<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2000
Or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period ___________________ to _____________________
Commission file number: 0-26456
ARCH CAPITAL GROUP LTD.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
Delaware 06-1424716
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
20 Horseneck Lane
Greenwich, Connecticut 06830
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (203) 862-4300
RISK CAPITAL HOLDINGS, INC.
--------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
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 No ______
-------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock.
CLASS OUTSTANDING AT MARCH 31, 2000
----- -----------------------------
Common Stock, $.01 par value 12,329,398
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<PAGE>
ARCH CAPITAL GROUP LTD.
INDEX
<TABLE>
<CAPTION>
PAGE NO.
-------------
<S> <C>
PART I. FINANCIAL INFORMATION
ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS
Review Report of Independent Accountants 1
Consolidated Balance Sheet
March 31, 2000 and December 31, 1999 2
Consolidated Statement of Income and Comprehensive Income For the
three month periods ended March 31, 2000 and 1999 3
Consolidated Statement of Changes in Stockholders' Equity For the
three month periods ended March 31, 2000 and 1999 4
Consolidated Statement of Cash Flows
For the three month periods ended March 31, 2000 and 1999 5
Notes to Consolidated Financial Statements 6
Unaudited Pro-Forma Condensed Consolidated Financial Data
As of March 31, 2000 and for the three month period ended March 31, 2000
and for the year ended December 31, 1999 17
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 24
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 32
PART II. OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS 33
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K 33
</TABLE>
<PAGE>
REVIEW REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Arch Capital Group Ltd.
We have reviewed the accompanying interim consolidated balance sheet of Arch
Capital Group Ltd. (formerly known as Risk Capital Holdings, Inc.) and its
subsidiaries as of March 31, 2000 and the related consolidated statement of
income and comprehensive income, changes in stockholders' equity and of cash
flows for the three-month period ended March 31, 2000. This financial
information is the responsibility of the Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying consolidated interim financial information for it to
be in conformity with generally accepted accounting principles.
We previously audited, in accordance with generally accepted auditing standards,
the consolidated balance sheet as of December 31, 1999, and the related
consolidated statements of income and comprehensive income, of changes in
stockholders' equity, and of cash flows for the year then ended (not presented
herein), and in our report dated February 1, 2000, except as to Note 14, which
is as of March 2, 2000, we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth in
the accompanying condensed consolidated balance sheet as of December 31, 1999,
is fairly stated in all material respects in relation to the consolidated
balance sheet from which it has been derived.
/s/ PricewaterhouseCoopers LLP
New York, New York
May 2, 2000
1
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS)
<TABLE>
<CAPTION>
(UNAUDITED)
MARCH 31, DECEMBER 31,
2000 1999
--------- ----------
<S> <C> <C>
ASSETS
Investments:
Fixed maturities (amortized cost: 2000, $214,608; 1999, $270,345) $ 206,302 $ 261,067
Publicly traded equity securities (cost: 2000, $49,971; 1999, $105,747) 42,887 158,631
Privately held securities (cost: 2000 $59,583; 1999, $85,748) 58,231 83,969
Short-term investments 140,766 72,785
--------- ---------
Total investments 448,186 576,452
--------- ---------
Cash 11,447 9,457
Accrued investment income 3,737 4,527
Premiums receivable 115,371 119,320
Reinsurance recoverable 77,590 73,122
Deferred policy acquisition costs 22,285 23,585
Investment accounts receivable 36,628
Federal income tax recoverable 8,150 8,758
Deferred income tax asset 10,103 7,834
Other insurance assets 36,281 36,975
Other assets 4,472 4,329
--------- ---------
TOTAL ASSETS $ 774,250 $ 864,359
========= =========
LIABILITIES
Claims and claims expenses $ 378,297 $ 364,554
Unearned premiums 103,469 108,743
Reinsurance balances payable 16,043 14,666
Investment accounts payable 398
Federal income tax payable
Deferred income tax liability
Other insurance liabilities 22,344 24,541
Other liabilities 4,446 5,341
--------- ---------
TOTAL LIABILITIES 524,997 517,845
--------- ---------
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value:
20,000,000 shares authorized (none issued)
Common stock, $.01 par value:
80,000,000 shares authorized
(issued: 2000, 17,106,936; 1999, 17,109,736) 171 171
Additional paid-in capital 342,012 342,034
Deferred compensation under stock award plan (224) (317)
Retained earnings (deficit) (16,367) (22,175)
Less treasury stock, at cost (2000, 4,777,538; 1999, 21,766 shares) (59,597) (387)
Accumulated other comprehensive income (loss) consisting of unrealized (depreciation)
appreciation of investments, net of income tax (16,742) 27,188
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 249,253 346,514
--------- ---------
Total Liabilities & Stockholders' Equity $ 774,250 $ 864,359
========= =========
</TABLE>
See Notes to Consolidated Financial Statements.
2
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
2000 1999
------------ ------------
<S> <C> <C>
PREMIUMS AND OTHER REVENUES
Net premiums written $ 52,889 $ 64,437
(Increase) decrease in unearned premiums 5,273 (1,515)
------------ ------------
Net premiums earned 58,162 62,922
Net investment income 5,290 4,483
Net investment gains (losses) 29,300 (1,152)
------------ ------------
TOTAL REVENUES 92,752 66,253
EXPENSES
Claims and claims expenses 53,875 80,732
Commissions and brokerage 16,753 19,538
Other operating expenses 2,568 3,661
Foreign exchange loss 1,159 388
------------ ------------
TOTAL EXPENSES 74,355 104,319
INCOME (LOSS) BEFORE INCOME TAXES, EQUITY IN NET INCOME (LOSS) OF INVESTEES
AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE 18,397 (38,066)
Federal income taxes:
Current 264 (6,000)
Deferred 12,355 (7,621)
------------ ------------
Income tax expense (benefit) 12,619 (13,621)
------------ ------------
INCOME (LOSS) BEFORE EQUITY IN NET INCOME (LOSS) OF INVESTEES AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE 5,778 (24,445)
Equity in net income (loss) of investees 30 (163)
------------ ------------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 5,808 (24,608)
Cumulative effect of accounting change (383)
------------ ------------
NET INCOME (LOSS) 5,808 (24,991)
------------ ------------
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX
Change in net unrealized depreciation of investments, net of tax (43,930) (10,500)
------------ ------------
COMPREHENSIVE INCOME (LOSS) ($ 38,122) ($ 35,491)
============ ============
AVERAGE SHARES OUTSTANDING
Basic 15,517,163 17,086,601
Diluted 15,518,341 17,102,353
PER SHARE DATA
Net Income (Loss) - Basic $ 0.37 ($ 1.46)
- Diluted $ 0.37 ($ 1.46)
Comprehensive Income (Loss) - Basic ($ 2.46) ($ 2.08)
- Diluted ($ 2.46) ($ 2.08)
</TABLE>
See Notes to Consolidated Financial Statements.
3
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
UNAUDITED
THREE MONTHS ENDED,
MARCH 31,
2000 1999
--------- ---------
<S> <C> <C>
COMMON STOCK
Balance at beginning of year $ 171 $ 171
Common stock issued (cancelled)
--------- ---------
Balance at end of period 171 171
--------- ---------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year 342,034 341,878
Common stock issued (cancelled) (22)
--------- ---------
Balance at end of period 342,012 341,878
--------- ---------
DEFERRED COMPENSATION UNDER STOCK AWARD PLAN
Balance at beginning of year (317) (1,062)
Restricted common stock (issued) cancelled 22
Compensation expense recognized 71 231
--------- ---------
Balance at end of period (224) (831)
--------- ---------
RETAINED EARNINGS (DEFICIT)
Balance at beginning of year (22,175) 10,261
Net income (loss) 5,808 (24,991)
--------- ---------
Balance at end of period (16,367) (14,730)
--------- ---------
TREASURY STOCK, AT COST
Balance at beginning of year (387) (284)
Purchase of treasury stock (59,210) (25)
--------- ---------
Balance at end of period (59,597) (309)
--------- ---------
ACCUMULATED OTHER COMPREHENSIVE INCOME CONSISTING OF
UNREALIZED (DEPRECIATION) APPRECIATION OF INVESTMENTS,
NET OF INCOME TAX
Balance at beginning of year 27,188 47,038
Change in unrealized depreciation (43,930) (10,500)
--------- ---------
Balance at end of period (16,742) 36,538
--------- ---------
TOTAL STOCKHOLDERS' EQUITY
Balance at beginning of year 346,514 398,002
Issuance of common stock (22)
Change in deferred compensation 93 231
Net income (loss) 5,808 (24,991)
Purchase of treasury stock (59,210) (25)
Change in unrealized depreciation
of investments, net of income tax (43,930) (10,500)
========= =========
Balance at end of period $ 249,253 $ 362,717
========= =========
</TABLE>
See Notes to Consolidated Financial Statements.
4
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
UNAUDITED
THREE MONTHS ENDED,
MARCH 31,
2000 1999
--------- ----------
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ 5,808 ($ 24,991)
Adjustments to reconcile net income
to net cash provided by operating activities:
Liability for claims and claims expenses 13,743 65,357
Unearned premiums (5,274) 12,124
Premiums receivable 3,949 (15,212)
Accrued investment income 790 (779)
Reinsurance recoverable (6,645) (14,594)
Reinsurance balances payable 1,377 13,716
Deferred policy acquisition costs 1,300 (1,836)
Net investment (gains)/losses (29,300) 1,152
Deferred income tax asset 12,371 (7,728)
Other liabilities (3,092) (6,612)
Other items, net 2,279 (6,543)
--------- ---------
NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES (2,694) 14,054
--------- ---------
INVESTING ACTIVITIES
Purchases of fixed maturity investments (83,092) (63,727)
Sales of fixed maturity investments 136,903 52,165
Net (purchases)/sales of short-term investments (66,982) (2,711)
Purchases of equity securities (12,119) (16,321)
Sales of equity securities 89,178 8,714
(Purchases) disposal of furniture and equipment 6 (161)
--------- ---------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 63,894 (22,041)
--------- ---------
FINANCING ACTIVITIES
Common stock issued (22)
Purchase of treasury stock (59,210) (25)
Deferred compensation on restricted stock 22
--------- ---------
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES (59,210) (25)
--------- ---------
Increase (decrease) in cash 1,990 (8,012)
Cash beginning of year 9,457 12,037
--------- ---------
Cash end of period $ 11,447 $ 4,025
========= =========
</TABLE>
See Notes to Consolidated Financial Statements.
5
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION
Arch Capital Group Ltd. (the "Company"), formerly known as Risk Capital
Holdings, Inc., is a holding company that was incorporated in March 1995 under
the laws of the State of Delaware and commenced operations in September 1995
upon completion of an initial public offering. In September 1995, through its
initial public offering, related exercise of the underwriters' over-allotment
option and direct sales of 16,750,625 shares of the Company's common stock, par
value $.01 per share (the "Common Stock"), at $20 per share, and the issuance of
warrants, the Company was capitalized with net proceeds of approximately $335.0
million, of which $328.0 million was contributed to the statutory capital of
Risk Capital Reinsurance Company (which name is being changed to Arch
Reinsurance Company and is referred to herein as "Arch Re"). In July 1998,
Arch Re capitalized its wholly owned subsidiary, Cross River Insurance Company
("Cross River"), with $20 million. Cross River received its Nebraska license in
October 1998, and is currently authorized to write insurance on an excess and
surplus lines basis in 22 other states.
Class A warrants to purchase an aggregate of 2,531,079 shares of Common Stock
and Class B warrants to purchase an aggregate of 1,920,601 shares of Common
Stock were issued in connection with the direct sales of Common Stock in the
Company's initial public offering. Class A warrants are immediately exercisable
at $20 per share and expire September 19, 2002. Class B warrants are exercisable
at $20 per share during the seven year period commencing September 19, 1998,
provided that the Common Stock has traded at or above $30 per share for 20 out
of 30 consecutive trading days. To date, the Class B warrants have not become
exercisable.
2. GENERAL
The accompanying interim consolidated financial statements have been prepared in
conformity with generally accepted accounting principles ("GAAP") and in the
opinion of management, reflect all adjustments necessary (consisting of normal
recurring accruals) for a fair presentation of results for such periods. These
consolidated financial statements should be read in conjunction with the 1999
consolidated financial statements and related notes contained in the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 1999.
3. COMPREHENSIVE INCOME
In presenting its financial statements, the Company has adopted the reporting of
comprehensive income in a one financial statement approach, consistent with
Statement of Financial Accounting Standards No. 130 of the Financial Accounting
Standards Board ("FASB"). Comprehensive income is comprised of net income and
other comprehensive income, which for the Company consists of the change in net
unrealized appreciation or depreciation of investments, net of income tax, as
follows:
6
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. COMPREHENSIVE INCOME (CONT'D)
<TABLE>
<CAPTION>
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
2000 1999
-------- ---------
<S> <C> <C>
Net income (loss) $ 5,808 ($24,991)
Other comprehensive income, net of tax:
Unrealized appreciation (depreciation) of investments:
Unrealized holdings gains (losses) arising
during period (1) (24,885) (11,249)
Less, reclassification adjustment for net realized (gains)
losses included in net income (19,045) 749
-------- --------
Other comprehensive income (loss) (43,930) (10,500)
======== ========
Comprehensive income (loss) ($38,122) ($35,491)
======== ========
</TABLE>
(1) Includes deferred tax valuation allowance of $5.8 million at March 31, 2000.
See Note 6.
4. EARNINGS PER SHARE DATA
Earnings per share are computed in accordance with FASB Statement No. 128
"Earnings Per Share."
Basic earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of shares of
Common Stock outstanding for the periods. Diluted earnings per share reflect the
potential dilution that could occur if Class A and B warrants and employee stock
options were exercised or converted into Common Stock. 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.
The following table sets forth the computation of basic and diluted earnings per
share:
<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT SHARE DATA)
THREE MONTHS ENDED
MARCH 31,
2000 1999
------------ ------------
<S> <C> <C>
NET INCOME
BASIC EARNINGS PER SHARE:
Net income (loss) $ 5,808 ($ 24,991)
Divided by:
Weighted average shares outstanding for the period 15,517,163 17,086,601
Basic earnings (loss) per share $ 0.37 ($ 1.46)
DILUTED EARNINGS PER SHARE:
Net income (loss) $ 5,808 ($ 24,991)
Divided by:
Weighted average shares outstanding for the period 15,517,163 17,086,601
Effect of dilutive securities:
Warrants
Employee stock options 1,178 15,752
------------ ------------
Total shares 15,518,341 17,102,353
============ ============
Diluted earnings (loss) per share $ 0.37 ($ 1.46)
</TABLE>
7
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. EARNINGS PER SHARE DATA (CONT'D)
<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT SHARE DATA)
THREE MONTHS ENDED
MARCH 31,
2000 1999
----------- -----------
<S> <C> <C>
COMPREHENSIVE INCOME
BASIC EARNINGS PER SHARE:
Comprehensive income (loss) ($ 38,122) ($ 35,491)
Divided by:
Weighted average shares outstanding for the period 15,517,163 17,086,601
Basic earnings (loss) per share ($ 2.46) ($ 2.08)
DILUTED EARNINGS PER SHARE:
Comprehensive income (loss) ($ 38,122) ($ 35,491)
Divided by:
Weighted average shares outstanding for the period 15,517,163 17,086,601
Effect of dilutive securities:
Warrants
Employee stock options 1,178 15,752
------------ ------------
Total shares 15,518,341 17,102,353
============ ============
Diluted earnings (loss) per share ($ 2.46) ($ 2.08)
</TABLE>
5. INVESTMENT INFORMATION
The Company classifies all of its publicly traded fixed maturity 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, which have a maturity of
one year or less at the date of acquisition, are carried at cost, which
approximates fair value.
All of the Company's publicly traded equity securities and privately held
securities were issued by insurance and reinsurance companies or companies
providing services to the insurance industry. At March 31, 2000, the publicly
traded equity portfolio consisted of the following:
8
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D)
<TABLE>
<CAPTION>
MARCH 31, 2000
------------------------------
ESTIMATED
FAIR VALUE
AND NET
CARRYING UNREALIZED
VALUE GAINS (LOSSES) COST
------- ------ -------
<S> <C> <C> <C>
COMMON STOCK:
ACE Limited $ 7,398 ($ 744) $ 8,142
XL Capital Ltd. 14,397 5,522 8,875
E.W. Blanch Holdings, Inc. 7,140 (181) 7,321
Farm Family Holdings, Inc. 1,844 (98) 1,942
IPC Holdings, Ltd. 6,444 (8,549) 14,993
Limit PLC 1,450 (1,361) 2,811
Meadowbrook Insurance Group 915 (2,167) 3,082
Renaissance Re 2,044 334 1,710
PREFERRED STOCK:
St. Paul Companies, 6% Convertible Preferred 1,255 160 1,095
OTHER
Markel Corp (62,239 Contingent Value Rights) -- -- --
------- ------- -------
Total $42,887 ($7,084) $49,971
======= ======= =======
</TABLE>
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).
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 records its proportionate share of
income or loss for such investments in results of operations.
9
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D)
Goodwill for privately held equity securities carried under the equity method of
accounting was $8.3 million at March 31, 2000, compared to $8.9 million at
December 31, 1999.
The estimated fair value of investments in privately held securities, other than
those carried under the equity method or those with quoted market values, 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 a write-down. The Company periodically reviews the
valuation of investments in privately held securities with Marsh & McLennan
Capital, Inc., its equity investment advisor, with respect to certain of the
Company's privately held securities.
Privately held securities consisted of the following:
<TABLE>
<CAPTION>
(IN THOUSANDS)
MARCH 31, DECEMBER 31,
2000 1999
------- -------
<S> <C> <C>
CARRIED UNDER THE EQUITY METHOD:
The ARC Group, LLC $ 7,858 $ 8,687
Arx Holding Corp. 2,680 2,654
Island Heritage Insurance Company, Ltd. 4,123 4,356
LARC Holdings, Ltd. -- 24,039
New Europe Insurance Ventures 770 819
Sunshine State Holding Corporation 1,854 1,885
------- -------
Sub-total 17,285 42,440
------- -------
CARRIED AT FAIR VALUE:
Altus Holdings, Ltd. 16,000 19,173
American Independent Insurance Holding Company 7,350 4,250
GuideStar Health Systems, Inc. 500 500
Sorrento Holdings, Inc. 908 1,517
Stockton Holdings Limited 10,000 10,000
Trident II, L.P. 6,188 6,089
------- -------
Sub-total 40,946 41,529
------- -------
Total $58,231 $83,969
======= =======
</TABLE>
10
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D)
During the 2000 first quarter, the Company received a distribution from The ARC
Group, LLC totaling $1,080,000.
The Company also received $618,000 from Sorrento Holdings, Inc. ("Sorrento") for
the redemption of 609 shares of preferred stock of Sorrento, which redemption
amount included a payment of $1,000 per share and interest income at 6%.
At March 31, 2000, the Company had investment commitments relating to its
privately held securities totaling approximately $23.1 million. The outstanding
commitments at March 31, 2000 included $18.9 million committed to Trident II,
L.P., an investment fund formed in 1999 dedicated to making private equity and
equity related investments in the global insurance, reinsurance and related
industries.
Set forth below is certain information relating to the Company's private
investment activity for the 2000 first quarter:
ALTUS HOLDINGS, LTD.
In March 2000, the Company reduced the carrying value of Altus Holdings, Ltd. by
$3.2 million, realizing an after-tax loss of $2.1 million.
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY
On March 6, 2000, the Company provided an additional loan in an aggregate
principal amount of $3.5 million to American Independent Insurance Holding
Company ("AIHC"). The loan is secured by a second priority pledge of the
capital stock of AIHC and assets of AIHC, and matures on September 6, 2001
(which date may be extended to March 6, 2002 upon the occurrence of certain
events). The net proceeds of the loan were contributed to the surplus of
AIHC's subsidiary, American Independent Insurance Company. In connection with
the loan, the Company was issued warrants (in addition to the warrants issued
to the Company in connection with a prior loan to AIHC) granting the Company
the right to acquire equity in AIHC.
As of March 31, 2000, based on a comparison of the AIHC notes to bonds with
similar characteristics, the Company recorded a $1.1 million pre-tax unrealized
loss to adjust the aggregate carrying value of the aggregate of $8.5 million in
loans made to AIHC ($5 million in February 1999 and $3.5 million in March 2000).
LARC HOLDINGS, LTD.
As of March 2, 2000, the Company transferred to XL Capital Ltd. the Company's
interest in privately held LARC Holdings, Ltd. (parent of Latin American
Reinsurance Company), valued at $25 million, in connection with the Company's
repurchase from XL Capital of the Common Stock it previously held. See Note 8.
6. INCOME TAXES
The Company, Arch Re and Cross River file a consolidated federal income tax
return and have a tax sharing agreement (the "Tax Sharing Agreement"),
allocating the consolidated income tax liability on a separate return basis.
Pursuant to the Tax Sharing Agreement, Arch Re and Cross River make tax sharing
payments to the Company based on such allocation.
11
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. INCOME TAXES (CONT'D)
The provision for federal income taxes has been determined on the basis of a
consolidated tax return consisting of the Company, Arch Re and Cross River.
An analysis of the Company's effective tax rate for the three months ended March
31, 2000 and 1999 follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
2000 1999
-------- ---------
<S> <C> <C>
Income taxes (benefit) computed on pre-tax income (loss) $ 6,439 ($13,323)
Addition (reduction) in income taxes resulting from:
Valuation allowance 6,285
Tax-exempt investment income (162) (165)
Dividend received deduction (127) (237)
Other 184 104
-------- --------
Income tax expense (benefit) on pre-tax income (loss) $ 12,619 ($13,621)
======== ========
</TABLE>
The Company's current federal tax expense (benefit) for the three months ended
March 31, 2000 and 1999 was based on regular taxable income.
The net deferred income tax asset reflects temporary differences between the
carrying amounts of assets and liabilities for financial reporting and income
tax purposes, net of a valuation allowance for any portion of the deferred tax
asset that management believes will not be realized. Significant components of
the Company's deferred income tax assets and liabilities as of March 31, 2000
and December 31, 1999 were as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
MARCH 31, DECEMBER 31,
2000 1999
-------- --------
<S> <C> <C>
Deferred income tax assets:
Net claim reserve discount $ 15,628 $ 15,639
Net operating loss -- 7,334
Net unearned premium reserve 6,171 6,573
Net unrealized depreciation of investments 5,859 --
Loss on investees, net 2,040 7
Compensation liabilities 223 372
Other, net 126 165
-------- --------
Total deferred tax assets 30,047 30,090
-------- --------
Deferred income tax liabilities:
Deferred policy acquisition cost (7,800) (8,255)
Net unrealized appreciation of investments (14,001)
-------- --------
Total deferred tax liabilities (7,800) (22,256)
-------- --------
Valuation allowance (12,144) --
-------- --------
Net deferred income tax asset $ 10,103 $ 7,834
======== ========
</TABLE>
During the 2000 first quarter, the Company recorded a deferred tax asset
valuation allowance of $12.1 million, of which $6.3 million is included in
income tax expense reflected in net income and $5.8 million is included in the
change in net unrealized depreciation of investments contained in other
comprehensive loss. A valuation allowance has been established due to the future
uncertainty of realizing a portion of deferred tax assets at March 31, 2000.
12
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. INCOME TAXES (CONT'D)
The repurchase of Common Stock held by XL Capital resulted in a 27.8% change in
ownership by 5% stockholders. If, in the ensuing three years, there is more than
a 22.2% additional change in ownership by 5% stockholders, an "ownership change"
will have taken place for federal income tax purposes. If such ownership change
occurs, the amount of loss carryforwards that can be used in any subsequent year
may be severely limited and could be eliminated in certain circumstances.
7. ACCOUNTING PRONOUNCEMENTS
START-UP COSTS
Effective January 1, 1999, the Company changed its method of accounting for
start-up costs in accordance with the Accounting Standards Executive Committee's
Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up
Activities." The change in accounting principle resulted in the write-off of the
start-up costs capitalized as of January 1, 1999 for the Company and its
investee companies carried under the equity method of accounting. The cumulative
effect of the write-off, which totals $383,000, after-tax, or $0.02 per share,
has been expensed and is included in the 1999 first quarter net loss. The effect
of the change on the net loss in the first quarter of 1999 was not material.
MARKET RISK SENSITIVE INSTRUMENTS
The Securities and Exchange Commission ("SEC") issued Financial Reporting
Release ("FRR") No. 48 which included amended rules requiring domestic and
foreign issuers to clarify and expand existing disclosure for derivative
financial instruments, other financial instruments and derivative commodity
instruments (collectively, "market risk sensitive instruments"). The amendments
require enhanced disclosure of accounting policies for derivative financial
instruments and derivative commodity instruments (collectively, "derivatives").
In addition, the amendments expand existing disclosure requirements to include
quantitative and qualitative information about market risk inherent in market
risk sensitive instruments, which disclosure will be subject to safe harbor
protection under the new SEC rule (see "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included elsewhere in this Form
10-Q). These amendments are designed to provide additional information about
market risk sensitive instruments which investors can use to better understand
and evaluate market risk exposures of registrants, including the Company. There
have been no material changes in market risk exposures that affect the
quantitative and qualitative disclosures presented as of the year ended December
31, 1999.
13
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. XL TRANSACTION
On March 2, 2000, the Company repurchased from XL Capital, then the Company's
single largest stockholder, all of the 4,755,000 shares of Common Stock held by
it for a purchase price of $12.45 per share of Common Stock, or a total of
$59.2 million. The per share repurchase price was determined as the lesser of
(1) 85% of the average closing market price of Common Stock during the 20
trading days beginning on the third business day following public
announcement of the stock repurchase and asset sale (January 21, 2000), which
was $14.65, and (2) $15. The Company paid XL Capital the consideration for
the repurchase with (i) the Company's interest in privately held LARC
Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at
$25 million, and (ii) all of the Company's interest in Annuity and Life Re
(Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8
million in the aggregate. XL Capital paid the Company in cash the difference
(equal to $3.6 million) between the repurchase price and the value of the
Company's interests in LARC Holdings and Annuity and Life Re. The value per
share of Annuity and Life Re was determined by taking the average of the
closing price of Annuity and Life Re shares for the same period used in
determining the repurchase price of the Company's shares. The value of the
warrants was determined using a Black Scholes methodology.
The cost of the stock repurchase of $59.2 million was recorded as a reduction to
stockholders' equity reflected as treasury stock.
Arch Re's statutory surplus was reduced by $62.8 million due to the distribution
to the Company of the stock and warrants in both LARC Holdings, Ltd. and Annuity
and Life Re Holdings, Ltd. based on statutory carrying values.
9. FOLKSAMERICA TRANSACTION
On May 5, 2000 the Company sold the 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 in an aggregate amount
equal, in book value (as set forth on the Company's estimated closing date
balance sheet), to the book value (as set forth on the Company's estimated
closing date balance sheet) 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 for certain tax costs) in cash at the closing,
subject to possible post closing adjustments based on an independent actuarial
report of the claim liabilities transferred and independent audit of the net
assets sold. The actuarial report and audit and related adjustments, which could
be material, could be completed as early as the second quarter of 2000, subject
to a dispute resolution mechanism (if necessary).
Under the terms of the agreement, $20 million has been placed in escrow for
a period of five years. These funds will be primarily used to reimburse
Folksamerica to the extent that the loss reserves (which were $35.1 million at
March 31, 2000) 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. To the extent that such loss reserves are redundant, all of the
escrowed funds will be returned to the Company and Folksamerica will pay the
Company an amount equal to such redundancy. An additional amount of up to $5
million may be placed in escrow for a period of five years to the extent that
Arch Re's reserves at closing are less by at least a specified amount than those
estimated by its independent actuaries. In connection with either escrow
arrangement, the Company will 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.
14
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. FOLKSAMERICA TRANSACTION (CONT'D)
Under the terms of the agreement, the Company has also purchased
reinsurance protection covering the Company's 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 for a net financial loss it may incur that is
in excess of $5.4 million for aviation losses under certain circumstances
prior to May 5, 2003.
The GAAP book value of the assets and liabilities transferred to
Folksamerica recorded in the accompanying financial statements at
March 31, 2000 are as follows:
<TABLE>
<CAPTION>
(IN MILLIONS)
<S> <C>
Fixed maturities and short-term investments $ 254.5
Premiums receivable 115.4
Reinsurance recoverable 77.6
Deferred policy acquisition costs 22.3
Deferred income tax asset 14.0
Other insurance assets 36.3
--------
Total Assets $ 520.1
--------
Reserve for claims and claims expenses $ 378.3
Net unearned premium reserve 103.5
Reinsurance premiums payable 16.0
Other insurance liabilities 22.3
--------
Total Liabilities $ 520.1
--------
Net book value of assets and liabilities to be transferred --
========
</TABLE>
The actual GAAP book value of the assets and liabilities transferred to
Folksamerica was updated for estimated underwriting results and estimated cash
flow activity through May 5, 2000 and was not materially different from the
amounts set forth above at March 31, 2000.
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 that are in-force will be notified
that Folksamerica has assumed Arch Re's obligations and, unless the reinsureds
object to the assumption, Arch Re will be released from its obligations to those
reinsureds. Assuming that none of the reinsureds object to the assumption, the
gross liabilities for such business will be removed from the accounts of
Arch Re for statutory and GAAP accounting purposes.
Arch Re will continue to record gross liabilities in its accounts for
reinsureds that object to the release of Arch Re from its obligations to such
reinsureds. In such instances, an offsetting accounts receivable amount from
Folksamerica would be recorded as an asset equal to such gross liabilities. This
would also result in a portion of any pre-tax gain on the asset sale being
deferred and amortized into income as gross liabilities are extinguished.
15
<PAGE>
ARCH CAPITAL GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. ARCH RE DISTRIBUTION
Upon payment of a contemplated distribution from Arch Re to the Company
that is currently anticipated to occur in the second quarter, the Company's
assets would consist of fixed maturity and short term investments (including
amounts placed in escrow for five years as described above), publicly traded
equity securities and privately held securities. The Company will also continue
to own all of the outstanding capital stock of Arch Re and Cross River, each
with statutory surplus of up to approximately $20 million (or any greater
amount the Nebraska Insurance Department requires Arch Re to retain in the event
there are any objections from reinsureds to the release of Arch Re from further
liability under the reinsurance agreements transferred pursuant to the transfer
and assumption agreement). The Company's remaining $18.9 million investment
commitment to Trident II, L.P. would also remain in place.
16
<PAGE>
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA
The following unaudited pro forma balance sheet as of March 31, 2000 reflects
our historical accounts as of that date, adjusted to give pro forma effect to
the sale of our reinsurance business to Folksamerica Reinsurance Company
("Folksamerica"), which closed on May 5, 2000, as if the transaction had
occurred on March 31, 2000.
The following unaudited pro forma statement of income and comprehensive income
for the quarter ended March 31, 2000 and for the year ended December 31, 1999
reflects our historical accounts for that period, adjusted to give pro forma
effect to the asset sale as if the transactions had occurred on January 1, 1999.
The pro forma financial data and accompanying notes should be read in
conjunction with the description of the asset sale contained in this report and
the unaudited consolidated financial statements and related notes for the
quarter ended March 31, 2000 also included in this report as well as our audited
consolidated financial statements and related notes and the description of the
asset sale included in our special meeting proxy statement. We believe that the
assumptions used in the following statements, which are set forth in the
accompanying notes, provide a reasonable basis on which to present the pro forma
financial data. The pro forma financial data is provided for informational
purposes only and should not be construed to be indicative of our financial
condition or results of operations had the asset sale been consummated on the
dates assumed and are not intended to project our financial condition on any
future date or results of operations for any future period.
17
<PAGE>
ARCH CAPITAL GROUP LTD.
PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET
MARCH 31, 2000
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOLKSAMERICA
HISTORICAL TRANSACTION(1) PRO FORMA
---------- -------------- ----------
<S> <C> <C> <C>
ASSETS
Investments:
Fixed maturities and short-term investments $347,068 ($252,972)(2) $94,096(7)
Publicly traded equity securities 42,887 42,887
Privately held securities 58,231 58,231
---------- --------- --------
Total investments 448,186 (252,972) 195,214
Cash 11,447 (1,616)(5) 9,831
Accrued investment income 3,737 (1,779)(2) 1,958
Investment accounts receivable 36,628 36,628
Premiums receivable 115,371 (115,371)(2) -
Reinsurance recoverable 77,590 (77,590)(2) -
Deferred policy acquisition costs 22,285 (22,285)(3) -
Deferred income tax asset 10,103 (5,235)(4) 4,868
Other assets 48,903 (36,281)(2) 12,622
---------- --------- --------
TOTAL ASSETS $774,250 ($513,129) $261,121
---------- --------- --------
---------- --------- --------
LIABILITIES
Claims and claims expenses $378,297 ($378,297)(2) -
Unearned premiums 103,469 (103,469)(2) -
Reinsurance balances payable 16,043 (16,043)(2) -
Other liabilities 27,188 (22,344)(2) $4,844
---------- --------- --------
TOTAL LIABILITIES 524,997 (520,153) 4,844
---------- --------- --------
STOCKHOLDERS' EQUITY
Common stock, $.01 par value: 171 171
Additional paid-in capital 342,012 342,012
Deferred compensation under stock award plan (224) (224)
Retained earnings (deficit) (16,367) 3,167(6) (13,200)
Less treasury stock, at cost (59,597) (59,597)
Accumulated other comprehensive income (loss)
consisting of unrealized depreciation of
investments, net of income tax
(16,742) 3,857(6) (12,885)
---------- --------- --------
TOTAL STOCKHOLDERS' EQUITY 249,253 7,024(6) 256,277
---------- --------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $774,250 ($513,129) $261,121
---------- --------- --------
---------- --------- --------
SHARES OUTSTANDING - BASIC 12,329,398 12,329,398
BASIC BOOK VALUE PER SHARE $20.22 $20.79
</TABLE>
18
<PAGE>
NOTES TO PRO FORMA BALANCE SHEET
1. Reflects the asset sale, pursuant to which Folksamerica Reinsurance Company
has assumed Arch Re's liabilities under the reinsurance agreements
transferred to it and Arch Re transferred to Folksamerica Reinsurance
Company assets in an aggregate amount equal, in GAAP book value (as set
forth on our estimated closing date balance sheet), to the GAAP book
value (as set forth on our estimated closing date balance sheet) 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 for certain tax costs) in cash at the closing, subject to possible
post closing adjustments based on an independent actuarial report of the
claim liabilities transferred and an independent audit of the net assets
sold. The report and audit and related adjustments, which could be
material, could be completed as early as the second quarter of 2000,
subject to a dispute resolution mechanism (if necessary).
2. Represents securities and insurance assets and insurance liabilities
transferred to Folksamerica based on March 31, 2000 financial statement
amounts. The actual GAAP book value of the assets and liabilities
transferred to Folksamerica was updated for estimated underwriting results
and estimated cash flow activity through May 5, 2000 and was not materially
different from the amounts set forth herein at March 31, 2000.
At the closing of the asset sale, Arch Re and Folksamerica Reinsurance
Company entered into a transfer and assumption agreement, under which
Folksamerica Reinsurance Company assumed Arch Re's rights and obligations
under the reinsurance agreements being transferred in the asset sale.
Following the closing of the asset sale, Folksamerica Reinsurance Company
will notify the reinsureds under such agreements that are in-force that
it has assumed Arch Re's obligations and, unless the reinsureds object to
such assumption, Arch Re will be released from its obligations to those
reinsureds. The pro forma accounting for this transaction assumes that none
of Arch Re's reinsureds will object to such assumption and, accordingly,
the gross liabilities for its reinsurance business will be removed from the
accounts of Arch Re for statutory and GAAP accounting purposes.
Arch Re will continue to record gross liabilities in its accounts for
reinsureds that object to the release of Arch Re from its obligations to
such reinsureds. In such instances, an offsetting accounts receivable
amount from Folksamerica Reinsurance Company would be recorded as an asset
equal to such gross liabilities.
3. Elimination of deferred policy acquisition costs related to the liability
for unearned premiums transferred to Folksamerica.
4. Net reduction in deferred income tax asset as follows (in thousands):
<TABLE>
<S> <C>
Reduction in net deferred tax asset for
elimination of temporary differences
between financial statements and income
tax return amounts resulting from the
Folksamerica transaction $13,875
Less, estimated tax benefit resulting
from the transaction (8,640)
-------
Net reduction in deferred tax asset $ 5,235
-------
-------
</TABLE>
The net reduction in deferred tax asset includes a valuation allowance of
approximately $1 million.
5. Represents cash payment received from Folksamerica at the closing of the
asset sale of $20.084 million less estimated related transaction costs of
$21.7 million, which include investment banking, legal and accounting fees,
severance costs, and costs for the purchase of additional insurance and
reinsurance protection in connection with the transaction, as well as
certain write-offs of furniture, equipment and leasehold improvements and
lease obligations.
19
<PAGE>
6. The pro forma book value gain resulting from the Folksamerica transaction
based on financial statement amounts at March 31, 2000 is calculated as
follows (in thousands):
<TABLE>
<S> <C>
Consideration received, consisting of the following:
Total liabilities transferred $520,153
Cash premium received 20,084
--------
540,237
--------
Assets transferred 483,993
Amortization of deferred policy acquisition costs 22,285
Transaction costs 21,700
--------
527,978
--------
Pre-tax gain 12,259
Tax expense 5,235
--------
Net transaction gain 7,024
Realized loss, net of tax for securities transferred at market value (3,857)
--------
Net income 3,167
Change in net unrealized depreciation of investments, net of tax 3,857
--------
Comprehensive income and net book gain $7,024
--------
--------
</TABLE>
The pro forma accounting for this transaction assumes that none of Arch
Re's reinsureds will object to the release of Arch Re under the transfer
and assumption agreement and, accordingly, the gross liabilities for such
business are removed from the accounts of Arch Re for statutory and GAAP
accounting purposes (see note 2 above). Arch Re will continue to record
gross liabilities in its accounts for reinsureds that object to the release
of Arch Re from its obligations to such reinsureds. This would result in a
portion of the pre-tax gain on the transaction being deferred and amortized
into income as the gross liabilities are extinguished.
7. Includes $20 million of fixed income securities deposited in an escrow
account for a five year period primarily to reimburse Folksamerica for
claims and claim expenses exceeding reserves recorded by Arch Re as of the
closing date resulting from business produced on behalf of Arch Re by a
certain managing underwriting agency. At March 31, 2000, such reserves
approximated $35.1 million, which were recorded based on Arch Re's best
estimate for such business based on its actuarial practices. The Company
could record a loss at any time during the five year period to the extent
that such reserves are deficient. Amounts in escrow may also be released to
Folksamerica to satisfy its indemnification claims against the Company
relating to undisclosed liabilities, Arch Re's reinsurance agreements and
the managing underwriting agency referred to above. Under the asset
purchase agreement, the Company may be required to deposit an additional
amount of up to $5 million into a supplemental escrow account based on
an actuarial report to be completed shortly after the closing of the asset
sale. The above unaudited pro forma condensed consolidated balance sheet
has been prepared assuming that such supplemental escrow account will not
be required.
20
<PAGE>
ARCH CAPITAL GROUP LTD.
PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2000
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOLKSAMERICA
HISTORICAL TRANSACTION(1) PRO FORMA
---------------- -------------------- -----------------
<S> <C> <C> <C>
REVENUES
Net premiums written $52,889 ($52,889) -
(Increase) decrease in unearned premiums 5,273 (5,273) -
---------------- -------------------- -----------------
Net premiums earned 58,162 (58,162) -
Net investment income 5,290 (3,515) $1,775
Net realized investment gains (losses) 29,300 1,748 31,048
---------------- -------------------- -----------------
Total revenues 92,752 (59,929) 32,823
OPERATING COSTS AND EXPENSES
Claims and claims expenses 53,875 (53,875)
Commissions and brokerage 16,753 (16,753)
Other operating expenses 2,568 (868) 1,700
Foreign exchange (gain) loss 1,159 (1,159)
---------------- -------------------- -----------------
Total operating costs and expenses 74,355 (72,655) 1,700
INCOME (LOSS)
Income (loss) before income taxes and equity in net income of
investees 18,397 12,726 31,123
Federal income taxes expense (benefit) 12,619 (1,160) 11,459
---------------- -------------------- -----------------
Income (loss) before equity in net income of investees 5,778 13,886 19,664
Equity in net income of investees 30 30
---------------- -------------------- -----------------
Net income (loss) 5,808 13,886 19,694
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX
Change in net unrealized depreciation of investments,
net of tax (43,930) (708) (44,638)
---------------- -------------------- -----------------
COMPREHENSIVE INCOME (LOSS) ($38,122) $13,178 ($24,944)
---------------- -------------------- -----------------
---------------- -------------------- -----------------
AVERAGE SHARES OUTSTANDING
Basic 15,517,163 15,517,163
Diluted 15,518,341 15,518,341
PER SHARE DATA
Net Income (Loss) - Basic $0.37 $1.23
- Diluted $0.37 $1.23
Comprehensive Income (Loss) - Basic $2.46 ($1.61)
- Diluted $2.46 ($1.61)
</TABLE>
21
<PAGE>
ARCH CAPITAL GROUP LTD.
PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
FOR THE YEAR ENDED DECEMBER 31, 1999
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOLKSAMERICA
HISTORICAL TRANSACTION(1) PRO FORMA
---------------- -------------------- -----------------
<S> <C> <C> <C>
REVENUES
Net premiums written $306,726 ($306,726) -
(Increase) decrease in unearned premiums 4,642 (4,642) -
---------------- -------------------- -----------------
Net premiums earned 311,368 (311,368) -
Net investment income 20,173 (10,253) $9,920
Net realized investment gains (losses) 17,227 1,192 18,419
---------------- -------------------- -----------------
Total revenues 348,768 (320,429) 28,339
OPERATING COSTS AND EXPENSES
Claims and claims expenses 305,841 (305,841)
Commissions and brokerage 80,540 (80,540)
Other operating expenses 14,816 (10,666) 4,150
Foreign exchange (gain) loss (198) 198
---------------- -------------------- -----------------
Total operating costs and expenses 400,999 (396,849) 4,150
INCOME (LOSS)
Income (loss) before income taxes, equity in net income of
investees and cumulative effect of accounting change (52,231) 76,420 24,189
Federal income taxes expense (benefit) (19,557) 27,171 7,614
---------------- -------------------- -----------------
Income (loss) before equity in net income of investees
and cumulative effect of accounting change (32,674) 49,249 16,575
Equity in net income of investees 621 621
---------------- -------------------- -----------------
Income (loss) before cumulative effect of accounting change (32,053) 49,249 17,196
Cumulative effect of accounting change (383) (383)
---------------- -------------------- -----------------
Net income (loss) (32,436) 49,249 16,813
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX
Change in net unrealized depreciation of investments,
net of tax (19,850) 4,553 (15,297)
---------------- -------------------- -----------------
COMPREHENSIVE INCOME (LOSS) ($52,286) $53,802 $1,516
---------------- -------------------- -----------------
---------------- -------------------- -----------------
AVERAGE SHARES OUTSTANDING
Basic 17,086,732 17,086,732
Diluted 17,086,808 17,086,806
PER SHARE DATA
Net Income (Loss) - Basic ($1.90) $0.98
- Diluted ($1.90) $0.98
Comprehensive Income (Loss) - Basic ($3.06) $0.09
- Diluted ($3.06) $0.09
</TABLE>
22
<PAGE>
NOTES TO PRO FORMA STATEMENT OF INCOME AND COMPREHENSIVE INCOME
1. Represents all revenue and expense and other comprehensive income items
recorded during the quarter ended March 31, 2000 and the year ended
December 31, 1999 related to our reinsurance business sold to Folksamerica
Reinsurance Company. Net investment income, net realized investment gains
(losses) and unrealized appreciation (depreciation) of investments have
been allocated based on the proportion of the average amount of fixed
maturities and short term investments related to the business transferred
to the average total fixed maturities and short term investments in the
quarter ended March 31, 2000 and the year ended December 31, 1999.
All other revenue and expense items were allocated based on specific
identification.
23
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
GENERAL
THE COMPANY
Arch Capital Group Ltd. (formerly known as Risk Capital Holdings, Inc.) is
a holding company that was incorporated in March 1995 and commenced operations
in September 1995 upon completion of our initial public offering. We received
aggregate net proceeds from the offering of approximately $335 million, of which
$328 million was contributed to the capital of our wholly owned subsidiary Risk
Capital Reinsurance Company (which name is being changed to Arch Reinsurance
Company and is referred to herein as "Arch Re"). On November 6, 1995, Arch Re
was licensed under the insurance laws of the State of Nebraska and is currently
licensed or accredited as a reinsurer in 44 states. As of March 31, 2000, the
statutory surplus of Arch Re was approximately $191.5 million. In July 1998,
Arch Re capitalized its wholly owned subsidiary, Cross River Insurance Company
("Cross River"), with $20 million. Cross River received its Nebraska insurance
license in October 1998, and is currently authorized to write insurance on an
excess and surplus lines basis in 22 other states.
FOLKSAMERICA TRANSACTION
On May 5, 2000, we sold the 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 in an aggregate amount equal, in book
value (as set forth on our estimated closing date balance sheet), to the
book value (as set forth on our estimated closing date balance sheet) 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 for certain tax costs) in cash at the closing, subject to possible
post closing adjustments based on an independent actuarial report of the
claim liabilities transferred and independent audit of the net assets sold.
The actuarial report and audit and related adjustments, which could be
material, could be completed as early as the second quarter of 2000, subject
to a dispute resolution mechanism (if necessary).
Under the terms of the agreement, $20 million has been placed in escrow for
a period of five years. These funds will be primarily used to reimburse
Folksamerica to the extent that the loss reserves (which were $35.1 million at
March 31, 2000) 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. To the extent that such loss reserves are redundant, all of the
escrowed funds will be returned to us and Folksamerica will pay us an amount
equal to such redundancy. An additional amount of up to $5 million may be placed
in escrow for a period of five years to the extent that Arch Re's reserves at
closing are less by at least a specified amount than those estimated by its
independent actuaries. In connection with either escrow arrangement, we will
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.
Under the terms of the agreement, we have also purchased
reinsurance protection covering our 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 we believe that any
such net financial loss will not exceed $5.4 million, we have agreed to
reimburse Folksamerica for a net financial loss it may incur that is in
excess of $5.4 million for aviation losses under certain circumstances prior
to May 5, 2003.
24
<PAGE>
The GAAP book value of the assets and liabilities transferred to
Folksamerica recorded in the accompanying financial statements at March 31, 2000
are as follows:
<TABLE>
<CAPTION>
(IN MILLIONS)
<S> <C>
Fixed maturities and short-term investments $254.5
Premiums receivable 115.4
Reinsurance recoverable 77.6
Deferred policy acquisition costs 22.3
Deferred income tax asset 14.0
Other insurance assets 36.3
------
Total Assets $520.1
------
Reserve for claims and claims expenses $378.3
Net unearned premium reserve 103.5
Reinsurance premiums payable 16.0
Other insurance liabilities 22.3
------
Total Liabilities $520.1
------
Net book value of assets and liabilities to be transferred --
------
------
</TABLE>
The actual GAAP book value of the assets and liabilities transferred to
Folksamerica was updated for estimated underwriting results and estimated cash
flow activity through May 5, 2000 and was not materially different from the
amounts set forth above at March 31, 2000.
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 that are in-force will be notified
that Folksamerica has assumed Arch Re's obligations and, unless the
reinsureds object to the assumption, Arch Re will be released from its
obligations to those reinsureds. Assuming that none of the reinsureds object
to the assumption, the gross liabilities for such business will be removed
from the accounts of Arch Re for statutory and GAAP accounting purposes.
Arch Re will continue to record gross liabilities in its accounts for
reinsureds that object to the release of Arch Re from its obligations to such
reinsureds. In such instances, an offsetting accounts receivable amount from
Folksamerica would be recorded as an asset equal to such gross liabilities. This
would also result in a portion of any pre-tax gain on the asset sale being
deferred and amortized into income as gross liabilities are extinguished.
XL TRANSACTION
On March 2, 2000, we repurchased from XL Capital, then our single largest
stockholder, all of the 4,755,000 shares of our common stock held by it for a
purchase price of $12.45 per share of our common stock, or a total of $59.2
million. The per share repurchase price was determined as the lesser of (1)
85% of the average closing market price of our common stock during the 20
trading days beginning on the third business day following public
announcement of the stock repurchase and asset sale (January 21, 2000), which
was $14.65, and (2) $15. We paid XL Capital the consideration for the
repurchase with (i) our interest in privately held LARC Holdings, Ltd.
(parent of Latin American Reinsurance Company Ltd.), valued at $25 million
(which was carried by us at $24 million at December 31, 1999); and (ii) all
of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per
share and $18.50 per warrant, or $37.8 million in the aggregate. XL Capital
paid us in cash the difference (equal to $3.6 million) between our repurchase
price and the value of our interests in LARC Holdings and Annuity and Life
Re. The value per share of Annuity and Life Re was determined by taking the
average of the closing price of Annuity and Life Re shares for the same
period used in determining the repurchase price of our shares. The value of
the warrants was determined using a Black Scholes methodology.
25
<PAGE>
The cost of the stock repurchase of $59.2 million was recorded as a
reduction to stockholder's equity reflected as treasury stock.
Arch Re's statutory surplus was reduced by $62.8 million due to the
distribution to us of the stock and warrants in both LARC Holdings, Ltd. and
Annuity and Life Re Holdings, Ltd. based on statutory carrying values.
ARCH RE DISTRIBUTION
Upon payment of a contemplated distribution from Arch Re to us that is
currently anticipated to occur in the second quarter, our assets would consist
of fixed maturity and short term investments, publicly traded equity securities
and privately held securities. We will also continue to own all of the
outstanding capital stock of Arch Re and Cross River, each with statutory
surplus of up to approximately $20 million (or any greater amount the
Nebraska Insurance Department requires Arch Re to retain in the event there
are any objections from reinsureds to the release of Arch Re from further
liability under the reinsurance agreements transferred pursuant to the
transfer and assumption agreement). Our remaining $19 million investment
commitment to Trident II, L.P. would also remain in place. See "Liquidity and
Capital Resources" below for a discussion of the regulatory issues relating
to distributions by Arch Re.
FUTURE OPERATIONS
Subsequent to the sale of our reinsurance business to Folksamerica, our
present strategy is to pursue business combinations and ventures with operating
businesses. Our success will depend to a large extent on the operations,
financial condition and management of the companies with which we may merge
or which we may acquire in whole or in part. We have not yet identified
specific business opportunities that we intend to pursue. Accordingly, the
financial and operational risks that we may encounter in the future cannot be
specified.
RESULTS OF OPERATIONS
We had consolidated comprehensive loss for the three months ended March 31,
2000 of $38.1 million, which was composed of net income of $5.8 million and
other comprehensive loss of $43.9 million, consisting of the change in after-tax
unrealized depreciation of investments. Net income for the three months ended
March 31, 2000 included after-tax realized investment gains of $19 million and
equity in net income of investees of approximately $30,000. These amounts
compare with comprehensive loss for the three months ended March 31, 1999 of
$35.5 million, which was composed of net loss of $25 million and the change in
after-tax unrealized appreciation of investments of $10.5 million. Net loss for
the three months ended March 31, 1999 included after-tax realized investment
losses of $749,000, equity in net loss of investees of $163,000 and a loss of
$383,000 from the cumulative effect of an accounting change.
Following is a table of per share data for the three months ended March 31,
2000 and 1999 on an after-tax basis:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
2000 1999
------- ------
<S> <C> <C>
BASIC AND DILUTED EARNINGS PER SHARE:
Underwriting loss ($1.10) ($1.58)
Net investment income .24 .19
Net realized investment gains (losses) 1.23 (.04)
Equity in net income (loss) of investees - (.01)
Cumulative effect of accounting change - (.02)
------- ------
Net income (loss) .37 (1.46)
Change in net unrealized appreciation (depreciation) of investments (2.83) (0.62)
------- ------
Comprehensive income (loss) ($2.46) ($2.08)
------- ------
------- ------
Average shares outstanding (000's)
Basic 15,517 17,087
Diluted 15,518 17,102
</TABLE>
26
<PAGE>
At March 31, 2000, consolidated stockholders' equity totaled $249.3
million, compared with $346.5 million at December 31, 1999. On a basic and
diluted basis, book value per share was $20.22 based on 12,329,398 shares
outstanding at March 31, 2000, compared with $20.28 based on 17,087,970 shares
outstanding at December 31, 1999.
Book value and per share amounts at March 31, 2000 reflect the repurchase
on March 2, 2000 from XL Capital Ltd of all of the 4,755,000 shares of our
common stock it held for $59.2 million, or $12.45 per share, recorded as
treasury stock.
IN-FORCE BUSINESS
With respect to our divested reinsurance operations, Arch Re had
approximately 340 renewable in-force reinsurance treaties on April 1, 2000
(such renewal is subject to negotiation and evaluation during the renewal
period), with approximately $234 million of estimated annualized net premiums
written, compared to $249 million at January 1, 2000. Such in-force premiums
at April 1, 2000 represent estimated annualized premiums from treaties
entered into during 1999 and the year 2000 renewal periods that were expected
to generate net premiums written during 2000.
The 6% decline in in-force business at April 1, 2000 compared to January 1,
2000 is due to several factors which included (i) the previously announced
asset sale; (ii) discontinuing aviation and space business in 1999; and (iii)
non-renewals in other classes of business, due to (a) our adherence to
underwriting standards in competitive market conditions and (b) the effect on
cedents of our poor underwriting performance, coupled with a decline in Arch
Re's A.M. Best rating from A to A- during 1999. Such decline was partially
offset by increased in-force premiums in Accident & Health business where
significant underwriting capacity has exited the market since 1998, and we
believe reinsurance pricing improvements have occurred in 1999 and 2000.
NET PREMIUMS WRITTEN
Net premiums written for the three months ended March 31, 2000 and 1999
were as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
THREE MONTHS ENDED MARCH 31,
-------------------------------------
CORE BUSINESS 2000 1999
------- -------
<S> <C> <C>
Property $2,680 $12,245
Casualty 12,129 19,850
Multi-line 11,965 17,455
Other 4,307 (4,592)
------- -------
Sub-total Core Business 31,081 44,958
------- -------
SPECIALTY BUSINESS
Accident & Health 19,422 8,068
Aviation & Space (294) 5,642
Marine 2,197 3,965
Surety & Fidelity 483 1,804
------- -------
Sub-total Specialty Business 21,808 19,479
------- -------
Total $52,889 $64,437
------- -------
------- -------
</TABLE>
Net premiums written for the 2000 first quarter were $52.9 million,
representing a 22% decrease from the $64.4 million of net premiums written for
the 1999 first quarter. See "In-Force Business" above for a discussion of the
decline in in-force business that also relates to the decline in net premiums
written in the 2000 first quarter.
27
<PAGE>
Net premiums written for the 1999 first quarter for other business was
reduced by $10.6 million for the retrocession of a treaty which covered multiple
future rocket launches. The reduction of net premiums written resulting from
this retrocession increased the commission and operating expense ratio
components of the statutory composite ratio by 4.7 points, but had no impact on
operating results.
Set forth below are our statutory combined ratios for the three months
ended March 31, 2000 and 1999:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
----------------------------
2000 1999
------ ------
<S> <C> <C>
Claims and claims expenses 92.6% 128.3%
Commissions and brokerage 29.2 33.2
Other operating expenses 4.6 5.5
------ ------
Statutory combined ratio 126.4% 167.0%
------ ------
------ ------
</TABLE>
The statutory combined ratio for the 2000 first quarter was adversely
affected by a pre-tax underwriting loss of $11 million (excluding operating
expenses) from aviation business, which added 19.6 points to the statutory
composite ratio.
The statutory combined ratio for the 1999 first quarter was adversely
affected by pre-tax underwriting losses of $38.8 million (excluding operating
expenses) from the following sources: aviation business ($5.8 million),
satellite business ($6.8 million), business produced by a managing underwriting
agency ($23.7 million) and property business ($2.5 million). Such underwriting
losses added 59.1 points to the 1999 first quarter statutory combined ratio.
FOREIGN EXCHANGE
Pre-tax foreign exchange gains and losses are recorded separately from
statutory underwriting results and are therefore excluded from the statutory
combined ratio. Unhedged monetary assets and liabilities are translated at the
exchange rate in effect at the balance sheet date, with the resulting foreign
exchange gains or losses recognized in income. We do not have any remaining
assets or liabilities denominated in foreign currency as a result of the asset
sale to Folksamerica Reinsurance Company.
NET INVESTMENT INCOME
Invested assets, including accrued investment income, net of investment
accounts receivable and payable, consisted of the following at March 31, 2000
compared to December 31, 1999:
<TABLE>
<CAPTION>
MILLIONS
MARCH 31, DECEMBER 31,
2000 1999
--------- ------------
<S> <C> <C>
Fixed maturities
Taxable - Investment Grade $151.0 $171.2
- High Yield 35.9 37.6
Tax Exempt - Investment Grade 19.4 52.3
------ ------
206.3 261.1
Publicly traded equity securities 42.9 158.8
Privately held securities 58.2 83.9
Cash, short-term investments and accrued interest 192.2 86.7
------ ------
Total $499.6 $590.5
------ ------
------ ------
</TABLE>
Approximately 90% of the fixed maturity and short-term investments were
rated investment grade by Moody's and Standard & Poor's and had an average
quality rating of AA and average duration of 2.3 years.
28
<PAGE>
During the 2000 first quarter, we liquidated a substantial portion of the
public equity portfolio and reduced our investment in tax-exempt securities for
tax planning purposes. All funds were reinvested in short-term securities in
anticipation of the delivery of a substantial portion of the investment
portfolio to Folksamerica Reinsurance Company in connection with the asset sale
and had the effect of reducing the average duration of the fixed maturity and
short-term investments by approximately 1.4 years compared to December 31, 1999.
All fixed maturity and short-term investments transferred on May 5, 2000 to
Folksamerica and the securities placed in the escrow account are rated
investment grade.
At March 31, 2000, our private equity portfolio consisted of 11
investments having an aggregate carrying value of $58.2 million, with
additional investment portfolio commitments in the aggregate amount of
approximately $23 million.
During the 2000 first quarter, we provided an additional loan in an
aggregate principal amount of $3.5 million to American Independent Insurance
Holding Company, one of our investee companies, and increased our investment
in Trident II, L.P. by approximately $100,000.
See Note 5 under the caption "Investment Information" of the accompanying
notes to our unaudited consolidated financial statements for the 2000 first
quarter for certain information regarding our publicly traded and privately held
securities and their carrying values.
Net investment income for the 2000 first quarter was $5.3 million, compared
to $4.5 million for the 1999 first quarter, which reflects higher pre-tax and
net of tax yields of 4.2% and 3.0%, respectively, in 2000, compared to 3.4% and
2.5% in 1999. Our yields have moderately increased as proceeds from the sales of
public equity securities have been allocated into fixed maturity and short-term
investments over the last several quarterly periods.
Our sources of net realized investment gain (losses) for the 2000 first
quarter were as follows (in thousands):
<TABLE>
<S> <C>
Fixed maturities ($2,399)
Publicly traded equity securities 35,359
Privately held securities (3,660)
-------
Total $29,300
-------
-------
</TABLE>
During the 2000 first quarter, we disposed of, or reduced our position in,
several publicly traded equity security investments, including our investment in
Annuity and Life Re (Holdings), Ltd. for a net gain of $17.3 million. The
realized loss on privately held securities includes a net loss of $487,000
resulting from the disposition of our investment in LARC Holdings, Ltd. and a
write-down of $3.2 million in the carrying value of our investment in Altus
Holdings, Ltd.
The change in after-tax net unrealized depreciation of investments of $43.9
million for the 2000 first quarter reflects the following (in thousands):
<TABLE>
<S> <C>
Net unrealized losses on investments held during the period $29.3
Reclassification for net realized gains recorded in net income 29.3
-----
Pre-tax net unrealized depreciation of investments 58.6
Less: Deferred tax asset 20.5
Valuation allowance (5.8)
-----
Deferred tax benefit 14.7
-----
Change in net unrealized depreciation of investments, net of tax $43.9
-----
-----
</TABLE>
The $29.3 million in net unrealized losses on investments held during the
period was principally due to declines in the market values of publicly traded
equity securities.
29
<PAGE>
INCOME TAXES
During the 2000 first quarter, we recorded a deferred tax asset valuation
allowance of $12.1 million, of which $6.3 million is included in income tax
expense reflected in net income and $5.8 million is included in the change in
net unrealized depreciation of investments contained in other comprehensive
loss. A valuation allowance has been established due to the future uncertainty
of realizing a portion of deferred tax assets at March 31, 2000.
RATINGS
Effective with the sale of the reinsurance business to Folksamerica, A.M.
Best has withdrawn it's A- rating of Arch Re and has assigned the classification
of NR-3 (Rating Procedure Inapplicable), which applies to companies in run-off
with no active business writings or that are effectively dormant.
LIQUIDITY AND CAPITAL RESOURCES
We are a holding company and currently have no significant operations or
assets other than our ownership of the capital stock of Arch Re. We rely on cash
dividends and distributions from Arch Re to make payments, including for any
operating expenses that we may incur and for any dividends or stock repurchases
as our board of directors may determine. Our board currently does not intend to
declare dividends or make any other distributions. However, our board intends to
make a determination regarding stock repurchases. Arch Re's ability to pay
dividends or make distributions to us is dependent upon its ability to meet
regulatory standards of the State of Nebraska, as described below. There are
presently no contractual restrictions on Arch Re's payment of dividends or the
making of distributions to us. We intend to cause Arch Re to make an
extraordinary distribution to us. See "-- General -- Arch Re Distribution."
Nebraska insurance laws provide that, without prior approval of the
Nebraska Director of Insurance (the "Nebraska Director"), Arch Re cannot pay a
dividend or make a distribution (together with other dividends or distributions
paid during the preceding 12 months) that exceeds the greater of (i) 10% of
statutory surplus as of the preceding December 31 or (ii) statutory net income
from operations from the preceding calendar year not including realized capital
gains. Net income (exclusive of realized capital gains) not previously
distributed or paid as dividends from the preceding two calendar years may be
carried forward for dividends and distribution purposes. Any proposed dividend
or distribution in excess of such amount is called an "extraordinary" dividend
or distribution and may not be paid until either it has been approved, or a
30-day waiting period has passed during which it has not been disapproved, by
the Nebraska Director. Notwithstanding the foregoing, Nebraska insurance laws
provide that any distribution that is a dividend may be paid by Arch Re only
out of earned surplus arising from its business, which is defined as
unassigned funds (surplus) as reported in the statutory financial statement
filed by Arch Re with the Nebraska Insurance Department for the most recent
year, including any surplus arising from unrealized capital gains or
revaluations of assets. Any distribution that is a dividend and that is in
excess of Arch Re's unassigned funds, exclusive of any surplus arising from
unrealized capital gains or revaluation of assets, will be deemed an
"extraordinary" dividend subject to the foregoing requirements. Due to the
distribution that was required to be made in connection with the XL Capital
stock repurchase, we may not declare any other distribution for twelve months
from the closing date of the stock repurchase unless such subsequent
distribution is approved by the Nebraska Director.
Net cash flow provided by (used for) operating activities for the 2000
first quarter and 1999 first quarter was approximately ($2.7) million and $14.1
million, respectively, consisting principally of premiums received, investment
income (excluding net realized investment gains), offset by operating costs and
expenses.
The primary sources of liquidity of the Company subsequent to the asset
sale will be from short-term and fixed maturity investments presently owned
directly by the Company ($11.8 million at March 31, 2000) and the invested
assets to be distributed to the Company by Arch Re as an extraordinary
distribution, which could occur during the second quarter of 2000, provided
applicable regulatory approval is obtained. Such invested assets would
include $58.2 million of privately held securities at March 31, 2000, which
are generally restricted as to resale, do not have readily ascertainable
market values or are otherwise illiquid.
30
<PAGE>
The fixed maturity investments contemplated to be restricted or unavailable
for liquidity purposes subsequent to the asset sale will include $20 to $25
million to be held in escrow for a period of five years under the terms of the
asset sale and our investments in Arch Re and Cross River, each contemplated
to have up to approximately $20 million in statutory surplus (or any greater
amount the Nebraska Insurance Department requires Arch Re to retain in the
event there are any objections from reinsureds to the release of Arch Re from
further liability under reinsurance agreements transferred pursuant to the
transfer and assumption agreement).
We do not currently have any material commitments for any capital
expenditures over the next 12 months. We expect that our financing and
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
operations. Following the sale of the reinsurance operations to Folksamerica,
our objective is to pursue business combinations and ventures with operating
businesses. We have not yet identified any specific business opportunities
that we intend to pursue. Accordingly, we may need to secure additional
financing to carry out our business plan. We cannot assure you that we will
be successful in obtaining any such financing or in the implementation of our
future business strategy.
MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
In accordance with the SEC's Financial Reporting Release No. 48, we
performed a sensitivity analysis to determine the effects that market risk
exposures could have on the future earnings, fair values or cash flows of our
financial instruments as of December 31, 1999. (See "Management's Discussion
and Analysis of Financial Condition and Results of Operations" included in
our 1999 Annual Report on Form 10-K.) 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. At March 31, 2000, there
have been no material changes in market risk exposures that affect the
quantitative and qualitative disclosures presented as of December 31, 1999.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward-looking statements. This report or any other written or oral
statements made by or on behalf of the Company may include forward-looking
statements which reflect our current views with respect to future events and
financial performance. All statements other than statements of historical fact
included in 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," "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 and include:
-- the availability of investments on attractive terms;
-- competition, including increased competition;
-- changes in the performance of the insurance sector of the public
equity markets or market professionals' views as to such sector;
-- general economic conditions;
-- regulatory changes and conditions;
-- claims development, including as to the frequency or severity of
claims and the timing of payments;
-- our future business operations and strategy; and
-- loss of key personnel.
31
<PAGE>
In addition, the sale of our reinsurance operations to Folksamerica
Reinsurance Company referred to in this report is subject to various risks and
uncertainties including the risks that the costs (including tax costs) of the
transaction and purchase price and reserve adjustments will be greater than
currently expected with resulting effects on our income statement and book
value.
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.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Reference is made to the information appearing above under the subheading
"Market Sensitive Instruments and Risk Management" under the caption
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," which information is hereby incorporated by reference.
32
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to litigation and arbitration in the ordinary course
of business.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
Exhibit No. Description
----------- -----------
10 Amendment to Sub-Sublease Agreement, between Arch
Reinsurance Company and Marsh & McLennan Capital, Inc.
15 Accountants' Awareness Letter and Limitation of
Liability (regarding unaudited interim financial
information)
27 Financial Data Schedule
(b) Reports on Form 8-K.
The Company filed reports on Form 8-K during the three month period ended
March 31, 2000 on:
(1) January 18, 2000 (reporting the sale of the Company's
reinsurance operations to Folksamerica Reinsurance Company
and the XL Capital stock repurchase) and
(2) March 2, 2000 (reporting the closing of the XL Capital
stock repurchase).
Omitted from this Part II are items which are inapplicable or to which the
answer is negative for the period covered.
33
<PAGE>
SIGNATURES
===============================================================================
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RISK CAPITAL HOLDINGS, INC.
----------------------------------------
(REGISTRANT)
/s/ Peter A. Appel
----------------------------------------
DATE: MAY 15, 2000 PETER A. APPEL
PRESIDENT AND CHIEF EXECUTIVE OFFICER
/s/ Paul J. Malvasio
----------------------------------------
DATE: MAY 15, 2000 PAUL J. MALVASIO
CHIEF FINANCIAL OFFICER
34
<PAGE>
EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
10 Amendment to Sub-Sublease Agreement, between Arch Reinsurance
Company and Marsh & McLennan Capital, Inc.
15 Accountants' Awareness Letter and Limitation of Liability
(regarding unaudited interim financial information)
27 Financial Data Schedule
35
<PAGE>
EXHIBIT 10
AMENDMENT OF SUB-SUBLEASE
Amendment of Sub-Sublease ("Amendment") dated as of the 1st day of
April, 2000, by and between RISK CAPITAL REINSURANCE COMPANY ("Sub-Sublandlord")
having an office at 20 Horseneck Lane, Greenwich, Connecticut 06830 and MARSH &
McLENNAN CAPITAL INC. (formerly known as Marsh & McClennan Risk Capital Corp.)
("Sub-Subtenant") having an office at 20 Horseneck Lane, Greenwich, Connecticut
06830.
W I T N E S S E T H :
WHEREAS, by Sub-Sublease Agreement dated as of March 18, 1996 entered
into between Sub-Sublandlord and Sub-Subtenant (the "Sub-Sublease"),
Sub-Sublandlord sub-subleased to Sub-Subtenant approximately 11,514 square feet
of rentable area on the first floor of the building (the "Building") located at
and known as 20 Horseneck Lane, Greenwich, Connecticut. (The portion of the
Building so sub-subleased to Sub-Subtenant is herein referred to as the "M&M
Space").
WHEREAS, Sub-Sublandlord and Sub-Subtenant agree that approximately
6,431 rentable square feet on the first floor of the Building (the "BOI Space"),
occupied by Bank of Ireland Asset Management (US) Limited ("BOI") pursuant to a
Sub-Sublease Agreement dated as of April 30, 1997 by and between Sub-Sublandlord
and BOI ('the "BOI Sublease") will be vacated by BOI on or prior to March 31,
2000 pursuant to the Sub-Sublandlord Termination Agreement by and between BOI
and Sub-Sublandlord dated as of November 8, 1999.
WHEREAS, Section 14 of the Sub-Sublease provides that upon the
termination of the BOI Sublease, the Sub-Subtenant's Pro Rata Share of BOI Space
would be added to the M&M Space and the Sub-Sublandlord Expansion Space would be
retained by the Sub-Sublandlord, unless Sublandlord elected not to retain the
Sub-Sublandlord Expansion Space and make it available to Sub-Subtenant.
WHEREAS, Sub-Sublandlord does not desire to retain the Sub-Sublandlord
Expansion Space and the Sub-Subtenant desires to (a) add the M&M Expansion Space
and the Sub-Sublandlord Expansion Space to the M&M Space; and (b) to amend the
Sub-Sublease in the manner hereinafter set forth.
NOW THEREFORE, in consideration of the mutual covenants herein
contained and other good and valuable consideration the receipt and sufficiency
of which are hereby acknowledged, the parties hereto agrees as follows:
1. All capitalized terms used herein, and not otherwise defined
herein, shall have the meanings ascribed to them in the Sub-Sublease.
2. A. The entire BOI Space, marked as the "Additional Space" on
EXHIBIT A annexed hereto and made a part hereof (the "Additional Space") is,
from and after the Additional Space Commencement Date (as hereinafter defined)
added to and shall form a part of the M&M Space with the same force and effect
as if originally demised under the Sub-Sublease and, from and after the
Additional Space Commencement Date, the term "M&M Space", as used in the Sub-
<PAGE>
Sublease, shall include the Additional Space. Notwithstanding any contrary or
inconsistent provision contained herein or in the Sub-Sublease, Sub-Sublandlord,
at all times during the term of the Sub-Sublease shall have unrestricted access
to those areas of the Additional Space utilized for the common services and
facilities of the Building, such as mechanical rooms and stairways.
B. Sub-Subtenant accepts the Additional Space in its "as is"
condition.
C. Sub-Subtenant, at Sub-Subtenant's sole cost and expense,
shall take all actions required to design and construct all improvements
necessary or desirable to permit Sub-Subtenant's use and occupancy of the
Additional Space (the "Additional Space Fit-Up") in accordance with all Plans
(the "Plans") to be approved by the parties hereto. Sub-Subtenant shall be
responsible for the costs of all design services of such architects and
engineers who have prepared the Plans. All additional property assessments and
real estate taxes incurred by Sub-Sublandlord as a result of the Additional
Space Fit-Up shall be billed to, and paid by, Sub-Subtenant as additional rent.
D. The "Additional Space Commencement Date" shall be
April 1, 2000.
E. This Amendment shall not be effective until such time as a
counterpart or reproduced copy of this Amendment shall have first been delivered
to the Coca-Cola Bottling Company of New York, Inc. ("Coke") in accordance with
the Sublease Agreement by and between Sub-Sublandlord and Coke dated as of March
18, 1996.
3. Effective upon the Additional Space Commencement Date, provided
the condition set forth in Paragraph 3E has been satisfied, the Sub-Sublease is
hereby amended in the following respects:
A. Section 3 of the Sub-Sublease is amended to provide that
Sub-Subtenant's Pro-Rata Share shall be 47.3%.
B. Section 4 of the Sub-Sublease is modified and amended to
provide that Sub-Subtenant's Security Deposit shall be increased from $37,082.51
to $46,733.412 and such amount shall for all purposes under the Sub-Sublease be
"Sub-Subtenant's Security Deposit".
C. Sub-Sublandlord and Sub-Subtenant agree that, for purposes
of Section 13 of the Sub-Sublease, Sub-Subtenant's Pro-Rata Share of the
indoor parking spaces shall be twenty-seven (27) spaces.
D. Sub-Sublandlord waives and releases its right to retain the
Sub-Sublandlord Expansion Space as set forth in Section 14 of the Sub-Sublease.
4. Sub-Sublandlord and Sub-Subtenant each represent to the other
that they have dealt with no broker or brokers in connection with this
Amendment. Sub-Sublandlord and Sub-Subtenant each hereby agree to indemnify and
hold the other harmless from any and all loss, cost, claim, damage or expense
(including, without limitation, reasonable attorneys' fees and
2
<PAGE>
disbursements) incurred by the other and arising out of any inaccuracy or
alleged inaccuracy of the above representation made by the indemnifying party.
5. Except as expressly amended herein, the Sub-Sublease is in all
respects, confirmed, ratified and approved and is on the date of this Amendment,
subject to the terms thereof, in full force and effect and, to the best
knowledge of each of Sub-Sublandlord and Sub-Subtenant on the date hereof, there
are defaults by either party under the Sub-Sublease.
IN WITNESS WHEREOF, Sub-Sublandlord and Sub-Subtenant have duly
executed this Amendment of Sub-Sublease as of the day and year first above
written.
RISK CAPITAL REINSURANCE COMPANY
By: /s/ LOUIS T. PETRILLO
--------------------------------
Vice President
MARSH & McLENNAN CAPITAL, INC.
By: /s/ RICHARD GOLDMAN
--------------------------------
Principle and Financial Director
3
<PAGE>
STATE OF CONNECTICUT )
) ss. GREENWICH
COUNTY OF FAIRFIELD )
On this 7th day of March, 2000, personally appeared, RISK CAPITAL
REINSURANCE COMPANY, by Louis T. Petrillo, its Vice President hereunto duly
authorized, who acknowledged that he/she signed, sealed and delivered the above
and foregoing instrument as his/her free act and deed, and the free act and deed
of said corporation, for the purposes therein stated, before me.
/s/ LISA M. MORRISSEY
-----------------------------------
Notary Public
Commissioner of the Superior Court
My Commission Expires: May 31, 2003
------------
STATE OF CONNECTICUT )
) ss. GREENWICH
COUNTY OF FAIRFIELD )
On this 13th day of April, 2000, personally appeared, MARSH & McLENNAN
CAPITAL INC., by Richard A. Goldman, its Principle and Financial Director
hereunto duly authorized, who acknowledged that he/she signed, sealed and
delivered the above and foregoing instrument as his/her free act and deed, and
the free act and deed of said corporation, for the purposes therein stated,
before me.
/s/ SANDRA A. SANDLOCK
----------------------------------------
Notary Public
Commissioner of the Superior Court
My Commission Expires: February 28, 2004
-----------------
4
<PAGE>
EXHIBIT 15
ACCOUNTANTS' AWARENESS LETTER AND LIMITATION OF LIABILITY
We are aware of the incorporation by reference in the Registration Statement on
Form S-3 (Registration No. 33-34499) and in the Registration Statements on Form
S-8 (Registration No. 33-99974 and Registration No. 333-86145) of Arch Capital
Group Ltd. of our report dated May 2, 2000 (issued pursuant to the provisions of
Statement on Auditing Standards No. 71) appearing in this Form 10-Q. We are also
aware of our responsibilities under the Securities Act of 1933.
We are not subject to the liability provisions of section 11 of the Securities
Act of 1933 for our report dated May 2, 2000 (issued pursuant to the provisions
of Statement on Auditing Standards No. 71) on the unaudited interim consolidated
financial information of Arch Capital Group Ltd. because our report is not a
"report" or a "part" of the Registration Statement on Form S-3 (Registration No.
33-34499) or of the Registration Statement on Form S-8 (Registration No.
33-99974 and Registration No. 333-86145) prepared or certified by us within the
meaning of sections 7 and 11 of the Securities Act of 1933.
/s/ PricewaterhouseCoopers LLP
New York, New York
May 15, 2000
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET OF ARCH CAPITAL GROUP LTD AND ITS SUBSIDIARY AT MARCH
31, 2000 AND THE RELATED STATEMENT OF INCOME, AND IS QUALIFIED IN ITS ENTIRETY
BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-2000
<PERIOD-START> JAN-01-2000
<PERIOD-END> MAR-31-2000
<DEBT-HELD-FOR-SALE> 206,302
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 101,118
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 448,186
<CASH> 11,447
<RECOVER-REINSURE> 77,590
<DEFERRED-ACQUISITION> 22,285
<TOTAL-ASSETS> 774,250
<POLICY-LOSSES> 378,297
<UNEARNED-PREMIUMS> 103,469
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 0
0
0
<COMMON> 171
<OTHER-SE> 249,082
<TOTAL-LIABILITY-AND-EQUITY> 774,250
58,162
<INVESTMENT-INCOME> 5,290
<INVESTMENT-GAINS> 29,300
<OTHER-INCOME> 0
<BENEFITS> 53,875
<UNDERWRITING-AMORTIZATION> 16,753
<UNDERWRITING-OTHER> 3,727
<INCOME-PRETAX> 18,397
<INCOME-TAX> 12,619
<INCOME-CONTINUING> 5,808<F1>
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 5,808<F1>
<EPS-BASIC> 0.37<F1>
<EPS-DILUTED> 0.37<F1>
<RESERVE-OPEN> 308,628
<PROVISION-CURRENT> 48,703
<PROVISION-PRIOR> 5,172
<PAYMENTS-CURRENT> 3,715
<PAYMENTS-PRIOR> 41,753
<RESERVE-CLOSE> 317,035<F2>
<CUMULATIVE-DEFICIENCY> 5,172
<FN>
<F1>Includes equity in net income of investees of $30. Net income excludes Other
Comprehensive income (loss) which the Company adopted 1st Qtr 1998 in a one
financial statement approach. Comprehensive loss was $38,122 or $2.08 per share
Basic and Diluted.
<F2>Loss reserves net of reinsurance.
</FN>
</TABLE>
