption agreement (and not reinsurance), and, accordingly, the loss reserves (and any related reinsurance recoverables) relating to the transferred business are not included as assets or liabilities on our balance sheet. However,Company inthe event that Folksamerica is unable to make payment of claims on the reinsurance business assumed by it in the May 2000an asset salewe would be liable for such claims. Folksamerica has an A.M. Best rating of "A-" (Excellent). See Note 3, "Acquisition(see note 13, "Acquisitions of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements). In addition, because of these factors, as well as the other factors described in this report, including those noted under the sections entitled "Cautionary Note Regarding Forward-Looking Statements" and "Our Company—Risk Factors," our historical financial results, for 2001 and 2000, do not provide you with a meaningful expectation of our future results.The following table sets forth net income (loss) and earnings per share data:
Years Ended December 31, 2002 2001 2000 (in thousands except share data) Income (loss) before extraordinary item. $ 55,096 $ 22,016 $ (8,012 ) Extraordinary gain 3,886 — — Net income (loss) $ 58,982 $ 22,016 $ (8,012 ) Diluted net income (loss) per share. $ 0.99 $ 1.29 $ (0.61 ) Diluted average shares outstanding 59,662,178 17,002,231 13,198,075 Due to the significant number of preference shares outstanding in 2002 and 2001, basic earnings per share data is not meaningful, as discussed below.
The increase in diluted average shares outstanding from 2001 to 2002 was primarily due to: (1) the issuance of 35,687,735 convertible preference shares and 3,776,025 class A warrants in connection with our capital infusion in November 2001; (2) 7,475,000 common shares in connection with an offering completed by us in April 2002; and (3) 875,753 convertible preference shares on June 28, 2002 and 2,831,177 convertible preference shares on December 16, 2002 pursuant to the subscription agreement entered into in connection with the November 2001 capital infusion. See note 11, "Share Capital," of the notes accompanying our consolidated financial statements.
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The following table sets forth an analysis of underwriting income or loss, together with a reconciliation of underwriting income or loss to net income or loss for the years ended December 31, 2002, 2001 and 2000:
Years Ended December 31, 2002 2001 2000 (in thousands) Gross premiums written $ 1,487,212 $ 119,202 $ 102,034 Net premiums written $ 1,261,627 $ 36,216 $ (10,604 ) Net premiums earned $ 654,976 $ 30,918 $ 87,530 Policy-related fee income 9,418 8,755 — Losses and loss adjustment expenses (424,538 ) (23,448 ) (76,263 ) Acquisition expenses (118,961 ) (813 ) (26,756 ) Operating expenses (61,676 ) (15,426 ) (6,855 ) Provision for loss of escrowed assets, net — 2,414 (15,000 ) Underwriting income (loss)—GAAP basis 59,219 2,400 (37,344 ) Net investment income 51,249 12,120 15,923 Net realized investment gains (losses) (839 ) 18,382 20,045 Other fee income 4,790 3,671 — Other income 2,175 2,608 1,945 Other expenses (15,023 ) (12,266 ) — Net foreign exchange gains (losses) 2,449 — (1,159 ) Non-cash compensation (49,480 ) (2,771 ) (1,098 ) Gain on sale of prior reinsurance operations — — 2,191 Income before income taxes and extraordinary item 54,540 24,144 503 Income tax benefit (expense) 556 (2,128 ) (8,515 ) Income (loss) before extraordinary item 55,096 22,016 (8,012 ) Extraordinary gain, net of $0 tax 3,886 — — Net income (loss) $ 58,982 $ 22,016 $ (8,012 ) The following table sets forth the components of premiums written:
Years Ended December 31, 2002 2001 2000 (in thousands) Premiums Written: Direct $ 629,988 $ 117,406 — Assumed 857,224 1,796 $ 102,034 Ceded (225,585 ) (82,986 ) (19,731 ) Unearned premium portfolio transfer and assumption — — (92,907 ) Net $ 1,261,627 $ 36,216 $ (10,604 )
Gross Premiums Written
Gross premiums written for 2002 were $1.5 billion, of which 61.1% were attributable to our reinsurance operations and 38.9% were attributable to our insurance operations. For 2001, premiums written were generated from insurance subsidiaries which had been acquired by us during 2001. For 2000, premiums written reflect the results of our prior reinsurance operations, which were sold in May 2000.
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Ceded Premiums Written
In the normal course of business, we purchase reinsurance to increase capacity and to limit the impact of individual losses and events on our underwriting results by reinsuring certain levels of risk with other insurance enterprises or reinsurers. During 2002, we ceded approximately 15% of our gross premiums written, substantially all of which relates to our insurance operations.
Net Premiums Written
Net premiums written for 2002 were $1.26 billion, of which our reinsurance and insurance operations contributed net premiums written of $882.7 million, or 70%, and $378.9 million, or 30%, respectively. See
"Risk Factors--Risks Relating"—Segment Information" for additional information on premiums by segment.
Combined Ratios
The combined ratio represents a measure of underwriting profitability, excluding investment income, and is the sum of the loss ratio and underwriting expense ratios. A combined ratio under 100% represents an underwriting profit and a combined ratio over 100% represents an underwriting loss.
Years Ended December 31, 2002 2001 2000 Statutory Basis(1) Loss ratio 64.8 % 75.8 % 87.1 % Acquisition expense ratio(2) 17.7 % (17.3 )% 32.1 % Other operating expense ratio 7.2 % 42.1 % 4.6 % Combined ratio 89.7 % 100.6 % 123.8 % GAAP Basis(1) Loss ratio 64.8 % 75.8 % 87.1 % Acquisition expense ratio(2) 16.7 % (25.7 )% 30.6 % Other operating expense ratio 9.4 % 49.9 % 7.8 % Combined ratio 90.9 % 100.0 % 125.5 %
- (1)
- The loss ratios for statutory and GAAP are based on earned premiums. The statutory expense ratios are based on net premiums written, while the GAAP expense ratios are based on net premiums earned.
- (2)
- The acquisition expense ratio is reflected net of certain policy-related fee income.
Underwriting Results
For the year ended December 31, 2002, underwriting income for our insurance and reinsurance segments was $59.2 million, which reflected a 90.9% combined ratio on a GAAP basis. The underwriting results for 2002 benefited from better than expected experience on catastrophe-related business. The loss ratio, which was 64.8% for 2002, was comprised of 11.9 points of paid losses, 13.4 points related to case reserves and 39.5 points related to IBNR reserves, and included 0.6 points related to prior year reserve development in our insurance segment. See "—Segment Information—Insurance Segment" for further discussion. Since most of our business is new, very limited data has been reported to us as of December 31, 2002. As a result, a significant portion of the loss ratio is attributable to the increase in IBNR reserves.
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For the year ended December 31, 2001, premiums written, losses incurred and acquisition costs resulted primarily from our insurance subsidiaries which were acquired during 2001. The remaining portion of our net income for 2001 was generated through our investment activities, offset by other operating expenses. The corresponding amounts for the year ended December 31, 2000 reflect the results of our prior reinsurance operations, which were sold in May 2000.
Acquisition and Other Expenses
The acquisition expense ratio includes commissions, brokerage, premium taxes and other costs incurred to acquire our insurance and reinsurance business. This ratio is stated net of commission income on business ceded to reinsurers and is also calculated net of certain policy-related fee income. This ratio for 2002 was materially influenced by two factors: (1) the mix of insurance and reinsurance business; and (2) the accrual of profit commissions in our reinsurance segment based on the level of claims activity on certain non-traditional contracts during 2002, which increased acquisition expenses and reduced incurred losses by an equivalent amount. Other operating expenses include costs incurred in the staffing of our insurance and reinsurance operations and the building of related infrastructure. Our
Company--We soldoperating expense ratio is expected to decline in 2003 due to an expected increase in earned premiums; however, consolidated operating expenses are anticipated to increase in 2003 as we continue to build the infrastructure of our insurance operations.See "—Segment Information" for a discussion regarding the underwriting results of our insurance and reinsurance segments.
Provision for Loss of Escrowed Assets
In connection with the sale of our prior reinsurance operations in May 2000,
and may have liability to the purchaser and continuing liability from those reinsurance operations if the purchaser should fail to make payments on the reinsurance liabilities it assumed." In connection with that salewe placed $20.0 million of the purchase price in escrow. The agreement required that these funds would be held for a period of five years to reimburse Folksamerica if certain loss reserves transferred to it in the asset sale became deficient as measured at the endoffor such five-year period or to satisfy certain indemnity claims Folksamerica may have had during such period. In February 2002, we reached a definitive settlement agreement with Folksamerica pursuant to which wewill satisfysatisfied all of our obligations under the escrow agreement for an amount equal to approximately $17.0 million, plus accrued interest income of $1.8 million. In connection with this settlement agreement, for 2001, we recorded a $2.4 million benefit to reflect the net effects of this agreement. During 2000, our net loss included a $15.0 million charge related to the escrowed assets. See note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements.
Net Investment Income
At December 31, 2002, approximately 98% of our invested assets consisted of fixed maturity and short-term investments, compared to 94% at December 31, 2001, exclusive of securities held in escrow. Net investment income was approximately $51.2 million, $12.1 million and $15.9 million in
cash. LIQUIDITY AND CAPITAL RESOURCES2002, 2001 and 2000, respectively. Such amounts are net of investment expenses of $1.3 million, $0.1 million and $0.9 million, respectively. The net investment expenses were offset by advisory fee income that we received from a former investment advisor in the amount of $1.15 million, $1.25 million and $1.25 million in 2002, 2001 and 2000, respectively. The advisory agreement under which we earned such fee income was terminated in 2002.The substantial increase in net investment income in 2002 was due to the significant increase in our invested assets resulting from (1) the capital raised in November 2001, (2) cash flow from operations and (3) proceeds received from the public offering of our common shares in April 2002 and the exercise of class A warrants in September 2002. The decrease in net investment income in 2001
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compared with 2000 primarily reflects the decline in our average invested asset base resulting from the sale of our prior reinsurance operations.
Our investment yields were as follows:
Years Ended December 31, 2002 2001 2000 Pre-tax 3.7 % 5.2 % 4.3 % Net of tax 3.2 % 4.6 % 3.1 % These yields were calculated based on the amortized cost of the portfolio. At December 31, 2002, our investment portfolio primarily consisted of short duration, high quality fixed maturities and short-term investments, and is managed on a total return basis. Yields on future investment income may vary based on economic conditions, investment allocation decisions and other factors. The decline in yields in 2002 is primarily due to a reduction in the level of yields available in the financial markets.
Other Expenses and Other Fee Income
Other expenses primarily represent certain holding company costs necessary to support our growing worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. In addition, other expenses and fee income include the results of Hales & Company Inc.
Income Taxes
ACGL changed its legal domicile from the United States to Bermuda in November 2000. Under current Bermuda law, we are not obligated to pay any taxes in Bermuda based upon income or capital gains. We have received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act of 1966 that in the event legislation is enacted in Bermuda imposing tax computed on profits, income, gain or appreciation on any capital asset, or tax in the nature of estate duty or inheritance tax, such tax will not be applicable to us or our operations until March 28, 2016.
ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. taxpayers. ACGL does not consider itself to be engaged in a trade or business within the U.S. and, consequently, does not expect to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL's shareholders' equity and earnings could be materially adversely affected. ACGL's U.S. subsidiaries are subject to U.S. income taxes on their worldwide income. See "Our Company—Risk Factors—Risks Relating to Taxation" and "Our Company—Tax Matters."
Our weighted average statutory tax rate for the years ended December 31, 2002 and 2001 of 4.0% and 38.6%, respectively, has been calculated by using the pre-tax income (loss) in each jurisdiction multiplied by that jurisdiction's applicable statutory tax rate. The 2002 and 2001 income tax provisions resulted in effective tax rates of 12.5% and 44.0%, respectively, excluding the effect of changes in our valuation allowance in the amount of $7.4 million and $8.5 million, respectively. Our effective tax rate fluctuates from year to year consistent with the relative mix of income reported by jurisdictions due primarily to the varying tax rates in each jurisdiction. The 2002 effective tax rate, excluding the effect of
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certain non-cash compensation, net realized investment gains or losses, net foreign exchange gains or losses and other income, was approximately 5.3%. We currently estimate that our comparable income tax provision in 2003 will result in an effective tax rate of approximately 12.5%, although no assurances can be given to that effect. See note 8, "Income Taxes," of the notes accompanying our consolidated financial statements for a reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average statutory tax rate for the years ended December 31, 2002, 2001 and 2000.
At December 31, 2002, we have a valuation allowance of $2.1 million against a deferred tax asset in one of our subsidiaries that currently does not have a business plan to produce significant future taxable income. See note 8, "Income Taxes," of the notes accompanying our consolidated financial statements, and "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Valuation Allowance."
We have net operating loss carryforwards in our U.S. operating subsidiaries totaling $42.5 million at December 31, 2002. Such net operating losses are currently available to offset our future U.S. taxable income and expire between 2011 and 2021. Full utilization of our net operating losses would reduce future taxes payable by $14.9 million. In addition, we have an alternative minimum tax credit carryforward in the amount of $1.0 million, which can be carried forward without expiration. In addition, we have capital loss carryforwards of approximately $0.3 million which expire by 2006. On November 20, 2001, we underwent an ownership change for U.S. federal income tax purposes as a result of the capital raised at that time. As a result of this ownership change, limitations are imposed upon the utilization of our existing net operating losses, capital loss carryforwards and the alternative minimum tax credit carryforward. See note 8, "Income Taxes," of the notes accompanying our consolidated financial statements.
Net Realized Gains or Losses on Investments
Following is summary of net realized investment gains (losses) for the years ended December 31, 2002, 2001 and 2000:
Years Ended December 31, 2002 2001 2000 (in thousands) Fixed maturities $ (6,350 ) $ (2,116 ) $ (15,550 ) Publicly traded equity securities (269 ) 22,896 30,088 Privately held securities 5,780 (2,398 ) 177 (839 ) 18,382 14,715 Loss on fixed maturities included in gain on sale of prior reinsurance operations — — 5,330 Net realized investment (losses) gains (839 ) 18,382 20,045 Income tax expense 1,779 7,242 7,408 Net realized investment (losses) gains, net of tax $ (2,618 ) $ 11,140 $ 12,637 Currently, our portfolio is actively managed to maximize total return within certain specific guidelines. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced.
The net realized losses of $6.4 million and $2.1 million for the years ended December 31, 2002 and 2001, respectively, on our fixed income portfolio resulted from the sale of certain securities to reduce credit exposure, and from sales related to rebalancing the portfolio. In 2000, net realized gains included $11.0 million of pre-tax losses, or $8.7 million, after-tax, recorded during the 2000 fourth quarter
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resulting from the restructuring of our investment portfolio in connection with our redomestication to Bermuda on November 8, 2000.
Net Foreign Exchange Gains or Losses
We underwrite risks on a worldwide basis. At December 31, 2002, approximately 10% of our aggregate net premiums written are denominated in currencies other than our functional currency, which is the U.S. dollar. Net foreign exchange gains for the year ended December 31, 2002 of $2,449,000 consisted of an unrealized loss of $36,000 and a realized gain of $2,485,000. The net unrealized loss resulted from the translation of foreign denominated monetary assets and liabilities at December 31, 2002, as defined and required under GAAP. Foreign exchange gains and losses vary with fluctuations in currency rates. Accordingly, these gains and losses could add significant volatility to our net income in future periods. We have not attempted, and currently do not expect to attempt, to reduce our exposure to these exchange rate risks by using hedging transactions or by investing in securities denominated in local (foreign) currencies. We may therefore suffer losses solely as a result of exchange rate fluctuations.
Other Income
At December 31, 2002, we held six investments in privately held securities. Three of such investments are accounted for under the equity method of accounting. Under the equity method, we record a proportionate share of the investee company's net income or loss based on our ownership percentage, which, for 2002, amounted to $2.2 million on a pre-tax basis and is included in other income. Approximately $0.6 million of such amount was generated from an investment which was sold in April 2002.
Reversal of, or Provision for, Deferred Tax Asset Valuation Allowance
The reversal of the deferred tax asset valuation allowance was based on our recently completed restructuring of our U.S.-based insurance underwriting operations and our business plan. The tax valuation allowance for the years ended December 31, 2002, 2001 and 2000 is discussed above under "—Income Taxes," and in note 8, "Income Taxes," of the notes accompanying our consolidated financial statements.
Loss on Sale of Prior Reinsurance Operations
In connection with the sale of our prior reinsurance operations to Folksamerica on May 5, 2000, we recognized an after-tax loss, as described in note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements.
Non-Cash Compensation
Restricted Stock
During 2002 and 2001, we made certain grants (primarily of restricted common shares) to employees and to Robert Clements, chairman of our board of directors, under our stock incentive plans and other arrangements. These grants were made primarily in connection with our underwriting initiative. After-tax non-cash compensation expense included in net income for the year ended December 31, 2002 was $48.9 million, of which $39.5 million related to certain restricted common shares for which the vesting terms had been accelerated during 2002, as discussed below.
During 2002, our board of directors accelerated the vesting terms of certain restricted common shares granted to Mr. Clements, which had been issued in connection with the November 2001 capital infusion, and Mr. Clements agreed to repay the outstanding $13.5 million loan previously made to him
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by us. Mr. Clements was granted 1,689,629 restricted common shares which were initially scheduled to vest in five equal annual amounts commencing on October 23, 2002. The vesting period and the amounts have been changed as follows: 60% of the shares vested on October 23, 2002 and the balance of the shares will vest in two equal annual amounts on October 23, 2003 and October 23, 2004.
The $13.5 million loan made by us to Mr. Clements was used by him to pay income and self employment taxes. Under his retention agreement, Mr. Clements received additional compensation in cash in an amount sufficient to defray the loan's interest costs. In order to facilitate the repayment of the loan, we agreed to repurchase an amount of Mr. Clements' shares equal to the principal balance of the loan, less any cash payment made by Mr. Clements, for a price per share based on the market price for the common shares as reported on the NASDAQ National Market on the date of sale. In addition, we agreed to make gross-up payments to Mr. Clements in the event of certain tax liabilities in connection with the repurchase. Pursuant to such arrangements, we repurchased 411,744 common shares from Mr. Clements for an aggregate purchase price of $11.5 million. Mr. Clements used all of such sale proceeds and $2.0 million in cash to repay the entire loan balance on November 12, 2002. Following such share repurchase, our book value per diluted share decreased by approximately $0.04 per share. During the loan period, compensation to Mr. Clements under his retention agreement included payments of $638,000 from us, of which $364,000 was used by him to pay interest on the loan and the balance was used to pay his related income tax liabilities.
Stock Options
As discussed above under the caption "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Stock Issued to Employees," we have elected to continue to account for stock-based compensation in accordance with APB No. 25 and have provided the required additional pro forma disclosures. Such pro forma information has been determined as if we had accounted for our employee stock options under the fair value method of SFAS No. 123. The fair value of employee stock options has been estimated at the date of grant using the Black-Scholes option valuation model. See note 2, "Significant Accounting Policies—Stock Options," of the notes accompanying our consolidated financial statements.
For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options' vesting period. The weighted average fair value of options granted during the years ended December 31, 2002, 2001 and 2000 was $13.4 million, $26.0 million and $0.9 million, respectively.
Our net income (loss) per share would have been adjusted to the pro forma amounts indicated below; however, the expensing of stock options would have had no impact on our shareholders' equity.
Years Ended December 31, 2002 2001 2000 (in thousands except share data) Net income (loss), as reported $ 58,982 $ 22,016 $ (8,012 ) Total stock-based employee compensation expense under fair value method, net of tax (13,451 ) (5,638 ) (1,890 ) Pro forma net income (loss) $ 45,531 $ 16,378 $ (9,902 ) Earnings (loss) per share—basic: As reported $ 2.93 $ 1.71 $ (0.61 ) Pro forma $ 2.27 $ 1.27 $ (0.75 ) Earnings (loss) per share—diluted: As reported $ 0.99 $ 1.29 $ (0.61 ) Pro forma $ 0.76 $ 0.96 $ (0.75 ) 58
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models, such as the Black-Scholes model, require the input of highly subjective assumptions, including expected stock price volatility. As our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, we believe that the existing option valuation models, such as the Black-Scholes model, may not necessarily provide a reliable single measure of the fair value of employee stock options. The effects of applying SFAS No. 123 as shown in the pro forma disclosures may not be representative of the effects on reported net income for future years.
Extraordinary Gain
On November 30, 2002, we acquired PSIC, a non-standard automobile insurer, for $2.5 million. For the year ended December 31, 2002, we recorded an extraordinary gain of $3.9 million, or $0.07 per share, from this acquisition. The extraordinary gain represented the excess of the fair value of acquired net assets of $6.4 million over the purchase price of $2.5 million. PSIC is included in our insurance segment.
Segment Information
We classify our businesses into two underwriting segments, reinsurance and insurance. SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. For a description of our underwriting segments, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements. Segment performance is evaluated primarily based on underwriting income or loss. Due to the significant changes in our business during the years 2002, 2001 and 2000, we believe that comparisons of the results of operations of our business segments are not relevant.
During the year ended December 31, 2001, we had only one reportable operating segment—insurance. During 2001, the insurance operating segment generated revenues of $59.9 million and net income of $12.4 million. The remaining portion of our net income was generated through our investment activities, offset by other operating expenses. In addition, during 2001 we produced our business through general agents and managing general agents, none of which accounted for more than 10% of total gross premiums written.
During the year ended December 31, 2000, due to the sale of our prior reinsurance operations to Folksamerica in May 2000, segment information is not meaningful.
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Reinsurance Segment
The following table sets forth our reinsurance segment's underwriting results for the year ended December 31, 2002:
(in thousands) Operating Information Gross premiums written $ 908,732 Net premiums written $ 882,700
Net premiums earned
$
500,980
Losses and loss adjustment expenses (315,766 ) Acquisition expenses (105,391 ) Operating expenses (18,849 ) GAAP underwriting income $ 60,974 Statutory Basis(1) Loss ratio 63.0 % Acquisition expense ratio 22.2 % Other operating expense ratio 3.4 % Combined ratio 88.6 % GAAP Basis(1) Loss ratio 63.0 % Acquisition expense ratio 21.0 % Other operating expense ratio 3.8 % Combined ratio 87.8 %
- (1)
- The loss ratios for statutory and GAAP are based on net premiums earned. The statutory expense ratios are based on net premiums written, while the GAAP expense ratios are based on net premiums earned.
Underwriting Gain. For the year ended December 31, 2002, the combined ratio on a GAAP basis for the reinsurance segment was 87.8%. The components of the reinsurance segment's underwriting gain are discussed below.
Premiums Written. Net premiums written for the year ended December 31, 2002 were $882.7 million. Of such amount, 59% of net premiums written were generated from pro rata contracts and 41% were derived from excess of loss treaties.
We are currently retaining substantially all of our reinsurance premiums written. We do, however, participate in "common account" retrocessional arrangements for certain treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurer, such as us, and the ceding company. We will continue to evaluate our retrocessional requirements.
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Set forth below is summary information regarding the reinsurance segment's net premiums written and earned by major line of business for the year ended December 31, 2002:
Net Premiums
Written% Of
TotalNet Premiums
Earned% Of
Total(in thousands) Major Line of Business: Casualty $ 245,236 27.8 % $ 94,290 18.8 % Other specialty 173,087 19.6 % 109,293 21.8 % Property excluding property catastrophe 166,344 18.8 % 87,907 17.5 % Property catastrophe 110,989 12.6 % 82,702 16.5 % Marine, aviation and space 60,383 6.8 % 30,127 6.0 % Non-traditional 109,978 12.5 % 82,425 16.5 % Casualty clash 16,683 1.9 % 14,236 2.9 % Total $ 882,700 100.0 % $ 500,980 100.0 % For information regarding net premiums written produced by geographic location for the reinsurance segment for 2002, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements.
Certain reinsurance contracts included in our non-traditional business are deemed, for financial reporting purposes, not to transfer insurance risk, and are accounted for using the deposit method of accounting. For those contracts that contain an element of underwriting risk, the expected estimated profit margin is deferred and amortized over the contract period and such amount is included in our underwriting results. We recorded $7.1 million on such contracts for the year ended December 31, 2002 in our underwriting results and, on a notional basis, the amount of premiums attaching to such contracts was $175.8 million. For those contracts that do not transfer an element of underwriting risk, the expected profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income. We did not record any contracts using the interest method for the year ended December 31, 2002.
The reinsurance segment commenced operations with the January 1, 2002 renewal season. As a result, premiums written for the segment reflect only new business. Given this fact and current market conditions, we currently anticipate significant premium growth in 2003, although no assurances can be given to that effect. The amount of premiums written with respect to our various lines of business may fluctuate from year-to-year based on many factors, including changing market conditions.
Net Premiums Earned. For 2002, approximately 56.8% of the reinsurance segment's net premiums written were earned. Due to the significant growth in premiums written during 2002, there is a significant difference between written and earned premiums for such year. Of net premiums earned in 2002, 45.8% were generated from pro rata contracts and 54.2% were derived from excess of loss treaties.
Losses and Loss Adjustment Expenses. Reinsurance segment losses and loss adjustment expenses incurred for the year ended December 31, 2002 were $315.8 million. The 63.0% loss ratio included 6.6 points of paid claims, 16.6 points related to case reserves and 39.8 points related to IBNR reserves. For a discussion of the reserves for losses and loss adjustment expenses, please refer to the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses."
Underwriting Expenses. For the year ended December 31, 2002, reinsurance segment acquisition expenses were 21.0% of net premiums earned. The acquisition expense ratio for 2002 was influenced by three factors: (1) our mix of excess of loss business compared to pro rata business, which is typically
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written at a higher expense ratio and lower loss ratio than excess of loss business; (2) the accrual of profit commissions based on the level of claims activity on certain non-traditional contracts during 2002, which increased acquisition expenses and decreased losses and loss adjustment expenses by an equivalent amount; and (3) the effect of a $2.5 million payment to terminate a non-competition covenant, as described in note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements. For the year ended December 31, 2002, other operating expenses were 3.8% of net premiums earned. Since the staffing and infrastructure building of the reinsurance segment has been substantially completed, the anticipated operating expense ratio for 2003 currently is expected to be stable, given current market conditions, although no assurances can be given to that effect.
Insurance Segment
The following table sets forth our insurance segment's underwriting results for the year ended December 31, 2002:
(in thousands) Operating Information Gross premiums written $ 578,480 Net premiums written $ 378,927
Net premiums earned
$
153,996
Policy-related fee income 9,418 Losses and loss adjustment expenses (108,772 ) Acquisition expenses (13,570 ) Operating expenses (42,827 ) GAAP underwriting loss $ (1,755 ) Statutory Basis(1) Loss ratio 70.6 % Acquisition expense ratio(2) 7.3 % Other operating expense ratio 16.1 % Combined ratio 94.0 % GAAP Basis(1) Loss ratio 70.6 % Acquisition expense ratio(2) 2.7 % Other operating expense ratio 27.8 % Combined ratio 101.1 %
- (1)
- The loss ratios for statutory and GAAP are based on net premiums earned. The statutory expense ratios are based on net premiums written, while the GAAP expense ratios are based on net premiums earned.
- (2)
- The acquisition expense ratio reflects acquisition expenses net of policy-related fee income.
Underwriting Loss. For the year ended December 31, 2002, the combined ratio on a GAAP basis for the insurance segment was 101.1%, which included 2.6 points related to development of prior year reserves in our non-standard automobile and program business. Our total combined statutory ratio for 2002 was 94.0%. In calculating expenses incurred under GAAP, only a portion of operating expenses are deferred. Accordingly, when premiums are growing rapidly, the GAAP expense ratio will be higher
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than the statutory expense ratio. With respect to businesses in a start-up phase, like us, the statutory expense ratio generally provides a more accurate indication of a company's cost of producing business. The components of the insurance segment's underwriting loss are discussed below.
Premiums Written. During 2002, our insurance segment began staffing its specialty operations and established new profit centers in various specialty lines, which significantly contributed to revenues in the latter half of the year. Accordingly, gross premiums written and net premiums written in 2002 increased significantly over 2001 levels to $578.5 million and $378.9 million, respectively. In addition, in our program business, we substantially reduced the amount of premiums ceded to unaffiliated reinsurers and added a significant number of new programs. We currently expect that premiums written in the insurance segment will continue to increase substantially in 2003, although no assurance can be given to that effect.
Set forth below is summary information regarding the insurance segment's net premiums written and earned by major line of business for the year ended December 31, 2002:
Net Premiums
Written% Of
TotalNet Premiums
Earned% Of
Total(in thousands) Major Line of Business: Casualty $ 95,419 25.2 % $ 26,069 16.9 % Programs 93,868 24.8 % 36,921 24.0 % Property 50,772 13.4 % 16,638 10.8 % Executive assurance 49,479 13.0 % 18,288 11.9 % Healthcare 23,624 6.2 % 5,263 3.4 % Professional liability 20,436 5.4 % 5,817 3.8 % Other 45,329 12.0 % 45,000 29.2 % Total $ 378,927 100.0 % $ 153,996 100.0 % For information regarding net premiums written produced by geographic location for the insurance segment for the year ended December 31, 2002, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements.
Net Premiums Earned. For 2002, approximately 40.6% of the insurance segment net premiums written were earned. Due to the significant growth in premiums written during 2002, there is a significant difference between written and earned premiums for such year.
Policy-Related Fee Income. Policy-related fee income, such as billing, cancellation and reinstatement fees, is primarily recognized as earned when substantially all of the related services have been provided. Policy-related fee income will vary in the future related to such activity and is earned primarily in our non-standard automobile business.
Losses and Loss Adjustment Expenses. Insurance segment losses and loss adjustment expenses incurred for 2002 were $108.8 million. The 70.6% loss ratio included 29.1 points of paid claims (of which 16.5 points were generated from our non-standard automobile business), 3 points related to case reserves and 38.5 points related to IBNR reserves. Our 2002 reported loss ratio reflects a 2.6 point, or $4 million, deficiency in our 2001 reported reserves. Approximately 49% of this deficiency occurred in a small number of program accounts written during 2000 and 2001 and the balance of 51% was in our non-standard automobile business as a result of an actuarial review performed in 2002. For a discussion of the reserves for losses and loss adjustment expenses, please refer to the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses."
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Underwriting Expenses. The acquisition expense ratio for our insurance segment of 2.7% was calculated net of certain policy-related fee income (which reduced the ratio by approximately 6 points), and was influenced by, among other things (1) the amount of business ceded to unaffiliated reinsurers and (2) the amount of business written on a surplus lines (non-admitted) basis. The combination of these two factors resulted in a significant reduction in our acquisition expense ratio for 2002. Other operating expenses for 2002 were 27.8% of net premiums earned, and reflected the start-up nature of the insurance segment. We currently expect that operating expenses will continue to increase as we continue to build our insurance group's infrastructure. However, as a percentage of net premiums earned, operating expenses are currently expected to decline in 2003 since net premiums earned are expected to grow significantly, although no assurances can be given to that effect.
In building our insurance segment's infrastructure, we capitalized certain software development costs. At December 31, 2002, approximately $8.6 million of such costs were capitalized and will be amortized over the software's useful life.
Liquidity and Capital Resources
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, we depend on our available cash resources, liquid investments and dividends or other distributions from our subsidiaries to make payments, including the payment of operating expenses we may incur and for any dividends our board of directors may
determine, and we may need to utilize 52funds from such sources in connection with acquisitions.determine. ACGL does not currently intend to declare anydividends or make any other distributions. The ability of our regulated insurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. Prior approval of the Bermuda Supervisor of Insurance is required if any dividend payments or other distributions of Arch Re (Bermuda) would reduce its total statutory capital by 15% or more. At December 31, 2001, Arch Re (Bermuda) had statutory capital of $508 million. As of December 31, 2001 our U.S. insurance and reinsurance subsidiaries may not pay any significant dividends or distributions during 2002 without prior regulatory approval. In addition, the ability of our insurance subsidiaries to pay dividends could be constrained by our dependence on financial strength ratings from independent rating agencies. Our ratings from these rating agencies depend to a large extent on the capitalization levels of our insurance subsidiaries.dividends.Pursuant to a shareholders agreement that we entered into in connection with the November 2001 capital infusion, we have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of our preference shares, pro rata, on the basis of the amount of each of these shareholders' investment in us at the time of such repurchase, preference shares having an aggregate value of $250.0 million, at a per share price acceptable to these shareholders.
Our new underwriting initiativeDuring 2002, ACGL contributed its ownership interest in Arch-U.S. and
related capital infusion are designed to position us to address current and anticipated future needs for capacity intheglobal insurance marketplace. During the fourth quarter of 2001, we expanded our underwriting activities, initially with a primary focus on reinsurance, and we intend to continue to expand significantly ourU.S. insurance and reinsuranceunderwriting activitiesgroup to Arch Re Bermuda, which increased Arch Re Bermuda's surplus to approximately $1.2 billion as of December 31, 2002. In addition, our U.S. group was restructured in April 2002 such that Arch Re U.S. has become thefuture. Ourparent of our principal U.S. insurance subsidiaries, Arch Insurance, Arch Specialty and Arch E&S. At December 31, 2002, Arch Re U.S.'s statutory capital and surplus was approximately $359 million. On a consolidated basis, our aggregate invested assets, including cash and short-term investments, totaled$1.0approximately $2.0 billion at December 31,2001, compared to $276.1 million at December 31, 2000. The increase in cash and invested assets from 2000 to 2001 resulted primarily from the receipt of the proceeds from the capital infusion in November 2001.2002. As ofDecember 31, 2001, oursuch date, and following such restructurings, ACGL's readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled$108.5$8 million.Such amount consisted of $26.4 million of cash and short-term investments and $82.1 million of fixed maturity investments. As of that date, investments that are restricted or generally unavailable for liquidity purposes (other than our ownership interests in our subsidiaries and the invested assetsThe ability of our regulated insurance
subsidiaries) included $35.4 millionand reinsurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Arch Re Bermuda is required to maintain a minimum solvency margin (i.e., the amount by which the value ofprivately held securitiesits general business assets must exceed its general business liabilities) equal to the greatest of (1) $100,000,000, (2) 50% of net premiums written (being gross premiums written by us less any premiums ceded by us, but we may not deduct more than 25% of gross premiums when computing net premiums written) and$22.2 million(3) 15% offixed maturity investments heldloss and other insurance reserves. Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial year if it is not inescrowcompliance with its minimum solvency margin. In addition, Arch Re Bermuda is prohibited from declaring or paying inconnectionany financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year's statutory balance sheet) unless it files, at least seven days before payment of64
such dividends, with the
saleBermuda Monetary Authority an affidavit stating that it will continue to meet the required margins. In addition, Arch Re Bermuda is prohibited, without prior approval of the Bermuda Monetary Authority, from reducing by 15% or more its total statutory capital, as set out in its previous year's financial statements. At December 31, 2002, Arch Re Bermuda had statutory capital and surplus as determined under Bermuda law of $1.2 billion (including ownership interests in its wholly owned subsidiaries). Accordingly, as of December 31, 2002, 15% of Arch Re Bermuda's capital, or approximately $179 million, is available for dividends without prior approval under Bermuda law, as discussed above. As of December 31, 2002, our U.S. insurance and reinsurance subsidiaries, on a consolidated basis, may not pay any significant dividends or distributions during 2003 without prior regulatory approval. In addition, the ability of ourpriorinsurance and reinsuranceoperationssubsidiaries toFolksamericapay dividends could be constrained by our dependence on financial strength ratings from independent rating agencies. Our ratings from these agencies depend to a large extent on the capitalization levels of our insurance and reinsurance subsidiaries.ACGL, through its subsidiaries, provides financial support to certain of its insurance subsidiaries and affiliates, through certain reinsurance arrangements essential to the ratings of such subsidiaries. Except as described in
May 2000. In addition, at December 31, 2001, we had investmentthe preceding sentence, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of ACGL's subsidiaries or affiliates is solely responsible for its own liabilities and commitmentsrelating to our privately held investment, Distribution Investors, LLC,(and no other ACGL subsidiary or affiliate is so responsible). Any reinsurance arrangements, guarantees or other financial support contractual arrangements that are in place are solely for the benefit ofapproximately $0.6 million. In connection withthecapital infusionACGL subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements.Cash flow from operating activities on
November 20, 2001, we were released from our obligations to make any further capital contributions to Trident II, other than with respect to outstanding capital calls of approximately $6.5 million, which we funded in November 2001. Cash flowsa consolidated basis are provided by premiums collected, fee income, investment income(excluding net realized investment gains)and collected reinsurancereceivable balances,recoverables, offset by losses and loss adjustment expense payments, reinsurance premiums payableloss and loss expense paymentsand operating costs. Consolidated cashflowsprovided by (used for) operating activities for the years ended December 31, 2002 and 20012000was approximately $669.1 million and1999 were approximately($5.6) million,$2.6 million and $7.5 million,respectively.The decline in cash flow in 2001 was primarily due to an increase in reinsurance recoverables at American Independent, and start-up costs related to the new underwriting initiative. 53Our expanded underwriting activities will initially be supported by our capital, and we expect that our other operational needs for the foreseeable future will be met by our balance of cash and short-term investments, as well as by funds generated from
premiumsunderwriting activities and investment income and proceeds on the sale or maturity of our investments. We have an effective shelf registration statement with the Securities and Exchange Commission. It permits us to issue various types of securities, including unsecured debt securities, preference shares and common shares, from time to time, up to an aggregate of $500 million.CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS Set forth below,During April 2002, we issued 7,475,000 of our common shares and received net proceeds of approximately $179 million, net of transaction costs. The net proceeds of the offering were principally used to increase the surplus of our insurance and reinsurance subsidiaries. The unused portion of our shelf registration is approximately $309 million following the offering intabular form, is information asApril 2002. Any additional issuance of common shares by us could have the effect of diluting our earnings per share and our book value per share.From August to September 2002, an aggregate of 3,748,946 common shares were issued upon the exercise of all 3,842,450 outstanding class A warrants, which were exercisable for $20.00 per share and were scheduled to expire on September 19, 2002. The proceeds from the exercise of class A warrants on a cash basis increased shareholders' equity by approximately $74.3 million. In October 2002, ACGL contributed such proceeds to Arch Re Bermuda.
At December 31, 2002 and December 31, 2001, our consolidated shareholders' equity was approximately $1.4 billion and $1.0 billion, respectively. The substantial increase in consolidated shareholders' equity was primarily attributable to the effects of (1) operating income for the
periods indicated below concerningyear ended December 31, 2002, (2) proceeds received by us from the issuance of common shares in the stock65
offering in April 2002 and the exercise of class A warrants in September 2002 and (3) an increase in unrealized appreciation of investments.
Certain Matters Which May Materially Affect Our Results of Operations and/or Financial Condition
Reserves for Losses and Loss Adjustment Expenses
We establish reserves for losses and loss adjustment expenses which represent estimates involving actuarial and statistical projections, at a given point in time, of our
obligationsexpectations of the ultimate settlement andcommitmentsadministration costs of losses incurred. Estimating loss reserves is inherently difficult, which is exacerbated by the fact that we are a new company with relatively no historical experience upon which tomake future payments under long-term obligations: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 appropriate loss reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. See the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses."
Reinsurance Protection and Recoverables
For purposes of limiting our risk of loss, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. For the year ended December 31, 2002, ceded premiums written represented approximately 15% of gross premiums written. In our insurance segment, we retained a greater amount of premiums written in our program business in 2002 as compared to 2001 as a result of the new underwriting initiative and our improved financial position. The development of loss reserves, on a gross basis, from 2001 and prior years in our program business in the amount of $58 million substantially increased our amounts recoverable from reinsurers in 2002.
The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Currently, the market for these arrangements is experiencing high demand for various products and it is not certain that we will be able to obtain adequate protection at cost effective levels. As a result of such market conditions and other factors, we may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements. Further, we are subject to credit risk with respect to our reinsurers and retrocessionaires because the ceding of risk to reinsurers and retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our existing reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect our financial condition and results of operations.
We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. At December 31, 2002, approximately 81% of our reinsurance recoverables on paid and unpaid losses of $225.6 million (not including prepaid reinsurance premiums) were due from carriers which had an A.M. Best rating of "A-" or better. We had no amounts recoverable on unpaid losses from a single entity or group of entities that exceeded 5% of our total shareholders' equity.
66
The following table details our reinsurance recoverables at December 31, 2002:
CONTRACTUAL OBLIGATIONS ----------------------- LESS THAN MORE THAN TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS 5 YEARS -------- --------- ----------- --------- --------- (IN THOUSANDS)Operating Leases........................... $5,081 $1,213 $2,751 $1,117 -- ====== ====== ====== ====== ======% Of Total Best
A.M.
Rating(1)Sentry Insurance a Mutual Company(2) 16.7 % A+ Lloyd's of London syndicates(3) 12.3 % A- Hartford Fire Insurance Company 8.0 % A+ Swiss Reinsurance America Corporation 6.4 % A++ Folksamerica Reinsurance Company 6.4 % A- Alternative market recoverables(4) 5.2 % NR GMAC Insurance Group 4.8 % A+ Odyssey Reinsurance Corporation 4.0 % A GE Reinsurance Corporation 3.9 % A+ AXA Corporate Solutions Reinsurance Company 3.2 % B St. Paul Fire & Marine Insurance Company 3.1 % A Gerling Global Reinsurance Corporation of America 2.4 % NR PMA Capital Insurance Company 2.4 % A- Lumbermens Mutual Casualty Company 1.7 % B Trenwick America Reinsurance Corporation 0.2 % C Commercial Risk Re-insurance Company 0.1 % B++ All other(5) 19.2 % Total 100.0 % We
- (1)
- The financial strength ratings are as of March 25, 2003 and were assigned by A.M. Best based on its opinion of the insurer's financial strength as of such date. An explanation of the ratings listed in the table follows: ratings of "A++" and "A+" are designated "Superior"; the "A" and "A-" ratings are designated "Excellent"; the "B++" rating is designated "Very Good"; the "B" rating is designated "Fair"; and the "C" rating is designated "Weak". Additionally, A.M. Best has five classifications within the "Not Rated" or "NR" category. Reasons for an "NR" rating being assigned by A.M. Best include insufficient data, size or operating experience, companies which are in run-off with no active business writings or dormant, companies which disagree with their rating and request that a rating not be published or insurers that request not to be formally evaluated for the
processpurposes ofputtingassigning a rating opinion.- (2)
- In connection with our acquisition of Arch Specialty in
placeFebruary 2002, the seller, Sentry Insurance a Mutual Company ("Sentry"), agreed to reinsure or otherwise assume all liabilities arising out of Arch Specialty's business prior to the closing of the acquisition. The balance due from Sentry includes all such amounts.- (3)
- The A.M. Best group rating of "A-" (Excellent) has been applied to all Lloyd's of London syndicates.
- (4)
- Includes amounts recoverable from separate cell accounts in our alternative markets unit. Approximately 85% of such amounts are collateralized with letters of credit or deposit funds.
- (5)
- The following table provides a breakdown of the "All other" category by A.M. Best rating:
% Of Total Companies rated A- or better 12.9 % Companies not rated 6.3 % Total 19.2 % 67
Natural and Man-Made Catastrophic Events
We have large aggregate exposures to natural and man-made catastrophic events. Catastrophes can be caused by various events, including, but not limited to, hurricanes, floods, windstorms, earthquakes, hailstorms, explosions, and severe winter weather and fires. Catastrophes can also cause losses in non-property lines of business such as workers' compensation or general liability. In addition to the nature of property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration tend to generally increase the size of losses from catastrophic events over time.
We have substantial exposure to unexpected, large losses resulting from future man-made catastrophic events, such as acts of war, acts of terrorism and political instability. These risks are inherently unpredictable and recent events may lead to increased frequency and severity of losses. It is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. It is not possible to eliminate completely our exposure to unforecasted or unpredictable events and, to the extent that losses from such risks occur, our financial condition and results of operations could be materially adversely affected. Therefore, claims for natural and man-made catastrophic events could expose us to large losses and cause substantial volatility in our results of operations, which could cause the value of our common shares to fluctuate widely.
In certain instances, we specifically insure and reinsure risks resulting from terrorism. Even in cases where we attempt to exclude losses from terrorism and certain other similar risks from some coverages written by us, we may not be successful in doing so. Moreover, irrespective of the clarity and inclusiveness of policy language, there can be no assurance that a result-oriented court or arbitration panel favoring the insured or ceding company will enforce the language as written; such a tribunal may adopt a strained interpretation of the policy language, invoke public policy to limit enforceability of policy language, ignore policy language, make factual findings unwarranted by the evidence or otherwise seek to justify a ruling adverse to us.
For our catastrophe exposed business, we seek to limit the amount of exposure we will assume from any one insured or reinsured and the amount of the exposure to catastrophe losses in any geographic zone. We monitor our exposure to catastrophic events, including earthquake, wind and specific terrorism exposures, and periodically reevaluate the estimated probable maximum pre-tax loss for such exposures. Our estimated probable maximum pre-tax loss is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. We seek to limit the probable maximum pre-tax loss to a percentage of our total shareholders' equity for severe catastrophic events. Currently, we generally seek to limit the probable maximum pre-tax loss to approximately 25% of total shareholders' equity for severe catastrophic events that could be expected to occur once in every 250 years. There can be no assurances that we will not suffer pre-tax losses greater than 25% of our total shareholders' equity from a catastrophic event 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 in the data provided by clients and brokers, the modeling techniques and the application of such techniques. In addition, depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to limit the probable maximum pre-tax loss to a higher percentage of our total shareholders' equity for our catastrophe exposed business.
For 2003 exposures, our insurance operations have entered into a reinsurance treaty which provides coverage for catastrophe-related losses equal to 95% of the first $70 million in excess of a $50 million retention of such losses. In the future, we may seek to purchase additional catastrophe or other reinsurance protection. The availability and cost of such reinsurance protection is subject to market conditions, which are beyond our control. As a result of market conditions and other factors,
68
we may not be successful in obtaining such protection. See "—Reinsurance Protection and Recoverables" above.
Foreign Currency Exchange Rate Fluctuation
We write business on a worldwide basis, and our results of operations may be affected by fluctuations in the value of currencies other than the U.S. dollar. Changes in foreign currency exchange rates can reduce our revenues and increase our liabilities and costs, as measured in the U.S. dollar as our functional currency. We have not attempted and currently do not expect to attempt to reduce our exposure to these exchange rate risks by using hedging transactions or by investing in securities denominated in local (foreign) currencies. We may therefore suffer losses solely as a result of exchange rate fluctuations.
Management and Operations
As a relatively new insurance and reinsurance company, our success will depend on our ability to integrate new management and operating personnel and to establish and maintain operating procedures and internal controls (including the timely and successful implementation of our information technology initiatives) to effectively support our business and our regulatory and reporting requirements, and no assurances can be given as to the success of these endeavors.
Shareholders Agreement
The Warburg Pincus funds and the Hellman & Friedman funds together control a majority of our voting power on a fully-diluted basis and have the right to nominate a majority of directors to our board under the shareholders agreement entered into in connection with the November 2001 capital infusion. The shareholders agreement also provides that we cannot engage in certain transactions, including mergers and acquisitions and transactions in excess of certain amounts, without the consent of a designee of the Warburg Pincus funds and a designee of the Hellman & Friedman funds. These provisions could have an effect on the operation of our business and, to the extent these provisions discourage takeover attempts, they could deprive our shareholders of opportunities to realize takeover premiums for their shares or could depress the market price of our common shares. By reason of their ownership and the shareholders agreement, the Warburg Pincus funds and the Hellman & Friedman funds are able to strongly influence or effectively control actions to be taken by us. The interests of these shareholders may differ materially from the interests of the holders of our common shares, and these shareholders could take actions that are not in the interests of the holders of our common shares.
Contingencies Relating to the Sale of Prior Reinsurance Operations
See note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements.
Industry and Ratings
We operate in a highly competitive environment, and since the September 11, 2001 events, new capital has entered the market. These factors may mitigate the benefits that the financial markets may perceive for the property and casualty insurance industry, and we cannot offer any assurances that we will be able to compete successfully in our industry or that the intensity of competition in our industry will not erode profitability for insurance and reinsurance companies generally, including us. In addition, we can offer no assurances that we will participate at all or to the same extent as more established or other companies in any price increases or increased profitability in our industry. If we do not share in such price increases or increased profitability, our financial condition and results of operations could be materially adversely affected.
69
Financial strength and claims paying ratings from third party rating agencies are instrumental in establishing the competitive positions of companies in our industry. Periodically, rating agencies evaluate us to confirm that we continue to meet their criteria for the ratings assigned to us by them. Our reinsurance subsidiaries, Arch Re U.S. and Arch Re Bermuda, and our insurance subsidiaries, Arch Insurance, Arch Specialty and Arch E&S, each currently have financial strength ratings of "A-" (Excellent) from A.M. Best. With respect to our non-standard automobile insurers, American Independent has a financial strength rating of "C++" (Marginal) from A.M. Best, and PSIC has a financial strength rating of "A-" (Excellent) from A.M. Best. We do not believe that American Independent or PSIC's non-standard automobile business are particularly ratings sensitive because their insureds purchase insurance primarily to satisfy state and local insurance and financial responsibility requirements.
Recently, rating agencies have been coming under increasing pressure as a result of high-profile corporate bankruptcies and may, as a result, increase their scrutiny of rated companies, revise their rating policies or take other action. We can offer no assurances that our ratings will remain at their current levels. A ratings downgrade, or the potential for such a downgrade, could adversely affect both our relationships with agents, brokers, wholesalers and other distributors of our existing products and services and new sales of our products and services.
Contractual Obligations and Commercial Commitments
At December 31, 2002, the future minimum rental commitments, exclusive of escalation clauses and maintenance costs and net of rental income, for all of our operating leases with remaining non-cancelable terms in excess of one year are as follows:
(in thousands) 2003 $ 5,983 2004 6,329 2005 5,965 2006 5,754 2007 5,079 Thereafter 18,756 $ 47,866 All of these leases are for the rental of office space, with expiration terms that range from 2004 to 2012. Rental expense (income), net of income from subleases, was approximately $3.2 million, ($132,000) and $190,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
In April 2002, we established a letter of credit facility for up to $200 million.
We expect that this facility will have a one-year term.The principal purpose of this facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements. Such letters of credit when issuedwill beare secured by afirst priority, perfected security interestportion of our investment portfolio. In addition, the letter of credit facility also requires the maintenance of certain financial covenants, which we were ininvestment securities. Any issuedcompliance with at December 31, 2002. At such date, we had approximately $77.6 million in outstanding letters of creditwill expire 364 days fromwhich were secured by investments totaling $89.2 million. In addition to letters of credit, we have and may establish insurance trust accounts in thedateU.S. and Canada to secure our reinsurance amounts payable as required.This bank facility expires April 16, 2003. It is anticipated that the letter of
issuance. We have agreed to make a non-recourse loan of up to $13.5 million to our Chairman, whichcredit facility will beusedrenewed on expiry, but such renewals are subject topay incomethe availability of credit from banks which we utilize. In the event such support is insufficient, we could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by our investment portfolio70
or funds withheld using our cash resources. The amount of letters of credit issued is driven by, among other things, the timing and
self-employment taxes, payablepayment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. If we are unable to post security inApril 2002, on restricted shares granted to him on October 23, 2001. See Note 9, "Commitments,"the form ofthe notes accompanyingletters of credit or trust funds when required, ourfinancial statements. INVESTMENTSoperations could be significantly and negatively affected.Investments
At December 31,
2001,2002, consolidated cash and invested assets totaled approximately$1.0$2.0 billion, consisting of$486.8$572.2 million of cash and short-term investments,$468.3 million$1.4 billion of publicly traded fixed maturityinvestments, $22.2 million of short-term investments held in escrow, $41.6securities and $31.5 million of privately held securities. At December 31, 2002, our fixed income portfolio, which includes fixed maturity securities and$0.2 millionshort-term investments, had an average Standard & Poor's quality rating ofpublicly traded equity securities. Investments included"AA-" and an average duration of 2.1 years. Our fixed income investment portfolio is currently managed by external investment advisors under our direction in accordance with investment guidelines provided by us. Our current guidelines stress preservation of capital, market liquidity and diversification of risk. At December 31, 2002, there were no securities in ourprivateinvestment portfolioincludewhich had market values below their cost basis for a period longer than six months.The following table reconciles the estimated fair value and carrying value of our fixed maturity securities and equity securities to amortized cost at December 31, 2002:
Estimated
Fair Value and
Carrying ValueGross
Unrealized
GainsGross
Unrealized
(Losses)Amortized
Cost(in thousands) Fixed maturities: U.S. government and government agencies $ 179,322 $ 5,242 $ (4 ) $ 174,084 Corporate bonds 949,003 33,305 (708 ) 916,406 Mortgage and asset backed securities 253,779 9,632 — 244,147 1,382,104 48,179 (712 ) 1,334,637
Equity securities:
Privately held 31,536 232 (326 ) 31,630 Total $ 1,413,640 $ 48,411 $ (1,038 ) $ 1,366,267 The following table presents the Standard & Poor's credit quality distribution of our fixed maturity securities at December 31, 2002:
Estimated
Fair Value and
Carrying Value% of Total (in thousands) Fixed Maturities: AAA $ 464,494 33.6 % AA 98,511 7.1 % A 503,198 36.4 % BBB 315,901 22.9 % Total $ 1,382,104 100.0 % 71
As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. Our investment portfolio is currently managed on a total return basis. The total return approach may result in realized gains or losses in any given period as the portfolio is adjusted to reflect perceived changes in relative value.
Our privately held equity securities consist of securities issued by privately held companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies.
Lack of a secondary market and resale restrictions may result in an inability by us to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security we seek to sell.At December 31,2001,2002, our private equity portfolio consisted ofeightsix investments totaling $31.5 million in fair value, with additional investment portfolio commitments in an aggregate amount of approximately$3.7$0.4 million. We do not currently intend to make any significant investments in privately held securities over and above our current commitments. SeeNote 4,note 6, "Investment Information," of the notes accompanying our consolidated financial statements.At December 31, 2001, almost all of our fixed maturity and short-term investments were rated investment grade by Moody's or Standard & Poor's and had an average Standard & Poor's quality rating of "AA-" and an average duration of approximately 1.9 years. 54We have not invested in derivative financial instruments such as futures, forward contracts, swaps or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. Our portfolio includes
market sensitive instruments, such asmortgage-backed securities whichare subject to prepayment risk and changes in market value in connection with changes in interest rates.contain embedded options. Our investments in mortgage-backed securities, which amounted to approximately$91.1$253.8 million at December 31,2001,2002, or8.9%12.7% of cash and invested assets, are classified as available for sale and are not held for trading purposes.RESULTS OF OPERATIONS Comparisons of our 2001 and 2000 results of operationsBook Value Per Share
Our diluted per share book value at December 31, 2002 increased to
each other and to prior year periods are not relevant due to the changes in our business during 2000 and 2001, including (1) the sale of our prior reinsurance operations in May 2000, (2) our change of legal domicile and reorganization completed in November 2000, (3) our recent acquisition activity, (4) our new underwriting initiative and (5) the capital infusion. In addition, because of these factors, as well as the other factors noted in "Cautionary Note Regarding Forward-Looking Statements," our historical financial results do not provide you with a meaningful measure of our future results. We have attempted to describe certain of these potential changes below. Statement of Financial Accounting Standards No. 131 requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. At$21.20 from $18.28 at December 31, 2001,our primary operating segment was insurance. Inas adjusted on a pro forma basis to give effect to the issuance during 2002we expect to operate in two different business segments, insurance and reinsurance. We had consolidated net income (loss)of$22.0 million, ($8.0) million and ($35.6) million for the years ended December 31, 2001, 2000 and 1999, respectively.additional preference shares, as described below. The increase innet income isdiluted book value per share was primarilya result ofattributable to the effects ofthe sale of our prior reinsurance operations in May 2000, the realignment of our investment portfolio in connection with the sale of our prior reinsurance operations (and the realization of gains thereon in connection therewith), and the reversal of a portion of the deferred tax valuation allowance, which was originally established as a result of that sale. Such reversal resulted primarily from the expected tax effects of the new underwriting initiative at our U.S.-based underwriting operations. Based on all information available to us to date, we believe that our insurance and reinsurance subsidiaries do not have any material exposures to the events of September 11, 2001. UNDERWRITING ACTIVITIES For(1) operating income for the year ended December 31,2001, premiums written, losses incurred2002, (2) an increase in unrealized appreciation of investments, (3) the issuance of 7,475,000 common shares in the stock offering completed in April 2002 andcommissions(4) the issuance of 3,748,946 common shares upon the exercise of 3,842,450 class A warrants in September 2002.The following book value per share calculations are based on shareholders' equity of approximately $1.4 billion and
brokerage resulted primarily from the acquisitions of American Independent and ART Services. The corresponding amounts for the years ended$1.0 billion at December 31,20002002 and 2001, respectively. Book value per share excludes the effects of stock options and class B warrants.
December 31, 2002 December 31, 2001 Common Shares
and Potential
Common SharesCumulative Book
Value Per ShareCommon Shares
and Potential
Common SharesCumulative Book
Value Per ShareCommon shares(1) 27,725,334 $ 21.48 13,513,538 $ 20.05 Series A convertible preference shares(2) 38,844,665 $ 21.20 39,394,665 $ 19.29 Dilutive class A warrants(3) — — 1,206,206 $ 18.86 Restricted common shares(4) — — 1,689,629 $ 18.28 Common shares and potential common shares 66,569,999 55,804,038
- (1)
- Book value per common share at December 31, 2002 and December 31,
1999 reflect2001 was determined by dividing (i) theresultsdifference between total shareholders' equity and the aggregate liquidation preference of the Series A convertible preference shares of $815.7 million and $749.4 million, respectively, by (ii) the number of common shares outstanding. Restricted common shares are72
included in the number of common shares outstanding as if such shares were issued on the date of grant.
- (2)
- Includes 35,687,735 preference shares that were issued on November 20, 2001 in exchange for $763.2 million of cash. The number of preference shares issued was based on the estimated per share price of $21.38. The estimated per share price was based on (i) total shareholders' equity as of June 30, 2001 (adjusted for certain amounts as described in the Subscription Agreement entered in connection with the capital infusion), divided by (ii) the total number of common shares outstanding as of June 30, 2001, which was 12,863,079. In addition, the amount of preference shares at December 31, 2002 includes an additional 3,706,930 preference shares issued pursuant to the Subscription Agreement as follows: (i) 875,753 preference shares were issued on June 28, 2002 pursuant to a post-closing purchase price adjustment mechanism under the Subscription Agreement; and (ii) 2,831,177 preference shares were issued on December 16, 2002 pursuant an agreed upon adjustment under the Subscription Agreement. We had agreed to issue to the new investors additional preference shares such that the per share price would be adjusted downward by $1.50 per preference share when the closing price of our common shares was at least $30 per share for at least 20 out of 30 consecutive trading days on or prior
reinsurance operationsto September 19, 2005, whichwere sold in May 2000. Approximately 55%condition was met on December 16, 2002. Each preference share is convertible at any time and from time to time at the option of the holder thereof into one fully paid and nonassessable common share, subject to possible adjustment. In addition, in December 2002, 550,000 preference shares were converted into an equal number of our common shares.- (3)
- Includes the net number of common shares that could be issued upon the assumed exercise of class A warrants calculated at December 31, 2001
net premiums writtenusing the treasury stock method. Class A warrants to purchase an aggregate of 5,401,707 common shares wereattributable to American Independent, and approximately 40% were attributable to ART Services. The remaining 5% was attributable to new business written by Arch Re (Bermuda) effectiveoutstanding as of December 31, 2001.We expectClass A warrants were exercisable at $20 per share and were scheduled to expire on September 19, 2002. During 2002, all 5,401,707 class A Warrants thatour new underwriting initiative and improving market conditions will produce very substantial growth in our direct, assumed and net premiums written in 2002. 55A summarywere outstanding as ofpremiums written is as follows:
YEAR ENDED DECEMBER 31, ------------------------------- 2001 2000 1999 -------- --------- -------- (IN MILLIONS)Direct premiums written.................................. $117.4 $ -- $ -- Assumed premiums written................................. 1.8 102.0 386.8 ------ ------ ------ Gross premiums written................................. 119.2 102.0 386.8 Ceded premiums written................................... (83.0) (19.7) (80.1) ------ ------ ------ Subtotal............................................... 36.2 82.3 306.7 Unearned premium portfolio transfer and assumption....... -- (92.9) -- ------ ------ ------ Net premiums written................................... $ 36.2 $(10.6) $306.7 ====== ====== ======REINSURANCE CEDED We follow the customary industry practice of reinsuring a portion of our exposures, paying to reinsurers and retrocessionaires a part of the premiums received on the policies we write. We monitor the financial condition of our reinsurers and retrocessionaires and attempt to place coverages only with substantial, financially sound carriers. During 2001, we ceded approximately two-thirds of our business written on a proportional basis in accordance with our then current business plan. Comparisons of premiums written between 2001 and 2000 are not meaningful because of the changes in our business discussed above. AtDecember 31, 2001substantially allwere exercised, which resulted in the issuance ofour reinsurance recoverables were due from carriers which had an A.M. Best rating4,195,554 common shares and the receipt by us of"A-" or better and we had no amounts recoverable from a single entity or group of entities that exceeded 5% of shareholders' equity. As a result ofcash proceeds totaling $74.3 million.- (4)
- Represents restricted common shares issued in connection with the
new underwriting initiative and our enhanced financial position, we expect to retain a significant amount of business written by American Independent and ART Services as well as premiums written by Arch Re (Bermuda) and Arch Re (US). In 2002, reinsurance may be purchased on both a facultative and treaty basis primarily to reduce net liability on individual risks and, if deemed necessary, to reduce our exposure to catastrophic losses. NET INVESTMENT INCOME At December 31,November 2001approximately 94% of our invested assets consisted of fixed maturity and short-term investments, exclusive of securities heldcapital infusion transaction. These restricted common shares are included inescrow, compared to 53%common shares at December 31,2000. Net investment income was approximately $12.1 million2002.Pursuant to the Subscription Agreement, a post-closing purchase price adjustment will be calculated in
2001, comparedNovember 2003 (or such earlier date as agreed upon by us and the investors) based on an adjustment basket. The adjustment basket will be equal to$15.9 million in 2000(1) the difference between value realized upon sale and$20.2 million in 1999. Such amounts for 2001, 2000 and 1999 are netthe GAAP book value at the closing ofinvestment expenses of $0.1 million, $0.9 million and $5.5 million, respectively. The investment expense amounts include investment advisory fees of $0.7 million, $0.8 million and $2.0 million, respectively. The 2001 and 2000 net investment expenses are offset by advisory fee income that we received from MMC Capital, Inc. in the amount of $1.25 million. The decrease in net investment income in 2001 compared with 2000 reflected primarily the decline in our average invested asset base resulting from the sale of our prior reinsurance operations. The impact was partially offset by investment income earned on the proceeds received fromthe capital infusion in November 2001as well as(as adjusted based on a pre-determined growth rate) of agreed upon non-core businesses; plus (2) theinclusiondifference between GAAP net book value of theresultsinsurance balances attributable to our core insurance operations with respect to any policy or contract written or having an effective date prior to November 20, 2001 at the time ofAmerican Independentthe final adjustment andART Services. The decreasethose balances at the closing; minus (3) reductions innet investment income in 2000 compared with 1999 primarily reflectedbook value arising from costs and expenses relating to thedecline intransaction provided under the Subscription Agreement, actual losses arising out of breach of representations under the Subscription Agreement and certain other costs and expenses. If the adjustment basket, which will be calculated by ouraverage invested asset base resulting fromindependent auditors, is less than zero, we will issue additional preference shares to thesale of our prior reinsurance operations, partially offset byinvestors based on the decrease ininvestment expenses described above and a higher interest rate environment. 56Our investment yields at amortized cost were as follows for the periods set forth below:
YEAR ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Investment yields: Pre-tax......................................... 5.2% 4.3% 3.6% Net of tax...................................... 4.6% 3.1% 2.7%Proceeds from the capital infusion were initially invested in short duration, high quality fixed maturities and short-term investments. Yields on future investment income may vary based on investment allocation decisions, economic conditions and other factors. Investment yields in 2000 and 1999 reflect a significant allocationvalue of thetotal investment portfolio in equity securities, which yield less current income than fixed maturity investments. At December 31, 2000 and 1999, public and private equity securities approximated 40% and 41%, respectively, of total cash and invested assets. Additionally such investment yields exclude the equity in net income or loss of private equity investments accounted for under the equity method of accounting. RESERVE FOR LOSS OF ESCROWED ASSETS In connection with the definitive settlement agreement reached with Folksamerica in February 2002 (as described above under "--General--May 2000 Sale of Our Prior Reinsurance Operations"), for 2001, we recorded an after-tax benefit of $0.4 million to reflect the net effects of this agreement. During 2000, our net loss included an after-tax charge of $9.8 million related to the escrowed assets. See Note 3, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations,"components of thenotes accompanying our consolidated financial statements. OTHER OPERATING EXPENSES Other operating expenses were $27.7 millionadjustment basket. If the adjustment basket is greater than zero, we are allowed to use cash in2001, compared to $6.9 million and $14.2 million for the years ended December 31, 2000 and 1999, respectively. The increase in operating expenses is primarily due to the 2001 acquisitions. In addition, during the fourth quarter of 2001, we incurred approximately $4.0 million of costs from the formation of our new reinsurance operations. We expect that we will incur a significantan amountof additional costs in 2002 in connection with the expected increase in our insurance and reinsurance operations. PROVISION FOR NON-CASH COMPENSATION During 2001, we made certain grants to new and existing employees under our stock incentive plans and other arrangements, resulting in pre-tax charges of $2.8 million. These grants were made primarily in connection with our new underwriting initiative, which resulted inbased on the increase innon-cash compensation in 2001. As a resultvalue of thenew initiative, we expectcomponents of the adjustment basket toreflectrepurchase common shares (other than any common shares issued upon conversion of the preference shares or exercise of the class A warrants). In addition, on the fourth anniversary of the closing, there will be asignificant increase in non-cash compensation in 2002. In 2000 and 1999, we made grants under our stock incentive plans and other arrangements that resulted in pre-tax chargescalculation of$1.1 million and $0.6 million, respectively. 57NET REALIZED GAINS (LOSSES) ON INVESTMENTS Our sources of net realized investment gains (losses) were as follows:
YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- -------- (IN THOUSANDS)Fixed maturities......................................... $(2,116) $(15,550) $(1,776) Publicly traded equity securities........................ 22,896 30,088 16,798 Privately held securities................................ (2,398) 177 2,205 ------- -------- ------- Subtotal............................................... 18,382 14,715 17,227 Loss on fixed maturities included in gain on sale of prior reinsurance operations........................... -- 5,330 -- ------- -------- ------- Net realized investment gains........................ 18,382 20,045 17,227 Income tax expense....................................... 7,242 7,408 6,029 ------- -------- ------- Net realized investment gains, net of tax............ $11,140 $ 12,637 $11,198 ======= ======== =======INCOME TAXES Under current Bermuda law, we are not obligateda further adjustment basket based on (1) liabilities owed topay any taxes in Bermuda based upon income or capital gains. We have received a written undertaking from the Minister of Finance in BermudaFolksamerica (if any) under theExempted Undertakings Tax Protection Act 1966 that,Asset Purchase Agreement, dated as of January 10, 2000, between us and Folksamerica, and (2) specified tax and ERISA matters73
under the Subscription Agreement. For a more detailed description of these adjustment provisions, see "Our Company—Risk Factors—Risks Relating to Our Company—We may be required to issue additional preference shares to the investors in the
event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on anyNovember 2001 capitalasset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to us or our operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda. ACGL and our Bermuda and other non-U.S. subsidiaries will be subject to U.S. federal income tax to the extent that they derive U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the United States and is not exempt from U.S. tax under an applicable income tax treaty with the United States. They will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors. In addition, Arch Re (Bermuda) will be subject to excise taxes on United States insurance and reinsurance premiums received by it. We do not consider ACGL or our Bermuda or other non-U.S. subsidiaries to be engaged in a trade or business within the United States and, consequently, do not expect them to be subject to direct U.S. income taxation. See "Risk Factors--Risks Relating to Taxation" and "Business--Tax Matters." Our U.S. subsidiaries will continue to be subject to U.S. income taxes on their worldwide income. Our 2001 income tax expense was $2.1 million, resulting in an effective tax rate of 9%. The effective tax rate was lower than the U.S. federal income tax rate of 35% primarilyinfusion as a result ofa reduction in the valuation allowance on certain deferred tax assets, which was slightly offset by foreign losses not subjectvarious purchase price adjustments agreed toU.S. tax. This reduction resulted primarily from the expected tax effects of the new underwriting initiative at our U.S.-based underwriting operations, which included an increase in our on-shore investment portfolio. Our 2000 income tax expense was $8.5 million, compared with an income tax benefit of $20.9 million in 1999. In 2000, income tax expense on our pre-tax net loss included a charge to establish a valuation allowance of $5.7 million that adjusted our deferred income tax asset to its estimated realizable value. Income tax expense for 2000 also included the write-off of certain deferred tax assets in the amount of $3.0 millionin connection with it, and the value of ourchangecommon shares may, therefore, be further diluted."Inflation
Our ultimate exposure for losses and loss adjustment expenses on claims not yet settled is increased by the effects of
legal domicileinflation, and changes in inflation therefore could be a significant factor in determining the appropriateness of our reserves for losses and loss adjustment expenses and our premium rates. Generally, our methods of calculating the reserves for losses and loss adjustment expenses and determining our premium rates take into account the anticipated effects of inflation. However, until claims are ultimately settled, the full effect of inflation on our results cannot be known.Market Sensitive Instruments and Risk Management
We are exposed to
Bermuda.potential loss from various market risks, including changes in equity prices, interest rates and foreign currency exchange rates.In
581999, Arch Re (US)'s underwriting results had significantly deteriorated, resulting inaccordance with the SEC's Financial Reporting Release No. 48, we performed apre-tax net losssensitivity analysis to determine the effects thatgenerated an income tax benefit formarket risk exposures could have on theyear. Atfuture earnings, fair values or cash flows of our financial instruments as of December 31,2001,2002. Market risk represents thenet deferred income tax asset was $13.7 million after reflecting a valuation allowancerisk of$9.6 million recorded to reduce the net deferred income tax asset to the amount that management expects to more likely than not be realized. This valuation allowance primarily relates to certain deferred income tax assets of ART Services, which was acquired during 2001, and also reflects the reductionchanges in thevaluation allowance recorded atfair value of a financial instrument and consists of several components, including liquidity, basis and price risks.The sensitivity analysis performed as of December 31,
2000 due to the expected tax effects of the new underwriting initiative, as discussed above. At December 31, 2000, we had a valuation allowance of $5.7 million that adjusted the net deferred income tax asset to its estimated realizable value of $8.2 million. At December 31, 1999, we did not have a valuation allowance because we believed at that time the entire deferred tax asset was realizable due to our ability to generate future taxable income. See "--Critical Accounting Policies, Estimates and Recent Accounting Pronouncements--Valuation Allowance." We have net operating loss carryforwards totaling $43.3 million at December 31, 2001. Such net operating losses are currently available to offset our future taxable income and expire between 2011 and 2021. We also have an alternative minimum tax credit carryforward in the amount of $1.0 million which can be carried forward without expiration. On November 20, 2001, we underwent an ownership change for U.S. federal income tax purposes as a result of the capital infusion. As a result of this ownership change, limitations are imposed upon the utilization of our existing net operating losses. Upon our change of legal domicile to Bermuda in November 2000, Arch Capital (US) distributed substantially all of its public equity portfolio to its Bermuda parent, ACGL, at the then current market values and realized gains for tax purposes of $21.0 million. The associated U.S. federal income tax expense of $7.4 million reduced our net operating loss carryforwards by a corresponding amount. However, for financial reporting purposes, since the securities had not been sold to an unrelated third party, the realized gain had been deferred and was reported as unrealized appreciation in our consolidated financial statements. Accordingly, the income tax expense was also deferred and reduced unrealized appreciation in the consolidated financial statements. In 2001, we divested of this public equity portfolio in its entirety and, accordingly, have recognized the U.S. federal income tax expense of $7.4 million in our consolidated financial statements for the year ended December 31, 2001. See Note 7, "Income Taxes," of the notes accompanying our consolidated financial statements. MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT The following analysis2002 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments whicharewere held by usas ofon December 31,20012002 and are sensitive to changes in interest rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future eventsorof losses.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.The focus of the SEC's market risk rules is on price risk. For purposes of specific risk analysis, we employ 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. The financial instruments included in the following sensitivity analysis consist of all of our cash and invested assets, excluding investments carried under the equity method of accounting.
59EQUITY PRICE RISK
Interest Rate Risk
The aggregate hypothetical loss generated from an immediate parallel, adverse shift in the treasury yield curve of 100 basis points would result in a decrease in market value of approximately $39.1 million on our fixed income portfolio, including short-term investments, as of December 31, 2002, and would decrease diluted book value per share by approximately $0.59 as of such date.
Equity Price Risk
We are exposed to equity price risks on the private equity securities included in our investment portfolio. All of our privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance
and reinsuranceindustry. We typically do not attempt to reduce or eliminate our market exposure on these securities. Investments included in our private portfolio include74
securities issued by privately held companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. Investments in privately held securities issued by privately held companies may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities). Our privately held equity securities, which at December 31,
20012002 were carried at a fair value of$41.6$31.5 million, have exposure to price risk. The estimated potential losses in fair value for our privately held equityportfoliosportfolio resulting from a hypothetical 10% decrease in quoted market prices, dealer quotes or fair value is$4.2 million. INTEREST RATE RISK The aggregate hypothetical loss generated from an immediate adverse shift in the treasury yield curve of 100 basis points would result in a decrease in total return of 1.9%, which would produce a decrease in market value of $8.6 million on our fixed maturity investment portfolio, valued at $468.3approximately $3.2 million at December 31,2001. There would be no material impact on our short-term investments. CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RECENT ACCOUNTING PRONOUNCEMENTS The preparation of consolidated financial statements requires us to make estimates2002.
Foreign Currency Exchange Risk
Foreign currency rate risk is the potential change in value, income, and
judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to insurance and other reserves, intangible assets, bad debts, income taxes, pensions, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparentcash flow arising fromother sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the following critical accounting policies affect our more significant judgments and estimates usedadverse changes inthe preparation of our consolidated financial statements. PREMIUM REVENUES AND RELATED EXPENSES Insurance premiums written are recorded in accordance with the termsforeign currency exchange rates. A 10% depreciation of theunderlying policies. Reinsurance premiums assumed are recognized as income on a straight line basis over the terms of the related reinsurance contracts. These amounts are based on reports received from ceding companies, supplemented by our own estimates of premiums for which ceding company reports have not been received. Subsequent differences arising on such estimates are recorded in the period they are determined. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of contracts in force. Certain of our contracts included provisions that adjusted premiums or acquisition costs based upon the experience under the contracts. Premiums written and earned as well as related acquisition expenses under those contracts are recorded based upon the expected ultimate experience under these contracts. 60Acquisition costs, which vary with and are primarily related to the acquisition of policies, consisting principally of commissions and brokerage expenses incurred at the time a contract is issued, are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are carried at their estimated realizable value based on the related unearned premiums and take into account anticipated losses and loss adjustment expenses, based on historical and current experience and anticipated investment income. LOSSES AND LOSS ADJUSTMENT EXPENSES Insurance reserves are inherently subject to uncertainty. Loss and loss adjustment expense reserves represent estimates involving actuarial and statistical projections at a given point in time of our expectations of the ultimate settlement and administration costs of claims incurred. We utilize actuarial models as well as historical insurance and reinsurance industry loss development patterns to assist in the establishment of appropriate claim reserves. In contrast to casualty claims, which frequently can be determined only through lengthy and unpredictable litigation, non-casualty property claims tend to be reported promptly and usually are settled within a shorter period of time. Nevertheless, for both casualty and property claims, actual losses and loss adjustment expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. For reinsurance assumed, such reserves are based on reports received from ceding companies, supplemented by our estimates of reserves for which ceding company reports have not been received, and our own historical experience. If our loss and loss adjustment expense reserves are determined to be inadequate, we will be required to increase the reserves with a corresponding reduction in net income in the period in which the deficiency is determined. It is possible that claims in respect of events that have occurred could exceed our reserves and have a material adverse effect on our results of operations in a particular period or our financial condition in general. Even though most insurance contracts have policy limits, the nature of property and casualty insurance and reinsurance is that losses can exceed policy limits for a variety of reasons and could very significantly exceed the premiums received on the underlying policies. We will attempt to limit our risk of loss through reinsurance and retrocessional arrangements. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. COLLECTION OF INSURANCE BALANCES We maintain allowances for doubtful accounts for probable losses resulting from our inability to collect premiums. In addition, we are subject to credit risk with respect to our reinsurance and retrocessions because the ceding of risk to reinsurers and retrocessionaires does not relieve us of our liability to the companies we reinsure. If the financial condition of our reinsurers or retrocessionaires were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. VALUATION ALLOWANCE We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and feasible tax planning strategies in assessing the need for a valuation allowance, in the event we were to determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. In addition, if we subsequently assessed that the valuation allowance was no longer needed, then a benefit would be recorded to income in the period such determination was made. 61INVESTMENTS We currently classify all of our publicly traded fixed maturity, short-term investments and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturity securities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. STOCK ISSUED TO EMPLOYEES We follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), and related interpretations in accounting for our employee stock options because the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation," requires use of option valuation models that were not developed for use in valuing employee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized by us to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date. In addition, under APB No. 25, we do not recognize compensation expense for stock issued to employeesU.S. dollar against other currencies under ourstock purchase plan. See Note 10, "Stock and Stock Option Plans," of the notes accompanying our financial statements. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, "Business Combinations." SFAS No. 141 requires, among other things, the purchase method of accounting to be applied for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. We do not expect the application of SFAS No. 141 to have a material impact on our financial position or results of operations. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets," which became effective for us on January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of the amortization of goodwill and the introduction of impairment testing in its place. In addition, SFAS No. 142 includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. Atoutstanding contracts at December 31,2001, we had goodwill2002 would have resulted in approximately $8.7 million ofapproximately $26.3 million. Pursuantunrealized losses. For further discussion on foreign exchange activity, please refer toSFAS No. 142, we will test our goodwill for impairment upon adoption and, if impairment is indicated, record such impairment as a cumulative effect of an accounting change. We have not yet developed an estimate of the impact of the adoption of SFAS No. 142 on our consolidated results of operations. We believe that the adoption of SFAS No. 142 will not have a material impact on our consolidated financial condition. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." SFAS No. 144 applies to all long-lived assets (including discontinued operations) and consequently amends portions of Accounting Principles Board Opinion No. 30, "Reporting"—Results ofOperations--Reporting the Effects of Disposal of a Segment of a Business." SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001, and we adopted it on January 1, 2002. We do not expect the application of SFAS No. 144 to have a material impact on our financial positionOperations—Net Foreign Exchange Gains orresults of operations. INFLATION Inflation may have an effect on us because inflationary factors can increase damage awards and potentially result in larger claims. Our underwriting philosophy is to adjust premiums in response to 62inflation, although this may not always be possible due to competitive pressure. Inflationary factors will be considered in determining the premium level on any multi-year policies at the time contracts are written.Losses."
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKPlease referReference 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--Market Sensitive Instruments and Risk Management.Operations," which information is hereby incorporated by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATASee our consolidated financial statements and notes thereto and required financial statement schedules on pages F-1 through
F-44F-43 and S-1 throughS-7.S-7 below.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURENone.
6375
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The
following individuals areinformation required by this item is incorporated by reference from the information to be included in ourdirectors and executive officers and other membersdefinitive proxy statement ("Proxy Statement") for our annual meeting ofsenior management:
NAME AGE POSITION - ---- -------- ------------------------------------------Robert Clements........................... 69 Chairman and Director of ACGL Peter A. Appel............................ 40 President, Chief Executive Officer and Director of ACGL Paul B. Ingrey............................ 62 Chief Executive Officer of Arch Re (Bermuda) and Director of ACGL Constantine Iordanou...................... 52 Chief Executive Officer of Arch Capital (US) and Director of ACGL John D. Vollaro........................... 57 Executive Vice President and Chief Financial Officer of ACGL John L. Bunce, Jr......................... 43 Director of ACGL Kewsong Lee............................... 36 Director of ACGL James J. Meenaghan........................ 63 Director of ACGL John M. Pasquesi.......................... 42 Executive Vice Chairman and Director of ACGL Robert F. Works........................... 54 Director of ACGL Dwight R. Evans........................... 49 President of Arch Re (Bermuda) Debra M. O'Connor......................... 42 Senior Vice President, Controller and Treasurer Louis T. Petrillo......................... 36 Senior Vice President, General Counsel and SecretaryROBERT CLEMENTS was elected chairman and director of ACGL at the time of our formationshareholders to be held inMarch 1995. From March 1996 to February 2001, he was an advisor to MMC Capital, with whom he served as chairman and chief executive officer from January 1994 to March 1996. Prior thereto, he served as president of Marsh & McLennan Companies, Inc. since 1992, having been vice chairman during 1991. He was chairman of J&H Marsh & McLennan, Incorporated (formerly Marsh & McLennan, Incorporated), a subsidiary of Marsh & McLennan Companies, Inc., from 1988 until March 1992. He joined Marsh & McLennan, Ltd., a Canadian subsidiary of Marsh & McLennan Companies, Inc., in 1959. Mr. Clements was a director of XL Capital from 1986 to 2002 and was formerly a director of Annuity and Life Re (Holdings), Ltd. and Stockton Reinsurance Limited and ACE Ltd. He is chairman emeritus of the board of overseers of the School of Risk Management, Insurance and Actuarial Science of St. John's University and a member of Rand Corp. President's Council. PETER A. APPEL has been president and chief executive officer of ACGL since May 5, 2000 and a director of ACGL since November 1999. He was executive vice president and chief operating officer of ACGL from November 1999 to May 5, 2000, and general counsel and secretary of ACGL from November 1995 to May 5, 2000. Mr. Appel previously served as a managing director of ACGL from November 1995 to November 1999. From September 1987 to November 1995, Mr. Appel practiced law with the New York firm of Willkie Farr & Gallagher, where he was a partner from January 1995. Mr. Appel is currently a member of the board of overseers and a member of the executive committee of the School of Risk Management, Insurance and Actuarial Science of St. John's University. 64PAUL B. INGREY has served as a director of ACGL and as chief executive officer of Arch Re (Bermuda) since October 2001. He was the founder of F&G Re Inc., a reinsurance subsidiary of USF&G Corporation, and served as its chairman and chief executive officer from 1983 to 1996. Prior to that, he was senior vice president of Prudential Reinsurance, an underwriter of property and casualty reinsurance. He has also served as a director of USF&G Corporation (until its sale to The St. Paul Companies, Inc. in 1978) and E.W. Blanch Holdings, Inc., the holding company for E.W. Blanch Co.,2003, whichprovides risk management and distribution services through several subsidiaries (until its sale to Benfield Greig, the London-based international reinsurance broker, in April 2001) and is currently on the board of Fairfax Financial Holdings Limited, an insurance and reinsurance company with a focus on property and casualty insurance. CONSTANTINE IORDANOU has served as a director of ACGL and as chief executive officer of Arch Capital (U.S.) Inc. since January 1, 2002. From March 1992 through December 2001, Mr. Iordanou served in various capacities for Zurich Financial Services and its affiliates, including as senior executive vice president of group operations and business development of Zurich Financial Services, president of Zurich-American Specialties Division, chief operating officer and chief executive officer of Zurich-American and chief executive officer of Zurich North America. Prior to joining Zurich, he served as president of the commercial casualty division of the Berkshire Hathaway Group and served as senior vice president with the American Home Insurance Company, a member of the American International Group. JOHN D. VOLLARO has been executive vice president and chief financial officer since January 2002. Prior to joining us, Mr. Vollaro acted as an independent consultant in the insurance industry since March 2000. Prior to March 2000, Mr. Vollaro was president and chief operating officer of W.R. Berkley Corporation from January 1996 and a director from September 1995 until March 2000. Mr. Vollaro was chief executive officer of Signet Star Holdings, Inc., a joint venture between W.R. Berkley Corporation and General Re Corporation, from July 1993 to December 1995. Mr. Vollaro served as executive vice president of W.R. Berkley Corporation from 1991 until 1993, chief financial officer and treasurer of W.R. Berkley Corporation from 1983 to 1993 and senior vice president of W.R. Berkley Corporation from 1983 to 1991. JOHN L. (JACK) BUNCE, JR. has served as director of ACGL since November 2001. Mr. Bunce has served as a managing director at Hellman & Friedman since 1988. Before joining Hellman & Friedman, Mr. Bunce was vice president of TA Associates. Previously, he was employed in the Mergers & Acquisitions and Corporate Finance Departments of Lehman Brothers Kuhn Loeb. He is currently also a director of Digitas, Inc., National Information Consortium, Inc., and Western Wireless Corporation. He has also served as a director of Duhamel Falcon Cable Mexico, Eller Media Company, Falcon Cable TV, National Radio Partners, VoiceStream Wireless Corporation, and Young & Rubicam, Inc. Mr. Bunce also was an advisor to American Capital Corporation and Post Oak Bank. KEWSONG LEE has served as a director of ACGL since October 2001. Mr. Lee has served as a member and managing director of Warburg Pincus LLC and a general partner of Warburg Pincus & Co. since January 1, 1997. He has been employed at Warburg Pincus since 1992. Prior to joining Warburg Pincus LLC, Mr. Lee was a consultant at McKinsey & Company, Inc., a management consulting company, from 1990 to 1992. His present service as a director includes membership on the boards of Knoll, Inc., Eagle Family Foods, Inc. and several privately held companies. JAMES J. MEENAGHAN has been a director of the Company since October 2001. From October 1986 to 1993, Mr. Meenaghan was chairman, president and chief executive officer of Home Insurance Companies. He also served as President and Chief Executive Officer of John F. Sullivan Co. from 1983 to 1986. Prior thereto, Mr. Meenaghan held various positions over 20 years with the Fireman's Fund Insurance Company, including President and Chief Operating Officer and Vice Chairman of its parent company, American Express Insurance Services Inc. JOHN M. PASQUESI has been our vice chairman and a director since November 2001. Mr. Pasquesi has been the managing member of Otter Capital LLC, a private equity investment firm founded by him in January 2001. Prior to January 2001, Mr. Pasquesi was a managing director of Hellman & Friedman LLC since 1988. 65ROBERT F. WORKS has been a Director of the Company since June 1999. Mr. Works was a Managing Director of Jones Lang LaSalle (previously LaSalle Partners) until he retired on December 31, 2001. He joined Jones Lang LaSalle in 1981, where he has served in various capacities, including manager of both the Property Management and Investment Management teams of the Eastern Region of the United States. Mr. Works was also manager for the Times Square Development Advisory and Chelsea Piers Lease Advisory on behalf of New York State and the President of GCT Ventures and the Revitalization of Grand Central Terminal for the Metropolitan Transportation Authority until he retired on December 31, 2001. DWIGHT R. EVANS has served as president of Arch Re (Bermuda) since October 2001. From 1998 until October 2001, Mr. Evans was executive vice president of St. Paul Re. From 1983 until 1998, Mr. Evans was employed as executive vice president for F&G Re Inc. Prior to that, Mr. Evans served as assistant vice president at Skandia Reinsurance Company and as a reinsurance underwriter at Prudential Reinsurance Company (now Everest Re Company). DEBRA M. O'CONNOR has been senior vice president, controller and treasurer of ACGL since June 9, 2000. From 1995 to June 9, 2000, Ms. O'Connor was senior vice president and controller of Arch Re (US). From 1986 until 1995, Ms. O'Connor served at NAC Re Corp. in various capacities, including vice president and controller. Prior to that, Ms. O'Connor was employed by General Re Corp. and the accounting firm of Coopers & Lybrand. Ms. O'Connor is a certified public accountant. LOUIS T. PETRILLO has been senior vice president, general counsel and secretary of ACGL since May 5, 2000. From 1996 until May 5, 2000, Mr. Petrillo was vice president and associate general counsel of ACGL's reinsurance subsidiary. Prior to that time, Mr. Petrillo practiced law at the New York firm of Willkie Farr & Gallagher. BOARD OF DIRECTORS COMPOSITION Pursuant to our shareholders agreement,wehave agreed to restrictions on the composition of our board of directors. Pursuant to this agreement, the Warburg Pincus funds and the Hellman & Friedman funds are entitled to nominate a prescribed number of directors based on the respective retained percentages of their preference shares purchased in November 2001. Currently, our board consists of nine members, including one director nominated by the Warburg Pincus funds and one director nominated by the Hellman & Friedman funds. Once we have received the remaining regulatory approvals required in connection with the capital infusion, the size of our board may be increased to up to 17 members. As long as the Warburg Pincus funds retain at least 75% of their original investment and Hellman & Friedman funds retain at least 60% of their original investment, these shareholders together will be entitled to nominate a majority of directors to our board. SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Securities Exchange Act of 1934 requires our directors and executive officers, and persons who own more than 10% of our common shares,intend to file with the SECinitial reports of beneficial ownership and reports of changes in beneficial ownership of our common shares. Such persons are also required by SEC regulation to furnish us with copies of all Section 16(a) reports they file. To our knowledge, based solely on a review of the copies of such reports furnished to us and representations that no other reports were required, we believe that all persons subject to the reporting requirements of Section 16(a) filed the required reports on a timely basis during the year ended December 31, 2001.before April 30, 2003.
ITEM 11. EXECUTIVE COMPENSATIONThe
following table sets forthinformationregarding compensation paidrequired by this item is incorporated by reference from the information toour executive officers for services rendered during fiscal years 2001, 2000 and 1999. 66SUMMARY COMPENSATION TABLE
LONG TERM COMPENSATION ---------------------------------- PAY- AWARD(S) OUTS ANNUAL COMPENSATION ----------------------- -------- ----------------------------------- RESTRICTED OTHER ANNUAL SHARE SECURITIES LTIP ALL OTHER NAME AND PRINCIPAL COMPENSATION AWARDS UNDERLYING PAYOUTS COMPENSATION POSITION YEAR SALARY($) BONUS($) ($) ($)(1) OPTIONS(#) ($) ($)(2) - ------------------ -------- --------- -------- ------------ ---------- ---------- -------- ------------Peter A. Appel............... 2001 375,000 -- -- 750,000 422,407 50,841 President, Chief Executive 2000 375,000 500,000 -- 756,250 100,000 -- 49,711(5) Officer and a Director of 1999 375,000 250,000 -- -- -- -- 51,339 ACGL Paul B. Ingrey............... 2001 143,200 -- -- 7,366,778 422,407 -- -- Chairman and Chief Executive Officer of Arch Reinsurance Ltd. and a Director of ACGL(3) Dwight R. Evans.............. 2001 95,500 -- -- 872,000 100,000 -- -- President of Arch Reinsurance Ltd.(3) Debra M. O'Connor............ 2001 188,300 175,000 -- -- 20,000 -- 21,170 Senior Vice President, 2000 170,000 118,000 -- -- 10,000 -- 19,800(5) Controller and Treasurer(4) Louis T. Petrillo............ 2001 206,200 400,000 -- 75,000 50,000 -- 21,116 Senior Vice President, 2000 174,000 120,000 -- -- 10,000 -- 19,932(5) General Counsel and Secretary(4)- -------------------------- (1) The value of each restricted share award is based upon the closing price of the common shares as reported on the Nasdaq National Market as of the grant date of such award. As of December 31, 2001, 422,407 unvested restricted shares, with a value of $10,876,980, were held by Mr. Ingrey. Subject to the applicable award agreement, such restricted shares will vest on October 23, 2004. An aggregate of 145,000 restricted shares vested to the named executive officers from 1996 through 2001. During the vesting period, cash dividends (if any) wouldbepaid on outstanding shares of restricted stock. Stock dividends issued with respect to such shares (if any) would be subject to the same restrictions and other terms and conditions that apply to restricted shares with respect to which such dividends are issued. (2) Includes: (1) matching contributions under an employee 401(k) planincluded in theamounts of (A) $7,650, $6,310 and $7,200 to Mr. Appel for 2001, 2000 and 1999, respectively; (B) $7,650 and $6,070 to Ms. O'Connor for 2001 and 2000, respectively; and (C) $7,650 and $6,310 to Mr. Petrillo for 2001 and 2000, respectively; (2) pension contributions under a money purchase pension plan in the amounts of (A) $12,980, $13,190 and $12,370 to Mr. Appel for 2001, 2000 and 1999, respectively; and (B) $12,980 and $13,190 to each of Ms. O'Connor and Mr. Petrillo, respectively, for 2001 and 2000; (3) contributions to Mr. Appel under an executive supplemental non-qualified savings and retirement plan in the amounts $29,725, $29,725 and $31,175 for 2001, 2000 and 1999, respectively; and (4) term life insurance premiums in the amounts of (A) $486, $486 and $594 to Mr. Appel for 2001, 2000 and 1999, respectively; (B) $540 to Ms. O'Connor for 2001 and 2000; and (C) $486 and $432 to Mr. Petrillo for 2001 and 2000, respectively. (3) Mr. Evans was appointed president of Arch Re (Bermuda), and Mr. Ingrey was appointed to the board of directors of AGCL and as chief executive officer of Arch Re (Bermuda) on October 23, 2001. See "--Employment Arrangements" for a description of their respective employment arrangements. (4) On June 9, 2000, Ms. O'Connor, formerly senior vice president and controller of the company's reinsurance subsidiary, became our senior vice president, controller and treasurer. On May 5, 2000, Mr. Petrillo, formerly vice president and associate general counsel of the company's reinsurance subsidiary, became our senior vice president, general counsel and secretary. (5) See "--Change in Control Arrangements" for a description of certain payments made upon the closing of the sale of our prior reinsurance operations on May 2000. The following table provides information regarding grants of stock options made during fiscal year 2001 to each of the named executive officers. 67OPTION GRANTS IN LAST FISCAL YEAR
INDIVIDUAL GRANTS --------------------------------------- NUMBER OF % OF TOTAL POTENTIAL REALIZABLE VALUE AT SECURITIES OPTIONS ASSUMED ANNUAL RATES OF UNDERLYING GRANTED TO STOCK PRICE APPRECIATION FOR OPTIONS EMPLOYEES IN EXERCISE OR OPTION TERM(3) GRANTED FISCAL BASE PRICE EXPIRATION ------------------------------ NAME (#)(1) YEAR(2) ($/SH) DATE 5% 10% - ---- ---------- ------------ ----------- ---------- ------------- --------------Peter A. Appel..................... 422,407 22.1% $20.00 10/23/11 $5,312,990 $13,464,159 Paul B. Ingrey..................... 422,407 22.1% 20.00 10/23/11 5,312,990 13,464,159 Dwight R. Evans.................... 100,000 5.2% 20.00 10/23/11 1,257,789 3,187,485 Debra M. O'Connor.................. 10,000 0.5% 20.00 15.00 10/23/11 125,779 318,748 10,000 0.5% 01/30/11 82,699 203,692 Louis T. Petrillo.................. 40,000 2.1% 20.00 10/23/11 503,116 1,274,994 10,000 0.5% 15.00 01/30/11 82,699 203,692- ------------------------ (1) The terms for the options, including vesting schedules, are described below under the caption "Incentive Compensation for Management and Directors." (2) Pursuant to applicable SEC rules, percentages listed are based on options to purchase a total of 1,915,690 common shares granted to employees during fiscal year 2001. (3) Potential realizable value is calculated based on an assumption that the fair market value of our common shares appreciates at the annual rates shown (5% and 10%), compounded annually, from the date of grant until the end of the option term. The 5% and 10% assumed rates are mandated by the SEC for purposes of calculating realizable value and do not represent our estimates or projections of future share prices. The following table provides information regarding the number and value of options held by each of our named executive officers as of December 31, 2001. No options were exercised by any executive officer during 2001. AGGREGATED 2001 FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED IN-THE- OPTIONS AT MONEY OPTIONS AT DECEMBER 31, 2001 DECEMBER 31, 2001(1) --------------------------- ----------------------------- NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - ---- ----------- ------------- ------------- -------------Peter A. Appel.................................. 315,800 372,407 $2,103,556 $2,141,340 Paul B. Ingrey.................................. 140,802 281,605 809,613 1,619,229 Dwight R. Evans................................. 33,333 66,667 191,665 383,335 Debra M. O'Connor............................... 57,332 6,668 354,203 38,341 Louis T. Petrillo............................... 61,126 26,674 396,170 153,376- ------------------------ (1) For purposes of the above table, options are "in-the-money" if the market price of the common shares on December 31, 2001 (I.E., $25.75) exceeded the exercise price of such options. The value of such options is calculated by determining the difference between the aggregate market price of the common shares subject to the options on December 31, 2001 and the aggregate exercise price of such options. EMPLOYMENT ARRANGEMENTS In connection with the capital infusion, Arch Re (Bermuda) appointed a new management team, consisting of Paul B. Ingrey and Dwight R. Evans. In addition, we appointed John M. Pasquesi as our executive vice chairman. We also appointed Constantine Iordanou as chief executive officer of Arch Capital 68Group (U.S.) Inc. We further appointed John D. Vollaro as our executive vice president and chief financial officer. Set forth below is a summary of the material terms of the employment, restricted share and option agreements with each of Messrs. Ingrey, Evans, Pasquesi, Iordanou and Vollaro. You should read these summaries in conjunction with our new 2001 Long-Term Incentive Plan for New Employees (the "Incentive Plan") and the employment, restricted share and option agreements, which are filed as exhibits hereto and incorporated herein by reference. PAUL B. INGREY AND DWIGHT R. EVANS Mr. Ingrey has been appointed to our board of directors and as chief executive officer of Arch Re (Bermuda). His employment agreement provides for an annual base salary of $750,000. Mr. Evans has been appointed president of Arch Re (Bermuda). His employment agreement provides for an annual base salary of $500,000. The annual base salary is subject to review annually for increase at the discretion of the board. The target rate for the annual cash bonus is 100% of the annual base salary. Messrs. Ingrey and Evans are eligible to receive annual cash bonuses and stock-based awards at the discretion of our board and to participate in our employee benefit programs. The initial term of each employment agreement ends on October 23, 2004, but we or the executive may terminate his employment at any time. The agreement will be automatically extended for additional one-year periods, unless we or the executive gives notice at least 60 days prior to the expiration of the original term or any extended term. The agreement provides that if the employment of Mr. Ingrey or Mr. Evans is terminated without cause or for good reason before October 23, 2004, he will be entitled to receive an amount equal to his annual base salary. Each of Messrs. Ingrey and Evans agreed that, during the employment period and for the period of two years after termination of employment, he will not compete with the businesses of the company or any of its subsidiaries as such businesses exist or are in process or being planned as of the date of termination. The noncompetition period will be one year following termination if we terminate his employment without cause, he terminates for good reason or he gives notice of his intent not to extend his employment term in accordance with the employment agreement. In such case, we may extend the noncompetition period to up to an additional six months following this one-year period if we pay his base salary for the additional six-month period. Each of Messrs. Ingrey and Evans also agreed that he will not, for a period of two years following termination, induce or attempt to induce any of our employees to leave his or her position with the company or induce any customer to cease doing business with us. On October 23, 2001, as inducements essential to their entering into employment agreements, we granted Messrs. Ingrey and Evans restricted shares and options under the Incentive Plan as set forth in the table below.
NAME OPTIONS RESTRICTED SHARES - ---- -------- -----------------Paul B. Ingrey....................................... 422,407 422,407 Dwight R. Evans...................................... 100,000 50,000The options are exercisable at $20.00 per share and expire on October 23, 2011. For each of Messrs. Ingrey and Evans, one-third of his options vested and became exercisable at the closing of the investments, one-third will become exercisable on October 23, 2002 and the remaining one-third will become exercisable on October 23, 2003. If we terminate Mr. Evans without cause, the terminated employee's options will remain exercisable (to the extent then exercisable) for 90 days following termination of employment (but not beyond the term of the option). In the event that Mr. Evans ceases to be an employee due to death or permanent disability, all such employee's options will vest in full and remain exercisable for the remainder of the term of the option. In the event that Mr. Ingrey's employment terminates due to his death or permanent disability, all of his options shall immediately vest and become exercisable. In the event that Mr. Ingrey is terminated for 69cause, all of his options will cease to be exercisable and will be immediately forfeited. In the event that we terminate his employment other than for cause or he resigns for good reason, Mr. Ingrey's options will vest according to the schedule in the preceding paragraph and have a remaining term of three years following termination. In the event of termination for any other reason, all vested options held by Mr. Ingrey will remain exercisable for a period of 90 days from termination. To the extent that any of Mr. Ingrey's options have not vested at the time of his termination, the options will be forfeited. The restricted shares will vest on October 23, 2004 for Messrs. Ingrey and Evans. If Mr. Evans is terminated due to his death or permanent disability, the restricted shares granted to him will vest based upon the following schedule:
VESTED AMOUNT UPON DATE OF TERMINATION TERMINATION - ---------------------------------------------------------- ------------------Prior to first anniversary of grant date.................. 1/3 of shares Prior to second anniversary of grant date, but after first anniversary of grant date............................... 2/3 of shares After second anniversary of grant date.................... All sharesAny unvested shares held by Mr. Evans will be forfeited if he otherwise terminates his service with us. Further, in the event that Mr. Evans is terminated within two years after a change of control without cause or due to permanent disability or he terminates his employment for good reason, all of his restricted shares will vest immediately upon such termination. In the event that Mr. Ingrey's employment terminates due to his death or permanent disability or his employment is terminated by us without cause or he resigns for good reason, all of his restricted shares will immediately vest. In the event that Mr. Ingrey's employment is terminated by us without cause or he resigns for good reason, his restricted shares will become fully transferable pursuant to the normal vesting schedule (except that, following such termination, he may sell an amount of shares to fund any income and employment taxes relating to the award). In the event of termination for any other reason, all restricted shares held by Mr. Ingrey will be forfeited. JOHN M. PASQUESI Mr. Pasquesi has been appointed our executive vice chairman. Mr. Pasquesi's employment agreement provides for an annual base salary of $30,000. The term of the employment agreement ends on October 24, 2003, but we or Mr. Pasquesi may terminate his employment at any time. The agreement provides that if Mr. Pasquesi's employment is terminated without cause or for good reason before October 24, 2003, he will be entitled to receive an amount equal to six months of his monthly base salary, reduced by amounts he receives from other employment or self employment during such period. As one of our executive officers, he is not entitled to any additional compensation for his service as a director. Mr. Pasquesi agreed that he will not, for a period of two years following termination of employment, induce or attempt to induce any of our employees to leave his or her position with us. On October 23, 2001, as an inducement essential to his entering into the employment agreement, we granted Mr. Pasquesi options under our Incentive Plan to purchase 375,473 common shares at an exercise price of $20.00 per share. These options will vest on October 23, 2003 and expire on October 23, 2011. If Mr. Pasquesi's employment is terminated without cause or for good reason or due to his death or permanent disability, these options will vest and be exercisable for the remainder of the option period. If he terminates his employment without good reason or his employment is terminated by us with cause his unvested options will be forfeited, and his vested options, to the extent then exercisable, may be exercised for the remainder of the option period. In addition, on October 23, 2001, in consideration for his providing structuring and advisory services to us in connection with the investment, we granted Mr. Pasquesi options to purchase 750,946 common shares at an exercise price of $20.00 per share. These options vested upon grant and expire on October 23, 2011. 70This grant of options to purchase 750,946 common shares will be rescinded if it is not approved by our shareholders prior to October 23, 2002. We will seek shareholder approval of this grant at our next annual general meeting, and the investors have committed to vote in favor of approval of these grants. CONSTANTINE IORDANOU In January 2002, Mr. Iordanou was appointed to our board of directors and as chief executive officer of Arch Capital Group (U.S.) Inc. As chief executive officer of Arch Capital Group (U.S.) Inc., Mr. Iordanou will be responsible for the general management and oversight of the U.S. insurance operations of Arch Capital Group (U.S.) Inc. and its affiliates. His employment agreement provides for an annual base salary of $1,000,000. His base salary is subject to review annually for increase at the discretion of the board. Mr. Iordanou is eligible to participate in an annual bonus plan on terms established from time to time and to participate in our employee benefit programs. The target rate for the annual cash bonus is 100% of his annual base salary. The initial term of Mr. Iordanou's employment agreement ends on January 1, 2007, but we or Mr. Iordanou may terminate his employment at any time. The agreement provides that it will be automatically extended for successive one-year periods after the initial five-year term unless either we or Mr. Iordanou gives at least 12 months notice of the intention not to renew. The agreement provides that if Mr. Iordanou's employment is terminated by his death, he will receive a prorated portion of his bonus that would have been paid for the year of his death and an amount equal to two times the sum of his base salary and target annual bonus payable in a lump sum. His agreement also provides that if his employment is terminated by permanent disability, he will receive a prorated portion of his bonus that would have been paid for the year in which he becomes disabled, as determined by the board, and an amount equal to 40% of his base salary payable in monthly installments during the period of his disability extending through the time period provided for the company's disability plan. The agreement further provides that if we terminate Mr. Iordanou's employment without cause or he resigns for good reason, he will receive a prorated portion of his bonus that would have been paid for the year of his termination and an amount equal to two times the sum of his base salary and target annual bonus payable over an 18-month period in equal monthly installments. Mr. Iordanou's major medical insurance coverage benefits pursuant to his employment agreement shall continue for 18 months after the date of termination in the event that (1) his employment ends due to death or permanent disability, (2) he is terminated other than for cause or (3) he resigns for good reason (or until such time as he has major medical insurance coverage under the plan of another employer). The agreement also provides that if Mr. Iordanou's employment is terminated by the company for cause or he resigns other than for good reason, he will receive his base salary through the date of termination. Mr. Iordanou has agreed that, during the employment period and for the period of 18 months after termination of employment, he will not compete with the businesses of the company or any of its subsidiaries as such businesses exist or are in process or being planned as of the date of termination. If we terminate Mr. Iordanou's employment without cause or he terminates for good reason, the term of his non-competition period will extend only as long as he is receiving benefits under the company's major medical insurance coverage. Further, Mr. Iordanou has agreed to extend the non-competition period for a period of 18 months in the event of termination due to the expiration of the five-year term of his agreement if he is paid an amount equal to two times his base salary and annual target bonus (payable in equal monthly installments over that period) and he remains covered by the company's major medical insurance plan. Mr. Iordanou also agreed that he will not, for an 18-month period following his date of termination, induce or attempt to induce any of our employees to leave his or her position with the company or induce any customer to cease doing business with us. As inducements essential to his entering into his employment agreement, as of January 1, 2002, we granted Mr. Iordanou, under the Incentive Plan, 106,383 restricted shares as a signing bonus, 325,000 71additional restricted shares and options to purchase 425,000 common shares at an exercise price equal to $23.50 per share. Mr. Iordanou's options expire on January 1, 2012. One-third of his options vested and became exercisable on the date of grant; one-third will become exercisable on January 1, 2003; and the remaining one-third will become exercisable on January 1, 2004. In the event that his employment terminates due to his death or permanent disability, all of Mr. Iordanou's options shall immediately vest and become exercisable. In the event that Mr. Iordanou is terminated for cause, all of his options will cease to be exercisable and will be immediately forfeited. In the event that we terminate his employment other than for cause or he resigns for good reason, Mr. Iordanou's options will vest according to the schedule described above and have a remaining term of three years following termination. In the event of termination for any other reason, all vested options held by Mr. Iordanou will remain exercisable for a period of 90 days from termination. To the extent that any of Mr. Iordanou's options have not vested at the time of his termination, the options will be forfeited. The restricted shares Mr. Iordanou received as a signing bonus will vest on December 31, 2002, and the remainder of his restricted shares will vest on December 31, 2006. In the event that his employment terminates due to his death or permanent disability or his employment is terminated by the company without cause or he resigns for good reason, all of his restricted shares will immediately vest. In the case of termination by the company without cause or resignation for good reason, however, the newly vested shares may not be transferred (1) in the case of restricted shares granted as a signing bonus, until December 31, 2002 and (2) in the case of all other restricted shares, until December 31, 2006 (except that, following such termination, he may sell an amount of shares to fund any income and employment taxes relating to the award). In the event of termination for any other reason, all restricted shares held by Mr. Iordanou will be forfeited. JOHN D. VOLLARO Mr. Vollaro has been appointed as our executive vice president and chief financial officer. Mr. Vollaro's employment agreement provides for an annual base salary of $400,000. Mr.Vollaro is eligible to participate in an annual bonus plan on terms established from time to time by our board and to participate in our employee benefit programs. The target rate for the annual bonus is 100% of his annual base salary. The term of his employment agreement ends on January 18, 2005, but we or Mr. Vollaro may terminate his employment at any time. The agreement provides that it will be automatically extended for successive one-year periods after the initial three-year term unless either we or Mr. Vollaro gives at least 60 days notice of the intention not to renew. The agreement provides that if Mr. Vollaro's employment is terminated without cause or for good reason before January 18, 2005, he will be entitled to receive an amount equal to the greater of (1) 18 months of his base salary and (2) the total remaining base salary which would have been paid for the remainder of his employment term (payable in equal monthly installments commencing on the first month anniversary of the date of termination). The agreement also provides that if Mr. Vollaro's employment is terminated for cause, as a result of his resignation or leaving employment other than for good reason, as a result of death or permanent disability, or by written notice of the intention not to renew the agreement by us or Mr. Vollaro, he will be entitled to receive solely his base salary through the date of termination. The agreement further provides that if Mr. Vollaro's employment is terminated by reason of death or permanent disability, he will also be entitled to receive his annual bonus prorated through the date of termination, provided that such bonus will not be less than the average annual bonus received for the preceding three years; and, if he has not received bonuses for three years, he will receive a prorated portion of the average of the bonuses received, if any, but not less than a prorated portion of 90% of his base salary. 72Mr. Vollaro has agreed that, during the employment period and for a period of two years after termination of employment for cause or as a result of his resignation or leaving employment other than for good reason, he will not compete with the businesses of ACGL or any of its subsidiaries as such businesses exist or are in process or being planned as of the date of termination. If we terminate Mr. Vollaro's employment without cause or he terminates for good reason, the term of his non-competition period will extend only as long as he is receiving his severance payments and benefits under our major medical insurance coverage. Further, Mr. Vollaro has agreed to a non-competition period of two years if his termination results from notice of the intent not to renew the agreement by us or Mr. Vollaro, and we agree in writing to pay him the sum of base salary and target annual bonus for such period, payable in monthly installments over such period. Mr. Vollaro also agreed that he will not, for a period of two years following his date of termination, induce or attempt to induce any of our employees to leave his or her position with us or induce any customer to cease doing business with us. As inducements essential to his entering into his employment agreement, on January 18, 2002 we granted Mr. Vollaro, under our Incentive Plan, 50,000 restricted shares and options to purchase 85,000 common shares at an exercise price of $25.30 per share. Mr. Vollaro's options expire on January 18, 2012. One-third of his options vested and became exercisable on the date of grant; one-third will become exercisable on January 18, 2003; and the remaining one-third will become exercisable on January 18, 2004. In the event that his employment terminates due to his death or permanent disability, all of Mr. Vollaro's options shall immediately vest and become exercisable. In the event that Mr. Vollaro is terminated for cause, all of his options will cease to be exercisable and will be immediately forfeited. In the event of termination for any other reason, all vested options held by Mr. Vollaro will remain exercisable for a period of 90 days from termination. To the extent that any of Mr. Vollaro's options have not vested at the time of his termination, the options will be forfeited. Mr. Vollaro's restricted shares will vest on January 18, 2007. In the event that his employment terminates due to his death or permanent disability or his employment is terminated by the company without cause or he resigns for good reason, or if his employment terminates due to written notice by us of the intent not to extend his employment contract, a pro rata number of restricted shares subject to the award will vest in full on the date of termination, determined by multiplying the total number of restricted shares subject to the award by a fraction, the numerator of which is the number of months or part of a month elapsed since January 18, 2002 and the denominator of which is 60. In the case of termination by us without cause or resignation by Mr. Vollaro for good reason, however, the newly vested shares may not be transferred until January 18, 2007 (except that, following such termination, he may sell an amount of shares to fund any income and employment taxes relating to the award). In the event of termination for any other reason, all restricted shares held by Mr. Vollaro will be forfeited. In the event that, within two years following a change of control of ACGL, Mr. Vollaro's employment terminates due to his death or permanent disability or his employment is terminated by us without cause or he resigns for good reason, all of his restricted shares will immediately vest. INCENTIVE COMPENSATION FOR MANAGEMENT AND DIRECTORS Also in connection with the investments, certain directors and members of management were granted stock-based awards under our existing incentive compensation plans or otherwise, as described below. You should read these summaries in conjunction with the restricted share and option agreements, which are filed as exhibits hereto and incorporated by reference. ROBERT CLEMENTS Mr. Clements, our chairman, was granted a total of 1,689,629 restricted shares. Of this total, 1,668,157 restricted shares were granted on October 23, 2001 and 21,472 restricted shares were granted on November 19, 2001. The restricted shares will vest in five equal annual installments commencing on 73October 23, 2002. However, if Mr. Clements' service as chairman is terminated by us or is not continued by us for any reason, or his service terminates due to his death or permanent disability, the restricted shares will vest in full upon such termination of service. Any unvested shares will be forfeited if Mr. Clements otherwise terminates his service with us. In addition, Mr. Clements has agreed that, in the event his service is terminated by us prior to the fifth anniversary of the date of grant, he will not compete with us during the period ending on the later of such fifth anniversary or one year following such termination of service. These grants to Mr. Clements will be rescinded if they are not approved by our shareholders prior to October 23, 2002. We will seek shareholder approval of these grants to Mr. Clements at our next annual general meeting, and the investors have committed to vote in favor of approval of these grants. In connection with these transactions, we entered into a retention agreement with Mr. Clements, which replaced our existing retention and change in control agreement with Mr. Clements. Under the retention agreement, he will continue to receive compensation at an annual rate equal to one-half of the salary of ACGL's chief executive officer, payable in restricted shares that vest on January 1 of the following year. For 2001, under this formula, he received 7,282 restricted shares ($187,500 divided by $25.75, the closing market price of our common shares on January 1, 2001), which will vest on January 1, 2002. Mr. Clements will continue to be eligible to receive a cash bonus at the discretion of the compensation committee. If Mr. Clements's service as chairman of our board is terminated for any reason, he will be entitled to receive an amount equal to a prorated portion of his compensation for that year. In addition, a subsidiary of ACGL has agreed to make a loan of $13,530,000 to Mr. Clements, which will be used to pay income and self employment taxes, payable in April 2002, on the restricted shares granted to him on October 23, 2001. The loan will bear interest at the applicable federal rate and mature on the fifth anniversary of borrowing. If we terminate Mr. Clements' service as chairman of the board for cause, the loan will become immediately payable. Mr. Clements will receive additional compensation in cash in an amount sufficient to defray the interest cost. In addition, we have agreed to make gross-up payments to him in the event of certain tax liabilities. Mr. Clements agreed that, for a period of one year after termination of service, he will not induce or attempt to induce any of our employees to leave his or her position with the company. In connection with these arrangements, Mr. Clements waived his right to receive any non-employee director compensation. Mr. Clements' previous retention and change in control agreement provided that upon involuntary termination (other than for cause) or constructive termination within 24 months following a change in control, Mr. Clements would be entitled to a payment equal to 2.99 times the sum of his annual compensation plus his bonus for the previous year. This provision is no longer in effect. PETER APPEL. Mr. Appel, our chief executive officer, was granted options to purchase a total of 422,407 common shares at an exercise price of $20.00 per share. Of these options, 50,000 vested and became exercisable upon grant; 172,407 will become vested and exercisable on the Vesting Date, and 200,000 will become vested on the Vesting Date and become exercisable on the later of (x) the Vesting Date and (y) the earliest of (i) our common shares trading at or above $30.00 per share for 20 out of 30 consecutive trading days, (ii) the occurrence of a change of control and (iii) the date on which no class B warrants are outstanding. "Vesting Date" means the earlier of (1) the date we have consummated the sale or other disposition or settlement of at least 50% of certain of our non-core assets and (2) October 23, 2002. If we terminate Mr. Appel's service as chief executive officer for any reason, his service terminates due to his death or permanent disability, or he terminates his service for good reason, any unvested options granted to Mr. Appel will vest in full upon such termination of service and continue to be exercisable for the remainder of the option period. In the event that Mr. Appel terminates his service without good reason, any vested options will continue to be, or become, exercisable for the remainder of the option period, but any unvested options will be forfeited. In addition, Mr. Appel has agreed that during the term of his employment and, in the event his service with us is terminated for any reason, for a period ending two years after his termination, (1) he will not compete with any of our or our subsidiaries' insurance or reinsurance businesses as they exist on the date of his termination and (2) he will not induce or attempt to induce any of our employees to leave his or her position with the company. 74DEBRA O'CONNOR AND LOUIS PETRILLO. Mr. Petrillo was granted options to purchase 40,000 common shares and Ms. O'Connor was granted options to purchase 10,000 common shares. These options are exercisable at an exercise price of $20.00 per share. One-third of these options became exercisable at the closing, one-third will become exercisable on October 23, 2002 and the remaining one-third will become exercisable on October 23, 2003. If we terminate Mr. Petrillo or Ms. O'Connor without cause, the terminated employee's options will remain exercisable (to the extent then exercisable) for 90 days following termination of employment (but not beyond the option period). In the event that any such employee ceases to be an employee due to death or permanent disability, all such employee's options will vest in full and remain exercisable for the remainder of the option period. Ms. O'Connor's terms of employment provide for an annual base salary of $225,000. The salary is subject to review annually for increase at the discretion of the board. The target rate for the annual cash bonus for Ms. O'Connor is 50% of her annual base salary. Ms. O'Connor is eligible to receive an annual cash bonus and stock-based awards at the discretion of the board and to participate in our employee benefit programs. The company or Ms. O'Connor may terminate her employment at any time. Mr. Petrillo's terms of employment provide for an annual base salary of $275,000. The salary is subject to review annually for increase at the discretion of the board. The target rate for the annual cash bonus for Mr. Petrillo is 75% of his annual base salary. Mr. Petrillo is eligible to receive an annual cash bonus and stock-based awards at the discretion of the board and to participate in our employee benefit programs. The company or Mr. Petrillo may terminate his employment at any time. DIRECTORS. In addition, each current director of the company (other than Messrs. Clements and Appel), and Mr. Ian Heap, who resigned from the board in 2001, were granted options to purchase 15,000 common shares at an exercise price of $20.00 per share. These options vested upon grant and expire on October 23, 2011. OTHER. The restricted share awards and option grants for Messrs. Ingrey, Evans, Pasquesi, Iordanou and Vollaro are described under "--Employment Arrangements." CHANGE IN CONTROL ARRANGEMENTS The sale of our prior reinsurance operations to Folksamerica Reinsurance Company in May 2000 constituted a change in control for purposes of our prior change in control arrangements. Under these arrangements, all unvested stock options and restricted shares held by our employees and the members of our board of directors (other than Mr. Clements) vested in connection with the asset sale. In addition, the following payments were made to our executive officers upon closing of the asset sale: Mark D. Mosca, $2,716,714; Peter A. Appel, $1,476,563; Paul J. Malvasio, $1,220,625; and Debra M. O'Connor, $475,440. These amounts were equal to a specified multiple of the sum of such executive officer's annual base salary and target annual bonus (or, in the case of Mr. Mosca, a notional target amount equal to 100% of his annual base salary). The specified multiple was 2.99 for Mr. Mosca, 2.25 for Messrs. Appel and Malvasio, and 2.0 for Ms. O'Connor. Such payments did not exceed an amount that would trigger the payment of excise taxes, and were not subject to mitigation in the event that such officer receives any compensation from other employment following his termination. In addition, a prorated portion of the following executive officer's target annual bonus (or, in the case of Mr. Mosca, a prorated portion of a notional target amount equal to 100% of his annual base salary) was paid to such officers at the closing of the asset sale, as follows: Mr. Mosca: $156,398; Mr. Appel: $96,823; Mr. Malvasio: $80,040; Ms. O'Connor: $30,457; and Mr. Petrillo: $30,446. Each executive officer is also entitled to continuance of his health care, dental, disability and group-term and life insurance benefits for prescribed periods. In addition, Robert Clements, chairman of our board, received a special bonus 75of $300,000 upon the consummation of the asset sale. There are no continuing change in control arrangements with our present officers and employees, except that in connection with his employment as general counsel and secretary, we entered into a change in control arrangement with Mr. Petrillo which provides that upon involuntary termination (other than for cause) or constructive termination within 24 months following a change in control, Mr. Petrillo would be entitled to a payment equal to 2.0 times the sum of his annual base salary and target annual bonus. In addition, upon termination of his employment following a change in control, we will pay him a prorated portion of his target annual bonus for such year and continue health care, dental, disability and group-term and life insurance benefits for 24 months. DIRECTOR COMPENSATION Each non-employee member of our board of directors is entitled to receive an annual cash retainer fee in the amount of $25,000. Commencing with the 1999-2000 annual period, each non-employee director is entitled, at his option, to receive this retainer fee in the form of common shares instead of cash. If so elected, the number of shares distributed to the non-employee director is equal to 120% of the amount of the annual retainer fee otherwise payable divided by the fair market value of our common shares. Each non-employee director also receives from the company a meeting fee of $1,000 for each board or committee meeting attended. In addition, each non-employee director serving as chairman of the (1) executive committee or compensation committee received an annual fee of $3,000 and (2) audit committee received an annual fee of $5,000. All non-employee directors are entitled to reimbursement for their reasonable out-of-pocket expenses in connection with their travel to and attendance at meetings of the board or committees. Directors who are also employees of the company or its subsidiaries receive no cash compensation for serving as directors or as members of board committees. In 2001, pursuant to our long-term incentive and share award plans, upon joining the board, each non-employee director received an option to purchase 300 common shares at an exercise price per share equal to the then market price of a common share. In 2001, our plans also provided for automatic annual grants to non-employee directors of options to purchase common shares on January 1 of each year. Commencing January 1, 2000, the amount of shares covered by this annual grant was increased from 500 to 1,500 shares. COMPENSATION AND STOCK AWARDS COMMITTEES INTERLOCKS AND INSIDER PARTICIPATION The compensation committee of our board of directors currently consists of John Bunce (chairman), Kewsong Lee, James Meenaghan and Robert Works. None of the members of the committees are or have been officers or employees of the company. In addition, no executive officer of the company served on any board of directors or compensation committee of any entity (other than the company) with which any member of our board serves as an executive officer. Pursuant to the shareholders agreement entered into in connection with the private placement, Messrs. Bunce and Lee have been designated as members of our board of directors by funds affiliated with Hellman & Friedman LLC and Warburg Pincus LLC, respectively.Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTThe
following table sets forthinformationavailable to us as of March 8, 2002 with respect torequired by this item is incorporated by reference from theownership of our voting shares by (1) each person known to usinformation to bethe beneficial owner of more than 5% of any class of our outstanding voting shares, (2) each director and executive officer of ACGL, and (3) all of the directors and executive officers of ACGL as a group. Except as otherwise indicated, each person named below has sole investment and voting power with respect to the securities shown. 76Please note that this table addresses ownership of voting shares; it does not address the voting power of those shares, which, in some cases, is different than the percentage set forth below.
COMMON SHARES - --------------------------------------------------------------------------------------------------------- (A) (B) (C) NUMBER OF COMMON SHARES RULE 13D-3 FULLY-DILUTED BENEFICIALLY OWNED PERCENTAGE OWNERSHIP PERCENTAGE NAME AND ADDRESS OF BENEFICIAL OWNER (1) (1) (2) - ------------------------------------ ------------------ -------------------- -------------Warburg Pincus (3) ........................... 20,943,229 57.1% 33.8% c/o 466 Lexington Avenue New York, New York 10017 H&F Corporate Investors IV (Bermuda), Ltd. (4) ........................ 11,636,491 42.5 18.8 c/o A.S.&K. Services Ltd. 41 Cedar Avenue Hamilton HM 12, Bermuda Insurance Private Equity Investors, L.L.C. 2,585,583 14.1 4.2 (5) ........................................ 3003 Summer Street Stamford, CT 06905 EQSF Advisers, Inc. and M.J. Whitman Advisers, Inc. (6) ......................... 2,426,905 15.4 3.9 767 Third Avenue New York, New York 10017 Marsh & McLennan Risk Capital Holdings, Ltd. (7) ......................... 1,632,231 10.3 2.6 1166 Avenue of the Americas New York, New York 10036 Trident II, L.P. (8) ......................... 1,713,681 9.8 2.8 Craig Appin House 8 Wesley Street Hamilton HM 11 Bermuda The Trident Partnership, L.P. (9) ............ 1,636,079 9.5 2.6 Craig Appin House 8 Wesley Street Hamilton, HM11, Bermuda Farallon Partners, L.L.C. (10) ............... 1,292,791 7.6 2.1 One Maritime Plaza Suite 1325 San Francisco, CA 94111 Artisan Partners Limited Partnership (11) .... 1,162,684 7.4 1.9 1000 North Water Street, #1770 Milwaukee, Wisconsin 53202 Beck, Mack & Oliver LLC (12) ................. 1,113,850 7.1 1.8 330 Madison Avenue New York, New York 10017 Steinberg Priest Capital Management 1,438,147 9.1 2.377
COMMON SHARES - --------------------------------------------------------------------------------------------------------- (A) (B) (C) NUMBER OF COMMON SHARES RULE 13D-3 FULLY-DILUTED BENEFICIALLY OWNED PERCENTAGE OWNERSHIP PERCENTAGE NAME AND ADDRESS OF BENEFICIAL OWNER (1) (1) (2) - ------------------------------------ ------------------ -------------------- -------------Co., Inc. (13) ............................. 12 East 49th Street New York, New York 10017 Franklin Resources, Inc. (14) ................ 842,900 5.3 1.4 777 Mariners Island Boulevard San Mateo, California 94404 Crabbe Huson Group, Inc. (15) ................ 809,887 5.1 1.3 121 SW Morrison, Suite 1400 Portland, Oregon 97204 Robert Clements (16).......................... 2,315,751 14.3 3.9 Peter A. Appel (17)........................... 502,406 3.1 1.4 John L. Bunce, Jr. (18)....................... 11,636,491 42.5 18.8 Paul B. Ingrey (19)........................... 666,632 4.2 1.5 Constantine Iordanou (20)..................... 573,050 3.6 1.4 Kewsong Lee (21).............................. 20,944,592 57.1 33.9 James J. Meenaghan (22)....................... 17,113 * * John M. Pasquesi (23)......................... 1,138,784 6.7 2.5 Robert F. Works (24).......................... 23,972 * * Dwight R. Evans (25).......................... 104,017 * * John D. Vollaro (26).......................... 78,333 * * Debra M. O'Connor (27)........................ 72,319 * * Louis T. Petrillo (28)........................ 70,131 * * All directors and executive officers (13 38,143,591 75.9% 64.2% persons)....................................
SERIES A CONVERTIBLE PREFERENCE SHARES - --------------------------------------------------------------------------------------------------- NUMBER OF PREFERENCE RULE 13D-3 SHARES BENEFICIALLY OWNED PERCENTAGE OWNERSHIP NAME AND ADDRESS OF BENEFICIAL OWNER (29) (29) - ------------------------------------ ------------------------- --------------------Warburg Pincus (3)............................... 18,939,311 53.1% H&F Corporate Investors IV (Bermuda), Ltd. (4)... 10,521,839 29.5 Insurance Private Equity Investors, L.L.C. (5)... 2,338,186 6.6 Robert Clements (16)............................. 93,527 * Peter A. Appel (17).............................. 46,763 * John L. Bunce, Jr. (18).......................... 10,521,839 29.5 Paul B. Ingrey (19).............................. 93,527 * Constantine Iordanou............................. 0 078
SERIES A CONVERTIBLE PREFERENCE SHARES - --------------------------------------------------------------------------------------------------- NUMBER OF PREFERENCE RULE 13D-3 SHARES BENEFICIALLY OWNED PERCENTAGE OWNERSHIP NAME AND ADDRESS OF BENEFICIAL OWNER (29) (29) - ------------------------------------ ------------------------- --------------------Kewsong Lee (21)................................. 18,939,311 53.1 James J. Meenaghan............................... 0 0 John M. Pasquesi (23)............................ 350,728 1.0 Robert F. Works.................................. 0 0 Dwight R. Evans (25)............................. 18,705 * Debra O'Connor................................... 0 0 Louis T. Petrillo................................ 0 0 All directors and executive officers (13 persons)....................................... 30,064,400 84.2%- ------------------------ * Denotes beneficial ownership of less than 1.0%. (1) Pursuant to Rule 13d-3 promulgated under the Exchange Act, amounts shown include common shares that may be acquired by a person within 60 days of March 8, 2002. Therefore, column (B) has been computed based on (a) 15,765,332 common shares actually outstanding as of March 8, 2002 and (b) common shares that may be acquired within 60 days of March 8, 2002 upon the exercise of options and warrants and conversion of preference shares held only by the person whose Rule 13d-3 Percentage Ownership of Common Shares is being computed. Each preference share is convertible into one common share, subject to adjustments. The preference shares are mandatorily convertible under certain circumstances. Under the subscription agreements, the purchase price for the preference shares is subject to certain adjustments, which may resultincluded in theissuance of additional preference shares and class A warrants to the purchasers. For a description of the adjustments, see "Business--Recent Developments--The Capital Infusion--Subscription Agreement--Purchase Price Adjustments." (2) Amounts shown under column (C) in the above table have been computed based on (a) 15,765,332 common shares actually outstanding as of March 8, 2002 and, (b) common shares that may be acquired upon the exercise of all outstanding options and warrants and conversion of all preference shares, whether or not such options and warrants are exercisable within 60 days held by all persons, and as of March 8, 2002, there were outstanding (i) class A warrants to purchase an aggregate of 5,401,707 common shares, (ii) class B warrants to purchase an aggregate of 150,000 common shares, (iii) options to purchase an aggregate of 4,883,811 common shares and (iv) 35,687,735 preference shares. The class A warrants are currently exercisable at $20 per share and expire on September 19, 2002. The class B warrants are exercisable at $20 per share at any time after our common shares have traded at or above $30 per share for 20 out of 30 consecutive trading days or a change of control has occurred and expire on September 19, 2005. See note (1) for a description of the preference shares. (3) The security holders are Warburg Pincus (Bermuda) Private Equity VIII, L.P. ("WP VIII Bermuda"), Warburg Pincus (Bermuda) International Partners, L.P. ("WPIP Bermuda"), Warburg Pincus Netherlands International Partners I, C.V. ("WPIP Netherlands I") and Warburg Pincus Netherlands International Partners II, C.V. ("WPIP Netherlands II"). Warburg Pincus (Bermuda) Private Equity Ltd. ("WP VIII Bermuda Ltd.") is the sole general partner of WP VIII Bermuda. Warburg Pincus (Bermuda) International Ltd. ("WPIP Bermuda Ltd.") is the sole general partner of WPIP Bermuda. Warburg, Pincus & Co. ("WP") is the sole general partner of WPIP Netherlands I and WPIP Netherlands II. WP VIII Bermuda, WPIP Bermuda, WPIP Netherlands I 79and WPIP Netherlands II are managed by Warburg Pincus LLC ("WP LLC"). The foregoing is based on a Schedule 13D and a Form 3 dated November 30, 2001 filed with the SEC by these entities. Amounts in columns (A), (B) and (C) reflect common shares issuable upon conversion of preference shares or exercise of class A warrants issued under the subscription agreements. (4) The security holders are HFCP IV (Bermuda), L.P. ("HFCP IV Bermuda"), H&F International Partners IV-A (Bermuda), L.P. ("HFIP IV-A Bermuda"), H&F International Partners IV-B (Bermuda), L.P. ("HFIP IV-B Bermuda") and H&F Executive Fund IV (Bermuda), L.P. ("HFEF Bermuda," and together with HFCP IV Bermuda, HFIP IV-A Bermuda and HFIP IV-B Bermuda, the "H&F Funds"). H&F Investors IV (Bermuda), L.P. ("HFI IV Bermuda") is the sole general partner of the H&F Funds. H&F Corporate Investors IV (Bermuda) Ltd. ("HFCI Bermuda") is the sole general partner of HFI IV Bermuda. HFI IV Bermuda may be deemed to control the H&F Funds. The foregoing is based on a Schedule 13D and a Form 3 dated November 30, 2001 filed with the SEC by these entities. Amounts in columns (A), (B) and (C) reflect (a) common shares issuable upon conversion of preference shares or exercise of class A warrants issued under the subscription agreements, (b) 1,263 common shares owned by Mr. Bunce for the benefit of these entities and (c) 100 common shares issuable upon exercise of currently exercisable options held by Mr. Bunce for the benefit of these entities. (5) Insurance Private Equity Investors, L.L.C. ("Insurance") is a wholly owned subsidiary of General Electric Pension Trust ("GEPT"), which is an employee benefit plan for the benefit of employees of General Electric Company ("GE"). GE Asset Management Incorporated ("GEAM"), a wholly owned subsidiary of GE, acts as manager of Insurance and as investment manager of GEPT. Insurance, GEPT and GEAM may be deemed to share beneficial ownership. Excludes securities held by Orbital Holdings, Ltd., which is an indirect wholly owned subsidiary of GE, as to which Insurance, GEPT and GEAM disclaim beneficial ownership. Based on a Schedule 13D filed on November 30, 2001 by these entities. Amounts in columns (A), (B) and (C) reflect common shares issuable upon conversion of preference shares or exercise of class A warrants issued under the subscription agreements. (6) Based upon a Schedule 13G/A dated February 5, 2002, filed with the SEC jointly by EQSF Advisers, Inc. and M.J. Whitman Advisers, Inc. ("MJWA"), each an investment advisor, and Martin J. Whitman. In the Schedule 13G/A, EQSF reported that it has sole voting power and sole dispositive power with respect to 1,203,500 common shares and MJWA reported that it has sole dispositive power with respect to 1,223,405 common shares and sole voting power with respect to 1,144,355 common shares. (7) Amounts in columns (A), (B) and (C) reflect common shares issuable upon conversion of preference shares or exercise of class A warrants issued under the subscription agreements and 1,536,005 common shares owned directly by MMRCH. The preference shares and class A warrants are held by Marsh & McLennan Capital Professionals Fund, L.P. and Marsh & McLennan Employees' Securities Company, L.P., which are beneficially owned by employees of Marsh & McLennan, Inc. A subsidiary of MMRCH is the sole general partner of these funds, as well as the sole general partner of Trident II L.P. and The Trident Partnership L.P. (8) Amounts in columns (A), (B) and (C) reflect common shares issuable upon conversion of preference shares or exercise of class A warrants issued under the subscription agreements. (9) Amounts in columns reflect (a) 250,000 common shares owned directly by The Trident Partnership, L.P. and (b) 1,386,079 common shares issuable upon the exercise of class A warrants held by The Trident Partnership, L.P. Based upon a Schedule 13D dated March 27, 1998, filed with the SEC by The Trident Partnership, L.P. The sole general partner of the partnership is a subsidiary of MMRCH. 80(10) The security holders are Farallon Capital Partners, L.P., Farallon Capital Institutional Partners II, L.P., Farallon Capital Institutional Partners III, L.P. and RR Capital Partners, L.P. Farallon Partners, L.L.C. is the sole general partner of each of these holders. Amounts in columns (A), (B) and (C) reflect common shares issuable upon conversion of preference shares or exercise of class A warrants issued under the subscription agreements. (11) Based upon a Schedule 13G dated February 13, 2002, filed with the SEC by Artisan Partners Limited Partnership and certain of its affiliates (collectively, "Artisan"). In the Schedule 13G, Artisan reported that it has sole voting power and sole dispositive power with respect to 1,162,684 common shares beneficially owned by one or more discretionary clients of Artisan. (12) Based upon a Schedule 13G dated February 11, 2002, filed with the SEC by Beck, Mack & Oliver LLC, an investment advisor. In the Schedule 13G, Beck reported that it has shared dispositive power with respect to 1,113,850 common shares beneficially owned by its clients. (13) Based upon a Schedule 13G dated January 28, 2002, filed with the SEC jointly by Steinberg Priest Capital Management Co., Inc. ("SPCM"), an investment advisor, and Michael A. Steinberg & Co., Inc., a broker-dealer. In the Schedule 13G, SPCM reported that it has sole voting power with respect to 659,450 common shares and sole dispositive power with respect to 1,416,277 common shares, and Steinberg & Co. reported that it has sole dispositive power with respect to 21,870 common shares. (14) Based upon a Schedule 13G dated February 14, 2002, filed with the SEC by Franklin Resources, Inc. and certain of its affiliates (collectively, "FRI"). In the Schedule 13G, FRI reported that it has sole voting power and sole dispositive power with respect to 842,900 common shares beneficially owned by one or more managed accounts which are advised by investment advisory subsidiaries of FRI. (15) Based upon a Schedule 13G dated February 3, 2000, filed with the SEC by the Crabbe Huson Group, Inc., an investment advisor. In the Schedule 13G, Crabbe Huson reported that it has shared voting power with respect to 774,287 common shares and shared dispositive power with respect to 809,887 common shares beneficially owned by its clients. (16) Amounts in columns (A) and (B) reflect (a) 1,810,600 common shares owned directly by Mr. Clements (including 1,696,911 restricted shares, which are subject to vesting), (b) 200,000 common shares issuable upon exercise of class A warrants owned directly by Mr. Clements, (c) 107,125 common shares issuable upon exercise of currently exercisable options owned directly by Mr. Clements, (d) 55,000 common shares owned by Taracay Investors, (e) 39,603 common shares issuable upon exercise of class A warrants owned by Taracay Investors and (f) common shares issuable upon conversion of preference shares or exercise of class A warrants owned by SoundView Partners, L.P. The amount in column (C) includes 107,198 common shares issuable upon exercise of class B warrants, which are not currently exercisable within 60 days of the date hereof. Taracay Investors is a general partnership, the general partners of which consist of Mr. Clements and members of his family and the managing partner of which is Mr. Clements. Mr. Clements is the general partner of SoundView. (17) Amounts in columns (A) and (B) reflect (a) 134,895 common shares owned directly by Mr. Appel, (b) 315,800 common shares issuable upon exercise of currently exercisable options and (c) common shares issuable upon conversion of preference shares or exercise of class A warrants. The amount in column (C) includes 372,407 common shares issuable upon exercise of stock options that are not likely to become exercisable within 60 days of the date hereof. (18) Amounts in all columns reflect securities held by or the benefit of the entities listed in note (5). Mr. Bunce is a member of an investment committee of HFCI Bermuda which has investment discretion over the securities held by the H&F Funds. Mr. Bunce is a 9.9% shareholder of HFCI 81Bermuda. All shares indicated as owned by Mr. Bunce are included because he is a member of our board and is affiliated with HFCI Bermuda. Mr. Bunce may be deemed to have an indirect pecuniary interest (within the meaning of Rule 16a-1 under the Exchange Act) in an indeterminate portion of the shares beneficially owned by the H&F Funds. Mr. Bunce disclaims beneficial ownership of all shares owned by the H&F Funds, except to the extent of his indirect pecuniary interest in the issuer held through the H&F Funds. Based on a Form 3 dated November 30, 2001 filed with the SEC by Mr. Bunce. (19) Amounts in columns (A) and (B) reflect (a) 422,407 restricted shares (all of which are subject to vesting), (b) 140,802 common shares issuable upon exercise of currently exercisable options and (c) common shares issuable upon conversion of preference shares or exercise of class A warrants. The amount in column (C) includes 281,605 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days of the date hereof. (20) Amounts in columns (A) and (B) reflect (a) 431,383 restricted shares (all of which are subject to vesting) and (b) 141,667 common shares issuable upon exercise of currently exercisable options. The amount in column (C) include 283,333 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days of the date hereof. (21) Amounts reflect (a) securities held by the entities listed in note (4), (b) 1,263 common shares owned directly by Mr. Lee and (c) 100 common shares issuable upon exercise of currently exercisable options. Mr. Lee is a general partner of WP, a managing director and member of WP LLC and a beneficial owner of certain shares of capital stock of WP VIII Bermuda Ltd. and WPIP Bermuda Ltd. All shares indicated as owned by Mr. Lee are included because he is a member of our board and is affiliated with these Warburg Pincus entities. Mr. Lee may be deemed to have an indirect pecuniary interest (within the meaning of Rule 16a-1 under the Exchange Act) in an indeterminate portion of the shares owned by WP VIII Bermuda, WPIP Bermuda, WPIP Netherlands I and WPIP Netherlands II. Mr. Lee disclaims beneficial ownership of all shares owned by these Warburg Pincus entities. Based on a Form 3 dated November 30, 2001 filed with the SEC by Mr. Lee. (22) Amounts in columns (A) and (B) reflect 1,813 common shares owned directly by Mr. Meenaghan and 15,300 common shares issuable upon exercise of currently exercisable options. The amount in column (C) includes 1,500 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days of the date hereof. (23) Amounts in columns (A) and (B) reflect (a) 750,946 common shares issuable upon exercise of currently exercisable options and (b) common shares issuable upon conversion of preference shares or exercise of class A warrants. The amount in column (C) includes 375,473 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days of the date hereof. (24) Amounts in columns (A) and (B) reflect 5,672 common shares owned directly by Mr. Works and 18,300 common shares issuable upon exercise of currently exercisable options. The amount in column (C) includes 1,500 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days hereof. (25) Amounts in columns (A) and (B) reflect (a) 50,000 restricted shares (all of which are subject to vesting), (b) 33,333 common shares issuable upon exercise of currently exercisable options and (c) common shares issuable upon conversion of preference shares or exercise of class A warrants. The amount in column (C) includes 66,667 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days of the date hereof. (26) Amounts in columns (A) and (B) reflect (a) 50,000 restricted shares (all of which are subject to vesting) and (b) 28,333 common shares issuable upon exercise of currently exercisable options. The 82amount in column (C) includes 56,667 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days hereof. (27) Amounts in columns (A) and (B) reflect (a) 14,986 common shares owned directly by Ms. O'Connor and (b) 57,333 common shares issuable upon exercise of currently exercisable options. The amount in column (C) includes 6,667 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days hereof. (28) Amounts in columns (A) and (B) reflect (a) 8,998 common shares owned directly by Mr. Petrillo and (b) 61,133 common shares issuable upon exercise of currently exercisable options. The amount in column (C) includes 26,667 common shares issuable upon exercise of stock options that are not currently exercisable within 60 days hereof. (29) Under the subscription agreements, the purchase price for the preference shares is subject to certain adjustments, which may result in the issuance of additional preference shares to the purchasers. For a description of the adjustments, please see "Business--Recent Developments--The Capital Infusion--Subscription Agreement--Purchase Price Adjustments." 83Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSTHE CAPITAL INFUSION Please refer to theThe information
appearing above under the subheading "The Capital Infusion" included as part of "Business," which informationrequired by this item is incorporated byreference. In addition, priorreference from the information to be included in thecapital infusion, we also had entered into certain non-binding letters of intent to acquire three fee-based businesses, including Tri-City Brokerage, Inc. ("Tri-City"), each of which would have been considered a non-core business. In connection with our decision to concentrate our attention exclusively on building our insurance and reinsurance business, our board of directors determined not to proceed with any of these acquisitions.Proxy Statement.
ITEM 14. CONTROLS AND PROCEDURESOur
board of directors was informed that if the company were not to pursue the acquisition of Tri-City, certain members of ourmanagement, includingPeter Appel,ourpresident andchief executive officer andRobert Clements, our chairman, may participate, as investors, inchief financial officer, have conducted anacquisition of Tri-City. Subsequently, Messrs. Appel and Clements, together with members of Tri-City management and certain other investors, including Distribution Investors LLC, a private equity fund affiliated with Hales & Company Inc. described below, acquired Tri-City. No member of our management has any management responsibilities with Tri-City. TRANSACTIONS INVOLVING AFFILIATES OF MARSH & MCLENNAN On November 8, 2001, ACGL, funds affiliated with Warburg Pincus and Hellman & Friedman, The Trident Partnership, L.P. ("Trident I"), Trident II, L.P., Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH") and employee co-investment funds affiliated with MMRCH entered into an agreement. Trident I and Trident II, L.P. are affiliates of MMRCH and MMRCH and MMC Capital are affiliates of each other. Under this agreement, the Warburg Pincus investors assigned their right and commitment to purchase $35.0 millionevaluation of thepreference shareseffectiveness of disclosure controls andClass A warrants to Trident II and the co-investment funds. MMRCH agreed to exchange all of its existing Class A warrants for newly issued common shares (assuming that they had been exercisedprocedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, our chief executive officer and chief financial officer concluded that the disclosure controls and procedures are effective in ensuring that all material information required to be filed in this annual report has been made known to them in acashless exercise) and to exchange all of its Class B warrants for cash at a price equal to $7.50 per Class B warrant (see Note 12 of the notes accompanying our consolidated financial statements). In addition, the board observer and board nomination rights of MMRCH and Trident I were terminated, and the company was also released from its remaining $11.0 million capital commitment to Trident II for new investments. During 1999, the company had committed to invest $25 million as a limited partnertimely fashion. There have been no significant changes inTrident II, a partnership managed by MMC Capital. Pursuant to a certain investment advisory agreement, which terminatesinternal controls, or in2003 (subject to renewal or early termination under certain circumstances), MMC Capital provides the company with certain services. Fees incurred under the agreements during fiscal years 2001, 2000 and 1999 were approximately $262,000, $298,000 and $1.5 million, respectively. In connection with its amended investment advisory agreement with MMC Capital, the company receives from MMC Capital $1.25 million per annum during the initial four-year term, subject to certain conditions (see Note 8 of the notes accompanying our consolidated financial statements). On June 22, 2001, the company completed the acquisition of all of the remaining ownership interests in one of its investee companies, Arch Risk Transfer Services Ltd., for a purchase price of approximately $38.8 million. Of such amount, $38.4 million was paid in cash to MMRCH and Trident I in return for their interests in ART Services, and the balance was paid in the form of our common shares to certain management shareholders of ART Services. See Note 3 of the notes accompanying our consolidated financial statements. In addition, the company has made investments in entities in which affiliates of Marsh and Trident have invested (see Note 4 of the notes accompanying our consolidated financial statements). Commencing in 1996, MMC Capital subleased office space from the company for a term expiring in October 2002. Future minimum rental income, exclusive of escalation clauses and maintenance costs, 84under the remaining term of the sublease will be approximately $832,000. Rental income was $1,032,000, $636,000 and $430,000 in 2001, 2000 and 1999, respectively. Affiliates of MMC Capital's ultimate parent, Marsh & McLennan Companies, Inc. ("Marsh"), may act as reinsurance intermediaries or brokers for our reinsurance and insurance operations (see note 15 of the notes accompanying our consolidated financial statements). The company has also utilized affiliates of Marsh as insurance brokers for the company's insurance needs. DISTRIBUTIONS INVESTORS, LLC As of December 31, 2001, the company has committed to invest approximately $1.5 million as a member of Distribution Investors, LLC, the general partner of a fund affiliated with our subsidiary, Hales & Company (see Note 4 of the notes accompanying our consolidated financial statements). With $50 million of committed capital, such fund focuses on equity investments in insurance distribution and distribution-related service companies, and its target investment amount is $3 million to $5 million. OTHER We have agreed to make a non-recourse loan of up to $13.5 million to our chairman, which will be used to pay income and self employment taxes, payable in April 2002, on restricted shares granted to him on October 23, 2001. See Note 9, "Commitments," of the notes accompanying our financial statements. Graham B. Collis, a director of certain of our non-U.S. subsidiaries, is partner in the law firm of Conyers Dill & Pearman, which provides legal servicesfactors that could significantly affect internal controls, subsequent to thecompanydate our chief executive officer andits subsidiaries. In April 1996, we acquired a 33% economic interest (9.75% voting interest) in Island Heritage Insurance Company, Ltd., a Cayman Islands insurer, for an aggregate purchase price of $4.5 million. Certain of our directors and other investors invested in the securities of Island Heritage at the same per share price paid by us. In February 1999, we made an additional investment in Island Heritage in the amount of approximately $1.0 million. Investors affiliated with certain of our directors have certain rights to require us to register under the Securities Act of 1933 the securities they hold, and to "piggyback" on registrations that we make. In connection with all such registrations, we are required to bear all registration and selling expenses (other than underwriting fees and commissions and the fees of any counsel for the holders participating in such registrations).chief financial officer completed their evaluation.76
ITEM
14.15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM8-K.8-K
FINANCIAL STATEMENTS AND SCHEDULESFinancial statements and schedules listed in the accompanying index to our financial statements and schedules on page F-1 are filed as part of this report, and are included in Item 8.
The exhibits listed in the accompanying exhibit index are filed as part of this report.
These exhibits include, without limitation, certain management contracts and compensatory plans as described therein.We filed the following reports on Form 8-K during the fourth quarter of 2002: (1) November 7 to furnish the 2002 third quarter earnings release issued by ACGL and to report that ACGL had entered into amendments to restricted share agreements with Robert Clements, the chairman of the board, and that ACGL and Mr. Clements had entered into a share repurchase agreement; and (2) November 14 for the purpose of providing the certifications of the president and the chief financial officer of ACGL under Section 906 of the Sarbanes-Oxley Act of 2002. We also filed a report on Form 8-K
duringon February 25, 2003 to furnish the20012002 fourth quarteron November 9, 2001earnings release issued by ACGL.
ITEM 16. PRINCIPAL ACCOUNTANT FEES AND SERVICESThe information required by this item is incorporated by reference from the information to
report the capital infusion. We also filed Form 8-K on January 4, 2002 (and an amendment thereto on January 7, 2002) to report the consummation of that transaction and to file certain exhibits relating to it. 85be included in our Proxy Statement. 77
Pursuant to the requirements of Section 13 or 15(d) 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)
By:/s/
/s/ PETER A. APPEL-----------------------------------------
Name: Peter A. Appel
Title: President & Chief Executive OfficerMarch
18, 200231, 2003Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
NAME TITLE DATE ---- ----- ----/s/Name Title Date
/s/ PETER A. APPEL
Peter A. Appel
President and Chief Executive------------------------------------Officer (Principal ExecutiveMarch 18, 2002 Peter A. AppelOfficer) and Director
March 31, 2003
*------------------------------------
Robert Clements
Chairman and Director
March18, 2002 Robert Clements31, 2003
/s/ JOHN D. VOLLARO
John D. Vollaro
Executive Vice President,andChief/s/ JOHN D. VOLLAROFinancial Officer and Treasurer (Principal------------------------------------Financial and PrincipalMarch 18, 2002 John D. VollaroAccounting Officer)* ------------------------------------ Director
March18, 200231, 2003
*
Wolfe "Bill" H. Bragin
Director
March 31, 2003
*
John L. Bunce, Jr.* ------------------------------------
Director
March18, 200231, 2003
*
Robert E. Glanville
Director
March 31, 200378
*
Paul B. Ingrey* ------------------------------------
Director
March18, 200231, 2003
*
Constantine Iordanou* ------------------------------------
Director
March18, 200231, 2003
*
Kewsong Lee* ------------------------------------
Director
March18, 200231, 2003
*
James J. Meenaghan86
NAME TITLE DATE ---- ----- ----* ------------------------------------
Director
March18, 200231, 2003
*
John M. Pasquesi* ------------------------------------
Director
March18, 200231, 2003
*
David R. Tunnell
Director
March 31, 2003
*
Robert F. Works
Director
March 31, 2003- ------------------------
- *
- By John D. Vollaro, as attorney-in-fact and agent, pursuant to a power of attorney, a copy of which has been filed with the Securities and Exchange Commission as Exhibit 24 to this report.
/s/JOHN D. VOLLARO
Name: John D. Vollaro
Attorney-in-Fact79
Certification of Chief Executive Officer
Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002I, Peter A. Appel, certify that:
- 1.
- I have reviewed this annual report on Form 10-K of Arch Capital Group Ltd.;
- 2.
- Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
- 3.
- Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
- 4.
- The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
- a.
- designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
- b.
- evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
- c.
- presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
- 5.
- The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
- a.
- all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
- b.
- any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
- 6.
- The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 31, 2003
/s/By: /s/ PETER A. APPEL Name: Peter A. Appel Title: President and Chief Executive Officer 80
Certification of Chief Financial Officer
Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002I, John D. Vollaro, certify that:
- 1.
- I have reviewed this annual report on Form 10-K of Arch Capital Group Ltd.;
- 2.
- Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
- 3.
- Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
- 4.
- The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
- a.
- designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
- b.
- evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
- c.
- presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
- 5.
- The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
- a.
- all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
- b.
- any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
- 6.
- The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 31, 2003
By: /s/ JOHN D. VOLLARO --------------------------------------Name: John D. Vollaro Attorney-in-FactTitle: Executive Vice President, Chief Financial Officer and Treasurer 8781
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
PAGES --------ARCH CAPITAL GROUP LTD. AND SUBSIDIARIESPages
Arch Capital Group Ltd. and Subsidiaries
Report of Independent Accountantson Financial Statements.........................
F-2
Consolidated Balance Sheets at December 31,20012002 and2000.........................2001
F-3
Consolidated Statements of Income for the years ended December 31, 2002, 20012000and1999............................................................................2000
F-4
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2002, 20012000and1999................................................2000
F-5
Consolidated Statements of Comprehensive Income for the years ended December 31, 2002, 20012000and1999.............................................................2000
F-6
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 20012000and1999........................................................................2000
F-7
Notes to Consolidated FinancialStatements........................................Statements
F-8SCHEDULES
Schedules
Report of Independent Accountants on Financial StatementSchedules................Schedules
S-1
I.
Summary of Investments Other Than Investments in Related Parties at December 31,2001..............................2002
S-2
II.
Condensed Financial Information ofRegistrant...............Registrant
S-3
III.
Supplementary Insurance Information for the years ended December 31, 2002, 20012000and1999..........................2000
S-6
IV.
Reinsurance for the years ended December 31, 2002, 20012000and1999......................................................2000
S-7Schedules other than those listed above are omitted for the reason that they are not applicable.
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
Report of Independent AccountantsTo the Board of Directors and Shareholders of
Arch Capital Group Ltd.In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows present fairly, in all material respects, the financial position of Arch Capital Group Ltd. and its subsidiaries at December 31,
20012002 and2000,2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31,20012002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion./s//s/ PricewaterhouseCoopers
Hamilton, BermudaLLPNew York, New York
February
28, 2002,19, 2003F-2
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, exceptas to the matters described in Note 18 to the consolidated financial statements which are as of March 7, 2002share data)
December 31, 2002 2001 Assets Investments: Fixed maturities available for sale, at fair value (amortized cost: 2002, $1,334,637; 2001, $467,154) $ 1,382,104 $ 468,269 Short-term investments available for sale, at fair value (amortized cost: 2002, $480,541; 2001, $477,058) 480,541 476,820 Publicly traded equity securities available for sale, at fair value (cost: 2002, $—; 2001, $960) — 235 Securities held in escrow, at fair value (amortized cost: 2002, $—; 2001, $22,156) — 22,156 Privately held securities (cost: 2002, $31,630; 2001, $41,587) 31,536 41,608 Total investments 1,894,181 1,009,088 Cash 91,717 9,970 Accrued investment income 17,127 7,572 Premiums receivable 343,716 59,463 Funds held by reinsureds 58,351 — Unpaid losses and loss adjustment expenses recoverable 211,100 90,442 Paid losses and loss adjustment expenses recoverable 14,462 14,418 Prepaid reinsurance premiums 120,191 58,961 Goodwill 28,867 26,336 Deferred income tax asset 16,514 13,716 Deferred acquisition costs, net 148,960 5,412 Other assets 46,142 18,323 Total Assets $ 2,991,328 $ 1,313,701 Liabilities Reserve for losses and loss adjustment expenses $ 592,432 $ 111,494 Unearned premiums 761,310 88,539 Reinsurance balances payable 89,191 47,029 Reserve for loss of escrowed assets — 18,833 Investment accounts payable 45,960 1,746 Other liabilities 91,191 25,691 Total Liabilities 1,580,084 293,332 Commitments and Contingencies
Shareholders' Equity
Preference shares ($.01 par value, 50,000,000 shares authorized, issued: 2002, 38,844,665; 2001, 35,687,735) 388 357 Common shares ($.01 par value, 200,000,000 shares authorized, issued: 2002, 27,725,334; 2001, 13,513,538) 277 135 Additional paid-in capital 1,347,165 1,039,887 Deferred compensation under share award plans (25,290 ) (8,230 ) Retained earnings (deficit) 47,372 (11,610 ) Accumulated other comprehensive income consisting of unrealized appreciation (decline) in value of investments, net of income tax 41,332 (170 ) Total Shareholders' Equity 1,411,244 1,020,369 Total Liabilities and Shareholders' Equity $ 2,991,328 $ 1,313,701 See Notes to Consolidated Financial Statements
F-2F-3
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATEDBALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)STATEMENTS OF INCOME
DECEMBER 31, --------------------- 2001 2000 ---------- --------ASSETS Investments: Fixed maturities available for sale, at fair value (amortized cost: 2001, $467,154; 2000, $37,849)........... $ 468,269 $ 38,475 Short-term investments available for sale, at fair value (amortized cost: 2001, $477,058; 2000, $97,387)........... 476,820 97,387 Publicly traded equity securities available for sale, at fair value (cost: 2001, $960; 2000, $24,987).............. 235 51,322 Securities held in escrow, at fair value (amortized cost: 2001, $22,156; 2000, $20,887)............................. 22,156 20,970 Privately held securities (cost: 2001, $41,587; 2000, $57,913).................................................. 41,608 56,418 ---------- -------- Total investments........................................... 1,009,088 264,572 ---------- -------- Cash........................................................ 9,970 11,481 Accrued investment income................................... 7,572 1,432 Premiums receivable......................................... 59,463 -- Unpaid losses and loss adjustment expenses recoverable...... 90,442 -- Paid losses and loss adjustment expenses recoverable........ 14,418 -- Prepaid reinsurance premiums................................ 58,961 -- Goodwill.................................................... 26,336 6,111 Deferred income tax asset................................... 13,716 8,192 Deferred policy acquisition costs........................... 5,412 -- Other assets................................................ 18,323 4,119 ---------- -------- TOTAL ASSETS................................................ $1,313,701 $295,907 ========== ======== LIABILITIES Reserve for losses and loss adjustment expenses............. $ 113,507 $ -- Unearned premiums........................................... 88,539 -- Reinsurance balances payable................................ 47,029 -- Reserve for loss of escrowed assets......................... 18,833 15,000 Other liabilities........................................... 25,424 8,608 ---------- -------- TOTAL LIABILITIES........................................... 293,332 23,608 ---------- -------- COMMITMENTS AND CONTINGENCIES (SEE NOTE 3 AND NOTE 9) SHAREHOLDERS' EQUITY Preference shares ($.01 par value, 50,000,000 shares authorized, issued: 2001, 35,687,735; 2000, 0)............ 357 -- Common shares ($.01 par value, 200,000,000 shares authorized, issued: 2001, 13,513,538; 2000, 12,708,818)... 135 127 Additional paid-in capital.................................. 1,039,887 288,016 Deferred compensation under share award plan................ (8,230) (341) Retained earnings (deficit)................................. (11,610) (33,626) Accumulated other comprehensive income consisting of unrealized appreciation (decline) in value of investments, net of income tax......................................... (170) 18,123 ---------- -------- TOTAL SHAREHOLDERS' EQUITY.................................. 1,020,369 272,299 ---------- -------- TOTAL LIABILITIES & SHAREHOLDERS' EQUITY.................... $1,313,701 $295,907 ========== ========
(In thousands, except share data)
Years Ended December 31, 2002 2001 2000 Revenues Net premiums written $ 1,261,627 $ 36,216 ($ 10,604 ) (Increase) decrease in unearned premiums (606,651 ) (5,298 ) 98,134 Net premiums earned 654,976 30,918 87,530 Net investment income 51,249 12,120 15,923 Net realized investment (losses) gains (839 ) 18,382 20,045 Fee income 14,208 12,426 — Other income 2,175 2,608 1,945 Gain on sale of prior reinsurance operations — — 2,191 Total revenues 721,769 76,454 127,634 Expenses Losses and loss adjustment expenses 424,538 23,448 76,263 Acquisition expenses 118,961 813 26,756 Other operating expenses 76,699 27,692 6,855 Net foreign exchange (gains) losses (2,449 ) — 1,159 Non-cash compensation 49,480 2,771 1,098 Provision for loss of escrowed assets, net — (2,414 ) 15,000 Total expenses 667,229 52,310 127,131 Income Before Income Taxes and Extraordinary Item 54,540 24,144 503 Income taxes: Current 7,373 656 — Deferred (7,929 ) 1,472 8,515 Income tax (benefit) expense (556 ) 2,128 8,515 Income (Loss) Before Extraordinary Item 55,096 22,016 (8,012 ) Extraordinary gain—excess of fair value of acquired net assets over cost (net of $0 tax) 3,886 — — Net Income (Loss) $ 58,982 $ 22,016 ($ 8,012 ) Net Income (Loss) Per Share Data Basic: Income (loss) before extraordinary item $ 2.74 $ 1.71 ($ 0.61 ) Extraordinary gain $ 0.19 — — Net income (loss) $ 2.93 $ 1.71 ($ 0.61 ) Diluted: Income (loss) before extraordinary item $ 0.92 $ 1.29 ($ 0.61 ) Extraordinary gain $ 0.07 — — Net income (loss) $ 0.99 $ 1.29 ($ 0.61 ) Average Shares Outstanding Basic 20,095,698 12,855,668 13,198,075 Diluted 59,662,178 17,002,231 13,198,075 See Notes to Consolidated Financial Statements
F-3F-4
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT SHARE DATA)
YEARS ENDED DECEMBER 31, --------------------------------------- 2001 2000 1999 ----------- ----------- -----------REVENUES Net premiums written.................................. $ 36,216 $ (10,604) $ 306,726 (Increase) decrease in unearned premiums.............. (5,298) 98,134 4,642 ----------- ----------- ----------- Net premiums earned................................... 30,918 87,530 311,368 Net investment income................................. 12,120 15,923 20,173 Net realized investment gains (losses)................ 18,382 20,045 17,227 Fee income............................................ 12,426 -- -- Equity in net income (loss) of investees.............. 2,608 1,945 (3,968) Gain on sale of prior reinsurance operations.......... -- 2,191 -- ----------- ----------- ----------- TOTAL REVENUES........................................ 76,454 127,634 344,800 ----------- ----------- ----------- EXPENSES Losses and loss adjustment expenses................... 23,448 76,263 305,841 Net commissions and brokerage......................... 813 26,756 80,540 Other operating expenses.............................. 27,692 6,855 14,188 Provision for non-cash compensation................... 2,771 1,098 628 Provision for loss of escrowed assets, net of other related reserves.................................... (2,414) 15,000 -- Foreign exchange (gain) loss.......................... -- 1,159 (198) ----------- ----------- ----------- TOTAL EXPENSES........................................ 52,310 127,131 400,999 ----------- ----------- ----------- INCOME (LOSS) BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE......................... 24,144 503 (56,199) ----------- ----------- ----------- Income taxes: Current............................................... 656 -- (9,021) Deferred.............................................. 1,472 8,515 (11,925) ----------- ----------- ----------- Income tax expense (benefit).......................... 2,128 8,515 (20,946) ----------- ----------- ----------- Income (Loss) Before Cumulative Effect of Accounting Change.............................................. 22,016 (8,012) (35,253) Cumulative effect of accounting change................ -- -- (383) ----------- ----------- ----------- NET INCOME (LOSS)..................................... $ 22,016 $ (8,012) $ (35,636) =========== =========== =========== NET INCOME (LOSS) PER SHARE DATA Basic................................................. $ 1.71 $ (0.61) $ (2.09) Diluted............................................... $ 1.29 $ (0.61) $ (2.09) AVERAGE SHARES OUTSTANDING Basic................................................. 12,855,668 13,198,075 17,086,732 Diluted............................................... 17,002,231 13,198,075 17,086,732See Notes to Consolidated Financial Statements F-4ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY(IN THOUSANDS)
YEARS ENDED DECEMBER 31, -------------------------------- 2001 2000 1999 ---------- -------- --------PREFERENCE SHARES Balance at beginning of year................................ -- -- -- Preference shares issued.................................... $ 357 -- -- ---------- -------- -------- BALANCE AT END OF YEAR...................................... 357 -- -- ---------- -------- -------- COMMON SHARES Balance at beginning of year................................ 127 $ 171 $ 171 Common shares issued........................................ 11 4 -- Common shares retired....................................... (3) (48) -- ---------- -------- -------- BALANCE AT END OF YEAR...................................... 135 127 171 ---------- -------- -------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of year................................ 288,016 342,034 341,878 Common shares issued........................................ 11,345 5,736 156 Common shares retired....................................... (48) (59,754) -- Preference shares issued.................................... 740,380 -- -- Stock options issued........................................ 194 -- -- ---------- -------- -------- BALANCE AT END OF YEAR...................................... 1,039,887 288,016 342,034 ---------- -------- -------- DEFERRED COMPENSATION UNDER SHARE AWARD PLAN Balance at beginning of year................................ (341) (317) (1,062) Restricted common shares (issued) cancelled................. (10,466) (1,122) 117 Deferred compensation expense recognized.................... 2,577 1,098 628 ---------- -------- -------- BALANCE AT END OF YEAR...................................... (8,230) (341) (317) ---------- -------- -------- RETAINED EARNINGS (DEFICIT) Balance at beginning of year................................ (30,916) (22,175) 10,261 Adjustment to retroactively adopt the equity method of accounting for the original investment in ART Services.... (2,710) (3,439) (239) ---------- -------- -------- Balance at beginning of year, as adjusted................... (33,626) (25,614) 10,022 Net income (loss)........................................... 22,016 (8,012) (35,636) ---------- -------- -------- BALANCE AT END OF YEAR...................................... (11,610) (33,626) (25,614) ---------- -------- -------- TREASURY SHARES, AT COST Balance at beginning of year................................ -- (387) (284) Treasury shares purchased................................... (48) (59,415) (103) Treasury shares retired..................................... 48 59,802 -- ---------- -------- -------- BALANCE AT END OF YEAR...................................... -- -- (387) ---------- -------- -------- ACCUMULATED OTHER COMPREHENSIVE INCOME UNREALIZED APPRECIATION (DECLINE) IN VALUE OF INVESTMENTS, NET OF INCOME TAX Balance at beginning of year................................ 18,432 27,188 47,038 Adjustment to retroactively adopt the equity method of accounting for the original investment in ART Services.... (309) (745) -- ---------- -------- -------- Balance at beginning of year, as adjusted................... 18,123 26,443 47,038 Change in unrealized appreciation (decline)................. (18,293) (8,320) (20,595) ---------- -------- -------- BALANCE AT END OF YEAR...................................... (170) 18,123 26,443 ---------- -------- -------- TOTAL SHAREHOLDERS' EQUITY.................................. $1,020,369 $272,299 $342,330 ========== ======== ========
(In thousands)
Years Ended December 31, 2002 2001 2000 Preference Shares Balance at beginning of year $ 357 — — Preference shares issued 31 $ 357 — Balance at end of year 388 357 — Common Shares Balance at beginning of year 135 127 $ 171 Common shares issued 147 11 4 Common shares retired (5 ) (3 ) (48 ) Balance at end of year 277 135 127 Additional Paid-in Capital Balance at beginning of year 1,039,887 288,016 342,034 Common shares issued 319,866 11,345 5,736 Common shares retired (13,097 ) (48 ) (59,754 ) Preference shares issued (316 ) 740,380 — Stock options issued 825 194 — Balance at end of year 1,347,165 1,039,887 288,016 Deferred Compensation Under Share Award Plan Balance at beginning of year (8,230 ) (341 ) (317 ) Restricted common shares issued (66,245 ) (10,466 ) (1,122 ) Deferred compensation expense recognized 49,185 2,577 1,098 Balance at end of year (25,290 ) (8,230 ) (341 ) Retained Earnings (Deficit) Balance at beginning of year (11,610 ) (30,916 ) (22,175 ) Adjustment to retroactively adopt the equity method of accounting for the original investment in ART Services — (2,710 ) (3,439 ) Balance at beginning of year, as adjusted (11,610 ) (33,626 ) (25,614 ) Net income (loss) 58,982 22,016 (8,012 ) Balance at end of year 47,372 (11,610 ) (33,626 ) Treasury Shares, At Cost Balance at beginning of year — — (387 ) Treasury shares purchased — (48 ) (59,415 ) Treasury shares retired — 48 59,802 Balance at end of year — — — Accumulated Other Comprehensive Income Unrealized Appreciation (Decline) in Value of Investments, Net of Income Tax Balance at beginning of year (170 ) 18,432 27,188 Adjustment to retroactively adopt the equity method of accounting for the original investment in ART Services — (309 ) (745 ) Balance at beginning of year, as adjusted (170 ) 18,123 26,443 Change in unrealized appreciation (decline) 41,502 (18,293 ) (8,320 ) Balance at end of year 41,332 (170 ) 18,123 Total Shareholders' Equity $ 1,411,244 $ 1,020,369 $ 272,299 See Notes to Consolidated Financial Statements
F-5
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(IN THOUSANDS)
YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------COMPREHENSIVE INCOME (LOSS) Net income.................................................. $22,016 $ (8,012) $(35,636) Other comprehensive income (loss), net of tax Unrealized appreciation (decline) of investments: Unrealized holding gains (losses) arising during year... (7,153) 4,317 (9,397) Less: reclassification of net realized gains included in net income............................................ 11,140 12,637 11,198 ------- -------- -------- Other comprehensive income (loss)......................... (18,293) (8,320) (20,595) ------- -------- -------- COMPREHENSIVE INCOME (LOSS)................................. $ 3,723 $(16,332) $(56,231) ======= ======== ========
(In thousands)
Years Ended December 31, 2002 2001 2000 Comprehensive Income (Loss) Net income (loss) $ 58,982 $ 22,016 $ (8,012 ) Other comprehensive income (loss), net of tax Unrealized appreciation (decline) in value of investments: Unrealized holding gains (losses) arising during year 38,884 (7,153 ) 4,317 Reclassification of net realized losses (gains) included in net income 2,618 (11,140 ) (12,637 ) Other comprehensive income (loss) 41,502 (18,293 ) (8,320 ) Comprehensive Income (Loss) $ 100,484 $ 3,723 $ (16,332 ) See Notes to Consolidated Financial Statements
F-6
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS(IN THOUSANDS)
YEARS ENDED DECEMBER 31, -------------------------------- 2001 2000 1999 --------- --------- --------OPERATING ACTIVITIES Net income (loss)........................................... $ 22,016 $ (8,012) $(35,636) Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Net investment gains................................ (18,382) (11,542) (17,227) Provision for non-cash compensation................. 2,771 1,098 628 Reserve for loss of escrowed assets................. 3,733 15,000 -- Changes in: Reserve for losses and loss adjustment expenses, net............................................. 8,309 7,069 147,897 Unearned premiums................................. 8,558 (5,226) (4,642) Premiums receivable............................... (8,331) 10,733 (30,710) Accrued investment income......................... (5,181) 3,095 (1,895) Reinsurance recoverables.......................... (13,568) (11,093) (31,938) Reinsurance balances payable...................... 560 (5,121) 9,270 Deferred policy acquisition costs................. (1,076) 344 (70) Deferred income tax asset......................... 1,665 6,855 (10,327) Other liabilities................................. (1,605) 8,098 11,695 Other items, net.................................. (5,098) (8,669) (29,499) --------- --------- -------- NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES........ (5,629) 2,629 7,546 --------- --------- -------- INVESTING ACTIVITIES Purchases of fixed maturity investments..................... (560,246) (131,788) (374,862) Sales of fixed maturity investments......................... 182,904 228,456 270,325 Purchases of equity securities.............................. -- (18,233) (39,364) Sales of equity securities.................................. 47,144 89,862 92,045 Net sales (purchases) of short-term investments............. (365,238) (171,173) 41,898 Acquisition of ART Services, net of cash.................... (34,546) -- -- Acquisition of American Independent Insurance Holding Company, net of cash...................................... 102 -- -- Acquisition of Hales........................................ -- (1,792) -- Sales or disposal (purchases) of furniture, equipment and other..................................................... (6,311) 6 (338) Proceeds from sale of prior reinsurance operations.......... -- 517 -- --------- --------- -------- NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES........ (736,191) (4,145) (10,296) --------- --------- -------- FINANCING ACTIVITIES Common shares issued, primarily stock based compensation.... 10,923 5,620 156 Preference shares issued.................................... 740,737 -- -- Purchase of treasury shares................................. (48) 3,430 (103) Deferred compensation on restricted shares.................. (10,466) (1,122) 117 Debt retirement............................................. (450) -- -- Shares issued in connection with acquisitions............... (387) (4,388) -- --------- --------- -------- NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES........ 740,309 3,540 170 --------- --------- -------- Increase (decrease) in cash................................. (1,511) 2,024 (2,580) Cash beginning of year...................................... 11,481 9,457 12,037 --------- --------- -------- CASH END OF YEAR............................................ $ 9,970 $ 11,481 $ 9,457 ========= ========= ======== Net income taxes paid (received)............................ $ 330 -- $ (8,605) ========= ========= ========
(In thousands)
Years Ended December 31, 2002 2001 2000 Operating Activities Net income (loss) $ 58,982 $ 22,016 ($ 8,012 ) Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Net realized investment losses (gains) 839 (18,382 ) (11,542 ) Provision for non-cash compensation 49,480 2,771 1,098 Reserve for loss of escrowed assets — 3,733 15,000 Net unrealized foreign exchange gains 36 — — Excess of fair value of net assets acquired over cost (3,886 ) — — Changes in: Reserve for losses and loss adjustment expenses, net of unpaid losses and loss adjustment expenses recoverable 348,268 8,309 7,069 Unearned premiums, net of prepaid reinsurance premiums 606,360 8,558 (5,226 ) Premiums receivable (279,419 ) (8,331 ) 10,733 Deferred acquisition costs (143,548 ) (1,076 ) 344 Funds held by reinsureds (58,294 ) — — Reinsurance balances payable 41,554 560 (5,121 ) Accrued investment income (9,332 ) (5,181 ) 3,095 Paid losses and loss adjustment expenses recoverable 6,823 (13,568 ) (11,093 ) Deferred income tax asset (8,099 ) 1,665 6,855 Other liabilities 57,870 (1,605 ) 8,098 Other items, net 1,418 (5,098 ) (8,669 ) Net Cash Provided By (Used For) Operating Activities 669,052 (5,629 ) 2,629 Investing Activities Purchases of fixed maturity investments (1,253,637 ) (560,246 ) (131,788 ) Release of escrowed assets (18,833 ) — — Sales of fixed maturity investments 407,144 182,904 228,456 Purchases of equity securities — — (18,233 ) Sales of equity securities 13,726 47,144 89,862 Net sales (purchases) of short-term investments 45,666 (365,238 ) (171,173 ) Acquisitions, net of cash (4,829 ) (34,444 ) (1,792 ) Sales or disposal (purchases) of furniture, equipment and other (17,710 ) (6,311 ) 6 Proceeds from sale of prior reinsurance operations — — 517 Net Cash Used For Investing Activities (828,473 ) (736,191 ) (4,145 ) Financing Activities Proceeds from common shares issued 254,338 457 4,498 Preference shares issued — 740,737 — Repurchase of common shares (13,102 ) (48 ) 3,430 Debt retirement (68 ) (450 ) — Shares issued in connection with acquisitions — (387 ) (4,388 ) Net Cash Provided By Financing Activities 241,168 740,309 3,540 Increase (decrease) in cash 81,747 (1,511 ) 2,024 Cash beginning of year 9,970 11,481 9,457 Cash end of year $ 91,717 $ 9,970 $ 11,481 Net income taxes paid $ 2,863 $ 330 — See Notes to Consolidated
Financialfinancial StatementsF-7
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS1.
ORGANIZATIONOrganizationArch Capital Group Ltd. ("ACGL") is a Bermuda public limited liability company
with more than $1 billion in equity capital, providingwhich provides insurance and reinsurance on a worldwide basis through its wholly owned subsidiaries.ACGL was formed in September 2000 and became the sole shareholder of Arch Capital Group (U.S.) Inc. ("Arch-U.S.") pursuant to an internal reorganization transaction completed in November 2000, as described below. Arch-U.S. is a Delaware company formed in March 1995 under the original name of "Risk Capital Holdings, Inc."
Arch-U.S. commenced operations following the completion of its initial public offering in September 1995. In connection with its initial public offering, the Company issued Class A Warrants to purchase an aggregate of 2,531,079 Common Shares and Class B Warrants to purchase an aggregate of 1,920,601 Common Shares. Class A Warrants are immediately exercisable at $20 per share and expire September 19, 2002. Class B Warrants will become exercisable at $20 per share after the Common Shares have traded at or above $30 per share for 20 out of 30 consecutive trading days or a change of control (as defined in the Class B Warrants) has occurred. The Class B Warrants expire on September 19, 2005.Prior to May 5, 2000, Arch-U.S. provided reinsurance and other forms of capital for insurance companies through its wholly owned subsidiary, Arch Reinsurance Company ("ArchRe"Re U.S."), a Nebraska corporation formed in 1995 under the original name of "Risk Capital Reinsurance Company."On May 5, 2000, Arch-U.S. sold the prior reinsurance operations of Arch Re U.S. to Folksamerica Reinsurance Company ("Folksamerica")
.in an asset sale. The Folksamerica transaction was structured as a transfer and assumption agreement (and not reinsurance) and, accordingly, the loss reserves (and any related reinsurance recoverables) related to the transferred business are not included in the Company's balance sheet. However, in the event that Folksamerica refuses or is unable to make payment of claims on the reinsurance business assumed by it in the May 2000 sale and the notice given to reinsureds is found not to be an effective release by such reinsureds, Arch Re U.S. would be liable for such claims. See Note 13.On November 8, 2000, following the approval of Arch-U.S.'s shareholders, Arch-U.S. completed an internal reorganization that resulted in Arch-U.S. becoming a wholly owned subsidiary of ACGL. ACGL performs the holding company functions previously conducted by Arch-U.S., and the shareholders of Arch-U.S.
have becomebecame the shareholders of ACGL.PriorIn October 2001, the Company launched an underwriting initiative to meet current and future demand in the global insurance and reinsurance markets that included the recruitment of new management teams and an equity capital infusion of $763.2 million. In April 2002, the Company completed an offering of 7,475,000 of its common shares and received net proceeds of $179.2 million. Due to the
reorganization, ACGL had nosignificantassets or capitalizationchanges in the Company's business andhadoperations resulting from the new underwriting initiative and related capital infusions, comparisons of 2002 to 2001 and 2000 results are notengaged in any business or prior activities other than in connection with the reorganization. Arch-U.S. remains the holding company for certain United States subsidiaries.meaningful.As used herein, the "Company" means ACGL and its subsidiaries, except when referring to periods prior to November 8, 2000, when it means Arch-U.S. and its subsidiaries. Similarly, "Common Shares" means the common shares, par value $0.01, of ACGL, except when referring to periods prior to November 8, 2000, when it means the common stock of Arch-U.S.
On October 24, 2001, the Company announced the launch2. Significant Accounting Policies
(a) Basis of
a new underwriting initiative to meet current and future demand in the global insurance and reinsurance markets. Simultaneously with the launch of its new underwriting initiative, the Company entered into subscription agreements with investors led by Warburg Pincus investment funds and Hellman & Friedman investment funds (the "principal investors") and certain members of management. On November 20, 2001, the Company issued 35,687,735 Series A convertible preference shares and 3,776,025 Class A Warrants in exchange for $763.2 million in cash under such agreements (see Note 12). In a related transaction, upon the closing of this investment, 905,397 previously existing Class A Warrants held by Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH") were canceled in exchange for 140,380 newly issued Common Shares, and Class B Warrants to purchase 1,770,601 Common Shares held by MMRCH were canceled in exchange for a cash payment by the Company of $7.50 per Class B Warrant (approximately $13.3 million in the aggregate) (see Note 8). F-8ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (A) BASIS OF PRESENTATIONPresentationThe consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP") in the United States and include the accounts of ACGL, Arch Reinsurance Ltd. ("Arch Re Bermuda"), Arch Re U.S., Arch-U.S.,
HalesArch Insurance Company ("Arch Insurance"), Arch Specialty Insurance Company ("Arch Specialty"), Arch Excess & Surplus Insurance CompanyInc.("Hales"Arch E&S"), Arch Risk Transfer Services Ltd. ("ART Services"), American Independent Insurance Holding Company ("AIHC"),Arch Risk Transfer Services Ltd., formerly known as Altus Holdings, Ltd. ("ART Services"), Arch Re and Cross RiverPersonal Service Insurance Company ("Cross River"PSIC") and Hales & Company Inc. ("Hales"). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requiresF-8
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.
(B) PREMIUM REVENUES AND RELATED EXPENSES
(b) Premium Revenues and Related Expenses
Insurance premiums written are recorded at the policy inception and are earned in accordance with the terms of the
underlyingpolicies. Unearned premium reserves represent the portion of such premiums written that relates to the unexpired terms of insurance policies in force.Reinsurance
premiums assumed are recognized as incomecontracts and policies written on apro ratalosses occurring basis cover losses which occur during the term of the contract or policy, typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts written on a risks attaching basis cover losses which attach to the underlying insurance policies written during the terms of therelatedcontracts. Premiums earned on a risks attaching basis usually extend beyond the original term of the reinsurancecontracts. These amounts arecontract, typically resulting in recognition of premiums earned over a 24 month period.Premiums written include estimates based on reports received from ceding companies, supplemented by the Company's own estimates of premiums for which ceding company reports have not been received. Subsequent differences
arisingpertaining to such estimates are recorded as an adjustment to premiums written in the period they are determined. Premiums onsuch estimatesthe Company's excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the date of the treaty. Estimates of premiums assumed under pro rata contracts, primarily written on a risks attaching basis, are recorded in the period in which the underlying risks are expected to incept and are based on information provided by brokers and ceding companies and estimates of the underlying economic conditions at the time the risk is underwritten. For multi-year reinsurance treaties which are payable in annual installments, only the initial annual installment is included as written at policy inception due to the ability of the insured or reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term. As actual premiums are recorded by the ceding companies, management evaluates the appropriateness of the premium estimates and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to original premium estimates could be material and such adjustments may directly and significantly impact earnings in the period they aredetermined.determined because the subject premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums, net of commissions, are not currently due based on the terms of the underlying contracts.Reinsurance premiums assumed are earned generally on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of contracts in force.
Certain of the Company's contracts
includedinclude provisions thatadjustedadjust premiums or acquisitioncostsexpenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses underthosethese experience-related contracts, are recorded based upon theexpectedprojected ultimate experience under these contracts.Acquisition costs, whichF-9
The Company also writes certain business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, the Company assumes a measured amount of insurance risk in exchange for a specified margin. The contractual terms may include additional or return premium based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages and financial quota share coverages.
Under GAAP, acquisition expenses and other expenses that vary with and are
primarilydirectly related to the acquisition ofpolicies, consisting principally of commissions and brokerage expenses incurred atbusiness related to thetime a contract is issued,Company's underwriting operations are deferred and amortized over the period in which the related premiums are earned. Under statutory accounting principles, underwriting expenses are recognized immediately as premiums are written.Acquisition expenses consist principally of commissions, brokerage and taxes paid to obtain business. A significant portion of such costs are paid based on a percentage of the premium written and will vary for each class or line of business that the Company underwrites. Other operating expenses also include expenses that vary with and are directly related to the acquisition of business. Acquisition expenses for the insurance segment are reflected net of ceding commissions from third party reinsurers as described below. Deferred acquisition costs are carried at their estimated realizable value based on the related unearned
premiums and takepremiums. In estimating the estimated realizable value, the Company takes into account anticipated losses and loss adjustment expenses based on historical andcurrentprojected experience, and anticipated investment income.(C) REINSURANCE CEDED
(c) Deposit Accounting
Certain reinsurance contracts included in the Company's non-traditional business, which pursuant to Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," issued by the Financial Accounting Standards Board ("FASB"), are deemed, for financial reporting purposes, not to transfer insurance risk, are accounted for using the deposit method of accounting as prescribed in Statement of Position 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in the Company's underwriting results. For those contracts that do not transfer an element of underwriting risk, the estimated profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income.
(d) Reinsurance Ceded
In the normal course of business, the Company
seekspurchases reinsurance toreduceincrease capacity and to limit theloss that may arise fromimpact of individual losses and eventsthat could cause unfavorableon its underwriting results by reinsuring certain levels of risk with other insurance enterprises or reinsurers. The Company usesquota-share, surplus share andpro rata, excess of loss and facultative reinsurance contracts. Reinsurance commissions are recognized as income on a pro rata basis over the period of risk. The portion of such commissions that will be earned in the future is deferred and reported as a reduction topolicyacquisition costs. The accompanying consolidated statement of income reflects premiums and losses and loss adjustment expenses andpolicyacquisition costs, net of reinsurance ceded (see Note6)4). Ceded unearned premiums are reported as prepaid reinsurance premiums and estimated amounts of reinsurance recoverable on unpaid losses are included as unpaid losses and loss adjustment expenses recoverable. Reinsurance premiums and unpaid losses and lossF-10
adjustment expenses recoverable are estimated in a manner consistent with that of the original policies
F-9ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)issued and the terms of the reinsurance contracts. To the extent that any reinsurer does not meet its obligations under reinsurance agreements, the Company must discharge the liability.Provision is made for estimated unrecoverable reinsurance. (D) FEE INCOME
(e) Fee Income
Policy-related fee income, such as billing, cancellation and reinstatement fees, are primarily recognized as earned when substantially all of the related services have been provided. Fee income in connection with advisory services is recognized as earned when all services have been performed and the underlying transactions are substantially completed.
Policy related fee income, such as billing, cancellation and reinstatement fees are primarily recognized when billed. (E) INVESTMENTS
(f) Investments
The Company currently classifies all of its publicly traded fixed maturity, short-term investments and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturity securities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. Short-term investments include certain cash equivalents which are part of investment portfolios under the management of external investment managers and comprise securities due to mature within one year of the date of issue.
Investments in privately held securities
issued by privately and publicly held companies,may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities) and debt securities. Privately held securities are subject to trading restrictions or are otherwise illiquid and do not have readily ascertainable market values.The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in the Company's inability to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security which the Company seeks to sell.Such investments are classified as "available for sale" and carried at estimated fair value, except for investments in which the Company believes it has the ability to exercise significant influence (generally defined as investments in which the Company owns 20% or more of the outstanding voting common stock of the issuer), which are carried under the equity method of accounting. Under this method, the Company initially records an investment at cost, and then records its proportionate share of comprehensive income or loss for such investment after the date ofacquisition.acquisition as other income. The estimated fair value of investments in privately held securities, other than those carried under the equity method, is initially equal to the cost of such investments until the investments are revalued based principally on substantive events or other factors which could indicate a diminution or appreciation in value, such as an arm's-length third party transaction justifying an increased valuation or adverse development of a significant nature requiring awrite down. Investment gains or losses realized onwrite-down.In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the
sale ofCompany periodically reviews its investmentsare determined by the first-in first-out method and reflected in net income. Unrealized appreciation orto determine whether a decline in fair valueof securities which are carried atbelow the amortized cost basis is other than temporary. If such decline in fair value isexcluded from net income and recordedjudged to be other than temporary, the Company would write down the investment to fair value as aseparate componentnew cost basis and the amount ofother comprehensivethe write-down would be charged to incomenet of applicable deferred income tax.as a realized loss. The new cost basis would not be changed for subsequent recoveries in fair value.Net investment income, consisting of dividends and interest, net of investment expenses, is recognized when earned. The amortization of premium and accretion of discount for fixed maturity investments is computed utilizing the interest method. Anticipated prepayments and expected maturities are used in applying the interest method for certain investments such as mortgage and other asset-backed securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The
F-10ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)net investment in such securities is adjusted to the amount that would have existed had the newF-11
effective yield been applied since the acquisition of the security. Such adjustments, if any, are included in net investment income when determined.
Investment gains or losses realized on the sale of investments are determined by the first-in first-out method and are reflected in net income.
(F) LOSSES AND LOSS ADJUSTMENT EXPENSESUnrealized appreciation or decline in value of securities which are carried at fair value is excluded from net income and recorded as a separate component of other comprehensive income, net of applicable deferred income tax.
(g) Reserves for Losses and Loss Adjustment Expenses
The reserve for losses and loss adjustment expenses consists of estimates of unpaid reported losses and loss adjustment expenses and estimates for losses incurred but not reported.
These reserves are based on case basis evaluationsThe reserve for unpaid reported losses andstatistical analysis, and are not discounted. For reinsurance assumed, such reserves areloss adjustment expenses is established by management based on reportsreceivedfrom ceding companies and claims from insureds and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company. Such reserves are supplemented bythe Company'smanagement's estimates of reserves for losses incurred for whichceding companyreports or claims have not beenreceived, andreceived. Since theCompany's own historical experience. To the extent that the Company's ownCompany has limited historical experienceis inadequate for estimating reserves,upon which to base such estimates, the estimates are determined based upon industry experience, information used in pricing contracts and policies and management's judgment. Theultimate liability may vary from suchCompany's reserving method for 2002 was primarily the expected loss method. The Company selects the initial expected loss and loss adjustment expense ratios based on information derived by its underwriters and actuaries during the initial pricing of the business. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. These estimates are reviewed regularly and,anyas experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments,to such estimatesif any, are reflected in income in the period in which they are determined. Inherent in the estimates of ultimate losses and loss expenses are expected trends in claims severity and frequency and other factors which may vary significantly as claims are settled. Accordingly, ultimate losses and loss expenses may differ materially from the amounts recorded in the accompanying consolidated financial statements. Losses and loss adjustment expenses are primarily recordedwithout consideration of potential salvage or subrogation recoveries which are estimated to be immaterial. Such recoveries, when realized, are reflected as a reduction of losses incurred. (G) FOREIGN EXCHANGEon an undiscounted basis.
(h) Foreign Exchange
The United States dollar is the functional currency for all of the Company's
foreignbusiness.Gains and losses on the translation into United States dollars of amounts that are denominated in foreign currencies are included in net income. Foreign currency revenue and expenses are translated at average exchange rates during the year.Unhedged monetary assets and liabilities denominated in foreign currencies aretranslatedrevalued at the exchange rateof exchangein effect at the balance sheetdate. (H) INCOME TAXES The Company utilizesdate with the resulting foreign exchange gains and losses included in net income. Revenues and expenses denominated in foreign currencies are translated at average exchange rates during the year. Under GAAP, accounts that are classified as monetary assets and liabilities, such as premiums receivable and the reserve for losses and loss adjustment expenses, are revalued at each balance sheetmethod of accounting for income taxes.date. Pursuant to GAAP, accounts that are classified as non-monetary, such as deferred acquisition costs and the unearned premium reserves, are not revalued.
(i) Income Taxes
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. A valuation allowance is recorded if it is
"more-likely-than-not"more-likely-than-not that some or all of a deferred tax asset may not be realized.(I) EARNINGS PER SHARE DATAF-12
(j) Earnings Per Share Data
Earnings per share are computed in accordance with SFAS No. 128, "Earnings
per share" (see Note 13 for the Company'sPer Share." The calculation of basic earnings per sharecomputations). Basic earnings per share excludeexcludes dilution and is computed by dividing income available to common shareholders by the weighted average number of Common Shares, including vested restricted shares, outstanding for the periods.DilutedThe calculation of diluted earnings per sharereflectreflects the potential dilution that could occur if Series A convertible preference shares ("PreferenceShares,Shares"), ClassA andBwarrants,Warrants, nonvested restricted shares and employee stock options were exercised for Common Shares. When a loss occurs, diluted per share amounts are computed using basic average shares outstanding because including dilutive securities would decrease the loss per share and would therefore be anti-dilutive.F-11ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (J) STOCK OPTIONSThe following table sets forth the computation of basic and diluted earnings per share:
Years Ended December 31, 2002 2001 2000 (in thousands, except share and
per share data)Basic Earnings Per Share: Net income (loss) $ 58,982 $ 22,016 $ (8,012 ) Divided by: Weighted average shares outstanding for the period 20,095,698 12,855,668 13,198,075 Basic earnings (loss) per share $ 2.93 $ 1.71 $ (0.61 ) Diluted Earnings Per Share: Net income (loss) $ 58,982 $ 22,016 $ (8,012 ) Divided by: Weighted average shares outstanding for the period 20,095,698 12,855,668 13,198,075 Effect of dilutive securities: Preference shares 36,818,376 4,106,534 — Warrants 905,135 — — Nonvested restricted shares 1,004,055 5,987 — Employee stock options 838,914 34,042 — Total shares 59,662,178 17,002,231 13,198,075 Diluted earnings (loss) per share $ 0.99 $ 1.29 $ (0.61 ) Stock options to purchase 161,131, 1,237,305 and 1,101,004 Common Shares at per share prices averaging $29.44, $21.33 and $20.82 were outstanding as of December 31, 2002, 2001 and 2000, respectively, but were not included in the computation of diluted earnings per share because the options' exercise prices were greater than the average market prices of the Common Shares of $27.93, $17.71 and $15.17, respectively, for such years. In addition, Class A Warrants to purchase Common Shares at $20.00 per share were outstanding as of December 31, 2001 and 2000, but were not included in the computation of diluted earnings per share because the warrants' exercise price of $20.00 per share was greater than the average market price of the Common Shares for such years.
F-13
(k) Stock Awards
Stock Options
The Company
followshas adopted the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25") (see Note 11 for information relating to the Company's stock options), and related interpretations in accounting for itsemployee stock options because the alternative fair value accounting provided for under SFAS No. 123 "Accounting for Stock-Based Compensation" ("SFAS No. 123") requires use of option valuation models that were not developed for use in valuingemployee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized by the Company to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date.In addition,As provided under SFAS No. 123, "Accounting for Stock-Based Compensation," the Company has elected to continue to account for stock-based compensation in accordance with APB No. 25 and has provided the required additional pro forma disclosures. Such information has been determined for the Company
doesas if the Company had accounted for its employee stock options under the fair value method of this statement. The fair value for the Company's employee stock options has been estimated at the date of grant using the Black-Scholes option valuation model, with the following weighted average assumptions for options issued in 2002, 2001 and 2000, respectively:
Years Ended December 31, 2002 2001 2000 Dividend yield 0.0 % 0.0 % 0.0 % Expected volatility 24.0 % 41.0 % 32.0 % Risk free interest rate 3.1 % 4.0 % 5.0 % Expected option life 6.0 years 6.0 years 6.0 years For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options' vesting period. The weighted average fair value of options granted during the years ended December 31, 2002, 2001 and 2000 was $13.4 million, $26.0 million and $0.9 million, respectively. The Company's net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts indicated below:
Years Ended December 31, 2002 2001 2000 (in thousands, except per share data) Net income (loss), as reported $ 58,982 $ 22,016 $ (8,012 ) Total stock-based employee compensation expense under fair value method, net of tax (13,451 ) (5,638 ) (1,890 ) Pro forma net income (loss) $ 45,531 $ 16,378 $ (9,902 ) Earnings (loss) per share—basic: As reported $ 2.93 $ 1.71 $ (0.61 ) Pro forma $ 2.27 $ 1.27 $ (0.75 ) Earnings (loss) per share—diluted: As reported $ 0.99 $ 1.29 $ (0.61 ) Pro forma $ 0.76 $ 0.96 $ (0.75 ) F-14
2. Significant Accounting Policies (Continued)
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models, such as the Black-Scholes model, require the input of highly subjective assumptions, including expected stock price volatility. As the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, the Company believes that the existing option valuation models, such as the Black-Scholes model, may not
recognize compensation expensenecessarily provide a reliable single measure of the fair value of employee stock options. The effects of applying SFAS No. 123 as shown in the pro forma disclosures may not be representative of the effects on reported net income for future years.The effect on net income and earnings per share after applying SFAS No. 123's fair valuation method to stock issued to employees under the Company's Employee Stock Purchase Plan does not materially differ from the pro forma information set forth above with respect to the Company's employee stock options. During December 2002, the Company suspended the operation of its
stock purchase plan. In March 2000,Employee Stock Purchase Plan.
Restricted Shares
The Company has adopted the
Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation", an interpretationprovisions of APB No. 25(the "Interpretation").and related interpretations in accounting for its restricted share awards. TheInterpretation became effective July 1, 2000Company records deferred compensation equal to the market value of the restricted share awards at the measurement date, which is amortized andis requiredcharged tobe applied prospectively (subject to certain exceptions) to all new awards, modifications to outstanding awards, and changes in employee status after that date. While there are certain exceptions to prospective application,income over theCompany has adopted the Interpretation and its requirements are applied prospectively. (K) AMORTIZATION OF INTANGIBLE ASSETSvesting period.
(l) Goodwill
Goodwill of acquired businesses represents the difference between the purchase price and the fair value of the net assets of the acquired
businesses and is amortized on a straight-line basis over the expected life of the related operations acquired, which generally does not exceed 15 years.businesses. The Company recorded goodwill relating to its acquisitions of Hales, AIHC,andART Services and Arch Specialty and has not allocated any amounts to other intangible assets relating to such acquisitions. The Companyevaluatesceased amortization of its goodwill beginning in 2002 (see Note 2(o)). The Company assesses whether goodwill is impaired by comparing therecoverabilityfair value of each reporting unit to its carrying value, including goodwill. If the reporting unit's fair value is greater than its carrying value, goodwill is not impaired. Impairment occurs when the implied fair value of a reporting unit's goodwill is less than its carrying value. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit's identifiable assets and liabilities from the fair value of the reporting unit as a whole. The Company conducts its goodwill impairment test annually. Additional impairment assessments may be performed on an interim basis if the Company encounters events or changes in circumstances indicating that more likely than not the carrying value of goodwillrelating to acquired businesses on an undiscounted basis to ensure it is properly valued. If it is determined that an impairment exists, the excess of the unamortized balance will be charged to earnings at that time. In connection with the Company's acquisitions of privately held equity securities recorded under the equity method of accounting, goodwill is amortized on a straight-line basis over 25 years (see Note 2 (n) and Note 4). (L) RECLASSIFICATIONShas been impaired.
(m) Reclassifications
The Company has reclassified the presentation of certain prior year information to conform to the current presentation. Such reclassifications had no effect on the Company's net income, shareholders' equity or cash flows.
(M) RESTATEMENTSF-15
(n) Restatements
The Company filed with the Securities and Exchange Commission ("SEC") an amended Form 10-K for the year ended December 31, 2000 and an amended Form 10-Q for the quarter ended March 31, 2001 to restate the financial statements included in such filings. The restatements were required as a result of the Company's acquisition of the remaining ownership interests in ART Services in June 2001. The Company was required under
generally accepted accounting principlesGAAP governing aF-12ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)"step acquisition" of an investee company to retroactively adopt the equity method of accounting for its original minority ownership interest in ART Services for the periods prior to the acquisition and to restate its historical financialresults (see Note 3).results. The accompanying consolidated financial statements include the effects of this required restatement and should be read in conjunction with the restated financial statements contained in such amended SEC filings.(N) RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial and
(o) Recent Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 141 "Business Combinations." SFAS No. 141 establishes accounting and reporting standards for business combinations and requires the purchase method of accounting be applied for all business combinations initiated after June 30, 2001 and eliminates among other things, the pooling-of-interests method. The Company has accounted for its recently completed acquisitions using the purchase method of accounting and does not expect the application of SFAS No. 141 to have any material impact on its financial position or results of operations.PronouncementsIn June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets," which
willbecome effective for the Company on January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of the amortization of goodwill and the introduction of impairment testing in its place. The adoption of SFAS No. 142will resultresulted in the Company's discontinuation of amortization of its goodwill beginning in 2002. The Company will continue to be required totestperform impairment tests annually and whenever events or circumstances indicate that the value of goodwillfor impairment under the new standard, which could have an adverse effect on future results of operations to the extent an impairment exists.or other intangible assets might be impaired. Under SFAS No. 142, goodwill recorded after June 30, 2001willis notbe amortized. Goodwillamortized, and goodwill recorded prior to July 1, 2001 has been amortized through the year ended December 31, 2001.The Company did not record goodwill subsequent to June 30, 2001 (see Note 3).In addition, the standard includes provisions for the reclassification of certain existing recognized intangibles such as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill.SFAS No. 142 also requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. Pursuant to SFAS No. 142, the Company will test goodwill for impairment upon adoption and, if impairment is indicated, record such impairment as a cumulative effect of an accounting change.TheCompany is currently evaluating the effect that the adoption may have on the consolidated results of operations and financial position. The Company has not yet developed an estimate of the impact of theadoption of SFAS No. 142on its consolidated results of operations. The Company does believe that the adoption of SFAS No. 142 willdid not have a material impact onconsolidated financial condition. In August 2001, FASB issued SFAS No. 144, "Accounting fortheImpairment or Disposal of Long-Lived Assets." SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." SFAS No. 144 applies to all long-lived assets (including discontinued operations) and, consequently, amends portions of Accounting Principles Board Opinion No. 30, "Reporting Results of Operations--Reporting the Effects of Disposal of a Segment of a Business." SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001, and will be adopted by the Company on January 1, 2002. The Company does not expect that the application of SFAS No. 144 will have a material impact on itsCompany's financial position or results of operations.F-13ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED)In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 will be applied prospectively to exit or disposal activities initiated after December 31, 2002 and requires companies to recognize costs associated with exit activities when they are incurred, rather than at the date of a commitment to an exit or disposal plan. The Company is currently evaluating this standard.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure." SFAS No.��148 amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No.148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for financial statements for fiscal years and interim periods ending after December 15, 2002. The disclosure provisions of SFAS No.148 have been adopted by the Company.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities—an interpretation of ARB No. 51," which requires the consolidation of certain entities
F-16
considered to be variable interest entities ("VIEs"). An entity is considered to be a VIE when it has equity investors which lack the characteristics of a controlling financial interest or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE's expected losses or residual returns if they occur. FIN 46 provides certain exceptions to these rules, including qualifying special purpose entities subject to the requirements of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." VIEs created after January 31, 2003 must be consolidated immediately, while VIEs that existed prior to February 1, 2003 must be consolidated as of July 1, 2003. Certain ceding companies may meet the definition of a VIE due to the protection provided to the ceding company's equity investors from the absorption of expected losses. The Company is currently evaluating this standard.
3.
ACQUISITION OF SUBSIDIARIES AND DISPOSITION OF PRIOR REINSURANCE OPERATIONS AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY On February 28, 2001,Segment InformationThe determination of the Company's business segments is based on how the Company
completedmonitors the performance of its underwriting operations. The Company classifies its businesses into two underwriting segments—reinsurance and insurance—and atransaction pursuantcorporate and other segment (non-underwriting). The Company does not manage its assets by segment and, accordingly, investment income is not allocated towhich the Company acquired alleach underwriting segment. In addition, other revenue and expense items are not evaluated by segment. Management measures segment performance based on underwriting income or loss. The accounting policies of thecommon stocksegments are the same as those used for the consolidated financial statements. Inter-segment insurance business is allocated to the segment accountable for the underwriting results in accordance with SFAS No. 131, "Disclosures about Segments ofAIHC, previously onean Enterprise and Related Information."The reinsurance segment consists of
its investee companies (see Note 4). AIHCthe Company's reinsurance underwriting subsidiaries. The reinsurance segment's strategy is to write significant portions of business on a select number of specialty property and casualty treaties. Classes of business focused on include property catastrophe reinsurance, other property business (losses on a single risk, both excess of loss and pro rata), casualty, other specialty business, marine, aviation and space, casualty clash and non-traditional business.The insurance
holding company that, through its subsidiaries, markets and underwrites nonstandard personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania, as well as in Maryland and Delaware. The Company purchased a portionsegment consists of theoutstanding sharesCompany's insurance underwriting subsidiaries which primarily write on a direct basis. The insurance segment consists ofAIHC for $1.25 million.six profit centers, including property, casualty, executive assurance, healthcare, professional liability insurance and program business, and other (primarily non-standard auto and collateralized protection business).The
remaining outstanding sharescorporate and other segment (non-underwriting) includes net investment income, other fee income and other expenses incurred by the Company, net realized investment gains or losses, net foreign exchange gains or losses and non-cash compensation. The corporate and other segment also includes the results ofAIHC were redeemed by AIHC in exchange forHales, theright to receive a portionCompany's merchant banking subsidiary.F-17
The following table sets forth an analysis of the
proceeds resulting from the final adjudicationCompany's underwriting income orsettlementloss by segment, together with a reconciliation ofcertain lawsuits that AIHC, as plaintiff, has previously filed against certain defendants. A third party also forgave the obligations owingunderwriting income or loss toit under certain notes previously issued by AIHC in the aggregate principal amount of $4 million and returned certain warrants to purchase shares of AIHC in exchange for the right to receive a portion of the proceeds resulting from the final adjudication or settlement of such lawsuits. Immediately after the Company's purchase of AIHC, the Company contributed to the capital of AIHC notes in the aggregate principal amount of $8.5 million that were issued to the Company in connection with loans it had previously made to AIHC and also returned certain warrants to purchase shares of AIHC. Following the purchase, the Company also made a capital contribution to AIHC in the amount of $11.0 million. In connection with the loans the Company had previously made to AIHC, the Company had obtained rights to provide reinsurance to AIHC's subsidiary, American Independent Insurance Company ("American Independent"), for specified periods, which rights had been transferred to Folksamerica in the asset sale on May 5, 2000. In connection with the Company's acquisition of AIHC, Folksamerica released American Independent from these reinsurance commitments at a cost to American Independent of $1.5 million. ARCH RISK TRANSFER SERVICES LTD. On June 22, 2001, the Company completed the acquisition of all of the remaining ownership interests in one of its investee companies, ART Services, for a purchase price of approximately $38.8 million. The purchase price consisted of approximately $38.4 million in cash and 24,200 ACGL Common Shares. Through its wholly owned subsidiaries, including First American Insurance Company ("First American"), an admitted insurer with licenses in 49 states and an A.M. Best rating "A- (Excellent)," ART Services provides insurance and alternative risk transfer services through rent-a-captive and other facilities. After the Company's acquisition of its initial 27.9% ownership interest in ART Services in March 1998, the investment was carried at its estimated fair value from the initial purchase through March 31, 2001 in accordance with generally accepted accounting principles. The Company accounted for its initial interest in ART Services under "fair value" because the Company did not have the ability to exercise significant influence over this investment due to the Company's limited voting and consent rights. Upon acquiring the remaining ownership interests in ART Services, the Company was required under generally accepted accounting principles governing a "step acquisition" of an investee company F-14ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 3. ACQUISITION OF SUBSIDIARIES AND DISPOSITION OF PRIOR REINSURANCE OPERATIONS (CONTINUED) to retroactively adopt the equity method of accounting for its original minority ownership interest in ART Services for the periods prior to the acquisition and to restate its historical financial results. The required change to the equity method of accounting for this investment resulted in a reduction in the Company's book value at December 31, 2001 in the amount of $3.5 million and decreasednet incomeby $475,000for the year ended December 31,2001. Restating2002:
Year Ended December 31, 2002 Operating Information by Segment Reinsurance Insurance Total (in thousands) Net premiums written(1) $ 882,700 $ 378,927 $ 1,261,627 Net premiums earned $ 500,980 $ 153,996 $ 654,976 Policy-related fee income — 9,418 9,418 Losses and loss adjustment expenses (315,766 ) (108,772 ) (424,538 ) Acquisition expenses (105,391 ) (13,570 ) (118,961 ) Operating expenses (18,849 ) (42,827 ) (61,676 ) Underwriting income (loss) $ 60,974 $ (1,755 ) $ 59,219 Net investment income 51,249 Net realized investment losses (839 ) Other fee income 4,790 Other income 2,175 Other expenses (15,023 ) Net foreign exchange gains 2,449 Non-cash compensation (49,480 ) Income before income taxes and extraordinary item 54,540 Income tax benefit 556 Income before income taxes 55,096 Extraordinary gain, net of $0 tax expense 3,886 Net income $ 58,982 Underwriting Ratios(2) Loss ratio 63.0 % 70.6 % 64.8 % Acquisition expense ratio(3) 21.0 % 2.7 % 16.7 % Other operating expense ratio 3.8 % 27.8 % 9.4 % Combined ratio 87.8 % 101.1 % 90.9 %
- (1)
- Reinsurance segment results include $86.1 million of net premiums written assumed from the
amounts previously reported decreasedinsurance segment.- (2)
- Underwriting ratios are calculated based on net premiums earned.
- (3)
- The acquisition expense ratio is adjusted to include certain policy-related fee income.
F-18
Set forth below is summary information regarding net premiums written by client location and by major line of business for the
net lossreinsurance and insurance segments for the year ended December 31,2000 by $729,000 and increased2002:
Year Ended
December 31, 2002Net Premiums
Written% Of Total (in thousands) Reinsurance Segment Client Location(1): United States $ 469,585 53.2 % United Kingdom 163,838 18.6 % Bermuda 51,562 5.8 % Canada 45,749 5.2 % Germany 42,899 4.9 % France 26,751 3.0 % Japan 11,920 1.4 % Switzerland 11,806 1.3 % Other 58,590 6.6 % Total $ 882,700 100.0 % Major Line of Business(1): Casualty $ 245,236 27.8 % Other specialty 173,087 19.6 % Property excluding property catastrophe 166,344 18.8 % Property catastrophe 110,989 12.6 % Marine, aviation and space 60,383 6.8 % Non-traditional business 109,978 12.5 % Casualty clash 16,683 1.9 % Total $ 882,700 100.0 % Insurance Segment Client Location(1): United States $ 375,725 99.2 % United Kingdom 1,179 0.3 % Bermuda 777 0.2 % Canada 555 0.1 % Switzerland 307 0.1 % Other 384 0.1 % Total $ 378,927 100.0 % Major Line of Business(1): Casualty $ 95,419 25.2 % Programs 93,868 24.8 % Property 50,772 13.4 % Executive assurance 49,479 13.0 % Healthcare 23,624 6.2 % Professional liability 20,436 5.4 % Other 45,329 12.0 % Total $ 378,927 100.0 %
- (1)
- Reinsurance segment results include $86.1 million of net premiums written assumed from the
net loss for the year ended December 31, 1999 by $3.2 million, respectively (see Note 4). PRO FORMA FINANCIAL INFORMATION (UNAUDITED) The following unaudited pro forma financial information includes the audited financial information for ART Services and AIHC forinsurance segment.F-19
During the year ended December 31, 2001, the Company had only one reportable operating segment—insurance. During 2001, the insurance operating segment generated revenues of $59.9 million and
2000 as ifnet income of $12.4 million. The remaining portion of theacquisitions had occurred on January 1, 2000. The unaudited pro forma financial informationCompany's net income was generated through the Company's investment activities, offset by other operating expenses. In addition, during 2001, the Company produced its business through general agents and managing general agents, none of which accounted for more than 10% of total gross premiums written.During the year ended December 31, 2000,
excludes the acquisition of Hales (which occurred on December 4, 2000) because it was not significant. The pro forma financial information is based upon information available and includes certain assumptions that the Company's management believes are reasonable. The pro forma financial information does not purport to be indicative of the Company's results of operations that would have occurred or resulted had the transactions been completed on such dates nor is the information intended to be a projection of the Company's results of operations or financial condition for any future periods.
(IN THOUSANDS, EXCEPT SHARE DATA) PRO FORMA RESULTS YEARS ENDED DECEMBER 31, --------------------------------- 2001 2000 --------------- ---------------Total Revenues................................. $101,872 $174,139 Net Income (Loss).............................. $ 24,876 $(20,854) Basic earnings (loss) per share................ $ 1.93 $ (1.58) Diluted earnings (loss) per share.............. $ 1.46 $ (1.58)HALES & COMPANY On December 4, 2000, the Company acquired substantially all of the assets of Hales Capital Advisors, LLC, a privately held merchant banking firm specializing in the insurance industry. Founded in 1973, Hales is a merger and acquisition advisor to middle-market insurance organizations and the manager of the general partner of Distribution Partners Investment Capital, L.P., a private equity fund with $51 million of committed capital. Distribution Partners focuses on equity investments in insurance distribution and distribution-related service companies. The purchase price for the Hales assets consisted of 300,000 Common Shares (which shares are subject to a two-year lock-up through December 4, 2002) and $1.9 million in cash, representing a total purchase price of approximately $6.4 million (based on the closing market price of the Common Shares on December 4, 2000). Substantially all of this amount is reflected as goodwill. F-15ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 3. ACQUISITION OF SUBSIDIARIES AND DISPOSITION OF PRIOR REINSURANCE OPERATIONS (CONTINUED) Hales provides merger and acquisition advisory and valuation services to its clients. Hales' clients include insurance distributors, insurance companies, banks and other financial institutions with interests in insurance distribution. GOODWILL RELATING TO ACQUISITIONS The carrying amount of goodwill at December 31, 2001 was $26.3 million, consisting of $5.7 million, $13.6 million and $7.0 million, respectively, relating to the acquisitions of Hales, AIHC and ART Services. At December 31, 2000, goodwill consisted of $6.1 million relating to the acquisition of Hales. Amortization of goodwill for the year ended December 31, 2001 was $1.4 million (see Note 2(n)). FOLKSAMERICA TRANSACTION On May 5, 2000, the Company sold the prior reinsurance operations of Arch Re pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica"). Folksamerica Reinsurance Company assumed Arch Re's liabilities under the reinsurance agreements transferred in the asset sale and Arch Re transferred to Folksamerica Reinsurance Company assets estimated in an aggregate amount equal in book value to the book value of the liabilities assumed. In consideration for the transfer of Arch Re's book of business, Folksamerica paid $20.084 million (net of a credit equal to $251,000 granted to Folksamerica for certain tax costs) in cash at the closing, subject to post-closing adjustments based on an independent actuarial report of the claim liabilities transferred and an independent audit of the net assets sold. Following the completion of such report and audit, the parties agreed upon net post-closing adjustments in the amount of approximately $3.2 million payable by the Company, which consisted of a $4.2 million reduction in the purchase price less $1 million in net book value of the assets and liabilities actually transferred at closing. Under the terms of the agreement, $20 million of the purchase price has been placed in escrow for a period of five years. Such amounts represent restricted funds that appear under a separate caption entitled "Securities held in escrow" on the Company's consolidated balance sheet. These funds will be used to reimburse Folksamerica if the loss reserves (which were $32.3 million at the closing of the asset sale) transferred to it in the asset sale relating to business produced on behalf of Arch Re by a certain managing underwriting agency are deficient as measured at the end of such five-year period or to satisfy certain indemnity claims Folksamerica may have during such period. In connection with the escrow arrangement, the Company would record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five-year period. If such loss reserves are redundant, all of the escrowed funds will be released from escrow to the Company and Folksamerica will pay the Company an amount equal to such redundancy. The agreement also provided that an additional amount of up to $5 million would be placed in escrow for a period of five years to the extent that Arch Re's reserves at closing on all business other than that covered by the $20 million escrow were less by at least a specified amount than those estimated by its independent actuaries. No such supplemental escrow was required. As required under the agreement, Folksamerica reported to the Company that adverse development had occurred in the loss reserves subject to the Folksamerica escrow agreement for the period from May 5, 2000 to December 31, 2000. Based on such information and an independent F-16ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 3. ACQUISITION OF SUBSIDIARIES AND DISPOSITION OF PRIOR REINSURANCE OPERATIONS (CONTINUED) actuarial analysis, the Company recorded in the 2000 fourth quarter a loss contingency of $15 million, on a pre-tax basis, to recognize a probable deficiency in such reserves. The actuarial analysis was based on estimates of losses and loss adjustment expenses incurred as of December 31, 2000. In February 2002, the Company reached a definitive settlement agreement with Folksamerica to satisfy its obligations under the escrow agreement for consideration of $17.0 million, plus accrued interest income of $1.8 million. Accordingly, during the 2001 fourth quarter, the Company recorded an after-tax benefit of $0.4 million, which consisted of a charge of $2.5 million, offset by a reversal of a related reserve in the amount of $2.9 million. The related reserve had been provided for the purchase of reinsurance, which is no longer requireddue tothe fact that the escrow arrangements have been terminated under the above settlement agreement. Under the terms of the agreement, the Company had also purchased in 2000 reinsurance protection covering the Company's transferred aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed $5.4 million, the Company has agreed to reimburse Folksamerica if a loss is incurred that exceeds $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. The Company also made representations and warranties to Folksamerica about the Company and the business transferred to Folksamerica for which the Company retains exposure for certain periods. Although Folksamerica has not asserted that any amount is currently due under any of the indemnities provided by the Company under the asset purchase agreement, Folksamerica has indicated a potential indemnity claim under the agreement in the event of the occurrence of certain future events. Based on all available information, the Company has denied the validity of any such potential claim. F-17ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 3. ACQUISITION OF SUBSIDIARIES AND DISPOSITION OF PRIOR REINSURANCE OPERATIONS (CONTINUED) The net book value gain resulting fromthe sale of the Company's prior reinsurance operations to Folksamericawas calculated as follows (in thousands):
Consideration received, consisting of the following: Total liabilities transferred............................... $514,330 Cash premium received....................................... 16,920 -------- 531,250 -------- Assets transferred.......................................... 478,687 Amortization of deferred policy acquisition costs........... 23,242 Transaction costs........................................... 21,800 -------- 523,729 -------- Pre-tax gain on sale of reinsurance operations.............. 7,521 Realized loss on securities transferred at market value..... (5,330) -------- Net pre-tax gain............................................ 2,191 Income tax expense (1)...................................... 4,137 -------- Net loss reflected in the consolidated statement of income.................................................... (1,946) Change in net unrealized appreciation of investments, net of tax (2)................................................... 5,330 -------- Comprehensive income and net book value gain................ $ 3,384 ========- ------------------------ (1) The income tax benefit of $1.5 million relating to post-closing adjustments of $4.2 million was offset by an equivalent deferred tax asset valuation allowance. (2) The income tax benefit of $1.9 million relating to the realized loss on securities transferred at market value was offset by an equivalent deferred tax asset valuation allowance. Transaction costs consisted of the following (in millions):
Severance and other related costs........................... $11.0 Reinsurance costs........................................... 4.8 Investment banking, legal and accounting fees............... 2.3 Write-off of furniture, equipment and leasehold improvements.............................................. 1.7 Write-off of lease obligation............................... 1.3 Other....................................................... 0.7 ----- Total....................................................... $21.8 =====As of December 31, 2001, accrued and unpaid transaction costs amounted to approximately $477,000. Of such amount, $453,000 relates to the write-off of the Company's lease obligation expected to be paid over the remainder of the lease term expiringinOctober 2002. During the 2001 fourth quarter, the Company reversed approximately $4.4 million of such accrued and unpaid transaction costs that had been provided for the purchase of reinsurance, whichMay 2000 (see Note 13), segment information isno longer required due to the fact F-18ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 3. ACQUISITION OF SUBSIDIARIES AND DISPOSITION OF PRIOR REINSURANCE OPERATIONS (CONTINUED) that the purchase price escrow has been terminated under the definitive settlement agreement between the Company and Folksamerica, as described above. The GAAP book value of the assets and liabilities transferred to Folksamerica at closing were as follows (in millions):
Fixed maturities, short-term investments and accrued interest income........................................... $249.9 Premiums receivable......................................... 108.6 Reinsurance recoverable..................................... 73.2 Deferred policy acquisition costs........................... 23.2 Deferred income tax asset................................... 13.5 Other insurance assets...................................... 47.0 ------ Total assets................................................ $515.4 ------ Reserve for losses and loss adjustment expenses............. $371.6 Net unearned premium reserve................................ 103.4 Reinsurance premiums payable................................ 9.5 Other insurance liabilities................................. 29.8 ------ Total liabilities........................................... $514.3 ------ Net book value of assets and liabilities transferred........ $ 1.1 ======At the closing of the asset sale, Arch Re and Folksamerica entered into a transfer and assumption agreement, under which Folksamerica assumed Arch Re's rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements were notified that Folksamerica had assumed Arch Re's obligations and that, unless the reinsureds object to the assumption, Arch Re will be released from its obligations to those reinsureds. None of such reinsureds objected to the assumptionnot meaningful and, accordingly,the gross liabilities for such business have been removed from the accounts of Arch Re for statutory and GAAP accounting purposes. However, Arch Re will continue to be liable under those reinsurance agreements if the noticeisfoundnotto be an effective release by the reinsureds. Folksamerica has agreed to indemnify the Company for any losses arising out of the reinsurance agreements transferred to Folksamericapresented herein.4. Reinsurance
Company in the asset sale. However, in the event that Folksamerica refuses or is unable to perform its obligations to the Company, Arch Re may incur losses relating to the reinsurance agreements transferred in the asset sale. F-19ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION NET INVESTMENT INCOME The components of net investment income were derived from the following sources:
(IN THOUSANDS) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Fixed maturities................................. $ 6,750 $ 9,728 $14,924 Short-term investments........................... 4,969 5,167 5,677 Publicly traded equity securities................ 371 1,373 4,019 Privately held securities........................ 146 513 1,007 ------- ------- ------- Gross investment income.......................... 12,236 16,781 25,627 Investment expenses.............................. 116 858 5,454 ------- ------- ------- Net investment income............................ $12,120 $15,923 $20,173 ======= ======= =======REALIZED AND UNREALIZED INVESTMENT GAINS (LOSSES) Net realized investment gains (losses) were as follows:
(IN THOUSANDS) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Fixed maturities................................ $(2,116) $(15,550) $(1,776) Publicly traded equity securities............... 22,896 30,088 16,798 Privately held securities....................... (2,398) 177 2,205 ------- -------- ------- 18,382 14,715 17,227 Loss on fixed maturities included in gain on sale of prior reinsurance operations.......... -- 5,330 -- ------- -------- ------- Net realized investment gains................... 18,382 20,045 17,227 Income tax expense.............................. 7,242 7,408 6,029 ------- -------- ------- Net realized investment gains, net of tax....... $11,140 $ 12,637 $11,198 ======= ======== =======In 2000, net realized gains included $11.0 million of pre-tax losses, or $8.7 million, after-tax, recorded during the 2000 fourth quarter resulting from the restructuring of the Company's investment portfolio in connection with its redomestication to Bermuda on November 8, 2000. F-20ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION (CONTINUED) The following tables reconcile estimated fair value and carrying value to the amortized cost of fixed maturities and equity securities:
(IN THOUSANDS) DECEMBER 31, 2001 ------------------------------------------------ ESTIMATED FAIR VALUE AND GROSS GROSS CARRYING UNREALIZED UNREALIZED AMORTIZED VALUE GAINS (LOSSES) COST ---------- ---------- ---------- ---------Fixed maturities: U.S. government and government agencies........... $137,861 $2,026 $ (782) $136,617 Corporate bonds................................... 239,261 1,414 (1,538) 239,385 Mortgage and asset backed securities.............. 91,147 321 (326) 91,152 -------- ------ ------- -------- 468,269 3,761 (2,646) 467,154 -------- ------ ------- -------- Equity securities: Publicly traded................................... 235 -- (725) 960 Privately held.................................... 41,608 21 -- 41,587 -------- ------ ------- -------- 41,843 21 (725) 42,547 -------- ------ ------- -------- Total............................................. $510,112 $3,782 $(3,371) $509,701 ======== ====== ======= ========
(IN THOUSANDS) DECEMBER 31, 2000 ------------------------------------------------ ESTIMATED FAIR VALUE AND GROSS GROSS CARRYING UNREALIZED UNREALIZED AMORTIZED VALUE GAINS (LOSSES) COST ---------- ---------- ---------- ---------Fixed maturities: U.S. government and government agencies........... $ 27,122 $ 523 $ (32) $ 26,631 Corporate bonds................................... 5,835 92 (14) 5,757 Mortgage and asset backed securities.............. 5,518 57 -- 5,461 -------- ------- ------- -------- 38,475 672 (46) 37,849 -------- ------- ------- -------- Fixed maturities held in escrow -- municipal Bonds............................................. 20,970 84 (1) 20,887 -------- ------- ------- -------- Equity securities: Publicly traded................................... 51,322 26,335 -- 24,987 Privately held.................................... 56,418 -- (1,495) 57,913 -------- ------- ------- -------- 107,740 26,335 (1,495) 82,900 -------- ------- ------- -------- Total............................................. $167,185 $27,091 $(1,542) $141,636 ======== ======= ======= ========F-21ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION (CONTINUED) Privately held securities consist of the following:
(IN THOUSANDS) DECEMBER 31, PERCENTAGE ------------------- OWNERSHIP 2001 2000 ---------- -------- --------CARRIED UNDER THE EQUITY METHOD: The ARC Group, LLC.............................. 27.0% $ 8,725 $ 8,468 Arx Holding Corp................................ 35.2% 3,714 3,514 Island Heritage Insurance Company, Ltd.......... 33.4% 4,950 4,534 New Europe Insurance Ventures................... 14.6% 609 642 Sunshine State Holding Corporation.............. 23.0% 1,838 1,766 Arch Risk Transfer Services Ltd................. 27.9% -- 12,981 ------- ------- 19,836 31,905 ------- ------- CARRIED AT FAIR VALUE: Stockton Holdings Limited....................... 1.7% 10,000 10,000 Trident II, L.P................................. 2.0% 10,876 6,813 American Independent Insurance Holding Company.. -- 7,350 Distribution Investors, LLC..................... 2.5% 896 100 GuideStar Health Systems, Inc................... 2.6% 0 250 ------- ------- 21,772 24,513 ------- ------- Total........................................... $41,608 $56,418 ======= =======The Company had investment commitments relating to its privately held securities in the amounts of $3.7 million and $22.6 million at December 31, 2001 and 2000, respectively. Goodwill in privately held equity securities at December 31, 2001 and 2000 was $7.6 million and $8.0 million, respectively. Amortization of goodwill included in equity in net income (loss) of investees in 2001, 2000 and 1999, was approximately $0.4 million in each year (see Note 2(n)). Set forth below is certain information relating to the Company's investments and investment commitments in privately held securities at December 31, 2001. INVESTMENTS CARRIED UNDER THE EQUITY METHOD: THE ARC GROUP, LLC In 1997, the Company acquired a 27.0% economic and voting interest in The ARC Group, LLC ("ARC") for approximately $9.5 million. ARC, founded in 1986, is an independent wholesale insurance broker and managing general agent specializing in the placement of professional liability insurance, primarily directors and officers' liability coverage. The Company is a co-investor with MMRCH, MMC Capital, Inc.'s ("MMC Capital") parent, and ARC's founders, who continue to have managerial control over the daily operations. The Company records its equity in the operating results of ARC on a two-month lag basis and has received cumulative distributions from ARC in the amount of $8.5 million, which have been recorded as reductions to the carrying value of the investment. F-22ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION (CONTINUED) ARX HOLDING CORP. In December 1997, the Company acquired a 35.2% economic and voting interest in Arx Holding Corp. ("ARX") for $2,425,000. ARX, through its wholly owned subsidiary American Strategic Insurance Corp., underwrites homeowners policies in the State of Florida produced in the open market, and may also seek to offer other lines of insurance in Florida and other states. The investment in Arx is recorded under the equity method of accounting and the Company records the operating results of Arx on a quarter-lag basis. ISLAND HERITAGE INSURANCE COMPANY, LTD. In 1996, the Company acquired a 33.4% economic interest (9.75% voting interest) in Island Heritage Insurance Company, Ltd. ("Island Heritage"), a Cayman Islands insurer, for an aggregate purchase price of $4.5 million. Island Heritage commenced operations in May 1996 as an insurer of high value personal and commercial property insurance in the Caribbean. Certain directors of the Company and other investors invested in the securities of Island Heritage at the same per share price as that paid by the Company. In February 1999, the Company made an additional investment in Island Heritage in the amount of approximately $1.0 million. The investment in Island Heritage is recorded under the equity method of accounting and the Company records the operating results of Island Heritage on a quarter-lag basis. NEW EUROPE INSURANCE VENTURES In 1997, the Company, through a wholly owned special purpose subsidiary, committed to pay $5 million over the long term to fund its partnership interest, currently at 14.6%, in New Europe Insurance Ventures ("NEIV"), a Scottish limited partnership that targets private equity investments in insurance and insurance-related companies in Eastern Europe. The Company records its participation in this partnership under the equity method of accounting and applies the specialized accounting practices for investment companies. Unrealized gains and losses on private equity investments, consisting mostly of foreign exchange fluctuations, are recorded in the income statement when such investments are revalued into United States dollars each quarter. During June 2000, the partners of NEIV determined to attempt to sell NEIV's current investment holdings, and that further investments in existing portfolio companies may be made but only on an exceptional basis and as part of a clear exit strategy. The Company's $609,000 investment balance at December 31, 2001 represents four investments in Eastern Europe in insurance related companies. The Company's remaining unfunded commitment remaining at December 31, 2001 was approximately $3.2 million. SUNSHINE STATE HOLDING CORPORATION In 1997, the Company acquired a 21.5% economic and voting interest in Sunshine State Holding Corporation ("Sunshine State") for $1.4 million. The investment in Sunshine State is recorded under the equity method of accounting and the Company records the operating results of Sunshine State on a quarter-lag basis. F-23ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION (CONTINUED) Sunshine State and its subsidiaries, which includes Sunshine State Insurance Company, a Florida-domiciled insurer, underwrite homeowners policies in the State of Florida obtained from the Florida Residential Property and Casualty Joint Underwriting Association in accordance with the Market Challenge Program of the Florida Department of Insurance. Sunshine State also insures homeowners policies produced through the open market and offers other lines of insurance in Florida and other states. ARCH RISK TRANSFER SERVICES LTD. The Company owned approximately 27.9% of ART Services through June 22, 2001. On such date, the remaining ownership interests in ART Services were acquired by the Company and, accordingly, the financial results of ART Services have been consolidated with the Company (see Note 3). INVESTMENTS CARRIED AT FAIR VALUE: STOCKTON HOLDINGS LIMITED In June 1998, the Company acquired for $10 million a 1.7% interest in Stockton Holdings Limited ("Stockton"), a Cayman Islands insurance holding company. Stockton conducts a world-wide reinsurance business through its wholly owned subsidiary, Stockton Reinsurance Limited. The Company's investment was made as part of a private placement by Stockton. TRIDENT II, L.P. Trident II, L.P. ("Trident II") is an investment partnership, which makes private equity and equity related investments in the global insurance, reinsurance and related industries. The fund targets investments in existing companies that are in need of growth capital or are under performing as well as in newly formed companies. On June 4, 1999, the Company committed to invest $25 million as a limited partner of Trident II a partnership managed by MMC Capital. On November 8, 2001, the Company was released from its remaining $11.0 capital commitment to Trident II pursuant to an agreement entered into between ACGL, the principal investors, The Trident Partnership, LP. ("Trident"), Trident II, and MMRCH (see Note 8). The term of Trident II expires in 2009. However, the term may be extended for up to a maximum of three one-year periods at the discretion of MMC Capital to permit orderly dissolution. During the first six years of the fund, the Company will pay an annual management fee, payable semi-annually in advance, equal to 1.5% of the Company's aggregate $25.0 million commitment as well as a percentage of cumulative net gains on invested funds. After such six-year period, the annual management fee will be 1.5% of the aggregate funded commitments. During the year ended December 31, 2001, the Company funded $6.5 million of its investment commitment to Trident II and wrote-down its carrying value in Trident II by $2.1 million. Fees and expenses of $404,000, $375,000 and $250,000 were paid in 2001, 2000 and 1999, respectively, to MMC Capital relating to its management of Trident II. F-24ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION (CONTINUED) AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY On February 28, 2001, the Company completed a transaction pursuant to which the Company acquired all of the common stock of AIHC. In connection with the acquisition, the Company's outstanding loans to AIHC were contributed to AIHC's capital and the Company also returned certain warrants to purchase shares of AIHC (see Note 3). DISTRIBUTION INVESTORS, LLC In connection with the Company's acquisition of Hales, the Company has committed to invest approximately $1.5 million as a member of Distribution Investors, LLC ("Distribution Partners"), which is the general partner of Distribution Partners Investment Capital, L.P. (the "Fund"), a private equity fund affiliated with Hales. As part of the transaction, the Company also acquired Hales' existing $100,000 investment in Distribution Investors. For the year ended December 31, 2001, the Company funded $836,000 of its capital commitment to the Fund. Distribution Investors, at $51 million of total committed capital, focuses on equity investments of $3 million to $10 million in insurance distribution and distribution-related service companies. FIXED MATURITIES Contractual maturities of fixed maturities at December 31, 2001 are shown below. 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.
(IN THOUSANDS) DECEMBER 31, 2001 --------------------- ESTIMATED FAIR AMORTIZED VALUE COST --------- ---------Available for sale: Due in one year or less............................... $ 9,351 $ 10,438 Due after one year through five years................. 322,923 321,315 Due after five years through 10 years................. 34,751 31,445 Due after 10 years.................................... 10,097 12,804 -------- -------- 377,122 376,002 Mortgage and asset-backed securities.................. 91,147 91,152 -------- -------- Total................................................... $468,269 $467,154 ======== ========As of December 31, 2001, the weighted average contractual and expected maturities of the fixed maturity investments, based on fair value, were 3.2 years and 1.9 years, respectively. Proceeds from the sale of fixed maturities during 2001, 2000 and 1999 were approximately $183 million, $228 million and $270 million, respectively. Gross gains of $2,668,000, $1,097,000 and $1,522,000 were realized on those sales during 2001, 2000 and 1999, respectively. Gross losses of $4,784,000, $16,647,000 (of which $7,611,000 million related to losses resulting from restructuring the Company's investment portfolio in connection with its redomestication to Bermuda in November 2000) and $3,298,000 were realized during 2001, 2000 and 1999, respectively. F-25ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 4. INVESTMENT INFORMATION Approximately 100% of the fixed maturity investments held by the Company at December 31, 2001 were rated investment grade by Standard & Poor's Corporation or Moody's Investors Service, Inc. There were no investments in any entity in excess of 10% of the Company's shareholders' equity at December 31, 2001 other than investments issued or guaranteed by the United States government or its agencies. SECURITIES PLEDGED AND ON DEPOSIT At December 31, 2001, securities with a face amount of $15.3 million were on deposit with the Insurance Department of the State of Nebraska and other states in order to comply with insurance laws. 5. 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 for the years indicated:
(IN THOUSANDS) DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Reserve for losses and loss adjustment expenses at beginning of year................................................... -- $364,554 $216,657 Unpaid losses and loss adjustment expenses recoverable...... -- (55,925) (30,468) -------- -------- -------- Net unpaid losses and loss adjustment expenses at beginning of year................................................... -- 308,629 186,189 Increase in net losses and loss adjustment expenses incurred relating to losses occurring in: Current year............................................ $ 23,025 73,563 275,455 Prior years............................................. 423 2,700 30,386 -------- -------- -------- Total net incurred losses and loss expenses......... 23,448 76,263 305,841 Net losses and loss adjustment expense reserves acquired.... 14,320 -- -- Less net losses and loss adjustment expenses paid relating to losses occurring in: Current year............................................ 10,635 311,330 95,367 Prior years............................................. 4,068 73,562 88,034 -------- -------- -------- Total net paid losses............................... 14,703 384,892 183,401 Net reserve for losses and loss adjustment expenses at end of year................................................... 23,065 -- 308,629 Unpaid losses and loss adjustment expenses recoverable...... 90,442 -- 55,925 -------- -------- -------- Reserve for losses and loss expenses at end of year......... $113,507 $ -- $364,554 ======== ======== ========The Company believes that its exposure, if any, to environmental impairment liability and asbestos-related claims was minimal since no business had been written for periods prior to 1996. Subject to the following, the Company believes that the reserves for unpaid losses and loss adjustment expenses are adequate to cover the ultimate cost of losses and loss adjustment expenses F-26ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 5. RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES (CONTINUED) incurred through December 31, 2001. The reserves are based on estimates of losses and loss adjustment expenses incurred and, therefore, due to the inherent uncertainties of estimating claims and claims expense the ultimate reserves may be more or less than such estimates. To the extent reserves prove to be inadequate, the Company may have to augment such reserves and incur a charge to earnings. Such a development could occur and result in a material charge to earnings or stockholders' equity in future periods. Actual losses and loss adjustment expenses paid may deviate, perhaps materially, from estimates reflected in the Companies reserves reported in its financial statements. Estimates of prior accident year claims were increased by approximately $3 million in 2000 primarily due to aviation and property business. Estimates of prior accident year claims were increased by approximately $30 million in 1999. A substantial portion of this amount resulted from (i) the Company's review of additional claims information and actuarial analysis of the business produced by a certain managing underwriting agency, (ii) notification of additional satellite losses received in 1999 pertaining to 1998, (iii) aviation losses, principally the 1998 Swiss Air crash, and (iv) property losses reported on several international treaties that were in run-off in 1999. 6. REINSURANCEIn the normal course of business, the Company's insurance subsidiaries cede a substantial portion of their premium through
quota share, surplus,pro rata, excess of loss and facultative reinsurance agreements. The Company's reinsurance subsidiaries are currently retaining substantially all of their assumed reinsurance premiums written. The Company's reinsurance subsidiaries participate in "common account" retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as the Company's reinsurance subsidiaries, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers' ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, the Company's insurance subsidiaries would be liable for such defaultedamounts. With respect to 2001 results reflected below, theamounts (see Note 10).The following table sets forth the effects of reinsurance on the Company's reinsurance and insurance subsidiaries
which were acquired during 2001.with unaffiliated reinsurers. With respect to 2000 results reflected below, thefollowingtable sets forth the effects of reinsurance on the Company's prior reinsurance operations, which were soldonin May5,2000 toFolksamerica.
(IN THOUSANDS) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------PREMIUMS WRITTEN: Direct........................................ $117,406 -- -- Assumed....................................... 1,796 $102,034 $386,848 Ceded......................................... (82,986) (19,731) (80,122) Unearned premium portfolio transfer and assumption.................................. -- (92,907) -- -------- -------- -------- Net........................................... $ 36,216 $(10,604) $306,726 ======== ======== ======== PREMIUMS EARNED: Direct........................................ $110,022 -- -- Assumed....................................... 619 $107,404 $380,880 Ceded......................................... (79,723) (19,874) (69,512) -------- -------- -------- Net........................................... $ 30,918 $ 87,530 $311,368 ======== ======== ========F-27ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED)Folksamerica (see Note 13).
Years Ended December 31, 2002 2001 2000 (in thousands) Premiums Written: Direct $ 629,988 $ 117,406 — Assumed 857,224 1,796 $ 102,034 Ceded (225,585 ) (82,986 ) (19,731 ) Unearned premium portfolio transfer and assumption — — (92,907 ) Net $ 1,261,627 $ 36,216 $ (10,604 ) Premiums Earned: Direct $ 345,252 $ 110,022 — Assumed 473,220 619 $ 107,404 Ceded (163,496 ) (79,723 ) (19,874 ) Net $ 654,976 $ 30,918 $ 87,530 Losses and Loss Adjustment Expenses Incurred: Direct $ 300,950 $ 99,761 — Assumed 305,875 1,091 $ 88,676 Ceded (182,287 ) (77,404 ) (12,413 ) Net $ 424,538 $ 23,448 $ 76,263 F-20
5. 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 for the years indicated. With respect to 2000 results, the table includes the reserve activity on the Company's prior reinsurance operations, which were sold in May 2000 to Folksamerica (see Note 13).
December 31, 2002 2001 2000 (in thousands) Reserve for losses and loss adjustment expenses at beginning of year $ 111,494 — $ 364,554 Unpaid losses and loss adjustment expenses recoverable 90,442 — (55,925 ) Net unpaid losses and loss adjustment expenses at beginning of year 21,052 — 308,629 Increase in net losses and loss adjustment expenses incurred relating to losses occurring in: Current year 420,574 $ 23,025 73,563 Prior years 3,964 423 2,700 Total net incurred losses and loss expenses 424,538 23,448 76,263 Net losses and loss adjustment expense reserves acquired 11,370 14,320 — Exchange rate effects 642 — — Less net losses and loss adjustment expenses paid relating to losses occurring in: Current year 59,288 12,648 311,330 Prior years 16,982 4,068 73,562 Total net paid losses 76,270 16,716 384,892 Net unpaid losses and loss adjustment expenses at end of year 381,332 21,052 — Unpaid losses and loss adjustment expenses recoverable 211,100 90,442 — Reserve for losses and loss expenses at end of year $ 592,432 $ 111,494 — Insurance reserves are inherently subject to uncertainty. The reserves for losses and loss adjustment expenses represent estimates involving actuarial and statistical projections at a given point in time of the Company's expectations of the ultimate settlement and administration costs of losses incurred and it is likely that the ultimate liability may exceed or be less than such estimates. The Company's reserving method for 2002 was primarily the expected loss method, which is commonly applied when limited loss experience exists. The Company selects the initial expected loss and loss adjustment expense ratios based on information derived by its underwriters and actuaries during the initial pricing of the business. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market.
In its reserving process, the Company recognized that there is a possibility that the assumptions made could prove to be inaccurate due to several factors, including the Company's start-up nature and the fact that very limited historical information has been reported to the Company through December 31, 2002. It is possible that claims in respect of events that have occurred could exceed the Company's reserves and have a material adverse effect on its results of operations in a particular period or the Company's financial condition in general. Net losses and loss adjustment expenses
F-21
incurred for 2002 increased significantly over 2001 due to the Company's October 2001 underwriting initiative.
6.
REINSURANCE (CONTINUED)Deposit Accounting
(IN THOUSANDS) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------LOSSES AND LOSS ADJUSTMENT EXPENSES INCURRED: Direct........................................ $ 99,761 -- -- Assumed....................................... 1,091 $ 88,676 $348,979 Ceded......................................... (77,404) (12,413) (43,138) -------- -------- -------- Net........................................... $ 23,448 $ 76,263 $305,841 ======== ======== ========Certain reinsurance contracts included in the Company's non-traditional business are deemed, for financial reporting purposes, not to transfer insurance risk, and are accounted for using the deposit method of accounting. For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in the Company's underwriting results. The Company recorded $7.1 million on such contracts for the year ended December 31, 2002 in its underwriting results and, on a notional basis, the amount of premiums attaching to such contracts was $175.8 million. For those contracts that do not transfer an element of underwriting risk, the expected profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income. The Company did not record any contracts using the interest method for the year ended December 31, 2002.
7.
INCOME TAXESInvestment InformationThe following tables reconcile estimated fair value and carrying value to the amortized cost of fixed maturities and equity securities:
December 31, 2002 Estimated
Fair Value and
Carrying ValueGross
Unrealized
GainsGross
Unrealized
(Losses)Amortized
Cost(in thousands) Fixed maturities: U.S. government and government agencies $ 179,322 $ 5,242 $ (4 ) $ 174,084 Corporate bonds 949,003 33,305 (708 ) 916,406 Mortgage and asset backed securities 253,779 9,632 — 244,147 1,382,104 48,179 (712 ) 1,334,637 Equity securities: Privately held 31,536 232 (326 ) 31,630 Total $ 1,413,640 $ 48,411 $ (1,038 ) $ 1,366,267 F-22
7. Investment Information (Continued)
December 31, 2001 Estimated
Fair Value and
Carrying ValueGross
Unrealized
GainsGross
Unrealized
(Losses)Amortized
Cost(in thousands) Fixed maturities: U.S. government and government agencies $ 137,861 $ 2,026 $ (782 ) $ 136,617 Corporate bonds 239,261 1,414 (1,538 ) 239,385 Mortgage and asset backed securities 91,147 321 (326 ) 91,152 468,269 3,761 (2,646 ) 467,154 Equity securities: Publicly traded 235 — (725 ) 960 Privately held 41,608 21 — 41,587 41,843 21 (725 ) 42,547 Total $ 510,112 $ 3,782 $ (3,371 ) $ 509,701
Fixed Maturities
Contractual maturities of the Company's fixed maturities at December 31, 2002 are shown below. 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.
December 31, 2002 Estimated
Fair
ValueAmortized
Cost(in thousands) Available for sale: Due in one year or less $ 19,671 $ 20,149 Due after one year through five years 1,058,158 1,023,151 Due after five years through 10 years 21,966 24,100 Due after 10 years 28,530 23,090 1,128,325 1,090,490 Mortgage and asset-backed securities 253,779 244,147 Total $ 1,382,104 $ 1,334,637 As of December 31, 2002, the weighted average contractual and expected maturities of the Company's total fixed maturity and short-term investments, based on fair value, were 4.5 years and 2.1 years, respectively. Approximately 100% of the fixed maturity investments held by the Company at December 31, 2002 were rated investment grade by Standard & Poor's Corporation or Moody's Investors Service, Inc. There were no investments in any entity in excess of 10% of the Company's
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shareholders' equity at December 31, 2002 other than investments issued or guaranteed by the United States government or its agencies.
Net Investment Income
The components of net investment income were derived from the following sources:
Years Ended December 31, 2002 2001 2000 (in thousands) Fixed maturities $ 48,325 $ 6,750 $ 9,728 Short-term investments 4,201 4,969 5,167 Publicly traded equity securities — 371 1,373 Privately held securities 407 146 513 Gross investment income 52,933 12,236 16,781 Investment expenses 1,684 116 858 Net investment income $ 51,249 $ 12,120 $ 15,923
Realized Investment Gains (Losses)
Net realized investment gains (losses) were as follows:
Years Ended December 31, 2002 2001 2000 (in thousands) Fixed maturities $ (6,350 ) $ (2,116 ) $ (15,550 ) Publicly traded equity securities (269 ) 22,896 30,088 Privately held securities 5,780 (2,398 ) 177 (839 ) 18,382 14,715 Loss on fixed maturities included in gain on sale of prior reinsurance operations — — 5,330 Net realized investment (losses) gains (839 ) 18,382 20,045 Income tax expense 1,779 7,242 7,408 Net realized investment (losses) gains, net of tax $ (2,618 ) $ 11,140 $ 12,637 Proceeds from the sale of fixed maturities during 2002, 2001 and 2000 were approximately $536 million, $183 million and $228 million, respectively. Gross gains of $3.7 million, $2.7 million and $1.1 million were realized on those sales during 2002, 2001 and 2000, respectively. Gross losses of $10.0 million, $4.8 million and $16.6 million (of which $7.6 million related to losses resulting from restructuring the Company's investment portfolio in connection with its redomestication to Bermuda in November 2000) were realized during 2002, 2001 and 2000, respectively. For the year ended December 31, 2002, the Company recorded pre-tax net realized investment losses of $0.8 million. The Company realized net realized gains on certain of its U.S. source investments which resulted in an income tax expense of approximately $1.8 million.
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Securities Pledged and on Deposit
At December 31, 2002, securities with an estimated fair value of $24.8 million were on deposit with the Insurance Department of the State of Nebraska and other state insurance departments in order to comply with insurance laws.
Privately Held Equity Securities
At December 31, 2002 and 2001, privately held securities of $31.5 million and $41.6 million consisted of $12.4 million and $19.8 million, respectively, of investments carried under the equity method of accounting and $19.1 and $21.8 million of securities carried at fair value, respectively. The Company's investments in privately held equity securities were made as part of its prior investment strategy to hold equity positions in insurance and reinsurance companies or companies providing services to the insurance industry. The Company had investment commitments relating to its privately held securities in the amounts of $0.4 million and $3.7 million at December 31, 2002 and 2001, respectively.
8. Income Taxes
ACGL is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to ACGL or any of its operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda.
ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors. ACGL does not consider itself to be engaged in a trade or business within the U.S. and, consequently, does not expect to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL's shareholders' equity and earnings could be adversely affected. ACGL's U.S. subsidiaries
will continue to beare subject to U.S. income taxes on their worldwide income.F-28ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED)F-25
The components of income taxes attributable to operations for the years ended December 31, 2002, 2001
2000and19992000 were as follows:
(IN THOUSANDS) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Current (benefit) expense: U.S. Federal................................... $ 506 -- $ (9,021) U.S. State..................................... 150 -- -- Non-U.S........................................ -- -- -- ------- ------ -------- $ 656 -- $ (9,021) ------- ------ -------- Deferred (benefit) expense: U.S. Federal................................... 1,472 $8,515 (11,925) U.S. State..................................... -- -- -- Non-U.S........................................ -- -- -- ------- ------ -------- 1,472 8,515 (11,925) ------- ------ -------- Total income tax (benefit) expense............... $ 2,128 $8,515 $(20,946) ======= ====== ========
Years Ended December 31, 2002 2001 2000 (in thousands) Current expense: U.S. Federal $ 6,536 $ 506 — U.S. State 837 150 — Non-U.S. — — — $ 7,373 $ 656 — Deferred (benefit) expense: U.S. Federal (7,929 ) 1,472 $ 8,515 U.S. State — — — Non-U.S. — — — (7,929 ) 1,472 8,515 Income tax (benefit) expense $ (556 ) $ 2,128 $ 8,515 The expected tax provision computed on pre-tax income (loss) at the weighted average tax rate has been calculated as the sum of the pre-tax income (loss) in each jurisdiction multiplied by that jurisdiction's applicable statutory tax rate. A reconciliation
fromof thefederal statutorydifference between the provision for income taxes and the expected taxrate of 35% toprovision at theCompany's effectiveweighted average tax rate for the yearsendedDecember 31,2001, 2000 and 1999 follows:
(IN THOUSANDS) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Income tax (benefit) expense computed on pre-tax income at the federal statutory rate........... $ 8,450 $ 176 $(19,670) Valuation allowance............................ (8,518) 5,650 -- Write-off of deferred tax asset................ 251 2,993 -- Goodwill....................................... 360 -- -- Tax-exempt investment income................... (12) (341) (733) Dividend received deduction.................... -- (250) (958) Limitation on executive compensation........... -- 397 -- Foreign (income) loss.......................... 880 (278) -- Other.......................................... 717 168 415 ------- ------ -------- Income tax expense (benefit)................... $ 2,128 $8,515 $(20,946) ======= ====== ========The Company had no current federal tax expense or benefit for the years ended December 31,2002, 2001 and 2000due to its net operating losses and the full utilization of the two year carry-back provision at December 31, 1999. During 2000, the Company recovered $8.6 million of previously paid income taxes. Actual federal income taxes paid in 1999 was $1.9 million. The amount paid in 1999 was the final installment related to the 1998 tax return.follows:
Years Ended December 31, 2002 2001 2000 (in thousands) Expected income tax expense computed on pre-tax income (loss) at weighted average income tax rate $ 2,204 $ 9,330 $ (102 ) Addition (reduction) in income tax expense (benefit) resulting from: Valuation allowance (7,421 ) (8,518 ) 5,650 Write-off of deferred tax asset — 251 2,993 Goodwill — 360 — Tax-exempt investment income (132 ) (12 ) (341 ) Dividend received deduction — — (250 ) Limitation on executive compensation 1,656 — 397 Other 3,137 717 168 Income tax (benefit) expense $ (556 ) $ 2,128 $ 8,515 The Company has net operating loss carryforwards in its U.S. operating subsidiaries totaling
$43.3$42.5 million at December 31,2001.2002. Such net operating losses are currently available to offset future U.S. source taxable income of the Company andF-29ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED)expire between 2011 and 2021. The Company also has an alternative minimum tax ("AMT") credit carryforward in the amount of $1.0 million which can be carried forward without expiration. In addition, the Company has capital loss carryforwards of approximately $0.3 million, which expire by 2006.F-26
On November 20, 2001, the Company underwent an ownership change for U.S. federal income tax purposes as a result of the investment led by investment funds associated with Warburg Pincus
fundsLLC ("Warburg Pincus") and Hellman and Friedman LLC ("Hellman &Friedman funds.Friedman"). As a result of this ownership change, limitationsarehave been imposed upon the utilization of existing net operating losses. Utilization of the net operating losses, capital loss carryforwards and the AMT credit carryforward is limited to approximately $5.2 million per year in accordance with Section 382 of the Internal Revenue Code.In 2000, upon the Company's redomestication to Bermuda, Arch-U.S. distributed substantially all of its public equity portfolio to ACGL, its Bermuda parent, at the current market values and realized gains for tax purposes of $21.0 million. The associated income tax expense of $7.4 million reduced the Company's net operating loss carryforwards by a corresponding amount. However, for financial reporting purposes, since the securities had not been sold to an unrelated third party, the realized gain was deferred and was reported as unrealized appreciation in the consolidated financial statements. Accordingly, the related income tax expense was also deferred and reduced unrealized appreciation in the consolidated financial statements. In 2001, the Company divested its public equity portfolio in its entirety and, accordingly,
hasrecognized U.S. federal income tax expense of $7.4 million in its consolidated financial statements. In addition, in 2000, the Company hadwritten offwritten-off $2.0 million of deferred tax assets relating to losses recognized in the consolidated financial statements on the Company's privately held investments, which amount will not be deductible in future U.S. income tax returns since Arch-U.S. distributed these investments to ACGL, its Bermuda parent.Deferred income tax assets and liabilities reflect temporary differences based on enacted tax rates, between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company's deferred income tax assets and liabilities as of December 31, 2002 and 2001
and 2000 were:
(IN THOUSANDS) DECEMBER 31, ------------------- 2001 2000 -------- --------Deferred income tax assets: Net operating loss....................................... $15,151 $7,215 Reserve for loss of escrowed assets...................... 5,950 5,250 AMT credit carryforward.................................. 965 651 Discounting of net unpaid loss reserves.................. 335 -- Net unearned premium reserve............................. 1,975 -- Unrealized loss on marketable securities................. -- 606 Compensation liabilities................................. -- 250 Other, net............................................... 1,403 48 ------- ------ Total deferred tax assets.................................. 25,779 14,020 ------- ------ Deferred income tax liabilities: Equity in net income on investees, net................... (551) (117) Deferred policy acquisition cost......................... (1,718) -- Net unrealized appreciation of investments............... (240) (61) ------- ------ Total deferred tax liabilities............................. (2,509) (178) ------- ------ Valuation allowance........................................ (9,554) (5,650) ------- ------ Net deferred income tax asset.............................. $13,716 $8,192 ======= ======F-30ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED) As of December 31, 2001, thewere as follows:
December 31, 2002 2001 (in thousands) Deferred income tax assets: Net operating loss $ 14,860 $ 15,151 Reserve for loss of escrowed assets — 5,950 AMT credit carryforward 965 965 Discounting of net unpaid loss reserves 2,807 335 Net unearned premium reserve 8,583 1,975 Compensation liabilities 1,163 — Other, net 67 1,403 Total deferred tax assets 28,445 25,779 Deferred income tax liabilities: Equity in net income on investees, net (969 ) (551 ) Deferred policy acquisition costs (2,888 ) (1,718 ) Net unrealized appreciation of investments (5,942 ) (240 ) Total deferred tax liabilities (9,799 ) (2,509 ) Valuation allowance (2,132 ) (9,554 ) Net deferred income tax asset $ 16,514 $ 13,716 F-27
The Company has provided a valuation allowance to reduce certain deferred tax assets to an amount which management expects to more likely than not be realized. For the year ended December 31, 2002, the Company reversed a portion of the valuation allowance on certain of its deferred tax assets and recorded a benefit of $7.4 million. The valuation allowance reversal was based on the Company's restructuring of its U.S.-based insurance operations and its new business plan, which included a substantial increase in its taxable investment portfolio. In addition, for the year ended December 31, 2001, as a result of the Company's
pursuit of U.S.-basedcapital infusion and new underwritingoperations,initiative, whichincludedresulted in an increase in the Company'son-shoretaxable investment portfolio, the Company reversed a valuation allowance on certainotherdeferred tax assets and recorded a benefit of$7.8$8.5 million. At December 31, 2002, a valuation allowance of $2.1 million is provided against a deferred tax asset in one of the Company's subsidiaries that currently does not have a business plan to produce significant future taxable income.9. Transactions with Related Parties
During 2002, the Company's Board of Directors accelerated the vesting terms of certain restricted common shares granted to the Robert Clements, Chairman of the Board of Directors, which had been issued in connection with the November 2001 capital infusion, and Mr. Clements agreed to repay the outstanding $13.5 million loan previously made to him by the Company by November 12, 2002. Mr. Clements was granted 1,689,629 restricted Common Shares which were initially scheduled to vest in five equal annual amounts commencing on October 23, 2002. The vesting period and the amounts have been changed as follows: 60% of the shares vested on October 23, 2002 and the balance of the shares will vest in two equal annual amounts on October 23, 2003 and October 23, 2004 (see Note 11).
The $13.5 million loan made by the Company to Mr. Clements was used by him to pay income and self employment taxes. Under his retention agreement, Mr. Clements received additional compensation in cash in an amount sufficient to defray the loan's interest costs. In order to facilitate the repayment of the loan, the Company agreed to repurchase an amount of Mr. Clements' shares equal to the principal balance of the loan less any cash payment made by Mr. Clements, for a price per share based on the market price for the Common Shares as reported on the NASDAQ National Market on the date of sale. In addition, the Company agreed to make gross-up payments to Mr. Clements in the event of certain tax liabilities in connection with the repurchase. Pursuant to such arrangements, the Company repurchased 411,744 Common Shares from Mr. Clements for an aggregate purchase price of $11.5 million. Mr. Clements used all of such sale proceeds and $2.0 million in cash to repay the entire loan balance on November 12, 2002. The Company's book value per diluted share decreased by approximately $0.04 per share following such share repurchase. During the loan period, compensation to Mr. Clements under his retention agreement included payments of $638,000 from the Company, of which $364,000 was used by him to pay interest on the loan and the balance was used to pay his related income tax liabilities.
In connection with the Company's information technology initiative in 2002, the Company has entered into arrangements with two software companies, which provide document management systems and information and research tools to insurance underwriters, in which Mr. Clements and John Pasquesi, the Vice Chairman of ACGL's Board of Directors, each own minority ownership interests. The Company will pay fees under such arrangements based on usage. Under one of these agreements, fees payable are subject to a minimum of approximately $575,000 for the two-year period ending
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July 2004. The Company has made payments of approximately $232,000 under such arrangements for the year ended December 31,
2001. As2002.The Company agreed to reimburse Warburg Pincus and Hellman & Friedman for their costs and expenses in connection with the November 2001 capital infusion. The Company has reimbursed Warburg Pincus and Hellman & Friedman approximately $2.3 million in the aggregate under such agreements. For a description of
December 31, 2000,certain agreements entered into by the Companyhadand the investors in connection with the capital infusion, see Note 11, "Share Capital—Series A Convertible Preference Shares."During 2002, the Company leased temporary office space from Tri-City Brokerage Inc. (together with its affiliates, "Tri-City"), a
valuation allowancecompany in which Peter Appel, President and Chief Executive Officer of$5.7 million that adjusted the net deferred income tax asset to its estimated realizable valueACGL, Mr. Clements and Distribution Investors, LLC hold ownership interests, for aggregate rental expense of$8.2 million. Deferred income tax expenseapproximately $201,000 for the year ended December 31,2000 included a charge for such allowance of $5.7 million. 8. AGREEMENTS WITH RELATED PARTIES On November 8, 2001, ACGL, the principal investors, Trident, Trident II, MMRCH and employee co-investment funds affiliated with MMRCH entered into an agreement. Under this agreement, the Warburg Pincus investors assigned their right and commitment to purchase $35.0 million of the preference shares and Class A Warrants to Trident II and the co-investment funds. MMRCH agreed to exchange all of its existing Class A Warrants for newly issued Common Shares (assuming that they had been exercised pursuant to a cashless exercise) and to exchange all of its Class B Warrants for cash at a price equal to $7.50 per Class B Warrant (see Note 12).2002. In addition, Tri-City, as broker, has placed business with theboard observer and board nomination rights of MMRCH and Trident were terminated,Company's insurance operations and the Companywas also released from its remaining $11.0has incurred commission expenses of approximately $1.5 millioncapital commitment to Trident IIunder such arrangements fornew investments. During 1999,theCompany had committed to invest $25 million as a limited partner in Trident II, a partnership managed by MMC Capital. Effective July 1, 1999, the Company amended its investment advisory agreement with MMC Capital, which governs management of the Company's portfolio of public equity securities ("Public Portfolio") and a portion of its portfolio of privately held equity securities, primarily in issuers engaged in, or providing services to, the insurance and reinsurance business ("Private Portfolio"). MMC Capital is also an investment advisor to Trident, a dedicated insurance industry private equity fund organized by MMC Capital and other sponsors. MMC Capital's direct parent, MMRCH, owns 1,632,231 shares, or approximately 12% of the outstanding Common Shares. Atyear ended December 31,2001, Trident owns 250,000 shares, or approximately 2%, of the outstanding Common Shares, and Class A warrants2002. During 2002, Hales was engaged by Tri-City topurchase 1,386,079 Common Shares. Pursuant to the amended agreement, which has a term of four years (subject to renewal or early termination under certain circumstances), MMC Capital provides the Company with investment management andprovide advisory serviceswith respect to investmentsinthe Private Portfolio whose value exceeds (i) $10 million during the first year of the term, (ii) $15 million during the second year of the term, and (iii) $20 million during the third and fourth years of the term. Under such amendments, the Company pays MMC Capital an annual fee equal to (x) 20% (previously 7.5%) of cumulative net realized gains including dividends, interest and other distributions, received on the Private Portfolio over (y) cumulative compensation previously paid in prior years on cumulative net realized gains (as defined in the agreement) on the Private Portfolio managed by MMC Capital, but the Company will not pay MMC Capital a management fee (previously 1.5% per annum of the quarterly carrying value of the Private Portfolio). With respect to the management of the Company's Public Portfolio, the Company pays MMC Capital a fee equal to 0.50% of the first $50 million under MMC Capital's F-31ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 8. AGREEMENTS WITH RELATED PARTIES (CONTINUED) management and 0.35% of all amounts in excess of $50 million (subject to a minimum fee of $250,000 per annum). Fees incurred under the agreements during fiscal years 2001, 2000 and 1999 were approximately $262,000, $298,000 and $1.5 million, respectively. Inconnection withits amended investment advisory agreement with MMC Capital,theCompany receives from MMC Capital $1.25 million per annum during the initial four-year term, subject to certain conditions. On June 22, 2001, the Company completed the acquisitionpotential sale ofall of the remaining ownership interests in one of its investee companies, ART Services, for a purchase price of approximately $38.8 million. Of such amount, $38.4 million was paid in cash to MMRCH and Trident in return for their interests in ART Services and the balance was paid in the form of Common Shares to certain management shareholders of ART Services (see Note 3). Commencing in 1996, MMC Capital subleased office space from the Company for a term expiring in October 2002. Future minimum rental income, exclusive of escalation clauses and maintenance costs, under the remaining term of the sublease will be approximately $832,000. Rental income was $1,032,000, $636,000 and $430,000 in 2001, 2000 and 1999, respectively.Tri-City.As of December 31,
2001,2002, the Company has committed to investapproximately $1.5an additional $0.4 million as a member of the general partner of Distribution Investors, LLC, a fund affiliated withHales (see Note 4). On March 2, 2000,Hales.10. Commitments and Contingencies
Concentrations of Credit Risk
The creditworthiness of a counterparty is evaluated by the Company,
repurchased from XL Capital, then its single largest shareholder, alltaking into account credit ratings assigned by independent agencies. The credit approval process involves an assessment of factors including, among others, the counterparty, country and industry credit exposure limits. Collateral may be required, at the discretion of theCommon Shares heldCompany, on certain transactions based on the creditworthiness of the counterparty.The areas where significant concentrations of credit risk may exist include unpaid losses and loss adjustment expenses recoverable, prepaid reinsurance premiums and paid losses and loss adjustment expenses recoverable net of reinsurance balances payable (collectively "reinsurance recoverables"), investments and cash and cash equivalent balances. The Company's reinsurance recoverables at December 31, 2002 amounted to $256.6 million and resulted from reinsurance arrangements entered into in the course of its operations. A credit exposure exists with respect to reinsurance recoverables as they may become uncollectible. The Company manages its credit risk in its reinsurance relationships by
XL Capitaltransacting with reinsurers that it considers financially sound and, if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.F-29
10. Commitments and Contingencies (Continued)
In addition, the Company underwrites a
transaction described in Note 12. Priorsignificant amount of its business through brokers and a credit risk exists should any of these brokers be unable tosalefulfill their contractual obligations with respect to the payments of insurance and reinsurance balances owed to the Company. During 2002, approximately 20.2%, 16.6% and 11.9% of the Company'sreinsurance operations on May 5, 2000, affiliates of MMC Capital's ultimate parent,consolidated gross written premiums were generated from or placed by Marsh & McLennan Companies,Inc. ("Marsh"), actedAON Corporation and its subsidiaries and Willis Group Holdings and its subsidiaries, respectively. Each of these companies are large, well established companies and there are no indications that any of them are financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written for the year ended December 31, 2002.The Company's available for sale investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification, which limit the allowable holdings of any single issue. There were no investments in any entity in excess of 10% of the Company's shareholders' equity at December 31, 2002 other than investments issued or guaranteed by the United States government or its agencies.
Letter of Credit Facility
In April 2002, the Company established a letter of credit facility for up to $200 million. The principal purpose of this facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance
intermediaries to Arch Re as indicated in Note 15. Thecounterparties with which the Company hasalso utilized affiliatesentered into reinsurance arrangements. Such letters ofMarsh as insurance brokers forcredit, when issued, are secured by a portion of the Company'sinsurance needs. The Company also agreed to provide a loan to the Chairman of the Board of Directors of the Company, which will be used to pay income and self-employment taxes on restricted shares granted to him on October 23, 2001 (see Note 9).investment portfolio. In addition, the letter of credit facility also requires that the Companyhas made investments in entities in which affiliates of Marsh, Trident and XL Capital have invested (see Note 4). F-32ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 9. COMMITMENTS LEASEScomply with certain other financial covenants. At December 31,2001,2002, the Company had approximately $77.6 million in outstanding letters of credit which were secured by investments totaling $89.2 million. In addition to letters of credit, the Company has and may establish insurance trust accounts in the U.S. and Canada to secure its reinsurance amounts payable as required. This bank facility expires April 16, 2003. It is anticipated that the letter of credit facility will be renewed on expiry, but such renewals are subject to the availability of credit from banks which the Company utilizes.
Leases
At December 31, 2002, the future minimum rental commitments, exclusive of escalation clauses and maintenance costs and net of rental income, for all of the Company's operating leases with remaining non-cancelable terms in excess of one year are as follows:
(IN THOUSANDS) --------------2002........................................................ $1,213 2003........................................................ 918 2004........................................................ 931 2005........................................................ 902 2006........................................................ 1,117 Thereafter.................................................. -- ------ $5,081 ======
(in thousands) 2003 $ 5,983 2004 6,329 2005 5,965 2006 5,754 2007 5,079 Thereafter 18,756 $ 47,866 F-30
All of these leases are for the rental of office space, with expiration terms that range from
20022004 to2006. During 2001, 2000 and 1999, rental2012. Rental expense (income)expense,, net of income from subleases, was approximately $3.2 million, ($132,000),and $190,000 for the years ended December 31, 2002, 2001 and$576,000,2000, respectively.EMPLOYMENT AND OTHER ARRANGEMENTS
Employment and Other Arrangements
At December 31,
2001,2002, the Company has entered into employment agreements with certain of its executive officers for periods extending up to October 2006. Such employment arrangements provide for compensation in the form of base salary, annual bonus,stock-basedshare-based awards, participation in the Company's employee benefit programs and the reimbursements of expenses.
Folksamerica
On May 5, 2000, Arch-U.S. sold the prior reinsurance operations of Arch Re U.S. to Folksamerica in an asset sale. The
Company has agreedFolksamerica transaction was structured as a transfer and assumption agreement (and not reinsurance) and, accordingly, the loss reserves (and any related reinsurance recoverables) related to the transferred business are not included in the Company's balance sheet. However, in the event that Folksamerica is unable to makea loanpayment ofupclaims on the reinsurance business assumed by it in the May 2000 sale and the notice given to$13.5 millionreinsureds is found not to be an effective release by the reinsured, Arch Re U.S. would be liable for such claims. See Note 13.11. Share Capital
Authorized and Issued
The authorized share capital of the Company consists of 200,000,000 Common Shares, par value of $0.01 per share, and 50,000,000 Preference Shares, par value of $0.01 per share. Prior to the reorganization described in Note 1, authorized share capital of Arch-U.S. consisted of 80,000,000 Common Shares, par value of $0.01 per share, and 20,000,000 Preference Shares, par value of $0.01 per share.
Common Shares
Changes in the Company's outstanding Common Shares for the years ended December 31, 2002, 2001 and 2000 are reflected below:
Years Ended December 31, 2002 2001 2000 Common Shares: Balance, beginning of year 13,513,538 12,708,818 17,109,736 Shares issued 12,275,171 179,878 318,079 Restricted shares issued 2,398,794 627,949 74,218 Shares repurchased (462,169 ) (3,107 ) (4,793,215 ) Balance, end of year 27,725,334 13,513,538 12,708,818 F-31
In April 2002, the Company completed an offering of 7,475,000 of its Common Shares and received net proceeds of $179.2 million. In November 2002, the Company repurchased 411,744 Common Shares for an aggregate purchase price of $11.5 million (see Note 9).
In November 2001, 905,397 previously existing Class A Warrants were canceled in exchange for 140,380 newly issued Common Shares, and Class B Warrants to purchase 1,770,601 Common Shares were canceled in exchange for a cash payment by the Company of $7.50 per Class B Warrant (approximately $13.3 million in the aggregate). During 2002, all 5,401,707 Class A Warrants that were outstanding as of December 31, 2001 were exercised which resulted in the issuance of 4,195,554 Common Shares and the receipt by the Company of cash proceeds totaling $74.3 million. As of December 31, 2002, warrants outstanding consisted of 150,000 Class B Warrants.
In March 2000, the Company repurchased from XL Capital, then the Company's single largest shareholder, all of the 4,755,000 Common Shares held by it for a purchase price of $12.45 per share, or a total of $59.2 million.
Restricted Common Shares
During 2002, 2001 and 2000, the Company issued an aggregate of 2,398,794, 627,949 and 74,218 restricted shares, respectively. The Chairman of the Board of Directors
of the Company, which will be used to pay income and self-employment taxes, payable in April 2002, on restricted shares granted to him on October 23, 2001 (see Note 10). 10. STOCK AND STOCK OPTION PLANS 1995 LONG TERM INCENTIVE AND SHARE AWARD PLAN In September 1995, the Company adopted the 1995 Long Term Incentive and Share Award Plan (the "1995 Stock Plan"), which is administered by the Company's Board of Directors and its Stock Awards Committee. The Company may grant, subject to certain restrictions, stock options, stock appreciation rights, restricted shares, restricted share units payable in Common Shares or cash, stock awards in lieu of cash awards, and other stock-based awards to eligible employees and directors of the Company. Awards relating to not more than 1,700,000 Common Shares may be made over the ten-year term of the 1995 Stock Plan. In April 1999, the Company adopted the 1999 Long Term Incentive and Share Award Plan (the "1999 Stock Plan"). The 1999 Stock Plan, like its predecessor, is intended to provide incentives to attract, retain and motivate employees and directors in order to achieve the Company's long-term growth and profitability objectives. The 1999 Stock Plan provides for the grant to eligible employees and directors of stock options, stock appreciation rights, restricted shares, restricted share units payable in Common Shares or cash, stock awards in lieu of cash awards, dividend equivalents and other stock F-33ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 10. STOCK AND STOCK OPTION PLANS (CONTINUED) based awards. The 1999 Stock Plan also provides the non-employee directors with the opportunity to receive the annual Board retainer fee in Common Shares. An aggregate of 900,000 Common Shares has been reserved for issuance under the 1999 Stock Plan (of which no more than 300,000 of such shares may be issued pursuant to grants of restricted shares, restricted share units, performance shares and performance units), subject to anti-dilution adjustments in the event of certain changes in the Company's capital structure. At December 31, 2001, substantially all of the shares reserved for issuance under the 1995 and 1999 Stock Plans had been issued. In October 2001, the Company adopted the 2001 Long Term Incentive Plan for New Employees (the "2001 Stock Plan"). The 2001 Stock Plan is intended to provide incentives to new employees as an inducement essential to such employees entering into employment arrangements with the Company. An aggregate of 4,600,000 common shares has been reserved for issuance under the 2001 Stock Plan. RESTRICTED COMMON SHARES During 2001, 2000 and 1999, the Company granted an aggregate of 627,949, 74,218, and 2,500 shares, respectively, of restricted shares for financial statement purposes. In addition, the Chairman of the Boardof the Company was granted a total of 1,689,629 restrictedshares.shares during 2001. Of such amount, 1,668,157 restricted shares were granted on October 23, 2001 and 21,472 restricted shares were granted on November 19, 2001. These grantscould be rescinded ifwere reflected in the Company's consolidated financial statements on the measurement date, which occurred during 2002 (see Note 9). These grants to Mr. Clements were subject to rescission had theyarenot been approved by the Company's shareholders prior to October 23, 2002,and, accordingly, are not reflectedwhich approval was obtained inthe Company's consolidated financial statements at December 31, 2001.2002. The Company records deferred compensation equal to the market value of the shares at the measurement date, which is amortized and charged to income over the vesting period. The deferred compensation was $66.2 million, $10.5 million and $1.1 million,and ($117,000),and the amortization of the deferred compensation was $49.2 million, $2.6 million and $1.1 million, for 2002, 2001 and$628,000, for 2001,2000, respectively. The Company may withhold, or require a participant to remit to the Company, an amount sufficient to satisfy any federal, state or local withholding tax requirements associated with awards under the Company's share award plans. This includes the authority to withhold or receive shares or other property and1999, respectively.to make cash payments in respect thereof. The issuance of restricted shares and amortization thereon has no effect on the Company's consolidated shareholders' equity.STOCK OPTIONS
Series A Convertible Preference Shares
Changes in the Company's outstanding Preference Shares for the years ended December 31, 2002, 2001 and 2000 are reflected below:
Years Ended December 31, 2002 2001 2000 Preference Shares: Balance, beginning of year 35,687,735 — — Shares issued 3,706,930 35,687,735 — Shares converted to common shares (550,000 ) — — Balance, end of year 38,844,665 35,687,735 — F-32
On November 20, 2001, the Company issued 35,687,735 Preference Shares and 3,776,025 Class A Warrants in exchange for $763.2 million in cash and entered into subscription agreements with investors led by Warburg Pincus and Hellman & Friedman and certain members of management (the "Subscription Agreement"). The number of Preference Shares issued was based on the estimated per share price of $21.38. The estimated per share price was based on (i) the Company's total shareholders' equity as of June 30, 2001 (adjusted for certain amounts as described in the Subscription Agreement entered into in connection with the capital infusion), divided by (ii) the total number of Common Shares outstanding as of June 30, 2001, which was 12,863,079. During 2002, the Company issued an additional 3,706,930 Preference Shares pursuant to the Subscription Agreement as follows: (i) 875,753 Preference Shares were issued by the Company on June 28, 2002 pursuant to a post-closing purchase price adjustment mechanism under the Subscription Agreement; and (ii) 2,831,177 Preference Shares were issued by the Company on December 16, 2002 pursuant an agreed upon adjustment under the Subscription Agreement. The Company had agreed to issue to the new investors additional Preference Shares such that the per share price would be adjusted downward by $1.50 per Preference Share when the closing price of the Company's Common Shares was at least $30 per share for at least 20 out of 30 consecutive trading days on or prior to September 19, 2005, which condition was met on December 16, 2002. In addition, during December 2002, 550,000 Preference Shares were converted into an equal number of Common Shares.
Each Preference Share is convertible at any time and from time to time at the option of the holder thereof into one fully paid and nonassessable common share, subject to possible adjustment. The Preference Shares vote, together with the Common Shares, on an as-converted basis. Pursuant to the Subscription Agreement, a post-closing purchase price adjustment will be calculated in November 2003 (or such earlier date as agreed upon by the Company and the investors thereunder) based on an adjustment basket. The adjustment basket will be equal to (1) the difference between value realized upon sale and the GAAP book value at the closing of the capital infusion (November 2001) (as adjusted based on a pre-determined growth rate) of agreed upon non-core businesses; plus (2) the difference between GAAP net book value of the Company's insurance balances attributable to the Company's core insurance operations with respect to any policy or contract written or having an effective date prior to November 20, 2001 at the time of the final adjustment and those balances at the closing; minus (3) reductions in book value arising from costs and expenses relating to the transaction provided under the Subscription Agreement, actual losses arising out of breach of representations under the Subscription Agreement and certain other costs and expenses. In addition, on the fourth anniversary of the closing, there will be a calculation of a further adjustment basket based on (1) liabilities owed to Folksamerica (if any) under the Asset Purchase Agreement, dated as of January 10, 2000, between the Company and Folksamerica, and (2) specified tax and ERISA matters under the Subscription Agreement.
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11. Share Capital (Continued)
Pursuant to the shareholders agreement entered into in connection with the capital infusion in November 2001, the Company agreed to restrictions on the composition of its Board of Directors. Pursuant to this agreement, Warburg Pincus and Hellman & Friedman are entitled to nominate a prescribed number of directors based on the respective retained percentages of their Preference Shares purchased in November 2001. Currently, the Company's Board of Directors consists of 12 members, including three directors nominated by Warburg Pincus and two directors nominated by Hellman & Friedman. As long as Warburg Pincus retains at least 75% of their original investment and Hellman & Friedman retains at least 60% of their original investment, these shareholders together will be entitled to nominate a majority of directors to the Company's Board of Directors.
The shareholders agreement also provides that the Company cannot engage in certain transactions, including mergers and acquisitions and transactions in excess of certain amounts, without the consent of a designee of Warburg Pincus and a designee of Hellman & Friedman. In addition, the shareholders agreement provides the investors who provided the 2001 capital infusion with certain other rights, including registration rights.
Voting Rights Limitation
At December 31, 2002, the bye-laws of the Company contain a provision limiting the rights of any U.S. person (as defined in section 7701(a)(30) of the Internal Revenue Code of 1986, as amended (the "Code")), that owns shares of the Company, directly, indirectly or constructively (within the meaning of section 958 of the Code), representing more than 9.9% of the voting power of all shares entitled to vote generally at an election of directors. The votes conferred by such shares or such U.S. person will be reduced by whatever amount is necessary so that after any such reduction the votes conferred by the shares of such person will constitute 9.9% of the total voting power of all shares entitled to vote generally at an election of directors. Notwithstanding this provision, the Board of Directors may make such final adjustments to the aggregate number of votes conferred by the shares of any U.S. person that the Board of Directors considers fair and reasonable in all circumstances to ensure that such votes represent 9.9% of the aggregate voting power of the votes conferred by all shares of the Company entitled to vote generally at an election of directors. The Company will assume that all shareholders (other than Warburg Pincus and Hellman & Friedman) are U.S. persons unless they otherwise receive assurance satisfactory to them that they are not U.S. persons.
The Company held a special meeting of its shareholders in March 2002 as required by the Subscription Agreement. At such meeting, the shareholders approved, among other things, (1) the issuance of such number of Common Shares issuable upon conversion of the Preference Shares, that together with the number of Common Shares issuable upon exercise of the Class A Warrants, is in excess of the amount that may be issued without shareholder approval under the NASDAQ National Market rules and (2) the adoption of amendments to the provision of the Company's bye-laws that limits voting rights of shareholders to 9.9% of the total voting power of all outstanding voting shares to provide that, as described above, such voting limitation applies only to votes conferred (directly or indirectly or by attribution) by shares of the Company held by any U.S. person.
Long Term Incentive and Share Award Plans
In September 1995 and April 1999, the Company adopted the 1995 Long Term Incentive and Share Award Plan and the 1999 Long Term Incentive and Share Award Plan. The Company reserved
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1,700,000 Common Shares and 900,000 Common Shares, respectively, for issuance under such Stock Plans and, as of December 31, 2002, all of the shares reserved for issuance under these share award plans had been issued.
In October 2001, the Company adopted the 2001 Long Term Incentive Plan for New Employees (the "New Employee Plan") in order to provide incentives to attract and motivate new hires in connection with the launch of the Company's new underwriting initiative. An aggregate of 4,600,000 Common Shares had been reserved for issuance under the New Employee Plan. Of such amount, 3,295,170 of such shares were awarded under the New Employee Plan. As eligibility under the New Employee Plan was restricted to new hires, none of the shares under the New Employee Plan were available for grants to directors or existing employees. As a result, in order to be in a position to provide long-term incentive compensation for the Company's employees and directors, in June 2002, following shareholder approval, the Company adopted the 2002 Long Term Incentive and Share Award Plan (the "2002 Plan"), and the New Employee Plan was terminated. An aggregate of 3,165,830 Common Shares has been reserved for issuance under the 2002 Plan. The 2002 Plan provides for the grant to eligible employees and directors of stock options, stock appreciation rights, restricted shares, restricted share units payable in Common Shares or cash, share awards in lieu of cash awards, dividend equivalents and other share-based awards. The 2002 Plan, like its predecessor, provides the Company's non-employee directors with the opportunity to receive their annual retainer fee for Board of Directors service in Common Shares.
Stock Options
The Company generally issues stock options to officers and directors, with exercise prices equal to the fair market values of the Company's Common Shares on the grant dates. Options to officers generally vest and become exercisable in three equal installments commencing on the grant date and thereafter on the first and second anniversary thereof, and expire ten years after the grant date. Initial options granted to non-employee directors vest and become exercisable in three equal installments, commencing on the grant date and annually thereafter. Annual options granted to non-employee directors in office on January 1 of each year vest on the first anniversary of the grant date.
F-34ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 10. STOCK AND STOCK OPTION PLANS (CONTINUED)F-35
Information relating to the Company's stock options is set forth below:
YEARS ENDED DECEMBER 31, ------------------------------------ 2001 2000 1999 ---------- ---------- ----------NUMBER OF OPTIONS Outstanding, beginning of year........... 1,222,775 1,281,356 1,347,075 Granted.................................. 2,898,036 146,000 18,800 Canceled................................. (52,500) (204,581) (84,519) Exercised................................ -- -- -- Outstanding, end of year................. 4,068,311 1,222,775 1,281,356 Exercisable, end of year................. 2,698,052 1,122,000 683,388 AVERAGE EXERCISE PRICE Granted.................................. $ 19.97 $ 15.13 $ 17.25 Canceled................................. $ 15.33 $ 21.02 $ 21.81 Exercised................................ -- -- -- Outstanding, end of year................. $ 20.09 $ 20.18 $ 20.90 Exercisable, end of year................. $ 19.83 $ 20.23 $ 20.45Exercise prices
Years Ended December 31, 2002 2001 2000 Number of options Outstanding, beginning of year 4,068,311 1,222,775 1,281,356 Granted 1,573,900 2,898,036 146,000 Canceled — (52,500 ) (204,581 ) Exercised (42,800 ) — — Outstanding, end of year 5,599,411 4,068,311 1,222,775 Exercisable, end of year 3,867,593 2,698,052 1,122,000
Average exercise price
Granted $ 26.28 $ 19.97 $ 15.13 Canceled — $ 15.33 $ 21.02 Exercised $ 19.28 — — Outstanding, end of year $ 21.85 $ 20.09 $ 20.18 Exercisable, end of year $ 20.87 $ 19.83 $ 20.23 The following table summarizes information about the Company's stock options for options outstanding
atas of December 31,2001 ranged from $12.66 to $24.25. The weighted-average remaining contractual life of these options is approximately eight years. PRO FORMA INFORMATION As provided under SFAS No. 123, "Accounting for Stock-Based Compensation," the Company has elected to continue to account for stock-based compensation in accordance with APB No. 25 and has provided the required additional pro forma disclosures. Such information has been determined for the Company as if the Company had accounted for its employee stock options under the fair value method of this statement. The fair value for the Company's employee stock options has been estimated at the date of grant using a Black-Scholes option valuation model, with the following weighted-average assumptions for options issued in 2001, 2000 and 1999, respectively: dividend yield of 0.0% for 2001, 2000 and 1999; expected volatility of 41.0% in 2001, 32.0% in 2000 and 25.0% in 1999; risk free interest rate of 4.0% in 2001, 5.0% in 2000 and 6.5% in 1999; and an average expected option life of six years for 2001, 2000 and 1999. The weighted-average fair value of options granted during the years ended December 31, 2001, 2000 and 1999 was $26.0 million, $866,000 and $123,000, respectively. F-35ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 10. STOCK AND STOCK OPTION PLANS (CONTINUED) For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options' vesting period. The Company's net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts indicated below:
(IN THOUSANDS, EXCEPT PER SHARE DATA) YEARS ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- --------Net income (loss), as reported.................. $22,016 $(8,012) $(35,636) Pro forma net income (loss)..................... $16,378 $(9,902) $(37,294) Earnings (loss) per share as reported: Basic......................................... $ 1.71 $ (0.61) $ (2.09) Diluted....................................... $ 1.29 $ (0.61) $ (2.09) Pro forma earnings (loss) per share: Basic......................................... $ 1.27 $ (0.75) $ (2.18) Diluted....................................... $ 0.96 $ (0.75) $ (2.18)The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models, such as the Black-Scholes model, require the input of highly subjective assumptions (particularly with respect to the Company, which has a limited stock-trading history), including expected stock price volatility. As the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, the Company believes that the existing option valuation models, such as the Black-Scholes model, may not necessarily provide a reliable single measure of the fair value of employee stock options. The effects of applying SFAS No. 123 as shown in the pro forma disclosures may not be representative of the effects on reported net income for future years. The effect on net income and earnings per share after applying SFAS No. 123's fair valuation method to stock issued to employees under the Company's Employee Stock Purchase Plan does not materially differ from the pro forma information set forth above with respect to the Company's employee stock options. 11. RETIREMENT PLANS2002:
Options Outstanding Options Exercisable Range of Exercise Prices Number
Outstanding
at Dec. 31,
2002Weighted
Average
Remaining
Contractual
Life in YearsWeighted
Average
Exercise
PriceNumber
Exercisable
at Dec. 31,
2002Weighted
Average
Exercise
Price$12.66-$17.63 661,003 6.0 $ 16.38 660,903 $ 16.38 $19.63-$20.00 2,430,883 8.4 $ 20.00 1,852,102 $ 20.00 $20.13-$23.00 605,525 4.4 $ 22.57 605,525 $ 22.57 $23.13-$23.80 718,100 9.0 $ 23.62 338,711 $ 23.66 $24.00-$27.00 574,000 9.2 $ 25.98 207,011 $ 25.95 $27.09-$30.17 573,600 9.4 $ 28.31 191,237 $ 28.31 $30.32-$31.28 36,300 9.4 $ 30.76 12,104 $ 30.76 $12.66-$31.28 5,599,411 8.0 $ 21.85 3,867,593 $ 20.87 12. Retirement Plans
For employee retirement benefits, the Company maintains defined contribution retirement plans, which vary for each subsidiary. Contributions are based on the participants' eligible compensation. In 2002, 2001
2000and1999,2000, the Company expensed $1.8 million, $0.4 million$0.3 millionand$0.6$0.3 million, respectively, related to these retirement plans.12. SHARE CAPITALF-36
13. Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations
Personal Service Insurance Company
On November 30, 2002, the Company acquired PSIC, a non-standard automobile insurer licensed in Ohio and Indiana and located in Columbus, Ohio from GuideOne Property & Casualty Insurance Company ("GuideOne") for $2.5 million. The
authorizedCompany recorded an extraordinary gain of $3.9 million, or $0.07 per share,capitalfor the year ended December 31, 2002 from the acquisition of PSIC. The extraordinary gain represents the excess of the fair value of acquired net assets of $6.4 million over the purchase price of $2.5 million. PSIC is included in the Company's insurance segment (see Note 3).
Arch Specialty Insurance Company
On February 1, 2002, the Company
consistsacquired Arch Specialty (formerly known as Rock River Insurance Company), an approved excess and surplus lines insurer in 46 states and the District of200,000,000 common shares, par value U.S. $0.01 per share,Columbia and50,000,000 preferred shares, par value U.S. $0.01 per share. Prioran admitted insurer in one other state, from Sentry Insurance a Mutual Company ("Sentry") for $19.5 million. At closing, Arch Specialty, which is included in the Company's insurance segment (see Note 3), had net assets of approximately $17.0 million. Sentry, which had an A.M Best rating of "A+" (Superior) as of December 31, 2002, agreed to reinsure or otherwise assume all liabilities arising out of Arch Specialty's business prior to thereorganization described in Note 1, authorized share capitalclosing ofArch-U.S. consisted of 80,000,000 shares F-36ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 12. SHARE CAPITAL (CONTINUED) of common stock, par value U.S. $0.01 per share, and 20,000,000 shares of preferred stock, par value U.S. $0.01 per share. At December 31,the acquisition by the Company.
Arch Risk Transfer Services Ltd.
On June 22, 2001, the
bye-lawsCompany completed the acquisition ofACGL contained a provision limiting the voting rights of any person who owns (directly, indirectly or constructively under the United States Internal Revenue Code) Common Shares with more than 9.9% of the total voting power of all shares entitled to vote generally at an election of directors to 9.9% of such voting power. This provision will not restrict the ability of any person holding Common Shares that were either (1) converted from shares of Arch-U.S. owned on September 8, 2000 or (2) issued upon exercise of warrants owned by such person on September 8, 2000 which were assumed by ACGL, from voting such shares except with respect to the election of directors. This provision is intended to prevent ACGL from being characterized as a controlled foreign corporation which could cause U.S. persons owning 10% or more of the Common Shares to suffer adverse U.S. tax consequences. The bye-laws of ACGL also contained a provision limiting the rights of any group (within the meaning of the United States Securities Exchange Act of 1934) that owns shares with more than 9.9% of the total voting power of all shares entitled to vote generally at an election of directors to 9.9% of such voting power. This provision will not restrict (a) the ability of any such group holding Common Shares that were converted from shares of Arch-U.S. by such person on September 8, 2000 or acquired upon exercise of warrants owned by such person on September 8, 2000 which were assumed by ACGL or (b) any person or group that the board of directors, by the affirmative vote of at least 75% of the existing board, may exempt from this provision, from voting such shares. See Note 18--Subsequent Event. XL CAPITAL SHARE REPURCHASE On March 2, 2000, the Company repurchased from XL Capital, then the Company's single largest shareholder,all of the4,755,000 Common Shares held by itremaining ownership interests in one of its investee companies, ART Services, for a purchase price of$12.45 per share, or a total of $59.2approximately $38.8 million. Theper share repurchasepurchase price consisted of approximately $38.4 million in cash and 24,200 Common Shares. After the Company's acquisition of its initial 27.9% ownership interest in ART Services in March 1998, the investment wasdetermined ascarried at its estimated fair value from thelesser of (1) 85% of the average closing market price of the Common Shares during the 20 trading days beginning on the third business day following public announcement of the share repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15.initial purchase through March 31, 2001 in accordance with GAAP. The Companypaid XLaccounted for its initial interest in ART Services under "fair value" because theconsiderationCompany did not have the ability to exercise significant influence over this investment due to the Company's limited voting and consent rights. Upon acquiring the remaining ownership interests in ART Services, the Company was required under GAAP governing a "step acquisition" of an investee company to retroactively adopt the equity method of accounting for its original minority ownership interest in ART Services for therepurchase with: (i)periods prior to the acquisition and to restate its historical financial results accordingly. ART Services is included in the Company'sinterestinsurance segment (see Note 3).The required change to the equity method of accounting for this investment resulted in
privately held LARC Holdings, Ltd. (parenta reduction in the Company's book value at December 31, 2001 in the amount ofLatin American Reinsurance Company Ltd.), valued at $25$3.5 million and(ii)decreased net income by $475,000 for the year ended December 31, 2001. Restating the amounts previously reported decreased the net loss for the year ended December 31, 2000 by $729,000.
American Independent Insurance Holding Company
On February 28, 2001, the Company completed a transaction pursuant to which it acquired all of the
Company's interestcommon stock of AIHC, previously one of its investee companies. AIHC is a specialty property and casualty insurance holding company that, through its subsidiaries, markets and underwrites non-standard personal automobile liability and physical damage lines of insurance, primarily inAnnuityF-37
Pennsylvania, as well as in Maryland and
Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 millionDelaware. AIHC is included in theaggregate. XL paidCompany's insurance segment (see Note 3).The Company purchased a portion of the outstanding shares of AIHC for $1.25 million. The remaining outstanding shares of AIHC were redeemed by AIHC in exchange for the right to receive a portion of the proceeds resulting from the final adjudication or settlement of certain lawsuits that AIHC, as plaintiff, has previously filed against certain defendants. A third party also forgave the obligations owing to it under certain notes previously issued by AIHC in the aggregate principal amount of $4.0 million and returned certain warrants to purchase shares of AIHC in exchange for the right to receive a portion of the proceeds resulting from the final adjudication or settlement of such lawsuits. Immediately after the Company's purchase of AIHC, the Company contributed to the capital of AIHC notes in the aggregate principal amount of $8.5 million that were issued to the Company in
cashconnection with loans it had previously made to AIHC and also returned certain warrants to purchase shares of AIHC. Following thedifference (equalpurchase, the Company also made a capital contribution to$3.6 million) betweenAIHC in therepurchase priceamount of $11.0 million.In connection with the loans the Company had previously made to AIHC, the Company had obtained rights to provide reinsurance to AIHC's subsidiary, American Independent Insurance Company ("American Independent"), for specified periods, which rights had been transferred to Folksamerica in the asset sale on May 5, 2000. In connection with the Company's acquisition of AIHC, Folksamerica released American Independent from these reinsurance commitments at a cost to American Independent of $1.5 million.
Pro Forma Financial Information (Unaudited)
The following unaudited pro forma financial information for the year ended December 31, 2001 includes the audited financial information for ART Services and AIHC for the
valueyear ended December 31, 2001 as if the acquisitions had occurred on January 1, 2001. Pro forma financial information has not been prepared for the acquisitions of Arch Specialty or PSIC because neither comprised a significant portion of the Company'sinterests in LARC Holdingsfinancial position or results of operations for the year ended December 31, 2002.The pro forma financial information is based upon information available and
Annuityincludes certain assumptions that the Company's management believes are reasonable. The pro forma financial information does not purport to be indicative of the Company's results of operations that would have occurred or resulted had the transactions been completed on such dates nor is the information intended to be a projection of the Company's results of operations or financial condition for any future periods.Unaudited pro forma results for the year ended December 31, 2001 reflecting the acquisitions of ART Services and
Life Re. The valueAIHC are as follows: (i) total revenues, $101,872; (ii) net income, $24,876; (iii) basic earnings per share, $1.93; and (iv) diluted earnings per share, $1.46.
Goodwill Relating to Acquisitions
The carrying amount of
Annuitygoodwill at December 31, 2002 was $28.9 million, consisting of $23.2 million relating to the Company's insurance subsidiaries ($13.6 million, $6.8 million andLife Re was determined by taking$2.8 million relating to theaverageacquisitions of AIHC, ART Services and Arch Specialty, respectively) andF-38
$5.7 million relating to the
closing priceacquisition ofAnnuity and Life Re sharesHales. Amortization of goodwill for thesame period used in determiningyear ended December 31, 2001 was $1.4 million pre-tax, or $0.9 million after-tax. Net income for therepurchase price of the Common Shares. The value of the warrants was determined using a Black Scholes methodology. The cost of theyear ended December 31, 2001, adjusted to exclude goodwill amortization expense, would have been $22.9 million, or $1.78 and $1.35 per basic and diluted share,repurchase of $59.2 million was recorded as a reduction to shareholders' equity reflected as treasury shares, which shares were subsequently cancelled. F-37ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 12. SHARE CAPITAL SERIES A CONVERTIBLE PREFERENCE SHARES AND CLASS A WARRANTS On November 20, 2001,respectively. As required by SFAS No. 142, the Companyissued 35,687,735 preference sharescompleted a transitional goodwill impairment test upon adoption and,3,776,025 Class A Warrants for $763.2 millionpursuant to such test, determined that no impairment existed at January 1, 2002. The annual impairment test was completed at December 31, 2002 and, pursuant to such test, the Company determined that no impairment existed at December 31, 2002.
Folksamerica Transaction and Related Contingencies
On May 5, 2000, the Company sold the prior reinsurance operations of Arch Re U.S. pursuant to an agreement entered into as of January 10, 2000 with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica"). Folksamerica Reinsurance Company assumed Arch Re U.S.'s liabilities under the reinsurance agreements transferred in
cash. The purchase price forthepreference sharesasset sale andClass A Warrants paid at closing was based onArch Re U.S. transferred to Folksamerica Reinsurance Company assets estimated in an aggregate amount equal in book value to the book value of theCommon Sharesliabilities assumed. In consideration for the transfer of Arch Re U.S.'s book of business, Folksamerica paid $20.084 million (net of a credit equal to $251,000 granted to Folksamerica for certain tax costs) in cash atJune 30, 2001. Subject tothelimitation described below, each preference share will be convertible into one Common Share. This conversion ratio isclosing, subject tocustomary anti-dilution protection. The preference shares vote, together with the Common Shares, on an as-converted basis. The purchase price may be subject to apost-closingadjustmentadjustments based on an independent actuarial report of the claim liabilities transferred and an independent audit of theCompany's balance sheet asnet assets sold. Following the completion ofJune 30, 2001. In addition, if on or prior to September 19, 2005 (1)such report and audit, theclosing priceparties agreed upon net post-closing adjustments in the amount of approximately $3.2 million payable by theCommon Shares is at least $30.00 per share for at least 20 outCompany, which consisted of30 consecutive trading days or (2)achange of control occurs,$4.2 million reduction in the purchase priceunderless $1 million in net book value of thesubscriptionassets and liabilities actually transferred at closing.The Folksamerica transaction was structured as a transfer and assumption agreement
will be adjusted downward by $1.50 per preference share purchased. The purchase price under(and not reinsurance) and, accordingly, thesubscription agreement will also be adjusted based on actuallossexperiencereserves (and any related reinsurance recoverables) relating to the transferred business are not included as assets or liabilities on the Company'spre-closing insurance operationsbalance sheet. Folksamerica assumed Arch Re U.S.'s rights andcertain otherobligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements were notified that Folksamerica had assumed Arch Re U.S.'s obligations and that, unless the reinsureds object to the assumption, Arch Re U.S. will be released from its obligations to those reinsured. None of such reinsureds objected to the assumption. However, Arch Re U.S. will continue to be liable under those reinsurance agreements if the notice is found not to be an effective release by the reinsureds. Folksamerica has agreed to indemnify the Company for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale. However, in the event that Folksamerica refuses or is unable to perform its obligations to the Company, Arch Re U.S. may incur losses relating to the reinsurance agreements transferred in the asset sale. Folksamerica has an A.M. Best rating of "A-" (Excellent).Under the terms of the agreement, $20 million of the purchase price had been placed in escrow for a period of five years. Such amounts represented restricted funds that appeared under a separate caption entitled "Securities held in escrow" on the Company's consolidated balance sheet
developmentsat December 31, 2001. These funds were to be used to reimburse Folksamerica if the loss reserves (which were $32.3 million at the closing of the asset sale) transferred to it in the asset sale relating to business produced on behalf of Arch Re U.S. by a certain managing underwriting agency were deficient asF-39
measured at the end of such five-year period or to satisfy certain indemnity claims Folksamerica may have had during such period. On February 25, 2002, the Company reached a definitive settlement agreement with Folksamerica pursuant to which the Company satisfied its obligations under the escrow agreement for consideration of $17.0 million, plus accrued interest income of $1.8 million. Accordingly, during the
period from July 1,2001throughfourth quarter, thesecond anniversaryCompany recorded an after-tax benefit ofclosing (or such earlier date as is agreed upon by the investors and the Company), with the possibility$0.4 million, which consisted of alimited further adjustment thereafter based on specified tax and other matters. Any purchase price adjustmentcharge of $2.5 million, offset by a reversal of a related reserve infavor of the investors will be made through the issuance of additional preference shares. Pursuant to the Company's bye-laws (until amended by the shareholders), each investor's voting rights were limited to 9.9% of the total voting power of all outstanding voting shares. In addition, prior to shareholder approval, conversion of the preference shares was limited so thatthe amount ofCommon Shares issued did$2.9 million. The related reserve had been provided for the purchase of reinsurance, which was no longer required due to the fact that the escrow arrangements have been terminated under the above settlement agreement.Under the terms of the agreement, the Company had also purchased in 2000 reinsurance protection covering the Company's transferred aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed
the amount permitted to be issued under Nasdaq rules without shareholder approval. See Note 18--Subsequent Event. Finally, prior to regulatory approval, conversion of the preference shares will be limited so that the amount of Common Shares issued does not exceed the amount permitted to be issued without regulatory approval. If the shareholder or regulatory approvals are not obtained, or if the ultimate purchase price adjustment exceeds $250.0$5.4 million,at the investors' option, the preference shares will become convertible into a pro rata portion (assuming that all issued preference shares are convertible) of the shares of a newly-formed subsidiary of the Company that will hold all of the Company's core insurance and reinsurance operations. As a condition to the obligations of the investors to purchase the securities,the Company hasentered into a shareholders agreement with the investors (the "Shareholders Agreement"). Pursuant to the Shareholders Agreement, since the closing, Warburg Pincus has the right to designate one director for appointment to the Company's Board and H&F has the right to designate one director for appointment to the Company's Board. In addition, after receipt of the shareholder and regulatory approvals described above, Warburg Pincus and H&F will have the right to designate additional directors. After giving effect to the resignations and appointments contemplated, designees of Warburg Pincus and H&F collectively will constitute a majority of the Board of Directors. The Shareholders Agreement also provided the investors with certain registration rights. Pursuant to the subscription agreement, the Companyagreed toholdreimburse Folksamerica if aspecial meeting of its shareholders, (1)loss is incurred that exceeds $5.4 million for aviation losses under certain circumstances prior toapprove the issuance of such number of Common Shares issuable upon conversion of the preference shares, that together with the number of Common Shares issuable upon exercise of the Class A Warrants, is in excess of the amount that may be issued without shareholder approval under the Nasdaq Stock Market rules, (2)May 5, 2003. The Company also made representations and warranties toapprove the adoption of amendments to the Company's F-38ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 12. SHARE CAPITAL (CONTINUED) bye-laws that restrict voting rights of shareholders and that require directors of certain subsidiaries of the Company to be elected directly by shareholders ofFolksamerica about the Company and(3)the business transferred toelect Mr. Paul Ingrey as a director of Arch Re Bermuda (see Note 18--Subsequent Event). 13. EARNINGS PER SHARE The following table sets forthFolksamerica for which thecomputation of basicCompany retains exposure for certain periods, anddiluted earnings per share:
(IN THOUSANDS, EXCEPT SHARE DATA) YEARS ENDED DECEMBER 31, --------------------------------------- 2001 2000 1999 ----------- ----------- -----------BASIC EARNINGS PER SHARE: Net income (loss)..................................... $ 22,016 $ (8,012) $ (35,636) Divided by: Weighted average shares outstanding for the period.... 12,855,668 13,198,075 17,086,732 =========== =========== =========== Basic earnings (loss) per share....................... $ 1.71 $ (0.61) $ (2.09) =========== =========== =========== DILUTED EARNINGS PER SHARE: Net income (loss)..................................... $ 22,016 $ (8,012) $ (35,636) Divided by: Weighted average shares outstanding for the period.... 12,855,668 13,198,075 17,086,732 Effect of dilutive securities: Preference shares................................. 4,106,534 -- -- Warrants.......................................... -- -- -- Nonvested restricted shares....................... 5,987 -- -- Employee stock options............................ 34,042 -- -- ----------- ----------- ----------- Total shares.......................................... 17,002,231 13,198,075 17,086,732 =========== =========== =========== Diluted earnings (loss) per share..................... $ 1.29 $ (0.61) $ (2.09) =========== =========== ===========Stock optionsmade certain other agreements, including that the Company would not compete with Folksamerica topurchase 1,237,305, 1,101,004 and 1,273,856 Common Shares at per share prices averaging $21.33, $20.82 and $20.93 were outstanding as of December 31, 2001, 2000 and 1999, respectively, but were notacquire or reinsure any treaties included in thecomputationassumed business until May 5, 2004. In consideration ofdiluted earnings per share becausea $2.5 million payment by theoptions' exercise prices were greaterCompany in October 2002, Folksamerica agreed to terminate this non-competition provision and all related obligations under such provision have been extinguished. The amount was recorded by the Company in the 2002 third quarter and is reflected in acquisition expenses.In addition, the Company retained its tax and employee benefit liabilities and other liabilities not assumed by Folksamerica, including all liabilities not arising under reinsurance agreements transferred to Folksamerica in the asset sale and all liabilities (other than liabilities arising under reinsurance agreements) arising out of or relating to the
average market pricesmanaging underwriting agency referred to above. Although Folksamerica has not asserted that any amount is currently due under any of theCommon Shares of $17.71, $15.17 and $15.40, respectively. In addition, Class A Warrants toindemnities provided by the Company under the asset purchaseCommon Shares at $20 per share were outstanding as of December 31, 2001, 2000, and 1999 but were not includedagreement, Folksamerica has indicated a potential indemnity claim under the agreement in thecomputation of diluted earnings per share because the warrants' exercise price of $20.00 per share was greater than the average market priceevent of theCommon Shares foroccurrence of certain future events. Based on all available information, the Company has denied the validity of any suchyear. Diluted per share amounts are computed using basic average shares outstanding when a loss occurs since the inclusion of dilutive securities in dilutive earnings per share would be anti-dilutive.potential claim.14.
STATUTORY INFORMATION BERMUDAStatutory Information
Bermuda
Under The Insurance Act of 1978 (as amended) and related regulations of Bermuda, Arch Re Bermuda, the Company's Bermuda reinsurance and insurance subsidiary, is required to prepare statutory financial
F-39ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 14. STATUTORY INFORMATION (CONTINUED)statements and file a statutory financial return in Bermuda. The Insurance Act also requires Arch Re Bermuda to maintain certain measures of solvency and liquidity during the year.DeclarationDeclarations of dividends from retained earnings and distributions from additional paid-in-capitalisare subject to these solvency and liquidity requirements being met. At December 31, 2002 and 2001, such requirements were met.Statutory capital and surplus for Arch Re Bermuda, including investments in U.S. insurance and reinsurance subsidiaries, was
$508$1.2 billion and $508.0 million at December 31, 2002 and 2001,F-40
respectively. Arch Re Bermuda recorded a statutory net loss of $47.0 million for the year ended December 31, 2002 and statutory net income
wasof $18,000 for the year ended December 31, 2001. The primary difference betweenstatutorynet income andstatutorycapital and surplus presented under Bermuda statutory accounting principles and net income andshareholders'shareholder's equity presented in accordance with U.S. GAAParerelates to deferred acquisitioncosts and non-admitted assets.costs.Under the Insurance Act, Arch Re Bermuda is registered as a Class 4 insurer and reinsurer, and is restricted with respect to the payment of
dividends in any one financial year to 15%dividends. Arch Re Bermuda is prohibited, without prior approval of theprior year'sBermuda Monetary Authority, from reducing by 15% or more its total statutory capital,and surplus. UNITED STATESas set out in its previous year's financial statements, or approximately $179.0 million. Dividends or distributions, if any, made by Arch Re Bermuda would result in an increase in available capital at ACGL, Arch Re Bermuda's parent company.
United States
The Company's U.S. insurance and reinsurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulators. Statutory net income and statutory surplus, as reported to the insurance regulatory authorities,
differsdiffer in certain respects from the amounts prepared in accordance with GAAP. The main differences between statutory net income and GAAP net income relate to deferred acquisition costs and deferred income taxes. In addition to deferred acquisition costs and deferred income tax assets,the mainother differences between statutory surplus and GAAP shareholder's equity are unrealized appreciation ordepreciation ondecline in value of investments and non-admitted assets.Combined statutory surplus of the Company's U.S. insurance and reinsurance subsidiaries was $386.6 million, $306.8 million
$29.9 millionand$290.1$29.9 million at December 31, 2002, 20012000and1999,2000, respectively. The Company's U.S. insurance and reinsurance subsidiaries had a combined statutory net loss of $455,000 for the year ended December 31, 2002 and statutory net income ofthese operations was$7.9 million$59.6 millionand$44.6$59.6 million for the years ended December 31, 2001 and 2000,and 1999,respectively.The Company's U.S. insurance and reinsurance subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate. The ability of the Company's regulated insurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. These regulations include restrictions that limit the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities. Dividends or distributions, if any, made by the Company's U.S. regulated insurance and reinsurance subsidiaries to non-insurance affiliates would result in an increase in available capital at Arch-U.S., the Company's U.S. holding company, of which a significant portion is owned by Arch Re Bermuda. As of December 31,
2001,2002, the Company's U.S. insurance and reinsurance subsidiaries may not pay any significant dividends or distributions during20022003 without prior regulatory approval.The National Association of Insurance Commissioners (the "NAIC") adopted the Codification of Statutory Accounting Principles guidance, which replaces the current Accounting Practices and Procedures manual, as the NAIC's primary guidance on statutory accounting as of January 1, 2001. The accounting codification did not have a material impact on the results of operations or policyholders' surplus of the Company's insurance subsidiaries.
F-41
15.
SEGMENT INFORMATION SFAS No. 131 requires certain disclosures about operating segments in a manner that is consistent with how management evaluatesComprehensive IncomeFollowing are the
performance of the segment. At December 31, 2001, the Company F-40ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 15. SEGMENT INFORMATION (CONTINUED) had only one reportable operating segment--insurance. The Company's insurance operating segment includes the operations of the following five business entities: ART Services, which provides insurance and alternative risk transfer services through rent-a-captive and other facilities; AIHC, which markets and underwrites non-standard personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania; Arch Re Bermuda, the Company's Bermuda-based reinsurance subsidiary, and Arch Re and Cross River, U.S.-based reinsurance and insurance subsidiaries of the Company. At December 31, 2001, the Company's insurance operating segment included total assets of $1.2 billion. For the year ended December 31, 2001, the insurance operating segment generated revenues of $59.9 million and net income of $12.4 million. The remaining portion of the Company's net income was generated through the Company's investment activities, offset by other operating expenses. The results of the Company's advisory business conducted by Hales was not material to the Company's consolidated results of operations or financial position. For the year ended December 31, 2001, the Company produced its business through general agents and managing general agents, none of which accounted for more than 10% of total gross premiums written. Since the Company sold its prior reinsurance operations on May 5, 2000, the following data relating to 1999 is not meaningful for 2000 or future years. During 1999, one client contributed $42.1 million, or 13.7%, of net premiums written and $33.8 million, or 13.5%, of net premiums earned, and a second client contributed $39.2 million, or 12.8%, of net premiums written and $43.7 million, or 14%, of net premiums earned. The following lists individual broker business greater than 10% of the 1999 year's net premiums written:
Balis & Co., Inc. (1)....................................... 15.0% Guy Carpenter & Co. (1)..................................... 10.7% Aon Group................................................... 17.4% ---- Total....................................................... 43.1% ====- ------------------------ (1) In addition, approximately 7.4% of net premiums written in 1999 were produced by other brokers who are affiliated with Marsh & McLennan Companies, Inc. Net premiums written and earned recorded from client companies which were Lloyd's syndicates or were located in the United Kingdom, Bermuda and Continental Europe (some which are denominated in U.S. dollars) were $46.9 million and $58.0 million, respectively, which represented 15.3% and 18.6% of net premiums written and earned for the year ended December 31, 1999. F-41ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 16. OTHER COMPREHENSIVE INCOME Therelated tax effects allocated to each component of the change in other comprehensive income (loss)were as follows::
BEFORE TAX TAX EXPENSE NET OF TAX AMOUNT (BENEFIT) AMOUNT ---------- ----------- ----------YEAR ENDED DECEMBER 31, 2001 Unrealized appreciation (decline) on investments: Unrealized holding gains (losses) arising during year....... $ (6,993) $ 160 $ (7,153) Less reclassification of net realized gains included in net income.................................................... 18,382 7,242 11,140 -------- -------- -------- Change in other comprehensive income (loss)................. $(25,375) $ (7,082) $(18,293) ======== ======== ======== YEAR ENDED DECEMBER 31, 2000 Unrealized appreciation (decline) on investments: Unrealized holding gains (losses) arising during year....... $ 4,745 $ 428 $ 4,317 Less reclassification of net realized gains included in net income.................................................... 20,045 7,408 12,637 -------- -------- -------- Change in other comprehensive income (loss)................. $(15,300) $ (6,980) $ (8,320) ======== ======== ======== YEAR ENDED DECEMBER 31, 1999 Unrealized appreciation (decline) on investments: Unrealized holding gains (losses) arising during year....... $(14,319) $ (4,922) $ (9,397) Less reclassification of net realized gains included in net income.................................................... 17,227 6,029 11,198 -------- -------- -------- Change in other comprehensive income (loss)................. $(31,546) $(10,951) $(20,595) ======== ======== ========
Before
Tax
AmountTax
Expense
(Benefit)Net
of Tax
Amount(in thousands) Year Ended December 31, 2002 Unrealized appreciation (decline) on investments: Unrealized holding gains (losses) arising during year $ 46,256 $ 7,372 $ 38,884 Less reclassification of net realized losses included in net income (839 ) 1,779 (2,618 ) Change in other comprehensive income (loss) $ 47,095 $ 5,593 $ 41,502 Year Ended December 31, 2001 Unrealized appreciation (decline) on investments: Unrealized holding gains (losses) arising during year $ (6,993 ) $ 160 $ (7,153 ) Less reclassification of net realized gains included in net income 18,382 7,242 11,140 Change in other comprehensive income (loss) $ (25,375 ) $ (7,082 ) $ (18,293 ) Year Ended December 31, 2000 Unrealized appreciation (decline) on investments: Unrealized holding gains (losses) arising during year $ 4,745 $ 428 $ 4,317 Less reclassification of net realized gains included in net income 20,045 7,408 12,637 Change in other comprehensive income (loss) $ (15,300 ) $ (6,980 ) $ (8,320 ) F-42
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following16. Unaudited Quarterly Financial Information
Following is a summary of quarterly financial data:
(IN THOUSANDS, EXCEPT PER SHARE DATA) QUARTER ENDED --------------------------------------------------- DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, 2001 2001 2001 2001 ------------ ------------- -------- ---------INCOME STATEMENT DATA: Net premiums written............................ $ 12,212 $14,448 $ 6,719 $ 2,837 Net premiums earned............................. 11,921 11,799 5,565 1,633 Fee income...................................... 3,476 3,524 3,711 1,715 Net investment income........................... 3,373 2,509 3,078 3,160 Net realized investment gains (losses).......... (37) (190) 9,605 9,004 Equity in net income (loss) of investees........ 721 966 33 888 Operating expenses.............................. 20,639 17,207 9,363 5,101 Net income (loss)............................... $ 4,731 $ 892 $ 8,400 $ 7,993 PER SHARE DATA: Net income (loss) Basic......................................... $ 0.37 $ 0.07 $ 0.65 $ 0.63 Diluted....................................... $ 0.16 $ 0.07 $ 0.65 $ 0.63 COMMON SHARE PRICES: High.......................................... $ 28.34 $ 19.20 $ 17.06 $ 18.06 Low........................................... $ 16.40 $ 15.45 $ 14.81 $ 14.38 Close......................................... $ 25.75 $ 16.75 $ 15.75 $ 15.88
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31, 2000 2000 2000 2000 ------------ ------------- -------- ---------INCOME STATEMENT DATA: Net premiums written............................ -- -- $(63,493) $52,889 Net premiums earned............................. -- -- 29,368 58,162 Net investment income........................... $ 3,017 $ 3,359 4,257 5,290 Net realized investment gains (losses).......... (12,789) 728 (367) 32,473 Equity in net income (loss) of investees........ 434 878 853 (220) Operating expenses.............................. 17,205 1,502 34,069 74,355 Net income (loss)............................... $(15,388) $ 2,286 $ (2,607) $ 7,697 STATUTORY COMBINED RATIO:....................... -- -- -- 126.4% Per Share Data: Net income (loss) Basic and diluted............................. $ (1.23) $ 0.18 $ (0.21) $ 0.50 COMMON SHARE PRICES: High.......................................... $ 15.88 $ 15.88 $ 16.63 $ 16.75 Low........................................... $ 13.88 $ 14.63 $ 14.56 $ 11.38 Close......................................... $ 15.00 $ 15.75 $ 14.94 $ 16.38F-43ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED STATEMENTS (CONTINUED) 18. SUBSEQUENT EVENT ACGL held a special meeting
(in thousands, except per share data) Fourth Quarter Third Quarter Second Quarter First Quarter 2002 Income Statement Data: Net premiums written $ 439,207 $ 318,684 $ 223,026 $ 280,710 Net premiums earned $ 290,011 $ 183,979 $ 113,459 $ 67,527 Fee income 3,166 3,337 4,131 3,574 Net investment income 15,602 14,869 11,611 9,167 Net realized investment (losses) gains (1,014 ) (836 ) 2,476 (1,465 ) Other income 414 185 778 798 Losses and loss adjustment expenses (173,574 ) (120,121 ) (80,304 ) (50,539 ) Acquisition expenses (54,869 ) (39,026 ) (17,755 ) (7,311 ) Other operating expenses (29,059 ) (19,462 ) (14,854 ) (13,324 ) Net foreign exchange (losses) gains (69 ) (726 ) 3,352 (108 ) Non-cash compensation (7,188 ) (29,528 ) (8,636 ) (4,128 ) Income tax (expense) benefit (3,795 ) (392 ) 4,968 (225 ) Income (loss) before extraordinary item $ 39,625 $ (7,721 ) $ 19,226 $ 3,966 Extraordinary gain (net of tax) 3,886 — — — Net income (loss) $ 43,511 $ (7,721 ) $ 19,226 $ 3,966 Per Share Data: Net income (loss) Basic $ 1.71 ($ 0.36 ) $ 0.95 $ 0.30 Diluted $ 0.65 ($ 0.36 ) $ 0.33 $ 0.08
2001 Income Statement Data:
Net premiums written $ 12,212 $ 14,448 $ 6,719 $ 2,837 Net premiums earned $ 11,921 $ 11,799 $ 5,565 $ 1,633 Fee income 3,476 3,524 3,711 1,715 Net investment income 3,373 2,509 3,078 3,160 Net realized investment gains (losses) (37 ) (190 ) 9,605 9,004 Equity in net income of investees 721 966 33 888 Losses and loss adjustment expenses (7,181 ) (9,196 ) (5,526 ) (1,545 ) Acquisition (expenses) income (2,157 ) (337 ) 1,199 482 Other operating expenses (11,852 ) (7,399 ) (4,761 ) (3,679 ) Net foreign exchange gains (losses) — — — — Non-cash compensation (1,863 ) (275 ) (275 ) (359 ) Provision for loss of escrowed assets, net of other related reserves(1) 2,414 — — — Income tax benefit (expense) 5,916 (509 ) (4,229 ) (3,306 ) Net income $ 4,731 $ 892 $ 8,400 $ 7,993 Per Share Data: Net income Basic $ 0.37 $ 0.07 $ 0.65 $ 0.63 Diluted $ 0.16 $ 0.07 $ 0.65 $ 0.63
- (1)
- Excludes expenses of
its shareholders as required by$1.5 million in thesubscription agreement, as indicated in Note 12. At such meeting, the shareholders approved, among other things, (1) the issuance of such number of Common Shares issuable upon conversion of the preference shares, that together with the number of Common Shares issuable upon exercise of the Class A Warrants, is in excess of the amount that may be issued without shareholder approval under the Nasdaq Stock Market rules and (2) the adoption of amendments2001 fourth quarter which were charged against investment income, representing accrued investment income related to theprovisionloss ofACGL's bye-laws that limits voting rightsescrowed assets.F-43
Report ofshareholders to 9.9% of the total voting power of all outstanding voting shares to provide that such voting limitation applies only to votes conferred (directly or indirectly or by attribution) by shares of ACGL held by any U.S. person. Regulatory approvals required in connection with the private placement completed in November 2001 have been obtained in Nebraska, Missouri and Wisconsin, and required regulatory approvals are pending in Pennsylvania and Florida. F-44REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULESIndependent Accountants on
Financial Statement SchedulesTo the Board of Directors and Shareholders of
Arch Capital Group Ltd.
Our audits of the consolidated financial statements referred to in our report dated February
28, 2002, except as to the matters described in Note 18 to the consolidated financial statements which are as of March 7, 2002,19, 2003, appearing on Page F-2 of this Annual Report on Form 10-K also included an audit of the financial statement schedules listed on Page F-1. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements./s//s/ PricewaterhouseCoopers
Hamilton, BermudaLLPNew York, New York
February28, 200219, 2003S-1
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES(IN THOUSANDS)
DECEMBER 31, 2001 ------------------------------------- AMOUNT AT WHICH SHOWN IN AMORTIZED FAIR THE BALANCE COST VALUE SHEET ---------- ---------- -----------Type of Investment: FIXED MATURITY SECURITIES U.S. government and government agencies and authorities............................................ $ 136,617 $ 137,861 $ 137,861 Mortgage and asset-backed securities..................... 91,152 91,147 91,147 Corporate bonds.......................................... 239,385 239,261 239,261 ---------- ---------- ---------- Total Fixed Maturities................................. 467,154 468,269 468,269 EQUITY SECURITIES Publicly traded.......................................... 960 235 235 Privately held........................................... 41,587 41,608 41,608 ---------- ---------- ---------- Total Equity Securities................................ 42,547 41,843 41,843 SHORT-TERM INVESTMENTS Unrestricted............................................. 477,058 476,820 476,820 Held in escrow........................................... 22,156 22,156 22,156 ---------- ---------- ---------- Total Short-Term Investments........................... 499,214 498,976 498,976 ========== ========== ========== Total Investments...................................... $1,008,915 $1,009,088 $1,009,088 ========== ========== ==========
(Dollars in thousands)
December 31, 2002 Amortized
CostFair
ValueAmount
at Which
Shown in
the Balance
SheetType of Investment: FIXED MATURITY SECURITIES U.S. government and government agencies and authorities $ 174,084 $ 179,322 $ 179,322 Corporate bonds 916,406 949,003 949,003 Mortgage and asset-backed securities 244,147 253,779 253,779 Total Fixed Maturity Securities 1,334,637 1,382,104 1,382,104 EQUITY SECURITIES Privately held 31,630 31,536 31,536 Total Equity Securities 31,630 31,536 31,536 SHORT-TERM INVESTMENTS 480,541 480,541 480,541 Total Investments $ 1,846,808 $ 1,894,181 $ 1,894,181 S-2
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEET (PARENT COMPANY ONLY) (DOLLARS IN THOUSANDS)
DECEMBER 31, --------------------- 2001 2000 ---------- --------ASSETS Investment in wholly owned subsidiaries..................... $ 878,814 $ 57,271 Fixed maturities available for sale, at fair value (amortized cost: 2001, $79,717, 2000, $28,230)............ 79,872 28,646 Short-term investments available for sale, at fair value.... 11,536 75,746 Publicly traded equity securities available for sale, at fair value (cost: 2000, $44,074).......................... -- 49,366 Securities held in escrow, at fair value (amortized cost: 2001, $22,156, 2000, $20,887)............................. 22,156 20,970 Privately held securities (cost: 2001, $26,722, 2000, $42,086).................................................. 26,722 41,777 Cash........................................................ 11 Other assets................................................ 5,918 1,133 ---------- -------- TOTAL ASSETS............................................ $1,025,029 $274,909 ========== ======== LIABILITIES Accounts payable and other liabilities...................... $ 4,660 $ 2,610 SHAREHOLDERS' EQUITY Preference shares, $0.01 par value: 50,000,000 shares authorized (issued: 2001, 35,687,735; 2000, 0)............ 357 -- Common shares, $0.01 par value: 200,000,000 shares authorized (issued: 2001, 13,513,538; 2000, 12,708,818)... 135 127 Additional paid-in capital.................................. 1,039,887 288,016 Deferred compensation under share award plan................ (8,230) (341) Retained earnings (deficit)................................. (11,610) (33,626) Accumulated other comprehensive income consisting of unrealized appreciation (decline) in value of investments, net of income tax......................................... (170) 18,123 ---------- -------- TOTAL SHAREHOLDERS' EQUITY.............................. 1,020,369 272,299 ---------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.............. $1,025,029 $274,909 ========== ========Balance Sheet
(Parent Company Only)
(Dollars in thousands)
December 31, 2002 2001 Assets Investment in wholly owned subsidiaries $ 1,390,117 $ 878,814 Fixed maturities available for sale, at fair value (amortized cost: 2002, $6,392, 2001, $79,717) 6,463 79,872 Short-term investments available for sale, at fair value 367 11,536 Securities held in escrow, at fair value (amortized cost: 2002, —, 2001, $22,156) — 22,156 Privately held securities (cost: 2002, $5,780, 2001, $26,722) 5,780 26,722 Cash 1,081 11 Other assets 13,670 5,918 Total Assets $ 1,417,478 $ 1,025,029 Liabilities Accounts payable and other liabilities $ 6,234 $ 4,660
Shareholders' Equity
Preference shares, $0.01 par value: 50,000,000 shares authorized (issued: 2002, 38,844,665; 2001, 35,687,735) 388 357 Common shares, $0.01 par value: 200,000,000 shares authorized (issued: 2002, 27,725,334; 2001, 13,513,538) 277 135 Additional paid-in capital 1,347,165 1,039,887 Deferred compensation under share award plan (25,290 ) (8,230 ) Retained earnings (deficit) 47,372 (11,610 ) Accumulated other comprehensive income consisting of unrealized appreciation (decline) in value of investments, net of income tax 41,332 (170 ) Total Shareholders' Equity 1,411,244 1,020,369 Total Liabilities and Shareholders' Equity $ 1,417,478 $ 1,025,029 S-3
SCHEDULE II ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STATEMENT OF INCOME (PARENT COMPANY ONLY) (DOLLARS IN THOUSANDS)
SUCCESSOR (1) PREDECESSOR ------------------------ ----------------------- FOR THE FOR THE YEAR PERIOD FROM PERIOD FROM YEAR ENDED NOV. 8, 2000 JAN.1, 2000 ENDED DEC. 31, TO TO DEC. 31, 2001 DEC. 31, 2000 NOV. 7, 2000 1999 -------- ------------- ------------ --------REVENUES Net investment income.............................. $ 5,945 $ 1,245 $1,032 $ 641 Net investment gains/(losses)...................... (2,350) (11) (1) -- Loss on sale of reinsurance operations............. -- (442) -- ------- ------- ------ -------- Total revenues..................................... 3,595 1,234 589 641 OPERATING COSTS AND EXPENSES Operating expenses................................. 6,881 502 794 485 ------- ------- ------ -------- Income before income tax expense................... (3,286) 732 (205) 156 Income tax expense................................. -- -- (67) 55 ------- ------- ------ -------- Net income before equity in earnings in subsidiaries, investee company and cumulative effect of accounting change...................... (3,286) 732 (138) 101 Equity in net income (loss) of wholly owned subsidiaries..................................... 25,361 (8,950) 563 (35,725) Equity in net income(loss) of investee............. (59) (219) Cumulative effect of accounting change............. -- -- -- (12) ------- ------- ------ -------- NET INCOME (LOSS).................................. $22,016 $(8,437) $ 425 $(35,636) ======= ======= ====== ========- ------------------------Statement of Income
(Parent Company Only)
(Dollars in thousands)
Successor(1) Predecessor Year Ended
Dec. 31, 2002Year Ended
Dec. 31, 2001For the
period from
Nov. 8, 2000
to Dec. 31, 2000For the
period from
Jan. 1, 2000
to Nov. 7, 2000Revenues Net investment income $ 3,104 $ 5,945 $ 1,245 $ 1,032 Net investment losses (218 ) (2,350 ) (11 ) (1 ) Loss on sale of reinsurance operations — — — (442 ) Total revenues 2,886 3,595 1,234 589
Operating Costs and Expenses
Operating expenses 7,874 4,996 502 794 Non-cash compensation 39,782 1,885 — — Total expenses 47,656 6,881 502 794
Income (loss) before income taxes
(44,770
)
(3,286
)
732
(205
)
Income tax benefit
—
—
—
(67
)
Income (loss) before equity in net income (loss) of wholly owned subsidiaries, other income (loss) and extraordinary item
(44,770
)
(3,286
)
732
(138
)
Equity in net income (loss) of wholly owned subsidiaries
99,037
25,361
(8,950
)
563
Other income (loss) 829 (59 ) (219 ) —
Income (loss) before extraordinary item
55,096
22,016
(8,437
)
425
Extraordinary gain—excess of fair value of acquired assets over cost (net of $0 tax)
3,886
—
—
—
Net Income (Loss)
$
58,982
$
22,016
$
(8,437
)
$
425
- (1)
- Refer to reorganization described in Note 1 of the notes accompanying the consolidated financial statements.
S-4
SCHEDULE II ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STATEMENT OF CASH FLOWS (PARENT COMPANY ONLY) (IN THOUSANDS)
SUCCESSOR (1) PREDECESSOR -------------------------- ----------------------- FOR THE FOR THE YEAR PERIOD FROM PERIOD FROM YEAR ENDED NOV. 8, 2000 JAN.1, 2000 ENDED DEC. 31, TO TO DEC. 31, 2001 DEC. 31, 2000 NOV. 7, 2000 1999 ---------- ------------- ------------ --------OPERATING ACTIVITIES Net income (loss)............................... $ 22,016 $ (8,437) $ 425 $(35,636) Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Equity in net (income) loss of wholly owned subsidiaries.............................. (25,361) 8,950 (563) 35,725 Net investment (gains)/losses............... 2,350 11 1 -- Provisions for non-cash compensation........ 2,771 -- -- 628 Net change in other assets and liabilities............................... (1,074) 2,243 7,109 137 --------- -------- ------- -------- NET CASH PROVIDED BY OPERATING ACTIVITIES....... 702 2,767 6,972 854 INVESTING ACTIVITIES: Purchases of fixed maturities............... (490,256) (14,007) (3,500) (3,000) Sales of fixed maturities................... 159,991 16,012 4,000 5,000 Net change in short-term investments........ (350,142) (4,772) (3,077) (2,036) Acquisition of subsidiaries................. (61,043) --------- -------- ------- -------- NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES.................................... (741,450) (2,767) (2,577) (36) FINANCING ACTIVITIES: Common shares issued........................ 10,923 -- 1,223 66 Preference shares issued.................... 740,737 -- -- -- Purchase of treasury shares................. (48) -- 3,430 (103) Deferred compensation on restricted shares.................................... (10,466) -- (1,122) 117 Shares issued in connection with acquisition............................... (387) -- -- -- --------- -------- ------- -------- NET CASH PROVIDED BY FINANCING ACTIVITIES....... 740,759 -- 3,531 80 Increase in cash................................ 11 0 7,926 898 Cash at beginning of period..................... 0 0 4,313 3,415 --------- -------- ------- -------- Cash at end of period........................... $ 11 $ 0 $12,239 $ 4,313 ========= ======== ======= ========- ------------------------Statement of Cash Flows
(Parent Company Only)
(Dollars in thousands)
Successor(1) Predecessor Year Ended
Dec. 31, 2002Year Ended
Dec. 31, 2001For the
period from
Nov. 8, 2000
to Dec. 31, 2000For the
period from
Jan. 1, 2000
to Nov. 7, 2000Operating Activities Net income (loss) $ 58,982 $ 22,016 $ (8,437 ) $ 425 Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Equity in net (income) loss of wholly owned subsidiaries (99,037 ) (25,361 ) 8,950 (563 ) Net investment (gains)/losses 219 2,350 11 1 Provisions for non-cash compensation 39,783 2,771 — — Excess of fair value of net assets acquired over cost (3,886 ) — — — Net change in other assets and liabilities 4,313 (1,074 ) 2,243 7,109 Net Cash Provided By Operating Activities 374 702 2,767 6,972
Investing Activities:
Purchases of fixed maturities (86,675 ) (490,256 ) (14,007 ) (3,500 ) Release of escrowed assets (18,833 ) — — — Sales of fixed maturities 142,101 480,432 16,012 4,000 Net change in short-term investments 33,548 64,209 (4,772 ) (3,077 ) Capital contributions to subsidiaries (305,852 ) (734,792 ) — — Acquisition of subsidiaries (4,829 ) (61,043 ) — — Net Cash Used For Investing Activities (240,540 ) (741,450 ) (2,767 ) (2,577 )
Financing Activities:
Proceeds from common shares issued 254,338 457 — 101 Preference shares issued — 740,737 — — Repurchase of common shares (13,102 ) (48 ) — 3,430 Shares issued in connection with acquisition — (387 ) — — Net Cash Provided By Financing Activities 241,236 740,759 — 3,531
Increase in cash
1,070
11
0
7,926
Cash at beginning of period 11 0 0 4,313 Cash at end of period $ 1,081 $ 11 $ 0 $ 12,239
- (1)
- Refer to reorganization described in Note 1 of the notes accompanying the consolidated financial statements.
S-5
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION(IN THOUSANDS)
FUTURE POLICY BENEFITS, BENEFITS, CLAIMS, DEFERRED LOSSES, LOSSES LOSSES POLICY AND LOSS NET AND ACQUISITION ADJUSTMENT UNEARNED PREMIUM INVESTMENT SETTLEMENT COSTS EXPENSES PREMIUMS REVENUE INCOME EXPENSES ----------- -------------- -------- -------- ---------- ----------DECEMBER 31, 2001 Property-Casualty...................... $ 5,412 $ 23,065 $29,578 $ 30,918 $12,120 $ 23,448 ------- -------- ------- -------- ------- -------- Total................................ $ 5,412 $ 23,065 $29,578 $ 30,918 $12,120 $ 23,448 ======= ======== ======= ======== ======= ======== DECEMBER 31, 2000 Property-Casualty...................... -- -- -- $ 60,402 $15,923 $ 56,600 Accident and Health.................... -- -- -- 27,128 -- 19,663 Unearned premium portfolio transfer and assumption........................... -- -- -- -- -- -- ------- -------- ------- -------- ------- -------- Total................................ -- -- -- $ 87,530 $15,923 $ 76,263 ======= ======== ======= ======== ======= ======== DECEMBER 31, 1999 Property-Casualty...................... $23,585 $277,271 $98,133 $261,029 $20,173 $267,622 Accident and Health.................... -- 31,358 -- 50,339 -- 38,219 ------- -------- ------- -------- ------- -------- Total................................ $23,585 $308,629 $98,133 $311,368 $20,173 $305,841 ======= ======== ======= ======== ======= ========AMORTIZATION OF DEFERRED POLICY OTHER ACQUISITION OPERATING PREMIUMS COSTS EXPENSES WRITTEN ------------ --------- --------DECEMBER 31, 2001 Property-Casualty...................... $ 813 $27,692 $ 36,216 ------- ------- -------- Total................................ $ 813 $27,692 $ 36,216 ======= ======= ======== DECEMBER 31, 2000 Property-Casualty...................... $18,996 $ 6,855 $ 56,316 Accident and Health.................... 7,760 -- 25,987 Unearned premium portfolio transfer and assumption........................... -- -- (92,907) ------- ------- -------- Total................................ $26,756 $ 6,855 $(10,604) ======= ======= ======== DECEMBER 31, 1999 Property-Casualty...................... $64,279 $14,188 $256,388 Accident and Health.................... 16,261 50,338 ------- ------- -------- Total................................ $80,540 $14,188 $306,726 ======= ======= ========
(Dollars in thousands)
Deferred
Acquisition
Costs, NetReserves for
Losses and Loss
Adjustment
Expenses, NetUnearned
Premiums, NetPremium
RevenueNet
Investment
IncomeLosses and
Loss
Adjustment
Expenses
IncurredAmortization of Deferred
Acquisition
CostsOther
Operating
ExpensesPremiums
WrittenDecember 31, 2002 Property-Casualty $ 148,960 $ 380,514 $ 641,119 $ 653,329 $ 51,209 $ 423,478 $ 118,961 $ 76,176 $ 1,259,980 Accident and Health — 818 — 1,647 40 1,060 — 523 1,647 Total $ 148,960 $ 381,332 $ 641,119 $ 654,976 $ 51,249 $ 424,538 $ 118,961 $ 76,699 $ 1,261,627 December 31, 2001 Property-Casualty $ 5,412 $ 21,052 $ 29,578 $ 30,918 $ 12,120 $ 23,448 $ 813 $ 27,692 $ 36,216 Total $ 5,412 $ 21,052 $ 29,578 $ 30,918 $ 12,120 $ 23,448 $ 813 $ 27,692 $ 36,216 December 31, 2000 Property-Casualty — — — $ 60,402 $ 15,923 $ 56,600 $ 18,996 $ 6,855 $ 56,316 Accident and Health — — — 27,128 — 19,663 7,760 — 25,987 Unearned premium portfolio transfer and assumption — — — — — — — — (92,907 ) Total — — — $ 87,530 $ 15,923 $ 76,263 $ 26,756 $ 6,855 $ (10,604 ) S-6
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
REINSURANCE(IN THOUSANDS)
ASSUMED FROM PERCENTAGE OF CEDED TO OTHER OTHER AMOUNT ASSUMED GROSS AMOUNT COMPANIES COMPANIES NET AMOUNT TO NET ------------ -------------- ------------ ---------- --------------DECEMBER 31, 2001 Premiums Written: Property-Casualty........ $117,406 $(82,986) $ 1,796 $ 36,216 5.0% -------- -------- -------- -------- ----- Total.................. $117,406 $(82,986) $ 1,796 $ 36,216 5.0% ======== ======== ======== ======== ===== DECEMBER 31, 2000 Premiums Written: Property-Casualty........ -- $ 19,731 $ 76,047 $ 56,316 135.0% Accident and Health...... -- -- 25,987 25,987 100.0% Unearned premium portfolio transfer and assumption............. -- -- (92,907) (92,907) -- -------- -------- -------- -------- ----- Total.................. -- $ 19,731 $ 9,127 $(10,604) N/M ======== ======== ======== ======== ===== DECEMBER 31, 1999 Premiums Written: Property-Casualty........ -- $ 80,122 $336,510 $256,388 131.3% Accident and Health...... -- -- 50,338 50,338 100.0% -------- -------- -------- -------- ----- Total.................. -- $ 80,122 $386,848 $306,726 126.1% ======== ======== ======== ======== =====
(In thousands)
Gross Amount Ceded to Other
CompaniesAssumed From
Other
CompaniesNet Amount Percentage of
Amount Assumed
to NetYear Ended
December 31, 2002Premiums Written: Property-Casualty $ 629,988 $ (225,585 ) $ 855,577 $ 1,259,980 67.9 % Accident and Health — — 1,647 1,647 100.0 % Total $ 629,988 ($ 225,585 ) $ 857,224 $ 1,261,627 67.9 %
Year Ended
December 31, 2001
Premiums Written: Property-Casualty $ 117,406 $ (82,986 ) $ 1,796 $ 36,216 5.0 % Total $ 117,406 $ (82,986 ) $ 1,796 $ 36,216 5.0 %
Year Ended
December 31, 2000
Premiums Written: Property-Casualty — $ 19,731 $ 76,047 $ 56,316 135.0 % Accident and Health — — 25,987 25,987 100.0 % Unearned premium portfolio transfer and assumption — — (92,907 ) (92,907 ) — Total — $ 19,731 $ 9,127 $ (10,604 ) N/M S-7
EXHIBIT NUMBER DESCRIPTION - --------------------- -----------Exhibit
NumberDescription 3.1 Memorandum of Association of Arch Capital Group Ltd. ("ACGL") (n)(l)3.2 Bye-Laws of ACGL(n) 3.3ACGL(l)3.3.1 Form of Amended and Restated Bye-law 45 and Bye-law 75(w) 3.475(r)3.3.2 Form of Amended and Restated Bye-law 20(w) 4.1 Certificate of Designations of Series A Convertible Preference Shares(w) 4.1Shares(r)4.2 Specimen Common Share Certificate(s) 4.2.1 Class A Common Share Purchase Warrants issued to Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH") on September 19, 1995(b) and September 28, 1995(c) 4.2.2 Class A Common Share Purchase Warrants issued to The Trident Partnership, L.P. ("Trident") on September 19, 1995(b) and September 28, 1995(c) 4.2.3 Class A Common Share Purchase Warrants issued to Taracay Investors ("Taracay") on September 19, 1995(b) and September 28, 1995(c)Certificate(o)4.3 Class B Common Share Purchase Warrants issued to MMRCH on September 19, 1995(b) and September 28, 1995(c) 4.4 Form of Class A Warrant Certificate(w) 4.5Shareholders Agreement, dated as of November 20, 2001, among ACGL and the shareholders party thereto, conformed to reflect amendments dated as of January 3, 2002, andMarch 15, 2002 and September 16, 2002 (filed herewith)4.64.5 Subscription Agreement, dated as of October 24, 2001, between ACGL and the purchasers party thereto, conformed to reflect amendments dated as of November 20, 2001, January 3, 2002, andMarch 15, 2002 and January 20, 2003 (filed herewith)10.1.1 Amended and Restated Subscription Agreement, between ACGL and Trident(b) 10.1.2 Amendment, dated October 31, 2000, to Subscription Agreement, dated as of June 28, 1995, between ACGL and Trident(o)Trident(m)10.2.1 Amended and Restated Subscription Agreement, between ACGL and MMRCH(b) 10.2.2 Amendment, dated October 31, 2000, to Subscription Agreement, dated as of June 28, 1995, between ACGL and MMRCH(o)MMRCH(m)10.3 Amended and Restated Subscription Agreement, between ACGL and Taracay(b) 10.4.1 Investment Advisory Agreement, between ACGL and MMC Capital, Inc. ("MMC Capital")(b) 10.4.2 Investment Advisory Agreement, between Arch Reinsurance Company (formerly known as Risk Capital Reinsurance Company, "Arch Re") and MMC Capital(b) 10.5.1 SubleaseLease Agreement, dated as of March 18, 1996,September 26, 2002, between ArchReInsurance Company andCoca-Cola Bottling Company of New York, Inc. ("Coca-Cola")(b) 10.5.2 Sublease Amendment Agreement and Consent,BFP One Liberty Plaza Co. LLC (filed herewith)10.4.2 Sub-sublease, dated as of November 11, 1997,December 31, 2002, between ArchRe and Coca-Cola(e) 10.5.3 Sub-Sublease Agreement, dated as of March 18, 1996, between Arch Re and MMC Capital(f) 10.5.4 Amendment to Sub-Sublease Agreement, between Arch Re and MMC Capital(k) 10.6.1 Tax Sharing Agreement, between Arch U.S. and Arch Re (amended)(e) 10.6.2 Addition of Cross RiverInsurance Companyto Tax Sharing Agreement(g) 10.6.3 Addition of Hales &and Folksamerica Reinsurance CompanyInc. ("Hales") to Tax Sharing Agreement(s) 10.7.1(filed herewith)10.5.1 ACGL 1999 Long Term Incentive and Share Award Plan(h)+ 10.7.2Plan(g)†10.5.2 ACGL 1995 Long Term Incentive and Share Award Plan (the "1995 Stock Plan")(b) + 10.7.3†10.5.3 First Amendment to the 1995 Stock Plan(c) +E-1
EXHIBIT NUMBER DESCRIPTION - --------------------- -----------10.7.4†10.5.4 ACGL Long Term Incentive Plan for New Employees(y)+ 10.8.1Employees(t)†10.5.5 ACGL 2002 Long Term Incentive and Share Award Plan(y)† 10.6.1 Restricted Share Agreements--ExecutiveAgreements—Executive Officers(d)+ 10.8.210.6.2 Restricted Share Agreement--PeterAgreement—Peter A.Appel--AprilAppel—April 24, 2000grant(p)+grant(n)† and as of January 30, 2001grants(v)+ 10.8.3grants(q)†10.6.3 Restricted Share Agreements--Robert Clements--MayAgreements—Robert Clements—May 5, 2000 grants,(p)+(n)† January 1, 2001grant(s)+grant(o)†, as of January 30, 2001grants(v)+grants(q)†, October 23, 2001grant(w)+grant(r)† and November 19, 2001grant(w)+ 10.8.4grant(r)†10.6.4 Restricted Share Agreement, dated as of January 1, 2002, between ACGL and Constantine Iordanou(w)+ 10.8.5Iordanou(r)†10.6.5 Restricted Share Agreement, dated as of January 1, 2002, between ACGL and Constantine Iordanou(w)+ 10.8.6Iordanou(r)†E-1
10.6.6 Restricted Share Agreement, dated as of January 18, 2002, between ACGL and John Vollaro (filed herewith)+ 10.8.7Vollaro(x)†10.6.7 Amended and Restated Restricted Share Agreement, dated as of October 23, 2001, between ACGL and Paul Ingrey(v)+ 10.8.9Ingrey (filed herewith)†10.6.8 Restricted Share Agreement, dated as of October 23, 2001, between ACGL and Dwight Evans(v)+ 10.8.10Evans(q)†10.6.9 Restricted Share Agreement, dated as of October 23, 2001, between ACGL and Marc Grandisson(v)+ 10.8.11Grandisson(q)†10.6.10 Restricted Share Agreement, dated as of January 30, 2001, between ACGL and Louis Petrillo(v)+ 10.9.1Petrillo(q)†10.6.11 Amendment No. 1 to Restricted Share Agreement, dated as of March 19, 2003, between ACGL and John Vollaro (filed herewith)† 10.7.1 Stock Option Agreements--Executive Officers--1995Agreements—Executive Officers—1995 and 1996 grants,(d) 1997 and 1998grants(g)grants(f) and 2000grants(p)+ 10.9.2grants(n)†10.7.2 Stock Option Agreements--Robert Clements--1996Agreements—Robert Clements—1996 grant,(d) 1997 grant(e) and 1998grant(g) 10.9.3grant(f)10.7.3 Amendments to Stock Option Agreements--RobertAgreements—Robert Clements (dated March 22, 2000)(p)(n) and ExecutiveOfficers+Officers† and Directors (dated May 5, 2000)(s)+ 10.9.4(o)†10.7.4 Stock Option Agreements--Non-Employee Directors--1996Agreements—Non-Employee Directors—1996 and 1997 annual grants,(c)+† 1998 annual grants,(e)+† 1999 annual grants,(g)+(f)† 2000 annualgrants(j)+grants(i)† and 2001 annualgrants(s)+ 10.9.5grants(o) †10.7.5 Stock Option Agreements--Non-Employee Directors--initial grants(g)(j)+ 10.9.6Agreements—Non-Employee Directors—initial grants(f)(i)†10.7.6 Share Option Agreement, dated October 23, 2001, between ACGL and Ian Heap(aa)+ 10.9.7Heap(v)†10.7.7 Employee Share Option Agreement, dated October 23, 2001, between ACGL and John M. Pasquesi(w)+ 10.9.8Pasquesi(r)†10.7.8 Share Option Agreement, dated as of October 23, 2001, between ACGL and John M. Pasquesi(w)+ 10.9.9Pasquesi(r)†10.7.9 Share Option Agreement, dated as of October 23, 2001, between ACGL and Peter A. Appel(w)+ 10.9.10Appel(r)†10.7.10 Amended and Restated Stock Option Agreement, dated as of October 23, 2001, between ACGL and Paul Ingrey(v)+ 10.9.11Ingrey (filed herewith)†10.7.11 Stock Option Agreement, dated as of October 23, 2001, between ACGL and Dwight Evans(v)+ 10.9.12Evans(q)†10.7.12 Stock Option Agreement, dated as of October 23, 2001, between ACGL and Marc Grandisson(v)+ 10.9.13Grandisson(q)†10.7.13 Share Option Agreement, dated as of January 1, 2002, between ACGL and Constantine Iordanou(w)+ 10.9.14Iordanou(r)†10.7.14 Stock Option Agreement, dated as of January 18, 2002, between ACGL and John Vollaro (filed herewith)+E-2
EXHIBIT NUMBER DESCRIPTION - --------------------- -----------10.9.15Vollaro(x)†10.7.15 Stock Option Agreements, dated as of January 30, 2001 and October 23, 2001, between ACGL and Debra O'Connor(v)+ 10.9.16O'Connor(q)†10.7.16 Stock Option Agreements, dated as of January 30, 2001 and October 23, 2001, between ACGL and Louis Petrillo(v)+ 10.10.1Petrillo(q)†10.7.17 Stock Option Agreement, dated as of June 27, 2002, between ACGL and Dwight Evans (filed herewith)† E-2
10.8.1 Retention Agreement, dated January 4, 2002, among ACGL, Arch U.S. and Robert Clements, including Form of Promissory Note(w)+ 10.10.2Note(r)†10.8.2 Employment Agreement dated as of June 9, 2000 between ACGL and Debra M. O'Connor(m)+ 10.10.3O'Connor(k)†10.8.3 Employment and Change in Control Agreement, dated as of May 5, 2000, between ACGL and Louis T. Petrillo(m)+ 10.10.4Petrillo(k)†10.8.4 Employment Agreement, dated as of October 23, 2001, among ACGL, Arch Reinsurance Ltd. (Arch Re Bermuda) and Paul Ingrey(w)+ 10.10.5Ingrey(r)†10.8.5 Employment Agreement, dated as of October 23, 2001, among ACGL, Arch Re Bermuda and Dwight Evans(w)+ 10.10.6Evans(r)†10.8.6 Employment Agreement, dated as of October 23, 2001, among ACGL, Arch Re Bermuda and Marc Grandisson(w)+ 10.10.7Grandisson(r)†10.8.7 Employment Agreement, dated as of December 20, 2001, among ACGL, Arch U.S. and Constantine Iordanou(w)+ 10.10.8Iordanou(r)†10.8.8 Employment Agreement, dated as of January 18, 2002, between ACGL and John Vollaro (filed herewith)+ 10.10.9Vollaro(x)†10.8.9 Employment Agreement, dated October 23, 2001, between ACGL and John M. Pasquesi(w)+ 10.11Pasquesi(r)†10.8.10 Agreement, dated as of November 12, 2002, between ACGL and Robert Clements(z) 10.9 Assumption of Change in Control Agreements(s) 10.12.1Agreements(o)10.10.1 ACGL 1995 Employee Stock Purchase Plan(a) + 10.12.2 Arch Re Money Purchase Pension Plan (the "Pension Plan")(b)+ 10.12.3 Amendment and Restatement of the Adoption Agreement relating to the Pension Plan(c)+ 10.12.4 Amendment to the Adoption Agreement relating to the Pension Plan(g)+ 10.12.5 Arch Re Employee Savings Plan (the "Savings Plan")(b)+ 10.12.6 Amendment and Restatement of the Adoption Agreement relating to the Savings Plan(c)+ 10.12.7 Amendment to the Adoption Agreement relating to the Savings Plan(g)+ 10.12.8†10.10.2 Arch Re Executive Supplemental Non-Qualified Savings and Retirement Plan (the "Supplemental Plan") and related Trust Agreement(b) + 10.12.9†10.10.3 Amendment No. 1 to the Adoption Agreement relating to the Supplemental Plan(c) + 10.12.10†10.10.4 Amendment No. 2 to the Adoption Agreement relating to the Supplemental Plan(g)+ 10.13Plan(f)†10.11 Asset Purchase Agreement, dated as of January 10, 2000, among Arch-U.S., Folksamerica Holding Company, Inc. ("FHC") and Folksamerica Reinsurance Company ("FRC") (i) 10.14(h)10.12 Transfer and Assumption Agreement, dated May 5, 2000, between Arch Re and FRC(l) 10.15FRC(j)10.13 Escrow Agreement, dated December 28, 2000, among ACGL, FHC, FRC and the Escrow Agent(s) 10.16Agent(o)10.14 Agreement, dated May 5, 2000, among Arch-U.S., Arch Re, FHC and FRC regarding Aviation Business(l) 10.1710.15 Agreement and Plan of Merger, dated as of September 25, 2000, among Arch-U.S., ACGL, The Arch Purpose Trust and Arch Merger Corp. (n) 10.18 Asset Purchase Agreement, dated as of October 31, 2000, among Arch-U.S., Hales Capital Advisors, LLC, its members and Hales(q) 10.19 Reorganization Agreement, dated as of December 31, 2000, among ACGL, American Independent Insurance Holding Company and other signatories thereto(r)E-3
EXHIBIT NUMBER DESCRIPTION - --------------------- -----------10.20 Stock Repurchase Agreement, dated January 17, 2000, among ACGL, Arch Re and XL Capital Ltd(i) 10.21(l)10.16 Form of Voting and Disposition Agreement, among Arch U.S., Arch Re and XL Capital Ltd(i) 10.22Ltd(h)10.17 Agreement, dated November 20, 2001, among ACGL, Warburg Pincus Private Equity VIII, L.P., Warburg Pincus International Partners, L.P., Warburg Pincus Netherlands International Partners I, C.V., Warburg Pincus Netherlands International II, C.V. and HFCP IV (Bermuda), L.P. (collectively, the "Original Signatories") and Orbital Holdings, Ltd. (w) 10.23(r)10.18 Agreement, dated November 20, 2001, among ACGL, the Original Parties and Insurance Private Equity Investors, L.L.C. (w) 10.24(r)10.19 Agreement, dated November 20, 2001, among ACGL, the Original Parties and Farallon Capital Partners, L.P., Farallon Capital Institutional Partners II, L.P., Farallon Capital Institutional Partners III, L.P. and RR Capital Partners, L.P. (w) 10.25(r)E-3
10.20 Agreement, dated as of November 8, 2001, among ACGL, the Investors, Trident, Trident II, L.P., MMRCH, Marsh & McLennan Capital Professionals Fund, L.P. and Marsh & McLennan Employees' Securities Company, L.P. (v) 10.26(q)10.21 Management Subscription Agreement, dated as of October 24, 2001, between ACGL and certain members of management(v) 10.27 Reorganizationmanagement(q)10.22.1 Letter of Credit and Reimbursement Agreement, dated as of March 23, 2001,April 17, 2002, by and amongAltus Holdings, Ltd.Arch Re Bermuda, Arch Re U.S.,Trident, TRYCO II, Ltd., MMRCH, Glenn L. Ballew, David G. MayAlternative Re, Alternative Re Limited, Arch Insurance Company andACGL(u) 10.28 Administrative Services Agreement, between ACGL and Arch U.S.(t)Fleet National Bank ("Letter of Credit")(y)10.22.2 Amendment to Letter of Credit, dated as of November 4, 2002 (filed herewith) 10.22.3 Amendment to Letter of Credit, dated as of November 27, 2002 (filed herewith) 10.22.4 Amendment to Letter of Credit, dated as of January 1, 2003 (filed herewith) 21 Subsidiaries of Registrant (filed herewith) 23 Consent of PricewaterhouseCoopers (filed herewith) 24 Powers of Attorney (filed herewith) - ------------------------
- (a)
- Filed as an exhibit to our Registration Statement on Form S-8 (No. 33-99974), as filed with the SEC on December 4, 1995, and incorporated by reference.
- (b)
- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1995, as filed with the SEC on March 30, 1996, and incorporated by reference.
- (c)
- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1996, as filed with the SEC on March 31, 1997, and incorporated by reference.
- (d)
- Filed as an exhibit to our Report on Form 10-Q for the period ended June 30, 1997, as filed with the SEC on August 14, 1997, and incorporated by reference.
- (e)
- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1997, as filed with the SEC on March 27, 1998, and incorporated by reference.
- (f)
Filed as an exhibit to our Report on Form 10-Q for the period ended June 30, 1998, as filed with the SEC on August 14, 1998, and incorporated by reference. (g)- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1998, as filed with the SEC on March 30, 1999, and incorporated by reference.
(h)- (g)
- Filed as an exhibit to our Definitive Proxy Statement, as filed with the SEC on April 14, 1999, and incorporated by reference.
(i)- (h)
- Filed as an exhibit to our Report on Form 8-K as filed with the SEC on January 18, 2000, and incorporated by reference.
(j)- (i)
- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1999, as filed with the SEC on March 30, 2000, and incorporated by reference.
E-4(k) Filed as an exhibit to our Report on Form 10-Q for the period ended March 31, 2000, as filed with the SEC on May 15, 2000, and incorporated by reference. (l)- (j)
- Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on May 19, 2000, and incorporated by reference.
(m)- (k)
- Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on September 8, 2000, and incorporated by reference.
(n)- (l)
- Filed as an annex to our Definitive Proxy Statement/Prospectus included in our Registration Statement on Form S-4 (No. 333-45418), as filed with the SEC on September 26, 2000, and incorporated by reference.
(o)E-4
- (m)
- Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on November 9, 2000, and incorporated by reference.
(p)- (n)
- Filed as an exhibit to our Report on Form 10-Q for the period ended September 30, 2000, as filed with the SEC on November 14, 2000, and incorporated by reference.
(q) Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on December 5, 2000, and incorporated by reference. (r) Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on March 15, 2001, and incorporated by reference. (s)- (o)
- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 2000, as filed with the SEC on April 2, 2001, and incorporated by reference.
(t) Filed as an exhibit to our Report on Form 10-Q for the period ended March 31, 2001, as filed with the SEC on May 15, 2001, and incorporated by reference. (u)- (p)
- Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on July 6, 2001, and incorporated by reference.
(v)- (q)
- Filed as an exhibit to our Report on Form 10-Q for the period ended September 30, 2001, as filed with the SEC on November 14, 2001, and incorporated by reference.
(w)- (r)
- Filed as an exhibit to our Report on Form 8-K, as filed with the SEC on January 4, 2002, and incorporated by reference.
(x)- (s)
- Filed as an exhibit to our Report on Form 8-K/A, as filed with the SEC on January 7, 2002, and incorporated by reference.
(y)- (t)
- Filed as an exhibit to our Registration Statement on Form S-8 (No. 333-72182), as filed with the SEC on January 8, 2002, and incorporated by reference.
(z)- (u)
- Filed as an exhibit to our Registration Statement on Form S-3 (No. 333-82612), as filed with the SEC on February 12, 2002, and incorporated by reference.
(aa)- (v)
- Filed as an exhibit to our Registration Statement on Form S-8 (No. 333-82772), as filed with the SEC on February 14, 2002, and incorporated by reference.
+- (w)
- Filed as an annex to our Definitive Proxy Statement, as filed with the SEC on June 3, 2002, and incorporated by reference.
- (x)
- Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the SEC on March 18, 2002, and incorporated by reference.
- (y)
- Filed as an exhibit to our Report on Form 10-Q for the period ended June 30, 2002, as filed with the SEC on August 14, 2002, and incorporated by reference.
- (z)
- Filed as an exhibit to our Report on Form 10-Q for the period ended September 30, 2002, as filed with the SEC on November 14, 2002, and incorporated by reference.
- †
- A management contract or compensatory plan or arrangement required to be filed pursuant to Item 14(c) of Form 10-K.
E-5