Item 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. (“Arch Capital” and, together with its subsidiaries, “we” or “us”) is a Bermuda public limited liability company with approximately $11.17 billion in capital at December 31, 2018 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

Our objective is to achieve an average operating return on average equity of 15% or greater over the insurance cycle, which we believe to be an attractive return to our common shareholders given the risks we assume. We continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline and continue to write a portion of our overall book in catastrophe-exposed business which has the potential to increase the volatility of our operating results.

The broad property casualty insurance market environment continues to be competitive, with only a few specialty areas providing opportunities to deploy capital at returns which meet our risk-adjusted return requirements. In most of our insurance lines of business, rate increases appear to be in excess of loss cost trends. However, the spread between rate changes and loss trend is a key variable in assessing expected returns and, in specialty lines, is volatile by nature. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts, shrinking premiums in more commoditized lines such as general liability and directors and officers, and by utilizing reinsurance purchases to reduce volatility on large account, high capacity business. Writings in property catastrophe-exposed business continued to remain low in 2018.

Our mortgage segment continues to experience generally favorable market conditions, with pricing in the U.S. stabilizing in the third quarter following the rate changes announced in the first half of 2018. Our results continue to reflect our success in making high quality credit underwriting risk decisions and building customer relationships.

Arch remains committed to providing solutions across many offerings as the marketplace evolves, including new mortgage credit risk transfer programs initiated by government sponsored enterprises, or “GSEs,” in 2018. Such programs have begun generating business with banks developing new systems to handle the programs and momentum beginning to build. In

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addition, we completed multiple Bellemeade risk transfers to the capital markets throughout 2018, increasing our protection for mortgage tail risk.

FINANCIAL MEASURES

Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for Arch Capital’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 Arch Capital’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 accretive or dilutive impact on book value per share depending on the purchase price. Book value per share was $21.52 at December 31, 2018, a 6.0% increase from $20.30 at December 31, 2017. The growth in 2018 reflected strong underwriting results, partially offset by the impact of an increase in interest rates on our fixed income securities.

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 investments accounted for using the equity method, net foreign exchange gains or losses and transaction costs and other, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to Arch common shareholders. See “Comment on Non-GAAP Financial Measures.” Our Operating ROAE was 10.7% for 2018, compared to 5.7% for 2017 and 9.4% for 2016. The higher Operating ROAE for 2018 reflected strong mortgage insurance underwriting performance, while 2017 returns reflected a higher level of catastrophic loss activity.

Total Return on Investments

Total return on investments includes investment income, equity in net income or loss of investments 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, 20180.33%-0.60%
Year Ended December 31, 20175.87%4.74%
Year Ended December 31, 20162.07%2.13%
(1)Our investment expenses were approximately 0.36%, 0.30% and 0.34%, respectively, of average invested assets in 2018, 2017 and 2016.

Total return for our investment portfolio outperformed that of the benchmark return index in 2018, reflecting strong performance from our alternative investments. Excluding foreign exchange, total return was 1.13% for 2018, compared to 4.98% for 2017 and 2.35% for 2016. Total return for 2018 reflected the impact of rising interest rates and widening credit spreads, which dampened the total return on our investment grade fixed income portfolio, and negative returns on equities.

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, 2018, the benchmark return index had an average credit quality of “Aa2” by Moody’s, an estimated duration of 3.23 years.

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The benchmark return index included weightings to the following indices:

%
ICE BoAML 1-10 Year U.S. Corporate & All Yankees, A - AAA Rated Index20.00%
ICE BoAML 1-5 Year U.S. Treasury Index15.00
ICE BoAML 1-10 Year U.S. Municipal Securities Index14.50
ICE BoAML 3-5 Year Fixed Rate Asset Backed Securities Index7.00
Bloomberg Barclays CMBS Invest Grade Aaa Total Return Index5.00
MSCI ACWI Net Total Return USD Index5.00
ICE BoAML German Government 1-10 Year Index5.00
ICE BoAML U.S. Mortgage Backed Securities Index4.00
Hedge Fund Research HFRX Fixed Income Credit Index3.50
Hedge Fund Research HFRX Equal Weighted Strategies3.50
ICE BoAML 5-10 Year U.S. Treasury Index3.00
ICE BoAML 1-5 Year U.K. Gilt Index3.00
ICE BoAML U.S. High Yield Constrained Index2.50
ICE BoAML 1-5 Year Australian Governments Index2.50
S&P Leveraged Loan Total Return Index2.50
ICE BoAML 0-3 Month U.S. Treasury Bill Index2.00
ICE BoAML 1-5 Year Canada Government Index1.50
ICE BoAML 20+ Year Canada Government Index0.50
Total100.00%

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 investments accounted for using the equity method, net foreign exchange gains or losses, transaction costs and other, loss on redemption of preferred shares 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 investments accounted for using the equity method, net foreign

exchange gains or losses, transaction costs and other and loss on redemption of preferred shares in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investments 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 investments 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 investments accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. Transaction costs and other include advisory, financing, legal, severance, incentive compensation and other transaction costs related to acquisitions, including UGC. During the 2016 fourth quarter, transaction costs and other included non-recurring expenses related to a change in the our approach on the deferral of certain internal underwriting costs which are no longer being deferred. We believe that transaction costs and other, due to their non-recurring nature, are not indicative of the performance of, or trends in, our business performance. The loss on redemption of preferred shares related to the redemption of our Series C preferred shares in September 2017 and January 2018 and had no impact on shareholders' equity or cash flows. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investments accounted for using the equity method, net foreign exchange gains or losses, transaction costs and other and loss on redemption of preferred shares from the calculation of after-tax operating income available to Arch common shareholders. In addition, income tax expense for 2017 included a $21.5 million charge

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due to the revaluation of the Company’s net deferred tax asset resulting from the reduction in the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Due to the non-recurring nature of this item, we excluded it from 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 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 4, “Segment Information,” to our consolidated financial statements in Item 8, 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 4, “Segment Information,” to our consolidated financial statements in Item 8.

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 investments 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,
201820172016
Net income available to Arch common shareholders$713,616$566,502$664,668
Net realized (gains) losses297,755(148,836)(77,081)
Net impairment losses recognized in earnings2,8297,13830,442
Equity in net (income) loss of investments accounted for using the equity method(45,641)(142,286)(48,475)
Net foreign exchange (gains) losses(59,890)113,613(31,987)
Transaction costs and other12,37722,15041,729
Loss on redemption of preferred shares2,7106,735—
Income tax expense (benefit) (1)(14,566)22,139(1,852)
After-tax operating income available to Arch common shareholders$909,190$447,155$577,444
Beginning common shareholders’ equity$8,324,047$7,481,163$5,841,542
Ending common shareholders’ equity8,659,8278,324,0477,481,163
Average common shareholders’ equity (2)$8,491,937$7,902,605$6,113,718
Annualized return on average common equity % (2)8.47.210.9
Annualized operating return on average common equity % (2)10.75.79.4
(1)Income tax on net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investments accounted for using the equity method, net foreign exchange gains or losses, transaction costs and other and loss on redemption of preferred shares reflects the relative mix reported by jurisdiction and the varying tax rates in each jurisdiction.
(2)2016 period reflects the weighted impact of the $1.10 billion of convertible non-voting common equivalent preferred shares 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 President and Chief Executive Officer of Arch Capital and the Chief Financial Officer of Arch Capital. 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 tables set forth our insurance segment’s underwriting results:

Year Ended December 31,
20182017% Change
Gross premiums written$3,262,332$3,081,0865.9
Premiums ceded(1,050,207)(958,646)
Net premiums written2,212,1252,122,4404.2
Change in unearned premiums(6,464)(9,422)
Net premiums earned2,205,6612,113,0184.4
Losses and loss adjustment expenses(1,520,680)(1,622,444)
Acquisition expenses(349,702)(323,639)
Other operating expenses(364,138)(359,524)
Underwriting income (loss)$(28,859)$(192,589)n/m
Underwriting Ratios% Point Change
Loss ratio68.9%76.8%(7.9)
Acquisition expense ratio15.9%15.3%0.6
Other operating expense ratio16.5%17.0%(0.5)
Combined ratio101.3%109.1%(7.8)
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Year Ended December 31,
20172016% Change
Gross premiums written$3,081,086$3,027,0491.8
Premiums ceded(958,646)(954,768)
Net premiums written2,122,4402,072,2812.4
Change in unearned premiums(9,422)1,623
Net premiums earned2,113,0182,073,9041.9
Losses and loss adjustment expenses(1,622,444)(1,359,313)
Acquisition expenses(323,639)(304,050)
Other operating expenses(359,524)(350,260)
Underwriting income$(192,589)$60,281(419.5)
Underwriting Ratios% Point Change
Loss ratio76.8%65.5%11.3
Acquisition expense ratio15.3%14.7%0.6
Other operating expense ratio17.0%16.9%0.1
Combined ratio109.1%97.1%12.0

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 tables set forth our insurance segment’s net premiums written by major line of business:

Year Ended December 31,
20182017
Amount%Amount%
Professional lines$450,40620.4$452,74821.3
Programs393,26317.8386,61818.2
Construction and national accounts320,93714.5327,64815.4
Travel, accident and health290,40113.1247,73811.7
Property, energy, marine and aviation219,1749.9172,2408.1
Excess and surplus casualty168,4677.6179,5118.5
Lenders products96,0944.396,8674.6
Other273,38312.4259,07012.2
Total$2,212,125100.0$2,122,440100.0

2018 versus 2017: Net premiums written by the insurance segment were 4.2% higher in 2018 than in 2017. The increase in net premiums written reflected growth in travel, due to both new business and growth in existing accounts, and in property, primarily due to new business and rate increases. These increases were partially offset by a reduction in contract binding and accident and health in response to market conditions.

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Year Ended December 31,
20172016
Amount%Amount%
Professional lines$452,74821.3$440,14921.2
Programs386,61818.2330,32215.9
Construction and national accounts327,64815.4328,99715.9
Travel, accident and health247,73811.7224,38010.8
Property, energy, marine and aviation172,2408.1175,3768.5
Excess and surplus casualty179,5118.5214,86310.4
Lenders products96,8674.6105,6505.1
Other259,07012.2252,54412.2
Total$2,122,440100.0$2,072,281100.0

2017 versus 2016: Net premiums written by the insurance segment were 2.4% higher in 2017 than in 2016. The increase in net premiums written reflected growth in programs, due to the continued effects of two newer programs, in travel, accident and health, reflecting both new travel business and continued expansion in existing travel accounts, and in professional lines, reflecting increases in small and medium sized accounts. Such amounts were partially offset by a reduction in excess and surplus casualty in response to market conditions.

Net Premiums Earned.

The following tables set forth our insurance segment’s net premiums earned by major line of business:

Year Ended December 31,
20182017
Amount%Amount%
Professional lines$458,42520.8$444,13721.0
Programs389,18617.6364,63917.3
Construction and national accounts322,44014.6324,51715.4
Travel, accident and health297,14713.5257,35812.2
Property, energy, marine and aviation205,0699.3173,7798.2
Excess and surplus casualty172,4247.8195,1549.2
Lenders products94,2484.397,0434.6
Other266,72212.1256,39112.1
Total$2,205,661100.0$2,113,018100.0
Year Ended December 31,
20172016
Amount%Amount%
Professional lines$444,13721.0$431,39120.8
Programs364,63917.3357,71517.2
Construction and national accounts324,51715.4322,07215.5
Travel, accident and health257,35812.2219,16910.6
Property, energy, marine and aviation173,7798.2188,9389.1
Excess and surplus casualty195,1549.2219,04610.6
Lenders products97,0434.698,5174.8
Other256,39112.1237,05611.4
Total$2,113,018100.0$2,073,904100.0

Net premiums earned by the insurance segment were 4.4% higher in 2018 than in 2017, reflecting changes in net premiums written over the previous five quarters. Net premiums earned by the insurance segment were 1.9% higher in 2017 than in 2016.

Losses and Loss Adjustment Expenses.

The table below shows the components of the insurance segment’s loss ratio:

Year Ended December 31,
201820172016
Current year70.0%77.2%67.1%
Prior period reserve development(1.1)%(0.4)%(1.6)%
Loss ratio68.9%76.8%65.5%

Current Year Loss Ratio.

2018 versus 2017: The insurance segment’s current year loss ratio was 7.2 points lower in 2018 than in 2017. The 2018 loss ratio included 3.4 points of current year catastrophic event activity, primarily related to Hurricanes Florence and Michael and the California wildfires, compared to 10.3 points in 2017, primarily related to Hurricanes Harvey, Irma and Maria and California wildfires. The balance of the change in the 2018 loss ratio resulted, in part, from changes in mix of business and the level of large attritional losses.

2017 versus 2016: The insurance segment’s current year loss ratio was 10.1 points higher in 2017 than in 2016. The 2017 loss ratio included 10.3 points of current year catastrophic event activity, primarily related to Hurricanes Harvey, Irma and Maria and the California wildfires, compared to 2.2 points in 2016. The 2017 loss ratio also reflected changes in the level of attritional large losses and changes in the mix of business.

Prior Period Reserve Development.

The insurance segment’s net favorable development was $24.4 million, or 1.1 points, for 2018, compared to $8.6 million, or

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0.4 points, for 2017, and $33.1 million, or 1.6 points, for 2016. See note 5, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements in Item 8 for information about the insurance segment’s prior year reserve development.

Underwriting Expenses.

2018 versus 2017: The insurance segment’s underwriting expense ratio was 32.4% in 2018, compared to 32.3% in 2017. The comparison of the underwriting expense ratios reflects changes in the mix of business due to growth in lines of business with higher acquisition costs.

2017 versus 2016: The insurance segment’s underwriting expense ratio was 32.3% in 2017, compared to 31.6% in 2016 reflecting changes in the level of reinsurance ceded on a quota share basis and changes in the mix of business.

Reinsurance Segment

The following tables set forth our reinsurance segment’s underwriting results:

Year Ended December 31,
20182017% Change
Gross premiums written$1,912,522$1,640,39916.6
Premiums ceded(539,950)(465,925)
Net premiums written1,372,5721,174,47416.9
Change in unearned premiums(111,356)(31,853)
Net premiums earned1,261,2161,142,62110.4
Other underwriting income(682)11,336
Losses and loss adjustment expenses(846,882)(773,923)
Acquisition expenses(211,280)(221,250)
Other operating expenses(133,350)(146,663)
Underwriting income$69,022$12,121469.4
Underwriting Ratios% Point Change
Loss ratio67.1%67.7%(0.6)
Acquisition expense ratio16.8%19.4%(2.6)
Other operating expense ratio10.6%12.8%(2.2)
Combined ratio94.5%99.9%(5.4)
Year Ended December 31,
20172016% Change
Gross premiums written$1,640,399$1,494,3979.8
Premiums ceded(465,925)(440,541)
Net premiums written1,174,4741,053,85611.4
Change in unearned premiums(31,853)2,376
Net premiums earned1,142,6211,056,2328.2
Other underwriting income11,33636,403
Losses and loss adjustment expenses(773,923)(475,762)
Acquisition expenses(221,250)(212,258)
Other operating expenses(146,663)(142,616)
Underwriting income$12,121$261,999(95.4)
Underwriting Ratios% Point Change
Loss ratio67.7%45.0%22.7
Acquisition expense ratio19.4%20.1%(0.7)
Other operating expense ratio12.8%13.5%(0.7)
Combined ratio99.9%78.6%21.3

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,

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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.

Premiums Written.

The following tables set forth our reinsurance segment’s net premiums written by major line of business:

Year Ended December 31,
20182017
Amount%Amount%
Other specialty$507,97137.0$459,21339.1
Casualty400,17829.2340,42929.0
Property excluding property catastrophe310,29322.6243,69320.7
Property catastrophe79,6245.870,1556.0
Marine and aviation38,0132.832,7592.8
Other36,4932.728,2252.4
Total$1,372,572100.0$1,174,474100.0
Pro rata$782,26857.0$708,69460.3
Excess of loss590,30443.0465,78039.7
Total$1,372,572100.0$1,174,474100.0

2018 versus 2017: Gross premiums written by the reinsurance segment in 2018 were 16.6% higher than in 2017, while net premiums written were 16.9% higher than in 2017. The increase in net premiums written reflected growth in casualty lines and property lines, primarily due to new business and rate increases, and in other specialty, primarily due to new international motor contracts. Net premiums written in 2018 also included reinstatement premiums of $4.0 million, primarily for Hurricanes Florence and Michael, Typhoon Jebi, California wildfires and adjustments for other events, compared to $15.9 million in 2017 for Hurricanes Harvey, Irma, Maria, as well as adjustments for other events.

Year Ended December 31,
20172016
Amount%Amount%
Other specialty$459,21339.1$348,85233.1
Casualty340,42929.0305,25229.0
Property excluding property catastrophe243,69320.7267,54825.4
Property catastrophe70,1556.075,7897.2
Marine and aviation32,7592.837,7903.6
Other28,2252.418,6251.8
Total$1,174,474100.0$1,053,856100.0
Pro rata$708,69460.3$558,67153.0
Excess of loss465,78039.7495,18547.0
Total$1,174,474100.0$1,053,856100.0

2017 versus 2016: Gross premiums written by the reinsurance segment in 2017 were 9.8% higher than in 2016, while net premiums written were 11.4% higher than in 2016. Premiums written reflected growth in other specialty business, primarily in international motor quota share contracts, and in casualty business, primarily due to a $45.4 million retroactive reinsurance contract which was substantially earned in the period and resulted in a corresponding increase to losses and loss adjustment expenses. Net premiums written in 2017 included reinstatement premiums of $15.9 million for Hurricanes Harvey, Irma and Maria. Such amounts were partially offset by a reduction in property excluding property catastrophe business, primarily related to a targeted reduction in onshore energy writings.

Net Premiums Earned.

The following tables set forth our reinsurance segment’s net premiums earned by major line of business:

Year Ended December 31,
20182017
Amount%Amount%
Other specialty$474,56837.6$408,56635.8
Casualty347,03427.5341,12229.9
Property excluding property catastrophe287,78822.8255,45322.4
Property catastrophe75,2496.073,3006.4
Marine and aviation39,2383.136,2143.2
Other37,3393.027,9662.4
Total$1,261,216100.0$1,142,621100.0
Pro rata$719,86057.1$657,49057.5
Excess of loss541,35642.9485,13142.5
Total$1,261,216100.0$1,142,621100.0
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Year Ended December 31,
20172016
Amount%Amount%
Other specialty$408,56635.8$329,99431.2
Casualty341,12229.9300,16028.4
Property excluding property catastrophe255,45322.4282,01826.7
Property catastrophe73,3006.473,8037.0
Marine and aviation36,2143.252,5795.0
Other27,9662.417,6781.7
Total$1,142,621100.0$1,056,232100.0
Pro rata$657,49057.5$561,98653.2
Excess of loss485,13142.5494,24646.8
Total$1,142,621100.0$1,056,232100.0

Net premiums earned in 2018 were 10.4% higher than in 2017, reflecting changes in net premiums written over the previous five quarters, including the mix and type of business written. Net premiums earned in 2017 were 8.2% higher than in 2016.

Other Underwriting Income (Loss).

Other underwriting loss in 2018 was $0.7 million, compared to other underwriting income of $11.3 million in 2017 and $36.4 million in 2016. 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,
201820172016
Current year78.1%82.2%65.7%
Prior period reserve development(11.0)%(14.5)%(20.7)%
Loss ratio67.1%67.7%45.0%

Current Year Loss Ratio.

2018 versus 2017: The reinsurance segment’s current year loss ratio was 4.1 points lower in 2018 than in 2017. The 2018 loss ratio included 10.1 points for current year catastrophic event activity, primarily related to Hurricanes Florence and Michael, Typhoon Jebi and the California wildfires, compared to 16.0 points in 2017, primarily related to Hurricanes Harvey, Irma and Maria and the California wildfires. The 2018 loss ratio includes the impact of a large attritional casualty loss arising from the California wildfires that increased the loss ratio by 1.7 points. The balance of the change in the 2018 current year loss ratio resulted, in part, from the effects of market conditions and changes in the mix of business.

2017 versus 2016: The reinsurance segment’s current year loss ratio was 16.5 points higher in 2017 than in 2016. The 2017 loss ratio included 16.0 points for current year catastrophic event activity, primarily related to Hurricanes Harvey, Irma and Maria and the California wildfires, compared to 4.1 points in 2016. In addition, the loss ratio for 2017 reflects the impact of the retroactive reinsurance contract noted above (net premiums earned at a high loss ratio), which increased the current year loss ratio by 1.3 points. The balance of the change in the 2017 current year loss ratio resulted, in part, from the effects of market conditions and changes in the mix of business.

Prior Period Reserve Development.

The reinsurance segment’s net favorable development was $138.5 million, or 11.0 points, for 2018, compared to $165.4 million, or 14.5 points, for 2017, and $218.8 million, or 20.7 points, for 2016. See note 5, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements in Item 8 for information about the reinsurance segment’s prior year reserve development.

Underwriting Expenses.

2018 versus 2017: The underwriting expense ratio for the reinsurance segment was 27.4% in 2018, compared to 32.2% in 2017, reflecting lower operating expenses of $13.3 million due to lower performance based compensation costs, a reduction of 1.1 points in the expense ratio. In addition, federal excise taxes decreased by $19.7 million, a reduction of 1.6 points in the expense ratio, due to the non-renewal of certain reinsurance agreements between our U.S. based insurance and reinsurance subsidiaries and Arch Re Bermuda on a cutoff basis as of January 1, 2018 and the impact of a loss portfolio transfer in 2017. The remainder of the change was due to changes in the mix and type of business.

2017 versus 2016: The underwriting expense ratio for the reinsurance segment was 32.2% in 2017, compared to 33.6% in 2016. Due to intercompany loss portfolio transfers effective on December 31, 2017 that transferred $1.36 billion of net retained reserves for losses and allocated loss adjustment expenses between subsidiaries, the reinsurance segment’s 2017 acquisition expense ratio reflected 1.2 points of federal excise taxes in connection with such activity.

Mortgage Segment

Our mortgage operations include U.S. and international mortgage insurance and reinsurance operations as well as participation in GSE credit risk-sharing transactions. Our mortgage group includes direct mortgage insurance in the U.S. primarily through Arch Mortgage Insurance Company and United Guaranty Residential Insurance Company (together, “Arch MI U.S.”); mortgage reinsurance through Arch Re Bermuda to mortgage insurers on both a proportional and non-

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proportional basis globally; direct mortgage insurance in Europe through Arch MI Europe and in Hong Kong through Arch MI Asia; and participation in various GSE credit risk-sharing products primarily through Arch Re Bermuda.

The following tables set forth our mortgage segment’s underwriting results. On December 31, 2016, we completed the acquisition of UGC. As such, the 2018 and 2017 results reflect the combination of Arch and UGC while the 2016 results do not reflect UGC activity.

Year Ended December 31,
20182017% Change
Gross premiums written$1,360,708$1,368,138(0.5)
Premiums ceded(202,833)(256,796)
Net premiums written1,157,8751,111,3424.2
Change in unearned premiums28,361(54,176)
Net premiums earned1,186,2361,057,16612.2
Other underwriting income13,03315,737
Losses and loss adjustment expenses(81,289)(134,677)
Acquisition expenses(118,595)(100,598)
Other operating expenses(142,432)(146,336)
Underwriting income$856,953$691,29224.0
Underwriting Ratios% Point Change
Loss ratio6.9%12.7%(5.8)
Acquisition expense ratio10.0%9.5%0.5
Other operating expense ratio12.0%13.8%(1.8)
Combined ratio28.9%36.0%(7.1)
Year Ended December 31,
20172016% Change
Gross premiums written$1,368,138$499,725173.8
Premiums ceded(256,796)(108,259)
Net premiums written1,111,342391,466183.9
Change in unearned premiums(54,176)(104,750)
Net premiums earned1,057,166286,716268.7
Other underwriting income15,73717,024
Losses and loss adjustment expenses(134,677)(28,943)
Acquisition expenses(100,598)(21,790)
Other operating expenses(146,336)(96,672)
Underwriting income$691,292$156,335342.2
Underwriting Ratios% Point Change
Loss ratio12.7%10.1%2.6
Acquisition expense ratio9.5%7.6%1.9
Other operating expense ratio13.8%33.7%(19.9)
Combined ratio36.0%51.4%(15.4)

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,
201820172016
Net premiums written by client location
United States$1,051,375$1,005,437$280,509
Other106,500105,905110,957
Total$1,157,875$1,111,342$391,466
Net premiums written by underwriting location
United States$948,323$903,329$186,826
Other209,552208,013204,640
Total$1,157,875$1,111,342$391,466

2018 versus 2017: Gross premiums written by the mortgage segment in 2018 were 0.5% lower than in 2017. The reduction in gross premiums written primarily reflected a lower level of Australian mortgage reinsurance business partially offset by higher U.S. premiums due to insurance in force growth. Net premiums written for 2018 were 4.2% higher than in the 2017 period and reflected lower ceded premiums on the quota share agreement with AIG that continues to run-off, partially offset by higher ceded premiums related to Bellemeade transactions in 2018. The 2017 period also reflected higher retrocessions of Australian mortgage reinsurance business. The persistency rate of the primary portfolio of mortgage loans of Arch MI U.S. was 81.5% at December 31, 2018 compared to 81.8% at December 31, 2017. 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.

2017 versus 2016: Gross premiums written by the mortgage segment in 2017 were 173.8% higher than in 2016, while net premiums written increased 183.9%, primarily reflecting growth in insurance in force due to the acquisition of UGC,

Arch MI U.S. generated $69.5 billion of new insurance written (“NIW”) during 2018 compared to $62.0 billion during 2017. NIW represents the original principal balance of all loans that received coverage during the period.

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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,
201820172016
Net premiums earned by client location
United States$1,116,007$1,014,439$265,527
Other70,22942,72721,189
Total$1,186,236$1,057,166$286,716
Net premiums earned by underwriting location
United States$1,009,765$901,858$155,929
Other176,471155,308130,787
Total$1,186,236$1,057,166$286,716

Net premiums earned for 2018 were 12.2% higher than in 2017, primarily due to growth in insurance in force for Arch MI U.S. Growth from 2016 to 2017 primarily reflected the impact of the acquisition of UGC, which occurred as of December 31, 2016.

Other Underwriting Income.

Other underwriting income, which is primarily related to GSE risk-sharing transactions receiving derivative accounting treatment, was $13.0 million for 2018, compared to $15.7 million for 2017 and $17.0 million for 2016.

Losses and Loss Adjustment Expenses.

The table below shows the components of the mortgage segment’s loss ratio:

Year Ended December 31,
201820172016
Current year16.0%21.7%17.5%
Prior period reserve development(9.1)%(9.0)%(7.4)%
Loss ratio6.9%12.7%10.1%

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 delinquent, mortgage insurance loss reserves are not an estimate of ultimate losses. In addition to establishing loss reserves for delinquent loans, under GAAP, we are required to establish a premium deficiency reserve for our mortgage insurance products if the amount of expected future losses and maintenance costs exceeds expected future premiums, existing

reserves and the anticipated investment income for such product. We assess the need for a premium deficiency reserve on a quarterly basis and perform a full analysis annually. No such reserve was established during 2018, 2017 or 2016.

Current Year Loss Ratio.

2018 versus 2017: The mortgage segment’s current year loss ratio was 5.7 points lower in 2018 compared to 2017. The current year loss ratio for 2018 reflects the current favorable macroeconomic environment as the percentage of loans in default on first lien business decreased from 2.23% at December 31, 2017 to 1.60% at December 31, 2018. In addition, the loss ratio for 2017 was slightly impacted by delinquencies emanating from new notices from areas impacted by the 2017 third quarter hurricanes that subsequently cured during 2018.

2017 versus 2016: The mortgage segment’s current year loss ratio was 4.2 points higher in 2017 compared to 2016. The current year loss ratio for 2017 reflects changes in the mix of business due to the UGC acquisition when compared to 2016, and the minor impact of delinquencies emanating from new notices from areas impacted by the 2017 third quarter hurricanes.

We insure mortgages for homes in areas that have been impacted by catastrophic events, including 2018 events such as Hurricanes Florence and Michael and the California wildfires, and 2017 events such as Hurricanes Harvey and Irma. Generally, mortgage insurance losses occur only when a credit event occurs and, following a physical damage event, when the home is restored to pre-storm condition. Our ultimate claims exposure will depend on the number of delinquency notices received and the ultimate claim rate related to such notices. In the event of natural disasters, cure rates are influenced by the adequacy of homeowners and flood insurance carried on a related property, and a borrower's access to aid from government entities and private organizations, in addition to other factors which generally impact cure rates in unaffected areas.

Prior Period Reserve Development.

The mortgage segment’s net favorable development was $107.6 million, or 9.1 points, for 2018, compared to $95.0 million, or 9.0 points, for 2017, and $21.2 million, or 7.4 points, for 2016. The 2017 increase in net favorable development was primarily on the acquired UGC reserves. See note 5, “Reserve for Losses and Loss Adjustment Expenses,” to our consolidated financial statements in Item 8 for information about the mortgage segment’s prior year reserve development.

Underwriting Expenses.

2018 versus 2017: The underwriting expense ratio for the mortgage segment was 22.0% for 2018, compared to 23.3% for 2017, reflecting the increase in net premiums earned combined

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with a $3.9 million decrease in other operating expenses due to expense savings from integration efforts. This decrease was partially offset by a higher level of acquisition expenses, due to higher NIW.

2017 versus 2016: The underwriting expense ratio for the mortgage segment was 23.3% for 2017, compared to 41.3% for 2016. The decrease in the underwriting expense ratio primarily reflects the higher level of net premiums earned from the impact of the UGC acquisition.

Corporate (Non-Underwriting) Segment

The corporate (non-underwriting) segment results include net investment income, other income (loss), corporate expenses, transaction costs and other, amortization of intangible assets, interest expense, items related to our non-cumulative preferred shares, net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investments accounted for using the equity method, net foreign exchange gains or losses and income taxes. 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,
201820172016
Fixed maturities$403,449$336,894$242,310
Equity securities12,65012,70313,823
Short-term investments17,8029,3433,619
Other (1)70,94679,78966,300
Gross investment income504,847438,729326,052
Investment expenses (2)(66,889)(56,657)(48,859)
Net investment income$437,958$382,072$277,193
(1)Amounts include dividends and other distributions on investment funds, term loan investments, funds held balances, cash balances and other.
(2)Investment expenses were approximately 0.36% of average invested assets for 2018, compared to 0.30% for 2017 and 0.34% for 2016.

The pre-tax investment income yield was 2.36% for 2018, compared to 2.06% for 2017 and 1.92% for 2016. The higher level of net investment income for 2018 compared to 2017 and 2016 reflected an increase in the embedded book yield on fixed income securities, partially offset by a higher level of expenses.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 $58.6 million for 2018, compared to $61.6 million for 2017 and $49.4 million for 2016. 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. The lower level of corporate expenses in 2018 compared to 2017 and 2016 was primarily due to lower incentive compensation costs.

Transaction Costs and Other.

Transaction costs and other were $11.4 million for 2018, compared to $22.2 million for 2017 and $41.7 million for 2016. Amounts for 2018 were primarily attributable to the write off of intangible assets related to insurance licenses for a subsidiary of UGC which was merged with another subsidiary. For 2017, transaction costs and other primarily related to severance and severance related costs related to the UGC acquisition. For 2016, transaction costs and other included $32.3 million of non-recurring costs such as advisory, financing and legal related to the UGC acquisition.

Amortization of Intangible Assets.

Amortization of intangible assets for 2018 was $105.7 million, compared to $125.8 million for 2017 and $19.3 million for 2016. Amounts in 2018 and 2017 primarily related to amortization of finite-lived intangible assets related to the UGC acquisition.

Interest Expense.

Interest expense was $101.0 million for 2018, compared to $103.6 million for 2017 and $53.5 million for 2016. Interest expense reflects amounts related to our outstanding senior notes, revolving credit agreement borrowings and other. We issued $950.0 million of senior notes in December 2016 in connection with the UGC acquisition and borrowed $400.0 million on our revolving credit agreement, resulting in higher borrowing costs in 2017 when compared to 2016. We repaid $375 million and $125 million of our revolving credit agreement borrowings during 2018 and 2017, respectively, resulting in lower borrowing costs for 2018 than in 2017.

Loss on Redemption of Preferred Shares.

In September 2017, we redeemed $230 million of 6.75% Series C preferred shares and, in accordance with GAAP, recorded a loss of $6.7 million to remove original issuance costs related to the redeemed shares from additional paid-in capital. In January 2018, we redeemed the remaining $92.3 million of 6.75% Series C preferred shares outstanding and recorded a loss of $2.7 million. Such adjustments had no impact on total shareholders’ equity or cash flows.

Net Realized Gains (Losses).

We recorded net realized loss of $284.4 million for 2018, compared to net realized gains of $148.8 million for 2017 and net realized gains of $69.6 million for 2016. Currently, our

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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 2018, we recorded $2.8 million of credit related impairments in earnings, compared to $7.1 million in 2017 and $30.4 million in 2016. The impairment losses recorded in 2018 were primarily related to foreign currency. The impairment losses recorded in 2017 were primarily related to foreign currency and the liquidation of one portfolio, while the 2016 period 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. See note 8, “Investment Information—Other-Than-Temporary Impairments,” to our consolidated financial statements in Item 8 for additional information.

Equity in Net Income (Loss) of Investments Accounted for Using the Equity Method.

We recorded $45.6 million of equity in net income related to investments accounted for using the equity method for 2018, compared to $142.3 million for 2017 and $48.5 million for 2016. The 2017 results reflected strong returns on funds invested in global equities and other strategies. Investments accounted for using the equity method totaled $1.49 billion at December 31, 2018, compared to $1.04 billion at December 31, 2017. See note 8, “Investments—Equity in Net Income (Loss) of Investments Accounted For Using the Equity Method,” to our consolidated financial statements in Item 8 for additional information.

Net Foreign Exchange Gains or Losses.

Net foreign exchange gains for 2018 were $58.7 million, compared to net foreign exchange losses for 2017 of $113.3 million and net foreign exchange gains for 2016 of $31.4 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.

Income Tax Expense.

Our income tax provision on income before income taxes resulted in an expense of 13.1% for 2018, compared to an expense of 17.1% for 2017 and an expense of 4.3% for 2016. 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. Income tax expense for 2017 included a net $8.1 million charge due to the revaluation of our net U.S. deferred tax asset resulting from the reduction in the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018.

See note 14, “Income Taxes,” to our consolidated financial statements in Item 8 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 2018, 2017 and 2016.

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 11, “Variable Interest Entity and Noncontrolling Interests,” and note 4, “Segment Information,” to our consolidated financial statements in Item 8 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 recoverables, allowance for doubtful accounts, investment valuations, goodwill and 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, 2018. Actual results will differ from these estimates and such differences may be material. We believe that the following

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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, or Loss Reserves, that arise from the business we underwrite. Loss Reserves for our insurance, reinsurance and mortgage 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.

See note 6, “Short Duration Contracts,” to our consolidated financial statements in Item 8 for additional information on our reserving process.

At December 31, 2018 and 2017, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:

December 31,
20182017
Insurance segment:
Case reserves$1,489,644$1,648,910
IBNR reserves3,266,7963,272,351
Total net reserves4,756,4404,921,261
Reinsurance segment:
Case reserves1,082,9171,033,413
Additional case reserves191,002158,377
IBNR reserves1,578,9071,499,962
Total net reserves2,852,8262,691,752
Mortgage segment:
Case reserves355,606443,069
IBNR reserves122,304104,169
Total net reserves (1)477,910547,238
Other segment:
Case reserves364,052260,876
Additional case reserves36,51232,587
IBNR reserves551,266465,168
Total net reserves951,830758,631
Total:
Case reserves3,292,2193,386,268
Additional case reserves227,514190,964
IBNR reserves5,519,2735,341,650
Total net reserves$9,039,006$8,918,882
(1)At December 31, 2018, total net reserves include $375.8 million from U.S. primary mortgage insurance business, of which 72.8% represents policy years 2008 and prior and the remainder from later policy years. At December 31, 2017, total net reserves include $477.1 million from U.S. primary mortgage insurance business, of which 79.8% represents policy years 2008 and prior and the remainder from later policy years.

At December 31, 2018 and 2017, 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,
20182017
Professional lines (1)$1,247,914$1,308,261
Construction and national accounts1,166,1431,094,300
Excess and surplus casualty (2)631,370672,903
Programs482,045644,340
Property, energy, marine and aviation388,710437,518
Travel, accident and health83,83686,122
Lenders products52,00753,912
Other (3)704,415623,905
Total net reserves$4,756,440$4,921,261
(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.

At December 31, 2018 and 2017, 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,
20182017
Casualty (1)$1,551,550$1,489,933
Other specialty (2)582,420523,321
Property excluding property catastrophe (3)422,612376,020
Marine and aviation130,683135,484
Property catastrophe90,63598,622
Other (4)74,92668,372
Total net reserves$2,852,826$2,691,752
(1)Includes executive assurance, professional liability, workers’ compensation, excess motor, healthcare and other.
(2)Includes non-excess motor, surety, accident and health, workers’ compensation catastrophe, agriculture, trade credit and other.
(3)Includes facultative business.
(3)Includes life, casualty clash and other.

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, 2018 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, 2018, 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, 2018, 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

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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 SEGMENTHigher Expected Loss RatiosSlower Loss Development Patterns
Reserving lines selected assumptions:
Property, energy, marine and aviation5 points3 months
Third party occurrence business106
Third party claims-made business106
All other106
Increase (decrease) in Loss Reserves:
Property, energy, marine and aviation$22,535$25,570
Third party occurrence business242,617128,893
Third party claims-made business116,092124,271
All other138,959148,815
INSURANCE SEGMENTLower Expected Loss RatiosFaster Loss Development Patterns
Reserving lines selected assumptions:
Property, energy, marine and aviation(5) points(3) months
Third party occurrence business(10)(6)
Third party claims-made business(10)(6)
Multi-line and other specialty(10)(6)
Increase (decrease) in Loss Reserves:
Property, energy, marine and aviation$(21,926)$(20,646)
Third party occurrence business(242,224)(115,036)
Third party claims-made business(116,092)(95,565)
Multi-line and other specialty(133,762)(103,161)
REINSURANCE SEGMENTHigher Expected Loss RatiosSlower Loss Development Patterns
Reserving lines selected assumptions:
Casualty10 points6 months
Other specialty53
Property excluding property catastrophe53
Property catastrophe53
Marine and aviation53
Other53
Increase (decrease) in Loss Reserves:
Casualty$113,253$131,860
Other specialty58,54833,113
Property excluding property catastrophe14,44936,179
Property catastrophe2,7194,874
Marine and aviation7,24311,212
Other4,9723,270
REINSURANCE SEGMENTLower Expected Loss RatiosFaster Loss Development Patterns
Reserving lines selected assumptions:
Casualty(10) points(6) months
Other specialty(5)(3)
Property excluding property catastrophe(5)(3)
Property catastrophe(5)(3)
Marine and aviation(5)(3)
Other(5)(3)
Increase (decrease) in Loss Reserves:
Casualty$(113,264)$(104,119)
Other specialty(58,548)(52,975)
Property excluding property catastrophe(14,475)(33,988)
Property catastrophe(2,719)(3,028)
Marine and aviation(7,255)(11,130)
Other(4,972)(3,067)

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, 2018 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, 2018 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 27% of the unpaid principal balance at December 31, 2018), we estimated that our loss reserves would change by approximately $17.0 million at December 31, 2018. For every one percentage point change in our primary net default to claim rate (which we estimate to be approximately 36% at December 31, 2018), we estimated a $13.0 million change in our loss reserves at December 31, 2018.

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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, 2018, 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 SegmentReinsurance SegmentMortgage SegmentTotal
Loss Reserves (1)$4,756,440$2,852,826$477,910$8,087,176
Simulation results:
90th percentile (2)$5,772,504$3,577,073$571,959$9,483,035
10th percentile (3)$3,799,556$2,219,249$390,240$6,777,556
(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 $1.40 billion, or $3.38 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 $1.31 billion, or $3.17 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, 2018.

Mortgage Operations Supplemental Information

The mortgage segment’s insurance in force (“IIF”) and risk in force (“RIF”) were as follows at December 31, 2018 and 2017:

(U.S. Dollars in millions)December 31,
20182017
Amount%Amount%
Insurance In Force (IIF) (1):
U.S. primary mortgage insurance$276,53872.1$253,91472.2
Mortgage reinsurance25,9756.828,0178.0
Other (2)81,14721.269,90519.9
Total$383,660100.0$351,836100.0
Risk In Force (RIF) (3):
U.S. primary mortgage insurance$70,99592.3$64,90492.3
Mortgage reinsurance2,2172.92,4733.5
Other (2)3,7284.82,9214.2
Total$76,940100.0$70,298100.0
(1)Represents the aggregate dollar amount of each insured mortgage loan’s current principal balance.
(2)Includes participation in GSE credit risk-sharing transactions and international insurance business.
(3)Represents 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 credit risk-sharing or reinsurance transactions.

The insurance in force and risk in force for our U.S. primary mortgage insurance business by policy year were as follows at December 31, 2018:

(U.S. Dollars in millions)IIFRIFDelinquency
Amount%Amount%Rate (1)
Policy year:
2008 and prior$20,5017.4$4,7386.79.07%
20097090.31620.23.25%
20106460.21750.22.62%
20112,5300.97011.01.57%
20129,6503.52,6643.80.78%
201316,8236.14,6766.60.89%
201418,2746.64,9477.00.97%
201533,78112.28,84912.50.69%
201652,32418.913,40718.90.77%
201754,28719.613,79319.40.55%
201867,01324.216,88323.80.15%
Total$276,538100.0$70,995100.01.60%
(1)Represents the ending percentage of loans in default.
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The insurance in force and risk in force for our U.S. primary mortgage insurance business by policy year were as follows at December 31, 2017:

(U.S. Dollars in millions)IIFRIFDelinquency
Amount%Amount%Rate (1)
Policy year:
2008 and prior$26,14010.3$6,0039.210.24%
20091,0720.42530.42.94%
20101,0890.42950.52.31%
20113,8281.51,0461.61.37%
201213,2475.23,6295.60.75%
201321,8408.65,9969.20.95%
201422,8849.06,1129.41.10%
201541,99116.510,82816.70.77%
201662,02024.415,64324.10.80%
201759,80323.615,09923.30.35%
Total$253,914100.0$64,904100.02.23%
(1)Represents the ending percentage of loans in default.

The following tables provide supplemental disclosures on risk in force for our U.S. primary mortgage insurance business at December 31, 2018 and 2017:

(U.S. Dollars in millions)December 31,
20182017
Amount%Amount%
Credit quality (FICO):
>=740$41,06657.8$37,79458.2
680-73923,95433.721,21332.7
620-6795,4857.75,1597.9
<6204900.77381.1
Total$70,995100.0$64,904100.0
Weighted average FICO score743743
Loan-to-Value (LTV):
95.01% and above$7,91811.2$6,3379.8
90.01% to 95.00%39,37055.536,17455.7
85.01% to 90.00%20,64329.119,48230.0
85.00% and below3,0644.32,9114.5
Total$70,995100.0$64,904100.0
Weighted average LTV93.0%92.9%
Total RIF, net of external reinsurance$55,755$49,100
(U.S. Dollars in millions)December 31,
20182017
Amount%Amount%
Total RIF by State:
Texas$5,4917.7$5,1517.9
California4,5056.33,8035.9
Florida3,5415.02,8814.4
Virginia2,9314.12,7734.3
Georgia2,5733.62,3313.6
North Carolina2,5053.52,4103.7
Illinois2,4823.52,2293.4
Washington2,4083.42,2943.5
Maryland2,4073.42,2343.4
Minnesota2,4003.42,1653.3
Others39,75256.036,63356.4
Total$70,995100.0$64,904100.0

The following table provides supplemental disclosures for our U.S. primary mortgage insurance business related to insured loans and loss metrics for the years ended December 31, 2018 and 2017:

(U.S. Dollars in thousands, except loan and claim count)Year Ended December 31,
20182017
Rollforward of insured loans in default:
Beginning delinquent number of loans27,06829,691
New notices (1)37,31041,846
Cures(39,896)(38,413)
Paid claims(3,817)(6,056)
Ending delinquent number of loans (1)(2)20,66527,068
Ending number of policies in force (2)1,289,2951,213,382
Delinquency rate (1)(2)1.60%2.23%
Losses:
Number of claims paid3,8176,056
Total paid claims$159,474$265,924
Average per claim$41.8$43.9
Severity (3)102.0%103.4%
Average reserve per default (in thousands) (1)(2)$17.4$16.5
(1)2018 year includes no new notices and approximately 200 ending delinquent loans at December 31, 2018 from areas impacted by the 2017 third quarter hurricanes.
(2)Includes first lien primary and pool policies.
(3)Represents total paid claims divided by RIF of loans for which claims were paid.

The risk-to-capital ratio, which represents total current (non-delinquent) risk in force, net of reinsurance, divided by total statutory capital, for Arch MI U.S. was approximately 13.0 to 1 at December 31, 2018, compared to 10.8 to 1 at December 31, 2017.

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

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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 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, reinsurance and mortgage 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.”

Effective July 1, 2018, our insurance operations had in effect a reinsurance program which provided coverage for certain property-catastrophe related losses equal to $275 million in excess of a $75 million retention per occurrence. Such amounts compare to $200 million in excess of a $150 million retention per occurrence prior to July 1, 2018.

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 23.2% of gross premiums written for 2018, compared to 22.1% for 2017 and 22.5% for 2016. 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. 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

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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.”

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, 2018:

December 31, 2018
Gross AmountAcquisition ExpensesNet Amount
Other specialty$248,580$(59,304)$189,276
Casualty224,025(71,613)152,412
Property excluding property catastrophe104,250(32,656)71,594
Marine and aviation49,072(13,084)35,988
Property catastrophe1,759(103)1,656
Other80,295(11,673)68,622
Total$707,981$(188,433)$519,548

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, 2018.

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 accounts for each element separately where practical. 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 amount or timing of 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

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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.

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, and incorporates anticipated interest income. 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 2018, 2017 and 2016.

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

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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.

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 9, “Fair Value,” to our consolidated financial statements in Item 8 for a summary of our financial assets and liabilities measured at fair value at December 31, 2018 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 other-than-temporary impairments (“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.

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 2018, we recorded $2.8 million of credit related impairments in earnings, compared to $7.1 million in 2017 and $30.4 million in 2016. See note 8, “Investment Information—Other-Than-Temporary Impairments,” to our consolidated financial statements in Item 8 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,” to our consolidated financial statements in Item 8 for disclosures concerning recent accounting pronouncements.

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FINANCIAL CONDITION

Investable Assets

At December 31, 2018, total investable assets held by Arch were $19.57 billion, excluding the $2.76 billion included in the ‘other’ segment (i.e., attributable to Watford Re).

Investable Assets Held by Arch

The Finance, Investment and Risk Committee (“FIR”) of our board of directors establishes our investment policies and sets the parameters for creating guidelines for our investment managers. The FIR 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 strategy. Our Chief Investment Officer administers the investment portfolio, oversees our investment managers and formulates investment strategy in conjunction with the FIR.

The following table summarizes the fair value of investable assets held by Arch (i.e., excluding the ‘other’ segment):

Investable assets (1):Estimated Fair Value% of Total
December 31, 2018
Fixed maturities (2)$14,881,90276.1
Short-term investments (2)995,9265.1
Cash583,0273.0
Equity securities (2)368,8431.9
Other investments (2)1,261,5256.4
Investments accounted for using the equity method1,493,7917.6
Securities transactions entered into but not settled at the balance sheet date(18,153)(0.1)
Total investable assets held by Arch$19,566,861100.0
Average effective duration (in years)3.38
Average S&P/Moody’s credit ratings (3)AA/Aa2
Embedded book yield (4)2.89%
December 31, 2017
Fixed maturities (2)$14,798,21375.1
Short-term investments (2)1,509,7137.7
Cash551,6962.8
Equity securities (2)576,0402.9
Other investments (2)1,476,9607.5
Investments accounted for using the equity method1,041,3225.3
Securities transactions entered into but not settled at the balance sheet date(237,523)(1.2)
Total investable assets held by Arch$19,716,421100.0
Average effective duration (in years)2.83
Average S&P/Moody’s credit ratings (3)AA-/Aa2
Embedded book yield (4)2.32%
(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.
(3)Average credit ratings on our investment portfolio on securities with ratings by Standard & Poor’s Rating Services (“S&P”) and Moody’s Investors Service (“Moody’s”).
(4)Before investment expenses.

At December 31, 2018, approximately $14.08 billion, or 72%, of total investable assets held by Arch were internally managed, compared to $13.73 billion, or 70%, at December 31, 2017.

ARCH CAPITAL782018 FORM 10-K

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, 2018
Corporate bonds$5,735,52638.5
Mortgage backed securities535,7633.6
Municipal bonds1,012,3086.8
Commercial mortgage backed securities729,4424.9
U.S. government and government agencies3,601,26924.2
Non-U.S. government securities1,713,89111.5
Asset backed securities1,553,70310.4
Total$14,881,902100.0
December 31, 2017
Corporate bonds$4,787,27232.4
Mortgage backed securities328,9242.2
Municipal bonds2,158,84014.6
Commercial mortgage backed securities545,8173.7
U.S. government and government agencies3,484,25723.5
Non-U.S. government securities1,704,33711.5
Asset backed securities1,788,76612.1
Total$14,798,213100.0

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, 2018
U.S. government and gov’t agencies (1)$4,194,67628.2
AAA3,551,03923.9
AA2,129,33614.3
A3,069,65620.6
BBB1,251,2058.4
BB275,2011.8
B183,6141.2
Lower than B61,2710.4
Not rated165,9041.1
Total$14,881,902100.0
December 31, 2017
U.S. government and gov’t agencies (1)$3,771,83525.5
AAA4,080,80827.6
AA2,440,86416.5
A2,470,93616.7
BBB1,157,1367.8
BB313,2862.1
B254,0111.7
Lower than B77,5430.5
Not rated231,7941.6
Total$14,798,213100.0
(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 ValueGross Unrealized Losses% of Total Gross Unrealized Losses
December 31, 2018
0-10%$8,722,837$(190,170)92.5
10-20%87,188(13,012)6.3
20-30%3,359(1,058)0.5
Greater than 30%2,363(1,266)0.6
Total$8,815,747$(205,506)100.0
December 31, 2017
0-10%$9,598,768$(93,057)87.6
10-20%82,638(11,269)10.6
20-30%2,108(671)0.6
Greater than 30%1,881(1,184)1.1
Total$9,685,395$(106,181)100.0

The following table summarizes our top ten exposures to fixed income corporate issuers by fair value at December 31, 2018, excluding guaranteed amounts and covered bonds:

Estimated Fair ValueCredit Rating (1)
JPMorgan Chase & Co.$203,200A-/A1
Bank of America Corporation190,088A-/A3
Wells Fargo & Company171,886A/Aa3
Apple Inc.164,486AA+/Aa1
Citigroup Inc.152,321A/A2
Nestle S.A.114,889AA-/Aa2
Daimler AG108,692A/A2
Morgan Stanley102,420BBB+/A3
The Goldman Sachs Group, Inc.94,379BBB+/A3
Deere & Company91,792A/A2
Total$1,394,153
(1)Average credit ratings as assigned by S&P and Moody’s, respectively.
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The following table provides information on our structured securities, which include residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and asset backed securities (“ABS”):

AgenciesInvestment GradeBelow Investment GradeTotal
Dec. 31, 2018
RMBS$488,862$15,410$31,491$535,763
CMBS104,547602,86522,030729,442
ABS—1,485,15068,5531,553,703
Total$593,409$2,103,425$122,074$2,818,908
Dec. 31, 2017
RMBS$284,466$14,581$29,877$328,924
CMBS3,112465,98076,725545,817
ABS—1,691,23297,5341,788,766
Total$287,578$2,171,793$204,136$2,663,507

The following table provides information on the fair value of our Eurozone investments at December 31, 2018:

Country (1)Sovereign (2)Corporate BondsOther (3)Total
Germany$338,409$3,119$45,834$387,362
Netherlands77,088143,30823,420243,816
France—33,08031,44264,522
Luxembourg—10,85812,55523,413
Spain—1,3248,1449,468
Ireland—4,7271,4826,209
Finland—4,3491,8216,170
Italy——1,7481,748
Austria——1,1221,122
Portugal——897897
Greece74—496570
Supranational (4)————
Estonia————
Total$415,571$200,765$128,961$745,297
(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, 2018.
(2)Includes securities issued and/or guaranteed by Eurozone governments.
(3)Includes bank loans, equities and other.

At December 31, 2018, our investment portfolio included $368.8 million of equity securities, compared to $576.0 million at December 31, 2017. Our equity portfolio includes publicly traded common stocks in the natural resources, energy, consumer staples and other sectors.

The following table summarizes our other investments:

December 31,
20182017
Available for sale securities:
Asia and emerging markets$—$135,140
Investment grade fixed income—53,878
Credit related funds—18,365
Other—57,606
Total available for sale (1)—264,989
Fair value option:
Term loan investments (par value: $288,841 and $326,339)281,635326,085
Lending524,112399,099
Credit related funds152,361132,131
Energy117,509132,709
Investment grade fixed income101,902102,347
Infrastructure45,37182,291
Private equity24,38323,593
Real estate14,25213,716
Total fair value option1,261,5251,211,971
Total$1,261,525$1,476,960
(1)The Company reviewed the accounting treatment for three limited partnership investments which were accounted for as available for sale at December 31, 2017 during the 2018 first quarter and determined, based on reconsideration during the period of the Company’s percentage ownership, that the equity method of accounting was appropriate for such investments.

The following table summarizes our investments accounted for using the equity method:

December 31,
20182017
Credit related funds$429,402$263,034
Equities375,273292,762
Real estate232,647176,328
Lending125,04166,093
Private equity114,01996,310
Infrastructure113,74899,338
Energy103,66147,457
Total$1,493,791$1,041,322

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 10, “Derivative Instruments,” to our consolidated financial statements in Item 8 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 9, “Fair Value,” to our consolidated financial statements in Item

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8 for a summary of our financial assets and liabilities measured at fair value at December 31, 2018 and 2017 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. 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.

The following table summarizes investable assets in the ‘other’ segment:

December 31,
20182017
Investments accounted for using the fair value option:
Other investments$1,050,414$924,410
Fixed maturities922,8191,177,033
Short-term investments282,131256,755
Equity securities56,63867,868
Total2,312,0022,426,066
Fixed maturities available for sale, at fair value393,351—
Equity securities32,206—
Cash63,52954,503
Securities sold but not yet purchased(7,790)(34,375)
Securities transactions entered into but not settled at the balance sheet date(35,635)(6,127)
Total investable assets included in ‘other’ segment$2,757,663$2,440,067

Reinsurance Recoverables

At December 31, 2018 and 2017, approximately 63.0% and 69.9% of reinsurance recoverables on paid and unpaid losses (not including ceded unearned premiums) of $2.92 billion and $2.54 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better while 37.0% and 30.1%, 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, 2018 and 2017. The largest reinsurance recoverables from any one carrier was approximately 2.7% and 2.2%, respectively, of total shareholders’ equity available to Arch at December 31, 2018 and 2017.

The following table details our reinsurance recoverables at December 31, 2018:

% of TotalA.M. Best Rating (1)
Everest Reinsurance Company6.4A+
Munich Reinsurance America, Inc.5.1A+
Hannover Rückversicherung AG4.7A+
Swiss Reinsurance America Corporation4.3A+
XL Catlin plc4.1A+
Partner Reinsurance Company of the U.S.4.1A
Transatlantic Reinsurance Company3.4A+
Berkley Insurance Company3.1A+
Lloyd’s syndicates (2)2.9A
Liberty Mutual Insurance Company2.5A
Renaissance Reinsurance2.2A
All other -- fully collateralized reinsurers (3)12.9NR
All other -- “A-” or better20.0
All other -- not rated (4)24.3
Total100.0
(1)The financial strength ratings are as of February 4, 2019 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)Such amount is fully collateralized through reinsurance trusts.
(4)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 LAE (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.

ARCH CAPITAL812018 FORM 10-K

Shareholders’ Equity and Book Value per Share

Total shareholders’ equity available to Arch was $9.44 billion at December 31, 2018, compared to $9.20 billion at December 31, 2017. The increase in 2018 was primarily attributable to underwriting results, partially offset by share repurchases.

The following table presents the calculation of book value per share:

(U.S. dollars in thousands, except share data)December 31,
20182017
Total shareholders’ equity available to Arch$9,439,827$9,196,602
Less preferred shareholders’ equity780,000872,555
Common shareholders’ equity available to Arch$8,659,827$8,324,047
Common shares and common share equivalents outstanding, net of treasury shares (1)402,454,834409,956,417
Book value per share$21.52$20.30
(1)Excludes the effects of 20,076,593 and 19,770,174 stock options and 1,307,304 and 913,488 restricted stock units outstanding at December 31, 2018 and 2017, respectively.

LIQUIDITY

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.

Liquidity is a measure of our ability to access sufficient cash flows to meet the short-term and long-term cash requirements of our business operations.

Arch Capital is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, Arch Capital 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.

In 2018, Arch Capital received dividends of $398.7 million from Arch Re Bermuda, our Bermuda-based reinsurer and insurer. In 2018, Arch-U.S. received $25.0 million of dividends from Arch Re U.S., our U.S. licensed reinsurer, and $525.0 million of dividends from Arch U.S. MI Holdings. Arch U.S. MI Holdings received aggregate dividends and return of capital from subsidiaries of $971.1 million in 2018. Arch U.S. MI

Holdings used such proceeds to pay down $375.0 million of its revolving credit agreement borrowings and pay dividends to Arch-U.S.

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 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.

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.

ARCH CAPITAL822018 FORM 10-K

Dividend Restrictions

Arch Capital has no material restrictions on its ability to make distributions to shareholders, however the ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is limited by the applicable local laws and relevant regulations of the various countries and states in which we operate. See note 23, “Statutory Information,” to our consolidated financial statements in Item 8 for additional information on dividend restrictions.

The payment of dividends from Arch Re Bermuda is, under certain circumstances, limited under Bermuda law, which requires our Bermuda operating subsidiary to maintain certain measures of solvency and liquidity.

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 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. Each state requires prior regulatory approval of any payment of extraordinary dividends.

We also have insurance subsidiaries that are the parent company for other insurance subsidiaries, which means that dividends and other distributions will be subject to multiple layers of regulations in order for our insurance subsidiaries to be able to dividend funds to Arch Capital. The inability of the subsidiaries of Arch Capital to pay dividends and other permitted distributions could have a material adverse effect on Arch Capital’s cash requirements and our ability to make principal, interest and dividend payments on the senior notes, preferred shares and common shares.

In addition to meeting applicable regulatory standards, the ability of our insurance and reinsurance subsidiaries to pay dividends 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 our insurance and reinsurance subsidiaries. We believe that Arch Capital has sufficient cash resources and available dividend capacity to service its indebtedness and other current outstanding obligations.

Restricted Assets

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, 2018 and 2017, such amounts approximated $6.76 billion and $6.01 billion, respectively, excluding amounts related to the ‘other’ segment.

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 $1.77 billion at December 31, 2018 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.

Cash Flows

The following table summarizes our cash flows from operating, investing and financing activities, excluding amounts related to the ‘other’ segment:

Year Ended December 31,
201820172016
Total cash provided by (used for):
Operating activities$1,331,278$809,580$1,103,529
Investing activities(268,734)(884,452)(2,597,738)
Financing activities(987,679)(166,829)1,830,042
Effects of exchange rate changes on foreign currency cash(16,383)15,584(14,005)
Increase (decrease) in cash$58,482$(226,117)$321,828

  • Cash provided by operating activities for 2018 was higher than in 2017, primarily reflecting an increase in premiums collected, a lower level of net losses paid and lower purchases of tax and loss bonds. The 2017 period reflected a higher level of paid losses and purchases of tax and loss bonds, while 2016 reflected lower net losses paid.

  • Cash used for investing activities for 2018 was lower than in 2017, reflecting changes in cash collateral related to securities lending for both. Activity for 2016 reflected our acquisition of UGC, which closed on December 31, 2016.

  • Cash used for financing activities for 2018 was higher than the cash used in 2017, reflecting share repurchases of $282.8

ARCH CAPITAL832018 FORM 10-K

million, a $375 million repayment of borrowing on our revolving credit and changes in cash collateral related to securities lending. Activity for 2017 reflected changes in cash collateral related to securities lending and a $125 million repayment of borrowing on our revolving credit agreement. Cash provided by financing activities for 2016 reflected various capital raising activity, such as the issuance of $950.0 million of senior notes and $450.0 million of preferred shares combined with $400.0 million of borrowings under our revolving credit facility in order to fund some of the cash consideration portion of the UGC acquisition.

Investments

At December 31, 2018, our investable assets were $19.57 billion, excluding the $2.76 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, 2018 included $415.6 million of securities issued and/or guaranteed by Eurozone governments at fair value, $3.60 billion of obligations of the U.S. government and government agencies at fair value and $1.01 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.

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.

The following table provides an analysis of our capital structure:

(U.S. dollars in thousands, except share data)December 31,
20182017
Debt:
Senior notes, due May 2034$300,000$300,000
Arch-U.S. senior notes, due Nov 2043 (1)500,000500,000
Arch Finance senior notes, due Dec 2026 (1)500,000500,000
Arch Finance senior notes, due Dec 2046 (1)450,000450,000
Deferred debt issuance costs on senior notes(16,472)(17,116)
Revolving credit agreement borrowings due Oct 2021 (2)—375,000
Total$1,733,528$2,107,884
Shareholders’ equity available to Arch:
Series C non-cumulative preferred shares (3)—92,555
Series E non-cumulative preferred shares450,000450,000
Series F non-cumulative preferred shares330,000330,000
Common shareholders’ equity8,659,8278,324,047
Total$9,439,827$9,196,602
Total capital available to Arch$11,173,355$11,304,486
Senior notes to total capital (%)15.515.3
Revolving credit agreement borrowings to total capital (%)—3.3
Debt to total capital (%)15.518.6
Preferred to total capital (%)7.07.7
Debt and preferred to total capital (%)22.526.4
(1)Fully and unconditionally guaranteed by Arch Capital.
(2)$500 million unsecured facility for revolving loans and letters of credit.
(3)Redeemed on January 2, 2018.

Arch Capital and Arch-U.S. are each holding companies and, accordingly, they conduct substantially all of their operations through their operating subsidiaries. Arch Capital Finance LLC (“Arch Finance”) is a wholly owned subsidiary of Arch U.S. MI Holdings Inc., a U.S. holding company. As a result, Arch Capital, 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 Arch Capital, Arch-U.S. and Arch Finance, respectively.

See note 17, “Debt and Financing Arrangements,” to our consolidated financial statements in Item 8 for additional disclosures concerning our senior notes and revolving credit

ARCH CAPITAL842018 FORM 10-K

agreement borrowings. For additional information on our preferred shares, see note 19, “Shareholders’ Equity,” to our consolidated financial statements in Item 8.

During 2018, 2017 and 2016, we made interest payments of $100.1 million, $103.7 million and $50.4 million, respectively, related to our senior notes and other financing arrangements.

In November 2017, Arch Capital, 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.

Capital Adequacy

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.

In addition, Arch MI U.S. is required to maintain compliance with the GSEs requirements, known as the Private Mortgage Insurer Eligibility Requirements or “PMIERs.” 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. Arch MI U.S. satisfied the PMIERs’ financial requirements as of

December 31, 2018 with a PMIER sufficiency ratio of 141%, compared to 129% at December 31, 2017.

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.

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. In addition to common share capital, we depend on external sources of finance to support our underwriting activities, which 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.

Arch Capital, 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. Historically, our U.S.-based insurance, reinsurance and mortgage insurance subsidiaries have entered into separate reinsurance arrangements with Arch Re Bermuda covering individual lines of business. The reinsurance agreements between our U.S.-based property casualty insurance and reinsurance subsidiaries and Arch Re Bermuda were canceled on a cutoff basis as of January 1, 2018. As a result, the level of subject business ceded to Arch Re Bermuda was substantially lower in 2018 than in prior periods.

Except as described in the above paragraph, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of Arch Capital’s subsidiaries or affiliates is solely responsible for its own liabilities and commitments (and no other Arch Capital 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 Arch Capital subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements.

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Share Repurchase Program

The board of directors of Arch Capital has authorized the investment in Arch Capital’s common shares through a share repurchase program. Since the inception of the share repurchase program through December 31, 2018, Arch Capital has repurchased approximately 386.2 million common shares for an aggregate purchase price of $3.97 billion. At December 31, 2018, approximately $163.7 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.

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CONTRACTUAL OBLIGATIONS AND COMMITMENTS

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.

Contractual Obligations

The following table provides an analysis of our contractual commitments at December 31, 2018:

Payment due by period
Total20192020 and 20212022 and 2023Thereafter
Operating activities
Estimated gross payments for losses and loss adjustment expenses (1)$10,820,538$2,782,107$3,247,828$1,719,215$3,071,388
Deposit accounting liabilities (2)15,7397,6401,1491,6255,325
Contractholder payables (3)2,079,111674,417720,908288,657395,129
Operating lease obligations193,15131,08859,84247,47654,745
Purchase obligations39,47123,22415,9253157
Contingent consideration liabilities (4)68,21558,00010,215——
Investing activities
Unfunded investment commitments (5)1,765,2821,765,282———
Financing activities
Securities lending payable (6)274,125274,125———
Senior notes (including interest payments)3,525,75290,465180,929180,9293,073,429
Capital lease obligations13,0706,2046,866——
Total contractual obligations and commitments$18,794,454$5,712,552$4,243,662$2,238,217$6,600,023
(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.
(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)Pursuant to our 2014 acquisition of the CMG Entities, we are required to make remaining contingent consideration payments as re-calculated over an earn-out period. For purposes of this table, the maximum exposure has been shown using an estimated payout pattern.
(5)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.
(6)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.

Letter of Credit and Revolving Credit Facilities

In the normal course of its operations, the Company enters into agreements with financial institutions to obtain secured and unsecured credit facilities.

On October 26, 2016, Arch Capital and certain of its subsidiaries entered into an $850.0 million five-year credit facility (the “Credit Facility”) with a syndication of lenders. The Credit Facility consists of a $350.0 million secured facility for letters of credit (the “Secured Facility”) and a $500.0 million unsecured facility for revolving loans and letters of credit (the “Unsecured Facility”). 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. Arch Capital has a one-time option to convert any or all outstanding revolving loans of Arch Capital and/or Arch-U.S. to term loans with the same terms as the revolving loans except that any prepayments may not be re-borrowed. Arch-U.S. guarantees the obligations of Arch Capital, and Arch Capital 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 Arch Capital. Secured letters of credit are available for issuance on behalf of Arch Capital insurance and reinsurance subsidiaries. The Credit Facility is structured such

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that each party that requests a letter of credit or borrowing does so only for itself and for only its own obligations.

The Credit Facility contains certain restrictive covenants customary for facilities of this type, including restrictions on indebtedness, consolidated tangible net worth, minimum shareholders’ equity levels and minimum financial strength ratings. Arch Capital and its subsidiaries which are party to the agreement were in compliance with all covenants contained therein at December 31, 2018.

Commitments under the Credit Facility will expire on October 26, 2021, and all loans then outstanding must be repaid. Letters of credit issued under the Unsecured Facility will not have an expiration date later than October 26, 2022.

Under the $350.0 million secured letter of credit facility, Arch Capital’s subsidiaries had $174.8 million of letters of credit outstanding and remaining capacity of $175.2 million at December 31, 2018. In addition, certain of Arch Capital’s subsidiaries had outstanding letters of credit of $167.5 million, which were issued in the normal course of business. When issued, these letters of credit are secured by a portion of the investment portfolio. At December 31, 2018, these letters of credit were secured by investments with a fair value of $362.0 million.

The Company’s outstanding revolving credit agreement borrowings were as follows:

Year Ended December 31,
20182017
Arch-U.S.$—$375,000
Total revolving credit agreement borrowings$—$375,000

RATINGS

Our ability to underwrite business is affected by the quality of our claims paying ability and financial strength ratings as evaluated by independent agencies. Such ratings from third party internationally recognized statistical rating organizations or agencies are instrumental in establishing the financial security of companies in our industry. We believe that the primary users of such ratings include commercial and investment banks, policyholders, brokers, ceding companies and investors. Insurance ratings are also used by insurance and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers and reinsurers, and are often an important factor in the decision by an insured or intermediary of whether to place business with a particular insurance or reinsurance provider. Periodically, rating agencies evaluate us to confirm that we continue to meet their criteria for the ratings assigned to us by them. S&P, Moody’s, A.M. Best Company and Fitch Ratings are ratings agencies which

have assigned financial strength ratings to one or more of Arch Capital’s subsidiaries.

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.

The ratings issued on our companies by these agencies are announced publicly and are available directly from the agencies. Our Internet site (www.ir.archcapgroup.com, under Credit Ratings) contains information about our ratings, but such information on our website is not incorporated by reference into this report.

CATASTROPHIC EVENTS AND SEVERE ECONOMIC EVENTS

We have large aggregate exposures to natural and man-made catastrophic events and severe economic events. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, tornadoes, explosions, severe winter weather, fires, droughts and other natural disasters. Catastrophes can also cause losses in non-property business such as mortgage insurance, 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

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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.

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 available to Arch. We reserve the right to change this threshold at any time.

Based on in-force exposure estimated as of January 1, 2019, our modeled peak zone catastrophe exposure is a windstorm affecting the Northeastern U.S., with a net probable maximum pre-tax loss of $374 million, followed by windstorms affecting Florida Tri-County and the Gulf of Mexico with net probable maximum pre-tax losses of $330 million and $299 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, 2019, our modeled peak zone earthquake exposure (San Francisco area earthquake) represented approximately 77% 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.

We also have significant exposure to losses due to mortgage defaults resulting from severe economic events in the future. For our U.S. mortgage insurance business, we have developed a proprietary risk model (“Realistic Disaster Scenario” or “RDS”) that simulates the maximum loss resulting from a severe economic downturn impacting the housing market. The RDS models the collective impact of adverse conditions for key economic indicators, the most significant of which is a decline in home prices. The RDS model projects paths of future home prices, unemployment rates, income levels and interest rates and assumes correlation across states and geographic regions. The resulting future performance of our in-force portfolio is then estimated under the economic stress scenario, reflecting loan and borrower information.

Currently, we seek to limit our modeled RDS loss from a severe economic event to approximately 25% of total tangible shareholders’ equity available to Arch (total shareholders’ equity available to Arch less goodwill and intangible assets). We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of January 1, 2019, our modeled RDS loss was less than 12% of tangible shareholders’ equity available to Arch.

Net probable maximum loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. RDS loss estimates are net of expected reinsurance recoveries and after income tax. Catastrophe loss estimates are reflective of the zone indicated

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and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our catastrophe loss estimates include clash estimates from other zones. Our catastrophe loss estimates and RDS 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 or tangible shareholders’ equity from one or more catastrophic events or severe economic 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 or severe economic 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, reinsurance and mortgage portfolios, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business and mortgage default exposed business. See “—Critical Accounting Policies, Estimates and Recent Accounting Pronouncements—Ceded Reinsurance” for a discussion of our catastrophe reinsurance programs.

OFF-BALANCE SHEET ARRANGEMENTS

We have entered into various aggregate excess of loss reinsurance agreements with various special purpose reinsurance companies domiciled in Bermuda. These 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, 2018, our estimated off-balance sheet maximum exposure to loss from such entities was $11.2 million. See note 11, “Variable Interest Entity and Noncontrolling Interests,” to our consolidated financial statements in Item 8 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, 2018. 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, 2018 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which were held by us on December 31, 2018 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

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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, 2018 and 2017:

(U.S. dollars in billions)Interest Rate Shift in Basis Points
-100-50-+50+100
Dec. 31, 2018
Total fair value$19.23$18.91$18.62$18.30$17.98
Change from base3.3%1.6%(1.7)%(3.4)%
Change in unrealized value$0.61$0.30$(0.32)$(0.63)
Dec. 31, 2017
Total fair value$19.11$18.85$18.59$18.33$18.09
Change from base2.8%1.4%(1.4)%(2.7)%
Change in unrealized value$0.52$0.26$(0.26)$(0.50)

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 investments 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.

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, 2018 and 2017:

(U.S. dollars in billions)Credit Spread Shift in Percentage
-100-50-+50+100
Dec. 31, 2018
Total fair value$19.08$18.84$18.62$18.39$18.15
Change from base2.5%1.2%(1.2)%(2.5)%
Change in unrealized value$0.47$0.22$(0.22)$(0.47)
Dec. 31, 2017
Total fair value$18.96$18.77$18.59$18.40$18.22
Change from base2.0%1.0%(1.0)%(2.0)%
Change in unrealized value$0.37$0.19$(0.19)$(0.37)

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, 2018, our portfolio’s VaR was estimated to be 3.02%, compared to an estimated 3.10% at December 31, 2017.

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, 2018 and 2017, the fair value of our investments in equity securities, privately held securities and certain other investments totaled $368.8 million and $576.0 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 $36.9 million and $57.6 million at December 31, 2018 and 2017, respectively, and would have decreased book value per share by approximately $0.09 and $0.14, respectively.

Investment-Related Derivatives. At December 31, 2018, 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 $4.95 billion, compared to $2.44 billion at December 31, 2017. If the underlying exposure of each investment-related derivative held at December 31, 2018 depreciated by 100 basis points, it would have resulted in a reduction in net income of approximately $49.5 million, and a decrease in book value per share of $0.12, compared to $24.4 million and $0.06, respectively, on investment-related derivatives held at December 31, 2017. If the underlying exposure of each investment-related derivative held at December 31, 2018 appreciated by 100 basis points, it would have resulted in an increase in net income of approximately $49.5 million, and an increase in book value per share of $0.12, compared to $24.4 million and $0.06, respectively, on investment-related derivatives held at December 31, 2017. See note 10, “Derivative Instruments,” to our consolidated financial statements in Item 8 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

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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 10, “Derivative Instruments,” to our consolidated financial statements in Item 8 for additional information.

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, 2018December 31, 2017
Net assets (liabilities), denominated in foreign currencies, excluding shareholders’ equity and derivatives$(561,311)$401,966
Shareholders’ equity denominated in foreign currencies (1)478,678345,743
Net foreign currency forward contracts outstanding (2)241,442(123,732)
Net exposures denominated in foreign currencies$158,809$623,977
Pre-tax impact of a hypothetical 10% appreciation of the U.S. Dollar against foreign currencies:
Shareholders’ equity$(15,881)$(62,398)
Book value per share$(0.04)$(0.15)
Pre-tax impact of a hypothetical 10% decline of the U.S. Dollar against foreign currencies:
Shareholders’ equity$15,881$62,398
Book value per share$0.04$0.15
(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.

Previous: Item 6. SELECTED FINANCIAL DATA · Next: Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK