Arch Capital Group Ltd. (NASDAQ:ACGL) reports that net income available to Arch common shareholders for the 2015 second quarter was $110.3 million, or $0.88 per share, compared to $202.5 million, or $1.48 per share, for the 2014 second quarter. The Company also reported after-tax operating income available to Arch common shareholders of $146.0 million, or $1.16 per share, for the 2015 second quarter, compared to $160.7 million, or $1.17 per share, for the 2014 second quarter. The Company’s after-tax operating income available to Arch common shareholders represented an annualized return on average common equity of 9.9% for the 2015 second quarter, compared to 11.2% for the 2014 second quarter. For the trailing twelve months ended June 30, 2015, after-tax operating income available to Arch common shareholders produced a 10.0% return on average common equity while net income available to Arch common shareholders produced a 14.0% return on average common equity. The Company’s book value per common share was $47.49 at June 30, 2015, a 0.6% decrease from $47.80 per share at March 31, 2015 and an 8.6% increase from $43.73 per share at June 30, 2014.

After-tax operating income or loss available to Arch common shareholders, a non-GAAP measure, is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. See ‘Comments on Regulation G’ for a further discussion of after-tax operating income or loss available to Arch common shareholders. All earnings per share amounts discussed in this release are on a diluted basis.

The following table summarizes the Company’s underwriting results, excluding amounts related to the ‘other’ segment (i.e., results of Watford Re). Although the Company owns approximately 11% of Watford Re’s common equity, pursuant to generally accepted accounting principles, it consolidates the results of Watford Re in its financial statements. All discussions of line items in this release exclude amounts related to the ‘other’ segment. For segment results reflecting the contribution of the ‘other’ segment, see pages 11 to 14 of the Company’s Financial Supplement dated June 30, 2015.

 
(U.S. dollars in thousands)         Three Months Ended June 30,     Six Months Ended June 30,
2015     2014     % Change 2015     2014     % Change
Gross premiums written $ 1,155,253 $ 1,256,934 (8.1 ) $ 2,466,931 $ 2,552,070 (3.3 )
Net premiums written 823,392 920,126 (10.5 ) 1,765,809 1,952,922 (9.6 )
Net premiums earned 836,249 894,172 (6.5 ) 1,674,247 1,751,786 (4.4 )
Underwriting income 108,343 125,133 (13.4 ) 223,046 258,711 (13.8 )
Underwriting Ratios % Point Change % Point Change
Loss ratio 52.8 % 53.4 % (0.6 ) 52.9 % 52.1 % 0.8
Acquisition expense ratio 17.4 % 17.2 % 0.2 17.2 % 17.9 % (0.7 )
Other operating expense ratio 17.7 % 15.6 % 2.1   17.6 % 15.5 % 2.1  
Combined ratio 87.9 % 86.2 % 1.7   87.7 % 85.5 % 2.2  
 

The following table summarizes, on an after-tax basis, the Company’s consolidated financial data, including a reconciliation of after-tax operating income available to Arch common shareholders to net income available to Arch common shareholders and related diluted per share results:

 
(U.S. dollars in thousands, except share data)         Three Months Ended     Six Months Ended
June 30, June 30,
2015     2014 2015     2014
After-tax operating income available to Arch common shareholders $ 145,956 $ 160,669 $ 295,802 $ 325,073
Net realized gains (losses), net of tax (28,074 ) 50,267 33,860 68,540
Net impairment losses recognized in earnings, net of tax (1,113 ) (14,749 ) (6,912 ) (17,720 )
Equity in net income of investment funds accounted for using the equity method, net of tax 16,113 9,054 21,645 12,218
Net foreign exchange gains (losses), net of tax (22,577 ) (2,710 ) 43,762   (8,564 )
Net income available to Arch common shareholders $ 110,305   $ 202,531   $ 388,157   $ 379,547  
 

Diluted per common share results:

After-tax operating income available to Arch common shareholders $ 1.16 $ 1.17 $ 2.33 $ 2.38
Net realized gains (losses), net of tax (0.22 ) 0.37 0.27 0.50
Net impairment losses recognized in earnings, net of tax (0.01 ) (0.11 ) (0.06 ) (0.13 )
Equity in net income of investment funds accounted for using the equity method, net of tax 0.13 0.07 0.17 0.09
Net foreign exchange gains (losses), net of tax (0.18 ) (0.02 ) 0.34   (0.06 )
Net income available to Arch common shareholders $ 0.88   $ 1.48   $ 3.05   $ 2.78  
 
Weighted average common shares and common share equivalents outstanding - diluted 125,885,420 136,889,944 127,156,713 136,716,889
 

The Company’s investment portfolio continues to be comprised primarily of high quality fixed income securities with an average credit quality of “AA/Aa2.” The average effective duration of the Company’s investment portfolio was 3.05 years at June 30, 2015, compared to 3.34 years at December 31, 2014. Including the effects of foreign exchange, total return on the Company’s investment portfolio was (0.04)% for the 2015 second quarter, compared to 1.80% for the 2014 second quarter. Total return in the 2015 second quarter reflected the impact of the U.S. Dollar weakening against the British Pound Sterling, Euro and other major currencies on non-U.S. Dollar denominated investments and benefited from strong returns on alternatives and non-investment grade fixed income securities. Excluding the effects of foreign exchange, total return was (0.38)% for the 2015 second quarter, compared to 1.63% for the 2014 second quarter.

Net investment income for the 2015 second quarter was $0.53 per share, or $67.2 million, compared to $0.53 per share, or $72.5 million, for the 2014 second quarter, and $0.55 per share, or $70.3 million, for the 2015 first quarter. The lower level of net investment income per share compared to the 2015 first quarter was primarily related to a lower level of income on certain fund investments. The annualized pre-tax investment income yield was 2.05% for the 2015 second quarter, compared to 2.05% for the 2014 second quarter and 2.09% for the 2015 first quarter. Such yields reflect the effects of low prevailing interest rates available in the market and the Company’s investment strategy, which puts an emphasis on total return. Cash flow provided by operating activities was $231.8 million for the 2015 second quarter, compared to $254.2 million for the 2014 second quarter, primarily reflecting a lower level of net premiums collected than in the 2014 second quarter.

On a pre-tax basis, net foreign exchange losses for the 2015 second quarter were $22.6 million, compared to net foreign exchange losses for the 2014 second quarter of $2.8 million. For both periods, such amounts were primarily unrealized and resulted from the effects of revaluing the Company’s net insurance liabilities required to be settled in foreign currencies at each balance sheet date. Changes in the value of available-for-sale investments held in foreign currencies due to foreign currency rate movements are reflected as a direct increase or decrease to shareholders’ equity and are not included in the consolidated statements of income. The Company has not matched a portion of its projected liabilities in foreign currencies with investments in the same currencies and may not match such amounts in future periods, which could increase the Company’s exposure to foreign currency fluctuations and increase the volatility of the Company’s shareholders’ equity.

Interest expense of $4.0 million for the 2015 second quarter included $12.4 million related to the Company’s senior notes and other borrowings, partially offset by an $8.4 million reduction in interest expense on a deposit accounting liability (i.e., a contract that, in accordance with GAAP, does not pass risk transfer). The reduction in the 2015 second quarter resulted from a reassessment of this estimated ultimate liability due to a determination that paid losses are expected to be lower than previously anticipated.

The Company’s effective tax rate on income before income taxes (based on the Company’s estimated annual effective tax rate) was 5.5% for the 2015 second quarter, compared to 3.4% for the 2014 second quarter. The Company’s effective tax rate on pre-tax operating income available to Arch shareholders was 3.9% for the 2015 second quarter, compared to 3.6% for the 2014 second quarter. The Company’s effective tax rate fluctuates from year to year based upon the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction. The Company’s quarterly tax provision is adjusted to reflect changes in its estimated annual effective tax rate, if any.

During the 2015 second quarter, the Company repurchased 3.2 million common shares for an aggregate purchase price of $199.0 million under its share repurchase program. Since the inception of the share repurchase program through June 30, 2015, ACGL has repurchased 124.0 million common shares for an aggregate purchase price of $3.60 billion. At June 30, 2015, $525.3 million of repurchases were available under the share repurchase program.

At June 30, 2015, total capital available to Arch of $7.03 billion consisted of $791.2 million of senior notes, representing 11.3% of the total, $100.0 million of revolving credit agreement borrowings, representing 1.4% of the total, $325.0 million of preferred shares, representing 4.6% of the total, and common shareholders’ equity of $5.81 billion, representing 82.7% of the total. At March 31, 2015, total capital available to Arch of $7.18 billion consisted of $791.2 million of senior notes, representing 11.0% of the total, $100.0 million of revolving credit agreement borrowings, representing 1.4% of the total, $325.0 million of preferred shares, representing 4.5% of the total, and common shareholders’ equity of $5.96 billion, representing 83.1% of the total.

The Company will hold a conference call for investors and analysts at 11:00 a.m. Eastern Time on July 30, 2015. A live webcast of this call will be available via the Investors section of the Company’s website at http://www.archcapgroup.com. A telephone replay of the conference call also will be available beginning on July 30, 2015 at 3:00 p.m. Eastern Time until August 6, 2015 at midnight Eastern Time. To access the replay, domestic callers should dial 888-286-8010 (passcode 92454111), and international callers should dial 617-801-6888 (passcode 92454111).

Please refer to the Company’s Financial Supplement dated June 30, 2015, which is available via the Investors section of the Company’s website at http://www.archcapgroup.com. The Financial Supplement provides additional detail regarding the financial performance of the Company. From time to time, the Company posts additional financial information and presentations to its website, including information with respect to its subsidiaries. Investors and other recipients of this information are encouraged to check the Company’s website regularly for additional information regarding the Company.

Arch Capital Group Ltd., a Bermuda-based company with approximately $7.03 billion in capital at June 30, 2015, provides insurance and reinsurance on a worldwide basis through its wholly owned subsidiaries.

 
Supplemental Information
 

Book Value Per Common Share

 

(U.S. dollars in thousands, except share data)        

June 30,

2015

      

December 31,

2014

Calculation of book value per common share:
Total shareholders’ equity available to Arch $ 6,137,515 $ 6,130,053
Less preferred shareholders’ equity 325,000   325,000
Common shareholders’ equity available to Arch 5,812,515 5,805,053
Common shares outstanding, net of treasury shares (1) 122,403,909   127,367,934
Book value per common share $ 47.49   $ 45.58
 
(1)   Excludes the effects of 7,913,680 and 7,804,033 stock options and 438,155 and 447,073 restricted stock units outstanding at June 30, 2015 and December 31, 2014, respectively.
 
 

Investment Information

 
(U.S. dollars in thousands, except share data)         Three Months Ended       Six Months Ended
June 30, June 30,
2015       2014 2015       2014
Components of net investment income (1):
Fixed maturities $ 61,191 $ 64,499 $ 123,559 $ 126,948
Term loan investments (2) 4,566 5,233 8,841 10,902
Equity securities (dividends) 2,742 3,271 5,421 6,192
Short-term investments 183 103 378 508
Other (3) 10,472   9,067   23,209   13,785  
Gross investment income 79,154 82,173 161,408 158,335
Investment expenses (11,983 ) (9,715 ) (23,949 ) (18,884 )
Net investment income $ 67,171   $ 72,458   $ 137,459   $ 139,451  
Per share $ 0.53 $ 0.53 $ 1.08 $ 1.02
 
Investment income yield, at amortized cost (1) (4):
Pre-tax 2.05 % 2.05 % 2.07 % 2.07 %
After-tax 1.90 % 1.91 % 1.92 % 1.93 %
Total return (1) (5):
Including effects of foreign exchange (0.04 )% 1.80 % 1.07 % 2.84 %
Excluding effects of foreign exchange (0.38 )% 1.63 % 1.68 % 2.67 %
 
Cash flow from operations (1) $ 231,762 $ 254,168 $ 247,361 $ 451,563
 
(1)   Excludes amounts related to the ‘other’ segment.
(2) Included in “investments accounted for using the fair value option” on the Company’s balance sheet.
(3) Includes income on other investments, funds held balances, cash balances and other.
(4) Presented on an annualized basis and excluding the impact of investments for which returns are not included within investment income, such as investments accounted for using the equity method and certain equities.
(5) Includes net investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains or losses generated by the Company’s investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses.
 
 

Investment Information (continued)

 
(U.S. dollars in thousands)         June 30, 2015     December 31, 2014
Amount     % of Total Amount     % of Total
 
Investable assets (1) (2):
Fixed maturities available for sale, at fair value $ 9,927,603 68.4 $ 10,750,770 73.6
Fixed maturities, at fair value (3) 387,941 2.7 377,053 2.6
Fixed maturities pledged under securities lending agreements, at fair value 373,969   2.6   50,802   0.3  
Total fixed maturities 10,689,513 73.7 11,178,625 76.6
Short-term investments available for sale, at fair value 875,727 6.0 797,226 5.5
Cash 470,011 3.2 474,247 3.2
Equity securities available for sale, at fair value 701,623 4.8 658,182 4.5
Equity securities, at fair value (3) 248 — — —
Other investments available for sale, at fair value 377,677 2.6 296,224 2.0
Other investments, at fair value (3) 899,763 6.2 878,774 6.0
Investments accounted for using the equity method (4) 472,926 3.3 349,014 2.4
Securities transactions entered into but not settled at the balance sheet date 26,066   0.2   (32,802 ) (0.2 )
Total investable assets managed by the Company $ 14,513,554   100.0   $ 14,599,490   100.0  
 
Investment portfolio statistics (1):
Average effective duration (in years) 3.05 3.34
Average credit quality (Standard & Poor’s/Moody’s Investors Service) AA/Aa2 AA/Aa2
Embedded book yield (before investment expenses) 2.07 % 2.18 %
 
(1)     Excludes amounts related to the ‘other’ segment.
(2) This table excludes the collateral received and reinvested and includes the fixed maturities and short-term investments pledged under securities lending agreements, at fair value.
(3) Represents investments which are carried at fair value under the fair value option and reflected as “investments accounted for using the fair value option” on the Company’s balance sheet. Changes in the carrying value of such investments are recorded in net realized gains or losses.
(4) Changes in the carrying value of investment funds accounted for using the equity method are recorded as “equity in net income (loss) of investment funds accounted for using the equity method” rather than as an unrealized gain or loss component of accumulated other comprehensive income.
 
 

Selected Information on Losses and Loss Adjustment Expenses (1)

 
(U.S. dollars in thousands)         Three Months Ended     Six Months Ended
June 30, June 30,
2015     2014 2015     2014
Components of losses and loss adjustment expenses incurred
Paid losses and loss adjustment expenses $ 465,053 $ 435,370 $ 897,687 $ 861,284
Change in unpaid losses and loss adjustment expenses (23,305 ) 41,954   (11,702 ) 50,924  
Total losses and loss adjustment expenses $ 441,748   $ 477,324   $ 885,985   $ 912,208  
 

Estimated net (favorable) adverse development in prior

year loss reserves, net of related adjustments

Net impact on underwriting results:
Insurance $ (17,167 ) $ (16,137 ) $ (22,122 ) $ (26,554 )
Reinsurance (58,802 ) (67,700 ) (116,081 ) (137,802 )
Mortgage (1,108 ) 58   (3,920 ) (1,112 )
Total $ (77,077 ) $ (83,779 ) $ (142,123 ) $ (165,468 )
Impact on losses and loss adjustment expenses:
Insurance $ (18,595 ) $ (19,388 ) $ (27,349 ) $ (34,960 )
Reinsurance (57,798 ) (69,115 ) (115,809 ) (139,514 )
Mortgage (1,125 ) 88   (3,740 ) (1,046 )
Total $ (77,518 ) $ (88,415 ) $ (146,898 ) (175,520 )
Impact on acquisition expenses:
Insurance $ 1,428 $ 3,251 $ 5,227 $ 8,406
Reinsurance (1,004 ) 1,415 (272 ) 1,712
Mortgage 17   (30 ) (180 ) (66 )
Total $ 441   $ 4,636   $ 4,775   $ 10,052  
Impact on combined ratio:
Insurance (3.4 )% (3.2 )% (2.2 )% (2.7 )%
Reinsurance (21.5 )% (20.2 )% (21.0 )% (20.4 )%
Mortgage (2.1 )% 0.1 % (3.8 )% (1.2 )%
Total (9.2 )% (9.4 )% (8.5 )% (9.4 )%
Impact on loss ratio:
Insurance (3.6 )% (3.8 )% (2.7 )% (3.5 )%
Reinsurance (21.1 )% (20.6 )% (20.9 )% (20.6 )%
Mortgage (2.1 )% 0.2 % (3.6 )% (1.2 )%
Total (9.3 )% (9.9 )% (8.8 )% (10.0 )%
Impact on acquisition expense ratio:
Insurance 0.2 % 0.6 % 0.5 % 0.8 %
Reinsurance (0.4 )% 0.4 % (0.1 )% 0.2 %
Mortgage — % (0.1 )% (0.2 )% — %
Total 0.1 % 0.5 % 0.3 % 0.6 %
 

Estimated net losses incurred from current accident year

catastrophic events (2)

Insurance $ 6,019 $ 3,739 $ 9,200 $ 6,353
Reinsurance 9,842   12,748   11,272   15,682  
Total $ 15,861   $ 16,487   $ 20,472   $ 22,035  
Impact on combined ratio:
Insurance 1.2 % 0.7 % 0.9 % 0.6 %
Reinsurance 3.6 % 3.8 % 2.0 % 2.3 %
Total 1.9 % 1.8 % 1.2 % 1.3 %
 
(1)   Excludes amounts related to the ‘other’ segment.
(2) Equals estimated losses from catastrophic events occurring in the current accident year, net of reinsurance and reinstatement premiums. Amounts shown for the insurance segment are for named catastrophic events only. Amounts shown for the reinsurance segment include (i) named events with over $5 million of losses incurred by its Bermuda and Europe operations and (ii) all catastrophe losses incurred by its U.S. operations. Amounts not applicable for the mortgage segment.
 

Segment Information

The following section provides analysis on the Company’s 2015 second quarter performance by operating segment. For additional details regarding the Company’s operating segments, please refer to the Company’s Financial Supplement dated June 30, 2015. The Company’s segment information includes the use of a combined ratio excluding catastrophic activity and prior year development for the insurance segment and reinsurance segment and a combined ratio excluding prior year development for the mortgage segment. These ratios are “non-GAAP financial measures” as defined in Regulation G. See ‘Comments on Regulation G’ for further details.

Insurance Segment

        Three Months Ended June 30,
(U.S. dollars in thousands) 2015     2014     % Change
 
Gross premiums written $ 744,810 $ 852,231 (12.6 )
Net premiums written 509,067 578,882 (12.1 )
Net premiums earned 509,825 507,712 0.4
Underwriting income 23,643 34,422 (31.3 )
 
Underwriting Ratios % Point Change
Loss ratio 62.9 % 61.4 % 1.5
Acquisition expense ratio 15.0 % 15.1 % (0.1 )
Other operating expense ratio 17.5 % 16.9 % 0.6  
Combined ratio 95.4 % 93.4 % 2.0  
 
Catastrophic activity and prior year development:
Current accident year catastrophic events, net of
reinsurance and reinstatement premiums 1.2 % 0.7 % 0.5
Net (favorable) adverse development in prior year loss
reserves, net of related adjustments (3.4 )% (3.2 )% (0.2 )
Combined ratio excluding catastrophic activity and prior year development 97.6 % 95.9 % 1.7  
 

Gross premiums written by the insurance segment in the 2015 second quarter were 12.6% lower than in the 2014 second quarter while net premiums written were 12.1% lower than in the 2014 second quarter. Changes in foreign currency rates resulted in a decrease in net premiums written in the 2015 second quarter of approximately $8 million, or 1.4%, compared to the 2014 second quarter. The lower level of net premiums written reflected reductions in property, energy and marine business, programs, professional lines and alternative markets business. The decrease in property, energy and marine business reflected rate decreases and strategic reductions in certain lines, while the reduction in program business reflected underwriting decisions to terminate two programs. The decline in professional lines was primarily related to the timing of premiums on renewal accounts while the decrease in alternative markets primarily reflected changes in renewal dates on business acquired as part of the renewal rights agreement entered into in the 2014 second quarter. Net premiums earned by the insurance segment in the 2015 second quarter were 0.4% higher than in the 2014 second quarter, and reflect changes in net premiums written over the previous five quarters.

The 2015 second quarter loss ratio reflected 1.2 points of current year catastrophic activity, compared to 0.7 points in the 2014 second quarter. Estimated net favorable development in prior year loss reserves, before related adjustments, reduced the loss ratio by 3.6 points in the 2015 second quarter, compared to 3.8 points in the 2014 second quarter. The estimated net favorable development in the 2015 second quarter primarily resulted from better than expected claims emergence in short-tail business from more recent accident years. The balance of the increase in the 2015 second quarter loss ratio primarily resulted from a higher level of non-catastrophic large loss activity.

The underwriting expense ratio was 32.5% in the 2015 second quarter, compared to 32.0% in the 2014 second quarter. The acquisition expense ratio was 15.0% in the 2015 second quarter, compared to 15.1% in the 2014 second quarter. The operating expense ratio was 17.5% in the 2015 second quarter, compared to 16.9% in the 2014 second quarter, and consistent with the 2015 first quarter ratio.

 

Reinsurance Segment

        Three Months Ended June 30,
(U.S. dollars in thousands) 2015     2014     % Change
 
Gross premiums written $ 342,101 $ 349,841 (2.2 )
Net premiums written 252,655 290,847 (13.1 )
Net premiums earned 273,965 335,627 (18.4 )
Other underwriting income 2,658 303 777.2
Underwriting income 68,073 81,904 (16.9 )
 
Underwriting Ratios % Point Change
Loss ratio 40.6 % 44.8 % (4.2 )
Acquisition expense ratio 21.3 % 19.7 % 1.6
Other operating expense ratio 14.2 % 11.2 % 3.0  
Combined ratio 76.1 % 75.7 % 0.4  
 
Catastrophic activity and prior year development:
Current accident year catastrophic events, net of
reinsurance and reinstatement premiums 3.6 % 3.8 % (0.2 )
Net (favorable) adverse development in prior year loss
reserves, net of related adjustments (21.5 )% (20.2 )% (1.3 )
Combined ratio excluding catastrophic activity and prior year development 94.0 % 92.1 % 1.9  
 

Gross premiums written by the reinsurance segment in the 2015 second quarter were 2.2% lower than in the 2014 second quarter, while net premiums written were 13.1% lower than in the 2014 second quarter. The difference in gross versus net premiums written primarily reflects an increase in cessions to Watford Re in the 2015 second quarter compared to the 2014 second quarter, primarily in casualty lines. Changes in foreign currency rates resulted in a decrease in net premiums written in the 2015 second quarter of approximately $14 million, or 4.8%, compared to the 2014 second quarter. The lower level of net premiums written reflected decreases in other specialty and property catastrophe business. The decrease in other specialty reflected non-renewals and share decreases in response to current market conditions, primarily in proportional motor contracts. The lower level of property catastrophe business reflected non-renewals and share decreases, also in response to current market conditions. Net premiums earned in the 2015 second quarter were 18.4% lower than in the 2014 second quarter, and primarily reflect changes in net premiums written over the previous five quarters, including the mix and type of business written.

The 2015 second quarter loss ratio reflected 3.7 points of current year catastrophic activity, compared to 4.1 points of catastrophic activity in the 2014 second quarter. Estimated net favorable development in prior year loss reserves, before related adjustments, reduced the loss ratio by 21.1 points in the 2015 second quarter, compared to 20.6 points in the 2014 second quarter. The estimated net favorable development in the 2015 second quarter primarily resulted from better than expected claims emergence in short-tail business from more recent underwriting years and in longer-tail business across earlier underwriting years. The balance of the decrease in the 2015 second quarter loss ratio primarily resulted from a lower level of non-catastrophic large loss activity, partially offset by the effects of a lower level of property catastrophe business than in the 2014 second quarter.

The underwriting expense ratio was 35.5% in the 2015 second quarter, compared to 30.9% in the 2014 second quarter. The acquisition expense ratio for the 2015 second quarter was 21.3%, compared to 19.7% for the 2014 second quarter. The comparison of the acquisition expense ratios in each period is influenced by, among other things, the mix and type of business written and earned, including a lower contribution from property catastrophe business than in the 2014 second quarter, and an increase in the level of ceding commissions. The operating expense ratio for the 2015 second quarter was 14.2%, compared to 11.2% in the 2014 second quarter, primarily reflecting the lower level of net premiums earned.

Mortgage Segment

        Three Months Ended June 30,
(U.S. dollars in thousands) 2015     2014     % Change
 
Gross premiums written $ 68,572 $ 55,476 23.6
Net premiums written 61,670 50,397 22.4
Net premiums earned 52,459 50,833 3.2
Other underwriting income 3,686 1,216 203.1
Underwriting income 16,627 8,807 88.8
 
Underwriting Ratios % Point Change
Loss ratio 18.4 % 30.4 % (12.0 )
Acquisition expense ratio 19.4 % 22.6 % (3.2 )
Other operating expense ratio 37.5 % 32.0 % 5.5  
Combined ratio 75.3 % 85.0 % (9.7 )
 
Net (favorable) adverse development in prior year loss
reserves, net of related adjustments (2.1 )% 0.1 % (2.2 )
Combined ratio excluding prior year development 77.4 % 84.9 % (7.5 )
 

The mortgage segment includes the results of Arch Mortgage Insurance Company (“Arch MI U.S.”), a leading provider of mortgage insurance products and services to the U.S. marketplace, along with the Company’s other global mortgage insurance, reinsurance and risk-sharing products.

Gross premiums written by the mortgage segment in the 2015 second quarter were 23.6% higher than in the 2014 second quarter, while net premiums written were 22.4% higher than in the 2014 second quarter. Net premiums written in the 2015 second quarter included $30.6 million of business underwritten by Arch MI U.S., compared to $24.6 million in the 2014 second quarter. The 2015 second quarter amount reflected $23.8 million from credit union clients and $6.8 million from banks and other mortgage originators while substantially all of the 2014 second quarter amount related to credit union clients. Premiums written on reinsurance treaties covering U.S. and international mortgages were higher by $5.3 million compared to the 2014 second quarter.

Net premiums earned for the 2015 second quarter were 3.2% higher than in the 2014 second quarter, reflecting the contribution of Arch MI U.S. business and higher earnings from the mortgage segment’s quota share reinsurance business. Other underwriting income, which is primarily related to risk-sharing products issued to GSEs and mortgage lenders, was $3.7 million for the 2015 second quarter, compared to $1.2 million for the 2014 second quarter, and in line with the $7.7 million in the 2015 first quarter when taking into consideration approximately $3.5 million of non-recurring income in the period.

The loss ratio for the 2015 second quarter continues to reflect relatively low levels of reported delinquencies and reflects new business generated by the mortgage segment. As noted previously, the mortgage segment’s underwriting expense ratio is expected to stay at an elevated level until Arch MI U.S. reaches scale. At June 30, 2015, the mortgage segment’s risk-in-force consisted of $6.05 billion from Arch MI U.S. and an additional $4.61 billion through the mortgage segment’s reinsurance and risk-sharing operations. Arch MI U.S. generated $2.71 billion of new insurance written (“NIW”) during the 2015 second quarter, of which approximately 50% was from bank channel clients. For additional information on the mortgage segment, please refer to the Company’s Financial Supplement.

Cautionary Note Regarding Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. This release or any other written or oral statements made by or on behalf of the Company may include forward-looking statements, which reflect the Company’s current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this release are forward-looking statements. Forward-looking statements, for purposes of the PSLRA or otherwise, can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe” or “continue” and similar statements of a future or forward-looking nature or their negative or variations or similar terminology.

Forward-looking statements involve the Company’s current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this release and in the Company’s periodic reports filed with the Securities and Exchange Commission (the “SEC”), and include:

  • the Company’s ability to successfully implement its business strategy during “soft” as well as “hard” markets;
  • acceptance of the Company’s business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and its insureds and reinsureds;
  • the Company’s ability to maintain or improve its ratings, which may be affected by its ability to raise additional equity or debt financings, by ratings agencies’ existing or new policies and practices, as well as other factors described herein;
  • general economic and market conditions (including inflation, interest rates, foreign currency exchange rates, prevailing credit terms and the depth and duration of a recession) and conditions specific to the reinsurance and insurance markets (including the length and magnitude of the current “soft” market) in which the Company operates;
  • competition, including increased competition, on the basis of pricing, capacity, coverage terms or other factors;
  • developments in the world’s financial and capital markets and the Company’s access to such markets;
  • the Company’s ability to successfully enhance, integrate and maintain operating procedures (including information technology) to effectively support its current and new business;
  • the loss of key personnel;
  • the integration of businesses the Company has acquired or may acquire into its existing operations;
  • accuracy of those estimates and judgments utilized in the preparation of the Company’s financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation, and any determination to use the deposit method of accounting, which for a relatively new insurance and reinsurance company, like the Company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to the Company through June 30, 2015;
  • greater than expected loss ratios on business written by the Company and adverse development on claim and/or claim expense liabilities related to business written by its insurance and reinsurance subsidiaries;
  • severity and/or frequency of losses;
  • claims for natural or man-made catastrophic events in the Company’s insurance or reinsurance business could cause large losses and substantial volatility in its results of operations;
  • acts of terrorism, political unrest and other hostilities or other unforecasted and unpredictable events;
  • availability to the Company of reinsurance to manage its gross and net exposures and the cost of such reinsurance;
  • the failure of reinsurers, managing general agents, third party administrators or others to meet their obligations to the Company;
  • the timing of loss payments being faster or the receipt of reinsurance recoverables being slower than anticipated by the Company;
  • the Company’s investment performance, including legislative or regulatory developments that may adversely affect the fair value of the Company’s investments;
  • the impact of the continued weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies, and the resulting effect on the value of securities in the Company’s investment portfolio as well as the uncertainty in the market generally;
  • losses relating to aviation business and business produced by a certain managing underwriting agency for which the Company may be liable to the purchaser of its prior reinsurance business or to others in connection with the May 5, 2000 asset sale described in the Company’s periodic reports filed with the SEC;
  • changes in accounting principles or policies or in the Company’s application of such accounting principles or policies;
  • changes in the political environment of certain countries in which the Company operates, underwrites business or invests;
  • statutory or regulatory developments, including as to tax policy matters and insurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers and/or changes in regulations or tax laws applicable to the Company, its subsidiaries, brokers or customers; and
  • the other matters set forth under Item 1A “Risk Factors”, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of the Company’s Annual Report on Form 10-K, as well as the other factors set forth in the Company’s other documents on file with the SEC, and management’s response to any of the aforementioned factors.

All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

Comments on Regulation G

Throughout this release, the Company presents its operations in the way it believes will be the most meaningful and useful to investors, analysts, rating agencies and others who use the Company’s financial information in evaluating the performance of the Company. This presentation includes the use of after-tax operating income or loss available to Arch common shareholders, which is defined as net income available to Arch common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. The presentation of after-tax operating income or loss available to Arch common shareholders is a “non-GAAP financial measure” as defined in Regulation G. The reconciliation of such measure to net income available to Arch common shareholders (the most directly comparable GAAP financial measure) in accordance with Regulation G is included on page 2 of this release.

The Company believes that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses in any particular period are not indicative of the performance of, or trends in, the Company’s business performance. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of the Company’s operations, the decision to realize investment gains or losses, the recognition of the change in the carrying value of investments accounted for using the fair value option in net realized gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of the Company’s 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 the Company’s investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of the Company’s 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 the Company’s proportionate share of the net income or loss of the funds (which include changes in the fair value of the underlying securities in the funds). This method of accounting is different from the way the Company accounts for its other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. Due to these reasons, the Company excludes net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses from the calculation of after-tax operating income or loss available to Arch common shareholders.

The Company believes that showing net income available to Arch common shareholders exclusive of the items referred to above reflects the underlying fundamentals of the Company’s business since the Company evaluates the performance of and manages its business to produce an underwriting profit. In addition to presenting net income available to Arch common shareholders, the Company believes that this presentation enables investors and other users of the Company’s financial information to analyze the Company’s performance in a manner similar to how the Company’s management analyzes performance. The Company also believes that this measure follows industry practice and, therefore, allows the users of the Company’s financial information to compare the Company’s performance with its industry peer group. The Company believes that the equity analysts and certain rating agencies which follow the Company and the insurance industry as a whole generally exclude these items from their analyses for the same reasons.

In addition, the Company’s segment information includes the use of a combined ratio excluding catastrophic activity and prior year development for the insurance segment and reinsurance segment and a combined ratio excluding prior year development for the mortgage segment. These ratios are “non-GAAP financial measures” as defined in Regulation G. The reconciliation of such measures to the combined ratio (the most directly comparable GAAP financial measure) in accordance with Regulation G are shown on the individual segment pages. The Company’s management utilizes the adjusted combined ratio excluding current accident year catastrophic events and favorable or adverse development in prior year loss reserves in its analysis of the core underwriting performance of each of its underwriting segments.