filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements and, therefore, undue reliance should not be placed on them. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the sections entitled “Cautionary Note Regarding Forward-Looking Statements,” and “Risk Factors.”
This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto presented under Item 8. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted.
GENERAL
OVERVIEW
Arch Capital Group Ltd. (“ACGL” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with approximately $10.49 billion in capital at December 31, 2016 and, through operations in Bermuda, the United States, Europe and Canada, writes specialty lines of property and casualty insurance and reinsurance, as well as mortgage insurance and reinsurance, on a worldwide basis. It is our belief that our underwriting platform, our experienced management team and our strong capital base have enabled us to establish a strong presence in the insurance and reinsurance markets.
The worldwide property casualty insurance and reinsurance industry is highly competitive and has traditionally been subject to an underwriting cycle in which a hard market (high premium rates, restrictive underwriting standards, as well as terms and conditions, and underwriting gains) is eventually followed by a soft market (low premium rates, relaxed underwriting standards, as well as broader terms and conditions, and underwriting losses). Property casualty market conditions may affect, among other things, the demand for our products, our ability to increase premium rates, the terms and conditions of the insurance policies we write, changes in the products offered by us or changes in our business strategy.
The financial results of the property casualty insurance and reinsurance industry are influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in
interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence, among other things, the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market.
Mortgage insurance and reinsurance is subject to similar cycles to property casualty except that they have historically been more dependent on macroeconomic conditions.
CURRENT OUTLOOK
The broad property casualty insurance market environment continues to be competitive in our property/casualty business, consistent with our view in prior quarters. In our insurance segment, we experienced a slight deterioration in rates across certain sectors, while there are signs that reinsurance terms, especially ceding commissions, have bottomed out. This has led us to continue to reduce writings in certain property casualty lines in 2016. With the continued low interest rate environment, additional price increases are needed in many lines in order for us to achieve our return requirements. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts and by utilizing reinsurance purchases to reduce volatility on large account, high capacity business.
Our mortgage operations continue to experience favorable market conditions. Within the U.S. mortgage insurance sector, we continued to expand into the marketplace. Our market share continued to increase, reflecting growth in the bank channel and the impact of RateStar, our risk-based pricing program, which has met with wide acceptance from bank and credit union clients. In addition, international business and credit risk-sharing transactions continue to provide growth opportunities for our mortgage operations.
In addition, on August 15, 2016, we entered into a Stock Purchase Agreement (the “Stock Purchase Agreement”) with American International Group, Inc. (“AIG”) pursuant to which we agreed to purchase from AIG all of the issued and outstanding shares of capital stock of United Guaranty Corporation, a North Carolina corporation (“UGC”). The acquisition under the Stock Purchase Agreement is referred to herein as the “UGC acquisition.”
On December 31, 2016, the UGC acquisition was completed. As such, our balance sheet reflects the acquisition of UGC while our results of operations for 2016 do not include UGC activity other than the impact of capital raising activity and transaction
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costs. The aggregate purchase price paid by ACGL was approximately $3.26 billion, consisting of cash consideration of $2.16 billion and convertible non-voting common-equivalent preference shares of ACGL with a fair value of $1.10 billion.
Our objective is to achieve an average operating return on average equity of 15% or greater over the insurance cycle, as opposed to any one calendar year, which we believe to be an attractive return to our common shareholders given the risks we assume. We continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline and continue to write a portion of our overall book in catastrophe-exposed business which has the potential to increase the volatility of our operating results.
Changing economic conditions could have a material impact on the frequency and severity of claims and, therefore, could negatively impact our underwriting returns. In addition, volatility in the financial markets could continue to significantly affect our investment returns, reported results and shareholders’ equity. We consider the potential impact of economic trends in the estimation process for establishing unpaid losses and loss adjustment expenses and in determining our investment strategies. In addition, weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with potential downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio.
NATURAL CATASTROPHE RISK
We monitor our natural catastrophe risk globally for all perils and regions, in each case, where we believe there is significant exposure. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. Currently, we seek to limit our 1-in-250 year return period net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders’ equity available to Arch. We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of January 1, 2017, our modeled peak zone catastrophe exposure is a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $492 million, followed by windstorms affecting the Gulf of Mexico and Florida Tri-County with net probable maximum
pre-tax losses of $427 million and $394 million, respectively. Our exposures to other perils, such as U.S. earthquake and international events, were less than the exposures arising from U.S. windstorms and hurricanes in both periods. As of January 1, 2017, our modeled peak zone earthquake exposure (Los Angeles area earthquake) represented approximately 61% of our peak zone catastrophe exposure, and our modeled peak zone international exposure (Japan earthquake) was substantially less than both our peak zone windstorm and earthquake exposures.
Net probable maximum pre-tax loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. The loss estimates shown above do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer a net loss greater than 25% of total shareholders' equity available to Arch from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event. Actual losses may also increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See “Risk Factors—Risk Relating to Our Industry” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Natural and Man-Made Catastrophic Events.”
FINANCIAL MEASURES
Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for ACGL’s common shareholders:
Book Value per Share
Book value per share represents total common shareholders’ equity available to Arch divided by the number of common shares and common share equivalents outstanding. Management uses growth in book value per share as a key measure of the value generated for our common shareholders each period and believes that book value per share is the key driver of ACGL’s share price over time. Book value per share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an
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accretive or dilutive impact on book value per share depending on the purchase price. Book value per share was $55.19 at December 31, 2016, a 15.8% increase from $47.64 at December 31, 2015. The growth in 2016 was primarily generated through underwriting and investment returns and benefited from the accretive impact of fair valuing our convertible non-voting common equivalent preferred shares issued as part of the UGC acquisition.
Operating Return on Average Common Equity
Operating return on average common equity (“Operating ROAE”) represents annualized after-tax operating income available to Arch common shareholders divided by average common shareholders’ equity available to Arch during the period. After-tax operating income available to Arch common shareholders, a “non-GAAP measure” as defined in the SEC rules, represents net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to Arch common shareholders and has set an objective to achieve an average Operating ROAE of 15% or greater over the insurance cycle, as opposed to any one calendar year, which it believes to be an attractive return to common shareholders given the risks we assume. See “Comment on Non-GAAP Financial Measures.” Our Operating ROAE was 9.4% for 2016, compared to 9.7% for 2015 and 11.2% for 2014. The lower Operating ROAE for 2016 primarily reflected a higher level of average equity than in 2015, which more than offset a higher level of after-tax operating income.
Total Return on Investments
Total return on investments includes investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by Arch’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses excluding amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. Management uses total return on investments as a key measure of the return generated to Arch common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods.
The following table summarizes the pre-tax total return (before investment expenses) of investment held by Arch compared to the benchmark return (both based in U.S. Dollars) against which we measured our portfolio during the periods:
| Arch Portfolio (1) | Benchmark Return | ||
| Pre-tax total return (before investment expenses): | |||
| Year Ended December 31, 2016 | 2.07% | 2.13% | |
| Year Ended December 31, 2015 | 0.41% | -0.38% | |
| Year Ended December 31, 2014 | 3.21% | 2.58% |
| (1) | Our investment expenses were approximately 0.34%, 0.35% and 0.28%, respectively, of average invested assets in 2016, 2015 and 2014. |
Total return for our investment portfolio underperformed that of the benchmark return index in 2016 and primarily reflected low investment returns on our investment grade fixed income portfolio, partially offset by strong returns on non-investment grade fixed income and alternatives. Total return was impacted by strengthening of the U.S. Dollar against a number of major currencies which reduced total return on non-U.S. Dollar denominated investments during 2016. Excluding foreign exchange, total return was 2.35% for 2016, compared to 1.62% for 2015 and 4.26% for 2014.
The benchmark return index is a customized combination of indices intended to approximate a target portfolio by asset mix and average credit quality while also matching the approximate estimated duration and currency mix of our insurance and reinsurance liabilities. Although the estimated duration and average credit quality of this index will move as the duration and rating of its constituent securities change, generally we do not adjust the composition of the benchmark return index except to incorporate changes to the mix of liability currencies and durations noted above. The benchmark return index should not be interpreted as expressing a preference for or aversion to any particular sector or sector weight. The index is intended solely to provide, unlike many master indices that change based on the size of their constituent indices, a relatively stable basket of investable indices. At December 31, 2016, the benchmark return index had an average credit quality of “Aa2” by Moody’s Investors Service (“Moody’s”), an estimated duration of 3.57 years.
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The benchmark return index included weightings to the following indices, which are primarily from The Bank of America Merrill Lynch (“BoAML”):
| % | ||
| BoAML 1-10 Year AA U.S. Corporate & Yankees Index | 21.25 | % |
| BoAML 1-5 Year U.S. Treasury Index | 13.00 | |
| BoAML U.S. Mortgage Backed Securities Index | 10.00 | |
| BoAML 3-5 Year Fixed Rate Asset Backed Securities Index | 7.00 | |
| BoAML 1-10 Year U.S. Municipal Securities Index | 7.00 | |
| BoAML U.S. High Yield Constrained Index | 5.50 | |
| BoAML 0-3 Month U.S. Treasury Bill Index | 5.00 | |
| Barclays CMBS Inv. Grade, AAA Rated Index | 5.00 | |
| Barclays Agency Bullet, 1-10 Year Index | 5.00 | |
| MSCI All Country World Gross Total Return Index | 5.00 | |
| BoAML 1-10 Year Euro Government Index | 4.50 | |
| BoAML 5-10 Year U.S. Treasury Index | 3.25 | |
| BoAML 1-5 Year U.K. Gilt Index | 3.00 | |
| BoAML 1-10 Year Australian Governments Index | 2.50 | |
| BoAML 1-5 Year Canada Government Index | 1.50 | |
| BoAML Euro Government Index | 1.00 | |
| BoAML 20+ Year Canada Government Index | 0.50 | |
| Total | 100.00 | % |
COMMENT ON NON-GAAP FINANCIAL MEASURES
Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to Arch common shareholders, which is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and other and income taxes, and the use of annualized operating return on average common equity. The presentation of after-tax operating income available to Arch common shareholders and annualized operating return on average common equity are non-GAAP financial measures as defined in Regulation G. The reconciliation of such measures to net income available to Arch common shareholders and annualized return on average common equity (the most directly comparable GAAP financial measures) in accordance with Regulation G is included under “Results of Operations” below.
We believe that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for
using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. UGC transaction costs and other include non-recurring advisory, financing, legal and other transaction costs related to the UGC acquisition and non-recurring expenses related to a change in our approach on the deferral of certain internal underwriting costs which are no longer being deferred. We believe that UGC transaction costs and other, due to their non-recurring nature, are not indicative of the performance of, or trends in, our business performance. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses and UGC transaction costs and other from the calculation of after-tax operating income available to Arch common shareholders.
We believe that showing net income available to Arch common shareholders exclusive of the items referred to above reflects the underlying fundamentals of our business since we evaluate the performance of and manage our business to produce an underwriting profit. In addition to presenting net income available to Arch common shareholders, we believe that this presentation enables investors and other users of our financial information to analyze our performance in a manner similar to how management analyzes performance. We also believe that this measure follows industry practice and, therefore, allows the users of financial information to compare our performance with our industry peer group. We believe that the equity analysts
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and certain rating agencies which follow us and the insurance industry as a whole generally exclude these items from their analyses for the same reasons.
Our segment information includes the presentation of consolidated underwriting income or loss and a subtotal of underwriting income or loss before the contribution from the ‘other’ segment. Such measures represent the pre-tax profitability of our underwriting operations and include net premiums earned plus other underwriting income, less losses and loss adjustment expenses, acquisition expenses and other operating expenses. Other operating expenses include those operating expenses that are incremental and/or directly attributable to our individual underwriting operations. Underwriting income or loss does not incorporate items included in our corporate (non-underwriting) segment. While these measures are presented in Note 5, “Segment Information,” of the notes accompanying our consolidated financial statements, they are considered non-GAAP financial measures when presented elsewhere on a consolidated basis. The reconciliations of underwriting income or loss to income before income taxes (the most directly comparable GAAP financial measure) on a consolidated basis and a subtotal before the contribution from the ‘other’ segment, in accordance with Regulation G, is shown in Note 5, “Segment Information” of the notes accompanying our consolidated financial statements.
We measure segment performance for our three underwriting segments based on underwriting income or loss. We do not manage our assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income and other non-underwriting related items are not allocated to each underwriting segment. For the ‘other’ segment, performance is measured based on net income or loss.
Along with consolidated underwriting income, we provide a subtotal of underwriting income or loss before the contribution from the ‘other’ segment. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. Watford Re has its own management and board of directors that is responsible for its overall profitability. In addition, we do not guarantee or provide credit support for Watford Re. Since Watford Re is an independent company, the assets of Watford Re can be used only to settle obligations of Watford Re and Watford Re is solely responsible for its own liabilities and commitments. Our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions. We believe that presenting certain information excluding the ‘other’ segment enables investors and other users of our financial
information to analyze our performance in a manner similar to how our management analyzes performance.
Our presentation of segment information includes the use of a current year loss ratio which excludes favorable or adverse development in prior year loss reserves. This ratio is a non-GAAP financial measure as defined in Regulation G. The reconciliation of such measure to the loss ratio (the most directly comparable GAAP financial measure) in accordance with Regulation G is shown on the individual segment pages. Management utilizes the current year loss ratio in its analysis of the underwriting performance of each of our underwriting segments.
Total return on investments includes investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by Arch’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses, excludes amounts reflected in the ‘other’ segment, and reflects the effect of financial market conditions along with foreign currency fluctuations. In addition, total return incorporates the timing of investment returns during the periods. There is no directly comparable GAAP financial measure for total return. Management uses total return on investments as a key measure of the return generated to Arch common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against benchmark returns which we measured our portfolio against during the periods.
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RESULTS OF OPERATIONS
The following table summarizes our consolidated financial data, including a reconciliation of net income available to Arch common shareholders to after-tax operating income available to Arch common shareholders. Each line item reflects the impact of our approximate 11% ownership of Watford Re’s common equity.
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | 2014 | |||||||||
| Net income available to Arch common shareholders | $ | 664,668 | $ | 515,800 | $ | 812,417 | |||||
| Net realized (gains) losses | (77,081 | ) | 108,690 | (130,026 | ) | ||||||
| Net impairment losses recognized in earnings | 30,442 | 20,116 | 30,150 | ||||||||
| Equity in net (income) loss of investment funds accounted for using the equity method | (48,475 | ) | (25,456 | ) | (19,883 | ) | |||||
| Net foreign exchange (gains) losses | (31,987 | ) | (63,011 | ) | (82,777 | ) | |||||
| UGC transaction costs and other | 41,729 | — | — | ||||||||
| Income tax expense (benefit) | (1,852 | ) | 9,060 | 7,431 | |||||||
| After-tax operating income available to Arch common shareholders | $ | 577,444 | $ | 565,199 | $ | 617,312 | |||||
| Beginning common shareholders’ equity | $ | 5,841,542 | $ | 5,766,714 | $ | 5,284,157 | |||||
| Ending common shareholders’ equity | 7,481,163 | 5,841,542 | 5,766,714 | ||||||||
| Average common shareholders’ equity (1) | $ | 6,113,718 | $ | 5,804,128 | $ | 5,525,436 | |||||
| Annualized return on average common equity % | 10.9 | 8.9 | 14.7 | ||||||||
| Annualized operating return on average common equity % | 9.4 | 9.7 | 11.2 |
(1) Average common shareholders’ equity and the related returns on average common equity reflect the weighted impact of the $1.10 billion of convertible non-voting common equivalent preferred shares, which were issued on December 31, 2016 as part of the UGC acquisition.
Results in all periods presented reflected the impact of current insurance and reinsurance market conditions and the impact of low interest yields on our investment portfolio.
Segment Information
We classify our businesses into three underwriting segments — insurance, reinsurance and mortgage — and two other operating segments — corporate (non-underwriting) and ‘other.’ Our insurance, reinsurance and mortgage segments each have managers who are responsible for the overall profitability of their respective segments and who are directly accountable to our chief operating decision makers, the Chairman and Chief
Executive Officer, the President and Chief Operating Officer, and the Chief Financial Officer of ACGL. The chief operating decision makers do not assess performance, measure return on equity or make resource allocation decisions on a line of business basis. Management measures segment performance for our three underwriting segments based on underwriting income or loss. We do not manage our assets by underwriting segment, with the exception of goodwill and intangible assets, and, accordingly, investment income is not allocated to each underwriting segment.
We determined our reportable segments using the management approach described in accounting guidance regarding disclosures about segments of an enterprise and related information. The accounting policies of the segments are the same as those used for the preparation of our consolidated financial statements. Intersegment business is allocated to the segment accountable for the underwriting results.
Insurance Segment
The following table sets forth our insurance segment’s underwriting results:
| Year Ended December 31, | ||||||||||
| 2016 | 2015 | % Change | ||||||||
| Gross premiums written | $ | 3,027,049 | $ | 2,944,018 | 2.8 | |||||
| Premiums ceded | (954,768 | ) | (898,347 | ) | ||||||
| Net premiums written | 2,072,281 | 2,045,671 | 1.3 | |||||||
| Change in unearned premiums | 1,623 | (863 | ) | |||||||
| Net premiums earned | 2,073,904 | 2,044,808 | 1.4 | |||||||
| Other underwriting income | — | 1,993 | ||||||||
| Losses and loss adjustment expenses | (1,359,313 | ) | (1,292,647 | ) | ||||||
| Acquisition expenses | (304,066 | ) | (299,317 | ) | ||||||
| Other operating expenses | (353,782 | ) | (354,416 | ) | ||||||
| Underwriting income (loss) | $ | 56,743 | $ | 100,421 | (43.5 | ) | ||||
| Underwriting Ratios | % Point Change | |||||||||
| Loss ratio | 65.5 | % | 63.2 | % | 2.3 | |||||
| Acquisition expense ratio | 14.7 | % | 14.6 | % | 0.1 | |||||
| Other operating expense ratio | 17.1 | % | 17.3 | % | (0.2 | ) | ||||
| Combined ratio | 97.3 | % | 95.1 | % | 2.2 |
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| Year Ended December 31, | ||||||||||
| 2015 | 2014 | % Change | ||||||||
| Gross premiums written | $ | 2,944,018 | $ | 3,008,669 | (2.1 | ) | ||||
| Premiums ceded | (898,347 | ) | (862,015 | ) | ||||||
| Net premiums written | 2,045,671 | 2,146,654 | (4.7 | ) | ||||||
| Change in unearned premiums | (863 | ) | (129,284 | ) | ||||||
| Net premiums earned | 2,044,808 | 2,017,370 | 1.4 | |||||||
| Other underwriting income | 1,993 | 2,135 | ||||||||
| Losses and loss adjustment expenses | (1,292,647 | ) | (1,260,953 | ) | ||||||
| Acquisition expenses | (299,317 | ) | (316,308 | ) | ||||||
| Other operating expenses | (354,416 | ) | (335,157 | ) | ||||||
| Underwriting income (loss) | $ | 100,421 | $ | 107,087 | (6.2 | ) | ||||
| Underwriting Ratios | % Point Change | |||||||||
| Loss ratio | 63.2 | % | 62.5 | % | 0.7 | |||||
| Acquisition expense ratio | 14.6 | % | 15.7 | % | (1.1 | ) | ||||
| Other operating expense ratio | 17.3 | % | 16.6 | % | 0.7 | |||||
| Combined ratio | 95.1 | % | 94.8 | % | 0.3 |
The insurance segment consists of our insurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include:
| • | Construction and national accounts: primary and excess casualty coverages to middle and large accounts in the construction industry and a wide range of products for middle and large national accounts, specializing in loss sensitive primary casualty insurance programs (including large deductible, self-insured retention and retrospectively rated programs). |
| • | Excess and surplus casualty: primary and excess casualty insurance coverages, including middle market energy business, and contract binding, which primarily provides casualty coverage through a network of appointed agents to small and medium risks. |
| • | Lenders products: collateral protection, debt cancellation and service contract reimbursement products to banks, credit unions, automotive dealerships and original equipment manufacturers and other specialty programs that pertain to automotive lending and leasing. |
| • | Professional lines: directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity and other financial related coverages for corporate, private equity, venture capital, real estate investment trust, limited partnership, financial institution and not-for-profit clients of all sizes and medical professional and general liability insurance coverages for the healthcare industry. The business is predominately written on a claims-made basis. |
| • | Programs: primarily package policies, underwriting workers’ compensation and umbrella liability business in support of desirable package programs, targeting program managers with unique expertise and niche products |
offering general liability, commercial automobile, inland marine and property business with minimal catastrophe exposure.
| • | Property, energy, marine and aviation: primary and excess general property insurance coverages, including catastrophe-exposed property coverage, for commercial clients. Coverages for marine include hull, war, specie and liability. Aviation and stand-alone terrorism are also offered. |
| • | Travel, accident and health: specialty travel and accident and related insurance products for individual, group travelers, travel agents and suppliers, as well as accident and health, which provides accident, disability and medical plan insurance coverages for employer groups, medical plan members, students and other participant groups. |
| • | Other: includes alternative market risks (including captive insurance programs), excess workers’ compensation and employer’s liability insurance coverages for qualified self-insured groups, associations and trusts, and contract and commercial surety coverages, including contract bonds (payment and performance bonds) primarily for medium and large contractors and commercial surety bonds for Fortune 1000 companies and smaller transaction business programs. |
Premiums Written.
The following table sets forth our insurance segment’s net premiums written by major line of business:
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Professional lines | $ | 440,149 | 21.2 | $ | 434,024 | 21.2 | |||||
| Construction and national accounts | 328,997 | 15.9 | 299,463 | 14.6 | |||||||
| Programs | 330,322 | 15.9 | 423,157 | 20.7 | |||||||
| Travel, accident and health | 224,380 | 10.8 | 160,132 | 7.8 | |||||||
| Excess and surplus casualty | 214,863 | 10.4 | 204,856 | 10.0 | |||||||
| Property, energy, marine and aviation | 175,376 | 8.5 | 203,186 | 9.9 | |||||||
| Lenders products | 105,650 | 5.1 | 106,916 | 5.2 | |||||||
| Other | 252,544 | 12.2 | 213,937 | 10.5 | |||||||
| Total | $ | 2,072,281 | 100.0 | $ | 2,045,671 | 100.0 |
2016 versus 2015: Net premiums written by the insurance segment were 1.3% higher in 2016 than in 2015. The increase in net premiums written reflected growth in travel, accident and health, construction and national accounts and alternative markets business, partially offset by a reduction in programs and property lines. The growth in travel, accident and health reflected both new business and continued expansion in existing accounts. The increase in construction and national accounts
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primarily reflected new business and audit premiums while the increase in alternative markets resulted from new accounts, exposure growth and audit premiums. The reduction in program business primarily reflected the continued impact of the non-renewal of a large program in the latter part of 2015 while the lower level of net premiums written in property lines reflected continued weak market conditions.
| Year Ended December 31, | |||||||||||
| 2015 | 2014 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Professional lines | $ | 434,024 | 21.2 | $ | 476,604 | 22.2 | |||||
| Construction and national accounts | 299,463 | 14.6 | 286,994 | 13.4 | |||||||
| Programs | 423,157 | 20.7 | 480,580 | 22.4 | |||||||
| Travel, accident and health | 160,132 | 7.8 | 145,732 | 6.8 | |||||||
| Excess and surplus casualty | 204,856 | 10.0 | 212,519 | 9.9 | |||||||
| Property, energy, marine and aviation | 203,186 | 9.9 | 244,640 | 11.4 | |||||||
| Lenders products | 106,916 | 5.2 | 100,407 | 4.7 | |||||||
| Other | 213,937 | 10.5 | 199,178 | 9.3 | |||||||
| Total | $ | 2,045,671 | 100.0 | $ | 2,146,654 | 100.0 |
2015 versus 2014: Net premiums written by the insurance segment were 4.7% lower in 2015 than in 2014. Decreases in programs, property, energy, marine and aviation and professional lines were partially offset by increases in travel, accident and health and construction and national accounts. The reduction in program business primarily reflected the non-renewal of a large program and underwriting decisions to terminate two programs while the lower level of property, energy, marine and aviation and professional lines reflected the timing of premiums and market conditions. Growth in travel, accident and health reflects primarily resulted from expansion in existing and new distribution channels while the increase in construction and national accounts included new business and higher audit and endorsement premium on national accounts.
Net Premiums Earned.
The following table sets forth our insurance segment’s net premiums earned by major line of business:
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Professional lines | $ | 431,391 | 20.8 | $ | 424,968 | 20.8 | |||||
| Construction and national accounts | 322,072 | 15.5 | 296,828 | 14.5 | |||||||
| Programs | 357,715 | 17.2 | 446,512 | 21.8 | |||||||
| Travel, accident and health | 219,169 | 10.6 | 153,578 | 7.5 | |||||||
| Excess and surplus casualty | 219,046 | 10.6 | 208,091 | 10.2 | |||||||
| Property, energy, marine and aviation | 188,938 | 9.1 | 216,127 | 10.6 | |||||||
| Lenders products | 98,517 | 4.8 | 90,906 | 4.4 | |||||||
| Other | 237,056 | 11.4 | 207,798 | 10.2 | |||||||
| Total | $ | 2,073,904 | 100.0 | $ | 2,044,808 | 100.0 |
| Year Ended December 31, | |||||||||||
| 2015 | 2014 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Professional lines | $ | 424,968 | 20.8 | $ | 456,508 | 22.6 | |||||
| Construction and national accounts | 296,828 | 14.5 | 277,811 | 13.8 | |||||||
| Programs | 446,512 | 21.8 | 460,392 | 22.8 | |||||||
| Travel, accident and health | 153,578 | 7.5 | 127,691 | 6.3 | |||||||
| Excess and surplus casualty | 208,091 | 10.2 | 182,024 | 9.0 | |||||||
| Property, energy, marine and aviation | 216,127 | 10.6 | 244,974 | 12.1 | |||||||
| Lenders products | 90,906 | 4.4 | 94,438 | 4.7 | |||||||
| Other | 207,798 | 10.2 | 173,532 | 8.6 | |||||||
| Total | $ | 2,044,808 | 100.0 | $ | 2,017,370 | 100.0 |
Net premiums earned by the insurance segment were 1.4% higher in 2016 than in 2015, reflecting changes in net premiums written over the previous five quarters. Net premiums earned by the insurance segment were 1.4% higher in 2015 than in 2014.
Losses and Loss Adjustment Expenses.
The table below shows the components of the insurance segment’s loss ratio:
| Year Ended December 31, | ||||||||
| 2016 | 2015 | 2014 | ||||||
| Current year | 67.1 | % | 65.5 | % | 65.4 | % | ||
| Prior period reserve development | (1.6 | )% | (2.3 | )% | (2.9 | )% | ||
| Loss ratio | 65.5 | % | 63.2 | % | 62.5 | % |
| ACGL 2016 FORM 10-K | 81 |
Current Year Loss Ratio.
2016 versus 2015: The insurance segment’s current year loss ratio was 1.6 points higher in 2016 than in 2015. The 2016 loss ratio included 2.2 points of current year catastrophic event activity, compared to 1.0 points in 2015. The 2016 loss ratio reflected changes in the mix of business.
2015 versus 2014: The insurance segment’s current year loss ratio was 0.1 points higher in 2015 than in 2014. The 2015 loss ratio included 1.0 points of current year catastrophic event activity, compared to 0.7 points in 2014. The 2015 loss ratio reflected changes in the mix of business.
Prior Period Reserve Development.
2016 prior period reserve development: The insurance segment’s net favorable development of $33.1 million, or 1.6 points of net earned premium, consisted of $8.7 million of net favorable development from short-tailed lines and $24.4 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines predominantly consisted of $17.2 million of net favorable development in property lines, primarily from the 2008 to 2014 accident years (i.e., the year in which a loss occurred), partially offset by $11.1 million of adverse development on travel, accident and health business from the 2012 to 2015 accident years. Contained within the short tail release in property lines was favorable development of $11.3 million from named catastrophic events from prior accident years. Net favorable development in medium-tailed and long-tailed lines of $24.4 million included $53.8 million of net favorable development on professional lines, primarily from the 2008 to 2012 accident years, partially offset by $33.1 million of net adverse development in program business, primarily from the 2013 to 2015 accident years. The adverse development in program business was driven by a few inactive programs that were non-renewed in 2015 and early in 2016.
2015 prior period reserve development: The insurance segment’s net favorable development of $47.2 million, or 2.3 points of net earned premium, consisted of $27.3 million of net favorable development from short-tailed lines and $19.9 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines predominantly consisted of $32.4 million of net favorable development in property lines, primarily from the 2011 to 2014 accident years. Contained within this short tail release was favorable development of $5.7 million from named catastrophic events from prior accident years. Net favorable development in medium-tailed and long-tailed lines of $19.9 million included $29.7 million of net favorable development on professional lines, primarily from the 2005 to 2010 accident years, partially offset by $15.0 million of net adverse development in program business, primarily from the 2013 and 2014 accident years. The adverse development in program business was driven by a few
inactive programs that were non-renewed in 2015 and early in 2016.
2014 prior period reserve development: The insurance segment’s net favorable development of $58.7 million, or 2.9 points of net earned premium, consisted of $73.5 million of net favorable development from short-tailed lines, partially offset by $14.8 million of net adverse development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines predominantly consisted of $60.5 million of net favorable development in property lines, primarily from the 2008 to 2013 accident years, with the balance emanating from lenders products, primarily from the 2012 accident year, and travel and accident, primarily from the 2012 and 2013 accident years. Contained within this short tail release was favorable development of $7.9 million from named catastrophic events from prior accident years. Net adverse development in medium-tailed and long-tailed lines of $14.8 million included a net increase of $41.3 million in construction reserves, primarily from the 2009 to 2013 accident years. The adverse development in construction was largely driven by general liability claims involving New York labor law matters. In addition, the insurance segment experienced $26.2 million of net adverse development in program business, primarily from the 2011 and 2012 accident years. Such amounts were partially offset by $39.0 million of net favorable development on professional lines, primarily from the 2003 to 2011 accident years, and $7.8 million of net favorable development on surety business, primarily from the 2011 to 2013 accident years.
Underwriting Expenses.
2016 versus 2015: The insurance segment’s underwriting expense ratio was 31.8% in 2016, compared to 31.9% in 2015. The acquisition expense ratio was 14.7% for 2016, compared to 14.6% for 2015. The insurance segment’s other operating expense ratio was 17.1% for 2016, compared to 17.3% for 2015. The comparison of the underwriting expense ratios and the underlying acquisition expense and other operating expense ratios were generally flat in 2016 when compared to 2015.
2015 versus 2014: The insurance segment’s underwriting expense ratio was 31.9% in 2015, compared to 32.3% in 2014. The acquisition expense ratio was 14.6% for 2015, compared to 15.7%for 2014. The insurance segment’s other operating expense ratio was 17.3% for 2015, compared to 16.6% for 2014. The comparison of the underwriting expense ratios and the underlying acquisition expense and other operating expense ratios reflects an increase in the level of business ceded on a quota share basis in 2015 and changes in the mix business.
| ACGL 2016 FORM 10-K | 82 |
Reinsurance Segment
The following table sets forth our reinsurance segment’s underwriting results:
| Year Ended December 31, | ||||||||||
| 2016 | 2015 | % Change | ||||||||
| Gross premiums written | $ | 1,494,397 | $ | 1,419,022 | 5.3 | |||||
| Premiums ceded | (440,541 | ) | (380,614 | ) | ||||||
| Net premiums written | 1,053,856 | 1,038,408 | 1.5 | |||||||
| Change in unearned premiums | 2,376 | 38,727 | ||||||||
| Net premiums earned | 1,056,232 | 1,077,135 | (1.9 | ) | ||||||
| Other underwriting income | 36,403 | 10,606 | ||||||||
| Losses and loss adjustment expenses | (475,762 | ) | (440,350 | ) | ||||||
| Acquisition expenses | (212,375 | ) | (223,632 | ) | ||||||
| Other operating expenses | (143,408 | ) | (155,811 | ) | ||||||
| Underwriting income | $ | 261,090 | $ | 267,948 | (2.6 | ) | ||||
| Underwriting Ratios | % Point Change | |||||||||
| Loss ratio | 45.0 | % | 40.9 | % | 4.1 | |||||
| Acquisition expense ratio | 20.1 | % | 20.8 | % | (0.7 | ) | ||||
| Other operating expense ratio | 13.6 | % | 14.5 | % | (0.9 | ) | ||||
| Combined ratio | 78.7 | % | 76.2 | % | 2.5 |
| Year Ended December 31, | ||||||||||
| 2015 | 2014 | % Change | ||||||||
| Gross premiums written | $ | 1,419,022 | $ | 1,527,245 | (7.1 | ) | ||||
| Premiums ceded | (380,614 | ) | (261,254 | ) | ||||||
| Net premiums written | 1,038,408 | 1,265,991 | (18.0 | ) | ||||||
| Change in unearned premiums | 38,727 | 13,337 | ||||||||
| Net premiums earned | 1,077,135 | 1,279,328 | (15.8 | ) | ||||||
| Other underwriting income | 10,606 | 3,167 | ||||||||
| Losses and loss adjustment expenses | (440,350 | ) | (532,450 | ) | ||||||
| Acquisition expenses | (223,632 | ) | (261,438 | ) | ||||||
| Other operating expenses | (155,811 | ) | (147,964 | ) | ||||||
| Underwriting income | $ | 267,948 | $ | 340,643 | (21.3 | ) | ||||
| Underwriting Ratios | % Point Change | |||||||||
| Loss ratio | 40.9 | % | 41.6 | % | (0.7 | ) | ||||
| Acquisition expense ratio | 20.8 | % | 20.4 | % | 0.4 | |||||
| Other operating expense ratio | 14.5 | % | 11.6 | % | 2.9 | |||||
| Combined ratio | 76.2 | % | 73.6 | % | 2.6 |
The reinsurance segment consists of our reinsurance underwriting units which offer specialty product lines on a worldwide basis. Product lines include:
| • | Casualty: provides coverage to ceding company clients on third party liability and workers’ compensation exposures from ceding company clients, primarily on a treaty basis. Exposures include, among others, executive assurance, professional liability, workers’ compensation, excess and umbrella liability, excess motor and healthcare business. |
| • | Marine and aviation: provides coverage for energy, hull, cargo, specie, liability and transit, and aviation business, including airline and general aviation risks. Business written may also include space business, which includes coverages for satellite assembly, launch and operation for commercial space programs. |
| • | Other specialty: provides coverage to ceding company clients for proportional motor and other lines, including surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and political risk. |
| • | Property catastrophe: provides protection for most catastrophic losses that are covered in the underlying policies written by reinsureds, including hurricane, earthquake, flood, tornado, hail and fire, and coverage for other perils on a case-by-case basis. Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and loss adjustment expense from a single occurrence or aggregation of losses from a covered peril exceed the retention specified in the contract. |
| • | Property excluding property catastrophe: provides coverage for both personal lines and commercial property exposures and principally covers buildings, structures, equipment and contents. The primary perils in this business include fire, explosion, collapse, riot, vandalism, wind, tornado, flood and earthquake. Business is assumed on both a proportional and excess of loss basis. In addition, facultative business is written which focuses on individual commercial property risks on an excess of loss basis. |
| • | Other: includes life reinsurance business on both a proportional and non-proportional basis, casualty clash business and, in limited instances, non-traditional business which is intended to provide insurers with risk management solutions that complement traditional reinsurance. |
| ACGL 2016 FORM 10-K | 83 |
Premiums Written.
The following table sets forth our reinsurance segment’s net premiums written by major line of business:
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Other specialty | $ | 348,852 | 33.1 | $ | 298,794 | 28.8 | |||||
| Casualty | 305,252 | 29.0 | 303,093 | 29.2 | |||||||
| Property excluding property catastrophe | 267,548 | 25.4 | 280,511 | 27.0 | |||||||
| Property catastrophe | 75,789 | 7.2 | 91,620 | 8.8 | |||||||
| Marine and aviation | 37,790 | 3.6 | 50,834 | 4.9 | |||||||
| Other | 18,625 | 1.8 | 13,556 | 1.3 | |||||||
| Total | $ | 1,053,856 | 100.0 | $ | 1,038,408 | 100.0 | |||||
| Pro rata | $ | 558,671 | 53.0 | $ | 537,556 | 51.8 | |||||
| Excess of loss | 495,185 | 47.0 | 500,852 | 48.2 | |||||||
| Total | $ | 1,053,856 | 100.0 | $ | 1,038,408 | 100.0 |
2016 versus 2015: Gross premiums written by the reinsurance segment in 2016 were 5.3% higher than in 2015, while net premiums written were 1.5% higher than in 2015. Premiums written reflects the 2016 second quarter loss portfolio transfer in the other specialty line which resulted in $52.1 million of gross premiums written and $40.2 million of net premiums written. Such premium was substantially earned in the period and resulted in a corresponding increase to losses and loss adjustment expenses. Excluding the loss portfolio transfer, net premiums written were lower by 2.4%, reflecting decreases in property (both catastrophe and non-catastrophe exposed) and marine and aviation lines, reflecting a higher level of ceded premiums and competitive market conditions.
| Year Ended December 31, | |||||||||||
| 2015 | 2014 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Other specialty | $ | 298,794 | 28.8 | $ | 405,126 | 32.0 | |||||
| Casualty | 303,093 | 29.2 | 317,996 | 25.1 | |||||||
| Property excluding property catastrophe | 280,511 | 27.0 | 343,043 | 27.1 | |||||||
| Property catastrophe | 91,620 | 8.8 | 137,471 | 10.9 | |||||||
| Marine and aviation | 50,834 | 4.9 | 50,444 | 4.0 | |||||||
| Other | 13,556 | 1.3 | 11,911 | 0.9 | |||||||
| Total | $ | 1,038,408 | 100.0 | $ | 1,265,991 | 100.0 | |||||
| Pro rata | $ | 537,556 | 51.8 | $ | 663,135 | 52.4 | |||||
| Excess of loss | 500,852 | 48.2 | 602,856 | 47.6 | |||||||
| Total | $ | 1,038,408 | 100.0 | $ | 1,265,991 | 100.0 |
2015 versus 2014: Gross premiums written by the reinsurance segment in 2015 were 7.1% lower than in 2014, while net premiums written were 18.0% lower than in 2014. The differential in gross versus net premiums written primarily reflects increased cessions to the ‘other’ segment (Watford Re) in 2015 compared to 2014. In addition, the decline in net premiums written reflected reductions in property lines and
other specialty business. The reduction in property catastrophe business reflected non-renewals and share decreases in response to current market conditions and a higher usage of retrocessional coverage. In addition, property excluding property catastrophe business in 2014 included an incoming unearned premium portfolio transfer of $50.2 million from Gulf Reinsurance Limited (“Gulf Re”) which we subsequently acquired in 2015. The decrease in other specialty business reflected non-renewals and share decreases in response to current market conditions, primarily in proportional motor contracts.
Net Premiums Earned.
The following table sets forth our reinsurance segment’s net premiums earned by major line of business:
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Other specialty | $ | 329,994 | 31.2 | $ | 311,307 | 28.9 | |||||
| Casualty | 300,160 | 28.4 | 310,249 | 28.8 | |||||||
| Property excluding property catastrophe | 282,018 | 26.7 | 295,487 | 27.4 | |||||||
| Property catastrophe | 73,803 | 7.0 | 96,865 | 9.0 | |||||||
| Marine and aviation | 52,579 | 5.0 | 50,808 | 4.7 | |||||||
| Other | 17,678 | 1.7 | 12,419 | 1.2 | |||||||
| Total | $ | 1,056,232 | 100.0 | $ | 1,077,135 | 100.0 | |||||
| Pro rata | $ | 561,986 | 53.2 | $ | 563,585 | 52.3 | |||||
| Excess of loss | 494,246 | 46.8 | 513,550 | 47.7 | |||||||
| Total | $ | 1,056,232 | 100.0 | $ | 1,077,135 | 100.0 |
| Year Ended December 31, | |||||||||||
| 2015 | 2014 | ||||||||||
| Amount | % | Amount | % | ||||||||
| Other specialty | $ | 311,307 | 28.9 | $ | 424,725 | 33.2 | |||||
| Casualty | 310,249 | 28.8 | 327,518 | 25.6 | |||||||
| Property excluding property catastrophe | 295,487 | 27.4 | 303,496 | 23.7 | |||||||
| Property catastrophe | 96,865 | 9.0 | 150,761 | 11.8 | |||||||
| Marine and aviation | 50,808 | 4.7 | 61,118 | 4.8 | |||||||
| Other | 12,419 | 1.2 | 11,710 | 0.9 | |||||||
| Total | $ | 1,077,135 | 100.0 | $ | 1,279,328 | 100.0 | |||||
| Pro rata | $ | 563,585 | 52.3 | $ | 686,201 | 53.6 | |||||
| Excess of loss | 513,550 | 47.7 | 593,127 | 46.4 | |||||||
| Total | $ | 1,077,135 | 100.0 | $ | 1,279,328 | 100.0 |
Net premiums earned in 2016 were 1.9% lower than in 2015, reflecting changes in net premiums written over the previous five quarters, including the mix and type of business written and a higher level of retrocessions. Net premiums earned in 2015 were 15.8% lower than in 2014.
| ACGL 2016 FORM 10-K | 84 |
Other Underwriting Income.
Other underwriting income in 2016 was $36.4 million, compared to $10.6 million in 2015 and $3.2 million in 2014. The 2016 period included $19.1 million related to a contract which was commuted during the 2016 second quarter. This contract had been reflected as a deposit accounting liability (i.e., a contract that, in accordance with GAAP, does not pass risk transfer) prior to the commutation.
Losses and Loss Adjustment Expenses.
The table below shows the components of the reinsurance segment’s loss ratio:
| Year Ended December 31, | ||||||||
| 2016 | 2015 | 2014 | ||||||
| Current year | 65.7 | % | 61.8 | % | 62.5 | % | ||
| Prior period reserve development | (20.7 | )% | (20.9 | )% | (20.9 | )% | ||
| Loss ratio | 45.0 | % | 40.9 | % | 41.6 | % |
Current Year Loss Ratio.
2016 versus 2015: The reinsurance segment’s current year loss ratio was 3.9 points higher in 2016 than in 2015. The 2016 loss ratio included 4.1 points for current year catastrophic event activity, compared to 3.5 points in 2015. The 2016 current year loss ratio reflected a significantly lower contribution from property lines than in 2015. In addition, the loss ratio for 2016 reflects the impact of the loss portfolio transfer noted above (net premiums earned at a high loss ratio), which increased the current year loss ratio by 2.1 points.
2015 versus 2014: The reinsurance segment’s current year loss ratio was 0.7 points lower in 2015 than in 2014. The 2015 loss ratio included 3.5 points for current year catastrophic event activity, compared to 3.5 points in 2014. The 2015 current year loss ratio reflected a significantly lower contribution from property lines than in 2014.
Prior Period Reserve Development.
2016 prior period reserve development: The reinsurance segment’s net favorable development of $218.8 million, or 20.7 points of net earned premium, consisted of $133.8 million from short-tailed lines and $85.0 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines included $113.6 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2009 to 2015 underwriting years (i.e., losses attributable to contracts having an inception or renewal date within the given twelve-month period). Contained within this release was favorable development of $8.7 million from named catastrophic events from prior accident years. The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity
than previously anticipated which led to decreases in certain loss ratio selections during 2016. Net favorable development of $85.0 million in medium-tailed and long-tailed lines included reductions in casualty reserves of $86.1 million, primarily from the 2002 to 2013 underwriting years.
2015 prior period reserve development: The reinsurance segment’s net favorable development of $224.8 million, or 20.9 points of net earned premium, consisted of $107.6 million from short-tailed lines and $117.2 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines included $80.9 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2011 to 2014 underwriting years. Contained within this release was favorable development of $11.8 million from named catastrophic events from prior accident years. The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2015. Net favorable development of $117.2 million in medium-tailed and long-tailed lines included reductions in casualty reserves of $99.7 million, primarily from the 2003 to 2006 underwriting years and the 2008 and 2009 underwriting years, and marine and aviation reserves of $11.7 million, primarily from the 2008 to 2012 underwriting years. The balance of net favorable development was spread across various lines and underwriting years.
2014 prior period reserve development: The reinsurance segment’s net favorable development of $267.3 million, or 20.9 points of net earned premium, consisted of $146.7 million from short-tailed lines and $120.6 million of net favorable development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines included $107.6 million from property catastrophe and property other than property catastrophe reserves, primarily from the 2011 to 2013 underwriting years. Contained within this release was favorable development of $23.3 million from the named catastrophic events from prior accident years. The net reduction of loss estimates for the reinsurance segment’s short-tailed lines primarily resulted from varying levels of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2014. Net favorable development of $120.6 million in medium-tailed and long-tailed lines included reductions in casualty reserves of $101.6 million, primarily from the 2003 to 2006 underwriting years and the 2009 and 2010 underwriting years, and marine and aviation reserves of $14.7 million, primarily from the 2008 to 2012 underwriting years. The balance of net favorable development was spread across various lines and underwriting years.
| ACGL 2016 FORM 10-K | 85 |
Underwriting Expenses.
2016 versus 2015: The underwriting expense ratio for the reinsurance segment was 33.7% in 2016, compared to 35.3% in 2015. The 2016 ratio reflected approximately 1.3 points of benefit from the loss portfolio transfer noted above (net premiums earned with no related expenses). The acquisition expense ratio for 2016 was 20.1%, compared to 20.8% for 2015 while the operating expense ratio for 2016 was 13.6%, compared to 14.5% for 2015.
2015 versus 2014: The underwriting expense ratio for the reinsurance segment was 35.3% in 2015, compared to 32.0% in 2014. The acquisition expense ratio for 2015 was 20.8%, compared to 20.4% for 2014. The comparison of the 2015 and 2014 acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commissions incurred. The operating expense ratio for 2015 of 14.5% was higher than the 2014 ratio of 11.6% primarily reflecting a lower level of net premiums earned.
Mortgage Segment
Our mortgage operations include U.S. and international mortgage insurance and reinsurance operations as well as GSE credit risk sharing transactions. Our mortgage group includes direct mortgage insurance in the U.S. primarily provided by Arch Mortgage Insurance Company (“AMIC”) and operating subsidiaries of UGC as well as through Arch Mortgage Guaranty Company; mortgage reinsurance provided primarily by Arch Re Bermuda to mortgage insurers on both a proportional and non-proportional basis globally; direct mortgage insurance in Europe provided by Arch Mortgage Insurance Designated Activity Company (“Arch MI Europe”); and various GSE credit risk-sharing products provided primarily by Arch Re Bermuda.
AMIC, United Guaranty Residential Insurance Company and United Guaranty Mortgage Indemnity Company have each been approved as an eligible mortgage insurer by Fannie Mae and Freddie Mac, subject to maintaining certain ongoing requirements.
The UGC acquisition was completed on December 31, 2016. As such, the mortgage segment’s results for 2016 do not reflect UGC activity.
The following table sets forth our mortgage segment’s underwriting results:
| Year Ended December 31, | ||||||||||
| 2016 | 2015 | % Change | ||||||||
| Gross premiums written | $ | 499,725 | $ | 295,557 | 69.1 | |||||
| Premiums ceded | (108,259 | ) | (28,064 | ) | ||||||
| Net premiums written | 391,466 | 267,493 | 46.3 | |||||||
| Change in unearned premiums | (104,750 | ) | (53,383 | ) | ||||||
| Net premiums earned | 286,716 | 214,110 | 33.9 | |||||||
| Other underwriting income | 17,024 | 18,430 | ||||||||
| Losses and loss adjustment expenses | (28,943 | ) | (40,247 | ) | ||||||
| Acquisition expenses | (32,065 | ) | (45,076 | ) | ||||||
| Other operating expenses | (101,293 | ) | (82,370 | ) | ||||||
| Underwriting income | $ | 141,439 | $ | 64,847 | 118.1 | |||||
| Underwriting Ratios | % Point Change | |||||||||
| Loss ratio | 10.1 | % | 18.8 | % | (8.7 | ) | ||||
| Acquisition expense ratio | 11.2 | % | 21.1 | % | (9.9 | ) | ||||
| Other operating expense ratio | 35.3 | % | 38.5 | % | (3.2 | ) | ||||
| Combined ratio | 56.6 | % | 78.4 | % | (21.8 | ) |
| Year Ended December 31, | ||||||||||
| 2015 | 2014 | % Change | ||||||||
| Gross premiums written | $ | 295,557 | $ | 227,356 | 30.0 | |||||
| Premiums ceded | (28,064 | ) | (22,519 | ) | ||||||
| Net premiums written | 267,493 | 204,837 | 30.6 | |||||||
| Change in unearned premiums | (53,383 | ) | (11,264 | ) | ||||||
| Net premiums earned | 214,110 | 193,573 | 10.6 | |||||||
| Other underwriting income | 18,430 | 4,840 | ||||||||
| Losses and loss adjustment expenses | (40,247 | ) | (55,674 | ) | ||||||
| Acquisition expenses | (45,076 | ) | (49,400 | ) | ||||||
| Other operating expenses | (82,370 | ) | (66,891 | ) | ||||||
| Underwriting income | $ | 64,847 | $ | 26,448 | 145.2 | |||||
| Underwriting Ratios | % Point Change | |||||||||
| Loss ratio | 18.8 | % | 28.8 | % | (10.0 | ) | ||||
| Acquisition expense ratio | 21.1 | % | 25.5 | % | (4.4 | ) | ||||
| Other operating expense ratio | 38.5 | % | 34.6 | % | 3.9 | |||||
| Combined ratio | 78.4 | % | 88.9 | % | (10.5 | ) |
| ACGL 2016 FORM 10-K | 86 |
Premiums Written.
The following table sets forth our mortgage segment’s net premiums written by client location and underwriting location (i.e., where the business is underwritten):
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | 2014 | |||||||||
| Net premiums written by client location | |||||||||||
| United States | $ | 280,509 | $ | 193,617 | $ | 184,333 | |||||
| Other | 110,957 | 73,876 | 20,504 | ||||||||
| Total | $ | 391,466 | $ | 267,493 | $ | 204,837 | |||||
| Net premiums written by underwriting location | |||||||||||
| United States | $ | 186,826 | $ | 125,317 | $ | 98,809 | |||||
| Other | 204,640 | 142,176 | 106,028 | ||||||||
| Total | $ | 391,466 | $ | 267,493 | $ | 204,837 |
2016 versus 2015: Gross premiums written by the mortgage segment in 2016 were 69.1% higher than in 2015, reflecting growth in Australian mortgage reinsurance, in U.S. primary business and from GSE credit risk-sharing transactions receiving insurance accounting treatment. The lower increase in net premiums written of 46.3% reflected retrocessions on Australian mortgage reinsurance business covering exposures written since May 2015, including a substantial portion representing catch up premiums.
The persistency rate of the U.S. primary portfolio of mortgage loans (combined AMIC and UGC) was 76.1% at December 31, 2016. The persistency rate represents the percentage of mortgage insurance in force at the beginning of a 12-month period that remains in force at the end of such period. In addition, net premiums written in 2016 reflected an increase in GSE credit risk-sharing transactions accounted for under insurance accounting guidance.
2015 versus 2014: Net premiums written in 2015 included new Australian mortgage reinsurance business, which is primarily a single premium market, and an increase in business written by AMIC compared to 2014.
AMIC generated $26.87 billion of new insurance written (“NIW”) during 2016. NIW represents the original principal balance of all loans that received coverage during the period.
Net Premiums Earned.
The following table sets forth our mortgage segment’s net premiums earned by client location and underwriting location (i.e., where the business is underwritten):
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | 2014 | |||||||||
| Net premiums earned by client location | |||||||||||
| United States | $ | 265,527 | $ | 202,930 | $ | 187,194 | |||||
| Other | 21,189 | 11,180 | 6,379 | ||||||||
| Total | $ | 286,716 | $ | 214,110 | $ | 193,573 | |||||
| Net premiums earned by underwriting location | |||||||||||
| United States | $ | 155,929 | $ | 113,062 | $ | 92,236 | |||||
| Other | 130,787 | 101,048 | 101,337 | ||||||||
| Total | $ | 286,716 | $ | 214,110 | $ | 193,573 |
Net premiums earned for 2016 was substantially higher than in 2015, primarily due to the growth of AMIC’s business along with a higher earned contribution from the mortgage segment’s quota share reinsurance business. Growth from 2014 to 2015 primarily reflects growth of AMIC.
Other Underwriting Income.
Other underwriting income, which is primarily related to GSE risk-sharing transactions receiving derivative accounting treatment, was $17.0 million for 2016, compared to $18.4 million for 2015 and $4.8 million for 2014.
Losses and Loss Adjustment Expenses.
The table below shows the components of the mortgage segment’s loss ratio:
| Year Ended December 31, | ||||||||
| 2016 | 2015 | 2014 | ||||||
| Current year | 17.5 | % | 24.5 | % | 29.3 | % | ||
| Prior period reserve development | (7.4 | )% | (5.7 | )% | (0.5 | )% | ||
| Loss ratio | 10.1 | % | 18.8 | % | 28.8 | % |
Unlike property and casualty business for which we estimate ultimate losses on premiums earned, losses on mortgage insurance business are only recorded at the time a borrower is delinquent on their mortgage, in accordance with primary mortgage insurance industry practice. Because our primary mortgage insurance reserving process does not take into account the impact of future losses from loans that are not in default, mortgage insurance loss reserves are not an estimate of ultimate losses. In addition to establishing loss reserves for loans in default, under GAAP, we are required to establish a premium deficiency reserve for our mortgage insurance products if the amount of expected future losses and
| ACGL 2016 FORM 10-K | 87 |
maintenance costs exceeds expected future premiums, existing reserves and the anticipated investment income for such product. We evaluate whether a premium deficiency exists quarterly. No such reserve was established during 2016.
Current Year Loss Ratio.
The mortgage segment’s current year loss ratio was 7.0 points lower in 2016 compared to 2015 and 4.8 points lower in 2015 compared to 2014. The current year loss ratio for 2016 reflects changes in the mix of business earned, when compared to 2015, and the impact of a decrease in the number of delinquent loans and a lower claim rate on such loans. The lower current year loss ratio for 2015 compared to 2014 also reflected changes in the mix of business earned and a decrease in delinquent loans and claim rates.
Prior Period Reserve Development.
The mortgage segment’s net favorable development was $21.2 million, or 7.4 points, for 2016, compared to $12.3 million, or 5.7 points, for 2015 and $0.9 million, or 0.5 points, for 2014.The mortgage segment’s net favorable development for 2016 included $18.5 million of favorable development on AMIC business, reflecting a decrease in the number of delinquent loans and a lower claim rate on such loans. Such development was primarily from the 2004 to 2008 and 2014 origination years. The mortgage segment also experienced net favorable development of $2.7 million on U.S. mortgage reinsurance business.
Underwriting Expenses.
2016 versus 2015: The underwriting expense ratio for the mortgage segment was 46.5% for 2016, compared to 59.6% for 2015. The acquisition expense ratio was 11.2% for 2016, compared to 21.1% for 2015. The operating expense ratio was 35.3% for 2016, compared to 38.5% for 2015. The decrease in the underwriting expense ratio reflects the expansion of the mortgage segment’s insurance in force in 2016.
2015 versus 2014: The underwriting expense ratio for the mortgage segment was 59.6% for 2015, compared to 60.1% for 2014. The acquisition expense ratio was 21.1% for 2015, compared to 25.5% for 2014. The operating expense ratio was 38.5% for 2015, compared to 34.6% for 2014, reflecting efforts to expand the mortgage segment’s underwriting platform in 2015.
Corporate (Non-Underwriting) Segment
The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, interest expense, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method, net foreign exchange gains or losses, UGC transaction costs and
other, income taxes and items related to our non-cumulative preferred shares. Such amounts exclude the results of the ‘other’ segment.
Net Investment Income.
The components of net investment income were derived from the following sources:
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | 2014 | |||||||||
| Fixed maturities | $ | 242,310 | $ | 241,389 | $ | 257,387 | |||||
| Term loan investments | 26,550 | 19,290 | 21,521 | ||||||||
| Equity securities | 13,823 | 14,339 | 13,005 | ||||||||
| Short-term investments | 3,619 | 574 | 904 | ||||||||
| Other (1) | 39,750 | 41,721 | 28,803 | ||||||||
| Gross investment income | 326,052 | 317,313 | 321,620 | ||||||||
| Investment expenses (2) | (48,859 | ) | (45,633 | ) | (37,284 | ) | |||||
| Net investment income | $ | 277,193 | $ | 271,680 | $ | 284,336 |
| (1) | Amounts include dividends and income distributions on investment funds and other items. |
| (2) | Investment expenses were approximately 0.34% of average invested assets for 2016, compared to 0.35% for 2015 and 0.28% for 2014. |
The pre-tax investment income yield was 1.92% for 2016, compared to 2.06% for 2015 and 2.08% for 2014. The comparability of net investment income between the periods was influenced by our share repurchase program, as well as the decrease in the pre-tax investment income yield, due in part to the prevailing interest rate environment. The pre-tax investment income yields were calculated based on amortized cost. Yields on future investment income may vary based on financial market conditions, investment allocation decisions and other factors.
Corporate Expenses.
Corporate expenses were $49.4 million for 2016, compared to $49.7 million for 2015 and $47.6 million for 2014. Such amounts primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly traded company.
Interest Expense.
Interest expense was $53.5 million for 2016, compared to $41.5 million for 2015 and $45.6 million for 2014. Interest expense reflects amounts related to our outstanding senior notes, revolving credit agreement borrowings and other. The lower level of interest expense for 2015 primarily resulted from a reduction in interest expense in the 2015 second quarter on a deposit accounting liability contract. Such contract was commuted in the 2016 second quarter. We issued $950.0 million
| ACGL 2016 FORM 10-K | 88 |
of senior notes in December 2016 in connection with the UGC acquisition and borrowed $400.0 million on our revolving credit agreement. As such, our borrowing costs for 2017 will be higher than in 2016 and prior periods.
Net Realized Gains (Losses).
We recorded net realized gains of $69.6 million for 2016, compared to net realized losses of $99.1 million for 2015 and net realized gains of $133.4 million for 2014. Currently, our portfolio is actively managed to maximize total return within certain guidelines. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. Net realized gains or losses from the sale of fixed maturities primarily results from our decisions to reduce credit exposure, to change duration targets, to rebalance our portfolios or due to relative value determinations. Net realized gains or losses also includes realized and unrealized contract gains and losses on our derivative instruments, changes in the fair value of assets and liabilities accounted for using the fair value option along with re-measurement of contingent consideration liability amounts.
Net Impairment Losses Recognized in Earnings.
For 2016, we recorded $30.4 million of credit related impairments in earnings, compared to $20.1 million in 2015 and $30.2 million in 2014. The impairment losses recorded in 2016 included reductions on two asset backed securities based on information received from external investment managers and a review of cash flow projections in order to determine expected recovery values. In addition, impairment losses included reductions on certain corporate bonds, equities and other investments, with smaller contributions from other sectors. See note 9, “Investment Information—Other-Than-Temporary Impairments,” of the notes accompanying our consolidated financial statements for additional information.
Equity in Net Income (Loss) of Investment Funds Accounted for Using the Equity Method.
We recorded $48.5 million of equity in net income related to investment funds accounted for using the equity method for 2016, compared to $25.5 million for 2015 and $19.9 million for 2014. Investment funds accounted for using the equity method totaled $811.3 million at December 31, 2016, compared to $593.0 million at December 31, 2015.
Net Foreign Exchange Gains or Losses.
Net foreign exchange gains for 2016 were $31.4 million, compared to net foreign exchange gains for 2015 of $62.6 million and net foreign exchange gains for 2014 of $82.7 million million. Amounts in such periods were primarily unrealized and resulted from the effects of revaluing our net insurance
liabilities required to be settled in foreign currencies at each balance sheet date.
UGC Transaction Costs and Other.
UGC transaction costs and other were $41.7 million for 2016. UGC transaction costs, which relate to non-recurring costs such as advisory, financing, legal, etc. related to the UGC acquisition discussed below, were $32.3 million. In addition, we recorded an out-of-period charge of $9.4 million in the 2016 fourth quarter related to a change in our accounting policy with respect to deferred acquisition costs. This change in accounting policy, which was reflected retroactively in our financial statements, also resulted in adjustments to the deferred acquisition costs, other assets, and retained earnings accounts on the balance sheet. See note 1, “General,” of the notes accompanying our consolidated financial statements for additional information.
Income Tax Expense.
Our income tax provision on income before income taxes resulted in an expense of 4.3% for 2016, compared to an expense of 7.0% for 2015 and an expense of 2.7% for 2014. Our effective tax rate fluctuates from year to year consistent with the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction. See note 14, “Income Taxes,” of the notes accompanying our consolidated financial statements for a reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average statutory tax rate for 2016, 2015 and 2014.
Other Segment
The ‘other’ segment includes the results of Watford Re. Pursuant to generally accepted accounting principles, Watford Re is considered a variable interest entity and we concluded that we are the primary beneficiary of Watford Re. As such, we consolidate the results of Watford Re in our consolidated financial statements, although we only own approximately 11% of Watford Re’s common equity. See note 4, “Variable Interest Entity and Noncontrolling Interests” and note 5, “Segment Information,” of the notes accompanying our consolidated financial statements for additional information.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RECENT ACCOUNTING PRONOUNCEMENTS
The preparation of consolidated financial statements in accordance with GAAP requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance
| ACGL 2016 FORM 10-K | 89 |
recoverables, allowance for doubtful accounts, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to us through December 31, 2016. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies affect significant estimates used in the preparation of our consolidated financial statements.
Reserves for Losses and Loss Adjustment Expenses
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses (“Loss Reserves”) that arise from the business we underwrite. Loss Reserves for our insurance and reinsurance operations are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured events which have occurred at or before the balance sheet date. Loss Reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
On December 31, 2016, the UGC acquisition was completed. As such, our mortgage segment Loss Reserves and disclosures in this section reflect the acquisition of UGC.
See note 7, “Short Duration Contracts,” of the notes accompanying our consolidated financial statements for additional information on our reserving process.
At December 31, 2016 and 2015, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:
| December 31, | |||||||
| 2016 | 2015 | ||||||
| Insurance: | |||||||
| Case reserves | $ | 1,414,603 | $ | 1,434,986 | |||
| IBNR reserves | 3,187,451 | 3,080,122 | |||||
| Total net reserves | 4,602,054 | 4,515,108 | |||||
| Reinsurance: | |||||||
| Case reserves | 762,730 | 699,860 | |||||
| Additional case reserves | 92,524 | 99,343 | |||||
| IBNR reserves | 1,517,983 | 1,593,186 | |||||
| Total net reserves | 2,373,237 | 2,392,389 | |||||
| Mortgage: | |||||||
| Case reserves | 593,222 | 86,278 | |||||
| IBNR reserves | 59,791 | 23,211 | |||||
| Total net reserves | 653,013 | 109,489 | |||||
| Other: | |||||||
| Case reserves | 125,703 | 64,875 | |||||
| Additional case reserves | 9,513 | 5,199 | |||||
| IBNR reserves | 353,865 | 209,353 | |||||
| Total net reserves | 489,081 | 279,427 | |||||
| Total: | |||||||
| Case reserves | 2,896,258 | 2,285,999 | |||||
| Additional case reserves | 102,037 | 104,542 | |||||
| IBNR reserves | 5,119,090 | 4,905,872 | |||||
| Total net reserves | $ | 8,117,385 | $ | 7,296,413 |
At December 31, 2016 and 2015, the insurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
| December 31, | |||||||
| 2016 | 2015 | ||||||
| Professional lines (1) | $ | 1,293,667 | $ | 1,346,882 | |||
| Construction and national accounts | 976,109 | 876,278 | |||||
| Excess and surplus casualty (2) | 687,305 | 682,286 | |||||
| Programs | 667,677 | 687,405 | |||||
| Property, energy, marine and aviation | 302,057 | 330,104 | |||||
| Travel, accident and health | 72,726 | 64,537 | |||||
| Lenders products | 42,147 | 44,273 | |||||
| Other (3) | 560,366 | 483,343 | |||||
| Total net reserves | $ | 4,602,054 | $ | 4,515,108 |
| (1) | Includes professional liability, executive assurance and healthcare business. |
| (2) | Includes casualty and contract binding business. |
| (3) | Includes alternative markets, excess workers’ compensation and surety business. |
| ACGL 2016 FORM 10-K | 90 |
At December 31, 2016 and 2015, the reinsurance segment’s Loss Reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
| December 31, | |||||||
| 2016 | 2015 | ||||||
| Casualty | $ | 1,355,362 | $ | 1,386,084 | |||
| Other specialty | 428,205 | 420,865 | |||||
| Property excluding property catastrophe | 297,200 | 301,757 | |||||
| Marine and aviation | 147,700 | 137,969 | |||||
| Property catastrophe | 86,026 | 94,991 | |||||
| Other | 58,744 | 50,723 | |||||
| Total net reserves | $ | 2,373,237 | $ | 2,392,389 |
Potential Variability in Loss Reserves
The tables below summarize the effect of reasonably likely scenarios on the key actuarial assumptions used to estimate our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, at December 31, 2016 by underwriting segment (excluding the ‘other’ segment). The scenarios shown in the tables summarize the effect of (i) changes to the expected loss ratio selections used at December 31, 2016, which represent loss ratio point increases or decreases to the expected loss ratios used, and (ii) changes to the loss development patterns used in our reserving process at December 31, 2016, which represent claims reporting that is either slower or faster than the reporting patterns used. We believe that the illustrated sensitivities are indicative of the potential variability inherent in the estimation process of those parameters. The results show the impact of varying each key actuarial assumption using the chosen sensitivity on our IBNR reserves, on a net basis and across all accident years.
| INSURANCE SEGMENT | Higher Expected Loss Ratios | Slower Loss Development Patterns | |||||
| Reserving lines selected assumptions: | |||||||
| Property, energy, marine and aviation | 5 points | 3 months | |||||
| Third party occurrence business (1) | 10 | 6 | |||||
| Third party claims-made business (2) | 10 | 6 | |||||
| All other (3) | 10 | 6 | |||||
| Increase (decrease) in Loss Reserves: | |||||||
| Property, energy, marine and aviation | $ | 15,680 | $ | 21,340 | |||
| Third party occurrence business (1) | 108,499 | 93,982 | |||||
| Third party claims-made business (2) | 224,098 | 156,134 | |||||
| All other (3) | 123,784 | 128,724 |
| INSURANCE SEGMENT | Lower Expected Loss Ratios | Faster Loss Development Patterns | |||||
| Reserving lines selected assumptions: | |||||||
| Property, energy, marine and aviation | (5) points | (3) months | |||||
| Third party occurrence business | (10) | (6) | |||||
| Third party claims-made business | (10) | (6) | |||||
| Multi-line and other specialty | (10) | (6) | |||||
| Increase (decrease) in Loss Reserves: | |||||||
| Property, energy, marine and aviation | $ | (15,680 | ) | $ | (15,992 | ) | |
| Third party occurrence business | (108,499 | ) | (76,809 | ) | |||
| Third party claims-made business | (224,098 | ) | (130,545 | ) | |||
| Multi-line and other specialty | (123,784 | ) | (102,506 | ) |
| REINSURANCE SEGMENT | Higher Expected Loss Ratios | Slower Loss Development Patterns | |||||
| Reserving lines selected assumptions: | |||||||
| Casualty | 10 points | 6 months | |||||
| Property catastrophe | 5 | 3 | |||||
| Property excluding property catastrophe | 5 | 3 | |||||
| Marine and aviation | 5 | 3 | |||||
| Other specialty | 5 | 3 | |||||
| Other | 5 | 3 | |||||
| Increase (decrease) in Loss Reserves: | |||||||
| Casualty | $ | 113,511 | $ | 132,275 | |||
| Property catastrophe | 12,799 | 14,617 | |||||
| Property excluding property catastrophe | 17,046 | 37,022 | |||||
| Marine and aviation | 7,799 | 12,099 | |||||
| Other specialty | 37,572 | 20,113 | |||||
| Other | 3,937 | 2,179 |
| REINSURANCE SEGMENT | Lower Expected Loss Ratios | Faster Loss Development Patterns | |||||
| Reserving lines selected assumptions: | |||||||
| Casualty | (10) points | (6) months | |||||
| Property catastrophe | (5) | (3) | |||||
| Property excluding property catastrophe | (5) | (3) | |||||
| Marine and aviation | (5) | (3) | |||||
| Other specialty | (5) | (3) | |||||
| Other | (5) | (3) | |||||
| Increase (decrease) in Loss Reserves: | |||||||
| Casualty | $ | (113,511 | ) | $ | (104,681 | ) | |
| Property catastrophe | (12,799 | ) | (10,296 | ) | |||
| Property excluding property catastrophe | (17,046 | ) | (35,321 | ) | |||
| Marine and aviation | (7,799 | ) | (12,251 | ) | |||
| Other specialty | (37,572 | ) | (35,161 | ) | |||
| Other | (3,937 | ) | (2,031 | ) |
| ACGL 2016 FORM 10-K | 91 |
It is not necessarily appropriate to sum the total impact for a specific factor or the total impact for a specific business category as the business categories are not perfectly correlated. In addition, the potential variability shown in the tables above are reasonably likely scenarios of changes in our key assumptions at December 31, 2016 and are not meant to be a “best case” or “worst case” series of outcomes and, therefore, it is possible that future variations may be more or less than the amounts set forth above.
For our mortgage segment, we considered the sensitivity of loss reserve estimates at December 31, 2016 by assessing the potential changes resulting from a parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in primary claim severity (which we estimate to be 32% of the unpaid principal balance at December 31, 2016), we estimated that our loss reserves would change by approximately $20.0 million at December 31, 2016. For every one percentage point change in our primary net default to claim rate (which we estimate to be approximately 38% at December 31, 2016), we estimated a $16.5 million change in our loss reserves at December 31, 2016.
Simulation Results
In order to illustrate the potential volatility in our Loss Reserves, we used a Monte Carlo simulation approach to simulate a range of results based on various probabilities. Both the probabilities and related modeling are subject to inherent uncertainties. The simulation relies on a significant number of assumptions, such as the potential for multiple entities to react similarly to external events, and includes other statistical assumptions. The simulation results shown for each segment do not add to the total simulation results, as the individual segment simulation results do not reflect the diversification effects across our segments.
At December 31, 2016, our recorded Loss Reserves by underwriting segment, net of unpaid losses and loss adjustment expenses recoverable, and the results of the simulation were as follows:
| Insurance | Reinsurance | Mortgage | Total | ||||||||||||
| Loss Reserves (1) | $4,602,054 | $2,373,237 | $653,013 | $7,628,304 | |||||||||||
| Simulation results: | |||||||||||||||
| 90th percentile (2) | $5,591,394 | $3,002,464 | $781,521 | $8,955,759 | |||||||||||
| 10th percentile (3) | $3,702,815 | $1,834,192 | $533,222 | $6,416,379 |
| (1) | Net of reinsurance recoverables. Excludes amounts reflected in the ‘other’ segment. |
| (2) | Simulation results indicate that a 90% probability exists that the net reserves for losses and loss adjustment expenses will not exceed the indicated amount. |
| (3) | Simulation results indicate that a 10% probability exists that the net reserves for losses and loss adjustment expenses will be at or below the indicated amount. |
For informational purposes, based on the total simulation results, a change in our Loss Reserves to the amount indicated at the 90th percentile would result in a decrease in income before income taxes of approximately $1.33 billion, or $10.64 per diluted share, while a change in our Loss Reserves to the amount indicated at the 10th percentile would result in an increase in income before income taxes of approximately $1.21 billion, or $9.72 per diluted share. The simulation results noted above are informational only, and no assurance can be given that our ultimate losses will not be significantly different than the simulation results shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined. We do not have significant exposure to pre-2002 liabilities, such as asbestos-related illnesses and other long-tail liabilities. It is difficult to provide meaningful trend information for certain liability/casualty coverages for which the claim-tail may be especially long, as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to us through December 31, 2016.
| ACGL 2016 FORM 10-K | 92 |
Mortgage Operations Supplemental Information
Amounts in the following tables reflect the acquisition of UGC on December 31, 2016. The mortgage segment’s insurance in force (“IIF”) and risk in force (“RIF”) were as follows for the last four quarters:
| (U.S. Dollars in millions, except policy count) | December 31, 2016 | September 30, 2016 | June 30, 2016 | March 31, 2016 | |||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | Amount | % | ||||||||||||||||||||
| Insurance In Force (IIF) (1): | |||||||||||||||||||||||||||
| U.S. mortgage insurance | $ | 234,518 | 74 | $ | 40,258 | 35 | $ | 33,367 | 31 | $ | 28,433 | 31 | |||||||||||||||
| Mortgage reinsurance | 24,315 | 8 | 22,071 | 19 | 22,242 | 21 | 22,393 | 24 | |||||||||||||||||||
| Other (3) | 56,776 | 18 | 53,826 | 46 | 52,926 | 49 | 41,172 | 45 | |||||||||||||||||||
| Total | $ | 315,609 | 100 | $ | 116,155 | 100 | $ | 108,535 | 100 | $ | 91,998 | 100 | |||||||||||||||
| Risk In Force (RIF) (2): | |||||||||||||||||||||||||||
| U.S. mortgage insurance | $ | 59,712 | 93 | $ | 10,168 | 69 | $ | 8,396 | 65 | $ | 7,165 | 63 | |||||||||||||||
| Mortgage reinsurance | 2,489 | 4 | 2,557 | 17 | 2,567 | 20 | 2,661 | 23 | |||||||||||||||||||
| Other (3) | 2,242 | 4 | 2,104 | 14 | 1,993 | 15 | 1,636 | 14 | |||||||||||||||||||
| Total | $ | 64,443 | 100 | $ | 14,829 | 100 | $ | 12,956 | 100 | $ | 11,462 | 100 | |||||||||||||||
| Ending number of policies in force | 1,153,630 | 199,661 | 172,666 | 153,984 |
| (1) | The aggregate dollar amount of each insured mortgage loan’s current principal balance. |
| (2) | The aggregate amount of each insured mortgage loan’s current principal balance multiplied by the insurance coverage percentage specified in the policy for insurance policies issued and after contract limits and/or loss ratio caps for risk-sharing or reinsurance transactions. |
| (3) | Includes GSE credit risk-sharing transactions and international insurance business. |
The following table provides supplemental disclosures for our U.S. mortgage insurance operations related to insured loans and loss metrics:
| (U.S. Dollars in thousands, except loan and claim count) | Three Months Ended | Year Ended | |||||||||||||||||
| December 31, 2016 | September 30, 2016 | June 30, 2016 | March 31, 2016 | December 31, 2016 | |||||||||||||||
| Rollforward of insured loans in default: | |||||||||||||||||||
| Beginning delinquent number of loans | 2,423 | 2,245 | 2,325 | 2,702 | 2,702 | ||||||||||||||
| Plus: new notices | 1,161 | 1,251 | 1,033 | 1,048 | 4,493 | ||||||||||||||
| Less: cures | (1,026 | ) | (925 | ) | (919 | ) | (1,206 | ) | (4,076 | ) | |||||||||
| Less: paid claims | (153 | ) | (151 | ) | (193 | ) | (222 | ) | (719 | ) | |||||||||
| Less: delinquent rescissions and denials | (2 | ) | 3 | (1 | ) | 3 | 3 | ||||||||||||
| Plus: acquired delinquent loans (1) | 27,288 | — | — | — | 27,288 | ||||||||||||||
| Ending delinquent number of loans | 29,691 | 2,423 | 2,245 | 2,325 | 29,691 | ||||||||||||||
| Ending percentage of loans in default | 2.6 | % | 1.2 | % | 1.3 | % | 1.5 | % | |||||||||||
| Losses: | |||||||||||||||||||
| Number of claims paid | 153 | 151 | 193 | 222 | 719 | ||||||||||||||
| Total paid claims | $ | 6,080 | $ | 5,513 | $ | 7,744 | $ | 9,168 | $ | 28,505 | |||||||||
| Average per claim | $ | 39.7 | $ | 36.5 | $ | 40.1 | $ | 41.3 | $ | 39.6 | |||||||||
| Severity (2) | 92.3 | % | 90.4 | % | 94.8 | % | 93.9 | % | 93.1 | % | |||||||||
| Average reserve per default | $ | 20.5 | $ | 25.2 | $ | 27.8 | $ | 32.1 |
| (1) | Includes first lien primary and pool policies. |
| (2) | Represents total paid claims divided by RIF of loans for which claims were paid. |
| ACGL 2016 FORM 10-K | 93 |
For each quarter end in 2016, the following table provides supplemental disclosures for our U.S. mortgage insurance operations’ risk in force:
| (U.S. Dollars in millions) | December 31, 2016 | September 30, 2016 | June 30, 2016 | March 31, 2016 | |||||||||||||||||||||||
| Amount | % | Amount | % | Amount | % | Amount | % | ||||||||||||||||||||
| Total RIF by credit quality (FICO): | |||||||||||||||||||||||||||
| >=740 | $ | 34,867 | 58 | $ | 5,817 | 57 | $ | 4,766 | 57 | $ | 3,995 | 56 | |||||||||||||||
| 680-739 | 18,976 | 32 | 3,425 | 34 | 2,779 | 33 | 2,354 | 33 | |||||||||||||||||||
| 620-679 | 5,050 | 9 | 834 | 8 | 753 | 9 | 712 | 10 | |||||||||||||||||||
| <620 | 819 | 1 | 92 | 1 | 98 | 1 | 104 | 2 | |||||||||||||||||||
| Total | $ | 59,712 | 100 | $ | 10,168 | 100 | $ | 8,396 | 100 | $ | 7,165 | 100 | |||||||||||||||
| Weighted average FICO score | 743 | 742 | 741 | 739 | |||||||||||||||||||||||
| Total RIF by Loan-to-Value (LTV): | |||||||||||||||||||||||||||
| 95.01% and above | $ | 5,781 | 10 | $ | 1,221 | 12 | $ | 1,135 | 14 | $ | 1,052 | 15 | |||||||||||||||
| 90.01% to 95.00% | 32,986 | 55 | 5,430 | 53 | 4,379 | 52 | 3,677 | 51 | |||||||||||||||||||
| 85.01% to 90.00% | 18,140 | 30 | 2,982 | 29 | 2,438 | 29 | 2,056 | 29 | |||||||||||||||||||
| 85.00% and below | 2,805 | 5 | 535 | 5 | 444 | 5 | 380 | 5 | |||||||||||||||||||
| Total | $ | 59,712 | 100 | $ | 10,168 | 100 | $ | 8,396 | 100 | $ | 7,165 | 100 | |||||||||||||||
| Weighted average LTV | 92.9 | % | 92.9 | % | 92.9 | % | 93.0 | % | |||||||||||||||||||
| Total RIF by State: | |||||||||||||||||||||||||||
| Texas | $ | 4,961 | 8 | $ | 583 | 6 | $ | 469 | 6 | $ | 401 | 6 | |||||||||||||||
| California | 3,222 | 5 | 865 | 9 | 727 | 9 | 622 | 9 | |||||||||||||||||||
| Virginia | 2,586 | 4 | 377 | 4 | 300 | 4 | 237 | 3 | |||||||||||||||||||
| Florida | 2,367 | 4 | 544 | 5 | 422 | 5 | 345 | 5 | |||||||||||||||||||
| Washington | 2,331 | 4 | 302 | 3 | 279 | 3 | 261 | 4 | |||||||||||||||||||
| Georgia | 2,111 | 4 | 301 | 3 | 247 | 3 | 215 | 3 | |||||||||||||||||||
| Illinois | 2,090 | 4 | 348 | 3 | 279 | 3 | 218 | 3 | |||||||||||||||||||
| Maryland | 2,080 | 4 | 299 | 3 | 241 | 3 | 199 | 3 | |||||||||||||||||||
| Minnesota | 1,986 | 3 | 388 | 4 | 351 | 4 | 319 | 5 | |||||||||||||||||||
| Ohio | 1,916 | 3 | 312 | 3 | 260 | 3 | 212 | 3 | |||||||||||||||||||
| Others | 34,062 | 57 | 5,849 | 58 | 4,821 | 57 | 4,136 | 58 | |||||||||||||||||||
| Total | $ | 59,712 | 100 | $ | 10,168 | 100 | $ | 8,396 | 100 | $ | 7,165 | 100 | |||||||||||||||
| Weighted average coverage (1) | 25.5 | % | 25.3 | % | 25.2 | % | 25.2 | % | |||||||||||||||||||
| Analysts’ persistency (2) | 76.1 | % | 75.4 | % | 75.6 | % | 74.2 | % | |||||||||||||||||||
| Risk-to-capital ratio (3) | 12.0:1 | 15.4:1 | 12.4:1 | 11.1:1 | |||||||||||||||||||||||
| U.S. mortgage insurance total RIF, net of reinsurance (4) | $ | 42,183 | $ | 8,918 | $ | 7,198 | $ | 6,274 |
| (1) | Represents the end of period RIF divided by end of period IIF. |
| (2) | Represents the percentage of IIF at the beginning of a 12-month period that remained in force at the end of the period. |
| (3) | Represents total current (non-delinquent) RIF, net of reinsurance, divided by total statutory capital. Ratio calculated for GSE eligible mortgage insurers (estimate for December 31, 2016 including UGC). |
| (4) | Total RIF for the U.S. mortgage insurance operations after external reinsurance. |
Ceded Reinsurance
In the normal course of business, our insurance and mortgage insurance operations cede a portion of their premium on a quota share or excess of loss basis through treaty or facultative reinsurance agreements. Our reinsurance operations also obtain reinsurance whereby another reinsurer contractually agrees to indemnify it for all or a portion of the reinsurance risks underwritten by our reinsurance operations. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as “retrocessional reinsurance” arrangements. In addition, our reinsurance subsidiaries participate in “common account” retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all
companies participating on such treaties, including the reinsurers, such as our reinsurance operations, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, our insurance or reinsurance operations would be liable for such defaulted amounts.
The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Although we believe that our insurance and reinsurance operations have been successful in obtaining
| ACGL 2016 FORM 10-K | 94 |
adequate reinsurance and retrocessional protection, it is not certain that they will be able to continue to obtain adequate protection at cost effective levels. As a result of such market conditions and other factors, our insurance and reinsurance operations may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements and may lead to increased volatility in our results of operations in future periods. See “Risk Factors—Risks Relating to Our Industry—The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or results of operations.”
Our insurance operations had in effect during 2016 a reinsurance program which provided coverage for certain property-catastrophe related losses equal to $200 million in excess of a $150 million retention per occurrence, consistent with the program in place for 2015. In the 2017 first quarter, our insurance operations renewed its reinsurance program with the same limits.
For purposes of managing risk, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. On a consolidated basis, ceded premiums written represented 22.5% of gross premiums written for 2016, compared to 20.4% for 2015 and 19.6% for 2014. We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We evaluate the credit worthiness of all the reinsurers to which we cede business. If our analysis indicates that there is significant uncertainty regarding our ability to collect amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. See “Risk Factors—Risks Relating to Our Company—We are exposed to credit risk in certain of our business operations” and “Financial Condition, Liquidity and Capital Resources—Financial Condition—Premiums Receivable and Reinsurance Recoverables” for further details.
Premium Revenues and Related Expenses
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in our insurance operations’ programs, specialty lines, collateral protection business and for participation in involuntary pools. The amount of such insurance premium estimates, included in premiums receivable and other assets, was $67.1 million at December 31, 2016, compared to $81.9 million at December 31, 2015. Such premium estimates are derived from multiple sources which include the historical experience of the underlying business,
similar business and available industry information. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of in-force insurance policies.
Reinsurance premiums written include amounts reported by brokers and ceding companies, supplemented by our own estimates of premiums where reports have not been received. The determination of premium estimates requires a review of our experience with the ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management’s judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to us. On an ongoing basis, our underwriters review the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business, taking into account our historical experience with the brokers or ceding companies. In addition, reinsurance contracts under which we assume business generally contain specific provisions which allow us to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined. Premiums written are recorded based on the type of contracts we write. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, premiums are recorded as written based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
Reinstatement premiums for our insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described above in “—Reserves for Losses and Loss Adjustment Expenses.”
| ACGL 2016 FORM 10-K | 95 |
The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by type of business were as follows at December 31, 2016:
| December 31, 2016 | |||||||||||
| Gross Amount | Acquisition Expenses | Net Amount | |||||||||
| Casualty | $ | 205,016 | $ | (64,563 | ) | $ | 140,453 | ||||
| Other specialty | 141,943 | (39,392 | ) | 102,551 | |||||||
| Property excluding property catastrophe | 64,483 | (21,544 | ) | 42,939 | |||||||
| Marine and aviation | 30,560 | (8,669 | ) | 21,891 | |||||||
| Property catastrophe | 1,158 | (66 | ) | 1,092 | |||||||
| Other | 55,569 | (12,657 | ) | 42,912 | |||||||
| Total | $ | 498,729 | $ | (146,891 | ) | $ | 351,838 |
Premium estimates are reviewed by management at least quarterly. Such review includes a comparison of actual reported premiums to expected ultimate premiums along with a review of the aging and collection of premium estimates. Based on management’s review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned.
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Based on currently available information, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates at December 31, 2016.
Reinsurance premiums assumed, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a “losses occurring” basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a “risks attaching” basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period.
Certain of our reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned,
as well as related acquisition expenses, are recorded based upon the projected experience under such contracts.
Retroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered by the underlying policies reinsured. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and, accordingly, we bifurcate the prospective and retrospective elements of these reinsurance contracts and account for each element separately. Underwriting income generated in connection with retroactive reinsurance contracts is deferred and amortized into income over the settlement period while losses are charged to income immediately. Subsequent changes in estimated or actual cash flows under such retroactive reinsurance contracts are accounted for by adjusting the previously deferred amount to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction, with a corresponding charge or credit to income.
Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premiums on a monthly, annual or single basis. Upon renewal, we are not able to re-underwrite or re-price our policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the estimated expiration of risk of the policy. If single premium policies related to insured loans are canceled due to repayment by the borrower and the policy is a non-refundable product, the remaining unearned premium related to each canceled policy is recognized as earned premium upon notification of the cancellation.
Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. A portion of premium payments may be refundable if the insured cancels coverage, which generally occurs when the loan is repaid, the loan amortizes to a sufficiently low amount to trigger a lender permitted or legally required cancellation, or the value of the property has increased sufficiently in accordance with the terms of the contract. Premium refunds reduce premiums earned in the consolidated statements of income. Generally, only unearned premiums are refundable. However, when we pay a claim on a delinquent loan, all servicer paid premiums received on the delinquent loan covering any period after the default date will be refunded, in accordance with the terms of the contract.
| ACGL 2016 FORM 10-K | 96 |
Acquisition costs that are directly related and incremental to the successful acquisition or renewal of business are deferred and amortized based on the type of contract. For property and casualty insurance and reinsurance contracts, deferred acquisition costs are amortized over the period in which the related premiums are earned. Consistent with mortgage insurance industry accounting practice, amortization of acquisition costs related to the mortgage insurance contracts for each underwriting year’s book of business is recorded in proportion to estimated gross profits. Estimated gross profits are comprised of earned premiums and losses and loss adjustment expenses. For each underwriting year, we estimate the rate of amortization to reflect actual experience and any changes to persistency or loss development.
Acquisition expenses and other expenses related to our underwriting operations that vary with, and are directly related to, the successful acquisition or renewal of business are deferred and amortized based on the type of contract. Our insurance and reinsurance operations capitalize incremental direct external costs that result from acquiring a contract but do not capitalize salaries, benefits and other internal underwriting costs. For our mortgage insurance operations, which include a substantial direct sales force, both external and certain internal direct costs are deferred and amortized. Deferred acquisition costs are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income.
A premium deficiency occurs if the sum of anticipated losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs and anticipated investment income exceed unearned premiums. A premium deficiency reserve (“PDR”) is recorded by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency.
To assess the need for a PDR on our mortgage exposures, we develop loss projections based on modeled loan defaults related to our current policies in force. This projection is based on recent trends in default experience, severity and rates of defaulted loans moving to claim, as well as recent trends in the rate at which loans are prepaid. Evaluating the expected profitability of our existing mortgage insurance business and the need for a PDR for our mortgage business involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of potential losses and premium revenues. The models, assumptions and estimates we use to evaluate the need for a PDR may prove to be inaccurate, especially during an extended economic downturn or a period of extreme market volatility and uncertainty.
No premium deficiency charges were recorded by us during 2016, 2015 and 2014.
Fair Value Measurements
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).
We determine the existence of an active market based on our judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. We use quoted values and other data provided by nationally recognized independent pricing sources as inputs into our process for determining fair values of our fixed maturity investments. To validate the techniques or models used by pricing sources, our review process includes, but is not limited to: quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to their target benchmark, with significant differences identified and investigated); a review of the average number of prices obtained in the pricing process and the range of resulting fair values; initial and ongoing evaluation of methodologies used by outside parties to calculate fair value; comparing the fair value estimates to our knowledge of the current market; a comparison of the pricing services’ fair values to other pricing services’ fair values for the same investments; and back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. Where multiple quotes or prices were obtained, a price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used from a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, we will challenge any prices for a security or portfolio which are considered not to be representative of fair value.
| ACGL 2016 FORM 10-K | 97 |
The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above.
We review our securities measured at fair value and discuss the proper classification of such investments with investment advisors and others. See note 10, “Fair Value,” of the notes accompanying our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value at December 31, 2016 by valuation hierarchy.
Other-Than-Temporary Impairments
On a quarterly basis, we perform reviews of our investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of OTTI. The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include: an analysis of the liquidity, business prospects and overall financial condition of the issuer; the time period in which there was a significant decline in value; the significance of the decline; and the analysis of specific credit events.
We evaluate the unrealized losses of our equity securities by issuer and determine if we can forecast a reasonable period of time by which the fair value of the securities would increase and we would recover our cost. If we are unable to forecast a reasonable period of time in which to recover the cost of our equity securities, we record an OTTI equivalent to the entire unrealized loss. For debt securities, we separate an OTTI into two components when there are credit related losses associated with the impaired debt security for which we assert that we do not have the intent to sell the security, and it is more likely than not that we will not be required to sell the security before recovery of its cost basis. The amount of the OTTI related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors (e.g., interest rates, market conditions, etc.) is recorded as a component of other comprehensive income
or loss. The amount of the credit loss of an impaired debt security is the difference between the amortized cost and the greater of (i) the present value of expected future cash flows and (ii) the fair value of the security. In instances where no credit loss exists but it is more likely than not that we will have to sell the debt security prior to the anticipated recovery, the decline in fair value below amortized cost is recognized as an OTTI in earnings. In periods after the recognition of an OTTI on debt securities, we account for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For debt securities for which OTTI were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted or amortized into net investment income.
For 2016, we recorded $30.4 million of credit related impairments in earnings, compared to $20.1 million in 2015 and $30.2 million in 2014. See note 9, “Investment Information—Other-Than-Temporary Impairments,” of the notes accompanying our consolidated financial statements for additional information.
Reclassifications
We have reclassified the presentation of certain prior year information to conform to the current presentation. Such reclassifications had no effect on our net income, shareholders’ equity or cash flows.
Recent Accounting Pronouncements
See note 3(q), “Significant Accounting Policies—Recent Accounting Pronouncements,” of the notes accompanying our consolidated financial statements.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Financial Condition
Investable Assets
| • | Investable Assets Held by Arch |
The finance, investment and risk management (“FI&R”) committee of our board of directors establishes our investment policies and sets the parameters for creating guidelines for our investment managers. The FI&R committee reviews the implementation of the investment strategy on a regular basis. Our current approach stresses preservation of capital, market liquidity and diversification of risk. While maintaining our emphasis on preservation of capital and liquidity, we expect our portfolio to become more diversified and, as a result, we may expand into areas which are not currently part of our investment
| ACGL 2016 FORM 10-K | 98 |
strategy. Our Chief Investment Officer administers the investment portfolio, oversees our investment managers and formulates investment strategy in conjunction with the FI&R committee.
On December 31, 2016, the UGC acquisition was completed. As such, our balance sheet reflects the acquisition of UGC while our results of operations for 2016 do not include UGC activity other than the impact of capital raising activity and transaction costs.
The following table summarizes the fair value of the investable assets held by Arch (i.e., excluding amounts in the ‘other’ segment):
| Investable assets (1): | Estimated Fair Value | % of Total | ||||
| December 31, 2016 | ||||||
| Fixed maturities (2) | $ | 14,521,774 | 77.9 | |||
| Short-term investments (2) | 676,547 | 3.6 | ||||
| Cash | 768,049 | 4.1 | ||||
| Equity securities (2) | 558,008 | 3.0 | ||||
| Other investments (2) | 1,276,841 | 6.9 | ||||
| Investments accounted for using the equity method | 811,273 | 4.4 | ||||
| Securities transactions entered into but not settled at the balance sheet date | 23,697 | 0.1 | ||||
| Total investable assets held by Arch | $ | 18,636,189 | 100.0 | |||
| December 31, 2015 | ||||||
| Fixed maturities (2) | $ | 11,200,437 | 76.5 | |||
| Short-term investments (2) | 587,904 | 4.0 | ||||
| Cash | 444,776 | 3.0 | ||||
| Equity securities (2) | 629,980 | 4.3 | ||||
| Other investments (2) | 1,209,285 | 8.3 | ||||
| Investments accounted for using the equity method | 592,973 | 4.0 | ||||
| Securities transactions entered into but not settled at the balance sheet date | (20,524 | ) | (0.1 | ) | ||
| Total investable assets held by Arch | $ | 14,644,831 | 100.0 |
| (1) | In securities lending transactions, we receive collateral in excess of the fair value of the securities pledged. For purposes of this table, we have excluded the collateral received under securities lending, at fair value and included the securities pledged under securities lending, at fair value. |
| (2) | Includes investments carried as available for sale, at fair value and at fair value under the fair value option. |
At December 31, 2016, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had average credit quality ratings from Standard & Poor’s Rating Services (“S&P”)/Moody’s of “AA-/Aa3” and an average yield to maturity (embedded book yield), before investment expenses, of 2.03%. At December 31, 2015, our fixed income portfolio had average credit quality ratings from S&P/Moody’s of “AA/Aa2” and an average yield to maturity of 2.16%. Our investment portfolio had an average effective duration of 3.64 years at December 31, 2016, compared to 3.43 years at December 31, 2015. At December 31, 2016,
approximately $13.90 billion, or 75%, of total investable assets held by Arch were internally managed, compared to $10.01 billion, or 68%, at December 31, 2015.
The following table summarizes our fixed maturities and fixed maturities pledged under securities lending agreements (“Fixed Maturities”) by type:
| Estimated Fair Value | % of Total | |||||
| December 31, 2016 | ||||||
| Corporate bonds | $ | 4,696,079 | 32.3 | |||
| Mortgage backed securities | 504,677 | 3.5 | ||||
| Municipal bonds | 3,713,434 | 25.6 | ||||
| Commercial mortgage backed securities | 536,051 | 3.7 | ||||
| U.S. government and government agencies | 2,804,811 | 19.3 | ||||
| Non-U.S. government securities | 1,142,735 | 7.9 | ||||
| Asset backed securities | 1,123,987 | 7.7 | ||||
| Total | $ | 14,521,774 | 100.0 | |||
| December 31, 2015 | ||||||
| Corporate bonds | $ | 2,960,694 | 26.4 | |||
| Mortgage backed securities | 812,557 | 7.3 | ||||
| Municipal bonds | 1,626,281 | 14.5 | ||||
| Commercial mortgage backed securities | 764,152 | 6.8 | ||||
| U.S. government and government agencies | 2,423,455 | 21.6 | ||||
| Non-U.S. government securities | 992,792 | 8.9 | ||||
| Asset backed securities | 1,620,506 | 14.5 | ||||
| Total | $ | 11,200,437 | 100.0 |
At December 31, 2016, below-investment grade securities comprised approximately 5% of our Fixed Maturities, compared to 5% at December 31, 2015. In accordance with our investment strategy, we invest in high yield fixed income securities which are included in “Corporate bonds.” Upon issuance, these securities are typically rated below investment grade (i.e., rating assigned by the major rating agencies of “BB+” or less). At December 31, 2016, corporate bonds represented 51% of the total below investment grade securities at fair value, mortgage backed securities represented 5% of the total and 44% were in other classes. At December 31, 2015, corporate bonds represented 70% of the total below investment grade securities at fair value, mortgage backed securities represented 13% of the total and 17% were in other classes. Unrealized losses include the impact of foreign exchange movements on certain securities denominated in foreign currencies and, as such, the amount of securities in an unrealized loss position fluctuates due to foreign currency movements.
| ACGL 2016 FORM 10-K | 99 |
The following table provides the credit quality distribution of our Fixed Maturities. For individual fixed maturities, S&P ratings are used. In the absence of an S&P rating, ratings from Moody’s are used, followed by ratings from Fitch Ratings.
| Estimated Fair Value | % of Total | |||||
| December 31, 2016 | ||||||
| U.S. government and gov’t agencies (1) | $ | 3,210,899 | 22.1 | |||
| AAA | 3,918,739 | 27.0 | ||||
| AA | 3,148,226 | 21.7 | ||||
| A | 2,338,834 | 16.1 | ||||
| BBB | 1,203,942 | 8.3 | ||||
| BB | 226,321 | 1.6 | ||||
| B | 156,405 | 1.1 | ||||
| Lower than B | 90,833 | 0.6 | ||||
| Not rated | 227,574 | 1.6 | ||||
| Total | $ | 14,521,774 | 100.0 | |||
| December 31, 2015 | ||||||
| U.S. government and gov’t agencies (1) | $ | 3,060,869 | 27.3 | |||
| AAA | 4,000,750 | 35.7 | ||||
| AA | 1,651,760 | 14.7 | ||||
| A | 1,431,138 | 12.8 | ||||
| BBB | 457,251 | 4.1 | ||||
| BB | 203,426 | 1.8 | ||||
| B | 138,770 | 1.2 | ||||
| Lower than B | 130,545 | 1.2 | ||||
| Not rated | 125,928 | 1.1 | ||||
| Total | $ | 11,200,437 | 100.0 |
| (1) | Includes U.S. government-sponsored agency mortgage backed securities and agency commercial mortgage backed securities. |
The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for all Fixed Maturities which were in an unrealized loss position:
| Severity of gross unrealized losses: | Estimated Fair Value | Gross Unrealized Losses | % of Total Gross Unrealized Losses | |||||||
| December 31, 2016 | ||||||||||
| 0-10% | $ | 7,078,582 | $ | (127,909 | ) | 71.6 | ||||
| 10-20% | 155,403 | (24,219 | ) | 13.5 | ||||||
| 20-30% | 89,887 | (25,929 | ) | 14.5 | ||||||
| Greater than 30% | 1,496 | (702 | ) | 0.4 | ||||||
| Total | $ | 7,325,368 | $ | (178,759 | ) | 100.0 | ||||
| December 31, 2015 | ||||||||||
| 0-10% | $ | 6,956,754 | $ | (74,229 | ) | 54.4 | ||||
| 10-20% | 173,441 | (28,789 | ) | 21.1 | ||||||
| 20-30% | 86,997 | (26,227 | ) | 19.2 | ||||||
| Greater than 30% | 10,638 | (7,160 | ) | 5.2 | ||||||
| Total | $ | 7,227,830 | $ | (136,405 | ) | 100.0 |
The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for non-investment grade Fixed Maturities which were in an unrealized loss position:
| Severity of gross unrealized losses: | Estimated Fair Value | Gross Unrealized Losses | % of Total Gross Unrealized Losses | |||||||
| December 31, 2016 | ||||||||||
| 0-10% | $ | 155,258 | $ | (3,978 | ) | 2.2 | ||||
| 10-20% | 7,727 | (1,235 | ) | 0.7 | ||||||
| 20-30% | 2,313 | (727 | ) | 0.4 | ||||||
| Greater than 30% | 1,496 | (701 | ) | 0.4 | ||||||
| Total | $ | 166,794 | $ | (6,641 | ) | 3.7 | ||||
| December 31, 2015 | ||||||||||
| 0-10% | $ | 176,343 | $ | (5,139 | ) | 3.8 | ||||
| 10-20% | 28,707 | (4,807 | ) | 3.5 | ||||||
| 20-30% | 12,500 | (4,410 | ) | 3.2 | ||||||
| Greater than 30% | 10,520 | (7,107 | ) | 5.2 | ||||||
| Total | $ | 228,070 | $ | (21,463 | ) | 15.7 |
We determine estimated recovery values for our Fixed Maturities following a review of the business prospects, credit ratings, estimated loss given default factors and information received from asset managers and rating agencies for each security. For structured securities, we utilize underlying data, where available, for each security provided by asset managers and additional information from credit agencies in order to determine an expected recovery value for each security. The analysis provided by the asset managers includes expected cash flow projections under base case and stress case scenarios which modify expected default expectations and loss severities and slow down prepayment assumptions.
The following table summarizes our top ten exposures to fixed income corporate issuers by fair value at December 31, 2016, excluding guaranteed amounts and covered bonds:
| Estimated Fair Value | Credit Rating (1) | ||||
| Microsoft Corporation | $ | 89,820 | AAA/Aaa | ||
| Apple Inc. | 72,861 | AAA/Aaa | |||
| Bank of New York Mellon Corp. | 67,360 | AA+/Aa1 | |||
| Oracle Corporation | 66,058 | A/A1 | |||
| JPMorgan Chase & Co | 64,470 | AA-/A1 | |||
| Royal Dutch Shell PLC | 58,019 | A-/A3 | |||
| Daimler AG | 53,042 | A/Aa2 | |||
| Bank of America Corporation | 51,193 | A/A3 | |||
| MetLife, Inc. | 49,576 | BBB+/Baa1 | |||
| Massmutual Global Funding II Corp | 47,767 | AA-/Aa3 | |||
| Total | $ | 620,166 |
| (1) | Average credit ratings as assigned by S&P and Moody’s, respectively. |
Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. At December 31, 2016, our investments in residential mortgage-
| ACGL 2016 FORM 10-K | 100 |
backed securities (“RMBS”) amounted to approximately $504.7 million, or 2.7% of total investable assets held by Arch, compared to $812.6 million, or 5.5%, at December 31, 2015. As with other fixed income investments, the fair value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Declines or flattening in residential property values may result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Such developments may have a significant adverse effect on the prices of loans and securities, including those in our investment portfolio.
Changes in interest rates can expose us to changes in the prepayment rate on these investments. In periods of declining interest rates, mortgage prepayments generally increase and RMBS are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates. Conversely, in periods of rising rates, mortgage prepayments generally fall, preventing us from taking full advantage of the higher level of rates. However, economic conditions may curtail prepayment activity if refinancing becomes more difficult, thus limiting prepayments on RMBS.
Our portfolio also includes commercial mortgage backed securities (“CMBS”). At December 31, 2016, CMBS constituted approximately $536.1 million, or 2.9% of total investable assets held by Arch, compared to $764.2 million, or 5.2%, at December 31, 2015. The commercial real estate market may experience price deterioration, which could lead to delinquencies and losses on commercial real estate mortgages.
The following table provides information on our non-agency RMBS and non-agency CMBS at December 31, 2016 by issuance year, excluding amounts guaranteed by U.S. government agencies. Non-agency RMBS and non-agency CMBS were 0.6% and 2.8% of total investable assets held by Arch, respectively.
| Issuance Year | Amortized Cost | Average Credit Quality | Estimated Fair Value | |||||||
| 2004-2008 | $ | 43,603 | C+ | $ | 47,426 | |||||
| 2011 | 276 | AA+ | 273 | |||||||
| 2012 | 142 | AAA | 145 | |||||||
| 2013 | 85 | AAA | 75 | |||||||
| 2014 | 3,367 | B- | 3,368 | |||||||
| 2015 | 1,959 | BBB- | 1,944 | |||||||
| 2016 | 59,562 | AA+ | 58,258 | |||||||
| Total RMBS | $ | 108,994 | BB+ | $ | 111,489 | |||||
| 2002-2008 | 33,973 | AA | 33,295 | |||||||
| 2009 | 380 | BBB- | 379 | |||||||
| 2010 | 374 | B+ | 367 | |||||||
| 2012 | 25,795 | AAA | 25,831 | |||||||
| 2013 | 84,090 | AAA | 85,709 | |||||||
| 2014 | 159,369 | AA+ | 160,202 | |||||||
| 2015 | 122,142 | AAA | 120,377 | |||||||
| 2016 | 100,666 | AA+ | 96,991 | |||||||
| Total CMBS | $ | 526,789 | AA+ | $ | 523,151 |
| Non-Agency | Non-Agency | |||||
| Additional Statistics: | RMBS | CMBS (1) | ||||
| Weighted average loan age (months) | 71 | 29 | ||||
| Weighted average life (months) (2) | 90 | 80 | ||||
| Weighted average loan-to-value % (3) | 60.6 | % | 56.3 | % | ||
| Total delinquencies (4) | 6.9 | % | 0.3 | % | ||
| Current credit support % (5) | 14.6 | % | 33.5 | % |
| (1) | Loans defeased with government/agency obligations were not material to the collateral underlying our CMBS holdings. |
| (2) | The weighted average life for RMBS is based on the interest rates in effect at December 31, 2016. The weighted average life for CMBS reflects the average life of the collateral underlying our CMBS holdings. |
| (3) | The range of loan-to-values is 16% to 93% on RMBS and 0% to 412% on CMBS. |
| (4) | Total delinquencies includes 60 days and over. |
| (5) | Current credit support percentage represents the percentage for a collateralized mortgage obligation (“CMO”) or CMBS class/tranche from other subordinate classes in the same CMO or CMBS deal. |
The following table provides information on our asset backed securities (“ABS”) at December 31, 2016. ABS were 6.0% of total investable assets held by Arch, respectively.
| ACGL 2016 FORM 10-K | 101 |
| Weighted Average | |||||||||||||
| Sector | Amortized Cost | Credit Quality | Credit Support | Estimated Fair Value | |||||||||
| Credit cards | $ | 613,355 | AAA | 17 | % | $ | 611,492 | ||||||
| Autos | 262,514 | AAA | 30 | % | 262,181 | ||||||||
| Loans | 83,467 | BBB | 22 | % | 83,464 | ||||||||
| Equipment | 103,985 | AA | 5 | % | 104,520 | ||||||||
| Other (1) | 60,295 | BB | 16 | % | 62,330 | ||||||||
| Total ABS (2) | $ | 1,123,616 | AA+ | $ | 1,123,987 |
| (1) | Including rate reduction bonds, commodities, home equity, U.K. securitized and other. |
| (2) | The effective duration of the total ABS was 1.5 years at December 31, 2016. |
At December 31, 2016, our fixed income portfolio included $25.3 million par value in sub-prime securities with a fair value of $23.3 million and average credit quality ratings from S&P/Moody’s of “CCC/Caa3.” At December 31, 2015, our fixed income portfolio included $45.5 million par value in sub-prime securities with a fair value of $35.9 million and average credit quality ratings from S&P/Moody’s of “CCC/Caa3.” Such amounts were primarily in the home equity sector of our ABS, with the balance in other ABS, RMBS and CMBS sectors. We define sub-prime mortgage-backed securities as investments in which the underlying loans primarily exhibit one or more of the following characteristics: low FICO scores, above-prime interest rates, high loan-to-value ratios or high debt-to-income ratios.
The following table provides information on the fair value of our Eurozone investments at December 31, 2016:
| Country (1) | Sovereign (2) | Corporate Bonds | Other (3) | Total | |||||||||||
| Netherlands | $ | 90,951 | $ | 137,414 | $ | 3,712 | $ | 232,077 | |||||||
| Germany | 74,772 | 41,520 | 7,458 | 123,750 | |||||||||||
| France | 302 | 55,972 | 11,136 | 67,410 | |||||||||||
| Luxembourg | — | 23,386 | 2,522 | 25,908 | |||||||||||
| Belgium | 13,878 | 7,638 | 1 | 21,517 | |||||||||||
| Ireland | — | 1,818 | 5,905 | 7,723 | |||||||||||
| Supranational (4) | 7,454 | — | — | 7,454 | |||||||||||
| Italy | — | — | 4,403 | 4,403 | |||||||||||
| Spain | — | — | 3,720 | 3,720 | |||||||||||
| Finland | — | — | 3,576 | 3,576 | |||||||||||
| Greece | 81 | 711 | — | 792 | |||||||||||
| Total | $ | 187,438 | $ | 268,459 | $ | 42,433 | $ | 498,330 |
| (1) | The country allocations set forth in the table are based on various assumptions made by us in assessing the country in which the underlying credit risk resides, including a review of the jurisdiction of organization, business operations and other factors. Based on such analysis, we do not believe that we have any other Eurozone investments at December 31, 2016. |
| (2) | Includes securities issued and/or guaranteed by Eurozone governments. |
| (3) | Includes bank loans, equities and other. |
| (4) | Includes World Bank, European Investment Bank, International Finance Corp. and European Bank for Reconstruction and Development. |
At December 31, 2016, our equity portfolio included $558.0 million of equity securities, compared to $630.0 million at
December 31, 2015. Our equity portfolio includes publicly traded common stocks in the natural resources, energy, consumer staples and other sectors.
The following table provides information on the severity of the unrealized loss position as a percentage of cost for all equity securities classified as available for sale which were in an unrealized loss position:
| Severity of gross unrealized losses: | Estimated Fair Value | Gross Unrealized Losses | % of Total Gross Unrealized Losses | |||||||
| December 31, 2016 | ||||||||||
| 0-10% | $ | 214,364 | $ | (8,776 | ) | 50.1 | ||||
| 10-20% | 52,034 | (7,100 | ) | 40.5 | ||||||
| 20-30% | 1,983 | (607 | ) | 3.5 | ||||||
| Greater than 30% | 1,000 | (1,034 | ) | 5.9 | ||||||
| Total | $ | 269,381 | $ | (17,517 | ) | 100.0 | ||||
| December 31, 2015 | ||||||||||
| 0-10% | $ | 176,451 | $ | (5,926 | ) | 33.3 | ||||
| 10-20% | 39,728 | (6,528 | ) | 36.7 | ||||||
| 20-30% | 13,700 | (4,164 | ) | 23.4 | ||||||
| Greater than 30% | 2,396 | (1,178 | ) | 6.6 | ||||||
| Total | $ | 232,275 | $ | (17,796 | ) | 100.0 |
On a quarterly basis, we evaluate the unrealized losses of our equity securities by issuer and forecast a reasonable period of time by which the fair value of the securities would increase and we would recover the cost basis. All of the unrealized losses on equity securities were on holdings which have been in a continual unrealized loss position for less than 12 months at December 31, 2016. We believe that a reasonable period of time exists to allow for recovery of the cost basis of our equity securities that are in an unrealized loss position at December 31, 2016.
| ACGL 2016 FORM 10-K | 102 |
The following table summarizes our other investments:
| December 31, 2016 | December 31, 2015 | ||||||
| Available for sale: | |||||||
| Asian and emerging markets | $ | 84,778 | $ | 206,861 | |||
| Investment grade fixed income | 33,923 | 31,370 | |||||
| Credit related funds | 7,469 | 22,512 | |||||
| Other | 41,800 | 39,733 | |||||
| Total available for sale | 167,970 | 300,476 | |||||
| Fair value option: | |||||||
| Term loan investments (par value: $385,436 and $356,096) | 378,877 | 345,855 | |||||
| Mezzanine debt funds | 127,943 | 121,589 | |||||
| Credit related funds | 218,298 | 219,049 | |||||
| Investment grade fixed income | 75,468 | 63,053 | |||||
| Asian and emerging markets | 178,568 | 34,761 | |||||
| Other (1) | 129,717 | 124,502 | |||||
| Total fair value option | 1,108,871 | 908,809 | |||||
| Total | $ | 1,276,841 | $ | 1,209,285 |
| (1) | Includes fund investments with strategies in mortgage servicing rights, transportation and infrastructure assets and other. |
Certain of our other investments are in investment funds for which we have the option to redeem at agreed upon values as described in each investment fund’s subscription agreement. Depending on the terms of the various subscription agreements, investments in investment funds may be redeemed daily, monthly, quarterly or on other terms. Two common redemption restrictions which may impact our ability to redeem these investment funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the investment fund’s net assets which may otherwise hinder the general partner or investment manager’s ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. If our investment is eligible to be redeemed, the time to redeem such investment can take weeks or months following the notification.
Certain of our investment managers may use leverage to achieve a higher rate of return on their assets under management, primarily those included in “other investments available for sale, at fair value,” “investments accounted for using the fair value option” and “investments accounted for using the equity method” on our balance sheet. While leverage presents opportunities for increasing the total return of such investments, it may increase losses as well. Accordingly, any event that adversely affects the value of the underlying holdings would be magnified to the extent leverage is used and our potential losses would be magnified. In addition, the structures used to
generate leverage may lead to such investments being required to meet covenants based on market valuations and asset coverage. Market valuation declines could force the sale of investments into a depressed market, which may result in significant additional losses. Alternatively, the levered investments may attempt to delever by raising additional equity or potentially changing the terms of the established financing arrangements. We may choose to participate in the additional funding of such investments.
Our investment strategy allows for the use of derivative instruments. We utilize various derivative instruments such as futures contracts to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. See note 11, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives.
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. See note 10, “Fair Value,” of the notes accompanying our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value at December 31, 2016 and December 31, 2015 segregated by level in the fair value hierarchy.
| • | Investable Assets in the ‘Other’ Segment |
Investable assets in the ‘other’ segment are managed by Watford Re. HPS Investment Partners, LLC (formerly Highbridge Principal Strategies, LLC) (“HPS”) manages Watford Re’s non-investment grade credit portfolios, and we manage Watford Re’s investment grade portfolios, each under separate long term services agreements. The board of directors of Watford Re establishes their investment policies and guidelines. Watford Re’s investments are accounted for using the fair value option with changes in the carrying value of such investments recorded in net realized gains or losses.
| ACGL 2016 FORM 10-K | 103 |
The following table summarizes investable assets in the ‘other’ segment:
| December 31, 2016 | December 31, 2015 | ||||||
| Cash | $ | 74,893 | $ | 108,550 | |||
| Investments accounted for using the fair value option: | |||||||
| Term loan investments (par value: $823,101 and $841,047) | 811,922 | 762,162 | |||||
| Fixed maturities | 734,260 | 569,022 | |||||
| Short-term investments | 309,127 | 285,923 | |||||
| Equity securities | 2,314 | — | |||||
| Total investments accounted for using the fair value option | 1,857,623 | 1,617,107 | |||||
| Securities sold but not yet purchased | (33,157 | ) | (30,583 | ) | |||
| Securities transactions entered into but not settled at the balance sheet date | (41,596 | ) | 1,033 | ||||
| Total investable assets included in ‘other’ segment | $ | 1,857,763 | $ | 1,696,107 |
Premiums Receivable and Reinsurance Recoverables
At December 31, 2016, 81.0% of premiums receivable of $1,072.4 million represented amounts not yet due, while amounts in excess of 90 days overdue were 5.2% of the total. At December 31, 2015, 80.8% of premiums receivable of $983.4 million represented amounts not yet due, while amounts in excess of 90 days overdue were 5.3% of the total. Approximately 6.7% of the $30.6 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue at December 31, 2016, compared to 3.9% of the $38.5 million of paid losses and loss adjustment expenses recoverable at December 31, 2015. No collection issues were indicated on the amount in excess of 90 days overdue at December 31, 2016. At December 31, 2016 and 2015, our reserves for doubtful accounts were approximately $21.0 million and $15.7 million, respectively.
At December 31, 2016 and 2015, approximately 75.7% and 77.9% of reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.11 billion and $1.87 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better while 24.3% and 22.1%, respectively, were from companies not rated. For items not rated, over 90% of such amount was collateralized through reinsurance trusts or letters of credit at December 31, 2016 and 2015. The largest reinsurance recoverables from any one carrier was approximately 2.4% and 3.4%, respectively, of total shareholders’ equity available to Arch at December 31, 2016 and 2015.
The following table details our reinsurance recoverables at December 31, 2016:
| % of Total | A.M. Best Rating (1) | |||
| Everest Reinsurance Company | 9.4 | A+ | ||
| Munich Reinsurance America, Inc. | 8.6 | A+ | ||
| Hannover Rückversicherung AG | 4.9 | A+ | ||
| Partner Reinsurance Company of the U.S. | 4.8 | A | ||
| Swiss Reinsurance America Corporation | 4.7 | A+ | ||
| Lloyd’s syndicates (2) | 4.7 | A | ||
| XL Catlin plc | 4.4 | A | ||
| Transatlantic Reinsurance Company | 4.3 | A+ | ||
| Berkley Insurance Company | 4.0 | A+ | ||
| Odyssey America Reinsurance Corporation (3) | 3.7 | A | ||
| Allied World Assurance Company, Ltd. | 2.4 | A | ||
| All other (4) | 44.1 | |||
| Total | 100.0 |
| (1) | The financial strength ratings are as of February 16, 2017 and were assigned by A.M. Best based on its opinion of the insurer’s financial strength as of such date. An explanation of the ratings listed in the table follows: the rating of “A+” is designated “Superior”; and the “A” rating is designated “Excellent.” |
| (2) | The A.M. Best group rating of “A” (Excellent) has been applied to all Lloyd’s syndicates. |
| (3) | A significant portion of amounts due from Odyssey America Reinsurance Corporation is collateralized through reinsurance trusts. |
| (4) | Such amount included 19.9% due from companies rated “A-” or better and 24.2% from companies not rated. For items not rated, over 90% of such amount is collateralized through reinsurance trusts or letters of credit. |
Reserves for Losses and Loss Adjustment Expenses
We establish reserves for losses and loss adjustment expenses (“Loss Reserves”) which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of losses incurred. Estimating Loss Reserves is inherently difficult, which is exacerbated by the fact that we have relatively limited historical experience upon which to base such estimates. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of Loss Reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Reserves for Losses and Loss Adjustment Expenses” and “Business—Reserves” for further details.
| ACGL 2016 FORM 10-K | 104 |
Shareholders’ Equity and Book Value per Share
Total shareholders’ equity available to Arch was $8.25 billion at December 31, 2016, compared to $6.17 billion at December 31, 2015. The increase in 2016 was primarily attributable to the issuance of $1.10 billion of convertible non-voting common equivalent preferred shares (included in common shareholders’ equity) and $450 million of non-cumulative preferred shares (included in preferred shareholders’ equity), along with underwriting and investment returns.
The following table presents the calculation of book value per share:
| (U.S. dollars in thousands, except share data) | December 31, | ||||||
| 2016 | 2015 | ||||||
| Total shareholders’ equity available to Arch (2) | $ | 8,253,718 | $ | 6,166,542 | |||
| Less preferred shareholders’ equity | 772,555 | 325,000 | |||||
| Common shareholders’ equity available to Arch (2) | $ | 7,481,163 | $ | 5,841,542 | |||
| Common shares and common share equivalents outstanding, net of treasury shares (1) | 135,550,337 | 122,627,783 | |||||
| Book value per share (2) | $ | 55.19 | $ | 47.64 |
| (1) | Excludes the effects of 6,872,494 and 7,482,462 stock options and 381,461 and 413,364 restricted stock units outstanding at December 31, 2016 and December 31, 2015, respectively. |
| (2) | Balance for December 31, 2015 reflects a cumulative effect of an accounting change. See note 1, “General,” of the notes accompanying our consolidated financial statements for additional information. |
Liquidity and Capital Resources
This section does not include information specific to Watford Re. We do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from reinsurance transactions with Watford Re.
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, ACGL depends on its available cash resources, liquid investments and dividends or other distributions from its subsidiaries to make payments, including the payment of debt service obligations and operating expenses it may incur and any dividends or liquidation amounts with respect to our preferred and common shares. ACGL’s readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled $4.3 million at December 31, 2016, compared to $6.9 million at December 31, 2015. During 2016, ACGL received dividends of $196.9 million from Arch Re Bermuda, our Bermuda-based reinsurer and insurer.
The ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Arch Re Bermuda is required to maintain an enhanced capital requirement which must equal or exceed its minimum solvency margin (i.e., the amount by which the value of its general business assets must exceed its general business liabilities) equal to the greatest of (1) $100.0 million, (2) 50% of net premiums written (being gross premiums written less any premiums ceded by Arch Re Bermuda, but Arch Re Bermuda may not deduct more than 25% of gross premiums when computing net premiums written) and (3) 15% of net discounted aggregated losses and loss expense provisions and other insurance reserves. Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with its enhanced capital requirement, minimum solvency margin or minimum liquidity ratio. In addition, Arch Re Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet) unless it files, at least seven days before payment of such dividends, with the Bermuda Monetary Authority (“BMA”) an affidavit stating that it will continue to meet the required margins. In addition, Arch Re Bermuda is prohibited, without prior approval of the BMA, from reducing by 15% or more its total statutory capital, as set out in its previous year’s statutory financial statements. As a Class 4 insurer, Arch Re Bermuda is required to maintain available statutory capital and surplus pertaining to its general business at a level equal to or in excess of its enhanced capital requirement (“ECR”) which is established by reference to either the BSCR model (“BSCR”) or an approved internal capital model. At December 31, 2016, as determined under Bermuda law, Arch Re Bermuda had statutory capital and surplus of $7.88 billion ($5.43 billion at December 31, 2015), which amounts were in compliance with Arch Re Bermuda’s ECR at such date. Such amounts include ownership interests in U.S. insurance and reinsurance subsidiaries. Accordingly, Arch Re Bermuda can pay approximately $1.97 billion to ACGL during 2016 without providing an affidavit to the BMA, as discussed above. Under BMA guidelines, the value of the assets of our insurance group (i.e., the group of companies that conducts exclusively, or mainly, insurance business) must exceed the amount of the group’s liabilities by the aggregate minimum margin of solvency of each qualifying member of the group (the “Group MSM”). A member is a qualifying member of the insurance group if it is subject to solvency requirements in the jurisdiction in which it is registered. We were in compliance with the Group MSM at December 31, 2016.
Our U.S. insurance and reinsurance subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate. The ability of our regulated insurance subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. These regulations
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include restrictions that limit the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities. Dividends or distributions, if any, made by Arch Re U.S. would result in an increase in available capital at Arch Capital Group (U.S.) Inc. (“Arch-U.S.”), a wholly-owned subsidiary of ACGL. During 2016, Arch-U.S. received dividends of $25.0 million from Arch Re U.S. Arch Re U.S. can declare a maximum of approximately $128.4 million of dividends during 2017 subject to the approval of the Commissioner of the Delaware Department of Insurance (“Commissioner”). In addition, with respect to dividends in excess of the $128.4 million (extraordinary dividend), no payment can be made until (1) 30 days after the Commissioner has received notice of the declaration thereof and has not within such period disapproved such payments; or (2) the Commissioner shall have approved the payment within the 30-day period. Delaware insurance laws also require that the statutory surplus of Arch Re U.S. following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate to its financial needs.
AMIC, United Guaranty Residential Insurance Company and United Guaranty Mortgage Indemnity Company have each been approved as an eligible mortgage insurer by Fannie Mae and Freddie Mac, subject to maintaining certain ongoing requirements (“eligible mortgage insurer”). In April 2015, the GSEs published comprehensive, revised requirements, known as the Private Mortgage Insurer Eligibility Requirements or “PMIERs.” As clarified and revised by the Guidance Letters issued by the GSEs in December 2016, the PMIERs apply to our eligible mortgage insurers, but do not apply to Arch Mortgage Guaranty Company, which is not GSE-approved. The PMIERs impose limitations on the type of risk insured, the forms and insurance policies issued, standards for the geographic and customer diversification of risk, procedures for claims handling, acceptable underwriting practices, standards for certain reinsurance cessions and financial requirements, among other things. The financial requirements require an eligible mortgage insurer’s available assets, which generally include only the most liquid assets of an insurer, to meet or exceed “minimum required assets” as of each quarter end. Minimum required assets are calculated from PMIERs tables with several risk dimensions (including origination year, original loan-to-value and original credit score of performing loans, and the delinquency status of non-performing loans) and are subject to a minimum amount.
The amount of assets required to satisfy the revised financial requirements of the PMIERs at any point in time will be affected by many factors, including macro-economic conditions, the size and composition of our eligible mortgage insurers’ mortgage insurance portfolio at the point in time, and the amount of risk ceded to reinsurers that may be deducted in our calculation of “minimum required assets.” Our eligible
mortgage insurers satisfied the PMIERs’ financial requirements as of December 31, 2016.
Under the PMIERs, AMIC was deemed to be a “newly-approved insurer.” As a result of this status, until January 2017, AMIC was subject to additional PMIER requirements, including restrictions on dividends to affiliates or making any investment, contribution or loan to any affiliate. Since January 2017, none of our eligible mortgage insurers are classified as a “newly-approved insurer” under PMIERs.
In conjunction with the acquisition of UGC and the related approval of the change of control by the GSEs, the GSEs imposed additional requirements on our eligible mortgage insurers, including maintaining capital in excess of PMIERs requirements on a consolidated basis and requiring notifications relating to certain integration activities.
Our U.S. mortgage insurance subsidiaries are subject to detailed regulation by their domiciliary and primary regulators, the Wisconsin Office of the Commissioner of Insurance (“Wisconsin OCI”) for AMIC and Arch Mortgage Guaranty Company, and the North Carolina Department of Insurance (“NC DOI”) for United Guaranty Residential Insurance Company and United Guaranty Mortgage Indemnity Company, and by state insurance departments in each state in which they are licensed. As mandated by state insurance laws, mortgage insurers are generally mono-line companies restricted to writing a single type of insurance business, such as mortgage insurance business. Each company is subject to either Wisconsin or North Carolina statutory requirements as to payment of dividends. Generally, both Wisconsin and North Carolina law precludes any dividend before giving at least 30 days’ notice to the Wisconsin OCI or NC DOI, as applicable, and prohibits paying any dividend unless it is fair and reasonable to do so. In addition, the state regulators and the GSEs limit or restrict our eligible mortgage insurers’ ability to pay stockholder dividends or otherwise return capital to shareholders. Under North Carolina law, United Guaranty Residential Insurance Company can declare a maximum of approximately $313.3 million of dividends during 2017 subject to the approval of the NC DOI. In certain instances, approval by the GSEs would be required for dividends or other forms of return of capital to shareholders due to the requirements under PMIERs, including the minimum required assets imposed on our eligible mortgage insurers by the GSEs. Such dividend would result in an increase in available capital at Arch U.S. MI Holdings Inc., a subsidiary of Arch-U.S.
In addition to meeting applicable regulatory standards, the ability of our insurance and reinsurance subsidiaries to pay dividends to intermediate parent companies owned by Arch Re Bermuda is also constrained by our dependence on the financial strength ratings of our insurance and reinsurance subsidiaries from independent rating agencies. The ratings from these agencies depend to a large extent on the capitalization levels of
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our insurance and reinsurance subsidiaries. We believe that ACGL has sufficient cash resources and available dividend capacity to service its indebtedness and other current outstanding obligations.
Our insurance, reinsurance and mortgage insurance subsidiaries are required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support their operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. Our insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. At December 31, 2016 and 2015, such amounts approximated $5.48 billion and $5.20 billion, respectively, excluding amounts related to the ‘other’ segment.
Our non-U.S. operations account for a significant percentage of our net premiums written. In general, the business written by our non-U.S. operations, which is heavily weighted towards reinsurance business, has been more profitable than the business written in our U.S. operations, which is weighted more towards insurance business. In general, our reinsurance segment has operated at a higher margin than our insurance segment, largely due to the mix and type of business written. A significant component of our pre-tax income is generated through our investment performance. We hold a substantial amount of our investable assets in our non-U.S. operations and, accordingly, a large portion of our investment income is produced in our non-U.S. operations. In addition, ACGL, through its subsidiaries, provides financial support to certain of its insurance subsidiaries and affiliates, through certain reinsurance arrangements beneficial to the ratings of such subsidiaries. Our U.S.-based insurance, reinsurance and mortgage insurance subsidiaries enter into separate reinsurance arrangements with Arch Re Bermuda covering individual lines of business. For the 2016 calendar year, the U.S. groups ceded business to Arch Re Bermuda at an aggregate net cession rate (i.e., net of third party reinsurance) of approximately 53% (compared to 53% for 2015). All of the above factors have resulted in the non-U.S. group providing a higher contribution to our overall pre-tax income in the current period than the percentage of net premiums written would indicate.
Except as described in the above paragraph, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of ACGL’s subsidiaries or affiliates is solely responsible for its own liabilities and commitments (and no other ACGL subsidiary or affiliate is so responsible). Any reinsurance arrangements, guarantees or other financial support contractual arrangements that are in place are solely for the benefit of the ACGL subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements.
The following table summarizes our cash flows from operating, investing and financing activities, excluding amounts related to the ‘other’ segment:
| Year Ended December 31, | |||||||||||
| 2016 | 2015 | 2014 | |||||||||
| Total cash provided by (used for): | |||||||||||
| Operating activities | $ | 1,109,913 | $ | 705,128 | $ | 997,815 | |||||
| Investing activities | (2,602,714 | ) | (357,038 | ) | (422,879 | ) | |||||
| Financing activities | 1,830,042 | (367,529 | ) | (515,880 | ) | ||||||
| Effects of exchange rate changes on foreign currency cash | (13,967 | ) | (10,031 | ) | (18,686 | ) | |||||
| Increase (decrease) in cash | $ | 323,274 | $ | (29,470 | ) | $ | 40,370 |
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Cash provided by operating activities for 2016 was higher than in 2015, primarily reflecting a higher level of premiums collected. The 2015 period also reflected a higher level of outflows related to our mortgage operations.
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Cash used for investing activities for 2016 was higher than in 2015. Activity for 2016 reflected our acquisition of UGC which closed on December 31, 2016, along with higher net purchases of investments than in the 2015 period.
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Cash provided by financing activities for 2016 reflected various capital raising activity, such as the issuance of $950.0 million of senior notes, $400.0 million of borrowings under our revolving loan facility and $450.0 million of preferred shares in order to fund the cash consideration portion of the UGC acquisition. Cash flows also reflect a lower level of repurchases under our share repurchase program in 2016 compared to 2015.
Our insurance and reinsurance operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time losses are paid. The period of time from the occurrence of a claim through the settlement of the liability may extend many years into the future. Sources of liquidity include cash flows from operations, financing arrangements or routine sales of investments.
As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. However, due to the nature of our operations, cash flows are affected by claim payments that may comprise large payments on a limited number of claims and which can fluctuate from year to year. We believe that our liquid investments and cash flow will provide us with sufficient liquidity in order to meet our claim payment obligations. However, the timing and amounts of actual claim payments related to recorded Loss Reserves vary based on many factors, including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claim payments could differ materially from our estimated amounts. Certain
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lines of business written by us, such as excess casualty, have loss experience characterized as low frequency and high severity. The foregoing may result in significant variability in loss payment patterns. The impact of this variability can be exacerbated by the fact that the timing of the receipt of reinsurance recoverables owed to us may be slower than anticipated by us. Therefore, the irregular timing of claim payments can create significant variations in cash flows from operations between periods and may require us to utilize other sources of liquidity to make these payments, which may include the sale of investments or utilization of existing or new credit facilities or capital market transactions. If the source of liquidity is the sale of investments, we may be forced to sell such investments at a loss, which may be material.
Our investments in certain securities, including certain fixed income and structured securities, investments in funds accounted for using the equity method, other alternative investments and investments in ventures such as Watford Re and others may be illiquid due to contractual provisions or investment market conditions. If we require significant amounts of cash on short notice in excess of anticipated cash requirements, then we may have difficulty selling these investments in a timely manner or may be forced to sell or terminate them at unfavorable values. Our unfunded investment commitments totaled approximately $1.29 billion at December 31, 2016 and are callable by our investment managers. The timing of the funding of investment commitments is uncertain and may require us to access cash on short notice.
At December 31, 2016, our investable assets were $18.64 billion, excluding the $1.86 billion of investable assets related to the ‘other’ segment. The primary goals of our asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including debt service obligations. Generally, the expected principal and interest payments produced by our fixed income portfolio adequately fund the estimated runoff of our insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the fair value of the fixed income portfolio exceeds the expected present value of the net insurance liabilities, as well as the positive cash flow from newly sold policies and the large amount of high quality liquid bonds, provide assurance of our ability to fund the payment of claims and to service our outstanding debt without having to sell securities at distressed prices or access credit facilities.
Changes in general economic conditions, including new or continued sovereign debt concerns in Eurozone countries or downgrades of U.S. securities by credit rating agencies, could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business,
financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio. Our investment portfolio as of December 31, 2016 included $187.4 million of securities issued and/or guaranteed by Eurozone governments at fair value, $2.80 billion of obligations of the U.S. government and government agencies at fair value and $3.71 billion of municipal bonds at fair value. Please refer to Item 1A “Risk Factors” for a discussion of other risks relating to our business and investment portfolio.
On December 31, 2016, we completed the acquisition of UGC pursuant to the Stock Purchase Agreement with AIG. The aggregate purchase price paid by ACGL was approximately $3.26 billion, consisting of cash consideration of $2.16 billion and convertible non-voting common-equivalent preference shares of ACGL with a fair value of approximately $1.10 billion.
In September 2016, ACGL completed a $450.0 million underwritten public offering of 18.0 million depositary shares, each of which represents a 1/1,000th interest in a share of its 5.25% Non-Cumulative Preferred Shares, Series E, have a $0.01 par value and $25,000 liquidation preference per share (equivalent to $25 liquidation preference per depositary share). Except in specified circumstances relating to certain tax or corporate events, the preferred shares are not redeemable prior to September 29, 2021. We used the net proceeds from the offering of $434.9 million to fund a portion of the UGC acquisition.
In October 2016, we entered into a five-year agreement for a $500.0 million unsecured revolving loan and letter of credit facility and a $350.0 million secured letter of credit facility. We borrowed the full remaining capacity available from the unsecured revolving loan and letter of credit facility ($400.0 million) and used the proceeds to fund a portion of the UGC acquisition. At December 31, 2016, we had no remaining capacity under the unsecured revolving loan facility and $187.9 million of remaining capacity under the secured letter of credit facility. Refer to note 16, “Commitments and Contingencies—Letter of Credit and Revolving Credit Facilities,” of the notes accompanying our consolidated financial statements for a discussion of our available facilities, applicable covenants on such facilities and available capacity.
In December 2016, Arch Capital Finance LLC (“Arch Finance”), a wholly-owned subsidiary of ACGL, completed a public offering of $500.0 million principal amount of 4.011% senior notes issued at par and due December 15, 2026 (“2026 notes”) and $450.0 million principal amount of 5.031% senior notes issued at par and due December 15, 2046 (“2046 notes”), both fully and unconditionally guaranteed by ACGL. The 2026 notes and 2046 notes are unsecured and unsubordinated obligations of Arch Finance and ACGL, respectively, and rank equally and ratably with the other unsecured unsubordinated indebtedness of Arch-U.S. and ACGL. We used the combined
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net proceeds from the offering of 2026 notes and 2046 notes of $940.7 million to fund a portion of the UGC acquisition.
Pursuant to our 2014 acquisition of the CMG Entities, we are required to make contingent consideration payments based on the closing book value of the pre-closing portfolio of the CMG Entities as re-calculated over an earn-out period and payable at the third, fifth and sixth anniversaries after closing (subject to a one time extension period of one to three years at the sellers’ discretion). The maximum amount of contingent consideration payments is $136.9 million over the earn-out period (or 150% of the closing book value of the CMG Entities less amounts paid at closing). We currently expect that the maximum amount will be paid over the earn-out period and that the first payment, due in April 2017, will be approximately $70 million. To the extent that the adjusted book value of the CMG Entities drops below the cumulative amount paid by us, no additional payments would be due.
We expect that our liquidity needs, including our anticipated insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by funds generated from underwriting activities and investment income, as well as by our balance of cash, short-term investments, proceeds on the sale or maturity of our investments, and our credit facilities.
In addition, we monitor our capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by several ratings agencies, at a level considered necessary by management to enable our key operating subsidiaries to compete; (2) sufficient capital to enable our underwriting subsidiaries to meet the capital adequacy tests performed by statutory agencies in the U.S. and other key markets; and (3) our non-U.S. operating companies are required to post letters of credit and other forms of collateral that are necessary for them to operate as they are “non-admitted” under U.S. state insurance regulations.
As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements and such other factors as our board of directors deems relevant.
The board of directors of ACGL has authorized the investment in ACGL’s common shares through a share repurchase program. Since the inception of the share repurchase program through December 31, 2016, ACGL has repurchased approximately 125.2 million common shares for an aggregate purchase price of $3.68 billion. At December 31, 2016, approximately $446.5 million of share repurchases were available under the program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through December 31, 2019. The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations. We will continue to monitor our share price and, depending upon results of operations, market conditions and the development of the economy, as well as other factors, we will consider share repurchases on an opportunistic basis.
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. We can provide no assurance that, if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all. Any adverse developments in the financial markets, such as disruptions, uncertainty or volatility in the capital and credit markets, may result in realized and unrealized capital losses that could have a material adverse effect on our results of operations, financial position and our businesses, and may also limit our access to capital required to operate our business.
If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our operating subsidiaries, which could place those operating subsidiaries at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our operating subsidiaries are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of bank credit and letters of credit. In addition, under certain of the reinsurance agreements assumed by our reinsurance operations, upon the occurrence of a ratings downgrade or other specified triggering event with respect to our reinsurance operations, such as a reduction in surplus by specified amounts during specified periods, our ceding company clients may be provided with certain rights, including, among other things, the right to terminate the subject reinsurance agreement and/or to require that our reinsurance operations post additional collateral.
In addition to common share capital, we depend on external sources of finance to support our underwriting activities, which
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can be in the form (or any combination) of debt securities, preference shares, common equity and bank credit facilities providing loans and/or letters of credit. As noted above, equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities.
In November 2016, ACGL, Arch-U.S. and Arch Finance filed a universal shelf registration statement with the SEC. This registration statement allows for the possible future offer and sale by us of various types of securities, including unsecured debt securities, preference shares, common shares, warrants, share purchase contracts and units and depositary shares. The shelf registration statement enables us to efficiently access the public debt and/or equity capital markets in order to meet our future capital needs. The shelf registration statement also allows selling shareholders to resell common shares that they own in one or more offerings from time to time. We will not receive any proceeds from any shares offered by the selling shareholders. This report is not an offer to sell or the solicitation of an offer to buy nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state.
At December 31, 2016, total capital available to Arch of $10.49 billion consisted of $1.73 billion of senior notes, representing 16.5% of the total, $500.0 million of revolving credit agreement borrowings due in October 2021, representing 4.8% of the total, $772.6 million of preferred shares, representing 7.4% of the total, and common shareholders’ equity of $7.48 billion, representing 71.3% of the total. At December 31, 2015, total capital available to Arch of $7.06 billion consisted of $791.3 million of senior notes, representing 11.2% of the total, $100.0 million of revolving credit agreement borrowings, representing 1.4% of the total, $325.0 million of preferred shares, representing 4.6% of the total, and common shareholders’ equity of $5.84 billion, representing 82.8% of the total. The increase in total capital in 2016 was primarily attributable to capital raising activity related to the UGC acquisition and underwriting and investing returns.
NATURAL AND MAN-MADE CATASTROPHIC EVENTS
We have large aggregate exposures to natural and man-made catastrophic events. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, tornados, explosions, severe winter weather, fires, droughts and other natural disasters. Catastrophes can also cause losses in non-property business such as workers’ compensation or general liability. In addition to the nature of property business, we believe that economic and geographic
trends affecting insured property, including inflation, property value appreciation and geographic concentration, tend to generally increase the size of losses from catastrophic events over time.
We have substantial exposure to unexpected, large losses resulting from future man-made catastrophic events, such as acts of war, acts of terrorism and political instability. These risks are inherently unpredictable. It is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. It is not possible to completely eliminate our exposure to unforecasted or unpredictable events and, to the extent that losses from such risks occur, our financial condition and results of operations could be materially adversely affected. Therefore, claims for natural and man-made catastrophic events could expose us to large losses and cause substantial volatility in our results of operations, which could cause the value of our common shares to fluctuate widely. In certain instances, we specifically insure and reinsure risks resulting from terrorism. Even in cases where we attempt to exclude losses from terrorism and certain other similar risks from some coverages written by us, we may not be successful in doing so. Moreover, irrespective of the clarity and inclusiveness of policy language, there can be no assurance that a court or arbitration panel will limit enforceability of policy language or otherwise issue a ruling adverse to us.
We seek to limit our loss exposure by writing a number of our reinsurance contracts on an excess of loss basis, adhering to maximum limitations on reinsurance written in defined geographical zones, limiting program size for each client and prudent underwriting of each program written. In the case of proportional treaties, we may seek per occurrence limitations or loss ratio caps to limit the impact of losses from any one or series of events. In our insurance operations, we seek to limit our exposure through the purchase of reinsurance. We cannot be certain that any of these loss limitation methods will be effective. We also seek to limit our loss exposure by geographic diversification. Geographic zone limitations involve significant underwriting judgments, including the determination of the area of the zones and the inclusion of a particular policy within a particular zone's limits. There can be no assurance that various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, will be enforceable in the manner we intend. Disputes relating to coverage and choice of legal forum may also arise. Underwriting is inherently a matter of judgment, involving important assumptions about matters that are inherently unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance. One or more catastrophic or other events could result in claims that substantially exceed our expectations, which could have a material adverse effect on our financial condition or our results of operations, possibly to the extent of eliminating our shareholders' equity.
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For our natural catastrophe exposed business, we seek to limit the amount of exposure we will assume from any one insured or reinsured and the amount of the exposure to catastrophe losses from a single event in any geographic zone. We monitor our exposure to catastrophic events, including earthquake and wind and periodically reevaluate the estimated probable maximum pre-tax loss for such exposures. Our estimated probable maximum pre-tax loss is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. We seek to limit the probable maximum pre-tax loss to a specific level for severe catastrophic events. Currently, we seek to limit our 1-in-250 year return period net probable maximum loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders’ equity. We reserve the right to change this threshold at any time. Net probable maximum loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. Our loss estimates do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer pre-tax losses greater than 25% of our total shareholders' equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event. In addition, actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See “Risk Factors—Risk Relating to Our Industry.” Depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business. See “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Ceded Reinsurance” for a discussion of our catastrophe reinsurance programs.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The following section does not include information specific to Watford Re. We do not guarantee or provide credit support for
Watford Re, and our financial exposure to Watford Re is limited to our investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions.
Letter of Credit and Revolving Credit Facilities
As of December 31, 2016, ACGL and certain of its subsidiaries had a $350.0 million secured facility for letters of credit and a $500.0 million unsecured facility for revolving loans and letters of credit (the “Credit Agreement”). Obligations of each borrower under the secured facility for letters of credit are secured by cash and eligible securities of such borrower held in collateral accounts. Subject to the receipt of commitments, the secured facility may be increased by up to an aggregate of $350.0 million, and the unsecured facility may be increased to an amount not to exceed $750.0 million. ACGL has a one-time option to convert any or all outstanding revolving loans of ACGL and/or Arch-U.S. to term loans with the same terms as the revolving loans except that any prepayments may not be reborrowed. Arch-U.S. guarantees the obligations of ACGL, and ACGL guarantees the obligations of Arch-U.S. Borrowings of revolving loans may be made at a variable rate based on LIBOR or an alternative base rate at the option of ACGL. Secured letters of credit are available for issuance on behalf of ACGL insurance and reinsurance subsidiaries. The Credit Agreement and related documents are structured such that each party that requests a letter of credit or borrowing does so only for itself and for only its own obligations.
The Credit Agreement contains customary representations, conditions to issuance of letters of credit and borrowings which include, among other things: (i) the maintenance of a debt to total capital ratio of not greater than 0.35 to 1; (ii) consolidated tangible net worth in excess of $5.63 billion plus 25% of future aggregate net income (not including any future net losses) for each quarterly period ending after December 31, 2016 plus 25% of future aggregate net cash proceeds from the issuance of common or preferred equity (other than the proceeds of which are used to fund the repurchase or redemption of our preferred securities (“Refinanced Preferred Securities”)), minus 70% of up to $750.0 million of the aggregate book value of any preferred securities of ACGL which are repurchased or redeemed by ACGL or its subsidiaries (other than Refinanced Preferred Securities); and (iii) that ACGL’s principal insurance and reinsurance subsidiaries that are borrowers under the Credit Agreement maintain a financial strength rating of at least a “B++” from A.M. Best or “BBB+” from S&P. In addition, certain of ACGL’s subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders’ equity levels. Commitments under the Amended Credit Agreement will expire on October 26, 2021, and all loans then outstanding under the Amended Credit Agreement must be repaid. Letters of credit issued under the Amended Credit Agreement will not have an expiration date later than October 26, 2022. ACGL and its subsidiaries which are party to the Credit Agreement were
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in compliance with all covenants contained in the Credit Agreement at December 31, 2016.
In addition, certain of ACGL’s subsidiaries had outstanding letters of credit of $178.5 million, which were issued on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the “LOC Facilities”). The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from our reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, these letters of credit are secured by a portion of our investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which we were in compliance with at December 31, 2016. At such date, we had approximately $340.6 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of $400.2 million, and had $500.0 million of borrowings outstanding under the Credit Agreement. Under the $350.0 million secured letter of credit facility, we had remaining capacity of $187.9 million at December 31, 2016.
Senior Notes
On May 4, 2004, ACGL completed a public offering of $300.0 million principal amount of 7.35% senior notes due May 1, 2034 (“2034 notes”). The 2034 notes are ACGL’s senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. Interest payments on the 2034 notes are due on May 1st and November 1st of each year. ACGL may redeem the 2034 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The fair value of the 2034 notes at December 31, 2016 and 2015 was $392.0 million and $390.1 million, respectively.
On December 13, 2013, Arch-U.S., a wholly-owned subsidiary of ACGL, completed a public offering of $500.0 million principal amount of 5.144% senior notes due November 1, 2043 (“2043 notes”), fully and unconditionally guaranteed by ACGL. The 2043 notes are unsecured and unsubordinated obligations of Arch-U.S. and ACGL, respectively, and rank equally and
ratably with the other unsecured and unsubordinated indebtedness of Arch-U.S. and ACGL, respectively. Interest payments on the 2043 notes are due on May 1st and November 1st of each year. Arch-U.S. may redeem the 2043 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The fair value of the 2043 notes at December 31, 2016 and 2015 was $521.6 million and $513.9 million, respectively.
On December 8, 2016, Arch Finance, a wholly-owned subsidiary of ACGL, completed a public offering of $500.0 million principal amount of 4.011% senior notes due December 15, 2026 (“2026 notes”), fully and unconditionally guaranteed by ACGL. The 2026 notes are unsecured and unsubordinated obligations of Arch Finance and ACGL, respectively, and rank equally and ratably with the other unsecured and unsubordinated indebtedness of Arch Finance and ACGL, respectively. Interest payments on the 2026 notes are due on June 15th and December 15th of each year. Arch Finance may redeem the 2026 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The fair value of the 2026 notes at December 31, 2016 was $509.3 million.
On December 8, 2016, Arch Finance completed a public offering of $450.0 million principal amount of 5.031% senior notes due December 15, 2046 (“2046 notes”), fully and unconditionally guaranteed by ACGL. The 2046 notes are unsecured and unsubordinated obligations of Arch Finance and ACGL, respectively, and rank equally and ratably with the other unsecured and unsubordinated indebtedness of Arch Finance and ACGL, respectively. Interest payments on the 2046 notes are due on June 15th and December 15th of each year. Arch Finance may redeem the 2046 notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The fair value of the 2046 notes at December 31, 2016 was $476.0 million.
ACGL and Arch-U.S. are each holding companies and, accordingly, they conduct substantially all of their operations through their operating subsidiaries. Arch Finance is a wholly owned subsidiary of Arch U.S. MI Holdings Inc., a U.S. holding company. As a result, ACGL, Arch-U.S. and Arch Finance's cash flows and their ability to service their debt depends upon the earnings of their operating subsidiaries and on their ability to distribute the earnings, loans or other payments from such subsidiaries to ACGL, Arch-U.S. and Arch Finance, respectively.
During 2016, 2015 and 2014, we made interest payments of $50.4 million, $49.6 million and $46.4 million, respectively, related to our senior notes and other financing arrangements.
| ACGL 2016 FORM 10-K | 112 |
Contractual Obligations
The following table provides an analysis of our contractual commitments at December 31, 2016 (excluding amounts related to the ‘other’ segment’):
| Payment due by period | |||||||||||||||||||
| Total | Less than 1 year | 1-3 years | 3-5 years | More than 5 years | |||||||||||||||
| Operating activities | |||||||||||||||||||
| Estimated gross payments for losses and loss adjustment expenses (1) | $ | 10,200,960 | $ | 2,636,891 | $ | 3,008,378 | $ | 1,545,090 | $ | 3,010,601 | |||||||||
| Deposit accounting liabilities (2) | 22,150 | 1,038 | 1,015 | 1,652 | 18,445 | ||||||||||||||
| Contractholder payables (3) | 1,716,435 | 565,485 | 617,697 | 239,557 | 293,696 | ||||||||||||||
| Operating lease obligations | 178,096 | 29,881 | 56,578 | 42,166 | 49,471 | ||||||||||||||
| Purchase obligations | 24,807 | 18,280 | 6,527 | — | — | ||||||||||||||
| Contingent consideration liabilities (6) | 95,193 | 28,215 | 33,489 | 33,489 | — | ||||||||||||||
| Investing activities | |||||||||||||||||||
| Unfunded investment commitments (4) | 1,286,218 | 1,286,218 | — | — | — | ||||||||||||||
| Financing activities | |||||||||||||||||||
| Securities lending payable (5) | 762,554 | 762,554 | — | — | — | ||||||||||||||
| Senior notes (including interest payments) | 3,710,810 | 93,192 | 180,929 | 180,929 | 3,255,760 | ||||||||||||||
| Contingent consideration liabilities (6) | 41,762 | 41,762 | — | — | — | ||||||||||||||
| Capital lease obligations | 25,420 | 10,784 | 14,636 | — | — | ||||||||||||||
| Revolving credit agreement borrowings (7) | 500,000 | 500,000 | — | — | — | ||||||||||||||
| Total | $ | 18,564,405 | $ | 5,974,300 | $ | 3,919,249 | $ | 2,042,883 | $ | 6,627,973 |
| (1) | The estimated expected contractual commitments related to the reserves for losses and loss adjustment expenses are presented on a gross basis (i.e., not reflecting any corresponding reinsurance recoverable amounts that would be due to us). It should be noted that until a claim has been presented to us, determined to be valid, quantified and settled, there is no known obligation on an individual transaction basis, and while estimable in the aggregate, the timing and amount contain significant uncertainty. Approximately 63% of our reserves for losses and loss adjustment expenses were incurred but not reported at December 31, 2016. |
| (2) | The estimated expected contractual commitments related to deposit accounting liabilities have been estimated using projected cash flows from the underlying contracts. It should be noted that, due to the nature of such liabilities, the timing and amount contain significant uncertainty. |
| (3) | Certain insurance policies written by our insurance operations feature large deductibles, primarily in construction and national accounts lines. Under such contracts, we are obligated to pay the claimant for the full amount of the claim and are subsequently reimbursed by the policyholder for the deductible amount. In the event we are unable to collect from the policyholder, we would be liable for such defaulted amounts. |
| (4) | Unfunded investment commitments are callable by our investment managers. We have assumed that such investments will be funded in the next year but the funding may occur over a longer period of time, due to market conditions and other factors. |
| (5) | As part of our securities lending program, we loan securities to third parties and receive collateral in the form of cash or securities. Such collateral is due back to the third parties at the close of the securities lending transactions, a majority of which is overnight and continuous by nature. |
| (6) | Pursuant to our 2014 acquisition of the CMG Entities, we are required to make contingent consideration payments based on the closing book value of the pre-closing portfolio of the CMG Entities as re-calculated over an earn-out period and payable at the third, fifth and sixth anniversaries after closing (subject to a one time extension period of one to three years at the sellers’ discretion). The maximum amount of contingent consideration payments over the earn-out period is $136.9 million (or 150% of the closing book value of the CMG Entities less amounts paid at closing). For purposes of this table, the maximum exposure has been shown using an estimated payout pattern. |
| (7) | Amounts outstanding under credit facilities include $100 million borrowed by ACGL and $400 million borrowed by Arch U.S. MI Holdings Inc., its wholly owned subsidiary. Due to the variable nature of the interest payments on these borrowings and the ability to repay such borrowings at will, no interest payments have been reflected. |
| ACGL 2016 FORM 10-K | 113 |
OFF-BALANCE SHEET ARRANGEMENTS
Bellemeade Re I Ltd. and Bellemeade Re II Ltd. are special purpose variable interest entities that are not consolidated in our financial results because we do not have the unilateral power to direct those activities that are significant to its economic performance. As of December 31, 2016, our estimated off-balance sheet maximum exposure to loss from Bellemeade Re was $2.4 million. See note 4, “Variable Interest Entities—Bellemeade Re I and II,” of the notes accompanying our consolidated financial statements for additional information.
MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Our investment results are subject to a variety of risks, including risks related to changes in the business, financial condition or results of operations of the entities in which we invest, as well as changes in general economic conditions and overall market conditions. We are also exposed to potential loss from various market risks, including changes in equity prices, interest rates and foreign currency exchange rates.
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, 2016. Market risk represents the risk of changes in the fair value of a financial instrument and consists of several components, including liquidity, basis and price risks.
The sensitivity analysis performed as of December 31, 2016 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which were held by us on December 31, 2016 and are sensitive to changes in interest rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses.
We have not included Watford Re in the following analyses as we do not guarantee or provide credit support for Watford Re, and our financial exposure to Watford Re is limited to its investment in Watford Re’s common and preferred shares and counterparty credit risk (mitigated by collateral) arising from the reinsurance transactions.
The focus of the SEC’s market risk rules is on price risk. For purposes of specific risk analysis, we employ sensitivity
analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments. The financial instruments included in the following sensitivity analysis consist of all of our investments and cash.
Investment Market Risk
Fixed Income Securities. We invest in interest rate sensitive securities, primarily debt securities. We consider the effect of interest rate movements on the market value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments which invest in fixed income securities and the corresponding change in unrealized appreciation. As interest rates rise, the market value of our interest rate sensitive securities falls, and the converse is also true. Based on historical observations, there is a low probability that all interest rate yield curves would shift in the same direction at the same time. Furthermore, at times interest rate movements in certain credit sectors exhibit a much lower correlation to changes in U.S. Treasury yields. Accordingly, the actual effect of interest rate movements may differ materially from the amounts set forth in the following tables.
The following table summarizes the effect that an immediate, parallel shift in the interest rate yield curve would have had on our investment portfolio at December 31, 2016 and 2015:
| (U.S. dollars in billions) | Interest Rate Shift in Basis Points | ||||||||||||||||||
| -100 | -50 | - | +50 | +100 | |||||||||||||||
| Dec. 31, 2016 | |||||||||||||||||||
| Total fair value | $ | 17.95 | $ | 17.62 | $ | 17.31 | $ | 17.00 | $ | 16.70 | |||||||||
| Change from base | 3.7 | % | 1.8 | % | (1.8 | )% | (3.5 | )% | |||||||||||
| Change in unrealized value | $ | 0.64 | $ | 0.31 | $ | (0.31 | ) | $ | (0.61 | ) | |||||||||
| Dec. 31, 2015 | |||||||||||||||||||
| Total fair value | $ | 14.04 | $ | 13.80 | $ | 13.57 | $ | 13.34 | $ | 13.12 | |||||||||
| Change from base | 3.4 | % | 1.7 | % | (1.7 | )% | (3.3 | )% | |||||||||||
| Change in unrealized value | $ | 0.47 | $ | 0.23 | $ | (0.23 | ) | $ | (0.45 | ) |
In addition, we consider the effect of credit spread movements on the market value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments and investment funds accounted for using the equity method which invest in fixed income securities and the corresponding change in unrealized appreciation. As credit spreads widen, the fair value of our fixed income securities falls, and the converse is also true.
| ACGL 2016 FORM 10-K | 114 |
The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on the portfolio at December 31, 2016 and 2015:
| (U.S. dollars in billions) | Credit Spread Shift in Percentage | ||||||||||||||||||
| -100 | -50 | - | +50 | +100 | |||||||||||||||
| Dec. 31, 2016 | |||||||||||||||||||
| Total fair value | $ | 17.79 | $ | 17.55 | $ | 17.31 | $ | 17.07 | $ | 16.83 | |||||||||
| Change from base | 2.8 | % | 1.4 | % | (1.4 | )% | (2.8 | )% | |||||||||||
| Change in unrealized value | $ | 0.48 | $ | 0.24 | $ | (0.24 | ) | $ | (0.48 | ) | |||||||||
| Dec. 31, 2015 | |||||||||||||||||||
| Total fair value | $ | 13.97 | $ | 13.77 | $ | 13.57 | $ | 13.37 | $ | 13.17 | |||||||||
| Change from base | 3.0 | % | 1.5 | % | (1.5 | )% | (3.0 | )% | |||||||||||
| Change in unrealized value | $ | 0.40 | $ | 0.20 | $ | (0.20 | ) | $ | (0.40 | ) |
Another method that attempts to measure portfolio risk is Value-at-Risk (“VaR”). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio’s initial value. In other words, 95% of the time, should the risks taken into account in the VaR model perform per their historical tendencies, the portfolio’s loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio’s initial value. As of December 31, 2016, our portfolio’s VaR was estimated to be 3.75%, compared to an estimated 3.01% at December 31, 2015.
Equity Securities, Privately Held Securities and Other Investments. Our investment portfolio includes an allocation to equity securities, privately held securities and certain other investments. At December 31, 2016 and 2015, the fair value of our investments in equity securities, privately held securities and certain other investments totaled $558.0 million and $630.0 million, respectively. These securities are exposed to price risk, which is the potential loss arising from decreases in fair value. An immediate hypothetical 10% depreciation in the value of each position would reduce the fair value of such investments by approximately $55.8 million and $63.0 million at December 31, 2016 and 2015, respectively, and would have decreased book value per share by approximately $0.41 and $0.51, respectively.
Investment-Related Derivatives. At December 31, 2016, the notional value of all derivative instruments (excluding to-be-announced mortgage backed securities which are included in the fixed income securities analysis above and foreign currency forward contracts which are included in the foreign currency exchange risk analysis below) was $2.12 billion, compared to
$2.81 billion at December 31, 2015. If the underlying exposure of each investment-related derivative held at December 31, 2016 depreciated by 100 basis points, it would have resulted in a reduction in net income of approximately $21.2 million, and a decrease in book value per share of $0.16, compared to $28.1 million and $0.23, respectively, on investment-related derivatives held at December 31, 2015. If the underlying exposure of each investment-related derivative held at December 31, 2016 appreciated by 100 basis points, it would have resulted in an increase in net income of approximately $21.2 million, and an increase in book value per share of $0.16, compared to $28.1 million and $0.23, respectively, on investment-related derivatives held at December 31, 2015. See note 11, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives.
For further discussion on investment activity, please refer to “—Financial Condition, Liquidity and Capital Resources—Financial Condition—Investable Assets.”
Foreign Currency Exchange Risk
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Through our subsidiaries and branches located in various foreign countries, we conduct our insurance and reinsurance operations in a variety of local currencies other than the U.S. Dollar. We generally hold investments in foreign currencies which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities. We may also utilize foreign currency forward contracts and currency options as part of our investment strategy. See Note 11, “Derivative Instruments,” of the notes accompanying our consolidated financial statements for additional information.
| ACGL 2016 FORM 10-K | 115 |
The following table provides a summary of our net foreign currency exchange exposures, as well as foreign currency derivatives in place to manage these exposures:
| (U.S. dollars in thousands, except per share data) | December 31, 2016 | December 31, 2015 | |||||
| Net assets (liabilities), denominated in foreign currencies, excluding shareholders’ equity and derivatives | $ | (63,077 | ) | $ | (163,199 | ) | |
| Shareholders’ equity denominated in foreign currencies (1) | 290,752 | 328,133 | |||||
| Net foreign currency forward contracts outstanding (2) | (250,263 | ) | (97,658 | ) | |||
| Net exposures denominated in foreign currencies | $ | (22,588 | ) | $ | 67,276 | ||
| Pre-tax impact of a hypothetical 10% appreciation of the U.S. Dollar against foreign currencies: | |||||||
| Shareholders’ equity | $ | 2,259 | $ | (6,728 | ) | ||
| Book value per share | $ | 0.02 | $ | (0.05 | ) | ||
| Pre-tax impact of a hypothetical 10% decline of the U.S. Dollar against foreign currencies: | |||||||
| Shareholders’ equity | $ | (2,259 | ) | $ | 6,728 | ||
| Book value per share | $ | (0.02 | ) | $ | 0.05 |
| (1) | Represents capital contributions held in the foreign currencies of our operating units. |
| (2) | Represents the net notional value of outstanding foreign currency forward contracts. |
Although the Company generally attempts to match the currency of its projected liabilities with investments in the same currencies, from time to time the Company may elect to over or underweight one or more currencies, which could increase the Company’s exposure to foreign currency fluctuations and increase the volatility of the Company’s shareholders’ equity. Historical observations indicate a low probability that all foreign currency exchange rates would shift against the U.S. Dollar in the same direction and at the same time and, accordingly, the actual effect of foreign currency rate movements may differ materially from the amounts set forth above. For further discussion on foreign exchange activity, please refer to “—Results of Operations.”
Effects of Inflation
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect our reserves for losses and loss adjustment expenses and interest rates. The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The anticipated effects of inflation on us are considered in our catastrophe loss models. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled.
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