<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 September 30, 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)
Bermuda Not Applicable
(State or other jurisdiction of
incorporation or organization) (I.R.S. Employer Identification No.)
20 Horseneck Lane
Greenwich, Connecticut 06830
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (203) 862-4300
----------------------------------------------------------------
(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 September 30, 2000
----- ---------------------------------
Common Stock, $.01 par value 12,408,017
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<PAGE>
ARCH CAPITAL GROUP LTD.
INDEX
PAGE NO.
--------
PART I. FINANCIAL INFORMATION
ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS
Review Report of Independent Accountants 1
Consolidated Balance Sheet
September 30, 2000 and December 31, 1999 2
Consolidated Statement of Income and Comprehensive Income
For the three and nine month periods ended September 30,
2000 and 1999 3
Consolidated Statement of Changes in Stockholders' Equity
For the nine month periods ended September 30, 2000 and 1999 4
Consolidated Statement of Cash Flows
For the nine month periods ended September 30, 2000 and 1999 5
Notes to Consolidated Financial Statements 6
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 20
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 29
PART II. OTHER INFORMATION
ITEM 2 - CHANGE IN SECURITIES AND USE OF PROCEEDS 30
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K 30
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Arch Capital Group Ltd.:
We have reviewed the accompanying consolidated balance sheet of Arch Capital
Group Ltd. (formerly known as Risk Capital Holdings, Inc.) and its subsidiaries
as of September 30, 2000, and the related consolidated statement of income and
comprehensive income for each of the three-month and nine-month periods ended
September 30, 2000 and 1999 and the consolidated statements of changes in
stockholders' equity and of cash flows for the nine-month periods ended
September 30, 2000 and 1999. These financial statements are 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 auditing standards generally accepted in the
United States of America, 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 accounting principles generally accepted in the United
States of America.
We previously audited in accordance with auditing standards generally accepted
in the United States of America, the consolidated balance sheet as of December
31, 1999, and the related consolidated statements of income and comprehensive
income, 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 accompanying
consolidated balance sheet information 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
October 30, 2000
1
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------- ------------
<S> <C> <C>
ASSETS
Investments:
Fixed maturities (amortized cost: 2000, $80,556; 1999, $270,345) $ 74,241 $ 261,067
Publicly traded equity securities (cost: 2000, $43,793; 1999, $105,747) 54,425 158,631
Privately held securities (cost: 2000, $59,805; 1999, $85,748) 58,435 83,969
Securities held in escrow (amortized cost: 2000, $20,494) 20,597 --
Short-term investments 47,036 72,785
--------- ---------
Total investments 254,734 576,452
--------- ---------
Cash 15,756 9,457
Accrued investment income 2,202 4,527
Premiums receivable -- 119,320
Reinsurance recoverable -- 73,122
Deferred policy acquisition costs -- 23,585
Investment accounts receivable 68 --
Federal income tax recoverable -- 8,758
Deferred income tax asset 2,547 7,834
Other insurance assets -- 36,975
Other assets 1,704 4,329
========= =========
TOTAL ASSETS $ 277,011 $ 864,359
========= =========
LIABILITIES
Claims and claims expenses -- $ 364,554
Unearned premiums -- 108,743
Reinsurance balances payable -- 14,666
Investment accounts payable $ 256 --
Other insurance liabilities -- 24,541
Other liabilities 8,329 5,341
--------- ---------
TOTAL LIABILITIES 8,585 517,845
--------- ---------
COMMITMENTS AND CONTINGENCIES
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, 17,198,432; 1999, 17,109,736) 172 171
Additional paid-in capital 343,375 342,034
Deferred compensation under stock award plan (642) (317)
Retained earnings (deficit) (16,660) (22,175)
Less treasury stock, at cost (2000, 4,790,415; 1999, 21,766 shares) (59,802) (387)
Accumulated other comprehensive income consisting of
unrealized appreciation of investments, net of income tax 1,983 27,188
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 268,426 346,514
--------- ---------
Total Liabilities & Stockholders' Equity $ 277,011 $ 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)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2000 1999 2000 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
PREMIUMS AND OTHER REVENUES
Net premiums written $ 76,749 ($ 10,604) $ 232,703
(Increase) decrease in unearned premiums 3,714 98,134 (2,330)
------------ ------------ ------------ ------------
Net premiums earned 80,463 87,530 230,373
Net investment income $ 3,359 5,965 12,906 15,265
Gain on sale of reinsurance operations 2,191
Net investment gains 728 5,236 29,661 27,470
------------ ------------ ------------ ------------
TOTAL REVENUES 4,087 91,664 132,288 273,108
EXPENSES
Claims and claims expenses 75,058 76,263 221,228
Commissions and brokerage 20,453 26,756 62,860
Other operating expenses 1,502 3,364 5,748 10,797
Foreign exchange (gain) loss (292) 1,159 (354)
------------ ------------ ------------ ------------
TOTAL EXPENSES 1,502 98,583 109,926 294,531
INCOME (LOSS) BEFORE INCOME TAXES,
EQUITY IN NET INCOME OF INVESTEES AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE 2,585 (6,919) 22,362 (21,423)
Federal income taxes:
Current (786) (2,038)
Deferred 870 (1,996) 18,030 (6,490)
------------ ------------ ------------ ------------
Income tax expense (benefit) 870 (2,782) 18,030 (8,528)
------------ ------------ ------------ ------------
INCOME (LOSS) BEFORE EQUITY IN NET
INCOME OF INVESTEES AND CUMULATIVE
EFFECT OF ACCOUNTING CHANGE 1,715 (4,137) 4,332 (12,895)
Equity in net income of investees 544 400 1,183 433
------------ ------------ ------------ ------------
INCOME (LOSS) BEFORE CUMULATIVE
EFFECT OF ACCOUNTING CHANGE 2,259 (3,737) 5,515 (12,462)
Cumulative effect of accounting change (383)
------------ ------------ ------------ ------------
NET INCOME (LOSS) 2,259 (3,737) 5,515 (12,845)
------------ ------------ ------------ ------------
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX
Change in net unrealized appreciation
(depreciation) of investments, net of tax 10,841 (6,757) (25,205) (24,420)
------------ ------------ ------------ ------------
COMPREHENSIVE INCOME (LOSS) $ 13,100 ($ 10,494) ($ 19,690) ($ 37,265)
============ ============ ============ ============
AVERAGE SHARES OUTSTANDING
Basic 12,402,693 17,087,831 13,429,315 17,086,757
Diluted 12,405,101 17,087,834 13,430,612 17,086,787
PER SHARE DATA
Net Income (Loss) - Basic and diluted $ 0.18 ($ 0.22) $ 0.41 ($ 0.75)
Comprehensive Income (Loss) - Basic and diluted $ 1.06 ($ 0.61) ($ 1.47) ($ 2.18)
</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)
NINE MONTHS ENDED,
SEPTEMBER 30,
2000 1999
--------- ----------
<S> <C> <C>
COMMON STOCK
Balance at beginning of year $ 171 $ 171
Common stock issued 1 --
--------- ---------
Balance at end of period 172 171
--------- ---------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year 342,034 341,878
Common stock issued 1,341 165
--------- ---------
Balance at end of period 343,375 342,043
--------- ---------
DEFERRED COMPENSATION UNDER STOCK AWARD PLAN
Balance at beginning of year (317) (1,062)
Restricted common stock issued (1,122) 15
Compensation expense recognized 797 540
--------- ---------
Balance at end of period (642) (507)
--------- ---------
RETAINED EARNINGS (DEFICIT)
Balance at beginning of year (22,175) 10,261
Net income (loss) 5,515 (12,845)
--------- ---------
Balance at end of period (16,660) (2,584)
--------- ---------
TREASURY STOCK, AT COST
Balance at beginning of year (387) (284)
Purchase of treasury stock (59,415) (80)
--------- ---------
Balance at end of period (59,802) (364)
--------- ---------
ACCUMULATED OTHER COMPREHENSIVE INCOME CONSISTING OF
UNREALIZED APPRECIATION OF INVESTMENTS, NET OF INCOME TAX
Balance at beginning of year 27,188 47,038
Change in unrealized appreciation (25,205) (24,420)
--------- ---------
Balance at end of period 1,983 22,618
--------- ---------
TOTAL STOCKHOLDERS' EQUITY
Balance at beginning of year 346,514 398,002
Issuance of common stock 1,342 165
Change in deferred compensation (325) 555
Net income (loss) 5,515 (12,845)
Purchase of treasury stock (59,415) (80)
Change in unrealized appreciation
of investments, net of income tax (25,205) (24,420)
========= =========
Balance at end of period $ 268,426 $ 361,377
========= =========
</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)
NINE MONTHS ENDED,
SEPTEMBER 30,
2000 1999
---------- ----------
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ 5,515 ($ 12,845)
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
Liability for claims and claims expenses 7,069 139,216
Unearned premiums (5,226) 12,960
Premiums receivable 10,733 (44,442)
Accrued investment income 664 (2,339)
Reinsurance recoverable (11,093) (27,666)
Reinsurance balances payable (5,121) 7,329
Deferred policy acquisition costs 344 (908)
Net investment (gains)/losses (24,331) (27,470)
Deferred income tax asset 5,386 (6,463)
Other liabilities 7,718 6,936
Other items, net 10,402 (12,133)
--------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES 2,060 32,175
--------- ---------
INVESTING ACTIVITIES
Purchases of fixed maturity investments (96,915) (293,176)
Sales of fixed maturity investments 158,478 199,943
Purchases of equity securities (18,233) (33,275)
Sales of equity securities 77,853 84,732
Net (purchases)/sales of short-term investments (120,997) 10,610
Proceeds from sale of reinsurance operations 517
Sale or disposal (purchases) of furniture and equipment 6 (349)
--------- ---------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 709 (31,515)
--------- ---------
FINANCING ACTIVITIES
Common stock issued 1,222 165
Purchase of treasury stock 3,430 (80)
Deferred compensation on restricted stock (1,122) 15
--------- ---------
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES 3,530 100
--------- ---------
Increase in cash 6,299 760
Cash beginning of year 9,457 12,037
========= =========
Cash end of period $ 15,756 $ 12,797
========= =========
</TABLE>
See Notes to Consolidated Financial Statements
5
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
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
Arch Reinsurance Company ("Arch Re"), formerly known as Risk Capital Reinsurance
Company. At September 30, 2000, Arch Re had statutory capital of $237 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 license in October 1998, and is currently authorized to write insurance
on an excess and surplus lines basis in 22 other states. On May 5, 2000, the
Company sold the reinsurance operations of Arch Re to Folksamerica Reinsurance
Company in the asset sale described below in Note 9. On November 8, 2000, the
Company completed a reorganization in which the Company has become a wholly
owned subsidiary of a newly-formed Bermuda holding company. See Note 10.
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
made concurrently with 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 accounting principles generally accepted in the
United States of America ("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. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. COMPREHENSIVE INCOME (CONT'D.)
<TABLE>
<CAPTION>
(IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30,
2000 1999
---------- -----------
<S> <C> <C>
Net income (loss) $ 5,515 ($12,845)
Other comprehensive income, net of tax:
Unrealized appreciation (depreciation) of
investments:
Unrealized holdings gains (losses) arising
during period (5,925) (6,564)
Less, reclassification adjustment for net
realized (gains) losses included in net income (19,280) (17,856)
-------- --------
Other comprehensive income (loss) (25,205) (24,420)
======== ========
Comprehensive income (loss) ($19,690) ($37,265)
======== ========
</TABLE>
4. EARNINGS PER SHARE DATA
Earnings per share are computed in accordance with FASB Statement No. 128
"Earnings Per Share."
Basic earnings per share exclude 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. When a loss occurs,
diluted per share amounts are computed using basic average shares outstanding
because including dilutive securities would decrease the loss per share and
would therefore be anti-dilutive.
7
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. EARNINGS PER SHARE DATA (CONT'D.)
The following table sets forth the computation of basic and diluted earnings per
share:
<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2000 1999 2000 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
NET INCOME
BASIC EARNINGS PER SHARE:
Net income (loss) $ 2,259 ($ 3,737) $ 5,515 ($ 12,845)
Divided by:
Weighted average shares
outstanding for the period 12,402,693 17,087,831 13,429,315 17,086,757
Basic earnings (loss) per share $ 0.18 ($ 0.22) $ 0.41 ($ 0.75)
DILUTED EARNINGS PER SHARE:
Net income (loss) $ 2,259 ($ 3,737) $ 5,515 ($ 12,845)
Divided by:
Weighted average shares
outstanding for the period 12,402,693 17,087,831 13,429,315 17,086,757
Effect of dilutive securities:
Warrants
Employee stock options 2,408 -- 1,297 --
------------ ------------ ------------ ------------
Total shares 12,405,101 17,087,831 13,430,612 17,086,757
============ ============ ============ ============
Diluted earnings (loss) per share $ 0.18 ($ 0.22) $ 0.41 ($ 0.75)
</TABLE>
<TABLE>
<CAPTION>
(IN THOUSANDS, EXCEPT SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2000 1999 2000 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
COMPREHENSIVE INCOME
BASIC EARNINGS PER SHARE:
Comprehensive income (loss) $ 13,100 ($ 10,494) ($ 19,690) ($ 37,265)
Divided by:
Weighted average shares
outstanding for the period 12,402,693 17,087,831 13,429,315 17,086,757
Basic earnings (loss) per
share $ 1.06 ($ 0.61) ($ 1.47) ($ 2.18)
DILUTED EARNINGS PER SHARE:
Comprehensive income (loss) $ 13,100 ($ 10,494) ($ 19,690) ($ 37,265)
Divided by:
Weighted average shares
outstanding for the period 12,402,693 17,087,831 13,429,315 17,086,757
Effect of dilutive securities:
Warrants
Employee stock options 2,408 -- -- --
------------ ------------ ------------ ------------
Total shares 12,405,101 17,087,831 13,429,315 17,086,757
============ ============ ============ ============
Diluted earnings (loss) per
share $ 1.06 ($ 0.61) ($ 1.47) ($ 2.18)
</TABLE>
8
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION
Realized investment gains (losses) for the three and nine month periods
ended September 30, 2000 consisted of the following:
<TABLE>
<CAPTION>
(IN THOUSANDS)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2000 SEPTEMBER 30, 2000
----------------------------------- ------------------------------------
NET NET
GROSS GROSS REALIZED GROSS GROSS REALIZED
REALIZED REALIZED GAINS REALIZED REALIZED GAINS
GAINS LOSSES (LOSSES) GAINS LOSSES (LOSSES)
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Fixed maturities $ 38 ($ 332) ($ 294) $ 380 ($ 3,615) ($ 3,235)
Publicly traded equity
securities 358 358 37,858 (1,966) 35,892
Privately held
securities 914 (250) 664 914 (3,910) (2,996)
-------- -------- -------- -------- -------- --------
Total $ 1,310 ($ 582) $ 728 $ 39,152 ($ 9,491) $ 29,661
======== ======== ======== ======== ======== ========
</TABLE>
The following table reconciles estimated fair value and carrying value to
the amortized cost of fixed maturities and equity securities:
<TABLE>
<CAPTION>
(IN THOUSANDS)
SEPTEMBER 30, 2000
---------------------------------------------------
ESTIMATED
FAIR VALUE
AND GROSS GROSS
CARRYING UNREALIZED UNREALIZED AMORTIZED
VALUE GAINS (LOSSES) COST
----------- -------- -------- ---------
<S> <C> <C> <C> <C>
Fixed maturities $ 74,241 $ 559 ($ 6,874) $ 80,556
Publicly traded equity
securities 54,425 18,828 (8,196) 43,793
Privately held securities 58,435 (1,370) 59,805
Securities held in escrow 20,597 111 (8) 20,494
-------- -------- -------- --------
Total $207,698 $ 19,498 ($16,448) $204,648
======== ======== ======== ========
</TABLE>
The Company classifies all of its publicly traded fixed maturities and
equity securities as "available for sale" and, accordingly, they are carried at
estimated fair value. The fair value of publicly traded fixed maturities 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.
9
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D.)
At September 30, 2000, 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 such date, the
publicly traded equity portfolio consisted of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, 2000
--------------------------------------------------
ESTIMATED
FAIR
VALUE AND GROSS GROSS
CARRYING UNREALIZED UNREALIZED
VALUE GAINS (LOSSES) COST
----------- ----------- ---------- -------------
<S> <C> <C> <C>
COMMON STOCK:
ACE Limited $12,693 $ 4,551 $ 8,142
XL Capital Ltd 19,240 10,365 8,875
Farm Family Holdings, Inc. 968 56 912
IPC Holdings, Ltd. 9,842 ($5,026) 14,868
Limit PLC 1,992 (819) 2,811
Meadowbrook Insurance Group 732 (2,351) 3,083
Renaissance Re 3,197 1,487 1,710
Metropolitan Life Insurance
Company 5,761 2,369 3,392
OTHER:
Markel Corp (62,239 Contingent
Value Rights)
------- ------- ------- -------
Total $54,425 $18,828 ($8,196) $43,793
======= ======= ======= =======
</TABLE>
Investments in privately held securities 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.
Goodwill for privately held equity securities carried under the equity
method of accounting was $8.1 million at September 30, 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
10
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D.)
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)
SEPTEMBER 30, DECEMBER 31,
2000 1999
-------- ------------
<S> <C> <C>
CARRIED UNDER THE EQUITY METHOD:
The ARC Group, LLC $ 8,116 $ 8,687
Arx Holding Corp. 3,050 2,654
Island Heritage Insurance Company, Ltd. 4,469 4,356
LARC Holdings, Ltd. 24,039
New Europe Insurance Ventures 678 819
Sunshine State Holding Corporation 1,709 1,885
------- -------
Sub-total 18,022 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. 250 500
Sorrento Holdings, Inc. 1,517
Stockton Holdings Limited 10,000 10,000
Trident II, L.P. 6,813 6,089
------- -------
Sub-total 40,413 41,529
======= =======
Total $58,435 $83,969
======= =======
</TABLE>
During the nine month period ended September 30, 2000, the Company received
distributions from The ARC Group, LLC totaling $1,890,000.
Sorrento Holdings, Inc. ("Sorrento") has redeemed all of the Company's
preferred stock in Sorrento. During the nine month period ended September 30,
2000, the Company received $1,548,000 from Sorrento for the redemption of 1,517
shares of preferred stock of Sorrento, which redemption amount included a
payment of $1,000 per share and interest income at 6%.
At September 30, 2000, the Company had investment commitments relating to
its privately held securities totaling approximately $22.4 million. The
outstanding commitments at September 30, 2000 included $18.2 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 nine month period ended September 30, 2000:
11
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D.)
ALTUS HOLDINGS, LTD.
In the 2000 first quarter, the Company reduced the carrying value of Altus
Holdings, Ltd. ("Altus") by $3.2 million, realizing an after-tax loss of $2.1
million. In reducing the carrying value of Altus, the Company, in consultation
with its investment advisor, took into account the 1999 financial results of
Altus and certain other factors, and based such write-down on a conservative
valuation of Altus' economic book value at December 31, 1999.
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 September 30, 2000, based on a comparison of the AIHC notes to bonds
with similar characteristics, the Company has a $1.1 million pre-tax unrealized
loss adjusting the aggregate carrying value of $8.5 million in loans made to
AIHC ($3.5 million in March 2000 and $5 million in February 1999). Approximately
$350,000 of such unrealized loss was recorded in the 2000 first quarter and
$750,000 was recorded in 1999.
GUIDESTAR
In the 2000 third quarter, the Company, in consultation with its investment
advisor, reduced the carrying value of GuideStar by 50% to $250,000 and realized
an after-tax loss of $162,500.
LARC HOLDINGS, LTD.
As of March 2, 2000, the Company transferred to XL Capital Ltd ("XL
Capital") 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.
TRIDENT II, L.P.
During the nine month period ended September 30, 2000, the Company funded
$2.8 million of its investment commitment to Trident II, L.P. and received a
return of capital of $2.1 million, a return of expenses of $42,000, and a
distribution of profits of $764,000. At September 30, 2000, the Company's
outstanding commitment to Trident II was $18.2 million.
12
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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.
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 nine months ended
September 30, 2000 and 1999 follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30,
2000 1999
--------- ---------
<S> <C> <C>
Income taxes (benefit) computed on pre-tax income (loss) $ 7,827 ($ 7,498)
Addition (reduction) in income taxes resulting from:
Valuation allowance 10,205 --
Tax-exempt investment income (304) (520)
Dividend received deduction (240) (777)
Limitation on executive compensation 405 --
Other 137 267
======== ========
Income tax expense (benefit) on pre-tax income (loss) $ 18,030 ($ 8,528)
======== ========
</TABLE>
The Company had no current federal tax expense or benefit for the nine
months ended September 30, 2000 due to its net operating losses and the full
utilization of the two-year carry-back provision at December 31, 1999. The
Company's current federal tax benefit for the nine months ended September 30,
1999 was based on regular taxable income.
As a result of the Company's net operating losses in 1999 and 2000, the
Company has net operating loss carryforwards totaling $31.2 million at September
30, 2000. Such net operating losses are currently available to offset future
taxable income of the Company with the following expiration dates: $18.3 million
expiring in 2019 and $12.9 million expiring in 2020. The Company also has an
alternative minimum tax ("AMT") credit carryforward in the amount of $651,000,
which can be carried forward without expiration.
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.
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 may not be realized. Significant
components of the Company's deferred income tax assets and liabilities as of
September 30, 2000 and December 31, 1999 were as follows:
13
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. INCOME TAXES (CONT'D.)
<TABLE>
<CAPTION>
(IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------- ------------
<S> <C> <C>
Deferred income tax assets:
Net operating loss $ 10,909 $ 7,334
AMT credit carryforward 651
Net claim reserve discount 15,639
Net unearned premium reserve 6,573
Loss on investees, net 1,863 7
Compensation liabilities 176 372
Other, net 221 165
-------- --------
Total deferred tax assets 13,820 30,090
-------- --------
Deferred income tax liabilities:
Deferred policy acquisition cost (8,255)
Net unrealized appreciation of
investments (1,068) (14,001)
-------- --------
Total deferred tax liabilities (1,068) (22,256)
-------- --------
Valuation allowance (10,205)
-------- --------
Net deferred income tax asset $ 2,547 $ 7,834
======== ========
</TABLE>
As of September 30, 2000, the Company has a deferred income tax valuation
allowance of $10.2 million that adjusts the net deferred income tax asset to its
estimated realizable value of $2.5 million. Such deferred income tax asset is
net of a deferred income tax liability of $1.1 million, representing a future
income tax liability for the cumulative unrealized appreciation of investments
of $3.1 million. Deferred income tax expense for the nine months ended September
30, 2000 included a charge for such allowance of $10.2 million. During the 2000
third quarter, the Company decreased its deferred income tax valuation allowance
recorded in comprehensive income by $3.1 million to adjust for the $11.9 million
increase in net unrealized appreciation of investments during such period.
At December 31, 1999, the Company did not have a deferred income tax
valuation allowance because it believed at that time that its entire deferred
tax asset was realizable due to the Company's ability to generate future taxable
income from its invested asset base of $576.5 million. At that time, the closing
of the Folksamerica transaction was uncertain and, consequently, the tax
implications of the transaction were not considered in evaluating the
realizability of the deferred tax asset. During the 2000 first quarter, the
Company entered into the agreement with Folksamerica to sell the Company's
reinsurance operations. The asset sale generated a tax loss of $30 million
(excluding unrealized loss on fixed maturities, of which $5.3 million was
realized upon the related transfer of assets to Folksamerica) (See Note 9). The
transfer of assets to Folksamerica at closing also resulted in a significant
reduction in the Company's invested assets and its ability to generate future
taxable income. In addition, the market values of the Company's invested assets
depreciated significantly resulting in the 2000 first quarter change in net
unrealized depreciation of $58.6 million (including $5.3 million of unrealized
loss on fixed maturities which was realized upon the transfer of assets to
Folksamerica). Based on these factors, the Company recorded a $12.1 million
valuation allowance in the 2000 first quarter. For the 2000 first quarter,
deferred income tax expense included a charge for such allowance of $6.3 million
and the deferred income tax benefit of the change in net unrealized depreciation
of investments was decreased by $5.8 million for such valuation allowance. For
the 2000 second quarter, deferred income tax expense included a charge for such
allowance of $3.9 million and the deferred income tax benefit of the change in
net unrealized depreciation of investments was increased by $2.7 million for
such valuation allowance.
14
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 totaled $383,000, after-tax, or $0.02 per share,
was included in the 1999 first quarter net loss.
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 SEC rules (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, except that the Company no longer has any foreign currency exchange
rate risk.
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.
15
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 estimated in an aggregate
amount equal in book value to the book value of the liabilities assumed. In
consideration for the transfer of Arch Re's book of business, Folksamerica paid
$20.084 million (net of a credit equal to $251,000 granted to Folksamerica for
certain tax costs) in cash at the closing, subject to post-closing adjustments
based on an independent actuarial report of the claim liabilities transferred
and an independent audit of the net assets sold. Following the completion of
such report and audit, the parties agreed upon net post-closing adjustments in
the amount of approximately $3.2 million payable by the Company, which consisted
of a $4.2 million reduction in the purchase price less $1 million in net book
value of the assets and liabilities actually transferred at closing.
Under the terms of the agreement, $20 million has been placed in escrow for
a period of five years. Such amounts represent restricted funds that appear
under a separate caption entitled "Securities held in escrow" on the Company's
consolidated balance sheet at September 30, 2000. 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. In connection with the 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. To the extent that such loss reserves are redundant, all of the escrowed
funds will be released from escrow to the Company and Folksamerica will pay the
Company an amount equal to such redundancy. The agreement also provided that an
additional amount of up to $5 million would be placed in escrow for a period of
five years to the extent that Arch Re's reserves at closing on all business
other than that covered by the $20 million escrow were less by at least a
specified amount than those estimated by its independent actuaries. No such
supplemental escrow was required.
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 Company also made representations and warranties to Folksamerica
about the Company and the business transferred to Folksamerica for which the
Company retains exposure for certain periods. Although Folksamerica has not
asserted that any amount is currently due under any of the indemnities
provided by the Company under the asset purchase agreement, Folksamerica has
indicated a potential indemnity claim under the agreement in the event of the
occurrence of certain future events. Based on all available information, the
Company denies the validity of any such potential claim.
16
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. FOLKSAMERICA TRANSACTION (CONT'D.)
The net book value gain resulting from the sale of the Company's
reinsurance operations to Folksamerica is calculated as follows (in thousands):
<TABLE>
<S> <C>
Consideration received, consisting of the following:
Total liabilities transferred $ 514,330
Cash premium received 16,920
---------
531,250
---------
Assets transferred 478,687
Amortization of deferred policy acquisition costs 23,242
Transaction costs 21,800
---------
523,729
---------
Pre-tax gain 7,521
Income tax expense (1) 4,137
---------
Net gain 3,384
Realized (loss), net of income tax, for securities
transferred at market value (2) (5,330)
---------
Net (loss) (1,946)
Change in net unrealized depreciation of investments, net of tax (2) 5,330
---------
Comprehensive income and net book value gain $ 3,384
=========
</TABLE>
(1) The income tax benefit of $1.5 million relating to post-closing adjustments
of $4.2 million was offset by an equivalent deferred tax asset valuation
allowance.
(2) The related income tax benefit of $1.9 million was offset by an equivalent
deferred tax asset valuation allowance.
Transaction costs consist of the following (in millions):
<TABLE>
<S> <C>
Severance and other related costs $ 11.0
Reinsurance costs 4.8
Investment banking, legal and accounting fees 2.3
Write-off of furniture, equipment and
leasehold improvements 1.7
Write-off of lease obligation 1.3
Other 0.7
========
Total $ 21.8
========
</TABLE>
As of September 30, 2000, accrued and unpaid transaction costs amounted to
approximately $6.4 million. Of such amount, $1.4 million relates to severance
and other related costs expected to be paid to employees terminated as of June
30, 2000 during the next 15 months under the Company's severance arrangements;
$1.1 million relates to the write-off of the Company's lease obligation expected
to be paid over the remainder of the lease term expiring in October 2002; and
the balance of $3.9 million is expected to be paid by early 2001.
17
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. FOLKSAMERICA TRANSACTION (CONT'D.)
The GAAP book value of the assets and liabilities transferred to
Folksamerica recorded in the accompanying financial statements at closing are as
follows (in millions):
<TABLE>
<S> <C>
Fixed maturities, short-term investments and accrued interest income $ 249.9
Premiums receivable 108.6
Reinsurance recoverable 73.2
Deferred policy acquisition costs 23.2
Deferred income tax asset 13.5
Other insurance assets 47.0
--------
Total Assets $ 515.4
--------
Reserve for claims and claims expenses $ 371.6
Net unearned premium reserve 103.4
Reinsurance premiums payable 9.5
Other insurance liabilities 29.8
--------
Total Liabilities $ 514.3
--------
Net book value of assets and liabilities transferred $ 1.1
========
</TABLE>
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 were in-force were notified that
Folksamerica had assumed Arch Re's obligations and that, unless the reinsureds
object to the assumption, Arch Re will be released from its obligations to those
reinsureds. None of such reinsureds objected to the assumption and, accordingly,
the gross liabilities for such business have been removed from the accounts of
Arch Re for statutory and GAAP accounting purposes. However, Arch Re will
continue to be liable under those reinsurance agreements if the notice is found
not to be an effective release by the reinsureds. Folksamerica has agreed to
indemnify the Company for any losses arising out of the reinsurance agreements
transferred to Folksamerica Reinsurance Company in the asset sale. However, in
the event that Folksamerica refuses or is unable to perform its obligations to
the Company, Arch Re may incur losses relating to the reinsurance agreements
transferred in the asset sale.
10. SUBSEQUENT EVENTS
BERMUDA REORGANIZATION
On November 8, 2000, the Company consummated the previously announced
reorganization transaction that resulted in the Company becoming a wholly owned
subsidiary of a newly-formed Bermuda holding company ("Arch Capital
Group-Bermuda"). Arch Capital Group-Bermuda retains the name of "Arch Capital
Group Ltd." and the Company has been renamed "Arch Capital Group (U.S.) Inc."
Arch Capital Group-Bermuda performs the holding company functions previously
conducted by the Company, and the stockholders of the Company have become the
stockholders of Arch Capital Group-Bermuda. The common shares of Arch Capital
Group-Bermuda continue to trade on the Nasdaq National Market under the symbol
"ACGL."
In connection with the reorganization, and following the approval of the
Nebraska Director of Insurance under Nebraska law, Arch Reinsurance Company is
distributing to the Company approximately $223 million of its net assets, which
distribution is being completed in the 2000 fourth quarter. Following such
distribution, Arch Reinsurance Company and Cross River Insurance Company, the
indirect insurance
18
<PAGE>
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. SUBSEQUENT EVENTS (CONT'D.)
subsidiaries of Arch Capital Group-Bermuda, will continue to have an aggregate
surplus of approximately $24 million in order to maintain the insurance licenses
and other authorizations they currently hold.
AGREEMENT TO ACQUIRE HALES & COMPANY
On October 31, 2000, the Company entered into a definitive agreement to
acquire substantially all of the assets of Hales & Company ("Hales"), a
privately held merchant banking firm specializing in the insurance industry.
Founded in 1973, Hales is a leading merger and acquisition advisor to
middle-market insurance organizations and the manager of the general partner of
Distribution Partner Investment Capital, L.P., a private equity fund with
investments in insurance distribution, outsourcing and technology companies. The
purchase price will consist of 300,000 common shares of Arch Capital
Group-Bermuda (which shares will be subject to a two-year lock-up) and
$2,000,000 in cash, representing a total purchase price of approximately
$6,650,000 (based on the closing market price of the Common Stock on October 30,
2000). Substantially all of this amount will be reflected as goodwill and will
be amortized over a period not to exceed 15 years. As part of the acquisition of
Hales, the Company will make a commitment of $1.2 million to the fund managed by
Hales.
19
<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 Arch
Reinsurance Company ("Arch Re"), formerly known as Risk Capital Reinsurance
Company. 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 September 30, 2000, the statutory surplus of Arch Re was
approximately $237 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.
BERMUDA REORGANIZATION
On November 8, 2000, we consummated the previously announced reorganization
transaction that resulted in the Company becoming a wholly owned subsidiary of a
newly-formed Bermuda holding company ("Arch Capital Group-Bermuda"). Arch
Capital Group-Bermuda retains the name of "Arch Capital Group Ltd." and the
Company has been renamed "Arch Capital Group (U.S.) Inc." Arch Capital
Group-Bermuda performs the holding company functions previously conducted by the
Company, and the stockholders of the Company have become the stockholders of
Arch Capital Group-Bermuda. The common shares of Arch Capital Group-Bermuda
continue to trade on the Nasdaq National Market under the symbol "ACGL."
In connection with our reorganization, and following the approval of the
Nebraska Director of Insurance under Nebraska law, Arch Reinsurance Company is
distributing to us approximately $223 million of its net assets, which
distribution is being completed in the 2000 fourth quarter. Following such
distribution, Arch Reinsurance Company and Cross River Insurance Company, the
indirect insurance subsidiaries of Arch Capital Group-Bermuda, will continue to
have an aggregate surplus of approximately $24 million in order to maintain the
insurance licenses and other authorizations they currently hold. See
"--Liquidity and Capital Resources."
AGREEMENT TO ACQUIRE HALES & COMPANY
On October 31, 2000, we entered into a definitive agreement to acquire
substantially all of the assets of Hales & Company ("Hales"), a privately held
merchant banking firm specializing in the insurance industry. Founded in 1973,
Hales is a leading merger and acquisition advisor to middle-market insurance
organizations and the manager of the general partner of Distribution Partner
Investment Capital, L.P., a private equity fund with investments in insurance
distribution, outsourcing and technology companies. The purchase price will
consist of 300,000 of common shares of Arch Capital Group-Bermuda (which shares
will be subject to a two-year lock-up) and $2,000,000 in cash, representing a
total purchase price of approximately $6,650,000 (based on the closing market
price of our common stock on October 30, 2000). Substantially all of this amount
will be reflected as goodwill and will be amortized over a period not to exceed
15 years. As part of the acquisition of Hales, we will make a commitment of $1.2
million to the fund managed by Hales.
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, Inc. (collectively, "Folksamerica").
Folksamerica Reinsurance Company assumed Arch Re's liabilities under the
20
<PAGE>
reinsurance agreements transferred in the asset sale and Arch Re transferred to
Folksamerica Reinsurance Company assets estimated in an aggregate amount equal
in book value to the book value of the liabilities assumed. In consideration for
the transfer of Arch Re's book of business, Folksamerica paid $20.084 million
(net of a credit equal to $251,000 granted to Folksamerica for certain tax
costs) in cash at the closing, subject to post-closing adjustments based on an
independent actuarial report of the claim liabilities transferred and an
independent audit of the net assets sold. Following the completion of such
report and audit, the parties agreed upon net post-closing adjustments in the
amount of approximately $3.2 million payable by us, which consisted of a $4.2
million reduction in the purchase price less $1 million in net book value of the
assets and liabilities actually transferred at closing.
Under the terms of the agreement, $20 million has been placed in escrow for
a period of five years. Such amounts represent restricted funds that appear
under a separate caption entitled "Securities held in escrow" on our
consolidated balance sheet at September 30, 2000. 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. In connection with the 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. To
the extent that such loss reserves are redundant, all of the escrowed funds will
be released from escrow to us and Folksamerica will pay us an amount equal to
such redundancy. The agreement also provided that an additional amount of up to
$5 million would be placed in escrow for a period of five years to the extent
that Arch Re's reserves at closing on all business other than that covered by
the $20 million escrow were less by at least a specified amount than those
estimated by its independent actuaries. No such supplemental escrow was
required.
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.
We also made representations and warranties about us and the business
transferred to Folksamerica for which we retain exposure for certain periods.
Although Folksamerica has not asserted that any amount is currently due under
any of the indemnities provided by the Company under the asset purchase
agreement, Folksamerica has indicated a potential indemnity claim under the
agreement in the event of the occurrence of certain future events. Based on
all available information, the Company denies the validity of any such
potential claim.
21
<PAGE>
The GAAP book value of the assets and liabilities transferred to
Folksamerica recorded in the accompanying financial statements at closing are as
follows (in millions):
<TABLE>
<S> <C>
Fixed maturities, short-term investments and accrued investment income $ 249.9
Premiums receivable 108.6
Reinsurance recoverable 73.2
Deferred policy acquisition costs 23.2
Deferred income tax asset 13.5
Other insurance assets 47.0
--------
Total Assets $ 515.4
--------
Reserve for claims and claims expenses $ 371.6
Net unearned premium reserve 103.4
Reinsurance premiums payable 9.5
Other insurance liabilities 29.8
--------
Total Liabilities $ 514.3
--------
Net book value of assets and liabilities transferred $ 1.1
========
</TABLE>
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 were in-force were notified that
Folksamerica had assumed Arch Re's obligations and that, unless the reinsureds
object to the assumption, Arch Re will be released from its obligations to those
reinsureds. None of such reinsureds objected to the assumption and, accordingly,
gross liabilities for such business have been removed from the accounts of Arch
Re for statutory and GAAP accounting purposes. However, Arch Re will continue to
be liable under those reinsurance agreements if the notice is found not to be an
effective release by the reinsureds. Folksamerica has agreed to indemnify us for
any losses arising out of the reinsurance agreements transferred to Folksamerica
Reinsurance Company in the asset sale. However, in the event that Folksamerica
refuses or is unable to perform its obligations to us, Arch Re may incur losses
relating to the reinsurance agreements transferred in the asset sale.
See Note 9 to the accompanying consolidated financial statements.
FUTURE OPERATIONS
Our 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. Accordingly, the financial and
operational risks that we may encounter in the future cannot be specified.
RESULTS OF OPERATIONS
We had consolidated comprehensive income for the three months ended
September 30, 2000 of $13.1 million, which was composed of net income of $2.3
million and other comprehensive income of $10.8 million, consisting of the
change in after-tax unrealized appreciation of investments. Net income for the
three months ended September 30, 2000 included after-tax realized investment
gains of $473,000 and equity in net income of investees of $544,000. These
amounts compare with comprehensive loss for the 1999 third quarter of $10.5
million, which was composed of net loss of $3.7 million and other comprehensive
loss of $6.8 million, consisting of the change in after-tax unrealized
appreciation of investments. The 1999 third quarter net income included
after-tax realized investment gains of $3.4 million and equity in net income of
investees of $400,000.
We had consolidated comprehensive loss for the nine months ended September
30, 2000 of $19.7 million, which was composed of net income of $5.5 million and
other comprehensive loss of $25.2 million, consisting
22
<PAGE>
of the change in after-tax unrealized appreciation of investments. Net income
for the nine months ended September 30, 2000 included after-tax realized
investment gains of $19.3 million and equity in net income of investees of $1.2
million. These amounts compare with comprehensive loss for the nine months ended
September 30, 1999 of $37.3 million, which was composed of net loss of $12.9
million and other comprehensive loss of $24.4 million, consisting of the change
in after-tax unrealized appreciation of investments. Net loss for the nine
months ended September 30, 1999 included after-tax realized investment gains of
approximately $17.9 million, equity in net income of investees of $433,000 and a
loss of $383,000 from the cumulative effect of an accounting change.
Following is a table of per share data for the three and nine month periods
ended September 30, 2000 and 1999 on an after-tax basis:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2000 1999 2000 1999
------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
BASIC AND DILUTED EARNINGS PER SHARE:
Underwriting loss ($ 0.69) ($ 1.64) ($ 2.44)
Net investment income $ 0.10 0.25 0.67 0.64
Net realized investment gains 0.04 0.20 1.43 1.04
Equity in net income of investees 0.04 0.02 0.09 0.03
(Loss) on sale of reinsurance operations (0.14)
Cumulative effect of accounting change (0.02)
------------- ------------ ------------ ------------
Net income (loss) 0.18 (0.22) 0.41 (0.75)
Change in net unrealized appreciation
(depreciation) of investments 0.88 (0.39) (1.88) (1.43)
------------- ------------ ------------ ------------
Comprehensive income (loss) $ 1.06 ($ 0.61) ($ 1.47) ($ 2.18)
============= ============ ============ ============
Average shares outstanding (000's)
Basic 12,403 17,088 13,429 17,087
Diluted 12,405 17,088 13,431 17,087
</TABLE>
23
<PAGE>
The sale of our reinsurance operations to Folksamerica resulted in a net
book value gain of approximately $3.4 million, or $0.27 per share, based on
12,400,117 shares outstanding, which amount includes the post-closing
adjustments described above (See "--General--Folksamerica Transaction"). The net
book value gain on the sale of our reinsurance operations is calculated as
follows (in millions):
<TABLE>
<S> <C>
Gain on sale $ 7.5
Tax expense (1) 4.1
------
Net gain 3.4
Realized (loss) on securities transferred at market value (2) (5.3)
------
Net (loss) (1.9)
Change in after-tax unrealized depreciation of investments (2) 5.3
------
Comprehensive income and net book value gain $ 3.4
======
</TABLE>
(1) The related income tax expense includes a charge of $1.5 million resulting
from our deferred tax asset valuation allowance.
(2) The related income tax benefit of $1.9 million was offset by an equivalent
deferred tax asset valuation allowance.
See Note 9 to the accompanying consolidated financial statements.
At September 30, 2000, consolidated stockholders' equity totaled $268.4
million, compared with $346.5 million at December 31, 1999. On a diluted basis,
book value per share was $21.63 based on 12,411,644 shares outstanding at
September 30, 2000, which included dilutive options outstanding, compared with
$20.28 based on 17,087,970 shares outstanding at December 31, 1999. At September
30, 2000, book value and per share amounts reflect the repurchase from XL
Capital Ltd of all of the 4,755,000 shares of our common stock held by it for a
total of $59.2 million, or $12.45 per share. (See Note 8 to the accompanying
consolidated financial statements).
NET PREMIUMS WRITTEN
With respect to our reinsurance operations, which were sold to Folksamerica
on May 5, 2000, net premiums written for the nine month period ended September
30, 2000 and for the three and nine month periods ended September 30, 1999 were
as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS
ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 2000 1999
------------- -------- ---------
<S> <C> <C> <C>
CORE BUSINESS
Property $ 19,633 $ 15,809 $ 58,978
Casualty 16,539 19,743 54,561
Multi-line 14,043 12,808 51,844
Other 5,917 4,224 6,686
-------- -------- --------
Sub-total Core Business 56,132 52,584 172,069
-------- -------- --------
SPECIALTY BUSINESS
Accident & Health 12,633 26,862 33,385
Aviation & Space 1,781 (1,895) 10,146
Marine 5,439 3,739 12,111
Surety & Fidelity 764 1,013 4,992
-------- -------- --------
Sub-total Specialty Business 20,617 29,719 60,634
-------- -------- --------
Unearned premium portfolio
transfer and assumption (92,907)
-------- -------- --------
Total $ 76,749 ($10,604) $232,703
======== ======== ========
</TABLE>
24
<PAGE>
Premiums written for the nine month period ended September 30, 2000 include
business recorded through May 5, 2000, the closing date of the sale of our
reinsurance operations to Folksamerica and, consequently, the comparisons with
prior periods are not meaningful. The decline in net premiums written for the
business recorded through May 5, 2000 was 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.
Set forth below are our statutory combined ratios for the nine month
periods ended September 30, 2000 (prior to recording the transfer and assumption
of reinsurance liabilities to Folksamerica on May 5, 2000) and 1999:
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
2000 1999
-------- -------
<S> <C> <C>
Claims and claims expenses 87.1% 96.0%
Commissions and brokerage 32.1 27.4
Other operating expenses 4.6 4.5
====== =====
Statutory combined ratio 123.8% 127.9%
====== =====
</TABLE>
The statutory combined ratio for the first nine months of 2000 (which
included results through May 5, 2000, the closing date of the sale of our
reinsurance operations) was adversely affected by poor underwriting results in
our aviation and property lines of business.
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.
NET INVESTMENT INCOME
Invested assets, including accrued investment income, net of investment
accounts receivable and payable, consisted of the following at September 30,
2000 compared to December 31, 1999 (in millions):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
--------------- ----------------
<S> <C> <C>
Fixed maturities
Taxable - Investment grade $ 39.5 $ 171.2
- Non-investment grade 34.7 37.6
Tax Exempt - Investment grade 52.3
Tax Exempt - Escrowed funds 20.6
-------- --------
94.8 261.1
Publicly traded equity securities 54.4 158.8
Privately held securities 58.4 83.9
Cash, short-term investments and accrued interest 65.0 86.7
-------- --------
Total $ 272.6 $ 590.5
======== ========
</TABLE>
Approximately 63% 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 2.8 years.
25
<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. On May 5, 2000, we transferred to Folksamerica $249.9
million of fixed maturities, short-term investments and accrued investment
income in connection with the sale of our reinsurance operations. All fixed
maturity and short-term investments transferred on May 5, 2000 to Folksamerica
and the securities placed in the escrow account in connection with the asset
sale are rated investment grade.
At September 30, 2000, our private equity portfolio consisted of 10
investments, having an aggregate carrying value of $58.4 million, with
additional investment portfolio commitments in the aggregate amount of
approximately $22.4 million.
See Note 5 under the caption "Investment Information" of the accompanying
notes to our consolidated financial statements for the nine months ended
September 30, 2000 for certain information regarding our publicly traded and
privately held securities and their carrying values.
After-tax net investment income for the 2000 third quarter was $2.3
million, compared with $4.2 million for the 1999 third quarter. For the first
nine months of 2000, after-tax net investment income was $8.9 million, compared
with $11.0 million for the comparable prior year period. Pre-tax and net of tax
yields were approximately 4.0% and 2.8%, respectively, for the first nine months
of 2000, compared to 3.7% and 2.8%, respectively, for the same prior year
period. Our yields have moderately increased as proceeds from the sales of
public equity securities have been allocated into fixed maturity and short-term
investments over the last several quarterly periods.
Our sources of net realized investment gain (losses) for the three and nine
month periods ended September 30, 2000 were as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, 2000
-----------------------------
<S> <C> <C>
Fixed maturities ($ 294) ($ 3,235)
Publicly traded equity securities 358 35,892
Privately held securities 664 (2,996)
-------- --------
Sub-total 728 29,661
Fixed maturities transferred to
Folksamerica -- (5,330)
-------- --------
Total $ 728 $ 24,331
======== ========
</TABLE>
During the nine months ended September 30, 2000, 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 write-down of
$3.2 million in the carrying value of our investment in Altus Holdings, Ltd., a
write-down of $250,000 in the carrying value of our investment in GuideStar, and
a net loss of $487,000 resulting from the disposition of our investment in LARC
Holdings, Ltd. The realized loss was partially offset by a profit distribution
of $764,000 from Trident II. (See Note 5 to the accompanying consolidated
financial statements.)
The change in after-tax net unrealized appreciation of investments of $25.2
million for the first nine months ended September 30, 2000 reflects the
following (in millions):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999 CHANGE
------------- ------------ -------
<S> <C> <C> <C>
Pre-tax unrealized appreciation (depreciation) $ 3.1 $ 41.8 ($ 38.7)
Deferred income tax (benefit) expense 1.1 14.6 (13.5)
------ ------- -------
After-tax unrealized appreciation (depreciation) $ 2.0 $ 27.2 ($ 25.2)
====== ======= =======
</TABLE>
26
<PAGE>
During the 2000 fourth quarter, we expect to sell a portion of our
investment portfolio that had unrealized depreciation at September 30, 2000 to
enable us to capture tax benefits associated with the realization of losses that
would otherwise be permanently disallowed upon distribution of the securities in
the reorganization, although there can be no assurances that we will be able to
complete such sales.
INCOME TAXES
As of September 30, 2000, we have established a deferred income tax asset
valuation allowance of $10.2 million that adjusts our deferred income tax asset
to its estimated realizable value of approximately $2.5 million. Such deferred
income tax asset is net of a deferred income tax liability of $1.1 million,
representing a future income tax liability for the cumulative unrealized
appreciation of investments of $3.1 million. Deferred income tax expense for the
nine months ended September 30, 2000 included a charge for such allowance of
$10.2 million. (See Note 6 to the accompanying consolidated financial
statements.)
LIQUIDITY AND CAPITAL RESOURCES
Prior to our redomestication to Bermuda on November 8, 2000 (see
"-General--Bermuda Reorganization" and Note 10 to the accompanying consolidated
financial statements), we did not have any significant assets other than our
ownership of the capital stock of Arch Re. Accordingly, we relied on the cash
dividends and distributions from Arch Re to make payments, including for any
operating expenses. Arch Re's ability to pay dividends or make distributions to
us is dependent upon its ability to meet the applicable regulatory standards of
the State of Nebraska, which require, among other things, that Arch Re obtain
the prior approval of the Nebraska Director of Insurance before paying dividends
or making distributions in certain circumstances.
In connection with our reorganization, and following the approval of the
Nebraska Director under the applicable regulatory standards, Arch Re is
distributing to us approximately $223 million of its net assets, which
distribution is being completed during the 2000 fourth quarter. After reflecting
this distribution, and assuming September 30, 2000 values, our primary sources
of liquidity include $126.9 million in liquid short-term and fixed maturity
investments and $41.9 million in publicly traded equity securities. Our invested
assets also include $57.5 million in privately held securities, which are
generally restricted as to resale, do not have readily ascertainable market
values or are otherwise illiquid. Arch Re and Cross River Insurance Company, our
insurance subsidiaries which are subject to the above regulatory standards of
the State of Nebraska, will continue to have an aggregate surplus of
approximately $24 million in order to maintain the insurance licenses and other
authorizations they currently hold. Investments that are restricted or
unavailable for liquidity purposes also include $20.6 million of fixed maturity
investments currently held in escrow for a period of five years under the terms
of the asset purchase agreement with Folksamerica. In addition, we have
investment commitments relating to our privately held securities totaling
approximately $22.4 million. See Notes 5 and 9 to the accompanying consolidated
financial statements.
Net cash flow provided by operating activities for the nine months ended
September 30, 2000 and the comparable prior year period was approximately $2.1
million and $32.2 million, respectively, consisting principally of premiums
received, investment income (excluding net realized investment gains), offset by
operating costs and expenses.
We do not currently have any material commitments for 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 investment income. Our objective
is to pursue business combinations and ventures with operating businesses and,
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.
27
<PAGE>
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 September 30, 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:
o the availability of acquisition candidates and other investments on
attractive terms;
o competition, including increased competition;
o changes in the performance of the insurance sector of the public
equity markets or market professionals' views as to such sector;
o general economic conditions;
o regulatory changes and conditions;
o claims development and losses, including as to the frequency or
severity of claims and losses and the timing of claim reports, on
aviation business and business produced by a certain managing
underwriting agency for which the Company has retained exposure
under certain indemnity obligations to Folksamerica Holding Company,
Inc. and Folksamerica Reinsurance Company in connection with the
sale of the Company's reinsurance business to Folksamerica;
o our future business operations and strategy; and
o loss of key personnel.
In addition to risks and uncertainties related to the Company's business,
the proposed acquisition of Hales is subject to various risks and uncertainties
including, but not limited to, the risks the conditions to closing will not be
satisfied as well as risks relating to the successful integration of Hales'
business.
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.
28
<PAGE>
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.
29
<PAGE>
PART II. OTHER INFORMATION
ITEM 2. CHANGE IN SECURITIES AND USE OF PROCEEDS
Upon consummation of the reorganization discussed in Note 10 of our
consolidated financial statements, the holders of common stock of the
Company became holders of common shares of Arch Capital Group-Bermuda.
There are significant differences in the rights of holders of common
shares of Arch Capital Group-Bermuda as compared to the rights of
holders of common stock of the Company, because of differences in
Bermuda law and Delaware law and in the constituent documents of the
two companies. These differences are described in our proxy statements
for the annual meeting of stockholders held on November 6, 2000 under
the captions "Description of Authorized Shares of Arch Capital
Group-Bermuda" and "Comparison of Rights of Shareholders."
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS.
EXHIBIT NO. DESCRIPTION
----------- ---------------------------------------------------
10.1.1 Restricted Share Agreement--Peter A. Appel (dated April
24, 2000)
10.1.2 Restricted Share Agreements--Robert Clements (dated May 5,
2000)
10.2.1 Stock Option Agreement--Peter A. Appel (dated April 24,
2000)
10.2.2 Stock Option Agreements--Debra M. O'Connor and Louis T.
Petrillo (dated May 5, 2000)
10.2.3 Amendment to Stock Option Agreements--Robert Clements
(March 22, 2000)
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 a report on Form 8-K during the three month period
ended September 30, 2000 on September 8, 2000 providing information on
the sale of the Company's reinsurance operations to Folksamerica
Reinsurance Company. In addition, the Company filed a report on Form
8-K on November 8, 2000 to report the consummation of its
redomestication to Bermuda.
Omitted from this Part II are items which are inapplicable or to which
the answer is negative for the period covered.
30
<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.
ARCH CAPITAL GROUP LTD.
------------------------------------
(REGISTRANT)
/s/ Peter A. Appel
------------------------------------
Peter A. Appel
Date: November 13, 2000 President & Chief Executive Officer
/s/ Debra M. O'Connor
------------------------------------
Date: November 13, 2000 Debra M. O'Connor
Senior Vice President, Controller &
Treasurer
31
<PAGE>
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
----------- ---------------------------------------------------
10.1.1 Restricted Share Agreement--Peter A. Appel (dated April
24, 2000)
10.1.2 Restricted Share Agreements--Robert Clements (dated May 5,
2000)
10.2.1 Stock Option Agreement--Peter A. Appel (dated April 24,
2000)
10.2.2 Stock Option Agreements--Debra M. O'Connor and Louis T.
Petrillo (dated May 5, 2000)
10.2.3 Amendment to Stock Option Agreements--Robert Clements
(March 22, 2000)
15 Accountants' Awareness Letter and Limitation of Liability
(regarding unaudited interim financial information)
27 Financial Data Schedule
